Divisional Court Upholds OSC Finding that Trading Software License Contracts are Securities Within Meaning of Securities Act

The Ontario Superior Court of Justice in Furtak v Ontario (Securities Commission), 2018 ONSC 6616, has upheld the Ontario Securities Commission’s (OSC) merits and sanctions decisions with respect to the Strictrade Offering, which we previously reported on here.

Background

In 2015, OSC Staff brought enforcement proceedings against Edward Furtak, Axton 2010 Finance Corp., (Axton), Strict Trading Limited (STL), Strictrade Marketing Inc. (SMI), Trafalgar Associates Limited (TAL), Ronald Olsthoorn, and Lorne Allen (collectively the Strictrade Parties) arising out a scheme that involved the marketing and offering of a set of computerized trading software license contracts (the Strictrade Offering).  Under the Strictrade Offering, third party participants signed a promissory note in favour of Axton, a company operated by Furtak, for the purchase of a license to use the Strictrade computerized trading software. The participants simultaneously contracted with STL, another company operated by Furtak, to host the Strictrade software and trade in financial instruments.  Participants purchased licenses in $10,000 units and were required to pay upfront annual fees and interest to Axton and STL.  In exchange, participants received annual trading report payments.  The annual fees and interest paid by purchasers exceeded the trading report payments they received.  The Strictrade Offering was marketed to investors as a tax-planning vehicle meant to provide participants with an opportunity to take advantage of business tax deductions.

In a merits decision released on November 24, 2016 (2016 ONSEC 35), the OSC found that the set of contracts being marketed in the Strictrade Offering were “investment contracts” and were therefore “securities” within the meaning of the Securities Act, RSO 1990, c S. 5 (the Act).  As a result, the OSC found that:

  • Furtak, Axton, STL, SMI, and Allen engaged in, or held themselves out as engaging in, the business of trading in securities without registration, contrary to subsection 25(1) of the Securities Act, RSO 1990, c S. 5 (the Act);
  • all of the Strictrade Parties distributed securities without filing and obtaining a receipt for a preliminary prospectus, in violation of subsection 53(1) of the Act;
  • Furtak, Olsthoorn and Allen, as officers and directors of the corporate respondents authorized, permitted or acquiesced in the corporate respondents’ non-compliance with Ontario securities law, in violation of section 129.2 of the Act; and
  • Oslthoorn failed to fulfill his Know Your Client obligations, failed to fulfill his obligations as Chief Compliance Officer and Ultimate Designated Person of TAL, and failed to take reasonable steps to determine whether the Strictrade Offering was suitable for investors, contrary to sections 3.4, 13.2 and 13.3 of National Instrument 31-103.

In a separate sanctions and costs decision released May 4, 2017 (2017 ONSEC 12), the OSC reprimanded the Strictrade Parties and imposed a number of hefty sanctions including cease trade orders, administrative monetary penalties, disgorgement of proceeds, and costs in the amount of $186,013.  In a minority opinion, Vice-Chair D. Grant Vingoe disagreed with the scope of the cease trade orders imposed by the majority, indicating that he would have allowed an exception to permit the remaining investors in the Strictrade Offering to continue their investments if they so wished.

Appeal to the Divisional Court

The Strictrade Parties appealed the OSC’s merits and sanctions decisions to the Ontario Superior Court of Justice, Divisional Court. The Strictrade Parties argued that the OSC (i) erred in finding that the set of contracts met the legal test for an “investment contract”, (ii) erred in making factual findings and drawing inferences unsupported by evidence, and (iii) imposed unreasonable sanctions.

Standard of Review

The Divisional Court determined that the reasonableness standard of review applied to all three grounds of appeal.  The Court rejected the Strictrade Parties’ argument that the presumption in favour of a reasonableness standard that applies where a tribunal is interpreting its home statute was rebutted in this instance because the issue on appeal was not related to the OSC’s threshold jurisdiction to sanction conduct and was not a matter of central importance to the legal system outside of the OSC’s specialized expertise.  The Court also rejected the Strictrade Parties’ submission that the standard of “palpable and overriding error” should apply to the Commission’s findings of fact, holding that that standard is not applicable in a judicial review of an adjudicative tribunal’s decision.  Rather, factual errors may only be a ground for overturning a tribunal’s decision if they go to a “core finding” that is fundamental to the reasonableness of the ultimate decision.

Investment Contracts

In determining that the set of contracts marketed under the Strictrade Offering were “investment contracts”, the OSC adopted the test from Pacific Coast Coin Exchange v Ontario Securities Commission, [1978] 2 SCR 112 and outlined the following four elements of an “investment contract”:

1.  an investment of money,

2.  with an intention or an expectation of profit,

3.  in a common enterprise in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties,

4.  whether the efforts made by those other than the investor are the undeniably significant ones – essential managerial efforts which affect the failure or success of the enterprise.

The Divisional Court found that, while the OSC broke down the test for an “investment contract” into four components in a manner not reflected in the Supreme Court of Canada’s decision in Pacific Coast Coin, the OSC recognized that the elements of the test are not “airtight compartments” and many of the same considerations may apply to more than one aspect of the test.  The OSC’s reformulation captured the “essence” of the test. The Divisional Court further held that the OSC’s application of the test to the Strictrade Offering and the finding that the set of contracts constituted “investment contracts” and were therefore “securities” under the Act was reasonable.

Factual Findings

The Strictrade Parties argued that the OSC made a number of factual errors and drew improper inferences not supported by the evidence.  In dismissing this ground of appeal, the Divisional Court noted that the Strictrade Parties had failed to demonstrate that any of the factual errors alleged would have impacted the OSC’s conclusion that the set of contracts were “investment contracts”.  In essence, the Strictrade Parties were asking the Divisional Court to improperly re-weigh the evidence that was before the OSC.  In any event, the Divisional Court found that the OSC referred to evidence that amply supported its conclusion and its findings were therefore reasonable.

Sanctions

The Strictrade parties argued that the sanctions imposed by the OSC were unreasonable, disproportionate to the nature of the misconduct, and failed to serve any identifiable public interest goals.  The Divisional Court disagreed, holding that the OSC properly considered all of the relevant factors, including the different circumstances, roles, and histories of the various Strictrade Parties and imposed sanctions that fell within its broad discretion.

The Divisional Court also considered Vice-Chair Vingoe’s minority opinion that would have allowed an exemption to the cease trade orders to permit the remaining participants to continue their investment in the Strictrade Offering.  The Divisional Court determined that both the majority and Vice-Chair Vingoe, in the minority, provided a reasonable basis for their respective positions on the cease trade orders and that each was defensible.  Faced with two reasonable interpretations, the Divisional Court concluded that it was obliged to defer to the findings of majority, and upheld the sanctions decision.

 

The Hard Way – SEC announces first penalties and compliance roadmap for unregistered ICOs

On November 16, 2018, the Securities and Exchange Commission (SEC) announced consent orders settling actions in respect of two unregistered initial coin offerings (ICOs), including the first fines levied against non-compliant ICO issuers made by the SEC to date.

The consent orders demonstrate the SEC’s willingness to follow through with enforcement proceedings against issuers of ICOs not in compliance with securities laws, and provide a roadmap for how existing ICOs can bring themselves into compliance going forward.

The parties – Airfox and Paragon

The issuers charged in the two SEC enforcement actions each raised substantial amounts of capital through an ICO for vastly different purposes:

  1. CarrierEQ Inc., doing business as Airfox, is a financial services company focused on emerging markets that raised $15 million in digital assets through an ICO to finance the creation of a token ecosystem by which users would earn and exchange tokens in connection with the acquisition of data and interaction with advertisements;  and
  2. Paragon is an online company that raised $12 million through an ICO with a view to implementing blockchain technology in the cannabis industry.

According to the SEC’s consent orders for Airfox and Paragon, neither company or its ICO was registered with the SEC.  In each case, the SEC charged that the company marketed its ICO on the representation that it expected its coin to appreciate in value with an opportunity for future profit.

Consent orders level heavy penalties and lay out a compliance framework

The penalties leveled against Airfox and Paragon are largely similar, and demonstrate the SEC’s intention to backstop its enforcement of regulation against ICO issuers along with its commitment to ensuring other would-be issuers understand the path to proper compliance.

Both Airfox and Paragon were ordered to pay a civil money penalty of $250,000.  While the Airfox penalty was ordered payable within 90 days, the Paragon penalty is payable in three instalments spread over 240 days.  Airfox and Paragon also undertook in their consent orders to issue press releases notifying the public of the order.

