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 transaction.

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.

For exempt 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

The 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.

The 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 dealer.

Determining Whether an Exemption is Available

The 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.

Training - 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.

Supporting documentation - 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, lawyer).

Suitable investments - 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 client records.

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.

Reporting - 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 offering.

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.

Notes:

1. 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.

2. 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 - davidgilkes@northstarcompliance.com