Canada: Supreme Court of Canada Will Hear "Kerr v. Danier Leather" Appeal: Court to Examine IPO Disclosure and the Application of the Business Judgment Rule to Mandatory Disclosure Rules

The much anticipated Supreme Court of Canada leave to appeal decision in Kerr v. Danier Leather was released today, June 22, 2006, and to the relief of the shareholder plaintiffs and their counsel the Court has agreed to hear their appeal due to the importance of the issues to Canadian capital markets.

Readers who have followed our coverage of Danier through trial and the Ontario Court of Appeal¹ will recall that last December, following the first shareholder class action to go to trial in Canadian history, the Ontario Court of Appeal reversed a significant trial victory for the plaintiff shareholders. In so doing a $17 million dollar verdict plus a costs award of $8 million in favour of the plaintiffs were set aside, and the plaintiffs faced to prospect of having to pay a multi-million costs award to the defendants.

By way of background, Danier arose out of its May 1998 IPO. The receipt for the final prospectus was issued on May 6 and the offering closed on May 20. The prospectus contained actual financial results for the first three quarters ending March 28, along with projected results for the fourth quarter ending June 27, 1998 (the "Forecast"). The Forecast contained cautionary language as to assumptions used and the fact that the assumptions could turn out to be wrong and that there was no guarantee that the projections would be achieved.

As it happened, on May 10, ten days before closing, Danier’s CEO and CFO became aware that there was a shortfall in actual fourth quarter revenues to date; however they believed that Danier could still achieve the results projected in the Forecast by the June 27 fiscal year end, therefore they did not seek advice regarding the impact of actual results to date on the IPO, and there was no disclosure to the market of the shortfall in fourth quarter revenues prior to closing.

The IPO closed on May 20, 1998. A total of 6,040,000 shares were issued at $11.25 per share for total gross proceeds of $67,950,000.

On June 4, 1998, Danier issued a press release revising the Forecast downward ("Revised Forecast"). The stated reason for the Revised Forecast was that unseasonably warm weather had had a negative impact on the sale of leather apparel to date.

Following the press release the market reacted negatively. On June 2, 1998 the, last trading day before the press release, shares traded at $11.65 per share. On June 9, 1998, three trading days after the press release, the shares reached a low of $8.25 per share, a drop of approximately 29%.

Nevertheless, on July 6, 1998, Danier issued a press release announcing actual revenue for its fourth quarter, with results for the quarter and for the year exceeding the Revised Forecast and substantially achieving the results contained in the prospectus Forecast. The turnaround in fourth quarter results was partly due to the fact that the unseasonably warm weather experienced in May did not continue through June, and a "50% off everything" sale was held throughout the month of June.

So in spite of the negative results announced in the Revised Forecast, the actual results substantially achieved the initial results contained in the Forecast.

The action proceeded by way of a class action of a statutory claim under s.130 of the Ontario Securities Act ("OSA") for damages for misrepresentations contained in the May 6, 1998 prospectus. The class members included shareholders who purchased shares under the IPO, and who continued to hold those shares after the announcement of the Revised Forecast.

The shareholders claimed that the Forecast appearing in the prospectus contained actionable misrepresentations, and they sought recovery of their investment losses which crystallized with the market.s negative reaction to the Revised Forecast.

The trial judge found liability and awarded substantial damages based in large measure on the following analysis:

• In spite of the fact that Part XV of the OSA requires disclosure of "material changes" but not "material facts" following prospectus receipt and before closing, the trial judge interpreted the civil liability provisions of s. 130 of the OSA and the statutory definition of .misrepresentation. as also requiring disclosure of material facts prior to closing.

• 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. Because of the actual partial fourth quarter results coming to their attention on May 10, 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, there was an actionable misrepresentation.

In its December 15, 2005 decision, the Ontario Court of Appeal reversed the trial decision in three significant respects:

1. The decision was in error in concluding that, under the OSA, Danier had a continuing obligation to disclose material facts occurring between the date of its prospectus (May 6, 1998) and the date of closing (May 20, 1998) and was therefore in error in concluding that because the appellants did not disclose Danier's Q4 results to the date of closing, they were liable for prospectus misrepresentation.
2. The decision was in error in concluding that Danier's prospectus contained the implied representation that the Forecast was objectively reasonable.
3. The decision was in error in failing to give any deference to the business judgment of Danier's senior management and in failing to take into account that the Forecast was substantially achieved. The decision was therefore in error in concluding that the Forecast was not objectively reasonable on May 20, 1998.

In applying for leave to appeal to the Supreme Court of Canada, the shareholders summarized their argument as follows²:

"In summary, the issues of national and public importance are as follows:

1. Whether section 130 of the Ontario Securities Act (the "OSA") requires the disclosure of all material facts arising up to the date of completion of a securities offering? The Court of Appeal determined that section 130 OSA imposes no obligation to disclose material facts that arise in a securities offering, after the date of receipt of the prospectus and before the closing of the offering, despite the fact that such facts, if disclosed, would significantly affect the market price or value of the securities.
2. Whether a financial forecast in a prospectus contains the implied factual assertion that it is objectively reasonable? The trial judge, Lederman J., held that a company’s prospectus forecast of future revenues and earnings includes the implied representation that the forecast is objectively reasonable The Court of Appeal determined that this was a question of fact, and there was "no basis" upon which Lederman J. could have concluded that this representation was implicit.
3. Whether the business judgment rule applies to the assessment of the materiality of undisclosed facts? The Court of Appeal rejected the trial judge’s conclusion that an objective standard applies to the assessment of the materiality of undisclosed facts in a public offering. This determination impacts the assessment of materiality not only in the context of a securities distribution but also in insider trading cases.
4. Whether the established principle of deference to the factual findings of the trial judge should apply in the context of a prospectus misrepresentation claim? After 44 days at trial, the trial judge made finding of facts, supported by the evidence including the expert evidence, that there were undisclosed material facts relating to adverse intra-quarter financial results which made the forecast unreasonable, that arose before the closing date of the public offering on May 20, 1998. He also found as a fact, after a substantial review of the evidence, that management had acted unreasonably and without due diligence in failing to fully and properly assess this adverse information. The Court of Appeal refused to show deference to these findings".

With today’s granting of leave to appeal, it is fair to say that some or all of these arguments resonated with the Supreme Court; however, it is important to note that by granting leave the Supreme Court is not suggesting that the Court of Appeal got it wrong (or right). Rather, today.s decision means no more than the Danier raises issues of national and public importance, and that the Supreme Court agrees that it should consider the issues and provide its views. Suite Barring any unforeseen events which would cause a departure from the various filing deadlines set out in the Rules of the Supreme Court of Canada, one would expect a hearing of the Danier appeal in 8 to 10 months, and a decision 6 to 8 months hence, or by November or December 2007.

Shortly after the Court of Appeal decision in December 2005, a headline in The Globe and Mail read: "Court gives Danier lawyers an early Christmas present."³ With today’s announcement, the issues in Danier should be finally decided by Christmas 2007, 9 ½ years after the completion of the IPO.

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