INDY Committee Meeting

STANDING COMMITTEE ON INDUSTRY

COMITÉ PERMANENT DE L'INDUSTRIE

EVIDENCE

[Recorded by Electronic Apparatus]

Thursday, February 11, 1999

• 0911

[English]

The Chair (Ms. Susan Whelan (Essex, Lib.)): I'll call the meeting to order pursuant to Standing Order 108(2), consideration of access to financing for small businesses.

Originally we scheduled three witnesses for 9 o'clock. You probably have a copy of a brief. Did everyone get a copy in their offices?

Mr. Stan Keyes (Hamilton West, Lib.): The massive brief with all the small print in it, Madam Chair?

The Chair: No.

A voice: Those are the regulations.

The Chair: You should have received a brief from Dr. Alfie Morgan, from the University of Windsor, who unfortunately, due to—

Some hon. members: No.

The Chair: Okay. I don't know where they are. The clerk has now disappeared. She will be right back.

You should also have received a brief from Professor Marc Van Audenrode.

In any event, when the clerk comes back, I'm sure she'll distribute them. Neither of those two professors can be with us today. Professor Morgan let us know on Tuesday that he could not be here today and Professor Van Audenrode let us know yesterday.

We're still expecting Professor Brean from the University of Toronto to join us. We understand he has arrived in Ottawa. He has just not arrived here yet.

We were going to invite the Department of Industry officials to discuss the regulations for Bill C-53 after Professor Brean. I propose that we change that order.

Maybe the clerk could ensure that the briefs are distributed for Dr. Morgan and Dr. Van Audenrode, from the two witnesses who are not here.

The Clerk of the Committee: They were distributed to the members' offices.

The Chair: Do you have copies of them here?

[Translation]

Ms. Francine Lalonde (Mercier, BQ): We haven't received them yet.

Madam Chair, we have not been summoned to this meeting to hear the Department of Industry. I'm sorry, but I've looked at my notice of meeting and I do not see...

[English]

Mr. Jim Jones (Markham, PC): Is there an English version?

The Chair: My understanding is that there is another notice of meeting, which was amended. I apologize if your staff hasn't given it to you. It went out last night at 6 o'clock. It's up to your office staff to look at your e-mail. There's nothing I can do.

We have only so many days based on the amendment we passed in the legislation, so all we've done is invite the officials here to discuss the regulations in order to see how the committee wants to pursue them—if the committee wants to pursue them.

Madame Lalonde.

[Translation]

Ms. Francine Lalonde: I want to say something. This morning, I would have gone to an important symposium on information technology and the law in Montreal, if there had not been this presentation by three professors that we had invited to speak about job creation and credit. Since we had requested that meeting, I felt obligated to come here. Therefore, I did not attend this symposium. We can hear representatives of the Department of Industry any time, and I was not summoned for that. I'm not very happy with this.

[English]

The Chair: Madame Lalonde, I can't help it if Professor Van Audenrode from Laval University cancelled after the meeting yesterday afternoon. I didn't know he was going to cancel. He didn't call until yesterday afternoon because he's ill.

Professor Morgan cancelled because the hospital found a bed for him so he can have some surgery that he's been waiting for.

We have Professor Brean. We decided to go ahead with that. He has not yet arrived. We know he has checked into his hotel.

• 0915

I decided this last night when we knew we'd have some extra time, because I didn't think we'd take two hours with Professor Brean and because the regulations have a timeframe of February 26 as the final date—if the committee even wants to look at them. I have the department here to discuss the changes to the regulations or what regulations have now been proposed. It just seemed to make sense to me. If there's a problem with that, we can meet on the regulations on Monday. I don't care.

Mr. Stan Keyes: The officials are here.

The Chair: I'm going to invite the officials to the table to discuss the regulations. Does that sound all right? Is everyone in agreement?

Some hon. members: Yes.

The Chair: Fine. The senior officials from the department will be here.

Mr. Stan Keyes: Madam Chair, were those cancellations from the different professors by any chance put on the e-mail to us?

The Chair: In fact, you should have noted on your agenda for today that originally we had three witnesses listed. The agenda for meeting 87 was sent out on Tuesday, I believe, and showed that there were only two. It didn't specify that one had cancelled. The agenda that went out last night showed we were down to one.

Mr. Stan Keyes: So it was on the e-mail last night?

The Chair: Yes, at 6 o'clock.

Mr. Stan Keyes: Okay.

The Chair: As soon as we knew, it was on e-mail.

Mr. Stan Keyes: So if you have an efficient staff, they put the e-mail on your desk and—

Some hon. members: Oh, oh.

Mr. Stan Keyes: —they let you know what's going on, what's transpiring, so that you can set your agenda for the next day. I guess some members need more babysitting than other members do.

The Chair: Mr. Keyes, I'll just remind committee members that we've asked people to submit briefs in advance, particularly for Bill C-54.

Can I have some order?

I really would appreciate it if everyone would ask their staff to constantly check their e-mail, because we are getting briefs to our offices on Bill C-54 and we're going to receive them as they're translated in our offices. It's not going to be three or four days in advance—or it could be three or four days in advance. You already have some briefs on Bill C-54. When you come to committee, don't say you didn't get them. They are there. They also were distributed to your offices for this morning.

That being said, I'm very pleased to have the departmental officials here: Mr. Webber, Mr. Croteau, Mr. Dunlop and Madam Scanlon. I appreciate you coming here to discuss the regulations on such short notice. We know that when we were dealing with Bill C-53 a number of concerns were raised about the draft regulations. I understand that there have been many meetings and much consultation and that a lot of those issues have been resolved.

Because I asked you only last night to be here today, I understand that there is no official text to be distributed. It was my decision to allow this to happen, but I understand that you might have some opening comments for us.

Mr. Robert Dunlop (Director General, Entrepreneurship and Small Business Office, Department of Industry): Thank you, Madam Chair.

[Translation]

Thank you, Madam Chair and members of the committee.

As you've said, we do not have a formal presentation, but simply a few opening remarks. These remarks are divided into three parts: process issues, substantial issues and administrative issues.

