BCSC Rules: Trade Secrets

Under BCSC rules, all publicly traded companies that privately sell shares or issue options must file a form – known as a Form 20 – listing the names and addresses of all purchasers and optionees. Until April 2003, those forms were publicly available, either in hard copy at the commission office or electronically on the BCSC website.

April 24, 2003 might very well rank as the most ignominious day in the 20-year history of the B.C. Securities Commission (BCSC). There was no major stock scandal that highlighted the regulatory deficiencies of the commission, no stinging article in a major media outlet that reinforced Vancouver’s image as a haven for penny-stock hustlers, no disciplinary decision that made a mockery of securities rules. It was, rather, the day that BCSC chair Doug Hyndman and his fellow commissioners made a simple policy change that forever hindered the capacity of reporters, analysts and investors to delve into the murky world of offshore stock dealings and other nefarious practices that underpin much of the deceit and treachery that characterizes the junior securities market. Under BCSC rules, all publicly traded companies that privately sell shares or issue options must file a form – known as a Form 20 – listing the names and addresses of all purchasers and optionees. Until April 2003, those forms were publicly available, either in hard copy at the commission office or electronically on the BCSC website. But after that date, they became hidden from view. The private sale of shares and the granting of options, orchestrated by insiders, are two of the key ways that unscrupulous promoters of penny stocks stack the deck to their advantage – and to the disadvantage of public investors. Large blocks of relatively cheap shares and options are parcelled out to insiders or their associates, often through nominee accounts (accounts in the names of people who act as fronts for insiders). Then the promotion is ramped up, the insiders flood shares onto the market and the stock sinks. Typically, the promoters end up drinking Dom Pérignon while public investors end up crying in their beer. A prime example is Arakis Energy Corp., a publicly traded company run by Vancouver promoter Terry Alexander in the mid-1990s. Reviewing the Form 20s at the time, I discovered that while the promotion was still in the formative stages, Arakis sold large blocks of cheap stock to unknown companies in Jersey, a well-known tax and secrecy haven in the Channel Islands. Arakis’s share price soared, then plunged. In the ensuing post mortem, I asked Alexander whether he had sold any shares. “Well, I haven’t because I believe in this project,” he told me. I didn’t believe him. The pattern was becoming much too familiar. I raised hell with Hyndman and his enforcement staff. For the first time in commission history, they sent investigators offshore. With the co-operation of Jersey authorities, they determined that Alexander was, in fact, the beneficial owner of several of those companies. They also found that Alexander, contrary to his earlier assertion, had dumped millions of dollars worth of Arakis shares without filing insider-trading reports. He was fined $1.2 million and booted from the B.C. securities market for 20 years. In a curious twist that showed this was not a one-off occurrence, commission investigators discovered that Alexander’s lawyer, Michael Seifert of Vancouver, was also secretly trading through Channel Island accounts. So was Howe Street promoter Doug Mason, then president of Vancouver-based Clearly Canadian Beverage Corp. They were both suspended from the market. Lost in the flurry of regulatory backslapping was the fact that none of these frauds would have been detected without Form 20 disclosure and the ensuing media exposure. Despite this example and dozens like it, the BCSC, under pressure from issuing companies, decided in the spring of 2003 it would no longer make these forms available to the public. All Form 20s – past, present and future – were removed from public view, eliminating or at least grossly diminishing the ability of reporters, analysts and investors to conduct one of the market’s most basic and critical due-diligence procedures. “Nobody can ever charge that I should have known who or what was behind a company that I covered, because now I can’t know,” says John Kaiser, a San Francisco analyst who closely watches Vancouver junior companies. More than four years have passed since Form 20s were removed from public view, and, despite numerous appeals to the commission, the BCSC has refused to revoke the policy change. Hyndman cites numerous reasons for the change, but none of them – in my view and the views of Kaiser and other critics – justifies what amounts to a major subordination of consumer interests to producer interests. With scandals buried in commission filing cabinets, promoters, brokers, exchange officials and other industry participants have been able to claim that our stock market has entered a new era of fair dealing. This, however, belies a universal truth of junior equity markets: it is far easier to make money by promoting stock than by building a business. It is the height of naïveté to suggest that illicit practices that tilt the table in favour of corporate insiders and against public investors have gone by the wayside. On the contrary, they are most likely flourishing behind the wall of secrecy that the commission created on April 24, 2003. It was January 1996. Vancouver Sun reporter Jeff Lee and I were chasing the so-called Hydrogate scandal. IPC International Power Corp., a private subsidiary of BC Hydro that was developing a power project in Pakistan, had filed a Form 20 revealing that it had privately sold several hundred thousand shares to three mysterious companies in the British Virgin Islands (B.V.I.). The registered agent for the B.V.I. companies was Michael Sampson, director of Integro Trust Ltd., one of dozens of firms that help people set up companies in offshore secrecy havens. (Integro was also the trustee that helped Alexander set up his Jersey accounts.) When I asked Sampson who was behind the B.V.I. companies, he refused to say. “I have a banker’s duty of confidentiality,” he said in a telephone interview from the B.V.I. “Why would the three British Virgin Islands investors want to keep their stock purchases secret?” I mused in a February 1996 article in the Sun. “The simple answer could be that they are reclusive and want their business to remain confidential. But there could be more nefarious reasons. Are they trying to evade Canadian taxes? Are they hiding assets from an estranged spouse or a dissatisfied creditor? Or are they hiding a potentially embarrassing conflict?” Under questioning by Lee, John Laxton, chair of BC Hydro at the time, claimed he didn’t know who was behind the companies. I was skeptical. Laxton was directing the share sale, and he had hired his son-in-law, Richard Coglon, to act as IPC’s filing solicitor. They were intimately involved in every facet of the company’s affairs. How could they not know? Sure enough, after the Sun ran several probing articles, Laxton delivered a confession to the Sun newsroom. He admitted that he and his son-in-law were behind the B.V.I. companies. His explanation was that the share offering was foundering. To rescue it, he decided to buy shares on his own account. But because then-B.C. premier Glen Clark had expressly prohibited him from buying shares due to conflict-of-interest concerns, they had disguised their share purchases through offshore accounts. Laxton claims he did this for altruistic reasons, but was forced to resign as BC Hydro chairman, and the Law Society of B.C. slapped both him and his son-in-law with practice suspensions for making false statements to the press. Given the high incidence of illicit offshore trading activity, I asked Hyndman in March of 1996, right after the scandal broke, what he was going to do about it. “Well, I wish there were a simple answer to the problem,” he replied at the time. “I think we have the same problem dealing with it that all those other authorities have.” Well, not quite. Vancouver is the penny-stock capital of North America. It is axiomatic that the sort of tightly held, asset-poor junior companies that populate our market are much more likely to be manipulated, and there is no better way to manipulate stock than through offshore accounts. This makes Form 20 disclosure more critical for B.C. than any other jurisdiction in Canada. Nobody knows this better than the BCSC enforcement department. “The enforcement division disagrees with the change,” senior investigator Romolo Di Fonzo stated in an April 29, 2004 memo to then-executive director Steve Wilson. “By having a member of the public, such as Mr. Baines, review the exempt distribution reports [Form 20s], it allows important matters to be brought to our attention that may otherwise be overlooked.” In the end, however, Di Fonzo’s admonitions were ignored. So why did the BCSC withdraw Form 20s from public view? Hyndman has offered several reasons:

• “Disclosure of this information through the website is probably inconsistent with privacy legislation,” he wrote in a July 2004 letter to me. Privacy legislation, however, has been in effect in B.C. for more than a decade, and there was never any suggestion from the privacy commissioner that Form 20 disclosure violated the spirit or letter of the act. Nor did the BCSC solicit an opinion or ruling from the privacy commissioner before he changed the policy.
• Disclosure of names and addresses had “invited abuse of personal information,” Hyndman added, referring to reports that promoters were using the lists to cold-call prospective investors for other deals. To support this point, Hyndman provided letters from two companies, Creo Inc. and Endeavour Financial, complaining that brokers had used the Form 20s to solicit employee option holders as clients. Neither of these companies provided any particulars, and, in any event, two complaints hardly seems sufficient to dismantle an entire disclosure regime. The affected employees could presumably have said “no thanks,” and if the commission still felt it was necessary, it could simply make a rule prohibiting the use of Form 20s for marketing purposes.
• “No similar disclosure is provided for purchasers in public offerings or the secondary market,” Hyndman continued in his letter. This is true. Issuers do not have to report who buys stock from initial public offerings or through open-market purchases. But this is an apples-and-oranges type of argument. IPOs and open-market transactions must be conducted through registered brokers who have know-your-client and gatekeeper responsibilities. Private placements do not. This makes it doubly important that these transactions be as transparent as possible.

Another key difference is that private placements are sold in big blocks at discounts to the prevailing market price. That makes it a special deal that is not generally available to the public, a point that was duly noted by Patricia Taylor, then a senior lawyer in the BCSC litigation department. “There is all sorts of language in the case law that suggests that once you are involved in this regulated environment – most of the language is directed at registrants but I recall it also being said of investors – you lose some of the privacy that you might enjoy elsewhere,” she wrote in an internal email. Kaiser, the stock analyst, says streetwise stock-market players automatically assume that when an obscure offshore company buys stock in private placements, it is somehow related to the insiders, promoters, brokers or fund managers who are behind the stock. “While nobody can be sure, this is the general suspicion,” he said in an interview. In my view, nobody knows this better than Hyndman. He is one of the most senior regulators in the country and has witnessed dozens of rig jobs. “As you point out, the media and analysts have often played an important role in scrutinizing private placements made to private offshore companies,” he conceded in a July 2004 letter to me. “Disclosure of this information has also in the past allowed investors and market observers to monitor the investment activities of known market players.” However, he added, “purchasers in private placements who are not insiders think it is inappropriate that we disclose their names and information about their investments.” Despite numerous appeals, Hyndman remains intransigent. “We have achieved the right balance by continuing to provide the public with access to important private placement information while protecting the privacy of investors,” he said in a written statement to BCBusiness. “We established this policy in line with other jurisdictions and after carefully weighing the issues of privacy and market transparency.” This is the tension around which the debate revolves: the beneficiaries of this private investment process would rather keep their names confidential. Public investors, stock analysts and reporters who are interested in doing due diligence want the names public. Gradually, the producers have been winning this tug-of-war. Other provinces have been systematically restricting disclosure of Form 20 information, to the point that B.C. was the only province requiring it. This made B.C. the odd man out – for good reason, given the particularly treacherous character of the Vancouver securities market. But there has been a drive among provincial commissions to make rules consistent from one province to another. It is a program that has been preoccupying regulators who want to save their provincial fiefdoms rather than default to national regulation. The BCSC, under Hyndman, has apparently been quite willing to sacrifice Form 20 disclosure for the sake of harmonization among the provinces. “The BCSC was the last holdout” for public disclosure of private placees, says Kaiser. “Now the battle is completely lost.” John Woods, editor of Stockwatch, a Vancouver-based market information journal, notes the TSX Venture Exchange used to disclose all private placees and, in the case of corporate placees, required disclosure of the beneficial owners. But this too went by the wayside. “This information just didn’t do the image of the exchange or the jurisdiction any good,” says Woods. “People were able to add two and two and come up with four. Journalists could use the information to warn the public. It caused considerable embarrassment for the exchange. In fact, it was one after the other.” This, he is convinced, is the true reason for the policy change: “The commission and the exchange are utterly concerned with their image.” Form 20s and their latest version (Form 45-902F) also require issuers to provide details of option grants: who gets them, how many and at what price. Investors or analysts who are serious about due diligence can tell a lot about a company’s character by its option list. These are the people who have a serious vested interest in the company’s future stock price. That includes the investor-relations people who breezily move from promotion to promotion. It also includes celebrities and luminaries who, it seems, are so enamoured with the company’s product that they are willing to lend their name to it. An example is Don Cherry, pitchman for the popular cold and flu remedy COLD-fX, made by Edmonton-based CV Technologies Inc. Cherry swears that COLD-fX works for him. “It’s a beauty,” he enthuses in TV and radio ads. Does Cherry have stock options? Now that Form 20s are hidden from view, nobody knows for sure. When a shareholder posed that question to president Jacqueline Shan at the company’s annual meeting, she allowed that Cherry had been given options, but refused to say how many or at what price. This makes it difficult for COLD-fX consumers and company shareholders to assess whether Cherry is really in love with the product, or with the options. An even greater danger is that issuers will grant options to people who are simply nominees for insiders, including close associates or family members who aren’t really providing any useful service to the company. In March 1999, Unique Broadband Systems Inc., an Ontario-based company that was a reporting issuer in B.C., granted options to buy 200,000 shares at $1 each to Maven Communications, an unknown company based in the Turks & Caicos Islands. The stock soared to a high of $17.75, then imploded in controversy. The independent directors hired forensic accountants to review the company’s affairs. Among other things, the accountants couldn’t find any rational reason for Maven getting options. “Other than a Turks & Caicos lawyer who speaks for Maven, the company has been unable to identify who its principals are or what industry knowledge or skill set, if any, is offered by Maven,” the directors stated in an October 2001 management proxy circular. In the absence of any other explanation, it is quite likely that the option grant was simply a way to funnel cheap stock to persons unknown. So why, then, did the BCSC decide to remove option grants from public view? Hyndman says it was because issuers didn’t want option packages, which form all or part of employees’ or consultants’ compensation, to be revealed for competitive reasons. I think it’s more basic than that: issuers simply don’t want public investors to know whom they are paying to tout the stock. For whatever reason, the BCSC seems quite willing to place producer interests ahead of consumer interests. What makes the BCSC’s policy change so retrogressive is that the rest of the financial world, due to heightened concerns over drug trafficking, money laundering and terrorist financing, is moving toward more – not less – transparency in offshore dealing. In the wake of the 9/11 terrorist attacks, the Ontario Securities Commission (OSC) coordinated a survey of offshore accounts at Canadian brokerage firms. The survey, released in February 2002, found that Canadian firms were operating about 13,000 accounts for clients located in 23 offshore jurisdictions that were blacklisted by the Organization for Economic Co-operation and Development. Of these, just over 1,300 were operated by brokerage firms headquartered in B.C. The survey found that “few firms have adopted specific controls on opening accounts from offshore jurisdictions.” OSC enforcement director Michael Watson said in a February 2002 interview that his staff kept “running into brick walls in substantial investigations [involving offshore accounts]... [W]e have seen very substantial amounts of money going through these accounts, hundreds of thousands or millions of dollars. These are just the ones we see.” These findings, as alarming as they were, didn’t stop the BCSC from burying Form 20 information. It’s not clear whether commission staff even look at these forms when they come in. When asked, officials refused to say. “We don’t publicly disclose the specifics of what we do,” says BCSC communications manager Patricia Bowles. “It could provide a road map for those who want to avoid detection.” This is the classic “trust us” response that regulators routinely default to when dealing with information they deem confidential. So I made a proposal to Bowles: why not let me come and see what BCSC staff do and talk to them on an off-the-record basis? That way, I could get the assurance I need without breaching security concerns. “We simply cannot do that,” she replied. Hyndman notes that the TSX Venture Exchange, by policy, issues public notices that identify private placees who are insiders (officers, directors or anybody who owns more than 10 per cent of a company’s outstanding shares). While this sounds reassuring, the fact is that insiders can easily avoid disclosure by using nominee or spousal accounts. To have any chance of understanding what’s going on, investors need to be able to see the entire list of purchasers. The exchange’s notices also identify private placees who are registered brokers (commonly called “pros”) and finders (people who help find private investors and receive a commission for doing so). But so-called arm’s-length investors – the sort of B.V.I. and Jersey companies that Laxton and Alexander used – are not. Hyndman also notes that, by making a Freedom of Information (FOI) request, anybody can request the names and addresses of corporate placees. But this has two serious limitations. First, how do you know what to ask for? It’s like handing somebody a phone book and saying, “There are 100,000 names in there. Two hundred of them are crooks; all you have to do is phone them.” Without any indication of who they are, you’ll never phone the right numbers. In any event, if and when you do make an FOI request, it takes weeks to get the information. By that time, the moment has often passed. The second limitation is that Stockwatch used to plug the names of all private placees and optionees listed on Form 20s into its database. This made it easy to determine whether any particular company had been financed by an offshore entity such as Anker Bank. As far as individual (as opposed to corporate) placees and optionees are concerned, forget it. The BCSC will not release this information, even with an FOI request, unless the individual consents. Clearly, a person who is up to no good will never consent. “If Al Capone or Vito Rizzuto were buying a few hundred thousand shares of a junior company, that would surely be of interest to public investors,” says Woods. “But you can’t see the cockroaches because the commission has turned the lights off.”