Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 2 - Evidence of October 30, 2002
OTTAWA, Wednesday, October 30, 2002
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:10 p.m. to examine and report
upon the present state of the domestic and international financial system (Canadian perspective to the Enron collapse).
Senator David Tkachuk (Deputy Chairman) in the Chair.
The Deputy Chairman: I will be in the chair this afternoon since the chairman had to be away.
We have a number of pretty important witnesses this afternoon. We will try to give each one of them serious
consideration. We will sit as long as we can.
We are very happy to have before us this afternoon Mr. David Brown and Mr. John Carchrae of the Ontario
Securities Commission. I assume you have a presentation to make. How long will you be, Mr. Brown?
Mr. David A. Brown, Q.C., Chair, Ontario Securities Commission: I have about 15 minutes of remarks and then I
will be pleased to answer questions.
The Deputy Chairman: Please proceed.
Mr. Brown: I appreciate this opportunity to discuss with you the need to restore confidence in our capital markets in
light of the recent financial scandals in the United States.
The OSC and other regulators are working with governments, industry stakeholders and investors to implement
reforms that inspire investor confidence and protect investors.
I have tabled a report with your committee that is similar to a letter that I propose to send to all market participants
in Ontario within the next few days. That letter and the report that I have tabled with this committee, reports on the
steps that we have taken over the past few months to deal with this issue.
We know that there has been a spillover effect from the damage to investor confidence in the United States. We
must address that. If we are to attract both foreign and Canadian investors, they must have confidence in the safety of
our markets. At the same time, if we are to attract issuers, we need a regulatory system that is not too burdensome or
costly. That is the balance that we must achieve to ensure that our markets remain competitive.
Regulators and provincial governments have a clear responsibility to deal with this issue. The problem will not be
solved simply by pointing fingers at individuals, professions or stakeholder groups. It is a systemic problem demanding
leadership and a plan of action.
For the first time, we are witnessing a ``disconnect'' between the robust real economy and a weak capital market. It
is easy to blame directors or audit committees, CEOs, CFOs, auditors and analysts, lawyers and rating agencies,
regulators and investors themselves. Some seem to feel that, if a few people are punished, and if the professions and
organizations involved in the system promise a new attitude, then the problem will be solved.
The weakness in that thesis is that it assumes that these participants took on their rolls as ill-intentioned people bent
on malfeasance and fraud. In fact, overwhelmingly, we are dealing with well-intentioned people. For the most part,
they were reacting to the environment of the 1990s, responding to market pressures, reacting to incentives, and taking
advantage of apparently legitimate opportunities.
The problem is that parts of our regulatory system are flawed, providing incentives that individuals find hard to
ignore. We need to analyze these flaws in the system and correct them. We need to do that with surgical precision. The
Sarbanes-Oxley Act has done precisely the same thing, cleaning up the flaws, discrepancies and weaknesses in the U.S.
As responsible regulators, our job is to learn from the U.S. experience. This does not imply that we graft the
Sarbanes-Oxley Act in its entirety onto our market. We need to determine the exact regulatory remedies that are right
for the Canadian market.
To the extent that a change in attitude can solve a problem, we are already seeing considerable progress. We are
seeing large companies voluntarily committing to improve their forms of corporate governance and enhancing
voluntary disclosure. A coalition of senior executives adopted a new voluntary code for its members. We are seeing
large institutional investors making improved governance and transparency a priority and promising to hold
corporations to their commitments. This market self-correction is an important step forward, but there is a limit to the
market's ability to correct itself, especially in areas like audit quality, disclosure standards and conflicts of interest. As
we have seen, corporate executives do not always have the right incentives to follow the appropriate practices, and
investors do not necessarily have all the information needed to police them. We are not content to see some
corporations improve their practices, while others lag significantly behind.
We have to lock in these improvements and make them a market norm. By strengthening and clarifying
requirements in financial reporting and corporate governance, as opposed to simply encouraging voluntary action, we
can ensure that high standards are followed consistently by all public companies. We can level the playing field and
ensure consistent corporate behaviour. Thus, high standards of transparency and accountability become the floor that
all traded companies stand on rather than a ceiling that many may never approach.
By locking in reform, we can ensure that it does not follow the cyclical pattern that characterizes so many market
corrections. They tend to be borne in down markets, but lost to the irrational exuberance of boom markets. Locking
into reform also ensures that standards are comparable across the country. otherwise, some companies may be tempted
to pursue a competitive surge for the weakest regulatory regimes, prompting a race to the bottom.
In that respect, the OSC is pleased to be working closely with colleagues in the other 12 provincial and territorial
commissions. The integrity of our capital markets is too important to be left entirely to voluntary action. Today,
people can invest wherever they want. We have to give them the confidence they need to invest here. It comes down to
this: Public confidence in financial reporting and corporate governance cannot depend on individual commitment and
judgment. It must be backed up by regulation.
We need to send a strong message that we are restoring confidence and protecting investors in a uniquely Canadian
way that recognizes the importance of maintaining our competitiveness in a relatively small market. We need a made-
in-Canada solution — one that takes into account our unique circumstances such as the large proportion of small cap
It is important that we reassure U.S. regulatory authorities of the integrity of our market. Such confidence is
essential to maintaining the multi-jurisdictional disclosure system under which Canadian-based issuers are able to
access U.S. capital markets simply by complying with Canadian listing and disclosure requirements.
I am pleased to tell that you the OSC and the SEC are engaged in an active dialogue regarding the cross-border
issues raised by Sarbanes-Oxley. The SEC is interested to learn how Canada proposed to deal with the issues addressed
by Sarbanes-Oxley and whether there will be any substantial conflicts between the two regimes. We understand that the
SEC is prepared to consider ways to accommodate home country requirements and regulatory approaches, where
We need to assure our American neighbours and our market participants that Canadian markets are safe for
investors and open for business. The measures that the government and our commission propose to put in place will
strengthen our ability to protect investors and restore confidence in our markets.
There are six principal areas where I think significant progress is being made. I will list them and then talk about
them individually. They are: first, audit committee roles and composition; second, CEO and CFO certification; third,
public oversight of auditors; fourth, auditor independence; fifth, broadened sanctions for wrong doing; and, sixth, civil
liability for continuous disclosure. I would like to touch on each of these areas, but in reverse order.
We are pleased to that the Government of Ontario introduced legislation earlier today that empowers consumers,
strengthens our enforcement capabilities and gives the commission additional tools to protect investors and restore
confidence. The legislation proposes to amend the Securities Act to provide for civil liability for secondary market
disclosure. This will provide rights of action to secondary market participants who represent the overwhelming
majority of capital market activity. Our CSA colleagues have approved these proposals and they were endorsed by the
Purdy-Crawford five-year review committee.
The Sarbanes-Oxley Act was built upon the existence of a well-established civil liability regime. I am pleased that we
will be able to level the playing field and provide Canadian investors with similar rights to sue public companies,
officers or directors for false or misleading disclosure.
Second, the legislation proposes to strengthen the OSC's enforcement capabilities with new powers enabling the
commission to impose a maximum fine of $1 million for violations of the Securities Act, increasing the maximum jail
term for insider trading from two to five years, increasing court-imposed fines to a maximum of $5 million, and
clarifying offences such as securities fraud, market manipulation and misleading financial statements. The commission
also has the authority to order firms to disgorge profits made as a result of illegal activity.
Third, in the area of auditor independence, the Public Interest and Integrity Committee of the Canadian Institute of
Chartered Accountants has issued for public comment an exposure draft containing proposed new Canadian
independence standards for auditors. I understand that Mr. Smith, the CEO of the CICA, will be addressing this
committee after we are finished.
Although the CICA's independence project began before the string of corporate failures in the U.S. and the passage
of the Sarbanes-Oxley Act, its proposals contain many of the new independence requirements now mandated in the
U.S. The CICA has undertaken to consider adding additional requirements now set out in Sarbanes-Oxley.
Fourth, in the area of public oversight of auditors, this past summer federal and provincial regulators and the
Canadian Institute of Chartered Accountants announced the creation of a Canadian public accountability board to
oversee auditors of public companies across Canada. The board will be responsible for regularly reviewing the audit
practices of firms auditing public companies. Where appropriate, the board will work with provincial institutes and
regulators to impose remedial measures and sanctions. A council of governors that I chair is engaged in a public
process of choosing a chair and seven other members of the board. Indeed, we expect to announce the chair
Of the six issues that I identified earlier, two of them, namely, civil liability and sanctions for wrongdoing, are now
legislative initiatives. Two others, namely, auditor independence and public oversight, are being addressed on separate
tracks. We fully support the Ontario government on the legislative initiatives and will continue to monitor and support
the other two initiatives.
Much of our attention is now focused on the remaining two issues: certification and audit committees. Let me start
with the issue of requiring CEOs and CFOs to certify that their company's financial disclosure fairly presents its
The legislation that requires CEO and CFO certification is a first. This is the legislation in the United States. Up
until now, auditors have only vouched for the fact that a company's statements are presented fairly in accordance with
generally accepted accounting principles. Sarbanes-Oxley goes beyond that. U.S. executives now must assure investors
that the entire package of information given to the public is a fair representation of the financial condition of the
company. They must also give assurances about the adequacy of the company's internal controls.
Canadian investors expect and demand the same qualitative assurances. I should point out that almost all of the
feedback that we have received on this proposal has been positive, including from the Toronto Stock Exchange. The
expectation is that we will introduce this requirement into Canada.
The final issue I want to discuss is the role and composition of the audit committee. One of the lessons learned from
the U.S. experience is that auditors must be responsible to shareholders. Technically, that is how it should work. In
reality, however, shareholders are too widely disbursed to direct the auditors. Management has been taking on that
role, but it is management that the auditors are supposed to be scrutinizing. Led by Sarbanes-Oxley, there is now a
move worldwide to transfer this function to a body independent of management. In many countries such as Canada,
this will be the audit committee. In short, the audit committee, independent of management, will be the proxy for the
shareholders. The audit committee will become the auditor's client, not management. The audit committee will hire
and fire the auditor and it will direct the performance of the audit.
For this cultural shift to be effective, however, the audit committee must be truly independent of management. It
must be able to say no to management. The legislative package introduced today proposes to give the OSC the
authority to make rules governing the functions and responsibilities of audit committees. This issue has been a
contentious one in our consultations. The TSX, for example, has proposed that changes to audit committees be in the
form of voluntary guidelines. Voluntary guidelines may have some value in that they provide direction and flexibility,
but they do not ensure consistency. Consistency in corporate practices is essential to confidence.
You may recall that just a few years ago a predecessor of mine, Peter Day, headed a task force on corporate
governance on behalf of the Toronto Stock Exchange. That task force put forward a number of voluntary guidelines
that raised the corporate governance bar that existed at that time. The only binding requirement on listed companies
was to report annually on their form of corporate governance, elaborating on which of the governance guidelines they
had not met and why. The result, according to a subsequent follow-up study by the TSX, entitled ``Five Years to the
Day,'' found that a number of the TSE guidelines are now broadly accepted business practices. However, the study also
pointed out that important areas remain where general practice falls short of the guideline's intent. Indeed, a post-
mortem examination by the Day committee itself was even more critical. They concluded that the response by
corporate Canada had been more formal than substantive, and that the corporate sector in Canada had not yet
achieved a culture of compliance. At best, the results were uneven; best practices were not locked in.
Given this poor track record, it is questionable whether we can improve public confidence if we rely solely on
voluntary compliance and disclosure by companies to adopt fundamental changes to the role and independence of the
Some regulators and industry participants have raised concerns about the impact of these changes on small cap
companies that have smaller boards and limited resources. Once we complete our analysis, we may decide that some
exemptions or possibly thresholds may be appropriate for smaller companies but, frankly, good governance is
important to all investors in all companies, regardless of size. We need to carefully assess the costs of implementing
these regulatory requirements against the benefits to investors and our markets. Relief should be granted only where
the costs are not justified.
Without a question, there are considerable challenges that we need to address before we can restore investor
confidence, but we are also seeing considerable efforts to address this problem through cooperative efforts by federal
and provincial governments and by regulators. The will is there that investors need to be assured that reform will not
be fleeting and that it will not disappear with the next bull market. They need to know that reforms are not just
adopted, but locked in by regulation.
