The questions to be answered
62. The suggestions of collusion and conflicts of
interest are not the only allegations of improper conduct which
have been made. The AITC also drew attention to funds allocating
an inappropriate proportion of their charges to the capital account
of the fund rather than the income account in possible contravention
of their SORP (Statement of Recommended Accounting Practice),
which requires the allocation to be in proportion to the expected
returns. As noted earlier, such a practice can artificially maintain
the income returns while eroding the capital base at the expense
of zero shareholders (and others with an interest in the capital).
63. APCIMS noted that the board of the trust and
the fund managers "are
the only people with ongoing responsibilities to the trust once
it has been launched and the shares placed".
Although the board of an investment trust might thus be expected
to prevent any improper activity, there are in practice weaknesses
in its position. Quite apart from the fact that many or all of
the directors will initially have been put on the board at the
instance of those initiating the trusti.e. the fund manager
or the brokerthe fund manager would normally provide the
management contract for the board to agree, and this would often
contain provisions making "it
difficult or expensive to sack a fund manager".
64. We have been left in little doubt that there
is substance in the suggestions that there was a form of 'magic
circle' operating in a manner harmful to the interests of shareholders.
It may be that only a relatively small number of people in a small
number of companies were actively involved. A range of questions
must be addressed about the way in which splits were established
and managed in the late 1990s and subsequently, in order to establish
more clearly what improper practices went on. The questions need
to be put to each fund manager, trust board, auditor and other
adviser for each split, and they involve complex professional
accounting and other issues. The exercise should help to reveal
not only where there was misconduct, but also to identify those
splits and advisers which were well managed.
65. Suggestions put to us for the kinds of question
which need to be answered include:
For the fund managers of each split:
- did the percentage of investments made in
other splits remain within the guidance given to investors at
- at its peak, what proportion of the trust's
assets were invested in other trusts (a) managed by you (b) managed
by other companies with investments in your trust?
- how did you assess proposed restructurings
in other trusts in which your trust held investments; which ones
did you (a) support and (b) oppose? What steps did you take to
avoid conflicts of interest when the proposed restructuring was
in another trust managed by you?
- where the trust invested in other trusts managed
by you, what steps were taken to avoid double charging?
- were there any occasions on which you were
led to understand that not supporting an issue or a restructuring
would have any implications for your dealings in other areas?
- on what occasions did you support new issues
or restructurings by using investments already held or by issuing
new securities (rather than cash)? In such cases, what assessment
was made of whether the price was the most attractive available?
- on what occasions did you receive securities
rather than cash to support your trust's new issues or restructurings?
- on what occasions did you engage in securities
transactions on a special ex-dividend or special cum-dividend
basis, and in each case what assessment was made of the effect
on the capital account?
For the boards of each split capital investment
- how many of your board members are/were (a)
employed by or directors of your fund manager (b) involved with
companies in which your trust invested (c) neither? To what extent
were different stances on major investment policy taken by the
different categories of director? What steps were taken to avoid
conflicts of interest for directors discussing other companies
in which they had an interest?
- where a proposed restructuring of your trust
or one in which you invested was being considered, what consideration
did you give to the different effects on your different classes
- (for trusts with zeros) what discussions did
you hold on the changing risk factors facing your zero holders
as asset values fell?
- where a restructuring in a trust in which
you held investments was under consideration, to what extent were
the board consulted by the fund manager?
For the brokers for each split:
- were there any occasions on which you were
involved in or learnt about agreements between individuals to
support each other's issues?
- what consideration was given in any prospectuses
in which you were involved (a) to including information on 'wipe
out' rates for zeros as a result of introducing bank borrowing
(b) renaming zeros as 'geared' or 'subordinate' zeros in cases
where there was prior bank debt or (c) giving more prominence
within the documentation to the risk statements?
- where brokers received a fee based on the
total money raised (ie including bank debt) to what extent was
this a change from past practice of receiving a fee only on money
raised from shareholders?
For the auditors of each split
- to what extent was the SORP governing practice
on allocation of charges between capital and current accounts
followed at all times?
- to what extent did you have discussions with
fund managers and brokers about charging policy before the launch
of a split? Do you have any evidence of trusts being launched
offshore as a way of avoiding the application of the SORP?
