Canada: OSC Concerned Over Sale Of Exempt Securities To Non-Accredited Investors

Copyright 2011, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Securities, May 2011

Highlights

In a recent Staff Notice, the OSC advises that:

• Issuers and their dealers have the responsibility for determining whether an investor may purchase exempt securities pursuant to the AI Exemption.
• Dealer should be collecting adequate know-your-client information to accurately determine whether an investor is an Accredited Investor. The OSC has set out a non-exhaustive list of steps that dealers should take when selling under the AI Exemption.
• It is not sufficient for issuers and their dealers to simply rely on the client's initialling or checking-off of the box on an accredited investor certificate, or to rely on verbal representations.

The Ontario Securities Commission (the OSC) recently released OSC Staff Notice 33-735 – Sale of Exempt Securities to Non-Accredited Investors. The notice sets out the OSC's concern that some issuers and dealers are selling exempt securities in reliance on the accredited investor exemption (the AI Exemption) to individual investors who do not in fact meet the definition of an Accredited Investor (as defined in National Instrument 45-106 – Prospectus and Registration Exemptions (NI 45-106)), which raises significant investor protection concerns.

The notice provides guidance on the OSC's expectations for issuers and dealers who sell exempt securities to Accredited Investors, and the OSC asks that issuers and dealers review their current practices for selling exempt securities to Accredited Investors.

The OSC notes that going forward it will closely monitor the activities of issuers and dealers who sell exempt securities, including conducting compliance reviews, and commencing enforcement proceedings or taking other regulatory action where necessary.

Accredited Investor Exemption

In Ontario, a security may be sold to an investor without a prospectus (a Prospectus Exemption) if such a sale falls within an exemption set out in NI 45-106. A security that is sold under a Prospectus Exemption is known as an "exempt security". One such Prospectus Exemption is the AI Exemption, which refers to a sale of a security to an Accredited Investor and is most commonly defined with reference to an individual investor's income or asset threshold.

In the notice, the OSC states that a frequent misunderstanding of the definition of Accredited Investor relates to a confusion between the two concepts of "financial assets" and "net assets". "Net assets" is a broader concept that captures all of the investor's assets (minus liabilities), including an investor's personal residence and other real estate. By comparison, "financial assets" is a narrower concept that includes assets such as cash, securities and contracts of insurance, but does not include real estate assets. The OSC notes that some dealers are not making it clear to clients that the client's personal residence or other real estate cannot be included in the calculation of their "financial assets", often resulting in an investor not actually meeting the "financial assets" threshold (currently C$1-million) and thus not qualifying to be an Accredited Investor.

Expectation for Issuers and Dealers

The OSC has found that many dealers do not collect adequate know-your-client (KYC) information to reasonably determine whether an investor is in fact an Accredited Investor.

The OSC notes it is the responsibility of the issuer and the dealer selling the security to determine whether an investor may purchase exempt securities pursuant to the AI Exemption. The OSC further notes that while an issuer generally engages a dealer to distribute securities to investors, the issuer still has an obligation to ensure that a distribution of exempt securities through a dealer will be made in compliance with securities laws.

The OSC set out the following non-exhaustive list of steps that dealers should take in order to meet their obligations under securities laws when selling under the AI Exemption:

• Read and understand the definition of Accredited Investor. The OSC expects that firms will train their chief compliance officers and dealing representatives so that they can properly determine if a client qualifies as an Accredited Investor.
• Develop an accurate form for collecting KYC information. Information collected on a KYC form should help determine whether the client meets the definition of an Accredited Investor.
• Explain the Accredited Investor definition to clients and ensure that their KYC forms are properly completed. Dealers should explain the Accredited Investor definition to clients, particularly the distinction between "net assets" and "financial assets".
• Do not sell an exempt security if there is insufficient information to determine whether the client qualifies as an Accredited Investor. The OSC notes that it is not sufficient for issuers and their dealers to simply rely on the client's initialling or checking-off of the box on an accredited investor certificate, and that the information contained in the client's completed KYC form or other documentation must also demonstrate that the investor meets the test.
• Ensure the exempt security is suitable for the client. Even if the client qualifies as an Accredited Investor, registrants must still assess the suitability of the investment product by understanding the investment needs and objectives of their clients and the attributes and risks of the securities that they recommend.
• Review the KYC form. The OSC notes that the Chief Compliance Officer (CCO) of the dealer should review completed KYC forms to ensure that the information collected is complete and consistent. Where conflicting information exists, the dealer must take follow-up steps to ensure that the investor is in fact an Accredited Investor, and evidence of such follow-up procedures should be documented in client files and reviewed by the CCO.
• Retain documentation. Dealers should maintain records to support a sale of exempt securities in reliance on the AI Exemption. The OSC emphasizes that verbal representation from the investor that they are an Accredited Investor is not sufficient.
• Establish policies and procedures. Dealers should establish policies and procedures to ensure that exempt securities are sold under the AI Exemption only to investors who are in fact Accredited Investors.
• Report the sale of exempt securities to the OSC. Issuers must ensure that sales of exempt securities in reliance on the AI Exemption are reported to the OSC by filing a Form 45-106F1 – Report of Exempt Distribution, including in it full purchaser details.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.