Insider trading can be a slippery slope for in-house counsel

When Claude Chagnon, a former chief executive officer of one of Canada’s largest cable companies, was sued for more than $23 million for allegedly improperly profiting from insider trading nearly a decade ago, one of his lines of defense was to put the blame squarely on the shoulders of an in-house counsel.

It was not a compelling argument. In a ruling that provides guidance over allegations of insider trading, clarifies insider trading rules applicable to corporate officers and sheds light on the meaning of privileged information under the Quebec Securities Act, Quebec Superior Court paid little heed to the claim that the in-house counsel was partially at fault because he breached his professional duty.

In-house lawyers across the province may have heaved a sigh of relief at the ruling which dismissed the suit brought by Quebecor Media Inc. and its cable subsidiary Vidéotron Group Ltd. against Chagnon, but the action also underlines the mounting exposure to liability in-house counsel now face. Complex and constantly evolving regulatory schemes requiring corporations to meet a slew of compliance and disclosure duties may have vaulted corporate counsel Into key management positions — but at a premium. In-house counsel are expected to shoulder the imposing responsibility of ensuring that their companies comply with the complicated domestic and international regulations, including legal requirements for insider trading.

“In-house counsel have the burden of regulatory compliance,” noted Jonathan Levin, a corporate lawyer who was the former chair of the Fasken Martineau DuMoulin LLP’s partnership board. “If there is a regulatory issue of non-compliance, the in-house counsel almost always has to live with the consequences because they are viewed as the person on the ground who should know the regulatory regime applicable to the company and should be in charge of making sure that there is compliance with it.”

In-house counsel feel the weight. Nearly one in four in-house lawyers rank regulatory compliance as the most challenging area of law, followed by issues relating to governance, according to a 2009 survey conducted on behalf of the Canadian Corporate Counsel Association. Adding to the encumbrance is the current economic climate, which has adversely impacted in-house legal departments. One in three say they have decreased the size and number of staff, face more work, depend less on outside legal services and have a tighter and more scrutinized budget, reveals the survey. “Organizations downsize in the compliance area at their peril,” said Kristine Robidoux, formerly the director of corporate compliance of Alberta electric utility ENMAX Corp. and general counsel for national propane gas company Superior Propane Corp. “From a business standpoint, implementing effective internal controls in the end is far less expensive than defending a criminal or regulatory act,” added Robidoux, who used to head a consulting firm that specialized in ethics and corporate compliance programs before joining Gowling Lafleur Henderson LLP’s Calgary office where she is a partner.

It’s not only a question of expense. Insider trading can exact a heavy price, and can lead to both regulatory and criminal sanctions, including possible fines and imprisonment. It also can constitute grounds for immediate dismissal with cause. While prohibited for many years under provincial securities acts, insider trading and informing became an offence under the Criminal Code of Canada five years ago after Bill C-13 was proclaimed in force as “part of the federal government’s response to the recent spate of corporate scandals that have plagued the United States and weakened investor confidence in capital markets around the world,” according a legislative background report on the bill. But while the wording of the Criminal Code provision is quite different from the wording in provincial securities act provisions, it covers most of the potential insider trading and informing situations addressed in provincial securities acts.

In short, illegal insider trading is committed when a person in a “special relationship,” including a business relationship, trades with the knowledge of a material fact or material change that has not yet been generally disclosed. An intent to benefit from inside knowledge is not a required element of the offence so as long as a person has knowledge of undisclosed material information at the time of trading, the offence is committed.

Generally, provincial securities legislation requires any insider — usually a director, senior officer or a significant security holder — of a public company or reporting issuer to file reports disclosing the insider’s direct or indirect beneficial ownership of, or control or direction over, securities of that company and any changes in that ownership.

“The real key to insider trading is whether you have material, undisclosed information, and the determination of materiality is frankly always as much an art as it is a science,” said John Blair, the securities litigation group leader of the Calgary office with Borden Ladner Gervais LLP. Every insider of every publicly-traded company, points out Blair, has information every hour of the day that the public does not. They may know the sales for the week, or that there is a meeting with a prospective new customer, or that the groundwork for a potential merger and acquisition is being laid. “The challenge for in-house counsel is determining materiality of information because increasingly these days it is part of their role,” added Blair.

