Issues Facing Technology Companies in Canada

Overview of the Technology Marketplace in 2004

After a dismal market for Canadian and U.S. technology companies from 2001 through 2003, 2004 demonstrated an improving environment in terms of both increased revenues and stock performance. Revenues generally grew among technology companies, but growth was choppy. Certain technology sectors performed well, while others-notably the telecommunication equipment manufacturers-continued to struggle. Performance differentials were also apparent in comparing technology companies of different sizes. The larger Canadian technology companies, such as Cognos and RIM, performed better in 2004 than their smaller public and private competitors.

Overall M&A activity in the past year was modest, although certain large hardware companies-Broadcom, Ciena and Cisco in particular made a number of strategic purchases in 2004, and a trend to consolidation among software solution providers (driven by customers' wishes) was apparent. Especially interesting and encouraging on the M&A front in 2004 was a decrease in private companies engaging in M&A at fire-sale prices or in connection with windup transactions relative to those engaging in strategic mergers and acquisitions with public companies in order to grow or to fill gaps in the acquiror's product portfolio. Initial public offerings continued to be quite limited in 2004.

Successful IPOs, such as those of Google, Salesforce.com and Eyetech Pharmaceuticals, were counterbalanced by a number of companies that went public in 2004 (especially early in 2004) and that are currently trading below their initial offering prices.

U.S. venture capital continued to express interest in Canadian technology companies. In particular, U.S. interest in the Canadian life sciences sector heated up considerably in 2004. Canadian entrepreneurs continue to see the United States as a viable and attractive arena in which to raise capital and develop relationships. With respect to domestic financing options, Ontario acted in 2004 to halt the creation of new labor-sponsored investment funds and make changes to the rules governing existing funds. Consolidation in the labor-sponsored investment fund arena should allow the funds that survive to commit to being long-term investors with sufficient capital to fund their portfolio companies through successive rounds of financing.                                   

Governance

Public Canadian technology companies, other than a short list of notable exceptions such as Nortel, Cognos, RIM and ATI, are generally smaller than Canadian-listed issuers in other industries. The increase in corporate governance rules therefore has a relatively larger impact on technology companies, both in terms of the time and effort management would otherwise dedicate to growing the business and in terms of out-of-pocket fees to lawyers, accountants and other consultants to advise on these matters. Private technology companies may also feel pressure to comply with the new rules to appear as "good corporate citizens" to investors. The increased burden is leading a number of smaller public companies to consider privatization alternatives (as well as M&A paths).

Canadian Investor Confidence Rules Finalized

Under final rules adopted in the first quarter of 2004, and related measures, Canadian securities administrators imposed a number of control and certification rules to strengthen investor confidence in the public filings of issuers. The rules and requirements are substantially similar to comparable provisions of the U.S. Sarbanes-Oxley Act of 2002, and U.S. stock market requirements. The measures are subject to recently extended phase-in provisions and certain issuers (e.g., foreign and venture issuers receive slightly different treatment). Highlights of the new rules include the following:

• Certification of Annual and Interim Filings. Four times a year, the chief executive officer and chief financial officer must personally certify that, to their knowledge, the issuer's AIF and interim filings (i) do not contain a misrepresentation; and (ii) fairly present in all material respects the issuer's financial condition, results of operations and cash flows as of and for the periods presented in the filing.

• Disclosure Controls. The CEO and CFO must design, or supervise the design of, controls and procedures to provide reasonable assurance that information required to be disclosed by the issuer in its AIF or other reports filed under securities legislation is recorded, processed, summarized and reported within applicable time periods. Controls must encompass procedures for accumulating and communicating information to management to allow for timely decisions regarding required disclosure. Four times a year, the CEO and CFO must certify that they have designed or reviewed the controls, and on an annual basis attest to the effectiveness of such controls.

• Internal Control over Financial Reporting. The CEO and CFO must design, or supervise the design of, a system intended to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. As with disclosure controls, the CEO and CFO must certify four times a year that they have designed or reviewed the system and corrected any deficiencies. Many U.S.-listed companies are already subject to so-called 404 audits, under which external auditors must audit and report on these controls. Most Canadian-listed-only companies will become subject to comparable expensive and time-consuming audits commencing in the 2006-2007 range.

• Ontario Bill 198. This Bill will impose extended liability for secondary market disclosure and is expected to be proclaimed in 2005. The Bill will promote increased focus by directors on the other investor confidence provisions.

Role and Composition of Audit Committees

Issuers must have at least three directors on their audit committees, all of whom must be "independent" in accordance with a recently revised detailed definition. Venture issuers are not subject to this requirement, although corporate law may require them to have an audit committee comprising a majority of non-management directors. All members of the audit committee of an issuer must be financially literate or become financially literate within a reasonable period after appointment. Financial literacy is judged on the ability to read and understand financial statements of comparable breadth and level of complexity to the issuer's financial statements.

Each audit committee must have a written charter that sets forth its mandate and responsibilities. The audit committee is now responsible for engaging and overseeing the work of the external auditors, including resolving disputes, pre-approving all non-audit services and reviewing the financial statements, MD&A and earnings news releases of the issuer before information is publicly disclosed. Each audit committee must establish procedures for the receipt, retention and treatment of complaints about accounting, internal controls or auditing matters and for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters ("whistleblower procedures"). Audit committees must be given the authority to engage independent counsel and other advisers, set the compensation for any advisers retained and communicate directly with the internal and external auditors.

New Corporate Governance Best Practices and Disclosure Rules

Canadian securities regulators recently finalized their (a) policy setting out corporate governance guidelines that reflect best practices, and (b) disclosure rule requiring public companies to describe specific aspects of their governance practices.  The disclosure rule will apply to financial years ending on and after June 30, 2005.

The governance guidelines are thoughtful, and are very similar in substance to the listing standards of the New York Stock Exchange, reflecting current North American best practices in governance, which public companies will want to consider. These guidelines are not dramatically different from the 14 corporate governance guidelines adopted by the Toronto Stock Exchange in 1995. They deal with board composition; meetings of independent directors; board mandate; position descriptions of the CEO, board and committee chairs; orientation and continuing education; code of business conduct and ethics; nomination of directors; compensation; and regular board assessments.

The governance guidelines are not mandatory. Public companies are simply encouraged to consider them when formulating their own governance practices, thus continuing the approach favoured by the Toronto Stock Exchange. It is this feature—voluntary compliance coupled with a disclosure requirement—that distinguishes the Canadian approach from mandatory listing standards adopted by the U.S. stock exchanges for U.S. domestic issuers.

Relationship of the Board and Management

The combination of the new regulatory environment and additional investor and media scrutiny of corporate governance practices has produced a number of noteworthy dynamics at the board level, among executives in management and between the board and management. This is especially true with technology companies, which have historically had insular boards comprising investors and members of management.

Based in part on new committee composition requirements, more independent directors (especially those considered "financially literate") are being sought. Directors are taking their responsibilities more seriously and demanding timely and useful information, firm meeting dates, an annual board agenda and leadership through the board's responsibilities. The renewed dedication to board responsibilities is a positive step in corporate governance, but does increase the financial burdens on smaller technology companies.

Separation of the roles of the chairman and CEO is increasing, in recognition of the fact that the board's business is different from that of management. On boards where one individual holds the chairman and CEO titles, there is increasing use of lead directors to ensure leadership and independent functioning of the board.

Management relationships have become increasingly complicated. Corporate governance changes have stressed that executives have duties beyond those owed to their management superiors. Apart from the need to implement and manage whistleblower programs, executives and general counsel are being held responsible for securities and accounting transgressions that they should have reported to others (at least to relevant directors). Both the SEC and the Law Society of Upper Canada have instituted so-called up-the-ladder reporting requirements that formalize these obligations. Technology companies should expect to see action in this area, as their business (involving the exploitation of intellectual property) tend to offer much room for significant judgment calls.

The increase in director responsibility and workload is reflected in demands for increased director compensation. On many boards, compensation has doubled for directors, and key board and committee members (and particularly the audit committee chair) often receive substantial additional compensation. Directors are also increasing their use of advisers to deal with complex accounting, compensation, legal and human resources issues.

