Disclosure is supposed to be the cornerstone of securities regulation in Canada. But the complexity of some products being sold to retail investors makes a mockery of the notion that the current quality of transparency is good enough to provide adequate investor protection.

The Canadian Securities Administrators issued notices over the summer that highlight some serious concerns about two investment vehicles that are largely targeted at retail investors: principal-protected notes and income trusts. Both products have been wildly popular with issuers and have been snapped up by investors, even though they are often terribly complex.

That complexity is at the heart of many of the regulators’ concerns. In the case of PPNs, the intricacy stems from the fact that the products are structured so they fall outside most securities laws. They sometimes carry impenetrable fee structures, and are often geared toward assets that are themselves opaque, such as hedge funds or managed futures.

In a notice, the CSA indicates that it is concerned about PPNs because they have proven so popular with retail investors. They represent “the development of increasingly complex structures that pose investment risks that investors may not be fully informed about,” it says.

The CSA cautions investors that their advisors may have to do some work just to figure out the total fees charged in the products, and to generate a realistic estimate of their return potential. “The investment strategy of the PPN manager and the PPN’s fee structure may be very complicated,” the CSA notice warns. “At present, there are few rules that dictate what PPN managers must tell investors about the investment.”

Although PPNs represent a re-latively new segment of the investment industry, the income trust sector has been around for more than a decade and is a much weightier force. It, too, is dogged by disclosure issues.

The CSA recently published the results of a continuous-disclosure review of income trust issuers, which found that just seven of the 45 issuers it examined had no problems with their continuous-disclosure documents. An equal number offered disclosure that was deficient to the point at which they either had to refile or file additional disclosure. The remaining 31 issuers had to agree to improve some aspect of their disclosure in the future.

Overall, the CSA concludes, “In-come trust issuers need to significantly improve the nature and extent of their disclosure and, in particular, their distributable cash disclosure in management’s discussion and analysis.”

Income trusts’ reporting of their distributable cash has long been an issue that analysts have flagged, primarily because issuers have great flexibility in what they report because it isn’t a measure defined by GAAP.

The CSA review also found plenty of other disclosure deficiencies. It says that, in many cases, income trusts did not provide sufficient disclosure about their sources of funding for cash distributions. And there are other areas in which disclosure was lacking, including descriptions of the risks and uncertainties, overall performance and results of operations, goodwill impairment testing, executive compensation disclosure, the promptness of their disclosure and disclosure of material contracts.

Gaps and errors are inevitably uncovered in continuous-disclosure reviews, but it appears that problems are somewhat more prevalent in the income trust area. By comparison, a continuous-
disclosure review of all types of issuers carried out by the Ontario Securities Commission in 2003 found 40% of the reviews required no changes, compared with just 15% of income trust issuers in the latest review. Similarly, in the OSC 2003 review, 9% of issuers had to refile some part of their disclosure or file added disclosure in response to the review, compared with 15% of trusts.

The bottom line is that regulators have revealed significant disclosure deficiencies in segments of the industry that are heavily travelled by the least sophisticated and least knowledgeable players in the market. The big question is what will be done about it.

So far, with the notices, regulators have put the players in those parts of the business on alert. The notices spell out the regulators’ concerns and provide guidance to market players without going through the full rule-making process. In some cases, that may be enough. “Sometimes, rules aren’t needed, just interpretation,” says Simon Romano, a partner at Stikeman Elliott LLP in Toronto.

Indeed, such sorts of interpretations may become even more important if regulators move toward more principles-based regulation, says industry observer Glorianne Stromberg. Although many in the industry claim that they would prefer principles to prescriptive rules, they also want certainty in the grey areas of securities regulation, she notes.

@page_break@For income trust issuers, the CSA has spelled out what it wants to see in terms of effective disclosure, particularly when it comes to reporting distributable cash.

In the case of PPNs, the CSA also warns issuers to provide adequate disclosure. Although regulators may not hold much sway over the products’ managers, they appear to be applying pressure in areas in which they do have some authority: the dealers that sell the products. Even if regulators can’t currently force PPN issuers to provide more useful disclosure, they can demand that dealers ensure suitability and insist that their know-your-client obligations are fulfilled.

The problem is that many PPNs are sold through limited market dealers, which the OSC found earlier this year have plenty of regulatory deficiencies of their own.

In June, the OSC revealed that a compliance review of the LMDs that it conducted in 2005 had found widespread deficiencies. The biggest problem was proper KYC and suitability documentation — 80% of the firms reviewed were found to be deficient. More than 35% were found to have misleading marketing materials and inadequate disclosure in offering memoranda, among other problems.

The OSC notes that about two-thirds of the dealers with deficiencies have rectified their problems, some cases have been referred to enforcement and others are subject to close monitoring. The regulator pledges to ensure that all of the problems are resolved one way or another, and to conduct more regular compliance reviews of the dealers.

Although that’s good news for future investors, such problems have afflicted this area of the industry for some time. If the securities commissions didn’t already know about the regulatory concerns surrounding PPNs and their dealers, they were certainly alerted to them more than a year ago when the Investment Dealers Association of Canada published a report on the hedge fund industry that brought many of the issues to light.

“While PPNs may fit within the current definition of exempt securities, they include significant risks to investors that directly contradict the apparent rationale for making them exempt in the first place — that such products are simple and low-risk because of the financial stability of the issuer or guarantor,” the IDA observed in its May 2005 report. “The risk that investments locked in for as long as 10 years will earn a zero return is no small risk to a retail investor.

“The regulatory issue, particularly with respect to PPNs, is whether these types of investments, with locked-in maturity periods of as long as five to 11 years, little or no certainty of positive returns, minimal disclosure and minimal assessment of suitability, should continue to be sold to small retail investors on an exempt basis, without even the asset and income backing of an accredited investor,” the IDA report stated.

The IDA report also identified the problems with LMDs that are under the commissions’ direct oversight, noting, “There is little or no substantive regulation and active oversight of LMDs.”

These fundamental issues have yet to be resolved. Although regulators have highlighted their concerns, what they haven’t done is tighten the rules in order to eliminate the problems. The CSA indicates that it plans to consult with the industry regarding PPNs to determine whether any new rules or guidance is necessary. The LMDs might also see changes to their registration regime as part of the CSA’s registration reform project. Ultimately, the regulators could decide not to make any rule changes, content that their added guidance is sufficient.

It remains to be seen whether the regulators’ efforts adequately protect investors. If the principle at the heart of securities regulation is that investors must receive full and fair disclosure, it appears from what the regulators have discovered that investors aren’t getting it yet. IE