How Regulation in Canada Affects Both Companies and Investors
Investing is simply another word for educated gambling.
You risk your money in hopes for a better return. You speculate on what you believe will give you the best risk/reward based on your investment style.
Many of you play poker. You play because it is exciting, and there is a chance to make money.
When you play poker, you know there are 52 cards in a deck. You know the two cards you start with. As the cards turn, your understanding of the hand you’ve been dealt becomes clearer, and you can wisely choose to fold, hang tight, or take the risk and up your bet.
When you invest in a company, it really is no different.
If you invest in a junior grassroots exploration play, you’ve been dealt two cards – just enough information to decide if you want to make a bet.
Every time a new card is turned over, you know more about the project; you’re given more information to decide if you want to continue investing in your hand.
The differences between poker and investing in stocks is that stocks give you the opportunity to pull out money at anytime, you can choose to enter the game even after the flop, and there are many times when everyone is a winner.
I believe that most of you who invest in the stock market know that you’re risking your money.
I believe that most of my readers are sophisticated enough to understand that.
But for some reason, the rule makers believe otherwise. Let me explain.
Regulation: Investor Protection or Capital Market Constriction?
I made a correlation a few weeks back that shows how the TSX Venture’s dramatic decline may have been exacerbated by recent regulatory changes.
In this letter, I will address some very simple examples of Canadian securities regulatory changes that are making the capital markets less efficient by preventing investors from making their own choices.
Before I do, let’s take a brief look at how Canadian securities regulation works.
Canadian Securities Regulation
The goal of securities regulation is to protect investors, promote efficient financial markets, and to uphold the fairness and integrity of the market
Regulation is important because investors have the right to know what they’re investing through accurate transparency and disclosure, so they can make informed decisions about their investments. If information weren’t easily accessible to investors, they would lose confidence in the financial markets and therefore reduce the efficiency of these markets.
However, over regulation can be a major disadvantage.
For example, the risk of error and higher penalties for non-compliance may scare off executives who are more anxious to comply with regulation than to move the company forward. This could prevent important news information from being disseminated in a timely manner because executives are afraid certain news pieces might not meet regulatory requirements. This could also lead to more executives who are less conscientious of regulation, thereby increasing the risk of fraud.
Regulation is extremely important, but it should be about investor protection and efficiency of the market. Rules should be designed to inform investors, not constrict issuers.
When companies in Canada have to deal with so many different regulatory bodies, this constriction gets worse.
Canada is the only developed or industrialized country without a single securities regulator. Every issuer has to comply with the respective jurisdiction(s) where they operate.
In Canada, regulation of securities trading and related activities fall under 13 separate provincial and territorial bodies – many of them are called securities commissions, such as the BC Securities Commission (BCSC) and the Ontario Securities Commission (OSC).
All of these bodies group together to form the Canadian Securities Administrators (CSA) that work together to harmonize regulation between the different governing bodies. However, the multiple jurisdictions remain.
Notwithstanding the lack of a federal regulator, the majority of provincial security commissions operate under a “passport” system, so that the approval of one commission essentially allows for registration in another province.
However, concerns with the system remain. For example, Ontario, Canada’s largest capital market, does not participate in the Passport regime.
In addition to the provincial and territorial regulators, issuers also have to comply with a completely separate governing body, the Investment Industry Regulatory Organization of Canada, or IIROC.
IIROC is the national self-regulatory organization, which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada. IIROC’s board is comprised of many industry experts, including big bank executives from BMO, Scotia Capital, and Merryll Lynch*. Collectively, they set regulatory and investment industry standards, with goals of protecting investors and strengthening market integrity while maintaining efficient and competitive capital markets.
(*We won’t talk about the conflict of interest today, but perhaps there should be some more executives at IIROC from the junior side.)
Furthermore, issuers then also have to comply with the respective exchange rules their company is listed on.
As you can see, the many different regulatory bodies that an issuer has to comply with can be extremely constricting and difficult to keep up with – even for lawyers in the industry.
It has been argued for decades, and more recently by Finance Minister Jim Flaherty, that Canada should be under one centralized governing body. However, there are arguments for, and against, one centralized governing body; both sides have strong and valid arguments.
We won’t discuss that today.
Investor Protection at the Expense of Efficiency?
Last year, Canadian securities regulators made waves through a number of tough sanctions against issuers with non-compliant technical disclosure, including cease trade orders issued by the BCSC and Autorie des Marches Financiers in Quebec.
Many bought deals were also terminated due to regulatory concerns over technical disclosure.
Speaking with investors, these cease trade orders seems to have hurt investors in these companies, rather than protected them.
Do cease trade orders protect investors?
While disclosure and transparency should be clear, how can an issuer be sure they are following every possible guideline, when the guidelines themselves are unclear?
Even the CSA acknowledges that one of the most frequent sources of trouble for mining issuers relates to the disclosure of economic analysis of their properties that is either not appropriately supported by a current technical report or that is otherwise made without regard for the restrictions imposed by NI 43-101, a standard of disclosure for mineral projects.
Should an issuer have to redo the work that someone else has already done to bring a resource up to NI 43-101 standards? Should they have to raise more money to prove up work that has already been done previously by a reputable company? Is that an efficient use of capital?
2012 Market Performance
2012 was already a bad year for the mining sector. But when combined with strong regulatory changes, it quickly went from bad to worse.
Both the number of financings and the amount of capital raised in the Canadian mining sector were drastically reduced in 2012 from 2011, on both the TSX and the TSX Venture.
Junior miners were the hardest hit, with the TSX Venture down more than 52% in 2012 from its 2011 highs. The TSX Capped Material Index was down 29% over that same period.
As I mentioned in a previous letter, both the value and number of shares traded on the TSX Venture last year were down substantially.
M&A activity also decreased. According to data compiled by Crosbie & Co, 76 deals were announced through December 15, 2012, with a value of approximately $4.9 billion. In 2011, there were 101 announced deals worth $26.8 billion.
It’s Not Only Them, It’s You
Regulation is not only getting tougher for issuers, but also for investors.
Recent rule changes are now preventing investor participation by limiting an investor’s ability to speculate; thus, limiting access to capital for issuers both on the TSX and the TSX Venture.
Let me give you some simple examples of what I mean.
For those of you in the industry, what I am about to explain may seem simple. But for the majority of Canadians retail investors, it may shed light on just some of the things that go on behind the scenes.
One of them is the “Northwest Exemption” (B.C. Instrument 32-513) to the capital raising rules.
The Northwest Exemption
The exemption allows persons or companies who are not registered as brokers with the securities commission to be capital “finders” for companies when using one of four categories of prospectus exempt trades under NI 45-106: accredited investor; minimum amount; friends, family and close business associates; and the offering memorandum exemption.
Simply put, if this rule were to be revoked, public companies on the TSX Venture and the TSX will be limited to the amount of capital available to them, as any finder who is considered to be in the business of trading securities who places a British Columbia resident in a private placement will be required to register as a dealer or EMD (Exempt Market Dealer).
Right now, the BC Securities Commission (BCSC) is looking to revoke this rule. They believe that because only 1% of financing in B.C. (by private issuers) has relied on this exemption, it should be revoked because:
- it would have a negligible impact on raising capital;
- those relying on the exemption are not complying with investor protection conditions: and
- investors would be better protected if they bought such investments from brokers registered with the commission instead.
I understand the BCSC is trying to protect investors. I most certainly do not blame them for trying, as I have witnessed many scams in my days. However, their reliance on the “1% of financing in B.C.” reflects only private issuers, and doesn’t include public issuers.
In a letter to the BCSC from the TSX Venture Exchange president John McCoach, he stated that:
“…of the estimated $6 billion raised by TSX-V issuers in 2012, approximately $4 billion was raised on a prospection-exempt/private placement basis. Of the 1,844 non-IPO financings … 1,719 (93%) of these were completed on a prospectus-exempt/private placement basis. Our review of a sample of the associated exchange filings indicated that 30% to 35% of these financings involved non-registrants acting as finders for a least a portion of the financing.”
