The Hide Business: A Review of the Facts and Issues in Kerr v Danier Leather
Tomorrow, the Supreme Court of Canada will hear the appeal in the Danier Leather case, a case which has been followed by the securities bar and is, sadly, not about bawdy houses in Montreal. At issue in this case is the interpretation of some key terms and provisions in the Ontario Securities Act, RSO 1990, c S-5 (“material change” and “material fact”), the operation of s. 57(1) of that Act, whether prospectuses contain an implied warranty of “reasonableness,” and whether the business judgment rule is a defence available to senior management when issuing a prospectus.
Both judgments below had remarkable features, and differed sharply over the central issues. If it can be said of a securities case, it’s going to be fun.
The Facts in Brief
Danier makes leather goods, mainly clothes for the retail market. It issued a final prospectus for an IPO in May, 1998. The final prospectus included an “optimistic” forecast of fourth quarter earnings for a fiscal year end of June 1998, and valued the IPO at $11.25 per share. After issuing the prospectus, but before the distribution, Danier’s internal reports showed projected earnings were lower than the forecast. Danier’s management did not advise the directors, auditors or lawyers or amend the prospectus. The distribution took place, and about a week later management sought guidance on whether to disclose the new information on earnings projections.
In early June, Danier issued a “material change” report with a revised forecast reflecting the lower projected revenue and net earnings for its fourth quarter. This report precipitated a 25% decline in its share price. Danier’s management took some unusual measures to achieve better sales in May and June. In early July the actual results were announced, which nearly matched the original prospectus forecast. Danier’s share price rose, but not to the IPO issue price. A class action was commenced against Danier, and its CEO and CFO personally, under section 130 of the Securities Act for misrepresentation in a prospectus.
The Decisions in Brief
At trial, Lederman J. held Danier, as well as its CEO and CFO, liable for prospectus misrepresentation (see Kerr v Danier Leather (2004), 46 BLR (3d) 167). The trial judge found that the main cause of Danier’s poor fourth quarter sales up to May 20 was unseasonably warm weather, but held that the impact of this unseasonably warm weather did not constitute a “material change” in Danier’s business or operations.
Instead, he held that the prospectus included an implied representation that the prospectus forecast was objectively reasonable both on May 6 (the date of the prospectus) and on May 20 (the date the IPO closed), and that the internal reports were a “material fact” that required disclosure prior to the May 20th date. The trial judge found that although management subjectively believed they could meet the forecast, this was not a reasonable belief at the time, given the earnings forecast, and based on insufficient diligence. The trial judge awarded the plaintiffs substantial damages, as well as legal costs including a $1 million premium to be paid by the defendants to plaintiffs’ class action counsel. This decision was considered extraordinary on a number of counts.
The Court of Appeal (Laskin, Goudge and Blair JJ.A.) disagreed with Lederman J. (see Kerr v Danier Leather (2005), 77 OR (3d) 321). The Court of Appeal based its decision on three grounds.
First, it found that there was no continuing obligation to disclose new “material facts” prior to completion of a distribution, and distinguished “material fact” from “material change.” It held that Part XV – Prospectuses – Distributions (sections 52 to 64) of the Securities Act is a complete code for prospectus disclosure. The Court of Appeal ruled that issuers are not bound to amend a prospectus for changes in material facts (but are obligated to make disclosure of material changes) occurring after the date that the securities regulator issues a receipt for a final prospectus, and prior to completion of the distribution under the prospectus, provided that the material fact does not constitute a material change.
Second, the Court of Appeal overruled the trial judge’s findings on the reasonableness of management’s belief that it could meet the projected forecast, in part because he did not give sufficient deference to managements expertise and experience. The Court of Appeal held that the question as to whether a prospectus contains a representation, whether explicit or implied, is a question of fact.
Third, Court of Appeal agreed that in most cases a forecast in a prospectus can be taken to contain implied representations that management has employed its best judgment, has used reasonable care and skill, and that management believed the forecast to be reasonable. However, the Court of Appeal did not find that there was an implied representation in the Danier prospectus that the forecast was objectively reasonable, speculating that no reader of the prospectus would conclude that Danier management was implicitly representing that its best judgment in the forecast was shared by other reasonable business people or by an objective standard.
