VANCOUVER, B.C. (CN) – Canadian investors suffer more harm on U.S. and German stock exchanges than on Canadian ones, the Canadian government said in a report.
The Royal Canadian Mounted Police’s Criminal Intelligence Division wrote “Capital Market Fraud: The Canadian Perspective,” and released it internally in June 2011. It was released recently, with redactions, under Canada’s Freedom of Information Law.
“This criminal intelligence brief was prepared to provide a Canadian overview of the criminal trends associated with capital market fraud and the involvement of organized crime and criminalized professionals,” the report states in its opening, 1-sentence section, “Purpose.”
The report is the only intelligence survey of capital market fraud in Canada since the RCMP Integrated Market Enforcement Team (or IMET) was created in 2003.
It is based on data collected from 26 law enforcement agencies, including U.S. ones.
Recent news in Canada has focused on foreign companies that list on Canadian exchanges to take advantage of Canada’s capital markets. But Canadian fraudsters prefer to make and launder their ill-gotten gains on the more loosely regulated foreign exchanges, the RMCP said in its 45-page report.
In response to corporate scandals in the United States, such as Enron and WorldCom, Canada decided to enhance enforcement of serious corporate fraud offenses in 2002, the report states.
Over-the-counter markets are the ones most commonly exploited for market fraud, according to the report. This is true for the Pink Sheets and OTC markets in the United States, and more recently the Frankfurt Stock Exchange in Germany, because of their limited regulation and reporting. It is less of a risk with other junior markets such as the TSX Venture Exchange in Canada because of their tougher listing requirements.
Companies that conduct business in Canada but are incorporated in Nevada and Delaware, and to a less extent in Florida and Wyoming, are at higher risk, due to their secrecy and looser regulation, especially for shell companies.
“In instances where a public market or exchange was indicated, approximately 75 percent of occurrences contained at least one company which was registered in the state of Nevada or Delaware,” the report states. “Due to less stringent registration and reporting requirements, lack of transparency, and other business advantages, corporate registration in these states can represent a red flag or potential fraud indicator in capital-market related files.”
Delaware, ranks 45th among the states in population, with fewer than 910,000 residents. The state’s tax revenue is principally earned through its corporation laws. Delaware give corporations and shareholders maximum flexibility in ordering their affairs, and has a bias against regulation.
Nevada models its business court system after Delaware’s and offers numerous advantages for companies to incorporate there. Some of the financial benefits include no corporate income tax, no taxes on corporate shares, no franchise taxes, and nominal annual fees.
Nevada corporations also may buy, hold, sell or transfer shares of their own stock and may issue stock for capital, services, personal property or real estate, including lease and options. Corporate directors may determine the value of any of these transactions, and their decision is final.
Reverse mergers are another device that can be used for fraud, the RMCP said. In a reverse merger, a corporation buys a previously registered corporate shell, and essentially takes it over, like a hermit crab. Chinese corporations have recently come under scrutiny for using this technique in the United States.
“The states of Florida and Wyoming are also of interest, as they are recognized as registry states for dormant shell companies,” the report states. “In these two states, it was found that directors will own a few dozen companies (and often many more), which sit dormant as registered empty shell companies. These empty shells were typically operated with the intention of going public. … Once sufficient corporate history is established and maintained, they are sold off in reverse merger transactions with private companies, resulting in a new company being quoted or listed on small capitalization marketplaces.”
The newly formed public companies, sometimes Canadian-based, ignore SEC waiting periods and associated costs of registration by being listed or quoted on marketplaces immediately through the reverse takeover. The new public companies may issue false prospectuses and use illegal promotion schemes.
Typically, the original private company continues its existence as a wholly owned subsidiary of the new company, which receives a new name, a new ticker symbol, and often leaves its original state of registry in the lenient states of Delaware and Nevada.
These companies are also susceptible to being used as vehicles for market manipulations by criminalized professionals, sometimes unbeknownst to the actual directors and officers of the company, the RCMP said.
Switching of company names is another problem.
“Another potential indicator of market malfeasance is numerous and sudden changes in business names and sectors of operation,” the report states. “This periodically occurs once the newly formed public company has secured funding from the public marketplace, which can create concerns for regulators. From a criminal perspective, companies which evolve, for example from a pharmaceutical company to a mining one, may have misrepresented investments to prospective investors.
“Often, these types of companies are shell corporations, with no real capital or underlying business.”
A Nevada-registered company listed on the OTCBB serves as an example of the abuse of the lenient OTC markets. The company changed its name and ticker symbol five times in a short period. It also changed its business operations, aligning its focus to unrelated industries that coincided with market trends.
Unsophisticated investors can be fooled by companies, such as this one, which boast of grandiose results without ever having any substantial operations, the RCMP said. In such cases, when doubts and negative media coverage arise after false promotional campaigns, the companies may duck public forums, switch their directors, give themselves a new name and new business plan, then start another fraudulent scheme with the renamed company as the vehicle.
Such frauds have been seen repeatedly on the OTC bulletin boards and Pink Sheets, but there appears to be a recent move toward the Frankfurt Stock Exchange.
The RCMP noted the case of former Toronto stockbroker George Georgiou, who was sentenced to 25 years in prison for securities fraud by a Philadelphia judge in 2010, for his role in a multimillion-dollar stock scam.
The judge found that Georgiou had manipulated the stock values of Hydrogen Hybrid Technologies Inc., which was incorporated in Nevada, with headquarters in Ontario, and was listed on international OTC markets, Pink Sheets and the Frankfurt Exchange.
More companies are seeking quotations on the Frankfurt exchange because of its lack of oversight and reporting requirements.
In fact, the Frankfurt website states: “Investors must be aware that there is less information available and that there are high risks.” On the Frankfurt exchange there is “free trading,” meaning no restrictions on sale of securities – even for insiders.
The Frankfurt exchange, which lists 300 trading member firms, is divided into four tiers. The RCMP report focuses on the First Quotation Board (FQB) segment of the exchange because it has no transparency rules.
In a note on the victims of market offenses, the RCMP said that even though most offenses occurred in international markets, Canadian residents were affected by 90 percent of the occurrences.
The number ranged from a few individual investors up to 3,000 people and entire corporations. The losses ranged from $11,000 to $180 million, with an average of $29 million.
Capital market offenses are not always reported, due to embarrassment, a general reluctance to report crime, and lack of awareness one has been defrauded.
During investigations, as victims are found and interviewed, the estimated investor losses increase.
Fraud in carbon trading markets also could be a problem.
Under its 1997 Kyoto Protocol commitments, the Canadian government announced the creation of a carbon emissions trading market.
The criminal exploitation of carbon credit trading is well known in the European Union, and in 2010 police in France, Germany, Spain and the United Kingdom launched operations against criminal networks involved in carbon credit fraud.
Deloitte reported that similar problems could happen in Canada. The carbon markets may be vulnerable to fraud during their infancy due to lack of knowledge and experience of market participants.
The IMET program coined the term “criminal professional” for people who facilitate market crime indirectly and often escape notice. These may include securities lawyers, investment advisers, stockbrokers, accountants, transfer agents and promoters.
Repeat offenders often use nominees in legal and financial transactions to escape detection. The OTC markets are targeted by criminal professionals and organized crime groups because of their leniency in listing and reporting, lower trading volumes and the smaller number of shareholders holding a company’s stock.
Finally, the RCMP called for law reforms in Canada.
In July 2010, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act to improve accountability and transparency, after the 2008 financial crisis, which was partly caused by unregulated swaps and derivative markets.
Canada may suffer OTC derivatives-based fraud if gaps in Canadian law are not addressed, the RCMP reported.