The Supreme Court of Canada’s recent decision in Kerr v. Danier Leather provides welcome clarification for issuers and their officers and directors about the scope and application of section 130 of the Securities Act (Ontario) (the Act). The decision confirms that if an issuer complies with its disclosure obligations under sections 56 to 58 of the Act, it will not be held liable under section 130 of the Act. It also confirms that issuers and their senior management will not be afforded the protection of the business judgment rule when the question before the courts is whether there has been compliance with the disclosure obligations under the Act.
The final chapter in the story of Kerr v. Danier Leather has now been written. On October 12, 2007 the Supreme Court of Canada released its much anticipated decision concerning whether Danier Leather and two of its senior officers were liable under section 130 of the Act for failing to disclose material facts that became known to them after the filing of the prospectus at issue but before the closing of the offering. The trial judge had found the defendants liable to the plaintiffs, a class of Danier shareholders, under section 130 of the Act. The Court of Appeal of Ontario had reversed that decision, dismissing the plaintiffs’ action. The Supreme Court dismissed the plaintiffs’ appeal from that decision.
The following key points can be drawn from the Supreme Court of Canada’s decision:
- After a prospectus has been filed, there is no obligation on issuers to update the prospectus to disclose material facts that do not amount to a “material change.”
- A material change is limited to changes in the issuer’s business, operations or capital. The concept is not intended to capture factual developments that may have an impact on the results that the issuer’s business or operations is able to generate but which are external developments that do not amount to a material change to the issuer’s business, operations or capital.
- Issuers have no statutory obligation to make timely disclosure of intra-quarterly results of operations per se, absent a material change.
- Disclosure decisions are not entitled to judicial deference. The deference traditionally accorded by the courts to other types of business decisions under the business judgment rule has no application in determining whether an issuer has made the right decision about its disclosure obligations under the Act.
It is also worth noting that as a result of the Supreme Court’s decision, underwriters need not change their practices to establish a due diligence defence. This can be contrasted to the change in practice that emerged immediately after the trial judge’s decision. At that time, it was generally thought prudent to conduct a pre-closing bring-down due diligence session with management.
In May 1998, Danier made an initial public offering of its shares through a prospectus. In addition to providing the company’s actual results for the first three quarters of its 1998 financial year, Danier’s prospectus contained an earnings forecast for the company’s fourth quarter ending in June 1998. The final prospectus was filed on May 6, 1998. The offering closed on May 20, 1998 without any actual financial results for the fourth quarter being incorporated into the forecast or otherwise communicated to the public. An internal company analysis prepared after the final prospectus was filed but before the offering closed showed that Danier’s fourth quarter results were lagging behind its forecast. Danier did not disclose its poor intra-quarterly results before closing.
The shares were issued at a price of $11.25 per share. On June 4, 1998 – less than two weeks after the distribution under the prospectus had closed – Danier issued a press release announcing that it had revised its earnings forecast for the fourth quarter downward due to unseasonably warm weather in most markets which had negatively impacted its sales of leather apparel. Following the press release, the Danier share price declined significantly to a low of $8.25 on June 9, 1998. On July 6, 1998 Danier released its actual fourth quarter results, announcing that it had substantially achieved its original earnings forecast.
The Trial Decision
The trial judge found that, as of the date of the prospectus, the earnings forecast did not contain a misrepresentation. However, between that date and the closing of the offering, senior management came into possession of information concerning the company’s actual fourth quarter results to date that made the earnings forecast objectively unreasonable. The trial judge concluded that although this information about the fourth quarter results did not amount to a “material change” requiring an amendment to the prospectus under section 57 of the Act, the information was a “material fact.” As such, section 130 of the Act imposed a separate and continuing obligation on the company to disclose material facts arising after the date of the prospectus but before the closing of the distribution where the failure to disclose such material facts would result in the prospectus containing a misrepresentation.
The trial judge concluded that the failure of Danier to disclose information about the actual fourth quarter results caused the earnings forecast to constitute a misrepresentation as of the closing date because the forecast had ceased to be objectively reasonable as of that date. The trial judge awarded damages of $2.35 per share, based on the difference between the prospectus share price and the price of the shares after the market had absorbed the misrepresentation. The trial judge did not require individual shareholders to demonstrate an actual loss caused by the misrepresentation.
The Court of Appeal Decision
The Court of Appeal found that the trial judge had made three fundamental errors. First, the trial judge erred in finding that section 130 of the Act imposed a continuing obligation on issuers to disclose material facts that occur after the date of the prospectus but prior to the closing date. The Court of Appeal concluded that sections 56 and 57 of the Act constitute a complete code of prospectus disclosure obligations, both for compliance purposes and for purposes of determining civil liability under section 130 of the Act. Second, the Court of Appeal found that the trial judge had erred in concluding that the prospectus contained an implied representation that the earnings forecast was objectively reasonable. Finally, the Court of Appeal held that, even if the trial judge were correct that the prospectus contained an implied representation that the earnings forecast was objectively reasonable, the trial judge erred by failing to grant deference to the business judgment of Danier’s senior management in determining whether the forecast was within a range of reasonableness.
The Supreme Court of Canada Decision
The primary question before the Supreme Court of Canada was whether compliance with the disclosure requirements of sections 56 to 58 of the Act provided a complete defence to an action under section 130 of the Act. The Court answered this question in the affirmative, but then went on to address the question of whether the Danier prospectus contained an implied representation that the earnings forecast was objectively reasonable and whether the business judgment rule applies to disclosure decisions.
No continuous disclosure requirement for a material fact
The Supreme Court of Canada started from the premise that the Act attempts to reach a balance between the interests of investors and issuers. The Act compels issuers to disclose information as a means of protecting investors, while at the same time limits what is required to be disclosed in recognition of the burden that compelled disclosure places on issuers. Ultimately, the Court determined that the protection offered to investors after the filing of the prospectus but before the closing of the distribution is limited to an assurance that there have been no “material changes” during that period.
The Court therefore upheld the finding of the Court of Appeal that sections 56 to 58 of the Act constitute a complete code of prospectus disclosure obligations. These sections impose an obligation on reporting issuers to disclose “material changes” occurring after the date of the prospectus, but do not require disclosure of “material facts” that occur during the same period. The Court held that the distinction between “material change” and “material fact” in the Act must be understood to be deliberate and policy-based, and therefore must be respected by the courts. Given that these sections constitute a complete code concerning prospectus disclosure obligations, section 130 of the Act cannot be interpreted as obliging an issuer to disclose material facts arising after the date of the prospectus; to do so would disregard the court’s duty to interpret the statute harmoniously as a whole. The result is that an issuer does not face civil liability under section 130 of the Act for failing to disclose post-filing “material facts” that do not amount to a “material change.”
This finding confirms that underwriters need not change existing due diligence practices concerning whether to hold a bring-down due diligence session immediately prior to closing a public offering. To establish a statutory due diligence defence to claims made under section 130 of the Act, underwriters must show that they conducted a reasonable investigation so as to provide reasonable grounds for a belief that the prospectus did not contain a misrepresentation at the time it was filed. However, in light of the trial judge’s finding that the prospectus must disclose all material facts as of the time of closing, underwriters had changed their practice after the trial decision by, for example, holding bring-down due diligence sessions prior to closing. The need for this practice was less obvious after the Court of Appeal’s decision.
Holding such a session immediately prior to closing is a practice that underwriters may understandably choose to follow where circumstances warrant. Issuers are, of course, still under a duty to update a prospectus for material changes that occur between the filing of the prospectus and the completion of the distribution. In addition, underwriting agreements will likely continue to require issuers to notify underwriters of any material change and any material fact that would have been required to be stated in the prospectus, as well as to sign a bring-down certificate, to be tabled at closing, stating that there have been no material changes and that the prospectus contains full, true and plain disclosure as of the closing date. We expect that underwriters will want to ensure that their underwriting agreements permit them to request a bring-down due diligence session immediately prior to closing if they determine that one is desirable.
Poor intra-quarterly results of operations are not per se a material change
The plaintiffs also argued that Danier’s poor intra-quarterly results of operations were a material change. The Court disagreed, noting that there is an important distinction between changes in operations and changes in the results of operations. The statutory definition of a “material change” requires a change in operations. Danier’s poor results were caused by unseasonably warm weather – an external factor – and not a change in Danier’s operations. The Court also noted that the term “results of operations” appears in a number of places in the Act and that the legislature could have included “results of operations” in the definition of “material change” if it had intended to cast the disclosure obligation so broadly.
This finding has great practical significance. Under the prospectus and statutory civil liability regimes, issuers are therefore under no legal obligation to make timely disclosure of intra-quarterly results of operations per se, absent a material change. Nonetheless, while poor intra-quarterly results are not per se a material change, the cause of the poor results may very well be such a change (in its decision, the Court used the example of a restructuring). As a matter of both business and legal prudence, whenever management becomes aware of unexpected results of operations, it should initiate an investigation process that is appropriate to the business and try to determine the cause. Even if the cause of poor results is not a material change management may, in some instances, decide that it is appropriate to implement a material change in response to poor results in an attempt to improve business performance.
