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Leave to Assert Secondary Market Liability Claim under Part XXIII.1 of the Ontario Securities Act Granted in Proposed Class Action

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In Zaniewicz v. Zungai Haixi Corp (2012 ONSC 6061), Perell J. heard and granted the plaintiffs’ unopposed motion for leave to assert a secondary market liability claim under section 138.3 of Part  XXIII.1 of the Ontario Securities Act, R.S.O. 1990, c. S.5 (the “Act”).

The defendant corporation, Zungui, is an Ontario public company that indirectly owned a shoe company incorporated and operating in the People’s Republic of China, and was a reporting issuer under the Act. The individual defendants Fengyi Cai, Jixu Cai, and Yanda Cai (the “Cai Brothers”), who were directors and/or officers of Zungui, were varyingly responsible for approving, or overseeing the audit committee’s approval of, both Zungui’s audited annual financial statements and its unaudited interim financial statements.

In December 2009, Zungui raised approximately $40 million in Ontario’s capital markets through an initial public offering. In Zungui’s financial statements, Zungui and the Cai Brothers represented to the investing public that the financial statements presented Zungui’s financial position fairly in all material respects, and that Zungui’s IPO offering documents contained full, true and plain disclosure of all material facts relating to the offering of securities.

On August 22, 2011, Zungui issued a press release announcing that Ernst & Young (“E&Y”), its auditor, had suspended its audit of Zungui’s financial statements for the year ended June 30, 2011. Zungui’s shares immediately lost 77% of their value, and are now virtually worthless. The Ontario Securities Commission commenced an investigation and, in February 2012, ruled that the Cai Brothers had engaged in conduct contrary to the public interest. The investigation also revealed that when E&Y resigned on September 23, 2011, it advised that all audit opinions that formed part of the IPO prospectus and Zungui’s June 2010 financial statements could no longer be relied upon.

In their claim, the plaintiffs alleged that Zungui’s financial statements (both those contained in its IPO prospectus and others later prepared and disseminated in the secondary securities market) were neither accurate nor reliable, and that the Cai Brothers made misrepresentations in Zungui’s secondary market continuous disclosure documents.

In order for leave to be granted under section 138.8 of the Act, a plaintiff must demonstrate that (i) the proposed action is brought in good faith, and (ii) there is a reasonable possibility that the proposed action will be resolved at trial in the plaintiffs’ favour. In granting leave, Perell J. noted that Part XXIII.1 mandates a preliminary, low-level merits based leave test and that, as at the date of writing, three Ontario courts had considered the test and agreed that the standard is a “relatively low threshold” depending “on the evidence that the parties put before the court” (as described in Silver v. Imax Corporation (2009), 66 B.L.R. (4th) 222 (Ont. S.C.J.)). Perell J. held that there was no reason to doubt the plaintiffs’ good faith and that, while the evidence adduced by the plaintiffs would have satisfied the second arm of the test, the Cai Brothers had been noted in default and their deemed admissions of the factual allegations in the Statement of Claim were sufficient to satisfy the section 138.8 test.