United States: Under Scrutiny: Governance in Canada

Published in Directors and Boards, Fall 2004.

Corporate Governance in Canada is under intense scrutiny. Like the U.S. Securities and Exchange Commission, Canadian securities regulators have been in an unprecedented regulatory frenzy in the aftermath of the Enron scandal. Corporate governance is a hot topic in Canadian boardrooms, and interested parties — governments, stock exchanges, businesspeople, institutional investors, and governance experts — are weighing in. Given the strong economic ties between the U.S. and Canada, it isn’t surprising that U.S. governance practices are having a significant impact in Canada.

Canada is the only country that has a bilateral agreement on securities regulation with the U.S. The Canada-U.S.Multijurisdictional Disclosure System (MJDS), adopted in 1991, gives large public Canadian companies access to U.S. markets without having to follow all the SEC’s disclosure rules. Eligible Canadian companies can offer their debt and equity securities without the SEC reviewing the registration statement. The SEC’s rationale underlying the MJDS is that Canadian regulation is sufficiently similar to its own that duplicate regulation is considered inefficient and unnecessary. This rationale is one important incentive for the Ontario Securities Commission (OSC) and other Canadian securities regulators to follow the SEC’s lead to regulate corporate governance more strictly.

On balance, Canadian companies value MJDS much more highly than U.S. companies do. Because Canadian companies rely on U.S. capital, the regulators of Canada’s comparatively small markets must always be aware of new legal requirements and the evolution of best practices south of the Canadian border. Participants in Canada’s capital markets fear that preferential access for Canadian companies to the U.S. markets could be threatened if Canadian securities regulators don’t keep pace with the SEC.

The Sarbanes-Oxley Act of 2002 (SOX) applies to U.S. and foreign companies alike. MJDS companies, like all other companies reporting with the SEC, must comply in a host of ways, such as CEO/CFO certifications, off-balance-sheet transaction disclosure, internal control reports (including auditor’s attestation), independent audit committees, and prohibition on loans to directors and executive officers. This means that the cost of complying with U.S. rules has increased significantly for cross-border Canadian companies. Even if Canadian companies were exempt from compliance with SOX, many MJDS companies would comply voluntarily, because they want investors and analysts to view them as being on a par with their U.S. competitors.

But the desire to preserve MJDS and achieve harmonious cross-border securities regulation doesn’t tell the whole story of why Canada cares about corporate governance. Regulators in Canada want to protect investors and rebuild domestic and international confidence in Canada’s capital markets in light of Canada’s own corporate scandals, including Bre-X Minerals, YBM Magnex, Nortel Networks, and others. Nortel is cited as "Canada’s Enron." Its 2003 financials are being restated for the second time. The company fired its CEO, CFO, and controller in April 2004, and shareholders are filing class-action lawsuits. The SEC and the OSC are investigating, and the Royal Canadian Mounted Police are conducting a review. Nortel’s stock was worth nearly $100 per share during the tech boom, but is now worth less than $4 (although the decline can’t be attributed entirely to governance failures).

Canadian regulators recently finalized several investor confidence measures, many of which are very similar to those of SOX and various U.S. stock exchange listing standards:

• The CEO/CFO certifications of annual and quarterly reports look much like SOX Section 302 certifications. Like U.S. companies,Canadian companies will have to certify that their periodic reports contain no material misstatements or omissions and provide a fair presentation of the company’s financial condition. They will have to adopt disclosure controls and procedures.

• Public companies must have fully independent and financially literate audit committees. But instead of the SOX requirement that companies disclose whether their audit committee includes a financial expert, Canadian regulators require disclosure of the education and experience of all committee members (on the theory that investors can judge the committee’s expertise for themselves). Audit committees must have a charter, adopt whistleblower procedures, and preapprove nonaudit services.

• Audit committees are not required to hire and fire the independent auditors as they are under SOX, because Canadian corporate law vests this power in the shareholders. Instead, the audit committee will make a recommendation to the board about the auditor who will be proposed to the shareholders. If the board does not follow the audit committee’s recommendation, it must disclose this fact.

• The Canadian Public Accountability Board now oversees the auditing profession. Independent auditors are prohibited from performing various nonaudit services for their audit clients.

Canadian securities regulators have also proposed regulating other aspects of governance that are enforced through the stock exchange listing standards in the U.S. Two sets of proposals are currently out for comment.One set, endorsed by the OSC and the majority of the other provincial and territorial securities commissions, contains 18 recommended best practices and an accompanying disclosure rule. The recommended best practices are similar to the final New York Stock Exchange listing standards for governance. The recommendations include the following:

Public companies would then be required to disclose how their practices measure up against the recommended best practices. If their practices fall short, companies would have to explain why the board believed that non-compliance was appropriate.

An alternative approach put forward by securities regulators in British Columbia, Alberta, and Quebec would require public companies to explain their governance practices without comparing them with a set of best practices. It is too early to predict which regime will prevail — market participants are hopeful that a uniform regime will emerge — but, either way, Canada will continue the disclosurebased approach of the Toronto Stock Exchange (TSX). Ten years ago, the TSX adopted the requirement that companies listed on the exchange disclose their governance practices in relation to 14 guidelines published in the TSX Company Manual. The TSX has stated that it will relinquish its historical role as Canada’s corporate governance standard-setter once the securities regulators take over this role.

The optional nature of the Canadian approach to matters of corporate governance distinguishes it from the mandatory approach adopted by the U.S. stock exchanges. The merits of U.S.-style mandatory rules versus Canada’s traditional disclosure-based approach have been seriously debated in Canada.

