Fasken Martineau DuMoulin LLP Barristers and Solicitors Patent and Trade-mark Agents Toronto

September 30, 2003

A Review of Directors Duties and Deal Protection Techniques in Take-Over Bids and Business Combinations

H. Garfield Emerson, Q.C. William A. Chinkiwsky Fasken Martineau DuMoulin LLP 66 Wellington Street West Suite 4200, Toronto Dominion Bank Tower Box 20, Toronto-Dominion Centre Toronto, Ontario, Canada M5K 1N6

TABLE OF CONTENTS Page

1. 2.

INTRODUCTION............................................................................................................1 FIDUCIARY OBLIGATIONS OF BOARDS OF DIRECTORS IN A CHANGE OF CONTROL SITUATION .......................................................................3 (a) (b) (c) Duties of Directors when the Company is in-play..............................................3 (i) WIC Western International Communications Ltd .....................................4 (ii) Maple Leaf Foods and Schneider Corporation ........................................11 The Business Judgment Rule ...............................................................................17 The Onus of Proof ................................................................................................22

3.

DEAL PROTECTION TECHNIQUES .......................................................................23 (a) (b) (c) Break Fees ............................................................................................................23 Options on Assets and Options on Treasury Shares ............................................28 Shareholder Lock-ups ..........................................................................................31

4. 5.

FIDUCIARY-OUTS AND THE OMNICARE DECISION ...................................32 SUMMARY OF CERTAIN BREAK FEES ................................................................37 (a) (b) Clarica/Sunlife Transaction..................................................................................38 GreatWest Lifeco/Canada Life Transaction.........................................................40

-i-

1.

INTRODUCTION There are various techniques that prospective purchasers and target companies

may employ in the context of a proposed merger or acquisition which can be designed to induce a purchaser to make an offer for the target company and/or to mitigate the purchasers risks in entering into a proposed merger or acquisition. The possible deal protection techniques

employed will depend on several factors, such as whether the proposed transaction will proceed by way of a merger or an acquisition of shares of the target company; whether the directors of the acquisition candidate view the proposed acquisition as a response to an unsolicited hostile bid or a strategic transaction with a chosen partner; whether there are other likely bidders for the target company; and whether the acquisition candidate has a controlling shareholder group and, if so, its disposition toward the proposed acquisition, to mention only a few. In the pre-acquisition phase the primary objective for the bidder in negotiating with the target company is generally to obtain the support of the board of directors, and/or of any significant shareholders, for the proposed merger or acquisition. In the most typical situations where a pre-acquisition support agreement is entered into, in consideration for the bidder agreeing to make its offer to purchase the shares of the target company or agreeing to enter into a business combination transaction with the target company, the board of the target company will agree to recommend to its shareholders that they accept the bidders offer, either by way of tendering into a take-over bid, or by voting in favour of the proposed merger. At the outset of negotiations, it is also common for prospective bidders and target companies to enter into confidentiality and standstill agreements, whereby the target company furnishes the prospective purchaser with non-public confidential information concerning itself

-2and the purchaser agrees to keep that information confidential and not to acquire any securities of the target, or to make any offers or announcements regarding an acquisition of the target companys securities or assets, for a specified period of time without the prior authorization of the target companys board of directors.1 As part of a support agreement, the prospective buyer and target company may also negotiate no shop and no talk provisions whereby the target company agrees not to solicit competing offers or to provide information to potential third party offerors which could lead to a competing offer. Where the target company is already subject to a potential change of control transaction, the target company may also agree to cease any existing discussions with others, not to release third parties from any confidentiality agreements (including standstill covenants) that the target and a third party may have entered into, unless such third party makes an unsolicited superior proposal, and immediately to request any such third party to return or destroy all information provided to it. To provide further protection to the bidder, the target company may also agree to grant a break-fee or an option on certain corporate assets or treasury shares which become payable or exercisable in the event that the target company breaches the support agreement or a competing offer emerges which is successful. If there are any significant shareholders of the target company, the bidder may also attempt to lock-up those shares by obtaining the agreement of those shareholders to tender, sell or vote their shares in support of the transaction. Although not the subject of this paper, another type of protective provision which commonly appears in support agreements, as well as merger or acquisition agreements

The efficacy of confidentiality and standstill agreements is reflected in the facts of the case of Rogers Communications Inc. v. Maclean Hunter Ltd., [1994] O.J. No. 408; 2 C.C.L.S. 233 (Ont. Gen. Div.).

-3themselves, is the material adverse change clause. Also known as material adverse effect clauses, these are also protective techniques employed by purchasers, not to ensure the success of the transaction, but to allow them to avoid the transaction in the event of a change or occurrence which has, or could have, a material adverse change on the value of the target company. A key consideration for the board of directors of any target company in approving a support agreement, will be the extent to which their fiduciary duties, including their duty to maximize shareholder value, place limits on their ability to approve deal protection provisions. Provisions commonly know as fiduciary-out clauses typically allow the board of directors of the target company to approve an unsolicited alternative offer where the directors determine that the competing proposal will be on such superior terms that the directors have a fiduciary duty to pursue it. In the event that the target company receives any such superior offer, the bidder may also have a right to match it by amending its offer to provide terms that are as favourable as, or superior to, the terms of the unsolicited superior proposal. This paper briefly examines the duties of directors where a company finds itself in a change of control situation and the structure and judicial treatment of some common dealprotection techniques. 2. (a) FIDUCIARY OBLIGATIONS OF BOARDS OF DIRECTORS IN A CHANGE OF CONTROL SITUATION Duties of Directors when the Company is in-play The rules regarding the general duties of directors are well know and are set out in subsection 122(1) of the Canada Business Corporations Act (the CBCA) and subsection 134(1) of the Business Corporations Act (Ontario). Directors must act honestly, in good faith, and with a view to the best interests of the corporation. Further, directors must exercise the care,

-4diligence and skill that a reasonable person would exercise in like circumstances. However, in the context of change of control situation, the specific duties of directors become more complex. In the context of hostile take-over bids in particular, two leading Ontario cases, CW Shareholdings v. WIC Western International Communications Ltd.2 and Pente Investment Management Ltd. v. Schneider Corp.3 have articulated the general principles defining the duties of directors in situations where the corporation is in play. (i) WIC Western International Communications Ltd.

The triggering events of the WIC case began on March 24, 1998 when CanWest Global Communications Corp. (CanWest) made an offer to acquire all of the Class A voting shares (which were held as to approximately 49.96% by Shaw Communications Inc. (Shaw) and as to 50% by Cathton Holdings), and all of the publicly traded Class B non-voting shares of WIC Western International Communications Ltd. (WIC) at a price of $39 per share. In response, the WIC board struck a special committee, which included WICs CEO4, to consider CanWests offer. The WIC board subsequently recommended in its directors circular that its shareholders not accept the CanWest offer and immediately adopted, without shareholder approval, a limited duration or tactical shareholders rights plan, which was shortly thereafter cease traded by the Ontario, Alberta and British Columbia Securities Commissions (the Commissions) on application made by CanWest.5

CW Shareholdings v. WIC Western International Communications Ltd. (1998), 39 O.R. (3d) 755; 1998 Ont. Rep. LEXIS 389 3 Maple Leaf Foods Inc. v. Schneider Corp., (1998), 42 O.R. (3d) 177, 83 A.C.W.S. (3d) 51 (Ont. C.A.); dismissing appeal from (1998), 40 B.L.R. (2d) 244, 79 A.C.W.S.(3d) 930 (Gen.Div.) 4 In addition to the problems of non-independence arising from the participation of the WIC CEO as a member of the special committee of the board formed to review the bid, another director, who represented Cathton Holdings, the largest holder of WIC Class A shares, was initially authorized to attend meetings of the special committee but without voting rights. The OSC considered that the special committee was not an independent committee and set up for convenience only: (1998), 21 O.S.C.B. 2899 at 2908. 5 Re CW Shareholdings Inc. and WIC Western International Communications Ltd. (1998), 21 O.S.C.B. 2899. At the Commission hearings on the shareholder rights plan, Shaw advised the OSC that it also did not support the plan.

