PDO_TXT-Sec02-Chap06_2023_08_EN_V01.pdf

The Distribution of Securities 6 CONTENT AREAS Introduction Bringing Securities to the Market Exempt Issues Maintaining Publicly Trading Status Special Considerations for Investment Dealers...

The Distribution of Securities 6 CONTENT AREAS Introduction Bringing Securities to the Market Exempt Issues Maintaining Publicly Trading Status Special Considerations for Investment Dealers Summary LEARNING OBJECTIVES 1 | Describe the main factors involved in bringing securities to market, including prospectus requirements, purchaser rights, and restrictions on trading. 2 | Discuss the various prospectus exemptions. 3 | List the key requirements for maintaining publicly trading status, including continuous disclosure and proxy solicitation. 4 | Explain the rules and recommendations related to underwriting and the distribution of securities. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 3 INTRODUCTION In the previous chapter, we focused on the compliance and risk management challenges investment dealers face when carrying on investment banking activities. For executives operating in this branch of the securities industry, an understanding of all aspects of the business is necessary to ensure that risk management policies and procedures are appropriate and adequate. In this chapter, we turn our attention to the distribution of securities in the market. We discuss the rules and requirements for the issuance of securities when the issuer is entering the market for the first time and when it is bringing new securities of a previously traded class of securities to the market. We also discuss what is required for issuers to maintain publicly traded status. We end the chapter with a focus on some of the challenges and risks that the distribution of securities presents to investment dealers and individual registrants. Executives at a dealer member must have a thorough understanding of the way securities come to market. Even if you are already familiar with the process, this chapter can serve to refresh your knowledge for the purpose of managing legal and compliance risk at your firm. BRINGING SECURITIES TO THE MARKET Corporations raising funds from the public through the issuance of securities are subject to a number of safeguards and disclosure requirements imposed by the securities administrators. These requirements are in place to ensure the integrity of the capital markets, while at the same time allowing the orderly flow of capital into the economy to support the issuing corporations. The purpose of regulation in this respect is to balance these two competing demands and to allow clients who wish to invest to do so on an informed basis. To that end, the securities administrators have developed various procedures and disclosure rules pertaining to the preparation of a detailed document called a prospectus and to the subsequent sales of previously issued securities. Unless an exemption has been granted, all provincial securities acts require that a prospectus be filed and delivered for every offering or sale of securities that is deemed a distribution to the public. In simplified terms, a prospectus is the investment contract between the investor and the corporation offering its securities for sale. The document is designed to provide full, true, and plain disclosure regarding the material facts about the security in question. On this basis, investors considering purchasing the security are able to evaluate it and make an informed decision. All prospectuses must adhere to pro forma (i.e., standard) requirements regarding the information they must contain, as specified in securities legislation. The prospectus requirement generally applies to three types of trades in securities: Trades by or on behalf of an issuer, such as trades in a new issue from treasury Trades from a control position Trades in securities previously acquired by way of a prospectus exemption Each trade type is discussed briefly below. TRADES IN NEW ISSUES When a company wishes to raise equity capital in the marketplace, it issues securities from its own treasury. These issues are new securities, distinct from securities currently being publicly traded in what is known as the secondary market. The newly issued securities are issued from the company and then sold to the public, and the proceeds are received by the company issuing the securities. © CANADIAN SECURITIES INSTITUTE 6 4 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 If a company is issuing securities for the first time, the issue is considered an initial public offering (IPO), for which a prospectus must first be filed with the regulators. However, newly issued securities, although often generally referred to as new issues, may not necessarily be an IPO. A new issue may be an additional effort to raise capital from an already public company. A company that has issued shares to the public in the past and is issuing additional securities into the marketplace is referred to as a reporting issuer. Reporting issuers are subject to continuous disclosure requirements, meaning that they must file documents such as financial statements and prospectuses on the System for Electronic Document Analysis and Retrieval (SEDAR). A prospectus is normally still required in such cases, unless a prospectus exemption is available. The prospectus of a reporting issuer may be less detailed than one associated with an IPO because there is already publicly available information about the company. This type of prospectus, called a short form prospectus, permits a qualifying issuer to incorporate certain information by reference, rather than repeating it. Referenced material may include such information as the company’s disclosure record, financial statements, and annual information forms (AIFs). DID YOU KNOW? SEDAR is the electronic system for the official filing of documents by public companies and investment funds in Canada. Its purpose is to facilitate the following processes: Electronic filing of securities information and payment of filing fees Public dissemination of securities information collected through the filing process Electronic communication between filers, filing agents, and the regulatory authorities National Instrument 13-101 sets out the general rules for electronic filing that have been implemented in each Canadian jurisdiction. Information that must be filed on SEDAR includes the following documents, among others: Prospectuses AIFs Financial statements Annual reports Reports of material changes Press releases Circulars DIVE DEEPER For a complete list of documents that must be filed on SEDAR, readers can find NI 13-101 on any CSA member website. MUTUAL FUNDS Mutual funds are in a state of continuous distribution. NI 81-101 requires that mutual funds produce and file a simplified prospectus, an AIF, and a Fund Facts document. The Fund Facts document is a plain language document containing key information about each class or series of a mutual fund. It must be made available on the mutual fund’s website or the fund manager’s website, and it must be delivered to investors before they purchase the fund in question. Delivery of the document satisfies current prospectus delivery requirements. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 5 The purpose of the Fund Facts document is to provide investors with the information they need to make a knowledgeable decision before investing in a mutual fund. The document must meet the following criteria: It must summarize the key facts about the fund in no more than two pages. It must be written in language that is easy to understand. It must include the following information: A description of the fund, including its holdings Historical performance data Risk rating Costs or fees associated with buying, owning, and redeeming the fund TRADES FROM A CONTROL POSITION A control person is a person or company (or a combination of persons or companies) owning sufficient shares to materially affect control of an issuer. In all provinces, a 20% holding is deemed to represent control. Provinces other than Quebec treat a sale of previously issued securities from a control position as a distribution of securities. Typically, the filing and delivery of a prospectus is necessary to effect a sale from a control position. Most provinces, along with the Toronto Stock Exchange (TSX), allow a controlling shareholder to distribute securities of a reporting issuer without a prospectus. To do so, however, the shareholder must comply with special hold-period rules, along with declaration and filing requirements. Care must be taken in handling accounts of controlling shareholders to avoid violating regulations when executing sell orders for the accounts. For account holders who execute transactions in the securities of a company they control, the rules for the sale from a control position may apply. Registrants should take proper steps before executing any such transactions and should contact the compliance or legal department if they have any questions or concerns. TRADES OF SECURITIES ACQUIRED BY WAY OF A PROSPECTUS EXEMPTION Unless otherwise exempted, securities originally acquired under a prospectus exemption cannot be sold until a restricted period (called a “seasoning period”) has passed. The requirements relating to first trades acquired under an exemption are found in NI 45-102 Resale of Securities. Securities sold without a prospectus are sold in the exempt market and are called exempt market securities, or simply exempt securities. NI 45-106 contains the prospectus and registration exemptions and a small number of provisions that do not apply in certain provinces. It also contains several provisions that allow a province to impose different requirements than those imposed by other CSA jurisdictions. Dealer members who sell exempt market securities should have established policies and procedures for validating whether a client is eligible to claim a particular prospectus exemption. We discuss prospectus exemptions in detail later in this chapter. THE PROSPECTUS Most provinces require the filing of both a preliminary prospectus (also called a “red herring” prospectus) and a final prospectus. The appropriate regulator is typically the provincial securities commission that leads the review of the prospectus, which is located in the principal jurisdiction or head office of the issuing company. The period between the regulator’s issuance of a receipt for the preliminary prospectus and a receipt for the final prospectus is called the waiting period. © CANADIAN SECURITIES INSTITUTE 6 6 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 PRELIMINARY PROSPECTUS The preliminary prospectus must include a statement in red ink on its front cover (hence the term red herring) stating that a preliminary prospectus has been filed, that it is not in final form, and that it is therefore subject to completion or amendment. The statement is a prominent warning that the securities may not be sold, nor may offers to buy be accepted, until a receipt for the final prospectus has been obtained from the appropriate regulator. In this manner, purchasers are assured of having the opportunity to review all final details of the offering before confirming their intention to purchase. All provinces other than Quebec require a preliminary prospectus to be filed, Quebec allows one to be filed, but does not mandate it. When an offering is made in more than one province, or when it is intended to solicit expressions of interest, a preliminary prospectus must be filed and reviewed by the securities commission that is acting as the principal regulator. One purpose of the preliminary prospectus is to allow the distributor of a new issue to determine the extent of public interest in the issue while it is being reviewed and before it is priced and distributed. The form and content of a preliminary prospectus must comply substantially with the requirements of provincial securities legislation, which are harmonized in many respects. The preliminary prospectus must cover the form and content of a final prospectus but may exclude information on the price paid to the underwriter and the price at which the securities will be offered to investors. The auditor’s report may also be excluded. The preliminary prospectus is reviewed and commented on by the jurisdiction’s principal regulator (or by the jurisdiction’s principal regulator and the issuer’s principal regulator if the two are different). The system designed to harmonize the process between CSA jurisdictions is discussed below. PASSPORT SYSTEM All CSA jurisdictions except Ontario adopted Multilateral Instrument (MI) 11-102 Passport System, which gives issuers streamlined access to the capital markets in multiple jurisdictions. Under MI 11-102, the issuer deals with and files documents only with its principal regulator, thus meeting the requirements of one set of harmonized laws. The other jurisdictions automatically issue a deemed receipt as long as the following conditions are met: The issuer filed a prospectus in its principal jurisdiction with its principal regulator The principal regulator issued a receipt The issuer gave notice to the local jurisdictions in which it otherwise would have filed the prospectus. The Passport System can be used only in specified jurisdictions, specifically, British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, Quebec, New Brunswick, and Nova Scotia. Approval automatically applies in all other passport provinces and territories. National Policy (NP) 11 202 and NP 11-203 both provide guidance on how to identify the principal regulator. (With a few exceptions, the principal regulator for purpose of filing a prospectus is the one in the jurisdiction where the issuer’s head office is located.) Even though Ontario did not adopt MI 11-102, under that instrument it is still considered a principal regulator. This status gives issuers in Ontario access to the capital markets in other passport jurisdictions by dealing only with the OSC for the purpose of filing a prospectus or applying for a deemed exemption. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 7 DID YOU KNOW? If the OSC issues a receipt for a prospectus where the OSC itself is the principal regulator, the local regulators in the specified jurisdictions where the issuer would otherwise have had to file will automatically issue a deemed receipt for the prospectus. For the above to hold true, it is assumed that the prospectus was filed on SEDAR and that the issuer has given notice to the local regulator under MI 11-102 that it intends to rely on the deemed receipt provision. The deemed receipt has the same legal effect as the receipt issued by the principal regulator. Similarly, if the OSC approves an application for exemption, an automatic exemption is provided for the equivalent exemption provision in the other passport jurisdiction, as long as notice was given by the applicant that it intends to rely on the Passport System under MI 11-102. When Ontario is involved but is not the principal regulator, a dual review takes place with the OSC. Under the Passport System, a company must pay fees in every province and territory in which it is relies on the system’s deemed receipt provisions for prospectus filing. However, in the case of discretionary exemptions, it must pay fees only to the principal regulator. A filer files an application for exemption only with its principal regulator to obtain an automatic exemption in each other relevant passport jurisdiction. Multilateral Instrument 11-102 applies to continuous disclosure documents, preliminary prospectuses, pro forma prospectuses, related prospectuses, and amendments to a prospectus, assuming they were all filed on or after March 17, 2008. It does not apply to an amendment made to a prospectus that was filed before March 17, 2008. In addition, MI 11-102 does not relieve an issuer from filing a French language prospectus in Quebec, as required by that province’s Securities Act, if Quebec is a jurisdiction that relies on the Passport System. Furthermore, certain non-harmonized, continuous disclosure provisions exist in each jurisdiction listed in Appendix A of MI 11-102. Those provisions must be complied with in the passport jurisdictions, despite a deemed receipt having been issued. THE WAITING PERIOD During the waiting period, the underwriters may solicit expressions of interest from potential purchasers of the security. A copy of the preliminary prospectus must be provided to anyone who expresses interest, whether solicited or unsolicited. The underwriter, agent, or company distributing securities to the public must maintain a record of all persons and companies to whom a preliminary prospectus has been sent. If a preliminary prospectus is determined by the securities commission to be defective, or if there is an amendment or other difference between the preliminary prospectus and the final prospectus, a revised preliminary prospectus must be sent (along with the final prospectus) to each recipient of the first preliminary prospectus as soon as it is available. Most other activities considered to be in furtherance of a trade are prohibited during the waiting period, including the execution of an agreement to purchase the security in question. However, it is permissible during that time to advertise the proposed issue to let the public know that the preliminary prospectus is available. Other information that can be made available includes the price (if determined) and the name and address of the dealer member or registrant from whom the security may be purchased. No other material may be distributed to interested investors during the waiting period. FINAL PROSPECTUS A final prospectus must provide full, true, and plain disclosure of all material facts relating to the securities being offered for sale. It is on that basis that interested investors are able to assess whether they wish to purchase the securities. Their decision is based solely on the information contained in the prospectus. © CANADIAN SECURITIES INSTITUTE 6 8 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 A material fact is considered anything that could significantly affect the market price or value of the securities. Such details include the offering price to the public, the proceeds to the issuer or selling security holders (or both), the underwriting discount, and any other required information that may have been omitted in the preliminary prospectus. As evidence of compliance with regulatory requirements, the final prospectus must be accompanied by the written consent of experts whose reports or opinions are referred to in the prospectus and other documents. Such experts might include appraisers, auditors, and lawyers. A copy of the final prospectus must be mailed or otherwise delivered to all purchasers of securities offered in a distribution. Delivery must be made to the purchaser or the purchaser’s agent by no later than midnight on the second business day after an agreement of purchase and sale has been entered into. Given this requirement, it is important that market participants maintain a list of people who received a preliminary prospectus to ensure that their final decision to purchase the security is based on the final, and not the preliminary, prospectus. The items in a final prospectus must be presented in narrative or tabular format, as necessary, to ensure clarity. Again, the goal is to provide purchasers with the details necessary to make an informed decision based on the material presented. Some of the most important items in a final prospectus are as follows: Cover page disclosure The cover page contains a great deal of information that is relevant for investors, including details about the value of the offering, the identity of the stakeholders and their means of compensation, and whether the prospectus is preliminary or final. Summary The summary highlights information that appears elsewhere in the prospectus that would be most likely to influence the investor’s decision to purchase the securities. Information relating to Information relating to the issuer includes such details as the issuer’s name the issuer and business, selected financial information, capital structure, recent facts, and trends that could have a material impact on the business. Information relating to Information relating to the security includes details such as the type of product, the security use of proceeds, distribution method, and eligibility of investment, as well as a description of the securities. Information relating to the Information about the officers and principal shareholders includes details such officers and shareholders as names and addresses of directors and officers with five-year histories of principal occupations and shares owned. It also includes: Disclosure of specified information with respect to executive compensation and indebtedness of directors and senior officers to the issuer or its subsidiaries. Information regarding any bankruptcies, cease-trade orders, or securities regulatory violations. Details of any outstanding options, rights, or warrants to purchase securities of the issuer, of shares held in escrow, and of any prior sales of the securities being offered. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 9 Information relating to the The prospectus contains a number of representations, declarations, and parties involved certificates from the parties who are involved in the issuance of a security. These documents include two certificates: A certificate signed by the issuer’s chief executive officer and chief financial officer, two directors on behalf of the board, and any promoters stating that the information in the prospectus constitutes full, true, and plain disclosure of all material facts relating to the securities offered. A certificate signed by the underwriters that, to the best of their knowledge, information, and belief, the information in the prospectus constitutes full, true, and plain disclosure of all material facts relating to the securities offered by the prospectus. Information relating to A reference to the conditional aspects of the underwriting, called “out clauses”, conditional aspects is required on the cover page of the prospectus, along with a cross-reference to the location of further details under the Plan for Distribution in the prospectus. DID YOU KNOW? An out clause permits the underwriter to cancel an offering without penalty under certain conditions. For example, a market out clause permits an underwriter to terminate its obligation to purchase if market conditions make the security unsaleable. Another example is a disaster out clause, which permits an underwriter to terminate its obligation to purchase if an event of national or international consequence occurs that seriously affects the financial markets or the business of the issuer. Full disclosure is required in a prospectus of any out clauses that might result in a cancelation of the offering. SHORT FORM PROSPECTUS All Canadian provinces have adopted compatible legislation, policies, and practices allowing certain qualifying securities issuers to have quicker access to capital markets by using a short form prospectus. The system may be used by those issuers on the basis that much of the information found in a long form prospectus is already available and widely distributed elsewhere. A short form prospectus omits information that can be found in the issuer’s AIF and other continuous disclosure documents (as described later in this chapter). It focuses on matters relating primarily to the securities being distributed, such as price, distribution spread, use of proceeds, and the securities’ attributes. This system saves time and streamlines the process for qualified issuers. Under NI 44-101 Short Form Prospectus Distributions an issuer is permitted to use a short form prospectus if it meets the following conditions: It files electronically through SEDAR. It is a reporting issuer in at least one Canadian jurisdiction (and relies on the Passport System if it files in other jurisdictions). It has filed current annual financial statements and a current AIF in at least one Canadian jurisdiction in which it is a reporting issuer. It is not an issuer whose operations have ceased or whose principal asset is cash, cash equivalents, or exchange listing. It has equity securities listed and posted for trading or quoted on a short form eligible exchange. © CANADIAN SECURITIES INSTITUTE 6 10 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Issuers meeting the short-form prospectus criteria must still file a long-form prospectus for the following types of offerings: An IPO An offering by an inactive or dormant issuer An offering for the purpose of financing a material change in the issuer’s business National Instrument 44-102 Shelf Distributions also grants the following permissions to issuers who meet the short-form prospectus criteria: Permission to distribute securities off the shelf Permission to distribute securities pursuant to a prospectus that provides for a non-fixed-price basis Note that a non-fixed-price basis means that only the method of determining the price is disclosed, and not the price itself. For example, it may be determined by reference to the prevailing price of a specified security in a specified market at the market price prevailing at the time of sale or at prices to be negotiated with purchasers. Off-the-shelf distributions must meet the following conditions: The disclosure documents required to be approved by regulatory authorities must be cleared in advance of the proposed distribution. A prospectus supplement containing, among other things, a description of the securities being offered must be filed with the administrators. PURCHASERS’ STATUTORY RIGHTS The CSA adopted a statement of withdrawal and rescission rights for purchasers to be included in all prospectuses (NI 41-101 General Prospectus Requirements). The three major rights are summarized below based on the conditions they contain: Right of withdrawal Purchasers have the right to withdraw from an agreement to purchase securities within two business days after receipt or deemed receipt of a prospectus or any amendment to a prospectus. The purchaser must give notice to the vendor or its agent. If a distribution requiring a prospectus is effected without a prospectus, most provinces permit a purchaser who still owns the security to revoke the transaction, subject to applicable time limits. In Quebec, the purchaser has the option to apply for an adjustment of the purchase price. Right of rescission Purchasers have the right to rescind a contract for the purchase of securities if the prospectus or amended prospectus offering the security contains a misrepresentation. However, the action to enforce this right must be brought within applicable time limits. In most provinces, a purchaser alleging misrepresentation must choose between the remedy of rescission and the alternative of damages. Right of action for damages An issuer and its directors, and anyone who signs a prospectus, may be liable for damages if the prospectus contains a misrepresentation. The same liability applies to an expert (such as an auditor, lawyer, geologist, or appraiser) whose report or opinion, or a summary thereof, appears with their consent in a prospectus. However, the misrepresentation must be with respect to the report or opinion for it to apply to the expert. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 11 DID YOU KNOW? Legislation provides for a number of defences to an action for rescission or damages based on misrepresentation. The underwriter or directors will not be held liable if they conduct a thorough investigation that provides reasonable grounds to believe that there has been no misrepresentation. A defence is also available if the person or company can prove that the purchaser bought the securities with full knowledge of the misrepresentation. The acts impose certain limits with respect to maximum liability and the length of the period during which an action may be brought. In October 2007, the Supreme Court of Canada ruled that there is an obligation to disclose a material change during a distribution of securities, but no obligation to disclose a material fact. SECONDARY MARKET LIABILITY Secondary market legislation provides statutory rights to investors who purchase a security not through a prospectus or offering document, but after the IPO, when the shares are freely trading in the secondary market. In the event of a misrepresentation in certain documents that that issuer is required to file, such as financial statements, the investor can initiate an action. The liability varies depending on whether the responsible person is the issuer itself, a director or officer, an expert, or an influential person. An important feature of the legislation is that the court’s permission is required before starting an action. DIVE DEEPER For more detail regarding second market liability, see Part XXIII.1 of the Securities Act (Ontario). EXEMPT ISSUES Securities may be offered to the public without a prospectus if certain conditions or requirements are met. Exemptions from the requirement to file a prospectus relate to either the nature of the securities or trade, or to the resale of securities purchased under other exemptions. Exemptions to the prospectus requirement are primarily set out in NI 45-106. Dealer members selling exempt securities must verify that their clients qualify to purchase the securities in question and that the amounts invested do not exceed the prescribed limits. Furthermore, under the Companion Policy to NI 45-106, the seller of exempt securities must take reasonable steps to verify the representations made by the purchase. In this section, we discuss the key exemptions to the requirements for a prospectus, which fall into five main categories: 1. Capital raising exemptions 2. Transaction exemptions 3. Investment fund exemptions 4. Employee, executive officer, director, and consultant exemptions 5. Miscellaneous exemptions We will also discuss the rules for securities crowdfunding, which are set out in NI 45-110. © CANADIAN SECURITIES INSTITUTE 6 12 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 EXEMPTIONS RELATED TO RAISING CAPITAL Some of the key exemptions under the capital-raising category are described below. ACCREDITED INVESTOR EXEMPTION Accredited investors are certain financial institutions, governments, regulated pension funds, trust companies, certain investment funds, registered advisors and dealer members, affiliates of an issuer, and registered investment advisors. Individuals who meet any of the following requirements can also be considered accredited investors: Either alone or together with a spouse, they beneficially own financial assets in excess of $1 million before taxes. Their individual net income before taxes exceeds $200,000 in each of the past two years. Their net income together with a spouse exceeds $300,000 in each of the past two years. Accredited investors are also corporations, trusts, estates, and limited partnerships that have net assets of at least $5 million. To receive securities based on the accredited investor exemption, individual accredited investors must submit a completed and signed risk-acknowledgement form. The applicability of the exemption must then be confirmed. The dealer member evaluates whether a particular client is an accredited investor by using the information in the client’s account application form provided by the firm’s investment advisor. The investment advisor must maintain thorough notes and documentation to support a claim for the exemption in case it is not readily apparent from the information maintained by the dealer. There are other means to qualify for the accredited investor exemption that are highly fact specific. For these reasons it is very important to ensure that a review is done in each particular instance to ensure an exemption is available. PRIVATE ISSUER EXEMPTION A private issuer is a company with up to 50 shareholders, not including employees or former employees, whose securities are subject to restrictions on transfer. Securities of a private issuer can be purchased without a prospectus by any of the following persons: A director, officer, employee, founder, or control person of the issuer A spouse or close relative of a director, officer, employee, founder, or control person A close personal friend or business associate of a director, officer, employee, founder, or control person A security holder of the issuer An accredited investor FAMILY, FRIENDS, AND BUSINESS ASSOCIATES EXEMPTION The family, friends, and business associates exemption allows issuers other than investment funds to distribute securities to the issuers’ directors, executive officers, control persons, and founders, as well as to certain of their family members, close personal friends, and close business associates. There is no restriction on the number of persons that the issuer may sell securities to under this exemption. However, a suspiciously large number of people claimed under this exemption may suggest that not all of the purchasers are qualifying persons, which might render the exemption unavailable. This exemption cannot be used in Ontario or Saskatchewan without a signed risk acknowledgement form from the purchaser. In Ontario, the risk acknowledgement form must be signed by the purchaser, the executive officers of the issuer, and the relevant principal. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 13 OFFERING MEMORANDUM EXEMPTION The offering memorandum exemption allows an issuer to sell its securities to anyone, regardless of his or her relationship with the issuer or level of wealth. However, the exemption is subject to investment limits. Furthermore, the issuer must obtain a signed risk acknowledgement form from the purchaser and deliver an offering memorandum in the prescribed form before the purchaser signs the purchase agreement. The offering memorandum must provide for the rights of rescission or a right of action if these are not available by regulation. A careful review of the offering memorandum exemption is necessary given specific differences across provincial jurisdictions. In most provinces, the exemption is subject to a limit of $10,000 unless the purchaser is an eligible investor, in which case higher purchase limits may be applicable depending on the province in question. To qualify as an eligible investor, the person must have obtained advice from a registered dealer member authorized to give advice. In such cases, the KYC rule and suitability requirements must be observed. Otherwise, an eligible investor includes a person or company with the following characteristics: Has net assets, alone or with a spouse, in excess of $400,000 Has net income before taxes in excess of $75,000 in each of the two most recent calendar years and expects to exceed that income level in the current year Has net income before taxes, combined with that of a spouse, in excess of $125,000 in each of the two most recent years, and reasonably expects to exceed that income level in the current year Is an accredited investor Is a person described in the family, friends, and business associates section Has obtained advice regarding the suitability of this investment from a dealer member or its equivalent, registered under the applicable securities act MINIMUM AMOUNT EXEMPTION A prospectus is not required if the cost to the purchaser is at least $150,000 paid in cash. However, this exemption is not available if an entity made up of numerous purchasers was created solely for the purpose of qualifying for it. In other words, the purchase amount cannot be syndicated among a number of separate purchasers. EXEMPTIONS RELATED TO TRANSACTIONS AND INVESTMENT FUNDS Exemptions under these categories include the following transactions: Transactions such as amalgamations, mergers, reorganizations, or arrangements made pursuant to an information circular Asset acquisitions of a fair value not less than $150,000 Trades by an issuer in a security of its own issue as consideration for the acquisition of petroleum, natural gas, or mining properties Trades by an issuer to settle a bona fide debt with a creditor Takeover bids or issuer bids Trades representing reinvestments of dividends or distributions by an investment fund (subject to a 2% maximum for optional cash payments in a plan) Additional purchases in an investment fund, where the original purchase was at least $150,000 Private investment clubs with no more than 50 beneficial security holders © CANADIAN SECURITIES INSTITUTE 6 14 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 EXEMPTIONS RELATED TO EMPLOYEES, EXECUTIVE OFFICERS, DIRECTORS, AND CONSULTANTS Under this category, a trade may be made by an issuer, or a control person of an issuer, to an employee, executive officer, director, or consultant of the issuer, as long as participation in the trade is voluntary. Participation is considered voluntary if there is no inducement such as expectation of employment (or continued employment), appointment, or engagement. Trades among these persons are permitted if the trade is voluntary, the issuer is not a reporting