Ontario Court Affirms OSC’s Disclosure Decision in Coventree

The Ontario Superior Court of Justice (Divisional Court) has upheld the 2011 decision of the Ontario Securities Commission in Coventree Inc. The Divisional Court’s reasons confirmed that decisions of the OSC in disclosure cases will be afforded considerable deference when they are appealed. The appeal decision also provides helpful commentary on the challenging disclosure issues presented by Coventree: the application of the materiality standard and the evaluation of disclosure that involves external events and the risks to which an issuer is exposed.

Background

Coventree sponsored non-bank asset-backed commercial paper (ABCP). Coventree’s initial public offering was in November 2006. The OSC’s decision dealt with Coventree’s disclosure in its prospectus regarding developments in the ABCP market and Coventree’s continuous disclosure during 2007 as challenges grew for that market, culminating in the freezing of that market in August 2007. The OSC found that Coventree breached its obligations to make timely disclosure of material changes at a number of points during this period, when Coventree’s business was adversely affected, and that its two most senior officers permitted, acquiesced in or facilitated Coventree’s non-compliance with Ontario securities law. The OSC subsequently imposed sanctions on the company and the two senior officers.

The officers appealed the OSC’s decision, arguing that the OSC applied the wrong materiality standard and took the wrong approach to evaluating Coventree’s disclosure. The Divisional Court dismissed the appeal, confirming that the OSC applied the right materiality standard and took the right approach to evaluating Coventree’s disclosure.

Materiality and the Evaluation of Disclosure

Materiality

In its jurisprudence, the OSC has articulated two different materiality standards for disclosure purposes: the "market impact" standard and the "reasonable investor" standard. The market impact standard arises from the statutory definitions of "misrepresentation," "material change" and "material fact." By this standard, information is material if it would reasonably be expected to have a significant effect on the market price or value of an issuer’s securities. This is the standard applicable to civil litigation based on the causes of action created by securities legislation. It is also the standard applicable to certain regulatory allegations, including that an issuer failed to make timely disclosure of a material change. The OSC has also established a broader materiality standard based on what a reasonable investor would wish to know in making an investment decision, a standard that is relevant to whether disclosure was "misleading" for the purpose of regulatory liability.

In Coventree, OSC staff had alleged that the issuer had failed to make timely disclosure of material changes, an allegation based on the application of the market impact standard. The officers argued on appeal that in its decision, the OSC incorrectly applied the lower, reasonable investor standard. The Divisional Court rejected this argument, finding that the OSC correctly applied the market impact standard. The appeal decision in Coventree confirms that there are two materiality standards under Ontario securities law, and that the reasonable investor standard that may be applied in regulatory proceedings is broader and therefore lower than the market impact standard. To avoid both regulatory and civil liability, an issuer will therefore have to meet both standards. The Divisional Court noted in its reasons that the market impact test is subsumed in the perspective of a reasonable investor. The reasons also provide a useful articulation of the way an issuer should consider a disclosure question that encompasses both standards: "materiality should be assessed objectively from the perspective of an investor and prospectively through the lens of expected market impact."

Evaluating Disclosure

Ontario securities law recognizes that disclosure decisions involve the exercise of judgment and are not to be assessed with the benefit of hindsight; at the same time, however, the business judgment rule does not shield disclosure decisions from ex post evaluation. The problem of the evaluation of disclosure decisions is particularly acute when the disclosure relates to risks an issuer faces during a period when the nature of those risks can be shifting and when that shifting risk may be caused by external events. These related matters arose in Coventree, where the disclosure issues were especially difficult.

The appellants argued that the OSC judged the disclosure made during the period leading up to the freezing of the ABCP market from the wrong vantage point. They argued that, at the time disclosure decisions were made about the risks that Coventree faced in a worsening ABCP market, the outcome of these developments was uncertain and therefore the OSC improperly evaluated Coventree’s disclosure choices on the basis of what ultimately happened with that market. The Divisional Court found that the OSC did not make that error in evaluating Coventree’s disclosure. The appellants also argued that the changes that were occurring in the ABCP marketplace were external events that did not need to be disclosed. The Divisional Court rejected these arguments as well.

The Divisional Court stated that external events, and the risks they pose to issuers, may be material facts that require appropriate MD&A (management’s discussion and analysis) disclosure only; however, when external events and those risks actually cause a change to the issuer’s business, operations or capital, a timely disclosure obligation arises. Similarly, even where the magnitude of the ultimate impact of a development on an issuer is uncertain, there may nonetheless be a disclosure obligation if a material change has occurred. If management believes that the final outcome of a development is uncertain and indeed may not be negative, the issuer can include that view in the disclosure it is required to make. In this respect, the Coventree case not only provides guidance on the way disclosure will be evaluated ex post, and therefore how disclosure decisions should be made, but it also serves as a reminder that a confidential material change report may be an appropriate way to address the kinds of disclosure challenges that the issuer in this case was facing.