Canada’s securities regulators believe it is essential that public issuers in Canada be subject to corporate governance rules that are as robust as those in the United States but tailored to the Canadian markets. On June 27, they released three draft rules, accompanied by cost-benefit analyses and detailed questions to solicit public comments. If the rules are adopted, most public issuers in Canada will have to provide CEO and CFO certifications and comply with audit committee rules that are substantially similar to comparable provisions of the U.S. Sarbanes-Oxley Act of 2002 (S-Ox), and SEC and U.S. stock market requirements. In addition, public issuers will only be permitted to appoint auditors who are in good standing with the Canadian Public Accountability Board.
The recently released Report of the Standing Senate Committee on Banking, Trade and Commerce makes several recommendations to the federal government, including CEO/CFO certification, and audit committee independence, financial literacy and expertise. The Report also calls for additional corporate governance requirements, many of which track the U.S. rules closely. Therefore, the three draft rules discussed below are likely to be the first of several investor confidence initiatives to be undertaken in Canada.
Personal Certification by CEOs and CFOs of Annual and Interim Filings
This certification rule will apply to all reporting issuers, other than investment funds. There will be exemptions from this rule for (a) Canadian cross-border issuers that provide certifications under section 302 of S-Ox (but only if the financial statements filed in Canada are covered by the S-Ox certifications); (b) certain non-Canadian issuers; and (c) certain issuers of exchangeable or guaranteed securities.
Misrepresentations and Fair Presentation
Four times a year, the CEO and CFO will have to personally certify that, to their knowledge, their company’s annual or interim filings (the AIF, annual or interim financial statements, and annual or interim MD&A, together with documents incorporated by reference) (i) do not contain a misrepresentation; and (ii) fairly present in all material respects the company’s financial con dition, results of operations and cash flows as of and for the periods presented in the filing. CEOs and CFOs will not be permitted to qualify their fair presentation certification by the phrase “in accordance with generally accepted accounting principles.” These certifications will be required for filings made after December 31, 2003.
According to the regulators, fair presentation includes
• the selection and proper application of appropriate accounting policies;
• disclosure of financial information that is informative and reasonably reflects the underlying transactions; and
• disclosure that is necessary to provide investors with a materially accurate and complete picture of the company’s financial condition, results of operations and cash flows.
Disclosure Controls and Internal Controls
Public issuers will have to design and implement disclosure controls and procedures that provide reasonable assurances that material information required to be disclosed by the company is made known to the CEO and CFO and is disclosed within the time periods required by Canadian securities laws. Like the recently amended SEC rule, issuers will also have to design internal controls that provide reasonable assurances that their financial statements are fairly presented in accordance with GAAP. CEOs and CFOs will be required to certify this four times a year. Annually, the CEO and CFO will be required to evaluate the effectiveness of the disclosure controls and the internal controls, and present their conclusions in the annual MD&A. The requirement to certify in respect of disclosure controls and internal controls will begin with annual and interim certificates required to be filed after December 31, 2004. Canadian securities regulators are studying, but did not include in the draft rule, the SEC’s requirement for auditor attestation of and reporting on management’s assessment of internal controls.
The Role and Composition of Audit Committees
It is a fundamental premise of good governance that the external auditors report to a body that is independent of management. Auditors are, in theory, responsible to the board and audit committee, acting in the best interests of the shareholders. The threat that the auditors will be beholden to management is addressed in this draft rule—by requiring independence, financial literacy and a direct reporting relationship between the audit committee and the external auditors.
This rule will apply to all reporting issuers other than investment funds, issuers of asset-backed securities, certain non-Canadian issuers and certain subsidiaries of reporting issuers. In addition, U.S.-listed issuers will be exempt if they include in their AIF disclosure of instances where the board did not adopt a recommendation of the audit committee to nominate or compensate an external auditor.
The rule distinguishes between large issuers and venture issuers. “Large issuers” are reporting issuers listed or quoted on the TSX, the NYSE, the AMEX, the Nasdaq National Market, the Nasdaq SmallCap Market, the Pacific Exchange or a market outside of Canada and the United States. All other reporting issuers, including those listed on the TSX Venture Exchange, are “venture issuers”.
Number and Independence of Audit Committee Members
Large issuers will be required to have at least three directors on their audit committee, all of whom will have to be independent. Venture issuers will not be subject to this requirement, although corporate law may require them to have an audit committee comprised of a majority of non-management directors. Venture issuers will be required to disclose in their AIFs the name of each audit committee member and whether or not the member is independent.
Meaning of Independent
To be considered independent for audit committee purposes, the draft rule requires that a person have no direct or indirect material relationship with the issuer. A “material relationship” is one that could, “in the view of the issuer’s board of directors, reasonably interfere with the exercise of a member’s independent judgment.” Individuals will lack independence if, in the past three years, they (or in most cases, immediate family members) were (a) officers or employees of the issuer (or its parent, subsidiaries or affiliates); (b) affiliated with the company’s auditor; or (c) an executive officer of another company that had an executive officer of the issuer on its compensation committee. In addition, anyone who accepts, directly or indirectly, any consulting, advisory or other fee from the company (other than directors’ fees and committee fees), or is “affiliated” with the issuer, will lack independence. Officers and executive directors of affiliated companies are considered “affiliates” for this purpose. The threeyear “look-back” period is being phased in, so relationships before January 1, 2004 will not taint independence.
