It’s quebec, so nobody cares, offers one industry exec, explaining Bay Street’s seemingly sanguine reaction to the news that Quebec regulators have shuttered a Montreal-based fund manufacturer, alleging that at least $70 million has disappeared from its mutual funds.

On August 25, the Autorité des marchés financiers obtained an order from the Bureau de décision et de révision en valeurs mobilières against Norbourg Asset Management Inc. , requiring that it cease operations and freezing its assets. Norbourg manages the Évolution and Norbourg fund families and is parent company to fund dealer Tandem Wealth
Management Inc. That same day, police executed a search warrant at several locations.
Now both the AMF and the Montreal branch of the RCMP’s integrated market enforcement team are investigating the firm.

In a statement, the AMF alleges that there’s a discrepancy of $70.7 million between the funds’ latest financial statements and the assets under management; that almost $69.8 million belonging to investors in the Évolution and Norbourg funds was embezzled via various schemes; that Norbourg’s annual financial statements for the past three years contain misrepresentations; and that documents were fabricated and falsified in connection with Norbourg’s operations and following AMF requests in the course of its investigation.

None of these allegations has resulted in charges, and none of the allegations have been proven. Although, if the allegations prove true, the missing money would represent a large portion of the total invested in the firm’s funds. Morningstar Canada reports that, as of July 31, the 19 Évolution funds and eight Norbourg funds held a combined $180.2 million in assets. However, Morningstar has since suspended coverage of the funds, citing doubts about the integrity of data it has received from the firm in light of the investigation and the nature of the allegations.

For now, Quebec’s finance minister, Michel Audet, has appointed Ernst & Young LLP to administer the firm. E&Y is expected to produce an accounting of Norbourg’s financials and its funds’ financials by the end of September (after Investment Executive went to press).

Until then, the AMF is remaining tight-lipped about the investigation and the funds’ investors have little idea what is happening with their accounts. If it turns out that money has been misappropriated from the funds, their losses probably won’t be covered by
Quebec’s contingency fund nor by that of the Mutual Fund Dealers Association. The provincial fund provides only for dealer-created losses, and the MFDA fund protects only against dealer bankruptcies.

The MFDA’s director of compliance, Karen McGuinness, says MFDA involvement in the case is limited to the fact that the parent company of one of its members has been placed into administration by regulators. But, so far, there have been few implications for the dealer and its clients. Tandem also has operations in New Brunswick, and the New
Brunswick Securities Commission has temporarily suspended the registration of Vincent
Lacroix, who acted as the firm’s chief compliance officer. He is also Norbourg’s founder and the figure at the centre of the case.

In statements to the Quebec media, Lacroix has pledged to co-operate with police and regulators to resolve the situation. Philippe Roy, spokesman for the AMF, indicates
Lacroix did not co-operate with them in earlier inquiries and it no longer needs his help.

The AMF certainly could have used some assistance when it first noticed a discrepancy in Norbourg’s financials, back in late 2004. Roy says the problem was uncovered as part of an examination of fund companies by regulators across Canada, but, at the time, it didn’t have enough evidence to act against the company. That evidence apparently didn’t emerge until two Norbourg officials came forward with information showing misrepresentations in the firm’s financials over the past three years.

Roy says the AMF received the evidence just days before it moved to halt Norbourg’s business. Cpl. Pat Gelinas, spokesman for the RCMP in Quebec, reports police began their investigation in late June, acting on information from a source about “accounting irregularities” at the firm. Ordinarily, the RCMP wouldn’t disclose an ongoing investigation and, Gelinas notes, it has never named the target of its inquiry. However, RCMP officers were observed entering Norbourg’s offices, and the AMF revealed police involvement when it announced the firm’s suspension. Gelinas reports that police investigators are going through documents seized when the RCMP executed its warrant in an effort to validate allegations. He admits this could take months.

@page_break@The long delay between detection of a possible problem at Norbourg and action by the regulators is troubling — not least because reports in the Montreal media indicate the total amount of missing funds may run as high $100 million. The documents filed by the AMF backing up its initial allegations detail only the alleged discrepancy as it stood at the end of December 2004. During the time the regulator was aware of a problem but apparently unable to act, the total may have grown substantially.

This raises questions about the adequacy of regulators’ powers and their ability and/or willingness to intervene in such situations. It also raises the spectre of the possibility that other, similar cases may be going detected but unresolved.

Officials in both the compliance and enforcement departments of the Ontario Securities Commission indicate that almost all of their attention on fund managers in the past year has been devoted to market-timing matters and that they aren’t playing much of a role in the AMF’s investigation. “I think it’s fair to say that we don’t have any substantive involvement,” says Mike Watson, director of enforcement at the OSC in Toronto. “We’re not actively assisting.”

The one area in which the case has affected the OSC is in the regulator’s relationship with the fund industry trade association, the Investment Funds Institute of Canada.
Following the revelation of the investigation into Norbourg, IFIC’s chairman, Michel Fragasso, resigned. Fragasso is chairman of Fonds Evolution Inc. , a firm that was acquired by Norbourg in 2003. The two firms were just in the process of reorganizing the fund lineup when the regulators moved to shut them down.

In a statement, IFIC indicated that the executive advisory committee of its board of directors “has regretfully accepted the offer by Michel Fragasso to step aside as chair.”
He has been replaced by Brenda Vince, president of RBC Asset Management Inc. Robert
Frances, president and CEO of Peak Financial Group, remains as IFIC’s vice chairman.

While there is no suggestion that Fragasso is involved with the problems at Norbourg, the simple fact that the chairman of the industry trade association had to resign in the face of an investigation (the third time this has happened in the past 10 years) has changed to some extent the dynamic of how the OSC works with IFIC, reports Susan Silma, director of the OSC’s investment funds branch.

Apart from the simple fact that IFIC’s chairman has resigned as a result of the ongoing investigation, the allegations in the Norbourg case raise other fundamental questions about the structure and safety of investors’ money in the fund industry. How is it possible that a fund manager could divert fund assets without alerting the attention of its auditors or custodians, never mind the regulators? Is there a structural problem in allowing related companies to serve as both manager and trustee to funds, and/or allowing fund companies to operate with little independent oversight?

Regulators are just now contemplating the imposition of fund governance requirements, although they propose only to deal with possible conflicts of interest, not oversight of internal controls and other functions performed on behalf of fund unitholders.

In the view of Glorianne Stromberg, former OSC commissioner and author of two landmark reports on the mutual fund industry, this lack of independent oversight may represent a fundamental flaw in the regulatory system for mutual funds.

“The system wasn’t designed for an industry that has become a mass-marketing machine serving many different masters — with the distributors being at the top of the food chain,” Stromberg says. “It was designed for professional money managers. This is why I concentrated so many of my fund governance recommendations on the manager/trustee — why I called for independence at the manager/trustee level, and why I felt it necessary that manager/trustees be registered and meet specified conditions of registration.”

At this point, it’s probably too early to say whether the Norbourg case reveals fundamental flaws in the system. John Murray, senior vice president of member regulation at IFIC, reports that he has heard concerns, primarily from financial advisors, about the fact that this is the first real case of alleged embezzlement by a fund manager.
He suggests it remains to be seen whether this represents a failure of enforcement or a real gap in the rules. If it is a rule issue, Murray says, IFIC will work with the regulators to beef up the rules in an effort to ensure this doesn’t happen again. But, he notes, we have yet to see what the facts will reveal.

The OSC’s Silma agrees the commission needs to know more before concluding that there may be a fundamental flaw in the system. “We don’t know yet what the implications are,” she says.

Given the magnitude of the sums and the type of firm involved — a mutual fund manager and IFIC member — it’s surprising the industry isn’t more alarmed by the possible implications. Compare the relatively muted reaction to this case with the hue and cry raised over allegations of wrongdoing at Portus Alternative Asset Management Inc. , which indicated a problem in a small albeit fast-growing, industry niche.

By contrast, mutual funds have almost $550 billion of investor assets under management at last count, and the industry purports to be highly regulated. While it may be impossible to regulate fully against fraud, the industry should be asking itself whether an admittedly rare case highlights unnecessary vulnerabilities for an industry that positions itself squarely in the mainstream of retail financial services.

If nothing else, the case raises the question of whether there should be a contingency fund to cover investor losses at fund managers in cases of fraud or bankruptcy. There have been efforts to get such a fund up and running in the past, but they have not succeeded.
Larry Waite, president and CEO of the MFDA, has recently pointed to this as a gap in the regulatory safety net. But, Murray says, there isn’t currently any move underway at IFIC to revive the idea.

As for what happens to the assets that remain in the Norbourg funds, that, too, has yet to be determined. In a statement released soon after the Norbourg case was first revealed, Audet asked investors to trust in the police, regulators and the administrator he has appointed, noting that their ongoing inquiries “will allow us to evaluate the possibility of recovering the misappropriated funds.”

Previous incidents in the fund industry have been smoothed over by a bailout by a rival firm. Roy says it’s conceivable Norbourg could be sold, or allowed to restart operations.
Murray says he’s not aware of any effort to arrange a sale just yet. “In the past, those kinds of arrangements have happened before they got to this stage,” he notes.

The fund industry may be hoping that the fact the Norbourg case occurred in Quebec will keep public outrage to a minimum in the rest of Canada, but it appears there are plenty of uncomfortable questions that have yet to be answered. IE