– October 30, 2023 –

When issuing securities under the accredited investor exemption in National Instrument 45-106 – Prospectus Exemption (NI 45-106), issuers must take steps to verify purchasers qualify as accredited investors. This article discusses regulatory requirements, best practices, and the potential consequences of inadequate verification.

Who Qualifies as an Accredited Investor?

In Canada, the definition of an accredited investor (AI) is outlined in section 1.1 of NI 45-106. This definition helps determine who is eligible to participate in certain private placement investment opportunities, typically those that are considered higher risk or restricted to sophisticated investors.

One category of accredited investors includes individuals who meet specific income or net worth thresholds. To qualify under this category, an individual must have either a minimum annual income of $200,000 in each of the last two years (or $300,000 when combined with their spouse) or possess financial assets worth at least $1 million or net assets of at least $5 million net of related liabilities. The financial assets can include bank deposits, investment holdings, real estate, or other assets that can reasonably be valued. Net assets mean all of the purchaser’s total assets minus all of the purchaser’s total liabilities.

Requirements for Verification of Accredited Investor Status

Section 1.9 of the NI 45-106 Companion Policy states that issuers are responsible for determining whether a purchaser meets the definition of an accredited investor since the issuer is relying on the exemption. Issuers cannot rely solely on a form of subscription agreement or another document that states: “I am an accredited investor” or an initial beside a category on the Individual AI Form unless the issuer has taken reasonable steps to verify the representation made by the purchaser.

The Companion Policy provides guidance on reasonable verification steps like:

• documenting how the issuer identified or located a potential purchaser,
• asking questions of the purchaser to obtain details about how a purchaser qualifies as an AI,
• gathering background information about the purchaser,
• reviewing information to confirm a purchaser met either the income test, financial asset test or net asset test to be considered an AI,
• involving a registered person to meet with or provide information about the issuer to the purchaser, and
• following up if information appears questionable.

These steps, and confirmation an investor is an AI, should be taken BEFORE discussing the particulars of the issuer’s investment opportunity with that potential purchaser.

Verification Procedures

Securities regulators expect issuers to establish policies and procedures that all parties acting on their behalf are required to follow to confirm a potential purchaser is an AI. These policies and procedures should include:

• confirmation everyone involved in the offering understands the requirements of the AI exemption and can explain to potential purchasers the different accredited investor tests and differences between the alternative qualification criteria under the exemption,
• keep notes on how a potential purchaser was identified or located,
• take steps to verify AI through a questionnaire and/or meeting. Ask questions about the purchaser’s net income, financial assets, or net assets, or ask other questions designed to elicit details about the purchaser’s financial circumstances and take notes of the conversation,
• ask additional follow-up questions if a potential purchaser’s initial responses are ambiguous or raise uncertainty regarding their compliance with AI criteria,

Additional steps to consider if questions remaining regarding a potential purchaser’s eligibility as an AI:

• obtain confirmation from a third party such as an accountant, lawyer, registrant, or portfolio manager that a purchaser is an AI, or
• request and review financial statements or tax returns of potential purchasers to confirm income or asset levels.

Written representations from purchasers, signed risk acknowledgment forms (Form 45-106F9), and detailed meeting notes can also provide verification evidence.

Best Practices for Verification

Best practices include:

• have written policies and procedures in place detailing the method for confirming a prospective investor’s AI status, ensuring consistency and compliance across all transactions,
• confirm the term “accredited investor” and requirements are discussed with, and understood by, each potential investor,
• confirm a potential investor meets one of the AI tests BEFORE discussing the investment opportunity and well BEFORE committing to investing,
• keep all documentation, including notes, forms, and additional evidence, accumulated during the verification and investment phases. This practice safeguards the issuer in regulatory reviews or audits,
• obtain a signed risk acknowledgment form from each individual qualifying under the AI income test, financial asset test, or asset test and keep it for eight years as required by NI 45-106, and
• regularly evaluate and refine your verification strategies by comparing them against practices employed by similar issuers. This benchmarking helps keep procedures in line with industry norms.

