Canadian Securities Administrators Publish Instrument Relating To Internal Control Reporting And Certification Requirements - Financial Services

Originally published in Blakes Bulletin on Securities Regulation, September 2008

The Canadian Securities Administrators (CSA) recently published a notice that Multilateral Instrument 52-109 – Certification of Disclosure in Issuers' Annual and Interim Filings (MI 52-109) will be replaced with the new National Instrument 52-109 – Certification of Disclosure in Issuers' Annual and Interim Filings (NI 52-109). NI 52-109 is subject to ministerial approval in Alberta, British Columbia, Ontario and Quebec and, subject to such approvals, will come into force on December 15, 2008 and apply to all annual and interim filings for periods ending on or after that date. The key differences between the new NI 52-109 and the current MI 52-109 are summarized below under "Significant Changes in NI 52-109".

NI 52-109 requires management of "non-venture issuers" to evaluate the issuer's internal control over financial reporting (ICFR) in addition to its disclosure controls and procedures (DC&P), and provide management's

discussion and analysis (MD&A) disclosure about their conclusions on the effectiveness of the issuer's ICFR and DC&P based on such evaluation.

NI 51-102 reflects certain minor changes to the proposed National Instrument 52-109 which the CSA previously published for comment on April 18, 2008 (the Proposal). For a summary of the Proposal, see our May 2008 Blakes Bulletin on Securities Regulation – Canadian Securities Administrators Publish Revised Proposed Replacement of Instrument Relating to Internal Control Reporting and Certification Requirements on Blakes Web site in our Publications – Corporate Finance & Securities Regulation section. The few changes made to the Proposal reflect comments received by the CSA during the comment period which ended on June 17, 2008. These changes are summarized below under "Changes to Proposal".

NI 52-109 distinguishes between (i) "venture issuers", meaning reporting issuers that are not listed on the Toronto Stock Exchange (TSX) or a major exchange or quotation and reporting system outside of Canada, and (ii) "non-venture issuers", meaning reporting issuers that are not venture issuers (referred to hereinafter as issuers).

SIGNIFICANT CHANGES IN NI 52-109

The key features of NI 52-109 when compared with the current MI 52-109 are set out below. Other than the description of the new certificate available for venture issuers, the following requirements under NI 52-109 apply solely to issuers and do not apply to venture issuers.

Additional Guidance on Design of Disclosure and Internal Controls

NI 52-109 explicitly requires that issuers establish and maintain DC&P and ICFR, whereas the current MI 52-109 only requires certifying officers to certify that they have designed DC&P and ICFR. Although NI 52-109 does not require specific components for DC&P or ICFR, the new Companion Policy provides more guidance than the current MI 52-109 on the components that should be included.

In determining the full scope of these components, the CSA suggest that certifying officers should use a top-down, risk-based approach in the design process and should design such components using their judgment, acting reasonably, giving consideration to various factors particular to an issuer, including its size, nature of business and complexity of operations. The Companion Policy to NI 52-109 (the Companion Policy) contains significant guidance on how this approach should be undertaken.

NI 52-109 allows the certifying officers of an issuer to limit the scope of the design of its DC&P and ICFR to exclude DC&P controls, policies and procedures of underlying entities in which the issuer has an interest such as proportionately consolidated entities, variable interest entities and businesses that the issuer acquired not more than 365 days before the end of the period to which the certificate relates. However, the issuer must disclose in its MD&A the scope of this limitation and summary financial information of such underlying entities. An issuer cannot limit its design of DC&P or ICFR in respect of proportionately consolidated entities and variable interest entities unless the certifying officers do not have a reasonable basis to make the necessary representations in the annual or interim certificates because such officers have insufficient access to the relevant entity or entities to design and evaluate controls, policies and procedures carried out by such entity or entities.

Evaluation of Internal Control over Financial Reporting

Certifying officers of issuers will be required to certify in their annual certificates that they have evaluated the effectiveness of the issuer's ICFR at the financial year end and that they have caused the issuer to disclose in its annual MD&A their conclusions from this evaluation. NI 52-109 does not prescribe how the certifying officers should conduct their annual evaluation of an issuer's ICFR. However, the Companion Policy does provide guidance on the tools that they should use in their evaluation, which includes self-assessments. In the Companion Policy, the CSA also indicate that the nature, timing and extent of evaluation procedures necessary for certifying officers to obtain reasonable support for the effective operation of ICFR depends on the level of risk each component is designed to address.

Guidance is also provided in the new Companion Policy to assist certifying officers in determining whether a deficiency is addressed by a compensating control or a mitigating procedure and how that determination affects their conclusions on the effectiveness of ICFR.

