Originally Published In The Lexpert Magazine, February 2011
Shareholders of private companies may not be subject to securities regulation, but as guest columnists Gary Solway and Benjamin Gliksman of Bennett Jones LLP write, that doesn't mean they can flout insider-trading rules
If you thought insider trading laws only applied to publicly traded companies in Canada, you would be in good company. But you would be wrong. Canadian courts have frequently held that shareholders do not have fiduciary duties to each other, so it might be fair to assume that this is the end of the issue. It is not.
Since directors of private companies are often shareholders who trade the company's shares, this insider trading issue raises a corporate governance concern for directors. Subsection 131(4) of the Canadian Business Corporations Act (CBCA) – and similar provisions in some provincial legislation including the Business Corporations Act (Ontario) – provides that:
An insider who purchases or sells a security of the corporation with knowledge of confidential information that, if generally known, might reasonably be expected to affect materially the value of any of the securities of the corporation is liable to compensate the seller of the security or the purchaser of the security, as the case may be, for any damages suffered by the seller or purchaser as a result of the purchase or sale ...
The CBCA provision targets insiders of both public and private companies. The term "insiders" is broadly defined and includes directors and shareholders owning 10 per cent or more of a company's stock. For some reason, these provisions are not at all well known, and there has been very little judicial guidance on their meaning.
In the two cases that have addressed these provisions, the issue was whether a purchasing shareholder, aware of a third party's potential interest in buying the entire company and not having fully disclosed that information to the vending shareholder, used "specific confidential information" improperly in its purchase of shares from the vending shareholder. In both cases, all purchased shares were resold subsequently by the purchasing shareholder, at a higher price. The plaintiffs argued that they should be compensated for the price difference.
In the 1996 decision of Tongue v. Vencap Equities, the Alberta Court of Appeal upheld the lower court's decision finding the purchasing shareholders liable for insider trading under the CBCA. Prior to the plaintiffs' sale of shares, the purchasing shareholders were aware of a "serious expression of interest by a major company." The lower court held that the purchasing shareholders deprived the plaintiffs of information that materially affected the value of the stock they had sold.
Although the defendants had disclosed that there were potential offers to purchase the company and had caused the plaintiffs to sign acknowledgements and waivers to that effect, the defendants had failed to disclose that a particular expression of interest was from a major, international firm and that the offer was for potentially more than three times the purchase price. The courts found that the information had reached the threshold of "specific confidential information."
The court also found that the absolute general release signed by the plaintiffs was unenforceable because, under s. 122(3) of the CBCA, directors are forbidden from contracting out of their duties under the CBCA. The court held that the only exception would be if the plaintiff were aware that he or she had not been treated in accordance with the CBCA and still signed the release.
In the 2005 decision of Agrium Inc. v. Hamilton, the Alberta Queen's Bench distinguished Tongue, holding that the defendant shareholders were not liable for insider trading under the Business Corporations Act (Alberta) because the third party's mere expression of interest without a specified price did not constitute "specific confidential information." The lack of a specific price was the key differentiating factor.
These two cases are not determinative in analyzing s. 131(4), because the word "specific" was removed from the CBCA in 2001 with the intention of broadening the scope of the provision. A plain reading of the statute suggests that insider trading while in possession of any confidential information that might reasonably be expected to affect materially the value of the shares could be a violation of the section. The Business Corporations Act (Ontario) and the Business Corporations Act (Alberta) have retained the phrase "specific confidential information."
Defences are available to directors. The most significant is that a director will not be liable under the CBCA if the confidential information was known or "ought reasonably to have been known" by the plaintiffs, although this is not entirely clear.
In the context of the sale of a business by way of a share sale, where the purchaser sues a selling director-shareholder for failing to disclose confidential information, the director might well argue that the purchaser ought to have known the information. The director might say that the purchaser conducted due diligence and received representations and warranties in the sharepurchase agreement that were intended to address everything the purchaser was interested in knowing about.
If the purchaser did not ask a question, a director could contend that the purchaser's diligence was deficient (or adequate to the purchaser's needs) and the purchaser ought reasonably to have known (or did not care about) the confidential information. In other words, the claim should be denied if reasonable due diligence would have revealed the confidential information.
The scope of the insider trading provision, however, is extremely broad, and caveat emptor does not seem to offer much of a defence. Rather, the section seems to put the onus on the insider to disclose confidential information that could affect the value of the security — even if he or she is prohibited from disclosing that information by confidentiality restrictions. The director is restricted in his or her ability to contract out by virtue of s. 122(3), as noted in Tongue.
Directors are also protected if they reasonably believed the information had been generally disclosed or they conducted trades pursuant to certain pre-existing legal obligations. It is not clear whether "generally disclosed" means "public" disclosure or simply that the director believes the information was disclosed to the third party transacting with the director.
In situations where a director is a representative of a corporate insider shareholder, it is not clear what happens if the shareholder sells while the director is in possession of confidential information. If the director has not disclosed the information to the individual making the decision on behalf of the corporate shareholder to sell, it would seem unfair to impute the director's knowledge to the selling shareholder. The Securities Act (Ontario) has certain exemptions in cases of this sort; the CBCA does not.
One approach to resolving this issue, as a seller, may be to obtain an acknowledgement in the share-purchase agreement that the purchaser has asked all the questions it wants to ask and that the answers are reflected in the representations and warranties given by the seller in the agreement. The agreement should also state that, to the extent any of the representations or warranties is wrong, the purchaser agrees to some predetermined maximum amount of damages (probably some percentage of the purchase price) and that, absent a breach of the representations and warranties, the purchaser will not be entitled to any compensation or other remedies for lack of disclosure.
These insider trading prohibitions can also be problematic in the context of the rights of first refusal that are frequently contained in the shareholders' agreements of private companies. Typically, these provisions require that, in the event shareholders want to sell their shares, they must offer them to other shareholders before selling them to a third party.
Ordinarily, the other shareholders would simply decide whether they wanted to accept the selling shareholder's offer. However, if a shareholder is a director or other insider, he or she also needs to consider whether he or she is in possession of material confidential information relating to the private company. If so, it would seem that the insider is obliged to tell that information to the selling shareholder before buying shares from him or her, or risk liability under the insider trading provision.
If the director is restricted from disclosing that information – due to confidentiality obligations to the company or a third party – the director may not be able to purchase company shares under the offer, even though those shares will likely be sold to a third party at the same price offered to the director. The result is that the director is deprived of one of the principal benefits under the shareholders' agreement and potentially ends up with a new (unwanted) partner or a diluted stake in the company.
The Canadian Bar Association is encouraging the federal government to change these provisions, and that initiative has had some success. A recent report of the Standing Committee on Industry Science and Technology entitled Statutory Review of the Canada Business Corporations Act, dated June 2010, concluded that the issue of whether insider liability for tipping on private companies should be removed from the CBCA was one of a number of CBCA issues that should be reviewed through broad public consultation over the next two years.
However, for the time being, given the lack of judicial guidance and the fact-specific nature of these questions, a director of any private company selling or buying shares of the company should consider seeking legal advice regarding his or her potential disclosure obligations.
Gary Solway is Managing Partner of the Bennett Jones Technology, Media and Entertainment practice group and Co-Head of the Corporate Commercial Transactions practice group. His practice focuses on corporate/commercial, corporate governance and securities matters. Benjamin Gliksman is an articling student at Bennett Jones LLP currently in his corporate practice rotation.
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