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Securities Law

NIN 98/56 - Trading by Registrants under Certain Prospectus and Registration Exemptions [NIN - Rescinded]

Published Date: 1998-09-11
Effective Date: 1998-09-09
The purpose of this Notice is to set out the views of Commission staff on the obligations of registrants that trade in securities under certain prospectus and registration exemptions. Specifically, staff take the position that both dealers and registered individuals must comply with the "know your client" and suitability-of-investment rules when selling securities to clients under the "$97,000", "50 purchaser" and "$25,000" exemptions. Staff also take the position that a dealer whose registered salespersons trade under these exemptions must supervise those transactions to ensure compliance with securities legislation and with the written business procedures established by the dealer.

Summary The "$97,000", "50 purchase" and "$25,000" exemptions under securities legislation are made available to give issuers an opportunity to raise capital, without incurring the costs of preparing a prospectus, from persons able to assess the merits of the investment opportunity without full regulatory protection. Securities offered under these exemptions, particularly securities of non-reporting issuers, are generally riskier and less liquid than securities offered by prospectus, traded in secondary markets or traded under other exemptions, such as those for government bonds. The "know your client" and suitability-of-investment rules apply to all securities trades made by registrants on behalf of clients. These rules require that the registrant:
  • make enquiries concerning each client to learn the essential facts about the client and determine the general investment needs and objectives of the client,
  • determine the suitability of any proposed purchase or sale for the client, and
  • advise the client if a proposed purchase or sale is not suitable.
In addition to these general requirements, a registrant trading under the $97,000, 50 purchaser or $25,000 exemptions has particular obligations to:
  • ensure that all of the conditions for use of the exemption are met, and
  • consider the suitability of the investment for the client in light of the risks of the investment and any resale restrictions on the securities.
Dealers are required to establish and apply written prudent business procedures for dealing with clients in compliance with securities legislation. These procedures should include steps to ensure that the dealer:
  • thoroughly understands any securities offered to clients under the exemptions,
  • offers the securities only to clients for whom they are suitable,
  • complies with all of the conditions of the exemption,
  • supervises all registered individuals trading on behalf of the dealer, and
  • maintains adequate records of all transactions.
Registrants who fail to comply with these obligations are exposed to regulatory enforcement action by the Commission and civil liability to clients.

The following sections provide a more detailed explanation of these obligations. Securities Offered under Exemptions Sections 45(2)(5) and 74(2)(4) of theAct and sections 89(a), 128(a), 89(b), 128(b) and 128(c) of theRulesprovide commonly used exemptions from the registration and prospectus requirements (for section 128(c), only the prospectus requirement) of the Act. These are referred to as the "$97,000", "50 purchaser" and "$25,000" exemptions, respectively. The sale of securities pursuant to these exemptions is permitted only if all of the requirements of the particular exemptions are met.

These exemptions provide an opportunity for issuers to raise capital without incurring the costs involved in preparing prospectuses. However, securities offered under these exemptions are intended to be sold only to persons able to assess the merits of the investment opportunity without the benefits of regulatory protection. Securities offered under these exemptions, particularly securities of non-reporting issuers, are generally riskier and less liquid than securities offered under prospectuses, securities of exchange listed companies traded in secondary markets and securities traded under the exemptions in sections 46 and 75 of the Act. Know your Client and Suitability Obligations - Trading under Exemptions Section 48 of the Rules requires all dealers, salespersons and other persons registered to trade in securities to make enquiries concerning each client in order to, among other things, determine the general investment needs and objectives of the client, the appropriateness of any recommendation made to the client, and the suitability of a proposed purchase or sale for the client. Section 48 further provides that, if a registrant considers that a proposed purchase or sale is not suitable for the investment needs and objectives of an individual client, the registrant must make a reasonable effort to so advise the client before executing the proposed transaction.

Where a person registered to trade securities (i.e., a dealer or a partner, director or officer of, or salesperson employed by, a dealer) sells securities to a client pursuant to Act exemptions, the registrant is required to follow the "know your client" rule and determine the suitability of the proposed investment for the client. In a decision of May 2, 1997, In the Matter of Bruce Russell Foerster, the Commission found that the respondent registrant had violated the "know your client" rule by selling securities that were unsuitable for his clients pursuant to the $97,000, 50 purchaser and $25,000 exemptions. The Commission said:

The fact that Foerster was selling securities pursuant to exemptions under the Act did not relieve him of his responsibility to determine the suitability of those investments for his clients. A registrant must meet his or her know your client obligations regardless of the specific type of security being sold or recommended.

