Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 13 - Evidence
OTTAWA, Wednesday, February 19, 2003
The Standing Senate Committee on Banking, Trade and Commerce met this day at 1:33 p.m. to examine and report upon the present state of the domestic and international financial system (Canadian perspective to the Enron collapse).
Senator E. Leo Kolber (Chairman) in the Chair.
The Chairman: We are meeting to continue our examination of and report upon the present state of the domestic and international financial system, which we call the Canadian perspective to the Enron collapse, or "Enronitis.''
We have four groups of witnesses. The first group, via video conferencing, is from KPMG Canada, in the persons of Mr. Bill MacKinnon, Chief Executive Officer, Mr. Axel Thesberg, Partner in Charge, Professional Standards, and Mr. Peter Sahagian, General Counsel.
Mr. William A. MacKinnon, Chief Executive Officer, KPMG Canada: I would like to make a brief opening statement and then we will be happy to answer any questions the committee may have.
Thank you, Mr. Chairman, and committee members, for the opportunity to present our firm's perspective on market and regulatory responses to Enron and the related financial scandals that came to light last year.
I plan to cover three subjects that we believe are important to this debate. First, I will speak to the major regulatory reforms that have resulted from the Enron failure, and in particular, the CA profession's role in putting them in place. Second, I will focus on the concern about duplicate regulation in Canada as these reforms begin to take place, and last, I will briefly address the current situation regarding liability legislation as it affects the members of my profession in Canada.
Enron did not occur in Canada, but since the beginning of this crisis, KPMG and the other major Canadian accounting firms have been deeply concerned about that situation and the failure of investor confidence that resulted from it.
Very early, we recognized that the market's faith in the financial reporting process had been badly shaken. We acknowledged that we had a significant responsibility as a profession, shared broadly with company management, audit committees, boards of directors and regulators, to reassure investors about the integrity of financial information, the transparency of disclosures and the independence and objectivity of the auditors who attest to them.
We have accepted that responsibility, and we have taken decisive action to address it. Working closely with Canada's regulators and the Canadian Institute of Chartered Accountants, our profession has voluntarily adopted an integrated solution to improve investors' confidence in the quality of financial reporting.
At the heart of this solution is a new system for the oversight of the accounting firms that audit Canadian public companies by a body that is independent of the profession. That is a very significant change, because as you likely know, our profession has been, until now, self-regulated throughout its entire history.
The independent body charged with enforcing this oversight system will be the Canadian Public Accountability Board. The Canadian Securities Administrators, the Office of the Superintendent of Financial Institutions and the Canadian Institute of Chartered Accountants announced the formation of this new body in July 2002.
This body will be chaired by the former Governor of the Bank of Canada, Gordon Thiessen, and will include a majority of members from outside the accounting profession. It will be empowered to carry out inspections of the audit quality of firms that audit public companies and to impose tough sanctions on firms that do not adhere to professional standards and the board's regulations.
Well before Enron, our profession was actively developing new standards to strengthen the independence of auditors from the clients they serve. The standards, which were introduced in draft form last fall, identify nine specific non-audit services that are inappropriate for auditors to perform for their audit clients. They mandate rotation of the audit engagement partner on public company clients. They address threats to independence posed by partners and audit team members accepting employment with audit clients.
The profession's Generally Accepted Auditing Standards have also been strengthened. Auditors are now obliged to have discussions with the audit committee about the "grey areas'' of a company's financial reporting, the accounting estimates and judgments that management has made in preparing the financial statements.
The Canadian oversight system, in addition to new practice-inspection procedures, also includes new disciplinary processes and legislation that empowers securities regulators to, amongst other things, require CEO and CFO certifications of financial reports and internal controls.
All these initiatives add up to an integrated set of Canadian reforms designed to achieve the same objectives as the Sarbanes-Oxley Act, the U.S. corporate accountability legislation that was announced last July.
On January 28 of this year, the U.S. Securities and Exchange Commission approved new rules that clarify how Sarbanes-Oxley will affect SEC registrants and their audit firms. Among other matters, the SEC rules prohibit auditors of public companies from providing certain non-audit services to those clients. All other services are allowable if they are pre-approved by the audit committee. We have every expectation that the Canadian reforms I outlined earlier will be harmonized with those rules in the near future.
As a result, there will be fundamental changes to the way that Canadian audit committees, management and auditors carry out their work.
These changes are underway today, and we at KPMG welcome them. We believe they will contribute to greater trust in financial reporting and will help restore confidence in the financial markets. We believe they are good for investors and for our profession, and based on what we have seen in the marketplace, corporate Canada agrees with us.
My partners and I are continuously in touch with senior executives, directors and audit committee members of public company clients across the country. I can tell you that the integrity and transparency of financial and corporate reporting is a very important issue to the great majority of these companies.
Our clients are focusing closely on compliance with the new independence rules. They are working with us to clarify the non-audit services that are appropriate for us to provide, establishing policies concerning pre-approval of services, and where necessary, they are developing strategies for audit partner rotation. Some companies that are not SEC registrants are voluntarily complying with certain of these Sarbanes-Oxley provisions, including disclosure of fees paid to auditors, even though they are not yet required to do so.
We have also noticed a significant change in the way that audit committees are approaching their work. Audit committee meetings are lasting longer and being held more frequently, with better prepared members who are asking tougher, more detailed questions, both of management and us, the auditors.
In summary, we believe that Canadian market participants are effectively addressing the Enron crisis. The CA firms, the standard setters and regulators are working cooperatively and collectively to introduce made-in-Canada measures that are fair, reasonable, effective and aligned with similar reforms in the U.S. Management and directors of public companies are responding positively to these measures. We believe this is good news for investor confidence in the quality of financial reporting in Canada.
Nevertheless, we see some potential pitfalls ahead. First, we must work on ensuring that we do not subject Canadian corporations to duplicate regulation in Canada and the United States. It is important to recognize that Canada has far more SEC registrants than any other country outside the U.S., and a significant number of these are quite small. It would be unfortunate and unnecessary, frankly, if these Canadian registrants were forced to comply with two systems of regulations and two separate enforcement bodies that are aimed at achieving the same goal. Such a double regulatory burden would, unquestionably, hamper Canadian companies' competitiveness.
The same is true for our role as auditors of public companies. It would serve no one's interests if we were subject to oversight, inspection and discipline processes in the United States, when we are already working within a very similar framework in Canada.
What we need, and what we are building today, is a Canadian system that, while largely harmonized with the U.S. regulatory system, also addresses the unique needs of the Canadian market. To finalize this process, we will need mutual recognition and acceptance by Canada and the U.S. of each other's regulatory systems.
As a model or demonstration of how this might work, I will cite the Multi-Jurisdictional Disclosure System, MJDS. The SEC and the Canadian Securities Administrators established this system in a cooperative manner. Under the system, Canadian SEC registrants may file audit reports using Canadian Generally Accepted Auditing Standards, GAAS. Canada is the only country with which the SEC has such an agreement.
We believe that the SEC is showing a willingness to listen to Canadian concerns about regulatory overlap and duplication. In December 2002, they sought input from non-U.S. standard setters concerning rules for implementing the Sarbanes-Oxley Act. In January this year, the Canadian Institute of Chartered Accountants provided input concerning the aspects of these rules that addressed auditor independence.
However, we must keep pursuing this cross-border dialogue. Going forward, only a coordinated effort by governments, regulators and the professions will ensure that the U.S. stakeholders understand the need for, and the value of, our Canadian solution. We would welcome and appreciate any efforts you could make on our behalf in this matter.
Before I close, I would like to touch on an issue that is closely related to Enron and is of critical importance to my profession. I am referring, of course, to the need for liability reform. We believe that a more realistic approach to the legal liabilities of auditors is essential to the health of our profession and, we believe, to the health of our financial markets.
When we issue an audit opinion, the concept of professional liability puts our assets, both personal and business, at direct risk. Today, as investors and directors are demanding higher levels of assurance about corporate financial statements and other corporate disclosures, such as management discussion and analysis, this risk has increased dramatically.
Let me be clear about this issue. Our audit profession is prepared to accept greater responsibility in the financial markets. However, the profession also requires an equitable balance between the additional responsibilities we are assuming under the new regulatory regime and the additional risk of liability that this regime has put on us.
Fundamentally, we believe that liability should be proportionate — that is, limited to the auditor's share of responsibility for a plaintiff's loss. Such is not the case under most of the current legislation in Canada. Today, an audit firm could be held liable for the full amount of investors' losses resulting from a major corporate collapse, even though others, including management and directors, may have played a larger, more important and direct role in the business's failure. In the interest of fairness, we believe that this inequitable situation needs to be corrected.
I would point out that the members of this committee took a strong position in favour of proportionate liability in a 1998 report that proposed amendments to the Canada Business Corporations Act. These proposed changes have since been passed into law. That was an excellent first step, but additional measures are necessary to fully address the inequity.
We also stress the need for legislation that would provide greater protection for the personal assets of partners in audit firms in liability judgments, while still maintaining the proportionate liability of audit firms themselves. To accomplish this, we recommend broadening the existing LLP legislation to provide full-shield protection against both professional and commercial liabilities.
In conclusion, I would like to make a personal observation directly related to the Enron crisis and its aftermath. For all its many negative consequences, Enron has significantly raised the consciousness of Canadians about the importance of reliable and transparent financial information to our capital markets. I believe that Canada's CA profession recognized this change and took decisive steps in response. I am confident that the revised system of accountability and oversight that is emerging will be one of flexibility, transparency and trust, and that it will bring confidence to all those who rely on it.
You have my commitment that we at KPMG, working with our colleagues in the other accounting firms, with regulators, with our clients, with shareholders and with other interested parties, will continue to fulfil our role to the high standards expected of us.
We are now pleased to take any questions that you may have.
The Chairman: Thank you for a good presentation. If any of your colleagues would see fit to answer questions, please ask them to identify themselves.
Mr. MacKinnon: On my left is Mr. Thesberg. He will take questions, if necessary. On my right, is Mr. Sahagian, our general counsel, who will also take questions where appropriate.
Senator Kelleher: We appreciate your input today and I am glad to know that you are concerned about a potential problem with the Sarbanes-Oxley Act and what Canada may or may not be doing in this area.
Committee members will go to New York and Washington at the end of March. We understand that we may be meeting with the two people after whom the bill is named: Sarbanes and Oxley. We are concerned that the legislation has already been passed. The Americans are not inclined to change their legislation for too many people. Just last week, we heard from some of the larger corporations that they would like us to bring in something close to Sarbanes- Oxley because they are already inter-listed. Whether they agree or not, they will be caught by it. Therefore, the closer our legislation can be to the American legislation, the easier it will be for them.
It has been indicated to us, however, that the smaller companies, which constitute the majority of businesses in Canada, will face problems. Perhaps we must try to persuade the Americans to give us some leeway in this respect. I noted on page 6 of your presentation, Mr. MacKinnon, that you mentioned the current Multi-Jurisdictional Disclosure System, MJDS. Will this offer us any help in our discussions with the Americans?
Mr. MacKinnon: I think it might well help because this system works very well. It really means that a Canadian company, when it wants to file statements in the United States, does not have to go through the process that the European companies go through in conforming to the U.S.'s Generally Accepted Auditing Standards. I think that it has worked well, and both the SEC and the Canadian Securities Administrators would say that it has worked well. It would provide you with a good example to offer in your discussions with U.S. regulators.
