Lock-ups, squeeze-outs, and Canadian takeover bid law: a curious interplay of public and private interests.

• Author: Nicholls, Christopher C.

Securities law permits takeover bidders to enter into prebid lock-up agreements with major target shareholders. Lock-up agreements may have a stifling effect on takeover auctions, but allowing them is thought to entice more bidders to make offers in the first place. Locked-up shares may then be counted in the minority approval vote needed to authorize a subsequent going-private transaction. In effect, these transactions override dissenting shareholders' property rights in the broader public interest of facilitating takeover bids.

Examining the decisions in BNY Capital Corp. v. Katotakis, the author considers the interplay between the current securities law practice and the effect of rights of first offer and first refusal in shareholder agreements, which can functionally resemble lock-up agreements. After canvassing the nature of such rights and the general regulatory framework governing takeover bids and going-private transactions, the author considers the Katotakis decisions by the Ontario Securities Commission and in the courts. These decisions provide rare insights into an area that has largely been unexplored by Canadian courts.

Some curious aspects of shareholders' contractual rights and minority shareholders' property interests in the takeover bid context are revealed. The case illustrates, but does not conclusively resolve, the issue of how the courts' and the regulators' divergent views of the relative importance of the public interest in encouraging takeover auctions and the private contractual and property interests of shareholders can affect the outcome of takeover litigation.

Le droit regissant le marche des valeurs mobilieres autorise le vote sur les actions obtenues dans le cadre d'un accord de fermeture en pre enchere dans des operations de fermeture malgre l'effet d'etouffement entourant les operations de fermeture aux encheres. En effet, le droit regissant le marche des valeurs mobilieres outrepasse les interets contractuels des actionnaires ainsi que leurs interets en matiere de propriete dans le bur public de faciliter les operations de fermeture aux encheres.

En se basant sur les decisions, BNY Capital v. Katotakis, l'auteur exanune l'interaction entre ce principe en droit du marche des valeurs mobilieres et les effets concrets des droits de premiere offre et de premier refus dans le cadre d'accords entre actionnaires. Apres une analyse de la nature de ces droits et du cadre de reglementation regissant les offres publiques et les operations de fermeture, l'auteur analyse les decisions rendues par la Commission des Valeurs Mobilieres de l'Ontario ainsi que celles rendues par les tribunaux. Ces decisions offrent des perspectives uniques sur un domaine que les tribunaux canadiens ont laisse inexplore.

L'auteur expose quelques aspects inquietants en matiere de droits contractuels des actionnaires qui font face a une situation d'offre d'achat a mainmise. Cette situation demontre a quel point les actionnaires minoritaires peuvent utiliser leurs droits de premiere offre pour enclencher un achat de mainmise aux encheres malgre l'interet public plus large voulant que ces encheres soient controlees.

Introduction I. Rights of First Offer and First Refusal II. Background to Rules Governing Canadian "Going-Private Transactions" III. Facts in BNY Capital Corp. v. Katotakis IV. The OSC Hearing V. The Court Hearing Conclusion Introduction

Under certain circumstances, small shareholders of Canadian public companies can be forced to sell their shares against their will. The law sometimes overrides a shareholder's private interest to protect a greater public interest. It aims to indirectly benefit minority shareholders in general by encouraging takeover offers. Indeed, even the private interests of larger shareholders are susceptible to unexpected regulatory modifications made in the public interest.

This sort of interplay between shareholders' property and contractual rights, and the broader public interest in the case of publicly traded corporations, has generated few Canadian court decisions. By way of contrast, in Delaware the same interplay has led to an impressive number of high-profile judicial pronouncements on lock-ups, freeze-out mergers, and going-private transactions generally. (1) Nevertheless, one recent Canadian case, BNY Capital Corp. v. Katotakis, (2) addressed these issues squarely. It exposed something curious and unique about Canadian takeover rules when they are applied to parties to a shareholders' agreement containing mutual rights of first offer and first refusal. The case showed how an existing securities regulatory framework can interact in unusual ways with shareholders' contractual commitments. It also highlighted the interplay that occurs in contested Canadian takeover bids between provincial securities regulators and the courts.

