Tuesday, June 14, 2011

SEC CTOs crowdsourced (or is it crowdsoused?) beer company offering

The SEC recently issued a cease and desist order against two advertising executives in the first enforcement action targeting the use of social media to offer securities.

Michael Migliozzi II and Brian William Flatow wanted to acquire the Pabst Brewing Company, but didn't have the $300 million they figured would be required. They created a Facebook page and sent Twitter messages directing potential investors to BuyaBeerCompany.com (it's been shut down, so I can't provide a hyperlink).

In the first stage, the two sought pledges and required that pledgors only supply an e-mail address, first name, last name, and pledge amount. If they received $300 million in pledges, the second stage would consist of collecting the pledges and purchasing Pabst. Initially, website visitors were asked to commit to pledging a minimum amount and to provide their name and e-mail address. If at least $300 million was pledged, each investor would receive a "crowdsource certificate of ownership" and beer worth the amount invested.

By February 2010, more than $200 million had been pledged by more than five million people. No money was actually collected.

Migliozzi and Flatow did not register their offering with the SEC, as required under section 5 of the Securities Act of 1933. The SEC release is silent on whether offering beer violated the act, but that would be stretching the definition of "security."

This is becoming more of an issue. I frequently see postings on LinkedIn soliciting investments. Not only is there a problem with failing to comply with local securities laws, there is the danger that almost any securities commission could consider the securities to be offered for sale in their jurisdiction because of the global reach of the networks. At most, companies seeking to use social media to raise capital should simply state that they are looking to engage a registered dealer to assist them to sell securities in X jurisdiction and say nothing more.

Tuesday, May 10, 2011

SCOTUS clarifies materiality standard for corporate disclosure

The recent US Supreme Court decision in Matrixx Initiatives, Inc. v. Siracusano clarifies the materiality standard for corporate disclosure, and will be relevant to Canadian issuers.

The case was an appeal of a motion to dismiss a securities fraud class action on the basis that the alleged misleading statements concerning Matrixx's leading cold remedy were not material. The District Court granted the motion to dismiss and was overturned by the Ninth Circuit Court of Appeal.

As the case concerned a motion to dismiss before trial, the court assumed that the facts alleged in the plaintiff's pleadings were true.


Matrixx is a manufacturer of over-the-counter pharmaceuticals. One of these, Zicam Cold Remedy, accounted for about 70% of Matrixx's sales. The active ingredient in Zicam was zinc gluconate.

In 1999, Matrixx became aware of a possible link between Zicam and a loss of the sense of smell for users. In 2002, Matrixx's vice president for research and development received a number of complaints about a loss of sense of smell and was given abstracts of studies done in the 1930s and 1980s confirming "zinc's toxicity." Matrixx had done no studies of its own. In 2003, Matrixx learned that two doctors were planning to present findings about Zicam at a meeting of the American Rhinologic Society and warned them that they did not have permission to use Matrixx's or Zicam's names in their presentation. The doctors deleted the references.

One month after the doctors' presentation, the first of four class action lawsuits claiming Zicam caused a loss of smell were filed.

In October 2003, after the presentation, Matrixx issued a statement that Zicam "was poised for growth" and the company had "very strong momentum" with revenues increasing by 50% and earnings per share increasing by 25-30%.

In November 2003 Matrixx filed a Form 10-Q stating that product liability claims may result in a material adverse effect, whether or not proven valid. The form did not disclose that litigation had been commenced.

In January, 2004, Matrixx revised its revenue and earnings targets upward. On January 30, news reports stated that the Food and Drug Administration was looking into complaints about Zicam. The stock fell from $13.55 to $11.97 on the news. Matrixx issued a press release denying a link between its product and a loss of sense of smell. The stock rebounded, but fell again after a Good Morning America broadcast highlighted the issue and noted that four class actions had been launched. A new class action, this time on behalf of purchasers of Matrixx stock, followed.

The basis for the motion to dismiss

Matrixx argued that the plaintiffs had not alleged a "statistically significant correlation" between the use of Zicam and loss of smell to make a failure to publicly disclose the complaints or the earlier studies a material omission. They also argued that the plaintiffs had not stated with particularity facts giving rise to a strong inference of scienter (an intent to deceive, manipulate or defraud), which is a requirement in securities fraud litigation.

The court decision

In a unanimous opinion delivered by Justice Sotomayor (as far as I'm aware, her first) the court upheld the Ninth Circuit decision.

Sotomayor, J. noted that the test for materiality is whether there is a substantial likelihood that a reasonable investor would consider disclosure of a fact to significantly alter the "total mix" of available information. Matrixx was proposing a bright-line test of statistical significance that would "artificially exclude" information that would be significant to trading decisions. Both medical professionals and the FDA consider evidence of causation that isn't statistically significant, and it is reasonable to assume investors would as well.

