Proposed new rules in the exempt market could do more harm than good and more study is needed before regulators implement reforms, argues a new paper from Jack Mintz, director of the University of Calgary’s School of Public Policy.
The paper notes that exempt markets have come to vastly outstrip public equity markets in recent years. It reports that, between 2010 and 2012, exempt market offerings have raised four times as much capital as public equity offerings. Yet, it says that the reasons for their growing significance as a source of capital are not well understood.
“The precise reasons behind the immense popularity of exempt markets can only be guessed at,” it says. While the market’s growth may be due to issuers and investors desire to avoid the regulatory costs of raising capital in public markets, it notes, “We are left to speculate, however, because the Canadian exempt market remains relatively unstudied, despite its enormous role in funding capital investments in Canada.”
And yet, regulators are proposing a variety of reforms to the rules that do apply to exempt offerings — which, it warns, may turn out to be counter-productive. “Unfortunately, with so little information available about these markets, whatever the aim of the reforms in pursuing the goals of effective market regulation, they may end up being more harmful than helpful,” it says.
These reforms include expanding the number of available prospectus exemptions, and imposing new investment limits, among other things. (See Exempt-market proposals provoke ire, Investment Executive, August 2014.)
“All of these proposals are intended to protect investors from the higher risks that are presumed of exempt markets. However, there is no evidence — given the paucity of information about them — that exempt markets
necessarily pose a greater risk of fraud or poorer returns and losses than do heavily regulated public markets,” the paper says.
Moreover, it warns that these proposals may make it harder for better-quality firms to signal their worthiness to investors. For instance, the paper argues that setting an arbitrary investment limit will have the effect of imposing greater costs on bigger, more developed companies seeking larger amounts of capital, than on smaller companies that are looking to raise smaller amounts.
“Increasing the transaction costs for a better-quality company to operate in the market for larger capital amounts undermines market performance by making it harder for these firms to signal their quality to separate themselves from less able firms seeking smaller amounts in the market. Regulations should instead make it more difficult for lesser quality firms to mimic high-quality firms,” it says. Indeed, it says that imposing investment limits, “is precisely the wrong approach to regulation to improve both efficiency and investor protection.”
What’s needed, it says, is more study of these markets before regulators tinker with the rules in this area. “It would be useful for regulators to develop a coherent set of policies that support market efficiency, financial market stability and investor protection,” the paper concludes. “However, to do so, it is important that the appropriate regulatory framework be developed based on analysis and evidence to support this relatively understudied market. Relying on ad hoc regulatory measures could do more harm than good.”