BACKGROUND
It is almost tautological to say that but for the time value of money the study of economics and finance would be meaningless. As governments force interest rates to near zero in an environment where inflation often exceeds the rate of interest on government bonds, modern valuation methods lose meaning when formulaic approaches to the “value” of traded securities produce results that may be either meaningless or trend towards infinity. A typical valuation approach is to discount repeatable cash flows by a “required rate of return” including inflation less a growth rate. $1 of repeatable cash flows growing at 3% annually in a zero-inflation world with a “required rate of return” of 3% produces an infinite value and with a “required rate of return” of 2% a meaningless number. Finance and economics are befuddled when interest rates become negative.
Corporate Finance and Corporate Law realms require lawyers, judges, economists, and investment managers capable of navigating these troubled waters. The results are not always satisfactory. There is an old saw which says that if you put two economists in a room to solve a financial issue, they will emerge with three opinions.
Sociologists, political scientists, and anthropologists might agree with me that societies, countries, and corporations came to exist to bring people together in the expectation that their cooperation will contribute to the creation of more wealth than their individual efforts would yield. They did so with little more than a surface understanding of what they mean by “wealth".
WEALTH
In his classic 1776 book, Scottish economist Adam Smith articulated one of the first definitions of “wealth” which is usefully summarized by the phrase: “All wealth is created by altering the shape of matter at or near the Earth’s surface”.[1] All other economic activities of man must by implication deal with the distribution or destruction of wealth rather than its creation. It seems obvious the primary function of government is not only to regulate the creation of wealth to protect its citizens but also to redistribute wealth to mitigate inequitable outcomes.
This fundamental concept has been oft disputed. Even one of my brilliant children challenged me by saying that Gross Domestic Product (“GDP”) includes services and that surely good health must count as “wealth”. My response was true to Adam Smith. I said when I pass, I will leave him my teeth which benefited from considerable expense on dental services during my lifetime and will leave my other children an equal amount of money. Simply stated, the basic concept of “wealth” must mean something transferrable or that can become a bequest and an inheritance. Services are not wealth, they are “well being”.
Governments often claim they seek a more equal distribution of “wealth” and attempt to achieve this end through legislation and regulation. Most government expenditures are for services including the costs of government itself. At best, governments through pensions, a progressive tax code, children’s allowances, and other “transfers” allow less advantaged citizens a greater amount of money to spend, the bulk of which will be spent on consumption and services. No one that I know has become “wealthy” because of government transfers.
Governments have a major role in economic outcomes through their intervention in markets adding complexity to the science of finance. The intersection of finance and government comprises a plethora of statutes including tax law, securities law, and corporate law. While rare that governments create wealth, it is commonplace for governing bodies to enact laws that attempt to achieve societal goals that include a more equitable distribution of wealth than might occur in the absence of government legislation. These attempts more often result in the creation of less wealth while doing little to affect its equitable distribution. Debates rage on about whether open markets free from regulation produce greater societal benefits than regulated markets controlled by well-meaning leaders, with the emergence of “economists” on both sides of the issue. Milton Friedman [2] became famous for his defense of the free market while John Maynard Keynes [3] legacy has been supportive of more government intervention in financial markets, and Karl Marx’s [4] contribution has been to advocate full government control of the means of production and distribution.
Keynes’ influence has resulted in the relentless growth of sovereign debt with governments theoretically able to reduce debt during strong economies but politically incapable of doing so. Friedman’s role was instrumental in the development of Estonia which became one of the wealthiest countries in Eastern Europe adopting his free market ideas. [5]
Marx’s role while popular with intellectuals has a troubled history. Efforts by Lenin, Trotsky, Stalin, Chairman Mao, and Chavez have left millions of corpses in their wake in vain efforts to produce “justice”, “fairness” and “equality”. All of these have been ephemeral goals used to justify extraordinary measures that have limited individual freedoms with draconian laws imposed on large populations without measurable improvement in achieving equality of outcomes while usually causing aggregate wealth to decline.
We are indebted to Vilfredo Pareto for his empirical studies of wealth distribution which concluded that inequitable wealth distribution was present in every form of government and all systems of government. Pareto found that 80% of the wealth creation of society arose from the activities of 20% of the population and that of that 80% sixty-four percentage points reflected the contribution of 4% of the society’s members. The Pareto distribution [6] is best known for the emergence of the “80 – 20” rule which has broad application.
Harvard economist Thomas Sowell applied common sense to the efforts to redistribute wealth through government actions taken in the name of “fairness” and “equity” asking: “Since this is an era when many people are concerned about 'fairness' and 'social justice,' what is your 'fair share' of what someone else has worked for?” [7] In Western democracies, the argument about whether governments should take actions to compel more “equitable wealth distribution” or support “individual freedoms and open markets” has polarized society into so-called “left” and “right” with the left advocating a shift towards socialism and the right supportive of unbridled capitalism. The fury of the debate has left few political groups or leaders in the center, supportive of a capitalist system with a high degree of social safety nets such as public health care; public education; publicly funded pensions; welfare; and government funded infrastructure, although this has been the outcome in most Western democracies despite the divergent rhetoric.
A favorite complaint of the “left” is “income inequality” pointing to the extravagant compensation of CEO’s of large public companies as examples of “unfairness”. Dr. Sowell puts that complaint into perspective. Quoting from his book “Dismantling America” [8] Sowell writes:
“It is not even that the average corporate CEO makes as much money as any number of professional athletes and entertainers. The average pay of a CEO of a corporation big enough to be included in the Standard & Poor’s index is less than one-third of what Alex Rodriguez makes, about one-tenth of what Tiger Woods makes and less than one-thirteenth of what Oprah Winfrey makes.
But when has anyone ever accused athletes or entertainers of “greed”?
It is not the general public that singles about corporate CEO’s for so much attention. Politicians and the media have focused on business leaders, and the public has been led along, like sheep.
