Source: Originally published in Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals.
 

Overview of common EMD regulatory filing deficiencies

By Stephen Warden, CA, CMC, EMDA Director and Partner, MNP LLP

EMDs are now four full years into the implementation of National Instrument 31-103 (NI 31-103) which introduced a new national regulatory regime for EMDs. Under Part 12 of NI 31-103, EMDs are required to comply with regulatory capital requirements, books and records requirements and
monthly and yearend reporting and audit requirements.

Since implementation, provincial securities regulators have been conducting on-site compliance reviews and desk reviews to assess capital adequacy. The focus of this article is to outline common filing deficiencies so that we can learn and avoid repeating mistakes in our future filings.

There, but for the grace of God, go I!

In the most recent OSC Annual Report for the year ended March 31, 2011, the OSC notes that it oversees approximately 1,250 firms that trade or advise in securities or commodity futures, or act as investment fund managers. The OSC also oversees firms registered with the self regulatory
organizations, the Mutual Fund Dealers Association (MFDA) and the Investment Industry Regulatory Organization of Canada (IIROC) although significant elements of that oversight are delegated to the SRO’s. In its report, the OSC noted that it would take a strong regulatory response to findings of registrant misconduct. The OSC noted that about 10% of its on-site compliance reviews of registered firms in each of the last two fiscal years resulted in referrals to the OSC’s Enforcement Branch for investigation.

Furthermore, its registrant risk model now takes into account whether registrants evidence the three fundamental criteria for determining suitability for registration, which are integrity,
proficiency and solvency. It also considers the sponsoring firm’s track record of submitting error-free submissions and sponsoring suitable candidates for registration. The OSC indicated that it plans to refine its approach further to take into account firms with rigorous hiring practices
and effective supervisory structures. For EMDs registered in Ontario, this suggests that it is vitally important to learn from past deficiencies in financial regulatory reporting.

Compliance Reviews – Who Gets Them and Why?

The OSC conducts compliance reviews of selected firms on a continuous basis. Generally, they use a riskbased approach to select registrants for review; however, occasionally firms are selected for review on a random basis which helps the OSC evaluate the effectiveness of its risk based approach. Compliance reviews of registered firms generally focus on their conduct, practices, operations and capital adequacy. The risk-based approach is intended to identify those firms that are most likely to have material issues. The majority of reviews are proactive in nature, but reviews may be performed on a for-cause basis where the regulators are aware of a potential compliance issue, for example, as a result of a complaint, internal OSC concern or from an SRO or another regulator. The OSC also conduct sweeps, which are compliance reviews of a sample of firms on a specific topic or in an industry sector over a short period of time. Sweeps allow the regulator to respond on a timely basis to industry-wide concerns or issues. In its report, the OSC indicated that its reviews, 31% resulted in "Enhanced Compliance” findings, 57% resulted in "Significant Enhanced Compliance” findings; 3% resulted in "Terms and Conditions” being placed on registration and 9% resulted in referrals to the Enforcement Branch.

In addition, one firm was suspended immediately under new powers available to the Compliance and Registrant Regulation Branch of the OSC. Based on my experience with other regulators in Canada and the US, firms should pay close attention to their regulatory compliance reports
and remediate each finding as soon as practicable. On the  next compliance review, you can expect your regulator will perform follow up audits on the status of remediation and expect that findings are corrected.

In June 2011, the OSC issued an updated and integrated Risk Assessment Questionnaire (RAQ) to firms which included questions relating to different areas of a firm’s operations such as registration, business activities, financial condition, custody, fee arrangements, and compliance.
The completed questionnaires were risk-ranked, and each firm was assigned a risk ranking. Similar to other regulators such as IIROC, the OSC will use the risk ranking as a tool to allocate their staff resources effectively by focusing compliance activities on higher risk firms. The OSC
indicated that in 2012 it has started conducting on-site compliance reviews of firms that are higher risk based on their responses to the RAQ.

The OSC has also indicated that it will no longer provide reminders with respect to the deadline for filings, believe that it is the responsibility of the firm to have a sufficient compliance structure in place that enables it to comply with all regulatory requirements. If a filing deadline is not met,
it may affect a firm’s continued suitability for registration and may result in terms and conditions being imposed on the firm’s registration or even suspension of registration.

In addition, firms will incur late filing fees of $100 for each business day that the filing is late, to a maximum of $5,000 annually. Ouch.

IFRS and Financial Reporting

Part 12, Division 4 of NI 31-103 sets out the financial reporting obligations for registered firms. It requires Ontario-based registrants to deliver their annual audited financial statements (and related calculation of excess working capital- the NI31-103F1) to the OSC within 90 days after their financial year end. For financial years beginning on or after January 1, 2011, Ontario-based registrants are required to deliver to the OSC their annual audited financial statements that are prepared using IFRS. IFRS also applies to certain Ontario-based registrants that are required to prepare and deliver interim financial information to the OSC. An exemption is available to registrants from the requirement to provide comparative information in financial statements and interim financial information for the financial year beginning in 2011; however, in my experience, for many EMDs the cure is worse than the disease. It is oftentimes more work to address the reasons for not providing comparative information than just getting it done.

Calculating Excess Working Capital

The OSC noted that some firms are not accurately calculating their excess working capital on Form 31-103F1 Calculation of Excess Working Capital (Form 31-103F1). When calculating excess working capital, registered firms should exclude any current assets that are not readily
convertible into cash, such as prepaid expenses and security deposits with service providers. The OSC also have concerns with firms that include accounts receivables, especially from related parties, that are not readily convertible to cash. Any receivables that are not able to be converted to cash in a prompt and timely manner should be excluded from the excess working capital calculation.

Insurance Coverage

The OSC noted some instances of inadequate insurance coverage where the amount of insurance required is based on calculations which include the firm’s total assets as well
as clients’ assets under management. Registered firms should account for the expected growth in their business in determining the amount of insurance coverage to ensure that their coverage is adequate.

Registered firms should also ensure that their bonding or insurance provides for a "double aggregate limit” or "full reinstatement” of coverage. To ensure adequate insurance coverage, registered firms should: (1) factor in any expected increase in the firm’s assets or their clients’ assets under management for the next year when determining the amount of their insurance coverage, and, (2) regularly review the adequacy of their insurance coverage, especially when there is a material change in their business or circumstances

A Reminder for Chief Compliance Officers

The OSC notes that there is often no evidence that a registered firm’s Chief Compliance Officer (CCO) has submitted an annual report to the firm’s board of directors (or its equivalent) that assesses the firm’s, and its registered individuals’, compliance with securities law. Section 5.2
of NO 31-103 outlines the responsibilities of the firm’s CCO and thus firms and CCO’s are reminded to prepare a written annual report. In my experience, the report should be appended to the director minutes.

In summary, I always find it useful to learn from the experiences of others. I recommend you review the OSC‘s comments to see what may be applicable to your firm. The EMDA provides an in-depth forum to look at financial regulatory requirements at the EMDA’s CFO Education Series: Regulatory Financial Reporting Certificate Program that was held in Calgary, Vancouver and Toronto in November this year. In future articles, I will continue to discuss other emerging developments of interest to EMDs.

For more information contact:
Stephen Warden - stephen.warden@mnp.ca

For more articles, please download the Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals

By: David Gilkes, EMDA Vice Chair and President of North Star Compliance & Regulatory Solutions Inc.

Most exempt market dealers think of the major banks or IIROC member firms when thinking about compliance with Anti-Money Laundering and Terrorist Financing (AML/ATF) laws and regulations. Many exempt market dealers don’t realize that there is a lot more to AML/ATF laws and regulations than filing of monthly ‘nil’ reports to the securities regulators to verify new clients aren’t on one of the UN or other watch lists.

