The recent decision of the Ontario Court of Appeal in Rahimi v. SouthGobi Resources Ltd., 2017 ONCA 719 provides further guidance concerning the role of the judge on a motion for leave to commence a secondary market class action pursuant to s. 138.8(1) of the Securities Act (the Act) and the application of the defence of reasonable investigation.
In particular, the decision stands for the following:
- On a motion for leave under s. 138.8, the motion judge’s obligation is to critically scrutinize the entire body of evidence filed on the motion, including gaps in the evidence filed by the defendants. If contentious issues of credibility cannot be resolved on the record before the court, the motion for leave should succeed;
- The defence of reasonable investigation mayl be difficult to establish where a corporation has issued a restatement. An acknowledgement by a corporation in its continuous disclosure “that its financial statements cannot be relied upon and that there is a material weakness in its internal financial reporting controls… is powerful evidence that strongly contradicts a defence of reasonable investigation” both by the corporation and its officers and directors; and
- Defendants who defend a leave motion by advancing a position that is unsupported by any contemporaneous evidence should not expect to succeed in defeating leave.
SouthGobi Resources (SGR) is a coal mining company listed on the TSX and the Hong Kong exchange. SouthGobi Sands LLC (SGS), a subsidiary of SGR, processed its sales of coal using “bill and hold” contracts – an arrangement which allowed SGS to bill its customers before delivery was taken. SGR’s revenues were comprised solely of SGS’ sales, which SGR reported in accordance with International Financial Reporting Standards (IFRS). IFRS allowed SGR to recognize revenue from SGS’ bill and hold contracts prior to receiving payment, provided that title transferred to the customer and payment could be reasonably expected.
In 2012, varying economic conditions resulted in many of SGS’ bill and hold customers being unable to make payments. At that time, SGR stopped using bill and hold arrangements and adopted a revenue recognition policy that required delivery of coal to the customer as a prerequisite to revenue recognition. SGR determined that there was no need to amend its 2010 – 2012 financial statements as a result of this change.
Notwithstanding this decision, on November 8, 2013, SGR issued a formal restatement of its prior financial statements. In its press release of that date, it stated that as a result of a review by its auditors, it had determined that certain transactions had previously been recognized prior to meeting relevant revenue recognition criteria. Following that announcement, SGR’s share price dropped by 18%.
On November 14, 2013, SGR released a second press release, referencing a “material weakness in the Company’s internal controls over the financial reporting” and stating that “the previous financial information provided by the company in respect of the periods to be covered by the restated financials are no longer accurate and should not be relied upon.” The adjustments to SGR’s gross revenue between 2010 and 2012 proved significant. For instance, in Q4 of 2010, SGR’s original gross revenue of $46,314,989 plummeted to $24,359,328.
Rahimi sought leave under s. 138.8(1) to proceed with a misrepresentation claim on behalf of all shareholders who purchased SGR’s shares between March 30, 2011 and November 17, 2013 against SGR, its former chief financial officers and certain board members (collectively, the Individual Respondents).
The Motion For Leave
On the motion for leave, the respondents relied upon the defence of reasonable investigation pursuant to s. 138.4(6)(a) of the Act.
In support of what the Court referred to as “a very unusual position,” the respondents asserted that contrary to the company’s announcements in 2013, the financial statements did not need to be restated, and that SGR had no material weaknesses in its internal reporting controls. Rather, the change in the company’s revenue recognition policy purported to be the consequence of external pressures, including the refusal of the United States Securities Exchange Commission to approve SGR’s financials unless they were compliant with Generally Accepted Accounting Principles (GAAP). The respondents also asserted that they did not mean the November 14 press release to convey that the earlier financial statements contained any misrepresentation of revenue.
The motion judge determined that Rahimi’s claim presented “a reasonable possibility of success,” granted the motion for leave against SGR based on the language in the restatement and in the November 14 press release about deficiencies in its earlier revenue reports, but refused to grant leave against the Individuals Respondents, concluding that there was no reasonable possibility that they would not be able to establish a reasonable investigation defence at trial. The chief financial officers named as defendants has carefully concluded that the IFRS criteria were properly applied, and had reasonably relied upon the company’s auditors. With respect to the directors named as defendants, the November 14 press release was never put to them, and they had no reasonable grounds to believe that the company’s prior financial statements were untrue.
Rahimi appealed the decision not to grant leave against the Individual Respondents and SGR appealed the decision to allow leave against the company. Rahimi’s appeal succeeded, and the appeal by SGR failed.
The Court of Appeal considered the application of the defence of reasonable investigation in the context of a leave motion, stating that where defendants advance a reasonable investigation defence, the motion judge must ask whether they “will not be able to establish one or more of the branches of the reasonable investigation defence at trial.” This task involves a review of the evidence filed on the motion, as well as a consideration of the evidence which is not before the judge or has yet to be produced.
The Court found that the motion judge failed to acknowledge the limited record and erred in treating the leave motion like a mini-trial. The motion judge failed to account for gaps in the Individual Respondents’ evidence, the existence of other information in the record inconsistent with the evidence of the Individual Respondents which raised credibility issues, and their failure to provide contemporaneous evidence that was consistent with their affidavit evidence, finding that “the lack of a clear record makes evident that the leave must be granted because there is no certainty that the reasonable investigation defence will succeed.” Further, if, as the Individual Respondents asserted, the information in the company’s November 14 press release was false, there was an obligation to correct the information. As disclosure is at the heart of securities litigation, it must be scrupulously accurate and fair. There is no room for prevarication or double-talk”.
Ultimately, the Court concluded that the discrepancy between the position advanced by the Individual Respondents at the leave motion and the company’s position in the restatement and November 14 press release was “so jarring” that the motion judge should not have refused to grant leave against any of them.
‘The author wishes to thank Joseph Palmieri, Student-At-Law, for his contribution to this article.