Last Chance: The Urgent Need for Reform of Securities Regulation in Canada

June 1, 2003

INTRODUCTION

Capital markets play a vital role in economic growth. They help individuals build wealth through access to investment opportunities. They help enterprises to invest and to grow through access to capital at a competitive price.

Canada’s capital markets have suffered for many years from excessive fragmentation that undermines both their efficiency and their dynamism. Previous efforts at reform have foundered for a variety of reasons, but today, the need for significant reform has become too compelling for any government or market participant to ignore.

The forces of continental and global integration require further efforts to unify Canada’s economic space on many fronts. International developments in corporate governance, notably the major reforms flowing from the Sarbanes-Oxley Act in the United States, demand coherent Canadian leadership in securities regulation in particular. While the Canadian approach must be appropriate for the small-cap issuers that predominate in Canadian markets, the need to respond continuously to rapidly changing circumstances has outstripped the adaptive capacity of Canada’s existing model.

As the WPC Committee to Review the Structure of Securities Regulation in Canada (WPC) noted in its discussion paper, 14 percent of the net new equity and about 50 percent of the bonds issued by Canadian corporations between 1998 and 2002 was placed abroad, a factor that was not even part of the debate during previous attempts at reform. Reform is no longer merely desirable; it is necessary for the survival of meaningful capital markets in Canada and for the entrepreneurial activity that flows from the existence of such markets.

Efficient and dynamic capital markets are vital to innovation, productivity, competitiveness and economic growth. They are too important to let jurisdictional jealousies get in the way of what is right for Canada.

FLAWS IN THE CURRENT REGULATORY SYSTEM

The size of Canada’s economy as a whole is roughly equivalent to that of the state of Texas. As big as it is, Texas would not even think of regulating securities at the county level, and Canada’s maintenance of 13 distinct regulatory bodies within an equivalent market simply makes no sense.

The current system of securities regulation in Canada is too fragmented, too costly, too variable and too slow to manage change.

In any regulatory field, consolidation offers economies of scale. Maintaining 13 regulatory structures will always be more expensive than administering the same rules through a single structure. In addition to the need for multiple administrative structures and duplicate staff, those being regulated must pay for legal and other services in each jurisdiction.

As Professor Howell Jackson of Harvard Law School has noted, the cost of securities regulation per dollar of market capitalization is about one and a half times greater in Canada than in the United Kingdom, and almost three times higher than in the United States. Higher regulatory costs reduce the return to investors and raise the cost of capital to issuing companies.

Higher costs are not the only damage done by fragmentation. The Canadian Bankers Association has pointed out that perhaps because the cost of registering in smaller jurisdictions exceeds the benefits of reaching their investors, only 5 percent of reporting issuers in Canada bother to report in all 13 jurisdictions, and only one in ten companies reports in all provinces.

Fragmentation therefore effectively prevents issuers from reaching out to all potential investors in Canada and deprives many Canadians, especially those living in the territories and smaller provinces, of the opportunity to participate in many potentially worthwhile ventures.

Differences in regulatory requirements between provinces clearly add to costs. In addition, as noted in the Blueprint for Uniform Securities Laws for Canada published in January 2003 by the Canadian Securities Administrators (CSA), the administration and interpretation of rules can vary between jurisdictions even where regulations are substantially the same. Such variability between jurisdictions does further damage by raising the level of uncertainty and risk for market participants.

Finally, the present fragmented system of securities regulation has proven to be utterly incapable of updating rules on a timely basis in a global marketplace characterized by rapid change. As the Blueprint noted, for instance, even relatively minor and non-controversial amendments have taken as much as four years to be passed by the legislatures of all jurisdictions.

OPTIONS FOR REFORM

There are effectively five paths forward. Two would represent enhanced versions of the present system. Two would lead to a single commission model. The final path represents the future for Canada in the absence of meaningful action.

1. Harmonization of securities regulation. Harmonization is the path being pursued by the CSA. The Blueprint demonstrates convincingly that almost all of the rules in Canada could quite easily be harmonized.

It also acknowledges, however, that keeping a harmonized framework updated on a timely basis would be difficult. To address this issue, it recommends uniform framework legislation that would be passed by all provinces and that would move significant powers from statute to regulation, to enable regulators to make most changes in a coordinated way without the need for action by their respective legislatures.

To reduce complexity and costs for market participants, it also introduces the concept of delegation. Without surrendering their jurisdictional authority, one provincial regulator could delegate its power to deal with particular issues to another regulator, potentially leading to a single window for at least some purposes.

