Canadian companies and their directors and officers are facing intense scrutiny from regulators, stock exchanges, institutional investors, shareholders and the media. Regulators in both Canada and the United States have been very active in imposing new governance and disclosure requirements and are increasingly vigilant in enforcing those requirements, particularly in the wake of the recent financial market turmoil. In addition, directors’ duties, conflicts of interests and processes of deliberation are being scrutinized more closely by investors and the courts, significantly increasing the exposure of directors to lawsuits and potential liability. These developments, and others, have created new risks for Canadian public companies and their directors and officers.  

Canadian Investor Confidence Rules

Canadian securities regulators have adopted a number of rules to strengthen investor confidence in the public filings of companies. The Canadian rules are substantially similar to comparable provisions of the US Sarbanes-Oxley Act of 2002 (SOx) and US stock exchange requirements. Some of the measures are being phased in over time, and certain companies (e.g., foreign and venture issuers) receive slightly different treatment. Highlights of these initiatives are discussed below.  

CEO and CFO Certification Requirements  

The CEO and CFO of every public company are required to personally stand behind financial statements and other documents. They must personally certify several aspects of the company’s disclosure:

  • integrity of interim and annual filings;
  • design and evaluation, and disclosure of conclusions as to the effectiveness, of disclosure controls and procedures; and
  • design of, and disclosure of material changes in, internal control over financial reporting.  

In addition, beginning with periods ending on or after December 15, 2008, the CEO and CFO of every public company (except investment funds) will be required to provide expanded certifications with respect to its internal control over financial reporting (ICFR). Specifically, CEOs and CFOs will be required to certify annually that they have

  • evaluated, or caused to be evaluated under their supervision, the effectiveness of the company’s ICFR; and  
  • disclosed in the annual management’s discussion and analysis (MD&A) their conclusions about the effectiveness of the company’s ICFR.  

CEOs and CFOs will also have to certify annually that they have disclosed to the company’s auditors and either the board of directors or the audit committee any fraud involving management or other employees with a significant role in ICFR. Canadian companies will not be required to obtain an auditor’s attestation of the effectiveness of internal control over financial reporting, as is required of US and cross-border companies under SEC rules. These certifications take on even greater significance given that the civil liability regime described below imposes personal liability for damages on directors and officers for disclosure violations.  

Role and Composition of Audit Committees  

Every public company must have an audit committee that complies with the requirements of the audit committee rule adopted by Canadian securities regulators. The audit committee must be composed of at least three members, and, with limited exceptions, each member must be “independent” and “financially literate”.  

For a director to be independent, the board of directors must determine that the director has no direct or indirect material relationship with the company, its parent or any of its subsidiaries. A “material relationship” is defined as a relationship that could, in the board’s view, reasonably interfere with the exercise of a director’s independent judgment.The rule also identifies a number of specific relationships and circumstances that result in a director being deemed to have a material relationship with the company, and therefore not being independent. In interpreting the rules related to independence, a board should consider the overall philosophy and approach of the corporate governance rules and recommended best practices, and the definitions of independence used by institutional investors and proxy advisory firms.  

For a director to be financially literate, he or she must have the ability to read and understand a set of financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to those that can reasonably be expected to be raised by the company’s financial statements. Companies are also required to disclose every audit committee member’s education and experience in financial matters.  

The audit committee’s responsibilities include (a) recommending to the board the external auditor to be nominated by the board for appointment by the shareholders, and the auditor’s compensation; (b) overseeing the auditor’s work, including the establishment of a direct reporting relationship; (c) pre-approving all non-audit services provided by the auditor; (d) reviewing financial statements, MD&A and earnings news releases before public release; (e) ensuring that appropriate procedures are established to receive complaints and anonymous tips regarding accounting, auditing and internal control matters; and (f ) ensuring that appropriate policies are established to hire employees or partners of the external auditor.  

The independence requirements set forth in the rule have created a new standard for measuring a director’s ability to exercise independent judgment. In addition, the direct responsibilities of the audit committee bring with them a heightened exposure to personal liability. Individuals with accounting and related financial expertise are increasingly in demand as audit committee members and chairs.  

Disclosure of Corporate Governance Practices  

Canadian securities regulators have adopted a set of corporate governance guidelines that reflect best practices and an accompanying disclosure rule that requires public companies to describe specific aspects of their governance practices.  

The governance guidelines are substantially similar to the listing standards of the New York Stock Exchange and reflect current North American best practices in governance. These guidelines deal with matters such as board composition;meetings of independent directors; board mandate; position descriptions of the CEO, board and committee chairs; orientation and continuing education; code of business conduct and ethics; nomination of directors; compensation; and regular board assessments.  

The corporate governance guidelines are not mandatory. However, they represent securities regulators’ views of best practices in corporate governance matters, and public companies are encouraged to consider them when formulating their own governance practices. This feature – voluntary compliance coupled with a disclosure requirement – distinguishes the Canadian approach from mandatory listing standards adopted by the US stock exchanges for US companies.  

Failure to provide adequate corporate governance disclosure is a breach of securities laws and can expose the company to enforcement proceedings and sanctions. Regulators have indicated that they will use their continuous disclosure reviews to ensure that corporate governance disclosure reflects what is actually happening in the boardroom and is not merely boilerplate. The TSX is also monitoring corporate governance disclosure, and any listed company with deficient disclosure may be required to publish amended disclosure in its next quarterly report. Continuing non-compliance could result in suspension or delisting.  

A best practice is, by definition, not an articulation of existing practice, but rather of a standard that regulators wish practices to move toward. However, as companies’ actual practices move toward an articulated best practice, accepted norms are changing. What was previously accepted practice is no longer so. As a result, companies that fail to move toward best practices accepted by others in the market, by definition, may not have taken due care.  

Canadian securities regulators are undertaking a broad review of existing guidelines for best practices in corporate governance and related corporate governance disclosure requirements. The regulators are expected to publish their findings and any proposed amendments for comment in late 2008 or early 2009.  

Executive Compensation  

New Disclosure Rules  

Canadian securities regulators have overhauled rules relating to executive compensation disclosure. The regulators believe that these new rules will result in better communication of what boards of directors intend to pay executives, and will also allow investors to assess how decisions about executive compensation are made.  

The new rules are similar – but not identical – to the US Securities and Exchange Commission’s (SEC’s) rules on executive compensation disclosure that came into effect in 2007. The new rules will apply to executive compensation disclosure in respect of financial years ending on or after December 31, 2008. A company is not required to restate, for comparative purposes, disclosure for prior financial years.  

Highlights of the new rules are as follows:

  • The most significant aspect of the new rules is the requirement to provide a “compensation discussion and analysis” (CD&A) that describes all significant elements of compensation and explains the rationale for specific compensation programs and decisions for each “named executive officer” (NEO). The regulators have long complained about the lack of meaningful analysis in companies’ reports on executive compensation. Companies should be applying the same level of rigor to their CD&A as they do to their MD&A, taking into account the regulators’ interpretative guidance for MD&A disclosure.We expect the regulators to focus on the CD&A in upcoming continuous disclosure reviews.  
  • Companies must disclose performance goals that are based on objective, identifiable measures, such as the company’s stock price or earnings per share, if those goals are significant to compensation decisions. (If goals are subjective, the company may describe them without providing specific measures.) There is an exception if disclosure would seriously prejudice the company’s interests, but in that case, the company must disclose the percentage of the NEO’s compensation that relates to the undisclosed information and how difficult it could be for the NEO, or how likely it will be for the company, to achieve the undisclosed goal. If any goals constitute non- GAAP financial measures, the company must disclose the way it calculates the goals from its financial statements. Companies should consider these disclosure requirements in formulating goals and adopting new compensation plans.  
  • The summary compensation table, which remains the main vehicle for executive compensation disclosure, must disclose total compensation for each NEO, including the dollar value of share and option awards (based on grant date fair value), non-equity incentive plan compensation and pension compensation amounts. The treatment of share and option awards differs from the US rules, which require disclosure of the compensation cost, as per the financial statements, in the summary compensation table.  
  • The identity of the NEOs will be based on total compensation (excluding pensions) rather than just salary and bonus. Severance and other payments resulting from termination of employment are excluded from the calculation but other onetime compensation amounts (such as signing bonuses or equity replacement awards to new hires) are not.  
  • Retirement benefits must be quantified for each NEO under both defined benefit and defined contribution plans. This requirement addresses the criticism that the current pension benefits disclosure provides only general information on benefit entitlements for selected compensation levels and years of service but does not disclose the particular circumstances or entitlements of each NEO.  
  • The new rules call for detailed disclosure about incremental payments or other benefits for each NEO related to the following triggering events: retirement, resignation, termination, a change of control of the company or a change in the NEO’s responsibilities. Companies will have to quantify the potential payments on the assumption that the triggering event occurred at the end of the most recent fiscal year. (If the event occurred earlier in the year, actual payments and benefits will be disclosed rather than hypothetical payments.) These disclosure requirements are consistent with the US rules but substantially exceed current Canadian requirements and are intended to prevent investors from being surprised, after the fact, by the size of an NEO’s severance or other payment package.  

