The Ontario capital markets welcomed with open arms the introduction of the offering memorandum exemption that was introduced January 2016. The exemption blew open access to the private capital markets to everyone with a pulse and a bank account.
The private market is often referred to as the “exempt market” as issuers (i.e., companies that issue shares) in the private market are exempt from many of the rigorous reporting requirements required of issuers in the public markets – those markets where an issuer’s shares trade openly.
An issuer in the public market must abide by numerous reporting obligations to the regulatory authorities and to the issuer’s own securities holders. An issuer in the public market can only issue its shares pursuant to a “prospectus” – a document that is reviewed by the regulatory authorities where the issuer chooses to sell its shares. A prospectus is a very detailed document that provides extensive disclosure about the issuer, the securities it is offering, the industry in which it is in, its directors and officers and other key information thought necessary for potential investors to have before making a decision to invest in the issuer.
Not so in the exempt markets!
Welcome to the Offering Memorandum Exemption
For individual investors, prior to the introduction of the OM exemption, the private market in Ontario had evolved into the preserve of the “accredited investor”. With respect to individual persons this boiled down to individuals of high net worth. Most commonly they subdivided into two groups: (i) people who earn $200,000 in current and past two years and fully expect to make the same in the forthcoming year or (ii) individuals who have net financial assets of $1,000,000 or more (for our purposes, cash and bonds only). There are numerous other subsets of accredited investors, but this is suffice for our purpose. There is no need to provide an offering document of any kind to an accredited investor. It is common to complete a transaction with an accredited investor on nothing more than a term sheet. They are unrestricted by how much they may invest.
With the introduction of the OM exemption in January 2016 (see National Instrument 45-106, s. 2.10) everyone who couldn’t qualify as an accredited investor, could now participate as either an “eligible” or “ineligible” investor. (Yes, it appears to be a paradox that an “ineligible” investor is actually eligible to invest!)
The offering memorandum exemption hangs on the issuer preparing a document that is akin to a prospectus in so far it provides some detailed prescribed information (meaning information required by law) about the issuer and the securities being issued by the issuer. Though the offering memorandum is filed with the regulators, it is only filed AFTER a trade occurs and it is NOT reviewed by the regulators. A prospectus is reviewed by the regulators to insure it complies with what is required by law; the regulator does not review the actual merits of the deal (i.e., whether it is a good invest or not). The offering memorandum is retained by the regulators for the purposes of audit and accountability.
Though an offering memorandum is not a prospectus, it is still a very complicated document to draft. An issuer can easily spend anywhere from $10,000 to $50,000 for a relatively simple offering document. For an issuer though it may make economic sense as now its offering can extend to so many more people. Not only can accredited investors subscribe under the Offering memorandum exemption but so can everyone else!
New Classes of Investors – the eligible “ineligible investor”
The offering memorandum exemption introduced two general categories of investors. The first is the “eligible” investor which includes the well known accredited investor and persons who purchase under the “Friends, Family, Business Associates Exemption”. It adds the investor who is an individual who makes $75,000 (or, together with spouse, makes $125,000) in the same time frames as the accredited investor above or has net assets of $400,000 (there are variations these tests for spouses, etc.). Corporations and trusts where a majority of the shareholders or trustees, as applicable, are individuals who qualify as eligible investors are eligible investors as well. The eligible investor can subscribe for up to $30,000 worth of security in any one year under this exemption, or, if the investor has the advice of a registered securities dealer (like Fundscraper for example), the investor may subscribe for up to $100,000.
The second category of investor, which is a seeming paradox, is the “ineligible investor”. Though described as ineligible, this investor is still able to invest in certain product offerings provided those offerings are carried out under the offering memorandum exemption. An ineligible investor is anyone who is not an eligible investor and does not have available another exemption under which to subscribe. An ineligible investor who is an individual person is limited to subscribing up to $10,000 in any one year under the offering memorandum exemption.
So, with an offering memorandum in hand, the issuer and its agent may feel the investor pool is deep! Not so.
Because an Investor Can, Does not Mean an Investor Should!
Though an issuer with an offering memorandum may get giddy about being able to solicit the world for its issue, there is a concurrent obligation on it and its agent that requires the issuer/promoter to assess whether the investment is suitable for the prospective investor regardless of who the investor might be.
What’s this?“Suitability” means more than simply checking a box. Regardless of whether or not an individual can make the investment because the potential investor has passed any of the financial thresholds set out in the exemption, does not mean the potential investor should make the investment.
