In Rahimi v. SouthGobi Resources Ltd., the Ontario Court of Appeal considered the reasonable investigation defence in ss. 138.3(6) and (7) of Ontario’s Securities Act, in respect of a motion for leave to bring a misrepresentation claim. The motion judge granted leave to bring a misrepresentation claim against the defendant corporation, but declined to grant leave to proceed against certain directors and officers (D&Os). The Court of Appeal reversed his decision with respect to the D&Os, clarifying the legal test and, in particular, the application of the “reasonable investigation” defence.
The action arose out of a formal restatement by the corporate defendant of its financial statements, and a press release in which it stated “that there was ‘a material weakness in the Company’s internal controls over the financial reporting.’” (para. 15) On the leave motion, the D&Os took the “unusual position” that there was no misrepresentation during the class period; rather, any potential misrepresentation was in the restatement and/or the press release. (para. 18) In support, the D&Os led “nearly identical” evidence that they did not mean to convey that the financial statements contained misrepresentations; instead, reference “to the inaccuracy and unreliability of the earlier financial statements [in the press release] ‘flowed, ipso facto, from the restatement decision itself.’” (paras. 18-21)
Ruling by the Motions Judge
Confronted with a “limited record and significant credibility issues”, the motions judge determined that it would be appropriate to determine these credibility issues in the course of assessing if there was a reasonable possibility that the defendant would not be able to establish the defence.
Court of Appeal’s Analysis
The Court of Appeal overturned the motion’s judge decision because these issues could not be resolved on the existing record. (para. 50) In so doing, the Court of Appeal endorsed the same test for the reasonable investigation defence that it endorsed for s. 138 leave, namely, “whether there is a reasonable possibility that the defendant will not be able to establish one or more of the branches of the reasonable investigation defence at trial” (para. 44; the Court of Appeal had previously affirmed this test in its decision in Green v. CIBC, para. 94). It followed that the motions judge was not in a position to conclude “that the reasonable investigation defence will succeed.”
A pivotal aspect of the case, according to the Court of Appeal, lay in the discrepancy between the affidavit evidence filed on behalf of the D&Os, the available documentary evidence, and the precise nature of the gaps in the record. The Court of Appeal identified four central evidentiary deficiencies:
- The D&Os’ affidavit evidence was unsupported by the sparse record. There was no “contemporaneous document that is consistent with the [D&Os] current narrative”, with the limited evidence on the record supporting the other narrative; (paras. 52-55)
- The concession of a material weakness in internal controls, coupled with the fact that there was no subsequent correction of what was allegedly false information, “raises another important credibility issue” and supports the inference that the D&Os’ current position is “not truthful”; (paras. 56, 59)
- As a result of the gaps in the record and the above credibility issues, the Court was not prepared to give credence to the D&Os’ evidence that they relied on their auditors’ advice (at least not without affidavit evidence filed on the auditors’ behalf affirming this position); (para. 60) and
- The evidentiary record did not actually support the D&Os’ explanation as to why the formal restatement was issued (namely, pressure from U.S. securities regulators, among others, to issue the restatement). (paras. 61-74)
The issue for the Court of Appeal was that, for policy reasons, “very strong evidence” is required for an issuer to release a restatement and “later resile from that restatement” because “the conflicting positions raise serious credibility issues.” (para. 79) All of this is to say that there is an important distinction that arises in Rahimi between the test set down by the Court of Appeal – being the same as the test for s. 138 leave – and the distinctive way it had to be applied, flowing from the “very unusual facts of this case.” (para. 78)
- The test for the reasonable investigation defence is the same test as for leave under s. 138 of the Securities Act: “whether there is a reasonable possibility that the defendant will not be able to establish one or more of the branches of the reasonable investigation defence at trial.” (para. 44; cf. Green, para. 94, as noted above).
- A defendant will be unlikely to establish the reasonable investigation defence without credible evidence; however, even if there are credibility issues arise, the defence may still be made out if, read in the totality of the circumstances, the contemporaneous documentary evidence supports the defendant’s narrative.