Canadian Securities Law : Canadian Securities Lawyer & Attorney : Stikeman Elliott Law Firm : Montreal, Ottawa, Calgary, Vancouver, Montreal, Toronto

The Staff Notice highlights deficiencies noted by staff as well as areas where, in staff’s view, disclosure can be enhanced. The areas covered by the Staff Notice include the following:

Identification of FLI

The Staff Notice highlights that issuers have taken different approaches to identification of FLI (as required by section 4A.3 of NI 51-102), including that many issuers identified material FLI solely through a cautionary paragraph at the beginning or end of the disclosure document. Where issuers do identify material FLI in such manner, the CSA have encouraged issuers to give readers an indication of the nature of the material FLI covered in the document, which, in staff's view, would allow an investor to more readily identify material FLI in the document in question. 

Disclosure regarding material risk factors and material factors or assumptions

In respect of the requirement to identify material risk factors and material factors or assumptions, (as required under section 4A.3 of NI 51-102) staff note that various issuers have either neglected to discuss the underlying factors or assumptions or stated that there were factors or assumptions without identifying them: disclosure which, in their view, does not satisfy the requirements of NI 51-102. With respect to the issue of incorporating relevant material risk factors and material factors or assumptions by reference, the Staff Notice states that while NI 51-102 does not preclude this, issuers should consider whether incorporation by reference enables a reader to readily inform himself or herself of the material risk factors, and material factors or assumptions, associated with the material FLI. The Staff Notice also cautions that issuers should avoid “boilerplate” disclosure, and strive to disclose material risk factors and material factors and assumptions that are relevant to the FLI being presented. Finally, staff are also encouraging issuers to consider using more user-friendly formats for disclosing FLI, such as tables or other methods that allow readers to clearly link specific material risk factors and material factors and assumptions to the particular FLI.

Disclosure of goals or targets, purpose of FLI and updating requirement

With respect to the disclosure of goals or targets, the purpose of FLI and the requirement to update FLI, the Staff Notice advises that:

• in certain circumstances, disclosure of a goal or target can constitute FLI (namely, where the achievement of the target or goal would be "possible" based on assumptions about future economic conditions and courses of action) and that in such circumstances, the disclosure should comply with the requirements of NI 51-102;
   
• the requirement (under section 4B.3(b) of NI 51-102) to disclose the purpose of the FLI and caution readers that the information may not be appropriate for other purposes is in addition to the material risk factors and material factors or assumptions disclosure generally required by section 4A.3, and that disclosure of material risk factors and material factors or assumptions contained in a cautionary paragraph at the beginning or end of a document generally will not satisfy this requirement; and
   
• that section 5.8(2) of NI 51-102 requires issuers to update previously disclosed FLI in certain circumstances, as such, issuers should ensure their policies comply with these requirements and should not be making statements to the effect that the issuer does not assume any obligation to update FLI.

Finally, the Staff Notice reminds issuers that future-oriented financial information (FOFI) or a financial outlook must be based on the accounting policies that the reporting issuer expects to use to prepare its historical financial statements for the period covered. As reporting issuers will be required to transition to international financial reporting standards (IFRS) for fiscal years beginning on or after January 1, 2011, this means that issuers should ensure that FOFI and financial outlooks that cover their 2011 fiscal year are based upon IFRS.

As a result of the amendments to OSC Rule 45-501, uncertainty has arisen in the market in the context of foreign issuer private placements and the disclosure requirements, if any, regarding forward-looking information, including future-oriented financial information and financial outlooks. To address this uncertainty, the OSC recently granted exemptive relief to certain foreign dealers allowing for the distribution of securities by way of private placement to "accredited investors", provided the foreign offering documents contain safe-harbour disclosure that complies with U.S. federal securities laws or a disclaimer that the disclosure may differ from that which is required under Ontario securities laws. To deal with this issue in the long-term, the OSC has also proposed to repeal these requirements from OSC Rule 45-501. However, if implemented, this proposed repeal will not take effect until December 2008. Until then, staff at the OSC have advised that they will attempt to deal with exemptive relief applications on an expedited basis.

Until such time as the OSC repeals the forward-looking information disclosure requirements in OSC Rule 45-501, foreign dealers and issuers offering foreign securities into Canada should be aware of these potential issues in order to avoid any unnecessary delays when carrying out private placements into Canada. In addition, consideration should be given to applying for exemptive relief from the forward-looking information requirements in OSC Rule 45-501 consistent with the relief recently granted by the OSC.
 

The requirements in the amended NI 51-102 will apply to all FLI disclosed by a reporting issuer, other than FLI contained in oral statements.  The Companion Policy 51-102CP makes clear that these FLI requirements apply not only to information filed with securities regulators, but also amongst other things, news releases, website material and marketing materials.

