Over half of
my friends and family have asked me for money. Some wanted to buy a new
car, a new home, or start or expand their business. Some needed help
paying their rent. When you have experienced a certain amount of success
in your life you start to look like an ATM machine to some of the people
around you that are not as far along in their own lives financially. All
of my loans and investments in friends’ businesses have resulted in my
losing the entire amount advanced. Over the years I have learned to say
no to my friends and family.
As a growing issuer one day you will run
out of friends, family and close business associates interested or able to
invest in your company. When that day happens you will need to look to
other potential investors to fund the next stage of your business growth.
This usually means funding from accredited investors. Accredited
investors include angel investors, venture capitalists, and other high net
worth individuals. Canada has a much smaller pool of these types of
investors than United States. For example, being single and having an
income over $200,000 a year is one of the income categories used by
Canadian securities regulators to define who is an accredited investor for
investment purposes. In 2006 (the last census polled), 3% of Canadians
were found to earn more than $200,000 a year. This amounts to just under a
million Canadians who would be considered accredited investors. (See:
As Canadians we don’t really discuss
openly how much we earn each year or the value of our total net assets.
In our opinion it’s “No one’s GD business.” As a result, we tend to make
assumptions about other people’s annual income and net worth based on
outward appearances. Unfortunately, making assumptions about whether
someone is an accredited investor can land you in a lot of trouble with
securities regulators if you get it wrong and can’t show your assumption
was reasonable under the circumstances.
In part two of this three part series, I
will first set out the definition and rules of the accredited investor
exemption. I will then suggest steps you must and can take to meet your
obligation to confirm the accredited investor exemption may be relied upon
by you when issuing securities.
Who is an “accredited
definition of who is an accredited investor in subsection 1.1 of
is quite long and reprinted
here. The definition includes a list of investors such as large
financial institutions and government agencies who we are not going to
address in this particular series. Our focus instead is on those
individuals who are considered accredited investors. It is this type of
investor that issuers tend to seek out when conducting a private
placement beyond their friends and family.
individual to be considered an accredited investor for the purpose of
NI 45-106 they must meet either an income test or financial asset test. The
individual must either (1) have made at least $200,000 each year for the
last two years ($300,000 with his or her spouse if married) and have the
expectation to make the same amount this year; or (2) have financial
assets exceeding $1 million (excluding primary residence); or have net
assets of at least $5 million (including net value of primary residence).
The exact method of calculation of financial assets and net assets is set out in subsection 3.5
The number of
Canadians who are accredited investors is a small group of individuals.
As mentioned previously about 3% of Canadians make over $200,000 a year.
Canada has approximately 900,000 individuals who meet the income
requirement to be defined as an accredited investor under
NI 45-106 and
another 400,000 who would likely meet the combined income definition of an
accredited investor. It is anyone’s guess how many households meet the $1
million in financial assets test when you exclude their primary
residence. This type of information is more difficult to access than
income information as Statistics Canada includes home equity when it
calculates net worth for census purposes. We can however make some
assumptions based on the limited data provided. For instance, the
2008 Report Changes in Wealth by Statistics Canada used data from 2005
to determine 9% of Canadians had a net worth over $1 million (2.8 million
Canadians). They went on to state the average millionaire family had a
net worth of $1.9 million. Given this information we can assume
approximately 2 million Canadians would meet the $1 million financial
assets test once the value of their home was removed from their total net
The trouble with
identification and verification of accredited investors
in part one of this series, the onus is on you as the issuer of securities
to confirm that an exemption is available (subsection 1.9 of
Bilinski 2002 BCSECCOM 102 and
Limelight Entertainment Inc. 31 OSCB 1727). It is also worth
repeating that although subsection 1.9 of 45-109CP allows you to rely on
the factual representations by an investor as to whether they meet the
requirements of a particular exemption you need to do so with caution and
Most issuers when conducting a private
placement of securities provide each investor with a subscription
agreement, investor questionnaire and certificate. Issuers often rely on
these documents alone to satisfy themselves that an investor meets the
financial requirements of an accredited investor. It is a good start but
it is not fool proof in confirming to a regulator you have properly
identified a particular investor as an accredited investor.
In reviewing the decisions in British
Manitoba, Ontario and
New Brunswick where issuers were held to have improperly relied on the
accredited investor exemption five cautionary themes emerged: (1) How you
identified someone initially as an accredited investor can be the start of
your trouble; (2) Letting the documents speak from themselves as to who is
an accredited investor is often a mistake; (3) You cannot rely on third
parties, including registered brokers, to qualify who is an accredited
investor for you ; (4) Do not ignore red flags indicating an investor may
not be accredited; and (5) The only way to be 100% certain someone is
accredited and that you have satisfied your regulatory obligation to
confirm an investor is indeed an accredited investor is to be un-Canadian
and ask for direct proof of income or net assets.
