Rules and prevarications: Bill 198 is in force and the OSC's new rules are under review. All of this is promising, but it's only as powerful as we make it.

When the Sarbanes-Oxley Act was first introduced last summer, Canada and the rest of the world got a sense of how securities laws would change for everyone in the near future. It took the Ontario government longer to table a comparable bill, but it did happen in October and was enacted in December 2002--Bill 198.

Bill 198 is just one of a number of recent measures to boost investor confidence in Canada's capital markets. The Canadian Public Accountability Board (CPAB) was also launched by the CSA, the Office of the Superintendent of Financial Institutions and the Canadian Institute of Chartered Accountants (CICA), to provide independent oversight of auditors of public companies. There was also a commitment by the TSX to revise its procedures to include new corporate governance listing standards. And the Senate Banking Committee has recommended new fiduciary responsibilities for boards, while also making suggestions on how boards should interact internally and with management.

But Bill 198 is unique in that it is law, and it should have the power to help create a better governance environment, if used effectively. The Bill draws on both the Five Year Review Committee, established by Ontario's Minister of Finance, and the U.S. Sarbanes-Oxley Act for its substance. It emphasizes that: the Ontario Securities Commission (OSC) should have enhanced rule-making authority, including determining the responsibilities and make-up of audit committees; the OSC should have more effective enforcement powers and that there should be enhanced sanctions for courts; there should be statutory civil liability for secondary market disclosures; and that there should be an express prohibition of fraud and market manipulation in the Securities Act.

Bill 198 also deals with many of the same fundamental issues as Sarbanes-Oxley, including: auditor independence; director and audit committee responsibilities and their independence from management; CEO and CFO accountability for financial reporting and internal controls; better and faster disclosure to the public; and enhanced penalties for illegal activities.

Rules and penalties

In April of this year, most of the bill's amendments to the Securities Act were put in place, though the most controversial provisions were postponed. The latter included anti-fraud provisions that specifically censure fraud and market manipulation, and the introduction of civil liability for secondary market disclosure. If these are passed in their current form, it will mean that investors will have the right to sue issuers, directors and officers (and others, depending on the situation) for misrepresentations or not disclosing information in a timely manner. This applies to both written and oral misrepresentations, though the penalties are more severe and wide-reaching for written statements. The civil liability for misrepresentation in a document would be limited to $1 million or 5% of the issuer's market capitalization (whichever is greater), which could still be quite damaging for many companies. The Ontario government plans to go ahead with these provisions in some form before the end of the year.

Bill 198 shifts the burden of proof in misrepresentation cases from the plaintiff to the defendant. This will place substantial burdens on directors, officers and issuers that didn't exist before. The burden of proof rests with the defendant if the misrepresentation is made in a core document--a prospectus, takeover bid circular, annual financial statement, rights offering circular, management's discussion and analysis, annual information form, information circular, and material change report--or where the defendant is an expert. That creates a pretty open field for civil action. Nor does the plaintiff have to prove that she relied on the misrepresentation.

The OSC, meanwhile, can now issue fines as high as $5 million for a person or company (or its directors or officers) that breaches Ontario's securities laws and/or makes a misleading or untrue statement to the OSC or in a filing. Possible imprisonment can be set as high as five years less a day as well. Any insider trading could garner a $5 million fine as well. Fines can be levied for any other failures to comply with Ontario securities law, or for acquiescing in non-compliance.

The OSC also has enhanced powers to improve transparency and disclosure and audit committee design. These subjects were all covered in the OSC's draft corporate governance rules, released in late June 2003. The rules state that both CEOs and CFOs will have to certify the accuracy of end-of-year and quarterly financial statements. The wording of this is important. The statement will have to clearly state that the filings don't contain a misrepresentation; that the company's financial statements fairly represent the financial condition of the issuer (without qualifying the statement with references to GAAP); and that there are reasonable internal controls. This second statement demonstrates the emphasis that will be placed on fair presentation of financial conditions--complying with GAAP obviously isn't good enough anymore.

Internal controls take on a new significance with Bill 198 as well. Once the certification process has been in place for a year, CEOs and CFOs are required to review their internal controls and disclose any problems to the company's audit committee and independent auditors. The bill gives the OSC the right to require CEOs and CFOs to certify and evaluate appropriate disclosure controls and procedures.

