Courts. v. regulators: The blurred boundaries in securities regulation

The buzz in securities circles these days is about the rise of the securities regulators. What does this do the jurisdiction of the courts? How do counsel ensure they are protecting client interests in both places?

It started in contested take-over bids and related-party transactions but is spreading into areas such as proxy access, executive compensation policies and dilutive acquisitions.

Over time, regulators have continued to extend their reach under their public-interest jurisdiction, says Edward Waitzer of Stikeman Elliott LLP in Toronto, although “the concept remains somewhat amorphous.”

Waitzer, a former chair of the Ontario Securities Commission (OSC), says the encroachment is putting boards of Canada's publicly traded corporations on shaky ground.

“On the one hand, you're saying to directors: ‘You've got statutory duties to act in the best interests of the corporation. We're going to hold you to those duties and have broad remedial powers to enforce that.'” This was the basis of the legislative and judicial powers.

Waitzer continues, “Then securities regulators step in and say: ‘We're going to decide what your duties are, not you. We're going to decide how long a pill should be outstanding. We're going to decide whether you've conducted yourself properly on a related-party transaction. And we're going to make those decisions not based on a court proceeding, where you have evidentiary discipline and a rigorous process. We're going to make it on the basis of a casual one-day or half-day hearing where there's no formal evidence. Oh, and we're bringing the proceeding, not shareholders.'

“You end up undermining the responsibility of directors, who just say; ‘Okay, we'll do whatever the commission tells us to do.' Somebody needs to step back and redefine the boundaries because they're getting very blurred.”

This issue hasn't yet attracted much attention but Waitzer says it should. He is among those calling for a fundamental policy reexamination in Canada. And practitioners are increasingly concerned that the lack of clear borders is harming their ability to steer clients' issues with accuracy.

Tension is building.

Some observers blame shareholder activism for upsetting the equilibrium. As the movement gains ground in Canada it has given rise to more stringent governance practices which, in turn, appear to have triggered a power struggle over who is actually driving the bus, shareholders or the board.

Traditionally both parties had distinct roles and obligations. Directors ran the business and affairs of the corporation and were subject to statutory duties, while shareholders had the right to elect and remove directors and had statutory remedies.

Their interests are generally the same — but not always.

When boards and their largest shareholders clash, Canadian securities regulators, with their emphasis on investor protection, come down hard for shareholder choice. Corporate law defers to the business judgment of the board.

Two different sides, two different kinds of champions.

A problem? Some people think so.

If you wonder why securities regulators are stepping in earlier or more often, the answer might surprise you. It's partly because they can — and partly because they're being asked to.

Stepping back for a moment, securities law traditionally focused on the world outside the corporation. Regulators governed efficient market integrity and efficiency, protecting investors from unscrupulous brokers and promoters. Courts meanwhile, interpreted corporate matters that happened inside, from directors' duties to shareholder rights.

Those borders started to crumble when regulators assumed responsibility for protecting minority shareholders in related-party transactions. They then expanded that to situations like take-over defences.

Will it prove to be a slippery slope?

In fairness, according to the OSC's own assessment, as reported in The Globe and Mail, it “launched fewer new enforcement cases last year, but completed a far larger total of outstanding cases and won more jail terms for offenders. The commission's annual enforcement report shows it began 27 new cases in 2013, a slight reduction from 30 new cases in 2012.” Some practitioners then, would have a basis to disagree that securities commissions are displacing courts.

However, Waitzer says the way things went down when Magna International proposed collapsing its dual share structure speaks volumes.

It's a case he acted on and, like so many other Canadian deals these days, it was done as a plan of arrangement, which requires the purchaser to go to court for a fairness hearing after the shareholders vote.

A number of Canadian pension funds opposed the transaction on the grounds that company founder Frank Stronach would receive a 1,800 per cent premium for giving up control. Two weeks after the circular was mailed, the Ontario Securities Commission called a hearing, alleging the deal was contrary to the public interest.

The two-day OSC hearing was filled with squabbling. Ultimately, the OSC rejected arguments that Magna's board had failed to comply with its fiduciary duties, and found there was no reason to conclude the transaction was abusive of common shareholders. But it ordered Magna to provide additional disclosure, which the company did.

