What should companies disclose?

It is rare that the Supreme Court of Canada gets an opportunity to comment on the securities laws of Canada, let alone offer guidance. In the case of Sharbern Holding Inc. v. Vancouver Airport Center Ltd, it has though in a big way. The concept at issue in Sharbern is “materiality” – determining what information should be disclosed to investors by issuers in offering documents. The Supreme Court’s decision clarified the test for what is “material”, borrowing a test from American securities law and ultimately siding with the issuer.

Sharbern was a claim by investors in a Hilton Hotel at (or near) the airport in Vancouver. The defendant, Vancouver Airport Center Ltd. (“VAC”), was developing two hotels (the Hilton and a Marriott) and a shopping plaza on the same site. The Marriott, as an investment (investors purchased strata lots), was marketed after the Hilton, and different financing arrangements were offered to the Marriott investors. Essentially, VAC’s management fee (skimmed off the hotel’s revenues) was lower for the Hilton than the Marriott, but Marriott investors were offered a guarantee by VAC not open to those buying into the Hilton. VAC also took an “incentive management fee” based on hotel revenue from the Marriott only. The Hilton generated a flat fee for VAC.

The fact of the second hotel development was known to Hilton investors, but VAC did not disclose to them the details of the Marriott offer. Hilton strata lot purchasers did not know of the incentive management fee or the guarantee. Anyone who’s ever been marooned at Vancouver Airport might suspect the hotels there are money-makers for their owners. Somehow, however, the Hilton hotel was a bad investment for the initial purchasers and the investors responded in the time-honoured way of a lawsuit.

As a lawyer, I say, long may that practice continue.

They alleged the management incentive fee taken from the Marriott’s revenue did a good job of incentivizing management to focus on the Marriott and ignore the Hilton. The guarantee was said to have the same effect – it was a stick to the incentive fee’s carrot, encouraging management to do everything it could for Marriott investors, with less time spent as a result, it was alleged, on the Hilton. The Hilton investors alleged that, had they known of the Marriott financing arrangements, they would not have invested in the project at all (or demanded better terms).

The British Columbia Supreme Court (the equivalent to the Court of Queen’s Bench, or the Superior Court, in other provinces) agreed, finding VAC liable for the Hilton investor’s losses. The Court of Appeal overturned that ruling, concluding that the Marriott’s financing arrangements were not material to Hilton investors. The investors appealed that decision to the Supreme Court of Canada.

Two BC laws governed VAC’s disclosure obligations – the Securities Act and the Real Estate Act. Although the content varies, this structure generally holds true in other provinces when the investment is a property development. The BC Real Estate Act did not give a definition of the word “material”, opening the door for the Supreme Court to interpret the meaning of that word.

The Court found that materiality is a balancing act; contrary to the attitudes of many plaintiffs in lawsuits arising from a bad investment, there is such a thing as ‘too much information’. Onerous disclosure obligations up the cost of a transaction, and excessive disclosure is not always transparent. Investors can be burdened by the volume of information provided, losing sight of the most important facts when considering whether to invest (or to stay invested). The Court recognized this, establishing the test for whether a piece of information is material for disclosure as being that of the “reasonable investor”.

The question is “would this information matter to the hypothetical, objective investor when considering whether to invest?” The reasonable investor is neither ignorant nor especially astute, neither impressionable nor inordinately sceptical. The “reasonable person” is a concept well familiar to lawyers, and provides a common sense baseline for evaluating the disclosure of the ocean of data associated with a complex project or issuer.

It wasn’t all bad news for investors. The “reasonable investor” standard a neutral one, and plaintiffs are not required to prove that the reasonable investor (let alone the actual investor) would not have invested if the information had been disclosed. Such a sina qua non standard is found in other jurisdictions and is often proposed to courts by defendant issuers. Instead, the investor is burdened with proving that the information in question would have been part of the overall consideration of the investment. Cross-border issuers will recognize this test as the materiality standard in the United States. With the Sharbern decision, the Supreme Court has domesticated it.

For lawyers, proving what information the reasonable investor would have considered involves turning to standard practices in the issuer’s industry or sector, and emphasizing the importance of past performance. As a result, the reasonable investor test as the effect of streamlining the disclosure discussion for issuers and their advisors, and limits the chances that activist investors with particular agendas can launch a successful claim on the back of any non-disclosure they can find.

In Ontario, this materiality standard will have particular relevance for continuous disclosure obligations under Section 75 of this province’s Securities Act, which generally obliges disclosure of any “material change”. The word “material” is a favourite of securities legislation, such that some lawyers would recommend that boards and audit committees keep away from the use of that word unless (and even if) “material changes” or disclosures are specifically on the agenda.