An unsuitable investment is easy to define: a high probability of unacceptable losses (or inordinately low return) and considerable distress for the investor. Suitability is more than simply the inverse of that proposition.
What’s involvedSuitability involves assessing a potential investor’s willingness to assume risk, and, more importantly, the investor’s ability to carry the risk. Assessing whether an investment is suitable also entails looking at a prospective investor’s existing portfolio and understanding how a proposed investment may fit within it. Further, what does the investor want to accomplish through the investment being made.
Many financial advisors will say that suitability will generally come down to asset allocation. Does the asset allocation make sense for the potential investor at that point in time when the investor is making the investment decision.
Assessing suitability is not easy. Some basic knowledge of financial planning and retail investor portfolio construction is necessary. Understanding how various investments work within a portfolio is critical.
The consequence of turning a blind eye to suitability may result not only in a loss of licence for a registered dealer, but regulatory sanctions and investor lawsuits for both the dealer and issuer involved.
Meeting the New Ineligible Investor
A simple example. ABC Exempt Market Dealer Inc. (“ABC”) represents a broad array of exempt market offerings related to private real estate. Many of these offerings are relatively complicated yet common investment structures in which many Canadians are invested. With respect to one particular offering ABC receives the following enquiry.
Meet BobBob pops by the offices of ABC. Bob just heard about a deal through his good friend Tina who showed him a thick document called an “offering memorandum”. Tina, who incidentally was the director of finance at their house of worship, told Bob that it paid 7% per annum and was “a heck of a lot better than anything you’d see from a bank”. Bob always thought Tina very smart. He happened to have $10,000 to invest, and though Tina never told him that he should invest, if Tina thought it was the right thing, then he would invest! Bob was ready to pull the trigger, holding his cheque book in hand. Bob stated right up that he really didn’t know anything about investing, but he was good with anything Tina liked.
Bob’s FactsABC had Bob complete its “know-your-client” package that asks not only what Bob earns and what assets he owns, but what his investment portfolio looks like, how it is divided, Bob’s expectations, risk tolerance, investment experience, etc. Most of this was pure gibberish to Bob. Upon a review of the information Bob provided, ABC learned that Bob made $41,000 a year as a general contractor and has assets of $200,000, $10,000 of which was liquid cash available for investment. Bob wants a reliable stream of income because his monthly cash flow goes up and down. He also hopes to buy a new truck, but he tells you that can wait.
Well, immediately ABC knows Bob is qualified to invest in the product. This product has an offering memorandum which means the paradoxical group of “ineligible” investors may invest. Our proposed investor has $10,000 which, coincidentally, happens to be the maximum amount he can invest under the offering memorandum exemption. On one side of the suitability ledger Bob passes. At one time, that was enough – neither ABC or the issuer had any further obligation to the investor. Bob was free to go ahead and make his investment without further adieu!
The Suitability TripwireNot anymore. The regulators (in Ontario that includes both the Ontario Securities Commission and the Financial Services Regulatory Authority) now mandate that both dealers and issuers make documented assessments as to whether an investment is suitable for a potential investor. In respect of the OSC, see generally N.I. 31- 103, Part 13. Readers interested should also look at CSA Staff Notice 31-336, OSC Staff Notice 33-735, and for keeners, CSA Consultation Paper 33-403 (Note: This is a consultation paper and not the law. It is worthwhile reading through as it gives one a glimpse into the mind of the regulator.) All of this can be found on the OSC website. In respect of FSRA, see generally Ontario Regulation 188/08, section 24 and following.
Most of us instinctively know that Bob should be nowhere near this investment.
Why Bob Should Stay Away!The obvious reasons are (i) 100% concentration risk (this should never be greater than 10% the regulators suggest), (ii) Bob has no clue what he’s investing in (this should be enough to show Bob the door), (iii) though Bob has the cash to make the investment, he really cannot afford it and (iv) it doesn’t meet his investment objectives. We could list a dozen more.
- First, concentration risk needs no more comment – no one should have all their eggs in one basket. Concentration risk here is compounded by the fact that the investment is all in exempt market security.
- Secondly, like a majority of Canadians, Bob has no idea what an “exempt market” is. Exempt market means the market is private, outside of public scrutiny. Securities in the exempt market do not trade, they cannot be “liquidated” or easily exchanged for money. The fund that has sold this security to Bob may have no real obligation to buy it back from him, or, if there is a right of redemption, it may be restricted in favour of the asset manager.
