(November 2005) Regulatory worries about the proliferation of principal protected notes (PPNs) may well spill over into the Guaranteed Investment Certificate market, at least index or market-linked ones, which have hitherto been exempt from securities rules.
At issue is what might be called a series of “K’s” that follow from the Know Your Client imperative every advisor must heed before offering investment recommendations. Lately, Know Your Product has come to the fore — a concern for many advisors who have traditionally relied on their compliance officers for guidance, with the Mutual Fund Dealers Association, for one, is saying that’s no longer good enough — and now two more “K’s” are emerging: Know Your Product’s Suitability and Know Your Records, lest the regulators come knocking.
That’s not quite how OSC vice-chair Paul Moore stated it last week at the annual Dialogue with the OSC conference. But on summing up discussions over how regulators should proceed with hedge funds — a new arena, he admits, and one he is reporting on to a committee of the Canadian Securities Administrators — he affirmed that regulators should not rule on products. That is an old securities tradition, one that regulators could rely on through section 61 of Ontario’s Securities Act. That “blue-sky” section originated in Kansas’s nineteenth-century securities regulations that allowed regulators to ban the sale of products contrary to the public interest, such as offerings that promised a piece of the sky.
Instead, Moore said, regulators should rely on four pillars: universal registration of all market participants; advisor responsibility for recommending suitable investment products; full disclosure of the characteristics and fees for the product — along with proper use of the exemptions from full prospectus disclosure — and, finally, “more and more compliance reviews and enforcement.”
Will that regime apply to GIC-like instruments — investment products sold with a bank guarantee? It depends on how regulators reassess the work of the 1999 OSC Task Force Report on Debt-Like Derivatives, established to survey a world that had evolved beyond stocks, bonds and savings accounts.
Debt-like derivatives — essentially GICs or notes whose principal was guaranteed but whose ultimate payoff depends on the uncertain performance of some underlying investment, such as a stock market index. At the time, the task force noted: “derivative instruments … possess many of the features of securities but may technically not be securities. In Ontario, as in many other jurisdictions, the history of the regulation of derivative instruments has been an exercise in attempting to fit derivatives within pre-existing regulatory structures which were designed with the regulation of non-derivative securities in mind.”
That said, the scope of the task force’s inquiry was quite wide, with suspicion falling even on the safe product du jour: real return bonds: “The Task Force considered, among other financial instruments which have been distributed in the Ontario capital markets, index and commodity warrants, index and commodity linked notes, equity and equity index linked deposits, mortgage-backed securities, co-ownership certificates, government and corporate strip bonds, real return bonds and government issued warrants.”
Debt issues guaranteed by Canada, foreign countries, the provinces, Schedule I and II banks, trust and insurance companies and certain international banking organizations, or those issued by municipalities or credit unions were exempt from prospectus qualification, and their issuers were exempt from registration. The same applied to promissory notes of under $50,000. The task force recommended: “where adequate disclosure is provided to investors about the product in question, there is no convincing reason why a debt-like derivative instrument should not benefit from the statutory exemptions to the same extent as more conventional evidences of indebtedness.”
Instead, the OSC was content with “term-sheet disclosure,” so that investors would get some disclosure, but less than that of a prospectus. That made index-linked GICs, for example, safe from registration and prospectus requirements, and certain rights of rescission.
As the task force explained: “The statutory rights of withdrawal and the statutory rights of action for damages or rescission for misrepresentation available to purchasers in the context of a prospectus offering were developed in the context of conventional securities offerings where the security in question is not simply a financial instrument but has intrinsic value derived from the business and affairs of the issuer. Debt-like derivatives, on the other hand, are generally extremely time sensitive and fluctuate in value based on factors which are external to the issuer. Accordingly, a right of withdrawal would provide to purchasers of debt-like derivatives a free and inappropriate option to walk away from an investment in a financial instrument if the market moves adversely.”
Even though most hedge funds are exempt offerings — they are only available to investors who can either afford to invest $150,000 a throw, or who have $1 million in financial assets, or income of $200,000 a year — the fear is that hedge funds have gone retail. And they have, as closed-end funds based on underlying hedge funds have gone through IPOs, but more importantly, because some hedge fund manufacturers chose the “debt-like derivative” route, with principal-protected notes.
“While PPNs may fit within the current definition of exempt securities,” the Investment Dealers Association said in a report on the regulation of hedge funds earlier this year, “they include significant risks to investors that directly contradict the apparent rationale for making them exempt in the first place — that such products are simple and low risk because of the financial stability of the issuer or guarantor. The risk that investments locked in for as long as 10 years will earn a zero return is no small risk to a retail investor.”
Still, the OSC’s Moore says that the regulator has looked at the information statements of nine PPNs and said “the disclosure pretty much complied” with the 1999 task force recommendations. Nevertheless, he wonders whether the 1999 exemption should not be re-examined. The original rationale for the exemption was that products were simple to understand, low risk and their issuers were stable. Since then, such products have grown in complexity.
Issuance of hedge-fund-linked PPNs has more or less ceased since the Portus scandal broke, even though Portus did not issue PPNs, but rather bought them on behalf of clients through a series of trusts, only one of which was actually legally constituted. But issuance of PPNs linked to the performance of instruments more established than hedge funds — baskets of income trusts or commodity indexes, for example — has carried on strongly, as too has the issuance of income-trust, mortgage-backed-securities and commodity-indexed-linked closed-end trusts.
That worries Mark Gordon, executive vice-president of the MFDA. IDA registrants have little to worry about when it comes to exempt products, since they are fully licensed. Whether a product is exempt or registered, brokers still have to go through the four “K’s” — and they have to run it through their dealer.
Thanks to regulatory arbitrage, Gordon is concerned that advisors with an insurance licence can sell an exempt product outside the securities regime. More than that, PPN’s have been structured as deposit instruments rather than securities, because that doesn’t have to go through a dealer.
This stems from a concession made at the formative stage of the MFDA. Although mutual fund advisors had only a limited registration, there was a “carve-out” to let them sell GICs. “All of sudden what we meant by that term has morphed into a security,” Gordon says.
He doesn’t say whether index-linked GICs should be treated as securities — that was a question asked at the OSC conference — but says “to the extent that these deposit instruments have a security element to them, we want to find a way to bring those products back into the securities regulatory regime.
More than that, though, he is concerned about product suitability. “It’s not rocket science when we say know your product,” he warns. “If it’s a security you’re not licensed in then don’t sell it.”
Filed by Scot Blythe, Advisor.ca, email@example.com.