On October 20, 2023, Ontario’s Capital Markets Tribunal (“Tribunal”) released a first-of-its-kind decision considering the application of the “necessary course of business” (“NCOB”) exception to the prohibition against tipping of material non-public information (“MNPI”).
The Tribunal found that Michael Paul Kraft (“Kraft”) had breached section 76(2) of Ontario’s Securities Act (the “Act”) because he made a tip to his long-time friend, Michael Stein (“Stein”), that was deemed to not be done in the necessary course of business. In this recent decision, the Tribunal really sheds light on the use of the exception and delineates when this exception may be relied upon.
Insider trading and tipping
Section 76(1) of the Act prohibits any person in a “special relationship” with an issuer from purchasing or selling in securities of the issuer while in possession of MNPI (i.e. insider trading). Section 76(2) of the Act prohibits such a person from informing another person of MNPI (i.e. tipping), other than in the necessary course of business. In addition, section 76(3.1) of the Act prohibits such a person from making any investment transaction recommendations while in possession of relevant MNPI (i.e. no recommendations with MNPI).
Section 76(5) of the Act provides a broad definition for a person in a “special relationship” with the issuer, including directors, officers, insiders and employees of the issuer. In particular, section 76(5)(e) captures people who received tips through someone who they know or ought reasonably to have known to be in a special relationship with the reporting issuer. In addition, the Tribunal has demonstrated its willingness to use its public-interest powers (section 127 of the Act) to sanction persons who have traded, tipped or recommended securities while in possession of MNPI, even if such person was not in a special relationship with the issuer.
The “necessary course of business” exception
NCOB is not defined in the Act, leaving the only previously available guidance to be found in National Policy 51-201 Disclosure Standards (“NP 51-201”). NP 51-201 states that the NCOB exception exists “so as not to unduly interfere with a company’s ordinary business activities.” NP 51-201 also provides some helpful guidance, but it does not provide any bright-line test or safe-harbour information that would result in a definitive ability to apply any set of facts to the availability and appropriate use of the NCOB exception.
Kraft (Re) is the first trial decision to consider the application of the NCOB exception to the prohibition against tipping. In doing so, the Tribunal in Kraft (Re) also clarified that NP 51-201 is non-binding and that each application of the NCOB exception must be established on the relevant facts.
What happened in Kraft (Re)
In the Fall of 2017, WeedMD Inc. (“WeedMD”), a reporting issuer listed on the TSX Venture Exchange, was in the midst of negotiating a plan to significantly expand the capacity of its cannabis production facilities. This would entail leasing greenhouse space from Perfect Pick Farms Ltd. with an option for WeedMD to purchase the facility (the “Transaction”). During the time of the negotiations, Kraft was the chair of the board of directors of WeedMD.
Prior to the public announcement of the Transaction, Kraft sent his long-time friend, Stein, an email that included near-final draft documents of the lease and the definitive option to purchase agreement. Although Stein had been a consultant to WeedMD in the past, his consulting agreement had expired and there was no other engagement letter or employment agreement in place at the time the email was sent to him. While in possession of this MNPI, and exactly one day before WeedMD released its press release announcing the Transaction, Stein purchased 45,000 WeedMD shares in the open market. He then proceeded to sell these shares over the next two days making approximately $29,345 off the sale, representing approximately a 43% profit.
The Ontario Securities Commission (“OSC”) alleged that Kraft was in violation of section 76(2) of the Act for tipping Stein about the Transaction prior to the information becoming public. The Tribunal ultimately found that Kraft had breached the tipping prohibition in the Act by sending Stein the email containing the draft documents, and that Kraft could not rely on the NCOB exception. The Tribunal also found that Stein illegally traded shares of WeedMD while in possession of MNPI, which is contrary to section 76(1) of the Act (i.e. insider trading).
Burden of proof
The Tribunal confirmed that the person seeking to rely on the NCOB exception (the tipper) bears the burden of establishing that the NCOB exception applies. The OSC still bears the burden of establishing the general elements of the tipping prohibition.
Meaning of “necessary”
“Necessary” in the NCOB exception increases the criteria for allowable selective disclosure or tipping beyond a mere business purpose or business rationale. The word “necessary” in the NCOB exception imports a greater importance than the “ordinary course of business.” The word “necessary” goes beyond the word “ordinary” to mean something that is “essential,” “indispensable” or “requisite” to the business. “Necessary course of business” is therefore distinct from “ordinary course of business” because “necessary” requires that the purpose of the selective disclosure should go beyond “a mere business purpose or business rationale.” The disclosure must meet a level that is necessary to the business to warrant an exception to the blanket prohibition against selective disclosure. The NCOB exception under the Act, “prohibits a person in a special relationship with an issuer from informing, other than in the necessary course of business, another person of an undisclosed material fact or material change with respect to the issuer.”
Meaning of “business”
The NCOB exception also uses the term “business;” however, the Tribunal took a careful look at the wording of the NCOB exception and found that the word “business” is not qualified by the phrase “the issuer’s.” The Tribunal found that the interpretation of “business” is fact/scenario dependent and may not be limited to a consideration of what may be the necessary course of the issuer’s business. Accordingly, the NCOB exception can be utilized if it is in the necessary course of the communicator’s (tipper’s) business, where the communicator may be, for example, the issuer, an advisor to the issuer or its counterparty, a credit-rating agency, a securities dealer or an investor.
The NCOB exception must be established on an objective basis. The Tribunal will not allow a person to solely rely on the tipper’s subjective belief that the disclosure of MNPI was necessary, even if the tipper held that opinion in good faith.
Materiality is assessed objectively through the lens of a “reasonable investor.” Only the selective disclosure of material information is subject to the prohibitions against insider trading, tipping and recommending. The “market impact test” is often used by the Tribunal to determine if certain information is considered material by looking at whether the information would reasonably be expected to have a significant effect of the market price or value of a security. In Kraft (Re), the Tribunal stated that materiality does not need to be in any particular form and that the market impact analysis is not required for the Tribunal to determine materiality. The Tribunal outlined the following non-exhaustive factors:
- developments in the industry;
- the side and nature of the business and its operations;
- the specifics of the information disclosed; and
- the likelihood of the information materializing.
These factors point to the “indicia of interest” in the transaction, considered when assessing whether a proposed transaction was likely or certain to occur such that it was material at the time that the MNPI was disclosed. Before any MNPI is disclosed, well-documented discussions should typically occur with members of the issuer’s senior management team (and the board, if appropriate) to determine whether the disclosure of MNPI is indeed “necessary” for a legitimate business purpose. With contentious or grey-area situations, process is paramount and process considerations will be a key consideration for the issuer and any subsequent communicator (tipper) of the MNPI. In order to satisfy the onus on the tipper that the NCOB exception should objectively apply, it is highly recommended to follow a proper process and create proper documentation that will allow the applicable persons to reasonably rely on the NCOB exception.
Factors to consider
The Tribunal also provided a non-exhaustive list of factors to consider in determining whether the NCOB exception is established, including:
- 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;
- relevance of the MNPI to the relationship between the tippee and the issuer;
- the tipper’s reason for making selective disclosure to the tippee; and
- the credibility of the tipper seeking to establish the NCOB exception.
In addition, it should also be considered that if a person’s necessary-communication objective can be achieved without disclosing the MNPI or certain portions thereof, then the NCOB exception will not likely be available. Accordingly, the use of code names for transactions and their parties and the importance of maintaining the secrecy of any MNPI that is not essential to the person’s communication objective should always be considered too.
Should you have any questions regarding the NCOB exception or securities regulation matters, please contact any member of Miller Thomson’s Capital Markets and Securities group.