Civil Remedies for Breach of
Continuous Disclosure Obligations
under Ontario’s Securities Act
Christopher J.H. Donald*
This paper considers the issue of whether a civil
cause of action should be available to individual investors
under Ontario’s Securities Act to sue for investment losses
suffered due to inaccurate continuous disclosure. The Allen
Committee’s recent proposals for statutory reform are con-
sidered. Managers (directors and officers) control the dis-
closure process. Any liability rule should therefore be
aimed at providing managers with an incentive to take rea-
sonable care when making disclosure. It is argued here that
disclosure provides a benefit to shareholders as a group.
Accordingly, an appropriate entity
to bring an action
against the managers in the event that they fail to take rea-
sonable care when making disclosure is the corporation it-
self. Such a liability rule is called a managerial liability
rule. A managerial liability rule already exists in that the
corporation has the right to sue managers where they
breach their general duty of care owed to corporations un-
der corporate legislation. The Allen Committee’s proposed
statutory civil cause of action would result in the issuer
being liable for the wrongs of managers and as such is a vi-
carious liability rule. The question is whether the vicarious
liability rule adds anything to the managerial liability rule.
It may in that by holding the issuer liable, the support of
existing shareholders in monitoring management in its dis-
closure may be enlisted. However, the free-rider problem
will limit the scope of how carefuily shareholders will
monitor management’s disclosure. Further, there is a risk of
multiple actions under the vicarious liability rule that does
not exist under the managerial liability rule. Accordingly, it
is an empirical issue as to which rule is superior.
Cet article vise h determiner si des investisseurs de-‘
vraient disposer d’une cause d’action civile individuelle en
vertu de la Loi sur les valeurs mobili&es d’Ontario pour les
dommages subis A la suite d’inexactitudes dans la divulga-
tion continue de renseignements corporatifs. A cette fin, i
examine les propositions rcentes de rtforme 16gislative
dmises par le comit6 Allen. ttant donn6 que les adminis-
trateurs et les dirigeants contr~lent le processus de divulga-
tion, Ia rfgle relative A la responsabilit, devrait avoir pour
objectif de les inciter A faire preuve de diligence raisonna-
ble lorsqu’ils remplissent ces fonctions. L’auteur avance
que, la divulgation se faisant A l’avantage de l’ensemble
des actionnaires, l’entit6 la plus appropride pour intenter
une action contre les administrateurs et les dirigeants en cas
de manquement A l’obligation de diligence raisonnable est
la compagnie elle-mEme. Une telle rfgle de responsabilit6
des administrateurs et des dirigeants existe ddjh en ce que
les lois corporatives permettent aux compagnies de pour-
suivre leurs administrateurs et dirigeants pour manquement
A leur obligation gdndrale de diligence. Toutefois, ]a cause
d’action d’origine I6gislative proposde par le comitd Allen
constituerait une rfgle de responsabilit6 du fait d’autrui, en
ce qu’elle rendrait l’6metteur responsable pour la faute de
‘administrateur ou du dirigeant Cette r~gle ajouterait-elle
quelque chose h celle de responsabilit6 des administrateurs
et des dirigeants? II se pourrait que le fait de tenir
l’6metteur responsable incite les actionnaires A contribuer A
Ia supervision de la divulgation continue, ce qui amdliore-
rait son efficacit6. Toutefois, cet incitatif pourrait etre miti-
g6 dans Ia mesure oti meme les actionnalres ne participant
pas de pros A ce processus de supervision bdndficieraient
des efforts qui y seraient consacrds par les autres actionnai-
res. De plus, la rfgle de responsabilitd pour autrui soul~ve
la possibilit6 d’actions multiples, ce qui n’est pas le cas de
la rfgle de responsabilit6 des administrateurs et des diri-
geants. L’auteur conclut qu’en ‘absence d’exprience con-
crhte, on ne peut avancer que Ia solution proposde par le
comit Allen est prdfdrable h la rfgle actuelle.
College of Law, University of Saskatchewan.
McGill Law Journal 2000
Revue de droit de McGill 2000
To be cited as: (2000) 45 McGill L. 609
Mode de rtf&ence : (2000) 45 R.D. McGil 609
610
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Introduction
I. Agreement on the Information to Be Continuously Disclosed
II. Agreement on Liability and Damages Rules
A. Managers Personally and Solely Liable for Disclosure: The Existing
Liability Rule
1. Absolute Liability Rule
2. Reasonable-Care Liability Rule
3. A Refinement to the Reasonable-Care Rule: Material Errors
4. Damages
5. Conclusions
B. Vicarious Liability Rule: The Allen Committee’s Proposals
1. Loss Suffered by New Shareholders Where There is Overly Op-
timistic or Insufficiently Pessimistic Disclosure
2. Loss Suffered by Former Shareholders Where There is Overly
Pessimistic and Insufficiently Optimistic Disclosure
3. Damages
4. Who Should Have Standing to Sue?
5. Conclusions
Conclusion
2000]
C.JH. DONALD – ONTARIO’S SECURITIES ACT
Introduction
This paper contributes to the debate on a current policy issue in the area of secu-
rities law. This issue is whether there should be an amendment to securities legisla-
tion’ to provide for a statutory civil cause of action in the event that issuers make con-
tinuous disclosure that is inaccurate. Under current securities legislation, there is a
statutory civil cause of action for a misrepresentation in a prospectus document
However, for most provinces, there is no statutory equivalent when there is a misrep-
resentation made by an issuer in a continuous disclosure document? It is a statutory
offense to make a misrepresentation in a continuous disclosure document.” However,
there is a concern that due to budgetary constraints, securities regulators are unable to
effectively enforce the statutory obligation.’ Further, recourse is available in a com-
mon law action for negligent misrepresentation. However, this remedy is considered
to be virtually ineffective against misleading continuous disclosure.6
The Allen Committee7 recently considered the matter. It concluded that there is
cause for concern about the growing incidence of misleading continuous disclosure!
It therefore proposed amendments to the OSA9 to provide a similar remedy to that
found under American securities legislation. In particular, the Allen Committee’s pro-
posal (which is stated at this point in somewhat general terms and outlined in more
detail below) is that where an issuer discloses information that is not accurate to a
certain degree, both the issuer and its managers (directors and officers) should be li-
able to pay damages to investors who disposed of or who acquired shares of the issuer
Ontario’s Securities Act, R.S.O. 1990, c. S.5 [hereinafter OSA] is used as the model Securities Act.
Other provinces and the territories, however, have enacted similar legislation: Securities Act, S.A.
1981, c. S-6.1 (Alberta); Securities Act, R.S.B.C. 1996, c. 418 (British Columbia); The Securities Act,
1.S.M. 1988, c. S50 (Manitoba); Security Frauds Prevention Act, R.S.N.B. 1973, c. S-6 (New
Brunswick); The Securities Act, R.S.N. 1990, c. S-13 (Newfoundland); Securities Act, R.S.N.S. 1989,
c. 418 (Nova Scotia); Securities Act, R.S.N.W.T. 1988, c. S-5 (Northwest Territories); Securities Act,
R.S.P.E.I. 1988, c.S-3 (Prince Edward Island); Securities Act, R.S.Q. 1990, c. V-1.1 (Quebec); The
Securities Act, S.S. 1988, S-42.2 (Saskatchewan); and Securities Act, R.S.Y. 1986, c. 158 (Yukon).
2 See OSA, ibid, s. 130.
3 M. Gillen, Securities Regulation in Canada, 2d ed. (Scarborough: Carswell, 1998) at 209. See also
Toronto Stock Exchange, Committee on Corporate Disclosure, Toward Improved Disclosure: A
Search for Balance in Corporate Disclosure (Toronto: TSE, 1995) at 34 [hereinafter Allen Committee
Interim Report]. The Allen Committee prepared this interim report The Allen Committee issued its
final report in March, 1997: Toronto Stock Exchange, Committee on Corporate Disclosure, Responsi-
ble Corporate Disclosure: A Search for Balance (Toronto: TSE, 1997) [hereinafter Allen Committee
Final Report].
4OSA, supra note 1, s. 129.
5 Allen Committee Interim Report, supra note 3 at 53.
6!bk at51.
7 See supra note 3 and accompanying text
‘Allen Committee Interim Report, supra note 3 at 22.
9 See OSA, supra note 1.
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between the dates when the inaccurate disclosure was made and when it was cor-
rected. However, it is further proposed that neither the issuer nor its managers would
be liable if due diligence were exercised, or alternatively, if reasonable care were
taken, to ensure that the disclosed information was accurate. If damages are awarded,
a plaintiff would be entitled to recover investment losses but there would be a limit on
the total amount that could be recovered.
One of the shortcomings of the Allen Committee’s Report is that it does not have
an adequate theory of the function of disclosure or why we have securities legislation.
The notion that is built upon here is that securities are simply specialized contracts.'”
Private bargaining between issuers, managers, and investors, the principal parties to
the securities contract, will determine what information is to be disclosed. Disclosure
provisions in the securities contract will promote the production of information that is
productive in nature and discourage the production of information that is purely re-
distributive in nature.” Information is productive if it improves the allocation of re-
sources. Information is purely redistributive if all it does is enable a party to a trans-
action who possesses the information to make trading gains at the expense of the
other party. Indeed, arguments such as these explain contract doctrines relating to the
allocation of information such as the doctrines of unilateral mistake and frustration.’2
Disclosure is productive in that it reduces the costs to shareholders as a group of
monitoring management (also called agency costs) and the costs to all shareholders of
disposing of or acquiring the firm’s shares in the capital market (also called liquidity
costs). As such it is in the mutual interests of shareholders as a group to reach an
agreement with managers, who control the process of producing and disclosing in-
formation, whereby managers provide disclosure of information that reduces agency
and liquidity costs.
The function of disclosure is not to enable individual investors to make specula-
tive profits. Disclosure may be of a private benefit to individual investors if an investor
is able to obtain information about the underlying value of an issuer before other in-
vestors uncover it. An informed investor is thereby able to use such information to
make trading gains or speculative profits at the expense of uninformed investors. This
creates a private incentive on the part of individual investors to incur expenditures to
obtain an informational advantage over other investors. However, it is argued here that
” There has been a growing literature that analyzes securities law from the perspective that securi-
ties are specialized contracts. See generally R Easterbrook & D. Fischel, The Economic Structure of
Corporate Law (Cambridge, Mass.: Harvard University Press, 1991) at 1-39 [hereinafter Economic
Structure]; and . Easterbrook & D. Fischel, “Optimal Damages in Securities Cases” (1985) 52 U.
Chi. L. Rev. 611 at 614 [hereinafter “Optimal Damages”]. Even the Allen Committee implicitly takes
a “contractarian” approach to analyzing securities law (see Allen Committee Interim Report, supra
note 3 at 3-5).
“This is a goal of contracts law in general. See e.g. R. Cooter & T. Ulen, Law and Economics, 2d
ed. (Reading, Mass.: Addison-Wesley, 1997) at 245-48.
‘ Ibid. See generally A. Kronman, ‘istake, Disclosure, Information and the Law of Contracts”
(1978) 7 . Leg. Stud. 1.
2000]
C.J.H. DONALD – ONTARIO’S SECURITIES ACT
613
disclosure for such a purpose is redistributive in nature. Investors, as a group, there-
fore have an incentive to reach an agreement with managers whereby managers dis-
close some information, but not detailed information, that may be used for the pur-
poses of making speculative profits. Such minimal disclosure will reduce the private
incentive for individual investors to incur wasteful expenditures to uncover the infor-
mation.
Thus, private bargaining will result in disclosure of information that reduces
agency and liquidity costs, and the private incentive to incur expenditures uncovering
information about the issuer. Indeed, private bargaining in the absence of transaction
costs will provide for much the same disclosure that is also provided for under securi-
ties legislation. The function of securities legislation is to “enable” the formation of
securities contracts by providing a model contract that most issuers, managers, and
investors would make in the absence of transactions costs. By adopting the model
contract, the parties to the securities contract are thereby saved the expense and in-
convenience of negotiating disclosure terms.
