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INTRODUCTION

Concern with restoring investor confidence in the capital markets and deterring corporate malfeasance has resulted in numerous corporate governance initiatives being undertaken in recent years in Canada. The introduction of these initiatives, together with the increased scrutiny of directors by the public and regulators, has led to concern about the degree of responsibility and liability attaching to appointees to Canadian boards. How these initiatives will affect the assessment of directors' responsibilities and liabilities by the Canadian courts and regulators remains to be seen. In this Bulletin we consider the current standard of care imposed by Canadian corporate law on directors and how this standard of care has been interpreted, with a view to determining the effect the new initiatives, and in particular the new audit committee rules introduced by the Canadian Securities Administrators (the "CSA"), may have on directors' duties and liabilities.

A RE-CAP OF RECENT GOVERNANCE INITIATIVES

Following a ten-month consultation initiated by the Ontario Securities Commission (the "OSC"), the CSA¹ released for public comment new proposed rules regarding audit committee composition and functions (the "Audit Committee Rule").² These rules, together with those relating to certification of interim and annual financial statements and public company auditor independence requirements, represent the first foray of the CSA into corporate governance. Corporate governance has traditionally been the domain of corporate statutes and The Toronto Stock Exchange which, prior to the entry of the CSA into the area, had published proposed amendments to its Listing Rules that, for the first time, moved from a solely disclosure-based policy on governance to a rules-based policy. These amendments have been postponed and may be eliminated in light of the CSA initiatives. For further details on the TSX Proposals see our December 2002 InfORmation Bulletin.

The CSA also anticipate introducing corporate governance policies regarding the creation and maintenance of compensation and nominating committees, board independence and requirements for the creation and disclosure of corporate governance charters, board mandates and codes of ethics.  As a result, the provincial securities regulators will, in the future, more closely prescribe how Canadian public companies and their directors govern their affairs.

The federal government also indicated in the last budget that it is considering the introduction of amendments to federal corporate law regarding nominating and compensation committees and mandates for nominating committees.

REQUIREMENTS OF THE AUDIT COMMITTEE RULE

The Audit Committee Rule addresses two principal concerns of the CSA: the independence of the audit committee from management and the establishment of committees with appropriate expertise.  As a result, each issuer (other than venture issuers) must have an audit committee consisting of at least three members, each of whom must be independent.  Independence will be based upon the director not having a material relationship with the issuer.  In order to ensure an effective audit committee, the Audit Committee Rule requires that each member of the audit committee be "financially literate".  The definition of financial literacy is the ability to read and understand a set of financial statements that present a breadth and level of complexity of accounting issues comparable to those which might be raised in the issuer's financial statements.  In enacting this definition of financial literacy, the CSA recognize that the financial literacy of audit committee members may differ between issuers.

The Audit Committeee Rule will also require an issuer to disclose if there is a "financial expert" on the audit committee, and if not, why not.  The definition of financial expert is similar to that adopted under the U.S. Sarbanes-Oxley Act of 2002 and provides that such expert must have all of the following five abilities:

• an understanding of financial statements and generally accepted accounting principles ("GAAP") used by the issuer to prepare its financial statements;
• an ability to assess the application of GAAP in accounting for estimates, accruals and reserves;
• experience in preparing, auditing, analysing or evaluating financial statements that would raise accounting issues comparable to those of the issuer, or in supervising persons engaged in those activities;
• an understanding of internal and financial reporting controls; and
• an understanding of the audit committee functions.

The CSA have chosen not to include a "safe harbour" regarding directors' liabilities in the Audit Committee Rule as the U.S. Securities and Exchange Commission did in their comparable rule, but rather to state in the Companion Policy the view of the CSA that the mere designation or identification of a person as a financial expert does not impose upon such person "any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such person as a member of the audit committee and board of directors in the absence of such designation or identification."  Concern has been expressed that designation as a financial expert may result in increased responsibility for the director concerned and that the view of the CSA will not mitigate the situation.

The Audit Committee Rule also requires the audit committee to have a charter setting out its mandate and responsibilities. The audit committee must have responsibility for certain functions which include direct oversight of the external auditors (including resolution of disagreements between management and the external auditors) and the review of interim and annual financial statements.  The rule further prescribes that the audit committee, in performing these functions, must be allowed to communicate directly with the internal and external auditors.  Disclosure of the committee charter and certain related matters is to be made by the issuer on an annual basis.

