In one of your recent columns you mentioned a fund that is available only to "accredited investors." What is an accredited investor?
Investments are often sold via a prospectus, which contains detailed information about the company or fund issuing the securities and the risks involved in purchasing them. One of the main purposes of a prospectus is to protect the investor.
However, accredited investors – who are presumed to have a higher level of knowledge and a greater capacity to absorb financial losses – are permitted to purchase securities that are issued without a prospectus. A junior company, for example, might want to raise capital without going to the expense and trouble of issuing a prospectus.
Accredited investors include institutions such as banks, insurance companies, pension funds, governments, Crown corporations and others with a high level of investment knowledge.
Individuals can also qualify as accredited investors if they meet certain financial tests. For example, a person who, either alone or with a spouse, has net financial assets of at least $1-million – excluding real estate – qualifies. So does an individual whose net income before taxes exceeded $200,000, or whose combined income with a spouse exceeded $300,000, in each of the two previous calendar years, and who expects to exceed those thresholds in the current year. A person with net assets of more than $5-million – including real estate –also qualifies.
There's another way to qualify to purchase securities sold without a prospectus, and that's if you invest a minimum of $150,000. Presumably a person with that sort of cash would have a higher level of sophistication than the average retail investor.
A "flawed" system
The accredited investor and minimum amount exemptions have inherent problems, however, which is why both rules are under review by the Canadian Securities Administrators (CSA), the umbrella group for provincial and territorial securities regulators.
"We have found that many dealers do not collect adequate know-your client (KYC) information to reasonably determine whether the investor is in fact an accredited investor. This raises significant investor protection concerns," the Ontario Securities Commission said in a notice last year.
Some dealers, for example, don't make it clear to clients that their personal residence and other real estate cannot be included in their financial assets. "As a result, these issuers and dealers may be selling exempt securities in reliance on the [accredited investor]exemption to investors who do not, in fact, meet the definition of an accredited investor, contrary to securities laws," the OSC said.
Rich doesn't equal sophisticated
Poor compliance is only part of the problem. Critics say that having a certain level of income or assets, or meeting the $150,000 minimum, doesn't necessarily mean that a person is qualified to evaluate a complex investment that could lead to substantial losses.
"Individuals may have significant wealth, but may lack investment or other experience that enables them to make an investment decision without the protections afforded by a prospectus offering," the CSA said when it launched the review last fall.
Another problem is that the thresholds have not been adjusted for years. The $200,000 income test, for example, was first introduced by the U.S. Securities and Exchange Commission in 1982. Adjusted for inflation, the threshold would be closer to $450,000 in 2012 dollars.
One of the most vocal critics of the current system is the Canadian Foundation for Advancement of Investor Rights (FAIR Canada). In its recent submission to the CSA, it said it considers the "presumptions underlying both the [minimum amount]exemption and [accredited investor]exemption to be flawed."
The system is largely self-policing and exercises little control over who is accredited, making it possible for people to qualify even if they don't meet the tests. "It seems that all one needs is the funds to buy," FAIR said. What's more, the seller often does not determine if the investment is suitable for the client or disclose the large commissions that are often collected.
"Both exemptions take, as their clear but unspoken premise, that individuals with a particular level of financial assets or income do not require the full protection of securities law," FAIR said. As a result, the existing exemptions "encourage promoters of poor products to target investors with sufficient wealth and/or assets."