CSA Enforcement Report 2012: Is a Change in Focus Due?
By: Stephanie A. McManus
Any serious professional in the financial services industry understands the need for a strong enforcement process. You will rarely get an argument from the hard-working and ethical people in this business against the ideal that those who break the law and steal from investors should be punished. The problem is, in this writer’s view, the current enforcement system is off-kilter, with policy sometimes focusing on the wrong things and numbers not necessarily telling the whole story.
On February 19th, 2013, the Canadian Securities Administrators (CSA) published their Annual Report on Securities Enforcement in Canada for 2012. The report covers enforcement activities by all securities commissions (or securities regulatory authorities) and also refers to the enforcement activity of Self-regulatory Organizations. The 40 pages are a fairly easy read, made up of comparative charts and short summaries of the bigger cases investigated and prosecuted.
I think it’s important though, to have a hard look at the numbers with a clear understanding of what they actually mean. For example, Table 1 of the report summarizes the proceedings commenced by category over the last 3 years:
This is the first year ‘fraud’ has been categorized on its own. In previous years, fraudulent activity was included with other types of offence. According to the CSA, “A separate category for fraud cases reflects the priority placed by CSA members on countering fraud in the Canadian capital markets.”
Also, there are many cases where the violation could be classified as more of a technical violation (i.e. illegal distributions are cases where the perpetrator didn’t follow the right securities laws – and that may or may not have resulted in losses to investors). And while it isn’t always easy to detect, where the evidence does support it, there is a world of difference in the risk to the investing public and to the Canadian capital markets between a technical violation that doesn’t result in losses and a criminal or fraudulent violation. Yet often, those participants who, for example, discover a compliance failing, repair it and self-report without any harm to the market or an investor, are dragged through the same costly processes and penalized as heavily as those who are more blameworthy. This is a detriment to the capital markets because it weakens participants who are largely compliant and making an effort. It also expends valuable enforcement resources when they could be used more productively elsewhere.
Another interesting chart is Table 4 Fines and Administrative Penalties. Monetary penalties on the surface tend to suggest that much is being done to deter illegal activity.
Those numbers are distinct from the numbers relating to Restitution, Compensation and Disgorgement whose totals for the same period were:
But, ‘fines and administrative penalties’ are paid to the regulator not the victims who’ve lost money. ‘Restitution’ and ‘compensation’ are theoretically payable to the harmed investor and disgorgement is usually a ‘taking back’ of the gain earned in the illegal activity. Like fines, disgorgement-related funds, if collected are paid to the regulator. It’s important to note that not all Securities Acts allow for commissions to order compensation or restitution. So victims can very rarely hope for that outcome and the numbers above blend restitution, compensation and disgorgement totals together. It’s therefore not possible to determine exactly how much, if any, was paid to investors.
Significantly I think, the report quietly says on page 14, “While penalties, costs and other monetary sanctions/orders can be difficult to collect, every effort is made by the regulator to do so, including using the services of collection agencies.”
The truth is, only a very small fraction of fines have historically been collected. If the report disclosed that number, it would likely demonstrate just how ineffective monetary fines and penalties truly are in deterring illegal securities activity. The MFDA’s 2012 annual report, for example, says that of the $1,464,000 in fines levied against Approved Persons, $140,000 was collected (less than 10%). That’s because the MFDA only has power to collect fines from respondents still in the industry, except in Alberta, where they claim to make “all reasonable collection efforts.”
It’s safe to say that a Securities Commission prosecuting an unregistered fraudster who has stolen millions of dollars, finds that a monetary fine is effectively irrelevant to such an individual. If the fraudster lacks the conscience to refrain from fraudulent activity, there will be little compelling him to pay a fine that can’t be collected.
On the other hand, it is heartening to see that the CSA members are both carving out fraudulent activity in performance measurements and making more active use of their criminal prosecution powers. Courts in Ontario, Alberta, British Columbia, Manitoba and New Brunswick ordered jail terms for seven individuals in 2012 on securities-related violations.
Unfortunately, as with other criminal prosecutions, the severity of sentencing often still leaves much to be desired. The terms for those sentenced ranged from 30 days to three years. In total, roughly nine years of jail time was handed down to 7 offenders in 2012. In one New Brunswick case, William Priest perpetrated perhaps the most offensive type of fraud – affinity fraud – where he exploited family and community relationships to obtain $600,000 for personal use and to pay off other clients. He was charged and pleaded guilty to 9 counts of fraud, and was sentenced to 9 terms of 3 years each to be served concurrently (at the same time) rather than consecutively (one after the other).
The CSA itself recognizes that investors taken in by frauds seldom recover their money. Their solution, in addition to working to shut down the schemes is to educate investors through websites, programs and investor resources on how to recognize and avoid suspicious or fraudulent investments.
No doubt, investor education is important, key even. However, there are several things that could go a long way deter fraud and strengthen securities enforcement efforts. For starters:
1) Enforcement penalties should focus less on monetary sanctions and more on:
- remedial penalties, such as repairing faulty processes and stepping up training for those cases where there has been no display of criminal intent, or
- criminal prosecutions with teeth, increasing in severity with aggravating factors like planning and investor loss.
Monetary penalties should be reserved for situations where neither of the above is appropriate and there is a strong likelihood of recovery of the fines.
2) The money that is recovered in situations of significant investor harm should be returned to the victims of the illegal activity. How would public perception of the integrity of the markets be improved with an active and robust compensation and restitution structure?
An encouraging example of progress in that direction – though originating with the criminal justice system rather than the CSA - is the recently published outcome in the Nanaimo case of Michael Chodorowski. A complex Ponzi scheme was investigated by the RCMP and the result was a guilty plea to 4 counts of fraud and a sentence of 6 years in prison. Mr. Chodorowski was also ordered to pay $1.6 million in restitution to investors. The BC Securities Commission has also charged him with 30 counts of fraud.
If enforcement focused on remediation in appropriate cases, reputations of largely compliant players could be preserved, registrants strengthened and the capital markets’ health improved. If fraudsters were severely and swiftly prosecuted, it would send a message to those contemplating crime that there is more than an uncollectible fine awaiting them. And if harmed investors received restitution orders that were collectible, that too would restore faith in the strength of the system.
Numbers are important. Measurement of efforts made and trends year over year tell us much. But it is critically important to keep our eye on what can be done to continually improve the actual effectiveness of enforcement and to strengthen Canadian capital markets.