MI 51-105 – an Unorthodox Solution for Canadian Issuers Quoted in the U.S. OTC Markets

MI 51-105 – an Unorthodox Solution for Canadian Issuers Quoted in the U.S. OTC Markets

The Canadian Securities Administrators (the “CSA”), except the Ontario Securities Commission[1], announced that Multilateral Instrument 51-105 respecting Issuers Quoted in the U.S. Over-the-Counter Markets (“MI 51-105” or the “Instrument”) will finally become effective on July 31, 2012[2]. The Instrument subjects to continuous disclosure and other regulatory obligations any issuer whose securities are quoted only on a US OTC market and that has a significant connection to a Canadian jurisdiction. Those companies that are OTC reporting issuers under MI 51-105 will have to quickly get up to speed in order to prepare and file any disclosure documents on SEDAR as required.

1. Application

MI 51-105 applies to any OTC Issuer with a significant jurisdictional nexus with Canada. An OTC Issuer is an issuer that has a class of securities which are quoted on any U.S. over-the-counter markets or are reported on the grey market, but is not an issuer that has a class of securities listed on a North-American stock exchange[3]. An OTC Issuer becomes subject to the requirements of MI 51-105 ( hence, an OTC Reporting Issuer) if it is directed or administered from a jurisdiction in Canada, promotional activities are conducted in or from a jurisdiction in Canada, or it distributed seed shares[4] in Canada prior to obtaining a ticker symbol. The Instrument also applies to an OTC Issuer that is already a reporting issuer in a Canadian jurisdiction at the time the regulation comes into force.

Conversely, an OTC Issuer ceases to be an OTC Reporting Issuer if: (a) its business has not been directed or administered, and promotional activities have not been carried on, from a Canadian jurisdiction for at least one year and more than one year has passed since the ticker-symbol date[5]; (b) a class of its securities has become listed on a North-American stock exchange[6]; or (c) the issuer receives an order from the securities regulatory authority in the jurisdiction that it is no longer a reporting issuer in that jurisdiction[7]. For some reason, the above criteria do not apply in Quebec and the OTC Reporting Issuer must apply to have its reporting issuer status revoked by to the Autorité des marchés financiers in a discretionary process.

2. An Alternative Road for Ending the OTC Reporting Issuer Status

The Instrument fails to contemplate that a class of securities may cease altogether to be quoted on the U.S. over-the-counter market and hence that the issuer may cease to be qualified as an OTC Issuer (being generally assumed that it is at the very least impractical to remove a class of securities from quotation on OTC Markets). Yet as I have explained in a previous post, this result can be attained by reclassifying the outstanding common stock of a non-reporting Delaware issuer into two or more classes of restricted shares of stock.

In order to comply with the rule against the retroactive application of transfer restrictions at § 202(b) of the Delaware General Corporation Law , the issuer can submit a proposal to the stockholders that they adopt the merger of a wholly-owned subsidiary into the parent corporation (the surviving corporation), in the course of which each share of common stock then held by a shareholder of record will be cancelled and converted into the right to receive, at the election of the shareholder, either (i) the newly restricted stock or (ii) cash. At the same time, the conclusion of the transaction is made conditional on a relatively high percentage of shareholders accepting the stock consideration or, conversely, on the company not being required to acquire more than a defined number of shares for cash either pursuant to the terms of the merger or pursuant to dissenters’ rights of appraisal. The shareholders that vote in favor of the restrictions receive the new restricted stock; those that do not are cashed out.

In the course of the merger, the issuer’s stock is also reclassified into one or more classes of preferred stock of less than 2000 overall shareholders and 500 non-accredited shareholders each in order not to trigger Exchange Act registration requirements. Furthermore, in the event that the issuer’s reporting obligation in relation to its class of common stock were suspended under section 15(d) of the Exchange Act, it will be prudent to limit holding of the new class of common stock by less than 300 holders of record. At the end of the operation, the formerly free trading class of common stock of the issuer is restructured into one new class of restricted common stock and one or more distinct classes of restricted preferred stock. Hence, the issuer’s securities are no longer quoted on the OTC markets. Thereafter, the issuer would need to obtain an order from the securities regulatory authority in the relevant Canadian jurisdiction that it is no longer an OTC reporting issuer in that jurisdiction.

Finally it is important to note the following. As we shall see, from July 31, 2012 any OTC Issuer subject to MI 51-105 will be ipso facto a reporting issuer under applicable Canadian securities legislation. Whereas before the entry into force of MI 51-105, a non-reporting issuer would have been able to complete the above reclassification without any securities disclosures on either side of the border; after the Instrument will become effective, the transaction will at a minimum be subject in Canada to MI 61-101 Protection of Minority Security Holders in Special Transactions.

3. Disclosure Requirements

The first objective of MI 51-105 is to introduce continuous disclosure requirements for OTC Reporting Issuers and by the same token reduce these markets’ traditional exposure to illicit promotional campaigns[8]. OTC Issuers that are not SEC filers must meet the same periodic disclosure requirements that apply to other domestic reporting issuers, notably under National Instrument 51-102 Continuous Disclosure Obligations and, for oil and gas issuers, under National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities. OTC Issuers that are SEC filers can comply with the disclosure requirements by using the reports they already file with the SEC. Insiders of OTC Reporting Issuers must file insider reports on SEDI and directors, officers, promoters or control persons must file personal information forms (PIF). In addition to normal disclosure requirements, OTC Issuers are required to disclose information about their promoters, their engagement and compensation in the form of Form 51-105F2 Notice of Promotional Activities. Issuers should note that, in British Columbia, the introduction of new disclosure requirements for OTC Reporting Issuers had been followed by substantial disclosure compliance reviews which in many cases resulted in the issuance of cease trade orders against nonconforming issuers.

4. Resale Restrictions

Another important objective of the Instrument is to introduce restrictions to resales to prevent the occurrence of illicit activities and manipulative practices. These requirements are in addition to existing resale limitations provided by United States securities laws. Seed shares acquired after MI 51-105 has become effective can only be traded within a reorganization or merger transaction, or if: the security is properly legended; the trade is effected by a person through a registered investment dealer from an account registered in the name of that person; and the trade is executed in a OTC market in the United States. The legend must state the following: “Unless permitted under section 11 of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets, the holder of this security must not trade the security in or from a jurisdiction of Canada unless (a) the security holder trades the security through an investment dealer registered in a jurisdiction of Canada from an account at that dealer in the name of that security holder, and (b) the dealer executes the trade through any of the over-the-counter markets in the United States of America.”

Private placement securities acquired after the OTC Reporting Issuer has received a ticker-symbol can only be resold after a 4-month period has passed either from the date of the original distribution or the date a control person distributed the security. Additional restrictions apply: a person can only trade up to 5% of the OTC reporting issuer’s outstanding securities of the same class in any given 12-month period; the person must trade the security through a Canadian-registered investment dealer, who executes the trade through an OTC market in the US; there is no unusual promotional effort; no extraordinary commissions are paid for the trade; and the security bears a legend stating: “The holder of this security must not trade the security in or from a jurisdiction of Canada unless the conditions in section 13 of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets are met.” Finally, MI 51-105 also creates additional restrictions to the issuance of securities for services to the issuer’s directors, officers, or consultants.

5. Transition

On the day that MI 51-105 comes into force, on July 31, 2012, an OTC Issuer that satisfies the conditions set forth in s. 3 of MI 51-105 will be ipso facto a reporting issuer under applicable securities legislation and will immediately become subject to disclosure obligations. However, the Instrument provides a transition period for OTC reporting issuers that are not SEC filers. The obligation to file annual financial statements, related MD&A and annual certificates applies only to financial years beginning on or after January 1, 2012, and the filing deadline expires 120 days after the end of the financial period. A company with a December 31 year-end would have until April 30, 2013 to file. The obligation to file interim reports applies to interim periods that begin on or after January 1, 2012 and end after July 31, 2012. For a company with a December 31 year-end, the first interim period after July 31 would fall on September 30, and the filing deadline would expire 60 days later. As announced in response to comments to the proposed regulations, “Canadian securities regulatory authorities will generally not grant exemptive relief to a reporting issuer to extend a continuous disclosure filing deadline to enable an issuer to avoid a default [9].”

6. Planning the future

Clearly, the Instrument’s disclosure requirements will impose a significant new burden on currently non-reporting OTC Markets issuers, and a decision on whether to continue to be a reporting company will undoubtedly be a high priority issue for these issuers and their advisers. I have provided above an unorthodox course of action precisely to this end. In the immediacy, however, the first item on the agenda should be to start preparing the interim reports and laying the groundwork for the first annual audited financial statements. Audited financial statements will be required in any event, whether the Issuer resolves to remain a reporting company or whether it attempts instead to cease to qualify as an OTC Reporting Issuer.

[1] The province of Ontario did not participate in proposed MI 51-105, having decided that it could not evidence abusive activity being conducted in Ontario in relation to OTC issuers. Of course one could only come to this conclusion by ignoring what is arguably one of the single largest fraudulent use of shell corporations in Canadian history. See: Ontario Securities Commission Amended Statement of Allegations, In the Matter of Irwin Book et al., (January 4, 2012) at http://www.osc.gov.on.ca/en/Proceedings_soa_20120104_boocki.htm (last visited on July 25, 2012).
[3] The instrument enumerates seven organized stock exchanges, namely (i) TSX Venture Exchange Inc.; (ii) TSX Inc.; (iii) Canadian National Stock Exchange; (iv) Alpha Exchange Inc.; (v) The New York Stock Exchange LLC; (vi) NYSE Amex LLC; and (vii) The NASDAQ Stock Market LLC. However, as the CSA pointed out following the comment period, an issuer will be able to obtain relief by demonstrating that a specific exchange has similar oversight and governance requirements as the listed exchanges. This should cover the situation of issuers dually quoted on a US OTC market and on AIM or Frankfurt.
[4] A seed share being a security issued before the issuer is first assigned a ticker-symbol.
[5] The change of status does not occur automatically upon the change of circumstances. The issuer is required to notify its regulator by filing Form 51-105F1 Notice – OTC Issuer Ceases to be an OTC Reporting Issuer.
[6] In which case the issuer must file Form 51-105F4 Notice – Issuer Ceases to be an OTC Reporting Issuer. In Quebec, the issuer must apply to the securities regulatory authority to have its status as an OTC reporting issuer revoked in order to cease to be an OTC issuer.
[8] See: BC Notice 2007/24, BCSC Response to Abusive Practices in British Columbia Involving US Over-the-Counter Markets (June 25, 2007). This document is still to this day the most complete public policy statement about MI 51-105 and its predecessor, BC Instrument 51-509.