• Exempt Market Dealers’ Misuse of the ‘Accredited Investor’ Exemption in Private Placement Financings
  • March 7, 2013
  • Law Firm: Perley-Robertson Hill McDougall LLP/s.r.l. - Ottawa Office
  • In November 2012 the Ontario Securities Commission (“OSC”) released a report entitled OSC Staff Notice 33-738 2012 Annual Summary Report for Dealers, Advisers and Investment Fund Managers which provides information for dealers that are directly regulated by the OSC, including exempt market dealers (“EMDs”). The report summarizes new and proposed rules and initiatives impacting registrants, current trends in deficiencies from compliance reviews of registrants and suggested practices to address such deficiencies.

    The report states that some EMDs are misusing the accredited investor exemption by selling prospectus-exempt securities to investors without ensuring that investors qualify as ‘accredited investors’ within the meaning of National Instrument 45-106 Prospectus and Registration Exemptions (“NI 45-106”).

    What is an Exempt Dealer?

    EMDs are exempt market securities dealers registered under provincial securities legislation in one or more jurisdictions in Canada. The regulatory framework for EMDs is set out in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (“NI 31-103”) which applies in every jurisdiction across Canada.

    EMDs may act in two primary capacities in the capital markets:

    as a dealer or underwriter for any securities which are prospectus exempt; or

    as a dealer for any securities provided they are sold to clients who qualify for the purchase of exempt securities pursuant to NI 45-106, notably investors who qualify as ‘accredited investors’.

    Who Qualifies as an ‘Accredited Investor’?

    The lengthy definition of an ‘accredited investor’ includes a list of investors such as large financial institutions, government agencies and individuals who fall within the definition in subsection 1.1 of NI 45-106.  For an individual to be considered an accredited investor for the purpose of NI 45-106 they must meet either an income test or financial asset test. The individual must either:

    have made at least $200,000 each year for the last two years ($300,000 with his or her spouse if married) and have the expectation to make the same amount this year; or

    have financial assets exceeding $1 million (excluding primary residence); or

    have net assets of at least $5 million (including net value of primary residence). 

    The OSC assumes that accredited investors do not need the protection offered by a prospectus because they can obtain and analyze the information needed to assess an investment without a prospectus and handle the loss of their entire investment, if things go wrong.

    Misuse of the Accredited Investor Exemption

    The report states that the OSC is concerned that individuals who are purchasing securities as ‘accredited investors’ do not meet the required minimum income or asset thresholds. Many EMDs continue to incorrectly interpret the definition of "financial assets" for purposes of determining if an investor satisfies the financial assets test in paragraph (j) of the accredited investor definition in subsection 1.1 of NI 45-106.

    Identifying and Verifying Accredited Investors - A Due Diligence Exercise for EMDs

    Section 1.9 of the Companion Policy to NI 45-106 states that it is the responsibility of the person distributing or trading securities to determine whether an exemption is available. Accordingly, such person can rely on factual representations by an investor provided that the person has no reasonable grounds to believe that those representations are false. Such person should retain all necessary documents that show the person properly relied on the exemption.

    Know your client (KYC) and suitability

    Dealers and advisers must ensure that any security purchase or sale recommended for a client is suitable. In order to meet the suitability obligation, EMDs should understand:

    the general investment needs and objectives of their clients and any other factors necessary for them to determine whether a proposed purchase or sale is suitable, and

    the attributes and associated risks of the products they are recommending to clients (commonly referred to as know your product or KYP).

    EMDs should be asking the investors questions regarding, among other things, their profession, income sources, liabilities and financial assets. EMDs must ensure the information collected from investors supports the use of the accredited investor exemption. The report states that where EMDs simply rely on a statement from the investor stating that he or she meets the accredited investor definition without collecting any other information to support this statement, the EMDs have failed in their obligation to take reasonable care and diligence to assess the investor’s ability to rely on the exemption.

    If the client is not an accredited investor and another prospectus exemption is not available, a prospectus is required, and the EMD is acting outside of its registration category.

    Suggested Practices Proposed by the OSC

    In order to ensure that an investor will be able to rely on the accredited investor exemption, the OSC suggests that EMDs and their registered individuals adopt the practice of (i) having a process in place to collect and document sufficient information for each prospective investor to determine whether the product can be sold pursuant to the accredited investor exemption and (ii) understanding the criteria that must be met to qualify under the accredited investor definition.