Two Steps Backward: The battle cry against the proposed Exempt market investor limits
By: Zack Siezmagraff
“I find this proposed amendment unduly and unfairly restrictive.” - Vince G., Investor
The comment period for Multilateral CSA Notice of Publication and Request for Comment Proposed Amendments to National Instrument 45-106 ended June 18, 2014. Since these proposed changes landed with atomic shock on the Exempt Market community on March 20, stakeholders from across the industry, such as: NEMA, investors, dealing representatives, EMDs, issuers, and securities lawyers - have universally panned the proposed cap of $30,000.
As NEMA has communicated through its thorough consultations and town halls, and stakeholders agree, that our regulatory regime appears to show a fundamental bias and misunderstanding of the Exempt Market and its offerings.
Regulating for the Past - Not the Present (Nor the Future)
The Exempt Market unquestionably experienced some growing pains over the past ten years. High profile failures and frauds cast a dark shadow over the fledgling industry, and all but negated much of the good news that was coming out of the Exempt Market.
After years of discussions, analysis, and consultations, the industry emerged with NI 31-103 in 2010. The regulators at that time were in near universal agreement that the path forward for the Exempt Market was through registration reform. This introduced multi-layered accountability, focus on client suitability, enhanced scrutiny on issuers, and greater regulatory involvement. NI 31-103 was not perfect, but it was a huge step in the right direction for all participants: “Registrants act as gatekeepers of the integrity of the capital markets. They should not, by act or omission, facilitate conduct that brings the market into disrepute… KYC information forms the basis for determining whether trades in securities are suitable for investors. This helps protect the client, the registrant and the integrity of the capital markets.” 1
With the stroke of a pen, the regulators propose to take us backwards - undoing all the collaborative work and maturation since 31-103. The proposed cap effectively neuters registrants from performing their client obligations. This approach is ham-fisted, unilateral, arbitrary, and runs contrary to the regulatory mandate of “fostering fair and efficient capital markets.”
A Solution in Search of a Problem
“To restrict investment as proposed is simply a slap in the face to the industry, advisors, and the investing public.” - John H., Dealing Representative
The main, and most contentious part, of the proposal is to limit the aggregate amount an investor can invest in the exempt market under the Offering Memorandum exemption to $30,000 per 12-month period. This is with the apparent goal of “limit[ing] the potential exposure of an investor to a risky investment.”
NEMA has reviewed hundreds of written submissions and has conducted three town halls (in Edmonton, Calgary, and Toronto) to engage in dialogue with stakeholders about these proposed changes. As the reality of what these proposed changes would mean for the industry began to take hold, several key concerns emerged.
(1) You Either Believe in Registration Reform, Or You Don’t.
“To implement dramatic, arbitrary investor restrictions on our industry before the long term effects of NI31-103 can be seen quantified and studies shows a level of disrespect to the immense amount of work done by industry participants, their professional advisors and the quality securities commission employees who have worked so hard over the past three years on NI 31-103 implementation.” - Kenneth E., C.A., Exempt Marker Issuer
The proposed changes contradict the regulators’ views on registration and NI 31-103. The $30,000 cap effectively eliminates the role of the registrant. It is the regulator implying is that ‘below $30,000, we have full confidence in the registrant to perform KYC, KYP, and suitability for the client. But at the magic number of $30,000 - the registrant suddenly loses the ability to perform any of those functions effectively.’ This is absurd, unfounded, and insulting.
The Eligible Investor category has a tremendous permutation of possible investor profiles. A ‘one size fits all’ approach is not appropriate. As the regulators themselves have stated:
“[Assessing suitability] requires meaningful dialogue with the client to obtain a solid understanding of the client’s investment needs and objectives, and to explain how a proposed investment strategy is suitable for the client in light of the client’s than a mechanical fact-finding or “tick the box” investment needs and objectives.” 2
(2) Negative Impact on Investors
“When my exempt market investments mature, I hope to re-invest in order to take advantage of compounding. If there is a $30,000 annual limit, compounding will no longer be available to me. I will be forced to buy GICs, or mutual funds, which I refuse to do again. This is unfair and will only benefit GIC and mutual fund entities.” - Jerome W., Investor
Investors are alarmed at the drastic impact this may have on their investment portfolio and income. This arbitrary cap suggested by the regulators will close the door for the majority of retail investors to the lucrative and profitable products only available in the Exempt Market.
