Reprinted with permission from the 2008 Canadian Legal Lexpert Directory
PRACTICE AREA DEFINITION
Lawyers practising director and officer law advise corporations, directors, officers and insurers on director and officer liability, indemnity and insurance options, corporate governance obligations and risk management strategies. Previously under the umbrella of general corporate advice, it is now recognized that issues of particular importance to directors and officers require a more focused approach. Practitioners familiar with the statutory, common law and ethical obligations applied to directors and officers are now called upon to provide the sophisticated advice required, whether for significant corporate events such as M&A transactions and insolvencies or for ongoing business operations.
RECENT DEVELOPMENTS OF IMPORTANCE
A number of important developments have taken place in Canada over the past year regarding the potential for directors and officers to incur liability, specifically in the areas of (i) timely disclosure obligations (including the use of confidential material change reports); (ii) civil liability for secondary market disclosure violations; (iii) the re-affirmation of the business judgment rule in the mergers and acquisitions context and the rejection of the business judgment in the context of securities law disclosure; and (iv) directors' and officers' insurance. Each of these topics is discussed in detail below.
TIMELY DISCLOSURE OBLGATIONS
Canadian securities laws impose obligations on a publicly traded issuer (and, in effect, its directors and officers) to forthwith disclose any material changes regarding the issuer. A material change is defined under Ontario securities laws as 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 any securities of the issuer and includes a decision to implement such a change made by the board of directors of the issuer or by senior management of the issuer who believe confirmation of the decision by the board of directors is probable. Similar definitions exist under securities legislation in the other Canadian provinces and territories.
Although requirements to disclose material changes, also referred to as "timely disclosure requirements," have long been in force, securities regulators have recently become more active in enforcing these requirements, particularly in the context of merger and acquisition transactions (referred to in this article simply as merger transactions or mergers). As practitioners in this area are well aware, pinpointing the precise time at which negotiations between parties have reached a point where a material change (as defined under securities laws) has occurred is often difficult. Combining this difficult assessment with more active regulatory enforcement has significantly increased the scope of liability of directors and officers for timely disclosure violations. There are, however, some practical considerations that can reduce the chances of liability, as discussed below.
Take Care When Making Decisions And Avoid Letters Of Intent
Directors and officers, and their advisors, must be careful how they frame decisions during the various stages of the negotiation process to avoid triggering a material change before the parties reach agreement on all key elements. Upon the successful completion of negotiations is typically when parties desire to make disclosure; early disclosure can result in significant risk to the execution of the deal and can be very disruptive to an issuer's business. Therefore, definitive decisions and corresponding directors' resolutions should be avoided until the final stage of negotiations is completed and a fairness opinion (where this is being obtained) has been delivered. Only then should directors formally approve a merger transaction and determine to make any recommendations to shareholders (if applicable).
This approach should be reflected in the minutes of board and relevant committee meetings that take place throughout the process, with directors reiterating from time to time in those minutes that no definitive decisions have yet been made.
In a related vein, parties to a potential merger transaction should be wary of using letters of intent that set out key transaction terms. Parties often use these letters at an early stage in the negotiation process to ensure a meeting of minds on significant points and to focus subsequent negotiations. However, though such letters are typically non-binding, they may be damaging to an argument that no material change has occurred because they can create the appearance that all key terms have been settled and that a decision to implement has been made. Due to these concerns, in our experience letters of intent are rarely used any more in the context of public company mergers. Confidentiality and exclusivity arrangements are still acceptable in that they will not trigger a material change in and of themselves, provided that they are carefully drafted with the foregoing considerations in mind. In particular, these arrangements should avoid setting out any potential transaction terms, including price terms.
Avoid Generic Disclosure When Clarifying Rumours Or Unusual Trading
Canadian securities regulators and stock exchanges expect, and often require, companies to clarify rumours that arise in the marketplace about a possible merger transaction, particularly if these rumours may be causing unusual trading activity. Issuers will accordingly file media releases to clarify the situation. However, such a media release can create regulatory issues (as well as civil liability for secondary market disclosure issues — discussed in more detail below) if it creates an incorrect or a potentially misleading perception in the market regarding the stage a company has reached in negotiations. A tailored and specific disclosure, as opposed to a generic approach, may be required if the issuer is beyond the most preliminary of discussions.
Consider Using Confidential Material Change Reports
Canadian securities laws permit issuers to file material change reports on a confidential basis as a means of satisfying obligations to disclose material changes, provided that the issuer reasonably believes that public disclosure would be unduly detrimental to its interests. The issuer must renew the confidential material change report every 10 days after it is filed, applying the same unduly detrimental standard, or until public disclosure is made.
