The year 2004 saw a continuation of the very strong Canadian income fund market, with approximately 35 new income funds taken public. The market for cross-border income funds using innovative structures designed to solve the complexities of cross-border tax issues has been slower to take off than was predicted last year. Mergers and acquisitions activity has been brisk, with significant transactions such as the merger of Molson and Coors, the combination of BFI Canada Income Fund and IESI Corporation, the acquisition by Nexen of Encana's North Sea assets, the acquisition by CHUM of Craig Media and the acquisition by Midnight Oil and Gas of Vintage Petroleum.
Recent developments of importance include the following:
Kerr v. Danier Leather Inc.
Kerr v. Danier Leather Inc. ("Danier") is a landmark case for Canadian securities law. When certified as a class action under the Class Proceedings Act (Ontario ) in 2001, it became one of the first securities class actions in Canada. In May 2004, Danier became one of the few class actions to proceed to trial resulting in a judgment on the common issues certified by the certification motions judge. Danier is one of the few civil judgments under Canada 's securities legislation and one of the few cases dealing with the so-called due diligence defence. Because the judgment deals with liability for a forecast in a prospectus, it is also a precedent-setting decision. Finally, the decision is noteworthy because of Justice Lederman's reference to and reliance on the common law and on U.S. decisions in interpreting the civil liability provisions of the Securities Act (Ontario ).
The decision has caused issuers and underwriters to reconsider certain practical aspects of how securities offerings are conducted in Canada.
In connection with its IPO, Danier prepared three preliminary prospectuses over the period from November 1997 to April 1998. The final prospectus was dated May 6, 1998. The offering was completed on May 20, 1998.
As is relatively common in Canada, Danier's prospectus contained a forecast of financial results, which was amended in each successive prospectus. The final prospectus contained the results of the first three quarters of the 1998 financial year and a forecast for the last quarter. The forecast was unchanged from that of the last preliminary prospectus.
Two weeks after the IPO was completed, Danier issued a press release revising its fourth-quarter forecast downward. On the last trading day before the revised forecast, the shares traded at $11.65, up from the original issue price of $11.25. Following the press release, the share price dropped to $8.25. The final results for the year were better than the revised forecast. Over the next six weeks or so, the share price fluctuated between $9.25 and $10.00.
The main issue at trial was whether the forecast constituted a misrepresentation under the Securities Act and at common law. This question gave rise to a number of subsidiary issues, including whether a forecast is a representation; whether a representation that is true when made can become a misrepresentation if the maker of the statement discovers information that makes the representation untrue; whether in such a case the maker of the statement has a duty to disclose the new information to the recipients of the original statement; the effect on liability of cautionary statements in a prospectus; and the measure of damages for a misrepresentation in these circumstances.
Forecast as a Representation
The law only imposes liability for a misrepresentation of a present fact. A statement about the future will generally not support a claim for misrepresentation. Therefore, one might conclude that a forecast, being a prediction of the future, could not be the basis for a claim for misrepresentation.
However, the law has long recognized that a statement regarding the future may constitute a representation about the state of mind of the maker of the statement, and the maker's state of mind could constitute a representation of fact. Justice Lederman held that the forecast could constitute a material fact for purposes of the Securities Act. He acknowledged that a forecast will not constitute a misrepresentation merely if the results are not actually achieved, but may be so if it does not represent management's best judgment, because: (i) the forecast was not prepared using reasonable care and skill; (ii) management did not generally believe the forecast; (iii) management's belief in the forecast was not reasonable; or (iv) management was aware of facts that would undermine the forecast.
Justice Lederman held that, in the period between the filing of the final prospectus on May 6 and closing on May 20, certain factual assumptions underlying the forecast were untrue and that the belief of the CFO and CEO that the forecast remained achievable could not have been reasonable. As a result, he concluded that the prospectus contained a misrepresentation.
Under the Securities Act, a misrepresentation of fact can only give rise to liability if it is "material." In essence, the same is true at common law. Danier argued that its forecasts could not be material because of cautionary language that appeared in the prospectus. The cautionary language is in fact a requirement imposed by National Policy 48, the securities regulators' policy governing the disclosure of forward-looking financial information.
