Will Canada Make Room for Crowdfunding?

Andrea Johnson, Partner & Lara Vos Smith, Associate at Dentons

When the US changed its securities laws to (eventually) enable equity crowdfunding, advocates of the practice to the North started urging Canadian securities administrators to follow suit. Just what reforms are needed to enable equity crowdfunding in Canada? We answer this question by looking at how crowdfunding fits (or more to the point, doesn't fit) within current Canadian securities law.

Legality of Equity Crowdfunding in Canada

No specific rule or law prohibits equity crowdfunding in Canada. However, Canadian issuers may raise capital only by filing a prospectus (a costly proposition) or relying on an exemption from prospectus requirements. In addition, funding portals must probably register under Canada's dealer and investment adviser registration regime. Most issuers that want to crowdfund do not have the resources to prepare a prospectus (or prospectus-like) offering document or to involve a registered dealer or investment adviser. At the same time, equity crowdfunding does not fit comfortably into any of the current array of Canadian prospectus and registration exemptions. As a result, existing rules in Canada are too restrictive to allow for easy adoption and scalability of crowdfunding.

Registration of Funding Portals

The fact that crowdfunding portals, and potentially the issuers using them, fall within Canada's dealer and investment adviser registration rules poses the main barrier to equity crowdfunding in Canada. Low value investments in high risk, start-up issuers simply don't mesh with the laborious know-your-client, know-your-product, suitability, and other exercises that Canadian registrants are obliged to carry out (not to mention the associated liability for failing in these duties).

Why are portals and the companies using them subject to Canada's registration regime?

In Canada, anyone "in the business" of trading securities must register with securities regulators in the interest of protecting investors and ensuring the integrity of Canadian capital markets. Operating a portal touches on many of the criteria indicating a "business purpose" - the trigger for registration requirements under National Instrument 31-103 (NI 31-103). Indicia of having a "business purpose" include setting up a business to promote securities, intermediating in securities trades or making a market for them, taking compensation (whether transaction- or value-based) for these activities, and contacting anyone to solicit securities transactions. Given this breadth, portal activities quite likely require registration. This analysis was recently confirmed with the publication of Ontario Securities Commission Staff Notice 33-738, which states that "internet platforms that seek to showcase investment opportunities to investors in return for fees from issuers and dealers that advertise on the platform" are considered to be in the business of trading or advising (and therefore must register). At approximately the same time this notice was published, the Canadian Securities Administrators (CSA) released Multilateral CSA Notice 45-311 stating the CSA staff view that operating a funding portal that "intermediates trades" triggers a dealer registration requirement under NI 31-103.

Registering as a dealer or investment adviser in Canada is no small task. Under NI 31-103, intermediaries must not only be accredited, but also have the education, training, and experience to act as a broker or adviser. Registrants are expected to understand their investment products' structure, features, and risks well enough to advise investors on suitability. In keeping with "know your client" obligations, registrants need to learn their client's profile, investment goals, and risk tolerance - a dealer-client relationship that seems to be completely at odds with online crowdfunding portals seeking to automate securities sales and dramatically reduce costs for small transactions. Not surprisingly, the key players in the Canadian start-up ecosystem have no interest in becoming registrants and few registrants are interested in the low-fee, high-liability stakes of raising funds for start-ups. No Canadian jurisdiction has established special rules for funding portals, so it comes as no surprise that no registered funding portals seem to exist in Canada.

Canadian companies attempting to raise capital through a portal might also need to register as brokers or investment advisers. Although issuers raising capital are not generally considered to be "in the business" of trading securities, if they trade in securities "frequently" or "solicit investors actively" they may be considered to be "in the business", triggering registration requirements.[1] Might these rules apply to equity crowdfunding? The answer is not clear.

It is equally unclear whether and when online advertising or soliciting for otherwise prospectus-exempt offerings crosses the line into activity requiring dealer or adviser registration. For example, Section 3.1 of 45-106CP (the Companion Policy to National Instrument 45-106) states that issuers may use registrants, finders, or any form of advertising (including internet or e-mail) to solicit buyers in prospectus-exempt offerings. At the same time, National Policy 47-201 states that Canadian securities regulatory authorities generally consider any person or company that posts on the internet anything offering or soliciting securities trades to be "trading" in Canada if the post is accessible to persons or companies in Canada. The policy goes further, specifying that those who post offering documents on the internet must register to trade in the local jurisdiction. This policy was created in the internet's early days of 1999, and has not been reconciled with NI 31-103 or 45-106CP. The co-existence of these rules suggests that while advertising and soliciting may be allowed for prospectus-exempt offerings, systematically doing so over the internet could, somewhat circuitously, bump the activity up to "trading" and trigger the dealer registration requirement.