On the compliance side, among other requirements, Airfox and Paragon undertook to register their respective tokens as a class of securities, and to establish a claims process for purchasers of those tokens:  specifically, within 60 days after registering their tokens as securities, each company must notify all purchasers of their potential claims under section 12(a) of the Securities Exchange Act of 1934 including the right to sue to recover the consideration paid with interest for the security, less any income received from that purchase.  Each company is required to provide token purchasers with a claim form, and to pay the amount due pursuant to section 12(a) to each person submitting a proper claim form by the deadline specified in the order, with some opportunity for the company to seek documentation from the claimant to support their claim.  The companies will then have to report the results of this claims process to the SEC on a monthly basis.

SEC orders send clear compliance message

The Airfox and Paragon orders make clear that token issuers that fail to comply with securities laws will (a) be prohibited from profiting from their breaches, (b) face substantial penalties, and (c) end up required to comply with securities laws in any event.  The message is clear: “Comply now, or we will take action to force you to be compliant.”  Anyone considering a token offering with any doubt about the SEC’s willingness to sanction unlawful ICOs should take serious notice.

Alberta Securities Commission Introduces Whistleblower Program

On November 19, 2018, the Alberta Securities Commission (ASC) implemented its first whistleblower program (the Program) through the release of ASC Policy 15-602 Whistleblower Program (the Policy) and simultaneous amendments to the Alberta Securities Act (the Act).

The Program is effective as of November 19, 2018.  Its protections apply retroactively to securities misconduct but only in relation to tips communicated to the ASC on or after November 19, 2018.

According to the ASC, the highlights of the Program include the following:

  • the facilitation of simple reporting by providing a dedicated telephone “tip” line and access to forms for submission by email, mail or in-person
  • whistleblower access to trained, knowledgeable ASC staff
  • rigorous protection of the confidentiality of the identity of whistleblowers
  • prohibition of obstruction and reprisal
  • protection of whistleblowers from the application of contractual clauses that directly or indirectly attempt to prevent whistleblowing.

No Whistleblower Awards

Unlike certain whistleblower programs in other jurisdictions (such as Ontario), the Program does not provide for the payment of awards to whistleblowers.  It only goes so far as to provide for possible credit for cooperation in the case of whistleblowers who are themselves involved in securities misconduct.

Under the Ontario Securities Commission Whistleblower Program, for example, individuals who meet certain eligibility criteria and who voluntarily submit information regarding breaches of Ontario securities laws may be paid a whistleblower award if there is an “award eligible outcome” and the Commission, in its discretion, determines it appropriate to order an award.

Efficacy of Whistleblower Programs

It remains to be seen whether the Program will be an effective tool in connection with the ASC’s enforcement of Alberta’s securities laws, particularly in that whistleblowers will not be eligible to receive any financial awards.

According to an OSC press release issued in June 2018, the OSC Whistleblower Program has been very effective in “shining a light on information that previously would have remained in the shadows”.  To that date, the OSC Program had generated approximately 200 tips, of which 45 were under review, 19 had been referred for enforcement, and 68 were or are in the process of being shared with another OSC operating branch or another regulator for further action.

To date no awards have been announced by the OSC.

In its fiscal year ending September 30, 2018, the United States Securities and Exchange Commission (SEC) received over 5,000 tips, including over 200 FCPA-related complaints.  The tips originated from over 70 different countries, and awards of almost US $170 million were paid out to 13 individuals.

The authors would like to thank Sunny Mann, articling student, for his contribution to this article.

Re Fauth: A Primer on ss. 75(1)(a), 92(4.1) and 93(b) of Alberta’s Securities Act

The Alberta Securities Commission (ASC) recently released its decision in the matter of Re Fauth, finding the respondent, Vernon Ray Fauth (Fauth), in breach of ss. 75(1)(a), 92(4.1) and 93(b) of Alberta’s Securities Act, RSA 2000, c S-4 (the Act). The decision offers some important insight on issues regarding limitation periods, illegal dealing, misrepresentations, and fraud under the Act. The decision also discusses the use of hearsay evidence in proceedings before the Commission; specifically, the use of transcripts of witness interviews conducted by the Alberta Securities Commission Staff (Staff) in the course of their investigation.

Facts

Fauth operated a financial and estate planning business through Fauth Financial Group Ltd. (Fauth Financial), a corporation licensed to sell insurance and mutual funds. Fauth was also involved in a number of other corporations and limited partnerships:

  1. Espoir Capital Corporation (Espoir): Espoir was set up to raise funds from the public for re-investment in other opportunities. The investments would then generate the returns to be paid to Espoir investors. Fauth was the founder and sole shareholder, director, officer and signing authority of Espoir.
  2. FairWest Energy Corporation (FairWest): FairWest was a publicly-traded oil and gas company listed on the TSC Venture Exchange. Fauth and his son were two of the six FairWest directors. FairWest became insolvent and sought protection under the Companies’ Creditors Arrangement Act in December 2012.
  3. Limited Partnerships: Fauth had an interest in and control over a number of other oil and gas entities, including Royalty Investments Limited Partnership (Royalty LP). Royalty LP’s general partner was AFM Management Inc. (AFM Management), of which Fauth was president, sole director and sole voting shareholder. Royalty LP was described as a “conglomeration of one corporation [AFM Management] and six partnerships”. Fauth was involved with and had an interest in all six of these partnerships.

From November 2002 through November 2012, Espoir issued approximately $15 million in debentures (Debentures) to over 70 investors in Alberta, British Columbia, and Ontario. In soliciting investments, Espoir distributed one-page summaries to investors and potential investors, describing the kinds of investments that Espoir would make. Although there were minor variations in these summaries over the years, they all represented that Espoir was established to invest in a pool of interest paying investments such as money market, treasury bills, mortgages, GICs and term deposits.

Some of the Debentures were described as “unsecured” (Unsecured Debentures) while the others were described as “secured” (Secured Debentures). The certificate accompanying the latter stated on its face that it represented a “Secured Debenture”. The Unsecured Debentures stated in their preambles that “[t]he Debenture is an unsecured obligation of [Espoir] and is specifically subordinated to Senior Indebtedness, as defined herein”. “Senior Indebtedness” was defined to include all of Espoir’s other indebtedness, apart from the Unsecured Debenture itself and any other subordinated indebtedness. Both Debentures also contained a “No Security” clause stipulating that:

The Holder [i.e., the purchaser] acknowledges that no security interest is granted to the Holder by [Espoir] hereby and the Holder covenants that he shall not seek to cause any registration of the Debenture against [Espoir] or its assets in any jurisdiction.

According to Fauth, the only real differences between Espoir’s Unsecured Debentures and its secured Debentures were the interest rate and the date of issue. His evidence was that, despite their names, both had “the same” underlying security: “the assets that were in…Espoir…”. The Unsecured Debentures typically offered an interest rate of 10.5% while the Secured Debentures typically offered an interest rate of 8%.

In addition to the Debentures, Espoir also issued a number of promissory notes (Espoir Notes). Each had been issued in 2012, had a two-year term and paid 8% interest per annum.

Around 2010, Espoir became unable to repay the Unsecured Debentures as they matured. In response, Fauth began asking the Unsecured Debenture holders to enter into amending agreements, the majority of which reduced the interest rate on those paying 10.5% to 8%, extended the term (usually for a further three years), and changed the timing of interest payments from semi-annually to quarterly.

By mid-2013, Espoir ceased making interest payments to Debenture holders. Espoir’s financial records showed that, as of December 31, 2014, it owed its investors over $12.3 million.

A Notice of Hearing was subsequently issued on May 11, 2016 by the Staff, alleging that Fauth breached statutory prohibitions on engaging in unregistered trading contrary to s. 75(1)(a) of the Act, making a misrepresentation contrary to s. 92(4.1) of the Act and perpetrating a fraud contrary to s. 93(b) of the Act. Twelve witnesses testified at the 12 day hearing before the ASC. These included eight investors, two current members and one former member of the ASC investigative staff and one individual who used to work with Fauth. Fauth refused to testify, but instead chose to rely on the transcript of his interview conducted by the Staff during the course of their investigation.  The Commission allowed Fauth to file the transcript of his investigatory interview, but took into account that Fauth had not made himself available for cross-examination at the hearing and, thus, it could not directly assess his credibility.

A recurring theme in the evidence of all eight investor witnesses was that Fauth assured them that their transactions were “secure” and represented low risk. He variously represented to the investors that their money would be used to invest in “real estate”, in “[real estate developments] secured against land registered on title”, “in mortgages”, “in property around Alberta”, and in “shopping centres and business office buildings”. Fauth also represented to the various investors that their investment “was about as safe as anything [they] could do”, would “be first on title if something happened”, and was “a hundred percent secured…by property”. Fauth expressly represented to one investor that he would not invest his money in FairWest, the investor being aware of the financial woes of FairWest at the time.

