The Securities Commission's Decision in The Matter of HudBay Minerals Inc.—Implications for Dilutive Business Combinations in

By Andrea L. Burke, Steven M. Harris and James Bunting

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The Ontario Securities Commission's Decision in The Matter of HudBay Minerals Inc.—Implications for Dilutive Business Combinations in Canada

By Andrea L. Burke, Steven M. Harris and James Bunting Davies Ward Phillips & Vineberg LLP

The Ontario Securities Commission's decision in HudBay has implications for dilutive business combinations in Canada. Market quality and integrity, manifested in the fair treatment of shareholders, may trump deal certainty and may require more than just baseline compliance with corporate laws in certain circumstances.

The ("TSX") is one of the few major stock exchanges that provides a qualified exemption from shareholder approval requirements where a proposed transaction by a listed issuer involves meaningful share dilution. There is no bright-line test in the TSX rules requiring shareholder approval where a specified level of dilution is exceeded in the acquisition of a public company. In contrast, most major stock exchanges, such as the Stock Exchange ("NYSE"), NASDAQ, London and Hong Kong, prohibit listed issuers from issuing additional securities that would exceed a certain prescribed dilution threshold, usually between 20 and 30%, without shareholder approval.

In the recent decision of the Ontario Securities Commission ("OSC") in The Matter of HudBay Minerals Inc., the OSC reviewed and set aside a decision of the TSX not to exercise its discretion to require shareholder approval as a condition of allowing the issuance of shares of HudBay Minerals Inc. ("HudBay") as the purchase price for the acquisition of another public company (Lundin Corporation ("Lundin")).

The issues raised before the OSC were matters of first instance. There are no prior decisions of the OSC that have considered the factors relevant to the exercise of the TSX's discretion to require shareholder approval in such circumstances.

Views differ on the impact of the OSC's decision in HudBay. While the case is certain to be the leading case on how the TSX will apply its discretion in future under the applicable TSX rules, the OSC itself emphasized that its decision simply interpreted and applied an existing provision of the TSX rules and was not intended to rewrite or incorporate new factors into those rules. The OSC also described the circumstances underlying the HudBay matter as "extraordinary". That said, the OSC's decision surprised many M&A practitioners. Given the emphasis placed by the OSC on "quality of the marketplace" which the OSC interpreted to include the fair treatment of shareholders, the decision is certain to be factored into considerations regarding whether to give an acquiror's shareholders a vote in highly dilutive transactions, even where such a vote is not strictly mandated under applicable corporate laws.

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BACKGROUND

HudBay Minerals Inc.

HudBay is a vertically integrated base minerals mining company, incorporated in Canada with its shares listed on the TSX.

Before November 21, 2008, HudBay was well-positioned in spite of the troubled global economy because of its cash reserves of $844 million (representing $5.52 per share), its absence of debt, its world class, productive, profitable mines, its cash flow positive status, and its lack of exposure to high risk jurisdictions. A number of analysts published reports in 2008 describing HudBay as a "potential acquisition target" because of its "large cash position" and other attractive attributes.

As at November 21, 2008, HudBay had 153,000,124 common shares outstanding and a market capitalization of approximately $800 million.

Lundin Mining Corporation

Lundin is an international base metals mining and exploration company, incorporated in Canada with its shares listed on the TSX and the NYSE.

Before November 21, 2008, Lundin was in difficult financial circumstances, with only US$45 million in cash, US$240 million in debt, and limited or no ability to raise additional capital either by way of an equity financing or access to further bank credit. In the nine months ended September 30, 2008, Lundin had suffered net losses of more than $228 million. Approximately $200 million of those losses were suffered in the three months ended September 30, 2008. The "comprehensive losses" of Lundin during the three months ended September 30, 2008 were more than $480 million.

As at November 21, 2008, Lundin had 390,436,279 common shares outstanding and a market capitalization of approximately $394 million, less than 50% of the market capitalization of HudBay on the same date.

Jaguar Financial Corporation

Jaguar is a Canadian merchant bank that invests in a variety of industry sectors and specializes in undervalued small capitalization companies. On November 21, 2008, following the announcement of the Transaction described below, Jaguar purchased approximately 1% of HudBay's outstanding common shares.

The Transaction

On November 21, 2008, HudBay and Lundin announced that they had entered into an agreement (the "Arrangement Agreement") pursuant to which HudBay would acquire all of the outstanding common shares of Lundin, by way of plan of arrangement, on the basis of 0.3919 HudBay shares per Lundin share (the "Transaction").

