In December 2012, the Toronto Stock Exchange ("TSX") and the TSX Venture Exchange ("TSXV" and, together with the TSX, the "Exchanges") published a Consultation Paper on Emerging Market Issuers (the "Consultation Paper") as part of their review of listing requirements for issuers with a significant connection to an emerging market jurisdiction outside of Canada, the United States, Western Europe, Australia and New Zealand ("Emerging Market Issuers" or "EMIs"). The Consultation Paper presents the potential risks associated with listing Emerging Market Issuers identified by the Exchanges, provides preliminary guidance to issuers and their advisors regarding listing considerations applicable to EMIs and seeks comments from market participants on matters related to listing EMIs. The Consultation Paper also contains a proposed TSXV policy document (the "Policy"), which sets forth specific guidance and requirements applicable to the listing of EMIs on the TSXV and seeks to address the risks associated with such listings. Comments on both the Consultation Paper and the proposed TSXV policy document are to be submitted by February 28, 2013.
Potential Risks Associated With Listing Emerging Market Issuers
The Exchanges identified four principal areas of risk associated with listing EMIs: (1) management and corporate governance; (2) financial reporting; (3) non-traditional corporate/capital structures; and (4) legal matters relating to title and ability to conduct operations.
Management And Corporate Governance
The Consultation Paper outlines the following risks relating to management's lack of experience and familiarity with Canadian securities law and regulatory requirements, communication-related issues due to language and geographic barriers and management's unfamiliarity with local business practices:
- a potential increase in the likelihood of non-compliance with, or misunderstanding of, Canadian securities law requirements and TSX and TSXV requirements as well as the legal and regulatory requirements of the jurisdiction where the EMI principally carries out its business;
- inadequate oversight of senior management by the board of directors;
- the inability of advisors to adequately communicate with senior management and the board of directors;
- the inability of the chief financial officer to properly carry out his or her duties;
- the inability of the audit committee to property carry out its duties; and
- the inability of senior management to adequately communicate with the Exchanges and applicable securities regulatory authorities.
The Exchanges note the following risks with respect to an EMI's financial reporting:
- an increase in the likelihood of errors or oversights in the audit process, and correspondingly in financial statements and related disclosure, due to the EMI's Canadian auditors' lack of sufficient experience and expertise in the applicable emerging market jurisdiction;
- an increase in the likelihood of errors and misstatements in financial statements due to inadequate internal controls over financial reporting matters; and
- an increase in the likelihood of errors or oversights in the audit process and financial statements due to the EMI's chief financial officer or audit committee not having sufficient expertise and experience with applicable audit practices and procedures.
Non-Traditional Corporate/Capital Structures
The Exchanges identified the following potential risks associated with the use of complex corporate or capital structures, which they recognize may be desirable or necessary due to tax or foreign ownership restrictions:
- if the structure requires that legal ownership of the EMI's operating assets be vested in a non-affiliated entity, title to and control over such assets by the EMI may be compromised;
- the structure may limit or otherwise inhibit the ability of shareholders to have recourse against the EMI's assets; and
- inadequate public disclosure of the nature, material characteristics and risks associated with the structure.
Legal Matters Relating To Title And Ability To Conduct Operations
The Consultation Paper points out the following risks relating to the validity of an EMI's title to its principal operating assets and its legal right to conduct operations:
- an increase in title risk or difficulty demonstrating the legitimacy and certainty of title to the EMI's principal operating assets, which are fundamental requirements for the listing of an issuer on the Exchanges; and
- impact on an EMI's ability to carry out its business operations due to the emerging market jurisdiction's requirements for specific permits or business licences.
Some Of The Proposed Requirements
In light of the risks associated with the listing of EMIs, the Exchanges strongly recommend that any EMIs contemplating listing on either the TSX or the TSXV arrange a pre-filing meeting with the applicable Exchange. The EMI must satisfy the applicable Exchange that it is able to meeting all applicable listing requirements and mitigate the potential risks.
The TSX is also contemplating requiring comfort around internal controls in the form of a certification, management report or other similar report on internal control systems to be submitted by an auditor at the time of listing of EMIs. Similarly, the TSXV has proposed that an EMI's internal controls over financial reporting be reviewed and evaluated by the EMI's auditors prior to listing.
Related Party Transactions
Related party transactions may be prevalent among EMIs that have a controlling security holder and such transactions may not necessarily meet the definition of "related party transactions" under securities law. The TSX is contemplating classifying EMIs that have a controlling security holder as "non-exempt" and be subject to additional oversight for related party transactions or taking an expanded view of "related party transactions". The TSXV policy document also proposes that EMIs be required to adopt specific internal written policies in respect of related party transactions and transactions with non-arm's length parties that would address matters such as independent director oversight and approval, adequate timely disclosure to the public, adequate disclosure in the financial statements and compliance with all applicable regulatory requirements.
