Appearances can be deceiving and no better case to illustrate this than a recent British Columbia Supreme Court decision, International Hi-Tech v. FANUC Robotics et al. This case reinforces the need for dealers and advisors to scratch deeper than the surface when conducting due diligence and before investing clients' money.
International Hi-Tech, listed on the Toronto Stock Exchange, appeared to be a thriving business, involved in the development and commercialization of prefabricated building panels. It had a high-profile board, which over the years included engineers, architects, accountants and a solicitor. Numerous joint ventures were announced around the world, indicating substantial demand for its product. The British Columbia action arose out of IHI's purchase of robotic welding equipment from the defendant, FANUC Robotics. IHI stated it acquired the equipment to automate its construction process, but it claimed the robots did not work, refused to pay for them and sued alleging it lost more than $80-million in the deal. Counsel for the defendant, Shayne Strukoff, of Vancouver, introduced a different theory as to why the plaintiff did not use the robots in its manufacturing process, one that was more sinister and turned out to be true.
Mr. Strukoff 's theory: "People will believe a big lie sooner than a little one, and if you repeat it frequently enough people will sooner or later believe it."
Although listed on the TSX, IHI was not a legitimate business enterprise; there never was any real market for its panel technology, only an illusionary one created by the company. IHI raised more than $50-million through public offerings. The case lasted six months and involved an extensive review of IHI's press releases and publications.
"As early as 1994, IHI has routinely issued lofty news releases to the public that contained inaccurate, misleading, and plainly untruthful statements about its operations, the status of commercial production, the existence and status of joint-venture interest and the volume of its business," the trial judge found. The judge concluded, when considering the light of economic reality, the joint-venture documents gave the impression of a "massive shell game."
The case highlights the need to scrutinize a company's public disclosures, particularly with speculative ventures.
In O.E.X. Electromagnetic Inc., another case that analyzed the anatomy of a stock promotion, the judge warned certain promoters had: "An ability to receive and disseminate good news but a disability to receive and disseminate bad news. The invariable pattern was to issue optimistic news releases magnifying the prospects for each venture and leaving it to investors or perspective investors to discover the bad news eventually revealed by audited financial statements. The news releases contained bloated proclamations and the financial statements dismal truth.
"The evidence makes clear that the speculative stock market is no place for the amateur and shows that stock issues can be both a success and a failure in that initially prices can surge upward on the strength of anticipation and shrewd investors can get out with a profit. Some buy and sell more than once to make money each time. The professional trader has an edge; he is better at reading the entrails. The ultimate losers are those who hang on too long and ride the stock until it dies under them."
Advisors and dealers should be cautious when conducting due diligence. A telltale sign of an improper stock promotion are consistently rosy press releases, instead of balanced ones. Another indicator is the announcement of orders in far-flung countries, which are difficult to verify. Also, watch out for overly complicated corporate structures, particularly if they involve offshore entities. These factors do not necessarily mean the company is involved in an improper stock promotion, but the presence of one or more of them should lead to further questions.
Regulatory filings, available online in the United States and Canada, are a good source of information. Although unsavoury promoters may try to mislead the investing public, they will rarely try to mislead regulatory authorities, because the inevitable prosecution creates too much downside. Consequently, if an investor wants to compare a company's "appearance" with "reality" it is important to compare the news releases with the information on file with regulatory authorities. Hopefully they match. If not, put your client's money elsewhere.