On March 20, 2013, Justice Morawetz of the Ontario Superior Court of Justice (ONSC) approved a settlement by Ernst & Young LLP in the Sino-Forest Canada (SFC) class proceedings (Labourers’ Pension Fund of Central and Eastern Canada v. Sino-Forest Corporation). The $117-million settlement is the largest third-party settlement made by an auditor in a Canadian class action. Since securities legislation across all Canadian jurisdictions was amended to make it easier to sue for negligent misrepresentation – including against third-party experts, such as auditors – it seems likely that Canadian class action litigation will increasingly include claims similar to those made in the SFC proceedings.
The settlement was approved over the objections of a group of plaintiffs who argued that the agreement compromised their opt-out rights in the class action and sought to retain the option of filing their own suit against the auditor. Citing Robertson v. Proquest Information and Learning Co (Robertson) and ATB Financial v. Metcalfe and Mansfield Alternative Investments II Corp. (ATB Financial), the ONSC dismissed the objecting plaintiffs’ arguments and approved the settlement.
The Class Proceedings
SFC was a Chinese integrated forest plantation operator and forest productions company with a registered office in Ontario and a head office in Hong Kong. Its shares began trading on the TSX in 1994. From March 19, 2007, through June 2, 2011, SFC issued and had outstanding various debt instruments and made three prospectus offerings of common shares on the Toronto Stock Exchange (TSX) involving various underwriters.
The class actions and the Companies' Creditors Arrangement Act (CCAA) proceedings arose following a June-2011 report by short-seller Muddy Waters Research that claimed SFC had engaged in a complex fraudulent scheme, which the auditors were alleged not to have uncovered. Three class proceedings were commenced in Ontario against SFC. Two of these actions were stayed following a carriage motion in January 2012. SFC’s auditors Ernst & Young (auditor from 1994-1998, 2000-2004 and 2007-2012) and BDO Limited (auditor from 2005-2006), as well as 11 underwriters, were also named as defendants in the Ontario proceedings.
The plaintiffs alleged that:
- SFC repeatedly misrepresented its financial position and its compliance with Generally Accepted Accounting Principles (GAAP) in its public disclosure; and that
- The auditors and underwriters failed to detect these misrepresentations, causing an artificial inflation in SFC’s share price.
The claims against Ernst & Young included statutory primary and secondary market claims under sections 130 and 130.1 of the Ontario Securities Act, as well as common law claims of negligence and negligent misrepresentation related to the prospectuses and offering memoranda. Auditors can face liability both under common law causes of action, as well as the applicable provincial securities legislation, which has now removed the traditional common law requirement that plaintiffs establish reliance on the impugned misrepresentation in order to advance a secondary market claim successfully.
The class action was stayed in March 2012 when SFC entered into CCAA proceedings. As a result, the certification motion, originally scheduled to be heard in November 2012, was postponed. The Ernst & Young settlement was announced in December 2012, and the settlement hearing took place on February 4, 2013.
The Hearing and Decision
The objecting plaintiffs opposed the no-opt-out and full third-party release features of the Ernst & Young Settlement, making two main arguments. First, they argued that if approved, the settlement would vitiate the opt-out rights of class members as granted by section 9 of the Ontario Class Proceedings Act (CPA), and therefore the proposed settlement had to be approved solely under the CPA. Second, they argued that the release was not integral or necessary to the success of SFC’s restructuring plan, and the settlement was not essential or related to the restructuring.
Justice Morawetz dismissed both arguments. In response to the first position, he found that, since SFC is under CCAA protection, the claims against Ernst & Young could not properly be considered in isolation from the CCAA proceedings. As the ONSC noted, "it is not possible to ignore the CCAA proceedings." Although the right to opt-out of a class action is a fundamental right of procedural fairness, the objectors would in any event be left with a claim against Ernst & Young that would have to be put forward in the CCAA proceedings.
In response to the second argument, Justice Morawetz found that the release was rationally related to the purpose of the restructuring plan and necessary for its implementation. He rejected the claim that the settlement was not essential or related to the plan, finding that "a significant aspect of the Plan is a distribution to SFC’s creditors. The significant and, in fact, only monetary contribution that can be directly identified, at this time, is the $117 million from the Ernst & Young Settlement."
Factors Considered by the ONSC
When assessing a settlement in the CCAA context, the ONSC will take into consideration the following three factors, as articulated in Robertson:
- Whether the settlement is fair and reasonable;
- Whether it provides substantial benefits to other stakeholders; and
- Whether it is consistent with the purpose and spirit of the CCAA.
In order to be considered fair and reasonable, the release to be given by the parties had to be justified as part of the settlement. The ONSC applied the "nexus test" to assess the connection between the third-party claim being compromised by the plan and the restructuring achieved by the plan. This test, adopted in ATB Financial, considers the following factors:
- Are the claims to be released rationally related to the purpose of the plan?
- Are the claims to be released necessary for the plan of arrangement?
- Are the parties who have claims released against them contributing in a tangible and realistic way? and
- Will the plan benefit the debtor and the creditors generally?
In this case, the ONSC considered the above and determined that:
- A significant contribution to SFC’s creditors came by way of the settlement;
- All of the claims are intertwined and related to the purpose of the plan;
- The settlement helps achieve the objectives of the plan;
- The settlement contributes to the plan in a tangible way;
- The settlement benefits claimants in the form of a tangible distribution (and the approving, voting creditors had knowledge of the nature and effect of the releases); and
- The releases are fair and reasonable and not overly broad or offensive to public policy.
Implications for Auditors
Amendments to securities legislation across provinces and territories have made it easier for plaintiffs to pursue securities class actions not only against issuers themselves, but also third-party advisors, such as auditors. This is particularly important in cases where the issuers may no longer be solvent or otherwise unable to satisfy any future judgments against them, motivating plaintiffs to identify more attractive defendants to include in an action. Auditors will therefore remain an important target for plaintiffs. Audit firms should consider establishing strong internal governance and risk management policies, as well as taking steps to better understand their areas of potential litigation risk in this hostile class action environment.