Q3 2018 review: venture capital financing and deal activity decline after record-setting H1

PwC and CB Insights recently released their Q3’18 “MoneyTree Canada report (the Report), which provides an overview of investments in Canadian venture-backed companies. According to the Report, after an exceptional H1’18 (which we’ve covered in an earlier post), Q3’18 has seen a decrease in the number of deals, as well as in dollars invested.

General overview

According to the Report, Canadian venture capital (VC) funding has decreased for the second quarter this year, falling 42% to USD $541M in Q3’18 (from USD $927M in Q2’18). Similarly, despite a record-high of 127 deals in Q2, Canadian companies only completed 87 deals in Q3’18.

Despite these falling numbers, corporate VC investment in Canadian start-ups increased to 39% of all deals in Q3’18, which marks a significant increase from 32% in Q2. This is an area that has seen a lot of growth in recent years, rising from 17% of all deals in Q4’16.

Canadian investors continue to make up the majority of investors across the various funding stages, especially in the seed and later stages, followed by US investors.

Sector trends

Consistent with the past few years, the Internet sector witnessed the highest number of deals and investments, with 42% of all Q3’18 deals in this sector and approximately USD $256M invested across 37 deals. The sector, however, continues to experience a decline in activity for the second straight quarter, falling from 46 deals and USD $357M invested in Q1’18.

The healthcare sector is the second highest sector in terms of deal flow, with 12 deals in Q3’18. While healthcare has experienced a slight increase from 12% of deals completed in Q2’18 to 13% in Q3’18, Canadian healthcare companies only raised USD $45M in Q3’18 – the lowest across seven quarters, falling from USD $341M in Q4’16.

Thematic areas

After a record Q2’18, investments in artificial intelligence companies fell from 14 deals and USD $163M to nine deals and USD $106M in investments in Q3’18. Funding for Canadian Financial Technology (FinTech) companies, on the other hand, is on the rise, hitting a high for 2018 of 12 deals and USD $115M in Q3’18. Interestingly, five out of the 12 FinTech companies funded in Q3’18 are headquartered in British Columbia, demonstrating that the province is a Canadian hub for FinTech.

While the Canadian healthcare sector may be at a low for now, investment in the Canadian digital health space increased 170%, with USD $83M raised in Q3’18, compared to USD $31M in Q2. This is the third-straight quarterly increase in Canadian digital health investments.

Canadian markets

The Toronto market continues to lead, both in terms of the number and size of deals (30 deals, USD $248M raised), followed by Vancouver (21 deals, USD $104M raised), and Montreal (16 deals, USD $95M raised). Both the Toronto and Vancouver markets experienced a significant decline this quarter, with total investments falling from USD $301M in Toronto last quarter, and USD $120M in Vancouver last quarter.

Despite the downward trends in Q3’18, the Report suggests that there is little reason for concern, especially given the high bar set by H1’18. The Canadian VC landscape remains exciting as it continues to evolve, and we will be keenly following the trends in the last quarter of 2018.

The author would like to thank Ahmed Labib, articling student, for his assistance in preparing this legal update.

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Securities laws – you should follow them

Raising money is exciting. Complying with securities legislation, however, is not quite as exciting, but it is necessary. It is a pain, at the best of times, and a constant struggle between lawyers, who would like every investor in your company to fill out a fifty page document detailing exactly how risky the investment is, and their clients, who would like the money now, please.

A big part of my job is seeking exemptions for my smaller clients from having to comply with the requirement to file a prospectus when they are taking in money. A prospectus is about 200 pages and $200,000 in legal fees (that’s not a price quote, to be clear – if you want more details I can put you in touch with one of my colleagues who does more work in this space). Such exemptions can be through accredited investor exemptions, family, friends and business associates exemptions, private issuer exemptions, minimum investment amount exemptions and a few other exemptions that I may be able to tailor to the specifics of your investors. If we can get all of your investors under an exemption from the prospectus requirement, you don’t need a prospectus and everyone is happy.

Usually.

My frame of reference when helping a client with prospectus exemptions is that I have gotten them down from 200 pages to 20 pages. Unfortunately, though very understandably, my securities laws disclosures and certificates to get there often takes their simple share purchase document from 5 pages in their mind to 20 pages when all is said and done. I think I am reducing your paper by 90%. To you, it feels like I am quadrupling it.

