Due Diligence Defence Deemed Available for Issuance of Securities in Breach of Securities Laws

Written By Christian P. Gauthier, Kwang Lim, Brigeeta C. Richdale, Sabrina Royer, and Patrick J. Sullivan

The B.C. Securities Commission's (the Commission) decision in Re SunCentro (2017 BCSECCOM 58) provides rare guidance on the availability of a due diligence defence to parties that have illegally distributed securities. The Commission held that a due diligence defence was available to an issuer and certain of its directors, officers and promoters for the improper use of the "Family, Friends and Business Associates" prospectus exemption.

SunCentro Corporation (SunCentro) is a Vancouver-based private solar company. Between 2011 and 2013, SunCentro raised a total of US$250,525 from 26 investors. The Commission initiated administrative proceedings against SunCentro, its officers and its promoters alleging that securities issued to investors under these offerings did not qualify under a prospectus exemption. Based on the evidence submitted at the hearing, the Commission considered whether a due diligence defence was available to one or more of the respondents.

In its written decision, the Commission determined that a due diligence defence is available under common law to administrative proceedings brought under Securities Act (British Columbia), and provided the following general guidance to sellers of securities:

• the steps that are reasonable will vary depending upon the facts and circumstances of the purchaser, the offering and the exemption being relied upon;
• while sellers should obtain and retain documentation of certain key facts, including obtaining representations and warranties and/or confirmation of a purchaser’s financial or other personal status, that those steps will not be sufficient in and of themselves;
• sellers should understand the terms and conditions of the exemption that they intend to rely upon;
• sellers should adopt appropriate policies and procedures to ensure that persons acting on their behalf understand the terms and conditions of the exemptions being relied upon; and
• sellers take steps to verify the factual basis of the information being relied upon including asking questions of the purchaser.

The Commission found that SunCentro took the following steps to ensure the legality of its exempt distributions of securities:

• established a board policy for the private placements;
• educated board members on the prospectus exemptions being used by SunCentro;
• obtained properly executed subscription agreements from the investors; and
• delegated responsibility for the administrative tasks necessary to complete financings to a member of the senior management of SunCentro.

The Commission found that SunCentro and its officers were able to establish the due diligence defence for distributions made to six investors under the "Family, Friends and Business Associates" exemption. While SunCentro and its officers had received representations from a director that these six investors were his close friends, the evidence before the Commission established that these six investors were business associates of the director's father, and did not qualify for the "Family, Friends and Business Associates" exemption. Although the Commission ultimately held that the evidence did not support the director's representations, it found that SunCentro and its officers were entitled to rely on them. When combined with the aforementioned steps, this was sufficient to successfully establish the due diligence defence in relation to these six distributions.

However, the Commission found that none of the respondents succeeded in establishing the due diligence defence for distributions made to nineteen investors referred to SunCentro by a promoter. Securities had been distributed to these investors on the incorrect assumption that the promoter was an "affiliate" of SunCentro, and that the promoter's close friends and family would accordingly qualify for the "Family, Friends and Business Associates" exemption. None of the respondents had sought professional guidance on whether the promoter was in fact an affiliate of SunCentro, and were not entitled to rely on the due diligence defence.

The following sanctions were imposed by the Commission:

• SunCentro was subject to a permanent cease trade order;
• SunCentro was ordered to disgorge the full $165,500 obtained from the 19 investors referred by the promoter;
• the respondents were each ordered to pay an administrative penalty;
• certain respondents were prohibited from acting as a director or officer of an issuer for several years; and
• no trade orders were made against certain respondents.

The Commission's decision establishes the availability of the defence of due diligence in such administrative proceedings. Due diligence means that issuers and their directors, officers and promoters must, at least, understand the terms and conditions of the exemptions on which they intend to rely, establish a system to ensure that others acting on their behalf have appropriate understanding of such exemptions and that appropriate controls are in place to obtain and verify information and retain documentation. Representations should be sought and obtained from the relevant officer or director where the issuer seeks to rely on the "Family, Friends and Business Associates" exemption. Basic precautionary steps will likely be insufficient where the exemption relied on warranted further consideration and guidance. The treatment of the due diligence defence in subsequent decisions is uncertain and should be followed closely.