[English]

On the process, note that the process on the regulations really began on October 22 with the tabling before this committee of a discussion draft of the regulations. There were hearings in the committee, and industry officials were consulting with the interested stakeholder groups around that as well.

As you know, Bill C-53 received royal assent on December 10. We've been using the time since then to incorporate the results of those consultations into the draft regulations. At the same time, if you've had a chance to look at the regulations, you'll note as well that the Department of Justice drafters used that time to reorganize them a little to make them more logical and coherent, reflecting the fact that this was their opportunity—for a 37-year-old program—to put things in a more orderly way. The consultations with the stakeholders continued during this drafting phase. The regulations that you now have before you reflect the results of those consultations.

Pursuant to subsection 14(c) of the Canada Small Business Financing Act, the pre-publication version of the regulations was tabled in the House of Commons and Senate on February 3 and was circulated to the stakeholder groups as well.

• 0920

You will note that the regulations have a pre-publication period of 15 days, with a five-day period for the submission of comments. When regulations haven't been subject to this much pre-consultation, normally the pre-publication period is longer. We note as well that there's an interest on behalf of both the program users and lenders to have the regulatory regime in place as soon as possible to ensure a smooth transition to the new program, which as you know begins on April 1 of this year.

As part of the consultations, we had extensive time with program users and potential users in focus groups over the last spring. As well, in the process after tabling with this committee, we've been dealing extensively with a number of groups, including: the Canadian Restaurant and Foodservices Association, the Canadian Federation of Independent Business, the Canadian Franchise Association, the Canadian Bankers Association, the Credit Union Central of Canada and the Confédération des caisses populaires et d'économie Desjardins in Quebec.

We also note, of course, that in the pre-publication period all interested parties are available to provide recommendations to the minister for incorporation in the final regulations.

In terms of substantive issues, you'll recall that the issues brought before the committee concerned primarily four proposals introduced in the discussion draft that would have had the effect of restricting access to the program. You'll recall that one concerned a proposed prohibition on the use of the program to finance existing leasehold improvements. Another prohibited the use of the program to finance non-arms'-length purchases of going concerns. In some instances, we were seeking borrowers to receive a waiver from a landlord. The final one was a requirement that franchisees obtain a 50% buy-back agreement from franchisors.

As you'll recall, what we agreed on at the time was that we would look for alternatives to these proposals, but that if the minister and the interested groups could not reach a mutually satisfactory alternative, we would maintain the regulatory regime that existed under the previous act, the Small Business Loans Act.

As we told you at the time, we were not able to find agreements about alternatives. As a result, the regulations you have now reflect the regulatory regime from the Small Business Loans Act. We've been in contact with the groups about this. The Canadian Restaurant and Foodservices Association has told us in a preliminary way that they are in agreement with the regulatory package as presented to you now and they are just consulting with their members to confirm that this is in fact the case. They hope to have a final response by as early as Monday.

Finally, with respect to administrative issues, we've made a number of adjustments in the regulations to reflect our consultations, primarily those with the lenders. As you'll notice in looking at the regulations, in terms of volume most of them deal with issues such as the transfer of loans between lenders, registration and issues like that.

We've been consulting extensively with the lenders, and a number of administrative changes have been made to the regulations. I wouldn't propose to take the committee through them in detail, but would be pleased to answer questions. From our ongoing contact with the lenders, though, we have no indication that there are any major, outstanding issues that won't be dealt with in the pre-publication process.

[Translation]

Madam Chair, that concludes our remarks. We are available to answer questions from members of the committee.

[English]

The Chair: Okay. Just to let committee members know, I've asked the clerk to contact those individuals or groups that had expressed concern about the proposed draft regulations to see if they have any objections or any problems with the current regulations. From that response, I believe, we can determine whether or not we want to have any more hearings on the regulations.

That being said, Mr. Pankiw, do you have any questions at this time?

Mr. Jim Pankiw (Saskatoon—Humboldt, Ref.): I would just like it to be clarified for me. There were some legitimate concerns.

• 0925

For example, you mentioned the concern brought before the committee that franchisors would be required to agree to this 50% buy-back—which they wouldn't. So that would exclude anybody from qualifying for this program if his business was to purchase a franchise. Are you saying that in the regulations you've been unable to address those concerns?

Mr. Robert Dunlop: No. We're saying that we sought an alternative way to deal with the issue behind that proposal. We weren't able to come to a mutually acceptable agreement. As a result, pursuant to the agreement that we made before, we dropped that proposal. That's no longer in the regulations at all.

Mr. Jim Pankiw: Oh. All the things you mentioned are no longer there.

Mr. Robert Dunlop: Exactly.

Mr. Jim Pankiw: Okay. That's clarified.

The Chair: Ms. Barnes.

Mrs. Sue Barnes (London West, Lib.): I'm not sure if your comments have covered this already. My only concern is with respect to how we are going to ascertain this with the restaurant sector when they haven't even heard about it yet.

The Chair: I've had preliminary conversations with Michael Ferrabee, who first represented the Canadian Restaurant and Foodservices Association, and a number of people there. They've circulated the regulations to all of their members and have asked for their comments. He suggested yesterday that he wouldn't know until mid-week next week, and I have explained to him that because of the way the House is in session the only time we would hold hearings would be next week, because the timeframe is February 26 and the following week the House is not sitting.

That being said, if there were an awful lot of people who wanted to, we could hold hearings during the week the House is not in session. But as it stands now, I believe that the department has addressed many of the concerns and I don't by any means anticipate a large number of witnesses wishing to come before the committee.

Mrs. Sue Barnes: For the record, then, I'll just say that subject to the restaurant association getting back to us, I'm happy at this point with the responses addressing some of the concerns that were raised. But the restaurant association is a crucial one—

The Chair: Right.

Mrs. Sue Barnes: —and if they're not happy, I think we should be doing some further—-

The Chair: But I do believe from what the department has been able to do with the regulations that they have addressed all the concerns, and as Mr. Dunlop has said, they couldn't come to any type of alternative arrangements so they just removed the sections in the regulations that were causing the restaurant association to have concerns—for now. That's the proposal for now.