Under the new rules an issuer may not disclose FLI unless it has a "reasonable basis" for the FLI.  In addition, disclosure of any material FLI must comply with each of the following elements:

• FLI must be identified as such;
• Users must be cautioned that actual results may vary from the FLI and material risk factors that could cause actual results to differ materially from the FLI must be identified;
• The material factors or assumptions used to develop the FLI must be stated; and
• The issuer must describe its policy for updating FLI if it includes procedures in addition to those described in the section of NI 51-102 dealing with updates to FLI required in the Management's Discussion and Analysis (MD&A) or MD&A supplement.

These may sound familiar as some of the above requirements comprise elements of the defence to misrepresentation in FLI as contained in the secondary market civil liability provisions of the Securities Act (Ontario) and the securities legislation of other provinces.

FOFI and financial outlooks comprise a subset of FLI and, in addition to those set out above, further requirements exist for this category of FLI.  In preparing FOFI or a financial outlook, a reporting issuer must:

• Use assumptions that are "reasonable and appropriate in the circumstances";
• Limit the period covered by the FOFI or financial outlook to a period for which the information in the FOFI or financial outlook can be reasonably estimated;
• Use the accounting policies the reporting issuer expects to use to prepare its historical financial statements for the period covered by the FOFI or the financial outlook;
• State the date management approved the FOFI or financial outlook; and
• Explain the purpose of the FOFI or financial outlook and caution readers that the information may not be appropriate for other purposes.

Disclosure Requirements Relating to Previously Disclosed Material FLI

NI 51-102 will also require that a reporting issuer must discuss in its MD&A or MD&A supplement, disclosure relating to updates, comparison to actual results and withdrawal of material FLI.  Exceptions are available from the inclusion of such information in certain circumstances where the prescribed disclosure has already been included in a news release.

Peripheral Amendments

The amendments to NI 51-102 will be complemented by the revocation of NP 48, as well as amendments to various other instruments, rules, policies and forms.  Amendments to the Companion Policy to NI 51-102 will include interpretation guidelines, while other instruments and forms will be amended to clarify that the FLI requirements in NI 51-102 apply to documents such as short and long form prospectuses, rights offering circulars and offering memoranda prepared in Form 45-106F3 and F4. The contents of offering memoranda in general (i.e. those not governed by National Instrument 45-106 Prospectus and Registration Exemptions) are governed by securities legislation at the provincial or territorial level, and it remains to be seen whether these requirements will be uniformly adopted in all Canadian jurisdictions for such offering memoranda as well.  At the time of writing this update the Ontario Securities Commission had proposed amendments to its rules, also effective December 31, 2007, that will require any document that qualifies as an "offering memorandum" in Ontario to comply with these new FLI disclosure requirements.  These new FLI disclosure requirements will apply to all reporting issuers, but also to non-reporting issuers in certain prescribed circumstances.

Implementation and transition

The new FLI requirements are scheduled to come into force on December 31, 2007.

Under NI 51-102, disclosure of FLI will have to comply with each of the following elements:

• FLI must not be disclosed unless the issuer has a "reasonable basis" for the FLI;
• FLI must be identified as such;
• Users must be cautioned that actual results may vary from the FLI and material risk factors that could cause actual results to differ materially from the FLI must be identified;
• The material factors or assumptions used to develop the FLI must be stated; and
• The issuer must describe its policy for updating FLI if it includes procedures in addition to those described in the section of NI 51-102 dealing with updates to FLI required in a Management's Discussion and Analysis (MD&A) supplement.

FOFI and financial outlooks comprise a subset of FLI and, along with the requirements set out above, will be subject to the following additional requirements:

• In preparing FOFI, assumptions used must be "reasonable and appropriate in the circumstances";
• The period covered by the FOFI or financial outlook must be limited to a period for which the information in the FOFI or financial outlook can be reasonably estimated;
• Accounting policies used should be those the issuer expects to use to prepare its historical financial statements for the period covered by the FOFI or the financial outlook;
• Disclosure of FOFI or a financial outlook must state the date it was approved by management, explain the purpose of it and caution to readers that the information may not be appropriate for other purposes.

The application of the proposed amendments to prospectuses and rights offering circulars is national in scope. As the contents of offering memoranda are governed by securities legislation at the provincial or territorial level it remains to be seen whether these requirements will be uniformly adopted for offering memoranda in all Canadian jurisdictions. At the time of writing this update the Ontario Securities Commission had proposed amendments to its local rules that would require FLI contained in an offering memorandum to comply with these requirements.