-5After the decision to cease trade the rights plan was released on April 9, 1998, WIC began negotiations with Shaw, who owned about 14% of the Class B non-voting shares in addition to 49.96% of the Class A voting shares. The negotiations resulted in Shaw agreeing to make a cash and share offer valued at $43.50 per share for all of the outstanding Class B nonvoting shares. As an inducement to make this competing and financially superior bid, on April 17, 1998, WIC and Shaw entered into a pre-acquisition agreement whereby Shaw was entitled, inter alia, to a break fee of $30 million6 in certain events and was also granted an irrevocable option to purchase WICs radio assets at a fixed price of $160 million for a limited period following an event that triggered the payment of the break fee.7 In order to keep the asset option in context, in the Court application to set aside the pre-acquisition agreement, the Court noted that the WIC radio assets represented something less than 15% of WICs total revenues and 12.8% of its total assets. The radio assets were acknowledged to have been underperforming and in 1997 they were responsible for only 0.6% of WICs total income.8 The pre-acquisition agreement with Shaw prohibited WIC from soliciting or encouraging any other acquisition proposals, but provided a fiduciary-out clause that permitted WIC to negotiate, approve and recommend an unsolicited bona fide acquisition proposal, which, the board of directors of WIC determines in good faith (after consultation with its financial advisor, and after receiving a written opinion of outside counsel, or advice of outside counsel that is reflected in the minutes of the board of directors of WIC, to the effect that the board of directors is required to do so to discharge properly its fiduciary duties) would, if consummated in

As a percentage of the value of the Shaw bid, and without adding the value of the option on the radio assets, the $30 million break fee was approximately 3% of the $975 million offer. 7 Unlike in most take-over situations, the Pre-Acquisition Agreement dated April 17, 1998 between Shaw and WIC was annexed in full to Shaws publicly filed material change report dated April 20, 1998. 8 Supra, note 2 at 788.

-6accordance with its terms, result in a transaction more favourable to the [WIC] Shareholders than the [Shaw Bid]. On April 20, 1998, CanWest applied to the Commissions for, inter alia, a cease trade order with respect to the Shaw bid and, in particular the tendering to or the taking up and payment for any Class B non-voting shares of WIC pursuant to the Shaw bid, pending the removal of the break fee and asset option. CanWest also applied to the court in Ontario for an order under section 241 of the CBCA to set aside the pre-acquisition agreement, which was adjourned by the court to allow the Commissions to deal with the proceedings before them. The Ontario Securities Commission (the OSC or the Commission) stayed the proceedings before it for a cease trade order, holding that it would not be in the public interest to cease trade the Shaw bid thereby leaving a lower bid by CanWest as the only bid, with no third party bids likely to come forward.9 The Commission also held that the relief requested by CanWest in its application for cease trade orders and that requested in its concurrent application to the Court to set aside the pre-acquisition agreement were essentially the same and were both based on an attack against the pre-acquisition agreement and the question of whether the WIC board had properly performed its fiduciary duties in entering into that agreement. As the OSC agreed that there was no jurisdiction for the Commission to set aside the pre-acquisition agreement and as the OSC did not view the break-up fee or asset option as improper defensive tactics, it was held that the Court should deal with the matter. The views expressed by the OSC on break fees and asset options are referred to later under Deal Protection Techniques.

Re CW Shareholdings Inc., Shaw Communications Inc., Shaw Acquisition Inc. and WIC Western Communications Ltd. (1998), 21 O.S.C.B. 2910 at 2920.

-7In its reasons given in the prior proceeding relating to its decision to cease trade the tactical shareholders rights plan adopted by the WIC board shortly after the date of the CanWest bid, the Commission considered the scope of the duty of directors in the context of a hostile take-over bid situation. Referring to National Policy 62-202, the OSC stated that the role of board is limited to advising shareholders and attempting to provide them with alternatives and that the board is not entitled to participate in the decision as to whether to accept the bid. Thus, the board should not adopt measures that could limit the shareholders ability to accept the alternative they prefer. In its reasons to cease trade the shareholder rights plan, the Commission stated: We should also note that Mr. Eyton's apparent view that the board of a target company, as well as its shareholders, are entitled to take part in the decision as to whether to accept the bid is not correct, based on previous decisions of the Commission, if by his statement to that effect Mr. Eyton meant any more than that the board of the target company is entitled to advise the shareholders and attempt to provide them with alternatives. The Commissions view on this question was first articulated In the Matter of Canadian Jorex Limited and Manville Oil and Gas Limited (1992), 15 O.S.C.B. 257, as follows: Underlying our conclusion was our view of the public interest in matters such as this. As is amply reflected in National Policy 38 [predecessor to NP 62-202], the primary concern of the Commission in contested take-over bids is not whether it is appropriate for a target board to adopt defensive tactics, but whether those tactics are likely to deny or severely limit the ability of the shareholders to respond to a take-over bid or a competing bid or may have the effect of denying to shareholders the ability to make a [fully informed] decision and of frustrating an open take-over bid process. If so, then as National Policy 38 clearly indicates, the Commission will be quite prepared to intervene to protect the public interest as we see it. For us, the public interest lies in allowing shareholders of a target company to exercise one of the fundamental rights of share ownership the ability to dispose of shares as one wishes without undue hindrance from, among other things, defensive tactics that may

-8have been adopted by the target board with the best of intentions, but that are either misguided from the outset or, as here, have outlived their usefulness.10 On April 30, 1998, CanWest increased its bid to $43.50 but contingent upon the Court setting aside the pre-acquisition agreement. As noted, in addition to its proceedings before the OSC and other Commissions, CanWest also applied to the Court in Ontario seeking to have the pre-acquisition agreement set aside and for relief under the oppression remedy in section 241 of the CBCA, submitting that the WIC directors had exercised their powers in a manner which was contrary to their statutory and fiduciary duties in take-over bid situations and that this failure had resulted in prejudice to CanWest as a WIC shareholder. CanWest was the largest equity owner in WIC, holding about 36% of the WIC Class B non-voting shares. Finding that CanWest was not precluded from having status as a complainant under the oppression remedy provisions, the narrow issue before the Court was whether WICs Board had breached its fiduciary duties by approving the preacquisition agreement with Shaw. While the Court criticized certain aspects of the preacquisition agreement and questioned the independence of the special committee, it did not set aside the pre-acquisition agreement and concluded that the WIC Board had acted in accordance with its fiduciary duties. In his judgement, Mr. Justice Blair provided some definition to the concept of the when a corporation in in play and described the duties of directors in such circumstances: The law as it relates to the general duties of the directors of Canadian corporations is not controversial. The directors must exercise the common law fiduciary and statutory obligations (a) to
10

Re CW Shareholdings Inc. and WIC Western Communications Ltd. (1998), 21 O.S.C.B. 2899 at 2905.

-9act honestly and in good faith with a view to the best interests of the corporation, and (b) in doing so, to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances: see the Canada Business Corporations Act, R.S.C. 1985, c. C-37, s.122. In the context of a hostile takeover bid situations where the corporation is in play (i.e., where it is apparent there will be a sale of equity and/or voting control) the duty is to act in the best interests of the shareholders as a whole and to take active and reasonable steps to maximize shareholder value by conducting an auction.11 [emphasis added] In the American authorities, this shareholder maximization-though-auction duty is known as the Revlon Duty, after the Delaware Supreme Court decision in Revlon v. McAndrews & Forbes Holdings, Inc.12 The Court in Revlon, in a passage adopted by Blair J., said: The duty of the board had thus changed from preservation of Revlon as a corporate entity to the maximization of the companys value at a sale for the stockholders benefit. This significantly altered the boards responsibilitiesthe directors role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.13 It should be noted that the U.S. authorities have distinguished the situations where a Revlon duty will be invoked. In Paramount Communications v. QVC Network Inc.14, and Omnicare Inc. v. NCS Healthcare Inc.15, the Delaware court held that general Revlon principles will govern in situations where either the board initiates a bidding process to sell the corporation, where a change of corporate control will occur, or where the board makes a break up of the
11 12

Supra, note 2 at 768. Revlon v. McAndrews & Forbes Holdings, Inc., 506 A.2d 173 (1986 Del. Sup. Ct.)., 1986 Del. LEXIS 1053. 13 Ibid., at 182. 14 Paramount Communications v. QVC Network Inc., 637 A.2d. 34 (Del. Sup. Ct.) at 46, 1994 Del. LEXIS 57. 15 Omnicare Inc. v. NCS Healthcare Inc. et al., 818 A. 2d 914 (Del. Sup. Ct.) at 928, 2003 Del. LEXIS 195.

