Prospectus Forecasts and the Business Judgement Rule: Danier Case

Background
Trial Decision
Court of Appeal Decision

In an eagerly awaited decision the Ontario Court of Appeal has reversed the May 2004 ruling of Justice Sidney Lederman in Kerr v Danier Leather Inc, which had held that Danier and certain of its senior officers were liable to investors for a misrepresentation relating to an earnings forecast included in a prospectus.

The Court of Appeal's decision in Danier is important because the Court of Appeal clarified that, under the Ontario Securities Act, a prospectus is required to provide full, true and plain disclosure of all material facts only as of the date of the prospectus (not the date of closing), and issuers are required to amend it for material changes, but not for material facts. The court further strongly endorsed what is referred to as the 'business judgement rule'.

Background

In May 1998 Danier (a manufacturer and seller of leather clothing and accessories) undertook an initial public offering of its shares. 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 the offering closed but after the final prospectus had been filed, showed that Danier's fourth-quarter revenue and earnings were lagging behind a front end-loaded internal store budget. However, on the date of closing Danier's senior management still believed that Danier could achieve the forecasted results, in part because of two planned sales promotions scheduled for the last six weeks of the fiscal year: the annual Victoria Day sale and a June promotion.

The Victoria Day sale began the day after the offering closed. Unfortunately, the results of the sale were disappointing. Upon considering the results and investigating the matter further, Danier's chief executive officer concluded that the unexpected low sales were due to unseasonably hot weather across Canada. He told the underwriters that if the unseasonably hot weather continued, he could no longer be confident that Danier would meet the forecast. Danier's lawyer recommended that Danier assume the worst (that the hot weather would continue into June), and that the company prepare and file a revised forecast (under then National Policy 48) with the Ontario Securities Commission, which it did.

Danier's announcement of the revised forecast precipitated a significant temporary decline in its share price on small volumes. However, the weather later cooled and Danier's sales rebounded. By the end of the fiscal year, Danier had substantially achieved its original forecast.

Nonetheless, the plaintiffs began a class proceeding for prospectus misrepresentation under Section 130(1) of the Securities Act.

Trial Decision

After a lengthy trial, Lederman found Danier and certain of its senior officers liable for statutory misrepresentation regarding the forecast.

The trial judge's finding of liability was based primarily on the following conclusions:

• The poor fourth-quarter revenue and earnings occurring after the prospectus was issued were material facts that Danier was required by the Securities Act to disclose before closing (although they were not a material change).
  
  
• The prospectus implied that the forecast was objectively reasonable both on the date of the prospectus and on the offering's closing date.
  
  
• Due to Danier's failure to disclose the poor fourth-quarter results, this implied representation, although true on the date of the prospectus, became false on the closing date.

Having found Danier and its senior officers liable, the trial judge awarded substantial damages, using the fall in Danier's share prices as the prima facie measure of that award.

Court of Appeal Decision

In its decision, released on December 15 2005, the Ontario Court of Appeal reversed Lederman's finding of liability against Danier and its senior officers and dismissed the class action. In particular, the court held that the trial judge erred in:

• concluding that Danier had a continuing obligation to disclose material facts occurring between the date of its prospectus and the date of closing when no material change had occurred;
  
  
• concluding that Danier's prospectus contained the implied representation that the forecast in question was objectively reasonable; and
  
  
• failing to give any deference to the business judgement of Danier's senior management and to take into account that the forecast was substantially achieved.

Disclosure ruled sufficient
The court held that Danier had complied with its disclosure obligations by filing a prospectus which was true on its date and by not filing any amendment to the date of closing of the offering, as no material change had occurred. The court rejected the trial judge's interpretation of the Securities Act that issuers have an obligation to update all material facts to the date of closing.

Business judgement rule strongly endorsed
The court held that the trial judge erred by failing to give any deference to the business judgement of Danier's senior management. On this point, the court emphasized that the 'reasonableness' that is the centrepiece of the business judgement rule involves a "range of reasonableness".

The court went on to quote the following passage from a previous court of appeal decision (a passage also recently quoted by the Supreme Court of Canada in the Peoples Department Stores Case):

"The court looks to see that the directors made a reasonable decision, not a perfect decision. Provided the decision taken is within a range of reasonableness, the court ought not to substitute its opinion for that of the board even though subsequent events may have cast doubt on the board's determination. As long as the directors have selected one of several reasonable alternatives, deference is accorded to the board's decision. This formulation of deference to the decision of the board is known as the 'business judgment rule'."

Adopting this approach, the court held that while the senior officers' view regarding the forecast might have been optimistic, it deserved deference because it represented "one of several reasonable alternatives" and was "within a range of reasonableness".

At a time when directors and officers of Canadian companies are increasingly concerned about liability, this strong endorsement of the business judgment rule by the Ontario Court of Appeal should provide some level of comfort.

For further information on this topic please contact Scott Bell, Paul Goldman or David Redford at Goodmans LLP by telephone (+1 604 682 7737) or by fax (+1 604 682 7131) or by email (sbell@goodmans.ca or pgoldman@goodmans.ca or dredford@goodmans.ca).