A recent Ontario decision confirms that lawyers must carefully scrutinize the evidentiary record (particularly expert reports) before arguing a motion for leave to commence an action for secondary market misrepresentation under Part XXIII.1 of the Securities Act (Ontario). On September 14, 2012, the Ontario Superior Court Justice released the reasons of Justice Strathy in Gould v. Western Coal Corporation,1 which denied leave to proceed with a proposed class action that alleged that the company and certain of its former directors had misrepresented the true financial status of the company. Further, Justice Strathy denied Gould's request to certify the action as a class proceeding. The action alleged that certain former directors and institutional investors conspired to artificially depress the company's share price in order to create false panic with investors, increase their own holdings at a discount and gain a windfall when the stock later surged in value.
The Key Players
Western Coal Corporation (WCC) is a British Columbia company involved in the exploration, acquisition and development of coal mining properties. It is listed on the TSX and was a reporting issuer under the Securities Act. WCC's major shareholder was the defendant, Cambrian Mining PLC. The defendant, Audley Capital Advisors LLP, was a major shareholder of Cambrian. The plaintiff, Gould, was an investor, who between January and November 2007 purchased $100,000 worth of WCC debentures.
The Going Concern Note
On November 14, 2007, WCC released its financial results for Q2 2008. The alleged misrepresentation, which was at the root of all of Gould's claims, was contained in a note to the financial statements and in the MD&A (the going concern note) and read, in part:
At current coal prices and Canadian/US dollar exchange rates, the Company does not expect to have sufficient funds to meets its long term debt obligations as they come due…and accordingly the Company will require equity or debt financing from its major shareholder and/or external sources. These circumstances lend substantial doubt as to the ability of the Company to meet its obligations as they come due and, accordingly, the appropriateness of the use of accounting principles applicable to a going concern.
Immediately after the release of the Q2 2008 results, there was a significant decline in the value of WCC's common shares (from $1.68 to $0.58). On November 15, 2007, Gould read a newspaper article about WCC's financial results that suggested the company was on the "brink of collapse". Gould immediately liquidated all of his WCC holdings, leaving him with a capital loss of $30,000.
On November 30, 2007 (two weeks after the release of the Q2 results), Audley made a vital investment of $30 million in WCC by way of debentures convertible at $0.75 per share (the Audley Financing) allowing the company to honour its obligations with its main lender. In April 2008, coal prices rose sharply, dramatically increasing WCC's profitability and share price. Ultimately, in 2011, Walter Equity bought WCC for $11.50 per share.
Gould asserted three claims: an action for misrepresentation in the secondary securities market under the applicable provisions of the Securities Act; a conspiracy claim; and, an oppression claim under the Business Corporations Act (British Columbia).
Gould alleged that the defendants fabricated a financial crisis in the November 2007 disclosure as part of a master plan to spread alarm among investors, enrich themselves and seize control of WCC. Gould also asserted that the alleged misrepresentations violated generally accepted accounting principles (GAAP) and artificially depressed WCC's share price.
Further, Gould challenged a number of transactions that followed shortly after the release of the company's Q2 results, most notably the acquisition of shares by three WCC directors and the Audley Financing. Gould alleged the latter transaction, along with two transactions between WCC and Cambrian, were the "end game of the conspiracy" and were oppressive because they diluted class members' holdings in the company.
Gould attempted to bring the action on behalf of a class of investors who held or disposed of WCC's securities between the release of the Q2 2008 financial statements and the filing of a Material Change Report confirming the completion of the Audley Financing.
Justice Strathy noted that the plaintiff's case had "morphed" over time in the face of extensive and largely unchallenged evidence of the defendants. Most notably, the plaintiff had nearly abandoned his assertion that the alleged misrepresentation was part of a scheme to enable Audley to seize an interest in WCC.
The Leave Test Confirmed
The central issues were whether WCC's financial statements contained a misrepresentation and were prepared in accordance with GAAP. Consistent with the decision of Justice van Rensburg in Silver v. IMAX Corporation,2 Justice Strathy confirmed that the leave motion requires an evidence-based analysis of whether the plaintiff's claim has a reasonable possibility of success at trial. The threshold for satisfying the leave test is low; the plaintiff need only establish more than a mere possibility of success at trial.
Justice Strathy took a critical look at the evidence before him. He noted that none of the plaintiff's evidence reflected any first-hand knowledge of the transactions at issue or the underlying facts behind the Q2 2008 disclosure. By contrast, the defendants put forward affidavits from 15 different individuals, all of whom were personally involved in the relevant events. Only four of these witnesses were cross-examined. Counsel for the plaintiff objected to this "mountain of evidence" and argued that such a practice improperly enables well-resourced and powerful defendants to overwhelm would-be class actions. Justice Strathy rejected this position noting that Gould was advancing serious allegations on behalf of the class and seeking damages of $200 million. According to Justice Strathy, the "defendants are entitled to put a record before the court to establish that the plaintiff's misrepresentation claim has no reasonable possibility of success."
Justice Strathy was exceptionally critical of the expert accounting evidence that the plaintiff relied on, questioning its independence to the point where he had no confidence in its reliability. In particular, Justice Strathy criticized the accounting expert's propensity for:
opining on matters outside of his expertise including, corporate financing, corporate governance and securities law;
engaging in "blatant advocacy, making exaggerated, inflammatory and pejorative comments and innuendos, which were argument rather than evidence";
attributing motive and speculating about events over which he had no first-hand knowledge;
attempting to find a "boogie man under every bed"; and
engaging in inappropriate fact finding.
Justice Strathy noted that the expert's willingness to engage in "advocacy, exaggeration and over-statement and his failure to make a balanced assessment of the evidence…casts serious doubt on his independence and objectivity" and "did not come close to the standard for acceptable expert evidence". These failings, together with shortcomings in the expert's logic gave the Court no confidence that the expert's evidence could possibly be relied upon at trial.
Disclosure Must Be Viewed in Context
Justice Strathy noted that the going concern note could not be read in isolation, but rather had to be considered in the context of the financial statements and MD&A as a whole. Moreover, the note had to be considered from the perspective of a reasonably informed investor. Justice Strathy noted that the Handbook of the Canadian Institute of Chartered Accountants (CICA) and OSC Staff Notice 52-7194 required the disclosure of going concern risk to be clear and robust and identify the uncertainties that cast doubt on the ability of the issuer to continue as a going concern.
The Court found that the language contained in the going concern note originated with the company's auditors and was initially resisted by management based on its expectation that the company would weather the financial crisis. The language was only included upon the insistence of the company's auditors who indicated that such disclosure was required under GAAP. By accurately stating the circumstances facing WCC, the company was doing precisely what the law required it to do. Consistent with the principles established in Kerr v. Danier Leather Inc.,3 Justice Strathy noted that it would have been improper for WCC's directors to "sugar-coat" disclosure of the risk on the basis of management's subjective belief that the company would obtain the necessary financing. The fact that Gould and other members of the class focused only on the negative parts of WCC's disclosure did not mean the disclosure was inappropriate.
With respect to the allegation of insider trading, the Court found that there was no evidence that any insider had any material undisclosed information when they made their trades. The purchases were an attempt to send a positive signal of support to the market and not done as part of a master plan or conspiracy.
Justice Strathy concluded that leave to pursue the claim for secondary market misrepresentation should not be granted because Gould's claim had no reasonable possibility of success at trial. This conclusion made it virtually impossible for Gould's claims of conspiracy and oppression, both of which were founded on the alleged misrepresentations, to be certified. Accordingly, Justice Strathy also dismissed the motion for certification.
The decision in Gould confirms that the threshold for plaintiffs obtaining leave to pursue secondary market liability claims remains low; however, Justice Strathy’s carefully reasoned decision makes it clear that the leave test should be considered a meaningful hurdle for plaintiffs to surmount. In particular, the low threshold will not prevent the Court from engaging in a robust evaluation of the evidence before it. Further, the standards to be expected of expert opinions will not be relaxed in the context of leave motions. Therefore, lawyers and parties alike will need to carefully consider and scrutinize the evidence they are putting before the Court. Finally, Justice Strathy's decision is a sharp reminder to all experts of their duty to provide fair, objective and non-partisan evidence within the confines of their area of expertise.
2012 ONSC 5184.
 O.J. No. 5573, leave to appeal ref'd,  O.J. No. 656 (Div. Ct.).
 3 S.C.R. 331.