Investors and issuers need to know that we will be taking proactive steps to ensure a safe market as well as dynamic
one. A robust economy needs both people who are prepared to invest capital and people who are able to use it to create
I am pleased to have been invited to brief you on some of the changes that are being implemented and some that are
being considered; and I look forward to your questions.
Senator Angus: Welcome, gentlemen. It is nice to have you here before the committee, especially at this time with
corporate scrutiny going on and ``corruption,'' as Senator Prud'homme points out. It is very timely inasmuch as we
have just learned from you that your legislation was just tabled in the Ontario legislature today. That is, perhaps, a
good place to start.
I have read a lot of reportage lately that the Sarbanes-Oxley legislation in the United States was a knee-jerk reaction
to a situation that could be described as, ``the bubble bursting,'' if you will, as a result of the systemic problem that you
have described well. However, it is being said that it went way too far and that it is extreme in its nature. A lot of this
reportage is to the effect that Canada should not do the same, but that guidelines and voluntary guidelines — perhaps
not voluntary guidelines — is the way to go in Canada rather than legislation.
I noted several weeks ago that you announced that you felt legislation would be a good thing, so I am assuming that
the bill was introduced today. Perhaps we could obtain a copy of that bill as soon as possible. It must be available
Mr. Brown: I do not have a copy of it because I understand it was being tabled as I travelled to Ottawa today.
Senator Angus: The item in our favourite national newspaper on Tuesday brought it into focus for me. That was the
piece about the Quebec Securities Commission, QSC.
Senator Prud'homme: That was not in the NationalPost, I hope.
Senator Angus: No, the Globe and Mail article stated that the Quebec Securities Commission voices caution on
governance. The article went on to state that the whole issue of one-size-does-not-fit-all and it dealt with the risks of
legislating with a broad brush. Could you comment on this, because it is an area where there is already a debate?
Perhaps your bill, which is not akin to the American Sarbanes-Oxley Act of 2002 here in Canada, will be a different
kind of law.
Mr. Brown: The legislative package that was introduced today is designed to do precisely what you are alluding to,
and that is, that it will enable us to look at the elements of the system that the analysis, in the aftermath of WorldCom
and Enron, has identified, and that needs some fixing. It will allow us to address each of those individually, rather than
on a broad-brush basis. We will be able to look at each of the elements that appeared to have failed in the United
States, so that we will know whether we have the same potential issues because, in Canada, our markets have the same
structure and so we will be able to determine how we will fix them in the backdrop of the Canadian system.
We have already done some things in Canada better than they have done in the United States, and we do not need to
fix those. We have different institutions in Canada from those in the United States. We already have a robust system of
certifying chartered accountants and reviewing the work product of chartered accountants.
We need to take what they are doing in the United States and adapt that for Canada. We need to look at each of the
provisions that we might adapt to Canada and determine whether they make sense only for large companies or for
companies from the top to the bottom of the spectrum. To the extent that they do not make sense for smaller
companies, we could determine how we might grant relief, given that the system is attempting to fix some systemic
problems and, at the same time, to ensure that Canada maintains a reputation as a place safe for investors where we
have robust governance and other requirements.
Senator Angus: The investor would certainly agree with you that there has been a spillover and a falling away of
investor confidence in Canada. It is no wonder because many of the big companies on the stock market are American.
People talk about Enron and WorldCom and the study we are doing uses those names. However, many of us have
received input from Canadians asking why we refer to Enron and WorldCom, rather than Livent, CINAR, or Nortel,
for that matter which at one time last year was your main client in terms of the percentage of market capital on the
Toronto Stock Exchange, the TSX.
How bad is it in Canada? The spillover exists, the confidence is gone, and nobody believes the numbers. It is out in
front of the retail investor all of the time. I know that the Ontario Securities Commission is the watchdog and that it is
not music to your ears. The little guy does not think he has a chance now. The small investor does not know what to
believe and he does not get the information he needs. I know the problem is bad, but how bad is it?
Mr. Brown: One of the barometers for the OSC has been the pension funds, mutual funds and other money
managers. A large percentage of Canadians who have investments in the market do it indirectly through their pension
funds or through mutual funds. A large percentage of Canadians have investments in the market but many of them are
As you may have seen a few months ago, a large number of those institutions — professional money managers —
joined together in a coalition to try to address the corporate governance issues and the lack of investor confidence.
They feel strongly that we need to look seriously at these measures to try to restore confidence in these markets. They
believe that, until we do that, our markets will not recover to the levels that people expect.
Senator Angus: In other words, it is pretty bad in Canada. I am not just talking about the lack of confidence but
about the underlying reason for the lack of confidence.
Mr. Brown: As you have pointed out, we have had our own issues in Canada. Some of the problems that have
surfaced in the United States during the analysis are similar to the problems that we have seen here. There is no reason
for us to believe that we do not have the same structural problems in Canada.
Senator Kroft: We have a hidden factor for consideration because of the proposed Ontario legislation which was
introduced today. You have not had a chance to look at it and nor have we.
We had the opportunity to begin our discussions in June and we are now continuing. We also had the opportunity
to have a session with the President of the TSX. I would suggest that you and the exchange represent two main points
of view, but that may not be a fair characterization, so I would invite you to comment on my opening presumption.
However, as a starting point, could you give your assessment of the gap, or the differences? Is there a major difference
in viewpoints? Does that represent some of the open questions? To what extent does the proposed new legislation
address the issues that you have been discussing; or does it reconcile them; or are their still two major points of view?
Mr. Brown: Thank you, senator. I will address the first question. I do not think there is a major difference between
what we have been saying, what the Toronto Stock Exchange has been saying and, indeed, what other commentators
have been saying. There is a group that urges caution and asks us to ensure that we understand the ramifications of
some of these new requirements for small business, particularly small business with constrained resources and difficulty
in attracting independent directors. Clearly, we have to listen to that group, and we have to find the balance. We have
to hear from investors because this issue is about investor confidence. We have to understand what will motivate
investors to return to the market and regain the trust that they had in corporate Canada before.
We are listening to the opinions of small issuers, and we also need to know what the market investors have to say so
that we may find a balance between them. We believe that we have to assist our markets in maintaining a reputation of
a safe and fair place to invest. The dangers of not achieving that goal are twofold: first, investors, who now have the
mobility to put their money anywhere in the world where they believe they will receive a fair return and have the
necessary safety, will migrate away from our markets, and we will lose some of our liquidity. That is important to the
soundness of our markets. Second, Canadian companies need the ability to raise capital in other markets, and they do
not want to go to other markets, particularly in the United States, having to apologize for the fact that, in their home
country, they are not perceived to be as safe and as robust as in the U.S.
It is important for us to address perception and investors' perception, and to ensure that we do not institute rules
and regulations that make our businesses uncompetitive. That is the balance that we are trying to develop and, in the
early days of this dialogue that has been waged publicly — and we deliberately tried to precipitate a public dialogue —
we heard more from the issuer side. We are now starting to hear from the investor side.
As you your second question, the legislative package that was introduced today will give us the ability to promulgate
rules to fix some of these areas. Our rule-making process is such that we draft rules usually after broadly consulting.
We then put them out for consultation. They are out often for 60 days or more for consultation before they become
final. The legislative package introduced today will give us the tools that we need to go to the next step, which will
involve a great deal more consultation.
Senator Kroft: My sense of the position you were taking in June, from reading some of your statements, and from
having the opportunity to listen to you, was that you were taking quite an appropriately cautious approach. I refer to
Senator Angus' concerns as to not to get too far ahead of the curve, not to become too rigid and not to make Canada
too difficult a place, on a comparative basis, for capital markets to function and for investors to be attracted. As I see
the product of your work now, you are certainly an advocate of firming up our position and ensuring that there is no
discomfort level between us and other markets.
I am curious about what you have learned through the process because you started with one view, and now I of hear
you as not being the advocate of a harder line — and that may be an exaggeration. However, it seems that there has
been an evolution in your thinking, which is quite natural. Events have changed and things have happened. Could you
share with us how you viewed this, and the progress of the development of your thinking?
Mr. Brown: There has been an evolution in our thinking, senator. In the past 90 days, we have been consulting
almost daily, and sometimes several times a day, with various group trying to draw out people's views.
The evolution is more that we moved from the general to the specific. Our comments earlier in the year were to
ensure that Canadians understood that there was a package of legislation in the United States that was very serious in
terms of reforming the legislative framework in the United States, and indeed, in reforming corporate governance in
the United States. We, as Canadians, could not afford to ignore that. I still believe that to be the case.
In the past few months, we have been focusing on individual pieces of that legislation and ask our constituents how
they view those. We started with the one that we believe is the cornerstone of the U.S. proposals, and that is the CEO-
CFO certification. We have gotten virtually no push back on that issue.
Interestingly, the response is almost the same for large companies as it is for small. Many CEOs are saying that they
certify to the auditors every year exactly what they are being asked to certify to the public. They say that they do the
work anyway so that it is not a big leap to say to the public what they say to the auditors.
Smaller companies and investors in smaller companies are saying that more and more of the information about the
company is in the mind of CEO, so it makes even more sense for the CEO to be telling the market about the disclosure.
We are finding very broad support on that issue.
Senator Kelleher: I get a fairly strong feeling from what you have said that you go along with the idea that one size
will not fit all, and that we have a lot more small cap companies here in Canada than they do in the States. We will
probably end up with different rules and regulations for them, which, I think, makes a lot of sense.
Have you travelled any further down that road other than the principle? If so, is there any hints or thoughts that you
can give us as to where you are going in that area without betraying something confidential?
Mr. Brown: To use your metaphor, we have mapped the route and we are starting to build a database. We have
discovered that there are not databases in Canada to help answer some of these tough questions. We do not know with
precision how many independent directors there are on small companies. We do not know whether they have audit
committees or how many independent directors sit on audit committees. We do not know level of financial literacy.
We have done a joint venture with the Rotman School in Toronto and we are starting to build a database that will
answer some of those questions.
As well, the Alberta Securities Commission, where there is an even higher percentage of smaller cap companies than
in Ontario, did quite an extensive survey with their market participants. They received a satisfying response from it.
They are collating those results and helping us try to get information about the composition of those boards.
I think that we will find that there are some provisions that are important for companies large and small, and that
will not impose an unacceptable burden even on smaller companies. However, I think do that we will find that there
are some provisions that we have to modify for smaller companies, perhaps with encouragement that they will migrate
to a higher level. We will not be able to impose the same requirements on them.
Senator Kelleher: I would presume that family-owned companies will give you a certain amount of trouble in this
area? Canada still appears, thank goodness in many respects, to have large family-owned institutions. It is going to be a
little more difficult there.
Mr. Brown: You are absolutely right. It is one of the areas in which we do not get much assistance from the U.S.
rules. We need to tailor the rules that will work for us in Canada.
Senator Kelleher: Perhaps it is unfair to say it this way, but it appears that you have been looking primarily at what
the U.S. is doing. Are we looking at other jurisdictions? For example, Britain did quite an overhaul of their financial
system a couple of years ago. Have we looked to the Brits at all?
Mr. Brown: Yes, absolutely. As a matter of fact, I have just completed my term as chair of the policy-making body
for the International Organization of Securities Commissions, IOSCO. My last role on was to chair a committee of the
chairs of the major jurisdictions to address, specifically, the issues that have come out of the United States. The chair of
UK FSA, Sir Howard Davies, has been a member of that committee, as have the chairs of all the major European
countries, Japan, Brazil and a few others.
Interestingly, we have just published four papers on some of the very issues that we are talking about today. One of
them deals with auditor independence. I am pleased to say that the provisions that have come out of the CICA paper
and some of the other things with which we are dealing are consistent, internationally, with what regulators and my
colleagues in major jurisdictions are saying.
We have had the benefit of coordinating with all of the jurisdictions — with their thinking — as they move through
this process. It is fair to say that all of the members of this group that I chair, with the exception of the United States,
began by reacting very sceptically to what was going on in the United States. Over the course of almost nine months of
frequent meetings and deliberations, we have arrived at an understanding that there are a number of issues that all
countries need to address and will address.
The Chairman: Thank you.
Senator Kelleher: I guess I have been cut off.
The Chairman: You have time for a short question and a short answer.
Senator Kelleher: This is a follow-up point from an issue that my friend Senator Angus raised. Again, I get the
feeling from reading the articles that the Quebec Securities Commission is not exactly enthusiastic about putting an
awful lot of these reforms or new rules or regulations in writing. Is that a correct perception? If so, do you agree with
Mr. Brown: I do not think it is a correct perception. Senator Angus made reference to the comments made by Pierre
Godin, the newly-appointed chair of the CBMQ. I believe he is expressing the kind of caution that we started talking
about, and that is that we have to make sure that we do not try to impose rules that make sense for large corporations
but do not make sense for small corporations. I expect to be working very closely with Mr. Godin, and we have
continued to work closely with the Quebec Securities Commission on all of these issues.
Senator Taylor: Coming from Alberta and being in the mining and oil business for over half a century, of course I
had a lot to do with different securities companies and different exchanges across Canada. It drives you a little buggy at
times because the U.S, as you know, has a centralized regulatory system, and the same applies to the UK, unless they
have started allowing Scotland and Wales to set up their own securities commissions. However, I do not think they are
What work was or is being carried out between the provinces, your commission and others to try to establish a
national standard for Canada? It might encourage the faith of the investors, if they knew that there was a national
body that was looking after them rather than the way it is now. At present, I think, you sort of encourage the
exploitation of one securities commission after another.
I can remember many years ago wandering from province to province to find out what I could get away with, and I
admit that but others would not. Is there any work in process to try to do that, because I think if we do not do that,
there will be a lot of pressure, because of Enron, on the national government to start sticking their nose into what, up
until now, have been considered provincial issues. What are you doing to standardize regulations across the country?
Mr. Brown: Harmonization of regulation among the securities commissions has become our number one priority.
We have a project that is now well under way to create a uniform securities act that we expect or hope all provinces will
As we get into the project, we were, ourselves, quite dismayed to see in how many areas the statutes have drifted
apart. However, we are making good progress in bringing that back together. That is a very high priority.
In addressing the issues that we are now addressing for investor confidence, we have been talking, through our
national organization called the CSA, Canadian Securities Administrators, about all these issues. Some of these
projects will become national projects and will be run by committees of staff across the country. Others will allocate
one or more provinces to take the lead. Our hope is that, as we address these issues, they will be national and not just
province by province.
Senator Taylor: I am glad to hear that. I think that is a big step in the right direction. I remember when securities
commissions would not even answer each other's letters, so it is nice to know that you are at least talking about
phoning each other.
The second point is with respect to the audit committee. I see in the literature that the audit committee is to be
divorced from management. However, that is, I believe, pie in the sky because audit committees are usually appointed
by board and the board, in turn, is the management. I think you have an incestuous circle here. I do not think it means
that the auditor will be any more independent under an audit committee than what we have now. It might be directly
appointed by the chief executive officer, who also is one of the big shareholders.
Have you looked at the system? I believe I saw somewhere in my mining promotion material an article stating that,
in one instance, the names of every auditing company were put in a hat and the securities commission pulled a name
out a good 60 days before the annual report was due, so that there was no way the auditor could be influenced by
management directly or indirectly. Have you looked at the name-in-the-hat idea rather than the audit-committee idea?
Mr. Brown: I must say that is the first time that an audit lottery has been suggested to us. No, we have not.
As to your first point, I think very much a thrust of what is happening in the United States, and even the way the
market forces are pushing companies here in Canada, is that companies will take seriously the need to have
independent people on the board, people who are truly independent of management, and who are prepared to ask
tough questions of management. It is those people who, we believe, should comprise the audit committee, so that when
they are dealing with the auditor, they are dealing independent of management and much more as representatives of
Senator Taylor: I would agree with you if you can find independent directors. However, I do not know how you are
going to get a company to appoint independent directors. They are immediately not independent as soon as they are
appointed. If I appointed your directors and you appointed mine, then I would consider them to be independent.
Mr. Brown: I think that is a problem in itself.
Senator Taylor: I think that is pie in the sky.
Let us go a step further on the audit issue, which bothers me to no end. On the many boards that I have been on, the
auditors were — and I hate to use the word ``cancer'' — like the camel in the Arab's tent: once they get their nose in,
they want to do this survey, that survey and hire a management consultant and so on and so forth. You can't stop
them. Are you going to put in some sort of regulation that an auditor is an auditor is an auditor and is not allowed to
be a specialist in any other way or to prepare any other reports for the corporation?
Mr. Brown: I would encourage you to ask Mr. Smith, who will be following me in this seat, that question.
Senator Taylor: I do not want to warn him ahead of time.
Mr. Brown: I looked over and saw him squirming a little bit.
The auditor independence rules that the CICA has put out for comment, which follow closely what has been
happening in the United States, are designed, in large part, to counter the very thing that you are talking about. It is to
ensure that the other relationships that the audit firm has with the company are not such as to impair the auditors'
independence in its ability to be able to give a truly objective view of the financial statements.
Senator Taylor: Do you mean they cannot issue an audit to tell you how smart you were for hiring them the year
Senator Di Nino: Welcome, gentlemen.
The task that you have chosen is certainly going to be a difficult one, as it is for this committee. However, at the end
of the day, I guess we are talking about responsible governance.
As to responsible governance, as far as I can determine, the problems have occurred in two areas. The first is fraud
and criminality. I am not sure you will be able to catch those folks, because they seem to be a step ahead of the laws.
The second area that we have not talked a lot about is competence. Whether we are talking about governance or
governance within the audit committee, the concern that I have is that those people will be chosen from a restricted
pool of prospects and that the members of the board will have been invited by management or the ownership to
participate. Would you address how we can ensure that there is competence in that audit committee to be able to define
Mr. Brown: We have been addressing only a small handful of the many provisions that have been enacted by the
Sarbanes-Oxley statute in the United States. There are other provisions within that statute and within the New York
Stock Exchange rules that deal with the need to have a nominating committee of the board that is comprised of
independent directors. In Canada, the guidelines of the Toronto Stock Exchange also say that the best practice would
be for a board to have a nominating committee.
I think most of the major corporations now move the election of directors away from management into the hands of
a nominating committee independent of management. They create a board profile. They determine what skill sets they
need in order to be able to address the issues that the company is likely to be faced with. They then try to find people
who will fill those skill sets. Thus, to the extent that corporations are doing that, and are successful in doing it, they will
have a much better pool out of which to draw people for the audit committee and some of the others.
One of the issues that we have not turned our attention to will be some of these other provisions that supplement or
buttress the kinds of things you are talking about.
Senator Di Nino: When you talk about provisions, are you talking about in law or in regulations in some form or
other to create fiduciary responsibility?
Mr. Brown: No. The fiduciary responsibility is in the law already. These are corporate governance provisions that
are currently shown as best practices by the Toronto Stock Exchange. Companies must report on their adherence or
failure to adhere to those best practices. One of the questions that the stock exchange is helping us with is whether
some of those practices should be turned into mandatory requirements or whether we are comfortable in leaving them
just as best practices.
Senator Di Nino: My last question deals with the separation of responsibilities. There have been some discussions
about the chairman being a non-executive chairman with separate responsibilities from the CEO. Do you have any
comments or thoughts on that?
Mr. Brown: We have not turned our attention to that issue either, senator. We have seen some statistics which
indicate that, in Canada, there is a much higher percentage of corporations where the chair and CEO roles are separate
than in the United States. However, we have not turned our attention to that question. It is one of the issues raised in
the new requirements coming from the United States, and it has been raised from time to time in other governance
analyses that have been done in Canada. However, we have no final position on it at this point.
Senator Cordy: When the average Canadian reads the newspaper and sees what happens, the fact of whether it is in
the United States or Canada is a blur to them. They only see what CEOs and executives have been given in companies.
I agree with your statement that we have to restore confidence and tell people that Canada is a safe place in which to
invest. However, when the average Canadian looks at some of the perks that people have gotten, whether they are
birthday parties, expensive items or exorbitant salaries, they are quite aghast at what these people have been receiving.
You said that you believed that these were well-intentioned people. I also believe that to be true. However, I think
there was a great deal of rationalization going on with executives saying, ``It is all right for me because the other
companies are doing it.'' There was almost a snowball effect with executives getting into these situations.
How do we legislate ethical behaviour? I am not sure it is possible to legislate it. You have mentioned guidelines. Is
that the best that we can do? Right now, I do not think these kinds of things would happen but what about in 10 years'
time or 15 years' time? How do we deal with it? What exactly do we do?
Mr. Brown: There has been a great deal written about ethical behaviour. ``Tone at the top'' is another term that has
been used. I think it is impossible to legislate or regulate ethical behaviour. If we were to set out to try to do that, we
would fail miserably.
What I think we can do, though, is look at the incentives in the system and ensure that the incentives are not
encouraging people to act in ways that you and I would think are unacceptable. We can also look at checks and
balances in the system to ensure that there are sufficient checks and balances so that those who have the power to be
making these decisions within the corporation are overseen by others who can take an independent view of it.
That is the thrust of what a lot of what we are trying to do here. We are trying to identify these inappropriate or
even perverse incentives to ensure that we eliminate them from the system, and to then ensure that the system of checks
and balances is working.
Senator Cordy: I agree that you could not legislate it. Do we introduce these types of guidelines and maintain hope
that those will continue throughout the years?
Mr. Brown: If I may, senator, the other part of our system that is very important is to make sure that investors have
complete knowledge and a complete understanding of what is happening as well. In particular, in the case of executive
compensation, we must ensure that the compensation is disclosed, that investors understand it, that there are no parts
hidden, and that investors can themselves determine whether they want to invest in a company that would remunerate
its officers in a certain way.
As you may know, there has been quite a debate about the use of stock options and whether the accounting
treatment of them has exposed the real cost of those stock options to the company in an way that is understandable.
The accounting standards setters are dealing with that issue; and in Canada the accounting standards setters have put
out or are putting out a proposal to require stock options to be shown as an income item.
Senator Cordy: Are they also looking at any requirements that would force executives to have to wait a certain
period of time before they would exercise their stock options, because many stockholders lost great amounts of money
and then looked at CEOs who had cashed in their stock options?
Mr. Brown: Those are not being legislated or made into rules at this point. The coalition of major institutional
investors has strong views about the structure of stock option plans, and they are making their views known. They are
making it clear that, if management plans do not have the kind of features about which you are speaking, they will cast
their votes against them. Those initiatives are starting to have quite a considerable effect in corporate Canada.
The Deputy Chairman: Mr. Brown, you are a very important witness to us here, and I know some senators wanted to
ask more questions.
Senator Prud'homme: You mentioned Mr. Godin a few times. I must admit I am a new member of this committee,
because I felt my expertise was in some other field. However, I will learn.
I do not like these differences of opinions being expressed amongst security commissions. I also recognize that
people look for the weak spot in Canada. How can we reconcile the fact that they will have Mr. Godin in Quebec? You
have a new task to do. Will you work in close cooperation? It need not be legislated that you must work in close
cooperation with him.
Is it advisable for the chair to call him as a witness, since he has been quoted two or three times, to find out what
they are up to?
Mr. Brown: I can tell you that we work closely together. His predecessor, Carmen Crepin, and I probably spoke on
the phone more than once a week and we met more than once a month as we tried to regulate these markets. The
markets in Ontario and Quebec are very much intertwined. Many companies who are listed on the Toronto Stock
Exchange have their headquarters in Quebec, so the coordination between our two commissions is quite sound.
As to Mr. Godin, I can tell you that he does not take office until Monday. He might want a little bit of time to get
his feet wet before he appears before your committee.
Senator Angus: Many of the reforms that you are proposing, and that are dealt with in the Sarbanes-Oxley Act, have
to do with accountability and independence to protect shareholders from improper behaviour. I have read the
Sarbanes-Oxley Act and the regulations. I find that their definition of independence, when it comes to an audit
committee member, or an HR committee member, or a governance committee member, is a wide net. It is almost
impossible to find. I am on one board where there are 13 directors, and if you apply the extreme letter of Sarbanes-
Oxley 11 of our 13 directors are not independent, and yet I think anyone using the reasonable-Canadian-man test
would say they are all independent.