The model contract set out in securities legislation, in addition to providing for
what information will be disclosed, will also provide a mechanism to ensure that the
disclosure is accurate. Such a mechanism is called a liability rule. The liability rule
provides an incentive to managers, who control the disclosure process, to take reason-
able care in the production and disclosure of information. Since the parties to the dis-
closure agreement are, on the one hand, shareholders as a group, and on the other, the
managers, it is appropriate for the corporation itself to enforce the agreement on be-
half of the shareholders. The term given here to a liability rule that provides for the
corporation, or its shareholders as a group, to sue the corporation’s managers if they
fail to take reasonable care in the production and disclosure of information is the
“managerial liability rule”. Corporate legislation arguably already provides a manage-
rial liability rule in that managers owe a duty to exercise reasonable care in the per-
formance of their duties as managers.’3 This remedy could, in theory, be invoked if
managers failed to exercise reasonable care to ensure that disclosure was accurate.
It would seem at first glance, therefore, that there is little need to provide indivi-
dual investors with a statutory civil remedy against the issuer in the event that manag-
ers make inaccurate disclosure. Such a liability rule is termed a “vicarious liability
rule” in that the issuer is liable for the conduct of its managers. Essentially, the liabil-
ity rule proposed by the Allen Committee is a vicarious liability rule. A number of
questions about the Allen Committee’s proposals arise. If managers control the proc-
ess of disclosure, why should the issuer, or alternatively, the shareholders as a group,
be vicariously liable? Further, why is the class of plaintiffs limited to those sharehold-
ers that traded in the firm’s shares between the dates when inaccurate disclosure was
made and when it was corrected? Why are these plaintiffs entitled to recover their in-
dividual investment losses?
3 See Canada Business Corporations Act, RS.C. 1985, c. C-44, s. 122(1)(b) [hereinafter CBCA]
and Business Corporations Act, RIS.O. 1990, c. B.16, s. 134(1)0,) [hereinafter OBCA].
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Despite the questions about the Allen Committee’s proposal, the vicarious liabil-
ity rule nevertheless has some merit. A managerial liability rule may not result in
managers taking reasonable care when making disclosure if they do not have the re-
sources to pay any damages award in the event they are found to be liable. If manag-
ers are judgment proof, their incentive to take care is reduced. However, it is argued
here that as long as recovery of investment losses is limited, a vicarious liability rule
will provide an incentive for existing shareholders to monitor managers more care-
fully to ensure that they take reasonable care when producing and disclosing informa-
tion. For this reason, managers may be more likely to take reasonable care when pro-
ducing and disclosing information under a vicarious liability rule than under a mana-
gerial liability rule.
However, because liability is shared among so many shareholders, this creates a
free-rider problem that reduces the incentive for any individual shareholder to monitor
management’s disclosure. Further, because there are so many more potential plaintiffs
under the vicarious liability rule than under the managerial liability rule, there is a risk
of a multiplicity of lawsuits that is not present under the managerial liability rule.
Whether the benefits of the vicarious liability rule are outweighed by its costs is an
empirical question. On balance, therefore, it is unclear whether the vicarious liability
rule provides any additional gains that the managerial liability rule, which already ex-
ists under corporate law, cannot provide.
The rest of the paper will proceed as follows. In Part I, there is a brief discussion
on the theory of disclosure and the function of disclosure legislation along the lines
outlined above. Part II, which deals with liability and damage rules, is the heart of the
paper. After reaching an agreement over what information will be disclosed, the par-
ties will provide for mechanisms, namely liability and damages rules, to ensure that it
is accurate. If it could be determined at the time of disclosure whether the information
was accurate, there would be no need for such rules. The purchaser of information,
who is the shareholder, simply would not pay for the information unless it were accu-
rate. However, there is a timing problem in that it may be some period of time after
disclosure is made before it can be determined whether disclosure is accurate. In this
case, there would be scope for opportunistic behaviour on the part of those who pro-
vide the information, namely the managers of the issuer. Accordingly, liability and
damages rules are required to deter such opportunistic behaviour.
In Part IIA, the managerial liability rule is discussed. Two possible managerial li-
ability rules are considered. The first to be considered is a rule whereby managers
guarantee the accuracy of the information they disclose so that if disclosure is not rea-
sonably accurate or accurate to a certain degree, managers are liable to pay damages.
This would give managers an incentive to take reasonable care or cost-justified pre-
cautions when producing and disclosing information. This is a sensible result since
managers control the process of producing and disclosing information. However, such
a rule would also effectively result in managers insuring investors against losses due
to inaccuracies in disclosure that investors are better at insuring against themselves.
Investors can insure against these losses through their ability to diversify their invest-
ment portfolios.
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C.J.H. DONALD – ONTARIO’S SECURITIES ACT
615
An alternative liability rule would be for managers to be liable only if disclosure
were not reasonably accurate, and managers failed to take reasonable care in the pro-
duction and disclosure of information. This would give managers an incentive to take
reasonable care when making disclosure. It would also provide shareholders with an
incentive to insure themselves against these losses due to inaccurate disclosure. Thus,
a reasonable-care managerial liability rule would be more efficient than a rule where
managers guarantee the level of accuracy of disclosure.
As for a damages rule, it is argued here that under a rule where managers are per-
sonally and solely liable if they fail to take reasonable care, there would be no agree-
ment that managers would be liable for investment losses suffered by shareholders as
a result of inaccurate disclosure. As mentioned above, the parties to the securities
contract will agree that disclosure is to be made to reduce agency and liquidity costs,
and the private incentive to incur expenditures in order to obtain an informational ad-
vantage over other investors. Information, however, also creates expectations by in-
vestors and the market about the future value of the issuer’s shares. Accordingly, if
disclosure is inaccurate, it may result in mistaken expectations by investors and the
market. Those who traded in the firm’s shares between the dates when disclosure was
made and when the inaccuracy was discovered may suffer trading losses. If managers
were liable for investment losses, they would in effect be insuring investors against
investment risk. Again, this is something that investors can better insure themselves
against than can managers. Thus, the damages rule would not result in managers be-
ing liable for investment losses.
Investment losses are, therefore, similar in nature to consequential losses that
arise as a result of breach of contract for which, generally, contracts law is loath to
permit recovery. In this respect, the theory developed here for a managerial liability
rule is consistent with the law of contracts. Managers would, however, be liable to
return wages that they were paid to produce information if they failed to take reason-
able care in the production of information. Removing any reward for taking less than
reasonable care in making disclosure will remove any incentive to take less than rea-
sonable care.
The conclusion to Part HA develops the argument that a managerial liability rule
already exists under corporate law in that managers have a duty to exercise the same
degree of skill and care that a reasonably prudent person would exercise in managing
his own affairs.
In Part II.B, the vicarious liability rule proposed by the Allen Committee is dis-
cussed. After managers, existing shareholders are in the best position to control the
accuracy of disclosure because they can monitor whether management is taking rea-
sonable care and they have the legal power to dismiss management if it is not taking
reasonable care. Accordingly, it would be useful to enlist their efforts to increase the
likelihood that disclosure is accurate. Issuer vicarious liability is a mechanism to enlist
that support.
The Allen Committee proposes that some investors should be able to recover their
investment losses, which is inconsistent with the argument that under a managerial li-
ability rule, investment losses would not be recoverable. How can the Allen Commit-
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tee’s recommendation be justified? It is argued here that if securities legislation is to
promote economic efficiency, it should be more concerned with deterring inaccurate
disclosure than with compensating investors for their investment losses as a result of
inaccurate disclosure.” This is because investor compensation simply means that in-
vestors are insured against investment losses. However, as mentioned above, investors
can efficiently insure themselves against losses by diversifying their portfolios.
If the goal of securities legislation is to deter inaccurate disclosure rather than to
compensate investors, then the right to sue should be allocated to those persons who
can prosecute an action against the issuer and managers most efficiently. It is argued
that the best prima facie prosecutors are those persons who traded in the issuer’s stock
between the dates when inaccurate disclosure was made and when it was corrected. In
order to give such persons the incentive to sue, they must be permitted to recover at
least some of their investment losses, provided that the total investment losses recov-
ered do not exceed the actual harm caused to all shareholders by inaccurate disclo-
sure. If recovery of investment losses is not limited, managers will be deterred too
much from making inaccurate disclosure and will take too much care when making
disclosure. Further, shareholders will be induced to monitor their managers too much.
The paper concludes that, on balance, it is unclear whether the vicarious liability
rule would add much more to what is already provided under the managerial liability
rule.
I. Agreement on the Information to Be Continuously Disclosed
Private bargaining could, in the absence of transaction costs, determine what in-
formation issuers of securities would provide on a continuous basis. Generally, con-
tracts may provide for the allocation of information by one party to another.” A dis-
tinction, however, is made between two types of information: productive information
and redistributive information.”‘ Information is productive if, when it is produced and
disclosed, it improves the allocation of resources or increases the total wealth of the
parties. Typically, the production and disclosure of such information is also costly.
The parties to the contract may reach an agreement for one of the parties to produce
and disclose the information up to the point where the marginal joint expected bene-
fits of doing so are equal to the marginal joint costs.’7 The agreement will also provide
for a sharing of the resulting joint net benefits between the parties.
” Whether the goal of the liability rule should be compensation or deterrence was one of the ques-
tions considered by the Allen Committee (see Allen Committee Interim Report, supra note 3 at 58).
‘5Cooter & Ulen, supra note 11 at 245.
‘MTbd. at 245-48.
‘7 An efficient contract for the disclosure of information will maximize the parties’ joint net ex-
pected benefits from information. The optimal amount of information is obtained where the marginal
joint expected benefits are equal to the marginal joint costs of producing information. That is to say,
the first step in bargaining is to maximize the size of the pie to be divided between the parties. The
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C.J.H. DONALD – ONTARIO’S SECURMES ACT
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Information is redistributive if, where one party to a transaction has information
that another does not, the informed party is able to make gains from trade at the ex-
pense of the uninformed party. Redistributive information does not add to the joint
wealth of the parties. Rather, it simply redistributes the wealth. If no party has an in-
formational advantage over any other party but an informational advantage can be ac-
quired by incurring expenses or making an investment in information, each party has
a private incentive to make such an investment. However, if each party behaves in the
same way, nobody is able to obtain an informational advantage. Each party ends up as
equally well informed as the other, and no party is able to make a trading gain at the
expense of the other. Indeed, the parties are jointly worse off because each has in-
curred expenses to acquire the information. It would therefore be in the interests of
the parties to reach an agreement that neither will invest in redistributive information.
However, such an agreement would be costly to enforce. An alternative to such an
agreement would be to pay someone to make an investment in such information and
publicly disclose it. The amount of information that would be disclosed would be just
sufficient so as to remove the private incentive for all parties to make investments in
such information.”
It should also be noted that information may be productive and redistributive. 9
For example, if there are several principals to a contract and they engage an agent to
uncover information and disclose it to all of them, all the principals will enjoy an in-
crease in wealth because the information is productive. However, if one principal is
able to obtain the information from the agent before the other principals and then buy
out the other principals’ interest in the contract, he will be able to enjoy the entire in-
crease in wealth for himself. Accordingly, there will still be a private incentive on the
part of principals to the contract to incur expenditures to uncover the information. On
balance, however, economic efficiency will be improved if the increase in wealth as a
result of the production of the information exceeds the costs incurred by principals
trying to uncover the information.
The OSA provides for the continuous disclosure by issuers of considerable
amounts of information about themselves to the secondary market. Under sections 77,
78, and 79 of the OSA, issuers are required to file interim financial statements and
audited annual financial statements with the Ontario Securities Commission, and to
provide copies of these documents to their security holders.” There is also a provision
next step to bargaining is to divide the maximized pie between the parties. How that pie is divided
will depend upon the bargaining power of the parties.
