Skip to main content

Buyers need to pay attention if they purchase exempt securities.B Szewczyk/The Globe and Mail

If you are wealthy enough to qualify as an accredited investor under Canadian Securities Administrators regulations, you are able to buy exempt securities. But should you?

The quick answer is yes, if only for purposes of diversification and gaining exposure to small and private companies, where innovation and growth can be unparalleled. However, a number of reports and studies from regulators, investor advocates and academics suggest that investors need to exercise a great deal more care in how they select exempt securities.

Exempt securities are so named because the companies issuing them are exempt from the regulatory requirement to file a prospectus, a weighty document that describes the company and business risks in detail. The removal of this administrative burden helps businesses of all sizes raise capital.

Families meeting CSA's wealth criteria, such as having at least $300,000 in household net income or $5-million in net assets, are deemed sophisticated enough to make smart decisions without a prospectus – or they are otherwise able to hire financial advisers to help them make decisions and withstand the losses that can sometimes arise with riskier investments like these.

Exempt securities are sold by companies and exempt-market dealers to investors via private channels, not through public markets like the Toronto Stock Exchange. Nor do they trade on the exchanges afterward, making them hard to resell. Regular financial reports are not sent out to investors either.

The companies and dealers that sell exempt securities want to see investors do well. But companies are also interested in maximizing the amount of capital they can raise and dealers want to boost their commissions – so there are incentives for both groups to encourage investors to buy up a good number of securities.

On public exchanges such as the TSX, this incentive is tempered by Know Your Client (KYC), Know Your Product (KYP) and suitability rules, which require dealers and brokers to make sure their clients own investments appropriate to their needs. Companies selling exempt securities are not bound by such rules; and while exempt-market dealers are bound by these rules, compliance may not be widespread, according to several reviews and studies.

Of note, the Alberta Securities Commission (ASC) concluded in a report last May that while many dealers adhered to the KYC, KYP and suitability rules, numerous others had "significant deficiencies in the collection and documentation of KYC information." Furthermore, a large number of instances were uncovered where brokers' clients possessed unsuitable investments such as: low-risk investors holding high-risk securities; income investors holding growth securities; short-term investors holding long-term securities; and investors with portfolios overconcentrated in exempt securities.

Other provincial regulators, such as the Ontario Securities Commission and British Columbia Securities Commission, have similar observations. For example, in its Private Placement Review Program (June, 2014), the BCSC "found that companies have a poor understanding of the exemptions, do not keep adequate records of their private placements [i.e. exempt securities], and use professional advisers who do not have specialized knowledge of the … private placement market."

This issue has caught the eye of the Canadian Foundation for Advancement of Investor Rights (FAIR). The compliance problems need to be made a "priority, especially considering the unacceptable level of non-compliance by exempt-market participants," urged the investor advocacy group in September.

The exempt market has been growing in leaps and bounds, and has now become quite large. Exempt-market financings reported in Canada from 2010 to 2012 averaged $125-billion annually, according to estimates in a March, 2015, study by Carleton University professor Vijay Jog titled "Exempt Markets in Canada – Empirics, Observations and Recommendations." Most of the financing was debt-related, with equity-related financing estimated to be a quarter of the amount, or about $31-billion a year.

Such estimates "are startling," comments University of Toronto professor Jeffrey MacIntosh in his study, "Enforcement Issues Associated with Prospectus Exemptions in Canada," released in August, 2017. By comparison, equity financing in the public market averaged approximately $16.5-billion a year in each of 2010 and 2011 – comprising $3-billion in initial public offerings, $1.5-billion in private-venture funding and $12-billion in secondary offerings (based on Prof. Jog's estimates).

Indeed, the exempt market "dwarfs the public market," says Prof. MacIntosh. Given the enormous size of the exempt-securities market, the amount of harm inflicted on investors could be considerable if extensive non-compliance exists, he adds.

The main takeaway is that considerable care needs to be exercised in the selection of exempt securities, lest investors end up with a collection that does not fit their needs. This may not be such a big concern when a rising economic tide is lifting all boats. But when the cycle turns and companies begin to struggle, it could be another story.

Larry MacDonald is an economist, author and financial writer.