The CSA’s Uniform Securities Legislation project has shown that harmonization of the rules themselves is quite feasible, but reinforces the case for structural reform as well. Harmonization is a necessary but not sufficient response to the need for enhanced securities regulation.

2. A "passport" system. The passport model for regulation is the option being advanced by provincial ministers responsible for securities regulation. Under this model, issuing companies would have to register in only one province, and approval by the "primary" jurisdiction’s regulator would be deemed to be an approval from all other jurisdictions.

While each company would have to deal with only one regulator, the costs of operating 13 regulators would remain. The ministers’ June 2003 discussion paper, Securities Regulation in Canada: An Inter-Provincial Securities Framework, suggests that these costs would continue to be passed on to issuers, albeit through a single electronic transaction.

The passport approach can only work if securities regulations are and remain harmonized. The task of updating these harmonized rules on a timely basis remains a serious problem. And the need for each jurisdiction to monitor the rules and interpretations of each other jurisdiction to ensure harmonization might even lead to higher rather than lower total costs.

Within a passport model, any differences between jurisdictions in either rules or interpretation could prove highly disruptive. As the discussion paper notes, for instance, investors would have recourse to the courts not in the "primary" jurisdiction of the issuer, but in their jurisdiction of residence.

The passport model could provide a modest incremental improvement to the current system of securities regulation, but is not sufficient to achieve the goal of an efficient and dynamic securities marketplace in Canada.

3. A single Canadian regulator. Consolidating regulatory activities into a single body responsible for all capital markets in Canada would offer real advantages on several levels.

Issuers would have access to investors from coast to coast. Investors from every region would have access to all opportunities in the marketplace. Participants would have to bear the costs of only one regulatory body, and would be subject to a single set of rules. Interpretation and enforcement would be consistent in all provinces. The updating of rules to reflect changing circumstances would be more efficient. And Canada would be able to speak internationally with a single voice.

A single regulator for Canada would be most appropriate for the size of this country’s market in the global context. It could be flexible enough to allow local rules that did not undermine the basic principles of the national regulatory regime. And it could be created within the existing constitutional framework through the power of delegation recommended as part of the harmonization Blueprint put forward by the CSA.

There are two possible approaches to the creation of a single regulator on a cooperative basis. The first would see a pan-Canadian regulator created and run jointly by provincial and territorial governments alone. The second would include federal participation.

Either approach is viable, but on balance, federal participation seems preferable on three counts. First, a federal presence could help to prevent the new regulator from being dominated by one or two provinces. Second, federal legislation could ensure seamless authority in enforcement between as well as within provinces. Third, without taking away from provincial control in terms of governance, federal legislative authority for a single Canadian regulator could provide clearer accountability.

4. Federal pre-emption. An argument can be made that despite provincial jurisdiction over securities regulation within each province, the federal government has the right to establish a national securities body to regulate federally registered companies and transactions that flow between provinces.

The United States experience shows that when subnational governments persist in obstructing necessary progress, a federal government can impose an alternative approach. The 1996 National Securities Market Improvement Act effectively pre-empted state authority in some areas (such as regulation of issuers listed on national exchanges and registration requirements for federally registered investment companies) and required states to harmonize their rules with those of the Securities and Exchange Commission in others. The result appears to have been lower costs for market participants, especially for small issuers.

Creation of a new federal securities regulator in Canada would increase rather than reduce regulatory complexity in the short term. The inevitable court challenges also would add to the degree of uncertainty faced by market participants. Federal pre-emption is not the preferred path forward, but remains an option that may have to be considered if provincial governments prove unwilling or unable to work together in the national interest.

5. International pre-emption. The history of attempts at regulatory reform in Canada suggests that despite the compelling reasons for action, current efforts to enhance the regulation of securities may fail once again.

Today, however, most major Canadian issuers already are subject to rules in the United States or other foreign jurisdictions. Continued fragmentation of Canadian regulators with the resulting high cost of access to relatively small pools of capital will simply accelerate the trend toward the United States market as the primary and preferred point of access to capital for Canadian issuers.

In the absence of significant structural reform of securities regulation in Canada, the result by default will be the effective delegation of substantial authority over Canadian issuers to foreign regulators, especially to the United States Securities and Exchange Commission.

RECOMMENDATION

The WPC has indicated that it is considering two approaches to the reform of securities regulation: an enhanced version of the current system or a single commission model. The Council strongly supports the creation of a single Canadian regulator, preferably on a cooperative basis between the provincial, territorial and federal governments.

To ensure seamless authority from coast to coast, the single regulator should be mandated by federal legislation with accountability through the federal Minister of Finance. At the same time, respect for provincial jurisdiction could be ensured in three ways: