Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 42 - Evidence
OTTAWA, Wednesday, May 8, 2002
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:10 p.m. to examine and report upon the present state of the domestic and international financial system.
Senator E. Leo Kolber (Chairman) in the Chair.
[Français]
The Chairman: We are very pleased to have from, Rosen and Associates Limited, Mr. Lawrence S. Rosen, who has an extremely impressive CV, which would take me a long time to read out. He is a chartered accountant, a certified management accountant, and has a whole host of other credentials.
Mr. Rosen, the floor is yours. Please proceed.
Mr. L. S. (Al) Rosen, President, Rosen & Associates Limited: Honourable senators, I will go through the first five pages of the handout material using the overhead, just to hit the highlights, after which it can be turned over to questions.
I want to add to the package you have before you.
You keep hearing about Enron and the special entities and so forth. I want to stress that, in Canadian terms, that is not really a major issue. I cannot say that it is not a problem; however, in Canadian terms, we have far more serious problems than that.
Canada is unique in the world among the large nations because it gives both auditing and accounting responsibilities to the same group. In that situation, the auditors have to audit their own rules, and the question then is whether the rules are adequate for the investment community in the country.
There are many situations where Canadian rules are very easy to get around. Several years ago, I filed an affidavit with the Supreme Court of Canada to the effect that there are hundreds, even thousands, of ways of accounting for exactly the same transaction. Not every transaction has 1,000 ways of accounting for the same transaction, but some have so many possibilities that there is just no comparability from company to company. One of the arguments for letting us have one group have a monopoly is that we are getting comparable financial statements. Unfortunately, that is just not so at all.
We now come to the point of the profits. In this situation, it is not uncommon in Canada to have this level of profit being reported by a company using Canadian accounting rules. However, given those same transactions, if U.S. rules were applied the profit would be much lower, or it could be a loss.
Quite often, we get the argument that if Canada tightened up it would be offside with the U.S. and with the other countries that we are in competition with for goods and services. However, that is just not what the data shows. Too frequently, the Canadian profits will be much higher and they will swing in relation to the U.S. There is not a consistent pattern there. A Canadian investor looking at a Canadian company may think it is very profitable; however, if one used another accounting system, either U.S. or international, one would get much lower or much different results. That is an important point, because it takes considerable digging into the financial information to realize that that is what is happening.
I have two businesses, in a sense, since leaving teaching. One is advising the pension funds and the mutual funds in Canada, saying that, for a particular company, we do not like the following ways in which they are treating transactions and that, therefore, they should adjust the financial statements because we do not think it is conveying what it ought to be conveying.
In that connection, as example, there are a few pieces from Nortel. There is one Financial Post article dated July 26, 2000. Did that get distributed?
The Chairman: Yes, it did.
Mr. Rosen: You will notice in that article that there are references to the chief executive of Nortel and to me, in the far right column. The point being made there is that if we make the adjustments that I am describing it will be difficult for Canadians to finance their business. What is interesting about this is what has happened to Nortel, because these types of circumstances, where you say that you are not going to be able to finance, do not hold up for very long. Eventually, people come to realize that the Canadian accounting system has some serious problems.
Circling this particular problem is that if the auditors set their own rules, and if those rules are loose and allow for considerable judgment, then they will have watered-down principles, or rules. That, in turn, leads to Canadian profits being much higher.
The second business is the forensic accounting investigative business. In that regard, we see these Ponzi frauds, where the investors are being given back their own money and calling it profit. Under U.S. or international rules, this would not be considered profit. In that scenario, people believe that they are dealing with a very profitable Canadian company and as such they bid up the stock price. Then you get the Nortel-like situation happening.
Slide number 4 involves an extremely serious problem, because the rules are in the Canadian handbook of the CAs talk about the importance of creditors and investors, saying that financial statements are for the benefit of creditors and investors. I am disturbed by the number of times auditors being sued go into court and argue that that is not the purpose of financial statements. They argue that financial statements are not there to help individual investors make their investment decisions. In effect, these auditors are arguing the exact opposite of what is found in their accounting rules.
That is the court posture, and it has been accepted up to the Supreme Court of Canada. How is it possible for us to let the auditors set the rules? The rules should be set up to protect investors. If auditors argue in court that it is not their job to protect investors then there is something awry in the system.
Canada is uniquely giving auditors two roles, that of setting the accounting rules and the audit rules. They go into court and deny responsibility. What does the investor do? Where does the investor look to get some help?
We have some very strange situations that are, unfortunately, unique to Canada. They are troublesome from an investor's point of view.
I shall now turn to slide number 5. This compounds the situation because we are trying to have one set of rules. This is unlike the U.S. and other countries, but not everywhere. We are trying to have one set of rules applied to every industry.
I speak from my forensic accounting practice. If you look back at the failures of the last 15 or 20 years, for the most part they have been in banking and real estate. What is it about the Canadian accounting rules that make them unsuitable for banks and finance companies? The answer is that not enough attention is paid to the cash side.
One of the packages has the financial statements of Victoria Mortgage Corporation Ltd. over two years, the Canadian Commercial Bank, Standard Trustco and Confederation Life.
