July 13, 2010
After reading Magna's revised proxy circular issued on Friday, July 9, 2010, our view continues to be that the proposed transaction to collapse the company's dual-class voting structure is unfair to subordinate voting shareholders and that the premium to the controlling shareholder is excessive. Moreover, none of the additional disclosure provides any comfort to Class A shareholders that the Magna Board believes that the transaction is in the best interests of the organization.
Similarly, we are concerned that, if successful, the proposed transaction will establish the same dual-class structure for the electric car (E-Car) venture that Magna is trying to eliminate through the current transaction.
For these reasons, Ontario Teachers' Pension Plan intends to vote against the proposed transaction.
As a reminder, there are three parts to Magna's proposed transaction:
- Elimination of the dual-class share structure whereby the Stronach Trust will receive a US$300 million cash payment and 9 million Class A (single voting) shares, with a total financial value of US$863 million in exchange for 726,829 Class B (multiple voting) shares, representing an unprecedented 1,800% premium to eliminate Magna's multiple-voting structure
- Continuation of Mr. Stronach's consulting contract to the end of 2014 (in connection with which Magna has now indicated the estimated fees to be an additional $120 million).
- Establishment of a private joint venture, controlled by Mr. Stronach, for Magna's E-Car business.
The Magna Board is asking the subordinate voting shareholders to decide for themselves whether the proposed transaction is fair and reasonable. The Magna Board will then be asking the Ontario Superior Court of Justice to determine that the Plan of Arrangement is fair and reasonable, something the Special Committee considered a "key procedural safeguard."
The questions we continue to ask ourselves about the proposed transaction follow.
Is it appropriate for Magna to pay an 1,800% premium to eliminate its multiple-voting share structure?
The revised disclosure provided in the July 9, 2010 proxy circular confirms that the Special Committee was advised by its independent financial adviser CIBC World Markets (CIBC) that it is rare for controlling shareholders to receive a premium over the value of the subordinate voting shares when companies eliminate multiple-voting shares. In most relevant cases cited by CIBC, the multiple-voting shares were exchanged for common shares on a one-for-one basis when the dual-voting structure was collapsed.
The revised circular describes the thinking of Magna's management in designing a proposal they thought would be acceptable to Mr. Stronach and, on page 7, lists ten benefits to Magna of eliminating the dual-class share structure. In our view, this is tantamount to Magna's own admission as to why the dual-class share structure and Mr. Stronach's continuing control are contrary to the best interests of the company. Specifically,
- The marketability and liquidity of Magna's equity securities are negatively impacted by the dual-class structure;
- Magna's cost of capital is higher because of the dual-class structure than it would be if the structure were collapsed;
- There are unresolved succession issues at Magna that threaten the preservation of the company's core values and operating philosophies;
- Concern has been expressed as to the alignment of interests of all shareholders; and
- There is uncertainty around the consulting agreements.
In light of this, it is shocking that the Board and management's only approach to addressing these issues was to offer a substantial payment to the Stronach Trust, as holder of the multiple-voting shares, in the hope it would agree to eliminate the multiple-voting shares.
There does not appear to have been any discussion with Mr. Stronach by management or the Board about the dual-class structure being a burden to Magna or that the company and all its shareholders would be better served by the elimination of this structure. Rather, the revised circular reveals that management only dared to raise the matter with Mr. Stronach by coupling it with a substantial payment to the Stronach Trust.
Are the Class B shares worth US$863 million?
Under the terms of the Ontario Securities Commission's order issued June 25, 2010, Magna was required to clearly articulate how it arrived at the consideration to be paid to the Stronach Trust and the potential economic benefits to the shareholders.
The revised circular fails to do so. Our view is that had the dual-class share structure of Magna been eliminated without any payment to the holder of the multiple-voting shares, as CIBC noted has typically been the case in Canada, the benefit to Class A shareholders would have been clearly evident.
Instead, the revised circular describes the challenge faced by Magna management in trying to devise the so-called "win-win" situation where Mr. Stronach would receive a large payment for agreeing to eliminate Magna's dual-class share structure and that would also allow sufficient benefits to the Class A shareholders such that they would agree to it.
The benchmark Magna management adopted as a reference to what would be acceptable to Mr. Stronach was the Russian Machines transaction in 2007.
Based on the explanation of the Russian Machines transaction in the revised circular, it is difficult to draw analogies as to why the current proposed sale of control back to Magna by the Stronach Trust is referable to 9 million Class A subordinate voting shares, let alone to understand how it supports that the Class B shares could be worth US$863 million today. In any event, with what Magna calls "the significant deterioration of the global economy as a whole and the automotive industry in particular" since that transaction, it calls into question whether that transaction is even relevant.
It seems clear from the revised circular that the basis for the determination of the value of the Class B shares was really the estimated value of the trading discount relative to peers, which management hoped would be reduced as a result of the collapse of the dual-class share structure.