Madame Lalonde, do you have any questions?

[Translation]

Ms. Francine Lalonde: Yes, I have a question.

I heard Mr. Dunlop say in English that since the party had been unable to reach an agreement, the current regulations reflect the former regulations. In French, the word "refléter" does not mean exactly the same thing. Therefore, I would like to know whether there have been changes to the old regulations or if it's exactly the same thing.

Mr. Robert Dunlop: We have exactly the same system for these issues, madam.

Ms. Francine Lalonde: Can you tell me what the main points of these agreements were between the parties that prevented them from coming to an agreement?

Mr. Robert Dunlop: At the time, there was the issue of the possibility of abuse. We didn't have a lot of evidence of abuse, but we had made proposals with a view to avoiding potential abuse. We agreed that the proposal we had made was much too harsh in light of the problems that we had observed. We had agreed to hold talks with the associations in order to find some way to broach the question of potential abuse in a way that is acceptable to everyone and to propose changes. However, we had agreed to say that without such an agreement, we would keep the current system and if ever we did observe abuse in the future, we would retain the possibility of presenting actual evidence as well as proposals for change. Right now, we're keeping exactly the same regulations as the ones that prevailed under the old program.

Ms. Francine Lalonde: But you will keep a closer watch on things.

Mr. Serge Croteau (Director General, Programs and Services Branch, Operations Sector, Department of Industry): Indeed, that's one of the agreements we have with the stakeholders.

• 0930

First of all, we will make changes to our information systems to enable us to monitor this type of file, in order to know, for instance, the frequency of purchase financing and leasehold improvements, or the rate of default on such financing. We will thus be in a position to state scientifically, or at least on much more solid ground, whether or not that aspect of the program is being abused.

If we did observe such abuse, our first step would be to tell the lenders in question that there seems to be an exaggerated rate of default for a given type of loan, and we would ask them to determine whether they can take corrective action to lower the rate of default.

If that didn't work and if the problem was more generalized, we would have to make proposals for regulatory change in order to solve those problems. At that point, we would pursue those procedures. Proposed amendments would once again be tabled before the Industry Committee.

Ms. Francine Lalonde: If lenders know that you are watching things more closely, will people who want to buy franchises have greater difficulty in accessing credit in some banks or caisses populaires who might be more cautious?

Mr. Serge Croteau: I wouldn't state the problem that way. However, those who will finance these assets will be watching things more closely with regard to transaction costs. For instance, if they know that the franchisor has bought back these assets for—

Ms. Francine Lalonde: For next to nothing.

Mr. Serge Croteau: —$1,000 and wants the caisse populaire to refinance it for $100,000, that will undoubtedly motivate certain persons to pay closer attention to the value of these transactions. In the cases we have examined, that is what led to repetitive and substantial losses. The franchisor bought these assets at a very low cost after the franchisee went out of business and resold basically the same assets as if they were virtually new.

I think that the impact will be felt more at the level of the caisse populaire or bank manager. He will be more aware of this phenomenon and will ask more probing questions about the value of the assets. If that is done, it will be to the borrower's advantage, as he will be able to finance used assets at lesser rates. Losses have already been paid out on those assets. However, I can't give you any assurance about how this will go.

Ms. Francine Lalonde: I understand your reasoning. Your reasoning may be correct, just as mine may be. We'll see with time.

[English]

The Chair: Thank you. Mr. Lastewka.

Mr. Walt Lastewka (St. Catharines, Lib.): I have just two things to say.

The problem we were talking about earlier was brought forward pretty strongly. I hope that with the department, the restaurant association and the banking association, we can face that problem on an ongoing basis and get a solution. I just want to ask the department about any preliminary feedback on the regulations from the bankers' association or the restaurant association or any others.

Mr. Robert Dunlop: Obviously we don't want to speak for them. These are associations that have members and they want to consult with them. We're dealing with their experts on these issues. Our understanding is that we have agreement that these regulations are addressing their issues.

There are a few minor issues that we're still discussing with the banks, but again, these deal with technical issues about the relationship between ourselves, as the program administrator, and the banks, primarily. The restaurant association and the franchise association were really interested in those big four issues I mentioned before. As I said, the current regulations are exactly the same as the previous ones. As I understand it, they're just examining this to see if there are any other aspects of the regulations that might have some impact on them, but you'll be in touch with them directly.

Mr. Walt Lastewka: Yes.

The Chair: Mr. Jones, do you have any questions?

Mr. Jim Jones: No.

• 0935

The Chair: I don't have anyone else on my list, but I just wanted to clarify something. You say they're exactly the same, yet in the preamble of the regulatory impact analysis statement with the regulations, you talk about the fact that it's going to provide a clear definition of related borrowers. Is that a change?

Mr. Serge Croteau: This is one element that was not part of the elements that were really contested by the four groups. It's an element that the AG asked us to address. The purpose of the related borrower definition is to make sure we do not have business studies being split into several parts, therefore allowing for a loan that would be well in excess of the $250,000.

The Canadian Bankers Association commented that the wording was a bit cumbersome, that this would be difficult to enforce. They've worked on it. When we met with them, they agreed that they would come back to us with the proposed re-draft for that. They did suggest some words, but I believe they experienced the same kinds of difficulties that our legislative drafters experienced. It's not an easy concept to put into words.

But as far as I know, the wording we have at this time is acceptable to them. We have agreed to continue to refine our interpretation of this wording through the guidelines, and there may be further adjustments that will be required along the line to make sure that the various branches of the lenders have a similar understanding of what that particular section means.

The Chair: Actually, this was raised during the committee hearings, this concern about whether or not husbands and wives would both be able to apply under the Canada Small Business Loans Act now if they are operating two separate businesses. The way I read the definition, we just refer everyone to the Income Tax Act. Am I missing something in the regulations? Is there another section I'm not addressing?

