Canadian Investors’ Perceived Vulnerability to Fraudsters
A recent Globe and Mail article highlights the difficulty Canadian investors have in recovering proceeds of crime from fraudsters. Examining 30 years’ worth of regulatory enforcement proceedings, the Globe comes to the conclusion that Canada’s “toothless” regulatory system permits criminals to get “barely punished” and commit their financial crimes again. Focusing on repeat financial recidivism, the article quotes the former Bank of Canada governor David Dodge to the effect that there exists a “widely held perception that Canadian authorities aren’t tough enough” on financial fraud. In the words of Professor Douglas Cumming, Canada has a reputation for being a place where “no one ever goes to prison … for doing white-collar crimes.” The perception is not entirely true. For instance, Livent founder Garth Drabinsky was sentenced to seven years in jail for accounting fraud in connection with the theatre company he had founded.
Nevertheless, the Globe notes that the perception raises an important issue: “From low-level swindlers who bilk investors out of a few million dollars to some of the biggest financial scandals in Canadian history – such as Bre-X Minerals and others – the inability of regulators to mete out serious punishment in cases of securities fraud has raised questions about how much deterrence is actually taking place.”
Bre-X: Example of Regulatory Failure
Bre-X litigation offers a prominent example of the apparent inability of Canadian regulators to obtain severe penalties for securities fraud. Bre-X Minerals Ltd. (“Bre-X”) was a junior mining company. In 1989, its shares were listed on the Alberta Stock Exchange. Bresea Resources Ltd. held shares in Bre-X and was controlled by the directing minds of Bre-X. In May 1993, Bre-X and Bresea issued a press release stating that the property showed sufficient gold to yield an annual after-tax cash flow of US $10 million to Bre-X. Thereafter, Bre-X and Bresea issued a series of 160 press releases and other statements building on the favourable results in the first release. Starting in January 1994, Bre-X reported drilling results that gave investors reason to believe that its Indonesian properties contained one of the largest gold deposits ever discovered. The price of Bre-X shares rose from 50 cents in 1993 to more than $200 in late 1996. In fact, there were no economic gold deposits in Bre-X’s Indonesian properties. The gold samples had been “salted” (artificially contaminated) with gold. A massive fraud had been committed.
In 1997, Bre-X collapsed. Its shares became worthless, and many Canadians suffered substantial losses. Despite investigations by police and regulators in Canada and the U.S., those behind the scandal were never caught. No one was convicted for the fraud. (John Felderhof, a geologist, was the only former Bre-X official to face possible jail time. His legal proceedings before the Ontario Securities Commission on insider trading and spreading false information charges lasted from 2000 to 2007. Mr. Felderhof was acquitted on all charges).
Not only were there no convictions arising from the Bre-X scandal, but no one paid any money to the victimized investors either. The class action on behalf of Bre-X investors was largely unsuccessful. At its conclusion, only $3.5 million was recovered. Such a small amount was impractical to distribute to investors, most of whom would recover just a fraction of a penny on the dollar, and the funds were distributed to charity instead. Parallel US litigation was also unsuccessful.
Nortel and Foreign Exchange: Examples of Class Actions Success in the Face of Regulatory Failure or Inaction
In contrast, the criminal prosecutions in the Nortel litigation resulted in the acquittal of three former top executives at that firm. However, securities class actions in the US and Canada resulted in court-approved settlements.
Like Nortel, the foreign exchange litigation provides an example of how class actions can fill the gap left by regulatory action. Regulators in the U.S., U.K. and other countries have investigated and levied significant penalties upon a number of banks for allegedly coordinating trading activity in the foreign exchange markets through the use of electronic chatrooms. Several traders have been criminally charged in the United States in connection with the scandal.
There was no Canadian regulatory or criminal prosecution in connection with this alleged foreign exchange manipulation. However, class actions on the basis of similar allegations have resulted in large settlements which have been approved by the Courts (see: here and here). Foreign exchange litigation presents an example of the utility of class actions in the face of regulatory inaction.
The problem of the apparent invincibility of Canadian white collar criminals has numerous sources, including regulators’ limited budgets, the fragmented nature of Canadian securities enforcement regime, and the legislative restrictions placed on regulators’ ability to punish offenders. As Professor John Coffee Jr. notes in his book Entrepreneurial Litigation: Its Rise, Fall and Future, some observers also believe that regulators may feel politically constrained by the fear that strong enforcement would destabilize the financial markets. In this sense, private enforcement of securities law retains the “safety valve” function – it remains available even if public enforcers are unavailable to proceed against a particular target.
Role of Class Proceedings in the Canadian Regulatory System
Assuming the perception of impunity described by the Globe in the quote above, at least in part, the reality of Canada’s capital markets, class actions brought on behalf of defrauded investors offer an important additional enforcement tool. Class actions offer both an enhanced prospect of recovery for victims of fraud and the possibility of greater deterrence against corporate wrongdoers.
In a recent American study, Stephen Choi and A.C. Pritchard conducted an empirical comparison of SEC investigations and securities class actions. The authors found greater incidence of top officer resignation at companies that were defendants in class action lawsuits than at companies that only faced an SEC investigation. Further, the authors found that earnings responsiveness and institutional ownership declined more for companies that were defendants in a class action rather than an SEC investigation, suggesting that “private class action attorneys target disclosure violations more precisely than the SEC.” These findings indicate that class actions, and class actions combined with regulatory investigations, achieve greater deterrence than regulatory action alone. In addition, as noted by Professor Coffee, private securities litigation produces a significant deterrent benefit when it is directed at secondary participants in capital markets misconduct, including, most notably, accountants and investment bankers.
Of course, class actions are themselves subject to inherent limitations. Class counsel are unlikely to initiate litigation where the fraudster has dissipated the proceeds of crime or hid them abroad in a way that makes recovery prohibitively expensive. Class counsel also have far fewer investigative tools than Crown lawyers, and even fewer prior to certification. For instance, they cannot seek a warrant to wiretap the alleged fraudster’s communications to assist in tracing the assets. Nevertheless, in today’s resource-constrained world, class actions remain a necessary tool for the enforcement of securities laws and the recovery of assets obtained through fraud.