issuer, and the price is established by a formula set out in a written agreement. Resales are permitted under NI 45-102. Various exemptions under the miscellaneous category include dividends paid in kind, trades by control persons for collateral, acting as an underwriter, certain debt arrangements, and transfers involving RRSP accounts by the beneficial holder. EXEMPTIONS IN RESPECT OF A RESALE OR FIRST TRADE EXEMPTIONS Generally, a prospectus must be filed on a subsequent disposition of securities originally acquired under a prospectus exemption. Two exceptions to this rule are if the securities are traded under an available prospectus exemption or if the subsequent disposition is made under one of the first trade exemptions (called final exemptions in Quebec). However, the security can only be sold after complying with the seasoning period. DIVE DEEPER For full details, readers can find NI 45-102 on any CSA member website. CROWDFUNDING EXEMPTION Several jurisdictions including Ontario have introduced securities crowdfunding to allow start-ups and early stage issuers as a means to raise capital. The participating regulators have adopted harmonized registration and prospectus exemptions that allow start-ups and early-stage companies to crowdfund in these jurisdictions. The start-up prospectus exemption permits non-reporting issuers to issue eligible securities subject to the following conditions, among others: The head office of the issuer must be located in a participating jurisdiction. The issuer must distribute eligible securities of its own issue through an online funding portal. No single non-accredited investor can invest more than $2,500 per distribution (this can increase to $10,000 provided the purchaser has obtained advice from a registered dealer that such investment is suitable for the purchaser). The issuer group cannot raise more than $1,500,000 on aggregate. The issuer must provide each purchaser a contractual right to withdraw within 48 hours of the purchaser’s subscription. The purchaser completes a risk acknowledgement form in the prescribed format which, among other things, confirms that the purchaser has read and understands the issuer’s completed offering document. DIVE DEEPER For additional information on the crowdfunding prospectus exemption and requirements, readers should carefully consult National Instrument 45-110 Start-Up Crowdfunding Registration and Prospectus Exemptions on any participating CSA member’s website. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 15 All of the above circumstances in which a prospectus need not be filed with respect to a distribution have been described in general terms only in a non-exhaustive list. Furthermore, in addition to the above exemptions, administrators generally have broad authority to exempt other distributions from the prospectus and resale requirements, as long as it is not prejudicial to the public interest to do so. Registrants intending to rely on any of these exemptions should consult their supervisors, the relevant provincial act, and legal counsel to ensure that a particular exemption is available and that all required conditions are satisfied. MAINTAINING PUBLICLY TRADING STATUS As stated above, security issuers must provide full, true, and plain disclosure in a prospectus when a new securities issue is distributed. As well, provincial securities legislation requires securities issuers to report financial and other material information about themselves on a regular basis throughout the year. This process is what is meant by continuous disclosure. The rules apply to reporting issuers, securities issuers with prospectus, issuers of a securities exchange offering, and issuers who have securities listed on a stock exchange. All issuers must also make timely disclosure of material changes through press releases and by filing material change reports. FINANCIAL DISCLOSURE Most securities acts require reporting issuers to provide shareholders with adequate and continuing disclosure of their financial affairs. Such companies must file annual and interim financial statements with the administrators and with the SRO. These statements must meet prescribed standards of disclosure and are open to public inspection through SEDAR. National Instrument 51-102 Continuous Disclosure Obligations sets out the requirements for the filing of financial statements. Issuers must file audited financial statements within 90 days of year-end, and venture issuers (i.e., companies with no listing on the TSX or other stock exchange) must do so within 120 days. The time limits for interim financial statements are 45 days for senior issuers and 60 days for venture issuers. Interim financial statements need not be audited; however, they should include a notice stating that they have not been audited. All statements must be approved by the company’s board of directors. Companies are not required to send annual financial statements and management discussion documents to shareholders. Instead, they are must ask investors each year whether they would like copies. The following financial statements must be filed: Audited annual statements comprising an income statement, a statement of retained earnings, a cash flow statement, and a balance sheet for the most recent financial year and the preceding year, along with notes to the financial statements On an interim basis, a balance sheet, income statement, statement of retained earnings, and a cash flow statement for the interim year-to-date period, and comparative financial information for the corresponding period in the prior year, along with notes to the financial statements The management of all reporting issuers must analyze the issuer’s annual financial statements in a process called Management’s Discussion and Analysis (MD&A). The MD&A must be sent to shareholders who have asked to receive the annual report to provide an explanation of the current financial situation and future prospects of the issuer. It must accompany the annual audited financial statements of the issuer, either as a separate document or in the annual report. An MD&A is also required for all interim financial statements. It must disclose information regarding the issuer’s outstanding shares and summarized information about the assets, liabilities, and results of operations of a significant business investment, which is accounted for on an equity basis. © CANADIAN SECURITIES INSTITUTE 6 16 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 In addition, reporting issuers must file an AIF each year containing relevant background information about the nature of the issuer, its operations, and its prospects for the future. The purpose of the information in the AIF and MD&A is to enhance the investors’ understanding of the issuer’s business. The issuer must file the AIF with the administrators along with its annual financial statements and must make it available to its security holders upon request. The issuer must also provide the AIF to anyone else upon request or upon payment of a reasonable fee. PRESS RELEASES AND MATERIAL CHANGE FILINGS National Instrument 51-102 provides that a reporting issuer must issue a press release to the public and file it with the administrator as soon as it becomes known to management that a material change has occurred in the issuer’s affairs. A material change is generally defined as a change in the business, operations, or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of its securities. Requirements include the disclosure of any probable material change that the board of directors or senior management decides to undertake. The reporting issuer must also file a Material Change Report with the administrator as soon as practicable after such a change occurs, or within 10 days. If disclosure would be prejudicial to the interests of the reporting issuer, a material change can be kept confidential under certain conditions. Issuers must also file a business acquisition report within 75 days after a significant acquisition. DID YOU KNOW? A significant acquisition is generally defined as a business representing 20% of the issuer’s consolidated assets, investments, or income. For venture issuers, the proportion is 40%. NATIONAL POLICY 51-201 DISCLOSURE STANDARDS Selective disclosure occurs when an issuer discloses material non-public information to a select few individuals or companies, but not broadly to the investing public. An example is an accidental disclosure made by a company CEO or analyst on a conference call. Because selective disclosure poses a threat to investor confidence in the fairness and integrity of capital markets, NP 51-201 was adopted to address concerns about the practice. The policy contains the following components: It describes the timely disclosure requirements and the confidential filing mechanisms available under securities legislation. It defines legislative prohibitions against selective disclosure and insider trading. It provides examples of the types of information likely to be material under securities legislation. It describes high-risk disclosure practices, including conducting private briefings with analysts or entering into confidentiality agreements with analysts. It provides a list of best disclosure practices that issuers should adopt to help ensure good disclosure practices and compliance with securities legislation. PROXIES AND PROXY SOLICITATION Reporting issuers must have periodic shareholders’ meetings at least annually. Shareholders can vote on various matters at these meetings, either in person or by proxy. Management or other issuer members often solicit shareholder proxies to give shareholders the opportunity to vote without the need to attend a meeting in person. Another aspect of the full, true, and plain disclosure required by provincial securities legislation is seen in the various requirements imposed on reporting issuers with respect to proxy solicitation. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 17 MANDATORY PROXY SOLICITATION Most acts require the management of a reporting issuer to solicit proxies from its shareholders whenever it calls a shareholders’ meeting. At the same time, management is required to supply the shareholders with an information circular. Information circulars must state whether the solicitation is made on behalf of management. They must also contain information on directors to be elected, remuneration of management, matters to come before the meeting, and any interest of management in such matters. The issuer must explain in detail how to complete the proxy, including how to instruct a nominee to vote for or against a specific matter referred to in the proxy. The issuer must also specify whether the shareholder from whom the proxy is sought has the power to revoke it. The form of proxy may confer discretionary authority on the proxy holder in certain circumstances, provided that a specific statement to this effect is made in the information circular. SHAREHOLDER COMMUNICATION PROCEDURES The purpose of the requirements in NI 54-101 Communication with Beneficial Owners of Securities of a Reporting Issuer is to ensure that beneficial security owners (i.e., shareholders) continue to receive proxy-related materials, and that they have ample opportunity to vote on the securities they own. The concept of beneficial security owners is referenced because most, if not all, shareholders do not physically hold shares of issuers. Rather, they are held by the custodian for use by the shareholder’s dealer member on the shareholder’s behalf. In other words, the dealer member acts on behalf of the shareholder, who is the beneficial owner of the securities, once instructions to do so are received. The information required from the shareholder is typically gathered when the shareholder opens an account with the dealer member. Procedures outlined in NI 54-101 provide for the following activities: Direct communication between reporting issuers and beneficial owners of the issuer’s securities Materials to be sent to beneficial owners by any means, including electronic delivery, provided that consent is first obtained The minimum period allowed (55 days) for obtaining shareholder mailing information and for sending standard annual meeting materials Reporting issuers to pay fees to dealer members to obtain beneficial ownership information Reporting issuers to reimburse dealer members for the costs of sending such materials to security holders Note that direct communication between reporting issuers and beneficial owners is permitted only if the latter are considered non-objecting beneficial owners (NOBO). This designation signifies that they do not object to the release of their names and other information. Reporting issuers have the right to obtain updated NOBO lists from intermediaries containing the names, addresses, email addresses, and securities holdings. However, NOBO lists may be used only in connection with efforts to influence voting and the sending of shareholder materials, information regarding takeover bids, or any other matter relating to the affairs of a reporting issuer. Reporting issuers must send annual and special meeting materials to beneficial owners. If a reporting issuer elects to send proxy-related materials directly to NOBOs, it must assume the same responsibilities imposed on intermediaries in this regard. For example, reporting issuers must make sure that the materials sent to NOBOs include a request for voting instructions rather than the traditional proxy form. They must also properly tabulate and execute the voting instructions received from NOBOs. Reporting issuers are permitted, but not required, to use shareholder communication procedures to send materials that are not proxy-related, such as voluntary corporate communications. They should continue to send interim financial statements and related interim MD&A directly, based on mailing lists they maintain. Anyone contesting a proxy vote or proposing a takeover bid can identify NOBOs and communicate with them directly. This activity was difficult, if not impossible, under the previous securities registration system. © CANADIAN SECURITIES INSTITUTE 6 18 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Under NI 54-101, dealer members must send a mandated set of instructions and a client response form to new clients. The form must ask clients which documents they wish to receive and whether they wish to be classified as a NOBO or an objecting beneficial owner (OBO). Until these instructions are received back from the client (in written or oral form), dealer members are prohibited from holding securities on the client’s behalf. Regarding existing clients, intermediaries can either seek new instructions from clients or rely on the choices the client made previously. National Instrument 54-101 requires that material be sent by the issuer directly to NOBOs at least 21 calendar days before the date fixed for the meeting. If a reporting issuer is sending materials to an intermediary, such as a dealer member, it must generally be sent three or four business days before the 21-day period begins (depending on whether the mailing is sent by first class, courier, or regular mail). The intermediary is then required to mail or courier materials within the same number of business days to beneficial owners and to other intermediaries. If more than one level of intermediary exists, the next level of intermediary has one business day to forward materials to the beneficial holders. Some exceptions, restrictions, and additional requirements may apply, depending on various factors. However, the same mailing deadlines noted above generally apply. Clients may decline to receive materials relating solely to routine business, such as the election of directors, annual reports and financial statements that are not part of proxy materials, and any materials not required to be sent by securities laws. However, the issuer must send certain materials, such as special meeting information, to all shareholders. Dealer members must obtain email addresses from clients who have one, and they must ask for the clients’ consent to deliver relevant documents electronically. Consent must be obtained from the client before sending any shareholder communication or sales materials. If a reporting issuer wishes to send materials directly to a NOBO by email, the NOBO’s consent to electronic delivery must first be obtained. VOTING BY DEALER MEMBERS For shareholders classified as OBOs, a dealer must deliver proxy-related materials to each person entitled to vote or to receive notice of a shareholder meeting no later than 25 days before the meeting date. However, OBOs may waive the right to vote and to receive proxy-related materials by giving written instructions to that effect. Proxy- related materials generally include the notice of meeting, information circular, financial statements (in the case of an annual meeting), and form of proxy where the holders of securities are entitled to vote. A dealer may either forward a signed proxy to the shareholders or request voting instructions from them. If receiving a proxy, the security holder may forward the completed proxy to the issuer. If receiving voting instructions, the dealer delivers those proxies pertaining to the voting instructions to the issuer no later than two days before the meeting date. When dealer members hold securities on behalf of clients, they must vote in accordance with specific written voting instructions received from the OBO (the client) on whose behalf the securities are held. Except in extremely limited circumstances, a dealer member cannot exercise any voting rights in respect of the security of which it is not the beneficial owner. Fund companies are required to publish their proxy voting record on their websites. An OBO may revoke voting instructions or waive the right to receive materials at any time by written notice, and the dealer must use its best efforts to carry out those instructions. However, if the instructions are not received at least seven days before the meeting, the dealer is not required to carry them out at the meeting. SPECIAL CONSIDERATIONS FOR INVESTMENT DEALERS A critical component of the capital-raising process when bringing new issues to market includes the function and role of the underwriter. As we will discuss below, the underwriter is considered gatekeeper in the marketplace and when acting in this capacity is carrying out activities that are critical to maintaining the integrity of the underwriting process as well as fostering fair and efficient capital markets. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 19 In this section, we discuss matters that are of particular relevance to investment dealers. The purpose is to identify the relevant considerations that a dealer member should be aware of in order to properly discharge all regulatory and legal obligations that it may have when carrying out a corporate finance or underwriting function as a market participant. THE BOUGHT DEAL As discussed in the previous chapter, a bought deal is a refinement of a conventional underwriting, in which an underwriter agrees to make its best efforts to sell securities of an issuer to the public. With a bought deal, the underwriter commits to buying a specified number of securities at a set price, which it then resells to the public. It is the dealer member in a bought deal who bears the risk that the securities it has bought will not sell. On the other hand, if the securities do not sell in a conventional underwriting, the issuer simply does not receive the proceeds of the expected sale. There is no expense or risk to the underwriter. In a bought deal, the underwriter pays the full proceeds to the issuer regardless of whether it has been able to resell the securities to the public. In these situations, the underwriter agrees to assume the risk of selling the security, which, based on its due diligence, it presumably perceives as a small risk. When a bought deal takes place, the investment dealer typically has a charge to its firm’s capital position, given that the dealer is taking the risk on resale. Under existing securities regulations, the underwriter can solicit investor interest in these newly offered securities for up to four business days before the filing of the preliminary prospectus. The underwriter must make a firm commitment to purchase the securities, and the issuer must file the preliminary prospectus within four business days of the commitment. GUIDANCE IN RESPECT TO UNDERWRITER DUE DILIGENCE Underwriters act as gatekeepers to the capital markets, as do the auditors, legal counsel of the issuers and underwriters, other professional experts, and the exchanges. In the role of underwriter for an offering of securities, investment dealer members discharge their role by completing a due diligence investigation, participating in the preparation of a prospectus, and certifying the contents of the prospectus. These activities are critical to fostering fair and efficient capital markets. In effect, they ensure that the facts contained in the prospectus are true. In legal terms, each dealer member participating as an underwriter of a public offering must sign a prospectus in which the firm certifies that, to the best of its knowledge, information, and belief, the prospectus constitutes full, true, and plain disclosure of all material facts relating to the offered securities. Due diligence regarding the material facts underlying the disclosure in the prospectus allows the underwriter to responsibly sign the prospectus certificate. It further allows the underwriter to demonstrate that it conducted an investigation sufficient to establish a statutory due diligence defence in the event that the prospectus contains a misrepresentation. Dealer members should take an approach to due diligence that goes beyond mere avoidance of liability and mitigation of risk to dealer members. Dealer members must incorporate certain due diligence considerations into their policies and procedures manual. These considerations ensure that dealer members properly discharge all of their regulatory and legal obligations when carrying out a corporate finance or underwriting function. In this regard, Guidance Note 3500-21-005, Guidance Respecting Underwriter Due Diligence, outlines CIRO’s expectations and informs compliance reviews of dealer members’ underwriting policies and procedures. However, it does not impose concrete terms, requirements, or expectations; therefore, it cannot be used as a simple checklist exercise. When used properly, however, the Guidance Note helps dealer members create policies and procedures that are both flexible and robust, and that address all regulatory expectations while still supporting the specific dealer member’s business model. This approach is consistent with principles-based regulation, which permits firms to tailor their approach to compliance in a manner that best suits their business model and size. © CANADIAN SECURITIES INSTITUTE 6 20 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 UNDERWRITING DUE DILIGENCE POLICIES AND PROCEDURES Dealer members are generally obliged to create, maintain, update, and apply policies and procedures that promote and establish an effective system of compliance. This system should ensure that the firm and its registrants comply with applicable rules and securities legislation. It should also identify the level of business risk that the firm is prepared to accept in its day-to-day operations. The written policies and procedures in regard to the dealer member’s function as an underwriter must reflect the firm’s specific circumstances and the range of activities it engages in. Specifically, the Guidance Note suggests that a dealer member’s approach to underwriting due diligence should contemplate the following concepts: Due diligence Dealer members must take reasonable steps to ensure that the underwriting process results in the prospectus containing all prescribed information. In addition, the process must ensure that information provided to the underwriter by the issuer is thoroughly investigated before it is included in the prospectus. In other words, at the conclusion of the underwriting process, the prospectus must contain full, true, and plain disclosure of all material facts relating to the securities being offered. Contextual Dealer members should consider all circumstances of each underwriting to determine determination what is considered reasonable in respect to due diligence. The underwriter and its senior investment banking staff must exercise professional judgment in its decisions. External consideration Depending on the specific circumstances, the dealer member must take additional steps, outside of the basic due diligence process, to effect a complete review. The underwriter should depart from a strict checklist approach and evaluate any relevant additional information before executing the prospectus certificate. Readers should be mindful of the types of obligations that dealer members take on by virtue of their participation in investment banking and related activities. They should be aware that some of these activities may translate into liability in the event of negligence or other failures. Where dealer members are executing certificate pages in a prospectus, they are attesting to the prospectus containing full, true, and plain disclosure. If it is subsequently found that the dealer member has not discharged this duty appropriately, liability may arise. EXAMPLE (LEGAL CASE) Sino-Forest Corporation (Sino) was a reporting issuer in Ontario. The majority of its business was the purchase and sale of trees in the People’s Republic of China. Sino’s stock price increased approximately 340% between 2006 and 2011. However, as a result of a report published in June 2011, the stock price dropped dramatically. The report contained allegations of fraud against Sino related to its ownership of trees and of the actual existence of such trees. These assets, and their reference in the company’s financial statements (where they were referred to as timber holdings or standing timber), were the basis on which shareholders invested in Sino’s securities. The OSC opened an investigation into Sino and several of its senior officers and subsequently filed a statement of allegations against the company and its executive management team. The OSC alleged that management committed the following offences, among others: Engaged in fraud to inflate assets and revenue Made materially misleading statements in public disclosure Falsified ownership of standing timber Concealed control weaknesses and failures that obscured the true nature of transactions among subsidiaries Failed to make its auditors aware of those practices © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 21 EXAMPLE (LEGAL CASE) (cont'd) The OSC also opened an investigation against Sino’s CFO, which was settled in 2014. The CFO was permanently banned from acting as a director or officer of a registrant, and was required to pay $700,000 in costs to the OSC. The CFO also settled a class action lawsuit that was filed against him by paying $5.6 million in damages. The OSC then opened an investigation against Sino’s auditor, which was settled in 2014 with the auditor paying $8 million. In the settlement agreement with the auditor, the OSC noted two major infractions: The auditor did not obtain sufficient audit evidence in respect to the ownership and existence of certain standing timber assets recorded in the financial statements. The auditor also did not exercise sufficient professional skepticism when executing and evaluating the applied audit procedures. The auditor then settled a class action lawsuit that was filed by Sino shareholders in 2013 by paying $117 million in damages. Between 2003 and 2010, Sino raised US$3 billion through the issuance of equity and debt securities. The underwriters involved in the process of raising that capital