CFPOA (Bribery) Enforcement Action on the Rise

July 8, 2011

 

Risk Management will be a particular challenge based on the “ground level” exposures and the difficulty identifying and controlling risk that is created by a vast number of activities conducted by a large number of people with significant geographic and supervisory separation.

Therefore, based on single aggregate limits, and considerable number of parties and matters insured under a typical D&O insurance policy, a full understanding of how and where limits are sharing should be a top priority for D&O buyers.

In past blog posts I have been critical of Canadian regulation and enforcement of Bribery. But, I can now suggest there has been an extraordinary increase in Canadian corporate bribery enforcement. I am not suggesting the alarm bells should be raised, as the number of cases has gone from one to two (two to three if you include individuals), and I am sure that 99.something % of Canadians (and nearing that number of politicians) could not tell you what CFPOA stands for. This is not as easily said of FCPA. The Foreign Corrupt Practices Act, here, in the US has seen significant press over the last year. This should be no surprise, the US government provides a website listing enforcement actions in chronological order (there are 14 actions under ‘A’ alone), a dedicated email address for reporting violations, and transparency on settlements/judgments (which have been in the hundreds of millions of dollars.)

I wouldn’t be worried about wiretaps and agents posing as foreign government officials……, if your organization does absolutely no business (purchasing or selling, travel or expenses) outside of Canada. We are not known for aggressively fighting white collar (I prefer the term “financial”) crime. However, if you do any business outside of Canada, perhaps some risk identification and loss control is a good idea.

CFPOA stands for The Corruption of Foreign Public Officials Act. It can be found on a Canadian government site, here, but there is no “enforcement” section, or any obvious “report bribery or corruption” contact information. I don’t even recommend a search of Canadian government information regarding corruption or bribery, as it is a time wasting and frustrating exercise in ineffective links and extraordinarily outdated reports. Prior to this very recent case, I could find reference to only two criminal prosecutions in Canada since the 1999 inception the act and the only one with a dollar figure was for $25,000.

In June, enforcement of bribery in Canada actually made publication. I would like to say that it made headlines, but the only page-one google hits for “bribery enforcement in Canada” were law firm briefs and low profile blogs.

The recent case is Niko Resources Ltd., here, which is based on bribery of a junior energy minister in Bangladesh. As per the Reuters report by Scott Haggett, “the charges stemmed from providing a car worth $191,000 and a $5,000 trip”, but the fine is $8,260,000 plus a victim surcharge of 15% for a total $9.5 million fine. This does not include legal costs and it does not contemplate the reputational damage to Niko, or their 3.2% fall in market cap of their shares (which equates to more than $120 million.) Class action securities claims have been started for less.

A CFPOA settlement in this range is material to even the biggest Canadian corporations and it obvious that the intent is to send a warning signal to all Canadian companies, directors and senior management (and to try to get the Government out of the news for being complete ineffective on bribery and corruption.)

Here is the corporate governance, risk management and insurance spin. For this we will have to look outside of Canada because, in the article here at Canadian Lawyer Magazine by Andi Balla, it has been expressed by the head of the RCMP unit in charge of investigation corruption of foreign officials that “Canadian legislation is very short and hard to interpret.”

Based on the US experience with FCPA, and the very recent UK Bribery Act, the issue of Bribery will receive increased focus as a material Corporate Governance, Risk Management and Compliance responsibility. Risk Management will be a particular challenge based on the “ground level” exposures and the difficulty identifying and controlling risk that is created by a vast number of activities conducted by a large number of people with significant geographic and supervisory separation.

Like most other corporate risks, good loss control will come from establishing, communicating, enforcing and monitoring policies and procedures. But identifying, qualifying and quantifying risk in order develop specific risk based policies and procedures is much easier (not to mention quicker) to say than do.

The U.K. Ministry of Justice, regarding the new U.K. Bribery Act (took effect July 1, 2011), here, has provided some Guidance, here, to their legislation. But enacting policies and procedures is further complicated by the vague language of the official guidance which uses phrases like “extremely unlikely to engage Section 1” (the section prohibiting Active and Passive bribery), and introduces the “reasonable person” test and “common sense approach”. One area that makes it difficult to define or identify risk is the “associated persons” language which is not easily defined and includes any person or entity who “performs services” for the company. Therefore, direct and even indirect contractors could create a risk of liability for the corporation.

Other concerns with the U.K. guidance is that many terms are not defined. One such term is “close connection”, because this close connection to the U.K. could apply to the person committing the offence, or to place of incorporation, or to the location of the consenting senior officers. Another important term “carry on business”, because the parent company or even a subsidiary entity does not have to be incorporated in the U.K. in order to be responsible under the Act.

Directors of affected companies will to have look at the “relative ‘value’ of the spend” in every foreign business dealing and determine its ‘proximity’ to a pending business deal in order to identify activities that generate risk. They will then have to prioritize which activities could become the subject of scrutiny under the Act and direct resources accordingly.

The insurance response has yet to be determined. Some ideas are presented by Anjali Das, a partner in the Chicago office of the Wilson Elser law firm, are published in The D&O Diary Blog, here.

Insurance underwriters will eventually be requesting copies of Anti-Bribery policies and procedures, but that has not started (in Canada) and we hope to provide warning of any such change.

Directors, if not already, will soon be asking their General Counsel, CFO, Corporate Secretary, or whoever else is their go-to-person on personal liability and directors’ and officers’ liability insurance (D&O), about the potential response of their D&O policy to a CFPOA investigation. Since there are many dozens of different D&O policy wording and hundreds of endorsements in current use in Canada, there is no one-size-fits-all answer to this question. Your current in force policy wording needs to be reviewed. I suggest asking for an electronic searchable version from your insurance broker and searching for the term “fine”. If you are attempting to find the answer in paper form I recommend starting from the last endorsement and working backward. It is common for large publicly-traded companies to have more than 20 endorsements on their D&O policy, changing a good portion of the base policy wording. You will likely see a “fines and penalties” exclusion (unfortunately not in the exclusion section,) hidden in the definition of Loss. However, there may be a ‘carve-back’ (and exception to the exclusion) for defence costs.

Before you do anything regarding affirmative insurance coverage for an CFPOA action, an examination of priorities is warranted. Meaning, what do all of the Insureds, or at least Classes of Insureds, want the policy to do? I have not seen a CFPOA exclusion used in Canada, and Canadian underwriters are not likely to take a knee-jerk reaction to the Niko CFPOA enforcement action. I have also not seen any specific CFPOA endorsements in the Canadian marketplace, but I am sure they are in the works. But, the “broadening” of coverage to include Loss based on CFPOA actions may not be in the best interest of all Insureds. There is usually only one limit of liability available and it is shared by every director, officer, employee and the corporate entity (including every subsidiary) for every individual allegation, investigation and lawsuit. Also, it is common that in the middle of a potentially large group of claims (or circumstances which could lead to a claim) policy limits are not renewed (refreshed) at the expiry of the policy and therefore the one limit of liability may be the only limit available for all of these parties and matters for many years.

Therefore, based on single aggregate limits, and considerable number of parties and matters insured under a typical D&O insurance policy, a full understanding of how and where limits are sharing should be a top priority for D&O buyers.

I try not to subject my readers to 2,000 words in a post, but this does not give the corporate governance, risk management and insurance spin the detail it deserves. Therefore, if you would like more details in these areas, or if you would like help understanding your D&O policy and its potential triggers (positive and negative) regarding CFPOA enforcement, notice obligations or risk of limit exhaustion, please don’t hesitate to call me directly.

Greg Shields is a D&O, Professional Liability and Crime insurance specialist and a Partner at the University and Dundas (Toronto) branch of Mitchell Sandham Insurance Services. He can be reached at gshields@mitchellsandham.com,  416 862-5626, or Skype at risk.first. And more details of risk and loss control can be found on the Mitchell Sandham blog at https://mitchellsandham.wordpress.com/

CAUTION: This article does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered and truly independent insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this document from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


What is the Direction of Canadian Corporate Fraud?

June 23, 2011

 

Interesting article on Corporate Fraud and Executive Compensation available, here, at Marketwatch.

