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The Ontario Securities Commission has launched a review of its prospectus-exempt distribution framework, following industry calls to open the exempt market to more investors. The review will look for inspiration to this year's U.S. JOBS Act legislation on small-business capital raising, the commission said.
The regime allows small- and medium-sized businesses to issue securities without the time and expense associated with preparing a prospectus. Small issuers struggling to raise capital in the aftermath of the 2008 market crash have increasingly turned to the private exempt markets and they raise billions of dollars that way. Industry stakeholders have called on Canadian regulators to revise the exemption criteria to expand the market and improve companies' ability to raise capital.
Under Ontario's current regime, exempt distributions are only available for purchase by individuals if they are employees of the issuer or investors that meet certain financial criteria. The Ontario Securities Commission, or OSC, is Canada's most influential securities regulator under the country's provincial system.
A "minimum-amount" exemption allows investors to purchase prospectus exempt securities only if the investment amount exceeds C$150,000 and is paid in cash. Alternatively, an "accredited-investor" exemption allows individuals to purchase exempt distributions only if their net-income and assets exceed a minimum threshold, or if they had experience as registered advisors or dealers (but not limited-market dealers).
The law assumes that accredited investors do not need the protections offered by a prospectus, because they are sophisticated enough to acquire and analyse information about the investment without one. It also assumes that accredited investors can withstand the loss of the entire investment.
Doug Bedard, senior vice president of MNP Corporate Finance and a board member of the Exempt Market Dealers Association, told Thomson Reuters that Canada's exempt-market would benefit from the proposed reforms.
The financial focus of the current minimum-amount and accredited investor regulations did not serve as adequate proxies for sophistication, Bedard said. On one hand, the current regime occasionally allowed inexperienced individuals to take inappropriate risks, while on the other it blocks access to genuinely sophisticated investors, he said.
Despite being designed to protect investors, Bedard said that the minimum-amount exemption left room for trouble. He noted, for example, that beyond basic financial statements, dealers required very little information to prove investor eligibility. "What if somebody borrows the money [to qualify] under the C$150,000 exemption," Bedard asked. "That might be a huge concentration for that investor and a huge loss if they lose that money." He added that registrants and dealers should have sufficient know-your-customer (KYC) guidelines from regulators to ensure a customer's suitability and to make sure they were not concentrating excessive risk.
Additionally, a recent review of the minimum amount exemption by the Canadian Securities Administrators (CSA) generated strong industry feedback. "[Many stakeholders] felt that [the minimum amount exemption] had the effect of causing investors to invest C$150,000 in one investment when an investment in smaller amounts or a more diversified approach would have been more appropriate." Some respondents called on the CSA to set a maximum investment amount, expressed either as a dollar amount or a percentage of the investor?s assets or net income.
On the issue of accredited investors, Bedard observed that the current income and asset requirements excluded 98 per cent of Canadians, including some highly sophisticated investors whose experience and/or education should otherwise qualify them.
He described a scenario whereby an individual had a track-record of limited and exempt-market investments, with a portfolio of exempt-market securities, but who was now retired with less income. "If you're holding private placements in your portfolio, those should be allowed to go into your net assets," Bedard suggested. "We would love to have the CSA put out guidelines for other qualifications."
Other sophisticated investors also failed to meet the accredited investor thresholds because they purposely reduced their income for tax purposes. "Some investors control their income so they don't have a large tax liability each year," Bedard said. "So despite being financially secure and sophisticated investors, they still don't qualify."
In its consultation notice, the OSC stated that its expanded review would draw inspiration from the Jumpstart Our Business Startups (JOBS) Act, recently enacted in the United States. Bedard supported the move, saying that the OSC should recognize that capital was fluid and would follow the path of least resistance. "I think if you make access to the exempt market easier, and maybe look at different classes of investors who can get in for the right reasons, it can stimulate new business growth and opportunity," he said.
When asked if additional investor classes would exacerbate current KYC compliance burdens, Bedard said: "Regulators have said that some dealers have not done thorough enough KYC, or that a person claiming to be an accredited investor isn't ? so there is a burden there that we recognise." He suggested that the CSA and OSC could permit the use of third parties to conduct KYC and customer due diligence.
"There might be some push-back [from dealers], but we feel that most of us are fully qualified," Bedard stressed. He added, however, that better guidance from regulators would improve compliance practices.
The OSC said that it was considering the adoption of an offering memorandum prospectus exemption, which would accommodate a broader range of investors by imposing certain disclosure requirements on issuers. It added that the availability of a prospectus exemption may be contingent on the involvement of registrants subject to know-your-customer, know-your-product (KYP) and suitability obligations.
Bedard expressed strong support for the offering memorandum exemption, but hoped that the CSA would harmonise the system nationally. He noted that memoranda requirements currently differed from one province to another, which multiplied the compliance burden and limited access to capital from other jurisdictions.
Bedard called on the OSC not only to adopt an offering memorandum exemption, but also to require that the memoranda be published electronically. "It would create an electronic marketplace for [exempt market] dealers and investors; it would be a more transparent, more harmonised system," he explained.
Electronic filing would also improve the quality of offering memoranda by giving issuers access to peer documents, Bedard said. "You'll see what peers and competitors are doing; it will raise the bar."
"There are a lot of deficiencies in offering memoranda. Nobody wants to be deficient, but there's a lot of confusing information out there, like what material agreements should be included, if you're including predictions, structural issues, clearly identifying securities, describing the use of proceeds, and so on."
This article was originally published for Thomson Reuters - Accelus by Daniel Seleanu.
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