SECURITIES LAW EXAM SUMMARY

Introduction......................................................................................................................................2Historical and Constitutional Issues, Objectives/Strategies of Regulation.....................................4Overview of Regulators and Markets..............................................................................................6Definitions.......................................................................................................................................9The Prospectus...............................................................................................................................24The Prospectus: Alternatives.........................................................................................................31The Prospectus: Civil Liability......................................................................................................32Continuous Disclosure: Periodic Disclosure.................................................................................35Continuous Disclosure: Certification............................................................................................37Continuous Disclosure: Timely and Effective Disclosure – Material Changes............................39Continuous Disclosure: Civil Liability..........................................................................................42Insider Reporting and Insider Trading I........................................................................................45Insider Reporting and Insider Trading II: Defences......................................................................49Prospectus Exemptions..................................................................................................................51Resale Rules and Control Distributions.........................................................................................56Takeover Bids................................................................................................................................59Takeover Bids: Defensive Tactics.................................................................................................65Enforcement and Public Interest Considerations...........................................................................69

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Introduction

What are Securities? They are a vehicle for companies to raise capital. Two key features:

o Business not under obligation to pay back the loano The investor receiving an ownership stake in the company

Both of these features deal specifically with shares. This does not apply to bonds or income trust units (which are still securities).

What is Securities Law? Securities law is the law relating to the issuing of various types of financial instruments or

claims, known as securities, by business or financial organizations to purchasers, with a view to raising capital for enterprises.

Securities law sets out the legal requirements (and exceptions) placed on issuers in order to validly sell to purchasers, and the ongoing responsibilities of issuers.

Purposes Codified in 1.1 of the OSA: “1.1 The purposes of this Act are, (a) to provide protection to investors from unfair, improper or fraudulent practices; and (b) to foster fair and efficient capital markets and confidence in capital markets

o Fraud is reasonable, but is it reasonable to protect against unfair practices like excessive commissions or improper information disclosure?

o New rules always cite this purpose as their justification, and this also provides guidelines for regulators when interpreting rules.

Three main strategies of regulation:o Disclosure of informationo Registration requirementso After-the-fact enforcement by regulators and investors themselves.

Rules change constantly based on the policy objectives of the regulators. Securities law balances efficient capital-raising and the operation of efficient markets with comfort for investors that capital markets are a good place to make investments (section 2 of OSA)

o Ontario Ministry of Finance Review of the Securities Act (2003) recommended that more principles be added, including promoting informed investors and facilitating innovation and competition.

Regulators are a real force for change, which is different than corporate law.

Securities Issues: While capital allocation makes up most of the market (97%), most rules and securities law

arises from the context of capital generation.o Issuers are still involved in capital allocation, because issuers have ongoing disclosure

obligations. Securities law must balance the expertise and knowledge of professional investors and the

private inexperienced investors: o Securities law creates some exemptions to disclosure requirements when dealing with

so-called accredited investors.o Pension reform has pushed individual investors to take a more active role in their

pension investments (defined contribution pension – employer won’t guarantee a fixed amount for the rest of one’s life – provokes more interest in securities market)

National scope of trading and multiple jurisdictions:o Most issuers in Canada report in multiple jurisdictions. All issuers are intra-

provincial, if only because investors can come from any jurisdiction. 1/3 of issuers report in every Canadian jurisdiction.

o Note that with the principal regulator instrument now in place, most issuers are reporting issuers since they now only have to comply with the rules of their principal regulator plus the Ontario regulator.

Three Perspectives for Studying Securities Markets – Page 4

Neoclassical Economic Analysis Basic building block of analysis: the individual acting rationally to maximize his own

utility/preference and that it is rational for individuals to be driven for their own self-interest. Two types of neoclassical economic analysis (from Trebilcock):

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o Positive Economics : (descriptive or predictive analysis) predicting the possible outcomes of policies on the assumption that individuals are motivated by rational self-interest to maximize individual utilities.

o Normative Economics : (prescriptive or judgmental analysis) (welfare economics) asks whether a policy will make individuals affected by it better off in terms of how they perceive their own welfare (Pareto Efficiency and Kaldore – Hicks Efficiency)

Behavioural Finance – Page 8 Empirically, people do not always behave rationally. Behavioural approach is a more recent

framework to reflect that people make decisions based on many criteria, not all rational.o Loss Aversion: Disposition Effect: Endowment Effect: Option Paralysis: House-

Money Effect: Risk-Aversion Effect: Cognitive Dissonance: Mental Accounting:

Socio-Legal Approach for Making Securities Laws – CONDON WRITES ON THIS Socio-legal perspective on securities embraces a diverse set of normative and empirical

approaches (consider markets as embedded in a set of social and cultural relations). For example, what is the difference between a securities market where a few wealthy

individuals control the market or where there is a large dynamic market full of institutional investors? How do powerful groups in the system shape the overall system?

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Historical and Constitutional Issues, Objectives/Strategies of Regulation

History Objectives of regulation are now to protect investors and foster fair and efficient capital

markets, however earlier law was concerned only with protecting investors. The first comprehensive modern legislation came in Ontario in 1945. Influences:

o First an English trajectory of full disclosure and private remedies. The American evolution went beyond disclosure and introduced a comprehensive licensing requirement – ‘blue sky legislation’

o We have seen a SHIFT from English influence to US influence (blue sky) and backo 1928 Ontario punished securities violations by fines or imprisonment, not civil

remedies. Disclosure came back into prominence with 1944 changes o Next major change came in 1966 legislation, which was influenced heavily by the

Kimber Report. This change heavily favoured disclosure requirements, both as a way to protect investors and to encourage efficiency.

Constitutional Powers to Regulate Security – Page 32 [in textbook]

Case Name Year Court HoldingMayland v. Lymburn

1932 Privy Council

Provincial securities legislation did not encroach on the federal legislative power with respect to criminal law; federally incorporated companies can be subject to provincial law

R. v. Smith 1966 SCC Criminal powers are OK in a provincial securities act even if it covers the same ground as the criminal code, as long as this does not lead to an irreconcilable conflict (laws can operate concurrently) – Push to provincial regulation(Mayland was sited with approval)

R. v. McKenzie Securities

1966 Man CA Brokers were operating in Manitoba (by selling to a Manitoban resident from Ontario), and therefore were liable under Manitoba law for trading securities in Manitoba without being registered. A person can be liable even though he is not a resident of the province or does not physically enter the province to solicit trade. Action of accused was not intra-provincial trading (therefore not federal)

Multiple Access v. McCutcheon

1982 SCC Highwater mark for provinces : federal government has the power to regulate insider trading, but it is also valid for provincial securities to regulate insider trading concurrently (both sets of laws are intra vires). If both laws can be followed, paramountcy cannot be invoked.Double Aspect theory (affirmed in Global Case)

Quebec v. OSC

1992 ON CA When Quebec (or any other province) enters the capital markets of another province, it must abide by the rules of that province.

Global Securities v. BCSC

2000 SCC Assisting foreign agencies properly falls under the 92(13) property and civil rights power of the province. Reciprocal cooperation with other agencies is appropriate because it will assist with provincial securities regulation, therefore the BCSC’s actions were intra vires.Pith and substance of provision of BC is within BCSA authority and therefore intra vires. It is aimed and furthering the effective enforcement of domestic securities laws and as such falls within the provinces powers under s. 92(13) of Constitutional Act.

The Structure of the Canadian Capital Markets

- Each province and territory has the constitutional ability to regulate capital markets within its own jurisdictiono The end result is that Canada has a disparate and fragmented system of regulation

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- Calls for National Regulator o White paper by Douglas Harriso Committee headed by Harold MacKay – Wise Persons’ Committee to examine the

structure of securities regulation in Canada Single regulator New Canadian Securities Act capital market regulation for Canada

Takes into account the CSA USL project Regulations must be passed by majority of provinces Mandate of the Commission reflects the needs to foster fair and efficient

capital markets, the importance of regulatory innovation, and the unique characteristics of Canadian capital markets

o Constitutionality of a National Regulator L. Yves Fortier “constitutional opinion”

Parliament has the constitutional power to enact the proposed acto General branch of federal trade and commerce power

under s. 91(2) provides parliament with the strongest basis Provinces have the power to incorporate the Act and dissolves

existing regulator bodies Parliament is not prevented from including a paramountcy clause

that precludes provincial securities law in their entirety.o No caselaw to support this, however

o MacIntosh and Choudry present the view that the WPC take on the constitutionality of a Natioanl Regulator is extremely liberal – in that, provincial jurisdiction must be conceded or that the federal government must get the consensus from the main principal provinces to adopt a national regulatory framework.

Both suggest that the provinces will be accommodated by the courts in typical Canadian comprise – likely through overlapping jurisdictions with provincial laws governing in areas with high uniformity with fed law, and paramountcy of fed law in conflicting areas of securities law

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Overview of Regulators and Markets

How Securities Markets are Structured:

Primary Markets Primary market transactions, also called distributions, occur when an issuer sells its own

securities or sells them through an underwriter. The securities must be previously unissued.o Private Placement is a sale of securities by the issuer directly to investors

Securities in this scenario are not listed on the public market but still require a prospectus or a prospectus exemption.

o IPO occurs when an issuer is first offering securities to the public. Even if the company is established with lots of public securities, if new securities are issued

this still goes to the primary market as a distribution.

Secondary Markets After an issuer issues securities through a prospectus offering, it becomes a ‘reporting issuer’

and must comply with ongoing reporting obligations.o If shares came from a private placement, the value of the securities is determined by

the buyer and seller in accordance with the restrictions of the exempt market.o Where shares came from an IPO, shares are normally traded on stock exchanges.

Marketplace Operation A marketplace is either an exchange, a quotation and trade reporting system (QTRS) or an

alternative trading system (ATS). Regulated by two national instruments:o NI 21-101 Marketplace Operation: NI exists to address the needs of ATS (3.1, 3.3) as

well as the more traditional QTRS (3.2).o NI 23-101 Trading Rules: deals with specific trading practices by setting standards

for best execution by dealers, establishment of trading hours, regulatory halts, prohibition of manipulation and fraud, audit trails.

National Exchanges and Self-Regulatory Organizations Exchanges are key securities market participants and are considered self-regulatory

organizations (SROs) and are recognized under NI 21-101o The extent of an SRO’s sanctions is to de-list an issuer, while the OSC has much

broader authorityo An example of an SRO is the Regulation Services company that regulates the TSX.

Canada’s markets were consolidated in 1999. o The TSX assumed the role of the exchange for senior equities

Now a for-profit publicly-traded company Market regulation is now delegated to Regulation Services (RS) – operates at

arm’s length. RS regulates actual trading (see below) While TSX formerly had governance requirements, these are now passed

down from the CSAo Alberta and Vancouver exchanges merged to form the Canadian Venture Exchange

(CDNX/TSX Venture) controlling junior equities (bought by TSX in 2001)o Montreal became the centre for derivatives trading in Canada (Bourse de Montreal)

Derivatives are contracts (underlying issues like bonds, bankers’ acceptances, dollar, stocks indices, and commodities). Used for hedging.

Derivatives have no tangible worth of their own, but ‘derive’ value form the claim they give their owners to some other financial asset or security.

The most common derivative contracts are options and futures contracts. All transactions are guaranteed by the Canadian Derivatives Clearing

Corporationo Winnipeg Commodity Exchange is the national commodities futures and option

exchange.o Other exchanges: the Canadian Trading and Quotation System (CNQ), Nasdaq

Canada, and the Canadian Unlisted Board (not a trading system)

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Quotation and Trade Reporting System (QTRS) A QTRS is an operating facility that permits the dissemination of price quotations for the

purchase and sale of securities and reports of completed transactions in the securities for use of registered dealers.

A QTRS can monitor and enforce their own requirements governing its members

Alternative Trading Systems (ATS) An ATS is a computer-based system that automates the process of trading in securities.

Systems can be continuous auction books, dealer markets, call markets, or anonymous matching networks using prices determined in the principal marketplace.

o An ATS is an alternative to an exchange, and matches orders from buyers and sellers of listed securities using predetermined, established methods or rules.

An ATS must enter into an agreement with a regulation services provider and its subscribers must also enter agreements that form the basis upon which a regulation services provider will monitor the trading activities of the ATS. NI 23-101 sets out the rules for an ATS:

ATSs raise questions about market fragmentation and illiquidity, as well as long-term implications for the survival of independent capital markets in Canada.

o Resistance to ATSs may be more about major Canadian financial players protecting their own interests than foreign control.

The Current Canadian Regulatory Structure Provincial Statute (last major overhaul in 1978) (most mirror Ontario)

o Canada’s securities regulation are generally characterized as a ‘closed system’ (distributions of securities are subject to regulation) but some provinces have ‘open’ aspects under their legislative framework.

Provincial Rules and Regulations (delegated authority from legislators under section 143 – 60 areas with power to regulate – 1994 update created this power)

o Regulators create draft rules, and interested parties have 90 days to comment on any rule changes (similar to US model) Transparency problem: most commentators are law firms / TSX commenting on behalf of clients.

o Some critics recommend moving to a ‘basket’ approach (no list needed) Policy Statements Canadian Securities Administrators (CSA) and National Instruments and Multilateral

Instrumentso CSA has developed 25 national instruments. Established the Mutual Reliance Review

System (MRRS) – NP 43-201o MRRS allows the issuer to ask that one regulator act as principal regulator, which

then provides comments and a decision on behalf of all the other regulators.o CSA also developed the System for Electronic Document Analysis and Retrieval

(SEDAR) system, a national web-based filing system – NI 13-101 and the System for Electronic Disclosure by Insiders (SEDI)

o Uniform Securities Legislation : The USL is advocated by the CSA in its harmonization efforts. Key aspects of the USL:

Ability to delegate decision-making to another securities regulator Streamlined system for inter-jurisdictional registration of firms and

individuals Civil liability regime for secondary market participants. Streamlined securities act to allow for future flexibility and efficiency.

Staff notices from OSC and CSA Self-Regulatory Organizations (SROs) –

o Investment Dealers Association (IDA), the Mutual Fund Dealers Association (MFDA), Canadian Depository for Securities (CDS), Canadian Investor Protection Fund, Canadian Public Accountability Board (for auditors)

o Market Regulation Services Inc (RS) has the mandate to self-regulate the securities markets themselves by applying universal market integrity rules (UMIRS): Deals with prohibitions on deceptive or manipulative trading, short selling, and the requirement of ‘best execution’ of a customer’s trade.

RS owned in part by TSX, which may create conflict of interest though it is in the best interest of the market to operate with integrity and RS has rules to preserve some independence.

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Appellate court decisions: Prominent cases include Pacific Coast v. OSC (1978), Pezim v. BC (1994), Asbestos v. OSC (2001), Cartaway (2004), and Global Securities v. BC (2000).

Regulatory Decisions, Orders, and Rulings Internationally : International Organization of Securities Commissions (IOSCO)

o Technology, new financial products, and fewer trade barriers have increased the complexity and pace of capital market transactions and have facilitated global securities trading

o Competition is fierce: investors will only invest in markets with sufficient protection, and issuers who can sell in multiple jurisdictions will look for markets with efficient and low cost rules and regulations.

Administrative Law Issues: The level of review undertaken by the appellate courts of securities regulatory decisions.

o The standards that court look to is a reasonableness standard (see Iacobucci) Is it problematic that the commission both investigates and prosecutes in an enforcement

context, and also adjudicates on the issues (issue generally in administrative law)?o The SCC has repeatedly held that multi-functional administrative agencies are

permitted if authorized by statute. However at issue is not whether the agencies are permissible, but whether it still gives rise to perceptions of unfairness.

o OSC has tried to enhance the independence of adjudication. Commissioners are not allowed to adjudicate if they have had any role in the proceedings.

o OSC established a fairness committee (chaired by Coulter Osbourne) in 2004 which overwhelmingly found need for bifurcation. However recommendation was wrapped up with the nationalization of securities law in Canada, meaning that bifurcation would only occur if nationalization failed.

Case Name Year Court HoldingBC Securities Commission v. BDS

2003 BC Deference of courts to regulators: there is no constitutionally-protected right to cross-examine a securities regulator (no violation of principles of natural justice)

Committee for Asbestos v. OSC

2001 SCC Endorses broad powers that securities regulators have to intervene in the market in the public interest and court will only review commission decisions on the standard of reasonableness.

Re Cartaway Resources

2004 SCC Deterrence is a reasonable objective and a justification of sanction by regulators. Reinforces deference to regulators

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Definitions

Three-Stage Test for Securities Regulation Is the item being bought or sold a security? If yes, law applies. Is the security being traded? If no, there are no registration or disclosure requirements. Does the trade amount to a distribution or offering of securities? If no, there is no need for a

prospectus.

Stage 1- is it a Security?

Section 1(1) of the OSA definition (broad and open ended) “security” includes,(a) any document, instrument or writing commonly known as a security,(b) any document constituting evidence of title to or interest in the capital, assets,

property, profits, earnings or royalties of any person or company,(c) any document constituting evidence of an interest in an association of legatees or

heirs (Historic, no longer relevant)(d) Any document constituting evidence of an option, subscription or other interest in or

to a security, (The option is a security itself, not just the asset that it derives from)         (e)    any bond, debenture, note or other evidence of indebtedness, share, stock, unit, unit

certificate, participation certificate, certificate of share or interest, preorganization certificate or subscription other than a contract of insurance … evidence of deposit issued by a bank (banks have own rules)

          (f)    any agreement under which the interest of the purchaser is valued for purposes of conversion or surrender by reference to the value of a proportionate interest in a specified portfolio of assets…

         (g)    any agreement providing that money received will be repaid or treated as a subscription to shares, stock, units or interests at the option of the recipient or of any person or company,

         (h)    any certificate of share or interest in a trust, estate or association,          (i)    any profit-sharing agreement or certificate,          (j)    any certificate of interest in an oil, natural gas or mining lease, claim or royalty

voting trust certificate,         (k)    any oil or natural gas royalties or leases or fractional or other interest therein,          (l)    any collateral trust certificate,        (m)    any income or annuity contract not issued by an insurance company,

(n) any investment contract , (Definition that gives rise to most litigation. Courts take a purposive approach to look at the substance of a transaction)

See Caselaw below(o) any document constituting evidence of an interest in a scholarship or educational plan

or trust, and (such as RESPs)(p) any commodity futures contract or any commodity futures option that is not traded on

a commodity futures exchange registered with or recognized by the Commission under the Commodity Futures Act

Derivatives are not specifically mentioned in this definition, but all derivatives are either options, futures, or combination of the two.

Case Law on the Definition of Investment Contract – OSA Section 1(1)(n) Note the court has the ultimate goal of getting people back their money and that the public’s

money was used in this case to finance the opening of the store (capital). Courts are moving more and more towards a policy– and results-oriented application of the

legal definition of securities. On Pacific Coast: reasoning runs the risk of being over-extended. Could any contract

between 2 people could be a securities exchange? Laskin’s dissent does not think that test should be broadened based solely on some idea of policy, and prefers a narrower definition.

Case Name Year Court HoldingSEC v. Howey

1946 US Supreme Court

Non-identified land in an orange grove is a security. Test for securities is Case defines an investment contract as (4-part test): (1) investing money in a (2) common enterprise to (3) expect profits (4) solely from the efforts of the promoter or a third party.

Hawaii v. 1971 Hawaii Pyramid Scheme. Broadens the Howie test for investment

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Hawaii Market Center

Supreme Court

contracts. Now, the test is an investment in a common enterprise which is subject to the risks of the enterprise but is expected to generate profit. Most importantly, the investor does not receive the right to exercise practical control over the enterprise (risk capital test)

Pacific Coast Coin Exchange v. OSC

1978 SCC Sale of silver. Case is more policy-driven and loose in its analysis (like Hawaii): If policy objectives of security act are triggered by a transaction, the law will apply. It is not whether the commodity futures contracts are securities (it is agreed they are not) but the nature of the relationship between PC and its margin customers. Investors were dependent on PC to properly hedge silver.

Albino 1991 OSC On ‘phantom stock options’: OSC did not agree on whether PSOs where securities, but still regulated the transactions under its broad discretionary power to uphold the integrity of the markets

The current test in determing if it is investment property is by applying Howie as modified by Pacific Coast Coin

7) Interests in Property

Section 1(1)(b) – includes any document constituting evidence of title to or interest in the capital, assets, property, profits, earnings or royalties of any person or company. 

Title to or interest in ... property ... of any person or company – the possible reach of this part of the definition is clear. If all that is required is a document constituting evidence of an interest in property, then a bill of sale is a security, a deed evidencing an interest in land, a mechanic's lien registered against a property, a mortgage, a vendor's interest in a vacuum cleaner bought on credit, and many other common types of interests in property.

R. ex rel. Swain v. Boughner – nothing more than a simple property interest must be required to create a security

Barbe purchased a half interest in a pair of royal chinchillas from Boughner. A bill of sale recorded the sale of the interest to Barbe, which transferred a property interest and one-half the natural increase of said Chinchillas. A certificate was issued to Barbe that certified his ownership in the chinchillas and provided for the care of the animals and the disposition of the young.  

The Crown contended that the certificate constituted a security under what is now s. 1(1)(b) but at the trial level, the magistrate held that no security existed because the words "of any person or company" of (b) required Barbe to hold an interest in property belonging to another person, rather than actually owning the property (i.e., the chinchillas or a half interest in them) himself.

Ontario High Court of Justice reversed this decision, holding that the "property" in question need not remain in another person or company, because the statute does not use the words "of 'another' person."

Therefore any document evidencing an interest in property is a security (the Ontario High Court of Justice erred on this specific point – the definition of security becomes far wider than is necessary or desirable to carry out the purpose of the statute). Reading the statute as if it says "another person" better comports with the fundamental concept underlying the meaning of the term "security," which is the furnishing of risk capital by one person to another.

The final outcome in Boughner is correct b/c the interest (as evidenced by both documents furnished to Barbe) could have been characterized as a security under the "investment contract" part of the definition of security. Although Barbe nominally purchased only chinchillas, the agreement obligated Boughner to care for, and ultimately dispose of, the animals in a manner that both parties hoped would generate a profit to be split between them. Thus, Barbe was clearly purchasing more than a simple property interest. He was led to expect that a profit over and above his initial stake would arise from his investment. The purchase of the chinchillas plus an interest in the profits bore little difference in substance from a purchase of shares in the chinchilla ranch.

R. v. Dalley – same wide reading by ON CA “[under this interpretation] almost any agreement becomes a security since

nearly every such document affords evidence of title to, or interest in, some property. But where the meaning of the statute is plain, as it appears to be here, the Court must give effect to it”

Ontario (Securities Commission) v. Brigadoon Scotch Distributor (Can.) Ltd. – preferable interpretation

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Warehouse receipts were sold to a variety of purchasers. The receipts nominally evidenced only the passing of title in casks of whiskey. However, each cask remained in the possession of the vendor for the purpose of aging and eventual sale on behalf of the owner to a whisky blender. This was anticipated to make a profit that would be distributed to the owners.

Alleged that the warehouse receipts constituted securities within the meaning of part (b) of the definition.

Court stated: “The definition would not include documents of title which are bought and sold for purposes other than investment, for example, bills of lading and receipts for goods purchased for inventory or consumption purposes. Such an intention on the part of the Legislature can be inferred from the basic aim or purpose of the Securities Act, 1966, which is the protection of the investing public through full, true and plain disclosure of all material facts relating to securities being issued” and without further explanation, the court held that the warehouse receipts were securities under part (b).

Therefore properly interpreted, part (b) of the definition of security adds nothing to the meaning of "investment contract"

The warehouse receipts were securities b/c the purchasers were led to believe that a profit would accrue over and above their initial investments. It is this element of investing for profit, and not merely an interest in property, that results in a characterization of the interest as a security.

Because of the potential for an overly ambitious interpretation by securities regulators and courts, it would perhaps be best if part (b) were removed from the definition of security.

 

8) Profit-sharing Agreements

Section 1(1)(i) – includes any profit-sharing agreement or certificate. Few cases have been litigated under this part of the definition. In virtually every case in which it is alleged that there is a profit-sharing agreement, it is also alleged that

the interest is a security by virtue of its being an investment contract b/c (1) profit sharing is at the heart of the test for an investment contract and (2) the case law dealing with investment contracts is much more detailed than that dealing with profit-sharing agreements

Therefore little harm would be done by eliminating this part of the definition from the statute.