Justice Lederman held that the cautionary language did not relieve Danier from responsibility for its accuracy. He observed that nothing in National Policy 48 suggested that management would be immune from liability if they included standard cautionary language. To the contrary, Justice Lederman held that the cautionary language could be seen as emphasizing that the forecast was management's best judgment, made after exercising reasonable care and skill.
Next, Justice Lederman considered the date at which the truthfulness of the forecast should be tested. He held that the relevant date was the date of purchase, which was the date of closing on May 20.
Application of the Law to the Facts
Justice Lederman found that the forecast was a statement of material fact. While it was true at the time it was made, it became untrue as the corporation became aware of additional information between the date of the final prospectus and the closing date. Justice Lederman found that "the materiality of the information was supported by the market reaction to the information. Consequently, Danier was liable for its misrepresentation under s.130 of the Securities Act."
Measure of Damages
The court held that the measure of damages was the difference between the price paid for the shares and the post-misrepresentation price, or value, of the shares. This measure was consistent with the measure of damages for misrepresentation at common law. The defendants could, however, try to show that some or all of the reduced price was the result of other factors, such as a general decline on the stock market. On the other hand, plaintiffs were free to show that the post-misrepresentation price was higher than the value of the shares because of other factors, such as stock manipulation.
Who is Entitled to Relief?
The court held that s.130 of the Securities Act did not limit recovery to those who had sold and crystallized their loss. A person who held his or her stock after the misrepresentation became known could also recover damages. On the other hand, a person who bought and sold before the misrepresentation was disclosed suffered no loss as a result of the misrepresentation. Justice Lederman also rejected an argument that purchasers outside of Ontario could not recover because their places of residence did not determine whether the Securities Act applied.
Liability of Members of Management
One of the most interesting parts of Justice Lederman's judgment is his discussion of the liability of the two individual defendants. Section 130(5) of the Securities Act provides a due diligence defence to everyone other than the issuer or the selling security holder. However, the due diligence defence can only be successfully invoked by those who act as reasonably as a prudent person in the circumstances of the case would act.
One of the individual defendants was a director, the president and CEO. The other individual defendant was the CFO and secretary. Their "insider" status, Justice Lederman said, was a relevant factor in determining whether they acted prudently in the circumstances, and resulted in a higher standard for them than would be the case for an outside, or independent, director. On the other hand, the onus of proving that the defendants were not entitled to rely on the due diligence defence rested with the plaintiffs.
Applying these principles to the facts of the case, Justice Lederman held that the plaintiffs had shown that the individual defendants had failed to conduct such reasonable investigations so as to provide reasonable grounds for their belief that there had not been a misrepresentation. The defendants had failed to make an adequate analysis of the financial results as of May 20, 1998. Therefore, they could not show that they had a reasonable belief that the forecast could still be met. Moreover, they had not consulted any professional advisors.
Justice Lederman held that purchasers who held on to their shares until after June 10, 1998 were entitled to recover $2.35 per share. Those who sold between June 4 and June 10 (the date the court determined the new information had been fully absorbed by the market) were entitled to recover the difference between the initial purchase price and the actual sale price, even if this was greater than $2.35 per share.
Practical Implications for Issuers and Underwriters
The judgment of the court has already had a number of practical implications on how securities offerings are conducted. Justice Lederman acknowledged that the existing regime under securities law required the filing and delivery of prospectuses and amendments to them. After filing the final prospectus, the law requires that it be delivered to purchasers, together with any amendment required by the occurrence of a "material change" after the filing of the final prospectus. This delivery requirement runs to the end of the second day after the particular purchaser has entered his or her agreement of purchase and sale (evidenced by receipt of the confirmation of the sale). The purchaser has a right to withdraw from the purchase for two days following the receipt of the latest prospectus or any amendment.
This regime does not require that prospectuses be continuously updated to reflect new "material facts" occurring with respect to an issuer after the date of the final prospectus. Note however that in Quebec, an amendment to the final prospectus must be made whenever a material change occurs "in relation to the information presented in the prospectus,” which may include the occurrence of new material facts. The term "material fact" encompasses significantly more information than the term "material change." Justice Lederman found, however, that s.130 of the Securities Act operates independent of the prospectus filing and delivery regime and gives purchasers a right of action if the prospectus contains a misrepresentation at the time of closing. He found that in the 14 days between the date of the final prospectus and the date of the closing, facts had come to the attention of the executives of Danier, and for this reason the prospectus contained a misrepresentation at the date of closing, giving rise to a claim for liability under s.130.
