Canada: U.S. And Canadian Securities: Regulatory Reform In 2006 And The Implications For 2007

The announcement of the Canadian Government on October 31, 2006 rocked not only the tax world but the Canadian public markets and the Canadian corporate finance world as well. While it seems relatively clear what the immediate impact on conversion of businesses into income trusts will be, the medium to long-term impact on Canadian corporate finance and M&A activity remains to be seen.

What is known at this stage is that real estate investment trusts are not negatively impacted in the same manner as "business trusts" and that REITs are expected to continue to be a significant investment vehicle in Canada. The Canadian Government has been lobbied by the energy trust sector for differential treatment and there are calls for a 10-year as opposed to a 4-year phase-in of the new taxation rules.

The announcement and clarification in mid-December of the so-called "undue expansion" rules will have an impact on M&A activity among income trusts themselves. What is not evident is what impact the new rules will have on Canadian M&A activity in general. There may be a significant impact with respect to the approach of strategic/industry players. The developments could also have an impact on private equity M&A activity.

If one believed the media reports, the announcements were expected to create a "cheap pool" of Canadian assets held by business trusts that were ready for the taking by foreign buyers. The Canadian market was told to prepare itself for an influx of acquisitions by foreign acquirors. However, the potential for re-conversion back to a conventional corporate structure may play against that anticipated phenomenon. Private equity buyers have traditionally viewed income trust conversions as one of the principal ways to create value and as a primary avenue in their exit strategies in that regard, it is not clear what impact, if any, the announcements could have on private equity M&A activity in the near term but acquisitions by private equity buyers is expected to be a continuing phenomenon.

On December 31, 2005, a new regime of civil liability for secondary market disclosure came into force in the province of Ontario. Other Canadian provinces, including Québec, have now announced or begun the process of introducing similar regimes. While there has yet to be any real meaningful use of the Ontario provisions, the measure constituted a significant legislative development for participants in the Canadian public markets.

In implementing the regime, the Ontario legislator had the benefit of decades of judicial application and analysis of Rule 10b-5 under the U.S. Securities Exchange Act of 1934 (or "10b-5" as it is generally known) and made a conscious choice not to import the rule into Canada in its U.S. form. It remains to be seen whether the Ontario regime will be more effective than 10b-5 in policing and deterring misrepresentations and omissions or whether it will lead to a rash of abusive and speculative litigation, including class actions, despite the regime's built-in protective mechanisms. While they share certain similarities, the Ontario regime is not quite "10b-5 North". The provisions do share the same basic purpose, to establish a basis for statutory civil liability for misrepresentations or omissions. However, in their scope and application, the regimes are much more cousins than they are siblings.

The expected flood of securities class actions in Canada has not yet taken place as predicted when Ontario introduced its regime and the jury is still out on the merits of the new system. It is possible that 2007 will bring with it increased use of the provisions and shed some light on the utility and benefits, or harm, of a Canadian regime for civil liability for secondary market disclosure as other provinces usher in their regimes and litigants seek to make use of the new avenues for actions.

If the last few years following the corporate scandals in the United States have been about rule implementation, it is expected that 2007 will continue the trend evidenced and announced by the securities regulators of a focus on enforcement. It is becoming clear that securities regulators have come to the realization that a complex regime of specific rules tailored to prevent scandal and fraud without a functioning enforcement regime is not worth much more than the paper on which such elaborate rules are written.

It is expected that, while securities regulators will continue their mission of implementing rules to deal with potential corporate wrongdoing, there will be increased focus on enforcement. In this regard and by way of example, both the Toronto Stock Exchange and the Canadian Securities Administrators have issued staff notices to deal with the granting of options at a time when there is material, undisclosed information and the phenomenon of "option backdating" that has received much media and regulatory attention, particularly in the United States, in the latter half of 2006. (See discussion below.) It is expected that regulatory scrutiny will continue and intensify in this area in 2007.

In the United States, the trends that we will be following include developments in the options backdating "scandal", changes to the securities offering processes in the light of the securities offering reform adopted by the Securities and Exchange Commission just over a year ago, potential relief from some of the perceived burdens of the Sarbanes-Oxley Act, especially for smaller companies, and, possibly, increased use of tender offers in reaction to the recent amendments to the "best-price rule" under the United States' tender offer regulations.