Could you comment on that? Will we have a problem in Canada finding directors if we legislate a test like Sarbanes-
Mr. Brown: Clearly, if we cast the net too broadly we will have such a diminished pool of directors that we will not
be successful. I agree with that.
It is another issue where we have to look carefully at our own Canadian requirements.
From my point of view, the most important part of the independence definition is true independence from
management, so that directors can make decisions that are not influenced by management, or not influenced by the
fact that they have remuneration from other major contracts that management can either withhold or dole out. Those
are the areas where I think we need to focus.
Where I do not have an answer yet, and we need to get much more input from interested parties, is how we deal with
the controlling shareholder phenomenon, which is so much more apparent in Canada than in the United States. On the
one hand, a controlling shareholder is a shareholder and ought to have the same interests as other shareholders, and so
you would think that their interests are co-extensive. On the other hand, the president of a parent company has
probably hired the president of the publicly traded subsidiary. Thus, there is a relationship there that is pretty close to
management. We need to find an answer somewhere in there that gives us a requisite degree of independence without
disenfranchising the controlling shareholder who has invested good money in this subsidiary.
Senator Kroft: We had the opportunity to speak very briefly before starting and you mentioned to me that the
provisions introduced today bring in civil remedies for the first time. My question to you, which it opens a very wide
and interesting area, is: Do you think that the existence of civil remedies will add a bit of an edge and a bit of a new
flavour to the CEO-CFO certifications? Attached to that is the question of the use of examples. The U.S. seems to feel,
in terms of the effect on market confidence, that there is usefulness in creating examples and to suggest that no one is
beyond the reach of a remedy.
I leave that for you to deal with however you like.
Mr. Brown: The requirement for CEO-CFO certification in the United States has been introduced against a
backdrop of a robust civil litigation system in the United States. When we started talking about CEO-CFO
certification in Canada we did not have anything even close to that type of a civil remedy. With the introduction this
morning of legislation in Ontario that will provide civil remedies for shareholders, it will make the CEO-CFO
certification a far more meaningful instrument in building investor confidence among other things, but it will also
make it more important that the certification be correct, that the officers take the necessary steps to inform themselves
that what they are saying is, to the best of their knowledge, correct.
There is no suggestion that this will be a strict liability — that if the CEO or CFO is wrong and makes an innocent
mistake or is wrong for reasons beyond his or her control that there will be liability. The intention here is for them to
convey, to the best of their knowledge, the situation.
In designing the civil remedy system in Canada — and this is a matter that all securities commissions across the
country agreed on, this was a CSA project — we tried to ensure that we built in some safeguards in the Canadian
system so that some of the abuses that we have seen in the U.S. cannot come into Canada. We are comfortable that the
package gives us a civil remedy that will provide a deterrent, but will not have any of the abuses and some of the
excesses that we have seen in the United States.
Senator Taylor: On the question of stock options, an intriguing point is the fact that stock options are fixed on stock
prices alone. As a result, you will get the executive making a fantastic gain because the market has gained yet the profit
has gone down in the corporation. You might recall that when the banks moved from a low to a high and all the bank
presidents retired, yet bank earnings were down. Has any work been done on tying stock options to not only price but
the profit of the corporation as well, so that the chief executive officers will not be able to cash out on something that is
a general trend because of the market upgrade, while the company is doing done poorly?
Mr. Brown: There may have been work done in that area by followers of corporate governance and even some of the
institutional investors who have some strong views on these issues. These are not issues that we see as regulatory issues,
though. We see these as matters for the board of directors who, hopefully, are taking into account the best interests of
the corporation and its shareholders in all of the decisions that they make. This is one of the reasons we think we need
to ensure the checks and balances and incentives are right so that boards of directors and, indeed, committees of
boards that are independent of management can make these decisions without inherent conflicts of interest. As
regulators, we think that that is a far better way for corporate Canada to grow and prosper than having us sitting at the
The Deputy Chairman: I have a question that goes back to your original premise that the people who did these things
that we are concerned about were all well-intentioned people.
Mr. Brown: I think I said ``for the most part,'' senator.
The Deputy Chairman: It seems to me, though, that we have compensatory exuberance, scandalous behaviour, or
outright theft and fraud. Those are the things that have concerned the marketplace. How will all the regulations in the
world stop the theft and fraud? The other things were all public anyway. The analysts and everybody else involved in
the system just did not report those things. The problem is not just a question of the behaviour of the CEOs and the
boards, but the fact that the information was out there and no one reported it. You can make all the regulations you
want and make all the companies that have nothing to do with this, that are good companies, all of a sudden pay a
huge price because several people went to jail. How do we stop that? Maybe we should increase jail time. How will this
Mr. Brown: First, we must punish instances of theft and fraud. We must seek those people out and punish them.
That is one of the reasons why we believe the legislative package that was announced today is so important to us. It
gives us the necessary tools to be able to follow through on that.
Also, the other remedies that we are talking about are intended to give corporations, directors and others within the
quality control mechanisms in the corporations the tools they need to deal with these issues as they arise, in the hope
that some of them at least will be discovered before they become serious issues.
I agree with your premise, sir, that it will not be possible for us, by way of any kind of a regulatory regime, to
completely eliminate the ability for fraudulent conduct. I do think, however, that we can reduce the incidence of it and
control it as best we can.
The Deputy Chairman: Thank you very much, gentlemen. This has been an excellent hour and 15 minutes. Thank
you for being here.
I will now call our next witness, Mr. David Smith, the President and CEO of the Canadian Institute of Chartered
Mr. David Smith, FCA, President and CEO, Canadian Institute of Chartered Accountants: Thank you for inviting me
back to participate in this examination of the state of domestic and international financial systems in this post-Enron
Since I saw you in June or July, we have had a busy summer, to say the least. When I appeared before you last June,
I said that Canada's chartered accountants were paying serious attention to the erosion of investor confidence in the
wake of Enron and other corporate failures in the U.S. I also indicated that we were working very closely with federal
and provincial regulators, CA firms and the stakeholders to strengthen the financial reporting system, as well as our
own profession's discipline process, practice inspection system and rules of conduct.
In the intervening months, our top priority has continued to be to restore the trust of investors and confidence in
our capital markets. Over the summer, we have also continued to work closely with other stakeholders on a variety of
issues. I am pleased to update you today on our progress on several fronts, including quality control, accounting
standards and auditor independence.
As you heard earlier today from David Brown of the OSC, one of our most significant initiatives was launched on
July 17 with the announcement of our new independent public oversight for auditors of public companies. The
Canadian securities administrators, the Office of the Superintendent of Financial Institutions and Canada's chartered
accountants jointly announced the new system, which includes more rigorous inspection of auditors of public
companies, tougher independence rules, and new quality control requirements for firms auditing those public
The new requirements will be administered and enforced by the new Canadian Public Accountability Board. As you
heard, the chair of that board will be appointed very shortly.
I would also like to note that Canada's major CA firms have voluntarily agreed to implement the new oversight and
quality control measures once CPAB is operating.
In the matter of accounting standards, a number of important steps have also been taken in the area of accounting
standards. As I indicated to you in June, the Accounting Standards Oversight Council, the independent body that
oversees the Accounting Standards Board, has an action plan to deal with accounting and financial reporting issues
raised by that Enron failure.
As a result of meetings and deliberations by both the council and the board, two draft guidelines dealing with
consolidation of special purpose entities — known as SPEs — and the disclosure of guarantees were issued in August.
The treatment of special purpose entities and guarantees has been cited as contributing factors in the Enron
As discussed earlier, accounting for stock options has also been a controversial issue. Earlier this month, the
Accounting Standards Board decided to activate a project to require the recognition of stock-based compensation
expenses for all employee stock-based compensation transactions. This would replace the current option to disclose the
effect on earnings on pro forma basis, and the board expects to issue its proposal for comment by the end of this year.
Just as we have established public oversight of the body that sets accounting standards, the time had come for
similar oversight of the body that sets auditing and assurance standards in Canada. Last week we announced the
creation of the Assurance Standards Oversight Council, which will provide input, strategic direction and a prospectus
of users into setting Canadian auditing and assurances standards. That council, which will have a majority of members
drawn from outside the audit profession, will be chaired by a prominent securities lawyer and former chair of the
Ontario Securities Commission, James Bailey.
Finally, we expect to release in late November, a final guidance document on the preparation of Management
Discussion and Analysis Reports known as MD&A. The draft document was released for comment last December,
and the final version reflects the consultation during that period. We believe a good MD&A provides a broader context
to help investors more fully understand a company, its performance and its prospects. It also provides additional
context in which to consider and approve financial statements. It can also help directors understand the company's
business, and evaluate the appropriateness of management's business strategies and the assessment of that risk.
Moreover, we believe this enhanced MD&A disclosure leads to a lower cost of capital, better capital allocation
decisions and improved corporate governance.
I would like to speak now about auditor independence which was another key issue raised in the wake of Enron. As
I indicated last June, the Canadian chartered accountants profession was developing measures to enhance auditor
independence prior to Enron, including a new assurance standard that requires auditors to communicate with audit
committees about issues of independence and to disclose their non-audit fees. In September, the CICA's Public Interest
and Integrity Committee released a new draft independence standard to apply to Canadian auditors and other
assurance providers. It is based on a conceptual framework of principles rather than on an outline of specific rules. It
provides more detailed guidance that helps to identify potential threats to independence, and it can be applied to
diverse situations that all practitioners face, regardless of the size of their firms.
The new draft standard describes apparent and actual threats to auditor independence, as well as the safeguards put
in place to protect that independence. It also recognizes that there are certain activities for which there cannot be
adequate safeguards, so it prohibits auditors from providing a number of non-assurance services to their clients.
According to the principles articulated in this new standard, auditors must ensure that their independence is not
impaired by threats that could arise from providing assurance on their own work, benefiting from financial interest in a
client, promoting a client's position or opinion, or becoming too sympathetic to a client's interest or being intimidated
by that client.
Here we have a uniquely Canadian situation that takes into account existing international thinking and that
considers merging regulations in the United States once they are known. We live in a global world and it serves
everyone who is involved in protecting the credibility of financial statements in the capital markets to move in that
direction. Given Canada's that greatest and largest trading partner is the U.S, which has the largest capital market in
the world, it is proposed that the Canadian standard continue to be as rigorous as the SEC rules.
The period for comment on this independence release in draft form ends tomorrow. Subject to an amendment as a
result of SEC changes, the new rules will be finalized later this year. They will then be sent to our provincial institutes
and ordered for adoption in 2003. I would also note that Canada's major CA firms have voluntarily agreed to
implement the new requirements for subsequent audits of public companies, once the Canadian Public Accountability
Board is operating, which will speed up that implementation.
I would also like to mention the successful forum that we held last month sponsored by the Canadian Institute of
Chartered Accountants and the Institute of Corporate Directors. It was called ``Canadian Audit Committees —- A
Call to Leadership.'' It was a one-day forum that brought together more than 100 of Canada's top corporate directors,
auditors, lawyers and regulators to discuss audit committee effectiveness in the post-Enron world. The two honorary
chairs of the forum were Claude Lamoureux, President and Chief Executive Officer of the Ontario Teachers' Pension
Plan, and Richard Haskayne, Chairman of TransCanada Pipelines.
Participants in this forum emphasized that it is more important than ever for boards and their audit committees to
demonstrate high standards of leadership and ethics, and to make a commitment to performing their duties with
integrity. Those who attended the forum provided comments on a draft set of practices for Canadian boards and their
audit committees. Once the document is revised to reflect the input, it will be distributed to boards and audit
committees to provide us with further feedback on how it works. Following that consolidation, the best practice for
Canadian audit committees will be further updated and distributed at large in Canada.
In conclusion, I would like to take a moment to reflect on some of the lessons learned over the past 11 months. Even
though Enron, WorldCom, Tyco and Global Crossing occurred south of our border, the issues raised clearly affect us
all. The existence of these hearings, as well as many other Canadian initiatives and examinations and reports, certainly
recognize this and underscore just how much these events have affected investor confidence and public expectation.
