|September 22, 2012|
Previously published on September 2012
The Ontario Securities Commission (OSC) is conducting a public consultation that could end up providing businesses with broader access to fresh capital and investors with greater opportunities to buy securities issued by those businesses.
The OSC consultation concerns the so-called exempt capital market. Pursuant to Canadian securities laws, any company issuing stocks, bonds and other securities in Canada is obliged to prepare and publish a prospectus that details what is being offered, so that investors will be able to make thoroughly informed purchasing decisions.
There are, however, exemptions from the time-consuming and expensive prospectus requirement -- the “private issuer” exemption, that tends to be used by private companies, is one example, and the “accredited investor” exemption, that tends to be used by public companies, is another.
The OSC is soliciting comment on whether current prospectus exemptions available in Ontario should be narrowed or broadened.
The sale and purchase of prospectus-exempt securities in Canada has become increasingly important for investors and issuers, particularly for those who participate in the exempt capital market in Ontario.
The total amount of capital raised through all prospectus-exempt distributions reported to the Ontario Securities Commission (OSC) in 2011 was approximately $142.9 billion. Approximately $86.5 billion of that was raised directly in Ontario, of which approximately $72.8 billion was raised using the “accredited investor” prospectus exemption.
This prospectus exemption, plus the underlying principles regarding prospectus exemptions available to residents of Ontario, is now under review. The results of this review will depend on the comments that the OSC receives from issuers, investors, registered dealers and other interested stakeholders that participate in the exempt capital market in Ontario.
On November 10, 2011, the staff of the Canadian Securities Administrators (CSA), the voluntary umbrella organization of all provincial and territorial securities regulators, published CSA Staff Consultation Note 45-401 - Review of Minimum Amount and Accredited Investor Exemptions. This note provided background information on the two prospectus exemptions under review, set out a series of consultation questions, and asked interested stakeholders to submit their comments to their respective provincial/territorial securities commissions by February 29, 2012.
After CSA’s comment period closed last June 7, the OSC published OSC Staff Notice 45-707 - OSC Broadening Scope of Review of Prospectus Exemptions. In this notice, the OSC announced that it is expanding its review of the prospectus exemptions available in Ontario.
Specifically, it is going to publish a second consultation note and, over the next year, will give all market participants (issuers, investors, dealers and other interested stakeholders) a chance to comment on the accredited investor prospectus exemption and the minimum purchase prospectus exemption. The OSC would also like to receive comments regarding some of the broader issues that were raised during the CSA consultation period, including harmonizing some of the Ontario prospectus exemptions with the prospectus exemptions available in the rest of Canada.
The OSC stated that in considering changes to the prospectus exemptions available in Ontario, it would be guided by two principles -- protecting investors from unfair, improper, or fraudulent practices, and fostering fair and efficient capital markets and confidence in those markets.
As part of its consultation process, the OSC will consider under what circumstances investors do not require the protections afforded by a prospectus.
Comments from Ontario Issuers and Investors
One of the questions raised in the CSA consultation note was whether the income threshold criteria for qualifying as an “accredited investor,” (as set out in National Instrument 45-106 - Prospectus and Registration Exemptions) is too low. The CSA noted that the current individual annual income threshold of $200,000 was initially based on the individual annual income figures established by the United States Securities and Exchange Commission (SEC) in 1982. This threshold was subsequently adopted in many Canadian provinces and territories in the early 2000s and in Ontario in 2001. Adjusted for inflation, this individual annual income threshold would equate to over $443,000 (based on 1982 dollars) or $245,000 (based on 2001 dollars).
One of the principles underlying the annual income and capital accumulation threshold tests in the accredited investor exemption is that wealth is a measurement of sophistication. The assumptions underpinning the income threshold test are that:
(i) if an individual is able to generate a yearly income of $200,000, then the individual must be sophisticated enough to determine whether the purchase of a security sold without the disclosure contained in a prospectus is the correct fit for the investor’s investment objectives and risk tolerance, and
(ii) if the investor were to lose the entire investment amount, the investor has sufficient wealth-generating capacity or has accumulated sufficient wealth to withstand the loss of that investment.
The consultation note contained numerous questions with respect to whether the income threshold tests for accredited investors should be raised. However, a common theme that the OSC heard from market participants during its participation in the CSA consultation process was that wealth was a poor measurement of sophistication. The income threshold test was perceived by many to be undemocratic in that it restricted participation in the exempt capital market to a select group of investors that represented less than 1 per cent of the total population of Canada (247,450 Canadians in 2009). Raising the individual income threshold figure to $250,000 to account for inflation since 2001 would further reduce that number to 156,520 Canadians (0.63 per cent of the population), which would restrict the size of the exempt capital market for issuers and also deny a number of individuals access to investment products in which they had previously invested.1
There is also the issue of whether the income threshold test has the effect of also discriminating against Canadians by geographic region. For example, in Newfoundland, only 0.49 per cent of the population has an annual income over $200,000 whereas, in Ontario and Alberta, individuals with annual incomes over $200,000 comprise 1.14 per cent and 1.94 per cent of the population respectively.
The net effect of an arbitrary annual income-level test under the accredited investor prospectus exemption is to create a regime that provides certain individuals with investment opportunities based on their income-generating capacity, magnified by regional economic differences, rather than a regime founded on an equality of investment opportunity as measured by the actual sophistication of the investor.
Another issue with respect to using the annual income threshold as a measurement of sophistication is the idea that the individual investor is the person who has to possess the appropriate level of sophistication before he or she can actually purchase an exempt market security. The annual income threshold test ignores both the investor’s level of education and the investor’s ability to obtain investment advice from registered investment dealers.
The proposal that was presented by a number of commentators on the CSA Consultation Note was that, given the rise in education levels in Canada, many investors possess the requisite sophistication to determine their own investment objectives and risk tolerance or engage a qualified investment adviser to help them make an investment decision.2
Many commentators also perceived the lack of equality of opportunity as going beyond the regulator’s mandate of investor protection because it denies a significant number of individuals the right to determine their own investment objectives.
Another major theme was the lack of harmonization of prospectus exemptions available in Canada. For example, Ontario is the only province that does not allow investors to buy an exempt-market security using the “offering memorandum” prospectus exemption. (An offering memorandum is an offering document that discloses the issuer’s business model and the investment risk.) Although securities are sold in Ontario using an offering memorandum, Ontarians are usually only able to buy these securities if they qualify as accredited investors. In Alberta, on the other hand, any investor can purchase a security that is offered pursuant to the offering memorandum prospectus exemption so long as the size of the purchase is limited to $10,000.3
Another example of a prospectus exemption that lacks harmonization across Canada is the “Family, Friends, and Business Associates” exemption. Because Ontario does not recognize this exemption, situations arise whereby “close business associates” or “close personal friends” of a director or executive officer of an issuer who live in any province of Canada, other than Ontario, can buy a security of that issuer while Ontario family, friends and business associates, typically, cannot -- unless they earn in excess of $200,000 and therefore qualify as accredited investors.
For issuers of securities in Ontario’s exempt capital market, this lack of harmonization restricts the size of the capital market pool to which the issuer has access. For investors resident in Ontario, this lack of harmonization restricts the number and variety of their investment opportunities. In many cases non-accredited investors are simply denied access to exempt market securities, regardless of whether they have the sophistication to determine the quality of the investment product or are able to obtain advice from a registered investment dealer. Many commentators stated that this creates a small “elite” group of investors who are granted access to the exempt capital market and disenfranchises other investors who want to participate in that market.
The comments above speak to only a few of the issues that the OSC Staff Notice has identified for further review. Ontario issuers and investors now have a window of opportunity to determine the size of the exempt capital market and their ability to participate in it. Companies that issue, or wish to issue, prospectus-exempt securities in Ontario, or investors who would like to buy, or continue to buy, prospectus-exempt securities, should review the OSC Staff Notice and contact their legal counsel to determine how they can best make their views known to the OSC.
1 Source - Total Canadian Income figures published online by Statistics Canada.
2 For example, in 1990, only 40 per cent of the population had any college or university education, according to Statistics Canada. By 2005, that figure had increased to 56 per cent.
3 Note that the CSA has also published Multilateral CSA Staff Notice 45-309 - Guidance for Preparing and Filing an Offering Memorandum under National Instrument 45-106 - Prospectus and Registration Exemptions. In this notice the CSA has outlined a number of common deficiencies that the various provincial securities commissions have identified with respect to the disclosure provided in offering memorandums. While the offering memorandum prospectus exemption may provide a more “democratic” regime by allowing a wider spectrum of investors to participate in the exempt securities market, critics of the offering memorandum point to the number of common deficiencies in such documents as evidence of a prospectus exemption that does not provide adequate protection for the less “sophisticated” investor. Some of the issues the OSC will be reviewing in its extended consultation period will be: (i) the level of disclosure provided in a prospectus exempt offering document, (ii) the provision of statutory rights of rescission (the right to cancel the agreement and have the money refunded) or an action in damages where there is a misrepresentation in such a document, and (iii) the involvement of a registrant or broker whenever a security is sold to an investor under a prospectus exemption.