The logic is simple: Demonize those whose place or power you plan to usurp.
Politicians who want the power to micro-manage business and the economy know that demonizing those who currently run businesses is the opening salvo in the battle to take over their roles.
There is no way that politicians can take over the roles of Alex Rodriguez, Tiger Woods or Oprah Winfrey. So they can make any amount of money they want and it doesn’t matter politically.
Those who want more power have known for centuries that giving the people somebody to hate and fear is the key.”
Politicians typically use aggregate data to “prove” inequality and support their claim that the “inequality” is a massive social problem. A Forbes article by Dr. Peter Ubel claims that inequality is “killing us” based on life expectancy data by income percentile. [9] Ubel’s article is typical of the rhetoric but ignores the reality that a significant determinant of income is age and the “upper income” people being lambasted are the parents of those raising the outcry. To be specific, the median income of people aged 65 was $55,600 in 2019, about 80% greater than the median income of 35-year-olds. [10] While there are individuals of great wealth in all societies, their wealth is not the primary contributor to “inequality” and tends to be transient. Elon Musk and Jeff Bezos will only be the two richest people on Earth if the shares Tesla and Amazon.com retain market popularity. The thousands of jobs they have created will endure.
Financial theory and government regulation have in common a desire to find “fairness” with governments concerned with a "fair” distribution of wealth and financial theory concerned with “fair value” of financial instruments. Both result in legislation, regulation and enforcement mechanisms targeted at ensuring “fairness” and protecting vulnerable individuals from themselves and others. Both face the complexity of determining what is “fair” and how to achieve it, with governments looking to taxation policy as a key instrument of policy.
FAIRNESS
In 1974, General Electric (“GE”) sponsored a massive study called “Profit Impact of Market Strategies” (“PIMS”) which collected detailed data from 3,800 companies and developed models of the impact of market share on profitability. [11] In 1978, I joined GE and a few years later became Vice President, Corporate Development, of Canadian GE. The extraordinary PIMS study found inter alia the following”:
1. Market share is a primary driver of corporate profitability; and,
2. The average company earns 5% net income to sales and a 15% return on invested capital (“ROIC”).
In a 2019 Forbes article, David Trainer reviews the ROIC of American public companies by sector. The results show that not much has changed since the PIMS study.[12]
Standard & Poor reports that the average return on the S&P index since 1957 is approximately 8%.[13] Why investors are satisfied with returns about half of what corporations earn on capital employed is an open question. In the manifold studies of economies and markets, little theory emerged to explain why investors accept returns materially less than enjoyed by the corporations in which they are invested, a result that may indicate the demand for investment vehicles exceeds the supply.
COMPETING MARKET THEORIES
Beginning in the 1950’s, a litany of Nobel laureates developed theories on markets directed primarily at determining whether it is possible for investors to systematically earn returns that exceed the market averages. The evolution of financial theory since the 1950’s has passed a number of key milestones:
Harry Markowitz and Eugene Fama separately proposed an “efficient market hypothesis” that posited that stock prices reflect all available information at any point in time and hence no investor can gain an informational advantage from publicly available data. This attractive theory became the centerpiece of portfolio theory for decades leading to the conclusion that a properly diversified portfolio would produce the maximum return available for a given level of risk with William Sharpe finding that higher returns were achievable solely through judicious use of financial leverage, under the assumption that investors could both borrow and lend at the risk-free interest rate.
Franco Modigliani and Merton Miller (often called M-M) concluded that financial leverage was irrelevant to value and that dividends were no more than a financing decision rather than a source of added value. William Sharpe joined M-M in an expansion of these theories to develop the Capital Asset Pricing Model (“CAPM”) which became the cornerstone of securities and corporate valuation theory for decades and remains in wide use today.
The “science” of economics has much in common with the “science” of climate change. Both financial markets and climate are chaotic, complex non-linear systems. The crop of scientists in both fields cannot resist using linear regression and its handmaiden statistical analysis based on the Gaussian “normal distribution” as their primary tools for research, ignoring the better fit that a bounded Pareto distribution provides in the case of economics and the implications of the laws of physics in the case of climate. To do so they force themselves to rationalize sets of assumptions that deviate from empirical evidence but have a certain appeal often founded on anecdotal evidence chosen to support the desired outcome. Both linear regression and Gaussian statistical analysis are powerful tools, but too often chosen where better tools are available but ignored. Multivariate approaches such as factor analysis and multivariate regression find few adherents but may produce more sensible results when complex relationships are present.
IMPLICATIONS FOR LAWYERS AND JUDGES
The combination of (a) efficient market theory, (b) diversification as the key factor in managing portfolio risk and (c) CAPM as the fundamental consideration in determining value predominated corporate finance in business schools and in wealth management firms from their inception through the present. The robust adherence to these ideas found their way into laws and jurisprudence where the assessment of “fair value” was left to the Courts or to a government official.
The “war of experts” is present in many civil actions and the range of theory applied demonstrates the lack of any standard or accepted approach. In Deer Creek Energy Limited v Paulson & Co. Inc. [14] the Court heard from no fewer than thirteen “experts” each claiming competence but presenting an opposing view and theory. The case dealt with the valuation of an oil sand project at a very early stage of production, so all the experts had to rely on projected outcomes which incorporated both expected volumes of production; oil prices; future taxes and royalties; and some judgment on what rate of return was appropriate. I can state with certainty that the actual outcome of the oil sands development bore no resemblance to the projections used by the experts, but at least they had as guidance the actual results from output of 300 barrels of oil a day and a plan to get to 600 barrels of oil a day.
That is not the most absurd case I came across in my review of reported judgments relying on financial experts. The Supreme Court of Canada upheld the Mineral Taxation Act, 1948, c. 24 (the “Act”) which left it to the Lieutenant Governor of Saskatchewan to determine the “fair value” of minerals contained in parcels of Saskatchewan land for the purposes of taxation. [15] Neither the SCC nor the Act provided any guidance as to how the Lieutenant Governor was to carry out this daunting task for which I submit he was woefully inadequate. There is no valid financial theory that would produce a reliable valuation of minerals in the ground before anyone had examined the grade, tonnage of likely waste, capital costs, and all the other factors that necessarily go into a project financial analysis not the least of which is the commodity price that will in fact be realized. I am confident that counsel for the Government and for C.P.R. were similarly out of their depth, which may explain why the complexity of the task was not an issue raised in the case.
FAIR VALUE OF MINERAL DEPOSITS
Concepts like “efficient markets”, “diversification” or “CAPM” would have been of little assistance in the C.P.R. case, since the fair value of the minerals in the subject lands could not be arrived at using any of those theoretical tools, and the tools themselves had weaknesses. Aswath Damodaran has suggested that resource deposits can be valued as a “real option” using either binomial theory or Black Scholes which has common sense appeal. [16] Black-Scholes model of valuing options might have been of value in the C.P.R. case but was not discussed.
Mining and mineral deposits pose serious valuation problems. Unlike most industries, a mine is going out of business the moment it starts production. Miners cannot control the two key variables that determine the success or failure of the mine – how much ore is in the deposit and the price of the ore once mined. At best, following a discovery of an ore body, a miner can use the geological information from the exploratory activities to estimate the grade, degree to which waste must be mined to release the ore, and the capital costs to put the mine into production. Still unknown will be the costs to meet the Environmental, Social and Governance (“ESG”) goals of the broad society or the community in which the ore body is located and the costs and delay of the environmental approval process.
ESG ISSUES
From discovery to production the miner must navigate a “minefield” of barriers posed by the legislative authorities in the jurisdiction and the legal and social relationship between the indigenous people in the community closest to the mine or through whose lands the miner will need access to both develop the mine and ship the ore once mined. The time between discovery and production is often decades and fraught with risks as governments change and bureaucrats seek to impose new obligations on the miner. Costs of construction of the mine may be dwarfed by the ultimate costs to meet the ESG goals which frequently include obligations to employ locals, to construct community infrastructure such as schools, hospitals and roads, training costs and the costs of remediation of the mined area to return it to a state acceptable to regulators and to the community. None of these costs can be known with precision at the time of discovery nor during the production period.
Defining ESG goals and reporting against those goals is becoming a trend some corporate finance “experts” claim will lower the cost of capital for those miners who emerge as leaders in defining clear ESG goals and transparent reporting against those goals. That claim is specious. There is little evidence that strong ESG leadership and clear ESG reporting result in any premium for the share prices of companies embracing this trend. Aswath Damodaran provides a skeptical look at the claims in his September 2020 article: “Sounding good or Doing good? A Skeptical Look at ESG” [17]
There is no doubt that well-managed miners will pay attention to environmental issues and the impact of their activities on the communities in which they operate as part of their corporate governance policies. I have served on the board of directors of both a miner and an oil & gas exploration and development company and saw environmental and social issues being dealt with responsibly long before the emergence of ESG label. ESG has become a buzzword which conflates the expected sound governance of public and private corporations with some expectation that these corporations are instruments of public policy rather than centers of economic activity. In part, the ESG phenomenon has gained momentum as the claims that CO2 causes “global warming” have infected large parts of government and society worldwide. These claims originate with the Club of Rome in the 1970’s when George Soros, Pierre Trudeau and a host of United Nations executives saw the benefit of raising a climate alarm as a tool to rally support for a new world socialist order in a post-national world. In the words of Timothy Wirth while he was President of the U.N. foundation: “We have got to ride this global warming issue. Even if the theory of global warming is wrong, we will be doing the right thing in terms of economic and environmental policy”. [18] It is plain and obvious that man caused “climate change” is a political rather than scientific issue by simply observing that views on the subject are almost evenly divided with the “left” advancing a “climate change” agenda and the “right” resisting it.
The primary driver of whether the mine will succeed or fail will typically be the price of the commodity. That price has varied from $0.50 to over $4.00 a pound since 1960 according to COMEX records.
Similar price volatility exists for virtually every commodity mined. Tools such as net present value (“NPV”), internal rate of return (“IRR”), Sharpe-Markowitz “efficient frontier” analysis; or CAPM produce little meaningful output when the input factors have material inherent errors and large standard deviations from historic averages.[19] Nonetheless, based on the adage that “if your only tool is a hammer, every problem looks like a nail”, these theoretical tools continue to be used with NPV and IRR appearing in virtually every NI 43-101 technical report or Final Economic Analysis (“FEA”) for a proposed mine and CAPM in the financial industry’s valuation of publicly held mining companies. Garbage in – garbage out.
In a 2017 study, using the Polish mining industry as an example, Anita Michalak concluded that the expected return on investments in the mining industry ranged from 12.69% to 13.97%. [20] I cannot resist smiling when I read a report from a presumed financial expert who concludes that expected returns can be estimated to the accuracy of four significant digits. Michalak uses the conventional financial theories with some modifications which I am sure she sees as improvements. I presume she had not seen the 2016 Price Waterhouse study published by the Northern Miner which cited that Mining earned a 4.4% ROI in 2015 [21] with most CEO’s of mining companies mentioned seeing the outlook was bleak for improved outcomes. For the past 10 years, the S&P/TSX Mining index return has averaged less than 1%. [22]
The divergence between actual and “expected” returns should come as no surprise given the manifold assumptions implicit in the calculation of “expected returns” and the oversimplification inherent in the CAPM and related models.
TAXATION
Governments frequently use the tax code to attempt to redistribute income or wealth in accordance with their social goals. The result has been regular policy driven changes to the tax codes including in Canada, where income taxes were first introduced as a temporary measure to fund the first world war. [23] A progressive tax code has since become part and parcel of the financial system of Western democracies subject to changes routinely enacted as part of annual budget legislation. In Canada today, the top 20% of taxpayers pay 57% of all taxes paid and the bottom 20% pay less than 2% of the taxes. [24] In the United States, the top 20% of taxpayers pay 87% of all taxes paid while the bottom 60% of taxpayers pay no tax at all. [25]
Taxation policies in capitalist societies need to balance the desire to redistribute income with the need to retain enough incentives that entrepreneurship, job creation and economic expansion continue to thrive. This does not stop left wing leaders from advocating even higher taxation of the highest income earners.
Canada’s tax code was first introduced September 20, 1917 as the Income War Tax Act and comprised 45 pages. By 1948 it became permanent and was enacted as the Income Tax Act. Its ultimate successor, the Income Tax Act R.S.C. 1981 c. 5 is 3,656 pages long. I would wager there exists no lawyer, no judge and no taxpayer who has read and understood the complete publication which is replete with myriads of cross references and internal inconsistencies.
A significant portion of the Income Tax Act deals with corporate taxation. One wonders why the government saw fit to tax corporations at all, since corporations are legal fictions and can only exist while profitable, so any taxes levied against a corporation are ultimately passed through to the corporation’s customers. In effect, corporate taxes are not progressive but are resolved in prices paid by ordinary Canadians for the goods and services that the corporations supply. Despite this obvious circumstance, many Canadians think corporations should pay more taxes, particularly Canadians who support left wing political parties whose rants about making corporations pay “their fair share” are incessant.
The complexity of the Canadian tax code has made taxation a key issue in all areas of corporate finance, from the structure of debt or equity securities to the nature of banking relations and decisions on capital projects or mergers and acquisitions. This has created another “cottage industry” of tax specialists in accounting and law firms whose fees become material elements of the costs of transactions.
COTTAGE INDUSTRIES
Judges are randomly confronted with corporate finance issues that turn on valuation, tax or accounting expertise that lies beyond their comfort level if not their competence. This has resulted in the growth of the boutique firms I describe as “cottage industries” of professionals who hold certifications as Chartered Business Valuators (“CBV’s”); Chartered Public Accountants (“CPA’s”) claiming to be tax specialists; Chartered Financial Analysts (“CFA’s”) or tax lawyers. Parties are normally allowed to engage their own specialists to argue their cases although the Court has the power to appoint its own experts if a judge so desires. The war of the “experts” results in a debate where judges and litigation counsel are little more than spectators to the argument although the judge is called upon to resolve the dispute.
Expert valuation is the area subject to the most abuse. CBV’s often are CPA’s who have the added credential of CBV and whose typical approach to “valuation” is a comparative analysis. These experts have rarely managed a business but are encouraged to select as reference points companies’ which in the CBV’s judgment are comparable to the subject corporation or business. The CBV then estimates earnings before interest, tax, depreciation, and amortization (“EBITDA”) for the “comparable” companies and with reference to those that are publicly traded calculates for each an EBITDA to Enterprise Value (“EV”). EV is equal to the sum of Equity and Debt of each corporation. By comparing the EV/EBITDA ratio of the “comparable” companies to the subject company, the CBV produces an estimate of value.
The abuse lies in the choice of so-called comparable companies and the choice of the appropriate EV/EBITDA ratio to use where the average of the “comparable” companies does not suit the valuator’s judgment. To create the appearance of objectivity, the CBV will normally choose a range of EV/EBITDA values that bracket the chosen one to show that the value arrived at lies in the center of a reasonable range and is reliable. It is not.
In a particular piece of litigation where I was a party, the party opposite chose a CBV who was also a CPA and did precisely what I have described. To counter this “expert” I engaged Douglas Cumming (“Cumming”) a tenured professor of Finance at York University at the time of the action, to complete an objective valuation of the subject private corporation. Cumming found the corporation had a value more than $10 million higher than the CBV, and during his qualification hearing gave the following evidence in respect of the comparable company EV/EBITDA approach used by the opposing CBV: [26]
“THE COURT: Is that what you meant when you referred to theoretical a few moments ago?
1A. Atheoretical.
THE COURT: Atheoretical.
A. So, it is no theory behind comparables methods. They are as I joke about it in my MBA classes, they are the uninformed guy's approach to valuation and in – in practice, people that are making investment decisions would never solely rely on comparables.
The outcomes with comparables can vary widely depending on the particular comparables that are picked and in fact, most companies aren't directly comparable and so therefore, if you were to base any conclusions on a comparables method you really – and particularly for example if you are valuing a company with a unique business process, unique customers, different sets of competitors, you’d really be doing yourself a disservice because it’s not something that you would formally rely on. “
Cumming had also given evidence that he had never met me before being engaged; that he had no stake in the outcome of the dispute; and that he would have come to the same conclusion had he been engaged by the opposite party.
The test as to whether a proposed expert should be qualified by the Court to give evidence is set out succinctly by Cromwell J. in a 2015 decision of the Supreme Court of Canada. [27]
Expert witnesses have a duty to the court to give fair, objective and non-partisan opinion evidence. They must be aware of this duty and able and willing to carry it out. The expert’s opinion must be impartial in the sense that it reflects an objective assessment of the questions at hand. It must be independent in the sense that it is the product of the expert’s independent judgment, uninfluenced by who has retained him or her or the outcome of the litigation.
It must be unbiased in the sense that it does not unfairly favour one party’s position over another. The acid test is whether the expert’s opinion would not change regardless of which party retained him or her.
The presiding judge decided not to qualify Dr. Cumming and chose to rely on the valuation provided by the opposing CBV despite is lack of theoretical foundation and Cumming’s obvious competence.
That decision cost me a substantial amount of money. It drove home for me the frailty of a judicial system where judges may lack the ability to discern the competence of experts or the reliability of the reports they receive. Listening to a judge prefer an incompetent “expert” relying on an unreliable valuation approach to one who has mastered the science of valuation relying on a technically valid methodology reminded me of Eric Arthur Blair’s famous words: “The quickest way of ending a war is to lose it”. [28] Business valuation is complex and imprecise and the tools arcane. Judges’ deference to “experts” is of little value where judges are not competent to discern who is “expert” or whether the proffered evidence is reliable.
