The Incredible Flow-Through Leak

January 29, 2006

Former Canadian finance minister Ralph Goodale’s department is currently under investigation by the RCMP regarding an alleged leak of information concerning the decision in his (most recent) income trust fiasco. The formal allegations were brought forward by the NDP during the election campaign. They allege that Bay Street insiders privy to the leak benefitted by purchasing income trusts and dividend paying stocks, which stood to rise after the decision became public, which it did on Nov 23, 2005. Further background to this can be found here.

Notable nay-sayers to the likelihood of a leak include the Bay Street community, according to various media reports. Of course they are hardly unbiased, not being eager to point the finger at themselves. However, in this case they are one group with enough (indeed, more than enough) knowledge of and familiarity with the situation to actually draw the right conclusion, as opposed to those who saw the trading frenzy of Nov 23, and in a knee-jerk or partisan reaction cried “Leak!”

Here I want to outline and explain the argument against a leak, which is based on correct market anticipation as grounds for the pre-announcement trading activity. Of course I don’t know if there was a leak or not, but based on the reasoning below I find it highly improbable.

In September 2005, the finance department initiated a public consultation regarding perceived tax problems related to income trusts. The consultation was scheduled to take public input for consideration until Dec 31, with a decision expected to be reached early in the new year. Among the options being explicitly considered was the possibility of introducing a new tax on trusts. It wasn’t long before the uncertainty created by this situation resulted in a significant drop in income trust market values. (To be sure, a coincident drop in oil prices also depressed the values of energy trusts, but this factor was far from alone.)

This trust value scalping made minister Goodale the target of criticism from many sides: trust investors large and small, trust managements, investment bankers, would-be trust convertees. This only aggravated the problems of the tottering Liberal minority government. Moreover, the media was eager to unearth any tidbits they could regarding this on-going situation. Any time the minister gave them even a vague comment relating to hypothetical outcomes, the markets stirred in reaction. It soon got to the point where, for fear of misdirecting trigger-happy traders, the minister publicly refused to provide any further comment on the situation until 2006 when the consultation would be completed. This is a very important thing to realize, which many leak-seekers probably don’t take into account.

Now move ahead to Nov 22. After a long period of silence, and with the Liberals on the brink of non-confidence, Goodale finally has something to say: the trust situation will be resolved imminently, before the fall of the government. This, in essence, was the leak; and it was public! If you actually think about this, the implications are immense and fairly clear. First, an imminent announcement signals a decision either having been made (or about to be finalized). And second, an early end to the consultation.

Concerning the decision to be made, it could be either bad or good. A “bad” decision would have been along the lines trust stakeholders were dreading, something like “we’re putting a new tax on trusts” and perhaps other restrictive or draconian measures. For the minister to close off public input prematurely, before everyone could have their say, and impose a decision like that, particularly in the face of other concurrent anti-Liberal sentiment (Gomery et al), was just not a real possibility.

So, if the decision couldn’t be bad, it had to be “good”. Namely, at the very least: no new measures or taxes affecting income trusts directly. This is what almost everyone wanted, and is really the only possible acceptable reason for ending the consultation early.

And what about dividend stocks? It was widely realized by those somewhat familiar with the tax system that the “problem with income trusts” was largely a problem of duplicate taxation, in particular concerning dividends. This had been widely reported in the media, and had been pointed out in early publicly released submissions to the trust consultation, along with the suggestion to eliminate duplicate taxation of dividends. In his mini-budget, the minister even thanked early contributors for such thoughtful and useful suggestions.

Therefore, it was not a big leap to conjecture that the minister’s decision would involve a tax reduction on dividends. This was a sensible idea, would be well received, and moreover would inject some substance into the decision, rather than just saying “we’re backing out early and doing nothing for now”, implicitly because “we can’t take the heat”. (Incidentally, the actual proposal by which dividend taxes were to be reduced, also adopted by the Tories, appears to be rather pedestrian.)

All of the above reasoning is of a highly probable nature. Bay Streeters doubtlessly thought along these lines during the day from Nov 22 to Nov 23, and those of them eager to place bets before an announcement began buying income trusts and high dividend paying stocks on Nov 23 (if not already nibbling at them on Nov 22). This would not require knowledge that an announcement was to come on the evening of Nov 23. One was coming soon, so best get in early or simply jump on the bandwagon. This could easily have cascaded into the broad frenzy that did take place in those securities that day.

Seeing this strong anticipatory reaction, finance would have had little choice: best to finalize and out the decision at once, before the speculation could run wild any longer. Thus the near haste with which the announcement was revealed after market close on Nov 23 may have been partly in reaction to the building frenzy. Some concluding remarks:

  • A leak can never be ruled out for certain, even if the RCMP dismisses the case for lack of evidence. However, all of the publicly available evidence can be readily and reasonably explained as outlined above, with no need to assume a leak. An unbiased person doesn’t even have to be an financial insider to see this. The markets are very good at reading these kinds of tea leaves, and they usually get it right.
  • Conservative leader Stephen Harper played this incident very well politically. While always hedging his statements, he slanted them strongly in favor of a leak. But his true beliefs were probably revealed by the fact that he left it up to Jack Layton’s NDP to launch a formal complaint on the matter. In that way, when the final RCMP report in all likelihood comes out negative or inconclusive, the egg will be planted squarely on Layton’s face.
  • As for Ralph Goodale, I find it quite implausible that he was involved in this alleged leak, but I don’t feel too sorry for him. Given his repeated, incompetent meddling with the income trust sector, one might call it retributive justice if a baseless scandal broke loose and bit him on the butt.

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