Directors are increasingly focused on D&O insurance, and there is new sophistication being brought to bear on coverage proposals. The D&O insurance market is not an efficient one. While D&O premiums soared in the last five years even as available coverage contracted, 2004 saw a return to the market of many traditional insurance sources and first entries by others into the D&O field. Premiums are lower, and available coverage is greater now than it was a year ago—but still a substantial expense for many smaller technology companies. Beyond limits, D&O issues now include careful attention to the divergent needs of the company, management and the directors, as evidenced in rescission claims, requests for severability and Side A coverage and independent director coverage.

Expensing Stock Options

As of January 1, 2004, Canada became the first major jurisdiction to require expensing for all public company stock options awards made to employees, officers and directors. Section 3870 of the Accounting Standards Handbook dealing with stock-based payments is effective for financial years of public companies beginning on or after January 1, 2004 (January 1, 2005, for most private companies). The new rule requires all share-based compensation transactions to be measured on a "fair value" basis.

When the Canadian Accounting Standards Board announced the adoption of the new rules, it stated that its plan was to harmonize the Canadian standard with the U.S. standard, once known, and to strive to ensure that both standards converge with the international standard. The new U.S. rule issued by the Financial Accounting Standards Board has been announced and will take effect June 15, 2005. As a result, further changes in this area may be expected.

Continuous Disclosure Harmonization and Enhancements

National Instrument 51-102—Continuous Disclosure Obligations, adopted February 16, 2004, makes the continuous disclosure obligations for reporting issuers uniform in all Canadian provinces and territories. Highlights include

• accelerated annual and interim filing deadlines for issuers other than venture issuers of 45 days from quarter-end and 90 days from year-end, and

• revisions to existing continuous disclosure forms and expanded filing requirements. New filing requirements include filing

• a "business acquisition report" within 75 days of the completion of a significant acquisition (based on 20% of assets, revenues or investments test) describing the business acquired and attaching historical and pro forma financial information, and

• agreements that materially affect the rights or obligations of security holders generally, including the issuer's articles and bylaws, any shareholder or voting trust agreements or rights plans, and

                        • material contracts not made in the ordinary course.

Ability for Canadian Companies to Look Like U.S. Public Companies

Canadian technology companies are increasingly seeking access to the United States to raise capital in addition to selling their products and services. Foreign companies often find it desirable from a capital-raising perspective to make it as easy as possible for U.S. investors to compare them to other U.S. companies on an "apples to apples" basis. As a result, many Canadian technology companies have already listed, or are considering listing, their shares on U.S. stock markets and preparing their financial statements in accordance with U.S. GAAP.

National Instrument 52-107—Acceptable Accounting Principles, Auditing Standards and Reporting Currency and National Instrument 51-102—Continuous Disclosure Obligations, each adopted in the first quarter of 2004, give Canadian cross-border issuers (companies that are reporting issuers in Canada and that have a class of securities registered under U.S. securities laws) more flexibility to present themselves in the same fashion as their U.S. counterparts.

Canadian cross-border issuers are permitted to file financial statements with securities regulators in Canada that have been prepared in accordance with U.S. GAAP. In the first two years of reporting under U.S. GAAP, the issuer must explain any material differences between Canadian and U.S. GAAP as they relate to recognition, measurement and presentation; quantify the effect of such material differences; and provide supplemental disclosure consistent with Canadian GAAP to the extent that disclosure is not already reflected in the issuer's financial statements. If the issuer switches to U.S. GAAP reporting midyear, the previously filed Canadian GAAP interim financial statements must be restated in accordance with U.S. GAAP and be filed with the Canadian securities regulators.

With the notable exception of the recently amended Canada Business Corporations Act, many Canadian corporate statutes (including Ontario 's Business Corporations Act) still require that Canadian GAAP financial statements and an auditor's report prepared in accordance with Canadian GAAP be presented to the shareholders. Now that the Canada Business Corporations Act has been amended, we expect other provincial jurisdictions will follow.