Perhaps we could spend a minute looking at Canadian Commercial Bank. Labour Day 1985 is when Northland Bank and Canadian Commercial Bank were put into bankruptcy. The reverse side of the first page reads: ``Canadian Commercial Bank — Consolidated Statement of Income.''
The last year before bankruptcy, 1984, Canadian Commercial Bank was showing a net income. In 1983, the net income was much higher, at $6.5 million. The Canadian rules are allowing these profits to be reported. Some changes have occurred in the accounting rules since then, but let us try to follow it through.
Senator Furey: The snapshot we are seeing for Canadian Commercial Bank is a company that had a net profit two years prior to bankruptcy — actually, it would be less than 12 months prior to bankruptcy.
Mr. Rosen: Yes.
Senator Oliver: What should be different? If you look at the interest income, what should be stated differently?
Mr. Rosen: The provision for losses, as it turned out, was $14 million, so it was much higher. This is generally the difference between a cash basis of accounting and GAAP accounting, the accounting rules of Canada. In any business where cash is a concern, GAAP tend to hide it, or the Canadian accounting rules tend to hide it.
It is the same with real estate companies. If you have to use the original cost in accordance with the Canadian accounting rules, the value can drop or the value can go much higher, but you are stuck under the Canadian accounting rules with this historical cost. With our students, we use the example of the Beverly Hillbillies, where Jed fired into the ground and up came the bubbling crude. The point is this: Where is bubbling crude on the balance sheet, page 1, of Jed's oil company? It is not there under Canadian rules. What is there is the cost of the bullet. This is how out of phase these things can get.
Senator Furey: Before you move on, with respect to ``Provision for loan losses'' in the consolidated statement of Canadian Commercial Bank, could that be something as simple as a potential tax rebate that eventually gets written off?
Mr. Rosen: In Canada, these companies eventually tend to have these under-reported expenses and losses, and they take what is called a one-time writedown. It is these one-time writedowns that are catching most investors. A company can have two or three years of what most people would call an artificial profit and then eventually take what is called a big bath writedown.
The Chairman: Are provisions for loan losses in banks basically a guess?
Mr. Rosen: They are, but if you go into the range of guess, that is where the problem is. I testified at the Northland Bank case. You can say. ``Within a limit of this much, it could be a loss of here, could be a loss of there, but it is not way over there.'' Of course, there is judgment in accounting, and considerable judgment. However, if the facts are that many of the people have not made payments for the longest time, the loan has been restructured once or twice, the payments have been lowered, the interest rate has been lowered, the value of the collateral has dropped considerably, this is way beyond judgment now and you are into saying: ``I am sorry, there is one chance in 100 of that being so.''
The Chairman: I follow that, but what do you do in a case like Teleglobe, where BCE says that it will make good on Teleglobe's debt but then, because of BCE's problems and Teleglobe's problems, BCE reneges? Suddenly, billions of dollars have vanished, and probably no banker could have guessed it.
Mr. Rosen: I am not too sure about the latter part, that ``no banker could have guessed it.'' We were writing up concerns about BCE two years ago.
The Chairman: Because of Teleglobe?
Mr. Rosen: Because of Teleglobe and some of the other companies, yes. This is one of the points I wanted to make. If the few people in our firm can detect this type of thing and write it up, because we put it into the newspapers and magazines and so on — we are well on the record of calling these things two and three years before they happen — then other people can certainly figure it out.
The Chairman: I would accept that.
Senator Furey: The question I had previously asked, although I used the phrase ``provision for loan losses,'' I had intended to ask about ``income taxes (recoverable),'' and how those are written down to compound the problem of a writedown on provision for loan losses. How widespread is this practice? Are accountants often setting up potential tax recoveries that they know in a couple of years they will have to write off?
Mr. Rosen: Yes. I did a column in Canadian Business magazine a few months ago about exactly that, companies saying they have had losses and will recover them, so they set up an asset saying the tax is to be recovered, and then they rethink it a year later and they take a big bath expense.
Senator Furey: For that one year, their share prices go up.
Mr. Rosen: It could be for two or three. My worst call of all was Loewen Group. I thought: ``Here are the problems. It could happen any time in the next year.'' It took four years. That is how far out you can be trying to do this, but you know eventually the company is going to have trouble. With respect to Nortel, we were calling that a year and a half, two years, while the stock was $120 — and that is in some of the handouts you have.
I found one this morning on QLT — I was looking for something before I flew up here. We were calling those problems and, as you might know, QLT dropped in the last day or two. In some of the appendices, there is a list of a number of other companies where the stock prices dropped tremendously.
Senator Tkachuk: Have you ever called something that never happened?
Mr. Rosen: A few times, I am sure. However, do not forget, in our practice of advising the pension funds and the mutual funds, we are mainly looking for what is called the torpedoes. When we really dig into things and say, ``For certain, this company is in big trouble,'' by then we are super confident.
Senator Kroft: I do not want to detract from what you are doing here, but I want to understand the process of how you operate, the way you communicate and what people do with that information.
Let us assume a perfect marketplace, in which everyone has equal information or similar information. If you and others like you are exposing or passing on this information to the public, in terms of articles you write, or to your clients, in terms of private communication you have with them, and given that you have the credibility, which we know you have, I am curious for some comment from you as to how those people you advise react to this information. If they do not react, why not?