In 2006, the Securities and Exchange Commission revealed its wide-ranging investigation into options backdating. In July, the SEC brought two enforcement actions, one relating to Brocade Communications Systems and another involving Comverse Technology. In both cases, parallel criminal charges were also brought against senior company executives.

While the Brocade and Comverse cases were the first to be brought in the crackdown on options backdating, they were merely the tip of the iceberg: the SEC has indicated that there are over 100 companies currently under investigation and many executives at other companies have resigned or been dismissed in the scandal.

The Brocade and Comverse cases involved fraudulent schemes of intentional backdating and, in the case of Comverse, more elaborate schemes of granting backdated options to fictitious employees. The conduct alleged against Brocade and Comverse was apparently not isolated and the SEC has indicated that, while it does not expect to bring enforcement actions against all of the companies that it has investigated (many of which may be guilty only of sloppy procedures and record keeping), it will be bringing more cases against the worst conduct. In addition, boards of directors continue to launch their own internal investigations into options backdating to determine whether there have been abuses and, if so, to take remedial action before the SEC and/or the U.S. Attorney's office takes the initiative.

Whether or not the SEC takes enforcement action, companies discovering options backdating practices will nevertheless have to grapple with significant tax and accounting consequences. Companies will have to restate their earnings to reflect compensation expense for the granting of in-the-money options which don't enjoy the favorable accounting treatment that at-the-money options once enjoyed. In addition, the Internal Revenue Service will likely seek to recover uncollected tax from offending companies and from the recipients of in-themoney options. While the SEC might not institute proceedings in every case, shareholder litigation has been widespread.

For 2007, we can expect more announcements of enforcement actions and more executive resignations. In addition, the scandal may have an impact on policy development as the scandal fuels demands for change of executive compensation practices generally.

The SEC's new securities offering reform rules and rule amendments have now been in effect for about a year. We expect to continue to see offerors availing themselves of the reforms of the offering process afforded by the rules, including liberalized communications before and during the offering process and the streamlining of the registration process, especially for the largest issuers (well-known seasoned issuers, or "WKSIs"), and that practices will continue to be refined in light of the changes to the rules determining liability for disclosure in public offerings at the time that investors make their investment decisions.

Liberalized Communications. Under the rules, WKSIs are generally free to continuously communicate with the market, including making offers of securities, without regard to previously applicable "gun jumping" restrictions. All other issuers may now publish or otherwise communicate information without committing a "gun jumping" violation if the information is communicated at least 30 days before a registration statement is filed and does not refer to a securities offering. In addition, the rules permit the use of the "free-writing prospectus" in addition to the traditional prospectus used in connection with an offering. While the use of term sheets as free-writing prospectuses, particularly in the context of debt offerings, has become rather commonplace, as expected, the use of other, more marketing focused documents as free-writing prospectuses has not been as widespread.

Streamlining the Securities Registration Process. The most significant change to the registration process was the creation of "automatic shelf registration", which is available only to WKSIs and provides for automatic effectiveness of the registration statement immediately upon filing without any SEC review. Required information in the base prospectus is minimal, with offering-specific information to be provided by posteffective amendment, prospectus supplement or incorporation by reference to the issuer's Exchange Act reports. Automatic shelf registrations are good for three years, at which time a new registration statement must be filed. Almost 600 automatic shelf registration statements have been filed by U.S. companies since the rules became effective, and over 30 non-U.S. companies had filed automatic shelf registration statements as of the end of 2006. It is anticipated that ultimately most WSKIs will file these registration statements.

Liability for Prospectus Disclosure. Previously, under the Securities Act, liability for misstatements in or omissions from a prospectus used in a registered public offering was determined by reference to the final prospectus, which was generally not delivered to investors until several days after they had made their investment decisions. Under the new rules, prospectus liability will be determined by reference to whatever information has been "conveyed" to an investor at or prior to the time of sale (i.e., when the investor orally or otherwise confirms his purchase), and any information conveyed after that, including information in the final prospectus, will not be taken into account. As a result, the process for conveying pricing and price-related information, particularly in debt offerings, has become more formalized, primarily through the use of term sheets delivered by facsimile or email to investors which confirm their purchases. Although the new liability regime is not applicable to Rule 144A and other unregistered offerings, underwriters are increasingly using term sheets to convey pricing information in these transactions as well as part of their "best practices". There have also been changes in underwriting agreements, and the legal opinions and accountants' comfort letters required to be delivered to the underwriters, as a result of the new regulatory landscape. These changes include the introduction of the concept of a "disclosure package" or "information package" concept, which includes all of the information, including information contained in a free-writing prospectus, that is delivered to the investors at the time of purchase, and the requirement that the representations and warranties, as well as legal opinions, cover all the information contained in the disclosure package or information package, as opposed to being limited to the registration statement and related prospectus, as was the case prior to the implementation of the reform rules.