And it doesn’t end there. OSC guidance says that you actually need to be reasonably satisfied that your investors fall under the exemption that they say they are under. That means that if your investor, a nurse out in Oakville, fills out the forms by indicating that he is a Schedule 1 Bank under Canadian law, you can’t just drive on and say that’s his problem, not yours. The OSC expects you to take an active role in ascertaining and verifying that your investors know what they are getting themselves into.

The corollary of that expectation is that if you don’t, your company is at risk, and you personally too. Your company can be forced to return the investor’s money, you can be personally liable for certain fines, and you can be barred from trading in securities for as long as ten years.

So, when your company is taking in money from an investor, talk to your lawyer about what sort of documentation you need. We will say we have a streamlined process, but it will still seem like we are making it more difficult. We will say we have this down to a simplified set of documents, but it will still seem like we are creating more paperwork. We get that. At the same time, however, we’re inconveniencing you now so the OSC doesn’t ruin the next several years of your life later, which we think is a good deal at the end of the day.

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Key findings: 2018 SRS Acquiom Buy-Side Representations and Warranties Insurance (RWI) Deal Terms Study

SRS Acquiom recently published its first Buy-Side Representations and Warranties Insurance (RWI) Deal Terms Study. The study analyzed the terms of 588 private-target acquisitions that closed between 2015 and 2017, the majority of which are not required to be publicly disclosed. As Canadian M&A deals continue to use RWI at an increasing pace, insights from firms such as SRS Acquiom offer valuable perspective on popular terms in RWI covered deals. Some of the study’s key findings are outlined below.

Financial terms

  • Escrow. One of the most pronounced effects of RWI coverage is the reduction in the amount of the purchase price to be held in escrow in satisfaction of potential indemnity obligations. In deals that were covered by RWI, the median escrow size is 1% of the purchase price compared to a median escrow size of 10% of other deals.
  • Purchase price adjustment. Deals covered by RWI were very likely (to the tune of nearly 90%) to include a purchase price adjustment mechanism. This is a significant increase over the 71% of other deals that did not contain a purchase price adjustment mechanism. The purchase price adjustment mechanism was most often tied to an explicit working capital adjustment process

Qualifiers and Individual Representations and Warranties

  • Sandbagging. In deals that were covered by buy-side RWI, parties were over twice as likely to agree to anti-sandbagging provisions. Additionally, only 32% of deals contained pro-sandbagging provisions which is a significant reduction compared to 56% of deals that were not reported to be covered.
  • Materiality. While buy-side RWI coverage did not significantly change the how often materiality scrapes were used, it did have an impact on the language of materiality scrapes. In deals that were covered by RWI, materiality was far more likely to be relevant in determining both whether a breach exists and determining damage amounts. There was a corresponding decrease in the use of the materiality qualifier for determining damages only in covered deals.

Loss Mitigation

  • Offset of indemnity. Deals that were covered by RWI were significantly more likely to have an provision expressly prohibiting the offset of indemnity claims against future earnout payments. In any case, approximately 6% of deals with buy-side RWI coverage were silent on this point, compared to 10% of deals where no RWI was reported.
  • Baskets. Deals with buy-side RWI coverage showed a strong preference towards a simple deductible basket with 67% of covered deals having that provision. The popularity of deductible baskets comes at the expense of first dollar baskets which were seen in 22% of covered deals, down from 56% of non-covered deals.

The author would like to thank Daniel Weiss, articling student, for his assistance in preparing this legal update.

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Treaty won, battle lost? Reviewing developments in international tax law

No one would ever suggest international tax law is simple, but with Canada’s impending ratification of the OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the “MLI“), a new layer of complexity has been added when determining whether a taxpayer is eligible to receive a particular treaty benefit. The recent decision in Alta Energy Luxembourg S.a.r.l v The Queen[1](“Alta Energy“) might be a new high-water mark for taxpayers in treaty interpretation, but it may also be their last win.

The decision in Alta Energy considered the application of the Canada-Luxembourg Tax Treaty (the “Luxembourg Treaty“), which along with the Canada-Netherlands Tax Treaty (and a few others), contains a distinctive provision that exempts capital gains on the disposition of shares of companies that derive more than half of their value from immovable property situated in Canada in which the business of the company is carried on.[2] In the context of inbound foreign investment into resource companies, private equity funds and other investors that structure their investments through offshore holding structures in Luxembourg, or the Netherlands, may benefit from the aforementioned exemption (the “Tax Act“).