The imputed price that HudBay agreed to pay was $2.05 per Lundin share, representing a 103% premium to Lundin's closing price the day before the Transaction was announced and a

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32% premium based on the 30-day volume weighted average trading prices on the TSX of the shares of Lundin and HudBay prior to November 21, 2008.

The proposed Transaction was significantly dilutive to HudBay's shareholders. Giving pro forma effect to the Transaction at November 21, 2008, HudBay's shareholders would be diluted by slightly more than 100%. Even though HudBay's market capitalization was twice that of Lundin as of November 21, 2008, Lundin's shareholders would hold 50% of the combined company.

As at September 30, 2008, HudBay had cash of $844 million or $5.52 per share and no long- term debt. On a post-Transaction basis, the combined HudBay-Lundin would have had pro forma net cash of $603 million and long-term debt of US$240 million, or cash of only $1.97 per share.

The Loan Transaction and Subscription Transaction

HudBay and Lundin also entered into a letter agreement (the "Letter Agreement") with respect to a sizeable loan to be made by HudBay to Lundin. HudBay and Lundin agreed to negotiate and enter into a definitive loan agreement pursuant to which HudBay would lend to Lundin approximately $136 million on a subordinated basis to fund Lundin's capital investments and for other general corporate purposes (the "Loan Transaction").

HudBay and Lundin also entered into a subscription agreement (the "Subscription Agreement") pursuant to which HudBay subscribed for and agreed to purchase approximately 97 million Lundin common shares at a price of $1.40 per Lundin share, representing approximately 19.9% of Lundin's common shares after giving pro forma effect to the share issuance (the "Subscription Transaction"). The total gross proceeds to Lundin of this Subscription Transaction matched the amount of the Loan Transaction, and were intended to be used by Lundin to immediately repay HudBay's loan. In this case, the $1.40 subscription price represented a 39% premium to the $1.01 Lundin market price per share on November 20, 2008, the day before the announcement of the Transaction.

On December 11, 2008, HudBay announced that it had abandoned the Loan Transaction but had closed the Subscription Transaction.

No Shareholder Vote

The Transaction was structured as a plan of arrangement of Lundin. Even though the shareholders of HudBay and Lundin would (as a group) each receive roughly half of the shares of the merged company post-Transaction, only Lundin's shareholders were given the opportunity to vote on the Transaction. Under Canadian corporate law there was no requirement to obtain HudBay's shareholders' approval of the Transaction and HudBay's Board determined not to give the HudBay shareholders an opportunity to approve the Transaction.

The Overwhelming Negative Reaction to the Transaction

The market reaction to the Transaction was extremely negative. On the same day that the Transaction was announced, HudBay's shares dropped in value by approximately 40%.

Numerous analysts who follow HudBay also reacted negatively to the proposed Transaction. In particular, analysts noted that Lundin was in a particularly weak financial position at the time it

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entered into the Arrangement Agreement yet, surprisingly, secured a transaction that significantly favours Lundin's shareholders.

HudBay's shareholders were also highly critical of the Transaction. In the wake of the announcement of the Transaction, at least two groups of HudBay's shareholders, including a group holding approximately 16% of HudBay's shares, requisitioned or attempted to requisition shareholders' meetings to replace HudBay's Board of Directors. After rejecting two such requisitions, on December 19, 2008, HudBay's Board announced that SRM Global Master Fund Limited ("SRM") had again requisitioned a shareholders' meeting for the purpose of removing the current Board and electing a slate of directors to be proposed by SRM. On December 30, 2008, HudBay's Board advised in response that it was calling a Special Meeting of the HudBay shareholders to be held on March 31, 2009. This date was well after the scheduled closing date for the Transaction of January 28, 2009.

On January 12, 2009, two HudBay shareholders commenced an oppression application in the Ontario Superior Court of Justice seeking an order directing HudBay to call, hold and conduct a special meeting of shareholders of HudBay to consider and vote on the Transaction.

THE TSX DECISION

Overview of Relevant Provisions of the TSX Manual

An issuer whose shares are listed on the TSX (such as HudBay) is subject to the requirements of the TSX Company Manual (the "TSX Manual").