- 10 corporate entity inevitable. However, in a merger of two widely-held companies where both companies would be owned by a fluid aggregation of unaffiliated stockholders both before and after the merger, and neither corporation could be said to be acquiring the other, the Delaware court has held there was no change of control, and hence, that Revlon was not invoked.16 More recently, the Supreme Court of British Columbia considered an argument from the target companys largest shareholder, who opposed the transaction, that a plan of arrangement providing for the acquisition of all the shares of Pacifica Papers Inc. (Pacifica) by Norske Skog Canada Limited should not be approved by the court under section 192 of the CBCA because, among other things, Pacifica did not engage in an open competitive bidding process in connection with the sale of Pacifica which it was alleged would have ensured the best value for Pacificas shares. This case was not in the context of Pacifica responding to a hostile take-over bid, but was rather a voluntary sale transaction initiated by the board of Pacifica. The Court did not accept the proposition that the directors of Pacifica acted improperly in not engaging in an open auction and commented:17 In answer it is said that there are two ways to approach the sale of a company like Pacifica. It can be publicly put up for sale in the hope of creating a competition amongst prospective buyers, or a sale can be privately negotiated with an appropriate break fee and announced with a view to then seeing whether the price agreed attracts a better offer. Pacificas board apparently favoured the latter. In any event, the evidence is that it was well known in the industry that Pacifica was for sale. Pacificas acceptance of a period of exclusivity was a feature of the negotiations upon which Norske insisted and some exclusivity is accepted to be customary in transactions of this kind.
16 17

Supra, note 14 at 46. Re Pacifica Papers Inc., 2001 BCSC 1069, 106 A.C.W.S. (3d) 837 (B.C. Sup. Ct.) at paras. 114-116; appeal dismissed, 2001 A.C.W.S.J. LEXIS 17596 (B.C.C.A.).

- 11 It may well have been better if Pacifica had been able to inject competitive bidding for its equity into the process, but the fact is that was a luxury it did not have, and it remains far from clear that anything could have been done about it. It seems to me that, once it is accepted that Norske could be expected to pay the most for Pacifica because of the substantial synergies between them, it is difficult to see how competitive any other entity could be. The transaction was driven largely, as it had to be, on evaluations of the share exchange ratio the price that made the combination worthwhile for both Pacifica and Norske. Mr. Johnstone and Mr. Hystrom [of Pacifica] approached Mr. Horner [of Norske] at a time when discussions with STM [another potential purchaser of Pacifica] were the only discussions of any consequence. Pacifica had tried to come to terms with STM at least twice before and, at least from its perspective, had gotten nowhere. (ii) Maple Leaf Foods and Schneider Corporation

In the Schneiders decision, the Ontario Court of Appeal declined to apply the Revlon duty and found that directors need to not hold an auction each time that a company is in play.18 alternatives.19 In that case, the target, Schneider Corp. (Schneiders), was controlled by Schneider family shareholders such that, absent the triggering of a coattail provision in the corporations articles, any successful take-over bid for the company had to be tendered to by the family. Maple Leaf Foods Inc. (Maple Leaf) announced on November 5, 1997 its intention to make an unsolicited take-over bid for Schneiders at $19 per share for both classes of shares. The Schneider's board established a special committee consisting of the independent non-family directors to review the Maple Leaf offer, while senior management negotiated with bidders. The special committee retained legal and financial advisors and a data room was established. A Rather, directors must make decisions that fall within a range of reasonable

18 19

Supra, note 3 at 199. Ibid., at 192.

- 12 number of potential suitors, including Smithfield Foods Inc. (Smithfield) and Booth Creek (Booth), signed confidentiality and two-year standstill agreements to gain access to the Schneiders data room. On November 23, 1997, the Schneiders board issued its directors circular recommending rejection of the Maple Leaf offer stating that is was committed to maximizing shareholder value and that the family might consider accepting a financially more attractive offer. On December 2, 1997, the Schneiders board adopted a temporary shareholder rights plan for the purpose of enabling the board to explore fully all options for maximizing shareholder value. On December 11, 1997, the CEO of Schneiders wrote to Maple Leaf stating that it would be receiving alternative offers and invited Maple Leaf to deliver an enhanced offer by December 12, stating that the process of shareholder value maximization was fast approaching its climax. On December 12, Maple Leaf increased its bid to $22 per share but the family rejected this offer. On the same day, Schneiders received higher offers from both Smithfield and Booth. The family indicated that it had non-financial criteria, in addition to financial value, for accepting or rejecting a bid, which included the continuity of employment for employees and the effect of any transaction on customers and suppliers. On December 14, 1997, the Schneider family advised the Schneiders board that, after reviewing the three offers, the only offer they were willing to accept was a Smithfield offer at $25 per share. After negotiations, on December 16, Smithfield increased its share exchange offer to $25.20 On December 17, the Schneider family announced to the Schneiders board that it wanted to accept the revised Smithfield offer and the family advised the board that it had come to the conclusion that now was the time to sell
20

Booth Creek also increased its offer to $25.50 per share, but as its offer was all cash, it was less financially attractive to the Schneider family on an after-tax basis than the Smithfield share exchange proposal. The Ontario Court of Appeal also referred to the after-tax value of offers to the Schneider family as valid factors for the special committee to consider.

- 13 the control of the company. In order for the Schneider family to agree to tender its shares to a Smithfield take-over bid, which was a condition of the Smithfield proposal, the family requested that the board release Smithfield from its standstill agreement and remove the rights plan. The special committee received advice from its financial advisors that the present value of the consideration offered by Smithfield was $23.50, while the nominal value was at the low end of the $25-29 fair price range but that if the Smithfield offer was not accepted and no other transaction was consummated, the shares of Schneiders would drop back into a trading range of $18 to $20. Based on these considerations, the board of Schneiders, on the recommendation of the special committee, waived the standstill agreement and the Schneider family entered into an irrevocable lock-up agreement with Smithfield on December 18, 1997. In the reasons dismissing the Maple Leaf suit, the trial judge, Farley J. noted that the family entered into a hard lock up agreement with Schneider to tender to its forthcoming offer and that There was a consensus however that a hard lock up effectively terminated the bidding process.21 The original proposal, as submitted by Smithfield, contemplated that the proposed transaction would proceed by way of plan or arrangement or merger. That is, the board would approve the family entering into a lock-up agreement with Smithfield, then the merger proposal would be voted upon by all shareholders and approved by the court. Before asking the

shareholders and the court to approve the merger the board would have had to provide an opinion that the transaction was fair. In light of the financial advisors discounted valuation of the Smithfield proposal, the Board was unwilling to do so. As a result, Smithfield made offers by

21

Pente Investment Management Ltd. v. Schneider Corp. (1998), 40 B.L.R. (2d) 244 (Ont. Gen. Div.) at para. 8.

