IIROC’s 2018 Enforcement Report: Strengthening Enforcement Authority Across Canada

Overview

On May 16, 2019, the Investment Industry Regulatory Organization of Canada (IIROC) published its 2018 Enforcement Report (the Report).  The Report summarizes IIROC’s enforcement activities in 2018 and provides an update on the progress of IIROC’s enforcement priorities, chief among which has been the strengthening of IIROC’s legal authority and enforcement powers across Canada.

Enforcement Activities

IIROC conducted 127 investigations in 2018, 40% of which resulted in prosecutions.  The number of prosecutions increased from 44 in 2017, to 52 in 2018. Of those 52 prosecutions, 42 were against individuals and 10 were against firms.  Ontario had the most investigations and prosecutions, with 77 and 26 respectively.  British Columbia had the next highest number, with 20 and 9 respectively.

With respect to sanctions in 2018, the Report indicates that IIROC suspended 21 individuals, permanently barred five individuals from working in a registered capacity, and imposed financial penalties against individuals totalling $3.2 million.  According to the Report, IIROC also terminated two firms and imposed almost $1 million in financial penalties against firms.  Although IIROC imposed fewer sanctions against firms than individuals in 2018, 85.3% of the total fines received by IIROC were collected from firms.

Enforcement Priorities

According to the Report, strengthening its legal authority across Canada remained a key priority for IIROC in 2018.  IIROC intends to acquire a “full enforcement toolkit” in each Canadian province and territory.  For IIROC, a “full enforcement toolkit” means (i) the legal authority to collect fines, (ii) the legal authority to collect and present evidence, and (iii) statutory immunity for IIROC and its personnel when acting in the public interest.  IIROC has now obtained a full enforcement toolkit in four Canadian provinces (Alberta, Quebec, PEI and Nova Scotia), and, in 2018, made significant progress in several other jurisdictions.

Legal Authority to Collect Fines

In 2018, IIROC acquired the legal authority to collect fines through the courts in six additional provinces and territories: Nova Scotia, Northwest Territories, Nunavut, Yukon, Manitoba and British Columbia.  According to the Report, although firms and individuals who wish to remain IIROC Dealer Members or registrants must pay their fines, many choose to avoid payment by leaving the securities industry and abandoning their registration.  The authority to collect fines in the courts is intended to address this problem.

Saskatchewan was added to this list of jurisdictions in 2019.  As a result, IIROC can now collect fines through the courts in every province and territory except New Brunswick and Newfoundland and Labrador.

Legal Authority to Collect and Present Evidence

IIROC also made progress in 2018 by acquiring legal authority to collect and present evidence for disciplinary proceedings from six additional provinces and territories: Northwest Territories, Nunavut, Yukon, Quebec, Nova Scotia, Prince Edward Island (PEI).  Although IIROC can compel the cooperation of individual registrants and Dealer Members, without specific authority IIROC cannot force other individuals and entities to cooperate, even if they have relevant evidence.  Before 2018, only two provinces had granted IIROC the authority to collect evidence from non-regulated parties.  As a result of legislative changes in 2018, IIROC can now collect evidence and compel cooperation in every Canadian province except British Columbia, Saskatchewan, New Brunswick, Newfoundland and Labrador, and Ontario.

Statutory Immunity and Protection

Finally, in 2018, IIROC succeeded in obtaining statutory immunity protection in four additional provinces.  IIROC is seeking statutory immunity for good faith performance of its regulatory functions because IIROC believes that such immunity is necessary to allow IIROC and its personnel to take appropriate regulatory action in the public interest without fear of reprisal.  Alberta was the first Canadian province to grant IIROC this type of protection in June 2017.  With the legislative developments in 2018, IIROC now has statutory immunity protection in Alberta, Manitoba, Quebec, Nova Scotia, and PEI.

 

The author would like to thank Lauren Rennie, Summar Law Student, for her contribution to this article.

Request to Stay a Securities Regulatory Sanctions Hearing: An Uphill Battle

In Re Mountainstar Gold Inc., 2019 BCSECCOM 123, the British Columbia Securities Commission gave short shrift to a request by the respondents for a stay of the Commission’s imposition of sanctions against them until after certain legal proceedings in Chile.

