On May 13, 2011, the Ontario Securities Commission (OSC) Staff released OSC Staff Notice 33-735 Sale of Exempt Securities to Non-Accredited Investors (Notice) which expressed concerns that some issuers and dealers are relying on the accredited investor exemption (AI Exemption), contained in National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106), to sell securities to individual investors who do not meet the applicable requirements of the exemption. This Bulletin highlights the expectations of the OSC for issuers and dealers selling securities pursuant to the AI Exemption.
Background of the AI Exemption
In Ontario, issuers and registered dealers are permitted to sell exempt securities without a prospectus if investors meet certain requirements (Accredited Investors). Although NI 45-106 contains several categories of Accredited Investors, the focus of the Notice is directed to those categories relating to individuals who satisfy defined minimum financial assets or net assets thresholds, namely,
- an individual who, either alone or with a spouse, beneficially owns financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000; or
- an individual who, either alone or with a spouse, has net assets of at least $5,000,000.
Financial Assets Versus Net Assets
The Notice cautions that there is a frequent misunderstanding in respect of the concepts of financial assets and net assets, and that the concepts should not be confused with each other.
Pursuant to NI 45-106, financial assets include: (i) cash, (ii) securities, or (iii) a contract of insurance, deposit or an evidence of a deposit that is not a security for the purposes of securities law. The Notice confirms that the value of an individual investor's house or other real estate is not included in determining an individual investor's financial assets. In contrast, net assets include all of the individual investor's assets, minus all of his/her liabilities, which means that an individual investor's real estate or home may be included.
The Notice notes that some issuers and dealers are not making it clear to investors that financial assets do not include real estate or the individual investor's home. Therefore, issuers and dealers may be selling exempt securities in reliance on an AI Exemption to investors who do not meet the definition of Accredited Investor.
Before an issuer can distribute a security in reliance on the AI Exemption the issuer must ensure that the investor does in fact meet the definition of an Accredited Investor. Thus, the responsibility of ensuring compliance is ultimately on the issuer. However, in many instances a dealer will be engaged by an issuer to assist in the distribution of the exempt securities to investors. In those cases, the dealer involved in a distribution of exempt securities must also ensure that an individual investor meets the definition of Accredited Investor, and must also, among other things, comply with National Instrument 31-103 Registration Requirements and Exemptions (NI 31-103), the "know your client" (KYC) rules under NI 31-103 and any agency or underwriting agreement governing the distribution.
In most instances, the subscription agreement used in an exempt distribution transaction will contain an accredited investor form, known as an "accredited investor certificate", which lists categories of Accredited Investors which often repeat the relevant statutory provisions. Each investor is required to check off a box reflecting which category of Accredited Investor is suitable for that investor. Generally, a subscription agreement will contain a clause that the issuer and dealer may rely on the representation made by the investor on this certificate; however, the Notice states it is not sufficient for issuers and dealers to rely on this certificate alone.
The Notice also sets forth a non-exhaustive list of steps that dealers should take in order to ensure that they are complying with securities laws when selling exempt securities to an Accredited Investor. The steps suggested include:
- Providing adequate training to the dealer's chief compliance officer (CCO) and dealing representatives to ensure that they understand the definition of Accredited Investor, including the difference between "financial assets" and "net assets";
- Reviewing KYC information to determine whether a client meets the definition of Accredited Investor and ensuring this information is updated regularly;
- Explaining the Accredited Investor definition to clients before completing the KYC form and highlighting the distinction between financial assets and net assets;
- Reviewing the KYC form to ensure completeness, consistency with the definition of Accredited Investor and the suitability of the trade for the client. In the event of conflicting information the dealer must take follow-up steps to ensure that the investor is an Accredited Investor;
- Retaining evidence of follow-up procedures and dealer representative notes;
- Maintaining complete and accurate records; verbal representations from a client are not sufficient;
- Complying with CSA Staff Notice 33-315 Suitability Obligation and Know Your Product and NI 31-103, which requires dealers to understand the general investment needs and objectives of their clients, whether the proposed investment is suitable and the attributes and risks of the securities recommended to clients;
- Establishing policies and procedures to ensure that exempt securities are distributed only to investors that meet the definition of Accredited Investor; and
- Reporting the sale of the exempt securities to the OSC.
Recent OSC Enforcement Proceedings
On May 13, 2011, the OSC published its reasons for decision in Goldpoint Resources Corporation, et al1 (Goldpoint). Goldpoint involved a scheme whereby Goldpoint, a private issuer, and certain of its directors, officers and employees (Respondents) distributed securities without a prospectus or being registered under the Securities Act (Ontario).
Goldpoint addressed various issues under securities laws, including matters related to the AI Exemption. Consistent with the approach taken in the Notice, the OSC confirmed in Goldpoint that persons trading securities are responsible for determining whether, given the facts available, the AI Exemption is available. In Goldpoint the OSC stressed that it is not appropriate for a person to assume that an exemption is available. In addition, the OSC highlighted the financial asset and net asset categories of the definition of Accredited Investor, and that real estate should not be included in the calculation of financial assets.
In Goldpoint many of the investors were provided with definitions of Accredited Investor which inappropriately included real estate in calculating the financial asset test. In addition, not every investor was asked about their financial position or whether they were an Accredited Investor. As a result, the steps taken by the Respondents were found to be insufficient to comply with the AI Exemption. In respect of the financial asset and net asset categories, the OSC stated that the Respondents should have determined whether each investor was an Accredited Investor based on the information investors provided to the Respondents about their financial position. The fact that investors provided a representation in the subscription agreement that they qualified as an Accredited Investor was not adequate. Quoting the Companion Policy to NI 45-106, the OSC confirmed that sellers must have a reasonable belief that an investor understands the meaning of the definition of Accredited Investor. Moreover, prior to discussing the particulars of an investment, sellers should discuss with investors the various criteria for qualifying as an Accredited Investor and whether such investors meet the criteria of an Accredited Investor, and request details on how such investors satisfy the tests in the definition.
In addition to Goldpoint, the OSC recently released a series of settlement agreements entered into between the OSC and Nelson Financial Group Ltd., Nelson Investment Group Ltd. and certain officers, employees and a registered dealing representative of the foregoing entities (Nelson Settlements2). The Nelson Settlements demonstrate the OSC's continued monitoring of the application of the AI Exemption by issuers and dealers, and the consequences for distributing securities where the AI Exemption is not available.
The OSC has indicated that it will continue to monitor issuers and dealers who distribute securities under the AI Exemption, and that it will take enforcement proceedings or other regulatory action against issuers and dealers who sell exempt securities under the AI Exemption to investors who are not Accredited Investors. Although in Goldpoint the OSC was dealing with a scheme where it was evident that those engaged in the financing activity were deficient in their application of the AI Exemption, Goldpoint serves as a reminder to issuers and dealers of the importance of ensuring that investors indeed fall within the definition of Accredited Investor and collect documentary evidence and use follow-up procedures to that end.
1. In the Matter of the Securities Act, R.S.O. 1990, c. S.5, as amended And In the Matter of Goldpoint Resources Corporation, Pasqualino Novielli, Brian Patrick Moloney and Zaida Pimentel, (OSC bulletin release date: 13 May 2011), OSC Decision, online: OSC website.
2. In the Matter of the Securities Act, R.S.O. 1990, c. S.5, as amended And In the Matter of Nelson Financial Group Ltd., Nelson Investment Group Ltd., Marc D. Boutet, Stephanie Lockman Sobol, Paul Manuel Torres, H.W. Peter Knoll, (OSC bulletin release date: 20 May 2011), OSC Settlement Agreements, online: OSC www.osc.gov.on.ca/documents/en/Proceedings-SET/set_20110512_nelson.pdf, www.osc.gov.on.ca/documents/en/Proceedings-SET/set_20110511_nelson-torres.pdf, and www.osc.gov.on.ca/documents/en/Proceedings-SET/set_20110516_nelson-sobol.pdf.
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