The directors and officers of a company mining coal in Mongolia were named personally as defendants in a securities class action in Ontario.  On the plaintiff’s motion for leave to bring the action, the court permitted the claim to proceed against the company, but not the directors and officers. Not so fast, said the Ontario Court of Appeal in allowing the claim against the individuals to go ahead.

In Rahimi v. SouthGobi Resources Ltd., shareholders claimed against SouthGobi Resources Ltd., two former CEOs and three Directors after the company restated previous audited financial statements. The company announced in a press release that the statements did not meet revenue recognition criteria, resulting in a share price drop.

Under the Ontario Securities Act, leave of the court is required to proceed with a misrepresentation claim of this sort. This is a relatively new cause of action that calls for a balancing between providing an effective remedy for investors while protecting companies from costly, unmeritorious claims.  Consequently, leave can only be granted if the court is satisfied that the action is brought in good faith and has a reasonable chance of success.

The SouthGobi directors and officers opposed the leave motion relying on a reasonable investigation defence included in the Act.  That defence states that a person or company is not liable for a misrepresentation if they prove they have conducted a reasonable investigation and had no reasonable grounds to believe that the statement contained a misrepresentation.

The directors and officers argued that there was no misrepresentation in the financial statements, but rather that any misrepresentation was in the company’s press release.  They claimed to be unaware of the content of the press release when it went out. The motions judge granted leave to proceed against the company, but not against the directors and officers on the basis that there was no reasonable prospect of their being personally liable given their reliance on external auditors, amongst other investigations efforts.

The Court of Appeal disagreed, saying that the purpose of the requirement for obtaining leave was to screen out clearly unmeritorious claims, especially those that might be improperly intended to impact share price. The Court faulted the motions judge for going beyond a screening function to conduct a mini-trial on the basis of insufficient evidence. In particular, the motions judge should have considered what evidence was unavailable because the motion preceded any obligation on the part of the prospective defendants to make disclosure of relevant evidence.

The Court of Appeal concluded that there were serious gaps in the evidence as well as credibility issues relating to the issue of reasonable investigation.  At the centre of the Court’s concern was the press release. The press release acknowledged material weaknesses in internal revenue reporting controls. The Court saw that acknowledgement as powerful evidence that there was no reasonable investigation. The Court further questioned, if the directors and officers disagreed with the press release after it was issued, why did they not require that the error be corrected? The Court was sceptical that the directors and officers were genuinely unaware of the press release despite being in crisis mode at the time.  Leave to claim against the directors and officers was therefore granted on appeal because a full trial would be required to resolve these issues.

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James Lane’s practice includes defence of accountants, engineers and other professionals in civil claims and discipline proceedings as well as insurance defence under other specialty line coverages.

This blog was republished by Kevin LaCroix as a guest post on the D & O Diary.