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Just because investors can throw $150,000 at an investment doesn’t mean they’re sophisticated and don’t need to look at prospectuses.

Increasingly, regulators understand that. Case in point: the Canadian Securities Administrators is reviewing prospectus exemptions available to “accredited investors” as well as the $150,000 minimum investment amounts that are often employed by small-and medium-sized companies for raising capital. Investors who can pony up that much cash are deemed “sophisticated” by current rules.

The CSA can recommend retaining the current exemptions, amending them, or repealing them. Two facts triggered this review:

  1. A large investment doesn’t assure investor sophistication; it only indicates the investor has a lot of cash or credit and potentially the ability to withstand a financial loss.
  2. The $150,000 threshold hasn’t been adjusted for inflation (if it were, it would have topped $265,000 in 2011).

It’s dawning on regulators and other market participants that a high investable asset threshold doesn’t, on its own, indicate any level of financial knowledge. And, without a thorough suitability assessment, there’s no proof an investor is equipped, either financially or mentally, or both, to sustain loss.

In the U.S., the SEC eliminated the $150,000 threshold because it didn’t guarantee sophistication. Australia and the U.K., by contrast, retained their minimums. Canada would benefit from the second course (provided the minimum is adjusted for inflation on a regular basis), since our smaller companies need these capital-raising mechanisms.

For its part, the CSA is open to alternative criteria to define an accredited investor—including reviewing a client’s investment experience, work experience, and education.

But does someone’s earning a PhD in history or buying GICs for two decades mean someone has strong investment knowledge? Likely not.

How to proceed, then?

While the regulators mull the future, you need to ensure suitability. That’s hard with prospectus-exempt securities. Many have limited or no liquidity, long time horizons for achieving real returns and are highly speculative.

If you don’t understand the security, don’t recommend it. And don’t sell them to clients with less than high risk tolerance. And then, even if there’s room in a client’s portfolio for a speculative investment, you need to be certain that:

  1. The client can afford to lose the full amount of the investment without having a material impact on his or her lifestyle
  2. The client understands the timeline for receiving return of principal, income or capital gains (express this clearly in the number of years); the ongoing costs of holding the investment, including any financing charges; and the possibility there will be no or minimal return
  3. borrowing to invest increases the risk regardless of any increase in any associated tax benefits
  4. Investing to get an immediate tax credit or deduction with little chance of getting a reasonable return makes little—if any—economic sense

If a client insists on getting into one of these investments despite your best advice, test if he’s really listening to the risks: Purposely say something that conflicts with an immediate prior statement.

For example, “This investment is risky, but there is no need to worry or be concerned about getting your money back.” If he doesn’t react, explain that leads you to believe he is ignoring the risk. Then, go back to square one and ask him to tell you why this investment is suitable. Chances are, he can’t—so he shouldn’t invest.

Richard E. Austin is counsel at Borden Ladner Gervais LLP in Toronto. He also has a B.A. (Honours) majoring in Economics and an MBA majoring in Finance. He began his career as a financial services lawyer and became increasingly involved in securities, and mutual fund dealer, financial planning and securities dealer matters in particular, over the last 15 years.

Originally published in Advisor's Edge

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