By: David Gilkes, EMDA Director and President of North Star Compliance & Regulatory Solutions Inc.
National Instrument 31-103 (NI 31-103)
is not just a registration rule and the Canadian Securities
Administrators reinforced this message by changing the title of the Rule to Registration Requirements, Exemptions and Ongoing Registrant Obligations
in July 2011. The requirements for exempt market dealers do not end
with being granted registration,there are ongoing compliance
requirements that need to be addressed each and every day and with each
The cornerstone of securities regulation for dealers
is the requirement to treat your clients honestly, fairly and in good
faith. This requirement is the basis for the Know Your Client and
Suitability requirement under NI 31-103. The focus on KYC and
Suitability by regulators is evident in every compliance report issued
by the securities regulators. There are scores of references to KYC and
Suitability made by the regulators in companion policies, staff
notices,compliance reports, and other publications.
market dealers KYC and suitability requires making a proper
determination that an exemption is available under National
Instrument45-106 – Prospectus and Registration Exemptions (NI 45-106).
This article will look at the recent issues raised by the regulators in
relation to using the Accredited Investor exemption under NI 45-106. It
will also provide the steps exempt market dealers can take to remain
compliant with securities legislation.
Accredited Investor Exemption
Accredited Investor exemption is a commonly used exemption for raising
capital across the country.However, in Ontario, where the Offering
Memorandum is not available, the AI exemption is the most commonly used
exemption by issuers and dealers to sell to arms-length investors.
Determining an investor meets the definition of an Accredited Investor
is not simple considering there are 22 categories in the definition.
regulators tend to focus on individuals who are Accredited Investors
and therefore must meet the income test (1), the financial assets test
(2) or the net assets test (3). The dealer is expected to make
appropriate inquiries or investigations to determine if an investor
meets the definition of an accredited investor. If the client lies to
the dealer about meeting the definition of an Accredited Investor there
are no consequences for the client. There are consequences to the dealer
despite making appropriate inquiries. The regulators are aware of the
difficulty facing dealers and they often focus on patterns and
documentation before concluding there is a compliance issue with the
Determining Whether an Exemption is Available
BCSC discussed the determination of whether an investor meeting an
exemption in a Compliance Outreach presentation delivered on November
24,2011. The BCSC made it clear that the person making the trade must
make the determination that an exemption is available. In the case of
EMDs, it is the dealer that is making the trade (the investor places the
order) that EMD has the burden of proving the exemption is available.
If the EMD does not document its determination, it is unlikely that the
regulator would find that the exemption was available. Representations
by the client are likely to be insufficient without corroborating
evidence retained by the EMD.
The OSC provided guidance relating to whether an individual is an Accredited Investor in OSC Staff Notice 33-735 – Sale of Exempt Securities to Non-Accredited Investors (Notice 33-735) on
May 13,2011. Notice 33-735 provides a number of steps thatEMDs can take
to ensure its dealing representatives are recommending securities to
individuals who are Accredited Investors.
- NI 31-103 requires firms to provide adequate training to ensure that
dealing representatives understand the Accredited Investor definition,
especially the difference between financial assets and net assets.
Dealing representatives should understand the Accredited Investor
definitions and be able to explain it to clients. EMDs should be able to
point to the training program in the course of a compliance field
review by the securities regulator.
Know Your Client form
- EMDs should create and use an accurate form for collecting KYC
information.The KYC form (often a new client account opening form) must
include information about client’s financial circumstances, investment
objective and risk tolerance but should also have information to confirm
an individual is an Accredited Investor.
Communication with the client
- Explain the Accredited Investor definition to clients and ensure that
their KYC forms are properly completed. Completing the KYC form is not a
form filling exercise but a dialogue with the client about their
investment needs. Clients should not believe all they need to do is
check the Accredited Investor box rather the definition should be
clearly explained to clients before they complete their KYC form. Any
relevant notes about the client’s status as an Accredited Investor
should be made on KYC form or kept with the form in the EMD’s files.
- Do not sell an exempt security if you do not have sufficient
information to determine whether the client qualifies as an Accredited
Investor. An EMD must verify that the KYC information satisfies the
appropriate Accredited Investor definition. An EMD cannot simply rely on
a signed subscription agreement or the client’s representation of the
commonly used statement "Of course I’m an Accredited Investor”. In some
cases even a business card could be a supporting document(e.g. dentist,
- In addition to making certain the client meets the Accredited
Investor definition, an EMD must ensure the exempt security is suitable
for the client. Section 13.3 of NI 31-103 sets out the suitability
requirement. The companion policy of NI31-103 and CSA Staff Notice 33-315 – Suitability Obligation and Know Your Product, provide useful guidance to dealing representatives in relation to determining whether a proposed trade is suitable.
CCO review -
The CCO must review the KYC form to ensure that the information
collected is complete,accurate and consistent with the appropriate
Accredited Investor definition and the trade is suitable for the client.
The CCO is in effect the "second set of eyes” to ensure compliance with
the EMD’s gatekeeper role.
Record keeping -
EMDs should retain records that support reliance on the Accredited
Investor definition and that the client was properly eligible to rely on
the Accredited Investor exemption. Regulators will want to review this
documentation when conducting a compliance field review of the EMD. It
is a good practice for a dealing representative to have a back-upset of
Policies and procedures - An EMD’s Policies and Procedures Manual (PPM)
should establish policies and procedures to ensure securities sold
under the Accredited Investor exemption are sold only to investors who
satisfy the appropriate Accredited Investor definition. The CCO has the
responsibility of ensuring the PPM is followed in conjunction with the
Ultimate Designated Person.
- The sale of exempt securities must be reported to the appropriate
securities commission.The CCO is responsible for verifying that the
issuer has filed a Form 45-106F1 for sales made in reliance on the
Accredited Investor exemption. A copy of a signed Form 45-106F1 should
be included in a closing book in connection with a private placement
As noted above, the requirement to treat your clients
honestly, fairly and in good faith is considered the cornerstone of
securities regulation. When dealing with Accredited Investors meeting
this requirement starts with the definition of Accredited Investor and
knowing your client meets the definition.
An individual whose net income before taxes exceeded $200,000 in each
of the 2 most recent calendar years or whose net income before taxes
combined with that of a spouse exceeded $300,000 in each of the 2 most
recent calendar years and who, in either case, reasonably expects to
exceed that net income level in the current calendar year.
An individual who, either alone or with a spouse, beneficially owns
financial assets having an aggregate realizable value that before taxes,
but net of any related liabilities, exceeds $1,000,000.
3. An individual who, either alone or with a spouse, has net assets of at least $5,000,000.
For more information contact: David Gilkes - email@example.comFor more articles, please download the Exempt Market Update - the national magazine of the EMDA