Are You Contemplating Raising Funds While Also Remaining Private?
June 2, 2011
Are you contemplating raising funds and remaining "private" without having to file documents with the Autorité des marchés financiers (AMF)? This article will endeavour to guide issuers with respect to the Securities Act (Québec) requirements that apply in this context.
Under the provisions of the Securities Act, every person intending to make a distribution of securities shall prepare a prospectus, unless an exemption is available. Regulation 45-106 respecting Prospectus and Registration Exemptions provides that the obligation to prepare a prospectus does not apply to the distribution of a security by a "private issuer" to a person belonging to a prescribed class who purchases the security as principal. A private issuer does not have to file any document or distribution report with the AMF, nor does it have to pay any fee pursuant to the Act when it raises funds.
What is a private issuer?
"Private issuer" means an issuer that meets the following requirements:
- It is not a reporting issuer (generally an issuer that has issued securities pursuant to a prospectus) or an investment fund.
- Its securities, other than non-convertible debt securities,
- are subject to restrictions on transfer that are contained in the issuer’s constating documents or security holders’ agreements; and
- are beneficially owned by not more than 50 persons (not including employees and former employees of the issuer or its affiliates).
- It meets one of the following requirements:
- it has distributed its securities only to persons belonging to the prescribed class; or
- it has completed a transaction and, immediately following the completion of the transaction, its securities were beneficially owned only by persons belonging to the prescribed class and since then has distributed its securities only to such persons.
Who are the persons to whom securities may be issued?
The persons belonging to the prescribed class include the following:
- directors, officers, employees, founders or control persons of the issuer or of an affiliate of the issuer;
- the spouse, parents, grandparents, brothers, sisters, children or grandchildren of a director, executive officer, founder or control person of the issuer;
- the parents, grandparents, brothers, sisters, children or grandchildren of the spouse of a director, executive officer, founder or control person of the issuer;
- a close personal friend of a director, executive officer, founder or control person of the issuer;
- a close business associate of a director, executive officer, founder or control person of the issuer;
- an accredited investor; and
- a person that is not the public.
What is an accredited investor?
Regulation 45-106 contains a detailed list of accredited investors, including a bank, municipality, government, crown corporation, registered dealer, and a corporate entity having net assets of at least $5,000,000 as shown in its most recently prepared financial statements. An individual is also an accredited investor if he or she meets certain specific criteria, including: (i) an individual whose net income before taxes exceeded $200,000 in each of the two most recent calendar years, or together with a spouse, exceeded $300,000 and who, in either case, reasonably expects to exceed that net income level in the current calendar year; (ii) an individual who, either alone or with a spouse, beneficially owns financial assets (the value of a principal residence does not enter into the calculation of financial assets) having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000; and (iii) an individual who, either alone or with a spouse, has net assets of at least $5,000,000 (including the net value of a principal residence).
Certain classes are objective, such as the "accredited investor." Others contain subjective qualification criteria, for example, "a close personal friend," "a close business associate," or an individual that is not the "public."
The term "close personal friend"
In order for the private issuer exemption to apply, "a close personal friend" of a director, an executive officer, a founder or a control person of an issuer is an individual who knows the director, executive officer, founder or control person fairly well and who has known such person long enough to be able to assess his or her capabilities and trustworthiness. The term "close personal friend" can include a member of the family who is not explicitly referred to in the prescribed class, to the extent such family member meets the above-mentioned criteria.
The relationship between the individual and the director, executive officer, founder or control person must be direct. For example, the exemption is not available to a close personal friend of a close personal friend of a director of an issuer. An individual is not a close personal friend solely because the individual is a relative, a member of the same organization, the same association or the same religious group, a client or customer, or a former client or customer.
The term "close business associate"
A "close business associate" is an individual who has had sufficient business dealings with a director, an executive officer, a founder or a control person of an issuer to be able to assess his or her capabilities and trustworthiness.
An individual is not a close business associate solely because the individual is a member of the same organization, the same association or the same religious group, a client or customer or a former client or customer.
The relationship between the individual and the director, executive officer, founder or control person of an issuer must be direct. For example, the exemption is not available for a close business associate of a close business associate of a director of an issuer.
The concept of "public"
The answer as to whether an individual is a member of the public depends on the facts of each particular case. The courts have interpreted the concept of "public" very broadly in the context of securities trading, and the question as to whether an individual is a member of the public depends on the particular facts of each case in accordance with the criteria developed by the jurisprudence.