Although this option has been available for some time, the use of the confidential material change report has only started in earnest recently, largely in reaction to the implementation of civil liability for secondary market disclosure. However, it can be a powerful tool in protecting directors and officers from liability in relation to timely disclosure violations, particularly in the penultimate stages of transaction negotiations, when disclosure decisions are the most difficult.
Issuers should take two important factors into account in deciding whether to use a confidential material change report. First, it may be argued that by filing this report, the issuer and its directors and officers are implicitly acknowledging that a material change has in fact occurred. Therefore, the confidential material change report should (depending on the circumstances) contain language indicating that it is being filed as a precautionary measure and should not be construed as an admission that a material change has occurred.
Second, in the United States, the Security and Exchange Commission does not permit confidential material change filings. SEC-reporting companies that are foreign private issuers (which includes almost all Canadian companies listed on US stock exchanges) must furnish a report to the SEC on Form 6-K, disclosing material events. However, this does not have to be done until the material event is publicly disclosed in Canada — that is, a confidential Canadian filing will not trigger a disclosure obligation under US law for a foreign private issuer. That being said, we believe that filing confidentially in Canada without the availability of a comparable procedure in the United States entails risks for cross-border companies under the US civil liability regime.
CIVIL LIABILITY FOR SECONDARY MARKET DISCLOSURE VIOLATIONS
The Civil Liability Regime To Date
At the start of 2006, legislation (colloquially referred to as "Bill 198") went into effect to amend the Ontario Securities Act by providing for a regime of statutory civil liability for issuers, directors and officers for secondary market disclosure violations. Specifically, the legislation provides for liability in respect of misrepresentations contained in documents released by the issuer and in oral statements made on behalf of the issuer. It also provides for liability for the issuer's failure to make timely disclosure of material changes. In addition, the legislation removes the key common-law hurdle of shareholder plaintiffs having to establish reliance on misrepresentations in order for an action to be successful, and provides a scheme for calculating damages.
However, far from the proliferation of US-style class action cases that were expected to be brought, proceedings under Bill 198 have been rare so far: only three have been publicly commenced to date. There are two reasons for this. First, many elements of Bill 198 remain to be fleshed out by courts in judicial decisions. However, plaintiffs' counsel are cautious about setting precedents that limit their ability to successfully bring claims — that is, they do not want bad facts to create unfavourable Bill 198 law. Accordingly, plaintiffs' counsel are initially bringing actions only when they believe the facts are strongly in their favour.
Second, Bill 198 requires that leave from the court be obtained in order to prevent against so-called strike suits, unmeritorious claims, and early settlement of such claims by defendants concerned about legal costs and damage to reputation. Therefore, a proceeding may be commenced only with leave of a court and where the court is satisfied that (i) the action is being brought in good faith and (ii) there is a reasonable possibility that the action will be resolved at trial in favour of the plaintiff.
The leave requirement is intended to weed out frivolous actions by requiring a merit-based hearing early on. None of the current actions has yet reached the leave hearing stage, though at least one action was expected (at time of writing) to have a leave hearing before the end of 2007. The outcome of these hearings will play an important role in determining the scope of civil liability for secondary market disclosure violations.
Practical Steps To Avoid Civil Liability
Even though Bill 198 actions are still in their infancy, there are practical steps that directors and officers can take to protect themselves from civil liability. The legislation provides directors and officers with a due diligence defence — that is, they will not be liable for disclosure violations if they can establish that they carried out a reasonable investigation in respect of disclosure matters. The precise scope of this defence remains to be defined by courts. However, to increase the likelihood of such a defence being available, directors and officers should consider (i) establishing a disclosure policy in respect of an issuer, covering timely disclosure, the internal process for reviewing and releasing periodic disclosure (financial statements, management's discussions and analysis, etc.) and procedures for making public oral statements (including analyst calls); (ii) establishing a disclosure committee composed of the issuer's senior officers and charged with responsibility for implementing the disclosure policy, monitoring disclosure issues and reporting to directors in this regard; and (iii) keeping a careful record of minutes of board and committee meetings in which disclosure matters are discussed.
These practices will contribute to the ability of directors and officers to establish a due diligence defence. By creating a rigorous oversight mechanism, the practices also provide greater comfort that disclosure violations will not in fact occur. In addition, in this civil liability context, the use of confidential material change reports can – as in the case of regulatory actions for failure to make timely disclosure – provide a complete defence. To rely on this defence in the civil liability context requires, in addition to the elements described under "Consider Using Confidential Material Change Reports," above, that a reasonable basis exists for filing the material change report on a confidential basis. The practices described under "Take Care When Making Decisions and Avoid Letters of Intent" and "Avoid Generic Disclosure When Clarifying Rumours or Unusual Trading," above, equally apply to reduce the likelihood of civil liability for timely disclosure violations.