Potential crowdfunding regulation is complicated by the fact that securities laws are regulated provincially and territorially in Canada. In parts of Canada - namely Alberta, British Columbia, Saskatchewan, Manitoba, the Northwest and Yukon Territories, and Nunavut - there is a view that non-registrants can in theory operate funding portals. These jurisdictions passed blanket exemption orders (together called the Northwest Exemption) relieving intermediaries trading in the exempt market from NI 31-103 registration requirements if they meet certain conditions: the individual is neither currently registered nor required to register, provides no suitability advice or financial services to purchasers, has no access to investor assets, and complies with mandated risk disclosure and regulatory filings. Intermediaries relying on the Northwest Exemption must also restrict their trading activities to their own[2] or other jurisdictions in the north-western block and trades falling within specified capital-raising exemptions. We suspect the Northwest Exemption was not intended for systematic trading through funding portals. Moreover, British Columbia recently announced that it is considering repealing the exemption entirely. At any rate, the territorial limitations of the Northwest Exemption pose practical problems for any internet-based platform.

Prospectus Exemptions

National Instrument 45-106 (NI 45-106) is a consolidated instrument setting out most of the available prospectus exemptions in Canada. Unfortunately, crowdfunding does not fall neatly into any of the established prospectus exemptions.

Start-ups typically use the "private issuer" and "accredited investor" exemptions. To qualify under the "private issuer" exemption, issuers may have no more than 50 non-employee shareholders who all have a pre-existing relationship with the issuer, its founders, or its management. The arbitrary 50 investor limit is a poor fit for equity crowdfunding models, which envision a higher number of investors contributing smaller amounts of capital, and crowdfunding investors cannot be expected to have a close relationship (or any relationship) with the company. Moreover, the "accredited investor" exemption sets certain thresholds (based on income, assets or level of capital market sophistication) that probably preclude most small shareholders from investing. On the other hand, the "accredited investor" exemption does work for angel and venture capital financing. However, many start-ups have little reach into angel and VC communities, which are notoriously underdeveloped in Canada.

There has been much discussion in Canada about whether the existing "offering memorandum" (OM) exemption could work for crowdfunding. The OM exemption is available everywhere in Canada except Ontario. An OM is a detailed disclosure document designed to help investors evaluate investments. OMs are intended to be less onerous to prepare than prospectuses. At first blush, the OM exemption provides a potential vehicle for crowdfunding. But a closer look reveals it to be an imperfect solution:

  • The OM exemption is not available in Ontario and not uniform where available. For instance, British Columbia's broad exemption allows any number of buyers to invest any amount of money, so long as they execute a risk acknowledgement and receive the proper OM document from the issuer (different forms are prescribed for "qualifying" and "non-qualifying" issuers). Alberta applies more restrictions, such as capping investments at CAD$10,000 for all but "eligible investors". Some provinces follow British Columbia's model and others follow Alberta's (again, except for Ontario). This discontinuity is a problem for internet-based platforms which ideally seek to reach investors across Canada.
  • The OM exemption requires audited financial statements from issuers, even those with no history of operations, to be included in the OM form. Audited statements can cost upwards of $25,000 - unrealistically steep for most start-ups, especially if investors end up with no meaningful information. (In recognition of this, some Canadian jurisdictions have recently provided relief from audit requirements for certain small offerings under the OM exemption (see Multilateral CSA Notice 45-311).)
  • OM forms have been criticized for presenting information in a way unsophisticated investors would probably not understand. [3] For example, some OM documents read like prospectuses (and cost as much to prepare), making "DIY" efforts seem deficient by contrast.

Regulating Later Transactions

A primary concern in equity crowdfunding is the large number of small shareholders it creates, especially given that Canada's securities regulations include several exemptions geared to non-public companies that are lost to issuers exceeding certain numbers of shareholders. The "private issuer" exemption, for instance, is no longer an option after an issuer has over 50 non-employee shareholders. Because the "private issuer" exemption also covers resale, investors in private companies could find selling their shares difficult when the company no longer falls within the exemption. Similarly, Ontario's OSC Rule 62-504 restricts the "non-reporting issuer" exemption for take-over and issuer bids to those with fewer than 50 non-employee shareholders, meaning that share sales of companies in this category and buy-backs of shares must comply with either the formal take-over or issuer bid regime.

Having large numbers of small shareholders is also a headache under Canadian corporate law. For example, because the concept of a "majority written consent" does not exist in Canada, 100% of the shareholders must sign written resolutions to pass a resolution without holding a duly-constituted meeting. This can mean that early-stage companies with lots of investors will find it difficult and expensive to make fundamental changes, or even take care of ordinary housekeeping. For these and other reasons, some commentators suggest that crowdfunding investors should be pooled under a single corporation or trustee. In Canada, pooling within a single corporation is probably not tax-effective; on the other hand, the trustee model might work.

Jurisdictional Issues

The internet's nature raises complex jurisdictional issues for equity crowdfunding regulation. By introducing the "Rule 506 crowdfunding" changes, the US makes it possible for Canadian issuers to use US portals to solicit investment from US accredited investors, giving rise to some serious concerns:

  • National Policy 47-201 (47-201) warns that Canadian authorities generally consider entities to be trading in securities in a local jurisdiction when they post documents offering or soliciting securities trades on the internet, if individuals or companies in Ontario have access to those documents. Ontario issuers not wanting to run afoul of 47-201 may need US equity funding portals to block Canadian IP addresses or somehow fence offerings by, for example, requiring users to enter a valid US address to prove residency (consider online travel booked through US websites accessed from Canada).
  • By contrast, the Interpretation Note replacing repealed OSC Policy 1.5 describes the Ontario Securities Commission's view that Ontario or non-Ontario issuers' distributions outside of Ontario might be considered distributions within Ontario if "connecting factors with Ontario" exist. Though which "connecting factors" would act as triggers is unclear, the OSC has said a prospectus or other exemption is not needed where reasonable steps are taken to ensure that the securities connected with the extra-provincial distribution will remain outside of Ontario. According to the Interpretation Note, the issuer's measures to stop foreign issued securities from entering the Ontario market should be stringent enough to ensure that non-residents ultimately hold the securities and intermediaries cannot acquire securities for resale in Ontario.
  • Provincial deeming rules further cloud questions of jurisdiction. Section 2.3 of 47-201 is a case in point: the section considers an online extra-provincial distribution by a company incorporated in British Columbia, Alberta or Quebec to be a distribution within that province as well.

The bottom line is US funding portals wishing to serve Canadian issuers need to carefully consider their distribution model and whether they must register as dealers in Canada.

Building a Canadian Crowdfunding Model

Canadian securities regulators have two priorities: (1) to protect investors from unfair, improper, and fraudulent activities and (2) to foster fair and efficient capital markets that inspire confidence. Online activity has received particular attention. For example, the CSA launched the "Blue Hedge" campaign to tackle concern over online investment fraud and educate the public about online scams. The campaign featured a fake investment website, promoted by email blasts, social media and advertisements on prominent web pages that encouraged visitors to invest immediately in a fictitious fund. Like their US counterparts, Canadian regulators will need to be convinced that the potential for fraud and abuse can be managed, especially in relation to unsophisticated investors who seem more susceptible to online fraudsters and more vulnerable to financial loss.

Crowdfunding advocates assert that proposed measures for combating fraud in the US and other jurisdictions should suffice in Canada as well. Today, early-stage capital-raising in Canada is cobbled together informally, at times with help from unregistered "finders" operating under securities regulators' radar. When it comes to fraud, a regulated crowdfunding portal may actually enhance existing investor protections by moving these activities under a spotlight.

Ontario has recently opened a public consultation on a possible new crowdfunding exemption, as well as three other potential new exemptions. The OSC has prepared an in-depth analysis of crowdfunding for the purposes of this consultation (OSC Staff Consultation Paper 45-710). The consultation paper includes questions on a potential new crowdfunding exemption, including whether a new category of registration should be created for funding portals. Comments are due by March 8, 2013.

The Crowdfunding Impact

If permitted, crowdfunding could have a real impact on the early-stage financing landscape in Canada, especially since Canadian start-ups are chronically underfunded compared to their US counterparts. Canadian securities regulators have in the past shown an ability to be innovative (for example, in creating a proportional regulatory infrastructure for the TSX-V), and crowdfunding presents a further opportunity to demonstrate their

[1] Companion Policy 31-103CP Registration Requirements and Exemptions.

[2] Note that as per ASC Blanket Order 31-505 s.6(b), for example, the exemption precludes foreign registrants.

[3] In the mutual fund area, this particular concern has been nicely addressed by the new "Fund Facts" requirement. As of January 1, 2011, mutual fund companies are required to provide a Fund Facts disclosure document to investors at the point of sale (free of charge) that describes its offerings in plain and understandable language.

Andrea C. Johnson, Partner

Andrea's practice focuses on corporate and securities law, with an emphasis on technology and emerging growth companies. She has extensive experience in the private equity and venture capital area and has acted as lead counsel on many of the largest VC financings in Canada. Andrea also advises TSX-listed companies on IPOs, financings (including PIPEs), mergers and acquisitions, stock-based compensation and corporate governance.

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Lara Vos Smith, Associate

Lara's practice focuses on corporate and securities law with emphasis on corporate finance and mergers and acquisitions. Her transactional experience includes domestic and cross-border public and private corporate finance transactions representing issuers and underwriters as well as merger and acquisitions transactions. She also advises public issuers on general corporate and securities law matters including stock exchange listings, continuous disclosure obligations and other regulatory compliance issues.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Fraser Milner Casgrain LLP. This work reflects the law at the time of writing.