 

9) Investment Contracts

a) Introduction

Section 1(1)(n) – includes any investment contract Considered to be the broadest part of the definition of security Most litigated part of the definition. The courts' guidance under this part of the definition is transposable to other parts of the definition of

security. The Canadian tests for determining when an investment contract exists are the same as those adopted in the

United States.

 

b) SEC v. C.M. Joiner Leasing Corp.

The first U.S. Supreme Court case interpreting "investment contract".

 

SEC v. C.M. Joiner Leasing Corp.

Facts: D, C.M. Joiner Leasing (Joiner), purchased a number of leases of potentially oil-bearing property in Texas. These leases were conditional on Joiner drilling test wells. To raise the money to conduct the drilling program, Joiner resold some of its lease rights. Fifty purchasers bought parcels ranging in size from 2.5 to 5 acres, at prices ranging from $5 to $15 per acre with most purchases totalling no more than $25. The sales solicitation contained the undertaking that Joiner would drill test wells to determine the value of the properties.

Issue: Whether the interests constituted securities.

Ratio:

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i) The Importance of the Element of Economic Inducement, or the Creation of an Expectation of Profit

The court recognized that Joiner was not merely selling leasehold interests. It was selling a hope of profit – “it is clear that an economic interest in the well-drilling undertaking was what brought into being the instruments that defendants were selling and gave to the instruments most of their value and all of their lure”

ii) The Statutory Policy of Investor Protection

The court in Joiner held that “courts will construe the details of an act in conformity with its dominating general purpose, will read text in the light of context and will interpret the text so far as the meaning of the words fairly permits so as to carry out in particular cases the general expressed legislative policy.  In this case, the legislative policy is one of investor protection. Thus, the Act must be interpreted to further that policy”

But circular – to define an interest as a security, one must look to see if the person acquiring that interest is an investor.  But must then ask who is an investor and an investor is a person who buys a security.

References to the investor protection mandate emphasize that the interest in question must have an "investment" element to it and the investor must be led to expect that a return will accrue over and above her initial stake (the courts are not timid in interpreting the statute)

iii) Substance Governs, Not Form

The defendant in Joiner argued that the interests could not be securities because, under Texas law, the lease assignments conveyed interests in real estate. It was argued, in other words, that something is either an interest in real estate or a security, but not both. The court rejected this reasoning, holding that the formal nature of the interest alleged to be a security is essentially irrelevant. The courts will be guided by substance, rather than form.

Conclusion: These interests constituted securities within the meaning of the U.S. Securities Act of 1933.  

c) The Howey Test

The test for "investment contract" was further elaborated

 SEC v. W.J. Howey Co.

Facts: Howey Co. raised money for the cultivation of citrus crops by selling some of its acreage. However, it was not just a sale of a piece of real estate b/c Howey Co. urged potential buyers to enter into a service K with Howey-in-the-Hills, a subsidiary company that cultivated, harvested, and marketed the citrus crop (they told them that it was not feasible to invest in citrus groves without a service K). Most of the purchasers entered into these Ks. The Ks gave Howey-in-the-Hills a leasehold interest with possession. Howey-in-the-Hills pooled the fruit, sold it, and allocated profits based on the output of each tract. The purchasers were mostly out-of-state residents who knew nothing about the citrus business.

Issue: Whether the sale of an investment contract was involved in the transaction.

Ratio: The most widely used test for the existence of an investment contract: “An investment contract for the purposes of the Securities Act means a contract, transaction or scheme, whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party” (Joiner).  Problems: what does it means to have a “common enterprise”; the use of the word “solely” i.e. what if the investor also engages in efforts, however minimal, to produce a profit?

Four part test for the purchase of security (vs. commodity) – for unusual forms of investments 1. Payment of money by investor 2. Expectation of profit 3. From common enterprise 4. Profit made solely through efforts of others

Other relevant points:

i) The Character of the Buyers

The buyers' inability to protect themselves was an important element. The court stressed that most of the buyers were out-of-state residents who knew nothing about the citrus business and these buyers were in need of the “full and fair disclosure” that would be furnished by compliance with the Securities Act.

ii) Degree of Risk

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Howey argued that no security existed because the investment was not speculative or promotional in character (i.e. it was not high risk) but the court held that only some risk is needed to create an investment contract.

iii) Irrelevance of the Existence of Value Independent of the Success of the Enterprise

Howey argued that the land sales were not securities because the land had value independent of the success of the enterprise as a whole but the court held that substance triumphs over form, and an interest may be a security even though it has value independent of the enterprise as a whole.

Analysis: The test was met: the buyers were “attracted solely by the prospects of a return on their investment” (interested in simply profits) b/c they did not have access to the land except when permitted and they had no desire to occupy or develop it themselves.  There was an expectation of profit – the investors provide the capital and share in the earnings.  There was a common enterprise in that they all bought fractions of an orange grove managed, controlled and operated by third parties.  The sale of an investment contract was involved in the transaction, triggering the registration requirement of the Securities Act of 1933.

Conclusion: The combination of the land sales contract, the deed giving title to land, and the service contract was a security. 

d) The Hawaii Test

Other commonly used test of what interests constitute investment contracts.

 

Hawaii v. Hawaii Market Center Inc. (Supreme Court of Hawaii)

Facts: The Hawaii Market Center (HMC) operated a retail store. To raise money to carry on business, HMC recruited founder members, who were either founder distributors or founder supervisors. A distributor purchased $70 worth of merchandise for $320. A supervisor purchased $140 worth of merchandise for $820. Both distributors and supervisors received purchase authorization cards that were distributed to potential shoppers. Only those with such cards were allowed to purchase merchandise at the store.  Founder members could make money in two ways: (1) if people to whom they had distributed purchase authorization cards bought merchandise, the members received a commission and (2) by signing up others as founder members.  HMC argued that the Howey test required purchasers to be “led to expect profits solely from the efforts of the promoter or a third party”. However, founder members could generate profits through their own efforts, and therefore did not rely solely on the efforts of a third party.

Issue: Whether the interests were investment K and therefore securities.

Ratio: Different four part test (risk capital test – put at risk and rely on others to minimize and remove that risk) for the existence of an investment K:

Payment of funds by investor – an offeree furnishes initial value to an offeror Risk of loss – a portion of this initial value is subjected to the risks of the

enterprise (flipside of expectation of profits and broader) – people here at risk b/c depending on competence of others so wouldn’t lose money therefore narrows risk element (results-oriented process) – if security, there is redress for investor

Investment not subject to investor’s control – the offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise – even though some effort was still shared b/w them and owners (watering down – even a partial effort)

Expectation of a benefit when invest money – the furnishing of the initial value is induced by the offeror's promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise

Analysis: The Hawaii test makes states that not all of the “initial value” needs to be subjected to the risks of the enterprise (but still consistent with Howey). It also sidesteps the problem created by Howey's requirement that the purchaser be led to expect profits “solely” from the efforts of a third party, by requiring only that the purchaser have no “practical and actual control” over management decisions (focuses on the policy of affording broad protection to investors even if they only participate to a limited degree in the operation of the business).

Conclusion: The interests were securities. 

e) Canadian Cases  

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Pacific Coast Coin Exchange of Canada v. Ontario (Securities Commission)

Facts: Pacific Coast Coin Exchange (PC) sold silver on margin (i.e., on credit – put up % and PC would give loan for rest). PC did not intend to actually deliver the silver (they kept less than was necessary to make delivery to all buyers). I.e. PC sold a contractual right to receive silver. The buyer acquired the option to demand actual delivery of the silver on giving PC forty-eight hours' notice or the buyer could demand a notional sale of her silver (most customers did this), in which case the buyer would receive (or pay) the difference between the price of silver when the contract was entered into and the price of silver when the contract was liquidated. When a contract was closed out, PC would collect interest on the loaned portion of the purchase price, commissions, and storage charges. PC was exposed to risk b/c if the price of silver rose, they would be liable to pay any buyer who chose to liquidate the contract the difference between the contract price and the price of silver at the time of liquidation, or to enter the market, purchase the required quantity of silver, and deliver it to the buyer. If the price of silver rose dramatically, PC might be unable to meet all of its buyers' claims and, therefore, become insolvent. Therefore PC purchased silver futures (in a futures contract, the buyer agrees to pay a fixed price for a stated quantity of a good for delivery on a stated date in the future), which protected PC against a rise in the price of silver. If the price of silver rose, PC would still be able to take delivery of the specified quantity of silver at the fixed futures contract price. A futures contract may typically be resold to a third party, who then assumes the obligation to pay the price and receive the goods on the stated date. Thus, if the market price of silver rose, PC could at any time liquidate the futures contract by selling it at a premium to a third party (the premium reflecting the rise in the price of silver). PC's exposure to the risk of changes in silver prices was therefore hedged (i.e. they held offsetting risks) – if the price of silver rose, PC would lose money on the contracts it had made to sell silver to its purchasers, but it would make money on its futures contracts. PC distributed promotional brochures that emphasized the value of silver not only as an investment, but also as a protection against inflation, which they predicted along with the possible return of a major depression. PC said were not obligated to repurchase but “never failed to” resell in the past (K).  PC did not compile and distribute a prospectus to its buyers. As a consequence, the ON regulators issued a cease trade order, banning further trading activity by PC until such time as a prospectus was filed and distributed. PC argued that the contracts it sold did not constitute securities within the meaning of the ON legislation (and therefore the prospectus requirement did not apply because it attaches only to interests that are securities).

Issue: Whether the interests sold by PC constituted investment contracts (and therefore securities).

Ratio: The SCC purported to adopt the Howey test but applying the Howey test literally would likely have resulted in the finding that there was no security. The buyers were not led to expect profits solely from the efforts of PC b/c the price of silver in international markets, over which PC had no control, was the key factor in the buyer's return.  Therefore the SCC accepted a modification of the word solely in the Howey test, stating that to give a strict interpretation to the word solely would not serve the purpose of the legislation. “Solely”: whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.  The SCC also refined the meaning of “common enterprise”: an enterprise in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties; the commonality necessary for an investment contract is that between the investor and the promoter (there is no need for the enterprise to be common to the investors between themselves). 

The SCC made a number of other rulings re what constitutes an investment contract: In determining whether an interest is a security, U.S. cases on point are relevant

because the policy behind the legislation in the two countries is exactly the same The definitions in the OSA are not mutually exclusive, but rather are catchalls to

be given their widest meaning Securities legislation is remedial legislation to be construed broadly in the

context of the economic realities to which it is addressed (purposive approach): if the particular set of legal rights and obligations under review was found to be a security, the investing public would be protected through full, true and plain disclosure of all material facts in a prospectus.  Investors would also enjoy statutory rights to claim for rescission or damages if the prospectus contained a misrepresentation, and the offering could be made only through persons duly registered as dealers or salespersons under the relevant statute

Substance, not form, governs the interpretation of what is a security The policy of securities legislation is full and fair disclosure wrt those

instruments commonly known as securities

Analysis: There was investment of money here.  There was also a common relationship/interest in deriving profit in coins – they were investing collectively in a single enterprise (low test): “such an enterprise exists when it is undertaken for the benefit of the supplier of capital (the investor) and of those who solicit the capital (the promoter). In this relationship, the investor's role is limited to the advancement of money, the managerial control over the success of the enterprise being that of the promoter; therein lies the community”.  There was also riskiness and control b/c investors were dependant on PC to make any money in 2 ways (1) expertise in administering funds – must deal with funds appropriately in order to be able to pay out in end = broad dependence b/c always one is always dependant in K for the K to be performed and (2) deliver the silver and act proper in silver market generally so there is something in the end therefore maintenance of solvency and expertise in silver market – they need to decide what futures Ks it needs to enter into which is risky and there is dependence to maintain control i.e. the court held that the essential managerial efforts were made by PC: the result of the investment was dependent upon the quality of the expertise brought to the administration of the funds obtained by appellant from its customers i.e. if PC did not properly invest the pooled deposit, the purchaser would obtain no return on his investment regardless of the

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prevailing value of silver (the key to the success of the venture is the efforts of the promoter alone).  But PC weren’t setting price of silver (no greater than retail stores) and nowhere in their literature to induce to buy coins do they say they will advise/give expertise to investors (don’t suggest they are acting in trustee/fiduciary).  But individual assumed and relied on fact that PC were experts (element of reasonableness). PC said never promised expertise but bragged about their activities in silver market in the past and made clear to investors that no other exchange would purchase/make good (no alternative if didn’t sell back to PC – dependency) therefore selling them a commodity (PC argues).

Conclusion: The Howey test applied and the interests were investment contracts (the Hawaii risk capital test would lead to the same result).

Commentary:

Dissent (Chief Justice Laskin) – the interests were not securities. The source of the buyers' risk was not the quality of the management brought to the project by PC, but the market risk inherent in the price of silver. The only difference between buying from PC and buying silver in the spot market was a concern over PC's solvency. Laskin C.J. would have held that a concern over the solvency of the enterprise is not enough to render the interests securities.  All that distinguished the scheme in question from a purchase of silver in the spot market was solvency risk. And, if solvency risk is enough to render an interest a security, it is difficult to know when to stop finding that particular interests are securities (every commercial K to buy and sell involves a dependence that the other side will be solvent and able to fulfill their side). The degree of risk in these interests that would be deemed securities would likely be small, and requiring a prospectus/exemption would be too costly relative to the benefit to be obtained.

In the Pacific Coast case, the sums of money involved and the risk taken by the purchasers were highly significant and therefore there is a greater need for the application of the securities legislation. Also, PC attempted to induce investors to part with their money by making exaggerated and inflammatory, if not simply irresponsible, claims about the future of the financial markets. 

Policy underlying the legislation: investor protection. The more a court or administrator perceives that capital contributors need protection, the more likely it is to find the interest to be a security. The amount of money involved, the degree of risk taken, and the likelihood that contributors of capital will be taken advantage of by promoters of the scheme all play a role in this regard. The net benefit to be achieved by applying the regulatory apparatus (i.e., the benefit less the cost) will also likely be a factor. While a court will rarely, if ever, make explicit reference to all, or indeed any, of these factors, it is beyond doubt that they will operate sub rosa, whether consciously or unconsciously. Predicting whether an interest will be considered a security thus involves two levels of analysis. One is an avowedly legal analysis, which will be played out in the context of the tests that the courts have enunciated for the meaning of the term security. The other analysis takes place within the legal subtext, which includes those things that influence a judge to make a particular finding, but which are not explicitly referred to in the judgment.

“A last word. At the invitation of the parties, I have examined the facts in the sole light of the Howey and Hawaii tests. Like the Divisional Court, however, I would be inclined to take a broader approach.  It is clearly legislative policy to replace the harshness of caveat emptor in security related transactions and Courts should seek to attain that goal even if tests carefully formulated in prior cases prove ineffective and must continually be broadened in scope. It is the policy and not the subsequently formulated judicial test that is decisive”

11) What if There Is No "Security:" Does the OSA Apply?

The application of various provisions of the OSA turn on whether there is a security. In our view, this is entirely appropriate. The OSA was meant to deal with securities, not with consumer protection.

Securities regulation covers five major areas: primary market offerings, secondary market trading, activities of market professionals, insider trading, and take-over bids. It is implicit that a condition precedent to the operation of the OSA is the presence of a security.

This is clearly true in relation to primary market offerings (e.g. Sunfour). If what is being offered for sale is not a security, the prospectus requirement has no application.

The presence of a security is also a condition precedent for the regulation of secondary trading. E.g. only reporting issuers are subject to the continuous disclosure requirements of the OSA and reporting issuers are those companies that have issued securities to the public.

The class of persons who must register under the OSA is limited to those who are engaged in trading (s. 25(1)), which involves the trading of a security.

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The application of the take-over bid (s. 89(1)) and insider-trading provisions (ss. 76(1, 2), 134) depends on the presence of a security.

The securities regulators also have jurisdiction even in cases that do not involve a security – arises from one of eight "public interest" powers – empowers the OSC to make a variety of orders "if in its opinion it is in the public interest to make the order or orders." (s. 127(1))

A case in which one of the public interest powers was applied despite the absence of a security is

 Re Albino

Facts: Rio Algom set up an incentive plan for its CEO, Albino, under which Albino was notionally issued a certain number of shares (units of phantom stock) of RA. Albino held an option to designate a date upon which the actual price of the company's stock would be compared to the price of the stock when the phantom stock units were issued. The difference was to be awarded to Albino in cash. Albino allegedly possessed confidential information that would, when made public, impact negatively on the company's stock price (material change to the detriment of RA). Albino delayed public disclosure of this information until after he was able to exercise his phantom stock options, allegedly in order to enhance the value of the phantom stock units. OSC staff asked the OSC to find that Albino had engaged in insider trading.

Issue: Whether “phantom stock units” constitute securities (not buying/selling security, just getting a price difference).

Ratio:

Commissioner Blain concluded that the insider-trading provisions had no application because the phantom stock units did not constitute securities.

Commissioner Salter would have found that the units were securities because they were derivatives. Commissioner Hansen declined to decide the issue of whether the phantom stock units were securities,

although her reasons suggest that had she decided the issue, she would have sided with Commissioner Blain.

Thus, only one of three commissioners was prepared to find that the interest in question was a security. Hansen and Salter took the view that the OSC had the jurisdiction to make an order under s. 127 denying

Albino trading exemptions in Ontario (denies the benefit of the registration (s. 34), prospectus (ss. 71, 72) and take-over bid (s. 92) exemptions). They held that the jurisdictional test for the issuance of a public interest order is not whether there is a security, but whether the transaction exhibits a significant connection to the capital markets of Ontario.

Analysis: Whether the phantom stocks constituted securities:

Blain:

Phantom stock plans, such as the Incentive Plan, cannot be said to be a document, instrument or writing commonly known as a security

They are not documents constituting evidence of title to or interest in the capital, assets, property, profits, earnings or royalties of any person or company b/c under the Incentive Plan, while the amount to be paid by Rio Algom is not known until encashment, it does nevertheless represent a debt in the sense of being an obligation of Rio Algom to pay an amount ascertainable upon encashment. The fact that the amount to be paid is determined from the market price does not provide, a sufficient nexus with the capital market to say that the situation is different from the other type of compensation arrangement referred to above.  This is simply the yard stick to determine Rio Algom's money obligation under the Incentive Plan and is basically no percentage of profits or sales

The Incentive Plan is not a security under the general section itself (the non-exhaustive "security includes") b/c “if the Legislature, in an area as managed and controlled as security trading, has deliberately chosen not to define a term which, admittedly, embraces different kinds of transactions, of which some are innocent, and prefers to rest on generality, I see no reason of policy why Courts should be oversolicitous in resolving doubt in enlargement of the scope of the statutory control” (Pacific Coast).

However, Blain did hold that Albino’s conduct was reprehensible: “the conduct of Albino cannot be condoned. It seems clear…that he manipulated the time of the disclosure…to his own advantage so that this news was not made public until the window had opened for encashment of award units under the Incentive Plan”

Salter: Given the clear and close relationship between Rio Algom common shares and Rio Algom award units, the latter is properly seen as a derivative of the former, should be classified as a security and so regulated.  

Conclusion: The phantom stock units did not constitute securities.

Commentary: Broad view of OSC’s jurisdiction but supported – the regulators and courts take the view that the public interest powers may be invoked in the absence of a breach of any feature of the OSA, rules, regulations, policy statements, notices, documents, or expressed views of the OSC.  

Quebec (Sa Majeste du Chef) v. Ontario Securities Commission (ON CA)

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Ratio: Constitutional issue of when the public interest powers may be invoked – not even a transactional nexus to Ontario is required to trigger Ontario's constitutional jurisdiction. All that is required to invoke the public interest powers, as a matter of constitutional law, is that the transaction have an effect on Ontario shareholders sufficient to prejudice the public interest. This reasoning was subsequently endorsed by the Supreme Court of Canada in a subsequent case arising from the same set of facts.

Although the correctness of this decision may be questioned, it nonetheless represents the current state of the law. Combining Albino and Asbestos, it appears that the public interest sanctions in the OSA may be invoked even where there is no security, and even where the transaction in question takes place outside the jurisdiction, so long as the transaction has a prejudicial impact on Ontario security holders.

 

12) Derivative Securities

Derivative securities usually consist of some combination of options and futures contracts. An option contract is a contract that gives the holder a right to buy or to sell an underlying asset or interest

that typically can be exercised either on or before a certain future date. E.g. a "put" option allows the holder to insist that another person purchase the

optioned securities from the holder at a certain price (the "strike" or "exercise" price) on or before a certain date.

Another commonly used option is a "right," which gives the holder the option of purchasing the securities of a particular corporation (directly from that corporation) on or before a certain date.

A futures contract obligates one party to the contract to sell and the other party to buy a stated quantity of a good on a future date for a stated price.

The name "derivative" security originates from the fact that the value of the instrument is derivative of the value of something else, which is generally called the "underlying interest."

E.g. in the case of a silver futures contract, the underlying interest is silver. The value of the futures contract at any point in time depends on the price of silver when the time comes for delivery. Those who trade in silver futures contracts make forecasts of the future price of silver and adjust what they are willing to pay for the futures contract accordingly.

Some derivative instruments are clearly securities within the meaning of the securities legislation – put options and rights are both instruments commonly known as securities (s. 1(1)(a)); a right also confers an option to purchase other securities, which again qualifies it as a security under the OSA (s. 1(1)(d)); a call option is also clearly a security (s. 1(1)(a, d)).

Put and call options constitute "exchange traded" derivative securities – typically traded over the Canadian Derivatives Clearing Corporation and are subject to regulation by both the securities regulators (ss. 76, 134) and the exchange over which they trade (no controversy b/c clearly securities and those who buy and sell them are unsophisticated retail traders)

Controversy – "over-the-counter" (OTC) derivative securities – privately negotiated contracts that are typically entered into between sophisticated parties such as financial institutions (banks, trust companies, insurance companies, pension funds, and mutual funds), securities dealers, large corporations, utilities, and governments (although for the sake of convenience, the International Swaps and Derivatives Association (ISDA) has formulated standardized documentation for trades in OTC derivatives, the terms of OTC derivative transactions remain subject to individual negotiation).

Derivative contracts are most frequently entered into to hedge risk. E.g. a corporation situated in Canada, but selling most of its product in the U.S.,

is subject to exchange rate risk. If all its sales contracts require payment in U.S. dollars, the value of these contracts falls if the U.S. dollar falls relative to the Canadian dollar. The company may wish to hedge this risk by buying derivative products whose underlying interest is the value of the Canadian dollar vis-a-vis the U.S. dollar, so that if the value of the U.S. dollar falls relative to the Canadian dollar, the value of the derivatives contract rises.

A swap contract is the most common form of OTC derivative (but questions about whether such interests constitute securities) – e.g. (in practice, swaps are commonly entered into with financial intermediaries, rather than between two end-users) Company A has outstanding debt obligations with fixed interest payments. Company B has outstanding debt obligations with interest payments that float with the prime rate. Each contractually "swaps" its interest obligation with the other. Under this arrangement, each company will continue to pay the interest due on its own debt obligations; however, each is obliged to pay to the other any difference between its own interest obligation and the other's.

E.g. company A and company B are both obliged to pay their creditors $1,000 in interest per period when they enter the swap. Interest rates then fall such that in the next period, company B must pay its creditors only $500 in interest while company A, with fixed interest payments, remains obliged to pay $1,000. Company A pays its own creditors the $1,000 that it owes them, but is contractually entitled to collect $500 from company B. This is because, in the swap, company A agreed that it would notionally pay company B's creditors, and company B agreed that it would notionally pay company A's creditors. In each period, a "netting" or settling-up occurs between the two companies that puts each company in the same position it would have been in had the two companies actually paid the interest on each other's debt.

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Is there a security in this transaction? When the definition was formulated, few derivatives existed, and many derivatives, such as swaps, were unknown.

Policy of the statute - the protection of investors – often impossible to determine who is the vendor of the "security," and who is the "investor," in order to determine who needs the protection of the OSA. As noted above, the parties to a swap arrangement are typically financial institutions, corporations, and governments. All of these are sophisticated parties that generally do not require the protections furnished by securities legislation.

