M&A UPDATE
JUNE 2007
Stub equity structures: a new era in private equity?
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by Stuart Carruthers
Do the “stub equity” components of the recent Harman and
Clear Channel buyouts in the U.S. herald a major change in
North American private equity transactions?
When to disclose merger talks
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by Jeffrey Singer
The Ontario Securities Commission’s AiT proceeding could start a
trend towards earlier public disclosure
Recent Case
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In re Netsmart Technologies, Inc. Shareholders Litigation
Board erred in restricting participation in limited auction to private equity players;
post-signing “window shop” period not adequate to satisfy Revlon duties
in the case of a micro-cap
Stikeman Elliott M&A Group
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An update on M&A Group activity
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“Stub equity” structures:
a new era in private equity?
Stuart Carruthers of Stikeman Elliott’s Toronto office considers whether the “stub equity” components
of the recent Harman and Clear Channel buyouts in the U.S. herald a new era in North American
private equity transactions.
Lee Partners for Clear Channel Communications,
the radio, television and outdoor advertising firm.
The final bid was the bidders’ third offer, the first
two having been rejected by Clear Channel’s board
and resisted by activist hedge funds and other
institutional investors.
In recent weeks, two U.S. buy-out offers made by
KKR/Goldman Sachs and Bain Capital/Thomas H.
Lee Partners, respectively, have contained an
innovative offer structure that may herald a new era
in North American private equity transactions. In
each, the transaction was structured as an all-cash
offer, but with the target shareholders being offered
the chance to take a minority interest in the
acquiring company, and thus an opportunity to
share in any profit on a subsequent sale or IPO of
the target company. Under the terms of the offers,
the current public shareholders could end up
holding as much as 27% and 30%, respectively, of
the new companies. In each case, the share portion
of the transaction is optional and current
shareholders can elect to receive only cash, a
combination of cash and shares, or all shares (with
the share portion pro-rated if over-subscribed). The
new shares will be registered with the SEC, but not
listed for trading on any exchange (although there
has been some speculation that trading may develop
on the “pink sheets” centralized quotation service in
the United States for over-the-counter securities).
The innovative structure, known colloquially as a
“stub” (as in a ticket stub), apparently has not
previously been employed in the United States in the
current buy-out wave, although it has been reported
in the Financial Times that several buy-out groups
had been flirting with the concept for several months.
It represents a concession to public shareholders,
who, in the U.S. market, have recently voiced
concerns about tendering their shares to private
equity groups, only to watch the buyers profit
handsomely upon a sale or IPO of the company
several years, or even months, later. The recent use of
this structure may well convince shareholders to press
for stub provisions in future similar transactions (in
order to help quell criticism that they are currently
leaving “too much cash on the table” in such
transactions), and make private equity firms more
willing to offer stubs. In this respect, stubs may well
serve as a palatable middle-ground for target
shareholders and private equity buyers.
The first transaction was the U.S. $8 billion offer
by KKR and Goldman Sachs for Harman
International Industries, the maker of JBL speakers
and Harman Kardon home theatre systems.
Harman was founded in 1953 by Dr. Sidney
Harman, the now 88-year-old chairman, who will
remain as executive chairman following the
transaction. Interestingly, Harman had previously
been sold by Dr. Harman in 1977 to the Beatrice
Company, under whose ownership it performed
poorly. Dr. Harman bought the company back in
1980 for U.S. $55 million.
However, wider use of stubs is not assured, and
indeed in some respects each transaction can be
viewed as somewhat of an anomaly: in Harman,
given the founder’s historical close association and
involvement with the company and the history of
the prior buyout; and in Clear Channel, in light of
the protracted process (during which the
shareholder vote was postponed four times) and
need to offer a sweetener sufficient to secure
approval of the Board and certain large
shareholders. In addition, Clear Channel is
The second transaction was the protracted U.S.
$19.5 billion bid by Bain Capital and Thomas H.
