Jack Mintz On Exempt Market Regulation

Jack Mintz has published an excellent commentary titled Muddling Up The Market: New Exempt-Market Regulations May Do More Harm Than Good To The Integrity Of Markets:

From private debt and equity markets to crowd funding, exempt markets have been used to raise more money for Canadian enterprises in recent years than all public offerings put together. Vastly more: Between 2010 and 2012, exempt-market offerings raised four times as much capital as the initial and secondary public offerings during the same period. The precise reasons behind the immense popularity of exempt markets can only be guessed at; it may well be due to the desire, by both issuers and by investors, to avoid the regulatory costs associated with raising capital in public markets. We are left to speculate, however, because the Canadian exempt market remains relatively unstudied, despite its enormous role in funding capital investments in Canada.

The lack of information about exempt markets, however, is not stopping provincial regulators in Canada’s largest markets from charging ahead with new proposals for rules that would govern exempt markets. Unfortunately, with so little information available about these markets, whatever the aim of the reforms in pursuing the goals of effective market regulation, they may end up being more harmful than helpful.

Ontario is proposing to broaden the category of investors eligible to participate in these markets under a new exemption. But the category will remain stricter than in many other markets and Ontario proposes to also put very low limits on how much each investor is allowed to put at risk. Quebec, Alberta and Saskatchewan are also proposing the same $30,000 limit for any given 12-month period. And Ontario will prohibit the sale of exemptmarket securities by agents that are related to, or affiliated with, the registrant, even if measures are employed that have previously been accepted in managing and mitigating conflicts of interest. This will have a direct and damaging impact on exempt-market dealers, who are only allowed to sell exempt-market securities.

All of these proposals are intended to protect investors from the higher risks that are presumed of exempt markets. However, there is no evidence — given the paucity of information about them — that exempt markets necessarily pose a greater risk of fraud or poorer returns and losses than do heavily regulated public markets. And if risk is indeed higher in the exempt markets, one would expect these proposed regulations to assist high quality firms from distinguishing themselves in the exempt market from low-quality firms. However, these regulations may actually have the opposite effect, making it harder for better-quality firms to signal their worthiness to investors.

Canadian productivity — which continues to lag relative to other developed economies — relies heavily on businesses being able to acquire capital for investing in new technologies. Canadian companies and investors appear to be voting with their feet for exempt markets in raising that capital, possibly discouraged from public markets by regulatory costs and inefficiencies. For policy-makers to layer additional regulation on top of exempt markets without fully understanding the impact that it will have, could well result in making Canadian markets, and Canada’s economy, weaker, rather than stronger.

The paper was prompted by an initiative led by the OSC:

Currently, Ontario primarily limits exempt markets to “accredited investors” who must satisfy certain rules, such as an investor and spouse having at least $1 million in net financial assets, or $5 million in total net assets, or net income above $200,000 (or $300,000 with a spouse) over the previous two years with a reasonable expectation of exceeding that in the current year.

Generally, few limitations are imposed on how much equity an investor may acquire or the size of offerings of exempt securities, and there is no requirement for the issuer to provide any disclosure to the accredited investor.

The proposed Ontario rules will broaden the category of investors to include “eligible investors” in a way that is similar, but not the same as, existing rules in all other provinces. The proposed Ontario rules would allow investors to invest in exempt securities, if they have:
(i) $400,000 in net assets or more, including their primary residence; or
(ii) $250,000 in net assets or more, excluding their primary residence; or
(iii) $75,000 in net income (or, with a spouse, $125,000 of net income) in the previous two years, with the expectation of having the same or larger net income in the year of the offering.

This is all provided that the issuer gives to the investor an offering memorandum (described below) prior to the investment.

Each “eligible investor” will also be restricted from purchasing, in aggregate from the market as a whole, no more than $30,000 in exempt securities over a rolling 12-month period under such an offering-memorandum exemption. Investors in Ontario who are not accredited investors or eligible investors will be restricted to acquiring, in aggregate from the market as a whole, not more than $10,000 in exempt securities over a rolling 12-month period under such an offering-memorandum exemption.

Mr. Mintz points out:

Certainly, risks can be significant for ill-informed investors, and exempt securities can have significantly less liquidity than securities issued by some public issuers. Yet, despite these risks, the exempt markets are a significant source of capital. This raises the question of whether businesses are accepting the higher financing costs due to any additional investor risk with less information disclosure, in exchange for faster speed of raising capital and lower regulatory costs than would be faced in the public markets. In other words, are businesses and investors voting with their feet to move to exempt markets? If so, this raises questions about the effectiveness of financial-market regulations with respect to market efficiency, financial stability and investor protection, to which I now turn.

Well, sure. While Mr. Mintz is exclusively concerned with firms raising bricks-and-mortar capital on the exempt market, Assiduous Readers will remember that my fund Malachite Aggressive Preferred Fund is not a public fund because it would cost too much. At least $500,000 for a prospectus, probably more, and grossly inflated operating costs due to the necessity for an Independent Review Committee and a Custodian; the cost of which means better distribution is absolutely required, which means membership in the big boys’ FundSERV which is not exactly cheap, and trailer fees because, bleating of do-gooders notwithstanding, ain’t nobody gonna sell it for free, (or if trailer fees are banned, I might just as well burn my money because of the ‘nobody ever got fired for buying IBM’ mindset, as well as the not-really-tied-selling-honestly in bank channels) … all of which would mean

  • higher costs for investors
  • I have to change my title to “Chief Salesman”, a job for which I am ill-suited and totally disinterested
  • I’d have to employ an ex-regulator whose job would be to tell his old buddies how totally on top of compliance he is

Screw that, as they say in French. But it would be nice, very nice, to be able to offer the fund to a wider potential clientele.

Mr. Mintz concludes:

The largely unstudied exempt markets account for a major share of securities issues by Canadian businesses. This paper provides an overview of the regulatory framework, suggesting that much more effort is needed to study this important market. The exempt market plays an important economic role in Canadian capital markets — regulations should be optimal in their design to balance market efficiency, financial stability and investor protection as objectives.

Regulations vary by province with different standards used to regulate disclosure requirements and investor qualifications for holding exempt securities. However, these regulations are set in a vacuum of information, as we do not understand the characteristics of exempt markets, the economic impact of various restrictions and alternative forms of investor protection. Certainly, regulators should consider not just the characteristics of investors but also other factors, such as different levels of disclosure, in formulating regulatory policy.

In a recent panel discussion:

Mr. Mintz isn’t so sure such a cap is necessary, nor is he convinced the current rules must be changed. After thorough research, he’s concluded there is almost no data on the private markets. “The first question we should be asking is: what is the problem?” he said during a panel discussion to discuss his new paper in Toronto Monday.

When it comes to regulation, [former OSC chair] Mr. [Ed] Waitzer said, “we don’t know what works in protecting investors from fraudsters. We don’t know what works in protecting investors from themselves.” That doesn’t meant the OSC’s proposals are bad, but he believes the rules may not be necessary or the best means of protection. Instead of targeting caps on private investments, maybe regulators should simply ensure investment advisers follow their fiduciary duties, he argued.

The OSC has responded in a letter that has been published as a PDF image, in order (as far as I can tell) to hinder public dissemination via copy-pasting. Interested parties are assured that the OSC is “taking a more balanced approach that includes important investor protections”. The letter addresses process, not evidence and argument.

Terence Corcoran commented in the Financial Post:

Instead of responding to the substance of Mr. Mintz’s paper, Mr. Turner waffled through hundreds of words that said nothing.

There were ‘extensive consultations that support our proposals,’ he said. There is data, he insisted, there have been stakeholder meetings, and in any case “we believe an incremental approach to broadening access is appropriate.”

Sounds like the precautionary principle creeping into the regulator’s office.

And Mr. Mintz has responded:

“I believe the Ontario Securities Commission is following a prudent path in creating an Offering Memorandum regime similar to those in Quebec, Alberta, BC and other provinces.

However, Ontario is also considering imposing new restrictions on the exempt market that have not existed before. Particularly, the $30,000 cap on individual investments. Now, a similar cap is being considered by other provinces.

Per my research, I remain concerned that this cap could do more harm than good by inhibiting business capital financing, especially for better companies. Further, there remains an absence of empirical evidence that a ‎cap is needed at all. Before imposing a cap like this, it is important to take a step back, gather empirical data, and understand the potential impacts of a cap on investment into the exempt market.

Finally, I am grateful that the OSC has taken such an interest in my research. However, to the points made in the letter, I do not believe that “consultation” is a substitute for empirical, data-based research on the impacts of regulatory changes to the exempt market. The onus is on regulators to engage in this research and gather data before proposing changes that could have a significant negative impact on what is a very important source of business funding in Canada.”

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