Distribution-of-securities-to-the-public test developed by the jurisprudence
In the event investors do not qualify under the prescribed class provided in Regulation 45-106, the issuer may be deemed to have made a distribution of securities to the public, with all the consequences that result to the extent no other prospectus exemption is available in respect to the distribution. The concept of distribution of securities to the public is a factual question. Each case is a specific case. The consequences for an issuer of making or having made a distribution of securities to the public, even inadvertently, are significant.
The Act does not define the concept of "distribution of securities to the public," leaving it to be interpreted by the jurisprudence. Thus, two leading judgments that are constantly cited developed tests to determine if an issuer is making a distribution of securities to the public: the judgment in R v. Piepgrass (1959) 29 WWR 218 developed the "common-bond-of-interest" test, and the judgment in SEC v. Ralston Purina Co. (1953) 346 US 119 developed the "need-to-know" test.
The association relationship
In the Piepgrass case, an officer sold shares in a private company to five individuals. The court found there was a distribution of securities to the public because the individuals who bought the shares were at no time friends or associates of the officer, and did not share common bonds of interest or association with that person. The reasoning of the court was based on the fact that people sharing mutual bonds of friendship or association have access to the type of information normally contained in a prospectus, making such document superfluous. In the case of R. v. Buck River Resources Ltd., (1984) 25 BLR 209, the court made it clear that the association relationship must be present between the investor and the corporate executive having access to all the information that would otherwise be contained in a prospectus.
The need to know
In the Ralston Purina case, a private company allowed certain of its employees to buy the company’s shares. The Supreme Court of the United States analyzed the purposes of the Act, in particular to protect investors by compelling the securities issuer to make a full disclosure of information through a prospectus. The court concluded that it is necessary to confirm the employee has access to all relevant information to determine whether the employee needs the protection of a prospectus. For example, a senior officer of the company who has access to all the information otherwise contained in a prospectus will not be considered a member of the public according to this criteria; on the other hand, if the employee does not have access to this type of information in connection with his or her job, the employee will benefit from the protection of the Act and is entitled to the protection of a prospectus because he or she will be deemed to be a member of the public.
The case-law in Québec
The Court of Québec in appeal from a decision of the Québec Securities Commission in the case of Commission des valeurs mobilières du Québec v. Durocher, (500-27-13712-850, April 21,1989) and the Commission in the case of Roland Gingras, (CVMQ, Decision 92-DC-07, Bulletin XXIII No. 36) introduced into Québec law the association-relationship and need-to-know tests.
Consequently, an issuer will be making a distribution of securities to the public within the meaning of the Act in the event it distributes its securities to members of a community who need the protection of the Act in order to make an informed investment decision. Either an investor is included in the definition of the public if he or she needs to know the information on an issuer that is generally contained in a prospectus – or he or she maintains a relationship with the issuer that is close enough to avoid the necessity of a prospectus.
Consequences of making or having made a distribution of securities without a prospectus exemption
The Act provides that every person intending to make a distribution of securities shall prepare a prospectus, unless an exemption is available. Furthermore, a person who acts as dealer or advisor in connection with the distribution of securities cannot do so unless he or she is registered as such with the regulatory authorities or an exemption is available. Even if only a single security is distributed by the issuer to an investor who does not belong to a prescribed class provided in Regulation 45-106, the issuer may be in breach of the Act, if no other exemption is available, and would no longer be deemed a "private issuer" under Regulation 45-106. An issuer should therefore require every investor to provide representations confirming that he or she belongs to a prescribed class.
Every distribution made in violation of the Act is illegal and may give rise to criminal and civil penalties, as well as a securities-trading restriction. For any distribution made without a prospectus or a prospectus exemption, the Act provides that the person who is guilty of the infraction may be liable to a fine of $5,000 to $5,000,000. Furthermore, a person who has subscribed for or acquired securities in a distribution of securities effected without a prospectus may apply to have the transaction rescinded or the price revised, at his or her option, without prejudice to his or her right to claim damages. The plaintiff may sue for damages, as the case may be: the issuer, the promoter of the deal, their directors or officers, or, in certain circumstances, the dealer responsible for the offering.
Furthermore, a distribution of securities made in violation of the Act can have consequences at the time of future transactions involving the issuer, e.g., merger, consolidation, financing, initial public offering, securities transfers, and so forth.
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