MERGERS & ACQUISITIONSPrepared by:
Tel: (416) 369-7281 ÿ Fax: (416) 862-7661
Tel: (416) 369-6648 ÿ Fax: (416) 862-7661
Gowling Lafleur Henderson LLP
1600- 100 King St W, 1 First Cdn Pl
Toronto, ON M5X 1G5
CANADIAN M&A ACTIVITY IN CANADA
Summary of 2010 Activity
According to the Financial Post Crosbie: Mergers & Acquisitions in Canada Reports (Crosbie), both the value and number of Canadian M&A deals increased steadily on a quarter-by-quarter basis in 2010, resulting in a stronger year overall compared to 2009.1 The total value of deals rose steadily from $19.7 billion in Q1, to $34.8 billion in Q2 and $48.2 billion in Q3, before peaking at $51.9 billion in Q4.2 These figures can be compared to $41.5 billion, $25 billion, $30.2 billion and $32.9 billion, respectively, in 2009.
The overall value of activity was largely driven by the number of mega deals (which are defined as transactions of $1 billion or more). Although mega deals accounted for less than 5 per cent of all deals in 2010, they represented approximately 50 per cent of the total value, a continuation of the trend seen in 2009. The increase in the number and value of these large deals, particularly in the second half of the year, can be attributed primarily to increased activity by Canadian banks and pension funds. Such transactions included Bank of Montreal's acquisition of Wisconsin-based Marshal & Ilsely Corporation for $4.2 billion and TD Bank's acquisition of Chrysler Financial Group for $6.4 billion.
The number of mid-market deals (which are defined as transactions of up to $250 million) represented approximately 85 per cent of all M&A activity in 2010. The value of these deals ranged, on a quarterly basis, from $9.1 billion to $10.2 billion. Though mega deals might have a greater impact on the total value of deals, mid-market deals are the real driver of the Canadian M&A market. In 2009, mega deal activity was relatively slower than in 2010 and approximately 90 per cent of all M&A deals were mid-market transactions.
In 2010, approximately 47 per cent of all Canadian M&A deals involved cross-border acquisitions. Continuing a trend which started in 2009, approximately two-thirds of cross-border transactions involved the acquisition of a foreign business by a Canadian entity, while only a third involved a foreign take-over of a Canadian target. The most active sectors throughout this period were oil & gas and real estate.Summary of 2011 Activity
After a brief dip in the first quarter of 2011, both the value and number of deals rebounded in the second and third quarters of 2011 before decreasing again in the fourth quarter.
The total value of deals slid to $38 billion in the first quarter before rebounding to $53.3 billion in the second and $45.5 billion in the third and then slowing somewhat to $33.4 billion in the fourth quarter. Though Crosbie noted that the pull-back in the first quarter came as a surprise, it attributed the trend, in part, to a push by companies to announce deals before the end of 2010. Crosbie attributed the relative strength in M&A in Q2 and Q3 as a function of corporate buyers viewing acquisitions as a means to create growth in a weak-growth environment and sellers remaining attracted to favourable valuations in many sectors and the relative weakness in Q4 to worsening global economic conditions.
The movement in value of deals between quarters was once again driven primarily by mega deal activity. The number of mid-market deals dipped to 194 in Q1 before rising to 248 in Q2, 233 in Q3 and 235 in Q4. Mid-market deals as a percentage of all deals remained above 85 per cent throughout 2011.ABA DEAL TERMS STUDY — HOW DIFFERENT ARE CANADA AND THE US?
In December 2010, the American Bar Association (ABA) released its study of Canadian private M&A transactions. The study sampled 62 deals where private targets were acquired by reporting issuers. It is interesting to compare some of the results of the Canadian study with a similar study undertaken in 2009 by the ABA in the United States.
One area of significant difference relates to post-closing purchase price adjustment clauses. Such provisions were included in only 50 per cent of Canadian transactions compared to 79 per cent of American transactions. The most common basis for the adjustment in each country was working capital (at 70 per cent), while American deals included more provisions based on debt (at 29 per cent compared to 6 per cent in Canada) and cash (at 19 per cent compared to 6 per cent in Canada) as alternative base adjustments to the purchase price. Our experience is that, contrary to the 50 per cent statistic in the study, most Canadian deals include a purchase price adjustment provision based on some formulation of net working capital. Most buyers appreciate that changes in net working capital can be significant to the economics of a transaction and the amount of net working capital can be easily manipulated. Most sellers want credit if they deliver more working capital to the buyer than had been anticipated.
