To Comply or Not to Comply – Do Securities Laws Apply to Private B.C. Companies?

Securities laws apply to all issuers of securities from the moment of their incorporation or formation. Further, every issuer must comply with the registration and prospectus requirements or be able to rely on an exemption from those requirements. If you do not qualify for an exemption, you are likely deemed to be a reporting issuer. Most private companies rely on the “private issuer” exemption. The most important requirement for qualification as a “private issuer” is the company must have fewer than 50 security holders, excluding employees and former employees. If you lose your private issuer status you do not automatically become a reporting issuer.

There are five other exemptions available for an issuer that is in the “nonprivate, non-reporting” phase of development.

Background

There is a common misconception that securities laws only apply to incorporated companies listed on stock exchanges. Actually, securities laws apply to any issuer, incorporated or unincorporated, including those not listed on a stock exchange.

Securities laws apply to all issuers from the moment of their incorporation or formation. This is done by regulating the trading of all securities in BC through the Securities Act, rules, regulations, policies and instruments.

There are two basic requirements underlying our securities laws:

1. Registration – Every person who “trades” (sells) securities must be registered (licensed) with the Commission. This requirement is intended to ensure that people selling securities are knowledgeable and able to properly advise investors.

2. Prospectus – Every person who “distributes” (trades) previously unissued securities (i.e., new securities being issued for the first time) must file and obtain a receipt for a prospectus with the Commission. A prospectus is a comprehensive document that discloses all material information about the issuer and the securities being sold. This requirement ensures that investors receive sufficient information to allow them to make an informed investment decision.

Both these requirements refer to a person. In BC, the term “person” has a broad legal meaning that includes an individual, corporation, partnership, party, trust, fund, association, or any other organization.

The term security also has a broad legal meaning. It includes:

• common and preferred shares
• options, warrants and other convertible instruments
• debentures, notes and other instruments of indebtedness
• limited partnership units
• memberships in co-operative associations
• units in a resort property (sharing in the rental profits for the whole building or property)

Reporting Issuers

BC securities legislation contains many provisions that apply only to reporting issuers. A reporting issuer includes any issuer that has:

• filed a prospectus and obtained a receipt for it from the BC Securities Commission
• merged with a reporting issuer by a business combination or takeover bid
• previously had its securities listed on a BC stock exchange
• received an order from the Commission designating it a reporting issuer

A reporting issuer must provide information about its affairs on a regular basis to the Commission, its security holders and the investing public. If your organization is not a reporting issuer, you do not have to comply with the public disclosure requirements. For more specific detail please see a copy of the Securities Act for a definition of Reporting Issuer.

Every issuer must comply with the registration and prospectus requirements or be able to rely on an exemption from those requirements. If you do not comply with the requirements and you are not able to rely on an exemption from them, you are violating BC securities laws. This may result in penalties such as severe fines or the shutdown of your operations.

Exemptions from Reporting Issuer requirements

The Commission recognizes that the prospectus and registration requirements, which serve to protect the investing public, are not always necessary. For example, people who are related to the principals of an issuer may not need the information provided in a prospectus before they buy securities. For these reasons, the Commission provides exemptions – exceptions by which individuals and companies are freed from registration and prospectus obligations. You can use these exemptions to create your organization, reward your employees, raise money to finance the development of your business, and reorganize or sell your business.

The Commission provides a number of exemptions from the registration and prospectus requirements. These include:

• private issuer exemption
• family, friends and business associates exemption
• employee, director, officer and consultant exemption
• accredited investor exemption
• $150,000 exemption
• offering memorandum exemption

You do not have to apply to the Commission to use any of these exemptions. You do have to ensure that you meet all of the conditions of the exemption. Please note the following descriptions:

1. Private issuer exemption

By using the private issuer exemption, you can issue securities to form your organization and you can sell securities in any amount without any disclosure, provided these trades are only to the following:

• directors, officers, employees or control persons of the issuer
• family members (spouse, parent, grandparent, sister, brother or child) of the directors, senior officers or control persons, close personal friends or close business associates of the directors, senior officers or control persons
• current security holders
• family members of the selling security holder
• accredited investors

You do not have to report the use of the private issuer exemption to the Commission. However, you should keep a record of all the persons you have sold securities to and note how they fit the terms of the exemption.

