Equity ownership is becoming an increasingly important part of executive compensation packages. Many public companies have compensation policies that permit, or in some cases require, directors and executives to own equity in the company. Furthermore, awards of equity-based incentive compensation are common. As a result, participation in share ownership plans and grants of stock options, restricted share units, restricted stock, deferred share units and performance share units is often a significant component of overall director and executive compensation.
Share ownership and options are treated as securities for insider reporting purposes, and are generally governed, in Ontario, by the Securities Act, which requires insider reporting of securities.1 Insider reporting obligations for awards of equity-based awards, such as restricted and deferred share units, arise under a rule – adopted by most Canadian securities regulators – that imposes reporting for arrangements that change an insider’s economic interest in the company.2 However, there is currently a lack of clarity regarding whether these awards are subject to the insider reporting requirements of both the Securities Act and the multilateral instrument.
This newsletter reviews (i) the insider reporting requirements imposed by Ontario securities laws on purchases of shares under employee share purchase plans and awards of equity-based compensation; (ii) the exemptions from insider reporting; and (iii) recently proposed amendments to these exemptions.
Who Must File Insider Reports
Insiders must file insider profiles and insider reports. An “insider” generally includes (i) every director or officer of a reporting issuer; (ii) a director or officer of an insider or a subsidiary of the reporting issuer; (iii) a person or company who directly or indirectly owns at least 10% of the voting securities of the reporting issuer; and (iv) a reporting issuer that has purchased or redeemed any of its own securities. A “security” is broadly defined under section 1(1) of the Securities Act and includes a variety of instruments. For example, awards under a stock option plan or shares purchased under a purchase plan would be securities.
Insider Reporting Requirements
In Ontario, insiders are required to file their insider profiles on the System for Electronic Disclosure by Insiders (SEDI), an online database that can be reviewed by the public. These profiles must comply with the requirements set out in Form 55-102F1 Insider Profile of National Instrument 55-102, System for Electronic Disclosure by Insiders. When an insider’s profile changes – for example, if the insider’s name or relationship to any reporting issuer changes – the insider must file an amended profile. An insider must also file an insider report for certain transactions and comply with the requirements set out in Form 55- 102F2. Insider profiles and reports must generally be filed within 10 days of (i) a person becoming an insider; (ii) a change in the insider’s profile; or (iii) a transaction that triggers an insider reporting obligation.3
Exemptions from Insider Reporting
National Instrument 55-101 Reporting Exemptions
National Instrument 55-101, Insider Reporting Exemptions, provides exemptions from insider reporting obligations. 4 The insider reporting requirement generally does not apply to directors or senior officers who have no access to information regarding material facts or material changes before they are disclosed.5 However, the chief executive officer, chief operating officer, chief financial officer and other key officers of the issuer and its major subsidiaries are not eligible for the exemption and must each provide an insider report for a change of ownership in a security of the reporting issuer. These officers are presumed to routinely have access to information regarding material facts and material changes. NI 55-101 also contains the exemptions available to directors and officers of subsidiaries and affiliates of the reporting issuer.
Automatic Purchase Plans
Employee share purchase plans can generally be set up as automatic purchase plans. Generally, an automatic securities purchase plan (ASPP) for purposes of Canadian securities law, leads to two consequences. First, the administrator of an ASPP can continue to make purchases of securities under the ASPP, even when participants in the ASPP have material undisclosed information and during blackout periods. Second, insiders who participate in the ASPP are permitted to file their insider reports annually, within 90 days of the year-end; however, if an insider sells shares purchased under the ASPP before the year-end, both the purchase and sale must be reported within 10 days of the time of the sale.
To qualify as an ASPP, a plan must impose meaningful restrictions on an insider’s ability to make discrete investment decisions. For example, plans often provide that (i) to enroll in a plan, a participant must give 30 days notice prior to the start of a monthly or quarterly period under the plan; (ii) purchases are generally made after the end of the period; (iii) a participant who withdraws an amount from the plan is not permitted to make contributions to the plan for a six-month period; (iv) the participant cannot change the amount he or she elects to apply to the purchase of securities while he or she possesses material undisclosed information or during a blackout period; and (v) any increase or decrease in a participant’s level of contribution is effective 30 days after notice of the change is given.
The Ontario Securities Commission is sensitive to ASPPs and to the issue of insider reporting; companies should therefore be alert to unusual activity in the plan and may wish to ask the plan administrator to report unusual activity in the plan – for example, a participant’s changing the amount of his or her contributions more than twice as often as the plan average. This report should be provided at least twice a year, but ideally at the time the activity exceeds the “normal” threshold. In addition, it would be helpful for the plan administrator to notify the company of all changes to contribution levels by insiders. The purpose of these restrictions is to eliminate any practical risk of insider trading.
The automatic share purchase plan exemption set out in NI 55-101 will not apply in the following circumstances:
- in respect of securities acquired under the cash-payment option of a dividend or an interest reinvestment plan;
- in respect of securities acquired under the lump-sum purchase provisions of a share purchase plan or a similar provision under a comparable automatic plan;6
- to an insider who has direct or indirect ownership, control or direction over more than 10% of the voting securities of a reporting issuer;7
- to an insider who has discretion under the plan to make decisions related to individual grants or investment decisions;8
- to an insider who is an executive officer or director of a reporting issuer or major subsidiary, unless the reporting issuer has disclosed the material terms of a stock option or other similar grant in a notice filed on SEDAR before the insider would have been required to file an insider report under the regular insider reporting requirements.9
Multilateral Instrument 55-103 Reporting Requirements and Exemptions
MI 55-103 and its companion policy10 also provide both insider reporting requirements and exemptions from those requirements. MI 55-103 imposes insider reporting obligations on transactions that may not be caught by NI 55- 101 and requires insiders to report in respect of “any agreement, arrangement or understanding of any nature or kind” that has the direct or indirect effect of altering the insider’s “economic interest” in a security of the company or the insider’s “economic exposure” to the company. “Economic interest in a security” is defined as
(a) a right to receive or the opportunity to participate in a reward, benefit or return from the security, or
(b) exposure to a loss or a risk of loss in respect [of] the security.11
MI 55-103 defines “economic exposure” as the extent to which the economic or financial interests of a person or company are aligned with the trading price of securities of the reporting issuer or the economic or financial interests of the reporting issuer.12
The definitions of an economic interest in a security and economic exposure capture a broad variety of transactions and incentive plans, including grants under plans that provide only for a cash payment based on the value of the reporting issuer’s shares and that do not provide for the issuance of shares. MI 55- 103 effectively imposes insider reporting requirements on all types of real and phantom equity-based compensation.
A number of exemptions are available from the insider reporting requirements of MI 55-103. The most useful of these, for our purposes, is the specific exemption for “compensation arrangements.” This exemption applies, on its face, to qualifying share appreciation rights, restricted shares, restricted share units, options, phantom stock and performance share units.13 To qualify for the exemption, the organization must meet one of two conditions: (i) the compensation arrangement must be described in annual financial statements or public filings; or (ii) the terms of the compensation arrangement must be set out in writing and any alteration to the employee’s economic exposure or economic interest must be based on a preestablished condition or term in the compensation arrangement that does not involve the insider’s discrete investment decisions.14
Uncertainties in Reporting Obligations
Although the Securities Act and corresponding instruments provide guidance on insider reporting and exemptions, some uncertainties remain regarding whether some forms of compensation will require an insider report. In addition, amendments to the Securities Act not yet in force could have the effect of limiting currently available exemptions from insider reporting requirements.
Arrangements Not Clearly Addressed by Securities Laws
A purchase of shares by an insider under an employee share purchase plan requires an insider report unless the insider qualifies for an exemption. Insider reporting of other share-based compensation, such as restricted share units and deferred share units, is not as clearly addressed because there are two bases on which the grant of a restricted or deferred share unit could require insider reporting: (i) the unit may be subject to MI 55-103;15 or (ii) the unit may be a security.
The treatment of restricted and deferred share units is clear under MI 55-103, which includes both an insider reporting requirement and exemptions from the insider reporting for restricted or deferred share units. If the terms of a grant of restricted or deferred share units are described in annual financial statements or public filings, there is an exemption from the reporting requirements. 16 55-103CP sets out the following guidance:
Subparagraph 2.2(b)(i) provides an exemption for a compensation arrangement which is required to be disclosed, or is disclosed, in a public document such as audited annual financial statements or another form of regulatory filing. For example, an issuer may establish a deferred share unit (DSU) plan with a view to enhancing the alignment of the interests of its directors with those of its shareholders. Assuming that the DSU plan is not otherwise covered by the insider reporting requirements under Canadian securities legislation, an insider who participated in the plan would likely be required to file insider reports as a result of the insider’s participation in the plan since the plan would likely satisfy the economic exposure test contained in section 2.1 of the Instrument. However, if the DSU plan is disclosed in a public document such as a Management Proxy Circular, an insider who participated in the DSU plan would not be required to file insider reports relating to the insider’s participation in the plan, since the insider would be entitled to rely on the exemption in subparagraph 2.2(b)(i).17
The italicized text in the quote above illustrates the uncertainty over insider reporting of restricted and deferred share units. An insider must complete a second analysis in addition to the analysis under MI 55-103 to determine whether the restricted or deferred share unit is a security. If the award does not involve an investment decision by the insider (usually because the insider has no say in the amount or timing of the grant or, in the case of deferred share units, there is a lengthy hold period determined by income tax requirements) or capital outlay, the award may not be a security. This analysis is strengthened if the award is satisfied in cash or company has the discretion to do so. Market practice will also be relevant to determining whether a restricted or deferred share unit is a security. Currently, there is no predominant market practice regarding insider reporting of restricted or deferred share units. Accordingly, an insider may decide to follow a conservative approach by reporting these awards. This will ensure that the insider will not be subject to criminal and civil penalties for failure to insider report in a timely fashion.18
Proposed Changes to Securities Laws
On December 20, 2006, amendments were made to the Securities Act, including to insider reporting requirements;19 however, these amendments are not in force at the time of writing of this article.
If these amendments become effective, they will extend the insider reporting requirements to include interests in “related financial instruments.” These interests would include economic exposure to the company and economic interest in a security of the company. This would require insider reporting if an award is made under a variety of different types of compensation arrangements, including compensation arrangements that do not provide for the grant of a company’s shares. More important, the amendments would negate or limit the availability of the exemptions from insider reporting set out in MI 51-103, including the exemptions created specifically for compensation arrangements. Given the significance that this would have on the obligations of insiders, we expect that further guidance and changes to the insider reporting regime will be forthcoming before the amendments to the Securities Act come into effect.20
Insider Reporting and Option Backdating
Recent newspaper and academic articles have suggested that a close correlation exists between the failure to file timely insider reports and the increased incidence of option backdating. It has also been suggested that the Ontario Securities Commission is not doing enough to enforce timely insider reporting. For these reasons, we expect the regulators to pay significantly greater attention to insider reporting. This may result in increased insider reporting of compensation awards, even where there is no clear legal requirement to make an insider report.