The Ontario Securities Commission's Recent Decision in MI Developments Inc. Highlights Related Party Transaction Rules For Public Companies in Canada
For the first time in Canada, a recent Ontario Securities Commission (OSC) decision has cast light on the availability of exemptions from the minority shareholder approval and formal valuation requirements applicable to public companies engaged in related party transactions. The decision also provides important guidance on when complainants may bring enforcement proceedings under the “public interest” provisions of the Securities Act.
MI Developments Inc. (MID) is a real estate operating company publicly traded on the Toronto Stock Exchange and the New York Stock Exchange.
MID held a 54% equity interest and a 96% voting interest in, and thereby controlled, Magna Entertainment Corp. (MEC). MEC owns and operates horse racetracks in North America.
MID is controlled by entities affiliated with Mr. Frank Stronach (the Stronach Group), including, among them, an estate planning vehicle named Fair Enterprise Ltd. (Fair Enterprise). MEC was also controlled by the Stronach Group through MID. Fair Enterprise originally owned approximately 21.5% of the Class A shares of MEC, representing less than 1% of the voting power attached to MEC’s outstanding voting securities.
On November 25, 2008, Fair Enterprise sold its shares in MEC to the Azalea 2008 Trust (the Azalea Trust). In exchange, Fair Enterprise received a non-recourse promissory note from the Azalea Trust.
The following day, on November 26, 2008, MID announced that it had entered into a new loan transaction with MEC and extended existing loans previously advanced to MEC. As well, MID, MEC and the Stronach Group agreed to implement a proposed corporate reorganization of MID and MEC (the November Transactions).
On February 18, 2009, MID announced that it would not proceed with the proposed corporate reorganization for reasons which included the global economic conditions and disruptions in the financial markets.
About two weeks later, on March 5, 2009, MEC made voluntary filings under Chapter 11 of the U.S. Bankruptcy Code. In connection with MEC’s bankruptcy proceedings, MID agreed to provide debtor-in-possession financing to MEC, and to purchase certain MEC assets pursuant to a “stalking horse” bid subject to higher and better offers (the March Transactions).
Several minority shareholders of MID including Greenlight Capital and Farallon Capital Management (the Dissident Shareholders) brought proceedings at the OSC alleging MID had violated Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions (MI 61-101) in undertaking the November Transactions and the March Transactions. The Dissident Shareholders represented approximately 49% of the minority shares of MID.
In particular, the Dissident Shareholders asked the OSC to find that the November Transactions and the March Transactions violated MI 61-101 because formal valuations and minority shareholder approval of the transactions were not obtained and because no exemption was available. Moreover, they sought orders that would, in effect, prohibit MID from relying on any exemption from the requirement to obtain minority shareholder approval under MI 61-101 in connection with any future related party transactions – even if such exemptions were otherwise available. In other words, the Dissident Shareholders sought orders that would have required all prospective related party transactions between MID and MEC to be subject to minority shareholder approval. As a practical matter, this would have had the effect of preventing any such future transactions given the blocking power of the Dissident Shareholders.
The OSC Decision
On December 23, 2009, the OSC released written reasons for its decision made on September 14, 2009 whereby it dismissed the applications brought by the Dissident Shareholders in their entirety.
MID, MEC and Fair Enterprise were all related parties for purposes of MI 61-101. The November Transactions and the March Transactions also fell within the designated types of related party transactions caught by the requirements of MI 61-101.
In general, MI 61-101 is a securities law that regulates related party transactions and affords certain procedural protections to minority shareholders in connection with the implementation of such transactions. Unless exempted, a related party transaction must be approved by at least a simple majority of the votes cast by minority shareholders, and for certain types of related party transactions, unless exempted, an issuer proposing to carry out a related party transaction is required to obtain a formal valuation of the assets involved in a related party transaction from a qualified and independent valuator.
MID relied on several exemptions from these related party transaction rules to carry out the November Transactions and the March Transactions. One of the key exemptions at issue was the “downstream transaction exemption”, which exempts transactions between an issuer (e.g., MID) and a related party of the issuer (e.g., MEC) from the minority shareholder approval and valuation requirements where: (i) the issuer is a control person of the related party; and (ii) to the knowledge of the issuer after reasonable inquiry, no related party of the issuer (e.g., Fair Enterprise) beneficially owns or exercises control or direction over, other than through its interest in the issuer, more than 5% of any class of voting or equity securities of the related party that is party to the transaction (e.g., MEC).
The policy rationale of the downstream transaction exemption is based on the assumption that when an issuer transacts with a related party that it controls, the issuer will act in its own best interests, thereby also benefitting its minority shareholders. Because there are no conflicts of interest at play, there is no need to provide minority shareholders with procedural protections. This underlying assumption may be undermined, however, when a related party of an issuer holds a direct interest in the transacting related party. In this circumstance, the related party may have an economic incentive to exert its control and cause the issuer to enter into a transaction that is unfavourable to the issuer but favourable to the transacting related party. This type of conflict of interest could lead the issuer to ignore its best interests with the result that the transacting related party may obtain benefits (that coincidentally benefit the related party) at the expense of the issuer and its shareholders. Consequently, the minority shareholder approval and valuation requirements continue to apply in these circumstances.
