October 2007

  Inside This Issue:

The Supreme Court of Canada Justices’ decision in Kerr v. Danier Leather Inc., 2007 SCC 4 (Oct. 12, 2007) has put to rest a class action suit that has been going on for nine years. It has also clarified that a company and its officer and directors will not be held liable for failing to disclose material facts that become known to them after the filing of the prospectus at issue but before the closing of the offering. Liability only emerges on failure to disclose a material change post filing.

Four issues were considered by the Supreme Court of Canada Justices:

1. Whether s.130(1) of the OSA requires company to disclose material facts arising after prospectus filed?
2. Whether change in a company’s results amounted to material change requiring disclosure?
3. Whether forecast contained implied representation of objective reasonableness?
4. Whether Business Judgment Rule has any application to disclosure requirements of OSA?

Section 130(1) reads " Where a prospectus together with any amendment to the prospectus contains

In the facts provided in this case the Justices held that the Prospectus did not contain a misrepresentation at the time of filing and there was no obligation on the issuer to update the prospectus to disclose a material fact or material facts that did not amount to a "material change" as defined in section 57(1) of the OSA.

Section 57(1) of the OSA limits the obligation of post-filing disclosure to notice of a "material change", which the OSA defines in section 1 as "a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer".

The Justices held Danier did not experience a material change that required disclosure under section 57(1) of the OSA. There was no evidence that Danier made a change in its business, operations or capital during the period of distribution. The revenue shortfall instead was caused by the unusually hot weather, a factor external to Danier. A material change

is limited to changes in the issuer’s business, operations or capital. The concept is not intended to capture factual developments that may have an impact on the results that the issuer’s business or operations is able to generate but which are external developments that do not amount to a material change to the issuer’s business, operations or capital.

The Justices held that the forecast provided in the Prospectus clearly stated it was based on information available to management on a date certain and the forecast was reasonable as of that date. There was no implied representation of reasonableness or duty to update past this date. Forecasting is a matter of business judgment and disclosure is a matter of legal obligation. Issuers have no statutory obligation to make timely disclosure of intra-quarterly results of operations per se, absent a material change or contractual obligation.

The business judgment rule was confirmed by the SCC in People’s Department Store v Wise [2004] S.C.J. No. 64. In that decision the Justices held: "Many decisions made in the course of business, although ultimately unsuccessful, are reasonable and defensible at the time they are made, with high stakes and under considerable time pressure, in circumstances in which detailed information is not available. It might be tempting for some to see unsuccessful business decisions as unreasonable or imprudent in light of the information that becomes available ex post facto. Because of this risk of hindsight bias, Canadian courts have developed a rule of deference to business decisions called the "business judgment rule", adopting the American name for the rule." [para 64].

The Justices in Danier held that the traditional justifications for the business judgment rule did not apply in this case. It was their opinion disclosure decisions, unlike business decisions, were not entitled to judicial deference as to whether an issuer has made the right decision about its disclosure obligations under the OSA. The court could and should decide whether an issuer has met their disclosure obligations.

The new form would be electronically filed through a designated SEC filer website similar to that currently used to file insider reports on Forms 3, 4 and 5. The SEC would also like state securities regulators to permit this electronic filing with the SEC to satisfy state law filing requirements for offerings covered by a federal Form D filing. This new electronic filing system could provide companies with substantial savings if also adopted by state regulators. The SEC proposal is silent as to how state filing fees due in connection with the offering would be received and whether the new electronic system will include Form U-2, Form U-2A and other related state filing forms.

• adopting a new "large accredited investor" exemption (Rule 507);
• clarifying the existing definition of "accredited investor";

The proposed SEC revisions if adopted will add a layer of complication to who is an "accredited investor" for the purpose of Regulation D. The proposed changes to the accredited investor definition includes:

• adding an alternative "investments-owned" standard to Rule 501(a);
• defining the term "joint investments";
• establishing a mechanism to adjust the dollar-amount thresholds in the definitions in the future to reflect inflation; and
• adding several categories of permitted entities to the list of accredited and large accredited investors.

