CSA Rejects SOX 404 For Canada

The Canadian Securities Administrators ("CSA") announced on March 10, 2006 that the Canadian securities regulatory authorities do not intend to adopt section 404 of the Sarbanes-Oxley Act of 2002 ("SOX 404") in Canada and that they are not proceeding with Multilateral Instrument 52-111 Reporting on Internal Control over Financial Reporting ("MI 52-111"). Instead, the CSA is proposing to expand Multilateral Instrument 52-109 Certification of Disclosure in Issuers’ Annual and Interim Filings ("MI 52-109") to include the following additional provisions in respect of internal control over financial reporting:

• The CEO and CFO of a reporting issuer, or persons performing similar functions, will be required to certify in their annual certificates that they have evaluated the effectiveness of the issuer’s internal control over financial reporting as of the end of the financial year and caused the issuer to disclose in its annual MD&A their conclusions about the effectiveness of internal control over financial reporting as of the end of the financial year based on such evaluation.

• The issuer will not be required to obtain from its auditor an internal control audit opinion concerning management’s assessment of the effectiveness of internal control over financial reporting.

• These requirements will apply to all reporting issuers, other than investment funds, in all Canadian jurisdictions.

• The earliest that these requirements will apply is in respect of financial years ending on or after December 31, 2007 ¹

This decision of the CSA reflects a dramatic change in direction and presents management of public companies and their boards with significant challenges to provide the same rigor in the design and evaluation of internal control over financial reporting and the same level of investor protection as does SOX 404.

The tone of the CSA’s notice, however, reflects that its position on this issue may evolve to a higher level of regulatory requirements in the future, depending on experience with SOX 404 in the U.S. and with these proposed Canadian rules and on possible SEC initiated future changes to SOX 404. While changes are to be expected, some preliminary comments based on the current Canadian development are reflected in the following points:

• The withdrawal of MI 52-111 is bad news for the Canadian capital markets and investor protection and very unpleasant news for independent directors of companies listed only in Canada. In its deference to issuers, the CSA may have misjudged the expectations of Canadian and foreign investors for higher levels of corporate governance over financial reporting and ones which are at least substantively equal to those applicable to Canadian companies listed in the U.S.
• The Canadian domestic capital market will have a two-tier regulatory approach to internal control over financial reporting: inter-listed companies will comply with the U.S. rules which require separate management reporting plus auditor attestation ("SOX 404 Inside"); and domes-tically-listed companies will have only certification of disclosure by the CEO and CFO without auditor attestation.
• As the result of the withdrawal of MI 52-111, directors of Canadian domestically-listed companies will have increased personal responsibility and liability in satisfying their obligations to oversee the adequacy of the company’s internal control over financial reporting and to approve accurate and complete disclosures concerning the effectiveness of such control.
• If the MD&A or AIF contains a misrepresentation concerning the company’s internal control over financial reporting, including the accuracy of the CEO’s and CFO’s conclusions about the effectiveness of internal control over financial reporting and the process for evaluating that effectiveness, the directors may be personally liable for damages under Bill 198 unless the directors prove that they conducted a "reasonable investigation" (due diligence) in relation to such disclosures. They will not be able to rely on an auditor’s "expert" report that they would receive under SOX 404.
• Independent directors will shiver in fearful anticipation of regulatory investigations and lawsuits if their company has to restate prior year financial statements and they do not have an adequate due diligence defence.
• Independent directors will be well advised to reject pressures from company management that they do not need to engage the auditors to assist them in their review of the effectiveness of internal control over financial reporting and the accuracy of the company’s disclosure about such effectiveness.
• To avoid personal liability under Bill 198, CEOs and CFOs will have to be uncharacteristically frank and disarming in disclosing the effectiveness of their company’s internal control over financial reporting and particularly in disclosing identified material weaknesses.
• Notwithstanding the decision of the CSA not to proceed with SOX 404 in Canada, in light of potential liability under Bill 198, as well as responding to the expectations of their investors, CEOs, CFOs and directors of Canadian listed companies will be wise to adopt voluntarily the substance of SOX 404.
• Canadian issuers that expect to raise capital in the U.S. markets should adopt SOX 404, notwithstanding the CSA’s decision that it is too costly.
• Hopefully, the CSA approach will not jeopardize the ability of Canadian listed companies, which do not adopt SOX 404 voluntarily, to access the MJDS system.

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