I have sympathy for judges who are burdened with the impossible task of “finding facts” in circumstances where at least one party is doing its best to conceal them. The attraction of “expert evidence” and “science” has become infectious despite its limitations and has resulted in judges making findings of fact on no evidence and just parroting the conventional wisdom or the politically correct narrative without applying any critical thinking. The worst example I have seen is when Ontario’s Chief Justice Strathy in hearing Ontario’s appeal of the “carbon tax” legislation imposed by the Trudeau government found in paragraphs 6 to 7 of his judgment dismissing Ontario’s appeal: [29]
“Greenhouse Gas Emissions and Climate Change
[6] Climate change was described in the Paris Agreement of 2015 as “an urgent and potentially irreversible threat to human societies and the planet.” It added that this “requires the widest possible cooperation by all countries and their participation in an effective and appropriate international response.”
[7] The is no doubt that global climate change is taking place and that human activities are the primary cause. The combustion of fossil fuels, like coal, natural gas and oil and its derivatives, releases GHGs into the atmosphere. When incoming radiation from the Sun reaches Earth’s surface, it is absorbed and converted into heat. GHGs act like the glass roof of a greenhouse, trapping some of this heat as it radiates back into the atmosphere, causing surface temperatures to increase. Carbon dioxide (“CO2”) is the most prevalent GHG emitted by human activities. This is why pricing for GHG emissions is referred to as carbon pricing, and why GHG emissions are typically referred to on a CO2 equivalent basis. Other common GHG’s include methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulfur hexafluoride, and nitrogen trifluoride.”
No doubt Justice Strathy believed what he wrote despite its glaring departures from the laws of physics and material omissions. His list of GHGs ignored the largest and perhaps the only relevant GHG to any discussion of climate – water vapour, which comprises as much as 50,000 ppm of atmosphere compared to 410 ppm for CO2. [30] No one would expect Justice Strathy to be familiar with the reality that CO2 is capable of interaction with outgoing Long Wave Infrared Radiation (“LWIR”) only in narrow the 15-micron wavelength or with Wien’s Law [31] which provides that LWIR radiating from a black body peaks at a wavelength equal to 2,898 divided by the temperature of the black body in degrees Kelvin. LWIR in the 15-micron band radiated from Earth’s surface peaks at surface temperatures at or colder than minus eighty degrees Celsius, a rarity on Earth. Likewise, Justice Strathy would not have learned in Law School that any LWIR photons than encounter a CO2 molecule are re-radiated in all directions in femtoseconds. [32] Parroting a left-wing narrative that CO2 is a GHG that “acts like the roof of a greenhouse” presents an absurdity that demonstrates how conventional wisdom about “global warming” has permeated even our high Courts despite its weak foundation in science. Before making a finding that there is “no dispute that global climate change is taking place and that human activities are the primary cause” Justice Strathy might have heard from at least one scientist.
The appeal was based on constitutional grounds, not scientific ones. The fact is that at least sixty-six Nobel laureates dispute that human activities are causing climate change [33] and there is a significant debate about the existence of any scientific consensus on the issue. [34]
FRAILTY OF THE FINANCE TOOLS
Despite their widespread acceptance, the portfolio and valuation tools proved frail. Fama, often considered the father of the efficient market theory, found that CAPM did not fully explain “look back” trading prices of publicly traded securities and with Kenneth French in 1992 developed a three-factor model [35] after observing that small capitalization stocks and stocks with a high book value to market price ratio seemed to outperform the markets over considerable periods. His three-factor model includes not only Beta (the ratio of volatility in the subject company’s stock price to that of the market as a whole) but also the book to price ratio of the subject company’s stock and the relative market capitalization of the company to the average company in the index. Fama remained committed to the concept of “efficient markets”.
The assumption of “efficient markets” has been attacked by Nobel Laureate Bob Shiller who demonstrated that empirical evidence does not support the “efficient market” hypothesis. [36] Shiller suggests that it is not only possible to outperform the stock market but also that selecting a portfolio of stocks based on low cyclically adjusted price earnings (“CAPE”) multiples should produce that result. The CAPE metric was developed by Shiller whose 2000 book “Irrational Exuberance” [37]exposed the risk of market “bubbles” based on high CAPE multiples. Shiller joined Chicago professor Richard Thaler in exploring a new area of finance called “behavioral economics” which explores the psychological underpinnings of market behavior.
Motivated by interesting work by Amos Tversky and Nobel Laureate Daniel Kahneman [38] demonstrating that graduate students would give diametrically opposite answers to identical questions based simply on how the questions were framed, Nobel Laureate Richard Thaler explored the behavioral aspects of market valuation of publicly traded securities. Thaler and Werner De Bondt demonstrated that the underlying assumptions of risk aversion and profit maximization were fragile bases for the conventional theory, by publishing evidence that a strategy of buying out of favor stocks (the worst performing members of the S&P index) and holding those stocks for three to five years not only outperformed the S&P index by several hundred basis points but also outperformed the S&P index with those “worse performing” stocks removed. [39]
Thaler’s work was consistent with psychological theories developed by B.F. Skinner[40] whose models of variable and fixed ratio operant conditioning explained the self-destructive behaviour of gamblers in casinos including those who would wear adult diapers to remain seated at one-armed bandits until their money was exhausted hoping they would win a large jackpot. In a nutshell, it is specious to believe that, as a group, investors are both risk-averse and profit maximizing – two assumptions foundational to the efficient market hypothesis and CAPM. Not surprisingly, 90% of investment professionals produce returns that are below the market averages despite the performance claims that proliferate their advertising materials. [41]
For most people, their home is their major investment. A whole class of professionals known as realtors charge fees of between 4% and 6% of the selling price a home to assist in the sale, husbanding statistical data not publicly available to buyers or sellers to create a virtual monopoly of information. Canadians tend to move every 3 to 5 years and arithmetic implies that the entire value of the housing stock is transferred from homeowners to realtors every 50 to 75 years. As one pundit put it when commenting on realtors: “the world would be 6% better off without them”.