Identification. How you
first identify someone as being a possible accredited investor can often
be your first mistake. In the 1990s, agents and issuers used to pour
through the list of investors set out in Schedule A to the
offering reports filed with Canadian securities regulators to
create “accredited investor contact sheets” when this information was
considered public. Today Schedule A to the exempt offering reports is
considered non-public information and is no longer available to
enterprising issuers looking to create an accredited investor call list to raise capital. As a result of this change
some issuers are now relying on third party services to obtain an
accredited investor contact sheet.
Breadstreet Investor Union,
First National Information Network,
DirectMailInvestorLists.com, are a few of the many companies which
provide accredited investor lists for a price. Others issuers post their
pitch online on websites promising access to accredited investors in
Canada such as
P2P Financial Inc.
Relying on third parties to identify who
might be an accredited investor is not against the rules. You
cannot, however, rely on such lists or referrals as definitive proof an
investor is indeed accredited. You are required to do your own
investigation as to their income and financial status.
Euston Capital Corp., an Ontario incorporated company, used
InfoCanada to create its accredited investor contact sheet.
InfoCANADA provides the names of owners/managers of businesses along with
estimated total revenue and credit rating. They also provide similar
consumer lists to their subscribers. As held by the
Saskatchewan Financial Services Commission and the
Manitoba Securities Commission, Euston could not rely on a list
prepared by using InfoCANADA that an individual identified through that
process was indeed an accredited investor. Euston needed to confirm
independently for itself that an investor did in fact meet the definition
of an accredited investor. The subscription agreement Euston had
investors sign also was of little help. Although the subscription
agreement did contain representations and warranties that an investor was
an accredited investor it was signed after the actual purchase of Euston’s
New Brunswick Securities Commission came to similar conclusions in its
Mr. Sang H. Park. Mr. Park’s company entered into a referral
relationship with an insurance company. The investors referred by the
insurance company listened to a presentation by Mr. Park and filled out
subscription documents. The third party referral and signing of
subscription agreements with representation and warranties were found to
be insufficient on their own to confirm the investors were indeed
Documents Only = Huge Risk.
The form of private placement subscription
agreements, investor questionnaires and corresponding certificates are
fairly standard in Canada. Issuers will often draft their own version of
these documents without the assistance of a lawyer using a previous
offering’s documents as a template or using a set of documents provided by
a friend. In most instances this is not problematic as long as a lawyer
reviews the final documents to make any necessary regulatory updates or
correct any inconsistencies before the issuer proceeds with the actual
What is problematic, however, is that
issuers often believe these documents hold special power and by their very
use alone that they absolve themselves of any need to personally confirm
an investor meets the requirement of a particular exemption. This is
just not true. The securities regulators in British Columbia,
Alberta (see para 37-39), Saskatchewan,
Ontario and Nova Scotia have all sanctioned issuers for improperly
relying on the accredited investor exemption despite the existence of
signed offering documents.
Representations and warranties made by
an investor by way of a subscription agreement may only be relied upon if it
can be confirmed that the investor (1) read the representations and
warranties and (2) understood the meaning of accredited
investor prior to signing.
The best practice is for issuers is to draw
investor’s attention to the fact that only accredited investors are
eligible to participate in the issuer’s private placement. Issuers should
also go over orally who is and is not considered an accredited investor
with each potential investor. Issuers should then confirm the investor
understands the definition as described to them. Under no circumstances
should issuers fill in any part of the investor questionnaire or
certificate required to be confirmed by the investor. Investors need to
fill out these sections of the subscription documents in their own
handwriting. Documents not filled out in full should be sent back to
the investor to be completed before an issuer accepts that subscription or cashes that investor's cheque.
For the super cautious, issuers should consider having the investor
initial under the accredited investor definition in the subscription
documents to confirm this section was indeed read and understood by the
It should also go without saying investors
need to sign the subscription documents prior to committing to investment
or there is no point in getting them to sign anything at all.
(3) Third Party
Verification Not First Hand Knowledge.
Issuers often use
brokers, underwriters or
when conducting a private placement of securities to accredited investors.
The use of an agent, even if that agent is
registered under the
applicable securities laws, does not relieve issuers with the obligation
to ensure that these agents are complying with all applicable securities
laws and selling the issuer’s securities only to accredited investors.
