Shareholder responsibility over auditor tenure

Following the recent collapse of the United Kingdom’s second largest construction firm, due in part to overvaluation of contracts by its long-time auditors, the debate over auditor tenure has been re-energized.  Concerns about the terms or length of auditor engagements are nothing new and recent scandals provide good reason for Canadian companies to reconsider their audit governance practices.

In 2016, the European Union implemented mandatory rotations of audit firms for public companies, which was similarly considered, though rejected, in the United States. While Canada has not implemented mandatory auditor rotation, the annual appointment of auditors is an area in which shareholders have considerable power and responsibility, particularly following transactions that substantially change the nature and structure of a company.

Each year, business corporations legislation requires shareholders to approve the appointment of its auditors. Often these decisions are made by the board of directors and simply recommended for approval by shareholders as a formality.  The norm of shareholder passivity in this area highlights an opportunity to help mitigate some of the risks that frequently follow M&A transactions or long periods of status quo.

Traditionalists have long argued that audit quality increases with the length of tenure of a company’s auditors. However, a 2018 study suggests that misstatements are discovered faster after the appointment of a new auditor, and most significantly, in the new auditor’s first ten years with the company.[1]  The study found that longer auditor tenure also resulted in misstatements of greater magnitude. Supporters of short auditor tenure point to the importance of auditor independence, suggesting that as the relationship between an auditor and a company grows, the auditor’s impartiality is compromised.

On the other hand, critics of regular auditor rotation argue that companies benefit from long term relationships with their auditors, stating that longstanding relations allow auditors to develop and specialize their knowledge of the companies they work for and fine tune their skills to meet their needs. Critics also argue that the initial learning curve for auditors with a new company can be steep and costly.[2]  Interestingly, their claims appear to be supported by investor sentiment, as the results of a 2005 Accounting Review study revealed that investors perceived companies with longer auditor tenure more favourably.[3]

While the debate over auditor tenure rages on, shareholders should take notice that auditor appointment is an area over which they exercise important oversight, and arguably, have a responsibility to do so. Though auditor appointments rarely receive much attention, it may be time for shareholders to take on a more active role or risk subjecting their company to bigger problems down the road.

[1] See: Zvi Singer & Jing Zhang, “Auditor Tenure and the Timeliness of Misstatement Discovery” (March 2018) 93:2 The Accounting Review 315-338 at 335.

[2] See: Van E Johnson, Inder K Khurana & J Kenneth Reynolds, “Audit-Firm Tenure and the Quality of Financial Reports” (2002) 19:4 Contemporary Accounting Research 637-660 at 641-642.

[3] See: Aloke Ghosh & Doocheol Moon, “Auditor Tenure and Perceptions of Audit Quality” (2005) 80:2 The Accounting Review 585-612 at 609.

The authors would like to thank Devon Lenz, summer student, for her assistance in preparing this legal update.

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Gauging the impact of a Canada-U.S. trade war on cross-border M&A

On May 31, 2018 the United States (U.S.) government announced that it would be imposing tariffs on a number of Canadian products, including steel and aluminum at a rate of 25% and 10% respectively. In response, the Canadian government imposed its own surtaxes of approximately C$16.6 billion on imports of steel, aluminum, and other products from the U.S. These countermeasures came into effect on July 1, 2018 and will remain in force until the U.S. repeals its tariffs on Canadian steel and aluminum.

At a market level, this escalating “trade war” between Canada and the U.S. has the potential to significantly impact cross-border M&A activity. With increased barriers to entry into the U.S. market, it is likely that valuations of Canadian companies could fluctuate wildly and risk-adverse investors may be resistant to acquire Canadian companies due to the uncertain geopolitical climate. Steel and aluminium are also essential resources in the oil and gas industry, and increased input costs resulting from tariffs could deter M&A activity in the energy space.

