Commentary: R. vs. Felderhof — an industry post-mortem

Judge Peter Hryn acquitted John Felderhof, former vice-president of Bre-X Minerals, on Securities Act charges (four of insider trading and four of misleading disclosure, all in connection with the 1997 salting fraud at the Busang project in Indonesia) on July 31. The disappointment for some people has been acute.

Naturally, shareholders that lost a bag of money on Bre-X wanted a scalp. That attitude is understandable, if unjustified by the evidence. Equally, some instant experts are thundering that Felderhof’s acquittal makes us look like the ungovernable Barbary of the capital markets. What those critics share is a very poor understanding of the charges and the circumstances of the case: consider Ramy Elitzur, a professor in the school of management at the University of Toronto, who was quoted in the Toronto Star as saying, “Somebody robs a bank in this country, they get mandatory jail time. Somebody robs investors, usually of much larger amounts of money, and doesn’t get a thing.”

Well, Felderhof wasn’t a bank robber, and it is not proven that he robbed investors either. And the Royal Canadian Mounted Police commercial crime unit, which abandoned its criminal investigation of Bre-X’s Busang salt fraud in 1999, was almost certainly right that it would never have got a conviction on criminal fraud. There is a reasonable explanation for that: Felderhof might very well be innocent.

That won’t be heard above the baying from the financial columnists, for whom Felderhof’s guilt was an article of religion. But he wasn’t the salter, there is no definite evidence he was a conspirator, and on the last of the issues — the Securities Act offences — he has been acquitted.

He’s not guilty, and not just because Judge Hryn told us so. A securities offence is different from a criminal one, and the charges under Section 122 of the Securities Act require more than just the demonstration that Felderhof did not know about the salting. The Act says, “no person or company is guilty of an offence under (misleading disclosure provisions) if the person or company did not know and in the exercise of reasonable diligence could not have known that the statement was misleading or untrue,” and the charges and the defence both turned on the question of his diligence.

Judge Hryn saw Felderhof exercising the same care as many other people in the industry. That may say more about the industry, as it was in 1997, than it says about Felderhof. But the system is better at policing itself now, and in that — somewhat limited — sense, Felderhof was no worse than the others that missed the fraud. On the specific question of due and reasonable care, the defence was better at proving it than the Ontario Securities Commission at disproving it.

Now for the Damning But.

When you look at the judgment, you find there are a great many facts the Commission did not bring out, many of which bear directly on Judge Hryn’s final opinion. In essence, Judge Hryn says that a great many professionals — and he names some — saw no evil either, and that those who did — the investigators from Strathcona Mineral Services, hired by Bre-X when the salt scam began to appear, and the exploration team from Freeport-McMoRan Copper & Gold, whose twin holes first brought it to public notice — had the benefit of hindsight.

Newsletter writer John Kaiser summed up the defence: “In effect (the defence) used the professional status of all parties which handled data and samples supplied by Bre-X, and their failure to voice any complaints, as an argument that there were no visible red flags.” Judge Hryn, in his decision, frequently takes refuge in the professional repute of those parties when the expert evidence is in conflict. The standing of others that missed the fraud, more than the battle of the expert witnesses, is what won the case for Felderhof.

We know Kilborn Pakar Rekayasa, the engineering firm that did the resource calculations on the Busang gold project, stayed blissfully ignorant of the fraud, partly thanks to their practice of taking Bre-X’s numbers and copy-typing them into their spreadsheets without independently verifying them. We know Normet, Bre-X’s metallurgical consultants, saw nothing unusual in what Freeport’s Colin Jones called “the best description of an alluvial gold grain ever written” or in the curiously large gold grains in Busang samples. And we all know the investment houses and lenders that hung on John Felderhof’s every word back when Busang was going to be the next big thing. Many of us know what we thought, and how we were fooled, and for how long.

The mineral industry has probably got past Busang. There’s much more healthy skepticism now. But it is an education to look at who came well out of the Felderhof case — apart from Felderhof himself — who came out poorly, and who should probably have come out worse.

The professionals

Judge Hryn cites “Kilborn, Normet, Hazen, Oretest, Mintek, Petra Science, Paul Semple, R(oger) Pooley, Roger Townend, John Borner, Anne Thompson, Martha Schwartz, Sophie Ashby, MRDI, Indo Assay, John Irvin, J.P. Morgan, Republic National Bank” as “well-recognized, reputable professionals,” not one of whom “raised a red flag,” with the plain implication that any of them, seeing evidence of tampering, would have.

We should point out straightaway that Indo Assay and its manager, John Irvin, did not have the task of determining the speciation of the gold. The lab’s job is to measure the amount of gold in the sample it gets, and Irvin, as manager, made sure Indo Assay did that job well. They weren’t looking for signs of tampering and need not have been. We can drop two “well-recognized, reputable professionals” from Judge Hryn’s list right there.

Similarly, petrographic evidence put together by specialist consultants Anne Thompson (of Petra Science), John Borner (of Mintek), Martha Schwartz (of Hazen) and Roger Townend was clear enough. Asked to describe the samples, they did — and Thompson’s study for Petra Science was specific to the wall rock alteration, not the gold mineralization.