I am personally not that keen on this proposed definition change. Issuers will need to consult legal counsel each and every time they conduct a private placement to an "accredited investor" solely to confirm the inflation formula is correct. Regulation D should be simplified to the point issuers can read the rule and be in compliance without the assistance of legal counsel. Over 85% of the companies relying on Regulation D are private issuers.

The SEC received over 600 comments about its proposed definition of "accredited natural investor" proposed in December 2006 in conjunction for certain pooled investment vehicles in Securities Act of 1933 Rules 216 and 509 relying on Rule 506 of Regulation D. The majority of the comments were adamantly against this new definition. The SEC has made a couple of tweaks to its original proposed definition. The new definition of an "accredited natural person" would be a two-part test—investors would be required to satisfy the current standard to qualify

as accredited investors, as defined in (i) Rule 501(a)(5) or (6) for transactions under Rule 506 or (ii) Rule 215(e) or (f) for transactions under Section 4(6) of the Securities Act, and also to own at least $2.5 million in "investments," as that term would be defined in proposed Rule 509 or proposed Rule 216, as applicable.

This new definition is really only of concern to those involved in selling pooled investment vehicles. Hopefully, the SEC will make that clear when and if it revises the definition section of Regulation D.

Rule 502(a) provides that two similar offerings conducted six months from one another will not be treated one and the same offering for the purpose of Regulation D. This is particularly important when issuers are relying on an exemption that restricts the total capital to be raised or the number of unaccredited investors who may participate in the offering. The SEC is proposing to shorten the existing time frame for the integration safe harbor for Regulation D offerings from six months to 90 days to help provide increased flexibility to issuers. .

The SEC is proposing a new provision as part of Rule 502 which would bar all issuers from relying on the exemptions provided in Regulation D where the issuer, any of its predecessors, any affiliated issuers, any director, officer or general partner of the issuer, any beneficial owner of 20 percent or more of any class of its equity securities, any promoter of the issuer presently connected with the issuer, have

committed relevant violations of laws and regulations. These violations include:

• having filed a registration statement within the last five years that is the subject of a currently effective permanent or temporary injunction or an administrative stop order;
• having been convicted of a criminal offense in the last 10 years that was in connection with the offer, purchase or sale of a security or involved the making of a false filing with the Commission;
• having been subject to an adjudication or determination within the last five years by a federal or state regulator that the person violated federal or state securities or commodities law or a law under which a business involving investments, insurance, banking or finance is regulated;152
• being subject to an order, judgment or decree by a court entered within the last five years that restrains or enjoins the issuer or a person from engaging in any conduct or practice involving securities and other similar businesses, including an order for failure to comply with Rule 503 (the filing of Form D);153
• being subject to a cease and desist order entered within the last five years issued under federal or state securities or similar laws;154 or
• being subject to a suspension or expulsion from membership in or association with a member of a national securities exchange or national securities association for an act or omission constituting conduct inconsistent with just and equitable principles of trade.

The length of disqualification from reliance on Regulation D in the proposal is five to ten years depending on the nature of the violation.

Issuers purporting to rely on the exemption provided in Rule 504(b)(1)(iii) have been conducting Rule 504 offerings of non-restricted securities. It is a loophole which has been abused by some companies and promoters to conduct what is known as "pump and dump" securities frauds. The SEC is proposing amending Rule 504 to make the shares issued in such offerings "restricted securities" for the purpose of Rule 144. The SEC is also considering amending Rule 144 to provide that non-affiliates receiving restricted securities of non-reporting companies would be eligible to resell those securities after 12 months without any restrictions.

The information in this newsletter is of a general nature only about recent developments of interest to our clients.  You are encouraged to contact legal counsel before acting on any information provided.

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