- what assessment did you make of the validity
of the assumptions about growth etc on which charging allocations
- on what occasions did you come across securities
transactions on a special ex-dividend or special cum-dividend
basis, and what was the accounting treatment in each case? Are
you aware of any case in which the same dividend was recorded
as income in the accounts of two separate trusts?
- what steps did you take to assess whether
the actual starting portfolio of a split corresponded with the
model portfolio described in the prospectus?
66. We considered whether we might conduct such an
investigation ourselves, but we take the view that a select committee
of the House is not the appropriate vehicle for such an exercise:
the kind of investigation we are calling for here is more of a
close examination of possible malpractice in a professional field,
rather than an assessment of the political accountability of a
public body. The issues involved require forensic research among
67. The FSA indicated in July 2002 that its own investigations
into allegations of collusive behaviour had revealed enough information
for it to be worth investigating further. They mentioned specifically
stock swaps and suggested that half a dozen firms might be involved.
In October 2002 they indicated that a formal enforcement investigation
"into the issue of
collusion in the splits market" had been commenced. While
they indicated that at the early stages of the investigation they
were looking at relatively few firms (all fund managers) they
would not say which companies were involved and that the position
could change as the inquiry progressed; they could not say how
long the process would take.
The FSA emphasised that the issues were complex and their investigation
had to be detailed and thorough, with "thousands
of transactions to get through".
Since then, the FSA has indicated that its inquiries have widened
significantly, covering more than ten firms; outside external
resources have been brought in and the inquiry is now the FSA's
largest current investigation.
68. Although the events relating to splits do give
rise to issues of accountability for the Financial Services Authority
in the exercise of its functions (and indirectly therefore for
the Treasury), which we turn to later in this report, nonetheless
we conclude that the investigations currently being undertaken
by the FSA should cover all the issues on which we have called
for an inquiry. We request that it publish a timetable by which
this will be completed. The results of the inquiry should be published.
We trust that AITC, APCIMS and all those with evidence of
any possible wrongdoing, will discuss their suspicions with the
FSA and make their evidence available to it. If, because of
limitations in the Authority's statutory powers and responsibilities
in respect of investment trusts themselves,
the FSA cannot perform the task, then it is for the Treasury to
establish a vehicle which can.
69. The FSA set out to us their powers should they
find there has been misconduct of a significant kind. These include
criminal prosecutions, financial penalties, and withdrawal of
a firm's or individuals' authorisation. They could also include
restitution orders, if these are more appropriate than awards
by the Financial Ombudsman Service or a scheme under section 404
of the Financial Services and Markets Act 2000.
Clearly, if there are findings that individual firms or practitioners
have been guilty of any significant misconduct, then very severe
penalties would be appropriate and the case for redress for investors
who have suffered losses will go beyond simple compensation for
possible mis-selling. Not only those who invested in risky products
without adequate warning but also those who invested in products
knowing (or who should have known) there was risk, such as investors
in the income shares in splits and professional investors in zeros,
may also be entitled to redress. Again, however, there are
questions about how these inquiries by the FSA are to link in
with those being conducted both by the FSA itself and the Financial
Ombudsman Service into mis-selling.
Reform of corporate governance
70. The events relating to splits, and the fact that
questions about possible corruption have had to be asked, raise
the question of whether the existing rules on corporate governance
are satisfactory. APCIMS suggested that "Governance
issues have not always been addressed appropriately by managers
and boards. From fee-charging to the over-seeing of illiquid or
connected investments, from the response to rapidly changing market
conditions to risk assessment and guidance, investors' realistic
expectations have not been met. Defining what a board's job entails,
and who should in future be regarded as truly independent, is
merely the necessary start to this process."
They proposed a number of measures for reform of corporate governance,
including the creation of a legal obligation on boards and fund
managers to act in accordance with "the
reasonable expectations of an independent investor."
71. The AITC also have recognised the importance
of governance issues, and have been giving active consideration
to the question of what reforms are necessary. They note some
of the unusual features of investment trusts compared to other
companies, including the fact that the shareholders and customers
of the company are the same, and the fact that the fund manager
can have a disproportionate influence over the board compared
to the position of shareholders.
