Cross-Border Counselor

In December 2015, the Canadian Securities Administrators (CSA) announced an amended regime for a prospectus-exempt rights offering in Canada. This amended regime allows certain public companies in Canada to conduct a prospectus-exempt rights offering without prior CSA review of the rights offering circular, and using a greatly simplified rights offering circular that assumes, without incorporation by reference, that the shareholder is familiar with the issuer’s other continuous disclosures. While the new regime revitalized the market in Canada for rights offerings, it raised several questions regarding the extension of the rights offering to U.S. shareholders. Form F-7 under the Multi-Jurisdictional Disclosure System (MJDS) has historically provided a means for eligible Canadian issuers to register securities issued in a rights offering under the U.S. Securities Act of 1933, as amended (the 1933 Act). Based on the SEC’s determination that Canadian disclosure requirements are adequate, Form F-7 allows the offering document (whether prospectus or rights offering circular) to comply principally with Canadian requirements, imposing only a few additional SEC requirements. Unlike most SEC registration forms, conducting an offering on Form F-7 does not subject the issuer to ongoing SEC reporting requirements. However, because the securities are treated as having been issued in a registered offering, the issuer is liable under the 1933 Act for any material misstatement or omission in the offering document, as it is in other registered public offerings. Following the passage of the December 2015 amendments, it was unclear whether the SEC would allow the use of Form F-7 under the new, abbreviated Canadian regime. Preliminary verbal guidance received from the SEC’s staff suggested that the staff was not, at that time, sufficiently comfortable with the new regime to give any assurance of Form F-7’s availability in such circumstances. It was also unclear how, if such registration was permitted, an issuer would protect itself from liability under the 1933 Act for material misstatements or omissions, given the limited amount of disclosure that is required or permitted under the new Canadian regime. As a result, since December 2015, Canadian issuers have not extended rights offerings under the new regime into the United States on Form F-7, and have often prevented U.S. shareholders from participating in the rights offering. Last week, the SEC published a no action letter allowing the use of Form F-7 for rights offerings by eligible Canadian issuers under NI 45-106, as amended by the CSA. The no action letter was issued following the receipt of an acknowledgment from the law firms submitting the request that: “When so registering securities on Form F-7, an issuer would need to assure that the registration statement and the prospectus satisfied the antifraud and liability provisions under the [1933 Act]”, and assurances that: “To do so, for purposes of the offering materials made available to U.S. holders, the issuer could provide a brief description of its business, risk factors, discussion of results of operations and capital resources and such other matters as it deemed material or otherwise in the offering circular.” Therefore, it appears that the SEC will allow the use of Form F-7 for rights offerings extended under NI 45-106, as amended by the CSA; however, a Canadian issuer taking advantage of this form of registration must include in the offering document sufficient information to protect itself from liability under the 1933 Act for material misstatements or omissions. It remains to be seen how the market will react to the SEC’s no action letter, including (1) the amount of disclosure that issuers will be comfortable including, and omitting, from a rights offering circular that is filed on Form F-7, knowing that the offering will be subject to U.S. prospectus liability, and (2) how frequently issuers will decide to follow this approach.

In recent years, many Canadian companies have sought to create a U.S. market for their shares by listing on the OTCQX. Qualifying Canadian companies that have their primary listing on the Toronto Stock Exchange, the TSX Venture Exchange or the Canadian Securities Exchange may generally obtain a quotation on the OTCQX or the next lower tier of the OTC Markets, the OTCQB, without filing a registration statement with, or becoming subject to ongoing reporting requirements with, the U.S. Securities and Exchange Commission. During 2016, the initial listing requirements for OTCQX included a minimum share price of US$0.25, a minimum market capitalization of US$10 million, an operating business, no current bankruptcy or reorganization proceedings, at least 50 beneficial round lot shareholders, an exemption from SEC reporting, and an exemption from penny stock status (typically satisfied through net tangible assets of at least US$2 million, or US$5 million if the company has been in operations for less than three years). A company obtaining an OTCQX quotation was also required to retain an attorney or broker approved by the OTC Markets to serve as the company’s Principal American Liaison, or PAL.  PALs were tasked with confirming the company’s compliance with OTCQX listing qualifications, delivering a letter of introduction to the OTC Markets, and providing an annual letter to the OTC Markets confirming the company’s continued satisfaction of the OTCQX continued listing qualifications. Effective January 1, 2017, the OTCQX has eliminated the requirement for an annual PAL letter. Approved attorney or broker PALs, now referred to as “Sponsors,” will only be required to provide an initial letter of introduction, thereby reducing the ongoing cost of an OTCQX listing. Dorsey has assisted more than 80 Canadian clients in obtaining OTCQX quotations, and is an approved Sponsor (previously, an approved PAL).

