Trading with the Sharks

How can we best protect ordinary investors?

Alice Campbell is the first victim we meet. A long-time employee of Nortel, both her disability income and her pension were badly compromised by the company’s descent from technology leader to its current receivership. When Bruce Livesey, then a producer with CBC’s Investigative Unit, shared with Alice information on million-dollar bonuses paid to Nortel senior managers, she was outraged. Nortel executives justified these bonuses by “cooking the books” to convert their losses into profits. And while some of those responsible are now facing their day in court, we later learn that Alice passed away prematurely.

Although one of the most spectacular, Nortel’s is just one of many cases Livesey shares with readers in Thieves of Bay Street: How Banks, Brokerages and the Wealthy Steal Billions from Canadians, his well-written and passionate tour of the past several decades of scandals and failures. From Bre-X to Hollinger to Earl Jones and from YBM Magnex to asset-backed commercial papers, numerous retold stories show how innocent Canadians were duped, swindled and otherwise victimized by corporate crash landings. And Livesey does not spare lawyers and bankers; their enabling roles in aiding culprits is well documented and criticized. In all this, Thieves is a carefully researched chronicle of the wide variety of schemes and mismanagement that have caused investors to lose their hard-earned savings and have damaged the balance sheets of corporate Canada.

Livesey views the financial world through the lens of his parents’ experience. They nearly lost their retirement savings to the fraud-related failure of Principal Group of Edmonton in the 1980s, until they and other Principal investors had most (although not all) of their savings reimbursed by government. Later, in 2008, both Livesey and his widowed mother suffered losses in mutual funds. These troubles provided Livesey with a close-up look at how ordinary people can become the victims of investment failures and financial scams. His journalistic lens begins most stories focused on an individual victim or victims, to instil the lost investment with personal consequence. We also meet corporate executives such as former publisher Paul Winkler, who saw his early warning to the Ontario Securities Commission regarding David Radler and Conrad Black’s manipulations at Hollinger ignored.

This approach makes Thieves a compelling read, as well-heeled villains are juxtaposed against their deeply suffering victims. Livesey captures the human consequence of financial loss in an understandable and compassionate fashion. His own anger at the injustice he uncovers is never far from the surface or absent from his writing.

The cast of characters includes executives such as Black and fellow convicted former CEO Garth Drabinsky, who seem to have missed the reality that public companies with public shareholders cannot be run in the same manner as private companies. By treating shareholders’ money as their own they ran afoul of the law. Their investors lost everything. Yet these are both brilliant men of enormous achievement.

Bre-X, on the other hand, is the poster child for a pure fraud. At its mine, gold was found by salting the drill core samples, that is to say adding the gold after the drill cones had been extracted. It was a fraud from start to finish. And a very large number of investors, amateur and professional, were duped. One saying often repeated among seasoned and cynical investors is attributed to Mark Twain: a mine is “a hole in the ground owned by a liar.”

But Thieves suffers a little from an overly black and white perspective. The insiders of the Canadian establishment are portrayed as conspiring against small investors. Yet many of the villains, such as Earl Jones who ran a Ponzi scheme that harmed more than 150 investors, turn out to be relatively small time themselves. His investors, for example, lost $51 million. The obvious exception is Conrad Black. Lord Black is far from a universal favourite among Canada’s establishment. Although his return to Canada has been warmly embraced by an extraordinary spectrum of Canadians, running from National Post editorialists to Margaret Atwood, one of his best friends—Hal Jackman—opined that Black should never have run a public company. I will tread lightly here lest Black declare me to be “crabby” and “obscure” as he did the reviewer of his last book in these pages.

Livesey’s thesis in Thieves is clearly summarized in his own words.

 

The financial industry has drifted far from its original purpose, which had been … to raise money to help companies grow and to enrich investors willing to risk money in those businesses. Instead, it has morphed into a wealth destroyer, a parasitic reaper of money from the middle and working classes, transferring it to the very people who run the financial industry and Canada’s wealthiest citizens.

Yet in these few sentences Livesey misses two important realities.

First, although Livesey claims that “investment fraud is epidemic in Canada,” perhaps persistent and continuing would be a fairer choice of words: the equity side of Canada’s financial markets, valued at over $2 trillion, is far larger than the sum total of the scandals enumerated. Bay Street has helped to establish an oil and gas industry in Western Canada, to develop new technologies, to build cable networks, pipelines and railways. Without equity capital, much of what we take for granted would not have been built.

Second, trading volumes in Canada’s bond market are estimated to be 13 times larger than volumes in its equity market. Institutional investors such as the Canada Pension Plan, Teachers Pension Plan, OMERS and many others direct the pension savings of Canadians into the bonds issued by governments as well as by corporations. Without this less visible dimension of Bay Street the development of Canada’s hospitals, electric utilities, schools, roads and other infrastructure would not have been possible. Over the decades the fixed income side of Bay Street has contributed greatly to the building of our country. While the bond market is less the stuff of scandals, it is a very sizeable portion of what the financial industry contributes to job creation and growth in Canada.

Bay Street is not a charity, and despite the disasters and much regulation there will always be a risk of losses for investors. Some of these losses are indeed the consequence of fraud; some are the result of the hubris of visionary entrepreneurs who believe they will be able to grow their enterprise forever without regard for the laws of financial gravity; and still others can be ascribed to the lack of a skeptical approach by individual investors. There is no single cause of corporate failure, but there are a few discernible pathologies to be avoided by investors.

Many chief executives are larger-than-life characters, for instance, and it is often difficult to separate genuine wealth creators like Paul Desmarais of Power Corporation from wealth destroyers such as the leadership at Nortel. So investors need to look past executive charisma and examine the finances of the business. In their heyday Nortel executives were given to lecturing Canada’s political leaders on how the country should be run like their own company. Arguably, since the early 1990s they have not—thankfully so.

