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INTRODUCTION

A recent decision of the Ontario Superior Court of Justice should cause issuers, underwriters and their advisers to exercise caution in publishing and monitoring financial forecasts, particularly in the context of an initial public offering. Purchasers in the initial public offering of Danier Leather brought a class action pursuant to the Securities Act (Ontario) against Danier, its CEO and its CFO, alleging that Danier's prospectus contained a misrepresentation. The purchasers alleged that, as at the time of the closing of the offering, the financial forecast in the prospectus was no longer reasonable and was misleading and that, by failing to issue a revised forecast before the closing, the defendants were liable in damages for the misrepresentation under section 130 of the Act. The Court agreed.

THE FACTS

Danier undertook the IPO in the spring of 1998 and its final prospectus was dated May 6, 1998. The prospectus included forecast information regarding Danier's financial results for both the quarter and the year ending June 27, 1998. The offering closed on May 20, 1998. Two days prior to closing, management of Danier prepared an internal analysis comparing actual intra-quarter results with the forecast contained in the final prospectus. This analysis as at May 16, 1998, which was not shared with the underwriters, indicated poor sales of Danier's leather clothing due to recent warm weather. If the trend continued, there might be a significant shortfall in revenue as compared with the revenue forecast. Approximately two weeks following the closing of the offering, Danier issued a revised forecast reducing its projected financial results; Danier's share value dropped approximately 20%. Notwithstanding the revised forecast, by the end of the quarter, Danier had substantially achieved the financial results originally projected in its prospectus.

IS PROJECTED FINANCIAL INFORMATION A FACT?

At common law, a misrepresentation is only actionable if it constitutes a misrepresentation of a past or present fact. Accordingly, the courts have traditionally held that a prediction of future events will not give rise to a common law action in misrepresentation. Estimates of future performance or growth are by their nature predictions and, as a result, the view can be taken that they should be treated differently from other corporate facts and developments required to be disclosed in offering documents. As they are estimates, they will always, in hindsight, prove to be too high or too low. In addition, evaluating the continuing viability of an issuer's outlook could be considered a gradual process and, as a result, it may be difficult to determine at what precise point in time forecast information should be revised or updated. The Danier decision addresses both of these issues in the context of a claim of misrepresentation in an IPO prospectus brought under the Securities Act (Ontario).

The Court held that a forecast can be a material fact and can be an untrue statement of material fact if any of the factual assertions underlying the forecast are untrue. In this instance the failure to disclose the intra-quarter results meant that, as of closing, the prospectus contained a misrepresentation. A forecast can be untrue and therefore constitute a misrepresentation if it does not reflect the best judgment of management because the forecast was not prepared using reasonable skill or care, management does not generally believe the forecast, management's belief in the forecast is not reasonable, or management is aware of facts that would seriously undermine the forecast.

The Court held that there was an obligation to disclose material facts during the course of the distribution (such as the intra-quarter results) in order to correct the forecast. There was an obligation to state the material facts (i.e., the intra-quarter results) necessary to make the statement (i.e., the forecast) not misleading. The Court expressed the opinion that, once the issuers and its officers were aware of the intra-quarter results, they must have objectively known that there was little or no prospect of achieving the forecast if the trend regarding the shortfall in revenues and the estimated loss continued as a result of warm weather. This was despite the fact that management concluded at the time that, due to certain sales events that would occur shortly and inventory adjustments that would be made, the profits were equal to or ahead of the forecast. The Court held that the operative date for determining whether there was a misrepresentation was at the time of purchase. Thus, the Court took a snapshot of the forecast as at the date of closing rather than taking a longer term view.

WILL CAUTIONARY LANGUAGE PROVIDE IMMUNITY FROM CIVIL LIABILITY?

Cautionary language to accompany forecast information has been prescribed in both OSC policy and in the as yet unproclaimed Ontario secondary market civil liability legislation. Such language cautioning investors that projections might not be met was included in the Danier prospectus. The Court held that this standard cautionary language was not sufficient to protect the issuer, its CEO and its CFO from civil liability where the forecast in an IPO prospectus contained a misrepresentation.

WHEN DOES THE PERIOD OF DISTRIBUTION END IN AN IPO?

The Danier decision establishes that the right to sue for a misrepresentation contained in the final prospectus arises not only as at the date of the prospectus or the date a purchaser's withdrawal rights expire but as at the time of purchase and throughout the distribution period. The time of purchase in an IPO is the closing date (or the later termination of the period of distribution).

WHAT CAN ISSUERS AND THEIR ADVISERS DO TO REDUCE THE RISK OF LIABILITY IN RESPECT OF FORECASTS?

The Danier decision causes considerable concern for issuers and their advisers as to how to practically monitor and update financial forecasts contained in offering documents. Issuers and their advisers may be able to reduce their exposure to civil liability by implementing the following safeguards:

• The financial forecast should be carefully monitored throughout the period of distribution (that is, until closing or as long as the distribution period continues).
  
• Underwriters and officers who sign certificates indicating that a prospectus contains true, plain and full disclosure have a due diligence defence available to them in an action on a misrepresentation under the Securities Act (Ontario). In order to ensure that the defence is available, appropriate due diligence should take place not just as of the date of the final prospectus, but as of the closing. Underwriters or agents should obtain written certification from responsible officers of the issuer that the prospectus contains no misrepresentations, not just as at the date of the final prospectus, but also as at the date of completion of the distribution. In addition, consideration should be given to undertaking further inquiries and at least a bring-down, and possibly a formal, due diligence session, immediately prior to the closing of the offering.
  
• Management should be obliged to inform their advisers of any changes to the financial forecast during the distribution period.
  
• The time period between the expiry of purchasers' withdrawal rights (two days following delivery of the prospectus) and the closing should be shortened, to the extent possible, to avoid an extended "at risk" period.
  
• If a misrepresentation is discovered following the expiry of investors' withdrawal rights but prior to the closing of the offering, consideration must be given as to how to practically reduce the issuer's, management's and the underwriters' exposure to civil liability. Under securities legislation, an issuer is required to file an amended prospectus where there is a material change. The Danier decision does not clearly state that a material change occurred, but rather that there was a duty to disclose the intra-quarter results prior to closing. While the Danier decision may not offer express guidance on this point, the practical consequence of the decision is that certain steps may need to be taken in order to ensure that there is no exposure to civil liability. The need to file a revised forecast by means of a prospectus amendment and to re-open the withdrawal rights of purchasers should be considered.

CONCLUSION

Perhaps the lesson to be learned from Danier is the need for the issuer, its management and advisers to avoid unreasonable or aggressive forecasting and to continuously monitor the financial forecast during securities distributions. The lessons of Danier may potentially have some application to secondary market disclosure. Bill 198, when proclaimed, will amend the Securities Act (Ontario) and introduce secondary market civil liability in Ontario for misrepresentations in secondary market disclosures. While the Bill provides a safe harbour in respect of future-oriented financial information, such a safe harbour will still require the person or company to have a reasonable basis for drawing the conclusions or making the forecasts and projections.

Danier has indicated that it will appeal this decision. Consequently we can expect further guidance in the future on the various issues considered in the decision.

To access a copy of the decision in Danier Leather, click here .

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 or any member of the Firm on the points of law discussed.

For further information, please contact one of the members of the Securities Team mentioned below:

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Grant A. Jameson (613) 780-1530 gjameson@ogilvyrenault.com

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Ava G. Yaskiel (416) 216-3902 ayaskiel@ogilvyrenault.com

Vancouver

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Catherine Elaine Wade (604) 806-3865 cwade@ogilvyrenault.com

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