A new study looking into investment fraud in Canada calls for sweeping changes, not only to prevent investors from becoming victims but also to help them recoup their losses if they do fall prey to investment scams.

The Toronto-based investor advocacy group, the Canadian Foundation for Advancement of Investor Rights (FAIR Canada), has published a report that surveys a sample of the most significant investment frauds uncovered in the past 10 years in Canada, collectively resulting in almost $2 billion in investor losses. The report generates a host of recommendations for policy-makers to consider.

Although FAIR Canada’s research is not a comprehensive or systematic review of investment fraud in Canada, its examination of some of the biggest, most damaging cases in recent years still reveals some striking results.

For example, of the cases FAIR Canada looked at, almost 80% of the losses were attributable to firms or individuals licensed by securities regulators; only 20% of losses were perpetrated by people operating outside the regulated financial services industry.

Just as remarkable is the finding that most of the fraud occurred at firms that are directly regulated by the provincial securities commissions. Of the frauds that were committed within registered firms, about 80% occurred at firms that don’t belong to a self-regulatory organization. Overall, 61% of all investment fraud losses involved non-SRO firms, while only 17% of the losses originated at firms that belong to either the Investment Industry Regulatory Organization of Canada or the Mutual Fund Dealers Association of Canada.

Contrary to the image of SROs as the proverbial fox guarding the henhouse, FAIR Canada’s report finds that — at least, in terms of investment fraud — investors are much better off dealing with SRO-supervised firms. The report doesn’t offer a definitive explanation for this finding, although it does note that SROs, and their members, may have greater incentive to ensure that their members are well supervised, given that SRO firms finance contingency funds that may be called upon to compensate investors if a firm fails due to fraud. So, SRO-supervised firms have a reason to be more vigilant than provincial regulators that don’t face the same risks.

Whatever the reason for the lower incidence of fraud at SRO-supervised firms, FAIR Canada’s finding leads the group to recommend that all firms be required to belong to an SRO. The report also calls for other changes to encourage more vigilance from the industry, such as holding firms liable for misconduct by their advisors, including instances in which they are selling products outside the firm, as well as creating a professional duty for registrants to report misconduct by other registrants. The report also proposes offering financial incentives to the public to report suspected fraud cases to regulators and the police.

These ideas may yet get some traction with provincial securities regulators, which indicate they are looking for new ways to step up investor protection. In Howard Wetston’s first public speech since becoming chairman of the Ontario Securities Commission, he reported that the OSC is considering the adoption of several new tools to help bolster its enforcement capabilities — including the possible creation of a whistleblower program at the OSC, albeit one simpler than the new U.S. program that promises to reward whistleblowers with a portion of the penalties levied in certain cases.

The OSC may make other changes to encourage greater co-operation with its investigations. For example, it is considering the use of immunity agreements and possibly allowing offenders to agree to settlements that don’t require them to admit any wrongdoing. The OSC is also clarifying its policy of offering credit for co-operation.

The OSC’s enforcement branch is currently reviewing these ideas and how to implement them; it will be making recommendations to Wetston within the next month. If the OSC decides to proceed, it believes it will able to introduce these tools without legislative changes.

Along with the new carrots for co-operation, Wetston is promising more stick, too. In his remarks to the Economic Club of Canada, Wetston stressed that the OSC plans to pursue more cases in court, particularly for repeat offenders, and that the OSC aims to “maximize the deterrent effect of court-imposed sanctions, including jail terms, where appropriate.”

Indeed, provincial regulators have been pursuing more cases in court lately. The Canadian Securities Administrators, in its report on enforcement for 2010, indicates that the number of cases it’s working on and the number that are going to court are both on the rise. The CSA reports it initiated 178 enforcement proceedings in 2010, up from 124 in 2009. The CSA also closed more cases, concluding 174 cases during 2010 vs 141 the previous year. Of the cases wrapped up in 2010, many more were pursued in court rather than before regulatory tribunals. During 2010, the CSA concluded 64 cases in court proceedings, up from 35 in 2009 and 28 in 2008.@page_break@Enforcement activity was also on the rise among the SROs, as they concluded 115 cases in 2010, up from 97 in 2009.

Last year, the OSC wasn’t a big part of that trend. That regulator’s enforcement report indicates that it accounted for 35 new enforcement proceedings in 2010, and it concluded 27 cases. However, the OSC managed to secure only two jail sentences during the year — a four-month stretch for failing to comply with an OSC summons and a 75-day stint for breaching a cease-trade order. Although these cases represent the first time that jail time was given for these offences, they are hardly going to strike fear into the heart of a prospective fraudster.

It’s not that the OSC didn’t uncover fraud — of the 27 cases it concluded during 2010, 15 involved illegal distributions (which can include Ponzi schemes, boiler rooms and affinity frauds), resulting in findings of fraud against seven individuals in OSC hearings. Yet, none produced any jail time.

That’s consistent with FAIR Ca-na-da’s report, which observes there’s a public perception that investment scams go unpunished in Canada; and, when they are prosecuted, the sanctions are often inadequate, with fines that go uncollected and modest jail sentences that are only partially served.

One of the primary problems, FAIR Canada’s report suggests, is that no entity has ultimate responsibility for prosecuting these sorts of cases. Instead, the report points out that there’s a “bewildering array of government, regulators and police” to tackle investment fraud. Moreover, the report suggests that this fragmented responsibility, coupled with the slow-moving justice system and the complexity of these sorts of cases, means they typically take years to resolve.

And not only are offenders lightly punished, if at all, but investors aren’t likely to see much of their money back, either. In the cases reviewed in the FAIR Canada report, investors recovered only about 14% of the money they lost to investment fraud. This doesn’t include the Portus Alternative Asset Management Inc. case (although it was part of the overall study), because the funds in that case were misdirected rather than misappropriated, and investors have been paid back.

In the other cases reviewed in the FAIR Canada report, almost $148 million was recovered by investors; more than half of that came through either settlements or class-action litigation, $39 million was paid out by industry compensation funds, $26 million was recovered by receivers and slightly more than $4 million was returned through disgorgement.

The very low recovery rate in these cases leads the FAIR Canada report to conclude that more needs to be done to help victims recover lost funds, circling back to its recommendation that all registered firms should be required to belong to one of the existing SROs, which already have contingency funds in place to cover cases of fraud leading to insolvency. The report also suggests that regulators, SROs and the contingency funds should develop a strategy for dealing with gaps in compensation fund coverage.

In addition, the report recommends securities regulators be given a clear mandate to seek compensation for victims of financial fraud, and that regulators have consistent statutory powers to order compensation. (The need for better mechanisms for inves-tor restitution is something policy-makers have discussed for years, but investors still have relatively little to show for it.)

Of course, the most effective way to mitigate investor losses is to avoid becoming a victim, and the FAIR Canada report offers several recommendations aimed at prevention: regulators should provide an easy-to-use system for investors to check the registration status, disciplinary record and proficiency requirements of advisors; exempt-market requirements should be reformed to ensure unsophisticated inves-tors are protected; and regulators should undertake a major public education campaign to warn investors about the perils of financial fraud.

Finally, the report also calls on the federal government to consider creating a national agency, under the attorney general’s office, to target financial fraud. IE