A lack of substance

A lack of substance
Illustration:Robert Carter
The Ontario Securities Commission has fired a shot across the bows of emerging market companies listed on Canadian stock exchanges and those involved in bringing them to market in a scathing report that accused boards of directors, underwriters, auditors, and exchanges of falling short in their obligations.   
And while the jury is still out on whether the commission has the will to follow through on its tough talk with concrete action, most agree the spotlight shone on questionable practices in the area is unlikely to shift any time soon, especially with high-profile collapses still working their way through the regulatory and legal systems.
In March, the OSC released its Emerging Markets Issuer Review after a nine-month study of 24 Ontario reporting issuers with significant operations in emerging markets, such as Asia, Africa, South America, and eastern Europe. That sample accounted for just over one-fifth of Canada’s 108 emerging market issuers. Together, they had a market capitalization totalling around $40 billion.

Central to the OSC’s concern was an apparent “form over substance” approach to compliance by issuers and gatekeepers alike.

“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,” reads the report.

The OSC also found that the massive physical distance between issuers’ emerging market bases and their Bay Street partners was reflected in the disconnect between companies’ local management and their Canadian governance. Management oversight, they found, was also hampered by a lack of local business practice knowledge and language barriers. 

For Ermanno Pascutto, the executive director of investor rights group Canadian Foundation for Advancement of Investor Rights, the OSC is late to the party with its assessment, one he says is long overdue.

“These are concerns I’ve had for a long time. In two decades of promoting these listings, they haven’t addressed them at all. I’ve mentioned it to the Toronto Stock Exchange on a number of occasions, that the Canadian market is basically not equipped to handle emerging market issuers as the situation stands right now,” he says. “Everyone has been making lots of money, except investors, and very little attention is paid to the great problems until there’s a crisis.”

The review was launched in July 2011, one month after a devastating report by short-seller Carson Block labelled TSX-listed Sino-Forest Corp. a “multi-billion dollar Ponzi scheme.” Since then, the company has been delisted from the stock exchange, and the OSC has levelled its own fraud allegations against it and its former executives. Another Chinese company, sportswear manufacturer Zungui Xaixi Corp., which is listed on the TSX Venture Exchange, has also kept the issue in the headlines after it was accused of capital market abuse. Both companies are also the targets of proposed class actions by investors.

Still, late is better than never, according to Pascutto.

“It’s good to see this commission has at least acknowledged the problems and started to dig in,” he says. “The review has opened the eyes of the regulators to the extent of the problem, but it stopped halfway, in that it didn’t lay out a roadmap with concrete steps on how to tackle them, and a timetable to make sure they’re doing it on a timely basis.”

Instead of new rules or policies, the OSC emphasized its current expectations that issuers and gatekeepers “discharge all of their responsibilities in a way that promotes the protection of Ontario investors and confidence in our markets,” and recommended the “development of guidance, best practices, or enhanced vigilance” to help them get up to those minimum requirements.
Ed Waitzer, a former chair of the OSC, currently a partner at Stikeman Elliott LLP in Toronto, says the “aspirational” recommendations fall short.

“It’s fine for the OSC to say: ‘here’s what we expect.’ But what you would have hoped for is something about how you can get there, and what they’re going to do if you don’t meet those expectations. There’s no real practical guidance,” he says.

Notable by their absence in the report, Waitzer says, was a critique of the roles of lawyers and the OSC itself.

“They point the finger at all kinds of people, but not at themselves, which makes me think that people who live in glass houses shouldn’t throw stones,” he says. “Its incompleteness undermines the integrity of the analysis from my perspective.”

But John Wilkin, a partner in the securities group at Blake Cassels & Graydon LLP who has advised emerging market companies considering access to Canadian capital, says behind the scenes, OSC staff are asking noticeably more pointed questions of issuers in the wake of the report, and that players in the system have heeded the wake-up call from the regulator.

“On prospectus reviews, you’re seeing questions that prior to Sino-Forest maybe they weren’t necessarily focused on,” he says. “They’re asking about what measures the underwriters took in conducting due diligence, they want to know about title opinions, so they’re really testing the process. I think the impact has been better documentation and communication of those practices to the regulators.”

For issuers themselves, the OSC expressed concern that boards of directors lacked knowledge of the cultural and business practices in the jurisdiction where the business was based, and the potential risks that arise as a result of those differences. That meant there was a tendency to defer to senior management on the ground, and often little contact between the two. Transparency in the corporate structure and disclosure around related party transactions was also found wanting, according to the review.

Emerging market companies need to spend a lot more time thinking about who to place on their boards, says Wilkin, with language capability a key factor.
“We’re advising companies to make sure there is sufficient understanding of Canadian capital requirements on the board, as well as that link to the senior management team,” he says.

Companies have responded to the OSC’s focus on internal controls by improving communication and disclosure at every level, according to Wilkin.

“The OSC policy statement is really about making sure the information that is getting to the market is as good as it can be, and that can only serve to strengthen the capital markets,” he says.

