Managing the psychological impact of M&A

MA_680x220Studies reveal that 50 to 70% of M&A transactions ultimately fail to realize expected synergies and, in fact, many actually dilute shareholder value. One of the causes of M&A failures is that companies often neglect to adequately consider the psychological impact of M&A on their employees.

Will I be laid off? Will I be moved to a different position? Will I get along with my new colleagues? Like downsizing and other types of organizational change, M&A creates considerable uncertainty and has widespread psychological effects on employees in every level. A paper by People & Culture identifies the following potential psychological issues and sources of stress for employees:

  • Anxiety – employees face uncertainty about job prospects and impact on career
  • Social Identity – employees lose their old organizational identity
  • Acculturation – employees must adjust to a new culture and form new relationships
  • Role Conflict – employees face uncertainty about where they stand in the post-merger organization
  • Job Characteristics – employees must adjust to changes in their jobs as certain functions are changed to eliminate redundancies
  • Organizational Justice – employees lose trust if the company is unfair or not transparent about who they promote or layoff

The effects of these issues are well-documented. The stress and uncertainty caused by M&A results in lowered morale, job dissatisfaction, unproductive behaviour, increased turnover and absenteeism, among other things.

In fact, a study by researchers at the University of Calgary reveals that there is a statistically significant correlation between M&A activity and mental disorders. Employees exposed to M&A activity were 2.8 times more likely to have had a generalized anxiety disorder over the past year compared to those who were not exposed to M&A activity. The researchers stress that generalized anxiety disorder can eventually evolve into major depression.

Clearly, neglecting these issues can have severe consequences on productivity and ultimately reduce shareholder value. Management must be proactive in addressing these issues at all times during an M&A transaction and not simply brush it off as a post-merger matter for Human Resources.

The key to alleviating employee stress during M&A is effective communication early and at all stages of the transaction. While this may not always be practical given the commercially sensitive nature of some information, management should proactively inform employees (to the extent possible) about details which may impact them. This reduces uncertainty and prevents the spread of rumours which may be difficult to control after the fact.

Also, companies should adopt comprehensive mental health policies and practices if they have not already done so. Guidance for such policies is provided in the National Standard on Psychological Health and Safety in the Workplace, published in 2013 by the Canadian Standards Association and the Bureau de Normalisation du Quebec. A recent study of financial institutions by the Shareholder Association for Research & Education reveals that very few companies currently comply with the national standard. Of the 25 companies reviewed, only one company published a comprehensive policy or instituted training for managers on psychological health and safety matters.

For strategies on retaining key employees during M&A, please see our other recent articles: How can companies retain talent during M&A? and Employee retention: good people equals better results.

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Performance incentives for portfolio companies

Private equity investors (PEIs) when investing in new portfolio companies, seek to align management’s interests with that of the PEI to grow the value of the portfolio company and achieve a profitable return in the investment upon exit.

Typically, PEIs incentivize management to adopt such interests through compensation arrangements in  the form of performance incentives. Generally, PEIs will grant management an interest in the growth in value of the company via an interest in the equity of the company (e.g., stock options or performance shares) or in the profit/proceeds of the company, the latter of which is typically used for partnerships.

Notwithstanding that specifics naturally differ across all PEIs, there are some common elements in the amount and vesting among performance incentives. PricewaterhouseCoopers published a survey (the Survey) and a report (the Report) in 2013 and 2012, respectively, outlining such information which is summarized below.

Amount and participation

Determining the right percentage of interest in a portfolio company (or profit/proceeds) to be granted to sufficiently incentivize management is a fact-specific question. Generally, PEIs first determine the total compensation they wish to provide management upon a successful exit then “back-solve” for the amount and form of equity required to deliver that dollar amount. Further, both the Survey and the Report note that:

  • on average, PEIs reserve approximately 10% of the equity interest for management incentive plans (as a percentage of fully diluted shares) with a range of 4.5% to 17%; and
  • on average, the CEO and next four senior-most executives receive approximately 50% of this reserve.

Notably, PEIs also typically tie different percentages to different performance achievements.  For example, escalating percentages (e.g., 5%, 10%) can reflect different tiers, each tied to an escalating performance (or hurdle) rate.

