In the United States, shareholder litigation accompanies the announcement of virtually every deal involving a public company. It is a reality that dealmakers on both sides of the Canada-U.S. border must contend with. While there are fewer cases in Canada, shareholder litigation here is also on the rise. Canadian corporate and securities laws, however, make Canadian litigation different from its U.S. counterpart. This is because Canadian courts will generally defer to the decisions that directors make in change-of-control transactions. However, developments in securities regulation may lead to increased litigation before securities regulators, which have historically been more inclined to intervene in transactions.
The U.S. Experience
What Shareholders Are Fighting About
Shareholder litigation in the United States has exploded in recent years. According to one study, in 2011 litigation was involved in approximately 96% of announced public company transactions, up from 53% in 2007. Shareholder litigation usually takes the form of a putative shareholder class action and typically alleges breaches of fiduciary duty by the target's directors. Many lawsuits assert, for example, that a sale process was run improperly or resulted in deal terms that effectively precluded better offers for the target.
Shareholder litigation in the United States generally has the most traction when it is based on conflicts of interest. In the El Paso Corporation case, for instance, a number of conflicts could have adversely affected the deal price: the target's CEO did not disclose his interest in acquiring part of the target's business after the sale of the company was completed; the target's financial adviser was a significant shareholder of the bidder; and the lead banker for the target had an undisclosed personal investment in the bidder. All of this resulted in what the Delaware court called a deal "tainted by disloyalty."
Conflicts of interest arising from the competing interests of financial advisers can especially provide a strong basis for shareholder litigation, as seen in the Del Monte Foods Company litigation. In that case, conflicting interests of the target's financial advisers led to an injunction delaying a vote on the merger, the softening of dealprotection provisions in the merger agreement and ultimately to a sizable settlement payable to the target's shareholders.
Related party transactions have likewise been a hotbed for shareholder litigation, as was the case in Southern Peru Copper Corp. Here, the court found fault with a special committee whose "focus was on finding a way to get the terms [proposed by the controlling shareholder] to make sense," rather than aggressively testing the rationale for the transaction.
Coping with the Litigation Explosion
Shareholder litigation poses two main challenges for U.S. courts: crafting the appropriate remedy and dealing with the sheer volume of litigation.
As for remedies, the issue for the court is whether to impose a pre-closing remedy, such as an injunction or change to the merger agreement, or to award damages as a post-closing remedy. Delaware courts have traditionally been reluctant to issue injunctions that deprive the target shareholders of the opportunity to decide for themselves whether to accept a premium deal. Decisions such as those in Del Monte and El Paso have gone a step further by denying an injunction while effectively encouraging plaintiffs to seek a post-closing damages award from the purchaser, the investment bankers or other industry participants. Importantly, post-closing damages awards can be considerable. In the Southern Peru decision, for example, the plaintiffs were awarded damages of US$1.347 billion. While the defendant was permitted to satisfy the award by returning shares of the acquiror rather than paying out cash – effectively a book entry transaction since the defendant controlled the plaintiff – the size of the damages award garnered much attention.
The other challenge for U.S. courts is dealing with the volume of transaction-related litigation. In a decision made in early 2012, one Delaware judge noted, "I don't think for a moment that 90 percent – or based on recent numbers, 95 percent of deals are the result of a breach of fiduciary duty. I think that there are market imbalances here and externalities that are being exploited." Other Delaware judges have expressed similar views. Their criticism is based largely on the lack of merit of most cases. The vast majority of cases – over 90% – settle for additional disclosure in the proxy statement, meaning that the only interested parties that end up with a cash payment are the plaintiffs' lawyers.
Attorneys' Fees Being Increasingly Scrutinized
Perhaps it is not surprising, then, that policing fee awards to plaintiffs' attorneys has become a tool that U.S. courts increasingly employ in attempting to right the imbalance. The Compellant Technologies, Inc. decision illustrates the point. In that case, the court used a precise formula to analyze the value of the parties' settlement and determine the plaintiff's attorney's fees. That formula took into account the chance that the settlement (including the revised deal-protection provisions) could have led to a topping bid, the expected value of such bid and the extent to which the plaintiffs could legitimately claim credit for the settlement. Overall, Delaware courts tend to reward substantive changes to deal terms with meaningful fees, whereas disclosure-only settlements appear to attract only modest fees. Whether this trend will ultimately lead to unmeritorious cases being deterred remains to be seen.
