Defending D&O

Not long ago, an investor only had statutory recourse for misrepresentations made by an issuer in the prospectus when the investor participated in the offering that flowed from it (“primary market statutory civil liability”). This appeared ready to change on August 2, 2005, when the Government of Ontario announced that provisions with respect to the secondary markets introduced in Bill 198, “Keeping the Promise for a Strong Economy Act (Budget Measures)” (“Bill 198”) would take effect as of December 31, 2005.

Bill 198 significantly amends the Securities Act (Ontario)(“OSA”). It creates statutory civil liability for secondary market disclosure, expands enforcement powers of the Ontario Securities Commission (OSC) and establishes new offences and increased penalties for violations of Ontario’s securities law. The amendments to the OSA establish a statutory cause of action for persons who acquire or dispose of securities from third parties in the market (“secondary market statutory civil liability”) by granting these parties a right of action for misrepresentation or failure to make timely disclosure regardless of whether they actually relied on the misrepresentation or failure to make timely disclosure of any material change.

The amendments set out specific limits for damages available to a successful plaintiff; however, these limits are not set in stone. If a plaintiff proves the company or the individual defendant had knowledge of the violation of the OSA, then the damage caps no longer apply. No longer will a plaintiff have to show the courts there was reliance on the misrepresentation or failure to disclose the amendments make it clear that reliance is no longer necessary to prove liability. While the legislation creates the right of action, the courts still must grant leave to a plaintiff before the action can proceed. To obtain leave, the court will require a plaintiff to demonstrate a reasonable possibility of success at trial and that the action is brought in good faith.

Plaintiffs who choose to proceed under these new remedies can still seek recourse through any other statutory or common law remedy available to them, such as oppression remedies under the Ontario Business Corporations Act.

MISREPRESENTATIONS: DOCUMENTS AND PUBLIC ORAL STATEMENTS

The misrepresentation provisions in the OSA reference both documentary disclosure and public oral statements. The amendments define “document” broadly as any written communication (including electronic communication) filed with the OSC or any government or stock exchange, as well as any communication where the content could reasonably be expected to affect the market price or value of a security of the issuer. Given this broad language, almost any form of public communication will fall within the OSA.

Under the secondary market provisions, when a publicly disclosed document containing a misrepresentation remains uncorrected or when a misrepresentative public oral statement is made, individuals who are liable for losses incurred by investors trading in securities of the reporting issuer may include:

* Issuers;

* Directors of the issuer at the time the document was released;

* The person who made the public oral statement that contained the misrepresentation;

* Directors and officers who authorized, permitted or acquiesced in the making of the public oral statement;

* Officers of the issuer who authorized, permitted or acquiesced in the release of the document;

* Influential persons (i.e., a person in control, promoter, insider or investment fund manager) and each director and officer of an influential person, who knowingly influenced the release of the document or public oral statement which contained the misrepresentation; and

* Experts, such as an accountant, actuary, appraiser, auditor, engineer, financial analyst, geologist or lawyer, who consent in writing to the report, statement or opinion being used in a document or public, oral statement that is released to the public if their report, statement or opinion contains a misrepresentation.

FAILURE TO MAKE TIMELY DISCLOSURE OF A MATERIAL CHANGE

A material change is a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on market value of an issuer’s securities. The right of action exists regardless of whether or not the person or company relied on the responsible issuer having complied with its disclosure requirements. Possible defendants include:

Issuers

* Directors and officers of the issuer who authorized, permitted or acquiesced in the failure to make timely disclosure; and

* Influential persons who knowingly influenced the failure to make timely disclosure; and

* Directors and officers of an influential person who knowingly influenced the failure to make timely disclosure.

Damages and Limits on Liability

Perhaps the most significant issue is the exception that can lead a plaintiff to recover more than the set liability limits (for example, when a plaintiff establishes that the defendant had knowledge of the misrepresentations or failed to disclose material changes). Unlike existing common law and statutory remedies, where compensation of the aggrieved party is the primary objective, Bill 198’s primary policy objective is to improve the quality of secondary market disclosure. This is achieved by creating an additional incentive for market participants to diligently and rigorously comply with their disclosure obligations. Subject to the qualifications referred to above, the total damages payable by a defendant are subject to the following limits of liability:

* The total liability of an issuer or corporate influential person is the greater of 5% of its market capitalization and $1 million;

* The total liability of a director or officer of an issuer or an influential person, an individual influential person or a person who made a public oral statement, the greater of $25,000 and 50% of the aggregate of the person’s compensation from the responsible issuer (or influential person); and

* The total liability of an expert is the greater of $1 million and the total revenue the expert would have earned from the issuer during the 12 months preceding the misrepresentation.

Defences

The amended OSA contains and defines a number of defences available to defendants, including:

* Reasonable Investigation;

* Prior knowledge of the Misrepresentation by Plaintiff;

* Forward-looking Information / Safe Harbour

* Core/Non-core Documents and/or statements; and

* Reliance on Expert’s Reports

Class Actions

The new legislation removes a significant obstacle to the certification of shareholder class actions – namely, the requirement that the investor actually and reasonably relied on the inaccurate disclosure by the defendant. This, coupled with the inapplicability of the limits of liability where a plaintiff proves that the person or company knowingly authorized, permitted or acquiesced in the making of the misrepresentation or failure to make timely disclosure, creates significant potential liability exposure for corporate defendants. The result is a possible increase in class actions framed in such a manner. That being said, with cost sanctions available against unsuccessful plaintiffs and leave of the court required to commence the action, there are bars to “strike suits” within the legislation.

Possible underwriting changes

The Directors and Officers underwriting community has yet to give direction as to how it intends to approach these new amendments; however, one anticipates the amendments may
result in increased interest and inquiry in the following:

1. Insured’s disclosure policies and internal controls for reporting material changes.

2. Insured’s disclosure procedures, including asking such questions as:

* Are the disclosure procedures reviewed regularly?

* Are they reviewed by the Audit Committee?

* Is there an internal Disclosure Committee

comprised of senior individuals representing the legal, finance and sales departments?

3. Insureds’ record retention policies and procedures (stressing the importance of making and retaining electronic or other records of public presentations and oral statements).

4. Whether insureds have checks and balances to identify a misrepresentation and a process for correction.

5. Underwriters may start to seek communication with clients’ outside counsel to understand compliance with an appropriate disclosure policy, as well as to demonstrate risk management strategy.

The purpose of the amendments is to encourage investor confidence in the markets by demanding a higher level of corporate governance and expanding the responsibilities and accountability of corporations and their Directors and Officers. Therefore, publicly traded companies and their Directors and Officers must take measures to control their liability. Such measures should include implementing appropriate corporate governance practices and ensuring adherence to these practices. As well, adequacy of the corporate indemnity provisions and Directors and Officers insurance (both amount of limit and form of coverage) are crucial to ensure that maximum financial protection for both individual assets and the company’s balance sheet exist.

Expectations are that pleadings will include allegations of knowledge on behalf of the defendants in order to make an end run on the damage cap provisions. However, we must await the interpretation and application of the amendments to the OSA by the Ontario Securities Commission and courts. Until the case law develops and insurance carriers opine on coverage, it remains difficult to assess the impact of the amendments. What is certain is that change is coming and the insurance and business communities must prepare for it.

Disclaimer:

The summary of the legislation contained in this article is provided for information purposes only and should not be relied upon as legal advice, which the author is not authorized to provide. Readers should consult their own legal and financial advisors as to the full operation and scope of the legislation.