In response to the seizure of the market for asset-backed commercial paper (ABCP) in Canada, the Canadian Securities Administrators formed a working group to consider certain regulatory issues arising out of this seizure. The working group prepared a consultation paper (the ABCP Paper), the purpose of which was to propose responses to the causes of the turbulence in the credit markets for which regulatory action may be necessary or appropriate and to seek public comment thereon. While the bulk of the ABCP Paper was focussed on the matters specific to the ABCP market, the working group concluded that the existing private placement regime applicable for all securities may require changes.
In direct response to the ABCP crisis, the working group proposed that the existing prospectus and registration exemption for short-term debt be made unavailable for asset-backed short-term debt. While this may have significant effects on that particular market, the working group went further, calling into question the income and net financial asset tests used to qualify individuals as accredited investors for any private placement. As a result of numerous retail investors having significant assets invested in ABCP, the working group is questioning whether these thresholds for accredited investor status appropriately identify those persons able to withstand the loss of their investment. Additionally, the working group is questioning whether the $150,000 minimum amount exemption is at all justifiable.
The working group has not suggested in what manner the private placement regime might be changed (other than by implying that the thresholds are too low or, in the case of the minimum amount exemption, not appropriate), but has called for a separate review of the specific exemptions noted above and an overall review of the regime, the rationale for all exemptions and whether some form of disclosure in connection with private placements should be mandated.
While it is premature to speculate as to the outcome of any review of specific exemptions or of the regime generally, the income and net financial asset thresholds are clearly important to the exempt market, with significant numbers of accredited investors in more widely marketed private placements qualifying under these tests. Significant changes to these tests could impact issuers' ability to access capital and non-institutional investors through the exempt market. Equally important, the minimum amount exemption has proven to be very useful in facilitating private placements where, for example, accredited investor status is unable to be confirmed prior to closing and in private placements and other transactions where a party may not have technical accredited investor status. The difficulty of relying on the "private issuer" exemption has made the minimum amount exemption especially useful.
Generally, exemptions from the prospectus and registration requirements of securities laws are premised on there being no need for the disclosure and protections provided by a prospectus (e.g., due to information being available in another way, due to the sophistication of the investor or due to close connections with the issuer), on the ability to withstand a loss (measured by the financial tests in accredited investor definitions or by minimum amount) or on the nature of the securities (e.g., highly rated commercial paper). Other reasons may include encouraging small business financing or to facilitate certain capital markets transactions.
The problems with ABCP have shown that some safe securities may not be as safe as thought. The reaction by regulators - that a modification to this exemption may be necessary - is not unexpected. However, it is not as clear that because some accredited investors and others investing large amounts have suffered losses that the related exemptions are broken.
The problems with ABCP seem to stem, as the working group has noted, from an overreliance on ratings as a measure of overall safety and from failures in the "know your client" and "know your product" duties of those selling ABCP leading to purchases of, or quantities of, ABCP that may not have been suitable for particular investors.
The financial tests in the prospectus and registration exemptions can be viewed as proxies for the ability to withstand loss. The working group appears to be of the opinion that the ability to withstand a loss may not be assured by the current financial tests. It is not being suggested that all persons should be protected from losses, but it is suggested that certain persons should not be allowed to participate in certain financings due to their financial situation.
The question that will be considered if the review is undertaken is, basically, who should be permitted to forgo the protections afforded by prospectus-level disclosure and issuer liability. It has not yet been suggested that a class of sophisticated persons that should be able to forgo these protections is inappropriate. Membership in that class may see changes though.
With the focus on ability to withstand loss in the consultation paper, the issue of whether protecting only certain persons from losses that are not caused by misrepresentations, fraud or the like is either an appropriate goal for securities legislation or whether arbitrary financial tests will help achieve that goal is highlighted. On the former, securities legislation does not purport, in general, to protect persons from their own bad investment decisions in the secondary market, where they are free to invest their money and lose it all. The only check is the role of an individual's investment adviser or other dealer representative, if any, who is intended to ensure that the risk is understood and that the risk is consistent with the investors risk profile and objectives. With respect to the latter, a financial test that measures the ability to withstand a loss would have to take into consideration all other investments, all other potential liabilities, other business interests, the relative size of an investment against the person's overall portfolio and net worth and likely numerous other criteria - any fixed threshold could not assess this ability in isolation.
The issue ultimately may be how one measures the sophistication of the investor. Alternatives to financial tests include greater reliance on clear and voluntary assumptions of risk by persons with sufficient investment experience (the assessment of which may involve similar quantitative proxies) and greater reliance on advice from registered dealers and advisers who comply with "know-your-client" and "know-your-product" obligations (e.g., by limiting the registration exemption only). Securities legislation contemplates a buyer beware approach in many instances and the recent fair dealing initiative from the OSC specifically contemplated continuing a buyer beware system for certain investors. The private placement regime should likewise accommodate such an approach.
We would expect that proposals, if any, to change the private placement regime will be given due deliberation by regulators before being formally put out for comment, and that any significant changes will be appropriately considered for their impact on the exempt market by all participants. Past experience has shown that changes to exemptions take some time to be adjusted to.