Originally published in GlobeAndMail.com, October 24, 2007
After nine years of litigation, the Danier Leather Inc. class action suit was finally settled Oct. 12 when the Supreme Court of Canada ruled that the company had not violated securities disclosure laws.
Investor Rick Durst had challenged the information contained in Danier's prospectus. And not only did he lose the class action case, but he was also ordered to pay Danier's share of legal costs, a figure estimated to be in excess of $1-million.
The ramifications of the case are considerable. Join ReportonBusiness.com at noon EDT today for a discussion with Jasmine T. Akbarali, a lawyer with Lerners LLP who specializes in commercial litigation.
Ms. Akbarali was a member of the Lerners team representing the investors in the Danier case. This prospectus misrepresentation case was the first trial of a class action relating to the civil liability of corporate issuers and their directors for misrepresentation in a prospectus.
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Ms. Akbarali has summarized the case issues for ReportonBusiness.com.
1. The scope of liability for prospectus misrepresentation.
Section 130 of the Securities Act (Ontario) provides for liability on the part of issuers and others (including directors) where a prospectus contains a misrepresentation. One of the issues in Danier was the scope of that provision. The Supreme Court of Canada concluded that under s. 130, an issuer can be liable for a misstatement of material fact up to the date the prospectus is receipted, but only for failure to disclose a material change between receipt and closing. A material fact is a fact that can be expected to affect the market price of a security. A material change is a change in relation to the business, operations or capital of an issuer. By concluding that post-receipt, only material changes must be disclosed, the court has relieved the issuer of an ongoing responsibility to disclose material facts to avoid civil liability. This makes the due diligence process for issuers and underwriters much cleaner and more predictable. It also means that investors cannot be sure they have all material facts when they purchase securities under a prospectus.
2. The applicability of the business judgment rule
The Supreme Court considered whether the business judgment rule could be used to assess management's regulatory disclosure obligations. Traditionally, the business judgment rule has been applied where a board of directors has before it a range of business options, and its choice is being criticized after the fact. This may arise where, for example, a shareholder is unhappy with a corporate decision taken by the board (say, which of competing takeover bid offers to recommend) and seeks an oppression remedy. Courts have acknowledged that they do not have the expertise of business managers. Recognizing the policy that directors and management should feel free to take appropriate risks and make decisions in the best interests of the shareholders given their expertise, courts have applied the business judgment rule to decline to second guess those decisions as long as they are within a range of reasonableness. The question in Danier was whether to extend that rule to the securities context, where the issue was whether the issuer had complied with its obligations under the Securities Act. The Supreme Court of Canada found that the rationale behind the business judgment rule does not apply, as management has no advantage over courts when it comes to assessing the quality of disclosure.This finding strengthens investor protections under the Securities Act, because it recognizes that it is inappropriate to defer to management's assessment of whether it has met its regulatory obligations.
3. Costs in class actions
The Court considered whether to depart from the traditional rule that the unsuccessful party bears the successful party's costs. The Class Proceedings Act, in s. 31, allows a court to decline to award costs against a representative plaintiff, recognizing the unique access to justice issues that are engaged in a class action. The court declined to apply s. 31 in this case, and by doing so, may have "chilled" class actions. Representative plaintiffs may be less inclined to step up in view of the repercussions they might face if they are unsuccessful. These repercussions are greatest where the suit has merit but is eventually unsuccessful, because those are the cases where the costs awards will also be highest.
Ms. Akbarali acts on a broad range of civil litigation matters, encompassing both trial and appellate advocacy.
Ms. Akbarali's experience includes class action proceedings, product liability claims, investment dealer negligence, securities litigation, shareholder disputes, oppression remedy claims, contractual disputes and constitutional litigation. She has appeared in the Ontario Superior Court of Justice, the Divisional Court, the Court of Appeal for Ontario and the Supreme Court of Canada.
Ms. Akbarali received her Bachelor of Laws from the University of Windsor where she was the gold medallist of her law class. She received her Bachelor of Arts degree from McMaster University and her Suomi (Finnish) I & II Certificate from the University of Helsinki. Ms. Akbarali served as Clerk to the Honourable Mr. Justice J. C. Major, Puisne Justice of the Supreme Court of Canada.
Ms. Akbarali is a member of the Advocates' Society, the Toronto Lawyers' Association, the Ontario Bar Association and the Canadian Bar Association. She is a director of the George Hull Centre for Children and Families and volunteers with the Children's Bridge Foundation.
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Cathryn Motherwell, deputy editor, Report on Business: Hello Jasmine, and welcome to ReportonBusiness.com. We are delighted to have you join us today for a discussion that has certainly been the talk in legal circles, and in the investment community. And so to start, could you please summarize what you believe are the key points where the Supreme Court of Canada is breaking new ground?
Jasmine Akbarali: I'm happy to be here.
The Danier action involved Danier's initial public offering, which closed on May 20, 1998. The crux of the plaintiffs' complaint was that, after the prospectus was receipted on May 6, 1998, but before closing, Danier became aware of poor sales results but did not disclose them. The allegation was that the results made statements in its prospectus misleading and constituted a misrepresentation under s. 130 of the Ontario Securities Act. This would make Danier liable for damages to the class under the Act if proved. When the poor sales results were disclosed, two weeks after closing, Danier's share price fell. The trial judge found that investors lost approximately 22% of their investment. In the end, Danier substantially met its forecast, but even when those results were released, the share price did not recover.
The first issue the Supreme Court grappled with was the reach of s. 130, and specifically, whether the provision provided for liability for failing to disclose a material fact that arose after the prospectus was receipted but before closing. The Act defines material facts as those which can reasonably be expected to affect the price of the security. The material fact that was alleged not to be disclosed was the poor sales results.
However, under the scheme of the Securities Act, an issuer is obliged to disclose material facts up to the date of receipt, but only material changes thereafter. Material changes are changes in the business, operations or capital of an issuer. The Court had to consider whether the disclosure regime in the Act set the parameters for the civil liability created under s. 130 of the Act. In its conclusion, the Court found that there could not be civil liability under s. 130 for failing to disclose material facts after receipt. Since Danier had complied with its disclosure obligations (ie because the poor sales results did not amount to a material change), it had no liability for misrepresentation under s. 130.
The court also addressed how the business judgment rule applies in the securities context. The business judgment rule traditionally has application to corporate decision making, and is a judicial recognition that courts do not have the expertise of business people. However, extending the business judgment rule to the determination of whether adequate disclosure is made under the Securities Act was a novel application of the rule. The court concluded that the business judgment rule should not apply to disclosure decisions, since evaluating the quality of disclosure is appropriately for the courts and the legislature.
Last, the court was asked to depart from the traditional costs rules in civil litigation, in which the losing party pays part of the successful party's costs. The Class Proceedings Act allows the court to exercise its discretion and not award costs against an unsuccessful representative plaintiff. The court declined to depart from the traditional rule in this case, making the representative plaintiff liable for significant costs. This can be expected to have a chilling effect on class actions, since plaintiffs risk becoming responsible for costs that may be much greater than their personal financial stake in the litigation.
Evgeny Zborovsky writes: The Supreme Court found that Danier's forecast contained an implied representation of objective reasonableness as of the date the final prospectus was receipted, overturning both the Ontario Court of Appeal on the issue of objective reasonableness and the trial judge on the date issue. What do you think will be the impact of this aspect of the decision?
Jasmine Akbarali: That is an interesting point Evgeny. For those who are unfamiliar with this issue, I will add a little background.
The plaintiffs alleged that Danier's forecast of its fourth quarter and fiscal year 1998 included the implied representation that it was objectively reasonable and that this representation ceased to be true after May 6, but before closing, when Danier became aware of its poor sales results. One issue that was canvassed at the Court of Appel and the Supreme Court of Canada was whether the implied representation of objective reasonableness was one of fact or law.
The Court of Appeal concluded that there was no such implied representation either at law or in fact. Danier's prospectus called its forecast "management's best judgment". By the Court of Appeal's reasoning, that did not imply that management's best judgment was also objectively reasonable. The Supreme Court disagreed, concluding that, as a matter of fact, "management's best judgment" would be understood to be objectively reasonable.
This was bolstered by other statements in the prospectus, such as the auditor's statement that management's assumptions provided a reasonable basis for the forecast. However, the court also limited the impact of the representation to May 6, the date of receipt, finding that the forecast was a snapshot of the company's prospects at that time.
Because the findings are factual, the impact is circumscribed. However, what is important about the Supreme Court's approach is that it interpreted the language of the prospectus in the way that an investor would. Although there was no express representation of objective reasonableness, the court looked at how an investor would read and understand the prospectus. Issuers will be responsible for the messages they convey, whether explicitly or not.
Cathryn Motherwell: A number of big investors and funds have said the deck is stacked against them in Canadian courts. Does the Danier decision reinforce that perception?
Jasmine Akbarali: The Danier decision is a limit on issuer liability. By adopting an approach to s. 130 that does not require an issuer to correct statements in a prospectus that become untrue, if they are not material changes, the Supreme Court has limited recourse for investors in some circumstances. There are entities that will only invest in cross-listed securities, in part because they want access to the broader remedies available in the United States. Whether in the long run this will impact the ability of smaller issuers to raise capital in Canadian markets remains to be seen.
Cathryn Motherwell: The Danier lawsuit was launched before Bill 198 took effect in Ontario. If that bill had been in effect could there had been a different decision?
Jasmine Akbarali: I don't think so. Bill 198 is important for secondary market liability, which has different issues than liability for prospectus offerings. (A big concern about secondary market liability is indeterminate liability, since shares may change hands a number of times. That concern is not engaged in the primary market, where the purchasers under a prospectus are easily identifiable.)
Section 130 remains much as it was back in 1998 when Danier's IPO closed. The Supreme Court of Canada noted the amendments to the section and that they were not material to the issues raised in this case.
Cathryn Motherwell: Are you surprised that your client has been ordered to pay costs for both sides? Will that send a chill to other investors?
Jasmine Akbarali: This aspect of the Supreme Court's decision probably has the broadest effect on class actions generally, not just securities class actions.
The plaintiff had asked the court to decline to award costs by exercising its jurisdiction under s. 31 of the Class Proceedings Act. That section allows a court, considering whether the class action was a test case, raised a novel point of law or involved a matter of public interest, to decline to award costs against an unsuccessful representative plaintiff. This is because class actions generally engage access to justice issues. They are a vehicle to allow a number of claims, which individually might not justify litigation, to be brought to the court together. The representative plaintiff in a class action takes on a responsibility for the benefit of the class. On his or her own, the representative plaintiff may not have a sufficient financial stake in the litigation to proceed.
It is also important to remember that class actions involve additional steps not found in individual litigation, such as the motion to certify the action as a class proceeding. As a result, costs of class actions can be higher than individual actions. They will be even higher if the action is meritorious, but eventually unsuccessful, because one can expect more pre-trial motions and longer proceedings in those cases.
In this case, the court ordered the representative plaintiff to pay the defendants' costs, which will be significant. This decision is likely to produce a chilling effect on other class actions, because representative plaintiffs stand to lose significantly more than their potential gain.
However, it is also important to note that class actions generally are funded on a contingency basis. In other words, most plaintiffs' counsel will not be paid unless the class action is successful or settles. The costs exposure of a representative plaintiff is generally to the defence, not his or her own lawyers.
Another interesting aspect of this issue is how plaintiff class action lawyers will decide how to take on cases. There are some counsel who will indemnify representative plaintiffs against adverse costs awards. I think we will see counsel less willing to do that going forward. I think we will also see counsel less likely to take on difficult cases that perhaps should be brought to courts because of the concerns of costs exposure after this decision.
Richard Ballantyne from Vancouver writes: As a director, I find the decision heartening, but as an investor, it does seem to be a return to the Wild West where companies can duck duties to prospective investors. The part I am struggling with is that I find it hard to distiguish between the definition of material fact and material change. I would have thought that a drop in sales was a material change to operations. How did the court pin-point the distinction.
Jasmine Akbarali: That's a great question Richard. The court noted the distinction between a change in results of operations and a change in operations. The latter is clearly a material change, but the former is not. The court emphasized that poor intra-quarterly results may reflect a material change in operations, but on its own is not a change in the business, operations or capital of an issuer.
From a policy perspective, one reason why material facts are subject to lower disclosure thresholds than material changes is because material facts may be matters external to the issuer. There has been a reluctance to burden an issuer with the obligation to monitor and disclose facts external to it even if those facts could impact its share price.
Cathryn Motherwell: Thanks very much for shedding some much-needed light on this critical issue. Are there any points you would like to raise in summation?
Jasmine Akbarali: It's been a pleasure to be here.
I think the Danier decision has clarified the disclosure obligations of reporting issuers and let investors know what kind of protection they can expect from s. 130. The court, in its reasons, recognized that the Securities Act is remedial legislation, deserving of a broad interpretation. The Act works to protect investors from the risks of an unregulated market. It also works for issuers, by promoting the integrity and efficiency of the capital markets so as to enhance the pool of capital available to them. The Danier decision, at its heart, is about the balance between the interests of investors and the obligations of issuers.