On October 20, 2023, the Capital Markets Tribunal of Ontario (the "Tribunal") released a decision analyzing, for the first time, the "necessary course of business" exception (the "NCOB Exception") to the prohibition on selective disclosure contained in section 76(2) of the Securities Act (Ontario) (the "Act"). Market participants should consider the takeaways from this decision prior to relying on the NCOB Exception regarding disclosure of material non-public information ("MNPI").
Background
WeedMD Inc. ("WeedMD", now named Entourage Health Corp.) is a producer and distributor of cannabis that is listed on the TSX Venture Exchange. In 2017, WeedMD planned to enter into a material lease agreement and associated option to purchase with Perfect Pick Farm's Ltd., which would significantly expand its production capabilities (the "Transaction"). Prior to finalizing the Transaction, Michael Kraft, chairman and director of WeedMD, sent his long-time friend, Michael Stein, an e-mail containing MNPI relating to the Transaction for the purposes of seeking Mr. Stein's input. At all relevant times, Mr. Stein had no business, contractual, or employment relationship with WeedMD. After receiving the MNPI, Mr. Stein purchased 45,000 WeedMD shares, which he then sold after the Transaction was announced, realizing a 43 percent return.
Enforcement staff of the OSC alleged the following breaches of Ontario securities law and conduct contrary to the public interest:
- Mr. Kraft, while in a special relationship with an issuer, informed another person outside of the necessary course of business of a material fact or material change with respect to the issuer, before the material fact or material change had been generally disclosed, contrary to subsection 76(2) of the Act); and
- Mr. Stein, while in a special relationship with an issuer, purchased or sold securities of the issuer with the knowledge of a material fact or material change with respect to the issuer that had not been generally disclosed, contrary to subsection 76(1) of the Act.
A central issue that the Tribunal considered was whether Mr. Kraft provided Mr. Stein with MNPI in accordance with the NCOB Exception, and therefore not in breach of the Act.
Prohibition on tipping and insider trading
The Act prohibits an issuer, and any person or company in a special relationship with an issuer, from informing, other than in the necessary course of business, another person or company of a material fact or material change with respect to the issuer before the material fact or material change has been generally disclosed (also known as "tipping").
The Act also prohibits a person or company in a special relationship with an issuer from purchasing or selling securities of the issuer with the knowledge of a material fact or material change that has not been generally disclosed (also known as "insider trading").
Findings
The Tribunal found that Mr. Stein engaged in insider trading when he traded shares in WeedMD while in possession of MNPI, and that Mr. Kraft engaged in tipping when he provided Mr. Stein with MNPI. Further, the Tribunal determined that Mr. Kraft's selective disclosure to Mr. Stein was not made in reliance on the NCOB Exception.
The "Necessary Course of Business" Exception
"Necessary" information
Not all selective disclosure that is tied to a business purpose or rationale is "necessary." Rather, "necessary" selective disclosure must go beyond a mere business purpose or rationale, and must be "essential", "indispensable", or "requisite". Moreover, the purpose of the selective disclosure must be sufficiently important to the business to warrant an exception to the prohibition against selective disclosure.
The Tribunal also found that the word "business" in the phrase "the necessary course of business" does not necessarily mean in the issuer's business. The Tribunal determined that while "business" did mean WeedMD's business in this case, in other factual circumstances, the exception could apply to selective disclosure that is necessary to the recipient's business.
Onus of proof
The Tribunal determined that the NCOB Exception is to be applied as an exception to the prohibition on tipping, meaning that the respondent (in this case, Mr. Kraft), bears the onus of proving its availability.
Test to establish the NCOB Exception
To determine whether selective disclosure was made in reliance on the NCOB Exception, the Tribunal ruled that an objective test is to be applied. As a result, the tipper's subjective beliefs as to whether the selective disclosure was necessary is not determinative.
The Tribunal also clarified that the NCOB Exception is to be interpreted and applied narrowly, so as to ensure that everyone in the market has equal access to, and opportunity to act upon, material information.