I will let you read it, but the Greg’s notes on it, 1) “97% of companies on the S&P 500 Index pay incentive compensation to executives even when the company is underperforming its peers”, and 2) “FBI Director Robert Mueller recently told Congress that the FBI had 667 ongoing probes into corporate fraud and 1,700 open cases of securities fraud.”

In case the authors are correct in their observation that crime is not down we are just numb to it, why don’t we do a quick “lest we forget” and recount: Bernard Madoff, Jeffrey Skilling, Kenneth Lay, Dennis Kozlowski, John Rigas, Joe Nacchio, James McDermott Jr., Sam Waksal, Sam Israel, Bernie Ebbers (see the Time article, here, called Top 10 Crooked CEOs).

Now, just in case you are like many Canadians who have allowed themself to be lulled into a false sense of security, based on a lack of fraud enforcement in Canada and extraordinarly little media coverage attention to corporate fraud and a Canadian moral superiority complex, here is the Canadian content.

Please keep in mind that thanks to the absence of criminal enforcement in Canada, some of these cases should be classified as securities concerns and not allegations of fraud against any individuals. Based on the low level of media coverage, you may never have heard about these incidents – Barry Landen (here, Penna estate fraud, not huge, but very sad), Peter Sbaraglia and Robert Mander (here, accused by OSC of $40 million fraud), Milowe Brost and Gary Sorenson (here, Brost was jailed this year for forgery, but accused with Sorenson of a Ponzi scheme which could reach $400 million), Wolfgang Stolzenberg (here, accused of a $1 billion fraud in the Castors Holdings case), Ronald Weinberg, Hasanain Panju, and Lino Pasquale Matteo and John Xanthoudakis (here, facing 36 charges including fraud and publishing a false prospectus in the Cinar case, with Xanthoudakis also being part of Norshield (here, $215 million alleged fraud) and Matteo also part of Mount Real (here), Earl Jones (here, surrendered and pleaded guilty (so I don’t know how quick I would be to count that as a win for our justice system) to two fraud charges related to a $50 million Ponzi scheme that ran from 1982 to 2009),  Ian Thow (here, originally accused of a $32 million Ponzi fraud but pleaded guilty on amounts totaling $8 million and sentenced to 9 years). There are many more, but I have run out of time, and hopefully opened a few eyes.

I have decided to avoid pure Canadian class actions securities claims due to the risk of suggesting fraud in any of these cases, and/or the risk of reprisal for any such inference. But I can assure you that we have had more than our share of securities related games played in Canada resulting in massive losses suffered by Canadian investors.

Now the risk management spin. There are many ways for investors, fund managers, investment advisors, directors and officers to protect yourself.

  1. If things are going absolutely great and you have no complaints or concerns about your current position: pull your head out of the sand and start your own investigation immediately. Take two, three, four hours, pull out a recent prospectus, annual report or one of those intentionally complicated sell sheets, and read the fine print, notes and management assumptions. If it does not make any sense, read it again. If it still doesn’t make any sense, start asking questions and preface each question with “pretend you are answering this question like I am your mother or your five year old” (keep in mind that some of the people above did actually defraud their mother);
  2. If a few things are bugging you but you can’t put your finger on it, see point 1 above.
  3. If you have not invested or accepted the board position, see the points above;
  4. Request evidence of Fidelity/Crime insurance. You can’t rely on this in place of the points above, but at least you will get some comfort that the company and the individuals have been vetted by a large financial institution who shares a financial exposure to the company. Then take the evidence of insurance, Google the name of the insurer, call the company from the info online, not the one on the evidence of insurance, and confirm the company and policy actually exist. This four minutes will be more due diligence than most stakeholders perform, and it will improve your comfort level with your risk;
  5. Repeat point 4 for Directors’ and Officers’ liability insurance (D&O) and Professional Liability insurance (E&O). Many, but not all, fraudsters avoid any additional audit, review or questions, (unfortunately they don’t seem to be subject to much of that from regulators, auditors, lawyers, suppliers or investors), so they reject any suggestion of insurance coverage as a waste of money;
  6. Find the references to a contract, sales agreement, independent third party review, or other “feel good statement” attributed to any third party in any company document, pick two (or if you are really diligent, three) and take four minutes to Google the name, call the company or person from the online information, and confirm the details of the pronouncement;
  7. Read the Ian Thow link above and the victim statements detailed in the sentencing decision, and be thankful they allowed their tragic and embarrassing stories to be publicized so that we can learn without having to suffer more loss that we already have (yes, every mutual fund holder, pensioner, bank client and insurance buyer pays a significant amount for fraud losses every year.) It could be the most valuable 20 minutes of your life.

With prosecutions being rare and convictions (without a guilty plea) being almost non-existent, one can only surmise the actual number for frauds that are currently being perpetrated in Canada.

So what is the direction of Canadian corporate (aka, white collar, or financial) fraud? It doesn’t matter, there is plenty of it right now to warrant concern and the 4 hours and 44 minutes of time suggested above.

Greg Shields is a D&O, Professional Liability and Crime insurance specialist and a Partner at the University and Dundas (Toronto) branch of Mitchell Sandham Insurance Services. He can be reached at gshields@mitchellsandham.com,  416 862-5626, or Skype at risk.first. And more details of risk and loss control can be found on the Mitchell Sandham blog at https://mitchellsandham.wordpress.com/

CAUTION: This article does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered and truly independent insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this document from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


INSIDER TRADING and CANADIANS IN THE NEWS

July 21, 2010

 

Unlike many recent news events, this connection to Canada is a positive one because it showcases the efforts of Canadian researches, even if not involving Canadian statistics. From the Wall Street Journal Online, July 3, 2010, by Gregory Zuckerman, here, author of The Greatest Trade Ever, called Hedge-Fund Lending Draws Scrutiny, here, refers to a “coming publication in the Journal of Financial Economics” by 4 academics, Debarshi Nandy, Nadia Massoud and Keke Song, at York University’s Schulich School of Business in Toronto, and Anthony Saunders, at New York University’s Stern School of Business. The publication tracks the short-selling of U.S. company securities and compares such activity between companies that have borrowed money from a hedge fund and companies that have borrowed money from a bank. By studying over 350 companies and the short-selling activity in the five days leading up to the public announcement of company borrowing or loan agreement amendments,  and comparing it with the 60 day period before the deal, there is material difference between the companies that borrowed from banks and those that borrowed from hedge funds. The difference could suggest that the trading activity “raises questions about whether the very firms lending money are using nonpublic information to trade against their borrowers, or whether information is leaking out to others.

I look forward to reading the full study and to learning that securities regulators are acting on this information to identify and prosecute illegal insider trading and market manipulation.

The term insider trading is not by definition an illegal activity, but that is the way it is most commonly used. A 2005 article in CBC News, here, does a great job of explaining the term, and there are many more recent articles and publications to help update the legal and regulatory landscape.

The connection to insurance – illegal insider trading is commonly alleged within securities litigation. It can help motivate early settlement, but it can also increase the possibility of personal contribution out-of-pocket payment by directors and officers to this settlement. And YES I DO MEAN IN CANADA.

My concern is that many directors do not fully understand their insurance coverage, and may be misled into believing they need a Securities Claim Insuring Agreement in order to get coverage for a securities based lawsuit and for their defence against illegal insider trading allegations. This is simply not true. Most Directors’ and Officer’s Liability or Management Liability policies, even those without a Securities Claims Insuring Agreement, will respond to a securities claim and an insider trading allegation, subject to certain exclusions and terms which cannot be fully developed here, to individual directors and officers.

The Securities Claims Insuring Agreement, commonly referred to as ‘Side C’ may actually limit coverage, because it may extend the policy limit (and there is usually only one available) to the corporate entity, thereby increasing the possibility of exhausting limits otherwise available to the individual directors or officers, or it may apply exclusionary language that is not found in a standard Side A/B policy.

The protection of corporate assets is important, but directors are not obliged to do it out of their own pocket. The insurance agreement should be quoted, with full explanation and details made available for decision purposes, but that decision needs to be an educated one. It should include additional options of very high limits of liability, excess Insured Person’s coverage, excess independent director’s coverage, full explanation of severability, non-rescindable language, priority of payments (not just the CEO determined kind), etc., etc.

Subsequent to writing this Post, I enjoyed an exchange of emails with one of the Researchers, Mr. Nandy. He offered his permission to provide a link to the research paper, here, My comment and question for Mr. Nandy was “Cracking down on insider trading is necessary for Canada to promote its securities markets, but most good research material is U.S. focused. Your research in the study suggested your review of 360 US companies, did you attempt to gather the short-selling activity in Canadian company securities, and would a similar Canadian study even be possible based on publicly available information?

 His answer did nothing to improve my comfort in the Canadian Securities Regulator regime; “Unfortunately, we do not have similar data that is publicly available for the Canadian markets.”

Feel free to contact me for more information on identifying the needs of your ‘Insureds’ and structuring appropriate insurance coverage.
Greg Shields, Partner, Mitchell Sandham Insurance Brokers,       416 862-5626, gshields@mitchellsandham.com

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


Crime / Fidelity / Bond / 3D / Employee Theft / Financial Institution Bond / Fraud Insurance

July 9, 2010

Denial of Crime Coverage for Misrepresentation

Like most types of insurance coverage there can be many names within the same family of insurance policies. I will use them indiscriminately in this post, because it helps with Search Engine Optimization.

There are also a number of terms directly associated with the Bond, including but not limited to, ‘material non-disclosure’,  omission, concealment, misrepresentation, ‘incorrect statement of material fact’, and ‘false information’, and these terms are used with respect to the application for insurance that forms part of the 3D policy (Dishonesty, Disappearance, Destruction), and for the grounds for rescission of the Fidelity policy.

Denial of coverage by way of Cancellation ab initio (from the beginning) based on alleged misrepresentation in the application for Fraud insurance is far too common in Canada. There are many precedent setting cases and many more unknown situations not determined in court. The result can be catastrophic for the insured corporation, and for the individual directors and officers who had no knowledge of or involvement in the alleged misrepresentation.

Most Crime insurance applications require the signature of the Chairman and the CEO, or next highest person if the Chm and CEO are the same person. The concern here is that alleged misrep by the highest executives of the firm will at minimum fall within American jurisprudence which follows the “sole representative” doctrine, and therefore the knowledge of such will be imputed to the principal.

However, if the board of a corporation adopted the policy to select an independent committee to review the insurance application and have a fully independent director sign the application (in addition to the executive , because the underwriter might not accept an application signed only by a non-employee of the firm), it could improve the chances that a misrep by any of the signers would fall within the exception to the principal / agent rule because the fraud would have been perpetrated on the principal not on the Insurer (see. Bowstead on The Law of Agency, 15th ed. (Toronto: Carswell, 1985), p. 414, states that the presumption that knowledge will be passed on to the principal may be nullified by proof that the agent was defrauding the principal in that transaction.) They can assert that misrep by the executive in the application was the intent to further their fraud against the principal, especially in a regulated industry where the purchase of a bond is mandatory, not optional, and therefore more difficult for the insurer to suggest the misrep in the application for the FIB by the allegedly fraudulent executive was an obvious attempt to induce the insurer to provide a policy and perpetrate a fraud against the insurer.

There is also inconsistency between insurers with respect to the questions in their applications. Some applications do not specifically ask “are you aware of any claims or potential claims”,  but they will rely on the representations regarding ‘past losses’ (whether or not there was reimbursement), or previous cancellation of a Bond or denial of coverage. Therefore, the policy improvements or limitations may be found in the application.

Risk of rescission, cancellation, non-renewal or claim denial is present within any policy renewal, even if staying with the same insurer, because the application is completed each year. This risk increases if the buyer does not cover all their bases when changing insurance carriers, or when increasing the limits of liability. Some insurers will ask for an ‘increased limits warranty statement’ asking if the buyer knows of any situation which could lead to a claim under the proposed policy. Others will rely on the representations made in the renewal or new business application.

Current regulatory changes in Canada will significantly increase this risk because the Canadian Securities Administrators’ National Instrument 31-103 has come into effect, requiring many financial institutions (investment dealers, investment advisors and investment funds) to register or re-register, demanding new bond coverage in addition to working capital and other requirements. The result is companies buying new policies, where they never had before, or buying substantial increases in their limit (in some cases the $200,000 limit needs to be $10 million.)

The big concern is that poor explanation or negotiation of the new policies or new limits will not be known until a loss is discovered and a claim is made. Only at this point will you realize that your $5,000 premium savings cost you $5 million in insurance coverage.

For risk management techniques, loss control tools, and coverage enhancements, please feel free to call me directly.

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

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


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

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


Mortgage Fraud

May 7, 2010

News on this topic goes in waves. A few years ago Identity Theft and Mortgage Fraud got public attention when scams we detailed of perpetrators identifying a typically older single person who owns a home with a very small existing mortgage. The criminal will fake the homeowner’s identity and pay off that mortgage, and then remortgage the property to almost its full value. The homeowner does not find out about the fraud until the payments go into arrears and the lenders come calling, or until they attempt to pay-down their small mortgage and find it was already paid-off and a new credit search shows a very large amount owing to a different lender.

Now, the Oklahoman or Skip Transfer. A group, or several different groups, conspire to purchase lower priced homes in a given neighbourhood and then flip them to “straw buyers” for inflated prices. The straw buyers are paid a few thousand dollars for the use of their identity, their financial position is forged, and they get mortgages from mortgage lenders at prices typically $40,000 or more in excess of the property’s market value.

One of the big Canadian banks, in their Alberta operations, has recently announced a mortgage fraud involving $120 million in property. Many news organizations have been reporting on this, here, here, here. This scam could involve many interrelated organizations in many countries, and include many institutions, and, by fraud or negligence, many Canadian lawyers, mortgage brokers, and bank employees. Some reports suggest that irregularities were identified as early at 2006.  

My experience is that fraud is not contingent on new space-age technology or extraordinarily complicated strategies. One recent claim example was a loss of almost a half million dollars to a relatively small private company that, like many organizations, had a holding company and an operating company, where only the operating company was audited. A mid level employee in the finance department very simply included herself as an employee of both the holding company and the operating company. When senior finance requested a run of T4 slips she provided only photocopies, removing sequential numbering, and pulling one of the two T4 splits. This complex plan, diabolical in its brilliance, lasted ten years. When a new senior finance employee requested original sequential T4 slips, the criminal mastermind admitted guilt and offered to pay back the money.

Rarely in cases of Fraud (and for that fact, employee injury, general liability, product liability, etc.), is the Loss Control activity a new or original device. The Loss was likely dependent on lax oversight or application of long existing policies and procedures. Safety bars removed, eye protection not enforced, emails with sensitive information sent to former employee addresses, vendor lists not audited, not witnessing signatures, overlooking questionable behavior, not performing regular or periodic background checks, etc. etc. Any one of these can easily contribute to losses in the six and seven figures, but individually, they are just plain boring. Even in the case of a nine figure mortgage fraud, the sophistication of the scam is not based on 21st century listening devices, or some form of computer hacking, cross-site scripting, malware implanted virus, it is likely based on taking advantage of lax oversight of mundane operating activities, which individually are completely lackluster transactions, within multiple parties.

If you want a good history of mortgage fraud in Canada, I refer you to a May 6 article by By Jen Gerson, in the Calgary Herald, here. The article makes important distinction between Alberta real estate law, and says that “…because in a boom economy, it’s often easier to hide fraud because actual boom time values can quickly match fake inflated values. Banks, in this case, can recoup their losses. But when property values stabilize or fall, fraud becomes more apparent.” The article also provides an estimate by the Quebec Association of Real Estate Agents and Brokers that “fraud could cost $1.5 billion per year across the country.”

Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


Happy Fraud Awareness Month

March 17, 2010

The Canadian Government has a website dedicated to the topic (see here) and the loss control advice is directed to individuals and companies. The Canadian Securities Administrators also offer information for awareness and avoiding fraud (see here) with much of this material directed at individuals. Some of it may seem like common sense, but my experience is that most successful scams are simple. So it can’t hurt to take a look. One thing I did find interesting is that none of the material that I reviewed focused on fraud schemes by employees. As this is a leading cause of loss to companies large and small (one statistic I can’t immediately locate said that the leading cause of small and mid-sized business failure in Canada involved some form of employee theft) the need for proper risk management in the area of crime/fidelity/employee theft should be paramount. If you would like to discuss risk management, loss control or fidelity insurance, please call.

Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626