In Alta Energy, the Tax Court had to determine whether such planning was an abuse of the Luxembourg Treaty. As required under Article 13(4) of the Luxembourg Treaty, in order for the above exemption to apply, it would have to be demonstrated that the immovable property was used in the underlying business. In this case, the Crown first argued that Article 13(4) should be interpreted narrowly and only permit the exemption where a resource license was actively used for exploitation, looking at it on a strict license by license basis.[3] The Court rejected the Crown’s arguments, stating that Article 13(4) was designed to attract foreign direct investment with a view to granting the exemption “in accordance with industry practices”.[4] Secondly, while it was acknowledged that the transaction could be considered an “avoidance transaction” which gave rise to a “tax benefit” for the purposes of s. 245 of the Income Tax Act,[5] the Court stated that previous decisions[6] established that the Luxembourg Treaty contained a narrow anti-avoidance provision based on the concept of beneficial ownership and that a Luxembourg holding company should not be denied the benefits of the Luxembourg Treaty solely because the shareholders are not themselves resident in Luxembourg.

While Alta Energy is a welcome judgment for many cross-borders investors, the next, and perhaps larger question that looms is the impact of the MLI on bilateral tax treaties, specifically in the implementation of treaty shopping provisions.

Simply put, the MLI is a multilateral treaty that operates to modify the terms of existing bilateral treaties.[7] Though there are many variations of how the MLI might affect a treaty, currently, all of Canada’s bilateral treaties modified by the MLI will contain two mandatory provisions: (i) a mandatory preamble (the “Preamble“); and (ii) a substantive principal purpose test (the “PPT“).

The Preamble provides that a particular treaty is intended to operate without creating opportunities to reduce taxation through tax evasion or avoidance, and specifically includes reference to treaty-shopping arrangements. The PPT operates so that regardless of any of the other provisions of a tax treaty (e.g., Article 13(4) of the Luxembourg Treaty) no benefit will be granted if it can be shown that obtaining that benefit was “one of the principal purposes” of any arrangement or transaction that resulted in that benefit. However, the PPT also includes a safe harbour provision where it can be demonstrated that the benefit was received in circumstances that were in accordance with the object and purpose of the relevant provisions.

Interestingly, in the context of Alta Energy, the Court’s interpretation of the object and purpose of Article 13(4) may be viewed as fitting into the PPT’s safe harbour as the Court explicitly stated that it was designed to encourage trade and investment. However, given that the Preamble directly targets treaty-shopping arrangements, it is unclear what the impact of Alta Energy will have on the application of MLI-modified tax treaties go forward.

[1] 2018 TCC 152

[2] Article 13(4) of the Luxembourg Treaty.

[3] Taking the Minister’s view, drilling or extraction activities would actually have to occur on the property covered by that specific resource license.

[4] Alta Energy, at para 68.

[5] The general anti-avoidance provision of the Income Tax Act (Canada).

[6] See Canada v Prevost Car Inc, 2009 FCA 57 and Velcro Canada v The Queen, 2012 TCC 57.

[7] Provided that both of the treaty’s signatory nations elect to have it apply to the particular agreement.

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Managing information technology risk to improve M&A outcomes

An organization’s technology systems are an integral part of its business. Integrated into all aspects of its operations, the possible failure of these systems has been the top concern in Allianz Group’s survey of over 1,900 risk management experts for six straight years. High profile incidents such as the Visa service outage, where a systems error shut down all Visa transactions in the UK and Europe demonstrate that even large, sophisticated companies are at risk.

Given the considerable risk and consequences of technology errors, it is surprising that information technology (IT) systems are often an overlooked element in mergers and acquisitions. Largely inseparable from crucial considerations such as supply chains, the finance department, and data management for everything from payroll to project management, it is not surprising that a study of 141 acquisitions by Fortune 1000 firms found that high levels of IT integration capabilities corresponded to significantly higher performance in both the short and long terms.

Successful IT integration starts early in the M&A process and follows the entire M&A lifecycle. Working with lawyers, consultants, and internal teams, companies considering a transaction should create an M&A IT playbook, a prescriptive guide that documents which tasks are necessary to integrate new IT systems based on the deal parameters. Transactions come in all forms, and the playbook should be adaptable to a variety of situations, providing general guidance and checklists to reduce ad hoc decision-making. The type of target, the deal size, and the complexity of the business architecture must all be considered and accounted for to capture the full value of a deal.

It is critical to involve IT as early as possible during the pre-merger due diligence phase. This allows a greater understanding of the risks and the requirements to complete the deal. By identifying issues early on, parties can identify necessary divestments or carve-outs of IT systems that may be necessary to satisfy regulatory or competition requirements and would otherwise unnecessarily delay the transaction. In one study by Ernst & Young, almost half of the 220 senior executives surveyed said that more detailed IT due diligence could have prevented the deal’s value from eroding. The US National Institute of Standards and Technology’s (NIST) Special Publication 800-39, Managing Information Security Risk is an important tool to use to help create a playbook.

Overall, the key steps are to know your systems, involve IT early on, communicate deal objectives and synergy potential to the IT team, design a migration strategy, and create transitional service agreements to maintain continuity of previous operations. By prioritizing IT concerns early and throughout a transaction, organizations can better succeed in managing the risks associated with crucial IT infrastructure and unlock the full value of the transaction.

The author would like to thank Jamie Parker, articling student, for his assistance in preparing this legal update.

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Tokenizing securities: is it worth it?

Tokenization refers to the process of converting the right to an asset into a digital token, issued, stored, and transferred on a blockchain (the latter of which we’ve covered previously). Many real world assets can be tokenized, including fine art and real property.

Of particular interest in corporate finance is the tokenization of securities, such as bonds, stocks, and derivatives. A crucial feature of security tokens is that they would be issued in full compliance with securities laws and regulations, making them more appealing to institutional investors.

Lower costs, higher liquidity

Private securities are often significantly less liquid than public ones, given the restrictions on secondary trading of private securities, and the often required intermediaries (e.g. brokers). As such, there are numerous costs associated with facilitating such trades, and ensuring their compliance with the law. A significant percentage of such costs are often transferred to the investors, deterring many from investing.

Tokenized securities can be created, issued, traded, cleared, and settled on a digital infrastructure, all with much less assistance from third party intermediaries such as brokers, depositories, clearing houses and transfer agents, decreasing the costs associated with such services. Additionally, blockchain technology can potentially automate some regulatory compliance functions, including verifying an investor’s accredited investor status. Accordingly, tokenized securities can ease the secondary trading of such securities, and reduce the price for investing, thus encouraging more participants to buy and trade and increasing the securities’ liquidity.

Important considerations

Security breaches remain a serious threat for blockchain, especially for smaller private blockchains, with numerous potential ways to ‘cheat the system’.

Additionally, companies issuing security tokens must make the arrangements necessary to ensure that the information stored on the underlying blockchain allows their security tokens to be fully compliant with securities regulations. Moreover, reducing intermediaries shifts many responsibilities to the securities issuers themselves. Traditional roles (and their associated risks) of financial institutions and other intermediaries, such as underwriting the deals, and monitoring security and regulatory compliance, could now shift to the issuer.

Finally, in order to unlock the full potential of security tokens, new and integrated technical and regulatory market infrastructures need to be established. Technologically advanced infrastructures that allow for the regulated creation and trading of security tokens should be developed. Some countries are already moving closer towards creating such an ecosystem. For example, Switzerland’s stock exchange announced in June that it is building a specialized exchange that offers a fully integrated trading, settlement, and custody infrastructure for digital assets. The exchange’s service will be mainly based on Distributed Ledger Technology (blockchain’s underlying technology), fully regulated, and meant to encourage the tokenization of existing securities. Such a specifically tailored, unified, and comprehensive, technological and regulatory system is very promising, and is an exciting development to track.

Conclusion

The considerations discussed above should not be viewed as deterrents, but rather as opportunities. There are, for example, many investment opportunities associated with developing new technology products and solutions to support the creation and exchange of security tokens, or to facilitate their regulatory compliance. Developing a new infrastructure for security tokens also provides regulators with opportunities to address some of the longstanding issues faced in the current financial markets.

While their potential to increase asset liquidity, improve transactional speed and efficiency, and decrease costs, are all inviting, the selling feature of tokenized securities lies in their compliance with securities laws. As such, companies considering tokenization should examine whether they currently have the capacity to set up tokens with the necessary technical infrastructure required to ensure the tokens’ compliance with the laws, and whether doing so would significantly reduce the companies’ costs in the long run. Tokenization in and of itself does not inherently add value, and as such, companies should ensure embarking on the tokenization process suits their individual circumstances.