There is one other thing that you may be interested in, and which I find fascinating. There are 7,000 public companies in the U.S., as opposed to 4,200 in Canada. Therefore, you will understand how small many of our Canadian public companies are, comparatively speaking, and how much more of a burden this would be if all 4,200 were not listed in the U.S. Mr. Thesberg, how many SEC registrants do we have?
Mr. Axel Thesberg, Partner in Charge, Professional Standards, KPMG Canada: Probably close to 500 in Canada.
I have only a couple of additional comments. Mr. MacKinnon has indicated that Canada has far more SEC registrants than any other country around the world. There are indications in the rule-making that the SEC has been going through. They have gone through a significant process over the last few months of putting the rules in place to implement the act. In several instances, they have specifically asked for comments from foreign registrants or auditors. A case in point is the independence rules, where they clearly asked if there are any unique implementation issues, and maybe appropriate accommodations, in foreign countries.
I think that is a positive step. We need to continue that dialogue on each of these matters as the actual rules of the act are put in place and implemented in practice over the next year or so. I think there are some positive indications that there is a willingness to listen.
The Chairman: You talk about 500 SEC registrants. Then we were told there are about 180 inter-listed companies, in other words, Canadian companies listed on the New York Stock Exchange. Could you tell us how Sarbanes-Oxley applies to both or either? Is it the same, or are we confusing matters?
Mr. Thesberg: Sarbanes-Oxley applies to all Canadian companies that are listed on the New York Stock Exchange, NASDAQ, the American stock exchange, or whatever, because they all are subject to SEC regulations. Every Canadian public company that is subject to SEC regulations, regardless of size, is subject to Sarbanes-Oxley.
The Chairman: I did not mean that. Do they have to be listed on a recognized exchange? Is that what a SEC registrant means?
Mr. Thesberg: By a SEC registrant, we mean subject to the SEC regulations, which relate to anyone who issues securities in the U.S. That is a broader category than those actually listed on a recognized exchange.
The Chairman: However, they are treated equally?
Mr. Thesberg: Yes.
Senator Kelleher: I have been asking this question of the people who have been appearing before us. I must say you are the first group that has offered any meaningful suggestions as to how we might tackle this problem. Frankly, I had never heard of the Multi-Jurisdictional Disclosure System before. I agree with you, it looks somewhat promising. Would it be possible for you to give us any additional information on this particular system — how it works and how we might use it to the benefit of the smaller Canadian companies? Trying to comply with Sarbanes-Oxley will be a problem for them. Do you have any other thoughts on arguments that we can put forward for some sort of relief from this legislation?
Mr. MacKinnon: First, David Brown is working with the Canadian Securities Administrators to try to persuade Washington to allow the Canadian regulatory process to be considered equivalent to Sarbanes-Oxley, as is the Canadian Institute of Chartered Accountants. I would encourage you to get in touch with David Brown and David Smith. I think that would be useful.
Second, our regulatory system works. We have a very strong system. There are areas where we are much further ahead than the Americans — for example, in timely reporting disclosure. There are other areas where our disclosure is more advanced than theirs. There have not been big problems among Canadian companies filing in the U.S.
Mr. Thesberg: The Multi-Jurisdictional Disclosure System, MJDS, currently deals with the ability of certain Canadian public companies to use their Canadian filing documents to file with the SEC. However, there are a number of areas of the regulatory reform that we are talking about, and that have arisen out of Enron, that are not in the disclosure documents. For example, things like audit committee requirements, independence of audit committees and requirements to have financial experts are not part of the disclosure system. As a result, there may need to be additional or alternative regulatory mutual recognition mechanisms in addition to the MJDS. Other things could be included within it.
Mr. MacKinnon: We will send you some material on the MJDS tonight or first thing tomorrow morning, so you will have further details on exactly what that process is.
Senator Kelleher: I appreciate your help and assistance.
Senator Banks: I have a sort of curmudgeonly bias, in that I think most things used to be better in the good old days. The good old days, to me, were when banks were banks, trust companies were trust companies, auditing firms were auditing firms and consultants were consultants. Those were the businesses they were in, and never the twain met, as I fondly, and perhaps incorrectly, recall. Given that bias, I have some trepidation about the big four that are both consultants and auditors. I am a neophyte in all of this, but most Canadians, I think, worry a little about a possible conflict there.
If I were an auditor, with a consulting partner who suggested to a client that we go down road A rather than road B, I would perhaps be loath to say that was a terrible mistake. I know that is oversimplifying and exaggerating. However, you mentioned that you thought the LLP legislation ought to be extended to provide full-shield protection against both professional and commercial liabilities. Is it possible to reconcile that suggestion with the potential conflict that I see between being at once an auditor and a consultant?
Mr. MacKinnon: There are two or three things there. First, we recognize that consulting itself could be considered a conflict when you are an auditor. We disposed of our consulting business two-and-a-half to three years ago, so that we no longer provide information technology or other forms of consulting.
Second, the activities that public accountants can undertake have been studied in both the U.S. and Canada in great detail. There are nine specific activities we should not do for audit clients, and we have agreed we will not do them. They are laid out in both Sarbanes-Oxley and Canadian independence rules.
Third, what we are looking for in the liability issue is proportional liability versus joint and several; and the protection of personal assets in liability awards, as against business assets. I think those are the only two things we are looking for in liability reform. I may have oversimplified it.
We are out of the consulting business, and we will be very careful not to undertake activities that regulatory bodies do not think we should.
We are also looking for proportionate liability versus joint, and we do not think our personal assets should be subject to liability claims.
Mr. Thesberg: I will add an additional comment about auditor independence, consulting, and auditors being perceived to be auditing their own work. The new proposed Canadian independence standards and the ones now active in the U.S. deal with three principles. First, auditors cannot audit their own work; second, auditors cannot act as advocates for their clients; third, auditors cannot take on a management role. The proposed Canadian independence standards are built on that framework and are what you might call a principles-based approach. They also contain specific rules on non-audit services that, within that framework, have been judged as inappropriate for an auditor to provide to an audit client.
I believe those new standards, as they are implemented, address this question. There is also the business perspective, where we have sold our consulting practice, as have many of the other large firms.
Senator Banks: I am delighted to hear that and I hope that the proposed plans come into effect. I certainly agree that, in the circumstances as I perceive them, you ought not to be personally liable.
With respect to the proportionate liability, is there a plan in your mind as to a formula by which we would arrive at that, or would that be done on a case-by-case basis?
Mr. Peter Sahagian, General Counsel, KPMG Canada: As Mr. MacKinnon pointed out, this committee studied the issue and issued a report in 1998, and we endorsed the findings of the committee and the recommendations contained in that report. They were reflected in the amendments made within the last year to the Canada Business Corporations Act. We would advocate that the same approach be used in other legislation, for example, federal financial institutions legislation.
I should point out that amendments that deal with secondary market trading have recently been made to the Ontario Securities Act through Bill 198. In that legislation, they also endorsed the concept of proportionate liability. We are encouraged that there have been developments in that area, largely as a result of the report of this committee in 1998. That was the seminal report. Progress has been made, but there is corporate and securities legislation in all provinces across the country. There is room for proportionate liability to be introduced across the country at the provincial level, as well as in additional federal legislation.
Senator Meighen: I want to follow up on that. My recollection, having sat on that committee, was that everyone was happy that we managed to get a modified proportionate liability system into the Canada Business Corporations Act. As you pointed out, that has been of assistance. My understanding is that the proportionate liability deals with the firm, not with individuals. Is that correct? Are you looking for legislation introducing modified proportionate liability into areas of jurisdiction not covered by the Canada Business Corporations Act, and on the other hand, something to limit personal liability? For clarification, if that is so, would you also advocate that limitation of personal liability should extend to lawyers, architects, engineers and the like?
Mr. MacKinnon: I will ask Mr. Sahagian to deal with the first part of the question, but the answer to the second part is "yes.''
Mr. Sahagian: Our issue has been dealt with, to some extent, across the country. Of the 10 provinces, 6 now have some form of legislation that essentially means that partners' personal assets are protected from claims against their firm, save and except the partners responsible for the wrongdoing. This might mean the partner who acted negligently would have his assets exposed.
Senator Meighen: If there is wrongdoing, no one is suggesting that the individual be protected, am I correct?
Mr. Sahagian: That is correct. Six of the provinces have this type of legislation, but there are four that do not: British Columbia, New Brunswick, P.E.I. and Newfoundland. The others do have some form of limited liability partnership, but the problem is that there is no consistency across the board. In Ontario, the limited liability partnership legislation only protects against professional negligence claims; it does not protect against the breach of a lease or breach of contract. If a client argues that their engagement letter has been breached, we can be sued for breach of contract, but not professional negligence. There seems to be some inconsistency there. We are not sure why the legislation is not as comprehensive as we would like. Other provinces have broader legislation; for example, in Saskatchewan, the legislation covers both commercial and professional liabilities and is much more broadly drafted. We would like to see some consistency brought to bear. There has been uniform legislation brought together by a legal liability committee that deals with this appropriately. We would like to see that enshrined across the country.
As you pointed out, it is a matter of provincial jurisdiction.
Mr. MacKinnon: One of the other things we are seeing is jurisdiction shopping. If we have four provinces that do not provide the same protection as the other six, we are concerned about jurisdiction shopping, which often happens in the U.S. That is another reason why we would like consistency across the country.
The Chairman: We should at some point have a lawyer try to explain this to us. You asked an excellent question there. Maybe I am obtuse, but I do not understand the liabilities here. In terms of doctor malpractice, my understanding is that if someone is a rotten doctor, you cannot sue. We should get a briefing on what "liability'' means, because if there is no wrongdoing, why are you suing?
Mr. MacKinnon: I think you can certainly sue a rotten accountant.
The Chairman: Are there any?
Mr. MacKinnon: Not in this room, but unfortunately, I am sure there are. There is a tremendous increase in litigation against accountants. It is not an issue whereby people do not take action against accountants; they do and they should. Where we were not doing things correctly, we have to respond to that.
The Chairman: I am professing ignorance on the subject and suggest that we get a lawyer to talk to us.
Senator Meighen: The issue that we addressed in 1998 was that you could have a very small breach of duty or inadvertent mistake by an accounting firm. You would be responsible for one per cent of the problem, but you have the deep pockets, so you are the people who are sued. The plaintiff, if judged to be correct, could recover all the damages from you. You would then have to chase after the people who were really largely responsible for the wrongdoing or mistake, in order to collect from them. That might be hard, because they might be bankrupt or unavailable.
Mr. MacKinnon: You phrased that correctly, senator. That is what that report helped us with in 1998.
Senator Oliver: I have two questions. They both come from the presentation that you made. You spoke about building a Canadian system that, while largely harmonized with the U.S. regulatory system, also addresses the unique needs of the Canadian market. Could you tell us what those unique needs that you would like to have addressed are? My second question relates to the general tenor of your entire presentation. We are, after all, a parliamentary committee. What we do, among other things, is look at issues and problems and try to make recommendations for new public policies that help everyone.
When I read through your report, I did not find many strong suggestions for change that we as a parliamentary committee could examine and identify a problem. You do not provide recommendations to correct the problem for us to review.
