Investors be warned

By Mindy Paskell-Mede

Illustration: Mike Constable

ACCOUNTANTS WHO DISPENSE FINANCIAL INFORMATION MAY DO WELL TO HEED THE CSA'S ADVICE TO CANADIAN INVESTORS

On January 21 and January 22, the Canadian Securities Administrators (CSA) issued two press releases, which were also published in the OSC Bulletin. The press releases were aimed at alerting investors to protect themselves when investing. Although the CSA directs its comments to investors in publicly traded companies, the advice is sound for investors in any company.

From the viewpoint of courtroom battles that occur when companies fail, there are two particular points of interest in the CSA's releases.

Accountants are often called to task (with mixed results) for having recommended or introduced clients to investment opportunities that ultimately prove to be disastrous. Frequently these introductions are made in the context of giving sound tax-planning advice -- for example, when the accountant merely indicated the type of investment vehicle that would attract the desired tax benefit but insists he was not recommending any particular investment to his client. Often in these cases, he received no mandate to investigate on his client's behalf.

Nevertheless, there are circumstances in which courts have held that the client is entitled to take the reference to an investment as a recommendation. Alerting clients to the types of questions they should be asking or to the types of mandates they might wish to confer on the accountant to analyse the investment prospect appropriately is helpful to the client. It can also assist the accountant in later demonstrating precisely what his mandate was and that the client was warned to do his homework first or that he should have recognized the pitfalls and risks of not doing so.

The second observation regarding the CSA's advice to investors is that it might prove to be helpful to accountants who have reviewed or audited financial statements of the company in which the unfortunate investment was made. Very often, plaintiffs" lawyers will draft their pleadings on the assumption that it is perfectly appropriate for an investor or lender to make an investment or credit decision relying exclusively on the company's financial statements.

However, various Canadian courts have ruled in specific fact situations that the plaintiffs had, or should have sought, enough information from other sources to properly understand the risks and therefore could not blame the company's auditors for losses suffered on a speculative investment.

There are many decisions, however, with the opposite result. Accountants who are faced with having to defend themselves in such situations often therefore raise an issue as to the reasonableness of the plaintiffs" reliance on the financial statements. Such an argument does not assert that it is unreasonable to have relied on audited statements, but rather asserts it was unreasonable for the plaintiffs to have relied on them exclusively in the circumstances. As the Supreme Court of Canada pointed out in Hercules Managements Ltd. v. Ernst & Young [1997] 2 S.C.R. 165, it is to be generally expected that users will rely on financial statements for a variety of purposes. However, that is not enough to create a cause of action and the facts and circumstances must be considered more thoroughly. The court specifically stated: "The reasonableness of the plaintiff's reliance must be considered in negligent misrepresentation actions.'

Very often, the best use of financial statements is as a starting point for further investigation. As the CSA pointed out in the January 22 press release, much of that information is often found in the annual reports for public companies but often requires "reading between the lines.'

The January 21 release listed the five most frequent complaints the CSA receives regarding financial advisers and gave tips on how to avoid them. Those of interest to accountants whose clients are looking for a tax shelter investment include:

• Suitability: Investors are warned to give complete information to their advisers and update that information as circumstances or goals change.
• Scams and frauds: The CSA insists the best way to avoid becoming a victim of a scam is to do one's homework. It recommends registration of the adviser be checked with the local securities commission. (In our experience, promoters of tax shelters are often found to have had a checkered history and their standing with regulatory authorities can also be determined.) The CSA warns investors to read documents carefully and take with a grain of salt any guarantee of high return for low risk. (I would add this gives the accountant an opportunity to offer to review all prospectus material carefully on the client's behalf and conduct follow-up investigations, at least on the standing of the individuals involved in the offering. If the client declines to give the accountant such a mandate, at least he cannot later be blamed for having failed to have carried out the investigation.)

The January 22 press release offers 10 tips on "how to read between the lines of an annual report." If or when they are sued, accountants can use these tips to question whether the plaintiff acted reasonably in making his investment decision based solely on the financial statements, perhaps without looking at other indicia of risk. Simply put, these tips include:

• Have the company's activities changed from last year's or from what had been predicted?
• Has the business strategy changed?
• If there have been strategic acquisitions during the year, what impact did they have and what impact are they likely to have in the future?
• Is the company's research and development bearing fruit?
• Where are the company's earnings coming from?
• Was there an operating profit or loss? Specific questions should be asked if there were losses.
• Analyse the financial statements for changes in cash flow and determine how the company generated its funds.
• What are the company's future plans?
• Analyse the financial situation carefully. How does the company plan to meet its commitments?
• Will the company turn a profit next year?

Clearly, this information is not available in financial statements alone. Investors should look at annual reports, prospectuses, or even attend annual general meetings in the case of public companies. The information would be sought directly from management in the case of private ones. A plaintiff who has failed to ask these questions and has suffered a loss should bear at least some responsibility and might be found to have acted so negligently as to not be entitled to blame anyone else.

M indy Paskell-Mede, BCL, LLB, is a partner with the Montreal law firm of Nicholl Paskell-Mede, where she specializes in professional liability insurance. She is also CAmagazine's Technical Editor for Law.