October's compliance roundup

01 CSA eyes fixes to proxy voting infrastructure

The CSA has published Consultation Paper 54-401—Review of the Proxy Voting Infrastructure in a bid to address widespread “concerns regarding the integrity and reliability of the proxy voting infrastructure.”

It’s about time. “The current proxy voting system is a black box,” says Michael Waters, a Vancouver-based lawyer at Borden Ladner Gervais (BLG). “No one knows what’s going on inside, but there’s a good chance it isn’t good.”

In the present system, a broker takes voting instructions from shareholders. But securities lending complicates the process, Waters says. “Almost all brokers lend securities to third parties, which transfers legal entitlement and allows them to sell the shares into the market. These transfers can repeat many times over, under the current lending system.”

The transfer means the original shareholder relinquishes her voting rights. Problem is, many don’t know their right to vote has been nullified. “People consent to securities lending in their account opening documentation,” Waters notes. “But they aren’t getting notices informing them of the transfers and corresponding loss of voting rights.”

They still get all the shareholder meeting material and a voting information form, and complete them under the impression they’re voting their shares.

So, the number of votes the broker receives can be much higher than registered positions it holds. “And there are no rules on how those shares are actually voted,” says Waters. Brokers “can choose whose votes to accept or they can prorate the votes. Another option is to forward all votes to the agent conducting the shareholder meeting, which can lead to over-voting.

“In any case, there’s no way to determine what the broker has done and what happens to the votes after they leave the broker’s hands.”

Institutional players have led the charge in pressing regulators to address the issue.

“The problem is most acute in contested meetings where there’s high voter participation. In these situations, the results of the vote are critical and participants want to know if their votes were received and executed,” Waters explains.

The CSA’s consultation paper doesn’t get into solutions. Its aim is to define the problem and call for input on solutions from industry players. “The main goal is to develop an end-to-end vote confirmation system,” says Waters. “This would allow shareholders to determine whether their votes were counted.”

The OSC is also eyeing an amendment to its accredited investor exemption.

Currently, Ontario is the only province with a carve-out for investment funds in the managed account category. The regulator now plans to “permit fully managed accounts, where the advisor has a fiduciary relationship with the investor, to purchase any securities on an exempt basis, including investment fund securities.”

David Surat, a partner at BLG, says this will have significant impact. “The vast majority of the exempt market is in the investment fund space, so the fund industry would welcome the OSC’s move.”

02 OSC considers update to exempt market rules

The OSC has reviewed the exempt market and detailed potential prospectus exemptions, each aimed at facilitating capital raising by small- and medium-sized enterprises (SMEs). They include a:

Crowdfunding exemption: Develop a crowdfunding regulatory framework with a particular focus on investing through online funding portals.
Offering memorandum exemption: Propose an offering memorandum exemption that is substantially harmonized with the existing model available in Alberta and certain other Canadian jurisdictions, while considering whether there is a need for additional measures to protect investors.
Family, friends and business associates exemption: Consider a version of the family, friends and business associates exemption currently available in other Canadian jurisdictions with conditions that could mitigate any concerns identified with the existing exemption.

Crowdfunding exemption

Susan Han, a lawyer at Miller Thomson, notes the crowdfunding portal “would have some gatekeeping responsibility to protect against fraudulent issuers, though the OSC’s paper doesn’t go into detail. The provider would likely have limited dealer registration, but there would be no need to gather KYC information or do suitability assessments.”

She notes the gatekeeper requirements can’t be too onerous: “You can’t impose underwriter-type due diligence requirements on the portal and keep the cost of access to capital down.”

Han questions whether the crowdfunding exemption will be a solution for issuers. The limit for individual investors is low: $2,500 for any one investment. And issuers can only raise $1.5 million in any 12-month period.

“That means 100 investors for every $250,000 raised. Anyone who has administered a small business knows how difficult it is to handle even 10 or 15. It’s going to be economically burdensome.

“It’s not as if investors hand the money over and you never deal with them again. They have an ongoing relationship with the issuer and maintaining that relationship is expensive. Most start-ups have tiny staffs, so who’s going to do all this administrative work?”

Offering memorandum exemption

“Ontario’s in the cold,” says David Surat, a partner at BLG. “It’s the only province that doesn’t have an offering memorandum (OM) exemption.” The regulator is now considering Alberta’s model, he notes. This allows companies to raise significant amounts of money from retail investors without a prospectus and without going public.

Total capital raised in Ontario increased by 20% to approximately $104 billion, compared to $87 billion in 2011. Of that, approximately $37 billion was raised by issuers other than investment funds.
The accredited investor exemption accounted for approximately $94 billion, or 90% of the total capital raised in Ontario’s exempt market. That compares to $73 billion in 2011, or about 83%.

“It would be quite a change for the OSC, which has always taken the view that if you’re going to have a disclosure document to raise money, you should be using a prospectus,” Surat explains. “The change would allow private companies to raise money from retail investors based on an OM. The company won’t be subject to continuous disclosure as a reporting issuer.”

The OM document details contractual rights, Han notes, and if there’s a misrepresentation, the investor can hold the issuer to account.

She adds that the Alberta model places a limit on the amount that can be invested, depending on the category clients fall into. “Clients can only invest $10,000, unless they’re in the eligible investor category or higher.”

Family and friends exemption

Startups in Ontario can take advantage of the family member exemption under National Instrument 45-106, which allows them to raise money from relatives while bypassing the prospectus requirement. The assumption, notes Surat, is “there are fewer investor protection concerns in these cases.”

NI 45-106 also includes an exemption for “close personal friends” and “close business associates.” But Ontario residents can’t use it, because the OSC says these categories are stretched well beyond their intended scope.

“There have been enforcement actions in other jurisdictions because people didn’t have close friendships or business relationships with the owner, but checked the box anyway,” notes Surat.

The OSC says it will “consider adopting the broader family, friends and business associates exemption with the goal of substantial harmonization of the exemption across Canada.” But the regulator will examine whether “additional conditions could be added…to mitigate [its] concerns regarding the scope of close personal friends and close business associates.”

03 IIROC’s new OBA rules taking effect in December

Are you involved in outside business activities (OBAs)? If so, double-check that they comply with IIROC’s policies. The regulator recently amended the rules covering the personal financial dealings and OBAs of all dealer members. IIROC announced the new rules in a June release; they take effect December 13.

In that release, the regulator says its objectives are to:

Clearly articulate that any personal financial dealings with clients, subject to limited exemptions, are considered inappropriate conduct, a conflict of interest and a violation of the general business conduct standards; and
Codify its prior position regarding outside business activities, by imposing specific and positive obligations on registered representatives and investment representatives.

The regulator stresses advisors must disclose OBAs to the dealer member and obtain approval before engaging in any activities, lest they cause conflicts of interest.

Marsha Gerhart, a securities lawyer at BLG, notes, “The amendments put the onus on dealer-member firms to have detailed policies and procedures. This is where some dealers are falling behind. They don’t have detailed written procedure documents on how those policies are implemented.”

She also suggests erring on the side of caution when reporting OBAs. “Even if you sit on the board of your church or other religious body, report it. It may be construed as a position of influence that could affect clients.”

04 Should hedge funds advertise?

The SEC lifted its ban on hedge fund advertising on September 23. Should we expect a flurry of ads?

“The industry’s been under a reputational cloud, and funds now have the opportunity to tell their stories as well as underscore their strategies, expertise and returns as the markets recover,” says Davia Temin, CEO of Temin and Company, a New York-based marketing firm.

But the challenge, says Suzanne Oaks, the firm’s managing director, “will be how to opportunistically get their message out without creating new reasons for the ban to be put back in place.”

“Advertising could prove both a boon and a bane for the funds,” Temin warns. “Those who jump in without a strategy could risk harming their entire industry.”

She suggests a thought leadership approach to marketing. “Serious professional players distinguish themselves from ambulance chasers through their ideas, expertise and opinions. They contribute to the general knowledge base of their industry.”