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Part Two: Relying on the “Accredited Investor” Exemption
to Raise Private Placement Capital
(posted March 18, 2011)


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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: Tetrad ). 

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 investor”?

The definition of who is an accredited investor in subsection 1.1 of NI 45-106 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.

For an 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 of 45-106CP

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 worth.

The trouble with identification and verification of accredited investors

As mentioned 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 45-106CP,   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 due diligence.

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 Columbia, Alberta, 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.

(1) Initial 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 exempt 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, AccreditedInvestorLists.com, or 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 CommunityLend.com and 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 securities.

The New Brunswick Securities Commission came to similar conclusions in its action against 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 accredited investors.

(2) Relying on 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 offering. 

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, Manitoba, 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 investor.

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 agents (“agents”) 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 Alberta, British Columbia, Manitoba, Ontario and 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 accredited investor. 

(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. 

Issuer’s 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 documents

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 investigation.  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 accountant;
     (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.

Conclusion

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 potential investor.

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:

 

 

 


Alixe B. Cormick
Venture Law Corporation

618 - 688 West Hastings Street
Vancouver, B.C.
V6B 1P1
Phone: 604-659-9188
Fax: 604-659-9178
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