OSC’s Coventree Decision Tightens Disclosure Standards for Canadian Public Companies

I. Overview

1. Late in September 2011, the Ontario Securities Commission (OSC) released a decision in which it analyzes in detail, deficient disclosure judgments made by Coventree Inc. (Coventree), a public company, and its officers, in relation to the market disruption that occurred in the asset-backed commercial paper (ABCP) market in 2006-7. A sanctions hearing will be held later this month. Long delays have occurred in addressing the ABCP disruption. At the end of 2009, various participants in the ABCP market agreed to settle enforcement proceedings by paying significant monetary penalties. The current decision follows an exceptionally long 45-day hearing.

2. The decision is significant because it is the latest in a series of cases decided in the last 20 years that examines the concepts of "material facts" and "material changes," this time, in the context of prospectus disclosure and continuous disclosure obligations imposed by Canadian securities rules.

3. The decision examines the following important issues:

  1. what "material fact" and "materiality" mean;
  2. what a "material change" is and when it must be disclosed;
  3. when an "external event" is a material change;
  4. when the omission of a material fact makes a prospectus misleading;
  5. what "full, true, and plain disclosure" is in a prospectus;
  6. whether a material change in the business operations of a public company can be disclosed indirectly by disclosure in management discussion and analysis, or by way of risk factor disclosure;
  7. the extent to which officers and directors can properly make judgements that:
    1. events external to a public company and outside of its control cannot be material changes;
    2. material change disclosure is premature; and
    3. that material change disclosure need not be made because of management’s subjective judgement about how the public company will handle adverse developments;
  8. what evidence a securities regulator will look at to determine the materiality of an event;
  9. when officers and directors acquiesce in a breach of a public company’s disclosure obligations; and
  10. whether honesty and good faith on the part of an officer or director will excuse making defective judgements that violate public interest standards in the securities law.

II. Facts

4. Coventree was a Canadian public company carrying on business as a niche investment bank that earned fees from structured finance and offered various products, some of which are complex.

5. ABCP is commercial paper (i.e. debt having a term to maturity of less than one year) backed by the securitized assets. ABCP is issued by the conduits in reliance on a special prospectus exemption which requires that the paper carry a rating from a recognized rating agency.

6. In the simplest case, Coventree would form a trust (conduit) and borrow money in the commercial paper market by issuing ABCP backed by securitized assets (e.g. mortgages or credit card receivables) acquired by the conduit.

7. In much more complicated collateralized debt obligation (CDO) transactions, a conduit would use the proceeds of ABCP to fund the purchase of a basket of debt securities or to synthetically create an exposure to a portfolio of such securities through the purchase of credit default swaps. The CDO business was very important to Coventree.

8. In 2007, the sole provider of ratings, Dominion Bond Rating Service (DBRS) announced, in effect, that it would not be issuing ratings for conduits holding collateralized debt obligations. Also, during 2007, there was disruption in the ABCP market caused in part, by fear that Coventree conduits had significant exposure to U.S. sub-prime mortgage assets.

9. The case turns on how Coventree handled its disclosure obligations in a prospectus and continuous disclosure documents, in light of the change in the DBRS rating policy, which threatened the ability of Coventree to form conduits to purchase CDOs with ABCP proceeds.

10. The case also concerns the propriety of certain selective disclosure by Coventree of the exposure of its conduits to U.S. sub-prime mortgage obligations in 2007.

III. Important Findings

11. The case is important because it codifies and reinforces various principles of securities law relevant to disclosure illustrates what OSC staff and the tribunal think is material evidence, and applies the principles to flawed disclosure judgements made by a group of sophisticated executives who acted in good faith and generally co-operated with securities regulators.

12. In summary, the case reaffirms the principles noted below made in various important OSC decisions spanning the last 20 years and, in some of the following, breaks new ground.

  1. Disclosure of material facts is a fundamental concern of securities law: ¶114.
  2. Material facts are different from material changes: ¶148; the latter concept is broader.
  3. Material facts are facts that objectively would reasonably be expected to significantly affect the price or value of securities.
  4. Material changes require a change in the business operations or affairs of a public company, not merely a change in the way the business is performing ¶141.
  5. The materiality standard applicable to material facts and material changes is the same. Whether the materiality standard is met depends on the issuer and the particular circumstances. Making a materiality judgment requires a subjective assessment of contextual factors like market volatility, market conditions and whether a business has changed: ¶¶151 and 156.
  6. A judgement as to whether a material change has occurred should not be made technically or super critically i.e., apply common sense and, if in doubt, disclose or be prepared to give non-technical reason for not doing so: ¶582.
  7. An external event like the changed DBRS rating is a material change if it changes the business (e.g. portends the end of the CDO business): ¶¶152, 582 and 588.
  8. The OSC as a tribunal does not need expert evidence to identify whether a material change has occurred: ¶157.
  9. The OSC cannot analyze a materiality judgment with the benefit of hindsight garnered from knowing what happened after a change occurred: ¶159.
  10. Faulty judgments about material events are not protected by the business judgment rule: they are not excused by reliance on lawyers or process and are not protected from second guessing by the OSC: ¶162.
  11. Emails and audiotapes contemporaneous with the events requiring materiality judgment will be given great weight in determining what a public company’s true sense was of the events as they transpired. In this decision, the weight given to this evidence repeatedly trumps the evidence given by the authors of the emails at the hearing of what was happening: ¶132, and to illustrate: ¶¶184-5, 322.
  12. The optimism of management, that they can handle or correct material adverse events, does not justify concluding that a material change has not occurred: ¶184.
  13. A material change has to be disclosed by material change report and by press release, and the failure to so disclose cannot be excused by relevant or similar disclosure in another continuous disclosure document or in "risk factor" disclosure in a prospectus or annual information form: ¶268.
  14. Even if a careful reading of a prospectus would yield enough information to "connect the dots" and discover the materiality of a fact or event, full, true and plain disclosure means stating plainly in one place what is material.
  15. Issuers can omit certain facts that are not material but not without risking a breach of the "full, true and plain" disclosure principle: ¶¶199 and 240-1.
  16. The fact that a disclosure does not have a significant impact on the market price of a security does not mean that a material change has not occurred. The market may through the issuer’s deficient disclosure have failed to appreciate the significance of a fact or change. Nonetheless, the value of the underlying securities may have been significantly affected: ¶354.
  17. The expertise of inside officers in interpreting securities law is not a substitute for independent legal advice: ¶654.
  18. The failure to correctly recognize a material disclosable event is a breach on the day of the failure but not normally a breach on each ensuing day that the disclosure is not made: ¶761; but the length of the failure can affect: ¶762.
  19. The test for an officer or director to share in a company breach by permitting or acquiescing in it is quite low. Acquiescence is not cancelled out by good faith or honesty or cooperation on behalf of officers or directors. The OSC seems to be rejecting the idea there can be a good faith error in discharging a disclosure obligation: ¶767.