Regulating against securities fraud

The United States Securities and Exchange Commission has been under tremendous public scrutiny over the still on-going Bernard Madoff “Ponzi-scheme” scandal. Indeed, the U.S. Congress has accused the SEC of chronic blindness in ignoring credible allegations about Madoff’s improprieties.

Unlike the SEC under current U.S. securities laws, Canadian securities regulators directly regulate, with minimal exceptions, fund managers that make the investment decisions for their funds, generally by requiring them to register as advisers (investment counsel and portfolio managers). As registered advisers, these firms must comply with requirements that are designed to provide regulatory protections and controls to safeguard client assets. These include:

• maintaining financial solvency through meeting required levels of capitalization, annual audited financial statement filings, and reporting to the regulators immediately if this capitalization is compromised

• maintaining a prescribed financial institution bond, which is fidelity insurance covering losses due to events such as fraud, employee dishonesty, loss of securities and counterfeiting

• operating to a fiduciary standard of care and managing conflicts of interest in the best interests of clients

• following prescribed standards of account openings, including know-your-client and suitability obligations

• retaining client assets with a qualified, regulated custodian

• ensuring all individuals who are involved in investment management decisions meet prescribed educational and experience proficiency requirements and

• maintaining a system of compliance and controls to ensure compliance with regulatory requirements and good business practice which system will be subject to periodic compliance examination by securities regulators.

Does this mean that a Madoff scandal is unlikely to occur within the Canadian capital markets?

The Canadian marketplace has not been immune from fraudulent activity. Canadian-made scandals like Portus, Norbourg, and Norshield, the investigations and litigation of which are still ongoing, all involve alleged fraudulent activity and improper behaviour by fund managers.

The recent notice of hearing brought by the Ontario Securities Commission against Oversea Chinese Fund Limited Partnership and others — including Weizhen Tang, the self-described “Chinese Warren Buffett” — reinforces concerns that the Canadian marketplace continues to be vulnerable to securities fraud. The SEC has also brought enforcement proceedings against Tang and his entities in respect of what the SEC alleges to be a multi-million dollar Ponzi scheme and affinity fraud targeting members of the Chinese-American community, primarily in Dallas, Texas.

As a result, the Canadian regulators are moving forward with increased regulatory monitoring of capital market participants, particularly fund managers.

In March, the OSC launched a focused compliance review (or “sweep”) of hedge fund managers in Canada, no doubt in direct response to the Madoff affair. The AMF has launched a similar sweep. The regulators are clearly concerned about the spill-over effect of the Madoff scandal into Canada. Although the regulators have in the past few years beefed up their compliance audits of registrant firms, this hedge fund sweep can be expected to be much deeper and far-reaching than past hedge fund reviews.

Canadian regulators are also moving forward to finalize National Instrument 31-103, Registration Requirements, which rule is expected to be published in final form in mid-July, for anticipated implementation at the end of September. Among the major reforms expected in this rule are requirements to: register fund managers; register exempt market dealers in all Canadian provinces; maintain increased proficiency requirements for registered individuals, and maintain increased capital and insurance requirements across all categories of registration.

More rigorous “fit and proper” registration standards will be imposed, as will an increased focus on compliance systems, including a registrant’s policies and procedures, and management of conflicts of interest. With exceptions for specific activities carried on by non-Canadian entities, no one carrying on the business of fund management, securities advising or securities trading in Canada will be exempt from registration or regulatory scrutiny under the new rules. Hedge fund managers in Canada that are not already registered will not avoid registration under this new regulatory regime. Contrast this to the on-going saga concerning registration of advisers to hedge funds in the United States, many of whom continue to be outside of the SEC’s regulatory reach.

Nevertheless, just as criminal laws do not prevent criminal activity, securities laws cannot be expected to stop fraudsters. Securities laws set accepted standards of behaviour and reinforce good business practices in order to ensure investor protection and to promote efficient capital markets. Even-handed administration of those laws by dedicated, knowledgeable regulators who are on the lookout for red flags tipping them off to improper behavior is vital to ensure that non-compliance and fraud is both detected, stopped and those involved punished, where appropriate.

This column includes elements from a guest column published in the Globe and Mail on March 9, 2009 written by Laurie J. Cook, Rebecca Cowdery and Ronald Kosonic, all partners at Borden Ladner Gervais LLP.

(07/03/09)