The author would like to thank Ahmed Labib, articling student, for his assistance in preparing this legal update.

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Ripples of #MeToo in the M&A world: examining the “Weinstein Clause”

A recent report Bloomberg indicates the increasing relevance of buyers staying away from a “#MeToo company” in M&A transactions – i.e., a company facing sexual misconduct allegations. This does not suggest that buyers are staying away. Instead, buyers are developing novel ways of addressing the risk brought upon by a “#MeToo company.”

The first method that has seen increased prominence is by incorporation of a legal representation in the M&A agreement, requiring the target company to reveal allegations of sexual harassment. Known as a “Weinstein Clause” (also referred to as a “#MeToo rep”), this representation, which ultimately hinges on a materiality threshold, usually states that the seller represents that over the course of the previous three and five years (or even further in some cases), no sexual harassment or misconduct claims have been made against the company’s senior employees and/or that the company has not entered into any related settlement agreements, unless otherwise disclosed. In some deals, the buyers have even placed money into escrow, which allows them to claim the fund back if any associated issue emerges in the future.

The first instance of these clauses occurred in March 2018, and the Weinstein Clause has been identified in 15 M&A deals over the past 8 months, across an array of industries. There are two main reasons behind the increased popularity of the Weinstein Clause in M&A transactions. First, the direct economic consequences of these claims can be massive and companies want to avoid the costs associated with defending, litigating and resolving sexual misconduct allegations against senior employees. Second, the #MeToo era has heightened society’s perception of this type of behaviour, which consequently, has amplified the risk of reputational harm that accompanies these claims. In fact, a recent study revealed that a single sexual harassment allegation can diminish the public opinion of an entire organization.

The appearance of the Weinstein Clause in M&A deals signals the recognition of #MeToo issues as a serious business risk with a potential for significant liability. As pointed out by law professor Elizabeth Tippett, though it is not uncommon to include representations and warranties regarding ongoing lawsuits or threats of litigations, mere allegations of harassment have never been addressed. Further, employment-related lawsuits were generally considered immaterial in previous M&A deals. However, with the #MeToo movement, private equity firms are beginning to place a greater emphasis on sexual misconduct claims and are augmenting their traditional financial diligence with more robust inquiries into the target company’s culture, labour issues and social reputation.

Despite its expanded application, implementing the Weinstein Clause in an M&A transaction faces certain challenges. In a recent article, Jena McGregor presented the lack of incident reporting as the greatest challenge and cited a 2018 study by the Society for Human Resources Management, which found that 76% of non-managers who experienced sexual harassment in the workplace did not report it. Second, unlike other representations such as representations on environmental matters, where the regulations prescribe specific fines that provide a measurement of liability, it is difficult to assess — let alone predict — the damages that arise from sexual misconduct claims. Finally, these matters are highly sensitive in nature, which makes it difficult to properly evidence claims within the context of an M&A transaction while maintaining the confidentiality of the parties involved.

While companies start to include the Weinstein Clause in their due diligence toolbox, the Weinstein Clause alone is insufficient to address the heart of the problem: the culture itself. Jaclyn Jaeger recommends that before incorporating this representation within an agreement, the buyer should focus their efforts on human resource and labour issues, which includes reviewing the company’s diversity practices, examining their social media presence and searching court records for any employment claims. This increased scrutiny should serve as notice to target companies — and hopefully to all companies as well — that if they are even considering an exit plan, it is imperative to ensure that harassment and misconduct liabilities and preventative policies are properly documented and managed. Ultimately, however, the onus does not remain entirely with the seller, nor does it terminate upon the closing of a transaction. Post-closing, it is the responsibility of the buyer to develop and fundamentally improve the company’s culture such that the root cause of #MeToo is fully addressed.

The author would like to thank Neil Rosen, articling student, for his assistance in preparing this legal update.

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Vendor take-backs: a useful tool for financing M&A transactions

A vendor take-back (VTB) (or “vendor financing”) is a potential supplementary method of financing an acquisition transaction. It is often documented by a vendor take back note or promissory note. A VTB may be used as a type of non-consideration in conjunction with other forms of financing in order to facilitate an acquisition.

In a VTB financing arrangement, the purchaser satisfies a portion of the purchase price through financing, typically by issuing a note to the vendor. Under this arrangement, the vendor effectively loans a portion of the purchase price to the purchaser. VTBs can be used by parties to a transaction to address any shortfall between the purchase price and available cash flows. In effect, this financing tool results in the buyer purchasing the subject assets of the sale over the course of a period of time, by way of periodic payments to the vendor.

