AUDIT COMMITTEES: THE NEW CANADIAN RULES

Transcription

1 Fasken Martineau DuMoulin LLP Barristers and Solicitors Patent and Trade-mark Agents Toronto AUDIT COMMITTEES: THE NEW CANADIAN RULES H. GARFIELD EMERSON, Q.C. National Chair Fasken Martineau DuMoulin LLP June 1, 2004

2 TABLE OF CONTENTS Page 1. BACKGROUND TO MI (a) The Regulatory Impact...3 (b) Reporting Issuers subject to MI (c) Exemptions for Venture Issuers RESPONSIBILITIES AND AUTHORITY OF THE AUDIT COMMITTEE...6 (a) Direct Oversight of External Auditors...6 (b) Appointment and Compensation of the External Auditor...8 (c) Pre-Approval of Non-Audit Services by the External Auditor...8 (d) Other Regulatory Audit Committee Responsibilities...11 (e) Authority of the Audit Committee INDEPENDENCE REQUIREMENTS FOR AUDIT COMMITTEE MEMBERS...12 (a) Definition of Independence...12 (b) Relationships Considered to be Non-Independent Material Relationships...14 (i) Employees and Executive Officers of the Issuer...14 (ii) Immediate Family Member who is an Executive Officer of the Issuer...14 (iii) Affiliation with or Partner or Employee of Internal or External Auditor...15 (iv) Immediate Family Member who is Affiliated with or Partner or Employee of Internal or External Auditor...15 (v) Executive Officer of an Entity where Executive Officer of Issuer serves on the Compensation Committee...15 (vi) Receipt of Fees and Direct Compensation...15 (vii) Affiliated Entity (Control Person) of the Issuer...19 (c) Exemptions from requirement for Audit Committee Members to be Independent...21 (i) Exemptions in respect of Controlled Companies...21 (ii) Exemptions in respect of Initial Public Offerings...24 (iii) (iv) Exemption for Exceptional and Limited Circumstances...24 Exemptions for Events outside Control of Member and for Death, Disability or Resignation FINANCIAL LITERACY REQUIREMENTS FOR AUDIT COMMITTEE MEMBERS...27 (a) Definition of Financial Literacy i-

3 AUDIT COMMITTEES: NEW CANADIAN RULES H. Garfield Emerson, Q.C. National Chair Fasken Martineau Within an overall corporate governance framework, effective audit committees must operate within the right corporate culture with the right people performing the right functions. This statement may be illustrated as follows: An effective audit committee must operate within the right corporate culture with the right people performing the right functions The corporate culture must have integrity and transparency Audit committee members must have the right skills and experience Audit committee must carry out the right functions The Canadian Securities Administrators, other than British Columbia, have adopted Multilateral Instrument Audit Committees 1 ( MI or the Instrument ). The Instrument does not, quite naturally, deal with the required corporate culture of integrity and transparency. It does deal with membership and functions of audit committees, requiring reporting issuers to have audit committees that are composed of members who are both independent and financially literate. Among other duties, the audit committee is to be directly responsible for overseeing the work of the external auditor who is to report directly to the audit 1 See, Notice of Multilateral Instrument Audit Committees, (2004) 27 OSCB 792 (January 16, 2004; Multilateral Instrument Audit Committees, (2004) 27 OSCB 837 (January 16, 2004); and Companion Policy CP to Multilateral Instrument Audit Committees, (2004) 27 OSCB 849 (January 16, 2004). MI is also published in (2004) 27 OSCB 3252 (March 26, 2004), with Companion Policy CP.

4 - 2 - committee. The audit committee must fulfil other specific responsibilities and the reporting issuer must annually make required disclosure of the composition and qualifications of the audit committee members. The Instrument came into force on March 30, 2004 and applies to reporting issuers on the earlier of (i) the first annual meeting of the issuer after July 1, 2004, and (ii) July 1, BACKGROUND TO MI Following the unexpected and shocking bankruptcy of Enron Corporation in December 2001, on July 31, 2002, the President of the United States signed the Sarbanes-Oxley Act of 2002 ( Sarbanes-Oxley ) into law. Section 301 of Sarbanes-Oxley added section 10A(m)(1) of the Securities Exchange Act of 1934 (the Exchange Act ) which required the U.S. Securities and Exchange Commission ( SEC ) to direct, by rule, the nine U.S. national securities exchanges and the national securities association which operates Nasdaq to prohibit the initial or continued listing of any security of an issuer, including listed securities of Canadian issuers, that is not in compliance with the audit committee requirements under Sarbanes-Oxley. The SEC subsequently issued final Rule 10A-3 3 under the Exchange Act to implement these requirements of Sarbanes-Oxley. New Rule 10A-3 continues to apply to those Canadian companies whose securities are listed on a U.S. securities exchange or Nasdaq, in addition to the requirements of MI Following the submission of proposed corporate governance rule changes 4 by the New York Stock Exchange ( NYSE ) to the SEC commencing on August 16, 2002, among other things, to incorporate the audit committee requirements of Rule 10A-3 and to implement other significant corporate governance changes to its listing standards 5, on November 4, 2003, the SEC 2 MI , subsection 9.1(2). In Ontario, the Instrument received Ministerial approval on March 9, 2004 as a rule pursuant to subsection 143.3(3) of the Securities Act (Ontario): (2004) 27 OSCB 3142 (March 26, 2004). The authority of the Ontario Securities Commission to make rules regarding audit committees is contained in paragraph 143(1)57 of the Securities Act (Ontario). 3 SEC Release Nos and , Standards Relating to Listed Company Audit Committees (April 9, 2003). 4 SEC Release No , NYSE Rulemaking (April 11, 2003). 5 On February 13, 2002, former SEC Chairman Harvey Pitt asked the NYSE to review it corporate governance listing standards. The NYSE appointed a Corporate Accountability and Listing Standards Committee to review its listing standards which reported to the NYSE board on June 6, The NYSE board approved the Committee s recommendations to enhance its corporate governance listing rules on August 1, 2002.