For the vast majority of foreign non-reporting issuers that undertake private placements to "accredited investors" in Canada and include FLI or FOFI in their underlying documents these new rules will have no impact. These rules do not impose an audit requirement and the standards adopted for disclosure in the underlying documents would normally satisfy the new standards to be included in NI 51-102. The establishment of these rules does, however, remove uncertainty and for this reason alone is welcome.

Background

Forward-looking information is defined under the Securities Act as "disclosure regarding possible events, conditions or results that is based on assumptions about future economic conditions and courses of action and includes future oriented financial information with respect to prospective results of operations, financial position or cash flows that is presented as either a forecast or a projection."

To rely on the forward-looking information defence, the document or public oral statement in question is required to contain, "proximate" to the forward-looking information:

• reasonable cautionary language identifying the forward-looking information and the material factors (risk factors) that could cause actual results to differ from a conclusion, forecast or projection contained in it; and

• a statement of the material factors or assumptions that were applied in drawing a conclusion or making a forecast.

For public oral statements a person is deemed to have satisfied these requirements if he or she states that (i) the oral statement contains forward-looking information, (ii) actual results could differ materially from what is expected, (iii) certain factors or assumptions were applied in arriving at the forward-looking information, and (iv) that additional information about the material factors or assumptions that were applied in arriving at the forward-looking information and the material risk factors that may affect actual results is contained in a readily-available document. This means a document that is filed with the OSC or otherwise generally disclosed must contain the required cautionary statements and be identified for further reference. As well, to satisfy the forward-looking information defence for both documents and public oral statements, the person or company must have a reasonable basis for drawing the conclusions or making the forecasts or projections contained in the forward-looking information.

What the OSC says about the Defence

Recognizing that forward-looking information is both valuable and necessary "yet by its very nature carries a level of uncertainty," the Draft Policy states that the objective behind the forward-looking information defence is to avoid a "disclosure chill" on account of the risk of liability, while facilitating balanced and responsible disclosure about future prospects. The need for the OSC to provide clarification arises from the concern and confusion caused in the market by the specter of secondary market liability together with the technical aspects of the forward-looking information defence.

These technical aspects include the requirement that the cautionary language required to satisfy the defence be presented proximate to the forward-looking information itself and include a statement of both the relevant risk factors and the underlying assumptions. Depending on how these elements of the defence are interpreted and applied, it has the potential of rendering a disclosure document confusing, unwieldy and potentially of little use in conveying what is sought to be communicated to the reader.

In the Draft Policy, the OSC explains that it does not interpret the term "proximate" to require immediate juxtaposition of the cautionary language in every instance and where a disclosure document contains various threads of forward-looking information that are subject to common assumptions and risk factors, the proximity requirement may generally be satisfied by adding the required cautionary language either before or after the disclosure containing these threads. The OSC has also clarified that where particular assumptions and risk factors apply equally to multiple instances of forward-looking information, issuers should use their judgment in making cross-references to cautionary language in a manner that supports the principle underling the forward-looking information defence (namely, that an investor reading or hearing the information should be able to identify the forward-looking information, understand that it is being provided and be informed of the material assumptions and risk factors underlying or associated with it). In the OSC's view, these principles suggest that the more closely tied a particular risk factor or assumption is to a particular conclusion, forecast or projection, the more "proximate" it should be to the forward-looking information.

The OSC has also stated that in its view the reference to "material" risk factors requires the disclosure of only "significant and reasonably foreseeable" risk factors and does not require the issuer to anticipate and discuss every risk factor that could conceivably cause actual results to differ from expectations. Similarly, the requirement to state the assumptions underlying the forward-looking information is also subject to a materiality standard and does not require an exhaustive statement of every factor or assumption applied.

To satisfy the forward-looking information defence the person or company must also have a reasonable basis for drawing the conclusion or making the forecasts or projections contained in the forward-looking information. The OSC believes that the reasonableness of assumptions applied, inquiries made and the process followed in preparing and reviewing the information are all factors to be considered in determining what is a "reasonable basis" for this purpose.

With respect to the defence for misrepresentations in forward-looking information contained in public oral statements, the OSC states that the requirement that the person making the oral statement also make certain required cautionary statements (in order to be deemed to have satisfied the forward-looking information defence) should be interpreted pragmatically and is not meant to be exhaustive. This means, for example, that in appropriate circumstances these cautionary statements may be made by one person on behalf of another person who actually makes the statement containing the forward-looking information. Finally, the OSC has also expressed its view that it does not interpret the forward-looking information defence to impose a duty to update such information beyond what is currently required under Ontario securities law or otherwise.

The Draft Policy cautions that the guidance contained in it represents the views of the OSC only, which do not have the force of law. Notwithstanding this proviso, given the historic deference that courts have shown towards the OSC as a specialized regulatory body, the OSC's interpretation would conceivably be persuasive if not compelling before a court of law.

