A distribution requires an issuer to comply with the prospectus requirement by filing a preliminary prospectus and final prospectus. This course of conduct may obviously not favoured by a startup because the preparation of a prospectus involves considerable time and expense, and the offering will require the involvement of an underwriter who will expect to be compensated for its efforts and the potential liabilities to which it may be exposed. If the intended distribution is of a limited nature or involves a newly formed startup or a small business, satisfying the prospectus requirement may not be practical.
The Act provides, in section 72, exemptions from the prospectus requirement contained in section 53 on the basis of considerations parallel to those which support exemptions from the registration requirements enumerated in section 35. However, one should be cautious in reviewing section 72 since a variety of the prospectus exemptions contained in that section (including paragraphs 72(1)(a), 72(1)(d), 72(1)(1), and 72(1)(p) are no longer available as a consequence of the Exempt Distribution Rule. Instead, the Exempt Distribution Rule contains a variety of both prospectus and registration exemptions which are, generally, the most important exemptions relevant to the financing of small and medium sized business enterprises. In addition, the prospectus exemption and corresponding registration exemption found in paragraph 72(1)(n) and subsection 35(1)19 have been replaced by Multilateral Instrument 45-105 (MI 45-105 - the "Employee Rule") which governs trades to employees, senior officers, directors and consultants of a business enterprise.
There are two main types of exemptions from the prospectus requirement: (1) those exemptions found in section 72 or in the Exempt Distribution Rule and MI 45-105; and (2) exemptions that apply to the resale of securities which initially were distributed without a prospectus in reliance on one of the exemptions referred to in (1). The rationale for these exemptions is comparable to the rationale for the exemptions from registration of market participants. The Act recognizes that the disclosure of information as contemplated by the prospectus is unnecessary if the security is by nature a safe instrument, if the particular investor is not in need of the protection of the legislation, or if the distribution is subject to some other regulatory regime. Certain exemptions may at times be viewed as inconsistent with the underlying investor protection philosophy of the Act, however, they are justified as necessary for the efficient formation of capital by a newly created startup or a small business.
Section 72 Exemptions
Many of the exemptions found in section 72 of the Act are no longer operative. The Majority of exemptions found in that section are remaining in effect serve to exempt certain types of transactions where it is recognized that the nature of the transaction requires no need for the imposition of the prospectus requirement, such as, where an issuer completes a trade in its own securities to the holders of its securities by way of a stock dividend or issues new securities to an existing security holder on the exercise by that security holder of a previously granted conversion or exchange right to acquire such securities. Corresponding Registration exemptions for these types of transactions are found in subsection 35(1) of the Act. An interesting exemption is found in paragraph 72(1)(b). Pursuant to this paragraph, where an issuer whose usual business is not trading in securities makes an isolated trade for its own account, provided the trade is not made in the course of continued and successive transactions of a like nature, the trade may proceed without complying with the requirement to prepare a prospectus. While this exemption is by definition rarely relied upon, it can be available as a "safe harbour" for isolated transactions not otherwise subject to an exemption.
The Exempt Distribution Rule
The Exemption Distribution Rule was originally introduced in November 2001 and served to drastically change a variety of the more common registration and prospectus exemptions in an attempt to make it easier for small startup in Ontario to raise startup and expansion capital. Pursuant to section 2.1 of the Exempt Distribution Rule, registration and prospectus exemptions are given for trades in securities of a "closely held" issuer by either the issuer or a selling security holder provided, following the trade, the issuer remains a closely held company and the aggregate proceeds received by the issuer and any other issuer engaged in a common enterprise with the issuer, under the closely held issuer exemption does not exceed $3 million. Additionally, selling or promotional expenses cannot be paid or incurred in connection with the trade other than in relation to services provided by a dealer registered under the Act.
The "accredited investor" exemption, section 2.3 of the Exempt Distribution Rule, permits issuers to raise any amount of investment at any time from any number of accredited investors who purchase the securities for their own account. Accredited investors are presumed to be capable of making an investment decision without the information in a prospectus or the assistance of a registered dealer.
Another group of exemptions is found in MI 45-105 (which replaces subsection 35(1)19 and paragraph 72(1)(n) of the Act). They serve to exempt the issuer and others from complying with the registration and prospectus requirement when the purchaser are senior officers, directors or employees of the issuer or self-employed consultants to the issuer. The exemptions are based on the recognition that the issuer's employees and other service providers, by virtue of their association with the business, should be provided with the ability to invest in the business notwithstanding the fact that many may not have access to "prospectus-level" information or the ability to make an informed decision. The exemptions are frequently used for incentive arrangements with employees such as share purchase plans and option plans, however, MI 45-105 should be reviewed carefully since many of its exemptions are subject to a variety of conditions.