At the conclusion of the Commission’s hearing on the merits, it determined that over a 3-year period, Mountainstar Gold Inc. had repeatedly contravened section 168.1(1)(b) of the British Columbia Securities Act by making disclosure in its public filings concerning certain Chilean mining claims and related legal proceedings that was false or misleading in a material respect, and that Brent Hugo Johnson, an officer and director of Mountainstar, authorized, permitted or acquiesced in those contraventions.

According to the Commission, “the false or misleading disclosure in issue fundamentally misrepresented ownership of the mining interests comprising Mountainstar’s principal asset and key project”.  The Company’s MD&A represented that a party identified as “L” in the Commission’s decision was the registered holder of title to certain mining concessions which were the subject of an option agreement.  In fact, L had simply filed petitions with respect to those concessions.  L had not acquired any mineral or exploration rights to the areas subject to the petitions.  Accordingly, the Company’s MD&A “fundamentally misrepresented the status of L’s legal proceedings challenging title to the underlying mining interests”.

In denying the motion for a stay, the Commission indicated that the respondents had not demonstrated that the Chilean legal proceedings could have a determinative or substantial impact on the sanctions decision.

Further, the Commission found that even if it had accepted that the Chilean legal proceedings were relevant and that there was potential prejudice to the respondents if a sanctions decision was rendered and the Chilean legal proceedings were subsequently decided in L’s favour, it would not consider a stay to be in the public interest.  The contraventions were serious.  The time required to conclude the Chilean legal proceedings could result in indeterminate and potentially substantial delay.  The respondents’ continued participation in the capital markets posed a serious risk to investors and the markets.

Takeaway

This decision confirms the difficulties that respondents face when seeking a stay of securities regulatory proceedings.  In reaching its decision, the Commission referred to its prior decision in Starflick.com(Re), 2014 BCSECCOM 25, in which it noted with approval the comments made by the Supreme Court of Canada in RJR-MacDonald Inc. v. Canada (Attorney General), [1994] 1 SCR 311, that where a public authority is charged with the duty to promote and protect the public interest and its activities are undertaken pursuant to that responsibility, it should be assumed “that irreparable harm to the public interest would result from the restraint of that action”.

The AMF is not the sole arbiter of what is relevant and what should be disclosed

In AMF v. TMF, Baazov, et al. (Court File No. 500-11-052989-171), the Quebec Superior Court confirmed that the Financial Markets Administrative Tribunal (the Tribunal) has the power to order the Autorité des marchés financiers (AMF), Quebec’s securities regulator, to disclose documents to individuals against whom the AMF is seeking freeze orders and cease-trade orders in the course of an ongoing confidential investigation.

Freeze orders essentially prohibit a person from spending a single penny in his/her possession while cease-trade orders prohibit a person from trading on any and all securities he/she holds. These draconian orders are typically issued while the securities regulator is investigating the targeted person and remain in place for the duration of the investigation (i.e. months, if not years).

When applying to the Tribunal for the issuance of freeze and/or cease-trade orders, the AMF is free to decide which allegations it will make, which documents it will provide to support those allegations and which testimony it will put forward.  As applications for freeze and/or cease-trade orders are made in the course of an ongoing confidential investigation, the AMF will choose to disclose what it believes is required to obtain the orders sought, but no more, so as to preserve the confidentiality of its ongoing investigation to the greatest extent possible.

For the first time in its history, further to requests by David Baazov and others and before hearing the AMF application for freeze and cease-trade orders, the Tribunal ordered the AMF to disclose specific documents.

As there is no right of appeal from such an order, the AMF applied to the Quebec Superior Court for judicial review.  In its recent judgment, the Superior Court confirmed that even in the context of an ongoing and confidential securities investigation, the Tribunal has the power to order the disclosure by the AMF of documents:

  • that are directly related to the proceedings instituted by the AMF, to the allegations advanced by the AMF and/or to exhibits adduced in support thereof; and
  • that appear relevant, prima facie, to allow the individuals against whom the AMF is seeking orders to offer full answer and defense in the context of a fair hearing (débat loyal et équitable).

Moreover, given the significant consequences of freeze and cease-trade orders, the Superior Court confirmed that when the AMF chooses to launch proceedings seeking such orders, the AMF does not remain the sole arbiter of what is relevant and what needs to be disclosed.

Rather, insofar as the above two-pronged test is met and notwithstanding the confidentiality of the ongoing securities investigation, the Tribunal can, to preserve procedural fairness, order the disclosure by the AMF of additional documents to the individuals targeted by the AMF’s requests.

Large and generous interpretation of “investment contract” and “distribution” under the Quebec Securities Act: AMF v. Desmarais, 2019 QCCA 898

In its recent decision (AMF v. Desmarais), the Court of Appeal upheld the conviction of a Montreal lawyer who played a central role in the distribution of investment contracts without a prospectus and who acted as a dealer without being registered as such, while reducing his prison sentence and fine.

Facts of the case

Jean-Pierre Desmarais, a partner at a Montreal law firm, assisted Fondation Fer de Lance (FFDL) – a private not-for-profit foundation co-founded by Messrs. Desmarais and Gélinas – in recruiting and convincing 23 “sponsors” to sign a contract requiring them to make sums available to FFDL in the hope of future compensation.

Mr. Desmarais participated in the drafting of the contracts, met with potential investors in his law firm’s offices, received some of the investors’ funds, deposited some of these funds in his law firm’s trust account and later transferred them to FFDL’s trust account (of which he was signatory) or to Mr. Gélinas directly.  In total, FFDL raised close to US$1.4M.

Over the years, FFDL experienced various financial difficulties; while some “sponsors” were able to recover their capital, none ever got a return on their investment.

Rationale for the generous and large interpretation of “investment contracts” and “distribution”

The Court of Appeal reiterates that:

  • the goal of securities legislation is the protection of the investing public, and
  • it would be impossible for any legislator to include the wide array of financial arrangements that various companies can conceive of under one precise definition

such that the concepts of “investment contract” and “distribution” under the Quebec Securities Act (QSA) need to be given a generous and large interpretation.

What is an “Investment Contract”?

An investment contract is defined in the QSA as a contract whereby a person, having been led to expect profits, undertakes to participate in the risk of a venture by a contribution of capital, without having the required knowledge to carry on the venture or without obtaining the right to participate directly in decisions concerning the carrying on of the venture.

Mr. Desmarais argued that the contracts at issue referred to “sponsors” as opposed to “investors”, to the availability of funds as opposed to their investment and to “ “compensation” as opposed to “return”, such that the contracts should not be found to be “investment contracts” under the QSA and that no prospectus need be prepared.

The semantic arguments raised by Mr. Desmarais were all rejected, in favour of an analysis of the essence of the contract. Simply put, it’s substance over style.  The contracts between FFDL and the “sponsors” were found, in essence, to be “investments contracts” under the QSA. The Court added that in this case, the risk of the venture not only included the loss of the capital contributed but also the loss of the expected advantage or profit.

The Court also confirmed that the notion of “securities” (which appears in the definition of “distribution”) encompasses all the forms of investment to which the QSA applies, including an investment contract.  As a result, a prospectus had to be prepared ahead of its distribution.

Reduction of the Penalty

In determining the penalty, section 202 of the QSA allows the Court to “take particular account of the harm done to the investors and the advantages derived from the offence”.

Despite confirming that in this case, the most aggravating element was the breach of trust through the abuse of the seriousness of his profession, the Court of Appeal reduced Mr. Desmarais’ prison sentence from 18 months to 6 months and his fine from $345,000 to $70,000 on account of two mistakes made by the trial judge.

First, the trial judge had found that in a worst-case scenario, the investors could lose $290,000 and had taken this into account when deciding the penalty to be imposed on Mr. Desmarais. The Court of Appeal found that there was no evidence beyond a reasonable doubt that there would be any loss. It was thus a mistake in law for the trial judge to have considered losses as an aggravating factor, the existence of which had not been put into evidence.

Second, the trial judge had considered the fees of $305,000 paid to Mr. Desmarais’ law firm.  The Court of Appeal held that there was no evidence as to what portion of those fees, if any, had been received by Mr. Desmarais, such that they should not have been taken into account when deciding the penalty to be imposed on Mr. Desmarais.

In its discussion on sanction, the Court of Appeal confirmed that:

  • lack of remorse cannot be considered as an aggravating factor, particularly when a person contests having ever committed the infraction, and
  • an accused’s financial means and ability to pay the fine, together with the delay to pay, is a relevant factor.