A Canadian company is planning to adopt a deferred share unit plan (DSU plan) for its directors. Only one or two of its directors are U.S. citizens or U.S. residents (“U.S. Directors”). With only one or two U.S. Directors, you wonder whether it is important to consider U.S. tax implications. The answer is a resounding yes because the typical form of Canadian DSU plan will not comply with U.S. tax laws governing deferred compensation. Participation by a U.S. Director will result in significant adverse tax consequences for the U.S. Director under Section 409A of the Internal Revenue Code. Specifically, for U.S. federal income tax purposes, the value of the DSUs as of December 31st of the year in which the DSUs vest (i.e. the year in which the DSUs are awarded for the majority of DSU plans) will be included in the U.S. Director’s income for that year, regardless of whether actual payment/settlement of the DSUs is deferred until later termination of board service. In addition, a 20% penalty tax will be imposed. A typical Canadian DSU Plan runs afoul of Section 409A in two ways. First, such plans frequently allow the director to “redeem” the units following termination of services by electing a redemption date either during the year of termination or during the following calendar year. This violates section 409A because it allows the director to choose, at or after termination of service, which tax year the payment/settlement will occur. Since Section 409A requires both documentary and operational compliance, the mere inclusion of the problematic language in the document constitutes a 409A violation and triggers adverse tax consequences for the U.S. Director. In other words, you can’t simply postpone the U.S. tax review until later, figuring that you will fix it before the U.S. Director terminates board service. The second common Section 409A problem arises because most Canadian DSU plans are designed to comply with the requirements of Income Tax Regulation 6801(d), which provides a specific prescribed exception to the salary deferral arrangement rules for Canadian income tax purposes. However, the payment timing requirements under Section 409A upon the U.S. Director’s “Separation from Service” are in some circumstances inconsistent with the requirements of Income Tax Regulation 6801(d). Fortunately, through careful drafting and plan administration, a DSU plan can be designed and administered to avoid these problems. We work regularly with Canadian tax counsel to ensure compliance. Tip: In thinking about whether any of a company’s directors are U.S. taxpayers, remember that U.S. taxpayers are taxed on worldwide income, regardless of where they reside. U.S. taxpayers are: (i) U.S. citizens regardless of residency; (ii) non-resident aliens (“green card” holders); and (iii) non-citizens, non-green card holders who have a “substantial presence” in the United States under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties required).

A Canadian SEC reporting company that looks to acquire a company with outstanding equity grants in the United States will frequently need to address the question: What alternatives are available for the assumption of the target’s outstanding options or other equity-based compensatory awards? Under U.S. law, both the grant of the equity award and the exercise or conversion of the equity award must be registered under the 1933 Act or satisfy an available exemption. For Canadian issuers that are SEC reporting companies, the alternative approaches available to satisfy the 1933 Act requirements for the exercise or conversion of the assumed awards were formerly restricted to (i) an S-8 registration statement (either existing or newly filed) or (ii) an alternative exemption, such as Rule 506 of Regulation D, which would typically be available only in limited circumstances. Under recent SEC guidance, however, SEC reporting issuers may now also rely on Rule 701 for the exercise of outstanding equity awards of the target that are assumed by the issuer if the target relied upon Rule 701 for the original issuance. Rule 701 is commonly used by U.S. private companies and Canadian and other foreign public companies that aren’t subject to SEC reporting obligations to structure their compensatory equity programs. Greatly simplified, Rule 701 is available to issuers that do not report with the SEC in connection with offers and sales of securities pursuant to written compensatory benefit plans to employees, officers and directors, and certain limited types of consultants and other persons, subject to limits on the amount of awards and, in certain cases, the need to deliver specified disclosures. Notwithstanding the express language in Rule 701 that the exemption is available only to an issuer that is not subject to SEC reporting requirements, an SEC reporting issuer may rely upon Rule 701 for the exercise of the assumed awards, provided that the target satisfied the requirements of 701 at the time of the original grant. Issuers should note that this change in guidance does not provide an exemption for the issuance of the acquiror options or other securities in connection with the assumption or exchange of the target options. For purposes of that transaction, the acquiror must rely upon (i) another exemption (such as Rule 3(a)(10) in a typical plan of arrangement) or (ii) a “no sale” position, which would be available if the terms of the target compensatory plan, at the time of the original grant, permitted the assumption of the options without the consent of the option holders. This new guidance will provide issuers with additional flexibility in structuring acquisitions of companies that aren’t SEC reporting companies. Due to the technical nature of the 701 exemption, however, an acquiror and its advisors should carefully review the target company’s compliance with Rule 701 to satisfy themselves that the exemption was available to the target at the time of original issuance.

It is generally a good idea for companies not to disclose biographical information about their employees, such as marital status, religion, or age. Good HR professionals counsel managers not to ask for such information during interviews, for example, in order to avoid claims of discrimination in hiring. Under U.S. law, however, there is an important exception to this well-advised general rule. Under the Older Workers Benefit Protection Act (“OWBPA”), employers terminating two or more employees as part of a layoff and offering severance in exchange for a release must disclose the following information to each employee over 40 who is being terminated and offered severance: 1) a description of the class of employees considered for termination (e.g., all sales people in the state of Washington); 2) the age and title of each employee in the class considered for termination; and 3) whether or not each of the employees in the class considered for termination is in fact being terminated and offered severance. The employer must give these employees 45 days in which to consider the release agreement and must specifically advise the employees in writing to seek legal counsel. Canadian employers are often shocked to discover that such disclosures are not only allowed, but required under U.S. law. These disclosures allow each employee over 40 who is being offered severance to quickly assess whether the layoff will have a “disparate impact” against employees over 40 and thus to bring a suit for age discrimination. Whether a layoff has such a “disparate impact” involves some moderately complex math. However, it basically boils down to whether employees over 40 (or other protected classes) are disproportionately chosen for termination out of the pool of employees considered for layoff. When Canadian companies acquire businesses in the United States, they often engage in reductions in force post merger. It is important for these companies to not only comply with the disclosure requirements of the OWBPA, but also to vet the contemplated layoff for possible disparate impacts upon protected classes such as age, gender, religion, race and national origin. It is particularly important to assess whether the layoff has a disparate impact upon employees over 40, given the disclosures required by the OWBPA. Canadian companies laying off U.S. employees should make sure they have knowledgeable counsel regarding the requirements of the OWBPA to avoid setting themselves up for costly litigation.

Canadian companies should be aware that if they engage in certain “organizational actions” that affect the tax basis of shares held by U.S. persons (including many types of acquisitions and business combinations where shares are issued to U.S. persons), they are required by the U.S. tax laws to evaluate the effect of the action on the U.S. holder’s tax basis and disclose this information in a completed Form 8937 promptly following the action. Internal Revenue Code Section 6045B and IRS From 8937 require corporations to report an “organizational action” that affects the tax basis of its shares held by U.S. individuals and certain other tax entities. Canadian residents who are U.S. citizens or green card holders are treated as U.S. individuals for this purpose. The required reporting may be satisfied by filing Form 8937 with the IRS within 45 days of the organizational action (or if earlier, by January 15th of the following year) and also providing the Form 8937 to the impacted shareholders by January 15th of the following year. In the alternative, a corporation may satisfy the reporting requirements by timely posting the Form 8937 on its public website and maintaining it there for 10 years. Many public companies choose to post the Form 8937 on their public websites because this is administratively easier. “Organizational actions” include tax-deferred mergers and acquisitions under Code Section 368, contributions of property to controlled corporations under Code Section 351, contributions to capital without the issuance of additional shares, tax-free stock distributions, share consolidations, tax-free spin-offs, distributions that are treated as a return of capital (i.e., a distribution in excess of earnings and profits), taxable liquidations under Code Section 331 which involve more than one distribution in liquidation, recapitalizations and conversions under Code Section 368 and modifications of certain debt instruments. The instructions to Form 8937 specifically provide that reporting with respect to a corporation’s stock is required only if an organizational action impacts the tax basis of all holders of the issuer’s stock or all holders of a class of stock. A non-U.S. corporation is subject to the same rules as a U.S. domestic corporation, provided it has at least one shareholder who is a U.S. individual or partnership. For this purpose, a corporation includes any business entity that is treated as a corporation for U.S. federal income tax purposes. For example, a Canadian unlimited liability company which elects to be treated as a corporation for U.S. federal income tax purposes is treated as a corporation for Form 8937 reporting purposes. Penalties apply for failure to properly report an organizational action.