Those Numbers and Dates Again
The Court of Appeal decision lays most of these facts out in detail. For the first seven weeks of the fourth quarter in 1998, Danier was well below its forecast of “comparable store revenue growth,” which was 21.5% growth for the overall fourth quarter in 1998 over 1997. Its cumulative total sales growth in the first seven weeks was 6.3%, far lower than the forecast of 40.8% for the overall fourth quarter of 1998. The forecast itself projected a loss for the final half of the fourth quarter (May and June 1998) as, historically, Danier had lost money in the months of May and June. One commentator at trial noted that, as of May 16 when the internal report was generated, if Danier were to meet its projections as management said it could, it would at that point have to create a 100% increase in sales over the prior year, or 60% more sales than the original prospectus stated.
Stop there, because this becomes an important moment. At this point in time, management honestly, and maybe reasonably, thought that it would make the projections, despite those numbers. Would anyone else?
Between May 16 and the closing date of May 20, daily sales results continued to compare poorly to the previous year’s sales for the same dates. Things did not appear to be getting better. Advice was sought. On June 4, 1998, Danier issued a press release disclosing financial results to date in 1998 and a downward revision to its forecast. Danier’s share price declined from $11.65 to $8.25 per share over the following week.
Stop again. At this point, did management still believe? It might have, but its lawyers at Davies did not, and advised it to make a “material change” report. According to the evidence entered at trial, Danier then took some measures to attempt to meet projections, some of which were not mentioned in the prospectus. It held an unplanned “50% off everything” sale for the month of June, and in the final report for fiscal 1998, included inventory adjustments that not been included in the prospectus.
Finally, as both courts noted, Danier’s luck finally turned from bad to good, and the weather cooled off unseasonably, which helped stronger sales during June. In the end, the sales forecasts were almost met, and the share price rose again – but not to the IPO level, not for another two years. That suggests that the IPO itself was perhaps a little over-priced, although valuations are more art than science.
If you were an in-and-out trader, well, you were out of luck because you took a hit when the stock dropped. Courts are generally less sympathetic to these traders than they are to the pensioners who buy and hold. In this case, the buy-and-hold purchasers didn’t really suffer damages. They could even have made money if they sold in 2001, when the stock hit $18. But if you’re interested in the principle involved, the fact that management sat on adverse information, was wildly optimistic, then you have to look at the Securities Act and see what it says about situations like that.
The Scheme of the Securities Act
There are several sections at issue that one court “read together” and another court interpreted as distinct.
Section 1(1) contains the following definitions:
“material change,” when used in relation to an issuer that is not an investment fund
… means (i) a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer, or
(ii) a decision to implement a change referred to in subclause (i) made by the board of directors or other persons acting in a similar capacity or by senior management of the issuer who believe that confirmation of the decision by the board of directors or such other persons acting in a similar capacity is probable …
“material fact,” when used in relation to securities issued or proposed to be issued, means a fact that would reasonably be expected to have a significant effect on the market price or value of the securities … .
Under section 56(1),
A prospectus shall provide full, true and plain disclosure of all material facts relating to the securities issued or proposed to be distributed and shall comply with the requirements of Ontario securities law.
Under section 57(1),
Subject to subsection (2), where a material adverse change occurs after a receipt is obtained for a preliminary prospectus filed in accordance with subsection 53 (1) and before the receipt for the prospectus is obtained or, where a material change occurs after the receipt for the prospectus is obtained but prior to the completion of the distribution under such prospectus, an amendment to such preliminary prospectus or prospectus, as the case may be, shall be filed as soon as practicable and in any event within ten days after the change occurs.
Section 130 imposes liability on issuers and others if a prospectus or any prospectus amendment contains a misrepresentation at the time of closing. It provides in part,
Where a prospectus together with any amendment to the prospectus contains a misrepresentation, a purchaser who purchases a security offered thereby during the period of distribution or distribution to the public shall be deemed to have relied on such misrepresentation if it was a misrepresentation at the time of purchase and has a right of action for damages against,
(a) the issuer or a selling security holder on whose behalf the distribution is made;
(e) every person or company who signed the prospectus or the amendment to the prospectus.
The questions behind these sections are: does s, 130 create an obligation to disclose or an implied warranty of reasonableness; what is the difference between a material fact and a material change, and why are they distinguished? If you want an introduction to ideas and interests behind this regime, you’d be well served by Mary Condon’s Making Disclosure.
The Court of Appeal’s theory was that the legislature “drew a line” and decided that, after issuing the prospectus but before distribution, management would be required to amend the prospectus where there is a “material change,” but not where there is a change in a “material fact,” as a means of limiting unnecessary transitory information and amendments. I know that sounds confusing, but it is coherent in some sense, and I refer you to the appellate court decision for a better phrasing than mine.
Another theory has it that s. 57(1) does not read that way at all, but that management must report changes to material facts and material changes once the prospectus has been issued. This theory rests on the way these terms are defined, and something of the legislative history.
These defined terms (material fact and material change) came into force in 1979, as did s.130. The terms material change and material adverse change were already in s. 57 (then s. 55), and they were undefined.
Prior to the 1979 amendments, an amendment to a final prospectus was required to be filed pursuant to section 55 in situations “where a material change occurs during the period of distribution to the public of a security that makes untrue or misleading any statement of a material fact contained in a prospectus.” The requirement to file an amendment to a preliminary prospectus was contained in subsection 40(2), which applied when a “material adverse change occurs after the date of the preliminary prospectus … that makes untrue or misleading any statement of a material fact contained in the preliminary prospectus.” The terms material change and material adverse change were not defined. Section 55 and subsection 40(2) were combined in the 1979 amendments into what is now subsection 57(1).
This theory holds that the definition of “material change” in s. 1(1) does not apply to the use of that term in s. 57(1) for two reasons. The first is that s. 57 is effectively s. 55, and pre-dated the definitions created in 1979, which were intended to be defined for the purposes in the Act.
The second reason is that the meaning of “material change” in s. 57 is therefore different from the definition in s. 1(1). The definition in s. 1(1) includes the phrase “in relation to an issuer,” that is, “material change, when used in relation to an issuer that is not an investment fund… .” However, it is argued, the term “material change” in section 57 is not used in relation to an issuer, but in relation to a prospectus.
If that sounds confusing, it is, because suddenly we’re making more distinctions where there may not be any: a prospectus describes the business of an issuer, so how could the change relating to the prospectus not be relating to the issuer?
The Business Judgment Rule
Perhaps the most surprising part of the Court of Appeal decision was the invocation of a version of the business judgment rule in finding that management’s belief in its forecasts was reasonable — or somewhere on the spectrum of reasonable such that a court could not second-guess it.
To my knowledge, this is an expansion of the use of this rule into a statutory scheme. The business judgment rule is not mentioned as a defence in the Securities Act, which otherwise lists defences to statutory causes of action.
Traditionally, the rule has served to protect directors in making business judgments necessary to the proper functioning of the business, and to provide a defence to directors when, in hindsight, those decisions can be shown to be poor decisions. It is a small irony then that the Court of Appeal used the business judgment rule in part because hindsight showed that Danier met its projections, even if it required some extraordinary steps by management to do so. If the weather had not co-operated, would management’s judgment have then been unreasonable?
But more important is the underlying nexus of principles and rules expressing them. The current vogue in the UK and US is to discuss “principles-based” regulation, which is taken to mean many things. It has a good side: make management make the substantive judgment about compliance with the principle (i.e., full, clear and complete disclosure), which has the effect of discouraging technical avoidance of rules. It also provides cannon fodder for litigation, because anyone can debate compliance with a principle, and it places a lot of trust and emphasis on the very party holding all the marbles.
On the other end of the regulatory spectrum is the “bright line” rule, which would mandate specific actions in specific circumstances. Setting limits on ownership is a clear example: people get around these limits in any number of ways, and the bright line rule becomes something of a regulatory barrier serving no function.
In this light, we see something of the s. 57 regime: in either theory, management must disclose all material changes, and where material facts are sufficiently alarming, those too. If they don’t, liable, end of inquiry, and we move right to the damages reference. This has the feel of a bright line rule. But what is “material,” and with reference to what? One criterion is market based, objective: the impact on share price. It’s pretty clear in this case that disclosure of negative information caused a price decline of about 25%.
On the other hand, management thought it could make its goals, and it did, perhaps with a little luck. Was their judgment objective? Pretty quickly the inquiry turns to principles and we are back to litigating someone’s “best judgment”, which is by nature only something we can tell in hindsight. If it works out, that judgment looks pretty good, and if it doesn’t that judgment looks pretty bad.
Which is why forward looking statements say that past experience is not necessarily an indication of future performance, and then someone tries to sell it to you anyway.