72. The FSA, as part of its response to events, has
been examining what steps it might take, in its capacity as the
UK Listing Authority, to improve regulation of this area. In January
2003 it issued a Consultation Paper of which the main proposals
- a limit of 10% on the amount of a listed investment
company's gross assets that can be invested in other investment
companies which themselves invest in a portfolio of investments
and whose investment policies allow investing in other such companies
- mandating the inclusion of risk warnings in listing
documents for investment companies and identifying some of the
specific issues with which they should deal;
- enhancements to the Conduct of Business risk warnings
provided to those investors proposing to acquire holdings in geared
investment companies or investment companies that propose to invest
in geared investment companies themselves;
- monthly disclosure of any investment that exceeds
a given percentage of the value of the portfolio of an investment
company, together with 100% disclosure of all funds invested in
other investment entities;
- changes to the relationship between an investment
company and its manager;
- a requirement for all material changes to the company's
investment policy to receive prior shareholder approval.
73. The consultation period runs until April 2003.
These proposals, and the more detailed suggestions from APCIMS
and the AITC came out after we had completed taking evidence for
this inquiry, so we have not had an opportunity to question affected
parties on them. Nevertheless, we welcome the swift preparation
and issue of a consultation paper by the FSA on improvements to
the Listing Rules as they affect investment companies. We think
it likely that changes in the areas and directions suggested will
be appropriate. We think that the issues discussed in this Report,
including in particular the dangers of cross-membership of boards
and issues of transparency, should be taken into account. It may
be that some improvements can be made by voluntary agreement with
the industry, so long as there is complete participation in any
agreement from the whole of the sector. We trust that the FSA
will receive constructive cooperation from all sides (both representatives
of splits and of the individual investor) in refining and implementing
any changes in the Listing Rules which take place. We would expect
swift action after the consultation period is over. Of course,
in some respects the measures will amount to shutting the stable
door after the horse has bolted.
90 Ev 175, para 6 [Brewin Dolphin]; Qq 646, 652 ff. Back
Ev 33, para 4.23; Qq 149-156 Back
Appendix 3, paras 2.4, 2.6 Back
Ev 127; Q 258 Back
Qq 258-259 Back
Qq 261-3 Back
Q 290 Back
Ev 149, para 9 Back
Ev 150 ff. There is no clear correlation between the degree of
crossmembership of boards and the extent to which trusts
are in difficulties, or between those splits set up in/since the
late 90s and those with high crossmemberships. Further
information on the extent of cross-membership of boards, managed
by different fund managers, is given at para 3.10 of the FSA's
May 2002 Update report on splits. Back
Q 423 ff. Back
Q 624 ff. Back
Q 743 ff. Back
Ev 126 Back
Qq 663, 674 ff. Back
Q 757. In respect of the taking up by Brewin Dolphin's clients
of Brewin Dolphin-sponsored zeros at the time of launch, the figures
involved were relatively small (only 577 clients, investing sums
representing 0.07% of total funds) though we note that the rate
amongst discretionary clients was nearly four times that amongst
advisory clients (0.15% of discretionary client funds against
0.04% of advisory client funds) (Ev 217, paras 3-5). Back
Q 748 Back
Q 821 ff; Q 850 Back
Appendix 3 [Dr Adams] Back
Appendix 2, para 9.2 Back
Appendix 2, para 2.10 Back
Appendix 2, para 2.6 Back
See for example Appendix 7. Back
We note for example claims by Limbort Ltd against Collins Stewart
in connection with the CI Income Fund, a split managed by Collins
Stewart which has since had its shares suspended [Memorandum not
printed]; these claims are challenged by Collins Stewart in a
memorandum to the Committee (Ev 218). Back
Qq 205-208 Back
Ev 134, para 2 ff. and Qq 301-303 Back
Q 303 Back
Speech by Mr John Tiner to AITC 4 February 2003. Back
We discuss this below at paragraphs 75-78. Back
Ev 134, paras 6-9; section 404 allows for the setting up of a
scheme for systematically reviewing past business of authorised
persons and establishing amounts payable by way of compensation. Back
Appendix 2, para 3.2 Back
Appendix 2 (paras 9.4-9.5 and appendix 3) Back
FSA Consultation Paper No 164 January 2003 Back