Five year review committee final report reviewing the Securities Act (Ontario)

PART 4 REGULATING ISSUERS: DISCLOSURE, THE CLOSED SYSTEM AND CORPORATE GOVERNANCE

Enron collapsed in the fall of 2001. Its demise is being attributed, among other things, to its governance, accounting and disclosure practices. In this Part, we discuss whether the Act imposes disclosure obligations on public companies that are adequate to ensure that investors in the secondary markets can make informed decisions and have confidence in the reliability of corporate disclosure. We also discuss the existing 'closed system' and how the regulation of exempt offerings and hold periods restricts access to secondary market liquidity. We consider how the 'closed system' could be simplified without undermining investor protection and capital markets efficiency. We have made the case earlier in this report for the importance of Canadian capital markets being competitive on a global basis. Because capital formation is not constrained by national borders, it is critical that Canada be perceived, both domestically and abroad, as being a fair and safe place to invest. This in turn depends upon the emphasis we place on the integrity of our continuous disclosure system. When it comes to disclosure standards, we should strive to be 'best in class.'

Chapter 11 Continuous Disclosure

11.1 The Importance of Continuous Disclosure

The Importance of Continuous Disclosure One of the core requirements in the Act is that an issuer must provide a prospectus to prospective purchasers before it may sell securities to them.²³⁸ The prospectus must provide full, true and plain disclosure of all 'material facts²³⁹ relating to the securities to be issued. This is intended to allow the prospective purchaser to make an informed investment decision.

Once securities have been issued under a prospectus, they are 'freely tradeable.' In other words, investors may sell the securities they hold in the 'secondary market' without providing a prospectus or any other information about the securities or the issuer to the purchaser. A secondary market purchaser relies on the 'public record,' which consists of the prospectus and all of the information the issuer has been required to deliver to shareholders or file with the Commission pursuant to the 'continuous disclosure' regime in the Act.

Secondary market trading now accounts for approximately 95 per cent of all capital markets trading in Ontario.²⁴⁰ In order for investors to be prepared to buy securities in the secondary market in Ontario, they must be confident that the public record will provide them with reliable information on a timely basis.²⁴¹ This chapter discusses the current continuous disclosure regime and the Commission's role in monitoring and enforcing disclosure requirements.

11.2 The Current Regime

The Act requires reporting issuers to make certain disclosure on a regular basis throughout the year. This 'periodic disclosure' is described below (in subsection 11.2(a)). Other disclosure must be made upon the occurrence of certain events. This 'event-driven disclosure' is described in subsection 11.2(b) below. The theory is that the 'material facts' disclosed in the prospectus, taken together with all 'material changes' that have been disclosed since the date of the prospectus and all other information that forms a part of the issuer's continuous disclosure record, will keep the investing public current.

1. Periodic Disclosure

   The following is the disclosure that a reporting issuer is required to make each year.

   • A reporting issuer must send quarterly financial statements (accompanied by MD&A) to its shareholders.²⁴²
     
     
   • A reporting issuer must prepare and send to its shareholders, and file with the Commission, annual audited financial statements (accompanied by MD&A) no later than 140 days after year end.
     
     
   • Most issuers are also required to file an AIF with the Commission each year.²⁴³ The AIF provides much of the same information contained in a prospectus and in this way refreshes the narrative description of the issuer and its business on an annual basis.
     
     
   • Management must send a form of proxy and a management information circular to each shareholder in advance of every shareholder meeting (both annual and special). The circular must provide shareholders with information to help them make informed judgements about the matters being voted on at a meeting. The circular also must contain information about:
     
     
     • director and executive compensation;
       
       
     • indebtedness of officers and directors;
       
       
     • interests of insiders in material transactions; and
       
       
     • details relating to management contracts.
   
   
   

2. Event-driven Disclosure

Reporting issuers and their insiders must also make certain disclosure from time to time:

• the Act requires reporting issuers to disclose 'material changes' by issuing a press release describing the change (and filing a material change report with the Commission);
  
  
• and anyone who is an 'insider' (typically directors, senior officers and shareholders with 10 per cent or more of the company's outstanding voting shares) must file a report within 10 days of the day on which they became an insider and after that must file a supplementary report within 10 days after they have traded their shares in the company.

11.3 Alternative Approaches to Regulation Which Emphasize the Secondary Market

We reviewed two alternative proposed models to regulation which emphasize the secondary market.

1. Integrated Disclosure System

   In 2000, the CSA issued a concept proposal for an IDS. Under the IDS, issuers would be required to prepare and file enhanced continuous disclosure documents that would be available to all investors. Once these documents have been filed, issuers would be able to take advantage of a streamlined process for issuing securities that would consist of a 'term sheet' summarizing the terms of the securities being offered and would incorporate the continuous disclosure record of the issuer by reference. This would enhance the quality and timeliness of continuous disclosure information available to investors while providing issuers with a more efficient process for clearing prospectus offerings.²⁴⁴

   The primary aim of the IDS is to de-emphasize the prospectus as the issuer's cornerstone disclosure document and emphasize instead the quality of the issuer's ongoing continuous disclosure base.²⁴⁵ Under the IDS:

   • investors in the secondary and exempt markets would have access to enhanced public disclosure;
     
     
   • issuers could go to market more quickly with new securities issues;
     
     
   • and issuers could raise capital at a reasonable cost without compromising investor protection.
   
   
   

2. The Company Registration Model

   We also considered the company registration model proposed by the Wallman Report in the U.S. in 1996. Under this model, companies would file a generic document similar to an AIF so that information about the issuer and its operations would be on the public record. When the issuer wants to issue additional securities, only information about those securities would be required since information about the issuer itself is already on the public file. Issuers would benefit from the reduced transactional costs and greater flexibility associated with a streamlined registration process.

   The registration model is similar to the IDS discussed above. We note that the SEC has not adopted the approach recommended in the Wallman Report; however, we believe there is merit to this approach and the proposed IDS and the shift in focus they represent.

11.4 How Is Continuous Disclosure Monitored and Enforced?

There had been no regular review of the continuous disclosure practices of reporting issuers until January 1999, when the Commission created a continuous disclosure team (the 'CD Team'). The CD Team reviews continuous disclosure filings made by reporting issuers, issues comment letters similar to those provided in the prospectus review process, and monitors external sources for possible disclosure deficiencies.²⁴⁶ The CD Team performs two functions. First, it monitors compliance with statutory requirements, putting the Commission in a position to take action against reporting issuers who fail to comply. Second, because of the dialogue in which it engages with reporting issuers, the CD Team has begun to play an important role in helping reporting issuers understand their continuous disclosure obligations.

Sanctions under the Act for failure to comply with continuous disclosure requirements are no different from those applicable to any other breach of the Act. If it is determined that an issuer's disclosure is so deficient as to constitute a default, it may be placed on the defaulting issuer's list.²⁴⁷ The CD Team may initiate a hearing before the Commission under section 127 of the Act, and the Commission may require the issuer to amend its disclosure.²⁴⁸

The review of an issuer's continuous disclosure record is not unlike the review that other Commission staff conducts with respect to a prospectus. However, in the prospectus context, the Director has the ability to refuse a receipt for a prospectus under prescribed circumstances. The CD Team has no similar means of encouraging an issuer to respond to the issues it raises. The Act does not specifically contemplate continuous disclosure reviews (as it does prospectus reviews²⁴⁹ and compliance reviews²⁵⁰). We believe that statutory recognition of continuous disclosure reviews is appropriate to emphasize the importance of continuous disclosure obligations in the current environment.²⁵¹ We also note that most commenters support statutory recognition of continuous disclosure reviews.²⁵² In addition, civil liability for continuous disclosure (discussed below) will provide an important additional incentive for issuers, whose disclosure practices are lacking, to respond to issues raised with them by the CD Team.

In our Draft Report we recommended that the concept of continuous disclosure reviews be enshrined in the Act. We are pleased that the Government of Ontario has shown its support for our recommendation in this regard by incorporating this recommendation in legislation passed in December 2002.²⁵³ We also note that the 2002 Amendments will give the Commission the power in the context of a continuous disclosure review to request that issuers provide internal documents for review by the Commission. Information so received by the Commission is exempt from access under the Freedom of Information and Protection of Privacy Act if the Commission determines that the information should be maintained in confidence. We believe that these amendments are helpful in two ways. First, the amendments will permit the Commission to ask issuers for additional information that may assist Staff with its review without the necessity for the Commission to issue a formal investigation order - with the resulting stigma that may be seen to attach to such orders. Also, the amendments will provide assurances to reporting companies that highly confidential information given to the Commission will be kept out of the public domain where such disclosure could reasonably be expected to prejudice a company's competitive position or result in undue loss to a company.

While we endorse the Government of Ontario's decision to give the Commission such additional powers, we nonetheless urge the Commission to exercise restraint and caution when using them. In its recent review of TSX 100 companies that are based in Ontario, we understand that the Commission requested non-public corporate information in advance of reviewing a company's public disclosure record and in the absence of any specific concerns about a company's disclosure. This initiative, while unusual, was undertaken to accelerate the pace and increase the vigilance of reviews of Ontario's largest companies because of their impact on Ontario's capital markets.²⁵⁴ The review was part of the Commission's overall initiative to boost investor confidence in light of recent U.S. corporate failures. While the Committee acknowledges that rebuilding investor confidence is a worthy objective, in general we do not agree with the review process that was undertaken. Our recommendation in the Draft Report was intended to give statutory recognition to a very important Commission function and should not be construed as an invitation for the Commission to engage in a 'fishing expedition.'

11.5 Harmonization Issues

There is no harmonized approach to continuous disclosure across Canada. For example, there are differences among the provinces and territories in the following areas:

• the definition of 'material change';
  
  
• requirements relating to the preparation and filing of material change reports;
  
  
• the definition of 'insider';
  
  
• requirements relating to insider reporting;
  
  
• the deadlines for filing financial statements;
  
  
• requirements relating to the filing of quarterly financial statements;
  
  
• financial statement standards; requirements relating to MD&A; and
  
  
• the requirement to file an AIF.

We have made our case in Part I for the importance of cross-Canada harmonization in securities regulation, including continuous disclosure. To this end, we note that in June 2002, the CSA published for comment proposed National Instrument 51-102 Continuous Disclosure Obligations. The proposed national instrument is intended to:

• harmonize continuous disclosure requirements among Canadian jurisdictions;
  
  
• replace existing local continuous disclosure requirements;
  
  
• enhance the consistency of disclosure in the primary and secondary securities markets; and
  
  
• facilitate capital-raising initiatives such as an integrated disclosure system.

We are strongly supportive of this initiative and encourage the CSA to assign a high priority to this proposal to ensure its timely adoption across Canada. We agree with the approach adopted by the CSA whereby requirements are harmonized according to different tiers of issuers. Some requirements may be too onerous for junior issuers. It might be necessary to impose different disclosure requirements for junior issuers to better match the realities of their business and state of development in order to provide more meaningful disclosure to the marketplace.

Recommendation: We strongly support the CSA's initiative to harmonize Canadian continuous disclosure requirements and encourage the CSA to assign a high priority to this proposal to ensure its timely adoption across Canada.

11.6 Civil Liability for Continuous Disclosure

In our Draft Report, we recommended that the Government of Ontario enact legislation imposing civil liability for continuous disclosure that had been under consideration for some time. In December 2002, the Government of Ontario enacted this legislation as part of its investor confidence legislation. This section describes the background to the enactment of this legislation.

1. Background

   Over the past three decades, there have been a number of proposals to extend statutory civil liability to continuous disclosure. In 1979, the federal Proposals for a Securities Market Law of Canada recommended, among other things, a statutory civil liability regime covering continuous disclosure.²⁵⁵ The 1979 federal proposals were not adopted. In 1984, the Commission recommended legislative amendments that would have extended statutory civil liability to continuous disclosure documents.²⁵⁶

   In December 1994, the Dey Committee recommended that the issue of legislated civil liability with respect to timely and continuous disclosure should be put back on the policy agenda.²⁵⁷ Shortly thereafter, the Allen Committee was appointed. The Allen Committee's mandate was to review continuous disclosure by Canadian public companies and to evaluate the adequacy of such disclosure. It was also asked to consider whether additional remedies should be available, either to regulators or to investors, if issuers breach their continuous disclosure obligations.

   The Allen Committee issued its report in March 1997, concluding that there was evidence of a significant number of incidents of disclosure violations and perceived problems with the adequacy of continuous disclosure in Canada. It expressed concern that these circumstances could tarnish the reputation of our capital markets with resulting loss of investor confidence. This would also have direct cost implications for Canadian companies.

   Finally, in January 1999, the Mining Standards Task Force released its report entitled Setting New Standards: Recommendations for Public Mineral Exploration and Mining Companies.²⁵⁸ It endorsed the recommendations of the Allen Committee relating to statutory civil liability for misleading continuous disclosure as a positive step toward ensuring effective accountability of companies for disclosure relating to mineral exploration, development and production.

2. Statutory Civil Liability - Draft Legislation and the Government of Ontario's Response

   On November 3, 2000, the CSA published draft legislative amendments which would create a statutory civil liability regime for continuous disclosure.²⁵⁹ These Civil Liability Amendments were based largely on the recommendations contained in the Allen Report. In December 2002, the Government of Ontario passed legislation that generally mirrored the Civil Liability Amendments.²⁶⁰ Once these amendments have been proclaimed into force, they will give investors in the secondary market the right to sue any public company and other responsible parties²⁶¹ for making a public material misrepresentation,²⁶² written or oral, about the company or for failing to make required timely disclosure.²⁶³

   There was considerable opposition to the Civil Liability Amendments when they were first released for comment, primarily from public companies.²⁶⁴ The major concern focused on the costs to public companies, their directors and, ultimately, their shareholders, of having to defend against unmeritorious class actions. In response to this concern, the CSA made a number of changes to the Civil Liability Amendments, including the introduction of certain procedural mechanisms designed to screen out unmeritorious actions.²⁶⁵ The CSA believe that these new procedural mechanisms, together with the 'loser pays' cost and proportionate liability provisions, 'should ensure that any exercise of the statutory right of action occurs in a litigation environment ... less conducive to coercive strike suits.²⁶⁶ A relatively recent Ontario decision suggests that the courts will have little patience with American-style strike suits.²⁶⁷

   In our Draft Report, we concluded that the case for statutory liability had been made. The Government of Ontario has indicated their support for the legislation by introducing and passing it in the fall 2002 legislative session. We urge the Government of Ontario to proclaim the legislative amendments in force on a priority basis. In this regard, we note that we received many submissions from commenters who strongly support the passage of the Civil Liability Amendments.²⁶⁸ One commenter noted:

   Issuers should regard the Civil Liability Amendments' procedural mechanisms and limitations on liability as a preferable alternative to the indeterminate outcomes that may arise from class action proceedings brought outside of the Civil Liability Amendments. As well, the competitiveness of the Canadian capital markets depends, in part, on the ability to demonstrate that Canadian securities laws are as protective of investors' rights as those in other major markets. Accordingly, we agree with the Committee that the CSA's proposal to create a statutory civil liability regime for continuous disclosure should move forward.²⁶⁹

   We note that the BCSC recently published a revised civil liability proposal as part of its 'New Proposals for Securities Regulation.²⁷⁰ The BCSC's draft legislation proposes to make several changes to the Civil Liability Amendments. We view the BCSC's revised draft legislation as an unfortunate step backwards from the CSA's efforts to achieve uniformity in a critical area. Now that the CSA's draft legislation has been introduced and passed in Ontario, we encourage other provincial and territorial governments to adopt uniform legislation in their jurisdictions as well.