The proposal went to a shareholder vote and was approved by 75 per cent of the minority class A shares.

The institutions against the deal again voiced their concerns before a judge at the fairness hearing but, by then, the regulator had already found the transaction was not abusive and a majority of shareholders had approved it. The issue of substantive fairness had largely been subsumed by the question of disclosure.

It's not the only case in which courts have extended this level of deference to the securities commission.

The commission found inadequate disclosure, coercive and abusive conduct by a controlling shareholder seeking a privatization in In Re Sears Canada Inc. The court dismissed an application for judicial review, noting in its reasons that the standard of review of reasonableness “encompasses ‘the right to be wrong.'”

That highlights the problem, says Waitzer. “I think it annoys the courts because once a specialized tribunal adjudicates something, even if it's a matter of corporate law, they're supposed to defer. There is some unhappiness at having the commission step in ahead of them so they have to step back even though they think it may be bad law.”

Securities commissions don't need to protect minority shareholders to the same degree they once did, he says, because they now have access to the oppression remedy, an increasing number of business-savvy judges and to jurisprudence such as BCE Inc. v. 1976 Debentureholders, in which the Supreme Court of Canada expanded the scope of a director's fiduciary duties to all relevant stakeholders.

“Yet they still see themselves as the agent of investors even if it does investors a disservice, as it clearly did in Magna or a number of other cases where the commission shut down poison pills prematurely,” says Waitzer.

“Basically, the commission is second-guessing boards who are exercising their duties under corporate law.”

And that, he says, may be preventing the development of more rigorous judicial oversight of board conduct and the development of better corporate law.

Issuers and activists may not be the only ones at odds over the role of the regulators versus the courts. There appears to be an internal split inside Canada's securities commissions, says Jeffrey Leon, co-chair of litigation at Bennett Jones LLP in Toronto.

“I think what's happened on the corporate finance side of securities regulators is they're pushing these issues on to the board and presumably then to the courts, whereas the enforcement side of the commissions are getting more into corporate-law issues under their public-interest jurisdiction. You now have enforcement staff taking a much broader view of that.”

One thing is clear, he says. The longtime belief that conduct had to be abusive of capital markets to trigger a public-interest hearing has eroded. “The commissions - Ontario in particular – seem to have retracted from that, indicating in the Biovail case in particular that you don't have to have abusive conduct in order for it to be found contrary to the public interest.

“What that's done is spurred on enforcement staff to take an increasingly proactive approach relying on the public-interest power.”

Magna, he says, was just another example. “Before Magna, you used to be able to think the conduct has to reach an abusive standard before you tripped the interest of the securities commissions. Now you can't say that.

“Just about anything that staff thinks wasn't a nice thing to do may be the subject of an allegation of acting contrary to the public interest. It creates so much uncertainty and ambiguity that I think, in effect, it runs contrary to the public interest.”

The problem is that the lack of clarity makes it challenging to provide the right guidance to clients.

“Often I'll get brought in to give advice on whether something is likely to attract concern by commission staff, or, if we do it a certain way, is it likely to give rise to a challenge in the courts. You like to be able to rely on your experience and knowledge to apply judgment and give an answer. To the extent there is this shifting, it becomes much harder.”

When Sharon Geraghty, a partner at Torys LLP in Toronto, is working on a public-company deal that may have issues, one of the first things she does is to bring in one of her firm's litigators.

“Absolutely. If you're in a situation, and this happens so much in M&A, where we think someone might challenge what we're doing, we will definitely sit down and look at what we think is the best place for our client to be – where we will get the right result – and try to figure out how to get it there.”

Geraghty explains, “Securities regulators sharply put their stake in the ground in favour of shareholder primacy, which the institutional investors very much favour and like.

“The issuers, on the other hand, have very good arguments that shareholder primacy is not the right thing. They focus on the corporate law. They point to BCE and say quite rightly that the courts take a more deferential approach to boards.

“So their view is that corporate governance has really improved, so you should be trusting the board. They want securities regulators to get out of this space and leave it to the courts.”