It has been three years since the implementation of National Instrument 31-103 – Registration Requirements and Exemptions (NI 31-103) and the introduction of the exempt market dealer (EMD) registration category. Most EMDs have adapted to or are at least aware of the requirement to comply with securities legislation. However, the creation of the EMD category of registration made all participants in the exempt market subject to Canadian AML/ATF legislation. Too many EMD’s are still not aware of their AML obligations, and the significant risk of being offside.

Under The Proceeds of Crime (Money Laundering) and Terrorist Financing Act (the Act) and accompanying regulations (the Regulations) a "securities dealer” is defined as:

persons and entities authorized under provincial legislation to engage in the business of dealing in securities or any other financial instruments, or to provide portfolio management or investment advising services.

The AML/ATF laws serve important purposes:

• detecting and deterring money laundering and financing of terrorism;
• ensuring crime doesn’t pay; and
• fulfilling Canada’s international commitments to fight crime.

Exempt market dealers are "reporting entities” under the Act and Regulations and have certain obligations including:

• implementing a compliance regime;
• maintaining certain records and verifying client identification; and
  
• reporting suspicious transactions and terrorist property to FINTRAC.

As noted above, most EMDs are familiar with the monthly terrorist property reports sent to securities regulators (which eventually make their way to FINTRAC). Reporting suspicious transactions applies to dealers and all their employees and includes attempted transactions. For example, an "investor” whose full name is ‘Bugsy’ and has a P.O. Box for an address wishes to make a large investment with a suitcase of $100 bills, and then immediately asks how he can redeem his investment. Obviously a dealer should refuse to enter into this transaction, however, the dealer must also report this to FINTRAC as an attempted suspicious transaction.

transactions with a PEFP.

must include:

• appointment of an AML compliance officer;
• written policies and procedures to comply with the Act and Regulations;
• a written assessment of the AML/ATF risks of the business and mitigation;
• a training and compliance program for employees; and
• every two years a review must be done of the EMD’s policies and procedures, risk assessment, and training program to test their effectiveness.

The written assessment of the AML/ATF risks and mitigation, include identifying the risks presented by the EMD’s business model or its clients. Due to illiquidity and long hold periods, exempt securities generally present low risks of money laundering activity. However, they are not impervious to this activity or to risks from terrorist financing.

Finally, the EMD must have a review conducted of its AML/ATF compliance program. The review should be done by an internal or external auditor or an outside consultant. The review must address whether policies and procedures are in place, being adhered to, and comply with the AML/ATF laws and regulations. Testing effectiveness and adherence will likely include interviews with employees who meet with clients and a review of client files. The EMD can conduct a self-assesment which should be conducted by a person who is independent of the reporting, record-keeping, and compliance monitoring functions of the dealer.

Unlike the securities regulators, FINTRAC can levy a fine against an EMD for not meeting the requirements under the Act or Regulations. Failure to comply with the AML requirements, AML compliance regime, reporting, record keeping, high risk client monitoring or client identification requirements can lead to criminal charges against an EMD. Conviction for failure to retain records could lead to up to five years imprisonment, to a fine of $500,000, or both.

For more information on FINTRAC or to see the guidance on meeting the obligations under the Act and Regulations they provide, please visit: www.fintrac-canafe.gc.ca

For more information contact:
David Gilkes - davidgilkes@northstarcompliance.com

For more articles, please download the Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals

Source: Originally published in Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals.

By: Brian Koscak, EMDA Chairman and Partner, Cassels Brock & Blackwell LLP
Afzal Hasan, Associate, Cassels Brock & Blackwell LLP

The AI exemption is an important prospectus exemption in Canada since the most capital is raised under it. For example, Ontario Securities Commission (OSC) Notice 45-705 (1) states that:

"The exempt market in Canada has become increasingly important for investors and issuers. The total amount of capital raised through exempt distributions reported to the OSC in 2011 was approximately $142.9 billion. Approximately $86.5 billion of that amount was raised in Ontario. In 2011, approximately $72.8 billion was raised under the accredited investor prospectus exemption in Ontario.”

The OSC and other Canadian securities regulators are concerned that issuers and/or EMDs are failing to comply with the requirements of the AI exemption by selling exempt securities to investors who do not meet the definition of an AI. Specifically, the OSC is concerned with:

• individuals who are purchasing exempt securities as AIs (2) that do not meet the minimum income or asset thresholds;
• issuers and dealers who are incorrectly interpreting the definition of "financial assets” by including non-financial assets such as precious metals, the investor’s primary residence and other real estate as "financial assets”;
• failing to collect adequate know-your-client (KYC) information to reasonably determine whether an investor is in fact an AI; and
• EMDs simply relying on a statement that an investor is an AI (e.g., self-certification) without collecting any supporting information.
• Examples of recent OSC decisions illustrating the consequences of an EMD’s failure to comply with the AI exemption include Re Morgan Dragon Development Corp. et al (3) and Re Blueport and Hare (4), which are available on the OSC’s website. (5)
  

The AI exemption – what is it?

The definition of who is an AI is set out in the definitions section of NI 45-106. It includes 22 categories of investors who qualify as an AI including, specified governments, financial institutions and individuals who qualify based on certain income and asset tests.

The AI exemption - tests for AIs who are individuals

(a) Financial Asset Test

Financial assets means (a) cash, (b) securities or (c) a contract of insurance, a deposit or an evidence of a deposit that is not a security for the purposes of securities legislation, but does not include real property such as a personal residence.

The test permits individuals to include the value of any financial assets they "beneficially” own. (7)

(b) Net Asset Test

Unlike the financial asset test, an individual can include the value of their primary residence in their net asset test; however, they must also deduct the amount of any associated mortgage on the property. The calculation does not require a deduction for any future income taxes, but any taxes that are outstanding and payable at the time of the trade must be included.

(c) Income Test

Who is responsible for determining AI Status?

Securities regulators have stated that a person distributing or trading in securities is responsible for determining whether the AI exemption is available for an investor. (10)

Some market participants may believe they can solely rely on the self-certification of an investor who has ticked a box in a subscription agreement that they are an AI or otherwise factually represented that they are an AI (i.e., self-certification), assuming that the market participant has no reasonable grounds to believe those representations are false. However, this in itself may not be good enough. Prudent issuers and EMDs require additional information that supports a self-certification and shows that the AI exemption was properly relied upon.

The verification standard for determining AI status

The Companion Policy to NI 45-106 states that the verification standard for determining AI status must be reasonable, after careful consideration of the facts. (11)

Decisions by Canadian securities authorities and courts have confirmed this reasonable verification standard.For example:

• in a British Columbia Securities Commission decision, the Commission stated that "after making the appropriate inquiries, the issuer must have a reasonable belief that the facts are true and that the legal requirements for use of the exemption have been met”; (12)
• in an Alberta Securities Commission decision, the Commission noted that "[a]n issuer relying on an exemption in trading or distributing securities must have made a reasonable, serious effort, or taken whatever steps were reasonably necessary, to satisfy itself that the exemption was available to make the trade or distribution at the time of the trade or distribution” (13);
• in a Saskatchewan Court of Appeal decision, the Court stated that the Saskatchewan Financial Securities Commission could not sanction an issuer "if they acted with reasonable diligence to ensure the Saskatchewan purchasers of [securities] were accredited investors and had no reasonable basis to disbelieve the representations of purchasers to the effect that they were accredited investors” (14); and
  
• in an Ontario Court of Justice decision, the Court referenced the decision of the Saskatchewan Court of Appeal above as well as a previous Ontario Court of Justice case (15) as "clearly [outlining] the duties of sellers to take reasonable steps to ensure that investors fall within exemptions to the Regulations and Rules of the Securities Act” (16).

However, although compliance with the AI exemption does not have to be perfect from a securities regulatory perspective, this may not the case for a civil action by a disgruntled investor who wants their money back in circumstances where the issuer/EMD improperly relied upon the AI exemption. In such a situation, a disgruntled investor may have a cause of action against both the issuer and the EMD where the remedy sought would be to declare the sale of the securities sold either void or voidable. "Void” means treating the sale as if it never happened while "voidable” means giving the investor the option to decide whether or not they want their money back.

Arguably, if an investor is suing to get their investment back, such a distinction is irrelevant to an issuer or EMD; the investor wants their money back. Accordingly, issuers and EMDs should take every precaution necessary to ensure an investor understands and is in fact an AI when relying on the AI exemption. Lets’ examine two examples below.

Example #1

Assume the following:

• an issuer raised $5 million, through an EMD, relying on investors qualifying under the AI exemption;
• the proceeds raised were used by the issuer to acquire income-producing properties;
• the issuer has been regularly paying investors monthly dividends for over two years;
• a field review by a securities regulatory authority determined that $2 million of the proceeds raised was improperly sold to investors who were not AIs in reliance on the AI exemption and no other prospectus exemption was available;
• the securities regulatory authority is requiring the issuer to return the $2 million to the non-AIs;
• the issuer has no other funds available to repay the non-AIs; and
• the investors relied on the issuer/EMD to explain and determine that they were qualified under the AI exemption; and therefore, the investors have "clean hands”, so to speak.

In this situation, it is conceivable that the real property would have to be urgently sold by the issuer, likely at a reduced price, and the proceeds used to refund the non-AI investors. It would not matter that these investors received a regular dividend for over two years or that management was successfully executing its business plan. In fact, the issuer could be faced with a situation where it had to refund non-AI investors their money even if it meant bankrupting the issuer. Whether market participants agree with this result or not, it is a situation that no issuer or EMD would want to happen.

Example #2

• an investor was sold exempt securities under the AI exemption by an EMD;
• the issuer of the exempt securities is not performing well;
• the investor wants their money back and the issuer refuses to return their funds;
• the investor relied on the issuer/EMD to explain and determine that they were qualified under the AI exemption and therefore the investor has "clean hands”, so to speak;
• the investor was not an AI as a matter of law at the time of the trade; and
• the investor sues the issuer and the EMD.
  

In this example, the investor was sold securities under the AI exemption when they were not an AI. By doing so, the issuer/EMD may have effectively given this non-AI investor the option of unwinding the transaction at any time, subject to any limitation periods under applicable law etc. By selling securities to a non-AI under the AI exemption, the issuer/EMD may put the issuer’s business at risk as in Example #1, if the issuer does not have enough money to refund an investor, and exposes the issuer/EMD and their related management, boards and applicable registered individuals to possible regulatory action.

"We recommend that issuers and EMDs take every reasonable precaution to ensure they properly rely on the AI exemption in connection with a private placement. Better safe than sorry.”

Verification of AI status

A principles-based approach

So how do you verify an investor’s status as an AI? Unfortunately, there are no step-by-step rules from Canadian securities regulators on what exactly an issuer and/or EMD need to do to ensure compliance with the AI exemption. It is no different south of the border in the United States. Although the securities regulators in both Canada and the United States have considered such matters, they have both adopted a "principles-based” approach which does not set out any specific requirements.

Securities regulators have declined to provide a comprehensive list of adequate verification measures for various reasons, including the following (17):

• such a list may be ill-suited or unnecessary to a particular offering or investor, given the facts and circumstances; in essence, there is no ‘one-size fits all’ approach;
  
  
• a list would not provide market participants with the flexibility to adapt to:

» different approaches to verification depending on the circumstances;
» changing market practices; and
» implementing innovative approaches to meeting the verification requirement;

• reliance on a list would encourage a ‘check-the-box’ mentality which may cause the issuer to overlook or disregard information indicating that a purchaser is not in fact an AI or be viewed as mandatory verification methods to be applied in all circumstances, thereby eliminating the flexibility intended under a principles based approach;
  

• it is not possible to adequately capture the potentially wide range of verification issues and measures with a prescriptive rules-based approach. A method that  is reasonable in one set of circumstances may not be reasonable under a different set of circumstances; and
  

• producing a set of rules or a more prescriptive approach could open the doors to abuse by sophisticated fraudsters, who could ferret out loopholes permitting superficial compliance with the requirements while allowing participation by non-AIs.
  

Regardless of the reasons, it is worth exploring what these principles are, on both sides of the border, to give issuers and EMDs a better understanding of the expectations of securities regulators, so they can revisit their own best practices. These principles are discussed below.

A U.S. perspective

purchasers of the securities are AIs.(19)

(a) General

The SEC Release identifies three main factors that issuers may consider to verify that an investor is an AI:

• the nature of the purchaser and the type of AI the investor claims to be;
• the amount and type of information that the issuer has about the investor; and
• the nature of the offering, such as the manner in which the investor was solicited to participate in the offering and the terms of the offering, such as the minimum investment amount.

(b) Nature of the investor

Accordingly, the reasonableness of the steps may differ depending on the nature of the investor. For example, if an investor claims to be a registered broker-dealer (which is a type of AI in the U.S.), an issuer can verify this on FINRA’s BrokerCheck website. In Canada, existing and former registrant status can be similarly verified on the website of each Canadian securities regulatory authority.

The SEC recognizes that it may easier to obtain information about an individual’s annual income (e.g., through tax returns or other income documentation, like pay stubs) than verifying information about a person’s assets and liabilities. In fact, it may be more difficult to obtain proof of liabilities than proof of assets.

may prove helpful in demonstrating that an issuer/EMD took reasonable steps to verify an individual’s AI status. However, when in doubt, keep asking for more information and do not do the trade until you are satisfied; it is as simple as that.

(c) Information about the investor

The SEC sets out examples of the types of information about an investor that an issuer could review or rely upon, which may, depending on the circumstances, constitute reasonable steps to verify an investor’s AI status. For example, an issuer could rely on:

» if the investor is a named executive officer of a public company, one could review public filings in
any proxy statement (i.e., information circular); and
» if the investor is a corporation, one could review the audited financial statements of a corporation to determine whether the corporation satisfies certain
financial thresholds; and

» review the individual’s income tax returns;
» review industry or trade publications that disclose average annual compensation for certain levels of employment in a field or industry; or
» review and/or rely on the verification by a third party such as a broker-dealer, accountant or lawyer, provided that the issuer has a reasonable basis to rely on such third party verification.

(d) Nature and terms of the offering

How investors are solicited may also be relevant in determining the reasonableness of the steps taken to verify an investor’s AI status. For example, an issuer that solicits new investors through a website, through a widely disseminated e-mail or social media solicitation or through a newspaper (each being a General AI Solicitation), would need to take greater measures to verify an investor’s AI status than an issuer that solicits AIs from a reasonably reliable third party, such as a broker dealer in a brokered private placement.

dealer has about the prospective investor and the risk of attracting non-AIs – the public.

The terms of the offering could also affect whether the verification methods used by the issuer are reasonable. For example, an investor’s ability to meet a high minimum investment amount could be relevant to the types of steps that would be reasonable. If the terms of an offering require a high minimum investment amount, then it may be reasonable for the issuer to verify AI status simply by confirming that the investment is not being financed by a third party or the issuer, provided that there is no evidence suggesting that the investor is not an AI. (20)

A Canadian perspective

However, for ease of reference, the OSC’s non-exhaustive list of steps that EMDs should take in order to meet their obligations under securities laws when selling exempt securities to AIs is set out below.

• Read and understand the definition of AI;
• Develop an accurate form for collecting KYC information;
• Explain the AI definition to clients and ensure that their KYC forms are properly completed;
• Do not sell an exempt security if you do not have sufficient information to determine whether the client qualifies as an AI;
• Ensure the exempt security is suitable for the client;
• Review the KYC form;
• Retain documentation;
• Establish policies and procedures to ensure the AI requirements are satisfied; and
• Report the sale of exempt securities to the OSC.

Notwithstanding the OSC’s guidance discussed above, issuers and EMDs are cautioned against engaging in certain practices as discussed below.

A few cautions of what not to do

We caution that when verifying an investor’s status as an AI, issuers and EMDs should avoid the following pitfalls:

• exclusively relying on an investor’s self-certification that they are an AI by ticking and initialing a box regarding their AI status and signing the AI certificate attached to a subscription agreement;
• ignoring red flags suggesting an investor is not an AI;
• failing to update information about the investor as at the date of the trade;
• failing to keep detailed written records about the discussions and documents relied upon in determining an investor’s status as an AI;
• including investments in non-securities (e.g., precious metals, investment properties) as financial assets; and
• using creative calculations and interpretations of the criteria to determine an investor is an AI.

As a final caution, Canadian securities regulators, including the OSC, are calling investors to verify their AI status when they relied on the AI exemption to confirm the information in the KYC and subscription documents were accurate at the time of the trade.

In terms of any further guidance of what reasonable steps issuers and EMDs can take to verify an investors’ status as an AI, some market participants are using a KYC/investment questionnaire, as discussed below. KYC/Investment Questionnaire for determining an investor’s AI status EMDs have three fundamental obligations under Canadian securities law: KYC, ‘know-your product’ (KYP) and suitability obligations. A KYC/Investment Questionnaire is a useful tool for EMDs to verify the AI status of an investor.

It would typically be completed for new clients and should be regularly updated as required, but more importantly at the time of any trade. Below are sample questions that can be included in a KYC/Investment Questionnaire that can be used to assist market participants in determining the AI-status of an investor.

Issuers do not have KYC, KYP or suitability obligations under applicable law unless they are also in the business of trading, in which case, they are also required to be registered as a dealer under applicable securities law, or exempt from such registration. A questionnaire is a useful tool for issuers to verify the AI status of an investor, particularly in the context of a non-brokered private placement. (22)

Financial asset test

• What is the value of cash you have in all your accounts with any financial institution?
• What is the market value of all the securities you own?
• Do all of these securities trade on a stock exchange, automatic trading system or other quotation system or are they securities of a mutual fund?
• Do you believe these securities are liquid (e.g., can be easily sold) or relatively easy to liquidate?
• What is the cash surrender value of any contract of insurance that you have the right to, immediately if required, for your own personal benefit?
• Do you own any certificates of deposit or have evidence of a deposit that is not a security under securities legislation? What is its value?
• Have you included the value of any real estate, whether your principal residence, cottage, farm or other property for the purpose of satisfying this test?
• Have you entered into or intend to enter into any monetization scheme that will in effect provide you with available cash for purpose of satisfying this test?

Net asset test

• Is the value of the assets you have included, the fair value of those assets?
• Is there any current outstanding income tax payable in connection with that asset?
• Have you included the value of any real estate, whether your principal residence, cottage, farm or other property for the purpose of satisfying this test?
• Have you deducted the value of any loan, debt obligation, mortgage, claim or encumbrance against any of the assets you have identified that you own?
• Have you provided rough calculations or verifiable calculations as of the date of the questionnaire?

Income test

• Has your net income before taxes exceeded $200,000 in the two most recent calendar years?
• Has your net income before taxes, combined with that of your spouse, exceeded $300,000 in the two most recent calendar years?
• Do you expect to exceed that net income level in the current calendar year?

Other

• Do you understand the AI financial tests?
• Do you understand that it is illegal for you to make this investment if you do not satisfy one of the above AI financial tests?
• Has your EMD dealing representative explained what it means to be an accredited investor and provided you with the opportunity to ask any questions? If asked, were the questions answered to your satisfaction?
• Do you believe you have been pressured to make this investment by the issuer/EMD representative?
• Do you understand that you could potentially lose all the money you invested in any particular investment?
• Is the information you have provided in this questionnaire current as of the date you signed this document and will be as of the date of the trade?
• Do you understand you have a duty to update any answer, statement or information you have provided on or before the date of the trade?

The KYC/Investment Questionnaire should be completed based on a dialogue between the investor, and his or her EMD dealing representative and, if possible, signed by the investor and witnessed by an independent third party. A KYC/Investment Questionnaire can be in the form of a declaration and, if possible, a statutory declaration to give it greater legal effect. Although having a statutory declaration signed may be difficult or impractical in certain situations, such measures help protect issuers and EMDs if an investor’s status as an AI is ever questioned. (23)

Need for greater guidance

We believe that Canadian securities regulators should provide issuers and EMDs with additional guidance to assist them in determining an investor’s AI status. Although securities regulators on both sides of the border prefer a principles-based approach, evidence suggests issuers and EMDs need help.

We recommend Canadian securities regulators sharing the results of these field reviews in terms of best practices and unacceptable practices to allow the industry to see what others are doing with the idea of adopting such measures so issuers and EMDs can get it right and improve compliance.

Getting your input – a short survey

We hope to share the survey results with you in the next issue of the EMDA magazine and on the EMDA website and  perhaps use this as a basis to encourage Canadian securities regulators in providing greater guidance on reasonable steps issuers, EMDs and other market participants can take to properly rely on the AI exemption.

The contents of this article do not constitute legal advice and is provided for information purposes only. This article does not necessarily reflect the opinions of Cassels Brock & Blackwell LLP or any of its lawyers or clients. The content of this article is not intended to be used as a substitute for specific legal advice or opinions.

For more information contact:

Brian Koscak - bkoscak@casselsbrock.com
Afzal Hasan - ahasan@casselsbrock.com

For more articles, please download the Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals

23. We note that this approach is not without its detractors. Having an investor sign a statutory declaration under the penalty of perjury could have the effect of shifting the burden for compliance and associated liability from the issuer to the investor; but not necessarily. This may be an appropriate solution for sophisticated parties that are aware of the legal consequences for false representations but not for unsophisticated investors.

Source: Originally published in Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals.

By: Marsha Gerhart, EMDA Director, Counsel, Borden Ladner Gervais LLP

Following reforms underway in the U.S., the U.K., Australia and the E.U., the Canadian Securities Administrators (CSA) have released their long awaited Consultation Paper 33-403 – The Standard of Conduct for Advisers and Dealers: Exploring the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients (the CSA Paper) on fiduciary obligations of investment advisers and dealers. The CSA is seeking comment on the desirability and feasibility of a "statutory best interest standard” for advisers and dealers when providing investment advice to retail clients. Comments are due by February 22, 2013.

For purposes of the consultation, the CSA suggests the following as one possible way of phrasing the proposed best interest standard:

Every adviser and dealer (and each of their representatives) that provides advice to a retail client with respect to investing in, buying or selling securities or derivatives shall, when providing such advice:

(a) act in the best interests of the retail client, and
(b) exercise the degree of care, diligence and skill that a reasonably prudent person or company would exercise in the circumstances.

The CSA is explicit that this duty to "act in the best interests” of clients constitutes a fiduciary duty that is not open to contractual variation. Constituent elements of this duty include ensuring that: (1) clients’ interests are paramount, (2) conflicts of interests are avoided, (3) clients are not exploited, (4) clients are provided with full disclosure, and (5) services are performed reasonably prudently.

The CSA contemplates that this duty only applies when giving dealing "advice” to a retail client, and thus would not apply to discount brokers who only take orders from clients. Existing suitability requirements will continue to apply to advisers and dealers.While jurisdictions currently have different articulations of fiduciary standard, the CSA hopes to harmonize the standard across all jurisdictions.

"Retail client” is defined to mean any person or company that is not a "permitted client” (as defined in section 1.1 of NI 31-103). This encompasses individuals that have net financial assets of $5 million or less and companies that have net assets of less than $25 million. This definition of retail client is broader than the definitions proposed by the U.S. and Australia, and would include some accredited investors.

Canadian securities legislation currently requires registered advisers and dealers to deal fairly, honestly and in good faith with their clients. While industry participants debate whether this imposes a fiduciary standard, no court or regulatory body has yet come to this conclusion. There are other additional principle-based and rule-based requirements under securities law currently applicable to adviser and dealers that directly affect the client relationship including suitability obligations, conflicts of interest responsibilities and relationship disclosure information.

The CSA highlights what they believe to be five principal concerns with the current standard of conduct in Canada:

(1) The current standard of conduct is not based on the most principled foundation;
(2) The current standard does not address the problems associated with asymmetry in investment knowledge between advisers/dealers and their clients;
(3) Investors mistakenly believe that advisers and dealers already have a duty to act in their best interest, creating a gap between expectations and legal requirements;
(4) The suitability standard is not functioning to provide investors with the best investments; and
(5) The conflict of interest disclosure requirements are not being employed effectively.

While no decision to adopt a statutory best interest standard has been made, the CSA suggests that a fiduciary duty my be the best mechanism for addressing the above cited concerns, while providing enough flexibility to accommodate the concerns raised by some stakeholders, like those highlighted below.

Increased Costs - the increased due diligence likely to accompany a higher fiduciary standard has the potential to increase costs for advisers and dealers, which could negatively impact the choice, access, and affordability of advisory services for investors

Impact on Differing Business Models – a uniform standard could negatively impact advisers and dealers whose business involves advice that is specialized or restricted in some way (for example, some mutual fund dealers, exempt market dealers and scholarship plan dealers). Similarly, there is concern about the impact that this best interest duty will have on capital raising, namely, the effect on exempt market dealers and their role in raising venture capital for smaller Canadian issuers. The concern is that one universal duty is impractical and too restrictive for these widely differing business models.

Compensation Structures - stakeholders are concerned that some compensation structures, like volume based payments or embedded commissions paid by third parties to advisers and dealers, may be inconsistent with the proposed standard. While the reforms in the U.K. and Australia are moving toward banning embedded compensation practices, the SEC is taking a different approach and evaluating each broker-dealer compensation practice to determine whether they meet the test.

The EMDA submitted a comment letter on the CSA Paper, which you can review here.

For more information contact: Marsha Gerhart

For more articles, please download the Exempt Market Update, Issue 3 - the leading national magazine for the exempt market professionals

As the Exempt Market Dealers Association of Canada (EMDA) celebrates its 10th anniversary, one of its biggest and proudest moments was participation and impact on the development of NI 31-103. As a participant in the Registration Reform Working Group (the Working Group) and the Manager responsible for the project at the Ontario Securities Commission (OSC), I have good memories of meeting with members of the EMDA (then called the Limited Market Dealers Association of Canada).

In the last edition of Exempt Market Update, in the article Engagement Letter Best Practices - Part One, I focused on the importance of specifically delineating whether the mandate is exclusive or non-exclusive in an EMD’s Engagement Letter. Having discussed the critical reasons for that delineation, there is another important reason to discuss: what is commonly known in North America as the "fee-tail” and in Europe as the "tail gunner”.

The fee-tail or tail gunner is, in our experience, one of the least understood provisions of the EMD’s Engagement Letter and deserves to be understood in order to have a proper understanding (and optimal drafting) of the EMD’s Engagement Letter.The fee-tail or tail gunner, let’s stick to "fee-tail” for now, is a provision in the EMDs Engagement Letter relating to termination provisions. Commonly, if an EMD’s Engagement Letter is terminated by either the EMD or the Issuer, and a transaction is consummated within the designated "tail period” after termination (typically 12 to 24 months) with a party whom has been "introduced” (more on that later) by the EMD to the Issuer then the EMD will remain entitled to its full fees. In essence the fee tail triggers payment to the EMD as if the EMDs Engagement Letter was never terminated.

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By: Mark MacDonald, EMDA Director,Vice-President of Shareholder Relations, Bullion Management Group Inc.

Dealers of Bullion Bars are not to be confused with coin dealers and jewellers who sell coins on a retail basis at relatively high premiums. Bullion Bars dealers sell investment grade Bullion Bars, commonly gold, silver and platinum, at a small premium to the spot price. Attractive commission and trailer fee arrangements are available.

A properly balanced investment portfolio should contain at least some precious metals component but this currently is often not the case despite precious metals being the best performing asset class over the last 10 years. Many professionally managed "balanced” portfolios contain only the three asset classes: cash, stocks and bonds. The most negatively correlated asset class to these three common asset classes are precious metals, yet many "balanced” portfolios contain no precious metals component whatsoever. For the record, there are actually seven asset classes: cash, stocks, bonds, precious metals, real estate, commodities and collectibles. Arguably, down the road there may be litigation against advisors when investors who were represented that they had "balanced” portfolios fi nd out they were missing key asset classes.

Why is this the case? There are several possible explanations. One is that it is simply "inconvenient” for a regular adviser or broker to do so. In many cases, advisors are not aware of or have not been trained on precious metals. How many times has an investor called his advisor or broker to buy some physical gold Bullion Bars only to end up investing in speculative gold mining stocks? The fact is that currently, there are just not that many active Bullion Bars Dealers available to deal with and few investors that realize buying a Bullion Bar for the very first time is less complicated than purchasing a stock.

So the question on everyone’s mind is: what’s going to happen to the price of gold? About 10 years ago, I heard the commentary that despite conspiracy theories and market manipulations, 90% of the price movement of gold would be inversely correlated to the US dollar. Generally speaking, this has pretty well been true. As the price of the US dollar goes down, the price of gold has gone up, and vice versa. In order to think that the price of gold is risky then you have to think that the United States is going to start paying off some of its debt so that the US dollar will strengthen. This just isn’t going to happen! Gold is bound to go up – I just don’t know when.

A further consequence of this situation is that gold is not in a bubble. To the contrary – if only a small portion of the world’s 200 trillion dollars currently invested in financial assets were to convert to some of the 1.5 trillion dollars of gold available after allowing for the 1.5 trillion dollars of gold bullion held by central banks, then the price of gold would soar.

If the US dollar declines in value then everyday prices will rise. The extent to which the US dollar has lost its purchasing power in the past is illustrated by the fact that in the 1960s you could get a new car for $2,500 and a great meal for under $5.

Think of it this way - if you could choose to bury $10,000 of US dollars for 10 years or $10,000 of gold for the same period of time, which would you choose?

For more information contact: Mark Macdonald

An exempt market dealer (EMD) must not make a recommendation in any medium of communication to buy/sell/hold a security issued by the EMD or a "related issuer” or "connected issuer” of the EMD unless the EMD discloses, in the same medium of communication, the nature and extent of the relationship or connection between the fi rm and issuer (e.g., related and/or connected issuer disclosure). The terms related issuer and connected issuer are defi ned in National Instrument 33-105 Underwriting Conflicts (NI 33-105)

Section 13.6 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations sets out the disclosure requirements for EMDs who have relationships with related and connected issuers. However, many EMDs may not know that related and connected issuer disclosure requirements are also set out in NI 33-105.

NI 33-105, the disclosure obligations in NI 33-105 generally apply to EMDs that act as principal or agent in connection with most but not all types of prospectus-exempt distributions, including distributions made in reliance on the accredited investor exemption in section 2.3 of NI 45-106 Prospectus and Registration Exemptions. In Ontario, NI 33-105 does not apply to EMDs selling mutual fund securities or the following "exempt securities”:

Read More

The Saskatchewan Financial Services Commission (the SFSC) has previously issued a staff notice commenting on its review of OMs in SFSC Staff Notice 45-704 – Review of Offering Memorandums under NI 45-106 Prospectus and Registration Exemptions. The SFSC found material disclosure deficiencies in all OMs that were reviewed, noting that "[i]n general, the OMs were poorly prepared and did not provide the disclosure required” (3) by the Forms.

Based on a review of the number of cease trade orders that have been issued in British Columbia and Alberta for materially deficient OMs, the quality of OMs prepared in other provinces does not seem to be substantially better.

Read More

For more information contact: Stephen Warden

For more articles, please download the Exempt Market Update - the national magazine of the EMDA

For more information contact: Jacoline Loewen

For more articles, please download the Exempt Market Update - the national magazine of the EMDA

Some exempt market dealers and dealing representatives of EMDs (collectively, EMDs) are uncertain whether they can be compensated with securities (e.g., broker warrants) in connection with a private placement transaction. The confusion stems from the definition of an Accredited Investor under National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106), which carves out limited market dealers (LMDs) (a former registration category of dealer in Ontario).

The simply answer is yes, an EMD is an accredited investor.

Section 1.1(d) of NI 45-106 states that any registered person under securities legislation of a jurisdiction of Canada as an advisor or dealer, other than an LMD under one or both of the Securities Act (Ontario) orthe Securities Act (Newfoundland and Labrador), is an Accredited Investor.

The reference in Section 1.1(d) of NI 45-106 has caused some confusion since some market participants have assumed the reference to LMDs is extended to EMDs; it is not. The logic is that under Registration Reform the EMD category became a national and more robust registration category since it now imposes, proficiency, insurance, regulatory capital and other requirements which did not previously exist under securities legislation in Ontario or elsewhere in Canada.

Therefore, the next time you are offered securities (e.g.,broker warrants) as part of your EMD compensation,be comfortable taking them, since you satisfy the definition of an accredited investor.

A Caution for Northwestern Exemption Users

Unlike an EMD, a market intermediary operating under the Northwestern Exemption cannot be compensated with securities (e.g., broker warrants) in connection with a private placement unless he/she/it satisfies a prospectus exemption.

For more information contact:
Brian Koscak - bkoscak@casselsbrock.com
David Gilkes - davidgilkes@northstarcompliance.com

For more articles, please download the Exempt Market Update - the national magazine of the EMDA

A term sheet is just a stepping stone towards an actual deal. Exempt Market Dealers negotiating the term sheet with private equity or venture capital (VC) investors need to alert business owners that most investors will load term sheets with pre-conditions to financing as well as escape clauses in their favour.

In rushing to the finishing line, clients must be made aware of the potential bear traps with term sheets to be understood and avoided. Here is a list to share with your client, the business owner:

Bear Trap 1 - No-Shop Clause

The private equity investor will want to include the "no shop” clause, which means that you cannot show the business to other investors while this investor is humming and hawing whether to buy in as partners.

The investor may justify keeping you on the hook, saying "All of our partners need to see you.” Do not go for this justification; find out the fund’s approval process.

Forty days of being exclusive to one fund is the longest you need. Sixty days is too long to be out of the market looking for investors.

Bear Trap 2 - Investor’s Legal Expenses

Some private equity investors say, "I want my legal fees paid, even if I don’t get the deal closed.” This is not the norm and you should push back against including this in the term sheet.

If they are included, there should be a cap on legal expenses at a fixed amount. Do not leave the amount open-ended.

An investor should be kept motivated to close the deal if they know they have limited time to have sole rights to examine your business and that they must bear the costs of their own due diligence.

Bear Trap 3 - Confidentiality Clause

You need to make sure that the results of due diligence are confidential. The confidentiality clause protects the assets of your company. It must apply to both parties and must protect customer trade secrets. The investor cannot reveal the results to anyone as they could poison the market.

Bear Trap 4 - Share Ownership

The investor says, "I bet on you and your team and if you leave, then I’m paralyzed. Your shares should be surrendered.” Clauses for founders to sell back their shares if they leave the company are critical to define upfront. The period for exercise of shares should be short, not an open-ended time and it should be negotiated furiously.

Bear Trap 5 - Non-Compete

Investors may try to put the non-compete clause into the term sheet, rather than in the employment contract because it adds more teeth. The non-compete does not apply to the investor due to their broad focus across different parts of the value chain in one market. In other words, if it was dating, if you break up you are not allowed to date but the investor can.

Bear Trap 6 - Security and Covenants

In the early meetings, the onus is upon you to look at the private equity or VC investor’s portfolio of companies. Ask yourself if any of those portfolio companies could take your ideas and use them to your detriment. As you know, investors on boards of competitors have a fiduciary duty to report information that they learn about your company. Some investors may even meet you for an information gathering session to glean competitive information for their gain. One hint: If VC investors are using their Blackberry, then they are more likely to invest. If the VC investors are paying full attention, the meeting is more likely to be a fishing expedition rather than to invest in your company!

For more information contact: Jacoline Loewen - jbloewen@loewenpartners.com

One of the first steps a company (the Issuer) seeking to raise funding in the exempt market will take is the formal written engagement of an Exempt Market Dealer (the EMD) pursuant to an Engagement Letter. The Engagement Letter is typically in the EMD’s"standard form” and will as a matter of course deal with,amongst other things, issues such as the Nature of the Engagement, Scope of Services, Compensation,Reimbursement of Expenses, Information Exchange, Indemnification and Public Announcements. While in our experience, the entering into of an Engagement Letter tends to be somewhat perfunctory, a number of critical issues should be dealt with as a matter of "best practice” by an EMD. Over the next few issues of the Exempt Market Update, we will outline a number of recommended ‘best practices” for EMD’s and their Engagement Letters.

Best Practice #1 - Clearly identify the Nature of the Engagement: Exclusive, Non-Exclusive,Non-Exclusive with Protected List or Limited Protected List

The Engagement Letter should clearly set out whether the EMD’s engagement by the Issuer is in the nature of exclusive (i.e. the Issuer may not retain the services of any other EMD during the term),non-exclusive (i.e. the EMD may retain the services of other EMD’s during the term ) or non-exclusive with a protected list (i.e. the Issuer may engage the services of other EMD’s during the term, but the EMDwill be protected in terms of compensation for those investors identified on the Protected List). The practical consequence of not clearly setting out that the nature of the Engagement will in all likelihood lead to the Engagement being deemed to be non-exclusive, with the ability of the EMD to engage other EMD’s during the term of the Engagement Letter and compensation being paid to the first EMD only for those investors it introduces and for which there is a closing during the term.

Alternatively, a properly drafted exclusive mandate will entitle the EMD to exclusive representation of the Issuer during the term of the Engagement Letter and the right to receive compensation for any amounts raised during the term, howsoever the investment is procured (i.e. compensation whether the EMD introduces or procures the investor or the investor comes from another source without the EMD’s involvement). It is also critical in drafting an exclusive Engagement Letter that the exclusivity terms be consistent throughout the entire agreement.

Very often we see Engagement Letters that are internally inconsistent in their terms, namely, the"Engagement” section of the Engagement Letter appoints the EMD on an "exclusive” basis, but the Compensation section of the Engagement Letter speaks to the EMD being compensated for amounts"raised by the EMD”. This is sub-optimal drafting as"amounts raised by the EMD” implies the EMD must actually source the investor and be, in the words of courts who have considered the issue, the "procuring cause”of the investment, whereas in a properly drafted exclusive mandate, the EMD should be compensated for any amounts received by the Issuer during the term of the Engagement Letter, whether the EMD is the "procuring cause” of the investment or not.

The Non-Exclusive with Protected List mandate is a hybrid, occupying the middle ground between the Exclusive and Non-exclusive mandate, whereby the Issuer is free to retain the services of other EMD’s during the term of the Engagement Letter, but the EMD will only be compensated on a success basis for those investors for whom it is either the procuring cause and who are not identified on the Protected List and compensation will also flow for those investors who are specifically identified on the Protected List(the Protected List usually being appended to the Engagement Letter).

A slight variation to the foregoing is called the Limited Protected List mandate, which does not confer any mandate on the EMD other than to solicit those investors specifically identified on the Protected List.This type of mandate is often used to bridge the gap where the EMD has no pre-existing relationship with the Issuer, is approaching the Issuer for a mandate because the EMD believes it can source funding from a specified investor and the Issuer is leery to confer a mandate on the EMD, other than a limited one to approach the EMD’s specified investor(s) on the Protected List.

In all circumstances, whether Exclusive, Non-Exclusive, Non-Exclusive with Protected Listor Limited Protected List, best practice dictates that the nature of the mandate be clearly set out in writing in the Engagement Letter. Do not leave it vague and specifically use the terminology in the Engagement Letter that references "exclusive”, "non-exclusive” or"non-exclusive with a Protected List and the like. In addition, it is important to make sure the Engagement Letter is internally consistent as between the nature of the mandate (i.e. exclusive / non-exclusive or protected list) and the other sections of the agreement,especially the EMD’s "Compensation” provisions.

Negotiation Tip

In our experience, unsophisticated or first-time Issuers sometimes just assume that a non-exclusive engagement is necessarily in their best interests and try at the outset of the negotiation of the Engagement Letter to resist an exclusive engagement - this on the theory that a non-exclusive Engagement provides the Issuer more flexibility in terms of allowing the Issuer,should it decide, to engage more "feet on the street”to raise capital through various EMD’s simultaneously.I believe this is an incorrect assumption, which in many cases can and should be refuted.

Optimal results of a fundraising exercise are typically achieved by the EMD when (a) the EMD has a proven track record of raising capital in the Issuer’s particular industry domain (i.e. mining, high tech, manufacturing,biotech etc, etc) and (b) the EMD is in a position to create a professional, co-ordinated and controlled auction for the investment opportunity.

Nothing could we worse for an offering than the"deal collision” that results when two different EMD’s approach the same investor at the same time, or a scattered or shotgun approach to marketing through uncoordinated efforts is engaged in, which risks the impression of disorganization at best and desperation at worst. Experience teaches that an Issuer and its EMD only have one chance with a potential investor to make a good first impression and as such, an uncoordinated, duplicative marketing approach, which can result from two EMD’s engaged simultaneously, rightly or wrongly often reflects poorly on the investment opportunity itself. This should be clearly explained to the Issuer.Next Issue - Part Two: Best Practices when drafting "Fee-Tails” in EMD Engagement Letters.

For more information contact: David Brown - dbrown@weirfoulds.com

For more articles, please download the Exempt Market Update - the national magazine of the EMDA

On May 13, 2011, the Ontario Securities Commission (OSC) published OSC Staff Notice 33-735 – Sale of Exempt Securities to Non-Accredited Investors (OSC Staff Notice 33-735), which has two primary objectives:

• provides guidance on the financial assets versus the net assets tests of the definition of an Accredited Investor (principal residence and ‘other real estate’ excluded from the financial assets test); and
• sets out the OSC’s expectations for issuers and dealers selling securities to Accredited Investors.

Although OSC Staff Notice 33-735 is issued by the OSC and not the Canadian Securities Administrators, it provides helpful guidance in this area, especially its list of steps that issuers dealers and their dealing representatives should take in order to meet their obligations when selling exempt securities to an Accredited Investor.

It is not sufficient for issuers/dealers to simply rely on a client initialling or checking off a box in an Accredited Investor certificate (or a schedule to a subscription agreement) stating that the investor is purchasing the security as an Accredited Investor. More action is required as set out in this chart:

For more information contact:
Brian Koscak - bkoscak@casselsbrock.com
David Gilkes - davidgilkes@northstarcompliance.com

For more articles, please download the Exempt Market Update - the national magazine of the EMDA

By: David Gilkes, EMDA Director and President of North Star Compliance & Regulatory Solutions Inc.

National Instrument 31-103 (NI 31-103) is not just a registration rule and the Canadian Securities Administrators reinforced this message by changing the title of the Rule to Registration Requirements, Exemptions and Ongoing Registrant Obligations in July 2011. The requirements for exempt market dealers do not end with being granted registration,there are ongoing compliance requirements that need to be addressed each and every day and with each transaction.

The cornerstone of securities regulation for dealers is the requirement to treat your clients honestly, fairly and in good faith. This requirement is the basis for the Know Your Client and Suitability requirement under NI 31-103. The focus on KYC and Suitability by regulators is evident in every compliance report issued by the securities regulators. There are scores of references to KYC and Suitability made by the regulators in companion policies, staff notices,compliance reports, and other publications.

For exempt market dealers KYC and suitability requires making a proper determination that an exemption is available under National Instrument45-106 – Prospectus and Registration Exemptions (NI 45-106). This article will look at the recent issues raised by the regulators in relation to using the Accredited Investor exemption under NI 45-106. It will also provide the steps exempt market dealers can take to remain compliant with securities legislation.

Accredited Investor Exemption

The Accredited Investor exemption is a commonly used exemption for raising capital across the country.However, in Ontario, where the Offering Memorandum is not available, the AI exemption is the most commonly used exemption by issuers and dealers to sell to arms-length investors. Determining an investor meets the definition of an Accredited Investor is not simple considering there are 22 categories in the definition.

The regulators tend to focus on individuals who are Accredited Investors and therefore must meet the income test (1), the financial assets test (2) or the net assets test (3). The dealer is expected to make appropriate inquiries or investigations to determine if an investor meets the definition of an accredited investor. If the client lies to the dealer about meeting the definition of an Accredited Investor there are no consequences for the client. There are consequences to the dealer despite making appropriate inquiries. The regulators are aware of the difficulty facing dealers and they often focus on patterns and documentation before concluding there is a compliance issue with the dealer.

Determining Whether an Exemption is Available

The BCSC discussed the determination of whether an investor meeting an exemption in a Compliance Outreach presentation delivered on November 24,2011. The BCSC made it clear that the person making the trade must make the determination that an exemption is available. In the case of EMDs, it is the dealer that is making the trade (the investor places the order) that EMD has the burden of proving the exemption is available. If the EMD does not document its determination, it is unlikely that the regulator would find that the exemption was available. Representations by the client are likely to be insufficient without corroborating evidence retained by the EMD.

The OSC provided guidance relating to whether an individual is an Accredited Investor in OSC Staff Notice 33-735 – Sale of Exempt Securities to Non-Accredited Investors (Notice 33-735) on May 13,2011. Notice 33-735 provides a number of steps thatEMDs can take to ensure its dealing representatives are recommending securities to individuals who are Accredited Investors.

Training - NI 31-103 requires firms to provide adequate training to ensure that dealing representatives understand the Accredited Investor definition, especially the difference between financial assets and net assets. Dealing representatives should understand the Accredited Investor definitions and be able to explain it to clients. EMDs should be able to point to the training program in the course of a compliance field review by the securities regulator.

Know Your Client form - EMDs should create and use an accurate form for collecting KYC information.The KYC form (often a new client account opening form) must include information about client’s financial circumstances, investment objective and risk tolerance but should also have information to confirm an individual is an Accredited Investor.

Communication with the client - Explain the Accredited Investor definition to clients and ensure that their KYC forms are properly completed. Completing the KYC form is not a form filling exercise but a dialogue with the client about their investment needs. Clients should not believe all they need to do is check the Accredited Investor box rather the definition should be clearly explained to clients before they complete their KYC form. Any relevant notes about the client’s status as an Accredited Investor should be made on KYC form or kept with the form in the EMD’s files.

Supporting documentation - Do not sell an exempt security if you do not have sufficient information to determine whether the client qualifies as an Accredited Investor. An EMD must verify that the KYC information satisfies the appropriate Accredited Investor definition. An EMD cannot simply rely on a signed subscription agreement or the client’s representation of the commonly used statement "Of course I’m an Accredited Investor”. In some cases even a business card could be a supporting document(e.g. dentist, lawyer).

Suitable investments - In addition to making certain the client meets the Accredited Investor definition, an EMD must ensure the exempt security is suitable for the client. Section 13.3 of NI 31-103 sets out the suitability requirement. The companion policy of NI31-103 and CSA Staff Notice 33-315 – Suitability Obligation and Know Your Product, provide useful guidance to dealing representatives in relation to determining whether a proposed trade is suitable.

CCO review - The CCO must review the KYC form to ensure that the information collected is complete,accurate and consistent with the appropriate Accredited Investor definition and the trade is suitable for the client. The CCO is in effect the "second set of eyes” to ensure compliance with the EMD’s gatekeeper role.

