On March 20, 2012, the Ontario Securities Commission (OSC) released OSC Staff Notice 51-719 Emerging Markets Issuer Review (Notice). This review focused on issuers whose mind and management are largely outside of Canada and whose principal active operations are also outside of Canada in regions such as Asia, Africa, South America and Eastern Europe (EM Issuers). The Notice reported on a review of 24 issuers listed on Canadian exchanges with significant business operations in emerging markets. This review was done in response to concerns that Canadian investors in these issuers may be exposed to “inappropriate risks” with the goal of identifying areas of concern and making recommendations to contribute to the protection of investors and strengthen the integrity of Canadian markets. The Notice focused on the adequacy of issuer disclosure and corporate governance practices, as well as the adequacy of the gatekeeper roles played by auditors, underwriters and exchanges in bringing these issuers to the market. In conducting its review, OSC staff contacted issuers, their advisors and organizations such as Canadian exchanges, the Canadian Public Accountability Board and other provincial securities regulators.
Key concerns identified by the OSC
The Notice identified four principal concerns:
- the level of EM Issuer governance and disclosure;
- the adequacy of the audit function for an EM Issuer’s annual financial statements;
- the adequacy of the due diligence process conducted by underwriters in offerings of securities by EM Issuers; and
- the nature of the exchange listing approval process.
As a general comment, the OSC noted an overall concern with the apparent “form over substance” approach to compliance with applicable standards for disclosure, issuer governance, board oversight, audit practices and due diligence practices. The OSC expressed the view that the level of independent-mindedness applied by boards, auditors and underwriters in doing their jobs should have been more thorough.
Review of EM Issuers
The OSC conducted a review of the public disclosure records of the EM Issuers and examined information concerning the function of the EM Issuers’ boards and audit committees and identified four key areas of concern:
- Corporate governance practices - in some cases it was found that the board had very little contact with senior management in the emerging market jurisdiction and that the extent of knowledge the board and audit committee had of the cultural and business practices of such jurisdictions was lacking. In some instances it appeared that board members were relying solely on members of management to provide an overview of key business documents that were in a foreign language.
- Corporate structures - complex corporate structures may increase the risk profile of an EM Issuer as these structures may impact the ability of the board to properly oversee management or understand the full extent of the issuer's operations and may be difficult to describe to investors in disclosure.
- Related Party Transactions – related party transactions may represent an increased risk for EM Issuers as they can be abusive if they only benefit the related party and not the issuer. The OSC noted concern in some instances about the extent and frequency of related party transactions and the processes that were in place to identify and approve such transactions.
- Risk Management and Internal Control – the OSC noted that board members should be sensitive to the unique risks associated with operations in emerging market jurisdictions. Board members must ensure they understand the political and cultural risks impacting the EM Issuer and assess those risks in the context of the EM jurisdiction. These risks include political factors, governmental policies that may affect legal rights and property ownership, conversion of currency and legal title to assets. Boards should be satisfied that management has put appropriate internal controls in place to manage such risks.
Review of Auditors
The Notice states that the OSC is concerned that auditors may not always be performing sufficient procedures necessary to understand and scrutinize the information provided to them by an issuer and/or foreign component auditor. The OSC noted four key deficiencies with respect to external auditors of EM Issuers:
- auditors must be more sceptical of representations from management and take independent measures to verify information received from management;
- auditors lack knowledge of the local legal environment and cultural and business practices and as such their analyses do not reflect local circumstances;
- auditors rely too heavily on foreign component auditors and in some instances the working paper files of these foreign component auditors were not made available or could not be removed from the foreign jurisdiction which could prevent regulators from reviewing files; and
- auditors’ ability to communicate with management and examine documentation is impacted by language barriers and it was not clear how these issues were being addressed.
Review of Underwriters
The OSC noted that underwriters are uniquely placed to verify information regarding the issuer, its operations and management in prospectus offerings and listing applications and, in order to fulfill their role, should participate in the offering process with scepticism regarding management claims. The OSC noted the following concerns with respect to the role of underwriters:
- there are no explicit, standard requirements for the conduct of due diligence and as a result, the OSC noted that in some cases, risks that were identified were not always documented and if they were raised, there was little or no follow up recorded or evident in the due diligence materials;
- there is an insufficient level of professional scepticism and rigour in respect of red flags that were identified during due diligence such as unusual growth, financial metrics that were superior to industry average and significant reliance on government relationships or the founder/CEO that should have prompted further questioning by the underwriter;
- the due diligence information sometimes contained little documentation or discussion with respect to the risks associated with the EM Issuer’s operations; and
- in general, the level of due diligence documentation by underwriters with respect to EM Issuers was found to be deficient and as a result, it was not always evident that the approvals process called for by the underwriters’ own internal process was followed.
Review of Exchanges
Finally, the OSC considered the role of stock exchanges in protecting the integrity of Ontario’s markets. The OSC examined EM Issuers who accessed the market through different methods, including, IPOs, direct listings or RTOs and did not identify any particular method of accessing the market as being specifically problematic. The OSC identified the following deficiencies in the procedures and policies of exchanges with respect to EM Issuers:
- there is no requirement for an EM Issuer to maintain a meaningful Canadian presence which could include having a combination of directors, key officers, employees, books and records and assets located in Canada;
- there is no public disclosure made where exchange discretion is exercised to waive certain listing requirements for a particular issuer; and
- there was concern noted regarding the amount of reliance exchanges place on the role of sponsors to conduct due diligence given that the terms of sponsorship reports are generally negotiated between the sponsor and issuer and the sponsor is paid a fee for this service.
The Notice notes that EM Issuers represent an important growth market for Canadian investments and the OSC states that it will continue to assess areas that require policy examination and reform. The Notice generally makes recommendations that call for the creation of guidance documents, best practices and increased vigilance by the various stakeholders. Some specific recommendations include:
- improving disclosure of foreign risk factors;
- potentially creating minimum Canadian director residency requirements or minimum language competency requirements for Canadian-resident board members in the applicable local language;
- establishing a consistent and transparent set of requirements for the conduct of due diligence by underwriters and developing best practices around the documentation of all aspect of an underwriter’s due diligence; and
- reviewing the role of sponsors in bringing EM Issuers to market to ensure that there is adequate accountability placed on the sponsor and an appropriate level of transparency regarding the sponsor’s due diligence.