Michael Rumball  - Last week, I highlighted regulatory overkill in the U.S. where, together, Congress and the SEC have proposed scorched earth solutions to the issues raised by the financial crisis. Whereas the CSA commendably declined to imitate most of the more extreme U.S. initiatives, they seem to have gone off the rails somewhat in their approach to the exempt market. As was the case south of the border, the Canadian regulators have, in approaching a problem which could have been adequately addressed by a limited and targeted approach, instead mounted a multi-pronged attack. First, they proposed the removal of the existing prospectus exemptions for distributions of securitized products and the introduction of a new securitized product exemption which, although similar to the accredited investor exemption, is intended to exclude retail investors. Second, they would require that issuers deliver an information memorandum to investors which discloses “sufficient information about the securitized product and securitized product transaction to enable a prospectus purchaser to make an informed investment decision”. Finally, they proposed a certification requirement as to no misrepresentation for issuers and underwriters.

Certain commentators on these proposals strongly objected to the CSA’s “product-centered” approach, maintaining that traditional ABS products (as opposed to higher risk securitization products such as synthetic products and products created under an originate-to-distribute model) are not substantially different from, or have significantly different risk profiles than, other forms of complex debt financing and, accordingly, should not be treated any differently. It appears that the CSA may have taken cognizance of this complaint although their response may trend in the direction opposite from that which commentators may have hoped.

On November 10, 2011, the CSA issued Staff Consultation Note 45-401 in which they announced that they are undertaking a review of the minimum amount (MA) and accredited investor (AI) exemptions (together the “Private Placement Exemptions”). The reason for the review is perhaps revealing: “the global financial crisis and recent regulatory developments have raised questions about the use of [the Private Placement Exemptions].”

In the Consultation Note, the CSA maintains that the Private Placement Exemptions “have been premised on the investor having one or more of:

  • A certain level of sophistication,
  • The ability to withstand financial loss,
  • The financial resources to obtain expert advice, and
  • The incentive to carefully evaluate the investment given its size.”

I would enlarge on the foregoing by incorporating the view of the American Securitization Forum (ASF) in their comment letter on the securitized products proposal and apply it to complex exempt products in general: “Complex … products offered without all of the protections of the prospectus-delivery regime should be limited to investors who have the knowledge and experience to evaluate the securities they are considering for purchase and the ability to ascertain what disclosure, reports and other contractual features they require in connection with a prospective purchase”.

For convenience, the CSA premises and the ASF enlargement are together referred to below as investor sophistication. A completely reliable determination of investor sophistication is inherently a factual exercise which should be conducted on a case-by-case basis. In order for capital markets to function efficiently, however, tests of general application have been devised including the eligible securitized product investor test and the Private Placement Exemptions. As alluded to in the Consultation Note, the regulatory trick is to find a balance between a test which is so lax that it will allow unsophisticated, retail investors to participate in the exempt market and one that is so severe that it will close the market to investors who do not need the protections provided by a prospectus offering, thereby adversely affecting the raising of capital, especially by small and medium sized enterprises.

It is also undoubtedly true that investor sophistication is a somewhat relative concept which may vary in relation to the complexity of the investment. A given investor may be considered sophisticated when assessing of a vanilla corporate debt investment but a complex transaction of one sort of another may be beyond his level of sophistication. (Thus the ASF has proposed the concept of “qualified institutional buyer of structured finance products” to the SEC, which could be adapted to other complex products, and under which an investor would have to satisfy a quantitative test as to structured finance products under management as well as certain qualification standards relating to such investor’s knowledge and experience in the purchase and surveillance of structured finance products.) That the CSA recognize that this has implications beyond securitized products is implied in the Consultation Note where the CSA state that “the size of investment alone does not assure investor sophistication or access to information, particularly where the minimum amount is used to sell novel or complex products without any accompanying disclosure. At most, the size of the investment is an indicator only of the investor’s ability to withstand financial loss.”

The determination of the appropriate thresholds to be utilized in the various exemptions and which exemptions are appropriate in respect of which products will be the subject of much debate between the CSA and market participants and, while of crucial importance to the continued functioning of the exempt market, is not the subject-matter of this piece. My point here is a relatively simple, even fundamental, one; once an acceptable test for investor sophistication has been established, whatever the details may be, the one conclusion that necessarily follows is that there can be no public policy argument for requiring the delivery of disclosure to the investor; in other words, to find that the investor is sufficiently sophisticated is ipso facto to find that he is sufficiently knowledgeable and powerful enough to demand, obtain and understand all of the information necessary to allow him to exercise a prudent investment decision without the necessity of regulatory intervention or oversight. It is in superimposing a disclosure requirement (not to mention the certification requirement) on top of revising the exemption in order to better assure investor sophistication that the CSA are guilty of regulatory overkill in the case of the proposed securitized product rules. They are in essence saying that, although an investor may be sufficiently sophisticated to purchase without imposing disclosure, we are going to impose it anyway. But surely this is ultimately to entirely collapse the distinction between the private and the public markets and an attack on the basic right of contract which, in the absence of cogent public policy reasons to the contrary, should be unimpeded by regulatory intervention. It is of particular interest that the Consultation Note does not explicitly include any such requirements in the context of the Private Placement Exemptions (although there are various seemingly innocuous references to the relevance of disclosure which interested stakeholders should not let pass without comment).

It will be interesting to see how the CSA integrates their approach to exempt products in general with their approach to securitized products. That they will take cognizance of the latter is specifically acknowledged in the Consultation Note where they indicate that they will be considering the comments received in response to the securitized product proposals as part of their general review of the Private Placement Exemptions. “We believe it is important that our assessment of those exemptions be informed by the CSA’s proposals concerning securitized products and the comments of stakeholders with respect to those proposals”. It may be overly optimistic to hope that, in issuing Staff Consultation Note 45-401, the CSA may in fact be signalling a shift in direction away from the previous product-centered approach towards an approach of more general application. If so, it will be difficult for the CSA to justify a differentiated application of the exemptions between securitized products and other complex products. Indeed, logically, it almost seems inevitable that the true differentiation should be between vanilla products on the one hand and complex products of any sort on the other and the real challenge may well be in devising a workable definition of ‘complex’.