- 14 way of take-over bids to acquire both classes of shares on the condition that the family agree to tender its shares. On December 19, Maple Leaf raised its offer to $29 per share. Maple Leaf, and two small shareholders of Schneiders who supported Maple Leaf, brought an action seeking to have the court invalidate the familys lock-up agreement with Smithfield on two principal grounds. The first was that that the special committee was not in fact independent, and that the advice given by the special committee to the Board was not in the best interest of Schneiders and its shareholders. Second, Maple Leaf asserted that statements made by the family created an expectation that an auction for the familys control block of shares would be held and that those shares would be sold to the highest bidder. In this regard, Maple Leaf sought to have the lock-up agreement set aside under the oppression remedy on the basis that the process undertaken by the special committee and the board unfairly prejudiced and disregarded the interests of the nonfamily shareholders. The Ontario Court (General Division) dismissed Maple Leafs actions.22 In

relation to the first issue, Farley J. concluded that the special committee and the directors exercised their powers and discharged their duties honestly and in good faith, with a view to the best interests of the Schneiders and that they exercised the care, diligence and skill that a reasonable and prudent person would exercise in comparable circumstances in relation to dealing with the take over bid situation.23 With regard to the second issue, he found that because Schneiders was known to be controlled by the family, who could decide whether or not to sell its shares, the company was never truly in play and no public expectation was created that an

22 23

Pente Investment Mangement Ltd. v. Schneider Corp. (1998), 40 B.L.R. (2d) 244, 79 A.C.W.S. (3d) 903. Ibid., at 286.

- 15 auction would be held. Citing his judgment in Benson v. Third Canadian General Investment Trust Ltd.24, Farley J. observed: that the in play concept only becomes relevant in the aspect of concentrating on maximizing shareholder value when a corporation is truly in play. If there is a veto block of shareholders who are entitled to ignore, disregard, and/or reject an offer, then if that be the circumstances under the prevailing law, how can one say that the corporation is in play? The ballgame would only be played if the veto block were disqualified in some legal way. If not, the first pitch is not thrown. If not in play, then it is my view that maximizing shareholder value is only a subset of the best interests of the corporation for which the directors must have regard.25 The Court of Appeal affirmed Farley J.s determination that the directors, in allowing the shareholder lock-up agreement with Smithfield, acted in good faith and were entitled to deference. More particularly, the Court held that there was no obligation on the part of the directors to give Maple Leaf the opportunity to make a third bid to keep the bidding process alive given the family shareholders indication that they would not tender to a Maple Leaf bid. The Court of Appeal also rejected the argument of Maple Leaf that the directors of Schneiders were obligated in law to conduct an auction. In its reasons, Weiler J.A. for the Court of Appeal held26: The decision in [Revlon] stands for the proposition that if a company is up for sale, the directors have an obligation to conduct an auction of the companys shares. Revlon is not the law in Ontario. In Ontario, an auction need not be held every time there is a change in control of a company. An auction is merely one way to prevent the conflicts of interest that may arise when there is a change of control by requiring that directors act in a neutral manner toward a number of biddersThe
24 25

Benson v. Third Canadian General Investment Trust Ltd. (1993), 14. O.R. (3d) 493. Supra, note 22 at 285. 26 Supra, note 3 at 1998 A.C.W.S.J. LEXIS 90999 at paras. 91-92.

- 16 more recent Paramount decision in the United States has recast the obligation of directors when there is a bid for change of control as an obligation to seek the best value reasonably available to shareholders in the circumstances. [emphasis added] Instead, the Court of Appeal chose to apply the test used in the more recent Paramount decision which recast the obligation of directors when there is a bid for change of control as an obligation to seek the best value reasonable available to shareholders in the circumstances. In doing so the Court, referring to Paramount, stated: This is a more flexible standard, which recognizes that the particular circumstances are important in determining the best transaction available, and that a board is not limited to considering only the amount of cash or consideration involved as would be the case with an auctionThere is no single blueprint that directors must follow. When it becomes clear that a company is for sale and there are several bidders, an auction is an appropriate mechanism to ensure that the board of a target company acts in a neutral manner to achieve the best value reasonably available to shareholders in the circumstances. When the board has received a single offer and has no reliable grounds upon which to judge its adequacy, a canvass of the market to determine if higher bids may be elicited is appropriate, and may be necessary.27 [emphasis added] In the Schneider case, the Court concluded that what had occurred was market canvass, which was appropriate in the circumstances: The appellant submits that there was considerable evidence indicating that the Schneider Family had by December 17th, if not
27

Ibid., at para. 93.

- 17 before, concluded that a sale of its shares was inevitable. Having undertaken a market canvass, however, there was no obligation on the Special Committee to turn this canvass into an auction, particularly because to do so was to assume the risk that the competing offers that the market canvass had generated might be withdrawn. There was no obligation on the Special Committee or the Board to go back to Maple Leaf on December 17th and ask it to make another offer. A market canvass and not an auction was being conducted; the Special Committee and the Board only had a short time within which to consider Maple Leaf's offer; Maple Leaf had already been asked to make an appropriate offer and there was no certainty it would make a higher bid. There was an obligation on the Special Committee and the directors to consider the bids which their market canvass had realized in addition to Maple Leaf's bid. Farley J. found Maple Leaf knew, or should have known, that the bidding process was almost over when it made its $22 per share bid. Maple Leaf's board had authorized the issuance of enough Maple Leaf shares to finance a $29 a share bid for Schneider before the bidding process entered its final stage. Maple Leaf was nonetheless content to let its $22 bid stand despite knowing that there were competing bids that might be accepted in preference to its own, and despite the fact that Maple Leaf's board had authorized a higher $29 bid. This was a risk Maple Leaf chose to assume.28 (b) The Business Judgment Rule The business judgment rule operates to shield from court intervention business decisions which have been made honestly, prudently, in good faith and on reasonable grounds. In the context of a change of control, the paramount issue is often whether the objectively based business judgment rule will be applied, or whether, in light of heightened concerns regarding corporate governance and of the recent U.S. decision of Omnicare Inc. v. NCS Healthcare Inc.29, the courts will adopt a more interventionist role to safeguard the interests of shareholders. The Court of Appeal in Schneiders provided a useful overview of the law in with regard to the standards to which directors will be held in such circumstances. Citing the leading
28 29

Ibid., at para. 95. Supra, note 15.

- 18 cases of Teck Corporation v. Millar et al.30, Re Olympia & York Enterprises Ltd. v. Hiram Walker Resources Ltd.31 and Brant Investments Ltd. v. KeepRite Inc.32 the Court, in determining whether the directors have acted in the best interests of the corporation, began its analysis by reiterating the following principle: The mandate of the directors is to manage the company according to their best judgment: that judgment must be an informed judgment, it must have a reasonable basis. If there are no reasonable grounds to support an assertion by the directors that they have acted in the best interests of the company, a court will be justified in finding that the directors acted for an improper purpose. It must be recognized that the directors are not the agents of the shareholders. The directors have absolute power to manage the affairs of the company even if their decisions contravene the express wishes of the majority shareholder.However, acting in the best interests of the company does not necessarily mean that the directors must act in the best interests of one of the groups.There may be a conflict between the interests of individual groups of shareholders and the best interests of the company.Provided that the directors have acted honestly and reasonably, the court not ought to substitute its own judgment for that of the Board of Directors.If the directors have unfairly disregarded the rights of a group of shareholders, the directors will not have acted reasonable, in the best interests of the corporation and the court will intervene:.33 [emphasis added] In Schneiders, the appellants urged the Court to review the actions of the Schneiders board pursuant to the enhanced scrutiny standard derived from U.S. law, rather

30 31

Teck Corporation v. Millar et al. (1973), 33 D.L.R. (3d) 288 (B.C.S.C.). Re Olympia & York Enterprises Ltd. v. Hiram Walker Resources Ltd. (1986), 59 O.R. (2d) 2554 (H.C.); affirmed (1986), 59 O.R. (2d) 254 (Div. Ct.). 32 Brant Investments Ltd. v. KeepRite Inc. (1991), 3 O.R. (3d) 289. 33 Supra, note 3 at 190.