The court noted that its decision is not a requirement to disclose all adverse drug effects, but ones that reasonable investors would consider to alter the total mix of information must be disclosed. The mere existence of adverse effect reports is not sufficient to support a securities fraud claim. More is required, but the reports do not have to be statistically significant. In this case, consumers would likely be wary of Zantac as the risk of losing the sense of smell outweighed any benefit from the product, especially given the number of cold remedies on the market.

With respect to scienter, the court noted that Matrixx had dismissed "out of hand" findings of a link between Zicam and loss of smell despite having done no studies of its own. It had no basis for making such a claim.

Implications for Canadian companies

The test of materiality in Quebec is more or less the same as in the United States. In other provinces, the test is whether disclosure of the information would reasonably be foreseen to have a significant effect on the market price or value of securities. In most cases, including this one, the result would be the same. There is no bright line. Materiality must be assessed on a case-by-case basis. As is the case in the US, the mere existence of adverse reaction reports will not give rise to an obligation to disclose. But the number and context of such reports may give rise to an obligation to disclose well before they reach a statistically significant number.

Tuesday, April 5, 2011

Feds 0-2 on constitutionality of draft securities law

On the heels of the recent Alberta appellate decision striking down the proposed federal securities act, which I blogged about last month, the Quebec Court of appeal has released its own decision finding that the proposed law is unconstitutional. A link to the decision, which is only in French, is provided here.

The Quebec court generally agrees with the Alberta court's analysis. The ruling is not unanimous - there are two concurring majority opinions and one dissenting opinion finding the proposal is constitutionally valid. All of the judges agreed that the proposed law should not be given the usual presumption of constitutional validity because it was merely a proposal, not a law that had gone through the parliamentary requirements for readings, debates and committee hearings.

The Majority Decision

The majority believed that the federal law was concerned with regulation of an industry, namely the regulation of participants in the securities markets. The courts have consistently upheld the validity of provincial regulation in this field.

The majority then examined the "double aspect" doctrine, where federal and provincial legislation regulating the same conduct may have different purposes, each of which is valid. For example, a federal law prohibiting drunk driving has been held valid as an exercise of the criminal law power, while a provincial law imposing penalties for drunk driving has been held valid as a necessary aspect of regulation of local highways. The majority found that the proposed legislation regulated the same activities as the provincial legislation for the same purpose: protection of investors. They found only a single aspect that failed to meet the General Motors test for determining whether a matter could be under the federal power to regulate trade and commerce described in my previous post.

The majority held that the proposal concerned regulation of a single industry (the securities industry) rather than of trade and commerce in general, and the provinces were perfectly capable of regulating the field. The court contrasted the subject matter with other federal commercial legislation. While entities regulated by the securities act are in the securities industry, entities regulated by the competition act are not in the "competition industry," nor are entities regulated by trademark law in the "trademark industry." The fact that the securities industry has extra-provincial or international aspects does not change its fundamental characteristic. The court cited previous caselaw that held that the fact that the federal government has entered into a treaty governing a particular matter does not give it jurisdiction to pass implementing legislation if the subject matter is properly of provincial concern.

The Dissent

Mr. Justice Pierre Dalphond wrote a dissenting opinion upholding the proposed legislation as valid. He began by noting that the terms "capital markets" (marchés des capitaux), "securities market" (marché des valeurs mobilières), "trading/dealing in securities" (commerce des valeurs mobilières) and "securities industry" (industrie/secteur des valeurs mobilières) should not be considered synonyms.

Dalphond, J. agreed with the majority that the federal proposal should not be presumed to be constitutional. He disagreed with the majority's holding that the proposal could not be valid under the double aspect doctrine as it duplicated provincial law. It is possible for Parliament and the provincial legislatures to pass identical legislation provided the subject matter falls within each body's sphere of competence.

Dalphond, J. then gave an overview of the history of the capital markets in Canada and the relevant court decisions. This was particularly pleasing to a history buff like me. He noted that while a number of Privy Council decisions upheld the power of the provinces to regulate brokers and securities trading in the province, none of them were precedent establishing the ability of the provinces to regulate the capital markets as a whole.

Dalphond, J. held that the Canadian capital market is integrated and national in scope, with stock exchanges and self-regulatory organizations operating on a national level, characterized by transactions that are mostly extraprovincial in nature. More than 95% of issuers, including smaller ones, raise capital in more than one province.

This national market is more than simply a collection of provincial capital markets. It is also unlike the insurance industry, where each policy is an isolated contract and not part of a greater whole.

