A DOW JONES NEWSWIRES COLUMN By Monica Gutschi
The exempt market in Canada is growing rapidly as investors search for higher yields and diversification out of stocks
and bonds. But exempt-market products–such as mortgage funds, private placements, and farmland investments–can hold plenty of risks.
Advisers who look to the exempt market for alternatives need to conduct extensive due diligence, observers say.
Since these products are generally sold through an offering memorandum, rather than the more stringent prospectus,
“disclosure completely changes,” says Ed Skwarek, vice president of regulatory and public affairs at Advocis. “You’re certainly not dealing
with the same level of information that an adviser would want to deal with.”
There is a whole array of risks that advisers should be aware of before steering clients to an exempt-market product, William
McNarland, founder and managing director of consultancy ExemptAnalyst, said at a recent conference.
As the popularity of such products grows, the challenge for advisers will be to properly represent the risk of these
products, he said. “The regulations say all exempt products are high-risk speculative products, but not everything is the same risk,” he noted.
For example, of the 73 exempt-market products he analysed for clients over the past year, only about one-third were given the
green light. The remainder were either not good investments, or rated “average” in terms of disclosure and risks.
In some cases, the fees were hidden, disguised or astronomical–especially in the case of variable fees. Fees for
one product rose to 58% of the cost because of the relatively small number of investors attracted, he found, In another, one dealer charged a fee to find a
second mortgage even though the lender was a related entity. Other potential pitfalls include how the net
asset value is calculated, McNarland said, noting there is “a lot of creativity in how this is done,” even to the degree that “sometimes
they randomly make up the number.”
He also suggested advisers carefully examine the background and experience of key personnel and key partners such as
auditors and lawyers, the nature of any liabilities and redemption options, any exit strategy, and voting options. In one case, he warned, the dealer charged
C$2,000 for missing a vote. And advisers should also be wary of potential investor liability, which could result in losses beyond initial capital.
A potential aggravating factor is that there is no specific definition of an exempt product, solely that it is
“exempt” from the prospectus requirement. Securities lawyer Prema Thiele, a partner with Borden Ladner Gervais LLP, also notes that even though
these products can only be sold to accredited investors, more and more people in Canada now earn the C$200,000 annually needed to qualify. She warns that an
accredited investor isn’t necessarily a sophisticated one.
On the other hand, she says, just because a product or investment is exempt from a prospectus doesn’t always make it more
risky, and regulatory oversight of the industry is increasing.
Still, these issues are expected to become more prevalent as the exempt market continues to expand.
Darvin Zurfluh, chief executive of Calgary-based exempt market dealer Pinnacle Wealth Brokers, says the exempt
industry is growing at a “much, much faster place” than new investment in the Toronto Stock Exchange. He estimates the exempt market was
worth C$10 billion in 2008 and has expanded rapidly since. “I believe it is going to be a commonplace investment among advisers,” Zurfluh says.
Indeed, his company purchased Exempt Analyst last week, and partnered with Sentry Group of Waterloo, Ont., this week, as it ramps up its operations in the
exempt market.
Skwarek notes there is “a spike in the number of advisers who are becoming qualified for the exempt market. And there
certainly is increased demand from consumers who are interested and at the very least exploring that option.”
-By
Monica Gutschi, Dow Jones Newswires; 416-306-2017; monica.gutschi@dowjones.com