The Audit Committee Rule does not provide a private right of action by an investor if these rules are not complied with, but securities regulators will be able to take action against directors or officers under their powers to enforce the provisions of their legislation.

WHAT STANDARD OF CARE MUST DIRECTORS ADHERE TO?

Canadian corporate law generally requires that each director of a corporation in exercising his or her duties shall:

• act honestly and in good faith with a view to the best interests of the corporation (the "duty of loyalty" or "fiduciary duty"); and
• exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances (the "standard of care").³

The fiduciary duty or duty of loyalty concerns the motives of the director's conduct while the standard of care deals with how the director performs his or her duties and exercises his or her skill.  While the standard of care is a single standard, it has both objective and subjective elements.  Whether a director has met the requisite standard of care will be considered not against the purely objective standard of a reasonable person, but rather of a reasonable person in "comparable circumstances".

This wording was considered by the Federal Court of Appeal in Soper v. Canada.⁴ In that case the Court was considering the availability of a due diligence defence for a director in respect of his liability for withholding taxes under the Income Tax Act.⁵ In considering whether a director had established the due diligence defence, the Court held that the common law standard of care had not been reduced by statute and that a director need not exhibit, in the performance of his or her duties, a greater degree of skill or care than might reasonably be expected of a person of his or her knowledge or experience.  Therefore, for a reasonably prudent person who is unskilled, the standard of care required is commensurate with the standard that can reasonably be expected of an unskilled person.  Conversely, the standard will be adjusted upward where a person has considerable experience and expertise, as was the case for the director in the case before the Court.  A director is therefore expected to use his or her skills and education as a reasonably prudent person would in comparable circumstances.  The Court commented that it was more difficult for inside directors to establish such defences due to the amount of knowledge and experience they had in respect of the company's business.

This approach has been considered by the Ontario Securities Commission (the "OSC") in at least two instances.  In Standard Trustco Ltd. et al. (Re),⁶ the OSC, in deciding whether to issue an order of public interest under the Securities Act (Ontario) against the directors of Standard Trustco, considered the responsibility of the directors as a whole and that of specific individual directors.  While all the directors were held to be responsible for the release of misleading financial information, the OSC noted that the audit committee should bear somewhat more responsibility than the other directors, not because of a greater standard of care, but because their circumstances were different.  The circumstances identified by the OSC included the greater opportunity of the audit committee to obtain knowledge and to examine the affairs of the company as opposed to directors who were not members of the audit committee.  In addition, the OSC stated that the inside directors should bear most of the responsibility on the basis of access to information and control.

The recent decision of the OSC in YBM Magnex International Inc. (Re)⁷ reinforced certain principles outlined in Soper v. Canada.  In considering whether to sanction directors of YBM Magnex, the OSC stated that the standard of care for directors and officers is not a professional standard and their conduct is not to be governed by a single objective standard, but rather by a standard that embraces the elements of personal knowledge and background as well as board processes.  The OSC indicated that more may be expected of persons with superior qualifications such as experienced business persons.  As a result the OSC noted that all directors do not stand in the same position.  The decision further recognizes that due to improved access to information, more may sometimes be expected of directors depending on the function they are performing.  In this decision, those who sat on the special committee and were actively involved in its deliberations were determined to be more responsible than other directors.  In discussing the concept that certain directors may bear more responsibility than others, the OSC also identified members of the audit committee as potentially attracting more responsibility.  The OSC stated that an outside director who takes on committee duties may be treated like an inside director with respect to matters covered by the committee's work.

These decisions highlight that the skills and expertise of the director, the exposure of the director to knowledge and information and the function of the particular director may well be considered by the courts and regulators as important factors in determining the standard of care applicable to such director.

WHAT EFFECT WILL CORPORATE GOVERNANCE INITIATIVES HAVE ON DIRECTORS' LIABILITIES?

The provincial securities commissions, as stated above, have the power to enforce their rules and sanction directors who do not meet the standards set out in the securities legislation.  Such regulators do not have the power to amend or alter the common law or statutory standard of care for directors prescribed by Canadian corporate legislation, nor have they provided for a private right of action by shareholders to enforce violations of these requirements.  Therefore the proposed initiatives of the CSA do not alter the standard of care set out in Canadian corporate law which remains applicable to all directors.

That said, the proposed initiatives, while not changing the law, will provide courts and regulators with standards of behaviour and expertise against which to judge the activities of directors.  It is difficult to imagine that the courts will not consider the Audit Committee Rule and other initiatives in determining whether the standard of care has been properly discharged by a particular director.  The OSC has indicated a willingness not to treat all directors equally in the past and the recent governance initiatives will likely continue this trend and impose a higher responsibility on directors or officers who sit on particular committees or who are designated as having particular skill or expertise.

The requirement of the Audit Committee Rule that audit committees undertake specific functions, in particular direct oversight of the external auditors, may in the case of some issuers result in an increase in duties of the current committee.  The entrenchment of the expected functions of the committee and its members in a published charter may be interpreted by the courts as setting the minimum standards that an audit committee and its directors must meet.  As a result, the charter and requirements imposed by the Audit Committee Rule will provide issuer-specific evidence of the functions of the audit committee and what opportunities the audit committee had to perform these functions.  A court would likely consider the audit charter as a checklist of what the audit committee was required to do and failure to perform any of the functions required of it would mean that the standard of care for audit committee members was not met.  For example, an audit committee that failed to meet independently with its external auditors about concerns when the opportunity to contact the auditors directly and independently is prescribed in the legislation and the audit committee charter would be unlikely to meet the prescribed standard of care.  Many charters include exculpatory language to mitigate liability of members.  The effectiveness of such language has yet to be interpreted by the Canadian courts.

Secondly, the delineation of functions among the various committees may be considered by the courts in determining which directors should bear more responsibility for failure to meet the standard of care in respect of a particular function.  As seen from the OSC decisions, directors who are members of committees empowered to undertake certain matters are likely to bear more responsibility than other directors.  Again, documenting such functions will provide courts and regulators with evidence as to the respective roles of directors.

In allocating responsibility among members of a single committee, whether the designation of an audit committee member as a financial expert implies that the member bears more responsibility than another member is a difficult question.  The purpose of requiring a financial expert to be designated and of the general financial literacy requirement was to ensure that audit committees were constituted with persons with the necessary expertise to discharge the committee's functions.  Where directors have particular expertise that may allow them to better judge the deficiencies of the information given to them or the actions taken by the company, it is clear they are responsible for using that expertise (YBM Magnex ).  Therefore a financial expert, by reason of his or her skills, may well be judged differently from other members of the audit committee, given that the standard of care is both an objective and a subjective one.  While it may be correct to state that designation alone does not impose any greater duty, as set out in the Companion Policy, that position is not binding on the courts and it remains to be seen whether designation will be considered by the courts as a presumption regarding a director's expertise, and further,  whether such designation will be considered by the courts in determining whether other directors relied on him or her because of it.  In spite of this, designation will certainly assist a court in assessing the subjective element of a director's duties.  In such circumstances, a court might reasonably determine that holding out such individual to shareholders as an expert establishes the subjective standard of care and such individual may well be judged to be held more responsible than a director who is not held out as an expert.

CONCLUSION

It is not unreasonable to conclude that, in light of the CSA governance initiatives, the standards and expertise expected of a director will become higher in the future.  The corporate environment has changed with the result that there will be an increased focus on director conduct, increased documentation and evidence before the courts regarding the role of directors and the proper discharge of such duties and increased expertise required of directors, especially those who sit on audit committees and other specialized committees. Whether this will result in increased responsibility or liability attaching to specific directors is uncertain; however, it is not unreasonable to expect that a court or regulator will bring about this result.

1. The proposed rules were published for comment on June 27, 2003.  They are expected to be adopted in all Canadian jurisdictions except British Columbia and introduced in the first half of 2004.
2. Multilateral Instrument 52-110 (Audit Committees) and Companion Policy 52-110 CP.  The public comment period on the Multilateral Instrument and the Companion Policy expired on September 25, 2003.  It is anticipated that the final version of the Multilateral Instrument and the Companion Policy will be published shortly.
3. Canada Business Corporations Act, s. 122(1) and Business Corporations Act (Ontario), s. 134(1).
4. (C.A.) [1998] 1 F.C. 124.
5. The standard of care prescribed by the Income Tax Act is virtually identical to that contained in most Canadian corporate legislation.
6. (1992) 15 OSCB 4322.
7. (2003) 26 OSCB 5272.

©OGILVY RENAULT 2003 - All Rights Reserved

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