The securities commissions in
New Brunswick have all sanctioned
issuers who failed to take reasonable care and diligence in instructing
and supervising agents’ adherence to the securities laws. Issuers need to
take proactive steps when engaging agents to sell their securities to
accredited investors. These steps include: (1) explaining the importance
of compliance with the accredited investor exemption; (2) providing clear
instructions to the agents; (3) supervising the agent’s efforts; and (4)
independently confirming each investor meets the definition of an
(4) Red Flags to
Accredited Investor Status.
No one likes to turn down money especially if you really need it at the
time it is being offered. Issuers, however, need to confirm prior to
accepting any money that there is an air of reality to each investor being
an accredited investor beyond the representation and warranties found in
the subscription documents.
need to ask investors questions
regarding where they live, their profession, income sources, age, liabilities and financial assets. If an investor says they are
employed in a job or profession which is known to not pay well issuers
need to ask more questions; and if that particular investor did not
inherit millions from granddad Rothschild or win the lotto that investor
cannot be allowed to invest as an accredited investor.
Issuers will not be afforded the protection of the accredited investor
exemption solely on the basis of an investor signing a few
Again, regulators require issuers do more
than blindly assume investors have read the subscription documents and
understood what it means to be an accredited investor. Regulators require
issuers to directly confirm that the statements made by each investor as
to their status as an accredited investor are indeed correct to the best
of that issuer’s knowledge or at a minimum that the statements have a
reasonable air of being accurate. The regulators are going to ask direct
questions of these investors should they ever start an
Issuers need to get over the fact we as Canadians consider it impolite to
ask personal questions concerning money. Unless your accredited investor
is listed on the
Rich 100 list from Canadian Business start asking about their
financial status and take notes.
(5) Direct Independent
Verification of Accredited Investor Status.
The law in Canada at this point in time does not require issuers to
obtain independent verification of an investor’s status as an accredited
investor. Nor have there been any cases in Canada where a regulator has
said an issuer should have obtained independent verification. It is clear
when reviewing the case law and settlement orders, however, that issuers
face an evidentiary problem when questioned by regulators about how they
determined each investor was an accredited investor. Issuers tend to have
no back-up other than the subscription documents signed by an investor
indicating that an investor was indeed an accredited investor at the time
of investment. As discussed above, these documents alone are not enough.
You need something more and that something more should be in writing.
For several years now we have been
recommending our clients obtain independent third party verification of
accredited investor status when conducting a private placement in the US.
We have just started recommending they use a similar approach when relying
on the accredited investor exemption in Canada. About 75% of our clients
are uncomfortable with including a
request for independent
verification as part of their subscription package. Overall investors
when faced with this request have responded favorably. There is the odd
indignant screamer but it is to be expected. Not everyone wants to share
their true financial worth. What we suggest issuers try to obtain from
investors is a copy of one of the following:
(a) Tax Return;
(b) Notice of Personal Tax Assessment;
(c) balance sheet certified by an independent
(d) letter from independent accountant or legal counsel
as to whether individual meets the income or financial asset
requirements required to
be considered an accredited investor.
This is the only way issuers can be 100%
certain that an investor is indeed an accredited investor. Issuers are
also not faced with having to grill each potential investor or even spend
huge amounts of time going over the definition of who is an accredited
investor. The third party documents requested automatically confirm or
deny someone’s status as an accredited investor. Yes, it is un-Canadian to
ask for such personal information, but better to ask then find yourself
scrambling to explain to a regulator what you did and did not do to verify
someone was an accredited investor.
Issuers need to use care in each step of the
private placement process when relying on the accredited investor
exemption. Whether you use a list or a third party agent to identify who
is a potential accredited investor you need to do your own due diligence
to confirm each investor does indeed meet the requirements to be
considered an accredited investor. Subscription documents which require an
investor to provide the issuer with representations and warranties as to
their status as an accredited investor is a start but not
definitive proof alone an investor is indeed an accredited investor.
Issuers need to follow-up with each investor to ensure they understand
what it means to be an accredited investor and the importance of only
accredited investors participating in the private placement offering.
Issuers need to ask each investor questions and if the answers do not
confirm an individual is an accredited investor, issuers need to turn the
money down no matter how an individual answered in subscription documents.
Finally, to truly safeguard management and the company, issuers should ask
for third party verification as to the accredited investor status of each
In Part Three of this
three part series we will look at where issuers go wrong when relying on
the offering memorandum exemption.
Links to the other
articles in this series: