Juniors want regulatory reform
When the newly formed Venture Company Association has its official launch on June 18, its members and supporters will have a lot to discuss.
The association is aiming to get junior mining executives, independent brokers, and others who have a stake in the sector on the same page. Many of the people who make their living through Venture listed companies already agree that the juniors' current troubles go beyond a normal downturn.
They point to a number of regulatory problems that are helping to push the juniors lower – and worry that the entire Venture Exchange could be extinguished.
Here are some of the regulations that are bound to come up.
Regulations limiting liquidity
Commodities are in a rout, so it follows that juniors will be too.
But the lack of liquidity in the Venture exchange is exacerbated by longstanding restrictions on who can participate in private placements.
Private placement financings have, until recently, been the lifeblood for junior companies. They allow investors to buy units (comprised of a share plus full or half warrant) at a discount to the market, and have a holding period of a few months. Issuers don't have to file a prospectus with this type of financing, which means it's less expensive to do, but investors don’t get the same level of disclosure or protection (the right to sue if the prospectus contains misrepresentations) as they normally would.
As such, the only individuals who can participate are those deemed to be sophisticated or accredited investors – defined as an investor who meets certain income or financial asset thresholds, or who are registered advisers and dealers. (See Sprott Asset Management's exhaustive definition.
That excludes most investors in their 20s and 30s, Don Mosher, a cofounder of the Venture Company Association, points out, leaving a very small pool of investors. The Ontario Securities Commission (OSC) estimates that less 4% of Canada's population qualifies as accredited investors (around 850,000 people in 2010).
Mosher says the investor pool is made even smaller through Investment Industry Regulators of Canada (IIROC) suitability “know your client” rules, which discourage brokers from allowing investors over 65 to speculate in the junior market.
Short selling
Last October, Canadian regulator Investment Industry Regulatory Organization of Canada (IIROC) eliminated the “tick test,” which barred short-selling of securities on a “downtick.” In other words, a stock could only be shorted if its price was going up (the most recent order was at a higher price than the order before).
The move had been expected, following the removal of similar rules by the Securities and Exchange Commission (SEC) in the United States in 2007.
But there are a lot of advocates on the junior side who believe that short-selling shouldn’t be allowed for smaller-cap stocks (MacDonald Mines CEO Kirk McKinnon, for example).
Mosher notes that short-selling a junior stock that has a $10-million market cap and trades 20,000 shares a day can have devastating and crippling consequences in the current market conditions.
Ivan Lo of the investing newsletter Equedia also believes that short-selling has been abused and says the regulators can’t monitor all short-selling activities in real time in order to detect abusive activities.
“If it was up to me, I would say that you should just remove short selling on the junior market altogether,” Lo says. “Because ultimately, the junior market is about one thing: It's about investing in companies primed for growth and allowing that company to grow. You can't allow a company to grow if you allow short selling in that market.”
In a recent post, Lo writes that he believes the elimination of the uptick rule and the introduction of other rules in October that drain liquidity from the market have had a negative effect on the S&P-TSX Venture index.
Juniors have also complained about naked shorting, where a security is shorted without the trader having first borrowed stock or determining that stock can be borrowed.
Complaints about naked shorting in the juniors were also common during the 2008 financial crisis.
Algorithmic trading
Algorithmic trading systems are employed by institutions and traders to buy and sell shares. They allow a large order to be broken up and bought or sold at the best price with the least amount of impact on the security's price.
In the junior market, these trading systems can be used to zero in on stocks with good or bad news, as detected by a computer program looking at volume traded and other signals. In a recent interview with Financial Sense's Jim Papluva, John Kaiser describes how this type of trading inflated the junior market when it was rising in 2009 and 2010, and has pushed it further down since the tide turned in 2011.
Kaiser says that juniors are vulnerable to being destroyed by this type of trading because they lack an objective basis for valuation, such as cash flow, and he fears that if juniors are unable to make share price gains in the face of good news, investors will completely abandon the space.
Some of the blame for the TSXV’s dismal performance has been placed on a high frequency trading, a type of algorithmic trading that exploits small price differences in the market by buying and selling securities ultra-rapidly. Mosher, however, says that while this is a problem for the larger exchanges, this doesn’t affect the Venture much because the trading volumes are too low. Kaiser further notes that the junior market lacks the type of arbitrage opportunities that exist in the larger markets.
The Toronto Venture Exchange estimates high-frequency trading accounts for about 5% of trading on the exchange.
Lack of access to capital
While it is already difficult for juniors to access capital, the BCSC is proposing another regulatory change that could make it even harder. The regulator wants to revoke the "Northwest Exemption" which allows independent intermediaries, i.e. individuals or companies who are not registered brokers, to connect accredited investors with a public company looking to raise money through a private placement.
The BCSC says this would have a negligible impact on companies’ ability to raise capital, however, the TSXV notes that last year $4 billion of the total $6 billion raised by TSXV companies was by private placement or otherwise prospectus-exempt, and of non-IPO financings, 30-35% relied on non-registered intermediaries or “finders” for at least a portion of the financing.
Proposals that could help
There have been some responses to help juniors survive their current difficulties, although how effective they may be is arguable.
Since last August, the TSX Venture Exchange has been allowing struggling companies to complete private placement financings at less than the minimum 5¢ per share or unit price. It was meant to be a temporary exemption, but has so far been twice extended. It now expires in August. However, the extreme dilution that financings at this level entail don’t make this an ideal solution, especially for the longer-term viability of Venture stocks.
The Ontario Securities Commission OSC is looking at a couple of different ways to make it easier for startups and small and medium-sized companies to raise money.
One of those ways is through crowdfunding, a way to raise small amounts of money through non-prospectus financings from non-accredited investors.
However, the model the OSC is looking at would be of limited use to cash-burning exploration companies. The regulator is looking at capping investment at $2,500 per person per investment, or $10,000 per person per year. Moreover, issuers would not be allowed to raise more than $1.5 million a year via crowdfunding.
Mosher notes that, in any case, the SEC in the U.S. has already ruled out allowing securities to be distributed through crowdfunding (they have allowed products only), so it's unlikely to be approved in Canada.
Mosher points out there's far more investor protection on the Venture exchange, with its three levels of regulation, that there could ever be with a Crowdfunding model.
“Why not just change the rules and allow more people to participate in a regulated public market that specializes in Venture companies?”
The regulators are also considering allowing more non-accredited investors to participate in prospectus-exempt financings. They are examining an exemption for non-accredited investors with a high level of investment knowledge, or for those who have received advice from a registrant.
This is an idea that the Venture Association supports.
“That's the answer to our problem right there,” Mosher says.
Whether that will go far enough is debatable, and assumes that there is wider appetite among Canadian investors for junior mining stocks -- which will likely only return once the current crisis abates. |
