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24 February 2004
Under final rules recently adopted by the Canadian securities administrators, most public issuers in Canada(1) will have to provide certifications by the chief executive officer (CEO) and chief financial officer (CFO) and comply with audit committee rules that are substantially similar to comparable provisions of the US Sarbanes-Oxley Act 2002, and Securities Exchange Commission and US 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.
Further to "Rules Demand More from CEOs, CFOs and Audit Committees", Canadian securities regulators (other than the British Columbia and Quebec regulators) are seeking public comment on (i) a proposed policy statement that recommends 18 corporate governance best practices, and (ii) a proposed rule that requires public companies to disclose how their practices measure up against these best practices.
Principal differences from draft proposals
The points below highlight the principal differences between the draft investor confidence rules that were released in June 2003 and the final rules:
The certification rule will apply to all issuers other than investment funds.
There will be exemptions from this rule for:
Non-corporate issuers are subject to the same certification requirements as corporations. In the case of an income trust where executive management resides with the operating company or an external management company, the company's CEO and CFO should provide the certifications on behalf of the income trust.
Misrepresentations and fair presentation
Four times a year, the CEO and CFO will have to certify personally that, to their knowledge, the annual or interim filings (the annual information form (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 issuer's financial condition, 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 (GAAP)".
According to the regulators, 'fair presentation' includes:
The regulators have also indicated that the term 'financial condition' encompasses a number of qualitative and quantitative factors that are not captured in the financial statement concept of 'financial position'. These factors include liquidity, solvency, capital resources, overall financial health of the business, and current and future considerations, events, risks or uncertainties that might affect its financial health. Issuers are still required to present their financial statements in accordance with GAAP, but if the GAAP financial statements do not provide a fair indication of the issuer's financial condition, supplementary information must be provided in the MD&A or elsewhere in the filings.
The CEO and CFO must design (or supervise the design of) disclosure controls and procedures. 'Disclosure controls and procedures' are defined as controls designed to provide reasonable assurance that information required to be disclosed by the issuer in its annual filings, interim filings or other reports filed under securities legislation is recorded, processed, summarized and reported within the applicable time periods. Controls must encompass procedures for accumulating and communicating information to management to allow for timely decisions regarding required disclosure.
Four times a year, the CEO and CFO must certify that they have designed disclosure controls (or that they have reviewed and corrected any deficiencies if the controls were designed by a former CEO or CFO). They must evaluate the effectiveness of these controls as of the end of the financial year and disclose their conclusions in the annual MD&A.
Internal control over financial reporting
The CEO and CFO must design (or supervise the design of) a system of internal control over financial reporting, and the system must be implemented by the board of directors, management and others. 'Internal control over financial reporting' means a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. It includes policies and procedures that pertain to:
As with disclosure controls, the CEO and CFO must certify four times a year that they have designed the system of internal control over financial reporting (or reviewed and corrected any deficiencies if the controls were designed by a predecessor).
Annual certifications are required for financial years beginning on or after January 1 2004. A bare certificate (ie, a certificate dealing only with misrepresentations and fair presentation) may be filed for years ending on or before March 30 2005. For financial years ending on or after March 31 2005, the full certificate must be filed. Interim certifications are required for interim periods beginning on or after January 1 2004. A bare certificate may be filed for those interim periods ending prior to the end of the financial year for which the first full annual certificate must be filed.
An issuer with a calendar year-end will file bare interim certificates beginning
with the filings covering the quarter ending March 31 2004 and will file its
first bare annual certificate in respect of the year ending December 31 2004.
The first full certificate will be required for the annual filings for the year
ending December 31 2005, and full interim certificates will be required for interim
periods in the 2006 financial year.
Principal differences from draft proposals
The principal differences from the draft proposals regarding audit committees are as follows:
The audit committee rule will apply to all issuers other than:
Canadian issuers that are listed on a US stock exchange are exempt from most
of the requirements of the rule if they comply with the US stock exchange listing
standards that apply to domestic US issuers. However, one disclosure point will
have to be made (noted below).
The rule applies to both corporate and non-corporate issuers. For example,
an income trust should have an audit committee composed of at least three trustees
who are independent of both the trust and the operating business.
The rule distinguishes between venture issuers and non-venture issuers. An issuer
that is listed only on the Toronto Stock Exchange Venture Exchange is a venture
issuer and is subject to less stringent requirements.
