On February 27, 2014, the Canadian Securities Administrators (the “CSA”) published for comment proposed amendments to the accredited investor exemption under section 2.3 of National Instrument 45-106 Prospectus and Registration Exemptions (the “AI Exemption”) and the minimum amount investment exemption under section 2.10 of NI 45-106 (the “MA Exemption”) (together, the “Proposed Amendments”). The comment period for the Proposed Amendments will close on May 28, 2014.
The most significant change under the Proposed Amendments is the new requirement for issuers, investors, salespersons and finders to complete a risk acknowledgment form in Form 45-106F9 Risk Acknowledgement Form for Individual Accredited Investors (“Form 45-106F9”) in order to qualify for the AI Exemption. Other changes to NI 45-106 include the requirement to provide more extensive disclosure in reports of exempt distributions, the exclusion of individual investors from the MA Exemption, and the addition of accredited investor family trusts to the definition of accredited investor.
The Proposed Amendments are the most recent example of the CSA asserting its investor protection mandate, as issuers are being asked to bear an increasing burden of ensuring that investors fully understand the meaning of “accredited investor” and fully appreciate the risks of participating in the exempt market.
Risk Acknowledgment Form for Individual Accredited Investors and Other AI Exemption Changes
In response to the CSA’s review of the AI Exemption, including a review of enforcement decisions indicating the failure of many investors to properly qualify under the accredited investor thresholds, and in response to the perceived failure to communicate the particular risks associated with investing in the exempt market, the CSA proposes the following changes to the AI Exemption:
- Individuals who qualify for the AI Exemption must complete and sign the new Form 45-106F9. Issuers must maintain a record of all Form 45-106F9s for a period of eight years following the distribution. Form 45-106F9 requires the investor to indicate under which category of accredited investor they qualify and describes certain investor protections they are giving up by purchasing under the AI Exemption. “Permitted clients,” i.e. individual accredited investors who own financial assets with a net value in excess of $5 million, are exempt from the requirement to complete Form 45-106F9.
- Any salesperson or finder involved in the trade must also complete and sign Form 45-106F9. This applies regardless of whether the salesperson or finder is registered or not.
- Amendments to the Companion Policy to NI 45-106 set out the various steps issuers are encouraged to take to proactively verify potential investors’ eligibility to participate under the AI Exemption (and other capital raising exemptions). These steps go beyond current standard market practices of issuers raising funds in the exempt market and include:
- establishing policies so that issuers and their employees, agents or finders understand the AI Exemption (and other capital raising exemptions); and
- asking questions and gathering information from the purchaser to ensure eligibility for the exemption before discussing the investment.
Changes to the Report of Exempt Distribution Form
The Proposed Amendments include changes to the form of report of exempt distribution (“Form 45-106F1”) which must be filed no later than ten days following the distribution. Form 45-106F1 and Form 45-106F6, as it is in British Columbia, now require the following additional information:
- Issuers must provide the full name of any person compensated for the distribution to each respective purchaser.
- Issuers must indicate all applicable categories of accredited investor (or categories of other capital raising exemptions) for each purchaser, rather than just the broad category of exemption (i.e. accredited investor; family, friends and business associates, etc.)
- The list of industry categories is expanded from 12 to 23 categories.
Minimum Amount Investment Prospectus Exemption
Under the Proposed Amendments, the MA Exemption will be restricted to corporate and institutional investors, so that individual investors are now excluded from qualifying as prospectus exempt purchasers merely by virtue of investing a minimum of $150,000 at one time with one issuer. The CSA justifies this aspect of the Proposed Amendments by explaining that the $150,000 amount required to qualify for the MA Exemption is not a sufficient proxy for investor sophistication or for the ability of an investor to withstand the total loss of their investment.
The CSA did not elaborate on why a risk acknowledgment form is considered sufficient to alleviate concerns of investor protection for accredited investors, yet is not considered sufficient for the risks of investing amounts of $150,000 and above. In the case of the MA exemption, the CSA has chosen to eliminate the risk to individual investors entirely. Notwithstanding the change to the MA Exemption, individual investors will still be free to invest $150,000 or more in a single transaction under the AI Exemption and other exemptions.
Expanded Definition of Accredited Investor
Among the other changes to the AI Exemption, the definition of “Accredited Investor” will be expanded to include family trusts established by an accredited investor for the benefit of his or her family, provided that the majority of trustees are accredited investors and all of the beneficiaries are the spouse or a parent, grandparent, brother, sister, child or grandchild of that accredited investor or of that accredited investor’s spouse.
The Ontario Securities Commission also intends to allow fully managed accounts to purchase investment fund securities in Ontario. The rationale for the change is that existing fiduciary duties currently owed by registered advisers provide sufficient investor protection. This Ontario specific amendment will also bring the Ontario requirements more in line with the rest of Canada with respect to the managed account category.
Impact of Proposed Amendments on Issuers
The most significant impact of the Proposed Amendments on issuers will be the increased costs and additional steps associated with compliance.
In particular, the new requirement for Form 45-106F9 and the amendments to the Companion Policy will require revisions to existing forms of subscription agreements and more extensive due diligence on the part of issuers to confirm whether investors meet the test for the AI Exemption (and other capital raising exemptions) and have an adequate understanding of the risks of investing in the exempt market. Increased costs will be particularly evident in non-brokered financings where there is no ability to rely on the due diligence and compliance of agents or underwriters. In addition, directors and officers of issuers will also need to consider the increased exposure to liability for potential misrepresentations in Form 45-106F9.
The new requirement for all salespersons or finders, whether registered or not, involved in the trade to complete and sign the new Form 45-106F9 may have a chilling effect on their involvement in exempt distributions. Depending on the extent particular issuers currently rely on the participation of finders for raising capital, this may have a detrimental effect on the ability of small to medium sized issuers to raise capital in today’s markets.
Although the added information with respect to compensation and the specific category of capital raising exemption in Form 45-106F1 (and Form 45-106F6 in BC) is intended to assist regulators in collecting information for compliance and enforcement purposes, the effect is that issuers are asked to bear the cost of the regulators’ data collection. Further, such additional information may discourage the participation of sales people and finders in exempt distributions, ultimately reducing issuers’ access to capital.
The CSA reports that although the MA Exemption raises the second highest amount of capital in the exempt market after the AI Exemption, it is relied on less than 1% of the time for distributions to Canadian investors and that the percentage of individuals in comparison to non-individuals who invest under the MA Exemption represents less than 1% of the total amount invested by Canadians in 2011. The effects of the more limited MA Exemption remain to be seen.
Growing Investor Protection Mandate
The Proposed Amendments demonstrate the CSA’s assertive investor protection mandate. It is clear that the CSA continues to push for more meaningful communication between issuers and investors in exempt offerings and that regulators increasingly view their role in the exempt market as more active and involved. A contributing factor to the CSA’s increasing investor protection mandate may be that a considerable amount of the CSA’s enforcement time and resources are spent dealing with issues in the exempt market.
The CSA has stopped short, however, of raising the income and asset thresholds required to qualify as an accredited investor (which some market participants had advocated). The CSA likely elected not to increase these thresholds as a result of comments expressing concerns that increasing these thresholds would further limit issuers’ access to capital, particularly for small to medium sized issuers. In this respect, by maintaining the current income and asset thresholds under the AI Exemption, the CSA has struck an appropriate balance between an issuer’s ability to raise capital and the benefits of increasing investor protection.