Factors to consider
The Act does not define "necessary course of business", and does not provide guidance as to which factors are relevant in establishing the NCOB Exception. However, the Tribunal provided the following non-exhaustive list of relevant factors when determining whether selective disclosure satisfies the NCOB Exception:
- the business of the issuer;
- the relationship between the tipper and the issuer;
- the relationship between the tipper and the tippee;
- the nature of the MNPI that was disclosed;
- the relevance of the MNPI to the relationship between the tippee and the issuer (that is, whether the nature of the relationship between the tippee and the issuer necessitates the disclosure of the MNPI in question);
- the tipper's reason for making selective disclosure to the tippee; and
- the credibility of the tipper seeking to establish the NCOB Exception.
Additionally, National Policy 51-201 – Continuous Disclosure Obligations ("NP 51-201") provides some guidance on the types of recipients and categories of communication which may indicate it was made in reliance on the NCOB Exception. However, these factors are not determinative, and complying with them does not guarantee that the NCOB Exception will apply.
Application to Mr. Kraft's conduct
In applying these principles to Mr. Kraft's conduct, the Tribunal found Mr. Kraft's selective disclosure was not made in reliance on the NCOB Exception, but rather arose out of his personal preferences and habit. Mr. Kraft's desire to have someone that he trusted provide input on the documents was not equivalent to providing selective disclosure in the necessary course of WeedMD's business.
In coming to this conclusion, the Tribunal outlined the following:
- Mr. Kraft did not turn his mind to whether the selective disclosure was in the necessary course of business prior to disclosing the MNPI. Mr. Kraft hastily forwarded the e-mail to Mr. Stein out of habit;
- Mr. Stein had no business, contractual, or employment relationship with WeedMD at any time between when he received the MNPI, and when he sold his shares in WeedMD;
- Mr. Kraft did not ask Mr. Stein to act as an advisor or consultant to WeedMD, to enter into any agreements with WeedMD, or to keep the information he provided to Mr. Stein confidential;
- Mr. Stein reviewed the draft lease as a favour to Mr. Kraft, and was not compensated for his review; and
- Mr. Kraft did not consult with or advise WeedMD's management or directors regarding his desire to receive a second opinion, nor that he had reached out to Mr. Stein for this opinion. No other member of WeedMD's management or directors asked Mr. Stein to review draft documents related to the expansion.
Key takeaways
This decision provides important guidance on how the NCOB Exception will be applied. Reporting issuers and those in special relationships with reporting issuers should therefore consider the following prior to relying on the NCOB Exception for selective disclosure:
- Disclosure must be "necessary": The use of the term "necessary" (as opposed to "ordinary") in the language of the NCOB Exception elevates the requirement beyond a mere business purpose or business rationale. Accordingly, the purpose of the disclosure must be sufficiently important or necessary to warrant an exception;
- Burden of proof on the tipper: Once the elements of tipping are established, the onus shifts to the persons intending to rely on the NCOB Exception to prove its applicability and to show that the communication was in the necessary course of business. If the tipper does not succeed in proving that, the contravention is established. Anyone disclosing MNPI should ensure they can sufficiently demonstrate the basis for such disclosure in compliance with the NCOB Exception;
- An objective standard will apply: The NCOB Exception is to be established on an objective basis;
- Interpretation of "business": The Tribunal noted that the word "business" in the phrase "in the necessary course of business" is not qualified by the phrase "the issuer's". Accordingly, the Tribunal left open the possibility that it may be interpreted as applying to not only the business of the issuer. Persons intending to rely on the NCOB Exception should consider whether "business" will be deemed to refer to the issuer's business, or the tippee's business. There remains uncertainty as to the interpretation and application of the term "business" and the statement should not be taken as definitive guidance of the application of the exemption to extend to the business of the business of the tipper or tippee;
- Consider NCOB Exception prior to disclosure: The Tribunal notes that establishing that one has turned one's mind in advance to the question of whether the purpose of making selective disclosure is in the necessary course of business is not a precondition to availing oneself of the NCOB Exception, although it does note that it may help to establish after the fact the purpose for which the selective disclosure was made and that such purpose was in the necessary course of business. Accordingly, evidence of the tipper turning their mind to whether the disclosure is in the NCOB prior to making the disclosure is relevant; and
- Relevant factors: The Tribunal did not outline any bright line test for determining whether disclosure was made in reliance on the NCOB Exception, although they provided non-exhaustive factors (summarized above) to consider when determining whether the NCOB Exception is available, along with guidance contained in NP 51-201.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.