Publication
INTRODUCTION
Issuers and their advisers can breathe a sigh of relief given the recent and highly anticipated decision of the Ontario Court of Appeal in the shareholder class action suit Kerr v. Danier Leather Inc.[1] On December 15, 2005, the court unanimously reversed the Superior Court trial decision which held Danier and its senior officers liable for an alleged misrepresentation in a prospectus concerning an earnings forecast.
The Court of Appeal's ruling is of particular significance for public offerings given that the court provides clear guidance on the statutory framework for prospectus disclosure and the scope of potential statutory civil liability for prospectus misrepresentations. The decision may also provide guidance to issuers and their advisers as to the interpretation of the new statutory liability regime for secondary market disclosure which came into effect on December 31, 2005.
BACKGROUND
Danier undertook an initial public offering of its shares in the spring of 1998. The final prospectus dated May 6, 1998 included a forecast of Danier's anticipated revenue and earnings for the fourth quarter of its fiscal year ending June 27, 1998. A few days prior to closing, Danier's management undertook an internal analysis comparing actual intra-quarter results with the forecast contained in the final prospectus. The analysis indicated that sales were lagging behind what was projected. If the trend had continued, there might have been a significant shortfall in revenue in the fourth quarter as compared with that forecast in the prospectus. At the time, management believed that the forecast would ultimately be achieved by the end of the fiscal year. The public offering closed on May 20, 1998.
Approximately two weeks following the closing, Danier issued a revised forecast reducing its projected financial results and Danier's share value dropped approximately 20%. Notwithstanding the revised forecast, by the end of the fiscal year, Danier had substantially achieved the originally projected financial results. Purchasers of the offering commenced a class action against Danier and its senior management under section 130(1) of the Securities Act (Ontario), alleging that Danier's prospectus contained a misrepresentation.
The Ontario Superior Court of Justice decided in favour of the plaintiffs. The trial judge agreed with the defendants that the intra-quarter results did not constitute a material change which had to be disclosed pursuant to section 57(1) of the Act; however, he held that management's internal analysis which showed the potential poor fourth quarter results was a "material fact" and that section 130 of the Act imposed an obligation on Danier to disclose any material facts (i.e., the intra-quarter results) that arose after the filing of the final prospectus but prior to closing. This was necessary to make the forecast not misleading. Danier's failure to make this disclosure resulted in the prospectus containing a misrepresentation at the time of closing which attracted liability. The Court also held that there was an implied representation that the earnings forecast was objectively reasonable on both the date of the prospectus and the date of closing. In view of the intra-quarter results that were available during the period between the date of the final prospectus and the closing, the trial judge concluded that the earnings forecast was objectively unreasonable on the date of the closing. In reaching his decision, he found that senior management of Danier honestly believed that the forecast results would be achieved but he concluded that this belief was unreasonable. He did not give weight to the fact that the forecast was subsequently substantially achieved.
The trial judge awarded substantial damages to the plaintiffs based on the depreciation in the price of Danier's shares which followed the disclosure of the revised forecast, regardless of the fact that the forecast results were achieved soon after. He also awarded the plaintiffs costs, including a $1 million premium on legal costs. The decision caused confusion for issuers and advisers as to what updating of information was required during the period between filing a final prospectus and the conclusion of the distribution.
THE APPEAL DECISION
The decision clarifies several points of law. The Court of Appeal held that the trial judge erred when he:
- Found that Danier had a continuing obligation to disclose material facts that occurred between the date of the final prospectus and the date of the closing;
- Held that Danier's prospectus contained an implied representation that the financial forecast contained therein was objectively reasonable; and
- Failed to take into account the business judgment of Danier's senior management and the fact that the projected forecast was subsequently substantially achieved.
What disclosure obligations exist during the period between the date of the final prospectus and the closing of the offering?
The Court of Appeal decision clearly states that issuers have no obligation to amend a prospectus or to publicize and file a report in respect of material facts that occur after a final prospectus is receipted. The decision notes that sections 56 and 57 of the Act provide a complete code of prospectus disclosure obligations. The court held that these sections impose an obligation on issuers to disclose material changes that occur after the filing of a prospectus and prior to closing, but do not require the same disclosure obligation for the occurrence of material facts. Section 130 of the Act provides a statutory remedy for investors but does not impose any additional disclosure obligations. The decision highlights the difference between the definitions of a "material fact" and a "material change" found in the Act and recognizes that the definition of material fact is broader than that of material change. A material fact is any fact which would reasonably be expected to have a significant effect on a security's market price, while a material change is a change in the business, operations or capital of an issuer which would have a similar effect on the market price of its securities.
