Regulators have been taking a seemingly contradictory approach to the exempt market in recent years as they look to expand the availability of exemptions while also toughening investor protection. Those conflicting priorities are evident in the latest series of reforms to the exempt-market regime that regulators revealed in late February.
In particular, the Canadian Securities Administrators (CSA) announced a set of changes to a couple of the most commonly used prospectus exemptions – the accredited investor (AI) exemption and the minimum amount (MA) exemption – which are intended to enhance investor protection.
The CSA also adopted some amendments to the short-term debt exemption in order to boost investor protection and to curb possible systemic risk. To that end, the CSA has barred securitized products – such as the non-bank asset-backed commercial paper that was at the epicentre of the global financial crisis in Canada – from using that exemption.
At the same time, the Ontario Securities Commission (OSC) announced that it will be adopting its own version of a family, friends and business associates (FFBA) exemption, which is in use in other provinces.
Furthermore, the OSC has signalled that it intends to bring forth new rules to introduce an offering memorandum exemption and a crowdfunding exemption this summer, both of which may have to go out for further comment.
The various amendments that the CSA and the OSC have completed are set to take effect on May 5, subject to ministerial approval. But the ultimate impacts of these separate sets of reforms appear to be somewhat at odds.
On one hand, the CSA’s reforms aim primarily to bolster investor protection, whereas the OSC’s creation of new exemptions raises concerns for investor advocates such as the Toronto-based Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada), which worries about the lack of oversight and the added risk of abuse in this less regulated part of the market.
Indeed, policy contradictions seem endemic to the exempt market. For example, under the CSA’s reforms, the MA exemption no longer will be available to individual investors. The regulators have long been concerned that an exemption that requires an investor to risk a set amount, such as $150,000, is not a good measure of those investors’ ability to trade in the exempt market. In fact, the requirement may force investors to risk more than they otherwise would in order to qualify for the exemption.
Yet, at the same time, the CSA is sticking with their approach of using income and wealth as metrics to define who qualifies as an accredited investor.
The conflicting logic is concerning to FAIR Canada. Neil Gross, FAIR Canada’s executive director, says that although his organization is pleased to see the CSA’s move to eliminate the MA exemption for individual investors, FAIR Canada is disappointed that the CSA didn’t undertake a more fundamental reform of the AI exemption, which does away with financial measures as a way of determining investor sophistication.
By eliminating the MA exemption for individual investors, the CSA acknowledges that the amount invested is not a good way of assessing an investor’s sophistication or his or her ability to withstand a loss, Gross says: “But in somewhat contradictory fashion, the CSA has permitted wealth and income to remain proxies for investment sophistication in the AI exemption. That’s disappointing. We had hoped to see our regulators use this opportunity to reform the AI exemption fundamentally by limiting its use to those investors who meet a real and valid test of investment sophistication.”
In addition, Gross suggests, if regulators are going to continue to rely on wealth as a measure of sophistication, they should: exclude certain assets, such as RRSP and registered education savings plan holdings, from the calculation; adjust the requirements regularly for inflation; and restrict the amount that can be devoted to any particular investment in order to avoid overconcentration.
Instead, the CSA is introducing new guidance for dealers to ensure that investors who are being sold securities under the AI exemption actually qualify for it. Compliance reviews in this area often find inappropriate uses of the AI exemption, so the regulators are trying to ensure that investors actually meet the test of being an accredited investor.
As well, the CSA will require investors who rely upon the AI exemption to sign a new “risk acknowledgement” form confirming that they understand the added risks of trading in exempt securities.
Gross questions whether this last measure will be enough to boost investor protection: “No testing appears to have been done to find out whether this form actually will be effective in conveying information to investors. We [at FAIR Canada] feel this [test] should have been subjected to much more rigorous scrutiny before so much reliance was placed upon it.”
The OSC’s new FFBA exemption, on the other hand, aims to provide another cost-effective way for startups to raise money as it allows companies to sell securities to close friends and family members on the basis that these investors are close enough to the company to evaluate the quality of management and to acquire information about it without the aid of a prospectus.
Gross questions this premise that investors can be adequately protected by having close ties to an issuer: “Affinity frauds demonstrate that being familiar with the investment’s promoter doesn’t actually make investors better able to assess the investment’s validity.”
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