By Bradley A. Heys.1
The Ontario Securities Commission (OSC) recently released its decision in In Re Coventree Inc., in which it found that Coventree and two of its directors (the "Respondents") failed to disclose material changes to Coventree's business as required under the Ontario Securities Act (the "Act").2 Whether or not it reached the correct result, the OSC Panel's (the "Panel") reasons raise significant questions about the type of evidence required to demonstrate that a change in a company's business is material. No expert evidence was introduced by either the OSC Staff ("Staff") or by the Respondents on the materiality of the changes in question, and yet the Panel drew at least some inferences that it seems should have required expert evidence to support. Although the OSC Panel is recognized as a specialized tribunal with expertise in matters relating to the Act, the determination of whether a change in a company's business is "material" is typically based on empirical or expert evidence. The Panel's conclusions on materiality appear to be largely subjective and therefore provide little guidance for future litigants about the types of evidence that should be led in order to establish or disprove allegations of material changes.3 In this paper I consider the Panel's stated reasons for one of the findings of a material change and describe the assistance that expert economic evidence and analysis could have provided and that, arguably, should have been required to support the finding of materiality.4
Coventree was the largest third-party (or non-bank) sponsor of asset-backed commercial paper (ABCP) in Canada prior to the collapse of the ABCP market in August 2007. ABCP is short-term paper (typically with 30- to 90-day maturities) issued by special purpose entities (commonly referred to as "conduits") and backed by interests (either directly by holding the assets or synthetically through the use of credit default swaps) in the cash flows generated by pools of longer-term financial assets such as car loans, mortgage loans, and credit card receivables. Coventree, which described itself as "a niche investment bank specializing in structured finance using securitization-based technology," acted as securitization agent and administered the conduits which issued ABCP. It became a public company with shares listed on the Toronto Stock Exchange on 16 November 2006 and was the only publicly traded third-party sponsor of ABCP in Canada.
In August 2007, the Canadian market for non-bank-sponsored ABCP, such as the paper issued by Coventree's sponsored conduits, failed as ABCP investors were unwilling to purchase new paper or roll their investments in maturing paper. Due to the inherent mismatch between the long-term maturities of the underlying assets held by the conduits and the short-term maturities of the ABCP, the conduits became insolvent when they could no longer successfully place the ABCP. Following this market freeze, Coventree determined that it was no longer able to carry on its business and ultimately began the process of winding down.
Staff alleged that Coventree made material misrepresentations and/or omissions in its IPO Prospectus and failed to disclose significant material changes in its business or operations during the period between its IPO in November 2006 and the market freeze on 13 August 2007. In particular, Staff alleged:5
a. Coventree failed to make full, true, and plain disclosure in the Prospectus by failing to disclose the fact that Dominion Bond Rating Service Limited ("DBRS") had adopted more restrictive credit rating criteria for ABCP in November 2006 (contrary to section 56 of the Act);
b. Coventree failed to comply with its continuous disclosure obligations by failing to issue and file a news release, and file a material change report, disclosing that DBRS's decision in January 2007 to change its credit rating methodology as articulated in a DBRS press release—"the DBRS January Release"—resulted in a material change in Coventree's business or operations (contrary to subsections 75(1) and 75(2) of the Act);
c. Coventree made a misleading statement during presentations to ABCP investors on 25 and 26 April 2007 by telling the market that the total US subprime mortgage exposure ("subprime exposure") of its sponsored conduits was 7.4% (the "subprime statement"), and by failing to provide ABCP investors with a breakdown of that exposure by conduit and ABCP note series (contrary to subsection 126.2(1) of the Act); and
d. Coventree failed to comply with its continuous disclosure obligations by failing to issue and file a news release, and file a material change report, disclosing liquidity and liquidity-related events and the risk of a market disruption in the days leading up to the disruption in the ABCP market that occurred on 13 August 2007 (contrary to subsections 75(1) and 75(2) of the Act).
The Panel found that Coventree met its obligations with respect to its Prospectus disclosures and the November 2006 DBRS press release (allegation (a)) and did not make a materially misleading statement regarding the subprime exposure of its sponsored conduits (allegation (c)), but did find violations of the Act with respect to the Company's failure to make disclosures regarding the DBRS January Release (allegation (b)) and certain events that occurred in the lead-up to the market freeze in August 2007 (allegation (d)).
This paper specifically focuses on the reasons given for the finding that the DBRS January Release was a change in the business of Coventree that was material and therefore ought to have been disclosed (allegation (b)).
Subjective Nature of the Reasons of the Panel
The relevant standard of materiality in this context, as the Panel noted in its reasons, is the so-called "market impact test"—i.e., a fact or change is considered to be material if it "would reasonably be expected to have a significant effect on the market price or value" of an issuer's securities.6 The Panel concluded that:
"In our view, a reasonable shareholder or investor would consider Coventree's inability to carry out any future CDO related SFA transactions [i.e., the Panel's view of the implication of the DBRS January Release] important information in making an investment decision with respect to Coventree's shares. It is only common sense that Coventree was unable to carry on in the future a business that represented 40% of conduit assets.
"Accordingly, in our view, the DBRS January release constituted a change in Coventree's business that would reasonably be expected to have had a significant effect on the market price or value of Coventree shares..." [336-337]
This key passage seems to conflate what a shareholder or investor would consider important information in making an investment decision with a "material change," ignores the market impact test—namely whether the change at issue would reasonably be expected to have a significant effect on the market price or value of Coventree's shares—and appears to substitute "common sense" for evidence in order to reach this conclusion.
No expert evidence on materiality was offered in this case—either by Staff or by the Respondents—to assist the Panel in evaluating whether information that Coventree allegedly could have disclosed regarding the DBRS January Release meets the market impact test for materiality. In the absence of such evidence, the Panel was forced to either dismiss the case for a lack of evidence or settle for reaching conclusions about materiality based on apparently subjective reasoning. In this situation, the Panel chose the latter.
While in some cases issues of materiality may appear to be obvious or require only common sense to evaluate, this case does not seem to fall into that category.7 The DBRS January Release announced publicly a number of changes to the rating criteria that would be applied to certain types of transactions8 entered into by commercial paper issuers such as Coventree's sponsored conduits. These ratings criteria were clearly relevant and important to Coventree (and indeed to all ABCP sponsors in Canada) since a credit rating by an approved credit rating agency is required under the Act to be able to issue ABCP in Canada under the short-term debt prospectus exemption, and since DBRS was the only approved credit rating organization that rated ABCP in Canada. However, in order to understand whether additional disclosure by Coventree regarding the DBRS January Release would have reasonably been expected to have a significant effect on the market price or value of its shares, one would need to understand both what could (or should) have been disclosed by Coventree (the "but-for disclosure") and the importance of that but-for disclosure within the context of the mosaic of publicly available information about Coventree.
First, it is not clear from either Staff's allegations or from the decision of the Panel what disclosure Coventree should have made. Without a clear articulation of what but-for disclosure was required, it is impossible to understand exactly what information is being assessed for materiality.
Second, the particular facts in this case suggest that it was not obvious what the importance of any such but-for disclosure would have been to Coventree's shareholders in the context within which it could have been made. For example, Coventree argued that it was not material information in the context because it had already disclosed to the market that it did not expect the types of transactions referred to in the DBRS January Release "to be a significant source of future growth or revenues and the release did not affect a single transaction that Coventree was then proposing."9 As such, if this was true, the change in ratings approach reflected in the DBRS January release may not have been important new information to investors in the general context of the market's expectations about Coventree's business prospects. In other words, without more contextual analysis, it is not obvious that any reasonable but-for disclosure would have been material. The Panel did describe at some length in its reasons the context within which the DBRS January Release was made, but the basis for its conclusion as a matter of "common sense" is ultimately unclear and appears to reflect a subjective assessment of what would be important to Coventree's shareholders.
Economic Analysis Required
Despite the Panel's conclusion that this was a change in Coventree's business that "would reasonably be expected to have had a significant effect on the market price or value of Coventree's shares," there appears to have been empirical evidence (but not expert evidence) before the Panel that this information did not have a significant effect on the market price of the shares.
In particular, Coventree provided information related to the DBRS January Release and its impact on Coventree's business in its subsequent second quarter Management Discussion and Analysis ("Q2 MD&A") filing in May 2007. The Respondents argued that the fact that the market price of Coventree's shares did not decline significantly following the release of its Q2 MD&A indicated that any such change was not material to Coventree's shareholders. Although no expert evidence was before the Panel, this argument is related to the type of analysis that an economics expert would typically conduct in assessing issues of materiality—namely, an event study.