For Canadian issuers and their advisers, compliance with U.S. securities laws generally begins with the question: Is the issuer a “foreign private issuer”? The FPI definition, which is set out in Rule 405 under the Securities Act and 3b-4(c) of the Exchange Act, involves the following four inquiries: Are more than 50% of the issuer’s outstanding voting securities held of record, directly or indirectly, by residents of the United States? Are a majority of the issuer’s executive officers and directors citizens or residents of the United States? Are a majority of the issuer’s assets in the United States? Is the issuer’s business principally administered from within the United States? While the FPI test is a seemingly straightforward calculation, the application of the test in certain circumstances can be challenging.  The SEC staff has recently issued guidance that clarifies the application of the tests in certain circumstances and provides comfort for the application of reasonable methodologies that are consistently applied. Multiple Classes of Voting Securities.  Issuers that have multiple classes of outstanding voting securities with different voting rights may choose to make the calculation on the basis of voting power or the number of outstanding securities, provided that the methodology is applied on a consistent basis. United States Residency.  A person who has permanent resident status in the United States (a “Green Card” holder) is presumed to be a U.S. resident.  For purposes of other holders, an issuer may select other reasonable criteria, and apply them consistently, such as tax residency, nationality, mailing address, physical presence, location of financial or legal relationships, or immigration status. Officers and Directors.  In evaluating the citizenship and residency of executive officers and directors, each test must be separately applied to executive officers as a group and directors as a group. Administration of Business.  No single factor or group of factors is determinative of the location from which a business is administered.  An issuer must assess, on a consolidated basis, the location from which the issuer’s officers, partners or managers direct, control and coordinate the issuer’s business activities.  Absent other factors, shareholder meetings or occasional meetings of the board of directors in the United States would not indicate that the issuer’s business was administered in the United States. Location of Assets.  Issuers may look to the geographical segment information determined in the preparation of financial statements for purposes of calculating the location of assets.  Alternatively, an issuer may apply any other reasonable methodology on a consistent basis to determine location of assets. Foreign private issuer status is of considerable benefit to Canadian issuers that access the U.S. markets.  Issuers that are in danger of a change in status may find that the recent SEC guidance gives them some additional flexibility in satisfying the FPI test.  For those issuers, careful advance planning may make it possible to avoid the loss of the FPI benefits.

One of the biggest differences between employment in Canada and employment in the United States is the fact that, with the exception of a few jurisdictions, employment in the United States is “at will.”  While in Canada employees who are terminated without cause often must be paid severance, in the absence of a contract requiring severance, a U.S. employer is generally not obligated to pay severance when an employee is fired without cause. This fact has important implications for Canadian companies taking on employees in the United States.  While it might make sense for a Canadian employer to include a probationary period in its employment agreement to avoid paying severance after an early termination, this practice can backfire with U.S. employees.  U.S. courts have interpreted such probationary periods as evidence of an agreement that the employee will only be terminated for cause after the probationary period ends—undermining the presumption of at-will employment under U.S. law. Canadian companies should be sure to include disclaimers in any employment agreements or employee handbooks used with U.S. employees explaining that their employment is at-will.  While the presumption of at-will employment in the United States can be great for employers, there are many ways in which this presumption can be lost.  Promises that employment will continue for a particular period of time or that employees will be subject to particular progressive discipline procedure can undermine an employer’s ability to fire an employee at will.  Clear at-will disclaimers help prevent the presumption of at-will employment from being undermined. It is also important to understand the limitations of at-will employment in the United States.  While employers do not need cause to terminate employees, employers may not terminate employees for a long list of reasons that are deemed illegal such as the employee’s age, gender, race, religion, national original, disability, or age (if over 40), or the fact that the employee made a protected work-related complaint, for example, about being discriminated against or a safety issue in the workplace. Canadian companies taking on employees in the United States should make sure they have knowledgeable counsel regarding the benefits and limitation of at-will employment—both to enjoy its benefits and to avoid its pitfalls.

