Fraud slipping past Canadian regulators

May 1, 2012 | Last updated on May 1, 2012
4 min read

Canadian exchanges, when compared with those in the U.S. and U.K., report and litigate the lowest percentage of financial fraud cases each year. Unfortunately, this doesn’t mean Canadian fraudsters aren’t out there—it means our regulators aren’t catching them.

Worldwide, financial fraud in developed nations affects 7% of publicly traded firms annually, and investors suffer a 41% average plunge in shareholder value as a result of each fraud case. However, comparisons of fraud prevalence across the globe aren’t available and data on regulator efficiency isn’t shared with the investing public.

“Despite the widespread fascination with fraud and its influence on stock prices, liquidity and market quality, there is no direct source of evidence on actual litigated cases of fraud that enable an investor to compare different jurisdictions,” say Douglas Cumming and Sofia Johan, academic researchers at York University and Holland’s University of Tilburg.

To remedy this problem, Cumming and Johan have released a paper called A New Look at Reporting Fraud: By Exchange, which compares fraud risk among the leading exchanges in Canada, the U.S. and Britain for the first time. In all, they looked at over 4,000 cases of improper conduct over a six-year period up to 2011—poring through court records and news releases in the absence of regulator reports.

Overall, a grand total of 0.3% of Toronto Stock Exchange listings were subject to fraud litigation each year, compared with 1.9% of NYSE listed companies and 4.5% of NASDAQ firms, in a jurisdiction far more vigorous about rooting out rank behavior abusive to investors. Fraud cases against London Stock Exchange companies averaged just 0.4% of LSE-listed companies during that period.

The TSX in Canada was 16.8% more likely to be involved with fraud cases and 61.8% more likely to be involved with cases involving lesser crimes than NYSE companies. TSX-V companies are 47.8% more likely than NYSE companies to be associated with fraud cases.

“When you compare Canada and the U.K. to the United States, the results are quite shocking,” says Cumming, “There’s about 10 times less reporting or litigating of corporate fraud or fraud involving corporate shares in Canada. Also, although there are annual reports on litigated fraud [in Canada], there’s no document that enables an investor to make comparisons of litigated fraud between the TSX versus the junior Toronto Stock Exchange.”

Johan adds, “It is unlikely that the incidence of corporate fraud in Canada is that much different than in the United States.”

Also, while the UK and Canadian rates seem matched, Cumming and Johan suggest the requirement for brokerage firms to screen companies wanting to list on the AIM may help mitigate fraud in the UK. As a result, their lower number of reported cases may be more justified.

The paper looks at litigation cases involving financial fraud, misrepresentation, bribery, insider trading, boiler room schemes, market manipulation and the failure to file proper documentation to regulatory agencies like SEC and CSA.

“The very low level of detected fraud in Canada is perhaps best attributable to lower levels of enforcement in Canada, particularly with the separate provincial securities commissions,” the paper suggests. Fortunately, plans to create a national regulator may be revived, with Finance Minister Jim Flaherty revealing on Friday that provinces may finally be backing the creation of a unified regulatory body in Canada.

The researchers found Canadian data hard to find and unreliable prior to 2005, and most importantly, stress the absence of a unified regulator makes it “comparatively more difficult to detect fraud among publicly traded firms in Canada. The lower Canadian listing standards encourage the presence of marginal firms to raise capital and the presence of marginal promoters of stock to investors.”

The paper also suggests that “lower listing standards are associated with less transparent companies and are expected to be associated with greater challenges for regulators in detecting fraud.”

Both Cumming and Johan urge Canada, and all countries, to provide investors with full information on their exchanges and the associated risks with investing. They also stress the need to have a fully functioning regulator that can curtail any risks and dangers.

On junior exchanges, the paper says, “Having junior stock markets is not necessarily a bad thing; they can fill a void by providing firms with greater opportunities to raise capital and providing investors with a greater opportunity to diversify their portfolios. Investors in junior stock markets can be better served, however, if a reliable source of information is available with details on the possibility of fraud.”

The situation faced by customers of the bankrupt MF Global confirms the need for work to be down to protect clients and investors in North America, with customers still waiting to retrieve their funds, as well as hear news of what actually occurred after six months.

No case against the brokerage firm has been successful as yet and John Roe, leader of the Commodity Customer Coalition and introducing broker at BT Trading in Chicago, fears people will continue to misuse customer funds and have no criminal liability if nothing happens in terms of a criminal case. The situation is also eroding market sentiment and customer confidence.