Some argue that a disclosure requirement allows governance practices to be adapted to the unique circumstances of each company. They say that since Canadian public companies are often less widely held and are smaller than U.S. companies (making compliance costs relatively more significant), more flexibility is appropriate.With a better quality of disclosure investors can judge the adequacy of governance for themselves, and market forces will ensure that governance is improved where necessary.

Others argue that Canada’s approach is more lenient than the U.S. approach. History has shown that much of corporate governance disclosure is boilerplate and provides very little insight into what is actually happening in Canadian boardrooms. But by moving the disclosure requirements from the jurisdiction of the TSX — which arguably has a conflict of interest in enforcing standards, since it is in the business of attracting listings — to the jurisdiction of securities regulators, disclosure will be taken much more seriously. Securities regulators can police corporate governance disclosure better because inadequate disclosure will be a breach of securities laws that could result in enforcement proceedings and sanctions.

Despite similarities in the rules, to say Canada has simply copied SOX would be an oversimplification. Several SOX-related rules have not been adopted in Canada. There is nothing comparable to the criminal certifications required by Section 906 of SOX, nor is there a prohibition on insider loans.And at present there is no equivalent to the Section 404 management internal control report, although this requirement is expected to be proposed later this year. The regulators are still undecided about whether they will require the external auditor to attest to management’s evaluation of internal controls.

More fundamentally, no powerful, centralized SECequivalent exists in Canada. Securities laws fall under provincial and territorial jurisdiction, with 13 different regulators across the country. Increasingly, regulators disagree over corporate governance matters. For example, British Columbia has not adopted the certification rules described above and has proposed a separate set of audit committee rules for companies that report only in its jurisdiction. Because most public companies are reporting issuers in all 13 jurisdictions, they must comply with 13 sets of rules, plus the corporate laws imposed by their incorporating statute. The lack of uniformity is costly and time-consuming because companies must identify the myriad minor differences from province to province to ensure that they comply with the most stringent requirements.

Currently, a push to replace the patchwork of securities legislation with a uniform securities act has resulted in collaboration among all jurisdictions, except British Columbia, to achieve this. There is also intense debate about whether to establish a single, national securities regulator; but as yet no apparent consensus exists on the need for one. Ontario is home to Canada’s largest capital market.Other provinces, primarily British Columbia and Quebec, fear that a single regulator would be unresponsive to regional interests and are unimpressed by Ontario’s call for regulation to be more harmonized with that of the U.S.

Harmonizing the rules across the country involves negotiation; so the regulators compromise in an attempt to develop rules that as many jurisdictions as possible will endorse. The dual proposals on regulation of audit committees and disclosure of governance practices are examples of the regulators’ failure to compromise.

Some of the unique features of the Canadian marketplace are apparent from the exemptions that regulators have granted to certain kinds of companies. For example, companies listed only on the TSX Venture Exchange (Canada’s junior market, somewhat similar to the Nasdaq SmallCap Market) need not have an independent audit committee, nor must they have financially literate audit committee members. A large proportion of these Venture Exchange issuers are in the mining, technology, and oil and gas industries based in British Columbia and Alberta. This exemption shows a measure of sensitivity to the relatively higher costs of compliance for small companies and the greater difficulty they face in attracting qualified board members.

One common criticism of SOX has been its "onesize- fits-all" approach, which fails to take into account the disproportionate burden that compliance places on smaller companies.With the heightened scrutiny of corporate governance practices combined with a relatively small business community, Canadian companies are finding it harder to recruit board members.

Like their American counterparts, Canadian directors owe duties of care and loyalty to their companies and are required to act honestly, in good faith, and with a view to the best interests of the corporation. A director will not be covered by corporate indemnification or directors’ liability insurance if these standards are breached. D&O liability insurance is becoming more expensive and directors’ retainer fees are increasing. Canadian boards tend to be somewhat homogeneous and regional, and some governance experts would welcome greater diversity, including a greater U.S. presence, on Canadian boards (see accompanying sidebar).

In addition to new legal requirements, the market is driving Canadian companies to improve their governance.Dual-class share structures, which allow a founding family to maintain control without owning 50% of the company’s equity, are still popular but increasingly under attack. Of the 50 controlled companies in Canada’s S&P/TSX Composite Index, 26 of them have some form of unequal voting structure. While the U.S. exchanges generally wouldn’t list a domestic company with inequitable voting rights, they have historically not been as strict with foreign companies.

Institutional shareholders in Canada have followed the lead of their American counterparts by adopting proxy voting/corporate governance guidelines. In addition, the Canadian Coalition for Good Governance (an organization founded by the largest pension funds and institutional investors) has published governance standards and is lobbying companies to adopt its best practices. Canadian institutional investors are strongly opposed to share structures with inequitable voting rights. They also disapprove of companies that use stock options as compensation and those that do not separate the roles of CEO and board chair.

The Canadian capital markets are comparatively small: the NYSE is more than 10 times bigger than the TSX, measured by total market capitalization of listed companies.Yet many of Canada’s most important companies are cross-listed. Out of the 221 companies in the S&P/TSX Composite Index, 109 are listed on both the TSX and the NYSE,Nasdaq, or Amex. Interestingly, Canadian cross-listed companies that comply with SOX-related rules in the U.S. are exempt from Canada’s own corresponding rules. This exemption is perhaps one of the most telling features of Canada’s new corporate governance regime. It reflects the strong desire — some would say need — for a degree of harmony with U.S. regulation. The ongoing challenge is to strike just the right balance by taking account of Canada’s major cross-border companies and also its significant group of small, regional and emerging companies, and successfully negotiating new governance practices among all provincial and territorial regulators.

Andrew J. Beck is a partner in the New York office of Torys LLP, a leading international business law firm with offices in New York and Toronto. H. Leslie McCallum, Jennifer L. Friesen and Danielle A. Townley of Torys' Toronto office assisted in the preparation of this article.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.