Onerous and expensive are just some of the words that have been used to describe the “culture of compliance” created by stock exchanges and regulatory agencies in the United States and Canada. Like them or not, public companies must learn to conform to and live with the new governance requirements. In this article, two securities lawyers point out the differences in the requirements set out by regulatory bodies in Canada and the United States, and offer guidance for conforming to – and coping with – those requirements.

New corporate governance rules adopted and proposed by certain members of the Canadian Securities Administrators, or CSA, have added an additional layer of regulation for Canadian inter-listed companies that are subject to the Sarbanes-Oxley Act of 2002, or SOX, and the revised U.S. stock exchange rules (not to mention the endless number of “best practices” that have been published by the media and all kinds of quasi-governmental, accounting, legal and shareholder groups). What is the end result? In this article, we review the new Canadian corporate governance initiatives, including the proposed best practices and the recently adopted CEO and CFO certifications and audit committee rules. We also compare them to the existing U.S. rules and regulations. We believe our review will help directors and executives navigate the maze of North American corporate governance obligations. (This article is limited to a discussion of SOX and the corporate governance rules adopted by the NYSE and Nasdaq).

Different countries, different rules

Is it enough for a company to comply with SOX and the U.S. stock exchange rules? In most cases the answer is “Yes,” along with a few additional disclosure requirements if a company has securities listed on the NYSE and it complies with the NYSE rules applicable to U.S. domestic issuers. (The NYSE rules exempt foreign private issuers from all of the corporate governance rules except the SOX audit committee rules which must be complied with by July 31, 2005. By the earlier of the first annual shareholders meeting after January 15, 2004 or October 31, 2004, CEOs of listed foreign private issuers must provide prompt written notice to the NYSE of any non-compliance with the NYSE corporate governance rules applicable to such issuers, and must disclose the significant differences between the issuers’ corporate governance practices and those required by U.S. domestic companies subject to the NYSE listing standards. On August 3, 2004, the NYSE proposed amendments to the corporate governance rules requiring foreign private issuers to provide the NYSE with annual and interim written affirmations regarding compliance with the NYSE corporate governance rule applicable to them. The form of the affirmations has not yet been published and such affirmations will not need to be provided until after July 31, 2005. Although most Canadian inter-listed companies are exempt from the NYSE corporate governance rules, we have found that many Canadian inter-listed companies are complying or intend to comply with the NYSE rules applicable to U.S. domestic issuers.)

The new Canadian rules are very similar in substance to SOX and the NYSE rules that are applicable to U.S. domestic issuers. However, the form of the proposed Canadian corporate governance rules is distinctly Canadian as they are in the form of “comply or disclose” rather than mandatory rules as under SOX and the U.S. stock exchange rules. For example, the proposed corporate governance rules do not require that a board of directors be comprised of a majority of independent directors, only that a company disclose that a majority of the directors are independent and if not, why the board thinks this is appropriate.

Canadian inter-listed companies with securities quoted on Nasdaq will have a more difficult time complying with the Canadian rules than NYSE interlisted companies because many of the provisions were derived from SOX and the NYSE rules. Unlike the NYSE, Nasdaq requires all issuers, including foreign private issuers, to comply with its corporate governance rules. However, foreign private issuers may apply to the Nasdaq for an exemption from the rules, other than certain audit committee rules, and must disclose any exemptions in its annual report filed with the Securities and Exchange Commission. (Nasdaq requires U.S. domestic issuers to comply with the corporate governance rules by the earlier of the first annual shareholders meeting after January 15, 2004 or October 31, 2004, and by July 31, 2005 for foreign private issuers. If a foreign private issuer has applied for an exemption from the corporate governance rules, disclosure regarding the exemption must be included in the issuer’s filings with the SEC made after January 1, 2004.)

I. Policy and Rule

On January 16, 2004, members of the CSA, other than those in Quebec and British Columbia, published for comment proposed Multilateral Policy 58-201 Effective Corporate Governance, referred to herein as the Policy, and Multilateral Instrument 58-101 Disclosure of Corporate Governance Practices and Form 58-101F1, referred to herein as the Rule and collectively as the Canadian Corporate Governance Proposals. The Policy and Rule are designed to “provide greater transparency for the marketplace regarding the nature and adequacy of issuers’ corporate governance practices.” The Policy recommends 18 corporate governance best practices, while the Rule requires issuers to disclose whether they have complied with each recommended best practice, and if not, why not. The CSA commented in the Policy that the Canadian approach to corporate governance must “be sensitive to the realities of the greater numbers of small companies and controlled companies in the Canadian corporate landscape” and “recognize that corporate governance is in a constant state of evolution.” The main topics covered by the Policy are:

A. Board composition, qualifications and operations

The Canadian Corporate Governance Proposals recommend that the board of directors be comprised of a majority of independent directors, that such members hold regularly scheduled executive sessions without management, and that the chair of the board be independent or that an independent lead director be appointed if the chair is not independent. The board must also disclose whether or not it takes any measures to orient new board members and provide continuing education to existing members. If a company does not comply, the company must disclose in its annual information form the reasons why.

Both the NYSE and Nasdaq rules require U.S. domestic issuers to have a board of directors composed of a majority of independent directors. The NYSE requires the board to name the independent directors and discuss the basis for the board’s determination in a company’s annual proxy statement, while the Nasdaq requires disclosures be made in a company’s annual report filed with the SEC. Both the NYSE and Nasdaq exempt “controlled companies” (i.e. a company of which more than 50 percent of the voting power is held by an individual, a group or another company) from the independence requirements but they require the disclosure of such exemption.

i. Definition of independence

The CSA abandoned the previous Toronto Stock Exchange concept of “unrelated directors” in the Canadian Corporate Governance Proposals and, with a few variances, adopted the U.S. definition of independence. The proposed definition of “independence” under the Canadian Corporate Governance Proposals is derived from the NYSE rules and includes a broad fact-based test and specifically enumerated situations under which a director is determined not to be independent. The definition is based on the independence definition in Multilateral Instrument 52-110 Audit Committees, referred to herein as the Audit Committee Rule, except that two circumstances in which a director will not be independent have been excluded. The first is a director who has a relationship with the issuer pursuant to which the director may accept a non-board consulting, advisory or similar fee from the issuer or its subsidiaries. The second is a director who controls the issuer, or is both a director and an employee, or an executive officer, general partner or managing member of a controlled or controlling entity. Interestingly, the definition of “control” in the Audit Committee Rule is based upon the definition of control in the U.S. Securities Act of 1933, as amended, not the definition of “controlled companies” in subsection 1(2) of the Securities Act (Ontario).

One difference between the Canadian definition of independence and the NYSE rules is the reference to a material relationship with only the issuer, not to the issuer and its affiliates. Consequently, the president of a publicly traded company would not be precluded from being an independent director of a publicly traded subsidiary and could act as chairman of the board of the subsidiary. However, the CSA definition of independence does not exclude those considered to have a material relationship with an issuer, individuals who have an immediate family member who receives more than C$75,000 per year in direct compensation from the issuer, but does not perform a policy-making function with the issuer. Consequently, the chairman of the board of an issuer would not be independent if his brother-in-law is employed in a non-management role with the issuer and earns greater than C$75,000 a year. We expect that the CSA will publish amendments to the Audit Committee Rule to address these anomalies. The comment period for the Canadian Corporate Governance Proposals expired on May 31, 2004 and final rules have not yet been published.

The dollar thresholds under the Canadian Corporate Governance Proposals are lower than under the NYSE rules (i.e. C$75,000 versus US$100,000 for fees received as compensation in any given 12-month period, other than directors’ fees). Therefore, it is possible that a director will be considered independent under the NYSE rules but not under the Canadian Corporate Governance Proposals. The Nasdaq rules set a dollar threshold of US$60,000.

The definition of independence under the Canadian Corporate Governance Proposals is less onerous in its look-back provisions. Any relationships prior to March 30, 2004 would not be subject to the look-back provisions; while under the NYSE rules there is a one-year look-back for all relationships up to and including November 3, 2004 and a three-year look-back after such date. Nasdaq has a three-year look-back rule that is applicable to U.S. domestic issuers the earlier of the first annual shareholders meeting after January 15, 2004 or October 31, 2004 and applicable to foreign private issuers on and after July 31, 2005. Therefore, under the Canadian Corporate Governance Proposals, if the CEO of a company was no longer an executive officer of the company as of March 29, 2004 but remained on the board after March 30, 2004, the CEO would be considered “independent,” while under the NYSE or Nasdaq rules applicable to U.S. domestic issuers, the CEO would not be considered independent.

