The “Wild West” and The “Alberta Tiger”
By: Bill McNarland and Matthew McKellar
An article published by a national news magazine in late 2012, has become a discussion point in the exempt market world. For many newcomers to the industry, the article has created confusion, as the companies, practices, and regulatory structure mentioned in the article all seem quite unusual and antiquated. The modern exempt market, which people with fewer than three years in the industry have always known and participated in, seems to bear little resemblance to the “wild west” in the article.
The modern exempt market more closely resembles a prosperous, growing, and orderly emerging economy, such as those of the “Asian Tigers”: Singapore, Korea, Taiwan, and Hong Kong. It is the story of the Asian Tigers that is a much more applicable parable for the exempt market. Each of the four Asian Tigers entered into a high-growth phase in the mid-20th century after undergoing meaningful economic and policy reform; the exempt market has begun its ascent on a similar trajectory since the meaningful regulatory changes of 2009/10. Understanding past losses and failures in the market is important, but it is equally important to understand that the pace of change in the exempt market means that few of the past problems and issues are relevant if dealing with high-quality institutions and advisors in the market today.
Since the time frame mentioned in the article, the industry has undergone significant change. Many of the unsophisticated and inexperienced exempt market dealers have folded or have left the market, having been pushed out by both the regulators and by more successful, well-prepared dealers. Many novice dealers made the mistake of not investing in a thorough due diligence process before approving investments and soliciting client funds. These dealers often were sold on the pitch of the opportunity rather than on the structure of each deal. As an example, Pinnacle Wealth Brokers has been pitched roughly fifteen different investments involving real estate in the Phoenix area but has chosen only one to support and form a long-term partnership with. Finding the one-in-fifteen, or even the one-in-fifty, deal that is structured not only to perform well but also to protect investors’ interests is something that smaller dealers have generally found difficult. This is because they lack the capital-raising power and due diligence infrastructure to attract top-quality partners and to recognize them when they come along.
As a leading Exempt Market Dealer, Pinnacle has been leading many of the positive changes seen in the industry over the past two years. The due diligence process carried out by the in-house research department, which consists of on-site visits, management interviews, and an extensive review of all relevant documents and economic conditions, is a prime example for other EMDs. Pinnacle has pushed for other positive change in the industry, as well. A new product rating system places strong emphasis on investor safety and corporate governance measures, such as the use of a bare trustee or custodian and the installation of independent boards of directors. A bare trustee or custodian is a useful way to protect investor capital; management can direct how funds are spent, but each transaction is monitored to prevent abuses. An independent board of directors provides further management oversight, and as a party whose interests are aligned with those of other investors, it is also motivated to manage risk and control costs.
Some commentators have tried to suggest that investments offered on a prospectus basis, where all offering documents are reviewed by the provincial securities commissions prior to the investment being offered for sale to end investors, are inherently less risky. This is simply not true—as Bill Rice, Chair and Chief Executive Officer of the Alberta Securities Commission, states in the “Wild West” article: “It’s not our mandate to sanction people for incompetence.” Companies that trade on the TSX and TSX Venture exchanges are often involved in high-risk lines of business, such as mineral exploration and biotechnology research.
In the Exempt Analyst office, there is a sizeable library of financial books, publications, and reference guides. One of the more interesting books is titled FP Survey: Predecessor and Defunct, 2006. It’s a reference guide for the period of 1929 to 2006, which lists Canadian companies that were taken over, went bankrupt, were dissolved, were wound up, or otherwise ceased to exist. Many of these companies were publicly traded, and most would have had their offering documents reviewed by one or more provincial securities commissions before offering their shares for sale. However, the record is far from spotless; 24,100 companies are listed in the guide.
Some perspective is needed for the supposed $2 billion in losses the article claims took place. Although $2 billion (if that is in fact the number - which many doubt) is a large sum of money for any one corporation or person to control, it is a much more reasonable sum in the context of the Canadian capital markets. The Toronto Stock Exchange, with a total market capitalization of roughly $2 trillion, can swing several billion dollars over the course of a day. In the exempt market, it is estimated that $142 billion was raised in total in 2011. A $2 billion loss over the course of several years in some of the most turbulent economic times since the Great Depression is not as dire as it sounds in such a large market.
The majority of the exempt losses discussed would have occurred between 2007 and 2010, one of the most turbulent economic times in Alberta’s history. Real estate prices spiked enormously through to late 2008, spurring development across the province. Skyrocketing wages and a wave of immigration, sparked by $140/barrel oil, made many real estate ventures look promising. Unsophisticated investors rushed to invest in the real estate market, including in real estate development deals, which are risky investments even in the best of times. When the downturn started in late 2008, prices fell and many deals no longer looked economically feasible. Investors took losses, especially in cases where management were inexperienced in developing real estate.
Of course, it was not just the investments in the exempt market that suffered. Blue-chip stocks with long histories and some of the world’s best management teams sagged considerably. Coca-Cola fell from $31.89 per share at the beginning of 2008 to $19.55 by early 2009; shares in the Boeing Company fell to less than a third of their peak value; and General Motors and the Chrysler Group each needed a government bailout and thorough re-structuring. Other notable losses in the public market eclipse the $2 billion quoted in the article. Sino-Forest claimed to be one of the leading commercial forest plantation operators in China until they were exposed by Muddy Waters Research as being a Ponzi scheme. The firm had a market capitalization of roughly $5 billion until 2011; now it is questionable whether any value remains for shareholders. In the United States, the well-publicized Ponzi scheme organized by Bernard Madoff is estimated to have scammed investors out of perhaps $18 billion.
One of the more confusing points in the article is when the author tries to make readers question the wisdom of investing in exempt market offerings through their RRSPs. The RRSP is arguably the best investing vehicle for middle- and high-income Canadians, who can defer tax on income invested until they are in a much lower tax bracket. To invest on a cash basis before taking advantage of RRSP and TFSA contribution room—$23,820 and $5,500 for 2013, respectively—would unnecessarily expose the investor to taxes they shouldn’t have to pay. If you are well-off enough to have maxed out your RRSP and TFSA contribution room for the year and can only invest with cash, that’s fantastic – but you’re among a small portion of the Canadian public.
Although the history of the exempt market is worth examining and understanding, little of the information found in the “Wild West“ article is relevant in today’s modern exempt market. The more unscrupulous and incompetent characters mentioned in the article are no longer involved in the market, having been pushed out by vastly improved due diligence processes, industry standards, and securities regulations. The most important take-home message for investors is to develop a more thorough understanding of risk. Risky investments can exist in any market, public or private. When considering an investment of any kind, consult with an investment advisor about its suitability for your portfolio and your goals, and inquire about the investment dealer’s due diligence practices.