Securities Litigation Update – June 2005

by Kenneth Dekker, Affleck Greene McMurtry LLP

Contributing Authors: Kenneth A. Dekker , Paul Emerson, and Angela Yadav

The future of shareholder class actions in Ontario

The times are changing for shareholder class actions in Ontario. Last year, the Ontario Superior Court of Justice rendered Canada’s first-ever shareholder class action judgment arising from misrepresentations on an initial public offering (“IPO”) (Kerr v. Danier). Later this year, the Ontario government is expected to proclaim amendments to the Securities Act that will make it easier for investors on the secondary market (i.e. a stock exchange) to sue for corporate misrepresentations. While shareholder class actions have traditionally been largely a U.S. phenomenon, both of these developments promise to make shareholder class actions more prevalent in Ontario. At the same time, the U.S. Supreme Court’s recent decision in Dura v. Broudo will likely rein in shareholder class actions in the U.S.

Kerr v. Danier Leather Inc.[1]: In May 1998, much of Canada had an unseasonably warm spring. In May 2004, Canada’s pre-eminent leather goods manufacturer and retailer was hit with an estimated $15 million class action judgment. These two events bookend a six-year saga in which disgruntled purchasers of shares in Danier Leather’s 1998 IPO obtained Canada’s first-ever class action judgment in favour of investors arising from misrepresentations by a corporation prior to its IPO.

The action was brought under s.130 of the Ontario Securities Act, which allows initial purchasers of securities from an issuing company to recover their damages where the issuing company has made a misrepresentation in its prospectus. Initial purchasers of shares are deemed to have relied upon a company’s misrepresentation. This alters the normal legal requirement that a plaintiff show it actually relied on a misrepresentation. Section 130 does not apply to share purchasers on the secondary market – i.e. a stock exchange.

In this case, the misrepresentation involved Danier’s failure, after its May 6th prospectus, to release revised financial forecasts reflecting lower leather sales due to a warm spring. When this information was made public two weeks after the IPO, Danier’s share price dropped. In finding for the plaintiffs, Lederman J. found that Danier’s failure to release updated forecasts before the IPO was a material misrepresentation and it did not matter that its actual financial results later rebounded to approach those forecast in the May 6th prospectus. Lederman J. awarded share purchasers damages based on the difference between the purchase price for the shares and what they would have paid for their Danier shares on the IPO, had proper disclosure been made.

This decision makes it clear that a company must not only ensure the accuracy of forecasts in its prospectus; it must also update prospective purchasers with any information arising before the IPO that might affect its share value. This decision is under appeal with the hearing set for this summer.

Statutory civil liability for misrepresentations on the secondary market: Traditionally, class actions for corporate misrepresentations brought by purchasers of shares on a stock exchange have been curtailed by the requirement that each purchaser establish it actually relied upon the misrepresentation. This will soon change when recent Securities Act amendments come into force, making it easier for investors in the secondary market to sue for oral and written misrepresentations by public companies or influential persons with those companies.

Similar to s. 130, the new ss. 138.1 – 138.14 of the Securities Act[2] establish a presumption that investors relied upon a misrepresentation if they bought or sold their shares between its publication and when it was publicly corrected. Similar provisions allow actions to be brought for a public company’s failure to disclose a material change. In order to succeed, a shareholder must prove that the company or person intentionally made the misrepresentation or was grossly negligent or wilfully blind in doing so. It is notable that experts, such as auditors, can also be found liable to shareholders under this section – a marked change from the common law notion that a corporation’s auditors cannot be liable directly to its shareholders[3].

A public company sued under the new sections can avoid liability by proving that: (i) after a proper investigation, it had no reasonable grounds to believe its statement contained a misrepresentation; or (ii) the shareholder already knew of the inaccuracy of the representation when it traded its shares. Companies may also be protected when releasing forecasts to the public where those forecasts have a reasonable basis and are accompanied by appropriate cautionary language setting out the underlying assumptions and the factors that could cause actual results to differ from the forecast.

The new sections codify the calculation of damages due to a misrepresentation and cap the total liability of a company or individual for a particular misrepresentation. For a public company, the total liability is capped at the greater of $1 million or 5% of its market capitalization; while an individual’s liability is capped at $25,000.00 or 50% of their previous year’s compensation from the company. Experts’ liability is capped at the $1 million or the total compensation they received from the company during the prior year.

The legislation enacting the above provisions is expected to be in force, at the latest, by the end of this year. When that happens, it will almost certainly expand the number of securities-related class actions in Ontario and compel public companies to be vigilant in both ensuring the accuracy of information released to the public and quickly correcting any inaccurate information they do release.

Dura Pharmaceuticals, Inc. v. Broudo[4]: Last April, public companies with shares trading in the U.S. undoubtedly breathed a sigh of relief when the U.S. Supreme Court’s decision in Dura v. Broudo raised the bar for shareholders suing for damages from a public company’s misrepresentation. The Supreme Court overturned a decision below that found, similar to the Ontario court in Danier, that the plaintiffs need only establish an inflated share purchase price due to the misrepresentation in order to show that it caused them damages. This, the U.S. Supreme Court found, runs afoul of the common law requirement that a plaintiff prove that the misrepresentation was the proximate cause of its loss. Merely paying too much for shares, it found, does not cause loss unless the shareholder then sells those shares, suffers a loss on that sale and is able to establish that the loss was caused by the misrepresentation, rather than other market factors. Because the plaintiff failed to plead that anything more than an inflated purchase price was caused by the misrepresentation, its claim was struck. Dura is almost certain to have an impact on Canadian shareholder class actions, as Canadian courts tend to rely on U.S. cases for guidance in this area.

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