Avoid exempt market risks

Anyone in this space knows that as of September 28, 2010, the sale of exempt products in Canada, with a few notable exceptions, requires registration as a dealer and for individuals, as a dealing representative.

In many respects, the dealer compliance duties and individual representative duties are the same as those under IIROC and the MFDA. But there are some significant differences too. And if those aren’t taken into account in building the compliance infrastructure, there could be trouble at the firm and individual sales level down the road.

First, unlike dealers with Self-Regulatory Organizations (SROs), almost all products sold in the exempt market are considered by regulators to be high risk. According to the Exempt Market Products Course offered by IFSE, those products sold under a debt exemption (e.g. Principal Protected Notes sold under the bank debt exemption) are considered safer.

Apart from those few product types, exempt products generally have the following features in common that make them higher risk in the eyes of the regulators:

• They are not offered by prospectus and so their offering documents are not reviewed by regulators for completeness and don’t generally offer the same protections to investors;
• They are not insured in the same way deposits are and are not protected by the Canadian Investor Protection Fund (“CIPF”) or the Investor Protection Corporation (“IPC”);
• Many are illiquid, meaning investors cannot access their money for sometimes many years;
• They are often subject to more pronounced “Key Person” risk as issuers of exempt products are generally smaller operations than those that issue public securities;
• Issuers are not subject to the same transparency and ongoing disclosure obligations as publicly traded securities;
• If they are distributed by a firm related to the issuer, there may be significant conflict of interest issues;

That’s why the investor exemptions available are premised largely on the notion that these investors don’t need the typical protections offered under publicly-traded securities because of affluence and/or sophistication.

Many promoters and sellers of exempt products feel that their products are often less risky than publicly traded securities and mutual funds because they’re not subject to market volatility risk to the same extent and fair better during market downturns. Also, many feel there are varying degrees of risk within the broader category of high risk exempt products, an analysis with which I agree, but which must be backed by thorough due diligence and disclosure. But the fact remains, from a regulatory, and therefore a legal standpoint, exempt products are high risk.

So what does that mean to firms and individuals dealing in the exempt market?

A) Suitability

The suitability exercise is quite different. In a traditional firm, a client’s holdings can be balanced out so that there are different percentages of low, medium and high risk within an account. Not so with accounts at an exempt dealer. The whole account is effectively high risk. The question then becomes, “should the firm allow clients to place all their investable assets in the exempt market”? Clients may come through the door, who have heard about this or that product and feel that they want to catch the wave of promised profitability.

But, should the representative and dealer allow a client to put all their money into it? Or should they develop a policy where they must consider and record the whole net worth of the client and cap the percentage of that net worth they will allow a client to invest with the firm? Except in extraordinary circumstances where the client can demonstrate an uncommonly high tolerance for and understanding of risk.

B) Suitability v. Eligibility

During account opening, representatives must undertake and dealers must supervise for two completely separate things: suitability and eligibility.

Reps and dealers must first ensure the features, design and risk types of the product are in line with the client’s profile, investment objectives and risk tolerance;

Reps and dealers must then ensure that they understand the exemption the client is claiming and that they ask the right questions and record the right information to demonstrate the client is eligible for the exemption. If this involves, for example, a “financial asset” calculation to qualify for eligible or accredited investor status, that calculation should be recorded.

(C) Product Due Diligence and Training

Exempt products are not as transparent as publicly-traded securities and issuers don’t have ongoing disclosure duties prescribed by law. So it is up to the dealer and the representatives, more so than with public products, to understand the unique features, complexities, time horizon, and other risks associated with the products they offer. It is also key for the firm to have a well-developed, consistent and well-recorded product due diligence process and to offer mandatory and regular product training to representatives so that every product is well understood and sold properly.

In many cases, especially for firms and representatives who are new to securities regulation, this is a tall order. But there is no doubt that unless it is tackled now, the future will be dicey for both clients and financial service providers in the exempt market. Consider this from the 2010 ASC annual report:

>“Last year, Alberta-based issuers raised approximately $11.6 billion in the exempt market by relying on exemptions from the Securities Act (Alberta). Of this total, $3.2 billion was raised from Alberta-based investors…. With sums raised outside the prospectus regime equaling those raised under the prospectus system, investor protection issues in the exempt market are becoming of greater concern.”

Stephanie A. McManus LL. B. is a member of the Bar in Ontario and Alberta and a Principal of a Compliance Support Services, a firm that has been providing compliance help to the financial services industry since 2005.