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So, you think your money's safe

It was a scene right out of a courtroom drama, although hardly a glamorous one. The venue was an eighth-floor hearing room in the Ontario Securities Commission's less-than-majestic headquarters in downtown Toronto. The date was last Nov. 10. As the grey suits of corporate law dissected how Linden (Lenny) Dornford bankrupted his mutual fund sales firm, Money Growth Financial Services Inc., the once-proud president and owner sat quietly weeping. He was about to be convicted of administrative acts equivalent to treason in the mutual fund biz: accepting money from clients and not using it to purchase the funds they thought they had bought.
The facts of the case were not in dispute. Nor were Dornford's reasons for taking the money very exotic. Having expanded his firm's head office in midtown Toronto beyond what it could afford to pay in rent, Dornford siphoned $365,000 from the accounts of clients between June, 1995, and December, 1996. The transfers turned up during audits by BDO Dunwoody. Under pressure from the auditors, Dornford advised the Ontario Securities Commission that his firm was "offside by $357,000." In other instances, that might have resulted in a civil case for breach of trust or even a criminal prosecution for theft.

But the OSC did not throw the book at Dornford. On Nov. 24, it terminated his registration as a director, partner or officer of any securities firm. The decision contained some very harsh language: "It evidences, in our view, a complete disregard by Dornford of the duties which Money Growth and he owed to clients." However, given that he had co-operated with accountants and the OSC, he was given a morsel of grace. The commission ruled that he could return to selling funds in five years if he could persuade regulators that he "has changed sufficiently that he has become a fit and proper persons [sic] to be registered as a salesman of a dealer." Oh yes, and pass an ethics course too.

If you've ever bought mutual funds from an independent dealer or financial planner and wondered how safe your money is, that might rattle you a little. But there's another twist to the story. A document filed in the proceedings revealed that the mutual fund industry's lobby group, the Investment Funds Institute of Canada (IFIC), had helped arrange a hasty marriage to another fund sales firm. Money Growth, which had five branches in Ontario and 75 employees, was sold to Fortune Financial Corp. in January, 1997, for $320,000. In an unprecedented move, IFIC tossed in another $58,000--a dowry of sorts. As a result, no client lost any money.

Case closed? Not at all. The critical issues underlying the case remain unresolved: Is my money protected? Why is a lobby group providing a bailout? Who polices mutual fund dealers? The short answers aren't very comforting. Large segments of the mutual fund industry are still barely regulated at all. And after years of hemming and hawing, it is only starting to get its act together as the result of an ultimatum by securities regulators.

There are huge amounts of money at stake. At the end of December, 1998, Canadians had $326.6 billion invested in mutual funds--about $40 billion more than in bank deposits and a 15-fold increase over the total at the end of 1988. You can buy mutual funds from almost any financial institution--large banks, brokerage firms, trust companies and insurance companies, as well as small independent dealers and financial planners. Despite the apparent safety of size, many investors prefer the personal touch that the small firms provide.

Yet if clients want to know more specifics about who they are dealing with, they confront a paradox. Mutual funds themselves are run with transparent standards of performance and accounting for investments, fees paid and assets held. There is also abundant reporting by private data services, Internet discussion groups and the media. But the independent fund dealers who give advice and actually handle clients' money are, in accounting terms, unknowns.

Unless a fund sales firm is a public company, such as Winnipeg-based Investors Group, or, say, part of a bank group or some other publicly owned firm, its annual reports are not easily available to consumers. True, all fund dealers registered with a provincial securities commission must file audited financial statements. But most clients or potential clients don't ask for those statements, might not be shown them and might not understand what they mean.

Take another recent controversy involving Fortune Financial and its combative founder and controlling shareholder, David Singh. In January, the OSC fined Singh $50,000, suspended him from trading securities for 18 months and banned him from communicating with clients about investments for an indefinite period. The reason: Last April, two of Fortune's Infinity mutual funds invested $1.5 million in an income trust set up to pay commissions to investment advisers who sell Infinity funds. The funds exceeded limits for investing in related businesses when it looked like the trust couldn't raise enough from other investors.

