Material Facts about Kerr v. Danier Leather

The sound you heard coming from Bay Street last week may have been the collective sigh of relief from issuers of public securities, underwriters, and corporate lawyers. Or perhaps it was the cry of outrage from investors. Last Friday, the Supreme Court of Canada (“SCC”) released its much anticipated decision in Kerr v Danier Leather Inc, [2007] 3 SCR 331, one of the SCC’s first decisions dealing with securities legislation.

Background

The dispute stems from the tumultuous circumstances surrounding Danier Leather’s initial public offering in 1998. Under Ontario’s Securities Act, RSO 1990, c S.5, a company wishing to go public must file a prospectus, a document that must contain all material facts about the company that a potential investor may want to know before making the decision to invest. The Act also stipulates that if there are any “material changes” that occur within the period from receipt of the prospectus to closing, they must be disclosed through an amendment to the prospectus.

Danier included a forecast of expected revenues in its prospectus. Days before closing, management realized that the company might not be able to achieve this forecast because its inter-quarterly results were worse than expected and had been negatively affected by unseasonably warm weather. Nevertheless, the company proceeded with the IPO without amending its prospectus or disclosing the negative results. Two weeks after closing, upon obtaining further negative results, the company issued a news release revising its forecast downward. As you can expect, the result was a drastic decline in Danier’s share prices.

The ironic twist is that the weather eventually cooled off, Danier held a sales event which was a huge success, and it “substantially achieved its forecast” by the end of the quarter. Still, it took two years for Danier’s shares to return to the IPO price. Short-term investors who sold their shares in the stock within that time took a significant financial hit.

The Decision

This group of investors launched a class action lawsuit against Danier for misrepresentation in its prospectus. The problem for the plaintiffs is that the Securities Act does not contain an explicit requirement that issuers file an amendment for material facts, only for material changes. Material changes do not simply refer to a change in the information contained in the prospectus but a change in the “business, operations, or capital of the issuer.” As the SCC notes, inter-quarterly results do not relate to the operation of a company but to the results of that operation.

The plaintiffs’ main argument at the SCC was that Danier’s failure to disclose the inter-quarterly results constituted a misrepresentation because it was “an omission to state a material fact that is necessary . . . to make a statement not misleading in the light of the circumstances in which it was made” under s.1 of the Act. The SCC dismissed this submission on the basis of the last part of the statutory definitinion, which is in past tense, citing it as support for Danier’s argument that material facts are to be judged at the time the prospectus is filed. The trial judge had concluded that the revenue forecasts were objectively reasonable at the time they were made.

Further, the SCC held that there is no ongoing obligation on the issuer to disclose new material facts between the filing of the prospectus and closing. The SCC refused to interfere with the clear intention of legislature to create a regulatory scheme which specifically drew a distinction between material facts and material changes, only requiring ongoing disclosure for the latter.

Thoughts

The SCC’s decision was mainly based on an exercise in statutory interpretation. While there is some ambiguity in the provisions, the Securities Act is a highly structured and detailed regulatory scheme. Concepts such as misrepresentation or the difference between material facts and material change are clearly defined. The SCC simply followed its interpretation of this statutory language to its logical conclusions.

For investors, however, the decision makes little sense. If the purpose of the prospectus requirement is to provide potential investors with relevant information about the value of a company, there is no difference between material changes and material facts: both affect the price of a stock. Further, investors should be able to rely on the accuracy of the information contained in the prospectus not only at the time it is filed but right up to the point when the shares are purchased. While there has to be some cutoff point when all information has been disclosed and investors must make a decision, does it not make more sense that this ocurrs when the shares are actually sold, not at the preliminary stage?

It remains to be seen whether the SCC’s interpretation of the Act reflects the true intentions of Ontario’s legislature or whether it will be amended to better protect investors in the future.