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.
Canada’s regulators must reform the retail accredited investor exemption to ensure a proper level of investor protection and to be consistent with the principles on which it is based.
In particular, the Canadian Foundation for Advancement of Investor Rights (FAIR Canada) believes that many individuals who meet the accredited investor financial criteria are not truly sophisticated investors; that is, they may not have the financial knowledge to understand the key features of the security, including the risks and costs of the investment products that are being promoted to them. They may also not be able to withstand the financial losses. As a result, these individuals are not adequately protected under the existing rules.
According to the Canadian Securities Administrators, the accredited investor exemption has been premised on an investor having one or more of: a certain level of sophistication; the ability to withstand financial losses; the financial resources to obtain expert advice; and the incentive to carefully evaluate the investment given its size. The current accredited investor exemption permits investors to purchase prospectus-exempt securities if their annual net income exceeds $200,000 or if they have financial assets in excess of $1 million.
So, who are these sophisticated Canadian accredited investors? Examples include:
- The 70-year-old widow who was left with $1 million in financial assets when her husband died, but has no other sources of income aside from old-age security and the Canada Pension Plan. The widow’s husband had always managed the couple’s financial affairs and she has no knowledge or experience in financial matters.
- The baby boomers who have inherited money from their parents or sold their homes to downsize after the children have left and who have never invested in anything other than guaranteed investment certificates.
- The doctor or dentist with an annual income of at least $200,000 but who has zero financial literacy.
- The couple who have saved $1 million in their RRSPs (because, like the majority of Canadians, they have no defined-benefit pension [DB] plans).
These consumers are fair game for salespeople selling high-risk investments because the current regulations consider them to be “sophisticated” or “able to withstand financial losses.” Canadians with DB plans worth at least $1 million are not accredited investors because their pensions are off limits. But the pensions of Canadians who save for retirement in RRSPs, tax-free savings accounts or non-registered, taxable accounts are at risk. In fact, perhaps as many as a million Canadians fall into the accredited investor category. In addition, many who don’t qualify as accredited investors are improperly sold unregulated high-risk investments because of the poor compliance with laws in the exempt market.
FAIR Canada does not believe that strict financial measures of income or assets are a good proxy of sophistication or the ability to withstand losses. We also believe that retirement savings should not be included in the calculation of money investors can stand to lose.
Most Canadians do not have the sophistication to evaluate higher-risk, less-transparent, less-liquid, higher-cost exempt-market securities and are in need of the protections afforded by securities regulations.
Compliance with laws is also essential to the protection of investors. However, compliance has been demonstrated to be extremely lax in the exempt market. Many regulatory reports have identified reliance by exempt-market dealers on the accredited investor exemption in which the investor does not meet the criteria, lack of compliance with suitability requirements, inadequate risk disclosure and serious conflicts of interest (including lack of disclosure when selling securities of related or connected issuers) in which the interests of the dealer often take precedence over the those of investors
FAIR Canada believes that the “accredited investor” exemption must be reformed to ensure it accomplishes its goal. We have suggested that regulators look to the risks posed to investors to determine the appropriate regulatory protections. For example, we suggest that the exemption vary according to the type of issuer issuing the securities (listed or unlisted), the type of seller involved (self-regulatory organization member or not) and the complexity of the security.
FAIR Canada is concerned that regulators have shifted their focus from their mandate to protect investors toward primarily emphasizing capital formation. This has been illustrated by the push for crowdfunding and other exemptions throughout Canada. Thus, FAIR Canada calls on regulators to refocus on their core mandate of investor protection. Such a focus will improve the fairness and efficiency of Canadian capital markets and improve protections for investors, which will provide the basis for real capital formation.