Granted, Farquharson gave evidence in cross-examination that he would have expected petrographers to remark on gold grains that didn’t fit with the model of hypogene mineralization. Judge Hryn concluded that their silence was a sign there was nothing abnormal about what the petrographers saw. Perhaps; or perhaps a lot of mineralogists aren’t hot-shot geologists, either. But scratch four more people and two more companies from the list. (Hazen stays on, because it did other test work as well.)

Oretest was a metallurgical sub-consultant to Normet. It did its test work well, with results that were there for Normet and Kilborn to see. Scratch another name.

The “well-recognized, reputable professionals” we are left with — Normet, Hazen (corporately), Semple and Ashby (both of Kilborn), Pooley, MRDI, Morgan and Republic — are two metallurgical consulting firms, two banks hot for a place in the financing, an engineering consultant that had worked extensively for Bre-X and presumably had the inside track for the Busang development contract, a consultant that provided some early resource figures, and a consultant engaged in 1996 to assess Bre-X’s exploration program. Judge Hryn said they “did their test work at a high industry standard” — but there was a fraud going on under every nose on that list, and none of them smelled it. Is that a “high industry standard?” Believe me, if you were being sued, someone would be certain to ask that of you.

Judge Hryn is correct to say Felderhof should not be expected to do better than these specialists, but it is not clear that they, or Felderhof, were doing an adequate job. There is probably case law that shows just what is “adequate,” but it’s not at our fingertips; we have only the definition from R. vs. City of Sault Ste. Marie of “honest and reasonable.” There is no evidence to impute dishonesty to the Normets and Kilborns, but whether it is
reasonable to have missed the evidence can fairly be put up for debate.

On the question of hindsight, it is instructive to look at how some professionals, including Felderhof, reacted to the low assay results from the Freeport drill holes. Colin Jones of Freeport recalled that he and geologist David Potter recognized problems with the Bre-X database even before they had put holes in the ground. Bre-X, the laboratory, and Kilborn all had databases with differing numbers of samples, and moreover, check assays on crushed samples showed variability so extreme that Freeport concluded the results were unusable: all this before the “hindsight” of twin drill holes that found low gold values. If Kilborn, doing “their test work at a high industry standard” knew this at all — the technology is called “counting” — they didn’t make much of it.

Once Freeport had its twin-hole results, it sent them to Bre-X, who called in Strathcona. And while Freeport and Strathcona were uncovering a fraud — and Hellman suspected one too — the professionals in whose competence Judge Hryn set such store were missing it entirely, even with the same facts in front of them. Consider:

* Kilborn, called back to manage a Bre-X scientific counterattack, sent crushed (and salted) core around to Indo Assay and two Canadian laboratories as a belated check. Naturally, three honest and competent labs got comparable results. Kilborn, however, didn’t note that a whole chain of custody from the drill to the crusher ran the risk of salting, at a time when there was already reason to suspect that samples were being salted well before the laboratory got its hands on them.

* Normet’s managing director, Phillip Hearse, while professing to be “mystified as everyone else” by the “extraordinary turn of events” since the results of the Freeport holes came out, told the Calgary Sun that “If I had stock in Bre-X I’d certainly be hanging on to it.”

* Hellman records that representatives from both Kilborn and Normet, in meetings held after the Freeport announcements with Felderhof, Hellman, Leach, and Bre-X’s dishonest metallurgist Jerry Alo, shared “the belief that the gold mineralization at Busang was real,” even when Hellman himself advanced salting as “the most likely explanation for the Freeport results.”

* Bre-X issued a press release of its own on April 22, fully a month after Freeport gave it “the benefit of hindsight.” Results from 16 holes showed mineralization at grades near the resource grade, over those typical wide Busang intervals. Having been warned in advance — by both Freeport and Strathcona — that the company could not trust its own results, Bre-X management, including Felderhof and director Paul Kavanagh, disclosed those results anyway. (There were six holes that came up without significant gold, too: perhaps another bucketload of hindsight, poured over their heads, would have let them see that as a clue of sorts.)

* Judge Hryn also relied on testimony from Paul Kavanagh, and notes in his judgment that Kavanagh “continued to believe that there was a substantial amount of gold at Busang until Strathcona’s negative results” — about six weeks after the Freeport results that provide Judge Hryn’s “hindsight.” Kavanagh, like Kilborn and Normet, appears not to have derived much benefit from contact with the facts.

Graham Farquharson and Strathcona

Judge Hryn found Graham Farquharson’s testimony, as an expert for the Securities Commission, less believable than the experts for the defence. That is a direct function of defence counsel Joseph Groia’s very aggressive cross-examination. Groia jumped on phrases, inconsistencies, and vaguely related statements, and his cross-examination made Farquharson and Strathcona out to be partisan, inexperienced, Monday morning quarterbacks. They aren’t; but when it suits the defence to make you look like that, the defence will do its best, and Groia’s best was very, very good.

