Current state of the law in the United States

There has been a lot of discussion over the last couple of months in regard to the United States Securities and Exchange Commission (“SEC”) considering whether or not to ease the rules on private companies that issue shares. 

Currently, in the United States, private companies with less than 500 shareholders do not have to disclose their financial information publicly.  This presents a problem for companies such as Facebook, Twitter, Groupon and other technology companies and startups to issue stock and raise money, without having to face reporting requirements, which can be costly.  These companies may wish to focus their time, effort and limited capital on product development, rather than paying costs associated with meeting the financial reporting obligations, answering analysts’ questions about earnings and revenue and worrying if the company is in compliance with all other SEC rules for public companies.  As a result, the economic growth of these types of private companies is limited because they cannot seek out investment opportunities from a greater number of people.

Private exchanges, such as SecondMarket and SharesPost, have become popular in the United States, as they are more lightly regulated.  This is because only “sophisticated investors”, such as investment funds and individuals with a net worth of at least $1 million can participate, and not the average retail investor.  Given the wealth of these “sophisticated investors,” the SEC assumes that they can take care of themselves and do not require the kind of financial disclosure public companies are required to make.  Representatives of both private exchanges are in favor of the new rules that the SEC seeks to establish because they will improve the capital formation process for small high-growth companies and assist these companies to efficiently raise attractively priced growth capital.

Current State of the Law in Canada

In Canada, although each province generally has its own securities regulator, each with its own set of rules and regulations, the Canadian Securities Administrators have developed National Instrument 45-106 (“NI 45-106”) to create a harmonized set of rules applicable to all jurisdictions in Canada with respect to the exemption from the requirement to file a prospectus.  One of the exemptions available in NI 45-106 is the “private issuer exemption.”  Specifically, NI 45-106 defines a “private issuer” as an issuer that is not a reporting issuer or an investment fund, whose securities are subject to restrictions on transfer that are contained in the issuer’s constating documents or security-holders’ agreements, whose securities are beneficially owned by not more than 50 persons, and that has distributed securities only to persons described in this National Instrument. 

This includes:

  1. a director, officer, employee, founder or control person of the issuer;
  2. a spouse, parent, grandparent, brother, sister or child of a director, executive officer, founder or control person of the issuer;
  3. a parent, grandparent, brother, sister or child of the spouse of a director, executive officer, founder or control person of the issuer;
  4. a close personal friend of a director, executive officer, founder or control person of the issuer;
  5. a close business associate of a director, executive officer, founder or control person of the issuer;
  6. a spouse, parent, grandparent, brother, sister or child of the selling security holder or of the selling security holder’s spouse;
  7. a security holder of the issuer;
  8. an “accredited investor”;
  9. a person of which a majority of the voting securities are beneficially owned by, or a majority of the directors are, persons described in a – h;
  10. a trust or estate of which all of the beneficiaries or a majority of the trustees or executors are persons described in paragraphs a – h; or
  11. a person that is not the public.

There is clearly defined criteria to identify the persons the private company can solicit to raise capital.  If the issuer makes a distribution outside of the rules for a private issuer, it will automatically lose its private issuer status and will be prohibited from using this exemption thereafter.

In addition to avoiding the costly reporting obligations of public companies, some of the benefits of qualifying for the private issuer exemption include:

  1. No requirement to file a report of exempt distribution (i.e. Form 45-106F1);
  2. No payment of any fee to securities administrators; and
  3. No cap on the amount of money that can be raised under this exemption.

It must be noted, however, that while NI 45-106 applies to all jurisdictions in Canada, each jurisdiction will maintain its own set of exemptions.  For example, Ontario Securities Commission Rule 45-501 states that the family, friends and business associates and family, founder and control person exemptions are not available.  Instead, Ontario has adopted an exemption for founders, affiliates of founders, control persons and certain family members of founders, executive directors and officers.

Miller Thomson Analysis

Influence of SEC’s proposed changes on Canadian securities regulators

Despite the discussions in the United States regarding revisions to the rules governing private company share trading, there has not been much discussion in that same regard in Canada as of yet.  However, as the Canadian securities rules regarding corporate governance best practices and disclosure rules are generally very similar in substance to the listing standards in the United States, reflecting current North American best practices in governance, we can expect that Canadian securities regulators will follow the footsteps of what the SEC plans to do.  For example, back in the first quarter of 2004, Canadian securities administrators imposed a number of control and certification rules to increase Canadian investor confidence in the public filing of issuers.  These new rules and requirements were substantially similar and comparable to the provisions of the U.S. Sarbanes-Oxley Act of 2002, and U.S. stock market requirements. 

Impact on Canadian Private Companies

For private companies wishing to expand and grow, they may find it daunting that they must undergo measures to certify their annual and interim filings, and design and supervise controls and procedures to provide reasonable assurance for the financial information disclosed by them.  As public Canadian technology companies are generally smaller than Canadian-listed issuers in other industries, corporate governance rules have a relatively larger impact on them. 

As well, as many Canadian companies are increasingly seeking access to the United States to raise capital and to sell their products and services, private Canadian companies may nevertheless be subject to the new rules the SEC may impose for shareholder limits, if they are considering listing their shares in U.S. stock markets.

Although the current rules are in place to limit insiders from trading shares using information that is not publicly available, the fine line between protecting investors from insider trading and making it easier for private companies to raise money needs to be examined.  While it is of utmost importance that investors are given the assurance and confidence that they need to invest in the market by having financial information and protections available to them, private companies should not be overburdened by unnecessary and superfluous regulations.  Reducing private companies’ cost of compliance without sacrificing investor protection is the goal of the new rules that the SEC aims to establish.