BCN 2005/08 - BCSC Comments on Proposed Multilateral Instrument 52-111 [BCN - Lapsed]
| Published Date: | 2005-02-04 |
|---|---|
| Rescinded Date: | 2012-05-31 |
Concurrently Published:
Today, other members of the Canadian Securities Administrators (CSA) are publishing for comment proposed Multilateral Instrument 52-111 Reporting on Internal Control over Financial Reporting (the Internal Control Rule).
Issuers must have appropriate internal control over financial reporting in order to provide reliable and timely financial disclosure. However, we propose not to adopt the Internal Control Rule because we are not convinced that it is the right way to achieve the underlying objective of improving the quality of financial reporting, and because we think compliance with the Internal Control Rule would be too costly relative to the benefits.
Achievement of the objectives of the Internal Control Rule
The Notice and Request for Comment accompanying the Internal Control Rule (the CSA Notice) identifies the following objectives:
- improvement in the quality and reliability of financial reporting in Canada,
- promotion of an “internal control culture” through an enhanced focus on internal control over financial reporting in Canada, and
- maintenance and enhancement of the reputation of our markets.
Reliable and timely financial reporting by issuers in Canada is essential for investor decision-making and for maintaining and enhancing the reputation of our markets. However, we think that existing financial reporting requirements effectively require issuers to develop and maintain appropriate internal control over financial reporting. Although current BC rules do not explicitly require an issuer to have internal controls, any issuer that makes erroneous disclosure must be able to demonstrate due diligence in its financial reporting processes as a defence to allegations of improper behaviour. There is no doubt that some issuers need to improve their internal control over financial reporting, but we are not convinced that the Internal Control Rule is the right way to focus issuers’ attention and resources on the objectives listed above.
An “internal control culture” is a worthwhile goal, but we are concerned that the Internal Control Rule might instead promote a “box-ticking” approach to controls, rather than one that focuses both on the needs of the business and on regulatory compliance. We are also concerned that compliance with the Rule could consume an excessive amount of issuers’ scarce resources. In our view, a simple recommendation to issuers to design and maintain appropriate internal control over financial reporting, coupled with the normal market forces (especially shareholder action) that are already focusing increased attention on controls, would do a better job of delivering value to investors.
Costs compared to benefits
The Internal Control Rule is modeled after rules in the US implementing section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404). Surveys of SEC registrants indicate that SOX 404 imposes high costs. Those costs include the purchase of software and consulting expertise to document and evaluate controls, use of internal resources including management’s time, and external auditor fees. Initial surveys indicated that external auditor fees relating to SOX 404 comprise about one third of an issuer’s total SOX 404 costs and are in the range of 40 - 50% of the external auditing fees for financial statements. More recent information indicates that the cost of SOX 404 compliance is even higher than initially estimated.
US surveys indicate that the costs of compliance with SOX 404 rules are disproportionately higher for smaller issuers than for large issuers. As well, SOX 404 has increased the demand for internal accounting staff, auditors and consultants. In some markets the demand for skilled people exceeds supply.
The jurisdictions that are publishing the Internal Control Rule are also publishing a paper prepared for the Ontario Securities Commission entitled The Cost and Benefits of Management Reporting and Auditor Attestation on Internal Controls over Financial Reporting. Some of the assumptions and methodology in the paper might be challenged, but the paper, even as it stands, concludes that the costs of compliance for smaller issuers would exceed the benefits of the Internal Control Rule.
In addition to the direct costs identified in these studies, issuers might incur the cost of lost business opportunities, caused by the diversion of board and management attention from business issues to compliance with internal control requirements. Although board and management time and other costs spent on these issues might decline after an initial transition period, the rule could cause a permanent drag on shareholder value.
We are also concerned that the compliance costs imposed by the Internal Control Rule might erode issuers’ profitability and growth prospects and lead to a decreased number of reporting issuers in Canada.
We have seen no credible evidence that any benefits arising from the Internal Control Rule would outweigh these potentially significant costs and adverse outcomes.
Since investors ultimately pay the costs imposed on issuers by regulatory requirements, we cannot justify imposing requirements unless we reasonably think that the value to investors would exceed the costs. We are not yet convinced that the Internal Control Rule meets that test, although we will review this question again following the comment period on the rule.
Alternatives to the Internal Control Rule
We think the best way to improve the quality of financial (and non-financial) disclosure is to hold directors and senior managers accountable for an issuer’s disclosure. The BC Securities Act, like securities legislation in other jurisdictions, prohibits a reporting issuer from making a misrepresentation (false statement or omission) in its disclosure filings. The directors and senior management of the issuer are responsible, subject to due diligence defences where appropriate, if the issuer violates its disclosure obligations.
The CSA committee that developed the Internal Control Rule considered, and rejected, various alternative approaches with less onerous requirements than those proposed. We think that the following alternatives warrant further consideration and encourage market participants to comment on them. The alternatives are also discussed in the CSA Notice. At this point, we are inclined to support alternative #1 because it is the least prescriptive approach and focuses on holding directors and senior managers accountable for an issuer’s disclosure.
1. No new internal control reporting requirements
Do not impose any formal requirements to evaluate and audit internal control over financial reporting. Rather, recommend that issuers design and maintain appropriate internal control over financial reporting as part of the process of ensuring reliable and timely financial disclosure. If they do not, and something goes wrong as result, then the regulator may take enforcement action against the issuer and its directors and senior management.
As set out in the CSA Notice (Alternative #6), other CSA jurisdictions think an important element of this alternative would be reliance on Multilateral Instrument 52-109 Certification of Disclosure in Issuers’ Annual and Interim Filings (the Certification Rule). That rule requires the chief executive officer and chief financial officer to certify that they
- are responsible for establishing and maintaining internal control over financial reporting
- have designed, or caused to be designed, such internal control over financial reporting, and
- have caused the issuer to disclose certain changes in internal control over financial reporting.
The Commission decided not to adopt the Certification Rule (for more details see BCN 2003-25 published on June 27, 2003). However, we would be interested in your comments on whether we should reconsider that decision in conjunction with developing the alternative approach described above.
2. Voluntary compliance (Alternative #5 in the CSA Notice)
Present the concepts set out in the Internal Control Rule as recommended practice. Give issuers the choice to either
- annually evaluate the effectiveness of internal control over financial reporting using a recognized control framework, support the evaluation with evidence, disclose any material weaknesses, and provide an external auditor’s report on the effectives of the controls and on management’s assessment, or
- not perform all the tasks set out above and explain why the issuer believes such non-performance is appropriate.
3. No internal control audit report (Alternative #1 in the CSA Notice)
Require issuers to comply with all of the requirements in the Internal Control Rule, other than the requirement to file an internal control audit report prepared by the issuer’s external auditor.
4. Evaluate entity-level controls only (Alternative #4 in the CSA Notice)
Require an evaluation of only entity-level controls relating to financial reporting, and filing of a report of management’s assessment and corresponding auditor attestation. Entity-level controls focus on the “big picture” components of internal control over financial reporting and include ethics, code of conduct and “tone at the top.”
Request for Comments
The Commission requests that you consider our reasons for not adopting the Internal Control Rule when you provide comments to our CSA colleagues on the proposed rule.
The following questions might help you formulate your comments. Please include in your comments a description of any direct experience that has contributed to forming your views on the Internal Control Rule or the alternatives.
1. Do you think that the Internal Control Rule would significantly improve the quality of issuers’ financial reporting in Canada?
2. In your view, would the Internal Control Rule significantly prevent or deter fraud?
3. Do you think that the benefits of the Internal Control Rule justify the costs of compliance?
4. Would one of the alternatives described above, or some other alternative, achieve a more effective outcome than the Internal Control Rule?
We ask that you provide a copy of your comments on the Internal Control Rule, as they relate to the British Columbia position, in writing before June 4, 2005 to:
Sheryl Thomson
Senior Legal Counsel, Corporate Finance
British Columbia Securities Commission
P.O. Box 10142, Pacific Centre
701 West Georgia Street
Vancouver, BC V7Y 1L2
Fax: (604) 899-6814
Tel: (604) 899-6778
Or 1-800-373-6393 (In BC and Alberta)
sthomson@bcsc.bc.ca
February 4, 2005
Douglas M. Hyndman
Chair
Ref: Multilateral Instrument 52-111 Reporting on Internal Control over Financial Reporting, Multilateral Instrument 52-109 Certification of Disclosure in Companies’ Annual and Interim Filings, BCN 2003/25
This Notice may refer to other documents. These documents can be found at the BC Securities Commission public website at www.bcsc.bc.ca in the Commission Documents database or the Historical Documents database.