The forensic accounting evidence indicated that between January 1, 2009, and September 30, 2014, $8,453,915.49 was deposited to Espoir’s bank account. Of this, $5,851,581.24 was paid in interest and principal to holders of Debentures and Espoir Notes and $2,585,414.87 was paid to non-arm’s length parties (including Fauth Financial and FairWest). The forensic accountant concluded that the funds received by Espoir were generally used for three things: (i) to pay interest and principal owed to Espoir investors; (ii) to benefit the Fauths through the payment of management fees and transfers to other companies; and (iii) to benefit entities related to Fauth or over which Fauth had “significant influence”. The evidence further suggested that Espoir often loaned money to non-arm’s length parties without written loan agreements or any security.

In terms of the few secured investments/loans Espoir did participate in, the security provided either far-exceeded the debtor’s financial assets or, in the case of loans to non-arm’s length parties, the mortgages were discharged without any payment from the mortgagor. Finally, as of the end of 2007, Espoir did not hold any third-party mortgages.

ASC’s Analysis

Based on the evidence before it, ASC found Fauth in breach of ss. 75(1)(a), 92(4.1) and 93(b) of the Act.

Preliminary Matters

As a preliminary matter, the ASC had to determine the use that could be made of transcript evidence of two witnesses who were unable to testify before the ASC. The two witnesses were Espoir investors who were interviewed by the Staff during their investigation. One of these witnesses had passed away, while the other was elderly and too ill at the time of the hearing to testify. Relying on: ss. 29(e) and 29(f) of the Act;[1] the relevance of their transcript evidence; the fact that the evidence was given under oath; and the availability for cross-examination of relatives of the two unavailable witnesses,[2] the ASC decided to admit the impugned transcripts. The ASC did, however, ascribe less weight to these transcripts as compared to direct evidence of available witnesses.

Limitations[3]

From 2002 through December 16, 2014, s. 201 of the Act provided that “[n]o proceedings under this Part [i.e., Part 16 of the Act, Enforcement] shall be commenced in a court or before the [ASC] more than 6 years from the day of the occurrence of the event that gave rise to the proceedings.” As of December 17, 2014, the section was modified slightly to provide that “[n]o proceedings under this Part shall be commenced in a court or before the [ASC] more than 6 years from the day of the occurrence of the last event on which the proceeding is based.”

The ASC concluded, quoting Re Dennis, 2005 BCSECCOM 65 at paragraph 37, that “[w]hen a series of events or transactions in a continuing course of conduct spans a period of time, the ‘date of the events’, in the ordinary sense of that phrase, can only mean the date of the last event in the series that allows staff to allege a breach of the legislation…”. On this basis, the ASC was satisfied that the misrepresentations and fraud alleged in Re Fauth likewise constituted an ongoing scheme and continued course of conduct.[4]

s. 75(1)(a): Fauth Engaged in the Business of Selling Securities Without Being Registered

Section 75(1)(a) of the Act prohibits anyone from acting as a “dealer” in securities “[u]nless registered in accordance with Alberta securities laws”. The ASC began its analysis by noting that in order to find Fauth in breach of s. 75(1)(a) of the Act, it must be demonstrated that: (i) there was a security as defined in the Act; (ii) there was a trade as defined in the Act in relation to that security; (iii) Fauth engaged in or held himself out as engaging in the business of trading in securities; (iv) Fauth was not registered; and (v) Fauth could not rely on an exemption from the registration requirement.

The evidence was clear in satisfying the first, the second and the fourth prong of the test. In relation to the third prong, ASC noted the non-exhaustive list of factors contained in Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) relevant to determining whether a party has engaged or held itself out as engaging “in the business” of trading in securities. These factors include:

  • engaging in activities similar to a registrant (such as “promoting securities or stating in any way that the individual or firm will buy or sell securities”);
  • intermediating trades or acting as a market maker (which “typically takes the form of the business commonly referred to as a broker” or “[m]aking a market in securities”);
  • directly or indirectly carrying on the activity with repetition, regularity or continuity;
  • being, or expecting to be, remunerated or compensated; and
  • directly or indirectly soliciting securities transactions.

Relying on these factors, the ASC was satisfied that Fauth engaged in and held himself out as engaging “in the business” of trading in securities.

Regarding the final branch of the test, the ASC rejected Fauth’s argument that the Debentures fell under a prospectus exemption and, accordingly, he was exempt from registering with the ASC.[5] The ASC was not persuaded by this reasoning, noting that Fauth had the onus to prove the availability of and compliance with all of the terms of an exemption and he had failed to do so. The ASC also was not satisfied, as Fauth had argued, that this was a mere technical breach, noting that Fauth was a past registrant with considerable experience in the capital markets and the associated regulatory environment.

s. 92(4.1): Fauth Made Misrepresentations

The ASC began its analysis by noting the test under s. 92(4.1): (i) a statement was made by a respondent; (ii) the respondent knew or reasonably ought to have known that the statement was, in a material respect, untrue or omitted a fact required to be stated or necessary to make the statement not misleading; and (iii) the respondent knew or reasonably ought to have known that the statement would reasonably be expected to have a significant effect on the market price or value of a security.

Based on the evidence before it, the ASC was satisfied that Staff had proven all parts of the test under s. 92(4.1). Fauth had ensured investors that their investments were secure, low-risk, and would be invested in a certain way. Instead, he invested their money in non-arm’s length entities with meager protection for the investments and in circumstances where the investments were far from secure. Further, the misrepresentations were material and had a significant effect on the value of the Debentures since an investor would have been more willing to invest in Espoir when assured that his/her investment was “secure”.

s. 93(b): Fauth Committed Fraud
During the relevant time, s. 93(b) of the Act prohibited anyone from “directly or indirectly, engag[ing] or participat[ing] in any act, practice or course of conduct relating to a security…that the person or company knows or reasonably ought to know will…perpetrate a fraud on any person or company”.[6]

The ASC confirmed that the test for fraud under the Act is the same as set out by the Supreme Court of Canada, albeit in a different context, in R v Théroux, [1993] 2 SCR 5, and requires the Staff to prove:

  • the actus reus, which is established by proof of:
    • a “prohibited act, be it an act of deceit, a falsehood or some other fraudulent means”; and
    • “deprivation caused by the prohibited act, which may consist in actual loss or the placing of the victim’s pecuniary interests at risk”;

and

  • the mens rea, which is established by proof of:
    • “subjective knowledge of the prohibited act”; and
    • “subjective knowledge that the prohibited act could have as a consequence the deprivation of another”.

In relation to the actus reus, the evidence was clear that the investors were misled, their funds were exposed to the risk of loss, and then, ultimately, they suffered actual loss. Further, investors were not informed that their funds were exposed to a risk of loss that they did not anticipate, and, ultimately, were lost.

Finally, in terms of mens rea, the ASC was satisfied that Fauth had subjective knowledge of his prohibited acts and the consequences and potential consequences of these acts.

 

Key Takeaways

Re Fauth provides a useful summary of the test for establishing liability under each of ss. 75(1)(a), 92(4.1) and 93(b) of the Act.

Re Fauth is also a useful reminder that the rules of procedure and evidence applicable before the ASC are more relaxed than those applicable in a criminal trial before a court. As the ASC noted, in relation to a respondent’s ability to cross-examine a witness:

[I]n a regulatory context such as this, natural justice and procedural fairness do not necessarily dictate that an opportunity to cross-examine must be provided, as long as a party is given “a reasonable opportunity to comment on and challenge such evidence” in another way (citing Re Arbour Energy Inc., 2012 ABASC 131 at paras 49 and 52).

Further, the ASC was clear in noting that a respondent seeking to rely on a registration exemption must make a reasonable, serious effort – or take whatever steps were reasonably necessary – to satisfy himself that the exemption was available at the time of the trade of the security (citing Re Cloutier, 2014 ABASC 2 at para 308). Bald assertions of the presence of an exemption, or reliance on legal advice vis-à-vis the ostensible exemption, is not sufficient. Moreover, evidence is required to prove reliance on legal advice.

In terms of misrepresentations under the Act, the panel in Re Fauth reiterated that it is not necessary to prove reliance by specific investors on any specific statements or omission alleged to constitute a misrepresentation. Accordingly, what matters is the misrepresentation, the representor’s knowledge of the misrepresentation and the effect of the misrepresentation on the market price or value of the security.

On the issue of fraud, ASC emphasized that it is unnecessary to prove that the accused knew that what he was doing was wrong or that he intended to cause someone else to incur a financial loss. All that is required is proof that the respondent intentionally committed the prohibited acts knowing that the consequence could be deprivation, including the risk of deprivation. Moreover, evidence of personal benefit is not required.

 

The authors would like to thank Sunny Mann, articling student, for his contribution to this article.


[1] Section 29(e) of the Act stipulates that an ASC hearing panel “shall receive that evidence that is relevant to the matter being heard”. Section 29(f) provides that “the laws of evidence applicable to judicial proceedings do not apply [to a hearing before the ASC]”. These sections allow the admission of all relevant evidence, including hearsay, subject to the rules of natural justice and procedural fairness and the ASC’s discretion.

[2] These relatives too had invested in Espoir. They had personal knowledge of the unavailable witnesses investments and interactions with Fauth and gave viva voce evidence before the ASC during the hearing.

[3] The ASC was not required to consider whether the alleged breaches of s. 75(1)(a) in the Notice of Hearing were limitation barred since these occurred after May 11, 2010 and were therefore within the six-year limitation period.

[4] The ASC also relied on the British Columbia Securities Commission’s decision in Re Williams, 2016 BCSECCOM 18 in concluding that the misrepresentation and fraud allegations were not statute barred. In Williams, investors loaned money on the representation that it would be “put into safe investments”. Instead, the funds were used for other purposes, including payments to earlier investors. The panel in Williams concluded that it was a Ponzi scheme involving ongoing acts of deceit which persisted until the scheme collapsed. Accordingly, it was found to constitute a continuing course of conduct, none which was held to be statute-barred.

[5] The Debentures contained language whereby the subscribers, by signing, ostensibly acknowledged that Espoir was a “private issuer” and warranted that they either were family, friends or close business associates of a “director, senior officer or control person” of Espoir (i.e., Fauth) or were accredited investors. If proven, these facts could have established that a prospectus and registration exemption was available prior to September 28, 2010. A number of the investors, however, were neither family, friends or close business associates of Fauth nor accredited investors at the time they purchased their first Unsecured Debenture in July 2006.

[6] Section 93(b) now also prohibits an “attempt to engage or participate in any act, practice or course of conduct relating to a security …that the person or company knows or reasonably ought to know will…perpetrate a fraud on any person or company”.

Time is of the Essence: Public Interest Considerations on a Motion for Standing to bring a s. 127 Proceeding Before the Ontario Securities Commission

A private party cannot commence a proceeding under s. 127 of the Ontario Securities Act (the “Act”) seeking enforcement remedies as a matter of right.  In Pearson (Re), 2018 ONSEC 53 the Ontario Securities Commission provides further guidance concerning when it will permit someone other than Enforcement Staff to commence such a proceeding before it.

The Facts

In Pearson (Re), the Commission refused a motion by a disgruntled minority shareholder of LeadFX Inc. (“LeadFX”), for standing to bring a s. 127 proceeding against that company.  Pearson was seeking orders under s. 127, including an order restraining LeadFX from completing a going private transaction without complying with the requirement in Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions (“MI 61-101”) to obtain majority of the minority shareholders’ approval.

The application related to an upcoming special meeting of shareholders of LeadFX to consider and approve a going-private transaction to be completed by means of a statutory plan of arrangement under s. 192 of the Canada Business Corporations Act.  Pearson alleged LeadFX had structured the going-private transaction to circumvent the need for approval by a majority of the minority, including by entering into a prior transaction that made it possible for LeadFX to rely upon the “90 Per Cent Exemption” from the minority approval requirement contained in s. 4.6(1)(a) of MI 61-101.

Test for Obtaining Standing Under s. 127

The Commission determined that Pearson met most of the factors for obtaining standing to bring a s. 127 proceeding set out in MI Developments (Re), (2009), 32 OSCB 126.  The application related to both past and future conduct regulated by Ontario securities law, the application was not, at its core, enforcement in nature, the relief sought was future looking, the Commission had the authority to grant an appropriate remedy, and Pearson was directly affected by the conduct.

However, Pearson failed to persuade the Commission that it was in the public interest for it to hear Pearson’s application for orders under s. 127, a key element of the test for obtaining standing.  Pearson was late in bringing the application, had failed to establish a prima facie case that LeadFX had breached MI 61-101, and the Commission was not the appropriate forum for Pearson’s resolving complaints.

Delay

The Commission determined that Pearson could, and ought to have commenced the application for relief under s. 127 in a timelier manner following the press release announcing the going private transaction on July 23, 2018.  Waiting almost two months after that date was too long, even if the Management Information Circular was not issued until August 10.

According to the Commission, it is necessary to carefully scrutinize the speed with which such applications are brought “to protect reasonable expectations for certainty in corporate transactions that could be inappropriately frustrated through such delays.  It is also necessary to avoid incentivizing tactical delays that would affect the ability of the Commission and other parties to adequately prepare during a compressed hearing schedule”.

Existence of a Prima Facie Case

The Commission concluded that Pearson also failed to make out a prima facie case that a scheme had been employed to permit LeadFX to qualify for the 90 Per Cent Exemption without proper disclosure, or “as a result of non bona-fide multipart transactions as an end-run around a requirement of minority shareholder approval”.  In particular, there was simply no evidence of a multi-stage scheme to take LeadFX private and force minority shareholders out at the lowest possible price as Pearson alleged, only speculation.

Proper Forum

Finally, the Commission was not satisfied that a s. 127 hearing before it was an appropriate forum for resolving Perarson’s complaint about the conduct of LeadFX.

Pearson’s primary complaint was about the price fixed in the Plan of Arrangement.  His focus was on recouping at least his original investment.  Pearson had other remedies for pursuing his complaints about price, either in the fairness hearing to approve the Plan of Arrangement, in an oppression action, or pursuant to an appraisal remedy under the Canada Business Corporations Act.

In the circumstances, it would be inappropriate for the Commission to exercise its s. 127 jurisdiction to protect investors or the capital markets in the absence of “substantial evidence” that the purpose underlying the 90 Per Cent Exemption had been subverted by LeadFX.

Key Public Interest Take-Aways

Pearson (Re) confirms that the onus is on a private party seeking standing to obtain remedies under s. 127 of the Act to satisfy the criteria set out in MI Developments (Re).

In order to satisfy the Commission that it is in the public interest to grant the request for standing, it will be incumbent upon the party seeking standing to act quickly in bringing the application before the Commission.  In addition, it is important that evidence be filed to demonstrate that there is a prima facie case of misconduct justifying a s. 127 remedy, either in the interests of investor protection, or of  protection of the capital markets.

Finally, If the dispute is really about money, even if the Commission has jurisdiction to grant a remedy under s. 127, the availability of an appropriate remedy before the courts may incline the Commission to refuse the request for standing.

MFDA Publishes Principles-Based Sanction Guidelines

The Mutual Fund Dealers Association of Canada (MFDA) has published new Sanction Guidelines which will take effect on November 15, 2018.  The Sanction Guidelines, which replace the MFDA’s Penalty Guidelines, in place since 2006, are intended to promote consistency, fairness and transparency while focusing on a principles-based approach to sanctioning.  While the Sanction Guidelines are not binding on MFDA Hearing Panels, they are intended to provide a summary of the key factors that Hearing Panels may refer to in exercising their discretion in imposing sanctions.

The Sanction Guidelines identify the following Key Factors to be considered in determining sanctions that promote the MFDA’s goal of protecting the investing public:

  • General and specific deterrence. A sanction should achieve both general and specific deterrence in that it should (i) discourage the Respondent from engaging in future misconduct and (ii) strike an appropriate balance between the Respondent’s misconduct and the public’s expectations as to an appropriate sanction in the circumstances.
  • Public confidence. Sanctions should be in line with what the public would reasonably expect for the misconduct in question.
  • The seriousness of the proven allegations. Distinctions should be drawn between conduct that was unintentional or negligent and conduct that was intentional, manipulative and fraudulent. Whether the misconduct was an isolated event or part of a series of violations will also be relevant.  Other factors to consider in determining the seriousness of the allegations include:
    • Attempts to conceal, mislead, deceive or intimidate will be considered an aggravating factor.
    • Vulnerability. Evidence that the Respondent’s conduct involved vulnerable investors, including those who are at risk due to age, disability, limited investment knowledge, or a high level of trust and reliance on the Respondent, will be an aggravating factor.
    • Evidence of planning and premeditation will be an aggravating factor.
    • Reasonable reliance. Reasonable reliance by the Respondent on competent supervisory, accounting or legal advice will be a mitigating factor.
    • Prior warnings. Evidence that the Respondent engaged in misconduct despite having received prior warnings will be an aggravating factor.
  • The Respondent’s recognition of the seriousness of the misconduct. The Respondent’s acceptance of responsibility prior to intervention by the MFDA and an admission of wrongdoing will be considered mitigating factors.  Attempts to frustrate, delay or undermine the MFDA investigation or hearing will be aggravating factors.
  • Benefits received by the Respondent. Where the Respondent receives a financial benefit from the misconduct, which may include the avoidance of a loss, the sanction should reflect the extent of that financial benefit.
  • Harm suffered by investors. The harm suffered by investors can be quantified in terms of the type, number and size of transactions at issue, the number of investors affected by the misconduct, the size of the loss suffered, the length of time over which the misconduct took place, the impact on the investor, the reputation of the Member, and the integrity of the mutual fund industry as a whole.
  • Past conduct. Evidence of past misconduct on the part of the Respondent, which includes disciplinary measures imposed by the MFDA and other regulators and tribunals, should be considered in determining an appropriate sanction.  Hearing Panels should impose progressive sanctions for each successive instance of misconduct.
  • Prior sanctions. Generally, where the Respondent has already received a sanction from a Member or other regulator for the same misconduct at issue before the MFDA, that will be considered a mitigating factor.
  • Previous decisions. Previous sanctions imposed in similar circumstances will be instructive, but ultimately each case should be decided on its own facts.
  • Totality of the misconduct. Where there have been multiple violations, Hearing Panels should consider the gravity of the totality of the misconduct and impose a proportionate sanction.
  • Ability to pay. Evidence of the Respondent’s bona fide inability to pay a monetary sanction may result in a reduction or waiver of a contemplated fine, or the imposition of a payment plan.  The onus is on the Respondent to establish an inability to pay.  On the flip side, where the Respondent has significant financial resources, a higher fine may be warranted in order to achieve specific deterrence.
  • Voluntary implementation of corrective measures. Evidence that the Respondent voluntarily implemented corrective measures to avoid recurrence of the misconduct should be considered.
  • Voluntary acts of restitution. Evidence that the Respondent made voluntary acts of compensation, restitution or disgorgement should be considered by a Hearing Panel.  The Panel should consider whether the voluntary action was timely and whether efforts at full compensation were made.
  • Proactive and exceptional assistance. All Respondents are expected to cooperate with an MFDA investigation. However, evidence of proactive and exceptional assistance by the Respondent will be considered a mitigating factor.

The Sanction Guidelines also identify the types of sanctions available to a Hearing Panel, which include fines; suspension, permanent prohibition, or termination of a Member’s rights and privileges of membership; reprimands; conditions on the authority of an Approved Person; terms and conditions on the membership of the Member; the appointment of an independent monitor or consultant to oversee the Member’s activities; and directions for the orderly transfer of client accounts from the Member.

DOJ provides additional insight on compliance and investigations matters

On October 25, 2018, John Cronan, Principal Deputy Assistant Attorney General of the Criminal Division of the US Department of Justice (DOJ), delivered an important speech that touched on several key issues for legal and compliance counsel trying to balance business realities with regulator expectations, particularly with respect to compliance with the US Foreign Corrupt Practices Act (FCPA).[1] Of particular note, Cronan discussed:

  • The application of the DOJ’s FCPA Corporate Enforcement Policy;
  • The DOJ’s expectations as to what constitutes full cooperation in the course of an investigation;
  • The use of coordinated resolutions; and
  • The recent update to the DOJ’s policy on implementing monitors as part of an enforcement resolution.

The Corporate Enforcement Policy and voluntary disclosure

 

As noted in our prior client alert in November 2017, the DOJ announced a significant update to its process for evaluating and rewarding corporate cooperation and self-disclosure in FCPA cases. The DOJ subsequently clarified that the policy applies in the M&A context and expanded the policy to apply in non-FCPA cases as well. An important component of that policy is whether a company voluntarily self-discloses the existence of potential misconduct to the DOJ. For a self-disclosure to be “voluntary,” it must: (1) occur before “an imminent threat of disclosure or government investigation;” (2) be made “within a reasonably prompt time after [the company] becom[es] aware of the offense;” and (3) include all relevant facts known to the company about the alleged misconduct.

In his recent speech, Cronan emphasized that companies “should make their initial disclosures sooner rather than later” and “should not wait until completing a significant internal investigation before coming forward.”

Key takeaways

 

Although the DOJ encourages self-disclosure and the FCPA Corporate Enforcement Policy attempts to clarify its benefits, the decision to make such a voluntary self-disclosure is complex, particularly for cross-jurisdictional matters. As noted in our prior alert comparing the US and UK regimes, self-reporting is ultimately both a legal and a business decision, with wide-reaching implications that must be evaluated at an early stage, often before all the facts are known.

For a self-disclosure to qualify as “voluntary” under the new policy, a company must go to the DOJ before there is a threat of public disclosure. As a result, a company may fail to qualify for full credit, even if the DOJ or other regulators are unaware of the conduct, if the DOJ determines that information about the misconduct was about to become public through media reporting or other means. While a company may prefer to have all the facts from a robust internal investigation first, Cronan’s speech confirmed that the DOJ will not guarantee “self-disclosure” credit under such circumstances. On this issue, the DOJ retains significant discretion to determine whether the company has been “reasonably prompt” and whether there was an “imminent threat” of disclosure. Both are obviously subjective factors.

Cooperation expectations

 

In his speech, Cronan provided examples of what a company should do to best position itself to obtain maximum cooperation credit. For example:

  • When making an initial self-disclosure, in addition to summarizing the facts and the investigative steps being taken, explain who is conducting the investigation (e.g., external counsel, internal employees, other consultants) and who is overseeing the investigation (e.g., audit committee, general counsel);
  • Describe the steps taken to preserve and collect relevant evidence (including from electronic devices);
  • Provide a list of interviewees (both completed and planned) and individuals who know about the investigation, including third parties; and
  • Identify any types of information that the company is unable to share with the DOJ because of privilege, data privacy, blocking statutes, or other reasons.

Cronan also reiterated that cooperation typically requires providing the DOJ with a consistent flow of information, including disclosures of significant information as it is uncovered.

Key takeaways

 

Once again, understanding how to manage the DOJ’s expectations (which may be different from regulators in other relevant jurisdictions) is critical. Satisfying the criteria for credit under the Corporate Enforcement Policy is not a matter of checking off a series of boxes. Striking the right balance between performing sufficient due diligence to confirm the accuracy of information and keeping the DOJ fully informed of significant information on a real-time basis is critical to ensuring maximum cooperation credit.

Coordinated resolutions

 

Reiterating prior DOJ policy statements about discouraging the “piling on” of duplicative penalties from multiple regulators for the same conduct, Cronan also discussed the DOJ’s goal of “[p]ursuing fair and equitable outcomes … [by] working toward a resolution that avoids punishment that exceeds what is necessary to rectify the harm and deter future violations, particularly when a company faces a combination of criminal penalties along with civil or foreign penalties.” Cronan emphasized that the DOJ is actively working with other domestic and foreign regulators to ensure that companies do not face duplicative penalties and that any monetary fine, restitution or disgorgement is commensurate with the alleged misconduct.

Key takeaways

 

If a company becomes the focus of a multi-jurisdictional investigation, it should utilize a global, coordinated strategy to manage the investigations across jurisdictions and require that any external counsel or consultants implement a similar strategy. By doing so, a company may be able to minimize its total liability.

Corporate monitors

 

Cronan’s speech also addressed the DOJ’s recent memorandum updating its considerations regarding when to seek the imposition of a corporate monitor when resolving an investigation (the “Memorandum”).

The Memorandum notes that prior DOJ statements set forth two broad considerations to guide prosecutors as to whether a monitor is appropriate: (1) the potential benefits that employing a monitor may have for the corporation and the public, and (2) the cost of a monitor and its impact on the operations of a corporation. The Memorandum elaborates on those considerations by requiring prosecutors to take into account:

  • Whether the underlying misconduct involved the manipulation of books and records or the exploitation of an inadequate compliance program;
  • Whether the misconduct was pervasive across the business or approved/facilitated by senior management;
  • Whether the corporation has made significant investments in, and improvements to, its compliance programs; and
  • Whether any remedial improvements to the corporation’s compliance program have been tested for efficacy.

As Cronan noted, the DOJ shall consider “whether the misconduct took place under different corporate leadership or in a compliance environment that no longer exists, and whether the changes in leadership and the corporate culture adequately safeguard against a recurrence of the misconduct.” Other considerations include the remedial measures put in place (e.g., the termination of certain business relationships and practices related to the misconduct) and the unique risks and compliance challenges for the particular jurisdiction(s) and industry in which the company operates. Finally, prosecutors must consider the costs associated with a corporate monitor—not only the projected monetary costs, but also whether the proposed scope of a monitorship imposes undue burdens on the corporation’s business.[2]

When a monitor is warranted, the Memorandum requires the DOJ to appropriately tailor the scope of the monitorship to address the specific issues and concerns that created the need for the monitor in the first instance.[3] Cronan specifically noted that the imposition of a monitor is not meant to be “punitive” but rather to reduce the chances of future misconduct.

