There’s no question that the exempt market has become an increasingly critical component of the Canadian capital markets ecosystem in recent years. The problem is that no one knows just how critical it is, or how well investors are treated in it.
Despite questions about investor protection, regulators are intent on encouraging growth in the exempt market. Several Canadian jurisdictions have introduced new prospectus exemptions this year, and the Ontario Securities Commission (OSC) has pledged to finalize its own offering memorandum (OM) exemption, along with a new crowdfunding exemption, in the autumn. This push to expand the exempt market reflects a desire to help foster capital formation, despite a lack of data on both the market itself and the adequacy of investor protection.
Indeed, one of the central problems with regulation in the exempt market is that what’s happening there is just not clear. Exempt market reporting activity is fragmented throughout the country, reflecting the fact that the exemptions themselves aren’t harmonized among the provinces and that different markets often have diverging priorities.
Now, however, securities regulators are looking to address the reporting side of things. On Aug. 13, the Canadian Securities Administrators (CSA) proposed a new, harmonized reporting regime for exempt securities. The initiative aims to make things easier for issuers by giving them a single report to use throughout the country. The proposals also would increase the data that regulators collect in these reports, providing a better view of what’s going in the exempt market.
From the investment industry’s perspective, a harmonized reporting regime – coupled with recent CSA proposals to require exempt-market filings to be made electronically through the System for Electronic Document Analysis and Retrieval (comments on that proposal close on Aug. 31) and longer-term plans for an integrated filing system – represent steps toward reducing the compliance burden.
Geoff Ritchie, executive director of the Private Capital Markets Association (PCMA, the industry trade group), welcomes these developments. He indicates that the PCMA will be examining the details of the CSA proposals, but nevertheless is pleased with the promise of more efficient, harmonized reporting.
“The report versions have become increasingly fragmented in recent years – and that has led to unnecessary complexity and a compliance burden on the private markets – and for no evident purpose,” Ritchie says. “We are very encouraged by the commitment to harmonize and to move to electronic submissions.”
Although the introduction of a harmonized report seems like common sense, the content of those reports are likely to prove more contentious. Among other things, the proposed reporting regime would require exempt- market issuers to provide regulators with: data about themselves; the identities of their directors and executive officers; details about the exemptions being relied upon and the securities being distributed; and information on the compensation being paid to various participants in the distribution. Much of this information also would be available publicly.
The CSA hopes that collecting more consistent, expanded market data will generate better regulatory insight and lead to enhanced oversight. Indeed, the regulators foresee a broad range of uses for this information.
According to the CSA notice spelling out the proposals, the information collected in the proposed new regime would allow regulators to: build more comprehensive risk profiles for firms that operate in the exempt market; connect exempt-market reporting with derivatives transaction reporting to help to monitor systemic risk; and help regulators ferret out connections between issuers through common directors and executives, while also helping the regulators see the financial relationships that exist between issuers and the people being paid for distributions.
Enhancing regulators’ ability to oversee the exempt market is important because there remain concerns about investor protection. Anecdotally, there certainly appear to be compliance issues in the exempt market. Regulatory reviews of exempt-market dealers have raised concerns about their compliance with the “know your client” and suitability rules, as well as about significant conflicts of interest, particularly among firms that trade in the products of related issuers. Investment dealers have run into trouble in the exempt market, too.
For example, in early August, the Investment Industry Regulatory Organization of Canada (IIROC) settled an enforcement case against Scotia Capital Inc. after that firm uncovered widespread misuse of prospectus exemptions at DWM Securities Inc., a dealer Scotia Capital acquired recently.
An internal review by Scotia Capital revealed that approximately 1,700 clients were sold securities under exemptions that those clients didn’t qualify for, and that almost 600 of those clients suffered a combined $4.5 million in losses in those securities.
The firm has pledged to reimburse clients, with interest. Scotia Capital also is going to fine the reps involved and aims to recover a portion of the restitution the firm must pay to clients from the reps that sold the products improperly. In addition, Scotia Capital agreed to a $500,000 fine by IIROC in connection with the supervisory failures that allowed the improper sales to occur in the first place.
Whether the sort of reporting envisioned by the CSA will prevent, or enable earlier detection, of these sorts of systemic issues is not clear. But stepping up regulators’ oversight capabilities can’t hurt. At the same time, better market data also should lead to better policy-making in the exempt market.
For example, regulators would be able to assess whether recent reforms – such as the introduction of new prospectus exemptions – are having the desired effect of helping issuers raise funds cost-effectively and allowing investors access to a wider range of investment opportunities without compromising investor protection.
These goals are shared by the industry, too. “If we are to have informed policy discussion about regulation in the private market,” Ritchie says, “it must be based on empirical evidence.”
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