Vesting conditions

Performance incentives are typically subject to vesting conditions. While some performance incentives are time vesting, the Report states that the following two vesting conditions are the most commonly used:

  • performance based vesting conditions based on metrics related to achieving financial targets (e.g., EBITDA); or
  • exit based vesting conditions based on metrics such as the internal rate of return or a multiple of invested capital achieved upon a liquidity event.

PEIs may impose additional terms which may cause a person to forfeit their entitlement to any performance incentives upon the occurrence of certain events, such as that person’s resignation or termination.

The author would like to thank Nader Hasan, articling student, for his assistance in preparing this legal update.

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Changes to offering memorandum exemption finalized

Generally, companies may not distribute securities to investors unless such investors are provided with a prospectus which contains comprehensive disclosure of all material facts related to the company and the securities to be distributed. Companies that are reporting issuers supplement this disclosure by providing periodic and timely disclosure which, together with the prospectus, provides investors with the information required to make knowledgeable decisions on whether to buy or sell securities of such companies. In certain circumstances, however, companies may rely on an exemption from the prospectus requirements to distribute securities. The prospectus exemptions are generally available in circumstances where an investor demonstrates a certain level of financial sophistication or confirms his or her relationship with the principals of the issuer. Commonly used prospectus exemptions include the “accredited investor” exemption and the “family, friends and business associate” exemption. The prospectus exemptions available in Canadian jurisdictions are set out in National Instrument 45-106 (Prospectus Exemptions) (NI 45-106).

In March 2015, the Ontario Securities Commission, in conjunction with the securities regulatory authorities in Alberta, New Brunswick, Nova Scotia, Quebec and Saskatchewan (together, the participating jurisdictions), published various proposals to amend NI 45-106. Following a comment period that involved the collection of input from approximately 1,000 commentators, the participating jurisdictions published certain final amendments on October 29, 2015 to the offering memorandum exemption (the OM exemption). The amendments introduce an OM exemption in Ontario and amend the existing OM exemption in the remaining participating jurisdictions. The OM exemption generally permits issuers to raise capital from a more diverse group of investors than other more commonly used exemptions such as the “accredited investor” exemption. Investors are provided with a disclosure document (the offering memorandum) when the securities are purchased from the issuer.

The new amendments introduce the following key changes to the OM exemption:

  • Investment limits: The amendments to the OM exemption include investment limits for both eligible and non-eligible investors that are individuals:
    • the acquisition cost of all securities acquired by a non-eligible investor under the OM exemption in the preceding 12 months cannot exceed $10,000,
    • the acquisition cost of all securities acquired by an eligible investor under the OM exemption in the preceding 12 months cannot exceed $30,000, and
    • the acquisition cost of all securities acquired by a purchaser under the OM exemption in the preceding 12 months cannot exceed $100,000 provided that such purchaser is an eligible investor that receives advice from a portfolio manager, investment dealer or exempt market dealer that the investment above $30,000 is suitable;
  • Changes to the risk acknowledgement form: Investors relying on the OM exemption in the participating jurisdictions must continue to complete form 45-106F4 (Risk Acknowledgement), however, the amendments introduce two additional schedules to the form. In the first schedule, investors will be asked to confirm their status as an eligible investor, non-eligible investor, accredited investor or an investor who would qualify to purchase securities under the family, friends and business associates exemption. In the second schedule, investors will be asked to confirm that their investment falls within the investment limits (if applicable). Non-individual investors are not required to compete these new schedules;
  • Disclosure by non-reporting issuers: Non-reporting issuers that rely on the OM exemption will be required to provide investors with audited annual financial statements and a notice that sets out the use of proceeds received from funds raised from such investors. Additionally, upon the occurrence of any of the following events, non-reporting issuers in New Brunswick, Nova Scotia and Ontario must also provide notice to investors (in the prescribed form) within the 10 days of such event:
    • discontinuation of the issuer’s business;
    • a change in the issuer’s business; or
    • a change of control of the issuer; and
  • Incorporation by reference of marketing materials: Any marketing materials used by an issuer that relies on the OM exemption must be incorporated by reference into the offering memorandum. In the event that such marketing materials contain a misrepresentation, the issuer will be subject to the same liability as the disclosure in the offering memorandum.