Key takeaways

 

The DOJ’s recent pronouncements on the issue of corporate monitors reinforce the importance of having both an effective compliance program and the agility to promptly remediate if potential misconduct is uncovered – including taking any necessary personnel actions. Although a company cannot predict whether or when a government investigation may occur, conducting regular risk assessments and ensuring that the company’s compliance program is tailored to the company’s compliance risk profile are necessary first steps. The existence of a demonstrably robust program can be a critical factor in minimizing the fallout should a government investigation occur.


[1] A full copy of the speech.

[2] Id. at 2.

[3] Memorandum at 2.

What auditors need to know about blockchain

The implications of blockchain and other disruptive technologies for many legal areas have been addressed by a variety of regulators. While much attention has been focused on the pronouncements by bodies such as the US Securities and Exchange Commission, other regulators have been looking at these matters as well. A recent speech by a member of the Public Company Accounting Oversight Board (PCAOB) discusses implications of such technology for auditing, accounting and investors.

As noted on the PCAOB’s website, the PCAOB is a nonprofit corporation established by Congress to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate and independent audit reports. The PCAOB also oversees the audits of brokers and dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.

On November 2, 2018, PCAOB Board Member Kathleen M. Hamm gave a speech titled “Mexican Mangos, Diamonds, Cargo Shipping Containers, Oh My! What Auditors Need to Know about Blockchain and Other Emerging Technologies: A Regulator’s Perspective.” Although just a statement of Ms. Hamm’s own views and not necessarily those of other PCAOB board members or staff, her remarks provide useful insight to how the PCAOB may view how auditing procedures and financial reporting will need to address the challenges of blockchain and other disruptive technologies.

Ms. Hamm identified emerging technologies as an area that was a “strategic imperative” for the PCAOB to address. She focused primarily on blockchain technology but also noted such areas as robotic process automation, big data analytics and artificial intelligence. She cited experts as expecting worldwide spending on blockchain technology to be $1.5 billion this year, double the amount spent last year, and to reach almost $12 billion by 2022. As an illustration, she discussed how Walmart has piloted blockchain technology to track sliced Mexican mangos from farms, packing houses, brokers, import warehouses and processing facilities ultimately to Walmart stores, reducing the time it took to track a specific shipment back to the farm from almost a week to just 2.2 seconds. She noted how Maersk, the world’s largest container shipping company, is testing blockchain to track globally its cargo and related documents in near real-time, and how London-based Everledger uses blockchain to digitally track diamonds. She raised the prospect that “blockchain could be revolutionary” if companies, instead of using manual processes for account reconciliation, deployed blockchain technology “automatically, in near real-time, reconciling not only internal ledgers but also external ledgers.”

Faced with developments like these and countless new technologies that offer the promise of improving audit quality, Ms. Hamm addressed the question of “what auditors need to know.”

First, “the advent of emerging technologies does not change the fundamental financial reporting framework.” She explained:

“If an emerging technology is being used to meet financial reporting or internal control requirements established by the federal securities laws, then auditors need to understand the design and implementation of that technology. And at the risk of stating the obvious: For audits of public companies and broker-dealers, PCAOB standards still apply.

“In the case of blockchain, if an audit client uses it for business or operational activities, the auditor must understand the information systems, including the related business processes, relevant to financial reporting and how the use of blockchain affects the client’s flow of transactions.”

Second, “[b]lockchain does not magically make information contained within it inherently trustworthy.”:

“Events recorded in the chain are not necessarily accurate and complete. Recording a transaction on a blockchain does not alleviate the risk that the transaction is unauthorized, fraudulent, or illegal. Blockchain also does not address threats that parties to a transaction are related, or that side agreements exist that are not reflected in the chain. And nothing in the technology ensures proper classification of transactions in the financial statements.”

“Moving beyond blockchain to other emerging technologies,” Ms. Hamm raised some additional points:

  1. She stressed that “auditors must be clear-eyed about the new challenges that these technologies create. For example, many of these applications require systematic access to quality data. Clients may be reluctant to provide their auditors unfettered access to such data for control and security reasons. Here is where an auditor’s strong cybersecurity posture may go a long way to lessen those concerns.”
  2. She noted as another challenge “the risk that the technology does not operate as intended due to coding errors when developed, or intentional or unintentional changes made after the technology is deployed. Audit firms, therefore, should have robust controls in place around developing and testing tools before deployment and strong change-management processes for tools that are in use.”
  3. Last, she noted that “in changing environments, computer code underlying complex technology can degrade over time, becoming less responsive. As a result, processes should be in place to continuously monitor and confirm that the output of an application remains consistent with expectations.”

Ms. Hamm also discussed the “five broad principles” she applies when thinking about emerging technology:

“First, when used for matters within our [pur]view, as regulators, we are not here to pick winners and losers in the race for innovation through the use of emerging technology. Let ideas compete.

“Second, as regulators, we should not inappropriately impede creativity. We should be open-minded and prepared in appropriate circumstances to use our regulatory tool kit – guidance, experimental sandboxes, and, possibly under the right circumstances, no-action relief – to remove inappropriate hurdles to new, creative uses of technology…

“[Third,] When an innovation offers the potential to reinforce or enhance a public policy object, we as regulators should be open to removing barriers as appropriate. If the proposed solution offers the potential to drive audit quality forward, you have my attention. If a proposed solution reinforces one or more of the three pillars of the federal securities laws – investor protection, market integrity, or effective capital formation – I want to know more.

“[Fourth,] I am particularly impressed by emerging technology that builds regulatory requirements and cybersecurity into solutions from the start, rather than bolting them on after the fact.

“A fifth principle: To be most effective, as technology around financial reporting and auditing continues to evolve, stakeholders – including investors, preparers, boards, audit committees, auditors, regulators, and academics – should actively participate in that development, sharing their unique perspectives.”

In sum, Ms. Hamm concluded: “Mexican mangos, diamonds, cargo shipping containers and beyond, blockchain and other emerging and disruptive technologies offer immense promise; not only to change financial reporting, but also auditing and assurance activities” — developments that portend “exciting times” ahead for auditing and financial reporting.

Ms. Hamm’s remarks offer useful guidance to how the PCAOB may be likely to view the challenges posed to auditing and financial reporting by blockchain and other disruptive technologies. Companies whose operations are being transformed by such technologies would be well advised to take note of her views in this area.

Supreme Court of Canada Rules that Proposed Canadian Cooperative Capital Markets Regulatory System is Constitutional

Today the Supreme Court of Canada (the Supreme Court) released its much-anticipated decision on the reference regarding the proposed Canadian Cooperative Capital Markets Regulatory System, finding that the proposed national regulatory system is constitutional.

Previous Attempts to Create National Securities Regulator

It has been suggested by the a number of governments, academic commentators and others that a national securities system in Canada would protect investors, foster fair, efficient and competitive capital markets, and contribute to the integrity and stability of Canada’s financial system.  As a result, various attempts have been made to centralize the regulation of securities in Canada with limited success.  While certain interprovincial initiatives aimed at coordinating regulatory functions have succeeded – such as the adoption by some provincial securities commissions of various national and multilateral instruments, and the implementation of the “passport regime” – attempts to create a national securities regulator have failed.

The last major attempt to create a national securities regulator was in 2009, when the Federal government developed the Proposed Canadian Securities Act.  The system was designed to function on an opt-in basis such that each province retained its right to choose to participate or to keep its existing regulatory framework.

The constitutionality of the Proposed Canadian Securities Act was considered by the Supreme Court in 2011 in Reference re Securities Act, in which the federal government sought the Supreme Court’s opinion as to whether the proposed legislation would constitute a valid exercise of Parliament’s power over trade and commerce pursuant to s. 91(2) of the Constitution Act, 1867 (the Constitution).  The Supreme Court held that the proposed legislation would not be a valid exercise of Parliament’s power as it would be outside its sphere of legislative authority.  However, the Supreme Court acknowledged that certain aspects of the proposed legislation may be constitutional as falling within the federal sphere.  In particular, although the Supreme Court found the Proposed Canadian Securities Act to be unconstitutional, it recognized that a scheme based on a cooperative approach to regulating securities in Canada might be constitutional, if it allowed provinces to address issues falling within their powers over property and civil rights and matters of local nature, while leaving room for Parliament to address genuinely national concerns.

Background

After the Supreme Court’s decision on the 2011 reference, the Federal government and the governments of Ontario, BC, Saskatchewan, New Brunswick, PEI and Yukon developed a proposed national cooperative system for the regulation of capital markets in Canada, the Cooperative Capital Markets Regulatory System (the Cooperative System).  The Cooperative System’s framework is set out in an agreement between the federal government and participating territorial and provincial governments (the Memorandum).

Included in the Cooperative System are:

  • The Model Provincial Act , which deals with day-to-day aspects of securities trade. Section 5.5 of the Memorandum provides that any proposals to amend the Model Provincial Act are subject to a vote and must be approved by at least 50% of the members of the Council of Ministers (discussed below) and by the members representing the Major Capital Markets Jurisdictions (presently Ontario and BC).
  • The Draft Federal Act (DFA), which prevents and manages systemic risk and establishes criminal offences relating to financial markets. This would complement uniform provincial and territorial securities legislation.
  • A National Securities Regulator (the Authority), which would be a single operationally independent capital markets regulatory authority to which the federal government and the participating provinces would delegate certain regulatory powers. The Authority would have the power to make regulations but any regulations proposed by the Authority must be approved by the Council of Ministers before coming into force.
  • The Council of Ministers, which would comprise ministers responsible for capital markets regulation in each participating province and the federal Minister of Finance.

The Decision of the Quebec Court of Appeal

The Government of Quebec referred two questions pertaining to the Cooperative System to the Quebec Court of Appeal:

1. Does the Constitution of Canada authorize the implementation of pan-Canadian securities regulation under the authority of a single regulator, according to the model established by the most recent publication of the “Memorandum of Agreement regarding the Cooperative Capital Markets Regulatory System”?

The majority of the Court of Appeal answered this question in the negative and held that the Cooperative System would be unconstitutional.  The Court of Appeal held that the process for amending the Model Provincial Act, and the requirement for any amendments to be approved by the Council of Ministers (Memorandum, s. 5.5) effectively fettered the sovereignty of the participating provinces’ and territories’ respective legislatures. The process for making federal regulations set out in the DFA and Memorandum was deemed inconsistent with the principle of federalism, given that it allowed certain provinces to veto the adoption of a federal regulation.

2.  Does the most recent version of the draft of the federal “Capital Markets Stability Act” exceed the authority of the Parliament of Canada over the general branch of the trade and commerce power under subsection 91(2) of the Constitution Act, 1867?

The Court of Appeal answered this question in the negative.  The Court of Appeal recognized that although the DFA was within Parliament’s jurisdiction under the general trade and commerce power, the provisions setting out the role of Council of Ministers in making the federal regulations (ss. 76-79) were not constitutional and, unless removed, would render the entire DFA unconstitutional.

(For more details on the decision of the Quebec Court of Appeal, please see our previous blog post here.)

The Decision of the Supreme Court of Canada

The Attorneys General of Canada, Quebec and British Columbia appealed to the Supreme Court of Canada.  The Supreme Court analyzed the two questions referred to the Quebec Court of Appeal and held that that proposed national scheme was constitutional.

Question 1

A unanimous Supreme Court determined that the proposed pan-Canadian securities regulation is constitutional.  In large part, this was based on the Court’s view that the Quebec Court of Appeal had misread or misunderstood the proposed scheme.  The Supreme Court found that the proposed scheme would not improperly fetter the legislatures’ sovereignty nor would it entail an impermissible delegation of law-making authority.

Parliamentary sovereignty and the fettering of provincial legislative authority

The Supreme Court held that the terms of the Memorandum do not and cannot fetter the provincial legislatures’ primary law-making authority.  The Council of Ministers’ role is limited to proposals for amendments to the Model Provincial Act and the Council is not contemplated to have any formal involvement in the amendment of legislation already enacted by provinces. Further, the Memorandum does not imply that the legislatures of participating provinces are required to implement the amendments to the Model Provincial Act approved by the Council, nor that they are precluded from making any other amendments to their securities laws.  These legislatures are free to reject proposed statutes (as amended) if they choose. The definition of the Council cannot be understood as incorporating the voting rules of s. 5.5 into the statutory scheme. The Supreme Court rejected the proposition that the Cooperative System purports to fetter law-making powers of participating provinces’ legislatures.

More broadly, the Supreme Court recognized that the executive is incapable of interfering with the provincial legislatures’ powers to enact, amend and repeal legislation. Parliamentary sovereignty means that Parliament and the provincial legislature are supreme with respect only to matters that fall within their respective spheres of jurisdiction.  While the majority of the Quebec Court of Appeal took issue with the Memorandum because it believed that the combined effect of these sections would fetter the sovereignty of the participating provinces’ legislatures, the Supreme Court found that this reflected a misunderstanding of the Memorandum and rests on a flawed premise that the executive signatories are actually capable of binding the legislatures of their respective jurisdictions to implement any amendments as dictated by the Council, and precluding those legislatures from amending their own securities law without Council approval.

The principle of parliamentary sovereignty preserves the provincial legislatures’ right to enact, amend, and repeal their securities legislation independently of the Council’s approval. The Supreme Court found that even if the Memorandum actually purports to fetter this legislative power, it would be ineffective in this regard, rather than constitutionally invalid, given that it cannot bind the legislature.

The Supreme Court did draw attention to the fact that the Memorandum will have political effects distinct from its legal effects. To achieve uniformity, the legislatures of participating provinces would need to enact a statute that mirrors the Model Provincial Act, as amended from time to time. The Council then plays an important political role in the area of securities regulation. According to the Supreme Court, the  majority of the Quebec Court of Appeal went a step too far: it rejected the proposition that the Memorandum is merely a political undertaking that is not legally enforceable, instead finding it necessary to assume the Memorandum’s mechanisms will have their intended effect. The Supreme Court held that such an assumption cannot be relied upon.

Delegation of law-making powers

The Attorney General of Quebec argued that the Cooperative System is unconstitutional because of limits on the legislature’s authority to delegate law-making powers to some separate person or body. The Attorney General submitted that the Memorandum obliged the legislature of participating provinces to enact the provisions of the Model Provincial Act into law and to implement any amendments approved by the Council, and that the Memorandum otherwise prohibited participating provincial legislatures from amending that legislation.

The Supreme Court disagreed and held that, while Parliament or provincial legislatures may delegate regulatory authority to make subordinate laws in respect of matters over which it has jurisdiction to another person or body, a government is barred from transferring its primary legislative authority (to enact, amend and repeal statutes) with respect to a particular matter over which it has exclusive constitutional jurisdiction.

The Supreme Court found that the Cooperative System does not allow the Council to bypass provincial legislatures. The Memorandum does not create an unprecedented legislative body through the Council whose establishment goes against the Constitution. The Model Provincial Act will only have force of law if and when its provisions are properly enacted by legislature of a participating province. As such, the Council is and remains subordinate to the sovereign will of the legislatures.

Question 2

The unanimous Supreme Court agreed that the DFA falls within the general branch of Parliament’s trade and commerce power pursuant to s. 91(2) of the Constitution Act, 1867.  The provisions setting out the role of the Council of Ministers in making the federal regulations (ss. 76-79) were not unconstitutional and thus cannot render the DFA unconstitutional.

The Classification of the Draft Federal Act

The Supreme Court found that the pith and substance of the DFA is to control systemic risks having the potential to create material adverse effects on the Canadian economy.  It does not relate to the regulation of trade in securities generally.  It promotes and protects the stability of Canada’s financial system and protects capital markets, investors and others from financial crimes.  The DFA is less broad than the proposed legislation at issue in Reference re Securities Act, limiting the federal government’s role in regulating capital markets to detection, prevention and management of risk to the stability of the Canadian economy and the protection against financial crimes.  The intention of the DFA is not to displace provincial and territorial securities legislation, but to complement these statues by addressing economic objects that are considered to be national in character.

The Supreme Court further held that some aspects of securities regulation are actually national in character. Accordingly, Parliament is competent to enact legislation that pursues genuine national goals, including the management of systemic risk.  The concept of systemic risk can differentiate matters that are genuinely national in scope from those of local concern.

Using the framework from the decision General Motors of Canada Ltd. v. City National Leasing, [1989] 1 S.C.R. 641, the Supreme Court decided that the DFA  addresses a matter of genuine national importance and scope that relates to trade as a whole. The federal government’s foray into securities regulation under the DFA is limited to achieving these objectives and this supports the validity of the proposed statute. The Supreme Court determined that the legislation is therefore within parliament’s power over trade and commerce pursuant to s. 91(2) of the Constitution.

