On September 28, the Ontario Securities Commission (OSC) released its decision in the case against Coventree Inc. Coventree, an investment bank specializing in structured finance, was the largest third-party sponsor of asset-backed commercial paper (ABCP) in Canada. OSC staff had alleged, among other things, that Coventree failed to disclose material facts in its prospectus of November 2006, and also failed to disclose material changes regarding subsequent developments in the subprime market.
Ultimately, the OSC found that while Coventree did not breach disclosure requirements with respect to its prospectus, the company did fail to disclose material changes to its business that occurred in early 2007 and during the August 2007 disruption in the ABCP market. Particular points of interest in the decision include the OSC’s discussion of materiality, the use of prospectus disclosure as a baseline for assessing the materiality of future events and the distinction made between a change in the price of a security and a change in the value of a security.
The following are some key highlights emerging from the decision, some of which are discussed in detail below:
- while “material facts” are broader than “material changes” both are based on an objective assessment to be made in a contextual basis;
- prior disclosure can establish a “baseline” from which future disclosure decisions may be assessed (in that the company cannot later rely on the lack of impact that an event or occurrence may have if its prior disclosure did not provide adequate information for investors to be able to judge the subsequent event);
- disclosure of risks to which a company is subject is not sufficient to satisfy its material change disclosure obligation, if and when the risk actually transpires;
- materiality is based on the effect of the information on either the market price or the value of the securities;
- an issuer will not be liable for making premature disclosure where an event or occurrence has actually transpired, even though its impact or significance may be uncertain; and
- external events or developments that have a direct effect on or consequences for an issuer’s business or operations may constitute a material change.
As a preliminary matter, the OSC considered the difference between “material fact” and “material change”. While material facts are those facts that would reasonably be expected to have a significant effect on the market price or value of securities, a material change also requires a change in an issuer’s business, operations or capital. As such, the OSC confirmed that the definition of “material fact” is broader than that of “material change”, as the former will not necessarily arise from a change in an issuer’s business, operations or capital. The standard of materiality for both concepts, however, is the same and based on an objective standard. Importantly, the assessment of materiality also requires “a contextual determination that takes into account all of the relevant circumstances”. Assessments of materiality should not, however, be made with the benefit of hindsight. Thus, according to the OSC, Coventree’s disclosure decisions, which were made at the time events were unfolding, were not judged in light of the knowledge that a market disruption in the ABCP market actually occurred in August 2007. The OSC also confirmed that the business judgment rule does not apply to decisions regarding disclosure under the Securities Act. As such, Coventree’s disclosure decisions were not protected from scrutiny after the fact by an appeal to business judgment.
OSC Staff alleged that Coventree's prospectus, filed with the Commission on November 16, 2006, failed to disclose the fact that Coventree had received a letter from the Dominion Bond Rating Service (DBRS) on November 10 stating that the rating organization would henceforth be taking a more restrictive approach to rating credit arbitrage transactions. This was considered to be particularly important in this context, as Coventree relied on the prospectus exemption for suitably rated short-term debt in order for its conduits to issue the ABCP, and DBRS was the only approved organization rating ABCP with "Canadian style liquidity". Ultimately, however, the OSC found that the DBRS letter did not constitute a material fact, as the letter was: (i) unclear as to the criteria that would be applied in reviews of structured finance asset transactions; (ii) appeared to be a continuation of DBRS's existing "measured approach" to approvals; and (iii) did not affect outstanding transactions.
Despite this conclusion, the OSC did make a number of observations regarding the prospectus that were ultimately relevant in the Commission’s consideration of subsequent disclosure decisions. Of particular interest was the OSC’s pronouncement that the disclosure respecting the proportion of Coventree’s revenues deriving from credit arbitrage transactions (about 80%) was less than full, true and plain. According to the OSC, “full” disclosure is provided when disclosure is made of facts sufficient to permit investors to make an informed investment decision; “true” disclosure occurs if the disclosure is accurate, not misleading and does not omit a fact that is material or necessary to understand the facts as disclosed; and “plain” is disclosure that is understandable to investors in a plain language. The OSC also found that the prospectus failed to communicate that Coventree considered the credit arbitrage business to be “dead or dying”. The OSC’s observations in this respect were relevant insofar as the Commission concluded that the disclosure deficiencies it identified made it much more difficult for public shareholders and potential investors to fully understand the significance of subsequent developments.
DBRS release regarding credit rating methodology
OSC Staff also alleged that Coventree failed to disclose DBRS’s decision in January 2007 to change its credit rating methodology. According to Staff, the DBRS release was a material change and ought to have been immediately disclosed by Coventree.
While Coventree argued that the DBRS release did not change its business or operations in any way, the OSC found that the release imposed a requirement for global style liquidity that had not previously been required. Ultimately, the DBRS release was found to be an escalation of DBRS’s previous concerns regarding the credit arbitrage market and, given Coventree’s reliance on “Canadian style liquidity”, the DBRS release did in fact result in a material change to Coventree’s business.
Of particular interest is the OSC’s response to Coventree’s argument that the DBRS release could not have constituted a material change since there was no change in the market price of Coventree’s shares after the information was ultimately disclosed in Coventree’s second quarter MD&A. The OSC rejected this argument, stating that the fact that Coventree’s share price was not affected by the eventual disclosure did not mean that no material change had occurred. Rather, the OSC framed the issue as whether particular information would reasonably be expected to have had a significant effect on the value of securities, despite the lack of effect on the market price of the securities. According to the OSC, “one cannot assume…that the lack of impact on market price means that the information disclosed was not material.” In the immediate case, therefore, the OSC found that the DBRS release would reasonably be expected to have had a significant effect on the value of Coventree’s shares. Also, as described earlier, Coventree’s prospectus disclosure ultimately acted as a form of baseline from which to draw inferences regarding investors’ knowledge. Specifically, the OSC stated that investors did not appreciate how important credit arbitrage and CDO related SFA transactions were to Coventree’s business. Hence, the lack of a change in the market price did not necessarily imply that there had been no material change.
Material change prior to August 13, 2007
OSC Staff also alleged that Coventree failed to disclose liquidity related events in the days leading up to the disruption in the ABCP market that occurred on August 13, 2007, and that these events constituted a material change. In response, it was argued, among other things, that the events in question were external and widely known, and that specific disclosure by Coventree would have been premature. These arguments were, however, rejected by the OSC.
According to the OSC, it would not have been premature to disclose actual events and developments and their consequences to Coventree’s business, even if there was uncertainty as to their causes, future effects, financial impact or duration. As the OSC stated, “[a]n issuer does not subject itself to any liability…for premature disclosure where the disclosure made relates to events and their consequences that have occurred and is accurate, balanced and appropriately qualified.” According to the OSC, the possibility that ABCP market issues could be resolved as part of a negotiated “soft landing”, as believed by Coventree, was contingent, uncertain and highly speculative and did not insulate Coventree from its disclosure obligations.
The OSC also rejected Coventree’s argument that the events in question were external and did not require disclosure as per section 4.4 of NP 51-201 Disclosure Standards. According to the OSC, that provision is premised “on the assumption that investors will be aware of external economic developments and their general effects on reporting issuers.” In this context, the OSC was of the view that public shareholders and potential investors had very limited knowledge of the ABCP market and of events and developments affecting that market (again, looking back in part to the baseline of the prospectus).
Even if the exemption did apply, the OSC stated that the developments affecting Coventree were uncharacteristic of the effect generally experienced by other issuers in the same industry, due to Coventree’s size and its conduits’ exposure to ABCP and, as such, Coventree would be unable to rely on the provision regardless. According to the OSC, Coventree made a “critical error to the extent that it assumed that these external events or developments could not and did not have direct effects on, and consequences for, its business and operations that constituted changes in that business for purposes of the definition of ‘material change’ in the Act.”
In light of the OSC’s findings, on November 8, the Commission ordered Coventree to pay an administrative penalty of $1 million and costs of $250,000.