- 19 than the principles of the business judgment rule. The Ontario Court of Appeal in Schneiders34 paraphrased the Supreme Court of Delaware in Paramount, which described the enhanced scrutiny test as follows: The key features of an enhanced scrutiny test are: (a) a judicial determination regarding the adequacy of the decision-making process employed by the directors, including the information on which the directors based their decision; and (b) a judicial examination of the reasonableness of the directors actions in light of the circumstances then existing. The directors have the burden of proving that they were adequately informed and acted reasonably.35 The Delaware Court in Paramount noted that where Revlon duties devolve upon directors, the court will apply an enhanced judicial scrutiny as the test, before normal presumptions of the business judgement rule apply.36 The Delaware court has also noted that the enhanced scrutiny test, sometimes referred to as the Unocal standard after the decision of the Delaware Supreme Court in Unocal Corp. v. Mesa Petroleum Co.,37 may apply in situations where a board adopts defensive devices designed to protect a merger agreement. In Omnicare, the Court noted that in such circumstances, the court must first determine that those measures are not preclusive (of other bids) or coercive (of shareholders). If the defensive measures are not preclusive or coercive, then the board must demonstrate that it has reasonable grounds for believing that a danger to the corporation and its shareholders exists if the merger transaction is not consummated.38 Then the board has the onus to demonstrate that the defensive response was reasonable and proportionate to the threat posed.39 That burden is satisfied by showing good

34 35 36

Ibid., at 191. Supra, note 14 at 45. Ibid., at 45. 37 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985), 1985 Del. LEXIS 482. 38 Supra, note 15 at 932. 39 Ibid., at 933.

- 20 faith and reasonable investigation, and such proof is enhanced if it has been approved by an independent committee.40 As in the WIC decision, the Court of Appeal in Schneiders rejected the enhanced scrutiny test and adopted the business judgment rule. The Court elaborated on the rule as follows: The law as it has evolved in Ontario and Delaware has the common requirements that the court must be satisfied that the directors have acted reasonably and fairly. The court looks to see that the directors made a reasonable decision not a perfect decision. Provided the decision taken is within the range of reasonableness, the court ought not to substitute its opinion for that of the board even though subsequent events may have cast doubt on the boards determination. As long as the directors have selected one of several reasonable alternatives, deference is accorded to the boards decisionThis formulation of deference to the decision of the Board is known as the business judgement rule. The fact that alternative transactions were rejected by the directors is irrelevant unless it can be shown that a particular alternative was definitely available and clearly more beneficial to the company that the chosen alternative.41 [emphasis added] In arriving at this conclusion, Weiler J.A. for the Court of Appeal in Schneiders articulated the following principles: The mandate of the directors is to manage the company according to their best judgment; such judgment must be an informed judgment and must have a reasonable basis.42

40 41

Ibid., at 933. Supra, note 3 at 192. 42 Ibid., at 192.

- 21 In order to assess whether the directors were acting in the best interests of the corporation, it is important to ask what was uppermost in the directors minds after a reasonable analysis of the situation.43 The directors have the absolute power to manage the affairs of the corporation even if their directions contravene the wishes of the majority shareholder.44 The court must be satisfied that the directors have acted reasonably and fairly. As long as the directors select one among a range of reasonable alternatives, the court will show deference to the directors decisions. Where the court is satisfied that the directors have acted honestly and reasonably, it will defer to the business judgment of the directors. The business judgement rule was recently enunciated in Ontario in Krynen v. Bugg (2003), 64 O.R. (3d) 393. (Ontario Superior Court of Justice) where Killeen J. remarked at page 411 that the boards decisions will not be subject to microscopic examination and the court will be reluctant to interfere with and usurp the boards function in managing the corporation The Court then quoted the paragraph from the Ontario Court of Appeals judgment in Schneiders that is quoted commending on page 20 above.

Ibid., at 190. This point articulated in Schneider may have an unstated significance. This formulation of the proper motivation behind directors activities was first formulated by Farley J. in 820099 Ontario Inc. v. Harold E. Ballard Ltd. (1991), 3 B.L.R. (2d) 123 at 176 (Ont. Gen. Div.), in which he rejected as unduly harsh the test proposed by Richard J. in Exco Corp. v. Nova Scotia Savings & Loan Co. (1987), 35 B.L.R. 149 (N.S.T.D.). This latter test would have required that directors issuance of a corporations securities must be consistent only with the best interests of the company and inconsistent with any other interests. Farley J. thought the test too harsh because it might inhibit reasonable business decisions. 44 Ibid., at 191. In this, the Court cited Teck Corporation Ltd. v. Millar (1973), 33 D.L.R. (3d) 288 (B.C.S.C.), which case the Court had earlier referred to as having been adopted as the law in Ontario.

43

- 22 (c) The Onus of Proof The Court of Appeal in Schneiders noted that Canadian caselaw has not been uniform on the question of the onus, or burden of proof, with regard to the decisions of directors when dealing with a take-over bid.45 As mentioned, the enhanced scrutiny test, which has thus far been rejected by Canadian courts, places the onus on the directors to satisfy the court that they were adequately informed and acted reasonably. Some Canadian authorities such as Exco Corporation v. Nova Scotia Savings & Loan Company46, and Re 347883 Alberta Ltd. and Producers Pipelines Inc.47 have adopted a proper purpose test, which, like the enhanced scrutiny test, also shifts the burden of proof to the directors to show that their acts are consistent only with the best interests of the company and inconsistent with any other interests. While the Court found that it was not necessary to determine the question of onus in the Schneiders case, it stated in obiter that it may be that the burden of proof may not always rest on the same party when a change of control transaction is challenged. However, the Court said that where a board of directors successfully took steps to avoid conflicts of interests, acted on the advice of a special committee that has acted independently, in good faith and has made an informed recommendation, the business judgement rule will apply and the rationale does not arise for shifting the burden of proof to the directors. The court stated: I would add, however, that it may be that the burden of proof may not always rest on the same party, when a change of control transaction is challenged. The real question is whether the directors of the target company successfully took steps to avoid a conflict of interest. If so, the rationale for shifting the burden of proof to the directors may not exist. If the board of directors has acted on the advice of a committee composed of persons having no conflict of interest, and that committee has acted independently, in
45 46

Supra note 3 at 191. Exco Corporation v. Nova Scotia Savings & Loan Company (1987), 35 D.L.R. 149 (N.S.S.C.). 47 Re 347883 Alberta Ltd. and Producers Pipelines Inc. (1991) 80 D.L.R. (4th) 359 (Sask. C.A.).

- 23 good faith, and made an informed recommendation as to the best available transaction for the shareholders in the circumstances, the business judgment rule applies. The burden of proof is not an issue in such circumstances. 48 [emphasis added] 3. (a) DEAL PROTECTION TECHNIQUES Break Fees As mentioned, break fees are payments agreed to be made by a target company to induce a competing bidder into an auction or as part of a negotiated business combination. Typically, the fee becomes payable when the acquisition transaction fails for reasons other than the default of the purchaser, including where its bid is superseded by an unsolicited financially superior offer. As noted by the Court in WIC, partly the break fee is paid to compensate the bidder for is costs, time, effort and lost opportunity in putting forward the bid, and partly it may simply be bait to lure another party into the arena to generate a free-for-all for the prize.49 Oftentimes, even when it appears unlikely that a competing offer will emerge, break fees are negotiated as an indication that the parties are fully committed to the transaction. Deal protection techniques, including break fees, in and of themselves are not objectionable, and have been sanctioned by the courts and the securities commissions in National Policy 62-202 (NP 62-202), so long as they are designed to raise the bidding price for the benefit of the shareholders of the target company. The Canadian securities regulators authorities appreciate that defensive tacticsmay be taken by a board of directors of a target company in a genuine attempt to obtain a better bid. Tactics that are likely to deny or limit severely the ability of the shareholder to
48 49

Supra, note 3 at 191. Supra, note 2 at 771.

