IFRS and D&O Insurance Implications

June 30, 2010

For many years (on and off) I have followed the writings of Al Rosen, principal of Rosen & Associates, a forensic accounting firm in Toronto, and of Accountability Research Corp., an independent research company “free from money management conflicts,” here and here. The first thing that caught my attention was the business card Al Rosen, PhD, MBA, FCA, FCMA, FCPA, CGA, CFE, CIP, CPA, CA.IFA.

From most of what I have read, he is not a big fan of some of the activities of the big 4 auditing firms, and I can’t imagine they are big fans of his. Mr. Rosen’s accounting firm seems to keep itself very busy with forensic investigation of accounting fraud and providing professional testimony related to auditors’ professional negligence. But instead of keeping his head down, thereby maintaining the flow of scandals and his firm’s future revenue, he is writing articles, speaking at events and looking for people who will heed his warnings about ‘financial tricks’, ‘corporate cover-ups’ and the environment that allows and supports this behavior.  But, if you are one of the people, and unfortunately there seem to be many, who believe that Canadian Corporate Management, and their third party advisors, are all trustworthy, (the ‘bad things can’t happen to you’ group I will call ostriches) then you probably won’t listen, and you shouldn’t bother reading his stuff, or mine.

Trusting your management team and advisors doesn’t automatically mean you are in the ostrich group, but to stay out of it you need to, 1) believe that not all officers, directors, and advisors are completely honest in mind or deed, and 2) create an environment and corporate culture that protects the corporation, its shareholders, the board of directors, and the management team, and 3) agree that a good risk management structure does not cast doubt on the management team, it protects them.

If you are in the group of trusting but cautious people, and are still reading, you don’t have to like or agree with what Mr. Rosen says to benefit from it.

At a recent breakfast seminar for the Institute of Corporate Directors, Mr. Rosen reminds us of a very important precedent-setting case in Canada, Hercules Managements Ltd. v. Ernst & Young, here. I find it very interesting that this case has been cited 492 times, making it one of the most cited in Canada. I encourage you to read it because my summary is extremely short and will miss important points. Hercules is a case of accountant alleged negligence and accountants’ duty of care to the investors in the corporation audited by the accountant. The conclusion was the accountant owed a prima facie duty of care to the investors, but such duties are “negated by policy considerations”, “would be to expose auditors to the possibility of indeterminate liability” and “would amount to an unacceptably broad expansion of the bounds of liability drawn by this Court in Haig, supra.” (see case above)

Mr. Rosen suggests this case effectively removes any direct relationship between the shareholder of the corporation and the outside auditor of the financial statements of the corporation; and this, along with other case law upholding audit restrictions and disclaimers, and the strength of the auditors’ Self-Regulating Organizations (SRO), leaves “Directors to assume the “Shareholders’ Auditor” position.”

The connection to IFRS in this post will not do justice to Mr. Rosen, so I have attached a few articles, here, here, here. But, what I see as the theme: 1), IFRS takes a big step back from current North American accounting standards, 2) the gap between financial reporting and corporate performance measurement will become too large, 3) increased flexibility for management’s interpretation regarding revenue recognition (quality and timing) and cost of assets will weaken, not improve, comparability, and 4) all of these issues will make accountability and liability of auditors and management more difficult to determine, at the expense of investors and directors.

The key concern is that if the final implementation of IFRS actually creates too much reliance on broad principals, and leaves too many financial statement values open to the interpretation of, and assumptions by, executives, the size and likelihood of future scandals will increase. Arguments by IFRS proponents, that the transition to IFRS should be easy for Canadians because we already work in a ‘principals’ based system (vs the U.S. being ‘rules’ based), would suggest that we have no accounting rules. That is simply not true. Our history of major financial failures have provided us valuable experience and resulted in ‘rules’ to help plug the loopholes in our accounting principals. Al and Mark Rosen, in their four part series on IFRS in the National Post, “Financial Reporting in Canada Steps Backwards”, here, provide the example, “After the failures of two Canadian banks more than 20 years ago, our accounting rules were changed. We plugged loopholes that allowed uncollectible mortgages to remain on balance sheets at seemingly unimpaired values, and interest revenue to be recorded on bad loans. Without such clear requirements to report default and late payment rates and collateral values, troubled companies can appear healthy for years. This is precisely the sort of illusion that IFRS will invite again to Canada.

Some of the key areas where too much flexibility can be dangerous, 1) ‘fair-valuing’ of long term assets, make debt to equity and ROA ratios less useful, 2) allowing only two years of historical financial statements when assets are revalued, 3) “recognition, amount and timing of assets impairment charges, which are critical to establishing profitability”, 4) transparency of related-party transaction, because “inadequate related party measurement is already an epidemic under Canadian rules”, and 5) revenue recognition,  because “we have already been told of cases where revenue under IFR is higher than what is allowed under Canadian regulations”

The connection to insurance in this post will be directed at Directors’ and Officers’ liability insurance (D&O), rather than Fidelity (Crime, Fraud, Employee Theft, Financial Institution Bond) insurance, because there is far less public information about Fidelity insurance payments, probably due to privacy laws and the ‘first party’ nature of this coverage, vs the public lawsuit and ‘third party’ nature of D&O. And, a fidelity discussion would make this post far too long.

Difficulty determining accountability and liability will not reduce the number of lawsuits and will not make them cheaper to defend or settle, at least in the short run. And based on the current frequency and severity of D&O lawsuits in Canada, even a short term up-tick might last longer than we (except perhaps the lawyers) like, and be far more expensive than we have budgeted for.

This article will skip D&O personal liability 101 and indemnification, but feel free to read other posts for these references, or call to discuss.

Canadian D&O lawsuits (for this comment, see Part XXIII.1 of the Ontario Securities Act, R.S.O. 1990, c. S.5 as amended (“OSA”), (aka Bill 198)) commonly allege misrepresentation of financial statements, improperly recognizing certain sales as revenue, that did not fairly present the defendant’s financial results. These cases regularly include as defendants the corporate entity as well as directors, officers, and outside auditors. They cost many millions of dollars to defend and settle, as they are rarely litigated. And, Canadian cases are even seeing personal contribution to settlement of suits (see here).

The wording of the D&O policy is designed to respond to a securities suit, whether that policy is traditional coverage for non-indemnified directors and officers (aka Side A) and the corporate entity for amounts incurred defending indemnifying the directors and officers for their personal liability (Side B), or later policies which cover the corporate entity for amounts it incurs on its own (Side C, or hidden side c.) Just because a corporation has securities exposures doesn’t mean it has to buy Side C, but that is a discussion for another post.

If Al Rosen is right, “that IFRS is different because management controls all the numbers, because few restrictions or prohibitions exist”, and therefore increases the likelihood, duration and size of future securities frauds; and if Hercules continues to be upheld, thereby reducing auditors’ liability and their contribution to securities claims settlements and making the board “the shareholders auditor”; and if D&O coverage ‘limits of liability’ continue to be extended to more and more parties and matters, subjecting the board erosion of policy proceeds, then all board members should be turning their mind to risk management, not just risk transfer, and learning more about their current D&O coverage.

Loss control measures like:

  1. independence on the board and board committees,
  2. demanding and regularly questioning full disclosure of non-arm’s length transaction and all related party matters including all sources of officer remuneration,
  3. investigation by board committee of lender and supplier and customer background and their relationships, 
  4. internal audit reporting directly to board or board committee,
  5. whistle-blower protocol and whistle-blower protection established and monitored by the board,
  6. risk management reporting and exception reporting for management override activity,
  7. revenue recognition guidelines determined and overseen by board committee,
  8. and many more,

will go a long way to reducing risk, reducing loss costs, and reducing D&O insurance premiums.

In summary, let us learn from past mistakes, let us learn from knowledgeable people even if we don’t agree with everything they say, and let’s implement to tools to reduce risk.

I honestly believe that Al and Mark Rosen and their impressive group of colleagues would rather make their money advising boards and monitoring financial statements on behalf boards to prevent financial fraud, than responding to an investigation after the investors have suffered loss, which even the best forensic investigator can’t restore. But unfortunately I think the latter will cover more mortgage payments (and see more investor mortgage default), than the former.

Thank you for reading,

Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626, gshields@mitchellsandham.com

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