Quebec’s Bureau de décision et de révision (the BDR) recently considered1 the concept of “privileged information” as defined in Section 5 of the Securities Act (Quebec)2 (SA) in its decision rejecting the proceedings for alleged insider trading brought by the Autorité des marchés financiers (the AMF) against insiders of MEGA Brands Inc. (the Company).

The BDR stated that all of the facts of which the insiders had knowledge at the time they carried out the transactions, including what was reasonably foreseeable given the factual context, must be considered in determining whether information is “privileged information” within the meaning of the SA. For purposes of its analysis, it was important not to consider the information in isolation but to take into account the factual context of the information available at the time of the transactions.

The BDR also confirmed that the test to be used in Quebec is the “reasonable investor” test, but that the facts that will influence a reasonable investor’s decision generally include those that could affect the market price of the securities.

Context

In December 2005, insiders of the Company traded in the Company’s securities while at the time they had knowledge of the fact that a young child had died after swallowing pieces of a toy manufactured by a subsidiary acquired in July 2005. The transactions at issue were carried out in the days preceding a blackout period that was scheduled to end in May 2006.

In 2006 and 2007, several months after the stock exchange transactions took place, events occurred, including highly publicized lawsuits pertaining to alleged safety defects in the toys manufactured by the subsidiary and a voluntary recall of certain toys. The Company’s results and the market price of its securities were affected as a result of those events.

The AMF alleged that the insiders had traded in the securities when they were in possession of privileged information. It claimed a total of close to $6.5 million from the four insiders named in the proceedings.

The BDR held hearings on the matter in the winter of 2012 and handed down a decision rejecting the AMF’s application on September 5. The AMF indicated (link in French only) that it was studying the possibility of appealing the decision.

BDR’s analysis

Law applicable in Quebec

At the time the transactions were carried out, Section 187 SA stated that no insider of a reporting issuer (such as the Company) having privileged information relating to securities of the issuer may trade in such securities except in the case of certain exceptions that did not apply in this instance.

The BDR indicated that:

To establish that a person has violated Section 187 SA and therefore engaged in insider trading, the following elements must be present:

  • The person must be an insider (s 89 SA) in respect of a reporting issuer;
  • The person must have privileged information relating to the securities of the reporting issuer, namely:
    • any information that has not been disclosed to the public; and
    • information that could affect the decision of a reasonable investor (s 5 LVM); and
  • The person carries out a transaction involving such securities when in possession of such privileged information. [para 55]

The fact that the respondents were insiders of the Company and had traded in the securities of the reporting issuer was not contested. What was in dispute was whether the information that was known to the insiders at the time of trading qualified as “privileged information” within the meaning of Section 5 SA

Nature of the information

The BDR began by recapping the history of the concept of “privileged information.” Since 1990, Section 5 SA has specified, as indicated above, that privileged information is “any information that has not been disclosed to the public and that could affect the decision of a reasonable investor.” Before 1990, as pointed out by the BDR, the concept of privileged information referred to the likelihood of there being an impact on the market price of the securities and, before the 1987 amendment, also referred to the concept of “material fact.” The definition of “privileged information” in the SA has therefore evolved over time, in light of legal rulings regarding the prohibited use of privileged information that had demonstrated the difficulty faced by the prosecuting authority in meeting its burden of proof.

The BDR noted that the criterion of degree of probability of impact on the market price of the security, although removed from the “privileged information” definition, has nonetheless been preserved through the words “that could affect.” The BDR observed that [translation] “in American law, the materiality test in respect of the information’s impact on the decision of a reasonable investor includes facts that reasonably and objectively could affect the market price of the securities.” [para 75]

The BDR reviewed the applicable provisions in other Canadian jurisdictions, under which [translation] “the prohibition to trade in securities when an insider has knowledge of a relevant fact or material change is based on the potential significant effect of such information on the market price of the security” [para 78]. The BDR also noted [translation] “that tribunals in other Canadian jurisdictions often refer in their analyses to the reasonable investor concept and the test developed by the U.S. jurisdictions.” [para 79].

Moreover, the BDR stated that the Canadian Securities Administrators in National Policy 51-201 Disclosure Standards [translation] “confirm the convergence between the market impact test and the reasonable investor test” [para 80].

The BDR also observed that [translation] “in jurisdictions other than Canada and the United States, the privileged information concept likewise makes reference to both the market impact test and the reasonable investor test” [para 81].