- 24 respond to a take-over bid or a competing bid may result in action by the Canadian securities regulatory authorities.50 In Re Canadian Jorex Ltd. and Manville Oil and Gas Limited51, the OSC stated that, in regard to NP 62-202, For us, the public interest lies in allowing shareholder of a target company to exercise one of the fundamental rights of share ownership the ability to dispose of shares as one wishes without undue hindrance from, among other things, defensive tactics that may have been adopted by the target board with the best intentions, but that are either misguided from the outset orhave outlived their usefulness. In the OSCs hearings in WIC, the Commission again adopted and reiterated its rationale expressed in Canadian Jorex with respect to the duties of directors of a target company in responding to a hostile take-over bid and the Commissions interpretation of the public interest in considering whether defensive tactics are appropriate.52 The OSC also acknowledged that NP 62-202 expresses a secondary objective, to provide a regulatory framework within which takeover bids may proceed in an open and even-handed environmentbut this is clearly a subsidiary consideration.53 In its reasons in WIC staying (not dismissing) CanWests application pending the findings of the Court as to whether it would be appropriate for the Commission to consider the application further, the OSC commented on its jurisdiction to cease trade transactions on the basis that a break-up fee or an asset option may be an improper defensive tactic, without forming

50 51 52

Section 1.1(6) of National Policy 62-202 - Take-Over Bids Defensive Tactics, 20 O.S.C.B. 3525. (1992), 15 O.S.C.B 257 at page 266. Canadian Jorex quoted in the OSC decision cease trading the WIC shareholder rights plan at (1998), 21 O.S.C.B. 2899 at 2905, and in the OSC decision staying CanWests application to cease trade the Shaw bid at (1998), 21 O.S.C.B. 2910 at para. 57 of 1998 Carswell Ont 2152. 53 (1998), 21 O.S.C.B. 2910 at para. 58 of 1998 Carswell Ont 2152.

- 25 a conclusion whether the board of directors breached its fiduciary duties in granting the break fee and the asset option, as follows: Although break-up fees have become a more or less usual feature of the take-over bid landscape, the quantum of a specific fee could, in our view, result in the agreement to pay such a fee being an improper defensive tactic. However a break-up fee in an appropriate amount could, in our view, be properly agreed to by a target company if it were necessary to agree to it in order to induce a competing bid to come forward. As a result, we are unable to conclude, without entering into an examination of the factual background, that the mere existence of the break-up fee constitutes an improper defensive tactic. This examination would have to include consideration of the unusual pre-existing relationship between WIC and Shaw. As regards the option on WICs radio assets, we have a greater concern. It has certain aspects which seem to us to be unusual, in particular the fact that the option will be exercisable even if the CW Bid, made before the entering into of the Pre-Acquisition Agreement, is successful, thus having what amounts to a retroactive effect. However, we are unable to conclude, without entering into an examination of the factual background, that the mere existence of these features results in the option constituting an improper defensive tactic. A particular asset option may or may not be offensive, depending on whether it is necessary to obtain a competing bid and whether it has the effect of depriving shareholders of the ability to respond to a take-over bid or to a competing bid or is likely to deny or limit severely the ability of the shareholders of the target company to respond to a take-over bid or a competing bid. (See NP 62-202.). [Counsel for CanWest] assured us that CW will neither make a higher bid or take-up and pay under the CW Bid unless the option disappears. Given the prior history in connection with CanWests interest in WIC, we think it quite possible that this position will change if the Court does not strike down the Pre-Acquisition Agreement. In our view, the effect of the Pre-Acquisition Agreement will not be to kill competitive bidding. It is difficult to understand how it could be in the interests of the shareholders of WIC, other than CW, for the Commissions to cease

- 26 trade the Shaw Bid, thus leaving a lower bid by CW in place as the only bid, with no third party bid likely to come forward, especially in circumstances where we are told that it is probable that CW will not be taking up and paying under that bid because, even if we cease trade the Shaw Bid, it will leave the option to Shaw on WICs radio assets in place.54 [emphasis added] The decision of the Court in WIC is also useful because of its discussion of break fees and asset options as defence tactics. In his judgment Blair J. quoted with approval the statement on acceptable break fees made by the Commission quoted immediately above and enunciated the following principles which determine whether a break fee is appropriate: I accept that break fees are appropriate in such circumstances where: (a) as the Commission has noted, they are necessaryin order to induce a competing bid to come forward; (b) (c) that bid represents a better value for the shareholders; and where the break fee represents a reasonable commercial balance between its potential negative effect as an auction inhibitor and its potential positive effect as an auction stimulator.55 In a more recent decision of the Supreme Court of British Columbia in Re Pacifica Papers Inc.,56 Justice Lowrey held that a break fee of 4.5% of a target companys equity value was appropriate. This conclusion depended largely on the advice of the target

54 55 56

Ibid., at paragraphs 52 to 59 of 1998 Carswell Ont 2152. Supra, note 2 at 771. Re Pacifica Papers Inc., 2001 BCSC 1069, 106 A.C.W.S. (3d) 837 (B.C. Sup. Ct.); appeal dismissed, 2001 A.C.W.S.J. LEXIS 17596 (B.C.C.A.).

- 27 companys independent financial advisors who had indicated to the company that the accepted range was between 3-5%.57 The B.C. Supreme Court stated: As for the break fee, the increase from $16 million to $20 million was sought by Norske [the acquiror] to offset the 24% dissident rights which was asked to accept. The fee may have been somewhat high, but the dissident rights that Norske accepted were high. It was a matter of negotiation.The evidence does not establish the break fee was so high that it would have precluded offers for the equity of Pacifica. Indeed, the advice given by Pacificas financial advisors was that, at 4.5% of Pacificas equity value, it was within the accepted range (3-5%). [emphasis added] Justice Lowrys approach is also consistent with the business judgment rule that aptly recognizes the relative expertise of directors and officers with respect to business decision making, and the propriety of reliance on independent expert reports. (b) Options on Assets and Options on Treasury Shares A similar inducement offered by target companies to secure competitive financially superior bids is the asset option. As its name implies, an asset option granted is an option granted by the target company to a bidder to purchase specified assets of the target company. Asset options are generally irrevocable, meaning that a bidder remains entitled to exercise the option even if a superior bid is not induced and, in some cases, even if the bidder itself is successful. In Canada, the use of asset options appears to be rarer than the use of break fees, but asset options have been employed by target companies in several prominent take-over

57

Ibid., at para. 118.

- 28 bids, including the 1995 Interbrew bid for Labatts, and 1997 competitive Parmalat Foods Limited bid for Ault Foods Limited58, as well as in the Shaw take-over bid for WIC. In WIC, Justice Blair held that asset options are not per se illegal, but that in assessing their use, as with break fees, it is important to balance their auction-inhibiting qualities against their efficacy in attracting a higher bid for the shareholders: In my view the granting of an asset purchase option (or "asset lock-up", as it is sometimes called, in the jargon of the trade) to a potential bidder may be a proper and acceptable measure for a target corporation to adopt as a competitive-bid-stimulating inducement where - viewed in the context of the entire negotiated transaction, as in the case of break fees - it strikes a reasonable commercial balance between its potential negative effect as an auction inhibitor depressing shareholder value and its potential positive effect as an auction stimulator enhancing shareholder value.59 Without creating an exhaustive list, Blair J. then set out the following factors to be considered in distinguishing between an asset lock-up which is an auction stimulator and one which is an auction inhibitor. (a) whether the process by which the directors of the target company exercised their obligation to maximize shareholder value complied with their duties as target-corporation directors; (b) whether the overall commercial balance and proportion between the auction inhibiting and auction stimulating effect of such an agreement in

58

Following a hostile bid by Saputo Group Inc. at $28 per share, Ault Foods Limited (Ault) secured a competing bid from Parmalat Foods Inc. (Parmalat) for $34 per share. In the acquisition agreement with Parmalat, Ault agreed, among other things, that, in the event that Parmalat does not complete an acquisition of any common shares, Ault has granted to Parmalat an irrevocable option exercisable for 90 days following the announcement of a Superior Proposal, to purchase the assets of Aults Quebec fluid milk business for $65 million. Parmalat also received a right to reimbursement of expenses up to $2 million and a $12 million break fee. 59 Supra, note 2 at 772.