5 - 3 - approved the NYSE and Nasdaq corporate governance rule changes 6. In regards to the NYSE, its SEC-approved final corporate governance listing standards are codified in section 303A of the NYSE s Listed Company Manual. Canadian companies whose shares are listed on the NYSE are required to comply with the audit committee requirements of Rule 10A-3 under the Exchange Act. 7 Canadian companies listed on the NYSE are not required to comply with most of the NYSE s other new corporate governance rules, but many such Canadian companies may intend to do so voluntarily. 8 The principles of MI are based on and derived from Rule 10A-3, other related Sarbanes-Oxley enactments and the NYSE and Nasdaq listing standards affecting corporate governance that those exchanges adapted in November, (a) The Regulatory Impact In Ontario, MI is not a guideline or policy, but rather a statutory rule having the force of law. As noted, the Instrument was approved by the Minister as a rule pursuant to subsection 143.3(3) of the Securities Act (Ontario) and, as such, constitutes Ontario securities law SEC Release No , NASD and NYSE Rulemaking: Relating to Corporate Governance (November 4, 2003). 7 NYSE corporate governance rules, section 303A.06. For a review of the application of Rule 10A-3 to Canadian issuers, see H. Garfield Emerson, Audit Committees - Rules for Canadian Companies listed on United States Stock Exchanges, (May 2003) Fasken Martineau Corporate Governance Bulletin. 8 In addition to complying with the audit committee requirements of Rule 10A-3, Canadian NYSE-listed issuers must disclose any significant ways in which their corporate governance practices differ from those followed by U.S. domestic companies under NYSE listing standards (section 303A.11) and each Canadian listed company CEO must promptly notify the NYSE in writing after any executive officer of the listed company becomes aware of any material non-compliance with any applicable provisions of section 303A (section 303A.12(b)). 9 In its Notice of Multilateral Instrument Audit Committees, (2004) 27 OSCB 792, the adopting members of the Canadian Securities Administrators said at page 792: The Instrument is based on the audit committee requirements currently being implemented in the United States. In particular, it is derived from the audit committee requirements of [Sarbanes-Oxley], certain requirements of the [SEC] and listing requirements of the [NYSE] and Nasdaq. 10 See the definition of Ontario securities law, regulations and rules in subsection 1(1) of the Securities Act (Ontario).

6 - 4 - It should be noted that it is an offence to contravene Ontario securities law. 11 In addition, every director of officer of a company who authorizes, permits or acquiesces in the commission of an offence, including a contravention of Ontario securities law, is also guilty of an offence. 12 (b) Reporting Issuers subject to MI The Instrument s new requirements for audit committees apply to all reporting issuers, other than 13 (i) subsidiaries that do not have equity securities (other than non-convertible, non-participating preferred securities) trading on a marketplace 14 where the parent of the subsidiary is subject to the Instrument, or is subject to and in compliance with SEC Rule 10A-3 regarding the role and composition of audit committees of issuers with securities listed on a U.S. national securities exchange 15 ; (ii) investment funds 16 ; (iii) issuers of asset-backed securities 17 ; (iv) designated foreign issuers 18 ; (v) SEC foreign issuers 19 ; (vi) exchangeable security issuers 20 ; 11 Clause 122(1)(c) of the Securities Act (Ontario). 12 Ibid., subsection 122(3). 13 Sections 1.2 and 2.1 of the Instrument. 14 Marketplace is defined in National Instrument Marketplace Operation. 15 Subclause 1.2(e) of the Instrument. Accordingly, a wholly-owned subsidiary that is a reporting issuer because it issued debt securities pursuant to a prospectus is not subject to the Instrument. Such a subsidiary would, however, be required to comply with the audit committee requirements of the corporate law of its jurisdiction of incorporation. 16 As defined in National Instrument Continuous Disclosure Obligations ( NI ). 17 Asset-backed securities are defined in NI As defined in National Instrument Continuous Disclosure and Other Exemptions Relating to Foreign Issuers ( NI ). 19 As defined in NI

7 - 5 - (vii) credit support issuers 21. Importantly, in light of the fact that SEC Rule 10A-3 and the listing standards of the NYSE and other U.S. national securities, as well as Nasdaq, apply similarly principled requirements regarding the composition and responsibilities of audit committees to Canadian reporting issuers whose securities are listed in the United States, Part 7 of the Instrument provides that an issuer with securities listed or quoted on a U.S. marketplace is exempt from the principal provisions of the Instrument if the issuer is in compliance with the requirements of the U.S. marketplace applicable to issuers, other than foreign private issuers, regarding the role and composition of audit committees 22. This means that a Canadian company that is a foreign private issuer under the Exchange Act must be is full compliance with the applicable U.S. rules in order to be exempt from the similar provisions of the Instrument, and not simply rely on the exemptions in such U.S. rules available for foreign private issuers. (c) Exemptions for Venture Issuers In addition, there are significant exemptions for venture issuers 23, principally issuers listed on the TSX Venture Exchange, from certain of the principal requirements of the Instrument. First, a venture issuer is exempt from the composition and eligibility requirements for audit committees, namely, the general principles that every audit committee member must be independent and financially literate 24. As a result, the members of a venture issuer s audit committee are not required to be either independent or financially literate. However, venture issuers are required to disclose annually the name of each audit committee member and to state whether or not the member is independent and financially literate 25. Second, a venture issuer is only required to comply with reduced disclosure obligations, compared to other reporting issuers, under Form F2 to the Instrument. Venture issuers are, however, required to have audit 20 As defined in section 13.3 of NI As defined in section 13.4 of NI MI , section 7.1. If the reporting issuer relying on this exemption is incorporated in Canada, it will be subject to the disclosure obligation of clause 7.1(b), if any. 23 Venture issuers are defined in section 1.1 of the Instrument as an issuer that does not have any of its securities listed or quoted on any of The Toronto Stock Exchange, a U.S. marketplace (which is defined in the Instrument as the nine U.S. national securities exchanges and Nasdaq), or a marketplace outside of Canada and the U.S. 24 Ibid., section Ibid., section 6.2 and section 2 of Form F2.

8 - 6 - committees and such audit committees are subject to the Audit Committee Responsibilities of Part 2 of the Instrument referred to below. 2. RESPONSIBILITIES AND AUTHORITY OF THE AUDIT COMMITTEE The responsibilities and duties of the audit committee set out in NI are not meant to be inclusive or exhaustive of all the obligations that the audit committee should satisfy in fulfilling its mandate under the best corporate governance practices. 26 The Instrument contains only those duties that are required by the Canadian securities regulators. Many boards of Canadian public companies currently delegate to their audit committees additional roles and functions that encompass many items beyond those covered by the Instrument. While the Instrument requires the audit committee to have a charter that complies with the requirements of the Instrument 27, it neither requires nor prohibits the audit committee from having additional responsibilities. While Canadian NYSE-listed companies are not required to comply with the provisions of the NYSE corporate governance listing standards that mandate audit committee duties in its charter and address the purpose of an audit committee, section 303A.07(c) of the NYSE corporate governance rules contains a useful list, with commentary, of the roles and responsibilities of an audit committee that are applicable to U.S. issuers listed on the NYSE. (a) Direct Oversight of External Auditors Following the fundamental changes introduced by Sarbanes-Oxley and SEC Rule 10A-3, MI mandates the audit committee to supervise the external auditors of the issuer and implicitly removes authority from management of the issuer to oversee and direct the work of the external auditors. Redirecting the control over the external auditors from management to the audit committee is a significant change that will require major enhancements in most audit committee policies and practices in order to fulfil its new responsibilities in this area. In this regard, the Instrument specifically requires the audit committee to be directly responsible for overseeing the work of the external auditor engaged for the purpose of preparing or issuing an 26 Companion Policy CP to MI also states in section 1.4 that the Instrument is not intended to restrict the ability of the board to establish the audit committee s quorum or procedures. 27 MI , section 2.1.

9 - 7 - auditor s report or performing other audit, review or attest services for the issuer. 28 This oversight instruction to the audit committee covers the audit services 29 provided by the external auditor, and other review and attest services, but does not require the audit committee to oversee all non-audit services 30 for which the external auditor may be engaged. Also the Instrument itself does not impose an oversight function on the audit committee for non-audit services that may be provided by other audit firms who are not elected by shareholders as the external auditors of the company for the purpose of reporting on its financial statements. The charter of the audit committee may, however, extend the mandate of the audit committee to preapprove or receive reports from other auditing firms, who are not the issuer s external auditors, engaged by management for non-audit or consulting services that relate to the financial affairs of the issuer, including risk management assessments, disclosure controls and procedures and internal financial controls. In addition to the direct mandate that the audit committee oversee the audit services provided by the external auditor, the Instrument also specifically instructs the issuer to require its external auditor to report directly to the audit committee. 31 This provision becomes essentially a regulatory term in the retainer letter covering the engagement of the external auditor, whether or not expressly contained in the retainer letter. It is also not limited to audit services and would include the requirement that the external auditor be prepared to report to the audit committee on non-audit services, as well as audit services, for which the external auditor may be retained. (b) Appointment and Compensation of the External Auditor While it has been standard corporate practice for some time in many if not most public companies that the audit committee recommends to the board the nomination of the external auditors for appointment by shareholders, the Instrument now formally requires this 28 Subsection 2.3(3) of the Instrument. While that subsection also directs the audit committee to resolve disagreements between the auditor and management regarding financial reporting, audit committees have in practice performed that function, often at the request of the external auditor. 29 Audit services are defined in section 1.1 of the Instrument as professional services rendered by the issuer s external auditor for the audit and review of the issuer s financial statements or services that are normally provided by the external auditor in connection with statutory and regulatory filings or engagements. 30 Non-audit services are defined in section 1.1 of the Instrument as services other than audit services.