- Third, even if the investment pays as intended, Bob may still blow his brains out (metaphorically speaking of course!). What happens if Bob loses the transmission on his truck that he needs for his employment? The transmission will cost him $3,500 which, of course, he hasn’t got because he’s tied up all his money in the fund. We can come up with a dozen other real life possible events which will result in a similar crisis. Though Bob has $190,000 of other assets, it’s likely the remaining equity in his house after accounting for his mortgage. If Bob can’t leverage against that equity, he may have to sell his home!
- Finally, is this really what Bob wants? He says he wants a reliable stream of income. What he is getting for $10,000 is $58 a month assuming the fund actually pays monthly its 7% anticipated coupon on which he has to pay tax. Is this meaningful? How does this weigh against buying a new truck or investing in some other aspect of his contracting business which may not only stabilize his income but augment it as well?
As an aside, is this a “reliable stream of income”? Who knows!? Bob certainly doesn’t! Bob, again, like a majority of Canadians, is clueless about the investment. He doesn’t bother to ask a single question in connection with the investment and the likelihood of its success or failure. He’s relying on nothing more than the hearsay of a friend.
The Obligation Owed to BobThe obligation of the dealer is to walk Bob through all of this. It will be inordinately time consuming. A Dealing Representative cannot be indifferent when advising a client. He or she is obligated to tell the client why an investment may or may not be suitable. If the dealer simply lays out the facts of a deal and then lets the investor decide without providing the investor any suitability analysis, then the dealer may well end up losing his or her license.
But Bob Insists!What if Bob insists? If the dealer has advised Bob that the investment is unsuitable and Bob insists on making it nonetheless, may the dealer process the order? Yes. N.I. 31-103 referenced above provides at 13.3 (2) the following: If a client instructs a registrant to buy, sell or hold a security and in the registrant’s reasonable opinion following the instruction would not be suitable for the client, the registrant must inform the client of the registrant’s opinion and must not buy or sell the security unless the client instructs the registrant to proceed nonetheless.
Therefore the dealer would have the client sign an acknowledgement that states that (i) the risk has been described to them by the dealer and (ii) the investment may not be suitable because of the risk described. The acknowledgement will have coupled with it a direction to the dealer to complete the order notwithstanding the dealer has advised it is not suitable given the risk described. This should always be in writing or electronically documented. This is not only necessary for surviving regulatory audit (to which all of us dealers are regularly subject) but to protect the dealer against possible future lawsuits – as one regulator quipped to me, “Everyone one of your clients can be a future litigant! Practise accordingly!”
“But I want to sleep at night!”There is nothing in the legislation that compels a dealing representative to complete a trade on behalf of client where the dealer believes the proposed investment is unsuitable – even where the client is willingly and enthusiastically ready to acknowledge and waive risk and instruct the dealer to conclude the trade! We are allowed to be principled.
The Fundscraper Platform
The offering memorandum exemption opens the door on the private/exempt market to everyone. Though we can applaud the democratization of the exempt market, it also means a whole lot of folks shouldn’t be there! Sifting through who may be a suitable purchaser for an appropriate product among the masses might very well be Homeric in scope, the cost unreasonable for dealers to assume or issuers to pay. It is ironic that the cost of compliance can prevent the very people the offering memorandum exemption was designed to accommodate from investing in the capital markets.
Fundscraper provides a best-in-practice online environment for real estate investment in full compliance with the rules regulating distribution of securities under the offering memorandum exemption. With just a few inputs on any computer or tablet we invite investors to do in minutes what used to take a significant long time. Our environment is secure and help is available to answer simple questions related to sign-up. A dealing representative is available for anyone with a question about investing generally or about the products we host. We are able to quickly assess and process subscribers as they come on to the platform. Everyone who is qualified on our platform is contacted by a Dealing Representative to insure the accuracy of their information and their ability to participate in a particular investment. Based on the information provided to us, we will advise whether a proposed investment may be suitable or not in light of the risk that appears.
Processing subscriptions under the offering memorandum exemption, especially for those investors who are not “accredited”, will be challenging for dealing representatives and fraught with potential regulatory liabilities. Dealing representatives will have to honestly assess whether they have the resources to economically and effectively fulfill the obligations required of us under Part 13 of N.I. 31-103 when conducting distributions under the Offering Memorandum exemption. Fundscraper delivers a first class solution to this challenge.