CSA consults on venture issuer regulation

The Alberta, B.C., Manitoba, New Brunswick, Nova Scotia and Saskatchewan securities commissions have released a consultation paper on venture issuer regulation. The Ontario and Quebec commissions, while not fully participating in the consultation process, have urged their market participants to comment on the proposals. The comment period closes September 17.

The consultation paper contains the text of proposed rules, but these are for "conceptual purposes" only. Any rule changes resulting from the consultation process will be issued for comment in the normal course.

The paper notes that venture issuers (that is, issuers listed on the TSX Venture Exchange and the Canadian National Stock Exchange, or that trade over the counter in Canada or on international junior markets such as AIM on the London Stock Exchange) face particular compliance challenges given the complexity and breadth of modern securities regulation. It concludes that one size does not fit all and that a tailored approach to regulation of venture issuers is appropriate. Of course, whether this threshold assumption is valid is one of the questions asked.

The paper proposes that current exemptions for venture issuers and special rules tailored for venture issuers be contained in stand alone rules. To make the rules easier to understand, explanatory text will not be in a separate companion policy, but will be in short guidance notes contained within the body of the instrument.

Continuous Disclosure

The proposal will streamline disclosure obligations for venture issuers. The requirement to file first and third quarter financial statements will be removed. Instead, issuers will file an annual report that contains aspects of the current disclosure requirements for an annual information form (AIF), management's discussion and analysis (MD&A), and annual financials. It would be a mandatory document - today a venture issuer is not required to file an AIF unless it wants to use a short form prospectus or take advantage of a prospectus exemption that requires an up-to-date AIF. The MD&A will discuss objectives, targets and milestones, and progress against those targets, rather than annual information disclosure and a two-year summary of financial results.

Issuers would also be required to file a mid-year report including MD&A and financial statements for the six-month period, as well as updating any information in the annual report that has changed in the interim.

Venture issuers would not be required to file business acquisition reports but would file a report similar to a material change report. Confidential filings would not be permitted as they are today. The paper gives no explanation why, but perhaps the regulators are concerned about misuse of confidential filings to delay releasing bad news.

Information circulars would only be required to contain disclosure strictly necessary to allow a shareholder to understand the matters to be voted upon at the meeting. Other information, such as executive compensation and corporate governance disclosure, would be contained in the annual report and would not have to be included in the information circular unless the annual report had not been filed at the time the circular is filed.

Issuers will be able to use "notice and access" to electronically distribute material to shareholders rather than mail them.

Governance

The proposal contains several governance measures:

• Directors and officers would have to act honestly and in good faith and to act with the care, diligence and skill of a prudent person acting for a venture issuer will be imposed. Although this is largely duplicative of corporate law, the proposal notes that some issuers are incorporated under legislation that does not contain these obligations and some venture issuers, such as trusts and partnerships, are not incorporated at all.
• Boards of directors would have to have procedures to ensure they are made aware of, and have an opportunity to discuss, conflicts of interest between the board and management and any proposed related party transactions.
• Companies would have to have procedures to deter illegal insider trading.
• The CEO, CFO and two directors would have to sign a certificate filed with the annual and mid-year reports that the reports contain no misrepresentations and fairly disclose the information. They would also confirm that all of the directors and officers had confirmed their compliance with the proposed duty to act honestly and with the care and skill of a prudent person.
• Audit committees would be required to have a majority of members who are not officers or employees of the issuer or its affiliates.
  

The provisions regarding the rights and responsibilities of directors and officers fall squarely under corporate law rather than securities law, and it is hard to see how the commissions have the authority to implement them. However, that is a matter for another post, another time.

Prospectuses

The main proposal with respect to prospectuses is to reduce the requirement for three years' prior financial statements to two.

The Financial Crisis I: It's the Governance, Stupid!

We are seeing the butterfly effect writ large: a family in suburban Pittsburgh can't pay their mortgage, so Iceland goes bankrupt. Or perhaps a better analogy is the 1970s PBS show Connections, where James Burke showed how new inventions are based on older ones (and we wouldn't have modern telecommunications if the Normans hadn't worn stirrups at the Battle of Hastings).

Much has been written about the failure of legislators and regulators, and in a subsequent post I'll be playing pundit and make fearless predictions about regulatory responses. But in this post, I want to look at the failure of governance.

All Risk, No Reward

The current recession/depression (call it what you will) came about largely because there were incentives to take huge risks with very little apparent downside.

People bought houses they wouldn't be able to afford when their mortgage interest rate reset because they were told that they would have no trouble refinancing at a more attractive rate when the time came.

Mortgages were packaged and resold to investors, including banks. Normally, this would be a prudent thing, as having a large portfolio of mortgages should mean that most of them are sound and the few that will fail won't have a material impact on the value of the portfolio. What happened was anything but prudent: Because the lenders no longer owned the mortgage (and the risk of default), they were encouraged to lend to everyone in sight, whether or not they were creditworthy. In a recent article in the New York Times, Gretchen Morgenson reports that a mortgage loan underwriter at Washington Mutual was put under intense pressure to approve loans she strongly believed should be turned down.

Companies made investments in complex derivatives. Again, this could be a prudent move, as derivatives can be used to offset risk. However, many companies used derivatives to increase their risk. Although they potentially had good returns, they also had a huge downside risk. In part this was due to the decoupling of compensation from performance and lack of effective board oversight. Executives got substantial bonuses even though the company's stock performed badly. In a worst-case scenario they would be fired and collect huge golden parachute severances.

The net result is a financial crisis that is engulfing companies with exemplary governance practices. The gut response is to take a very cautious attitude and attempt to eliminate all risk. This is neither desirable nor practical. Things will get worse if there is no credit for worthy borrowers. Derivatives, even complex ones, can be an important tool to mitigate risk if used properly.

What to Do? What to Do?

The problem for boards, and audit committees in particular, is how to tell if a financial product is being used properly. This can be daunting when the investment is so complex you need postdoctoral studies in mathematics to understand them. That doesn’t mean they should be necessarily avoided, but they must be carefully scrutinized.

That said, what is a poor audit committee member to do? My advice is simple: don’t be afraid to look stupid. Keep asking questions. It is not necessary that you fully understand the product, but you need to satisfy yourself that management does. Ask questions such as:

• What is the maximum downside if everything that can possibly go wrong happens? Don’t accept an answer that a worst-case scenario will never happen. We’ve just seen that it does. If the worst-case scenario is insolvency, the product should either be avoided entirely or only a small investment made.


• What other individual factors can affect performance? In other words, what is the total risk involved and is it justified by the return.


• How is the risk being monitored? The more significant the risk, the more closely it must be managed. This may mean real-time risk management.


• What are the market signals that will indicate a position should be unwound? How easily can that be done? What if there is no liquidity in the market at that time?
  

These are just a few of many questions. If answers are evasive or unclear, it may either indicate that management knows the position has more risk than the board will be comfortable with or that they don’t fully understand the risks themselves. To turn an old cliché on its head, in these cases it is far better to speak up and be thought stupid than to remain silent and remove all doubt when the company goes under.