Human nature being what it is, financial fraud in developed nations affects an annual estimated 7 per cent of publicly-traded firms. The average cost to investors in each fraud case is a 41 per cent plunge in shareholder value. That’s what is at stake in assessing “fraud risk” when making a stock-market investment.
Yet comparisons of fraud prevalence among the world’s exchanges are not available to investors because they don’t exist. There is data on malfeasance, to be sure, but it isn’t readily shared with the investing public.
With that in mind, Douglas Cumming and Sofia Johan, seasoned academic researchers at York University and Holland’s University of Tilburg, respectively, undertook the first effort to compare “fraud risk” among the leading exchanges in Canada, the U.S. and Britain. In all, they looked at 4,190 cases of improper conduct at publicly traded firms over a six-year period ending in 2011. Doing so required them to pore through court records and media accounts, in the absence of reporting by securities commissions and exchanges.
What they found, in a report released Friday, is that while it’s to be expected that financial fraud will be committed at 7 per cent of Canadian publicly traded companies, a grand total of 0.3 per cent of Toronto Stock Exchange listings were subject to fraud litigation each year between 2005 and 2011. That compares with 1.9 per cent of New York Stock Exchange listed companies and 4.5 per cent of Nasdaq firms, in a jurisdiction far more vigorous about rooting out rank behavior abusive to investors.
Britain isn’t much better. Fraud cases against London Stock Exchange companies averaged just 0.4 per cent of LSE-listed companies during that period.
“When you compare Canada and the U.K. to the United States, the results are quite shocking,” says Cumming, “with about 10 times less reporting or litigating of corporate fraud or fraud involving corporate shares in Canada.
“Yet it is unlikely that the incidence of corporate fraud in Canada is that much different than in the United States.”
No argument there. The Ontario Securities Commission (OSC) has traditionally shown itself hapless to protect investors from the rapacity at Bre-X, Philip Services, YBM Magnex, Livent, Hollinger Inc. and Nortel.
And while the incidence of fraud may differ little, the chances of getting caught do. Canadian securities regulators, the co-authors calculate, are 8.9 per cent less likely to detect financial fraud in the markets than the U.S. Securities and Exchange Commission.
The SEC itself is no sterling benchmark of alacrity. It was AWOL for the white-collar crime wave of Enron, WorldCom, Tyco et al, and ignored a decade’s worth of warnings about a Ponzi-scheme operator named Bernie Madoff.
Stock market fraud we have in abundance in Toronto, now ranked by Forbes among the world’s top 10 financial centres. What we lack is detection, enforcement, and even an annual report card that benchmarks our vigilance against other jurisdictions in protecting investors.
Among the first signs of life at the OSC was incoming CEO Howard Wetston’s resolve last year in suspending trading of Sino-Forest Corp., a firm that has lost most of its peak $4 billion in market cap after suspicions arose over its claim to timberland in mainland China.
We now rank GTA hospitals on patient outcomes, and parents can match schools against each other. But we’ve yet to provide investors a similar tool in warning them off stocks traded on exchanges that have lowered their listing standards in a race to the bottom in attracting initial public offerings. And to warn them away from jurisdictions in which security regulation and enforcement is weak.
“We find it rather surprising that there is little or no direct source of evidence on actual litigated cases of fraud that enables an investor to compare the levels of investment risk in different jurisdictions, or even different exchanges within the same jurisdictions,” co-authors Cumming and Johan say in their report, Exchanges and Their Investors: A New Look atReporting Issues, Fraud, and Other Problems by Exchange.
Cumming and Johan are experienced hands at corporate governance. Between the two they’ve written or co-authored more than 100 papers on insider trading, bribery, market manipulation, improprieties by hedge fund and private equity outfits worldwide, in collaboration with researchers in the U.S., Britain, Germany, France, Singapore, Australia and Hong Kong.
Their most recent, provocative report was financed by stock market analysts via the Virginia-based CFA Institute. The institute administers the exam for earning the credential of certified financial analyst, and boasts more than 100,000 members in 57 countries. It’s a measure of Toronto’s increasing prominence in financial markets that its CFA membership, at 6,289, ranks third behind New York (10,945 members) and London (9,500).
Analysts have been in bad odour in the past decade or so over everything from touting worthless dot-com stocks to failing, along with just about every other responsible party, to foresee a Great Recession in which stocks would abruptly tumble by 40 percent in 2008-09.
Transparency, or more thorough and candid corporate disclosure, is the Holy Grail in which this profession is now in pursuit.
And a far greater degree of transparency is practical, especially given that much of the data is in the hands of securities commissions with no profit motive and mandates to encourage investment by promoting honest markets.
This isn’t about the merry chase of miscreants. Cumming describes his goal as “stimulating market activity.” A friend of markets, Cumming wants more TSX listings, higher trading volumes, and increased share values.
“Higher transparency not only means it is easier for regulators to detect fraud and prosecute cases,” Cumming says. “It also means that firms are less likely to commit fraud.” And it means Canada, in shedding a reputation as a regulatory backwater, would attract more capital from abroad and keep domestic capital from fleeing to perceived greater safety elsewhere. Which ultimately would reduce the cost of capital for Canadian firms.
Corrupt markets are inefficient. They undermine capitalism by misallocating limited investor capital toward badly run companies that cook their books to disguise their incompetence, and to self-interested executives who redirect shareholder funds into Italian sports cars and replicas of San Simeon.
That kind of “capitalism” isn’t sustainable, and no one will show up at its funeral. By contrast, the overdue reform of genuine transparency is worth fighting for as our financial sector becomes a still greater source of the GTA’s economic dynamism.
Ontario Securities Commission by the numbers:
$228 million: Fines issued by OSC between 2005-2011
$109.4 million: Amount of those fines actually collected.
126: Enforcement cases started by Canadian Securities Administrators’s 13 members (including OSC) in 2011.
178: Enforcement cases started by Canadian Securities Administrators members in 2010.
14 years, 7 months: Total prison sentences handed out by Ontario courts for securities violations in 2011
6 ½ months: Prison sentences handed out in 2010
45 days: Prison sentences handed out in 2009