   Finally, we received two comment letters urging the Committee to recommend certain changes to the primary offering civil liability regime to parallel the Civil Liability Amendments, such as the introduction of a proportionate liability regime.²⁷¹ One commenter noted that:

   The issue is particularly acute as the CSA move towards an integrated disclosure system whereby continuous disclosure documents are referenced in primary documents for securities offerings. A party can be engaged for continuous disclosure purposes, under the understanding that although there is a liability risk, there is a statutory ... apportionment of damages. However, that party can be seriously harmed when the same document may be incorporated into a prospectus at a later date, at risk of ... joint and several liability. Arguably, the party might be able to disassociate himself from the subsequent use of the document. However, if practiced on a broad basis, this could seriously affect the efficient functioning of the capital markets.²⁷²

   We believe that there are fundamental differences between primary and secondary offerings which should be taken into account when fashioning a civil remedy for investors in the primary and secondary markets. For example, in a primary offering, an issuer receives funds from the offering that can be used to compensate investors who have bought securities from the issuer and who have been prejudiced by a misrepresentation in a prospectus. In secondary market trading, an issuer receives no proceeds and it is ultimately the shareholders of the company who will bear the costs of a damages award against the issuer where there has been a misrepresentation in a continuous disclosure document. Despite these differences, however, we also believe that the passage of the Civil Liability Amendments necessitates a re-examination of some of the elements of the existing primary offering civil liability regime. In particular, we recommended that the Commission study the appropriateness of amending the existing primary offering civil liability regime to parallel the Civil Liability Amendments in the following areas:

   • changing the joint and several liability scheme to a proportionate liability scheme whereby each defendant is liable only for such defendant's proportionate share of the total damages awarded to the plaintiff;
     
     
   • extending a due diligence defence to the issuer; and
     
     
   • introducing a safe harbour for forward-looking information.

   While we make no specific recommendations as to whether any changes are appropriate, we believe that study is warranted.

Recommendations: We support the CSA proposal to create a statutory civil liability regime for continuous disclosure and urge the Government of Ontario to move forward as soon as possible to proclaim the legislation in force. We also encourage the governments of the other CSA jurisdictions to adopt the same regime. We recommend that the Commission study the appropriateness of amending the existing primary offering civil liability regime to parallel the Civil Liability Amendments in the following areas: changing the joint and several liability scheme to a proportionate liability scheme; extending a due diligence defence to the issuer; and introducing a safe harbour for forward-looking information.

Chapter 12 The Closed System

The closed system has been a cornerstone of our prospectus exemption system for over 20 years. While the closed system was never easy to grasp, over the years it has become increasingly complicated and difficult to administer and comply with. This is largely due to the fact that previous blanket rulings (now rules) add and remove prospectus exemptions and vary hold periods that would otherwise apply under the Act. In addition, other provinces also have closed systems, but with different exemptions and rules relating to hold periods. Accordingly, we considered whether the closed system should be replaced with an alternative approach, or whether certain aspects of it should be modified or eliminated. As part of this analysis, we considered whether hold period and seasoning period restrictions are necessary. Peripherally, we also considered the existing prospectus exemptions and the need for uniformity in this regard across Canada.

12.1 What Is the Closed System?

The requirement to issue a prospectus serves an important function. It requires the issuer to provide certain information to prospective investors to assist them in making their investment decision. In addition, the prospectus must be filed on SEDAR, which makes it generally available to the marketplace. There are, however, situations in which investors either do not need the information set out in the prospectus or are able to obtain that information themselves through direct discussion with the issuer. In these situations, the Act allows the issuer to avoid the time and expense of preparing a prospectus.

Prior to 1979, a prospectus was required if an issuer made a 'distribution to the public.' There was considerable confusion about the meaning of this phrase and, in particular, who constituted a member of 'the public.' In order to provide greater certainty about when a prospectus is required, the concept of a distribution to the public was eliminated and the 'closed system' was introduced. Under the closed system, a prospectus is required for all distributions of securities unless a specific prospectus exemption is available. Securities issued pursuant to an exemption can be traded using a further exemption, but the system is 'closed,' in that trades of those securities outside the exemption system are prohibited unless a prospectus is filed and receipted or certain resale restrictions are satisfied. In this way, securities issued pursuant to a prospectus exemption become part of the 'closed system' and are restricted from entering the secondary market. Generally, securities issued pursuant to an exemption can only be traded outside of the closed system (or in other words, become 'freely tradeable') if the issuer is or has been a reporting issuer for a specified period of time and in some cases, subject to the further restriction that the securities have been held for a period of time.²⁷³

There are two aspects of the closed system that are critical to understanding how it works: 'hold periods' and 'seasoning periods.' 'Hold periods' apply to securities acquired under certain prospectus exemptions, which prohibited them from being resold until they had been held for the required period of time. The rationale for hold periods is discussed in section 12.3. The hold periods of 6, 12 or 18 months were replaced in 2001 when the CSA introduced uniform hold periods to replace local hold periods in the various provincial statutes. These new hold periods provide that securities acquired under prospectus exemptions cannot be resold until the later of four months (in the case of a qualifying issuer) or 12 months (for a non-qualifying issuer) after the date of the exempt trade or the date upon which the issuer becomes a reporting issuer.²⁷⁴ Distributions of securities from a control block are permitted to be made without a prospectus, subject to compliance with hold periods, provided that the control block party gives the market advance notice by filing a notice of intention to sell and the seller certifies certain facts.

Certain prospectus exempt trades do not attract hold periods but they are subject instead to 'seasoning periods.' Under the Act, securities acquired pursuant to prospectus exemptions which are subject to seasoning periods only become freely tradeable if the issuer has been a reporting issuer for at least 12 months and is not in default of any requirement under the Act. The rationale for seasoning periods is that, since the issuer has been a reporting issuer for at least one year, it has established a sufficient disclosure record so that purchasers do not require prospectus-level disclosure. Multilateral Instrument 45-102 Resale of Securities harmonizes seasoning periods across the country, replacing the 12-month seasoning period under the Act with either a four-month (for qualifying issuers) or 12-month seasoning period (for non-qualifying issuers).

12.2 Problems with the Closed System

Under the closed system, every distribution of a security either requires a prospectus or falls within a specific exemption. The certainty that this approach provides has come at a high cost in terms of complexity and inefficiency. The legislation cannot capture all of the conceivable transactions that fit within the policy objectives of the exemptions. Accordingly, issuers must apply for discretionary exemptive relief for specific transactions which may be similar to, but do not fit within the four corners of, available statutory exemptions. This adds time and expense to issuers' transactions. Commissions across the country must, in turn, spend considerable time and effort dealing with these applications for discretionary relief. When a specific type of transaction becomes commonplace, this gives rise to the need for recurring relief, because the Commission no longer has the ability to issue blanket rulings. It is difficult to see how the Act's twin goals of investor protection and enhancing capital markets efficiency are supported through this process. In Chapter 7 of this Report, we recommend that the Commission be vested with the power to issue blanket orders.

Hold periods and seasoning periods make the resale of securities issued under prospectus exemptions a very complex matter requiring expert legal advice. While the implementation of MI 45-102 has helped to force greater convergence of hold period and seasoning period requirements in closed system jurisdictions, prospectus exemptions and resale restrictions continue to differ from province to province.

Prospectus exemptions have always varied across Canada. Recent reforms in Ontario, British Columbia and Alberta illustrate how regulators are continuing to move in different directions.²⁷⁵ Instead of harmonizing and simplifying the regime for raising capital in Canada, these divergent local initiatives have exacerbated the differences between the exemptions available across the country, in turn increasing the cost and complexity of exempt offerings across Canada. Local considerations and differences in regional markets are often cited as the reason for differences in the nature of the prospectus exemptions provided for under local legislation. We believe that local considerations can be reflected in a single, harmonized set of exemptions that are available across the country. We note that many commenters shared our concerns regarding the state of the closed system and the problems caused by unique local rules governing prospectus exemptions.²⁷⁶

Recommendation: We encourage the CSA to proceed with further reforms to the prospectus exemptions and the closed system with the goal of harmonizing and simplifying the requirements relating to private placements.

12.3 Recent Reforms to the Exempt Market Regime and the Resale Rules: Do They Go Far Enough?

1. Exempt Market Reform

   The closed system is based on specific exemptions from the prospectus requirement. The Act and subordinate legislation currently contain over 40 such exemptions. Some of these exemptions have been consolidated in OSC Rule 45-501 Exempt Distributions, which has effectively replaced various exemptions in the Act. OSC Rule 45-501 introduced two new exemptions - the 'closely held issuer exemption' and the 'accredited investor exemption.' The private company exemption,²⁷⁷ private issuer exemption,²⁷⁸ $150,000 exemption,²⁷⁹ and seed capital exemption²⁸⁰ are no longer available in Ontario.

   The recent exempt market reform in Ontario was largely based on the recommendations of The Report of the OSC Task Force on Small and Medium Sized Businesses.²⁸¹ British Columbia and Alberta have also recently undertaken exempt market reform (see footnote 275). In June 2002, the BCSC released a paper entitled 'New Proposals for Securities Regulation - A New Way to Regulate' for comment. The paper builds on the CSA's IDS proposals discussed in Chapter 11 by proposing a continuous market access system (CMA). Under the CMA, prospectuses would be replaced by an 'evergreen' continuous disclosure system, eliminating the need for prospectus exemptions or resale restrictions for CMA issuers.

   We believe that simplifying the exempt market regime and achieving harmonization across Canada is an important first step, even if it is only an interim step, toward a more radical, eventual overhaul of the regime. We do not propose eliminating the closed system in its entirety, but we do wonder whether certain aspects of the closed system (in particular, hold periods and seasoning periods) could be significantly streamlined and, in certain cases, eliminated.

2. Continued Need for Hold Periods

   In the previous section, we described recent reforms aimed at harmonizing and reducing the length of the hold periods that apply to prospectus exempt trades. In this section, we ask whether reform should go further: do hold periods continue to be necessary at all? In addressing this question, the Committee considered the various rationales underlying hold periods.

   We identified three rationales for hold periods:

   1. Hold periods prevent what are referred to as 'back-door underwritings' - the use of a private placement exemption to effect a public distribution without preparing a prospectus.²⁸² Hold periods prevent an issuer from privately placing securities for immediate resale to the public without the benefits of a prospectus standard of disclosure and the rights and obligations that flow from the prospectus.
      
      
   2. Hold periods protect investors by ensuring that information about the issuer is available and disseminated in the marketplace through the issuer's continuous disclosure filings prior to permitting resale of the restricted securities.
      
      
   3. Hold periods create an incentive for issuers to complete a public offering by reducing the price the private placee will pay for the securities given that they are not freely tradeable. In theory, public financings also afford the investing public the greatest protection since a prospectus, with the liability and resultant due diligence it attracts, is filed.

   With respect to the back-door underwriting issue, this concern could be addressed in a more targeted fashion. If private placees acquire securities with a view to distribution, this may bring them within the definition of 'underwriter' under the Act and subject to the associated requirements. The definition of distribution could be tightened up to capture only those exempt trades which are 'back-door underwritings' and make them subject to an appropriate hold period.

   The second rationale for hold periods described above is not particularly compelling today. The gap in the quality of disclosure as between the prospectus and continuous disclosure that existed when the closed system was introduced has narrowed considerably through regulatory reforms over the intervening period. In addition, while this suggested rationale for hold periods may support the need for seasoning periods, it does little to explain why hold periods apply even where an issuer has been a reporting issuer for a long period of time.

   Lastly, there does not appear to be a compelling reason to retain hold periods in order to discourage issuers from doing exempt offerings in favour of prospectus offerings. In our view, the key is to implement other reforms such as civil liability for continuous disclosure, upgrading of continuous disclosure standards and moving toward a more integrated disclosure system so that opportunities for regulatory arbitrage between private and public means of financings are reduced, if not eliminated.

   The CSA recently made great strides in reducing and simplifying hold periods to four months for qualifying issuers and 12 months for non-qualifying issuers. As illustrated above, however, the rationale for hold periods is not as compelling as it once was. Once the other reforms we contemplate are in place, it may be time to take the next logical step and eliminate hold periods for reporting issuers except in instances where 'back-door underwriting' continues to be a concern.²⁸³

   Recommendation: Once other reforms are implemented, such as civil liability for continuous disclosure, enhanced continuous disclosure standards for all reporting issuers, and a more integrated disclosure system overall, we believe hold periods for securities of reporting issuers could be eliminated without sacrificing investor protection while contributing significantly to more efficient capital markets.

   
   
   

3. Continued Need for Seasoning Periods

   Seasoning periods ensure that prospectus-level disclosure has been publicly available for a minimum period before securities of a reporting issuer acquired under a prospectus exemption may be traded outside of the closed system.

   There are two elements of the seasoning period: the issuer must be a reporting issuer; and it must have been a reporting issuer for some minimum period of time before its securities can be traded outside of the closed system.

   One commenter on our Issues List made the following comment about seasoning periods:

   The requirement that an issuer be a reporting issuer ensures that the issuer is subject to continuous disclosure requirements so that a purchaser in the secondary market will have the benefit of the continuous disclosure record. The need for a [12] month 'seasoning period' is less obvious.²⁸⁴

   We agree with this commenter. The usual justification for the reporting issuer 'seasoning period' is that this allows time for information about the newly minted reporting issuer to be disseminated and absorbed by the marketplace. It also allows time for the quality of the issuer's disclosure to improve before trading of exempt securities in the secondary market is allowed. With respect to the former, we note that SEDAR and other technological advances permit greater and faster access to information than ever before. Improvements in dissemination and accessibility of corporate disclosure have been dramatic since seasoning periods were first introduced. To the extent that quality of disclosure is the issue, it is unclear whether disclosure necessarily improves with the passage of time. Also, seasoning is not generally required to protect secondary market investors. For example, securities acquired under an initial public offering by prospectus can be immediately traded. We believe that if quality of disclosure is the real concern, it should be addressed directly.

   Recommendation: We believe the need for seasoning periods in the case of reporting issuers should also be revisited with a view to their elimination if the reforms we contemplate in this Report are implemented.

   
   
   

4. Non-Reporting Issuers

   As will be evident from the above discussion, the considerations which support re-examining the need for hold periods and seasoning periods in the case of reporting issuers do not apply to non-reporting issuers. Companies that are not obliged, and have not committed, to provide the marketplace with a steady flow of continuous disclosure have not satisfied the condition prerequisite for their securities to be freely tradeable in the secondary market.

   Recommendation: Hold periods and seasoning periods should continue to apply to non-reporting issuers.

   
   
   

5. Structuring Transactions to Avoid Control Block Hold Periods

   Some commenters on the Issues List questioned the practice whereby control block holders or other insiders appear to hold large positions in companies they founded or manage, and yet have disposed of their economic interests through the use of lending or derivative arrangements ('monetization structures') that do not trigger the insider reporting requirement.²⁸⁵ Some of these transactions may be subject to insider trading requirements of the Act, but not all are subject to the insider reporting requirements of every province, depending upon their structure.²⁸⁶ We think they should be, and address the need for insider reporting of these arrangements in Chapter 24.

   It was also noted that these monetization structures permit control block holders to cash out at significant premiums over the price paid for privately placed securities²⁸⁷ while circumventing applicable hold periods in the process. Control block holders should be prevented from structuring transactions to avoid applicable resale restrictions. To the extent that hold periods apply to securities held by control block parties, the Commission should address the conduct of those who, directly or indirectly, contravene these requirements.

   Recommendation: We recommend that the Commission examine the practice whereby control block holders reduce applicable hold periods through the use of derivatives and other monetization structures.

12.4 Where Do We Go from Here?

While we believe that there is a continued need for 'exempt financings,' the restrictions imposed on these financings must be re-examined in the context of the evolution of the broader regulatory regime including:

1. enhanced continuous disclosure standards across Canada;
   
   
2. active continuous disclosure review programs by the Commission and other securities regulators across Canada;
   
   
3. statutory civil liability for continuous disclosure;
   
   
4. rigorous enforcement of continuous disclosure standards across Canada;
   
   
5. appropriate escrow requirements applicable to securities held by management and insiders of companies that go public; and
   
   
6. the move toward a more integrated disclosure system in Canada.

Exemptions for specific financings should continue to exist and should be harmonized across Canada. Securities acquired in reliance upon these exemptions should not be freely tradeable until the issuer becomes a reporting issuer. We question whether there is a continued need or justification for hold periods and seasoning periods for reporting issuers. In view of the complexity of the current system, the level of compliance with the maze of rules relating to resales of securities that are subject to hold periods and seasoning periods is suspect. We do not believe the inefficiencies and cost of compliance associated with the existing regime are justified when weighed against the benefits and we urge the Commission to undertake a focused review of this issue with a view to implementing meaningful reform.

Chapter 13 Disclosure Standards

13.1 Material Fact, Material Change and Material Information

1. Material Fact vs. Material Change in the Context of Continuous Disclosure

   There is considerable confusion about the difference between a 'material fact' and a 'material change' and the purpose for which each of these terms is used in the Act. The distinction is perhaps best understood from the perspective of the evolution of an issuer's disclosure record.

   As discussed previously, the prospectus is the base document for an issuer's disclosure. Both the preliminary and the final prospectus must contain full, true and plain disclosure of all material facts relating to the securities issued or proposed to be distributed. A 'material fact' is defined as follows:

   'material fact', where used in relation to securities issued or proposed to be issued, means a fact that significantly affects, or would reasonably be expected to have a significant effect on, the market price or value of such securities.²⁸⁸

   Any 'fact' (specifically related to the issuer or not) will be a 'material fact' if it significantly affects (or would reasonably be expected to have a significant effect on) the market price or value of the securities being issued.

   After a preliminary prospectus has been filed, an issuer's disclosure record must be updated whenever there is a material change. A 'material change' is defined as follows:

   'material change', where used in relation to the affairs of an issuer, means a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer and includes a decision to implement such a change made by the board of directors of the issuer or by senior management of the issuer who believe that confirmation of the decision by the board of directors is probable.²⁸⁹

   The concept of 'material change' drives the issuer's disclosure in three ways. First, if a material adverse change occurs after a preliminary prospectus has been filed, an amended preliminary prospectus must be filed. Other material changes would presumably be 'good news' material changes and prospective purchasers would not be prejudiced by waiting for 'full, true and plain disclosure of all material facts' in the final prospectus, which would include all material changes since the preliminary prospectus. Second, after the final prospectus has been filed, until the time that the offering is 'out of distribution,' the issuer must file an amended prospectus if any material change occurs. Finally, the continuous disclosure requirements in the Act require the issuer to issue a press release and file a material change report when any material change occurs.

   How does a material change differ from a material fact? First there must be a 'change' (as opposed to the existence of a 'fact'). Second, the 'change' must be in the business, operations or capital of the issuer (a material 'fact' can be unrelated to an issuer's business, operations or capital as long as it has a significant effect on the market price or value of the securities being issued).²⁹⁰ Issuers are not expected to continually interpret external political, economic, and social developments as they affect the affairs of the issuer, unless the external development will result in a change in the business, operations or capital of the issuer, in which case, timely disclosure of the change must be made.²⁹¹ However, reporting issuers would discuss external developments and the effect of such events on their companies in their interim and annual MD&A. Finally, the threshold for a 'material change' is forward looking - the change in the business, operations or capital of the issuer must be one that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer.²⁹²

2. Material Information - Additional Disclosure Requirements

   Although the Act requires public disclosure only of material changes, the TSX and the Commission began to move issuers to an enhanced disclosure standard in the mid-1980s. At that time, the TSX adopted a requirement that listed companies disclose all 'material information' (a concept that incorporates material changes, material facts and certain other information). In 1987, the CSA supported this enhanced disclosure standard by adopting National Policy Statement 40 Timely Disclosure (NP 40), recommending that issuers disclose all 'material information.' Material information is 'information relating to the business and affairs of an issuer that results in or would reasonably be expected to result in a significant change in the market price or value of any of the issuer's securities.'

   The CSA rescinded NP 40 in connection with the adoption of National Policy 51-201 (NP 51-201) Disclosure Standards because much of the guidance in NP 40 was incorporated into NP 51-201. The CSA also determined that it could not, through a policy statement, change the test for triggering continuous disclosure obligations prescribed by statute. The Committee therefore considered whether the policy thrust of the TSX's timely disclosure policy and former NP 40 should form the basis of a legislative amendment requiring disclosure of all material information on a continuous disclosure basis.²⁹³

3. Disclosure Standards in the U.S.

   We note that U.S. issuers do not have a specific statutory duty to make timely public disclosure of material changes or material information.²⁹⁴ Periodic reporting requirements, such as Form 8-K, have instead been used to complement, rather than duplicate, the various U.S. stock exchange rules, which generally require disclosure of all material information.²⁹⁵ In this regard, Ontario securities legislation already imposes a higher disclosure obligation than that of the U.S. by virtue of the requirement to make prompt disclosure of 'material changes.²⁹⁶

4. Should the Disclosure Standard in Ontario Be Changed?

   We received a number of submissions on whether reporting issuers should be required to disclose 'material information' rather than 'material changes' on an ongoing basis. Most were opposed to moving to this change.²⁹⁷ Some noted that the current regulatory framework implicitly recognizes that it may be necessary for the proper functioning of the markets to require something less than full disclosure (such as in the context of incomplete negotiations). The commenters cautioned against a change that would disrupt this important policy consideration. For example, the IDA noted:

   The appropriate legal standard of materiality for the purposes of triggering a continuous disclosure obligation must strike a reasonable balance between the market's need to be informed on a timely basis of material developments concerning an issuer and the issuer's need for clarity as to the circumstances in which such disclosure must be legally made, particularly in light of the immediacy of the obligation. It is also essential to recognize that there are circumstances where an issuer (and its existing shareholders) legitimately has a need to keep material developments confidential. For these reasons, the IDA believes timely disclosure is best premised on 'material changes' rather than 'material facts' since in the latter case the issuer will typically require more time for thoughtful reflection as to the potential impact on share price or value of the development which has not yet progressed to the status of a change in the issuer's affairs. Premature disclosure of an intended financing or acquisition that may be considered a 'material fact' is not beneficial for the secondary markets and can cause significant price interference for such transactions. For this reason, the IDA prefers the existing 'material change' standard to a broader standard of 'material developments.'

   The proposal to change the current trigger for making timely disclosure from a 'material change' to 'material information' has some appeal. First, by requiring prompt disclosure of 'material information,' more information would be available to the marketplace, which in turn would enable investors to make more informed investment decisions. Second, removing the distinction between a 'fact,' 'change' and 'information' would also help to bring more clarity to this difficult disclosure area. And third, mandating disclosure of material information under the Act would reduce reliance on exchange requirements that, in practice, have been difficult to enforce.²⁹⁸ More specifically, if a violation occurs, an exchange can suspend trading in, or permanently delist, a company. Short of these relatively drastic sanctions, however, the exchanges have little ability to penalize violators for a failure to disclose 'material information.' Moreover, delisting is often viewed as an inappropriate remedy because it penalizes an issuer's securityholders by denying them the liquidity of an organized market rather than penalizing those directly responsible for the inadequate disclosure. We have tried to address this last concern in our recommendations dealing with enforcement. Our recommendation to expand the Act's enforcement mechanisms by giving the Commission the power to order compliance with exchange rules (rather than legislating a new disclosure requirement) will enhance the Commission's ability to deal with companies that breach exchange rules. At the same time, however, we strongly urge the exchanges to be more vigilant in policing and enforcing compliance by their listed companies with exchange timely disclosure requirements.

   There are four reasons why we do not recommend that the disclosure requirement be moved to 'material information.' First, we believe that when the Civil Liability Amendments are proclaimed in force, issuers will have a strong incentive to take a more principled and less technical view of developments or matters that ought to be disclosed as 'material changes,' which should contribute to a more robust timely disclosure regime.

   Second, as one commenter to the Committee noted, the 'issue of when to disclose becomes much more problematic and difficult for issuers when material information or facts must be disclosed, such as merger negotiations and financial difficulty, etc., especially when such disclosure can and will be reviewed in hindsight particularly should statutory civil liability be instituted.²⁹⁹ Phil Anisman's dissenting statement in the Allen Report also notes:

   Canadian securities legislation thus accommodates the fact that the materiality of corporate intentions and business plans develops with their progress and implementation. The legislation requires timely disclosure only after such plans have matured to the point where they are sufficiently firm that they may be characterized as a change in the issuer's business, operations or affairs, while recognizing that they may, if generally known, significantly affect share prices at an earlier stage and precluding those who are aware of them from using their knowledge to trade in the issuer's share before the change, and public disclosure, occurs.

   Third, disclosure of all material information would impose a significant burden on issuers to continually monitor matters external to them for the purpose of informing investors.

   Finally, if there are perceived gaps in information that is being disclosed by reporting companies on a continuous disclosure basis, the Commission has the necessary rulemaking authority to promulgate specific disclosure requirements similar to the SEC's Form 8-K approach noted above, and should be encouraged to do so where appropriate. Periodic reports, like the SEC's Form 8-K, should in our view be used to augment the existing framework of timely disclosure. In this regard, we note that one commenter was also strongly in favour of the Commission adopting an enhanced timely disclosure obligation for reporting issuers similar to the SEC's Form 8-K.³⁰⁰ The commenter urged the Commission to study the SEC's Form 8-K requirements and in particular, the requirement that agreements relating to the reported disclosure be filed as a schedule to the public report. While not advocating a change to a 'material information' timely disclosure standard, the commenter also suggested that the current definition of 'material change' and the requirements relating to material change reports be re-examined. In particular, the commenter noted:

   Issuers generally provide little or no additional information in the material change report than was disclosed in the corresponding press release. The material change report should be revised to provide clearer instructions for the level of detail of disclosure requirement and contain specific requirements to annex as exhibits written agreements entered into in connection with the reported event.
   
   The definition of 'material change' was introduced in the Act in 1978 as part of the integrated disclosure system reforms initiated in Ontario by the 1970 Merger Report. The standard for timely disclosure in Ontario has not changed since that time and it is submitted that it is now outdated and ineffective to serve investor interest in the current environment. ... [When] a 'change' has been accepted to have occurred, the type of 'change' requiring timely disclosure is limited and only applies with respect to a few narrow categories, namely a change 'in the business, operations or capital' of the reporting issuer. There are other significant categories of matters or factors concerning a reporting issuer that are equally or more material to investors.
   
   It may be noted that the decision in Pezim v. British Columbia (Superintendent of Brokers) might well have been different, on the same facts, if decided under the definition of 'material change' in the Act as opposed to the definition of 'material change' in the British Columbia Securities Act. In the latter statute, 'material change' is defined as a 'change in the business, operations, assets or ownership of the issuer'. As stated by Mr. Justice Iacobuccsi in Pezim for the Supreme Court of Canada ... :
   
   

   Consequently, I am of the view ... that the assay results constituted a change with respect to or in the companies' assets and is 'material' for the purposes of the Act.

   It is open to reasonable debate whether the information resulting from the drilling program constituted a 'change' in the 'business' or 'operations' of the company under the Act. Such a question of whether or not that information required public disclosure under the Act should never even be open to debate, however, because as a matter of public policy and principle, such discovery is clearly accepted, virtually unanimously, as a material piece of information for investors requiring timely public disclosure as soon as practicable after confirmation of the event.

   We believe that the SEC's Form 8-K approach and the concerns raised by the commenter merit further study and urge the Commission to consider these issues.

Recommendation: We recommend that the Act's timely disclosure provisions not be amended to require disclosure of 'material information.' We recommend that the Commission study whether the current definition of 'material change' and timely disclosure reporting obligations should be amended to encompass: a broader scope of discloseable events; itemized particular company-specific events requiring timely disclosure similar to the SEC' s 8-K approach; and a requirement that agreements relating to the reported disclosure be filed as a schedule to the public report.

13.2 What Is the Appropriate Standard for Materiality?

1. Market Impact vs. Reasonable Investor Test

   Under the Act, both 'material change' and 'material fact' are defined with reference to whether the change or fact 'would reasonably be expected to have a significant effect on the market price or value of a security.³⁰¹ This 'market impact' standard of materiality is common to all CSA jurisdictions other than Quebec.³⁰² In contrast, in the U.S. information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. To satisfy the U.S. materiality standard, there must be a substantial likelihood that a fact 'would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.³⁰³ This 'reasonable investor' test is not a statutory test, but has developed through case law.

   In 1997, the CSA considered amending the definitions of 'material fact' and 'material change' by replacing the Canadian 'market impact' test with the U.S. 'reasonable investor' test.³⁰⁴ The CSA received a number of comment letters, some of which were supportive. Some commenters raised a number of concerns, including that the proposed definitions raised too many issues of interpretation, that a single materiality standard was not viable and that such a change would introduce an unacceptable level of subjectivity and uncertainty.³⁰⁵ The CSA ultimately decided not to pursue the proposed changes.

   The comments we received on this issue reflect the continuing range of views. There are good arguments both to support preserving the status quo and to support a change in the materiality standard. Some proponents of the status quo argue that the current 'market impact' test works reasonably well and is a more objective test than the reasonable investor test. Others note that, since U.S. courts tend to consider market impact when applying the reasonable investor test, a change in the definition for Canadian law purposes would not produce a significant difference in result. Still others argue that this would require market participants to adopt a different disclosure standard, while contemporaneously becoming subject, for the first time, to a regime that imposes civil liability for non-compliance with such a standard. Accordingly, they argue that the implementation of any proposed change to the materiality standard should be delayed for some period until Canadian capital markets have adjusted to the implementation of the new liability regime.

   Advocates of changing the materiality trigger to conform to the U.S. reasonable investor test argue that the standard of 'full, true and plain' disclosure applicable to prospectuses is effectively the reasonable investor standard, and 'if we aim to promote credible capital markets, the same standard should be applied to trigger continuous disclosure and to its contents.³⁰⁶ We note also that this standard has already been imported into Ontario securities law in the context of specific regulatory instruments.³⁰⁷ Others argue that harmonizing Ontario (and ultimately Canadian) securities law with U.S. securities law will eliminate some of the complexity issuers currently face in fulfilling their disclosure obligations, particularly issuers whose securities are traded in both Canada and the U.S..³⁰⁸ Also, some observers have noted that the market impact test may allow issuers to take too formulaic an approach in determining what is material.³⁰⁹ As a result, in practice, the reasonable investor standard is often relied upon when advising issuers as to whether they have an obligation to disclose a particular change as a material change.³¹⁰

   Finally, some make the argument that there is really no difference between the Canadian 'market impact' test and the U.S. 'reasonable investor' test since a 'reasonable investor' will only be concerned with whether a fact or change would affect the price or value of the security. This argument can be used to support a change to the Canadian test because it will in fact result in no practical change at all; it can also be used to support the status quo, since change in this case will not result in any meaningful difference in the disclosure standard.

   The Committee deliberated extensively on this matter. We acknowledge that compelling arguments have been made to support keeping the market impact test and to support replacing it with the reasonable investor test. Throughout this Report, we have emphasized the need for increased regulatory harmonization, except where specific policy objectives preclude it. We believe that requiring issuers to contemplate what would be important to an investor is the appropriate standard and therefore recommend that the definition be changed to be consistent with the U.S. 'reasonable investor' test.

Recommendation: We recommend that the existing materiality standard should be changed for all purposes under securities legislation to a reasonable investor standard which is consistent with the materiality standard in the U.S.

Chapter 14

14.1 Selective Disclosure

Selective disclosure has received considerable attention in the last several years. The concern is with material non-public information that is disclosed to one or more individuals or companies and not broadly to the investing public. Much of the discussion has focused on the SEC's Regulation FD, which became effective on October 23, 2000.³¹¹ Regulation FD requires reporting companies to disclose material information through broad non-exclusionary public means rather than selectively to securities analysts and other market professionals.

Selective disclosure raises a number of issues. Most obvious is the unfairness resulting from some investors having material information before others and the opportunities that this creates for illegal insider trading. In adopting Regulation FD, the SEC also expressed the following concern:

If [corporate managers] are permitted to treat material information as a commodity that can be parceled out selectively, they may delay general public disclosure so that they can selectively disclose the information to curry favor or bolster credibility with particular analysts or institutional investors. Moreover, if selective disclosure were to go unchecked, opportunities for analyst conflicts of interest would flourish. We are greatly concerned by reports indicating a trend toward less independent research and analysis as a basis for analysts' advice, and a correspondingly greater dependence by analysts on access to corporate insiders to provide guidance and 'comfort' for their earnings forecasts. In this environment, analysts are likely to feel pressured to report favorably about particular issuers to avoid being 'cut off' from access to the flow of non-public information through future analyst conference calls or other means of selective disclosure. This in turn raises concerns about the degree to which analysts may be pressured to shade their analysis in order to maintain their access to corporate management.

Prior to the adoption of Regulation FD, there was no express statutory prohibition against selective disclosure under U.S. securities laws. U.S. courts instead implied such a prohibition under the general anti-fraud provision, Rule 10b-5, in the 1934 Act. This approach led to uncertain results in establishing which type of selective disclosure was prohibited in the U.S.³¹² Given the SEC's recognition that issuers retain control over the precise timing, audience and means for important corporate disclosure, it adopted Regulation FD as an issuer disclosure rule.

Canadian securities law, on the other hand, has a specific and comprehensive insider trading and tipping regime which prohibits, among other things, all selective disclosures except in the 'necessary course of business.³¹³ However, notwithstanding the clear statutory prohibition on selective disclosure in Canada, Canadian issuers have not always complied with this prohibition. In 1995, the Allen Committee raised concerns about the practice of selective disclosure in private meetings between issuers, analysts and professional investors.

In 1999, the Commission conducted a random survey of the corporate disclosure practices of 400 public companies. The survey indicated that the extent and nature of corporate disclosure policies and practices of reporting issuers in Ontario was not at that time sufficient to reduce the potential for selective disclosure.³¹⁴

In November 2001, the Analysts Standards Committee issued its final report, Setting Analyst Standards: Recommendations for the Supervision and Practice of Canadian Securities Industry Analysts. The Analysts Standards Committee was formed in late 1999 by the IDA, the TSX and TSX Venture Exchange 'in response to concerns about the supervision of research analysts, the standards of practice and how analysts deal with potential conflict of interest situations.³¹⁵ The final report contains a number of recommendations aimed at improving the independence of research and ensuring the professional practice of securities industry analysts, including recommendations for dealing with the practice of selective disclosure. In particular, the Analysts Standards Committee recommended that:

• the Saucier Committee should consider, as part of the corporate governance responsibility of a company's board of directors, the need for the development and review of a communications policy that addresses how a company's management interacts with analysts and the public, and how the company avoids selective disclosure; and
  
  
• public companies include the media and investors in analyst meetings and conference calls, thereby avoiding the risk of selective disclosure.³¹⁶

In July 2002, the CSA adopted a policy statement that discusses the Canadian legislative prohibitions against selective disclosure and sets out the CSA's views concerning the interpretation of these provisions.³¹⁷ The policy statement also highlights some 'best disclosure' practices that companies can adopt to ensure that they comply with securities legislation.

We share the concerns expressed by the above-noted committees and securities regulators. While issuer selective disclosure may not be a new phenomenon, the effect of such selective disclosure is greater in today's more volatile, earnings-sensitive markets. This is particularly disturbing when one considers that advances in communications and information technologies have made it easier for companies to disseminate important information more broadly and quickly. We endorse the CSA approach. As previously indicated in our Draft Report, we continue to believe that guidance from the CSA in the form of a policy statement coupled with increased emphasis on enforcement in this area³¹⁸ should be adequate to change market behaviour.

All commenters on this issue agreed that there are sufficient rules in Canada prohibiting selective disclosure.³¹⁹ Several commenters encouraged the Committee, however, to give further consideration to recommending the creation of a 24-hour safe harbour for non-intentional selective disclosures like the safe harbour available under the SEC's Regulation FD.³²⁰ In particular, one commenter stated:

There is no safe harbour in provincial securities legislation for an unintentional selective disclosure. The absence of a safe harbour could weigh against the prompt dissemination of an unintentional selective disclosure, notwithstanding the CSA policy suggesting that this would be a mitigating factor in an enforcement proceeding. There is no justification for the different treatment of unintentional selective disclosures in Canada and the U.S.³²¹

The proposing release for Regulation FD suggests that the SEC promulgated the 24-hour safe harbour in recognition that corporate officers may sometimes make mistakes without the intent to selectively disclose material non-public information.³²² When mistakes are made, absent intent or recklessness, the SEC did not believe that an issuer should be held responsible under Regulation FD for not having made simultaneous public disclosure. For example, a communication would not be 'intentional' under Regulation FD if it was disclosed inadvertently or because the individual mistakenly (but not in reckless disregard of the truth) believed that the information had already been made public or was not material.

We believe that the SEC's 24-hour safe harbour helps to ensure fair treatment of companies and their spokespersons in attempting to comply with the spirit of the regulation. In particular, the 24-hour safe harbour provides companies with specific comfort that good-faith attempts to comply with the selective disclosure provisions, including difficult judgements about 'materiality' that prove to be wrong in hindsight, will not subject a company or its officials to a violation of Regulation FD. We recognize that the CSA has in its policy statement attempted to provide companies with some degree of comfort in this area. We believe, however, that a policy statement approach on this issue does not go far enough as it does not have the force of law. We therefore believe that the CSA should introduce a safe harbour for 'unintentional' selective disclosures along the lines of the safe harbour that exists in the U.S. under Regulation FD. In this regard, we recognize that it may be necessary for the CSA to modify the U.S. safe harbour so that it works within the framework of the existing Canadian prohibitions against selective disclosure.

Recommendation: Except as noted below, we do not believe that legislative change is required in Ontario to address the issue of selective disclosure and we support the CSA's policy statement and an increased emphasis on enforcement in this area. We recommend that the CSA introduce a 24-hour safe harbour for 'unintentional' selective disclosures along the lines of the safe harbour that exists in the U.S. under Regulation FD.

Chapter 15 Finacial Statement Disclosure

15.1 Financial Statement Disclosure

We believe that a number of improvements need to be made in the financial reporting requirements set out in the Act. These improvements are described below.

1. Timing of Release of Financial Statements

   Reporting issuers must deliver quarterly financial statements to their shareholders (and file those statements with the Commission through SEDAR) no later than 60 days after the end of the quarter. They must deliver annual audited financial statements to their shareholders (and file those statements with the Commission through SEDAR) no later than 140 days after the end of the fiscal year.

   In our view, the 60- and 140-day filing deadlines are out of date. The fact that issuers routinely release quarterly and year end financial information well in advance of the date on which their financial statements are filed and sent to shareholders supports this contention. Information technology advances have increased the speed at which financial information can be collected and analyzed.

   In our Draft Report we recommended that the periods for filing annual financial statements be reduced to 90 days after the fiscal year end and that the time periods for filing interim financial statements be reduced to 45 days after the end of each quarter. Most commenters were supportive of this recommendation.³²³ After the release of our Draft Report, the CSA released for comment National Instrument 51-102 Continuous Disclosure Obligations. The National Instrument proposes to reduce the deadline for filing annual financial statements from 140 days to 90 days after the year end for senior issuers and 120 days for all other issuers. It is also proposed that the deadline for filing interim financial statements will be reduced from 60 days to 45 days after the quarter end for senior issuers, and remain at 60 days for all other issuers. The National Instrument uses TSX non-exempt company criteria as the benchmark measure for a senior issuer.³²⁴ We note that the time periods being proposed by the CSA for senior issuers are the time periods that have been existence in the U.S. for nearly 30 years. The SEC recently adopted rule amendments to further shorten these time periods for senior issuers to 60 and 35 days respectively.³²⁵

   We endorse the CSA's proposal to reduce the deadlines for filing annual and interim financial statements, including the different filing periods being proposed for junior issuers. We recognize that not all companies, particularly small and unseasoned companies, may have the infrastructure and resources necessary to prepare their reports on a shorter time frame without undue burden or expense. As noted in the Introduction, we believe that securities regulation in Canada must be sensitive to the nature of our capital markets and the participants that inhabit it, such as the large proportion of small-cap issuers that characterize our markets. This may require developing and applying different standards to different tiers of issuers. We do have concerns, however, about the TSX non-exempt company criteria chosen by the CSA to separate senior issuers from junior issuers. In our view, this benchmark is too complicated and difficult to use. We strongly encourage the CSA to consider a simpler formula that both market participants and investors can more easily understand. In this regard, we recommend that the CSA consider classifying senior issuers as those issuers whose securities are listed on the TSX and junior issuers as those issuers whose securities are listed on the TSX Venture Exchange.

   We also recommend that in due course the CSA consider shortening even further the filing deadlines for annual and interim financial statements to 60 and 35 days respectively to parallel recent rule changes made by the SEC.

   Finally, we note that we did receive one comment letter on our Draft Report that suggested that it would be difficult for large companies with international operations to comply with the reduced filing deadlines for annual and interim financial statements.³²⁶ While we have some sympathy for the concerns raised by the commenter, we believe that such situations could be better addressed by the Commission on a case-by-case basis by granting, where appropriate, exemptive relief.

   Recommendation: We support the CSA's proposal to reduce the filing period for filing annual financial statements to 90 days after the fiscal year end for senior issuers, and 120 days for junior issuers. We also support the CSA's proposal to reduce the filing period for filing interim financial statements to 45 days after the quarter end for senior issuers, and to maintain the current 60-day deadline for junior issuers. We recommend, however, that the CSA reconsider whether to use the TSX non-exempt company criteria to separate senior issuers from junior issuers. Instead, we recommend that the CSA consider classifying senior issuers as those issuers whose securities are listed on the TSX and junior issuers as those issuers whose securities are listed on the TSX Venture Exchange. We recommend that in due course the CSA consider shortening even further the filing deadlines for annual and interim financial statements to 60 and 35 days respectively to parallel recent rule changes made by the SEC.

   
   
   

2. Auditor Review of Quarterly Financial Statements

   In Ontario, quarterly financial statements must be reviewed by the board of directors or audit committee.³²⁷ This requirement was introduced in 2001 as a means of promoting the integrity of the financial statements and the role of the audit committee. If the board or audit committee does not play a role in the review of quarterly financial statements, then management is in control of the issuer's financial disclosure until year end, when the audit committee is required to review the annual financial statements before they are approved by the board of directors. At that point, if the audit committee has any issue with the accounting policies or judgements applied by management in preparing the financial statements, fourth-quarter adjustments can become an issue. Requiring the involvement of the audit committee at the end of each quarter reduces the potential for problems at the end of the year.

   The Act does not require external auditor review of the quarterly financial statements, although the Commission recommends it.³²⁸ The approach in the U.S. is the opposite. The 1934 Act requires auditor review of interim financial statements before they are filed with the SEC, but leaves it up to the issuer whether the board or audit committee should review the statements before they are filed. In our view it should be apparent to every board and audit committee that the auditors should review the quarterly financial statements. There is otherwise the potential for management and the audit committee (who approved the first three quarters) to be pitted against the auditors in the course of the audit and review of the annual statements. We recognize that additional costs will be associated with an auditor's review of the interim statements.

   However, in light of the importance of the integrity of financial statements, we believe that this additional cost should be accepted as a cost of being a public company.

   We received a number of comment letters that were supportive of mandating external auditor review of reporting issuers' quarterly financial statements.³²⁹ Some commenters suggested, however, that it might be appropriate to give junior issuers an exemption from this requirement as the costs associated with having external auditor review of interim financial statements would be disproportionately higher for smaller issuers.³³⁰ We are sensitive to this concern and endorse in principle providing junior issuers with an exemption from this requirement. The nature and scope of the exemption should be determined by the regulators, taking into account the costs and benefits associated with the requirement, with particular attention being paid to the type of issuer and the stage of development of the issuer. We would also recommend, however, that any issuer subject to an exemption from the requirement should be required to disclose that its quarterly statements have not been reviewed by an external auditor.

   Recommendation: We recommend that Ontario securities legislation be amended to require that quarterly financial statements must be reviewed by the issuer's external auditor. We endorse in principle providing junior issuers with an exemption from this requirement. The nature and scope of the exemption should be determined by the Commission, taking into account the costs and benefits associated with the requirement with particular attention being paid to the type of issuer and the stage of development of the issuer. We would also recommend, however, that any issuer subject to an exemption from the requirement should be required to disclose that its quarterly statements have not been reviewed by an external auditor.