Staff Notice 41-304 reflects the CSA's prospectus disclosure expectations in response to their concern that prospective income fund investors are not always being provided with adequate disclosure of the significant estimates and assumptions underlying the reconciling distributable cash or income adjustments. The Notice also addresses Staff's concerns about adjustments that are based on the expected economic effect of anticipated future events.

Adjusted EBITDA - A Forward-Looking Perspective

Staff Notice 41-304 makes clear Staff's view that any reconciling adjustment based on the expected economic effects of anticipated future events provides a "forward-looking perspective," and therefore raises many of the same issues that have concerned Staff with other forms of future-oriented financial information (FOFI). The Staff Notice seems to implicitly recognize a distinction, however, between a "forward-looking perspective" and FOFI; the former requiring enhanced disclosure in the prospectus from what has heretofore generally been provided, and the latter necessitating the inclusion of a forecast in accordance with National Policy 48 - Future-oriented financial information.

With Staff Notice 41-304, the CSA's aim is to provide prospective investors with sufficient disclosure to allow them to determine whether the adjustments used by management in arriving at estimated distributable cash represent a balanced and complete assessment of all factors affecting estimated distributable cash. To this end, the CSA expects the presentation of estimated distributable cash to include a discussion of (among other things):

• the work that was done by the issuer to ensure the completeness and reasonableness of the estimated distributable cash information;

• the nature of the adjustments, including a description of the underlying assumptions used in preparing each element of the forward-looking information as well as the forward-looking information as a whole, including how those assumptions are supported; and

• the specific risks and uncertainties that may affect each individual assumption and that may cause actual results to differ materially from the estimated distributable cash figure; general cautionary language accompanying the estimated distributable cash presentation, that "actual results may vary materially from the amounts presented", will be considered insufficient.

While we have noticed a trend over the past year towards requiring such enhanced disclosure, it is our expectation that in the future the CSA will require far greater disclosure of the underlying assumptions, how they are supported and the particular risks affecting them, than in most recent filings.  Staff has noted that it expects objective corroboration of the assumptions used in the distributable cash presentation. In many circumstances, providing such a level of disclosure should not be problematic; however, in other circumstances it may require specificity at a level that raises concerns over disclosure of competitively sensitive strategies, programs, contractual terms, and pricing and cost structures.

When FOFI Requires a Forecast

If (A) the estimated distributable cash information includes forward-looking adjustments that are based on "significant assumptions," and (B) those adjustments materially affect estimated distributable cash, then Staff expects that a forecast be prepared in accordance with CICA Handbook Section 4250 - Future-oriented financial information and included in the income trust's prospectus.

According to Section 4250, an assumption would usually be considered significant when:

• it reflects an expectation of economic conditions significantly different from those currently prevailing;

• there is a relatively high probability of a sizeable variation; or

• a small change in the assumption would have a significant impact on the forward-looking information.

The above definition, which is imported into the Staff Notice by reference, arguably sets a fairly high bar that, when combined with the second test (i.e., that the particular significant assumption materially affect estimated distributable cash), will likely provide most issuers with a safe harbour from the requirement to prepare a Section 4250 Forecast.

Aside from the time and expense involved in the preparation of a Section 4250 Forecast, and the attendant future disclosure obligations that result from providing one, most issuers and their professional advisors are reluctant to include a Section 4250 Forecast in a prospectus due to a general perception that it creates greater potential for liability.  Moreover, because many accounting firms have recently been interpreting the audit guidelines relating to the preparation of financial forecasts (examination of a financial forecast or projection included in a prospectus or other public offering documents) conservatively, issuers may find it difficult to engage a professional auditing firm to examine the required financial forecast.
 

Compendium

CSA Staff Notice 41-304 makes it clear that, at the very least, significantly enhanced and detailed disclosure of the adjustments used to arrive at estimated distributable cash will be required in prospectuses. Although in certain circumstances such disclosure may necessitate the preparation of a Section 4250 Forecast, even where a forecast is not required, the specificity and objective corroboration required by such enhanced disclosure may require issuers to disclose competitively sensitive strategies, programs, contractual terms, pricing and cost structures.

In situations where issuers anticipate making reconciling adjustments to estimated distributable cash that may necessitate a Section 4250 Forecast, issuers will need to work closely with their professional advisors in order to determine if such a forecast can be prepared. We would expect that issuers may find it increasingly difficult to include Section 4250 Forecasts in their prospectuses, and as a result creative alternative structures (e.g., "earn-ins" or "reverse grinds") will likely be employed to deliver to issuers and their sponsors the appropriate level of value.