Cannibalism in the Exempt Market
By: Craig Skauge
Conflict in our lives and particularly in business is not a rarity and the exempt market is no exception. There is a constant internal tug of war within many dealers about doing what is best for them versus what is best for the client. Nowhere is this conflict more prevalent than in the case of an offering where the same people are involved as both the issuer and the dealer and in rare cases where the dealer itself is the issuer.
A properly structured related party offering can often be a great thing for clients as it allows those whom the investors trust to retain access and utilization of the funds. If however, a related party offering is clearly serving the needs of the dealer/dealing reps and not the clients, there may prove to be a conflict that not only upsets clients but may even catch attention of the regulators.
There are two primary reasons that regulators may look at related party offerings in this light. The first is an offering that is too rich and contains too many fees, commissions, and other compensation for the related parties. All offerings are subject to fees but related party fees are often seen as egregious due to the lack of arms-length negotiations between the parties involved. The second, which may be even worse, is where clients funds are placed into what maybe a knowingly sinking ship in order to try and rescue a business deal in which the principals are involved, or even worse, to try and rescue the dealer itself. If the only reason the sale is being made is to keep the doors open, then that is in conflict with the objective of ensuring the sale is in the best interest of the client.
While nothing formal has been published as of yet, regulators across the country are taking particular note of related party offerings in the exempt market and determining if the sale of such investments to clients is in fact in the clients best interest or just in the interest of the dealer or dealing rep (due to higher commissions and other fees to related parties). In speaking with the Alberta Securities Commission’s Director of Market Regulation, Lynn Tsutsumi, she stresses that “this is a critical time for the exempt market community – a time where it earns credibility with the investing public, or loses it. The ultimate question comes down to whether or not an investment is suitable and in the best interests of a client.”
While there is nothing legal prohibiting a related party offering or governing fees (after all they’ve been done in IIROC and MFDA worlds for years) all participants in the exempt market and their counsel should be cautious when putting together offerings where there are conflicts of interest. Simply disclosing the fact that there are related parties involved may not prove to be enough in the eyes of a regulator. You need to ask yourself whether or not you would sell this product to a client if it was not compensating or assisting you in some additional fashion.
If this sounds like what may be going on in your firm, take note immediately and make the necessary amendments before your local regulator comes knocking. There’s nothing wrong with making a profit but as the old saying goes, pigs get fat while hogs get slaughtered.