10 - 8 - procedure. 32 Indeed, it is consistent with the audit committee s oversight responsibility of the work of the external auditor that the audit committee, and not management for instance, recommend who should be nominated by the company for appointment by shareholders as the external auditor. While the final decision as to which audit firm should be placed in nomination for appointment as the company s external auditors is that of the board and not the audit committee, the issuer is required to disclose in its annual information form ( AIF ) if the board did not accept the recommendation of the audit committee with respect to the nomination of the external auditor. 33 In addition, the board is also required, in these circumstances, to explain why it did not accept the audit committee s recommendation. The audit committee is also charged with recommending the compensation of the external auditors to the board. 34 This is a natural complementary duty to its oversight responsibility and it is common corporate practice for audit committees to do so. Again, if the board does not adopt the recommendation of the audit committee to compensate the external auditor, the board must disclose this fact in its AIF and explain why it did not. (c) Pre-Approval of Non-Audit Services by the External Auditor The Instrument requires the audit committee to pre-approve all non-audit services to be provided to the issuer or its subsidiaries by the issuer s external auditor. 35 As noted, nonaudit services are services other than audit services (which are basically defined as the services related to the audit and review of the financial statements or services in connection with statutory and regulatory filings 36 ). Requiring the audit committee to pre-approve all non-audit services of the external auditor to the company and its subsidiaries that are proposed by management permits the audit committee to have control over the type, extent and terms of the non-audit or consulting services that the external auditors may provide. This also allows the audit committee to monitor and preserve that aspect of the independence of the external auditors that could be adversely affected by the provision of an undue degree of consulting services to the company by 31 Ibid., section Ibid., clause 2.3(2)(a). 33 Form F1 to MI , section MI , clause 2.3(2)(b). 35 Ibid., subsection 2.3(4).

11 - 9 - the external auditors. The Instrument does not deal with nor require that the issuer engage the external auditor to provide non-audit services. It assumes that the external auditor may be engaged to do so. Some public companies have adopted a policy that they will not retain their external auditor for any non-audit services, or only for limited and specific audit-related nonaudit services, in order to separate completely the providers of audit and non-audit or consulting services to avoid any conflict of interest and threats to the independence of the external auditors. In addition to the requirements of the Instrument relating to the provision of non-audit services by the external auditor, the Canadian Institute of Chartered Accountants and the provincial and territorial institutes of chartered accountants have adopted independence rules that provide, among other things, that the external auditors are prohibited from providing certain types of nonaudit services, whether or not approved by the issuer or its management or audit committee. These prohibited non-audit services are bookkeeping, valuations, actuarial, internal audit outsourcing, IT system design or implementation, HR functions, corporate finance activities, legal services and certain expert services. The audit committee will be required to adopt specific policies and procedures governing its pre-approval process for the engagement of its external auditors to provide nonaudit or consulting services where it permits the external auditor to do so. 37 As part of satisfying its obligations in this area, the policies and procedures governing the non-audit services would include, at least, a detailed list of the non-audit services that are permitted to be provided by the external auditors, a requirement that the audit committee is informed of each non-audit service and that the audit committee does not delegate its responsibilities in this area to management, including its responsibilities to pre-approve such non-audit services. 38 Accordingly, the audit committee cannot delegate to management, including through pre-approval policies, the authority to approve retaining the external auditor for a non-audit service. The audit committee may delegate to one or more of its independent members the authority to pre-approve non-audit services. 39 Where this authority is so delegated and exercised by one or more independent members of the audit committee, which would usually be exercised 36 Ibid., section Ibid., section Ibid., clauses 2.6(a) to (c).