Under the Canadian Corporate Governance Proposals there is no restriction on categories of people that have paid or received payments from the company over a certain amount as contained in the NYSE and Nasdaq rules. Under the NYSE rules, there is a restriction on directors who are employees, or who have an immediate family member who is a current executive officer, of a company that made payments to or received payments from the company for property or services in an amount that exceeds the greater of US$1 million or 2 percent of such company’s consolidated gross revenues in any of the last three years. (The NYSE rules do not preclude charitable contributions above these amounts but require companies to disclose any charitable contributions that exceed these amounts.)

Under the Nasdaq rules, there is a restriction on directors who are partners, controlling shareholders, executive officers or whose family member is a partner, controlling shareholder or executive officer, of an organization to which the company has made, or from which the company has received payments, for property or services that exceed the greater of 5 percent of the recipient’s consolidated gross revenues or US$200,000. However, under the Canadian Corporate Governance Proposals, the general definition of “independence” does exclude persons that have a direct or indirect material relationship with the issuer. (Subsection 1.2(2) of the Rule states that “[A] ‘material relationship’ is a relationship which could, in the view of the issuer’s board, reasonably interfere with the exercise of a director’s independent judgment.”) Thus it is possible that a director would be caught under the Canadian Corporate Governance Proposals if the payment would create, or was the result of, a material relationship. The companion policy to the Audit Committee Rule states that material relationships could include commercial, charitable, advisory, accounting, legal, industrial, banking, consulting or familial relationships.

Boards are well advised to question certain relationships even if a director passes the bright line tests contained in the rules. For example, in 2003 and 2002, a few articles appeared in BusinessWeek and the L.A. Times, among others, that questioned the independence of some of Disney’s board members who included Michael Eisner’s personal architect and the principal of the school his children once attended. Although the architect and the principal would be considered independent under all of the U.S. and Canadian rules, the articles questioned the ability of these individuals to exercise independent judgment.

ii. Board operations

The Canadian Corporate Governance Proposals recommend that the chair of the board be independent. If this is not appropriate, an independent director maybe appointed to act as lead director. In addition, the Canadian Corporate Governance Proposals recommend that independent directors hold regularly scheduled executive sessions.

There is no requirement for the chair of the board to be independent or for the appointment of a lead director if the chair is not independent under the NYSE or the Nasdaq rules. Accordingly, a Canadian inter-listed company would need to appoint an independent chair or lead director. The Nasdaq rules require independent directors to meet in regularly scheduled executive sessions. Although the NYSE requires executive sessions without management, non-independent members of the board are permitted to attend such sessions as long as they are not officers of the company. However, the NYSE does recommend that, to the extent non-management directors are not independent, independent directors meet separately at least once a year.

iii. Orientation and continuous education

The Rule requires companies to disclose in their annual information forms measures boards of directors take to orient new board members and provide continuous education. There is a similar NYSE requirement for companies to address director orientation and continuous education in their corporate governance guidelines. Accordingly, there is no additional disclosure requirement for NYSE inter-listed companies. Nasdaq does not require companies to disclose measures relating to director orientation or continuous education. Therefore, Nasdaq inter-listed companies will need to disclose the measures they take to provide director orientation and continuous education in their annual information forms.

B. Board mandate

The Canadian Corporate Governance Proposals recommend that the board adopt a written mandate and require a company to disclose whether the board has adopted such a mandate and, if not, why the board has determined that this is appropriate. The Rule requires that the text of the board mandate be included in a company’s annual information form. The NYSE rules require the board to adopt corporate governance guidelines that must address director qualification standards, director responsibilities, access to management and independent advisors, director compensation, orientation and education, management succession and an annual performance evaluation of the board. The Canadian Corporate Governance Proposals contain the following additional items that must be addressed in the mandate: (1) a statement that the board assumes the “responsibility for the stewardship of the issuer, including responsibility for, to the extent feasible, satisfying itself as to the integrity of the CEO and other senior officers,” (2) adopting a strategic planning process, (3) identifying principal risks and implementing systems to manage these risks, (4) succession planning, (5) adopting a communications policy, (6) ensuring the integrity of the company’s internal control and management information systems, and (7) developing the company’s approach to corporate governance. The mandate should also include pre-approval policies for certain decisions, measures for receiving feedback from security holders and the board’s expectations of management. Consequently, a NYSE inter-listed company would need to expand its corporate governance guidelines to comply with the additional recommendations contained in the Canadian Corporate Governance Proposals; a Nasdaq inter-listed company would need to adopt a board mandate that addresses all of the items contained in the Canadian Corporate Governance Proposals.

Although the integrity of management is the cornerstone of good corporate governance, it may be difficult for board members to implement procedures to verify the personal integrity of the CEO and other members of senior management. The recommendation that directors are responsible, to the extent feasible, to vet the integrity of the CEO and other senior executives raises an interesting question regarding the procedures directors would need to implement to ensure the good character of the CEO and other senior executives. Would directors need to conduct criminal background checks, obtain character statements by objective third parties, and request other personal affirmations from senior officers?

C. Position descriptions and board assessments

The Canadian Corporate Governance Proposals recommend that boards develop a description of the roles and responsibilities for directors, the chair of the board and each of its committees. In addition, the board must describe how the performance of each member of the board is assessed. The NYSE requires that the corporate governance guidelines adopted by each company address the qualifications of directors, key board committee responsibilities and the evaluation of the board as a whole. Thus, NYSE inter-listed companies would need to expand their corporate governance guidelines to include individual job descriptions and evaluation methods for each board member. Nasdaq inter-listed companies would have to adopt a board mandate that would include a description of roles and responsibilities and assessments as set out in the Canadian Corporate Governance Proposals.

D. Nominations and compensation committees

The Rule requires the disclosure of whether a board has an independent nominations committee and an independent compensation committee, and if not, why the board thinks this is appropriate. There is no requirement under the NYSE or the Nasdaq rules for separate nominations and compensation committees as the responsibilities for nominating directors and determining executive compensation may be allocated to other committees composed entirely of independent directors. If a NYSE-listed or Nasdaq-quoted company has a nominations and/or compensation committee, or has delegated the responsibilities of such committees to another committee, such a committee must be comprised of independent directors (unless the company discloses that it is a “controlled company”) and have a published charter. However, the Nasdaq rules allow for an exception to the independence rules for one director of the nominations committee and/or compensation committee if that director is not a current officer or employee or a family member of an officer or employee, and the board has determined that the director’s appointment to such committee is in the best interests of the company, and the company discloses that determination in its proxy or annual report filed with the SEC. There is no such exception available under the Canadian Corporate Governance Proposals. Accordingly, Nasdaq issuers taking advantage of the exception would need to either disclose the exception under the Canadian Corporate Governance Proposals or ensure that all directors on the nominations committee and the compensation committee are independent.

E. Code of conduct and business ethics

The Canadian Corporate Governance Proposals require companies to disclose whether or not a code of business conduct and ethics applicable to directors, officers and employees has been adopted and if not, why the board thinks this is appropriate. The NYSE and the Nasdaq rules require the adoption and the disclosure of a code of business conduct and ethics. All of these rules also require the prompt disclosure to shareholders of any waivers given to directors or executive officers. SOX also requires companies to disclose whether or not they have adopted a code of ethics covering their senior financial officers, including the CEO, and to disclose any waivers granted under the code. Under SOX, the code and any waivers and amendments to the code must be disclosed by a company in its filings with the SEC. A U.S. domestic issuer must disclose waivers and amendments on a Form 8-K or on its Web site (if its annual report disclosed that such disclosure would be made on its Web site), and a foreign private issuer must disclose waivers and amendments in its next annual report or voluntarily on a Form 6-K.

Under the NYSE rules, the code must be disclosed on a company’s Web site and a cross-reference to the Web site must be included in the company’s annual report to shareholders. Nasdaq requires the code and any waivers to be disclosed publicly but does not specify that the code must be disclosed on a company’s Web site. However, the Nasdaq rules do require that any waivers be disclosed in a Form 8-K for U.S. domestic issuers or furnished on a Form 6-K or in the next Form 20-F or 40-F for foreign private issuers. The Canadian Corporate Governance Proposals require the code to be filed on SEDAR and that a news release be issued and filed on SEDAR when a waiver to the code is given to a director or officer. The news release must include the nature of such a waiver, the name of the person to whom the waiver was granted, the basis for granting the waiver and the date it was given. Canadian inter-listed companies may furnish the press release to the SEC under a Form 6-K to comply with the disclosure requirements under SOX. The issuance of the press release would also satisfy the NYSE and Nasdaq requirement to promptly notify shareholders of a waiver.

II. CEO and CFO certifications

On January 16, 2004, all of the securities commissions in Canada, with the exception of British Columbia, adopted Multilateral Instrument 52-109 Certification of Disclosure. It requires issuers to file, on SEDAR, CEO and CFO certifications for all quarterly and annual reports filed on or after March 30, 2004. (Only “bare certificates” are required to be filed for quarterly and annual reports covering fiscal periods ending before March 30, 2005.)

The certifications are almost identical to the Section 302 certificates required by SOX, except that the Canadian certificates do not require the CEO and CFO to evaluate the effectiveness of the issuer’s internal controls over financial reporting, nor do they require the CEO and CFO to certify that they have notified the auditors and the audit committee of any significant deficiencies or weaknesses in the design or operation of the issuer’s internal controls over financial reporting, or the occurrence of any fraud involving management or employees who have a significant role in internal controls over financial reporting. Canadian inter-listed companies may satisfy the new Canadian rule by filing their Section 302 certificates on SEDAR. However, many Canadian inter-listed companies have taken advantage of the foreign private issuer exemption and currently only file Section 302 certificates with their annual reports. The new Canadian rule requires companies to file certificates with their quarterly reports as well. Thus, a Canadian inter-listed company could continue filing only annual Section 302 certificates with the SEC and file separate Canadian certificates on SEDAR or choose to file Section 302 certificates quarterly with the SEC and file them with SEDAR to comply with the Canadian rules. The advantage of not filing Section 302 certificates with the SEC on a quarterly basis is that CEOs and CFOs would not have to certify quarterly as to the effectiveness of their companies’ internal controls over financial reporting. However, the SEC stated in its adopting release that even though foreign private issuers are not required to certify quarterly, it expects such companies to conduct evaluations on a quarterly basis.

III. Audit Committee Rule

On January 16, 2004, members of the CSA other than British Columbia adopted the Audit Committee Rule, which requires reporting issuers to have an audit committee composed of at least three independent board members who are financially literate. In addition, this rule requires the audit committee to (1) be responsible for hiring, retaining and overseeing the work of external auditors, (2) pre-approve all non-audit services, (3) review an issuer’s financial statements, MD&A and annual and interim earnings press releases, (4) ensure that adequate disclosure and internal control procedures are in place, and (5) ensure that procedures are in place to receive, retain and deal with complaints received by the issuer regarding the issuer’s accounting or internal controls, and to receive confidential anonymous submissions concerning questionable accounting and auditing matters by employees.

The rule is almost identical to the SOX, NYSE and Nasdaq rules regarding audit committees. However, the CSA did not adopt the requirement to identify an audit committee financial expert and did not set out a list of prohibited non-audit services as set out in SOX. The Canadian rule also does not require the board to determine whether an audit committee member can serve on more than three audit committees simultaneously and disclose such determination, as required under the NYSE rules. Under the NYSE and Nasdaq rules, there is no exemption from the audit committee independence rules for “controlled companies.” Canadian inter-listed companies are exempt from the Audit Committee Rule if the issuer is in compliance with SOX and the NYSE or Nasdaq rules applicable to U.S. domestic issuers relating to audit committees, and the issuer discloses, in its annual information form, any exemptions under the Canadian Corporate Governance Proposals from the independence requirements for being a director of an affiliated entity and/or a temporary exemption for limited and exceptional circumstances.

The CSA has adopted many of the provisions contained in SOX and the U.S. stock exchange rules. It will be interesting to see if the rules requiring management to report on an issuer’s internal controls over financial reporting and the auditors’ duty to attest to such a report will be adopted in Canada. Many Canadian inter-listed companies are currently in the process of implementing procedures to comply with the Section 404 management reports; these same companies have found the process to be time-consuming and very expensive. Financial Executives International recently conducted a survey of 321 U.S. companies. The survey found that companies that have annual revenues of US$5 billion or more estimated that the average costs to implement the Section 404 requirements would be $4.6 million. This amount is comprised of an increase of 35,000 internal hours, $1.3 million in external consulting and software costs and an additional $1.5 million in audit-related fees. Many Canadian companies hope that either the requirement will not be adopted in Canada, or if it is, inter-listed companies complying with SOX will be exempt from the Canadian requirements or the same report could be filed with the members of the CSA.

This information is accurate as of August 24, 2004. It is only a summary of some of the provisions of recent corporate governance rules adopted or proposed in Canada and the U.S. and should not be deemed legal advice.