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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incorporated under the laws of Texas, under which
approval of the transaction is required by
shareholders holding at least two-thirds of all
outstanding shares (in comparison with Delaware
law, for example, which requires only a simple
majority shareholder approval), which gives even
small institutional shareholders an out-sized role in
the bid process. Further, stubs are not without their
drawbacks, as a profitable outcome may never
occur or may take many years to realize, during
which period there could be little liquidity for the
stub equity and little opportunity for the public
shareholders to influence the controlling group.
Only time will tell whether these transactions
become landmarks, with such stub provisions
becoming common or even customary. If stub
equity becomes sufficiently prevalent, it has been
suggested that it may even give rise to “stub equity
funds” existing to invest in stub equity to attempt
to duplicate private equity returns. ■
Stuart Carruthers
scarruthers@stikeman.com
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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When to disclose merger talks
The OSC’s AiT proceeding could start a trend towards earlier public disclosure, notes Stikeman Elliott’s
Jeffrey Singer.
On April 25, 3M advised AiT that it was prepared
to offer $2.88 per fully-diluted common share of
AiT. Later that same day, the AiT board
unanimously passed a resolution recommending
that shareholders accept the offer, subject to the
receipt of a favourable fairness opinion from the
company’s financial advisor and the satisfaction of
the AiT board with respect to certain other terms of
the transaction (including the tax consequences to
shareholders). A letter was then circulated to certain
directors and employees of AiT who were known to
be aware of the proposed transaction with 3M. The
letter stated that the AiT board had approved “the
entry into an agreement in principal” [sic] with 3M
and reminded the employees that it was unlawful to
trade in securities of AiT until the information was
publicly disclosed.
Recent actions by the Ontario Securities
Commission (OSC) in connection with the
acquisition of AiT Advanced Information
Technologies by 3M Canada may lead to tighter
Canadian public M&A disclosure standards. The
unexpected proceedings targeted AiT and two of its
directors (its President/CEO and its legal counsel)
over their alleged failure to make timely disclosure
of the proposed transaction. The company and one
of these directors have settled with the OSC, but the
second director (the company’s legal counsel) has
chosen to defend her actions at a hearing.
Chronology
The chronology of events in the OSC’s statement of
allegations, set out below, is generally consistent
with the agreed statement of facts in the settlement
agreements.
The following day the two companies signed a nonbinding letter of intent relating to the proposed
acquisition. The letter of intent specifically noted
that the proposed transaction was subject to a
number of conditions, including a favourable due
diligence review by 3M, the entering into of
definitive documentation between AiT and 3M,
certain AiT shareholders entering into agreements
with 3M in support of its proposed transaction with
AiT, and the receipt of 3M management committee
and board approval as well as any required third
party consents and approvals.
On January 25, 2002, a committee of the AiT board
accepted management’s recommendation that the
company seek out a strategic buyer or merger
partner. Exploratory discussions ensued in February
with 3M Canada, which confirmed its interest in a
potential acquisition on March 4. On March 12, the
parties entered into a non-disclosure agreement.
On March 27 and 28, representatives of 3M
conducted preliminary due diligence on AiT,
including
receiving
presentations
from
management. In the weeks that followed,
representatives of AiT and 3M had preliminary
discussions related to value. On April 23, 3M
advised AiT that, upon approval by the AiT board,
3M’s interest in pursuing a transaction would be
confirmed in a non-binding letter of intent which
would be subject to a number of conditions,
including exclusivity until May 15, due diligence
and 3M board approval.
On May 9, AiT received a call from Regulation
Services inquiring about unusual trading that had
driven the company’s share price up by 41%. In
response, AiT issued a press release later the same
day, advising that in response to recent trading
activity in its stock, it was “exploring strategic
alternatives that would ultimately enhance value for
our shareholders”. However, the press release did
not mention the proposed 3M transaction.
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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Canadian M&A counsel at a meeting held at the
Toronto office of Stikeman Elliott LLP in February.