12 without a meeting of the audit committee, those non-audit services that have been so preapproved must be presented and reported to the audit committee at its first scheduled meeting following such pre-approval. 40 MI provides that the audit committee is considered to have satisfied its pre-approval requirement of non-audit services where 41 (i) the aggregate amount of non-audit services that are not pre-approved is reasonably expected to be no more than 5% of the total amount of fees paid by the issuer and its subsidiaries in the fiscal year; (ii) the issuer or its subsidiary did not recognize the services as non-audit services at the time of the engagement; and (iii) the services are promptly reported to the audit committee and approved, prior to the completion of the audit, by the audit committee, or a member to whom authority to approve non-audit services had been delegated. This is a rather narrow exemption to the requirement that the audit committee preapprove all non-audit services by the external auditor. This provision is a safe-harbour to cover the situation where management retains the external auditor in error for de minimis services without recognizing such services as non-audit services at the time of engagement and such nonapproved, non-audit services are subsequently approved by the audit committee before the completion of that year s audit. This example reflects that the policies and procedures adopted by the audit committee with respect to non-audit services should require both management and the external auditor to report all services, audit and non-audit, provided or to be provided by the external auditors to the company and its subsidiaries to the audit committee at each audit committee meeting. 39 Ibid., subsection 2.5(1). 40 Ibid., subsection 2.5(2). 41 Ibid., section 2.4.

13 (d) Other Regulatory Audit Committee Responsibilities While MI is not meant to cover all the duties that an audit committee should perform, it does mandate that the audit committee carry out several other specific tasks. These tasks are the following: (i) the audit committee must review the company s financial statements, MD&A and annual and interim earnings press releases before the issuer publicly discloses this information, 42 which matters are currently within the purview of most audit committees; (ii) the audit committee must be satisfied that adequate procedures are in place for the review of the issuer s public disclosure of financial information extracted or derived from the issuer s financial statements, other than the public disclosure referred to in the preceding item, and must periodically assess the adequacy of those procedures; 43 (iii) the audit committee must establish procedures for: (A) the receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters; 44 (B) the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters; 45 (iv) the audit committee must review and approve the issuer s hiring policies regarding partners, employees and former partners and employees of the present and former external auditor of the issuer Ibid., subsection 2.3(5). 43 Ibid., subsection 2.3 (6). 44 Ibid., clause 2.3(7)(a). 45 Ibid., clause 2.3(7)(b). 46 Ibid., subsection 2.3 (8).

14 (e) Authority of the Audit Committee The Instrument requires that the Audit Committee have specific authorities in order to fulfil its mandate. These authorities that the Audit Committee must have are the right to engage independent counsel and other advisors as it determines necessary to carry out its duties, the right to set and pay the compensation for any advisors employed by the audit committee, and the right to communicate directly with the internal and external auditors INDEPENDENCE REQUIREMENTS FOR AUDIT COMMITTEE MEMBERS (a) Definition of Independence Subject to certain exemptions, including the exemption for venture issuers, all audit committee members must be independent. 48 MI contains a detailed definition of what it means to be independent for the purposes of eligibility to serve on the audit committee of a company that is subject to its requirements. The definition of independence begins with the requirement that the audit committee member must have no direct or indirect material relationship with the issuer. 49 This phrase is then explained in the Instrument by defining a material relationship as a relationship which could, in the view of the issuer s board of directors, reasonably interfere with the exercise of a member s independent judgement. 50 At this point, one can see that it is necessary to have the board of directors affirmatively pass on the independence of those directors that the board intends to appoint to the audit committee. This requirement to involve the board to confirm the independence of the audit committee members follows a similar requirement of the corporate governance listing standards of the NYSE. The NYSE rules provide that no member is independent unless the board affirmatively determines 47 Ibid., section Ibid., subsection 3.1(3). Venture issuers (as defined in section 1.1) are exempt from this requirement: section Ibid., subsection 1.4(1). 50 Ibid., subsection 1.4(2).

15 that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). 51 MI , as well as the NYSE corporate governance rules as noted in the preceding footnote, comments on the broad scope of relationships between a director and an issuer that must be considered in order to determine whether a director has a material relationship with the issuer. Companion Policy CP provides that 52 : In our view, this relationship [between the director and the issuer] may include commercial, charitable, industrial, banking, consulting, legal, accounting or familial relationships. However, only those relationships which could, in the view of the issuer s board of directors, reasonably interfere with the exercise of a member s independent judgement should be considered material relationships within the meaning of section 1.4 [of the Instrument]. (b) Relationships Considered to be Non-Independent Material Relationships MI proceeds, however, then to provide 7 specific circumstances 53 where an individual has or had a relationship with the issuer within a prescribed period that is considered, or in effect deemed, to be a material relationship with the consequence that such individual is not independent for the purposes of satisfying the independent eligibility criteria to be a member of the audit committee. 54 The first 5 of these relationships that are in effect deemed to be material relationships are summarized as follows. 51 NYSE corporate governance rules, section 303A.02(a). The NYSE commentary to this rule states that: It is not possible to anticipate, or explicitly to provide for, all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of a director s relationship to a listed company. Accordingly, it is best that boards making independence determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director s relationship with the company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the [NYSE] does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding. [emphasis added] 52 Companion Policy CP, section MI , subsection 1.4(3), clauses (a) through (g). 54 NI , subsection 1.4(3), subject to the provisions of subsections 1.4(4) through (8).