Mr. Peter Webber (Team Leader, Small Business Financing, Entrepreneurship and Small Business Office, Department of Industry): I think that reference is limited to the question of whether they're operating at arm's length for the purpose of determining whether they're selling assets at arm's length or not at arm's length. But that's a very narrow distinction.

With respect to the related borrowers section, certainly if they're operating independent businesses there would be no problem with them getting it—assuming they're creditworthy.

The Chair: I understand that. I understand they have to meet the other qualifications.

Are there no other questions?

I appreciate you coming here on short notice and I appreciate the work you've done to address the concerns raised by a number of the witnesses who appeared before the committee with regard to Bill C-53 and the draft regulations at that time. We know it's a negotiation and we know you'll keep doing it, but we also believe that part of the reality, I guess, of solving or dealing with this is the accumulation of information and having evidence to look at in order to be able to determine which way it should go. That's one of the reasons we tabled our twelfth report in the House of Commons just last week on Bill C-53. We thank you very much for being with us.

I understand that our other witness has now joined us, so we'll excuse you.

Before we move to our witness, we now have a quorum to deal with Mr. Jones' motion, so I'll turn this over to Mr. Jones.

Mr. Jim Jones: The last time I brought this motion forward, you said it wasn't in order. Since then I've checked, and it was in order, so at least this committee has to deal with this motion.

The Chair: No. The way it was worded before was not in order. You've changed the wording, Mr. Jones.

Mr. Jim Jones: What was the wording before?

The Chair: You referred to an individual in the last one.

Mr. Stan Keyes: You added a person's name at the bottom of your motion.

Mr. Jim Jones: Oh, did I?

The Chair: Anyhow, that being said, go right ahead, Mr. Jones, and make your motion.

Mr. Jim Jones: My motion is that we invite the ethics councillor to be summoned before the industry committee to explain his mandate and responsibilities in the expenditures of his office as listed under Industry Canada.

• 0940

The Chair: For clarification's sake for committee members, I'll just repeat what I said at the last meeting. We are scheduled until March, until the last week before the break at Easter, to deal with Bill C-54 and the clause by clause. Immediately thereafter, we have to deal with Bill C-235. There's a timeline on that. It has to be dealt with prior to April 20, so I don't anticipate us having a lot of time before that. We will deal with the estimates sometime thereafter. That would be the opportune time to have Mr. Wilson before us—as part of our estimates for Industry Canada. Last year, we invited a number of different segments that fell within...I leave it to the committee members.

Mr. Bellemare.

Mr. Eugène Bellemare (Carleton—Gloucester, Lib.): This motion should be dealt with at steering committee. Steering committee is made up of members from all parties who decide

[Translation]

what the timetable will be for the various programs.

[English]

The Chair: Mr. Bellemare, Mr. Jones has a right to bring a motion to the full committee. He gave notice of motion on Tuesday that he was going to do this. That being said, the steering meeting could, at a later date, determine which groups they want to hear from on the estimates. That may be premature at this time since we haven't seen the estimates.

Mr. Keyes.

Mr. Stan Keyes: I think the chair has given a great explanation. I call the question.

(Motion agreed to)

The Chair: There you go, Mr. Jones. We'll be meeting with Mr. Wilson.

Mr. Pankiw.

Mr. Jim Pankiw: Madam Chair, I have a question. You said we were going to do Bill C-235. What's that?

The Chair: That is Dan McTeague's private member's bill, which passed in the House on October 20.

Mr. Jim Pankiw: And it was...?

The Chair: It has to do with amendments to the Competition Act.

Professor Brean, could you please join us at the table?

Does everyone have a copy of Professor Brean's statement?

Professor Brean, we want to thank you for joining us today. We apologize for the fact that the other two witnesses scheduled to appear with you have been taken ill. I don't know if the clerk has explained this to you, but Professor Morgan from the University of Windsor has been awaiting surgery and they found a bed for him, so that's where he has gone, and unfortunately, Professor Van Audenrode called yesterday to say he was too ill to travel. We apologize, but we are pleased that you are able to join us, and I'd like to ask you if you have some opening comments for us.

Professor Donald J.S. Brean (Faculty of Management, University of Toronto): First, I'm delighted to have been invited to appear before this committee. Also, following your remarks that you have invited three professors, two of whom were unable to show and one of whom came substantially late, there is enough evidence there for a hypothesis and some testing, I would think.

Some hon. members: Oh, oh.

Prof. Donald Brean: My profuse apologies for appearing late. There was a last-minute event, and I could not arrive 20 minutes earlier, I'm afraid. But I'm delighted to be here and I have prepared some comments dealing with the order of the day.

They are quite specific comments with respect to one particular aspect of the issue of the Small Business Loans Act in its latest version. I believe you have a copy of my comments before you. Therefore, I think I would like to take a few minutes to move through those comments to make the primary point of my presentation. I would be willing to then either stick with this particular point or deal with any other issue that may have been on your minds when you were thinking of inviting me to appear before the committee.

• 0945

My remarks today focus on a particular facet of the design and the administration of Canada's loan guarantee program for small business. The issue is the government's objective of cost recovery and the corresponding imposition on lenders of fees that are recoverable from borrowers.

I quote from a document prepared for the twelfth report of the standing committee:

The Standing Committee on Industry recognizes that the loan guarantee program will be undergoing a difficult transformation to cost recovery....

Under the SBLA, lenders are required to pay a one-time loan registration fee to the government equal to 2% of the amount of the loan. The fee is recoverable from borrowers, who may reimburse the lenders when their loans are advanced or have the amount of the fee added to their loan balances provided that the individual borrower's loan maximum of $250,000 in total is not exceeded.

In 1995, the government set the SBLA on a cost-recovery track. The evidence is that this administrative objective is being met. The program also appears to be highly sensitive to program parameters in economic conditions, by which I mean that the usage of the program is something that reflects the demand for borrowing by small business through this mechanism and a call on the guarantee that is not steady through time but is sensitive to all sorts of conditions within the program and to economic conditions. I note that further study of the way in which the program is used is something that it is proposed to develop further.

