Canada: Civil Liability For Secondary Market Disclosure

For the first time, issuers and their officers, directors, experts and others who are subject to Ontario securities laws will be exposed to a statutory right permitting investors to sue them for misrepresentations in continuous disclosure documents. The Ontario government has announced December 31, 2005 as the proclamation date for the amendments to the Securities Act (Ontario) (the "Act") which will expose issuers and their directors and officers (as well as certain other persons) to statutory civil liability for an issuer's continuous disclosure (the "Civil Liability Amendments"). Although no timing has been announced, it is expected that other jurisdictions will introduce similar amendments to their securities laws (with the possible exception of British Columbia, which has taken steps towards a different regime for civil liability for secondary market disclosure). This Perspective outlines the Civil Liability Amendments.

The Civil Liability Amendments impose a materially different liability regime on issuers and their directors and officers (as well as certain other persons who commonly provide services to issuers such as auditors, lawyers and financial advisors) than has historically existed in Canada. They also facilitate class action proceedings in connection with alleged misrepresentations in secondary market disclosure. They do this by eliminating what is currently the most significant impediment to certification of such actions in Canada – the requirement that the plaintiff prove reliance on such misrepresentations.

It is critically important that those affected by this new legislation become familiar with this new regime before it takes effect at the end of this year. A key message for issuers, their boards and management (as well as others caught by the Civil Liability Amendments) is the need for appropriate diligence processes, most importantly disclosure controls. Chief executive officers and chief financial officers of U.S. registrants are already accustomed to certifying that they are responsible for the issuer's disclosure controls. This aspect of the certification process will come into effect in Canada next year. The Civil Liability Amendments specifically provide a due diligence defence to a misrepresentation if the person or company in question conducted a reasonable investigation (or caused a reasonable investigation to be made) before the misrepresentation occurred. In determining whether an investigation was reasonable, the court is required to consider all relevant circumstances. These circumstances include the existence, if any, and the nature of any system to ensure that the issuer meets its continuous disclosure obligations.

Background

The principles behind the Civil Liability Amendments have been the subject of review for the past three decades. In 1979, a statutory civil liability regime relating to continuous disclosure was recommended in Federal Proposals for a Securities Market Law of Canada and, in 1984, the Ontario Securities Commission (the "Commission") contemplated extending statutory civil liability to continuous disclosure documents. In 1994, the Committee on Corporate Disclosure (known as the Allen Committee) was appointed by the Toronto Stock Exchange to review and evaluate the standards of corporate disclosure practices of Canadian companies. The Allen Committee's study culminated in the release of the Allen Report in 1997, which concluded that the adequacy of continuous disclosure in Canada's capital markets was in need of improvement. The Allen Report recommended imposing civil liability for misleading disclosure and outlined proposals for legislative amendments.

On November 3, 2000, based on recommendations contained in the Allen Report, the Canadian Securities Administrators published draft legislative amendments which would impose a statutory liability regime for continuous disclosure. These proposals were addressed and supported in the Five Year Review Committee Draft Report released May 29, 2002, and integrated into Bill 198. In December 2002, the Ontario government passed Bill 198, which included the Civil Liability Amendments. However, a change in government, the need for certain technical amendments to the bill as well as continuing consultation with affected stakeholders contributed to a delay of more than three years before the Civil Liability Amendments would come into effect.

What Are the New Liabilities?

The Civil Liability Amendments introduce a new statutory right that will permit investors to sue for damages with respect to continuous disclosure.

It is currently an offence under the Act for an issuer to make a misrepresentation in any material submitted to the Commission. The issuer is liable to a fine. Any director or officer of the issuer who authorized, permitted or acquiesced in the commission of the offence is liable to a fine, imprisonment, or both. Although the Commission has the authority to take action in this circumstance, investors currently enjoy no similar statutory right to sue with respect to continuous disclosure. The only civil cause of action that is currently available to investors in such circumstances is an action based on the common law of tort of negligent or fraudulent misrepresentation.

