The canadian securities Administrators has dropped its proposed internal-control reporting rule and, in doing so, has sent a major message to the Street. But its reversal raises the question: is opting out the right message?

The rule would have required issuers to have auditors vouch for the quality of their internal controls. Instead, the CSA will make internal-control reporting part of the certification procedure for chief executive and chief financial officers.

The decision is a watershed for a two reasons. For one, it displays a new-found sensitivity to the burdens imposed by regulations. It also demonstrates an unanimity among the members of the CSA that has often been lacking on issues, including on this specific issue.

The CSA’s proposed rule, which essentially mimicked a similar provision in the U.S. Sarbanes-Oxley Act (known as SOX 404), has been highly controversial with issuers. It would have required companies to assess the quality of their internal controls, to report any material deficiencies in the controls and have their auditors assess the controls as well.

Canadian issuers have been resistant, fearing the cost of compliance would be excessive and the benefits negligible. As evidence, they point to the U.S., where implementation of the rule has proven more expensive than many expected. There, companies have complained that it requires a large new audit expense and that implementation is excessively detailed.

From the outset, the CSA has heard Canadian issuers’ concerns and indicated it would make implementation of the rule less burdensome by taking a more risk-based approach and focusing on entity-level controls. U.S. issuers have complained that they’ve been forced to examine their controls right down to the level of individual transactions, and the focus on such minutiae is responsible for much of the cost of implementing the change.

But rather than take a gentler approach to implementation, the CSA has decided to scrap the audit requirement altogether.

The decision no doubt pleases the Street. It means Canadian companies won’t have to take on added audit costs. And it also appears to signal a philosophical shift at the CSA. The Street has been waiting to see what would happen when one of its own — former investment banker David Wilson — took over the helm of the Ontario Securities Commission. In his public speeches, Wilson had hinted at his concerns about the cost burden created by too much regulation. Until this decision, however, the Street didn’t have any concrete evidence of any new-found sensitivity.

Wilson took over as chairman of the OSC in November 2005. The commission, however, didn’t issue any meaningful directives in the first few months of his tenure. The internal-control reporting decision would appear to confirm the Street’s fondest hopes.

Michael Greenwood, chief operating officer of Vancouver-based Canaccord Capital Corp. , notes that Wilson appears to be taking the OSC in a new direction, and Greenwood suggests there’s reason for optimism when it comes to other sorts of regulatory reform as a result.

The fact that the CSA’s decision coincides with other signals of greater co-operation among the provinces is also stoking hopes for more uniformity. Notably, the British Columbia government has decided not to go ahead with its new securities legislation, which would have made the regulatory system in that province starkly different from the rest of the country.

On the internal-control issue in particular, B.C. was reluctant to follow Ontario’s lead, and it had contemplated taking its own direction if other members of the CSA went ahead with the rule they were contemplating.

Doug Hyndman, chairman of the B.C. Securities Commission, says that the decision to drop the internal-control reporting rule “reflects a renewed commitment by CSA members to work closely together to achieve harmonized solutions that meet the needs of Canadian investors and markets.”

Yet some are questioning whether the CSA’s new approach really does meet the needs of the Canadian market.

“I think it is a mistake and very shortsighted,” cautions independent industry commentator Glorianne Stromberg. “It is not going to boost the credibility of the Canadian capital markets.”

In fact, she warns, it may have the effect of making our markets less appealing to investors.

Indeed, the CSA appeared to believe as much a year ago when it last requested comment on the proposed rule. At that time, it explicitly considered, and later rejected, the idea that the audit component was not necessary for effective reporting: “We believe that the audit provides greater assurance regarding the consistency in the quality and appropriateness of management’s design and evaluation of internal control over financial reporting.

@page_break@“Without the audit requirement, it would be difficult for investors to assess and compare the quality and results of management’s evaluation of internal control over financial reporting. As a result, investors may assign a lower value to the internal-control reports filed in accordance with this alternative, as compared to those filed in accordance with the SOX 404 rules. This in turn may affect the reputation of our markets.”

It appears that either the CSA’s professed concern for the market’s reputation has eased or it has given way to even greater worries about the cost burden such measures would impose. David Brown, former chairman of the OSC, now back in private practice with Davies Ward Phillips & Vineberg LLP, declined to comment on the CSA’s about-face.

The same concerns are the subject of a lively, ongoing debate about SOX 404 in the U.S. Initially, the Securities and Exchange Commission delayed implementation of the requirements for smaller companies. Within a few weeks, it will consider recommendations from an SEC advisory committee focusing on smaller public companies, which is recommending that companies with market caps of less than US$700 million be exempted from the rule.

Although it remains to be seen what the SEC does, the notion that smaller companies should escape the burden of internal-control reporting is hardly unanimous there, either.

Indeed, a report from San Francisco-based research firm Glass Lewis & Co. LLC found that financial restatements by U.S. companies doubled in 2005, with 8.5% of U.S. public companies restating some aspect of their financials during the year. Based on that experience, Glass Lewis strenuously objects to the idea that smaller companies should get a pass on SOX 404. “After surveying last year’s accounting mishaps and do-overs, we couldn’t disagree more” with the recommendation that smaller companies be exempted, the firm says in its report. “Without this testing, we feel certain that investors would still be relying today on false financial statements at many of the thousands of companies that have restated their accounts over the past few years.”

Some critics suggest that the poor state of companies’ internal controls is primarily to blame for the excessive implementation cost associated with SOX 404.

Steve Salterio, professor of business and PricewaterhouseCoopers/Tom O’Neill faculty research fellow in accounting at Queen’s University in Kingston, Ont., says the initial costs of internal-control reporting have been high because the controls have fallen into disrepair at many companies.

“Corporations had to do ‘deferred maintenance’ on their lower-level controls so that entity-level controls would be effective,” Salterio says. At many firms, the lower-level controls were allowed to erode when companies were forced to tighten their belts in the 1990s, he suggests. In the years ahead, he predicts that compliance with SOX 404 will follow a more risk-based approach, and as such it won’t impose such an ongoing burden.

For Canadian investors, the CSA decision may leave them with less confidence in the reliability of many domestic companies’ financials. The bigger firms tend to be interlisted in the U.S., meaning they have to comply with SOX 404 anyway; it’s the rest of the field that may cause concern.

One possible solution, Salterio proposes, would be to exempt companies that are listed on the TSX Venture Exchange from reporting requirements but apply SOX 404-style requirements to all Toronto Stock Exchange-listed firms regardless of market cap. His rationale is that the average retail investor needs the protection of internal-control reporting. Because traders on the TSXV tend to be either sophisticated investors, institutional investors or investors who are implicitly taking a big risk, it may be reasonable to allow those companies an exemption.

Indeed, there are any number of ways the CSA could have taken a more nuanced approach to internal-control reporting in Canada, and it may yet do so.

The CSA notice indicates it will monitor the effects of its CEO/

CFO certification approach and may consider introducing an audit requirement in the future. For the time being, however, the Street can celebrate the CSA’s signal of heightened sensitivity to regulatory costs and the importance of harmonization.

Hopefully, investors won’t be the ones paying the postage on the message. IE