Given that there is no continuing obligation to update a prospectus for material facts that arise following the receipt of a prospectus, the Court of Appeal concluded that Danier had complied with its disclosure obligations by filing a prospectus which contained full, true and plain disclosure of all financial information as of the date of its filing.
Do forecasts include an implied representation that they are objectively reasonable?
While the Court of Appeal agreed with the lower court that forecasts in a prospectus generally include an implied representation that they represent management's best judgment, are prepared using reasonable skill and care, and are believed by management to be reasonable, the Court declined to find a further implied representation, namely that the forecast was objectively reasonable. The Court held that the finding of an implied representation of objective reasonableness was not supported in law or by the facts.
It should be noted that under the statutory liability regime for secondary market disclosure which came into force on December 31, 2005, in order to rely on the safe harbour and avoid liability for misrepresentations contained in forward-looking information, the person or company seeking to rely on the safe harbour must establish that they had a reasonable basis for drawing the conclusion or making the forecast set out in the forward-looking information. The interpretation of what constitutes a reasonable basis in that context remains to be considered by the courts.
Affirmation of Business Judgment Rule
The Court held that courts should give deference to management decisions on matters of business so long as the decision falls within a range of reasonableness. This rule, commonly referred to as the "business judgment rule", was clearly affirmed by the Court as the basis on which to evaluate the merits of management decision-making. That view is consistent with the Supreme Court of Canada's 2004 decision in Peoples Department Stores Inc. v. Wise.
In the Court's opinion, even if the trial judge was correct in holding that the forecast contained an implied representation that it was objectively reasonable, he erred in failing to take into account the knowledge, experience and expertise of Danier's management, despite the fact that a "forecast is a quintessential example of the exercise of business judgment." Accordingly, the appeal court concluded that although management's view of the forecast may have been optimistic, it was not unreasonable and fell within a range of reasonableness which should be accorded deference. The reasonableness of management's view was also confirmed by the fact that Danier did eventually achieve the financial results originally projected, a fact that the trial judge held was immaterial.
Damages
Given its disposition on the liability issues, the Court declined to address the appropriateness of the measure of damages. However, it did express doubt as to whether a premium could be properly awarded in a class proceeding.
GUIDANCE FOR ISSUERS AND UNDERWRITERS
The trial decision in Danier caused considerable concern for issuers and their advisers, particularly in respect of financial forecasts contained in prospectuses. However, issuers and underwriters can take comfort in the Court of Appeal decision which confirms that the obligation to amend a receipted prospectus before the closing of the distribution arises only where a material change has occurred.
The decision also draws a distinction between material facts and material changes. This distinction is recognized in the new civil liability regime which came into force on December 31, 2005. The new regime introduces liability for misrepresentations in documents and statements and also for failure of issuers to make timely disclosure in the secondary market. While OSC and stock exchange policies on timely disclosure have blurred the distinction between material facts and material changes, the new civil liability regime grants a right of action, in respect of a failure of an issuer to make timely disclosure, to a person or company who trades in the securities when a material change has not been disclosed as required under the Securities Act (Ontario). Finally, the Court's holding that section 130 of the Act (liability for prospectus misrepresentations) is a remedial section and does not impose additional disclosure obligations may also be useful in characterizing the new secondary market civil liability regime.
The Court's strong endorsement of the business judgment rule should provide comfort for issuers and their directors and officers in preparing forecasts for prospectuses. The decision reinforces the view that management is not expected to predict with absolute certainty what earnings a company may have for a projected period so long as the forecast falls within a range of reasonableness.
Plaintiffs' counsel have announced their intention to seek leave to appeal this latest decision to the Supreme Court of Canada, so further guidance may be forthcoming.
[1]. 2005 CanLII 46630 (ON C.A.)
The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault LLP or any member of the firm on the points of law discussed.
Contacts
Ava G. Yaskiel
Toronto
416.216.3902
ayaskiel@ogilvyrenault.com
Profile
Steve J. Tenai
Toronto
416.216.4023
stenai@ogilvyrenault.com
Profile
Alan Mark
Toronto
416.216.4865
amark@ogilvyrenault.com
Profile
Grant Jameson
Ottawa
613.780.1530
gjameson@ogilvyrenault.com
Profile
Geoffrey G. Gilbert
Ottawa
613.780.3764
ggilbert@ogilvyrenault.com
Profile
Andrew Fleming
Toronto
416.216.4007
afleming@ogilvyrenault.com
Profile
Jeremy J. Devereux
Toronto
416.216.4073
jdevereux@ogilvyrenault.com
Profile
Robert L. Armstrong
Toronto
416.216.4831
rarmstrong@ogilvyrenault.com
Profile