There may, however, be more opportunity for inbound M&A activity into the U.S. as foreign steel companies lose their competitive advantage over domestic producers. The increased tariffs could make the acquisition of American steel companies a more attractive option for foreign producers, who would prefer not to pay heavy import tariffs.

While the new U.S. tariffs on Canadian goods may impact cross-border M&A with U.S. companies, the fortunate news for the Canadian economy is that activities in other markets may operate to counter-balance the impact of these tariffs. As we have previously discussed, the potential rise of M&A activity in the cannabis industry could make Canada a global leader in the space. It appears likely that the last two quarters of 2018 will be characterized by a larger volume of domestic M&A deals and acquisitions by international companies looking to establish a presence in the Canadian cannabis market. Nevertheless, how the “trade war” affects other industries and M&A activity in other sectors should be an intriguing development going forward.

The author would like to thank Tegan Raco, summer student, for her assistance in preparing this legal update.

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Will Canada soon be a global leader in the cannabis space?

Recently, the Cannabis Act was granted Royal Assent, resulting in the official passing of the legislation for legalizing cannabis in Canada. The Act is expected to be in force as of October 17, 2018.

The Canadian government’s recent decision to legalize recreational marijuana may significantly impact capital markets and M&A deals. The decision to legalize recreational marijuana at the federal level is unique to Canada, compared to other jurisdictions like the U.S. where it remains illegal federally and is currently regulated by states (such as Colorado, California and Washington).

While the state model in the U.S. has experienced some early success, the prohibition at the federal level makes operational realities (e.g., banking, transportation) more difficult. Canada’s legal framework may therefore open the doors to greater foreign investment, particularly for those seeking to gain a foothold in the sector without having to operate in an ambiguous legal and regulatory environment such as the U.S.

Notwithstanding the opportunities presented by the passing of the Act, the influx of new companies into the cannabis space may present some significant challenges to immediate success.

Careful consideration must be paid by investors to factors such as:

  1. the increase of competition changing the current market dynamics;
  2. price uncertainty, including forecasting the illegal market’s dominance and potential tax on products;
  3. changing and evolving regulations;
  4. consumer behaviour; and
  5. start-up risks associated with a new and growing industry.

Some industry experts have expressed concern over the increase of competition, citing the rarity of a new industry emerging overnight. That said, others have suggested that the barriers to entry, such as stringent regulatory requirements, may be enough to deter immediate competition in the sector.

While we cannot be sure of the exact outcome on capital markets and the M&A space, it is reasonable to suggest that Canada may soon experience a boom of activity in the cannabis sector.

The author would like to thank Nazish Mirza, summer student, for her assistance in preparing this legal update.

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A forward look into emerging technologies in M&A

As previously noted, businesses are keen to shine their spotlights on the surge of disruptive technology, particularly with the opportunities it stands to introduce, the existing standards it proposes to displace, and the upside it promises for bottom lines. In recent years, the rise of disruptive technology has created a boom for some industries while potentially upending others. For legal practice, the result is the same in both instances – these technologies have created new challenges, particularly for corporate M&A lawyers.

A prominent example of a disruptive technology is cryptocurrency. The exponential growth of cryptocurrency and its related technologies has established a novel industry primed for continual expansion. The rise of this type of industry typically translates to amplified amounts of corporate law work and a rise in industry-wide transaction volume. Unfortunately, the same technologies creating such opportunities are not satisfied in stopping there.

Looking at the M&A practice generally, there are a number of innovative technologies hoping to completely uproot its foundation. Blockchain technology is now being leveraged by different ventures (and their respective platforms) in an attempt to simplify and streamline the M&A space. As another example, managed Cloud services and other Cloud-based technologies are being used in similarly innovative ways. Some of the approaches taken offer tailored solutions to assist in streamlining M&A transactions by improving the internal inventory and consolidation systems of businesses. These proactive technologies are designed to make necessary transitions involved in mergers and acquisitions simpler.

As a space that is notorious for its complication and costliness, corporate M&A legal work revolves around diligence, precision, and organization. It is no surprise that these types of technologies continue to gain the traction they have, especially ones offering desirable, fresh, simple, and cost-effective alternatives. Although the disruption may provide serious benefits and an influx in deal volume in the legal industry with its boom, its ripple effects on traditional corporate M&A practice should be an interesting trend to follow going forward.

The author would like to thank Daniel Lupinacci, summer student, for his assistance in preparing this legal update.

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Waste is picking up! M&A developments in the waste management and recycling industry

Historically a highly fragmented industry, the waste management and recycling sector has undergone a process of consolidation and increased M&A activity over the past several years. Analysts have offered various explanations for this trend, ranging from a desire for larger companies to expand their geographic coverage to a rise in clean-tech and recycling businesses.

Although typically not an industry that attracts the limelight, investors now view waste management and recycling companies as attractive targets due to the high barriers to entry and the presumed lower risk that comes with businesses providing essential services.[1] As a result of these and other factors (such as favourable borrowing conditions), M&A activity in the waste management and recycling industry has been robust the past several years.

According to a recent report, M&A activity set a record high in 2017 in the British waste management and recycling sector. Much like that of the United States, the sector has positioned itself for continuous consolidation. The report provides several reasons for the increased number of transactions, from the emerging technological prospects of creating fuel from waste products (akin to the “Mr. Fusion” powered DeLorean from Back to the Future II) to the impact of China’s “Operation Green Fence.” The “Green Fence” directive, implemented in late 2013, was aimed at stemming the tide of waste products exported to China from other jurisdictions, which totaled a staggering percentage of global plastic waste in the last decade. In 2017, China announced a complete ban on future plastic waste imports. For the UK, the potential loss of China as a market may have led companies to insure against risk by making acquisitions to bolster their domestic waste processing operations.

The report also highlights a marked increase in deals involving recycling companies, rising by 50% relative to 2016. This may be partly due to the recovery of global oil prices, but the economic stake of recycling companies has also been growing in line with a renewed focus by governments on the “circular economy”, which imagines resources being used for as long as possible. Initiatives such as Norway’s plastic bottle deposit system and Vancouver’s proposed requirement for all single-use cups and containers to be made of recyclable materials are examples of policies which may result in continued consolidation M&A in the recycling industry as companies seek to take advantage of new opportunities.

Canadian waste management and recycling companies have undergone some degree of consolidation, though not on the same scale as in the UK and US. However, with thousands of independent businesses in the Canada’s waste management and recycling industry and Canada’s position as one of the world’s biggest per capita generators of waste, the Canadian industry may soon follow the M&A trends set by its neighbours to the south.

[1] See: Grant Thornton UK LLP, “Annual Waste and Resource Management Review” (May 2018) at: https://www.williamblair.com/News-Items/2017/June/23/Waste-Expo-2017.aspx

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Evaluating the risks of open source software in M&A transactions

Open source software (OSS) has emerged as a significant market disruptor in recent years. OSS serves as an alternative to commercial software licensing wherein the licensee does not need to pay for the license. This tends to make it particularly attractive to start-ups attempting to keep their costs down. However, the free use of the OSS comes with some additional considerations which need to be managed before an acquirer purchases a company making extensive use of OSS.

Some analysts have noted that, in the acquisition context, OSS can present a number of challenges, including security risks and compliance. Compliance obligations can arise through the licenses of use for the OSS and understanding the nature of these risks going into a transaction can ensure a smoother transition. A possible method for of doing so may require the acquirer asking the target to manage any compliance issues beforehand, while another suggests that the acquirer devise strategies for addressing compliance issues once the transaction is complete.[1] Ideally, a target company will exercise best practices for tracking where OSS is used in its products. However, there may be undisclosed uses of OSS which an acquirer will need to be aware prior to undertaking a purchase. Otherwise, undisclosed uses of OSS can potentially result in costly liabilities and obligations.

Another method for managing the risks of OSS involves the use of an open source audit, which is a process by which the product’s code is mapped against third party code to determine the origin of certain aspects of the software. Importantly, this process can reveal which parts of the OSS are an original, proprietary development. The use of an audit gives the acquirer a relational map of which obligation arise as a result of any OSS integrations. These can assist in catching instances where OSS was used in a product, but the developer failed to track. The acquirer can further use an open source audit to determine a realistic value of the target’s software developments and plan for any roadblocks on the path to commercial distribution of the software.

Technical audits are an essential feature of any acquisition and can give the acquirer an understanding of the obligations that come with the integration of the OSS into the target’s systems.

[1] See: Ibrahim Haddad, Open Source Audits in Merger and Acquisition Transactions: The Basics You Must Know (The Linux Foundation, 2018).

The author would like to thank Tom Sutherland, summer student, for his assistance in preparing this legal update.

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Holding an oil and gas licence: a privilege, not a right

Say you are about to buy, sell, or invest in an Alberta oil and gas company. You are conducting your due diligence, negotiating the transaction documents, pursuing any necessary approvals and are looking forward to closing. Before you can proceed, get ready to add another item to your closing checklist. The Alberta Energy Regulator (AER) has recently made some changes concerning oil and gas licences and approvals that you will need to consider.

In December 2017, the AER re-issued Directive 067: Eligibility Requirements for Acquiring and Holding Energy Licences and Approvals. The revised directive tightens the eligibility requirements for individuals and companies to hold oil and gas licences and approvals in Alberta and gives the AER greater scrutiny regarding such licences and approvals. These new requirements could delay, increase the cost of or halt oil and gas related M&A transactions.

Parties should consider the following steps at an early stage of a transaction involving a target entity which is an AER licensee of oil and gas assets to see if Directive 067 could be a roadblock to a successful closing:

1. Do the extra due diligence to determine who is or will be in charge of the target entity

In addition to the standard suite of due diligence searches you may be conducting on the target entity, make sure that you are also doing your diligence on its current and/or proposed directors, officers and shareholders.

Consider checking the AER Compliance Dashboard to see if there are any outstanding compliance or debt issues involving any of the relevant parties and individuals involved in the transaction, as well as reviewing the “Section 106 Named Individuals” list on the AER’s website which names individuals who have been in contravention of AER requirements and will likely be prevented from working as a director, officer, agent or person in control of company subject to AER regulation.

2. Does the transaction cause a material change to the target entity?

A material change includes, but is not limited to: (1) a change to legal status or corporate structure; (2) an amalgamation, merger or acquisition; and (3) changes to directors, officers or control persons, being persons that hold or control more than 20% of a licensee’s outstanding voting securities.

An updated eligibility application form must be provided to the AER within 30 days of such material change, with the potential result that the AER revokes eligibility or imposes stricter terms on the licensee, if they feel such change creates an unreasonable risk.

If the transaction is likely to cause a material change to the target entity, the parties should request an advance ruling from the AER regarding whether the AER considers such change to be an unreasonable risk. Depending on the AER’s ruling, the parties can then proceed accordingly, including considering whether to continue with the transaction.

3. Do the transaction documents need AER-specific closing conditions or stipulations?

Depending on the circumstances, the purchase and sale agreement may need to include closing conditions with respect to an AER advance ruling, and representations and warranties with respect to the prospective purchaser’s structure, proposed team or its financial stability.

Further changes expected

There is still uncertainty regarding the impact of the changes to Directive 067 and future AER initiatives on oil and gas M&A deals in Alberta. More changes by the AER are anticipated as they attempt to further tighten their procedures for licensing and approvals which could have further impact on the Alberta oil and gas industry.

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Regulators comment on securities law implications for offerings of tokens

On June 11, 2018, the Canadian Securities Administrators (“CSA”) published Staff Notice 46-308 Securities Law Implications for Offerings of Tokens (“Notice”).