Ironically, using the rationale employed by the Magna Board and management, had the trading discount between Magna and its peers been even larger, the company could have offered Mr. Stronach even more for the Class B shares than US$863 million and still have created a "win-win" situation for the Class A shareholders. CIBC had identified corporate governance and multi-voting share concerns and concerns regarding compensation levels and consulting agreements with the Board chair as reasons for the relatively larger discount. It is especially ironic and perhaps perverse that the worse the corporate governance of the organization, the larger the discount borne by non-controlling shareholders and, hence, the greater the payment extractable by the controlling shareholder.
CIBC's presentation reproduced in Appendix B of the revised circular notes that the discount between Magna and its peers is attributable to a number of factors, in addition to those referred to above, including the following:
- Inefficient capital structure;
- Investments in non-automotive operations; and
- Concentration of "big three" automobile manufacturers.
Interestingly, none of these factors is being eliminated under the proposed transaction. There is no information in the revised circular that addresses whether the company's capital structure or these other factors will change going forward. With respect to the consulting contracts, that factor will not be eliminated completely until the expiry of the consulting contracts in 2014. The revised circular does make clear, however, that Mr. Stronach will continue to serve as a director of the company and will have significant influence going forward.
Despite being advised of these various factors by its advisers, Magna and its boards are telling shareholders that a substantial portion of the company's trading discount relative to peers is attributable to the dual-class share structure. If it turns out that this is not the case, and Magna shares continue to trade at a discount to peers over time because these other factors persist, Magna will have made a significant payment to the Stronach Trust and shareholders will have received nothing for it.
For further information, we refer you to our valuation analysis.
Did the Special Committee fail to engage in any meaningful negotiation with the Stronach Trust on behalf of shareholders?
The revised circular shows that the Board and Special Committee failed to engage in any meaningful negotiation with the Stronach Trust. In fact, the additional disclosure confirms that the deal was substantially negotiated between management and Mr. Stronach prior to the involvement of the Board or Special Committee. The final proposal presented to shareholders differed in only minor respects from the proposal brought to the Special Committee by management.
While the Special Committee recognized that the dilution to the Class A shareholders was far beyond any dilution demanded by controlling shareholders in precedent transactions, it appears that lead director Michael Harris chose to not engage in any meaningful negotiation with Mr. Stronach on that point. Instead, the Special Committee settled for the following non-material changes to the arrangement:
- A change to the compensation mechanism in the consulting contracts, which the Board's estimates indicate would actually increase the anticipated cash Mr. Stronach would receive under those contracts; and
- An additional contribution of $20 million in equity to be provided by Mr. Stronach for the E-Car venture - an additional amount equal to less than 2% of the aggregate compensation Mr. Stronach is set to receive.
The revised circular indicates that the Special Committee felt that this was the best deal on the table "at this time".
While we recognize that the Stronach Trust, through Mr. Stronach, is in a position of strength relative to the Board, the supplemental disclosure provides no guidance to the shareholders on how those relative strengths would have been impacted by postponing the negotiations for a period of time, for instance until Mr. Stronach's consulting contracts (the source of his vast annual payments from Magna) had lapsed (December, 31, 2010), or until control of the Stronach Trust had passed into the hands of Mr. Stronach's heirs. While the Stronach Trust's control of Magna may in theory be perpetual, Mr. Stronach's control of the Stronach Trust is not. Without Mr. Stronach's involvement, it is doubtful that either the E-Car venture or the consulting contracts would form part of the transaction.
It is our position that just because the Board felt that a bad deal was the only deal on the table does not mean that the assessment of that bad deal should be thrust on shareholders. If a board cannot say that the deal they reached is in the best interests of the corporation and is fair to shareholders, that deal should not be pursued. While an opportunity to collapse the dual-class share structure may not appear again for some time, the Magna Board must be willing to assess the best interests of the corporation in the long term, not just with respect to anticipated immediate impact on share price.
How is the Court approval process a procedural protection for shareholders when the only evidence of fairness would be the shareholder vote?
The Board has failed to present any objective evidence that the proposed transaction is fair to the shareholders, a failure reflected in their continued refusal to recommend the transaction to shareholders. The revised circular starkly highlights the fact that the only evidence of the fairness of the transaction to the Class A shareholders will be an affirmative vote of those shareholders in favour of the transaction.
In place of a recommendation or objective evidence, the Board continues to present the Court approval process as a source of comfort for shareholders. Yet the Board argues that in making its decision on the fairness of the transaction, the Court should give primary consideration to the result of the shareholder vote. Clearly, this circular reasoning should not provide any comfort whatsoever to shareholders.
The Board argues that the process underlying the shareholder vote is reasonable and appropriate in the circumstances, in part because the shareholders now have all the information required to make an informed decision, and that if this reasonable process results in an affirmative vote then the transaction itself must be fair and reasonable.
While the results of a shareholder vote are generally given significant weight by a Court, the voting results are also generally supported by Board recommendations and independent fairness opinions and/or valuations. In this instance, all are absent and the Court will be left to rely on the shareholder voting results alone.
