Limits versus Suitability
Is it Time to Re-think Investor Categories in the Exempt Market?
By: Cora Pettipas
There has been much discussion as of late by industry about the proposal of investor limits, by many regulatory bodies in Canada. The suitability regime, which the Exempt Market is now under since the implementation of NI 31-103, is principles based. This essentially means there are no hard and fast prescribed amounts and that every investor can be treated as a snowflake. Their investment portfolio will be assembled to reflect this, on a case by case basis. This means the registrant can base investment decisions on a case by case basis (within certain best practises guidelines), as each investor has a different combination of goals, timelines, risk tolerance, sophistication, experience, and idiosyncrasies. Investors are all different. So, now that we have suitability, are rules based concepts like categories and limits now outdated?
Alternatively, current investor categories and the proposed investor limits, are rules based. The rationale is that these limits and categories increase investor protection in the Exempt Market, but they may have opposite effect, as it changes the registrant’s focus from: ‘Is this a suitable investment for my client?’ to ‘Does my client qualify for this investment?’
Brent Aiken, Vice-Chair of the BCSC states “If the system encourages a tick-the-box mentality about compliance, it puts market integrity at risk. As market participants make thousands upon thousands of compliance decisions each day, there is no assurance that ticking all those boxes is actually protecting the interests of investors.” 1
In a recent publication, the CSA stated that: “The know-your-client (KYC), know-your-product (KYP) and suitability obligations are among the most fundamental obligations owed by registrants to their clients and are cornerstones of our investor protection regime.” 2
The suitability process is vital to the investor protection process; it should be embraced in the Exempt Market. The process of categorizing investors into labeled categories based on the size of their asset ‘buckets,’ should be eliminated, as it is now obsolete. This includes the eligible investor category, which predated NI 31-103. Investor categories were an arbitrary limits-based rule that was meant as a proxy for suitability pre NI 31-103, and has now outgrown its purpose since clients are now assessed individually when Exempt Market product is sold through a registrant.
The Eligible Investor criterion is based on the assumption, like the Accredited Investor exemption, that the wealthier someone is, the more sophisticated they are with investing; your asset ‘bucket’ is a quasi-measure for sophistication. This assumption has not been empirically proven. The only way to judge a client’s financial sophistication and risk tolerance is to interview them, like registrants do before accepting a subscription through the KYC process.
Also, with assistance, clients make decisions about large financial purchases every day that they are not sophisticated enough to make. The majority of the Canadian population owns homes and cars, for example. Most of them have no idea what deems a home or car to be in good shape, and a good value for the requested price. People enlist mechanics and home inspectors to assess the potential purchase before buying it. Anyone who does not attain third party advice is considered foolish. Even when you get a clean home or car inspection things can go wrong afterwards.
As a client would leverage the knowledge and experience of a home inspector or mechanic to assist in buying a home or car, one can leverage the knowledge and experience of a registered Dealing Representative in the Exempt Market. A registrant can provide the expertise and education required so that a client can invest in suitable issuers, even if they are deemed ‘unsophisticated’ by the measure of their investable assets.
Moving from a rules based culture to a principle based one does create significant standards on registrants. The Exempt Market registrants will have to act professionally and act good faith for their clients. The differences in the two deliveries are quite apparent. I was recently in the market for a pre-owned vehicle (of which I admittedly have no expertise in). What I was promised and what was delivered after the sale were different. The sales manager had the opinion that: “if it is not written down we did not say it.” Luckily, I found a place it was written down. However, the sales culture of doing the bare minimum of what was required by law haunted me a little, and breeds a culture of client mistrust. It is not client centric, and does not lead to long term prosperous relationships with the client.
Our leading Exempt Market Dealers have gone through great lengths and expense to assemble compliance process systems that focus on suitability principles (with a 10% best practise concentration rule). As is widely quoted by opponents of Exempt Market, the OSC noted significant deficiencies in suitability by registrants. This is possible, due to the recent of NI 31-103, and that Ontario does not yet have a truly retail Exempt Market, as access is (mostly) restricted to accredited investors. These registrants have previously been able to rely on the tick-the-box compliance method promoted by investor categories.
Now that there is a suitability regime in the Exempt Market, investor limits and investor categorization are redundant for registrants and the current BC OM model, where they do not have the eligible investor category (or investor limits) is most sensible. For non registrants, like those using the North-West Exemption, investor categories and limits are not redundant and make more sense in terms of investor protection. Since investor categorizations precede NI 31-103; they are now redundant. Suitability standards far exceeds the limit based regulation of both the eligible investor category as well as other investment limits, providing the Exempt Market product is distributed through a registrant.