An event study—a method commonly employed by economics experts in securities litigations in Canada, the US, and elsewhere—is often used to test for the materiality of an alleged misrepresentation. Often, the event study involves a statistical examination of a stock price reaction following an allegedly corrective disclosure. For example, in Danier the court observed that the fall of the share price following the allegedly corrective disclosure was an indication of materiality.10 Event studies have been accepted by Canadian and US courts in a variety of contexts, and in some cases the failure to conduct an event study has resulted in the exclusion of an expert's testimony.11
An event study of a corrective disclosure alone may not be sufficient to establish the materiality of an alleged misrepresentation. For example, where other new information is released at the same time as a corrective disclosure or where the economic context of the corrective disclosure is significantly different than the context at the time the proper disclosure should have been made, additional analysis may be required in order to draw inferences about the materiality of an alleged misrepresentation or omission.12 However, event study evidence is a very common and reasonable (and, arguably, often a required) starting point for determining materiality. Where the burden of proof lies on the party alleging the material change, as it did with Staff in this case, it would seem that without event study evidence (and/or economic analysis of why it may not be indicative of materiality) the reasonable and objective conclusion should be that the allegation is not proved.
In contrast, despite the lack of any event study or other expert evidence to the contrary, the Panel dismissed the Respondents' argument regarding the lack of any decline in the stock price by noting that "public shareholders and investors may have legitimately assumed that no material change had occurred as a result of the matters discussed in the Q2 MD&A."13 In addition to this statement being merely the recognition of a possibility without reference to any particular evidence that suggests it was actually the case (e.g., investor testimony, analyst reports, news commentary), this comment also seems to be contradicted by earlier statements in the reasons. For example, the Panel states that:
 The statement in the Q2 MD&A...indicates for the first time that it will be "very difficult, if not impossible", to satisfy DBRS's new criteria and that the DBRS January Release will have the effect of "substantially curtailing its ability to grow, if not halt in the short term," Coventree's credit arbitrage business. In our view, that disclosure was an acknowledgement by Coventree on May 14, 2007 of the materiality of the DBRS January Release and, in effect, that it constituted a material change with respect to Coventree...[emphasis in original]
If the Q2 MD&A did constitute adequate, if delayed, disclosure by Coventree of the impact of the DBRS January Release, then the fact that the stock price did not change significantly following that disclosure—and the fact that Staff did not provide expert evidence to the contrary—may have been strong evidence that this information was not material to investors. Put another way, if the stock price did not decline significantly following this disclosure by Coventree, that fact (or the lack of evidence to the contrary) suggests that its stock price already reflected the information that Coventree would no longer be able to conduct certain types of transactions from which it had generated significant revenue in the past and that the impact of this additional disclosure in the Q2 MD&A was not significant.
Market Price vs. Value and Testing for Market Efficiency
The Panel further suggested that it is necessary to look beyond the lack of impact on market prices to also consider the impact on value:
 ... one cannot assume ... that the lack of impact on market price means that the information disclosed was not material. ... one must also consider whether particular information would reasonably be expected to have a significant effect on the "value" of securities even if that disclosure would not, for some reason, be expected to affect the market price of the securities. We find in these circumstances that the DBRS January Release would reasonably be expected to have had a significant effect on the value of Coventree's shares.
It is true that in some circumstances market prices of securities may deviate from their "value."14 By definition, if the market for a company's shares is efficient, the market price of the stock will reflect all relevant publicly available information and will rapidly adjust to reflect new information as it is made available. The implication of the Panel's statement that market prices for Coventree's shares may not have reflected changes in their value is that the market for Coventree's shares was not efficient. But this is an empirical question that can, and should, be tested.
There is a vast literature in the field of finance devoted to the testing of the efficient markets hypothesis. The issue of testing for market efficiency has also come before the US courts in the context of shareholder class actions where defendants have led expert evidence in attempts to rebut the presumption of efficiency adopted after Basic Inc. v. Levinson, 485 U.S. 224 (1988) under the "fraud-on-the-market" theory.