OSC proposals for regulating OTC derivatives – seek to regulate transactions in derivatives on the basis of whether the parties to such transactions are in fact sophisticated traders capable of protecting their own interests or whether parties are in need of protection (e.g. where both parties to the transaction are "qualified parties," neither the prospectus, registration requirements, nor any other part of the legislation apply under the draft proposal) – reflect a purposive approach to securities regulation (begin with the purpose of securities regulation - the protection of investors - and attempt to construct a regulatory structure that serves that overriding purpose).  But the proposal does not clearly resolve the issue of whether derivative instruments, such as swaps, are securities. The introduction to the proposal notes that amendments made to the OSA in 1994 (which gave the OSC the power to make rules) conferred upon the OSC the power to make rules: Regulating or varying this Act in respect of derivatives, including,

i. providing exemptions from any requirement of this Act ii. prescribing disclosure requirements and requiring or prohibiting the use of

particular forms or types of offering documents or other documents iii. prescribing requirements that apply to mutual funds, non-redeemable

investment funds, commodity pools or other issuers (s. 146(1)35) The OSC’s proposal suggests: “The passing of [the above provision] permits the Commission to implement

a regulatory regime for OTC derivatives that it considers appropriate, without regard for artificial distinctions as to whether particular derivatives transactions constitute trades in securities”

The provision in question is drafted very broadly and appears to give the OSC carte blanche in regulating instruments that may be regarded "derivatives." The drafting is defective in at least two ways, however. First, the OSA does not define "derivatives." It is left to the OSC to determine what it shall regulate as derivative instruments. This cedes an overly broad discretion to the OSC. Second, and perhaps more serious, as noted earlier in this chapter, all the key provisions in the legislation apply only to instruments that are "securities." Thus, the application of existing securities law requirements to derivatives is left in doubt. Given the ever-increasing importance of derivative transactions to the economy, this uncertainty should be clarified by further legislative amendment.

 

Stage 2 – is it a Trade? – Page 211 If there is a trade, the trader typically has to be registered (OSA s.25) A trade has five main components (from definition in OSA section 1(1)):

o (a) Sale for valuable consideration: Issues: why ‘sale’ is included and not ‘purchase’ (what does this mean for

takeover bids?), and why there must be valuable consideration (what about gifts or corporations that issue stock dividends)?

Starting assumption is that there is an asymmetry of information between buyer and seller. Protecting investors means regulating sellers.

What about insider trading? What if you purchased securities based on insider information? Insider trading rules (see section 76) govern these.

Important to note that using a security as collateral for a debt is not a trade.o (b, c) Trades by professionals: consistent with policy objective of controlling access

to the activity of professional trading.o (d) Trades by Control Persons (for the purposes of giving collateral for a debt made

in good faith – note how this doesn’t apply to non-control holders) Note that pledging by non-control holders is specifically excluded based on

the assumption that control persons have superior access to information Control persons are defined under ‘distribution’

o (e) Acts in Furtherance of a Sale: greatly extends the scope of the definition of ‘trade’: includes providing a list of names of prospective securities purchasers, or advertising an IPO. Regulation of pre-sale activities helps regulate the markets.

Jurisdictional Issues in relation to Trading deals with issues of whether solicitations of all kinds, including via the Internet, fall under the definition of trades.

o There are some exceptions to the definition applying when the Internet site makes clear a disclaimer that the local jurisdiction of the investor is not involved in regulation of the trader. These disclaimers are contentious.

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Step 3 – is there a Distribution? Once it is determined that there is a security and a trade, the next question is whether there is

a distribution (or ‘offering’ in BC).o A prospectus is necessary if shares are being distributed (OSA, s.53)

Section 1(1) of the OSA: “distribution”, where used in relation to trading in securities, means,o (a) Securities Not Previously Issued – a person or company offering a security for sale

that has not previously been offered for sale constitutes a distribution in Ontario o (b) Reissue of Securities – If the issuer reissues securities this is also a distribution.

Somewhat of a moot point in Ontario, since corporate law requires that a corporation that buys back shares cannot hold tem for resale and must cancel.

o (c) Sales of Securities by Control Persons – sales by control persons are considered distributions (even though securities have been previously issued by the issuer):

(1) a control person may control management and have better access to information than the average investor, (2) a large sale could alter the share price of the securities, and (3) the control person could be part of the success of the enterprise, and this change should be made known to all investors.

A control block of shares is an amount that enables the holder to ‘materially’ affect the enterprise, and does not have to be actual control.

A holding of more than 20% of the voting securities is deemed to represent a control block unless there is evidence to the contrary

Less than 20% can still be a control block if there is qualitative evidence that this controlling person affects materially the enterprise.

A control block holding does not need to sell its entire stake to trigger a distribution: they need only sell a portion of their holding.

o (d and e) are of historical interest, and not really relevant to our purposes.o (f) Resale of Securities – Awkward provision, where a resale is deemed a distribution

when the original issuance was under a prospectus exemption.

What is a Reporting Issuer? A reporting issuer is responsible for continuous disclosure after a security is issued to the

public. Section 1(1) of the OSA: “reporting issuer” means an issuer,o (a) Securities Issued Under a Predecessor Act – corporations that issued voting

securities prior to the current act coming into force and obtained a prospectus receipt o (b) Obtaining a Receipt for a Prospectus – the most common definition of a reporting

issuer. Note that it is only a requirement for a prospectus receipt to be given, not for the actual securities to be distributed.

A distribution is only allowed once the OSC issues a receipt.o (b.1) Exchange Takeover Bid: closes a loophole where a company would buy an

inactive company that was an RI to avoid being a reporting issuer itself.o (c) Listing on a Recognized Stock Exchange – note that only the TSX is recognized

by the OSC for the purposes of this definition. Famous example: Bre-X qualified as a reporting issuer in Ontario without

ever qualifying a prospectus in the province (loose standard)o (f) Regulatory Power to Deem Issuers to be Reporting Issuers – newly acquired OSC

discretionary power. Used to deem reporting issuers in other Canadian jurisdictions to be reporting

issuers in Ontario where Ontario residents access their securities (or when issuers’ securities trade on exchanges not recognized by (c) in the Ontario definition) even though the issuer has never issued a prospectus in Ontario.

“That the commissioner as deemed to be a reporting issuer under section 83.1

Key Concepts behind Securities RegulationEfficiency Often linked with cost-benefit analysis, it is efficient to engage in activities where the

benefits outweigh the costs. Many securities laws and policy (like disclosure) are justified by efficiency arguments. Efficiency is used to justify reduced government interference and also strict disclosure requirements.

o Efficient Market Theory (EMT) explains why it is difficult to beat the market. Relevant new information is inherently unpredictable (otherwise it wouldn’t be new), therefore stock prices fluctuate randomly (though not arbitrarily) based on the information (which is absorbed into the stock price almost instantaneously).

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o Behavioural finance theorists and even EMT theorists have recently begun to challenge some of the presumptions of EMT.

o Modern financial theorists referring to EMT, they generally have in informational efficiency

Materiality Sets the threshold that distinguishes information that is legally disclosable from that which

isn’t. If information is material, it must be disclosed. The current statutory standard for materiality in Canada is the ‘market impact’ test – that is, information that should be disclosed is information that would affect the “price of value” of the issuer’s securities, while in the US it is what the ‘reasonable investor’ would consider relevant in making an investment decision.

Value Commonly the price at which a security is trading is not the same as its ‘value’. Financial

experts use several techniques to value shares:o Dividends: the value of shares of common stock is best thought of as a function of the

dividends that the corporation can be expected to pay out over its life. o Earnings: To the extent that earnings are retained and invested by the company, the

value of the firm’s assets and earnings and capacity to pay dividends should increase.

WHAT IS A TRADE?

Securities law is primarily transaction based i.e. it focuses on specific commercial transactions (the most fundamental being a “trade” in sec

Section 1(1) “trade”: (a) any sale or disposition of a sec for valuable consideration, whether the terms

of payment be on margin, installment or otherwise, but does not include a purchase of a sec or, except as provided in clause (d), a transfer, pledge or encumbrance of sec for the purpose of giving collateral for a debt made in good faith,

(b) any participation as a trader in any transaction in a sec through the facilities of any stock exchange or quotation and trade reporting system,

(c) any receipt by a registrant of an order to buy or sell a sec, (d) any transfer, pledge or encumbrancing of sec of an issuer from the holdings

of any person or company or combination of persons or companies described in clause (c) of the definition of “distribution” for the purpose of giving collateral for a debt made in good faith, and

(e) any act, advertisement, solicitation, conduct or negotiation directly or indirectly in furtherance of any of the foregoing

 

(a) “Any Sale or Disposition for Valuable Consideration”

Definition is not exhaustive (“includes”) Indicates that the OSA regulates sellers of sec, not purchasers Exempts gifts or other gratuitous dispositions – this is b/c of the investor protection rationale of the

legislation (if the sec are given rather than sold, there is little or no danger that the donor will take advantage of the donee)

“Valuable consideration” can take many forms therefore an issue or transfer of sec could constitute a trade even in cases where the recipient does not appear to be paying for the sec at the time of the transaction

 

(a and d) Definition of Trade Excludes Most Share Pledges

Sec such as shares are assets that can be used by owners as collateral for debt obligations – a common method of granting a security interest in a share or other corporate sec is a pledge

A pledge involves the transfer of the sec to the lender and when the loan is repaid the sec are returned to the borrower.  If the loan is not repaid, the lender is entitled to realize on its security

The OSA did not want to restrict the ability of sec holders to use the equity in their sec as loan collateral therefore pledges are excluded from the definition of a trade (s. 1(1) “trade” (a))

2 exceptions:

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1. The debt owed by the borrower to the lender must have been incurred “in good faith” i.e. people cannot attempt to avoid the application of the OSA by disguising a sale transaction as a secured-lending transaction

2. A pledge constitutes a trade if the grantor is a control person (s. 1(1) “trade” (d))

“Control person” is not defined in the Act “Control person distribution” (Rule 14-501) “Control person” (s. 1(1) “distribution” (c)) Generally speaking – holder of a significant block of voting shares of

an issuer The OSA treats control persons as though they were

the issuers of the sec b/c it is assumed generally that the people who control corporations or who have the power to materially influence control have special access to corporate information that is not available to smaller, public investors

OSA is not intended to make it impossible or unduly burdensome for control persons to pledge or otherwise encumber their sec but they are kept within the definition of trade to ensure that they are subject to the Act’s rules governing the use of material non-disclosed information

 

(b and c) Participation as a Trader: Receipt of an Order by a Registrant

Trading includes more than simply selling sec: (b) any participation as a trader in any transaction in a sec through the facilities

of any stock exchange or quotation and trade reporting system (c) any receipt by a registrant of an order to buy or sell a sec

“Registrant” – sec market professional who must register with the sec regulators before they may ply their trade (generally only play a facilitative role in consummating a purchase or sale of sec)

A registrant’s activities are defined as trades b/c of the policy rationale of the legislation – in order to adequately protect buyers of sec, it is insufficient to regulate only the actual sellers – market professionals who advise sellers participate in negotiating and structuring the terms of the sale and the activities of professional traders can have a critical impact on the functioning of the capital markets – protection of buyers, and of the markets generally, requires that market professionals be regulated

 

(e) Acts in Furtherance of a Trade

Most important part of the definition – (e) any act, advertisement, solicitation, conduct or negotiation directly or indirectly in furtherance of any of the other activities constituting a trade

Soliciting a purchase prior to an actual sale is a trade (ss. 25(1)(c), 65(2), 68) e.g. as soon as a prospective seller phones another person with a view to selling sec, the prospective seller engages in trading, whether or not the phone call results in a sale

Policy rationale of the legislation – the legislation is not merely reactive but it also allows the regulators to step in to prevent harm before it occurs

 

Trades That Are Not Distributions

The regulation of primary market activity attaches only to a trade that constitutes a distribution of sec but a trade that is not a distribution is still subject to regulation – any person engaged in trading must register with the sec regulators, either as a dealer or an advisor unless an exemption from registration applies

Registration requirements ensure that professionals engaged in sec market activities attain minimum standards of integrity, competence, and financial soundness

WHAT IS A DISTRIBUTION?

Section 1(1) “distribution: (a) a trade in sec of an issuer that have not been previously issued, (b) a trade by or on behalf of an issuer in previously issued sec of that issuer that

have been redeemed or purchased by or donated to that issuer,

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(c) a trade in previously issued sec of an issuer from the holdings of any person, company or combination of persons or companies holding a sufficient number of any sec of that issuer to affect materially the control of that issuer, but any holding of any person, company or combination of persons or companies holding more than 20% of the outstanding voting sec of an issuer shall, in the absence of evidence to the contrary, be deemed to affect materially the control of that issuer,

(d) a trade, by or on behalf of an underwriter in sec which were acquired by that underwriter, acting as underwriter, prior to the 15th day of September, 1979 if those sec continued on that date to be owned by or for that underwriter, so acting,

(e) a trade by or on behalf of an underwriter in sec which were acquired by that underwriter, acting as underwriter, within 18 months after the 15th day of September, 1979 if the trade took place during that 18 months, and

(f) any trade that is a distribution under the regulations, and on and after the 15th day of March 1981, includes a distribution as referred

to in ss. 72(4,5,6,7) and also includes any transaction or series of transactions involving a purchase and sale or a repurchase and resale in the course of or incidental to a distribution

Policy of OSA underlies the meaning of distribution – protecting members of the investing public by ensuring that buyers receive full disclosure of all material facts relating to a given sec before purchasing that sec

Distributions are trades in sec in which the information asymmetry b/w buyer and seller is likely to be at its greatest, with buyers having the greatest risk of being taken advantage of

If a trade is a distribution, the issuer is required to assemble, publicly file and distribute to all buyers a prospectus (s. 53)

A prospectus is highly detailed and expensive to prepare and its purpose is to ensure that those who are asked to contribute capital to the corporation have sufficient information with which to make an informed investment decision

 

“Distribution” Includes Trades Effected in 3 Circumstances:

1. (a and b) Trades by Issuers

Any sale by an issuer is a distribution to which the prospectus requirement applies (ss. 1(1), 53) b/c issuers almost always have better information about the true value of the sec they sell than do the buyers

 

2. (c) Trades by Control Persons

Anyone who holds a sufficient number of sec to “affect materially the control of that issuer” (i.e. a control person) is assumed potentially to have privileged access to information concerning the issuer of the sec

Therefore a sale by a control person is deemed to be a distribution to which the prospectus requirement attaches

Who is in a position to materially affect the control of the issuer? Does not require legal/de jure control – when a person or group of persons

acting together hold or exercise voting control over shares entitled to elect a majority of directors (i.e. 50.1% of shares of a corporation)

Does not require practical/de facto control – may arise with holdings of less than 50% of the shares b/c an ordinary resolution is one that is passed by the majority of the shareholders who actually vote rather than all shareholders (CBCA s. 2(1) “ordinary resolution”) – not all shareholders exercise their right to vote and therefore a shareholder/group of shareholders can be confident of securing the passage of an ordinary resolution (and therefore elect all the directors) by holding shares with only 15-20% of the total votes (the number of shares required for any single blockholder to attain practical control will therefore depend on how many shareholders typically vote as well as whether there are any other shareholders holding large share positions who might use their votes in opposition to that blockholder)

One might materially affect the control of an issuer without being able to exercise either legal or practical control – a blockholder with 5% of the common shares but lacking legal or practical control may have sufficient power to exert influence over management on important issues

There are exemptions from the prospectus requirement for certain control-block distributions

 

3. Sales of Restricted Sec Held by Exempt Purchasers

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Preventing a “backdoor underwriting” Regulating primary market issuances of sec requires protection against the

danger of a backdoor underwriting through the use of a prospectus exemption The “closed system”

In a closed system any trade in sec that qualifies as a distribution requires a prospectus

The system is closed b/c there are a limited number of ways of escaping the prospectus requirement

The OSA and related rules prescribe specific exemptions from the prospectus requirement and issuances of sec under these exemptions are “exempt market transactions” and the buyers of these sec are “exempt purchasers” (exempt purchasers only where the protection afforded by a prospectus is not needed e.g. when the buyer is sufficiently sophisticated to be able to protect her own interests when buying sec)

Exempt purchasers are subject to the prospectus requirement when they seek to resell the sec to others unless (1) they are selling to another exempt purchaser or (2) they hold the sec for a statutorily defined length of time (the restricted or hold period) before attempting to resell

What is a reporting issuer?

Only reporting issuers are subject to the OSA’s continuous disclosure rules Section 1(1) “reporting issuer” means an issuer:

(a) that has issued voting sec on or after the 1st day of May, 1967 in respect of which a prospectus was filed and a receipt therefore obtained under a predecessor of this Act or in respect of which a sec exchange take-over bid circular was filed under a predecessor of this Act,

(b) that has filed a prospectus and has obtained a receipt for it under this Act, (b.1) that has filed a sec exchange take-over bid circular under this Act before

December 14, 1999, (c) any of whose sec have been at any time since the 15th day of September,

1979 listed and posted for trading on any stock exchange in ON recognized by the Commission, regardless of when such listing and posting for trading commenced,

(d) to which the BCA applies and which, for the purposes of that Act, is offering its sec to the public,

(e) that is the company whose existence continues following the exchange of sec of a company by or for the account of such company with another company or the holders of the sec of that other company in connection with,

(i) a statutory amalgamation or arrangement, or (ii) a statutory procedure under which one company takes title to the

assets of the other company that in turn loses its existence by operation of law, or under which the existing companies merge into a new company,

where one of the amalgamating or merged companies or the continuing company has been a reporting issuer for at least 12 months, or

(f) that the Commission has deemed to be a reporting issuer under s. 83.1 The most common way in which an issuer of sec becomes a reporting issuer is through (b) the filing of a

prospectus and obtaining of a receipt for it Once an issuer is a reporting issuer, it is subject to all of the periodic and timely disclosure obligations until

the issuer applies to the OSC and is granted an order deeming that it has “ceased to be a reporting issuer” (s. 83) but if the reporting issuer has 15 or more sec holders the order must not be prejudicial to the public interest

The concept of the “reporting issuer” is fundamental to a “closed system” – those issuers that choose to access ON’s public markets oblige themselves to ensure that current information about their businesses is readily available to the investing public (so that investors buying or selling sec of such issuers in the secondary markets are better able to make informed trading decisions); also the fact that a body of information about issuers exists, and is regularly updated, facilitates the development of more streamlined procedures for additional public financings such as the short form, shelf, and PREP procedures

Section 83.1 Provides the OSC with the authority to deem an issuer to be a reporting issuer

where it would not be prejudicial to the public interest to do so

Ensures that companies with publicly traded shares (especially companies that have completed public offerings in other Canadian jurisdictions) may acquire the benefits and be subject to the obligations of reporting issuers in ON

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The Prospectus

The Prospectus Definition: a detailed circular setting out information underpinning the issuer’s distribution of

the securities to the public.o Section 53 of the OSA requires a prospectus filing (both preliminary and full) with the

OSC before distribution of a security. Prospectus is required for an IPO, a primary offering, and a secondary offering by a control block holder.

o Goal for rules for the prospectus: (1) investor protection (2) capital market efficiency (3) enhance public confidence in capital markets

Fundamental Aspects:o Issuer must prepare a preliminary and final prospectus.

Content of prospectus include- business forecast, financial statements most recent three years, description of factors that could make the security risky –

Overriding principle – is that there be full, true, and plain disclosure of all material facts OSA s. 56(1)

o Regulatory oversight of the processo Right of withdrawal and rescission for investorso Statutory liability for misrepresentation and omissions, or failure to deliver a

prospects

Underwriting an Offering – Page 235 Section 1(1) Definition: “underwriter” means a person or company who, as principal, agrees

to purchase securities with a view to distribution or who, as agent, offers for sale or sells securities in connection with a distribution and includes a person or company who has a direct or indirect participation in any such distribution, but does not include (certain exceptions)… Most underwriters are investment banking firms

o Note that there is no requirement to use an underwriter (Google) Roles of Underwriters:

o Underwriters offer credibility to issuers, bolstering their claims to future profits. o Underwriters usually set the price and terms of the offeringo Underwriters give governance advice, etc.o Underwriters have public obligations to make sure the integrity of the market is

maintained (‘gatekeepers’)o Underwriters must sign the prospectus of the issuer that to the best of their

knowledge, information, and belief, the prospectus constitutes full, true, and plain disclosure of all material facts – OSA s.59(1)

Slightly different than the issuer’s certificate, in that the standard is higher for issuers than underwriters (due to better access to the information).

Types of underwriter agreements:o Direct Offering: no underwriter used, issuer goes directly to the market (ie Google)o Agency: underwriter agree to use its ‘best efforts’ to sell the securities as agent of the

issuer. The underwriter takes a commission on the sale (up to 7% of offering price). Risk-free arrangement for underwriter, but less commissions usually.

o Firm Commitment: underwriter agrees to purchase all securities and resell them. Profit between issue price and sale price is also known as the underwriter’s ‘spread’.

Usually there will be a group of underwriters, and different investment bankers will jockey to be the lead underwriter.

Firm commitments affect remedies, since investor is not buying from issuer directly (Kerr v. Danier). However rescission against underwriter still possible under 130(1)(e)

Even with a ‘firm commitment’, underwriting agreement usually contains: A Market-out clause underwriter can terminate the agreement if it

determines (reasonably) that securities cannot be marketed profitably. A Disaster-out clause underwriter can terminate the agreement if a

significant event affects the issuer’s business or the capital markets. The prevalence and wording of these agreements depend on how ‘hot’

the markets are (if hot, likely there won’t be a market-out clause)o Bought Deal (more intense version of a firm commitment, due to timing): used when

a short form prospectus is contemplated, the underwriter makes a firm commitment to purchase a large block of securities within 2 days before the preliminary prospectus is

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filed at the securities commission, accompanied with a media release announcing the transaction. The underwriter then has two days to solicit expression of interest prior to filing the preliminary prospectus (NI 44-101)

Used to facilitate securities distribution and canvas potential purchasers. Conflicts of Interest in Underwriting – Page 240

Classic conflicts: In Toronto, all big investment banking firms are subsidiaries of banks: issuer may engage IB to raise money to pay down a bank loan; When shareholder is a shareholder of the issuer and the underwriter.

National instrument addressing conflicts in underwriting: (31-105CP to NI 33-105)o Policy instrument sets out three levels of conflict (from highest to lowest) 2.1(2)

The Underwriter as issuer or selling securityholder: prohibits the underwriter from acting for the issuer or security holder in this case.

Related issuer (cross-ownership): either the issuer or selling securityholder and the underwriter is an ‘influential securityholder’ of the other: underwriter can’t act as the direct underwriter for the issuer.

Connected issuer – issuer or selling securityholder has relationship with registrant (underwriter) which casts doubt on independence of transaction.

o 2.1(3) provides exceptions to the strict requirements in 2.1(2).

Case Name Year Court HoldingYBM Magnex 2003 OSC Role of underwriter for disclosure and certification (less

onus than issuer): Underwriters’ certificate under s.59(1) of the OSA must certify that ‘the prospectus contains ‘full, true, and plain disclosure of all material facts’, but only ‘to the best of our knowledge, information, and belief’. Underwriters can’t accept issuer statements as true: they must probe, question, verify (adversarial)

Kerr v. Danier 2001 ON GD

Effect of bought deal on 130 damages: A bought deal means that the purchaser has no remedy of rescission against the issuer for misrepresentations, although a claim for damages is allowed

Retrieve Resources v. Canaccord Capital and CLD Financial

1994 BCSC Considered the market out clause and whether an underwriter can terminate its agency agreement using a market-out clause: that the agreement can be determined due to the ‘the state of the financial markets’ applies specifically to the market in the specific shares to be placed

The Prospectus Process (note sanctions under 127 for failure to comply with this process)

Period Activities of the Period

Documents Included

Contents of Documents

Notes

Pre-Filing Period

Secure services of underwriter, gather documents needed for prospectus, develop PP, file PP, obtain receipt from Regulator

Preliminary Prospectus (PP)

Assumed by regulator that documents are near completion (except security price, class): resolution of board authorizing filing, UW agreement, financial statements, certification note by officers, caution that PP is not final

Regulator can refuse to issue a receipt if not in the public interest (unconscionable) (OSA s.61(2)) (rarely used) (Tricorp) Due process protection for issuer 61(4)

Regulator can prohibit PP distribution if there is a PP defect (OSA s.68)

Waiting Period (time between PP receipt and FP receipt)

Once receipt is issued for PP, issuer can get interest from investors (not before). Also revisions to PP occur.