U.S. investors still have trouble investing in Canada because of tax law problems—specifically, the Canadian-U.S. treaty does not recognize LLCs for reduced rates of tax—meaning that it can be costly for LLC investors to get their money out of Canada. Also, Canadian corporate law, though progressive, is not the same as Delaware law. As a result, many U.S. investors insist that Canadian technology companies set up Delaware companies in which the U.S. investors will invest. In addition to the expense, this can cause problems for tax incentives that might otherwise be available to Canadian technology companies, as well as tax problems for the Canadian investors.

IPO and Private Placement Hold Periods Shortened

Effective March 30, 2004, Canadian securities laws that determine how soon after an IPO shareholders may resell their securities were relaxed. Previous rules governing the resale of securities by shareholders following an IPO or a private placement required shareholders who bought securities while the company was private to wait at least one year after the company's initial public offering before selling their securities. This one-year "seasoning period" was eliminated for certain pre-IPO shareholders to permit the sale of securities immediately following the effectiveness of the company's final prospectus. Shareholders who control the company or who have held the securities for less than four months will still be required to observe a four-month seasoning period. Private placement rules have also been relaxed to generally allow all purchasers of securities in a private placement, unless they control the issuer, to resell the purchased securities after four months.

Intellectual Property

In Schmeiser v. Monsanto, the Supreme Court of Canada ruled 5 to 4 that Percy Schmeiser infringed Monsanto's patent to modified canola genes and cells by planting seeds and growing plants containing the patented genes and cells, even though Monsanto's patent did not claim canola plants or seeds themselves. The decision will be welcomed by the biotechnology and agriculture industries in Canada, who were concerned that the Court might apply its controversial 2002 judgment in Harvard College v. Canada (Commissioner of Patents) ("Harvard Mouse"), in which higher life forms (including plants and animals) were deemed unpatentable. The Schmeiser decision is also important for patent applicants in Canada because claims to modified genes and cells should now be allowable without the post-Harvard Mouse limitations imposed by the Canadian Intellectual Property Office.

In Law Society of Upper Canada v. CCH Canada Ltd., the Supreme Court of Canada decided that the "fair dealing" exception to copyright infringement under Canada 's Copyright Act can apply to limited copying of copyrighted material by businesses for research purposes. Although the copying complained of in the decision was limited to photocopying and faxing hard copies of legal decisions, statutes and articles in a law library, the reasoning may also apply to other settings, to other means of copying (such as downloading or printing material that is in electronic form) and to all copyrighted "works," including material on the Internet, computer programs, music, movies, photos and art. It is important to bear in mind, however, that only limited commercial copying will qualify under the fair dealing exception.

In BMG Canada v. John Doe, the Federal Court of Appeal upheld the decision of the Federal Court to deny motions by the Canadian recording industry seeking to compel Canada 's major ISPs to reveal the identities of customers who were allegedly engaged in copyright infringement through the use of peer-to-peer file sharing programs such as KaZaA. The Federal Court of Appeal has left it open to the Canadian recording industry to bring further motions.

In Robertson v. Thomson, the Ontario Court of Appeal ruled two to one that The Globe and Mail did not have the right to use articles it had previously purchased from freelance writers in a searchable electronic archive accessible through its website. The majority of the court determined that the rights granted to The Globe and Mail extended only to newspapers and that a searchable database is not a newspaper. The dissent rejected the notion that a database is not a newspaper and suggested that the format used to archive the articles was not relevant. The Supreme Court of Canada recently granted leave to appeal to both the plaintiff and the respondents from the decision of the Ontario Court of Appeal.

E-Commerce and Ontario 's New Consumer Protection Law

Ontario 's Consumer Protection Act, 2002 imposes new obligations on suppliers and gives new rights to consumers who conduct business on the Internet. These rights and obligations are not widely required in other Canadian provinces or the United States. The new regime, which begins when the Act comes into force on July 30, 2005, applies to consumer agreements entered into on the Internet (a) that involve a payment of more than $50; and (b) if either the supplier or the consumer is located in Ontario when the transaction takes place. Failing to comply with the Act can have significant adverse consequences on suppliers located in Ontario or doing business with Ontario consumers.