ONTARIO
Superior court green-lights IMAX secondary market securities class action; accepts relatively low thresholds for granting leave and certification
Silver v. IMAX Corporation et al., [2009] O.J. Nos.
5573 and 5585
Ontario Superior Court of Justice | Justice van Rensburg | December
14, 2009
Background
Securities class actions are relatively new to Canada. Governed
by provincial rather than federal law, they were difficult, if not
impossible, to bring prior to the adoption of modern class actions
legislation (which occurred in the 1990s in most provinces) and
even then were difficult to pursue in the "secondary
market" context. This changed on December 31, 2005 with the
adoption of the liberalized secondary market liability provisions
of Part XXIII.1 of Ontario's Securities Act (OSA)
(since replicated in nearly all other Canadian jurisdictions).
Nevertheless, in contrast with the extensive U.S. jurisprudence in
this area, the ground rules of Canadian secondary market class
actions remain a work in progress.
The issues
Two December 2009 rulings in a class action against IMAX Corp.
(the TSX and NASDAQ-listed entertainment technology company)
address important procedural issues surrounding secondary market
liability claims under Part XXIII.1 and its counterparts in other
provinces. The plaintiff shareholders are suing with respect to a
decline in share value that they argue was rooted in alleged
misrepresentations in IMAX's 2005 Form 10-K, in its 2005 Annual
Report and in press releases issued in early 2006. Justice
Katherine van Rensburg of the Ontario Superior Court of Justice
ruled on two threshold issues: the plaintiff shareholders'
application for leave to proceed with their secondary market
liability claim and their concurrent application for the
certification of their class action. "Leave" and
"certification" are statutory hurdles - in the first case
under the Part XXIII.1 secondary market liability provisions and in
the second case under class actions legislation, known in Ontario
as the Class Proceedings Act, 1992.
As detailed below, Justice van Rensburg granted both certification
and leave in these two concurrent rulings, interpreting the various
threshold requirements of each - e.g. duty of care, reliance, good
faith and "reasonable possibility of success" - in a
manner that will generally be well received by potential securities
class action plaintiffs. Among other things, these rulings are
significant because - pending appeal - they appear to mark at least
a small step in the evolution of Canadian business and shareholder
disputes toward the historically more litigious U.S. model.
Multinationals based in the U.S. and other foreign jurisdictions
should be aware that it is possible that they may be subject to
Canadian secondary market class actions even if they do not trade
publicly in Canada.
Certification ruling
While both the common law claim and the statutory secondary
market liability claim required certification to proceed to the
class action stage, the defendants chose to focus their opposition
to the Part XXIII.1 secondary market claim on the concurrent leave
application, agreeing to accept certification in the event that
leave were granted. Thus the certification hearing was largely
confined to the common law aspect of the claim, which focused
mainly on misrepresentation, the dominant issue being whether that
cause of action was properly asserted under the Canadian common law
test, i.e. whether a duty of care had been established (by showing
a "special relationship") and whether the plaintiff had
reasonably relied on the misrepresentation. The plaintiffs argued
(i) that IMAX and the individual defendants owed a duty of care to
the investing public in releasing its disclosure documents and (ii)
that the "efficient market" theory could be used to
establish that by the act of purchasing or acquiring IMAX
securities the plaintiffs relied on the misrepresentation.
Duty of care
Justice van Rensburg found that a duty of care may have been
owed in the circumstances, as the intended recipients of the
documents containing the misrepresentation were the investing
public, including the plaintiffs and proposed class members, and
that IMAX issued the documents for the purpose of attracting and
informing shareholders. Importantly, Justice van Rensburg refused
to limit or restrict the alleged duty of care based on public
policy concerns or concerns of indeterminate liability.
Reliance
With respect to reliance, the defendants argued that the
plaintiffs' assertion that reliance was established by the act
of purchasing or acquiring IMAX securities was insufficient as
there was no pleading that the proposed class members individually
relied on the misrepresentations in making their investment
decisions. The defendants maintained that the "efficient
market" theory put forward by the plaintiffs was akin to the
American "fraud on the market" theory, which is not
recognized in Canada.