Take-Away

No matter the terminology used, courts will favour substance over form when determining whether a particular contract or structure falls within the definition of “investment contract” in order to protect the investing public.

The author would like to thank Isaac Harris for his contribution to this article.

Imposition of OSC Sanctions Following a Conviction for an Offence Relating to Securities: The Availability of Carve-Outs in the Public Interest

In Theroux (Re), 2019 ONSEC 20 a hearing panel of the Ontario Securities Commission (OSC) was called upon to decide whether an individual convicted of five counts of fraud over $5,000 contrary to section 380(1)(a) of the Criminal Code should have the benefit of carve-outs from an order under section 127(10) of the Ontario Securities Act (Act) which would otherwise prohibit him from trading in securities and from being an officer or director of any company permanently.

Facts

Alain Theroux had pleaded guilty in the Ontario Court of Justice to five counts of fraud over $5,000. Theroux admitted that he had solicited and accepted funds from investors in excess of $1 million reflecting their investments in bonds, promissory notes and bridge financing marketed in respect of a biofuel venture with a company with which Theroux was associated.  Substantial portions of the funds raised were diverted to Theroux’s personal use or to pay other investors and were not invested in the biofuel market.

At a subsequent hearing before the hearing panel of the OSC under section 127(10) of the Act, the fraudulent investments were found to constitute securities under the Act, thereby giving the hearing panel jurisdiction to impose sanctions upon Theroux in addition to the sentence imposed under the Criminal Code of 12 months’ incarceration, two years’ probation, restitution in the amount of $170,800 and a fine in lieu of forfeiture in the amount of $75,000 to be paid within 15 years of his release from prison.

Sanction Carve-Outs

Theroux requested two carve-outs from the sanctions requested by OSC Staff, which included a permanent prohibition on his ability to trade securities and on his ability to act as an officer or director of any company.

He sought to retain the ability to trade securities in certain types of accounts to provide him with the ability to accumulate investment savings and increase the likelihood that he would satisfy the restitution order made under the Criminal Code. The hearing panel agreed that it was in the public interest to permit him to trade in securities or derivatives in a registered retirement savings plan, registered education savings plan, in any registered retirement income fund, and/or a tax-free savings account in which he has a beneficial interest, provided that any trades are carried out through a registered dealer.

However, his request that he be permitted to return to his role as a director of his private company at the end of his term of parole was denied, notwithstanding Theroux’s submission that the company was not involved in the public markets.  The concern was that the company could still be used to raise capital or market investment contracts through the exempt market, like the enterprise involved in the fraud that he had committed.  On that basis, it was not in the public interest to make that carve-out from the permanent prohibition on him acting as an officer or director of any company.

This decision is consistent with prior decisions of the OSC relating to requests for carve-outs from sanctions.  The granting of such carve-outs is not automatic, and must be justified on the basis that they are in the public interest.

Harrington v IIROC: No Equitable Duty Owed by Public Sector Regulators to Disclose Information to Victims of Wrongdoing

On December 31, 2018, the Ontario Superior Court of Justice dismissed an application by Harrington Global Opportunities Fund (Harrington) for a Norwich order against the Investment Industry Regulatory Organization of Canada (IIROC). Harrington sought the order to compel IIROC to provide information that would identify parties which had allegedly been involved in manipulating the market price of shares of a reporting issuer, to permit it to determine the viability of a civil action against them.

Justice Perell’s decision highlights the fact that the issuance of a Norwich order is “a rarely exercised extraordinary discretion”.  “[T]he protection of privileges and confidences and the interests of the innocent target of the order”, in this case a securities regulator operating under the public law regime, are “powerful forces” against the issuance of such an order.

This decision sends a clear message that applications for a Norwich order against other regulatory bodies operating in the public law sector will likely be an uphill battle.

Background

Between 2016 and 2018, Concordia International Corp. (Concordia) experienced a significant drop in share price, resulting in a loss of approximately $3.9 billion dollars of its market capitalization. Harrington, a sophisticated investor, believed that Concordia was a victim of a short-selling conspiracy involving a group of traders using social and mainstream media to disseminate misleading information designed to manipulate the market. In order to pursue a conspiracy claim against the alleged conspirators, Harrington applied for a Norwich order to compel IIROC to disclose certain identifying information about the suspected conspirators and certain trade reports generated by IIROC from data provided by investment dealers and trading venues. Investigations by IIROC into the alleged wrongdoing had led it to conclude that no manipulation had occurred.