Utility of the vendor take-back

VTB financing arrangements can be excellent tools for purchasers that are unable (or unwilling) to borrow senior financing, or that do not have sufficient assets against which to borrow. These financing arrangements result in vendors continuing to bear some of the risk of the business. VTBs therefore ensure that vendors continue to have skin in the game and a vested interest in support and integration. VTBs are particularly suitable where the vendor does not require immediate access to funds, and has an interest in retaining some control over the transition of the business.

Benefits of vendor take-back financing

VTB financing is flexible tool that can benefit both parties to an acquisition by enhancing the salability of the subject asset of the sale. Some benefits include:

  • Increasing the competitiveness of the sale/auction process by expanding the scope of eligible purchasers;
  • Negotiated interest rate between the parties may translate into higher potential returns during the course of the payback period, especially in a low interest rate environment;
  • Continued involvement of the vendor during the transition period, facilitating the transfer of know-how and expertise and retaining vested interest on the part of the vendor in the purchaser’s continued success;
  • An attractive alternative to financing an acquisition where other forms of debt financing are unavailable, or available at unattractive rates;
  • Avoiding ancillary fees associated with accessing the external debt market;
  • Avoiding need for the purchaser to fund 100% of purchase price at the outset; and
  • Potential tax benefits.

Challenges to vendor take-back financing

VTBs may also present challenges that should be considered and addressed by both sides to the transaction before being entered into as a method of financing, including:

  • The risk that a purchaser may default, in particular since VTB financing will be subordinated to senior debt (to extent that there is senior debt). The negotiated interest rate should adequately compensate for this inherent risk and the payback period should be appropriate;
  • Periodic interest rate payments will effectively increase the purchase price over the long term;
  • Added negotiation points may slow down or complicate the transaction, such as the amount of financing, security, payment terms (and frequency), and the interest rate, among others; and
  • More extensive conditions in favour of the vendor may be included, on account of the ongoing business relationship.

Other practical considerations

Where a purchaser is already financing part of the acquisition from another source, the vendor will, in most cases, need to postpone and subordinate its interest arising from the VTB. This is often achieved pursuant to a subordination agreement or a negotiated intercreditor agreement.

Secured vs. unsecured

VTBs can either be secured against assets of the purchaser or unsecured. In either instance, they will often be subordinated to other forms of third party debt. As a result of this subordination, the VTB will often be subject to a higher risk of default and will generally be compensated with higher interest rates. If the VTB is secured by assets of the business, execution of security documents and lien searches will be required.

Escrow agreements

An escrow agreement may also be entered into by the parties to VTB financing. Entering into an escrow agreement may mitigate some of the risks associated with this method of financing. Escrow agreements generally address the terms governing the holding and distribution of assets in escrow. When an acquisition is partially financed by a VTB, holding shares in escrow for the unpaid purchase price of the underlying business can afford the vendor a measure of protection against potential default.

Conclusion

VTB financing is a useful and important tool in the M&A toolbox. While complicated, and not suitable for every transaction, the flexibility afforded by VTB financing presents innovative alternatives to traditional lending or an attractive option to be used in conjunction with other forms of debt financing.

Speak with a member of our Banking and Finance team for assistance or questions when exploring VTB financing arrangements.

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Holding up the deal: the threat of “bumpitrage” to M&A

Considering the robust global M&A markets of the last few years, it is unsurprising that activist investors have increasingly sought to leverage these transactions for their own gain. To that end, shareholder activists have developed a variety of M&A-related strategies. Most commonly, they either seek to catalyze transactions by pressuring companies into a merger or acquisition, or to scupper deals that would otherwise have gone ahead. Another commonly-used strategy involves agitating for better deal terms. Often referred to as ‘bumpitrage’, the activist investor purchases shares in a company that is subject to a takeover bid, and then rallies other shareholders around the idea that the current bid is insufficient and ought to be renegotiated. In many cases, the mere threat of obstructing shareholder approval is sufficient to motivate a target board to renegotiate the equity terms of the deal.

The rewards of a successful bumpitrage campaign can be significant: research conducted by Activist Insight reveals that between 2013 and 2017, 18 successful campaigns led to an average increase in consideration of approximately 21%. Yet this approach is not without risk. In the majority of cases, bumpitrage campaigns did not meaningfully improve the initial deal terms offered. Occasionally, these campaigns even resulted in worse deal terms.

