The Supreme Court of Canada established three important principles in its decision in Kerr v. Danier Leather Inc.:
- In updating a prospectus, the distinction between "material facts" and "material changes" is key: the Securities Act (Ontario) does not require issuers to update a prospectus by disclosing material facts that occur after a receipt for a final prospectus is issued.
- The business judgment rule does not apply to protect disclosure decisions from second-guessing by the courts.
- In securities litigation brought by way of class action, such as Danier, the usual costs rule in commercial litigation applies: the loser pays the winner’s legal costs.
Danier was a prospectus class action – the first such case in Ontario to go all the way to trial. Danier offered shares in an initial public offering in May 1998. The prospectus for the IPO contained a forecast of anticipated revenue and earnings for the fourth quarter of its fiscal year. After the prospectus had been finalized, but before the closing of the IPO, senior management prepared an internal analysis that showed that the intra-quarterly results for the fourth quarter lagged behind the forecast. Senior management continued to believe that the original forecast was achievable and therefore did not update the prospectus. Following the closing of the IPO, and on the basis of new information, the company issued a revised forecast; the share price then dropped significantly. Ultimately, Danier substantially achieved the original forecast.
A class action was commenced under section 130 of the Securities Act (the section that creates a statutory cause of action for prospectus misrepresentation). The plaintiffs alleged that as a consequence of the internal analysis prepared before the IPO closed, the original forecast in the prospectus was a misrepresentation. The Supreme Court dismissed the plaintiffs’ case.
Prospectus Disclosure Obligations: Material Fact Versus Material Change
The Supreme Court held that if a prospectus, or an amendment to a prospectus, contains no misrepresentation on the date it is filed, failure to disclose subsequent information that amounts to a material fact – but not a material change – will not give rise to liability for prospectus misrepresentation under section 130 of the Securities Act.
A "material change" is 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." A "material fact," in contrast, is broader and extends to any fact that would reasonably be expected to have a significant effect on the market price or value of the issuer’s securities, whether or not it involved a change in the business, operations or capital of the issuer. The Supreme Court concluded that a change in intra-quarterly results is not itself a change in the issuer’s business, operations or capital and therefore does not constitute a material change requiring disclosure. The Court observed that sales often fluctuate in response to factors that are external to the issuer and suggested that such external factors as political, economic and social developments, which could have a material effect on an issuer’s business, are not material changes and therefore do not trigger disclosure obligations.
Although Danier concerned an issuer’s prospectus disclosure obligations, the distinction between material changes and material facts is also critical to an issuer’s timely disclosure obligations and to the secondary market liability regime under the Securities Act.
The Business Judgment Rule
The Supreme Court considered whether the business judgment rule has any application to an issuer’s disclosure decisions under the Securities Act. The Court concluded that the rule does not apply and hence courts will not defer to management and the directors in determining whether an issuer has met its disclosure obligations.
The business judgment rule is the principle according to which courts defer to management and the directors on business decisions. As long as the business decision falls within a "range of reasonableness," the courts will not substitute their judgment for that of management and the directors as to the course of action that is in the corporation’s best interests.
The Supreme Court has distinguished between business decisions, to which this principle applies, and disclosure decisions, to which the principle does not apply. With business decisions, there is a range of alternatives requiring a relative assessment of risk and reward. Disclosure decisions, in contrast, involve the application of a legal standard, prescribed by the Securities Act, on which there can be only one legally correct answer.
The Supreme Court’s ruling that disclosure decisions are not protected by the business judgment rule has serious potential implications for the exposure to liability of issuers, directors and officers under the secondary market liability regime of the Securities Act, and regulatory liability for breaches of the timely disclosure obligations under the Act. Assessments of materiality, on which disclosure decisions are based, can be very difficult judgment calls, given that they turn on an assessment of the likely market impact of the information in question. The prospect of these decisions being second-guessed by courts and securities regulators, perhaps with the benefit of hindsight, is an unwelcome development for issuers and their directors and officers.
The Supreme Court held that the representative plaintiff in this class action (characterized by the Court as "well resourced"), having lost the case, was responsible for the legal costs of the successful defendants on the basis of the "loser pays" rule that applies to commercial litigation generally. The fact that this case was a class action and the costs exposure outweighed any potential personal financial benefit for the representative plaintiff did not displace the usual rule. In the Supreme Court’s words, "protracted litigation has become the sport of kings in the sense that only kings or equivalent can afford it. Those who inflict it on others in the hope of significant personal gain and fail can generally expect adverse cost consequences."
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.