In addition to ensuring compliance, adopting securities regulators recommended best practices can streamline the verification process.

Consequences of Inadequate Verification

If an issuer does not properly verify purchasers as accredited investors, regulators can take enforcement action and purchasers may have rescission rights.

The consequences of inadequate verification of accredited investor status can be severe, impacting both the financial standing and reputation of the issuer. Canadian securities regulators, including the British Columbia Securities Commission (BCSC), Alberta Securities Commission (ASC), and Ontario Securities Commission (OSC), have historically taken firm actions to enforce compliance. Below are illustrative examples of enforcement actions that highlight the seriousness of such regulatory mandates:

• Re Bracetek, 2023 BCSECCOM 118 (March 8, 2023) and Re Sidhu 2022 BCSECCOM 359 – Bracetek Industries Group Ltd. (Braceteck) purported to rely on the AI exemption when it took a $1.75M investment from one investor. In its ruling, the BC Securities Commission tribunal stated: “The investor was so far removed from qualifying as an accredited investor that any genuine effort at inquiry would have uncovered that.” At the time of investment, the investor’s financial assets, excluding her primary residence, were considerably below the $1 million threshold. Her net assets did not meet the $5 million criterion, and her annual net income before taxes was substantially less than $200,000 in the relevant years. Representatives for Bracetek claimed they questioned the investor as to her status as an AI. The tribunal found this due diligence inadequate as it was made on the doorstep of the bank to obtain the bank draft for the investment and the subscription agreement had already been completed. The tribunal in its decision against Bracetek issued the company a seven-year securities market ban, an $850,000 fine and an additional $50,000 administrative penalty. In its early decision against Sidhu, it issued a 7.5-year securities market ban, a $900,000 fine, and a $50,000 administrative penalty. In July 2023, the BC Securities Commission posted a ruling to request claims and distribute the $900,000 collected from Mr. Sidhu. Hopefully, the victim in this instance was able to recoup a portion of her losses, Re Sidhu, 2023 BCSECCOM 359.

• Re Red Cloud Securities, 2023 CIRO 5 (CanLII) (July 18, 2023) – In this decision Canadian Investment Regulatory Organization (CIRO) found that Red Cloud during the period in question failed to establish and maintain a system of controls and supervision that was adequate to ensure that retail clients were qualified to purchase securities offered under the accredited investor exemption in s. 2.3 of NI 45-106. In its settlement agreement, Red Cloud agreed to disgorge fees earned in the amount of $611,306.18, a fine in the amount of $100,000, and costs in the amount of $15,000.

• Re First Global Data Ltd., 2022 ONCMT 25 (September 15, 2022) and Re First Global Data Ltd., 2023 ONCMT 25 (CanLII) (June 22, 2023) – Global Bioenergy Resources Inc. and its executives raised approximately $4.45 million from 80 investors for First Global Data Ltd. purporting to rely on the AI exemption. In its decision, the Ontario Capital Markets Tribunal found that the accredited investor exemption was unavailable to First Global because the investors presented at the hearing (1) did not qualify as an AI, (2) there was no evidence investors were given an explanation of the subscription agreement or accredited investor form and they signed blank documents or where they were told, and (3) management of First Global simply reviewed the forms to ensure that the accredited investor certificates were completed, without having any contact with the investors or independent verification. The tribunal its decision against all involved issued a seven-year securities market ban, a disgorgement of $4.46 million, and a total administrative penalty of $2,425,000. The administrative penalty was adjusted to account for the seriousness of each individual’s misconduct and involvement in the different transactions, as well as any mitigating factors.

Conclusion

Verifying that purchasers are AIs is crucial when relying on that exemption to distribute securities. A statement in the subscription agreement that an investor is an accredited investor or check a box approach is not enough to confirm you have taken reasonable steps to verify a potential purchaser is an AI. Following regulatory guidance and best practices in Section 1.9, 2.9, 3.1, 3.5, and 5.5 of the NI 45-106 Companion Policy can help issuers mitigate legal, financial, and reputational risks. Robust verification procedures are key to accessing capital responsibly.