Control Framework for Issuers

NI 52-109 requires an issuer to use a control framework in the design of its ICFR. The Companion Policy states that the framework used should be a suitable control framework that is established by a body or group that has followed due-process procedures. Although the CSA have not mandated the use of any particular framework, the Companion Policy refers to certain examples, such as:

the Risk Management and Governance: Guidance on Control (COCO Framework), formerly known as Guidance of the Criteria of Control Board, published by the Canadian Institute of Chartered Accountants;

the Internal Control – Integrated Framework (COSO Framework) published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO); and

the Guidance on Internal Control (Turnbull Guidance) published by the Institute of Chartered Accountants in England and Wales.

A smaller issuer may also refer to Internal Control over Financial Reporting – Guidance for Smaller Public Companies published by COSO, which provides guidance to smaller companies on the implementation of the COSO Framework.

Increased MD&A Disclosure

NI 52-109 requires an issuer's certifying officer to identify and disclose any "material weakness" in the design or operation of its ICFR, the definition of which was adopted from the U.S. definition of "material weakness" under Section 404 of the Sarbanes-Oxley Act of 2002. The threshold for meeting the definition of a "material weakness" is whether there exists "a deficiency, or combination of deficiencies in ICFR such that there is a reasonable possibility that a material misstatement of the reporting issuer's annual or interim financial statements will not be prevented or detected on a timely basis." If the certifying officers of an issuer identify a "material weakness" in the design or operation of its ICFR which exists as at the end of the period covered by its annual or interim filings, they cannot certify that the issuer's ICFR is effective. Under NI 52-109, an issuer is required to disclose in its annual and interim MD&A:

with respect to material weaknesses:
- a description of each material weakness in the design or operation of its ICFR;
- the impact of the material weakness on the issuer's financial reporting and its ICFR;
- the issuer's current plans, if any, or any actions already undertaken, for remediating the material weakness;

the certifying officers' conclusions about the effectiveness of its ICFR (annual only);

the name of the control framework used in the design of its ICFR; and

if applicable, any limitation in the scope of the design of its ICFR.

Expanded Certificates for Issuers

NI 52-109 expands the required full annual and interim certificates currently applicable to issuers to include representations from its certifying officers that:

the issuer has disclosed in its annual/interim MD&A information regarding the effectiveness of its ICFR and any material weakness identified therein (see above under "Increased MD&A Disclosure"); and

the certifying officers have disclosed to the issuer's auditors and the board of directors or the audit committee any fraud that involves management or other employees who have a significant role in the issuer's ICFR.

As an alternative to the full annual certificate, NI 52-109 permits issuers to file annual certificates that exclude certifications relating to ICFR for the first financial period after an initial public offering or reverse takeover.

New Certificates for Venture Issuers

Instead of requiring venture issuers to file full annual and interim certificates, NI 52-109 allows venture issuers to file a "venture issuer basic certificate" which does not include representations relating to the establishment and maintenance of DC&P and ICFR. The basic certificate includes a "note to reader" explaining how the basic certificate differs from the certificate required to be filed by issuers.

A venture issuer filing a basic certificate is not required to discuss in its annual or interim MD&A the design or operating effectiveness of DC&P or ICFR. However, if a venture issuer files a basic certificate and chooses to discuss the design or operation of one or more components of its DC&P or ICFR in its annual or interim MD&A, the CSA suggest in the Companion Policy that the venture issuer should include a discussion in such MD&A that is similar to the disclosure in the "note to reader" on its basic certificate. A venture issuer may, at its option, still file a full certificate.

Venture issuers are also permitted under NI 52-109 to file annual certificates that exclude certifications relating to ICFR for the first financial period after becoming a non-venture issuer (i.e., listed on the TSX or a major exchange or quotation and reporting system outside of Canada, with some exceptions).

CHANGES TO PROPOSAL

The changes to NI 52-109 from the Proposal (all of which were not, in the CSA's view, material) include the following:

NI 52-109 has been amended to conform with the guidance in the Companion Policy regarding when an issuer can limit its design of DC&P or ICFR to exclude controls, policies and procedures of a proportionately consolidated entity or variable interest entity in which it has an interest. NI 52-109 now states that an issuer cannot limit its design of DC&P or ICFR unless the certifying officers do not have a reasonable basis to make the necessary representations in the annual or interim certificates because such officers have insufficient access to the relevant entity or entities to design and evaluate controls, policies and procedures carried out by such entity or entities.

The Companion Policy has been amended to include " further guidance on various topics, including: (i) com-pensating controls versus mitigating procedures; (ii) determining when a weakness in DC&P is significant; (iii) the conduct of self-assessments and testing controls; and (iv) how to determine whether a scope limitation exists for a business acquisition.

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Canada: Canadian Securities Administrators Publish Instrument Relating To Internal Control Reporting And Certification Requirements