Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 46 - Evidence - March 4, 1999


OTTAWA, Thursday, March 4, 1999

The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:00 a.m. to examine the present state of the financial system in Canada (Equity Financing).

Senator Michael Kirby (Chairman) in the Chair.

[English]

The Chairman: Honourable senators, I see a quorum.

Joe Oliver, with whom we are all familiar, is here from the Investment Dealers Association of Canada. Unfortunately, neither Ron Begg, President of the Working Ventures Canadian Fund and the Canadian Venture Capital Association, nor Jeffrey MacIntosh, from the Faculty of Law of the University of Toronto, is here because neither the Toronto airport nor the Montreal airport was open.

Mr. Oliver has some opening comments to make and then we should like to proceed.

Mr. Joseph Oliver, President, Investment Dealers Association of Canada: Honourable senators, I appreciate the opportunity to present on behalf of the Investment Dealers Association of Canada the perspective of the securities industry regarding financing of small and medium-sized enterprises, the so-called SMEs.

My presentation will review the major sources of equity capital for SMEs with an emphasis on the role played by our member firms. I will then offer recommendations. Those recommendations will be the focus of my comments. My recommendations are designed to enhance equity financing for this critical sector of the Canadian economy. You will not be deluged by statistics; however, I have included more data in a written brief.

If there is more data that you should now like because the other witnesses who would be dealing with the venture side of the market are not here, I can supply that in my verbal remarks or in response to questions.

The goal of promoting start-up and expansion SMEs is a key objective of Canadian economic policy because small business is the engine of economic growth. Equity capital serves as the building block since it is the key to funds and the start-up and expansion of a business.

Let me comment on the securities industry before I get into the recommendations. Our industry plays a key role in raising capital for small and mid-cap companies.

Many investment dealers arrange seed capital financings, private placements and public offerings for smaller and mid-cap companies. Larger-sized financings for smaller and mid-cap businesses are typically structured by the firms and underwritten and distributed through the institutional sales desks and the retail branch networks. IDA member firms also provide research and advice on acquisitions and mergers, and they actively trade securities to provide liquidity for their institutional and retail clients.

Individual brokers often arrange small-sized financings, which are referred to as "early-stage financings." Those brokers are knowledgeable about the company and they understand the profile and interest of local investors.

The IDA has encouraged this form of early financing. However, it has imposed special disclosure rules and availability rules to level the playing field for the public. The objectives are to ensure fair treatment of public investors and to promote investor confidence in the marketplace.

Some of the large security firms have merchant banking affiliates that invest directly in promising small businesses. Some have established independent management funds to specialize in investing in small and mid-sized companies.

Let me give you just a few statistics. There were 225 initial public offerings or IPOs of all sizes last year for a total of $3 billion. The real focus probably should be on IPOs under $10 million. There were 192 issues in that category, which raised $136 million last year for an average of $700,000 per issue.

The Chairman: The 33 IPOs not included were huge, because you went from $136 million to $3 billion. We are interested in the 192 with the average $700,000.

Mr. Oliver: Exactly. I wanted to put it in the broader perspective. It is interesting that the 192 IPOs accounted for more than two-thirds of the IPOs last year, but represented only 5.5 per cent of the total capital raised.

Over the past five years, about half of the money went to mining or oil and gas companies. I could get into more detail as to where they were done, and perhaps I can respond to questions in that connection.

Senator Austin: To clarify, you were looking at three categories of early-stage financing for SMEs: seed capital, private placements and initial IPOs. You have not addressed how many seed capital financings have been done.

Mr. Oliver: That is correct.

Senator Angus: Mr. Oliver, is there a distinction to be made, because so many of those were oil-and-gas-type resource companies having a flow-through element to them or some rinky-dink tax scheme?

The Chairman: I think I started the problem. Perhaps we should let Mr. Oliver go through the rest of his presentation.

Mr. Oliver: I have a written submission that contains more of those details. I would be happy to get into them for you. I was not going to do that initially because I thought Ron Begg would cover it. However, if that is what you should like me to do, I would be happy to do it.

The Chairman: That would be helpful, sir.

Mr. Oliver: First, let me contrast the timing. Financings under $10 million last year totalled $1 billion versus $2 billion the previous year. The number of deals done was 560. The year before it was 460.

As I mentioned, about one-half the money went to oil or gas companies, typically with headquarters in Alberta, British Columbia or Ontario. The Alberta companies generated the most deals and raised the largest amount of capital, some $450 million in 1998.

The venture capital industry in Canada has grown steadily, although there was a downturn about 10 years ago. In 1997, the last year for which I have statistics, they disbursed $1.8 billion in capital to small companies. That is up from $1.1 billion in the previous year. The total assets of venture capital portfolios in 1997 totalled $8.4 billion, with labour-sponsored venture capital corporations, or the LSVCCs, managing about one-half of the total venture capital funds with assets of $4.2 billion out of the $8.4 billion.

Senator Meighen: Is there a commonly accepted definition of venture capital?

Mr. Oliver: I do not know. We would define it in terms of the stage of the financing, the riskiness of the venture and the amount raised.

Senator Meighen: Could a bank be a venture capitalist?

Mr. Oliver: Yes, it could be.

Mr. Gerry Goldstein, Advisor to the committee: There is a definition that came out of the study done by Jeff MacIntosh. The formal venture capital market is comprised of formal venture capitalists who are people with funds and professional managers of risk capital funds, capitalized both directly and/or indirectly by institutional sources, such as governments, banks, pension funds, life insurance companies, as well as by large corporations and by individual investors encouraged by tax incentives. The distinction is that it is more exhaustive when you get out of the initial two, what are called the "love money" and the "angel market" and before you get to the IPOs. Essentially, it is formal suppliers, which the angel market and the love money are not. It is when you get into people who are actually organized and looking around.