In December 2006, the SEC proposed for public comment interpretive guidance for management regarding their evaluations of internal control over financial reporting required by Section 404 of the Sarbanes-Oxley Act and amendments to the rules under the Act that would make it clear that a company choosing to perform an evaluation of internal control in accordance with the interpretive guidance would satisfy the annual evaluation required by those rules. The proposals were made in response to widespread commentary that implementation of the internal control evaluations was proving to be overly burdensome for reporting issuers, especially smaller issuers, in comparison to the protection afforded investors by such requirements.

The proposed guidance is described as a "risk-based" approach that is intended to address many of the concerns that have been raised to the SEC, including: excessive testing of controls generally; excessive documentation of processes, controls, and testing; and the ability to scale the evaluation to smaller companies. According to the SEC, the proposed guidance is principles-based guidance that is organized around two important principles that it believes will permit companies of all sizes and complexities to implement the SEC's rules more effectively and efficiently.

• First, management should evaluate the design of the controls that it has implemented to determine whether there is a reasonable possibility that a material misstatement in the financial statements would not be prevented or detected in a timely manner. This principle is designed to permit management to focus on those controls that are needed to prevent or detect material misstatement in the financial statements.
• Second, management should gather and analyze evidence about the operation of the controls being evaluated based on its assessment of the risk associated with those controls. The purpose of this principle is to allow management to align the nature and extent of its evaluation procedures with those areas of financial reporting that pose the greatest risks to reliable financial reporting.

The proposed interpretive guidance addresses four specific areas, including:

• Identification of risks to reliable financial reporting and the related controls that management has implemented to address those risks.
• Evaluation of the operating effectiveness of controls.
• Reporting the overall results of management's evaluation.
• Documentation.

If the proposed interpretive guidance and amendments to the SEC's rules are adopted, they, together with the new auditing standard on internal control over financial reporting being proposed by the Public Company Accounting Oversight Board, should enable U.S. reporting companies, especially smaller companies, to conclude that more efficiently structured internal control evaluations will satisfy the requirements of the SEC's Section 404 rules.

On December 8, 2006, amendments to the U.S. tender offer best price rule (Rule 14d-10 under the U.S. Securities Exchange Act of 1934) approved by the SEC became effective. The best price rule provides that no one may make a tender offer unless the consideration paid to any security holder during the tender offer is the highest consideration paid to any other security holder. As a result of certain courts finding that the payment or grant of executive compensation by a target company in connection with a tender offer (even if agreed to and made outside the tender offer period) constitutes disparate treatment of shareholders in violation of the best price rule, business combinations over the last several years have been primarily structured as one-step mergers if the grant of additional compensation to the subject company's executives is necessary or desirable. The amendments to the best price rule are intended to clarify that the rule applies only to the consideration paid for securities tendered in a tender offer and that employment compensation, severance or other employee benefits should not be considered part of the price being paid in a tender offer.

The amendments to the best price rule, which apply to both issuer and third-party tender offers, clarify that the rule applies only with respect to the consideration offered and paid for securities tendered in a tender offer, rather than consideration paid to any security holder pursuant to and during the tender offer. The exemption in connection with employment compensation, severance or other employee benefits is not limited to directors or employees of the target company, but includes all security holders of the target company. An arrangement will satisfy the exemption if it "is not calculated based on the number of securities tendered or to be tendered" and the arrangement "is being paid or granted as compensation for" services rendered or to be rendered. The amendments also provide for a safe harbor that would allow an independent compensation committee of the subject company (and the directors of the bidder if the bidder is a party to the transaction) to approve an employment compensation, severance or other employee benefit arrangement and, in doing so, satisfy the requirements of the exemption to the best price rule. The amendments to the rule may lead to an increased use of tender offers in the context of friendly acquisitions if practitioners become convinced that the amendments have substantially reduced the likelihood of successful lawsuits based on the rule.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.