The litigation in the Kerr v. Danier Leather Inc. case finally wound its way to an end this past October with the release of the decision of the Supreme Court of Canada (SCC) written by Justice Binnie. The issued reasons at the various court levels raise some interesting questions which appear unanswered.
Danier's initial public offering prospectus, filed as a preliminary on April 6, 1998, had a forward looking financial forecast for the balance of its fourth quarter ending June 27. An internal analysis, prepared after the final prospectus was held on May 6 but before the offering closed on May 20, showed Danier's fourth quarter results falling substantially below its forecast. Danier did not disclose this forecast prior to closing.
The plaintiffs brought a class action proceeding for prospectus misrepresentation pursuant to s.130(1) of the Securities Act (Ontario). In finding Danier liable, the trial judge concluded that the prospectus impliedly represented that the forecast was objectively reasonable, not only as of the date of the prospectus but also as of the date of closing. The poor results were found to be material facts required by s.130(1) to be disclosed before closing. Thus the implied representation, though true on the filing date, was false on closing.
The trial decision was reversed on appeal since the appellate Court was determined that s.57(1) provides a complete code that only requires a material change, not a material fact, to be disclosed during the distribution period prior to closing. The SCC dismissed the appeal.
The case eventually boiled down to a question of statutory interpretation and the difference in the definition between "material fact" and "material change." Material fact encompasses "a fact that would reasonably be expected to have a significant effect on the market price or value of the securities." The emphasized portion of that definition is repeated in the definition of material change, but this definition is narrowed by relating it to "a change in the business, operations or capital of the issuer."
We now know from the Court of Appeal decision that if all 55 Danier stores had burned down in the interim period, this would have been a material change that would have required a prospectus amendment. Such an event would not have been merely be a material fact as discussed by the trial judge.
It was eventually determined by Danier's CEO and CFO that unseasonably hot weather was the problem in the significant sales downturn of the first portion of this fourth quarter. The traditional Victoria Day sale held immediately after closing was a flop. A press release was given on June 4 indicating sales and net income for that quarter would be substantially reduced as a result of the weather conditions. The share price of the new issue slumped immediately by 22 per cent. It took a year to recover from this drop. An extraordinary "50 per cent off everything in the store" promotion increased sales to somewhere close to the original forecast. Interestingly, not only did sales rebound, but net profits also came close to the prospectus forecast. This recovery appeared to impress at least the Court of Appeal. But how was it achieved?
In reviewing the wording of the relevant sections and policy reasons, the appellate courts held that only a material change had to be disclosed in the period of distribution between the date of the prospectus and the closing of the offering — not any material fact which would include weather and its effect upon financial results. Justice Binnie referred to the 1983 remarks of a former chair of the Ontario Securities Commission in discussing disclosure requirements that "This is an attempt to relieve reporting issuers of the obligation to continuously interpret external political, economic and source developments as they affect the affairs of the issuer, unless the external change will result in a change in the business, operations or capital of the issuer, in which case, timely disclosure of the charge must be made" [emphasis by Justice Binnie].
Thus once a prospectus has been filed, it would seem that the major relevance of a material fact event would relate to the prohibition against insider trading while possessing undisclosed material facts. However if one steps back and analyzes the policy elements, query which entity in an IPO distribution situation functionally, if not legally, fits the role of the overwhelming major insider other than the issuer company itself. One wonders whether the Ontario Superior Court will request the government to amend the Securities Act to provide protection to purchasers in the distribution period from at least forecast material fact changes. After all, one presumes that a purchaser would be interested in that period over something that is within the control of the issuer (forecasting) and that has a significant effect on the value or price of what is being bought. It is curious that the legislation requires that a prospectus contain a certificate that there has been full, true and plain disclosure of all material facts prior to going final. However, the legislation does not require disclosure of internal material facts after the prospectus goes final notwithstanding that these would affect the value or price of the securities being distributed pursuant to that prospectus.
