Requiring more firms to belong to an SRO may be one useful solution

By James Langton | Mid-February 2010

Securities regulators have been promising to ramp up the fight against investment fraud for years, with seemingly little to show for it. Maybe it’s time to explore new ways to win that war.

In 2006, the Canadian Securities Administrators conducted a survey that, among other things, asked investors about their experience with fraud. Some of the results were pretty shocking: about 40% said they had been approached with an opportunity that they believe to be fraudulent; and, of those, about 10% actually invested. (In other words, about 4% of survey respondents thought they’d been victimized by an investment scam.)

This past autumn, the CSA conducted another survey, which found that little has changed over the past few years. The reported incidence of possibly fraudulent pitches was about the same, as was the level of victimization. If anything, the situation has gotten a little worse, as a higher percentage of investors reported that they have fallen for an investment scam more than once and that they invested more money in these sorts of swindles than previously.

Typically, securities regulators propose to fight this problem in a couple of ways: tougher enforcement and more education for investors on how to spot scams. Both are good ideas, but, while surely necessary, are easier said than done. It now may be time to consider other options.

For one, the CSA’s latest survey found that although investor education efforts may be working — in that investors report that they are more confident and knowledgeable about investing — that isn’t having the desired effect on inves-tor behaviour. Not only are inves-tors still falling victim to investment scams, many aren’t following their own basic beliefs about saving and investing, either.

Moreover, some new research by the Canadian Foundation for Advancement of Investor Rights (FAIR Canada), an investor advocacy group, suggests that even investors who are taking one of the fundamental steps that regulators recommend in order to protect themselves — checking registration — may not be doing themselves any favours, as registration is no indication that a firm is a safe one to deal with.

FAIR Canada looked at the biggest financial scams from 1999 through to the end of 2009. In the 15 cases it examined, which were primarily Ponzi-type schemes and other sorts of illegal distributions (not boiler rooms or pump-and-dump operations), it found that investors lost about $2 billion. Of those losses, it uncovered some surprising findings: although only about 9% of those losses could be traced back to firms that belong to a self-regulatory organization (in particular, the Investment Industry Regulatory Organization of Canada or the Mutual Fund Dealers Association of Canada), about 80% involved firms that were registered.

So, although investors are constantly advised to check registration before they invest, doing so wouldn’t have prevented them from being caught up in many of the big financial frauds in Canada. Advising investors to deal only with firms that belong to an SRO would be much more useful as a preventative measure, but it would put securities regulators in the awkward position of advocating for one segment of the industry over another. More problematic, this tactic would represent an admission that registration isn’t an effective screen against potential fraud artists — and that the commissions themselves don’t do as good a job as the SROs in policing the firms they oversee directly.

Hopefully, the recently completed reform of the registration system will improve this situation to some degree, as one of its primary goals is to create a culture of compliance at all registered firms. But FAIR Canada’s findings also raise the question of whether self-regulation should be expanded to cover all firms and individuals who deal with the public.

Indeed, although self-regulation has come under plenty of fire over the years — with critics claiming it is captive to the industry and doesn’t do a good enough job of investor protection — it appears that there is something to be said for the added oversight these regulators provide.

Ilana Singer, associate director of FAIR Canada, cautions against assuming a causal relationship between the relatively low incidence of major frauds at SRO firms vs non-SRO firms; however, she does suggest that there appears to be some link there that’s worth examining: “If you look at the research and only 9% of the dollar value of the losses can be traced back to firms that are members of SROs, it looks like the SROs are doing a good job. Is the industry doing a better job of policing itself?”