Monitor related-party transactions to shield clients

The German philosopher Friedrich Schiller said, “It is rascally to steal a purse, daring to steal a million, and a proof of greatness to steal a crown. The blame diminishes as the guilt increases.”

That’s the problem when it comes to white-collar crime in Canada—reduced blame and diminished consequences even when large amounts are stolen from multiple victims.

Recent federal initiatives to crack down on white-collar crime by increasing minimum sentences have missed the mark. What happens when there aren’t prosecutions in the first place? Or when there aren’t rules on which to hang a prosecution that could lead to tougher punishment?

No rules, no follow-through

We mentioned in “Ghosts of regulators past” (AER, October 2011) the decision regarding former executives of Royal Group Technologies. The executives privately purchased some land and flipped it the same day to the public company for a profit of $6.5 million.

In a Nutshell

We need three elements to hold people accountable for whitecollar crime: tough rules, follow-through on prosecutions and meaningful consequences.

The details were not disclosed to shareholders, and the judge in the case eventually decided the executives had not committed fraud. Things may have turned out differently had there been tougher accounting rules in place regarding the disclosure of related-party transactions like the one the executives had engaged in.

In the Livent appeal handed down in September 2011, the judges reduced the sentences of Garth Drabinsky and Myron Gottlieb. This was based partly on the view that although the bankruptcy caused significant losses for creditors, employees and investors, the losses could not “be laid entirely at the feet of [the defendants].”

While advisors can do little to change the lack of prosecutions or the weakened judgments being handed out, they can do something about weak financial reporting rules. They can understand how vague the rules are, and protect clients accordingly.

As forensic accountants, we see weekly examples of how today’s accounting and auditing rules do little to protect investors from executives who abuse related-party transactions.

Related-party transactions come in all forms, and usually concern dealings that take place between the company and an officer, director, or entity controlled by an officer or director.

Related-party transactions may not be a problem if:

• They’re completely understood and approved by the board;
• The board is independent;
• The transactions are fully disclosed to investors;
• The amounts are reported at fair value.

At least one condition is often missing. Take full disclosure to investors. We find undisclosed related-party transactions in our forensic investigations because auditing rules are too weak.

The rules primarily require that auditors ask management for a list of related parties and related-party transactions. Those get reported in the financial statements. The rules do not require auditors to actively look for related-party transactions that have not already been listed by management.

Even when companies do report all related-party transactions, some try to make matters more difficult for investors. For example, one company’s related party transaction note started with, “Unless mentioned elsewhere in the notes to these consolidated financial statements, the following are additional disclosures regarding related-party transactions.”

There’s no rule against disclosing something twice, so if you see anything like this in the financial statements of one of the companies you own, move on.

The board of directors is another weakness when it comes to related-party transactions. These days, we see fewer quid-pro-quo arrangements, where company directors were listed right alongside executives as parties with extracurricular financial arrangements.

In the past, a director would never have objected to the fairness of a transaction with an executive if he also had an arrangement of his own. Thankfully, governance has progressed. However, the board (no matter how independent and educated nowadays) can still fall victim to greedy executives because of weak accounting rules.

The heart of the problem

Related-party transactions do not have to be reported at fair market value. Even though Canada has switched over to using International Financial Reporting Standards (IFRS), which claim to be all about fair valuing amounts in the financial statements, related-party transactions are still recorded at exchange amounts.

That means the price the executive and company agreed to is the amount disclosed in the notes to the financial statements. And by “agreed to,” we mean something akin to your left hand shaking your right. The executive and the company are one and the same.

At this point, the board of directors should ask whether the amount the executive agreed to with himself constitutes fair value. This is where it gets uncomfortable. The executive will assure the board that the transaction is being carried out at cost, or cost plus a small profit.

The board is generally satisfied because they assume the executive’s costs would be competitive with third parties. However, the executive is simply abusing the accounting definition of the word “cost” in order to inflate the price before passing it along to the company.

There are many ways to pass on costs, not the least of which includes large salaries for the executive and his family through a private company, which then get embedded as overhead expenses when it comes to calculating the cost of the goods or services being sold to the public company.

Other embedded overhead expenses include travel (vacations), transportation (the family car), office rent (the family home), and club memberships. What might cost the executive’s company $5 per unit in third-party costs could end up costing the public company $7 per unit after unfair overhead expenses are added on.

Simply put, advisors need to be suspicious of related-party transactions—even those that are supposedly carried out at cost by the executive’s company.

Another trick: executives give their private company a name similar to the public company, such as Global Manufacturing Corp. and Global Distribution Inc.

That way, investors reading the note on related-party transactions assume any dealings are between the public company and one of its subsidiaries. A twist sometimes exists when it is actually a subsidiary, but with a minority interest held by the executives.

The final smell test

Advisors should also question whether a deal needed to occur with an executive’s company at all, and be very mindful of larger one-off transactions that involve purchases of land or buildings from the company. The Royal Group Technologies saga started with a transaction for a land parcel between executives and the public company. In such situations, it is important to know how long the executives held the property before vending it to the company.

A short time frame should be regarded as highly suspicious.The same caution exists in cases where the public company is renting a facility from an executive. Are there no decent third-party alternatives? Sometimes the arrangement exists simply so the public company can subsidize upgrades and improvements to the executive’s property.

In all cases, be suspicious of the disclosures made in financial statements. Above all, there is no requirement to disclose whether the transactions are being carried out at fair value, and boards of directors are not always effective at negotiating fair value for shareholders because of lingering independence issues and weak accounting jargon.

Dr. Al Rosen, FCA, FCMA, CIP, CFE, CPA and Mark Rosen, MBA, CFA run Accountability Research Corp., providing independent research to investment advisors across Canada. www.accountabilityresearch.com