MORTGAGE OVERSIGHT TAKES TOLL

Little relief in sight from syndicated investment morass

Arlene McDowell began investing in syndicated mortgages in 2012 and continued to commit more of her money as the initial eight-per-cent payments rolled in.

Other investors have also been piling into this growing segment of the real estate market. The syndicated mortgage market grew to $6 billion in 2016, from $3.7 billion two years earlier, according to the Financial Services Commission of Ontario.

Many investors, like McDowell, were likely unaware that two reports in 2014 criticized the way FSCO, a key financial regulator that oversees mortgage brokers, was handling its duties.

Now the payouts promised to McDowell have dried up, leaving much of her retirement money, close to $250,000, wiped out or in limbo after the developments she invested in, including one in Barrie, Ont., ran into trouble. “I just never anticipated ... this (money) was really at risk,” said McDowell, 62, who lives in Toronto. “I would never have entertained all of this.”

The Ontario government last year announced a plan to overhaul FSCO, replacing it with a new regulator as recommended by an expert advisory panel.

But the changes, announced nearly two years after the critical reports and still many months in the making, are quite likely too late for investors like McDowell.

With the help of a lawyer, McDowell took her complaints to a litigation firm that has filed five separate lawsuits claiming a total of $137.5 million in connection with the sale of syndicated mortgages to assorted clients.

The lawsuits, filed in the Ontario Superior Court of Justice, target a fraction of the overall syndicated mortgage market and have not been tested in court. But David Franklin, one of the lawyers involved with the suits, believes the government should have kept a closer watch on the FSCO, which is accountable to the Minister of Finance.

Both Ontario’s auditor general and the International Monetary Fund in 2014 had identified shortcomings at the market watchdog that regulates the mortgage brokerage sector in addition to loan and trust companies, parts of the auto insurance industry, and provincial pension plans in Ontario.

“The province bears responsibility for its agency,” said Franklin, who introduced McDowell to lawyers at Levine Sherkin Boussidan, the litigation firm that filed the lawsuits.

There is nothing inherently wrong with assembling a group of investors to back real estate developments through syndicated mortgages, and many do so without issue. Some of these investments back commercial and large-scale residential real estate developments in their early stages, and projects include condominium, office, and retail complexes.

But the lawsuits against a handful of purveyors under FSCO’s watch, and others involved with syndicated mortgages including Fortress Real Developments Inc., which has denied any wrongdoing, allege that retail investors were sold securities that were far too risky for them.

The suits also claim the true nature of the investments was not disclosed, and investors — who were led to believe the syndicated mortgages were attractive real estate investments to hold in their RRSPs and other savings vehicles — were not properly advised about what recourse they had if things went wrong.

For example, the lawsuits say investors were not told that developers receive less than 50 per cent of the funds raised, which is crucial information for investors to properly assess the likelihood of a project’s ultimate success.

When the number of lawsuits reached three late last year, Fortress issued a statement calling the claims “untrue” and “highly misleading,” and said they are “clearly aimed at damaging the reputation of Fortress and Fortress projects in an attempt to benefit its competitors.”

The firm moved to have the lawsuits thrown out, which will be heard by the court in late May, according to Fortress spokesperson Natasha Alibhai.

“As previously said, Fortress will vigorously defend the proposed class actions,” she said in an emailed statement.

Alibhai said the biggest sources of funding for Fortress projects are large institutional lenders such as banks and credit unions.

As a real estate development company, Fortress is not regulated by FSCO, she noted, though “Fortress projects have also been financed in part by syndicated mortgage loans, which are offered to members of the public in Ontario by mortgage brokers and agents who are licensed with and regulated by FSCO.”

As the lawsuits wind their way through the system, the regulatory overhaul creeps along.

Last June, an expert advisory panel convened by the Ontario government to review the mandate of FSCO concluded that there were “regulatory gaps” in the syndicated mortgage market, and recommended the sector be subject to the same level of scrutiny applied to other financial markets.

