Investors delighted but insurers concerned

A ruling that ordered an insurance company to pay $460,000 to a Quebec couple after their financial advisor invested their retirement nest egg in promissory notes in scandal-plagued Montreal financial group Mount Real Corp. has raised questions over the scope of professional liability insurance coverage in the province and ostensibly broadened investor’s protection.

Quebec’s financial and insurance sectors are now worried over the impact of a Quebec Court of Appeal unanimous decision that declared inoperative clauses excluding gross negligence in professional liability insurance policies under the Act respecting the distribution of financial products and services (ADFPS). Law insurance experts are speculating that the finding may have a reach beyond the ADFPS, and affect professional liability insurance policies held by the indemnity funds of Quebec’s 44 professional corporations, including the Barreau du Québec. The Quebec legal society declined to comment.

“Indemnity funds have reason to worry,” said André Bois, an insurance lawyer with the Quebec City law firm Tremblay Bois Mignault Lemay. “They have the same kind of clauses cited in the ruling. This will have an enormous financial impact because by excluding gross negligence insurers face higher exposure to risk” which in turn will lead to higher costs that will ultimately be passed on to professionals who need liability coverage to practice.

Questions have also surfaced over whether the Autorité des marchés financiers, Quebec’s securities regulator, will now accept professional liability insurance policies that contain clauses that exclude gross negligence. AMF spokesperson Cathy Beauséjour said in an email that while the regulator is ensuring that all professionals who operate under the ADFPS are covered by liability insurance, it is too early “to appreciate the impact” the ruling will have. A lawyer who used to work for the AMF said he doubts the financial watchdog will now scrutinize insurance policies to determine if they have the exclusionary clause because it would be a moot exercise. “The court has already established that the exclusion doesn’t apply,” said the lawyer.

Grocery store operators Denis Guillemette and France Mercier lost $232,000 when scandal-plagued Mount Real was shut down by the AMF in 2005, leaving 1,600 investors holding an estimated $130-million worthless promissory notes. The couple, who had little knowledge about financial markets, had entrusted their life savings to financial advisor and planner Yves Tardif and gave him instructions to invest only in secured assets which he did not do. The couple then sued Tardif, his firm iForum Financial Services Inc. and their liability insurer Lloyd’s Underwriters. (Tardif was fined $104,000 last year after pleading guilty to acting illegally as a dealer, aiding with illegal distributions and making misrepresentations in securities transactions. In 2010, he was fined $453,000 for similar violations in connection with the Mount Real matter).

Lloyd’s argued that the couple were partly to blame for their financial woes, and that the financial advisor acted outside the areas of professional responsibility covered by the insurance policy. But in a 36-page ruling that upheld a lower court ruling, the Quebec Court of Appeal in Souscripteurs du Lloyd’s c. Alimentation Denis & Mario Guillemette Inc. 2012 QCCA 1376 dismissed those arguments, and seemingly broadened the scope of  what constitutes “professional activities” covered by professional liability insurance policies.

Willful blindness was not an issue in this case, wrote Justice Marie-France Bich in her reasons. The appeal court found, based on the lower court’s appreciation of the evidence against Tardif, that the financial planner had breached his legal and professional obligations under the ADFPS. Informed by the oft-cited Supreme Court of Canada ruling in Laflamme v. Prudential-Bache Commodities Canada Ltd. 2000 SCC 26, [2000] 1 SCR 638, Justice Bich said that given the complexity of the investment sector and its inherent risks, “it must be recognized that if a person entrusts such decisions to a financial advisor or intermediary because he or she has little investment knowledge, that person is not under an obligation to constantly check and double check when, rightly so, the person has deferred to a professional in order to avoid” doing that.

Serge Létourneau, who successfully plead the case for the couple, said that allowing an investor with little investment know-how to “lower his vigilance” and defer to a professional is an important finding because Quebec courts often have interpreted the relationship between investor and financial advisor as a business relationship. That means that investors had to demonstrate that they paid the same attention and care as they would in a business relationship in their dealings with financial advisors. “The essence of a professional relationship is confidence, and this confidence allows an individual to defer to a professional,” said Létourneau, founder of  the Quebec City law firm Létourneau Gagné.

But Yan Paquette, a Quebec City litigator specializing in financial markets, warns that investors with limited knowledge do not have a free pass. Last October the Quebec Court of Appeal in Immeubles Jacques Robitaille inc. c. Financière Banque Nationale 2011 QCCA 1952 held that “even less seasoned” investors must be prudent, collaborate with the financial advisor and make a minimum effort to understand financial markets. Coupled with the Lloyd’s decision, Paquette says the appeal court is clearly stating that a financial advisor’s duty to inform is directly proportional with an investor’s knowledge. “The Lloyd’s decision places a burden on financial advisors to respect its duty to inform, said Paquette of Langlois Kronström Desjardins in Quebec City. “The less an investor understands the financial markets the greater burden a financial advisor faces to inform the client, and the reverse is true.”

