Danier Leather Wins Appeal of Prospectus Disclosure Case.

Ontario Court of Appeal overturns earlier class action judgment that Danier made misrepresentations to IPO shareholders

Introduction

The Ontario Court of Appeal recently decided that corporations or other entities issuing shares or other securities to the public pursuant to a prospectus are not obliged under the disclosure requirements found in the Ontario Securities Act to update the final prospectus to reflect changes to material facts. This means that under the Ontario Securities Act a final prospectus is required to contain full, true and plain disclosure of all material facts as of the date of the final prospectus, but not thereafter (including the date of the closing of the offering). Once a receipt for the final prospectus is issued, only a material change in the business, operations or capital of the issuer will require the preparation and filing of an amendment to the prospectus.

With important ramifications for the expected wave of upcoming securities class action lawsuits, the Court of Appeal also confirmed that consideration of the "business judgement rule" is applicable to the Court's analysis of a misrepresentation and that considerable deference should be given to the issuer's management in regard to making determinations concerning what constitutes "material changes" and "material facts."

Background

On December 15, 2005, the Ontario Court of Appeal released a unanimous decision1 overturning a 2004 Ontario Superior Court of Justice judgment2 whereby Danier Leather Inc. ("Danier") (TSX: DL.SV) and its CEO and CFO were found liable to investors for an amount totalling an estimated $15 million related to a misrepresentation made in Danier's prospectus for its $65 million initial public offering ("IPO"). The trial decision was the first judgment in Ontario where section 130 of Ontario's Securities Act was applied. Section 130 provides investors who purchase shares pursuant to a prospectus with the right to sue for damages if the prospectus contains a misrepresentation without the need for the investors to prove that they relied on the misrepresentation when making their investment decision.3

The investor plaintiffs in Kerr v. Danier Leather purchased shares in Danier in 1998 under its IPO. Two weeks before the closing of the IPO, Danier filed a final prospectus that contained a financial forecast for the remainder of Danier's fiscal fourth quarter. Ten business days after the closing of the IPO, Danier issued a press release announcing that "unseasonably warm weather" had reduced the expected sales of its leather goods. Danier revised its forecast for the fiscal fourth quarter and the market price of Danier's shares fell almost 30% in the next four days, leaving investors with millions of dollars in paper losses. However, by the end of the fourth quarter, the results in the original forecast contained in the final prospectus were in fact substantially achieved.

Investors in Danier's IPO sued for damages pursuant to section 130 of the Securities Act on the basis that the prospectus contained an untrue statement of a material fact and/or omitted a material fact. The investors in the Danier IPO alleged that when the IPO closed, the original forecast no longer reflected management's best judgement of the most probable economic conditions and expected results. In fact, since information regarding sales performance was available to management of Danier on a daily basis, the plaintiff investors claimed in part that management knew at the time of the IPO closing that there had been a business downturn and that the forecast contained in the prospectus was not management's best estimate. The investor plaintiffs argued that disclosure (by way of an amendment to the final prospectus prior to the closing of the IPO) was required to correct the false and misleading forecast and that the purchase price of the shares was artificially high due to the misrepresentation.

The trial judge accepted the plaintiffs' argument and held Danier and its CEO and CFO liable for the drop in the price of Danier's shares caused by the misrepresentation. The trial judge ruled that investors who bought shares in the IPO and sold them in the immediate aftermath of Danier's profit warning were entitled to recoup their losses. Those who did not sell their stock were awarded $2.35 per share in damages - an amount representing the fall in Danier's share price after the market had absorbed the effects of the revised forecast. Danier and its CEO and CFO appealed. The appellants appealed the trial court's judgment on five grounds, only three of which were addressed by the Court of Appeal.