It is anticipated that the final amendments will come into force in Ontario on January 13, 2016 and in Alberta, New Brunswick, Nova Scotia, Quebec and Saskatchewan on April 30, 2016. These amendments will not modify the OM exemption available in other Canadian jurisdictions other than the participating jurisdictions.

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Cyber security: what the hack?

In a previous blog post, we discussed how to manage cyber security risks during the negotiation and due diligence stages of an M&A transaction. In this post we discuss cyber security insurance as a tool for managing this unwelcome risk.

The cyber security risk

Although businesses have been ramping up their information security systems, the pace of cyber security breaches is not slowing down. One study estimates that cybercrime will cost businesses $2.1 trillion globally by 2019. And, as recent security breaches have taught us, a security breach can have reputational, moral, and deeply political complications. The 2014 hack of Sony Pictures cost the company $100 million, derailed plans for the distribution of a movie concerning North Korea, and raised ethical questions about the appropriate response to cyber terrorism.

On top of this, businesses will soon face stricter legal requirements around the disclosure of security breaches in Canada. New rules regarding the mandatory disclosure of security breaches were approved by Parliament in June 2015 and may come into force at any point. The Digital Privacy Act amends the Personal Information Protection and Electronic Documents Act and requires that an organization report any breach of security safeguards that reasonably creates a real risk of significant harm to an individual. Notification must be made to the Privacy Commissioner and to the individual involved. Significant harm under the statute includes financial loss, bodily harm, damage to reputation or relationships, and loss of employment, business or professional opportunities.

Cyber security breaches and their associated financial, reputational, and regulatory risks are here to stay.

Insurance as part of the solution

While the key to managing cyber security breaches will always be to implement strong data protection systems, cyber security insurance is becoming a popular way to address the financial consequences of cyber security breaches. A cyber security policy insures against risks to a company’s information technology and data assets, and leaves the insurance company with the uncertainty of actual damages in the case of a breach.

In the context of M&A, the problem with cyber security risk is valuing and allocating risk among parties. Similar to reps and warranty insurance (which we discuss here), cyber security insurance allows a company to allocate risk by transferring some to the insurance company and leaving the buyer and seller to allocate any remaining risk that falls outside the policy. Cyber security insurance is also valuable before M&A. Having a policy in place may help ease concerns of acquirers as the insurance would cover security breaches that may have already occurred prior closing but have yet to materialize. This has been found to hold true in jurisdictions that have data breach notification laws like the ones currently pending in Canada. Coverage can be a standalone product or can be built into existing policies such as business continuity insurance or supplier chain insurance.

Cyber security risk represents a new and significant risk to businesses. Simply being aware of this risk is critical in an M&A deal. Once recognized, however, placing appropriate security measures, conducting IT due diligence, and allocating risk by way of negotiation or insurance will help all parties cut through data breach uncertainty and settle material issues efficiently.

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The role of the strategic board in value creation

It is not in dispute that the role of the board of directors is to provide oversight of management and advise on the strategic direction of the corporation. However, the delineation of roles and responsibilities between management and directors in setting corporate strategy can often become blurred.

In collaboration with The Boston Consulting Group and RBC Capital Markets, we have released a paper offering a fresh perspective on an enhanced role for the board of directors in value creation and setting corporate strategy. We recommend that board members should engage regularly with management to critically examine value creation alternatives with the same scrutiny that an investor in the company would, and then pursue the corporate strategies that generate the greatest shareholder value. Such collaboration has the potential not only to unlock shareholder value but also to equip management teams and boards to respond more effectively to criticisms from the investor community and defend the company’s course of action.

Management allies

We believe that directors who take a strong role in overseeing shareholder value creation can be powerful allies of the management team. Board members have the depth and breadth of experience that make them well suited to serve as thought partners with senior management by challenging their assumptions and offering innovative ideas on strategy.  In addition, given that directors are removed from day-to-day operations, they can offer a fresh perspective on the company’s approach to value creation.

Board or committee?

The board as a whole can increase its engagement with value creation or the company can form a committee of board members with oversight responsibility. The oversight activities and the nature of the interaction with management should be analogous to the role played by members of the audit committee with respect to financial matters. Board members must understand the value-creation alternatives available to the company and be comfortable with the specific opportunities that management recommends pursuing. To ensure that board members can provide effective oversight, the management team should rigorously evaluate and clearly present the company’s value-creation alternatives and be receptive to the board’s guidance. We have prepared a sample charter setting out the mandate for a value-creation committee that outlines key activities for directors undertaking this role.

