In rethinking the rules for the exempt market, regulators are weighing how to shore up investor protection without killing commerce. Their consultations reveal a wide range of opinion about how to strike that balance.
Late last year, the Canadian Securities Administrators had initiated a consultation that focuses on two of the main prospectus exemptions – the $150,000 exemption and the “accredited investor” exemption – that allow firms to sell securities to clients who qualify for one of those exemptions without issuing a full-blown prospectus.
(The underlying idea is that if clients can afford to risk $150,000 or if they meet the accredited investor criteria, which is based on income and asset thresholds, then they are probably sharp enough to invest without the benefit of a prospectus, and wealthy enough to weather a loss.)
But regulators repeatedly have encountered problems in this sector of the market. Examining the fallout from the financial crisis, regulators have found that dealers were selling complex, exempt-market products they didn’t understand to clients who didn’t know what they were buying. Recently, the regulators have observed numerous compliance problems, too – including dealers selling securities to clients under the accredited investor exemption who don’t really qualify for it.
The CSA now is looking at whether it should reform these exemptions by changing the qualification criteria, restricting their use or perhaps even scrapping them altogether.
The consultation process has attracted a large volume of comments, and there is a wide array of ideas about just what the regulators should be doing.
Most industry players, it seems, would not mind the regulators eliminating the minimum amount exemption. While that view is not unanimous, it’s widely agreed that an arbitrary minimum investment level isn’t a good way of determining who should be considered shrewd enough to invest without a prospectus. And there’s a sense that most clients who qualify for this exemption also would qualify under the accredited investor exemption. So, removing the minimum investment exemption probably wouldn’t dramatically reduce the number of clients who could play in the exempt market.
That said, there also is some support for raising the amount of the minimum exemption (which was set in 1987) and perhaps index it to inflation.
But there also are comments that argue that the threshold should be lowered, so that more clients could use the exemption – and would have less money at risk.
There’s much more support for retaining the accredited investor exemption, albeit with revised criteria. Again, some comments recommend that the financial thresholds to qualify as an accredited investor be raised (the current levels were adopted in 2001); others suggest that they should be lowered; some want them left unchanged.
A new approach supported in some comments would restrict investments in the exempt market to a certain fraction of a client’s portfolio or their net worth – so clients would be allowed to risk only a certain portion – say, 5% or 10% – in the exempt market.
This criterion could be imposed in conjunction with the financial qualifications – or the financial thresholds could be eliminated entirely, allowing any client to participate in the exempt market, regardless of his or her income or net worth.
The latter approach would both eliminate the idea that wealth is somehow a proxy for investment savvy and expand the pool of potential investors rather than narrowing it (a possible result of rule changes that companies that rely on exempt market financing fear), while also introducing a constraint designed to limit clients’ exposure to investments that are made without the protection of a prospectus.
Some comments also propose expanding the range of available exemptions to allow things such as “crowd funding” to take place – in which startups can raise small amounts of money from individuals within a large group of people with little supervision – or to facilitate funding for so-called “social capital” endeavours, in which companies and projects aim both to generate financial returns and address social issues.
The CSA will have to determine how to calibrate the exemptions to ensure investor protection without unduly constraining the market. However, for most of the investor advocates that submitted comments, the solution is to impose a fiduciary duty on dealers that sell exempt securities.
Says the Canadian Advocacy Council for Canadian CFA Institute Societies in its submission: “Investor protection will come from mandating sufficient disclosure of risk factors and holding registrants to a fiduciary standard.”
This call for a fiduciary standard is echoed by the Small Investor Protection Association, the Canadian Foundation for Advancement of Investor Rights and the Ontario Securities Commission’s investor advisory panel.
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