IS D. Diamond, “Optimal Release of Information by Firms” (1985) 40 . Finance 1071 at 1073
[hereinafter “Optimal Release of Infonmation”].
‘9 Cooter & Ulen, supra note 11 at 247.
Issuers are required to prepare and file quarterly financial statements and annual audited financial
statements. Financial statements must be prepared in accordance with generally accepted accounting
principles and regulations (see OSA, supra note 1, ss. 77-79; and R.R.O. 1990, Reg. 1015, s. 2 [here-
inafter OSA Regulations]).
MCGILL LAW JOURNAL / REVUE DE DROIT DE McGLL
[Vol. 45
to promptly disclose material changes in the affairs of the corporation.2’ Coupled with
this is a prohibition against insiders trading on material information that has not been
made public. Generally, issuers with revenues or assets above a certain level are
also required to disclose an Annual Information Form4 and Management Discussion
and Analysis (“MD&A”) ‘ providing detailed information about the firm beyond what
is normally disclosed in financial statements.’
Included in MD&A is information that is intended to give the investor an analysis
of the firm’s future prospects. ‘ Such information provides investors with information
that enables them to make predictions about the future value of the firm’s shares. In-
vestors use such predictions to decide whether to trade in the firm’s shares with the
expectation of making trading profits. However, arguably the quantity of forecasting
information which issuers are required to disclose in MD&A is quite minimal. Fore-
casts are a type of forward-looking information. Another type of forward-looking in-
formation is the business plan of the firm. The regulation of the disclosure of the
21 See OSA, ibid., s. 75(1). A material change in the affairs of the company is one that is reasonably
expected to have a significant effect on the market value of its shares: see “material change”, OSA, s.
1(1).
Ibid., s. 76(1).
‘ See OSC Policy Statement 5.10, Part I, General Instructions, Exemptions (OSC Policy Statement
5.10 was first published in (1989) O.S.C.B. 4275, as am. by (1990) 13 O.S.C.B. 943). Generally, OSC
Policy Statement 5.10 applies to all issuers except to mutual funds, to issuers with shareholders’
equity or revenues of $10 million or less, to issuers that are registrants with the SEC of the United
States and which file a Form 10K or 20F with the SEC pursuant to the Securities Exchange Act of
1934, and to foreign issuers.
24 Ibid., Part 11, Annual Information Form, General Statement at para. 1.
Ibid., Part I11, Management’s Discussion and Analysis of Financial Condition and Results of Op-
erations, General Statement.
Ibid., Introduction.
2 MD&A requires management of the issuer to explain in narrative form the issuer’s current finan-
cial situation and future prospects, and is intended to give the investor the ability to look at the issuer
through the eyes of management by providing both an historical and a prospective analysis of the
business of the issuer. Thus, MD&A may be characterized as forward-looking in part in that it pro-
vides information about the future prospects of the issuer (see OSC Policy Statement 5.10, supra note
23, Part III, Management’s Discussion and Analysis of Financial Condition and Results of Opera-
dons). The AIF must also include some forward-looking information (see ibid., Part I, General In-
structions at para. 14). However, while the AlF and MD&A require disclosure of certain forward-
looking information, what is required is qualitative in nature. The issuer is not required to disclose
numerical projections or forecasts. But if issuers choose to disclose numerical projections or forecasts,
such forward-looking information (also called future-oriented financial information) must comply
with the requirements of National Policy Statement 48, which was first published in (1992) 15
O.S.C.B. 5978, as am. by (1993) 16 O.S.C.B. 194; App. A revised by (1993) 16 O.S.C.B. 716. Na-
tional Policy Statement 48 specifies the manner in which future-oriented forecasting information
(“FOFT”) is to be disclosed. FOFI is defined by the Statement as “information about prospective re-
suits of operations, financial position or changes in financial position, based on assumptions about
future economic conditions and courses of action. Future-oriented financial information is presented
as either a forecast or projection”.
2000]
C.J.H. DONALD – ONTARIO’S SECURITIES ACT
619
firm’s business plans is governed so as to prevent the firm’s competitive position from
being harmed by premature disclosure.’
Further, under section 86 of the OSA, any person who solicits proxies from secu-
rity holders to exercise on their behalf their right to vote at annual meetings must send
an information circular to each security holder whose proxy is solicited. Management
must solicit proxies where it gives or intends to give notice of a meeting to holders of
voting securities of a reporting issuer.” The management form of information circular
and any information circular voluntarily sent to holders of voting securities must be in
prescribed form,’ indicating, among other things, information concerning the interest
of the person making the solicitation in the matters to be voted upon, details of execu-
tive compensation, indebtedness of directors, executive officers and senior officers to
the issuer, and interests of insiders in material transactions.’
As already discussed, securities can be viewed as specialized contracts. 2 It is,
therefore, arguable that the parties to the securities contract would reach an agreement
providing for disclosure of many of the same things provided for in the statutory dis-
closure regime described above. In particular, the securities agreement would provide
for:
(a) the disclosure of financial statements and of the information required to be
disclosed in the information circular;
(b) the broad disclosure of information so that it is publicly available;
(c) the disclosure of more detailed information as the size of the firm increases;
(d) the minimal regulation of the firm’s disclosure of business plans;
(e) the prompt disclosure of material changes; and
(f) the disclosure of minimal amounts of forecasting information.
There would be an agreement to items (a) through (c) because such information is
productive. In particular, disclosure of such information makes it easier for sharehold-
ers to monitor the conduct of managers to ensure that they are not shirking their man-
agement responsibilities and it thereby reduces agency costs. Agency costs arise
‘ See OSA, supra note 1, s. 75(3), where disclosure of a material change would be unduly detri-
mental to the interests of the issuer, the issuer can make disclosure on a confidential basis. New busi-
ness plans are arguably “material changes” in the affairs of the issuer. Disclosure of such plans would
be detrimental to the interests of the issuer. Accordingly, there would be confidential disclosure of
business plans.
bid, s. 85.
‘ OSA Regulations, supra note 20, s. 176 and Form 30.
“, OSA Regulations, ibid., Form 30. See also Gillen, supra note 3 at 183.
32See supra note 10 and accompanying text.
620
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whenever a principal entrusts his affairs to an agent.’ Managers, however, bear the
burden of agency costs in the form of lower salaries.’ Therefore, managers will bear
the burden of the costs incurred to produce information that is useful for monitoring
managers.
With respect to item (d), the parties will agree to regulate the disclosure of busi-
ness plans only to a minimal degree. Business plans are clearly productive informa-
tion. Business plans enable the firm to determine how best to use its limited resources.
A better allocation of firm resources increases the profitability, and hence the value, of
the firm. However, business plans are also useful to rivals. If disclosed too early, a ri-
val would copy the plan and appropriate for itself some or all of the profits that the
firm making the business plan expected to enjoy. This would discourage the firm from
making the plans in the first instance.’ Accordingly, the timing of the disclosure of
plans will be left to the discretion of the managers of the firm so as to maximize the
net benefit to be enjoyed from the production and disclosure of business plans.
Moreover, by providing managers with incentive pay whereby their incomes are tied
to the value of the firm, managers will have a greater incentive to disclose business
plans at that time which maximizes the net benefit of doing so.
There would be an agreement to item (e) (prompt disclosure of material changes)
for perhaps two reasons. First, suppose there is a material change in the affairs of the
issuer that arises because of a purely random event. Thus, changes in the affairs of the
issuer caused by making business plans are excluded because business plans are not
purely random events. By virtue of their positions, managers of the firm will typically
acquire information about a purely random change before investors. This will make
managers more informed than shareholders and other investors. If managers were
permitted to trade in the firm’s shares with this informational advantage, they could
make trading gains at the expense of investors. If the random change were positive,
managers would buy shares in the firm to enjoy the profits when the change was made
public. If the random change were negative, managers could enjoy a profit by selling
short whereas purchasing investors would suffer a loss.
This could have the effect of discouraging other investors from investing in the
firm’s shares altogether, since making a trade is likely to be a losing proposition given
that managers always have an informational advantage. This in turn reduces the li-
” See M. Jensen & W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership” (1976) 3 J. Fman. Econ. 305 at 308; and P Mahoney, “Wandatory Disclosure as a Solu-
tion to Agency Problems” (1995) 62 U. Chi. L. Rev. 1047.
‘4Jensen & Meckling, ibid. at 319; and Mahoney, ibid at 1092.
” A business plan is like the discovery of an invention. As such, firms that make business plans will
have difficulty appropriating the full value of the plans. Business plans cannot be protected by means
of intellectual property laws such as patents, copyright, and trade-marks. Often, the primary means of
exploiting a business plan is being the first to make and implement the plan: see J. Kattan, “Antitrust
Analysis of Technology Joint Ventures: Allocative Efficiency and the Rewards of Innovation’ (1993)
61 Antitrust L.J. 937 at 943. However, if the plan is disclosed before the firm is in a position to im-
plement the plan, its first-mover advantage may be lost.
2000]
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quidity of the firm’s shares as it becomes more difficult for shareholders to find
someone with whom to trade. A solution to this problem is to prohibit managers
from trading on non-public information about purely random changes in the affairs of
the issuer. In other words, prohibiting insider trading reduces liquidity costs.37
A second reason why parties might agree to prompt disclosure of material charges
is that, assuming that managers did not trade on non-public information about purely
random changes in the affairs of the issuer, this would mean that there was some un-
disclosed information about the firm. It would be in the interest of investors to incur
expenditures to obtain the information ahead of other investors and thereby make
trading gains. Accordingly, such information is purely redistributive in nature. There
are, therefore, mutual gains to be made from an agreement whereby the managers
promptly disclose just a sufficient amount of information to remove the private incen-
tive for investors to incur expenditures to acquire the information.’
Investors would reach an agreement about item (f), for the public disclosure of
forecasts that relate purely to the future value of the firm’s shares, since such infor-
mation is redistributive in nature.
Also note that the prompt disclosure of such purely random changes has the
added benefit of removing the temptation from managers of trading on such informa-
tion. Thus, prompt disclosure of purely random material changes in the affairs of the
issuer will reduce the private incentive to invest in information about random changes
in the affairs of the issuer and it will reduce liquidity costs.
Finally, it should be noted that such agreements to disclose information would not
completely remove the incentive for investors to try to uncover undisclosed informa-
tion or to make forecasts about the future value of the firm? This is because informa-
tion can be both productive and redistributive in nature. For example, financial state-
ments are used to monitor managers and, if disclosed on a regular basis, reduce
3P. Milgrom & 1. Roberts, Economics, Organization and Management (Englewood Cliffs, NJ.:
Prentice Hall, 1992) at 468; D. Diamond & R. Verrecchia, “Disclosure, Liquidity, and the Cost of
Capital” (1991) 46 L Finance 1325.
“‘ See D. Carlton & D. Fischel, ‘The Regulation of Insider Trading” (1983) 35 Stan. L. Rev. 857.
The authors argue that there are efficiency benefits and costs to insider trading. They posit that it is
therefore ambiguous whether insider trading is efficient or inefficient. This suggests, they further ar-
gue, that insider trading should be left entirely as a matter for private bargaining between the parties to
the securities contract. However, it could be argued that the benefits to a rule that prohibits insider
trading are likely to exceed the costs of such a rule where the issuer is small and its shares are closely
held. Most parties to a securities contract would prefer that, when an issuer first goes public, which is
when it is most likely to be relatively small and its shares closely held, there be a rule that prohibits
insider trading until the issuer becomes large and its shares are widely held. Where that point occurs
is, however, uncertain. If securities law plays an enabling role, there is room for a provision in the
legislation for a rule to the effect that insiders of the issuer are prohibited from engaging in insider
trading, which rule would apply during the initial stages of an issuer’s public life.