To comply with the new rules, most companies will have to undertake a significant amount of work, involving legal, accounting and human resource advisors.  

“Say on Pay” Proposals  

Legislation has been introduced in the United States Senate that would entitle shareholders of US companies to a non-binding, advisory vote at annual meetings on whether they approve of the company’s executive compensation. The UK has already adopted advisory votes on executive compensation, and these have led to the practice of issuers “negotiating” their compensation policies with large institutional shareholders to avoid a negative vote.

Consistent with that development and the continuing focus on executive compensation, some shareholder organizations (including The Ethical Funds Company and SHARE) have written to TSX-listed senior issuers asking them to hold nonbinding votes at their annual meetings to allow shareholders to express their opinion about senior executive compensation. In Canada, these proposals continue to be advocated primarily by activist shareholders and have not yet been accepted as a best governance practice.We are not aware of a major Canadian issuer that has instituted an advisory vote.  

In January 2008, the Canadian Coalition for Good Governance (CCGG) announced that it would not support any regulatory changes or recommend universal backing for resolutions proposing mandatory advisory shareholder votes on executive compensation. In conjunction with its announcement, the CCGG released a position paper outlining its reasons for not supporting these types of resolutions, including the continued adoption of majority voting for director elections (which allows shareholders to express their concerns over issues such as executive compensation by withholding votes); the new securities law requirements for compensation disclosure, which will have an impact on linking pay to performance; an overall improvement in compensation disclosure practices since the last proxy season; and the increasing role of independent executive compensation advisors in the compensation process.  

Liability for Public Company Disclosure  

Under Ontario’s regime of statutory civil liability for secondary market disclosure, which came into force on December 31, 2005, companies, directors, officers and others have potential liability for misleading public disclosure and failing to make timely disclosure of material changes. This statutory regime is similar to the statutory liability regime that has existed for prospectuses for many years.  

Under this regime, companies, directors, officers and others are liable for damages suffered by any investor who buys or sells a company’s securities during a disclosure violation. A disclosure violation begins when a misrepresentation about the company is made in a public document or an oral statement, or when the company fails to make timely disclosure of a material change in its affairs; the violation ends when the disclosure is corrected or made. A plaintiff need not prove that he or she relied on the misrepresentation or failure to make timely disclosure. This statutorily deemed reliance removes a major obstacle to successfully suing on the basis of common law misrepresentation and to qualifying to bring a class action.  

The court will generally determine each defendant’s responsibility for the plaintiff ’s losses and each defendant will be liable for its proportionate share of the damages. In most circumstances, the liability of directors and officers is capped at the greater of C$25,000 and half of the individual’s compensation for the last year; the liability of companies is capped at the greater of C$1 million and five per cent of the company’s market capitalization. Clearly, this can be a very high threshold for a major public company. However, directors and officers who act “knowingly” in a violation may be fully liable, on a joint and several basis, for all damages.  