Waiting period minimum 10 days for long form prospectus (OSA 65(1)). Distribution of PP can be solicited or unsolicited, but advertising can only alert to availability of PP (re Cambior)

Filing of Final Prospects

Filing of final prospectus and issuance of a

Final Prospectus (FP)

Business Plan, Financial Statements of last 3 years

No shares can be distributed to public unless final prosp filed and receipt – OSA s. 65

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receipt (balance sheet, cash flow, income) (OSC 41-501), Capital Structure, Estimated proceeds of dist., purpose for capital, underwriter agreement, List of factors making security risky

Overriding Principle: Certification required by CEO, CFO, and 2 directors that prospectus contains full, true, and plain disclosure of all material facts.

Note Lapse Date: distribution can’t continue 12 months after FP receipt (OSA 62) – but according to s. 62(2) a pro forma prospectus must be filed not less than 30 days prior to the lapse date + a prospectus is filed not later than ten dats following the lapse date of previous prospectus + a receipt for the prospectus is obtained from the director within twenty days following the lapse date of previous prospectus

Pre-Closing Stage

Commercial copies of FP are delivered to investors

Investors cannot actually buy securities until after receipt for FP is received – OSA 53(1)

Cooling-off Period

Investors have 2 days to opt out of promise to buy after delivery of FP or amended FP – OSA 71 –[2]

Deals with interaction with Material Change reporting (s.57)

See Cooling off Period Examples below.

Post-Closing Stage

Distribution of securities (note receipt from regulator for FP needed)

Underwriters advise issuers that securities are ‘out of distribution’

Cooling Off Period ExamplesExample 1 Example 2 Example 3

Day 1: final prospectus receivedDay 2: agreement to buyDay 5: prospectus amendment filedDay 6: investor wants out. Can they?No, they made a binding agreement, and the cooling off period ended on day 3. Investor wouldn’t receive amendment that would trigger a new cooling off period.

Day 1: agree to buyDay 4: receive final prospectusDay 5: prospectus amendment filedDay 8: amendment deliveredDay 9: want out. Can they?You are entitled to get an amendment if it is filed during your cooling off period, and receipt on Day 8 triggers a new cooling off period (otherwise there wouldn’t be full information for the purchaser)

Day 1: receive prospectusDay 4: agree to buyDay 5: prospectus amendment filed. Entitled to receive?No. If you are beyond your cooling off period when you agree to buy, the cooling off period does not run.

Contents of a Prospectus

OSA Section 56(1) 2-part test for creating a prospectus: “A prospectus shall provide full, true and plain

disclosure of all material facts relating to the securities issued or proposed to be distributed and shall comply with the requirements of Ontario securities law” (see OSC rule 41-501)

o Failure to comply with section 56, the OSC Rule, or section 57 can lead to sanction under section 130 of the OSA (see YBM Magnex - YBM should have disclosed the material fact that it was being investigated by the FBI for money laundering)

OSC Rule 41-501 ‘General Prospectus Requirements’ In the consolidation, this rule covers 80 pages and contains 33 separate items (onerous).

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Contents of a Prospectus: there is a huge amount of time and detail that goes into producing a prospectus (often 100+ pages). Types of things to be disclosed:

o Description of offering (characteristics of securities offered for sale) (items 10 & 19)o Financial Statements (Part IV of the Rule). Three years of historical financial

statements must be provided, as well as interim financial statements (4.6) for the most recently completed interim statement (released more than 60 days before the prospectus release). Kinds of financial statements (4.1):

Assets and Liabilities (balance sheet); Cash flow statements; Income Statements (provides richest detail about revenues, expenses, and net income).

http://www.osc.gov.on.ca/Regulation/Rulemaking/Current/Other/ rule_20001215_general.pdf

[Not more than 90days before the date of the prospectus] Description of business and business history (3 year history) (items 5 & 6) Includes market trends, significant acquisitions, etc. Note that material

information could also have an impact on the market (very qualitative) Section 6 is a narrative of main business events, milestones, principle products

and services, markets, etc. Rule 41-501 (14.1) – final receipt must be gotten within 90 days of your

preliminary prospectus OSC, solve the problem of stale financial statements

o In a prospectus, the issuer must disclose risk factors (Item 20). Risk can be an internal business risk, but can also relate to the general

economy, the political environment, etc. Sub 2 of item 20 requires the issuers to disclose any risk to the security holder for the issuer’s liability (remember unit holders in a trust have a different exposure to risk than shareholders).

Shows a tension between disclosure of risk to meet legal requirements and also the motivation to use the prospectus as a sales tool for investors.

o Principle shareholders must also be disclosed (Item 15) Contentious issue, and many investors complain about inflated compensation.

o Executive compensation disclosure (Item 17).

Material Fact As noted above, the requirement for full, true, and plain disclosure of all material facts is an

essential requirement of the prospectus process Section 1(1) defines a ‘material fact’ as a fact that would reasonably be expected to have a

significant effect on the market price or value of the securities.o This definition is quite forward-looking. Other provinces have definitions that are

both retrospective and forward-looking.o Includes Internal and External facts that impact an issuer.

In Canada, the materiality of a fact or change is based on a market impact test while in the US the risk factors must be material to reasonable investors (which has been adopted in section 20.1 OSC Rule 41-501)

o The Ontario Ministry of Finance 5-year committee recommended adopting the US reasonable investor test in the interests of harmonization, while acknowledging that the test may have different effects on disclosure (possibly making it more subjective and possibly less inclusive to overall market conditions)

Material Change Material change is defined in section 1(1) of the OSA:

o (i) a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer, or (ii) a decision to implement a change referred to in subclause (i) made by the board of directors or other persons acting in a similar capacity or by senior management …

New National Instrument: harmonization of what a material change means across Canada with the introduction of NI 51-102 (definition essentially the same as in Ontario)

Section 57 describes an issuer’s reporting obligations if a material change occurs during the waiting or distribution period:

o Subject to subsection (2), where a material adverse change occurs after a receipt is obtained for a preliminary prospectus filed in accordance with subsection 53 (1) and before the receipt for the prospectus is obtained or, where a material change occurs after the receipt for the prospectus is obtained but prior to the completion of the

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distribution under such prospectus, an amendment to such preliminary prospectus or prospectus, as the case may be, shall be filed as soon as practicable and in any event within ten days after the change occurs. 

o (2) Where an amendment to a prospectus is filed under subsection (1) additional distribution shall not be proceeded for a period of ten days after the amendment is filed or, if the Commission objects to the further distribution, until such time as a receipt for the amended prospectus is obtained from the Director. 

o (3) An amendment to a preliminary prospectus shall be forwarded to each recipient of the preliminary prospectus according to the record maintained under section 67. 

If a material change occurs, section 75 of the OSA requires the issuer to issue a news release and also to file with the Commission a report of the change

Key Difference between material fact and material change: (from Pezim v. BC, 1994 SCC): Material fact includes all risk (including external) that could reasonably be expected to

significantly affect the security’s value, while a material change only deals with changes in the “business, operation, assets, or ownership of the issuer”

o In Kerr v. Danier: the obligation too revise the prospectus only extends to material changes, not material facts.

The courts have distinguished between material facts and material change in terms of statutory reporting obligations – Pezim, Iacobucci stated that material fact is much broader than material change – remember, prospectus must disclose all material facts, but is only require to amend prospectus where there is material change

Future-Oriented Financial Information – Page 275 One aspect of disclosure in a prospectus is forecasting future revenues and profits. If the

information is positive, this can induce more sales. There is considerable risk in forecasting if the information turns out to be inaccurate. For many years, regulators prohibited any future forecasts in a prospectus. Now, NP 48 gives guidance to issuers about including FOFI.

NP 48 (Information to be included in a FOFI) – there is a proposed rescission of NP 48, and to consolidate all forward looking information

into NI 51-102 Defines forecast : FOFI reflecting a company’s judgment based on the most probable set of

economic conditions applicable to the forecast.o Clearly, this judgment could be wrong. Issuers need to have rock solid evidence to

support their forecasts – usually accompanied with auditors reports Forecast should include a cautionary note that actual results may vary widely from forecast Information cannot forecast into the future more than 2 years. A business must be in operation for more than 2 years to issue a forecast. A business with

less than 2 years of history can only make projections (similar to forecast, but with a hypothesis about plausible circumstances rather than most probable economic conditions).

o In limited circumstances, a business more than 2 years old can apply to the OSC to make a projection instead of a forecast.

Forecasts must be material to the circumstances of the issuer: it is material if its omission or inclusion would probably change an investment decision.

Section 7.1(1) of NP 48 requires an issuer to update FOFI if there is a change in the events or assumptions used to prepare FOFI that has a material effect on such FOFI

NP 48 requires the issuer to compare the FOFI with the actual results as they come due Currently there is a proposal to rescind NP48 and replace with an amended NI 51-102

o Streamlining regulation that will simplify and clarify our expectations for issuers who prepare forward-looking information

o Will also include earnings guidance procedure for FOFI

Sanctions for Misrepresentation – see also Civil Liability Chapter below

Kerr v. Danier – Material Change Reporting and FOFI Facts : Issuer was making a public offering (IPO), but the sale was mostly a sale of the

founding shareholder’s shares, not shares from the company treasury. Issuer made a forecast in a prospectus. Timeline (1998):

o May 6 receipt obtained for final prospectuso May 16-19 Information assembled re: financial info for first half of Q4

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Information shows sales are seriously down, which deviated from forecasto May 20 Distribution closedo June 4 management revealed that it may have difficulty meeting the projected fourth

quarter results. Danier issues revised forecast and material change report. o June 27 Q4 ends, and major sales before the end of the quarter and substantially

meets its forecast. Investors still sued under section 130, based on a misrepresentation in a prospectus because

the material change was not disclosed. Issue : Having received results that showed a change in the forecasted 4th quarter results

before distribution closed, should the issuers have disclosed the information and updated the forecast (section 57) based on it being a material change? If it was not a material change, could the investors still sue for a misrepresentation under section 130?

Court Key Holdings Key DifferencesSuperior Court (2004)

Danier Management liable for statutory misrepresentation.

Under section 130, the issuer has a continuing obligation to disclose material facts until end of the distribution period.

The change in sales was not a material change (warm weather external to business)

A forecast is a fact A forecast is not an untrue statement of material fact if

the results are not achieved: a forecast is an untrue statement of material fact if the factual assertions implied are untrue. Factors: forecast not prepared using reasonable skill and care, management does not believe forecast, management’s belief in the forecast is unreasonable, or management is aware of facts that undermine forecast (italics were found to exist in this case)

Court of Appeal (2005)

Disclosure of material facts is only required up until the receipt for the final prospectus (section 57(1)), not end of distribution period.

Change in sales was a material fact, not a material change (since cause was external factor) (agrees with trial)

A forecast is a fact, since inferences can be drawn from it. Cautionary language in forecast does not negate the forecast’s status as a material fact (agrees with trial)

Unlike the trial decision, there is NOT an implied representation that management’s subjective belief that it would achieve its forecast is objectively reasonable.

Even if it is assumed that the forecast contained an implied representation of objective reasonableness, the trial judge failed to consider that (1) the forecast was ultimately achieved, and (2) should have deferred to the business judgement of the management

s. 56(1) and 57(1) constitute a complete code of prospectus disclosure, both for statutory compliance and for statutory civil liability.

While NP 48 may have required Danier to disclose that it would not meet its sales targets, this is not law and cannot be used by the investors to find liability.

CA disagreed that Ontario follows US jurisprudence making a forecast actionable if not reasonably based. (para 138)

CA admonished trial judge for failing to defer to the business judgement of management even if there was an implied representation of reasonableness (para 157 and 164)

Appeal a shift away from the trial judge’s interventionist approach to protect investors.

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Sanction for failure to deliver a Prospectus The requirement to deliver is found in s. 71(1): “A dealer not acting as agent of the purchaser

who receives an order or subscription for a security offered in a distribution to which subsection 53 (1) or section 62 is applicable shall, unless the dealer has previously done so, send by prepaid mail or deliver to the purchaser the latest prospectus and any amendment to the prospectus filed either before entering into an agreement of purchase and sale resulting from the order or subscription”

Penal sanction ; s. 122(1)(c): If you attempt to distribute securities without a prospectus or by incorrectly relying on an exemption you will be found to liable under s. 122 and you will be prevented from continuing to distribute the securities.

Administrative order for compliance s. 127(5): If the Commission is satisfied that Ontario securities law has not been complied with, an order that a release, report, preliminary prospectus, prospectus, return, financial statement, information circular, take-over bid circular, issuer bid circular, offering memorandum, proxy solicitation or any other document described in the order…[shall be made]

Civil sanction under OSA s 133: “A purchaser of a security to whom a prospectus was required to be sent or delivered but was not sent or delivered in compliance with subsection 71(1) or a security holder to whom a take-over bid and take-over bid circular or an issuer bid and an issuer bid circular, or any notice of change or variation to any such bid or circular, were required to be delivered but were not delivered in compliance with section 95 or section 98 has a right of action for rescission or damages against the dealer or offeror who failed to comply with the applicable requirement. 

o Jones and Deacon Hodgson (p. 339): Any contract that you entered into to purchase securities is void if there was failure to meet prospectus requirements.

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The Prospectus: Alternatives

Alternative Governing Instrument

Description Eligibility Contents

Short Form Prospectus (SFP)

NI 44-101 (all other rules that govern a prospectus also apply to SFP)

MRRS rules under NP 43-201 govern the review timelines.

Allows large, repeat issuers to make timely and cost-efficient public offerings. Due to recently-enhanced eligibility, long form prospectus will now only be used for IPOs

Issuer must be listed on TSX, TSX Venture or CNX; Debt securities must be rated by rating agency; SEDAR filing required, Issuer must be RI in at least one CDN jurisdiction. Quick review (3 days after issuance of receipt) under MRRS.

Initial and current AIF, SFP requirements on form 44-101F: distribution plan, intended market, use of proceeds, rights attaching to securities, include any CD filed during year (means misreps now actionable under 130). Summary Statement can also be filed that can be used to sell instead of a prospectus.

Shelf Prospectus

NI 44-102 A shelf prospectus allows an issuer to file a prospectus (an SFP) and then leave it ‘on the shelf’ for up to 25 months. Securities can be distributed at any time during that period.

Available to any issuer that qualifies for an SFP.

When it is time to distribute, only a [pricing] supplement, which updates info, is required.

Section 5.6 itemizes info that can be omitted from a base shelf prospectus (information about the securities, their price, information about the underwriter, etc). This info is provided when the security is issued.

Post-Receipt Pricing Prospectus (PREP)

NI 44-103 Main difference now between a PREP and an SFP is that the post-receipt period is much shorter (90 days on the shelf instead of 2 years). Also it is used for a specific transaction and a single type of security. To add, it can not be used for a rights offering

PREP is available to all issuers, not just those who qualify for an SFP

Basically same contents as an SFP.

MJDS Prospectus

NI 71-101 Enables prospectus offerings for distributions in CAN and US or distributions by US issuers in Canada where they comply with NI 71-101. Similar requirement characteristics to those of SFP and Shelf prospectus

Issuer must have a sufficient reporting history or be of a sufficient market size, etc based on the type of securities.

Major benefit to CDN issuers who want access to US capital markets (and vice versa). Facilitates the extension to Canadian investors in US issuers of take-over bids, issuer bids, etc.

Capital Pool Companies

OSC 41-601 and reqs for listing on exchange – CDNX Policy 2.4

special arrangement for companies that have no assets other than cash and have not commenced business activity

CPC will submit PP and FP, and after the distribution closes the CPC has 18 months to complete a qualifying transaction

Highly scrutinized by regulators due to increased risks. Popular by small mining companies needing funds for exploration.

Also note Part 7 of Rule 44-101 underwriters do not need an preliminary prospectus to solicit expressions of interest although, there needs to be disclosure of the expected price of the issuer etc.

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The Prospectus: Civil Liability

Civil Liability under Section 130 Section 130 allows investors to sue for a misrepresentation = misstatements and omissions

(failure to make full, true, and plain disclosure of material facts – OSA 1(1)) in a prospectuso Note that this is in addition to CL remedies (though reliance must be proved in CL)

A claim of misrepresentation to prove misstatement, reliance on that misstatement, and causation between the reliance and the damages suffered

130(1)  Where a prospectus, together with any amendment to the prospectus, contains a misrepresentation, a purchaser who purchases a security offered by the prospectus during the period of distribution or during distribution to the public has, without regard to whether the purchaser relied on the misrepresentation, a right of action for damages against,

Damages or Rescission (election in (e)) (can’t choose both)o (a) the issuer or a selling security holder on whose behalf the distribution is made;o (b) each underwriter of the securities who is required to sign the certificate required

by section 59; Damages only

o (c) every director of the issuer at the time the prospectus or the amendment to the prospectus was filed;

o (d) every person or company whose consent has been filed pursuant to a requirement of the regulations but only with respect to reports, opinions or statements that have been made by them; and (ie experts)

o (e) every person or company who signed the prospectus or the amendment to the prospectus other than the persons or companies included in clauses (a) to (d) (ie CFO)

Other statutory misrepresentation provisions: o For misrepresentation in an offering memoranda and takeover bid circulars (including

director’s circulars and issuer bid circulars)o For anyone in a ‘special relationship’ with a reporting issuer, who purchases or sells

securities of that issuer with knowledge of a material fact or material change that has not been generally disclosed, can be liable for misrepresentation

Plaintiff’s Onus The statutory test:

o Purchase of securities offered under the prospectuso Purchase made during the period of distributiono That there was a misrepresentation in the prospectus

Deemed reliance: Section 131(1) of the OSA does provide that purchasers have a remedy without regard to actual reliance on the representation.

o Like US CL position that inaccurate information is a fraud on the market

Limitations on Recovery Section 130(6) – (9) sets limits on how much can be recovered

o (6) Underwriters can only be liable for the portion that they underwroteo (7) If you can show other causes for depreciation in stock price other than

misrepresentation then this can lower the damages amount.o (8) Joint and several liabilityo (9) In no case shall the amount recoverable under this section exceed the price at

which the securities were offered to the public.  This means that opportunity costs cannot be claimed.

In Kerr v. Danier, trial court said that you don’t need to have sold your securities for a loss (ie crystallized loss) to be eligible to receive the damages.

o Court said that loss would be calculated on the date that the market totally absorbed the effect of the misrepresentation (which becomes very unpredictable)

o The US does not agree: in the US investors have to have sold the securities. Limitation periods are set out in section 138: Action cannot be commenced

o (a) in the case of an action for rescission, 180 days after the date of the transaction that gave rise to the cause of action; or

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o (b) in the case of damages, the earlier of, (i) 180 days after the plaintiff first had knowledge of the facts giving rise to the cause of action, (ii) three years after the date of the transaction that gave rise to the cause of action.

Statutory Defences Statutory defences are a key difference between CL actions for misrepresentation and

statutory actions. Defences balance investor protection with allowing good-faith transactions. On reasonableness : section 132: “In determining what constitutes reasonable investigation or

reasonable grounds for belief for the purposes of sections 130 and 131, the standard of reasonableness shall be that required of a prudent person in the circumstances of the particular case” (Mixed objective/subjective standard)

Name of Defence Section Description OnusPurchaser’s Knowledge of the Misrepresentation

OSA 130(2) Complete defence if purchaser had knowledge of the misrepresentation when the securities were purchased. Also available for OM and Takeover bid misrepresentations.

Defence

No Knowledge OSA 130(3)(a)

Defendant did not know about/consent to filing of prospectus. Note: Pleading ignorance is not very compelling (shows lack of attention to the business by the defendant)(also applies to takeover circulars (131(5)(a))

Defence

Withdrawal of Consent

OSA 130(3)(b)

Valid defence if the defendant withdraws consent previously given to the prospectus or takeover bid circular. Withdrawal must occur after the issue of a prospectus receipt and before a purchase of securities, must occur as soon as the defendant becomes aware of the misrepresentation, and the defendant must provide ‘reasonable general (ie public) notice’ of the withdrawal.

Defence

Reliance on Expert OSA 130(3)(c)

Defendant can avoid liability for an expert statement not made by them and no reasonable grounds to believe and did not believe it was wrong or that did not fairly represent report/opinion of expert (objective and subjective). Also available for takeover circulars.

Defence

Expert’s Defence OSA 130(3)(d)

Expert report was not represented fairly and properly by the issuer when it was included in the issuer’s prospectus. Expert can also rely on the withdrawal of consent defence, under the same conditions as a defendant.

Defence (Expert)

Due Diligence Defence – Experts

OSA 130(4) Conducted reasonable investigation to provide reasonable grounds for belief that no misrepresentation or did not believe there was a misrepresentation

Plaintiff – can show that defendant knew there was a misrep or had no reasonable grounds to believe there was not a misrep.- some would suggest that the onus should be on defendants as they have more evidence to draw upon

Due Diligence Defence – Non-experts (ie Directors – does

OSA 130(5), also s. 122 (quasi-

Conducted reasonable investigation to provide reasonable grounds for belief that no misrepresentation or did not believe

Plaintiff – can show that defendant knew

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not apply to issuer or underwriter)

criminal provisions)

there was a misrepresentation there was a misrep or had no reasonable grounds to believe there was not a misrep.

Case Law

Case Name

Year Court Holding

Escott v. BarChris

1968 U.S. Leading case on ‘reasonableness’ in the case of statutory defences. Note difference in US law: in US, onus of due diligence defence on defendant. Key Point: The court made a detailed individual-by-individual assessment to determine whether directors (insider and outside – outside lawyer held to higher standard) and officers exercised due diligence in a reasonable manner. Outside directors and underwriters need to attempt to verify data. The cause puts forward a tough objective standard, which is relaxed somewhat in YBM.

YBM Magnex

2003 OSC s.127 decision

One of the few Canadian cases to discuss what it takes to make a due diligence defence (though this falls under 127, not 130). OSC mixes an objective and subjective standard, but follows BarChris by considering the diligence of each director (inside, outside, and special committee), underwriter, and lawyer. Degree of conflict and experience considered.

Kerr v. Danier

2004 ON SC On the issue of due diligence, the court takes a deferential approach to the business judgment rule – linking business judgment to section 132 of the OSA (reasonableness)

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Continuous Disclosure: Periodic Disclosure

Continuous Disclosure Overview Once one issues securities in a distribution, and become a reporting issuer, there are

continuous disclosure obligations to the secondary market.o Definition of RI: has securities trading in the public domain through a previous

prospectus, merger, amalgamation, or arrangement, or when deemed so by a regulator (OSA section 83.1)

Two fundamental components of CD in Canada: o (1) Periodic disclosure of interim and annual financial statements and reports,

MD&A, AIF, Proxy circulars and o (2) Timely disclosure of material changes under OSA section 75

National Instruments and Multilateral Instruments for Reporting Issuer CD– Page 353 NI 51-102: General CD requirements across Canada.

o OSC Rule 51-801 implements NI 51-102 and indicates that certain statutory provisions do not apply too issuers complying with NI 51-102

NI 71-101: Multi-jurisdictional Disclosure System NI 51-101 and NI 53-101: Sector-specific CD requirements for Oil and Gas, and Mineral

Projects, respectively MI 55-103: Insider Reporting for Certain Derivative Transactions has CD requirements

Continuous Disclosure Obligations on Other Parties Insider reporting - OSA s.107

o There is a new System for Electronic Disclosure by Insiders (SEDI) Early Warning System (takeover context) - OSA s.101

o Comes into play in the case of a take-over. If you are planning on a take-over, you must give disclosure of security purchasing in advance.

Periodic Disclosure - Financial Statements: NI 51-102, Part 4 – Page 355 Each reporting issuer must prepare and file quarterly and annual financial statements. Statements include:

o Income statement, statement of retained earnings, cash flow statement, balance sheet Statements to be comparative to the previous year’s filings (s.4.1)

o Certification by board and officers (s.4.5)o Auditor committee review report (s.4.1(2) and s.4.3)

4.3 contains provisions for disclosure of the auditor’s review of annual statements (required) and also interim statements (optional – but if engaged ad then unable to complete or there were reservations, must be disclosed).