Clearly, a big part of the financings completed on the TSX Venture last year was completed with the help of non-registered “finders.” That means revoking the “Northwest Exemption” rule could have a significant impact on raising capital, contrary to the BCSC’s belief that “it would have a negligible impact on raising capital.”
If companies can’t raise capital, more projects are lost, and as a result, more jobs*.
What do you think? Should you have to become a registered dealer or EMD to introduce someone to an investment and take a commission?
If you think recent rule changes only affect issuers, think again.
Companies offer private placements when they need to raise money. This adds to the company’s shares outstanding and dilutes shareholders, but it also gives the company funds to move forward.
Generally, this private placement offer is at a discount to the market and includes a warrant, or half warrant, which allows the subscriber to purchase another share at a certain price.
I am sure many of you have seen companies announce a private placement and thought to yourself, “How come I can’t participate in that? How come I can’t get that discount?”
Well, you used to…but not anymore.
Unless, of course, you’re a bank, an insurance company, a pension fund, part of the government, a Crown Corporation, or an accredited investor. Since the majority of you are retail investors, you can really only fall into the accredited investor role, which essentially is a fancy word for having a lot of money.
Here are the requirements to be an accredited investor:
- You need to make at least $200,000 each year for the last two years ($300,000 with your spouse if married) and have the expectation to make the same amount this year;
- Or have financial assets exceeding $1 million net of liabilities (excluding primary residence);
- Or have net assets of at least $5 million (including net value of primary residence).
You are, however, exempt from these rules if you buy more than $150,000 worth of stock in the private placement.
In other words, it doesn’t matter how much you know about investing or how much due diligence you have done, you’re not allowed participating in a private placement, with a discount to the market, unless you have lots of money.
Unless you’re an accredited investor, you’re not allowed to help a company grow.
Unless you’re an accredited investor, you’re not allowed to speculate with a discount.
You are, however, allowed to buy as much stock through the open market, without a discount, as you want.
You can buy stock, but you can’t directly invest in a company’s growth.
Market Inefficiencies through Regulatory Changes
The market has become a place where the average investor can no longer help a company grow.
Remember that the role of securities regulators is to protect investors, promote efficient financial markets, and uphold the integrity of the market by ensuring a fair market place.
Do the recent rule changes do that? Is it a fair market place if you can’t participate in a prospectus-exempt private placement unless you meet the criteria to do so? Do recent regulatory changes truly promote an efficient market place? Are regulators trying to protect us so much that they end up hurting us?
Time for Change
Canada’s financial system is in need of a major overhaul.
More proposed rules are coming into our Canadian capital market. The days of a true free market are long gone and regulation has taken hold of the very essence that fuels innovation and growth: the ability for investors to actually invest.
I am not saying the regulators don’t have the right intentions. But are they doing the right thing?
There are so many things that can be done differently to police our Canadian capital market, but still keep it fair and honest.
For example, if regulators want prospectus exempt private placements available only to accredited investors to protect uneducated investors, then perhaps we should change the “accredited investor” definition.
Perhaps the definition of an accredited investor should be someone who has been educated, and completed their due diligence; someone who has passed a small test, and signed a document stating they are fully aware of the risks involved.
I know a lot of smart investors who may not be extremely wealthy, but fully understand the risks they take when investing. They should be given the opportunity to participate in private placements, regardless of wealth status.
I also know a lot of wealthy individuals who made their millionaires by participating in private placements.
Let’s not stop the dream.
The more we talk, the more we can educate the regulators and help them do their job, while keeping the market fair.By no means was this letter used to bad mouth the regulators. They are there to protect us and we should help them do that.
But sometimes, they can be overprotective – just like we can be as parents. Sometimes its better to let our kids spread their wings and learn for themselves, even if its the hard way.
Like poker, the cards are often stacked against you in the capital markets. But that hasn’t stopped many players from becoming millionaires.
Until next time,
The Equedia Letter