The AiT hearing, scheduled for July 9, 2007, will be
watched with interest by Canadian M&A market
participants. ■
On May 22, the AiT board received the favourable
fairness opinion and approved the definitive merger
agreement and related documents. The following
day, AiT and 3M signed the merger agreement and
AiT issued a press release and filed a material
change report.
The transaction was approved by AiT shareholders
on July 15 and completed July 19, 2002.
Jeffrey Singer
jsinger@stikeman.com
The OSC allegations
According to the OSC statement of allegations, the
proposed transaction between AiT and 3M
constituted a “material change” within the meaning
of the Securities Act (Ontario) that should have
been publicly disclosed by April 25 and in any event
not later than May 9. Under the Act, a material
change includes “a change in the business,
operations or capital of the issuer that would
reasonably be expected to have a significant effect
on the market price or value of any of the securities
of the issuer, or a decision to implement such a
change by the board…of the issuer.”
Market reaction
Regardless of how the matter is ultimately resolved,
Canadian public bidders and targets likely will be
treading all the more carefully (and, at times,
perhaps impractically so) in the wake of AiT – both
in relation to the manner in which they approach
material transactions as well as in their approach to
public disclosure thereof.
This trend is already manifesting itself in the
marketplace, with the decision in February by the
board of Algoma Steel Inc. to disclose early-stage
merger talks with Salzgitter AG, which disclosure
was followed by a steep increase in Algoma’s stock
price and the abandonment of the proposed deal.
Tentative merger talks between Wolfden Resources
Inc. and Zinifex Inc. were also recently publicly
disclosed. In that case, Wolfden disclosed the
expected offer price, producing a corresponding
increase the trading price of its shares. Many
purchasers were disappointed when Zinifex came in
with a lower offer after completing its due diligence.
These examples demonstrate some of the dangers of
early disclosure that were raised by leading
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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Recent Case
Board erred in restricting
participation in limited auction to
private equity players
Chancellor Strine described this scattershot
approach as “hardly the stuff of a reliable market
check”. The process that resulted in the decision to
limit auction participants seemed questionable in
light of the fact that the special committee
overseeing the sale process had not taken minutes
at its meetings (although it had created some ex
post facto). The decision was especially suspicious,
the Court noted, when one considered that the
deliberations of the special committee had clearly
been heavily influenced by management, which had
an incentive to prefer a private equity deal that
would keep it in place, likely with lucrative
incentives.
Post-signing “window shop” period not adequate to
satisfy Revlon duties in the case of a micro-cap,
Delaware court rules
In re Netsmart Technologies, Inc. Shareholders
Litigation, 2007 Del. Ch. LEXIS 35 (Delaware
Court of Chancery)
This March 14, 2007 Delaware Court of Chancery
decision arose from an auction process instigated
by Netsmart Technologies, Inc., a NASDAQ-listed
micro-cap medical software company. Vice
Chancellor Strine, the author of the ruling, was
critical of the Netsmart Board’s decision to seek
bids from private equity firms only, ignoring
possible strategic buyers. An important aspect of
the ruling was the Court’s emphasis on the
inadequacy of a “one size fits all” approach to
structuring an auction process. It held that a
process acceptable in a large-cap company context
might not be appropriate for a smaller niche player.
In Netsmart’s case, the Board’s decision to provide
for a post-signing “window-shop” period – in
which strategic buyers or others could theoretically
have come forward – did not satisfy the Board’s
Revlon duty to seek the best price reasonably
available. The Court reasoned that, as a littleknown micro-cap, Netsmart was highly unlikely to
attract a costly last-minute hostile bid.
