As regulators contemplate changes to the rules governing the exempt market, registered representatives can expect to face greater regulatory scrutiny when distributing these products, particularly with respect to know your client (KYC) and suitability rules, industry experts said on Monday.
At a conference in Toronto hosted by the Association of Canadian Compliance Professionals, David Di Paolo, partner at Borden Ladner Gervais LLP, said regulators are monitoring exempt market transactions much more closely as the scope of the market grows. He estimates that in 2010, $83.9 billion was raised in the exempt market.
“Issuers are increasingly looking towards the exempt market as an avenue to raise capital,” Di Paolo said. “And moreover, these exempt products are increasingly being sold through retail channels.”
The growing volume of transactions is leading to more regulatory investigations involving the sale of exempt market products, and more civil claims by investors against their advisors and dealers involving the sale of these products. This has prompted regulators to take a closer look at the rules governing this segment of the securities business.
“The exempt markets, and the rules surrounding the exempt markets, are increasingly being scrutinized by the Canadian Securities Administrators,” Di Paolo said.
In particular, the securities commissions are evaluating the two exemptions most commonly relied upon by investors: the accredited investor exemption, which is available to investors who have a certain amount of net income, financial assets or net assets; and the minimum amount exemption, which is available to investors who are purchasing at least $150,000 in the security of a single issuer.
Regulators are currently assessing these exemptions to determine whether stricter criteria may be necessary to ensure appropriate protection of exempt market investors.
“It’s quite likely that the prospectus exemptions available will be narrowed,” Di Paolo said.
In the meantime, regulators are also evaluating the extent to which dealers and advisors are complying with the existing exemptions.
“Regulatory enforcement of existing qualifications is going to heat up,” Di Paolo said. In particular, he said the Ontario Securities Commission is closely monitoring the KYC process for accredited investors. It has found that some dealers aren’t collecting adequate KYC information to reasonably determine whether clients are, in fact, accredited.
Even if clients say they qualify for the exemption, advisors and dealers must conduct due diligence to prove that clients do indeed qualify. “You have to be able to demonstrate that you’ve done adequate due diligence,” Di Paolo said.
If regulators continue to find abuse of the exemptions – and the accredited investor exemption in particular – Di Paolo said they’ll likely implement a requirement for accredited investors to be certified by a third party before they’re eligible to purchase exempt market securities from a dealer. This could mean hefty costs for dealers.
“It strikes me as being an extraordinary amount effort and an extraordinary impediment to selling exempt market products to clients,” Di Paolo said.
Regulators are also taking steps to ensure advisors selling exempt market securities completely understand how the products work, so that they can properly determine whether they’re suitable for clients. “The regulators are coming down hard on advisors and dealers who don’t adequately understand their products,” Di Paolo said.
Calgary-based Portfolio Strategies Corp. is one firm that’s taken steps to address this area of concern. It’s introduced a questionnaire that advisors must fill out when they’re seeking approval to distribute an exempt market product, according to Ken Parker, vice president of compliance and finance. The questionnaire asks about the advisor’s familiarity with the product and the company and individuals offering the product, among other things; forcing advisors to thoroughly familiarize themselves with product before selling it.
“They have to do a bunch of work up front,” Parker said.