In the context of the Transaction, the provisions of Part VI of the TSX Manual – "Changes in Capital Structure of Listed Issuers" applied. These provisions require that a listed issuer notify the TSX if it proposes to issue any of its securities (other than unlisted, non-voting, non- participating securities) and that the issuance may not proceed until the TSX has confirmed in writing its acceptance of the notice to issue securities.

Section 611 of the TSX Manual further provides that where the shares to be issued by the listed issuer are being issued in payment of the purchase price for an acquisition, absent an exemption, the issuance of such shares must be approved by the shareholders of the listed issuer if the number of shares issuable exceeds 25% of the outstanding shares of the listed issuer prior to such issuance. A qualified exemption to this approval requirement applies where the shares are being issued as payment for the purchase price of an acquisition of a reporting issuer with in excess of 50 beneficial security holders. This exemption applied in the case of HudBay's acquisition of Lundin. However, this exemption is expressly subject to the general discretionary powers of the TSX to impose conditions on a transaction pursuant to section 603 of the TSX Manual.

Section 603 contains a non-exhaustive list of the various factors the TSX will consider in deciding whether to exercise its discretion to impose conditions (such as requiring shareholder approval) on a share issuance, including: (i) the effect that the transaction may have on the quality of the marketplace; (ii) the involvement of insiders or other related parties of the listed issuer in the transaction; (iii) the material effect on control of the listed issuer; (iv) the listed issuer's corporate governance practices; (v) the listed issuer's disclosure practices; and (vi) the size of the transaction relative to the liquidity of the issuer.

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History of the TSX Decision

On November 26, 2008, counsel for HudBay wrote to the TSX requesting approval of the issuance of HudBay shares to the shareholders of Lundin in connection with the Transaction. This letter constituted HudBay's "notice" to the TSX. The TSX Listed Issuer Services Committee (the "Committee") is the body within the TSX that decides requests for approval to issue shares in this context.

The TSX received separate requests from four HudBay shareholders (including Jaguar) that the TSX require HudBay to obtain the approval of its shareholders in respect of the Transaction.

One of the TSX's Managers of Listed Services provided a brief two-page memorandum dated December 8, 2008 to the Committee in respect of HudBay's request for approval to issue shares which purported to summarize the applicable provisions of the TSX Manual and summarized the essential terms of the transaction as well as representations made to the TSX by counsel for HudBay. This memorandum contained the following recommendation in relation to the TSX's discretion under section 603:

While TSX does have the authority to use its discretion as prescribed under Section 603 of the Company Manual, it is my view that applying such discretion would not be appropriate in this circumstance.

On December 10, 2008, the Committee met to consider HudBay's request for approval to issue shares as payment for the acquisition of Lundin. The Minutes of the Meeting of the Committee (the "TSX Decision") repeated verbatim the memorandum of December 8, 2008, to which was added the following single sentence under the heading "Decision":

The filing committee was in agreement that in this circumstance the rules would not require that the transaction be approved by HudBay shareholders.

THE OSC PROCEEDINGS

On January 6, 2009, Jaguar applied to the OSC for a hearing and review of the TSX's Decision, seeking an Order setting aside the Decision and requiring, as a condition of the TSX's approval of the issuance of HudBay shares, that HudBay call and hold a meeting of its shareholders in order to obtain their approval of the Transaction.

Because the Transaction was scheduled to close on January 28, 2009, the OSC hearing was classic "real time" litigation that successfully proceeded on a highly expedited basis largely due to the cooperation of counsel and the flexibility of the OSC. The hearing took place over two days, on January 19 and 21, 2009, before a panel of three OSC Commissioners. Evidence-in- chief was adduced by way of affidavits, with cross-examinations conducted viva voce at the hearing. The parties were advised as to the hearing dates on January 9 and established a schedule the same day. In the less than ten days prior to the hearing, Lundin and the TSX were added as intervenors, affidavits and extensive written submissions were exchanged by the parties and documentary disclosure was ordered and produced. Given the time constraints, issues of confidentiality were essentially "parked" to be addressed at a later date, with various cross-examinations permitted to proceed in camera.

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The OSC's Decision

On January 23, 2009, the OSC issued a decision (with brief reasons) setting aside the TSX Decision and requiring HudBay to obtain shareholder approval of the Transaction as a pre- condition to the Transaction. On April 28, 2009, the OSC issued its full reasons for decision.

The OSC's decision addressed at length the appropriate standard of review applicable to a decision of a stock exchange. The OSC confirmed that it exercises original, rather than limited appellate jurisdiction, that the hearing and review can be conducted as a trial de novo and that the OSC may, in its discretion, admit new evidence that was not before the stock exchange. The OSC also confirmed that although it will generally show deference to decisions of the TSX, particularly in areas of the TSX's expertise, it may intervene in a TSX decision and substitute its own judgment for that of the TSX where the TSX has proceeded on an incorrect principle, has erred in law, has overlooked material evidence (or new and compelling evidence is presented) or where the OSC's perception of the public interest conflicts with that of the TSX. The OSC also confirmed that it may intervene if a decision was not made fairly. Further, the OSC considered the circumstances in which it will accord deference to a decision of the TSX and confirmed that in order to accord deference it must be satisfied that there is a reasonable basis upon which to do so.

The OSC determined that it could not defer to the TSX Decision as it related to the application of section 603 to the Transaction because the TSX Decision did not permit the OSC to determine the facts and circumstances before the TSX or the factors and considerations that were weighed, nor did it enable the OSC to understand the reasoning the TSX applied in making its decision.

Thus, the OSC proceeded to determine de novo what effect the Transaction might have on the "quality of the marketplace" and whether HudBay shareholder approval should be required, indicating that, notwithstanding the importance of deal certainty, it would require HudBay shareholder approval if it concluded that completion of the Transaction without such approval "could significantly and adversely affect the quality of the marketplace".

The OSC considered all of the relevant facts and circumstances and concluded that the cumulative effect of the following factors was that the quality of the marketplace would be significantly and adversely affected if the Transaction were to proceed without shareholder approval:

(i) Dilution: The significant dilution of HudBay's shareholders (in excess of 100%);

(ii) Economic Impact on Shareholders: The negative economic impact of the Transaction on HudBay's shareholders as reflected by the 40% drop in HudBay's share price immediately following announcement of the Transaction;

(iii) Corporate Governance: The fact that upon completion of the Transaction the Board of the merged entity would be "substantially reconfigured" such that five of the nine directors of the merged entity would be former directors of Lundin;

(iv) Shareholders' Meeting: HudBay's Board's decision to delay for as long as legally possible the calling of the requisitioned HudBay shareholders' meeting to vote on the removal of the HudBay Board and its decision to schedule the requisitioned shareholders' meeting well after the closing date of the Transaction,

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which the OSC characterized as having been made for the purpose of frustrating the legitimate exercise by HudBay's shareholders of their right to require a shareholders' meeting to consider the replacement of HudBay's Board (and, in effect, to vote on the Transaction);

(v) Transformational Impact of the Transaction: The fact that the Transaction would have a "transformational" effect on HudBay and its business, including that it would lead to a significant increase in HudBay's risk profile, exposing it to higher-risk jurisdictions, minority interests in joint ventures, an increase in its long-term debt and would affect cash per share, liquidity and other financial measures; and

(vi) Fair Treatment of Shareholders: The combined effect of the foregoing factors raised serious concerns as to the fair treatment of HudBay's shareholders.

SUBSEQUENT EVENTS

The Transaction was, in fact, never put to HudBay's shareholders for a vote. On February 23, 2009, HudBay announced that it was terminating the Transaction, citing strong feedback from its shareholders indicating that they would vote against the Transaction. On March 10, 2009, HudBay announced the resignation of the CEO of HudBay who had been key in negotiating the Transaction. On March 23, 2009, prior to the requisitioned shareholders' meeting scheduled for March 25, 2009, HudBay's Board of Directors resigned and the nominees of SRM were appointed in their place, thus terminating the proxy battle that had been sparked by the announcement of the Transaction.

PROPOSED AMENDMENT TO THE TSX MANUAL

In 2007, the TSX solicited public comment on whether the TSX Manual should specify a maximum dilution level above which shareholder approval should automatically be required and received widely divergent views. By the time of the OSC hearing in HudBay, no further steps had been taken by the TSX in connection with this proposal.

On April 3, 2009 (and likely because of the HudBay decision), the TSX published a Request for Comments in respect of a proposed amendment to the relevant provisions of the TSX Manual which would eliminate the exemption from the shareholder approval requirement and would establish a bright-line test requiring a listed company to obtain shareholder approval when issuing more than 50% of its shares (on a non-diluted basis) in connection with the acquisition of a public company. The comment period for the TSX's proposal expired on May 4, 2009. As of the date of writing this article, it is not known whether the TSX's proposal (or a modified version of its proposal) will be adopted.

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