Cost recovery in a program such as this demands secure revenues together with loan approvals that favour low measurable indices of default. Such terms, while financially prudent in a strictly competitive context, conflict with and compromise the aim of the program to correct a market failure in the finance of small, fledgling firms. Defaults under the act are in fact low relative to similar programs in other countries. The loss rate on loans has averaged about 5.6% over the 37-year life of the program, and forecasts suggest that the current fee structure will offset the claims costs of the program on loans made since 1995.

Loan guarantee programs are designed to redress an apparent flaw in credit markets: small firms face systematic barriers to debt capital. One form of bias against loans to small business relates to the fixed costs of credit administration; in particular, the average cost of administering a loan is inversely related to its size. The lender's need for a minimum degree of due diligence causes these fixed administrative costs to loom fairly large, relatively large, for small loans. Exacerbating the cost bias against small firms, lenders set collateral requirements as a function of the fixed cost of due diligence, which likewise makes the required collateral as a per cent of the loan inversely related to the size of the loan.

Governments in virtually all industrialized countries, and in many developing nations as well, underwrite loan guarantee programs for small business. Canada is not alone in this. In practice, loan guarantee programs run the risk of lax lending to bad credit risks and thus defaults, as well as subsidized loans to low-risk free riders, those who come into the program but probably don't need it.

In view of these chronic operational difficulties, the primary responsibility of the guarantor is to set an optimal level—and that's a difficult word, “optimal”—of loan guarantee, enhancing the lenders' incentive to lend without unduly undermining the lenders' responsibility to discriminate on the basis of borrower quality.

Turning to fees now, rather than being a constructive component of program design, fees on the administration of guaranteed loans must be seen as thinly disguised and ill-advised taxes used to support the overall program. Fees are especially suspect in programs intended to rectify a distortional loan cost structure. Fees deter access to loan guarantee programs. As fees deter applicants, the program costs are reduced, but only because they reduce the size of the program. The focus on fees detracts from the primary problem of market failure.

• 0950

Ultimately, since fees are fiscal revenues, one ought to question the efficiency of this particular form of taxation. There is no basis in the economics of distortion-correcting mediation to suggest that programs should be self-funding, where borrowers shoulder the cost through a form of earmarked taxation. Second-best arguments are basically the arguments that say, “Well, you really can't do what you want to do so you have to do something else that's close to it.” Second-best arguments aside, there's no obvious reason to develop a revenue-generating mechanism specific to—and built into—the SBLA program. In view of genuine capital market failure, fees represent inappropriate application of the benefit principle or, especially, the user-pay principle of taxation. It's not like we're setting a fee on water or natural gas. We're setting a fee on a program that is designed to correct a problem, and that in itself, I'm suggesting, may be ill advised.

There may be a better approach. If, for whatever reason, fees are to be applied, then I would suggest that to minimize both inefficiency and deterrence, fees should not be imposed unconditionally ex ante. Fees ought to be assessed ex post, conditional on successful investments, but not to subsidize losses. Ex post conditional fees may be construed as calls. Now, if I may move into the jargon of finance just a little bit, an ex post conditional fee is essentially like a call type of option on the earnings of the investment, written by the borrower and held by the guarantor. If a firm is successful and if it survives, the call expires “in the money”. In other words, the call itself has value because the firm has value and the opportunity to have some of its earnings later on is a valuable thing to have, whereas if the firm fails, the call expires with zero value—no fee.

Fees based strictly on ex post positive performance, which is bound to include some economic grants, some excess profit, some of the gains from being a fortunate winner—which has been supported by the program itself—would mitigate some of the deterrence effect that otherwise arises with unconditional ex ante fees. This is roughly the idea behind a forgivable loan. Ireland, perhaps the most successful in this line of industrial promotion, uses forgivable loans as the mainstay of its programs.

I acknowledge—and this gets us into technical issues which I will explore if you wish—that securities with so-called embedded options are a relatively costly means of finance, and that's what I am proposing. In this respect, the conditional fee-as-call fortunately is a limited call with maximum value equal to the required fee. In other words, if a firm is ultimately in a position to reimburse the cost of the guarantee, then so be it. If it doesn't, it doesn't have to pay it because it has failed, and there's nothing in the process itself of an upfront fee that would discourage commitment to the program.

In view of the long-standing use of fees, together with the fact that they are almost universally found in programs similar to the SBLA in other countries, I feel an obligation to search for a justifiable reason for fees. Perhaps it is to dissuade the nuisance, the ill-prepared applicant, or at the other end of the spectrum, to discourage the free riders, the borrowers drawn to the program without a genuine need for a guarantee. Such defences, I would argue, are spurious.

Indeed, if those are in fact reasons for fees, it would appear that fees are primarily for the benefit of the lenders and that they deter the development of proper administrative procedures. The requirement to prepare a clear and a complete application—an exercise that is the responsibility of the applicant and that bears unambiguous costs akin to a fee—ought to enable lenders to effectively and efficiently assess the merits of the application and the creditworthiness of the applicant, to dismiss the non-starters quickly and to reveal free riders.

In other words, separating wheat from chaff should not involve penalizing or laying a fee on both the wheat and the chaff. Banks are in the business of reviewing loan applications. They are doing it with increased efficiency. It has increasingly become a highly technical process, highly dependent on computers, for example, and I do think that's the stock in trade of banks.

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In short, if there is no market failure, there is no need for a market-correcting program and no need for a fee. On the other hand, if indeed there is a financial market failure and such a failure justifies mediation of the government, the prescriptive program then serves a welfare-enhancing public policy purpose that ought not to be compromised by the requirement that it be self-funding. That is the key point of my address today. To my mind, as a financial economist I see no particular reason to argue that the program itself should be self-funding. That it is self-funding is consistent with the vogue in public finance, but in this particular case it is ill advised.

This, then, leads to my final and more general comment. The focus of our attention is the technical detail of the program. However, loans sought by small business and the difficulties that borrowers and lenders face represent only one of a larger set of issues in finance facing small and medium-sized firms.

