A case of alleged regulatory failure

In general, regulators enjoy statutory immunity from civil action for carrying out their duties in good faith — however, an Ontario court has ruled that investors that fell victim to syndicated mortgage investment (SMI) scams have a potentially viable case against regulators for ignoring red flags and taking too long to tackle alleged misconduct.

The Ontario Superior Court of Justice has granted leave for a proposed class action alleging misfeasance of public office against the Crown and two former officials of the Financial Services Commission of Ontario (FSCO). It ruled that the proposed plaintiffs — a pair of seniors that invested $220,000 of retirement savings in a failed syndicated mortgage investment in 2016 — have an arguable case that FSCO’s failure to act against firms selling risky syndicated mortgage investments to unsophisticated retail investors amounts to bad faith, making them eligible to be sued.

FSCO is a predecessor of the Financial Services Regulatory Authority (FSRA) of Ontario.

The case hasn’t been certified as a class action, and the allegations haven’t been proven — however, the court has ruled that the investors may have a case.

“Based on the evidence before me, the plaintiffs may be able to show that the defendants’ conduct was so inexplicably and seriously careless that a trial judge should infer that they acted in bad faith,” Justice Ranjan K. Agarwal said in granting leave for the case to proceed.

That evidence includes allegations that the regulator ignored various warning signs about activity in the SMI sector, and didn’t take action quickly enough to protect investors.

Among other things, the court noted that the regulator ignored warnings from RBC about its concerns that several mortgage brokers were possibly engaged in a Ponzi scheme. In 2014, the bank alerted the Ontario Securities Commission (OSC), which connected the bank to FSCO — and the bank shared its concerns with the regulator.

“Inexplicably, FSCO took no steps to obtain further information from RBC,” the court said — adding that, “there’s a reasonable possibility” that a judge could find that the failure to follow up on RBC’s concerns “was inexplicable and incomprehensible” to the point that it constitutes bad faith.

“FSCO’s lack of a response to RBC’s disclosure is credible evidence of serious carelessness,” the court said. “RBC, Canada’s largest bank and its largest public company, alerted FSCO to possible fraud by several regulated individuals and entities. Though RBC had no legal obligation to do so, its internal investigator met with FSCO. She shared damning information about [the firm the plaintiffs ended up dealing with in 2016] and offered to share more. But there’s no evidence that FSCO followed up.”

Additionally, the court found that FSCO didn’t use its enforcement powers despite growing risk to the public amid the rapid growth of the SMI market and an accompanying surge in investor complaints.

“Even though FSCO had broad powers to investigate and examine mortgage brokers and brokerages in the SMI market, it took little or no steps to do so. Its strategy didn’t use any of these powers,” the court said. “Instead, it relied on consumers protecting themselves, and licensees self-regulating their actions.”

As a result, it concluded “that there’s a reasonable possibility that the plaintiffs can prove that FSCO’s failure to use its statutory powers … was an act of bad faith, especially if combined with the plaintiffs’ other allegations of bad faith.”

Other evidence of possible bad faith include the fact that FSCO failed to take action against the firm that was a custodian for client funds used in various real estate projects connected to the SMI investments, despite its concerns that the Alberta-based firm was operating in Ontario in violation of provincial legislation.

The court also said that the fact that the regulator granted a mortgage broker licence to a man, Vince Petrozza, who had been banned for 15 years by the OSC for breaching securities rules, could also be considered an act of bad faith. Ultimately, Petrozza would be convicted of fraud for his role at Fortress Real Developments Inc., which was the leading player in the SMI market.

“[T]he evidence that is available shows serious carelessness on the part of FSCO. Petrozza was regulated by the OSC. He broke the law. He admitted doing so. He was banned, for 15 years, from trading securities to protect the public. These are serious charges and a substantial penalty,” the court said. “If FSCO didn’t know about Petrozza’s ban, that’s inexplicable given its regulatory framework and the information publicly available. If FSCO did know, it’s incomprehensible how it concluded that Petrozza would deal with mortgages lawfully and with integrity.”

After finding that the plaintiffs may be able to establish bad faith in a number of areas, the court also concluded that they may be able to successfully make a case against FSCO for misfeasance in public office.

The plaintiffs aren’t arguing that any misconduct was intentional, the court noted. Instead they contend “that the court should infer misconduct from the defendants’ carelessness,” it said. “As a result, the plaintiffs have a reasonable chance of success in proving misfeasance in public office.”

However, the court also concluded that there’s no prospect of the plaintiffs being making a case of negligence against the defendants. “FSCO doesn’t owe the plaintiffs, or SMI investors more broadly, a duty of care,” it said. “There’s no proximity between them. Thus, there’s no reasonable prospect that the plaintiffs can prove this claim at trial.”

Ultimately, Justice Agarwal concluded that the plaintiffs’ evidence “proffers a credible case that the defendants were so careless or reckless that a trial judge may infer that they were acting in bad faith. Again, it’s not for me to decide whether the plaintiffs’ claim has been proven. But there’s enough here that they should be allowed to proceed.”