On October 12, 2007 the Supreme Court of Canada issued its decision in the shareholder class action suit Kerr v. Danier Leather Inc. The Court unanimously upheld the earlier Ontario Court of Appeal decision and determined that Danier and its senior officers were not liable for an alleged misrepresentation in a prospectus concerning an earnings forecast.
This rare decision of the Supreme Court on a securities law matter provides issuers and their advisers with guidance on the statutory framework of prospectus disclosure and the scope of potential statutory civil liability for prospectus misrepresentations.
HIGHLIGHTS OF THE DECISION
- Issuers only have an obligation to disclose “material changes” which arise between the date the final prospectus is receipted and the date the distribution of the offered securities is completed.
- The forecast contained in the prospectus included as a matter of fact an implied representation that it was objectively reasonable as at the date of the final prospectus (but not as at the date of closing of the offering).
- While not determinative of the outcome of the case, the Court commented that the business judgment rule does not qualify the duty to make disclosure as required by the Securities Act (Ontario).
Danier undertook an initial public offering of its shares in the spring of 1998. The final prospectus dated May 6, 1998 included a forecast of projected results for the fourth quarter of Danier’s fiscal year ending June 27, 1998. A few days prior to closing, Danier’s management undertook an internal analysis comparing actual intra-quarter results with those projected in the forecast. The analysis indicated that sales were lagging behind what was projected. If the trend had continued, there might have been a significant shortfall in revenue in the fourth quarter as compared with the forecast in the prospectus. At the time, management believed that the forecast would ultimately be achieved by the end of the fiscal year. The public offering closed on May 20, 1998. Approximately two weeks following the closing, Danier issued a revised forecast reducing its projected financial results and Danier’s share value dropped approximately 20%. Notwithstanding the revised forecast, by the end of the fiscal year, Danier had substantially achieved the originally projected financial results. Purchasers of Danier securities under the offering commenced a class action against Danier and its senior management under section 130(1) of the Securities Act (Ontario) (the Act), alleging that Danier’s prospectus contained a misrepresentation.
The Trial Decision: The Ontario Superior Court of Justice found Danier and its senior management liable for statutory misrepresentation under section 130(1) of the Act. In the trial judge’s view, management’s internal analysis showing potential poor fourth quarter results was a “material fact” which imposed a disclosure obligation on Danier that arose after the filing of the final prospectus but prior to closing. Danier’s failure to make this disclosure resulted in the prospectus containing a misrepresentation at the time of closing which attracted liability. The trial judge further held that there was an implied representation that the earnings forecast was objectively reasonable on both the date of the prospectus and the date of closing. In view of the intra-quarter results that were available during the period between the date of the final prospectus and the closing, the trial judge concluded that the earnings forecast was objectively unreasonable on the date of the closing, despite the fact that the forecast was subsequently substantially achieved.
The Court of Appeal Decision: The Court of Appeal reversed the decision of the trial judge and found that Danier had no obligation to disclose material facts that occurred between the date of the final prospectus and the date of the closing. The obligation to disclose was only triggered by a material change. The Court of Appeal further held that the trial judge erred in finding that the financial forecast contained an implied representation that it was objectively reasonable. Finally, the Court held that the trial judge failed to pay sufficient deference to the business judgment of Danier’s senior management that the forecast was objectively reasonable and to the fact that the projected forecast was subsequently substantially achieved.
THE SUPREME COURT DECISION
What disclosure obligations exist during the period between the date of the final prospectus and the closing of the offering?
The decision confirms the Court of Appeal’s view that issuers only have an obligation to amend a prospectus or make public disclosure after a receipt has been issued for a final prospectus where a “material change” (as defined in the Act) has occurred after the filing of the prospectus and prior to completion of the distribution of the securities offered. The required disclosure in these circumstances is set out in section 57(1), which limits mandatory disclosure to disclosure of any material changes. Section 130 of the Act provides a statutory remedy for investors where a prospectus contains a misrepresentation of a material fact or an omission to state a material fact, but does not impose any additional disclosure obligation. The judgment states that to impose an obligation under section 130 of the Act to disclose post-filing information which does not amount to a material change would be contrary to the disclosure scheme of the Act and the intent of the legislators.
The decision highlights the difference between the definitions of “material fact” and “material change” found in the Act and recognizes that the definition of material fact is broader than that of material change. A material fact is any fact which would reasonably be expected to have a significant effect on a security’s market price, while a material change is a change in the “business, operations or capital” of an issuer which would have a similar effect on the market price or value of its securities. In considering whether a change in intra-quarter results could constitute a material change, the Supreme Court states that such a change may not necessarily be a material change as it may be due to external factors and therefore not an actual change in the issuer’s business or operations. By way of clarification, the Court considered the situation where there is a material change in an issuer’s business or operations, such as a restructuring, which in turn causes poor intra-quarter results. In such a situation, a material change would be disclosable, but the basis for the disclosure obligation would be the restructuring, not the ensuing intra-quarter results.
As there is no continuing obligation to update a prospectus for material facts that arise following the receipt of a prospectus, the Supreme Court upheld the decision of the Court of Appeal in concluding that the prospectus contained no misrepresentation as of the date of its filing.
Did the forecast include an implied representation that it was objectively reasonable?
