Anita Anand holds the J.R. Kimber Chair in Investor Protection and Corporate Governance at the University of Toronto and a Fellow-in-Residence at the C.D Howe Institute.
Rare is the precedent-setting securities case that emerges from the Yukon Court of Appeal. The recent attempted arrangement between InterOil Corp. and Exxon Mobile Corp., however, has given rise to such a case. The decision contains a welcome judicial pronouncement on fairness opinions in the context of corporate mergers.
InterOil was set to merge with another corporation before Exxon came forward with a "white knight" offer. InterOil's financial adviser, Morgan Stanley, provided it with a fairness opinion stating that the merger (which was structured as an arrangement) was fair from a financial point of view.
While fairness opinions are common in merger transactions, their purpose may be legitimately questioned. Should they provide shareholders with information about their investment and the transaction under consideration? Or, in the words of the judge at first instance, are they simply "comfort letters" that provide boards with support for their decision to enter into the merger?
Neither the corporate statute nor securities legislation tells us the answers to these questions. The law contains no requirement that corporations obtain a fairness opinion and so it certainly does not mandate the contents of fairness opinions, despite the fact that other disclosure on which shareholders base their investment decisions is heavily regulated.
As the law currently stands, the corporation can accept the methodology of the investment bank retained to provide the fairness opinion. Interestingly, this includes the investment bank's decision "not to attribute value" to an aspect of the consideration to be paid to the shareholders, as Morgan Stanley chose to do with board permission in this transaction.
One of InterOil's shareholders spoke up, claiming that the fairness opinion provided insufficient information for shareholders to make a fully informed decision regarding whether to approve or reject the transaction. The court agreed in the context of its legal analysis regarding whether the arrangement was "fair and reasonable."
The decision not to attribute value in this instance was thus egregious but, given the absence of law regarding fairness opinions, it was egregious in hindsight only.
A second egregious decision rested with InterOil and the contingency fee arrangement with Morgan Stanley. The contingency fee meant that a veritable conflict of interest was at stake: Morgan Stanley was unable to provide an unbiased fairness opinion given that its compensation was contingent on the transaction's success. The Court opposed this conflicted relationship, holding that an opinion provided on an independent (i.e., flat fee) basis was necessary.
Some may argue that this decision is unnecessary and unwelcome; boards are wholly able to address conflicts of interest of this sort in the context of their legal duty to act in the best interests of the corporation. But this is not necessarily true especially in change-of-control transactions where directors and management are conflicted, or at least potentially conflicted. They have very personal interests at stake – these interests include how directors and senior managers themselves will fare if the transaction succeeds. An independent fairness opinion provided on a flat-fee basis is thus crucial.
The lower court's decision suggested that shareholders' approval of the transaction "cleansed" the deal irrespective of questionable governance and weak disclosure. (This result would have been consistent with the Ontario Superior Court's Magna decision.)
But the Court of Appeal poignantly disagreed, finding that the lower court "was required to do more than accept the vote of the majority as a 'proxy' for fairness."
In other words, courts themselves have real work to do in determining whether an arrangement is "fair and reasonable." They cannot abdicate this decision-making to the procedural mechanism of a shareholder vote.
The InterOil case should serve as a catalyst for further action. Regardless of our individual views regarding fairness opinions and contingent versus flat fees, the time for securities regulators to set forth rules – or at least guidelines – regarding fairness opinions is here. The interests of investors and merging corporations alike demand no less.
Securities regulators may assert that arrangements fall under the corporate statute and that, accordingly, they do not have the jurisdiction to set forth rules on the issue.
To sidestep this important debate, at least in the short-term, the call here is more limited: In mergers of public issuers, securities regulators should turn their explicit attention to conflicts of interests in change-of-control transactions involving arm's length parties, including the disclosure upon which investors base their decisions.