Recent guidance on selective disclosure in the necessary course of business
A recent decision from the Ontario Securities Commission (“OSC”) provides the first of its kind guidance to market participants on the meaning of the “necessary course of business” (“NCOB”) exception to the prohibition against selective disclosure (or “tipping”) of material non-public information (“MNPI”). The takeaways from this decision are important for issuers and insiders to consider when relying upon the NCOB exception.
Securities legislation in Canada contains prohibitions against both tipping and insider trading. The prohibition against tipping makes it illegal for a person in a “special relationship” with a reporting issuer to disclose MNPI to a third party, except where such disclosure is “in the necessary course of business.” The prohibition against insider trading makes it illegal for a person in a special relationship with a reporting issuer to trade in securities of that reporting issuer with knowledge of MNPI. A person is deemed to be in a special relationship with a reporting issuer when that person knows or ought reasonably to have known that the source of the MNPI is in a special relationship with the reporting issuer.
In Kraft (Re), Staff of the OSC commenced an enforcement proceeding against MK, then Chair and Director of a publicly traded cannabis company (the “Company”), and MS, who was MT’s longtime friend and business associate. MK had shared draft documents containing MNPI concerning the Company with MT, seeking MT’s input regarding a proposed material transaction between the Company and another company. Soon after his receipt of this MNPI and prior to any public announcement of the proposed transaction, MS acquired shares of the Company over the facilities of a stock exchange. Then, soon after the announcement of the transaction, MS sold his newly-acquired shares, earning a 43% profit on his short-term investment.
The Tribunal held that MK had engaged in illegal tipping when he sent MS the draft transaction documents, which constituted MNPI, and that MS had engaged in insider trading when he purchased shares while in possession of that MNPI.
The Necessary Course of Business Exception
Kraft(Re) is the first decision to consider the application of the NCOB exception to the prohibition against tipping (or selective disclosure) in s. 76(2) of the Securities Act (Ontario) (or corresponding provisions of other provincial and territorial securities laws). S. 76(2) reads:
(2) Tipping –No issuer and no person or company in a special relationship with an issuer shall inform, other than in the necessary course of business, another person or company of a material fact or material change with respect to the issuer before the material fact or material change has been generally disclosed. [emphasis added]
The Tribunal held:
- the party seeking to rely on the NCOB exception – MK in this case – will have the onus of proving that it applies;
- the NCOB exception must be interpreted and applied “reasonably narrowly”;
- necessity should be measured on an objective basis, and should not take into account the “subjective belief” of the person selectively disclosing the MNPI, not even when it represents that person’s good faith belief;
- the selective disclosure must be tied to a business rationale and a business purpose, but that alone will not be sufficient to meet the requirement of necessity. For instance, disclosures made in the ordinary course of business will also have a business rationale and purpose, but may not be “necessary”.
The Tribunal provided a non-exhaustive list of factors to consider when assessing whether selective disclosure is in the NCOB:
- the business of the issuer;
- the relationship between the tipper and the issuer;
- the relationship between the tipper and the tippee;
- the nature of the MNPI that was disclosed;
- the relevance of the MNPI to the relationship between the tippee and the issuer (that is, whether the nature of the relationship between the tippee and the issuer necessitates the disclosure of the MNPI in question);
- the tipper’s reason for making selective disclosure to the tippee; and
- the credibility of the tipper seeking to establish the NCOB exception.
Importantly, the Tribunal did not endorse Staff’s view that the NCOB exception only applies to selective disclosure that is necessary for the issuer’s” business purpose, noting that the NCOB exception in the statute is not expressly limited to the issuer. In doing so, the Tribunal has left open the possibility that the NCOB exception could also apply to selective disclosure that is necessary for a recipient’s or tippee’s business purpose, or that of other persons or companies in a special relationship with an issuer, other than the issuer itself.
Application to MK’s Conduct
Applying the above principles and factors, the Tribunal found that the selective disclosure of the draft materials by MK to MS was not made in the NCOB because:
- MK disclosed the draft materials to MS for a personal reason -- he wanted the advice of his friend, who he consulted with frequently about business and personal matters;
- MK did not discuss sharing the draft materials with Company management prior to sending them to MS, nor did he discuss the need for an outside opinion with Company management;
- At no time did Company management ask MS for his perspective on the draft materials;
- MK forwarded the draft materials to MS hastily, giving no indication that he had turned his mind to whether the disclosure was necessary for the Company’s business; and
- MK did not ask MS to enter into a confidentiality agreement, or even ask that he keep the draft materials confidential.
The Tribunal indicated that two factors – (1) a confidentiality agreement, and (2) evidence that the insider turned their mind to the necessity of the selective disclosure – will provide a higher likelihood that the selective disclosure was made in the NCOB. Neither was present in Kraft(Re). In addition, although not mentioned in the Tribunal’s reasons for determining that the NCOB exception was not available to MK in the circumstances, it probably did not help MK’s case that MS had traded with knowledge of the MNPI he had received from MK.
Reporting issuers and their insiders should consider the following when determining whether to make selective disclosure in reliance of the NCOB exception, an area that has long required careful consideration and counsel to mitigate the associated insider trading and tipping risks:
- Before any MNPI is selectively disclosed, well-documented discussions should occur, including in the case of issuers with the issuers’ management (and the board, if appropriate), to determine whether such disclosure is indeed “necessary” for a legitimate business purpose. As with many potentially contentious situations, process is paramount and both following a proper process and documenting that process may be critical to satisfying the onus on the tipper that the NCOB exception should apply.
- If selective disclosure is being made, the issuer or insider should consider securing a confidentiality agreement from the recipient prior to any disclosure. While such an agreement may not be critical in every situation, and the presence of such an agreement alone may not suffice to establish reliance on the NCOB exception, it may be a helpful factor. In the very least, it may be helpful for the discloser to advise the tippee in writing that the information may constitute MNPI and that the tippee should not trade in securities of the issuer until the MNPI is disclosed or becomes stale.
- It remains unclear if the NCOB exception only applies to selective disclosure that is “necessary” for the issuer’s business purpose, as opposed to “necessary” for a tipper’s or tippee’s purpose. While the Tribunal left open the possibility that the NCOB exception applies more broadly to any tipper’s business, its decision and findings must be confined to the particular facts of Kraft(Re), and the decision cannot be read as a definitive endorsement of the broader application of the exception to other tippers beyond issuers. As such, legal advice should be sought whenever any other person or company in a special relationship with an issuer may wish to rely on the NCOB exception.