Toronto-based Danier Leather Inc.
is a leading designer, manufacturer, and retailer of leather and suede clothing and accessories for women and men. The company’s merchandise is marketed under the Danier brand and is only available at its over 100 shopping mall, street-front, and power centre stores across Canada. It is, and has been for a considerable time, a financially successful company.
Danier is best known to Canadians for its frequent sleek, fashion photography advertisements. Reminiscent of a David Bailey-Jean Shrimpton photo shoot for Vogue from the mid-1960s, the fashion ads are direct, stylish, and not so subtly characterized by the sexual insolence of youth.
Danier is now best known to Canadian litigation and corporate lawyers as the decision released in May of this year by The Honourable Mr. Justice Sidney Lederman of the Ontario Superior Court of Justice. The decision has significant implications for future securities class action proceedings and corporate capital markets practice. It should be emphasized at the outset that the decision of Mr. Justice Lederman is under appeal by the defendants.
In a decision
that impacts on the entire capital market process—from the backrooms where the players structure the deals to the courtrooms where transactions unravel—Justice Sidney Lederman ruled that Danier Leather Inc. CEO Jeffrey Wortsman and CFO Bryan Tatoff were liable to investors who bought shares in the company’s $67.9 million initial public offering (IPO) in May 1998. The company and its management had breached s. 130 of Ontario’s Securities Act
by failing to disclose material facts of which they became aware between the filing of the prospectus and the closing of the IPO.
The market relevance of the decision is clear to everyone. As Susan Wolburgh Jenah, a vice-chair of the Ontario Securities Commission (OSC), notes: “Danier
deals with a lot of issues that mean something in the real world, including the dynamics of due diligence and important guidelines for those who give advice and make day-to-day decisions in the public offering process.”
Indeed, the 84-page, 374-paragraph judgment leaves little in the IPO process untouched, including issues as critical as the status of forecasts as “material facts,” the proper standard of disclosure between the time OSC “receipts” a prospectus and the closing of an offering.
Just as significantly, however, Danier
speaks to the deals that come undone—particularly the ones where investors empowered by class actions sue en masse
. As Larry Lowenstein, a senior corporate litigator with Osler, Hoskin & Harcourt LLP in Toronto, points out, “Danier
will put stock performance under very strict scrutiny from investors and the plaintiffs’ class actions bar.”
In other words, Danier
moves liability exposure in Canadian capital markets ever closer to the US model. “Some people say that US disclosure standards are more rigorous than in Canada,” says Paul Morrison at McCarthy Tétrault LLP in Toronto. “But Lederman relies very heavily on American authority to bridge that gap.”
gives real teeth to s. 130 and to disclosure obligations in general,” says Peter Jervis of Lerners LLP, who with George Glezos, Jasmine Akbarali and Melanie Schweizer, represented the plaintiffs in Danier
The case was a big win for Jervis and his colleagues. As the first action to be tried in the 30-year history of s. 130, the first securities class action to go to trial in Canada, and one of the first class actions of any kind to be heard on the merits, Danier
sends a clear message that securities class actions—still the bane of US capital markets despite recent attempts at reform—are here to stay.
—which applies only to IPOs and not to trading in the secondary market—allows purchasers of shares to claim damages if they can establish that the offering prospectus contained a misrepresentation. The section also incorporates the American doctrine of “fraud on the market.” Under this doctrine aggrieved purchasers are not required to show reliance on the misrepresentation, but instead are “deemed to have relied” on it.
It is this issue of reliance that has been a principal obstacle to attempts to certify class actions alleging misrepresentation. Most notably, the plaintiffs in the infamous Bre-X
litigation could not get around the hurdle in their attempts to sue brokerage houses involved in trading Bre-X shares. But Bre-X
was a secondary market case lacking a statutory basis for incorporating the fraud on the market doctrine and Ontario courts declined to apply the doctrine at common law.
