On August 9, 2017 the Ontario Securities Commission (OSC) approved a settlement agreement entered into by Home Capital Group Inc (HCG), a reporting issuer in the residential and commercial lending business, Gerald Soloway (Soloway), its former founder and CEO, Robert Morton (Morton), its former CFO and  Martin Reid (Reid), its former President. Both Morton and Reid were also members of the Company’s Disclosure Committee at the relevant time.

The settlement resolves allegations made by OSC Staff that, inter alia,

  1. over a period of several months in 2015, HCG materially misled its shareholders about the reason for a decline in the number of its new mortgage originations by failing to disclose until July 10, 2015 that it had terminated 3 underwriters, 2 brokerages and 30 brokers because of its discovery of falsified loan applications in its broker channels.  The terminated brokers and brokerages accounted for approximately 10% of HCG’s 2014 originations;
  2. HCG failed to issue a news release forthwith and to file a material change report announcing the reasons for the drop in originations, and that significant changes to the Company’s internal control structure were required and being implemented;
  3. Soloway made materially misleading oral statements in relation to the causes of the drop in mortgage originations during an earnings call;
  4. both Soloway and Morton certified a quarterly interim filing that was misleading; and
  5. Reid failed to ensure that statements made by HCG in that filing were not misleading.

The settlement was entered into on a “with admissions” basis, in conjunction with an agreement to settle a related shareholder class action. The terms of settlement with the OSC include payment of a total of $12 million, with $10 million to be paid by HCG, $1 million to be paid by Soloway, and $500,000 each to be paid by Morton and Reid. Of that amount, $11 million is allocated for the benefit of the proposed class in the civil class action, and $1 million to the OSC.

The settlement is noteworthy for several reasons.

Procedural Issues

OSC Staff obviously concluded that HCG was not eligible for a no contest settlement under its Revised Credit for Cooperation Program announced in 2014.

With the overhang of a securities class action relating to the same issues, and given the use that can be made in the class action of admissions made in the regulatory settlement agreement, entering into a settlement with OSC Staff was not a realistic option unless the Company also settled the class action.

Sufficiency of Disclosure

In the settlement HCG also accepts responsibility for disclosure in a quarterly interim filing which did not clearly reveal that mortgage originations had immediately declined as a result of the Company’s decision to terminate certain mortgage brokerages and brokers and to take remedial action, following its discovery that members of one of its underwriting teams had failed to complete required income verification procedures and falsified employment and income information. OSC Staff considered that the reason for the drop in originations and its impact on the Company’s business was material information that ought to have been promptly disclosed.

A reference in the quarterly filing to an ongoing review of HCG’s business partners, and that one of HCG’s operational risks was financial loss resulting from an event with a third party service provider and that HCG may change relationships as appropriate, was acknowledged by HCG to be insufficient “to allow an investor to appreciate the reasons for the drop in Originations or the material risk to future growth of HCG that the termination of brokerages and brokers, process changes and remediation represented.” As noted by the Hearing Panel that approved the settlement, the disclosure in the quarterly filing was deficient because it failed to mention “the specific effect of the terminations that had been effected months before and remedial efforts that had been undertaken for many months”.

This suggests that an issuer’s failure to make timely disclosure of the fact that an identified risk factor has in fact crystallized in circumstances where its impact on the business is material, and to explain its impact on the business and operations of the issuer in a manner that investors will understand, may expose the issuer to regulatory liability.  Required disclosures cannot be cloaked in language that is opaque.

Liability For Misleading Oral Statements 

In the settlement agreement, both HCG and Soloway accept responsibility for misleading oral statements made by Soloway in response to questions asked during an earnings call, contrary to s. 126.2(1) of the Securities Act. Morton and Reid also participated in the call.

The scope of the prohibition for making misleading statements in s. 126.2 is broader than in s. 122, which applies only to statements made in documents required to be filed under securities law or information submitted to the OSC during an investigation or examination.

The Commission’s willingness to sanction issuers and their officers for materially misleading oral statements under s. 126.2 parallels efforts by representative plaintiffs in securities class actions under s. 138.3(2) to hold them civilly liable for public oral statements alleged to constitute a misrepresentation.

This indicates that unscripted answers to questions posed during earnings calls is a high risk area for issuers and their officers.

Reliance on Legal Advisors Is Not A “Get Out of Jail Free” Card

In the Mitigating Factors section, the settlement agreement refers to HCG’s reliance upon external professional advisors, including the fact that HCG sought advice about the issuance of a clarifying statement after the earnings call and “in the result, no clarifying statement was issued”.

The fact that good faith reliance upon external advisors, presumably legal counsel, did not cause OSC Staff to decline to bring these proceedings suggests an unwillingness by the regulator to accept reliance upon legal advice as a defence to allegations of breach of securities law disclosure requirements.

This is unfortunate. Presumably it is in the interests of the capital markets generally that issuers are encouraged to seek out competent legal advice when faced with tough disclosure dilemmas.