In this case, the OSC acted because of the violation of securities laws concerning conflict of interest. The media also jumped on the story. As well, the income trust units are listed on the Toronto Stock Exchange. But Fortune's shares are not, and neither are those of its parent company, Destiny Financial Group. Also, neither Fortune's own fund sales representatives, nor other brokers and dealers who sell its funds, are obligated to provide audited financial statements of those companies to clients. Most mutual fund buyers don't review OSC decisions either.

In late February, Toronto-based Dundee Bancorp Inc. announced plans to buy Fortune, subject to a full review of its operations. That review could take months, creating more uncertainty about Fortune. But Dundee issued a statement assuring investors that the interim purchase agreement would give Fortune "greater financial strength during the due diligence and discussion period."

In the United States, the National Association of Securities Dealers operates a Web site where the public can check on any mutual fund dealer's history and standing, by city or by name, in minutes. No one offers a similar service in Canada. "What we have here is a system where securities regulators' fines can be seen as a cost of doing business [and] salespeople can collect commissions while being fined and even suspended," says Joe Killoran, a former stockbroker in Oshawa, Ont., who has become an outspoken consumer advocate for reform. To him, it's "Disneyland North compared to how the securities industry is regulated in the United States."

Provincial securities commissions know all about that regulatory gap, and closing it has become a crusade. But they don't have the resources or the authority to do the job themselves. There are jurisdictional overlaps with agencies that oversee banks, insurance companies and other institutions. And the fund business has just grown too huge for them to handle. Nevertheless, Jack Geller, then the acting chairman of the OSC and now vice-chairman, took the first step in March, 1997. He ordered all mutual fund sellers to join a self-regulatory organization (SRO) by July 1, 1998. "There is a concern that some people are hurting the industry and giving it a bad name," he said. "We insist that there be protection for investors."

In November, 1997, the industry unveiled plans for that new SRO, the Mutual Fund Dealers Association. But the MFDA is still drawing up rules and standards, and likely won't be enforcing anything for another year at least. Until the regulatory muddle is cleared up, protection for investors will continue to vary dramatically--from some to almost none--depending on where you buy your funds.

Mutual funds are not covered by the Canada Deposit Insurance Corp., but banks and the other big institutions have elaborate internal audit systems. Whatever else you may think of banks, it's pretty hard for their employees to steal from customers. Then, there are the brokerage firms that are members of the Investment Dealers Association of Canada. By and large, those firms have detailed internal compliance procedures governing brokers' conduct. IDA members are also backed by the Canadian Investor Protection Fund, which covers client accounts for up to $500,000 of losses, including $60,000 cash.

But if you buy from an independent fund dealer, you are probably relying on little more than personal trust. Many independents have no internal compliance structure to speak of, and there are only trifling contingency funds. In Ontario, independent dealers will pony up $5,000 per client account that goes up in smoke as a result of an insolvency. It's peanuts, but even that small protection is not available in most provinces.

Linden Dornford was not the first--nor the worst--instance of a mutual fund dealer taking money from clients. But the case has become prominent because of IFIC's role in providing money to make the sale of the firm happen. "It was the one and only time IFIC has ever done this," says IFIC spokesperson Terri Williams. The question is: Will it be the last?

Larry Waite--who is in a very good position to know--fears that there are other Money Growths festering out there. He was the OSC's director of enforcement from 1990 until last October, when he became the first chief operating officer of the MFDA. In a speech to an industry symposium in November, he reviewed the disturbing results of a 1997 OSC audit of 23 mutual fund distributors. "[It] did give us some sense of urgency," Waite said. "It showed a number of regulatory lapses and, in some cases, abuses, which clearly must be addressed by a new SRO."

Why has it taken so long to do something about those abuses? After all, it's been four years since then-OSC commissioner Glorianne Stromberg stung the industry with her 1995 report, Regulatory Strategies for the Mid-1990s. "Current oversight of dealers offers no protection for fraud, wrongdoing or stupidity," Stromberg wrote. She added that "investors should be assured of common standards" regardless of what institution they are dealing with. She called for a minimum capital requirement of $500,000 for each mutual fund dealer, a national contingency fund similar to the one stockbrokers have, detailed supervisory standards and an SRO that could impose meaningful penalties. In a follow-up report for Industry Canada's consumer affairs branch, released in January, Stromberg went over much of the same ground. "More remains to be done," she said.

