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Dare we say the ‘R’ word

Cover Story
|Written By Helen Burnett
Dare we say the ‘R’ word

Unpredictable, uncertain, busy for some — but definitely different. This is how some lawyers candidly describe the year ahead for areas of Canadian business law in 2008 following the “credit crunch” that hit the United States last August, recent market turmoil, and the constant reports of an emerging economic slowdown, dare we even say “recession.”

News of credit drying up, resulting in fewer large deals involving private equity groups, coupled with tough markets and lowered investor sentiment for some sectors, could ultimately mean slowdowns for lawyers in certain areas of practice and dramatic upswings for others. While exactly how the economic picture is likely to pan out this year remains unclear, lawyers across the Canadian business world tell Canadian Lawyer they are preparing for a shift in the type of work they have been seeing in recent times.

M&A, corporate finance, and securities law
Thanks in part to work that continues to flow down the pipeline from last year’s huge transactions (like the BCE deal),  M&A practices at Bay Street firms such as Torys LLP remain busy, says Sharon Geraghty, co-head of the firm’s M&A practice group. But while the level of activity continues, Geraghty and other lawyers in this area are noticing a significant change in the type of players dominating the M&A market, noting that a recession south of the border would eventually affect law firms.

Fuelled by easy access to credit — in Canada but more so in the United States — M&A was still booming through the first half of last year, says Simon Romano, a partner in the Toronto office of Stikeman Elliott LLP. In terms of the bigger transactions, Canadian, U.S., and international private equity players could access attractive debt, which helped them to win pricing. But the economic slowdown and credit crunch resulted in this phenomenon beginning to teeter in June and finally crash later in the year, Romano says, and the debt markets are now basically closed. This doesn’t mean it’s the end for M&A, but now that prices have come down, it will be the strategic buyers who will become more active. “We’ll just have a transition almost back to where it used to be, where there’s a healthier mix between financial buyers and strategic buyers . . . and a lot less use of leverage — at least high levels of leverage — in these transactions,” says Romano.

Geraghty agrees that the credit crunch has led to a shift of balance in the M&A market in favour of strategic players and foreign buyers that don’t need the same type of leveraged financing private equity funds need. As a result of the shift, lawyers are also seeing more caution in the M&A market this year, and processes are taking longer. “[There was] a period there where people were moving very, very quickly and getting very excited about transactions and running to deadlines that were quite tight,” says Geraghty. Buyers were prepared to take a lot of risk to get a deal.

Romano says he thinks mid-market M&A will be alright, as it is the big deals that require lots of debt in order to function. “In what we do, the private equity players are still out there in the mid-market the way they always were in purchases of divisions in private deals. But in the public deals we’re involved in, the auction transactions . . . private equity is playing much less of a role and, you know, even in some cases, not being invited to the party,” adds Geraghty.

Many clients are also looking to take advantage of distressed-type opportunities. “We have a lot of institutional clients who are acquisitive and . . . they actually see this situation in the market as an opportunity, so they’re looking at a lot of things,” says Geraghty. “In the strategic arena, our strategic-acquisitive clients, it’s business as usual or better. With the currency changes and the fact that private equity has sort of diminished in power in the public market, and businesses are under pressure, there are lots of buying opportunities for them. So it’s a shift in the type of work, but still I see this year ahead for us still being very, very busy in the M&A area — just a different mix.”

Romano notes: “It’ll be a different year; it’ll be the strategic and industry players coming back into the fore. It’s uncertain and choppy, though, right now.” However, Geraghty cautions, “we are ultimately all victims of a recession in the U.S. and eventually it hits the law firms.”

As mergers and acquisitions diminish, restructuring and insolvency grows, and in Geraghty’s practice — which she notes is fairly common on Bay Street — a lot of M&A practitioners end up getting involved in those types of deals, as they are effectively large-scale M&A deals.

In terms of capital markets transactions and corporate finance, things were quite hot from late 2003 until last July, says Gordon Chambers, head of the corporate finance and securities group at Lawson Lundell LLP in Vancouver, who notes that a large part of his practice is related to the mining industry. Lawyers involved in the mining sector have since seen a marked shift in activity from equity capital-markets work to M&A. The sector remains strong, says Chambers, and companies are affected much more by global commodity markets and local economic events where they are based around the world.

