Legal wrangle sheds light on Ontario’s unique securities regulation regime

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This is the story of the First Leaside Group, a residential real estate investment firm located in Uxbridge, Ont. It is not a happy story – a lot of people lost a lot of money, and the Ontario Securities Commission alleges (and the Investment Industry Regulatory Organization of Canada has already found) that this happened because First Leaside's founder David Charles Phillips and one of its salesmen, John Russell Wilson, were unscrupulous in their business practices.

But it's also a story about some weird legal wrangling that puts an amusing spin on an otherwise unfortunate situation, and maybe teaches us a little bit about Ontario's unique securities regulation regime.

The easiest place to begin is in the fall of 2011 when First Leaside raised $18.6-million from investors over a two-month period. Trouble was, when raising this capital, the OSC alleges that First Leaside failed to inform investors of the contents of an OSC-requested viability study of First Leaside by the accounting firm Grant Thornton Ltd.

The study did not suggest that First Leaside was particularly viable. It suggested that First Leaside would be in some trouble if it were unable to raise new capital. Mr. Phillips and Mr. Wilson went about raising such capital. Unfortunately, according to the OSC, they failed to inform investors of the contents of the report.

After soliciting investors for about two months, a First Leaside subsidiary was placed on an IIROC early warning list, and First Leaside agreed to a voluntary cease trade order with the OSC. Unable to raise further capital due to the cease trade order, First Leaside was forced to stop distributions to investors. First Leaside then filed for creditor protection and was subject to a wind-up proceeding that left investors with a small fraction of the $300-million or so they were owed by First Leaside. This led to an OSC fraud proceeding that has yet to be decided and, more interestingly, a lawsuit by First Leaside investors against the OSC.

In some sense, the investor lawsuit was inevitable. Investors were left in the lurch when a court turned over First Leaside's shells and found many fewer peas than investors initially put in. To be made whole, they needed to find someone culpable who could actually satisfy their debts. So, in January of this year, the investors that bought First Leaside securities during the fall of 2011 forwarded an interesting theory, alleging in a civil lawsuit that because the OSC knew about the Grant Thornton report the OSC is responsible for their losses.

This theory has the advantage of potentially allowing the investors to recover from a solvent entity as opposed to a hollow corporate shell. Deep pockets are important in litigation, and few have deeper pockets than the OSC. As I'm sure you've guessed by this point, it also has the disadvantage of being a long shot. The Securities Act gives broad protection to the good-faith actions or inactions of the OSC – it avoids punishing the regulator unless its actions were more than incompetent.

This brings us to a few weeks ago, where Mr. Phillips' and Mr. Wilson's lawyers appealed to the OSC for a stay in the commission proceedings until the civil lawsuit with investors is resolved. Their theory is that there is an incentive for the OSC, during the commission proceedings, to rule against First Leaside in order to cover its own hindquarters. Mr. Phillips and Mr. Wilson claim that this creates the appearance of a conflict of interest on the part of the OSC.

This is a creative idea. The courts will decide whether the responsibility for the transmogrification of nearly $300-million of investor funds into a revenue wasteland in desperate need of a new capital injection lies with management or the OSC. Regardless, it takes quite the set of legal cojones to use a long-shot investor lawsuit against the OSC as an argument that a decision in your related OSC fraud proceeding be stayed due to a conflict of interest.

Of course, the mere possibility of this motion is caused by the unique structure of the OSC. What we call the Ontario Securities Commission is really a lot of things – it is policy development, it is a regulatory compliance team, it is a litigation law firm and it is a quasi-judicial tribunal, each one located on a different floor, or different half-floor, of the office building located at 20 Queen St. West in Toronto.

By virtue of this, almost everything the OSC does looks, on some level, like it could be a conflict of interest. Every OSC proceeding features OSC staff prosecuting a claim against a defendant to a tribunal of OSC employees. Even if the civil lawsuit against the OSC resulted in a verdict that the OSC was at fault in not shutting down First Leaside earlier, it's hard to understand how that verdict affects the optics of the tribunal's judgment, since the tribunal is always put in the position of having to render a verdict on the work of another branch of the OSC.

This is the upshot of our securities regulatory system – one body is tasked with multiple roles. If the system is working properly, each branch of the OSC executes its functions independently and without influence from the other branches. The fact that the branches are all located in one building is irrelevant to the independence of the regulator.

Incidentally, First Leaside was found to be in an actual conflict of interest in a 2013 IIROC decision banning both Mr. Phillips and Mr. Williams from receiving IIROC approval. In that case, the IIROC tribunal found that the big thing called First Leaside featured one bigger thing owned by Mr. Phillips and that big thing owned smaller things that investors put their money into. IIROC found that Mr. Phillips benefited by having the bigger thing charge its smaller subsidiaries, and therefore First Leaside's investors, "rapacious fees."

Maybe First Leaside thought it could apply this same logic to the OSC. But this logic arguably misunderstands what the OSC is.