Danier, D&O and Disclosure

The Supreme Court of Canada rendered a decision on Oct. 12 that brought to conclusion a nine-year, precedent-setting legal battle between Danier Leather Inc. and a class action group of investors.

Directors and officers’ (D&O) insurers may take away a number of key points from Kerr v. Danier Leather Inc. First, directors and officers will need to be increasingly attentive to their disclosure requirements since, post-Danier, the “Business Judgement Rule” is unlikely to protect them as a substitute to their legal obligations. Second, while it may not have an immediate material impact on the D&O marketplace in Canada, Danier has created the potential for increased litigation costs should more cases ultimately proceed to trial; for example, the cost award against the plaintiffs in Danier may embolden the defence bar to pursue a trial rather than early settlement. Finally, should litigation increase, both in terms of time and cost, D&O insurance policy terms might be subject to increased scrutiny.

DANIER: THE BACKGROUND

In Danier, the plaintiffs, a class action group of investors, were initially successful at trial. But the Ontario Court of Appeal later overturned the trial judge’s decision, and the Supreme Court of Canada ultimately upheld the appellate court’s ruling.

Primarily at issue was whether the company and its executive team had violated certain securities disclosure laws. The case was precedent-setting: it was the first trial in Canada of a class action lawsuit related to the civil liability of corporations making an initial public offering for misrepresentations in a prospectus.

The decision of the Supreme Court effectively highlighted three key issues:

Scope of Liability:

Disclosure of a “Material Change”

In attempting to hold a corporate issuer liable for either misrepresenting information in a prospectus or for failing to disclose certain information, a determination must be made whether or not the information is a “material fact” or a “material change.” Both are defined terms under the Securities Act.

In interpreting the Securities Act, the Supreme Court held that material facts must be disclosed up to the date the prospectus is finalized or receipted. Material changes, on the other hand, must be disclosed between receipt and closing.

Effectively, this means once a prospectus has been filed, failing to disclose information that amounts to a material fact will not give rise to liability for misrepresentation in a prospectus. Material changes, however, are distinct: unlike material facts, they do require disclosure. In the circumstances of the case, the court determined a change in intra-quarterly results did not constitute a material change — defined in the Securities Act as a change in relation to the business, operations or capital of a corporate issuer — and therefore Danier was under no obligation to advise of the suspected poor results. What many have seen as a curious irony is that Danier was ultimately substantially successful in meeting its original financial forecast, as provided in the initial prospectus.

Application of the Business Judgment Rule

Historically, the “Business Judgment Rule,” a concept developed out of the common law, essentially holds that as long as the decisions made by a business and its executive team fall within a range of reasonableness, the courts are reluctant to substitute their judgment for that of the corporation and its directors. In this case, the Supreme Court of Canada considered whether the Business Judgment Rule has any application to the duties of disclosure that a corporate issuer may have under the Securities Act. Interestingly enough, the court held a distinction must be drawn between a “business decision” and a “disclosure decision.” Although business decisions may have a range of reasonableness, disclosure decisions do not, since they involve the application of a defined legal standard. As a result, the court ruled that disclosure decisions do not have the protection of the Business Judgment Rule.

Costs in Class Action Litigation

The class action litigation regime, when originally designed, was done so at least in part as a means to ensure access to justice for those who may not be able to afford the high cost of litigation. As such, the Class Proceedings Act gives the court discretion to decline awards of costs against unsuccessful representative plaintiffs. A significant development in this case was the Supreme Court’s holding that, having lost the case, the representative plaintiff was responsible for the legal costs of the successful defendants. In the Supreme Court’s words, “protracted litigation has become the sport of kings in the sense that only kings or equivalent can afford it. Those who inflict it on others in the hope of significant personal gain and fail can generally expect adverse cost consequences.”

DANIER: IMPACT ON D&O INSURANCE

Litigation Costs

The focus of most reaction to Danier has been with respect to the Supreme Court’s cost ruling. Some have speculated that the court’s decision to decline to relieve the unsuccessful plaintiff of its cost obligation — some say that obligation will be well in excess of Cdn$1 million — might result in a significant reduction in plaintiff class action lawsuits. Such a focus might be an oversimplification, since the case has the potential to impact the D&O insurance market in several ways.

First, despite the skeptical view that most class action suits are “frivolous” and mercenary in their objective, the Canadian class action litigation environment has not, for the most part, borne out this view. The Canadian plaintiff’s class action litigation bar appears to be somewhat more measured and strategic in its approach, which might explain the lower claims volume in Canada than in the United States, for example.

Furthermore, Danier is not the first class action lawsuit in which cost awards have been granted to successful defendants. It is worth noting, however, that such historical experience does not mean the Canadian class action litigation landscape will remain the same. One “disappointing” result for the plaintiff’s class action bar is unlikely to be enough to dissuade future litigation opportunities, particularly given recent amendments to the Securities Act and the creation of the secondary market liability regime (previously known as Bill 198).

Business Judgment Rule

Second, the Supreme Court’s ruling that the rationale behind the Business Judgment Rule — and the reluctance of the courts to interfere with reasonably-made business decisions — does not apply when it comes to disclosure decisions, and could have a greater impact than its “cost award” decision. The court’s reasoning could have a significant ripple effect on other circumstances and legislative regimes that involve appropriate and timely disclosure decisions (such as what is required under the secondary market liability regime), in that the protection of the Business Judgment Rule may not exist. Assessments by directors and officers related to “disclosure” decisions, which involve the application of a legal standard, are nevertheless difficult to make. Without the “safety net” defence of the Business Judgment Rule, decision makers may be more vulnerable.

Class Action Volume:

Up or Down, post-Danier?

Third, rather than dissuading class action litigation or limiting its volume, the impact of Danier for the Canadian D&O market may be that, given Danier’s successful defence, more suits will go through the full trial process and to final judgment rather than be settled earlier on. If the experience in the United States is an indicator, the vast majority of D&O lawsuits are resolved well before trial. Quite often the reason for this is that defendants wish to avoid heavy legal costs and potential cost awards associated with going to trial despite the strength of their defence. After Danier, however, the trend in Canada may be that plaintiffs bring cases that they inherently feel have strong merit and defendants may be willing to pursue their defence with equal vigor. Defendants may be willing to defend for longer periods, knowing that should they be successful, their defence costs may become the liability of the plaintiff. Settlement may not require the same sense of urgency as in pre-Danier circumstances.

EFFECT ON D&O TERMS AND CONDITIONS

Finally, a number of D&O policy coverage conditions may come under greater scrutiny by both insureds and insurers after Danier. For example, the existence of so-called ‘hammer clauses’ in some policies may become much more prominent in practice. Such clauses typically limit an insurer’s costs in the event they support a settlement position on a particular claim while the insured does not. If indeed more cases go to trial as a result of Danier, ‘hammer clauses’, as well as their impact on decisions as to whether or not to settle a case early, would need to be very carefully considered at the time the policy terms are being negotiated.

Other terms and conditions could also become increasingly important, including how allocations of costs are determined under a D&O policy. In all likelihood, pre-determining cost allocations up front in any policy negotiation will be critical. In addition, how insurers use deductible strategies in an effort to help them manage a trend of increasing defence costs will also become an important issue that insureds and their advisors will need to review carefully. The ‘personal conduct’ exclusions in D&O policies may also take on a greater significance, in addition to whether or not applicability of theses exclusions should be based on ‘in fact’ or ‘final adjudication’ language.