The Court also found that the Board’s concern that
negotiating with a strategic buyer would inhibit
sales of Netsmart’s product – that is, when
potential customers learned that they might soon
be dealing with another company – to be rather
disingenuous as it had not asked for confidentiality
agreements in the course of any of its previous
overtures to strategic buyers. In addition, unlike the
situation with the two large competitors involved
in the Oracle-PeopleSoft litigation, which the
Board’s counsel had apparently cited as precedent
for its concerns about customer loss, the “rational
customer” of a small niche player like Netsmart
could hardly be unaware that “it and other of its
competitors could be subject to acquisition” by a
larger company – nor had any convincing evidence
been produced that customers would be likely to
abandon the Netsmart product as a result.
The size and nature of Netsmart’s business
necessitated a focused pitch to strategic buyers. The
lesson is that meeting the standard in Revlon
requires the target board to structure the sale
process with a view to the particular circumstances
of the company. Thus, as already noted, the postsigning market check afforded by the “window
shop” clause – allowing the Board to consider but
not seek out higher bids for a period after signing –
was not adequate in these circumstances, even
coupled with the relatively low 3% break fee.
The Court’s Analysis
The Court rejected the argument that the Board
had been in contact with strategic buyers over the
years but, having found little interest (and being
about
confidentiality),
had
concerned
appropriately exercised its discretion in limiting the
auction to private equity firms. The approaches to
strategic buyers had been “erratic, unfocused and
temporally disparate” and had taken place at a
time when Netsmart was a very small start-up. Vice
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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Companies (particularly small cap companies)
undertaking a sale process will need to carefully
consider whether a passive market check is
appropriate, or whether the fiduciary out should be
a “go shop” – allowing active solicitation after
signing – rather than the “no shop” or “window
shop” that might be acceptable for larger and
better-known companies.
Limited Injunction Granted
Although the Board had not met its Revlon duty of
seeking to maximize value once a change of control
is inevitable, the Court declined to grant a broad
injunction against Netsmart’s merger agreement
with the successful private equity firm, preferring to
leave the agreement to a shareholder vote rather than
risk losing the private equity buyer. However, it did
enjoin the transaction from proceeding until the
proxy statement had been amended to include the
projections used by Netsmart’s investment banker in
arriving at the discounted cash flow (DCF) analysis
that had grounded its fairness opinion. ■
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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M&A Group > People News
J. Anthony Penhale and Sophie Lamonde spoke at the Canada-US Law Institute Annual Conference on
“Capitalizing on the Success of Entrepreneurship: Private Sales & IPOs; Tax Aspects; Residual interest of
entrepreneurs after Private Sale or IPO”, Cleveland, April 14, 2007.
William Scott spoke at the session on “Bringing Chinese Companies to Market Abroad: IPOs and Listings in
Canada” at the Inter-Pacific Bar Association’s 17th Annual Meeting and Conference in Beijing, April 20-23, 2007.
Brian Rose spoke at the Canadian Life and Health Insurance Association, Compliance and Consumer Complaints
Section Annual Meeting, Calgary, May 2, 2007.
Marc Barbeau spoke at the case study session “Anatomy of a Recent Canadian Going Private Transaction” at the
conference on Going Private Transactions: How to Avoid Legal Minefields and Serious Execution Risk, Toronto,
May 30, 2007.
William Braithwaite spoke on “Disclosure Obligations in the Context of Going Private” at the conference on
Going Private Transactions: How to Avoid Legal Minefields and Serious Execution Risk, Toronto, May 30, 2007.
Samantha Horn spoke on “Negotiating LP Agreements: Avoiding Disasters with Win-Win Partnerships” at the
conference on Forming and Investing in Private Equity Funds: Savvy Strategies for Increasing Profits and
Outperforming the Competition, Toronto, June 15, 2007.
For further information, please contact your Stikeman Elliott representative.
Alternatively, you can contact the editor, Ken Pogrin (kpogrin@stikeman.com),
or any of the authors listed.
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This publication provides general commentary only and is not intended as legal advice. © Stikeman Elliott LLP
STIKEMAN ELLIOTT LLP: M&A UPDATE, JUNE 2007
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