16 (i) Employees and Executive Officers of the Issuer 55 An individual who is or has been an employee or executive officer 56 of the issuer for the period that is the shorter of (x) the period commencing March 30, 2004 and ending at the date of determination, and (y) the 3 year period ending at the date of determination (the prescribed period ). 57 (ii) Immediate Family Member who is an Executive Officer of the Issuer 58 An individual whose immediate family member 59 is or has been an executive officer of the issuer, unless the prescribed period has elapsed. (iii) Affiliation with or Partner or Employee of Internal or External Auditor 60 An individual who is or has been an affiliated entity of, a partner 61 of or employed by a current or former or internal or external auditor of the issuer, unless the prescribed period has ended. 55 Ibid., clause 1.4(3)(a). 56 Executive officer is defined in section 1.1 of the Instrument as a chair or vice-chair (whether part-time or fulltime); the president; a vice-president in charge of a principal business unit, division or function including sales, finance or production; an officer of the company or any subsidiary who performs a policy-making function; and any other individual who performs a policy-making function in respect of the issuer. In Companion Policy CP to NI , it is noted in section 1.3 that an individual who performs a policy-making function in respect of the issuer includes an individual who is not employed by the issuer but who nevertheless performs such a policy-making function, whether through another person or company or otherwise. Such a relationship could include exercising policy-making functions in respect of a company through a management services agreement with the company. It is also to be noted that the definition of executive officer includes the office of chair and vice-chair. As referred to in the text below, clause 1.4(8)(b) of the Instrument provides that a chair and vice-chair who do not act on a full-time basis are not considered to have a material relationship and therefore remain independent in their capacity as a parttime chair or vice-chair. By way of contrast, the U.S. definition of executive officer in Rule 3b-7 under the Exchange Act does not include reference to the chair or vice-chair. 57 The prescribed period is defined in NI , subsection 1.4(4). The result is that there is no look back or retroactive period prior to March 30, 2004, the date on which the Instrument comes into force. 58 NI , clause 1.4(3)(b). 59 Immediate family member is defined in section 1.1 of the Instrument as the individual s spouse, parent, child, sibling, mother or father-in-law, son or daughter-in-law, brother or sister-in-law, and anyone (other than an employee of either the individual or the individual s immediate family member) who shares the individual s home. 60 NI , clause 1.4(3)(c). 61 For the purposes of both clauses 1.4 (3)(c) and (d), a partner does not include a fixed income partner whose interest in the internal or external auditor is limited to the receipt of fixed amounts of compensation (including

17 (iv) Immediate Family Member who is Affiliated with or Partner or Employee of Internal or External Auditor 62 An individual whose immediate family member is or has been an affiliated entity of, a partner of or employed in a professional capacity by, a current or former internal or external auditor, unless the prescribed period has elapsed. (v) Executive Officer of an Entity where Executive Officer of Issuer serves on the Compensation Committee 63 An individual who is or has been, or whose immediate family member is or has been, an executive officer of an entity if any of the current executive officers of the issuer serve on the entity s compensation committee, unless the prescribed period has elapsed. (vi) Receipt of Fees and Direct Compensation The sixth specific relationship identified in the Instrument that is considered to be a material relationship with the issuer causing the director not to be independent arises where the director (1) receives, directly or indirectly, specific types of fees (namely, consulting, advisory or other compensatory fees ) in any amount, without any de minimis threshold, or (2) receives direct compensation 64 from the issuer in excess of $75,000 per year, other than in his or her capacity as a director or part-time chair or vice-chair. Following the policies established by SEC Rule 10A-3, adopted by section 303A.06 of the NYSE corporate governance rules, the Instrument provides that a director is not independent where: (A) the director accepts, directly or indirectly, any consulting, advisory or other compensatory fee from the issuer or any subsidiary, other than as remuneration for acting as a member of deferred compensation) for prior service if the compensation is not contingent in any way on continued service: NI , subsection 1.4(5). 62 Ibid., clause 1.4(3)(d). 63 Ibid., clause 1.4(3)(e). 64 Section 303A.02(b)(ii) of the NYSE corporate governance rules provides that a director is not independent if the director receives more than $100,000 per year in direct compensation from the company, subject to certain exemptions. The NYSE considers payments to an individual s solely owned business entity to be direct