The Court of Appeal's Decision

The first ground of appeal was that the trial judge erred in concluding that, under section 130 of the Securities Act, Danier had a continuing obligation to disclose material facts occurring after the date of its final prospectus and until the date of the completion of the IPO. The Court of Appeal carefully examined the distinction between the definitions of "material change" and "material fact" found in the Securities Act. For a corporate issuer, a "material change" means a change (or a decision to implement a change) in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the issuer's securities.4 A "material fact" is a broader term and simply means a fact that would reasonably be expected to have a significant effect on the market price or value of an issuer's securities. Many matters could constitute material facts without necessarily constituting material changes. The Court of Appeal accepted that a change to a company's forecasted financial results is likely a material fact, but it is not by itself a material change. The Court of Appeal found there was no obligation under section 130 or elsewhere to disclose any new material fact that may arise after obtaining a receipt for the final prospectus and before the closing of an IPO unless the fact constitutes a material change.5 The Court of Appeal noted that the Securities Act has a "complete code of prospectus disclosure"6 requiring: (i) full, true and plain disclosure of all material facts to be included in a prospectus on the date it is finalized;7 and (ii) an amendment to a prospectus where a material change occurs after the receipt for the prospectus but prior to the completion of the distribution of the securities under the prospectus.8 In effect, the Court of Appeal found that the trial judge erred by reading the prospectus and related disclosure requirements as though the prospectus were to be effectively signed on the date of the IPO closing instead of on the date of the final prospectus. The Court of Appeal also found that if the Ontario Legislature had intended to require issuers to disclose material facts occurring between the date a receipt is given for a prospectus and the end of the distribution period, it would have expressly said so in the Securities Act as it does for material changes. Since prospectuses must be updated during the period of distribution only for material changes but not for material facts, purchasers of IPO shares are not entitled to assume that no new material facts have occurred that would reasonably be expected to have a significant impact on the market price or value of those shares after the date of the final prospectus and prior to the date on which they acquire the shares under the prospectus.9

The Court of Appeal recognized that securities regulators and the Toronto Stock Exchange ("TSX") have adopted policies incorporating disclosure obligations going beyond those in securities legislation. One example is National Policy 51-201 - Disclosure Standards ("NP 51-201"), which deals with timely disclosure. Section 4.5 of NP 51-201 acknowledges that the TSX has a policy requiring listed companies to make timely disclosure of all "material information," which includes both "material facts" and "material changes" relating to the business and affairs of the company.10 NP 51-201 states that it expects listed companies to comply with the TSX's requirements. Another example of the requirements of regulatory policy exceeding the disclosure requirements found in the Securities Act is National Policy 48 ("NP 48"), which deals with the preparation and disclosure of future-oriented financial information ("FOFI"). NP 48 also goes beyond legislative requirements. Part 7 of NP 48 addresses "Updating FOFI." Section 7.1(1) states:

When a change occurs in the events or in the assumptions used to prepare FOFI that has a material effect on such FOFI, such a change shall be reported in a manner identical to that followed when a material change occurs as defined under the Securities Legislation and Securities Requirements.

The scope of "change" in subsection 7.1(1) of NP 48 appears to be broader than "material change" under the Securities Act. Failure to comply with regulatory policies such as NP 51-201, the TSX's requirements or NP 48 may invite an administrative proceeding before a provincial securities regulator.11 However, the Court of Appeal in Kerr v. Danier Leather agreed with the trial judge and acknowledged that policy statements issued by securities regulators are not law. Policy statements may be relied on in proceedings before a securities regulator, but they cannot be used as the basis for an action for prospectus misrepresentation under section 130 of the Securities Act.12

The second ground of appeal was that the trial judge erred in concluding that Danier's prospectus contained an implied representation that its forecast was objectively reasonable. The Court of Appeal found that "there was no basis upon which the trial judge could have properly concluded that the Forecast [in Danier's prospectus] contained an implied representation of objective reasonableness."13 The Court of Appeal found that the existence of such an implied representation was an issue of fact rather than an issue of law and that the trial judge could not have properly concluded that the forecast in Danier's prospectus contained such a representation.

The third ground of appeal was that the trial judge made a palpable and overriding error in assessing the objective reasonableness of the forecast without considering the business judgement of Danier's senior management and the fact that, in the end, Danier came close to actually achieving its forecasted financial results. The Court of Appeal decided that since the forecasted results represented "one of several reasonable alternatives" and was "within a range of reasonableness," the trial judge erred in law by failing "to give any deference to the business judgment of Danier's senior management."14

This decision in the Danier matter has important implications for participants in the Canadian capital markets.

Implications of the Court of Appeal Decision

For issuers and underwriters, the most significant implication of the Court of Appeal's decision is that the exposure to potential statutory liability for a misrepresentation in a prospectus is more limited than that found in the trial decision. Issuers and their advisors can focus on the date of the final prospectus when considering if their prospectus contains full, true and plain disclosure of all material facts. Although the practice may not be consistent with NP 51-201 or the TSX's disclosure requirements, an issuer does not need to disclose a new material fact arising after the date of the final prospectus unless such a fact also constitutes a "material change."

It is important to point out that, although one may understand the difference between the definitions of "material fact" and "material change," in practice it is often difficult to conclusively make determinations in regard to these terms - as anyone who has attempted to apply these definitions in real situations will know. Determining the materiality of information is clearly an area where judgement and experience are of great value. In making materiality judgements, it is necessary to take into account a number of factors that cannot be captured in a simple bright-line standard or test. These include the nature of the information itself, the volatility of the issuer's securities and prevailing market conditions. The materiality of a particular event or piece of information may vary between issuers according to their size, the nature of their operations and many other factors. Similarly, whether an event constitutes a "change" in the business, operations or capital of the issuer can also be subject to considerable deliberations.15 Readers are encouraged to contact their legal counsel for advice and assistance.

