SARBANES-OXLEY ACT OF 2002: Special Considerations for Reporting Issuers that Use MJDS

Transcription

1 Client Publication September 2002 SARBANES-OXLEY ACT OF 2002: Special Considerations for Reporting Issuers that Use MJDS The Sarbanes-Oxley Act of 2002 (the Act ) makes important changes to the laws governing companies reporting with the Securities and Exchange Commission (the SEC ). This memorandum describes some special considerations under the Act for Canadian reporting issuers eligible to use Form 40-F under the Multi-jurisdictional Disclosure System ( MJDS ). For a more general discussion of the provisions of the Act, we refer you to our client publications Sarbanes- Oxley Act of 2002 and Sarbanes-Oxley Act of 2002: Highlights for Foreign Private Issuers, both dated August 2, 2002, Sarbanes-Oxley Act of 2002: Dramatic Changes for Executive Pay and Benefits, dated August 7, 2002, and SEC Approves Accelerated Filing Deadlines for Section 16(a) Reports, Executive Officer Certification of Periodic Reports and Phase In of Accelerated Filing Deadlines for Periodic Reports, dated August 30, 2002, and available on our website at or upon request. The SEC adopted MJDS in 1991 to eliminate duplicative regulation and facilitate cross-border securities offerings by Canadian reporting issuers in the U.S. capital markets (and U.S. reporting issuers in the Canadian capital markets). Under MJDS, eligible Canadian reporting issuers may offer securities using a prospectus filed with and reviewed by applicable Canadian securities commissions. These MJDS issuers may also fulfill their continuous reporting obligations under the U.S. Securities Exchange Act of 1934 (the Exchange Act ) by filing or submitting their Canadian disclosure documents with the SEC. MJDS companies file annual reports on Form 40-F and submit interim financial statements and other current material information on Form 6-K. As a result, the substantive disclosure requirements applicable to MJDS issuers (other than the requirement to provide a reconciliation describing material differences between Canadian GAAP and U.S. GAAP financial statements) are determined by Canadian laws and regulations rather than the rules promulgated by the SEC. In practice, the SEC does not review the registration statements and reports filed on MJDS forms, relying instead on the review performed by Canadian regulators. The Act contains mandatory features that will change how MJDS issuers prepare their disclosure documents, notwithstanding the principle that MJDS documents are governed by Canadian laws and regulations. The extent of these changes will depend on how the mandatory provisions of the Act are interpreted and the substance of the rules with respect to the provisions of the Act that are still to be implemented by the SEC. The Act does not contain any general exemption for MJDS issuers, or other foreign private issuers, but several provisions require SEC rulemaking to be finalized and, under existing law, the SEC has the power to create exemptions. The provisions of the Act of particular interest to MJDS issuers are as follows: addition of substantive disclosure requirements to MJDS forms; CEO/CFO certifications; disclosure controls and procedures and other potential changes in internal business practices; requirement for real-time disclosure; and a mandate for the SEC to review filings every three years. I. ADDITION OF SUBSTANTIVE DISCLOSURE REQUIREMENTS TO MJDS FORMS The Act specifies several new substantive disclosure requirements. There are no exemptions for MJDS issuers or other foreign private issuers. Until now, Form 40-F and Form 6-K have not contained any substantive disclosure requirements beyond those prescribed by Canadian laws and regulations (other than a U.S. GAAP reconciliation of Canadian GAAP financial statements in most Form 40-Fs). SEC rulemaking should clarify whether and how MJDS

2 2 issuers must add these new disclosure items to their Form 40-Fs or Form 6-Ks. Although it is possible for the SEC to create a broad exemption for MJDS issuers, for many of the reasons set forth below we believe it is unlikely to do so under the current regulatory atmosphere and in light of the sentiments of Congress. Set forth below is a brief description of the new disclosure requirements. Disclosure of Auditor Adjustments The Act requires disclosure of all material correcting adjustments identified by the issuer s registered public accounting firm in accordance with U.S. GAAP and SEC rules and regulations. We expect that MJDS issuers annual reports on Form 40-F containing financial statements that are required to be reconciled to U.S. GAAP will need to contain this additional disclosure. Off-Balance Sheet Items and Pro Forma Financial Information The SEC must adopt rules by January 26, 2003 requiring enhanced disclosure of off-balance sheet items and pro forma financial information, including requiring issuers to reconcile pro forma financial information to U.S. GAAP. Disclosure of Approved Non-Audit Services The Act sets out a list of non-audit services that registered accounting firms will be prohibited from performing for their audit clients including, among others, financial record-keeping, financial systems design, legal, valuation and actuarial services (tax services are allowed). Any other non-audit services must be pre-approved by the audit committee and disclosed in an issuer s periodic report. The SEC must issue final regulations effecting these requirements by January 26, Internal Controls Disclosure The SEC must adopt rules (the Act does not establish a deadline) for disclosure in annual reports of an internal control report, describing financial reporting procedures and management s assessment of them. Auditors will be required to report on and attest to the assessment made by management. Financial Expert on Audit Committee The SEC must promulgate rules by January 26, 2003 requiring companies to disclose in periodic reports whether or not their audit committee has at least one member who is a financial expert (to be defined by the SEC). Code of Ethics The SEC must adopt rules by January 26, 2003 requiring disclosure in periodic reports of whether or not (and if not, why not) an issuer has a code of ethics for its senior financial officers. II. CEO AND CFO CERTIFICATIONS Under Section 906 of the Act, a criminal provision, CEOs and CFOs must provide a certification of all periodic reports containing financial statements filed pursuant to Section 13(a) or 15(d) of the Exchange Act. The officers must certify that: the report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and the information in the report fairly presents, in all material respects, the financial condition and results of operations of the issuer. It is clear that Form 40-Fs must be accompanied by the Section 906 certification. It is our view that Form 6-Ks do not need to be certified under Section 906. Section 906 applies only to periodic reports filed with the SEC under the Exchange Act, whereas Form 6-Ks are merely furnished to the SEC and are not considered to be periodic reports under the Exchange Act. Full Compliance with the Exchange Act Generally stated, reporting issuers comply with Section 13(a) or 15(d) of the Exchange Act by providing the reports and disclosures mandated by SEC rules. For U.S. domestic issuers, disclosure requirements are contained in an extensive body of rules promulgated by the SEC under the U.S. federal securities laws, most notably Regulation S-K, the primary regulation governing disclosure, and Regulation S-X, the primary regulation governing financial statement presentation. However, the disclosure requirements of MJDS forms are governed by the rules and regulations of applicable Canadian securities regulatory authorities. The SEC stated in its 1991 release adopting MJDS that: the Commission in essence is adopting as its own requirements the disclosure requirements of Canadian forms. The effect is the same as if the Commission had set forth each Canadian requirement within the MJDS forms. MJDS issuers, when certifying that their Form 40-F fully complies with the Exchange Act, will be indirectly certifying as to the compliance of their annual information form, management s discussion and analysis and financial statements with the substantive form requirements of Canadian law.

3 3 Fair Presentation of Financial Condition and Results of Operations Section 906 of the Act requires certification that a report fairly presents, in all material respects, the financial condition and results of operations of the issuer. This financial certification requirement does not refer to U.S. GAAP or Canadian GAAP. The legislative history indicates that Congress intentionally omitted reference to GAAP, thereby establishing the position that compliance with GAAP is not necessarily determinative of whether the financial information fairly presents an issuer s financial condition and results of operations. As directed by Section 302 of the Act, on August 27, 2002 the SEC adopted rules requiring certification as to matters in an issuer s annual and quarterly reports from its principal executive officer and principal financial officer. This certification is in addition to the Section 906 certification, but there is some overlap in the substantive matters to be certified. While the Section 906 certification is a criminal provision, the Section 302 certification will be administered by the SEC s enforcement division. For MJDS issuers, the Section 302 certification is required to be included in annual reports on Form 40- F, but not in interim reports on Form 6-K, for periods ending on or after August 29, The officers must certify that: (i) the report has been reviewed by them, (ii) there are no material misstatements or omissions, (iii) the financial statements and other financial information included in the report fairly present, in all material respects, the issuer s financial condition, results of operations and cash flows, (iv) the officers are responsible for the establishment and maintenance of disclosure controls and procedures, and (v) they have disclosed to the auditors or audit committee deficiencies in internal controls and the occurrence of any fraud, whether material or not, by management or employees who have a significant role in the internal controls. In connection with this certification, issuers must disclose the effectiveness of the disclosure controls and procedures (based on an evaluation of the controls and procedures within 90 days of the report) and whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any actions taken to correct deficiencies and weaknesses. It may be some time before there are judicial interpretations of the Act that give guidance as to the meaning of fairly presents as used in Sections 906 and 302. The SEC staff has stated that, because Section 906 is not an amendment to the Exchange Act, it will not give guidance with respect to a criminal statute for which it is not responsible. However, the SEC stated in the final rule implementing the certification under Section 302 of the Act that fair presentation means the financial information meets a standard of overall material accuracy and completeness that is broader than compliance with GAAP. This includes the proper application of appropriate accounting policies, disclosure of financial information that is informative and reasonably reflects the underlying transactions and events and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer s financial condition, results of operations and cash flows. Additional disclosure (in the financial statements, the MD&A or otherwise) may be required for a fair presentation even if the financial statements strictly comply with GAAP. Since the concept of fair presentation of financial information goes beyond compliance with GAAP, CEOs and CFOs, in order to make the certifications under Section 906 and Section 302, must bring to bear their specialized and detailed knowledge of their company s operations to determine whether the standard has been met, and different considerations will apply to different companies and industries. We believe a set of standardized rules will be unworkable since the judgements will be highly company specific. However, we believe there are several sources that can offer guidance for CEOs and CFOs. 1. Canadian Laws, Regulations and Guidance MJDS companies must first consider their compliance with the substantive requirements of Canadian laws, regulations and non-binding regulatory guidance (e.g., pronouncements of the Ontario Securities Commission (the OSC )). We understand that the OSC is examining the Act and considering whether the implementation of any corresponding rules would be appropriate for the Canadian market, given the desirability of regulatory consistency. Even before the Act, in June 2002 the Canadian Securities Administrators (the CSA ) proposed changes to Canadian MD&A disclosure requirements similar to the recent proposals by the SEC, including MD&A disclosure relating to liquidity and capital resources and critical accounting policies. 2. SEC Rules and Proposals Related to MD&A The quality of MD&A disclosure will no doubt be critical in assessing whether an issuer s financial position, results of operations and cash flows are fairly presented. Therefore, we recommend that MJDS issuers, in drafting their MD&A disclosure, consider whether following some of the SEC s rules and guidelines in addition to the Canadian law requirements might give a more complete picture of the company, even though compliance is not presently

4 4 required by the MJDS forms. This additional disclosure may give comfort to the CEO and CFO when they certify their U.S. filings on MJDS forms. The SEC has issued a statement on MD&A disclosure clarifying its views on how such disclosure should be improved. The MD&A disclosure matters addressed by the SEC are liquidity and capital resources, including off-balance sheet arrangements; certain trading activities that include non-exchange traded contracts that are accounted for at fair value; and effects of transactions with related parties. The SEC suggests that companies use a chart or schedule of commitments as an aid in presenting the total picture of their liquidity and capital resources. For additional detail on the SEC s views on MD&A disclosure, please refer to the release at In addition to its statement about improving MD&A, the SEC has proposed new disclosure requirements relating to critical accounting policies. The proposals would require disclosure concerning: critical accounting estimates made by companies in applying their accounting policies; and the initial adoption of new accounting policies that are not mandatory and have a material impact on an issuer s financial condition and results of operations. An accounting estimate would be considered critical and would be required to be disclosed if it meets two tests: (i) the estimate requires the issuer to make assumptions regarding matters that are highly uncertain at the time the estimate is made; and (ii) different estimates that the issuer reasonably could have used, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the issuer s financial condition, changes in financial condition or results of operations. For each critical accounting estimate, an issuer would have to disclose enough information to allow investors to understand the estimate s impact on the financial status, including a sensitivity analysis of the estimate and whether senior management has discussed the estimate with the audit committee. For further information on the SEC s proposed rule, please refer to our client publication dated June 2002, SEC Proposes Required Disclosure of Critical Accounting Policies. MJDS issuers may find it useful to consider the above SEC guidelines to help in determining if their financial positions and results of operations are fairly presented. In addition, adopting this style of disclosure ensures MJDS issuers (i) can be compared on a consistent basis with their competitors who may be required to meet these standards and (ii) in the context of a securities offering will meet the expectations of U.S. investors. 3. Item 17 versus 18 GAAP Reconciliation The SEC has not indicated that compliance with U.S. GAAP is a minimum standard for financial information to be considered fairly presented. Therefore, MJDS issuers that prepare their financial statements in accordance with Canadian GAAP should not be prejudiced in being able to meet the new standard. Nonetheless, issuers who do not reconcile their statements or who do so pursuant to Item 17 of Form 20-F might consider whether completing the more extensive Item 18 reconciliation, which would comply with all the rules of U.S. GAAP and Regulation S-X, would yield important differences that could bear upon the fairness of the presentation. III. CHANGES IN INTERNAL BUSINESS PRACTICES In addition to the new disclosure requirements and certifications enumerated above, the Act may require reporting issuers, including U.S. domestic issuers, MJDS issuers and other foreign private issuers, to make modifications to the way they conduct their affairs and how they report their financial condition and results. For example, MJDS companies are now required, under new Exchange Act rules 13a-15 and 15d-15, to establish disclosure controls and procedures, distinct from their internal accounting controls, to ensure that material information is communicated to their CEOs and CFOs. These disclosure controls will facilitate the making of the certifications under Sections 302 and 906. Other modifications to business practices will be forthcoming in SEC rulemaking mandated under the Act. The new requirements are, like the new disclosure items, in contrast with the traditional MJDS principle of deference to Canadian laws and regulations. IV. REAL-TIME DISCLOSURE The Act requires the SEC to enact rules (no deadline is set) to require reporting issuers to disclose, on a rapid and current basis, information about material changes in their financial condition or operations. This provision potentially represents a very important change in U.S. securities law, since current law does not always require real-time disclosure of material events. For example, reporting issuers who currently may keep merger negotiations confidential until a deal is fully negotiated, absent abnormal stock market activity indicating that news may have leaked,

5 5 could find themselves pressed to make earlier disclosures. The SEC s rulemaking should clarify the extent of the change in law as well as its applicability to MJDS issuers. To the extent Canadian reporting issuers are already required under Canadian law to make realtime disclosure of material information, and therefore file Form 6-Ks periodically to reflect such information, this new requirement might have little effect on MJDS issuers. V. MANDATED SEC REVIEW SCHEDULE Under the Act, the SEC is required to review listed issuers periodic filings, including their financial statements, at least once every three years. The Act does not exempt MJDS filings from the SEC review requirement, nor does it direct the SEC to make rules that could include an exemption for MJDS issuers. This provision is in contrast to MJDS, under which the SEC will not review MJDS documents unless it has reason to believe there is a problem with the filing. Pending SEC rulemaking, the impact of this new requirement on MJDS issuers is unclear. The SEC stated some time ago that it intends to issue rules revising MJDS. One of its proposals was to eliminate Form 40-F, and we believe that the SEC may do so and require all Canadian reporting issuers to file annual reports on Form 20-F. Form 20-F is the annual report form used by foreign private issuers, contains more detailed disclosure requirements beyond Canadian annual information forms and is subject to review by the SEC. This memorandum is intended only as a general discussion of these issues. We would be pleased to provide additional details or advice about specific situations if desired. For more information on the topics covered in this memorandum, please contact: Brice T. Voran (416) bvoran@shearman.com Christopher J. Cummings (416) ccummings@shearman.com Jason R. Lehner (416) jlehner@shearman.com SHEARMAN & STERLING 599 Lexington Avenue, New York, NY Under the regulations of some jurisdictions, this material may constitute advertising.