Furthermore, issuers with securities listed on the Toronto Stock Exchange must be mindful of the TSX’s timely disclosure requirements, which mandate the disclosure of material information, being both material facts and material changes. Canadian securities regulators have stated that companies that do not comply with an exchange’s requirements could find themselves subject to an administrative proceeding before a provincial securities regulator.
Coincidentally, on the same day that the decision in Kerr v. Danier Leather was released, the Ontario Securities Commission announced that it had submitted consequential amendments to National Instrument 51-102 – Continuous Disclosure Obligations relating to material future-oriented financial information (FOFI) to the Minister responsible for securities regulation for approval. If approved, the new rule will come into effect on December 31, 2007 across Canada, superseding National Policy 48 – Future Oriented Financial Information, which will be rescinded.
Unlike National Policy 48, which required timely disclosure of material changes in the events or assumptions used to prepare FOFI as though they were material changes, the new rule will require issuers to update FOFI only on a periodic basis in their MD&A. Issuers will have to disclose in their MD&A material differences between actual results and previously released FOFI or financial outlooks for the period to which the MD&A relates, including earnings guidance. Issuers will also have to disclose any decision to withdraw previously released material forward-looking information.
The forecast included an implied representation of objective reasonableness
Unlike the Court of Appeal, the Supreme Court did find that as a matter of fact (and not by operation of law), the language contained in the prospectus did constitute an implied representation that the earnings forecast was objectively reasonable. In reaching this conclusion, the Court focused on the specific language included in the prospectus:
- A statement that “[t]he Forecast is based on assumptions that reflect management’s best judgment of the most probable set of economic conditions and the Company’s planned course of action as of April 2, 1998”;
- A statement in the Auditor’s Report that “the assumptions developed by management are suitably supported and consistent with the plans of the Company, and provide a reasonable basis for the forecast”; and
- The prospectus further stated that the assumptions in the forecast were “considered reasonable by the Company at the time of preparation of the forecast.”
However, the Court found that this implied representation extended only to the date of the filing of the prospectus. As the trial judge had determined that the forecast was objectively reasonable as of that date, the disagreement between the Supreme Court and the Court of Appeal on this issue ultimately had no impact on the question of whether the defendants were liable.
We note that the safe harbour for forward-looking information under the new civil liability regime in respect of secondary market disclosure – in particular, section 138.4(9) of the Act – requires that there be a reasonable basis for the forward-looking information. Furthermore, if adopted, the amendments to National Instrument 51-102 will require that an issuer not disclose forward-looking information unless the issuer has a reasonable basis for such information. Accordingly, to minimize the risk of liability, issuers should ensure that any forecasts they prepare are objectively reasonable.
The disclosure obligations under the Act are not to be subordinated to the exercise of business judgment
While the Court of Appeal found that there was no implied representation in the prospectus that the earnings forecast was objectively reasonable, it stated that, even if there had been such an implied representation, the trial judge had erred in failing to defer to the business judgment of management in determining whether the earnings forecast was within the range of reasonableness. Although it did not strictly need to address this issue, the Supreme Court stated clearly in its decision that the business judgment rule does not apply in determining whether an issuer has complied with its disclosure obligations under the Act. In other words, the issuer has either made the required disclosure or not and, in making such an assessment, there is no basis for a court to defer to the business judgment of management.
The Supreme Court rejected the representative plaintiff’s argument that he should be relieved of the usual obligation to pay the costs of the successful defendants. The court found that this case did not fall within the parameters of section 31(1) of the Class Proceedings Act, 1992 (Ontario). That section provides that in exercising its discretion to award costs in a class proceeding, a court may consider whether the proceeding was a test case, raised a novel point of law or involved a matter of public interest. The Court found that this case was, essentially “a commercial dispute between sophisticated commercial actors who are well resourced.” In rejecting the representative plaintiff’s argument on costs, the Court also stated broadly that “[t]hose who inflict [protracted litigation] on others in the hope of significant personal gain and fail can generally expect adverse cost consequences.”
The Supreme Court of Canada’s decision in Kerr v. Danier Leather provides welcome clarification for issuers and their officers and directors about the scope and application of section 130 of the Act. In particular, it confirms that if an issuer complies with its disclosure obligations under sections 56 to 58 of the Act, it will not be held liable under section 130 of the Act. In addition, the Supreme Court confirmed that issuers and their senior management will not be afforded the protection of the business judgment rule when the question before the courts is whether there has been compliance with the disclosure obligations under the Act. The decision therefore represents a balanced result for issuers and investors.