Ted Kelterborn is a member of the KNOWlaw group and the Public Markets Group, and Sandra Richmond is a member of the KNOWlaw group, of the Toronto law firm McMillan Binch.

Small businesses in Ontario have just been given an end-of-year gift. These businesses used to face enormous challenges trying to raise money from investors while not falling afoul of provincial securities laws, but that process may now be easier.

Basically, unless it can find an applicable exemption, any business that wants to raise money from investors must prepare a prospectus – a document that provides comprehensive information about a business for potential investors. This is an expensive and time-consuming process, which means it’s not a viable option for most small businesses.

Unfortunately, for many small businesses, finding an applicable exemption can be almost as difficult as issuing a prospectus.

The Ontario Securities Commission, the body that administers securities laws in Ontario, has introduced new rules to change all that.

The new regime

In September, the OSC introduced substantial changes in the way it proposes to regulate the ‘exempt market’ for the purchase and sale of securities in Ontario.

These amendments, which are expected to come into force on Nov. 30, 2001, are designed to relax the regulatory regime to make it easier for small businesses to raise capital from members of the public.

The most significant change was to remove the prospectus exemptions most commonly relied on by small businesses and replace them with two new, more accessible exemptions – the ‘closely-held issuer’ exemption and the ‘accredited investor’ exemption.

Closely-held issuer exemption

The ‘closely-held issuer’ exemption replaces the current ‘private company’ and ‘seed capital’ exemptions, and is designed to help small businesses raise start-up capital.

A closely-held issuer is an issuer (typically a corporation) who has no more than 35 investors who hold securities in the business and whose governing documents restrict the transfer of its shares (for example, through requiring director or shareholder approval).

However, the 35-investor limit does not apply to current or former directors, officers or employees of the issuer or its affiliates as long as they acquired their shares as compensation or under an incentive plan or to ‘accredited investors.’ A closely-held issuer can have any number of these types of investors.

As for the 35 investors, there are no restrictions on who they can be or on how little or how much they can invest in the business. Businesses should be aware, though, that investors who hold securities include not just shareholders, but also holders of debt securities such as promissory notes.

In addition, there is a cap on how much an issuer can raise in reliance on this exemption – a lifetime maximum of $3 million.

And the OSC has indicated it will not allow businesses to abuse the exemption by forming multiple closely-held issuers for the purpose of financing what is essentially a single business enterprise.

Accredited investor exemption

The second new exemption is the ‘accredited investor’ exemption. This effectively replaces the existing ‘$150,000’ exemption and other exemptions that were designed to exempt sales of shares to so-called ‘sophisticated purchasers’ from prospectus requirements.

This new exemption applies if the investor meets the definition of an accredited investor. There is no minimum or maximum limit on the amount of the investment under this exemption or on the number of times the exemption may be used.

There is a lengthy list of who qualifies as an accredited investor, including:

* an individual who alone or with a spouse has net financial assets (e.g., cash, shares, insurance contracts or deposits) of $1 million or more

* an individual whose net income before taxes exceeded $200,000 (or together with a spouse, exceeded $300,000) in each of the two most recent years and who has a reasonable expectation of exceeding the same net income level in the current year

* spouses, parents, grandparents and children of officers, directors or promoters of the entity in which the investment is being made

* a business, limited partnership, limited liability partnership, trust or estate (other than a mutual fund or non-redeemable investment fund) with net assets of at least $5 million

Which exemption to use

Despite the relative simplicity of using the closely-held issuer exemption to raise funds, a business thinking of raising money should always consider whether it is possible to rely on the accredited investor exemption instead.

Money raised from new investors in reliance on the accredited investor exemption will not count against the $3-million cap placed on the closely-held issuer exemption and accredited investors will not count against the 35-investor limit.

So, by relying on the accredited investor exemption where possible, a business will preserve its ability to raise additional funds under the more flexible closely-held issuer exemption if it needs to do so in the future.

Follow the rules

While this somewhat streamlined regime is an improvement over the existing exempt market regulation, businesses seeking to raise money from investors must still be attentive to their regulatory obligations and liabilities.

It is the responsibility of the business raising money – and not that of the investors – to make sure that the investment complies with regulatory requirements.

So, for example, a business raising money under the accredited investor exemption will have to make sure that the investors actually do qualify as accredited investors.

The OSC has indicated that reliance on a statutory declaration or written certification from an investor that sets out the facts to support their qualification (e.g., value of assets or level of income) will be acceptable proof of those facts, unless the business relying on the document knows otherwise.

And, for example, if a business wants to issue shares relying on the closely-held issuer exemption and after the issuance it will have more than five investors who hold securities in the business, it must provide all new investors with a mandatory ‘information sheet’ at least four days before the shares are issued.

The information sheet is a one-page document that describes some of the risks inherent in making an investment in a small business and provides certain information that may be helpful to the potential investor in considering whether or not to invest.

As before, reports of most exempt trades must be filed with the OSC. This time, though, the new forms require the names of purchasers to be disclosed.

More importantly, businesses wishing to preserve their closely-held issuer status should be aware that if they do not file the proper forms for an accredited investor exemption, the OSC may presume that the closely-held issuer exemption applies. In some cases, this may put the business over the 35-investor or $3-million limits.

For now, only in Ontario

Unfortunately, due to the patchwork nature of Canada’s provincial securities regulation, these changes to exempt market regulation will apply only in Ontario. Companies raising money still need to be aware of the different requirements in other provinces.

(THIS article contains general comments only. It is not intended to be exhaustive and should not be considered as advice on any particular situation.)

-www.mcbinch.com