Fairness hearings on trial

Yukon court of appeal shakes up longstanding M&A practice
Exxon Mobil Corp.'s bid to buy InterOil Corp. was stymied by a recent Yukon appellate court decision. REUTERS/Lucas Jackson
Exxon Mobil Corp.'s bid to buy InterOil Corp. was stymied by a recent Yukon appellate court decision. REUTERS/Lucas Jackson

THE LONG-ESTABLISHED PRACTICE of providing shareholders with a single one-line fairness opinion from the company’s own financial advisers on a proposed sale or merger has been challenged by a precedent-setting decision from an unlikely place: the Court of Appeal of Yukon.

It also involves one of the unlikeliest of companies, InterOil Corp., which is incorporated in the Yukon, has assets in Papua New Guinea, headquarters in Singapore, and trades on the New York Stock Exchange. Its shares do not trade in Canada.

Nonetheless, InterOil found itself at the centre of a very Canadian storm when the Yukon appeal court blocked ExxonMobil Corp.’s proposed $2-billion bid this fall, citing a number of red flags.

It pointed to the single fairness opinion, the passivity of InterOil’s committee of directors that was struck to oversee the negotiations, and the fact that negotiations were being led by InterOil’s CEO, who stood to receive about $35 million if the deal went through.

In fact, the potential fallout from InterOil Corporation v. Mulacek is considered so serious that senior practitioners from a small knot of Canada’s top corporate firms have formed an informal working group to consider practice implications, a source told Lexpert.

“It caught people’s attention in a very gripping way,” says Patricia Olasker, a senior partner in M&A at Davies Ward Phillips & Vineberg LLP. “It’s one of those few decisions where almost immediately lawyers start emailing lawyers at other law firms to say: ‘How are you planning to advise your clients?’ It doesn’t often happen where there’s something that strikes so immediately at the core of what is standard practice.”

It doesn’t stop there. The Ontario Securities Commission is looking actively at the decision to assess whether a regulatory response is warranted. And the investment banking community is concerned because the fairness opinion relied on by InterOil and dismissed by Yukon’s appellate court is arguably a Canadian market-standard fairness opinion: paragraphs of disclaimers followed by words to the effect of ‘We find this transaction financially fair.’

“The court said, ‘Not good enough,’ “ says Wendy Berman, a litigator at Cassels Brock & Blackwell LLP, who acted for the successful appellant in the lawsuit, Philippe Mulacek, a founder and former chairman and director of InterOil. “The court is saying if you want to rely on the fairness opinion as evidence of financial fairness for the court, one line doesn’t do it.”

Going forward, she believes Canadian companies that recommend their shareholders support a sale or merger “will arguably have to put the considerations that went into finding the transaction financially fair right into the information circular or elsewhere. Who will bear the responsibility for signing for that information will have to be sorted out between boards of directors and their financial advisors.”

Last summer giant ExxonMobil announced the proposed $2-billion “topping bid” for InterOil, which was considering an offer from another company. Exxon proposed an all-stock deal, offering $45 in Exxon shares for each InterOil share plus a capped contingent payment related to the future revenue stream of the development-stage of the Elk-Antelope gas field in Papua New Guinea, which is InterOil’s main asset.

Roughly 80 per cent of InterOil’s shareholders approved the sale. It should have been a slam dunk but, because it was being done as a plan of arrangement, it required the court’s blessing to close.

A plan of arrangement is a structure that has become hugely popular in Canada because it’s more flexible than a traditional takeover bid, and more favourable for companies that have large numbers of US shareholders because it gets the deal to get out from under the US Securities and Exchange requirements. Final court approval is almost never a problem.

Initially a Yukon Supreme Court judge approved the transaction despite dissent from Mulacek, who held 5.5 per cent of InterOil’s shares. Mulacek argued that InterOil failed to provide sufficient information for shareholders to make a “fully informed decision,” mainly because of lack of disclosure of the potential value of the Elk-Antelope gas field and the financial impact of the cap, especially if the field turned out to be a major find.

Mulacek appealed the lower court’s decision, and was granted a stay and an expedited hearing by the Court of Appeal of Yukon.

In overturning the lower court’s ruling, the Yukon appellate court said that a number of things prevented it from concluding the deal was objectively “fair and reasonable” as required by the Canada Business Corporations Act.

The justices pointed to what they saw as deficiencies in the Morgan Stanley fairness opinion, noting for one thing that Morgan Stanley did not provide any facts or analysis to support it. In fact, Morgan Stanley’s opinion expressly stated that it had “not attributed any specific value to the [capped payments] for purposes of arriving at the conclusion expressed in this letter.”

The justices also noted that the financial advisor was being paid a fee that was contingent on the success of the transaction.

Justice Mary Newbury, who wrote for the panel, criticized InterOil’s failure to retain a second, independent financial advisor on a flat-fee basis.

Sharon Geraghty, an M&A lawyer at Torys LLP, says a single fairness opinion is standard practice on Bay Street and she’s used a second, flat-fee opinion once or twice “at most” in all the deals she’s done in the last five years. Asked why a second, independent opinion is so seldom warranted, Geraghty says it’s unnecessary when boards are rigorously testing their financial advisers’ assumptions and asking the right questions, adding, “don’t forget there’s a very real cost to this. Remember, not all deals are $2-billion deals.”

Big-name investment banks charge $800,000-$1 million for independent opinions on large, complex deals, but the independents and accountants will do it for 25-35 percent of that on smaller deals, several lawyers said.

Geraghty says the concern is that InterOil may lead boards to retain an independent bank for a second opinion even when it’s not worthwhile to do so. “It becomes a kind of check-the-box thing and boards might feel uncomfortable if they don’t have it if it starts to be seen as a necessary element of their governance process.”

In what should be a wake-up call to all board members who sit on special committees formed to oversee negotiations involving a company’s sale, the Yukon appellate court roundly criticized the InterOil special committee, saying it seemed to be “merely receiving reports from management who led the negotiations.” Negotiations were being led by InterOil’s CEO, who stood to gain $2.6 million in termination payments and $32 million in share awards if the deal was completed.

“As we have seen, if the transaction proceeded, the CEO stood to realize significant compensation,” the Yukon appellate court said. “In these circumstances, it was incumbent on the Board to ensure that the arrangement negotiated by management did indeed reflect the fair value of the company.”

Patricia Olasker of Davies says that at the end of the day the decision “poses a threat” to the continuing use of plan of arrangement, that where there is concern there may be opposition, companies “may in fact look more closely at whether an amalgamation might work, where there’s no court component, or whether a more conventional takeover bid structure might be a better alternative.”

In any event, the Yukon ruling turned out to be something of a moot point.

A week before Christmas, ExxonMobil submitted a revised bid. As well as increasing the potential take from the Elk-Antelope gas field, the InterOil’s special directors’ committee retained Fasken Martineau LLP to provide transactional and corporate governance advice, and also engaged BMO Capital Markets to provide a detailed independent fairness opinion on a fixed-fee basis. BMO found the amended arrangement is financially fair to InterOil’s shareholders.

Shareholders will once again have to vote on the transaction; so, while it seems likely given the 80-per-cent support the deal received last time that it will finally be approved after another six months of effort, the question becomes whether its legal and governance legacy is one that will last far longer.