Whichever way it falls out, she says, the outcome of this tug-of-war will have “a huge impact” on Canada's capital markets.

“It's such a fast-moving area you need a lot of sophistication in deciding how to deal with these issues. I think our securities regulators have great sophisticated people who understand the market and have an appreciation of how deals work and how boards work and how institutions work. The problem is they have this narrow focus on shareholder primacy, a very narrow range of remedies to apply, and a process they themselves think is not adequately suited to a great fact-finding mission.

“They don't have the ability of the courts to get the range of evidence, to really get to the root of issues, and when they do they don't necessarily have the tools in the tool chest to deal with them. Those are all big impediments to leaving this to securities regulators.”

It's not as though the courts are perfect either, she quickly adds, saying “they don't have a great track record” dealing with corporate governance issues.

“They can be very deferential to the board where perhaps they should be asking questions, and they don't always seem to have appreciated the inherent conflict of what the board is grappling with. That is an issue.

“It's a problem because institutional investors have developed this mistrust of boards.”

There's no area where investor mistrust of boards has been closer to the surface than contested take-over bids and defensive tactics, where shareholders may suspect an offer is being turned down by directors wanting to entrench their board positions.

Securities commissions have been quick to jump into the fray. As a result, boards exercising their statutory right to rebuff a bid they feel is too low regularly face regulators stepping in to cease trade their poison pill as being detrimental to shareholders' right to sell the company.

That is about to change.

Last March, the Canadian Securities Administrators (CSA) and Quebec's Autorité des marchés financiers (AMF) both put out proposals that would see regulators step back in these situations.

The CSA has proposed rights plans be permitted to remain in force provided a majority of shareholders support it.

Quebec goes further, saying this is a perfect opportunity to do a more in-depth reform of the take-over bid regime – a call made by Waitzer and partner Sean Vanderpol in 2010.

Francis Legault, a senior partner at Norton Rose Fulbright Canada LLP in Montreal, analyzed the 74 response letters submitted to the competing proposals and found 57 per cent of respondents – the vast majority – were in favour of the AMF approach; 15 per cent were in favour of the more limited CSA proposal and 2.7 per cent were happy with the status quo, with the remainder either wanting different changes or more time to respond.

Quebec caught most people off guard at the end of February when Finance Minister Nicolas Marceau announced in the budget the government planned to amend the province's Business Corporations Act to give public companies incorporated in Quebec new power to block hostile take-overs.

The reforms will come from recommendations made by a task force on the protection of Quebec businesses, which recommends, among other things, giving shareholders who have owned the stock for at least two years a second voting right for each share and barring companies that succeed in a hostile bid from selling more than 15 per cent of the target's assets for five years after the fact.

The announcement made it clear Quebec will not wait to dovetail its reforms with the rest of Canada, although it was not clear whether the PQ government proposals would survive an election call.

There is yet another complication in this fight over who should regulate what. Industry Canada has proposals out for comment on modernizing the Canada Business Corporations Act (CBCA) that would put corporate law right back in the ring.

The consultation paper gets right to the point, raising questions such as whether corporate governance should be dealt with in the CBCA or securities regulators and stock exchanges. It also asks whether the statute should be more rigorous regarding publicly traded corporations and expand into areas such as mandated board diversity, take-over bids, corporate social responsibility and creating a role for shareholders on dilutive transactions.

Legault says some of the proposals, if accepted, would just create more overlap. He points to say-on-pay. “They're proposing a shareholder advisory vote on compensation packages and I think most people's reaction is that this is something securities regulators are already doing, mandating very detailed disclosure with respect to executive compensation.

“So, let me understand this. Disclosure is part of securities regulation, but say-on-pay would also be embedded in a CBCA statute?” He pauses. “Why?”

He's also asking why Ottawa is now considering weighing in on things like voting for individual directors as opposed to slates and imposing a maximum one-year term.

“Those things are already covered off by [Toronto Stock Exchange (TSX)] rules. It's strange because their consultation paper doesn't acknowledge that this stuff is already covered off by TSX rules that apply to Canadian TSX-listed companies. It's really strange.

