Proceedings

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IN THE MATTER OF THE SECURITIES ACT

R.S.O. 1990, c. S.5, AS AMENDED

- AND -

IN THE MATTER OF DIMETHAID RESEARCH INC.

 

Hearing:
Friday, March 7, 2003
 
Panel:
Robert L.Shirrif, Q.C.
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Commissioner (Chair of the Panel)
Kerry D. Adams, FCA
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Commissioner
Robert W. Davis, FCA
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Commissioner
Derek Brown - Commissioner
 
Counsel:
Kathryn J. Daniels
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For the Staff of the
J. Hughes
Ontario Securities Commission
S. Heldman
 
Jeremy P. Robinson
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Dimethaid Research Inc.
Vanessa Grant
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REASONS

I. The Proceeding

[1] The hearing was held in response to the request of Dimethaid Research Inc. (Dimethaid) pursuant to section 8 of the Securities Act R.S.O., 1990, c. S.5 (the Act) for a hearing and review of the Director's decision dated February 20, 2003 objecting to the use of the prospectus and registration exemptions in respect of a proposed rights offering to Dimethaid shareholders to purchase common shares of Dimethaid.

[2] The Director objected to Dimethaid's proposed rights offering on the basis that the annual financial statements of Dimethaid for the fiscal year ended May 31, 2002 were not in accordance with generally accepted accounting principles in Canada (Canadian GAAP). The Director took issue both with:

  1. the classification of the consideration owing on the acquisition of Oxo Chemie AG (Oxo Chemie acquisition) as a liability when the Director believed that it should be treated as equity, and
  2. the valuation of the consideration owing for the acquisition being recorded at its face amount rather than discounted to net present value. The Director believed that the obligation should be discounted to reflect its fair value as at the acquisition date (also the balance sheet date) because the consideration owing was on an interest free basis over a period of 5 years.

[3] In order to reach a conclusion about the Director's decision, the panel had to reach a conclusion about the accounting issues, relying on information Dimethaid provided about the terms of the acquisition, authoritative literature including the CICA Handbook, and written and oral testimony of expert witnesses.

II. Background

1. Dimethaid's Business

[4] Dimethaid is a fully integrated speciality pharmaceutical company governed by the laws of Ontario. Its core technologies are transdermal delivery technology and immune system regulating technology. It has a market capitalization of approximately $107 million and employs 124 people. The authorized capital of Dimethaid consists of an unlimited number of first preference shares issuable in series, an unlimited number of second preference shares issuable in series and an unlimited number of common shares, of which 52,497,776 were issued and outstanding as at January 31, 2003. Dimethaid's common shares are listed for trading on the Toronto Stock exchange. Dimethaid reports in Canadian GAAP with a voluntary US GAAP reconciliation.

[5] In 1992, Dimethaid was introduced to Oxo Chemie AG (Oxo Chemie), a private Swiss company committed to the development and commercialization of proprietary therapeutic products for the treatment of immune dysfunction diseases. Oxo Chemie was developing WF10, a drug to treat chronic ailments such as HIV /AIDS, hepatitis C, and several auto immune diseases.

[6] On June 18, 1996, Dimethaid made the first of a series of equity investments in Oxo Chemie. As of June 30, 1997, Dimethaid owned 20 percent of the shares of Oxo Chemie. The $20 million paid for this first series of investments was written off to research and development expense.

2. The Oxo Chemie acquisition

[7] On May 31, 2002, Dimethaid completed the acquisition of the remaining 80 percent of the outstanding common shares of Oxo Chemie giving Dimethaid 100% ownership of it. In the transaction, Dimethaid acquired current assets valued at CDN $763,788, plant and equipment valued at CDN $1,070,944 and patents valued at CDN $63,415,634. Dimethaid also assumed current liabilities valued at CDN $2,739,515 and a term loan of CDN $689,243.

3. Dimethaid's purchase obligation

[8] Pursuant to the Oxo Chemie purchase agreement dated May 14, 2002, the payment terms are as follows:

The purchaser may elect, in its sole discretion, to pay that portion of the purchase price which is not required below to be paid in the form of immediately available funds in the form of (a) immediately available funds, (b) Dimethaid Shares, or (c) a combination thereof. The parties agree that the Purchase Price will be paid in instalments (the "Instalments") as follows:

[9] The purchase agreement goes on to specify that the required payments (amounts are denominated in U.S. dollars) are as follows:

Already paid

Payable at closing - in available funds

Payable on or before November 30, 2002
of which $500,000 is payable in available funds

Payable on or before November 30, 2003

Payable on or before November 30, 2004

Payable on or before November 30, 2005

Payable on or before November 30, 2006
$100,000

$500,000

$4,500,000


$4,240,599

$9,240,599

$9,240,599

$9,240,599

[10] The purchase agreement further states that the number of Dimethaid shares to be issued will not, without obtaining regulatory approval, exceed 24.9% of the issued and outstanding capital of Dimethaid as at the date of the agreement. If the proposed number of Dimethaid shares to be issued would exceed 24.9% of its issued and outstanding capital as at the date of the purchase agreement and Dimethaid elects not to obtain regulatory approval to exceed that 24.9% threshold, the balance of the unpaid purchase price would be paid in immediately available funds. The purchase agreement provides that the issuance of the Dimethaid shares is subject to regulatory approval.

[11]    On November 30, 2002, Dimethaid made its first instalment payment. The payment consisted of US$500,000 (CDN$783,000) in cash and the equivalent of US$4 million (CDN$6.3 million) in Dimethaid shares, which totalled 3,239,092 shares (calculated in accordance with section 2.5 of the purchase agreement).

[12]    Dimethaid accounted for the Oxo Chemie acquisition on the basis of the payment obligation being a liability for the following reasons:

  1. Classification. Dimethaid determined that Canadian GAAP was unclear as to whether the Oxo Chemie acquisition should be classified as a liability or equity, or a combination thereof. Ultimately, Dimethaid elected to take the more conservative approach in presenting the acquisition as a liability. Further, Dimethaid made significant efforts to provide full disclosure of the Oxo Chemie acquisition.
  2. Valuation. It is not appropriate to discount Dimethaid's future commitment in respect of the Oxo Chemie acquisition. There are no guidelines in Canadian or US GAAP that require discounting with respect to future consideration in the context of a transaction such as the Oxo Chemie acquisition. Further, in the circumstances of the Oxo Chemie acquisition, discounting would be confusing as, among other things, it would be very difficult to determine the appropriate discount rate to be applied.

III. Dimethaid agrees to equity classification of payment obligation

[13]    Prior to the oral testimony of the expert witnesses, Dimethaid agreed to classify the obligation owing on the Oxo Chemie acquisition as being equity, in accordance with EIC-71, Financial Instruments That May Be Settled at the Issuer's Option in Cash or its Own Equity Instruments. This was appropriate because Dimethaid cannot be contractually forced to settle any of its 2003 - 2006 obligations in cash, unless it fails to seek, or is refused, regulatory approval to issue additional shares, an event not considered probable given the facts in this case.

[14]    Accordingly, the sole issue for the Commission to hear was whether discounting equity was appropriate to determine the fair value of the acquisition.

IV. Dimethaid's opposition to discounting equity

[15]    Dimethaid's opposition to discounting equity was based on two key points: (1) Canadian GAAP does not require it and (2) the consequences of discounting equity is confusing to the users of financial statements.

Canadian GAAP does not require it

[16]    Both of Dimethaid's expert witnesses stated that Canadian GAAP does not require discounting equity. Their stated reason was that discounting is discussed, in accounting literature, only in the context of payments of money and future cash flows. Mr. Rosen stated that discounting was not properly applicable to equity because of the income/ capital distinction that leads to capital transactions being recorded within shareholders' equity rather than flowing through the income statement as would occur in an income transaction.

[17]    Examples of financial statement presentation where non-interest bearing cash obligations were not discounted were presented as precedents to support this view.

Discounting equity is confusing to users of financial statements

[18]    Mr. Rosen testified that the ramifications of discounting equity would be counter productive and could have a number of misleading consequences. Mr. Rosen viewed discounting equity as an exercise of "immense trivia", a minor shuffle between retained earnings and capital as the discount is amortized prior to payment in the form of shares being issued. He testified that investors and creditors probably don't care about it because they are looking only at cash flows and income flows.

[19]    Both Mr. Rosen and Mr. Wiener testified that reducing the purchase price by discounting equity would result in lower subsequent amortization of the assets acquired which would have the result of then overstating income in subsequent years. Mr. Rosen viewed staff's request for discounting as misleading and Dimethaid's approach as more conservative.

The Discount Rate Selected would be arbitrary

[20]    A third objection to discounting the future payment obligations was that the discount rate selected would be arbitrary.

V. Staff's position

[21]    Staff argued that the Oxo Chemie acquisition is a business combination to which section 1581.22 of the CICA Handbook applies; i.e. the transaction should be recorded at the fair value of the consideration given or of the assets acquired, whichever is the more reliably measured. As the patents acquired are subject to many contingencies entirely beyond the control of Dimethaid, in particular, the outcome of further research and the regulatory review and approval process, the asset value is difficult to establish. In contrast, the obligation to pay is a fixed dollar amount over a 5-year period. The only uncertainty is whether Dimethaid will choose to pay in cash or in its own shares. Hence the fair value of the consideration given should be used to measure the transaction in this case.

Discounting contracted payments to establish fair value has authoritative support

[22]    Staff observed that Dimethaid's payment obligation is fixed and certain in dollar amount over a period of 5-years, but it bears no interest. Due to the time value of money (i.e. a dollar received today is worth more than a dollar received tomorrow), non-interest bearing future payment obligations are normally discounted at an appropriate rate of interest to establish their fair value at the transaction date.

[23]    Staff submitted that section 1581.A2, A5 and A8 provides authoritative support for using a net present value technique to determine the fair value of instalment payments.

Classification of payment obligation is independent of fair value determination for business acquired

[24]    Mr. Fowler's testimony, both written and oral, was that accounting for Dimethaid's acquisition of Oxo Chemie should be determined by establishing the fair value of the business acquired. Once fair value is established, the classification of financial instruments given as consideration follows. In his view, the classification of the payment obligation is not a relevant factor in the determination of the fair value of the business acquired.

Appropriate discount rate similar to other estimates

[25]    Staff argued that the use of estimates is a fundamental practice in accounting. Selection of the appropriate discount rate for the business combination will depend on a number of factors, and may require input of Dimethaid's accountants or investment bankers. The difficulty in establishing an appropriate discount rate is neither insurmountable nor a valid reason not to do so.

THE DECISION

[26]    We considered the evidence and the submissions and decided to reject the application and to uphold the Director's decision on this matter. We find that the transaction in question is a business combination to be recorded at fair value in accordance with section 1581.22 of the CICA Handbook.

[27]    We concur with staff that the fair value of the consideration given should be used in this case to determine the fair value of the business acquired. This fair value should be the same, whether Dimethaid elects to make future payments in cash or in shares of equivalent cash amount pursuant to the purchase agreement.

[28]    We also find that applying a proper discount would be the most appropriate method to determine fair value in this case.

[29]    The real question in this case is not discounting equity. Rather the question is the fair value of the Oxo Chemie acquisition. This fair value, or cost of the acquisition to Dimethaid, is unrelated to the question of classification of the payment obligation.

[30]    Evidence about Oxo Chemie's patent, indicating that further research is required, and that there is uncertainty to the regulatory process indicates that it is inappropriate to try to determine the fair value of the assets represented by Oxo Chemie – they represent a highly uncertain stream of future cash inflows. We therefore believe it is more appropriate to determine the fair value of the payment obligations - they are known amounts (whether in the form of cash or shares).

[31]    We accept, based on both the accounting authorities cited and the experience of two of our panel members, that use of the net present value method to determine fair value of the payments is appropriate when the contract does not call for a reasonable rate of interest to be paid for significant delays in payment. We did not find persuasive the specific examples cited where companies failed to discount non- interest bearing obligations due to their immateriality. Further, we are of the view that had the examples been material they would not have been in compliance with the well-accepted overarching principle of discounting at an appropriate rate of interest for non-interest bearing securities. This is consistent with Skinner's comments in the authoritative literature that failure to discount delayed payment amounts cannot be considered generally accepted in Canada.

[32]    We found nothing in the evidence and testimony submitted to indicate that discounting would be inappropriate in this case.

[33]    Rather, we found that there was a basis for discounting equity shares in the literature. EIC-71, Financial Instruments That May Be Settled at the Issuer's Option in Cash or its Own Equity Instruments, clearly guides the accounting profession in this matter by way of consensus that "the carrying amount of the principal element in equity should be amortized over the term to the specified maturity date through periodic charges to retained earnings or deficit."

[34]    Accordingly, discounting equity is not a new accounting principle required by staff as Dimethaid's counsel suggested. It has been promulgated by the Emerging Issues Committee of the CICA.

[35]    As to the difficulties of determining an appropriate discount rate, we are confident that appropriate resources are available to assist Dimethaid in its determination so that the rate selected should be neither arbitrary nor misleading, as they fear it might be. We agree with staff that the use of estimates is prevalent in accounting and that determining a discount rate, even for a risky project such as we see here, is a standard matter for research and development and technology companies.

[36]    Finally, we disagree with Dimethaid's expert witnesses that the users of Dimethaid's financial statements will not benefit from the requirement to present the fair value of the Oxo Chemie acquisition, with its resulting discounting of equity. The accounting result is not trivial in this case, and will have a material impact on balance sheet ratios and amortization amounts reflected in the income statements and earnings per share calculations. Contrary to these experts, we believe that earnings per share and balance sheet ratios are important analytical tools which assist investors in assessing a company's value and future prospects.



DATED at Toronto this 17th day of October, 2003.

"Robert L. Shirriff"
Robert L. Shirriff
"Kerry D. Adams"
Kerry D. Adams
"Robert W. Davis"
"Robert W. Davis"
"Derek Brown"
"Derek Brown"