A proposed prospectus exemption is facing resistance over concerns that it could facilitate pump-and-dump schemes and leave investors vulnerable.
The Canadian Securities Administrators (CSA) are proposing a new “listed-issuer exemption” that would enable companies that have already gone public to raise money from investors based on their existing continuous disclosure record.
The goal is to provide companies — particularly smaller firms, as offerings would be limited to $10 million — a way to raise capital without the expense of crafting a prospectus or the need to rely on an existing but limited exemption (such as the accredited investor exemption or the friends and family exemption).
The idea is facing backlash from both the legal and investment communities. Some institutions are warning the proposal would upend the traditional approach to new issues and investor protection by exposing unsophisticated retail investors to offerings that haven’t been subjected to regulatory scrutiny or filtered through an investment dealer’s gatekeeper function.
Bay Street law firm Davies Ward Phillips Vineberg LLP’s submission to the CSA called the proposed exemption “a perfect storm that we anticipate will result in exponentially more ‘pump and dump’ schemes and other mischief in the market.”
Those concerns were echoed by securities lawyer Phil Anisman, who recommended the CSA withdraw the proposal. The new exemption would be inconsistent with the investor protections provided under prospectus requirements or the existing exemptions, his submission stated.
With a prospectus offering, securities regulators review an issuer’s disclosure and ensure it meets certain requirements. Offerings made under existing exemptions apply to investors sophisticated enough to protect themselves — or, at least, wealthy enough to absorb losses without suffering severe financial damage.
Exempt offerings also typically impose hold periods on the newly issued securities, whereas the CSA’s proposal would allow investors to trade shares right away. Hold periods are intended to protect investors against “back door” underwritings that bring shares to market without the benefit of prospectus disclosure or the legal rights that accompany prospectus offerings, such as withdrawal rights and prospectus liability, Anisman’s submission stated.
The absence of these safeguards is raising alarm bells.
Davies’ submission stated that lack of regulatory or investment dealer protections and the absence of a hold period would increase the risk of investor abuse “exponentially.”
The offerings that would fall under the proposed exemption are likely to be from small issuers with weaker controls and limited market oversight (such as from analyst coverage), and likely to be purchased by ordinary retail investors “most in need of the protections afforded by a prospectus,” Davies’ submission suggested.
“Helping smaller issuers raise capital efficiently is an important goal. However, the ends do not justify the means. Facilitating capital raising should not come at the expense of market integrity,” Davies’ submission added.
While the proposed exemption would apply to offerings limited to $10 million, the potential harm would go well beyond the dollars lost to misconduct, Davies’ submission warned, as “multiple public frauds will cast doubt on the efficacy of Canadian securities regulation.”
The Investment Industry Association of Canada (IIAC) also wants the CSA to withdraw the proposal. The IIAC’s submission stated that while it shares the CSA’s goal of facilitating cost-effective capital raising, “there are inherent flaws in the proposal that will have unintended consequences which could compromise investor protection, leading to outcomes detrimental to the Canadian capital markets.”
The industry trade group pointed to the lack of regulatory review, the absence of investment dealer involvement and oversight, and the lack of investor qualifications as fundamental flaws: “The potential cost savings to a subset of issuers do not present a reasonable balance to the investor protection risks inherent in the proposal.”
The submission from the Canadian Advocacy Council of CFA Societies Canada (CAC) also raised concerns, but recommended regulators beef up investor protection in the proposal rather than scrapping it altogether.
The CAC and others called for regulators to apply prospectus liability to offerings made under the exemption.
The CSA’s existing proposal would impose only secondary market liability for misrepresentations made in these kinds of offerings, thus limiting the amount that harmed investors could recover in a lawsuit. Under secondary market liability, investors can collect, at most, 5% of an issuer’s market cap for misrepresentations, whereas prospectus liability may allow aggrieved investors to recover their full investment.
“By limiting the amount that investors can recover in such situations, the CSA in essence is transferring part of the risk for a misrepresentation to investors,” the submission from the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) stated. “This strikes us as patently unfair and unreasonable.”
Mining industry trade group the Prospectors and Developers Association of Canada supported the CSA proposal and argued that prospectus liability shouldn’t be part of the exemption, as it may undermine the goal of providing issuers with a cheaper, faster route to financing.
“In our view, the main incentive for issuers to provide accurate and complete disclosure is directly tied to their fiduciary duties and the need to earn investor and market trust,” the mining group’s submission stated. “The vast majority of issuers are good actors and regulators should focus enforcement efforts on bad actors in the market.”
Toronto-based law firm McMillan LLP’s submission applauded the CSA for attempting to devise a cost-effective financing mechanism: “In a market like ours, which is largely comprised of small issuers, it is imperative that the financing needs of small issuers are addressed if the CSA is to foster fair, efficient and vibrant capital markets.”
The proposed exemption represents “a real response to the needs of smaller issuers,” it stated, after years of other failed reform efforts.
However, McMillan’s submission ultimately suggested the existing capital-raising system needs a fundamental overhaul: “The current piecemeal approach whereby new exemptions are constantly proposed by regulators is intellectually lazy and risks creating confusion and market inefficiency. Regulators need to review the regulatory system as a whole to determine what systemic changes are most effective.”