CDS Declines to Accept Legended Securities in the Book-Entry System
With the coming into force of National Instrument 45-106 - Prospectus and Registration Exemptions (NI 45-106), the Canadian Securities Administrators (CSA) also adopted a number of consequential amendments to various related policies and instruments. These included consequential amendments to Multilateral Instrument 45-102 - Resale of Securities (now National Instrument 45-102 or NI 45-102).
Under NI 45-102, the first sale of securities issued in reliance upon certain private placement exemptions is considered to be a distribution (i.e. generally requiring a prospectus), unless certain prescribed conditions are satisfied. One of these conditions is that the certificate representing the security carries a legend indicating that the securityholder may not sell the security until the later of four months and a day after the acquisition date or the date the issuer becomes a reporting issuer. This requirement was amended, effective March 30, 2004 to respond to the increased use of book-entry-only securities. Since the time of this amendment, subsection 2.5(2)3 of NI 45-102 has required that the certificate representing the security, or an ownership statement issued under a direct registration system or other electronic book-entry system, carry the prescribed legend. Section 1.7 of the Companion Policy to NI 45-102 (the Companion Policy) stated (prior to the implementation of the amendment discussed below) that "[i]nvestors may receive either a paper certificate representing their security or an electronic alternative such as an ownership statement under a direct registration system."
As part of the consequential amendments made to NI 45-106 effective September 14, 2005, the CSA changed this provision of the Companion Policy to read that a "[b]eneficial securityholder must receive either a paper certificate or an electronic alternative such as an ownership statement under a direct registration system, scheduled to be phased into operation during 2005." The CSA’s intentions in requiring what appears to be the mandatory delivery of a confirmation statement to beneficial securityholders are not clear. Nor is it clear that, in adding this requirement, the CSA considered whether clearing agencies such as The Canadian Depositary for Securities Limited (CDS) would have the technological capability to carry it out. It is also not known what the CSA intended when referring to a "…direct registration system, scheduled to be phased into operation during 2005."
These, amendments, whose effects appear to have been inadvertent, are part of the Companion Policy and not part of the Instrument itself. While they may represent the view of the CSA, they do not have the force of law. CDS has nevertheless taken the position that it will no longer accept restricted securities (i.e. those required to carry a legend indicating a restriction on resale) in the book-entry system. This effectively means that unless an issuer can deliver an ownership statement carrying the required legend to each beneficial purchaser, every security issued under a private placement (pursuant to a prospectus or registration exemption) will have to be certificated.
However, in at least one offering, staff at the Ontario Securities Commission (OSC) agreed to an interim solution that allowed CDS to accept debt securities that were privately placed. In that case the issuer sent a letter to CDS, with a copy to the OSC, stating that the issuer was not a reporting issuer and was unlikely to be one, that the debt securities being offered would be sold under the "accredited investor" exemption under NI 45-106, that the issuer took the position that subsection 2.5 of NI 45-102 does not require it to legend the certificate representing the debt securities and therefore the issuer would deposit with CDS a global certificate representing the aggregate number of securities to be issued without the legend. Staff at the OSC confirmed that they would not object to the deposit by the issuer of the global certificate without a legend and CDS agreed to hold and transfer the debt securities in the book-entry system. This solution may be viable for offerings where the securities issued will always be subject to a restriction on resale. As discussed above, the conditions set out under subsection 2.5 of NI 45-102 must be satisfied so that the first sale of securities previously issued under a prospectus or registration exemption does not require a prospectus. Where the securities in question are not contemplated to be sold to secondary market purchasers, satisfaction of the conditions set out under section 2.5 of NI 45-106, including the condition that the security certificate or confirmation statement carry the required legend, is therefore not relevant.
In another transaction, we have been able to develop what appears to be an alternative interim solution that is also acceptable to CDS. We propose that a confirmation statement carrying the required legend be sent to purchasers at the time their purchase is confirmed by the applicable dealer (that is, at the time the dealer’s confirmation slip or ticket is sent to purchasers). In conjunction with this, the issuer of the security would apply to the applicable regulator for confirmation that the delivery of such a statement is in accordance with Section 1.7 of the Companion Policy (requiring that beneficial securityholders receive an ownership statement carrying the required legend). Based on discussions with CDS, we believe that this is an acceptable alternative interim solution that will allow other types of private placements to proceed in the book-entry system until the CSA have resolved this issue. While this method does impose an additional obligation to deliver a written confirmation statement, it has been proposed only as an interim measure to deal with CDS’s reluctance to accept these securities in the book-entry system. Ideally, any long-term solution implemented by the CSA would support more efficient methods of holding and transferring securities and not impose additional paper-based obligations.
Effectively barring privately placed securities from the book-entry system represents a significant setback in the progress that has been made in the electronic holding and transfer of securities over the last number of years. With an increasing number of issuers moving to a book-entry only system, and investors preferring this system, this issue is a matter of great significance for Canadian capital markets and it is to be hoped that it will be resolved in the very near future.
We are currently working with the CSA and CDS to resolve this issue for all types of offerings.
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