Goals: Enhancing investor confidence and reducing risk of auditor capture Filing Deadlines for Interim Statements (s.4.4) and Annual Statements (s.4.2)

o Venture vs. non-venture issuers (more time if you are a venture issuer) A venture issuer is one that does not have securities listed or quotes on the

TSX, a US market, or an international market.o For interim statements, non-venture issuer, they must be filed within 45 days before

end of quartero For annual financial statements, they must be filed within 90 days of the year end

Delivery requirements (51-102 s.4.6) o We are moving to an access equals delivery rule: now, issuers must only send a form

to shareholders enabling them to request a copy if desired. Continuous Disclosure for SEC Issuers (s.4.3(4))

o Reconciliation requirements for converting between US and Canadian GAAP Change of Auditor (s.4.11)

o If a reporting issuer changes auditors for any one of several reasons, the issuer must disclose this change, including the previous auditor’s reviews in certain cases.

A reporting issuer can apply for an exemption if it is not in the public interest to grant it

Management Discussion and Analysis (MD&A) - NI 51-102 Part 5 – Page 362 Definition of MD&A: narrative interpretation of issuer’s current financial position and future

prospects. Financial statements describe what happened; MD&A describe why it happened (and also predict what will happen going forward).

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In Canada, all reporting issuers are required to provide an MD&A.o Particularly important for junior companies without a history of profitable operationso Discloses nature of changes in issuer performance and manager’s opinion as reason

for change, discuss positive and negative developments, reconcile plans with results, disclose whether milestones or projections were achieved, disclose pending liabilities, related party transactions, disclose regulatory approval needed for transactions

Content of MD&A prescribed by NI-51-102 FIo Material Information . Definition of “materiality” to be used (NI 51-102 Part 1):

would a reasonable investor’s decision whether or not to buy, sell, or hold securities in your company likely be influenced or changed if the information in question was omitted or misstated? If so, the information is likely material (not market impact).

o Capital structure of the issuer (designation and number of shares and share classes) – NI 51-102 s.5.4.

o Forward looking information (Part 1)o Off-balance sheet arrangements (51-102F1 Item 1.8 (at p.1605)o Approval requirements by the board or audit committee (for interim MD&A) (s.5.5)o Filing requirements for MD&A (s.5.1(2))o Delivery requirements for MD&A (s.5.6)

Enforcement: regulators are increasingly scrutinizing the MD&A and requiring refiling.

Annual Information Form (AIF) - NI 51-102 Part 6 – Page 364 AIF is similar to a prospectus, because it requires detailed information about history,

operations, and financial affairs of the reporting issuer. AIF originally (and still) used by large issuers to communicate extensive information in order

to qualify for SFP process. Now required for all non-venture reporting issuers (s.6.1) Content of AIF: prescribed by NI 51-102F2

o Definition of materiality same as the MD&Ao 51-102F2 Items 5.1(4), 5.2 (risk factors): A new explicit requirement is social and

environmental policy information for policies fundamental to operations. Filing Requirement (NI 51-102 s.6.2)

o Must be filed within 90 days after the end of the issuer’s financial yearo Note there is no delivery requirement only SEDAR filing

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Continuous Disclosure: Certification

All of this is about strengthening the role and responsibilities of gatekeepers. Will they make a difference in terms of corporate performance or improve the behaviour of corporate issuers? It’s not entirely clear. The rules also provide major challenges to some issuers, especially small-cap. Certification requirements hold corporate officers accountable for the quality and accuracy of

an issuer’s disclosures. There are new certification requirements based on the U.S. SOX Act.o Canadian Issuers listed in the US must comply with SOX.

Name Rule Purpose Requirements Certification of Disclosure in Issuers’ Annual and Interim filings

MI 52-109 (not adopted by BC)

Meet a standard of overall material accuracy and completeness that is broader than financial reporting requirements under GAAP (applies to all non-foreign, non-investment fund issuers)

Liability: Subject to quasi-criminal, administrative, or civil proceedings. Subject to private actions for damages either at common law, civil law (Quebec), or statute (OSA).

CEO and CFO must personally certify that there is nothing misleading and that there is no misrepresentation in issuer’s annual and interim financial statements.

Must certify the establishment of disclosure controls for auditing.

Each certificate filed in SEDAR separately

Fair Presentation MI 52-109 CP

Broader than GAAP: ‘fairly present’ means a materially accurate and complete picture of the issuer’s financial condition. Financial condition includes qualitative and quantitative factors (CICA). There is deference to GAAP, but not if the standard fails to meet an obvious and reasonable standard of fair presentation readily apparent to the trier of fact (Kripps v. Touche, 1997 BCCA)

Fair presentation includes disclosure of accounting policies, proper application of those policies, informative financial info, and additional disclosure to provide material accurate picture of issuer.

Internal control over financial reporting

MI 52-111

Enhanced audit control rules are a direct transplant of SOX rule 404 (delayed due to issuer concerns), however reporting issuers say that this is too costly, since controls themselves are time-consuming and need to be audited.

Similar to 52-109, except that not only have audit control procedures been put in place, but that they are evaluated annually in comparison to a ‘suitable control framework’

Audit Committees

MI 52-110 (not adopted by BC)

Note: applies to non-venture issuers

An audit committee is a board committee responsible for oversight of financial reporting process. Rules in place to prevent auditor ‘capture’, to enhance independence and financial literacy of committee, and improve transparency (disclosure).Responsibilities include (MI 52-110 2.3): Helping directors meet their responsibilities; Enhancing communication between directors and external auditors; Enhancing independence of external auditor; Increasing the credibility and objectivity of financial reports; Strengthening the role of the directors; Must have Charter, 2.3(7); must establish procedures for dealing with complaints (‘whistleblower’ function); Pre-Approval of non-audit services provided by the external auditor

Must contain at least 3 directors of issuer (3.1(1))

F. Literacy, education, and experience of members disclosed in AIF

Whether audit committee exemptions utilized

Must be independent (1.4, 1.5) cannot have ‘material’ relationship with issuer (past officer, partner of firm providing legal or accounting, cannot have received more than $75K annual pay from issuer)

Must have ability to read broad and complex financial statements (GAAP knowledge optional, unlike US)

Disclosure of Corporate Governance

NI 58-101

Market-based approach: the best practices in NP 58-201, but the market should know if they are not followed

Disclosure of governance practices and the extent to which with these meet best

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Practices and be able to decide how to invest accordingly.

practice guidelines (Form 58-101F). If they are not followed, the directors are to explain why governance rules are not followed.

Disclosure of Corporate Governance Practices

NP 58-201

Adopts a ‘disclose and explain approach’ to corporate governance. Describes best practices.

Best Practices: Majority of board

independent (3.1) Chair independent (3.2) Independent members

should occasionally meet separately (3.3)

Board should have business mandate, code (3.4, 3.8-9)

Other: orientation, education, compensation

Canadian Public Accountability Board (CPAB)

NI 52-108

Sets out standards for accountants and auditors.

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Continuous Disclosure: Timely and Effective Disclosure – Material Changes

Statutes and Regulations OSA section 1: Definition of material change:

o “a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer” OR “a decision to implement a change referred to in subclause (i) made by the board of directors or other persons acting in a similar capacity or by senior management of the issuer…”

OSA s. 73: Material Changeo 73. Where a material change occurs that is likely to have a significant influence on

the value or the market price of the securities of a reporting issuer and is not generally known, the reporting issuer shall immediately prepare and distribute a press release disclosing the substance of the change

OSA s.75: Material Change Reportingo 75. (1) Subject to subsection (3), where a material change occurs in the affairs of a

reporting issuer, it shall forthwith issue and file a news release authorized by a senior officer disclosing the nature and substance of the change. 

o (2) Report of Material Change Subject to subsection (3), the reporting issuer shall file a report of such material change in accordance with the regulations as soon as practicable and in any event within ten days of the date on which the change occurs. 

o (3) Confidential Disclosure - If it would be unduly detrimental or a decision is pending approval of the board, a reporting issuer may file with the OSC the report marked confidential and the reasons for non-disclosure to the public.

The issuer has to advise the commission in writing every 10 days that it wishes the material change to remain confidential (4)

If it becomes apparent that people are trading based on the unreleased information, the commission will release it (5)

o Note that the OSA and the NI requirements are the same – but the form to be completed is found in the NI (Form 51-102F3)

Material change rule in Ontario under section 75 continue to apply, but only if a reporting issuer does not comply with the National Instrument.

NI 51-102, Part 7: Greater, harmonized requirements for Material Change Reportingo The introduction of NI 51-102 harmonizes the definition of material change: “a

change in the business, operations, or capital of the reporting issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the reporting issuer…” and a decision to implement a change made by the board or senior management that significantly impacts results of operations and financial position.

o Reporting 7.1 If material change occurs, news release must be filed, and material change report must be filed as soon as practicable or within 10 days (same as Ontario)

Change reports are generally short (1-2 pages), but regulators still tell firms how to put the report together.

Disclosure must reveal the significance of the change without having to refer to other material.

NP 51-201: (Page 387) (Best Disclosure Practices) – 2.2 – confidentiality, 2.3 maintaining ito Elements of best practices:

Establish corporate disclosure policy Review by board/audit committee Designate authorized spokespersons Establish policy re analyst conference calls and reports Establish policy re quiet periods and insider trading monitoring Establish policy re electronic communication

o Section 2.2: Issuers may withhold public disclosure if it unduly detrimental, but must still make a confidential filing with the regulator

o Section 2.3: If rumours leak or impact stock price then must make full disclosure. o Part 3 – Selective Disclosure – see belowo Section 4.2: examples of material information: changes of structure financial &

corporation, changes of financial operations. So regulators have made distinction between operations and structure.

Material facts and changes are both included in this policy.

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o Section 6.14: guidance re handling rumours: should adopt a no-comment policy.

Confidential Disclosure – Section 75(3) and NP 51-201 7.1(2) Disclosure to regulators but not disclosure to investors (doesn’t exist in US). Allows reporting issuers where their opinion has been arrived at in a reasonable manner, that

the disclosure required in earlier parts of section would be unduly detrimental, RI may material change report to SC saying it’s confidential along with written reasons.

o Example : sensitive stage of negotiating merger/takeover bid and public disclosure will cause bidder to get cold feet.

Selective Disclosure – NP 51-201 Part III Example : issuers have an interest in communicating with number of classes, including

institutional and retail investors. Concern about whether retail investors get same info as institutions. Issuers also talk to analysts in brokerage houses who follow their stock.

Legal issue is possibility of insider trading: Selective disclosure could amount to tipping. o Defence: gave info in the necessary course of business.

NP says giving info to analysts isn’t in the necessary course of business, though information to credit rating agencies is allowed (see page 1669)

Enforcement : if there is mitigating factors (ie if unintentional) in selective disclosure enforcement: 3.7 of NP (page 1675)

Disclosure of Significant Acquisition – NI 51-102 section 8.3 If a RI completes a significant acquisition of a business or related business it must file a BAR

(business acquisition report – includes balance sheet of RI) within 75 days of acquisition. Significance tests under section 8.2:

o Asset test, investment test, or income test: if any exceeds 20% of buyer’s assets, assets or income (respectively), then BAR must be filed.

Venture issuers have different tests.

Public Enforcement of Continuous Disclosure Obligations: Enforcement is possible under section 122 and 127 of the OSA.

o OSC conducts CD compliance reviews in conjunction with insider trading. CSA Staff notice 57-301 (2002): management cease-trade order issued when RI can’t file

financial statements on time. OSC Policy 57-603: management CTO (cease trade order) when default in filing

requirement (p2162) but regulators require material change report to be issued immediately.

Case Law: Principle: if unclear as to whether something is a material change, then err on side of

disclosure. If news is negative, issuers don’t want to hear this…

Case Name

Year Court Holding

Pezim 1994 SCC Failure to disclose mineral find. SCC holds that change in the value of assets is a material change (no difference between change in assets and change in value of assets – economic reality) Note that ‘assets’ is not found in OSA or NI definition of material change.

Three elements of “material change” definition: (1) Change must be in relation to the affairs of an issuer; (2) In the business, operations, assets or ownership of the issuer; and (3) Material (ie would reasonably be expected to have a significant effect on the market price or value of the securities)

Meaning of “as soon as practicable” when revealing material change to public – s. 67 creates duty to inquire on the part of directors wrt material changeThe standard of review of decisions of securities regulators is reasonableness – great deference.

Kerr v. Danier

2005 ON CA

Financial results do not form part of business operations or capital, and under normal circumstances are not a material change (differs from ‘economic reality’ principle in Pezim) (para 88)

Unseasonably warm weather is not a material change: it was a factor external to a company’s operations (66). The example of all of the company’s stores

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burning down is a material change, however.YBM Magnex

2003 OSC Supports the Probability/Magnitude test to determine whether future events are material changes. 2 prong test (qualitative): (1) assessment of probability event will occur, and (2) assessment of magnitude of change on reasonable investors. Here, auditor concerns of organized crime was a material change not adequately reported under 75(1). Auditor delay could have lead to a CTO. Likely this falls under a change in capital… (policy-oriented)

Donnini 2002 OSC Uses Probability/Magnitude Test to conclude that the accused was liable for insider trading

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Continuous Disclosure: Civil Liability

Private enforcement: Common Law Remedies: Pre-stat remedy the only option for investors pre 23.1 was a tort claim for fraudulent or

negligent misrepresentation. Problems for Ps: o 1) Courts have said that Ps have to show reliance on the misrepresentation in making

their decision to trade. This makes class action difficult to mount because it is very difficult to show reliance across a class.

o 2) In order to ground such claims, have to show that D owed P duty of care: see Hercules Management.

“Fraud on market theory” liability in Canada: o This assumes that securities markets are efficient. Because they are efficient they

include all info about the sec being traded. The price changes to reflect the information. If there is a misrepresentation, this becomes a fraud on the market.

o Fraud on market is legal platform in US for suing without demonstrating individual reliance on misrepresentation. Fraud on market means all investors relied on the misrepresentation (deemed reliance, part of the hurdle to find liability)

o In Canada, no judge has accepted Fraud on the market.

History of efforts to legislate: Primary Markets : S.130 allows investors to sue re misrepresentations in prospectus. Not lots

of litigation until Kerr v. Danier. Secondary Market : efforts to legislate remedy for 25 years. They escalated in late 90s when

TSX issued a report (Allen Report) that securities legislation in Ontario should include a civil right of action in the secondary market. 2000 report recommended same thing.

o Draft legislation was produced 2000 2002, but not passed until 2005.o Lots of lobbying: regulators pushed initiative to enable investors to sue in courts, but

issuers strongly resisted due to the increased liability that they would face.

Part XXIII of the OSA – New Section 138

Potential Defendants - Definitions – OSA Section 138.1 The Issuer, Directors, Officers Influential person = A control person, promoter, insider (not director or senior officer), or an

investment fund manager. (Legislation introduces concept that there are additional parties that can be Ds in action for damages).

o Control person = Securities holder or holders acting in concert who can materially affect the control of the issuer. Holder(s) who holds 20% + of securities is deemed a control person.

o Promoter = a person/company responsible for founding/reorganizing an issuero Insiders = Securities holders who hold 10% or more of securities of an issuer.

** Security Holder can be a D to an action. Legislation lifting the veil** Expert: Person or company whose profession gives authority to a statement made in a

professional capacity by the person or company including an accountant, actuary, appraiser, auditor, engineer, financial analyst, geologist or lawyer

Sources of Liability and Parties Liable – OSA Section 138.3 Documents that contain a misrepresentation (138.3 (1) and (3)) – released by issuer or docs

released about issuer by a person or company with actual, implied or apparent authority to act on behalf of a responsible issuer;

o Parties possibly liable: responsible issuers, directors, officers, influential persons (if knowingly influenced issuer), experts (where misrep contained in material they provided to issuer).

Public Oral Statements containing misrepresentation : 138.3 (2) and 138(3) if made by person with “actual, implied or apparent authority to speak on behalf of a responsible issuer”;

o Parties possibly liable: responsible issuers, directors, officers, influential persons (if knowingly influenced issuer), experts (where misrep contained in material they provided to issuer), and person who made the public statement

Documents/Statements made by Influential Person : 138.3(3) – if influential person makes a statement or produces a document with a misrepresentation, the same people as above can be

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liable, but the influential person can be liable without have to show that that person knowingly influenced the issuer.

Failure to make timely disclosure : 138.3(4).o Parties possibly liable: responsible issuer, directors/officers, and influential persons

Who has a Cause of Action? For docs containing misrepresentations : persons/companies acquiring/disposing of security

between time when document was released and time when misrepresentation corrected; For public oral statements : containing misrepresentations, same as above; Where failure to make timely disclosure : person/company acquiring/disposing of security

between time material change was required to be disclosed and subsequent disclosure of material change.

Procedural Issues Leave of court required under 138.8 by Plaintiffs before launching action

o Merit-based assessment (court as gatekeeper) – must be satisfied brought in good faith and satisfied that there is a reasonable possibility that the action will be resolved in favour of Plaintiff @ trial. Litigation chill could arise.

o Purpose of leave requirement? This keeps unmeritorious claims out of the court, which lowers the risk exposure to issuers (this change was introduced after issuers strongly protested about the introduction of CD statutory liability).

Deemed Reliance : No need anymore to show reliance on misrepresentation or to show reliance on issuer having complied with disclosure requirements

Sec 138.2 –list of transactions that don’t come within mandate of Part XIII. Court approval of settlements required: 138.10 Cost rules 138.11

o Possibility that this creates litigation chill if Ds win: prevailing party is entitled to cost determined in accordance w/rules of civil procedure. Disincentive for Ps?

o ‘Loser Pays’ cost rules are also an attempt to screen out unmeritorious claims, and were pushed for by issuers.

Onus on Plaintiff to ProveType of Misrepresentation

Docs Included For Director / Influential Persons

Docs Included For Issuers / Officers

Elements of Proof

Misrepresentation in Core Document

Prospectus, takeover bid circulars, MDA, AIF, annual financial statements, interim financial statements

Prospectus, takeover bid circulars, MDA, AIF, annual financial statements, interim financial statements and material change reports

Plaintiff must prove (1) acquisition or disposition of security at relevant time and (2) existence of misrepresentation (standard definition applies)

Misrepresentation in Non-Core Documents or Oral/Public Statements

Material Change Reports

In addition to core document test, (1) Defendant knew there was a misrepresentation; or(2) Defendant deliberately avoided acquiring such knowledge; or (3)Defendant was guilty of gross misconduct in connection with doc/statement;

Failure to Make Timely Disclosure – OSA 138.4(3)

Plaintiff must prove (1) Defendant knew of material change; or (2) Defendant deliberately avoided acquiring knowledge of material change; or (3)Defendant was guilty of gross misconduct in connection with failure to make timely disclosure.

Defences for Misrepresentation in Continuous Disclosure – Section 138.4

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(5): P acquired/disposed with knowledge of misrepresentation or with knowledge of the material change. Burden of proof on D.

(6): Defendant made reasonable investigation and had no reasonable grounds to believeo (a) There was a misrepresentation.o (b) That the failure to make timely disclosure would occur.o Note that onus is still on the defence, unlike 130 where onus switches to plaintiff on

the issue of due diligence. (7): Factors to be considered by ct with respect to reasonable investigations (due diligence)

o All relevant circumstances including nature of issuer, knowledge, office held, existence of any system designed to ensure responsible issuer meets its continuous disclosure obligations

(8): In defence of failure to make timely disclosure, a defendant also has the defence of Prior confidential disclosure: (Remember timely confidential disclosure allowed under 75(3))

o Must show reasonable basis for making disclosure on confidential basis (must show that unduly detrimental to make full disclosure at that time).

Limits on liability: Actions for damages only – no rescission Proportionate liability under 138.6

o (1) Proportionate re extent of breach of each D - o (2) Not proportionate (ie full amount can be assessed against one defendant) where

defendants other than issuers knowingly authorized or permitted misrepresentation or failure to disclose material change.

o Under section 130 there is joint and several liability. Assessment of damages under 138.5 – depending on when P investor sold securities.

o Issuer limit : greater of 5% market cap and $1 million dollars; o Individuals limit : greater of $25,000 and 50% of aggregate annual compensation.

So individual Ds aren’t going to be bankrupted.Statutory limits on liability – 138.7o (1) D only pays the lesser of the aggregate damages assessed and liability limitso (2) Limit does not apply to a defendant other than the responsible issuer if the

plaintiff proves that the defendant authorized, permitted or acquiesced in the making of the misrepresentation or the failure to make timely disclosure while knowing that it was a misrepresentation or a failure to make timely disclosure, or influenced the making of the misrepresentation or the failure to make timely disclosure while knowing that it was a misrepresentation or a failure to make timely disclosure.

Basically no limit if fraud Implications for leave application; will Ps have to claim fraud at the

beginning of application because of possibility of limits.

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Insider Reporting and Insider Trading I

Overview As long as insiders disclose their trades, and the trade does not result from material

undisclosed information, trading by insiders is permissible. o Legal insider trading is still regulated, in that is must be reported.

Policy Rationale : Why do we prohibit illegal insider trading? Should we prohibit insider trading? Why do we regulate insider trading?

o Fairness to other investors (not fairness to the actual insiders) who do not have access to the same information overall market confidence

o Law and economics say it is not necessarily clear that the benefits of preventing insider trading outweigh the costs. Insider trading could be allowed as a form of executive compensation, and can more accurately price securities. But there is a need to regulate when there is bad news, otherwise insiders are insulated from risk.

Why do we make insiders report their trades? Deterrence, but not that compelling. Also acts as a data point for other investors.

Definition of Insider Section 1(1): “insider” or “insider of a reporting issuer” means,

o (a) every director or senior officer of a reporting issuer,o (b) every director or senior officer of a company that is itself an insider or subsidiary

of a reporting issuer,o (c) any person or company who beneficially owns, directly or indirectly, voting

securities of a reporting issuer or who exercises control or direction over voting securities of a reporting issuer or a combination of both carrying more than 10 per cent of the voting rights attached to all voting securities of the reporting issuer for the time being outstanding other than voting securities held by the person or company as underwriter in the course of a distribution, and

o (d) a reporting issuer where it has purchased, redeemed or otherwise acquired any of its securities, for so long as it holds any of its securities;

Note that there is a retrospective aspect to this – section 1(8) and 1(9)o (8) Where an issuer becomes an insider of a reporting issuer, every director or senior

officer of the issuer shall be deemed to have been an insider of the reporting issuer for the previous six months or for such shorter period that he or she was a director or senior officer of the issuer. 

If you were a senior officer in a company planning to buy another company, you could buy stock in the other company and make a large windfall.

o (9) Where a reporting issuer becomes an insider of any other reporting issuer, every director or senior officer of the second-mentioned reporting issuer shall be deemed to have been an insider of the first-mentioned reporting issuer for the previous six months or for such shorter period that he or she was a director or senior officer of the second-mentioned reporting issuer. 

Senior officers of the target are also considered senior officers of the bidder.

Legal Insider Trading – Reporting Requirements – OSA section 107 Generally, the rule is that insiders must report within 10 days that they

o (1) Have become insiders (creates a reporting profile) Note that an insider with no ownership, direction, or control over any of the

issuer’s securities need not file an ITR.o (2) Has their ownership, direction, or control change (makes a trade) in the issuer as

an insider, or o (3) Has become an insider under 1(8) or 1(9) – note one must file the ITR within 10

days after merger of the two issuers being completed (retrospective report) How serious are the objectives of insider reporting requirements when there is a 10-day

period allowed for filing the report?o Authors recommend a 3-day period in line with clearance and settlement rules.

Reporting Mechanism - NI 55-102 – System for Electronic Disclosure by Insiders (SEDI) SEDI : requires insiders to create an Insider profile (55-102F1) and reports (55-102F2) on the

internet – from section 107

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o Under SEDI, ITR reports are available through SEDAR instead of only through commission and business publications.

Exemptions from Insider Reporting Requirements – Page 437

Exemption Rule Requirements/NotesIssuer change to all securities

NI 55-101 Arises if there is a dividend or amalgamation that affects equally or is available to all shareholders. Issuer must file within one business day.

Exemption for Directors/Officers or Subsidiaries

NI 55-101 D/O of Subs may not have any knowledge of the parent issuer, but are normally caught by (b) of the Insider definition under s.1. Note: CSA proposes to expand exemption for people with executive titles marketing purposes.