Perhaps today it is beyond the purview of this committee's current concerns with the SBLA, but in my view, the best direction for constructive and effective policy to support the dynamic, innovative and risk-taking small business sector is to encourage equity finance as opposed to debt finance. There is a conventional four-step sequence from founder's equity, levered by guaranteed bank debt—that's where we are right now with the SBLA—onward to angel finance, then into venture capital and finally to an initial public offering. This is the sequence that is so crucial to the establishment and then the growth of small business.

In fact, there is a close parallel between the negative effects of the fees for guaranteed loans and the regulatory requirements in equity markets for fledgling firms. For example, the market for angel capital is burdened with the requirement, subject to some exemptions, of course, that the company in which an angel wants to invest must prepare a detailed prospectus. The cost and the effort to prepare a prospectus are formidable for small firms—lawyers' and accountants' fees and valuable executive time—whereas the formal documentation that results from this effort is generally not crucial to an angel's decision to invest.

The purpose of the prospectus is to protect the uninformed. Angels, of course, are sophisticated investors who are generally highly informed about the technology, production and markets relevant to the firms that interest them. Similarly, returning to our main point, the delivery agents in the SBLA-CSBFA network are sophisticated credit analysts whose financial acumen is the most effective element in the integrity of the guaranteed loans program.

That's the end of my brief. Thank you very much.

The Chair: Thank you very much, Professor Brean. I'm sure members have a number of questions. I'll begin with Mr. Pankiw.

Mr. Jim Pankiw: Let me start by saying that I agree with most of what you've said, but I don't understand why you would propose this ex...what do you call it?

Prof. Donald Brean: I called it an ex post, which means after the fact.

Mr. Jim Pankiw: Okay. Why are you proposing that? It's still a fee; it's just after the fact. If fees are wrong, they're wrong. You're still penalizing the successful ones and you're going to be using that money to subsidize the program or to in effect subsidize the loans that defaulted. I agree with everything you've said, but I don't think you should have proposed that.

Prof. Donald Brean: Okay. Let me put it this way: I did preface it by saying “if they must be”. In other words, if we're locked into the mindset that says there has to be some revenue drawn from this, then this is a better way of doing it.

Mr. Jim Pankiw: Sure. But ultimately you'd say “don't have it”.

Prof. Donald Brean: Yes.

Mr. Jim Pankiw: Okay.

Prof. Donald Brean: But remember, I drew a parallel with forgivable loans. A forgivable loan is one that sometimes is construed as a giveaway, as one that will create incentives for those who don't have creditworthiness to come in and get these loans because they know they might not ever have to pay them. That's not the point. One of the most successful programs, the one in Ireland that I referred to, is based mainly on this.

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I was saying that if we must have a fee in place at all it should be after the fact, ex post, because if it's upfront, it imposes a burden on cashflow. In other words, it's a drain on cash at the stage where a firm is already struggling. So I was saying that at the very least it ought to be delayed well into the life of the firm, when it has established its success. If it hasn't established its success, it would fail, it would go. That's the reason.

Mr. Jim Pankiw: I guess my next question is for you, Madam Chair. Why is Professor Brean here now? This seems a little late, doesn't it?

The Chair: Mr. Pankiw, we had a number of discussions at committee, and a number of members of the committee raised concerns about Bill C-53. As you know, government legislation is constantly changing. In light of the fact that the draft regulations as proposed are not the regulations that have come into effect, we've done our own report suggesting that the government needs to more closely monitor the results of Bill C-53. We decided to pursue this conversation with three professors. That's why you have the other two briefs. We'll continue, as part of this committee's responsibilities, to monitor small and medium-sized business financing. Bill C-53 is part of that.

Mr. Jim Pankiw: Good, because he's right on track here.

You also raised the point about equity financing as opposed to debt financing. That's where the industry department and the government in general should be looking to improve businesses' access to their own equity as opposed to having more debt. That was where I had problems with this whole program in the first place, which you know.

Anyway, I thank you and I have no more questions.

The Chair: Thank you very much, Mr. Pankiw.

Mr. Lastewka.

Mr. Walt Lastewka: Thank you, Professor, for being here today. As I listen to your report and think of the SBLA and the CSBFA and discussions that we've had all along, the question becomes, what would happen if we didn't have a program like this? I'd like to hear your comments. What are some of the other alternatives that we should be looking at or monitoring in different countries in the future? You mentioned Ireland and forgivable loans. Maybe you could expand on that just a little more so I could have a better understanding of it.

Prof. Donald Brean: All right. You ask what the alternative is. The first obvious alternative to this program is no program at all, no government mediation in the process of bank lending into small firms. I can find you many knowledgeable people in finance who would say that is probably the way it should be, that banks are in the business of lending, of protecting themselves, of assessing credit risk and of putting impositions on loans to ensure that from the borrower's point of view there is good, prudent and responsible behaviour. That's what banks do, they would say.

One asks, then, why the program is in place. The program is in place because some people feel that in the lending process there is a fundamental bias against small firms. Again, that's not a point that's obvious to everyone. It's not immediately obvious to me that such is the case, but there is one particular argument that I made explicit in my brief, and that is, there is a fixed cost of administering a loan that is larger relative to the size of the loan for small loans and small firms than it is for large ones. So to some extent, this program is coming in and addressing that and saying that we will help alleviate that.

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But the alternative to a program such as the SBLA is not going to be fine tuning, because this particular program has been around for 37 years, it has been fine-tuned over those years and it is very similar to a large number of programs elsewhere in the world. It basically says that the government will come in and commit to the lender that it will bail them out on small loans if they should fail.

An alternative might be government support of syndicated loans, of a portfolio of loans, that are carried out by the private sector. Policy could then generally support that process of syndication of developing a large portfolio of loans to small business. Structurally that's a different program than the one we have in place.

I mentioned Ireland. Ireland's programs are recognized around the globe as being very effective in attracting industry, both large industry and small industry, because there is very substantial support of new industry in Ireland. That support is not just in the forgivable loans program but in tax policy, export policy and education policy.