The Decision

The court dismissed Harrington’s application.  While Justice Perell agreed that Harrington appeared to have a valid cause of action for unlawful means conspiracy, it did not satisfy any of the remaining criteria for a Norwich order.  In particular:

  1. Harrington failed to satisfy “perhaps the most important criterion for a Norwich order”, the existence of a connection or relationship between the target of the order (IIROC) and the wrongdoer or the wrongdoing. The issue was whether or not IIROC, operating in the public law sector, ought to have a duty to disclose trading information to an investor thinking of bringing a private law tort claim.

Justice Perell determined that it did not.  IIROC did not have a relationship with wrongdoing or wrongdoers in the industry that it regulates that would impose a duty upon it in equity to disclose information to victims of the alleged wrongdoing. Further, how IIROC carried out its obligation to investigate potential misconduct, and what information to disclose before, during or after its investigation was for IIROC to decide.

  1. The necessity requirement was not satisfied. Harrington already had a prospective action for civil conspiracy against a particular short seller and others that it believed may have conspired to short and distort the sale of Concordia shares.
  2. Balancing the interests of IIROC against the interests of Harrington tipped the balance against granting the order. IIROC’s duties of keeping confidences and protecting privacy interests, and its interest in maintaining its relationship with other regulators such as FINRA, stood against making the order. FINRA would be less likely to share client and broker data with IIROC in the future if IIROC could be required to disclose such data.
  3. The interests of justice did not favour the granting of the Norwich

Takeaways

  • Norwich orders are intrusive and should only be granted in extraordinary situations. It is not a means to search out and investigate speculative actions; and
  • In general, regulators like IIROC are under no equitable duty to disclose information to parties interested in pursuing a private law remedy against suspected wrongdoers under its jurisdiction.

The authors would like to thank Travis Bertrand, Articling Student, for his contribution to this article.

MFDA Annual Enforcement Report: Trends in Mutual Fund Dealer Regulation

The Mutual Fund Dealers Association of Canada (MFDA) recently published its 2018 Annual Enforcement Report (the Report), highlighting key enforcement activities and developments over the past year.

The MFDA commenced 136 enforcement proceedings in 2018 by Notice of Hearing or Notice of Settlement Hearing, a record number for the self-regulatory organization (SRO). The SRO attributes the record number, in part, to enhanced detection and reporting by its mutual fund dealer members (the Members). The Report highlighted the following trends:

Primary sources of cases to be assessed. Roughly 65% of the cases opened in 2018 stemmed from the MFDA’s Member Event Tracking System, through which Members can file event reports. The only other significant source of complaints (28%) was the general public. There were 50% less case openings prompted by event reports from the MFDA Compliance Department between 2017 and 2018 (from 16 to 8). Conversely, there was a marked uptick in complaints brought by the Canadian Securities Administrators and other regulators compared to last year (from 1 to 11).

Primary allegations. The top five alleged violations of MFDA Rules, By-Laws, or Policies in 2018 were the following: (1) pre-signed forms; (2) unauthorized commissions and fees; (3) unsuitable investments; (4) breaches of the MFDA Rule 2.1.1(b) business standards; and (5) unauthorized or discretionary trading without client approval. Compared to last year’s figures, allegations related to unauthorized commissions and fees more than doubled.  Allegations tied to the falsification of documents/misrepresentations and outside activities decreased by more than 50%.

Hearing types and penalties. Of the 132 hearings concluded by the Enforcement Department in 2018, almost 75% were settlement hearings (as opposed to contested or uncontested hearings).  41 hearings resulted in suspensions, 19 in permanent prohibitions, and 5 in educational course requirements. Further, the MFDA Hearing Panels imposed over $6M in fines, down from $8.5M in 2017 and $21.1M in 2016.

Expanded evidentiary powers.  In 2018, the MFDA was granted enhanced evidence gathering powers in three unidentified provinces which provide the SRO with the ability to compel evidence and cooperation from non-registrants.

New sanction guidelines. November 2018 also saw the introduction of the new MFDA Sanction Guidelines, which replaced the MFDA Penalty Guidelines that had been in place for over a decade. The Sanction Guidelines, in part, provide a framework for disciplinary actions, settlement negotiations, and determining appropriate sanctions.