When Enron first hit the news, a large portion of the blame was placed on the auditors. With the passage of time, it
is becoming increasingly clear that it was a systems failure — that the corporate processes that make up good
governance failed. In fact, governance is a team effort with boards, auditors, management, shareholders and regulators
all playing their parts.
Canada's chartered accountants take seriously this erosion of investor confidence just as we take our role in
governance as seriously. That is why we welcome the opportunity to be here today to relate how our profession has
responded to date and continues to respond to the legitimate concerns that exist throughout the marketplace.
We have learned a number of things in this process. One is that our oversight mechanisms, standards and rules must
conform to these new realities. That is why we have taken steps to ensure that the standards and principles guiding our
profession are second to none. We have also learned the value of working with other concerned parties, such as
regulators, to define the challenges and to develop solutions, such as the Canadian Public Accountability Board that
we announced in July.
Most important, we have renewed our commitment to protect the public interest, maintain the public trust and win
its confidence. No one can win as a result of events such as Enron, Global Crossing or WorldCom. However, we can
ask the hard questions, learn from the experience and make the right changes. That is just what we are doing in these
hearings. It is what the CA profession has been doing over the past months and will continue to do in the months
I thank you for the opportunity to appear before your committee today to talk about the progress that we have
made. I would be happy to answer your questions.
The Deputy Chairman: Thank you, Mr. Smith.
Senator Angus: Mr. Smith, I do not envy you your job and I complement you for the assiduous way in which your
profession has handled what some people call the ``Enron scandal'' and what others call the ``Arthur Andersen
meltdown.'' It was a dark day for your noble profession, and it is simply incredible that a firm such as Arthur Andersen
could disappear as a result of the malfeasance that was shown to have taken place. Whether the focus changed from
being on the auditors to the systems in general, the fact remains that the accounting profession was put into the frame
As I said a minute ago, I commend you on the efforts your profession has made. It is not easy to find the solution.
As I understand the debate in an independent forum, how do you justify continuing to be a self-policing and self-
I am a lawyer, and we are in the same situation in many ways. We are a self-regulating profession. One values that,
whether one be an accountant or a lawyer. I continue to read the literature. I am fascinated by the entire issue of the
governance in the role of the accountant. Could you comment on that?
I know a number of critics say that this is a bunch of people appointing their friends to supervise. It may not fly. I
saw the news of the appointment of Jim Bailey today, and that is great. I know that the person coming up will be ``Mr.
Independence.'' This is great, but I still I think that you have a bit of credibility problem there.
Mr. Smith: I accept your observation. One of the reasons that we have been able to weather this storm thus far is
that we invested in independence some time back. Many of the initiatives that you are now hearing about were started
pre-Enron. Tom Allan chairing the oversight board for the accounting standards setting is an example of that. When I
took my job last fall, just pre-Enron, one of the things that I believed that this self-regulated profession needed to do in
the new reality of the world was open the windows and doors and let the sunshine in. You should be able to stand the
test of public oversight. A profession that tries to set it is standards would not ask someone who was not in that
profession to set the standards. For example, the medical profession would not ask a person who was not a doctor to
set standards for the medical profession. The legal profession, lawyers, would work on their standards because they
have the knowledge. That is also true in our profession.
Now we have the balance by adding assurance and having the Canadian Public Accountability Board oversee the
public company aspect. I think we now meet the new standard of oversight. We may be even more independent than
some of the oversight that is being proposed in the United States because we are strongly influenced by government, as
you well know. Part of what got us to where we ended up was the debate in the Senate and so on.
We are independent. We are funded by 68,000 CAs. The government could fund us, but that would change the role.
Of those 68,000 CAs, some 60 per cent to 70 per cent do not practice public accounting. They are doing numerous
other things. They are members of cabinet, teachers and they work in the industrial world. It is quite a diverse
We do have critics, but I think we meet the test. Mr. Brown made that point today when he talked about
independence. As he said earlier, we meet the international test.
Senator Kelleher: Mr. Brown is a tough man. He is the chairman of the oversight of council and he will hold the feet
to the fire, and this is a good thing. It will be interesting to see how it plays out.
I am going to stay away from the touchy issue of whether auditors should be allowed to give tax advice to their
clients, which goes to the question of independence and I know that is being debated.
One thing that arises here frequently is a matter that I think hurts the credibility of the profession. Our economy is
intertwined with our neighbours to the south, and yet the difference between Canadian GAAP and U.S. GAAP are so
vast and seemingly irreconcilable that it seems like a mockery. Witnesses have demonstrated examples of money lost by
companies based on U.S. GAAP and yet they have also shown that, based on the Canadian GAAP, $100 million was
The international standards setting body is, perhaps, the best of all worlds. Could you comment on that, because I
think the discrepancies hurt the public confidence?
Mr. Smith: It is a misconception that Canadian accounting is different from U.S. accounting. You see different
results in heavily regulated industry, be it insurance or whatever, where the rules are different. It is not so much the
accounting principles. Canadian and U.S. accounting rules are different, so, you do end up with some differences.
We should strive for one standard. I felt somewhat positive on the announcement made recently by David Tweedie
of the International Accounting Standards Board and Bob Hertz of FASB in the U.S. that they had signed a letter of
agreement that they will move towards international accounting standards and try to reconcile their differences. They
are the two ``elephants,'' and if they could do that, we could make the target of, five years from now, having one
standard around the world. Certainly, we, as chartered accountants, would embrace that.
As you point out, our major trader is south of the board border and international accounting standards that are not
aligned. It makes it difficult to reconcile that. I am optimistic about that.
Senator Angus: That is good news. I hope that it might be sooner than five years because we are talking about
investor confidence today. The situation confuses the investors.
Mr. Smith: To add to that, Mr. Tweedie and Mr. Hertz said that they felt that they could reconcile some major issue
fairly quickly, but that is in international territory. The idea is to have everything harmonized within five years. If they
could get some of the major differences together, it would be helpful to all of us and towards restoring investor
Senator Angus: That is great. Keep up the good work.
Senator Kroft: I would like to focus in on one issue. It is outside your direct responsibilities, but it is core to what
you do. I am speaking of the issue of the audit committee, which is sort of the link between these two issues of
accounting and governance. If that key point is not functioning, then much of the system breaks down.
The commitment and the list of accomplishments are certainly impressive. As you say, many of them were started
earlier, but it is a remarkable list with many things ticked off. Obviously the harmonization of U.S. and international
standards is the biggest item now on your list.
Focussing on the audit committee, I would pose an open-ended question. Given the challenge related to the issues of
competence and the difficulty of the relationship between management and the audit committee, and all those
questions we know so well, I invite you to make any observations on how well that function is equipped. You can do
everything correctly in the world, but if that piece is not functioning there is a link point missing. Can we chat about
Mr. Smith: As I said in my remarks, you cannot go further to regain confidence in these markets without having the
team that produces these results work together and have their roles defined. This debate, which needs to take place, is
doing a good job of defining that.
Two things are happening. I have had a lot of discussion with audit committee members. I know many of them
personally from my past experience. We did have the forum to which I referred with the attendance of 100 directors
from small and large companies in Canada. We will publish a report on that meeting, but I will give you a snippet of
what happened. There had been a change of attitude in that they realized that they must be independent and that they
had certain responsibilities. They recognized that a debate might take place about whether to legislate them. There was
a consensus about the fact that they had certain responsibilities.
One of the points raised earlier when Mr. Brown was speaking related to the training and the capacity for these
directors to do this. We are working with the Institute of Corporate Directors, which we do fund as a profession,
believing it is important to do that, on director and audit committee courses, so that people can be educated on the
skills that are required for that, which are not just handed down from generation to generation in this new world.
I think all the audit committees that are actually operating today without the rule changes, certainly do sit down
with their auditors now and question their independence, certainly do talk to the management in much more detail
about what the accounting debate was on the accounting principles before those statements were put together. I mean
it is happening.
Is that enough? I think that we do have to be crisper, because they are looking for what the guidelines should be
because, as you know, you can get an overreaction to this, or you can also get stalemate because you do not want to
take any risk because of it. That can ruin a capital market too. One of my great concerns is that we overdo this and we
end up with a marketplace that is so contained it does not let any entrepreneurs live any longer. We would not be able
to have our mining companies of the past develop, to use our example earlier today.
I think a culture change is taking place. I think everyone starts to see what their role is. I think we have education
challenges. I think we have to make sure those defining roles are there. The meetings that take place between
management, auditors and audit committees must be more than form meetings. We used to see a lot of substance in
Some of the things that we have announced and some of the things that David referred to today will go a long way
to continue to encourage them to do that. Without those links, you are quite right that whatever we did would not be
enough. We could not do it. You could not legislate it, and you could not regulate it.
Senator Kelleher: My first question deals with — and this was discussed with our earlier witness — the balance. I
think it is recognized that had there has to be a balance struck between large companies and smaller cap companies. I
would like to focus on that for a moment and discuss the auditing and accounting problems with respect to those two
entities. Does your association subscribe to the fact that one rule will not fit all? If that is correct, which I believe it is,
how do you propose to deal with this concern and the problems that flow from it?
Mr. Smith: I agree with you, one rule does not fit all, especially in a country as diverse as ours. It is impossible.
At the top level where people talk about Sarbanes-Oxley and ask whether we would embrace it and be able to apply
it fully to public Canadian companies, I think that, when they develop the regulations that go with Sarbanes-Oxley,
they will find that they face many of challenges that we face. It applies to every public company, even bulletin board
companies, in the United States. They may have bigger pools of directors, but it is still just costly to do it. Many small
companies have been swept in with this, and they are going to have to deal with that. That is my personal observation.
Even if they do not, we have to deal with it in this country.
We must recognize that we have approximately 5,000 companies in this country, of which at least a couple of
thousand are very small, and that we cannot apply the same rules that we would apply to the top 50 companies in this
Tthere are principles that apply all the way down, some independence principles, with some boards being
independent in some way from management, because we do have to protect the public interest. The public have
invested in those companies, and we have to reflect that.
One of the challenges for us — and it is the same challenge that the previous witness had, and we are going to look at
the data — is actually getting the data on who makes up these small companies that would get swept in by this. Do they
have independent directors now? Is there an independent audit committee, and so on? We have our draft independence
document out on the street. We have received a number of points of view on how to deal with the smaller company.
The committee will have to debate that and try to find the balance between protecting the public interest and not
choking to death the smaller company.
That applies, I think, to some accounting principles which require significant disclosure for very large public
companies, and so on.
It is what takes the time in this country. When somebody develops an international standard, you bring it back and
say, ``Gee, it is a little different here. How can we take the principle and apply it without killing that entrepreneurship
that we need so much in our country to make the capital markets work?''
I do not know if that is helpful. It is a rambling answer. However, we are considering it fully, because it is a major
Senator Kelleher: That is very helpful.
My final question is: I listened to David Brown talking about the new legislation they are introducing. With that
there will be regulations and penalties. There will be fines and there will be jail terms. Like you, I come from a self-
governing profession. I am a lawyer as is my cohort Senator Angus. I have listened to the details of all these boards and
oversight committees. There is an oversight committee of the oversight committee. However, do any of these boards or
committees have any teeth? In other words, what happens to a ``bad boy'' in the auditing profession?
Mr. Smith: We have talked about three boards. Two of them oversee the setting of standards in the country. One is
accounting. One is audit or assurance, depending upon what word you like to use. They are not the enforcers; they are
The enforcer with regard to firms doing public audits or audits of public companies in this country is the Canadian
Public Accountability Board. It uses powers that already exist in the provincial institutes of chartered accountants —
discipline penalties, sanctions and fines — and the board can remove your CA designation, fine you, and so on. It can
use its power in respect of the larger companies that cross provincial lines and ensure that they are carrying out high
quality audits by doing reviews on an across-Canadian basis versus an individual provincial basis. That group would
have the same power as a provincial group. There are provisions that cover all of the same sanctions.
We have an extensive system in this country. We had it before Enron. It was provincially based. The U.S. did not
have a system of discipline that would have matched ours in any way, shape or form.
To take Ontario as an example of individual systems, an independent review that was just completed in the last year
ranked it as one of the highest in the world for quality and discipline. We have built off that to create an even stronger
oversight group. Therefore, I am confident we meet the U.S. system. They have yet to do it, to be frank.