In assessing the efficiency of the market for a particular security, an economics expert will look for certain indicators which are typically present in an efficient market. A number of tests of the market efficiency hypothesis have been developed in the academic finance literature. These tests are based on statistical analyses of actual historical market prices and examinations of whether prices respond to news.15 In addition, US courts have also set out certain specific criteria that should be considered in assessing the efficiency of the market for a particular security in the context of securities class actions. These criteria include:16
1. Turnover measured by weekly trading volume
2. The number of securities analysts following the company
3. The presence of arbitrageurs
4. The price response of the security to new information in the market
In contrast, in this case there was no such expert evidence. The Panel noted that the amount of trading in the market for the shares of Coventree was "relatively low," although relative to what is not entirely clear:
 We also note that the volume of trading in Coventree shares was relatively low given that a majority of its outstanding shares were owned by [the Respondents] and related entities or persons. That meant that information with respect to Coventree and its business was less likely to be reflected in the news media and interviewed and commented upon by analysts.
Again, this raises the possibility that the market for Coventree's shares may not have been efficient, but it is not clear that this was more likely the case than not. In order to support this finding, it would seem that a deeper set of economic analyses, and likely expert evidence of the type described above, should have been required.
Finally, even if the market for Coventree's shares was not efficient such that the market price was not the best indicator of value, the impact on the value of the shares of the information relating to the DBRS January Release also would best be explained by expert analysis. The value of a security to an investor will generally depend on the investor's expectations for the future benefits to be received from owning the asset. For example, an investment in the publicly traded common shares of a corporation may provide benefits in the form of dividends issued by the company, a higher market price for the security at some later date, or both. In general, the value of a stock is the present discounted value of expected future cash flows to the shareholder.17 In this case the value impact of the DBRS January release could have been assessed with evidence identifying and quantifying the impact that it might have had on expectations about the future cash flows of Coventree (both in terms of quantum and risk). This kind of analysis falls squarely within the domain of an economist or business valuator.
In its reasons, the Panel states that, "We find in these circumstances that the DBRS January Release would reasonably be expected to have had a significant effect on the value of Coventree shares." [¶354] The Panel did consider some aspects of the fundamentals of the Company— namely, its "revenue backlog" or revenues that it expected to generate based on the lifespan of previous financing transactions that it had facilitated and was administering. However, the relevance of this part of the reasons is not clear.
The Company argued that, although it had the benefit of future cash flows from its revenue backlog, it had already disclosed that it was shifting its focus away from the types of transactions that were addressed by the DBRS January Release and that it was pursuing so-called "Chapter Two" initiatives to pursue alternative sources of growth. The issue before the Panel was the extent to which the DBRS January Release impacted the expectations for that business relative to what was otherwise expected given the information made available to investors.
The Panel's reasons seem to suggest that if the revenue backlog was the only source of expected cash flows for the company that the company had surely declined in value since its "continued execution of funding transactions was key to Coventree's ongoing business and financial performance....Put another way, the value of Coventree's business had very substantially declined if that business was valued based only on revenue backlog and the relatively nascent Chapter Two initiatives." [¶¶361-362, emphasis in original] Even without formal analysis, it seems clear that the diminished ability of Coventree to conduct transactions of the type that had been a significant source of revenue in the past was material to investors. But, importantly, since the company had made prior disclosure about its changing business strategy, this statement about the revenue backlog does not address the issue of the materiality of any but-for disclosure that the Company could have made.
If the benefit of judicial reasons from a court or administrative tribunal is, in part, to provide future litigants with a clear understanding of the basis on which allegations will be assessed and decisions rendered, then it is important that those reasons be based on a clear and objectively articulated evaluation of the evidence before the tribunal. Subjective reasoning is necessarily unpredictable and offers limited assistance to future litigants.
Expert economic evidence—in the form of event studies and other objective analyses based on finance theory and accepted empirical methods—can assist courts and tribunals in making informed and objective determinations on issues of materiality and provides greater guidance for future litigants. Indeed, I would argue such evidence should be required in order support findings based on "materiality" to shareholders. Were that the case, it would provide an evidentiary basis that would enable more objective and predicable rulings for future proceedings.
No such expert evidence was led in the Coventree matter. Consequently, the Panel was forced to either dismiss the case for a lack of evidence or settle for reaching conclusions about materiality based on apparently subjective reasoning. In this situation, the Panel chose the latter. Regardless of whether it reached the correct result, the reasoning—and in particular the reasoning for the finding of a material change in respect of the DBRS January Release—seems to leave significant uncertainty for future litigants about what evidence will be required and how it might be received.