Under the Civil Liability Amendments, investors have the right to sue if they incur damages as a result of buying or selling securities of a "responsible issuer" concurrently with any of the following circumstances (collectively referred to as "Deficient Disclosures"):

  • a misrepresentation in a document released by or on behalf of the issuer;
  • a misrepresentation made in a public oral statement by or on behalf of the issuer;
  • a misrepresentation in a document or public oral statement released or made by an "influential person", such as a controlling shareholder or promoter of the issuer; and
  • the issuer's failure to make timely disclosure of a material change.

A "responsible issuer" is an issuer that is a reporting issuer in Ontario and any other issuer with a substantial connection to Ontario, any securities of which are publicly traded.

When Does an Investor Have the Right to Sue?

It is important to note that an investor need not have relied on a Deficient Disclosure in order to sue under the Civil Liability Amendments. This is a significant change from the current common law causes of action based on such misrepresentations. In order to determine whether an investor can sue, consider the following questions:

When Did the Investor Buy or Sell the Securities?

Any buyer or seller of a security of an issuer in a secondary market transaction during the period of a Deficient Disclosure has a statutory right of action for damages.

A period of a misrepresentation is the period between the time when a document was released (or statement made) containing the misrepresentation and the time such misrepresentation was publicly corrected. A period of a failure to make timely disclosure is the period between the time when a material change was required to be disclosed and the time it was disclosed.

Who Made the Misrepresentation and Where Was It Made?

Subject to other limitations on bringing an action described in this Perspective, investors have a right of action if the misrepresentation was made by (i) the responsible issuer, (ii) someone with "actual, implied or apparent authority" to act on behalf of the issuer, or (iii) an influential person, such as a controlling shareholder or a promoter of the issuer.

Written misrepresentations must be made in a "document" which includes any written communication that (i) is or must be filed with the Commission, a government body or stock exchange or (ii) has content which would reasonably be expected to affect the market price or value of the issuer's security.

Did the Investor Know About the Deficient Disclosure?

There is no statutory liability for misrepresentation or failure to make timely disclosure if an investor is found to have bought or sold securities with knowledge (i) that the document or statement contained a misrepresentation, or (ii) of the undisclosed material change.

When Did the Deficient Disclosure Occur?

To exercise its right of action for damages, an investor must commence an action by the earlier of:

  • three years after the date on which the Deficient Disclosure occurred; and
  • six months after the requisite issuance of a press release disclosing that leave has been granted to commence an action concerning such Deficient Disclosure.

The date on which a misrepresentation occurred is that on which the document or statement containing the misrepresentation was released or made. The date on which a failure to make timely disclosure occurred is that on which the requisite disclosure was required to be made.

When Will a Court Grant Leave to Proceed with an Action?

In order to proceed with an action for damages in connection with a Deficient Disclosure, an investor must obtain leave of the court. Each defendant must receive notice of the motion for leave to proceed. The court will grant leave only if it is satisfied that:

  • the investor is bringing the action in good faith; and
  • there is a reasonable possibility that the action will be resolved at trial in favour of the investor.

Whom Can the Investor Sue?

Liability for Deficient Disclosure varies according to the nature of the disclosure; namely, which of the four kinds of deficiencies has arisen.

Depending on the nature of the Deficient Disclosure and other limitations on liability described in the Civil Liability Amendments, an investor can sue any of the following:

Responsible Issuers

Responsible issuers are generally liable for any Deficient Disclosure, whatever its nature. However, where a misrepresentation has been made by an influential person, an investor can only sue the responsible issuer if one of its directors or officers authorized, permitted or acquiesced in the release or making of such misrepresentation.

Influential Persons such as Controlling Shareholders or Promoters

An influential person (and its directors and officers) may be held liable in connection with all four kinds of Deficient Disclosures (as outlined above under "What Are the New Liabilities?"). In addition to bearing liability for misrepresentations made on its own behalf, an influential person can be held liable if he or she knowingly influenced others to make or permit the making of any kind of Deficient Disclosure.

