Against the backdrop of heightened M&A activity in the financial services, industry practices are evolving to address potential conflicts of interest for the investment banks advising on those transactions.
When a significant transaction is challenged by investors or by potential acquirors before a court or a securities regulator, the advice the company’s board received from its bankers can be a focal point, resulting in criticism or claims based on conflicts of interest or on the scope of the advice given.
In this article, we survey the terrain where financial advisors can be attacked in the context of a contested M&A transaction, and practices which have been developed to mitigate those risks.
Navigating conflicts of interest for investment banks
Litigation risks and conflicts
Conflicts of interest for investment banks rose in prominence following a trio of Delaware cases involving M&A transactions. In these cases, target shareholders sued to enjoin transactions, or for damages, on the basis that the target board received financial advice tainted by its banker’s conflict resulting from having multiple engagements. The theory of the claims was that the conflicted advice resulted in deals that failed to maximize target shareholder value contrary to the Revlon principle under Delaware corporate law. These cases led to reflection on practice in the M&A context, including how to identify and manage potential conflicts of interest and the litigation risks they create.
Where can conflicts arise?
U.S. cases reveal a range of potential conflict scenarios that can affect financial advice:
- a sell-side advisor soliciting potential buyers despite a limited mandate;
- a sell-side advisor holding an interest in the bidder;
- sell-side advisors doing financing work for the buyer;
- underpricing a client’s securities to favour the interests of other clients buying in that transaction;
- sharing confidential non-client information;
- encouraging acquisition overpayment by a client to generate acquisition financing revenue;
- financing a bidder competing with the advisor’s client; and
- advising and funding a hostile bidder.
Canada has not seen cases factually or legally similar to the U.S. cases. However, banker conflicts and multiple role concerns have been considered by courts and securities regulators:
- In one Ontario case, the advisor was disqualified by the court from acting for a hostile bidder where it had previously acted for the target and owed a duty of confidentiality.
- In an Ontario Securities Commission case, multiple roles undertaken by a financial advisor (advisor and target shareholder on a takeover bid) gave rise to the allegation that a bank may be a joint actor with a bidder. The OSC in another case commented on conflicts that may arise as a result of compensation arrangements.
- In InterOil, discussed below, a court declined to approve a transaction on the basis of inadequate disclosure to shareholders regarding financial advice.
Managing the risks posed by conflicts
A financial advisor faces a number of risks arising from unmanaged conflicts: from a Delaware-style claim by target shareholders alleging they were damaged (loss of potential deal value) because the target board approved a transaction based on conflicted advice, to a client claim alleging a breach of the terms of the engagement agreement, or a client complaining that the conflict resulted in the client failing to obtain court approval for an arrangement transaction.
In the U.S., following the Delaware cases, financial advisor conflicts have been addressed through disclosure memos and/or in “board book” fairness presentations. Engagement letters can also include provisions to deal with conflicts. For example, relationships representations and covenants are used to discover potential conflicts and create ongoing disclosure obligations during the course of the engagement, and restricted services covenants restrict the services that the financial advisor may provide to another party to the transaction.
Evolving fairness opinions practices
The InterOil decision
The role and content of fairness opinions and the compensation of bankers attracted attention in Canada in the InterOil contested arrangement litigation.
In 2016, Exxon Mobile’s acquisition of InterOil in exchange for Exxon common shares and a “contingent resource payment” was approved by approximately 80% of InterOil shareholders, with around 10% exercising dissent rights. Opposition included the former CEO, a 5.5% shareholder. The motions court criticized InterOil but approved the arrangement, relying on the 80% shareholder vote and the availability of dissent rights. The Yukon Court of Appeal (comprised of judges from the British Columbia Court of Appeal) reversed the decision, on the basis that the transaction was not fair and reasonable, including because there was insufficient detail in the fairness opinion on the scope of the underlying analysis and the lack of an independent fairness opinion and disclosure of the advisor’s success fee. When an amended version of the transaction came back before the Yukon Supreme Court, it was approved on the basis that the target had obtained a second fairness opinion from an independent advisor entitled only to a fixed fee and that opinion contained detailed financial analysis.
The legal framework for fairness opinions
In Canada, other than mandatory valuations provided in connection with conflicted transactions governed by Multilateral Instrument 61-101 (MI 61-101), fairness opinions are not legally mandated. Their role is to assist the board in fulfilling the directors’ fiduciary duties (i.e., their duty of care). As the OSC said in the Magna case, “[g]enerally, fairness opinions are obtained by directors to assist them in establishing that they acted with due care and diligence in approving a transaction. Fairness opinions are not generally provided for the benefit of shareholders, although they are usually disclosed and shareholders may take some comfort from them”.
The legal framework for fairness opinions comes from securities law, corporate law, statutory instruments and case law. The framework addresses both the disclosure requirements for fairness opinions, including disclosure about the work the advisor did in reaching its conclusion, as well as the way advisors are compensated and disclosure of those arrangements.
The Canadian practice of financial advisors providing a “short-form” fairness opinion without detailed disclosure of the underlying financial analysis supporting the opinion was called into question in the InterOil litigation. In addition, the InterOil decision also questioned the board’s ability to rely on a fairness opinion where the financial advisor providing the opinion received a success fee—and whether the amount of the fee needed to be disclosed to shareholders.
Following the InterOil decision, staff of the Canadian Securities Administrators published its views and expectations on the disclosure of financial advice received by target boards in connection with material conflicted transactions governed by MI 61-101. The staff notice states disclosure with regard to financial advice obtained in connection with such transactions should include:
- the financial advisor’s compensation arrangements (but not the actual sums payable) and the board’s consideration of these arrangements;
- a description of the methodology, information and analysis used by advisors, meeting the standard that allows the shareholder to understand the basis for the opinion without overwhelming with detail; and
- disclosure of the board’s use of financial advisor.
While the staff guidance requires summary disclosure of the underlying financial analysis provided by a financial advisor in material conflicted transactions, it does not mandate a fixed fee fairness opinion nor require fee disclosure of the actual sums payable, putting it at odds with the InterOil decision.
The impact of the court’s criticisms appears to be more significant in British Columbia and Yukon than in the rest of Canada. According to a recent study:
- Boards of target companies in B.C. and the Yukon, in addition to obtaining a success fee based fairness opinion, obtained an fixed-fee fairness opinion in approximately 70% of all transactions that were announced in the 18 months following the InterOil decision, compared to 8.70% in the same period of time preceding InterOil.
- Outside of British Columbia and the Yukon. Boards of target companies who received a success fee based fairness opinion also obtained a fixed-fee fairness opinion in 20% of all transactions announced in the 18 months following the InterOil ruling, compared to 6% in the same period of time preceding the decision.
Short-form fairness opinions (which include a conclusionary fairness opinion without disclosure on the methodologies used or additional financial analysis) continue to be the most prevalent outside of B.C. and the Yukon—they were obtained in approximately 60% of transactions announced since InterOil. In B.C. and the Yukon, approximately 25% of transactions relied on a short-form fairness opinion only.
In approximately 20% of transactions, hybrid short-form/long-form fairness opinions (containing disclosure on the methodologies used but not the underlying financial analysis) were obtained outside of B.C. and the Yukon, compared to 25% in B.C. and the Yukon.
“Long-form” fairness opinions (containing detailed disclosure of the underlying financial analysis) were obtained in 20% of transactions outside of B.C. and the Yukon, compared to almost 50% of transactions in B.C. and the Yukon.