1 Vice President, NERA Economic Consulting. David Tabak, Mark Berenblut, Thomas Schopflocher, and James Mancini provided helpful comments on earlier drafts of this paper. I alone am responsible for any remaining errors.
2 In the Matter of Coventree Inc., Geoffrey Cornish and Dean Tai, Ontario Securities Commission, 28 September 2011 [Coventree].
3 For a more general discussion of this issue see, for example, Johanna Braden, "The Expertise of the Ontario Securities Commission," Stockwoods LLP working paper prepared for The Advocates' Society Securities Law Symposium, 14 September 2011.
4 For a more general description of these issues, see Bradley A. Heys, "Economic Analysis of Materiality for Canadian Securities Litigation," NERA Economic Consulting Working Paper, July 2011 (forthcoming in the Canadian Class Action Review). See: www.nera.com/67_7449.htm.
5 As set out at ¶18 of the reasons.
6 Coventree, ¶149.
7 See, for example, R v. Zelitt, 2003 ABPC 2 at para 34 [Zelitt]; and R v. White,  BCJ No 1543 (Prov Ct) [White], var'd  BCJ No 1431 at para19 (SC). In Sharbern Holding Inc v. Vancouver Airport Centre, et al 2011 SCC 23 [Sharbern], (which involved allegations of breach of the now-repealed Real Estate Act, R.S.B.C. 1996, c.397, but involved similar issues of materiality) the Supreme Court of Canada held that when common sense inferences are not sufficient to prove materiality, the party who bears the onus of proof must lead evidence which may sometimes require expert evidence.
8 Specifically, structured financial asset transactions (SFA transactions) involving collateralized debt obligations (CDOs).
9 Coventree, ¶272.
10 Kerr v. Danier Leather Inc (2004), 46 BLR (3d) 167, 23 CCLT (3d) 77,  OJ No 1916 (SCJ) [Danier] (reversed on other grounds), at ¶¶176–77, 186, and ¶¶275–76.
11 US courts have found event studies to be a scientifically objective form of analysis and have held that such analysis may be required in some contexts. See, for example, In re Executive Telecard, Ltd Securities Litigation, 979 F Supp 1021, 1997 WL 643722 (SDNY) ¶1027 ("The Expert Witness' failure to conduct a thorough 'event study' would be reason enough to exclude his proposed testimony.") and In re Imperial Credit Industries, Inc. Securities Litigation, 2003 WL 1563084 (CD Cal). Event studies may also be used for other purposes in the litigation context. In the securities litigation context, the event study may also be used to analyze issues of loss causation and damage quantification. For a discussion of these and other uses of event studies within the litigation context, see Tabak, David I. and Frederick C. Dunbar, "Materiality and Magnitude: Event Studies in the Courtroom," Litigation Services Handbook: The Role of the Financial Expert, 3rd ed., Weil, Roman L. et al. eds., John Wiley & Sons, Inc. (New York), 2001, Chapter 19.
12 For a broader description of these issues, see Bradley A. Heys, "Economic Analysis of Materiality for Canadian Securities Litigation," NERA Economic Consulting Working Paper, July 2011 (forthcoming in the Canadian Class Action Review).
13 Coventree, ¶348. It is possible that the Panel is saying that because the disclosure was in the MD&A and not in a press release, shareholders could have assumed it was not a material change. This of course assumes that shareholders are aware of the requirement that material changes be disclosed by way of press releases.
14 The term "value" can have several alternative meanings depending on the context. This term is not defined in the Act and to my knowledge it has not been defined by a court or tribunal in the context of the meaning of materiality. One common meaning in these types of situations is that of "fair market value." Black's Law Dictionary defines fair market value as "The price that a seller is willing to accept and a buyer is willing to pay on the open market and in an arm's-length transaction."
15 For a discussion of tests for the responsiveness of stock prices to news and their pitfalls, see David I. Tabak, "Use and Misuse of Event Studies to Examine Market Efficiency," NERA Economic Consulting Working Paper, 30 April 2010. See: www.nera.com/67_5486.htm .
16 The seminal case in this area is Cammer v. Bloom, 711 F.Supp. 1264.
17 For example, Richard Brealey, Stewart Myers, Gordon Sick, and Ronald Giammarino, Principles of Corporate Finance, 2nd ed (McGraw-Hill Ryerson Limited, Toronto, 1992) c 4.
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