Common misconceptions regarding availability of the “private issuer” exemption
Many business owners incorrectly assume that securities laws only apply to publicly traded companies – meaning companies listed on a stock exchange. However, any issuer of securities is subject to and required to comply with applicable securities laws. An “issuer” means any person or company who has issued, issues or proposes to issue securities. Within that definition, “company” includes publicly traded or privately-held companies and “person” includes an individual, partnership, unincorporated association, unincorporated syndicate, unincorporated organization, and trust.
Many business owners also do not realize that “securities”, which is defined in legislation, has a broad legal meaning and doesn’t just mean shares – it includes many different types of documents, instruments and interests. “Securities” includes the following: shares or partnership units; profit-sharing agreements; investment contracts; notes or other evidence of indebtedness; any document constituting evidence of an interest in assets, property, profits, earnings or royalties of any person or company; and any agreement under which the interest of the purchaser is valued by reference to the value of a proportionate interest in a specified portfolio of assets.
The bottom line is that securities laws apply to all issuers from the moment of formation, and not only to share issuances and transfers. If you are a business owner, director, or officer, our business law lawyers can provide you with the information and guidance needed to ensure your business venture is compliant with securities laws – including start-up, capital raising, debt offering, profit sharing, beneficial ownership of assets, and share issuances/transfers. It is important for business owners to consult their lawyer to ensure that a securities law exemption is available in the circumstances of a proposed distribution or transaction rather than risk inadvertently breaking the law.
To give an example, even with the knowledge that securities laws do in fact apply to private companies, a common misconception regarding application of securities laws is that private companies are free to issue shares as they see fit without meeting securities law requirements, provided they only issue shares to a limited number of investors. This is a mischaracterization of an exemption which does apply in many cases, known as the “Private Issuer” exemption, discussed in more detail below.
In general terms, when a company issues new shares the default securities law rule (which applies to public and private companies alike) in Section 53(1) of the Ontario Securities Act, R.S.O. 1990, c. S.5 (the “Securities Act”) prohibits a distribution of securities unless the company files a prospectus with the securities commission. The purpose of this default “prospectus requirement” is to mandate the disclosure of information which is deemed to be necessary for investors to make an informed decision about the investment – the goal is investor protection. However, the law recognizes that private companies need flexibility to raise capital, so there are a number of exemptions available which enable a company to issue shares without filing a prospectus. It is the company’s responsibility to ensure that it is eligible for an exemption before it distributes securities.
The most commonly used exemption for small and medium sized private companies is the “Private Issuer” exemption in Section 73(4) of the Securities Act. It can only be used by a company which meets the definition of “private issuer” contained in National Instrument 45-106.
Summarized in general terms, a “private issuer” means a company that (a) is not a reporting issuer/publicly traded, AND (b) the securities of the company are subject to restrictions on transfer in the articles of incorporation, AND (c) the shares of the company are not beneficially owned by more than 50 people, not including employees and former employees (meaning a company can exceed 50 shareholders if they are employees/former employees); AND (d) the company has only distributed to securities to the following permitted categories of persons:
a director, officer, employee, founder or control person of the issuer,
a director, officer or employee of an affiliate of the issuer,
a spouse, parent, grandparent, brother, sister, child or grandchild of a director, executive officer, founder or control person of the issuer,
a parent, grandparent, brother, sister, child or grandchild of the spouse of a director, executive officer, founder or control person of the issuer,
a close personal friend of a director, executive officer, founder or control person of the issuer,
a close business associate of a director, executive officer, founder or control person of the issuer,
a spouse, parent, grandparent, brother, sister, child or grandchild of the selling security holder or of the selling security holder’s spouse,
a security holder of the issuer,
an accredited investor,
a person of which a majority of the voting securities are beneficially owned by, or a majority of the directors are, persons described in paragraphs (a) to (i),
a trust or estate of which all of the beneficiaries or a majority of the trustees or executors are persons described in paragraphs (a) to (i), or
a person that is not the public.
It is important to note that many of the above categories of persons have been subject to legal interpretation and therefore it is not enough to assume on plain reading that a person or company falls into a particular category. Your lawyer will consult interpretive guidance in the companion policy to the securities law instrument and in case law to advise whether the exemption is available in the context of your particular transaction.
Where small companies often run astray is assuming that because they are not publicly traded, their articles of incorporation contain a restriction on transfer of shares (i.e. no transfer without director approval), and they have less than 50 shareholders that they can issue shares to a limited number of investors as they see fit. It is important to emphasize that shares can only be issued in reliance on the private issuer exemption (and a company only maintains its private issuer status) if shares are issued only to investors who fall within the permitted categories of persons. Any person or company who does not fit within the listed categories is a member of “the public” and the private issuer exemption cannot be relied upon for issuance of shares to that person or company. If shares are issued to anyone who falls outside of those categories (in absence of compliance with prospectus requirements or reliance on another exemption), a company does so in contravention of securities laws and loses its private issuer status - the company runs the risk of being subject to penalties under securities law and losing its private issuer status means that the exemption is not available for future share issuances.
This post has identified a few common misconceptions and misapplications of securities law rules and exemptions, however, there are a number of exemptions available to enable to you as a business owner to raise capital, expand ownership and grow your business.
Our business law lawyers are pleased to provide you with guidance and support for your all your business needs.
The content of this article is intended to provide a general guide to the subject matter and is not legal advice. Specialist advice should be sought regarding your specific circumstance.