OSC aims to improve compliance for emerging market issuers

The review, which the OSC launched in July 2011 following the revelation of apparent disclosure problems at China-based forestry firm, Sino-Forest Corp., examines a sample of 24 issuers listed on Canadian exchanges that have significant business operations in emerging markets. The regulator focused on the adequacy of issuer disclosure and corporate governance practices, as well as the roles played by auditors, underwriters and exchanges in bringing these issuers to market.

No specific policy actions are recommended as a result of the review. Instead, it identifies a variety of areas of regulatory concern, including issues related to the quality of emerging market issuer governance and disclosure, the adequacy of the audit function, the adequacy of the due diligence conducted by underwriters in these sorts of offerings, and the nature of the exchange listing approval process.

“One of our central concerns was the apparent ‘form over substance’ approach to compliance with applicable standards for disclosure, issuer governance, board oversight, audit practices and due diligence practices,” the report says. “In our view, the level of rigor and independent-mindedness applied by boards, auditors and underwriters in doing their important jobs – management oversight, audit, due diligence on offerings – should have been more thorough.”

One of the basic reasons that auditor and underwriter due diligence appears to be lacking is the fact that the core operations and assets of many of the issuers are located in emerging markets, and the firms have very little presence in Canada, it notes. A lack of understanding of local business practices, language barriers, and translation issues, also contributed to these problems, it says.

The review found several areas of potential concern for auditors including a lack of professional skepticism, a lack of knowledge about local cultural and business practices, too much delegation to foreign auditors, difficulty in obtaining domestic auditor working papers, and language barriers.

Similarly, for underwriters, the review found wide variation in due diligence practices and documentation, and a lack of professional skepticism and rigor, among other things. “We noted several instances where ‘red flags’ should have prompted further probing or questions. Our review indicated little or no follow-up in these instances to either understand or analyze the concerns, or disclose them,” it says.

In terms of exchanges, the review says that no particular form of listing, whether by IPO, reverse takeover, or direct listing, was specifically problematic. It did have concerns though, including whether additional listing requirements for emerging market issuers are necessary, a lack of transparency when exchanges waive certain listing requirements, and a heavy reliance on third parties in conducting due diligence.

The report says that the OSC will follow up with issuers, auditors, and underwriters in areas that it has identified for improvement, and that some issues uncovered in the review have been referred to enforcement. It also says that it will continue to work with the Canadian Public Accountability Board to address audit related concerns, with staff at the exchanges to address concerns related to the listing process, and with the Investment Industry Regulatory Organization of Canada on underwriting practices.

“Staff expect that [emerging markets] issuers, their auditors, underwriters and their other advisors, as well as the exchanges, will address the concerns identified in this report and will, where necessary, take immediate steps to improve their practices to effectively discharge their responsibilities to protect investors in Ontario,” it says.

The report proposes a list of recommendations, which it says do not necessarily require the creation of new policies or rules, but instead involve the development of guidance, best practices or enhanced vigilance to improve compliance with current requirements.

For issuers, this includes guidance to improve corporate governance practices, clarifying the regulatory expectations of CEOs and CFOs in conducting reasonable due diligence, better disclosure of complex corporate structures, better risk disclosure, ensuring the maintenance of appropriate books and records in Canada, the possibility of imposing a minimum language competency component for board members in the firm’s local language, and possible minimum Canadian director residency requirements.

For auditors, it calls for improved access to audit working papers; examining whether securities rules need to be enhanced to allow more information sharing for the oversight of audit firms, whether suitability standards for auditors should be developed, and whether auditors should be required to publicly disclose and explain their resignation from a file. It also calls for greater cooperation among securities regulators and audit oversight bodies.

For underwriters, the report recommends: establishing a consistent and transparent set of requirements for the conduct of due diligence, developing best practices for documenting due diligence, and best practices for due diligence calls and site visits.

Finally, it says that the exchanges will need to assess whether additional listing requirements are needed, provide greater transparency regarding waivers of any listing requirements, assess the extent of reliance on third parties in conducting due diligence and whether additional due diligence steps are warranted, and review the role of sponsors in bringing issuers to market, “to ensure that there is adequate accountability placed on the sponsor and if there is an appropriate level of transparency regarding the sponsor’s due diligence work.”

The TMX Group has already said that it is supportive of the report and its conclusions, noting that it has undertaken extensive consultations with market participants, issuers and others over the last several months, which it says will soon result in additional guidance for emerging markets issuers. The guidance will focus on senior management and director qualifications, corporate governance matters, and disclosure and financial reporting expectations.

“The OSC expects issuers and gatekeepers to act in a manner that promotes investor protection and supports confidence in our capital markets,” said Howard Wetston, chair and CEO of the OSC. “This review uncovered a number of areas where issuers and gatekeepers need to improve in order to meet their obligations and we will be monitoring their progress to ensure the interests of investors are placed first.”