Because the capital market is national, no one commission can fully regulate it. In particular, only the OSC regulates the TSX, which is a national institution. Only a national commission can simultaneously regulate all components of the market.

The dissent mirrors more or less my own thinking on this topic, and I will be finalizing a paper shortly. It remains to be seen which side the Supreme Court of Canada will fall on when the case is argued later this week.

Monday, March 14, 2011

Musings on the Alberta decision on federal securities legislation

Last week, the Alberta Court of Appeal issued a ruling that the federal government did not have the power under the Constitution Act, 1867 to adopt federal securities legislation. The ruling was in response to a reference by the Alberta government challenging the federal legislation.

The court began by noting that securities law is one of the four pillars of financial regulation (the others being banking, insurance and trust companies) and that, of the four, only banking is regulated federally and only then because of an express head of power in the Constitution. The court also noted that provincial jurisdiction over securities law has traditionally been upheld as an exercise of the "property and civil rights" power.

The federal government argued that it had the authority under the "general" trade and commerce power first set out by the Privy Council in 1881 in Citizens Insurance Co. of Canada v. Parsons. That case also held that the federal government could have jurisdiction over international and interprovincial trade, but the government did not assert these latter aspects as the proposed legislation would govern transactions within a province.

The general trade and commerce power was fleshed out by the Supreme Court in 1989 in General Motors of Canada Ltd. v. City National Leasing. That case set out a non-exclusive, five-point test for determining whether the federal government had a valid basis for legislating:

1. The legislation must be part of a general regulatory scheme;
2. The legislation must be concerned with trade as a whole, not a particular industry;
3. The legislation must establish a scheme subject to continuing oversight by a regulatory authority;
4. The provinces jointly or severally do not have the constitutional authority to enact similar legislation; and
5. The failure of one or more provinces to enact legislation would thwart the purpose of the legislation in other parts of the country.

The court conceded that the legislation was part of a regulatory scheme with continuing oversight by a regulatory authority, but found the legislation failed to meet the other tests. It did not consider the act to regulate "trade" but "a particular industry, namely that which raises money from the general public." It also found that the provinces do have the constitutional authority to enact securities legislation, and that the fact that the federal act will not initially apply nationally (as it allows provinces to opt in to the federal regime) means the fifth criterion is not met.

The court held that it is not enough that federal legislation be desirable or that it would impose uniform regulation across the country. If that were sufficient, any federal legislation would be valid and the property and civil rights power would have little meaning. It stated that the same argument could be used to justify federal regulation of insurance, which the courts have repeatedly held is a matter for exclusive provincial jurisdiction.

Although the federal government did not try to justify the legislation as an attempt to regulate international or interprovincial trade, the court held that securities legislation is at its core the regulation of raising funds from members of the general public, that securities are a form of property and that trading in that property is a series of contractual and property arrangements, none of which involves the cross-border movement of property. The court also noted that Canadian companies have relied upon access to international capital markets since Confederation.

A Critique

In my view, the court has taken an overly restrictive view of the nature of securities legislation. While it is true that the first provincial acts governed the sales of securities to local investors, the industry (and the scope of regulation) has grown substantially since then, to encompass regulation of issuers (not only of disclosure, but shareholder rights and corporate governance issuers), brokers, stock exchanges, self-regulatory organizations and clearing corporations to name but a few. It is much more than raising funds.

I think it would be better to think of the pith and substance (to use a term beloved of constitutional lawyers) of securities regulation not as regulation of capital raising or sales practices but as regulation of the capital markets as a whole. I believe that market participants, including foreign investors, see a Canadian capital market, not separate Ontario and Alberta ones, and that a failure by any one province to regulate its capital markets properly will damage the reputation of the capital markets as a whole. An argument can certainly be made that effective regulation of national capital markets can only be done at the federal level. This was the rationale in the General Motors case, which held that competition could only be effectively regulated at the national level.

A secondary matter is that much of securities legislation today has an extraprovincial effect. This is particularly true for Ontario, where a company that has raised money in the province or listed on the Toronto Stock Exchange becomes a "reporting issuer" subject to ongoing regulation by the OSC. Most of the TSX/S&P Index issuers were incorporated outside the province, meaning that OSC rules have a broad impact on corporate activity that may only marginally touch upon the province.

I also don't believe that trading does not involve cross-border elements. While it is true that a sale by a Victoria Investor to a Miami Investor on the TSX involves a number of discrete steps, it is equally true that the exchange and the clearing corporation are acting on a national basis. Furthermore, the fact that the trade occurred on the TSX may be happenstance, as an order may have been required to be routed there to meet "best price" obligations.