for Sino were also the subject of a class action lawsuit, which was eventually settled for $32.5 million. In that settlement agreement, the underwriters made no admissions of liability. RESTRICTIONS ON TRADING During the period commencing two business days before the price of an offering of securities is determined, and throughout the period of distribution, trading in those securities is restricted. Issuers, underwriters, dealer members, and others have specific restrictions in their ability to trade the securities, as prescribed by UMIR 7.7. These restrictions apply to any previously issued securities of the same type as those being underwritten, and to any convertible securities or any underlying securities of the securities being underwritten. These rules prevent underwriters and others from attempting to influence the price of securities that are the subject of the distribution. Dealer members typically maintain lists of these securities, which are distributed to traders, investment advisors, and other staff affected by the limitations. A number of exceptions to these trading restrictions exist with respect to trades that would arise in the normal course of business. Examples include a bid or purchase where the client’s order was not solicited, or, with solicited orders, where the solicitation occurred before the restricted period. The policies of the Administrators, SRO, and UMIR should be consulted in each circumstance to determine what restrictions apply, if any. BUSINESS CONDUCT During the period of distribution of securities to the public, dealer members must make a bona fide offering of their total participation in the issue to public investors. The length of this period is defined in provincial securities legislation. The definition of the term public investors excludes employees of the dealer member and employees of institutional investors who are regularly engaged in the purchase or sale of securities for those institutions. Excluded persons may not purchase a “hot issue” (i.e., an issue for which there is great public demand). Client priority must also be addressed in private placements (i.e., exempt market securities offerings). Dealer member who deal in private placement offerings to clients must communicate the general availability of private placements to their clients through a general mailing or other form of communication. Before accepting client subscriptions on a particular issue, the dealer member must make sure that the issuer has issued a press release © CANADIAN SECURITIES INSTITUTE 6 22 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 announcing the private placement. Non-client subscriptions can only be accepted three days thereafter. If a client subscription is received before allocations are forwarded to the issuer, client priority must still be observed. CAPITAL REQUIREMENTS The capital requirements on underwriting positions that are part of the uniform capital requirement calculation can be significant. We discuss capital requirements later in the course, but it is important to note a few things here. Individuals who are approved as executives within dealer member firms should have a basic understanding of how these requirements work, as detailed in the IDPC rules. Until a prospectus has been cleared by the provincial securities commission, the underwriter, as owner of the underwriting positions, must provide for margin for those positions. However, there are opportunities for significant margin reductions, depending on the terms and timing of the specific underwriting agreement. Margin can be reduced under the following conditions: Expressions of interest from exempt purchasers Out clauses in underwriting agreements Issuance of a standard-form new issue letter (SFNIL) EXPRESSIONS OF INTEREST In determining the applicable margin for any unsold position, allowance is made for any expressions of interest obtained from exempt purchasers (as defined in the securities acts) that have been written or verbally affirmed, but not yet contracted. The rationale for permitting a reduction to the unsold position for purchase commitments prior to contracting is based on low historical renege rates by this group of purchasers. As a result, the underwriter’s exposure to market loss for un-contracted positions is reduced during the period between the commitment date of the underwriting and clearance of the final prospectus. The reduction should be reflected in the underwriting margin calculation. OUT CLAUSES As described earlier in this chapter, out clauses (both market and disaster) permit the underwriter to cancel the offering without penalty under certain conditions. As a result, out clauses reduce the exposure to risk faced by a dealer member to an underwriting commitment. Underwriting margin rules therefore permit the significant reduction of margin rates otherwise required on the underlying securities underwritten for specified periods. For example, if the underwriting agreement contains a market out clause, the underwriting commitment’s margin is 10% of the normal new-issue margin requirement of the offered securities. STANDARD-FORM NEW ISSUE LETTER The SFNIL was adopted to provide stand-alone financing to an underwriter or banking group for a new issue or a secondary issue of securities. The SFNIL results in the actual transfer of the risk of loss in an underwriting from the dealer member to the issuer of the letter. Because of the transfer of risk, the SFNIL can be used to reduce margin on underwritten positions significantly. The following parties are eligible to issue an SFNIL: All acceptable institutions, with no collateral required to be received by the firm All other counterparties, with the funds to be drawn either fully collateralized by high-grade securities or held in escrow with an acceptable institution © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      THE DISTRIBUTION OF SECURITIES 6 23 SUMMARY In this chapter, we discussed the following key aspects of risk management in the context of securities distribution in the capital markets: Unless an exemption has been granted, securities legislation requires that a prospectus be filed and delivered if the offering or sale of securities is deemed to be a distribution to the public. This requirement generally holds for both new issues, including IPOs, and the sale of previously issued securities in the secondary markets. The Passport System gives issuers streamlined access to the capital markets in multiple jurisdictions. This system simplifies the regulatory approval process by allowing issuers to deal with only one regulator and one set of harmonized requirements. Purchasers of securities have the following statutory rights: Right of withdrawal, which allows them to withdraw from an agreement to purchase securities within certain time limits Right of rescission, which allows them to rescind a contract for the purchase of securities if the prospectus contains a misrepresentation Right of action for damages, under which they may be compensated for damages if the prospectus contains a misrepresentation Issuers are permitted to use a short form prospectus containing limited information in certain circumstances. For example, the issuer must file electronically using SEDAR and must be a reporting issuer in at least one Canadian jurisdiction. The requirement for continuous disclosure applies to reporting issuers and to those who have issued securities under a prospectus. It also applies to a securities exchange offering or securities listed on a stock exchange. Issuers are also required to make timely disclosure of material changes through press releases and filing of material change reports. The purpose of a proxy is to ensure that shareholders are able to exercise their voting rights. Most acts require the management of a reporting issuer to solicit proxies from holders of its voting securities whenever it calls a shareholders’ meeting. At the same time, it must supply such holders with an information circular that explains, in part, how to vote for or against a specific matter referred to in the proxy. Regarding capital requirements for underwriting commitments, a required margin can be reduced by expressions of interest from exempt purchasers, out clauses in underwriting agreements, or issuance of an SFNIL. The material in this chapter is meant to identify the most common issues and compliance challenges that securities market participants must be aware of when engaging in these types of activities. Given the importance of maintaining the integrity and stability of the capital markets in general, these rules are in place to protect all participants and also to ensure that end investors are making informed decisions about the issuers they choose to invest in. Dealer members and issuers are required to understand these challenges, and to have policies and procedures in place that enable them to comply with their obligations. This chapter brings us to the end of Section 2: The Securities Industry. You should now have a good understanding of the regulatory and business environment at an investment dealer, as well as the risks that these firms face. In Section 3, we will explore ethics and governance in the industry. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 6 Review Questions. © CANADIAN SECURITIES INSTITUTE