Many trusts will turn out to be scams, Rosen predicts

By Kate McCaffery | May 18, 2005 | Last updated on May 18, 2005
3 min read

(May 18, 2005) Outspoken forensic accountant Al Rosen has a bit of a reputation in the industry. And it’s no wonder. Rosen claims cooking the books is practically a national sport in Canada, laws make it impossible for investors to seek redress and because there are no big lawsuits, the issues are largely ignored by the media.

Right now, Rosen has his sights set on income trusts. He says the market is running the same scam Nortel executives used in the late 1990s, only this time around the accounting tricks are being used by companies who are targeting retired people.

A study of income trust balance sheets show many business trusts routinely pay out more income than they generate and people who are paying into income trusts today are essentially getting their own money back in distributions. “The essence of a Ponzi scheme is to get $100 from someone, give them part of it back and call it income,” he says. “They think it’s income. It’s nothing of the sort. There is no way this is going but to a collapse.”

There are some very good reasons to believe he might be right. The certified fraud examiner was one of the first to sound the alarms about Nortel’s accounting practices — nearly two years before the rest of the investment community caught on. Perfectly legal accounting rules allowed the company to turn huge losses into multimillion-dollar gains using Canadian Generally Accepted Accounting Principles (GAAP).

And nothing has changed since the heyday of tech investing. The same rules allow income trusts to be selective in their reporting and there is no standard definition in Canada for what companies call “distributable cash.”

“If you’re putting clients’ money into business income trusts without digging you’re facing huge risks. Nortel didn’t make a big enough dent in people heads.” He says the income trust fallout on the other hand probably will. “When you’re targeting 80 year-olds, and that’s exactly what is happening in this country right now, where is the protection? Who is protecting the retired people? It’s not the securities commissions, it’s not the auditors and it’s not the law firms.”

A 1997 case, Hercules Management v. Ernst & Young, decided that individuals could not sue auditors for their financial statements. “Investors cannot sue auditors. Is it sinking in just how significant that case is?” On top of this, auditors make up the rules for accounting in Canada.

The balance sheets and the risks are real enough: In a lunch presentation to delegates gathered at the Peel Institute Toronto Spring Symposium on Tuesday, Rosen held up several income trust balance sheets for scrutiny, pointing out that many companies like the Superior Plus Income Fund and the Yellow Pages Income Fund have distributions that far exceed accumulated earnings. The companies continue to grow their deficits and people continue to buy. “Half of business trusts will turn out to be scams. I am very confident of that.”

Although critics could say Rosen was selective in his sampling of companies, at issue is the fact that Canadian accounting rules and all of the related loopholes actually allow companies to providing misleading financial reporting like arbitrary payout ratios. Securities regulators meanwhile are not interested in the issue and there is very little investors can do if they’ve been had.

Advisors at the Peel conference were left to wonder just what exactly could be done about the situation if the game was so rigged. “You’re supposed to bitch and complain bitterly to politicians,” he told the crowd. “Tell them enough is enough is enough. These (the auditors) are the last people on earth who should be setting the rules.”

He says advisors should also ask very pointed research and analysis related questions when they meet money managers and wholesalers at road shows.

“Really, Canadian GAAP is so full of holes you would have to be a complete idiot to use it,” he says. “Beware fund managers who use it. Heaven help you.”

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Kate McCaffery