The Supreme Court agreed with the trial judge that, based on express language in the prospectus as to the reasonableness of the assumptions underlying the forecast and as to the fact that they reflected management’s “best judgment,” the forecast included an implied representation of objective reasonableness. The Court did not address the Court of Appeal’s rejection of the finding that an implied representation of objective reasonableness is a matter of law. Rather, it focused solely on the express language in the prospectus to find that, as a matter of fact, the forecast included an implied representation of objective reasonableness. The express language was sufficient for investors to infer not just that the forecast represented management’s best judgment (as the Court of Appeal had found) but also that management’s judgment was based on facts and assumptions that reasonable business people in possession of the same information as Danier’s management would reasonably regard as reliable for the purpose of a forecast. However, the Supreme Court held that the implied representation extended only to the date of the final prospectus, not to the date of closing as the trial judge had concluded.
It should be noted that the statutory liability regime for secondary market disclosure which came into force on December 31, 2005 provides for a safe harbour and avoidance of liability for misrepresentations contained in forward-looking information, where the person or company seeking to rely on the safe harbour establishes that they had a reasonable basis for drawing the conclusion or making the forecast set out in the forward-looking information.
In addition, on October 12, 2007, the same day the Danier decision was released, the Canadian Securities Administrators released amendments to National Instrument 51-102 – Continuous Disclosure Obligations regarding forward-looking information (the “Continuous Disclosure Amendments”). These amendments, which are expected to come into force on December 31, 2007, provide that all forward-looking information issued by an issuer (including forecasts in a prospectus) must be based on assumptions that are reasonable in the circumstances.
Application of the Business Judgment Rule
The Court considered the application of the business judgment rule to the disclosure regime applicable to prospectuses set out in sections 56 through 58 of the Act. The business judgment rule, which was most recently outlined by the Supreme Court of Canada in its 2004 decision in Peoples Department Stores Inc. (Trustee of) v. Wise, provides that courts should give deference to management decisions on matters of business so long as the decision falls within a range of reasonableness.
Although there was no need for the Court to determine the application of the business judgment rule, as they had determined that there was no misrepresentation as of the date of the final prospectus (which was the relevant date), the Court did make several comments on the application of the business judgment rule in the context of disclosure obligations. The Court stated that, while a forecast is a matter of business judgment, the disclosure regime sets out legal obligations which cannot be subordinated to business judgments of management. As a result, the business judgment rule cannot be used to qualify an issuer’s duty to disclose. Assuming that there had been an obligation to disclose (which the Court determined there was not), the fact that management believed its forecast would nonetheless be met would not have relieved Danier from its obligation to disclose a material change. Rather the Court commented that management, when disclosing its intra-quarter review, could also have disclosed its view that the forecast would still be met. The Court distinguished between disclosure decisions and cases involving business decisions that require choices among a range of alternatives. The Court held that the traditional justifications for the business judgment rule, namely the relative expertise of management and support for reasonable risk-taking, do not apply to disclosure obligations.
The Supreme Court considered whether the Court of Appeal erred in awarding costs against the main representative plaintiff shareholder. The Class Proceedings Act, 1992 (Ontario) provides that a court, in awarding costs under the Courts of Justice Act (Ontario), may consider whether the class proceeding was a test case, raised a novel point of law or involved a matter of public policy. The Supreme Court held that the case was a private commercial dispute raising questions of statutory interpretation between “sophisticated commercial actors who are well resourced.” It was not a test case nor did it raise a matter of public interest. The Court held that there was no reason to depart from the normal rules in awarding costs and therefore dismissed the appeal of the representative plaintiff shareholder against the earlier award of costs made in favour of the defendants. The fact that the representative plaintiff was a “person of substance” and had also made a substantial profit when he sold his shares in Danier was noted by the Court and the Court rejected the notion that class proceedings always engage access to justice concerns sufficient to justify withholding costs from the successful party.
GUIDANCE FROM THE DECISION
The trial decision in Danier caused considerable concern for issuers and their advisers. Issuers and underwriters can take comfort in this final decision, which confirms that the obligation to amend a receipted prospectus before the completion of a distribution of securities arises only where a material change has occurred and not on the occurrence of a material fact. The Supreme Court refused to impose greater disclosure obligations on issuers than those mandated under the Act. However, the decision also makes clear that disclosure obligations are not tempered in any way by the application of the business judgment rule.
This decision will also assist issuers in interpreting their potential liability under the continuous disclosure regime which came into force on December 31, 2005. While OSC and stock exchange policies on timely disclosure have blurred the distinction between material facts and material changes, the new regime maintains the distinction and only grants a right of action, in respect of a failure of an issuer to make timely disclosure, to a person or company who trades in the securities when a material change has not been disclosed as required under the Act.
While the Danier decision is an important case that clarifies the potential statutory civil liability for prospectus disclosure, issuers should be aware that the Continuous Disclosure Amendments, which are anticipated to take effect at the end of the year, will require issuers to update forward-looking information by discussing in their MD&A events and circumstances that are reasonably likely to cause actual results to differ materially from material forward-looking information previously disclosed. In addition, TSX-listed issuers must continue to be cognizant of their timely disclosure obligations under the TSX Timely Disclosure Policy.
Finally, for companies facing securities class actions, this decision supports the application of the usual cost rules and increases the risks to plaintiffs in bringing such suits against issuers and their directors and officers.