The report, referencing the shortcomings identified in 2014, recommended replacing FSCO and reconfiguring the role of other components of the province’s capital markets by creating a more credible, betterresourced regulator with a more proactive approach to enforcement.

“FSCO hasn’t shown a sense of urgency in protecting consumers,” said Neil Gross, a securities lawyer and president of Component Strategies Consulting in Toronto.

“There really is no other way to interpret the findings of the auditor general in 2014 and the Expert Advisory Panel (that recommended replacing FSCO in June) last year,” added Gross, who was, until recently, executive director of the Foundation for the Advancement of Investor Rights (FAIR Canada). “Their verdict — harsh but true — is that FSCO’s perceived as an agency unable or unwilling to take effective enforcement action.”

Many of the changes recommended by the expert panel are now under way, but in a recent draft statement of FSCO’s priorities for 2017, the regulator described the transition as a “complex project” that will take more time, with many government decisions yet to be made.

One industry source close to the overhaul estimates that, even once legislation is proclaimed, the new system for syndicated mortgages won’t be fully in place for a couple of years. The earliest estimate by another source familiar with the government’s process is mid-2018.

As an interim step, sources suggest Ontario’s government on April 27 may earmark more funds for FSCO in its spring budget, and possibly flesh out plans to bring syndicated mortgages under the purview of a more able regulator, perhaps one that already exists.

“The government is taking steps to ensure that strong investor protection is provided under the regulatory framework for syndicated mortgage investments,” said Jessica Martin, press secretary for Ontario finance minister Charles Sousa, in an email.

Martin said she could not comment on the lawsuits targeting syndicated mortgages, and did not respond directly to a question about whether weaknesses at FSCO identified in 2014 led to problems in the market going unchecked.

The auditor general’s report highlighted several problems at FSCO, and found that complaints “with high risks to consumers take several years to address.”

The report said 95 per cent of complaints involved the mortgage broker and insurance sectors, and it highlighted both “significant delays” and “weak enforcement action.”

Among the examples given was a case where it took FSCO more than two years to issue a proposal to revoke a mortgage agent’s licence following an anonymous report that he had declared bankruptcy, pleaded guilty to three charges under the Bankruptcy and Trustee Act for failing to comply with conditions of his bankruptcy, and failed to disclose this information as required by the regulator on licence renewal applications in 2010 and 2012.

The auditor general also criticized FSCO’s market conduct division on proactive investigations — those that are not triggered by a complaint.

“Based on the examination activity, it would take the Division about 10 years to examine mortgage brokerages, brokers and agents, even without the other sectors being examined,” the report said.

Given the significant issues raised by the auditor general, some industry watchers were surprised that little seemed to change following the report’s release, particularly since the regulator had already been flagged by an international monitor earlier in 2014.

The IMF, as part of a global survey on how regulators supervise business conduct, concluded FSCO was “constrained by limited resources” and deemed “reactive.” The IMF was less critical of other Canadian regulators and singled out Quebec’s Autorité des marchés financiers for operating “in line with international best practice.”

From the outside, there has been little indication FSCO directly addressed the issues raised by the pair of critical reports.

The regulator’s first major syndicated mortgage enforcement actions relating to a licensed broker or brokerage didn’t occur until Oct. 20, 2016, when it issued five licence suspensions and one cease and desist order. (It did, however, issue a “warning notice” on its website in March 2015 stating Titan Equity Group Ltd. was neither a licensed brokerage nor authorized to deal in syndicated mortgages in Ontario.)

Anecdotally, stories have made the rounds in investment circles for years that industry players who found themselves in the crosshairs of other regulators — such as the OSC, Investment Industry Regulatory Organization of Canada and Mutual Fund Dealers Association — would shift their focus to selling products regulated by FSCO, such as segregated funds.

Last year, FSCO took steps to reduce this regulatory arbitrage by pledging to share disciplinary decisions and sanctions with IIROC and the MFDA, two national self-regulatory agencies with oversight over investment products including mutual funds.

The same month FSCO posted its website warning about Titan, Ontario Finance Minister Charles Sousa appointed a three-member “expert advisory panel” to review the mandates of FSCO, the Financial Services Tribunal and the Deposit Insurance Corp. of Ontario.

A preliminary report landed in November 2015, and the final report was delivered in March 2016 (though it was not released publicly until June).

The report raised specific concerns about the syndicated mortgage market and noted an increase in what it called non-standard services including syndicated mortgage promoters.

While these relatively new players should be subject to existing legislation, “there are those who feel the regulator has not applied adequate scrutiny,” the report said.

The panel urged “active” monitoring of companies raising money from small investors for property development through the sale of syndicated mortgages.

It also suggested that it might be preferable to assign oversight and scrutiny to a securities regulator — rather than FSCO or even its replacement — to apply a more consistent approach to ensuring compliance with legislation and regulations governing investments.

The authors said a consistent message they received during their consultations was that the “credibility of the regulatory regime is undermined by the perception that FSCO is unable or unwilling to undertake effective enforcement.”

Last August — two months after publication of the panel’s final report and nearly than two years after the auditor general raised a red flag — FSCO finally issued a warning about the syndicated mortgage market.

A statement that remains on the regulator’s website warns, “FSCO considers SMIs (syndicated mortgage investments) to be high risk, and notes they may not be suitable for the average investor.”

In October, the regulator suspended the licences of two firms and a handful of individuals operating in the sector including Tier 1 Mortgage Corp. and First Commonwealth Mortgage Corp., alleging that certain syndicated mortgage transactions had contravened the Mortgage Brokerages, Lenders and Administrators Act.

Grant Thornton Ltd. was appointed by the courts to administer 11 corporations previously performing mortgage administration functions on behalf of syndicated mortgage investors in Tier 1 real estate development projects.

Jonathan Krieger, senior vice-president at Grant Thornton, said the situation illustrates a range of issues that can sometimes crop up with syndicated mortgages under the current system of regulation.

“One issue appears to be around the adequacy, completeness and transparency in the disclosure of information to investors, so that they fully understand the nature and risks associated with the investment,” he said.

Investors are drawn in by the high yield relative to other investments, and might not be familiar with the real estate underlying their investment, Krieger said. Institutional investors can be counted on to conduct sufficient due diligence on a syndicated mortgage investment, but retail investors typically do not.

Another issue, he said, is that in some cases “there isn’t accurate monitoring of the borrower to ensure that mortgage funds advanced are being used for their intended purpose.”

Despite the government’s pledge improve oversight, Franklin, the lawyer who kick-started the syndicated mortgage lawsuits, said not enough has been done to justify the continued marketing of such products to ordinary Canadians.

Ontario’s new framework for syndicated mortgages, once in place, should increase scrutiny on the sector, close some of the monitoring gaps, and go some way to enforcing the rules consistently rather than waiting for a complaint or audit.

Such changes would be welcome by investors, but still leaves them with at least one question: What took so long?

THE GOVERNMENT IS TAKING STEPS TO ENSURE THAT STRONG INVESTOR PROTECTION IS PROVIDED. THERE REALLY IS NO OTHER WAY TO INTERPRET THE FINDINGS OF THE AUDITOR GENERAL IN 2014 AND THE EXPERT ADVISORY PANEL. THEIR VERDICT IS THAT FSCO’S PERCEIVED AS AN AGENCY UNABLE OR UNWILLING TO TAKE EFFECTIVE ENFORCEMENT ACTION. — NEIL GROSS

DARREN CALABRESE / THE CANADIAN PRESS FILES A report from Bonnie Lysyk, Ontario’s auditor general, highlighted several problems at FSCO, and found that complaints “with high risks to consumers take several years to address.”