The Ontario Superior Court of Justice’s (Court) recent decision in Rahimi v. SouthGobi Resources (Rahimi) confirms that courts will consider and evaluate defences at the leave stage of a statutory secondary market disclosure proceeding under Part XXIII.1 of the Ontario Securities Act (OSA). The decision also illustrates how a court’s assessment of these defences may differ as between an issuer and its directors and officers such that, in certain cases, separate representation for the issuer and the individual defendants should be considered.
In Rahimi, the plaintiff sought leave under section 138.8 of the OSA to pursue the defendant issuer SouthGobi Resources Ltd. (SGR) as well as a number of SGR’s current and former directors and officers, based on alleged misrepresentations. The Court ultimately granted the plaintiff leave to pursue its statutory claim against the defendant issuer but dismissed the motion as against the individual defendants on the basis of the reasonable investigation defence.
The case involves alleged misrepresentations that appeared in SGR’s financial statements between 2010 and 2012. The alleged misrepresentations relate to the manner in which the company recognized revenue from its “bill and hold” arrangements involving the sale of coal from its main mine in Mongolia, near the Chinese border.
On November 8, 2013, SGR issued a press release announcing, among other things, that “certain revenue transactions were previously recognized in the Company’s consolidated financial statements prior to meeting relevant revenue recognition criteria” and that “the previous financial information provided by the Company in respect of the periods to be covered by the Restated Financials are no longer accurate and should not be relied upon.” The release went on to note that SGR was also “re-examining the Company’s internal controls over financial reporting and disclosure controls and procedures in order to identify material weaknesses with such processes which gave rise to the decision to prepare the Restated Financials.”
In the days following the November 8 press release, the SGR share price dropped dramatically and class actions were filed in New York and Toronto. The parties in the Toronto action agreed that the motion for leave would be decided prior to the motion for certification of a class proceeding.
The motion judge noted that since the Supreme Court of Canada (SCC) has yet to release its decision in the trilogy of limitation period cases (see our August 2014 Blakes Bulletin: Supreme Court of Canada to Hear Securities Class Action Limitation Period Cases), the leave test that was set out by the SCC in Theratechnologies Inc. v. 121851 Canada Inc.as augmented by an earlier decision of the Court of Appeal for Ontario would continue to apply: Is the plaintiff’s case so weak or has it been so successfully rebutted by the defendant, that it has no reasonable possibility of success?
The motion judge noted that the defendants presented “a large volume of compelling evidence” to support their position that the financial “misrepresentations” were actually true when made and, in any event, relied on the reasonable investigation defence.
MISREPRESENTATION AND REASONABLE INVESTIGATION DEFENCE
The motion judge granted leave to proceed against the issuer on the misrepresentation issue based on the “specificity and force of the November 8, 2013 restatement.”
The motion judge then turned to the reasonable investigation defence, pursuant to section 138.4(6) of the OSA. The defence provides that a person or company is not liable in a statutory misrepresentation action if that person or company proves two things: (1) that it conducted or caused to be conducted a reasonable investigation before the document was released, and (2) that it had no reasonable grounds to believe at the time of the document’s release, that the document contained the misrepresentation.
The motion judge acknowledged that the reasonable investigation defence is usually raised at trial, at which time the onus is on the defendants to prove the defence on a balance of probabilities. When the defence is raised at the leave stage, the motion judge noted that defendants must meet a “relatively high hurdle” and establish that there is no reasonable possibility that the defendants will not be able to establish one or both branches of the defence at trial.
The motion judge held that there is room for argument that the reasonable investigation defence on the part of the company itself may not succeed at trial, because:
- The fact of the restatement is itself arguably inconsistent with a reasonable investigation
- An admission of weakness in a company’s internal financial controls is evidence that is inconsistent with the company having performed a reasonable investigation
- No evidence was adduced on the motion from any member of the company’s management at the time of the restatement to explain why management said what it said
On this basis, leave was granted for the plaintiff to pursue the misrepresentation claims against SGR.
However, the motion judge found that the company’s current and former directors and officers who were named as individual defendants presented detailed and credible evidence, unchallenged on cross-examination, which showed that they did everything that could reasonably be expected of them in their respective roles and that they had no reasonable grounds to believe the financial disclosures released under their jurisdiction over the time periods in question contained any misrepresentations. Accordingly, the motion judge denied the plaintiff leave to proceed against the individual defendants on the basis that there was no reasonable possibility of the plaintiff proving at trial that the reasonable investigation defence had not been made out.
The Rahimi decision shows that courts are willing to consider defences that are supported by compelling evidence to deny leave to pursue claims under Part XXIII.1 of the OSA. It also highlights that different considerations can apply as between an issuer and its directors and officers relating to secondary market disclosure claims. As a result of these new developments, defending parties and their counsel should consider at an early stage whether issuers and officers and directors should have separate representation.