Securities Law: Prospectus Exemptions

Prospectus Exemptions in Securities Law
Introduction
One of the most significant barriers to growing a business corporation is financing. Among other methods, start-up founders may choose whether to secure a line of credit, acquire government subsidies or trade their cash for shares in a corporation. However, these options are restricted to the founders’ capacities of obtaining capital. In order to expand the pool of funds without violating the complex legal rules of expensive prospectus requirements, small business owners may consider offering shares to an exceptional group of friends, family or associates as detailed in the Canadian securities National Instrument 45-106.
Overview
Under Canadian securities law, a corporation must file a prospectus, which is a comprehensive legal document that discloses the material facts of an investment offering, prior to distributing its securities to the public. The public requires a prospectus in order to make an informed decision about purchasing respective shares. Such a requirement can be an expensive task, involving many professionals including investment bank underwriters, accountants, financial advisors and legal teams, which creates prohibitive obstacles for budding firms. Recognizing this limitation and driven to encourage small firm growth, the government passed the National Instrument 45-106.
The National Instrument 45-106 is a set of rules that governs all securities’ jurisdictions in Canada — except for Ontario, which permits exemptions under its own legislation not discussed here. Using the exemptions detailed in the instrument, a small firm may seek capital through distributing shares, without filing a prospectus, in certain transactions or to a limited group of investors. These investors include close family members, close business associates, or accredited investors, rich and sophisticated individuals for whom a significant amount of protections provided through securities legislation would be unnecessary. Below are a few examples of the exemptions available using this instrument.
Accredited Investor
According to section 2.3 of the National Instrument, the prospectus requirement does not apply if an issuer distributes securities to an accredited investor. An accredited investor includes financial institutions, banks, advisors, dealers, trusts, government organizations, or individuals who, alone or with their spouses, own assets exceeding $1,000,000 or $5,000,000 (the latter do not have to sign risk acknowledgement forms), or have net incomes of at least $200,000 in the past two years (or $300,000 with a spouse). A corporation may also fit into this category provided the fulfillment of certain conditions, such as having net assets of at least $5,000,000; however, the exemption does not apply if a corporation was created solely to hold securities as an “accredited investor”.
Family, Friends and Business Associates
Under section 2.5, a corporation may distribute securities to founders, employees, directors, officers, control persons or affiliates, their close family members, their close personal friends or business associates, or respective trusts or estates. The court has determined “close” by asking whether it would be acceptable to use a friend’s, family member’s, or business associate’s bathroom without asking.
Offering Memorandum
The issuer may choose to distribute offering memorandums through the required form of section 2.9 in lieu of a full prospectus. A corporation may issue shares to certain qualifying investors in Alberta without a prospectus, provided that:

1. the purchaser buys the security as a principal,
2. the acquisition cost of all securities acquired by a purchaser, who is an individual (not a corporation, partnership, trust, fund or any other entity), in the preceding 12 months does not exceed
   1. $10,000 if the purchaser is not an eligible investor;
   2. $30,000 if the purchaser is an eligible investor;
   3. $100,000 if the purchaser that is an eligible investor received advice from a portfolio manager, investment dealer or exempt market dealer that the investment is suitable,
3. At the same time or before the purchaser signs the agreement to purchase the security, the issuer
   1. Delivers an offering memorandum to the purchaser
   2. Obtains a signed risk acknowledgement form, and
4. The security distributed by the issuer is not either a specified derivative or a structured finance product.

To be an eligible investor under this instrument, an individual must have: net assets, alone or with a spouse, of more than $400,000; or a net income (before taxes), alone of with a spouse, that exceeded $125,000 in each of the two most recent calendar years and who reasonably expects to exceed that income level in the current year. Investors that are not individuals (such as corporations or other entities) are not subject to limitations, provided that they are not created for the purpose of the exemption.
While using an Offering Memorandum may widen the group of potential investors, this exemption carries the same level of disclosure and liability as issuing through a prospectus.
Private Issuer
The private issuer exemption applies to companies that have restrictions from trading securities in the open market without the director’s approval, that don’t have more than 50 shareholders, and that don’t report to any Securities Commission. Under these circumstances, a company may distribute securities to those connected to the firm, such as directors, officers, employees or control persons, their close family members, their close friends or business associates, or accredited investors. Furthermore, unlike the exemptions above, private issuers are not required to publicly report each distribution.
In conclusion, the National Instrument 45-106 provides opportunities for small companies to raise funds through share distribution under certain circumstances without the expensive prospectus requirement. If your organization is looking to make use of the opportunity or has questions regarding details of securities law, please do not hesitate to contact a caseworker at the BLG Business Venture Clinic.

Nick Konstantinov is a member of the BLG Business Venture Clinic, and is a 3rd year student at the Faculty of Law, University of Calgary.