If two years ago the information was there on a certain company, and it was widely known and understood, why does that not get reflected in the buying behaviour of your clients and ultimately, therefore, in the stock price? In other words, is it lack of exposure of this information, or lack of apparent impact, or is there just so much drive and momentum in the market that it goes on in spite of this information?
Mr. Rosen: There are three or four factors, and you have touched on a few of them. First, the people have to build up some confidence in you. When we first started off, I got into tremendous fights on Cott Corporation. This information was picked up in U.S. magazines, and eventually that stock came down very seriously. It is a whole new management now, so it is unrelated. However, my point is that them believing you is a major factor.
The whole issue that has to be investigated in this country, and the sooner the better, is index funds. If you happen to be one of four money managers of a university pension fund, for example, and your return on investment deviates too much from the others, they can just pull that away from you — what they try to do is mirror the market. Nortel got silly, in the sense that the Toronto index was so heavily weighted with Nortel that these companies had to buy up to the limit of Nortel. They were saying: ``You are telling us that at $120 Nortel is grossly overvalued, but I cannot sell all my Nortel because if the market keeps driving it for three or four months then I look like a bad money manager.'' We have to do something about these indexed mutual funds and indexed other types of funds because it means everyone clubs together and everyone drives off the cliff together, unfortunately.
We have been spending a bit more time on education. There are programs, such as the Canadian Securities Course, where what they are teaching is obsolete material. I met with them once, tried to convince them, got absolutely nowhere, so if you have many of the money managers who are going through this process of learning what I would consider to be obsolete material they are also not going to believe you unless you keep a total record.
Do not forget, we need to look at Canadian financial statements, and they are not giving us what we need. Hence, in order to get material, we have to start looking in the U.S., among many other places. If money managers do not take the time to do that, they will have a tendency, as you said, to just flow with the market.
The part that troubles me the most is that the people who have considerable dollars can look at this material; they can hire people such as ourselves. They are protected because they have the power, the dollars, and the previous experience.
Senator Oliver: They also have the knowledge base.
Mr. Rosen: Exactly. It is the small money manager and the average Canadian that is not protected, in my opinion. It comes back to the securities commissions being fragmented provincially, the accounting rules being set by the auditors, and some of the Supreme Court of Canada decisions. There are a number of missing protections.
What troubles me about it is the question of whether Canadians really have to go to the U.S. if they want protections because there are not many in this country.
Senator Furey: Would not fairly sophisticated investors be able to get at this kind of information?
Mr. Rosen: They would have trouble. They could get at it by going to the companies and saying, in so many words: ``I am investing considerable dollars in your company. I want this information.'' However, you then get into these problems of release of information to a power group versus the public. That is a very difficult form of early release and we have had some securities commissions working on that.
Senator Oliver: Going back to this income statement on Canadian Commercial Bank, you said that the problem with this particular one was that the provision for loan losses was $14 million. In terms of corporate governance, this would be a statement prepared by the company's auditors, but this would also have to go through the audit committee and ultimately to the board.
In terms of this misstatement of $14 million for provision for loan losses, could you comment on the level of responsibility for the accounting firm, the auditor, the audit committee and the board.
Mr. Rosen: First, the accounting that is used is chosen by the officers, presumably with the approval of the directors in a company. There can be multiple ways of accounting for something. A company has to decide whether it wants to take the one that shows the highest profit, the lowest profit, or in between? Let us assume a company decided to take the middle of the road approach and stay with it for five or six years. The audit committee and the auditors may talk about what is the next step. The auditors would have to decide whether they agree or disagree with the chosen accounting policy, whether it has been applied reasonably, and so forth.
For most of the situations I see, the audit committee does not have its own independent advisory group. We have been hired a few times to go in and tell the audit committee that what we see happening makes no sense, but it is certainly very rare in this country, as far as I can tell.
A statement is approved by the audit committee and then the whole board. Once the auditor has approved the statement, it is out there in the public. If the auditors have not been that happy, say, but were happy enough with the statement, they will sign off.
Therefore, in Canada, not only is it necessary to look at those rules, but you also have to stand back from the financial statements of a company and ask whether they are a reasonable representation of what is happening in that company. This is what we are doing as a business. We try to stand back.
When I pick up a financial statement, I am interested right away in whether there is a big difference — U.S. versus Canada difference — in the profits and so on. I then look at the accounting they are using. Sometimes I think the numbers are absolutely absurd, based on what I know about that company, and then we start to dig. At other times, I may feel I do not like it but it is not that far off.
Here we are with this strange situation of not requiring as a fundamental rule the standing back, looking at those financial statements as a whole and recognizing that these people have picked their way through this set of rules, and what they end up with in the end is silly. There are far too many of those in this country.
That is what is interesting about Victoria Mortgage, by the way. Your question is a good lead-in to that particular situation.
Senator Furey: To follow up on Senator Oliver's comment, last night we spoke to Mr. Brown from the securities commission. One of the questions I was interested in exploring was whether an independent auditor could be used for a corporation, independent of the corporation's accounting firm, which generally guides or assists or oversees the board's audit committee. I was not really interested in exploring the two-audit system, which countries like France use, but that is where he went. The basis of the question was whether it would be cost-prohibitive for a corporation to use an independent auditor, to oversee that company's audit committee?
