"A company offers to sell its securities to the public by a prospectus.  The prospectus contains a forecast of the company's anticipated revenue and earnings.  Does the prospectus contain an implied representation that the forecast is objectively reasonable?  If so, in assessing the objective reasonableness of the forecast should the court give any weight to the business judgment of the company's senior management?  Under Ontario's Securities Act, does the company have a continuing obligation to disclose material facts that cast doubt on the objective reasonableness of the forecast, and that would likely adversely affect the company's share price?"

The Ontario Court of Appeal answered these important questions when it released yesterday its reasons in Kerr v. Danier Leather Inc., a decision the Court suggested to be of "widespread precedential importance".

The Court of Appeal overturned an earlier decision of the Superior Court of Justice that awarded millions of dollars to investors who blamed senior management for not disclosing certain sales information between the date the prospectus was issued and the date the initial public offering closed.  Critical to the Court's reasoning is the distinction to be made between a material fact (i.e. any fact that significantly affects, or would reasonably be expected to have a significant effect on the market price or value of the securities) and a material change, a narrower concept which is defined in s.1(1) of Ontario's Securities Act (the "Act").(i.e., a change in the company's business, operations or capital that would be expected to have a significant effect on the market price or value of the securities) .

The Court of Appeal found that while there is a continuing obligation to disclose a material change, there is no similar obligation, once a prospectus has been issued, to disclose a material fact that does not amount to a material change. The Court also found that generally speaking, a prospectus does not contain an implied representation that any forecasts within it are objectively reasonable.  The Court further noted that the trial judge should have given considerably more weight to the "business judgment" rule and not second-guessed the honest assessment of senior management as to the achievability of the forecasts.

The Court of Appeal summarizes the facts giving rise to this class action lawsuit in the following way:

"In May 1998, the appellant, Danier Leather Inc., made an initial public offering of its shares through a prospectus.  The prospectus contained a forecast that included Danier's projected revenue and earnings for the last quarter of its fiscal year.  An internal company analysis prepared a few days before its public offering closed showed that Danier's fourth quarter revenue and earnings were lagging behind the forecasted figures.  Danier did not disclose its poor fourth quarter results before closing.  It did disclose these results after closing in a revised forecast, which precipitated a significant decline in its share price.  However, Danier's sales rebounded, and by the end of the fiscal year it had substantially achieved its original forecast."

On these facts, the Court of Appeal addressed three critical questions:

1. Is there a continuing obligation to disclose material facts once a prospectus has been issued?

The Act requires a company to disclose material changes following the issuance of a prospectus by way of amendment, along with a news release.  Failure to do so can attract liability.  The Act also requires full, true and plain disclosure of all material facts at the time the prospectus is issued.  Again, failure to do so can attract liability.  The Court of Appeal rejected the plaintiffs' arguments that Danier, in addition to the above requirement, had also an obligation to disclose material facts in the time between the issuance of the prospectus and the closing of the offering:

"The purchasers of Danier shares, however, were not entitled to assume that no facts had occurred after May 6 and before May 20 that would reasonably be expected to have a significant effect on the market price or value of Danier's securities.  Danier had no obligation to disclose material facts occurring between May 6 and May 20 (unless those material facts amounted to a material change, in which case the material change would have had to be disclosed).  In short, Danier had no obligation to disclose its Q4 results to May 16, 1998."

The Court goes on to say that poor intra-quarterly results may in certain circumstances amount to a material change requiring disclosure.  The Court also points out the securities regulators have imposed greater disclosure obligations on market participants than those found in the Act.  However, the disclosure obligations found in policy statements, such as National Policy 51-201, cannot be relied on to support a claim for prospectus misrepresentation under the Act.

2. Does a prospectus contain an implied representation that its forecast is objectively reasonable?

The Court of Appeal held that in most cases a forecast in a prospectus "can be taken to contain implied representations that the forecast represents management's best judgment, that the forecast was prepared using reasonable care and skill, and that management believes the forecast to be reasonable."  However, there is no implied representations that the forecast be objectively reasonable.  The Court goes on to say:

"Although in another case, the facts might yield a different conclusion, in this case there is no evidence – and nothing in the language of the prospectus itself – to suggest that the appellants' subjective belief that the Forecast was reasonable was shared by reasonable business people or was otherwise being put forward as "objectively reasonable".  A reasonable person reading the prospectus would certainly conclude that the Forecast represented management's best judgment.  The prospectus says so explicitly.  Indeed, in a competitive marketplace that is the judgment that the investor is looking for.  The reader of this prospectus would not, however, conclude that the appellants were also implicitly saying that their best judgment was shared by reasonable business people, or would be seen as reasonable by a trial judge, or was otherwise "objectively" reasonable."

3. How much deference should a Court give to the "business judgment" of senior management?

The Court of Appeal also held that the business judgment rule must be considered when a claim is made for prospectus misrepresentation under the Act, and noted, "A forecast is a quintessential example of the exercise of business judgment."  The business judgment rule requires the Court to give deference to the knowledge, experience and business judgment of senior management before second-guessing their decisions.  The business judgment rule acknowledges the autonomy and integrity of the company and recognizes the directors and officers of the company as those best positioned to assess a course of action and understand the impact such action will have on the affairs of the company

If you have any questions regarding the foregoing, please contact Ed Babin in the Toronto office (416-863-5503) or Louis Martin O'Neill in the Montréal office (514-841-6547)

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practises nationally and internationally from offices in Toronto, Montréal, New York and an affiliate in Paris and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments contained herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstances.  For particular applications of the law to specific situations, the reader should seek professional advice.