Editor’s note: This column was written by former Inside Track columnist Ermanno Pascutto. Pascutto is the founder, former executive director and member of the board of directors of the Canadian Foundation for the Advancement of Investor Rights (a.k.a. FAIR Canada). He has had a career spanning more than 30 years as a senior securities regulator and legal practitioner in the financial markets in Canada and Hong Kong.
Regulatory initiatives that are taking place to broaden the exempt market for retail investors in Canada are being driven by industry lobbying and the political imperative to expand funding for startups and small and medium enterprises (SMEs).
The rationale for regulatory exemptions is that some investors are sophisticated and not in need of protection. And there are certain parts of the exempt market (in which securities are issued on a prospectus-exempt basis) — such as institutional investors and exempt sales by listed companies, — that are less problematic. However, the retail investor portion of the exempt market has an abysmal track record when it comes to compliance and fraud. So, what is the justification for further broadening exemptions and permitting even more higher-risk unregulated securities to be sold to unsophisticated investors?
Offering Memorandum Exemption
The Ontario Securities Commission (OSC) recently announced that it intends to develop a proposal for an offering memorandum (OM) exemption in Ontario. An OM is a document that is intended to provide information about an entity and securities offered to prospective purchasers.
Currently, OM exemptions are available in all Canadian provinces and territories except Ontario. The OSC had previously chosen not to introduce the OM exemption, considering it too risky for retail investors. It had also championed the idea that the private-issuer exemption and other exemptions were adequate for startups and SMEs. It’s also proposing a new “crowdfunding” exemption.
Fraud and Poor Compliance
The OSC has billed the new OM exemption proposal as an effort aimed at “harmonization” with the other provinces. The Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) questions why one would want to replicate the experience of other provinces, which have found compliance to be woefully lacking and where retail investor fraud is regularly reported in the media.
Numerous compliance reviews by regulators indicate a high level of non-compliance with the OM exemption. For example, the Saskatchewan Financial Services Commission noted that during its detailed review of non-qualifying issuers’ OMs, “staff identified material disclosure deficiencies in all of the OMs reviewed. In general, the OMs were poorly prepared and did not provide the disclosure required.”
The Canadian Securities Administrators (CSA) have also issued a staff notice outlining many common compliance deficiencies with the OM exemption. These deficiencies are not minor mistakes; they are a systematic failure to provide the basic information that investors need to make informed investing choices.
There is widespread fraud and financial loss linked to the OM exemption. Just three recent OM scandals reported in the press amount to some $500m in retail investor losses. In many other cases, inflated and hidden fees were charged, making it difficult for an investor to make a return on an investment.
The Responsibility of Securities Regulators
The OSC rightly notes that is has a responsibility to examine whether Ontario securities law contributes to the efficient functioning of capital markets. According to the International Organization of Securities Commissions, in an efficient market, the dissemination of relevant information is timely and widespread and is also reflected in the price-formation process. FAIR Canada has not seen any empirical evidence that the OM exemption will contribute to the fair and efficient functioning of capital markets.
Securities regulators also have a responsibility to police securities laws. We question whether the OSC has adequate resources to oversee Ontario’s current exempt market. If the OM exemption is enacted, the OSC will need to dedicate more of its finite compliance and enforcement resources to this area.
Empirical Research and Better Compliance should be Prioritized
FAIR Canada suggests that the OSC focus on improving compliance with the current exempt market requirements before proceeding with an OM exemption that will expose all Ontario investors to unregulated high-risk investments.
In addition, prioritization of empirical research to determine the incidence of fraud, misrepresentation, and resulting investor losses through purported reliance upon the OM exemption is necessary prior to enacting any changes. Although there are many reports of non-compliance, fraud and misconduct, regulators lack empirical data.
FAIR Canada supports the efforts of the OSC and government to increase access to capital for SMEs. Regulators should prioritize this goal by streamlining the rights offering exemption and consider other exemptions for sales to existing shareholders for listed issuers. Such reforms will help listed SMEs that are regulated and that have provided proper disclosure and present fewer risks to retail investors.
With contributions from Lindsay Speed, legal counsel and corporate secretary at the Canadian Foundation for Advancement of Investor Rights.