On the income test, access to private investments turns on a dollar: $200,001 can open a door that $199,999 leaves closed.
Neither number says what the investor knows about the investment. Neither says what a loss would do to the investor’s finances. That is the problem with Canada’s accredited-investor rules. Wealth is easy to measure, so regulators have used it as a shortcut for harder questions.
The Canadian Securities Administrators (CSA) has decided that the shortcut needs to be rethought. Proposed Multilateral Instrument 45-111 would allow certain investors who do not meet the accredited-investor wealth threshold to participate in private placements if they have specified education, credentials or experience.
A chartered professional accountant (CPA) could qualify. The investor would certify the qualification, acknowledge the risks and be limited to $50,000 a year. Unless the seller knows — or would reasonably be expected to know — that the certification is false or misleading, no further verification is required.
Now put another investor in front of a registered dealer. The dealer must know the client, know the product and determine whether the recommendation is suitable. That means examining the client’s financial circumstances, investment knowledge, risk profile, objectives and time horizon.
The CPA can qualify through credentials and self-certification. The advised investor can be assessed on knowledge, finances, risk capacity, liquidity and concentration — and may still be stopped for failing to meet the wealth test. That is an odd result.
CSA chair Stan Magidson appears to think so too. On March 26, he told the Standing Senate Committee on Banking, Commerce and the Economy that if an investor has received suitability advice from a broker-dealer, regulators should consider if “maybe we don’t need that extra layer of needing to be an accredited investor.”
They should. The case is not that advice makes private placements safe. It does not. Nor is it that registered dealers should simply be trusted to decide who gets through the gate. The case is that an individualized assessment can answer questions the wealth test cannot.
Does this investor understand the investment? Can the investor absorb a total loss? What happens to liquidity? How concentrated would the portfolio become? Does an illiquid private security fit the investor’s circumstances?
Those are investor protection questions. A number on a tax return cannot answer any of them.
There is an uncertainty here that should not be glossed over. The advised exemption does not yet exist, so there is no compliance record showing that dealers would consistently perform this deeper assessment.
That is why the protection has to be built into the design.
If advice is going to replace the wealth test, the dealer’s file should have to show how investment knowledge, capacity for loss, liquidity and concentration were assessed. Not that they were considered — how they were considered. What the investor was asked and what the answers were. How much of the client’s liquid assets the commitment represents, and what is left if it goes to zero.
Outside the box
A box saying the investment was suitable records a conclusion without the reasoning behind it. When a client complains, that reasoning is the only thing anyone can examine. The documentation is not a record of the protection. It is part of it.
Some dealers may decide that the additional assessment, documentation and supervision are not worth the business. An exemption nobody uses helps nobody. But that is a commercial choice. It is not a reason to apply a wealth test where the firm is prepared to do the work.
Exposure limits still belong in the design.
The CSA has recognized that knowledge alone does not address an investor’s ability to withstand loss, which is why the self-certified route comes with a $50,000 annual cap. But a fixed amount ignores the size of the portfolio it comes out of. For one investor, $50,000 may be modest. For another, it may be dangerously large.
For the advised investor, the assessment has already measured loss capacity. Any exposure limit should therefore serve as a backstop to that assessment, not substitute for it. The limit should apply to total private-market exposure and be expressed in relation to the investor’s financial assets, with the percentage set by regulators.
The same proportionality question applies to the self-certified route. A $50,000 maximum can remain a ceiling, but regulators should consider whether smaller investors also need a lower portfolio-based limit.
Then test the result.
Regulatory file reviews should examine whether dealers are consistently documenting investment knowledge, capacity for total loss, liquidity and concentration and whether the resulting recommendations are pushing clients too far into private markets. If those reviews show that the individualized assessment is working consistently, the limits can be revisited.
That is a more defensible way to expand access than simply moving or eliminating the wealth thresholds.
The investor case for reform is not that private securities should be easier to sell. It is that investors should not be excluded by a crude proxy where a more relevant protection can take its place.
The current system asks a simple question because simple questions are easy to administer: does the investor earn enough?
A better system would ask what the investor understands, what the investor can afford to lose and what the investment would do to the rest of the portfolio.
Those questions take more work. They are also the ones that protect the investor.
