Dispelling the Prospectus myth: An analysis of the holy grail of securities law
By: Craig Skauge
The Exempt Market has been no stranger to scrutiny over the past few years…. and with good reason. Due to what is now obvious to have been a flawed past regulatory regime, many investors across Canada found themselves victimized by a long list of perpetrators who took the money and ran with little to no consequences. The ‘retail’ Exempt Market was easy to get into and easy to access capital from. Market participants, whether legitimate or not, were subject to little or no scrutiny or oversight. From full page newspaper ads, to thirty second spots on television, hotel rooms across the country became filled with investors looking to capitalize and salespeople looking to help them navigate the process: whether it was right for investors or not.
With blow up after blow up surfacing in 2008 and beyond, securities regulators were left with no choice but to make some changes. Big changes. Analyzing the system from a high level, there were two areas on which regulators could focus; the people selling the securities or the people buying them. Given their role in regulating market participants, not investors, National Instrument 31-103 was born and large barriers to entry to the Exempt Market were put in place.
The message was clear: if you wanted to actively participate in this space, you had to become registered with a commission just like other participants in the capital markets. You were no longer a salesperson but someone who had obligations to ensure suitable matches between the product and the client; similar to the IIROC world. In my opinion, they made the right choice. Interfering with, and restricting, investors and their choices would be difficult to implement and monitor and to do so would be fundamentally un-Canadian.
Despite the new system working well March 20th brought a surprise announcement from the Canadian Securities Administrators (on behalf of AB, SK, QB, and NB) looking to further regulate the Exempt Market. But this time they were targeting the investors. Given the amount of speaking I have done on the topic for the past 90 days, I did not want to yet again bore our readers with the countless sensible arguments against the proposed annual OM limits (for that you can read NEMA’s response letter) but still felt the need to write about it in some shape or form.
Given the nexus of these proposals is mitigating the ‘high risk’ associated with OM based investments we decided to take a look at the other side of the spectrum and see just how much less risky Prospectus based offerings were. Before we do so, we first need to understand the main differences between the two. Let’s have a look:
Despite the glaring similarities with OMs as relayed in the chart, regulators have held out Prospectuses as providing superior investor protection for years and in theory their argument is sound. In theory. Unlike an OM, a Prospectus is reviewed by a securities regulator before it goes to the market (as opposed to during/after). So while common sense would say a seasoned securities lawyer drafting an OM would ensure pretty much the same thing (being that the whole story that needs to be told to the investor), Prospectuses have that extra layer of protection in that they have been signed off on by the commissions.
‘Now what does this sign off cost?’ you may ask. Well, it costs a lot more in two areas than OMs do: being time and money. Given the back and forth between regulators and the Issuer’s counsel on multiple drafts, preparation of a Prospectus can take four months or more, whereas an OM can be completed in little over a month if the Issuer, their counsel, and their auditors are on their toes. Now as for money, pending on tax structuring, a good OM (including audited financial statements) can be prepared for as little as $25,000 whereas Prospectuses routinely cost upwards of $200,000 depending on the offering size and prestige of the author’s law firm.
Having said all that, it would be hard to argue that the extra time and cash is not worthwhile if Prospectuses do truly ‘protect’ investors. So do they? If so, how do they protect them? I think if you asked an average investor what was meant by protection the answer would be fairly simple…’that I don’t lose my money.’ So are Prospectuses accomplishing this? While the results are mixed, the overwhelming answer is no, they are not.
We reviewed the initial offering and current trading price of every company* that was listed on the TSX Venture Exchange between 2011 and 2013 (most presumably involving a Prospectus). Aside from a few gems, the numbers were abysmal. Of the 271 companies listed in that period, we found the following statistics:
- 63% (170 companies) now trade at a price lower than they were listed at
- 42% (115 companies) now trade at less than half the price than they were listed at
- 9% (24 companies) are now valued at less than 10% of the price than they were listed at
- 15% (41 companies) have had their trading halted or suspended
More surprisingly, these TSX Venture returns were during a run of record performance on the public markets! Regulators focus on making a change in the Exempt Market for which evidence necessitating it “does not exist.”** However, in the ‘holy grail’ of securities law, the Prospectus regime, evidence does exist, and it seems like it could use a bit of their attention instead.
If securities regulators are truly willing to infringe on investor freedoms in order to protect them from over-concentration in ‘risky’ securities, then it is time that our counterparts in the IIROC world receive some attention, as the numbers above speak for themselves. With performances like those above, perhaps a limit even lower than $30,000 is warranted in the Prospectus world...
Personally, I would rather the status quo remain and Canadians retain the freedom to invest as they see fit. But if a change is coming in the Exempt Market, it is also warranted elsewhere too. As Thomas Caldwell once stated in his speech Regulation Strangulation “the only thing a Prospectus protects is the lifestyle of those who write them.” This is ringing true.
The bottom line is that times are changing and long held theories about the inner workings of the capital market, both exempt and traditional, need to be analyzed and changed if evidence warrants doing so. Look at the Minimum Amount (MA) ($150,000) exemption. For years, Regulators looked at one being able to invest $150,000 in a single offering as a proxy for sophistication. People that were not wealthy or sophisticated were often leveraging their homes to make one large illiquid investment. When the CSA asked about the merits of the MA exemption, industry responded saying to toss it out (which looks to be happening).
Industry has spoken much louder about the proposed OM caps and Regulators need to now realize that their long held theories about risk in the Exempt Market and OM exemption related sales no longer stand true. Their investor protection efforts should be re-focused, if on nothing else then on properly educating investors about this sector of the capital markets that, despite their wishes, continues to grow.
* As at May 15, 2014. All info gathered from www.investcom.com and Yahoo Finance ** NEMA submitted a Freedom of Information Request to the Alberta Securities Commission asking for quantifiable information regarding “numerous investor complaints” surrounding investments made via the OM exemption as cited by them in March 20, 2014 CSA Notice regarding OM Exemption