Yet even before the MFDA held its first board meeting last June, some of the independents were already grumbling: portraying themselves Davids confronting an SRO stacked in favour of Goliaths. Last August, the Independent Mutual Fund Dealers Committee, a vocal group representing 25 small dealers with about 4,500 sales reps, went public, protesting that only two of the 21 board seats went to independent dealers.

Independents have complained--with some justification--that specific rules on the MFDA's drawing board will favour the big players. Take the idea of extending the brokerage business's $500,000-per-dealer minimum-capital requirement to small mutual fund sellers. "The risk assumed by an investment dealer that underwrites [stock and bond] issues with its own capital is of a much higher order of magnitude than that of a fund dealer who only holds client funds for transmission to a fund company," says John Mountain, IFIC's vice-president in charge of regulation in defence of a lower requirement for fund dealers.

Many independents fear that higher compliance costs alone could drive them out of business. Other dealers have visions of a more sinister conspiracy by the banks and the big brokers. Wrote one mutual fund sales rep in an on-line discussion forum on the Web site of The Fund Library, an industry database: "This is their attempt to get rid of us."

IFIC has covered much of this ground before, and its struggles to impose rules of its own on fund sellers aren't very encouraging. Before the MFDA was hatched, IFIC had lobbied to be the mutual fund SRO. Its members include fund companies as well as fund sellers, and its president is former federal Tory cabinet minister Tom Hockin.

In 1996, IFIC passed a voluntary sales code that, among other things, included provisions on so-called trailer fees. Fund companies had been paying dealer sales reps additional yearly commissions if their clients' total holdings with a company reached a certain threshold. That made it look like reps had an incentive to push one company's product over others. The OSC then stepped in with a sales code of its own, requiring companies to pay reps trailer fees from "dollar one."

IFIC's code also banned dealer reps from accepting free trips and other goodies from fund companies. But Fortune Financial skated around that one in May, 1997--making regulators livid. Fortune flew 100 of its top-selling employees and their spouses to Hawaii after persuading fund companies to kick in $100,000 each to gain personal access to them. The IFIC code allowed a fund company to defray up to 10% of the cost of a mutual fund dealer's own educational trips, and Fortune said the island getaway was just that.

Then IFIC's chairman, Toronto fund executive Dax Sukhraj, was sideswiped by one of the most notorious cases yet of dealer misconduct: the David Andrus affair. Andrus was president and, unfortunately, chief compliance officer of Toronto-based Provident Financial Services Inc. According to the facts outlined in an OSC decision handed down last July, Andrus removed a total of $809,150 from accounts of elderly clients from June, 1996, to September, 1997. He used $789,027 of that amount for personal benefit--using $7,500 on one occasion even to pay his Visa bill. He left a few thousand dollars in the accounts of an 85-year-old widow and a couple--he 97 and she 86. The OSC decision said that each transaction was misrepresented on Provident's books as a transfer for the benefit of a client.

In the end, the OSC terminated Andrus's registration to sell securities. "We recommend that he never again be registered in any capacity." Last November, police charged Andrus with two counts of fraud over $5,000.

This is where Sukhraj enters the picture. Sukhraj is president of both Keybase and Fortune Financial. (The two firms announced a merger in July, 1998.) In its decision in the Andrus case, the OSC cited a December, 1997, letter in which Keybase outlined plans to take over Provident, and "referred to reimbursement of losses borne by certain clients or former clients." But in testimony before the commission last July, Sukhraj and his lawyer said there was never any firm promise, and complained that the OSC was trying to divert attention from its own mishandling of the case. Whatever the merits of that argument, Sukhraj resigned as IFIC chairman to avoid any question of conflict of interest.

Alistair Crawley, a lawyer with Blake Cassels & Graydon in Toronto who represents claimants in the case, filed a lawsuit against Andrus. But he did not commence a claim against Keybase, even though it held cash transferred from Provident. In early March, OSC staff announced that they had reached a settlement with Sukhraj, and that Keybase had settled with the clients.