The Notice follows from the CSA’s previous guidance in Staff Notice 46-307 Cryptocurrency Offerings, where the CSA explained that many cryptocurrency offerings involve the distribution of securities and are therefore subject to securities laws (including prospectus, registration, and/or marketplace requirements). The Notice expands upon this guidance to focus in particular on offerings of “utility tokens,” which is an industry term often used to refer to a token that has one or more specific functions, such as allowing its holder to access or purchase services or assets based on blockchain technology.

The CSA explained that the fact that a token has a utility is not, on its own, determinative of whether an offering involves the distribution of a security. Most offerings of tokens which the CSA reviewed have involved the distribution of a security, namely an investment contract. In determining whether an offering of tokens involves the distribution of an investment contract, businesses and their advisors should consider and apply the case law interpreting the term “investment contract”, including whether the offering involves:

  1. An investment of money
  2. In a common enterprise
  3. With the expectation of profit
  4. To come significantly from the efforts of others

Examples of situations involving an investment contract

The Notice provides a non-exhaustive, illustrative list of examples of situations that may suggest the presence of an investment contract:

  • Platform not yet available. The proposed function of the token is to access or purchase goods and/or services on a software, online platform, or application, but that software, online platform, or application is yet to be made available to the holder of the token.
  • No immediate delivery. The token is not immediately delivered to purchasers.
  • Tokens as capital. The issuer states that the purpose of issuing the token is to raise capital.
  • Bounty program. The issuer offers free tokens or other benefits in exchange for promotion of the offering.
  • Management compensation. The issuer retains a significant number of tokens for its management as a form of compensation.
  • Reliance on management. The issuer has made representations that its management’s skills or expertise will likely increase the value of the token or that the token will have uses beyond the platform (for example, as a currency).
  • Finite number of tokens. Access to tokens, or the number of tokens issuable, is finite.
  • Disproportionate price-to-value. Issuer permits or requires the purchase of a large amount of tokens that does not align with the purported utility of tokens. For example, purchasing tokens in the amount of $100,000 that can be used only for downloading music for personal use.
  • Marketing to unlikely consumers. The offering targets persons who would not reasonably be expected to use the issuer’s product, service or application.
  • Representation by management. Management represents that the tokens will appreciate in value or compares them to other cryptocurrencies which have appreciated in value.
  • Tradeable on trading platforms. The tokens are reasonably expected or marketed to trade on one or more cryptoasset trading platforms or to otherwise be freely tradeable in the secondary market.

The CSA further expressed concern where offerings structured in multiple step are used in an attempt to avoid securities requirements. Regulatory and/or enforcement actions will continue against businesses which do not comply with securities laws.

While the Notice provides much needed guidance on token offerings, businesses must keep in mind that every token offering is unique and requires a detailed analysis of its characteristics to determine the applicability of securities laws. For more information or advice, please contact our cryptocurrency team at Norton Rose Fulbright Canada LLP.

The author would like to thank Alexandra David, summer student, for her assistance in preparing this legal update.

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Competition Bureau opens consultation on revised immunity and leniency programs

Last month, the Competition Bureau issued its revised immunity and leniency programs for public consultation (open until June 29), an important development as it represents the culmination of a process that began in 2015.

An initial draft of the immunity program, published last fall, was subject to public consultation and the Bureau made further revisions which aim, among other things, to clarify the Bureau’s approach.

Background

The immunity and leniency programs’ purpose is to uncover and stop criminal anti-competitive activity prohibited by the Competition Act. In fact, the programs have been described as one of the Bureau’s best tools to deter and stop criminal anti-competitive agreements.

The Bureau is responsible for investigating wrongdoing and recommending immunity and leniency to the Public Prosecution Service of Canada (PPSC). PPSC is then responsible for deciding if charges should proceed and who should be charged. The decision to grant immunity or leniency ultimately rests with PPSC counsel.

Immunity and leniency are extraordinary grants. The Crown can effectively forego prosecution or allow recommended sanctions to be reduced. The rationale for doing so lies in the public interest: offering immunity from prosecution can help the Bureau and PPSC with their investigations and prosecutions of other offenders participating in serious criminal activity.

The proposed changes

One of the main changes to the immunity program is the proposed increase to the number of steps required to obtain immunity. Currently, there are three steps: (1) marker, (2) proffer and (3) immunity agreement.

An additional stage is being proposed by the revised draft immunity program as a new third step – the interim grant of immunity, which is intended to facilitate faster access to documents and witnesses. This step was proposed in the initial 2017 public consultation, but came with concerns it would introduce uncertainties to the process, notably lengthening the timeline to finalize an immunity agreement.

Another change affects the proffer process. Usually, immunity applicants provide proffers verbally. Notes are taken, but no audio, video, or transcript recordings are made, minimizing the creation of records that could be subject to disclosure. The initial 2017 public consultation contemplated audio recordings, but did not refer to a paperless process. The revised version would permit a paperless process and it indicates subsequent witness interviews following the immunity grant may be recorded, while also addressing certain concerns brought forward.

A third change to the immunity program deals with privilege claims. The 2018 revised version does not contain the same regime as the initial 2017 public consultation, which had a detailed protocol for privilege claims and due process concerns. It now provides for an independent council to be used when agreed upon by the parties to resolve a disagreement regarding privilege.

The leniency program has also seen some changes since 2017. The 2018 revised version states that every leniency applicant may be entitled to (1) a cooperation credit of up to 50% and (2) an additional 10-20% credit for having an effective corporate compliance program in place. These credits would reduce the fine the party may otherwise face for committing a criminal offence under the Act.

Submissions

The consultation process ends on Friday, June 29.

Please contact our team at Norton Rose Fulbright Canada LLP to prepare submissions and advocate on your behalf to the Bureau.

The author would like to thank Justine Smith, articling student, for her assistance in preparing this legal update.

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Streamlining due diligence 101 – establish your virtual data room early

Whether you are gearing up for an acquisition or are in the early rounds of fundraising, one of the most valuable tools is often the most overlooked: the use of a Virtual Data Room (VDR). VDRs are not uncommon (gone are the days of physical data rooms) – rather, the planning of a VDR tends to be an after-thought. The pressure to create one from scratch, with a potential transaction looming, can be daunting.

Regardless, whether dealing with a potential buyer or investor, a common expectation among the parties is to see the same types of documents when conducting due diligence. Establishing a well-organized and comprehensive VDR ahead of time is an invaluable way to ensure that future transactions are assessed on their merits, while promoting transparency in the eyes of the counterparty.

The due diligence process can be tedious and complex, but neglecting to organize the process can potentially be fatal to a transaction. VDRs are a great tool to streamline the process and can be created at any time. In fact, establishing the framework and structure ahead of time will allow your team to focus on more important issues as deadlines approach. Whether this is your first transaction or you are a seasoned veteran, the following are some key details to consider when establishing a VDR:

  1. Know your audience: What documents would you like to see if the situation were reversed? What are the areas of concern that an acquirer or investor has voiced during the negotiations? Flag documents and materials to populate your VDR that will address these issues head-on.
  2. Ask your advisors: Most legal or financial advisors will have been involved in transactions that are similar to what your company is dealing with. It may feel novel to you, but the majority of transactions follow a similar trajectory and a standard form checklist can be provided by your advisors to get things started off on the right path.
  3. Appreciate the nuances: Transactions can be similar but there are going to be specifics that are unique to your company. Identify these differences and address them in the materials you populate your VDR with. Tailor the information as necessary. Can sensitive information be redacted? Do all parties need access to certain documents? These are among the considerations to have in mind.
  4. Shop around: There are a number of VDR providers available and many of them have different functionalities or pricing structures. Canvas the market and pick the right provider for your specific transaction / budget.

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