- 29 the circumstances has been struck, i.e., whether the agreement is likely to preclude further bidding, in the sense of harming or significantly dampening the auction process, and thus deprive the shareholders of potential additional value; (c) whether the price for the optioned asset is within the range of reasonable value attributed to that asset, or whether it represents such a discount that it would result in a disproportionate erosion in the value of the corporation making it uneconomical for others to bid; and (d) whether the competing bid induced by the asset lock-up agreement provides enough additional value to the shareholders to justify the granting of the option.60 Although not common practice in Canada, options on treasury shares have often been employed as protective measures in the U.S.61 These may take the form of an option to purchase unissued shares of the target company that is exercisable in the event of third party interference with the proposed transaction. There is, in theory, a great variety of possible asset or share option techniques, which can also be used in tandem. Options on shares may also be granted for securities of the target company other than those that are the subject of the bid, or the prospective bidder and target may grant each other reciprocal options in each other securities. Although the views of the courts and the securities regulators in Canada are far less clear on the use of share options in a change of control situation, there would appear to be no reason in principle why considerations similar to those applicable to asset options would not also
60 61

Ibid. at 773. The 1998 proposed merger of Royal Bank of Canada and Bank of Montreal, in addition to a cash break-fee, provided that each bank agreed to grant the other bank an option to acquire treasury shares at the pre-merger price.

- 30 apply in assessing the directors duties in the face of a proposed bid containing a share option. Indeed, it would likely be necessary to obtain the advice of the directors financial advisors as to these types of protective measures. In addition, depending on their terms and the structure of the proposed transaction, the use of options on shares would need to be carefully considered in the context of applicable regulatory requirements, which might include, for example, stock exchange approvals to the granting of the option on treasury shares and the pre and post-bid integration rules relating to take-over bids in provincial securities legislation. Options for treasury shares have been criticized by the courts in the U.S. in situations where the offeror was permitted to pay for the shares with a subordinated note instead of cash, or where the option had a cash put whereby the offeror was entitled to elect to require the target company to pay in cash a sum equal to the difference between the exercise price and the market price of the target companys stock. Share options have also been criticized where they were not capped to limit their maximum dollar value, thereby having the potential to reach unreasonable levels.62 (c) Shareholder Lock-ups As noted earlier, if there are significant shareholders of the target company, the bidder may also attempt to lock-up those shares by obtaining the agreement of one or more of those shareholders to tender, sell or vote their shares in support of the transaction. A shareholder lock-up may a soft lock-up which may permit the shareholder to avoid the lock-up agreement in the face of a superior competing offer, or a hard lock-up which is unconditional. In the case where the target company has a controlling shareholder, that shareholders support will be

62

Supra note 14 at 39.

- 31 necessary in order for the transaction to succeed. Moreover, the support of significant

shareholders for a transaction can also act as a deterrent to third party bids. Where the transaction is to be carried out by way of an amalgamation or statutory plan of arrangement, or where a take-over bid is to be followed by a second stage going private transaction, careful consideration must also be given to whether any requirements for minority approval of the transaction or approval of shareholders voting separately as a class will apply. Any requirement for a class vote could be significant, where, for example, the controlling shareholder holds voting control of the company by virtue of a dual class share structure. The securities regulators have usually been deferential with regard to lock-up agreements between an offeror and shareholders of the target company. In Re Tarxien Corp.63, the OSC referred to lock-up agreements between bidders and shareholders a private contracts, and expressed its reluctance to interfere with such agreements unless they contravened the Securities Act or were contrary to the public interest.64 4. FIDUCIARY-OUTS AND THE OMNICARE DECISION As noted above, pre- acquisition support agreements with target companies commonly contain provisions know as fiduciary-out clauses which allow the board of directors of the target company to approve an unsolicited alternative offer where the directors determine that the competing proposal will be on such financially superior terms that the directors have a fiduciary duty to pursue it. In the event that the target company receives such a superior offer, the bidder may often have a right to match it by amending its offer to provide terms that are as favourable as, or superior to, the terms of the superior proposal.
63 64

Re Tarxien Corp. (1996), 19 O.S.C.B. 6913. Ibid. at 6918.

- 32 In a recent landmark decision, the Delaware Supreme Court brought into question the validity of shareholder lock-up agreements where an effective fiduciary-out clause has been omitted. In Omnicare Inc. v. NCS Healthcare Inc.,65 NCS, an insolvent corporation was actively seeking potential acquirers. Following some preliminary discussions with Genesis, the Board of NCS established a special independent committee to make recommendations regarding possible transactions. The independent committee recommended that NCS seek a stalkinghorse partner, which would put forth a valuation for NCS and, in turn, foster a competitive bidding process. Genesis declined to play that role and instead insisted that it be able to consummate any transaction that it entered into with NCS. Genesis proposed a transaction in early June 2002, and insisted that NCS enter into an exclusivity agreement with it, which NCS did. In late July 2002, Omnicare made an attractive proposal to acquire NCS through a pre-packaged bankruptcy that was conditioned upon negotiating a merger agreement, obtaining third party consents and completing its due diligence. NCS brought this proposal to the attention of Genesis in an effort to obtain an improved offer. Genesis quickly responded with a new offer, but required that the transaction be approved the next day or else it would withdraw its offer. The improved offer included three key conditions: first, the offer required that NCS

shareholders vote on the merger agreement even if the NCS Board retracted its support of the transaction; second, the offer precluded the inclusion of a fiduciary out clause in the agreement; and finally, the offer required two shareholders, both of whom where directors (NCSs Chairman and its President and CEO) and who held approximately 65% of the outstanding voting shares, to execute voting agreements contemporaneously with the signing of the merger agreement.

65

Supra, note 15.

- 33 The independent committee met the following day and concluded that the Genesis deadline was genuine. It weighed the consequences of losing the Genesis deal against the benefits and uncertainty involved in the Omnicare offer and concluded that the only reasonable alternative for the Board of Directors [was] to approve the Genesis transaction.66 It was in this context that the NCS Board approved the merger agreement with Genesis. Following the execution of the Genesis merger agreement, Omnicare mounted a tender offer which was clearly superior. The NCS Board eventually withdrew its

recommendation of the Genesis merger and its financial advisors withdrew its fairness opinion. However, by that time NCS was already bound by the terms of the Genesis merger agreement, which required NCS to present the agreement to shareholders for a vote. Moreover, the voting agreement executed by NCSs two largest shareholders predetermined the outcome of that vote. Omnicare and NCS shareholders commenced an action to prevent the inferior Genesis merger from being consummated. The Delaware Court reviewed the deal protection measures according to the enhanced scrutiny standard. In applying the enhance scrutiny

standard, the Court found that the deal protection measures were both preclusive of other deals and coercive of stockholders to accept the Genesis merger: In this case, despite the fact that the NCS board has withdrawn its recommendation for the Genesis transaction and recommended its rejection by stockholders, the deal protection devices approved by the NCS board operated in concert to have a precluding and coercive effect. Those tripartite defensive measures the Section 251(c) provision [which required that the Genesis agreement be placed before the corporations stockholders for a vote], the voting agreements, and the absence of an effective fiduciary out clause made it mathematically impossible and realistically

66

Ibid., at p. 925.

- 34 unattainable for the Omnicare transaction or any other proposal to success, no matter how superior the proposal. The NCS directors defensive devices are not within a reasonable range of responses to the perceived threat of losing the Genesis offer because they are preclusive and coercive.67 The Court concluded that in approving the voting agreements and by requiring that the merger be presented to shareholders the Board was prevented from discharging its fiduciary duties towards minority shareholders by precluding the Board from representing the financial interests of minority shareholders in the face of a superior proposal. The Court

imposed on the NCS Board an obligation to negotiate a fiduciary-out clause, declaring it insufficient for the Board to simply agree to the absolute defence of the Genesis merger against any superior offers: By acceding to Genesis ultimatum from complete protection in futuro, the NCS board disabled itself from exercising its own fiduciary obligations at a time when the boards own judgment is most important, i.e. receipt of a subsequent superior offer. Just as defensive measure cannot be Draconian, however, they cannot limit or circumscribe the directors fiduciary duties. Notwithstanding the corporations insolvent condition, the NCS board had no authority to execute a merger agreement that subsequently prevented it from effectively discharging its ongoing fiduciary responsibilities68 The decision in Omnicare may surface in a Canadian court, given the large number of publicly traded companies that have controlling shareholders. However, in light of the Ontario courts support of the business judgment rule in WIC and Schneiders, the

67 68

Ibid, at 936. Ibid, at 938.

