YOUR WORST NIGHTMARE, CEASE TRADE ORDERS | How they happen, why they happen, and how to deal with them
By: Matthew Epp & Craig L. Bentham
Every week, the website of the Alberta Securities Commission (ASC), and occasionally the news wire, announces that an exempt market issuer has been the subject of a Cease Trade Order (CTO). In many cases, the CTO could have been avoided through the careful preparation of offering documents and close consultation with legal counsel familiar with the rules that govern capital-raising.
What is a CTO?
Put simply, a CTO is an order that is made by any of the Canadian securities regulators, which stops an issuer from trading or distributing its securities. The focus of this article is on CTO’s issued in Alberta, however, as the legislation is similar in most provinces, the discussion is generally applicable to other provinces as well.
As the primary regulator of Alberta’s capital markets, the ASC has the ability to issue a CTO and will do so where it is of the view that there has been a breach of the Alberta Securities Laws and that it is necessary in order to protect the public interest and the integrity of the capital markets.
As will be discussed in more detail below, the range of activities that can ‘trigger’ a CTO are extremely wide. In the context of an exempt market issuer distributing securities under an Offering Memorandum, anything from an alleged misrepresentation in the body of the document, to the failure to ensure that up-to-date financial statements have been prepared, could result in a CTO being issued by the ASC. An issuer relying on a term sheet and raising capital from accredited investors might face a CTO if an investor were to file a complaint and the ASC were to discover that investors were not properly qualified.
Finally, it is important to recognize that Exempt Market Dealers, like exempt market issuers themselves, can be subject to a CTO for failing to ensure that necessary documentation such as ‘Know Your Client’ forms are prepared and kept on record, or for failing to follow the appropriate ‘suitability’ parameters. The focus of this article is on CTOs as they apply to exempt market issuers, and primarily in the context of an Offering Memorandum.
How the Process Works
The provisions of Alberta’s Securities Act (Act) provide that an initial CTO may be issued without notice to the target. In other words, the CTO is put in place without the issuer (or an individual or EMD) even being aware of its existence. The ASC can, and does, issue CTOs for filing deficiencies without a hearing, and the conditions put in place by the ASC to allow for the lifting of the CTO can be onerous. An example of a filing deficiency that would attract a CTO is a disagreement between the commissions reported to the ASC in an Offering Memorandum and the filed report of exempt distribution. An issuer is free to appeal a CTO pursuant to s.33.1 of the Act; however, the process can be expensive and time-consuming.
The Act also provides for a CTO being issued for non-filing-related issues which can include allegations of misrepresentation or fraud. This process involves two steps: the first is an application before a panel of the ASC for an initial CTO that is put in place for 15 days; the second involves a further application that is heard on the 15th day after the initial CTO was issued, where a panel determines whether the initial CTO should be extended and, if so, under what terms.
ASC staff are responsible for preparing the evidence that it will put before the ASC, seeking to have it issue both the initial CTO and subsequently, extend it. This evidence is an affidavit(s) that is normally prepared by investigative staff, which sets out the breach(es) of the Alberta Securities Laws. Depending on the circumstances, these affidavits can be extremely lengthy and include a large amount of evidence.
The practical result of this short notice is that the target of the CTO has very little time to review the evidence, contact legal counsel and determine how to respond. Given this, it is not surprising that the vast majority of initial CTO applications are successful.
Once the initial CTO is put in place, the target then has 15 days to investigate the matter, and to determine whether the ASC’s concerns are well-founded and how to respond. The response can vary from determining that the ASC’s evidence is incorrect or incomplete, with the result that the issuer may decide to oppose the extension of the initial CTO, to cooperating with the ASC in order to cure any alleged deficiencies or breaches.
The nature of the target’s response will depend on the issues identified by the ASC and whether they can be remedied in a timely fashion. In addition, other more subjective factors, such as whether the ASC has formed the view that the deficiencies are the result of an oversight or instead, more serious concerns about the target’s activities, will impact the response.
During this 15 day period the ASC may continue to investigate the matter and can prepare additional evidence in order to support an extension of the initial CTO. If the CTO is extended, it may be for a finite period of time (six months, one year or some other period) or until such time as a hearing is held.
If the target decides to contest the extension of the initial CTO, it must normally prepare affidavit evidence to counter the evidence put forward by ASC investigative staff. Almost inevitably, this is an extremely expensive and time-consuming process that involves corporate counsel working with staff of the issuer and litigation counsel. Once the evidence is prepared, counsel for the target and the ASC then argue the matter before the ASC panel.
In addition to the above, the ASC may issue a ‘cease and desist’ letter to a target requiring that trading in the target’s securities cease until certain conditions are met. These letters have the same effect as a CTO since, if an issuer ignores them, the ASC may simply apply for a CTO. The authors have been involved in circumstances where the ASC, on the basis of minor issues relating to the form requirements of an Offering Memorandum, has issued a cease and desist letter without any prior notice, any order being issued or any hearing being scheduled.
In many cases, it is more effective to work with the ASC to address the matters raised in the CTO than to oppose the CTO. This is especially so when it is important to maintain a good working relationship with the ASC. For example, an EMD will likely want to foster a good working relationship with the ASC and address its concerns in a manner that is as non-confrontational as possible. This is especially relevant where filing deficiencies or Offering Memorandum form requirements are at issue.
What Triggers a CTO?