   
   
   

3. Release of Financial Information Prior to Board Approval

   The release of financial information before interim and annual financial statements are approved by the board of directors or audit committee is also an issue of concern. Many issuers announce their earnings or other financial information soon after the end of a reporting period, but well before the financial statements themselves have been approved. We think that this is inconsistent with the requirement under Ontario securities law that such statements receive board (or audit committee) approval, and creates further potential for the audit committee to be backed into a corner by management when it comes to approving the statements.³³¹

4. Earnings Guidance

   Quarterly earnings guidance from companies has become a common component of quarterly earnings announcements. Initially, earnings guidance was a tool used to improve transparency and reduce stock price volatility.³³² But with time, stocks have begun to move in response to earnings guidance. As a general matter, we have concerns about the practice of companies providing 'earnings guidance' to the marketplace. We believe that the practice encourages short-term focus on the part of management and may also create incentives to manage earnings. In this regard we view the recent announcement by some companies, like Coca-Cola Co., that they will no longer be providing earnings guidance as a positive development and hope that the trend will continue.³³³

5. Non-GAAP Financial Information

   Many issuers use non-GAAP numbers in communicating the results of operations to the public. The danger in non-GAAP numbers is that there is no common understanding of what they mean. There is therefore little basis for comparison of these numbers from one issuer to another. Moreover, they offer too much of an opportunity for an issuer to create a number that casts the financial results in a more positive light than would be the case if the numbers were derived from the financial statements. This practice was the subject of a CSA staff accounting notice early in 2002.³³⁴ We suggest that the CSA monitor the use of non-GAAP or pro forma numbers in corporate disclosures to determine whether the CSA staff notice is causing companies to be more balanced in their financial disclosure. If not, the CSA should consider whether more aggressive regulatory intervention is warranted.³³⁵

6. Filing News Releases

   Reporting issuers issue news releases for a variety of reasons. As discussed above, they may be required by the Act to disclose a 'material change' by way of a news release. The news release announcing the material change is appended to the material change report and filed on SEDAR. It is therefore readily accessible to anyone looking for the issuer's current disclosure record.

   There are obviously a number of other reasons why issuers issue news releases. They may have 'good news announcements' they wish to share with their investors or other stakeholders. They may simply wish to increase their profile or attract media attention. If the information does not constitute a 'material change,' an issuer may not file a copy of the news release on SEDAR.³³⁶

   In our Draft Report we considered the issue of whether any other type of news releases should be required to be filed on SEDAR. The issue that concerned us particularly was the release of earnings information in advance of the release of the financial statements. We expressed the view that news releases of this type form an integral part of an issuer's continuous disclosure record and such releases should be filed on SEDAR. Once the issuer's financial statements have been approved, as discussed above, then their release or the release of earnings information derived from them which has also been approved should be filed on SEDAR. This will ensure that this important disclosure is readily accessible to investors, to Commission staff conducting continuous disclosure reviews or investigating possible disclosure breaches, and to the marketplace generally. The majority of commenters were supportive of our recommendation in this regard.

   In our Draft Report we also invited specific comment on whether there are any other definable categories of news releases that reporting issuers should be required to file on SEDAR. Our preliminary view was that it is likely unnecessary to require issuers to file all their news releases on SEDAR. We acknowledged that a requirement to file every news release on SEDAR could result in important information being buried. It could also lend legitimacy to promotional news releases. In response to our question, two commenters suggested that SEDAR should function as a central repository for all publicly available 'material information' concerning each reporting issuer.³³⁷ The commenters noted that companies often issue news releases that contain non-financial information that may be just as important to a reasonable investor in making an investment decision.

   In response to the comments we received, we reconsidered our original concerns relating to the filing of all news releases on SEDAR. To the extent that issuers communicate with investors through news releases, we believe it is important that investors have a central location to access such information. We recommend that Ontario securities law should be amended to require issuers to file all their news releases on SEDAR. In implementing this recommendation, we would ask the CSA to consider, if possible, changes to SEDAR which will permit a filer to identify the type of news release filed. In particular, we would suggest that news releases be organized on SEDAR according to the following categories:

   • news releases filed in connection with a material change report;
     
     
   • news releases containing financial information; and
     
     
   • other.

   We believe that such categorizations will make it easier for investors to search for news releases of interest to them on SEDAR. In implementing this recommendation we also recommend that the CSA build enough flexibility in SEDAR to permit a reporting issuer to recategorize a news release after it has been posted on SEDAR.³³⁸

   Recommendation: We recommend that Ontario securities law be amended to require that all news releases of reporting issuers must be filed on SEDAR.

   
   
   

7. The GAAP Exemption for Banks and Insurance Companies

   Although reporting issuers are required to prepare their financial statements in accordance with GAAP, the Regulation under the Act provides an exemption³³⁹ from this requirement for banks listed in Schedule I or II to the Bank Act and life insurance companies licensed under the Insurance Act if their financial statements are 'prepared in accordance with a statute incorporating, continuing or governing the bank or insurance company and any applicable GAAP.³⁴⁰ Under federal legislation, OSFI has the authority to mandate accounting practices by regulated financial institutions. The effect of these sections is to allow OSFI to prescribe how Canadian GAAP should be applied and even to override GAAP.³⁴¹

   The GAAP exemption for banks and life insurance companies reflects the tension that sometimes exists between the objectives of securities regulation and prudential regulation. The focus of securities regulation is to ensure that capital markets and market participants operate in a transparent environment and that individuals have full information upon which to base their investment decisions. Prudential regulation, on the other hand, focuses on preserving the safety and soundness of financial institutions. This difference in focus has the potential to create conflicts. For example, in some cases prudential regulation may favour delayed disclosure or non-disclosure of certain events, whereas securities regulation would require full and prompt disclosure.

   Amendments to the Bank Act, contained in the FCAC Act, give OSFI the same power to override GAAP for bank holding companies.³⁴² This power appears to go beyond the existing override provision in securities legislation and raises additional implications as a result. Whereas existing regulations to the Act only contain special provisions for issuers incorporated under the Bank Act and the Insurance Act, under the amendments to the Bank Act it appears that alternative financial statements may be prepared by holding companies that are reporting issuers but are not incorporated under the Bank Act.

   While we appreciate the different focus of securities and financial institution regulation, we nonetheless have concerns about the current GAAP exemption available to banks and insurance companies under the Act and any potential extension of the GAAP override in the Act by virtue of the FCAC Act. We believe that disclosure is an important part of any regulatory regime. Disclosure requirements provide information on which investors can base their choices. We further believe that good accounting standards are a necessary precondition for sound market regulation and can help to stabilize market expectations. We note that the current GAAP exemption makes it difficult for Commission staff to undertake disclosure reviews of such institutions. Moreover, we note that the circumstances in which OSFI has exercised an override of GAAP are company specific, which can create arbitrary differences that distort comparability of reported results both among financial institutions and with other entities. For example, we understand that this statutory power has resulted in some banks, acting under a directive from OSFI, applying accounting treatments that are contrary to Canadian GAAP with respect to increases made to their loan loss provisions. In each case, OSFI permitted the bank in question to depart from GAAP by taking a charge for an increase in loan loss provisions through retained earnings rather than through the income statement. In at least one of these cases, the absolute amount of the loan loss provision after the increase was in excess of the amount permitted under GAAP. Given the choice between non-GAAP and GAAP reporting, the Committee ultimately favours transparency and the use of GAAP.

   There is no GAAP exemption available to banks and insurance companies in the U.S.. The SEC requires GAAP financial statements from all of its reporting issuers. U.S. banking and insurance regulators can prescribe accounting methods to be applied in special purpose filings with them, but to the extent those methods depart from GAAP, they would be unacceptable for purposes of filings with the SEC.

   We prefer the approach adopted in the U.S., for the reasons set out above. In our Draft Report we did, however, set out an alternative approach. The alternative approach would permit the GAAP override for prudential purposes, where the solvency of the institution or the financial services system would otherwise be placed at risk. This alternative was based on OSFI's role as a prudential regulator and the belief that if it is to have any override powers with respect to securities legislation, they should only be exercisable in circumstances where there is demonstrable prudential concern. In this regard we invited comment on whether the GAAP override should be eliminated, as we preferred, or modified so as to be exercisable only where there is demonstrable prudential concern. The vast majority of commenters supported the elimination of the GAAP override.³⁴³ In this regard, two commenters also noted that it is not necessary to override GAAP, because financial institution regulators can obtain the additional or adjusted financial information they need to make decisions on capital adequacy by requiring separate reports, if necessary.³⁴⁴

   In June 2002, the CSA released proposed National Instrument 51-102 Continuous Disclosure Obligations. NI 51-102 proposes to, among other things, remove the GAAP exemption for banks and insurance companies in Ontario and all other CSA jurisdictions that currently have a similar exemption. We believe for the reasons noted above that the current GAAP override is far too broad and we therefore endorse the proposal under proposed NI 51-102 to eliminate the override.

Recommendation: We recommend that the GAAP exemption available to banks and insurance companies in subsection 2(3) of the Regulation to the Act be removed.

15.2 Auditor Independence

In November 2000, the SEC adopted extensive amendments to its rules regarding auditor independence and new disclosure requirements aimed at:

• fostering high quality audits by minimizing the external factors that will influence an auditor's judgement; and
  
  
• promoting investor confidence in the financial statements of public companies.³⁴⁵

The new rules essentially provide that an accountant is not independent if he or she cannot exercise 'objective and impartial judgement' or if a reasonable investor would conclude that an accountant cannot exercise objective and impartial judgement. This determination is based on the circumstances of the particular case, but the SEC also provided specific rules on some common situations that raise independence issues. In particular, the rules identified particular services, relationships or interests that the SEC regards as incompatible with independence.³⁴⁶ The SEC rules further require companies to make certain disclosures in their proxy statements regarding relationships between a company and its auditors, including the fees paid to the independent auditor for audit and non-audit services.³⁴⁷ More recently, the SEC adopted further amendments to its auditor independence rules in response to the Sarbanes-Oxley Act of 2002.³⁴⁸

The November 2000 SEC rules on auditor independence generated significant debate, particularly with respect to the issue of whether auditors should be permitted to provide non-audit services to their audit clients. Proponents of the rules argued that accounting firms that provide non-audit services to their audit clients aren't truly 'independent' because non-audit work creates an incentive for auditors 'to go easy on their clients,' either to win more contracts or to prove that the advice of their colleagues was appropriate. Detractors, on the other hand, expressed concern that the rulemaking initiative would hurt businesses and that audits actually improve when firms perform auditing and non-auditing functions because it gives them a more comprehensive picture of a company's financial health. They also argue that the professional integrity of auditors creates an effective barrier to conflicts of interest.

On September 5, 2002, the Public Interest and Integrity Committee of the CICA (PIIC) released a new draft independence standard to apply to Canadian auditors and other assurance providers.³⁴⁹ The exposure draft is based on the principles-based framework for independence adopted by IFAC, the accounting profession's international body, in January 2002³⁵⁰ and incorporates the rigour of pre-Sarbanes-Oxley SEC requirements for auditors of listed entities.³⁵¹ The public comment period closed October 31, 2002. The PIIC has also undertaken to consider changing the proposed Canadian independence standards to reflect the more recent SEC rules in response to Sarbanes-Oxley.³⁵² Prior to the PIIC's proposed independence standard initiative, Canadian standards did not contain specific prohibitions on the scope of services that auditors could perform for their audit clients.

We have been following with interest the various auditor independence rulemaking initiatives and the new spotlight that has emerged on auditor independence in the wake of recent corporate failures in the U.S. (such as Enron and WorldCom). The last year has seen Canada make great strides in developing substantive auditor independence standards. We believe that auditors play a critical role in promoting investor confidence in the integrity and reliability of financial disclosure. In an era when companies face extreme pressure to report ever-increasing profits, and the markets severely punish those who don't meet expectations, auditor independence is vital. We therefore strongly encourage the PIIC to attach a high priority to completing its auditor independence initiative. We also encourage the Commission to continue to proactively monitor ongoing developments in this area so that Canada does not fall behind international standards. The external auditing function is the critical foundation upon which our financial disclosure system rests.

In our Draft Report we had recommended that the Commission adopt amendments to its proxy disclosure rules similar to those already adopted in the U.S., requiring companies to disclose the amounts they pay to their auditors, both for auditing services and non-auditing services. We noted that the SEC believed that such disclosure rules would ultimately allow investors to evaluate for themselves whether the proportion of fees for audit and non-audit services raise concerns about the auditor's independence. We expressed support for the SEC's position on the basis that sunlight is the best disinfectant. At the time, Canada was lagging U.S. initiatives in the area of auditor independence such that disclosure, at a minimum, would have plugged at least part of the emerging gap and focused some attention on the area. In light of the considerable progress that has recently been made in Canada to develop substantive independence standards, however, we believe that the urgency behind implementing changes to proxy disclosure has lessened. While we continue to believe that disclosure rules in this area are important and should be adopted, we would recommend that the Commission consider implementing any disclosure rules in conjunction with, and in the context of, the PIIC's proposed independence standards and the recent SEC proxy disclosure rule changes. In this regard, we note that most commenters were supportive of implementing disclosure rules in Canada.³⁵³ One commenter was of the view, however, that the U.S. proxy rules are flawed in how they categorize audit and non-audit services.³⁵⁴ We would encourage the Commission to consider such concerns in promulgating any rule proposals in this area.

Recommendation: We urge the Commission and the PIIC to adopt auditor independence standards on a priority basis, to proactively monitor ongoing U.S. developments relating to auditor independence and to consider what further reforms are necessary to ensure that Canada does not fall behind international standards. We recommend that the Commission adopt amendments to proxy disclosure rules to require public companies to disclose in their proxy statements their expenditures for both audit and non-audit services. Amendments to proxy disclosure rules should be undertaken once the PIIC has finalized its proposed independence standards and should take into account those standards as well as recent proposed SEC rule changes for auditor independence.

15.3 Investor Reliance on Audited Financial Statements

Securities law requires all reporting companies to have their financial statements audited on an annual basis. In this regard, auditors are entrusted with an important public interest mandate: to examine objectively and comment on the fairness of the financial statements of reporting companies.³⁵⁵ The integrity of our capital markets rests, in part, on a belief that this external audit function is objective and credible.

The courts have called into question the extent to which the public is entitled to rely on audited financial statements. In Hercules Management Ltd. v. Ernst & Young ³⁵⁶ the Supreme Court of Canada held that auditors owed no duty of care to shareholders with respect to their personal investment decisions.³⁵⁷ We believe that the Hercules decision underscores the importance of the CSA's Civil Liability Amendments discussed previously in Chapter 11. Notwithstanding the Hercules decision, the Civil Liability Amendments will help to enshrine that auditors are held accountable to investors who place reliance on audit reports in making their investment decisions.

Chapter 16 Corporate Governance and Accountabililty of Public Companies

16.1 Certification

In August 2002, under the direction of the Sarbanes-Oxley Act, the SEC adopted final rules imposing obligations relating to certification of SEC filings on both CEOs and CFOs.³⁵⁸ The new rules require CEOs and CFOs to certify the financial and other information contained in the company's quarterly and annual reports. The rules also require issuers to establish, maintain and regularly evaluate the effectiveness of disclosure controls and procedures designed to ensure that information required in reports under the 1934 Act is recorded, processed, summarized and reported on a timely basis. Specific disclosure regarding the evaluation of a company's disclosure controls and procedures, as well as its internal controls, is also required in a company's annual and quarterly reports.³⁵⁹

These rules effectively require CEO and CFO involvement with, and accountability for, their company's public disclosure. Following recent corporate failures in which senior officers testified that they delegated all responsibility for financial and other disclosure to management, U.S. Congress and the SEC have made it clear that they view such abdication to be inappropriate. In particular, the SEC noted:

We believe that all members of a company's senior management, including members of the company's board of directors, should accept and acknowledge an active role in the disclosure that their company makes in its quarterly and annual reports and reinforce their accountability for the accuracy and completeness of this disclosure. We believe that any senior corporate official who considers his or her personal involvement in determining the disclosure to be presented in quarterly or annual reports to be an 'administrative burden', rather than an important and paramount duty, seriously misapprehends his or her responsibility to security holders. ...

We believe that expressly requiring a company's principal executive officer and principal financial officer to certify that they have conducted this kind of review of the company's periodic reports would cause these officials to review more carefully the disclosure in their companies' quarterly and annual reports and to participate more extensively in the preparation of these reports. We expect that the quality and transparency of this disclosure would improve as a result of this type of mandated review.³⁶⁰

In response to our Draft Report, one commenter urged the Committee to recommend that the Commission pursue similar certification requirements. The commenter said:

We strongly urge the Committee and the Commission to review SEC Release No. 34-46300 and section 302 of Sarbanes-Oxley Act of 2002 and to recommend that an analogous filing certification procedure be adopted by the Commission and other Canadian securities regulatory authorities for the benefit of investors in Canada. Notwithstanding that an appropriate civil liability scheme may ultimately be introduced across the country that assures adequate private civil law remedies to investors in the secondary markets who rely, or are deemed to rely, on misrepresentations contained in documents filed by reporting issuers, we believe that securities regulators should be directly responsible for enforcement of the accuracy and completeness of filed documents of reporting issuers through an analogous certification requirement to be adopted in Canada. It would be incongruous that a Canadian reporting issuer should certify its periodic disclosure reports to the SEC but not to the Commission.

We recommend that the certification requirement for filed periodic reports under the Act be pursued by the Commission on its own in the event that the members of the CSA are not able to reach agreement.³⁶¹

In connection with the ongoing debate relating to what corporate governance reforms Canada should adopt in response to recent U.S. initiatives, several observers, including the TSX and the Canadian Council of Chief Executives, have also indicated their support for the adoption of similar certification requirements in Canada.362 The Canadian Council of Chief Executives states:

In the past, we always have signed off on the accuracy of our companies' financial statements. We acknowledge, however, that the U.S. Sarbanes-Oxley Act has raised the bar in this respect. Even though this legislation may not apply to all Canadian companies, we believe that as Canadian chief executives, we should be prepared to offer a comparable certification of our annual and quarterly reports.³⁶³

After the release of our Draft Report, the Government of Ontario passed the 2002 Amendments that give the Commission rulemaking authority to address all aspects of the certification regime adopted by the SEC. We agree with the policy rationale underlying the SEC's certification initiative and share the views expressed above by the numerous commenters who support certification in Canada. In this regard, we endorse the legislative amendments made by the Government of Ontario and urge it to proclaim the rulemaking amendments in force on a timely basis to permit the Commission to embark on rulemaking in this area.

Recommendation: We endorse the 2002 Amendments that, when proclaimed in force, will give the Commission rulemaking authority to address all aspects of the certification regime recently adopted by the SEC. In this regard, we urge the Government of Ontario to proclaim the rulemaking amendments in force on a timely basis to permit the Commission to embark on rulemaking in this area.

16.2 Audit Committees

Most (although not all) Canadian corporate statutes require public companies to have an audit committee composed of at least three directors (at least two of whom must be outside directors).³⁶⁴ The audit committee's statutory mandate is to review the issuer's annual audited financial statements before they are approved by the issuer's board of directors.

Although the statutory provisions relating to audit committees have changed very little since they were first introduced, best practices have established higher standards in terms of audit committee composition as well as broader mandates for audit committees. The CSA released a Notice on Audit Committees in 1990, responding to questions raised by issuers about the roles and responsibilities of audit committees.³⁶⁵ Building on some of the recommendations in the CSA Notice, the TSX issued the TSX Guidelines for Effective Corporate Governance in 1995.³⁶⁶ The TSX Guidelines recommend that an audit committee be composed only of outside directors and that the audit committee have a written mandate, direct communication channels with inside and outside auditors, and oversight responsibility with respect to management reporting on internal controls.

Recent developments in the U.S. have refocused attention in Canada on the importance of effective audit committees for the integrity of the financial reporting system. In September 1998, in response to growing concerns about reporting issuers misapplying U.S. GAAP in order to manage earnings expectations, former SEC Chairman Arthur Levitt launched an initiative aimed at improving the credibility and transparency of financial disclosure.³⁶⁷ At the request of the SEC, the NYSE and NASD sponsored the Blue Ribbon Committee. In February 1999, the Blue Ribbon Committee released its report containing 10 recommendations aimed at strengthening the role of corporate audit committees in overseeing the financial reporting process. The specifics of the Blue Ribbon Committee's recommendations on audit committees dealt with the composition and mandate of the audit committee, particularly the processes by which the audit committee could enhance the independence of outside auditors. The Blue Ribbon Committee's recommendations were adopted, with some modification, by the SEC, the NYSE, the NASDAQ, the American Stock Exchange and the accounting profession.

In July 2000, the TSX, TSX Venture Exchange and the CICA sponsored the Saucier Committee. The terms of reference of the Saucier Committee asked it to respond to the new U.S. requirements adopted as a result of the Blue Ribbon Committee Report. The Saucier Report was released in November 2001 and recommended that the TSX Guidelines be amended in a number of ways to bring them into line with then-current U.S. requirements. With respect to audit committees, the Saucier Committee recommended that:

• audit committees should be composed exclusively of outside, 'unrelated' directors (with some flexibility for TSX Venture Exchange Tier 2 companies that have small boards);
  
  
• all members of the audit committee should be financially literate, as determined by the board, with at least one member having accounting or related financial expertise; and
  
  
• the audit committee should: (i) adopt a written mandate, approved by the board, setting out its responsibilities, specifically with respect to its relationship with external and internal auditors, its oversight of internal controls and disclosure of financial and related information; (ii) disclose the mandate to the shareholders; and (iii) conduct a regular assessment of the committee's effectiveness.³⁶⁸

On April 26, 2002, the TSX proposed changes to its guidelines for effective corporate governance in response to the Saucier Committee's recommendations.

Since the release of the proposed changes to the TSX Guidelines, a number of significant developments have affected the role of the audit committee in the post-Enron environment:

• The U.S. Sarbanes-Oxley Act of 2002 was passed and in effect vests audit committees of listed U.S. companies with sole responsibility for the appointment, compensation and oversight of any registered public accounting firm employed to perform audit services. Also, the Sarbanes-Oxley Act requires audit committees to be composed of solely independent, outside directors.³⁶⁹
  
  
• On July 24 and August 16, 2002, NASDAQ and the NYSE respectively submitted to the SEC new rules which, if approved by the SEC, would impose heightened corporate governance standards for listed companies, including
  
  
  • requiring audit committees to be composed of solely independent directors;
    
    
  • granting audit committees sole authority to hire and fire independent auditors;
    
    
  • requiring at least one member of the audit committee to be a 'financial expert'; and
    
    
  • requiring audit committees to have a formal charter.

On August 15, 2002, the Commission wrote to the TSX asking that it re-examine its corporate governance guidelines and consider new measures to take into account recent U.S. developments. On September 18, 2002, the TSX responded to the Commission's letter by outlining proposed changes to its guidelines. While recommending that TSX-listed companies have fully independent audit committees, the TSX was not prepared to enshrine this as a mandatory rule. Instead, the rules will require that all issuers listed on the TSX have an audit committee with at least two independent committee members. Audit committees will also be required to have a charter setting out their roles and responsibilities. Beyond these two requirements, however, the TSX was opposed to implementing rules that would harmonize further with recent U.S. corporate governance reforms.

The TSX's response to the Commission has sparked a public debate in Canada about the appropriateness of instituting rules governing corporate governance versus maintaining a system based on voluntary guidelines and disclosure. Historically, there has been a strong preference in Canada not to legislate corporate governance practices beyond what is currently provided in the corporate statutes. The prevailing view has been that best practice guidelines, coupled with disclosure requirements, would drive most issuers toward best practices that were most appropriate for them. Some market participants and regulators have also raised concerns about the impact of corporate governance rules on small-cap issuers, which have smaller boards and fewer resources. Others have suggested that the number of Canadian public companies with a controlling shareholder calls out for a more flexible approach in Canada than in the U.S.

In light of the importance of the financial reporting process to the integrity of an issuer's financial statements and the regulatory force of audit committee standards in the U.S., we believe that it is appropriate today to seek to establish common standards and enforce compliance with these standards. As we mentioned at the outset, the requirement for audit committees had its genesis in corporate law statutes. However, we believe that reporting issuers should have audit committees that operate to common standards. Accordingly, in our Draft Report we recommended legislative amendments that would provide the Commission with rulemaking authority relating to the functioning and responsibilities of audit committees. In December 2002, the Government of Ontario passed legislation that gave effect to our recommendation.³⁷⁰ We strongly endorse this amendment and note that many of our commenters were also supportive of our recommendation.³⁷¹ Moreover, we think it is important that reporting issuers in all Canadian jurisdictions hold their audit committees to consistent standards. Accordingly, we encourage the other CSA jurisdictions to provide their Commissions with similar powers and for the CSA to work together on an expedited basis to establish standards for audit committees that will place Canadian audit committee standards in the 'best of class' internationally. In this regard, we also encourage the CSA to be sensitive to the needs and resources of small-cap issuers in crafting any rule proposals. In particular, we believe that it might be necessary to institute a two-tier system of regulation in this area.

Recommendation: We endorse the recent amendment to the Act that, when proclaimed in force, will give the Commission rulemaking authority to prescribe requirements relating to the functioning and responsibilities of audit committees of reporting issuers. We encourage other CSA jurisdictions to give their commissions similar powers, and we urge the CSA to work together on an expedited basis to establish standards for audit committees that will make Canadian audit committees 'best in class' internationally. We also encourage the CSA to be sensitive to the needs and resources of small-cap issuers in crafting any rule proposals.

16.3 Other Corporate Governance Requirements

In August 2002, both the NYSE and NASDAQ proposed a series of sweeping changes to their listing standards relating to the composition and functioning of boards of directors and compensation and nominating committees. In light of the increased public and regulatory attention that has been focused on corporate governance, we also considered whether the Commission should have rulemaking authority over corporate governance matters more generally.

Historically, securities legislation has focused attention on disclosure of information to investors and not on corporate management.³⁷² As one observer noted, however, 'corporate governance issues and the integrity of securities markets are inextricably intertwined.³⁷³ The structure and functioning of public companies, while clearly a 'corporate' matter, affects not only company shareholders as 'shareholders' but also as 'investors.'

We also believe that there are practical considerations which support giving the Commission rulemaking authority over corporate governance matters more generally. First, the Commission can adopt reforms in a more flexible and timely manner through a process that permits all interested parties to participate, versus adopting reforms through corporate legislation. Second, the CSA, through national instruments, can more effectively develop harmonized national corporate governance standards than is possible at the corporate law level. Finally, this approach would also offer benefits from an enforcement and compliance perspective because corporate statutes, unlike securities laws, are largely self-enforcing.

We would therefore support giving the Commission rulemaking authority over corporate governance matters more generally. For example, we would support giving the Commission rulemaking authority to make rules relating to the composition, functioning and responsibility of boards of directors and nominating and compensation committees. We would also urge the Commission, however, to exercise caution and restraint in imposing new regulations in these areas. In particular, the Commission should ensure that any of its rule proposals take into account existing corporate requirements and are not overly burdensome to both large- and small-cap companies. Also, the Commission should continue to work with the exchanges on corporate governance matters where relevant to listings standards.

Recommendation: We recommend that the Act be amended to give the Commission rulemaking authority over corporate governance matters more generally. For example, we would support giving the Commission rulemaking authority to make rules relating to the composition, functioning and responsibility of boards of directors and nominating and compensation committees.

