Canada: Auditing the Audit Requirement

Last Updated: October 27 2010
Article by Bryan Haynes

Previously published in the Canadian Lawyer magazine

Most jurisdictions in Canada require the unanimous consent of all shareholders, including nonvoting shareholders, in order for a nondistributing corporation to dispense with an audit. The requirement is absolute and mandatory — there are no other exemptions or qualifications. The public policy rationale behind the rule is laudable; however, the implementation in practice can be austere. It is time to revisit the universal audit requirement as it applies to nondistributing corporations.

The Canada Business Corporations Act, and its provincial counterparts, generally provide that shareholders of nondistributing corporations may resolve not to appoint an auditor provided that such resolution is consented to by all shareholders, including shareholders not otherwise entitled to vote.

Although the Prince Edward Island Companies Act is silent on this point, it does stipulate that the directors of every company shall lay before the shareholders a full and clear statement of the affairs and financial position of the company at or before each annual general meeting. In MacLeod and John L. MacLeod Transport, Consultant and Management Ltd. v. Murray and Murray, it was held that this requirement could only be satisfied by producing audited financial statements. In striking contrast to every other jurisdiction in Canada, New Brunswick permits, but does not mandate, the appointment of an auditor. Moreover, if an auditor is appointed in any given year, such appointment may be dispensed within the ensuing year by ordinary resolution (thus not requiring unanimity).

The underlying public policy rationale of the universal audit requirement is clear — investor protection, and in particular, the protection of minority shareholders. It has been held that shareholders (voting and non-voting) have a right to be informed, and have an independent assessment, of a company's financial position in order to inter alia enable shareholders to assess their investments (and management) on a continuing and consistent basis. The jurisprudence has routinely confirmed and upheld the sanctity of this right (including Merrill v. Afab Security, Chrisger Systems Inc.; Labatt Brewing Co. v. Trilon Holdings Inc.; Smith v. ECO Grouting Specialists Ltd.; Runnalls v. Regent Holdings Ltd.; Barbour v. Jamestown Lumber Co.). In Discovery Enterprises Inc. v. ISE Research Ltd., it was noted: "The refusal of a company to deliver audited financial statements can serve to hide the true financial position from a minority shareholder."

However, universal application of this onerous requirement can have unintended and severe consequences, particularly on small, privately held corporations. Often, an audit is unnecessary or prohibitively expensive and disproportionate to the financial resources of the company and the value of a shareholder's investment. Audits can cost tens of thousands of dollars and paying the cost of an audit can leave a company with reduced or no profits to distribute to shareholders, or worse yet, further indebted. Ironically, the very application of the principle that is intended to protect shareholders' investments could in fact jeopardize them.

Since dispensing with an auditor requires unanimous consent, the fate of a company, and every other shareholder's investment (and return on same) in that company, could rest in the hands of a single shareholder regardless of such shareholder's status as a voting or nonvoting shareholder and regardless of the size of such shareholder's investment. As much as it may be unfair to a minority shareholder to deny an independent assessment of a company's financial statement, it is equally, perhaps more, unfair to the remaining majority shareholders to endure the consequences of such an assessment if otherwise unnecessary or uneconomical.

The case law has held that a shareholder's motive in, and the financial consequences of, requiring an audit are irrelevant. Struck with the unwavering harshness of this rule, some judges have rightly tried to alleviate its ramifications. In Barbour, Justice Handrigan wrote: "I took this limitation into account by restricting the audit to Jamestown Lumber's most recent fiscal period. It would, in the circumstances here, be an unfair and unnecessary expense to the corporation and ultimately for its other shareholders to bear to require an audit for any longer period."

When compared with other leading corporate law jurisdictions, Canada's model of universality is draconian. Some American states (including New York and Delaware) do not require audited financial statements of private companies. In both the United Kingdom and Australia, statutory exemptions from audit requirements, based on revenues, assets, and number of employees, are provided to small private companies. However, notwithstanding that a company may otherwise qualify for exemption from audit requirements, members (voting and non) of U.K. companies representing at least 10 per cent of the nominal value of a company's share capital, and voting shareholders of Australian companies holding at least five per cent of the votes, may demand an audit.

Canada's ironclad audit requirement is ill-suited, imbalanced, and disproportionate for countless small, private companies. A better balance between the rights of minority and majority shareholders is called for.

Bryan Haynes is a partner and co-chairman of the commercial transactions practice group at Bennett Jones LLP.

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.

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