Canadian securities regulators have amended Multilateral Instrument 52-110, Audit Committees, which contains the tests for determining whether directors are independent. The definition of independence in MI52-110 applies not only for determining eligibility to serve on the issuer’s audit committee, but also for assessing whether directors are independent for the purposes of the new corporate governance disclosure rule that requires issuers to publicly identify which board members are and are not independent and to disclose whether or not the board is composed of a majority of independent directors and whether or not certain board committees are composed entirely of independent directors.

Generally, the amendments correct some technical glitches and further harmonize the definition of independence with the definition in the New York Stock Exchange’s corporate governance listing standards. The amendments, discussed below, will be effective on June 30, 2005.

Independence for Directors Generally

A director is "independent" if he or she has no direct or indirect material relationship with the issuer or, under the amendments, a parent company or a subsidiary of the issuer. A "material relationship" is one that could, "in the view of the issuer’s board, be reasonably expected to interfere with the exercise of a member’s independent judgment." The regulators have specifically acknowledged, as do the current TSX guidelines and the NYSE listing standards, that shareholding alone will not necessarily interfere with the exercise of a director’s independent judgment. However, the board should assess all other relationships between the issuer and a shareholder to determine whether any of those are material relationships.

A director will be deemed to have a material relationship with the issuer if he or she has one of the following relationships with the issuer (which in each case below must be read as including a parent company and a subsidiary of the issuer).

  • Employment with the Issuer. The director is or was within the last three years an employee or executive officer1 (or has an immediate family member who is or was within the last three years an executive officer) of the issuer. A director is not disqualified from being independent if he or she previously acted as an interim CEO of the issuer, or currently acts or previously acted as a part-time chair or vice-chair of the board or any board committee.
  • Relationship with the Auditor. The director (a) is a partner or employee of the issuer’s internal or external auditor; (b) was within the last three years a partner or employee of that auditing firm and personally worked on the issuer’s audit during that time; or (c) has a spouse, minor child or a child who lives in the director’s home and who (i) is a partner of the issuer’s internal or external auditor; (ii) is an employee of the auditing firm and works in the audit, assurance or tax compliance (but not tax planning) practice; or (iii) was within the last three years a partner or employee of that auditing firm and personally worked on the issuer’s audit during that time. For this purpose, a partner does not include a partner whose interest in the auditing firm is limited to the receipt of fixed amounts of compensation (including deferred compensation) for prior service if the compensation is not contingent in any way on continued service.
  • Compensation Committee Interlocks. The director is or was within the last three years (or has an immediate family member who is or was within the last three years) an executive officer of another entity if any of the issuer’s current executive officers serve or served at the same time on the compensation committee of that other entity.
  • Compensation Exceeding $75,000 per Annum. The director has (or an immediate family member who is employed as an executive officer of the issuer has) received more than $75,000 in direct compensation from the issuer during any 12-month period within the last three years, excluding (a) a fee for acting as a director or committee member, including as chair of the board or any committee of the board; and (b) fixed amounts of compensation under a retirement or deferred compensation plan for prior service with the issuer if receipt is not in any way contingent on continued service.

"Immediate family member" means a person’s spouse, parents, children, siblings, father- and mother-in-law, sons- and daughters-in-law, brothers- and sisters-in-law, and anyone (other than an employee) who lives in the person’s home.

The three-year look-back period is being phased in. Relationships with the issuer that ended before March 30, 2004 (the date on which MI52-110 became effective) will not taint a director’s independence. Directors will be given until June 30, 2005 to sever relationships with a parent company or subsidiary that taint their independence.

Additional Independence Criteria for Audit Committee Members

In addition to the above criteria, directors must meet the following two additional tests to be considered independent for audit committee purposes.

  • No Compensation. The director cannot after appointment to the audit committee accept, directly or indirectly, any consulting, advisory or other compensatory fee from the issuer or any of its subsidiaries,except (a) a fee for acting as a director, committee member, or part-time chair or vice-chair of the board or any board committee; and (b) fixed amounts of compensation under a retirement or deferred compensation plan for prior service with the issuer if receipt is not in any way contingent on continued service.

