Wednesday, December 14, 2005

The continued unravelling of many business income trusts presents an excellent time to acknowledge Canada's ineffective investor protections.

In 2002, shortly after Nortel's implosion and the wiping out of several hundred billion dollars in Canadian savings, a Senate committee held hearings on what Canada should do to restore investor confidence.

The resulting report made recommendations for broad change and re-examination of the status quo. But, in typical government fashion, little action has followed in the two and a half years since.

Several problems led to the loss of investor confidence back then, including conflicted accountants and auditors, and research analysts following the lead of investment bankers, and pushing pro-forma, unregulated financial figures.

The Senate report addressed both fronts of the problem by recommending that:

(1) "Legislation be introduced that would obviate real or perceived conflicts of interest by financial analysts"; and

(2) "The federal government convene a meeting of all stakeholders to discuss the entity that should have responsibility for the setting of - and, importantly, revisions to - accounting standards and rules.

The government must take a leadership role in ensuring that the entity to which responsibility is given has the necessary independence, accountability and transparency to safeguard investor confidence."

However, checking the back of almost any equity research report today will show that investment banking clients still receive better analyst ratings than non-investment banking clients. Clearly the conflicts of interest have not been eliminated.

Not surprisingly, the Canadian establishment has continued to turn a blind eye to the conflicted nature in which financial reporting standards are set in Canada. The same group that in 1997 disclaimed any duty of care to investors, the Canadian Institute of Chartered Accountants, is still responsible for rubber-stamping the rules that their clients use to craft financial statements.

The latest insult is the complete lack of interest from the accountants in terms of regulating distributable cash reporting, despite that fact that the figures appear in the audited notes to the financial statements of many income trusts. The lack of action has been typical of the government's stance of allowing insiders to continue pillaging the savings of individual investors. The political atmosphere over the past decade has been to maintain weak securities legislation, permit power groups to set their own self-serving rules, maintain weak class action legislation and otherwise limit investor recourse alternatives, and above all, pretend that no serious systemic problems exist.

Given that attitude, it's no shock that we have seen a rebirth of investor manipulation using the same old tricks. Many business income trusts are severely overvalued because investment-banking fees are tainting analysis, and unregulated distributable cash figures are being used to support lofty unit prices. Oh, how far we've come.

It's staggering that no effective legislation has been introduced anywhere in Canada since 1997 to combat the Supreme Court of Canada's absurd decision that auditors do not owe any duty of care to investors. Amazingly, the court decided that annual audited financial statements were not to be used for shareholder investment decisions. Hence, auditors in Canada are free to sign bogus financial statements without fear of repercussions. Obviously, this has made audits mostly irrelevant, but nevertheless they continue to be a legislated requirement for public companies.

A tiny attempt at correcting this massive oversight has recently been made in Ontario with Bill 198. The parts of the bill dealing with civil liability in the secondary market finally come into effect in 2006, marking the culmination of a decades-long process. The new head of the Ontario Securities Commission, David Wilson, has declared this to be "a milestone in the development of market confidence" and "a cornerstone in economic competitiveness and prosperity." That's either an incredible exaggeration or an admission that nothing of consequence existed in the first place.

Claims that the new securities legislation will greatly help investors who buy stock in the secondary market are far-fetched for several reasons. For most cases, the prescribed limits on penalties will be less than the cost of launching a lawsuit for recovery. For more serious cases, investors must prove the existence of recklessness or willful blindness. In fact, many class-action lawyers see the new law as nothing significant from an investor perspective.

Besides the lack of political action and the delusional securities regulators, another weak pillar in the Canadian investor-protection system is our reliance on self-regulatory agencies. For the most part, self-regulatory has become synonymous with self-serving.

As an example, just look at the Canadian Public Accountability Board, which was the public relations response of the auditors and securities regulators to supposedly increase audit quality. While the independent U.S. auditing-oversight board has found many serious deficiencies in audits by the big U.S. public accounting firms, Canada's CPAB has amazingly whitewashed the activities of these same firms.

The only logical conclusion is that, aside from the odd bit of strength here and there, our current investor-protection system is beyond inept and needs immediate, major revamping. It's an international embarrassment that actions against high-profile Canadian scams are commenced in the United States, before they are pursued domestically, if at all.

Al Rosen is a forensic accountant at Accountability Research Corp., an independent equity research firm.
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