It is important to recognize that traditionally, the ASC has been a complaint driven organization, with the result that the majority of its enforcement actions (which often begin with a CTO) originate with complaints from investors or members of the public. However, increasingly, it is conducting pro-active reviews of Offering Memoranda.
Common triggers for a CTO are misrepresentations made by an issuer, its management or its agents, in its offering documents or marketing materials. For issuers who are distributing securities through Offering Memoranda, where those Offering Memoranda have not been prepared in accordance with the requirements of Form 45-106F2, a CTO is a real risk.
Surprisingly, it is relatively common for issuers to fail to include, with their Offering Memoranda, financial statements that meet the requirements of Form 45-106F2. This can include stale dated financial statements, unaudited financial statements and/or financial statements prepared in accordance with GAPP as opposed to IFRS.
The failure of an issuer to include two years of financial statements with the Offering Memorandum, where an issuer has been in existence for two years or longer, is another common omission that can lead to a CTO.
Consequences of the Cease Trade Order
The consequences of a CTO can be significant for the issuer and/or named individuals. Typically, a CTO will set out the grounds for having been issued, and may include the remedial steps to be taken by an issuer in order for the CTO to be revoked. Alternatively, it may simply cease the trading in the issuer’s (or named party’s) securities without a remedy being provided.
It is in this latter situation where the issuer, its staff and legal counsel must then begin the task or working with the ASC in order to address its concerns. Depending on the basis upon which the CTO was issued, this can involve the preparation or re-statement of financial statements, revisions to the Offering Memorandum itself.
However, aside from addressing the specific concerns raised by the ASC which led to the CTO, the real difficulty can begin if and when the ASC begins its review of all matters relating to the issuer and the individuals named in the CTO.
This typically involves a near forensic review of the issuer’s current offering, past offering documents, financial statements, form F1 filings and even a review of the business plan of the issuer. This latter point can be especially problematic if the ASC is not familiar with the business of the issuer.
In addition, it is not unusual for the ASC investigative staff to interview investors, employees of the issuer and other third parties, such as development consultants or other contractors. As the ASC has significant resources and the power under the Securities Act to compel the production of documents such as bank records, emails and business records, as well as the ability to compel individuals to submit to an interview that is conducted under oath and transcribed, this review can be far reaching and time-consuming.
The cost and expense to an issuer as a result of a CTO can be significant both in terms of legal fees and time and opportunities lost. Time that should be spent raising capital is spent dealing with demands for documents, financial information and the attendance at interviews.
Other significant consequences of a CTO can include:
- The length of the ASC’s review/investigation can take months and can require significant internal and external resources.
- A CTO in one jurisdiction may trigger reciprocal CTOs in other jurisdictions. For instance, Alberta and British Columbia have an informal reciprocal CTO agreement whereby an issuer who is distributing in both provinces and is cease traded in one, will be the subject of a CTO in the other.
- The fact that a CTO has been issued against the issuer or individuals involved with it must be disclosed in future Offering Memoranda for a period of 10 years.
- Where the ASC has cease traded an issuer for the issuer having distributed through an Offering Memorandum that is not form compliant, the ASC could cause the issuer to make a rescission offer to all of the security holders who acquired securities under the allegedly deficient offering document.
- A CTO can also lead, ultimately, to a formal hearing before the ASC. This can take years to resolve and the cost to the issuer can be significant.
- As a consequence of a rescission order, the ASC could refuse to remove the CTO until such time the rescission period has ended and all rescission offers have been funded by the issuer.
- Additional issues relating to the issuer’s business can be challenged.
According to an issuer “our experience with a CTO was the result of not carefully scrutinizing our offering documents for all potential disclosure pitfalls. In addition, like most issuers we face the challenge of dealing with multiple securities regulators who each have their own approach to the exempt market. While we did not suffer any financial penalties, as we chose to voluntarily correct and disclose deficiencies we discovered, we did lose up to 8 months of business momentum. The big lesson learned is to deal with competent professionals across the spectrum of offering support services from legal to Trust Companies and maintain a focus on the highest standards of disclosure in the offering documents.”
How to Avoid a CTO
The key to avoiding a CTO is ensuring the retention of appropriate legal counsel who are experienced in the preparation of offering documents and who understand the requirements of the Act as well as all instruments and regulations. Equally important is the retention of auditors who are familiar with the preparation of financial statements in the context of the exempt market.
Finally, it is critical that all issuers, and those individuals involved in the raising of capital, understand the basic requirements of the Act and seek out and follow the advice of their legal advisers.
A Word on Publicity
Over the last several years, the ASC has improved its relationship with the media and has made a concerted effort to ensure that its decisions and orders (including CTOs) are reported as widely as possible. All CTOs are reported on the ASC’s website, and a simple Internet search will reveal them. Further, some CTOs may the subject of press releases and can reach the mainstream media.
In some cases, such as a true ‘scam’, this publicity serves the useful purpose of alerting the public. When a CTO is issued against a target for filing deficiencies, this publicity can have a negative effect by calling into question the legitimacy of the investment and the parties involved even when the circumstances do not warrant it. Obviously, investor confidence is critical to any investment, and an unwarranted and unnecessary press release can undermine this confidence and harm all investors
The key to addressing such publicity is pro-active and open communication with both the ASC and all investors as to the background to the CTO and the actions that the issuer intends to take to remedy the situation.
At the end of the day, the best strategy is one that avoids the issuance of a CTO in the first place.