- 35 acknowledgement in Schneiders of controlling shareholders gatekeeper and veto role in a change of control, and the OSCs view of shareholder lock-up agreements as private contracts, it is questionable whether Omnicare would be adopted in Canada. There remain strong

arguments that shareholders have the power to freely enter into voting agreements. Moreover, in Omnicare, the Court seemed to implicitly focus on the Boards role in approving the shareholder voting agreements in concert with the merger agreement. It was this combination of factors that made the protective measures coercive and which attracted enhanced judicial scrutiny. Nevertheless, directors should carefully consider their fiduciary duties and the

inclusion of an effective fiduciary-out clause where the corporation itself has been asked to approve a shareholder lock-up agreement. As Jeffrey S. Leon, a senior securities litigation partner at Fasken Martineau, has recently written: It is unlikely that Omnicare will significantly impact the law governing lock-up agreements in Canada. Canadian courts have not adopted the heightened Unocal standard to scrutinize the defensive measures adopted by a board, continuing instead to apply the business judgment rule. In Maple Leaf Foods Inc. v. Schneider, the Ontario Court of Appeal specifically stated, in the context of reviewing a boards defensive measures, that the business judgment rule will apply (i) where a board has acted on the advice of a committee composed of person with no conflicts of interest; and (ii) where that committee has acted independently, in good faith, and made an informed recommendation as to the best available transaction. In addition, in his dissenting opinion in Omnicare, Chief Justice Veasey, with Justice Steele concurring, accurately noted that the basis of the Unocal doctrine is the omnipresent specter of the boards self interest to entrench itself in office, which was not present in NCS. If the business judgment rule was applied to NCS in the place of the Unocal rule, it is likely that the Delaware Supreme Court would have upheld the deal protection measures that it struck down under the Unocal test.

- 36 It is likely, therefore, that to the extent the Canadian courts adopt Omnicare, its application will be restricted to those cases where lock-up agreement are adopted by self-interested members of boards, or where boards fail to act in good faith in reliance on the advice of experts and independent committees. The being said, Canadian courts have in the past shown great deference to decisions of the Delaware Supreme Courts. Therefore, directors of Canadian corporation would be well advised to avoid entering into lock-up agreements that make it mathematically impossible for another superior proposal to succeed, at least until Canadian courts provide clear guidance of the approach they will adopt towards Omnicare.69 5. SUMMARY OF CERTAIN BREAK FEES In the years since the WIC decision break fees have become the subject of considerable controversy and criticism by institutional investors. The beak fees agreed to in the Great-West Lifeco Inc. acquisition of Canada Life Financial Corporation, the Sun Life Financial Services of Canada Inc. acquisition of Clarica Life Insurance Company, and the merger of PanCanadian Energy Corporation and Alberta Energy Company Ltd. have perhaps received the most attention. The principles set forth in WIC are helpful in assessing the validity of break fees. However, as WIC was based on hostile take-over bid situation involving a change of control, it remains unclear whether the same analysis would apply in a negotiated merger or in a transaction that does not result in a change of control. As mentioned, the pre-acquisition agreement between Shaw and WIC provided for both a break fee and an option on WICs radio division. The break fee became payable, and the asset option immediately exercisable, upon any of the following events (a Fee Event):

69

Recent Developments in Shareholder Litigation: Responding to Corporate Governance Concerns, Jeffrey S. Leon, Partner, Fasken Martineau DuMoulin LLP, at page 32.

- 37 (1) the WIC board withdrew or changed its recommendation to shareholders to accept the Shaw offer in a manner adverse to Shaw, or it recommended acceptance by shareholders of, or WIC shareholders voted in favour of, an alternative acquisition proposal; (2) any person made an acquisition proposal that resulted in such person owning more than 50% of the outstanding WIC Class B non-voting shares; or (3) any person, other than Shaw or CanWest, made an acquisition proposal that resulted in such person owning more than 25% of the outstanding WIC Class B non-voting shares and more than the number of Class B non-voting shares owned by Shaw following completion or termination of its Offer. The break fee did not, however, become payable in the event that the WIC board recommended an alternative proposal and the Shaw bid was less than $39 per Class B share at the time, or in the event that the person who acquired more than 50% of the Class B shares under the second Fee Event trigger was CanWest under its $39 bid. Therefore, the break fee was payable if the Shaw bid was unsuccessful because a bid superior to the $39 Can West bid was made. The radio asset option was exercisable upon the occurrence of a Fee Event. In contrast, it is interesting to compare the structure of some break fees in merger transactions that have caused recent controversy. (a) Clarica/Sunlife Transaction In December 2001, Clarica and Sun Life entered into an acquisition agreement which provided that Clarica would be required to pay either an expense reimbursement amount

- 38 of $50 million and/or a termination fee of $310 million if the agreement was terminated in certain circumstances. At the time, the termination fee represented approximately 4.6% of the total equity value of the Clarica common shares. However, excluding the shares already held by Sun Life, the termination fee actually represented 4.9% of the equity value of the shares being purchased. In summary, the circumstances in which Clarica would have been required to pay the break fees were as follows: (1) Sun Life terminates the agreement if: (a) the Clarica Board fails to recommend or withdraws, modifies or changes its approval or recommendation in favour of the transaction in a manner adverse to Sun Life; (b) an alternative proposal is announced and the Clarica Board fails to affirm its approval of recommendation of the transaction within 5 business days of a request from Sun Life to do so; (c) Clarica breaches its no shop or non-solicitation covenants, including its obligation to provide Sun Life with the opportunity to match a superior proposal (if made); or (d) the Clarica Board approves an agreement with another part with respect to a superior proposal. (2) (i) prior to the date of the Clarica special shareholders meeting, an alternative proposal has been made, or any proposal or expression of interest by a third party regarding an alternative proposal has been publicly disclosed or announced, (ii) the agreement is terminated by either party because the transaction is not approved by shareholders and (iii) either (A) the alternative proposal is

- 39 subsequently completed or (B) within 12 months after the date of the shareholders meeting another alternative proposal is made or a proposal or expression of interest by a third party regarding an alternative proposal is publicly disclosed or announced and such alternative proposal is subsequently completed; or (3) The agreement is terminated by Clarica as the result of Sun Life Financial having failed to match a superior proposal. (b) GreatWest Lifeco/Canada Life Transaction In February 2003, the transaction agreement by Great-West Lifeco Inc. of Canada Life Financial Corporation also provided for a break fee and/or expense reimbursement in the face of an existing unsolicited competing bid by Manulife Financial Corporation. At the time, the termination fee of $287 million was equal to approximately 3.95% of the acquisition price. In summary, the circumstances in which Canada Life would have been required to pay the break fee were as follows: (1) Great West terminates the agreement if: (a) The Canada Life Board fails to recommend or confirm its

recommendation the transaction with two business days of being requested to do so by Great West; or it withdraws, modifies or changes its approval or recommendation in favour of the transaction in a manner adverse to Great West;

- 40 (b) Canada Life breaches its no shop or non-solicitation covenants, including its obligation to provide Great West with the opportunity to match a superior proposal (if made); or (c) The Canada Life Board accepts, approves, recommends or enters into an agreement with another party with respect to a superior proposal. (2) (i) prior to the date of the Canada Life shareholders meeting, an alternative proposal has been made (other than the initial offer made by Manulife) and (ii) the agreement is terminated by either party because the transaction is not approved by shareholders; or (3) The agreement is terminated by Canada Life as the result of Great West having failed to match a superior proposal.