The fact that a client may have acknowledged that he or she is a "sophisticated purchaser" and completed the applicable form (Form 20A) in accordance with the legislation does notabsolve the registrant of the responsibilities outlined above. In many instances a client may be able, by virtue of his or her net worth or otherwise, to meet the "sophisticated purchaser" definition, but may have limited investment experience or conservative investment needs and objectives (e.g., a need for low risk, liquid investments). Securities offered pursuant to the $97,000, 50 purchaser and $25,000 exemptions (and, more particularly, securities of non-reporting issuers offered pursuant to these exemptions) are often not suitable for such investors as they are usually high risk, illiquid investments and are generally subject to securities legislation resale restrictions, making them difficult or impossible to resell.

Dealers’ Responsibilities Section 44 of the Rulesprovides that dealers must establish and apply written prudent business procedures for dealing with clients in compliance with securities legislation. Section 47 of the Rulesfurther provides that a registrant must designate a compliance officer (and, in the case of a branch office of a dealer, a branch manager or administration officer) to approve the opening of new client accounts and supervise transactions made on behalf of clients.

To ensure compliance with the Rules, including the "know your client" and suitability-of-investment rules, a dealer must take steps to reasonably ensure that it has enough information concerning each investment it proposes to sell to clients to provide it with a thorough understanding of the nature of the investment and enable it to make an accurate determination of the nature and degree of the risks involved. Only in this way can a dealer ensure that adequate and accurate information concerning each investment is passed along to its salespersons, who will be making determinations as to suitability for the dealer’s clients.

Dealers should exercise particular caution when trading securities of non-reporting issuers pursuant to the $97,000, 50 purchaser and $25,000 exemptions. Dealers should ensure that, in every instance, they take steps to obtain sufficient information concerning the investment to reasonably ensure that their obligations as to suitability will be met. An appropriate review should be conducted by a dealer before approving an investment in a non-reporting issuer offered pursuant to the above-noted exemptions for sale by its salespersons. A written summary of the results of the dealer’s review, including a "risk rating" and detail concerning the types of investment needs and objectives for which the investment would be suitable (and unsuitable) should be prepared. Salespersons should thoroughly familiarize themselves with the nature of the investment, the risks involved and the types of investors for which the investment would and would not be suited, in order to ensure compliance with the "know your client" and suitability-of-investment rules. Salespersons should trade only in securities that have been approved by the dealer’s branch manager or provincial compliance officer.

The Commission has, in the past, taken disciplinary action against salespersons and dealers in connection with breaches of the know your client and suitability-of-investment rules (and, in the case of dealers, their failure to supervise) when trading under exemptions. Staff of the Registration division will continue to carefully monitor registrants’ trading activities under the above-noted and otherexemptions to ensure compliance with the legislation.

Registrants are also reminded that civil liability for, among other things, breach of fiduciary duty and negligence can flow from breaches of securities legislation, industry standards and dealers’ own rules of procedure in connection with client trades.1

1 See, for example, Hodgkinson v. Simms (1994), 117 D.L.R. (4th) 161 (S.C.C.), Varcoe v. Sterling (1992), 7 O.R. (3d) 204 (Ont. Ct. Gen. Div.), and Senft v. Claxton, [1998] B.C.J. No. 597 (unreported).

In a recent B.C. Supreme Court decision2

2Senft v. Claxton, supra.

the court found that a salesperson breached his ‘duty of care’ owed to a client (i.e., he was negligent) when he breached provisions of the Actin connection with a sale of securities to that client. The securities were purportedly sold to the client pursuant to an exemption from the prospectus requirement. The court found that the salesperson’s employer, then registered under the Act as a securities dealer, had acted with ‘wilful blindness’ in connection with the matter, and held it negligent and vicariously liable for the salesperson’s actions.

The Commission’s Notice dated June 30, 1997 (NIN#97/30) provides further guidance concerning the relationship between dealers and their salespersons, including a summary of dealers’ supervisory and record keeping requirements and related matters.

Recording of Trades Registrants are reminded that all trades under the $97,000, 50 purchaser and $25,000 exemptions must be recorded on the books and records of the dealer, rather than "off-book". The daily record of transactions (the "daily blotter") must show all purchases and sales, for review by the compliance officer or branch manager.

DATED at Vancouver, British Columbia, on September 9, 1998.

Michael J. Watson
A/Executive Director

REF: Hodgkinson v. Simms
Varcoe v. Sterling
Senft v. Claxton
In the matter of Bruce Russell Foerster