Directors of an Issuer or an Influential Person

Where a misrepresentation is in a document released by or on behalf of a responsible issuer, an investor may sue each director of the issuer at the time such document was released. In all other cases of Deficient Disclosure, an investor can only sue those directors of the issuer who authorized, permitted or acquiesced in the Deficient Disclosure.

An investor can also sue any director of an influential person if such director knowingly influenced others to make or permit the making of any kind of Deficient Disclosure. A person who is liable as a director of an influential person is relieved from this liability if he or she is also liable as a director or officer of a responsible issuer.

Officers of an Issuer or an Influential Person

An investor can sue only those officers of the issuer who authorized, permitted or acquiesced in a Deficient Disclosure, whatever its nature.

An investor can also sue any officer of an influential person if such officer knowingly influenced others to make or permit the making of any kind of Deficient Disclosure. A person who is liable as an officer of an influential person is relieved from this liability if he or she is also liable as a director or officer of a responsible issuer.

Experts

An investor can sue an "expert" in connection with any written or oral misrepresentation, however made, provided the following three conditions are met:

  • the misrepresentation is also contained in a report, statement or opinion made by the expert (an "Expert Report");
  • the document or statement includes, summarizes or quotes from the Expert Report; and
  • the expert consented in writing to the use of the Expert Report in a document released or statement made by someone other than the expert.

Experts have no statutory liability for failure to make timely disclosure.

Others

In the case of a misrepresentation contained in a public oral statement, the person who actually made the statement can be held liable.

What Defences Are Available to Those Sued for Misrepresentation?

A number of defences are available to persons who are sued by an investor in connection with a written or oral misrepresentation, including the following:

Due Diligence Defence

No person is liable for a misrepresentation in any document or public oral statement if that person is able to prove that the person both:

  • conducted or caused a reasonable investigation to be conducted before the document was released or the statement made; and
  • had no reasonable grounds to believe that the document or statement contained the misrepresentation at the time the document was released or the statement was made.

The Civil Liability Amendments provide that the court shall consider all relevant circumstances (including those listed in Schedule A) in determining whether the investigation was reasonable.

Reduced Standard of Care for Non-Core Documents

(Not Available for Experts)

A person (other than an expert) is not liable for a misrepresentation unless the plaintiff proves that the person either:

  • had knowledge that the document or statement contained a misrepresentation at the time the document was released or the statement was made; or
  • deliberately avoided acquiring such knowledge (at or before the time the document was released or the statement was made); or
  • was guilty of gross misconduct in connection with the release of the document or the making of the statement (through action or failure to act).

The plaintiff is not required to prove any of these circumstances if the misrepresentation appeared in a "core document", which is defined to include prospectuses, certain circulars, annual information forms and annual financial statements. It should be noted that the definition of "core document" is different for different persons caught by the Civil Liability Amendments. For example, where used in relation to a director of a responsible issuer who is not also an officer of the responsible issuer, "core documents" do not include interim financial statements or material change reports (although where used in relation to an officer of the reporting issuer, "core documents" do include those two forms of disclosure). There are no documents that are not core documents with respect to the issuer itself.

Cautionary Language for Forward-Looking Information

No person is liable for a misrepresentation in "forward-looking information" in any document (other than an initial public offering prospectus or financial statements) or in any public oral statement if that person is able to prove both that:

  • the document or statement contained, proximate to the forward-looking information, (i) reasonable cautionary language concerning such information and (ii) material assumptions applied in making a forecast or projection in such information; and
  • the person had a reasonable basis for making the forecasts or projections in the forward-looking information.

