THE OFFERING MEMORANDUM UNDER ONTARIO SECURITIES LAW By: Daniel A. Coderre Soloway Wright LLP Many companies raise capital by offering shares in their capital stock for sale at one time or another. When a company is not a reporting issuer, 1 it may prepare and deliver offering material to the proposed subscribers in connection with such a sale, subject to certain rules under Ontario securities laws. This paper explains those rules. Background Information Before discussing offering memoranda, it is useful to first discuss some of the other rules and regulations under the Securities Act (the Act ), 2 from which the rules concerning offering memoranda flow. Prospectus and Registration Requirements A company may not buy or sell securities at its leisure. 3 Prior to the transfer of a security from one person to another (including share subscriptions) the transferor must register as a dealer with the Ontario Securities Commission (the OSC ). A dealer is a person who has been licensed by the OSC to trade securities either on his, her or its own behalf, or as an agent for another person. Transfers of securities from one person to another are known as trades. 4 When the transferor is a company trading a security of its own issue, this type of trade (among others) is known as a distribution. Prior to the distribution of any security, a prospectus, disclosing all of the material facts relating to the securities to be distributed, must be filed with the OSC. Registering as a dealer and filing a prospectus are both time consuming, strictly regulated and expensive processes. For most privately owned companies and shareholders, registering as a dealer and filing a prospectus are too complex and expensive to be worthwhile. Fortunately, there is an alternative. The Exemption Regime The Act empowers the OSC to create rules with respect to various matters. Among those matters are the powers to create and remove exemptions from the dealer 1 A reporting issuer is a company whose securities are listed on a market recognized by the OSC. 2 Securities Act, RSO 1990, c-s.5. 3 The most common type of security is a corporate share. Shares are only one of a lengthy list of items that are considered to be securities, for example, a warrant or an option to purchase shares are also considered to be securities. For a full definition of security, please see section 1(1) of the Act. 4 The definition of trade encompasses more that just transfers. For a full definition of the term trade, please see section 1(1) of the Act.
2 registration and prospectus requirements. 5 Effectively this means that the OSC can amend certain parts of the Act and its regulations. It is unusual to give the power to amend and override legislation to an un-elected body; however, the Legislature determined that securities laws must be able to respond to the needs of the securities market in Ontario quickly. Therefore, the rulemaking power of the OSC is explained by that fact that the OSC, with its expertise in securities law, can create new rules to meet the purposes of the Act more efficiently than the Legislature can amend the Act or its regulations. A new rule known as National Instrument 45-106 - Prospectus and Registration Exemptions ( NI 45-106 ) was recently adopted by the OSC and the other securities commissions across Canada. NI 45-106 lists most of the dealer registration and prospectus exemptions available in Ontario. Only more seldom used exemptions are contained elsewhere. The OSC has also removed all of the dealer registration and prospectus requirements contained in the Act and deleted several old rules that contained exemptions that are now in NI 45-106. 6 As mentioned above, the OSC does not have the power to physically remove the exemptions found in the Act, only to render them ineffective. Despite this awkward outcome, at least all of the Act s exemptions are removed, not just some of them, which was the case prior to the adoption of NI 45-106. I have summarized the new exemptions that are applicable to the rules concerning offering memoranda below. In this paper I refer to these exemptions, as well as the other exemptions that are set out in s. 6.1 of Rule 45-501, 7 as the OM Exemptions. Exemptions Private Issuer Exemption. 8 The private issuer exemption replaces what was known as the closely held issuer exemption and is similar to the private issuer exemption that was available to companies in Ontario until September of 2001. The private issuer exemption is generally for a trade in a security of a company that has fifty or fewer shareholders (not counting employees and former employees of the company) and is not a reporting issuer. Trades of private issuers securities may only be made to a persons listed in the exemption (including, directors, executive officers, founders and control persons and their respective family members, close personal friends 5 Act, ss. 143(1)(8) and (20). 6 OSC Rule 45-802; OSC Rule 45.501, s. 5.1. 7 OSC Rule 45-501, ss. 6.1-6.2. The other exemptions that are set out in s. 6.1 of Rule 45-501 (additional investment in investment funds, and government incentive security) are used infrequently and therefore not discussed in this paper. 8 NI 45-106, s. 2.4.
3 and close personal associates). 9 In addition to the above, for the private issuer exemption to be applicable to a trade: (a) the private issuer s articles, shareholders agreement or other security holders agreement, must contain restrictions on the transfer of its securities; and (b) the private issuer must only have distributed its securities to the eligible transferees described in Schedule A. Accredited Investor Exemption. Purchases of securities by accredited investors are exempt from the dealer registration and prospectus requirements. The list of persons fitting the definition of accredited investor is lengthy. The most common type of accredited investors who are individuals are those: (a) who alone or together with a spouse have financial assets worth at least $1,000,000.00 (financial assets are generally cash or securities); (b) whose net income in each of the last two years was at least $200,000.00; (c) whose net income in each of the last two years together with a spouse was at least $300,000.00; and (d) who alone or together with a spouse have net assets worth at least $5,000,000.00. For a full list of accredited investors, please see Schedule B of this paper. Accredited investors are also a class of purchasers of securities that are exempt if the company issuing shares is a private issuer. Where possible, the private issuer exemption should be relied on in favour of the accredited investor exemption. The accredited investor exemption requires that a form 45-106F1 be filed with the OSC, along with the payment of a fee of $500. No such form or fee is required when the private issuer exemption is used in connection with a purchaser who is an accredited investor. Founder/Control Person Exemption. Even if the issuer is not a private issuer the dealer registration and prospectus requirements do not apply to trades in a security of a company to the following persons: (a) a founder of the company that continues to be actively involved in the company s business at the time of the trade or family members of the founder; or (b) a person who has material voting control of the company. 9 For a list of persons to whom securities may be distributed pursuant to this exemption, please see Schedule A.
4 Affiliates Exemption. Trades by a company of securities of its own issue, to its own affiliate, are exempt from the dealer registration and prospectus requirements. For the purposes of the Act, companies are affiliates if (a) one of them is the subsidiary of the other, of (b) each of them are controlled by the same person. Minimum Amount Exemption. If securities of a company are purchased for an aggregate cost of at least $150,000.00, then the trade is exempt from the dealer registration and prospectus requirements. Please be aware that if the person who purchases shares in reliance on this exemption is not a person otherwise listed in Schedule A, then the company will lose its status as a private issuer. The Offering Memorandum The Offering Memorandum Defined. When a company is attempting to raise capital through new share issuances, prospective purchasers will often require that some information about the company be set out in an offering memorandum of some description before agreeing to invest. There is nothing in Ontario securities law preventing a company from preparing an offering memorandum and voluntarily delivering it to prospective purchasers. In fact, according to the OSC, the only material (if any) delivered to prospective investors who are relying on an OM exemption should be (a) a term sheet, representing a skeletal outline of the features of a distribution without dealing extensively with the business and affairs of the company; and (b) an offering memorandum. 10 An offering memorandum is a document that: purports to describe the business and affairs of a company; has been prepared primarily for delivery to and review by a prospective purchaser in contemplation of soliciting an investment from the prospective purchaser; is designed to assist the prospective purchaser to make an investment decision in respect of securities being sold; and has been delivered in respect of a distribution that would require a prospectus but for the availability of one or more of the exemptions contained in Ontario securities law. 11 Most documents that are prepared and delivered to potential purchasers in order to 10 OSC Rule 45-501, Companion Policy s. 5.6(2). 11 Act, s. 1(1) and s. 5.1(2) to the Companion Policy of OSC Rule 45-501.
5 solicit subscriptions for securities (other than prospectuses) will be considered to be offering memoranda by the OSC. However, documents that set out current information about a company for the benefit of a prospective purchaser familiar with the company through prior investment or business contacts are not considered to be offering memoranda. There is no prospectus or registration exemption available in connection with the preparation or delivery of an offering memorandum in Ontario; however, other provinces do have such an exemption. 12 To see an example of the type of offering memorandum that other provinces require in order for a trade to be exempt from the prospectus and registration requirements, please see the form of offering memorandum required pursuant to NI 45-106. 13 Companies relying on the offering memorandum exemption in other provinces also must have their investors sign the risk acknowledgement form (or a similar form) that is set out at Schedule C. It is prudent for companies in Ontario to have any investors who received an offering memorandum sign this acknowledgement at the time of their respective subscriptions, even though it is not required under Ontario securities law. Disclosure to the OSC. If a company delivers an offering memorandum to any potential purchasers, that offering memorandum (and any amendments to it that are delivered to potential investors) must also be delivered to the OSC within ten days after any securities are distributed to persons who received the offering memorandum. 14 The offering memorandum is not generally reviewed by the OSC; however, if it becomes aware that an offering memorandum fails to disclose material information, the OSC may seek to effect remedial action. It is the OSC s policy to keep offering memorandums confidential, subject to requests made pursuant to the Freedom of Information and Protection of Privacy Act. Rights of Rescission and Damages. Ontario securities law does not generally prescribe the content of an offering memorandum. However, when a purchase of securities is made in reliance on any of the OM Exemptions the following rights must be described in the offering memorandum: 15 1. The purchaser has a right of action for damages against the issuing company if offering memorandum contains a misrepresentation, (without regard to whether the purchaser relied on the misrepresentation); and 12 NI 45-106, s. 2.9. 13 NI 45-106, s. 2.9; Schedule 45-106F2. 14 OSC Rule 45-501, s. 6.4. 15 Act, s. 130.1(1).
6 2. The purchaser may elect to exercise a right of rescission against the issuing company if the offering memorandum contains a misrepresentation, (without regard to whether the purchaser relied on the misrepresentation). If the purchaser exercises this right, the purchaser ceases to have a right of action for damages against the company. The purchaser s right of rescission must be exercised within 180 days after the date of the transaction that gave rise to that right. The purchaser s right to commence an action for damages must be commenced on or before the earlier of (a) 180 days after it has knowledge of the facts giving rise to the cause of action, and (b) three years after the date of the transaction that gave rise to the cause of action. 16 If the company proves that the purchaser purchased the securities with knowledge of the misrepresentation, then the company is not liable for damages. 17 If there is a misrepresentation in an offering memorandum the company may not be liable for all of the purchaser s damages. The company is not liable for (a) any portion of the damages that it proves do not represent the depreciation in value of the security as a result of the misrepresentation relied on, 18 or (b) any damages in excess of the price at which the securities were offered. 19 Forward-Oriented Financial Information. If an offering memorandum contains information about prospective results of operations, financial position or changes in financial position, based on assumptions about future economic conditions and courses of action (also known as forward-oriented financial information, or FOFI ), it is advisable to insert the following into the offering memorandum: (a) (b) reasonable cautionary language identifying such information as FOFI, and identifying material factors that could cause actual results to differ materially from a conclusion, forecast or projection in the FOFI, and a statement of the material factors or assumptions that were applied in drawing a conclusion or making a forecast or projection set out in the FOFI. The above inclusions are important because the company will not be liable for damages and no right of rescission will exist for misrepresentations in FOFI, if it can prove that (i) the provisions set out above are contained in the offering memorandum near 16 Act, s. 138. 17 Act, s. 130.1(3). 18 Act, s. 130.1(3). 19 Act, s. 130.1(6).
7 to the actual FOFI, and (ii) it had a reasonable basis for drawing the conclusions or making the forecasts and projections described in the FOFI. 20 Exceptions. An offering memorandum delivered in connection with a distribution in a security made otherwise than in reliance on the OM Exemptions does not give rise to the rescission and damage rights described above and need not be disclosed to the OSC. However, the OM Exemptions are those most commonly relied upon when non-reporting companies issue shares to new investors (that are not employees). Consequently, most of the time when non-reporting companies issue an offering memorandum they will be issuing shares in reliance on the OM Exemptions and will have to comply with the rules set out above. Attracting the Wrong Investors. As mentioned earlier in this paper, no prospectus or registration exemption available is available in Ontario in connection with the preparation or delivery of an offering memorandum. Consequently, despite the fact that a company s offering memorandum may attract unexpected interest (for example, from persons known to the target investors), unless the company files a prospectus and registers as a dealer, whether an offering memorandum is delivered or not, every subscriber must fall under an exemption to the registration and prospectus requirements of the Act. Potential investors that are not subject to an exemption must be turned away. Penalties for Offences In addition to the rights of rescission and to claim for damages that are accorded to subscribers who rely on a misrepresentation in an offering memorandum, companies and their directors and officers may be subject to a fine of up to five million dollars, five years imprisonment, or both if a statement is made in an offering memorandum that is misleading or untrue or does not state a fact that is required to be stated or that is necessary to make the offering memorandum not misleading. 21 The penalties will apply even if the offering memorandum is not filed with the OSC, because they apply to any document required to be filed or furnished under Ontario securities law, not just those that are actually filed or furnished. The OSC also has the power to make various orders if in its opinion it is in the public interest to do so. 22 If a company does not file an offering memorandum when it should have, the OSC might consider exercising this power. Orders that the OSC can make pursuant to this power include: An order that trading in any securities by or of a person or company cease 20 Act, s. 132.1(1). 21 Act, ss. 122(1) and (3). 22 Act, s. 127(1).
8 permanently or for such period as is specified in the order; An order that any exemptions contained in Ontario securities law do not apply to a person or company permanently or for such period as is specified in the order; An order that a person resign one or more positions that the person holds as a director or officer of an issuer; and If a person or company has not complied with Ontario securities law, an order requiring the person or company to pay an administrative penalty of not more than $1 million for each failure to comply. If the OSC conducts a hearing or and investigation into a person s or company s activities, and it is satisfied that the person or company has not complied with Ontario securities law or that the person or company has committed an offence under the Act, it can order that the person or company pay the OSC s costs related to that hearing or investigation. 23 Finally, in addition to the above penalties and orders, the OSC may apply to the Superior Court of Justice for a declaration that a company has not complied with Ontario securities law and if the Court makes such declaration it may make any order that it considers appropriate, including: 24 Prohibiting the voting or exercise or any other right attaching to securities; Appointing directors and officers in place of or in addition to those then in office; Requiring a person or company to pay general or punitive damages to any other person or company. Admittedly, some of the above penalties are unlikely to be applied to a company that neglects to file an offering memorandum; however, the severity of the penalties should serve as an indication that complying with Ontario securities laws is serious business. For further advice on offering memoranda or dealer registration and prospectus exemptions, please contact me any time at: Dan Coderre Soloway Wright LLP 366 King St. East, Suite 510 Kingston, Ontario K7K 6Y3 613-544-7334 dcoderre@solowaywright.com 23 Act, s. 127.1. 24 Act, s. 128.
9 SCHEDULE A PERSONS ELIGIBLE TO PURCHASE A SECURITY PURSUANT TO THE PRIVATE ISSUER EXEMPTION The dealer registration and prospectus requirements do not apply in respect of a trade in a security of a private issuer to a person who purchases the security as principal and is: (a) a director, officer, employee, founder or control person of the issuer, (b) a spouse, parent, grandparent, brother, sister or child of a director, executive officer, founder or control person of the issuer, (c) a parent, grandparent, brother, sister or child of the spouse of a director, executive officer, founder or control person of the issuer, (d) a close personal friend of a director, executive officer, founder or control person of the issuer, (e) a close business associate of a director, executive officer, founder or control person of the issuer, (f) a spouse, parent, grandparent, brother, sister or child of the selling security holder or of the selling security holder s spouse, (g) a security holder of the issuer, (h) an accredited investor, (i) a person of which a majority of the voting securities are beneficially owned by, or a majority of the directors are, persons described in paragraphs (a) to (h), (j) a trust or estate of which all of the beneficiaries or a majority of the trustees or executors are persons described in paragraphs (a) to (h), or (k) a person that is not the public. *Many of the terms used above are defined terms. Please consult NI 45-106 for a list of definitions. Schedule A to The Offering Memorandum Under Ontario Securities Law
10 SCHEDULE B ACCREDITED INVESTORS accredited investor means (a) a Canadian financial institution, or a Schedule III bank, (b) the Business Development Bank of Canada incorporated under the Business Development Bank of Canada Act (Canada), (c) a subsidiary of any person referred to in paragraphs (a) or (b), if the person owns all of the voting securities of the subsidiary, except the voting securities required by law to be owned by directors of that subsidiary, (d) a person registered under the securities legislation of a jurisdiction of Canada as an adviser or dealer, other than a person registered solely as a limited market dealer under one or both of the Securities Act (Ontario) or the Securities Act (Newfoundland and Labrador), (e) an individual registered or formerly registered under the securities legislation of a jurisdiction of Canada as a representative of a person referred to in paragraph (d), (f) the Government of Canada or a jurisdiction of Canada, or any crown corporation, agency or wholly owned entity of the Government of Canada or a jurisdiction of Canada, (g) a municipality, public board or commission in Canada and a metropolitan community, school board, the Comité de gestion de la taxe scolaire de l île de Montréal or an intermunicipal management board in Québec; (h) any national, federal, state, provincial, territorial or municipal government of or in any foreign jurisdiction, or any agency of that government, (i) a pension fund that is regulated by either the Office of the Superintendent of Financial Institutions (Canada) or a pension commission or similar regulatory authority of a jurisdiction of Canada, (j) an individual who, either alone or with a spouse, beneficially owns, directly or indirectly, financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000, (k) an individual whose net income before taxes exceeded $200,000 in each of the 2 most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the 2 most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year, (l) an individual who, either alone or with a spouse, has net assets of at least $5,000,000, (m) a person, other than an individual or investment fund, that has net assets of at least $5,000,000 as shown on its most recently prepared financial statements, (n) an investment fund that distributes or has distributed its securities only to i. a person that is or was an accredited investor at the time of the distribution, ii. a person that acquires or acquired securities in the circumstances referred to in sections 2.10 [Minimum amount investment], and 2.19 [Additional investment in investment funds], or Schedule B to The Offering Memorandum Under Ontario Securities Law
11 iii. a person described in paragraph (i) or (ii) that acquires or acquired securities under section 2.18 [Investment fund reinvestment], (o) an investment fund that distributes or has distributed securities under a prospectus in a jurisdiction of Canada for which the regulator or, in Québec, the securities regulatory authority, has issued a receipt, (p) a trust company or trust corporation registered or authorized to carry on business under the Trust and Companies Act (Canada) or under comparable legislation in a jurisdiction of Canada or a foreign jurisdiction, acting on behalf of a fully managed account managed by the trust company or trust corporation, as may be, (q) a person acting on behalf of a fully managed account managed by that person, if that person i. is registered or authorized to carry on business as an adviser or the equivalent under the legislation of a jurisdiction of Canada or a foreign jurisdiction, and ii. in Ontario, is purchasing a security that is not a security of an investment fund; (r) a registered charity under the Income Tax Act (Canada) that, in regard to the trade, has obtained advice an eligibility adviser or an adviser registered under the securities legislation of the jurisdiction of the registered charity to give advice on the securities being traded, (s) an entity organized in a foreign jurisdiction that is analogous to any of the entities referred to in paragraphs to (d) or paragraph (i) in form and function, (t) a person in respect of which all of the owners of interests, direct, indirect or beneficial, except the securities required by law to be owned by directors, are persons that are accredited investors, (u) an investment fund that is advised by a person registered as an adviser or a person that is exempt registration as an adviser, or a person that is recognized or designated by the securities regulatory authority or, except in Ontario Québec, the regulator as (i) an accredited investor, or (ii) an exempt purchaser in Alberta or British Columbia after this Instrument comes into force. *Many of the terms used above are defined terms. Please consult NI 45-106 for a list of definitions. Schedule B to The Offering Memorandum Under Ontario Securities Law
12 SCHEUDLE C FORM OF RISK ACKNOWLEDGEMENT Schedule C to The Offering Memorandum Under Ontario Securities Law
Schedule C to The Offering Memorandum Under Ontario Securities Law 13