The conduct of public offerings has undergone some changes as a result of the Danier decision, including the following:
- Underwriters are generally reviewing their forms of underwriting agreements to ensure that the issuer represents to them that the prospectus contains no misrepresentation as of the closing date (or later if the distribution has not been completed at that time), that there is an ongoing obligation on the part of the issuer to update the prospectus with respect to changes in material facts and that the indemnities in the agreement provide adequate coverage;
- consistent with U.S. practice, underwriters, directors and others who have a due diligence defence are now seeking confirmation as to the accuracy of the prospectus at the time of closing, not just the date upon which their certificate is signed or the prospectus is filed; and
- participants are generally trying to close offerings more quickly than the usual seven to ten days following filing of the final prospectus. Canadian practice varies from the U.S. practice of three-day closings, primarily because of the two-day withdrawal period following receipt of the final prospectus, which is not a feature of U.S. law. There is now a renewed incentive to distribute the prospectus as quickly as possible after filing and to tighten up the time to closing.
A further practical consideration is the matter of dealing with information that materializes between filing the final prospectus and closing. Should the closing be delayed while purchasers are advised of the new information? Is a press release sufficient to inform purchasers and eliminate s.130 liability? Should the prospectus be amended even if not required under the Securities Act because the new information does not constitute a material change? Should a new withdrawal period be granted even though not contemplated by the Securities Act? These are all concerns with which issuers, underwriters and other participants in the offering process will have to contend, given the broad reach of the decision.
We also anticipate that Danier will result in fewer prospectuses containing financial forecasts. This, we expect, will be particularly the case for issuers where their financial forecast differs very significantly from their historical financial results. These situations, of course, are precisely those in which a forecast is most valuable from a marketing perspective. Danier may also lead issuers to resist the current encouragement of Canadian securities regulators to include more forward-looking information in their disclosure documents.
Justice Lederman's judgment deals with a number of fundamental issues concerning s.130 of the Securities Act. His analysis is wide-ranging. On many issues his decision is a judgment of first impression. His judgment is even more important because it comes just before the introduction of liability for continuous disclosure materials. His judgment will undoubtedly be the starting point for the legal analysis of the issues under these provisions, as well as the leading precedent for claims under s.130.
Significant new regulatory developments are as follows:
New National Disclosure Rule
Securities regulatory authorities in Canada took a significant step toward a more uniform regulatory regime for Canadian public companies with the implementation of National Instrument 51-102-Continuous Disclosure Obligations. The instrument introduced important changes to the existing continuous disclosure regime in Canada. The instrument is comprehensive in scope, setting out obligations for public companies with respect to financial statements, annual information forms, MD&A, material change reporting, information circulars, proxies and proxy solicitation, filing of business acquisition reports in connection with certain significant acquisitions and other continuous disclosure obligations. The instrument came into force on March 30, 2004.
New Rules to Enhance Investor Confidence
Securities regulatory authorities in Canada adopted three important new rules (the "Investor Confidence Rules") aimed at building investor confidence in Canadian capital markets:
- Multilateral Instrument 52-109-Certification of Disclosure in Issuers' Annual and Interim Filings (the "Certification Rule");
- Multilateral Instrument 52-110-Audit Committees (the "Audit Committee Rule"); and
- National Instrument 52-108-Auditor Oversight (the "Auditor Oversight Rule").
The Investor Confidence Rules came into force on March 30, 2004, although the British Columbia Securities Commission decided to implement the Auditor Oversight Rule only.
The Investor Confidence Rules are substantially similar to rules adopted by the U.S. Securities and Exchange Commission after the enactment of the Sarbanes-Oxley Act of 2002. For reporting issuers in Canada that already certify their annual and quarterly financial statements under Sarbanes-Oxley and otherwise comply with the Act and its related SEC rules, the new Investor Confidence Rules impose very few additional compliance burdens.