Historically, sponsorship may have been waived for certain applicants completing an IPO or brokered financing, or graduating from the TSXV. However, the TSX has indicated that in assessing EMIs, sponsorship may be particularly helpful and the TSX is unlikely to waive the requirement. Similarly, the TSXV policy document would make certain modifications to the sponsorship requirements including changes to the availability of certain sponsorship exemptions. The TSXV would more actively request detailed sponsor reports where sponsorship of an EMI is required.
The TSX may, in its discretion, require supplemental ongoing requirements to mitigate particular risks; such requirements could include pre-clearance of a change of auditors and pre-clearance of new board members or new senior management. The TSX would impose any supplemental ongoing requirement at the time of listing and could periodically re-consider these requirements as the EMI's risk profile changes over time. Similarly, the TSXV would require all EMIs to continue to comply with the EMI requirements on an ongoing basis and for EMIs to be mindful of corporate actions that may impact continued compliance. The TSXV may from time to time, at its discretion, require an EMI to satisfy the TSXV that it remains in compliance with the applicable requirements.
McMillan Thoughts And Perspectives
We are in general agreement with the TSX and TSXV with the need to apply increased regulatory scrutiny to issuers engaged in emerging markets in order to both protect investors and to preserve the integrity of Canadian capital markets. However, we have a number of concerns with the proposed Policy which are both specific, a number of which are outlined below, and general.
Our general concern is that it will invariably be difficult, and perhaps impossible, to draft a set of prescriptive rules that will apply and be effective in regulating a wide variety of Emerging Market Issuers that will range greatly in terms of business size, nature of business operations and management sophistication across a wide variety of emerging markets, each of which will have their own characteristics and risks. Accordingly, we are of the view that the Exchanges should retain flexibility in how to apply their rules and policies and will need to actively tailor their review of Emerging Market Issuers in order to address specific risks applicable to each issuer. In other words, there is no "one size fits all" set of rules or policies that should be applied and the TSX and TSXV are going to have to focus their reviews on a "case by case" basis, with as much transparency to issuers as is possible. For instance, if the definition of Emerging Market Issuer is narrowed in a specific case to include other acceptable countries or regions, the decision of an Exchange should be published. Also, we suggest that the TSX and TSXV retain discretion as to how and to what extent to apply the requirements in their rules and policies, rather than impose up-front strict requirements that may not be necessary in all circumstances and that can only be avoided by way of waiver.
Specific concerns that we have include the following:
- Definition Of An Emerging Market Issuer: The current draft of "Emerging Market Issuer" captures issuers across the globe with principal business operations or operating assets located outside of North America, the UK, Western Europe, Australia and New Zealand. Accordingly, issuers based in a number of advanced and sophisticated economies, notably Hong Kong, Japan and Korea, are classed as Emerging Market Issuers. While many of the laws and cultures of these jurisdictions are clearly distinct from "Western" countries, many of these jurisdictions do have sophisticated legal systems and business cultures where the perceived risks associated with emerging markets are not present.
- Carve-Out For "Excluded Resource Issuers": We appreciate the rationale for carving out "Excluded Resource Issuers" from the full application of the policies for Emerging Market Issuers. However, we have two key concerns:
- Qualification as an "Excluded Resource Issuer" is tied to residency outside of Emerging Market Jurisdictions with respect to senior officers, directors and control persons. We are concerned that residency is not an accurate determination of the ability of the officers, directors or control persons to effectively manage the business of a public company. For example, a TSXV company with mining operations in Peru and majority South American management may be far more effective with appropriate education, professional qualification and designation and local management and mining expertise than a TSXV company with mining operations in Chile where the majority of management is based in North America but where the same standards of education, professional qualification and designation and local management and mining expertise are not met.
- The distinction between an "Excluded Resource Issuer" and an "Emerging Market Issuer" becomes based on the business operations of the issuer, rather than factors that are directly relevant to management of the issuer and risk factors associated with potential fraud or mismanagement. For example, an issuer with a gold mine in China may be exempt from many of the Emerging Market Issuer policies, whereas an issuer with a manufacturing facility next door to the mine and with a similar management and governance structure as the mining company may find itself caught by the policies in full.
- Auditor Review Of Interim Financial Statements: We agree with the TSX and TSXV that the reliability of an Emerging Market Issuers internal controls over financial reporting are key to reliability of financial reporting and financial statements. Accordingly, we generally agree with the proposed requirement that auditors be required to review the interim financial statements of Emerging Market Issuers following listing. However, we question whether this obligation should be ongoing for issuers in higher risk jurisdictions rather than only being required for two years following listing, as proposed, given that we see the risks associated with financial reporting as being ongoing for these issuers, and not just in the initial years following listing. It may therefore be appropriate to consider extending the time period beyond two years for specific regions or on a "case by case" basis, with as much transparency as is appropriate.
