Playing With Fire | 8 Industry Habits that Need Changing
By: Stephanie A. McManus LL. B. & Craig Skauge
When Adam Derges, VP of Raintree Financial Solutions, spoke at our recent education forum he made a strong point about both the great opportunity and responsibility that the Exempt Market, particularly in Western Canada, has in the coming years. The opportunity is evident in that there is a spotlight on our industry in the “new economy” as a potential investment and capitalization solution for investors and businesses respectively. The responsibility, which may not have been as obvious, is nonetheless just as important. Our responsibility as an industry is simple…to not screw up. Governments all over the world are trying to figure out how to correct a long ago broken system in our collective capital markets and get their respective economies back on track.
While most governments are still just trying to stay afloat on a day-by-day basis by printing money, some are in the conceptual planning stage as to how to get things back in gear in our new reality. Take the United States for example. Now that the never-ending story of the U.S. election is behind us (Obama having retained his seat) the final kinks are likely being worked out in the J.O.B.S. Act and crowdfunding will likely become a reality south of the boarder in 2013. Whether it proves to be a viable solution for entrepreneurs, a train wreck for naïve investors, or somewhere in between won’t be known for some time but the plan is in the works. The spotlight will be shining brighter than ever when theory becomes reality. However, for the time being it’s still just that…a theory.
In Western Canada on the other hand, our moment in the spotlight, albeit not as bright, is right now. While the Exempt Market has only recently become regulated in its present form (with EMDs, KYPs, KYCs, and a whole other list of acronyms being our reality), it has become a dominant force in our capital markets in the last 10 or so years. It’s been well-documented that the pre-NI 31-103 Exempt Market had its share of problems with unscrupulous promoters, uncaring salespeople, and failed deals. In addition to scaring away a vast majority of the big bad wolves of our industry, increased regulation has brought us much needed credibility with businesses (as a source for fundraising), Advisors (as a place with viable client solutions), and investors (as a place with investment options beyond Ponzi schemes). While the new regulations have begun the job of cleaning house and adding credibility, regulation in and of itself is not going to be enough to ensure the integrity of the Exempt Market on an ongoing basis. Regulation under NI 31-103 is principles-based. That means the instrument only tells you what you must do in principle, not how you must do it in practice. For many, that is a welcome change in approach, allowing freedom to develop policies and procedures that are tailored to the firm or business. But for the unscrupulous sorts, the approach leaves open the possibility of sidestepping intended requirements by claiming that the “principle” was respected. There is also much about the Exempt Market that has remained below the radar until recently. So there’s a need to bring it all up into the light so it can be well-understood and well-run.
It’s time for our industry to take the momentum we’ve been given, lose some leftover bad habits and show those that are watching that the solution in the new world economy is right here….right now.
Let’s tackle some of those bad habits referred to above…
Issuers and Advisors alike should ensure that commissions being offered and accepted are reasonable. Commission dollars that are above industry standard are coming from client pockets and may themselves jeopardize the viability of a deal. While that may not always be evident to clients because (in some cases) the compensation structure disclosure is either not there or is buried in a complex offering package, this information always comes to light eventually and is a black mark on the industry as a whole. Selling clients offerings with respectable compensation levels instead of those that bleed an offering to death will help ensure the long term existence of both an Advisor’s book of business and the viability of the offering itself. Advisors need to ask themselves, “If someone is willing to pay me that much
to raise money for them, how desperate are they for cash and how long is this thing going to run?"
While an EMD’s role is to support its Advisors, it’s a two-way street. Advisors must understand that it’s preferable to work with an EMD that has strong operations and rigorous compliance. These are the things that ensure the sustainability of the industry and establish a credible foundation for years to come. They also serve to protect the asset that is the Advisor’s business. But these things cost money and EMDs expecting a fair portion of commissions and fees shouldn’t be viewed by Advisors as greedy but rather as doing what they have to do to keep the lights on, improve operations and build a strong support system for their Advisor’s businesses. In fact, as part of the “investigation” process Advisors undertake in choosing which firm to ally themselves with, they should be wary of firms that offer very high payouts – because the corollary to that is almost always, very poor ongoing support.
Short Term Gain for Long Term Pain
Unlike in the brokerage or mutual fund sales industries, ongoing commissions and trailer fees are not usually generated from the sale of an exempt product. Compensation, with limited exceptions, is generally paid one time and up front and is generally higher than payouts in other investment areas.