Mr. Rosen: It could be very expensive to have two auditors, but that is not quite my point. I was getting at having the audit committee only have a separate budget and have its advisors, independent of the auditors, independent of other people.
Senator Furey: Independent of the company's accounting firm.
Mr. Rosen: That is not expensive at all. Some of the ones we have done cost $15,000 or $20,000. We go in and point out to the audit committee areas that need further thought. We tell them where they are exposed, and that eventually they will have to take a hit. I do not see that as that expensive.
Senator Oliver: Are a number of companies doing that now?
Mr. Rosen: We have only had two or three over the last year. It is probably a post-Enron situation, where people are saying, ``Let us get a second opinion on this.''
Our forensic practice has two elements as well, in terms of accountants and auditor negligence. Three-quarters of what we do are assessment cases for the insurance policy of the CAs, small firms. About a quarter involves going into court and testifying that the directors, officers and auditors did not do a good job in huge Canadian companies. I can tell you that most of the time our testimony is holding up and being accepted by the judges.
Senator Kroft: On this disparity issue, there are many Canadian companies that operate and are registered on stock exchanges in Canada and the U.S. They may report Canadian GAAP one side and U.S. on the other side.
Mr. Rosen: There is a reconciliation at the end.
Senator Kroft: Given the number of such companies with dual registration, and therefore reporting requirements that come with that, do these disparities not get quickly exposed by analysts who are faced with the same company with two sets of filings?
Mr. Rosen: I would like to see data on this. Your question has bothered me for the longest time. If you only report in the Canadian side — 70 per cent of an RRSP must be invested in Canada. This may be too cynical, but I often wonder whether it is the Canadians reading the Canadian accounting that drive up the stock prices and whether the Americans sit there shorting the stock, getting it down to the level that they want it.
This may sound silly, but one of the things we try to do is sell our newsletter into the U.S. as well. We are hearing from those money managers, who are asking, ``Why should I invest in Canada?'' I find that very troubling. There are a few who are clued in to the Canadian situation. Where we are getting a response, which I do not like personally, is from the hedge funds in the U.S. They are saying, ``You guys have a good record of torpedo stocks.'' It is obvious what they are going to do — they will short those stocks.
I wish I had some decent evidence on that, because I just do not know. However, I have a feeling that in a sense we are being fleeced by the Americans a bit too much — if we continue to have those stocks, even if they are driven up $1 or $2.
Senator Kroft: With the inter-listed stocks — if you get one that absolutely exposes something and kills the stock if the shorts just overwhelm it. If you get much disparity, vis-à-vis a difference of information, then the arbitrageurs will look after that pretty quickly, so the differences will get buried.
Mr. Rosen: What you are saying is fine in economic theory. However, that has not been my experience in what we are finding. One of the appendices I have in the material is a list of companies that have been driven down tremendously. You will see that quite a few of them are not inter-listed. Hence, Canadians are being, in a sense, duped into going along with those companies and then down they crash.
The Americans have quite a few stocks they can play with, so why would they pay that much attention to the Canadian ones, unless it can be a nice short sale?
Your question has bothered me for the longest time, but that is not what we are seeing in our litigation cases.
Senator Kroft: They wrote Nortel on both sides of the border the same way.
Mr. Rosen: Yes, and the consequences to Canada were serious. I have ex-students who were posted in London and Tokyo who are afraid to admit they are Canadians because they get needled repeatedly by people saying, ``Oh, yeah, the Bre-X, Nortel, et cetera, crowd.'' There is a serious side to this.
The Chairman: Nortel is not unique in the world of telecom. There are dozens. Marconi went from 100 to zero. Nokia has trouble, as well as Ericsson and Alcatel. We single out Nortel because it is our homeboy, but the fact is that it is not unique.
Mr. Rosen: It is and it is not. What is unique is how far down it has come.
The Chairman: There are worse.
Senator Oliver: It is still going down.
Mr. Rosen: We could make a list, for example, of the number of U.S. stocks that have had problems versus the number in the U.S, and the number of Canadian stocks that have had problems versus the total Canadian. My gut feeling is still that we have far more problems in Canada.
The Chairman: I am glad we are first in something.
I think we are unnecessarily picking on one company. It is a wonderful example of how things can go really rotten, but there are many of them.
Mr. Rosen: My handout includes several appendices. With respect to Appendix B, in a number of those cases the amount of money involved was not small, and there was a fair amount of Canadian money into it. Appendix D is a list of companies where there have been large stock price drops. I could have gone on for pages. I chose these as examples.
Once these get into court, it is not that hard to prove that there were serious accounting problems and serious auditing problems that led to these problems. If settlements are made on that basis, and if the judges go along with that situation, aside from the marketplace, it still points out that we have auditing problems, accounting problems, supervision problems, Securities Act problems and so forth.
The Chairman: Please continue, Mr. Rosen.
Mr. Rosen: Just to go further on those first few pages, I am bothered by this, and I hope you will have some testimony on this point. Is it possible that the small people are being pursued by the securities commissions, and they get their convictions, but we are not really having an impact on the bigger corporations and bigger underwriters and bigger auditors and so on? My gut feeling at this point is that you will see some convictions, but I do not think we can count those; we have to weigh them in terms of their relative importance.
Slide number 7 seems to have been a real favourite — that is, if you do not like the profit number you are getting then invent one. If you do not include all expenses and you are showing that this company appears to be very profitable, and the executives get a bonus on those numbers but the shareholders are getting next to nothing, then that is a very serious problem.
Senator Oliver: Would that not be fraud?
Mr. Rosen: For fraud, you have to prove intent, and that is difficult to do. It may be getting very close to it. Let me give you an example of fraud that horrifies me and is happening in Canada. It is a matter, again, of getting the right proof.
In this country, you can buy $100 million worth of machinery and pay $150 million for it. Why would you pay $50 million extra? The person getting the extra $50 million pays tax on it, and then gives it back to you. Let us suppose in $50 million extra you pay $20 million tax, $30 million left. They can feed $5 million or whatever back to you every quarter for six quarters. What happens? The extra $50 million becomes goodwill. The Canadian rules on goodwill is that you can value it each year, which is a change in the rules from last summer. You can feed back $5 million a quarter.
Senator Kroft: How? As equity?
Mr. Rosen: No, it just comes back in a contract for services. You say, ``You, the receiving company, contract with us, provide us with certain services and things like that, and we will provide you with services.'' The net effect is that $5 million in cash per quarter comes back to the company that bought the equipment. On that basis, you can, for so many quarters, increase your quarterly income before tax and drive up the stock price. Then what happens, of course, is that you either buy new equipment after six quarters or the stock price comes down. That is a fraud.
Senator Kroft: You are depreciating on the $150 million.
Mr. Rosen: You can do it over 20 or 30 years. What comes in is six quarters worth of $30 million, and the extra $50 million gets depreciated over perhaps 20 years, or in the case of goodwill, you can leave it there for the longest time.
I have had three of these, one of which I know one of the securities commissions knows about, and I am waiting to see what happens. Those are definite frauds. There is no question about intent on those situations. If the prosecutions do not start showing up, I will be very upset. This is how unregulated our markets can be at times.
Senator Kroft: This is obviously the question you are leaving with us. What possible opportunity is there for anyone in the market, even a sophisticated institutional investor, to get into that depth in a company to know what the value of a capital equipment transaction is?
Mr. Rosen: You have no hope at all. That is why you need tighter accounting rules and auditors who are looking for this type of thing. If you compare on fraud and the search for it, again, Canada is very weak in that area. The Americans, for example, and the Europeans are a little more concerned about it. They are telling their auditors: ``Here is what you are obligated to do as an auditor.''
It has to be someone acting on behalf of the investors or the shareholders.
Senator Kroft: In this case, you are saying that in the U.S. the auditor would, by rules or inclination, specifically inquire on a large cap expenditure like that?
Mr. Rosen: They should, unless it is a huge company. It depends on the size of the company, the terms and so forth. If you end up just throwing another $50 million into goodwill or property, plant and equipment — you have to have some feel about what was the last purchase you made.
You can miss this as an auditor, obviously, because auditing is sampling, but you should not be missing this year after year after year. There are instances where the auditors have missed frauds for 14 and 15 years. That is getting serious. The excuses vanish after a few years. The sampling had to have picked up something over that period of time.
Where I am going with this is to say that the Canada Business Corporations Act, regulation 44, should be changed so that an independent body deals with the accounting rules. Let the auditors have regulation 45, and improve what they are doing. However, in terms of a solution, I cannot imagine anything short of appointing a separate rule-making body that says, ``Look, here is how you have to account for certain of these transactions.'' It cuts out the choices.
Senator Oliver: Who should be on that independent committee, and how should they be appointed?
Mr. Rosen: I would think it has to be run out of probably the department, or OSFI. OSFI could run the bank side, the brokerage and that type, where there is cash involved. What probably needs to happen is a beefing up of the department handling the Canada Business Corporations Act. They would then be oversight. For $20 million or $25 million in this country, you can have enough staff and permanent people. You can set up this organization. While it is getting going, you can still use the old rules from the U.S. or Canada.
The Chairman: Are you aware that the CBCA applies only to federally incorporated companies, which I believe are in the great minority in this country?
Mr. Rosen: Yes, but it is a matter of educating the provinces to make similar changes. If you go back to the 1970s, the problem there was that one government group had to first approve the equivalent of regulation 44, and the others then fell into line as a result of that. Someone has to start the process.
The Chairman: Do you think that would work?
Mr. Rosen: We are now seeing too many of what I would call flagrant violations and stepping around loose rules, so we better try something. You can ask that question to other witnesses this committee will hear.
Thirty years ago this month, the Canadian Institute of Chartered Accountants published a study I did on the alternatives to historical cost. Over the 30 years, I have seen so little movement towards improving the rules. Perhaps I am too cynical about the chances of any improvement occurring if you leave the power base with the people who are both the auditors and the accountants. Something different must be tried.
Senator Hervieux-Payette: I am not the accountant in the family, but there is an accountant in the family. Yearly, I attend the International Fiscal Association conferences. They are addressing the question of having international protocols, so that when you read a financial statement, whether in Australia, France, Canada or the U.S., you can understand it.
Will we penalize ourselves if we go one way while the rest of the world goes another? What would the OECD say about it? From where should the leadership come? Are we going to penalize our companies? Canada always tends to be more Catholic than the Pope.
Mr. Rosen: Not in this area, no way.
Senator Hervieux-Payette: We see that on the international scene, in other areas, where sometimes we are the only one who believes in the new structure and the new rules, but eventually it is not necessarily in the best interests of the whole community.
In my thinking, it would be best if at least the G7 or the OECD countries moved together in this area. In that way, we would not be the only country acting on this; we would not isolate ourselves.
Mr. Rosen: Based on the evidence I have tried to present, in the material you have, Canada is far behind. Let me give you simple example.
You can have plant and equipment. You can show it on your balance sheet at the original cost. In Canada, it can stay there until you know the value has dropped considerably — the words are ``for several successive years.'' You can leave bad assets — land, buildings, equipment and so on — on your balance sheet.
The Americans say that that must be looked at in a shorter period of time and written down. The Europeans say that not only must you look at it, but also interest rate factors must be added.
It is like a bond. You spend $1,000 today, 10 per cent interest. Therefore, it is worth 50 per cent, plus higher. European countries are saying that if a company applies discounting in the American style it must take a write down. Canada is so far behind in that area. We are not leading anyone.
One of the reasons I am suggesting an independent group is exactly because of what you are saying. That independent group would liaise with the international accounting groups, find out what they are doing and find out what the Americans are doing. Eventually, we have to make a choice. Either we go with the international accounting group or we go with the Americans.
We are not, by any stretch of imagination, leading the way. We are very far behind. Again, all you have to do is look at these numbers that we produce. You can work Ponzi frauds in Canada so easily that it is depressing.
Senator Hervieux-Payette: The comparison that comes to mind is the accounting rules in Japan with their banking system. I have always had the impression that one of their great problems was the way they reported. They are paying a big price for that. My point is that if we act now we can probably prevent paying a dear price later.
Mr. Rosen: If you look at the first handout package I was working with, there is, in the middle, a section devoted to why now is the time to act. It is precisely for the reasons you mention. The international community is placing pressure on us. The U.S. is bringing pressure on us.
Canadian auditors admit in their own study that they are unique in the world. They have accounting rights and auditing rights, and no one else has both. That puts us way behind the rest of the world on independence. How can you audit your own rules when you set up weak rules?
Auditors have said that they do not protect the investors. They are running counter to the CBCA. Those things are literally getting us into the situation where we must do something right now. You will have a chance to read it later, but there are some serious reasons why we should do something, and this year or next, I would hope.
Senator Kroft: Why is it so bad? If we accept at face value the picture that you paint for us — and it is a persuasive one. This is not a country where we are normally inconsiderate of operating standards in anything we do. We tend to be careful and conservative people as a nation. What is your explanation of why we are we so far below the standard level that seems acceptable?
Mr. Rosen: I have spent over 20 years with two of the final four of the big accounting firms. It was so clear to me, in the recession of 1980-81 — the word went through the office to find more fees. Companies were amalgamating. ``Find more fees.'' It resulted more and more in the growth of consulting services, tax plans, and everything else. Sell, sell, sell. I think that is well documented. Since Enron came out, we are hearing many partners of firms say that.
We saw in Canada less interest in paying research people. I was one of the first people with a doctorate working in a public accounting firm in this country. It became less important to hire people who had a similar type of background. It was about more fees and less effort on research.
You follow the handbook of the CAs on the rules. You will see the rules becoming weaker and weaker.
Senator Kroft: We have the same macro-economic situation as in the States. I do not know how the large firms set their standards and disciplines internally for a firm that is operating both sides of the border. Is there no commonality in the way they conduct their practice?
Mr. Rosen: No, not at this point. I have said to some of the partners that they are not running their show any more. It is being run out of the U.S. Most of them will privately agree with me. Some will fight it.
Little effort is being put into these standards. Let's face it, in 1997, the decision in Hercules Management vs. Ernst and Young was that auditors could not be sued by individual investors. That has now been flaunted all over the place. I hear it repeatedly. The last five years has made it even worse. ``You cannot sue us unless it is a prospectus.'' That is the Victoria Mortgage situation.
Who was around in this country to tell the directors, the officers and the auditors to stop doing what they were doing? We have the fragmented securities commission. Look at the number of prosecutions. Ontario had Livent — and not too many others. I worked for them 15 years ago on the Calgroup Graphics case. There are not that many. If they had five a year, I would not be troubled.
I read David Brown's speeches. I do not philosophically disagree with his speeches, but I disagree totally with the lack of enforcement. If this applies right across the country, with the enforcement not being there, you have the protection of each of the provinces being the equivalent of regulation 44. Where is the incentive to do something?
Senator Kroft: The fragmentation of the security authorities has been a concern of this committee, or at least an observation of this committee for a long time, and also a great frustration in the fact that nothing has resulted. Do you specifically point to that issue as being a serious contributor to the problem?
Mr. Rosen: It is extremely serious in my opinion because without some enforcement, and some penalties, the provincial CA groups are not disciplining their members. The other accounting associations have very little discipline. Just so you know, I am the main evaluator of litigation against the smaller CA firms. Most of the cases come to me personally. I look at them and decide whether to fight a case in court or settle. Most of the time, I advise settlement because these things cannot be seriously defended in court. In a sense, it bothers me that other people do not see this.