Justice van Rensburg acknowledged that no case asserting the
"efficient market theory" has gone to trial. However, she
held that there was a conceivable claim in this case, based on the
plaintiffs' pleading of the "efficient market theory"
to establish reliance. In other words, instead of alleging
individual reliance (in the traditional sense) on the part of each
class member, it would conceivably be sufficient that the
plaintiffs were alleging that the market for IMAX's shares was
efficient (i.e. that the share price reflected all public
information) and that they therefore relied on the
misrepresentations in virtue of having acquired their shares during
the period that the misrepresentations remained public and
uncorrected. In so holding, Justice van Rensburg appears to have
accepted that the "efficient market" theory can be
applied in Ontario, at least at the pleading or certification
stage. (Exactly how "efficient market" theory relates to
the U.S. "fraud on the market" doctrine is something that
may be further clarified on appeal.)
Size of the class
In certifying a global class (consisting of all persons who
acquired securities of IMAX during the proposed Class Period and
who held some or all of those shares at the end of trading on
August 9, 2006 when IMAX released its press release announcing an
SEC investigation), Justice van Rensburg ruled that the fact that a
similar proceeding had been commenced (although not certified) in
the United States was inconsequential to the Ontario action. She
added that any conflict of laws concerns would be premature until a
statement of defence had been filed alleging reliance on laws of
other jurisdictions.
Leave ruling
The second of Justice van Rensburg's two concurrent rulings
focused on whether the plaintiffs should be granted leave to
proceed with the misrepresentation claim under the secondary market
liability provisions of Part XXIII.1 of the OSA. Section 138.8 of
the OSA requires that the Court grant leave where the plaintiffs
are acting in good faith and there is a reasonable possibility of
success at trial. As this case was the first to consider these
leave requirements, Justice van Rensburg's ruling marked an
important first step - given the high likelihood of an appeal in
this case and further refinements in subsequent litigation - in
clarifying both branches of the test.
Good faith
The defendants maintained that the plaintiffs bore the burden of
establishing good faith, arguing that this required them to
establish (i) that the action has been brought for the benefit of
the corporation and not for the plaintiffs' benefit and (ii)
that they hold a reasonable belief in the merits of their claim.
Justice van Rensburg rejected this characterization of "good
faith" in favour of the alternative view that the plaintiffs
are required only to establish that they brought the action in the
honest belief that they have an arguable claim and for reasons that
are consistent with the purpose of the statutory cause of action
and not for an "oblique or collateral purpose."
Justice van Rensburg found that the plaintiffs brought the action
to permit shareholders to recover damages and to hold the
defendants accountable for the company's alleged
misrepresentations (while deterring others from doing the same). In
her opinion, this was consistent with the statutory scheme of Part
XXIII.1. Therefore, the good faith requirement was satisfied.
Reasonable possibility
With respect to the "reasonable possibility"
requirement, both sides agreed that a preliminary consideration of
the merits of the case would be required. Needless to say, they did
not agree about the applicable threshold. The plaintiffs contended
that it was sufficient to show that there is at least some evidence
that, if accepted by the court, would be consistent with the
allegation of misrepresentation, while the defendants argued that,
given that the purpose of the leave requirement is to deter
unmeritorious claims and "strike suits", the threshold
should be high and (among other things) would require the
plaintiffs to show that they could overcome the statutory defences
raised by the defendants - "reasonable investigation" and
"expert reliance".
Justice van Rensburg held that the plaintiffs must submit evidence
with respect both to the alleged misrepresentation and to the
conduct of IMAX's officers or directors in relation to it.
However, in her opinion, "reasonable possibility"
requires only "something more than a de minimis
possibility or chance that the plaintiff will succeed at
trial", reflecting the view that the leave requirement was
intended only to prevent abuses of process and purely speculative
claims. In reviewing the evidence, Justice van Rensburg found that
the plaintiffs had satisfied this "low threshold", other
than with respect to two defendants who had been outside directors
of IMAX. While the statutory defences could be considered, Justice
van Rensburg found that they could affect the result of a leave
application only if they would demonstrably foreclose the
reasonable possibility of success at trial for the plaintiffs. In
this case, neither of the Part XXIII.1 statutory defences raised by
the defendants - the due diligence defence and the expert reliance
defence - met the test.
Appeal
As leave to appeal Justice van Rensburg's ruling has been
sought, it is unlikely that these rulings will be the final word on
these issues.
DELAWARE
Earn-out providing for return of assets if targets not met, rather than expressly requiring purchaser "effort", will not be rewritten just because the weak economy and other factors have made an asset return unpalatable to the seller
Airborne Health, Inc. v. Squid Soap, LP, C.A. No. 4410
VCL
Delaware Court of Chancery | Vice Chancellor Laster | November 23,
2009
This ruling by Vice Chancellor Laster of the Delaware Court of
Chancery reminds us that in a commercial relationship, the contract
reigns supreme. Even though it had a sympathetic story to tell, and
despite some creative appeals to tort and equitable doctrines,
Squid Soap couldn't get around the fact that the Asset Purchase
Agreement (APA) it had negotiated with acquiror Airborne Health -
with payment heavily weighted toward the earn-out - had not
adequately protected it against certain unanticipated post-closing
events that occurred, most notably the economic downturn.