Groia savaged Farquharson for talking just like everyone else in the mineral industry talks. For example, when he said there was “no gold there,” that was taken literally; it is standard in this business to say “no gold” when what is meant is no atypical, anomalous, or significant gold. The concession that what was meant was no “economic” gold was too generous; economics of a gold grade doesn’t enter into a discussion until there is some proof of prospective grade (call it enriched, anomalous or atypical if you like). That left the impression of inconsistency when what was really there was plain talk.

Lesson 1: we in this business have to stop talking about “no gold” when we mean “no more gold than you’d find in your backyard,” which is something even a judge might understand.

There seems to have been much made of Farqhuarson’s co-operation with the Securities Commission, as the role of an expert witness is expected to be more like a friend of the court. (The Commission levelled the same charge at defence experts, with considerably less effect.) Groia went after a memo from Strathcona geologist Henrik Thalenhorst that talked about how to “de-claw” a report on the Busang exploration project by MRDI, which had said the exploration standards at Busang were high. The effect was to paint Strathcona as partisans for the Commission and further undermine Farquharson’s credibility.

Lesson 2: Expert witnesses can’t afford to be seen that way. More to the point, prosecutors can’t let them be seen that way.

Lesson 3: When you’re an expert witness in a criminal or quasi-criminal proceeding, aggressive cross-examination and literalism will be the game. Be ready to play it, and understand that your reputation in the industry you serve does not, and should not, live and die with a trial transcript.

The defence experts

Phillip Hellman’s stature is intact. He owned up to the salt scam, did not think there is a gold deposit in Busang’s southeast zone, and brought useful knowledge to the court that counteracted some of Farquharson’s evidence. However, if there’d been more technical expertise on the prosecution bench, some of his assertions might have been undermined more during cross-examination. But on the evidence that came out, Hryn was absolutely right in naming him as the most credible witness.

On the other hand, Terry Leach (who died last February) emphasized how prospective Busang looked, and apart from his concern about specific drill holes (like the improbable 396 metres grading 12.6 grams per tonne the salters created during the battles over development of Busang) evidently did not consider salting to be a possibility. He was also the only witness suspected of a falsification (a post-dated report), but this seems to have counted little. Judge Hryn misjudged Leach’s evidence, possibly because he was on the same side as an excellent and credible witness, Hellman, saying many of the same things.

Leach’s associate Greg Corbett, who was also present for the unmasking of the fraud, refused to appear for the defence. That may say something.

It also says something if Leach could simultaneously hold in his head the ideas that (1) a salt scam on that massive scale was nearly impossible, and (2) it is more possible that a twin-hole campaign, carefully documented to reproduce Bre-X’s own procedures, could come up with no gold. That way lies madness.

The Ontario Securities Commission

The insider trading charges against Felderhof probably never had a chance, having little or nothing to do with the actual fraud. It might be that they were brought with the intention of bringing about a heavy fine, but to have made charges that were not central to the actual scam half the weight of the case looks like a strategic mistake. This trial was always going to be about the salt fraud.

The Commission’s case in the misleading disclosure charges rested on whether Felderhof was sufficiently diligent, rather than on hitting him with what he
knew and when. (Civil litigators may yet have a better opportunity to go after that.) The emphasis on diligence allowed the defence to throw up all the other people whose judgment of Busang turned out to be wrong and careless. Felderhof naturally looks better for missing the fraud when compared with professionals that also saw nothing.

The Commission was not as effective against the defence experts as Groia was against its witnesses. And the Commission failed to flood the zone: there were plenty of people who could have taken the stand to say they didn’t like Busang, and for good reason, without benefit of hindsight (Westralian geologists John Levings and Graeme Chuck; Teck geologists Wayne Spilsbury and James Oliver; statistician Jan Merks; Barrick’s vice-president Alex Davidson). At least their evidence would have clarified the difference between them and the people and firms that believed uncritically. Instead, the Commission put Paul Kavanagh, one of the last of Busang’s dead-end believers, on the stand.

But that’s all hindsight, isn’t it?

Joseph Groia

The bulldog defence lawyer lived up to his reputation. He was difficult, meticulous, and very, very effective. In a confrontation with an intelligent, informed, and fundamentally decent expert witness, he managed to find enough holes to damage the Commission’s case. A street fighter from Perth Avenue School came to land punches, and land them he did.

After the mid-trial appeal to get rid of Judge Hryn in this case, Groia was identified by Canadian Lawyer as “an epitome of (legal) incivility.” The case did, indeed, put some people’s tempers to the test, including Groia’s. But a tough attack on the Commission’s case is what Groia was getting paid for. Or, to be more precise, what he was billing for; he hadn’t been paid at last report.

I hope he gets it in full one day; he certainly earned it.

Judge Hryn

Judge Hryn got his head around many subtleties of the evidence rather well. He grasped a lot of the technical aspects of the case, and was good at compartmentalizing the questions at hand (distinguishing, for example, between the particulars of the four insider-trading charges). Any fair-minded reading of the decision puts to rest the Commission’s charge that he was biased.

That having been said, Hryn appears to have fallen (as many judges do) for the Argument from Repute; all these smart, rich, well-thought-of people that liked Busang, how could they have been inattentive; how could they have been less than diligent?

I think, based on some of the arguments above, that they could have, and were. Felderhof was no worse; and the verdict should tell them they were no better.


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