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Authors
Jennifer E. Butcher
Practice Areas
Mergers & Acquisitions
Offices
Toronto
OSC Staff Notice 51-719 Emerging Markets
ssuer Review
Securities and Mergers & Acquisitions Bulletin
August 8, 2012
On March 20, 2012, the Ontario Securities Commission (OSC) released OSC Staff Notice
51-719 Emerging Markets Issuer Review (Notice). This review focused on issuers whose
mind and management are largely outside of Canada and whose principal active
operations are also outside of Canada in regions such as Asia, Africa, South America and
Eastern Europe (EM Issuers). The Notice reported on a review of 24 issuers listed on
Canadian exchanges with significant business operations in emerging markets. This review
was done in response to concerns that Canadian investors in these issuers may be
exposed to "inappropriate risks with the goal of identifying areas of concern and making
recommendations to contribute to the protection of investors and strengthen the integrity of
Canadian markets. The Notice focused on the adequacy of issuer disclosure and corporate
governance practices, as well as the adequacy of the gatekeeper roles played by auditors,
underwriters and exchanges in bringing these issuers to the market. n conducting its
review, OSC staff contacted issuers, their advisors and organizations such as Canadian
exchanges, the Canadian Public Accountability Board and other provincial securities
regulators.
Key concerns identified by the OSC
The Notice identified four principal concerns:
the level of EM ssuer governance and disclosure;
the adequacy of the audit function for an EM ssuer's annual financial statements;
the adequacy of the due diligence process conducted by underwriters in offerings of
securities by EM ssuers; and
the nature of the exchange listing approval process.
As a general comment, the OSC noted an overall concern with the apparent "form over
substance approach to compliance with applicable standards for disclosure, issuer
governance, board oversight, audit practices and due diligence practices. The OSC
expressed the view that the level of independent-mindedness applied by boards, auditors
and underwriters in doing their jobs should have been more thorough.
Review of EM Issuers
The OSC conducted a review of the public disclosure records of the EM ssuers and
examined information concerning the function of the EM ssuers' boards and audit
committees and identified four key areas of concern:
Corporate governance practices - in some cases it was found that the board had very
little contact with senior management in the emerging market jurisdiction and that the
extent of knowledge the board and audit committee had of the cultural and business
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practices of such jurisdictions was lacking. n some instances it appeared that board
members were relying solely on members of management to provide an overview of key
business documents that were in a foreign language.
Corporate structures - complex corporate structures may increase the risk profile of an
EM ssuer as these structures may impact the ability of the board to properly oversee
management or understand the full extent of the issuer's operations and may be difficult
to describe to investors in disclosure.
ReIated Party Transactions related party transactions may represent an increased
risk for EM ssuers as they can be abusive if they only benefit the related party and not
the issuer. The OSC noted concern in some instances about the extent and frequency of
related party transactions and the processes that were in place to identify and approve
such transactions.
Risk Management and InternaI ControI the OSC noted that board members should be
sensitive to the unique risks associated with operations in emerging market jurisdictions.
Board members must ensure they understand the political and cultural risks impacting
the EM ssuer and assess those risks in the context of the EM jurisdiction. These risks
include political factors, governmental policies that may affect legal rights and property
ownership, conversion of currency and legal title to assets. Boards should be satisfied
that management has put appropriate internal controls in place to manage such risks.
Review of Auditors
The Notice states that the OSC is concerned that auditors may not always be performing
sufficient procedures necessary to understand and scrutinize the information provided to
them by an issuer and/or foreign component auditor. The OSC noted four key deficiencies
with respect to external auditors of EM ssuers:
auditors must be more sceptical of representations from management and take
independent measures to verify information received from management;
auditors lack knowledge of the local legal environment and cultural and business
practices and as such their analyses do not reflect local circumstances;
auditors rely too heavily on foreign component auditors and in some instances the
working paper files of these foreign component auditors were not made available or
could not be removed from the foreign jurisdiction which could prevent regulators from
reviewing files; and
auditors' ability to communicate with management and examine documentation is
impacted by language barriers and it was not clear how these issues were being
addressed.
Review of Underwriters
The OSC noted that underwriters are uniquely placed to verify information regarding the
issuer, its operations and management in prospectus offerings and listing applications and,
in order to fulfill their role, should participate in the offering process with scepticism
regarding management claims. The OSC noted the following concerns with respect to the
role of underwriters:
there are no explicit, standard requirements for the conduct of due diligence and as a
result, the OSC noted that in some cases, risks that were identified were not always
documented and if they were raised, there was little or no follow up recorded or evident
in the due diligence materials;
there is an insufficient level of professional scepticism and rigour in respect of red flags
that were identified during due diligence such as unusual growth, financial metrics that
were superior to industry average and significant reliance on government relationships
or the founder/CEO that should have prompted further questioning by the underwriter;
the due diligence information sometimes contained little documentation or discussion
with respect to the risks associated with the EM ssuer's operations; and
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in general, the level of due diligence documentation by underwriters with respect to EM
ssuers was found to be deficient and as a result, it was not always evident that the
approvals process called for by the underwriters' own internal process was followed.
Review of Exchanges
Finally, the OSC considered the role of stock exchanges in protecting the integrity of
Ontario's markets. The OSC examined EM ssuers who accessed the market through
different methods, including, POs, direct listings or RTOs and did not identify any particular
method of accessing the market as being specifically problematic. The OSC identified the
following deficiencies in the procedures and policies of exchanges with respect to EM
ssuers:
there is no requirement for an EM ssuer to maintain a meaningful Canadian presence
which could include having a combination of directors, key officers, employees, books
and records and assets located in Canada;
there is no public disclosure made where exchange discretion is exercised to waive
certain listing requirements for a particular issuer; and
there was concern noted regarding the amount of reliance exchanges place on the role
of sponsors to conduct due diligence given that the terms of sponsorship reports are
generally negotiated between the sponsor and issuer and the sponsor is paid a fee for
this service.
Next Steps
The Notice notes that EM ssuers represent an important growth market for Canadian
investments and the OSC states that it will continue to assess areas that require policy
examination and reform. The Notice generally makes recommendations that call for the
creation of guidance documents, best practices and increased vigilance by the various
stakeholders. Some specific recommendations include:
improving disclosure of foreign risk factors;
potentially creating minimum Canadian director residency requirements or minimum
language competency requirements for Canadian-resident board members in the
applicable local language;
establishing a consistent and transparent set of requirements for the conduct of due
diligence by underwriters and developing best practices around the documentation of all
aspect of an underwriter's due diligence; and
reviewing the role of sponsors in bringing EM ssuers to market to ensure that there is
adequate accountability placed on the sponsor and an appropriate level of transparency
regarding the sponsor's due diligence.
2012 Fasken Martineau DuMoulin LLP