Supervisory obligations. In 2018, 11 proceedings were concluded against Members and supervisors for failing to properly carry out a reasonable supervisory investigation. Members must track and monitor information that they receive, both internally and externally, pertaining to potential breaches of Member requirements and to take reasonable supervisory action in response to such reports.

Looking forward, the MFDA has explicitly cited sales incentive practices as a key enforcement area that it will continue to investigate in 2019. The MFDA is targeting any sales incentive practices that: (i) may impact product sales to clients; (ii) could engender conflicts of interest; and (iii) do not comply with National Instrument 81-105, Mutual Funds Sales Practices.

The author would like to thank Sarah Pennington, Articling Student, for her contribution to this article.

US Second Circuit rules Issuer’s statements concerning regulatory compliance too generic to constitute material misstatements

On March 5, 2019, the United States Court of Appeal for the Second Circuit affirmed the dismissal of a class action claim alleging securities fraud based on purportedly misleading statements made by an Issuer regarding its regulatory compliance efforts. The Second Circuit concluded that the Issuer’s statements were too generic to cause a reasonable investor to rely on them, and rejected the claim as a “creative attempt to recast corporate mismanagement as securities fraud.” Singh v. Cigna Corp., No. 17-3484-cv, 2019 U.S. App. LEXIS 6637 (2d Cir. Mar. 5, 2019).

Background:

In early 2012, Cigna Corporation (Cigna or the Company), a health services organization, acquired a regional Medicare insurer, which subjected the Company to strict Medicare regulatory responsibilities. Between 2014 and 2015, Cigna issued several public statements addressing the regulations, including disclosure that it had “established policies and procedures to comply with applicable requirements” and that the Company “expect[ed] to continue to allocate significant resources” towards compliance. Cigna also published a ‘Code of Ethics and Principles of Conduct’ pamphlet (Code of Ethics) affirming the importance of compliance and integrity to the Company. During this same period, however, Cigna received multiple notices from the Centers for Medicare and Medicaid Services (CMS) for a variety of compliance infractions. On January 21, 2016, CMS informed Cigna it would face sanctions for failing to comply with CMS requirements, causing the Company’s stock to fall substantially. Following this drop, a Cigna investor brought a putative class action suit against the Company, claiming that Cigna’s statements regarding its Medicare compliance were materially misleading, constituting fraud under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Securities and Exchange Commission (SEC) Rule 10b-5.

The Ruling:

The Second Circuit held that the District Court properly dismissed the claim on the basis that the plaintiffs failed to plausibly allege that there was a material misrepresentation (or omission) under Section 10(b) and Rule 10b-5. An alleged misrepresentation is material only if “there is substantial likelihood that a reasonable person would consider it important in deciding whether to buy or sell shares of stock.” According to the Court, neither Cigna’s Code of Ethics nor its public statements created such reliance.

The Court stated that Cigna’s Code of Ethics was a “textbook example of ‘puffery’,” rendering the statements inactionable. Similarly, Cigna’s generic assertions about its policies and procedures and intention to allocate resources towards compliance would not cause a reasonable investor to view the statements as “alter[ing] the total mix of information made available.” All of the Company’s public statements were also followed by acknowledgments of the complex and evolving nature of the regulatory environment. This lead the Court to conclude that the disclosure actually expressed Cigna’s uncertainty as to its ability to adequately comply with Medicare’s regulatory requirements, rather than suggesting accurate compliance. The Company’s statements, therefore, could not be considered materially misleading.

Implications:

There has been  an uptick in recent years of securities class actions based on corporations’ more general public statements regarding regulatory compliance, as compared to traditional actions which were solely focussed on allegedly misleading financial and accounting disclosure. However, as Singh demonstrates, at least some courts appear to be discouraging this trend. The decision in Singh should offer comfort that corporations’ generic statements about compliance policies and procedures cannot necessarily be recast as specific misrepresentations. Furthermore, the decision supports the notion that corporate mismanagement should not, by itself, give rise to a securities misrepresentation claim.

 

The author would like to thank Abigail Court, Student-At-Law, for her contribution to this article. 

Not ready yet: OSC rejects bitcoin fund prospectus

On February 15, 2019, the Ontario Securities Commission issued a decision in which it refused to issue a receipt for a prospectus filing made by 3iQ Corp. (3iQ) in respect of The Bitcoin Fund (the Fund).  The decision highlights the challenges faced by issuers seeking to do business in cryptocurrency markets, which regulators continue to view as highly problematic.

Background

3iQ designed the Fund as a non-redeemable investment fund (NRIF) that would expose investors to bitcoin and daily price movements of bitcoin relative to the US dollar.  3iQ filed a non-offering prospectus on behalf of the Fund in order to resolve the concerns of the OSC in advance of issuing units in the Fund.  It intended to convert and refile its prospectus as an offering prospectus to raise proceeds if and when those issues were resolved.

The prospectus indicated that the Fund would appoint Cidel Trust Company to act as custodian of the assets of the fund. However, as Cidel did not have the capacity to hold bitcoin on behalf of the Fund, it would appoint a sub-custodian.

Position of OSC staff

OSC staff submitted that it was simply too early for bitcoin to be considered an appropriate asset for an investment fund available to the public. Staff expressed concern about the gaps between regulatory regimes in other jurisdictions and the high potential for abuse in a cryptocurrency market that is still very difficult to monitor.  Staff also expressed concern about the fact the Fund had not yet received from any sub-custodian a copy of a customary Service Organizational Control (SOC) audit report and submitted that it would be very unusual to rely on a custodian that could not provide such a report on request.

Notably, staff argued that the Fund had not taken sufficient steps to protect investors against the risk of loss of bitcoin, such as by obtaining insurance. Staff also took the position that the prospectus was not compliant with NI 81-102, which limits a NRIF to investing no more than 20% of its net asset value in illiquid assets.  Staff took the position that bitcoin is an illiquid asset, because it is not traded on market facilities on which public quotations in common use are widely available.

Fund manager responses

Among other things, 3iQ argued that Canadian investors are already able to gain exposure to bitcoin through: (i) the securities of issuers holding cryptoassets that went public via reverse takeovers (ii) unregulated exchanges; and (iii) ATMs. Compared to those alternatives, the Fund would be a safer way to invest in cryptoassets with the benefit of the expertise of a professional portfolio manager.  It also argued that it would be able to perform diligence to establish the source of the bitcoin acquired by the Fund to minimize exposure to fraud or other illicit activities.  3iQ also disputed that bitcoin is illiquid with trading volume evidence.

OSC refuses receipt in the public interest

The OSC founded its decision on a concern about the lack of established regulation for the bitcoin market, which raises investor protection issues. In deciding whether it is contrary to the public interest to issue a receipt for the Fund’s prospectus, the OSC is required to consider whether fund operational risks are adequately managed by measures other than providing disclosure of such risks to investors.  It therefore focused its review on operational concerns.

The OSC expressed concern about accurate valuation due to the fragmented and unregulated bitcoin market. Despite the fact that 3iQ had taken steps to ensure reliable, reputable sources of valuation information, the OSC accepted staff’s submission that trading on less reputable platforms can impact pricing on more reputable platforms.  This exposure differentiates bitcoin assets from conventional investments assets.

While the OSC acknowledged that SOC reports are not normally required by staff for publicly-offered investment funds, it stated that “bitcoin is a novel digital asset that requires novel custodial arrangements”. It found that, without customary SOC reports or insurance to protect against the risk of loss of bitcoin held in cold storage, an investment in the Fund presents a novel risk that is unacceptable for a prospectus qualified fund offering.

The OSC also found that bitcoin is an illiquid asset, and as a result, 3iQ’s prospectus was not compliant with NI 81-102.

Decision expresses regulatory unease about cryptoassets

The OSC’s decision makes clear that cryptoassets are still a long way from being considered trustworthy asset classes.

It also emphasizes the unease created by the recent death of Quadriga’s founder Gerald Cotton and related inaccessibility of nearly USD $150 million in cryptoassets. The OSC’s concerns regarding financial reporting and insurance for coins in cold storage appear to be focused at least in part on making sure that the peculiar circumstances that led to the Quadriga situation are not repeated.

 

The author would like to thank William Chalmers, Articling Student, for his contribution to this article.

Alberta Securities Commission Declines to Stay Enforcement Proceedings In Face of Parallel Class Actions

In February 2019, the Alberta Securities Commission (ASC) declined to stay the hearing of pending ASC enforcement proceedings on the basis of the existence of parallel, pending class action proceedings.