The OSC's draft governance rules require that audit committees of TSX-listed companies be composed entirely of independent, and financially literate, directors. It also supports the leadership role of the CPAB, including the requirement that financial statements be audited by a firm that is in good standing with the CPAB.

Companies listed on the junior TSX Venture Exchange will be exempt from the audit committee design requirement. Also, issuers that are listed on a U.S. exchange and that comply with U.S. regulations will be exempt from the provisions of the OSC's audit committee rule.

The OSC's new rules have almost unanimous national backing; 12 of the 13 provincial and territorial securities regulators support the initiative. The only holdout is British Columbia. Douglas Hyndman, chairman of the British Columbia Securities Commission, issued comments rejecting two of the three core OSC proposals a day after their release. He felt that the CEO/CFO certification rule "adds nothing meaningful to the existing legal duties of the officers to ensure that the issuer's disclosure is not false or misleading." He went on to say that "The directors and executive officers of the issuer are responsible (subject to due diligence defenses where appropriate) if the issuer violates its disclosure obligations. Requiring the CEO and CFO to certify that the issuer's financial disclosure give a fair presentation of the financial condition arguably adds nothing but a nuisance filing requirement."

The B.C. Securities Commission felt that the audit committee rule simply went too far. In the same statement, Hyndman said, "We do not believe it is necessary, desirable or even possible to codify. (hoards) into a one-size-fits-all requirements."

Thus far, B.C. appears to be a lone voice in the wilderness. The deadlines for comments on these draft rules was in late September, so we shall see how much more resistance there is to these ideas now.

Realistic expectations

Chances are there won't be a lot of resistance to these rules. It is true that CEOs and CFOs shouldn't be held solely responsible for the financial well being of the company. However, an element of trust in the financial information given to them is essential for boards of directors to do their jobs correctly. It is not reasonable to expect them to review all of the financial information produced by the company. However, it is reasonable to expect that from the CEO and CFO. What is reasonable to expect from a board of directors is that they maintain key people within their ranks that can then interpret the information provided and pin-point areas of concern.

The new rules basically create a situation in which there are incentives to create greater accountability throughout the organization. If a CEO or CFO has to sign off on a report, they, in turn, will be sure to insist that their subordinates follow similar procedures.

One of the main arguments against a Canadian version of the Sarbanes-Oxley Act was that it would reduce governance to a series of axles, whereas Canada's governance structure has, by and large, been predicated on basic principles. Barbara Stymiest's original argument against reform measures was that more rules would make the Canadian market less appealing to investors. Indeed, in the U.S. there is evidence already that Sarbanes-Oxley's stringent regulations have convinced some publicly traded companies to go private (CMA Management, June/July 2003).

Canada's model, as set out by Bill 198, suggests that we have found some middle ground. The junior Venture Exchange remains more open for smaller companies, while the TSX will be more stringently monitored. Although this may mean the loss to the exchange of a few companies in the short term, in the long term it may bolster its image and its appeal. Also, there is a clear understanding that when a CEO or CFO signs off on financial statements, they are not doing so based on traditional financial measures or rules-based systems like GAAP alone--they are considering the complete financial picture of the company, in an honest, principled manner.

Teeth or teething?

All of this will be meaningless, however, without effective punishment for those that break the rules. So far, Ontario's regulator hasn't shown itself willing to be the bad cop, though. The OSC had a perfect opportunity to show that they were going to be tough with irresponsible directors in the recent YBM Magnex case--in which a company created by people allegedly connected with the Russian mafia raised millions on the TSE and then disappeared.

Basically five of the company's eight directors received the equivalent of a slap on the wrist for serious breaches of securities duty. One had to pay $250,000 and was barred from serving as an officer or director for five years. Two other directors had to pay $75,000 in costs and were barred for three years. But the OSC was also culpable in the case, having approved the prospectus despite the fact that the FBI was investigating the company, with the assistance of the RCMP and British authorities. Thus, in Canada we have an institution that is policy. maker and regulator--and, of course, now has new enforcement powers. But will it use those enforcement powers effectively? If the YBM case is anything to go by, it's unlikely. No rules will make a market more appealing if they aren't used. Without enforcement, bills and governance rules are meaningless.

Kenneth Biggs, FCA, CMA, FCMA is a past chair of CMA Canada and served on a number of corporate boards prior to his retirement. Robert Colman is editor-in-chief of CMA Management.