Given horror stories like the Andrus case, and tougher rules that are still a long way off, is it wise for people to buy from independent mutual fund dealers? Dan Richards, president of Marketing Solutions, a respected Toronto-based mutual fund research firm, says that it still makes sense, given the values of customers. "People want advice from someone who is knowledgeable, who can be attentive to their needs, and who can demonstrate interest in serving their business. Historically, however, investors are not worried about whether the fund seller is well capitalized."

Maybe they should worry. If a dealer goes bankrupt or acts fraudulently, they can only hope that IFIC or regulators will bail them out. They might be treated benevolently, as they were by IFIC in the Dornford case. Or they might be hung out to dry.

Independent financial advisers have much to offer their clients. There is no reason to doubt that most are reputable, and that many are wise and informed. But they remain in a regulatory limbo. While they do, self-reliance is definitely required. Caveat investor.

Decoding the acronyms

IDA--The Investment Dealers Association of Canada

Self-regulatory organization for the brokerage business. The IDA's 170 member firms are all full-service brokers.

SRO--Self-Regulatory Organization

Industry organizations such as the IDA that police their own members under the auspices of government regulators.

IFIC--The Investment Funds Institute of Canada

Research and lobby group that represents mutual fund dealers and mutual fund management companies.

MFDA--The Mutual Fund Dealers Association

New body created in 1997 to act as the self-regulatory agency for all mutual fund dealers.

CIPF--Canadian Investor Protection Fund

Private trust established by the brokerage business in 1969. The fund provides insurance protection for brokerage firm accounts in the event of insolvency. Limit is $500,000, including $60,000 cash, per individual and an equal amount for each person's RRSP. RRSPs and joint accounts are considered separate accounts in the event of a claim.

OSC--Ontario Securities Commission

The leading securities regulator in Canada. Tends to set rules that other provincial securities commissions follow.

CSA--Canadian Securities Administrators

Umbrella organization of

provincial securities regulators that tries to harmonize rules.

CAFP--Canadian Association of Financial Planners

Industry association and lobby group for financial planners.

RFP--Registered Financial Planner

Designation issued by the CAFP to financial advisers who have met educational requirements, have attained seniority in the industry and maintain errors-and-omissions insurance. Members must also follow a code of ethics.

Checklist for fund buyers

Buying a mutual fund? Here are eight steps that can help you avoid trouble. In addition to the reasonable steps that most people take even in hiring a house painter, such as getting recommendations, you can:

1. Spread your business around. Even when minimum-capital and account-protection measures are announced by the Mutual Fund Dealers Association, consider moving money to as many dealers as it takes to get all your funds sheltered.

2. Do research. "Ask questions and don't go totally on trust," urges Charlie Macfarlane, the OSC's executive director. Sensible advice, but individual investors cannot be expected to do the diligent research that a securities commission--with its lawyers and investigators--is paid to do.

3. Ask for the dealer's latest financial statements, if available. If you get them, ensure that the auditor has provided an unqualified opinion on the firm's financial statements, urges James Bull, president of Ernst & Young Investment Advisers Inc. in Toronto.

4. Ask if the adviser is a member of a recognized industry body, such as the Canadian Association of Financial Planners. It requires members holding its Registered Financial Planner designation to have errors and omissions insurance.

5. Always write a cheque to the mutual fund dealer "in trust," and write on the back the name of the assets you are buying. Never fork over cash. Cash is the bane of auditors and compliance departments, and responsible dealers shun it. Alternatively, write the cheque directly to the fund company whose products you are buying.

6. Beware of any dealer who tells you to forget about mutual funds and suggests investments offered directly by his or her firm instead. Substitution is a tip-off that the dealer has capital problems.

7. Compare all paperwork from mutual fund vendors with what the dealer says. If in doubt, call and ask for an explanation.

8. Be wary of any adviser who is reluctant to answer questions about how money is handled and about custodianship of fund units.

© 2007 The Globe and Mail. All rights reserved.

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