The Katotakis case has attracted considerable attention from securities lawyers and indeed, from securities regulators, for the trial judge's very restrictive interpretation of the bid financing requirement mandated by section 96 of the Ontario Securities Act. (3) That aspect of the case will not be discussed here. This comment will instead focus upon its implications for rights of first offer and first refusal contained in parties' shareholder agreements.

To appreciate precisely what Katotakis reveals about these matters, it is worthwhile to first review the concept of rights of first refusal and first offer in shareholder agreements, as well as some of the basic features of a common corporate transaction known as a "going-private transaction".

1. Rights of First Offer and First Refusal

   Two or more major shareholders of a public corporation may choose to enter into a shareholders' agreement that consolidates their effective control over the corporation by governing the way in which they will vote their shares. These agreements may also include share sale restrictions, designed to protect signatories from finding themselves forced to deal with incompatible or inappropriate business partners in the future. Sale restrictions might include rights of first offer or first refusal or both. A right of first offer requires a shareholder who wishes to sell his or her shares to offer those shares to the other parties to the agreement before looking for potential buyers beyond the existing shareholder group. A right of first refusal requires a shareholder who has already received a good faith (i.e., bona fide and noncollusive) offer from a third party to give the other signatories the chance to match that offer before concluding any sale with the third-party offeror.

   When triggered, such restrictions can effectively operate as "lock-up" agreements. A lock-up agreement in the share acquisition context refers to a contract between a prospective takeover bidder and shareholders of the target corporation, pursuant to which the bidder undertakes to launch a takeover bid at a price no lower than an amount specified in the contract. The shareholders in turn agree to tender their shares to the bidder's bid. (4) Once signed, lock-up agreements entered into by major shareholders of target corporations can stifle takeover auctions. (5) In many cases, however, lock-up agreements actually facilitate takeover auctions, since many bidders would not launch takeover bids in the first place without reasonable assurance of the eventual success of their bids. A lock-up agreement provides this assurance.

2. Background to Rules Governing Canadian "Going-Private Transactions"

   The majority shareholder of a Canadian public company may, under certain circumstances, eliminate (or "squeeze out") the minority shareholders against their will. As this process transforms a public company into a private company, it has traditionally been referred to as a "going-private transaction". It is still so called by many corporate statutes, (6) by corporate practitioners, and by the policy statement applicable in Quebec to such transactions, Policy Q-27. (7) For somewhat technical reasons, the Ontario Securities Commission ("OSC") substituted the term "business combination" in place of the term "going private transaction" in recent amendments to the applicable OSC Rule. (8) Terminology aside, these transactions permit the successful bidder to transform the target company into a private company, freeing it from public companies' reporting and other obligations.

   There are two basic methods by which the interests of minority shareholders may be eliminated following a takeover bid. The first, formally known as a "compulsory acquisition" rather than a "going-private transaction", is typically provided for by the incorporating statute of the subject company and can only be accomplished if the bidder has obtained at least ninety per cent of the outstanding shares of the target company. (9) This sort of compulsory acquisition was not at issue in Katotakis.

   Rather, the Katotakis case involved the second method of eliminating minority shareholders' interests, available when a takeover bidder has acquired less than ninety per cent of a public company's outstanding shares. This method can take several transactional forms, including share consolidations (or, as they are often called in the United States, "reverse stock splits"), arrangements, or reorganizations. Among the most common techniques in Canada is the "amalgamation squeeze". In an amalgamation squeeze, the target corporation is amalgamated with a second corporation controlled by the majority shareholder. The terms of the amalgamation provide that the minority shareholders, upon completion of the amalgamation, will not receive participating securities in the amalgamated corporation but instead will be given either cash or, more typically, redeemable preferred shares that will be promptly redeemed for cash. (10)

   Canadian corporate statutes typically require that an amalgamation be approved by a two-thirds vote of the shareholders of each of the...