“The proposed CBCA amendments cover all sorts of things. They cover over-voting and empty voting, looking for reaction, even as we have consultations by the Canadian Securities administrators on improvements to the back office on voting public-company shares. So there's a disconnect. The problem is it causes confusion in market participants.”

Legault is blunt. He hopes the revised CBCA does not beef up its oversight as it's hard to report to two masters. “With Canadian securities regulators occupying that field nowadays, and with TSX rules focused on governance, anything done under the CBCA has a significant risk of overlap and puts an additional burden on issuers. It's something that we'd like to avoid.”

There are lawyers who do see that there is a role for both the court and the regulator and says they are complementary rather than in conflict. Lawson Lundell LLP's John Smith is one. He does not consider that securities commissions are wading into disputes just because they can. He points to Telus and Canadian Pacific, both feisty battles between activists and boards, and says the regulators didn't get involved in those.

“I would take a lot of persuading to believe that the OSC has said they are going to look at every circular that goes through on contentious things and decide whether they want to hold a disclosure hearing. I can't believe that's what they want. They don't have the resources to do it, apart from everything else.”

Asked about Magna, he calls it “the interesting example. I would categorically say that to the extent the commission focused on making sure there's full disclosure by whatever means and at whatever stage in the process, that's completely within their jurisdiction. But it's a very big step for them to go beyond that and say they will adjudicate on their fairness of the transaction. That is not their job.”

The Ontario Securities Commission did, however, make a finding that the transaction was not abusive. He says that may have stirred a hornet's nest and answered the question of why this issue is suddenly causing so much buzz in business law.

“When you look at the Magna decision, it does go into the question of whether it's abusive, even though as an arrangement transaction the court was already obliged to engage on whether the transaction was fair. So it was already set for that hearing before the court.

“In this case, people probably feel fairness was being addressed by the court and why was the commission coming in. So I can imagine people saying so what business does the commission have getting involved? My guess is that's what's got people riled up.”

If regulators are jumping into the process before a transaction goes before the court it's because securities commissions have been much faster on their feet to modernize and change with the times, says Kent Kufeldt, regional leader of the Western Canada securities and capital markets group at Borden Ladner Gervais LLP's Vancouver and Calgary offices.

There are good reasons why it may actually be preferable to go before the commission, he says. For starters, in most provinces there is no guarantee the judge assigned to hear the case will have the business savvy or the experience to deal with a complex commercial matter. “I think there's sometimes a reluctance to roll the dice on judges,” says Kufeldt. “So you go to the regulator. At least with the regulator that's all they do.”

Also, until a regulatory hearing gets underway, counsel can pick up the phone and explain the client's position to staff — especially if it's felt something is not being properly understood.

“Absolutely,” he says. “Once you're before a panel of the securities commission it's very much like a court. But in the interim, when you're dealing with staff, there's an opportunity to have a conversation. And one thing that scares people off is court decisions are black and white. You have to be prepared for that. If you go to a panel, through the process I think there's an opportunity to reach a consensus or work out a solution.”

Kufeldt welcomes proposed changes to the CBCA as the corporate legislation “is not modernized and updated very often. I'm an advocate of refreshing and modernizing those positions. Whether it eliminates the disconnect, or dysfunction, between securities commissions and the courts, I don't know.

“I think there's always going to be some tension. They both have legislative mandates and there is this overlap so I'm not sure we'll ever be able to get rid of it.

“It would be nice if things were aligned a little bit better, that's why I'm in favour of a modernization of corporate law, so we catch up with the times.”

But Edward Waitzer says that it is securities regulation that may need modernizing in this instance.

“Ultimately, the debate is about corporate governance — who is best positioned to and should bear responsibility for mediating competing interests within the corporation. Corporate law places that responsibility on directors and holds them to high standards, particularly if there is any conflict of interest.

“By mechanically second-guessing the business judgment of directors, often with imperfect information and in inconsistent ways, securities regulators have upset that corporate law construct.

“At some point, the tension will have to be resolved.”

Sandra Rubin is a Toronto-based writer and strategic consultant.