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238. The Act, subsection 53(1). More specifically, a prospectus is required if a trade is a "distribution." A "distribution" is defined in subsection 1(1) of the Act and includes "a trade in securities of an issuer that have not been previously issued." The Act provides certain exemptions to this prospectus requirement, discussed in Chapter 12 of this Report.
239. The meaning of "material fact" is defined in subsection 1(1) of the Act.
240. CSA Notice 53-302 Proposals for a Statutory Civil Remedy for Investors in the Secondary Market and Response to the Proposed Change to the Definitions of "Material Fact" and "Material Change" (2000), 23 OSCB 7383 at Section II, "Background."
241. Under the existing regime, primary market investors have a statutory right to seek damages from issuers and others for losses attributable to a misrepresentation in a prospectus without having to prove reliance, which is required under existing common law rights of action. Secondary market purchasers do not have any statutory rights of actions for misrepresentations.
242. OSC Rule 52-501 Financial Statements (2000), 23 OSCB 8372 requires reporting issuers to include an income statement, statement of retained earnings and cash flow statement in interim financial statements for the current quarter, as well as an interim balance sheet and explanatory notes to the interim financial statements. A company's board of directors (or its audit committee) is required to review the interim financial statements before they are filed with the Commission. Companies are encouraged to consider retaining external auditors to review such statements. OSC Rule 51-501 AIF and MD&A (2000), 23 OSCB 8365 as amended (2001), 24 OSCB 7417 requires management to provide a narrative discussion and analysis (MD&A) of interim financial results together with interim financial statements.
243. Under OSC Rule 51-501 AIF and MD&A, each reporting issuer, other than a mutual fund, is required to file an AIF if either its shareholders' equity or revenues exceeded $10,000,000 in each of the three immediately preceding financial years, or if the aggregate market value of its outstanding equity securities for which there was a published market was more than $75,000,000 on the last day of each of the three immediately preceding financial years.
244. See CSA Notice and Request for Comment, 44-401, 51-401 Concept Proposal for an Integrated Disclosure System (2000), 23 OSCB 633.
245. Historically, the focus of securities legislation has been on the prospectus rather than continuous disclosure. IDS proposes to change this by decoupling the prospectus from relatively constant information describing the issuer. This information, known as the disclosure base, would be incorporated by reference into an abbreviated offering document whenever an issuer wanted to raise additional capital. A shortened prospectus would allow an issuer to quickly take advantage of market conditions to raise capital.
246. See OSC Staff Notice 51-703 Implementation of Reporting Issuer Continuous Disclosure Review Program (2000), 23 OSCB 4123. In March 2003 the Commission's Investment Funds Branch will introduce a continuous disclosure review program for all investment funds. OSC Staff Notice 81-705 Implementation of a Continuous Disclosure Review Program for Investment Funds (2003), 26 OSCB 1757.
247. OSC Policy 51-601 Reporting Issuer Defaults (2001), 24 OSCB 6587, paragraph 3.3(2)4.
248. The Act, paragraph 127(1)5.
249. The Act, section 61.
250. The Act, section 20.
251. We note that the Sarbanes-Oxley Act of 2002 requires the SEC to conduct 'regular and systematic' reviews of every public company, at least every three years.
252. See comment letters of Certified General Accountants of Ontario, Ontario Teachers' Pension Plan, Fasken Martineau DuMoulin LLP, and the Securities Subcommittee of the Ontario Bar Association.
253. See section 179 of the 2002 Amendments. '
254. OSC Increases Continuous Disclosure Reviews - More Staff, Higher Targets, Deficient Companies to be Named', (2002), 25 OSCB 5700.
255. P. Anisman, J. Howard, W. Grover & J.P. Williamson, Proposals for a Securities Market Law for Canada, (Ottawa: Minister of Supply and Services, Canada, 1979).
256. 'Civil Liability for Continuous Disclosure Documents Filed under the Securities Act - Request for Comments,' (1984), 7 OSCB 4910.
     Similarly, in 1994 the B.C. government developed a proposal to introduce a limited scheme of civil liability for certain disclosure in response to the Matkin Inquiry and recommendations reflected in the Matkin Report (J.G. Matkin & G.G. Cowper, Restructuring for the Future; Towards a Fairer Venture Capital Market, Report of the Vancouver Stock Exchange & Securities Regulation Commission (1994)). However, by this time, the Allen Committee had been established and the B.C. government agreed to await the release of that committee's report with the hope that any eventual recommendations could be adopted nationally.
257. 'Where Were The Directors? Guidelines for Improved Corporate Governance in Canada,' Report of The Toronto Stock Exchange Committee on Corporate Governance in Canada (December, 1994).
258. Published January 1999 by the TSX and the Commission. The Task Force was a joint task force between the Commission and the TSX.
259. The Civil Liability Amendments were 'primarily directed to providing a deterrent to misrepresentations and failures to make timely disclosure.' In this regard, the Civil Liability Amendments contained liability caps which varied between different categories of defendants. For an issuer, the liability cap was set at the greater of $1,000,000 or five per cent of the company's market capitalization. See CSA Notice 53-302 - Proposal for a Statutory Civil Remedy for Investors in the Secondary Market and Response to the Proposed Change to the Definitions of 'Material Fact' and 'Material Change' (2000), 23 OSCB 7383.
260. See section 198 of the 2002 Amendments.
261. Other potential defendants include director, officers, 'influential persons' (including control persons, promoters, insiders, and investment fund managers), and experts (including auditors).
262. A misrepresentation is defined under subsection 1(1) of the Act as: '(a) an untrue statement of material fact, or (b) an omission to state a material fact that is required to be stated or that is necessary to make a statement not misleading in light of the circumstances in which it was made.'
263. Defendants have several potential defences under the Civil Liability Amendments. For example, every defendant has a due diligence defence by proving that they conducted or caused to be conducted a reasonable investigation and that they had no reasonable grounds to believe that the document or public oral statement contained a misrepresentation, or that the failure to make timely disclosure would occur. There is also no liability for failing to make timely disclosure if the issuer filed a confidential material change report and other requirements are met. Defendants may also limit their potential liability for continuous disclosure violations made without their knowledge by taking corrective action. The Civil Liability Amendments also contain a 'safe harbour' for forward-looking information.
264. The Civil Liability Amendments were published for comment in May 1998 (see (1998), 21 OSCB 3367).
265. For example, the Civil Liability Amendments require a plaintiff to obtain leave of the court in order to bring an action. Before granting leave, the court must be satisfied that the action (i) is being brought in good faith and (ii) has a reasonable prospect of success at trial. The Civil Liability Amendments also require court approval before any action can be settled.
266. We note that, more recently, some observers who primarily represent the plaintiff bar have questioned whether the Civil Liability Amendments, when implemented, will be used by class action plaintiffs and, in such event, whether they will pose an effective deterrent.
267. See, for example, Epstein v. First Marathon Inc., [2000] 2 B.L.R. (3d) 30 (Ont. S.C.), where the court denounced American-style strike suits. The court used its powers under the Ontario Class Proceedings Act, 1992, S.O. 1992, c. 6, which requires court approval of any settlement of a class proceeding commenced under the Act, to disallow a proposed settlement agreement which would have provided no benefit to the proposed shareholder class and a substantial payment to class counsel. Cumming J. held that approval of the settlement 'would violate the public policy objectives underlying the legislature's enactment of the [Act]', and that the 'plaintiff's class proceeding is counter-productive to all these objectives.'
268. See comment letters of the Certified General Accountants of Ontario, Ontario New Democratic Party, Fasken Martineau DuMoulin LLP, Ontario Teachers' Pension Plan, PricewaterhouseCoopers LLP, the Investment Dealers Association , the Canadian Institute of Chartered Accounts, Canadian Investor Relations Institute, and BMO Nesbitt Burns.
269. See comment letter of Fasken Martineau DuMoulin LLP.
270. BCSC, 'New Proposals for Securities Regulation - A New Way to Regulate' (June 5, 2002) (www.bcsc.bc.ca).
271. See comment letters of the Canadian Institute of Chartered Accountants and PricewaterhouseCoopers LLP.
272. See comment letter of PricewaterhouseCoopers LLP.
273. In order to become a 'reporting issuer,' a company is generally required either to file a prospectus or become listed on an exchange in Ontario recognized by the Commission.
274. Multilateral Instrument 45-102 Resale of Securities (2001), 24 OSCB 7029.
275. See OSC Rule 45-501 Exempt Distributions, as contrasted with the new exemptions in British Columbia and Alberta: the 'family, friends and business associates exemption,' the 'offering memorandum exemption,' the 'accredited investor exemption' and a modified 'private issuer exemption' (Multilateral Instrument 45-103 Capital Raising Exemptions). These exemptions replaced a number of existing exemptions, including the '50 purchaser exemption,' the '$25,000 sophisticated purchaser exemption' and the 'friends and relatives exemption.' In November 2002, MI 45-103 was published for comment in amended form (See BCN 2002/39 'Proposed Amendments of Multilateral Instrument 45-103 Capital Raising Exemptions and Proposed Adoption in Additional Jurisdictions'). When finalized, it will also apply in Manitoba, Newfoundland, Northwest Territories, Nunavut, Prince Edward Island and Saskatchewan, although there will be certain differences among these jurisdictions regarding the offering memorandum exemption.
276. See comment letters of the Canadian Bankers Association, Royal Bank of Canada, TSX Venture Exchange, IDA and TSX.
277. The Act, paragraph 35(2)10 and subsection 73(1).
278. OSC Rule 45-501, section 2.17.
279. The Act, paragraph 35(1)5 and clause 72(1)(d).
280. The Act, paragraph 35(1)21 and clause 72(1)(p).
281. (1996), 19 OSCB 5757.
282. See the Merger Report, supra note 9.
283. The majority of commenters on this issue agreed with us. See comment letters of the BCSC, Torys LLP and Ontario Teachers' Pension Plan. Two commenters were concerned that it was too early to consider eliminating hold periods for reporting issuers. See comment letters of the TSX and Fasken Martineau DuMoulin LLP.
284. Comment letter of Torys LLP on the Issues List, which noted that: 'The specific hold periods were originally implemented for greater certainty as to when such a resale could occur but, based on experience, that objective has been outweighed by complexity and lack of cohesive purpose.'
285. See comment letters on the Issues List of the Ontario Teachers' Pension Plan and TSX Venture Exchange.
286. Subsection 76(1) of the Act prohibits a person or company in a special relationship with a reporting issuer from purchasing or selling securities of the issuer while in possession of material undisclosed information about the issuer (the insider trading prohibition). Subsection 76(6) provides that the term 'securities,' when used in the context of the insider trading prohibition, includes a put, call or security the market price of which varies materially with the market price of the security of the issuer. This expanded definition of security may capture many monetization structures so that they cannot be entered into with an insider if the insider is in possession of material undisclosed information. On the other hand, the insider reporting requirements of the Act (section 107) require insiders to report trades in 'securities' of the reporting issuer, but the definition of security is not expanded to include puts, calls or securities the market price of which varies materially with the market price of the security of the issuer.
287. See comment letter on the Issues List of the IDA.
288. The 2002 Amendments amend the definition of 'material fact' to delete the ex post facto examination of the effects of the disclosure on the market price or the value of the security. The amendment has not yet been proclaimed in force. The change in definition is being made as a consequence of the Civil Liability Amendments discussed in section 11.6. The change to the definition was first recommended by the Allen Committee, which believed that it would be inappropriate to expose issuers to liability for materiality determinations after the fact.
289. The Act, subsection 1.1(1).
290. For example, it may be a material fact that an issuer has engaged financial advisers with respect to a recapitalization. However, until the issuer makes a decision to proceed, no material change has occurred.
291. Speech of former Chairman, Peter Dey, (1983), 6 OSCB 2368.
292. It should be noted, however, that the 2002 Amendments, when proclaimed in force, will amend the definition of 'material fact' to delete the 'ex post facto' examination of the effects of the disclosure on the market price or the value of the security.
293. In 1995, the Allen Committee also considered whether the disclosure standard should be changed to 'material information,' the standard reflected at that time in NP 40. In its interim report, it concluded that the distinction between 'material facts,' 'material information' and 'material changes' causes some confusion for market participants and has contributed to a 'lack of clarity in the rules.' (See Interim Report of The Toronto Stock Exchange Committee on Corporate Disclosure, Toward Improved Disclosure (1996), 19 OSCB at page 83.) In this regard, the Allen Committee concluded that NP 40 and the TSE 'got it right.' However, the Allen Committee encountered significant resistance to this proposal and did not pursue this recommendation in its final report.
294. Unlike Ontario laws, U.S. federal securities laws impose no general duty to disclose material developments as they occur, except where: (i) it is necessary to correct a previous untrue statement that has become materially misleading and on which the market is still relying (i.e., 'duty to correct'); (ii) it is necessary to update forward-looking statements or projections on which the market continues to rely that were true when made, but later became materially false or misleading in the context of subsequent events (i.e., "duty to update"); or (iii) the issuer is in the process of buying or selling its own securities or wishes to facilitate such transactions by insiders (i.e., 'duty to disclose or abstain') (J. Robert Brown, The Regulation of Corporate Disclosure, 3rd ed., (Aspen Law & Business: New York) at pages 3-5). It should be noted, however, that the duty to update forward-looking statements or projections is a very unsettled area of U.S. federal securities law, characterized by considerable inconsistency in circuit court opinions as to whether such a duty exists. I
295. In June 2002, the SEC proposed that several new items or events be reported on Form 8-K in an effort to improve the quality, amount and timeliness of public disclosure of extraordinary corporate events. In addition, the SEC proposed that Form 8-K reports, also known as current reports, be filed within two business days instead of the current five to fifteen days.
296. The Sarbanes-Oxley Act of 2002 requires reporting companies to disclose 'on a rapid and current basis' in plain English such information as the SEC may require concerning material changes in financial condition and operations, including 'trend and qualitative information and graphic presentations.'
297. See comment letters of the Canadian Bankers Association, Royal Bank of Canada, Certified General Accounts of Ontario, Securities Subcommittee of the Ontario Bar Association, Davies Ward Phillips & Vineberg LLP, and Torys LLP. See also comment letters on the Issues List of Torys LLP, the IDA, Simon Romano, TSX Venture Exchange, and Peter McCarter of Aur Resources Inc., who were opposed to such a change.
298. Each of the TSX and TSX Venture Exchange have policies in place which have, in effect, expanded the timely disclosure obligations of listed companies. The exchanges require that all listed companies make timely disclosure of all material information. See the TSX's Policy Statement on Timely Disclosure and Related Guidelines and TSX Venture Exchange's Policy 3.3 Timely Disclosure.
299. See the comment letter on the Issues List of Peter McCarter.
300. See comment letter of Fasken Martineau DuMoulin LLP.
301. By way of background, it should be noted that the terms 'material fact' and 'material change' are applied in many contexts under the Act. The terms 'material fact,' 'material change' and 'misrepresentation' (itself defined by reference to 'material fact') apply in connection with: (i) disclosure requirements and remedies, including required standards of disclosure in such documents as prospectuses, offering memoranda, bid circulars, proxy circulars and material change reports, and remedies and sanctions for failures to meet the required standards of disclosure; and (ii) insider trading prohibitions, in relation to both the standard of materiality and remedies and sanctions for contraventions.
302. The insider trading and tipping prohibitions in Quebec refer to 'privileged information,' which is based on a reasonable investor standard of materiality. By contrast, for purposes of prospectus and timely disclosure, the Quebec Act uses a market impact test of materiality. In particular, section 13 of the Quebec Act provides that a prospectus must disclose all material facts likely to affect the value of the market price of the securities to be distributed. Similarly, the Quebec Act provides that 'where a material change occurs that is likely to have a significant influence on the value or the market price of the securities of a reporting issuer and is not generally known, the reporting issuer shall immediately prepare and distribute a press release disclosing the substance of the change.'
303. TSC Industries, Inc. v. Northway Inc., [1976] 426 U.S. 428, 449.
304. In November 1997, certain members of the CSA published for comment proposed amended definitions of 'material fact' and 'material change' which would have introduced a single materiality standard for all purposes under securities legislation based on the U.S. reasonable investor test (the 'Request for Comment'). The proposed amended definitions were published again in May 1998 as part of the proposed amendments to securities legislation which would create a statutory civil liability regime for continuous disclosure. See CSA Notice 53-302 Report of the CSA - Proposal for a Statutory Civil Remedy for Investors in the Secondary Market and Response to the Proposed Change to the Definitions of 'Material Fact' and 'Material Change' (2000), 23 OSCB 7383.
305. Ibid.
306. Tory Tory DesLauriers & Binnington, Canadian Securities Regulators Propose to Adopt Tougher U.S. Standards on Public Issuer Disclosure (December 6, 1997).
307. See, for example, Instruction 3 to Form 41-501F1 Information Required in a Prospectus.
308. See, for example, the comment letter of Philip Anisman, on behalf of the TSX, to the CSA dated December 22, 1997.
309. See comment letter of Davies Ward Phillips & Vineberg LLP.
310. Ibid.
311. See Release Nos. 33-7881, 34-43154, IC-24599, File No. S7-31-99 Selective Disclosure and Insider Trading.
312. See, for example, Dirks v. SEC, [1983] 463 U.S. 646, in which the U.S. Supreme Court stated that an analyst tippee would be subject to insider trading liability if the tipper breached a fiduciary duty to shareholders in disclosing material non-public information and the tippee knew or should have known of the breach. As articulated by the Supreme Court, breach of a fiduciary duty exists where the 'insider' will benefit, directly or indirectly, from the disclosure. This benefit may be in the form of a pecuniary gain or reputational benefit that will translate into future earnings.
313. In Ontario, see subsection 76(2) of the Act.
314. For example, 71 per cent of the respondents did not have written corporate disclosure policies; 81 per cent of the respondents reported that they have one-on-one meetings with analysts; 98 per cent of the respondents reported that they typically comment in some form on draft analyst reports; and 27 per cent of the respondents indicated that they express a level of comfort on earnings projections. See Ontario Securities Commission Staff Notice 53-701 Staff Report on Corporate Disclosure Survey (2000), 23 OSCB 5098.
315. TSX News Release, 'Analyst Standards Committee Recommends Mandatory Disclosure,' April 12, 2001 (http://www.tse.com/news/news_rel/news_523.html).
316. Setting Analysts Standards: Recommendations for the Supervision and Practice of Canadian Securities Industry Analysts (October 2001 - Final Report) at pages 72 and 73, (http://tse.com/cgi-bin/uni_framset.cgi?content=news/news_rel/news_523.html).
317. See National Policy Statement 51-201 Disclosure Standards (2002), 25 OSCB 4492.
318. See In the Matter of Gary George (1999), 22 OSCB 7171, where the Commission addressed in obiter the issue of a selective disclosure made by an issuer's chief executive officer to an analyst and the subsequent disclosure by the analyst to other members of his firm:

     It would appear that some corporate officers see the maintenance of good relations with analysts as being more important than ensuring the equality of material information among shareholders. The fact that it was thought [the analyst] was about to come out with a report as to [the issuer] which would overvalue its shares would in no way justify [the President] giving the information to [the analyst] rather than publicly disseminating it. If the information was material enough to cause [the analyst] to change his projections, it should have been publicly disseminated. In general, we view one-on-one discussions between an officer of a reporting issuer and an analyst as being fraught with difficulties.