Advocates of the strategy claim that in the right circumstances, bumpitrage protects shareholders of target companies by ensuring that bidders pay a fair price for their acquisitions. Proponents also claim that successful campaigns may result in target boards negotiating their initial deal terms more aggressively. Conversely, detractors warn that on a systemic level, the practice is likely to have a chilling effect on M&A, as bidders face additional risk when approaching targets.

Regardless of its circumstantial or systemic merits, the number of bumpitrage campaigns will likely increase in the future. In Canada, a strong M&A environment coupled with changes to Canadian takeover bid rules (available here) have created favourable conditions for this strategy. The minimum bid periods set out in NI 62-104 mean that opportunistic shareholders benefit from minimum periods of time during which they can try to convince fellow shareholders of their story. Moreover, in recent years the Canadian market has drawn increased attention from sophisticated US activists who are often better positioned to identify M&A opportunities.

Canadian boards therefore need to understand and plan for both M&A-related activism generally and bumpitrage specifically. Fortunately, company boards can look to a number of tried-and-true defence strategies developed in the context of M&A activism (some of which are outlined here). What underlies these various strategies is the need to sell existing shareholders on the board’s larger vision before, during, and after the announcement of a transaction. When a board facilitates frequent and open discussion with existing shareholders, and is responsive to any concerns raised, activist investors will face an uphill struggle in holding up transactions.

The author would like to thank Felix Moser-Boehm, articling student, for his assistance in preparing this legal update.

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Uncertainty at the root of U.S./Canada oil market fluctuations

Investors are struggling to price market uncertainties, with widely fluctuating market prices in both the United States and Canada. West Texas Intermediate, a U.S. crude benchmark, slid 2.9% during the first week of September, following a jump of more than 7% in August and has remained turbulent ever since. Meanwhile, Canadian energy stocks have failed to see any gains despite crude oil prices maintaining a nearly nine-week high. The discrepancy in the Canadian market and rapid fluctuations in the American market point to investors trying to make sense of recent changes and uncertainties, including:

1. Emerging market decline: The ongoing crisis in Venezuela and U.S. sanctions against Iran have led to oil supply declines. In May, the U.S. pulled out of a 2015 international agreement to curb Iran’s nuclear program and reinstated economic sanctions against the country. While the full force of the sanctions won’t take effect until November, importers of Iranian crude oil have already begun reducing their purchases and Iranian crude production fell sharply in August in response. John Kilduff, managing partner at Again Capital, a New York-based alternative investment management firm specializing in commodities, told the Wall Street Journal, “I do believe the lost Iranian barrels will hit the market and consumers hard.” The lost barrels from these two countries could cause a global supply shortage, pushing oil prices higher, which could then lead to lower oil consumption.

2. Increases in OPEC production: In response to concerns that high prices could hurt demand and global growth for oil, OPEC and partner producers agreed to amend their previous production cutting deal (which cut 2% of the global supply in 2017) and increase production by as much as one million barrels a day. This increase is seen as making a big dent in the shortage caused by U.S. sanctions of Iran, and OPEC producers are hopeful that by moving quickly, they will fill global supply outages and keep the market in balance. While this seems promising, uncertainty about whether OPEC will keep this production up is unlikely to be resolved until the members are able to come to terms on their production and the state of the oil market.

3. U.S. trade tensions: Trade discussions between the U.S. and China have also left the market cautious. In regards to talks between U.S. and China, President Trump posted on Twitter, “we are under no pressure to make a deal with China, they are under pressure to make a deal with us.”

4. The growth of U.S. fracking oil production: The U.S. is on the verge of becoming the leading oil producer in the world, surpassing both Russia and Saudi Arabia, due to the rapid expansion of fracking. Yet, fracking is not currently profitable for many producers due to high production costs and the lack of pipelines and associated infrastructure that would allow fracking producers to export oil from Texas and the Gulf of Mexico (where the largest number of producers are based) to global markets. If the costs remain high and oil prices do not increase, a reduction in supply could follow.

These sources of uncertainty are unlikely to abate quickly – likely causing risks to all parties: investors, producers and refiners as they plan the remainder of 2018.

The author would like to thank Abigail Court, articling student, for her assistance in preparing this legal update.

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