The exempt market has long been a major concern for investor advocates. Now, it is increasingly becoming a concern for regulators, too.

When securities regulators reformed the registration system two years ago, one of the purported benefits was that the litany of registration categories and exemptions that existed throughout the country would be harmonized. Regulators also sold the new regime as a better way to supervise the exempt market.

Certainly, the intention was good. Registration reform has created a new “exempt market dealer” category, which subjects the firms in that category to tougher regulatory conditions, including capital, proficiency and compliance requirements. In theory, investors should be better protected as a result.

However, regulators have been uncovering a series of problems within the EMD category over the past few months. In early September, the Canadian Securities Administrators revealed their latest concern, having discovered that a number of EMDs are carrying out brokerage activities (trading exchange-listed securities) for accredited inves-tors — something regulators never intended firms that register in the EMD category to be able to do.

The CSA says that it has concerns with firms doing this because the emergence of EMDs that are providing brokerage services effectively creates an unlevel playing field between these dealers and conventional investment dealers, who carry out their brokerage business under the added oversight of the self-regulatory Investment Industry Regulatory Organization of Canada.

The CSA notes that IIROC monitors brokerage activities and has developed rules and an oversight infrastructure to supervise this sort of activity.

If EMDs are conducting brokerage activities that would otherwise be carried out by IIROC dealers, the EMDs are both exploiting a regulatory arbitrage opportunity and possibly compromising investor protection by delivering the same services under less stringent regulatory oversight.

As a result, the CSA says, this practice by EMDs raises “serious policy issues” that both regulators and the financial services industry must examine.

The CSA will be reviewing this issue, and the consultation is likely to lead to rule changes. “Our goal,” says the CSA release, “is to ensure appropriate regulatory requirements apply to all firms that engage in brokerage activities in Canada.”

In the meantime, pending the conclusion of this process, regulators will be registering these dealers in the “restricted dealer” category, which puts certain terms and conditions on their registrations, and limits them to dealing only with permitted clients.

The spectre of firms using the EMD category to avoid more rigorous oversight also crops up in the CSA’s proposed rules regarding direct market access, which were published earlier this year. In those proposals, the CSA explicitly outlaws EMDs from becoming direct market access clients in order to prevent another form of regulatory arbitrage: “A dealer that wants [direct electronic access] should not be able to ‘opt out’ of the [trading rules] and should be an IIROC member.”

But the use of the EMD category as a form of regulatory arbitrage isn’t the only problem that regulators are flagging in this area. Earlier this year, the CSA reported that it has uncovered “a disproportionate rate of compliance deficiencies” among EMDs that are distributing the securities of related issuers (cases in which the management of the dealer and the issuer are the same people). In particular, the CSA makes note of suitability failures, a lack of “know your client” compliance and cases of dealers misdirecting the proceeds raised in exempt offerings.

The Ontario Securities Com-mission also has sounded the alarm about issuers and dealers selling securities under the “accredited investor” exemption to retail investors who don’t actually qualify as accredited inves-tors (which is based on minimum asset or income thresholds).

The OSC reports that it has found that “many dealers do not collect adequate [KYC] information to determine reasonably whether the investor is in fact an accredited investor. This raises significant investor protection concerns.”

All of these problems involve dealers that have registered as EMDs, at least, but there is a subset of the exempt market that doesn’t require even that. Indeed, the CSA’s registration-reform project didn’t achieve the level of uniformity, or regulatory rigour, that was initially intended.

Several western provinces and the territories had backed away from creating the EMD category, introducing what has become known as the “northwestern exemption” — which allows firms to operate in the exempt markets without registering in the EMD category in certain circumstances. As a result, there are a host of firms operating in the exempt markets in some jurisdictions (Alberta, British Columbia, Manitoba and the territories) that don’t have to be registered at all — and are operating without any of the elements of investor protection that were supposed to be introduced with registration reform.

As a result, the investor advocate known as the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) has called on regulators to scrap the so-called “northwestern exemption.”

FAIR Canada’s submission notes that this exemption effectively “allows anyone (even someone found to be dishonest or to be lacking in integrity) to sell high-risk, exempt-market products to the investing public, including vulnerable groups such as seniors.”

And this isn’t just a theoretical concern. There have been a couple of recent cases in B.C. in which individuals that have been sanctioned by securities regulators have turned to pitching exempt market products without any sort of regulatory oversight.

FAIR Canada maintains that all firms and individuals that sell investments to the public should be required to be registered, and the investor advocate is calling on the provinces and territories that have opted out of this part of the registration reform to reverse course.@page_break@Although it was the regulators that crafted this loophole in the new EMD registration category in the first place, it appears that they aren’t entirely comfortable with the current state of the exempt market, either. Kevin Falcon, B.C.’s finance minister, has asked the B.C. Securities Commission to examine the “northwestern exemption” and report back; and he has indicated that he’s open to changing that policy, if necessary.

And in an effort to bolster investor protection and improve market transparency, the BCSC also is adopting new disclosure requirements for exempt market issuers. As of Oct. 3, exempt market issuers will be required to reveal more detailed information about the identity of their insiders and promoters.

Although this requirement doesn’t address the deficiencies on the dealer side, it does indicate that securities regulators recognize that investor protection needs improvement in this segment of the market.

Even the insurance regulators in B.C. are worried about the freewheeling exempt markets in that province — particularly, unregistered life insurance agents promoting and selling exempt securities — and are moving to curb these advisors’ exempt market activities.

Earlier this year, the Insurance Council of B.C. indicated that it has concerns about life insurance agents who don’t have a securities registration but are dealing in exempt market securities. Specifically, the ICBC is worried about clients assuming that their insurance advisors are knowledgeable about all sorts of financial products, not just insurance, and that a recommendation on an exempt security from a life insurance agent would be a well-informed one. The ICBC’s notice to advisors on the matter states: “Without sufficient disclosure, a client may falsely believe that a life agent’s licence qualifies the life agent to sell an exempt market security or that the life agent’s licence validates the sale of such products, which is not the case.”

To avoid such situations, the notice says, agents that sell exempt securities should provide pre-sale written disclosure of the fact that these sales aren’t regulated, detailing the products’ risks and describing their own qualifications and experience in dealing in exempt securities, among other things.

The ICBC notice also says that agents must ensure the suitability of these trades, keep this business separate from their insurance practice and explain to clients how their funds will be handled.

Failure to adhere to these guidelines when dealing in the exempt market, contravening securities law or failing to exercise the proper care in selling exempt securities, whether to insurance clients or others, the notice adds, will reflect on an advisor’s competence and suitability to hold a life agent licence.

In other words, advisors can imperil their insurance licence by carelessly selling exempt securities.

In response to the problems that were exposed during the 2008-09 financial crisis, the CSA also is proposing new rules for securitized products that aim to narrow the class of investors that are eligible to purchase these products in the exempt market to truly “sophisticated” investors. (Among other things, the CSA proposes to raise the minimum financial asset threshold from $1 million to $5 million.)

This proposal recognizes that some products are simply too complex for ordinary retail investors to understand — and regulators, therefore, don’t think retail investors should be buying these products.

However, based on the comments that have been submitted on these proposals, much of the financial services industry largely opposes this step. And it remains to be seen if regulators will stick to their guns.

But FAIR Canada says regulators should be going further than merely toughening up the financial qualifications to be considered an accredited investor, proposing that regulators should impose an investor proficiency requirement instead.

In its comment on the proposed rules, FAIR Canada says that regulators should abandon their approach of using wealth or income as a proxy for accrediting investors: “Mere ability to absorb losses, for example, should not be used as a criterion of investor sophistication.”

This situation, the FAIR Canada comment adds, merely encourages promoters of poor products to target wealthy investors, which “damages the reputation of the market and market integrity, and is insufficient to ensure an acceptable level of investor protection.”

FAIR Canada believes that a new model of retail investor protection is needed, particularly where complex financial products are concerned. The investor advocate wants to do away with the traditional model of both accrediting investors based on their financial position and relying on disclosure to protect them. Rather, FAIR Canada recommends that regulators adopt a standard of “active investor knowledge” of the products they’re being sold.

FAIR Canada also recommends that regulators apply this approach to the entire exempt market, not just securitized products. The investor advocate says there is a significant problem with the existing exempt market, in that the interests of dealers, advi-sors and issuers are not aligned with the interests of investors. Currently, FAIR Canada believes, the exempt market sector has no real incentive to educate investors on what they are being sold.

This could be remedied, the FAIR Canada comment suggests, by requiring that investors have “active knowledge” of the products they are buying and mandating the same for dealers and advisors before they can provide advice on such products.

Says the FAIR Canada comment: “We believe that an active knowledge standard will align interests because dealers, advi-sors and issuers will have an incentive to enlarge the pool of exempt-market accredited investors by educating investors on how to evaluate such products and it will afford unsophisticated investors with more protection.”

In an area that seems besieged with so many fundamental problems, this change in approach certainly seems worth consideration by the regulators. IE