Full suite of strategic alternatives

Directors should require senior management to evaluate and present the full suite of alternatives for creating shareholder value. These options might include M&A activities or divestitures, significant investments to accelerate organic growth, cost reductions, alternative capital strategies, or transformational programs. Board members should be sufficiently engaged to understand the sensitivities, risks, and opportunities related to each such option. In applying the insights and input gained from its collaboration with management, the board should encourage bold moves to transform the company’s stand-alone operational performance.

Impact on TSR

A clear view is needed of what a company’s basic strategic plan will deliver in terms of total shareholder return (TSR) if executed successfully. Consideration should also be given to how the company’s various capital and transaction alternatives would affect TSR and how those returns compare with internal and market expectations. Management and board members can apply this evaluation to defend the company’s chosen strategy as the best option to unlock long-term shareholder value.

Second opinions

A useful source of insight for the board and management in evaluating strategic moves that the capital markets will reward is seeking an understanding of how the research and investment community values the company as a whole. For example, is a sum-of-the-parts valuation approach applied and, if so, does the company trade at a discount to its intrinsic net asset value? Investigating how management’s opinion about the company’s valuation differs from that of the research and investment community can provide a critical input in setting a strategic course.

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Keeping secrets: a refresher on confidentiality agreements

shred-680x220People often engage in reflexive behaviour without thinking about the function underlying such behaviour. Likewise, in recurrent M&A transactions, clients sometimes lose sight of why they engage in certain formalities.

One such formality concerns pre-acquisition agreements; more specifically, confidentiality agreements (CAs) – including their (i) purpose and (ii) scope.

Purpose of CAs

In preliminary M&A negotiations, the exchange of confidential information is essential to the terms of the transaction. As parties progress beyond preliminary stages to due diligence, increased disclosure is met with intensified risk of the compromise of proprietary information. Executing CAs allows the parties to securely progress beyond preliminary negotiations in order to effect the deal.

Scope of CAs

The scope of confidential information is a trade-off – while the seller prefers a broad or open definition of confidential information to protect itself from excessive disclosure, the buyer prefers a narrow definition in order to avoid breach. In defining the scope of confidentiality, consideration should be given to several factors, including:

  • Timing of disclosure. The CA should distinguish the confidential quality of disclosures made prior to or after the CA’s execution.
  • Means of disclosure. The CA should cover disclosures made orally, in writing and by electronic means (e.g., email or cell phone).
  • Length of disclosure. The survival of the CA is important because a lengthy term for confidentiality might not be enforceable. Typically, it is at the discretion of the parties to choose a period of between 12 and 24 months.
  • Derivative information. The CA should cover information arising from confidential information, such as information related to a party’s subsidiaries.
  • Restrictions on use. The CA should have a clearly stated purpose, such as undertaking M&A due diligence. This limits parties from using proprietary information for purposes contrary to the other party’s desires.
  • Security protocol. Storage of information, both physically and electronically (e.g., data rooms), is vital to its security.
  • Jurisdiction. In cross-jurisdictional M&A, the agreement should select governing law and forum for disputes arising from the relationship between the parties.

Breach of confidentiality should also be robustly defined, with consideration given to breaches arising intentionally, unintentionally and/or negligently. Appropriate remedies, damages and indemnities should be afforded to the breached party. The standard for breach should be agreed upon between the parties and should be an objective standard, such as “commercially reasonable efforts” (for the legal interpretation of this phase, see our recent post on interpreting “efforts” in commercial contracts).

The author would like to thank Sam Zadeh, articling student, for his assistance in preparing this legal update.

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2015: the year of the mega-deal

Last week’s announcement of a proposed transaction in the food and beverage industry for a staggering US $107 billion does not stand alone as a mega-deal in 2015, according to a recent Mergermarket report. The deal is part of what has been a record year for deal valuations. Through the first three quarters of this 2015, there have been a total of six deals worth more than US $50 billion. As a result of these mega-deals, deal value has totalled US $2.7 trillion, up 21% from the first three quarters of last year.

