The Ontario Court of Appeal has affirmed the "business judgment rule" in the context of management’s financial forecasts in an IPO prospectus. In Kerr v. Danier Leather Inc., the Court found that a forecast made by senior management is an exercise in business judgment and that courts should not second-guess management’s opinions as long as they fall within a "range of reasonableness".1
The Court also confirmed that in updating a prospectus, the distinction between "material facts" and "material changes" is key: there is no requirement under the Securities Act to update a prospectus by disclosing material facts that occur after a receipt for a final prospectus is issued.
Danier was a prospectus class action—the first such case in Ontario to go all the way to trial. Danier offered shares in an IPO in May 1998. The prospectus contained a forecast of anticipated revenue and earnings for the fourth quarter of Danier’s fiscal year. After the final prospectus had been filed and receipted, but before the offering closed, senior management prepared an internal analysis that showed sales levels running below what had been anticipated. Senior management continued to believe that the original forecast was achievable and did not amend the prospectus. Following the closing of the IPO, and on the basis of the new information, the company issued a revised forecast, after which the share price dropped significantly. Ultimately, Danier substantially achieved the original forecast.
A class action was commenced under section 130 of the Securities Act—the statutory cause of action for a "misrepresentation" in a prospectus. The plaintiffs alleged that, as a consequence of the internal analysis prepared before the IPO closed, the original forecast constituted a misrepresentation in the prospectus.
The plaintiffs were successful at trial. The trial judge found that the result of the internal analysis was a material fact and that section 130 of the Securities Act required Danier to update its prospectus. The failure of Danier to update its prospectus meant that it contained a misrepresentation at the time the IPO closed, held the trial judge. The trial judge also found that the prospectus contained an implied representation that the forecast was "objectively reasonable" but that, on the basis of management’s internal analysis, the forecast was not objectively reasonable at the time of the closing. In evaluating the reasonableness of management’s opinions, the trial judge did not apply the business judgment rule. The Court of Appeal disagreed with the trial judge’s approach and conclusions with respect to both Danier’s disclosure obligations and the application of the business judgment rule.
The Court of Appeal affirmed that sections 56(1) and 57(1) of the Securities Act constitute a complete code of prospectus disclosure for both statutory compliance and civil liability purposes. A prospectus must contain "full, true and plain disclosure of all material facts relating to the securities issued". An issuer is also required to amend a preliminary prospectus if a "material adverse change" occurs before a receipt for a final prospectus is issued, and to amend a final prospectus if a "material change" occurs after the receipt for the final prospectus is received and before end of the distribution. However, there is no additional obligation to disclose "material facts" that occur during these periods, and section 130 of the Securities Act does not impose any such additional obligation.
A "material change" is essentially defined as a "change in the business, operations or capital of an issuer that would reasonably be expected to have significant effect on the market price or value of any of the securities of the issuer" [italics added]. The definition of "material fact" does not require that a change have taken place in the business, operations or capital of an issuer. A fact is a "material fact" if it would reasonably be expected to have a significant effect on the market price or value of the issuer’s securities. In discussing the distinction, the Court stated:
The Legislature made a policy choice. It engaged in a line-drawing exercise. It decided to require issuers to update prospectuses for material changes but not for material facts. No doubt it weighed the considerations for and against broader continuous disclosure: on the one hand, the advantage of giving investors more information; on the other, the disadvantages of cost and inconvenience that flow from flooding the market with transitory information…[para 100]
Determining whether a particular development is a material fact or material change can be extremely difficult. The Toronto Stock Exchange requires timely disclosure of all material information, whether this comprises "facts" or "changes". But the distinction is preserved in the new civil liability rules that will come into force on December 31, 2005. Under those rules, directors and officers can be held personally liable for (a) a misrepresentation in public documents or public oral statements—that is, an untrue statement of a material fact or a failure to state a material fact necessary to make a statement not misleading, and (b) the failure to make timely disclosure of material changes. The comments by the Court about the business judgment rule, discussed below, are likely to be helpful to directors and officers who act reasonably in making judgments about whether a particular development would reasonably be expected to have a significant effect on the market price or value of an issuer’s securities.
Forecasts and the Business Judgment Rule
In Danier, the Court of Appeal affirmed, consistently with its prior decisions and the decision of the Supreme Court of Canada in Peoples Department Stores Inc. (Trustee of) v. Wise, that courts are to treat management’s judgments on matters of business with deference. The Court of Appeal in Danier held that the business judgment rule applied to management’s opinions on the achievability of the forecast.
The Court of Appeal noted that a forecast is a "quintessential example of the exercise of business judgment". Danier affirms that courts will defer to management, including management’s opinions regarding the achievability of forecasts, as long as those opinions fall within a range of reasonableness. It was not open to the trial judge to substitute his opinion for that of Danier’s senior management and to conclude that management’s opinion was unreasonable. And the reasonableness of senior management’s opinion in Danier was confirmed by the fact that the company did, in the end, substantially achieve the original forecast.
The business judgment rule affirmed by the Danier decision is intended to prevent judges from substituting their views about business decisions, made in hindsight, for the opinions and decisions of those persons who are best acquainted with the corporation a its business, as long as the opinions and decisions of senior management and directors are reasonable.
1. Torys LLP acted for the founder of Danier Leather and was successful in having the case against him dismissed on the eve of the trial.
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