For example, on page 4 of your report you say, "I can tell you that the integrity and transparency of financial and corporate reporting is a very important issue to the great majority of these companies.'' Throughout the report there were wonderful, high-sounding comments about how great KPMG was, but you did not give us many strong recommendations that we could use to build new public policies for Canada arising from the Enron debacle.
Can you tell us of specific actions that you would like us to recommend, to ensure that we never have an Enron situation in Canada?
Mr. MacKinnon: I will ask Mr. Thesberg to answer your first question.
We are not asking you for a great deal of legislative help. That is correct.
We think that the reforms that have been put in place, on oversight of auditors, how audit committees work, and empowering regulators to modify how audit committees and boards work are pretty good. They will go a long way. Generally, they do the job.
We are not looking for many new rules. We are looking for support in ensuring that we do not get duplicate regulatory regimes. We are looking for support for the proposals and changes in regulations that have been put in place by the security regulators and CICA, as well as those that will be put in place by the new Canadian Public Accountability Board.
We are supportive of the changes that have been made. We are definitely looking for help in the liability area. Again, we are looking for support because most of the items are within provincial jurisdiction.
You are right. We have not come to you with a great number of proposed changes. We think that the changes that have been put in place are good. We would welcome your support for those changes.
Mr. Thesberg: I have nothing to add on your second question. We are looking for support and recognition of the changes that are in place as a good and a relatively quick response to the Enron situation.
Your first question was, "What are the unique needs in Canada, or how is Canada different from the U.S. environment?'' Canada has a geographic spread that is different from the United States. We also have a larger number of smaller public companies, in particular, that are a very important part of the development of our industries in Canada.
The uniqueness of the nature of our industry concentration and the number of public companies, particularly smaller public companies, in Canada needs to be taken into account in any of the regulatory reforms. We are asking this committee to recognize that as it makes recommendations for possible regulatory reforms in Canada.
Mr. MacKinnon: You may find it interesting that KPMG Canada audits more SEC-registered companies than the rest of the non-U.S. KPMG world put together. We have a huge reliance on the U.S. capital market, more so than other countries in the world.
That makes the relationship between the U.S. and us that much more important. Avoiding duplicate regulation is possibly more important to Canada than to the rest of the world.
Senator Oliver: I will put my second question in another way. You state in your report that "my partners and I are continuously'' — meaning on a constant basis, week-by-week — "in touch with executives, directors and audit committee members of public companies across the country.''
It surprises me that a group of accountants and auditors that are constantly in touch with senior executives have not come across one thing that, if it were changed, would make things better. That shocks me.
Mr. MacKinnon: I am not expressing myself well then. We are no longer subject to self-regulation. We are subject to regulation by a third party that has the right to discipline us and can stop us from practising audits on public companies. That is how powerful the Canadian Public Accountability Board is.
We have agreed to auditor rotation. We have agreed to new sets of standards for accounting and auditing, chaired by non-CA individuals. We have agreed to partner rotation. We have agreed to a number of amendments as to how we do business. In the last nine months, we have discussed contingencies with the clients.
Do we think that we need to go beyond that? Frankly, senator, no.
However, those 10 or 12 reforms are now in place; therefore, we are not seeking additional reforms.
Senator Oliver: I do not think that you are addressing the question I asked. I will try once more.
Your group travels across Canada and meets regularly with senior executives, directors and audit committees. Is there anything in the operation of an audit committee that, if changed, would improve its operation?
I am not asking about your particular standards. As people who frequently deal with audit committees, have you seen anything that this committee should look at? Could you not offer two or three things that you have seen, which if changed, would improve standards in Canada? Is there nothing like that?
Mr. MacKinnon: I missed the point of the question. I am sorry.
Mr. Thesberg: There are things that come to mind immediately that enhance the quality of audit committees and their interaction with auditors. The requirement for audit committees to be independent and the proposed regulations in the U.S. that require at least one person with some level of financial expertise on the committee enhance the quality.
As well, an open dialogue with the auditors, new requirements that require the auditors to talk to the audit committee to explain what they think are the most significant judgments, alternative treatments in the preparation of the financial statements, are all practices that we are starting to see take hold in Canada that may not have existed to nearly the same extent a year ago. That is partly due to the new environment, partly due to the changes in standards currently being implemented and partly due to possible new regulations concerning many of those practices. We are starting to see those things put in place.
Mr. MacKinnon: I have one observation that I think is worthy of study. It has been studied a little.
It is important to consider how audit committee members are compensated. There are those who suggest that committee members should not avail themselves of stock options. Is that true? I do not know.
You might look at how audit committee members are compensated to ensure that the manner of compensation does not have the potential of appearing to affect their behaviour. Mr. Thesberg talked about training and financial acumen. Those are important.
It is important to study limitations on the time that people serve on a board. You could argue that people should be subject to term limitations.
Senator Oliver: Do you think that members of the audit committees should be paid more than members of the board because of their onerous duties and obligations?
Mr. MacKinnon: In my opinion, yes.
The Chairman: You must have a certificate or a college degree to engage in many professional endeavours. You do not seem to need anything to be on an audit committee.
Alan Greenspan, in testimony before Congress last year on this subject, said that he had been on some very important audit committees and never knew what to ask, which I find rather frightening. I was on the audit committee of the parent company of Dupont in Delaware. I sure as hell did not know what to ask. I knew some things, but they could have swept over me with a truck, and I would not have seen it.
Senator Prud'homme: Would they do that?
The Chairman: I think so. What I am saying is not new, by the way. Maybe there should be a two-week college course to remind people as to what they should look for in a balance sheet. It is not a simple task to be on the audit committee of a huge company.
Mr. MacKinnon: No, it is not, Mr. Chairman. Mr. Thesberg talked about transparency of financial reporting. That is, financial reporting should be as clear, simple and direct as possible.
The Chairman: This is not your problem.
Mr. MacKinnon: It is my problem.
The Chairman: You have to deal with it, but you are not appointing people to the audit committee.
Mr. MacKinnon: We are not appointing people to the audit committee, but we do function better with well- informed, knowledgeable, tough-minded audit committee members. We would support that. We have something called the "audit committee round table,'' which helps to educate audit committee members. As a profession, we should think about putting on a school and helping people in that area. It is an interesting suggestion, one that I will follow up on with the other members of the big four.
Senator Meighen: You pointed to the Multi-Jurisdictional Disclosure System as a possible guide on we might deal with rendering the Canadian system and the Sarbanes-Oxley legislation compatible. I wonder to what extent the fractionalization of Canadian security regulation impacts on that, and whether you think Mr. MacKay's recommendation for a group of wise persons to try to bring securities regulators together under one roof is the way forward or not.
Mr. MacKinnon: Senator Meighen, no doubt it is tougher in Canada to get things done when we have multiple securities regulators with somewhat different agendas. Would it be simpler if we only had one securities regulator? Yes. However, you know Canada as well as I. Is that likely to happen in the short term? No.
This one issue about harmonizing systems will not be a matter of debate with the regulators. They all want to harmonize systems and avoid duplicate regulations, so they should be of one mind on this. It appears, from what B.C., Ontario and Quebec said, that they are of one mind.
Mr. Thesberg: An integrated set of securities regulations will allow the Canadian securities market and regulators to be more responsive in a timely way. There are various models in the MacKay report and others that need to be investigated in order to determine the right one. A model that allows for a quick response and recognizes the uniqueness of the Canadian economy is important.
On the issue of duplication of regulation for Canadian companies that are SEC registrants, I think that all would be on the same page.
Senator Meighen: I am encouraged to hear you say you think all the regulators from the various jurisdictions are singing from the same song sheet in terms of compatibility with Sarbanes-Oxley, but where and how will we thrash this out and come to a final decision?
Mr. MacKinnon: I cannot answer that question specifically. I believe that David Brown, the Chairman of the Ontario Securities Commission, has taken the lead on this. I know there has been discussion among the various Canadian securities administrators, and they have a common theme on avoiding duplicate regulation. They are working with the SEC staff to see what can be accomplished. I simply do not know where they are at in that process right now.
Mr. Thesberg: There are two slightly different questions. What level of regulation should we have in Canada, and to what extent should it be comparable to Sarbanes-Oxley? There may be different views in that debate. Whatever the regulation is in Canada, let us try to ensure that it is given as much recognition as possible in the U.S. to avoid a Canadian company and Canadian auditors being subject to two sets of regulation.
The Chairman: Gentlemen, thank you for your time and your excellent presentation. Send us all the information that Senator Kelleher asked for, please.
Mr. MacKinnon: We will. We will also send you a publication we have just completed providing details on Sarbanes- Oxley. You might find that useful bedtime reading. If there is anything further we can add or any other information we can provide, we will be glad to do so.
The Chairman: That would be good, because in two weeks we are having a presentation on Sarbanes-Oxley from our government.
Mr. MacKinnon: You will have that detailed book on Sarbanes-Oxley and the information you requested on Friday.
The Chairman: Thank you.
We will now hear from our next witness, Mr. Peter Dey, who is with the firm of Osler, Hoskin and Harcourt and the author of the famous Dey report.
Welcome, sir. We are very interested in hearing what you have to say.
Mr. Peter Dey, Partner, Osler, Hoskin & Harcourt LLP: Honourable senators, it is an honour to have this opportunity to meet with the committee. The work of this committee is important and particularly timely given the statements that the Minister of Finance made yesterday in his budget address about the importance of corporate governance to investor confidence and to efficient capital markets. I gather that there was specific reference made to the work of this committee and how it would inform the policy of the federal government going forward in this area. Thus, I am pleased to be here.
I have distributed speaking notes. They are only useful in providing a road map of what I would like to cover. However, there may be some material in here that the committee would be happy for me to pass on and there may be other areas on which you would like me to focus.
In general terms, I thought I would give some background on where we are right now in Canada in the quality of our corporate governance. I will give some thoughts on Enron and what it has taught us. I will talk briefly about the relationship of this market to other markets and then address what I think is the central question that we are focused on in reforming governance in the country, that being the balance between voluntary guidelines and mandatory guidelines. The second question is how we address the governance of smaller companies that have not yet had to focus specifically on governance standards. Those are the areas I would like to cover.
I am advancing two themes today. The first is that I believe that in Canada we should have only one standard of governance for all public companies. I will explain that, because there is concern about how this one standard would impact smaller companies.
The second theme is that in order to move our system of governance forward and to make it competitive with the standards in other markets, in particular, the U.S. market, we need to go through an ongoing exercise to identify those guidelines that are currently voluntary and those standards coming out of the U.S. that should be elevated to a mandatory status.
Senator Meighen has already kidded me about a piece that appeared in the Report on Business a couple of weeks ago that said that I have changed my tune. The tune that I think was referred to was played in the 1994 report "Where Were the Directors?'' that was written by the committee of the then Toronto Stock Exchange that I chaired. At that time, the standards that we advocated were indeed all voluntary. The theory of that report was the importance of getting corporate Canada to focus on governance and learn about its benefits, and that the way to do that is to set out a set of best practices and then have each corporation develop its own system of corporate governance and disclose against those standards. That was the system that we proposed in 1994 and it was, indeed, adopted by the Toronto Stock Exchange.
That system depends on what we call "market regulation.'' It requires investors to look at the governance systems of companies and then attribute them a premium or discount their value based on the quality of governance. Accordingly, it requires an engaged investing public.