A fee is considered to have been indirectly received by the director if it is received by (a) the director’s spouse, a minor child or a child who lives in the director’s home; or (b) an entity in which the director is a partner, a member or an officer (such as a managing director or executive officer) if that entity provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any of its subsidiaries, unless the director is a limited partner or a non-managing member of the entity and plays no active role in providing services to the entity.
  • No Affiliation. The director is not an affiliated entity of the issuer or any of its subsidiaries. An "affiliated entity" means an individual or a company that controls, is controlled by or is under common control with the issuer. In addition, an individual is himself or herself an affiliated entity of the issuer if the individual holds any of the following positions with an affiliated entity: a director who is also an employee, an executive officer, a general partner or a managing member.

"Control" for this purpose means having the direct or indirect power to control the issuer, whether through ownership of voting securities or otherwise. An individual who owns, directly or indirectly, 10% or less of any class of voting securities of the issuer will be deemed not to control the issuer if the individual is not an executive officer of the issuer.

Exemptions That Permit Non-Independent Members to Serve on the Audit Committee

Issuers, other than venture issuers, are required to have an audit committee composed entirely of independent directors. There are, however, several situations where non-independent directors are permitted to serve on the audit committee.

  • Initial Public Offering. Following an initial public offering, an issuer has up to one year to constitute its audit committee with independent directors. Initially, there must be at least one independent director and a majority must be independent within 90 days of issuance of the receipt for the prospectus. The board of the issuer must, however, be satisfied that the exemption will not have a material adverse effect on the audit committee’s ability to act independently and satisfy the other requirements of the rule.
  • Controlled Companies. There are two exemptions in the context of controlled companies:

- An independent director of an affiliated entity may serve on the issuer’s audit committee if he or she is otherwise independent of the issuer.

- An individual who would otherwise be barred because he or she is an affiliated entity or has a tainting relationship with the issuer’s parent or subsidiary may nevertheless serve on the issuer’s audit committee if all of the following requirements are met: (a) he or she is not an executive officer, general partner or managing member of a publicly traded affiliated entity; (b) he or she does not chair the committee; (c) the board of the issuer determines that the individual is able to exercise impartial judgment and that his or her participation on the audit committee is in the best interests of the issuer and the shareholders; and (d) a majority of the members of the audit committee are independent. This exception permits controlling shareholders, executive officers of private holding companies and non-executive officers of public holding companies to serve on the issuer’s audit committee if they are otherwise independent of the issuer.
  • Events Beyond Control. When an audit committee member ceases to be independent for reasons beyond his or her control, or where a member dies, becomes disabled or resigns, the issuer is granted a cure period. The cure period expires on the later of the next annual meeting of shareholders and six months from the event that gave rise to the loss of independence or vacancy, as the case may be. The board of the issuer must, however, be satisfied that the exemption will not have a material adverse effect on the audit committee’s ability to act independently and satisfy the other requirements of the rule.
  • Limited and Exceptional Circumstances. An individual who lacks independence may serve on the audit committee for up to two years if (a) he or she does not chair the committee; (b) the board of the issuer determines that the individual is able to exercise impartial judgment and that his or her participation on the audit committee is in the best interests of the issuer and the shareholders; and (c) a majority of the members of the audit committee are independent.

To qualify for this "limited and exceptional circumstances" exemption, the individual cannot (a) accept, directly or indirectly, any consulting, advisory or other compensatory fee from the issuer or any of its subsidiaries (except (i) a fee for acting as a director, committee member, or part-time chair or vice-chair of the board or any board committee; and (ii) fixed amounts of compensation under a retirement or deferred compensation plan for prior service with the issuer if receipt is not in any way contingent on continued service); (b) be an affiliated entity of the issuer; or (c) be, or have an immediate family member who is, an employee or officer of the issuer.

The amendments to MI52-110, Audit Committees, can be obtained on the Ontario Securities Commission’s website at:
www.osc.gov.on.ca/Regulation/Rulemaking/Current/Part5/rule_20050415_52-110_audit-comm-cp.jsp

Footnotes

1. "Executive officer" includes the chair, the vice-chair, the president, vice-presidents in charge of principal business units, divisions or functions, and any other individual (whether employed by the issuer or not) who performs a policy-making function in respect of the issuer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.