In concluding its analysis, the BDR recognized the convergence between the market impact test and the reasonable investor test and indicated that [translation] “the test to be used [in Quebec] is the reasonable investor test, but the facts that will influence a reasonable investor’s decision generally include those that could affect the market price of the security” [para 89].

After recognizing this convergence, the BDR ruled that it was necessary to analyze the content of the information at the time the transaction was carried out to determine whether a reasonable investor’s decision would have been influenced by that information, while being sure not to consider the information in isolation but to take into account the factual context of the information available during the relevant period.

Facts known to the respondents and anticipated risks

What facts must be considered in order to determine whether information was “privileged” within the meaning of the SA? The answer is all of the facts of which the respondents had knowledge at the time they carried out the transactions, including the facts that were reasonably foreseeable given the factual context.

Facts subsequent to trading cannot form the basis of the analysis of what constitutes “privileged information.” Subsequent facts may however be useful for supporting the tribunal’s finding concerning the nature of the information.

The BDR summed up the facts that were known to the respondents at the time they carried out their transactions as follows:

[Translation]

In summary, the respondents knew that a 22-month old child had died, that the toy was intended for older children, that the toy’s safety was not in question, that a due diligence review of Rose Art [newly acquired subsidiary that had manufactured the toy] had just been carried out, that there had not, to their knowledge, been any other similar incidents, that the toy had not been used properly, that, according to an expert’s opinion, a recall was not foreseeable, and that the family had no intention of suing. [para 119]

According to the BDR, [translation] “[A] reasonable investor who was in possession of all of this information placed in its context was not likely to be influenced in his decision to trade or not trade in MEGA Brands securities. Moreover, the respondents had grounds to believe that this incident would not result in any negative consequences for the company.” [para 139]

Impact on the market price of the security

The BDR confirmed that, in an efficient market where a company is followed by analysts, any new information is quickly incorporated into the price of the security. However, insofar as a certain amount of time goes by between when an event occurs and when it is “disclosed to the public,” it may be difficult to determine its impact on the decision of a reasonable investor because other elements occurring within that time period may also have been considered by the reasonable investor.

The AMF argued that news that a toddler had died in December 2005 after swallowing pieces of a toy manufactured by a subsidiary of the Company had been sufficiently disseminated to become “disclosed to the public” only in March 2006 after it was announced that the dead toddler’s family had launched a lawsuit and a press release had been published announcing a voluntary product replacement campaign. The AMF argued that after the press release was published, the market reacted and analyst reports showed a 5% decline, demonstrating the impact of the news on the market price of the securities and on the decision of a reasonable investor. In somewhat contradictory fashion, the AMF had also submitted in its proceeding that after the information was disclosed in March 2006, the Company’s security had remained steady through June 2006 at around $27, i.e. the option exercise price in December 2005.

According to the respondents, “sufficient” dissemination of the news had occurred either on December 20, 2005, when a report about the toddler’s death had aired, or on January 5, 2006, when an analyst stock report on MEGA Brands Inc. had been published by RBC Capital Markets. From December 20, 2005, to January 6, 2006, the Company’s share price had changed from $27.01 to $27.07, demonstrating, according to the respondents, that the news had not had any impact on the market price of the securities and the decision of a reasonable investor.

Although “sufficient” dissemination of the news was a fact subsequent to the transactions being studied, the BDR considered its impact on the market price of the Company’s securities for the purposes of supporting its finding regarding the nature of the information known to the respondents at the time of their transactions. In so doing, the BDR came to the following conclusion regarding the impact on the market price of the securities:

[translation]

“Our main finding is supported by the observation that investors do not appear to have been influenced in their decision to invest in MEGA Brands securities by the publication of the news, when we look at the market price of the securities and the analyst report after publication of the news – namely, after December 20, 2005, January 5, 2006, and even after March 15, 2006, when the Sweets’ lawsuit was announced.

As for the market price of the securities after the release of the Q4 report and after the voluntary recall on March 31, 2006, it is important to remember that at this time, the information available to investors is not the same as the information that the respondents possessed when they traded in the securities.” [paras 160 and 161]

Conclusion

The BDR determined that the AMF had not met its burden of establishing that the information in the respondents’ possession when the transactions were carried out was privileged information. It consequently rejected the AMF’s application.

The BDR’s finding is based on the “privileged information” concept defined in Section 5 SA. While Quebec is the only jurisdiction in Canada that has adopted the “reasonable investor” test, upon reviewing the relevant case law in both Canada and the United States, the BDR found there was convergence between the “reasonable investor” test and the “market impact” test.3