Exemption for Directors/Officers of Affiliates of Issuer

NI 55-101 Same as exemption above (affiliate comes from special relationship definition in OSA 76(5)). Must not have knowledge of material facts or changes about the issuer. Issuer must notify regulators that it is using the exemption and provide the regulators with a list of those included.

Exemption at discretion of the OSA

OSA 122(2)(a) and (b)

Interested person may apply for an exemption, or commission may grant exemptions on its own motion where ‘just and convenient’ (cost doesn’t justify exemption). The test on whether to grant relief is whether the person has access to specific undisclosed confidential information.

Eligible Institutional Investors

NI 62-103 Part 9

Exemptions for eligible institutional investors if they have filed an early warning report and do not have knowledge of any material fact or change. Important: an investment manager could represent several retail investors, who in sum control <10% of a company, which otherwise would require an insider trading report.

Illegal Insider Trading – Page 439

Tradingo Trading – 76(1): “No person or company in a special relationship with a reporting issuer

shall purchase or sell securities of the reporting issuer with the knowledge of a material fact or material change with respect to the reporting issuer that has not been generally disclosed.” Elements of Proof

The accused was in a special relationship with the RI The accused purchased/sold securities of RI The accused made the purchase/sale with knowledge of material info (facts/change)

concerning the affairs of the RI, and the material info is not generally disclosed.

Tippingo Tipping – - 76(2): “No reporting issuer and no person or company in a special relationship

with a reporting issuer shall inform, other than in the necessary course of business, another person or company of a material fact or material change with respect to the reporting issuer before the material fact or material change has been generally disclosed.“ Elements of Proof:

The accused was in a special relationship with the reporting issuer The accused informed another person of material information (facts and changes)

with respect to the reporting issuer other than in the necessary course of business The accused informed another person of the material information before it was

generally disclosedo Notes: (also see the Rankin decision)

There does not have to be trading by the tippee in order for there to be tipping The tippee does not have to know that tipper is in a special relationship in order for

there to be tipping (only the activity of informing is important) However the tippee would only be guilty of trading or tipping if he knew the

tipper was in a special relationship with the issuer. Can a tippee also be a tipper?

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If the tippee knows (or reasonably ought to know) that the tipper is in a special relationship with the issuer, the tippee can also be a tipper since they will have a special relationship with the issuer (76(5)(e)). Therefore a chain of tippers can form.

Criminal Code insider Trading and Tipping- CB 595-597 Section 382.1(1) makes it an indictable offence to directly or indirectly buy or sell a security

knowingly using insider information” by virtue of various relationships to the issuer. Section 381.1(2) makes it an indictable offence to knowingly engage in tipping.

o Note that these criminal offences require that the accused knowingly committed the offence, which is a much higher onus to prove.

o Also, the provisions apply to all issuers, not just reporting issuers.o The provisions seem to apply to individuals who possess insider information by virtue

of being a shareholder, but not to investors who hold bonds or units in a trust.

What is the nature of a Special Relationship? – Page 440o S.76(5): “person or company in a special relationship with a reporting issuer” means,

o (a) a person or company that is an insider, affiliate or associate of, (i) the reporting issuer, (ii) a person or company that is proposing to make a take-over bid of issuer (iii) a person or company that is proposing to become a party to a

reorganization, amalgamation, merger, major asset purchase, etc. with the RIo (b) a person or company that is engaging in or proposes to engage in any business or

professional activity with or on behalf of the reporting issuer or with or on behalf of a person or company described in subclause (a) (ii) or (iii),

ie Lawyers, accountants, underwriterso (c) a person who is a director, officer or employee of the reporting issuer or of a

person or company described in subclause (a) (ii) or (iii) or clause (b),o (d) a person or company that learned of the material fact or material change with

respect to the reporting issuer while the person or company was a person or company described in clause (a), (b) or (c),

o (e) a person or company that learns of a material fact or material change with respect to the issuer from any other person or company described in this subsection, including a person or company described in this clause, and knows or ought reasonably to have known that the other person or company is a person or company in such a relationship. .

Anyone who learns of a material fact or change from anyone described in the definition as a whole and who should have known that the person was in a special relationship with the issuer can come within the definition

This provision is based on a reasonableness standard but nevertheless potentially implicates those who learn of the information, not simply those who convey it

Potentially extensive chain of people who can be guilty of insider trading. Broader than definition of insider for reporting purposes under section 107 or US Definition

Case Name

Year Court Holding

Re Donnini

2002 OSC D, financier of KCA, shorted KCA stocks to hedge against risk based on information not yet public. D had special relationship, sold securities, based on material information (court applies probability/magnitude test that info, while not confirmed, was a material fact), and material info not yet public. Court considers OSA Reg. 175 defence (grey lists) and find it doesn’t apply.

Re Harold P Connor

1976 OSC ‘General disclosure’ is a two-prong test: means that the information was disclosed to the market and the market must have sufficient time to digest the information. One full trading day deemed the appropriate time to wait after info disclosed before insiders can trade. Test is now codified in NP 51-201 3.5(2) (adopted in Pezim)

Pezim v. BC

1994 SCC Insiders have a duty to inquire about material changes and material facts at the issuer before making an insider trading transaction (even if the issuer uses Chinese walls to keep info confidential – problematic in large, multinational issuers)

R. v. Rankin

2005 ON First prosecution for tipping under section 76 (2) (brought under s.122): Rankin an I-banker at RBC. There was circumstantial evidence that Rankin

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was tipping his friend Duic, but this was not persuasive (info could have come from anyone at RBC, not just Rankin). However Duic testified against Rankin, which was the grounds of the conviction. Judge convicted Rankin despite him not knowing the extent to which Duic was trading.

Sanctions for Insider Trading Criminal: the maximum term for indictable offences is 14 years (s. 380(2) –Fraud Affecting

the Public Markets). Aggravating circumstances (page 596) can increase the harshness of the penalty.

Quasi-Criminal: s. 122 (especially 122(4)): If an accused makes a profit of $2 million from insider trading, a person could pay a fine of up to $6 million (3X the amount) as sanction

Civil section 134(1), (4), and 135 Administrative: ss. 127/128: Example is the Donnini decision.

Assessment of Illegal Insider Trading – Page 470 In 2003, the CSA established an independent task force to assess enforcement of illegal

insider trading in Canada.o Due to data limitations, it is currently very difficult to establish accurately the extent

of illegal insider trading in Canada. McNally and Smith did a study that suggests that insiders do not avoid trading prior to

announcements of material information, and that violations are infrequently enforced. Recommendations:

o Follow US strategy where people who snitch on insider traders get to keep a portion of the fine levied.

o Harmonize TSX and OSC Ruleso Require insider trades to be reported much sooner than the 10 day periodo Insiders should be restricted from trading in a period just prior to pre-planned

announcements such as earnings releases (many companies already voluntarily have such a procedure in place)

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Insider Reporting and Insider Trading II: Defences

Type of Defence

Statutory Provision

Onus Case Name Year Court Holding / Description

Reasonable belief that information has been generally disclosed

OSA 76(4) Accused Green v. Charterhouse Group

1976 ON CA

Hinting at the existence of material information in a letter is not significant enough to count as a disclosure of material information.

“ “ “ Re Harold Connor 1976 OSC Only when the disclosure is completely honest and forthright, and that the public would have had sufficient time to digest the information (deemed 1 day), is defence allowed.

Defence for companies when some people know of material info and other’s don’t

OSA Regulations 175

Accused Considered in Donnini there must be reasonable policies and procedures in place to prevent info sharing (Chinese Walls, Grey Lists)

Exemption from section 76 for the corporation if the person making the trade did not have knowledge of the material information held by someone else in the corp. See notes

Guidelines for Prevention of Information Dissemination

OSC Policy 33-601

Donnini supports Chinese Walls, but in Rankin, the court is highly skeptical of info containment procedures (thinks info is informally shared)

Includes education of employees (Insider rules, ethical standards, etc) and containment of insider info (codenames for files, grey lists, restricted lists,

Reasonable Mistake of Fact

CL: because insider trading is strict liability if this defence was not available, threshold for defence would be too high.

Accused – established on balance of probability

Lewis v. Fingold – note a 122 decision (quasi-criminal), that may not fly under s.127(administrative)

1999 ON GD

Fingold in special relationship, info was material, info would reasonably be expected to affect market, and F traded on info. Mistake of fact defence allowed: his experience made it reasonable to think that the poor results would not affect

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market (not material)

“ “ “ R. v. Harper 2000 ON H mistaken belief that negative result was not material is not reasonable given his experience, and H can’t rely on expert advice. Securities sanctions stiffer than criminal.

Necessary Course of Business

NP 51-201 for defence to tipping: ‘necessary course of business’ would not permit selective disclosure of material info to an analyst, institutional investor, or other market professional.

Accused – 76(4) of OSA

Royal Trustco v. OSC

1983 ON Disclosing information to a shareholder (that dividend would be paid) as part of an attempt to defend against a takeover bid is not ‘in the necessary course of business’, and is tipping.

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Prospectus Exemptions

Overview Exemptions allow issuers to issue securities without the accompanying mandated disclosure.

(prospectus and register as issuer etc)o Exemption rules apply to reporting issuers and non-reporting issuers.

Policy reasons for Exemptions:o Example of regulators favouring efficiency/cost reduction over protection/liabilityo Concern for start-ups/small issuers – reducing the regulatory burden and cost. Rules

have expanded the exempt market and made it easier for small issuers to get money.o Prospectus unnecessary for wealthy/sophisticated investors (capable of making

investment decisions without the information provided in a prospectus)o Prospectus unnecessary when there is a pre-existing relationship between the issuer

and the buyer of securities (for example when investor already a security holder – rights offering – or when investor is an employee, friend, family of issuer)

o Some securities, like government bonds, are extremely safe investments. Ontario has a closed system of regulation. This means that all legal ways of distributing

securities are considered under existing laws. Options available to issuers include:o Provide a prospectuso Qualify for explicit exemption with resale of those securities likewise being

considered a distribution unless the resellers qualify for the relevant resale rules. Closes off back door underwriting.

o Apply for a discretionary exemption (in Ontario, under section 74). Securities practitioners can advise their client that if the financing they want

raise cannot be structured so as to fit the terms of the various prospectus exempting rules, it is possible to apply to securities regulators to obtain a transaction-specific exemptions from the prospectus requirement

Exempt market consists of three levels of transactions:

Type of Transaction Statutory Provisions for Exemption Description

Between Issuers and Investors

NI 45-106 (September 2005) (attempt at harmonization)

OSC Rule 45-501: Covers some exemptions, mostly replaced by new NI

OSA Part XVII now mostly inoperative by NI

Can be grouped into categories of exemptions for SMEs, accredited investor exemptions, minimum investment exemptions, exemptions for pre-existing relationships, and residual discretion for exemptions by regulators.

Between Investors and Subsequent Investors (Resale Rules)

NI 45-102 applies to closed jurisdictions (Man., NB, YK are open, sections don’t apply)

Purpose: protection of investors and prevention of back door underwriting

See next section of the courseSecurities from Control Person/Block

Companion Policies for NI 45-106 and NI 45-102 give guidance.

SME and Startup Exemptions

Name Rule Description Rules on Securities Who can BuyGovernment Incentive Security (GIS) Exemption

OSC Rule 45-501 s.2.13

Facilitates the setting up of business entities for beneficial tax purposes (deductions to promote the activities of junior exploration issuers in the resource sector)

Max 75 investors solicited, max 50 may purchase (anti-avoidance rules apply)

Investor must receive substantially same info as a prospectus

Issuer cannot advertise or promote offering, and GIS can only be used once annually

Investor must be able to valuate security (unique requirement), or must be officer/director or child of such

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Investor must receive Offering Memorandum and the report of trading (to OSC)

Report must be filed within 10 days of trade (Form 45-501F s.7.1, 7.2)

Private Issuer Exemption (also can be grouped under an accredited investor exemption)

NI 45-106, s. 2.4

Applies to Private Issuers not Reporting Issuers

Securities must not be bonds or debentures

Securities must have restrictions on transfer in articles of inc, (or trust agreement)

Securities cannot be owned by more than 50 people

No cap on amount of $ that can be raised under exemption (different than old MI 45-103)

Distributions do not need to be reported to regulators + no registration or prospectus requirement when selling to the group mentioned in next box

Needs to be analysis whether purchaser is “the public”

Set out in 2.4(2):(a) Director, officer, founder, employee, control person(b-f) Spouse, Parents, grandparents, children, close personal friend, close business associate of directors, officers, founders, or control persons (or their spouse)(g) Other people in exempt class (resale rule)(h) Accredited investors [does not appear that they are excluded from the 50 ppl ceiling (unlike CHI exemption)(k) Person who are ‘not the public’ (Ralston Purina: employees = public, issue test: did the employees need a prospectus?) R v. Piepgrass “need to know test” and “common bond” test

Founder, Control Person, and Family Exemption

NI 45-106 s.2.7

ONLY AVAILABLE IN ONTARIO, targets first-generation financing

There is no limit on the financing available, and there are no reporting requirements (regulators only intervene if there is a complaint)

(a) Founders(b) Affiliate Founder (subs – 1.2)(c) Spouse, parent, sibling, grandparent, or child of officer, director, or founder(d) Control Person

Closely Held Issuer Exemption

s. 2.1(1) of OSC Rule 45-501

CHI’s are limited to raising capital up to $3,000,000 and to 35 investors (outside of the noted members). This is to keep the purpose of the exempt consistent with the objective of the policy.There is requirement that an information statement be provided to purchaser by seller – has a large disclaimer wrt to investing

Shares are subject to restrictions on transfer (require approval of directors, or shareholders) through a constating document or agreements + outstanding shares are owned by not more than 35 persons or companies, exclusive of key owners, employees, directors (p305)

- accredited investors

- employees, directors, former directors, etc

Family, MI 45- A exemption for - there is no restriction as to securities can be

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Friends, and Business Associates Exemption

103 s. 3.1 – replaced with 45-106

trading in securities of an issuer if the purchaser is family, etcThe issuer is required to file a report in the local jurisdiction in which the distribution takes place on or before the 10th day after the distribution (s. 7.1)

how many ppl it can be sold to - there is no prohibition on “the use of registrants, finders, telemarketing or advertising in any form to solicit or find purchasers under any of the exemptions (MI 45-103CP s.1.7) however an adverse implication will be drawn if fees are paid to find purchasers-further, there is qualitative assessment in determining close friend or associate which is based on the indiv knowing the director ,officer etc long enough to be in a position to assess the capabilities and trustworthiness (MI 45-103CP s. 2.2)

sold to family, friends, business associates, family of directors, a founder of issuer and family etc

but it excludes employees from whom they can be sold to with exemption

Accredited Investor Exemptions ( NI 45-106 s.2.3 ) ( Most Widely Used in Securities ) Rational underpinning that came from Ontario (OSC 45-501). Most accredited investors are

financial institutions who buy securities through private placements. Is it rational?o Do these factors mean that you no longer required the protections? Does that make

good sense? Maybe if you’re in the IB industry but otherwise…o The rules seem to suggest income and/or assets are a proxy for being able to access

investment advice (be able to hire an investment advisor). Anti-avoidance rule (s.2.3(6)): Can’t set up corporation and transfer individual shareholders

assets to meet 5m threshold under branch (l) of accredited investor definition Seller to accredited investor does not have to be an issuer: wording of 2.3 says nothing about

who the seller is, which makes it possible for one accredited investors to sell to another There is no minimum purchase requirement in this rule. Reporting requirement in s.6.1 (From 45-106FI): reporting obligation on the issuer to report

within 10 days after the distribution occurs.o But see NI 45-106 s.6.2: Issuers don’t have to file reports where they’re selling to

certain Canadian financial institutions (defined in the rule – covers credit unions, banks, loan corps, insurance companies)

Definition of accredited investor (section 1.1) (Page 1292) (a) Canadian financial institution (b) Business development bank of Canada (f) Government of Canada, provincial/territorial/municipal governments (i) Pension funds, (q) mutual funds, (p) trust companies, etc. (j-l) applies to individuals and covers different possibilities for investment savvy based on an

asset test [financial and net] or income test under section 3.5. o Financial asset test [branch (j) of definition]: Liquid Financial assets of investor (or

with spouse) exceeding $1 million net of any related liabilities Note that there is no proportionate requirement of one’s assets to the size of

the investment Factors indicative of beneficial ownership (NI 45-106 CP s.3.5): (1) physical

or a constructive possession of evidence of ownership, entitlement to receipt of any income generated by the financial asset, risk of loss of the value of the financial asset, and ability to dispose of the asset or otherwise deal with it as the individual sees fit.

o Income test [branch (k) of definition]: Net income before taxes exceeded 200,000 or with spouse 300,000 for past two years and expects to qualify in the current year (reasonable expectation of exceeding the same net income level in the current year)

o Net asset test [branch (l) of definition]: Not necessarily financial assets – just assets generally – over $5m (includes properties, etc) – business investor

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Minimum Investment exemption - NI 45-106 s.2.10 Exemption from prospectus if 150,000 paid in cash at time of the trade in a single issuer for a

single transaction (previously discarded by ON to encourage SME financing and get ride of artificial floor for financing, but brought back in NI for harmonization)

Section (3) contains an anti-avoidance rule and the reporting requirements (6.1) are same as the accredited investor exemption (see above)

Exemptions based on Pre-existing Relationships Underlying rationale: issuer has pre-exiting relationship with entity to which it is distributing

securities, and therefore a prospectus is not required.

Name Rule Description RulesDividends – Security as Payment

NI 45-106 s.2.31

Applies when new securities are used to pay dividends to security holders (formerly OSC Rule 45-502)

Must be (1) in respect of a trade by an issuer in a security of its own issue to a security holder of the issuer as a dividend, or (2) In respect of a trade by an issuer in a security of a reporting issuer as a dividend

Dividends – Interest or cash payments applied to acquire additional securities (dividend reinvestment plan)

NI 45-106 s.2.2

Dividends/interest/cash payments applied to acquire additional securities. Instead of giving stock as dividends, you give cash and the option to roll the cash into stock – dividend reinvestment plan (new distribution of securities)

Note limitations in section: must not exceed 2% of the issued and outstanding shares of a class - constrain operation of exemption – not selling too many securities through exemption to avoid disclosure

Reorganizations (good or bad)

NI 45-106 s.2.11

Good: amalgamation/merger with another business, which involves a share exchange for securities in new entity,

Bad: reorganization of issuer due to insolvency (CCAA), where debt is exchanged for equity

See also NI 45-106 CP s.4.2

Conversion, Exchange or Exercise

NI 45-106 s.2.42

Applies when securities that have with them a previous right granted of conversion, exchange, or purchase. When this right is exercised, technically new securities are issued, but an exemption is granted.

Examples: Warrants (options to acquire additional shares for cash), options, convertible debt, convertible preferred shares

Rights Offerings NI 45-106 2.1, and NI 45-202 s.2.2 and 45-501CP s.2.1

Offer of right to existing security holders to acquire additional securities. Exemption covers both granting of right and issuing of securities pursuant to the right.

Constrained use of this exemption so that it doesn’t end up being normal course alternative to the prospectus.

NI 45-101 s.2.2 and 45-101 CP 1.2: grounds on which rights offering exemption not available: increase of <25% of outstanding securities of class, to finance reactivation of dormant issuer, to finance a major new undertaking, where securities issued can be exercised into an new class. Disclosure requirements: advance notice to regulators via rights offering circular, regulator has 10 days to object

Distribution to Employees

NI 45-106 s.2.23-25

Allows for distribution of securities to employees without triggering a prospectus.

2.23(2): acceptable consideration has to be past services, not inducement of future employment,2.24: Participation in trade by employee must be voluntary2.25: For unlisted issuers, there is a limit to the #/% of securities that can distributed unless security holder approval

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Jones v. FH Deacon Hodgson (1986 ON HC) – Page 339: If an issuer relies on an exemption inappropriately, and should have actually provided a prospectus, those who purchased the securities are not time-limited in seeking a remedy under section 53, which can include rescission. If issuers are unsure about an exemption, consult with regulators.

Note on Offering Memoranda (OM) Definition of OM: OSA s.1 and OSC Rule 45-501: a document that provides info about

securities being sold used in conjunction with an exemption from the prospectus requirement Distinction between OM exemption in non-Ontario jurisdictions (NI 45-106 s.2.9) and use of

OM in Ontario (OSC Rule 45-501). Applicable Ontario rules:o You may give an OM if using exemption generally, but must provide it with the

government incentive exemptiono With accredited investor exemption (s.2.3) you can voluntarily give OM (likely that

they will request it anyway) – not a legal requirement for the exemption but as a matter of business practice it is expected.

Voluntary OM still subjects issuer to liability for misrepresentation (See OSC Rule 45-501 CP Part 5 - page 1402) – 130.1 OSA

Notes: Although a copy of an OM has to be filed with the OSC under s. 6.2 of Rule 45-501 [within 10 days of purchase], the regulators do not review the OM and they do not put it on SEDAR

Contents of OM – OSC Rule 45-501 GIS (government incentive security): Rule 45-501 s.2.1(1)

o Info about officers directors and promoters of business entity Otherwise little prescribed content (see OSC Rule 45-501 Part 6)

o The only requirement is description of rights available to buyer under s.130.1 (equivalent of s.130 for prospectuses – right of action for misrepresentation)

OM: Statutory Right of Action (OSA s.130.1)(45-501 s.6.2)- Section 130.1(1): “Where an offering memorandum contains a misrepresentation, a

purchaser who purchases a security offered by the offering memorandum during the period of distribution has, without regard to whether the purchaser relied on the misrepresentation [deemed reliance], the following rights: [Damages] or [Rescission] (same as 130)

- Defences: Purchaser knowledge when they purchased; Depreciation not due to misrepresentation; Not receiving proceeds – issuer was not receiving the proceeds (sale of securities is by a control person)

- Remedies: Statutory right of action under s.130.1 is NOT granted to CDN financial institution accredited investors

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Resale Rules and Control Distributions

Overview – Policy Objectives Very technical rules, no real consensus about what these rules are trying to achieve. Ontario

statutory resale rules are now out, and resale rules are now governed by NI 45-102 Policy Objectives of NI 45-102

o Disclosure – if exemptions pulls back on the goal of disclosure, the resale rules try to bring the role of disclosure back into play (by regulating downstream purchases)

o Preventing ‘backdoor’ underwriting – which is an initial distribution to an exempt purchaser, who then resells to the broader market (avoiding regulation)

o Pricing – resale rules provide an orderly mechanism for exempt securities to find their way into the general market (assists with pricing the securities)

o Control distributions – providing a mechanism for control persons to resell their securities (section 2.8)

Note: once a resale rule is satisfied which moves the security from the exemption system to the general market, resale rules no longer attach to that security or investor.

Substantive Requirements - NI 45-102 Securities issued under various exemptions attract either Appendix D (2.5 resale rules) or

Appendix E (2.6 resale rules) of NI 45-102o NI 45-102 2.5 (restricted period rule – more stringent)

Conditions on both the reseller and the issuer, imposed where regulators think that there is more potential for backdoor underwriting to take place.

o NI 45-102 2.6 (seasoning period rule) Conditions are only placed on the issuer.

Exemption under NI 45-106 Applicable NI 45-102 Resale RuleGovernment Incentive Security (GIS) Exemption – OSC Rule 45-501 s.2.13

2.5

Private Issuer Exemption – s.2.4 2.6Founder, Control Person and Family Exemption – s.2.7

2.5

Accredited Investor Exemption – s.2.3 2.5Minimum Investment Exemption – s.2.10 2.5Stock Dividend Exemption – s.2.31 and 2.2 2.6Re-organization Exemption – s.2.11 2.6Conversion. Exchange, Exercise Exemption – s.2.42 2.5 or 2.6 (depending on how

previously-issued security was acquired)Rights Offering Exemption – s.2.1 2.6Employees / Officers / Directors / Consultants Exemptions – s.2.24

2.6

Resale Rules for Control Persons - NI 45-102 s.2.8 If the control person sells through an exemption under NI 45-106 instead, the respective NI 45-102 resale rules apply

Resale Rules for Control Persons who are Eligible Inst. Investors - NI 62-103 and NI 45-106 (p4)

n/a

Restricted Period Rule – Section 2.5(2) (more stringent – conditions on issuers and resellers) if these requirements are not met, they are deemed to be a distribution Condition 1 - Seasoning requirement:

o Issuer is and has been a reporting issuer in Canada for the 4 months preceding the [reselling] trade (seasoning period)

4-month requirement means that there would be information on the market (ie a quarterly report). The 4-month period is a relaxation of older rules, and was likely a result of stricter continuous disclosure rules under NI 51-102.

Note effect of section 2.7: as long as issuer became a reporting issuer (by filing prospectus) by the time of the reselling trade, seasoning period is satisfied

Note, however, that if the issuer does not become a reporting issuer, the 4 month period remains unfulfilled and the security holder cannot resell the securities, unless he finds another exempt investor.

Condition 2 – Restricted/Hold Period Requirement:

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o The initial purchaser cannot resell within four months of the security first being issued (like a ‘hold period’ requirement)

o 1.11CP: 4 month Seasoning period (condition 1) does not need to be commensurate for the 4 month hold period (condition 2). Hold period must be met, even if 4 month seasoning period is already met by filing a prospectus

o 1.8CP Calculation of restricted periods where more than one exempt purchaser: hold period runs only once even if purchaser resells (doesn’t restart)

o NI 45-102 2.5(3) and 1.10CP: time period calculated from distribution date of original convertible security, not date of the conversion to new type of security.

Condition 3 – Legending Requiremento Issuers and resellers must disclose to other purchasers of their obligations to comply

with the resale requirements under the exemption (warning) (enhances transparency) Legending requirement does not apply to the trade of underlying security if

four months has passed since the original convertible security was issued.o Useful? The next accredited investor must also qualify for exemption (sophisticated)

Condition 4 – Trade is not a Control Distributiono Control block distributions have a different set of rules under section 2.8

Condition 5 – No Unusual Efforto Includes activities such as dissemination of soliciting material, formation of selling

grounds, sales to non-arm’s length purchases Condition 6 – No ‘extraordinary’ commissions

o Compensation cannont more than can be expected for other reselling of the size in question. BLG looseleaf (CB 333-34): the legislation itself does not elaborate on ‘unusual effort’ or ‘extraordinary commissions’, but the ASC Rules give a number of examples to describe these points.

Condition 7 – Selling Security Holder is an Insider or Officero This applies to selling in a non-control context. The seller must verify that they have

no reasonable belief that the issuer is in default of securities rules.o Deals with asymmetries of information between insiders and possible investors.

Seasoning Period Rule – Section 2.6 Main requirement is seasoning period for issuer (4 months)

o Note: seasoning period can be compressed by filing a prospectus – 2.7(2)o Other conditions similar to 2.5, except that there is no legending requirement, and no

restricted/hold period for purchaser What if the issuer is already a reporting issuer for several years when the securities are first

issued? As long as other requirements/conditions are met (see 2.5), then the security can be sold immediately (no 4 month term)

Questions Page 335 (Q3): Given that the seasoning period is reduced if the issuer becomes a reporting

issuer after distribution, does the seasoning period add anything of value to rules relating to when purchasers can resell under s.2.5?

o For reporting issuers: the seasoning period is a non-issue due to s.2.7o For non-reporting issuers: the seasoning period is a crucial hurdle. Investor needs the

issuer to become a reporting issuer, otherwise securities cannot generally be resold.o Rule therefore could be drafted differently for reporting and non-reporting issuers.

Page 336 (Q2): when do the resale rules apply to private issuers? o Example : Issuer XYZ qualifies to be private issuer according to definition in NI 45-

106 s.2.4. XYZ has 20 securities holders, A, B, and C are directors of XYZ. D is a close personal friend of A (being close friend of issuer is characteristic for buying private securities from issuer). E is a close personal friend of B

o XYZ corp. issues securities to F, a close friend of C Fine: F qualifies as a close friend, and there are still less than 50 total security

holders in XYZ. Sequential transactions by issuers can still qualify for a PI exemption, so long

as PI retains the status of a private issuer.o D (XYZ security holder) wishes to sell to E. Is this OK?

Yes. Disclosure requirements are not engaged, since the resale is to another accredited investor. (Remember PI must still be a PI [less than 50 security holders] after transactions)

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o XYZ does an IPO in March, 2006. April 1, 2006, E wants to sell her securities. Resale rule 2.6 applies (since PI is a 2.6 resale rule) Seasoning period was met since a prospectus was filed, therefore E can sell.

Resale Rules for Control Persons – NI 45-102 s.2.8 There are separate resale rules for control block persons, since control persons are held to a

higher standard than average security holders. Security sales by a control persona are still counted as a distribution – s.1 of OSA

Hypothetical: Control Persons Resale B becomes control block holder of XYZ, a private issuer, in Feb. 2006 XYZ does an IPO in March 2006 B wishes to sell securities in April, 2006

o B cannot sell, because the 4 month hold period is not met (2.8)o Note: if B was not a control block holder, B could have sold right away in March,

since the 2.6 seasoning period would have been met for the private issuer exemption.

Manner in which a control block holder can sell securities from their blockStrategy Description Conditions to Use Rules to FollowIssue a Prospectus

Not normally feasible due to cost, but sometimes done as a ‘tag on’ when an issuer is also filing a prospectus

Standard Prospectus Requirements

Discretionary Exemption – OSA s.74

Obtain an exemption from regulators to sell securities on the secondary market.

Not normally allowed due to purposes of securities law policy

Use another prospectus exemption

Use any other prospectus exemption, like one listed under NI 45-106. Benefit: the 4-month hold period under 2.8 could be avoided.

The seller (control block holder) needs to find a buyer who qualifies for an exemption (like an accredited investor)

This only works for exemptions that don’t set out who the seller can be (selling to accredited investor most likely)

The buyer would face restrictions based on the corresponding resale rule (2.5 or 2.6)

Use SpecificControl Person/Block Exemption – NI 45-102 2.8

Special exemption for control block persons / block which does not trigger the resale rules. Advantage: buyer does not need to be an accredited investor, and faces no further restriction in reselling.

5 conditions for a control person to be able to sell: (1) Seasoning period (though 2.7 applies which can erase this), (2) Hold Period (2.9(3) sets out time for convertible securities – combine underlying and convertible security time), (3) No unusual effort to market, (4) No extraordinary commission, (5) Seller has no reasonable grounds to believe issuer in default of securities law

Beyond the conditions, there are filing requirements in 2.8(3). At least 7 days Pre-trade, CP must file form 45-102F1 on SEDAR (must be certified and signed). Post-trade, ITR must be filed within 3 days. Note also separate rules for ‘eligible institutional investors who are control block holders (maybe due to investments of their clients added together) - NI 62-103 and Part 4, NI 45-106

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Takeover Bids

Overview Takeovers occur (for purposes of securities law) when a corporation (bidder) makes an offer

to purchase more than 20% of the outstanding shares of another corporation (target)o This is different than an amalgamation/merger or a sale of all or substantially all of a

business’ assets. Takeovers can be ‘hostile’ or ‘friendly’

o Hostile bids are less likely in Canada because it is more likely that a Canadian company will have a control block holder compared to the US.

Consequences of changing shareholder identity (by takeover)o In change of control, the successful bidder almost inevitably puts in place its own

board. Therefore questions are sometimes raised whether directors of the target are acting in their own self-interests when they engage in defensive tactics.

o Often, the interests of other stakeholders in the target go unconsidered (such as employees, towns where the target is located, etc).

Motivations for takeovers: business expansion, diversification by the bidder, the removal of competition in key markets (subject to competition law), to make the target more efficient and unlock value, synergies and efficiencies in the bidder’s business, for tax purposes, etc.

o Canadian legislation is clearly structured to encourage takeover bids based on the assumption that they are good for the economy.

o However, note that takeovers face competition law challenges in Canada, where our economy is quite concentrated (so many takeovers are therefore anti-competitive).

Types of consideration offered in takeovers:o Case, shares (valuation a key issue), or combination of the two.

Governance and the duty of the target boardo The board of the target must comply with securities legislation (Part XX of the OSA,

and NP 62-202) and fiduciary duties under corporate law. Protections afforded to target shareholders have developed by Caselaw and statute to:

o Give shareholders ample opportunity to change their mind if consider various bids and change their mind if they decide to withdraw their shares after tendering.

There have been recent reforms increasing the time periodso Be treated equally in terms of the consideration that the bidder offers to them.

Note the approach in the US, where the price often drops later in the bid as incentive for shareholders to tender early.

o Be able to make fully informed decisions But is disclosure actually a misplaced concern? Disclosure increases the cost

in a takeover bid and reduces the efficiency gain. History and Process Issues

o Kimber Report in 1965 made recommendations which were adopted, including: Insider trading restrictions in anticipation of a takeover Definition of takeover and establishment of the 20% threshold Allowance for changes of control by private agreement Establishment of 21 day period during which a takeover bid must remain open Implementation of pro rata takeup rules Requirement to provide shareholder lists and information regarding financing Variations to the offer price and takeover bid circulars.

o Updates and changes occurred since the Kimber Report: 1970 Report of the Committee of the OSC 1983 OSC Report prepared by ‘the report of the three wise men’ 1996 Zimmerman report to the OSC. Major changes:

Minimum deposit period extended from 21 to 35 days Bidder can begin bid by placing ad in financial newspapers (w/

circular mailed within 2 business days) Takeover legislation is generally harmonized across Canada.

o Unique element for Ontario and Quebec: conflict of interest transactions regulated by OSC Rule 65-501 (Relevant to related-party transactions, going-private transactions, issuer bids, and insider bids)

Are regulatory bodies or courts the appropriate forum for hearing disputes that arise in the context of a takeover bid? Re CW Shareholdings v. WIC Western International (1998 OSC)

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o Bidder complained of target’s defensive tactics (crown jewel sale) to OSC. Target argued that courts were appropriate place to review, not regulator. Decision: while commission has authority to oversee dispute, court is proper place based on a public interest test: If the matter is a public interest matter that concerns all shareholders, then the securities commission, with its power to regulated public markets, may be appropriate. If the matter is a private interest matter between a shareholder and the company, the courts are in a better position to adjudicate due to the judicial process (pleadings, examination for discovery, better remedies, etc.)

Definition of a Takeover Bid Section 89 of the OSA: “take-over bid” means an offer to acquire outstanding voting or

equity securities of a class made to any person or company who is in Ontario or to any security holder of the offeree issuer whose last address as shown on the books of the offeree issuer is in Ontario, where the securities subject to the offer to acquire, together with the offeror’s securities, constitute in the aggregate 20 per cent or more of the outstanding securities of that class of securities at the date of the offer to acquire.”

o ‘Offer’ can come from the bidder (offer to buy) or from the target (acceptance of offer to sell) (section 91)

o Note reason why definition includes equity securities: often, equity securities (like preferred shares) can convert into voting shares, and this is often triggered when a takeover bid is launched.

o Note that securities being acquired must be ‘outstanding’: this means that the offer is not being made to the issuer to issue more securities from the treasury.

o Note that a bidder does not need to hold less than 20% with the plan to own more than 20% for there to be a takeover. If you start off above the 20% threshold and plan to acquire even 1 additional share, then takeover rules are triggered

Global Assessment to reach 20% : Counting rules dictate that securities convertible into the relevant class (usually the voting class) within 60 days, or securities that offeror may or must acquire within 60 days by exercise of option or right are deemed to count towards the 20% threshold - OSA 90(1)

There will be a global assessment of the bidder’s stake in the target to determine when the 20% is met.

o Two or more parties cannot divide up the number of securities that they are bidding for in order to avoid takeover bid rules – OSA 90(2)

If two or more parties are acting jointly or in concert with each other to acquire the target, their securities will be counted together toward the 20%. See Section 91:

o “91.(1)  For the purposes of this Part, it is a question of fact as to whether a person or company is acting jointly or in concert with an offeror and, without limiting the generality of the foregoing, the following shall be presumed to be acting jointly or in concert with an offeror: (formal or informal agreement/commitment/understanding, or any associate or affiliate)

Note anti-avoidance rule re ‘indirect offers’ in section 92: o “a reference to an offer to acquire or to the acquisition or ownership of securities or to

control or direction over securities shall be construed to include a direct or indirect offer to acquire or the direct or indirect acquisition or ownership of securities, or the direct or indirect control or direction over securities, as the case may be.”

A, a holding company, has a majority stake in B. If C makes an offer to acquire A, then C may be considered to make an indirect offer to acquire B.

Launching a Takeover Bid Following Zimmerman, there are 2 ways of launching a takeover bid:

o Delivering a circular to all shareholders (OSA 100(2))o Publishing an announcement of the takeover bid in a major daily newspaper.

If pursued, a copy of the bid must be delivered to the target company’s office (OSA 100(7)) accompanied by a takeover bid circular (OSA 98(1))

Within 2 days of receiving a list of the target’s shareholders, bidder must also deliver circular to all shareholders of the target.

For both options, a circular must be delivered:o 98.(1) An offeror shall deliver, with or as part of a take-over bid or issuer bid, a take-

over bid circular or issuer bid circular, as the case may be.

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Under (2) and (4) there is an obligation to send out a notice of any variation (though not exactly a material change requirement – no market impact analysis, just reasonably expect to affect)

o 95(1)1. The bid shall be made to all holders of securities of the class that is subject to the bid who are in Ontario, and delivered by the offeror to all holders… of securities of that class and of securities that, before the expiry of the bid, are convertible into securities of that class.

Bidders prefer a quick process, while targets prefer a longer bid period. Allowing commencement of a bid by advertisement is a major advantage for bidder.

o 35-day period begins to run the date the bid is commenced – an announcement can typically be placed 10 days earlier than a bid document can be mailed.

o See example of a public announcement – page 490 CB

Equity, Disclosure, TimingEqual Treatment: Important for the market being perceived as fair, democratic, and functioning in the best

interests of investors. However regulators don’t want too many protections, which can imbalance capital flows, lead to imperfect competition, reduced innovation, etc.

2 main provisions ensuring equal treatment :o Pro Rata Takeup in ‘partial bid’: If more shareholders tender than the bidder desires,

the bidder will take up the shares on a pro rata basis so that the bidder will purchase the same proportion of shares from all tendering shareholders (OSA 95(7))

Replaced the old ‘first come, first served’ system.o Identical Consideration: all holders of the target’s securities shall receive identical

consideration. Groups of shareholders (like a control block) cannot receive additional consideration, even the non-monetary kind (OSA 97)

If consideration is increased later in the bid, there is a requirement to pay the higher consideration to the earlier tenderers

Pre-bid consideration rule – section 94(5)) If the bidder makes offers before the bid to security holders to generate

momentum for the bid before the formal takeover, the amount offered in the formal takeover must be the same amount.

Exception : A good faith reason for making a separate arrangement to a CEO to pay them slightly more money (for instance, for stability) may be allowed.

Disclosure: Disclosure is the cornerstone of investor protection: it ensures shareholders have full

information about the bid and the bidder. All shareholders are granted equal access to: Circulars : Circulars are required by the bidder and the target:

o Takeover Bid Circular : must be sent to shareholders when the bid is commenced, or as soon as a shareholder list is available after the bid is commenced by advertisement. Bidder can modify the bid, but this requires a notice to be delivered to every target shareholder (whose shares were not taken up at the date of the variation)

Form: Regulations to OSA, Form 32 (Page 305 of Consolidation): Item 15 : if part of offer is securities of the bidder, then prospectus-

level info about bidder is required. Item 18 : disclosure of plans that would equal material changes in the

affairs of the target (including asset sale, amalgamations, management/personnel changes, etc.)

o Director’s (of Target) Circular : After bid commenced, the target’s board have an obligation to prepare a director’s circular and deliver it to target shareholders. (OSA 99(1)). Circular’s most important feature is a recommendation to target shareholders to either accept or reject the bid (though legislation permits no recommendation)

Information included (prescribed by Regulations to OSA, Form 34) Item 7 : Relationship between target board/management and bidder (ie

compensation to target board) Item 10 : Trading by managers and directors Item 12 : Material changes in the target Item 14 : Recommending acceptance or rejection of bid

Directors circular must be delivered within 15 days after the date of the bid.o Enforcement : Consequences of not filing punishable under OSA 122(1)

Liability for misrepresentation (OSA 131(1)) and for directors (OSA 131(2))

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Applies to circulars from both the bidder and the target. If contravention of securities law violates the public interest there can be

administrative action (OSA 127) or court action (OSA 128) Early Warning’ System : OSA s.101 requires any person who acquires control over 10% of

voting or equity securities of an issuer to issue and file a press release.o 101(1) Every offeror that acquires beneficial ownership of, or the power to exercise

control or direction over, or securities convertible into, voting or equity securities of any class of a reporting issuer that, together with such offeror’s securities of that class, would constitute 10 per cent or more of the outstanding securities of that class,

Note how rule covers equity and voting securities because equity securities often can convert into voting securities, and often the conversion is triggered when a takeover is launched.

(a) Shall issue and file forthwith a news release containing the information prescribed by the regulations; and

Content set out in NI 62-103, Part 3 and Appendix E (page 2239) (b) Within two business days, shall file a report containing the same

information as is contained in the news release issued under (a). o Once 10% has been reached, every further increase of 2% of outstanding securities

requires a press release – OSA s.101(2)o Why have the early warning system? Prevents a bidder from getting a ‘toe hold’ in an

issuer in advance of a formal takeover, thus avoiding paying premium on some shareso Note: the US has a 5% threshold for the early warning system, and studies have found

that this decreased the number of takeovers, which market economists have criticized. Exemptions from Early Warning System – NI 62-103: Exemptions are granted for mutual

funds or ‘eligible institutional investors’, entities that have an increase in a class of securities that arose solely due to certain actions of the issuer, and underwriters (if shares owned only for underwriting purposes). Despite the exemption, news releases are often still required

o The exemptions cannot be used if one of the eligible institutional investors intends to make a formal takeover bid for the target’s securities.

o Also, there is the possibility of discretionary exemption under Part 11 of NI 62-103

Timing: The 35-Day Rule – Take-up and Payment A takeover bid must remain open for at least 35 days (OSA 95(2)) Bidder is not generally permitted to take up, or accept for purchase, any shares deposited by

tendering shareholders during the 35-day period (OSA 95(3)). Shareholders who have deposited shares are permitted to withdraw them (OSA 95(4))

Note that the bidder is still able to make market purchases of the securities (these are acquired outside the bid, and on the market):

o 94(3) Despite subsection (2), an offeror making a take-over bid may purchase, through the facilities of a stock exchange recognized by the Commission for the purpose of clause 93 (1) (a), securities of the class that are subject to the bid and securities convertible into securities of that class commencing on the third business day following the date of the bid until the expiry of the bid, if,

(a) the intention to make such purchases is stated in the take-over bid circular; (b) the aggregate number of securities acquired under this subsection does not

constitute in excess of 5 per cent of the outstanding securities of that class as at the date of the bid; and

(c) the offeror issues and files a news release forthwith after the close of business of the exchange on each day on which securities have been purchased disclosing information prescribed by regulations. 

Tensions: shareholders take comfort in knowing that they can withdraw their decision to deposit, but bidders look forward to the time where shareholders can no longer change their minds about the decision to tender.

Offeror has to take up securities not later than 10 days after the expiry of the bid (OSA 95(9)) Once taken up, selling shareholders must be paid within 3 business days (OSA 95(10))

If bidders do not get enough shares during the 35-day period, they can extend the date on which the offer will expire. However, bidders are only permitted to extend the bid if the securities previously deposited are first taken up – OSA 95(12)

o However bidders do not have to take up tendered shares if the shareholders still enjoy the right of withdrawal – OSA 95(12.1)

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o Remember pro rata apportionment if the bidder has more shares tendered that actually desired (OSA 95(7))

Bid Conditions Bidders can have conditions on their takeover offer. Guiding Rule: the fewer the conditions

the better (from the bidder’s point of view). Keeping the bid simple can make it easier to persuade target shareholders to tender.

Note: there cannot be conditions concerning financing (OSA s.96) (same as US approach)o Recent decision: BNY Capital v. Katotakis [2005 ON SC]: sets out the test for

‘adequate arrangements for financing’ means (from s.96): Means accurate, clear, and unequivocal assurance that the financing is in place. A public shareholder can be unequivocally assured that the funds are available to complete the transaction.

In this case, adequate arrangements were not met OSC Rule 62-503 (came into force in January 2006) (pg.2248 of consolidation)

o Reduces the uncertainty of Katotakis (which set very high threshold): there can be conditions in financing, but there must be reasonable belief by the bidder that the financing conditions will be met.

Re Canfor Corp (1995 OSC) – Page 496 The consideration offered by Canfor is deposit receipts, not Canfor shares. The Canfor bid

does provide for the taking up of deposited Slocan shares by the issuance of transferable Deposit Receipts. The take-up occurred within the 3-day window. Therefore valid.

Commission found that Canfor inadequately disclosed that the method of avoiding a change of control for the purposes of the Forest Act. Canfor should have done more to disclose the length and complexity of the approval process under the Forest Act

o In violation of Item 19 on Form 32 (OSA Regulations) While the court cautions that the director’s circular will not always remedy disclosure

problems, the court found that the director’s circular remedied the disclosure problem in the present case. No additional remedies are required.

The bid is not so abusive to investors or capital markets as to warrant intervention by section 127(1) of the Act (withdrawal right) or cease trade.

o Note, however, that the commission did extend the bid period by 10 days to give Slocan shareholders more time to consider the bid.

Exemptions from the Takeover Bid Requirements – OSA Section 93

Exemption Section Description RulesStock Exchange Bids

93(1)(a) and 93(4)

Bids made through the facility of stock exchanges are generally exempt from securities rules, but are subject to similar stock exchange rules

Under TSX rules, bids still require notice, must be filed, must be distributed to all CDN shareholders, details must be disseminated to media, and target directors must make recommendation. No conditions (other than max shares) are allowed.

Normal Course Purchase

93(1)(b) Allowances for a holder of 20% or more of a class of shares to make modest purchases if made in the normal course

Rule provides that (1) purchase price does not exceed market price, and (2) only 5% are purchased in any one-year period

Control Block Purchases under Private Agreement

93(1)(c) Transfers of control through the sale of control blocks for a premium are allowed under a private agreement as long as the premium is not substantial and the offer is made to five or fewer persons. Not widely used, as most control holders want substantial premium. Widely criticized when introduced, but needed due to many control companies in Canada.

Premium is substantial if it is 15% above the prevailing market price (regulation 183), and regulators make sure bidders don’t artificially increase price through repeated trading ahead of bid.

Closely Held Company

93(1)(d) Provided where the number of security holders of the class sought is less than 50, the bid is not for the shares of a reporting issuer, and there

The flipside to the private issuer prospectus exemption.

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is no published market for the securities subject to the bid.

Limited Relevance to Jurisdiction (de minimis)

93(1)(e) Exception when takeover does not involve many Ontario residents.

Less than 2% of securities of class held in Ontario, fewer than 50 holders of the securities in the province, bid is made in compliance with laws of other jurisdiction, and security holders in province still get material related to bid.

Discretionary Exemption Application

104(2)(c) Allow for an application to the commission for an exemption from takeover bid regulations where an enumerated exemption does not apply and such an exemption would ‘not be prejudicial to the public interest’

Example: bid may comply with de minimis, but 3% of securities are held in Ontario. Would grant exemption.

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Takeover Bids: Defensive Tactics

Types of Defensive Tactics For various reasons, the Board of the target may decide that a bid is inappropriate, and may

employ a variety of defensive tactics. Due to the conflict of interest potential, there are rules that govern this behaviour: NP 62-202

Note: the board cannot just say no to a takeover bid, but can engage in defensive tactics.o Tactics ‘buy time’ to consider the bid or seek alternatives.

Note on the Canadian Market:o Unlike the US, Canadian public companies are generally not as widely held. US

companies are more likely to adopt tactics that affect a broad range of target shareholders (like poison pills or issuer bids) while Canadian boards are more often responding to the interests and concerns of the controlling shareholder, through break fees or sale of the crown jewel.

Usually, when a target of a bid, the board will set up a committee of independent directors to review the bid in order to avoid conflicts of interest.

White Knight Target board finds a competing bidder that generates a better option for shareholders, and

hopefully increases the bid. Is the board really acting in the best interests of shareholders when finding a competing bid ?

This can be an issue when the white knight’s bid is not financially superior. The board may argue that it is still preferential by leaving the business, its assets, and stakeholders in tact.

Often a white knight will also negotiate other defensive tactics with the target board, including break fees for making their bid.