3 “Optimal Release of Information”, supra note 18.
‘9 See ibid. at 1088.
MCGILL LAW JOURNAL / REVUE DE DROITDE MCGILL
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agency costs. However, once disclosed, they affect the market value of the firm. To the
extent that an investor can obtain financial statements ahead of other investors, he can
make a trading gain. However, financial statements cannot be produced instantane-
ously. If disclosed too early, there is a risk that they will be inaccurate. This in turn
would make monitoring of the managers more difficult. Thus, the frequency with
which financial statements are disclosed will require the balancing of the objective of
avoiding inaccuracy in disclosure and the objective of discouraging private invest-
ments to uncover the information in the financial statements. Even where these two
objectives are balanced, there will be some investors who still incur expenditures to
uncover the information.
There is a similar problem with forecast information. Business plans, if not dis-
closed prematurely, will increase the value of the firm. The firm cannot disclose the
business plans too early otherwise the benefit of making the plans may be lost. How-
ever, individual investors will then have an incentive to invest in information about
undisclosed business plans. Once these business plans are uncovered, there will be a
further incentive to make forecasts of the firm’s future value based on the plans.
If private bargaining can efficiently determine the terms of the relationship be-
tween issuers, managers and investors, it might be asked what need there is for a secu-
rities regulator. However, there is an “enabling” role for the securities regulator to
play.’ By providing a model contract that the parties to securities contracts are free to
adopt if they so choose, the securities regulator reduces transaction costs in that the
parties avoid the cost of negotiating disclosure provisions, and liability and damages
rules when disclosure is inaccurate. As such, the securities regulator “enables” the
formation of securities contracts and thereby enhances economic activity. Given that
the securities regulator performs its “enabling” function by providing a model securi-
ties contract, contract law principles can provide considerable guidance to the securi-
ties regulator about the rules for the disclosure of information and on liability and
damages rules.
It might be objected that securities legislation is “mandatory” and that the concept
of an “enabling” role for securities legislation is inconsistent with “mandatory” dis-
closure. However, it is inaccurate to describe disclosure legislation as “mandatory”.”
There are numerous ways to opt out of the statutory disclosure regime through the
availability of automatic exemptions,’ 2 the discretionary exemption,’ 3 and blanket or-
ders.” If an exemption or a blanket order is unavailable, then compliance with the
Economic Structure, supra note 10 at 11.
‘Mahoney, supra note 33 at 1093.
4,See OSA, supra note 1, ss. 72 and 73.
‘3/bid, s. 74.
‘0 For a discussion on the “enabling” role played by corporate and securities law in general, see
The securities regulator may find that applications for a discretionary exemption under s. 74 of the
OSA occur with sufficient frequency in a particular type of transaction that the regulator’s time could
2000]
C.J.H. DONALD – ONTARIO’S SECURITIES ACT
statutory regime is required. In this sense the statutory disclosure regime is “manda-
tory”. However, exemptions and blanket orders cover many if not virtually all of the
situations where issuers, investors, and managers would want to opt out of the statu-
tory disclosure regime. Accordingly, the statutory disclosure regime is arguably more
“enabling” in nature than “mandatory”.
II. Agreement on Liability and Damages Rules
The securities contract will include provision for the continuous disclosure of in-
formation outlined above in Part I. In exchange for the service of providing continu-
ous disclosure, managers receive compensation. However, there is a timing problem
in that shareholders may not be able to immediately observe whether the information
provided by managers is accurate or sufficiently prompt. 5
This gives rise to a principal-agent problem. There is opportunity for managers to
behave opportunistically. They could avoid the effort of producing accurate informa-
tion, simply make disclosure without regard to its accuracy or timeliness, and then
quit after being compensated for providing it. Not only would shareholders have paid
good money to managers for inaccurate disclosure, the inaccurate disclosure will
likely affect the value of their investment and they may suffer a trading loss when the
inaccuracy is uncovered.’ Another form of managerial opportunistic behaviour by
managers would be to produce accurate information, make inaccurate disclosure over-
or understating the true state of affairs, and then trade in the firm’s stock to make
trading gains when the true state of affairs is eventually revealed. Shareholders who
buy from or sell to managers will suffer a loss. ”
If at the time shares are issued, the issuer offers no provision in the securities
contract to control opportunistic behaviour, investors simply will not acquire stock in
be saved by granting a “blankef’ order whereby an exemption applies to all transactions of that type
(see Gillen, supra note 3 at 258).
‘ The maiting of promises typically involves deferred exchanges – time passes before the exchange
is completed. This gives rise to the risks and uncertainties of opportunistic behaviour which, in the ab-
sence of enforceable contracts, would discourage the making of mutually beneficial exchange be-
tween parties to a potential transaction. Since at least the time of Thomas Hobbes, it has been recog-
nized that one of the principal purposes of contracts law is to enforce promises so that the benefits of
mutually beneficial exchange or co-operation can be enjoyed (see R. Posner, Economic Analysis of
Law, 5th ed. (New York: Aspen, 1998) at 103).
” However, the parties on the other side of the transaction will enjoy a gain that will offset the trad-
ing loss. But to avoid any loss, investors would have a private incentive to make investigations into the
accuracy and the timeliness of the disclosure provided by managers.
” The more efficient the market for the firm’s shares, however, the less the scope for making trading
gains by behaving opportunistically in this manner. See S. Ross, ‘T)isclosure Regulation in Financial
Markets: Implications of Modem F’mance Theory” in E Edwards, ed., Issues in Financial Regulation
(New York: McGraw-Hill, 1979) 177 at 181.
McGILL LAW JOURNAL / REVUE DE DROITDE McGILL
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the firm.’8 The result will be that the promoters of the firm will be unable to pursue the
investment project that they wish to finance by the issuance of shares. If the firm’s in-
vestment project does not proceed, the gains from an agreement between the firm’s
promoters and investors (whereby promoters sell shares in the firm in exchange for fi-
nancing by investors) are lost.
One mechanism to resolve the problem is for shareholders to withhold compen-
sation from managers until it is determined that the disclosure they made was accu-
rate. Alternatively, managers might be required to post a bond. However, managers
may not have the financial resources to finance their personal consumption or to cover
a bond until it is determined that the disclosure they made was accurate. It might be
considered whether managers could turn to an ordinary lender to borrow money for
this purpose. The lender would lend money to managers on the condition that the
money would be repaid once it was determined that the disclosure was accurate. At
that point in time, the manager/borrower would also receive his or her compensation
from the shareholders so that he or she would have the resources to repay the loan.
But this would then shift onto the lender the problem that shareholders face in being
unable to immediately observe whether the disclosure the managers made was accu-
rate. Accordingly, the manager may be unable to turn to an ordinary lender.
The shareholders are likely in a better position than an ordinary lender to monitor
whether the disclosure the managers made was accurate. Another mechanism to deal
with the principal-agent problem, therefore, is a liability rule whereby managers, in
exchange for receiving payment at the time of making disclosure, agree to pay dam-
ages in the event that it is later discovered that the disclosure is inaccurate. In Part
II.A, a liability regime where managers are personally and solely liable is considered.
It is argued that shareholders and managers will agree that in the event that disclosure
contains a material error, managers who fail to take reasonable care in the production
and disclosure of information will pay damages to shareholders. Moreover, managers
and shareholders will agree that managers will not be liable for investment losses suf-
fered by shareholders but will be liable for the implicit price paid by shareholders for
the disclosure, namely the wages paid to managers to produce and disclose the infor-
5 If the manager intends to stay employed with the firm on a long-term basis, the incentive to en-
gage in opportunistic behaviour will be reduced. Long-term relationships tend to be self-enforcing
because market mechanisms operate to deter opportunistic behaviour. For example, the managerial
labour market will assess the value of the manager based on his or her past performance, including
performance with previous employers. If the manager shirks his duties with one employer and this is
discovered after he quits, there will be a corresponding downward revision of the manager’s compen-
sation (see E. Fama, “Agency Problems and the Theory of the Firm” (1980) 88 1 Polit. Econ. 288 at
295-304). However, problems with opportunistic behaviour are encountered toward the end of the re-
lationship. If managers are close to retirement or the gains from shirking or cheating are large enough,
this market mechanism may not be effective. Specific contractual mechanisms to deal with such op-
portunistic behaviour are required. The contractual mechanisms proposed herein very likely comple-
ment market mechanisms. Because of the presence of market mechanisms to deal with opportunistic
behaviour, shareholders are less likely to have to rely on the legal system to enforce their contractual
rights.
2000]
C.J.H. DONALD – ONTARIO’S SECURITIES ACT
mation. The managerial liability rule is consistent with general principles on the law
of damages where there is breach of contract. This should be so if securities are
viewed simply as being specialized contracts.
In Part II.B, the Allen Committee’s proposals for a vicarious liability rule are con-
sidered in more detail. A managerial liability rule contemplates only managers being
held liable and, if they are liable, liability is to all shareholders. The Allen Committee
proposes, in addition to this, that the issuer be vicariously liable for damages in the
event that disclosure contains a material error and managers failed to take reasonable
care.” Further, it is proposed that not all shareholders would be able to recover dam-
ages As well, investment losses would be recoverable against the issuer but the
amount that is recoverable may be limited’ Nonetheless, as is argued below, issuers,
managers, and shareholders might agree to a rule of issuer vicarious liability and lim-
ited recovery of investment losses.
A. Managers Personally and Solely Liable for Disclosure: The
Existing Liability Rule
Within the liability regime where managers are personally and solely liable, there
are two possible liability rules: an absolute liability rule and a reasonable-care liability
rule. Under an absolute liability rule, the manager receives compensation upon mak-
ing disclosure but promises to compensate the shareholders for any losses that share-
holders may suffer in the event that it is later discovered that disclosure is not rea-
sonably accurate or is not accurate to a certain degree. Under this liability rule, the
manager guarantees a certain level of accuracy of disclosure and promises to pay
damages to shareholders for losses suffered if that level of accuracy is not achieved.
Under a reasonable-care liability rule, however, the manager guarantees that he will
take a certain level of care when making disclosure and promises to pay damages to
shareholders if that level of care is not achieved.
The question then becomes, as between these two liability rules, which rule
maximizes the gains from trade between shareholders and managers? It is in the inter-
ests of shareholders and managers to choose that rule that maximizes the gains from
trade.
49 The Allen Committee proposes that the issuer be held liable when a misrepresentation is made
(see Allen Committee Final Report, supra note 3 at 63).
” The Allen Committee proposes that a cause of action be available to any person who acquires or
disposes of shares in the period between the-time when the misrepresentation was made and when it
was corrected (ibid at 63).
“, The Allen Committee proposes that plaintiffs be entitled to recoyer “damages”. But “damages”
are defined in such a way as to include investment losses or the difference between the price paid for
the share and its price after the inaccurate disclosure is made (ibid at 63 and 69).
626
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1. Absolute Liability Rule
Under an absolute liability rule, managers guarantee the level of accuracy of dis-
closure and promise to pay damages that shareholders may suffer if disclosure does
not reach that level. What level of accuracy will managers guarantee? An efficient
contract between shareholders and managers would maximize the sum of the ex-
pected net benefits of disclosure enjoyed by managers plus the sum of expected net
benefits of disclosure enjoyed by shareholders.” Managers enjoy expected benefits
from disclosure because they reduce agency costs that managers bear 3 Because man-
agers exclusively enjoy the benefits of a reduction in agency costs, they will pay the
costs of producing disclosure that reduces agency costs. Shareholders also enjoy ex-
pected benefits from disclosure in that disclosure reduces liquidity costs and reduces
the private incentive to incur expenditures uncovering undisclosed information about
the issuer and forecasts about the future value of the issuer. Since shareholders alone
enjoy these expected benefits, they will bear the costs of producing disclosure for
these purposes.
Producing and disclosing information, whether used by managers or sharehold-
ers, requires the use of managerial effort and other resources. It is reasonable to sup-
pose, however, that managers cannot perfectly control the accuracy of disclosure be-
cause the process is also partly determined by exogenous random events. Managers
can only control the level of care taken to produce accurate disclosure. Thus, despite
the care taken by management to produce accurate disclosure, disclosure may still be
inaccurate due to events outside the control of managers. But it is assumed that the
more care managers take in the production and disclosure of information, the more
accurate the information likely will be.’
Therefore, the best that managers can do is take that level of care that maximizes
the joint expected net gains of the parties. We might define this level of care to be
“reasonable” care. If managers take “reasonable” care, or alternatively, use cost-
justified precautions when producing and disclosing information, their behaviour is
economically efficient. The level of accuracy that will be guaranteed is that level of
accuracy that is expected to be achieved when managers take reasonable care in the
production and disclosure of information. We might define this level of accuracy to be
“reasonable” accuracy. If disclosure is not reasonably accurate, then managers are li-
able to pay any damages suffered by shareholders. Thus, managers bear the risk of in-
accurate disclosure. It may alternatively be said that, effectively, managers insure
shareholders against the risk of less than reasonably accurate disclosure.
A reasonable assumption to make, however, is that managers are averse to risk.
Shareholders are also likely to be risk-averse but they can virtually eliminate the un-
“See supra note 17.
“See supra note 33 and accompanying text.
note 11 at 271).
A similar assumption is made to analyze the negligence rule in tort law (see Cooter & Ulen, supra
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C.J.H DONALD – ONTARIO’S SECURITIES ACT
627
compensated risk that they bear through diversification of their investment portfolios:’
Thus, shareholders are actually risk-neutral because a large risk can become quite
small when spread among a large group of shareholders. Managers, however, cannot
spread risks so easily.7 Their primary asset is their human capital, which may be firm-
specific, or tied to the issuer 8 and very difficult to diversify. 9
A liability rule that results in risk-averse managers insuring risk-neutral share-
holders against the risk of inaccurate disclosure is inefficient. Because managers are
more risk-averse than shareholders, managers would insist upon being paid a risk
premium for bearing the risk of inaccurate disclosure. Since risk-neutral shareholders
are prepared to bear the risk without being paid any risk premium, a more efficient
agreement between managers and shareholders would be one where shareholders
bore the risk of inaccurate disclosure instead of managers. ‘
2. Reasonable-Care Liability Rule
An alternative to an absolute liability rule would be to hold managers liable if
they failed to take a reasonable level of care to ensure that disclosure was accurate.
Provided that managers took reasonable care to ensure disclosure is accurate, they
would not be liable for any damages in the event that disclosure was inaccurate. How-
ever, if they failed to take reasonable care, they would be liable. Such a liability rule
would give managers the incentive to be efficient in the production of disclosure. By
definition, reasonable care in the production and disclosure of information is eco-
nomically efficient in that, as seen above, it is that level of care that maximizes the ex-
pected joint net benefits for managers and shareholders from disclosure. Provided that
managers took reasonable care in the performance of their duty to produce disclosure,
they would enjoy income certainty. Investors would bear the risk of inaccurate disclo-
sure. However, investors could eliminate this risk through portfolio diversification.
“5 Posner, supra note 45 at 471-76 for a discussion on how portfolio diversification can eliminate
uncompensated risk.
A. Sykes, “The Economics of Vicarious Liability” (1984) 93 Yale L.. 1231 at 1235; and “Opti-
mal Damages”, supra note 10 at 640-41.
57Economic Structure, supra note 10 at 99-100.
Firm-specific human capital is skilU and knowledge developed by an employee that are useful
only if he is employed under a specific employer. It includes methods of production and management
that are idiosyncratic to the firm. The employee will have invested time and energy leaming about
these idiosyncratic methods of production and management. Moreover, the employee and employer
will share in the cost of acquiring this information. However, if the employment relationship is termi-
nated before the employee is able to recoup the cost of his/her share of the investment, the employee
suffers a loss. The employee therefore takes a risk when he/she invests in firm-specific human capital.
The employee can, however, diversify his/her risk if he/she invests in general human capital, which is
useful with a variety of employers. For a discussion on firm-specific human capital, see G. Becker,
Human Capital, 2d ed. (New York: National Bureau of Economic Research, 1975) at 16-37.
59Posner, supra note 45 at 478.
oSykes, supra note 56 at 1235.
MCGILL LAW JOURNAL / REVUE DE DROITDE MCGLL
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The reasonable-care liability rule is therefore more efficient than an absolute li-
ability rule in that it ensures that managers end up doing what they do best, efficiently
producing disclosure, and that investors end up doing what they do best, insuring
against the risk of inaccurate disclosure through portfolio diversification. For this rea-
son, there will not be an agreement whereby managers guarantee the level of accuracy
of disclosure.
3. A Refinement to the Reasonable-Care Rule: Material Errors
When managers take reasonable care to produce and disclose information, it is
expected ex ante that disclosure will be reasonably accurate. Ex post, or after disclo-
sure is made, an assessment can be made relatively easily as to whether the disclosure
achieved the expected degree of accuracy, which is reasonable accuracy. One of the
problems with a reasonable-care liability rule, however, is that it may be difficult to
observe the level of care that managers take when producing and disclosing informa-
tion. Further, ax post, it is likely to be costly to gather evidence to prove that managers
did or did not take reasonable care. But it is, arguably, likely to be less costly to de-
termine expost whether disclosure was accurate or not.
If ex post disclosure were reasonably accurate, shareholders would likely not be
concerned about investigating the actual level of care taken by managers to produce
and disclose information. Since the information is reasonably accurate, which is rela-
tively easy to observe, it is likely the case that managers took reasonable care. There is
therefore likely to be little point in incurring the expense of finding out whether man-
agers actually took reasonable care. However, if disclosure is not reasonably accurate,
which again is relatively easy to observe, then there is a better chance that managers
failed to take reasonable care. In this case it is likely to be more worthwhile to incur
the expense of determining whether managers took reasonable care.
Thus, a threshold question will be considered before incurring the expense of in-
quiring whether reasonable care was taken: does the disclosure contain any material
errors? An efficient liability rule would be to hold managers liable to shareholders
where disclosure contained a material error. However, managers would have the de-
fence available to them that they would be relieved of liability where it was demon-
strated that they took reasonable care to ensure that disclosure was accurate. Since
managers are in a better position than shareholders to prove that they took reasonable
care to produce and disclose information, the burden of proof should be on managers.
4. Damages
What would be an efficient damages rule under a liability rule where managers
agree to be personally and solely liable if they fail to take reasonable care in their dis-
closure? Would managers and shareholders agree that managers would be liable only
for the implicit price paid to managers to produce and disclose information? Or would
the parties agree that managers also would be liable for investment losses suffered by
investors where it transpires that the managers failed to take reasonable care to pro-
duce accurate information? It is argued here that the parties will agree that the mana-
2000]
C.J.H. DONALD – ONTARIO’S SECURITIES ACT
gers would be liable only for the implicit price paid for the production and disclosure
of information. But the implicit price paid for the information is nothing other than
the wages paid by shareholders to the managers.
To see why this is so, consider the agreement to disclose accounting information.
Accounting information is produced for the purpose of enabling shareholders to
monitor managers. If shareholders can monitor managers better, this reduces agency
costs. However, as previously noted, agency costs are ultimately borne by managers
not shareholders. Managers bear agency costs in the form of lower compensation. Ac-
cordingly, if agency costs are reduced, managers will enjoy greater compensation. A
dollar reduction in agency costs should result in a dollar increase in compensation for
managers. But managers are compensated before it is known whether the information
they disclose is accurate; however, compensation in advance is on the condition that if
disclosure is not reasonably accurate and managers failed to take reasonable care, they
will pay damages.
If managers disclose inaccurate accounting information and failed to take reason-
able care, this will have two effects. First, it will increase agency costs. Since mana-
gers bear agency costs and agree to take reasonable care in the production and disclo-
sure of information used by shareholders to monitor managers, the payment of dam-
ages must at least involve repayment of the wages that the managers were paid.
The second effect that inaccurate disclosure will have is to cause some sharehold-
ers to suffer consequential losses. In addition to being used to monitor management,
accounting information is used by shareholders and the market to assess the future
prospects of the firm. On the strength of the accounting information disclosed by the
managers, the market may reach the conclusion that the prospects of the firm are bet-
ter than previously anticipated. This may cause the market to value the issuer more
highly than its underlying value. Those shareholders who purchased shares between
the date that the disclosure was originally made and when the error is uncovered will
suffer an investment loss.”
The argument made here is that under a rule where managers are personally and
solely liable for inaccurate disclosure, shareholders and managers would not reach an
agreement between themselves where managers bore the risk of investment loss due
to inaccurate disclosure. If managers agreed to compensate shareholders for these in-
vestment losses, in effect, managers insure shareholders against investment risks.
Shareholders would have no incentive to take precautions to protect themselves
against investment loss. They could over-rely on the disclosure and invest all their
wealth in the issuer without fear of suffering any investment loss due to inaccurate
disclosure. However, investment loss is a risk that shareholders can bear better than
can managers, due to shareholders’ ability to diversify their portfolios.
61 Conversely, those who sold their shares will enjoy an investment gain. The investment losses of
those who purchased shares will offset the investment gains of those who sold their shares.
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Managers also agree to provide information to shareholders for purposes other
than enabling shareholders to monitor them. For example, managers agree to
promptly disclose information, because it will decrease liquidity costs for sharehold-
ers. Also, managers agree to disclose certain information because it reduces the pri-
vate incentive for shareholders to incur expenditures to uncover undisclosed informa-
tion about the issuer and to make forecasts about the future value of the issuer. Dam-
ages for inaccurate information would compensate shareholders for the increased li-
quidity costs they incur as a result of inaccurate disclosure. Damages would also
compensate for the increased incentive to incur expenditures to uncover undisclosed
information and to make forecasts about the future value of the issuer. However, as
with inaccurate accounting information, damages for investment losses caused by the
disclosure of inaccurate information that is used primarily for other purposes would
not be recoverable because that would remove the incentive for investors to take pre-
cautions to prevent or to insure against investment losses through portfolio diversifi-
cation.
The function that damages serve, therefore, is to provide an incentive for manag-
ers to take reasonable care. The level of damages that achieves this may be called
“optimal” damages. By definition, reasonable care is the economically efficient level
of care to take when producing and disclosing information. If damages are set at a
level that will induce managers to take either more or less than reasonable care, dam-
ages are not optimal. Therefore, if damages are set at a level that makes managers ex-
actly indifferent between taking more or less reasonable care, damages will be opti-
mal. That level of damages will be approximately equal to the wages that the manag-
ers were paid on the condition that they take reasonable care in the production and
disclosure of information. This is so because if they fail to take reasonable care and
they are obliged to return the wages they were paid, they receive no benefit whatso-
ever for having failed to take reasonable care. 2 Conversely, if they take reasonable
care, they are compensated at their market wage rate for the time and energy they de-
voted to take reasonable care. As a result, managers would be just indifferent between
taking more or less than reasonable care.
Accordingly, shareholders and managers would agree that the damages that man-
agers would be liable to pay, if the information they produce is inaccurate and they
fail to take reasonable care, should be approximately equal to the increased wages that
the managers were paid on the condition that reasonable care be taken. This would
2 In fact, they will be worse off because one of the purposes for disclosure is to reduce agency
costs. If managers take reasonable care in their disclosure, managers can increase their wages by more
than it costs them in time and energy to provide reasonable disclosure. Therefore, if managers take
less than reasonable care and they are obliged to return their wages, their income will decrease by
more than what it would have cost them to take reasonable care.
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also provide shareholders with an incentive to take adequate precautions to prevent or
insure against investment losses through portfolio diversification. ,
The foregoing provided an explanation as to why, when shareholders and manag-
ers make private arrangements between themselves, they would agree that managers
would not be liable for investment losses. From a social perspective, such arrange-
ments are also optimal. What is socially optimal is to minimize the harm caused in the
aggregate by inaccurate disclosure. However, in the aggregate, the harm caused from
investment losses resulting from inaccurate disclosure is zero. This follows since for
every investor who suffers a trading loss, there is another investor who enjoys a trad-
ing gain. What has occurred in effect is a redistribution of wealth from those investors
who suffer trading losses to those who enjoy trading gains. Those investors who suf-
fer trading losses have suffered private losses but they are not losses from a social per-
spective. From a social perspective, damages should only be awarded to prevent
6 A similar result is achieved elsewhere in contracts law. Contracts law has a general hostility to-
ward consequential damages: Hadley v. Baxendale (1854), 96 R.R. 736 (Ex. CL). Consider the exam-
ple used by Posner, supra note 45 at 140-41 to illustrate the underlying principle of Hadley v. Baxen-
dale:
A commercial photographer purchases a role of film to take pictures in the Himalayas
for a magazine. The cost of developing the film is included in the purchase price. The
photographer incurs heavy expenses (including the hire of an airplane) to complete the
assignment He mails the film to the manufacturer, but it is mislaid in the developing
room and never found.
The full consequences of the breach include the hire of the airplane and the profits the photographer
would have made from the sale of the photographs to the magazine. Is the film manufacturer liable for
the price of the film or the full consequences of the breach? Consider the perverse incentive effects
that would result if the film manufacturer were liable for the full consequences of the breach. The
photographer would be indifferent between, on the one hand, successful completion of the assignment
and earning a profit and, on the other hand, failure of the assignment with compensation for conse-
quential damages from the film manufacturer. However, the photographer is in a better position to
take precautions to prevent the loss because he knows the value of the film whereas the film manu-
facturer does not. The film manufacturer cannot easily identify invaluable films from films without
value that come into its lab. In order to prevent such losses, the film manufacturer would have to take
extreme measures to care for all rolls of film that came into the lab. This could only be achieved at
great cost and would result in care being taken for rolls of film that were not valuable. It would also
raise the cost of film developing by a considerable amount But the photographer could take relatively
inexpensive measures to prevent the loss. For example, he could use two rolls of film instead of one,
or he could request special handling when he sends the film in to be developed. Accordingly, in order
to induce the photographer to take these inexpensive precautions, the courts deny him consequential
damages and limit his damages to the price of the film. A similar result follows, if the manager is li-
able to pay for investment losses suffered by investors as a result of inaccurate disclosure. This makes
the investor indifferent between, on the one hand, the manager making accurate disclosure with no in-
vestment loss being suffered and, on the other hand, the manager making inaccurate disclosure and
being liable to compensate the investor for the full consequences of the breach. The investor has no
incentive to take relatively inexpensive steps, such as portfolio diversification, to spread the risk of in-
vestment loss. For this reason, the investor should not be entitled to recover his full investment loss if
there is inaccurate disclosure. He should be limited to the price paid for the disclosure.
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losses to society. Therefore, it is not necessary to award damages to prevent invest-
ment losses since they do not represent losses to society. However, managers cannot
avoid liability altogether if they are negligent in their disclosure for they would other-
wise have no incentive to take care when making disclosure. ‘ Requiring managers to
repay the wages they were paid on the condition that they take reasonable care in pro-
viding disclosure removes the incentive to take less than reasonable care.
5. Conclusions
Before discussing the vicarious liability rule proposed by the Allen Committee, it
is argued that a managerial liability rule already exists under corporate law. The dis-
closure provided for under the existing statutory disclosure regime is productive in-
formation and it is useful to shareholders as a group. Disclosureis used by sharehold-
ers as a group to monitor managers more effectively. Also, it is of equal benefit to all
shareholders, hence to shareholders as a group, in that it increases the liquidity of the
firm’s shares. Finally, it is of equal benefit to all shareholders, hence to shareholders
as a group, in that it reduces the private incentive for all individual investors to incur
wasteful expenditures uncovering undisclosed information about the firm or to make
forecasts of the future value of the firm’s shares.
However, it must not be forgotten that the entire group of shareholders is simply
the corporation itself. Therefore, if managers make inaccurate disclosure, the interests
of shareholders as a group, or, alternatively, the corporation, are hurt. But the corpo-
ration already has a remedy available to it if managers make inaccurate disclosure and
they fail to take reasonable care in the production and disclosure of information.
Corporate law statutes impose a duty on officers and directors in exercising their
powers to use the care, diligence, and skill that a reasonably prudent person would use
in comparable circumstances.’ Further, if managers make inaccurate disclosure purely
for opportunistic or self-interested purposes and thereby act against the interests of the
corporation, they are arguably in breach of the fiduciary duty that they owe to the cor-
poration.” The corporation could therefore bring an action under corporate legislation
against the managers to recover damages if the managers breach their obligations to
the corporation. The managers and not the shareholders, however, have the power to
decide whether the corporation will commence any action against the managers for
any breach of their obligations to the corporation. But if the managers were to fail to
cause the corporation to commence an action that was against them, it is open to an
individual shareholder to apply to the court under corporate legislation to commence a
See also Allen Committee Interim Report, supra note 3 at 59.
See CBCA, supra note 13, s. 122(1)(b); OBCA, supra note 13, s. 134(1)(b).
“See CBCA, ibidl, s. 122(1)(a); OBCA, ibid., s. 134(1)(a).
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derivative action on behalf of the corporation against the managers.’ Moreover, it is
open to the court to award interim costs to such a shareholder.’
B. Vicarious Liability Rule: The Allen Committee’s Proposals
Under the liability rule considered in Part IIA, managers were personally and
solely liable only if disclosure was not reasonably accurate or contained a material er-
ror and managers failed to take reasonable care. The burden was on managers to show
that they took reasonable care. Shareholders were permitted to recover the implicit
price they paid for the production and disclosure of the information, namely the
wages paid to managers. However, they were not able to recover their investment
losses.
The liability and damages rules proposed by the Allen Committee shares some
similarities with the liability and damages rules proposed above. In particular, the Al-
len Committee proposes that managers be liable where they make disclosure that
contains a misrepresentation unless they show that they took reasonable care. ‘ The
term “misrepresentation” used by the Allen Committee has a similar meaning to the
term “material error” used above.” Under the Allen Committee’s proposals, even if
there is a material error, managers are not liable unless they fail to show that they took
reasonable care in their disclosure. Thus, the burden is on managers to prove that they
took reasonable care.”‘ This, too, is consistent with the managerial liability rule. Under
the Allen Committee’s proposals, a manager’s total liability is limited to the greatest
of $25,000 or half his income.’ This is consistent with the notion that managers
should be liable to repay their wages if their disclosure is inaccurate.
In other respects, however, the liability and damages rules considered above are
inconsistent with the proposals made by the Allen Committee. In particular, the
managerial liability rule contemplates managers being liable to all shareholders of the
firm or, alternatively, to the corporation. However, the Allen Committee proposes that
only persons who disposed of or who acquired shares in the firm between the dates
when the inaccurate disclosure was made and when it was uncovered have a cause of
action against managers.’ Further, the managerial liability rule contemplates a cause
of action against only the managers. In contrast, the Allen Committee proposes that
both the issuer and managers be liable.!’ In this sense the liability rule proposed by the
Allen Committee is a vicarious liability rule. Further still, the managerial liability rule
67See CBCA, ibid., s. 239; OBCA, ibid, s. 246.
6s See CBCA, ibd, s. 242(4); OBCA, ibid, s. 246(4).
0 AIlen Committee Final Report, supra note 3 at 63 and 64.
70 The Allen Committee defines “misrepresentation” to mean untrue statements of material fact or
an omission to state a material fact (ibid at 63).
711 bid
” bid at 70.
at63.
3Ibid
74/bid at 63 and 70.
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does not contemplate recovery of investment losses. However, the Allen Committee
proposes that plaintiffs be able to recover their investment losses from the issuer pro-
vided that total damages recovered from the issuer do not exceed certain limits where
these damages are likely to exceed the wages paid to managers for producing disclo-
sure in the first instance.:
Would the parties to the securities contract agree to a vicarious liability rule? Ar-
guably, they might so agree. Managers have limited assets and enjoy the protection of
bankruptcy laws in the event that their assets do not cover a damage award against
them. This gives rise to the problem of moral hazard. If managers do not have to pay
damages, their incentive to take reasonable care in disclosure is diminished. Thus,
some other mechanism to ensure that the managers exercise reasonable care is re-
quired.
One such mechanism to consider is to hold others, who are in a position to con-
trol management, vicariously liable where management fails to take due care. Who
then are these others? One group of persons to consider is the shareholders them-
selves. The shareholders may not be able to observe until after disclosure is made
whether the disclosure is accurate. However, the shareholders may have the ability to
observe the degree of care that managers exercise while they are producing informa-
tion. They also know that the more care that is taken in the production of information,
the more likely it is to be accurate. Moreover, the shareholders have the legal power to
dismiss managers if it appears that they are being careless in the production of infor-
mation. Thus shareholders may have a degree of power to prevent inaccurate disclo-
sure from being made by monitoring the managers while they produce information
and by threatening them with dismissal if they fail to take care. Holding shareholders
liable when managers fail to take reasonable care to produce disclosure would provide
shareholders with an incentive to monitor managers’
However, under a rule where managers are held personally and solely liable,
which is the liability rule considered in Part IIA, all shareholders have a cause of ac-
tion against managers. But under a vicarious liability rule, if all shareholders had a
right to sue, shareholders would be liable to themselves. Accordingly, if there is to be
a vicarious liability rule with shareholder liability, it must involve some but not all
shareholders having the right to sue and some but not all shareholders being liable
when managers fail to exercise reasonable care when providing disclosure. Which
shareholders should be liable and which shareholders should have the right to sue?
To answer this question, we may conceptually suppose that there are two periods
of time. In the first period, managers produce and disclose information. The investors
who are shareholders of the firm during this period are called “existing” shareholders.
It is also assumed that during this period, no trading of shares takes place. The second
period is the period of time that elapses after disclosure is made and until it is deter-
“ibid. at 68-69.
76See Sykes, supra note 56 for a general discussion on the economics of vicarious liability.
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635
mined whether the disclosure is accurate or not. During this period, some sharehold-
ers may sell their shares. These shareholders are called “former” shareholders. The
shareholders who buy their shares are called “new” shareholders. The remaining
shareholders continue on as shareholders. These shareholders may be called “con-
tinuing” shareholders. No one in this last group of shareholders buys or sells shares in
the firm during this period. For simplicity, it is assumed, however, that at the begin-
ning of the second period, the decision whether an existing shareholder sells his or her
share or continues as a shareholder is determined by exogenous factors.
1. Loss Suffered by New Shareholders Where There is Overly
Optimistic or Insufficiently Pessimistic Disclosure
It is arguable that holding the issuer liable to pay damages for investment losses’
suffered by new shareholders when there is overly optimistic or insufficiently pessi-
mistic disclosure will induce existing shareholders to monitor managers more care-
fully. When managers make disclosure that is overly optimistic or insufficiently pes-
simistic, this is equivalent to failing to accurately disclose bad news about the firm.
This means that the uncovering of the error will have the effect of reducing the market
value of the firm’s shares. The new shareholders suffer an investment loss as a result.
As between new shareholders and existing shareholders, existing shareholders are in a
better position than new shareholders to supervise and control management so as to
prevent the inaccurate disclosure. If the new shareholders were to have the right to sue
the existing shareholders (or equivalently, the former and continuing shareholders) to
recover damages related to the new shareholders’ investment losses, the existing
shareholders’ expected liability would provide existing shareholders with the incen-
tive to supervise management more carefully in its production and disclosure of in-
formation so as to deter management from taking less than reasonable care.
Provided shareholder turnover is relatively small, holding the issuer liable is a
close approximation to holding the former and continuing shareholders liable. The
benefit enjoyed by new shareholders as plaintiffs in being able to name the issuer as
defendant in any lawsuit is that a plaintiff only has to sue and enforce judgment
against one entity, the issuer, instead of against all the former and continuing share-
holders. The damage award paid by the issuer to new shareholders will reduce the
value of the issuer, including the value of shares held by the new shareholders. But
payment of the damage award is also shared by continuing shareholders. Since the
continuing shareholders effectively pay more than a pro rata share of the damage
award, new shareholders recover a positive amount if the issuer is required to pay
damages to new shareholders where management fails to take reasonable care and
disclosure is less than reasonably accurate.
In Part lI.B.3, below, it is argued that recovery of investment losses should be limited to optimal
damages, namely that level of damages needed to induce managers to take reasonable care.
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It might be noted, however, that if only the issuer is liable, former shareholders
apparently avoid liability. While they were existing shareholders, former shareholders
were also in a position to exercise control over management to ensure that reasonable
care was taken in the production and disclosure of information but they are not liable
to pay any damages once they become former shareholders. Arguably, this reduces
the incentive for existing shareholders to monitor management. This is because at the
time disclosure is made, existing shareholders do not know whether they will dispose
of their shares in the issuer, in which case they will become former shareholders, or
whether they will be continuing shareholders. If they are continuing shareholders,
they expect the firm will be liable to pay damages if disclosure is inaccurate. If they
become former shareholders, they will not be liable. The prospect that any given ex-
isting shareholder will become a former shareholder provides existing shareholders
with somewhat of a reduced incentive to supervise management prior to disclosure.
However, to the extent that the incentive to supervise management is reduced, the
incentive can be increased by raising the expected level of liability of existing share-
holders. The expected level of liability of existing shareholders is increased by in-
creasing the level of damages (about which more will be said below) that continuing
shareholders effectively pay. The prospect that any existing shareholder will be a con-
tinuing shareholder that must pay increased damages provides existing shareholders
with an increased incentive to supervise management.
Also, if former shareholders were liable, this would discourage existing share-
holders of the issuer from disposing of their shares until they could determine that the
disclosure was accurate. Waiting is a type of cost and it essentially reduces the liquid-
ity of the firm’s shares. All shareholders therefore benefit slightly from increased li-
quidity if they know at the time they acquire their shares that when they sell their
shares, they are not responsible for any inaccuracy in disclosure made beforehand.
The benefit of increased liquidity may in part offset any resulting reduction in the in-
centive to monitor management.
If the firm’s shares are widely held, however, the free-rider problem deters indi-
vidual shareholders, hence shareholders as a group, from directly supervising man-
agement in its disclosure and from mounting a campaign to dismiss management in
the event that management takes less than reasonable care when making disclosure.
Since each shareholder’s interest in the issuer is small, if any one shareholder goes
through the trouble of monitoring and supervising management in its disclosure, other
shareholder’s benefit without incurring any cost. This discourages individual share-
holders from monitoring management.’ Thus, for any given level of damages, the
free-rider problem will reduce the incentive effect that liability has on shareholders to
supervise management. But even in the presence of the free-rider problem, sharehold-
ers are in a better position to control management than outside investors. Therefore,
former and continuing shareholders would always be in relatively better position than
” However, the incentive to monitor can be increased by raising damages or the expected level of li-
ability.
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new shareholders to prevent inaccurate disclosure. Accordingly, there may be some
benefit to holding continuing shareholders liable.
2. Loss Suffered by Former Shareholders Where There is Overly
Pessimistic and Insufficiently Optimistic Disclosure
In Part ILB. 1, it was argued that holding the issuer liable to new investors for in-
vestment losses will induce existing shareholders of issuers to monitor management’s
disclosure more carefully. In this part, a similar argument is made with respect to is-
suer liability to former shareholders. Suppose now that disclosure is overly pessimis-
tic or insufficiently optimistic. This means that when the error in disclosure is uncov-
ered, the value of the firm will increase. Former shareholders will suffer a loss and
new shareholders will enjoy a windfall gain. If the issuer were liable to the former
shareholders for an amount not in excess of the investment loss suffered by them as a
result of the inaccurate disclosure, the value of the issuer would decrease by a corre-
sponding amount. Effectively, new shareholders would return some, but not all, of
their windfall gain to former shareholders. Continuing shareholders effectively would
pay the balance of the damage award. Since continuing shareholders essentially pay
more than a pro rata share of the damages, this provides existing shareholders with an
incentive to monitor management carefully before disclosure is made.
However, holding the issuer liable leads to the somewhat anomalous result that
former shareholders, who were once in a position to monitor managers, are able to re-
cover damages caused by their own failure to monitor managers when they were ex-
isting shareholders. If former shareholders are able to recover damages, they avoid re-
sponsibility for inaccurate disclosure just as they did in the case where disclosure was
overly optimistic or insufficiently pessimistic. This will tend to reduce the incentive to
monitor management in the first instance.
This reduced incentive to monitor can be restored, however, by increasing the
level of damages that the issuer has to pay. Furthermore, if former shareholders can
sue, this reduces their incentive to delay in selling shares until it is determined that the
disclosure is accurate. This in turn is a benefit to all shareholders because if they know
that they will not be responsible for errors in disclosure made after they sell, this will
increase the liquidity of the shares. This slight benefit will partially offset the adverse
effects from the reduced incentive to monitor managers.
Finally, as a practical matter, errors of this sort are not likely to occur too often
since managers have an incentive to overstate good news rather than to understate it
and to understate bad news rather than to overstate it. This is because they usually re-
ceive incentive pay that varies with the value of the firm. Thus, their income will tend
to increase in the face of good news and decrease in the face of bad news. Their in-
come will therefore be too low if they understate good news or overstate bad news.
They have a personal interest in seeing that this does not occur.
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3. Damages
Under the managerial liability rule discussed in Part IIA, managers were person-
ally and solely liable where disclosure was not reasonably accurate and managers
failed to take reasonable care. It was argued that the optimal level of damages was ap-
proximately equal to wages managers were paid in advance on the condition that the
information they produced and disclosed was reasonably accurate and reasonable care
was taken. It was also argued in the previous section that investment losses suffered
by those who traded in the firm’s shares between the dates when inaccurate disclosure
was made and when the error was uncovered were not recoverable. If investment
losses were recoverable, this would mean that managers were insuring shareholders
against investment risk. But shareholders are in a better position than are managers to
insure against investment risk because shareholders have the ability to diversify their
portfolios at very little cost. If investors could recover their investment loss, they
would have little incentive to diversify their portfolios and there would be sub-optimal
risk sharing.
Under the liability rule considered in this part, however, it was assumed that
shareholders who traded in shares between the dates when disclosure was made and
when it was discovered to be inaccurate could recover damages from the issuer and
managers for their investment losses. Thus, there is an apparent inconsistency be-
tween the approaches taken to investment losses under the managerial liability rule
and in the vicarious liability rule.
But there is no inconsistency provided that the amount of investment losses re-
covered does not exceed the optimal level of damages. In other words, investment
losses, provided they are limited, can serve as a proxy for optimal damages. Thus,
there is some sense in the Allen Committee’s proposal in permitting those who traded
in the firm’s shares between the dates when inaccurate disclosure was made and when
the inaccuracy was uncovered to recover their investment losses but to limit the
amount that can be recovered. In particular, the Allen Committee recommends that
there be a limit on investment losses that are recovered. As already noted, it proposes
that where an individual manager is liable to pay damages for investment losses, that
there be a limit on the amount that the manager pays equal to the greater of $25,000
and half the manager’s income 9 It also proposes that where the issuer is liable to pay
damages for investment losses, that there be a limit on the amount the issuer pays
equal to the greater of $1,000,000 and 5% of the market value of the firm.’
Nevertheless, the Allen Committee’s recommendations do pose some possible
problems. First, there is no guarantee that the proposed limits on investment losses re-
coverable bear any relation to optimal damages in any given situation. Second, where
optimal damages are less than the damage limits proposed by the Allen Committee,
there is no guarantee that a court would limit recovery of investment losses to the
79Allen Committee Final Report, supra note 3 at 70.
“Ibid. at 68-70.
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amount of optimal damages. If a court allowed recovery of investment losses in ex-
cess of the optimal damages, it would encourage too much care on the part of manag-
ers. Further, a problem could arise if the limits proposed by the Allen Committee are
below the optimal damages. In this case, damages would not induce enough care on
the part of managers.
Under the Allen Committee’s proposals, there is a chance that the damages that
an issuer is liable to pay would exceed the damages that a manager is liable to pay.
This makes sense for at least two reasons. First, as already discussed, the free-rider
problem reduces the incentive for individual shareholders to monitor managers. The
incentive to monitor managers, however, can be increased by raising the amount of
damages that the issuer must pay above the level that managers must pay. Second, un-
der the liability rule considered in this part, although the issuer is liable to pay dam-
ages, former shareholders are not required to pay damages. This may, as previously
discussed, have the effect of reducing the incentive for existing shareholders to moni-
tor managers. Again the incentive for existing shareholders to monitor managers can
be increased by raising the amount of damages the issuer must pay above the level
that the manager must pay. Thus, it will likely be the case that it is necessary to award
greater damages against the issuer to induce former shareholders to monitor managers
than what is awarded against managers in order to induce them to take reasonable
care.
4. Who Should Have Standing to Sue?
In the discussion above, it was assumed that those shareholders who suffered in-
vestment losses would have standing to sue managers and the issuer. The argument
was that if these plaintiffs could sue to recover their investment losses up to certain
limits, the prospect of liability to pay damages would provide managers with an in-
centive to take reasonable care when providing disclosure and existing shareholders to
monitor management to ensure that it took reasonable care when providing disclo-
sure. In this sub-section of the paper, it is argued that it is economically efficient to
allocate the exclusive right to sue to persons who suffered trading losses because,
primafacie, they are in the best position to commence an action against managers and
issuers. To the extent that they are not the most efficient prosecutors of actions, then
rules are required to make it easier to ensure that the right to sue ultimately ends up in
the hands of those persons who are the most efficient prosecutors of actions.
Damages are not intended to compensate investors for their investment losses but
to deter managers from taking less than reasonable care in making disclosure to
shareholders and to provide an incentive to existing shareholders to supervise man-
agement in its disclosure. If damages were intended to compensate investors who suf-
fered trading losses, it would be important that the persons who suffered trading
losses had the right to sue in order to ensure that they were compensated. However, if
damages were intended to compensate investors for their investment losses, this
would mean that investors were being insured against investment risks. But for rea-
sons already discussed, investors can adequately insure themselves against investment
risks through portfolio diversification. What deters managers from taking less than
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reasonable care when making disclosure is the liability they face if they take insuffi-
cient care. What deters existing shareholders from not supervising management is that
the issuer may be liable if they do not supervise and managers take insufficient care.
If the goal is to deter managers and issuers from inappropriate behaviour, it is ar-
guable that it does not matter who has the right to sue. Rather, it may be argued, what
is important is that someone has the right to sue and is entitled to damages. This is be-
cause the entitlement to damages will provide the plaintiff, whoever that is, with the
incentive to sue for damages. Moreover, it is the threat of liability that deters manag-
ers from taking less than reasonable care and issuers from failing to monitor manag-
ers. Does this mean that anyone who wishes to sue should have standing to sue in the
event that managers make inaccurate and careless disclosure?
