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Auditing the Audit

April 28, 2011

Most jurisdictions in Canada require the unanimous consent of all shareholders, including non-voting shareholders, in order for a non-distributing corporation to dispense with an audit. The requirement is absolute and mandatory – there are no other exemptions or qualifications. The public policy rationale behind the rule is laudable; however, the implementation in practice can be austere. It is time to revisit the universal audit requirement as it applies to non-distributing corporations.

The Canada Business Corporations Act, and its provincial counterparts, generally provides that shareholders of nondistributing corporations may resolve not to appoint an auditor provided that such resolution is consented to by all shareholders, including shareholders not otherwise entitled to vote. Although the Companies Act of Prince Edward Island is silent on point, it does stipulate however that the directors of every company shall lay before the shareholders a full and clear statement of the affairs and financial position of the company at or before each annual general meeting. In MacLeod and John L. MacLeod Transport, Consultant and Management Ltd. v. Murray and Murray, it was held that this requirement could only be satisfied by producing audited financial statements. In striking contrast to every other jurisdiction in Canada, New Brunswick permits, but does not mandate, the appointment of an auditor; moreover, if an auditor is appointed in any given year, such appointment may be dispensed with in the ensuing year by ordinary resolution (thus not requiring unanimity).

The underlying public policy rationale of the universal audit requirement is clear – investor protection, and in particular, the protection of minority shareholders. It has been held that shareholders (voting and non-voting) have a right to be informed, and have an independent assessment, of a company's financial position in order to inter alia enable shareholders to assess their investments (and management)on a continuing and consistent basis. The jurisprudence has routinely confirmed and upheld the sanctity of this right (including Merrill v. Afab Security; Labatt Brewing Co. v. Trilon Holdings Inc.; Smith v. ECO Grouting Specialists Ltd.; Runnalls v. Regent Holdings Ltd.; Barbour v. Jamestown Lumber Co.). In Discovery Enterprises Inc. v. ISE Research Ltd., it was noted that “The refusal of a company to deliver audited financial statements can serve to hide the true financial position from a minority shareholder.”

However, universal application of this onerous requirement can have unintended and severe consequences, particularly on small, privately-held corporations. In many instances, an audit is unnecessary or the cost prohibitively expensive and disproportionate to the financial resources of the company and the value of a shareholder's investment. Audits can cost tens of thousands of dollars and paying the cost of an audit can leave a company with reduced or no profits to distribute to shareholders, or worse yet, further indebted. Ironically, the very application of the principle that is intended to protect shareholders' investments could in fact jeopardize their investments.

Since dispensing with an auditor requires unanimous consent, the fate of a company, and every other shareholder's investment (and return on same) in that company, could rest in the hands of a single shareholder, regardless of such shareholder's status as a voting or non-voting shareholder and regardless of the size of such shareholder's investment. As much as it may be unfair to a minority shareholder to deny an independent assessment of a company's financial statement, it is equally, perhaps more, unfair to the remaining majority shareholders to endure the consequences of such an assessment if otherwise unnecessary or uneconomical. The case law has held that a shareholder's motive in, and the financial consequences of, requiring an audit is irrelevant. Struck with the unwavering harshness of this rule, some justices have (rightly) tried to alleviate its ramifications. In Barbour v. Jamestown Lumber Co., Justice Handrigan wrote “I took this limitation into account by restricting the audit to Jamestown Lumber's most recent fiscal period. It would, in the circumstances here, be an unfair and unnecessary expense to the corporation and ultimately for its other shareholders to bear to require an audit for any longer period.”

When compared with other leading corporate law jurisdictions, Canada's model of universality is draconian. Some American states (including New York and Delaware) do not require audited financial statements of private companies. In both the United Kingdom and Australia, statutory exemptions from audit requirements (based on revenues, assets and number of employees) are provided to small private companies. However, notwithstanding that a company may otherwise qualify for exemption from audit requirements, members (voting and non) of UK companies representing at least ten percent of the nominal value of a company's share capital, and voting shareholders of Australian companies holding at least five percent of the votes, may demand an audit.

Canada's ironclad audit requirement is ill-suited, imbalanced and disproportionate for countless small, private companies. A better balance between the rights of minority and majority shareholders is called for.

Please note that this publication presents an overview of notable legal trends and related updates. It is intended for informational purposes and not as a replacement for detailed legal advice. If you need guidance tailored to your specific circumstances, please contact one of the authors to explore how we can help you navigate your legal needs.

For permission to republish this or any other publication, contact Amrita Kochhar at kochhara@bennettjones.com.

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