Determining what constitutes an “active market” for securities can have significant implications for Investment Dealers, Approved Persons, and other market participants facing civil lawsuits and regulatory scrutiny. Such a determination provides ample assistance to investors seeking to quantify damages allegedly sustained through (1) misrepresentations in a company’s financial documents or (2) the negligence of their financial advisors. In Sutton (re), 2018 ONSEC 42, however, the failure to show an active market for securities proved devastating to the defence of a Chief Financial Officer (“CFO”) in charge of pricing those securities.
As CFO of First Leaside Securities Inc. (“FLSI”), Brian Sutton’s (“Mr. Sutton”) position required him to assess the price of certain unlisted securities (“Fund Units”) issued by three limited partnerships (“Funds”). In pursuit of meeting these obligations, Mr. Sutton relied on the Fund Units’ allegedly active market to ascribe an appropriate price.
The Industry Investment Regulatory Organization of Canada (“IIROC”) Panel found that Mr. Sutton failed to discharge his obligations under Dealer Member Rule 38.6(c). Rule 38.6(c) requires that CFOs monitor adherence to the Dealer Member’s policies and procedures to ensure compliance with IIROC’s financial rules. FLSI’s Policies and Procedures Manual described how it complied with IIROC’s requirements to verify security prices and determine the accuracy of those prices.
OSC Panel’s Finding & Active Market Assessment
The Ontario Securities Commission’s (“OSC”) Panel set aside the IIROC Panel’s decision regarding Mr. Sutton’s liability after finding that IIROC Staff made errors that, when taken together, constituted an error of law. However, the OSC Panel still concluded that Mr. Sutton breached Rule 38.6(c). The OSC Panel also increased the fine against Mr. Sutton from $25,000 to $50,000, and required Mr. Sutton to pay costs in the amount of $50,000.
In particular, the OSC Panel found that there was no “active market” for the Funds Units and that the market could not provide investors with reliable information about the market value of the Fund Units. In making this determination, the OSC Panel enumerated three principles relevant to determine whether the market for the Fund Units was active:
- Independence– Are the trades that purport to constitute the active market independent of any artificial constraint? In other words, did the trades occur at prices that reflect a true auction market, and/or freely negotiated arm’s-length transactions between a willing seller and a willing buyer?
- Recency – Are the trades sufficiently recent to justify reliance on them? In other words, are those trades now stale, giving rise to an appreciable risk that intervening events undermine the reliability of the prices?
- Frequency– Even if there are trades that are sufficiently recent, did the relied-upon trades occur frequently enough to provide an adequate basis for concluding that the recent price is a fair market price?
In considering the first principle, the OSC Panel found little reassurance in a report that priced the Fund Units based on trade tickets submitted by FLSI. The OSC Panel also noted that the President and Ultimate Designated Person of FLSI fixed the price at which every trade in the Fund Units was executed.
The OSC Panel considered other methods used by Mr. Sutton to determine the price of the Fund Units, such as the high yields paid by each of the Funds, a report that indicated the value of the real estate underlying the Fund Units, various financial statements, an independent accounting review of the Funds, and a report from an accounting firm regarding trading in one of the Funds.
While Investment Dealers may lament the OSC Panel’s finding against the CFO, the decision provides critical guidance to determining what legally constitutes an “active market” for securities in Ontario. The principles of independence, recency, and frequency should assist CFOs and Investment Dealer staff tasked with the unenviable job of pricing unlisted securities. These principles may also flow into other securities disputes, including class actions and civil actions against financial advisors, to substantiate and guide expert reports opining on a market activity.