In the recent decision of Kraft (Re), the Ontario Capital Markets Tribunal (the “Tribunal”) provided new guidance about when insiders and others can confidentially disclose material non-public information about a publicly-traded entity (“MNPI”) without violating the prohibition against “tipping” under Canadian securities laws on the basis that the disclosure is made in the “necessary course of business”. In finding the disclosure in this case was not made in the necessary course of business (and therefore constituted illegal tipping), the Tribunal established a high bar for determining when confidential disclosure is “necessary” and emphasized the importance of the process through which the availability of this exception is determined and the information is disclosed. The decision provides useful guidance about best practices when confidentially disclosing MNPI to mitigate the risk of illegal tipping.
Tipping and the Necessary Course of Business Exception
Canadian securities laws generally prohibit publicly-traded entities and those persons who are in a “special relationship” with those entities (including, among others, insiders, potential bidders, professional service providers and anyone who receives MNPI from any of the foregoing) from (i) trading in securities with knowledge of MNPI (referred to as “insider trading”), and (ii) disclosing MNPI about the issuer to any person, other than in the “necessary course of business” (referred to as “illegal tipping”). Accordingly, when special relationship persons disclose MNPI to another person (either within or outside their organization) the disclosure must be made in the necessary course of business. Tipping is prohibited so that everyone in the market has equal access to, and opportunity to act upon, material information. Insider trading and tipping prohibitions are designed to ensure that anyone who has access to MNPI does not trade or assist others in trading to the disadvantage of investors generally.
Before the Kraft decision, no Canadian court or securities regulator had defined the scope of the “necessary course of business” exception, other than limited policy guidance that includes a list of recipients whom the necessary course of business exception would generally cover (which includes, among others, employees, officers, board members, vendors, suppliers, lenders, legal counsel, auditors, underwriters, and financial and other professional advisors, parties to negotiations and governmental agencies and regulators). As discussed further below, the Kraft decision makes clear there are a number of important considerations beyond the identity of the tippee.
The Kraft Decision
In the fall of 2017, the Board of Directors of WeedMD Inc. (“WeedMD”), a TSXV-listed producer of medical cannabis, was negotiating a transaction to significantly expand its production capacity, which included a lease of greenhouse space and an option to subsequently purchase the facility (the “Transaction”). Before the public announcement of the Transaction, Michael Kraft (the then-current Chair and a director of WeedMD) solicited input from his long-time friend and “go-to advisor”, Michael Stein, by providing Mr. Stein with near final drafts of the Transaction documents to review. According to Mr. Kraft, the purpose of the disclosure was to seek Mr. Stein’s expertise in commercial real estate transactions.
While Mr. Stein had previously been engaged as a consultant to WeedMD in 2015, at the time of the disclosure he had no direct business, contractual or employment relationship with WeedMD. Mr. Kraft did not obtain prior authorization of the WeedMD Board or management before making the disclosure. Mr. Stein subsequently provided comments on one of the transaction documents to Mr. Kraft, as well as WeedMD’s CEO and CFO. The day before the Transaction was announced, Mr. Stein acquired 45,000 shares of WeedMD and then sold them shortly following the announcement of the Transaction, realizing a profit of approximately $30,000 (a 43% return).
The Tribunal concluded that Mr. Stein had engaged in illegal insider trading. The Tribunal also concluded that Mr. Kraft’s disclosure of the Transaction documents to Mr. Stein amounted to illegal tipping because the documents were MNPI and the disclosure was not made in the necessary course of business. In concluding that disclosure was not made in the necessary course of business, the Tribunal held:
- Mr. Stein had not been formally engaged by WeedMD in any official capacity.
- The disclosure was made because of Mr. Kraft’s own personal desire to have Mr. Stein provide a "second set of eyes".
- The disclosure took place hastily out of habit, without any prior discussion with the WeedMD Board or management or consideration of whether the disclosure was being made in the necessary course of WeedMD’s business.
- Mr. Stein was not asked to keep the information confidential and was not given any specific direction about the use that could be made of the information.
- There was no evidence Mr. Stein possessed any specialized expertise that was not already available to WeedMD.
- Burden of Proof. The Tribunal held that, once the elements of the tipping offence are established, the onus of establishing that the disclosure was made in the necessary course of business shifts to the tipper (in this case, Mr. Kraft). Those disclosing MNPI should therefore ensure they can demonstrate (through evidence) the reasons for disclosing MNPI.
- No Deference to Business Judgment. The Tribunal held that the question of whether disclosure was made in the necessary course of business is determined on an objective standard. A subjective belief by the alleged tipper that disclosure was in the necessary course of business – even if honestly held and in good faith – is insufficient to invoke the availability of the exception.
- Disclosure must truly be “necessary”. The Tribunal placed significant weight on the word “necessary” and concluded the “necessary course of business” exception was intended to be a narrow exception that permits disclosure that is “essential”, “indispensable” or “requisite” to the business. It requires more than a mere “business purpose” or “business rationale” and is a higher bar than “ordinary course of business”.
- Fact-Specific Inquiry. The Tribunal declined to set out any bright line tests or exhaustive lists of factors that are determinative as to whether disclosure was made in the necessary course of business. However, the Tribunal acknowledged certain factors may be relevant depending on the circumstances, including the following:
- the business of the issuer;
- the relationship between the tipper and the issuer;
- the relationship between the tipper and the tippee;
- the nature of the MNPI that was disclosed;
- the relevance of the MNPI to the relationship between the tippee and the issuer (that is, whether the nature of the relationship between the tippee and the issuer necessitates the disclosure of the MNPI in question);
- the tipper's reason for making selective disclosure to the tippee; and
- the credibility of the tipper seeking to establish the necessary course of business exception.
In its reasons, the Tribunal also addressed the OSC’s submission that the “business” referred to in the phrase “necessary course of business” can only mean the issuer’s business (even though that qualification does not appear in the legislation). While this question was not relevant to the facts in Kraft, the Tribunal refused to foreclose the possibility that the exception could apply with respect to the business of other stakeholders in other cases. However, the Tribunal did not provide any guidance about when selective disclosure could be made in the necessary course of a business other than the issuer’s business, and as such the potential scope for such disclosure remains unclear.
The decision in Kraft is not, in and of itself, expected to drastically alter the scope of parties to whom MNPI can be disclosed in the necessary course of business. However, the decision highlights certain pitfalls that should be avoided when making such disclosure and actions parties can take to mitigate the risk of being found to be in violation of the tipping rules. Moving forward, best practices for confidentially disclosing MNPI in circumstances where there could be a question as to whether the disclosure is being made in the necessary course of business may include (depending on the circumstances):
- discussing at the board or management level (i) the scope of information to be disclosed, (ii) the purpose of disclosing that information to the relevant person, and (iii) the prohibition against tipping and the reasons why the disclosure is in the necessary course of business;
- considering whether the issuer can achieve the desired outcome of the disclosure in another reasonable way that limits the disclosure of MNPI;
- instructing the recipient of the MNPI as to the permissible uses of the information and the recipient’s confidentiality obligations; and
- entering into a legal agreement with the relevant person that documents the foregoing matters.
In addition to the general prohibition on tipping applicable to all special relationship persons, Canadian securities laws also generally prohibit potential acquirers from disclosing MNPI to any person except where the information is given in the necessary course of business relating to the potential acquisition. Potential acquirers would be well advised to consider the guidance in Kraft when disclosing MNPI in connection with a potential acquisition transaction.
For further information regarding this update, please contact any member of our Capital Markets Group.
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