Like the SEC, Canadian securities regulators will not impose independence requirements on boards as a whole. Therefore, TSX-listed issuers must continue to consider the TSX guidelines on independence of the board and other corporate governance matters. The TSX has indicated that it will abandon proposed listing requirements and guidelines relating to audit committee independence and harmonize the definition of “unrelated director” with the definition of independence in the audit committee rule, although the extent of the harmonization remains to be seen. Other changes to the TSX guidelines are also expected.
Like the recently amended SEC rule, there is an important provision that will permit a representative of a parent company to be a member of the audit committee of a controlled, public company subsidiary. The representative will, however, have to be independent of both the parent company and the controlled subsidiary.
Financial Literacy and Financial Expert
All members of the audit committee of a large issuer will have to be financially literate (that is, able to read and understand a set of financial statements of breadth and complexity similar to the breadth and complexity of the issues expected to be raised by the issuer’s financial statements).
Like the SEC rules (but unlike the NYSE rules), there is no requirement to have a financial expert on the committee, although issuers will be required to disclose whether or not they have an audit committee financial expert serving on the committee. An “audit committee financial expert” is someone with a more in-depth understanding of GAAP and financial statements, internal controls and procedures for financial reporting and audit committee functions, than someone who is merely financially literate. If the audit committee financial expert has gained their expertise other than through (a) education and experience as a principal financial officer or auditor; (b) actively supervising a principal financial officer or auditor; or (c) experience overseeing or assessing the performance of companies or auditors, the issuer must provide a brief description of the person’s relevant experience.
Venture issuers will not be required to have financially literate audit committee members. They will be required to disclose in their AIF the name of each audit committee member and whether or not the member is financially literate.
Responsibilities of the Audit Committee
The draft rule focuses on the relationship between the company and its external auditors by requiring the external auditor to report directly to the audit committee. The audit committee also must have a written charter that sets out its mandates and responsibilities.
The draft rule requires the audit committee to, at a minimum (a) recommend to the board the external auditors to be nominated for appointment by the shareholders; (b) recommend the compensation of the external auditors; (c) be directly responsible for overseeing the work of the external auditors, including the resolution of disagreements between management and the auditors; (d) pre-approve nonaudit services to be provided to the issuer by the external auditors; (e) review the financial statements, MD&A and earnings press releases before the information is publicly disclosed; (f) be satisfied with and periodically assess the adequacy of procedures for the review of other corporate disclosure that is derived or extracted from the financial statements; (g) establish procedures for the receipt, retention and treatment of complaints about accounting, internal controls or auditing matters and for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters; and (h) review and approve the issuer’s hiring policies regarding employees and former employees of the present or former external auditors.
Audit committees will have to be given the authority to communicate directly with the internal and external auditors, engage independent counsel and other advisors, and set the compensation for any advisors retained.
Large issuers will have to disclose in their AIF (a) the audit committee charter; (b) the name of each member of the audit committee, and if they are not independent, the reason; (c) the identity of any audit committee financial expert(s) and if there is no such expert, that fact and the reason must be stated; (d) in some cases, the qualifications of the audit committee financial expert(s); and (e) whether the issuer has relied on an exemption from the rule and how that exemption materially affects the audit committee’s ability to act independently and satisfy the other requirements of the rule. The management proxy circular must include a cross reference to the section of the AIF where these disclosures are made. Venture issuers are subject to less robust disclosure requirements.
Other disclosures in the AIF will include (a) instances where the board did not adopt a recommendation of the audit committee to nominate or compensate an external auditor; (b) a description of specific policies and procedures, if any, for pre-approving non-audit services; and (c) detailed disclosures of various fees billed to the issuer by the external auditor, broken down by category.
The Canadian Public Accountability Board
The Chair of the Ontario Securities Commission described the third draft rule as one that “puts some teeth into the Canadian Public Accountability Board.” It requires that financial statements of public issuers be audited by a firm that is in good standing with the CPAB. Auditors that have restrictions placed on them by the CPAB or that are sanctioned by the CPAB must provide notice to the securities regulators and, in some cases, also to the public issuers they audit.
What You Should Do
Public issuers in Canada that presently comply with the U.S. corporate governance requirements will be largely unaffected by the new Canadian rules. For other public issuers in Canada, there may be a lot to do. At a minimum, public issuers must adopt appropriate disclosure controls and internal controls to put the CEO and CFO in a position to give the required certifications; procedures will be needed to assist the CEO and CFO to evaluate and publicly disclose their conclusions on the effectiveness of these controls; an appropriate audit committee charter will have to be developed or reviewed to ensure that the mandate of the audit committee is clearly stated and that the committee is imbued with the required authority; and the audit committee will likely have to be reconstituted to ensure that, for large issuers, the members are independent and financially literate.
Comments on the draft rules must be submitted to Canadian securities regulators by September 25, 2003.
This client memo is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss with you the issues raised by this client memo in the context of your particular circumstances.