The Canadian Experience
A Far Cry from the U.S. Approach
Three aspects of shareholder litigation in Canada distinguish it from the U.S. experience. First, although it is increasing in frequency as a feature of transactions, shareholder litigation is not nearly as endemic as it is in the United States.
Second, shareholder litigation in Canada does not tend to arise mainly from the target directors' fiduciary duties, and it is played out before securities regulators as often as before the courts. Whether this will continue to be the case, with the anticipated shift to proxy fights in a takeover bid context, remains to be seen (for further details, see trend 2, Hostile Bids).
Third, and most important, legal developments have made it difficult in Canada for shareholders or rival bidders to attack the transaction process in court. Decisions of the Supreme Court of Canada have broadened the scope of directors' duties, including in the deal context, by expanding the fiduciary duty beyond that of protecting shareholder interests. More broadly defined duties make the decisions of directors harder to fault. At the same time, the Supreme Court's corporate law jurisprudence has strengthened the protection afforded directors by the business judgment rule, making their decisions much harder to challenge. Attacking transactions in Canadian courts is therefore often an uphill battle. On the other hand, securities regulators have historically been inclined to intervene in transactions, and they also apply a set of securities law principles that, in the deal context, remain focused on protecting shareholder interests.
Canadian Securities Regulators and Courts at Odds
The contrast between the approaches of securities regulators and the courts is apparent in the proceedings involving Lions Gate Entertainment Corp. and an unsolicited takeover bid by Icahn Partners. The British Columbia Securities Commission cease traded a shareholder rights plan, or "poison pill," and applied securities law principles governing defensive tactics that are intended to promote auctions and favour shareholder choice but that are at odds with recent developments in Canadian corporate law. The court, however, refused to intervene to remedy a different defensive tactic – a dilutive conversion of debt into equity in the hands of a party sympathetic to the target. The court found that the directors of Lions Gate were entitled to take steps to obstruct Icahn's offer, and that their business judgment regarding the desirability of that offer was entitled to deference.
The result of these divergent approaches in Canadian deal litigation is uncertainty about what courts and securities regulators are required to do when adjudicating shareholder litigation, and which interests should be paramount and most deserving of protection. Developments in securities regulation may only intensify this uncertainty: regulators have announced initiatives to change the rules that govern related party transactions and defensive measures. Potential changes to the rules for related party transactions would introduce more corporate law requirements in the affected transactions, possibly resulting in increased shareholder litigation before securities regulators that focuses on the conduct of a target's directors. Proposed changes to the defensive measures policy are intended to deflect fights over poison pills from litigation before regulators to shareholders' meetings. (This is discussed in more detail in trend 2, Hostile Bids).
The Rising Spectre of Proxy Fights
One area of shareholder litigation in the courts that is clearly on the rise in Canada involves proxy fights, especially in the transaction context. Proxy fights as mechanisms for provoking transactions or disrupting them are increasingly used by activist shareholders (see trend 3, Shareholder Activism). Litigation in this context challenges the meeting and voting processes. The British Columbia courts have commented on the problem of "empty voting" by an activist shareholder in the context of Telus Corporation's proposal to collapse its dual class share structure. The courts noted concerns regarding the different interests of public shareholders and the activist who opposed the transaction and stood to profit from the failure of the company's proposal. The courts were not prepared to intervene on the basis of empty voting concerns in the Telus case, but on the subsequent application for approval of the plan of arrangement, the court considered "empty voting" in connection with an objection to the transaction. Securities regulators are considering the issue of "empty voting", and the increased use of proxy fights will make meeting-related litigation a more frequent part of Canadian transactions.
More Deal Litigation and More Uncertainty
As described above, M&A litigation by shareholders is widespread in the United States. Recent trends include the courts' close scrutiny of conflicts of interest, the increase in post-closing damages awards and an attempt by some judges to quell the surge of litigation by policing fee awards for the plaintiff's lawyers. In Canada, deal-related litigation is on the rise. The dualistic system in which both courts and securities regulators adjudicate shareholder litigation translates into greater uncertainty for deal participants. We predict that these uncertainties will continue, at least in the near term.
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