THE BUSINESS JUDGMENT RULE
In The Merger Transaction Context
The business judgment rule has long been an important concept in corporate law. Simply put, in evaluating whether directors have discharged their duty of care to an issuer (which duty requires directors to be active and attentive participants), courts will consider whether directors have made a reasonable and informed decision, not a perfect decision. This concept is rooted in the idea that courts are ill-suited to substitute their own business expertise for that of directors.
However, US courts long ago abandoned the business judgment rule in the context of merger transactions in favour of stricter and more prescriptive tests. Variously, there are "Unocal" standards, "Revlon" duties, "entire fairness" tests, restrictions on eliminating so-called fiduciary outs, and others. This prescriptive approach was confirmed in 2007 by the Delaware Court of Chancery in In Re Netsmart Technologies, Inc. Shareholders Litigation. In this case, which involved an auction and sale of Netsmart, the Court criticized the actions of the board for, among other things, (i) not suitably canvassing potential strategic buyers of Netsmart (and the Court was dismissive of confidentiality concerns raised in this regard); (ii) believing that, given Netsmart's particular circumstances, a fiduciary-out clause in the merger agreement (permitting Netsmart to accept a higher offer from an unsolicited buyer provided Netsmart paid a termination fee) could serve as an effective means of conducting a post-signing market check of interest from strategic buyers; and (iii) the role of the special committee vis-à-vis management in the sale process.
Meanwhile, Canadian courts have remained much more deferential to the business judgment of directors. This approach was re-affirmed by the Ontario Court of Appeal in the merger context early this year in Ventas, Inc. v. Sunrise Senior Living Real Estate Investment Trust. One of the issues raised in this case was the scope of directors to contract out of their fiduciary duties in a merger agreement by binding the company to a single purchaser and restricting the capability of the company to enter into an agreement with a subsequent higher bidder. In this case, the Court explicitly rejected the extent to which US courts have mandated that companies and directors maintain a wide-ranging ability to be able to accept higher bids. In particular, the Court confirmed an approach in the merger agreement that in essence precluded earlier bidders in an auction process from bidding again.
Application To Securities Laws
Although the business judgment rule has long been a part of corporate law, the Supreme Court of Canada recently considered its application to the securities law arena, in Kerr v. Danier Leather Inc. The specifics of this case involved civil liability for prospectus disclosure. One of the arguments before the Supreme Court was whether management's (or a board's) business judgment is a factor in determining whether a disclosure violation has occurred. The Supreme Court rejected any application of management's business judgment in the context of securities law disclosure. Specifically, the Supreme Court stated in respect of the business judgment rule:
The traditional justifications for the rule argue against its application here. It is said, truly enough, that judges are less expert than managers in making business decisions. Moreover, business decisions often involve choosing from amongst a range of alternatives. In order to maximize returns for shareholders, managers should be free to take reasonable risks without having to worry that their business choices will later be second-guessed by judges. These justifications – based on relative expertise, and on the need to support reasonable risk-taking – do not apply to disclosure decisions.
The Danier decision is certain to make it easier for both regulators and shareholders to successfully bring actions for securities law disclosure violations against issuers, directors and officers by giving little weight to contemporaneous business judgment and permitting a high degree of second-guessing.
UPDATE ON DIRECTORS' AND OFFICERS' INSURANCE
As a result of Bill 198 and the increased likelihood of director and officer exposure, it is important that directors and officers carefully consider the terms of their respective directors' and officers' insurance policies. Two recent developments in this area in particular are worth noting. First, most policies now include separate insurance coverage of the issuer for securities law claims (referred to as "Side C" or "entity coverage," with Side A coverage being insurance for directors and officers, and Side B coverage being insurance for the issuer in respect of indemnification payments made by the issuer to directors and officers). This is not necessarily a good development for directors and officers themselves since such coverage can reduce the overall coverage otherwise available to directors and officers (i.e., an insurance payment to an issuer under a Side C claim will reduce the portion of the coverage limit that remains available for directors and officers).
Second, it is becoming common for directors and officers to obtain a separate Side A policy that provides excess coverage beyond that available in the primary policy and that also has less restrictive exclusions on the types of claims that will be covered.
Directors and officers should carefully consider each such element with regard to their own policies.
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.