The Lloyd’s ruling has also drawn concerns over what constitutes “professional activities” under liability insurance policies. Lloyd’s argued that since Tardif illicitly procured financial products governed by the Québec Securities Act, his actions were outside the scope of professional activities covered by the insurance policy. But the appeal court held that Tardif’s actions should be viewed as a whole, and that his unauthorized actions were the manifestation of improper financial planning. Since “the harm suffered by the couple stems directly from his bad financial planning,” the fault arose out of services governed by the ADFPS and therefore meets the definition of professional activities covered by the insurer.

“This ruling says that there can very well be a link between offering advice while performing financial planning and the act of selling financial products,” remarked Létourneau. “Each should not be examined separately. That finding has plainly overturned conclusions reached by Superior Court judges in other cases.”

Létourneau now wonders whether the provincial financial regulator will compel financial professionals to obtain insurance coverage that will encompass all activities as opposed to coverage that is limited to professional activities they are authorized to perform.

At the very least the finding will lead insurers and professionals to closely examine professional liability insurance coverage, says Bernard Larocque of Lavery, de Billy in Montreal. Thanks to the ruling, the scope of professional activities must be considered in light of the specific circumstances surrounding the case and all of the actions taken by the financial professional to determine if the fault is covered by the insurance contract, added Larocque.

Lawyers representing Lloyd’s declined to comment.

Mount Real scandal: Three more convicted

A couple of weeks after three more individuals linked with the bankrupt Montreal financial group Mount Real Corp. were ordered to pay fines ranging from $7,000 to $104,500, its former president now faces charges in an another alleged fraud that dates back to 1998.

Lino Matteo was accused yesterday of conspiring to divert more than $120 million from scandal-plagued Montreal animation company Cinar to several investment companies in the Bahamas tied to Norshield Asset Management, which collapsed into bankruptcy in 2005.

Matteo, who was ordered in three years ago to pay $18,000 in fines after being found guilty of ethical violations by a three-person disciplinary committee of the Quebec Order of Certified Management Accountants, asked for a legal-aid lawyer to represent him in future proceedings. Matteo, whose wife took out a $50,000 mortgage on a property to secure his release, cannot leave the country and is not allowed to take part in investment work.

Approximately 1,600 retail investors lost $130-million on unregistered investment notes issued by Mount-Real and its affiliated companies. Mount Real was a firm that provided management and accounting service and strategic advice to companies and individuals. Its principal business activity, though, was selling magazine subscriptions. In operation from 1997 to 2005, Mount Real’s structure was extremely complex, with up to 120 companies linked to it. A Toronto Stock Exchange listed company, the company boasted $5.7-million in revenues and $89.7-million in assets in fiscal 2004. In November 2005, the Quebec securities regulator shut down its offices after a probe.

On January 24, 2007, the AMF filed 619 charges against 24 individuals who acted as representatives in the matter of Mount Real Corporation and its subsidiaries. The Crown is still examining whether criminal charges will be laid. “We have to be patient with the file,” said Crown prosecutor Matthew Ferguson. “It’s complex evidence of an international scale and there’s an abundance of evidence as well, so we have to take our time. We have to be patient in order for this to come to court.”

In the meantime, on February 15, 2011, René Proteau was fined $7,000 by Court of Quebec justice Claude Parent after pleading  guilty last November to seven counts of illegal practice as a securities dealer and adviser.

On February 8, 2011, William Marston, once one of Quebec’s most successful investment representatives, was fined $79,500 by Court of Quebec justice Jean Pierre Boyer after pleading guilty to 17 charges. He was also $25,000 for distribution without a prospectus in the Norshield case.

On February 2, 2011, Nick Mylonakis was fined $70,000 by Court of Quebec Justice Louise Villemure after pleading guilty last November to 22 charges, including 10 counts of illegally pursuing activities as a securities dealer, nine charges of aiding with an illegal distribution, and three charges of making misrepresentations.

Mount Real financial scandal – Conviction #19

When Paul Messier Jr. pled guilty in mid-January to 10 counts before Court of Quebec Justice Jean-Pierre Boyer, it marked the nineteenth conviction against individuals in the Mount Real financial scandal.

Quebec’s securities watchdog, the Autorité des marchés financiers (AMF) accused Messier of aiding Mount Real Acceptance Corporation and Investissements Real Vest Ltée. with illegal distribution,  and acting as a securities dealer or adviser without being registered. He was fined $104,000.

After a three-year investigation involving six investigators who sifted through 375 boxes of evidence and 1.5 million e-mails and other electronic documents, the AMF filed four years ago 619 charges against 24 individuals who acted as representatives in the matter of Mount Real Corporation and its subsidiaries. So far, 19 have been found guilty on 498 charges, and fined a total of $2.3 million.