The situation will change, however, when Ontario proclaims its civil liability amendments to the Securities Act
, known as Bill 198
. The long-awaited amendments eliminate the need to prove reliance when suing for misrepresentation in the secondary market. In other words, the US doctrine of “fraud on the market” will have arrived.
Anxiously awaiting the enactment of Bill
198 is the plaintiffs’ class action securities bar, which is still recovering from the Bre-X debacle and a few disastrous attempts at mimicking US strike suits. As pointed out by Joseph Groia at Toronto-based Groia & Company, “In some recent cases, the defence has been aggressively suggesting that Canadian courts have no time for shareholder cases. Danier puts an end to that by demonstrating these cases can be tried and they can be tried to judgment.”
To be sure, without reliance on the misrepresentation as an obstacle, plaintiffs’ lawyers will be aggressively asserting the Danier principles. Although some defence lawyers, like Robert Armstrong at Ogilvy Renault in Toronto, believe Danier is a fact-driven single misrepresentation case that will not affect secondary market litigation, they are in the minority. As Jenah at the OSC notes, “This case could well be relevant to the civil liability regime under Bill 198
What is particularly upsetting for defendants about Danier is that the judgment does not require a body count. Bad enough Lederman’s ruling that class members need not suffer actual loss to recover damages for misrepresentation, he also decided that a forecast can be a misrepresentation even when actual results bear out the predictions made. As noted by Harvey Strosberg, Q.C., of Sutts, Strosberg LLP in Windsor, “The truly fascinating part of the case is that the defendants lost even though they came so very close to beating the projections in the end.”
As well, Lederman simplified matters for plaintiffs by articulating a workable formula for calculating damages flowing from a misrepresentation. It comes as no surprise that Peter Jervis welcomes this development. “The elegance and simplicity of the damage calculation by the Court provides a consistent measure of damages that will make these securities class actions much easier to try.”
Once more, this may have implications for secondary market cases. As Jenah again points out, “Lederman’s approach, which is very impressive, is quite similar to the approach under the new civil liability regime.
is not welcome news for Corporate Canada. Paul Pape is a prominent corporate litigator in Ontario. He does not mince words respecting the significance of Danier. “Alan Lenczner (of Lenczner Slaght Royce Smith Griffin) and Ben Zarnett (of Goodmans LLP), the defence counsel on this case, are considered to be among the finest counsel in the province and they lost—not merely a certification but a common issues trial in which damages were fixed. If Lenczner and Zarnett can lose, the risks involved in a class action have risen across the board—not just in securities cases. This is going to frighten clients on the defence side and they’re going to be more nervous no matter what happens in the Court of Appeal. Plaintiffs will be able to settle class actions much more favourably.”
Or, as Barry Leon at Torys LLP puts it, “For issuing companies, Danier raises both the risk of inviting litigation and the risk of losing that litigation. The bottom line is we’ll be seeing more US style securities cases.”
Danier’s problems began
with the prospectus that the then privately held company filed on May 6, 1998 in support of its IPO. Danier’s executives certified in the prospectus that there was “full, true and plain disclosure of all material facts relating to the securities offered.”
Danier’s fiscal year ran from the beginning of July to the end of June. The prospectus set out the company’s financial results for the first three quarters of the current fiscal year, up to March 28, 1998. It also contained a future-oriented financial forecast (FOFI) for the fourth quarter and for the full fiscal year, but did not incorporate or disclose actual results for the fourth quarter to date.
The FOFI predicted a $384,000 loss in the fourth quarter but an overall profit of $4.5 million for the year. Around May 16, the company did an internal analysis that showed significantly disappointing revenues and profits for the fourth quarter to date. If the trend continued it was clear that both revenues and profits in the FOFI had been substantially overstated.
Jeffrey Wortsman (CEO) and Bryan Tatoff (CFO), however, did not believe that the trend would continue and concluded that the company’s final results would match the FOFI. They did not tell their underwriters, lawyers or accountants about the fourth quarter internal analysis. The IPO closed on May 20, 1998, seven and a half weeks into the fourth quarter, without public disclosure of the internal analysis. Danier issued its shares on the Toronto Stock Exchange at $11.25.
On June 4, two weeks after the closing, Danier issued a press release raising its fourth quarter loss to $1.1 million and reducing its annual profit to $3.7 million—both significant changes from the FOFI. The company blamed “unseasonably warm weather in most of its markets” for the downturn. Danier’s shares plunged from $11.65 following the press release, and by June 9, the price had dropped to $8.25.
As it turned out, Danier announced on July 6 that its actual loss for the fourth quarter was only $500,000 and that its net earnings for 1998 amounted to $4.4 million, practically matching the original projection. On July 29 Danier released its unaudited financial projections which confirmed the July 6 announcement.
Despite the fact that actual results virtually matched the FOFI, Justice Lederman ruled that two classes of investors had suffered recoverable losses. In both cases the losses should be measured by reference to the “post-misrepresentation price.” That price was the trading price of $8.90 on June 10, “the date that the forecast revision had been fully absorbed by the market and the market price was no longer affected by price stabilization activities (carried on by the underwriters).”
The purchasers who continued to hold or sold their Danier shares on or after June 10, had suffered damages amounting to the difference between the IPO price ($11.25) and the post-misrepresentation price ($8.90). This worked out to $2.35 per share. The purchasers who sold their shares after June 4 but before June 10 could recover their actual loss.
Justice Lederman’s decision contains several important rulings of first impression. Among them are the following:
The FOFI included an implied assertion of material fact that Danier and the individual defendants were not aware of any undisclosed facts which would seriously undermine the accuracy of the forecast;
The May 16 internal analysis was material information that seriously undermined the accuracy of the forecast;
The closing date of the IPO—the “date upon which the purchasers base their investment decisions”—was the material date for determining the truthfulness of the forecast;
The fact that Wortsman and Tatoff believed that their original forecast would be achieved (despite the internal analysis) did not relieve them of their obligation to disclose material information that would reasonably be expected to have a significant effect on the value of the shares;
The boilerplate cautionary language in the prospectus did not relieve the defendants of liability under s. 130;
The fact that the forecast was ultimately substantially achieved did not absolve Danier from liability because the closing date was the date upon which the truthfulness of the FOFI was determined; and
The plaintiffs must not have sustained an actual loss (i.e., sold the shares) in order to recover damages; rather, the proper measure of damages for purchasers who had not sold their shares was the difference between the price they paid and the value of the shares at the time of closing had proper disclosure been made.
Needless to say, the business community is not delighted with the decision. “I’ve received a number of calls from business people and MBA professors who are troubled that Danier
represents a break with reality,” says Lenczner. With colleague Craig Martin, Lenczner represented the corporate defendant Danier Leather Inc. “I agree with them. There isn’t a case in Christendom that stands for the principle that a misrepresentation can occur when you say you’ll do something and then you actually do it.”
Legal argument aside,
many corporate lawyers are of the view that Danier gives rise to considerable practical problems. Garth Girvan is a senior corporate lawyer at McCarthys in Toronto. Like Paul Pape, Girvan does not mince words. “From a practical point of view, Danier
is a dog’s breakfast and a pain in the butt. It’s one thing to contemplate an amendment for a material change and quite another thing to keep an eye out for anything that might constitute a material fact.”
Until Danier came along the investment community and its advisors believed that the Securities Act
mandated an amendment to a prospectus only if a material change—defined as a “change in the business, operations or capital of the issuer”—occurred after the OSC issued its receipt for the prospectus. Conventional wisdom was that if material facts that did not amount to a material change arose between the issue of the receipt and the closing of the IPO, disclosure was not required.
As Justice Lederman acknowledges, there was no material change in Danier. Rather, the change was in the unseasonably hot weather which affected sales. Nevertheless, Justice Lederman ruled that the obligation to disclose material facts, even if they did not constitute a material change, ran until closing. A number of litigators, such as Jeffrey Leon at Fasken Martineau DuMoulin LLP in Toronto, argue that Danier
will result in market uncertainty. “Danier
creates a moving target in terms of the information issuers have to provide. Some companies may start asking themselves whether they should be doing analyses as frequently as Danier did.”
The conundrum deepens as the period between receipt and closing is typically two weeks in Canada, creating a generous window for intra-quarter facts to emerge. Part of the reason for the delay arises from the fact that investors have two days from the time they see the final prospectus—which can only be delivered after the OSC issues its receipt—to change their minds about buying the shares.
“If investors do change their mind, underwriters have to find the money elsewhere and they need a little time for that,” says Girvan. “But now issuers are going to want to have their closing as soon as possible after they obtain their receipt.”
It is already happening. In the US closing must occur three days after the SEC issues its receipt and the American practice has entered Canadian practice via cross-border deals. As Andrew Fleming, a senior corporate lawyer at Ogilvy Renault in Toronto, points out, “Underwriters have been pushing shorter closings for some time now in order to reduce their risk.”
will also change due diligence practice. Currently the practice is to conduct due diligence confirmatory sessions only on the eve of filing the preliminary and final prospectuses. On the eve of closing underwriters require only a “bring down” certificate from issuers. The certificate merely confirms that there has been no material change that requires an amendment. The situation is changing. As noted by Stephen Erlichman at Fasken Martineau, “My view is that best practice now requires a full due diligence session on the eve of closing.”
As if that’s not enough, Peter Jervis at Lerners now suggests that the nature of due diligence will change in that issuers must disclose material facts right up to closing. “Canadian underwriters will no longer be able to avoid rocking the boat. Up until now they haven’t wanted to be a pain in the neck for fear of not getting a piece of the next deal. They’ve been taking bald answers from issuers in the form of a bring down certificate without asking for the paper to back it up. Now they’ll be expected to see actual numbers before closing.”
Those who fail to do so are playing with fire. As Paul Morrison at McCarthys confirms, “Danier
is an announcement to the securities industry that standards are higher than the industry previously believed them to be.”
Still, Andrew Fleming welcomes Danier as having a salutary effect on disclosure in the market. “What constitutes proper disclosure is usually the result of long agonizing discussions in which clients try to persuade their lawyers that certain facts are not so important. Now what I can say to them is that they should take this case as a wake-up call. They’re no longer off the hook after filing the prospectus. Their choice is simple.”
Larry Lowenstein at Oslers is very direct in his assessment. “Danier
is a huge case—a template case—from the perspective of liability for directors and officers. D&O insurers should be reading it closely.”
The difficulty lies in
Lederman’s finding that Wortsman and Tatoff had no motive or intention to mislead. Rather, they were liable because their belief that the market trend disclosed in the May 16 internal analysis would not affect the forecast was an unreasonable belief despite the fact that actual results later substantiated their optimism. Ben Zarnett at Goodmans, who with colleague Jessica Kimmell represented Wortsman and Tatoff, argues that the court’s second-guessing of experienced businessmen is troublesome. “There’s an important issue regarding the deference that courts will give to business decisions that go into things like forecasts or other judgmental statements in a prospectus.”
Complicating the liability issue is Justice Lederman’s ruling that the boilerplate cautions in the prospectus did not shield the company or the individual defendants from liability. The caution noted that assumptions considered reasonable by the company in making its forecast might prove to be inaccurate and that actual results might vary materially from forecast results.
What is certain is that future prospectuses will require different language that is much more specific to any particular IPO. What remains uncertain is precisely what that language must convey to avoid liability.
Alan Lenczner argues that the uncertainty introduced by Danier is untenable in a viable capital market. “The investment community has told me that they can’t make a move now in everyday life without dancing on the head of a pin.” Perhaps. But until Danier
is dealt with by the Court of Appeal, issuers and underwriters should pay careful attention to the dance music. There are some important new steps that are tricky.
Julius Melnitzer is a Toronto-based legal affairs writer.