Meaning of 'independence' for audit committee purposes
To be considered independent for audit committee purposes, the director must 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 judgement". These relationships may be commercial, charitable, industrial, banking, consulting, legal, accounting or familial.
A director will be deemed to lack independence for audit committee purposes in any of the following situations:
Number and independence of audit committee members
Issuers other than venture issuers must have at least three directors on their audit committee, all of whom must be independent. Venture issuers will not be subject to this requirement, although corporate law may require them to have an audit committee comprising a majority of non-management directors.
A number of exemptions from the independence requirements may be available
All members of the audit committee of an issuer, other than a venture issuer, must be financially literate. An individual is financially literate if he or she has the ability to read and understand a set of financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of the issues expected to be raised by the issuer's financial statements. A comprehensive knowledge of GAAP and generally accepted auditing standards is not required.
An audit committee member who is not financially literate may be appointed to the audit committee if he or she agrees to become financially literate within a reasonable period. However, the board of the issuer must be satisfied that this will not have a material adverse effect on the audit committee's ability to act independently and satisfy the other requirements of the rule.
Venture issuers will not be required to have financially literate audit committee
Responsibilities of the audit committee
The audit committee must have a written charter that sets out its mandates and responsibilities. The rule requires the audit committee, at a minimum, to:
The audit committee is permitted to delegate the pre-approval function to one
or more independent members of the audit committee who must report
back to the full committee. In addition, the audit committee may establish specific
policies and procedures for engaging the auditor to perform non-audit services.
An exemption from the pre-approval requirement is permitted where the fees are
de minimis (ie, the aggregate fees will not exceed 5% of the total fees
paid to the auditor) and the services were not recognized as non-audit services
at the time when the auditor was engaged to perform the service. These non-audit
services must be approved before completion of the audit.
Authority of the audit committee
Audit committees must be given the authority to engage independent counsel and other advisers, set the compensation for any advisers retained and communicate directly with the internal and external auditors.
Issuers must include additional disclosure in their AIF and include in their proxy circular a cross-reference to the section of the AIF where the disclosure is made. Venture issuers are subject to less robust disclosure requirements. The new disclosure obligations include the following:
The audit committee rule will apply to an issuer on the earlier of its first annual shareholder meeting after July 1 2004 and July 1 2005. For an issuer with a December 31 year-end, the rule will not apply until the spring of 2005.
The auditor oversight rule requires that financial statements of public issuers be audited by a firm that is in good standing with, and subject to the oversight programme of, the Canadian Public Accountability Board. Auditors that have restrictions placed on them by the board or that are sanctioned by the board must provide notice of these restrictions and/or sanctions to the securities regulators and, in some cases, to the issuers they audit.
In the case of Canadian auditors, the rule is effective for audit reports dated on or after March 30 2004, and in the case of foreign auditors, for audit reports dated on or after July 19 2004.
Issuers in Canada that currently comply with the US corporate governance requirements will be largely unaffected by the new Canadian rules. Other issuers in Canada may have a lot to do. At a minimum, issuers must adopt appropriate disclosure controls and internal controls that enable the CEO and CFO 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 disclosure controls (and eventually internal controls). An appropriate audit committee charter must 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. Finally, the audit committee of non-venture issuers may have to be reconstituted to ensure that the members are independent and financially literate.
The final rules can be obtained on the Ontario Securities Commission website at
For further information on this topic please contact Robert H Karp or Jennifer L Friesen at Torys LLP by telephone (+1 416 865 0040) or by fax (+1 416 865 7380) or by email (email@example.com or firstname.lastname@example.org ). The Torys website can be accessed at www.torys.com.
(2) 'Executive officer' includes the chair, vice-chair, president, vice-presidents in charge of principal business units, divisions or functions, and any other individual (regardless of whether employed by the issuer) who performs a policy-making function in respect of the issuer. However, for the purpose of assessing a director's relationship with the issuer, he or she is not considered to have a material relationship with the issuer solely because the director is a part-time chair or vice-chair of the board or any board committee.
(3) These two complex tests overlap and the securities regulators are expected to clarify the interaction of the two. Although the first test will generally trump the second test, there are situations in which the second test will come into play. For example, if the director's sister receives direct compensation of C$76,000 from the issuer, the director will lack independence due to the application of the second test.
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