I would say that through the first five years of that regime market regulation was not particularly activist. I think that through the first five or six years, Canadian corporations focused on corporate governance, but their response to those initiatives was more formal than substantive.
Indeed, I had a reunion of my committee in 2000 and our conclusion was that there had been significant advancement in the quality of governance, but that the response was more formal than substantive and did not reflect the achievement of what we called then "a culture of governance.''
While this was evolving, we had these corporate collapses in the United States, and suddenly there is a much higher premium attributed to good governance, particularly by investors, and it is recognized by corporations. Thus, there is a much greater focus on the importance of governance and the competitive edge that is afforded to companies that take corporate governance seriously.
I periodically get into a debate about the relationship between corporate governance and corporate performance. To me, it is straight common sense. None of us wants to be associated with, sit on the board of or work for a company that does not take governance seriously. There is no guarantee that good governance will assure good performance. However, there is no question that it positions a company to compete more effectively in the long term.
Before I move on to address the two questions I identified at the outset, I will say a few words about Enron.
When I first heard about these corporate collapses, I worried at the outset about what does this imply for the whole corporate governance movement? Upon reflection, it was important in teaching us that corporate governance structures can only take us so far in establishing the quality of governance of a corporation.
What we have learned is that with the appropriate infrastructure and corporate governance system we can only go so far. The real focus must then be on who is sitting in the boardroom and who is managing the company.
You might say, "Well, then, why are you so focused on governance standards?'' The reason I am focused on governance standards is that what we see taking place in the world right now is that institutional investors not only grade corporations on the quality of their governance, but they grade markets on the quality of their governance. They give a general discount or premium to the importance that is accorded to governance in that marketplace.
Having satisfied themselves that governance is taken seriously by a marketplace and by a particular corporation, they will then focus on what really counts; that is, the people in the boardroom and the people who are managing the business. They recognize that if you have a board of directors that is competent and of integrity, the chances are that they will recruit management of competence and integrity.
One of the themes that drives me to say that we should be moving a number of our voluntary guidelines into the prescriptive area is that if you look at all of these standards that we have been living with for the last eight or nine years, and you look at many of the initiatives coming out of the United States, they reflect simple common sense about how you would govern any organization. To my way of thinking, they do not impose that great a hardship upon companies that embrace them. That is one of the themes driving my position here.
There are things that I would do to upgrade the quality of governance in this country. As an aside, Canada can justifiably be regarded as one of the leaders in developing governance standards. I have had the opportunity over the last several years to be involved with the Global Corporate Governance Forum that is a joint venture of the OECD and the World Bank. We go to various parts of the world to talk about the merits of governance and some of the issues. The standards that have been adopted in Canada have been translated into many languages and are used as a significant point of reference in other parts of the world.
The standards that we have developed have provided some leadership. For us to continue down that track, we must take a fresh look at these guidelines and decide where they fit on this continuum between voluntary guidelines and mandatory requirements.
The exercise I would embark on now is to look at this menu of guidelines and to position them on this continuum. For small companies, I would take the same principles that underline or support these guidelines and make them guidelines only. We did that in 1995 for the senior companies. I would do that now for the small companies and say that these companies should be disclosing their governance system against these guidelines. There is nothing mandatory but a disclosure requirement.
I have not addressed the definition of "big'' and "small'' companies. I know the TSX is focusing on that. That line will be drawn to respond to the practices and needs of the companies that are listed on both the TSX and the TS Ventures Exchange.
The TSX is currently the only quasi-securities regulatory body in this country that has national breadth. When it implements standards, they have national impact. Thus, I think the TSX should continue to provide the leadership that it has in the past in developing governance standards. The TSX is the best-positioned quasi-regulator to do that. The TSX has provided leadership in the past and I believe they will continue to provide leadership.
The regulatory model, at least in the near term, will have a number of components. When Bill 198 of the Ontario legislature is proclaimed, that will give the OSC the power to pass rules dealing with the composition and conduct of audit committees and dealing with CEO and CFO certification of financial statements.
Some of our governance standards will be in the form of law. Other standards will be seen as mandatory listing requirements. The TSX has already proposed mandatory requirements. The first deals with the audit committee being composed of a majority of unrelated directors. The second deals with the fact that the board of every issuer must adopt a code of business ethics. These are mandatory listing requirements on the TSX.
There would be the OSC rules, the TSX listing requirements and then the balance are the governance guidelines with which we are generally familiar. As I understand it, currently the TSX proposes that those guidelines would continue to be voluntary, that the market regulation would continue and listed companies would disclose against those guidelines.
I identified a menu of initiatives out of the U.S. and a menu of the guidelines that are in sections eight and nine of my outline. When I look at them, I say to myself, "Why shouldn't every public company pre-approve audit and non- audit services? Why shouldn't every company spell out what are prohibited, non-audit services? Why shouldn't every public company have a nominating committee made up exclusively of unrelated directors? Why shouldn't every public company orient and educate their directors? Why shouldn't every public company give the board the power to engage outside advisers?'' — and so on.
Serious consideration must be given to converting these voluntary guidelines into mandatory requirements. In doing so, Canada will continue its reputation as a leader in governance reform.
Senator Oliver: Mr. Dey, you are a Canadian with incredible credentials for being able to speak about corporate governance, for some of the reasons you have already explained.
I wish to ask questions about audit committees, boards, directors and other committees. However, I shall restrict myself to one area today, and that is the people who actually govern corporations — the board — and how they are chosen, how they should be chosen, their competence, et cetera.
When I spoke with you before the meeting began, I said that I had read in the newspaper about the remarks you made at the Institute of Corporate Directors, ICD. Do you think that such a body should have a greater role in the training, the choice and the submission of directors for companies to consider? Should they not have a kind of certificate from the Institute of Corporate Directors, or a similar body, to show that they are qualified to serve as senior managers in major companies?
Earlier today, I had an opportunity to have a major discussion with a senior Canadian about the competence of the Board of Directors of Air Canada, which is having some difficulty. We were wondering about the competence of the directors. Should a body such as the Institute of Corporate Directors not have more power and more say in who become directors and how long they stay in that position? Should there not be some kind of ongoing test? That is simply a general question for your consideration.
Mr. Dey: The power to choose and qualify directors will continue to be with the individual corporations. It will be indirectly imposed on the corporation by investors, but the board of directors will ultimately have the power to choose and evaluate individuals to serve on the board.
The Institute of Corporate Directors, ICD, is actively embarked on a program to offer courses to educate existing directors and individuals who want to become directors. I do not know whether people who take the courses will get some credit for it. However, I have suggested to the ICD that they talk to some institutional investors and to people from some of the other services that rate the quality of governance of corporations to find out what they are doing for ongoing, continuing education for their board members. If boards send their directors to these various courses, and that should probably begin sometime in spring, I think corporations should receive higher marks when it comes to The Globe and Mail's Report on Business, ROB, Boardgames or some of the other rating processes that are current.
I suggested to the ICD that you cannot have a two-day course on governance. You could talk about it for one hour or so, but then it would start to wear. They should set up a series of lunch-hour or breakfast meetings and bring in the best people to talk about pension fund accounting, for example. I heard the previous witness, who said that he sat on an audit committee but was never sure of the questions to ask. That would be a perfect topic for the ICD to use for a two-hour luncheon round table, not for 100 people, but for 18 people who can sit around a table and really be educated on the questions that should be asked of an audit committee. That is where the ongoing education will come from. Ultimately, however, the power to choose and evaluate boards will continue with the boards.
The Chairman: I understood Senator Oliver's question somewhat differently and perhaps I am wrong, Senator Oliver.
When a corporation takes on auditors, the auditor has to have a certificate saying that he is qualified as such. Why should people not need some kind of certificate saying that they are capable of being a director? When I look back at all of the boards that I sat on, we had some cosmetic directors. When I was on the board of Metro Goldwin Mayer, Cary Grant became a director and did not have a clue what to ask. He was a wonderful man and a lovely person, but he just did not know.
This may seem ridiculous, but should there not be some kind of certification?
Mr. Dey: I think that ongoing education is important, but no one will ever be qualified to be a director simply because they have taken a bunch of courses and have some accreditation. I am learning this because, when I left my previous employment in 2001, I went on the board of three public companies. Notwithstanding all the yakking I have been doing over the last several years about governance, I have learned more about it from just sitting in these boardrooms and watching experienced directors at work.
Yes, I would benefit from education, particularly in some of the arcane aspects of accounting that you have to understand on the audit committee. However, that does not, by definition, qualify me to be a director. Ultimately, the choice of who sits on the board, how effective they are and who leaves the board, has to remain with the board.
The Chairman: No one suggested that the process should not remain with the board, but rather that the pool of talent from which they draw potential members should have some kind of credentials. As they say: Taking chicken soup for a cold cannot do much good, but it does not hurt either.
Mr. Dey: I do not dispute the importance of education and the provision of these courses. As I said: Ultimately, the board will judge your qualification as a director.
The Chairman: I find it hard to accept. I have had 110 years on boards and when I first joined, I was as wet behind the ears as one could be. I hope that I did not stay that way, but I certainly began that way.
Mr. Dey: Everybody recognizes that, once you go on a board, there has to be an orientation period of 18 months to two years before you really understand what is happening.
Senator Banks: I have two questions. I will defer the second question to the second round, should there be one.
Mr. Dey, if there is anyone who is qualified to do this, it is you. You said that there is either a premium or a discount that pertains to investors when they are dealing with either a market or a company and looking at the quality, if that is a fair word, of the governance of that corporation or that market in which it plays. Extrapolating from that, I will assume that, if there were a company or a market in which there was an extraordinarily high and widely recognized degree of ethical governance and protection of the interests of investors, it would be a magnet to investors. Is that a fair assumption?
Mr. Dey: I would characterize those as gating items. Then the investors, having satisfied themselves of the ethical quality and the commitment to governance, would focus on the fundamentals.
Senator Banks: That is what I am saying.
In some sense, it would be attractive to people and would attract the right kind of investor, as opposed to the wrong kind.
From this discussion, it appears to me, as an ignorant neophyte, that we are travelling along the same road. If all bets were off and you could go to Utopia and break the bounds of conventional practice and wisdom — start with a completely clean slate — what would we do? I ask this because, as Senator Oliver said earlier, we are trying to find a way to affect public policy, and I think that is what we are about.
Where should we go? If we wanted to make Canada a place not unlike Switzerland in attracting corporate investors, because both the market and corporate governance were so extraordinarily high compared to the rest of the world, what ought we to do? Is that a silly question? Should we stay on the road or is there another road?
Mr. Dey: That is the question that we must ask. It was implicit in yesterday's budget: what should the federal government be doing to move the quality of governance along this road?
I do not think we will ever get to Utopia when it comes to governance. As I said, there are two general components to good governance. One is the infrastructure, your corporate securities laws and the systems that corporations adopt to govern themselves. The other equally important component is the quality of individuals who function within the governance systems.
Public policy-makers can, in my view, deal with the infrastructure directly. They can make sure that we have current corporate and securities laws, and that we have well-funded agencies to enforce our laws. The other component, the quality of the individuals, comes back to the previous question; it is not only the quality, but also the competence and education of the individuals who are sitting in the boardrooms. All we can do over time is improve the quality of those individuals.
If I compare the status of governance in Canada now to what it was in 1995, I think it has improved considerably. One of the reasons it has improved is that boards of directors understand their responsibilities a lot more, and they feel, as one of the members of my committee said, empowered. They feel quite capable of challenging management and providing a point of view that may not agree with what management is proposing.
Therefore, it is a process that goes on over time. It will never reach what I said earlier was called the culture of governance, where everyone involved in every corporate system has a real passion about the execution of the corporation's strategy, and a commitment to the governance of the corporation. If that exists, we have the best of all worlds. We will never get there, but we have to keep working toward it.
One of the reasons for this committee's hearings is to consider how do we keep moving the process forward? One of the principal ways is taking the initiatives coming out of the U.S. that make sense for Canada — and I hasten to add that not all of them make sense for Canada — and taking the existing standards that were reflected in the 1994 report and assessing whether they should now be prescribed requirements for all public companies of a certain size.
Senator Banks: Does Joe Investor share your view that governance has improved?
Mr. Dey: Yes, without question. If you ask a major institutional investor such as Claude Lamoureux, who was on my committee back in 1994, he would have no hesitation in saying that governance has improved.
Senator Oliver: Why are Canadians not returning to the markets then?
Mr. Dey: There are a number of factors undermining investor commitment to the marketplace right now. I think what happened in the U.S. with Enron and some of the other corporate collapses had a very profound effect on investor confidence. That confidence has not been totally restored. I think investors recognize the efforts that the Securities Commission, the TSX, the U.S. Congress, the NASDAQ and the NYSE are making to restore investor confidence. However, I do not think we have brought it back to the levels that existed before some of these corporate collapses. We will get there, but we are not there yet. That is one factor, but obviously there are many macro- geopolitical factors that have an effect.
Senator Kelleher: I was interested in your remark that, in effect, one size does not fit all, and that we have to be careful about accepting the American legislation holus-bolus. One of the interesting things we will be doing at the end of March is going to New York and Washington and meeting Sarbanes and Oxley, these two famous gentlemen. I do not think we want to have duplication and overlap. I think there is a consensus developing that adopting Sarbanes- Oxley holus-bolus would not necessarily be in the best interests of companies in Canada, particularly our smaller ones, of which we seem to have quite a few.
Drawing on your experience, could you give us some suggestions as to an approach? We are dealing here with Americans, who do not particularly love us at the moment, and whose legislation is already passed. Trying to convince them to change their legislation, or to give us certain outs, is going to be somewhat difficult at best.
Mr. Dey: Well, we have a large number of inter-listed companies, Canadian companies that are listed in the U.S.
Senator Oliver: One hundred and eighty.
Senator Kelleher: A consortium of them appeared before us last week.
Mr. Dey: Right. They were represented, I believe, by one of my partners.
Senator Kelleher: Yes.
Mr. Dey: I sit on the board of a company that is listed in New York. We have gone through the whole Sarbanes- Oxley set of guidelines or requirements, and the New York Stock Exchange requirements, and we are going to comply.
Senator Kelleher: Does that mean "you'' as the inter-listed company?
Mr. Dey: Correct. As I said earlier, I think most of what Sarbanes-Oxley has prescribed reflects good common practice in governance. I identified a couple of areas where I think they have gone a bit too far, and that I would not incorporate into Canada. For example, the financial expert on the audit committee; the standard is probably very difficult to implement on all the audit committees in Canada. Right now, the standard is that you have to have financial expertise in Canada; to me, that is the better standard.
Another example is the requirement that the lead audit partner be rotated every five years. If you are listed in New York, you will have to comply with that; but if you are a Canadian company not subject to that U.S. requirement, you can decide whether you want to do that or not. I think rotating the partner is just symptomatic of the greater problem, which is the relationship of the external auditor to the corporation. If you have an effective relationship between the external auditor and the audit committee, some of these other issues about rotating the partner disappear, or can be dealt with within the judgment of the audit committee.
What I have done, Senator Kelleher, in my speaking notes, is identify some standards that come out of the U.S. initiatives that we should seriously consider implementing in Canada. The first set deals with auditor independence. The TSX has virtually incorporated all of these standards now. It has proposed a listing requirement that listed companies have an audit committee with a charter; and it has a guideline that spells out what should be in the charter. All of these Sarbanes-Oxley-type standards have been included by incorporation of the guideline about the charter by reference in the TSE listing requirement.
There are other issues. In Canada, we need to develop a good definition of a "related'' or "unrelated'' director. I believe the definition we have now is pretty good. However, because we have so many public companies with a significant shareholder, in the case of any individual who is associated with the significant shareholder sitting on the public company board, there is some question about whether that individual is related or not. My view is that anyone who is associated with a significant shareholder, absent other considerations, sitting on the board of a subsidiary company is an unrelated director.
Senator Meighen: Is or is not?
Mr. Dey: I said, "is an unrelated director.'' The test for relatedness is whether you, as a director of a company, have any constraints about firing the CEO.
Senator Oliver: If he is your father —
Mr. Dey: "If he is your father'' is a good example.
Senator Kelleher: Your name is Thomson.
Mr. Dey: Correct. If you are a 51 per cent shareholder, then you will be very vigilant as to the performance of the subsidiary company's CEO and you will have all the reason in the world to monitor that person.
I am responding generally to your question, Senator Kelleher, but I would say there are some guidelines coming out of the U.S. that we should incorporate in Canada. However, we really have most of the standards already, it is just a question of whether we want to move them up the continuum, from voluntary to mandatory. That, to me, is the issue being discussed by the TSX and the OSC. There are also some specific issues like this definition of director independence that are important in Canada.
Senator Meighen: That was my question about the related director. I have one other, for my own edification. Must a lead director be unrelated, in your definition? Can a lead director be related to the corporation?
Mr. Dey: A lead director could be related.
Senator Meighen: Similarly, could a non-executive chair be related and still qualify?
Mr. Dey: They could qualify as a non-executive chair, even though the individual was a related director. That would not be my preference, and you are touching on a point that perhaps requires further thought. The whole theory behind having a lead director is having someone who will manage the board independently of management. Certainly, there is a strong preference to have an unrelated director as a lead director or non-executive chair.
Senator Meighen: That is a good point.
I have a general question that, I advise you in advance, is not well formulated. You talk about how we must get the infrastructure right, which is probably all that we as a committee can get involved in. Then you have to choose the right people. Forgive me if I put words in your mouth, but I think the general consensus is that Enron was caused more by bad people than bad infrastructure. It is arguable, but certainly at least equally. There were a lot of people there who did venal things, as human beings are wont to do. Do you think we are being equally vigilant on that side of the equation? I am sure most of us try to choose the right people, but are we dealing with those who commit "crimes'' in the corporate governance area as severely as we should?
I take Senator Banks's term, "Joe Investor.'' I would suggest that Joe Investor is not too concerned about whether the audit committee chair once knew the sister of the company president. Of more concern would be why it takes so long to report insider trading. How come people just happened to dump their stock at that time and why did they not have the book thrown at them? That is what bothers the man or woman on the street, rather than the fine points of corporate governance. What are we doing on the other side of the equation about punishing those who behave improperly?
The Chairman: A large amount of money has been apportioned for vigilance.
Senator Meighen: That is a start. Do you share my view at all?
Senator Kelleher: I regard this as a little right-wing.
Senator Meighen: It has fascinated me, with electronic technology being where it is, that we could not register all the reporting issuers in whom we hold stock, or where we are insiders of a reporting issuer. As soon as you buy or sell, it could be automatically transmitted from your broker. There would not only be a sales slip to you. Everyone says "yes,'' but nothing happens. We still wait for someone to remember, in many cases, that they have to fill out reporting forms for the 100 shares they purchased. The officials get all excited about someone who inadvertently forgets, rather than someone who is consciously taking advantage of insider information.
Mr. Dey: There is no question that perhaps the most effective way to improve investor confidence is to sanction in a very significant way those who violate the securities rules. The publicity attached to that might do more to improve investor confidence than all of the regulation one could pass.
I think securities regulators recognize that and have done so for years. The resources have been scarce, but I think that has been corrected. I also think there are some jurisdictional issues in our federation that sometimes cause confusion when it comes to pursuing white-collar crime. Again, I think there must be more coordination between the provinces and the federal law enforcement agencies to avoid overlap and to achieve greater cooperation.
I agree, Senator Meighen, that with the technology we have, this kind of information should be instantaneously available. This committee has an opportunity to do something about it, given the invitation that was issued yesterday by the Minister of Finance.
Senator Prud'homme: If you read the Elections Act attentively, you are almost scared to run for office. You are not supposed to promise many things. Among these, you are not supposed to promise people that they will be on your staff if you are elected. If you read every line, you get so scared that you wonder why you should run, because everyone who is surrounded by people is bound to say, "You were so good during the election, you should come and work in my office.'' According to the Elections Act, that is not supposed to happen. Of course, it does.
Very briefly, this great world of yours, in which my colleagues will attest I am not yet an expert, is a close-knit club.
Do they not know that some are not as trustworthy as others?
I remember my father always telling me to look at people's lifestyles. I apply that to politics. People who supposedly have the same amount of revenue as others flash so much money that it should ring a warning bell. Where did they get that money?
This is a good briefing note, and I congratulate those who prepared it.
Should whistle-blower protection exist in Canada, as provided for by the Sarbanes-Oxley Act of 2002 in the United States? People inside know what is going on, but they are afraid to talk. They know that it will explode, as happened in the United States when the women from Enron started to speak out publicly.
Mr. Dey: I believe that whistle-blower protection should exist. Certainly, Canadian companies that are involved in the U.S. capital markets have already implemented systems to achieve that. Some Canadian companies that are not involved in the U.S. market have also gone in that direction.
There are independent services available, published within the corporation, where employees are informed about their availability. They are given a 1-800 number or access to some objective party who fields the inquiry. Working with the compliance officer or some other individual within the corporation, a decision is made on how to deal with the issue.
I think that Enron, in part, came to light due to whistle-blowing by the finance employee, Karen Watkins. It gave great credibility to that measure of protection against corporate misdeeds.
We will see this sort of strategy. Whether it should be mandated is an open question, but you will see many corporations adopting that sort of system voluntarily. It is a service that the company can simply recruit from an objective third party.
The Chairman: I would like to wind up with a philosophical question that may shed some light.
As has been pointed out by a number of senators, our job really is to recommend policy initiatives that can result in the average investor feeling that he has a real shot at choosing a company that is honest and operates with integrity. Over the years, the corporate culture has changed drastically. When I was in business 40-plus years ago, we did not worry about the next quarter. We did not worry about the first column and second column. We did not manage our businesses in three-month chunks, which I think is ultimately a stupid way to do it.
I do not know what government can do about changing a culture. Do you have any bright ideas about how a government can do that?
Mr. Dey: Much has to do with the compensation policies that are used within corporations. Part of the —
The Chairman: That comes back to corporate governance, because they approved the policies.
Mr. Dey: It does, I agree. However, we must have compensation committees that are dominated by unrelated directors and who understand how compensation can define the culture of a corporation. We are seeing activist postures by major institutional investors, who are now being very specific as to the terms of stock option plans.
They are focused on the performance metrics that should be included in the plan, and on aligning the interests of the recipients of the stock options with the long-term interests of investors.
I am sure that this committee has talked to some of the large institutional investors. They will be very explicit in expressing that they must take the long-term view. They work with corporations. They do not express their displeasure by buying and selling. Once they are committed, they are committed. That is why they all have governance officers who are focused on the performance of corporations.
Therefore, they do take a longer-term view. They become really frustrated when they see a stock option plan that reaches deep within the corporation and provides many employees and managers with a quick fix.
I was at a dinner last night at which we were talking about compensation. One of the individuals who spoke was a CEO of a major company. The question was, "How deep within the corporation should the stock option plan go?'' He was saying that they had done a study within his corporation. They found that the further down middle management that the stock options went, the quicker these individuals were to exercise and sell them, even if it meant making only a few bucks. They regarded it as some sort of a premium to be realized right away. There was no incentive to hold on and stick with the corporation.
Probably the most important way of changing this focus from a short-term quarter-to-quarter perspective on the performance of the corporation to a longer term one is through the management of the terms of the compensation plans.
The Chairman: Is there anything that government can do policy-wise about that? The idea of legislating in compensation is God-awful. However, I do not know the alternative.
Mr. Dey: This is one area where I would like to think that the market can address the issue. The market, with the right information, will be able to discipline boards of directors, compensation committees and CEOs so that the compensation systems align more effectively the interests of the key employees of the corporation with the longer term interests of institutional and public shareholders.
Senator Tkachuk: We have heard the discussion before about short-term compensation. The Japanese stock market is not doing well, and they have a long-term view. Where would you rather invest? Over the last decade, North America would have been the place.
The cultural problems are deeper than that. They are issues of doing what is right or wrong. We previously assumed that people in business would do what was right. Perhaps the problem is in the business schools.
I hope that this discussion on compensation does not go too far. I do not think that there is any evidence to show that receiving options, or the selling of options, has anything to do with prolific spending.
Obviously, it was not enough. They spent even more corporate money, or they stole corporate money. They took advantage not only of the options, but also filled their pockets from the corporate coffers.
That is a bigger problem. I think that if a person does well, he should be compensated.
All these mutual funds are worried. They were bragging to everyone over the last decade about how smart they were. They were out there siphoning cash into their funds, holding seminars and saying, "Look what I did for you.'' All of a sudden, the same people are now saying, "Gee, it is your fault.'' I do not think they were doing their due diligence either. They have a lot to answer for.
Here the two of us are disagreeing a little on these issues, but I think there is more to it than just the short-term stuff. It is greater than that. It is the mutual funds. Everybody played this game; everybody benefited from it; everybody is now blaming the corporate executive.
Mr. Dey: I focus on compensation because I think, obviously, every corporate manager is driven to a very substantial degree by the terms of his or her compensation. If the compensation is tied to the stock price, then there will be a focus on creating expectations that will enhance the stock price. These expectations are created often through management of financial information and what is disclosed to the public. I think there is a direct relationship between the ethics of disclosure and compensation.
There has to be a major shift — this is already taking place — away from compensation that is sensitive to the stock price, not only day to day, but hour to hour. There are some systems where people are literally tracking the stock hour to hour. There have to be terms imposed on options that are sensitive to performance. If options are exercised, the stock cannot be sold for a defined period of time. If an individual leaves a corporation, the stock cannot be sold for a period of time. These are measures that can be imposed upon compensation plans that I think will more closely align the performance of the corporation with the longer-term interests of investors.
Compensation is not the only way of achieving this realignment, but I think it is an important way.
The Chairman: Thank you very much, Mr. Dey.
We now welcome, from Grant Thornton, Alex MacBeath, Michel Lavigne and Don Thomson.
Mr. Alex MacBeath, Chief Executive Officer, Grant Thornton Canada: Honourable senators, joining me today are my colleagues Michel Lavigne, who is based in Montreal, and Don Thomson, from Vancouver. It is a pleasure to be here, gentlemen. We applaud the Senate and this committee for holding these hearings, and we thank you for the opportunity to address you.
I would like to open with a short introduction about Grant Thornton, because some of our best clients tell us that Grant Thornton is one of Canada's best-kept secrets.
Although some of this country's largest corporations are among our client roster, most of the organizations we work with are mid-market. We focus our attention on mid-market companies, which are the backbone of the Canadian economy. We define "mid-market'' to mean operations with $5 million to $500 million in annual revenue. Moreover, according to the Toronto Stock Exchange, about 82 per cent of companies listed on Canadian exchanges have a market capitalization of less than $500 million.
These entrepreneurial organizations do not often make the news headlines, and neither do their auditors and financial advisers. However, Grant Thornton Canada has consistently ranked among the top five national firms of chartered accountants and management consultants in this country. We practise in Quebec and the Ottawa region as Raymond Chabot Grant Thornton, and outside Quebec as Grant Thornton.
We are here today to provide our views as a national firm and an active member of our profession, but also to share our perspective based on the in-depth, daily experiences of many of our mid-market clients.
Rebuilding investor confidence is an important task for all participants of the capital markets, from regulators to investment bankers and auditors. It is especially critical for Canadian businesses, whether they are large or small, public or private, because they depend on efficient and effective financial markets to provide access to the capital they need to grow and create jobs.
Our first priority must be to re-establish confidence in the financial markets, the investment banking business, the accounting and auditing profession and the corporate world, including management and directors.
The second priority must be to achieve the right balance among important elements. We need a regulatory environment that features rules and guidelines, oversight and, where appropriate, sanctions, but it must not unduly restrict the freedom and flexibility that businesses need to succeed, nor should it prevent them from obtaining the full benefit of a professional accounting community that exercises its professional judgment.
We must build a system that delivers on the public's demand for accurate investment information, maintains the confidence of all stakeholders and continues to ensure that the corporate world has access to financial markets and the capital required to run and grow its operations.
We have seen a number of initiatives on both sides of the border to counter the negative sentiment, to restore confidence and to put in place a framework to ensure that changes are instituted and sustained. In fact, it is safe to say that the past year has resulted in some of the most extensive reforms in quite some time, not only to securities legislation, regulatory processes and corporate governance, but also to the way that the accounting profession on both sides of the border governs itself and sets standards.
There are many aspects to this discussion, but we would like to focus on two broad areas: the need for good governance at the corporate level and regulatory reform in the accounting profession.
First, reforms underway in Canada involving corporate governance can be broken into four categories; transparency and improved disclosure, the role of the audit committee, the role of the board of directors, and building a strong corporate culture.
Regulatory bodies in both Canada and the United States, as well as in other parts of the world, have strengthened the regulatory framework to ensure greater transparency and improved disclosure of financial information, as well as requiring greater accountability from management, boards of directors, auditors and analysts.
In evaluating the merits of these initiatives it is important to remember that all rules and regulations can only be the means to an end. It is almost becoming a cliché to say that good corporate governance is about people. That does not mean that we ignore the fact that we all, at any level of corporate or social responsibility, need to be held accountable, and we need to ensure a framework of transparency.
At the end of the day, good governance is about people doing the right thing, not just what the rules tell them to do. It is about creating a climate that encourages tough questions to be asked, both within the company and by independent auditors using their professional judgment.
This is probably even more relevant in mid-market companies. Our mid-market clients do not have the luxury of the layers upon layers of management and internal oversight of their larger peers. Rather, they rely on their accountants to assist them in building the structures they need. They trust their chartered accountants to provide advice on a range of issues that they face on a day-to-day basis. Our mid-market clients expect from us a frank and candid exchange of views. They rely on us not to gloss over critical issues that could have a negative impact on their business and its ability to grow and prosper. We must be careful not to put in place any restrictions that would impair that relationship.
The accounting profession is an important cornerstone for ensuring that all stakeholders in the investment community have confidence in the capital market system. It is also an important cornerstone for maintaining confidence in the services provided to the broader business community in this country.
If we are to meet public expectations, we must look at the entire profession, not only the major firms. We recognize that a few national firms audit most of the large public companies in Canada. However, maintaining confidence in the profession requires that the entire profession be held to the same high standard.
There are many reforms currently underway, ranging from the setting of standards to the inspection of accounting firms and an assessment of their performance and compliance with established standards. It is also important to remember that many of these reforms were underway before the collapse of Enron.
In Canada, there has been public oversight of the setting of accounting standards for a number of years. The vice chair of the Accounting Standards Oversight Council is one of your colleagues.
Moreover, the CICA has recently announced the formation of the Auditing and Assurance Standards Oversight Council as well as the formation of the Canadian Public Accountability Board, to be chaired by the former Governor of the Bank of Canada, Mr. Gordon Thiessen. The majority of its members will come from outside the accounting profession. The Canadian Public Accountability Board will put in place a national inspection unit that will have the responsibility to assess and report on the performance of accounting firms against established standards. A mechanism will be in place to discipline and sanction firms that have not met those standards.
We fully support the changes and reforms that are being put in place. As have all national accounting firms, Grant Thornton has stated publicly that it is prepared to be inspected at any time and commits to working with the Canadian Public Accountability Board to achieve continuous improvement in the auditing profession.
At the same time, we ask: How will some of these reforms impact mid-market companies? First, we applaud the creation of the Canadian Public Accountability Board, but we need to ensure that the board does not focus its attention only on the largest national accounting firms. Grant Thornton believes that in order to fully restore public confidence in the profession and the financial markets, it will be important that all accounting firms, regardless of size, be held to the same high standard. The expectations of the market should be no less, whether the accounting firm is a national firm, a multi-office regional firm, a large firm in one of our major cities, or a small local firm auditing the local municipality or the small-cap start-up. All of these firms should be subject to rigorous public inspection and any resulting discipline or sanctions. It will be important that sufficient resources be available to the Public Accountability Board to allow it to fulfil its mandate in a timely and efficient manner.
Second, we applaud the efforts of the Canadian Institute of Chartered Accountants in finalizing new independence standards for auditors. We generally support the changes that have been proposed and are committed to adopting any new standards promptly. As independence standards are adopted, we need to ensure mid-market companies can benefit from our profession's biggest asset — our professional judgment based on years of study and experience. Most of our mid-market clients do not have the internal infrastructure or resources of multinational corporations, who can afford multiple suppliers of advice on a day-to-day basis.
The proposed changes restrict an auditor's ability to help an audit client prepare its financial statements. Management has responsibility for preparation of all financial statements and may hire in-house staff to do most of the work. However, in smaller companies, this in-house experience is often supported by the auditor's advice in order to facilitate high-quality financial reporting. This type of advice by the auditor should not be unduly restricted.
We believe that it is important to balance the need to protect investors with the need of mid-market companies to rely on a range of services from their chartered accountants. A made-in-Canada solution will ensure that the accounting profession is competent and subject to public oversight, enforced with sanctions and discipline.
There is no doubt that investor confidence has been harmed by recent events south of the border. Our regulators and professional services firms have responded promptly and strongly to the threat. The challenge moving forward is ensuring that the solutions we bring to the table are made in Canada — solutions that address the unique structure of our economy and are reliant on entrepreneurial enterprises, while also appreciating our position in the global economy.
My colleagues and I would be happy to entertain your questions.
Senator Oliver: I would like to ask you about Sarbanes-Oxley. You say that we should not let the U.S.-style preference for detailed rules overshadow or remove professional judgment in the application of principles that are as important as independence. Which of the Sarbanes-Oxley rules would you not like to see brought into Canada?