Another surprising statistic is that the ABA study reports that earn-outs are much more common in the US where they were included in 29 per cent of deals compared to Canada where they were included in only 3 per cent of deals. Again our experience has been that earn-outs have been an important feature in many transactions in Canada over the past few years. There is no question that one of the consequences of the 2008 financial crisis was a widening of the gap between buyers and sellers in the valuation of companies. Earn-outs have become quite common as a means of addressing this valuation gap. There is significant variation in the benchmarks used by parties to determine earn-out amounts, including net income, revenue and operating cash flow, but the use of earn-outs, however structured, has facilitated the finalization of deals that might not otherwise have been made.
The ABA study suggests some variance between the two countries in the general survival of representation and warranties3. In Canada, 18 per cent of deals provided for a survival period of 12 months, 14 per cent of deals, 18 months, 31 per cent of deals, 24 months and 14 per cent of deals, 36 months. This can be contrasted with deals in the US where 20 per cent of deals had a survival period of 12 months, 38 per cent of deals, 18 months and 17 per cent of deals, 24 months. While the length of survival of representations and warranties is partially a function of whether buyers or sellers have more leverage in given market conditions, is it suggested that the general trend in Canada, like the US, has been towards a shortening of the survival period, with a greater percentage of more recent deals having survival periods of 18 months or less.
Another area of significant divergence between Canada and the US suggested by the ABA study relates to the maximum amount of sellers' liability for breaches of representations, warranties and covenants. While maximum liability, or caps, have been trending lower in both countries over the past few years, there is no doubt that sellers have been more successful reducing their liability in the US where in only 22 per cent of deals did the cap exceed 50 per cent of the purchase price. On the other hand in Canada, the study found that in 45 per cent of deals, the cap remains 100 per cent of the purchase price. It is suggested that the US trend toward lower caps will gravitate more and more into Canadian deals over the next few years.MAGNA INTERNATIONAL — HOW MUCH IS TOO MUCH?
A recent high profile Ontario Securities Commission decision concerning disclosure to shareholders illustrates the level of deference Canadian courts and regulatory agencies grant to the outcomes of shareholder votes and serves as a reaffirmation of the business judgment rule in the context of change-of-control transactions.
Magna International Inc. was founded in 1957 by Frank Stronach as a tool and dye shop operated out of his garage, and over the last 44 years has grown into Canada's largest auto-parts manufacturer and one of this country's most successful companies. When it went public, Magna, like a number of other family owned businesses in Canada, was organized with a dual class share structure. The purpose of the structure is to provide the founding family with control while simultaneously allowing the company to tap into the capital markets. Prior to the proposed transaction that became the focus of the Commission's decision, Mr. Stronach, through various entities, held a 66 per cent voting interest in Magna despite owning only a small fraction of the total equity. The broader public, including some of Canada's largest institutional investors, held most of the remaining equity but only one-third of the voting rights through shares listed on the New York and Toronto stock exchanges.
Interested in reorganizing the corporation's capital structure, Magna's management approached Mr. Stronach to explore the idea of eliminating the dual class share structure. Given Mr. Stronach was Magna's controlling shareholder, such a reorganization would constitute a related-party transaction under Canadian securities law, requiring compliance with specific procedures designed to protect the interests of the minority shareholders.
Mr. Stronach and management negotiated a proposed reorganization under which Mr. Stronach's super voting shares would be exchanged for 9 million regular common shares and US$300 million in cash. Magna's board established a special committee of independent directors to evaluate and advise on the reorganization. The special committee, which was chaired by the former Premier of Ontario Mike Harris, retained independent legal and financial advisors.
The special committee recommended that the transaction occur by a plan of arrangement and require a majority vote of the disinterested shareholders. Though this shareholder vote was not required by law, the special committee concluded such a vote would facilitate the required court approval of the plan of arrangement. The financial advisors did not issue a fairness opinion or formal valuation of the super voting shares. The special committee decided not to make a recommendation to shareholders on whether to vote in favour of the proposal.
In its information circular to shareholders, Magna disclosed a list of considerations, factors and information that the special committee considered, but did not discuss the implications of the transaction or disclose significant substantive information provided to the special committee by the independent financial advisors. The material provided to shareholders did disclose that Mr. Stronach was indifferent towards the proposed transaction and would be happy with a continuation of the status quo.
Several financial institutions challenged the transaction before the Commission. These shareholders opposed the transaction due to the high level of shareholder dilution which would result from the reorganization and the amount of the control premium being paid for the super voting shares, estimated to be approximately 1,800 per cent relative to the then market value of the common shares. The level of dilution and quantum of the premium were both well in excess of norms in similar transactions and were referred to as egregious by some commentators.