Background
Squid Soap had developed a child-friendly hand washing product.
A hit with U.S. TV morning shows and major magazines, "Squid
Soap" was soon picked up by Wal-Mart and other mass retailers.
As the brainchild of a single entrepreneur, the Squid Soap business
was ripe for a buyout. Despite interest from Procter & Gamble
and a major hedge fund, Squid Soap selected Airborne Health, Inc.,
a larger entrepreneurial company, as its acquiror. Airborne had
made its name with a highly successful vitamin and herb supplement
that was marketed as effective against coughs and colds.
The deal
Small up-front payment, big earn-out
In 2007, Squid Soap and Airborne signed the APA. The deal -
covering Squid Soap's brand name, goodwill, patents and other
assets - paid only $1 million on closing but provided for earn-out
payments of up to $26.5 million.
Assets to be returned if targets not met
The APA contained an Asset Return Provision (ARP), under which
Airborne was required to return the assets to Squid Soap if certain
marketing and sales targets weren't met. Squid Soap's idea
was to give Airborne a shot while reserving the right to take its
product back and try again with someone else if the specified
marketing and sales targets were not met.
No specific "effort" requirements
Although the ARP specified service levels below which the assets
would revert to Squid Soap, the APA did not include a standalone
commitment from Airborne to invest a certain level of effort and
money in the product. In other words, Squid Soap negotiated a
mechanism for getting its assets back, but not (or at least not
obviously) one that would require Airborne to put its muscle behind
the product (and, by extension, protect the potential value of
Squid Soap's earn-out).
How it all went wrong
Problems arose when Airborne's cold remedy claims came under
scrutiny - first by ABC News and then by the Federal Trade
Commission and various state authorities. There was also a class
action in California that was eventually settled for $23.5 million
plus a consumer rebate program. By this time, Squid Soap had been
rebranded as "Squid Soap by Airborne" and the ensuing
negative publicity, coupled with Airborne's failure to put its
now strained resources behind the product, damaged the
product's viability.
Product return rebuffed
In accordance with its interpretation of the APA, Airborne duly
offered to return the assets to Squid Soap. But the company was not
interested - possibly because it feared the loss of its potentially
valuable earn-out in a changed economy where alternative investors
were scarce (the value of the earn-out being especially significant
in a potential litigation context). Instead, it claimed that
Airborne had known full well about the problems, including the
California litigation, when the deal was being negotiated.
The court proceeding
Rebuffed in its effort to apply the ARP, Airborne brought an
action for specific performance and other equitable remedies,
including a declaration that Squid Soap could not assert a claim
against it. Squid Soap issued a defence and counterclaim, in
response to which Airborne moved for summary judgment. Vice
Chancellor Laster accordingly focused on Squid Soap's claims
and whether - on a best-case scenario - any were potentially strong
enough to preclude the issuance of the declaratory judgment
requested by Airborne. The principal claims fell under the
following headings:
- Fraud and fraudulent inducement;
- Extra-contractual misrepresentations;
- Breach of contract; and
- Breach of implied covenant of good faith and fair dealing.
In each case, as set out below, the court found that Squid
Soap's arguments could not overcome the clear language of the
APA.
Fraud and fraudulent inducement
Squid Soap's first claim was that Airborne's "no
pending litigation" representation in the APA was fraudulent
or a fraudulent inducement to enter into the contract. Under
Abry Partners V, L.P. v. F&W Acquisition LLP, 891 A.2d
1032 (Del. Ch. 2006), a knowingly false contractual representation
can ground an action in fraud. The problem for Squid Soap was that
Airborne had represented only that:
What made things worse was that Squid Soap's own "no
pending litigation" representation in the APA was far
stronger. Unlike the Airborne representation, it was not limited to
proceedings that would interfere with closing. The court held that,
given the wording, Squid Soap was out of luck: whatever proceedings
might have been pending or likely at the time of the agreement
clearly had not interfered with closing, "which appears to
have gone off without a hitch". Nor did the court accept Squid
Soap's arguments that "consummating the transactions"
encompassed all the post-closing events contemplated by the
parties, including earn-out payments. Not only did this contradict
the ordinary understanding of "consummating the
transactions" but it ignored the fact that the APA did not
actually require Airborne to make any efforts or to pay out any
earn-out payments (unless certain conditions were met).
