Canada: Due Diligence Defence For Distribution Of Securities In Breach Of Securities Law

In furtherance of a proposed merger or acquisition, it is common place for an issuer to complete a concurrent private placement in order to, among other things, fund its working capital and current operations, complete the transaction or satisfy regulatory or administrative requirements post-transaction i.e., exchange listing requirements upon completion of a reverse-take over.

Notwithstanding such reason, it is absolutely necessary to the future of the issuer, its directors and officers and any agents, finders, or promoters, to appreciate and understand their responsibilities upon conducting a private placement, as illustrated in the recent British Columbia Securities Commission (Commission) decision, Re SunCentro, 2017 BCSECCOM 58 (SunCentro).

The SunCentro decision

In SunCentro, SunCentro Corporation (the Issuer) relied upon the "family, friends and business associate" prospectus exemption to issue securities to investors introduced by two finders, YDS Energy, Resources and Humanitarian Relief Corporation (YDS) and Donald Weiss (Weiss, and together with YDS, the Finders), as well as an officer and director of SunCentro, John Leonard Carswell (Carswell). However, none of these investors qualified for the exemption and, accordingly, the Commission pursued administrative proceedings against each of the Issuer, Finders (and their directors and officers), as well as Carswell as sellers of the securities (see sections 1(1) and 61(1) of the Securities Act (British Columbia) (the Act) and 1.10 of the Companion Policy to National Instrument 45-106 Prospectus Exemptions (CP 45-106)).

The Commission importantly held that contraventions of the Act pursued in the administrative context are strict liability offences and, therefore, a due diligence defence was available to the Issuer, Finders and Carswell. The Commission referred to section 1.9 of CP 45-106 in providing the following guidance on the "reasonable steps" sellers must take to satisfy their responsibilities in ensuring the prospectus exemption is properly available in order to be afforded a due diligence defence:

  • while sellers should obtain and retain documentation of certain key facts, including obtaining representations and warranties and/or confirmation of a purchaser's financial or other personal status, such steps will not be sufficient in and of themselves;
  • sellers should understand the terms and conditions of the exemption that they intend to rely upon;
  • sellers should adopt appropriate policies and procedures to ensure that persons acting on their behalf understand the terms and conditions of the exemptions being relied upon (including ensuring such persons are able to describe the terms of the exemption to purchasers, know what information and documentation must be obtained from purchasers to confirm the conditions of the exemption have been satisfied and take reasonable steps to verify that each purchaser meets the criteria set out in the exemption); and
  • sellers should take steps to verify the factual basis of the information being relied upon including asking questions of purchasers.

Notably, the Commission emphasizes the above list is not exclusive or conclusive and the "reasonable steps" a seller must take will vary depending upon the facts and circumstances of the purchaser, the offering and the exemption being relied upon as well as the seller's offering.

Weiss and Carswell Investors

In connection with the distribution to investors introduced by Weiss and Carswell, the Commission held that the Issuer had taken all reasonable steps to ensure the prospectus exemption was available, which included verifying the investors met the criteria of the prospectus exemption by relying on express or implied assurances from a board member.

Accordingly, the Issuer was entitled to rely on the due diligence defence for distributions to these investors. Weiss and Carswell, however, were unable to rely on the due diligence defence since there was no evidence that either had taken any "reasonable steps." In fact, Weiss simply found investors and forwarded them on to the Issuer.

YDS Investors

While the Issuer board adopted many of the steps referred to in the list above, the board failed to obtain a full understanding of the prospectus exemption it was attempting to use for distributions to investors introduced by YDS, incorrectly interpreting "affiliate" to include YDS:

Having sought legal advice on the availability of an exemption, having determined that there remained an open legal question arising from that advice and having chosen to reach its own conclusion about the question, it is hard to view the SunCentro board as having taken reasonable steps to avoid a contravention of section 61 with respect to the distributions to the YDS investors.

Accordingly, the Issuer was unable to rely on the due diligence defence for distributions to these investors. Further, Yawar Sattar Khan (Khan) and David Kenge Kato (Kato), who were directors and officers of YDS, were also unable to rely on the due diligence defence as they failed to take "reasonable steps" to determine whether the prospectus exemption was available to them. In particular, they relied on the expertise of the directors and officers of the Issuer, including Carswell, but such persons were not lawyers. Khan and Kato also did not ask any questions of the legal counsel retained by the Issuer. Indeed, their failure to seek legal advice played a significant role in the Commission's finding that they did not take reasonable steps to avoid a contravention of the Act.

SunCentro is a rare case that illustrates the steps that an Issuer must take in order to avoid liability for contraventions of section 61 of the Act. The case underlies and emphasizes the importance of obtaining professional legal advice when conducting a private placement. Norton Rose Fulbright's Canadian deal lawyers can assist in ensuring you are able to complete your transaction while meeting any legal responsibilities along the way.

The author would like to thank Sadaf Samim, Summer Student, for her assistance in preparing this legal update.


About Norton Rose Fulbright Canada LLP

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