When we isolate one particular program, such as the SBLA, it's something that...the merits in its own right are questionable. If it is to operate as we now have it, I would say that we should reduce or eliminate one particular facet of it that I don't think is right, that which has the aspect, the nature, of a tax. I'm before you today simply saying, “If it is being redesigned, pull that component out and then proceed with it as it is.”

The Chair: Thank you, Mr. Lastewka.

Madame Lalonde.

[Translation]

Ms. Francine Lalonde: Thank you very much, Mr. Brean. This is extremely interesting. I too would have preferred hearing you when there was still time to propose amendments to the legislation.

Professor Brean, I would like to state at the outset that my background is in history, including economic history. When I saw how this program of loans to small businesses evolved, I felt that Canada had used it as an adjustment program. This program has been used in Canada as a counter-cycle measure even if that's not stated out loud. In periods of recession, conditions for access to credit were relaxed and when prosperity returned, the program was tightened. That was done on a few occasions. That surprises no one who has studied the history of the economy.

What I greatly appreciated in your presentation is that you've helped us in specific ways to see how this type of loan can be more effective. It corrects the assumed market errors, but at the same time, and this is what is of great interest to me, it means that companies that don't need the program or banks that might fob them off in that direction will not be tempted to use it. If someone doesn't really need this program and is sure that he will pay extra fees for it, he may decide not to use it. This is a kind of information that's not always given to lenders right now. Sometimes, the banks give them no other choice than to use the small business loans program even if it's more expensive.

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Basically, you are helping us design a program that will meet the desired objective more specifically. Is my understanding correct?

[English]

Prof. Donald Brean: Thank you for those responses. Perhaps I have most to say concerning your point about this program being used as a facet of countercyclical economic policy. I know that it has been used that way, at times quite aggressively, and I don't think that this is the forum of countercyclical policy that would most effectively achieve the objective of levelling out or smoothing out cyclical patterns in our economy.

It's targeted to a particular sector of the economy that has its own cyclical pattern, which is not necessarily in line with the cyclical pattern of the national economy. It is not a generally available program and it operates in ways that I don't think are the best interventions by policy-makers to manage business cyclical behaviour. I think that to some extent it's an abuse of a program primarily designed to correct a market failure, because the market failure is not in itself a cyclical market failure.

On your other point about the free rider, the idea that the government or a government program ends up guaranteeing loans to firms that perhaps don't need it, if I understand you correctly, you're saying that becomes the defence of the fee structure—if that's what you're suggesting—and I think I acknowledged that in my brief. That then suggests that if it's a penalty to those who can otherwise raise capital, the more creditworthy firms would not use this program. I would suggest that banks ought to be able to identify such firms easily. That's what banks do. Banks ought to be able to identify firms that are strong enough, firms that have sufficient cashflow, sufficient financial strengths and sufficiently strong records of borrowing, that they can borrow without resorting to the government guarantee, and they can be advised to do that.

I would suggest that if banks were required to do this more—my own students are moving into the banking sector and designing systems that monitor creditworthiness and credit records—banks would come in and be part of the process that would not let the free riders free-ride.

The Chair: Madame Lalonde.

[Translation]

Ms. Francine Lalonde: The issue of access to credit for small businesses is very important, and I imagine that you have examined it. If you will allow me to depart from your text somewhat, I would say that I suggested to my colleagues that we send a questionnaire to small businesses in our ridings. One of my colleagues took advantage of one citizen's knowledge to conduct a proper study, a true professional survey. One of the questions was as follows: “In your experience, do you feel that if small businesses had greater access to affordable credit and business counselling, they could develop more easily and go bankrupt less frequently?”

The responses were very interesting. We see that business owners who have owned their company for a long time feel that access to credit is more important, whereas women entrepreneurs, for instance, feel that business counselling is the most important point, especially in the early years.

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The rate of response of small business owners was very high. Some of these small businesses had been in existence for ten years and others for two years. What's striking is that over 60 p. 100 of these people say yes to both points: if there were more business advice and more affordable credit, there would be fewer bankruptcies and businesses would be more prosperous.

As a university professor, do you have any advice to give the government and all those who seek to improve the industrial and commercial fibre of society?

I know you'd need a whole course to answer, but...

[English]

Prof. Donald Brean: First, I want to commend you or the others who asked those questions and drew out those responses. I find what you have just said about the responses from the subset, the women entrepreneurs, very insightful. I agree with it. I've heard it before in other contexts.

Just to summarize your comments, what entrepreneurs are saying is that rather than simply having lower-cost credit, what's really needed is an understanding of management, which includes marketing, production, retailing and managing the human resources within a firm—just basically understanding how a good business operates. A good business then generates a strong cashflow, manages its costs, controls its revenues and knows what works and doesn't work. Finance is only part of that, because you need finance as part of the liquidity for a firm.

So taking those points that you made so clearly, I'm pleased to see that it is the orientation of entrepreneurs, and it is also consistent with my point that if finance is lax and easy and not subject to strong tests of creditworthiness and strong tests of business's ability to service a loan, simply reducing the cost of credit—for which there are many devices other than the SBLA—is not serving a good purpose.

I would say that anything that is within Industry Canada's purview to enhance the understanding of good practices in management—in marketing, in production and in management of human resources, as well as in management of finance—would be a good thing and would support business.

The Chair: Thank you very much, Professor Brean.

Thank you, Madame Lalonde.

Madam Jennings, please.

Ms. Marlene Jennings (Notre-Dame-de-Grâce—Lachine, Lib.): Thank you, Madam Chair.

Professor Brean, I really enjoyed your presentation. I'd like to address the section where you talk about the sequence of finance. You talk about the conventional four-step sequence, from founder equity to guaranteed loan to angel-financed venture capital and finally the initial public offering.

You make the point that if we're simply looking at the guaranteed bank debt as part of a sequence and SBLA falls under that, the issue of having a fee ex ante acts as a barrier. Then if we move to the next step, which is the angel financing, the requirement of having a prospectus, which involves significant costs to small business, also acts as a barrier.