CORPORATE FINANCE FOR MINING COMPANIES
Lawyers assisting mining companies with corporate finance issues can improve the value they provide to clients by considering the following:
1. For exploration companies, disclosure of the fact that only one in 6,000 companies is likely to ever make it into production and that for those that do, repeated financings will reduce investors ownership in the resource through the inescapable dilution.
2. Historically, returns on mining company investments have averaged less than returns for the broad market generally. Established mining companies with a diversified set of projects in production tend to be lower risk and higher return than smaller companies with only one or two mines.
3. ESG considerations have reduced the profit potential of prospective mines and led to longer delays in permitting, both of which reduce the returns investors should expect to realize. Disclosure of the costs of the ESG initiatives contemplated for the project should be included in the disclosure documents.
4. For companies issuing NI 43-101 studies of their projects, disclosure of the likelihood and potential costs of a major incident such as a tailings dam failure should be included to ensure potential investors in project financing or in the securities of the company itself have a reasonable appreciation of the economic risk the proposed capital program exposes them to, and the alternatives considered and rejected by the project sponsor.
5. Disclosure should include the commodity price at which the project would be shut down if it proceeds and the estimated costs of such shut down.
After review of several hundred NI 43-101 studies and a larger number of mining company prospectuses, I can report that I found no disclosure of the foregoing, yet in my opinion those facts are essential to coming to a rational investment decision.
CONCLUSION: IMPROVING EXPERT EVIDENCE
Over reliance on “expert evidence” weakens the justice system. Judges abdicate their vital role in weighing the evidence and finding facts, by deferring to expert witnesses called by the parties who are often neither “expert” nor objective. This is a problem in the intersection of law and finance where the “cottage industry” of paid “experts” provide parties with their “expert evidence” using atheoretical methodology subject to abuse with judges either unwilling or incapable of assessing the validity of the expert’s report preferring to defer to the experts.
This weakness is exacerbated by the poor level of understanding of financial theory by lawyers. The legal profession has a key role to play in corporate finance, for example:
· Assisting governments to draft statutes and regulations to protect participants in the financial system,
· Advising corporations in creating financial instruments and navigating securities laws,
· Representing litigants in complaints about financial abuses,
· As members of the judiciary, adjudicating disputes including issues of valuation of businesses and financial assets.
Lawyers rarely receive anything but the most basic training in economics and finance in law schools. What training they do receive is deficient in that it tends to accept the ageing theories of efficient markets, portfolio diversification and CAPM without question and leaves students with a misapprehension that they are competent to represent clients in this key area. Elected members of Parliament or legislatures are unlikely to have any better foundation in finance or economics. The result is laws which concentrate on mandated disclosure and restrictive regulations with the bulk of securities disclosure documents comprising legal boilerplate that shifts the burden of understanding the risks and benefits of the offered security to the investor from the financial intermediary and the corporate issuer. The concept of “full, plain and true disclosure” is painfully devoid of fullness or plainness and borders on untruths. I observe that most prospectuses contain more disclaimers than factual content. Investors get little protection from the disclosure regime and must turn to the Courts if they believe they have been unfairly treated.
The Courts suffer from the same deficiencies as the legal professions – a lack of understanding of finance and economics. To remedy this deficiency, the Courts impose on litigants the obligation to support their cases with “expert” evidence, creating a system where the tyranny of the cottage industry of “experts” is enabled. Lawyers eloquently argue in favor of the position of their chosen expert and urge judges to interpret statutes and regulations in a way that suits the interests of their clients regardless of the plain language of the relevant legislation or the stated intent of the legislators as recorded in the committee meetings giving rise to the laws or in Hansard.
Law schools are beginning to realize that prospective lawyers would benefit from an understanding of economics and finance and have begun to include very basic courses in their curricula. In my opinion, these courses should be directed at ensuring lawyers graduate with a good understanding of what they do not know rather than a false confidence that they understand the key concepts well enough to advise clients in these important areas. This might be accomplished by having speakers such as Bob Shiller, Gene Fama, Daniel Kahneman or Aswath Damodaran address classes and have a dialogue about the complexity of the issues and where they might look for guidance when faced with one in their practice. Shiller continues to teach at Yale; Fama at the University of Chicago; Kahneman at Princeton, and Damodaran at New York University.
Lawyers through their Law Societies and directly can improve the judicial process in Canada if they promote a change to the way expert evidence is used. I suggest the following:
1. Experts should be chosen and appointed only by the Court rather than by opposing parties and have duties solely to the Court. The costs of the experts should be apportioned between the parties by the Court based on the outcome of the case and the degree to which the expert evidence was required, and if it contradicted positions taken by any party.
2. Both parties should have the right to cross examine an expert so appointed and to engage their own experts to advise them in respect of where weaknesses in the evidence can be exposed through cross-examination rather than to have their expert advisers give evidence themselves.
3. Judges should consider the expert evidence in the context of the evidence as a whole and not give the expert evidence any priority, assigning it weight based on the judge’s assessment of its relevance and objectivity. Experts cannot supplant judges as the triers of fact.
Society as a whole and litigants will respect the judicial process only to the degree it is objective, impartial, and accords with common sense. Judges who decide cases by hiding behind the evidence of “experts” do a disservice to the judicial process.
