The Current State of the Exempt Market

It’s well-understood and well-documented that the Canadian exempt market suffered an enormous and widespread failure in 2008, one that left those in the market in a raw state of introspection amidst the loss of investment dollars and loss of confidence. As many people in the exempt market now agree, the market’s failure stemmed from a number of things, including a lack of oversight, a lack of formal market regulation and a lack of accountability from those operating in the market. In response, in late 2009, the Canadian Securities Administrators put in force a bill known as National Instrument 31-03 which was aimed at addressing and correcting some, if not all, the above-mentioned deficiencies that were at the heart of the exempt market’s 2008 failure.

As has been generally agreed upon, prior to the implementation of Bill 31-103, the exempt market was almost a completely deregulated investment space. In the pre-2008 exempt market, an issuer of an investment product would sell their investment product through agents and would enjoy very little scrutiny from any sort of regulatory body. To add to this, agents themselves had little obligation to obtain any sort of financial education or certification. Agents with little financial knowledge, issuers with no oversight, a marketplace with little regulatory input equals a perfect recipe for the failure in 2008.

But, what about now, post-2008? To provide a brief summary of the major changes authored in by Bill 31-103, many of which are common knowledge within the market, issuers of investment products in the Exempt Market now have to sell their product through a dealer. In turn, exempt market dealers must hold a license and are under the direct governance of their regional securities commission. In a similar vein, exempt market agents or representatives now have to fulfill a certain educational requirement in order to be a representative.

It’s clear what Bill 31-103 was trying to do. But, five years after its implementation, the key question is this: has the bill done enough? Are its mandates accurately and effectively addressing what was the wrong with the market pre-2008? And to add another question to the list – if another large-scale correction hits the private investment market, will it once more expose a house of cards – will it once more expose the kind of high-risk, uninformed investments that we saw in 2008 in the exempt market and which made the 2008 financial turmoil that much worse?

Frank Lonardelli and his commercial real estate development firm, Arlington Street Investments, have been working in Alberta’s exempt market ever since Arlington Street’s founding in 2005. Most recently, Arlington Street Investments was a winner of 2013’s Exempt Market Dealers Association of Canada (EMDA) Award. So, it’s clear that Frank Lonardelli, along with his team at Arlington Street, know fairly well the effects of Bill 31-103, as well as, more generally, the current state of the Canadian exempt market.

And as Frank Lonardelli equitably points out, “Bill 31-103 is a good first step to improving and safeguarding investors in the exempt market. However, in the end, more work still needs to be done.”

Following this general appraisal, Mr. Lonardelli quickly points out some specifics as to what can and should be done to improve the current exempt market. He cites the educational requirement of the exempt market representatives, which in Mr. Lonardelli’s mind is still too insufficient given the responsibility that representatives have to the integrity of the market as a whole and to the investment public. “The reality is that the exempt market contains investments that are fairly sophisticated and fairly complicated”, Frank Lonardelli points out. “And part of the problem that we had in the market pre-2008 was that we had too many representatives with low levels of financial education and proficiency. And that was very problematic. So, yes, I don’t want the same thing to happen twice, nor does anyone else. And that means I would like to see the education requirement for representatives increased, and not just initially, but I believe that there is a requirement for ongoing education.”

Frank Lonardelli then mentions one more feature of the current exempt market that needs to change, which is the cost of capital. Currently running at 6% to 12%, the cost of capital in the exempt market right now is much too high according to Mr. Lonardelli. “By cost of capital, I’m referring to the amount of commission in which dealers are demanding from their issuers, and in many cases, are fanning. The reality is that if a product sold in the exempt market is going to be successful, the cost of capital has to be reduced,” Frank Lonardelli mentions. “This is both for the well-being of the dealerships, as well as the issuers. In the end, even if we have a perfectly balanced and perfectly regulated exempt market, no one will want to be a part of it if the cost of doing business is too high – that’s just the bottom line.”