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Part I – Mind the Angle Shooters

The more dangerous malefactors are the men in high places who take a good property, overcapitalize it, appraise its value at many times what it is worth, use artful publicity and market methods to beguile the public into believing the stock is worth par or more, and foist it on investors at a figure which robs them of great sums of money.

It was inevitable that I would start out this series of short articles for accredited investors[1] with a consideration of George Rice’s 1913 autobiography, My Adventures with Your Money.[2] My non first-edition copy of My Adventures is of the tattered, coffee-stained variety found only in a ‘well-used-bookstore’. By infinitesimal odds, I tripped over it (together with a teetering stack of other books) in a popular San Francisco bookstore in 2015.

Rice (real name Jacob Herzig) was, by his own admission, an early 20th century US confidence trickster and crooked racehorse tipper, turned mining company promoter and master securities manipulator; a true swindler’s swindler. My Adventures includes his first-hand accounts of misrepresentations he and others made and methods they used to artificially inflate the prices of securities in Nevada and California gold, silver and copper mines during the early 20th century mining boom.

A number of the mines Rice promoted and sold shares in were no more than rudimentary shallow workings. ‘Prospect’ properties held even more dubious value. While there had been some success in frontier mining, profitable ore deposits were in short supply and initial offerings were hard to come by. Enter Rice and his colleagues. The public, enthusiastic from Rice’s artful advertising, subscribed for new shares or bought existing shares on exchanges, including the unregulated and fertile ground for shady operators, the New York Curb Market.[3] Investors threw their money at Rice and others for securities, at far more than the true value, if any. To use Rice’s words in relation to one company, the investors were to be ‘fleeced to a finish’.

Fortunately, 103 years after Rice wrote My Adventures, it is safe to say there are fairly robust securities laws to prevent and punish the type of outrageous misrepresentations that he said he made. By and large, those securities laws promote and maintain fair and efficient capital markets. However, now, as then, misrepresentations[4] artificially inflating the true value of securities will be made, whether innocently or fraudulently; and, when corrected, fortunes may be lost. If the issuer is not a reporting issuer, the question is then whether too much was paid to acquire the shares, and if so, how much? If the issuer is a reporting issuer, the question as to true value may be subject to the published market, if any, reflecting the change of information in the price of the securities. In either case, the next problem is what to do about it.

I have a tendency to fold corners of pages and pencil commentary into the margins of certain books that I like. That way, I can come back to a memorable passage easily. I am normally restrained in volume, but not so with My Adventures. A bevy of Rice’s warnings to would-be investors[5] are still relevant today. The crux of each warning is the same and can be summarized as: insidious misrepresentations are easily made and the true state of affairs may not always be disclosed.

The continued relevance of Rice’s central warning is, I believe, most acute for accredited investors who acquire securities under prospectus-exempt offerings. Ontario law assumes accredited investors do not need prospectus-type protections (i.e. they do not need full, true and plain disclosure of all material facts relating to the securities issued or proposed to be distributed). According to the Ontario Securities Commission, there are two related assumptions behind that. First, accredited investors are sophisticated, having regard to their investing experience and knowledge. That is, they are capable of obtaining expert advice and analyzing information needed to assess an investment without a prospectus. Second, they are able to withstand the loss of their entire investment if things go wrong.[6]

The legal effect of the main assumption is that, while accredited investors are given the contractual freedom to determine and negotiate the extent and form of offering disclosure they receive, they are on their own when it comes to analyzing and determining the sufficiency of that information. Similarly, the extent and form of offering disclosure they receive (i.e. no disclosure, term sheet/subscription agreement or offering memorandum) will influence the private rights of action they may have to seek redress for misrepresentation. By extension, there are litigation hurdles attached to some rights of action and not others. Such hurdles might include the need to prove reliance, negligence, fraud or some other culpable state of mind to obtain an order for damages or rescission.

It is appropriate to point out that not all investment failures are attributable to misrepresentation. As Rice correctly put it, big financiers are apt to make mistakes and so are little ones. The same applies to promoters and other insiders. Unrealized expectations, without more, do not mean that someone is a crook.[7] However, from my perspective, Rice’s warnings together with the fact that actionable misrepresentations are still made in the new millennium drive home the old adage that the best defence is a good offence.

Accredited investors constitute the largest source of capital in Ontario’s prospectus-exempt market. In 2014, they accounted for 92% of the $41 billion in prospectus-exempt capital raised in the province.[8] In my view, despite the passage of over a century, accredited investors should: (a) still reflect on the possibility that misrepresentations happen and they might be a mark for the unscrupulous, and (b) consider the litigation implications arising from the type of offering disclosure they receive. (b) is critical inasmuch as it responds to (a). Essentially, what (b) requires is that accredited investors, before acquiring prospectus-exempt securities, consider and/or take advice on whether they should mitigate, need to mitigate, have mitigated or substantially eliminated litigation hurdles that they might face in the prosecution of a private right of action for misrepresentation.

The litigation hurdles that may exist, why they should be considered and how they can be avoided, including by recording reliance and/or negotiating for expanded contractual rights of action, will be explored briefly in the next three parts of this series, hopefully with as much history.

[1] An “accredited investor” is defined in s. 1.1 of National Instrument 45-106, Prospectus Exemptions (“NI 45-106”).

[2] The Ridgway Company, Gorham Press, Boston Mass, USA.

[3] In 2010, Christopher Gray, author of the now discontinued Streetscapes column of the New York Times, cited early 19th century journalist Edwin Hill as “having witnessed [on the Curb Market] a man offering 40 shares of a cocker spaniel at 10 cents a share. After the animal’s price rose to 23 cents per share, he handed it over for $9.20 to a gas specialist.” See http://www.nytimes.com/2010/10/03/realestate/03scapes.html?_r=0

[4] The Ontario Securities Act defines a “misrepresentation” as an untrue statement of material fact or an omission to state a material fact that is required to be stated or that is necessary to make a statement not misleading in the light of the circumstances in which it was made. “Material facts” are defined as facts that would reasonably be expected to have a significant effect on the market price or value of the securities; Securities Act, RSO 1990 c S 5, s 1(1).

[5] Rice even cites former US steel magnate, Charles M. Schwab, for his lack of caution in investing in a certain frontier mining company.

[6] See: http://www.osc.gov.on.ca/en/21943.htm .

[7] My Adventures with Your Money, p 73, The Ridgway Company, Gorham Press, Boston Mass, USA.

[8] See https://osc.gov.on.ca/documents/en/Securities-Category4/nr_20151105_osc-proposes-four-capital-raising-backgrounder.pdf

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