Investors are outraged and indignant that the regulators have taken the attitude that they know what is best for investors - despite the comprehensive disclosure that issuers are required to make, and despite the tremendous maturation the Exempt Market has gone through in the past ten years.
- Under this cap, investors who have more than $30,000 will be forced to put the remainder of their funds into other investments.
- Exempt products are typically not connected to the stock market. By forcing investors to put less into the Exempt Market, this will increase the overall exposure to the stock market.
- Many investors have made a lot of money in the Exempt Market. By reducing the amount that investors can invest, this may severely reduce investor returns.
- Exempt Market buying behaviour is very different than other markets. Investors may invest a large amount of money in one investment, and then none for several years. This cap will cause investors to lose out on opportunities.
(3) Negative Impact on Issuers and Canadian Innovation
“Raising capital is already a challenge and takes tremendous efforts by the EMDs, and for the Issuers while demonstrating a strong track record which usually takes years of experience. As such, further limitation will not only limit individuals choices in life, but will shrink this industry resulting in higher unemployment in Canada and less investment choices for the Canadian middle class!” - Thomas B., Exempt Market Issuer
These changes will be a step backwards for many issuers who rely on investment capital as a flexible complement, or alternative to, traditional financing. Stakeholders have expressed concerns about the long-term consequences of this proposed change, which would include less consumer choice and greater barriers to start-up and innovation.
Access to capital is a major issue for Canadian start-ups and development projects. The Exempt Market has become a channel of choice for good ideas and solid investments to be accessed by retail investors. Less capital access will stifle Canadian innovation.
The ultimate beneficiary to greater market choice and competition is the consumer. With higher barriers to entry, there will be less market forces driving costs down, which will have negative impacts to investors.
(4) No Place for the State in the Investment Portfolios of the Nation
“I do not wish to have government policy ultimately decide where and how I should invest my money; it is a highly personal decision based not only on my income and net worth, but my sophistication, risk tolerance, goals, and preferences.” - Bernard B., Investor
The fourth main theme in the stakeholder feedback was a revolt against a heavy-handed and arbitrary intervention of the government (regulators) in the financial decisions of Canadians. Stakeholders have expressed concern, anger, and resentment at an approach that is not only seen as unfair for the exempt market, but also one that runs against our Canadian and free enterprise values.
- The governing principle of the Exempt Market is the investor is taking on the risk after receiving a comprehensive set of disclosure documents. Furthermore, the trade-off for the illiquidity of Exempt Market products is much higher returns. Exempt Market products are a great complement to an overall portfolio.
- Such a precedent would open up regulatory meddling into other sectors of the investing public.
Some Positive Steps
The proposed changes do contain some positive steps forward, most importantly the requirement that marketing materials be included as part of the offering documents. The regulators have not provided comprehensive direction on the use of marketing materials to date and this is an important and necessary step. The other changes, largely applauded by stakeholders, include greater investor rights with respect to ongoing issuer disclosure and audited financials, as well as harmonized NI 45-106 reporting.
A Collaborative Path Forward
It is in the best interests of all in the industry to reduce fraud, increase public awareness, and protect investors. On behalf of all stakeholders, NEMA will continue to work with the regulators to adopt a collaborative, consensus-driven approach to Exempt Market regulation. NEMA has been leading the charge in opposing these unfair and discriminatory proposed changes.
NEMA has facilitated an aggressive, multidimensional lobbying, education, and awareness campaign that has resulted in hundreds of letters of comment to the regulators. In addition to communicating stakeholder concerns and objections, NEMA has proposed concrete solutions and alternatives to address the underlying concerns behind the proposed changes.
It is our sincere hope that the regulators will listen to the overwhelming concerns from all Exempt Market stakeholders and will withdraw these proposed investment caps and will work with NEMA on a collaborative basis moving forward.
1 CSA Staff Notice 31-336: Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations. 2 Staff Notice 31-336: Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations.