Nick Wright, BA JD MBA LLM (Tax)
Wright Business Law

The private issuer exemption is one of the most frequently relied upon prospectus exemptions available to private businesses raising capital in Ontario. Found in subsection 2.4 of National Instrument 45-106 Prospectus Exemptions (NI 45-106), the private issuer exemption allows qualifying private issuers to distribute securities without filing a prospectus, provided the conditions of the exemption are satisfied.

For founders, family-owned businesses, privately held corporations and other closely held enterprises, the exemption provides an efficient means of raising capital from founders, management, employees, family members and other prescribed purchasers without preparing a prospectus.

The exemption is considerably narrower than many issuers appreciate. It is available only where the issuer satisfies the definition of a “private issuer” under NI 45-106, and every distribution must be made exclusively to purchasers who fall within the prescribed categories. An issuer that distributes securities to an ineligible purchaser, or otherwise fails to satisfy the requirements of the exemption, may permanently lose its private issuer status.

What Is the Private Issuer Exemption?

Canadian securities legislation generally prohibits the distribution of securities unless a prospectus has been filed and receipted by the applicable securities regulator or a prospectus exemption is available. For most privately held businesses, preparing a prospectus is neither commercially practical nor economically justified.

The private issuer exemption allows qualifying issuers to raise capital without preparing a prospectus where securities are distributed only to a limited class of purchasers who are expected to have an existing relationship with the issuer or who otherwise do not require the protections ordinarily provided by a prospectus.

Unlike exemptions that focus primarily on the characteristics of the investor, the private issuer exemption imposes requirements on both the issuer and the purchaser. The issuer must qualify as a private issuer throughout the financing, while every purchaser must fall within one of the categories prescribed by NI 45-106.

The exemption is commonly relied upon by founder-owned corporations, family businesses, professional corporations, privately held operating companies, early-stage technology companies, manufacturing businesses, service businesses, and other closely held enterprises seeking to raise capital from existing business relationships.

Because eligibility depends on both the issuer and the purchaser, issuers should confirm that every proposed subscription satisfies the exemption before accepting investment funds or issuing securities.

Who Can Use the Private Issuer Exemption?

The exemption is available only to issuers that satisfy the definition of a “private issuer” in NI 45-106. Simply being privately owned or having relatively few shareholders does not, by itself, qualify an issuer for the exemption. The definition contains several cumulative requirements. An issuer must satisfy each of them to qualify as a private issuer.

Under section 2.4, a private issuer is an issuer that: 

• is not a reporting issuer or an investment fund;
• has securities, other than non-convertible debt securities, that are subject to transfer restrictions contained in its constating documents or security holders’ agreements;
• has securities, other than non-convertible debt securities, beneficially owned by not more than 50 persons, excluding employees and former employees of the issuer or its affiliates, subject to the counting rules in NI 45-106; and
• has distributed its securities only to persons described in NI 45-106, s. 2.4(2).  

The exemption is available to corporations, trusts, and limited partnerships that satisfy these requirements. Whether an issuer qualifies depends upon its governing documents, ownership structure, capitalization, prior distributions, and the characteristics of each purchaser participating in the financing.

One requirement that is frequently overlooked is the exclusion of investment funds.

Why Investment Funds Cannot Rely on the Private Issuer Exemption

The definition of “private issuer” in NI 45-106 expressly excludes investment funds. Consequently, an issuer that qualifies as an investment fund cannot rely on the exemption even if it has only a small number of investors, restricts transfers of its securities, and distributes securities exclusively to family members or accredited investors.

Whether an issuer is an investment fund depends on its legal characteristics and business activities rather than its name or organizational form. A corporation incorporated under the Business Corporations Act (Ontario), for example, may nevertheless constitute an investment fund if it satisfies the applicable statutory definition.

In general terms, an investment fund is an issuer whose primary purpose is investing money provided by its security holders, where those investors rely principally on management to make investment decisions rather than participating in the operation of an active business. Whether an issuer is an investment fund depends on its organizational documents, business activities, investor expectations and the manner in which returns are generated.

The distinction is particularly important because many privately organized investment vehicles resemble ordinary private corporations. Private equity funds, venture capital funds, pooled real estate investment vehicles, mortgage investment entities, investment limited partnerships, and certain family investment structures may all require analysis under the investment fund definition.

By comparison, a corporation that manufactures products, develops software, provides professional services, or otherwise carries on an active commercial business will generally not be characterized as an investment fund merely because it has outside investors.

Real estate businesses frequently require particular attention. A corporation established to acquire, develop, manage, or operate its own real estate business may not constitute an investment fund. Investment vehicles involving real estate require careful analysis. Whether such a vehicle constitutes an investment fund depends on its structure, activities and the applicable statutory definitions, rather than the fact that it invests in real estate. The outcome depends upon the specific facts and the applicable statutory definition rather than the nature of the underlying assets.

Similarly, family investment companies should not automatically be assumed to fall outside the definition simply because their investors are related. Where an entity’s principal purpose is the passive investment of pooled capital, investment fund considerations may arise notwithstanding the limited number of investors.

Because an incorrect conclusion may invalidate reliance on the exemption and give rise to broader securities law concerns, issuers establishing pooled investment vehicles should obtain legal advice before assuming that the private issuer exemption is available.

What Are the Requirements for the Private Issuer Exemption?

To rely on the exemption, an issuer must satisfy every requirement set out in NI 45-106. Failure to satisfy even one requirement may prevent reliance on the exemption for a particular distribution and, in some circumstances, permanently eliminate private issuer status.

The exemption rests on four principal requirements: restrictions on the transfer of securities, a maximum of 50 security holders, distributions only to permitted purchasers, and the issuer’s continuing qualification as a private issuer.

Restrictions on the Transfer of Securities

Securities of a private issuer, other than non-convertible debt securities, must be subject to transfer restrictions contained in the issuer’s constating documents or security holders’ agreements. These restrictions help preserve the issuer’s closely held ownership by limiting transfers outside the permitted framework established by its constating documents or security holders’ agreements.

Transfer restrictions are commonly contained in articles of incorporation, by-laws, unanimous shareholder agreements, limited partnership agreements, or trust declarations. Before every financing, issuers should confirm that these restrictions remain in place, particularly following corporate reorganizations or amendments to governing documents. Failure to maintain appropriate transfer restrictions may jeopardize the continued availability of the exemption.

No More Than 50 Security Holders

A private issuer’s securities, other than non-convertible debt securities, generally must not be beneficially owned by more than 50 persons, excluding employees and former employees of the issuer or its affiliates.

Determining compliance requires more than counting registered holders. NI 45-106 applies a beneficial ownership test and contains specific counting rules for entities created or used solely to purchase or hold the issuer’s securities. Depending on the circumstances, issuers may need to consider beneficial ownership, jointly held securities, estate planning arrangements, and other ownership structures when assessing whether the statutory threshold has been exceeded.

Maintaining an accurate capitalization table is therefore an important element of ongoing compliance. Before each financing, share transfer, or corporate reorganization, issuers should confirm that the number of security holders remains within the prescribed limit.

Permitted Purchasers

The private issuer exemption is available only where every distribution is made to one or more of the categories of purchasers prescribed by section 2.4 of NI 45-106. Before issuing securities, an issuer should confirm that each subscriber falls within an eligible category and retain documentation supporting that conclusion.

Section 2.4(2) permits distributions to a broad range of prescribed purchasers, including directors, officers, employees and founders of the issuer and its affiliates, specified family members, close personal friends and close business associates, existing security holders, accredited investors, certain holding entities, and specified trusts and estates. 

Although many of these categories are relatively straightforward, others require careful factual analysis. In particular, the concepts of a “close personal friend” and a “close business associate” have been the subject of regulatory guidance and should not be interpreted expansively.

What Is a Close Personal Friend?

The private issuer exemption does not extend to casual acquaintances or individuals who have only recently become acquainted with a director, executive officer, or founder.

The Canadian Securities Administrators have explained that a close personal friend is someone who knows the relevant individual well enough, and for a sufficient period of time, to assess that person’s capabilities and trustworthiness. The relationship must be direct and personal. Familiarity through social media, community organizations, professional networking events, or mutual acquaintances will generally be insufficient.

Whether the relationship satisfies this standard depends on the surrounding facts. Relevant considerations include the duration of the relationship, the frequency and nature of the parties’ interactions, whether they maintain contact outside business settings, and whether the relationship would reasonably enable the purchaser to evaluate the character and reliability of the issuer’s representative.

For example, a long-standing family friend who has maintained regular personal contact over many years may qualify. By comparison, someone met at a conference, added through LinkedIn, or introduced shortly before the financing ordinarily will not.

Issuers should therefore avoid relying on this category simply because a prospective investor describes themselves as a “friend.” If the availability of the exemption is questioned, the issuer bears the responsibility of demonstrating that the purchaser satisfied the applicable requirements.

What Is a Close Business Associate?

The concept of a close business associate is similarly narrower than many issuers assume. Conducting business with an issuer or one of its principals does not, without more, establish the necessary relationship.

According to CSA guidance, the relationship must be sufficiently close to allow the purchaser to evaluate the capabilities and trustworthiness of the relevant director, executive officer, or founder. A conventional commercial relationship, standing alone, will rarely satisfy this standard.

The analysis depends upon the overall character of the relationship. Factors such as its duration, the extent of direct interaction between the parties, the significance of the business dealings, the level of mutual confidence developed over time, and the extent to which the relationship extends beyond isolated transactions may all be relevant.

A long-standing business partner who has worked closely with a founder over an extended period may qualify. By contrast, an occasional supplier, customer, lender, consultant, or professional adviser will generally not qualify solely because of that professional relationship.

Before completing a distribution, issuers should document the factual basis supporting their conclusion that the purchaser falls within this category.

Are Form 45-106F1 Reports Required?

One of the practical advantages of the private issuer exemption is that, in Ontario, a distribution completed in reliance on section 2.4 of NI 45-106 does not require the issuer to file a Report of Exempt Distribution (Form 45-106F1).

Under Ontario securities law, Form 45-106F1 is generally required only where a prospectus exemption has been specifically designated as a reporting exemption in National Instrument 45-106. The private issuer exemption is not one of those designated exemptions. As a result, issuers relying exclusively on section 2.4 are ordinarily relieved from both the filing requirement and the associated filing fee.

This distinguishes the private issuer exemption from many other commonly used prospectus exemptions. For example, distributions made under the accredited investor exemption or the family, friends and business associates exemption generally require the issuer to file a Form 45-106F1 within the prescribed filing period following the distribution.

The absence of a filing requirement should not be mistaken for an absence of compliance obligations. An issuer relying on the private issuer exemption must still be able to demonstrate that every condition of section 2.4 was satisfied. Securities regulators may request supporting records, and issuers should therefore retain complete subscription agreements, purchaser representations, capitalization tables, and documentation establishing that each purchaser fell within one of the permitted categories.

Issuers should also remember that this reporting relief applies only where the distribution is completed solely in reliance on the private issuer exemption. If the issuer instead relies on another prospectus exemption that carries a Form 45-106F1 filing obligation, the required report must be filed even if the issuer otherwise qualifies as a private issuer

How Is Private Issuer Status Lost?

Private issuer status is not determined only at the time an issuer is incorporated. It must be maintained throughout the issuer’s existence.

An issuer may lose its status by distributing securities to an ineligible purchaser, exceeding the permitted number of security holders, removing or weakening its transfer restrictions, or otherwise ceasing to satisfy the definition of a private issuer under NI 45-106.

In practice, one of the most common compliance issues arises where an issuer accepts a subscription from someone assumed to qualify as a close personal friend or close business associate without undertaking an adequate factual analysis. Estate planning transactions, share transfers, corporate reorganizations, and secondary sales may also inadvertently alter the issuer’s ownership structure in a manner that causes the exemption to become unavailable.

Once private issuer status has been lost, the issuer generally cannot rely on the exemption for future distributions. Subsequent financings must instead proceed under another available prospectus exemption.

Common Compliance Mistakes and Best Practices

Many compliance issues arise because issuers assume that the private issuer exemption is available whenever securities are distributed privately. In reality, eligibility requires ongoing attention to both the issuer’s own status and the characteristics of every purchaser.

Common errors include assuming every privately owned corporation qualifies as a private issuer, overlooking the exclusion for investment funds, failing to verify purchaser eligibility, relying too readily on the close personal friend or close business associate categories, failing to monitor the number of security holders, and maintaining inadequate subscription records.

A consistent compliance process can significantly reduce these risks. Before accepting subscriptions, issuers should:

• confirm that the issuer continues to satisfy the definition of a private issuer;
• review governing documents to ensure that transfer restrictions remain in place;
• verify each purchaser’s eligibility under the exemption;
• obtain appropriate subscription representations;
• maintain an accurate capitalization table; and
• retain documentation supporting reliance on the exemption.

A disciplined approach to these steps can substantially reduce the risk of inadvertently losing private issuer status and help demonstrate compliance if reliance on the exemption is later reviewed by securities regulators.

Conclusion

The private issuer exemption remains one of the most valuable prospectus exemptions available to closely held businesses raising capital in Ontario. When its requirements are carefully observed, it enables qualifying issuers to complete private financings without the expense and complexity associated with preparing a prospectus.

Its availability, however, should never be assumed. Because a non-compliant distribution may cause an issuer to lose access to the private issuer exemption for future distributions, issuers should adopt appropriate due diligence, record-keeping and compliance procedures before every financing.

Book a Consultation

If you are planning a private financing or have questions about relying on the private issuer exemption, contact us to schedule an initial consultation with Nick Wright.