On October 19, 2018, the Ontario Securities Commission (OSC) issued reasons for Re Meharchand, a case confirming core concepts in securities law including the definition of an “investment contract”, registration when in the business of selling securities, and the test for fraud.
The respondents, Mr. Meharchand and his company, Valt.X were in the business of cybersecurity. Valt.X purportedly developed, produced and sold cybersecurity hardware and software products. However, over the relevant time, Valt.X had very little sales ($15,000 relative to 1,600,000 contributed by investors). OSC Staff (Staff) brought an enforcement action alleging that Valt.X and Mr. Meharchand had distributed securities without a prospectus, engaged in the business of trading in securities without registering and committed fraud.
The hearing panel determined that the respondents breached the Securities Act (Act) in all three respects as alleged by the Staff.
Distribution without Prospectus
The hearing panel found that the respondents raised funds through a program called “CrowdBuy”. Under the CrowdBuy program, the respondents represented that participants could purchase Valt.X software licences at a discount and, through the resale of those licenses, earn lucrative “guaranteed results”. Participants were also offered an option to convert their CrowdBuy subscriptions into Valt.X common shares.
In determining whether the CrowdBuy program was a security by virtue of being an “investment contract”, the panel applied the test as set out in Pacific Coast. In that case, the Supreme Court of Canada held that an investment contract involves an investment of funds with a view to profit, in a common enterprise, where the profit is largely derived from the efforts of the person who controls the enterprise. The panel found that the CrowdBuy program met all the necessary criteria of an investment contract thereby making it a security.
As a result, the hearing panel found that the distribution of these investment contracts without a prospectus or an available exemption was a contravention of the Act.
Section 25 of the Act prohibits engaging in the business of trading in securities unless the person is registered under Ontario securities law. The OSC hearing panel found that the respondents maintained a website in which investors could pay for their Valt.X shares, actively encouraged existing investors to refer new investors, and distributed materials promoting exaggerated potential earnings. During the material time virtually all of Valt.X’s business was to trade in securities. Since the respondents were not registered, this amounted to a contravention of the Act.
The hearing panel noted that Mr. Meharchand informed his investors that he would use the funds that he raised for patents, research and development, product manufacturing, and additional staff. However, the panel found these statements misleading as the bank accounts provided little evidence that the funds were being put to any real commercial activity. The panel found Mr. Meharchand had defrauded investors and characterized Mr. Meharchand’s use of the funds as follows: “withdrawals of money for betting on horses, cash transactions for which no record was kept, the satisfaction of alleged debts to Mr. Meharchand, and other payments to him in priority to other Valt.X debt or expenses.”
At the sanctions hearing, the OSC ordered Mr. Meharchand and Valt.X to disgorge approximately $1.6 million to the Commission. In addition, Mr. Meharchand was permanently banned from serving as an officer or director for any issuer or registrant and was required to pay an administrative penalty of $550,000.
This proceeding serves as a reminder that substance prevails over form. Regulators will sniff out investments contracts in disguise and impose significant penalties for market participants trading in securities contrary to securities law.
The author would like to thank William Chalmers, Articling Student, for his contribution to this article.