Prospectus Exemptions for Registrants

Sophisticated investor, accredited investor, offering memorandums, minimum investment amounts, friends and family, business associates, employee exemptions…we throw around many terms when discussing the prospectus exemptions available, but sometimes registrants get those terms get confused. 

Background to the Exempt Market & the Requirements

 

Normally, an issuer, whether it's a company wanting to raise capital or a fund wanting to sell units, must file a prospectus to a securities regulator for review and receipting before it can sell shares or units to the public. This can be a lengthy and expensive process, so securities regulators provide exemptions from the prospectus requirement to raise capital more quickly and efficiently without compromising investor protection.

Although most people understand the nature of public offerings and selling shares on stock exchanges, the exempt market is a substantial part of British Columbia's capital market. Based on 2010 filings of exempt distribution reports, issuers from within and external to BC raised $8.5 billion from BC investors. Additionally, BC‐based issuers raised another $7.7 billion outside of BC, resulting in an exempt market worth over $16 billion.

The capital raising exemptions are in National Instrument 45‐106 Prospectus Exemptions (NI 45‐106). In this article, we will focus the discussion on exempt funds distributing units to investors under the exemptions from the requirement to file a prospectus.

Commonly Used Exemptions by Exempt Funds

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Registrants offering their own exempt or proprietary pooled funds directly to investors, without using managed accounts, will typically use the following exemptions in NI 45‐106:

  1. Accredited investor - section 2.3
  2. Family, friends and business associates - section 2.5
  3. Offering memorandum (OM) - section 2.9
  4. Minimum amount investment - section 2.10
  5. Additional investment in investment funds - section 2.19
  6. Employee, executive officer, director and consultant -section 2.24

Most of these exemptions are self‐explanatory, but we have seen some confusion and mixing up of some of these exemptions in marketing and advertising materials. For example, an information sheet for an exempt fund may stipulate that the fund is offered via an OM, but go on to stipulate a minimum investment amount and require that investors be qualified as accredited investors.

In our example, the information sheet has mixed up provisions from three separate exemptions instead of clearly outlining the exemptions the fund is using to distribute the units. A potential investor may think that he or she must qualify as an accredited investor, must invest a minimum amount of capital in the fund, and will receive an OM, which has statutory protections and civil remedies that, in fact, may not be available to the investor if he or she really purchased under another exemption.

Issuers of exempt products need to understand that the exemptions are discrete and standalone.

Minimum Amount

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The fund manager has the discretion to stipulate whatever minimum investment amount it deems appropriate and that amount can be less or more than $150,000. However, for the section 2.10 exemption to apply, the investor must invest, at one time, at least $150,000 even if the fund manager's minimum investment amount is less. The investor does not need to be qualified as an accredited investor, as this is a separate exemption. No offering document or information disclosure is required for the minimum amount exemption.

Accredited Investor

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If the fund distributes to an accredited investor under section 2.3 of NI 45-106, the fund manager must qualify the investor with one of the definitions of an accredited investor in NI 45-106. Typically, a fund manager does this with a subscription agreement, which will list out the accredited investor definitions and the investor will note which definition applies. No offering document or information disclosure is required for the accredited investor exemption and no minimum amount need be invested either.

No Sophisticated Investor Exemption

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While some of the exemptions may infer that the investor is sophisticated or experienced, fund managers should note that the current exemptions no longer refer to sophisticated investor and the term has not been in use since 2002 when the BCSC overhauled the exemptions regime.

The Offering Memorandum Exemption

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Some funds seek to broaden the investor base beyond accredited investors and those with the ability to invest $150,000 at one time. The OM exemption under section 2.9 of NI 45‐106 provides exempt funds with the ability to broaden the investor base; however, the fund must:

A key difference between the OM exemption and the accredited investor and minimum amount exemptions is that the OM provides the investor with statutory rights to civil remedies if the OM contains a misrepresentation. These statutory rights are not available to investors that purchase units through other exemptions available in NI 45‐106, as the instrument does not require the fund manager to provide any formal disclosure document to these investors.

We have seen some fund managers draft OMs, following Form 45‐106F2, but not use the OM exemption to distribute units of the fund. The fund manager provides the OM merely as information to prospective investors. However, exempt fund managers should ensure that they provide up front disclosure on the OM's cover page to make clear to the investors that the statutory rights contained in the OM will not apply to investors that purchase via other exemptions in NI 45‐106.

Exempt fund managers should consider whether they really need a Form 45‐106F2 OM for information purposes if they do not intend to use section 2.9 of NI 45‐106 to distribute the units. While producing an information document is a best practice, fund managers may want to avoid calling the information document an OM, which will help to reduce confusion with the investors.

Managed Accounts

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The exemptions discussed above are relevant for portfolio managers who only manage funds and directly distribute the units to investors. However, portfolio managers who offer advisory services to private clients and have discretionary management of individual, segregated client accounts may be able to use the exemption available under section 8.6 of NI 31‐103, if they use proprietary pooled funds to manage their clients' assets.

Traditionally, segregated, managed client accounts hold individual stocks and bonds; however, some portfolio managers find it easier and more efficient to use proprietary pooled funds to obtain the appropriate asset allocation to meet the clients' investment objectives.

Using the exemption under section 8.6 means that the portfolio manager is the principal and accredited investor of the pooled funds, not the client. The portfolio manager would then distribute the units of the pooled funds to the client accounts based on the agreed asset mix and investment objectives.

The portfolio manager is required to file a distribution report and pay fees on an annual basis (see next section).

Reporting Requirements

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Depending on the exemption, the fund may have a reporting requirement and a fee payment to the securities regulator when the fund makes distributions. Fund managers should review section 6.1 of NI 45‐106 for a list of the exemptions that require a Form 45‐106F1 Report of Exempt Distribution to be filed. In British Columbia, issuers must use the BCSC eServices web-based filing system to submit a report, unless they are filing reports of exempt distribution annually.

Normally, a fund manager must file a report of exempt distribution and submit a fee payment within 10 days of a distribution. However, some exemptions allow the fund manager to file a report and pay the required fee once a year. The annual filing provision is in section 6.2(2) of NI 45‐106 and funds that rely on the following prospectus exemptions in NI 45-106 may file reports annually:

  • Section 2.3 Accredited investor
  • Section 2.10 Minimum amount investment
  • Section 2.19 Additional investment in investment funds

The annual filing deadline is within 30 days of the calendar year‐end. For example, if a fund only distributes units using the three exemptions listed above, for any distributions in 2016, the fund must file the report and pay the fee by January 30, 2017.

Funds relying on other prospectus exemptions, such as the offering memorandum exemption, must file a report of exempt distribution and pay the required fee within 10 calendar days of the distribution.

Suitability

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No matter which exemption an exempt fund uses to distribute units of the fund, registrants who distribute the units have an obligation to know‐your‐client (KYC) and assess the suitability of the fund for the investor.

A subscription agreement is a common method of formalizing the purchase and sale contract between the exempt fund and the investor, but it does not replace the KYC obligation. We expect registrants who distribute exempt funds to complete a KYC form and suitability review for every new investor. Distributors can be fund managers or related parties registered as EMDs, portfolio managers or third party dealers.

Conclusion

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The exempt regime is a cost‐effective way to distribute units of exempt funds, but fund managers need to understand which exemptions are most appropriate for their investors.

Issuers that raise capital improperly can face regulatory action, such as:

  • a cease trade order against any new distributions
  • having to offer a right of rescission to investors
  • reputational damage to the firm and its related parties

Fund managers should review the exemptions separately and not combine them with each other, as each exemption is only appropriate for specific classes of investors.