Such investor disasters are driven by the belief of company management, following in the footsteps of the founders, that their particular business genius is unstoppable. Not covered in the genius-conquers-all syndrome is the reality of competition. Research in Motion developed a genius product—the BlackBerry—but lost ground to Apple on both iPhone and iPad launches. There is almost always a competitor, often with a newer product, deeper pockets or both.

Finally, many losses are the simple consequence of investors buying into euphoria at the top of the market and panic selling at the bottom.

Of fundamental importance in regulating financial markets are a few basic principles. Individual investors are motivated by two of the most powerful human emotions—fear and greed. And the swings between these opposing positions wreak havoc with markets and undermine steady returns for investors, who tend to be swept along by euphoria and panic.

Not all losses on Bay Street are the result of fraud or thievery. Many result simply from the volatility of the equity market and the triggering of emotions of fear and greed at the wrong times.

So how can we reduce the risk of losses to investors? Perhaps worn out by his tour of the thieves and their sins, Bruce Livesey runs out of steam when he gets to solutions. After 259 well-argued pages, he devotes only two pages to “What Can Be Done?”

His centrepiece is a national securities regulator. Livesey’s view is that the cozy Canadian establishment is unwilling to embrace a tougher regulatory regime. This view may have a measure of truth to it. However, the obstacle to a national securities regulator is neither Bay Street nor the comfortable Canadian establishment. It is the constitution of Canada. So long as at least four provinces oppose such a major structural move, it cannot be done: as Livesey notes, the Harper government proposal to put such a regulator in place has been rejected by the Supreme Court of Canada in a seven-to-zero decision. Whether a national securities regulator would have the desired result Livesey is looking for—more stability and accountability in financial markets—is a question unlikely to be answered in this generation.

There is also something appealing to Livesey about the more aggressive justice system in the United States. Participants in that system certainly did not blink or play favourites when they charged, tried and convicted Enron’s Ken Lay, Lord Black and many others. Yet the willingness to have harsh penalties seems connected with also having lax regulations, striking a very American balance. And their banks, not ours, collapsed in 2008. Their mortgage-lending institutions from Fannie Mae and Freddie Mac to Countrywide Financial Corporation flirted with bankruptcy while ours did not. Be careful what you wish for. In a choice between failed banks and those that are solid but not razor-sharp competitors when it comes to fees, most of us will grumble and pay the fees. Leave to us the small quantity of Canadian smugness this buys us! Canada may be less for hanging the bad guys in the town square, but we are more for firm regulation.

Other approaches may be less dramatic than throwing fraudsters in jail but more effective. There could certainly be improvements to disclosure and to regulation. In my view a sensible approach is the one taken by the Ontario Securities Commission, which calls for continuous improvement in the performance of those it regulates. While not as dramatic as prosecutions, it is leading to a stronger compliance regime in Canada’s financial sector. This will benefit investors. For example, the OSC has reviewed marketing materials and is enforcing rules that compel managers to disclose their actual returns fairly.

In addition, the Task Force on Financial Literacy has made a number of important recommendations for better education of Canadians on matters financial. Among the key recommendations is the inclusion of financial training in the formal high school curriculum—a very sound idea.

The fundamentals of such training need not be overly complicated. After 25 years of investing my own money and 14 years of the greater burden of investing the money of my clients, I have come to a few insights. None is revolutionary, but all can help investors avoid catastrophic losses of a Nortel, Bre-X or RIM variety, for instance.

Rule 1: Be a skeptic. Look for longevity in the companies in which you invest, not bold headlines about their stellar prospects. Do your own research before buying. When a company is on the front page, it is usually too late for it to be a bargain, and many of today’s highest of corporate high fliers become tomorrow’s disasters. So if it sounds too good to be true, it likely is.

Rule 2: Diversify. Do not put all your investment eggs in one basket. Try to hold a minimum of ten or twelve different positions and, if your account is large enough, twenty separate positions. Successful investing is about base hits, not home runs.

Rule 3: Boring is good. If you want excitement, go to the racetrack and bet $5 on the horses. If you want stable, long-term growth, invest in boring but profitable companies that pay regular dividends such as utilities, banks and other essential Canadian industries. Some of the best long-term investments are the banks and utilities that consumers often curse for their high fees and charges.

Rule 4: Invest close to home. Rather than getting investment ideas from the front page of the daily paper, have a look through your monthly bills. You are likely receiving bills from one or more banks for your credit cards; from Enbridge for your natural gas; from Rogers, Telus or Bell for your cable, internet and phone; and from an oil company to fuel your car or truck. These are companies with staying power. They are generally better investments for the long haul than those stocks your uncle is pitching. And you may feel mildly better paying monthly bills to a company in which you own shares.

Bay Street will continue to disappoint investors who blindly trust what they are told by the unscrupulous few. Unless investors become knowledgeable and informed they will also be paying high fees for mediocre performance to our bland but respectable institutions. Caveat emptor has never been a more valuable rule of thumb than when dealing with investment.

Take the time to read Thieves of Bay Street. Also strongly recommended are David Chilton’s two books, The Wealthy Barber: The Common Sense Guide to Successful Financial Planning and The Wealthy Barber Returns. Chilton brings a practical bent to his writing and keen eye to how the individual investor can avoid the traps of Bay Street. In The Wealthy Barber, he makes a convincing case for saving—pay yourself first. In his newest book Chilton provides a sound how-to guide to navigating the variety of investments available for savings, and their merits. Livesey cautions investors by chronicling all the ways those savings can be lost. Thieves is a wonderful but darker complement to the two Chilton books.

Read all three and absorb their wisdom, and you will be much harder to separate from your money.