18 the board or a board committee or as a part-time chair or vice-chair of the board or a board committee; 65 or (B) the director, or an immediate family member, receives more that $75,000 per year in direct compensation from the issuer, other than as remuneration for acting as a member of the board or a board committee or as a part-time chair or vice-chair of the board or a board committee, unless the prescribed period has elapsed. 66 In both of the above cases, the receipt of the compensatory fees, directly or indirectly, from the issuer or any subsidiary and the receipt of direct compensation from the issuer by a director, in each case as remuneration for acting in his or her capacity as a member of the board or a committee, or for acting as a part-time chair or vice-chair, is exempted from or not included in this deemed material relationship disqualification. Accordingly, director and committee retainer and meeting fees, including increased fees for acting as the chair of the audit committee, are not considered as either disqualifying compensatory fees or disqualifying direct compensation even if the amount exceeds $75,000 per year 67. It also follows that a full-time or executive chair of a board of directors who receives direct compensation of more than $75,000 per year is considered to have a material relationship with the issuer. Conversely, a part-time chair of the board that receives more than $75,000 per year in direct compensation is not considered to have a disqualifying material relationship with the issuer 68. Further, the Instrument has a specific exemption to provide that a person who has previously acted as an interim chief executive officer 69 or acts or has previously acted as a partcompensation: NYSE Listed Company Manual Section 303A Corporate Governance Listing Standards Frequently Asked Questions (updated February 13, 2004), Section C, item Ibid., subclause 1.4(3)(f)(i). There is no de minimis or non-material threshold level; the receipt of any such fee in any amount is sufficient to disqualify. 66 Ibid., subclause 1.4(3)(f)(ii). 67 The annual board and dedicated annual retainer fees for a director of the Royal Bank of Canada is $100,000 (excluding meeting and committee fees) and the chair of the audit committee of Royal Bank receives an additional $50,000 retainer fee (excluding meeting fees). 68 The average annual non-executive chair retainer in 2002 for companies with assets greater than $5 billion was $225,000. See, CORPORATE BOARD GOVERNANCE AND DIRECTOR COMPENSATION IN CANADA A REVIEW OF 2003, Patrick O Callaghan & Associates, at p MI , clause 1.4(8)(a).

19 time chair or vice-chair of the board or any board committee 70 is not considered to have a material relationship with the issuer, without any qualification as to the amount of direct or indirect fees or direct compensation received for services in any such capacity. Therefore, in relation to those facts of being a former interim chief executive officer of the issuer or a current or former part-time chair or vice-chair, such an individual remains independent. It is useful to observe that this exemption applies to all of the attributed material relationship factors in subsection 1.4(3), and not just the factor relating to receipt of fees and direct compensation. The Instrument provides that the receipt of both compensatory fees and direct compensation do not include fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the issuer if the compensation is not contingent in any way on continued service. 71 The prohibition on receipt, directly or indirectly, of any consulting, advisory or other compensatory fee is extended by the Instrument to include acceptance of any such fee by a person s spouse, minor child or stepchild, or a child or stepchild who shares the person s home. 72 Of even more significance, however, the indirect acceptance of such a fee is specifically extended to include the acceptance of such a fee by an entity (A) in which such a person is a partner, member, an officer such as a managing director occupying a comparable position or executive officer 73, or occupies a similar position (except limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity), and 70 Ibid., clause 1.4(8)(b). 71 Ibid., subsection 1.4(6). 72 Ibid., clause 1.4(7)(a). 73 Executive officer is a defined term in the Instrument and includes an individual who performs a policy-making function in the company. See, section 1.1 and footnote 53, supra.

20 (B) which provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary of the issuer 74. It should be noted that not all professional, business or commercial relationships between the public issuer and an entity with which the director has an affiliation and which receives compensatory fees from the issuer are deemed to constitute the indirect acceptance of a fee by the director. It is only those professional, business or commercial relationships that comprise accounting, consulting, legal, investment banking or financial advisory services that trigger the disqualification. For instance, where a director of a reporting issuer is partner of a firm or an executive office of a company that sells goods or provides services to the reporting issuer where the services provided are not accounting, consulting, legal, investment banking or financial advisory services, there is no attribution of receipt of an indirect fee and the director is not disqualified under this branch of deemed material relationships 75. For example, in its adopting release for Rule 10A-3, the SEC said that the similar prohibitions in that Rule do not include non-advisory financial services such as lending, check clearing, maintaining customer accounts, stock brokerage services or custodial and cash management services. 76 Whether or not such a professional, business or commercial relationship is itself a material relationship with the issuer, based on other factors, will depend on all the facts and circumstances related to such relationship. (vii) Affiliated Entity (Control Person) of the Issuer The seventh factor contained in MI that defines a relationship that is considered to be a material relationship with the issuer is where an individual is an affiliated entity of the company or any of its subsidiaries 77. This requires an analysis of the definition of affiliated entity which is contained in subsection 1.3(1) of the Instrument. Significantly, that definition provides that an individual is an affiliated entity of a company if 74 Ibid., clause 1.4(7)(b). 75 There is some uncertainty as to what is meant to be included in the phrase other compensatory fee. 76 SEC Release Nos and , Standards Relating to Listed Company Audit Committees (April 9, 2003) at text following footnote MI , clause 1.4(3)(g).

