“$windler$” by Al and Mark Rosen

In a nutshell

The Rosens’ book “Swindlers” can be best summarized in their own words that: all scams are “dependent on conflicted auditors, inadequate or non-existent regulations, ill informed directors, crooked managers and gullible investors.” They also say that scams remain “undetected because auditors, regulators, lawmakers and self-regulated professions in Canada have little incentives to uncover them until after they occur”, and that these “organizations have contributed to the complete and utter breakdown of investor protections in Canada”.  And, believe it or not, the Supreme Court in 1997 has ruled in the Hercules case that “statements in an annual report are not produced to enable shareholders to make investment decisions…and auditors have no duty of care toward investors”. And if you thought that Canadian investor protection already hit bottom, the Rosens predict that with the adoption of IFRS accounting standards in Canada in 2011 (by the way the U.S. has not adopted it), everything will likely get worse.

Their minimum recommendations are to: establish independent accounting/auditing standards boards free from the financial conflicts of current accounting/audit practitioners , “establish a national securities enforcement agency to act as a judicial counterpart to the proposed national securities regulator”, “dispense with principle based securities regulation” (like IFRS), “stop asking SROs (self-regulatory organizations) for solutions to problems they cause”, and “introduce legislation to fix Supreme Court of Canada’s decision in the Hercules” case.

(You can add actuaries to the conflicted, self-regulated professions, underpinned by inadequate regulations as they affected Canadian private sector pensions. At the risk of flogging a(n almost) dead horse, you can read about the pathetic level of private sector pension protection in Canada in a couple of my older blogs What’s wrong with private-sector DB pension plans? Problems and solutions and Systemic Failure in Canada’s Private Pensions: Who could have prevented it? What could be done now? ; is that an echo that I hear? The book enumerates assorted Nortel accounting scams including: revenue recognition, earnings from operations (rather than net income), bonuses, and expense reserve manipulations If these scams were in fact perpetrated as suggested by the authors (and Nortel did pay about $2.5B to settle-including hundreds of millions of cash that would have been better spent to shore up underfunded pensions) can you imagine that the pension fund was not scammed as well???) (Thanks to WET for recommending the book)

The details

-The authors list 50 Canadian fiascos, but they dedicate special chapters to: Nortel’s “treachery”, BITs (Business Income Trusts) “Ponzi scheme”, mining/resource company “depleting resource” accounting, ABCP, Livent, YBM, etc

-U.S. regulators took the lead in pursuing Canadian scams like Livent, YBM, Hollinger, Nortel, etc

-“TSX is the centre for mining listings in the world”…could it be due to Canada’s “lax enforcement, auditing, regulation, accounting and media have something to do with it”? “Con-artists love Canada’s resource sector”

-“depleting resource” companies can be like Ponzi schemes…whenever you are getting a combination of income and capital…the same accounting rules as used for manufacturing or retailing are inappropriate for  mining and insurance companies; and IFRS will give even “more reporting power and choice to management”

-Nortel accounting scams listed include: revenue recognition, earnings from operations (rather than net income), bonuses, and expense reserve manipulations (If these scams were in fact perpetrated as suggested by the authors (and Nortel did pay about $2.5B to settle-including hundreds of millions of cash that would have been better spent to shore up underfunded pensions) can you imagine that the pension fund was not scammed as well???)

-Hercules decision by the Supreme Court of Canada made “annual audits become close to meaningless to investors”

-“investors must recognize the serious deterioration of financial reporting integrity…in Canada since 1982”

-“legislators should have relieved auditors of their standard setting duties years ago” when CICA argued successfully “to the Supreme Court that investors could not rely on audited financial statements to make investment decisions”

-with the arrival of IFRS, Canadian investors might consider investing on companies cross-listed in the U.S. where financial statement are reported according to  US-GAAP rules.

-The book contains one of the clearest explanations of the recent “income trust” fiasco in Canada: “The fiasco of Business Income Trusts (BITs) could have occurred in no other country but Canada”…this was an “enhanced variation of a basic Ponzi fraud” …which… ”promised outsized returns while deliberately confusing return (income) and return of capital”….the new misleading term of “distributable cash” was introduced…and typically “excluded depreciation and amortization expenses”. And the clincher for many reader so upset about the tax changes damaging income trusts is their assessment that “The BITs market has been grossly overinflated by the deceptive practices of numerous greedy parties and a collapse was inevitable, without any changes in tax status”!

-the Life Insurance accounting chapter (sounds like pension accounting): “Actuarial estimates are loaded with assumptions”. So “expected returns”, “guarantees”, “disputable estimates”, are used by insurance companies to generate “cooked up financial figures, (so) the company then issues more debt to unaware investors”. IFRS will make situation worse again. (Would insurance companies behave differently if they were ‘mutual’ rather than ‘public’ companies? Should we continue holding life insurance companies in portfolios given the current and growing accounting uncertainties?)

-“boomers and retirees are particularly vulnerable” to scams  because they need income…and “lawmakers are sitting on the sidelines, along with securities regulators and auditors”…”meanwhile swindlers and high pressure salesmen roam free…”

-watch for ‘too good to be true’ investments like: Nortel with its “made-up performance metric”, BITs and their “made-up performance metric”, ABCPs…what next? must always ask: “where is the extra money coming from? At what additional risk?”…investors should watch out for leveraged ETFs, reverse mortgage companies!

-the authors dedicate a long chapter to why the introduction of IFRS “will make life miserable for investors” (pp. 180-194)…Appendix B might also be of interest to many on “Financial Statement Interpretation.

Bottom line

A very interesting and insightful book describing the sorry state of investor protection in Canada…the Nero continues to fiddle and Rome continues to burn…