For investors, the implication of the Court of Appeal's decision in Kerr v. Danier Leather is that purchasers of securities pursuant to a prospectus may no longer assume that a final prospectus contains full, true and plain disclosure of all material facts as at the day of the closing of their purchase. Assuming no amendment to the prospectus is filed, the date of the final prospectus is the relevant date for providing this disclosure and for any recourse that section 130 of the Securities Act may provide.

Civil Liability for Secondary Market Disclosure

The Court of Appeal's decision in Kerr v. Danier Leather will likely have interesting implications for Ontario's new statutory civil liability regime for secondary market disclosure which came into force on December 31, 2005.16 The Court of Appeal agreed that the change in Danier's forecast did not constitute a material change and it gave considerable deference to Danier's management in regard to their decision-making process and analysis of determining what matters constituted material facts and material changes. The Court of Appeal specifically rejected the argument that the business judgement rule has no application to the analysis of a misrepresentation.17 The Court of Appeal quoted an earlier judgment with approval:

The business judgment rule protects Boards and directors from those that might second-guess their decisions. The court looks to see that the directors made a reasonable decision, not a perfect decision. This approach recognizes the autonomy and integrity of a corporation and the expertise of its directors. They are in the advantageous position of investigating and considering first-hand the circumstances that come before it and are in a far better position than a court to understand the affairs of the corporation and to guide its operation.18

Therefore, it is predicable that future defendants, both under section 130 as well as the new statutory civil liability regime for secondary market disclosure, will be making reference to the Court of Appeal's decision in Kerr v. Danier Leather and arguing that considerable deference should be given to the issuer's management in regard to making determinations concerning what constitutes material changes and material facts.

Stay tuned - The plaintiffs who purchased Danier's IPO shares have 60 days to decide if they are going to seek leave to appeal to the Supreme Court of Canada. For more information on the subject of this bulletin, please contact the authors or any member of Fasken Martineau's Securities and Mergers & Acquisitions Group or Securities Litigation Group.

Footnotes

1. See: Kerr v. Danier Leather Inc. (Ontario Court of Appeal) (hereinafter "Kerr v. Danier Leather") currently unreported but available online at:http://www.ontariocourts.on.ca/decisions/2005/december/C41880.htm

2. Kerr v. Danier Leather Inc. [2004] O.J. No. 1916 (Sup. Ct)

3. The normal legal test is that a plaintiff must prove that a misrepresentation existed and that the plaintiff actually relied on the misrepresentation when the plaintiff made its investment decision.

4. Section 1(1) of the Securities Act

5. See para. 89 and 128 of Kerr v. Danier Leather

6. See para. 91 of Kerr v. Danier Leather

7. Section 56(1) of the Securities Act

8. Section 57(1) of the Securities Act

9. See para. 87 and 128 of Kerr v. Danier Leather

10. See section 408 of the TSX Company Manual

11. For example, in Re Royal Trustco Limited, Kenneth Allan White, and John Merton Scholes (1981) 2 OSCB 322C, the OSC considered whether the directors of a reporting issuer had an obligation to update information previously disclosed in a directors' circular in response to a take-over bid. The OSC stated as follows: "The [OSC] is of the view that there is in Ontario today a duty to update information previously communicated when that information in the light of subsequent events and absent further explanation, becomes misleading."

12. See paras. 101 to 104 of Kerr v. Danier Leather

13. See para. 142 of Kerr v. Danier Leather

14. See para. 170 and 175 of Kerr v. Danier Leather

15. For example, see Pezim v. British Columbia (Superintendent of Brokers), [1994] 2 S.C.R. 557, where the Supreme Court of Canada held that a change in assay and drilling results was a "material change" in the company's assets.

16. See Part XXIII.1 of the Securities Act

17. See para. 159 of Kerr v. Danier Leather

18. See para. 158 of Kerr v. Danier Leather which quotes from UPM-Kymmene Corp. v. UPM-Kymmene Miramichi Inc. (2002), 214 D.L.R. (4th) 496 (Ont. Sup.Ct.J.), aff'd [2004] 250 D.L.R. (4th) 526 (C.A.).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Mr Geoff Clarke

Fasken Martineau

PO Box 20, Suite 4200

66 Wellington Street West

Toronto

Ontario

M5K 1N6

CANADA

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