Senator Kelleher: I am not trying to go after your profession. Do not misunderstand me. Is there something that
provides, for example, for jail terms in extreme cases?
Mr. Smith: Yes, it becomes part of the criminal system. David Brown talked about the proposed legislation.
Senator Kelleher: Can that be applied to the accounting profession?
Mr. Smith: I have not seen the proposed legislation, so I should not speculate. Under the existing system, people
have been charged criminally and civilly and have received penalties and jail terms. For example, in Ontario in the last
two years, 15 chartered accountants had their ability to practice taken away from them, as well as their CA
designation. That is in addition to other penalties.
Senator Taylor: I have some trouble understanding how your profession is governed. The previous witness, Mr.
Brown, talked about securities commissions. He talked about what goes on in the provinces, but hopefully that will
spread across Canada. As you know, the licensing system in Canada is at the provincial level for many professions,
including lawyers, accountants and engineers. You mentioned 15 accounting firms in Ontario.
Mr. Smith: They were chartered accountants.
Senator Taylor: How would your organization discipline a chartered accountant from Saskatchewan or from
Alberta? Could they not tell you to go to a certain warm place and then continue practising in their province?
Mr. Smith: No, because we would refer the matter even today, never mind with the new oversight, to the institute in
Saskatchewan. The person would have to go through that discipline process or their CA would be removed. They
could be charged.
Senator Taylor: That is in Saskatchewan. What about your national institute? That is what I am having trouble
understanding. You are telling me what wonderful things this new association of accountants will be able to do from
the investors' point of view, but the average investor does not realize that auditors are licensed province by province.
Suppose they do not do what you want them to do. Where is the interface?
Mr. Smith: That is a good question.
Senator Taylor: It is particularly hard to keep track of Saskatchewan people.
The Deputy Chairman: Speak for yourself, senator.
Mr. Smith: If you are a firm auditing a public company in this country, you may become part of the public
accountability board. The vast majority will, and, if not, the securities regulators say they will make joining
compulsory. Let us assume all accountants handling public companies in this country joins. They will sign an
individual contract with the public accountability board that says they will do certain things. They will subject
themselves to inspections. How they do things and quality control will be scrutinized. They will review files, report
back, and subject themselves to being subject to the provincial legislation wherever it is appropriate.
If a particular office in Saskatchewan were part of a large firm across the country, and it was found that the office
was in default and required discipline and penalties, it would be sent to that group. If it is not satisfactorily dealt with,
the Canadian Public Accountability Board has the right to further deal with that firm because it has not corrected its
deficiency. The board could pull its contract, which means it could no longer audit public companies.
The discipline system is a Canadian solution because, as you pointed out, senator, the mandate lies within the
province, yet the actions to do a proper overview have to take place on a central basis. This is especially true of the
larger firms, where six of the largest firms audit some 85 per cent of the assets of public companies in this country.
That is a simplistic version of what we have come up with. I think it has teeth and I think it fits the Canadian way of
doing things without having to change the legislation. You know how difficult this is.
Senator Taylor: It is nice to understand there are some national teeth as well as provincial teeth.
Mr. Smith: I think it is a good model for us to study in a broader sense.
Senator Taylor: You were not here earlier when I was talking about audit committees not being such a smart idea. I
do not think the audit committee is likely to be that independent, so I do not think there is great progress on that front.
I had suggested that perhaps I appoint your auditors and you appoint mine. That did not seem to go over very well.
There is another system, which is rotating auditors. In other words, I believe the Sarbanes-Oxley Act specifies that
you are only allowed to keep an auditor for four or five years and then you have to hire a different firm. I believe it is
three years in Australia, but I could be wrong. Would you care to comment on that system?
Mr. Smith: With the Sarbanes-Oxley statute, there is an undertaking that — and I cannot give you the exact time
frame — in the next nine months, say, a report would be made around that particular issue and then come back and
deal with it. Our attitude toward that is that we would not do an independent study. We would see what that study has
I am not aware of Australia requiring compulsory rotation of auditors. I know in Italy that has been the case, and
that was every nine years. They were the only major country doing that sort of thing. Now that they are dealing within
a European market, that debate has been put aside because it seems not to have been picked up. It creates lots of
challenges to do that.
Senator Taylor: My last question deals with conflict. I could not quite understand from your report whether you
wanted companies doing the audit to be entirely removed from doing other business for the firm or whether they could
do the business as long as it was stated in the annual report that your auditors also did an efficiency audit or did a
management plan or something of that sort. Do you have any comment?
Mr. Smith: Perhaps I could try to clarify that. The draft proposal on the independent standard takes the principles
that are developed internationally and the SEC's rules for public companies and combines them. It states certain things
you should not do and excludes certain services. However, the committee, as they consulted on this in Canada,
concluded that going the international route was the way to go in principle, because you cannot write a rule for every
single instance, as we have seen in the United States.
Let us assume an audit firm is approached to do a valuation for its audit client. The first test they have to do is that,
if it is significant to the financial statements, they cannot do it. That is an exclusion on day one. They work their way
through a matrix or framework. The next test might be related to who is doing the work. Are they independent from
the audit team that is there? Is it a significant dollar amount in relation to the fees? This continues on. This framework
gives auditors the ability to go back to try to define each service they take on, whether it is independent or not.
Then, there are some specific ones that advise not to bother going through the exercise because you are not
independent. An example might be that you are putting in an information technology system for financial statements
and then auditing it afterward. You do not have to open the book for that one because it is prohibited. I am talking
about an internal audit and services like that.
That is the way we have approached it, and I believe this is the only country in the world that has developed
something that takes the international principle standard and the rigour of the SEC rules, where appropriate, and put
Senator Angus: In your opening comment, you mentioned the fact that one of these bodies has decided to make it
mandatory to expense stock options. However, I believe this goes against the wishes of corporate Canada because I am
told that there are only two tested ways of evaluating stock options; the principal one being the Black-Scholes method
inasmuch as so many of these options are underwater and, as Senator Taylor indicated earlier, because it is not a cash
item and because of varying circumstances. The independent auditors I have talked to say, ``You have to wait. Let's
not get carried away,'' and, ``This is not something we would recommend for you folks to do yet.'' Can you comment
on that? I believe this is a terrible mistake but I may be wrong.
Mr. Smith: As you know, the Accounting Standards Board is within the Canadian Institute of Chartered
Accountants but other than fund it we do nothing else. It is overseen by AcSOC, which is the group Tom Allen chairs.
They held public hearings in September on that matter alone, and received a number of submissions. Based on that, as
well as other input, they decided to make that announcement.
There will also be an announcement in November, which I think is being considered as the release date
internationally, which will hopefully come up with an agreed basis of calculation.
Senator Angus: Is that the calculation of the value?
Mr. Smith: That is right. It is the core of how it is done, and I am not your witness to get into that.
That is the next step. They will have that before they put out their draft on how to do this at the end of the year or
early January. It is not quite as leading edge as you might think. On the whole, the feedback over the last while has
been positive. There has been little negative feedback from all the stakeholders — regulators, shareholders — the
institutional investor group that Mr. Brown referred to, and it is discounted already in all the financial statements by
sophisticated investors. That debate took place in a public hearing. It is important, in Canada, to move that further for
consideration, and there will be a draft to have a debate around it in January.
Senator Angus: I will be anxious to see that draft. I have seen many calculations that just make a mockery of the
thing using traditional ways. Perhaps it is a good thing that we will get a new way to evaluate.
Mr. Smith: We are all anxiously awaiting that. The group is working on it internationally. The feedback we are
getting from the U.S. is that they will try to embrace it and get it out to the public for feedback.
The Deputy Chairman: Does the new auditor independence standard prohibit tax advice consulting services, or are
they treated the same as other services that you are obligated to follow up on?
Mr. Smith: It does have guidance on that, but it does not prohibit it, no. If you provided a tax service you would
have to go through the same matrix I just described for the evaluation example I gave you.
The Deputy Chairman: As an auditor, when you do the audit for a particular company, do you have to report the
fact that you are doing other services and how much you are paid for them?
Senator Angus: You cannot do them any more.
The Deputy Chairman: Let us say you do decide to perform the service because you believe it does not impede your
ability to do an audit.
Mr. Smith: Yes, there is now a requirement by us — and that was issued in the spring by us — which requires a
dialogue to take place with the audit committee. There has to be disclosure of whether someone is independent, the
services that were provided, what fees were charged, et cetera. It is detailed. The audit committee would be aware of
The Deputy Chairman: Is that made public?
Mr. Smith: At this point it is not a requirement that it be made public. Many companies are doing it. The technical
issue related to public disclosure of audit and non-audit lies outside of Canada, the problem is to report it so it does not
mislead. The definition for audit services in the U.S., which is the basis for that, is based on the 1933 SEC definition.
You can imagine how much the world has changed since then as to what constitutes an audit. Some companies are
disclosing, but they will ask, `` If you did a quarterly review and that has helped us in an audit sense, should that be
considered to be consulting?'' The debate is on how that is done. Certainly, the independent audit committee that we
keep referring to and who want to be independent are aware of it, and some companies are disclosing, while others are
The Deputy Chairman: If there are no other questions, we will now hear from our next witness, Mr. Nick Le Pan,
from the Office of the Superintendent of Financial Institutions.
Mr. Nick Le Pan, Superintendent, Office of the Superintendent of Financial Institutions: Mr. Chairman, thank you
for inviting me here today concerning the implications of the failure of Enron and similar circumstances for Canada.
While we have not been immune from similar problems in the corporate sector, none has been experienced recently
in the regulated financial services industry with which I am predominantly involved. However, I believe that some of
our experiences with financial institutions are potentially useful as the committee considers the wider issues.
There are fundamentally five broad issues in the Enron circumstance or similar circumstances: The adequacy of
financial reporting; enhancing the credibility of the audit process; strengthening corporate governance; ensuring
management accountability; and toughening enforcement.
The Secretary of State for International Financial Institutions has also noted three or four particular questions that
are before policymakers as we move forward. These are: to what extent are the Sarbanes-Oxley measures relevant in
Canada; to what extent should corporate governance rules be legislated versus voluntary; should we differentiate
between small and large firms and corporate governance requirements; and should we differentiate between widely
held and closely held companies?
My comments today will focus on corporate governance in the audit process rather than on some of the other issues,
although I am happy to take questions in all areas. I will provide my views on some of the operations of the provisions
that are already contained in the financial institutions legislation, with which this committee is relatively well familiar
from its previous work, because a number of those provisions are similar kinds of provisions — they are ahead of what
is in the U.S. already — to those that are being considered more generally.
Also, I want to emphasize that, in my view, circumstances like Enron are not predominantly just a failure of rules.
They are also a failure of the adequacy of behaviours by the various parties involved. That is why the answer is not
only potential alterations in rules, but also to continue to enhance checks and balances in the system. It is also why, in
my judgment, there is no limited number of measures, one or two measures alone that are the answer if we are to
reduce the likelihood of recurrences such as those we had south of the border.
Of course, Enron or similar entities are not subject to provincial regulation or supervision. I am coming from my
experience in the provincial regulation supervision area, but I think they are relevant to this. An entity such as Enron
was not subject to the rules or oversight by regulators that apply to federal financial institutions here in Canada.
While provincial regulation and supervision cannot provide a 100 per cent guarantee against failures, it reduces the
possibility of the kind of recurrences we have seen in Enron. Canadians have every reason to have a high degree of
confidence in the regulated financial institutions in our system.
Already the financial institutions legislation contains provisions that are not found in the general corporate statutes.
Take, for example, the risks associated with non-arm's-length transactions, which were a factor in the Enron
circumstance. The federal legislation for financial institutions and pension plans prohibits the related party
transactions that occurred in the Enron circumstances. Therefore, there is a much more limited scope for those kinds of
transactions to be a factor in the events we saw south of the border. If those events did occur, they would
fundamentally be a failure of the regulatory system in applying to financial institutions.
In the area of corporate governance, financial institutions legislation already contains several unique measures.