The Commission concluded that Magna had not provided sufficient disclosure to permit the shareholders to make an informed decision. In particular, the Commission found that since the special committee was unable to make a recommendation to the shareholders, it was essential that the disclosure to shareholders provide them with substantially the same information and analysis as was available to the special committee. The Commission ordered a temporary stay to the shareholder vote pending the dissemination of supplemental disclosure materials.
The Commission's decision to require enhanced disclosure is seen as mandating a new heightened level of disclosure in instances where neither the board nor a special committee of independent directors makes a recommendation as to how shareholders should vote in a change-of-control transaction. At the same time, by giving Magna the opportunity to provide corrective disclosure prior to the shareholder vote, the Commission upheld the primacy of shareholder approval. This decision has also been interpreted as reaffirming the business judgment rule, in which the court or tribunal focuses on the process of a board's decision and not the decision itself. Despite the unusually high level of dilution and the quantum of the control premium, the Commission was not prepared to interfere with the transaction provided a proper process was followed and full disclosure was made to shareholders prior to the vote.
Magna's shareholders ultimately approved the transaction.BUDGET 2011 — ACCELERATED RECOGNITION OF PARTNERSHIP INCOME
Partnerships and limited partnerships are often used to help structure acquisitions in a tax effective manner. The use of partnerships can, with a suitable choice of year end, result in the deferral of income. Eliminating this deferral has the potential to accelerate significant amounts of income, thereby accelerating the payment of tax. The temptation to increase tax revenues by eliminating this deferral has proven too difficult for the Canadian government to resist. The 2011 Canadian Federal Budget proposes complex new rules to accelerate the recognition of partnership income by corporate partners. As a result, a $2.8 billion increase in tax revenue over the next five years is forecast. Aside from accelerating the payment of tax, these rules will be the source of increased cost and administrative inconvenience for the corporations affected. The changes, if enacted, would materially alter the manner in which a corporate investor's partnership income is calculated. The proposed rules are significantly more complex where a stacked partnership structure exists.
Under current income tax rules, partnership income earned by a corporation is included in the income of the corporation for the taxation year in which the fiscal period of the partnership ends. Deferral can arise where the partnership's fiscal period ends after the end of the corporation's tax year. In that case, partnership income earned up to the end of the corporation's tax year is not brought into the corporation's income until the following taxation year.
Under the proposed new measures, partnerships will be permitted to maintain fiscal periods that differ from those of the corporate partners but doing so may result in accelerated taxation. Such accelerated taxation could cause unforeseen administrative burdens and result in the risk of additional income for one or more corporate partners. The proposals in Budget 2011 affect only corporate partners (other than professional corporations) that, together with affiliated and related parties, are entitled to more than 10 per cent of the partnership's income (or assets in the case of wind-up) at the relevant time.
Corporate partners affected by the proposed new rules for taxation years ending after March 22, 2011 would be required to accrue partnership income for the portion of the partnership's fiscal period that falls within the corporation's taxation year (a stub period) resulting in the recognition of partnership income for the stub period.
In the absence of relief, when the rules first apply the result could be the recognition of more than one year of partnership income by a corporate partner. To mitigate the initial impact of accruing stub period income, transitional relief will allow a corporate partner to bring the stub period amount into income over five taxation years. The transitional rules will apply only if certain conditions are met and, in some cases, continue to be met throughout the five year period.
A corporate partner's stub period accrual is determined by formula. Generally, the stub period accrual will be the corporate partner's share of the partnership's income, pro-rated for the period ending at the corporation's taxation year end. Alternatively, a corporation may designate a stub period accrual amount that is lower than the amount determined under the formulaic approach, but, by doing so, will be exposed to the risk of an additional income inclusion (essentially a penalty) if it designates the wrong amount.
To address the administrative inconvenience resulting from these proposed measures, a single-tier partnership may make a one-time tax election to change its fiscal period if certain conditions are met.
If a partnership has one or more partnerships as members, and the partnerships are not required under the existing rules to all have a December 31 fiscal period, the 2011 Budget proposals require that those partnerships adopt a common fiscal period. The partnerships are required, on a one-time basis, to choose a common fiscal period by filing an election in writing. The elected fiscal period must end before March 22, 2012, and must be no more than 12 months in duration. The election must be filed on behalf of the partnerships on or before the earliest of all filing-due dates for the returns of any corporate partner of any of the partnerships for the corporate taxation year in which the new fiscal period ends. If no election is filed, the common fiscal period of the partnerships will end on December 31, 2011, and subsequent fiscal periods will end on December 31.
Modified stub period accrual rules and transitional relief will apply to income earned by each corporate partner in a tiered partnership structure whose taxation year is not aligned with the fiscal period of the partnership.
It will be important in structuring future acquisitions that the new rules relating to partnership income recognition be considered carefully.FOREIGN INVESTMENT REVIEW — IS CANADA BECOMING LESS OPEN?