Mount Real was a firm that provided management and accounting service and strategic advice to companies and individuals. Its principal business activity, though, was selling magazine subscriptions. In operation from 1997 to 2005, Mount Real’s structure was extremely complex, with up to 120 companies linked to it. A Toronto Stock Exchange listed company, the company boasted $5.7-million in revenues and $89.7-million in assets in fiscal 2004. In November 2005, the Quebec securities regulator shut down its offices after a probe.

Approximately 1,600 retail investors lost $130-million on unregistered investment notes issued by Mount-Real and its affiliated companies.

Do jail sentences deter future white-collar crimes?

The courts appear to have heard calls from victims of white-collar crime demanding stiffer sentences against those found guilty of swindling investors.

In October 2009, Vincent Lacroix, a high-profile Quebec white-collar criminal found guilty of masterminding a $130-million fraud with 9,200 victims, was sentenced to 13 years in jail. A little over a year later, in February 2010, former Montreal financial adviser Earl Jones was sentenced to 11 years in prison, after pleading guilty to two fraud charges related to a $50-million Ponzi scheme he orchestrated.

But an accounting professor who published a study on occupational fraud is far from convinced that stiff jail sentences on white-collar criminals will prove to be an effective deterrent.

“Jail sentences do not deter future white-collar crimes,” said Dominic Peltier-Rivest, Chair and associate professor at the department of accountancy at the John Molson School of Business at Concordia University. There is no evidence or studies that suggest that extended incarceration yields additional deterrence, he maintains. “What discourages future white-collar criminals is the fear of getting caught, not the length of sentence.”

Peltier-Rivest asserts in his study, “Detecting Occupational Fraud in Canada: A Study of its Victims and Perpetrators,” that measures such as a fraud hotline or an anonymous reporting program, fraud awareness training programs as well as surprise and external audits can be effective tools to limit the losses incurred by occupational fraud.

Occupational fraud is costly. Peltier-Rivest, a certified fraud examiner (CFE) who earned his PhD studying financial statement fraud, estimates that public and private-sector Canadian organizations lose five per cent of sales to fraud every year, with small business (defined as having less than 100 employees) being particularly vulnerable. Smaller organizations, notes the study, tend to have fewer internal controls largely due to fewer or more limited resources.

The study discloses that 90 per cent of all occupational fraud cases involve asset misappropriation, with a median loss of $200,000. And it reveals that 42 per cent of occupational frauds were committed by employees, 38.6 per cent by managers and nearly 20 per cent by owners and executives.

But while owners and executives perpetrate less frauds, they commit larger frauds, with median losses estimated at $1-million compared to $165,000 for managers and $75,000 for employees. Executives typically have more opportunity to commit larger frauds “due to their high level of authority, which enables them to override controls more easily than lower-level employees,” according to the report. Executives also frequently have greater access to organizational assets than their subordinates, adds the study.

That’s why it is important for organizations to tailor anti-fraud measures, said Peltier-Rivest.  External audits are the most frequently tool to detect frauds, with nearly 80 per cent of organizations examined by Peltier-Rivest resorting to them. But they are from being the most effective anti-fraud measure. External audits detected only 6.7 per cent of frauds. In contrast 13 per cent of occupational frauds were detected by internal audits, 19 per cent by an organization’s internal controls, and a surprising 42 per cent through tips from employees, vendors, customers or anonymous sources.

In fact, organizations that use hotlines detect fraud far quicker and experience much lower median fraud losses than those that did not ($90,000 compared to $197,500). “This result brings some support to new audit committee regulations adopted by most Canadian provinces in the last few years, which require audit committees of publicly traded companies to establish reporting mechanisms to receive and address complaints regarding internal controls and financial matters of the company,” said Peltier-Rivest.

Peltier-Rivest believes that such reporting mechanisms should also apply to investment funds and private or close-end investment firms as a means to minimize and detect fraud such as was committed by Lacroix. At present, investment funds are not compelled to follow Regulation 52-110 respecting Audit Committees, which requires all reporting issuers to have an audit committee. Nor do investment funds and close-end investment firms have to abide by Regulation 52-109 respecting certification of disclosure in issuers’ annual and interim filings, which calls for every issuer to have disclosure controls and procedures and internal control over financial reporting.

“We should work on prevention and earlier detection as opposed to relying on giving somebody 12 years in jail and hoping that it will curb future crimes,” said Peltier-Rivest.

Michel Magnan, editor of the world-renowned quarterly journal Contemporary Accounting Research, also believes that stringent internal controls, rather than heavy prison sentences, are key to preventing occupational fraud. Magnan, like Peltier-Rivest, notes that there is a paucity of evidence emanating from studies over the efficacy of stiff prison sentences to deter occupational fraud.

“It is wiser to invest in prevention, that is, before the monies disappear,” said Magnan. “A stiff sentence will not deter occupational fraud. It will succeed in making these people more careful in the way that they will commit the fraud. Internal controls really are the key.”