As late as mid-December 2005, plaintiffs’ lawyers were poised to take advantage of Bill 198, which amends Ontario’s Securities Act. The new law, which took effect Dec. 31, 2005, created the first Canadian regime to impose civil liability for inaccurate or incomplete written and spoken corporate disclosures in the secondary market.
But on Dec. 15, 2005, the Ontario Court of Appeal broadsided the plaintiffs’ bar by reversing the May 2004 judgment of Superior Court Justice Sidney Lederman in the groundbreaking case Kerr v. Danier.
Danier was the first case tried under Section 130 of Ontario’s Securities Act since the provision was enacted some 30 years ago. The section, which applies to IPOs but not to trading in the secondary market, allows purchasers of shares to claim damages if they can establish that the offering prospectus contained a misrepresentation. If the appeals court had upheld Lederman’s decision, it would have required companies, boards and managers to be nearly perfect in their disclosures. It also would have made it much easier for plaintiffs to prove disclosure violations under Bill 198, which shares important similarities with Section 130.
“The court was sensitive to the well-greased wheels of the capital market,” says Nigel Campbell, a litigation partner at Blake Cassels & Graydon in Toronto. “It removed the climate of intimidation of management and directors that followed on the trial result.”
Naturally, the plaintiffs’ bar doesn’t see it that way. “The Court of Appeal has set a low bar for disclosure of material facts,” says George Glezos, a litigation partner in the Toronto office of Lerners, who, along with colleague Peter Jervis, represented the
To be sure, Judge Lederman’s ruling set a very high standard. The trial judge ordered Danier Leather Inc., a Canadian leatherwear retailer, as well as its CEO and CFO, to pay $13 million in damages to investors who bought shares in the company’s $60 million IPO in May 1998. Lederman reasoned that the defendants had breached Section 130 by failing to disclose material facts of which they became aware between the filing of the prospectus and the IPO’s closing–even though the prospectus eventually proved to be accurate.
Lederman ruled the prospectus contained a misrepresentation. He calculated that investors suffered losses equal to the difference between the IPO price of $8.27 and the $6.57 value of the shares after Danier revised its projections following the IPO’s closing.
All this left Bay Street, Canada’s equivalent of Wall Street, holding its collective breath. Likewise, the news of the judgment’s reversal led it to issue a collective outpouring of relief.
As the Court of Appeal saw it, the duty of disclosure arose from the prospectus filing and delivery provisions of the Securities Act, which require issuers to make full, true and plain disclosure of material facts when filing a prospectus.
The Securities Act, the court stated, makes a distinction between a “material change” that affected an issuer’s “capital, operations or business,” and a “material fact,” which didn’t have such an impact. The Court of Appeal held that an issuer is only obligated to disclose material changes.
The Court of Appeal agreed with Lederman that the change in the weather that led to lower sales than it expected constituted a new “material fact.” But that material fact, in the Court’s opinion, didn’t produce a material change in Danier’s capital, operations or business. Absent a material change, there was no misrepresentation or nondisclosure in the prospectus and liability didn’t arise for its failure to disclose it.
“Danier demonstrates that judges will read securities legislation purposefully keeping in mind the expertise of those who drafted it,” Campbell says.
As it turns out, Bill 198 liability also is predicated on failure to disclose a material change. This means plaintiffs making claims under the new law will face the same hurdle that confronted the Danier plaintiffs.
But a relaxed disclosure standard was not the only pleasant surprise that Danier offered the business community.
According to the appeals court, even if the company did have an obligation to update its prospectus, the Danier trial judge erred in failing to apply the business judgment rule, which prohibits courts from second-guessing the reasonable judgments of boards and management.
The Court of Appeal reasoned that if Justice Lederman had applied this rule, he would have found management’s belief reasonable.
“[Management's view] might have been an optimistic one,” the court stated, “but it was not unreasonable in the sense that it was outside the range of reasonable views of Danier’s situation.”
Not surprisingly, this approach finds favor with Alan Lenczner, the partner at Lenczner Slaght Royce Smith Griffin who represented Danier. “The trial judge shouldn’t have second-guessed management,” he says. “After all, how many leather coats has he ever sold?”
Even Harvey Strosberg, a partner at Sutts Strosberg in Windsor and arguably the dean of the plaintiffs’ class action bar in Canada, doesn’t quarrel with the court’s application of the rule.
“Nobody’s saying you can’t second-guess an Enron situation,” he said. “The appeal decision in Danier makes sense in the context of a balance between investors’ need to know and issuers’ need to have capable people act as directors without fear of liability.”
As Paul Morrison, a litigation partner at McCarthy T?? 1/2 trault’s Toronto office, puts it: “When you’re close to the line and into the gray areas, Danier’s reaffirmation of the business judgment rule has to be comforting to defendants.”
But perhaps not comforting enough.
A Premature Celebration
Although the Court of Appeal’s decision in Danier reinvigorated the business judgment rule and revitalized the distinction between a “material change” and a “material fact,” the decision is likely not a placebo for Bill 198 woes.
“The decision is timely but there is still a lot of consternation on the street about Bill 198 because of its broad extension of liability to the secondary market,” says William Braithwaite, a partner in Stikeman Elliott’s Toronto office.
While a due-diligence defense is available (see “At A Glance: Bill 198″), defendants relying on it must demonstrate that they have conducted a “reasonable investigation” into the true facts.
“Companies will have to implement a formal disclosure system that is expressly aimed at ensuring that the company meets its disclosure obligations,” says Larry Lowenstein, a partner at Osler Hoskin Harcourt in Toronto.
Andrew Fleming, a partner in Ogilvy Renault’s Toronto office, agrees that caution remains the order of the day: “If a client came to me and said ‘I don’t have to worry quite as much after Danier,’ I would agree with him, but I would also tell him to keep his worry beads in hand because Bill 198 still goes a long way to encouraging investors to exercise rights they could not previously exercise.”
At a Glance: Bill 198
Bill 198 creates civil liability for companies that make misrepresentations in continuous disclosures and filings made after Dec. 31, 2005.
Among those who can be sued under Bill 198 are directors and officers of publicly traded companies; that is to say, companies that are listed in Ontario or whose securities are publicly traded outside Ontario where the issuer has a substantial connection to the province.
Plaintiffs seeking to establish liability have the lowest burden of proof in relation to “core” documents. These include important filings such as financial statements and material-change reports. Once a plaintiff has proven a misrepresentation in a “core” document, the issuer must make out one of the defenses the legislation allows. The two key defenses available are a “due diligence” defense based on “reasonable investigation” and a “safe harbor” for misrepresentations in forward-looking information.
The burden is higher for plaintiffs relying on misrepresentations in noncore documents, as well as public oral statements. Here investors must show that defendants had knowledge of the misrepresentation, displayed a willful blindness or engaged in gross misconduct.