There is a “dramatic shift from companies just doing prospectus offerings to M&A,” says Chambers, which he thinks will continue throughout the year and will keep lawyers just as busy as corporate-finance work — so much so that the practice is considering adding additional capacity but is having a tough time finding the lawyers. “I’m optimistic about how busy we’re going to be this year,” he says.

Romano agrees the corporate-finance sector is slow at the moment, continuing to suffer from the fall off of the income-trust sector, which was driving intense amounts of activity in 2006. Coupled with the general negative environment for equities, Romano says he thinks it will be a difficult market in which to raise equity and debt. Commodities are still the one bright spot, he says, but it is a tough market.

It’s hard to tell whether this will pick back up by the end of the year, he says, as the public has to get comfortable.  That’s  not really happening as everyone is still uncertain due to day-to-day market swings.

In the west, the high costs of doing business at the moment, along with the low price of natural gas, have resulted in many Albertan junior to intermediate oil and natural gas producers falling out of favour with investors, says Kent Kufeldt, a partner with Macleod Dixon LLP in Calgary. Equity financings, in particular for the smaller producers, are going to be few and far between, he says, as it seems like investor sentiment is not focused on the oil and gas business at the moment.

Recent uncertainty in Alberta over the revised royalty regime, coupled with investor sentiment, could mean companies are not proceeding as fast with their capital expenditures and may find themselves squeezed between a low commodity price, no access to capital, and rising royalty and other costs, he says. This could likely force some smaller companies into an M&A type situation, he says. “I can expect far less activity on the financing front and more activity on the M&A front here as we move through the first part of 2008.”

As a result, for law firms there will be an adjustment in workloads due to busy spots and slower spots, because of the nature of a transactional-based atmosphere that will be in place for the next while, says Kufeldt. “I don’t think that . . . for law firms it’s going to be a precipitous drop off, but there will be slower periods than there have been in the last number of years.”

At the same time, he notes, insolvency and restructuring lawyers have a lot more work to do now than they had over the last five years. On the securities side, a slowdown or a choppy market, and then on the litigation/insolvency side, I think, the corresponding pickup as troubled companies require assistance,” he says.

Bankruptcy & restructuring
In Atlantic Canada, while the insolvency market has generally been quiet, John McFarlane, a partner with Stewart McKelvey in Halifax, is anticipating things to pick up this year, although the extent is difficult to foresee.

Justin Fogarty, a partner in the Toronto office of Bennett Jones LLP, is expecting bankruptcy and restructuring practices to be very busy in the second and third quarters of the year because of liquidity problems coupled with the high Canadian dollar and the impact of the slowdown in the U.S. economy.

Although there was a lot of liquidity in the marketplace at the start of 2007, says Fogarty, and a lot of funds chasing too few deals — which were done with a fair amount of credit risk — it has dried up with the arrival of the credit crisis. “There are companies that were able to — through an M&A deal — get themselves out of trouble,” he says, or companies that were able to get equity or financing even though performance was not that great when there was a lot of liquidity in the marketplace. However, at the moment, if there is a shift in sales or performance and a shift in the dollar companies that were able to take advantage of a competitive situation are not there.

His concern is for mid-market companies, rather than for the bigger Canadian operations that have already adjusted. “China has had an effect on Canadian business for some time . . . the Canadian economy has made adjustments for that already, but the U.S. economy will weaken demand for some of our products,” he says.

Banking & finance
While the industry is not expected to see the same number of large, leveraged deals as last year, there is still lots of demand for the services of banking and finance lawyers, because there are still acquisitions going on in the mid-market, says Jean Anderson, a partner with Goodmans LLP in Toronto. The terms on which lenders are prepared to lend have changed dramatically in the last year, as “the pricing has increased; the amount of leverage that a lender will tolerate has decreased; the covenants . . . have tightened up considerably. It’s just a much tighter market for credit,” she says. While lenders are still prepared to lend, across the board they are more cautious about the terms on which they are prepared to do so, says Anderson.

For lawyers in this area, there is now more negotiation as to the terms of the credit facility, as the leverage ratios and pricing that borrowers would have received up to early summer last year may not be relevant anymore. “Practising in the area, you have to be mindful of the fact that the credit market has changed and the resulting impact on the terms of a credit facility,” she says.

