Ontario Securities Commission provides guidance on ‘trading relationship’ and defence of reliance on legal advice

On March 28, 2022, the Ontario Securities Commission (OSC) released a merits decision in the case of Solar Income Fund (Re).^[1] The decision provides guidance on the interpretation of “trading relationship” under section 44(2) of the Ontario Securities Act (the Act), which prohibits making misstatements about matters which investors would consider relevant in deciding whether to enter into trading or advising relationships.

The decision also provides guidance to respondents named in OSC administrative proceedings on the circumstances in which the defence of reliance on legal advice is available to charges of securities law wrongdoing, particularly in cases that allege misstatements in securities filings.

The case

The corporate respondent, Solar Income Fund Inc. (SIF Inc.), developed and managed solar farms. SIF created various funds which raised money from the public through exempt market dealers who invested in solar projects and then paid SIF Inc. to provide consulting, development and management services.

OSC Staff’s Statement of Allegations focused on two income funds created by SIF. The first income fund, referred to as SIF #1, raised almost $60 million from investors who purchased the units from SIF Inc. but through an exempt market dealer. SIF #1 loaned money to the second income fund, SIF #2, which was used for various purposes, including distributions to SIF #2 unitholders and to pay the fees of exempt market dealers. OSC Staff alleged that this use of funds was not permitted by the SIF #1 offering memorandum and therefore breached sections 44(2) — the prohibition on making misstatements relevant to trading or advising relationships — and 126.1(1)(b) — the prohibition on fraud — of the Act, and constituted conduct contrary to the public interest.

In addition to SIF Inc., OSC Staff pursued allegations against the company’s various former officers.

Decision

Section 44(2) of the Act does not apply in these circumstances

Section 44(2) of the Act provides

Representation prohibited

(2) No person or company shall make a statement about any matter that a reasonable investor would consider relevant in deciding whether to enter into or maintain a trading or advising relationship [emphasis added] with the person or company if the statement is untrue or omits information necessary to prevent the statement from being false or misleading in the circumstances in which it is made.

OSC Staff alleged that SIF Inc. was in a trading relationship with SIF #1 unitholders because, among other things: investors purchased their units directly from SIF Inc.; SIF Inc. determined investors’ eligibility to purchases units; SIF Inc. wrote to investors to confirm details of their unit purchase and to invite questions; SIF Inc. determined the redemption price for SIF #1 units; and SIF Inc. could cancel units at its discretion.

The Commission panel disagreed with OSC Staff and found that a “trading or advising relationship” was essential to section 44(2) of the Act and that a “trading relationship” had never been found to exist except with respect to activities that were (or ought to have been) performed by registrants. The panel expressed concern that if OSC Staff’s contention was adopted, “every issuer could face a similar finding.” The Commission panel expressly rejected the notion that the administrative and investor relationship activities typically conducted by exempt market issuers could give rise to a “trading relationship.”

The use of funds was contrary to section 126.1(1)

Section 126.1(1)(b) of the Act provides

Fraud and market manipulation

126.1 (1) A person or company shall not, directly or indirectly, engage or participate in any act, practice or course of conduct relating to securities, derivatives or the underlying interest of a derivative that the person or company knows or reasonably ought to know,

            […]

            (b) perpetrates a fraud on any person or company.

The Commission panel determined that the term “fraud” in section 126.1(1)(b) required OSC Staff to establish that the “respondent knew or ought reasonably to have known that [SIF Inc.] perpetrated a fraud”.

“Fraud” includes unauthorized uses of funds

The Commission panel found that the fraud prohibition in section 126.1(1)(b) includes a “use of funds that is inconsistent with what was promised to investors.” In this case, the Commission panel found that although the SIF #1 offering memorandum was somewhat ambiguous, it did not authorize the use of investor funds to pay distributions to SIF #2 investors. The panel further found that SIF #1 investors were exposed to a risk of deprivation because the loans to SIF #2 created a risk that those monies would not be repaid.

The “reasonable reliance on legal advice” defence was not made out

The Commission panel found that a “reasonable reliance on legal advice” defence is available where Staff alleges fraud contrary to section 126.1(1)(b) of the Act. To avail themselves of the defence, respondents must establish that

1. the lawyer had sufficient knowledge of the facts on which to base the advice
2. the lawyer was qualified to give the advice
3. the advice was credible given the circumstances under which it was given
4. the respondent made sufficient enquiries and relied on the advice

The Commission panel found that although the respondents had received legal advice from a qualified securities lawyer that SIF #1 was permitted to lend funds to related entities, this advice could not be relied on because the lawyer had not been asked specifically if those funds could be used to pay SIF #2 distributions or exempt market dealer fees. As such, none of the respondents could avail themselves of the defence.

No conduct contrary to public interest

Notwithstanding having found fraud, the Commission panel did not find that the respondents had engaged in conduct contrary to the public interest. This was for the technical reason that OSC Staff’s Statement of Allegations contained a bare allegation of conduct “contrary to the public interest” without particulars.

Takeaways

Even though specific provisions of the Act — such as section 44(2) — may not directly apply to certain market participants, other provisions of the Act, as well as the Commission’s public-interest jurisdiction, capture impugned conduct otherwise prohibited by the Act.

Issuers should carefully scrutinize offering documents for restrictions on the use of funds as unauthorized uses may be found to be fraudulent or misleading. Issuers seeking to rely on legal advice should also ensure that they provide full particulars to their counsel and obtain fact-specific advice.

In the context of a regulatory proceeding, respondents should consider carefully the implications of waiver of privilege when attempting to rely on legal advice. While constitutional and other legal protections make clear that Staff and other investigative bodies cannot force respondents to waive privilege, Commission cases suggest challenges in relying on legal advice as a primary defence without waiving privilege over that advice. Respondents, with the help of counsel, should carefully navigate how the fact of legal advice is framed in the context of a defence. They should also thoughtfully balance the relativities and potential risks associated with a waiver of privilege, including the extent of the waiver, against the benefits of relying on legal advice. A discussion of some of these risks and benefits can be found in a recent Osler blog post.