Public company directors and offi cers, and their lawyers, were given some guidance by the Ontario Court of Appeal in late 2005 on the question of their potential liability for forecasts made in a prospectus, in circumstances where there may be a change in a "material fact" between the date the fi nal prospectus is issued and the closing date of the intended transaction. The Ontario Court of Appeal’s decision to overturn the trial judgment in the landmark case of Kerr v. Danier Leather Inc. et al ("Danier Leather") 1 provides considerable relief to the Canadian corporate world, and at the same time disappoints shareholder class action lawyers who had regarded the trial decision as a huge victory and precedent for similar class actions. The judgment, however, does leave the door open for other shareholder class actions in the future.
The Danier Leather decision concerned fi nancial forecasts included with the company’s fi nal prospectus prior to the company’s initial public offering in May 1998. At the time the fi nal prospectus was issued, the company had the fi nancial results for the fi rst 3 quarters of the year and a forecast of results for the fourth quarter (Q4). Between the time the prospectus was issued and the closing of the IPO two weeks later, sales were slower than expected as a result of unseasonably warm weather. The company’s CEO and CFO were aware of the slowdown but believed that if the company took aggressive measures, the forecasted sales might still be achieved. No steps were taken to issue any public statement regarding the slowdown or correct the prospectus. The IPO proceeded based on the fi nal prospectus. Shortly following the IPO, Danier revised its Q4 forecast downward to refl ect the effect of the warm weather on sales and issued a press release. The share price dropped from $11.65 to $8.25. Shareholders brought a class action suit in response, alleging that the prospectus contained a material misrepresentation. They were able to point to the drop in share price as proof that the diminished sales forecast was material to the market.
In its defence, Danier adduced evidence that its executives truly believed the sales forecast could be achieved at the time of the IPO and that, in fact, by the end of Q4, Danier was able to substantially accomplish the sales that had been forecast in the prospectus. In addition, Danier pointed out that the prospectus contained all the standard cautions that the forecast could prove to be inaccurate.
At trial, the judge found that Danier, its CEO and CFO were all liable for prospectus misrepresentation under the Ontario Securities Act. The critical question under consideration was at what time should a forecast in a prospectus be judged: at the time the prospectus is issued; at the time of the closing of the IPO; and/or with hindsight when the actual fi nancial results are known? The trial judge concluded that the prospectus impliedly represented that the forecast was objectively reasonable, both on the date the prospectus was issued and on the date that its public offering closed. He concluded that the impact of the warmer weather was not a "material change". However, he also concluded that in the two weeks between the fi nal prospectus and the IPO, the poorer sales results were "material facts" that Danier was required to disclose before closing. Danier’s failure to do so resulted in the implied representation in the prospectus that the forecast was reasonable becoming false on the closing date, despite the fact that it was ultimately achieved. The shareholders were awarded millions of dollars in damages and legal costs.
The Court of Appeal disagreed with these fi ndings and overturned the trial decision on the basis that the trial judge had made several errors.
First, the trial judge erred in concluding that, under the Ontario Securities Act, Danier had a continuing obligation to disclose "material facts" occurring between the date of its prospectus and the date of closing two weeks later. The Securities Act only requires prospectus amendments for "material changes" . The Court of Appeal noted that the trial judge erred when he read the prospectus as though it was signed on the date of closing instead of on the date of receipt.
Second, the trial judge erred in law in concluding that Danier’s prospectus contained the implied representation that, the forecast was objectively reasonable. The Court of Appeal accepted 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 case and skill, and that management believes the forecast to be reasonable. However, the Court of Appeal concluded that in this case this did not equate to an implied representation that the forecast was objectively reasonable.
Third, the trial judge erred in failing to give any deference to the business judgment of Danier’s senior management and in failing to take into account that the forecast was substantially achieved. The Court of Appeal concluded that the trial judge should have considered whether the CEO and CFO’s honest belief in the forecast’s achievability was within the range of reasonable alternative opinions open to business people in their position knowing what they knew and facing the circumstances they faced. The Court of Appeal noted that the trial judge’s point of view was necessarily a retrospective one, whereas the point of view of the CEO and CFO was a prospective one, informed by the circumstances as they were on the date of the IPO. The Court went on to conclude that the view of the CEO and CFO might have been an optimistic one, but it was not unreasonable nor outside a range of reasonable views of Danier’s situation at the time. The Court also noted that the fact that the forecast was ultimately substantially achieved was evidence that weighed in favour of the conclusion that the forecast was reasonable.
The result in Danier Leather gives considerable comfort to business executives who provide forecasts in a prospectus based on sound business judgment. However, that the forecast was, in the end, substantially achieved, weighed heavily in favour of the defence and made it much easier to prove that management had exercised sound business judgment in that case. But what about a case where the forecast is not substantially achieved? The Court of Appeal’s reasons did not shut the door entirely to shareholder class actions and it can be expected that claims will be brought in circumstances where a prospectus forecast is not met in which the plaintiff shareholders will attempt to adduce evidence that the forecast was not a reasonable business judgment at the time of the forecast.
Footnote
1. [2005] O.J. No.5388
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