Conventional securities are highly regulated — but stick them in a different sort of wrapper and suddenly the usual rules don’t apply. Faced with this sort of arbitrage opportunity, regulators are beginning to ponder whether it’s time to close that loophole.

Financial firms have proven remarkably innovative over the years, packaging and repackaging their products in different formats. Now, typically risky investment vehicles are sold with guarantee features; at the same time, safe-as-houses products are being bundled with performance-sweeteners, thereby being made increasingly risky as well.

For example, hedge funds, once purely the preserve of the ultra-wealthy, have been repackaged and sold to ordinary retail investors in the guise of principal-protected notes (PPNs). Segregated funds walk and talk just like mutual funds, but are still technically considered insurance contracts. And the most mundane of investments, GICs, have been sexed up with equity-linked features.

Despite the fact that each of these products may expose investors to the same sorts of risks as traditional securities, none of them are actually considered securities, nor are they subject to the same sort of regulation as straightforward equities or mutual funds. The reason these products don’t face the same obligations as conventional securities is that, if they are structured as insurance contracts or deposit instruments, they are specifically exempt from the definition of a security.

Overall, the legislative definition of a security is quite broad — for example in Ontario, it’s defined as, “any document, instrument or writing commonly known as a security.” However, insurance contracts issued by licensed insurance companies and deposit instruments issued by chartered banks are specifically exempt.

It’s as if a tire manufacturer decided to build cars, and could then sell them without meeting the crash safety or emission standards that traditional automakers face.

Doug Hyndman, chair of the B.C. Securities Commission, says these exemptions are a holdover from the days when banks, insurers, securities dealers and trust companies largely stayed in their own lanes and were subject to their own distinct regulatory regimes. “These things are vestiges of the old ‘four pillars’ system of regulation,” Hyndman recalls. “The activities of banks, insurance companies and trust companies were generally not subject to securities regulation, on the theory that their own regulators would take care of them.”

However, these business silos have crumbled in the past 20 years, and the restrictions on cross ownership have largely evaporated, Hyndman notes. But the distinctions remain in the legislation.

This is proving problematic for regulators as the roles — and inherent risk/reward characteristics — of traditional financial products have also been eradicated by industry innovation. “The trouble is that principal protected notes, index-linked GICs, etc. all come in under the ‘evidence of deposit’ exception because they are issued by banks so that they aren’t defined as securities,” says Paul Bourque, senior vice president, member regulation, at the Investment Dealers Association. “The assumption underlying the carve-out is that these products are simple and easily explained to the average investor. This is not necessarily the case.”

Indeed, as the IDA found in the report it issued on hedge funds earlier this year, “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 risk that investments locked in for as long as 10 years will earn a zero return is no small risk to a retail investor, and is difficult to quantify given the characteristics of hedge funds discussed in this paper.”

In that report, the IDA recommends that the Canadian Securities Administrators should take another look at whether these products should be treated in the same way as other exempt products. “I think what is required is a review of some of the provisions that allow certain securities to be issued by companies without a prospectus and sold by individuals who are not registered,” Bourque says.

He adds that the part of the definition that exempts “deposits” — such as PPNs and equity-linked GICs — should be reviewed, “and consideration given to including this type of product in the definition of a security.”

The Ontario Securities Commission is starting to contemplate whether the exemption should be changed, as part of its effort to increase regulatory oversight of hedge funds.

@page_break@At the OSC’s annual conference in mid-November, the commission’s new chair, David Wilson, referred to hedge funds as the OSC’s “new frontier” for regulation. In a panel discussion at the same conference, OSC vice chair Paul Moore suggested it might be time to revisit the deposit exemption. He noted, however, that the OSC would invite public consultation on the idea before it proposes such a fundamental change.

While hedge funds may be the commission’s immediate focus — following several high-profile scandals involving those products — they aren’t the only reason to be concerned about regulatory exemptions for “banking” and “insurance” products. There are also now PPNs that repackage other instruments, including stocks, indices, mutual funds, commodities and mixed-asset portfolios.

As part of the same panel discussion, Mark Gordon, executive vice president of the Mutual Fund Dealers Association of Canada, noted the association is also concerned that reps may not be processing products that are technically considered deposits through their fund dealers on the basis that they don’t count as “securities-related business” (which must be put through the dealer). This means they escape the sort of compliance provided by their dealer, and the oversight of the regulators. Gordon suggested the MFDA is looking at changing its carve-out for deposit products as a result.

Also, in the case of seg funds, Bourque points out, “It is difficult to justify the differential regulation applied to similar products [seg funds and mutual funds]. This is another area that warrants consideration for change.”

“In an ideal world, we would bring them all under the securities umbrella,” Hyndman allows. “But that is easier said than done. It’s always difficult to draw the boundary lines for these things and moving it raises concerns for both the regulators and the industry participants.”

Instead, he says, securities regulators have tried to work with the authorities from other industry sectors through the Joint Forum of Financial Market Regulators, “to promote equivalent regulation of similar products.” Hyndman also notes products that may be exempt from prospectus and registration requirements “are still subject to general prohibitions in some provinces on fraud, misrepresentation and unfair practices and, if securities registrants choose to sell them, they must fulfil suitability obligations.” IE