     In August 2001, the Commission approved a settlement agreement reached between Commission staff and Air Canada with respect to Air Canada's alleged disclosure of earnings information to analysts during the company's self-imposed 'quiet period.' In the Excerpt from the Settlement Hearing Containing the Oral Reasons for Decision, the Commission stated: 'Communication by a corporation with analysts is not covered under some exception; so what is disclosed to analysts, if it is material and will significantly affect the market price, or reasonably may be expected to significantly affect the market price of the shares of the issuer, should not be selectively disclosed' ((2001), 24 OSCB 4899).
319. See comment letters of the IDA, Ontario Teachers' Pension Plan, the TSX, Torys LLP, Fasken Martineau DuMoulin LLP, and Davies Ward Phillips & Vineberg LLP. See also the comment letters on the Issues List of Smith Lyons, the IDA, and The Canadian Bankers Association.
320. See comment letters of Fasken Martineau DuMoulin LLP, Davies Ward Phillips & Vineberg LLP and the BCSC. Under Regulation FD, the timing of required public disclosure differs depending on whether the issuer has made an 'intentional' or 'unintentional' selective disclosure. For an 'intentional' selective disclosure, the issuer is required to publicly disclose, in the manner required, the same information simultaneously with the 'intentional' selective disclosure. The Regulation's definition of 'intentional' requires that the individual making the disclosure must know (or be reckless in not knowing) that he or she would be communicating information that is both material and non-public. When an issuer makes a non-intentional disclosure of material non-public information which is subject to the Regulation, it is required to make public disclosure 'promptly'. For this purpose, 'promptly' means 'as soon as reasonably practicable,' but in no event after the later of 24 hours or the commencement of the next day's trading on the NYSE, after a senior official of the issuer learns that there has been a non-intentional disclosure of information by the issuer or a person acting on behalf of the issuer that the senior official knows, or is reckless in not knowing, is both material and non-public.
321. See comment letter of Fasken Martineau DuMoulin LLP.
322. See Proposing Release Nos. 33-7787, 34-42259, IC-24209, File No. S7-31-99 Selective Disclosure and Insider Trading.
323. See comment letters of Certified General Accounts of Ontario, the Association for Investment Management and Research, Fasken Martineau DuMoulin LLP, Ontario Teachers' Pension Plan, the Canadian Institute of Chartered Accountants, PricewaterhouseCoopers LLP, Davies Ward Phillips & Vineberg LLP, Torys LLP, the Canadian Bankers Association, and Royal Bank of Canada.
324. These criteria include having net tangible assets of at least $7.5 million, or in the case of oil and gas companies, proved developed reserves of at least $7.5 million.
325. On September 5, 2002, the SEC adopted rule amendments to accelerate the filing of quarterly and annual reports under the 1934 Act by domestic reporting companies that have a public float of at least $75 million, that have been subject to the 1934 Act's reporting requirements for at least 12 calendar months and that previously have filed at least one annual report. The changes for these accelerated filers will be phased in over three years. The annual report deadline will remain 90 days for year one and change from 90 days to 75 days for year two and from 75 days to 60 days for year three and thereafter. The quarterly report deadline will remain 45 days for year one and change from 45 days to 40 days for year two and from 40 days to 35 days for year three and thereafter. (See Final Rule: Acceleration of Periodic Report Filing Dates and Disclosure Concerning Website Access to Reports Securities and Exchange Commission - Release Nos. 33-8128; 34-46464; FR-63; File No. S7-08-02).
326. See comment letter of Power Corporation of Canada.
327. OSC Rule 52-501 Financial Statements, subsections 2.2(6), (7).
328. Companion Policy 52-501 to OSC Rule 52-201 Financial Statements, section 2.1.
329. See comment letters of Fasken Martineau DuMoulin LLP, Ontario Teachers' Pension Plan, the Canadian Institute of Chartered Accountants, PricewaterhouseCoopers LLP, Canadian Investor Relations Institute, Davies Ward Phillips & Vineberg LLP, Torys LLP, and the Ontario New Democratic Party.
330. See comment letters of Ontario Teachers' Pension Plan, the TSX Venture Exchange, and the TSX.
331. We have no concerns, however, with a company press releasing selected financial information from a company's financial statements prior to receiving board approval of the full financial statement, provided that the board (or audit committee) has approved the selected financial information to be pre-released.
332. Ernst & Young, 'Walking a Fine Line on Earnings Guidance' CrossCurrents (Fall 2002) (www.ey.com).
333. 'Leading the News: Coke to Abandon Profit Forecasts, Provide Data on Long-Term Goals' Wall Street Journal (December 16, 2002).
334. CSA Staff Notice 52-303 Non-GAAP Earnings Measures (2002), 25 OSCB 112.
335. In January 2003, the SEC adopted Regulation G, which applies whenever a company publicly discloses or releases material information that includes a non-GAAP financial measure. Regulation G requires a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure presented and the comparable financial measure or measures calculated and presented in accordance with GAAP (see Conditions for Use of Non-GAAP Financial Measures, SEC Release No. 33-8176).
336. It may make a copy of the news release available on its website under 'Investor Information,' but it is under no obligation to do so.
337. See comment letters of Davies Ward Phillips & Vineberg LLP and Fasken Martineau DuMoulin LLP. It should be emphasized, however, that the commenters were not advocating that reporting issuers should have an obligation to continuously report 'material information.'
338. This would permit, for example, an issuer to recategorize a news release in relation to a material change after initially having posted the news release in the 'Other' category.
339. Subsection 2(3) of the Regulation. A similar exemption exists in the securities legislation of Alberta and Manitoba. The Quebec Act contains a similar exemption for banks only. Securities legislation of the remaining provinces and territories does not contain such an exemption.
340. We understand that this exemption was originally adopted when banks, life insurance companies and property and casualty insurance companies were not fully included in the scope of the CICA Handbook. Over time, however, these institutions were brought fully within the scope of the Handbook. More specifically, the exemptions relating to property and casualty insurance companies, life insurance companies and banks were removed from the Handbook in September 1986, December 1987, and August 1992, respectively.
341. See, for example, subsection 308(4) of the Bank Act, S.C. 1991, c. 46.
342. See section 183 of the FCAC Act, which amends subsections 840(4) and 855(2) in Part XV Bank Holding Companies Division 6 of the Bank Act.
343. See comment letters of the Association for Investment Management and Research, Fasken Martineau DuMoulin LLP, Ontario Teachers' Pension Plan, the Canadian Institute of Chartered Accountants, the Canadian Bankers Association, the Nova Scotia Securities Commission, Royal Bank of Canada, and Torys LLP.
344. See comment letters of Fasken Martineau DuMoulin LLP and the Canadian Institute of Chartered Accountants.
345. See Final Rule, Revision of the Commission's Auditor Independence Requirements, Release Nos. 33-7919; 34-43602; 35-27279; IC-24744; IA-1911; FR-56; File No. S7-13-00. The rules became effective February 5, 2001, with transition periods for various types of transactions and relationships.
346. These rules were revised in January 2003 in response to the Sarbanes-Oxley Act. The revised rules identify nine non-audit service functions that may not be performed by independent auditors for public company audit clients, including (i) bookkeeping or other services related to the accounting records or financial statements of the audit client; (ii) financial information systems design and implementation; (iii) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (iv) actuarial services; (v) internal audit outsourcing services; (vi) management functions or human resources; (vii) broker or dealer, investment adviser, or investment banking services; (viii) legal services; and (ix) expert services unrelated to the audit.
347. These proxy disclosure rules were revised in January 2003 in response to the Sarbanes-Oxley Act. The new SEC rules provide new 'buckets' for the disclosure of fees paid to the auditor. In particular, issuers must disclose in their annual reports fees paid to the independent accountant for (i) audit services, (ii) audit-related services, (iii) tax services, and (iv) other services. Additionally, the disclosure must include the audit committee's policies and procedures for pre-approval of services by the independent accountant as well as the percentage of fees paid subject to specified de minimis exceptions.
348. See SEC rule: Strengthening the Commission's Requirements Regarding Auditor Independence, Release Nos. 33-8183; 34-47265; 35-27642. The new rules address issues such as: (i) required rotation of 'audit engagement team' members, (ii) audit committee pre-approval of audit and non-audit services, (iii) prohibitions on compensation of audit team partners based on non-audit services, (iv) disclosure of critical accounting policies, and (v) prohibitions on employment of audit engagement team members by client. Under the new rules, accountants may continue to be allowed to provide tax compliance, tax planning and tax advice to audit clients, subject to audit committee pre-approval.
349. The Public Interest and Integrity Committee of the CICA. Exposure Draft Independence Standards (www.cica.ca).
350. See http://www.ifac.org. The new IFAC code emphasizes that independence is a 'state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional scepticism.'
351. The PIIC's proposals would either prohibit or place strict limits on auditors performing a wide range of non-audit services for listed entities for which they are the auditor. The non-audit services include: appraisal or valuation services, or fairness opinions; management or human resources functions; investment dealer, adviser or investment banking services; legal services and expert services unrelated to the audit; bookkeeping services; design and implementation of financial information systems; actuarial services; and internal audits.
352. See letter dated September 23, 2002 to David Brown from Donald G. Wray, Chair, Public Interest and Integrity Committee (www.osc.gov.on.ca/en/HotTopics/prom_inv_conf.html).
353. See comment letters of the Certified General Accountants of Ontario, the Association for Investment Management and Research, Fasken Martineau DuMoulin LLP, Ontario Teachers' Pension Plan, Torys LLP, the Canadian Institute of Chartered Accountants, and the Canadian Bankers Association.
354. For example, the commenter noted that when a company prepares and files a prospectus, the company's auditor is required to perform substantial work in order to be able to among other things, file comfort and consent letters with the Commission. Such work is nonetheless characterized as a 'consulting' service under U.S. proxy disclosure rules. See comment letter of PricewaterhouseCoopers LLP.
355. Protecting the Public Interest: The Role of the Chartered Accountancy Profession, prepared for the CICA by Kroll Associates (2001) at page 2 (http://www.cica.ca/cica/cicawebsite.nsf).
356. [1997] 2 S.C.R. 165, where shareholders brought an action against a firm of accountants alleging that audits of the company's financial statements had been negligently prepared and, as a result, the shareholders had incurred investment losses.
357. The court concluded that 'to come to the opposite conclusion ... would> be to expose auditors to the possibility of indeterminate liability, since such a finding would imply that auditors owe a duty of care to any known class of potential plaintiffs regardless of the purpose to which they put the auditor's reports.'
358. Certification of Disclosure in Companies' Quarterly and Annual Reports, SEC Release Nos. 33-8124, 34-46427.
359. Section 13(2)(b) of the 1934 Act contains a long-standing provision requiring companies to devise and maintain internal controls.
360. Proposing Release for Certification of Disclosure in Companies' Quarterly and Annual Reports, SEC Release No. 34-46079.
361. See comment letter of Fasken Martineau DuMoulin LLP.
362. Letter to David Brown from Barbara Stymiest dated September 17, 2002 relating to U.S. corporate governance reforms (www.osc.gov.on.c./en/HotTopics) and 'Governance, Values and Competitiveness - A Commitment to Leadership,' A Statement of the Canadian Council of Chief Executives (September 2002).
363. 'Governance, Values and Competitiveness - A Commitment to Leadership,' A Statement of the Canadian Council of Chief Executives (September 2002) at page 13.
364. Audit committees are not required under the corporate statutes of Nova Scotia, Prince Edward Island or New Brunswick.
365. See CSA Notice 52-301 Audit Committees (October 19, 1990). We have found that there is comparatively little in subsequent literature (including the U.S. Blue Ribbon Commission Report discussed below) that was not covered in the CSA Notice on Audit Committees, other than the financial literacy of members of the audit committee.
366. Section 474 TSX Company Manual. The TSX Guidelines are based on the recommendations of the Dey Committee. The Dey Report proposed a number of practices that companies should follow in order to improve corporate governance.
367. See SEC Press Release, 'NYSE Chair Richard Grasso, NASD Chair Frank Zarb, and Blue Ribbon Panel Co-Chairs Ira Millstein and John Whitehead Announce ‘Ten-Point Plan' to Improve Oversight of Financial Reporting Process' at http://www.sec.gov/news/press/pressarchive/1999/99-14.txt.
368. The Saucier Report at page 29.
369. In January 2003, in response to the Sarbanes-Oxley Act, the SEC proposed rules that will direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements established by the Sarbanes-Oxley Act (see Proposed Rule: Standards Relating to Listed Company Audit Committees, SEC Release No. 33-8173; 34-47137).
370. See subsection 200(3) of the 2002 Amendments.
371. See comment letters of the Certified General Accountants of Ontario, Ontario Teachers' Pension Plan, Davies Ward Phillips & Vineberg LLP, Fasken Martineau DuMoulin LLP, and the Canadian Bankers Association.
372. Securities commissions do have authority, however, to deal with areas that have traditionally been viewed by some as 'corporate' matters, such as insider trading, proxy solicitation, take-over bids, and related party transactions. Similarly, commissions may 'regulate' corporate governance matters through the exercise of their oversight powers over SROs (e.g., oversight over the listing requirements of exchanges).
373. Philip Anisman, 'It's break point for break fees,' National Post (March 18, 2002).

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