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The Ontario Securities Commission (OSC) recently issued Staff Notice 51-720, Issuer Guide for Companies Operating in Emerging Markets (Guide).1 The Guide should be of interest to all companies that have operations or business in China (or any other emerging market) and that are listed on a Canadian exchange. It should also be of interest to officers and directors of such companies.
In March 2012, the OSC published Staff Notice 51-719, Emerging Markets Issuer Review, following a review of Ontario reporting issuers listed on Canadian exchanges with significant business operations in emerging markets (emerging market issuers).2 The purpose of the review was to assess the quality and adequacy of the issuers’ compliance with disclosure and other regulatory requirements, as well as the adequacy of the gatekeeper roles played by auditors, underwriters, and the exchanges.
The OSC identified several changes required to address the concerns outlined in the review. On November 9, 2012, the OSC published the Guide. The Guide is aimed at providing detailed guidance to emerging market issuers. More specifically, the Guide highlights eight key areas that should be considered by emerging market issuers and their directors and management. The Guide also sets out questions that should be considered by directors and management when deciding how to address risks of doing business in emerging markets. Lastly, the Guide outlines the OSC’s expectations for directors and management regarding compliance with existing disclosure requirements.
Eight Areas of Risk for Emerging Market Issuers
1. Business and Operating Environment
The Guide recognizes that Canadian directors of an emerging market issuer may have limited knowledge and experience regarding its operating environment. An issuer’s board and management must have a thorough understanding of the company’s political, cultural, legal, and business environments. Therefore, they must be cognizant of the need to exercise additional diligence to close any knowledge gap. Regardless of the location of its operations, an issuer is required to adhere to Canadian regulatory requirements. Issuers must ensure that their directors and management have the appropriate orientation to and training on Canadian capital markets’ requirements.
A company is required to describe its business and operations. The disclosure should:
- highlight those operating conditions applicable to the company as a result of operating in an emerging market; and
- capture issues, risks and characteristics unique to operating in the emerging market.
2. Language and Cultural Differences
The board of an emerging market issuer should include members who have appropriate experience in the emerging market. One challenge is that the language and culture of the emerging market may be different from those of North America. Boards should devise appropriate practices, such as the use of an independent translator, to overcome these language and cultural barriers. Boards should also be careful about placing full reliance on local management or local board members who are not independent of the company.
3. Corporate Structure
The Guide recognizes that in emerging markets there may be important reasons to use complex corporate structures, such as (i) structures with multiple layers and numerous subsidiaries and (ii) control through a special purpose entity. However, boards should consider the risks that may flow from complex structures, such as obscuring the misappropriation of assets or other fraudulent activities. Boards should assess whether a simpler structure could also achieve the company’s objectives.
The disclosure of an emerging market issuer should:
- contain a clear description of a company’s structure, and an explanation of how the structure facilitates the company’s business and aligns with the parameters of its operating environment;
- describe the risks associated with the structure and how the risks are managed;
- include a diagram depicting the corporate structure with the narrative disclosure; and
- explain how that structure is necessary or desirable given the company’s operating environment.
4. Related Parties
Related party transactions (RPTs) may represent a heightened risk for emerging market issuers. Boards should ensure that policies and procedures are in place to identify, monitor, and independently evaluate and approve RPTs. Boards should also ensure that the company complies with Form 51-102F1.3 In addition, certain RPTs are subject to Multilateral Instrument 61-101,4 which requires a formal valuation and minority shareholder approval.
Companies are required to disclose the review and approval process adopted by the board and the special committee involved, as well as the material factors on which directors relied in assessing the fairness of the transaction. Issuers are also expected to consider the materiality of RPTs (see Item 13 of Form 51-102F2). Comprehensive disclosure encompassing both quantitative and qualitative information is essential for investors to understand and evaluate RPTs. To achieve that goal, a company should disclose:
- the relationship and identity of the related person or entities;
- the business purpose of the transaction;
- the recorded amount of the transaction and the measurement basis used; and
- any ongoing contractual or other commitments resulting from the transaction.
5. Risk Management and Disclosure
Boards should be sensitive to any risks associated with operations in a particular emerging market and how they impact operations. Boards are required to ensure that they have a sufficient understanding of the legal, regulatory, political, and cultural risks. These risks should be evaluated in the context of the particular emerging market. Boards should recognize that certain risk analysis and mitigation techniques that may be appropriate in the North American context may be less effective in emerging markets.
Boards should ensure that sufficient information about the risks associated with operating in an emerging market is disclosed to investors and that such disclosure is entity-specific. The disclosure should also:
- where the issuer or its operating entities are domiciled in a foreign jurisdiction, explain the risks to investors’ ability to exercise statutory rights and remedies under Canadian securities law;
- describe the process used by the board to oversee the risk management process; and
- where appropriate, describe the company’s risk management strategy and the systems that management has in place to manage and mitigate the risks of operating in emerging markets.
6. Internal Controls
It is challenging for board members who reside in Canada to oversee a company whose operations are located in an emerging market. The time, language, and cultural differences can make communication difficult and may affect the accuracy and timeliness of financial reporting. The unique risks of operating in an emerging market magnify the importance of strong internal controls.
The audit committee of the board should actively oversee the monitoring of any identified weaknesses in internal controls, as well as the risks they create for the company. The audit committee and the board should also oversee the timely remediation of weaknesses and, in the interim, the mitigation of the related risks. When the effectiveness of internal controls is in doubt or ongoing material weaknesses are present, the audit committee should exercise a higher degree of skepticism when reviewing a company’s filings.
The disclosure should be entity-specific and contain information expected by regulators as discussed in Companion Policy 52-109CP. Transparency is important when a company identifies material weaknesses in internal controls over financial reporting (ICFR). The disclosure should allow its readers to understand:
- each of the internal processes or functions that contain a material weakness and its nature;
- the implications of each material weakness on financial reporting and on the company’s ICFR; and
- details of any mitigating factors and remediation plan.
7. Use of and Reliance on Experts
Companies operating in emerging markets may hire experts, such as tax or legal professionals, to assist with complex matters arising in the foreign jurisdiction. However, boards should keep in mind that industry professionals in emerging markets may not be subject to the same rules of professional conduct as they would be in Canada. Therefore, credentials and specialized knowledge of experts in emerging markets should be evaluated to see if they are similar to what would be expected in Canada. In addition, boards should evaluate the level of diligence exercised by experts.
In certain circumstances, companies required to file an AIF under securities law must disclose the names of experts and all of an expert’s interests in the company. Boards should ensure disclosure of experts’ interests is adequate and provides sufficient detail for investors. The disclosure should also:
- identify all experts, both in Canada and in the company’s foreign operations, who have been named in or referred to in a continuous disclosure filing;
- identify the report prepared by or certified by the expert and make reference to the continuous disclosure document that contains the report; and
- quantify all registered or beneficial interests held by, received by, or to be received by the expert in any securities or other property of the company.
8. Oversight of the External Auditor
Pursuant to National Instrument 52-110, a company’s audit committee is directly responsible for overseeing the work of the external auditor, including the resolution of any disagreements between management and the external auditor regarding financial reporting. The audit committee is required to determine if the company’s external auditors have the appropriate expertise and experience to carry out the audit.
The audit committee of an emerging market issuer should take into consideration factors relating to the auditor’s competence, experience, and qualifications in the foreign market. The committee should also enquire about and evaluate the external auditor’s approach in auditing the areas that present risks specific to the company, and understand how the auditor obtained sufficient audit evidence in these areas of risk. In addition to formal meetings, the committee should maintain informal and continuous communication with the auditor. "In-camera" sessions (meetings without the presence of management) with the auditor are also beneficial. Furthermore, the committee must pay particular attention to any signs of delay in the audit schedule or unusual management intervention in the audit process.
When an auditor resigns, directors are expected to consider whether the reasons for the auditor’s resignation should also be disclosed even if they do not represent a reportable event, so that investors have full access to pertinent information about the company.