Mindy Gilbert, a partner at Davies Ward Phillips & Vineberg LLP in Toronto, says general counsel at all issuers, emerging market or not, can learn lessons from the OSC comments. “They serve as useful reminders to all Canadian reporting issuers about good corporate practices,” particularly for more complex businesses, she says. “The OSC report highlights that issuers operating in multiple jurisdictions need to be aware of the risks associated with local business practices and the regulatory risks of operating in those jurisdictions. They need to make sure investors, management, and the board are all aware of those risks.”

For auditors, the OSC report may have made familiar reading. The profession’s regulator, the Canadian Public Accountability Board, released its own assessment of members’ performance one month before the OSC, based on an investigation of 24 issuers with primary operations in China. 

Both the OSC and CPAB identified language and cultural barriers as serious issues, as well as overreliance on management representations when it comes to the external confirmations. Where auditors delegated work to component or affiliated firms in China, CPAB and the OSC are hamstrung by privacy rules that prevent working papers from leaving China. Six of CPAB’s 24 reviews were rendered incomplete by their inability to access documents.

Brian Hunt, CPAB’s CEO, says he was disappointed at the findings, which he put down in part to growing pains as emerging market companies are increasingly targeted by Canadian stock exchanges for listing.

“This is a wake-up call. I think people were naively thinking they could go to China, with a team of Canadians who spoke the language, do the audit, and be very successful,” Hunt says. “I think they’ve realized you also need to understand the business practices in those countries and the legal structures. You can’t just take audit procedures that are done in Canada and apply them there. It’s not about whether those differences in business practices or legal structures are right or wrong, it’s just about recognizing them and adjusting your audit practices accordingly.”
Half of the files CPAB reviewed required remediation, and one audit firm saw its ability to operate in Chinese restricted following disciplinary action arising from the review. Further reviews are planned of issuer audits in other emerging markets.

“If we find that firms are continuing in their own ways and they’re not addressing these issues, we’ll take the appropriate action,” Hunt says.

Wilkin says he advises companies thinking about going public to get Canadian auditors involved early and to minimize the amount of delegation to local auditors.

“We are helping the issuer set up its internal processes in anticipation of going under the scrutiny, so we’ve got the Canadian auditors at the centre of the process, whereas they may have been dropped in at a much later stage in the past,” he says.

Underwriters also came under fire in the OSC report, which noted that there are no standard requirements for due diligence conducted by them. As a result, there were wide variations in the thoroughness of the process. The OSC documented abandoned site visits, unusual growth results that went unquestioned, and little discussion of the risks associated with an issuer’s operations. Pascutto once worked with the Hong Kong Securities and Futures Commission, and says he was struck by the contrast between underwriter practices there and in Canada.
“The underwriters in Hong Kong have a full staff in China who are experts in the financial markets there and taking companies public. Canadian underwriters don’t have that kind of infrastructure,” he says. “In fact, a lot of them have been underwriting Chinese companies without having any staff that even speak Chinese or know China. It’s unbelievable.”

In a statement, IIROC spokesman David Thomas said the organization was working with the OSC to address the gaps its report identified, and is also “in the process of establishing an industry advisory committee to discuss current underwriting standards and best practices, beginning with a dialogue on underwriter due diligence generally, as well as the unique challenges of underwriting securities for emerging market issuers.”

For stock exchanges, the OSC review suggested a rethink of policies and procedures geared towards emerging market issuers may be due, noting the lack of any requirements that issuers maintain a meaningful Canadian presence. The OSC was also concerned by exchanges’ reliance on third parties in the due diligence process and the lack of transparency when it waived previously published listing requirements for particular issuers.

Kevan Cowan, the president of TSX markets and group head of equities for TMX, says the TSX is currently in the middle of developing its own guidance for emerging market issuers, and consultations are ongoing with stakeholders involved in the listing process.

“In the past, we have imposed different rules on foreign issuers. As the world becomes more and more globalized, things change, and we can refine the rules and guidance,” Cowan says.

When the results are published later this year, he says they will boost investor confidence.

Wilkin says Canada is still an attractive market for foreign issuers. “It may take a bit more time for some issuers to complete the listing process, and a bit more pre-planning with their advisers to get properly dressed up, but I don’t see it being a significant barrier,” he says.

According to Waitzer, the OSC shied away from a real discussion on curtailing emerging market interest in Canadian capital. A greater focus on regulatory action against issuers and gatekeepers would have forced that issue, he says.

“As a price of admission to our market, are there prophylactic measures we want to have in place so that if something goes wrong we know that we can get in and do something about it,” he says. “Do we want to scare off these listings? That’s a legitimate debate to have, but I don’t see it laid out here.”

Pascutto says the TSX has made the lax regulatory environment in Canada a selling point for potential issuers in emerging markets, but the quality of the companies attracted is not always high. In China, for example, he says the top-tier issuers list in Shanghai or Hong Kong, leaving the rest of the world to chase the leftovers. He sees the review as an important first step, but warns investor confidence is still at risk unless the OSC makes more progress.

“Once the money leaves the country, you have no way of investigating, of getting access to books and records, or taking any action. That’s the problem. And if they can’t tackle that issue, you have to give some thought as to whether we should be listing these companies at all,” he says. “We’re still only in the second or third inning. It remains to be seen what kind of action they will take. We’ve still got a long way to go.”

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