* * *
FOOTNOTES
[1] The Wealth of Nations, Adam Smith, 1776. ISBN 978 1 84022 688 1
[2] Capitalism and Freedom, Milton Friedman, 1962, University of Chicago Press
[3] The General Theory of Employment, Interest and Money, John Maynard Keynes, 1936
[4] Das Kapital, Karl Marx, 1867
[5] How Estonia became one of the wealthiest countries in Eastern Europe, Luis Pablo de la Horra. Foundation for Economic Education, March 23, 2018 How Estonia—Yes, Estonia—Became One of the Wealthiest Countries in Eastern Europe - Foundation for Economic Education (fee.org)
[6] The Rise and Fall of Elites, Vilfredo Pareto, 1920
[7] Thomas Sowell Quotes. Thomas Sowell Quotes (Author of Basic Economics) (goodreads.com)
[8] Dismantling America, Thomas Sowell, 2010, Published in Basic Books 1s Edition.
[9] “Income inequality is killing us”, Dr. Peter Ubel, Forbes Magazine September 20, 2020.
[10] Dow Jones. Income Percentile Calculator for the United States [2020] (dqydj.com)
[11] Profit Impact of Market Strategies, 1974, Become a Market Leader with PIMS (Profit Impact of Market Strategy) | Business Strategy Hub (bstrategyhub.com)
[12] Long term trends revealed by analyzing ROIC by Sector, David Trainer. Forbes June 19, 2019 Long-Term Trends Revealed by Analyzing ROIC By Sector (forbes.com)
[13] Investopedia, February 19, 2020. What is the average annual return for the S&P 500? (investopedia.com)
[14] Deer Creek Energy Limited v. Paulson & Co. Inc., 2008 ABQB 326 (CanLII), <https://canlii.ca/t/1xm58
[15] C.P.R. v A.G. for Saskatchewan, 1952 CanLII 39 (SCC), [1952] 2 SCR 231, <https://canlii.ca/t/22wr4
[16] Ups and Downs: Valuing Cyclical and Commodity Companies, Aswath Damodaran, 2009, Stern School of Business.
[17] Sounding good or looking good? A skeptical look at ESG, Aswath Damodaran. Musings on Markets, September 21, 2020. Musings on Markets: Sounding good or Doing good? A Skeptical Look at ESG (aswathdamodaran.blogspot.com)
[18] In their own words: Climate alarmists debunk their ‘science’, Larry Bell. Forbes Magazine, February 5, 2013. In Their Own Words: Climate Alarmists Debunk Their 'Science' (forbes.com)
[19] Dealmakers take heed: CAPM can cause significant valuation errors, Betsy Vereckey, March 5, 2020. MIT Sloan Dealmakers take heed: CAPM can cause significant valuation errors | MIT Sloan
[20] Expected Return on Capital in the Mining Industry, Aneta Michalak, December 24, 2017. Expected Return on Capital in Mining Industry | IntechOpen
[21] Mining and Return on Investment, PWC, 2016 PwCFinalReport.pdf (glaciermedia.ca)
[22] SPGlobal.com S&P/TSX Global Mining Index - S&P Dow Jones Indices (spglobal.com)
[23] Canadian Income Tax history
[24] Measuring the Distribution of Taxes in Canada Today, Charles Lammam, Hugh MacIntire, and Milagros Palacious, Fraser Institute Measuring the Distribution of Taxes in Canada: Do the Rich Pay Their “Fair Share”? (fraserinstitute.org)
[25] Tax Report, April 6, 2018, Wall Street Journal, Top 20% of Americans Will Pay 87% of Income Tax - WSJ
[26] Voir Dire of Douglas Cumming, July 20, 2015
[27] White Burgess Langille Inman v. Abbott and Haliburton Co., 2015 SCC 23, [2015] 2 S.C.R. 182
[28] Polemic, May 1946, Eric Arthur Blair (under the pen name George Orwell)
[29] Reference re GreenhouseGas Pollution Pricing Act, 2019 ONCA 544 (CanLII)
[30] Earth’s atmosphere composition, Earthhow. Earth's Atmosphere Composition: Nitrogen, Oxygen, Argon and CO2 - Earth How
[31] What is Wien’s Displacement Law? Thermal Engineering, Nick Connor, May 22, 2019. What is Wien’s Displacement Law - Definition (thermal-engineering.org)
[32] There is no valid mechanism for CO2 creating global warming, CO2 absorption spectrum. CO2 Absorption Spectrum. (nov79.com)
[33] Leading scientists, including 60 Nobel prize winners dispute that trace amounts of CO2 cause overheated climate, James Matkin. (PDF) LEADING SCIENTISTS, including 60 Nobel winners, doubt trace amounts of Co2 emissions cause over heated climate. New Research shows "extreme value of CO2 to all life forms, but no role in any change of the Earth’s climate." Alarmism "statistically questionable." | James G Matkin - Academia.edu
[34] Putting the con in consensus, McKittrick, Fraser Institute, https://www.fraserinstitute.org/article/putting-the-con-in-consensus-not-only-is-there-no-97-per-cent-consensus-among-climate-scientists-many-misunderstand-core-issues
[35] The use of CAPM and Fama and French three factor model: portfolio selection, Belen Bianco. Public and Municipal Finance, Volume 1, Issue 2, 2012 Microsoft Word - PMF_2_2012__online_ (businessperspectives.org)
[36] Reflections on Market Efficiency, Robert J. Shiller, 2018 Microsoft Word - Robert J Shiller - Reflections on Market Efficiency - Final _4_ (bmoetfs.ca)
[37] Irrational Exuberance, 2000, Robert J. Shiller
[38] Thinking Fast, Thinking Slow, 2013, Daniel Kahneman
[39] Does the Stock Market Overreact? 1986, Werner F.M. De Bondt and Richard M. Thaler, Journal of Finance, vol. XL, no 3, p. 793-807
[40] Schedules of Reinforcement, B.F. Skinner and C.B. Ferster, Prentice Hall, 1957. ISBN 978-0-9899839-5-2
[41] Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors, Akipanedtaworn, di Mascio, Imas and Schmidt,MIT Sloan School of Management September 2019
BIBLIOGRAPHY
Books
The Wealth of Nations, Adam Smith, 1776. ISBN 978 1 84022 688 1
Capitalism and Freedom, Milton Friedman, 1962, University of Chicago Press
The General Theory of Employment, Interest and Money, John Maynard Keynes, 1936
Schedules of Reinforcement, B.F. Skinner and C.B. Ferster, Prentice Hall, 1957. ISBN 978-0-9899839-5-2
Das Kapital, Karl Marx, 1867
The Rise and Fall of Elites, Vilfredo Pareto, 1920
Dismantling America, Thomas Sowell, 2010, Published in Basic Books 1s Edition.
Polemic, May 1946, Eric Arthur Blair (under the pen name George Orwell)
Irrational Exuberance, 2000, Robert J. Shiller
Thinking Fast, Thinking Slow, 2013, Daniel Kahneman
Articles
How Estonia became one of the wealthiest countries in Eastern Europe, Luis Pablo de la Horra. Foundation for Economic Education, March 23, 2018 How Estonia—Yes, Estonia—Became One of the Wealthiest Countries in Eastern Europe - Foundation for Economic Education (fee.org)
Income inequality is killing us”, Dr. Peter Ubel, Forbes Magazine September 20, 2020.
Long term trends revealed by analyzing ROIC by Sector, David Trainer. Forbes June 19, 2019 Long-Term Trends Revealed by Analyzing ROIC By Sector (forbes.com)
Sounding good or looking good? A skeptical look at ESG, Aswath Damodaran. Musings on Markets, September 21, 2020. Musings on Markets: Sounding good or Doing good? A Skeptical Look at ESG (aswathdamodaran.blogspot.com)
In their own words: Climate alarmists debunk their ‘science’, Larry Bell. Forbes Magazine, February 5, 2013. In Their Own Words: Climate Alarmists Debunk Their 'Science' (forbes.com)
Expected Return on Capital in the Mining Industry, Aneta Michalak, December 24, 2017. Expected Return on Capital in Mining Industry | IntechOpen
Ups and Downs: Valuing Cyclical and Commodity Companies, Aswath Damodaran, 2009, Stern School of Business.
Mining and Return on Investment, PWC, 2016 PwCFinalReport.pdf (glaciermedia.ca)
Measuring the Distribution of Taxes in Canada Today, Charles Lammam, Hugh MacIntire, and Milagros Palacious, Fraser Institute Measuring the Distribution of Taxes in Canada: Do the Rich Pay Their “Fair Share”? (fraserinstitute.org)
Tax Report, April 6, 2018, Wall Street Journal, Top 20% of Americans Will Pay 87% of Income Tax - WSJ
What is Wien’s Displacement Law? Thermal Engineering, Nick Connor, May 22, 2019. What is Wien’s Displacement Law - Definition (thermal-engineering.org)
Leading scientists, including 60 Nobel prize winners dispute that trace amounts of CO2 cause overheated climate, James Matkin. (PDF) LEADING SCIENTISTS, including 60 Nobel winners, doubt trace amounts of Co2 emissions cause over heated climate. New Research shows "extreme value of CO2 to all life forms, but no role in any change of the Earth’s climate." Alarmism "statistically questionable." | James G Matkin - Academia.edu
Putting the con in consensus, McKittrick, Fraser Institute, https://www.fraserinstitute.org/article/putting-the-con-in-consensus-not-only-is-there-no-97-per-cent-consensus-among-climate-scientists-many-misunderstand-core-issues
The use of CAPM and Fama and French three factor model: portfolio selection, Belen Bianco. Public and Municipal Finance, Volume 1, Issue 2, 2012 Microsoft Word - PMF_2_2012__online_ (businessperspectives.org)
Reflections on Market Efficiency, Robert J. Shiller, 2018 Microsoft Word - Robert J Shiller - Reflections on Market Efficiency - Final _4_ (bmoetfs.ca)
Does the Stock Market Overreact? 1986, Werner F.M. De Bondt and Richard M. Thaler, Journal of Finance, vol. XL, no 3, p. 793-807
Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors, Akipanedtaworn, di Mascio, Imas and Schmidt, MIT Sloan School of Management September 2019
Dealmakers take heed: CAPM can cause significant valuation errors, Betsy Vereckey, March 5, 2020. MIT Sloan Dealmakers take heed: CAPM can cause significant valuation errors | MIT Sloan
Cases
Deer Creek Energy Limited v. Paulson & Co. Inc., 2008 ABQB 326 (CanLII), <https://canlii.ca/t/1xm58
C.P.R. v A.G. for Saskatchewan, 1952 CanLII 39 (SCC), [1952] 2 SCR 231, <https://canlii.ca/t/22wr4
Voir Dire of Douglas Cumming, July 20, 2015
White Burgess Langille Inman v. Abbott and Haliburton Co., 2015 SCC 23, [2015] 2 S.C.R. 182
Reference re Greenhouse Gas Pollution Pricing Act, 2019 ONCA 544 (CanLII)
Websites
Thomas Sowell Quotes. Thomas Sowell Quotes (Author of Basic Economics) (goodreads.com)
Dow Jones. Income Percentile Calculator for the United States [2020] (dqydj.com)
Profit Impact of Market Strategies, 1974, Become a Market Leader with PIMS (Profit Impact of Market Strategy) | Business Strategy Hub (bstrategyhub.com)
Investopedia, February 19, 2020. What is the average annual return for the S&P 500? (investopedia.com)
COMEX Copper Prices - 45 Year Historical Chart | MacroTrends
SPGlobal.com S&P/TSX Global Mining Index - S&P Dow Jones Indices (spglobal.com)
Earth’s atmosphere composition, Earthhow. Earth's Atmosphere Composition: Nitrogen, Oxygen, Argon and CO2 - Earth How
There is no valid mechanism for CO2 creating global warming, CO2 absorption spectrum. CO2 Absorption Spectrum. (nov79.com)