The report lists a number of factors that analysts believe have contributed to this year’s record deal valuations:

  1. Cheap debt. As permitted by low interest rates, cheap debt has raised the ceiling in terms of the price companies are actually able to pay.
  2. Shareholder pressure. The pressure to generate increasing dividend payouts has pushed management to pursue deals more aggressively.
  3. Industry-specific factors namely the tech boom and consolidation. Companies are feeling the need, now more than ever, to invest in mobile technology as well as in internet security, or else risk being left behind. In addition, slumping commodity prices and an over-competitive market have pushed players in commodity-based industries, such as the oil and gas industry, to consolidate.
  4. Slow organic growth. The inability to grow internally has forced companies to look externally in order to remain competitive. Analysts believe this factor to be the biggest contributor to the year’s run of high deal valuations.

Analysts remain confident mega-deals will continue for the near future. In spite of record deal valuations, analysts believe we are at least a year or two away from experiencing a valuation bubble burst.

As mega-deals persist, one of the primary legal challenges will be staying onside of anti-trust legislation. Parties to these deals should not expect regulatory approval to come easily and should anticipate delays and increased costs. Failure to minimize the costs and delays associated with anti-trust compliance could spell the end of the mega-deal.

The author would like to thank Michael Viner, articling student, for his assistance in preparing this legal update.

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Houlihan Lokey publishes Purchase Agreement Study: key indemnification findings

Houlihan Lokey (HL) recently published its annual Purchase Agreement Study for the 2014 calendar year (the Study). The Study is focused on middle-market change-of-control transactions in which HL served as the financial advisor to either the buyer or the seller, and undertakes a review select terms of the purchase agreements for such transactions. The scope of the Study is broad, covering both public and private deals which vary by industry, size, and purchase price (ranging from $10 million to more than $1 billion).

The results of the Study are valuable. By assessing the terms of purchase agreements – with a particular focus on the indemnification provisions and how such provisions relate to the agreements’ representations, warranties, and covenants – the Study offer valuable information and benchmarks within the middle market, and points to recent market trends as against the data set out in previous iterations of the study.

Indemnification overview

77% of all transactions in the last decade had representations and warranties that survived the closing of the deal. Within that group of transactions, the vast majority of the purchase agreements analyzed contained a claims basket, indemnity cap and/or an escrow.  While there is no consensus on what constitutes “fair and normal” or “market” for any of these indemnification provisions (each term would be highly negotiated and dependent on the facts of the particular transaction), the results of HL’s Purchase Agreements Studies over the past 10 years point to certain trends and patterns.

Below is a chart which sets out the mean, median and maximum values of the corresponding indemnification terms of the surveyed transactions over the past decade. In all cases, the magnitude of the numerical values is measured as a percentage of the purchase price.



The Study canvassed the purchase agreements with a view to identifying how many agreements contained aggregate claims basket, which provide that a seller is not required to indemnify for losses until the aggregate amount of all such losses exceeds a specified amount (the “basket”). There are two main types of baskets: (1) a dollar-one or “tipping” basket (i.e., when, once the aggregate amount of losses exceeds the basket, the seller is responsible for the aggregate amount of all losses) and (2) a deductible basket (i.e., when, once the aggregate amount of losses exceeds the basket, the seller is only responsible for losses in excess of the basket).

  • Of the transactions in which the reps and warranties survived the closing, 84% had a form of basket in 2014 (as opposed to 88% over the past 10 years).
  • Deductible baskets accounted for 76% of the baskets in 2014 (as opposed to 78% over the past 10 years)
  • Dollar-one baskets accounted for the remaining 24% of the baskets in 2014 (as opposed to 22% over the past 10 years)


The Study also considered the purchase agreements in order to identify how many agreements contained a cap on the amount of damages the buyer could recover from the seller under the indemnification provisions.

  • Of the transactions in which the reps and warranties survived the closing, 84% had cap on damages in 2014 (as opposed to 88% over the past 10 years).
  • The median cap (as a % of purchase price) in 2014 was 9.8% (as opposed to 10.0% over the past 10 years)
  • The mean cap (as a % of purchase price) in 2014 was 17.6% (as opposed to 13.8% over the past 10 years)


The Study also considered the purchase agreements with a view to identifying the frequency with which purchase consideration (consisting of money, securities, or other property or instruments) is withheld from the seller and deposited into an account at closing to provide protection to the buyer for the future payment of indemnification claims.

