Page 1 of 3On May 26, 2010 the Minister of Finance of Canada released a draft bill for a new Canadian Securities Act. In his press release he states that the proposed regime will provide better and more consistent protection for investors across Canada; improved regulatory and criminal enforcement to better fight securities-related crime; new tools to better support the stability of the Canadian financial system; faster policy responses to emerging market trends; simpler processes for businesses, resulting in lower costs for investors; and more effective international representation and influence for Canada. What’s not to like? In this commentary IndependentInvestor.info examines the weaknesses in investor protection in existing Canadian federal and provincial legislation, how the draft bill deals with those weaknesses, and the benefits for investors claimed in the Minister’s release. Are those benefits truly found in the draft bill? Read on.
The Minister, in his release announcing a draft bill for a new Canadian Securities Act
(the Bill) or as a PDF doc.1703, repeats a statement which has become his mantra, that Canada is the only major industrialized country that lacks a national securities regulator. This invites the public to measure the Bill against legislation in those other countries. For numerous reasons, most of which are too obvious to require repetition, a comparison with the situation in the US is the most appropriate.
The desire of the federal government to assume jurisdiction over securities goes way back, to at least 1935. So it has had plenty of lead-time to come up with legislation that demonstrably would improve the plight of Canadian investors. And since issuers, dealers and mutual fund and other institutional investors have the resources and expertise to defend themselves, the validity of any new securities legislation must be judged by how well it protects the interests of the retail investor. Never forget: without the retail investor, dealers would have no clients, institutions no pools of capital to invest, and issuers would have no liquid, active markets for their securities.
Therefore, in this commentary, we will look at how the Bill stacks up, in particular in addressing current weaknesses in Canadian retail investor protection, using the US as our benchmark; for more on this comparison, see Retail investing in the U.S. and Canada: a comparison on our site IndependentInvestor.info .
Current weaknesses of the Canadian securities system
Fraud and theft, for obvious reasons, sell newspapers. And it is no different in the fields of securities and investments. And the recent tragic events, such as the Bernie Madoff affair, may give the public and even regulators, the impression that this is where investors typically lose their hard earned money. In this view, more active, coordinated anti-fraud enforcement is the answer. But Canadian market participants know better.
Far and away the biggest source of loss for Canadian retail investors are the excessive, routine, day-to-day costs in the system. How much are we talking about? In the tens of billions of dollars, year after year; see for example Robert Pouliot’s estimate
doc.1559 in How to find a mutual fund manager blindfolded with your hands tied behind your back
on our site
Why don’t retail investors recognize it? It may be similar to the frog in hot water story:
The boiling frog story is a widespread anecdote describing a frog slowly being boiled alive. The premise is that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for the inability of people to react to significant changes that occur gradually. Source: Wikipedia
What are the principal causes of these excessive costs? In our opinion they are at least two-fold.
Mutual funds costs
For the typical retail Canadian investor, his or her largest investment is typically in mutual funds. IFIC members reported in May 2010 mutual fund assets of over $600 billion. The problem is that Canadian investors live in the country which, among all the major industrialized countries (to use the Minister’s wording), has the highest level of mutual fund fees (the last study was by Morningstar in 2009 – see Morningstar's verdict: Canada still last for mutual fund expense level
). Why? There are many reasons. We will give four of them here:
Is it any surprise that mutual fund fees in Canada are far higher than in the US?
a financial system characterized by a relatively small number of major financial institutions. Of course federal legislation setting out maximum ownership levels for Canadian chartered banks undoubtedly have, and continue to, greatly contribute to this.
- provincial rules that prevent very low-cost US mutual fund organizations from directly selling their products to Canadian investors. It is most ironic, to say the least, that the Canadian banks, who through their dealer subsidiaries are the principal beneficiaries of these protectionist rules, can with a straight face argue for a national securities regulator because this would, in their words, free trade in securities with other key jurisdictions and would allow Canadians to acquire these securities in an efficient and cost-effective manner; see the CBA 2008 submission to the expert panel Enhancing Canadian competitiveness by reforming the way securities are regulated in Canada , p.4 or as a PDF doc.1704.
- the absence of regulations that would mandate fund structures that force the funds to act in the best interests of the fund investors. In the US, rules mandate that fund boards have a majority of independent directors. No such requirement exists in Canada.
- In the US, investment advisers must act in the best interests of their clients, notably when recommending mutual fund investments, and pressure is increasing to impose a similar obligation on brokers. No such requirement exists in Canada.
Government of Canada bond issues
The most important investment decision an investor ever makes is determining the right Asset Allocation between equities and bonds for his circumstances. All investors should have some portion of their portfolio in low-risk bonds, and generally the percentage should increase with age. So being able to invest easily and cheaply in government bonds is essential for retail investors. What is the situation in Canada?
Any retail investor will tell you that it is next to impossible to buy newly issued Canadian government bonds. New issues are systematically resold by the big investment dealers who are qualified to bid on Bank of Canada bond auctions to their large institutional clients. Retail investors are not welcome, and are shuttled off to buy in the secondary market if, as and when they become available and only, of course, upon paying the dealer a commission. Alternatively, they must invest in bond funds to which dealers do magnanimously consent to sell newly issued government bonds directly. But going the latter route means investors pay on an ongoing basis wholly unnecessary management fees to the fund manager.
This is an extraordinary situation, one we have criticized on many occasions; see on our site Government of Canada bonds and Minister Flaherty. The simplest, most liquid, and safest investment in Canada is not available directly to those who would benefit the most from it. By way of parenthesis, in Quebec investors can buy a close substitute (Government issued CD’s with maturities of up to 10 years) directly and at no cost from their government. In the US, the situation is even more favorable to retail investors, since they can participate directly, and at no cost, in any US government bond issue.
We are unable to quantify the extra costs to Canadian retail investors (and therefore the extra fees to Canadian brokers) of this situation. It has to be very, very substantial. But the other concern we have is the number of retail investors who do not buy Canadian government bonds at all because the system makes it too complicated and expensive. Investors are having additional risk or assume additional costs by reason of their own government’s actions.
The Canadian Bankers Association, in the same previously-referenced submission arguing for a national regulator, states that a key element that needs to be taken into account when comparing Canada and the United States is the effectiveness of securities enforcement. The Minister, in his release, also insists on regulatory enforcement. We disagree.
Self-enforcement is generally the best approach, whether for brokers or investors (the Bill in fact does recognize self-regulatory organizations for brokers). Give retail investors the tools to go after those who, on the basis of misrepresentations, sell them poorly conceived or excessively-expensive products. Most investors buy in the secondary markets, and it is here that legal recourses are the most important. They currently exist in Canada if an investor is misled by the statements of a company whose securities the investor buys on an exchange (see for example section 138 of The Securities Act of Ontario ). But if the investor buys those same securities on the basis of misstatements by his or her adviser, no legal remedies are provided under current provincial securities legislation. In the US, a remedy, called Rule 10b-5 , is available for deliberate misstatements made to retail investors by anyone, including by advisers.