This is Part II to January's update entitled, Ensuring Governance Oversight of Shared Services and Management Services Agreements Among Affiliated Companies, by Duncan Card and Barry Reiter.
Part I of this two-part update alerted directors, corporate officers, and corporate counsel to the need to ensure that management (shared) service agreements between affiliated companies are negotiated on a defensible basis, are priced fairly and contain adequate compliance oversight, supervision and remedial provisions. Part II now examines the legal and regulatory requirements for publicly-traded companies to disclose shared services agreements that are material to their business.
Part I of this update addressed the growing trend of affiliated companies to consolidate and centralize many of their common business, administrative, and operational "back office" functions by retaining one of their affiliated companies to provide those common services to it and other of their affiliates. In that Update, we examined the requirement of directors to ensure that all of their governance, compliance and oversight duties (that would previously have been discharged through direct internal management controls and authority) are fully enabled by the intercompany management services agreement that is entered into between the affiliates. Whenever any part of a company's business operation is provided by third parties (even affiliates) operating externally to that company's internal chain of corporate command, governance oversight and supervision concerning those operations must be achieved through the service contract.
There are numerous statutory and regulatory circumstances in which management service contracts among affiliates may come under governance scrutiny. For example, these contracts may be scrutinized whenever consumer pricing within a regulated industry is related to a vendor's internal business costs (such as utilities), or in a situation where a regulator determines that regulated operations are being "outsourced" to an unregulated affiliate (such as pursuant to the OSFI Outsourcing Guidelines).
For publicly traded companies, service contracts may also trigger disclosure obligations.1 At the outset, reporting issuers should consider whether, as a result of such a service contract, they will need to file a material change report pursuant to s. 75(2) of the Ontario Securities Act (OSA). Section 1(1) of the OSA defines a material change as:
[A] change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer.
National Instrument 51-102 of the Canadian Securities Administrators (NI 51-102) stipulates that reporting issuers must file certain material contracts on SEDAR. NI 51-102 defines a "material contract" as a contract that a reporting issuer or any of its subsidiaries has entered into "that is material to the issuer". In the context of the filing of a material contract, it seems likely that materiality will be determined by using the "reasonable investor standard". According to this standard, a contract would be material if there is a substantial likelihood that a reasonable investor would consider the statement to be important in making an investment decision. In Re Biovail,2 the Commission looked at the treatment of the term "material". Although the decision rendered in that case was in the context of whether a press release issued by Biovail was materially misleading, the decision is noteworthy for the Commission determining that the reasonable investor standard was the appropriate standard of materiality. Further support for the reasonable investor standard comes from the Supreme Court of Canada's decision in Sharbern Holding Inc. v. Vancouver Airport Centre Ltd.3 In determining what is meant by the term "material" in British Columbia's Real Estate Act, as well as in the law more generally, the Court also used the reasonable investor standard.
Intercompany management service arrangements must be assessed on a graduated and proportional scale when considering whether or not they are material contracts. There may be companies who retain affiliates to provide non-essential "back-office" services with little material relevance to investor value or risk. At the other end of the continuum, there may be companies who have outsourced vital and essential management, compliance, financial and commercial services to affiliates, with a tremendous potential risk of detrimental impact on investor value should the service affiliate fail to perform as contemplated. Although the assessment of materiality is not a science, and involves a contextual assessment, it is very likely that the importance of the management services to the reporting issuer (and the reporting issuer's dependence on them), the significance or materiality of service fees payable (as a matter of transfer pricing), and/or the potential detrimental impact on the reputation or business affairs of the reporting issuer if the management services fail, are all reasonable factors when determining the materiality of service contracts.
Assuming that affiliated companies enter into management service arrangements that are material to their business and operations, Part 12.2 of NI 51-102 requires reporting issuers who are party to these contracts to file the material contracts on SEDAR in the following circumstances:
(i) unless previously filed, a reporting issuer must file a material contract that has been entered into within the last financial year (or before the last financial year if that material contract is still in effect); but,
(ii) as a general rule, material contracts that are entered into in "the ordinary course of business" are not required to be filed unless they constitute any one of six types of "ordinary course" material contracts – one of which includes "an external management or external administration agreement".
The CSA's Companion Policy for NI 51-102 provides the following guidance concerning what contracts constitute management service agreements:
External management and external administration agreements include agreements between the reporting issuer and a third party, the reporting issuer's parent entity, or an affiliate of the reporting issuer, under which the latter provides management or other administrative services to the reporting issuer.
Although reporting issuers in Canada are required to file the "material" management service contracts in the ordinary course of business with affiliated companies entered into, in practice, filing of this sort is rare. However, the Canadian Securities Administrators' Staff Notices 51-329 and 51-332 indicated that disclosure of material contracts will receive greater attention in reviews. Reporting issuers should consider being more vigilant in meeting their filing obligations. In October 2010, the Ontario Securities Commission's Staff Notice 51-706 addressed the connection between the fundamentals of corporate governance best practices and existing disclosure requirements as follows:
In addition to initiatives regarding shareholder rights, we continued our focus on disclosure surrounding the practices of those charged with "representing" shareholder interests, such as the board of directors. As part of our corporate sustainability reporting initiative, we reviewed the existing disclosure requirements regarding corporate governance matters during fiscal 2010. We heard feedback from stakeholders consulted that the existing disclosure requirements are adequate. However, they noted that compliance by reporting issuers with these requirements could be enhanced.
Further Regulatory Interest
Issuers should expect that the issue of material service contracts will be of increasing interest to regulators. Multilateral Instrument 61-101 (MI 61-101) deals with a reporting issuer's obligations when it engages in related party transactions. It is arguable that, in certain circumstances, service contracts may be included in MI 61-101's definition of a related party transaction. It is worth noting that the first draft of MI 61-101 explicitly included "service contracts" in this definition (although it was later removed). Reporting issuers should determine whether their service contracts will be caught by the definition in MI 61-101. If so, issuers may have to fulfill the requisite obligations of obtaining a formal valuation of the transaction, and obtaining minority approval for it.
The Ontario Securities Commission also announced recently that it is considering changes to its regulation concerning related party transactions. Under the proposal, where an exemption would have applied in the past, now, a special committee of a company's board of directors would be required to evaluate the proposed transaction and either recommend it, or at least deem it fair to minority shareholders, and then have it put to a vote without a recommendation.
Action Steps – Now
As we described in Part I of this update, as scrutiny over corporate governance continues to focus on the ability of directors and executive officers to effectively supervise and oversee the conduct of material business processes, operations and administration, it will become increasingly important to ensure that each management services contract between affiliated companies stands as an effective, practical and adequate implementation of governance oversight. Publicly traded companies are well advised to bring their material intercompany management service agreements up to "governance scratch" before any disclosure obligations are required to be met, and the ensuing transparency becomes embarrassing.
1 For the purposes of the update we have assumed that the affiliate is not a wholly-owned subsidiary.
2 Biovail Corp. (Re), 2010 LNONOSC 729.
3 Sharbern Holding Inc. v. Vancouver Airport Centre Ltd.,  S.C.J. No. 23.
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.