Strong Investor Protection leads to True Capital Formation
FAIR Canada has submitted its comments to the OSC on its exempt market review opposing the proposed equity crowdfunding exemption and offering memorandum exemption concepts. Crowdfunding and the OM exemption will undermine investor protection, make markets less efficient, undermine investor confidence in markets and ultimately result in less “real” capital formation for small and medium enterprises (“SMEs”). We suggest that the regulatory resources needed to introduce these concepts and properly police the exemptions in order to prevent widespread fraud would be better spent elsewhere. In particular, regulators should focus on the needs of the hundreds of SMEs listed on the exchanges in Canada that have gone to the effort and cost of complying with regulatory requirements and that are in need of equity financing.
Real Capital Formation
FAIR Canada is of the view that the policy objective of increasing the amount of capital raised from the exempt market for businesses, particularly SMEs, must be accomplished in a manner that protects investors, otherwise real capital formation, where monies are invested in productive assets (leading to increased jobs and economic growth), will not occur. Simply increasing the gross dollar amount of capital raised in the exempt market can be illusory, pointless and even destructive to the ability to raise capital for SMEs. The OSC and other provincial securities regulators should focus on the quality of capital formation given their mandates to foster fair and efficient capital markets and confidence in capital markets. A regulatory framework which provides for strong investor protection and efficient markets will also facilitate true capital formation, resulting in lowering the cost of capital and increasing confidence in our markets. Instead of viewing investor protection mechanisms as an impediment to capital raising efforts, they should be seen as essential features of a properly designed regulatory framework.
Lack of Compliance and Lack of Empirical Data
The lack of compliance with rules governing the various exemptions by issuers and registrants is a critical issue that needs to be resolved in order for there to be adequate investor protection in the exempt market. Non-compliance with the rules, weak enforcement, and a perception of weak enforcement harm investors and weaken confidence in the exempt market and our capital markets more broadly. Absent real compliance and due punishment for those who do not comply, broadening the exemptions that can be relied upon to raise capital will simply result in greater investor harm. There is also a lack of empirical data upon which to base policy decisions relating to the exempt market. We support the OSC’s suggestion that it mandate electronic filing of the reports on exempt distributions, and we suggest requiring other types of information to be reported that would help inform policy development.
How to Assess Prospectus Exemptions
A proposed exemption should be assessed based on whether it would foster fair and efficient capital markets, increase confidence in capital markets, and provide adequate protection to investors. Does the proposed exemption promote informational symmetry between issuer and investor and promote the ability of market participants to use that information effectively so as to make informed decisions? Or, does the proposed exemption increase informational asymmetry, discourage signaling (is there price discovery through published pre-trade and post trade information?) and encourage unsophisticated investors who lack investment knowledge (about the exempt product at issue) to participate? Moreover, is there effective oversight, enforcement and procedural fairness to ensure that investors are adequately protected?
Equity Crowdfunding a Really Bad Idea!
FAIR Canada believes that permitting equity crowdfunding will pose great harm to investors. FAIR Canada recommends that governments and securities regulators in Canada decline to introduce it on the basis that it is too risky for investors and will undermine investor confidence in the Canadian capital markets. FAIR Canada believes that the existing crowdfunding exemption concept results in too large a degree of informational asymmetry and too great a risk of fraud and potential for investor harm and, therefore, will not result in efficient markets nor the desired benefits that its proponents would argue it will achieve. The lowering of investor protections with the resultant increase in fraud has the real possibility of hurting legitimate businesses by increasing the cost of capital while making it easy for fraudsters and scammers to make off with investors’ funds. The North American Securities Administrators Association, which represents U.S. state and Canadian provincial securities regulators, listed crowdfunding and internet offers as one of its Top Investor Threats in its 2012 NASAA Enforcement Report.
The proponents of crowdfunding who argue that it will provide investors with more access to investment opportunities and thereby “democratize” the exempt market, are using a euphemistic term to make the concept more palatable. What “democratizing” really means is remove investor protection for people who are unsophisticated investors with limited income or financial assets so that high-risk unregulated products can be sold to them. What should concern securities regulators is not whether something is “accessible” or “democratic”, but whether it is designed so that the market is efficient and investors are adequately protected. Moreover, all investors are currently able to access SMEs through the public markets, mainly on venture exchanges where there are greater investor protections than are contemplated with the crowdfunding exemption concept. Many SMEs listed on exchanges are in real need of equity funding and regulatory resources are better spent focusing on how to make the existing regulated market more cost-effective.
While FAIR Canada opposes the introduction of equity crowdfunding, if it is nonetheless introduced, a number of measures (see page 24- 26) need to be implemented to reduce the harm that is likely to occur.
Do Not Introduce an Offering Memorandum (OM) Exemption in Ontario
FAIR Canada is strongly of the view that an OM exemption should not be adopted in Ontario. We question whether the issuers the OSC has targeted to assist through this consultation, particularly, SMEs, have the requisite sophistication and resources available to comply with the OM concept idea and note significant non-compliance by Exempt Market Dealers (EMDs) and with prospectus exemptions generally. In our view, the introduction of an OM exemption in Ontario has not been suggested to meet an investor need, is unprincipled, would reduce investor protection, and would undermine confidence in the Ontario capital markets.
FAIR Canada is of the view that risks to investors are increased when the security being sold is complex. We recommend that prospectus exemptions based on sophistication and advice only apply to non-complex products absent a separate consultation to consider the appropriateness of offering complex products to retail investors in the exempt market.
Investor Sophistication Test based on Knowledge and Experience
FAIR Canada agrees that an investor’s knowledge of a prospective investment as a result of his/her education or work experience and investment knowledge and experience is a more appropriate test for investment sophistication than a test that looks at income or net worth of a certain minimum amount. We believe that the premise of this proposed exemption is conceptually sound and provides a more reasonable justification for not providing the full protection of registrant involvement and prospectus-level disclosure.
FAIR Canada encourages the OSC to consider whether one year of relevant experience in the investment industry is a sufficiently long period of time within which to acquire the knowledge and sophistication to enable an investor to understand the risks and characteristics of exempt market distributions.
Accredit Sophisticated Investors
FAIR Canada recommends that, in place of (or in addition to) the proposed education qualifications, the OSC consider an accreditation program to accredit sophisticated investors. Such a program could be tailored and designed to ensure that individuals who wish to invest in the exempt market are fully aware of the reduced protections afforded in the exempt market and their rights, and that they meet a minimum level of investment knowledge.
Exemption Based on Advice
In principle, FAIR Canada believes that an exemption based on the provision of advice by an investment dealer who owes a fiduciary duty to his or her clients, in conjunction with investment knowledge could provide an appropriate level of protection for investors. We stress that compliance efforts will be essential to ensure that the required conditions are met.
To see the full submission, click here.