Senator Furey: What percentage of the problem would be just negligent advice as opposed to conflict situations where the accounting firm was also providing advice on outside issues?
Mr. Rosen: It is very difficult to tell at times. One of the problems with insurance policies is that if you prove fraud you invalidate the insurance policy. We will pursue up to a certain point — we have a solid case and then we drop it. We really do not get into cause and effect, so it is an interesting question.
Senator Furey: Many firms are still doing consulting work for their corporations even when they find themselves in conflict. Will this put them outside their general insurance rules?
Mr. Rosen: It could, but their insurance policies also have what is called ``innocent partner clauses.'' If it were an innocent partner, then those people would still be covered.
Senator Furey: What would be your view on companies doing consulting work?
Mr. Rosen: I have seen too many cases where it has interfered with the audit quality. That is not what I thought 10 years ago. I am even at the stage now where I think tax work is creating too many conflicts, but having auditing and accounting together is another major conflict.
I will give you one example. Concerning related-party transactions, which are becoming more and more a way of doing things in this country, the accounting and auditing rules are so weak that there can be all sorts of transactions going back and forth. There is no obligation in accounting or auditing to measure fair market value and compare it to the transaction. There are minimal exceptions to that. For example, on a financial statement, there is no note saying, ``Due from related party who got these goods at a price 90 per cent below-market value.''
As we grow, and as we come up with new financing and new transactions and so forth, the accounting must grow with it, and we are not doing that. Therefore, that whole area is exceedingly weak and something has to occur. This again comes back to the independent body to which I refer.
Senator Kroft: I hope you do not consider this next question to be inappropriate.
Mr. Rosen: Fire away. I taught for years.
Senator Kroft: I would ask you to compare the size of your circle of friends now to what it was 20 years ago, and more specifically, how you interrelate professionally? What do the accounting firms say about you when you appear on panels? Are you alone or is there a group of people like you who are arguing this case? I am just trying to put you in context. I hope you will understand where I am coming from.
Mr. Rosen: Typically, when I meet people one on one, they say, ``I agree with 90 per cent of what you say,'' but when I meet them in a group they refer to me as evil and do not talk to me. That is the pattern that developed many years ago. I long ago realized this was an important issue, among others, and I do not care. You pay the price for doing some of these things.
I paid the price last week where I knew I should not appear before the advisory committee that sits over top of the accounting standards group, but some of the people on the panel asked me to appear. I gave my speech. All the hearing aids were turned off, people were leaning back in their chairs, and so on. I expected that, and that is what happened. It did not bother me in a sense, because that group already has decided that accounting standards have to remain in the CICA's home.
By the way, this applies to quite a few of these groups now that have sprung up after Enron. It is vital to look at each one of them and ask: What is the mandate of the committee? Who is on the committee? Which of them have known votes? And which are opened up to other possibilities? At this point, I do not know of any group formed in Canada that has a wide-open clean sheet, or whatever descriptive term you wish to use. They tend to investigate within a small realm where they can tinker here and tinker there, but in the final analysis there will not be any significant change. That has been a pattern I have seen too many times.
Where do I sit? I do not have a lot of trouble with one-on-one conversations with most people, but it is different when they get together as a group.
Senator Kroft: They circle the wagons.
Mr. Rosen: Yes.
The Chairman: Do you have any specific advice for this committee? You are our first witness in what will probably be a four-month study. We will eventually want to come up with some concrete recommendations. I have no idea where the study will go. Could you give us an overview as to how you think we should approach it and where you think we should end up?
Mr. Rosen: I tried to present my evidence with my handouts today, and if you think I have not convinced you let me know and I will gather the information. There is so much in the media about people saying things that are not consistent with the evidence. Evidence can be gathered about audit failures, about accounting failures, about composition of committees and things like that. I feel it has to be treated like a court situation, where ``show me the evidence'' must be the overriding factor.
The committee should definitely pursue this idea of getting the accounting in a separate group like the U.S. Why is Canada offside on this issue?
Your committee should do whatever it can to try to convince anyone it can about this national securities commission or equivalent, or to look at the federal incorporations and perhaps getting them together with some of the other provinces.
However, the direction is that there is virtually no protection for investors in this country right now, in spite of the speeches and in spite of such talk as, ``We are going to do this and we are going to do that.'' Go back and read the comments that these people were making two to two and a half years ago. It is the same stuff.
I do not see regulation 44 as a difficult task. You form this new group; you will see that people will rally around the new group simply because it is national, federal, it has certain people on the committee. Last week, I was asked where people would come from to form this new group. There are many Canadians who can serve on it. The argument is that only accountants can serve on it. I do not accept that at all. What else can you do?
Senator Oliver: You need some lawyers on it.
The Chairman: Senator Oliver is a lawyer, you may have guessed.
Mr. Rosen: I deal with lawyers all the time.
As to who would serve, you would definitely need an OSFI person and someone from a corporation's branch equivalent — I am not sure of the title. You definitely need one university person; certainly several from the investment community; and the accountants and auditors should not be more than 20 to 25 per cent. We do desperately need change. We will not get change by turning back to the same sort of group.
I am extremely perplexed by the securities commission issue. I think the administrators are getting together way too often.
