Sunday, September 9, 2018

Effective and Fair OM Exemption complaint investigations

Effective and Fair OM Exemption complaint investigations

Based on discussions with unsophisticated retail clients that have been adversely impacted by the regulatory exemptions regarding exempt securities a nasty picture arises. Most do not appreciate the rules of engagement, the unique risks of this market and especially the lack of liquidity.  Any distribution of securities in Canada must either be qualified by a prospectus or be exempt from the prospectus requirement.

The Offering Memorandum (OM) exemption allows issuers to raise funds from investors who are either not sufficiently wealthy or not in a sufficiently close relationship with the issuer to qualify for certain other exemptions. It is found in section 2.9 of National Instrument 45-106 Prospectus Exemptions. Certain conditions of the OM exemption apply across all provinces and territories, while certain other conditions vary depending on the jurisdiction in which securities are distributed. The common conditions include a requirement that the OM contain financial statements of the issuer, and that investors acknowledge in writing that the investment is risky. The variable conditions include, in certain provinces and territories, an annual investment limit of $10,000 (all figures in CA$) per investor unless the investor satisfies certain criteria, including having a specified level of income or assets. Complaint investigators must become familiar with the varying provincial rules and how they are interpreted by regulators.  

OM investors are required to complete and sign a form highlighting the key risks associated with investing in securities acquired under the OM Exemption. Individual investors are also be required to complete two schedules to the offering memorandum which ask investors to confirm their status (as an eligible investor, non-eligible investor, accredited investor or an investor who would qualify to purchase securities under the family, friends and business associates exemption) and that the investor is within the investment limits, where applicable. The OM exemption is loaded with bear traps for unsophisticated retail investors.

Marketing materials used by issuers in distributions under the OM Exemption must be incorporated by reference into the offering memorandum and filed with the securities regulatory authority. As a result, the marketing materials are subject to the same liability for a misrepresentation as the disclosure provided in the offering memorandum itself. Misleading OM marketing materials have been a source of angst for retail investors but should come into play when investigating complaints.

The companies and Exempt Market Dealers (EMD) 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 conflicts-of-interest and incentives for both groups to encourage investors to buy exempt securities.

Problems/ complaints often arise because EMD Reps have not informed themselves as thoroughly as they should have about the investor's ’ situation ( KYC), the features and risks of the exempt investments they have recommended (KYP) and how those two Assessments should be applied to the client’s situation. For instance , someone with low to medium risk tolerance and capacity , low financial literacy and a large mortgage or credit card balance shouldn't be sold securities under the OM exemption even if they technically are eligible and are willing to sign the risk disclosure document. It is vitally important also for complaint investigators to recognize that (a) disclosure is NOT the same as transparency and (b) the well known downsides and limitations of disclosure.

In May 2017, the Alberta Securities Commission (ASC) concluded in a report that while many exempt market dealers adhered to the KYC, KYP and suitability rules, numerous others had significant compliance deficiencies in the collection and documentation of KYC information, inadequate Know your Product analysis , marketing materials that contained unsubstantiated or exaggerated claims and inadequate identification and response to conflicts-of-interest. 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 over-concentrated in exempt securities.

Unsuitable investments are bad enough but we have found that OM client complainants are also treated poorly. Attempts are made to blame the investor by citing he/she signed all the forms on risk and understood other complex matters related to investing in exempt securities. Complaint investigators need to go beyond the signed documents given the known vulnerabilities of retail investors.

In the EMD sector, OBSI closed 18 cases in 2017 with just one complaint (5 %) being upheld. This contrasts sharply with compensation recommendations for investment complaints generally- OBSI upheld 39% of investment complaints in 2017 (and 23% of banking complaints).

Our concern is that complaint investigators are not using proper complaint assessment principles to deal fairly with unique OM exemption complainants and complaints.

We suggest the following Checklist be adopted by OM complaint investigators to ensure complainants are treated fairly.
EMD complaint investigation checklist

·         Basic Principle : KYP, Suitability determination is the sole responsibility of the Exempt Market Dealer – suitability and eligibility are NOT the same thing. Eligibility should be validated before suitability assessment  
·         Has the dealer exhibited due diligence in evaluating the exempt security?
·         Is there objective evidence that eligibility was verified? Income tax returns/ payroll stubs should be checked if client appears uncertain on responses  
·         Are marketing materials misleading or different than the OM materials?
·         Did the Dealer rely solely on self- certification of eligibility? Many retail investors do not understand the relevant terminology or have low financial literacy
·         Employment stability checked as appropriate by Dealer?
·         Was product risk adequately disclosed in terms the investor can understand?
·         Was time horizon properly defined? Liquidity , redemption fees
·         Has the lack of liquidity of exempt securities been considered in suitability determination re KYC?
·         Is the client a vulnerable investor? Low financial literacy, senior, poor literacy, weak numeracy , language issues
·         Does client have experience with OM exemption?
·         Are client life objectives documented? IPS ? financial plan?
·         Is Dealer NAAF/ KYC form adequate given the nature of the risks? Debt obligations, cash income needs, number of dependents , age , tax rate
·         How was the client’s financial knowledge determined? If determined to be Low or Fair, extra Dealer controls are  required especially as regards eligibility information provided and understanding of risks
·         Was risk tolerance determined by a Dealer approved test and process? Is objective evidence available?
·         Did the Dealer depend solely on client self -assessment of risk?
·         Was client risk capacity determined? e.g. a retiree , an investor with  a large mortgage /young family, unemployed
·         Did the Dealer rely solely on client completed risk acknowledgement form?
·         Was “informed consent” obtained?
·         Are Rep Notes available for review?  
·         Has the Dealer documented the suitability assessment?
·         What is Rep background? Registration, disciplinary history , designations, qualifications  
·         Any there any regulatory/ legal actions against Dealer, Issuer or product?
·         Is marketing and sales literature misleading? Deceptive?
·         Was Suitability assessed per transaction or on portfolio basis? Should be on individual security and on portfolio ( concentration of assets) basis.

We believe that complaint investigators should use such a checklist in order to ensure a fair assessment of an OM complaint. We appreciate however that every case will be fact-specific considering all of the evidence.


Jeffrey MacIntosh, "Enforcement Issues Associated with Prospectus Exemptions in Canada,"  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…”

Guidelines for obtaining meaningful consent - Office of the Privacy Commissioner of Canada
The Office of the Privacy Commissioner will begin to apply these guidelines on January 1, 2019. The release of these guidelines is part of the Office’s work to improve the current consent model under the Personal Information Protection and Electronic Documents Act (PIPEDA). For further details, please refer to the consultation on consent under the PIPEDA. There are many issues re informed consent in the investment business especially given the asymmetry in knowledge and the clever (cunning) writing of consent agreements by industry participants. 

Ending abusive clauses in consumer contracts Report 2011