Management in public companies often struggles to determine how much or how little to disclose in connection with offerings of securities. Until now, other than market practice there has been little judicial guidance to assist management in making decisions. In Sharbern Holding Inc. v. Vancouver Airport Centre Ltd., 2011 SCC 23, the Supreme Court of Canada has recently provided such guidance by examining the test of what constitutes a "material false statement" under securities statutes.
The facts of Sharbern are sadly familiar: market optimism leads to a crash, which leads to litigation as disappointed investors seek to recoup their losses. In the mid-1990s, investors were tripping over themselves to invest in hotels near the Vancouver airport. There was much enthusiasm, with rosy projections of future profits. At the height of the boom, a developer built two interconnected hotels — one a Marriott, the other a Hilton — and sold each of the hotels to public investors through strata lots. The developer remained as manager of both hotels once they were constructed.
However, by 2001 the bubble had burst, and the Richmond, B.C. hotel market was one of the weakest in Canada. Unhappy investors in the Hilton property brought a class action against the developer, alleging non-disclosure under securities law, specifically whether the developer was liable for making material false statements in the offering memorandum and disclosure statement used to sell the Hilton strata lots. (They also alleged common law negligent misrepresentation and breach of fiduciary duty, but those allegations are not considered in this article.)
At trial, the plaintiffs succeeded. They convinced the trial judge that the developer had a conflict of interest because it had guaranteed a return to the Marriott investors but not to the Hilton investors, and because the developer had charged a lower management fee to the Hilton hotel than it did to the Marriott (the concern being that the developer would have an incentive to favour the Marriott in order to earn the higher fee). This conflict of interest had not been included in the disclosure statement provided to the Hilton investors under the applicable legislation. On appeal, the B.C. Court of Appeal reversed. A further appeal was heard by a full nine-member panel of the Supreme Court of Canada. In a unanimous decision authored by Justice Rothstein, the Supreme Court affirmed the B.C. Court of Appeal’s decision and dismissed the class action claim.
Although the provisions considered by the Supreme Court were under the British Columbia Real Estate Act (now repealed), which imposed liability for a "material false statement," the court’s description of the test of materiality in disclosure documents is relevant under securities legislation generally. Specifically, the court emphasized five points.
The "Reasonable Investor Standard"
First, materiality is to be determined objectively, from the perspective of a reasonable investor.
The Two-Part "Substantial Likelihood" Test
Second, a fact omitted from a disclosure document is material if there is a substantial likelihood that it would have been considered important by a reasonable investor in making an investment decision. It is not sufficient that the fact merely might have been considered important. In this regard, the Supreme Court adopted the test set out by the Supreme Court of the United States in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 428 (1976), and noted that the materiality standard is a balance between too much and too little disclosure. Too little disclosure is obviously problematic, but so is too much: it is not in the interests of investors to be buried in an avalanche of trivial information.
Third, the issue is not whether the fact would have changed the investment decision of the reasonable investor, but whether there is a substantial likelihood that the fact would have assumed actual significance in a reasonable investor’s deliberations.
Fourth, materiality depends on the specific facts, determined in light of all relevant considerations and the surrounding circumstances forming the total mix of information made available to investors. The approach adopted by the Canadian Securities Administrators in National Policy 51-201 Disclosure Standards (July 12, 2002) and by the United States Securities and Exchange Commission in SEC Staff Accounting Bulletin: No. 99 — "Materiality" (August 12, 1999) — a fact-driven and contextual approach — was endorsed.
Burden is on the Plaintiff
Fifth, a plaintiff alleging non-disclosure has the onus of proving materiality and must lead evidence on the point, except where common sense inferences are sufficient.
Applying these principles, the Supreme Court held that the trial judge had made three legal errors in finding the developer’s alleged conflict of interest to be material. First, she erroneously concluded that the conflict of which the plaintiffs complained was inherently material. This conclusion implied that issuers have an obligation to disclose all facts in order to permit investors to sort out what is material and what is not — an approach that would result in excessive disclosure by overwhelming investors with information. In turn, this outcome would impair, rather than enhance, investors’ ability to make decisions. Second, the trial judge reversed the onus of proof, requiring the developer to show that the conflict of interest was not material rather than requiring the plaintiffs to show that it was. Third, she failed to consider all the evidence available to her on the issue of materiality.
The Supreme Court was not only critical of the trial judge but also critical of the plaintiffs, noting that they had failed to adduce sufficient evidence, including expert evidence, to support their allegations of material non-disclosure. The Supreme Court set out evidence which, had it been adduced, might have led to a conclusion of materiality. The plaintiffs could have shown that potential investors who knew of the alleged conflict of interest declined to invest or expressed concern. The plaintiffs could have shown that potential investors declined to invest because they found that there was insufficient disclosure. The plaintiffs could have shown that once the Hilton investors learned of the alleged conflict of interest they had expressed concerns about it. The plaintiffs could have shown that the developer did not act diligently and in good faith in managing the Hilton hotel, or that the developer actually acted on the conflict of interest to the detriment of the Hilton investors. The absence of evidence of this type was fatal to the plaintiffs’ claims of materiality.
Sharbern Holding Inc. v. Vancouver Airport Centre Ltd. makes it more difficult for plaintiffs to recover damages under securities legislation. The concept of materiality has been interpreted robustly, the onus of proving materiality has clearly been placed on the shoulders of plaintiffs, and subject to a limited exception plaintiffs are required adduce evidence (including expert evidence) in support of an allegation of materiality. Yet while making life more difficult for plaintiffs, the decision does not necessarily make life easier for issuers. While Sharbern makes clear that it is not necessary for issuers to disclose every imaginable fact that might be considered in an investment decision, it also makes clear that issuers have an obligation not to defeat the purpose of disclosure by bombarding potential investors with a blizzard of non-material information.
McCarthy Tétrault Notes
Sharbern is important for two reasons. First, it provides guidance to issuers on how to approach disclosure. Second, it clarifies that plaintiffs need to prove whether a fact is material.
Sharbern imposes burdens on plaintiffs and issuers alike — on plaintiffs to prove that an undisclosed fact really mattered, and on issuers to get the balance right by disclosing everything that is material but without inundating potential investors with non-material information.