Mr. MacBeath: First, Sarbanes-Oxley is a real step in the right direction. Most of the provisions therein are quite appropriate. The certification of financial statements and financial information by executives is an excellent provision, as is the rotation of auditors.
Senator Oliver: Do you agree with the rotation of auditors?
Mr. MacBeath: Yes, it is quite appropriate, and those steps provide another level of independence in terms of the audit relationship.
Senator Oliver: Does that not mean that there will be a heavy financial burden on the company that has to bring the new auditor up to speed?
Mr. MacBeath: It is the rotation of the lead auditor within the firm, not the rotation of audit firms. If I may diverge for a second on that point, senator, we do not support the rotation of audit firms. Some research has indicated that many failures will occur in that initial period after a change of auditors. The change of the lead auditor within the firm is an appropriate step in independence.
As for other provisions of Sarbanes-Oxley, I referred in my remarks to the preparation of financial statements, in particular by smaller public companies. We need to remember that management and the company need to take responsibility for financial statements. The advice of the accounting firm, of the auditor, can lead to improved financial reporting based on their knowledge and expertise. Small companies should not be prohibited from doing that.
The ability of audit committees and boards of directors to attract qualified directors and financial experts will be a challenge for small companies in particular, certainly in the initial years.
Senator Oliver: Based upon your experience working for mid-cap companies, which you indicate is your expertise, as you go about the country performing audits, have you made any observations about the performance of audit committees in areas that you think should be changed or improved upon?
Specifically, when they call you in, as auditor, to give a report on what you have found to be the security and the risk protection for the company, do you find that they have the expertise to be able to put the right questions to you?
Mr. MacBeath: There really is a range of experience there. The best audit committees that we deal with, in my opinion, or that I have dealt with are the ones that ask the tough questions. They are not necessarily the ones that have the pedigree, if you will, or the background. The best audit committees will ask the tough questions, will challenge and take the time to fulfil their responsibilities seriously.
An environment that promotes tough questions within the audit committee or the board of directors is a critical aspect. If you were to look at the board of Enron, and at the qualifications on paper of some of the members, on the surface it would appear to be a reasonably respectable board. However, I suggest that the tough questions were not asked.
Senator Tkachuk: Should there be different regulations or different standards for smaller companies versus bigger companies? We always hear about Bell Canada and others, but there are also the little companies starting up on the TSX, the growing companies that may be in the $30-million to $50-million range. The system is already quite burdensome for many of these businesses. The regulations seem to be piling on with no end in sight, which is expensive.
Mr. MacBeath: To expect a small-cap company to achieve the same level of expertise as a large company such as Bell Canada is unrealistic. However, a set of guidelines and expectations for all boards, regardless of size, needs to be established in order to ensure that the audit committees and boards of directors will recognize and respond to those guidelines. An appropriate level of governance can be achieved within those companies.
Senator Tkachuk: Should regulations define who should sit on audit committees for public companies by profession, or should it be up to the board to decide?
Mr. MacBeath: As for the board, it is the range of experience that is important. Experience as a director enhances your ability to function effectively on an audit committee. Certainly, a financial background is an important attribute, although it may be difficult for small companies to find financial experts to sit on a board. Experience is one of the biggest assets.
Senator Meighen: We heard from Ms. Penny Collenette last week. She advanced the view that because there are not enough checks and balances in the business world, the day of professions regulating themselves is possibly coming to a close. As a lawyer, I find that interesting, if not disturbing. What are your views on that?
Second, I do not know if you were here when we had a conversation with Mr. MacKinnon of KPMG, who indicated that notwithstanding the introduction, in large part through the efforts of this committee, of the modified proportionate liability of your profession, he still felt that the lack of limited liability for members of the firm or the partnership in your profession caused ongoing difficulties. He wanted modified proportionate liability extended across the board for individuals. What are your comments?
Mr. MacBeath: There are two questions. The first spoke to self-regulation. Regulation in a professional environment involves a number of things: standards, monitoring of compliance, and sanctions. Within the accounting profession, there was public oversight of the accounting standard setting process pre-Enron. There is now in place the public oversight of auditing standards. That has been taken from the profession and put in the public domain.
The Public Accountability Board is being established. That board will have the ability and the mandate to monitor accounting firms against established standards. That board will have a majority of its members from outside the profession. That board will also have the mandate to provide sanctions and discipline, once again taking it outside the profession. That will achieve a reasonable balance in ensuring that there is input from the profession, but also adequate protection for the public.
The second question speaks to professional liability. I was not here to hear Mr. MacKinnon's remarks in that regard. However, in the current environment, and we are in a litigious environment, there is no question that professional advisers, and I assume it is true of lawyers also, are careful of what they opine on and what advice they provide with that in the back of their minds.
If you create an environment where you have more ready access to that professional advice, then that will start to serve the corporate world better.
The Chairman: Thank you for being with us, gentlemen. It has been helpful. Hopefully we will have a report out in a couple of months and I hope that you will be pleased with it.
I will now ask Senator Tkachuk to take the chair to introduce our last set of witnesses.
Senator David Tkachuk (Deputy Chairman) in the Chair.
The Deputy Chairman: Our next witness is Ms. Christine Sinclair from Ernst & Young.
Ms. Christine Sinclair, Partner, Financial Services Group, Ernst & Young: Honourable senators, I am a partner with Ernst & Young in the financial services practice. I am also the past chair of the Institute of Chartered Accountants of Ontario.
Our chairman and CEO, David Leslie, had a strong desire to meet with you today, but other commitments unfortunately made that impossible.
We thank you for the invitation to speak before you today and for providing our firm with the opportunity to participate in your discussions on the state of our domestic financial system in the post-Enron environment.
Our prosperity, the health of our economy and a productive business environment rely on properly functioning capital markets. The events of the last year and half have had a profound effect on the public's trust in capital markets, here and around the globe.
While Canada and the U.S. operate within unique regulatory and legal regimes, our economies are closely linked. As a result, the impact of the recent business failures in the U.S. has been felt by our Canadian investment and business community at all levels.
Many Canadian companies have raised significant amounts of capital across the border in order to sustain or grow their businesses, as the pool here is just not sufficient to meet their needs.
On both sides of the border, Enron has dealt a blow to the trust and confidence in our capital markets. Our primary goal, and the goal of those working in the markets, is to rebuild that trust.
We are very encouraged by the leadership of the individuals in the corporate sector and the level of commitment shown by a broad range of stakeholders — the Canadian Institute of Chartered Accountants, the Canadian Securities Administrators, the Office of the Superintendent of Financial Institutions, stock exchanges and governments — in all working together to develop a framework in Canada to maintain and increase investment confidence.
These hearings are very important, as no single professional group could address the concerns of the investing public, nor single-handedly restore confidence and trust in our capital markets. There are three points I wish to touch on today. I have seen from the some of the testimony these are not new points.
First, it is our view that it is not in the best interests of Canadian investors, or business generally in Canada, to adopt all the elements of Sarbanes-Oxley. We need to make changes to the American approach in the context of our unique market realities.
Second, we caution standard setters and rule makers about attempting to rebuild trust and confidence by simply introducing more rules without first revisiting the broad principles on which the conceptual framework for accounting, auditing and governance is based. In our view, if the principles and the intent are clear, you really need fewer rules to get to the end result.
Third, a number of positive changes have already occurred to raise the governance standards in Canada. Ernst & Young has been a first mover in adopting many of these improvements and is committed to ensuring standards remain high, so that Canadian issuers retain ready access to the U.S. and other capital markets.
I would like to address the differences between the U.S. and Canadian capital markets. It is in those differences, and not a desire for sovereignty, that we will find the need for different approaches as we work toward enhancing investor and public confidence.
The size of our Canadian market and our market mix dictate a made-in-Canada approach, including how we proceed on regulation. The costs of importing some of the solutions proposed in the U.S. will be substantial. In our view, it will not achieve a better result. The burden is not just in terms of increased infrastructure costs through the expansion of legal and compliance departments, but also over-regulation in a market the size of ours can be a major obstacle to both productivity and growth.
As we have heard, the accounting profession and the Canadian Securities Administrators were quick and decisive in reacting to the lessons learned from Enron. Ernst & Young has worked with others, inside and outside our profession, to consider the objectives and the potential impact of the Sarbanes-Oxley Act and other proposals.
We are all moving to act on solutions that we believe are in the best interests of the public and the market. We are undertaking initiatives that we believe will achieve the objectives of the Sarbanes-Oxley Act while using our regulatory framework and without overburdening Canadian issuers. The establishment of the Canadian Public Accountability Board is one positive step that we believe will help raise investor confidence in the audit opinion as a result of the implementation of a more rigorous and transparent audit practice inspection process.
The historical recognition by the SEC in the U.S. that the Canadian security system meets the high standards of American capital regulation is quite important. Canada is the only country permitted to use the Multi-Jurisdictional Disclosure System, MJDS. This process has served both countries well by being an efficient and cost-effective means for Canadians to access U.S. capital markets.
It is imperative that as our standards evolve, Canadian SEC-based registrants are not subject to dual regulation. Our profession is taking steps to ensure that recent initiatives, such as the new auditor independence standards, achieve the same objectives as the Sarbanes-Oxley Act, and that our issuers and their audit firms will be exempt from the U.S. independence requirements, practice inspection and disciplinary processes.
The U.S. accounting profession also recognizes the strength of the Canadian accounting profession. The reciprocity agreement between the two countries on the CA and CPA designations reflects the American recognition of our accounting, auditing and professional standards, our rules of conduct, the rigours of education and training of students, and the ongoing regulation of our accounting profession.
The historical difference between the American and Canadian approaches to accounting standard setting, corporate governance and market regulation has resulted in a marked difference in the response to the recent corporate failures. Generally, the Americans have adopted more of a rules-based approach, while in Canada we continue to seek our solutions within a principles-based framework.
Canadian accounting and auditing standards and rules of professional conduct are based on a set of principles that guide auditors and those who prepare financial statements as they make judgments about financial information. American standard setting, although based on a framework of principles similar to ours, has resulted in detailed rule making that has tended to produce more of a prescriptive answer.
Recognizing the growing complexity of business and the ever-changing market environment, there is a difficulty, and some might say a danger, in any attempt to prescribe rules that must try to take into account all circumstances, especially when new issues are of concern. It is always easier to find ways around a rule to achieve a financially appealing result than it is to get around a principle with clear intent.
Despite these differences in approach between the U.S. and Canada, the standard setters in both countries have worked over the years to harmonize standards, where possible. We welcome the fact that U.S. standard setters are currently challenging their framework. We believe that the Americans may shift more toward a principles-based approach.
While we caution against a carte blanche implementation of American rules, we support the objectives underlying the Sarbanes-Oxley legislation. A number of the resulting initiatives will enhance financial reporting, corporate governance and capital markets regulation in Canada.
In the U.S., the recently introduced requirement for companies to report on the existence and effectiveness of their system of internal controls will, if implemented effectively, raise the bar for corporate governance. It will create a comprehensive system for effective enterprise risk management that is fully aligned with a company's business objectives and embraced by the board and senior management.
The requirement for auditors to opine on management's assertions about internal controls is a major step forward in efforts to strengthen financial reporting. We do recommend that similar measures calling for management and auditor reporting on internal controls be introduced in Canada.
As an aside, the insurance act that came into effect in 1992 did have a greater focus on corporate governance and did introduce a requirement for the board to ensure that management has an appropriate system of internal control. Our financial institutions have been dealing with a similar type of principle in looking at internal controls. In my view, it has enhanced the internal controls structure within our financial institutions.
We also endorse regulation that would require auditors to review the quarterly filings of public companies as a means of early identification of those accounting issues that could have a significant impact on a company if left to wait for the annual audit.
Canada is a leader in its federal regulation of financial institutions. Of course, there is always room for improvement and refinement, but in this country we have had a proactive and transparent process that involves dialogue, cooperation and information exchange among regulators, companies and auditors.
By working together, we have been able to identify and address many issues before they have had a chance to cause problems. We have the flexibility to do that in the absence of an imposed set of rigid rules and inflexible regulations. There is a very healthy process within the financial institutions, the Office of the Superintendent of Financial Institutions and the audit firms to address issues in a proactive way before they become problems.
The events of the last year and a half have raised the profile of the critical role auditing plays in the effective functioning of capital markets. It is important that in Canada we have a fair environment for the profession to operate within. The current liability scheme in Canada of joint and several liability does not achieve this result and places audit firms in an unfair position where they can be forced to pay for the mistakes of others.
We are disappointed to hear that the Department of Finance will not recommend that the modified proportionate liability regime included in the Canada Business Corporations Act be introduced into the financial institutions legislation. We do appreciate the work of this committee in getting it into the CBCA, but we are disappointed that this will not be introduced into financial institutions legislation. Such modification would ensure that accountants are fairly held responsible for their work without being unfairly penalized for the negligence or wrongdoing of others. This issue, if not addressed, will not only impact the cost of audits as firms struggle under the weight of increasing insurance costs, but may affect the strength and competitiveness of the financial services industry.
In closing, I would like to leave you with these thoughts. Neither rules nor lawmakers can regulate trust. Rules and regulations cannot simply be imported into the Canadian marketplace. Trust and confidence in the public markets will be restored through solid corporate and professional leadership — people working to do the right thing. It will require a sustained effort by all market players, including regulators, professional bodies, accounting firms, audit committees and corporate leadership. Changes to our regulatory environment will need to be made in the context of our market, balancing our reliance on the U.S. capital markets with our own unique market needs. We must ensure that Canadian accounting standards, auditing standards, capital market regulation and the standards that govern the conduct of auditors maintain a level of excellence so that Canadian issuers are not disadvantaged in accessing the U.S. capital markets and are not subject to double regulation.
Ernst & Young has consistently led reforms to strengthen our profession and increase investor confidence in financial reporting and capital markets. Over two years ago, we supported proposals to limit the type of services firms can offer audit clients. We were the first to exit the consulting business. We are committed to playing a leadership role, and are confident that, working together, we can keep the Canadian markets safe, competitive and attractive to investors. I welcome your questions.
Senator Meighen: I have two questions. Do you have a scorecard on what parts of Sarbanes-Oxley you would recommend we embrace, or perhaps what parts we should not embrace? That would be very useful to us when we go down to the States at the beginning of April. The second question is, did the Department of Finance give you any reasons for not recommending that modified proportionate liability be included in the financial institutions legislation?
Ms. Sinclair: I do not know why it was not recommended. That was a fairly new development of which we just became aware.
Senator Meighen: If you should be blessed with some reasoning behind the decision, would you be able to communicate that to this committee?
Ms. Sinclair: I do not have a scorecard on Sarbanes-Oxley in front of me, but generally we support the principles and the direction. There are some good things in there: improving governance and management, CEO certification.
Senator Meighen: Do you know many people who are against that? I am being a bit facetious.
It would not come as a great surprise to our American counterparts if we were to say that we are all in favour of good governance. We had one or two specific suggestions from Mr. Dey, but it would be helpful to have an itemization of the things that would be either difficult or not necessary.
Ms. Sinclair: I would say there are a number of issuers here in Canada who do not support any of the Sarbanes- Oxley principles or rules. When you say everyone likes it, a number of issuers here do not.
Senator Meighen: Would they say publicly that they are against improved governance?
Ms. Sinclair: Legislated governance.
Senator Meighen: That is a fair difference. We are more leery, perhaps, of the legislation rather than the original "Mr. Dey'' approach.
Ms. Sinclair: Some CEOs would say that since they sign the annual financial statements and the balance sheet every year, they are already certifying those financial statements, so you do not need a rule that says they must do a separate certification. They feel they are already doing that.
Senator Banks: Come down from the mountain with your suggestions.
Senator Meighen: I have not climbed up that mountain. I am sitting at the bottom, waiting for the tablets to hit me on the head. I know Senator Oliver is interested in this too.
Ms. Sinclair: We think the CEO-CFO certification is good. It heightens the awareness, focuses people and allows organizations to spread that throughout, from the bottom to the top. That is good. We believe the internal controls direction is good, but caution you about detailed rule making. I point you to our federal insurance act, which contains the broad principles, but then we have guidelines to help people figure out how to do it. I think some of the independence rules again are too prescriptive. Broadly, we need to be independent. Broadly, the directors need to be independent. I think that prescribing the rules as to how that will happen is going too far.
Senator Oliver: I just wanted to ask a question about internal controls. I was under the impression that one of things that an audit committee did when they brought you, the auditor, before them was ask a number of questions about the statements. The audit committee would ask for your views about how the CFO was performing, and then they would ask you a series of questions about internal controls and monitoring. They would put the question, "In your opinion, are the controls in place sufficient to protect this company?'' They would go back and report what you told them as an audit committee to the board. I am certain that most good audit committees and companies in Canada today are doing that. My question is: When you say in your report to us today that it will raise the bar for corporate governance, are you suggesting that many companies do not ask these types of questions about internal control and do not report them to their board?
Ms. Sinclair: The difference is that this is putting the responsibility clearly on management to ensure that an appropriate system of internal control exists.
Senator Oliver: That is done by the audit committee now, is it not?
Ms. Sinclair: No, management, not the audit committee. This is putting the responsibility on the company to ensure internal controls exist, are documented and function as intended. Again, it makes the responsibility to ensure the control system works enterprise-wide. When an audit committee asks the auditor, "Give us your opinion on internal controls, whether they are working,'' the auditor can comment on the internal controls that they looked at to support their audit opinion, which may not have been enterprise-wide. There are a number of ways to do an audit, but we are not usually looking at every control in every part of the organization when we sign an audit opinion. There is a big gap between doing what you need to do to sign the financial statements and auditing a system of internal control.
Senator Oliver: When a member of an audit committee asks you a question about internal controls, you put a limit on your opinion by saying, "Insofar as we have not looked at this, this and this, it is our opinion that the internal controls seem adequate.''
Ms. Sinclair: That is correct. It is using slightly different words, but it is very much in the context of what we did and what we found, not a carte blanche that the internal controls are working.
Senator Oliver: You are talking about enterprise wide?
Ms. Sinclair: Absolutely, and the important aspect is that it is putting the onus on management to make sure that that system exists. They document it and test it. That does not exist today.
Senator Oliver: After management does that and it goes to the board, is there any requirement that this be made public so that ordinary shareholders can find out about it?
Ms. Sinclair: We are still in the early days because the rules will be coming in for year end 2003. Companies in the U.S. are just now starting to prepare for this without yet having the detailed framework. The intent is that certification will form part of the annual report, so there will be an opinion, but not all the details.
Senator Oliver: So shareholders will know, first, that there are internal controls, and probably the extent to which they have been developed?
Ms. Sinclair: That is correct. Then the auditor will opine on whether management's assertion is appropriate. A number of companies in the U.S. are currently going through the process of a dry run of testing so that they can fix whatever issues they identify, and hopefully be in compliance by the end of the year. It is a healthy process.
The Deputy Chairman: In your experience and that of your firm, are most audit committees good? You deal with them every day.
Ms. Sinclair: There is a wide range of competence among audit committees. I work and have worked for most of my career with financial institutions. I would put the financial institutions audit committees at the higher end of the scale. We have had legislated requirements for audit committees. Legislation tells audit committees broadly what they need to do. There are very good people on them who I think take their roles seriously and do an effective job. As you get further down the scale — and there are many small financial institutions in Canada that are not public, that is, small insurance companies and branches — you do not necessarily get the same degree of diligence, but generally in my experience, because I am in the financial services area, the audit committees are quite good.
The Deputy Chairman: When you have a meeting with an audit committee that is not so good, that is just happy to be there, and they do not ask questions of any relevance whatsoever, do you consider talking to someone about improving their performance, or do you let it go? We hear stories about audit committees. All the auditors meet with them. They must have an opinion on whether the committees know what they are doing. What happens when you get a bad audit committee?
Ms. Sinclair: Normally, in most audit committees meetings, there is a session at the end for auditors and the audit committee members only, without management. A competent person who is not that knowledgeable about audit committees will generally ask an auditor what they did not ask that they should have. That gives you the opportunity to tell them everything you think they should have asked. Usually, you can introduce that into the conversation.
The Deputy Chairman: If the light bulb does not go on, you do not take the initiative?
Ms. Sinclair: Personally, I do. I do tell an audit committee what I think it should know.
Senator Banks: I was very glad to hear you say that your firm is among those that have divested themselves of their consulting arms. I have a number of friends in your profession and I embarked upon a course of losing friends and losing influence with people a few years ago when I began to rail against firms that, on the one hand, offered consulting, and on the other, would audit you. That did not make sense to me. Am I right that some, but not all, of the larger accounting firms have divested themselves in that way?
Ms. Sinclair: That is correct. It is in process.
Senator Banks: I presume they are in the process, because these days, given the new regime, people want auditors whose opinion cannot be held in disdain or doubt by their shareholders. That must be at least a factor.
Titles are all very nice, but does Ernst & Young have a section called "the audit section,'' in addition to other things? What are the other things? I notice that you are a partner in the financial services group of what used to be called an accounting firm. What does the financial services group do, what are the other groups within Ernst & Young now and what do they do?
Ms. Sinclair: The big four firms would be organized similarly to the way we are. We have functional lines in terms of what we do and where we specialize. Functionally, I reside in the assurance practice, which is doing audits. We also have a tax practice that does tax compliance and tax consulting. We have risk management people who advise companies on internal controls and other risk-management-type activities. We have a business restructuring group that assists companies that are in financial difficulty in reorganizing. There is a whole host of services that Ernst & Young still offers.
"Consulting'' it is not a well-understood term in the marketplace generally. We sold our consulting business that offered a host of services, but that does not mean that we now only audit. There is a wide range of services still offered by the big four firms.
Senator Banks: I presume that risk management would also include whether a company ought to go in a different direction and make investments in areas in which it has not before, or take on contingent liabilities of some kind?
Ms. Sinclair: No, risk management is trying to deal with a company's stated policy on risk, what they are prepared to accept, and whether they have an infrastructure to ensure that people are doing what they are supposed to be doing. It is not transaction-by-transaction; it is the checks and balances to ensure that people are conducting themselves in the way they are supposed to. It really deals with the processes and controls.
Senator Banks: As opposed to the direction?
Ms. Sinclair: That is correct. It is not a strategy type of direction; it is dealing with the day-to-day management of risk.
The Deputy Chairman: There being no further questions, I thank you very much, Ms. Sinclair.
The committee adjourned.