One of the grey areas for real estate development, private equity and venture capital firms (“sponsors”) that serially launch new funds is how frequently a sponsor can come to market with a new fund offering without hitting the “business trigger” for dealer registration in Canada. Ontario Securities Commission (“OSC”) staff (“Staff”) are apparently seeking to answer this question in In the Matter of Go-To Developments Holdings Inc. et al. (the “Go-To case”), an enforcement proceeding concerning allegations of fraud and trading securities without registration. The Go-To case involves the launch of ten property development limited partnerships over a four-year period that raised almost $80 million from approximately 85 investors.
Background
Trading in securities for a business purpose is referred to as the “business trigger” for dealer registration. The Canadian Securities Administrators (“CSA”) view the business trigger for trading as one of the fundamental concepts that form the basis of the dealer registration regime. Factors that the CSA consider relevant in determining whether an individual or firm is trading in securities for a business purpose and, therefore, subject to the dealer registration requirement are set out in Companion Policy 31-103CP Registration Requirements, Exemptions and Ongoing Registrant Obligations (“31-103CP”).
One of the factors that the CSA consider in determining whether an individual or firm is trading in securities for a business purpose is whether the activity is directly or indirectly carried on with “repetition, regularity or continuity”. As guidance in 31-103CP elaborates:
“Frequent or regular transactions are a common indicator that an individual or firm may be engaged in trading or advising for a business purpose.”
Facts and Allegations
In the Go-To case, Staff allege that a real estate developer (“OF”) and the companies he controls defrauded investors and misled Staff during their investigation. However, they also allege that OF and Go-To Developments Holdings Inc. (“GTDH”) engaged in the business of trading securities without registration. While fraud is the “headline news” in this case, the allegation of trading securities without registration is a potential red flag for any sponsor that uses, or is contemplating using, the private issuer or accredited investor prospectus exemption on a frequent basis (including non-resident, cross-border issuers) without engaging a dealer.
Between May 2016 and June 2020, OF and GTDH raised almost $80 million from the sale of limited partnership units to approximately 85 Ontario investors through approximately 140 distributions. For each real estate project, GTDH formed a limited partnership (each, a “Go-To LP”) and incorporated a subsidiary to serve as the general partner (“GP”), with OF as the directing mind of each GP. At all relevant times, neither OF nor GTDH were registered with the OSC to engage in the business of trading, and Staff allege that no exemption from the dealer registration requirement was available.
While Staff allege that there was trading of securities without registration, they do not allege that a prospectus exemption was unavailable. Although the facts are not disclosed, the accredited investor exemption under National Instrument 45-106 Prospectus Exemptions (“NI 45-106”) is commonly relied on and given the relatively small number of investors involved (85) and the number of Go-To LPs that distributed securities (10), it seems reasonable to conclude that the Go-To LPs could have issued some or all of their securities in reliance on the private issuer exemption under NI 45-106. The private issuer exemption allows a non-investment fund issuer to distribute its securities to up to 50 persons (not including employees and former employees) subject to certain conditions. However, while the accredited investor and private issuer exemptions may have provided each Go-To LP, as well as OF and GTDH, with a prospectus exemption, they do not offer relief from the dealer registration requirement.
Implications for Sponsors of Serial LPs
The allegation of trading securities without registration in the Go-To case is an indication that Staff have turned their mind to the frequency of reliance on a prospectus exemption by a sponsor of serial limited partnerships and are forming views on when such reliance hits the business trigger for dealing. The takeaway is that sponsors of serial limited partnerships may be treated more like issuers that have securities-related businesses rather than as startup ventures. Entities with securities-related businesses are presumed to be in the business of dealing. Startup ventures that have an “active non-securities business” do not have to register as a dealer if they trade infrequently and meet other conditions set out in 31-103CP.
Depending on the disposition of this allegation by Ontario’s Capital Markets Tribunal, sponsors and their counsel may need to exercise more caution when forming a series of issuers that distribute their own securities under the accredited investor or private issuer exemption on a frequent or regular basis without engaging a dealer.
The issue of reliance on the private issuer exemption for startup financing came before the Ontario Court of Justice in Ontario Securities Commission v. Katmarian, 2024 ONCJ 151. Those proceedings involved Staff allegations of fraud, unregistered trading and illegal distribution in connection with an initial coin offering by a crypto startup. The court concluded that the distributions qualified for the private issuer exemption and all charges, including the charge of unregistered trading, were dismissed.
What’s Next?
The merits hearing for the Go-To case is scheduled to commence on July 8, 2024.
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