THE GATEKEEPER | The Role of the Exempt Market Dealer
By: Adam Derges
On September 28th, 2009, new legislation took effect in order to regulate the alternative investment industry – NI 31-103. These regulations basically stated that anyone who wants to sell private securities needs to sell them as a registrant of an Exempt Market Dealer (EMD). This legislation gave birth to the modern EMD in the Exempt market. The idea is simple, the EMD is tasked with finding Advisors who will register with their firm, find good investments to offer, and make sure that the investments are sold in a suitable and compliant fashion. The securities commission will oversee the EMD, and the EMD monitors the products, the advisors, and the transactions. Sounds simple, right?
In its most basic form, this setup is simple one. However, we are faced with some very interesting times in our current financial environment. Let’s face it, the financial world is broken. In my opinion, the financial world is broken for two very simple reasons:
- Most investments are sold under a cloud of conflict. More often than not, when an investment is offered to an investor, the person selling the investment is incented or encouraged to sell their firm’s in house product. They are not offering that product because it is best for the client; they are selling it because that is what is best for the firm they work for.
- Most investments lack alignment. In many cases, the people pulling the strings on the companies you invest in are heavily compensated regardless of whether or not they provide their investors a return. It is very typical to see investments in the traditional markets where an investor is paid last and hurt first.
If you take these two fundamental flaws and apply them to the traditional markets, the investor will likely see sub-par returns. However, the public markets are equipped with safeguards and regulations that should ensure that investors are not hurt too badly. In other words, investors might not make any money, but they probably aren’t going to lose everything they invest. If you take these flaws and apply them to the Exempt Market world, you are more likely to see a result with extreme consequences. When something goes wrong in the Exempt Market, it can result in a complete loss of capital.
Unfortunately, the investments that have resulted in a complete loss of capital have received a lot of press lately. Most of these bad investments were sold prior to the regulatory changes in September of 2010; however, they are still making headlines today. It is a sad reality for our industry. Only the bad investments get publicly noticed. ‘Client Receives 10% Return’ is not exactly front-page material!
what can the emd's do to change this?
This newly regulated industry is truly evolving. There are a few large EMD’s who are tasked with setting the standard for our industry. In our view, the role of the EMD is not only a regulatory compliance role; it is a role in which we have set out to do what is in the best interest of the investor. We, as EMD’s have an opportunity to raise the bar. The height at which this bar is set will have a long and significant impact on the financial industry. It will influence whether or not private securities are a viable and legitimate place for Canadians to invest their money, or if it will remain a haven for fraud, misalignment and conflict.
It is our job, as EMD’s to ensure that sub-standard offerings are not able to get distribution from the reputable dealers. Our firm has reviewed over 250 investments. We have found that most of the offerings are based on a sound business idea, however these deals are ‘won and lost’ in their structure. Many deals have mechanisms built in that are designed to protect the issuer in times of turbulence. Often times, these mechanisms come at the expense of the investor. When determining whether or not a deal is sound, the EMD must look at the deal now and at each stage in the future.
It is also our job to ensure that we only support top quality offerings by providing distribution. Assessing product issuers is a humongous undertaking. In order to do this, the EMD’s need to invest an incredible amount of time and capital in their up front, and continuing product due diligence. The EMD needs to communicate their standards clearly to the product issuers and make it crystal clear that these standards are non-negotiable.
The good news is, the bar has been raised and things are getting better. This is certainly very encouraging. If an EMD is operating in a responsible and ethical manner, the risk- balanced returns for the clients can be very strong. There is a borderline epidemic of baby-boomers who are now retiring with far less money than they thought they would. Most have made very little on their investments in the past 10 years and now are faced with a decision to either work longer or retire with less. Alternative investments are capable of providing enhanced risk-adjusted ROR, superior to those in the traditional markets. This can have a very positive effect on people who are trying to retire.
As industry continues to trend in the right direction, the exempt market can change the lives of Canadians for the better. In order for this to happen, the EMD’s need to set and maintain the highest possible standards requiring: discipline, transparency and competence. If we as an industry can raise the bar high enough, we have a legitimate chance at improving the way people invest their money. By setting the standard we will carry our industry forward for many years to come.