When fairness opinions aren’t fair

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Good business law is predictable business law. Boards of directors should be able to plan their actions around it. Unfortunately, recent decisions on the use of fairness opinions in plans of arrangement have made the law less predictable, and more arbitrary.

A plan of arrangement is a common type of merger made available to companies under the Canadian Business Corporations Act. To complete a plan of arrangement, two-thirds of each class of voting securities must approve of the transaction and a court must then review the plan according to several criteria: for statutory compliance; to evaluate whether the arrangement was put forth in good faith; and to see if the arrangement is fair and reasonable. While court approval is generally a low risk process, it's only a low risk process because solicitors and directors know how to satisfy the court's requirements.

One way to show that a transaction is "fair and reasonable" is for the board to receive a fairness opinion. A fairness opinion is a third party assessment of the proposed deal, and is provided to shareholders before the vote but generally without the detailed financial analyses that the board sees.

Right now, there's a split among Ontario courts as to what fairness opinions should contain. Justice Brown, in Champion Iron Mines, suggested that fairness opinions need to be beefed up to comply with the rules of evidence. He reasoned that fairness opinions need to include actual analysis, and not only assert an opinion.

In Bear Lake Gold Ltd, a decision released last month, Justice Wilton-Siegel disagreed with Justice Brown, stating that a fairness opinion is not a valuation but an opinion regarding the reasonableness of a transaction from a market perspective. Analysis or not, if shareholders do not object to the transaction after they receive the fairness opinion, it's evidence that shareholders think the transaction is fair and that the board has been reasonable. So far, so good.

Bear Lake further asserts, however, that shareholders will be able to assess the merits of a fairness opinion based on the market reaction to the announcement. Justice Wilton-Siegel argues that, "If the market reaction, as reflected in the market price of the shareholders' securities, is negative, there may be a basis for challenging the integrity of the directors' decision making process, including their reliance on the fairness opinion, and perhaps of the good faith nature of the transaction."

In short, Bear Lake suggests that if shareholders express disapproval based on movements in the share price, the board's decision-making process may then come under scrutiny.

This is a problem for two reasons. The first is that what constitutes a "negative" market reaction to a plan of arrangement is both ambiguous and uninformative. If a target company's board announces that the company has entered into a plan of arrangement and the company's share price increases, our first instinct is to call that a positive reaction. A price increase means that the market thinks that there's more value in the transaction, either in the form of a new buyer or a higher price. But, on another level, it can be construed as a negative reaction to the current offer: the price the acquirer is offering is lower than what the market thinks is the highest price for the company. In other words, the market thinks that the offer price is, if not insufficient, not the best price out there.

Similarly, a sell-off in the target's shares could be construed as a negative signal – the market thinks that the transaction has little chance of approval or that the deal terms are so unfavourable that the shares are no longer worth holding. But if the transaction is eventually approved, it could mean that the shareholders came to realize that this was the best price possible for the shares.

Either way, for the transaction to even get to the judge, two-thirds of shareholders must have approved it, suggesting that they've come to agree that the offer price and the market price should be the same.

The ambiguity of a "negative" market reaction is compounded by the fact that none of the factors driving the post-announcement change of the stock price are necessarily related to the "fairness" of the transaction, or the good-faith nature of the board's judgment. Arbitrageurs and others who drive the market price after the announcement of a transaction are interested in whether the price is a good one and whether shareholders are likely to approve a transaction, not whether the directors were fair and reasonable or whether they operated in good faith. This could be a problem if a board that has done everything possible to comply with its duties is confronted with a negative market reaction to the deal price, and with minority shareholder complaints. Dissenting shareholders may complain because a better deal failed to materialize, or because the accepting shareholders came around to the initial offer. Either way, it seems odd that complaints that are driven by movements in the post-announcement price should put a board's process under greater judicial scrutiny.

The second problem is that Bear Lake suggests that a "negative" market reaction, combined with some shareholder disapproval, provides grounds for challenging the board's process itself. In short, two identical processes that have different effects on the market price may be treated differently by courts. This makes it very difficult for boards to be sure they are complying with their duties – the best they can do is follow a good process, get a good fairness opinion, and then cross their fingers in the hope that the market reaction to the deal price will be "positive."

Judicial review comes after the shareholder vote on the plan and is supposed to be a check on the fairness of the board's procedure and a check on the board's business judgment, neither of which is a necessary component of the market price after the transaction is announced. By relying on the market reaction to provide the standard by which a board's process will be evaluated, Bear Lake has injected further uncertainty into a board's process when entering into a plan of arrangement.

Eventually, an appellate court will have to weigh in on just how much analysis a fairness opinion needs to contain. There are compelling arguments for both sides. What is clear, however, is that the fairness and reasonableness of a board's process, and whether a board exercised its obligations in good faith, should not be subjected to greater scrutiny simply because of "negative" movements in the market price.

Courts need to provide predictable legal standards for boards and use their legal judgment to evaluate a board's process. Market reactions should not determine legal standards, judges should.