- Internal Controls Over Financial Reporting: We agree with the TSX and TSXV as to the need for increased scrutiny over the internal control over financial reporting ("ICFR"). However, we have a number of comments on the proposed requirements for Emerging Market Issuers:
- First, the Policy calls for an issuer to have its ICFR reviewed and evaluated by its auditor prior to listing. We are unclear as to what would be the nature of this review and evaluation. The proposed Policy is clear that the review will not rise to the level of a SOX 404 auditor attestation report, however we would suggest that the TSX and TSXV provide more guidance on what is anticipated in order that Emerging Market Issuers have more clarity on this point and can better judge the required process and consequential expense.
- Second, the Policy calls for TSXV issuers that would be "venture issuers" under Canadian securities laws to file the full CEO and CFO certifications required for TSX issuers in order that they are forced into a higher standard of reporting on their evaluation on ICFR and any material weaknesses, if applicable, as a TSX issuer. We agree with this approach but again question whether it should only be for the two years following listing for Emerging Market Issuers in high risk jurisdictions as the ICFR risk may be ongoing for these issuers.
- Non-Traditional Corporate/Capital Structures: We anticipate the challenges faced by the TSX and the TSXV in listing issuers with complex non-traditional corporate structures, particularly issuers that conduct business in China through "variable interest entities" ("VIE's"). These structures are now being scrutinized by regulators globally, particularly by the SEC in the United States. With regards to the proposed policies, we have the following comments:
- It is proposed that the TSXV have the right to refuse listing of an Emerging Market Issuer where the Exchange is not satisfied that the non-traditional structure is "necessary". We submit that necessity is the incorrect test to apply to these structures. Rather, we submit that the Policy should focus on whether the non-traditional structure presents risks that the TSXV would consider unacceptable for a public company.
- It is proposed that the TSXV require legal opinions on the validity of the non-traditional structures addressing the concerns noted in the Policy. On this point, we suggest that the Policy more clearly focus on the types of opinions that will be required in order that Emerging Market Issuers can better focus their professional advisors to address these legitimate listing concerns. Opinions as to title of key properties and necessary permits and licenses are specifically required, however there are a number of opinions that could also be sought by the TSXV where specific risks are present. For example, opinions as to enforceability of contracts underlying VIE's and the ability to repatriate funds from overseas operations to the listed parent are opinions that the TSXV may want to consider obtaining in certain situations. Accordingly, we suggest that the Policy expand the specific types of opinions that that may be sought and provide guidance as to the factors that the TSXV will apply in determining which opinions will be required by the TSXV.
- Sponsorship: The TSXV has proposed in its Policy to remove the availability of certain exemptions from the sponsorship requirements for Emerging Market Issuers. We propose that removal of these exemptions is not appropriate for the following reasons:
- Section 3.1(a) of Policy 2.2 provides an exemption where an IPO is completed where the prospectus is executed by at least one Member. We believe that removal of this exemption will not be required given the anticipated increased standards to be imposed on underwriters by the Ontario Securities Commission as part of its implementation of high regulatory standards for Emerging Market Issuers.
- Section3.4(a)(ii) of Policy 2.2 provides an exemption where a bank or other major financial institution is involved in the transaction or the completion or a concurrent brokered financing where due diligence is conducted. Again, we anticipate that the anticipated increased standards to be imposed on underwriters by the Ontario Securities Commission as part of its implementation of high regulatory standards for Emerging Market Issuers should serve to address the concerns of the TSXV and remove any requirement to remove this exemption for Emerging Market Issuers.
- We especially support the use of pre-filing conferences and the potential need for corporate governance or reporting issuer management courses. Such training is required in connection with a listing on the Stock Exchange of Hong Kong, for instance, and is very useful in raising awareness. It is important that that there is an appropriate "tone at the top" of the listed entity that understands best practices of corporate governance, including respect for the Board and its decisions.
- We also believe that sponsors and agents should consider the use and application of the tools used in the private equity market to monitor and provide for consequences should there be instances of fraud or to guard against fraud or theft. These mechanisms could include:
- more stringent controls over bank account signing authority,
- supervision of use of proceeds,
- maintenance of some level of minimum working capital in Canada,
- forfeiture of shares in cases of malfeasance,
- security for key representations made by principals, and
- using appropriate dispute resolution forums whose judgments are enforceable in the jurisdiction where the business is located (for instance the use of Hong Kong's Arbitration Centre in connection with disputes involving business operations in Mainland China).
In conclusion, we believe the proposed Policy is a forward step in providing guidance to Emerging Market Issuers and their advisors that will help to remove much of the current uncertainty in the current marketplace as to how the listing of Emerging Market Issuers will be regulated. Again, we are of the view that the TSX and TSXV will need to be creative in creating governance structures that will address the particular risks faced by each particular Emerging Market Issuer on a case-by-case basis.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
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