Fewer claims have been brought under the civil liability regime than were anticipated when it was introduced. Some speculate that this is because of the liability caps and strike suit protections that, for example, require a plaintiff to obtain leave of the court before bringing a lawsuit and to convince the court that the suit is being brought in good faith and has a reasonable possibility of success. The full impact of this new liability regime will not be known until the courts have considered its operation in various circumstances and common disclosure practices emerge. In the meantime, the increased risk of personal liability for directors and officers has focused companies’ attention on the need to have effective disclosure controls and procedures throughout the organization.  

The additional pressure imposed by civil liability on disclosure decisions is being felt in the M&A context in particular. In 2008, the Ontario Securities Commission (OSC) released its decision in the Re AiT Advanced Information Technologies Corporation case, determining that AiT had not breached the disclosure rules by failing to disclose its agreement with 3M Company until a definitive agreement was signed. The decision supports the approach generally taken by legal practitioners in Canada. Canadian securities legislation does not require an issuer to promptly disclose all material facts, only material changes. The distinction between material changes and material facts has been critical in the analysis whether an issuer must disclose a potential M&A deal, and it was upheld by the OSC in this case. Until a material change occurs, the fact that the company is in negotiations may be a material fact, preventing insiders from trading, but there is no positive obligation to disclose until a material change occurs. The OSC took care to stress that there is no bright-line test for determining when a material change occurs, and in some cases it may occur before the definitive agreement is signed.However, if the transaction is surrounded by uncertainties and is still highly conditional, a commitment from only one party to proceed will not normally be sufficient to constitute a material change.  

In Kerr v. Danier Leather, the Supreme Court of Canada held that the “business judgment rule” does not protect disclosure decisions under securities laws against judicial second-guessing. The OSC recognized this principle in AiT, finding that the determination of when or whether a material change occurred could not be subordinated to the board’s business judgment regarding the potential negative impact of disclosure. However, the OSC went on to say that if a board’s governance process in making disclosure decisions is effective, it would be difficult to interfere with the judgments produced by that process.  

Relationship Between the Board and Management  

This new regulatory environment, together with the additional investor and media scrutiny of corporate governance practices, has altered the dynamics at the board level, among executives in management and between the board and management. As a result, more independent directors (especially those considered “financially literate”) are being sought. Directors are taking their responsibilities more seriously and demanding timely and relevant information, firm meeting dates, an annual board agenda and leadership through the board’s involvement in important strategic decisions. Many boards now have an independent lead director who acts as a point of contact for the independent directors on the board.  

Directors are also increasing their use of advisors – both regular corporate advisors and independent advisors – to deal with complex accounting, compensation, legal and human resources issues. Establishing a due diligence defence is often greatly assisted by reliance on the report of an outside expert such as a lawyer, an accountant or a financial advisor.However, directors must satisfy themselves that the expert has the appropriate qualifications and experience to advise on the particular question and has had access to all information relevant in the circumstances. Directors must also understand the expert’s assumptions and analysis, and cannot passively accept the expert’s advice.  

Directors, themselves subject to close scrutiny regarding independence, are increasingly vigilant regarding the potential for conflicts among their advisors. In the M&A context, this has led more boards and special committees to take the cautious approach of retaining separate advisors who have no roles or relationships with other parties in the transaction. The issue of conflicts was addressed in a recent decision of the Delaware Court of Chancery (Re Tele-Communications, Inc. Shareholder Litigation). In that decision, the Court questioned the quality and independence of the advice received in light of the special committee’s reliance on the company’s legal and financial advisors.  

Directors are paying more attention to D&O insurance coverage and becoming more sophisticated in their demands for coverage. Apart from limits, D&O issues now include careful attention to the divergent needs of, and the potential for conflicts among, the company, management and outside directors. Boards are much more involved in D&O decisions and are increasingly requesting legal representation to ensure that they are adequately protected.

This article originally published in The 2009 Lexpert/American Lawyer Guide to the Leading 500 Lawyers in Canada.