Beware of Exempt Market Investments and Securities

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Exempt market investments and securities are issued in Canada under National Instrument 45-106 – Prospectus Exemptions. To sell a security in the exempt market, an issuer must ensure that the investor qualifies under a specific exemption contained in the Instrument.

The most common exemptions include:

  • issue an offering memorandum
  • sell only to accredited investors – those with a net worth of $5,000,000 or at least $1,000,000 in financial assets;
  • sell only to family, friends, and business associates; or
  • sell a minimum of $150,000 per transaction.

Generally, securities offered to the public must be offered with a prospectus – a document that provides detailed information about the the investment and the associated risks to the investor. Investors in public-market securities are given a prospectus when investing in securities such as stocks, options, or bonds. On the other hand, exempt market securities are exempt from prospectus requirements, and as such can be sold without the protections that investors would enjoy with a prospectus.

The prospectus exemptions are used to help businesses raise money without the time and expense of preparing a prospectus. Investing in the exempt market offers investors an opportunity to participate in early stage companies with innovative products that are not large enough to be a public company. Investments like debt, equity, asset-backed securities, investment funds, and derivatives can be sold in the exempt market.

The risks

Although exempt market securities offer investors more choice of investment products to help them achieve their financial goals, they should be aware that there is a higher level of risk associated with investing in the exempt market.

Difficult to assess risk.

Companies raising money through a prospectus exemption may not be required to provide the same amount of valuable information as a public company. This can lead to major problems when assessing a company’s performance and risk. The truth is, some of these businesses will fail, and investors who bought the firm’s securities will lose all their money. The risk of this happening is in no way insignificant. According to an Industry Canada report, approximately 50 percent of new businesses fail within the first five years of startup.

Liquidity risk

Investors may not be able to resell an exempt market security when they need or want to. Exempt market securities are generally illiquid, meaning that once the funds are put into the investment, there is no easy way for the investor to get their invested capital out. Investment money could be tied up for years, or indefinitely. In many cases, a security sold under a prospectus exemption can only be resold if certain conditions are met, such as finding someone who is “qualified” to purchase the securities. There are no established secondary markets for exempt market securities. Exempt securities typically are not publicly traded, so investors may not be able to sell their investment quickly; or at all. This is also known as liquidity risk.

Scammers

Some scammers pitch fraudulent investments as “exempt” securities. If someone is trying to sell an investment and claims that they are exempt from registration or that the products they offer are exempt, investors are advised to go to http://AreTheyRegistered.ca to check if they are registered. Unless a firm is registered as an Exempt Market Dealer under the securities regulation of the provinces where they perform dealing activities, it is illegal to be in the business of selling these investments.

A Canadian government investigation into exempt market dealers uncovered problems with the investors to whom investments were being sold to and how firms collect and track key information about their clients. In most instances, the exempt market does not require extensive and expensive offering documents, and often documentation does not have to pass national regulators at all; because the firms are supposedly dealing with sophisticated, accredited investors who meet minimum investment, income, or asset requirements. The investigation discovered that 20% of exempt market dealers were selling securities to people who did not fall into the required category of “accredited” investor, and 75% of the dealers were found to have “inadequate” processes for collecting, documenting and maintaining information about clients; including their investing goals and risk tolerance.

In conclusion

Private capital investments can serve as portfolio diversifiers and yield healthy returns. However, they fall into the high-risk end of the investing spectrum. These securities should be purchased only if they suit an investor’s risk tolerance and fit into their investment plan. Anyone contemplating the purchase of an exempt market security should definitely not rely solely upon the information provided by the exempt market dealer, and complete their own independent due diligence. In this market, it is the responsibility of the independent investor, more so than with public products, to understand the unique features, complexities, time horizon, and other risks associated with exempt market products

Without the important information found in a prospectus, that has been reviewed by regulators for completeness, investors may be taking additional, unnecessary risk with their money. Moreover, investors may not have the same legal rights as they would with investments made under a prospectus. Likewise, if the issuer does not use a registered dealer as an agent, investors may not be given the same legal protection they would get when investing through a registered exempt market dealer.

All things considered, exempt market investments and securities are very risky and are definitely not recommended for everyone.

Author: Alfie Roberts

I offer a collection of tips, advice, and information to help new investors make educated decisions about their investment options and investing alternatives.