In its unanimous decision overturning the first class action judgment for an alleged prospectus misrepresentation, the Ontario Court of Appeal has calmed the nerves of directors and management of public companies in Canada. The decision was eagerly anticipated and represents a decisive reversal of the trial judgment that had awarded damages in favour of investors. It also gives important guidance for potential shareholder class actions in the future.
We discussed the trial decision in the December 2004 issue of The Material Change Report and described how it raised the disclosure bar for issuers and their advisers to assess, for the period between the date of receipt for a final prospectus and the date on which the offering closes, not only whether a material change has occurred but also whether there are additional material facts that belong in the final prospectus.
In Danier’s 1998 initial public offering, the final prospectus contained a forecast regarding the company’s anticipated financial results for the fourth quarter of its fiscal year. During the period between the date of the final prospectus and the closing of the offering, Danier’s management reviewed a further internal analysis comparing the actual results to date in that quarter with the forecast contained in the prospectus. The analysis showed lower sales of Danier’s products due to recent warm weather and concluded that if the trend continued, there would be a significant shortfall in revenue in the quarter as compared with the forecast. Danier’s management still believed at this point that the forecasted results were achievable because of some planned sales promotions. However, those sales improvements did not occur and about two weeks after the closing of the offering, Danier issued a revised forecast reducing the projected financial results and its share price fell about 20%. Later sales of Danier’s products did rebound and the quarterly financial results in the original forecast were ultimately substantially achieved.
The Trial Decision
The trial judge’s decision was significant for several reasons and was the subject of great debate. The trial judge based his judgment in favour of the disgruntled shareholders that brought the class action alleging prospectus misrepresentation on the following main points:
- a forecast in a prospectus can be a material fact and will be a misrepresentation if any of the factual information underlying the forecast is untrue. As a result of Danier’s additional internal analysis, management should have known that the implied representation that the forecast was objectively reasonable was incorrect and by not issuing a revised forecast before the offering closed, the company and management were liable for misrepresentation; and
- the actual fourth quarter results shown to date in the internal analysis after the final prospectus were material facts that Danier was required to disclose before the closing of the offering, even though no material change had occurred.
The trial judge awarded substantial damages to the plaintiffs after finding Danier and its senior officers liable and he used the drop in Danier’s share price after the release of the revised forecast as the basis on which to calculate the damages.
The Court of Appeal Decision
The Court of Appeal unanimously determined that the trial judge had made three errors:
- Danier was under no obligation to disclose material facts that occurred during the period between the date of the final prospectus and the date of closing. The Court of Appeal ruled that the Securities Act (Ontario) only requires disclosure of material changes that occur between the date of the final prospectus and the date of closing;
- the trial judge’s conclusions that including an earnings forecast in a prospectus gave an implied representation that the forecast and the basis for making it were objectively reasonable. The Court of Appeal held that there was no implied representation as of the closing date of the offering about the reasonableness of management’s belief in the forecast; and
- the trial judge failed to give deference to the business judgment of Danier’s senior management as to whether the forecast was reasonable and did not take into account the fact that the forecast was ultimately substantially achieved. The Court of Appeal emphasized that management’s business judgment needed to be within "a range of reasonableness" and relied on its own previous decision in the Schneider case and the Supreme Court of Canada’s decision in the Peoples Department Stores case. The Court of Appeal reiterated that the business judgment rule requires only that a reasonable decision be made, not a perfect one. Where one of several reasonable alternatives is selected, deference should be given to the decision taken. In Danier, the Court of Appeal held that while Danier’s management may have been too optimistic in viewing the forecast, it should be given deference because the decision regarding the forecast was within a range of reasonableness.
Conclusions to be Drawn
The Ontario Court of Appeal decision allows issuers, their management and advisers to breathe easier by clarifying that there is no continuing obligation to update a prospectus after the final receipt and before closing where additional material facts become evident (although material changes must still be disclosed). This is especially helpful for issuers facing a long period between the date of a final prospectus and closing. The Court of Appeal also gave a continuing strong endorsement to the business judgment of boards and management.
The plaintiffs have announced that they will seek leave to appeal the Court of Appeal decision to the Supreme Court of Canada. The decision has continued to prompt considerable debate in the securities industry as there is a contrary view among certain commentators that issuers should be obligated to update a final prospectus for new material facts that arise after it is filed. Among the ongoing issues arising from the Danier litigation are significant implications for shareholder class actions that will arise from the ultimate cost awards to be determined by the Court of Appeal as to whether the plaintiffs will have to pay the costs of Danier and its management in defending themselves.
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