The court states that the argument for federal regulation could be applied to insurance, but I don't think so. Although insurance companies operate nationally, it is fundamentally a series of bilateral contracts. If I take out an insurance policy (or a mortgage with a trust company), that is the beginning and the end of the transaction. There is no interprovincial aspect to my dealings(even if my insurer lays off its risk to a foreign re-insurer), which there easily could be in a trade in securities.

The argument that the legislation fails to meet the final test because of the opt in feature ignores the fact that the government is attempting to introduce the legislation in the most politically palatable manner, and insisting that the scope be national from the beginning is, to quote Voltaire, an example of the perfect being the enemy of the good. It would certainly put the cat among the pigeons if the court's ruling is interpreted to mean that the federal government cannot act in an incremental manner, but has the authority to occupy the whole field in one fell swoop.

What the Court Got Right

The Court quite properly didn't get into an analysis of whether federal regulation would be better or more desirable. These are political, not legal, arguments. If the federal government has the power to regulate, it can, no matter how disastrous the outcome may be. Similarly if it does not, it cannot no matter how inefficient and fragmented the markets may be under provincial jurisdiction.

The court also rebuked the federal government for arguing that federal regulation was necessary to address systemic risk, noting that there were no prudential provisions in the draft federal act dealing with systemic risk.

Interprovincial Trade

I'm somewhat perplexed that the federal government isn't attempting to justify the legislation under the interprovincial trade test. While it's true that the draft legislation regulates transactions within a province, limiting the scope of the federal power to interprovincial matters would still allow federal regulation of the vast bulk of securities law matters. In this respect, it would be similar to the United States, where state regulators still have authority over intrastate transactions. It is also the approach that the federal government took when adopting the Grain Futures Act in 1939, allowing it to regulate trading on the Winnipeg Commodity Exchange. It's interesting how few people in this industry realize that the Winnipeg exchange was regulated only at the federal level until 2000, when Manitoba enacted its Commodity Futures Act and the Manitoba Securities Commission assumed oversight authority.

Monday, February 14, 2011

Random Thoughts on Regulating the Merged TMX-LSE

It's not every day I get quoted in the Financial Post. Since I haven't posted for a while, I thought this was the perfect excuse to get back in the swim of things.

My views were a little confused in the article. Whether this was due to incoherence on my part or editorial tweaking I don't know, but I'd like to set down a few thoughts.

All I know about the proposed merger is what I've read in the press, which is to say I don't know all that much. At its most basic, this could end up as a number of stand-alone stock exchanges with common ownership. Although this raises fewer regulatory concerns, it means that the merger will be a non-event for investors, issuers and other market participants.

There is, of course, no international body to regulate global markets, so they have continued to be regulated at the local level. In this regard, the current approach of the Canadian Securities Administrators serves as a model for international regulation. The TMX Group, headquartered in Toronto, runs four exchanges: The Toronto Stock Exchange (TSX), the Montreal Exchange (ME), the TSX Venture Exchange (TSX VE) and the Natural Gas Exchange (NGX). It also owns a majority interest in the Boston Options Exchange (BOX).

The exchanges are overseen by the provincial securities commissions on a lead regulator model, where only one commission effectively regulates each exchange: Ontario for the TSX, Quebec for the ME and Alberta for the NGX. The TSX VE has both B.C. and Alberta as lead regulators, but they have divided their oversight responsibilities so there is no overlap. BOX is overseen by the SEC.

There is no reason why the same model can't work for the merged entity, with the TSX continuing to be regulated by the OSC, the LSE by the FSA in London and the Bolsa Italiana by the Italian regulator. If all of the various commission insist on having a say in regulating each exchange that is part of the group, it would likely be unworkable, particularly as the Canadian stock exchanges have a great self-regulatory role (either directly or through IIROC) than their European counterparts.

Of course, there will need to be co-ordination if the merged entity wants to harmonize rules across all markets.

The FP article also talked about a college of regulators and suggested that I see a role for IOSCO. This isn't the case. What I said was that it is possible for regulators to specialize to take advantage of local expertise. For example, in Canada, there is expertise for regulation of oil & gas issuers in Alberta and derivatives in Quebec. This does not mean that there will be one regulator of a particular product or issuer.

Take oil & gas. The disclosure standards in National Instrument 51-101 for oil & gas activities were probably largely developed by staff of the Alberta Securities Commission (I don't know this for a fact, but it is a logical assumption). They are national rules, but are not administered only by the ASC. They are in effect in Ontario because the OSC has adopted them as a local rule, and any prospectus by an oil & gas issuer that is cleared in Ontario will have its disclosure reviewed by the OSC. While it is possible a similar recognition of expertise could happen at the international level, I don't see a global regulator anytime soon.