While these may need to be strengthened as part of changes in general corporate governance requirements, I think
some of the thoughts behind the development and operation of those measures are instructive. For example, the
financial institutions legislation already requires financial institutions, regardless of size, to have an audit committee,
and it sets composition requirements for that audit committee and for the board of directors. Audit committees must
have a majority of non-affiliated directors, and no directors in audit committees for a federally regulated financial
institution may be management directors. That has been in the statutes since 1992. That is part of the Sarbanes-Oxley
material and some of those elements are what David Brown and others are considering for other kinds of entities in
Federal financial institutions must have a conduct review committee to oversee the operations of the rules governing
related-arty transactions. There are legislative requirements on the number of unaffiliated directors on the board of
directors. The committee may recall that there was a large debate, prior to these compositional requirements being
adopted in 1992, concerning such things as the effect on boards, the availability of good directors, et cetera. Overall, I
believe these measures have worked well. They have not themselves been the only element that we put in place in
federally regulated financial institutions to try to enhance governance, but they were an important element. I would not
oppose refinements to those in federal financial institutions if general corporate requirements change.
However, I think it is important that these rules were structured to achieve a reasonable balance. For example, the
statutes do not set an arbitrary size cut-off, to require that above a certain size the rules apply and to smaller
institutions they do not, nor do they distinguish explicitly between public and private companies. However, the rules
were put in place with a degree of flexibility so that they could apply generally, and they were rules more than just
principles, to come back to a point of the previous witness.
For example, the proportions of the audit committee or of the board of directors that were supposed to be
unaffiliated were chosen very carefully, after a lot of discussion and with some judgment, to try to create a meaningful
check and balance between the various members of the board without imposing an unworkable requirement on smaller
companies, or companies with controlling shareholders who legitimately —
The Deputy Chairman: Excuse me. Slow down just a bit.
Mr. Le Pan: The rules and the proportions were chosen very deliberately so that we would create a meaningful
check and balance between the various interests while at the same time allowing those rules on the composition of the
board to be applied to smaller companies and to both public and private companies — private companies, for example,
who legitimately wanted to have representations of the controlling shareholder on the board, and where we have seen
controlling shareholders who have been active in ensuring good governance of their subsidiary financial institutions.
I want to make several other points. I am happy to elaborate on some I have already made when we come to
Goods rules by themselves are not enough. OSFI's expectations of the governance processes in federally regulated
financial institutions are rising. They are further elaborated in, for example, the criteria that we use for assessing
governance — those criteria were distributed publicly to all financial institutions during the course of the summer —
and there are various governance requirements for federally regulated financial institutions and guidelines. Effective
behaviours, in my judgment, by boards and senior management are key. These include, for federally financial
institutions, such things as performing regular reviews of an institution's business objectives and strategies,
understanding and approving the overall risk tolerance, proactively reviewing the mandates, resources and scope of
some of the key oversight providers, risk management, internal audit and external audit.
Some may ask how directors can be expected to meet their escalating responsibilities. We have seen evidence of
directors who are able, when it matters, to ask key questions, to demand timely follow-up by management of things
they are not comfortable with, who have been prepared to seek additional expertise when required. I do not believe
directors have to become experts to do the kind of probing that is necessary and appropriate. At the same time, over
the recent past and in the near future directors have to be prepared to commit the increased time and effort required to
meet their responsibility.
Our supervisory program involves a review for federal financial institutions of the governance process, and when we
see deficiencies, including things like the kind of information that goes to the board, how the board is operating, in the
case of particular areas of risk that we have assessed, we will bring those to the attention of board if necessary, if it is
really serious. We have a range of powers to bring into play.
I have a few words on external oversight providers. I have been involved heavily in the creation of the Canadian
Public Accountability Board — the CPAB — which you have already talked about. I thought that was, on behalf of
the federal government, a very important initiative, and it was important that that initiative have credibility and
effectiveness. That included, in addition to the things that the previous witness talked about, the fact that it would
allow, I believe, a degree of verification that internal processes within audit firms, for complex transactions, were
working reasonably effectively.
Using the example of Enron, the Canadian Public Accountability Board would be in a much better position than the
current system to discover in a review of, let us say, Andersen and the treatment of special purpose transactions that
there was a considerable lack of communication between the actual partners doing the file and the partners with the
technical expertise on special purpose transactions and that in some sense there was a breakdown of internal
governance, arguably, within Andersen. These are the issues that the Canadian Public Accountability Board will have
a lot better capability to get into than does the existing system, because of the additional resources and expertise it will
bring to bear.
Regulators, including OSFI, have also made it clear that if an audit firm is not in good standing with the Canadian
Public Accountability Board we want to know. That brings in place other potential consequences, Senator Kelleher,
including the fact that OSFI has authority over whether audit firms are appointed to audit regulated financial
institutions, et cetera, consequences that I think have real implications and are part of the whole system having a better
and higher degree of checks and balances and consequences for inappropriate behaviour.
Also, for major financial institutions, additional resources are already being put in place but will be required for
audit functions, which means more time of audit and risk committees to understand and be satisfied with the scope and
nature of audits and to follow up on results. We already see that happening, but I believe it will continue. It means
more resources to cover external audit services. Costs will rise, but that is money well spent. We will continue to
monitor the amounts of resources being spent on external audit.
I also put in a reference to the fact that this is not only an issue of the audit world. We have been working now for
some time with the Canadian Institute of Actuaries, which is another type of service provider that boards and
governance processes rely on, and insurance companies, for example, to put in place a process of peer review, which
did not exist in the actuarial profession, and that is an important initiative. We expect to issue shortly draft guidance,
making a peer review process mandatory for federal financial institutions' actuarial reports.
From a purely prudential point of view, the failure of Enron and similar entities did not present a major prudential
issue to Canadian federal financial institutions. While some had exposures to the failed entities, these were broadly
manageable. This reflects the overall sound risk management control practices in these institutions.
Similarly, the scope for financial institutions regulated by my office to be involved in the kind of dangerous practices
we saw at Enron and similar entities is very much reduced to the kind of both legislative and regulatory system, as well
as good governance, that applies to those organizations.
At the same time, we are not complacent. We are expecting boards and audit committees to do more. Expectations
are rising, or they are communicating those to institutions. There are potential areas where the existing rules could be
enhanced because it is important, both for an efficient regulatory system and one Canadians can have confidence in,
that we continue to be able to rely on these kinds of processes.
Senator Angus: I take it from your concluding remarks that the federally regulated financial institutions, which are
your principal constituency, if you will, were not affected in terms of the governance issues coming out of Enron. In
fact, we were dealing with those kinds of issues following the failure of Confederation Life, when we had the hearings
here. You guided us through that, and there evolved a series of good governance practices and guidelines for
supervision of the federally regulated financial institutions and their governance at that time and through the 1990s.
It is the other element that I would like to question you on. You have always told us that a judgement-based kind of
oversight in regulation is much better than a strictly rules-based kind of regulation. When I saw the Sarbanes-Oxley
knee-jerk reaction to Enron, it made me wonder what Nick Le Pan thinks about that. Does it go too far, in your
opinion, and have the Americans got it wrong yet again?
Mr. Le Pan: Senator, there are a number of things in Sarbanes-Oxley that directionally — potentially all of them, in
one way or another — make a lot of sense. On a number of them, we are either ahead here or we are putting them in
place, for example, the Public Accountability Board over the audit profession. Part of Sarbanes-Oxley is an important
initiative for an effective system, not only for public companies, but also for regulated financial institutions because we
rely on the audit process as well in our supervisory work.
I think the devil in part is in the details, and what is important in thinking about applying the Sarbanes-Oxley rules
to Canada is exactly the kind of questions that we have been talking about, or some of the issues that I have debated. If
there are to be independence rules for the composition of a board or audit committee, how should they work? How
broadly should they apply? We have experience in federal financial institutions legislation that is helpful for that kind
of liberation, more broadly, but the issue is not whether there should be some but rather how broadly they should be
applied and how they should be structured.
To use my example in my opening statement, in rules and audit committees, it was hotly debated in 1992 for
financial institutions about what the percentage ought to be for unaffiliated directors. What is the definition of
``unaffiliated''? We struck those rules on a judgment of where — and parliamentary committees were heavily involved,
appropriately, in my view — we would get the benefits of having an unaffiliated group in these organizations without
having a deleterious effect on governance processes. Those questions are important as we think of the rules part of
Furthermore, I would never argue for a solely rules-based or judgment-based system. You have to have bit a bit of
both because you cannot legislate effective behaviour. You can have some checks and balances that try to promote
effective behaviour, and you can have guidance from regulators and others, including from OSFI in the case of
financial institutions, and feedback, if you will, which is one of the things that we do in our role, to institutions when
we think they are falling down a little or maybe a lot. However, we cannot just say that we are going to change this and
that and back away without focussing on the need to promote, through a variety of mechanisms, effective behaviours
on an ongoing basis. We also have to recognize that those jobs are not simple.
Senator Angus: That sort of outcome would address the issues that arise from Senator Kelleher. I mentioned earlier
with Mr. Brown that one size certainly does not fit all, even in the U.S., but more so in Canada, and we cannot have an
across the board thing. The idea of a blended system is the right one.
Let me shift direction from the strictly five or six points on governance arising from the Sarbanes-Oxley thing and
go to how the federally regulated Canadian financial institutions got burned in the Enron and WorldCom affairs. I
understand and, again, only from reading our national press, that some of these institutions took huge baths by
jumping on a bandwagon without perhaps doing their due diligence and getting to a point where they had to take hits
well in excess of $250 billion. Shareholders feel a hit.
Mr. Le Pan: Before I answer that, let me comment on your one-size-fits-all point. While I agree with that, one has to
be careful in concluding — in the world that I regulate — that there are a group of companies where nothing is the
answer in terms of rules.
My example of the requirements on audit committees is instructive. In 1992, we did not say audit committees have
to have a majority of unaffiliated directors and no management only for public committees. We did not do so because
policyholders and depositors, in even a non-public company that is a federally regulated financial institution, deserved
the protection afforded by that balance on the board. Therefore, we tried to figure out how to structure a rule that
would apply sensibly across the range and, similarly, for regulated financial institutions that were privately owned. It is
a challenge to structure a rule that can apply in a variety of circumstances, but I would not give up on that goal,
certainly, in the financial institutions kind of world.
With respect to the impact of Enron, WorldCom and so forth on institutions, it would be naive to expect regulated
financial institutions, in their dealings with counterparties, not to have losses. That is not the world they are in. They
are in the business of assuming, managing, measuring and monitoring risk. From time to time, those dealings with
counterparties will lead to losses, or potentially, they will be involved in transactions that somebody else will want to
sue somebody for. The issues, from my perspective at OSFI, are whether those losses are manageable or whether the
existence of those kinds of problems are indicative of a breakdown in internal control procedures — risk management
procedure — in those institutions. The fact of the losses is not, by itself, something that I want to be an alarmist about
and that is very important.
Let us step back. Yes, there were losses of a number of federal financial institutions, not only in these kinds of events
but also in other things. As I said earlier in my testimony, on the broad scale of things, those losses have been
manageable. The shareholders may not have liked the losses, but we have not eroded capital in system for regulated
financial institutions. There were actions that my office had taken several years in advance, because we were not
convinced that a sustained economic growth could continue forever, to promote the bolstering of capital reserves of
federally regulated financial institutions. Those were good actions to take in advance.
I do not believe that the kind of losses we have seen are indicative of fundamental systemic breakdowns in risk
management and control procedures in the institutions that I regulate and supervise. Will there be losses and issues
from time to time? Yes. Do people learn from them and get better? Yes. That is the nature of this world.
Senator Angus: Will you lend money to counterparty transactions? No. They are free to do business the way they see
Mr. Le Pan: Our role is to try to trust the internal governance and risk management systems, to verify that trust
through our supervision program and rules and to use the experiences, as they arise, as indicators of whether our trust
in those systems is well placed.
