Originally published in Blakes Bulletin on Corporate Finance, October 2007
In a decision that should be carefully considered by public company issuers, directors and officers, and securities underwriters, the Supreme Court of Canada has dismissed the appeal from the decision of the Ontario Court of Appeal in the Danier Leather case. This ruling has important implications for public offerings of securities in Ontario and the standards for disclosure and representations in prospectuses.
This case arose from the Danier Leather initial public offering (IPO) in May 1998. As part of the IPO, Danier filed a prospectus dated May 6, 1998 that included a forecast of revenue and earnings for the company’s fourth quarter of its fiscal year ending June 27, 1998. The prospectus contained customary cautionary language stating that Danier had used certain assumptions in preparation of the forecast that could turn out to be inaccurate and that there was no guarantee that the forecast would be achieved. A few days before the IPO closed, however, internal company analysis showed that Danier’s fourth quarter revenue and earnings were lagging behind the forecasted figures in the prospectus. Management did not disclose this shortfall, believing that the prospectus forecast would be achieved by year-end. The IPO closed on May 20, 1998.
On June 4, 1998, after further analysis, Danier issued a revised forecast reflecting the lower projected revenue and net earnings for its fourth quarter, which precipitated a significant decline in its share price. On July 6, 1998, Danier announced its results for the fourth quarter. The results exceeded the revised forecast of June 4 and almost matched the prospectus forecast. Danier’s share price rose, but not to the IPO issue price.
Notwithstanding the fact that Danier had substantially achieved the forecasted results in its IPO prospectus, a class action was commenced against Danier, and its CEO and CFO personally, under section 130 of the Securities Act (Ontario), for prospectus misrepresentation.
The action was certified as a class action and, after a lengthy trial, the trial judge (Lederman J.) held Danier, as well as its CEO and CFO, liable for statutory misrepresentation. The trial judge concluded that the prospectus impliedly represented that the forecast was objectively reasonable, both on May 6 (the date of the prospectus) and on May 20 (the date the IPO closed). He also determined that the company’s poor fourth quarter revenue and earnings, which had come to light a few days prior to the IPO closing, were material facts that Danier was required to disclose in an amendment to the prospectus. The trial judge awarded the plaintiffs substantial damages, as well as legal costs of CAD 7 million at trial, including a staggering CAD 1 million premium to be paid by the defendants to plaintiffs’ class action counsel.
Court Of Appeal Decision
In overturning the Trial Decision, the Ontario Court of Appeal (Laskin, Goudge and Blair JJ.A.) made three key decisions. First, the Appeal Court held that issuers are not required to disclose in a prospectus amendment a "material fact" occurring after the date a securities regulator issues a receipt for the final prospectus but prior to completion of the distribution under the prospectus, provided that the material fact does not constitute a "material change". (A "material fact" is currently defined in the Securities Act (Ontario) to mean a fact that would reasonably be expected to have a significant effect on the market price or value of an issuer’s securities; a "material change" is defined more narrowly and refers to a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of the issuer’s securities.) Second, the Appeal Court stated that courts should not readily second-guess the decisions made by directors and officers who act reasonably in forecasting sales based on years of hands-on retail experience (i.e., the Business Judgment Rule). Third, the Court of Appeal found that there was no implied representation in the Danier prospectus that the forecast in the prospectus was objectively reasonable.
Our December 2005 Blakes Bulletin on Securities Law discusses the Court of Appeal decision in detail and is available on Blakes Web site at www.blakes.com in our "Publications – Corporate Finance & Securities Regulation" section.
Supreme Court Of Canada
In its unanimous decision, the Supreme Court of Canada upheld the outcome of the Court of Appeal’s decision, but in doing so it refined and differed in some respects from the Court of Appeal’s reasoning.
1. No Continuing Obligation To Disclose New "Material Facts" Prior To Completion Of Distribution
The Supreme Court upheld the Court of Appeal decision that issuers are not required to disclose in a prospectus amendment a "material fact" occurring after the date a securities regulator issues a receipt for the final prospectus but prior to completion of the distribution under the prospectus, provided that the material fact does not constitute a "material change".
This decision relates to prospectus disclosure requirements under the Securities Act (Ontario) and does not apply to public companies’ continuous disclosure obligations under applicable securities laws and stock exchange rules, such as the Toronto Stock Exchange’s requirement for listed issuers to disclose both material facts and material changes.
2. Business Judgment Rule Does Not Apply To Statutory Disclosure Obligations
As noted above, in overturning the trial judge’s decision, the Court of Appeal invoked the Business Judgment Rule and its deference to directors’ and officers’ business decisions. The Supreme Court made a point to explicitly reject the proposition that a disclosure obligation under securities laws should be qualified or, in the words of the Supreme Court, "undermined", by the Business Judgment Rule.
The Business Judgment Rule provides that where directors and officers act reasonably in discharging their duties, even if they turn out to be wrong, courts will not readily second-guess their decisions. The traditional justifications of the Business Judgement Rule, as identified by the Supreme Court, are that management has more expertise than the court in making business decisions and managers need freedom to take reasonable risks without having to worry about being second-guessed by the courts.
The Supreme Court held that the traditional justifications for the Business Judgment Rule argued against its application to statutory disclosure obligations. The Supreme Court recognized that forecasting is a matter of business judgment but held that disclosure is a matter of legal obligation for the courts to evaluate.
By excluding the Business Judgment Rule from the context of disclosure decisions, the Supreme Court has mandated an objective rather than subjective standard with regard to the courts’ evaluation of disclosure obligations under securities laws.
3. Implied Representation That Forecasts Are Objectively Reasonable
The Court of Appeal held that the question as to whether a prospectus contains a representation, whether explicit or implied, is a question of fact. The Court of Appeal agreed that in most cases a forecast in a prospectus can be taken to contain implied representations that the forecast represents management’s best judgment, that the forecast was prepared with reasonable care and skill, and that management believes the forecast to be reasonable. (In fact, in the Danier prospectus there was an express representation that the forecast represented management’s best judgment.) However, the Court of Appeal rejected the finding that there was an implied representation in the Danier prospectus that the forecast was "objectively reasonable" stating that no reader of the prospectus would conclude that Danier management was implicitly representing that its best judgment in the forecast was shared by other reasonable business people or by any other "objective" standard.
The Supreme Court did not agree with the Court of Appeal’s reasoning on this point. The Supreme Court determined that, as a matter of fact, the forecast was put forward as being objectively reasonable as of May 6, the date of the prospectus. However, unlike the trial judge, the Supreme Court found that the forecast was not put forward as being objectively reasonable as at any date after May 6. Since the trial judge found that the forecast was objectively reasonable as of May 6 (and the Supreme Court held that the objective reasonableness of the forecast on any following date was irrelevant in these circumstances), the appellants’ appeal of the Appeal Court’s decision on this ground was dismissed.
4. Plaintiff(s) In Commercial Class Actions Will Run Significant Cost Risks
The Supreme Court upheld the cost award in favour of Danier against the representative plaintiff. In doing so, the Supreme Court reaffirmed the "loser pay" principle in cost awards. This is likely to have a significant bearing on future class proceedings in this area, and represents a judicial recognition that class actions are often advanced by sophisticated and well-financed parties and counsel who should not be protected from the usual costs sanctions. As the Supreme Court acknowledged, "the David against Goliath scenario does not necessarily represent an accurate portrayal of the real conflict in modern class action litigation."
This decision may well give future plaintiff class action claimants cause to reconsider commencing a class action given the potential cost consequences of being unsuccessful in the litigation.
The full text of the Supreme Court of Canada ruling in Danier Leather is available on Blakes Web site at www.blakes.com in our "Publications – Corporate Finance & Securities Regulation" section.
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.