OTTAWA--A Supreme Court of Canada ruling that limits the disclosure obligations of directors and officers and allows them to recoup defense costs if they prevail in securities litigation could minimize the number of D&O claims filed in Canada, insurance experts say.

The decision, however, is not a total victory for Canadian companies because the Supreme Court also said directors and officers may not use a business judgment defense when they fail to make legally required disclosures of material changes to their business, operations or capital.

"Taken as whole, I guess it's more of a positive decision than a negative one," said Brian Rosenbaum, a member of the legal and research practice of the financial services group of Aon Reed Stenhouse in Toronto. "Had it gone the other way, it probably would have had a more profound effect."

In May 1998, Toronto-based Danier Leather Inc.--a designer, manufacturer and retailer of leather and suede clothing and accessories--made an initial public offering of its shares through a prospectus, which contained projected revenue and earnings for its 1998 fiscal year.

An internal company analysis prepared a few days before its IPO closed on May 20, 1998, showed revenue and earnings lagging the forecasted figures due to unseasonably warm weather across much of Canada. The company did not disclose the lagging results until after the IPO closed; when Danier did revise its forecast in June 1998, its stock price dropped sharply, and shareholders went to court and received class action status in accusing the company and its officers of prospectus misrepresentation.

Disclosure obligations

A trial judge found in May 2004 that Danier should have disclosed the results before closing the IPO and awarded substantial damages, but the Ontario Court of Appeal overturned the ruling in 2005.

In Douglas Kerr vs. Danier Leather Inc., the Supreme Court ruled that after filing an IPO, Ontario's securities statute limits the disclosure obligations of directors and officers to material changes to an organization's business, operations or capital. Since its revenue shortfall was caused by unusually warm weather--a material fact rather than a material change--Danier did not breach its statutory obligation to disclose, the Supreme Court ruled.

"They made it fairly clear that a material fact that could affect revenues was not in and of itself a material change," said Eric Dolden, an insurance attorney with Vancouver-based Dolden Wallace Folick L.L.P.

The decision affirmed the Court of Appeal's finding that the trial judge erred in ruling that Danier had an obligation to disclose material facts during the distribution phase of an IPO--the time between filing a prospectus and closing an IPO, lawyers say.

"It stands for the fact that the language of a statute governs and you don't add to the language," said Alan J. Lenczner, a partner with Lenczner Slaght Royce Smith Griffin L.L.P. in Toronto, who represented Danier in the case. "Businesses can have certainty that they can rely on the statute. They don't have to worry about a judge saying they have to do more."

"I think it means if they comply with the disclosure obligations, they can't be successfully sued," said Ben Zarnett, a partner at Goodmans L.L.P. in Toronto, who represented Danier President, Chief Executive Officer and Director Jeffrey Wortsman and Chief Financial Officer and Secretary Bryan Tatoff in the case.

"Companies and officers should take this as a positive message as long as they're playing by the rules," Mr. Zarnett said.

From a risk management perspective, directors and officers are likely to seek legal advice on what constitutes a material change that requires disclosure, which could lead to increased or earlier disclosures, said Murn Meyrick, vp of the executive risk practice of Willis Risk Solutions in Toronto.

While the Supreme Court had been widely expected to affirm the Court of Appeal's ruling, it "shocked" D&O industry experts with its award of costs to Danier and its officers, experts said.

"I think that the best thing for the D&O industry is that the plaintiff was ultimately held responsible for the costs," said Jordan Solway, regional vp, claims and legal for Arch Insurance Canada in Toronto.

Canada's legal system generally operates on a "loser pays cost" basis, meaning that the losing party is responsible for reimbursing the costs of the successful party, although the amount of reimbursement varies by province.

Danier was a dispute between private commercial interests, the Supreme Court said. Under Ontario's class action legislation, a court may award costs in limited situations to ensure parties are not denied access to justice because of a lack of financial resources, including cases that involve a matter of public interest. The Court of Appeal properly determined that the public interest exception did not apply in this case, meaning the defendants are entitled to recover their legal expenses, the Supreme Court ruled.

There had been the expectation that the Supreme Court would rule the case was of significant public importance and the company should pay its defense costs regardless of the outcome, a common view in securities cases, Mr. Dolden said.

The decision will impose some discipline on class action plaintiffs because companies and directors and officers will be eligible for reimbursement of their substantial legal expenses if they prevail in the courts, Mr. Zarnett said.

The Supreme Court, though, also said that the business judgment of directors and officers does not trump their legal obligations to disclose material changes. "It is for the legislature and the courts, not business management, to set the legal disclosure requirements," the Supreme Court said in its ruling.

The Supreme Court clarified the Court of Appeal's position that the trial judge paid insufficient deference to company management's expertise by saying the business judgment rule did not apply in this case and could not be used in this context to determine whether a director or officer had a disclosure obligation, said Ian Rose, a lawyer with Lavery, de Billy L.L.P. in Montreal who practices in the D&O field.

"That's on the negative side for directors and officers, because they cannot use (business judgment) as a shield," Aon's Mr. Rosenbaum said.

Several insurance experts said the ruling could minimize frivolous litigation, leading to fewer D&O claims.

The ruling is unlikely to have an immediate impact on pricing for D&O coverage in Canada, which has been soft this year due to an influx of capacity from foreign insurers, brokers and insurers say.

"If the decision had gone the other way, there's a good chance it would have made the market more unstable," said Garth Pepper, a principal and national leader of the management risk practice for Integro (Canada) Ltd. in Toronto.

In the long-term, pricing could be affected if there are fewer D&O claims being filed, although that could be offset by higher legal costs incurred by defendants who think they will win securities claims and decide to proceed to trial rather than settle, Mr. Pepper said.

Douglas Kerr vs. Danier Leather Inc., Supreme Court of Canada, 2007 SCC44, Oct. 12, 2007

Implications for D&O market

The Supreme Court of Canada's ruling in the case of Douglas Kerr vs. Danier Leather Inc. has critical implications for the directors and officers liability insurance market: