Cabinet minister dismissed after damning report

The Principal Group Collapse: The Man Who Knew – August 1987

When the Principal Group financial empire went bankrupt in 1987 more than sixty-seven thousand Canadians were shocked to discover that their life savings, amounting to $457 million, were in jeopardy.

One man, however, could have said, “I told you so.” He was Jim Darwish, a former Alberta government regulator who had spent twenty-five years warning his political bosses about the Principal conglomerate’s shady business practices.

The Principal Group began life in 1954 as an Edmonton-based investment company, First Investors Corporation, which sold budget installment savings plans to people of modest means. A typical plan, similar to an insurance policy with a cash surrender value, would commit a person to save a few dollars a month over a specified number of years. At the end of that time the plan holder would receive the total saved plus interest. The plan holder had no direct stake in any of the investments bought by the company with the money, so each plan was in effect an IOU payable by the company at maturity.

Glenbow Archives photo
A Principal Trust investor learns that the company has declared bankruptcy: “Agreements continually violated and ignored.”

The company sold its savings plans – which it called “investment contracts” – to clients in Alberta and Saskatchewan, and the business grew rapidly. By 1958 the company was managing contracts valued at more than two million dollars.

Forty five percent of the company’s shares were controlled by president Donald Cormie, a Harvard-educated Edmonton lawyer who had acquired his first business experience as a twenty-one-year-old university student working as secretary-treasurer for his father’s mill company, North West Mill and Feed. After graduating from Harvard in 1946, at age twenty-four, Cormie articled with an Edmonton law firm and worked there for seven years.

In 1954, Cormie established his own practice, in partnership with a lawyer named Jack Kennedy, and began to specialize in real estate, commercial, and securities law. When he founded First Investors, his partners included Kennedy, former World Bank executive Ralph Forster, realtor Stan Melton, and chartered accountant Cliff Willetts.

In the fall of 1959, First Investors expanded into the United States. It couldn’t use the name First Investors because there was already a company by that name operating in the United States, so it took the name Principal for its American operations. It started with an office in Seattle and then opened offices in other parts of Washington, and in Oregon and Colorado. At this time, the company also opened offices in Nova Scotia, New Brunswick, and Newfoundland.

Toward the end of 1959, Cormie and his three partners sold their First Investors’ shares to a holding company they owned called Collective Securities. It was a deal that regulator Darwish would later call a “well-watered” stock transaction. The partners sold their shares at six times the original cost and thus grossly inflated the book value of Collective Securities.

At around the same time, in late 1959, Darwish began scrutinizing the operations of Cormie’s companies. Darwish was a thirty-year-old chartered accountant who had joined the Alberta government in 1949 as a messenger carrying documents back and forth between officials in the Department of Public Welfare. He was bright and energetic and showed such an aptitude for figures that his boss suggested he might use this talent to do some bookkeeping work for the department. He studied accounting at night, articled with the Provincial Auditor for five years, and became a chartered accountant in 1956 at age twenty-seven. He spent two years as an income tax officer with the federal government and then joined the Alberta Securities Commission as an auditor.

The Securities Commission was then the provincial authority responsible for regulating Alberta companies selling investment contracts. Darwish worked there for about a dozen years and was said to have the ideal temperament for a government regulator because, in the words of former deputy minister Jack Lyndon, he was “an honest, very hardworking son-of-a-bitch.”

Lyndon said his term of endearment for Darwish was “my favourite nitpicking accountant. He and I had a delightful relationship of dynamic tension. We didn’t always agree on things, but I did give him his head.”

Darwish was handed the First Investors’ file as part of his initial auditing responsibilities for the Securities Commission, and right away he noticed that something seemed to be wrong. Under the province’s Investment Contracts Act the company was supposed to maintain up to half a million dollars in cash or other assets in its bank account to cover its liability to contract holders.

Yet Darwish noticed that increases in First Investors’ share capital had been achieved through a series of paper transactions in which no money actually changed hands. Author Wendy Smith illustrated the strategy as follows in her book, Pay Yourself First: Donald Cormie and the Collapse of the Principal Group of Companies:

If I buy a mongrel puppy for a dollar and sell it to you in exchange for an IOU of $1,000, and you sell the puppy to your uncle for an IOU of $1,000, and he sells the puppy back to me for an IOU of $1,000 – is there $1,000 anywhere?

Certainly not. There’s just a mongrel puppy, a dollar bill, and a lot of damp paper.

Aside from these inflated increases in share capital, Darwish noticed that company officers paid themselves high salaries and were withdrawing huge amounts of company money to pay off personal bank loans.

In a 1961 memo to his supervisors, Darwish complained about exorbitant management fees paid to companies owned or controlled by Cormie, and warned that more cash or other assets would have to be put into First Investors to meet the financial requirements of the Investment Contracts Act.

Cormie didn’t like such regulatory interference in his affairs but he did undertake to comply with the requirements of the Act. It was an empty pledge.

Alberta Ombudsman Aleck Trawick would report later that the company “followed a pattern of operating to the very outside limits of the legislation and of challenging the regulators on every matter raised.”

The creation of Collective Securities was Cormie’s first step in the development of an increasingly elaborate corporate structure. The most significant layer in the system was created in 1966 when Principal Group Ltd. (with Cormie as president) was inserted as a holding and management company between Collective and its subsidiaries. Principal Group was designed as a vehicle that would provide complete one-stop personal financial services to customers. It billed itself as “The Department Store of Finance.” Its subsidiaries included, along with First Investors and Associated Investors of Canada (a 1962 Collective acquisition), two Canadian mutual fund companies and Principal Savings and Trust Ltd.

The savings and trust subsidiary soon became the flagship company in the burgeoning Principal conglomerate and would later become synonymous with one of the biggest collapses in Canadian financial history.

As the company grew so did the headaches for Darwish and his fellow regulators. In 1966, Darwish’s boss, Securities Commission Chairman Harry Rose, wrote a memo to Alberta’s Deputy Attorney General, John Hart, saying that Darwish had uncovered evidence of “manipulative practices designed to create a false picture of the status” of First Investors and Associated Investors. Millions of dollars in dividends were being paid to shareholders out of paper profits, and “exorbitant” management fees were being paid to related companies in which Cormie had a direct or indirect interest.

Rose expressed frustration over Cormie’s unwillingness to acknowledge “what I consider totally improper conduct in operating these two companies.” However, Hart never took any action on Rose’s memo. He said there was obviously a “serious personality conflict” between Cormie and the government regulators. A few years later, Hart retired from government service and went to work for Cormie as general counsel.

The Securities Commission did achieve a victory of sorts when it threatened to suspend the operating licences of First Investors and Associated Investors, and forced Cormie’s associates to return three hundred thousand dollars in management fees taken from one of the companies. The Commission also extracted a promise from Cormie that the questionable intercorporate transactions would cease.

But the victory was short-lived. The companies were soon living beyond their means again, borrowing from Peter to pay Paul. They borrowed to pay off maturing investment contracts while simultaneously loaning money and paying dividends and management fees to related companies.

Darwish left the Securities Commission in 1972 and moved to the Department of Consumer and Corporate Affairs where he was appointed superintendent of insurance and real estate. Responsibility for the Investment Contracts Act was transferred to Darwish’s office a year later, so once again he found himself dealing with the Cormie companies.

Between 1973 and 1975 Darwish and his fellow regulators sent a series of reports to provincial cabinet ministers expressing concern about the financial standing of First Investors and Associated Investors. In 1974, Darwish suggested that every Principal Group company be audited “so that the government will have the total picture.” In 1975, he urged that the Attorney General be called in to investigate whether “there has been a breach of trust or other Criminal Code violations.”

A report by an external auditor had led Darwish to conclude that the assets of the companies were over-valued by millions of dollars and that the companies were seriously deficient in terms of being able to meet certificate liabilities at maturity. The Attorney General never did become involved, but the regulators’ reports did result in strict new guidelines being established for the Principal companies and a timetable being set for compliance.

Darwish continued to worry that investors’ money might be at risk. He had reached what he thought was a “gentleman’s agreement” with Principal officials that the companies would operate with a debt-to-equity ratio of twenty-five to one (meaning they could borrow up to twenty-five dollars for every dollar invested). However, the agreement was – as Alberta Ombudsman Aleck Trawick noted later – “continually violated and ignored.”

In 1984, one of Darwish’s auditors, Allan Hutchison, reported that the two Principal Group units were “virtually insolvent” and had a “staggering” debt-to-equity ratio of 560 to one. The companies held a total of $18.8 million in foreclosed mortgages following the collapse of the Alberta real estate market in the early 1980s. In all, seventy-one percent of their entire mortgage portfolio was in arrears and forty-two percent was in foreclosure.

Hutchison estimated that if First Investors were liquidated, its debts would exceed its assets by more than $73 million. He recommended appraisals on all mortgages that were six months or more in arrears, and urged that the companies be made to comply with the Investment Contracts Act’s capital requirements.

Darwish, who was now an assistant deputy minister, sought a meeting with Connie Osterman, the minister of Consumer and Corporate Affairs, to explain the urgency of the situation. When she didn’t reply, he sent her a memorandum listing conditions with which the companies should immediately comply or have their licences pulled.

Among them was a demand that the companies reverse a transaction in which First Investors and Associated Investors paid $23 million to Principal Savings and Trust for nineteen mortgages and four properties of dubious value.

Osterman reacted furiously. In a telephone conversation on 30 April 1984, she told Darwish that she didn’t want any more advice from him.

“If you keep making these recommendations, you’re going to have to make a career decision,” she said. “You’re on the outside looking in. I have had discussions with company officials, and you don’t have a clue about the other side of this.” This was an apparent reference to a luncheon meeting Osterman had a couple of months previously with Cormie and some of his vice-presidents.

Principal’s executives had always enjoyed a friendly relationship with Alberta politicians. Over the years, Cormie and his associates had often sought relief from what they perceived as unreasonable demands from hostile public servants, and they had repeatedly warned that the province’s entire financial services industry would be endangered if the Principal companies were hurt.

This warning struck a sympathetic chord with the politicians because Alberta had a long history of favouring homegrown savings companies and credit unions over eastern financial institutions. Rather than rewrite and strengthen what the regulators regarded as an inadequate Investment Contracts Act, the politicians left their civil servants to make “gentlemen’s agreements” that invariably turned out to be shams.

Darwish interpreted Osterman’s telephone remarks as a threat to get rid of him. Six months later he took early retirement at age fifty-five. There was no retirement party to honour his thirty-five years of government service. Only his wife and a few of his colleagues knew that he had left involuntarily.

The Principal companies limped along for another two years after Darwish’s departure. Regulators continued to ask for an independent investigator to look at the companies but were told that Osterman would not authorize one “because it would cause a run on the companies.”

The companies lost $13.6 million in the first nine months of 1985. In June 1986, responsibility for the Investment Contracts Act shifted from Consumer and Corporate Affairs to Alberta Treasury. In November, an accountant was finally hired to determine whether the companies could survive.

The accountant reported that the companies would need at least $150 million to stay afloat. Cormie tried to negotiate government aid but to no avail. On 30 June 1987, Treasurer Dick Johnston cancelled the operating licences of First Investors and Associated Investors. Six weeks later Principal Group declared bankruptcy.

Calgary lawyer Bill Code was appointed by the courts to conduct one inquiry, and the provincial ombudsman, Aleck Trawick, did a separate investigation.

Darwish was a key witness. He struggled to hold back tears when he testified about his April 1984 phone conversation with Osterman. “She was agitated. As a matter of fact she was yelling at me,” said Darwish. “I feel that I was fired or forced out.” Osterman acknowledged that her reaction to Darwish’s memo was “reasonably negative” because she felt he was interfering as assistant deputy minister in areas that were no longer his concern.

The Code investigation found “evidence tending to prove” that Cormie and his partners had defrauded investors with misleading sales pitches, and had evaded taxes and manipulated stock markets. It also accused Osterman of being “neglectful and misguided” when she refused to act on the recommendations of her subordinates.

Trawick praised Darwish and his colleagues for reporting “thoroughly and tenaciously” in the face of a “clear failure” by their superiors to “heed or in some instances to understand” their warnings.

Darwish was jubilant. “It was one of the best things that ever happened to me,” he said. “I was able to stick by what I thought was right and, in the end, I was vindicated. It wasn’t that I felt that I had to be vindicated but it’s nice to have a couple of third parties agree with what you did.”

Premier Don Getty dismissed Osterman from his cabinet one week after the Code report came out in July 1989. At the same time he announced a partial compensation to Alberta investors of fifteen to eighteen cents on every dollar invested.

Cormie pleaded guilty under the Investors Act to misleading investors and was fined half a million dollars. The Tax Court of Canada ordered him to pay $4 million in back taxes on a $7.2 million loan he took from Principal just before it collapsed. A Court of Queen’s Bench judge ruled that he made improper payouts totalling half a million dollars to creditors who were family members or company employees, and ordered that the creditors give back the money.

It took fourteen years before the investors received their final payments. Most of them were elderly people who had entrusted their retirement savings to Principal. Seventy-five percent of them lived in Alberta, with the rest in British Columbia, Saskatchewan, and the Maritimes.

At the end of the day, the Albertans obtained about ninety cents for every dollar invested, with no compensation for any interest that might have accumulated. Investors in other provinces received less because their provincial governments set aside a smaller amount of money to reimburse them.

Darwish sued the province for $7,678 in back holiday pay and won. The severance package he negotiated with the Alberta government included about a year’s salary and full government pension, allowing him to ease comfortably into retirement.

He then took on a new role, challenging the Alberta government on environmental issues. He became a volunteer with Edmonton Friends of the North Environmental Society, fighting pulp mills, pollution, hazardous waste disposal, and the industrialization of agriculture. In 1993, the Rotary Club of Edmonton chose him as the recipient of its first Integrity Award.

Reprinted with permission from Boondoggles, Bonanzas, and Other Alberta Stories, © 2003 by Brian Brennan, published by Fifth House Publishers, Calgary.

Business Edge is running a selection of stories from the book of interest to business readers. This week, we revisit the infamous Principal Group fiasco.