What would you suggest if you had a wish list? We already know your wish list for the SBLA: that there is no fee ex ante, that if a fee needs to be imposed, if there's justification for it, it should be ex post for those firms that in the end are in fact successful and can bear the cost. In that way it's not a deterrent. So in terms of the financing other than that aspect of the sequence...?

Prof. Donald Brean: With respect to the second step, angel capital, for example?

Ms. Marlene Jennings: Yes.

Prof. Donald Brean: All right. I would like to acknowledge some work that's being done by colleagues of mine at the University of Toronto in the law school, where Professor Jeffrey MacIntosh has done work with Professor Jacob Ziegel.

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These two professors of law worked last year preparing a document for the Ontario Securities Commission in which they looked at exactly this particular point of the burden on the angel capital process in regard to firms having to prepare a detailed prospectus for angel capitalists. We know that there are many exemptions to the requirements of a prospectus, but those exemptions are not as broad as I think they should be.

I believe that the important source of equity capital for small firms, especially in the areas that are so innovative—technology in particular—that it takes a high degree of skill to be able to seek out or tease out, those investments that have greatest potential...that's what angel capitalists do.

But if by the same token the firms that are seeking angel capital have to go through this very costly exercise of preparing a prospectus when in fact there are angel capitalists there who are willing to provide equity capital in that second stage, the prospectus requirement is simply burdensome.

I would suggest that with respect to the proposals that are before the Ontario Securities Commission—I know Ontario is better than the others and often leads the way for the rest of the country—if they paid very careful attention to the to the MacIntosh-Ziegal proposals to reduce the burden of the requirement of raising an extensive prospectus, the angel capital market would in itself develop.

I would like to say one other thing that I think follows from what you are saying and is also consistent with what I feel about reducing the burdens that are placed on the process of getting equity capital to growing firms.

I returned not long ago from an international conference looking at natural resources development. I was asked to talk about the finance and taxation of natural resources development in this country. Now that's not highly technically sophisticated activity, but it's extremely important to us. Canada is now the international leader in equity finance for the natural resources sector's extractive industries.

Why? It's obvious. Canada is a country whose economic heritage lies in the ground relatively more than any other country in the world. We, then, have developed a subset or sub-part of our financial system that is able to go in and find out the risks, the cashflow fortunes of natural resources extractive firms, and we have been very good in developing the instruments to finance the natural resources sector. Now we are exporting capital in that way, but we're also exporting financial expertise.

Likewise, if the private part of the financial sector is encouraged to find good investments, recognizing that many will fail but that it's just part of the process, then, I think, our whole system would be better.

If you want to see consistency in my remarks, it is here: remove regulation, remove barriers and remove taxes or impositions on that process of getting capital into small firms.

Ms. Marlene Jennings: Another question: what's your view on employee stock ownership programs as a means of raising equity?

Prof. Donald Brean: I don't have strong views. I know that often they are tax driven, and I also realize that from a diversification point of view employees who end up investing in their own firms are actually reducing their diversification. I think we could demonstrate that it ends up being a less efficient way of managing the risk to the capital of this type of investment, but beyond that I don't have a lot to say.

Ms. Marlene Jennings: Do you know anything about the studies that show it actually increases productivity rates?

Prof. Donald Brean: No, I don't.

Ms. Marlene Jennings: Thank you.

The Chair: Thank you very much, Madam Jennings.

Mr. Jones.

Mr. Jim Jones: I have a few questions, but I just want to continue with that last question. A good example of stock ownership is Microsoft. They started out very small, with half the salaries of their employees in stock, and now they're worth a trillion dollars, market value. Maybe that's a good example.

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Have you done an analysis of our portfolio of people that we loan money to under the Small Business Loans Act and those in Ireland's program? Is there any difference in the type of loans that we're giving out with respect to the profile of the people?

Prof. Donald Brean: I certainly haven't studied it. I have studied the Irish system of finance-based industrial support and looked at the tax concessions within it plus the types of finance that they extend. The Irish were very eager to attract foreign investment and, in the early stage of the thing, many of their programs were directed to foreigners. The idea was that foreign firms—especially those from either America or Japan—wanting to go into Europe would be well suited to be in Ireland and then use Ireland as a launch pad into the rest of Europe. There was this very decided Irish-export bias to their programs. There was also a high technology bias to their programs.

But the SBLA is really focused on small firms not necessarily exporting, so I don't think one could push too far in seeing parallels between the Irish system and the Canadian system in general. But there were some principles within the Irish system that I thought were worth bringing up, that is, the idea of the forgivable loan.

Mr. Jim Jones: What I was trying to get at is whether you feel we should be financing working capital. Earlier you mentioned high tech, its innovation needs and angel developers. A lot of people I talk to say that angel and venture capitalists basically in some ways want to take half your business in order to finance your venture. Do you think there is a need there—a gap—for financing operating capital? If so, do you think government should help out in that area? If you think government should help, in what way?

Prof. Donald Brean: I would not want to extend the program into financing of working capital. The financing of working capital is a much more complex financial arrangement. It has to be much more liquid and much more flexible, and often it is financed by trade credit. So having a longer-term loan, such as those under the SBLA or any variant of it, moving into working capital is not something that I would propose. I just think that there is a system out there for financing working capital for ongoing operations and that's what we should stick with.

One thing I do see within the new program is an extension into capital leases, and that I would endorse. If this program is to be in place, it makes sense to me to have it encompass capital leases, as I see that it is.

The Chair: Is that it, Mr. Jones?

Mr. Jim Jones: Yes.

The Chair: Are there any other questions?

Professor Brean, we want to thank you very much for being with us today. We're sorry that you had to take us on all on your own, and we appreciate the thought that you put into your paper and your comments here today. As a committee, we take this issue of financing for small and medium-sized business very seriously. We meet with financial institutions from time to time and we're diligently going to pursue Bill C-53 and the follow-up thereto.

Prof. Donald Brean: It's been my pleasure. Thank you.

The Chair: The meeting is now adjourned.