Anyone with limited investment knowledge contemplating investing in exempt market issues should read the Ontario Securities Commission's 58-page reasons and decision in the matter of David Charles Phillips and John Russell Wilson, released Jan. 14. The same advice applies to anyone contemplating offering exempt market issues to people with limited investment knowledge.
Phillips was the head of the First Leaside Group of companies, while Wilson was the senior salesperson overseeing a sales team of six investment advisors and 19 sales associates.
First Leaside customers invested about $335 million in dozens of exempt issues. Apparently they will get back on average no more than 10 cents on the dollar. Many investors were counting on the Canadian Investor Protection Fund to cover their losses because their funds were held by insolvent First Leaside Securities Inc., a CIFP member, but so far claims have been rejected. Maybe it's time provincial legislatures pushed the investment industry self regulatory organizations to put mechanisms in place that protect victims of fraud if their dealer fails; the regulators should require all dealers to be members of an SRO in my opinion.
I wrote a two part series on the collapse of First Leaside in 2012 showing how, in my opinion, investors were victimized and asking why regulators didn't shut it down earlier.
The OSC hearing focused on a very narrow time period, from late August 2011 to the end of October 2011 when First Leaside Group raised about $18.76 million -- a fraction of the total amount people invested. Accounting firm Grant Thornton LLP released a report on Aug. 19, 2011, to First Leaside management. Grant Thornton concluded that the future viability of the First Leaside Group was contingent on its ability to raise new capital. Phillips and Wilson didn't disclose this information to prospective investors until early November 2011.
Specifically the OSC panel stated that Phillips and Wilson, "by favouring their own interests to raise additional capital for FLG, prejudiced FLG Investors. The conduct of the Respondents, in not disclosing the risks associated with an investment in FLG products, including (i) the $132.1 million equity deficit to equity holders of the FLG Entities, (ii) the cash flow deficiency of approximately $15.9 million over the three-year period of 2011 to 2013, and (iii) the viability of FLG, the Respondents' conduct constituted a breach of their duties as gatekeepers of the integrity of the capital markets."
It goes on to say "Each of the Respondents had a duty to conduct themselves with integrity and have an honest character. However, in engaging in a course of conduct that perpetrated a fraud on investors, the Respondents did not conduct themselves with integrity and acted contrary to the public interest."
It also says "We find that each of the Respondents engaged in or participated in an act, practice or course of conduct relating to securities that they knew would perpetrate a fraud on FLG Sales Investors, contrary to subsection 126.1(b) of the Act and contrary to the public interest."
Furthermore the panel states "We also find that the FLG Sales Investors were vulnerable because of their lack of investment knowledge and we accept their evidence that they relied on the advice of Wilson. We also find that this was or should have been evident to Wilson." Phillips and Wilson intend to appeal the OSC's decision.
I consider the phrase "vulnerable because of their lack of investment knowledge" important because the historical premise for allowing some securities to be sold without a prospectus was that the buyers were sophisticated investors such as pension funds, trust companies and insurance companies.
This not the case today when many exempt issues are flogged to the public. But whether a security is listed on an exchange or offered as an exempt issue, dealers and their salespeople have specific obligations to clients and prospective clients. First they have to know their client, which means knowing a client's investment objectives, his or her financial situation and personal circumstances. Dealers and their salespeople are also obligated to recommend only those investments that are suitable. To do this they have to know the product.
They are also obligated to explain to clients the risks, in particular to investors who have little investment experience. This has been the case for years but some exempt market dealers and advisors aren't meeting their know-your-client, know-your-product and suitability obligations. Furthermore, to fully explain the risks to a client the salesperson has to understand it himself. Sometimes I wonder what percentage of reps actually read the documentation.
Maybe the Canadian Securities Administrators should require that issuers of exempt products produce ‘Green Sheets' which are ‘for-dealers-only' summaries of offering documents showing the key risks and potential rewards and are used to educate salespeople too busy the read offering documents. In fact the regulators should go one step further and require the exempt market equivalent of a Fund Facts document showing the key risks an investor faces when buying the product.
In my opinion it isn't enough to state in the offering document that a product is suitable only for investors who can afford to lose some or all of their money. It should contain adequate and specific information about the company, its business, its management and any valuation quirks that will help an investor make an informed decision. Conversely, it should not omit any information that is needed to make an informed decision.
Of course investors have an obligation to themselves not to sign anything they don't understand and to read all documentation fully. One of the lessons I learned early in the investment business was to walk away from anything I didn't understand or about which I couldn't get satisfactory answers to my questions.