Record keeping - EMDs should retain records that support reliance on the Accredited Investor definition and that the client was properly eligible to rely on the Accredited Investor exemption. Regulators will want to review this documentation when conducting a compliance field review of the EMD. It is a good practice for a dealing representative to have a back-upset of client records.

Policies and procedures - An EMD’s Policies and Procedures Manual (PPM) should establish policies and procedures to ensure securities sold under the Accredited Investor exemption are sold only to investors who satisfy the appropriate Accredited Investor definition. The CCO has the responsibility of ensuring the PPM is followed in conjunction with the Ultimate Designated Person.

Reporting - The sale of exempt securities must be reported to the appropriate securities commission.The CCO is responsible for verifying that the issuer has filed a Form 45-106F1 for sales made in reliance on the Accredited Investor exemption. A copy of a signed Form 45-106F1 should be included in a closing book in connection with a private placement offering.

As noted above, the requirement to treat your clients honestly, fairly and in good faith is considered the cornerstone of securities regulation. When dealing with Accredited Investors meeting this requirement starts with the definition of Accredited Investor and knowing your client meets the definition.

Notes:

1. 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.

2. An individual who, either alone or with a spouse, beneficially owns financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000.

3. An individual who, either alone or with a spouse, has net assets of at least $5,000,000.

For more information contact: David Gilkes - davidgilkes@northstarcompliance.com

By: Stephen Warden, CA, EMDA Director and Partner, parker simone LLP

In an effort to provide timely input to issuers, last week on February 28, 2012 the OSC’s Office of the Chief Accountant released OSC Staff Notice 52-720,Financial Reporting Bulletin highlighting areas of interest that the OSC has observed from their review of IFRS adoption experiences by issuers in2011. Those EMDs with year ends beginning on or after January 1, 2011 similarly need to prepare their financial statement in accordance with IFRS and file these with the OSC.

The OSC had observations and recommendations in the following key areas:

Business Combinations

Business combination accounting is not usually a major issue for many EMDs as non-consolidated financial statements must be prepared for regulatory reporting under NI 31-103. On the other hand, EMDs involved with private placements and deals should be aware that the OSC has noted recognition and measurement issues with step acquisitions, the method of acquisition accounting (IFRS requires identifiable assets and liabilities assumed be recognized at full fair value even when the acquired interest is less than 100%).

Further, the new disclosure requirements for acquisitions are far more extensive under IFRS and this will put more demands on dealer due diligence, financial statement preparers and their auditors. Based on review of 2011interim filings, the OSC noted deficiencies in new IFRS disclosure requirements including:

• a qualitative description of what makes up goodwill.
• revenue and profit or loss of the acquiree since the acquisition date.
• pro-forma revenue and profit or loss of the combined entity.
• the reason for the acquisition.
• gross contractual amounts of acquired receivables and an estimate of the contractual cash flows expected to be collected.

The OSC asks, "From reading the financial statements, do investors understand what was acquired, how it was acquired and why it was acquired?”Common

Control Business Combination Transactions

IFRS does not currently provide guidance on accounting for common control transactions where the businesses are controlled by the same group before and after the business combination transaction. This sometimes impacts EMDs when they are combining or reorganizing related EMDs or other entities under a holding company ownership. The OSC identified 3approaches in use including:

• Book value accounting ( carry-over basis) for the current and comparative years as though they had always been combined ( similar to what had been required under previous EIC 89 Canadian GAAP).
• Book value accounting (carry-over basis) from only the date of acquisition, without combining from the beginning of the fiscal year nor restating the comparative year results.
• Applying purchase accounting on the basis that the acquirer is a separate unrelated entity.

The OSC‘s view is that investors should have financial information both before and after the common control transaction without any gaps in the periods presented. Thus the first method above would appear to be the preferred method to apply (which is consistent with previous Canadian GAAP). The OSC encourages consultation with them regarding an entities’ proposed accounting treatment for complex common control transactions.

Impairment

EMDs need to be aware that there are significant differences between the recognition and measurement of impairment losses (and reversals) under IFRS compared to previous Canadian GAAP.

Key areas of OSC interest include:

• Disclosures relating to each material impairment loss or reversal of impairment provisions (under IFRS what has gone down in value may go up and the provision reversed if appropriate). 
• Disclosures required for estimates used to measure recoverable amounts of cash generating units (CGUs) containing significant goodwill or intangible assets with indefinite lives irrespective of whether there has been any impairment or not.

The OSC is focusing on whether the financial disclosures provide the necessary information for investors to easily understand how recoverable amounts and fair values (including assumptions)are determined. The OSC also suggests that where the market cap of an issuer is less than the carrying amount of an issuer’s net assets, then there should be disclosure to explain the shortfall and why the carrying value of the net assets is supported. Finally,the OSC reminds issuers to ensure that cash flow projections are reasonable and supportable (e.g.forecast period, discount rate, growth rate, sales trends, working capital and cap ex requirements) as well as the approach for determining fair values for assets having unobservable market prices.

Critical Judgments and Sources of Estimation Uncertainty

When applying the Company’s accounting policies, IFRS requires disclosure of judgments having the most significant effect on amounts recognized in the financial statements. Canadian GAAP did not have a similar requirement and thus this will be new to EMDs and reporting issuers. IFRS also requires disclosure about assumptions made concerning sources of estimation uncertainty at year end which have a significant risk of resulting in a material adjustment to the carrying amount of assets and liabilities within the next fiscal year. You have to ask yourself, "Which estimates require management’s most difficult, subjective or complex judgments?”

You will have to be concerned with not "cluttering up” the financial statement with disclosures of insignificant or immaterial judgments. The OSC also reminds issuers that disclosures will not meet Staff expectations if disclosures are lacking in substance(aka Boilerplate) and/or does not separate critical judgments from sources of estimation uncertainty.This will result on EMDs putting more time and effort into the assessment of critical judgments, sources of estimation and more extensive tailored disclosures in their financial statements.

Going Concern

The OSC expects that issuers differentiate uncertainties that cast significant doubt on a company’s ability to continue as a going concern from uncertainties that do not cast such doubt. Here too, the OSC warns issuers not to use disclosures which could be considered "boilerplate” and lack specificity. As such,an issuer will need to explicitly identify the material uncertainties which cast significant doubt upon the company’s ability to continue as a going concern.Of course, where there is now a going concern condition, the auditor’s report should include a matter of emphasis paragraph (which was newly introduced to Canada in late 2010).

Non-GAAP Financial Measures and Additional GAAP Measures

Many EMDs will want to review CSA Staff Notice52-306 Non-GAAP Financial Measures and Additional GAAP Measures which has been recently revised to provide additional information on Staff’s expectations for disclosure of additional GAAP measures presented under IFRS.

The notice describes practices that help issuers and certifying officers address their obligations to ensure that the information they provide to the public is not misleading. The practices contain examples of subtotals that should not be presented in the statement of comprehensive income. These examples include subtotals without labels, "income before the under noted items”, adjusted EBITDA and adjusted EBIT. The OSC also reminds issuers who include"operating earnings” or similar subtotals to include all items of an operating nature within the subtotal.

In addition, the OSC provided a summary of areas of interest on which they will focus their reviews in 2012,including:

• Provisions - in particular, disclosure of whether the discount rate used is credit adjusted or not and the nature and changes in estimates where an estimate previously reported is significantly changed).
• Fair value measurement (consideration of the impact of current economic conditions on risk adjustments and discount rates).
• Debt classifications.
• Statement of comprehensive income - presentation.

For those EMDs now finalizing their December 31stfinancial statements or preparing for future year ends,you may wish to take a review of the OSC Financial Reporting Bulletin to ensure that you have addressed the applicable areas of OSC focus in your year end financial statements.

For more information contact: Stephen Warden - stephen@parker-simone.com

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