The Special Committee indicates that a fairness opinion was not obtained because the primary value of the transaction is the potential reduction of the discount in Magna's trading multiple relative to its peers. The Special Committee also acknowledges that fairness opinions generally address the impact on the fundamental value of a corporation and expressly disclaim any view on future trading prices. The Special Committee then maintains that any fairness opinion would have had to opine on possible future trading multiples. This is not the case. A standard fairness opinion, focusing on the fundamental value of Magna could have been produced. However, as the Special Committee acknowledges, such an opinion would have shown that the transaction does not significantly affect the fundamental value of Magna while resulting in significantly greater dilution than any precedent transaction.
Do shareholders have a sufficient understanding of the details of the Electric Car joint venture to make an informed decision as part of this proposed transaction?
The proxy circular proposes that the Stronach Trust would invest US $80 million in the E-Car venture and have a 27% interest. Magna would invest US $220 million for a 73% interest but the company would be controlled by Stronach Trust.
While Magna is arguing in the proposed transaction that eliminating Magna's multiple-voting shares would unlock shareholder value, it is at the same time stipulating that the E-Car business, as a corporation, would have a dual-class voting share structure. This will burden the new venture with the same dual-class share structure and consulting contracts that have had a negative impact on the valuation of Magna in the past. It is difficult to see which governance structure Magna really believes is in the best interest of shareholders and how Class A shareholders will participate in the value generated by the joint venture.
We continue to have the following questions and concerns about the E-Car joint venture;
- The creation of a new dual-class share structure raises concerns that, in the event the venture becomes a publicly traded company, Mr. Stronach will have little incentive to manage the venture appropriately, thereby increasing the venture's trading discount relative to its peers and allowing Mr. Stronach, his heirs or affiliates to extract another 1,800% premium for his shares should he decide to exit that venture.
- The revised circular speaks to other arrangements that were considered for the development of the E-car. What were these structures and why is this specific arrangement with Mr. Stronach the preferred option?
- Other than a general statement about investment risk, the revised circular does not articulate the risks to Magna of entering into the joint venture. We question whether Magna completed a thorough risk assessment on the E-Car business. While it appears that the rewards are substantial, shareholders should be advised of the magnitude of the risks.
- What is the expected financial impact of this transaction on Magna?
- With respect to the joint venture, Magna has mitigated $80 million of investment risk - which represents approximately 67 cents per share of mitigated risk for Magna shareholders after Mr. Stronach has received his 9 million shares. This amount of mitigated risk appears minimal and does not justify the creation of a new dual-class share structure.
- We question whether a joint venture is the best way for Magna to enter the E-Car market. PricewaterhouseCoopers LLP (PwC)'s valuation of the E-Car business, which is appended to the revised circular, summarizes a number of positive trends that would support the potential of the E-Car business. Given the significant upside potential, it would seem logical that the Magna management team is as capable of providing a "focused and strong hand" to guide the new business through its formative stages as is Mr. Stronach.
- Why was the scope of the PwC valuation limited to an estimate of value and not a comprehensive valuation? In their report, PwC indicates that a comprehensive valuation report may have resulted in a different conclusion. Granted, a comprehensive report is more costly and takes longer to complete, but we question why the Special Committee felt rushed in getting this transaction done when it would have been in the company's and shareholders' interest to have the most accurate information available to make an informed decision about the value of the E-Car business.
Why will Mr. Stronach's consulting agreements continue through 2014?
As noted in the proxy circular, the net benefit to Mr. Stronach of renewing the consulting agreements is approximately $120 million. It is not clear why the Special Committee agreed to shorten the consulting contract by half a year, yet pay Mr. Stronach roughly the same amount he would have received over the five-year term ($25 million per year for five years) as was presented in the original proposal. Other than the certainty argument raised in the original proxy circular, there does not appear to be a compelling reason given to continue the consulting contracts and to change the term from one year to four years.
Additionally, the consulting agreement Magna entered into with Mr. Stronach for 2010 describes the services he will provide to the company as including the following:
- Continued involvement in product innovation;
- Securing financial support from governments for research and development related to technologies and systems required in connection with alternative powered vehicles; and
- Efforts relating to the development of new markets, new customers and E-Car.
Through the existing consulting agreements, the company could request that Mr. Stronach focus his efforts on the E-Car venture, giving the venture the "focused and strong hand" he says it needs. It seems redundant that Mr. Stronach would be running the joint venture while being paid to consult to Magna given that the terms of the agreements will not change. It does not appear that the Special Committee gave any thought to the value of the consulting fees, as if they were simply another element of the price of Mr. Stronach agreeing to give up control.
For these reasons, we continue to believe that the proposed transaction is excessive, unprecedented and unfair to shareholders. While we support the elimination of dual-class share structures, we intend to vote against the proposed transaction. We encourage the company to develop a proposal that is fair to all shareholders.
Director, Communications and Media Relations
Ontario Teachers' Pension Plan