The Investment Canada Act (Canada) governs reviews of certain investments in Canada. Foreign Investments are reviewable if they exceed a prescribed financial threshold. For an investment by an investor from a World Trade Organization country, the current threshold is $312 million (soon to be increased to $600 million). For the financial services, transportation services, uranium and cultural sectors, the thresholds are substantially lower.
If a transaction is reviewable, the foreign investor must demonstrate that the investment or acquisition is likely to be of "net benefit to Canada". The Act enumerates several factors to be considered, but does not specify how the test is to be applied or what combination of factors must be met.
In April 2008, the Canadian government refused to give its approval to the proposed acquisition of the space technology division of MacDonald, Dettwiler & Associates by Alliant Techsystems Inc., a US arms manufacturer and defence contractor. At the time, the Alliant decision was unprecedented. Every other government review since 1985 had been approved. The decision received considerable publicity and raised concerns about Canada's openness to foreign investment.
Two more recent proposed transactions have further raised concerns about the vagueness of the "net benefit to Canada" test and whether Canada is exhibiting protectionist tendencies. In 2010, BHP Billiton plc made a US$38.6 billion hostile take-over bid for Potash Corporation of Saskatchewan. The Saskatchewan government objected to the proposed transaction, maintaining that Saskatchewan's potash was a "strategic resource" and that the acquisition would not be of net benefit to Canada. In November 2010, the Federal Minister of Industry released an interim decision that BHP Billiton's proposed acquisition did not, based on the plans and undertakings submitted by BHP Billiton, satisfy the "net benefit to Canada" test under the Act. BHP Billiton subsequently abandoned its bid to acquire Potash Corporation. Controversy followed the Minister's interim decision. In particular, critics complained that the review process lacked any sort of transparency or clarity as to how the "net benefit to Canada" test was applied and that the concept of protecting "strategic resources" had become a new basis for rejecting acquisitions by foreign investors. In addition, observers expressed concern that the decision seemed to have become politicized.
Following the BHP Billiton decision, the government announced that the review process would be assessed to ensure there would be greater clarity in how investments were reviewed under the Act; to date no changes or revisions to the process have been implemented.
On February 9, 2011, the TMX Group Inc. and the London Stock Exchange Group plc announced a "merger of equals" transaction. In fact, under the proposed merger, the LSE shareholders would own 55 per cent of the merged enterprise while the TMX shareholders would own 45 per cent. In addition, eight of the 15 board members of the merged entity would be appointed by the LSE. There was immediate reaction to the deal from all sides of the political spectrum, with many, including leading provincial politicians in Ontario and Québec, expressing concerns about the deal and raising the issue of whether the TMX, as the owner of the principal stock exchanges in Canada, should be considered a "national strategic asset". Others stated that any intervention by the government was dangerous and prejudicial to Canada's long term interests in a global economy.
Ultimately, a group of Canadian banks, pension funds and financial services companies formed a consortium called Maple Acquisition, and made an offer to buy the TMX Group, an action some observers described as a nationalistic move to keep the stock exchanges in Canadian hands. When it became clear that the merger would not receive sufficient votes for approval from the TMX shareholders, the deal was terminated.
While a decision under the Act was not rendered in the TMX/LSE merger, some critics suggested that the government's actions in the Alliant and the BHP Billiton situations made it easier for those opposed to the merger of TMX and LSE to play the "foreign takeover of a strategic asset" card to raise sufficient doubt with investors regarding whether the deal would ever be approved.
It must be recognized that potential foreign buyers may view certain Canadian companies more carefully than prior to these recent events. Some transactions will trigger political concerns and foreign investors should develop a very clear strategy for obtaining approval under the Act, taking such sensitivities carefully into consideration. In addition, pending clarification of how "net benefit to Canada" is to be determined, it is likely that the concept of "strategic asset or resource" is now part of the lexicon applicable to the review of foreign acquisitions. Investors understandably would like more clarity, transparency and certainty in the review process under the Act. Nonetheless, in the absence of a review process with such attributes, investors should not lose sight of the fact that virtually all acquisitions of Canadian companies by foreign investors are still approved.
* The authors wish to acknowledge and thank their colleagues at Gowlings, including Nicholas Dietrich, Ash Gupta and Pamela Hojilla for their valuable contributions to this article.
- All financial and statistical information in this section is derived from the Financial Post Crosbie: Mergers & Acquisitions in Canada Reports.
- Unless otherwise indicated, all references in this article to any dollar figure means Canadian dollars.
- The carve-outs to limited survival periods, including fraud, intentional misrepresentation and title to the purchased property, are not dissimilar between the two-countries.