OSC Staff Notice 33-735: Increased Scrutiny of Issuance of Securities to “Accredited Investors”

August 16, 2011

The Ontario Securities Commission (the “OSC”) has issued OSC Staff Notice 33-735 (the “Staff Notice”) in respect of its concerns that issuers and dealers of securities are improperly relying on the accredited investor exemption found in section 2.3 of National Instrument 45-106 – Prospectus and Registration Exemptions (“NI 45-106”) to issue securities to investors who do not truly qualify under that exemption.

The OSC identifies the issuance of securities to persons who do not properly qualify as accredited investors as arising from confusion between the terms “financial assets” and “net assets”. The Staff Notice also addresses the failure of issuers and dealers of securities to adequately collect and assess “know-your-client” (“KYC”) information to determine whether the prospective investor is in fact an accredited investor. As a result, the OSC has stated that it will closely monitor and review issuers and dealers of securities to ensure they are doing their due diligence when issuing exempt securities under section 2.3 of NI 45-106.

Importantly, the Staff Notice highlights the responsibility of issuers and dealers to ensure that they issue exempt securities only to those investors who fall properly under the accredited investor exemption.  The Staff Notice states that reliance on what is often referred to as the accredited investor certificate in a subscription agreement whereby an investor indicates the applicable category of accredited investor under which he or she qualifies, is not alone sufficient.

Accredited Investor and the Common Misunderstanding

Securities laws in Ontario allow for the issuance of exempt securities without a prospectus if the investors in such securities meet certain requirements set out in NI 45-106, one of these exemptions being the accredited investor exemption.

The accredited investor exemption captures a number of potential investors.  Amongst the various categories of “accredited investor”, as the term is defined in section 1.1 of NI 45-106, the following three definitions are creating the confusion that is the subject of Staff Notice

  1. An individual who, either alone or with a spouse, beneficially owns financial assets having an aggregate realizable value before taxes, but net of any related liabilities that exceeds $1,000,000;
  2. An individual whose net income before taxes exceeded $200,000 in each of the two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year; or
  3. An individual who, either alone or with a spouse, has net assets of at least $5,000,000.

The misunderstanding relates to the terms “financial assets” and “net assets” being used interchangeably, despite the fact that they differ significantly.  The term “financial assets” refers to current, or liquid assets (for example, a marketable security, note, or account receivable); and an individual’s residence may not be included in calculating “financial assets”.  “Net assets” on the other hand refers to a person’s net worth, meaning assets minus liabilities (and this concept includes a personal residence and other forms of real estate).

The OSC has noted that when issuers and dealers fail to adequately explain the difference between the financial assets and the net assets tests to investors, securities may be issued to investors who do not in fact, qualify as accredited investors. More stringent KYC procedures and discussions to ensure potential investors meet the definition of accredited investor are required.

Future Expectations for Issuers and Dealers Selling Securities to Accredited Investors

The improper issuing of exempt securities to non accredited investors has led the OSC to outline the following non-exhaustive list of tips to assist issuers and dealers to ensure they are meeting their securities law obligations:

Read, understand and relay the definition of accredited investor:

Dealers should provide adequate training to chief compliance officers and dealing representatives, in accordance with Part 11 of National Instrument 31-103 – Registration Requirements and Exemptions to ensure that they understand the definition of accredited investor.  The definition of an accredited investor must then be relayed to the investor, importantly, making a distinction between “financial assets” and “net assets” for accurate completion of the KYC form.

Develop an accurate form for collecting KYC information; refrain from selling an exempt security where the information provided is insufficient for the purpose of determining whether an investor qualifies under the accredited investor exemption:

Dealers should collect, review and update KYC information to ensure that the client’s financial circumstances, investment objectives and risk tolerance are accurate.  Where the KYC form and other documentation do not demonstrate that the investor is accredited, a dealer should not rely on the investor’s acknowledgement that they meet the criteria of an accredited investor.

Ensure the exempt security is suitable for the client:

A dealer must take reasonable steps to ensure that the security in question is suitable for his/her client, even after the client has met accredited investor status.  CSA Staff Notice 33-315 – Suitability Obligation and Know Your Product sets out two requirements for determining suitability; understanding the general investment needs and objectives of their clients (KYC), and knowing the attributes and associated risks of the securities being recommended (referred to as “Know Your Product”).

Retain documentation:

Dealers should maintain written records to support the reliance on the accredited investor definition; verbal assurance from the investor that they are accredited will not suffice.

Establish policies and procedures:

Policies and procedures should be put in place to ensure that exempt securities are distributed only to accredited investors.

Report the sale of exempt securities to the OSC:

Issuers must ensure that the sale of exempt securities as well as full purchaser details are reported to the OSC by filing Form 45-106F1 as per NI 45-106.

What this means for issuers and dealers:

The impact of the OSC Staff Notice is likely to be increased scrutiny by the OSC with respect to securities issued pursuant to s. 2.3 of NI 45-106.  Issuers and dealers should consider keeping a paper trail evidencing the KYC and Know your Product steps taken, as well as a record of discussions had with potential investors to ensure the investor understands whether he or she qualifies as an “accredited investor”.

Lawyers in the Miller Thomson Securities Group would be pleased to assist on this point.


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