To deter the natural drive to “over-sell” exempt products to keep cash flow healthy, (a strategy that could possibly create big problems for the industry as it matures), Issuers might be wise to offer a smaller up-front commission with ongoing trailer fees. This has the potential to improve the financial stability of Issuers, giving them more to work with in the early days of a venture, and it would provide an ongoing and predictable income stream for Advisors. A thorough analysis of and discussion around how the current model motivates Advisors to sell and market exempt products and their services would be a very useful exercise to help keep the industry above-board.
The Suitability Factor
Exempt market products, like every other investment product, should be recommended because they are a suitable fit for a client’s overall investment picture – not because a particular product pays a higher commission than another, not because the Issuer is a family friend, not because an Issuer has flashier marketing (and is easier to sell) than another, and not because there’s a Hawaiian vacation (or the like) in it for Advisors who sell the most of it. Every recommendation has to be founded on the client’s needs and circumstances. Advisors need to focus first and always on what’s in it for their client, not their own pocketbook.
The BIG Picture
Exempt market products are generally regarded by regulators at the moment as high risk. It is therefore rarely the case that a client should have all of their eggs in the Exempt Market basket, even if diversification is offered within that basket. Exempt products should be viewed as a complement to other types of investment vehicles. The percentage and mix should be determined by client circumstances. It is therefore important for Advisors to reach out to more/new prospects to meet their targets, rather than trying to sell a large variety of exempt products to existing clients and to bring all their clients’ funds into the Exempt Market.
The best business idea in the world can be destined for disaster before it gets out of the gate if structured poorly. One common early pitfall is being burdened with too much high rate debt or pre-offering dilution.
As with the compensation issue, EMDs and Issuers are in a constant tug of war over share and timing of payment for investors v. founders. Too often our industry has deals with high rate debt or equity-based hurdle rates that are unsupportable by the underlying business. EMDs want their investors to earn X% and despite their inability to generate it, certain Issuers will offer it just to get cash raised for them.
Many deals are designed so that the cash flow paid to investors can only be supported if the economy keeps growing and there are no misfires in the operation of the business itself. Some Issuers get desperate to generate the promised yields and desperation often leads to bad decisions. By pushing for the best rates and cash flow for their clients, certain EMDs may in fact be putting their clients at risk by putting unsustainable financial pressure on the Issuers of products they approve for their Advisors to sell. If there’s anything that we’ve learned over the past four years it’s that the economy moves in many ways and Issuers need to provide for a cushion to manage the unforeseen and the troughs that inevitably come with the economy as a whole and the operation of a business in particular.
Another item of concern in many offerings is the offering size. Many Issuers that offer “blind pools” think that they can manage an infinite amount of money as their opportunity is that good. Much like Wall Street, our industry has already seen the disastrous results of giving one or two people too much money for their multiple “can’t miss” opportunities. The truth is simple…there is no Superman. One person or group can only properly manage so much money. If an individual or group gets too much capital to manage, they generally get unfocused, sloppy, or worse…creative. EMDs would be wise to look for target maximum capitalization in an Issuer’s plan and satisfy themselves that the target is realistic and manageable, given all the circumstances.
A Seal of Approval
Our industry also needs to learn to keep communication channels more open and to collaborate more effectively. While there will obviously always be competition between EMDs for that elusive investment dollar, there are areas where sharing and working together can reduce costs and benefit all, equally. For example, independent due diligence reviews are commissioned by EMDs before they will approve a product for sale by their Advisors. At the moment, each EMD requires a separate and full-priced due diligence review for the same Issuer’s product. Any cost of this type is ultimately passed on to the investor and dilutes available profitability for everyone. Wouldn’t it be an idea to standardize the format of independent due diligence reviews and have a kind of online ‘library’ for reviews that all subscribing EMDs could access for free? Issuers might have to update the review annually but that would still be less costly than having to commission a new report for every EMD.
This would also have the effect of making public (through their absence from the library) those products that are less than credible. So this could both reduce costs and offer a kind of “seal of approval” - a huge step forward to attract larger more credible Issuers and keep the weaker ones at bay.
Lastly, our industry would do well to offer free education to the public at every available opportunity. The biggest source of conflict between investors and Dealers/Issuers, and at the heart of most lawsuits and regulatory actions, is when a client’s expectations are not met. The most effective way to address that, apart from at account opening, is through ongoing thorough and frank public education about the pros and the cons of the Exempt Market. At the end of the day, Adam Derges is right: the responsibility to keep this industry healthy and thriving is ours. There are many conscientious people and good minds in the Exempt Market. If we put our heads together and continue to work toward strengthening things, those working in the industry, investors and the Canadian capital markets will all benefit.