In the recent decision of Paniccia v MDC Partners Inc., Perell J. refused to grant leave to proceed with a putative secondary market securities class action under Part XXIII.1 of the Ontario Securities Act (OSA) against MDC Partners Inc and certain of its officers on the basis that the alleged misrepresentations were not material.  The decision presents valuable insight into the assessment of materiality, an issuer’s obligation to disclose a regulatory investigation, and a plaintiff’s obligation to plead a corrective disclosure under Part XXIII.1.

Background to the Decision

In August 2015 the Plaintiff brought a putative class action in Ontario for negligent misrepresentation and a statutory secondary market misrepresentation claim on behalf of shareholders of MDC. MDC’s shares traded on the TSX and NASDAQ, where 98.2% of the trading occurred.  However, only approximately 0.8% – 2.6% of MDC’s shares were held by residents of Canada.

While initially seeking to certify a global class, in response to a motion by the Defendants to limit the proposed class to purchasers on the TSX, the Plaintiff refined the class to persons or other entities in Canada who acquired shares of MDC on any domestic or foreign exchange or through an over-the-counter transaction during the class period.

The Plaintiff pleaded multiple misrepresentations between October 29, 2014 and March 2, 2015. In particular, the Plaintiff’s allegations were that a) MDC failed to disclose the issuance of a subpoena by the SEC requiring MDC to produce information about the expenses of Miles Nadal, the CEO of MDC, and its accounting practices, among other things;  b) MDC failed to disclose an internal investigation into its internal controls over accounting prompted by the subpoena;  c) MDC failed to disclose that it began reporting “adjusted” EBITDA because the SEC had required the qualification “adjusted” to be added;  d) MDC did not disclose the true amount of its CEO’s compensation;  and e) MDC misstated how it presented its business “segments”.

The Plaintiff argued that these misrepresentations were partially corrected on April 27, 2015 when MDC disclosed to the market that the SEC had served a subpoena. MDC also disclosed that it had formed a special committee of independent directors to investigate the matters raised by the SEC’s subpoena and that following the internal review, Mr. Nadal had agreed to reimburse the company in the amount of $8.6 million.  The following day, MDC’s shares dropped in value by 28% on both the TSX and NASDAQ.  On July 20, 2015, Mr. Nadal and MDC’s Chief Accounting Officer resigned and together repaid or forfeited approximately $40 million USD in severance and compensation.

In August and September 2015, the SEC raised a new matter with MDC about how MDC grouped or segmented its partner firms into reporting units. The SEC’s correspondence on this topic was publicly filed.

MDC’s auditor did not withdraw their unqualified audit opinions, require a restatement of MDC’s financial statements nor withdraw ICFR reports in connection with any of these events.

A parallel U.S. class action was commenced and dismissed before certification by the United States District Court – Southern District of New York in September 2016. However, the SEC brought an enforcement action against MDC and some of its officers resulting in “no contest” settlements with the SEC in January, May, and November 2017.

The Court’s Analysis

Justice Perell denied leave to commence a statutory claim for secondary market misrepresentation under s. 138.8(1) under the OSA, finding that all of the alleged misrepresentations shared a “fundamental flaw”: a lack of materiality.

His Honour summarized the law concerning the test for materiality under the OSA, which is determined objectively from the perspective of what a reasonable investor would consider important in deciding whether to invest and at what price. The determination of materiality involves a contextual and fact-specific inquiry.

On a motion for leave to pursue a statutory cause of action, the fact that a company restated its financial statements constitutes evidence that there was a material misrepresentation. However, the absence of a restatement does not mean that leave ought not to be granted. Without evidence of a restatement, a criminal or regulatory finding, or some other type of acknowledgement by the defendants that a misrepresentation was made, the onus will be on the Plaintiff to adduce other evidence demonstrating that there is a reasonable prospect of establishing a material misrepresentation.

Expert evidence on the issue of materiality is not determinative. While the Plaintiff’s expert, a certified public accountant, was qualified to opine on materiality from an accountant’s or auditor’s perspective, the assessment of materiality under securities law is ultimately the court’s prerogative:

“Depending on the nature of the alleged misrepresentation, a court may be assisted by understanding what is material from an auditor’s point of view and what is the appropriate accounting or auditing standard, […] ultimately, it is for the court to determine what is objectively important to a reasonable investor in making his or her investment decisions”.

Justice Perell undertook a careful examination of each of the alleged misrepresentations and determined that each failed for lack of proof of materiality. In each case, the evidence of a material misrepresentation was so weak that there was no possibility of success at trial.

Receipt of a Regulatory Subpoena is Not a Material Fact

He rejected the allegation that the receipt of the SEC subpoena was a material fact that ought to have been disclosed. In general, the mere service of a subpoena does not trigger a duty to disclose: “[a]n investigation is not a conclusion about a fact.” Further, under securities law, the existence of an investigation is confidential and ought not to be disclosed absent the consent to the regulator.  Premature disclosure of an investigation may in fact be harmful and adversely affect share values.  A reasonable investor would expect the company to respond to the subpoena, cooperate with the investigator, and conduct an internal investigation and then determine whether there was a material fact to correct or a material change to report to its investors.  This is precisely what occurred.

No Misrepresentation about Internal Controls

Justice Perell held that there was no misrepresentation about the effectiveness of MDC’s internal controls. No restatement had been required by MDC’s auditors and neither the Plaintiff nor its expert identified any specific weakness in MDC’s ICFR or a material misstatement about the ICFR.  The Plaintiff and its expert sought to infer a weakness from the fact that MDC later reported that it was taking steps to improve its ICFR.  According to Perell J., this inference was backwards and did not logically follow.

No Misrepresentation About EBITDA Reporting

The evidence established that MDC did in fact disclose its exchange of correspondence with SEC about the use of the term “adjusted EBITDA”, as it was publicly filed on EDGAR. Further, MDC’s EBITDA reporting was not false or misleading because it disclosed to investors how it calculated EBITDA.  Additionally, there was no public correction with respect to the alleged adjusted EBITDA misrepresentation in the pleaded corrective disclosures or otherwise.  This necessary element of the statutory cause of action was absent from the pleading.

No Material Misrepresentation about the CEO’s Compensation

There were no false statements about the CEO’s compensation nor any corrective disclosure of it. The reimbursement expenses were at all times reflected in MDC’s financial statements.  Furthermore, the quantity and nature of these expenses were not material.  The Company disclosed that it did not expect there would be any impact to its previously issued financial statements as a result of its conclusion that certain amounts had been inappropriately reimbursed to its CEO and no restatement of the financial statements has ever been made.  The SEC did not require a restatement as a result of its investigation.

No Segments Misrepresentation

Finally, Justice Perell also found no basis for the allegation that there was a business segments misrepresentation. The alleged segment misrepresentation issue arose after the disclosures pleaded as partially corrective, and the Plaintiff had not pleaded any specific public correction with respect to the alleged segments misrepresentation.  In any event, the alleged segments misrepresentation lacked materiality.

Justice Perell concluded with respect to each of the alleged misrepresentations that having considered all of the evidence, the plaintiff’s case was “so weak that it has no reasonable possibility of success”. On that basis leave, was denied.

Key Take Aways

The decision in Paniccia is significant for a number of reasons.

It emphasizes the importance of the materiality element of the statutory cause of action for misrepresentation and provides further clarity concerning both the test for materiality and proof of materiality.  In the absence of evidence of a material misrepresentation such as a restatement of financial statements,  a criminal or regulatory finding, or an acknowledgment of a misrepresentation by the defendants, plaintiffs must adduce other evidence to establish a material misrepresentation.  Courts will carefully scrutinize expert evidence on materiality.

The decision provides welcome clarity on the absence of an obligation to disclose the mere issuance of a subpoena, relying on U.S. case law such as the decision in In re Lions Gate Entertainment Corp., 2016 U.S. Dist. LEXIS 7721 and regulator guidance such as the Ontario Securities Commission’s Guidelines for Staff Disclosure of Investigations, set out in Staff Notice 15-703.  The “general rule” is that there will be no public disclosure of information about an on-going or closed investigation.

Finally, to our knowledge, this is the first decision where leave was expressly denied in respect of a misrepresentation allegation for failure to plead a corrective disclosure. The law in Canada has been developing on this issue, in particular with the decisions of Drywall Acoustic Lathing and Insulation Local 675 Pension Fund v. SNC-Lavalin Group Inc., 2016 ONSC 5784 and Swisscanto Fondsleitung AG v. BlackBerry Ltd., 2015 ONSC 6434 which laid the groundwork for understanding the corrective disclosure element of the statutory cause of action.  Justice Perell’s reasons demonstrate that a corrective disclosure is a core element of the statutory cause of action and a plaintiff must plead his/her case in such a manner that ties a correction to an alleged misrepresentation.