Speaking of investor naiveté….

Editorial: The naively affluent

I’m all for strict regulation and enforcement in our capital markets. For years, I’ve made the case that local regulators aren’t as effective as they should be. Here are a few examples:

– There’s a distinct regulatory habit of focussing on the small fry, like limited market dealers, while avoiding tough decisions with the big fish (see prior representative posts “First Gigi Pizza, next Livent?” May 12-11, “ABCP settlement: still a rigged table” Dec 22-09, “Cuomo provides CDN regulators another teaching moment” April 8-09 and “Canadian gumshoes ignore fraud & billions in losses” Feb 3-08)

– They haven’t got their arms around the investor risks posed by raising capital via the web (see prior posts “The perils of pushing Crowdfunding” May 29-12 and “Can a web-raise legally replace Angels and VCs?” Jan 27-11)

– There are no transparency / disclosure rules around mass Board departures (see prior post “Not so fast, easyhome!” Dec 27-11)

– For years, CEOs were allowed to pretend they still “owned” their company’s shares and report their stakes in the annual Proxy, even if they’d privately hedged them out and taken tens of millions of gains off the table via a forward sale with a local bank (see prior post “Remember Forward Sales?” Nov 26-10)

– Much of the regulatory discipline is done in private, and is universally faceless when large entities are involved (see prior post “Perp walk for cruelty to dogs, but not shareholders” Nov 27-09)

The fact that the Globe and Mail Editorial Board is focused on what constitutes a “sophisticated investor” isn’t necessarily time wasted, and the Ontario Securities Commission staff will be delighted to have the support of an influential newspaper. After all, they’ve been trying to raise this bar for years.

Protecting the “1%” from losing their assets is all well and good, but I can’t help but notice that it was less than two weeks ago when Bank of Canada Governor Mark Carney was advocating that liquid Canadians should be investing in “productive assets” and not more real estate in his interview with CTV News.

Now, there are two obvious ways for most Canadians to invest in “productive assets”: via the traditional capital markets, in stocks or corporate bond instruments, or in the shares of private companies. Naturally, private company entrepreneurs can always reinvest in their own firms, by using free cash flow to expand (buy machinery, hire staff, market their wares to new jurisdictions). But most Canadians need to put their money into the jeans of others if they want to “invest” in something “productive” (which I guess means we are no longer to solely focus on reducing our hosehold debt).

I agree that too many unsuspecting family doctors, among others, get entranced into investing large sums of money in the private shares of things like Adeyno (see prior post “The perils of pushing Crowdfunding” May 29-12). But improving and standardizing disclosure for private company capital raises seems like a more worthwhile effort than unilaterally deciding that everyone with, say, $5 million in financial assets, or $500,000 in annual salary, is a sophisticated investor; but not at $4 million in assets or $475,000 in annual income.

If the OSC is going to increase the threshold as to what defines “affluent” (as a proxy for “sophisticated”), it will be that much harder for entrepreneurs to raise investment privately. Which can’t be good for the economy.

If our securities regulators want to improve investor protection, perhaps they could institute a rule that requires accused fraudsters to disclose material prior lawsuits when they go to raise capital (see prior post “OSC needs to raise bar on Fund disclosure rules” June 14-12), privately or publicly. As of today, a Fund manager or Director of a Fund is not required to disclose that he/she contributed to, say, a $100 million settlement of a lawsuit regarding allegations that he/she made “false statements”, conducted “stock fraud”, traded “while in possession of or used and using material non-public information”, “improper revenue recognition” or “financial statement manipulation” on their last deal.

Try as they may, Regulators and politicians can’t teach everyone how to invest responsibly. From time to time, fradusters and charlatans will find a way to shake folks down no matter how high the “affluent investor” bar is raised; Garth Drabinsky, for example, fooled some very sophisticated investors. TSX-listed Sino Forest was an overweight holding at CPP Investment Board (see prior post “CPPIB also taken in by Sino-Forest story” Aug 30-11), Canada’s largest investment pool.

But Regulators can certainly do a better job helping investors identify the people who’ve already been accused of being fraudsters. Let’s start there.

And it would be so easy: harmonize the rules between public companies and publicly-traded investment funds; why are investors in the multi-billion dollar Fund industry second class citizens when it comes to disclosure requirements?

If you want to go the extra mile, add the requirement to private companies, and standardize the minimum disclosure requirements for every private company that raises capital in Canada. If you don’t like living by the old adage of “buyer beware”, require certification of private company marketing documents by the CEO, CFO and Board of Directors…that’ll smoke out many of the currently hidden landmines.

Regulators hold the keys to a better market, private or public. Not the “naivé” investor.

MRM
(disclosure – this post, like all blogs, is an Opinion Piece)