A private issuer means a person who:

• is not a reporting issuer or an investment fund
• has less than 50 beneficial owners, excluding employees and former employees
• has restrictions on the transfer of its securities in its articles, memorandum, bylaws or its shareholders agreement
• has sold its securities only to the persons in the bulleted list

If you issue or sell securities using the private issuer exemption, the purchaser should be aware that the securities are subject to resale restrictions. These resale restrictions are outlined in the issuer’s articles, memorandum, bylaws or its shareholders’ agreement. Generally, this means that the purchasers must obtain approval from the private issuer’s board of directors before selling their securities.

Many issuers remain private issuers and never have to use any other exemption. But if you no longer fit the private issuer criteria, you cannot use this exemption. Perhaps you have sold securities to someone not listed in the private issuer exemption. Once you lose your private issuer status, you cannot regain it. For this reason, it is important that you keep track of the number of your security holders and ensure that you sell securities only to the group listed in the exemption.

What happens if you lose your “private issuer” status?

If you lose your “private issuer” status you do not have to automatically file a prospectus and you do not automatically become a reporting issuer. Many issuers intend to become public companies in the future, but aren’t ready for that step yet. The following exemptions (#2 – #6) are available for an issuer that is in the “nonprivate, non-reporting” phase of development.

In fact, these exemptions are available for any type of issuer, whether they are reporting or non-reporting. However, if a private issuer uses these exemptions, it may unintentionally lose its private issuer status. Also, any issuer using these exemptions must file a report of exempt distribution with the Commission.

2. Family, friends and business associates exemption

Under this exemption, you can sell securities in any amount without providing any disclosure to the following:

• a director, senior officer or control person of the issuer
• a family member (spouse, parent, grandparent, brother, sister or child) of a director, senior officer or control person of the issuer
• a close personal friend or close business associate of a director, senior officer or control person of the issuer

There is no limit on the number of purchasers or the amount of money that can be raised using this exemption. However, if you use this exemption to sell to a large number of purchasers, the Commission may question whether all of the purchasers are really family, close personal friends or close business associates.

3. Accredited investor exemption

Under the accredited investor exemption, you can sell securities to an accredited investor in any amount without providing any disclosure about the issuer. There is no limit on the number of purchasers or the amount that can be raised using the accredited investor exemption.

An accredited investor includes:

• financial institutions
• registered advisers or dealers
• pension funds
• mutual funds selling only under a prospectus or to accredited investors or persons buying at least $150,000 of securities
• corporations, limited partnerships, trusts or estates having net assets of at least $5 million
• individuals who have at least $1 million in financial assets (cash and securities) before taxes. (In calculating an individual’s financial assets, any outstanding loans incurred to acquire those assets must be deducted.)
• individuals whose net income before taxes exceeds $200,000 (or $300,000 combined income with spouse) in each of the two most recent years and who reasonably expects to exceed that net income in the current year
• individuals who have at least $5 million in net assets

4. $150,000 exemption

Under the $150,000 exemption, you can sell securities to anyone without providing any disclosure to the purchaser, provided the purchaser buys at least $150,000 worth of securities.

5. Employee, director, officer and consultant exemption

Under this exemption, an issuer can sell securities in any amount without providing any disclosure to its employees, directors, senior officers or consultants, provided the purchaser is buying the security voluntarily. This means that the purchaser has not been persuaded to buy the security due to a promise that he or she will be, or will continue to be, employed, appointed or engaged by the issuer.

6. Offering memorandum exemption

The offering memorandum exemption allows an issuer to sell its securities to anyone, regardless of their relationship, wealth or the amount of securities purchased.

This exemption can only be used by an issuer selling its own securities. A security holder who wants to sell cannot use it.

Under this exemption, the issuer can sell securities in any amount to anyone, provided that before the purchaser signs the agreement to purchase the securities, the issuer:

• obtains a signed risk acknowledgement form from the purchaser, and
• delivers an offering memorandum, prepared in the required form, to the purchaser

Note that you must file the offering memorandum with the Commission within 10 days of selling the securities.

For more information on this article, please contact Patrick S. Cleary.