Senator Kroft: Mr. Le Pan, your world of responsibility is one in which we are accustomed to requiring a higher
threshold because of the nature of the institution and its implication to the economy and all the other reasons. In effect,
you have operated ahead of the curve and we are grateful for that. What are the key things that you have learned? You
point out that there are many things that are not in the general corporate governance. I am trying to understand what
we can find in taking the extraordinary degree of care and attention that has traditionally been part of the supervision
of financial institutions to see what the lessons are, what is applicable and what is not applicable. I think we would
become restrictive if we were to go across the board on corporate governance that everything applicable to financial
institutions should apply to all operating companies. We would risk choking the system. My question is directed. Are
there obvious things that you have become accustomed to as a natural part of your work that you have learned works,
whether it is requirements of boards or audit committees, or arm's-length transactions? Do you have a short list of
things that you have done and, without being restrictive, that you think would apply in a general way? Are you getting
your thoughts fed into the process effectively? Are you satisfied with what you see emerging?
Mr. Le Pan: Concerning the last part of your question, senator, we are involved in a variety of the processes that
were described earlier. I sit as a member of the Accounting Standards Oversight Council, so we have been involved in
discussions about special purpose entities, which has been a big issue for financial institutions. They are involved in
that so we have a fair amount of expertise in that area. We are also involved in the discussion about stock options, et
cetera. We have a close working relationship with accounting standards centres and we have experience on governance.
We have been talking with people, as you heard earlier, and sharing those kinds of experiences.
I am satisfied that the kind of experience we have is useful and available. If I had to come back to the questions that
are before the committee to try to distill several elements of the FI world, I would use the question of regulation as an
example and whether it should be regulatory or voluntary. The FI experience would say that there has to be a mix of
the two. It cannot be 100 per cent voluntary; it has to be partly legislated. I strongly believe in that. The need for
guidance on the kind of effective behaviours we look for is an important lesson from the FI world. Much has happened
in that area over the past number of years and more will happen in the future.
Whether these regulations, et cetera, should apply only to large firms, or to small and large firms, unfortunately, my
FI experience suggests there is no simple answer. In the FI world, we tried to structure rules that would apply across
the board. We believed that people deserved that kind of protection. One has to go down, for example, the Sarbanes-
Oxley list, and say: Is it okay that the CFO certification would apply to large and small firms? Yes, it should apply to
I have not heard an argument in favour of why it should not apply. On the other hand, when you have the
composition requirements of boards and audit committees, I think the potential for additional costs is quite important.
How to structure that kind of set of rules, whatever they may be, is a more complicated kind of judgment. That is the
experience of the FI world in the board composition area.
I am strongly supportive of the other element that is part of what the provincial regulators and the federal
government are looking at, the whole area of enforcement resources and capabilities. That is an important part of the
mix because it is important to the checks and balances. There must be a degree of credibility. The tools that we use at
OSFI for our regulation supervision have credibility and we can achieve results. You have to have that same degree of
credibility outside the FI world.
Senator Kelleher: There certainly has been a great deal of heightened discussion about special entity companies,
particularly in respect of Enron, as an example. Do you feel that we have adequate oversight and regulations in
Canada with respect to special entity companies? Is there more that we could do in those areas?
Mr. Le Pan: I will comment on federal financial institutions, predominantly, and then I will comment a bit beyond
that. Fundamentally, there is a highly developed set of rules around special purpose entities for financial institutions to
use to manage their own risks. My office has extensive guidelines that have elaborated on the accounting for those
entities for a number of years. Regulated financial institutions have a considerable degree of experience in managing
those kinds of structures. We also have a well-developed set of capital rules that focus on how much risk has been
transferred, because there is a whole range of degrees to which risk can be transferred to these vehicles.
I think, broadly speaking, that framework is working reasonably well. That framework includes the capability of my
office, for example, to identify situations where we do not believe that adequate amounts of risk have been transferred
and, at the end, they ought to be consolidated back onto the bank's balance sheet. We have used that authority on
occasion. There have not been big amounts, but we have used that, just as others have, including the United States.
Largely, the issues of changes in accounting in the United States and the parallel ones that are being looked at in
Canada are for special purpose entities outside those used by banks, let us say, where some of the rules that are already
in place are different.
I am strongly supportive of the general direction of the FASB rules and the similar Canadian Accounting Standard
Board's rules on special purpose entities, although I think comments in both Canada and United States indicate that
there are some technical details still to be worked out that are nontrivial and how those rules will work better to cover a
potential Enron-type of situation.
Broadly speaking, I think that the rules in the financial institutions area for one type of transaction are not bad.
There may be a few things that need to be tweaked and are in the process of being tweaked. Outside the use of those
entities by financial institutions, I think Enron clearly showed that there were problems with some of the accounting
rules. I am confident they are going to be addressed in a timely way through the processes that are operating on both
sides of border to change the accounting for these entities.
Senator Kelleher: I notice that you are quite careful, and I agree with you, to make the distinction between financial
institutions where we have quite a comprehensive regulated regime and companies like Enron where there were not too
many rules — at least there did not seem to be for the people at Enron. I get the impression or feeling that you feel that,
had the areas outside the regulated financial institutions had a little stronger regime and little bit more comprehensive
oversight and regulation, we probably would not have had the problems in those areas that we did have. Am I correct
in that? I know it would not completely cure the situation.
Mr. Le Pan: I want to be very careful, senator, in commenting on another regulatory regime.
One of the things that I did relatively early on after the Enron issue hit was read the report of the independent
directors that was commissioned as a post-mortem about what had happened. If you have not looked at it, it is
fascinating, in my judgment. It illustrates the point that I made in my opening statement, that this is not just an issue of
According to the report that members of the board did for the rest of the board, there were a number of points at
which somebody could have stood up and said, ``I do not like this,'' or ``I have this question,'' or ``We asked for this to
be done, did we follow-up and has it been done?'' If you read that report, you will notice that those opportunities were
consistently missed, it seems to me. There may be facts and so on that I do not know about.
I do not believe this is just an issue of rules. I think it is an issue of effective behaviours, and all that kind of stuff.
That is part of what I said earlier.
I think that my comment about the board and Enron also applies to a number of the other checks and balances.
That is why I am supportive, in Canada, of the Public Accountability Board for auditors, enhancing its capability to
look at the audit firm and increase the chance of catching the situation in which the technical partner on special
purpose transactions was not being adequately consulted by the people on the Enron case. There was arguably some
kind of problem with the internal control procedures at Andersen. I think it is very important that we increase the
ability to lessen the likelihood of those kinds of things.
Senator Prud'homme: You speak very fast for us.
Mr. Le Pan: I am sorry, senator.
I think that it is a multifaceted kind of response. I do not believe that that response requires extension of the full
kind of range of regulatory structure that applies to financial institutions outside of the financial institution world.
There are other reasons that Senator Kroft, for example, has referred to, that we have a prudential regulatory regime
and supervisory regime. However, it does imply some of those kinds of checks and balances being enhanced. The
challenge is to pick the right ones and not go too far in order to reduce the likelihood of these kinds of things
happening in the future.
Senator Kelleher: Now that you have had an opportunity to view the debacle that has gone on both here and in the
States — I do not want to have you pick one system against another — how would you compare the quality of
corporate governance here in Canada, as it presently exists, with what presently exists in the United States?
Mr. Le Pan: I really cannot answer that question, senator.
We are in a unique position, because we, as federally regulated financial institutions, have an insight as to how the
governance process is working through our supervisory framework and so on. We interact quite a lot with boards of
directors. We meet with audit committees at least once a year. We meet with them both with and without management
present. We have an opportunity to look at how certain issues that were challenges or risks to an institution were
handled by that institution, including by the governance processes. I do not have that capability for U.S. financial
institutions, because we do not supervise them or regulate them.
My overall impression from talking to financial regulatory colleagues in the United States is that, for the institutions
regulated by organizations similar to mine, banks and so on, the state of governance is quite comparable, if you will. It
is hard for me to compare that to the state of governance generally outside the regulated financial institution sector.
Certainly, what I read in the case of the independent director's report in Enron, for example, that kind of
governance, if it were to occur in a regulated financial institution in Canada, would be unacceptable. Indeed, there are
a number of things in our supervisory program and so on that would have a considerable chance of being able to
identify that kind of a problem.
Senator Kelleher: Yes. I can well imagine that you would come down rather hard.
Senator Taylor: I have a little trouble understanding — maybe you fellows are up on it — federal financial
institutions, where you start and where another one stops. For instance, the Bank of Alberta, is that a federal financial
institution? It has shares, a public issue.
Mr. Le Pan: Are we talking about the treasury branches?
Senator Taylor: No. The treasury branches no longer exist. They were put together to try to get around federal
Mr. Le Pan: Exactly. I do not believe the Bank of Alberta, per se, is a federally regulated financial institution.
Senator Taylor: Is that the case even though it issues shares?
Mr. Le Pan: I do not believe it is.
Senator Taylor: How about an oil or mining company out of Calgary or on the Western Exchange?
Mr. Le Pan: Fundamentally, we are talking about approximately 350 or 400 institutions. This includes all of the
chartered banks, including the Canadian Western Bank, operating in Western Canada, and foreign banks operating in
this country. We are talking about the vast majority of insurance companies, the life insurance companies. Some are
regulated provincially, but the vast majority are regulated federally. We are not generally talking about credit unions,
which are regulated provincially.
Senator Taylor: My other other question is entirely unrelated. It is about independent directors of institutions. It is
difficult to have an independent director, but one of the things I was thinking about was how you would handle the
case of a so-called independent director. As you know, when the notice for an annual meeting goes out, there is usually
a recommendation by management that the directors be reinstated. Suppose one of the independent directors from the
previous period had become more independent. In other words, he or she disagreed a bit with the management.
Suppose he or she does not make the list that is circulated to the annual meeting. With the present regulations, if
management does not recommend you, you have to finance your own publicity or circulation to shareholders to try to
How would you handle that kind of a fight where the independent directors became so independent they were not
recommended by the management in the information circulars that went out for the annual meeting?
Mr. Le Pan: I think, senator, this goes back to a very important point about independence being not only a question
of rules, but also a question of behaviours and effectiveness. We see a range of governance practices in the institutions
that we regulate and supervise. Some are good and some need to pull up their socks.
We have a series of powers under the federal financial institutions statute. What I would look for in the board that
resulted from the situation you describe would be a capability to adequately meet its responsibilities. If we did not see
that, there are a number of things we could do. We have acted to cause changes in the composition of boards of
directors. Since the passage of Bill C-8 we have fairly formal powers to remove directors My experience has been that
one does need not always use those kinds of powers in order to achieve results. There have been cases where boards
were not functioning adequately in regulated financial institutions. They might not have been functioning adequately
for a variety of reasons, and we have taken a number of actions including looking at the information going to the
board and, where necessary, causing some changes in composition.
Senator Taylor: That leads to a question. In the past, you have been acting on whether or not the directors were
doing the job. I understand in the new era, the post-Enron era, the importance of independent directors will become
quite important. How will you tell if a director is independent? Do you not have a responsibility to indicate to the
public of Canada or the public in general that there are four independent directors on a particular board? If one of
them is thrown out or is not re-nominated, where do you come in? Post-Enron, people want those independent
directors and somebody has to say they are such.
Mr. Le Pan: It is absolutely key that any rule on independence is fairly clear about what the definition of
``independence'' is. Since 1992, we have had a rule for federally regulated financial institutions. We use the term
``affiliated'' or ``unaffiliated'' as opposed to independent, but we have had a rule about the definitions of being
affiliated or unaffiliated. We look to see that there is a compliance program within these institutions that we regulate so
that the requirements of the statute are met. We would trust that compliance program, but also verify that it is
Occasionally, we might find a situation where an institution has mistakenly thought somebody met the technical
independence requirements, but did not. Then, they have to fix the situation. We also ask why their compliance
program did not catch this early enough. If we are not satisfied with the integrity of the compliance program within the
institution, we will make recommendations or require that the compliance process be improved.
That is the kind of process that we go through now. If the independence requirement were to change in federal
financial legislation or if the Canada Business Corporations Act were to change its definition, and it was adopted for
the Bank Act and the Insurance Companies Act, we would operate a similar process to verify that people met the
technical independence requirements. Part of my earlier answer emphasizes that it is not only important to meet the
technical independence requirements, it is also important that the board be able to act when necessary, and we look for
that as well. That is far more difficult, because it is not a matter of rules or law.
The Deputy Chairman: Thank you very much, sir. There are no further questions. We meet again tomorrow at 11