How does one conduct a 50 per cent off sale to increase sales (query whether there may also be some advertising issues regarding what was referred to as a two ticket policy) but at the same time increase profits and seemingly margins? If normal selling prices are slashed, but costs are fixed, then margins are squeezed and profits under siege, if not under water. This was unaddressed by Justice Binnie, but buried in the other reports is an indication that there was an $800,000 positive inventory adjustment which appears to be instrumental. Is it not reasonable to question on what basis this adjustment was made and why it was not made prior to the prospectus going final?
Danier cited its daily sales computer tracking system as one of its significant business tools; one would presume that management would be able to note discrepancies in year to year patterns reasonably easily and rather immediately. However, its CEO and CFO indicated that they were not all that concerned that the internal review prior to closing indicated revenues falling short of the forecast. Part of the explanation was that the sales in the quarter were front-end loaded by virtue of the incentives to the sales force that were designed to have sales occur earlier in the quarter to achieve bonus targets for the earlier portion. It was said that these sales would normalize over the full quarter so that the full quarter sales would be better. This would seem to be counter-intuitive (for if one front-end loads sales, then sales in the last portion of the period would logically have to be smaller to 'average out'), but this point does not appear to have been questioned in the reasons.
The appellate courts whacked the representative plaintiff Durst with a costs award against him of well in excess of $1 million. Justice Binnie observed that Durst was a wealthy man who also had made $1.5 million on the eventual sale of the shares he bought in the IPO — but this ignores what he might have made if he had been able to sell earlier without the blemish of the price drop on the release of the revised forecast, all other things being equal. Justice Binnie went on to say that Durst had not "raised a 'novel point of law.' As we have seen, the heart of the case is simply a shareholder dispute over a lot of money requiring the application of well settled principles of statutory interpretation to particular legislative provisions. This is the usual fodder of commercial litigation." Are the only representative plaintiffs entitled to enjoy the potential prospect of not having to pay costs in a losing cause? To those who are not wealthy? Does that possible attitude ignore the reality that, in many class proceedings, the functional plaintiff and driving force is the law firm which operates on a contingency basis and frequently gives an indemnity to the rather nominal named plaintiff?
Interestingly enough, the Court of Appeal stated in the first paragraph of its decision:
However, in its costs ruling, that court observed that "the case does not raise issues of genuine interest or importance to the public at large." I may be mistaken, but I seem to recall that the appellate courts took the fairly unusual step of publicizing the release date of their reasons, so presumably they thought these decisions had more than the usual importance. The trial judge's costs ruling disclosed that the defendants had made an offer which could be taken as compensation of $1.50 per share, so it would seem that there was a valid concern on their part as to potential liability. The plaintiff's side held out for $2.35 a share being the full amount of the price drop. Certainly this would not have helped Durst when the appellate courts went against him. This also illustrates why it is dangerous not to appreciate that very few cases are absolutely certain one way or the other — except that once the final court has spoken, a bird in the hand that may be worth two excellent, but losing, legal arguments in court.
However, one issue was dealt with so as to set right an inadvertent misstep at the Court of Appeal concerning the Business Judgment Rule:
Justice Binnie set the record straight regarding the Business Judgment Rule (see my earlier reflections in the March — June 2007 issue of this publication as to the nature of this Rule) when it intersects with a statutory disclosure (or other statutory obligation) requirement. Contrary to the musings of the Court of Appeal, he correctly noted that the statutory requirement prevails. The Rule can only be invoked where the directors and officers have canvassed in a reasonable fashion the pros and cons of the alternatives open to them in making a decision. But in the case of a statute directing what must be done, there are no alternatives — only the course of action which the statute has laid out.
In conclusion, it gets curiouser and curiouser — and in the end, perhaps all that is left is the grin of the Cheshire cat who must be enjoying the appropriate analysis of the Business Judgment Rule in this context.
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