Recent developments highlight the risks for directors and officers who trade when it is possible that a significant M&A transaction may be on the horizon. Canadian securities regulators have identified enforcement of insider trading as a priority and they are using their discretionary powers to impose sanctions in circumstances where insiders have benefitted from trading that the regulators consider is questionable even if not illegal. Recent cases involving officers of public companies illustrate the level of scrutiny regulators will apply where they think an officer may have had material information not available to the market at the time of a trade. In this environment, directors and officers should be very cautious to avoid potential liability and reputational harm.
Public Interest Enforcement Actions
Canadian securities regulators have broad jurisdiction to sanction conduct they regard as contrary to the public interest even where there is no technical breach of securities law. Two recent cases show how regulators have been using that jurisdiction to police trading by insiders.
In Re Lambert, the Alberta Securities Commission took issue with trades made by a CEO after his company received a non-binding expression of interest from a third party. The CEO had previously indicated to an investment banker that he would be receptive to considering a proposal. The expression of interest was unsolicited and contained no reference to any terms, price or the nature of a possible transaction; and no agreement on a transaction was reached until two months after the expression of interest. Those facts led the company to conclude that the expression of interest did not amount to material information. However, after the transaction closed, securities regulators brought proceedings against the CEO, who admitted, in settling the case, that his trading was inappropriate and contrary to the public interest because the facts suggested the company could in the near future be in play.
In Re Donald, the Ontario Securities Commission concluded that an officer who traded in securities of a company he knew to be a potential target of his employer acted contrary to the public interest. While at the relevant time the officer’s employer was no longer engaged in discussions with the target, it had an ongoing interest in acquiring the target and a belief that the target’s shares were undervalued. The commission took the position that trading in those circumstances "was abusive of capital markets and to confidence in the capital markets".
In the wake of Re Donald, the Securities Act (Ontario) was recently amended to expand the restrictions on trading by insiders in advance of a takeover bid or other change-of-control transaction. In Re Donald, the conduct of the officer was not technically insider trading because at the time of his trades his employer had not yet made a decision that it would be "proposing" to make a bid even though it was actively considering a potential transaction. The insider trading rules now capture trading in a target’s securities by an insider of a company that is "considering, evaluating or proposing" to make a takeover bid or other change-of-control transaction.
Materiality Determinations Subject to Second-Guessing in Hindsight
Under Canadian securities laws, it is illegal for a director or officer to trade while in possession of material undisclosed information. The market impact test for materiality—whether information, if disclosed, would have a significant effect on the trading price or value of a company’s securities—is on its face relatively simple. However, forming a view as to whether information is material can be very challenging, particularly when the information relates to a contingent or speculative event such as a potential M&A transaction. An assessment of materiality involves both legal and business judgments and is complex because no fact can be assessed in isolation and the same facts can have different implications depending on the particular circumstances. In addition, transactions rarely progress in a straightforward and predictable manner.
In Re Lambert, the receipt of an expression of interest was determined not to be material by the company’s general counsel, whose advice was confirmed by outside counsel. Based on the facts disclosed in the settlement agreement, the basis for that determination seems reasonable: unsolicited expressions of interest were common for the company and had historically never led anywhere; the expression of interest did not contain any specific transaction terms or details; and the company was not in play and had not retained any financial advisors (including the bank that had presented the expression of interest). However, looking at the facts in hindsight, enforcement staff regarded the mere expression of interest as material. While the commission did not conclude (because there was a settlement) that the expression of interest constituted material information, it nevertheless took the position that, in light of all the circumstances, the prudent course of action for someone in the CEO’s position would have been to refrain from any trading.
Directors and officers should be aware of the limitations of relying on a company’s trading blackouts to decide when it is and is not safe to trade. In both Re Donald and Re Lambert, the trading that was challenged occurred when the insiders were not in a blackout period. Blackout restrictions are self-imposed and even when a company has decided that developments do not warrant a trading blackout, individuals who trade are still open to being second-guessed by regulators who can argue, looking at the facts in hindsight, that a blackout should have been imposed. The risk of being second-guessed is most acute for senior officers and directors who may be perceived to have had more knowledge about, or the ability to influence, the negotiation of a transaction and the timing of any announcement.
A related issue concerns equity grants during a blackout period. TSX rules prohibit listed companies from granting stock options during a blackout period, and the same logic—that equity grants should be priced based on full information to avoid conferring unintended benefits on executives—applies to other forms of equity grants as well. The prohibition applies across the board and not just to those employees who are aware of the material undisclosed information. As a result, where a company is considering a significant M&A transaction, the only option may be to delay grants (which may signal something material is imminent or cause anxiety among employees) unless the company can conclude, on a basis that will withstand scrutiny in hindsight, that the facts do not amount to material undisclosed information. Interestingly, U.S. companies are not restricted in terms of when they can grant equity provided they disclose their policy to the market. It is common for U.S. companies to indicate that the timing of equity grants is predetermined and therefore they are able to proceed with normal course grants irrespective of whether the company at the relevant time has material undisclosed information (although doing so could expose directors to criticism).
Protecting Against Liability
Companies will sometimes go through periods requiring frequent judgments about whether trading should be permitted. Although in some cases it may be possible to restrict trading for long periods of time, in many circumstances that will not be practical. Recognizing the risks, companies are increasingly turning to their external counsel for comfort around trading decisions. Comfort can take the form of an opinion that it would be reasonable for the board to conclude that the facts relating to a potential transaction do not amount to material undisclosed information. An opinion of this nature requires counsel to have a full understanding of the facts and surrounding business circumstances. While lawyers cannot provide a view on whether disclosure of information is likely to move the market, they can assist in identifying the relevant facts, guiding the materiality analysis and documenting the factors supporting the company’s decision in a way that will provide good evidence in the event of a regulatory challenge. Such an opinion may be second-guessed by regulators in hindsight and, as illustrated in Re Lambert, is not a defence to regulatory liability if regulators take a different view. That said, the fact that the company relied on an opinion in deciding to allow directors and officers to trade should assist them in mitigating potential penalties.
Whenever a company is weighing whether insiders should be restricted from trading, it must also confront the question of whether the information in question should be disclosed. Disclosure is clearly a full solution to the risk of insider trading. However, in assessing whether disclosure is the right course, the board must consider all of the surrounding facts and circumstances. In many cases, that judgment will be a difficult one because the market could overreact to premature disclosure about a potential transaction and disclosure could prejudice the company’s ability to pursue the transaction. Where the board concludes that disclosure is not appropriate, it may nevertheless decide that prudence is the best approach and restrict trading.
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