March 11th, 2008

 

Title: Are Canadian investors being properly protected?

Sub-title: Recent financial scandals and fraudulent activities by high-profile public companies are only part of the problem.

 

Canadians are generally a trusting lot when it comes to the governments and organizations that pass laws, regulations and statutes. But when it comes to financial and equities markets, there is growing evidence that investors might be better off keeping their heads up.

 

That’s the picture that emerged during a day-long seminar held by the Quebec chapter of the Canadian Bar Association late last month which dealt with recent financial scandals in the province.  The failures of companies such as Norbourg, Mount Real and Northshield Financial, cost unsuspecting investors hundreds of millions of dollars and forced retirees who had lost their life savings back into the workforce.

 

“It is time that we take up the tools to fight better against economic crimes,” said Monique Jerome-Forget, Quebec’s Finance Minister and the event’s keynote speaker. “In the United States, Enron’s former president Jeffrey Skilling was condemned to 24 years and four months in prison. Bernard Ebbers from Worldcom and Denis Koslowski from Tyco each got 25 years. But here in Canada nothing happened in the Bre-X, Castor Holdings and Andrew Rankin cases.” The upshot, says Jerome-Forget, is that Canada needs to send a strong signal to world markets that the country will not tolerate these sorts of activities.

 

More than just a few bad apples

However according to some experts, the problems go beyond simple fraudulent behaviour involving just a few bad apples. There are numerous indications that widespread investor protection gaps litter the Canadian financial landscape.

 

Ironically, one of those key gaps is caused by turf-hungry provincial politicians, just like Forget, who refuse to agree to the formation of a national securities regulatory body similar to America’s Securities and Exchange Commission.

 

As a result, securities enforcement in Canada is left up to a slew of provincial bodies, with overlapping jurisdictions, confusing and differing guidelines, staffed by slew of well meaning bureaucrats, who love nothing better than to create new jobs and committees to “harmonize” the approaches of these various bodies. This slew of provincial regulatory bodies exacerbates the already-difficult challenges faced by law enforcement officials who need to battle constant inter-agency communication challenges coupled with overlapping federal and provincial legislation.

 

Auditors and international reporting standards

As bad as things are, according to one-time observer, things could get a lot worse if Canada, as expected, moves to adopt international accounting standards. While this may seem like a technical issue, the upshot of such a move would be that Canada’s public companies would have far more flexibility in determining just how much in earnings they want to report to the general public.

 

“International accounting standards are a joke,” says Al Rosen, a forensic accountant and a principal at Rosen & Associates limited. “Any time you get 100 countries to agree on a set of regulations, you have to accept a consensus that to some degree moves to the lowest common denominator,” says Rosen. “Instead of adopting the middle ground between America’s tougher accounting standards and what Canada needs, we are using rules suggested by countries like Trinidad and Barbados and many others, in which the tradition of corporate governance is weaker to say the least.”

 

According to Rosen, the weakness of international accounting guidelines was laid bare in the recent Banque Societé Generale scandal.  The French mega-bank, aided an abetted by its compliant auditors, charged billions of dollars of trading losses that it incurred as a result of activities by a rogue trader earlier this year (in 2008), to its 2007 results, in order to make its coming quarterly earnings reports look better.   

 

The biggest winners if Canada moves over to international accounting standards will be the country’s accounting firms. That’s because looser accounting standards are, the more flexibility they have in keeping their clients happy by allowing them to show the profit numbers they please.

 

Furthermore Canada’s accountants will for years be able to charge thousands of extra billable hours, due to the fact that public companies will be forced to maintain two sets of books as they transition from one set of rules to the other. However, if you believe Rosen, the biggest losers will be Canada’s investors.

 

America has problems too

Despite the fact that America has tougher accounting guidelines than Canada, that country has its problems too. And since many Canadian investors hold a disproportionate chunk of their international portfolios in U.S. securities, those problems flow up here.

 

In his annual letter to shareholders, which was released late last month, Berkshire Hathaway chairman Warren Buffet highlighted two key areas of concern which sound innocuous: the way companies account for stock options and for pension plans.

 

However because of the enormous latitude that U.S. congressman have allowed public companies in these areas, CEOs can now legally artificially boost their profits by simply increasing their estimates of the rate of return their defined benefit pension plans are expected to earn or by not expensing the stock options that they give out.

 

This is about as good as it gets

One of the greatest ironies regarding investor protection mechanisms in Canada is that despite how poorly they function, things aren’t much better elsewhere. For example a 2006 study by the World Bank and Lex Mundi ranked Canada 3rd among 155 countries studied in terms of its protection of savers. That same year, the OECD ranked Canada’s securities regulation regime 2nd out of its 29 member nations.

 

Furthermore, investing is by its very nature a risky business. Those that do so, to some degree undertake these actions at their peril.

 

That said, despite Canada’s limited success in these areas, there’s little reason for securities regulators, the auditing profession and lawmakers to rest on their laurels. Because they clearly could do a lot better.

 

Peter Diekmeyer (peter@peterdiemeyer.com) is Bankrate.ca’s Quebec correspondent.

 

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