Investors in First Leaside Group should be asking why sales of its products weren't closed to new investors several years before the Ontario firm entered creditor protection in February.
The severe financial problems should have long been apparent to its directors and regulators. For that matter, even ordinary investors would have realized the high risks of catastrophic losses, had they been given all the facts.
As noted in my previous column, First Leaside was in the business of putting together limited partnerships, primarily in the real- estate sector, which it sold through its own direct sales force. It raised more than $330 million, most of which was in promissory notes and equity positions through limited partnerships.
On Nov. 7, 2011, First Leaside Group informed its investors by letter that accounting firm Grant Thornton had concluded that the "future viability of the FL Group was contingent on their ability to raise new capital." The trouble is, the directors had known this material information since Aug. 19, 2011 -- almost three months earlier.
The November letter was signed by David C. Phillips, president; Douglas Hyatt, chairman, and Leo de Bever, a director. (De Bever, whose involvement had lent credibility to First Leaside, is also CEO and chief investment officer of the Alberta Investment Management Corp.)
Even had the First Leaside directors disagreed with Grant Thornton's bleak assessment, the accountants' opinion should have been shared with investors in a timely manner. Clearly, there were serious risks. In my opinion, there was at minimum a moral obligation to inform investors of the contents of the report without undue delay.
Instead, by the time the report was released, investors were trapped in money-losing investments. Worse still, new investors had come aboard.
The Ontario Securities Commission had requested in late October that trading cease on First Leaside proprietary products, and the company complied voluntarily to give it time to reorganize its affairs.
OSC staff advised First Leaside that in their view, "it is not appropriate to use money raised from new investors to fund the operating losses, rehabilitation costs and distributions of existing limitation of existing partnerships."
Even so, many investors fell between the cracks. Between the time the Grant Thornton report was delivered to management but not yet shared with investors and the time that trading ceased, $20 million of new investment was received from investors. (Currently, a group of these investors are weighing their legal options.)
In a Dec. 23 letter to investors in the partnerships, Phillips attempted to put the best face on a bad situation. In the letter, the First Leaside president referred to a new model, a new reality, and a new plan to move forward.
This message of hope to the partners was in sharp contrast to the prolonged delays in producing financial statements, and blunt warnings from Grant Thornton of the very real prospects of business failure.
Then in February 2012 the other shoe dropped. First Leaside was placed under the control of a court-appointed chief restructuring officer.
As I noted in my previous article, there was a more than three-year delay in producing the 2006 to 2008 audited statements for Wimberly Apartments Limited Partnership, the largest First Leaside issue.
When the statements were finally produced, they included going-concern notes from the auditors that questioned the continued viability of the entity. A going-concern note -- essentially a red warning flag for investors -- was also included in the 2010 financial statements.
From my perspective, anything as important as the audit of financial statements that is three weeks overdue -- let alone three years -- should make investors nervous. On this basis alone, there was reason for concern as far back as early 2007 as to the viability of the Wimberly Apartments LP.
Also withheld for months from investors were the contrasting views between the hopes expressed by First Leaside management, and the warnings issued by Grant Thornton.
In Grant Thornton's August report, First Leaside management was on record as stating that they could put together a bail-out package by throwing in $5 million in 2011.
Grant Thornton disagreed emphatically. It noted that the projections in management's model were not fully supported by the information presented, or by historical trends. It projected a cash-flow deficiency of approximately $15.9 million over the three-year period ended in 2013.
Some investors believe at least parts of First Leaside can be rescued. Several days after the May 1 investors' meeting in Bolton, Ontario, I learned of someone who would like to head up a group of fellow investors to go to the Texas properties and fix them up for approximately $100,000 in materials and $40,000 for air-conditioning units and appliances. This faint hope assumes that investors will supply their labour free of charge.
At some point, First Leaside directors are going to have to answer some very pointed questions: When did they first learn about the delays in completing audited statements? Did they consider this a material fact that should be disclosed to potential investors? Why would they allow sales to continue on after learning this?
On what basis did they allow sales to continue after the OSC required a third-party analysis of the viability of the companies? Was this not a material fact that should have been conveyed to investors?
Also facing scrutiny are the two First Leaside entities that sold the securities. They are First Leaside Securities Inc., an investment dealer regulated by the Investment Industry Regulatory Organization of Canada (IIROC), and F.L. Securities Inc., an exempt-market dealer regulated by the OSC.
Like other IIROC-regulated investment dealers, First Leaside Securities has specific obligations to the regulators and to clients, including recommending only investments that are suitable for specific investors. Salespeople are obligated to know their clients.
This raises the question as to whether and when IIROC reviewed know-your-client forms against the securities purchased. The Wimberly Apartment securities were risky and illiquid and in my opinion speculative given the auditors' concerns.
Some provinces require purchasers of exempt issues to sign a Schedule D risk acknowledgement that includes the following sentence: "I acknowledge that this is a risky investment and that I could lose all the money I invest."
That signed disclosure document may be designed to give the dealer and its salesperson some protection. But if it wasn't a suitable investment when recommended -- based on the investor's age, investment knowledge, objectives and risk tolerance -- all this piece of paper shows is that a salesperson recommended an unsuitable investment.
Investment dealers are supposed to keep a minimum amount of capital and adequate errors-and-omissions insurance. What coverage did the two dealers have? I assume more than a few lawyers are looking into this.
Here's yet another stewardship issue that raises questions: Grant Thornton's report to investors, dated May 1, points out that $500,000 was authorized to be paid to a holding company of First Leaside president Phillips. These funds cleared on Nov. 3, 2011. On what basis were these funds paid? Were the directors aware of this payment?