21 (A) (B) the individual controls 78 the company, or the individual is (I) (II) both a director and an employee of an affiliated entity (i.e., both a director and an employee of a person or company that controls the issuer), or an executive officer 79, general partner or managing member of an affiliated entity (i.e., an executive officer, general partner or managing member of a person or company that controls the issuer). Dealing with the definition of control first, unlike the definition of control in most corporate statutes, the control definition in the Instrument is based on de facto control, not de jure control. As in SEC Rule 10A-3 80, the term control is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person or company, whether through ownership of voting securities or otherwise 81. To determine whether a person or company controls a reporting issuer requires a factual determination of any control nexus based on a consideration of all relevant facts and circumstances. The Instrument does contain a safe harbour provision that a person will not be considered to be an affiliated person or to control an issuer if the person owns, directly or indirectly, 10% or less of any class of voting securities of the issuer and is not an executive officer of the issuer 82. Not being able to rely on this safe harbour does not mean that a person is a control person of the issuer. As stated in Companion Policy CP to the Instrument 83 : Subsection 1.3(4) is intended only to identify those persons who are not considered affiliated entities of an issuer. The provision is 78 Ibid., clause 1.3(1)(a). There is a specific definition of control in subsection 1.3(3) for purposes of the Instrument. 79 As noted earlier, the important definition of an executive officer is contained in section 1.1 of the Instrument. See, footnote 53, supra. 80 Rule 10A-3(e)(1) and (4). 81 MI , subsection 1.3(3). 82 Ibid., subsection 1.3(4). 83 Companion Policy CP, section 3.3.

22 not intended to suggest that a person who owns more than ten percent of an issuer s voting equity securities is automatically an affiliated entity of the issuer. Instead, a person who owns more than ten percent of an issuer s voting securities should examine all relevant facts and circumstances to determine if he or she is an affiliated entity within the meaning of subsection 1.3(1). Accordingly, securityholders that do not fall within the safe harbour provision, but believe that they do not control the issuer, can rely on a factual analysis of the relationship with the reporting issuer to disavow a control or affiliated entity status to that issuer. As noted in the SEC adopting release for the similar provisions of Rule 10A-3, on which MI is based: A director who is not an executive officer [of the issuer] but beneficially owns more than 10% of the issuer s voting equity could be determined to be not an affiliate under a facts and circumstances analysis of control. 84 Similarly, a director, employee or executive officer of a company that owns more than 10% of a class of voting securities of an issuer but that does not control that issuer would not be an affiliated entity of the issuer and would be entitled to be a member of the audit committee of the issuer, assuming no other material relationship with the issuer. (c) Exemptions from requirement for Audit Committee Members to be Independent As noted earlier, subject to certain exemptions, including the major exemption with respect to venture issuers 85, every audit committee member of a reporting issuer to which the Instrument applies must be independent 86. There are a number of exemptions from this requirement which are summarized below. 84 SEC Release Nos and , Standards Relating to Listed Company Audit Committees (April 9, 2003) at text following footnote As noted, venture issuers are exempt from the requirements of Parts 3 and 5 of MI : see section 6.1 of the Instrument. Venture issuer is defined in section 1.1 as an issuer that does not have any of its securities listed or quoted on any of The Toronto Stock Exchange, a U.S. marketplace, or a marketplace outside Canada and the United States of America. 86 MI , subsection 3.1(3).

23 (i) Exemptions in respect of Controlled Companies The first exemption is interesting because it is not clear that it is necessary, unless one assumes that being only a director of an affiliated entity or controlling shareholder of a reporting issuer (provided the director is also not an employee or executive officer of the affiliated entity) 87 is, by itself, a material relationship with the reporting issuer that could reasonably interfere with the exercise of that director s independent judgment as a director of the reporting issuer. The exemption provides that an audit committee member that is a director of an affiliated entity is exempt from the requirement that every audit committee member must be independent if the member, except for being a director of the reporting issuer and the affiliated entity, is otherwise independent of the issuer and the affiliated entity 88. This appears to assume that the single relationship of being an independent director of both an affiliated entity and the controlled reporting issuer is a disqualifying material relationship that needs an exemption. It is not clear that this is a necessary conclusion 89, either in all cases as a matter of fact or as an interpretation of the Instrument. While there may be other additional relationship factors that could disqualify an individual who is an otherwise independent director of both an affiliated entity and the controlled reporting issuer, one can at least read this exemption as confirming the interpretation that a material relationship with the issuer does not cover the narrow relationship contained in the exemption and does not disqualify such an interlocking independent director from membership on the audit committee. The contrary position is that such a narrow relationship is itself a disqualifying material relationship, otherwise the exemption would not be required. The second exemption from independence for controlled companies is somewhat more complex 90. It applies to an individual who is otherwise independent but for being an affiliated entity, namely, it allows a controlling shareholder or either a director and employee of 87 If an individual is both a director and an employee, or an executive officer, of an affiliated entity of an issuer, he or she is an affiliated entity of the issuer: paragraphs 1.3(1)(b)(i) and (ii). 88 Ibid., subsection 3.3(1). 89 None of the provisions of subsection 1.4(3) that are considered to constitute a disqualifying material relationship catch the factual relationship covered by the exemption including clause 1.4(3)(g) and the related definition of affiliated entity in section 1.3. If the director of the affiliated entity is also an employee or an executive officer of the affiliated entity, the individual would be an affiliated entity under clause 1.3(1)(b) and disqualified under clause 1.4(3)(g). The exemption in subsection 3.3(1) does not cover these facts.