Being a “foreign private issuer” is very important to a Canadian company’s treatment under U.S. securities laws.  If a Canadian company ceases to qualify as a foreign private issuer under the rules of the U.S. Securities Exchange Commission (SEC), it must generally: Change the way in which it offers and sells its own securities to persons in Canada and other non-U.S. jurisdictions, including the imposition of U.S. legends regardless of the jurisdiction of the purchaser, Begin reporting with the SEC unless its securities are held by a sufficiently small number of persons, and Report with the SEC on U.S. domestic forms rather than the more liberal forms that apply to most Canadian companies that report with the SEC. In addition, its directors, executive officers and 10% shareholders may become subject to the reporting and liability provisions of Section 16 of the U.S. Securities Exchange Act, which is a significant inconvenience and may require restructuring some of the company’s benefit plans and practices. A company incorporated under the laws of Canada or any Canadian province will be a foreign private issuer unless, as of the last business day of its most recently completed second fiscal quarter: More than 50% of the outstanding voting securities of the company are directly or indirectly owned of record by residents of the United States (Part 1), and Any of the following (Part 2): The majority of the company’s executive officers or directors are U.S. citizens or residents, More than 50% of the assets of the company are located in the United States, or The business of the company is administered principally in the United States. Because the result under Part 2 is often easier to determine, many companies will first assess the results of Part 2 in order to determine whether analysis of security ownership under Part 1 is necessary.  If analysis under Part 1 is necessary, a company may generally rely on the address of a securityholder as set forth in properly maintained securityholder records; however, it must generally “look through” the ownership of commercial depositaries such as CDS and Cede & Co., and other nominees such as brokers and banks that hold securities for the account of their customers.  In addition, it must generally take into account information set forth in beneficial ownership reports, and cannot give credence to a structure established to evade the U.S. securities laws.  The test set forth in Part 1 therefore generally requires, for a publicly traded company, a review of beneficial ownership reports and the company’s securityholder records and the commissioning of a beneficial ownership search through a service such as Broadridge. Companies that determine they are majority owned by U.S. residents may find themselves able to maintain foreign private issuer status by ensuring that they do not satisfy any of the criteria in Part 2 – by ensuring that their board and executive officers include a sufficient number of persons that are not U.S. citizens or residents, that their business is primarily administered outside the United States, and that a majority of their assets are located outside the United States. We frequently assist Canadian companies with assessing and maintaining their status as a foreign private issuer and, where appropriate, complying with the new regulations to which they are subject when they lose such status.

Most non-underwritten private placements of securities by Canadian companies to U.S. investors are made in reliance upon Rule 506 of Regulation D. Since September 2013, this exemption has been subject to “bad boy disqualifications.” Generally speaking, a company is prohibited from relying on Rule 506 if the company, any of its predecessors, any of its affiliated issuers, or any of its directors, officers, general partners, managing members or promoters has been subject to certain convictions, orders, judgments, decrees in the United States or suspension or expulsion of membership from certain organizations in the United States. In addition, if any person has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in the Rule 506 offering, then the offering will generally not qualify for Rule 506 if the person being paid, any general partner or managing member of such person or any director or officer of any of the foregoing has been subject to any such disqualifying events. A limited exception exists if the event occurred prior to September 2013 and is appropriately disclosed to prospective purchasers prior to the sale. Canadian companies that want to ensure the availability of Rule 506 should ask their directors, officers, 20% beneficial shareholders, general partners, managing members and promoters to periodically complete an appropriate Rule 506 bad boy questionnaire. We recommend that companies obtain a completed questionnaire from such persons at least annually, and that a questionnaire be completed by any person who newly becomes subject to the requirements (e.g., a newly appointed officer or a shareholder who first becomes a 20% beneficial shareholder). An appropriate form of questionnaire is available to clients upon request. In addition, Canadian companies should not agree to pay any person any remuneration or commission (directly or indirectly) for soliciting purchasers in a Rule 506 offering (e.g., an underwriter, agent or “finder”), unless it is first confirmed that the person is a U.S. registered broker-dealer that is legally permitted to receive such a commission and the parties enter into an appropriate contract in which the person confirms that no bad boy disqualifications are applicable. Companies should seek U.S. counsel’s advice on the appropriate language.

You’re a Canadian public company with no U.S. operations.  You don’t file reports with the SEC.  You plan to merge with another Canadian public company in a share-for-share exchange, structured as a Canadian plan of arrangement.  Do you need to hire U.S. counsel to assist on this Canadian deal? Yes. Canadian public companies invariably have shareholders resident in the United States.  If the acquirer will issue shares to the target shareholders, or if there will be an amalgamation in which shareholders of both companies receive shares of amalco, the transaction will be deemed to involve the offer and sale of securities to the U.S. shareholders.  This requires either registration with the SEC and applicable states, or an exemption.  The good news is that the U.S. requirements for a plan of arrangement are relatively manageable, and exemptions are available in most states.  New York likely requires an advance filing. Other reasons to involve U.S. counsel include: The acquirer is required to analyze the U.S. tax treatment to U.S. shareholders, and disclose this in a specific tax form; Securities registration or exemptions will be required for the future exercise or conversion of any stock options, warrants or other convertible securities outstanding and held by U.S. residents; If there are any U.S. executives, the tax consequences of the transaction to them and to the company should be analyzed; and A compliance review with respect to U.S. securities and other laws, especially if a party has U.S. investors, business activities, contracts, subsidiaries, regulatory filings or is listed on any U.S. market.