A decision rendered by the Ontario Securities Commission (OSC) in January 2008 that provides guidance over when merger negotiations must be disclosed also examines the issue of materiality. In the Matter of AiT Advanced Information Technologies Corporation, Bernard Jude Ashe and Deborah Weinstein, the OSC held that under normal circumstances public disclosure is only required once both parties have received requisite board approvals and a definitive merger agreement is executed. The OSC notes that merger negotiations must only be disclosed if they amount to a material change in the business, operations or capital of an issuer. Informed by the Supreme Court of Canada’s decision in Kerr v. Danier Leather Inc., [2007] 3 S.C.R. 331, 2007 SCC 44, the OSC ruling reiterates the distinction between material changes from material facts and their different disclosure requirements. While a material fact and a material change must reasonably be expected to have a significant effect on the market price or value of the issuer’s securities, the definition of a material fact is in fact much broader than that of a material change. A material change requires a “change” as opposed to the mere existence of a fact. Not all material facts will be significant enough to constitute a change in the business, operations or capital of the issuer, and therefore be a material change, said the 79-page ruling.

“That case is a perfect example of the struggles that lawyers face, and that would apply to outside and inside lawyers, on what to advise and when to advise on the disclosure of certain events — it can be a slippery slope,” said Blair.

An even stickier issue is in-house counsel whose companies are governed by the Quebec Securities Act (Act). In Le Groupe Vidéotron Ltée and Quebecor Media Inc. v. Claude Chagnon, Quebec Superior Court held that the meaning of “privileged” or inside information, pursuant to the Act, must be considered in its entire context, and according to the perspective of a “reasonable investor.” The Court noted that the concept of privileged information has evolved, and now no longer contains the term “material fact.”  Under s. 5 of the Act, privileged information is now defined as “any information that has not been disclosed to the public and that could affect the decision of a reasonable investor.” However, not all information per se shall be considered to be privileged. Instead it is necessary to determine whether the “type of information” can influence a securities-trading decision.

“In Quebec the test of privileged information doesn’t require the suing party to demonstrate that the information, had it been known by the public, would have materially affected the stock price of the securities,” said Sophie Melchers, a partner with Montreal-based Ogilvy Renault LLP who represented Quebecor and Vidéotron in the case. “All you need to show in Quebec is that the information would have affected the decision of a reasonable investor. A decision over insider trading then is truly one that rests on the facts of the case.”

All of which spells the need for in-house counsel to stay on top of developments, and determine how those developments may or may not affect the risk profile of their organization, said Nigel Campbell, a securities and corporate commercial litigator with Blake, Cassels & Graydon LLP in Toronto. In-house counsel must ensure that the compliance measures and the internal systems and controls that are in place are actually doing their job, and that if wrongdoing does occur that the mechanisms in place will detect it, added Campbell.

“The primary role of inside counsel is to anticipate problems that might occur, and ensuring that there is a strong foundation behind the internal policies, and keep refreshing the board and the executive in particular over the serious implications of insider trading or you can have people walk into problem accidently or inadvertently,” said Campbell, who believes like the majority of securities lawyers that most illegal insider trading occurs unintentionally.

A 2008 enforcement report by the Canadian Securities Administrators, which is the council of the 10 provincial and three territorial securities regulators in Canada, reveals that there were eight cases involving illegal insider trading in 2008, seven in 2007 and eight in 2006. But those figures are somewhat illusory, say securities lawyers. Securities experts point out that regulators have beefed up enforcement teams and are devoting a lot of time and energy towards uncovering illegal insider trading and informing (otherwise known as tipping). Indeed, investigations are on-going all the time, said Campbell, adding that he is aware of at least half a dozen investigations that were launched over the past six months.

When regulators do come knocking at the door because they suspect illegal insider trading took place, it is advisable to cooperate and retain outside counsel who have experience dealing with regulators, assert securities lawyers. While the different provincial securities legislation does not affect solicitor-client privilege, it should rarely be invoked when investigators seek out information. Companies often struggle with these issues because “they want to be cooperative and be seen as cooperating,” said David Hausman, a former enforcement counsel at the OSC who now practices exclusively in the field of securities litigation with Fasken Martineau in Toronto. “But then again, solicitor-client privilege is a right you have in law. So it is a fine balance whether to waive that privilege because it is your right to preserve it.”

Through it all, in-house counsel must walk a fine line and delicately balance their role as an advisor to the corporation while being in a sense a “bit of a watchdog,” as one lawyer put it. In-house counsel must be vigilant and be on the lookout for issues that might harm the corporation as well as foster a culture that will not hesitate to call someone on the carpet if there is conduct that threatens to expose the company to civil and criminal liability. “But if it’s not done carefully, then the corporation might start to perceive corporate counsel as being more than a watchdog, and almost an in-house prosecutor,” said Robidoux. “If that happens, in-house counsel might find that their access to management and the boardroom becomes limited, and their ability to influence decisions starts to decline.”

This story was originally published in In-House Counsel magazine.

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