The private issuer exemption: What is a “private issuer” and should you care if your business has lost this status?
There is a common misconception that Canadian securities laws apply only to public companies. However, securities laws apply to any person who (each, an “issuer”) (i) has a security outstanding, or (ii) is, or intends to, issue a security, whether or not they are incorporated, early-stage, well-established, or listed on a stock exchange. In fact, any time you buy, sell, distribute, trade, or otherwise dispose of securities (e.g. common shares, preferred shares, option, warrants, or other convertible instruments, debentures, notes, or other debt instruments, etc.) securities laws are at play. Consequently, many start-ups and early stage issuers unintentionally break the law, which can have immediate and/or long-term negative consequences for the issuer, including its directors, officers, and shareholders.
Fortunately, private issuers—those that qualify for the “private issuer” exemption (the “PI Exemption”) under National Instrument 45-106 – Prospectus Exemptions (“NI 45-106”)—are exempt from certain onerous securities reporting requirements. This Article summarizes the key elements of the PI Exemption, including its qualifying requirements and some of the pitfalls of losing private issuer status.
A brief background on Canadian securities law
Securities laws are intended to protect Canadian investors from unfair, improper, or fraudulent practices and foster fair and efficient capital markets. Securities laws apply to all issuers, including “private” and “non-reporting” issuers, not just “reporting” or “public” issuers.
There are two essential requirements underlying Canadian securities laws:
- Registration. Every person who is in the business of “trading” (defined in the Securities Act) securities must be registered/licensed to do so by the applicable securities regulator in the jurisdiction(s) where they effect such trade(s). Canadian securities laws also require registration for other regulated activities (e.g. a person must be registered if such person engages in, or holds himself, herself, or itself out as engaging in, the business of advising another with respect to an investment in, or the purchase or sale of, securities).
- Prospectus. An issuer that is “distributing” (defined in the Securities Act) its securities must file and obtain receipt for a prospectus by the applicable regulator unless it can rely on a prospectus exemption. A prospectus is a comprehensive document that discloses all material information about an issuer’s business, including its securities. Preparing this document is a time-consuming and expensive process.
A thorough discussion of the Canadian securities law regime and how it applies to your business goes beyond the scope of this article but it is important to recognize that all companies (and individuals for that matter) are subject to the above registration and prospectus requirements, unless they can rely on an appropriate exemption, such as the PI Exemption. Even when relying on an appropriate exemption, certain transfer restrictions remain applicable. Non-compliance with Canadian securities laws may result in serious penalties, such as severe fines, cease trade orders, or even jail time in certain instances.
For a more comprehensive overview of how Canadian securities laws generally apply to your business, please see our article “Securities 101 for start-ups: How securities laws apply to private companies”.
Public companies, reporting issuers, non-reporting issuers, private companies, and private issuers – a “defining” problem
Naturally, there is a clear distinction between, on the one hand, a reporting issuer (being a company that has filed a prospectus with, and been receipted by, an applicable securities regulator) or a publicly traded company (being a reporting issuer that has its securities listed on a stock exchange), and, on the other hand, a private company. However, the concepts of a “private company”, “non-reporting issuer”, and “private issuer” are frequently muddled.
Although there is no specific definition of a “private company” under NI 45-106, this categorization is often used colloquially as an umbrella term to describe any company that is not a reporting or publicly listed issuer. NI 45-106 technically refers to this concept as a “non-reporting issuer”; therefore, these terms are often used synonymously. In contrast, there is an important legal distinction between a “private company / non-reporting issuer” and a “private issuer”. Categorization as a private issuer requires strict compliance with the applicable requirements under NI 45-106 (discussed below). Consequently, all private issuers are considered private companies / non-reporting issuers but the opposite is not necessarily true.
“Private issuer” status and the “PI Exemption”
What is a private issuer?
A “private issuer” is an issuer that:
- is not an investment fund or a “reporting issuer”. Companies become reporting issuers by obtaining a receipt for a prospectus (which frankly never happens without intention);
- has restrictions on the transfer of its securities in its constating documents (e.g. articles of incorporation and articles/by-laws) or securityholders’ agreements. Generally, such a restriction requires purchasers to obtain approval from the issuer’s board of directors or its shareholders prior to distributing securities;
- has no more than 50 beneficial owners of its securities, not including employees and former employees of the issuer or its affiliates, provided that each person is counted as one beneficial owner unless the person is created or used solely to purchase or hold securities of the issuer, in which case each beneficial owner or each beneficiary of the person, as the case may be, must be counted as a separate beneficial owner; and that
- has only distributed its securities to “eligible” persons under the PI Exemption; or
- has completed a transaction and immediately following the completion of the transaction, its securities were beneficially owned only by “eligible” persons (described below) and since the completion of the transaction has distributed its securities only to such persons.
Who is an “eligible” person under the PI Exemption?
The PI Exemption requires an issuer to distribute its securities only to “eligible persons” under section 2.4(2) of NI 45-106 (note – Ontario has a separate, but similar, list of eligible persons identified under section 73.4 of the Ontario Securities Act). The following is a list of common eligible 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, control person or the spouse of the director, executive officer, or control person of the issuer or its affiliate;
- Close personal friends or close business associates of directors, executive officers or control persons 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 current securityholder of the issuer;
- An accredited investor; and
- A person that is not the public.
Notably, the above categories of eligible persons under the PI Exemption generally overlap (with some exceptions) with other common exemptions under NI 45-106 that are available to all issuers (not only private issuers). For example, all issuers are free to rely on the “accredited investor” exemption under section 2.3 of NI 45-106 (where applicable) and the definition of “accredited investor” remains consistent whether used under section 2.3 (Accredited Investor) or section 2.4(2)(i) (Private Issuer – Accredited Investor). Conversely, there is a slight but significant difference between the exemption available to all issuers under section 2.24 (employee, officer, director, or consultant) and the exemptions available only to private issuers under sections 2.4(a) and 2.4(b) (director, officer, employee, founder, or control person). Specifically, the PI Exemption in this case, among other things, does not cover distributions to persons in their capacity as consultants (although such consultants may rely on other exemptions, if available)…
Who or what is “the public”?
“The public” is a broadly interpreted concept and does not necessarily mean any specific number or group of persons. Whether or not a person is a member of the public must be determined on the facts of each particular case. The courts have interpreted “the public” broadly in the context of securities law. Whether a person is a part of the public will be determined on the particular facts of each case, based on the tests that have developed under the relevant case law. A person who intends to distribute securities in reliance upon the private issuer prospectus exemption in section 2.4(2) of NI 45-106 to a person not listed in paragraphs (a) through (j) of that section will have to satisfy itself that the distribution of the security is not to the public.
Generally, this concept of “the public” captures the notion that a person purchasing securities in reliance on the PI Exemption must have a connection or common bond to the private issuer. Again, this determination is fact specific, although, there are certain examples that can help delineate the threshold. For example, if an issuer uses an agent to solicit purchasers but then indicates these purchasers are close personal friends, there is a general presumption that those persons are a member of the public because an issuer would not need the services of an agent if those people were actually “connected” to the issuer. Further, members of an investment club or association that occasionally meet also typically lack a sufficient common bond to satisfy the “connection” requirement. Notably, if the owner of a private issuer sells the business of the private issuer by way of a sale of securities, rather than assets, to another party who acquires all of the securities, the sale will not be considered to have been to the public.
The benefits of the PI exemption
Since the categories of “eligible persons” under the PI Exemption discussed above generally overlap with other commonly used exemptions available to all issuers under NI 45-106, you may be wondering how the PI Exemption is beneficial? In addition to exempting private issuers from the prospectus requirement, the PI Exemption also permits private issuers to distribute securities without the additional burden of filing a report of exempt distribution with the applicable regulatory authority(ies) (together with the payment of prescribed filing fee(s)). Returning to our above example, an issuer that relies on section 2.3 (Accredited Investor) of NI 45-106 must file a report of exempt distribution with each securities commission in the jurisdiction in which it distributes securities, while a private issuer in reliance on section 2.4(2)(i) (Private Issuer – Accredited Investor) of NI 45-106 is exempt from such requirement. As such, private issuers are privileged because they can avoid the “red tape” associated with other commonly-used exemptions under NI 45-106.
Maintaining your private issuer status – common pitfalls and tips
As discussed above, an issuer must comply with specific requirements under NI 45-106 to maintain its eligibility as a private issuer. Once you lose your private issuer status, you cannot regain it except in certain limited circumstances. Fortunately, private issuers that lose their private issuer status may still qualify to use other exemptions. However, as discussed above, these other exemptions generally require issuers to file a report of exempt distribution with the securities regulator(s) in each jurisdiction in which the distribution takes place (which can be costly, and takes time and expertise).
The following is a non-exhaustive list of some “traps” and “pitfalls” that can lead to the loss of “private issuer” status:
- An issuer fails to include appropriate transfer restrictions in its constating documents or securityholders’ agreements).
- An issuer distributes (or permits the transfer) of its securities to more than 50 securityholders (excluding employees and former employees). This scenario may result from, among other reasons, an issuer’s failure to track its securityholders and/or properly identify an issuance of securities.
- An issuer distributes securities (often unknowingly) in reliance on an exemption other than the PI Exemption. For example, the PI Exemption does not explicitly cover distributions of securities to persons in their capacity as consultants (as discussed above).
Although you do not have to report the use of the PI Exemption, you should always keep a record of all the persons you have distributed/traded securities to and note how they fit the terms of such exemption. It is also prudent to have each purchaser sign a subscription/purchase agreement for the purchased securities. This agreement should set-out, among other things, the number of securities purchased, the amount paid for such securities, and the relationship between the purchaser and the issue/seller, including the specific exemption being relied on.
Balancing risk with practicality – when to seek legal advice?
As noted above, Canadian securities law can be a regulatory minefield with serious consequences for non-compliance. Given the specialized and often fact-specific nature of determining whether a distribution/trade is “exempt” under NI 45-106, issuers that do not seek proper legal advice often fall offside of the law. Although we have set-out some general considerations and non-exhaustive “best-practices” above, this article provides only general information about legal issues and developments, and is not intended to provide specific legal advice.
Should you have any questions about fundraising, the PI Exemption, or Canadian securities law more generally, we encourage you to reach-out, as we would be happy to assist.