Poison Pills or Shareholder Rights Plans (SRP) SRP works in the following way:

o Characteristic is added to the class of the shares that are the target of the bid (before the bid occurs). Dominant feature is that if a bid is made for the shares of that class, the holders of the shares of that class will be able to buy additional securities from the issuer of the security at a huge discount.

o This has the effect of flooding the market. Most importantly, the bidder is excluded from the bidder for the shares.

SRP will also usually allow a ‘permitted bid’ that does not trigger the operation of the SRP. Usually, a permitted bid is negotiated with the target board over the terms of the bid.

o Existence of the SRP is meant to deter hostile takeoverso MANY Canadian companies have poison pills in place

Issue : Is an SRP legal or appropriate when it excludes a bidder from an SRP plan, even though they are likely already a shareholder?

o Corporate law says that members of the same class cannot be treated differently.o Usually, regulators say that the SRP is legitimate, but only for a set period of time (to

allow the target to find a white knight) and not indefinitely.

Sale of Crown Jewel (Asset Option) Bid can be defended if major asset (desire of bidder) is sold off to someone else. Raises serious fiduciary issues: if asset is sold off at less than FMV to deter a bid, is this in

the best interests of shareholders? (see Western International v. WIC)

Litigation Preventing the bid through litigation, such as accusation of violating the competition act,

takeover rules (Canfor). Litigation delays and possibly thwarts the bid process Bidders have also gone to court, saying that the actions of the target board are oppressive.

However the courts have been reluctant to accept this argument (Rogers)

Issuer Bid Issuer may bid for its own shares, which would be in competition with the hostile bid. Enhanced disclosure requirements for issuer bids are governed by NI 61-501.

Break Fee – Page 512

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Board of target may sometimes offer an inducement to a competing bidder: even if the competing bid fails, the target will still pay them. This is typically in the order of 2%-3% (up to 5%) of bid value. If hostile bidder wins, paying the break fee increases the cost of the bid.

Note: Break fees do not involve the potential issuance of securities. Instead they are a corporate contract. Unlike poison pills, securities regulators do not have the jurisdiction to strike down the contract itself. However they can still regulate the bidder:

o Securities regulators only interfere if the break fee does not strike a reasonable commercial balance between marketing stimulator and market inhibitor (WIC CB 515). Securities regulators have never disallowed a break fee.

o Other actions available to shareholders who wish to challenge break fees are oppression remedies or derivative actions.

NP 62-202 – Guidelines for Defensive Tactics The primary objective of takeover bid law in Canada is to protect to bona fide interests of

target shareholders. However this is a policy, not an actual instrument.o Since the NP itself is not binding, securities regulators will intervene in a takeover

under section 127 of the OSA (public interest) Targets may adopt defensive tactics but they must not deny shareholders choice and must not

frustrate the open bidding process. Three types of actions may attract regulator scrutiny:o SRP; sale of Crown Jewel; Break Fees.

Role of Regulators versus the Role of the Courts There is a different focus of courts and regulators. Courts look at the best interests of the

company, while the regulators look more specifically at the interests of the shareholders.o These two interests may be identical, but they may also be different.

Often, if a target erects a poison pill, the bidder will contest it in front of regulators. The issue is brought to regulators because the bidder will want a cease trade order to prevent the triggering of the pill, since it involves securities issues (see Royal Host)

However if a target tries to sell an asset, then the court is likely a better place to resolve the issue than the regulators, since it is a corporate law issue dealing with contracts and duties.

Case Law – Guidelines for Target’s Use of Defensive Tactics

Re CW Shareholdings v. WIC Western International (OSC and GD 1998) – Page 513Crown jewel sales and break fees are appropriate defensive tactics when they strike the balance between auction inhibiting and stimulating and are in best interests of the target shareholders. Issue : Break fees are appropriate when:

o They are necessary in order to induce other bids;o The bid represents a better value to shareholders; and o Break fee strikes a balance between auction inhibitor and stimulator.

Issue : Test for Crown jewel sale: Does the sale of the crown jewel operate as an option stimulator or an option inhibitor? Page 516: Relevant factors in assessment:

o Was process in deciding to sell asset free of conflict of interest and in good faith?o Whether the overall commercial balance and proportion between auction inhibiting

and stimulating has been struck? Ie is sale likely to preclude further bidding?o Whether the price for the asset is reasonable, and whether it would result in

disproportionate erosion in the value of the corporationo Whether the competing bid induced by asset lock-up provides enough additional

value to the shareholders to justify the granting of the option

347883 Alberta Ltd. v. Producers Pipelines (1991 SK CA) – Page 517First case on SRPs, and the court developed a proportionality test. Here, the SRP was set aside. Facts : Producers was a publicly traded company. Alberta launched a hostile takeover for

Producers. Producers board employed a number of tactics in response, including an SRP without shareholder approval and an issuer bid.

o Alberta complained that it was unfair that an issuer bid could be launched and concluded while the SRP remained in effect.

Issues : Two competing views on poison pills:o Shareholder Interest : pill stops shareholders being coerced into accepting a low bid.

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o Management Entrenchment : management often loses their job in a hostile bid, and a pill may be used to preserve their tenure.

o Other issues: power of directors to act without shareholder approval in a hostile takeover, duties of directors to act in best interest of corporation and shareholders, and the right of shareholders to choose the disposition of their shares.

Decision : Appeal allowed. SRP set aside and dates of issuer bid extended to enable other bids for Producers. Directors must act in the best interests of the corporation, and their actions must be reasonable in relation to the threat posed.

o Demands of a high, all-cash offer were effectively impossible to meet. The terms were so onerous that a takeover bid was effectively prohibited.

o Issuer bid was forced on the shareholders and they were effectively coerced into accepting it (if they wanted to get any value out of their shares they had to accept)

Re Royal Host Real Estate Investment Trust (1999 OSC) – Page 524Leading Case on SRPs (unit holder rights plan here). Case sets out factors to determine when a pill must be removed, but these factors must be applied to the specific facts of the case. Issues : should the rights plan (for unitholders) be removed?

o Tension between allowing the board to fulfill their duty to act in the best interests of the corporation and the rights of a shareholder to decide to sell their shares in a bid

Decision : Determining the validity of an SRP is contextual and depends on several factors:o Nature of the bid: was it coercive or substantially unfair in some way (Regal)o Whether shareholders approved of the rights plano When the plan was adoptedo Whether shareholders broadly support the plan’s continued operationo Size and complexity of target companyo Other defensive tactics implemented by the targeto Number of potential viable offers for the targeto Steps taken by target to find alternative bidderso Likelihood that, if given more time, the target will find a better bido Length of time since the bid was announced and madeo Likelihood that the bid will not be extended if the rights plan is not terminated.

Responsibilities of Target Directors – Page 529 The old test for the actions of a target board in a hostile takeover was the ‘proper purpose’

test, but this test was reformulated to be the ‘best interests of the company’ test (Teck v. Milar 1972). In both cases, the directors will have had to act ‘properly’

Peoples v Wise: the SCC said that directorial duty is not owed to any particular shareholder, but to the corporation as a whole.

Re CW Shareholdings v. WIC Western International (GD 1998) – Page 530When a company is in play, boards have a duty to take active and reasonable steps to maximize shareholder value. The actions of the target board are reviewed by the business judgement rule Normally, the duty of the board is to the best interests of the corporation. When a company is

in play, boards have a duty to act in the best interest of shareholders as a whole and take active and reasonable steps to maximize shareholder value by conducting an auction.

o The duty must be undertaken while also trying to reduce conflict of interest as much as possible. Conflict of interest reduction is normally achieved by hiring independent legal and financial advisors and setting up special committees.

Blair’s discussion, page 534: Boards are subject to the business judgment rule, not the ‘enhanced scrutiny’ rule used in the United States.

o There is not a standard of perfection, only that decisions that were made were reasonable and informed, in good faith, honestly, and prudently.

Maple Leaf v. Schneider (1998 ON CA) – Page 535In order to maximize shareholder value, an auction may or may not be appropriate. When a company is in play and there are many bidders, an auction is appropriate. If only one bidder, canvassing the market may be appropriate. Case re-affirms the business judgement rule. Note that the court in this case is influenced by the controlling shareholder, who made its

views clearly known, meaning that the company was not really ‘in play’ Note the US position: in Revlon, the court said that when a company is up for sale, the

directors have an obligation to conduct an auction.

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Here, the court agreed that Schneider was not really ‘in play’ since the controlling shareholders refused to accept a bid from any bidder except Smithfields.

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Enforcement and Public Interest Considerations

Overview Securities enforcement in Canada can be distinguished by criminal enforcement (Criminal

Code and quasi-criminal powers under securities legislation), administrative enforcement, and civil enforcement.

o Only administrative enforcement provides for the provincial regulator to be the ultimate decision maker.

o The role of regulators in enforcement may change as the federal government devotes more resources to securities enforcement. The federal government recently created the integrated market enforcement team (IMETS)

o Self-regulatory organizations also play a role in enforcement, including RS.

Investigation Powers under Securities Law – Page 590

Scope of Investigation and Examination Powers Securities statute provides regulators with a range of powers of investigation and

examination. Under the OSA:o Section 11(1) (Investigation Order): “The Commission may, by order, appoint one or

more persons to make such investigation with respect to a matter as it considers expedient, for administration of securities law or market regulation in (a) Ontario or (b) another jurisdiction

o Section 11(3) (Scope of Order): A person appointed to make the investigation may investigate and inquire into, (broad scope to look at securities transactions, assets, and relationships of the person/company being investigated)

o Section 11(4) (Right to Examine): [documents or other things] whether they are in the possession or control of the person or company in respect of which the investigation is ordered or of any other person or company.”

o Section 12 allows the securities commission to order an examination of the financial affairs of a market participant.

These sections do not require evidence of any threshold level of suspicion on the part of enforcement staff in order to support the request for the order.

Once an order is granted under section 11 or section 12, section 13 gives the regulator power to compel testimony or document production: (same power as vested in the court – refusal to cooperate can make one in contempt of court)

o While section 13 includes a search power, the power does not extend to the search of private residences (section 13(9)). 

Safeguards for Subjects of Regulatory Investigation There are some boundaries to the reach of OSA investigation and examination powers. The

investigation order or any evidence that arises from it is strictly confidential (16(2)) Section 17 allows the commission to disclose the information described in section 16 only if

it is in the public interest.o s.17(5) allows a court hearing a prosecution by the OSC to compel production of any

of these materials and order their release to the defendant. Disclosure of testimony to criminal law enforcement requires the written consent of the

person from whom it was obtained. Section 18 says that testimony given under section 13 cannot be used against that person in a

prosecution for an offense under section 122.o Requires the OSC to be strategic: if they are pursuing a section 122 action they

should not interview the accused under section 13, but if they are pursuing a section 127 action they can still interview the accused.

It is still unclear as to whether the Charter provides (section 7 and 8 –reasonable expectation of privacy) applies when a securities action is primarily penal.

o When the offence is not penal, there is not a reasonable expectation of privacy since securities are so heavily regulated (Branch, SCC 1995).

Deloitte & Touche LLP v. OSC (2003 SCC) Pursuant to Rule 3.3(2) of the OSC rules of practice, OSC staff is required to disclose to a

defendant all ‘relevant’ material in its possession.

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o OSC staff decided that the compelled material from Deloitte was relevant and therefore should be disclosed to Philip (accused)

Staff sought an order from the OSC to disclose the information to Philip under section 17(1) and Deloitte opposed disclosure unless and until staff could demonstrate relevance.

Issue : What is the role of the OSC in disclosing compelled testimony to defendants in an OSA section 127 proceeding? Is disclosure to a defendant in the public interest?

Decision : The decision of the OSC to order disclosure must be made on the standard of reasonableness. Here, the decision to order disclosure was reasonable and should be upheld.

The OSC reached its decision by considering the relevance of the information. Factors applied to determine relevance included:

o Nature of the allegationso That the evidence had been produced subject to an OSC investigationo Indices provided by Deloitte in describing the fileso Representations by OSC staff that at least 2 of the defendants indicated they planned

to challenge the credibility of Deloitte in the s.127 proceedingo Some of the compelled material would be relied on by Staff in presenting its case.

Criminal Code Enforcement – Page 595 It is a federal offence to use a false prospectus, as well as buying and selling to engage in the

appearance of market activity, and insider trading Relevant sections include sections 380-384 and section 400.

o Section 380(1) makes it an indictable offence to defraud the public of more than $5000.

o Section 380(2) makes it an offence to manipulate the market price of securities with the intent to defraud.

o Section 382 makes it an offence to manipulate stock exchange transactions to create false or misleading appearances of active public trading.

o Section 400 makes it an offence to make a false prospectus with the intent to defraud Bill C-13 recently increased maximum sentences for some offences from 10 to 14 years and

also included ‘aggravating circumstances’ which may make the violation more serious. New offence for insider trading and tipping under section 382.1. However it will be very

difficult to prosecute someone under this new offence due to ‘knowingly’ standard. Reality is that people are hardly ever prosecuted under the criminal code, however it signals

that lawmakers take securities laws very seriously

Quasi- Criminal Offences – OSA Section 122 (Page 597) 122(1) Every person or company that,

o (a) makes a statement in any material, evidence or information submitted to the Commission, a Director, any person acting under the authority of the Commission or the Executive Director or any person appointed to make an investigation or examination under this Act that, in a material respect and at the time and in the light of the circumstances under which it is made, is misleading or untrue or does not state a fact that is required to be stated or that is necessary to make the statement not misleading;

o (b) makes a statement in any application, release, report, preliminary prospectus, prospectus, return, financial statement, information circular, take-over bid circular, issuer bid circular or other document required to be filed or furnished under Ontario securities law that, in a material respect and at the time and in the light of the circumstances under which it is made, is misleading or untrue or does not state a fact that is required to be stated or that is necessary to make the statement not misleading;

o (c) contravenes Ontario securities law, Is guilty of an offence and on conviction is liable to a fine of not more than $5 million or to

imprisonment for a term of not more than five years less a day, or to both. Section 122(2) gives an accused person a due diligence defence if the violation was not

known and could not have been known when committed if reasonable efforts were made. Note also section 122(3): Directors and officers can be prosecuted for acquiescing in an

offence, even where the company is not even being prosecuted. Note section 122(4) re insider trading

o Additional sanctions for contravention of section 76, the insider trading rules. Note update re offences in section 126.1 & 126.2

o New offences for fraud and market manipulation

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In general, there has not been a lot of enforcement actions under section 122 due to the higher criminal burden of proof, however more enforcement is now occurring.

General prosecution under section 122:

R. v. Zelitt (AB 2003) – Page 599 Facts : Zelitt lied that his company was developing 3D imagining technology. Decision : Zelitt is liable. In order for untrue statements or omissions to be misrepresentations

within the meaning of the securities act, they must relate to a material fact as defined by the Act. Here, his statements were material facts and were misleading.

o Ie must have a significant effect on the market price or value of the securities market impact

Zelitt was sentenced to 4 years in prison, a fine of $1.85 million, and prohibited in trading in securities or serving as a director or officer for 25 years.

o Court considered deterrence, denunciation, and protection of the publico Contributing factors: behaviour, breach of trust, magnitude and impact of violation

Insider Trading Prosecutions under section 122(4)

R. v. Harper (2003 ON CA) – Page 601 (Rankin also a 122 enforcement) Issue : Section 122 makes an accused liable “to a minimum fine equal to the profit made or

loss avoided by the person or company by reason of the contravention”o On sanction, Harper argued that the prosecution had to demonstrate that the loss

avoided was by reason of his contravening insider trading rules (page 601) Decision : Court of appeal said that you don’t need to show that loss avoided was by reason

of violation . Once the prosecution has proven that the insider trading rules were violated, and that a loss was avoided, that is sufficient.

o Direct causal linkage between nature of non-disclosure and fall or rise of stock price is not needed and not consistent with scheme or object of Act

Civil Enforcement Powers – Section 128 - Page 604 Provincial commissions rarely seek civil remedies from the court for securities law

infractions, which is different from the US, where civil penalties are increasingly common. Section 128 of the OSA allows the OSC to apply to the Ontario court for a declaration that a

person or company has not complied with or is not complying with Ontario securities law. If a court makes such a declaration, they can order compliance with the law, rescinding

transactions, requiring compensation or restitution, payment of damages, disgorgement, and the rectification of past non-compliance. Remedies are available in addition to section 122 or 127 remedies, though it is inconceivable for the OSC to pursue them all.

Administrative Enforcement Powers – Section 127 - Page 605 Section 127 is within the power of the regulators to apply. There is not a criminal standard of

proof. Regulators may make orders if it is in ‘the public interest’ to make them.o Public interest is interpreted in accordance with the regulator’s statutory mandate.

Making an order in the public interest does not require a breach of securities law, and it is also possible to make an order where there is quasi-criminal action on same matter.

o Making an order where there has also been a quasi-criminal action does not infringe on the accused protections against double jeopardy.

o See In the Matter of Glen Harvey Harper (2004) Harper prosecuted under 122 for insider trading, and also banned from officer or director for 15 years under 127.

Hearings by provincial regulators are typically governed by rules of civil procedure. The sanctions of section 127 are far less severe than sanctions under 122.

o It was only in the past few years that the regulators even got the power to issue fines

Variation in the Subject Matter of Public Interest Orders: Condon Study – Page 605 Different provinces exercise their section 127 powers differently:

o BC is focused on the sale of unregistered securitieso Ontario is focused on bad behaviour of registrants

Regulators across the country uniformly define the public interest that section 127 is protecting as the integrity of the markets and the protection of investors in the market.

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o Capital market efficiency, while important, has not been as much of a priority or factor when exercising discretion.

Recent Examples of Circumstances in which Enforcement Orders are Made – Page 607 Re Dix Jr. (2001 BCSCD) – Page 607: Distribution of securities to elderly people in their

homes without a prospectus or any independent third party review or oversight. L.O.M Medical (2004 BC): President of medical products company forced to pay $100K fine

and banned from trading for 10 years for selling $2 million in securities without a prospectus. Re WH Stuart Mutuals (2000 ASC): Stuart (a dealer) circumvented securities laws and was

given a lifetime ban for a first offence for general deterrence purposes Other examples: improper exemption use, failure to file documents in accordance with CD In the Matter of Nortel (2004 OSC) – Page 610: Cease trading order imposed on insiders

until Nortel deals with failure to file required documents (quarterly reports).

Enforcement Actions against Lawyers – Page 611 Under section 127, the OSC can reprimand ‘a person or company’. Wilder found that lawyers

can be reprimanded, however this is very controversial.

Wilder v. OSC (2000 ON GD) – Page 612 Facts : Judicial review of the OSC decision, which sanctioned the lawyer who was

responsibility for Filing YBM documents with the OSC. OSC alleges that Wilder made a ‘misleading misstatement of material facts’.

Issues : does section 127 have the power to reprimand a lawyer, or should the Law Society be the only entity that can discipline lawyers?

Decision : lawyers are subject to 127 as a ‘person’. Otherwise, the OSC would be unable to regulate capital markets appropriately (paragraph 20).

The Use of the Public Interest in the Absence of a Breach of Statute – Page 616 Very controversial : can the securities regulators make public interest orders absent an actual

breach of securities law? In BC, there must be actual breach of law in order to set down a fine

Re Canadian Tire Corp (1987 OSC) – Page 616Establishes the proposition that the securities commission can exercise its public interest powers even where the matter at issue does not involve a breach of the requirements of Ontario securities law. Facts : Involved a takeover transaction. Transaction designed to prevent coat-tail provision

from triggering, which meant most shareholders did not get to enjoy the substantial premium of the bid. Bid, while legal, privileged group of control block above others.

Issues : Is this an abusive transaction that should be prevented in the public interest under section 127 of the OSA (cease trading order)?

Decision : Securities commission says that this is an abusive transaction. While there is technical conformity to the rules, the commission protects the interest of non-voting shareholders. See excerpts starting at page 619.

o “The Legislature deliberately has given the commission a broad and unfettered power to move quickly to intervene in the capital markets to stop a trade or a transaction which it deems to be contrary to the public interest”

o The decision points out that the market is infinitely complex and dynamic, and that it is not feasible to have explicit rules for everything. That is why the regulator is given the power to rule on activities that are not actual breaches.

o Public interest, page 622: “If abusive transactions such as the one in issue here, and this is as grossly abusive a transaction as the Commission has had before it in recent years, are allowed to proceed, confidence in our capital markets will inevitably suffer and individuals will be less willing to place fund in the equity markets”

The Test : for the regulators to intervene absent an actual breach, there must be clear abuse of the markets, not just unfairness. The abuse must also raise a public interest issue.

o This rigorous test is to ensure that there is not undue uncertainty of regulator intervention, which could also harm the markets.

Note that this could also be dealt with by seeking an oppression remedy under corporate law, but securities regulators were used since a remedy could be reached much sooner.

o The court says that it does not need to consider corporate law when making an order, since it is more generally concerned with market operation. Evidence of breach of fiduciary duty cannot justify an order, but it is evidence that can support an order.

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Attempts to Structure the Discretion of Regulatory Officials – Page 626 With limited enforcement resources, regulators have set out criteria about when to pursue

investigations and full hearings. This is the ‘risk regulation’ approach OSC Staff Notice 11-719 (2002): guidelines for pursuing the potential breaches that appear

to have caused (or may continue to cause) the greatest harm to the integrity of Ontario’s capital markets, taking into account likelihood of successful resolution and resources required to reach resolution.

o Categories of Offences : Abusive trading (insider trading and market manipulation), abusive sales, deficient disclosure, failure to file, takeover bid issues, registrant misconduct, and sale of unregistered securities.

o Selection Criteria : nature of the activities, impact, urgency, investigative value, other factors, and diminishing factors.

Sanctions Available in Connection with Public Interest Orders – Page 628

Asbestos v. OSC (2001 SCC) – Page 629Regulators are required to keep in mind both the purposes of their governing statutes and where they are enumerated. Regulators are required to act in accordance with the philosophy underlying regulatory legislation in general, which is to protect societal interests rather than punish individual faults (protective and preventative rather than punitive) Court agreed that Quebec’s actions were abusive and manifestly unfair to minority

shareholders. However shareholders were not materially misled (asbestos was a speculative investment), that prevention would not have been a factor in a ruling, and that the transactional connection was insufficient to trigger section 127 sanctioning.

Paragraph 41: it is an error to focus only on the fair treatment of investors when deciding whether to exercise section 127, and the analysis should also focus on overall market efficiency and public confidence in the capital markets.

Section 127 is protective and preventative rather than punitive (though deterrence not really considered, even though it may have been relevant if applied generally to markets)

Re Cartaway Resources Corp (2004 SCC) – Page 636 Decision : General deterrence is a basis for making an order was in accordance with the

‘protective and preventative’ orientation of securities regulatory enforcement.o Conventional wisdom is that market players are rational actors, and if they see other

players are sanctioned, this will shape their behaviour The key is to note the distinction between general deterrence (of the public) and individual

deterrence (targeting the individual wrongdoer) The court notes that unreasonable weight given to a particular factor, including general

deterrence, will render the order itself unreasonable.o Example of unreasonableness would be a capricious or vexatious order

Convergence and Variation in Sanctioning Orders – Page 641 Most provinces have the power to order cease trading, and while most provinces can levy

fines, they may not all be able to levy the same maximum amounts. Few regulators have the power to order profits disgorged (Ontario has this power under

130(1)(10) Only Manitoba has the power to order restitution to investors. CSA Staff Notice 57-301 was an innovation in 2002 that allowed for regulators to issue

management-only CTOs. Before this notice, CTOs could only be made on all securities of an issuer. See Nortel as an example.

Judicial Review of Regulatory Decisions – Page 645

Donnini v. OSC (2003 ON) – Page 645 Decision : the court disagrees with many of the actions of the regulator, and the 15-year

restriction on trading that it imposed. Court reduces penalty to 4 years.o The court criticized the court for not levying a penalty which was more in line with its

previous decisions. Stare Decisis does not have to rigorously followed by tribunals, but it must not be completely ignored in order for there to be some predictability.

o The court criticized the tribunal for not explaining their claim for costs of $186K

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Note that when a party is sanctioned under section 127, they can be responsible for OSC costs of investigations, expert witness, staff, etc. These are levied under 127.1(4)

While courts must show deference to tribunals, but this does not mean that a court must accept whatever a tribunal concludes.

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