The Supreme Court of Canada released its decision in the Kerr v. Danier Leather Inc. case on October 12, 2007. This decision has been eagerly anticipated due to its importance for the Canadian capital markets, in the wake of the Ontario Court of Appeal’s decision to overturn the significant class action trial judgment awarded to investors for an alleged prospectus misrepresentation. In unanimously dismissing the appeal by the investors from the Ontario Court of Appeal decision, the Supreme Court of Canada, in a rare securities law decision, has now finally concluded the Danier saga, which has run for more than nine years.

The Supreme Court determined that Danier was under no obligation to amend its final prospectus for its 1998 initial public offering between the date it was filed and the date of the IPO closing, to reflect new interim sales figures that came to light before the closing and that were different from a forecast in the prospectus. In doing so, the Supreme Court concurred with the Ontario Court of Appeal’s view that the Securities Act (Ontario) (OSA) only required Danier to amend its prospectus to reflect a material change in its business, operations or capital that occurred and not a material fact that arose during that time period, and that, therefore, the prospectus did not contain a misrepresentation.

With respect to disclosure decisions by public issuers, the Supreme Court concluded that the business judgment rule was not applicable and that disclosure is a matter of legal obligation.

In the part of its decision that will likely decrease the enthusiasm of investors for launching future class action proceedings of this kind, the Supreme Court also confirmed the Ontario Court of Appeal’s award of costs against the representative investor.

We discussed the trial decision in the December 2004 issue of The Material Change Report and described how it raised the disclosure bar for issuers and their advisers. In the Spring 2006 issue of The Material Change Report, we examined the Court of Appeal’s unanimous decision to overturn the trial judgment and the calming effect that ruling had on directors and management of public issuers in Canada. The Supreme Court decision will now continue that calming effect.

Background 

In Danier’s 1998 IPO, the final prospectus contained a forecast regarding the company’s anticipated financial results for the fourth quarter of its fiscal year. During the period between the date of the final prospectus and the closing of the offering, Danier’s management reviewed a further internal analysis comparing the actual results to date in that quarter with the forecast contained in the prospectus. The analysis showed lower sales of Danier’s products and concluded that if the trend continued, there would be a significant shortfall in revenue in the quarter as compared with the forecast. Danier’s management still believed at that point that the forecast results were achievable because of some planned sales promotions. However, those sales improvements did not occur due to warm weather and about two weeks after the closing of the offering, Danier issued a revised forecast reducing the projected financial results and its share price fell about 20%. Later sales of Danier’s products did rebound and the quarterly financial results in the original forecast were ultimately substantially achieved.

The Trial Decision

The trial judge’s decision was significant for several reasons and was the subject of great debate. The trial judge based his judgment in favour of the disgruntled shareholders that brought the class action alleging prospectus misrepresentation on the following main points:

  • a forecast in a prospectus can be a material fact and will be a misrepresentation if any of the factual information underlying the forecast is untrue. As a result of Danier’s additional internal analysis, management should have known that the implied representation that the forecast was objectively reasonable was incorrect and by not issuing a revised forecast before the offering closed, the company and management were liable for misrepresentation; and
  • the actual fourth quarter results shown to date in the internal analysis prepared after the final prospectus were material facts that Danier was required to disclose before the closing of the offering, even though no material change had occurred.

The trial judge awarded substantial damages to the plaintiffs after finding Danier and its senior officers liable and he used the drop in Danier’s share price after the release of the revised forecast as the basis on which to calculate the damages.

The Ontario Court of Appeal Decision

In overturning the trial decision, the Ontario Court of Appeal unanimously determined that the trial judge had made three errors:

  • Danier was under no obligation to amend its prospectus to disclose material facts that occurred during the period between the date of the final prospectus and the date of closing of the IPO. The Court of Appeal ruled that the OSA only requires an amendment for material changes that occur between the date of the final prospectus and the date of closing;
  • the trial judge incorrectly concluded that including an earnings forecast in a prospectus gave an implied representation that the forecast and the basis for making it were objectively reasonable. The Court of Appeal held that there was no implied representation as of the closing date of the offering about the objective reasonableness of management’s belief in the forecast; and
  • the trial judge failed to give deference to the business judgment of Danier’s senior management as to whether the forecast was reasonable and did not take into account the fact that the forecast was ultimately substantially achieved. The Court of Appeal emphasized that management’s business judgment needed to be within "a range of reasonableness" and relied on its own previous decision in the Schneider case and the Supreme Court of Canada’s decision in the Peoples Department Stores case. The Court of Appeal reiterated that the business judgment rule requires only that a reasonable decision be made, not a perfect one. Where one of several reasonable alternatives is selected, deference should be given to the decision taken. In Danier, the Court of Appeal held that while Danier’s management may have been too optimistic in viewing the forecast, it should be given deference because the decision regarding the forecast was within a range of reasonableness.

The Supreme Court of Canada Decision

In dismissing the appeal, the Supreme Court decided the following:

  • the applicable sections of the OSA are to be read to mean that when a final prospectus is accurate at the time of filing, the issuer is only obligated to amend the prospectus prior to the closing of the offering where a material change occurs. The issuer has no similar obligation to amend the prospectus where information amounting to a material fact arises after the final prospectus is filed but before the offering closes. The Supreme Court determined that this was a distinction drawn deliberately by the Ontario legislature and it declined to interfere with that distinction. It also noted that the 1997 Allen Report of the Toronto Stock Exchange Corporate Disclosure Committee and the 2003 Crawford Report of the Ontario Ministry of Finance Five Year Review Committee had considered whether the OSA should be amended to require continuing disclosure by issuers of material facts or whether the policy of requiring the disclosure of only material changes should be continued and, in each case, recommended against changing the law;
  • the poor interim sales results shown in the internal analysis prepared prior to the IPO closing, caused by an external factor (the weather), did not amount by themselves to a material change for Danier. The Court noted that interim sales results may reflect a material change in a company’s operations while still not amounting to a material change by themselves. The Court acknowledged that an issuer’s failure to disclose a material change that occurs before the closing of an offering could support an action for prospectus misrepresentation under the OSA;
  • the Supreme Court disagreed with the Ontario Court of Appeal’s conclusion that the financial forecast in the prospectus contained no implied representation of objective reasonableness. The Supreme Court concluded that as a matter of fact, the forecast did carry an implied representation of objective reasonableness but, in any event, this implied representation extended only until the date that the final prospectus was filed and receipted;
  • in another departure from the Ontario Court of Appeal decision, the Supreme Court declined to apply the "business judgment rule" to the facts of the case, saying that while deferring to the business judgment of management is appropriate in the context of business decisions, it "… should not be used to qualify or undermine the duty of disclosure." While acknowledging its belief that the Court of Appeal did not intend to say otherwise, the Supreme Court rather bluntly concluded that the disclosure requirements under the OSA "… are not to be subordinated to the exercise of business judgment"; and
  • the Supreme Court declined the arguments of counsel for the investors that Danier and its management should not be the beneficiaries of a cost award in the event the investors were unsuccessful in their appeal to the Supreme Court. In awarding costs against the representative investor, the Court, again rather bluntly, observed that the case did not raise a novel point of law nor was this a test case selected to resolve other legal issues applicable to other pending cases. The Court made further observations that none of the parties were disadvantaged or lacked access to the court system and it did not disagree with the Court of Appeal’s view that " … this case is a piece of Bay Street litigation that was well run and well financed on both sides." The terms of the cost award are to be determined at a later date.

Conclusions

In its strong decision, the Supreme Court has reiterated that there is no continuing obligation under the OSA to update a prospectus where additional material facts become evident after the final receipt date and before the closing of the offering. The Supreme Court also reiterated that the OSA only obliges an issuer to disclose a material change that occurs and amend the final prospectus accordingly, which is beneficial to issuers facing a long period between the date of a final prospectus and closing. The Court also concluded that with respect to disclosure decisions by public issuers, the business judgment rule was not applicable and that disclosure is a matter of legal obligation. Finally, the Court also made it clear to the class action litigation bar that plaintiffs have to be prepared to shoulder the risk of adverse and potentially substantial cost awards in the event of unsuccessful proceedings.