Background

In June 2018, Staff of the ASC issued a notice of hearing against Alberta divisions of the Lutheran Church-Canada and several of their former officers and directors (the Respondents), alleging that the Respondents had made misrepresentations contrary to s. 92(4.1) of the Alberta Securities Act (material misleading statements) in connection with securities offered to members of the Lutheran Church.

The allegations followed the financial collapse of Church divisions in 2015 and ensuing proceedings filed under the Companies’ Creditors Arrangement Act.  The Respondents and other parties had also been sued in four class action proceedings commenced in British Columbia and Alberta.  The factual allegations supporting the class actions were similar but not identical to those supporting the ASC proceeding.  The causes of action asserted in the class actions (including breach of trust, breach of fiduciary duty, negligence, breach of contract and oppression) were different than the allegation of contravention of s. 92(4.1).

Applications for a Stay

The allegations of ASC staff were scheduled to be heard on their merits in May 2019.  In October 2018, the Respondents and some of the other defendants in the class actions filed a motion to stay the ASC proceedings pending final resolution of the Alberta class actions.  Subsequently, an additional group of defendants filed an application seeking a stay pending final resolution of all of the class actions.

Standing

The first issue to be determined was the standing of the various parties who were not named in the ASC proceeding.

As a matter of procedure, the panel determined it appropriate to hear submissions regarding standing and the merits of the stay application at the same time because no particular efficiencies would have been gained through bifurcation.  This is a matter of discretion.

Regarding standing, the panel considered the factors enumerated under ASC Rule 15-501, s. 6.1[1], which the panel saw as a codification of common law principles applicable to questions of standing.  The panel was also mindful of “flood gates” concerns raised by Staff regarding strangers to a proceeding being permitted to participate.  Ultimately, the panel concluded that certain applicants were not seeking to tender evidence or make submissions that was substantially different than that of the Respondents.[2]  They were denied standing.  On the other hand, standing was granted to one group of applicants who “presented a different perspective and made different submissions”.

Stay Denied

The panel noted that given its public interest mandate, for the panel to exercise its discretion to grant a stay there must be exceptional and extraordinary circumstances involving irreparable harm that outweighs the public interest in seeing the ASC proceeding concluded.  The evidence of irreparable harm must be clear and not speculative, and the harm must be to the applicant.

The panel emphasized that the fact of parallel legal proceedings is not sufficient to establish irreparable harm.  “ASC proceedings are often preceded or followed by criminal prosecutions, civil suits – including class actions – or both.”  Fears of making inconsistent statements, of having one’s statements in one proceeding used in another, or of inconsistent rulings, are speculative and insufficient.  The panel emphasised that “no matter how broadly a notice of hearing is framed, the ASC can only make findings against those who are named respondents, and only for the contraventions specifically alleged and proved by evidence on a balance of probabilities.”  Further, the trial judges in the class actions were capable of addressing evidentiary issues and ensuring fairness in those proceedings.

The panel also rejected the argument that a stay was warranted because the Respondents could only obtain the evidence necessary to defend the allegations made by ASC staff through the discovery process in the class actions.  The argument was speculative and begged the question as to what the Respondents would do if the ASC proceeding was the only outstanding proceeding.

The panel further concluded that the balance of convenience weighed in favour of the public interest in having the ASC proceeding be determined without delay.  The ASC’s public interest mandate to protect investors and foster a fair and efficient capital market “involves the entire market, and extends beyond the interest of a single group  or even several groups – of specific investors”.  Effective enforcement requires timeliness, efficiency and finality.

While not a surprise, this result highlights the challenges facing companies, directors and officers facing concurrent regulatory and class action proceedings arising out of the same matter.  Formerly, the ASC did not permit no-contest settlements of enforcement actions.  Effective May 4, 2018, the ASC decided that it would entertain no-contest settlement agreements in appropriate circumstances.   For more information on this, please go to:  https://www.albertasecurities.com/securities-law-and-policy/regulatory-instruments/15-601

 

[1] Non-Parties Seeking to Appear before a Panel.

[2] Citing Re Certain Directors, Officers & Insiders of Hollinger Inc., 2005 LNONOSC 858 at para. 48.

 

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