Mr. Oliver: There are many different channels. Small companies with tangible assets of less than $3 million and no track record of earnings or business performance will typically rely on informal sources. That is what you are referring to as love money: friends and family and their access to seed capital to finance start-up and early growth. We estimate that about 90 per cent of start-up companies use love money for initial financing.

The options for small business for tapping into new sources of capital increase as the small business builds a track record of fairly consistent earnings when they have successfully advanced beyond the start-up business phase. Angels are investors who supply entrepreneurial companies with equity or quasi-equity financing through the start-up and the early growth phase. The so-called angels do not participate beyond the time when other more conventional financing vehicles become available.

Senator Austin: Do they come between love money and conventional financing?

Mr. Oliver: Yes, between love money and venture capital money. First comes love money, then angels and then the venture capital money, although you can call angels venture capital.

Senator Austin: In the terms of the trade, first there is love money, then angels, then venture capitalists, then conventional financing; is that correct?

Mr. Oliver: That is right.

Mr. Oliver: Normally, venture capitalists do not participate above the $1 million or $2 million level. In their early stages, the SMEs will also turn to security firms, in particular regionally based dealers who have knowledge of local businesses. They will access local investors to raise seed capital directly.

To facilitate access to capital in public and private markets, small business can become a reporting issuer with a provincial securities commission and then list on the Alberta stock exchange or the Vancouver stock exchange. At this stage, the company would have flexibility to issue equity capital through private placements or public distributions.

Debt financing, which is not the focus of this discussion, becomes important to provide working capital once the company is operational. It is generally available through a number of channels, such as the chartered banks or other deposit-taking institutions, although the apparent reluctance to charge risk-based rates has narrowed the source. I believe you have explored that issue.

Government agencies such as the Business Development Corporation and the Export Development Corporation are also sources. As well, the high-yield corporate debt market, which is used for the financing requirements of larger companies, that is, less than the investment grade, has represented an important source of new capital for this category in the past few years. This is the so-called junk bond market. It is a relatively recent phenomenon. It is huge in the United States. It is building in Canada and becoming much more important.

Earlier, I referred to the LSVCCs and the fact that they have assets totalling about $4.2 billion. They have become the fastest growing venture fund source in the industry. That is because investors have responded aggressively to available provincial and federal tax credits. However, the funds have encountered problems allocating funds to suitable small-business investment. In recent years, the funds have turned away capital until fund ratios move higher. The inflow of funds into working ventures has fallen to $125 million in 1997 from $625 million in the previous year.

Senator Oliver: How much have they not invested now?

Mr. Oliver: Unfortunately, I do not have that statistic.

The Chairman: My gut feeling is that it is a very sizeable amount. Is that correct?

Mr. Oliver: It was quite sizeable. There are tax reasons for them having to get it out there. That has been a serious problem. Clearly, it has affected their returns. To some extent, it has also affected the amount of money raised.

In Alberta, a tax committee examined the whole issue of the LSVCCs.

The Chairman: The LSVCC is the Labour Sponsored Venture Capital Corporation; is that correct?

Mr. Oliver: Yes. That Alberta tax committee found that the slow pace of investment and the extensive tax credits combined with the administrative costs for the province were compelling reasons not to create that program in Alberta. The IDA actually was on side on that. I will address our philosophy on tax recommendations later.

Another specialized vehicle is the junior capital-pool program that was developed by the Alberta Stock Exchange. It is a unique mechanism to promote equity capital for listed emerging companies. Junior capital pools permit emerging companies to raise equity capital without the need to identify the business or the project that the proceeds would be spent on.

Many of the JCPs have also financed non-resource companies, including those in the high tech sector, although their focus has been junior oil and gas.

JCPs have become an important vehicle to meet early-stage financing needs. However, the program has accounted for only a very small portion of overall financing that was undertaken by Alberta Stock Exchange listed companies in the last two years. It was 2.6 per cent of total financings last year and 2.7 per cent in 1997. Last year they totalled only $28 million, which is 20 per cent below the number of the previous year. The financings on the Alberta exchange amounted to $1.1 billion last year. Depressed conditions in the oil and gas market were mainly responsible for the fall-off in financing activity.

I will now move to the situation in Vancouver. The Asian crisis and the fall in resource prices really hit the Vancouver Stock Exchange hard. The volume of shares dropped by 26 per cent from 1997 and the total value of shares fell almost 60 per cent for the previous year. The composite index slid 36 per cent.

The VSE companies raised a little over $600 million in equity funds in 1998, down 60 per cent from 1997. IPOs were down more than a half from about $52 million to $24 million. Private placements accounted for the majority of equity raised -- 95 per cent, in fact, last year, which is about the same as the year before. Those private placements fell 55 per cent. The financings were split 60-40 between resource companies and industrial-based companies.

The other market I should mention is the Canadian Dealer Network. It is Canada's only organized over-the-counter equity market. It improves the visibility of stock prices in the market for unlisted equity securities.

Unlike the listed exchanges where orders interact in an auction market, the CDN is a competitive dealer market, but it displays all market maker quotes. It is similar to Nasdaq. Generally, though, liquidity on the CDN is limited and therefore the market is less relied upon than the western exchanges. Still, the volume increased to 3 billion shares in 1997. The private placements totalled about $100 million last year.

The fact that financing for small companies is done on two exchanges and an OTC market has resulted in significant market fragmentation and reduced liquidity. The recent discussions between the exchanges are raising the real possibility of consolidation into a new small-business exchange not unlike the Nasdaq bulletin board, although perhaps of a higher quality. In my opinion, that would be a constructive development. I understand it has the preliminary support of the securities commission. We should stay tuned on this issue.

Senator Austin: Is that similar to the Nasdaq small cap?

Mr. Oliver: Yes, that is it. There is a Nasdaq market that we all know and then they have a bulletin board or a small-cap market as well.

I should like to move on to present some ideas and recommendations designed to enhance equity financing for small- and mid-sized companies.

First, on the regulatory side, the dilemma that is posed by small-business financing can be simply stated. On the one hand, small issuers usually pose greater risk than average risk for investors. On the other hand, those companies lack the financial and human resources to comply with a complex regulatory regime.

The way to resolve that dilemma in the private market has been to confine financing resources to institutions and to sophisticated individuals, with some exceptions. However, since regulators have been reluctant to define "sophisticated individual," they have relied on larger-sized purchases as a proxy for sophistication. However, this approach is inefficient because it excludes many sophisticated investors interested in purchasing investments in small denominations. It also includes some unsophisticated investors who may have the financial means to buy large-sized transactions.

Therefore, the approach of regulators has been to relegate small retail investors to the public marketplace where investor protection is afforded through comprehensive disclosure obligations on companies and reliance on investment advisors who are subject to the know-your-client rules and the suitability rules to recommend appropriate investments.

This leaves businesses with a dilemma. While they can issue securities in the public market to reach a large number of investors, prospectus filings and ongoing disclosure obligations are expensive and time consuming. On the other hand, reliance on private markets severely limits the company's access to investors.

Various industry groups and regulatory bodies in recent years have recognized the small-business dilemma and have argued for improvements to facilitate access to equity capital for small business. In particular, minimum purchase thresholds are generally considered to be an inefficient approach that unduly restricts access to capital for small business.

In 1997, the Joint Securities Industry Committee on Conflicts of Interest recommended that the CSA -- the Canadian securities administrators, who are the chairs of the securities commissions around the country, standardize different minimum purchase threshold across provincial jurisdictions, because those differences promote regulatory arbitrage. The committee also recommended that the CSA examine techniques to broaden small businesses' access to capital in a non-public or exempt market.

A year earlier, the OSC task force on small business had recommended the use of the accredited investor exemption which would permit issuers to raise any amount from individuals who had a net worth of $1 million and a net income of $200,000 per year over the last two years. The task force also recommended a closely held business issuer exemption, which is similar to regulation D in the United States.

This exemption would permit issuing securities on a prospectus-exempt basis to 35 persons, over and above sales to accredited investors. The reform would facilitate the investment of love money and investment by angels through various stages of small business development.

The Alberta Securities Commission and the B.C. Securities Commission have also adopted sophisticated investor definitions that permit small businesses to sell privately placed special warrants in amounts as low as $25,000 to investors that meet their definition as a sophisticated investor.

As well, a number of other regulatory proposals in the U.S. and other countries could be adopted to facilitate small business financing in Canada. In the U.S., the Small Corporate Offering Registration System, the so-called SCOR prospectus, allows small businesses to complete the paperwork without professional assistance. The program's benefits include lower costs for issuers and the provision of information that is more meaningful to the average investor.

Testing the waters is another innovative U.S. approach. That permits entrepreneurs to approach prospective investors without filing an initial document. If the reaction is positive, the company can then incur the cost of filing, with the confidence that a market exists for the shares.

Senator Austin: Can an investment dealer in the United States act as an agent for that small company in doing the same thing? Is preselling permitted?

Mr. Oliver: That is a very interesting question. I wish I knew the answer for sure. Let me define what I understand they are permitted to do.

They are not actually selling. They are soliciting interest, which they have to confirm once the document is filed. That is like the preselling for bought deals. It has a certain similarity.

Senator Oliver: There is not a commitment to buy.

Mr. Oliver: It is definitely not a commitment to buy. It is focused on a certain category of companies, not big companies.

With respect to your precise question as to whether an investment dealer can be involved, I would have thought so, but I am not absolutely sure about that. It is not designed for financing that would be of interest to investment firms. It is designed for real start-up situations where you are relieving the entrepreneur of the risk that they would incur all sorts of costs and then find there is no market. It is really a start-up mechanism. That is how it is targeted. It would only make sense if it were adopted for very small companies. That is what the concept is all about.

When the OSC proposed a number of recommendations in their committee in 1996, there was some negative reaction from the B.C. Securities Commission. Since then, no action has been taken. I have enquired and I understand that it is not at the top of the list of things that the CSA is studying at this time. I think it is an interesting concept and I do not see much regulatory risk involved with it.

Australia has also developed a popular financing mechanism. It is designed to promote individual investor participation in the public markets. It allows issuers to offer up to $1 million each year in public markets, up to 20 per cent of capitalization, with abbreviated disclosure documents. Both the underwriter and the company management are subject to holding periods of up to one year.

I also understand that the Vancouver Stock Exchange has struck a committee to look at a mechanism very similar to this, and I assume they will make some recommendations in that regard.

I should like to make a quick comment on escrow policy because it is relevant. The escrow rules for initial public distribution are imposed by the provincial regulators to ensure that management and the controlling shareholders remain in place in order to implement the company's strategic plan. However, the rules have acted as a disincentive to invest in small business IPOs because the escrow rules have unfairly caught certain investors, such as those investing in venture capital funds, and they have limited the liquidity of their invested shares.

I understand that Mr. Begg wanted to talk about that in some detail. However, the IDA has come up with an approach to that in response to the CSA. The securities commissions recently proposed a national escrow regime across the country to harmonize the rules and ease the escrow restrictions. Still, emerging companies would be subject to a six-year escrow and established issuers to a three-year escrow. Venture capital funds would still be caught in rules. In contrast, NASDAQ- and NYSE-listed shares are not subject to escrow, which places the Canadian markets at a disadvantage.

The IDA has recommended an alternative approach, which would allow management and controlling shareholders to sell their shares from an IPO 18 months after the IPO, subject to notification to the marketplace. This approach is analogous to the control-block selling rules. We think this makes a great deal of sense and would level the playing field between Canada and the U.S.

A number of modifications to the Income Tax Act would encourage investment in SMEs, and I would like to quickly run over them.

In comparison to other countries, the capital gains tax in Canada is 40 per cent versus 20 per cent in the U.S., generally. Our opinion is that it is far too high. As a result, investments migrate south where the tax regime provides investors with the higher returns that justify the risks associated with SMEs.

Successive governments have recognized that the tax system plays an important role in promoting or in discouraging investment in small business ventures. However, the typical approach has been to rely on targeted incentives to provide special tax breaks for business in particular sectors, such as the film industry, or for particular types of investments, such as labour-sponsored venture capital corporations.

Generally, the measures have proven somewhat inefficient or are a bit too narrowly focused. I mentioned the tax committee in Alberta looking at the LSVCCs.

A more effective approach, in our opinion, is to structure broadly based tax incentives that rely on market forces to channel equity capital to small business. I should like to mention several ideas designed to meet that objective.

The federal government could first reduce the inclusion rate for taxes on capital gains in respect to all Canadian equities. This option would increase capital flows to the equity market by increasing after-tax return.

Senator Meighen: Is that somewhat similar to what they have done with respect to the gifts of appreciated shares to registered charities?

Mr. Oliver: This would be a reduction in the capital gains rate, but for equity investments, not for any type of capital.

Senator Angus: Can you give an example of this?

Mr. Oliver: We are saying that right now the rate is three-quarters of the income tax rate. It should be lowered.

Senator Meighen: That is what they have done in terms of gifts of appreciated stock in publicly traded companies.

Mr. Oliver: That is right, but they were hoping to eliminate it. I will leave it to Mr. Johnson to make that case. There is an additional policy reason to justify that.

This is the broad-based reduction in the capital gains rate by reducing the 75 per cent.

A somewhat more specific approach would be to exempt from capital gains taxes investments in IPOs of companies under a threshold revenue or market capitalization, for example, for $10 million in revenue or $50 million in capitalization. The exemption would be granted to original purchases of treasury shares only. I think that would result in a very positive market reaction as well as a significant increase in capital available to small company IPOs.

Senator Austin: I tend to endorse that point. Would you necessarily give the same capital exemption to the love money and the angel money? These are the people who really are taking the risks of initial entrepreneurship. As you mentioned, they are locked up in escrows and they cannot realize the benefits, if any. Very often, there are no benefits; they are just straight "forget it" investments. I would suggest that the incentive would be stronger at that level than it would be at the initial level of a public offering.

Mr. Oliver: Another approach, which would include that concept, would be to say that anyone investing in a company does not have to pay capital gains up to and until the company reaches a certain size, let us say in capitalization. After that, the capital gains would start clicking in. You could pay capital gains at the end, but only in respect to the amount beyond that, which would be more inclusive.

I am told that the $500,000 capital gains exemption for Canadian-controlled private corporations has been a very important factor in attracting capital to the smaller companies. However, if a small business is public, the shareholders are taxed in the same way as if they purchased BCE. Thus, a suggestion is to reduce the inclusion rate for capital gains that are earned on listed shares of small companies. The measurement of that would be a matter for serious discussion. It could relate to asset size, revenue or market capitalization. You may need a number of alternatives because different industries produce different kinds of results. The knowledge-based industries in particular do not necessarily have the assets. However, they acquire the capitalization at an earlier stage.

Another idea is to permit the pass-through of business losses from small companies to their shareholders. This is similar to the pass-through provisions of subchapter S companies in the U.S.

I think the committee should also consider the U.S. approach to reducing capital gains rates for longer hold periods to discourage free riding or flipping investments.

Senator Meighen: Do you have any information as to how long that has been in force?

Mr. Oliver: I do not have that answer. I could get it for you. Would you like us to do that?

Senator Meighen: I would like any information as to what it does or does not generate. I am thinking that our present rules promote hanging on, doing nothing, sitting on the asset and not disposing of it because of the capital gains. I suppose the American rule is to the contrary, that is, the longer you hold on to it, the less you pay. I am wondering whether it applies to all capital gains investments or only ones in SMEs.

Mr. Oliver: I think I am correct in saying that if a stock is sold in less than one year, then it is regular income. That applies to everything. That is one aspect of it.

There are some dilemmas and contradictions here. You want to facilitate the process. Venture capital money comes in. It is critical at a certain stage, but they are always looking for an exit. When the exit is achieved, the money is available for new financing. That is the process you want to encourage. Unless the process is there and they see the exit, they will not put in money, or they will put in a lesser amount, or they will demand a higher return.

One controversial program covers scientific research tax credits. They would be beneficial for SMEs. However, I think one has to look at the program very carefully to see that it is structured properly.

Another point to comment on is that corporate income below $200,000 is taxed at a reduced rate of 16 per cent. The SMEs would benefit from raising the threshold. Alternately, of course, the corporate tax rate itself could be lowered from 16 per cent. Either initiative would improve the disappointing productivity performance of small Canadian manufacturers.

Those are some of the tax issues. There are other possible government initiatives as well which could be considered, provided they are properly structured. The federal government might consider sponsoring an independent program to assist small business obtaining equity capital. The support would be provided to small businesses to assist in early stage financing. It would be conditional upon private sector financing, for example, from angels. The funding would be directed to SMEs with a certain maximum asset level or some other criterion. These would be companies that have a potential for growth in key areas, such as employment or exports. We are cautious because there is a potential for waste. It should be started modestly, carefully monitored against defined objectives and managed by specialists. I know there are other programs in place.

Mr. Chairman, that completes my presentation. I would be happy to answer additional questions.

The Chairman: In terms of changes, you laid out two broad areas. One was tax policy in a variety of areas. Another was what I would call changes by securities commissions with respect to adopting a number of the mechanisms available. You talked about the U.S. and Australia. These changes make it easier for SMEs to be launched.

You mentioned that in 1996 an Ontario commission study was criticized by the Vancouver commission and nothing happened. What is the reluctance of securities commissions in this country to fairly rapidly adopt some of the changes that are being tried elsewhere in the world? Why do we seem to be so reluctant to move into some of these new areas?

Mr. Oliver: I talked about the small business dilemma. There is also a fundamental regulatory dilemma. The key mandate of the securities commissions is investor protection. Typically, the smaller the company, the greater the risk to the investor. What is being asked for here is to reduce the amount of regulation and, potentially, the amount of investor protection in the very companies that pose the greatest risk. That is the issue for them.

I believe that there is a distinction between effective protection and theoretical protection, just as there is a distinction between effective communication and technical communication.

We have seen enormously long prospectuses, including prospectuses for the distribution of mutual funds. They are extremely difficult to get through. They are forbidding and highly technical documents. They certainly comply with the legal requirement of full, true and plain disclosure. However, they are often neither readable nor understandable.

There is a theory of investor information that says that as long as some person such as a research analyst knows and can interpret it, it will filter through. That is not always the case for the individual who receives it.

In regard to mutual funds, until recently, there was a huge amount of material on trust arrangements and so on. They are important, however, they do not have to be described in any great detail. They can be filed with the commission. Certainly the individual does not have to know about them. It is relevant for an individual purchaser of a mutual fund to know what the objectives are, what the purchase price is and the track record, in addition to knowing what the investment is. That was not required.

You need to look at a graph. Compare how a fund has done on a relevant index.

I have no doubt that prospectuses could be shortened dramatically and made more communicative without losing very much. That is what the SCOR prospectus in the U.S. was designed to do.

To return to the question, there is a concern that if you include less, if you try to simplify, you may be missing something. In the most risky of investments, you are protecting the investor less.

The Chairman: It sounds like the securities commissions are designed to keep themselves out of trouble as opposed to trying to solve the problem of how to encourage investment in small and medium-sized businesses. Their instinct is to play it excessively safe, which had some very significant down sides to the problem that we are all trying to solve.

Mr. Oliver: I do not think that they are trying to keep it safe for themselves, but they are trying to keep it safe for investors.

The Chairman: They are doing that by keeping it safe for themselves. If investors have problems, so do the people who run the securities commissions.

Mr. Oliver: I have always felt that the commissions should have or do have a dual mandate: investor protection and the promotion of efficient and competitive capital markets.

In the U.S. and other major capital markets, the regulators take it as part of their mandate to enhance the strength and competitiveness of their market. The chairman of the SEC goes around the world trying to increase listings on the NYSE because he wants the American capital market to be as strong as it can possibly be.

Now, the challenges are different for a market that only represents 2 per cent of the total market. However, there is always a question of necessary regulatory balance. If you apply that principle to small business financing, there is a way to make the financing more accessible without unduly increasing investor risk.

The Chairman: The solution to that problem does not rest with government at either the federal or provincial level; it rests with the securities commissions.

Mr. Oliver: I would say that part of it rests with the securities commissions. I think the security commissions are attentive to the policy objectives of governments. Signals are often taken within the context of their responsibilities as they see them.

Senator Meighen: On a point of information, did I hear you say that a number of these things could be achieved without incurring additional investor risk? What I am getting at is, what is wrong theoretically with greater risk if there is greater return? Is everything designed so that the risk profile cannot increase?

Mr. Oliver: I am not talking about greater economic risk. I am talking about greater risks flowing from potentially inadequate disclosure of what the risk is. Clearly, we are talking about more risk in this sector, and that is not a changeable by policy makers, other than through tax policy, I must say.

Senator Austin: Senator Kirby touched on the area that I did wish to explore, and that is the role of the regulator. As you have pointed out, the risk is higher at that level, yet the arguments are to reduce the cost of entry for people seeking capital. It is a conundrum.

Should we approach that particular issue from the point of view of a special administrative regulator system at the provincial level, designed to handle only issues in this particular area? Therefore, while we have our regulators, there are divisions among them, and there are discrete and distinctive personnel who look only at the stimulation of activity in this area and supervise this type of program.

I am concerned with the problem that honey attracts flies. We do not have many systemic problems in this area because there is not much money in the high-risk end, in the love and angels part of the business.

If we create more incentives for people to raise capital in this end, then do we create a whole new level of people skimming by providing professional services in this particular area? Entrepeneurship is alive and well and I am all for it, but sometimes it goes over the line. That is why we have supervision and overview.

Could we require some level of approval or overview? When you come to the junior capital pools, I understand that one reason why the Alberta system has worked, contrary to the opinion of so many when it was created, is that the exchange itself took the responsibility for approving the proposed venture. The capital would be raised first, but they did not allow the entrepreneurs to put it into anything they wanted in an unsupervised way. They said, "You bring us the deal, we will vet it." That was an unusual step for an exchange to take.

Therefore, they endorsed the deal when they allowed the assets to be acquired by the capital pool funds. I am wondering if that kind of system is in some way importable into this level, which is anti-regulatory in the normal approach of regulators whose first function is transparency.

I do not disagree with Senator Kirby that regulators do a certain amount of butt-protecting, and I do not disapprove of it, having been a bureaucrat at one time. I agree that they see their role as increasing the efficiency of the market.

Those are the issues at this level and I am wondering how we get at them. If you do not have an answer, I appreciate that, too.

Mr. Oliver: I would be cautious about creating a separate structure to deal with this category. To some degree, it already exists among the Canadian securities administrators who, because they are provincially based, tend to have somewhat different responsibilities in respect to financing. The Alberta Securities Commission is looking at the issues that we have been discussing proportionally more than the Ontario and British Columbia commissions.

One of the advantages of a provincial system is that there is sensitivity to regional interests and, presumably, those interests are being reflected.

Having said that, it is interesting that when the Ontario commission proposed liberalization in respect to small business financing, the B.C. commission had the most concerns. That, I assume, reflected their knowledge of some of the abuses and they focused on that. It can go either way.

It would be good to have special committees looking at this issue again, but a parallel structure of regulation would not be appropriate. However, a liberalization of access and of rules is appropriate.

Senator Austin: I submit that the mentality of the regulator of large issues and larger and more conventional market performance is a different mentality than the one that we would need to move this forward in a secure fashion. That is why we have a Business Development Bank and why the Bank of Montreal calls for a small business bank.

It is a question of culture. I have dealt with regulators in the securities industry all my life. I question whether the culture of the regulator in this area is the right culture for the broader and more sophisticated part of the industry. That is a subject to which we can perhaps return. I do not want to continue it but I did want to make the point.

Mr. Oliver: To go back to the senator's earlier comments, there was a suggestion of vetting some of the investments. I personally would be cautious about trying to have outside regulators getting into the investment process very much, if at all.

Perhaps I misinterpreted what was said. If so, I apologize.

The Chairman: Regarding Senator Austin's culture comment, this committee will face that issue in another context. In our comments on the MacKay report, this committee urged effectively that rules and regulations be changed to encourage the establishment of either much smaller community banks or smaller, more locally based financial institutions. There is a view that the corporate culture of OSFI would mitigate against that.

We also recommended, as you have, an easier regulatory touch for the smaller institutions. There is a very interesting culture question as to whether that is doable under the current OSFI structure.

Mr. Oliver: There is another very big issue, which will not only change culture but will change the nature of the Canadian capital markets. Technology and globalization are combining to create a new world from which we cannot insulate ourselves. We are seeing an increasing number of Canadian companies moving to the U.S. if the capital is available there.

We must focus on being as competitive as possible. The exchanges right now are confronting the fundamental issue of whether they can keep the order flow in this country. Even if they do, can they keep it on the exchanges?

The world's capital markets are rapidly changing. Some of the implications of the changes will clearly relate to small businesses.

Senator Oliver: I learned from our dinner meeting with you and your associates that, almost to a person, you believe there is a lot of capital money in Canada that can be used for equity financing for some of these start-up small businesses, but you must find a way to get access to it. Right now there are many limitations and controls.

Our chairman has carefully itemized two of the main restrictions, one being the regulator and the second being the tax policy.

You represent the investment dealers. As an IDA, what steps are you prepared to take to help the "angel" or the professional person with excess money who is looking for ways to invest it? Can you help to open up some of these doors with the OSC? Why would the Investment Dealers Association have an interest in doing something in which they may not be able to participate or from which there is no profit or interest?

For example, if an angel wanted to go to a mom-and-pop operation that needed some equity, what is in it for the IDA? How far are you prepared to push to have some of these changes made?

Mr. Oliver: In terms of pure self-interest, the ability and willingness of angels to finance small companies implies that more companies will reach the IPO stage and, therefore, be clients for more traditional financing.

Senator Oliver: At the beginning, the angels do not need you, do they?

Mr. Oliver: They often need our firms' employees. The officers and directors of investment firms are very big players in private financing. Often they are, all publicity notwithstanding, angels. That is another aspect.

Senator Oliver: That does not generate any fee income for your clients.

Mr. Oliver: It does not do so immediately, but, obviously, if individuals at a brokerage firm have helped to start a company, it is likely that their firm will be involved in the financing. We must be very careful that there are no conflicts. That is one of the issues for the committee.

It is a natural kind of continuum; they supply the individual financing and then it goes on to the next stage. Conflicts exist, but they can be addressed.

That is another type of self-interest. In addition, some of our firms are actively involved as merchant bankers and venture capitalists. Some of them have distinct operations, including the bank-owned firms, because if it is done properly, it can be quite attractive.

There is one other thing to be said and this never gets a positive reaction, I must say. Some people who are complaining about not enough capital do not necessarily represent interesting opportunities. Sometimes companies do not get the funds because they should not.

The Chairman: They may have a bad idea.

Mr. Oliver: I cannot quantify that, but there is clearly more money desired than money received, and part of it relates to the soundness of the enterprise.

Senator Oliver: A number of angels who have money and who would like to place it would like to get rid of as much red tape as possible in making that investment. That is where the regulator comes in. How far are you prepared to go in terms of a minimum cap of, say, $100 million? Should we do away with a lot of the traditional regulator red tape in equity start-ups? How far are you prepared to go, or are you afraid that the risks could be so great that we could do irreparable damage to investing in Canada?

Mr. Oliver: I think we can go quite far without incurring too much additional or inappropriate risk. Lowering the thresholds to bring in money in smaller amounts makes a lot of sense. Those higher numbers do not really have the impact they should.

As I mentioned, many sophisticated people would be prepared to invest smaller amounts because they would like to diversify that kind of investment. I think the numbers should be reduced because the size of the individual investment is a very rough measure of sophistication. It is not directly related to sophistication at all. It is related to the amount of money available to an individual.

This issue was examined by the OSC, and there was much concern about opening it up. The most difficult thing was to come up with a definition of "sophistication." They could not seem to do it directly. They could not relate it to taking a course or investing for a certain period of time.

We all know that people can inherit money and not have any investment experience. There is a lot of concern that someone who has inherited a good amount but has no other means of support would somehow see that money eroded because of unscrupulous advisors.

Size was not a way to arrive at the "sophistication" definition. I think they were being cautious in deciding not to change it. That was a few years ago. However, I think something must be done.

Senator Oliver: Senator Angus threw out the phrase "flow-through shares" earlier. They were very popular in the mining industry in Quebec and were a way of raising capital. Are flow-through shares and other share structures something you would recommend as a way of getting access to more of this capital?

Mr. Oliver: I am not up-to-date on that specific vehicle, although it has been important.

In respect to some vehicles -- not that one particularly -- there is a tendency to purchase based upon the tax advantage rather than the economic value of the investment. Often in these cases someone will include, for example, the RRSP deduction, which is available for any type of investment, and attribute to that tax advantage investment that additional tax break, which has nothing to do with it. Then they will take a look at the return and include the tax rebate as part of the first-year return. That is analytically wrong. They should really look at the after-tax investment and see what return they get on that.

The advantage of the tax break is that a larger amount of money is available than was actually invested on an after-tax basis. Eventually, you have to recover that amount or you will be behind the eight ball.

Senator Oliver: Is the IDA thinking of bringing others forward?

Mr. Oliver: Not at the moment, no.

Senator Kroft: I wish to continue or broaden the subject of tax-related solutions to enhancing investment in small and medium-sized businesses. Senator Oliver came at it from the perspective of flow-through shares. You had a list of tax-related items. Most of them have been on my personal list for 25 years. Whether it is the flow-through of losses, preferential capital gains rates, or the ability to file a consolidated return, we have never been very good at using tax policy to enhance investment. The exception is targeted industrial areas, and they tend to have been in the cultural field. Obviously, it has been used in science with either too great a success or mixed success.

I happen to be a great believer in the use of tax policy as a way of encouraging investment in an area where the government has a policy objective, particularly as we are taxed at a disadvantage to our large neighbour and have to try to close some of that ground. As this committee continues to work, I will therefore always be preoccupied, among other things, with tax opportunities to achieve some of these goals.

Do you have an overall view as to how you would rate this by way of importance, but more broadly as to the cultural environment of tax issues? How far have you gotten with these issues when you raised them? Where were you rebuffed? Who said that will not work and why?

Mr. Oliver: I agree that tax policy is probably the most effective way to achieve fundamental objectives in respect to small business financing. As to why, there is no taxpayers' revolt in Canada yet.

I raised this question in the visits we have had with provincial finance ministers across the country. I raise the issue of tax policy with the Minister of Finance when we see him once a year.

The Government of Alberta, in particular, as you might imagine, is frustrated that there is not as much enthusiasm for tax reductions as one might have thought because, in principle, why would anyone want to pay more taxes?

I think they felt that a reduction in tax policy is viewed by people as a code for a reduction in certain specific, highly valued programs. They think about the program most important to them, and they think that will be reduced. Of course it may or may not be reduced, but probably will not be in the short term.

The public, understandably, is not always attuned to all the economic consequences of fiscal policy. I do not think they have been convinced yet that a reduction in taxes ultimately enhances employment, wealth and the ability to finance government programs.

Senator Kroft: You are coming at this in a very broad way. I am referring to the specific area of a small business looking for financing assistance, forgetting whether the taxpayer will get a benefit because that is too often a preoccupation of politicians looking over their shoulders.

The other side of that same coin is that some person trying to start a small business may have capital available that they would not have if there were no incentive to provide that capital. I am coming back to your annual meeting with the Minister of Finance. I would like some idea of the enthusiasm or specificity with which you and your organization have tended to pursue tax areas, or have they not been a significant part of your agenda?

Mr. Oliver: We have, each year, raised with the Minister of Finance the question of capital gains, and specifically more favourable capital gains treatment for small enterprises. We have, I think it is fair to say, not been given any indication that the government is about to do anything in that respect at this time. They have not necessarily disagreed with the concept, but we have been given no indication that they are about to do anything in that regard.

I would make one other broad comment in that respect, and this is something that we raised in our last visit. If you look at the U.S. experience, there is a paradox at work. When you reduce capital gains rates, the capital gains taxes collected increase. The government is therefore at an advantage, as are the individual investors who then feel liberated to dispose of investments. The tax policy is thus less intrusive and does not distort the economic process.

Some academic studies go the other way, but there is a lot of evidence to suggest that that does in fact work.

Senator Angus: You mentioned that you could supply us with studies and background materials. I think the capital gains tax must be the critical area here. I have always been of the view that at these high levels that currently exist in Canada, there are millions of dollars tied up in unrealized gains that would, in the normal course, be reinvested and used exactly for the type of SME investment we are talking about here. The net result would be levered many times over in terms of an industrial and economic plus. Yet, the naysayers and the people that Senator Kroft suggests are out there inhibiting progress keep saying, "No, no, it is revenue negative." You just said that there are studies that show that for every rate percentage you go down, there is more revenue.

It seems to me that some very persuasive statistics must be available to show that if, for example, we went from 40 to 20 right away, there would be a fantastic boon to our economy, but those statistics are not coming out. People like ourselves, who could, as Senator Kroft suggest, aggressively advocate such a change, with some credibility, do not have the tools. Can you provide us with something like that?

Mr. Oliver: I believe that there are studies available. I will attempt to locate them and present them to your committee, if I can do that.

Senator Angus: That would be great.

I agree with nearly everything you have said about the constructive things that your own members do in terms of supplementing the regulator and making prospectuses user-friendly to your clients. I cannot tell you how many dealers have told me that they would have so much more business if the capital gains tax were reduced. They have said that they would invest millions in trying to present the case in a proper way.

You also talked about regulatory arbitrage in Canada. Could you elaborate by telling us how prevalent it is in this country, giving a few specific, striking examples to make the point, and to show how it is detrimental to the flow of capital to small businesses?

Mr. Oliver: Happily, regulatory arbitrage is decreasing rapidly as the provinces harmonize regulations across the country. I referred to regulatory arbitrage in the context of the escrow policy. I understand there are some differences, but I guess there is a possibility of a company doing a financing in one provincial jurisdiction as opposed to another because the hold period is less. It is that kind of issue.

Regulatory arbitrage will be more of a problem for Canada overall compared to other jurisdictions if our rules are more stringent, regulation is more complicated, duplicative or costs more money, or if there is more regulatory uncertainty. That is why, in a period of globalization, we need to be as efficient and competitive as we can be.

Senator Angus: This is the argument for the national securities commission.

Mr. Oliver: It is certainly an argument for regulatory harmonization.

Senator Angus: I am interested in the flow-through shares. I have the same list as Senator Kroft. I do not know whether I have had it for 25 years, but it certainly seems to me to be a growing list. To the extent that some of these so-called tax incentives have been employed as ways of raising capital, I have come to the conclusion that they have been almost like an investor con. At the end of the day, it is never properly explained. You do your investment and you get your write-off on next year's tax, as you describe, but there is always a day of reckoning. First, you end up with a zero cost base on the shares, but also, to the extent that you have taken the write-offs, you have wiped out your access to the $500,000 capital gains exemption. Far from being an incentive, other than some short-term medicine on a guy's tax return, they end up creating terrible problems. They have been abused, perhaps unwittingly, by members of your association. Do you have any comments on that? Do I have it wrong?

Mr. Oliver: One of the problems with tax incentive programs is that sometimes people are just attracted by the immediate tax reduction without first looking at the fundamental economics of the investment and then how the tax program actually works. I think that if one does that, then there should not be a problem with these programs and they can be looked at objectively. They do make sense for many people. The problems come if they are being purchased without knowledge of the consequences.

Senator Angus: They give you one apparent quick fix.

The Chairman: They are a "here and now" solution.

Senator Angus: People are not aware of the complexity. They are taking away another incentive to investment in the SMEs. Clients are just blown away when they wake up to this fact. They are ready to make an investment in a small business and then find that the advantage that was supposedly there is not there. They are surprised.

As Senator Austin said, the menu is huge. I hope this is the beginning of many days like this so we can talk about it.

The Chairman: As a one-person round table, this has been terrific. I do not know how we would have handled two other witnesses.

Senator Meighen: I think the ground has been well tilled by everyone, but I want to go back to one point. I was passed a note that reinforces the problem of perception that seems to exist out there. I am informed that in the budget speech there was a mention that a 5 per cent reduction in the capital gains rate would result in a lost revenue of approximately $113 million. This is the mindset that is there. No doubt it would initially, if you just look at one side of the ledger, but there are other aspects that seem to be ignored. Most people, particularly in government, seem to think that capital gains deal solely with financial assets. They also deal with plant, equipment and immovable property and all kinds of things that are affected by the way we treat them.

I would hope that the IDA and others would hone in on the statistics, because we need to get at this perception that capital gains affect the rich only. In the public's mind, I think it covers the quick flipper in the stock market. I go back to that point about the American regulation that differentiates between the length of time the financial asset is held and the rate of tax it is subjected to when sold. That might go some way to alleviating the false perceptions.

Senator Angus said he was interested in the flow-throughs and indicated how he came at the question. I think he is quite right. To me, across-the-board, generalized reform would be better than putting too much faith in this cherry-picking. Governments, to be charitable, are no wiser than anyone else in picking the area they want to improve. In fact, they often get it wrong, as do the rest of us. That is more of an editorial comment than anything else, but I would think that an across-the-board reduction in capital gains, perhaps following the period an asset has been held, would do much to decide that we would favour this or that particular sector by a tax scheme for an indeterminate period of time.

The Chairman: Thank you very much for attending. You will give the data you have to our research staff, and we will be back to you. We have such a huge number of issues here that we will want to use the help of you and your staff as much as possible.

Mr. Oliver: I could also suggest that there are some members of our association whose firms are actively involved in this area, and they would be able to provide additional insight, if that is something in which you would be interested.

The Chairman: Thank you.

The committee adjourned.