CSA targets key exemptions

However, concerns about the exempt market have surfaced repeatedly in recent years; the use of these prospectus exemptions has been a common feature of some major scandals, ranging from the Portus Alternative Asset Management Inc. case in 2005 to the freezing of the market for non-bank ABCP in 2007.

Indeed, in the wake of the credit market turmoil that led to the failure of the non-bank ABCP market, a CSA working group that studied the episode had recommended that regulators re-examine the major prospectus exemptions to see whether they need to be revised. That report was issued a little over three years ago, and the regulators are only now getting around to launching that review, with the consultation slated to run to the end of February 2012.

In the meantime, the CSA did propose a new set of rules this past spring in response to some of the lessons learned in the credit crisis, which hint at where the regulators may be going. Those proposals would limit the scope of investors who are permitted to buy complicated securitized products in the exempt market by excluding many retail investors who currently qualify as accredited investors.

Now, the CSA is considering whether it should apply this same approach to the exempt market in general, regardless of the product that’s involved. One of the reforms the CSA is considering is narrowing the $150,000 and accredited investor exemptions so that they are available only to certain investors — namely, institutions.

Alternatively, the CSA may alter the financial criteria these exemptions are based on, which have not been adjusted for inflation since they were first established. The $150,000 minimum investment exemption, for example, was set back in 1987. The CSA indicates that simply adjusting the threshold to current dollars would push the minimum up to $265,000.

Similarly, the accredited inves-tor exemption’s financial criteria haven’t been revised since they were first set by the U.S. Securities and Exchange Commission in 1982 (and subsequently adopted by the CSA in the early 2000s). Currently, the annual income threshold is $200,000; if adjusted for inflation, this would rise to more than $443,000 (vs when it was first set) or to $245,000 (vs 2001, when the Ontario Securities Commission first adopted it).

However, some critics argue that raising the financial thresholds on these exemptions won’t do anything to deal with the underlying problem, which is that financial criteria just aren’t a good way of determining whether someone should be considered a sophisticated investor who doesn’t need the sort of investor protection provided by prospectus when buying securities. An investor can be wealthy, or highly paid, without being particularly shrewd or knowledgeable.

As the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) suggests in its submission on the CSA proposals dealing with securitized products: “Wealth is not an appropriate criterion to substitute for knowledge, experience or sophistication.” The paper argues that exempting investors on this basis, which leaves them with little protection, is “inappropriate.”

Moreover, FAIR Canada’s submission says, a willingness to make a big investment (above the $150,000 threshold) isn’t a good way of determining inves-tor experience: “Merely investing a large amount of money is not, under any circumstances, a criterion of investor sophistication.”

The OSC did scrap its minimum investment exemption in 2001, after concluding that requiring a minimum investment is not a good proxy for sophistication. The threshold was reintroduced in 2005 as part of national reforms to harmonize prospectus exemptions across the country.

Instead of using financial criteria, FAIR Canada recommends that regulators require investors to meet a test of “active knowledge” before they can be considered sophisticated enough to invest with little regulatory protection.

Moving to knowledge-based qualifications would have two fundamental benefits, FAIR Canada suggests: it would mean that investors are treated equally, regardless of their financial status; and it would provide an incentive for the securities industry and issuers to take a more active interest in educating their clients.

This knowledge would have to be independently verified or certified by a dealer that belongs to a self-regulatory organization backed by a compensation fund, the FAIR Canada submission suggests, and “subject to a strict liability standard.”

Although changing the criteria is one possible approach for the CSA, this also would leave regulators with a compliance challenge. They would have to ensure firms are adhering to the new criteria — something that doesn’t always happen now.

Indeed, earlier this year, the OSC indicated that it has discovered exempt-market issuers and dealers that are selling securities (relying on the accredited investor exemption) to retail inves-tors who don’t actually qualify as accredited investors. The OSC has found that many dealers weren’t collecting enough “know your client” information to determine reasonably whether an investor can qualify as an accredited investor.

So, however regulators decide to try to define investor sophistication, it appears they will also have to do a good deal of monitoring to ensure the criteria are being applied properly. That’s one of the advantages of the approach recommended by FAIR Canada, which would subject exemption qualifications to SRO oversight. This is typically more rigorous than the oversight by the securities commissions.

Yet, the desire to avoid such regulatory scrutiny is one of the exempt market’s main attractions. Earlier this year, the CSA raised an alarm about firms registering as exempt market dealers, apparently to carry out brokerage activities for accredited inves-tors — effectively dodging SRO oversight.

The CSA indicates that it has since initiated a consultation, along with the Invest-ment Industry Regulatory Organization of Canada, that aims to curb this regulatory arbitrage. EMDs, IIROC firms and U.S. firms may be affected by rule changes aimed at eliminating this practice.

But if the idea of ramping up exempt-market oversight doesn’t appeal to the CSA, it could decide just to eliminate these exemptions. The CSA consultation paper suggests that eliminating the $150,000 exemption is a possibility, but doesn’t offer that option for the accredited investor exemption.

Conversely, the CSA indicates it could leave the exemptions unchanged. The argument for doing nothing with the existing exemptions will surely centre on their growing importance as a source of capital. Despite the assorted regulatory problems that have flourished in this market, the exempt market has become increasingly significant. As OSC chairman Howard Wetston observed in a recent speech: “There has been a significant migration from the public to the private markets.”

For instance, Ontario-based issuers had raised about $44 billion in the exempt market in 2010, outpacing the $41 billion that had been raised across the country in new equities issues in the same period — yet, Ontario accounts for only slightly more than half of the total exempt market.

Reforming these exemptions will not necessarily kill this financing activity. It may be that much of this business would be just driven back into the public markets, which provide a minimum level of investor protection. IE