Regulations under the Draft Federal Act: ss. 76-79

The Council’s role in making regulations is set out in ss. 76-79 of the DFA.  Council’s approval is necessary before a regulation can be made.  The mechanism applicable to the approval or rejection of regulations by Council is set out in s. 5.2 of the Memorandum.  The majority of the Quebec Court of Appeal held that this, in combination with ss. 76-79, conferred a veto right over proposed federal regulations, which undermines the constitutional foundation of the DFA.

The Supreme Court found nothing problematic about the way in which the DFA delegates power to make regulations to the Authority under the supervision of the Council.  The DFA sets out a broad framework for the regulation of systemic risk in capital markets, but delegates extensive administrative powers, including the power to make regulations to the Authority.  This delegation is entirely consistent with parliamentary sovereignty since the delegated authority can always be revoked and its scope remains limited and subject to the terms of the governing statute.

The Supreme Court further held that the manner in which the DFA delegates regulation-making powers to the Authority under the oversight of the Council is not problematic from the perspective of federalism or the constitutional division of powers.  The delegation of administrative powers in a manner which solicits provincial input is not incompatible with federalism, provided that the delegating legislature has the constitutional authority to legislate in respect of the applicable subject matter.

Finally, the Supreme Court held that the fact that some regulations might never be adopted because of provincial opposition does not change the reality that the regulations that are adopted must be respected by all the provinces if the objectives of the DFA are to be achieved.  The fact that the Council is populated with minsters of provincial governments does not invalidate the delegation. Parliament can chose to structure the internal mechanics and approval process of the regulatory body in such a manner as deemed appropriate.

Final Thoughts

For nearly a century, calls for a Canadian national securities regulator have invariably been squashed by constitutional concerns.  While it remains to be seen what will come of the Supreme Court’s most recent decision, this may mark a turning point for Canadian securities law.  As the Supreme Court wrote in its conclusion:  “It is up to the provinces to determine whether participation is in their best interests.  This advisory opinion does not take into consideration many of the political and practical complexities relating to this Cooperative System.”

 

 

A tough break for third party litigation funding in Ontario? Not so fast.

The Ontario Superior Court (ONSC) issued two back-to-back decisions on acceptable litigation financing agreements, both involving the same third party funder.  While the ONSC continues to approve classic litigation financing arrangements, uncertainty remains as to whether third party financiers may profitably fund counsel fees in the context of class actions.

Classic funding schemes continue to receive unfettered court approval

In David v. Loblaw, 2018 ONSC 6469, Morgan J. approved IMF Bentham’s funding agreement in a class action regarding the alleged price-fixing of bread without modifications, recognizing litigation financing as a potential tool for access to justice.

The litigation funding agreement was straightforward: Bentham agreed to pay adverse costs, disbursements and court-ordered security for costs. In return, it would receive 10% of the litigation proceeds net of its expenses. The 10% return was capped according to a sliding scale, increasing with the duration of the proceedings.

In reviewing the terms, Morgan J. highlighted several factors that made the funding agreement “fair and reasonable”:

  • Claimants had sole right to direct proceedings and instruct counsel.
  • Bentham could only terminate the funding agreement with the leave of the court.
  • Bentham would pay costs up to the termination date.
  • Any assignments of the funding agreement had to be done with notice to all parties and court approval.
  • Claimants had received independent legal advice on the terms of the funding agreement.
  • The Court reviewed the unredacted funding agreement and was satisfied that Bentham’s obligation to fund the litigation was sufficient to cover any adverse cost awards.

David is the most recent in a series of decisions where the ONSC accepted similar funding agreements.

Funding plaintiff counsel fees in class proceedings may attract judicial scrutiny

In Houle v. St. Jude Medical Inc., 2018 ONSC 6352, (Houle’s appeal) Myers J. dismissed an appeal from Perell J.’s decision in Houle v. St. Jude Medical Inc., 2017 ONSC 5129, (Houle) to grant a nun pro tunc order, amending Bentham’s funding agreement due to clauses that he deemed were overly broad and potentially unfair.

The funding agreement in Houle was novel in Canadian law: Bentham agreed to pay for 50% of the plaintiffs’ counsels’ fees throughout the case in addition to 100% of disbursements, adverse cost awards and security for costs. In exchange, Bentham would receive an uncapped ~20-25% of any judgment or settlement, depending on when the matter was resolved.

Myers J. affirmed Perell J.’s following concerns about the agreement:

  • provisions in the agreement “bel[ied] any assurances of the Houles having autonomy and having control over the action,” particularly, the provision granting Bentham the right to terminate the agreement on ten days’ notice in its sole discretion; and
  • risk of overcompensation given the high uncapped percentage of the proceeds.

Perell J. required changes to Bentham’s funding agreement that would make it acceptable. He also pre-approved Bentham’s recovery of up to 10% of the class recovery at outset of the case. At the end of the case, the court would determine if any further compensation would be appropriate. In doing so, Perell J. (1) pegged Bentham’s return to the 10% levy received by Ontario’s Class Proceedings Fund and (2) subjected Bentham’s return to the same procedural mechanism used to assess lawyers’ fees at the conclusion of class proceedings.

The appellants and Bentham argued that Perell J. erred because:

  • Ontario’s Class Proceedings Fund receives a 10% levy of any awards or settlements in exchange for costs of disbursements and adverse costs. However, Bentham undertook higher risk than the Ontario’s Class Proceedings Fund because it funded far more than adverse costs and disbursement, which justified more than a 10% return;
  • The assessment of the fairness of fees for a third-party funder is different than the assessment of lawyers’ fees. While the assessment of the fairness of lawyers’ fees requires consideration of the amount and quality of effort performed by the lawyers, the assessment of returns for loaned funds does not;
  • Insufficient weight was given to the fact that independently advised parties made a commercial decision at arm’s length, providing an objective measure of the reasonableness of the proposed loan terms;

Myers J. disagreed.

Meyer J. affirmed that Bentham’s compensation should be pre-approved at 10% with reserve. He distinguished Houle from another case where the full funding fee was approved at the outset of the case on the basis that litigation financiers have never funded plaintiff counsels’ fees in return for an uncapped percentage return to the tune of ~20-25%. Moreover, courts must await the outcome to assess the reasonableness of lawyer fees. The same rationale applies to levies for loans used to fund legal fees.

Myers J. characterized the concern regarding the terms of the agreement “not just for the immediate parties but for some 8,000 absent parties whose interest are at play.” As such, he approved Perell J.’s decision to (1) strike clauses allowing Bentham to withdraw from its funding obligation on its own assessment and (2) add court approval as a pre-condition to Bentham’s withdrawal to guard against the “champertous fear of officious intermeddling”.

Concomitantly, these additional terms increase the complexity of litigation funders’ decision to lend by compounding the uncertainty of estimating litigation funding returns when financing counsel fees.

Houle already distinguished in non-class action matters

While Houle might leave litigation financiers guessing as to what courts might decide is a reasonable return on their capital at risk, a competing line of jurisprudence regarding the funding of counsel fees began in Quebec in early 2018.

In a CCAA proceeding, the Quebec Superior Court in 9354-9186 Quebec Inc. (Bluberi Gaming Technologies Inc.) v. Ernst & Young Inc., 2018 QCCS 1040, rejected the thrust of Perell J.’s decision in Houle. Michaud J. approved a litigation financing similar to the arrangement in Houle whereby Bentham paid a portion of the plaintiff counsel’s hourly rates, in addition to disbursements and adverse costs.

The Houle and Blueberi decisions considered similar clauses in a Bentham agreement. While Perell J. found that some clauses were too broad, Michaud J. saw no issue. Michaud J. began by distinguishing Bluberi from Houle on the basis that it “was rendered in the context of a class action where the motivation and ability of the plaintiff to pursue the litigation are important.” In CCAA proceedings, Michaud J. opined that “the objectives are different.”

Michaud J. then found that Bentham’s termination clause – also at issue in Houle – was reasonable in the context of CCAA proceedings:

“Taking into consideration the amount of time and money Bentham has invested so far […], it is obvious that Bentham has no intention of terminating the LFA unless it perceives that it would not gain from it.”

In a further divergence from his ONSC colleagues[1], Michaud J. found that the decision as a “whole” did not “allow Bentham to exert undue influence in the litigation”.

Effect of Houle’s appeal may ripple across non-class action proceedings

An intervener in Houle’s appeal requested that the Court circumscribe its reasons to class proceedings. The Court refused to grant the intervener’s request. Myers J. explained that it was not for him to determine “how other courts might use this decision if it is ever argued before them by counsel.” If the funding parameters in Houle applied to the litigation of private entities in Ontario, then the complexity and cost of financing litigation agreements for non-class proceedings would likely increase commensurably.

 


[1] Mr. Zarnett makes the same argument in Houle’s Appeal at para 47. Myers J. expressly rejects it.

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