Reliance on Expert Report

No person (other than an expert) is liable for a misrepresentation in a part of any document or public oral statement that includes, summarizes or quotes from an Expert Report with the written consent of the expert (not withdrawn prior to releasing the document or making the statement) if that person proves both that:

  • the person did not know (and had no reasonable basis to believe) that there was a misrepresentation in the part of the document or statement made on the authority of the expert; and
  • the part of the document or statement fairly represented the Expert Report.

No Expectation of Disclosure

No person is liable for a misrepresentation in a document (except as described below) if that person is able to prove that, at the time of the document's release, it did not know (and had no reasonable grounds to believe) that the document would be released. Understandably, this defence is not available for a document required to be filed with the Commission.

Reliance on Another Publicly Filed Document

No person is liable for a misrepresentation in any document or public oral statement if that person is able to prove all of the following:

  • the misrepresentation came from a document filed by someone other than the responsible issuer with a securities regulatory authority or stock exchange and was not corrected before the document was released or the statement made by the person;
  • the document or statement contained a reference identifying the source of the misrepresentation; and
  • the person did not know (and had no reasonable grounds to believe) that the document or statement contained a misrepresentation when it was released or made.

Corrective Action Was Taken (Not Available for Issuers)

A person (other than the responsible issuer) is not liable for a misrepresentation in any document or public oral statement if all of the following conditions are met:

  • the misrepresentation was made without that person's knowledge; and
  • after learning of the misrepresentation, that person: (i) notified the board of directors of the responsible issuer; and (ii) if no corrective action was taken within two days thereafter, notified the Commission.

What Defences Are Available to Those Sued for Failure to Make Timely Disclosure?

Other defences are available to persons who are sued by an investor in connection with a failure to make a timely disclosure. These defences include the following:

Due Diligence Defence

No person is liable for failure to make timely disclosure if that person is able to prove that the person both:

  • conducted or caused a reasonable investigation to be conducted before the failure to make timely disclosure first occurred; and
  • had no reasonable grounds to believe that the failure to make timely disclosure would occur.

The Civil Liability Amendments provide that the court shall consider all relevant circumstances (including those listed in Schedule A) in determining whether the investigation was reasonable.

Reduced Standard of Care

(Not Available for Issuers or Officers)

A person (other than a responsible issuer or its officers) is not liable for a failure to make timely disclosure unless the plaintiff proves that the person either:

  • had knowledge of the change and that it was a material change at the time the failure to make timely disclosure first occurred; or
  • deliberately avoided acquiring such knowledge (at or before the time the failure to make timely disclosure first occurred); or
  • was guilty of gross misconduct in connection with the failure to make timely disclosure (through action or failure to act).

Confidential Disclosure

A person is not liable in respect of a failure to make timely disclosure if all of the following conditions are met:

  • the person proves that the material change was disclosed to the Commission on a confidential basis as contemplated by the Act;
  • there was a reasonable basis for making the disclosure on a confidential basis;
  • disclosure of the material change was made public promptly when the basis for confidentiality ceased to exist (if it was still material);
  • the person (or the responsible issuer) did not release a document or make a public oral statement that, due to the undisclosed material change, contained a misrepresentation; and
  • the responsible issuer promptly disclosed the material change as required by the Act once the material change became publicly known in a manner other than as required by the Act.

Corrective Action Was Taken (Not Available for Issuers)

A person (other than the responsible issuer) is not liable for failure to make timely disclosure if all of the following conditions are met:

  • the failure to make timely disclosure was made without that person's knowledge; and
  • after learning of the failure to make timely disclosure before it was disclosed as required under the Act, that person: (i) notified the board of directors of the responsible issuer; and (ii) if no corrective action was taken within two days thereafter, notified the Commission.

Damages and Liability Limits

Calculation of Damages

The Civil Liability Amendments contain detailed provisions on how damages will be assessed in favour of an investor who acquired or disposed of securities after the Deficient Disclosure. Reference should be made to the exact provisions, as they are quite detailed. Essentially, damages are intended to be the amount necessary to put the investor in the position it would have been in had the Deficient Disclosure not occurred. For example, in the case of an investor that purchased securities which trade on a published market after the Deficient Disclosure and has not disposed of them, damages are calculated as:

number of securities x (average price per security paid for those securities – the trading price for the 10 trading days following the correction)

Assessed damages will not include amounts proven by the defendant to be caused by a change in the market price which is unrelated to the Deficient Disclosure.

Proportionate Liability

The court is required to determine each defendant's responsibility for damages assessed in favour of the plaintiff. Subject to the exception described below, each defendant is only liable for that portion of assessed damages that corresponds to that defendant's responsibility for the damages.

Limits on Damages

Subject to the exception described below, the Civil Liability Amendments limit the damages that can be assessed against any person to the lesser of the amount assessed against the person by a court and the amounts described below.

The limitations on damages (or "liability limits") vary according to whether the defendant is an individual, a corporate entity or an expert.

For individuals, including directors and officers, influential persons who are individuals and any other person who bears liability for making a public oral statement, damages are limited to the greater of:

  • $25,000; and
  • 50% of that individual's aggregate compensation from the responsible issuer and its affiliates (or, in the case of a director or officer of an influential person, 50% of its aggregate compensation from the influential person and its affiliates) in the 12 months immediately preceding the making of the misrepresentation.

For corporate entities, including responsible issuers and influential persons who are not individuals, damages are limited to the greater of:

  • 5% of such entity's market capitalization; and
  • $1 million.

For experts, damages are limited to the greater of:

  • $1 million; and
  • the revenue that the expert and the affiliates of the expert have earned from the responsible issuer and its affiliates during the 12 months preceding the misrepresentation.

No Limit on Liability or Damages Where Defendant Had Knowledge

If a defendant (other than the responsible issuer) is held by the court to have permitted or otherwise influenced the making of a Deficient Disclosure knowing it to be such, then the provisions relating to proportionate liability and limits on damages do not apply to such defendant. Accordingly, the whole amount of assessed damages may be recovered from such defendant.

There has been a great deal of discussion in the financial press and elsewhere in recent years about whether the trend towards greater liabilities "chills" the willingness of able people to serve in various advisory capacities to public entities, especially as "outside" directors. While the civil liability provisions we have outlined here are extremely broad in their coverage, outside directors, in particular, could probably take some comfort from a maximum liability exposure level, the greater of half the most recent year's compensation level or $25,000, that is fairly modest, or at least not potentially ruinous. However, since this maximum cap is lost in the case of "knowing" involvement in Deficient Disclosure, just how courts interpret "knowing" -- which in law is a term of anything but self-evident meaning -- will be a hugely important issue.

SCHEDULE A

RELEVANT CIRCUMSTANCES TO BE CONSIDERED BY THE COURT IN DETERMINING WHETHER AN INVESTIGATION WAS REASONABLE:

  • the nature of the responsible issuer;
  • the knowledge, experience and function of the person;
  • the office held, if the person was an officer;
  • the presence or absence of another relationship with the responsible issuer, if the person was a director;
  • the existence, if any, and the nature of any system to ensure that the responsible issuer meets its continuous disclosure obligations;
  • the reasonableness of reliance by the person on the responsible issuer's disclosure compliance system and on the responsible issuer's officers, employees and others whose duties would in the ordinary course have given them knowledge of the relevant facts;
  • the period within which disclosure was required to be made under the applicable law;
  • in respect of an Expert Report, any professional standards applicable to the expert;
  • the extent to which the person knew, or should reasonably have known, the content and medium of dissemination of the document or public oral statement;
  • in the case of a misrepresentation, the role and responsibility of the person in the preparation and release of the document or the making of the public oral statement containing the misrepresentation or the ascertaining of the facts contained in that document or public oral statement; and
  • in the case of a failure to make timely disclosure, the role and responsibility of the person involved in a decision not to disclose the material change.

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.

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