The Dissident Shareholders asked the OSC for orders imposing the minority shareholder approval and valuation requirements on all future related party transactions between MID and MEC because by the time of the hearing in September 2009, it was undisputable that the downstream transaction exemption had become available to MID. By that time, Fair Enterprise had disposed of its MEC shares and no longer owned, controlled or directed those shares. Accordingly, in the absence of the orders sought by the Dissident Shareholders being made, MID was free to transact with MEC on the basis of the downstream transaction exemption.
Following a very technical analysis of the elements of the downstream transaction exemption and a carefully reasoned application of the facts to the provisions of MI 61-101, the OSC concluded that Fair Enterprise did not, as a legal matter, beneficially own or exercise control or direction over the MEC shares after completion of the sale to the Azalea Trust. Accordingly, the exemption was available to MID on that basis. However, rather than resting at the legal conclusion, the OSC went beyond to consider whether Fair Enterprises’ continuing economic interest in the MEC shares (through a promissory note) continued to create a conflict of interest as a matter of substance. In that regard, and consistent with prior decisions of the securities regulators, the OSC reinforced that it would consider the “spirit and intent” of MI 61-101 in addition to the legal wording of the instrument in applying its provisions.
In the end, the availability of the downstream transaction exemption to the November Transactions remained undecided because the OSC found that other exemptions were clearly available and relieved MID from obtaining minority shareholder approval and a formal valuation. Nevertheless, the decision reminds practitioners that the OSC will not interpret securities laws in a purely legalistic manner but will go on to consider the policy and purposes underlying those laws.
The MI Developments decision is noteworthy because it represents the first time the OSC considered the related party transaction rules under MI 61-101. The decision highlights several matters of significance:
- A company may properly structure its affairs so as to make an exemption available or complete a bona fide transaction to qualify for an exemption. The Dissident Shareholders argued that the sale by Fair Enterprise of its MEC shares to the Azalea Trust was an “artificial transaction” and a “sham” designed to circumvent the minority shareholder approval and valuation requirements for related party transactions by making the downstream transaction exemption available to MID the day before the November Transactions were announced. After carefully examining and weighing the evidence before it, the OSC determined that the Azalea Trust Transaction was a bona fide transaction structured in order to permit Fair Enterprise to dispose of its MEC shares and the objective of which was to align the interests of the Stronach Group with the interests of the other shareholders of MID. The OSC stated, “[t]here is nothing inappropriate in a person organizing its affairs or completing a bona fide transaction in order to qualify for the [downstream transaction exemption]”.
Process matters. The OSC noted that all the business decisions to enter into the challenged related party transactions were reviewed and recommended by a special committee of disinterested directors and approved by the board of directors of MID, and there was no evidence to suggest that the directors of MID did not act appropriately and in compliance with their fiduciary duties.
The OSC has consistently recognised that a rigorous board and special committee process is a relevant consideration in deciding whether to exercise its public interest jurisdiction. Accordingly, corporate actions involving related parties that engage MI 61-101 should be taken only after having followed a proper process. To this end, boards must be able to demonstrate that they have acted in good faith, without conflicts of interest, in an informed manner after having received relevant expert advice, and that their decisions lie within a range of reasonable alternatives. In other words, regardless of whether the OSC explicitly defers to the business judgment of directors or applies a fiduciary duty analysis to directors’ decisions, the OSC will in any event closely examine the process undertaken by a board in arriving at its decisions.
- Crisis-driven transactions may be afforded greater deference. Consistent with other recent decisions of the securities regulators, the OSC considered the financially distressed condition of MEC at the time of the challenged related party transactions in applying the provisions of MI 61-101 and in deciding whether to exercise its public interest jurisdiction. Although the MI Developments decision was not ultimately based on the fact that MEC was either on the verge of insolvency or in bankruptcy at the relevant times, those were relevant considerations and further demonstrate that crisis-driven transactions will be decided on a highly contextual basis.
- Private party complainants cannot bring applications for the purpose of imposing sanctions in respect of past breaches of securities law as a matter of right. Section 127 of the Securities Act (Ontario) sets out the types of “public interest” orders that may be made by the OSC. That public interest power is generally applied to regulatory and enforcement matters and these applications are typically brought by OSC Staff.
The Dissident Shareholders brought applications under section 127 because of the wide powers available in that section to grant the orders sought (i.e., the denial of exemptions from the related party transaction rules for future transactions between MID and MEC on the basis of alleged past violations of MI 61-101). The OSC decided that, “persons other than Staff are not entitled as of right to bring an application under section 127 where the application is, at its core, for the purpose of imposing sanctions in respect of past breaches of the Act or past conduct alleged to be contrary to the public interest ... those purposes are regulatory in nature and enforcement related and such applications should be able to be brought as of right only by Staff. Section 127 should not be used merely to remedy misconduct alleged to have caused harm or damage to private persons”.
However, the OSC determined that it has discretion to permit persons other than OSC Staff to bring applications under section 127. The Dissident Shareholders were permitted to bring their applications under section 127 because: (i) the applications involved past and possible future related party transactions regulated under MI 61-101; (ii) the applications were not purely enforcement in nature; (iii) the relief sought was future looking in that it was intended to prevent the completion of proposed related party transactions and other possible future transactions without minority shareholder approval; (iv) the OSC determined that it appeared to have the authority to impose an appropriate remedy; (v) the Dissident Shareholders, as substantial MID shareholders, were directly affected by the past conduct of MID and would be directly affected by future related party transactions; and (vi) the OSC was satisfied that it was in the public interest in the circumstances to hear the applications.
Osler acted for Magna Entertainment in these proceedings and in connection with its proposed restructuring transactions with MI Developments.