On October 19, the Ontario Securities Commission (OSC) issued reasons in Re Meharchand and Valt.X Holdings Inc. (Valt.X), an enforcement case concerning the prospectus, registration and fraud provisions of the Ontario Securities Act. Although the case does not break new ground in these areas, it reinforces the meaning of key concepts in securities legislation such as the geographic reach of Ontario securities law, what constitutes an “investment contract”, and when an issuer’s fundraising activities cross the line into the business of trading in securities so that registration as a dealer is required.
A few facts: In brief, Valt.X Holdings served as the parent and source of funds for Valt.X Technologies Inc. (Valt.X Technologies), an operating company that purportedly developed, produced and sold cyber-security hardware and software. Mr. Meharchand was the chief executive officer of Valt.X Holdings, the president of Valt.X Technologies, and the secretary and a director of both companies. Neither company nor Mr. Meharchand (collectively, the Respondents) were ever registered with the OSC.
The Valt.X companies derived virtually all of their funding from Canadian and American investors who bought shares of Valt.X Holdings, loaned funds in return for convertible notes and/or participated in a licensing program called CrowdBuy (described below). No prospectus was ever filed with the OSC to qualify the securities for distribution.
The CrowdBuy program: The Respondents initiated the CrowdBuy program in early 2016, after the OSC issued a temporary order that, among other things, cease-traded securities in Valt.X Holdings and prohibited the Respondents from trading in securities generally. Under the CrowdBuy program, the Respondents solicited people through the Valt.X website and via email to purchase Valt.X software licenses at a discount, claiming that purchasers could earn guaranteed returns of 20-50% in the first year through resales of the licenses. Participants were also offered the opportunity to convert their CrowdBuy subscriptions into Valt.X Holdings common shares. The CrowdBuy program also contemplated that the Respondents would hire sales agents to resell the licenses on behalf of the CrowdBuy program purchasers.
In the course of its reasons, the OSC addressed four issues that arise from time to time in discussions with our clients:
- Geographic jurisdiction: We are not surprised that the OSC rejected the Respondents’ submission that all allegations relating to non-Ontario investors should be dismissed. The OSC emphasized that the relevant question isn’t whether investors are located in Ontario but whether the circumstances of the misconduct have a “real and substantial connection” to Ontario. The Respondents’ extensive, Ontario-based fund-raising and marketing activities met the real and substantial connection test.
- Funky fundraising structures are probably “investment contracts”, no matter what you call them: At an earlier stage of the proceedings, the Respondents half-heartedly argued that securities laws did not apply to the CrowdBuy program. Later on, they conceded that the program was an “investment contract”, so that every issuance of an opportunity to participate in the program was an illegal distribution of a security. Although the CrowdBuy program involved the sale of a software license, the purchasers expected to earn a profit from resales of the licenses and relied upon the Respondents to generate those profits through resales. This type of program fits squarely within the courts’ interpretation of “investment contract”: an investment of funds with a view to profit in a common enterprise, where the profit is to be derived largely from the efforts of the person or entity that controls the enterprise.
- The burden of proving entitlement to the “accredited investor” (or any other) exemption lies with the party claiming the benefit of the exemption. In particular, the OSC emphasized that:
“A seller of securities … cannot simply accept, without discussion, an investor’s self-certification that the investor falls within the [AI] definition. The seller must explain the exemption to the purchaser and, through reasonable diligence must determine facts upon which the seller can conclude that the purchaser qualifies as an accredited investor and that the exemption is available.”
- When do the fund-raising activities of an issuer and its principals cross the line between permissible solicitation and the business of trading? In its reasons, the OSC discussed and applied the “business purpose” test set out in the Companion Policy to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). It concluded that whatever legitimate cybersecurity business might have existed at one time, it did not persist. During the material time, the Respondents were primarily engaged in the business of trading without being registered to do so, as required by the Securities Act.
The Valt.X decision is also significant because it includes a detailed analysis of section 126.1(b), the relatively new anti-fraud provision in the Securities Act, and its application to the convoluted facts of this case.