  • Of the transactions in which the reps and warranties survived the closing, 77% had an escrow in 2014 (as opposed to 82% over the past 10 years).
  • The median escrow (as a % of purchase price) in 2014 was 5.0% (as opposed to 7.0% over the past 10 years)
  • The mean cap (as a % of purchase price) in 2014 was 6.0% (as opposed to 7.5% over the past 10 years)

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Interpreting “efforts” in commercial contracts

Encountering the phrases, “best efforts”, “reasonable efforts” and “commercially reasonable efforts” in commercial contracts sans definition leaves enough latitude for interpretation to cause uncertainty.  Nevertheless, a considerable amount of jurisprudence does provide some guidance.

A hierarchy has been accepted whereby “best efforts” imposes the most onerous requirement in comparison to “reasonable efforts” or “commercial reasonable efforts”. As between the latter two phrases, the courts have yet to clearly delineate the difference, if any.

In Atmospheric Diving Systems Inc. v International Hard Suits Inc., the BC Supreme Court summarizes existing case law to describe “best efforts” as follows:

Taking, in good faith, all reasonable steps to achieve the objective, carrying the process to its logical conclusion and leaving no stone unturned… Doing everything known to be usual, necessary and proper for ensuring the success of the endeavour.

The court cautioned that each analysis is a fact-based one, and that there is no absolute duty to achieve the contractual objective. Rather, the analysis will require an examination of whether the individual was acting in good faith with a true attempt at fulfilling the obligation. In sum, there is a high expectation of performance balanced by a standard of reasonableness.

The term “reasonable” has been judicially interpreted to mean the taking of all reasonable and measured steps to achieve an objective in the circumstances. Reasonableness is defined more by what it does not require, rather than by what it does require, in the given circumstances. The standard of reasonableness does not require an individual to expend efforts to the point of undue hardship.

The distinction, if there is one, is unclear between the phrases, “reasonable efforts” and “commercially reasonable efforts”. Not yet judicially determined, it can be contended that both phrases, in a commercial context, reference the same standard of effort.  While it may be suggested that “commercially reasonable efforts” means pursuing an objective until it becomes economically unreasonable for an individual to continue, it is arguable that the concept of “reasonable efforts” would yield substantively the same interpretation of effort in a commercial context.

In light of this open-to-interpretation and contextualized understanding of the differences between “best efforts”, “reasonable efforts” and “commercially reasonable efforts”, parties to a commercial contract would be prudent to clearly define the specific, tangible actions that must be taken in order to fulfill a particular “efforts” standard.

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Be aware: business acquisition reports

Under Canadian securities laws, reporting issuers are required to make periodic disclosure and timely disclosure upon the occurrence of specific events.  One of the timely disclosure obligations is the requirement for a reporting issuer to file  a business acquisition report (BAR), in prescribed form, upon the completion of a “significant” acquisition of a “business”.

An acquisition is considered significant where the acquisition meets one of the following significance tests: investment, assets or profit or loss. For venture issuers, the relevant tests are assets and investments. Whether the relevant test is met is based on financial statements.  Notably, however, if an acquisition qualifies as a reverse takeover or satisfies certain optional tests, a company may not be required to file a BAR.

A company must file a BAR within 75 days of the acquisition unless the acquired business’s most recently completed financial year is within 45 days of the acquisition in which case the filing deadline is either 90 or 120 days.

The BAR must include the acquired business’s financial statements and such statements must be accompanied by an auditor’s report that includes an unmodified or unqualified opinion, unless the opinion relates to inventory, in which case it may be qualified.

In addition to prescribed exemptions, regulators may grant case-by-case exemptions from the requirements to file the BAR or other related requirements. One recent example is seen in Endeavour Silver Corp., Re (36 OSCB 2889). In that case, an auditor was unable to verify certain matters as a result of the acquired business’s lack of historical information as well as the passage of time which prevented any verification of such information. As a result, the auditor was unable to provide an unqualified opinion relating to such matters. Nonetheless, the British Columbia Securities Commission, as the principal regulator, provided the applicant relief from the requirement to provide an unqualified opinion on the basis that the applicant (i) could otherwise comply with the requirements for the BAR and (ii) that the BAR would contain sufficient alternative information about the acquisition.

The author would like to thank Nader Hasan, articling student, for his assistance in preparing this legal update.

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