To put it another way, the court essentially declined to write a
MAE provision into the APA.
Extra-contractual misrepresentations
Squid Soap also alleged fraud with respect to extra-contractual
misrepresentations. Airborne argued that the APA's integration
(entire agreement) clause disclaimed reliance on extra-contractual
representations. Vice Chancellor Laster rejected this argument
because a standard integration clause does not suffice under
Delaware law as a disclaimer of reliance. Moreover, the APA's
exclusive remedy clause excepted "claims involving fraud or
intentional misrepresentation" with no suggestion that the
right being preserved was limited to claims founded on written
representations in the contract - one of many drafting points to
come out of the ruling.
Despite this small victory, Squid Soap's argument quickly
foundered on its failure to plead any specific instance in which an
actual misrepresentation had been made. Instead, it generalized
about Airborne's alleged misrepresentations, concealments etc.
The court commented:
The court would not permit the claim, or even permit Squid
Soap's counsel to re-plead. A claim in "equitable
fraud" also failed because no fiduciary relationship (or other
"special equities") existed in what was a commercial
relationship between sophisticated parties who were advised by
well-known law firms.
Breach of contract
Squid Soap was no more successful with breach of contract. Among
other things, it argued that Airborne had breached the APA by
failing to market and promote Squid Soap. But, as already noted,
the contract contained no such obligation. All that happened if
Airborne didn't market the product was that it had to be
returned to Squid Soap. Nor did the court accept Squid Soap's
argument that Airborne had breached the APA by failing to return
the assets as soon as the thresholds for retention were breached.
Again, the contract provided only that "the Purchaser shall
transfer the Purchased Assets existing as of such date (other than
inventory) back to the Seller." - not that they had to be
transferred on or by such date. The wording of this clause
also scuppered Squid Soap's claim that Airborne had breached
the agreement by (allegedly) dumping Squid Soap inventory into
"mega-discount stores".
Good faith and fair dealing
Under Delaware law, a covenant of good faith and fair dealing is
implied into all contracts. On this point, the key thing to
remember, as Laster V.C. noted, quoting a previous ruling, is the
following:
It must be clear that the parties "would have agreed"
to the covenant had they thought to address the issue in question.
Laster V.C. observed that Delaware courts have tended to imply good
faith and fair dealing cautiously.
In light of this interpretive background, Squid Soap's counsel
characterized the absent "efforts" requirement as
something that had simply not been addressed in the contract. As
such, it would arguably be subject to the implication of a good
faith/fair dealing covenant. Given the general purpose of the APA,
counsel argued, it would surely have had to be understood as
including some obligation on the part of the purchaser to
"make an honest go of it." However, while Laster V.C.
agreed that "Airborne.could not have refused arbitrarily or in
bad faith to pursue the Squid Soap business", he pointed out
that this wasn't actually what Squid Soap was alleging
throughout the rest of its claim, where it had repeatedly insisted
that Airborne had failed to promote the Squid Soap product not on
an arbitrary basis but because of the corporate crisis caused by
the California lawsuit and the FTC investigation.
Squid Soap's argument was further undercut, in the court's
opinion, by the "ease with which [it] could have insisted on
specific contractual commitments from Airborne regarding the
expenditure of resources, or some form of 'efforts'
obligation for Airborne." Squid Soap had instead contented
itself with highly conditional earn-out terms. Laster V.C. noted,
in concluding, that there was nothing necessarily
"irrational" or "unreasonable" about this
bargain: the APA simply loaded all of Squid Soap's downside
protection into the ARP, presumably (i) because the quid pro
quo of doing it this way was an enormous potential earn-out
and (ii) because Squid Soap believed that it had a great product
that could easily be shopped around again if, for whatever reason,
things did not work out with Airborne.
Conclusion
Squid Soap may not have anticipated that problems with the acquiror's other business lines could affect the reputation of its soap product or (more significantly) that an asset return might occur under economic conditions that would make it difficult to find new financing for any product, even a good one. But, in the view of the court, none of this allows "Squid Soap to rewrite the deal it cut in more optimistic days." Laster V.C. accordingly issued declarations barring Squid Soap from litigating against Airborne anywhere other than in Delaware and stating that Airborne had fully complied with the APA. The court stopped short of issuing a decree of specific performance compelling Squid Soap to accept the return of the assets, apparently only because it appeared unlikely that Squid Soap would fail to do so.
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