Let me come back to this Kripps case, as an example. That has to be pursued here. The Supreme Court of Canada, after hearing testimony at the lower court level — but it was through argument — had both the Canadian Institute of Chartered Accountants and the auditing firm go in and tell it that financial statements are not to be used by individual investors for investment decisions. That is totally contrary to their own rules; it is contrary to the corporations acts. How does that go to sleep in this country for five years? I would have thought that, within a year, each of the provinces, through their securities commissions, would have been saying, ``Look, this an intolerable situation because the investors are not getting protection.'' The auditors, who are the shareholders' auditors, in the laws of this country, have abandoned them. I do not know of anything happening.
Senator Tkachuk: Who do these people say they are supposed to do the audit for?
Mr. Rosen: They are saying that it is for the collective group to evaluate the directors and officers. This is where I am sorry to say that the Supreme Court of Canada was extremely naive, because who picks the accounting principles and policies in the first place? It is the directors and officers. What director and officer will pick a policy that makes her or him look bad? That is how absurd this one is.
Yet, nothing has happened in five years. That, to me, is the scariest fact of all, in terms of what is wrong with the securities commissions. Are they just too close and too comfortable with the auditors and accountants of Canada?
The Chairman: With the benefit of some hindsight, and if you look back two years, it says here that Nortel now expects revenue to expand 40 per cent; Roth singles you out for criticism and you happen to have been right all the time. When Greenspan spoke of irrational exuberance, could that have been prevented by better accounting rules? I have the feeling that maybe the thing is a little more complicated than just accounting.
Mr. Rosen: It is. There are multiple factors that affect a stock price, absolutely. My question is: Why should we as a country disadvantage ourselves and the average Canadian?
The Chairman: I am not disagreeing with you in the least. I am asking how much further we should go. We would like to talk about the stock option business, the compensation process. We would like to talk about the responsibility of lawyers. No one ever mentioned the responsibility of lawyers in the Enron case. They obviously goofed up something major. I do not know how we attack that.
Mr. Rosen: I think all you can do is say in your final report, or preliminary report: ``Here are the items that we think are the next round.'' I guess I am more concerned with simple things that could be done by this committee. Why do you not get those done and then in the next round you start to pick up the other factors?
There is no question the sell-side analysts require serious looks. There is no doubt at all in terms of the banking itself that we have to establish more than one accounting system. One has to look at cash; the other one can look at investor interest. However, all those things, I think, come later. It is the same thing. There is no way you can set up one rule- making group of, say, eight or nine people. There have to be the subcommittees that work on specialized problems.
Hardly anyone understands securitization and the financial instruments and everything else, even though they may have a CGA or CA or something like that. It is a very complex area. I do not think this committee can tackle that in the time that I see as important and available right now to come up with some fairly basic changes such as the regulations to the Canada Business Corporations Act.
The Chairman: Could you take your last five minutes or so and explain to us the dangers that some of us believe exist in the derivatives markets?
Mr. Rosen: I will lose most of the people in here. This is a crazy area. With a derivatives market, the effects are multiple. If you look at short selling, if a stock just drives to the sky and you have sold short down here, you have taken a tremendous loss. If you bought a put or a call, all you have is that amount at stake, whatever you paid for it.
What the derivatives market is doing is just grossly exaggerating the gains or losses a company can have, unless it hedges those off elsewhere.
Tying that into the financial statements, we do not know by looking at an annual financial statement how much derivative activity has occurred during that period of time. A company can simply disappear because it is so exposed in that period of time between the annual reports or even the quarterly reports. You are taking huge gambles.
The Chairman: Would a Canadian bank have to indicate, either in a footnote or somewhere else, what exposure it has to the derivatives markets?
Mr. Rosen: Not as much as they should. There are some requirements to market value these items.
The Chairman: It is like being a little big pregnant — either you are or you are not.
Mr. Rosen: You have well summarized the Canadian accounting rules. Most of the time they do not say to do this or do that. That is exactly what the problem is.
People talk about the freedom in judgment that exists in Canada, whereas the U.S. is more rules oriented. Sometimes you do need tight rules. However, there is no way after a financial statement has been published that you will know the number of transactions that these companies could get into. The only thing you can require, and it will be very difficult for this committee, is to say that there has to be, say, weekly reporting of particular derivative contingencies and that that has to be disseminated through press releases. That will never happen.
The Chairman: Do you think they know?
Mr. Rosen: They had better.
The Chairman: I know they had better, but do you think they do?
Mr. Rosen: No, because I have had cases where I know they do not.
The Chairman: That is what I think, but I, frankly, do not know.
Mr. Rosen: I have had several cases already where huge TSE companies did not have a clue and took multi-million- dollar losses.
The Chairman: Would you agree to come back and talk to us again?
Mr. Rosen: Sure. I think you know that I will be attacked. I would not mind seeing some of these arguments and then trying to gather evidence to show you that I think many of them are not consistent with the facts.
The Chairman: That would be very helpful. You sound like a breath of fresh air to me. I hope you do not get too badly attacked. We will get attacked as well, but that is part of our job.
Mr. Rosen: I am in court all the time and have to put up with cross-examination, so I am used to it.
The Chairman: Thank you for being with us, professor.
The committee adjourned.