Regulators are underfunded

Financial industry regulation is a business. And too often, regulators are unable to get the resources and funds they need to stay on top of their game.

Unfortunately, many wronged investors are unaware. Only after getting burned by lax securities enforcement, or weak accounting and auditing rules, do they realize they only need to follow the money to understand why they aren’t better protected from wayward execs.

Securities enforcement is widely regarded as being grossly deficient in Canada. When you ask the regulators themselves why they drop the ball, they will sometimes cite deficiencies in the law, or other procedural shortcomings, but the truth is, there isn’t enough money dedicated to enforcement.

That lack of spending is a conscious choice of the regulatory bodies themselves. They have a split mandate of paving the way for investment in the capital markets, while also protecting investors. It’s a delicate balance, and one that is arguably impossible to maintain, especially when money is the measuring stick of success.

The largest corporations in Canada push back against greater scrutiny. Companies simply don’t want to pay higher listing fees in order to maintain surveillance on companies that may be circumventing the rules.

The corporations relay this message: There are only a few misbehaving companies anyway, so why should everyone have to pay the price? While nothing could be farther from the truth, the regulators like how this message plays, because they are also responsible for portraying to the international community that Canada is a safe place to invest.

Money is throwing its weight around here. The corporations are spending the money, so they have the greatest voice. Investors, on the other hand, are not giving any money directly to the regulators, so their interests are greatly diminished. Strangely, this never comes back to bite the regulators, because if they don’t do the work, it rarely comes to the attention of the public. They can, if they desire, essentially represent a passive roadblock to companies being accused of wrongdoing.

This situation is mirrored when it comes to accounting and auditing for financial statements. Auditors know corporations, not investors, pay them. Worse, the accountants are allowed to set the rules they are responsible for upholding. This creates a classic conflict of interest because the accountants can simply set more pliable rules, which make their paying corporate clients happier.

Naturally, this is bad news for investors because the companies can stretch the bounds of acceptable financial reporting. This never creates a backlash against the auditors, because the overriding legal precedent in Canada for the last 14 years is that auditors do not owe any duty of care to investors who rely on audited annual financial statements. That means investors cannot sue auditors for signing off on misleading annual reports.

The longest case

But at least in this regard, the situation may be changing for the better in Canada, thanks to a recent court decision in a case 20 years in the making. The lack of protection for Canadian investors is summed up perfectly by the case of Castor Holdings Ltd., which at present is little known to most investors. This may well change due to the far-reaching implications of the Quebec Superior Court decision of April 15, 2011.

Castor Holdings was a real estate investment company that collapsed into bankruptcy in early 1992. The insolvency came as a complete surprise to investors because the audited financial statements had for years portrayed Castor as hugely successful. As it turned out, the problem was with the financial statements, which were completely detached from reality.

The man at the centre of the controversy, Castor co-founder Wolfgang Stolzenberg, has been sought by the RCMP on fraud charges for decades. He is believed to be still living in Germany, and stands today as yet another failure of white-collar criminal prosecutions in Canada.

The more compelling side of the case, however, is the civil charges against the auditors of Castor for failing to perform adequate audits and ensure the financial statements were free of material misstatements. The stakes in the case are enormous, even by international standards.

The audit firm Coopers & Lybrand (now part of Price-waterhouseCoopers) and dozens of its senior partners were named as defendants in upwards of 75 cases that were filed in the years after the collapse of Castor. Those cases were put on hold as one of them proceeded through the courts as a test of the broad merits of the complaints.

In total, the original cohort of cases sought roughly $800 million to $1 billion in damages from the auditors. Since that time, interest and legal costs have likely brought the total closer to $1.6 billion, for which the audit firm and its partners may be responsible.

The test case, brought by the estate of Peter Widdrington, former chief executive of John Labatt and chairman of the Toronto Blue Jays, was filed in 1994 and eventually came to trial in 1998. Legal observers originally expected the case to be over in eight months. Instead it took over 12 years, in what is believed to be the longest court battle in Canadian history.

While there were unexpected delays, including the resignation of one judge due to health reasons, much of the extensive foot-dragging was due to procedural wrangling and the minute examination of every conceivable detail. In fact, one witness testified for the better part of four years. The delays were really a testament to the stakes for the auditors. While the plaintiff in the test case (Widdrington) stood to gain $2.7 million plus interest and costs, the auditors feared the ultimate payday, which could be billions of dollars when all is said and done.

The decision

The decision finally came down in mid-April, and is regarded as an all-out win for the plaintiff, a likely win for the plaintiffs in the other Castor cases — and possibly a win for investors in general.

The full implications of the case will become clear over the next few months, as the decision — over 750 pages in length — is digested by both sides and the legal community as a whole. An appeal is likely to be filed by the defence, and they may try to maintain that the facts could be different when it comes to fighting (or settling) the other 75 or so Castor cases. However, as it stands, the major findings are significant, especially when it comes to the common legal issues, including:

• 1. The financial statements for Castor were misleading and materially misstated for the years in question.
• 2. Coopers & Lybrand failed to perform their professional services as auditors for the years in question.
• 3. Coopers & Lybrand issued various other faulty opinions related to Castor’s financial position during the years in question (including valuation letters).
• 4. The plaintiff’s reliance on Coopers was reasonable, and as a direct result of the defendant’s negligence, the plaintiff suffered damages.

Perhaps most importantly, the Court indicated it would have come to the same conclusions had the judge needed to apply the common law of Ontario or New Brunswick (the province of incorporation). This is good news for the other wronged Castor investors, which include Chrysler Canada’s pension plan — with $200 million invested — alongside numerous Canadian insurance companies and credit unions, as well as several European banks.

In the end, it’s not necessarily an all-out game changer for the average investor, but it does offer some significant hope for investors across Canada. At the very least, it may spur the audit firms to perform their audits in a manner that is more accountable to investors, and to stop hiding behind the legal shield afforded to them for more than a decade.

Implications for advisors

However, the Castor case is also a cautionary tale for investors and advisors. The case took 20 years and millions in legal costs to bring to a conclusion. Investors were originally attracted to Castor because the financial statements reported a return on assets in the range of 15% to 20%.

In perfect hindsight, investors and their advisors would have questioned why the returns were so high, and whether something might be amiss. Unfortunately, given the dearth of protections in Canada, investors sometimes have to play it safe, and avoid investments that seem questionable despite being given the green light by the various safety nets that are supposed to protect them.

While the lay of the land may shift in the future because of the Castor decision, the status quo is still that the almighty dollar stops market regulators from giving investors what they truly need. From securities commissions to self-regulatory organizations to financial statement standard-setters, investors need to follow the money to understand how little protection they have.