Canadian withholding tax on interest paid to foreign-based lenders was removed on Jan. 1, eliminating an entry barrier to U.S.-based lenders lending into Canada. Anderson says the potential impact on Canadian lawyers and the Canadian market is hard to assess. The question is, are U.S.-based lenders so preoccupied with their subprime losses that they haven’t turned their attention to lending in Canada? And will they be interested in coming to Canada?  This should be an interesting development over the coming year.

“If the U.S. banks take an aggressive approach in terms of lending into Canada, what typically happens where the U.S. lender’s the lead lender, most of the legal work gets done in the States, so it will be interesting to see what effect that has on people practising in this area,” she says.

Commercial real estate & construction law
Similar to the M&A space, a change is happening with the main players in commercial real estate. For Canadian lawyers in this area, how the year unfolds will depend a lot on the composition of their client base and the focus of their practice, says Greg Howard, a partner in the Toronto office of Davies Ward Phillips & Vineberg LLP.

Having been a buoyant market for the last few years, there is currently more uncertainty in the Canadian commercial real estate market than has been seen in quite some time, but Howard adds that they are definitely still seeing a lot of activity. In the past, a lot of the buying in commercial real estate was done by private equity or public entities listed on the stock market, such as REITs. Recently, their share prices have come off significantly, and the credit market has dried up, so it’s been more difficult for them to participate.

“You’re seeing other investors such as the pension funds and the pension plans and the insurance companies having an opportunity to acquire assets on terms that make sense to them,” says Howard. “There will always be a large appetite for the high-quality assets. The composition of the bidders, or the buyers, is likely to change, because the investors that have been dependant upon high levels of debt at very accretive rates will not be able to bid in the manner they have in the past.” Instead, he says, “You’re more likely to see the players that have internal funds stepping up and winning the bids for those types of high-quality assets.” As a result, lawyers with clients primarily in the private equity space who relied on debt will likely see their practice slow.

For those who focus more on institutional players, business is still extremely active. “If your client base is well-funded pension funds and other institutional investors, then the activity level could increase or at least remain steady,” says Howard.

Lawyers are also seeing continued demand from these investors for foreign real estate. “Certainly in our practice, many of our clients have focused internationally as opposed to domestically, because the opportunities there have just been much more attractive,” and the firm has been involved in a lot of offshore investments. A significant amount of development activity is also underway, notes Howard, and that will continue.

While it is difficult to predict whether there will be an economic slowdown or not, says David Little, leader of the B.C. region’s construction and procurement practice at Fasken Martineau DuMoulin LLP in Vancouver, the firm is remaining busy with major infrastructure projects. This includes roads and hospitals, as government timelines are longer and don’t run with a particular economic cycle, he says. Not to mention the upcoming winter Olympics in 2010.

The Alberta oil sands are also a huge area of growth, and front-end construction lawyers are busy with those types of projects. In British Columbia, the housing development market is still relatively strong. “What’s hard to predict is whether that trend continues, but so far we are still seeing that that’s busy,” says Little. “It’s kind of unpredictable. It’s not the great, 100-per-cent sure thing that we had two years ago, but nothing has happened yet that makes it seem like there’s a massive slowdown.”

On the litigation side, an economic slowdown could make contractors more at risk for insolvency issues, which could lead to defaults and sureties being called in on bonds. “It’s a big unpredictable. I don’t think we’ve particularly seen any increases; I think the general sense is that there’s still good solvency in the market,” he says.

If things do go bad, Little says construction lawyers focused entirely on the business side of things may have to find something else to do, while on the litigation side, there may be a shortage of litigators to focus on claims that arise. He does say there are many types of construction lawyers, including those who are busy because of what their clients are doing but who are not necessarily in it for the long haul, and if the market changes they may not pursue it. There is another core group that has been through different cycles, and would continue to find sufficient work, stay focused and adapt. “From my point of view on the business side of things, what is most difficult is uncertainty. What I’ve noticed is when things are predictably going up or predictably going down, then there tend to be a regular flow of transactions,” he says.

“Unpredictability means people don’t quite know what to do and they tend to delay things,” he says.