On March 20, the Ontario Securities Commission published a staff notice outlining the results of its regulatory review of emerging market issuers. The review was prompted by recent concerns involving some emerging market issuers, given the growing importance of these issuers to global and Canadian capital markets. As we discussed earlier this week, OSC Staff Notice 51-719 Emerging Market Issuers Review (the Staff Notice) identifies the following four principal areas of concern: (i) issuer governance and disclosure; (ii) the adequacy of the external audit function; (iii) due diligence conducted by underwriters; and (iv) the exchange listing and approval process.
The review encompassed issuers listed on the TSX, TSXV or the CNSX whose principal active operations were outside of Canada and in regions such as Asia, Africa, South America and Eastern Europe. This resulted in a pool of 108 issuers with a total market capitalization of $40 billion (in contrast to over 4,000 exchange-listed reporting issuers in Canada with a market capitalization of $2.39 trillion).
Issuer Governance and Disclosure
With respect to governance practices, OSC Staff noted deficient engagement of some boards and audit committees in their oversight of management and sense of responsibility for the stewardship of the issuer, including in some cases, very little contact with management in the emerging market jurisdiction running the business. While OSC Staff recognize that board members may face a steep learning curve in understanding the issuer's business and operating environment, they are concerned with the lack of knowledge shown by some with the cultural and business practices of the local jurisdiction. They also expressed concern about the propriety and transparency of certain complex legal structures (such as multiple legal entities supporting a single operating business) along with the ability to manage resulting risks.
OSC Staff recommend, among other things, improving corporate governance practices generally, clarifying the regulatory expectations of CEOs and CFOs in conducting reasonable due diligence to support their certifications, requiring better disclosure regarding complex corporate structures and relevant risk factors, maintaining appropriate books and records in Canada, and considering minimum language competency in the local language for directors as well as minimum Canadian director residency requirements.
The Staff Notice also notes several areas of potential concern regarding the external audit function. These include a lack of sufficient procedures to understand and scrutinize information provided by an issuer or foreign component auditor, as well as lack of an appropriate level of professional skepticism when examining relevant information. Examples include lack of independent verification of management representations and conclusions involving judgment that are not supported by underlying analysis. It was also not clear to OSC Staff in some cases what was done to understand the issuer's business environment. Further, OSC Staff expressed concern with insufficient involvement by the group auditor with underlying operations, particularly where those operations were entirely in emerging markets with the foreign component auditor performing all the audit procedures.
Recommendations focused on auditors include facilitating access to audit working papers of Ontario reporting issuers, working with the Canadian Public Accountancy Board (CPAB) to analyze whether securities rules can be enhanced to allow more information sharing in connection with the oversight of audit firms, and examining whether suitability standards for auditors of reporting issuers should be developed.
According to OSC Staff, being uniquely situated to verify information about an issuer, underwriters should participate in the offering process with a "healthy amount of scepticism" regarding claims of management. Due diligence procedures should therefore be designed to detect material misstatements and omissions in prospectus disclosure, and findings should be clearly and concisely documented. On this point, the report notes that a lack of explicit requirements for underwriter due diligence was evident in the wide range of policies and practices observed. OSC Staff also noted a lack of professional scepticism and rigor during the due diligence process in some cases, including when "red flags" should have prompted further follow-up. The amount and degree of due diligence documentation also varied, and in some instances did not reflect the process undertaken or the risks identified.
As such, the report ultimately recommends the establishment of a consistent and transparent set of requirements for the conduct of due diligence by underwriters, that includes best practices for documentation and for due diligence calls and site visits. Specific issues to be addressed include internal control and risk management, translation and foreign language issues, local business practices and business environment, and cultural norms affecting an issuer’s operations and business.
Concerns cited with the listing and approval process include the lack of requirements for emerging market issuers to maintain a meaningful Canadian presence, as well as the lack of public disclosure where the exchange waives listing requirements for a specific issuer. The Staff Notices also expresses concern regarding the significant reliance exchanges place on third parties such as sponsors to conduct due diligence of prospective listings.
OSC Staff thus recommend, among other things, that exchanges review whether additional listing requirements are needed for emerging market issuers as well the extent to which third parties should be relied on for due diligence, and provide greater transparency where listing requirements are waived.