On the one hand, giving standing to anyone who wishes to sue will increase the
likelihood that managers and issuers will be sued which in turn will provide the de-
sired deterrent effect against the lack of reasonable care by managers and the absence
of adequate supervision by issuers. On the other hand, the right to sue and enforce a
judgment may be regarded as a type of property right. If there are no standing rules so
that anyone may sue to recover damages for inaccurate disclosure, this effectively
makes the right to sue public property. Generally, whenever property is public, it tends
to be overused.” A similar result will occur if the right to sue is public property. It will
potentially result in a free-for-all among plaintiffs as they race to be the first to obtain
a judgment against issuers and managers.’ This in turn may result in litigation pro-
ceeding at an inefficiently fast speed as plaintiffs press the defendants toward trial.
The faster the matter is pushed toward trial, the more costly the lawsuit will tend to
be. Litigation will therefore be excessively intensive. Moreover, although liability
should be limited to optimal damages for the reasons already discussed above,’ the
defendants nevertheless would be subjected to multiple lawsuits with each plaintiff
claiming entitlement to damages. In the result, if anyone may sue, the benefits from
encouraging careful disclosure by management will be dissipated by excessively in-
tensive and extensive litigation.”
Thus, standing must be allocated to someone who has the exclusive right to sue in
order to prevent wasteful litigation. To whom, then, should the right be allocated? One
possible solution is to allocate that right to the securities regulator. This, however,
gives rise to two problems. First, because the employees of the securities regulator do
” See H.S. Gordon, “The Economic Theory of a Common-Property Resource: The Fishery” (1954)
62 L Polit. Econ. 124 reprinted in R. Dorfman & N.S. Dorfman, eds., Economics of the Environment,
2d ed. (New York. W.W. Norton & Company, 1977) at 130.
‘ See generally T.L. Anderson & PJ. Hill, ‘The Race for Property Rights” (1990) 33 J. L. & Econ.
177,
See Part II.B.3, above.
When property is publicly owned, the economic rents to be earned from the property are dissi-
pated as the property will tend to be used beyond the economically efficient level (see Gordon, supra
note 81),
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C.J.H. DONALD – ONTARIO’S SECURITIES ACT
not have a personal stake in the outcome of the litigation, they may not diligently
prosecute the managers and issuer.’ This is a type of principal-agent problem since
the employees of the securities regulator act as agents for taxpayers who are the prin-
cipals. Whenever a government agency is given the exclusive right to protect public
property, it can be expected that agency costs will be incurred.’ Moreover, the free-
rider problem will discourage individual taxpayers from monitoring the employees of
the securities regulator. The result is that the securities regulator cannot be expected to
efficiently prosecute actions against managers and issuers.
The second problem with giving the exclusive right to sue to the securities regu-
lator is that the regulator may face budgetary constraints that prevent it from vigor-
ously pursuing managers and issuers. Indeed, concern about the under-funding of the
securities regulator was a concern underlying the Allen Committee’s proposal that se-
curities legislation be amended to provide for a statutory civil cause of action.’
An alternative might be to randomly allocate the right to sue to individual plain-
tiffs. The opportunity to recover damages would give the randomly selected plaintiffs
a personal stake in the outcome of the litigation. This would address the principal-
agent problem. However, the state would then have to administer a lottery system of
allocating the right to sue, which would be costly. Further, the right to sue might not
end up in the hands of the most efficient prosecutors of actions. This latter problem
could be addressed if the right to sue could be traded. The right to sue would end up
in the hands of the most efficient prosecutors since they would be the ones willing to
pay the highest price to acquire the right to sue. But if there are transaction costs in
trading the right to sue, the state may as well simply auction off the right to sue to the
highest bidder so that the public treasury is benefited. This, however, would require
the securities regulator to maintain an administration that closely monitors the disclo-
sure of managers and issuers, determining that disclosure was inaccurate and then
running an auction to sell the right to sue. This too would be costly.
An efficient standing rule would allocate the right to sue to the persons who value
it most highly.’ These persons in turn are likely to be the persons who are able to
prosecute any lawsuit against the defendants most efficiently. The argument made in
Part I of this paper is that investors will demand that the issuer disclose information in
order to provide better monitoring of management, to address liquidity cost concerns,
and to remove the private incentive for investors to generate information about the
value of the firm. Ex ante, investors do not demand disclosure in order to enable them
to make better investment decisions. Nevertheless, after disclosure is made, the infor-
mation will have a bearing on the value of the firm. It may be that the disclosure of
the information suggests that the market price of the firm is understated. This will in-
= Posner, supra note 45 at 566.
See MJ. Trebilcock, “Economic Analysis of Lav’
in R.E Devlin, ed., Canadian Perspectives on
Legal Theory (Ibronto: Emond Montgomery, 1991) 103 at 114-15.
Allen Comminee Final Report, supra note 3 at 37.
Posner, supra note 45 at 640-41.
McGILL LAW JOURNAL / REVUE DE DROIT DE MCGILL
[Vol. 45
duce some investors to trade on that information. However, by trading on the infor-
mation, this will bid the price of the firm’s share up until the price fully reflects all the
available information about the firm. Primafacie, we would expect those persons who
relied on the disclosure to make a decision to invest in the issuer to value the right to
sue most highly. It is expected that these persons would be better situated than other
persons would be to prove the inaccuracy of the disclosure. One of the elements of the
cause of action against managers and issuers would be that the disclosure was not rea-
sonably accurate. Thus, inaccuracy of disclosure will have to be proved in any law-
suit, requiring knowledge of what information was disclosed in the first instance.
Those who relied on the inaccurate disclosure will have that knowledge.’ A further
alternative might then be to allocate the exclusive right to sue to those investors who
relied on the inaccurate disclosure.
There is a difficulty with this scheme, however, if those investors who relied upon
the inaccurate disclosure must prove that there was reliance on their part. Some in-
vestors will have traded in the firm’s shares without having relied on the inaccurate
disclosure. It will be costly for those investors who relied on the inaccurate disclosure
to distinguish themselves from those who traded in the firm’s securities but did not
rely on the inaccurate disclosure. If the shares of the issuer are held widely, then the
amount that each investor who has the right to sue would be awarded is likely to be
relatively small. The cost of proving that there was reliance may exceed any damages
that are recovered. Those who relied on the inaccurate disclosure will therefore likely
have little incentive to sue. As a result, it is unlikely that allocating the exclusive right
to sue to those shareholders who relied on the inaccurate information to trade in the
firm’s shares will generate much of a deterrent to managers and issuers from making
inaccurate and careless disclosure.
One potential solution to this problem is to give standing to all investors who
traded in the firm’s shares, regardless of whether they relied on the inaccurate disclo-
sure. This will obviate the need to prove that there was reliance. Further, it is reason-
able to expect that some portion of these investors would have relied on the inaccurate
disclosure so that some of them at least would be able to prove that disclosure was in-
accurate. However, there is a cost to allocating the right to sue to all investors who
traded in the firm’s shares.
Allocating the right to sue to individual investors will result in procedural prob-
lems. First, there will be a free-rider problem because if one investor incurs the cost of
proving that there was inaccurate disclosure and therefore that the investor is entitled
to damages, the result of that investor’s lawsuit will make it less costly for other in-
vestors to sue. Evidence adduced at trial will be publicly available. Other investors
will simply wait for someone else to sue first and then free-ride on that person’s ef-
forts. But if all investors behave the same way, then no investor will want to be the
“9 It must be acknowledged, however, that those who relied on the inaccurate disclosure are only
marginally better situated than are others to prove that disclosure was inaccurate. This is because the
information that is needed to provide the proof is so easily transferred to others.
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C.J.H. DONALD – ONTARIO’S SECURITIES ACT
643
first to commence an action. Second, if the issuer’s shares are widely held, the dam-
ages that may be recovered by any one individual shareholder may be outweighed by
the costs of litigation. This would discourage individual investors from commencing a
lawsuit.
One way around these problems is for an investor to apply to the courts under
class proceedings legislation for an order certifying a class action suit and appointing
him as the representative plaintiff.’ If the representative investor is paid a sufficiently
large share of the damages that each member of the class would receive, this will en-
sure that the reward is large enough to provide an incentive for someone to come for-
ward to be a representative plaintiff. This in turn will ensure that potential liability will
provide an adequate deterrent for managers and issuers. The court would then have a
supervisory role to ensure that the representative plaintiff is likely to prosecute the ac-
tion diligently. One problem with class proceedings legislation is that class members
have the right to opt out of the class action.”‘ This gives rise to the risk of a multiplic-
ity of lawsuits.
5. Conclusions
An argument can be made that the parties to the securities contract would agree to
a vicarious liability rule. Such a rule may have an advantage over the managerial li-
ability rule. Under a managerial liability rule, managers are liable to pay damages if
they fail to take reasonable care in the production and disclosure of information. If
managers are judgment proof, they may not have an incentive to take reasonable care.
By holding the issuer liable, this provides an incentive for existing shareholders of the
issuer to monitor management more carefully in its disclosure and to use the threat of
dismissal against managers as an incentive to take care when making disclosure.
However, where shares of the issuer are widely held, because of the free-rider
problem, it may be that the incentive for individual shareholders to monitor the care
taken by managers is not that great. Further, under a vicarious liability rule, there is a
risk of a multiplicity of lawsuits because so many persons have the right to sue.
Conclusion
It was argued in this paper that, in the absence of transaction costs, the parties to
the securities contract would negotiate an agreement providing for the disclosure of
information that would provide a benefit to all shareholders. In the presence of trans-
action costs, there is room for the securities regulator to “enable” the formation of se-
curities contracts by enacting legislation that serves as the model contract that most
parties to a securities contract would want to adopt. Much of the information that is-
‘ See e.g. Class Proceedings Act, 1992, S.O. 1992, c. 6, s. 2.
‘1bid, s. 9.
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suers are required to disclose under our existing disclosure laws can be explained by
this “contractarian” theory of disclosure.
The parties to the securities contract would also agree upon liability and damages
rules. Two liability rules were considered here: a managerial liability rule where man-
agers are liable to shareholders, or, alternatively, to the corporation if they fail to dis-
close reasonably accurate information, and they fail take reasonable care in the pro-
duction and disclosure of information. The parties to the securities contract would not
agree that managers would guarantee the accuracy of disclosure because that would
result in managers bearing the risk of inaccurate disclosure. Shareholders can bear
that risk better than managers can. For similar reasons, managers would not be liable
to pay damages for investment losses suffered by investors as a result of inaccurate
disclosure. Managers would, however, be liable to repay the wages they were paid on
the condition that they take reasonable care in the production and disclosure of infor-
mation. Such a liability rule already does exist under corporate law in that managers
have a general duty to exercise a reasonable degree of diligence when managing the
affairs of the issuer. Arguably, a failure to take reasonable care in the production and
disclosure of information is a breach of this general duty.
The Allen Committee has proposed an alternative liability rule where both the is-
suer and the manager are liable to investors who bought or sold shares between the
dates when the inaccurate disclosure was made and when it was corrected. Liability
will result where the information disclosed is not reasonably accurate, and the manag-
ers failed to take reasonable care in the production and disclosure of the information.
Plaintiffs will be entitled to recover their investment losses up to certain limits. This
liability rule was termed the “vicarious liability rule”.
It was argued in this paper that the parties to the securities contract might also
agree to the vicarious liability rule. The additional benefit that the vicarious liability
rule provides over the managerial liability rule is that it enlists the support of existing
shareholders of an issuer to monitor the care taken by managers when making disclo-
sure. However, it was concluded that where shares of the issuer are widely held, the
free-rider problem reduces the incentive for individual shareholders to monitor man-
agement’s disclosure. Further, there is a risk of a multiplicity of lawsuits under a vi-
carious liability rule. Such a risk does not exist under the managerial liability rule be-
cause only the corporation or a shareholder that had applied for the right to com-
mence a derivative action could sue the managers. On balance, therefore, it is not clear
whether the vicarious liability rule is superior to the managerial liability rule.
