Canada: Ontario Court Of Appeal Allows Secondary Market Securities Class Action To Proceed

Last week the Court of Appeal for Ontario released a decision in Rahimi v. SouthGobi Resources Ltd. , allowing class action claims to proceed against former directors in a secondary market securities class action under s. 138.8(1) of the Securities Act.

SouthGobi Resources Ltd ("SGR") is a coal mining company trading on the Toronto and Hong Kong stock exchanges and the defendant is this matter. Also named are two former CFOs of SGR, and directors and members of SGR's audit committee (collectively the "Individual Respondents"). SGR's revenue came from the coal mining operations of its subsidiary in Mongolia, which was a major coal supplier for the Chinese market. Customers would order coal which was stockpiled for custom pick up. The customers would pay the contract price for the coal as soon as the coal was delivered to the stock yard, thus enabling them to avoid rising prices in coal and providing greater flexibility in transporting it. SGR used International Financial Reporting Standards ("IFRS") to report its revenue, rather than the American GAAP method. The IFRS recognition rule IAS-18 provides that revenue from the sale of coal could be recognized as soon as the coal was delivered to the stockpile yard, rather than when the customer retrieved the coal provided that "a reasonable judgment could be made that the risk and rewards of ownership of the coal had been transferred to the customer upon delivery of the coal to the yard and that customer payment was probable".

In mid-2012 several events occurred which resulted in a halt in the production of coal by SGR's subsidiary and a drop in the price of coal in China which meant customers were unable to make timely payments. This resulted in several forfeitures and repossessions by SGR's subsidiary and, as a result, the likelihood of payment stipulation in IAS-18 was no longer being met for these customers. At this time, SGR adopted a revenue recognition policy that required delivery of coal to the customer as a prerequisite to recognition. SGR concluded that there was no need to change its earlier financial statements as a result of these subsequent changes in operation.

In November 2013, SGR reversed this position and did issue a formal restatement of its prior financial statements (the "Restatement"). Following this release, SGR's share price dropped 18%. SGR provided a press release indicating that there was "a material weakness in the Company's internal controls over the financial reporting". The "material weakness" was explained as a failure to ensure that "all aspects of sales arrangements were considered" in determining the appropriate financial accounting in respect of the mining operations. In other words, there was no assurance that the accounting was IFRS-compliant.

The proposed class action was for all purchasers of SGR shares between March 30, 2011 and November 17, 2013. The parties agreed that the issues of leave under the Securities Act should be determined prior to certification.

On the motion for leave, SGR and the Individual Respondents took the unusual position of relying on the defence of reasonable investigative efforts provided by section 138.4(6)(a) of the Securities Act. The Individual Respondents further argued that there was no misrepresentation during the class period but, rather, any potential misrepresentation was in the November Restatement and press release. They further said they had been pressured by their accountants and various financing entities and that they had reluctantly agreed to the restatement and press release.

The motion judge concluded that the misrepresentation claim should proceed against SGR because it has a reasonable possibility of success based on the "explicit language" in the restatement that SGR's earlier revenue reports were deficient and should not be relied on. The motion judge then assessed the reasonable investigation defence. He refused leave as against the Individual Respondents because he held that there was no reasonable possibility that they would not be able to establish a reasonable investigation defence at trial under the Securities Act. He held that the Individual Respondents carefully analyzed IFRS standards against the contracts and properly applied them. He further stated that the Individual Respondents provided credible and unchallenged evidence establishing their reasonable investigation defences. With respect to SGR itself, the motion judge held that there was a reasonable possibility that it would not be able to establish a reasonable investigation defence at trial and the fact that it had issued the Restatement was arguably inconsistent with a reasonable investigation defence as the restatement amounted to an acknowledgement of a "prior error" in a financial statement as defined under the IFRS.

The Court of Appeal held that the motion judge erred primarily by treating the leave motion as if it were a trial in which he had to finally resolve significant credibility issues on the record before him. He further failed to give meaningful consideration to gaps in the evidentiary record and the significant credibility issues apparent from that record. In particular, he failed to consider compelling evidence that contradicted the defence narrative offered by SGR and the Individual Respondents on the motion. The Court reiterated that in the face of a limited record and significant credibility issues, the proper course for a motion judge is not to try to resolve the issues on a limited record but rather the limited record makes it evident that the leave must be granted because there is no certainty that the reasonable investigation defence will succeed.

This decision is helpful, as the Court provides an overview of the leave requirements under section 138.8 and enphasizes the "underlying balancing" that is central to the leave requirement in secondary market misrepresentation cases and in particular the importance of the role played by the motion judge in such cases.

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.

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