The Certification Rule
The purpose of the Certification Rule is to improve the quality and reliability of reporting issuers' annual and interim disclosures. To that end, the Certification Rule requires that CEOs and CFOs personally certify that:
- the annual and interim filings (i.e., annual information form, financial statements and MD&A) do not contain a misrepresentation;
- the annual and interim financial statements, together with the other financial information included in those filings, fairly present in all material respects the financial condition, results of operations and cash flows of the issuer; and
- they have designed adequate disclosure and internal controls and procedures, evaluated such controls and procedures and have caused the issuer to disclose in its MD&A their conclusions and any change that occurred that has or may materially affect the issuer's internal control over financial reporting.
The first two of the foregoing certification requirements are presently in force. Draft rules concerning certification of internal controls and procedures were published for comment in February 2005 and are expected to come into force between 2006–2009, depending on the size of the issuer.
The Audit Committee Rule
The Audit Committee Rule is designed to encourage reporting issuers to establish and maintain strong, effective and independent audit committees.
The Audit Committee Rule requires issuers to have an audit committee and requires that an issuer's external auditor report directly to that committee. Subject to limited exceptions, every audit committee member must be independent and financially literate.
The Audit Committee Rule also sets requirements regarding the role of audit committees, including requiring them to:
- pre-approve all non-audit services to be provided by the external auditor (subject to certain exemptions for de minimis non-audit services);
- review the issuer's financial statements, MD&A and annual and interim earnings releases before the issuer publicly discloses this information; and
- establish procedures for complaints received by the issuer relating to accounting and auditor matters and the confidential, anonymous submission by employees regarding questionable accounting or auditing matters (so-called whistle-blowing policy).
The Auditor Oversight Rule
The Auditor Oversight Rule was introduced to enhance the authority of, and the role played by, the Canadian Public Accountability Board ("CPAB"), with a view to enhancing investor confidence in the credibility of auditors and audited financial information.
The Auditor Oversight Rule requires reporting issuers filing financial statements accompanied by an auditor's report to have the report prepared by an auditor that (a) participates in the CPAB's oversight program and (b) is in compliance with restrictions or sanctions imposed by the CPAB, in each case as of the date of such report.
Income Trust Liability
The Income Trusts Liability Act was proclaimed in force by the government of Alberta on July 1, 2004. The Act provides unitholders of an Alberta income trust with similar immunity from liability that shareholders of a corporation enjoy. The Act is intended to protect holders of trust units of an income trust from liability for any act, default, obligation or liability of a trustee of such income trust, provided that such act, default, obligation or liability arises after the Act was proclaimed in force. In addition, in order for unitholders of an income trust to obtain the benefit of the limited liability protection afforded by the legislation, the income trust must: (i) be created by a trust
instrument governed by the laws of Alberta, and (ii) be a "reporting issuer" for the purposes of the Securities Act (Alberta), which, in general, means that the income trust (or its predecessor) has offered its securities by prospectus.
The Act also made certain amendments to the Securities Act (Alberta ) in order to expand both the definition of what constitutes "control" for purposes of the Act and the categories of persons who are or may be determined by the Alberta Securities Commission to be "insiders" in respect of an issuer.
The amendments expand the categories of persons who are to be considered "insiders" in respect of an Alberta income trust to address the concern of the Alberta Securities Commission that the current definition of "insider" may not capture certain entities and persons within an income trust structure who, on a policy basis, ought to be subject to the rules pertaining to insiders of an issuer. These amendments are generally consistent with the approach of the Canadian Securities Administrators concerning insiders of an income trust, as reflected in National Instrument 41-201-Income Trusts and Other Indirect Offerings which was implemented by the Canadian Securities Administrators on December 3, 2004.
The amendment to the concept of "control" is significant as it changes the existing definition of control contained in securities law from a clear "bright-line" test for determining control (with control being determined on the basis of owning 50% or more of votes that may be cast to elect directors where the votes carried by such securities are sufficient to elect a majority of the directors) to a test that is more subjective.
On December 16, 2004 the Trust Beneficiaries' Liability Act, 2004 came into force in Ontario. This Act provides unitholders of an Ontario income trust with immunity from liability that is similar to that contained in Alberta 's Income Trusts Liability Act.