LIST OF CONCLUSIONS AND RECOMMENDATIONS
Risks: bank gearing, cross-investments, and falling
markets
(a) We believe that transparency in all aspects
of the charges borne by shareholders should be paramount. Management
fees should be published at the point of investment and any subsequent
changes should be brought specifically to the attention of investors
(paragraph 17).
(b) We strongly believe that the splits sector
should indeed have 'shouted louder' about the changing nature
of the sector. The key point is that any bank gearing made
zero shares in splits significantly more risky in falling markets
and, the higher the level of borrowing, the greater the danger.
It is clear that significantly higher levels of gearing were common
in splits launched from around 1999 compared to those in the early
1990s when the major expansion in zeros first began. Virtually
all of the holders of zeros were in the dark about the levels
of borrowing (paragraph 20).
(c) The increased use of cross-investments
in other splits made the shares in splits a much more complex
investment than they had previously been. They were potentially
more volatile, often more highly geared than was apparent, and
certainly more difficult to understand and to monitor. In some
cases, it amounted to little more than a sophisticated form of
pyramid selling, which we deplore (paragraph 24).
(d) Many zeros launched in the late 1990s
(and subsequently) were structured in such a way that, in adverse
market conditions, the zeros were not low risk products. They
were in effect different from earlier zeros and were now complex
derivative products. Even their designers appear not to have fully
understood how they would react to falling markets; we regard
this as a significant lapse in responsibility. They held
particular risks in the event of a significantly falling market;
and the fact that such market conditions were not in historical
terms likely does not justify them being sold as low risk (paragraph
29, (a)(d)).
(e) We recommend that, in future, before investment
trusts are launched, appropriate analysis should be carried out
to determine the market conditions which might result in significant
losses (paragraph 30).
Mis-selling of zeros
(f) We consider that Aberdeen's promotion
material and statements, in particular, were recklessly misleading
(paragraph 37).
(g) It seems clear to us that those primarily
responsible for the development of the 'newer' splits—the
board members themselves, some trust fund managers and some sponsoring
brokers—did not take the steps they could and should have
taken to bring the true nature of the risks in zeros to the attention
of the wider investment community. We deplore the fact that many
investors in the 'newer' zeros were not adequately warned by trust
fund managers of the risk to their investment, especially as the
managers subsequently increased that risk by substantially increasing
gearing (paragraph 41).
(h) We accept that not all individual investors
in zeros over the last five or more years are automatically entitled
to compensation, even if their investment was made using some
form of adviser or intermediary. The circumstances of each case
must be examined—initially by the adviser or company concerned
but if necessary by the Financial Ombudsman Service—but
we are in little doubt that there is a wide range of cases in
which it will be found that compensation is justified (paragraph
42).
(i) The statements of risk in the promotional
material must be assessed in the wider context of the way in which
clients were led to believe that zeros were, overall, a safe investment.
The greater was the general belief among inexpert investors that
investments were 'low risk' when they were not, the greater was
the onus on those advising them—or on those designing the
products and promoting them through advisers—to make clear
what the risks were. It was insufficient for the warnings to be
little more than small print (paragraph 42).
(j) We look to the various firms involved—trust
fund managers and sponsoring brokers—to be as positive and
accommodating as possible in their approach to compensating investors
who may have been mis-sold investments based on zeros in new-style
splits. We note that some steps have already been taken by the
companies involved. It may be in the interests of the investment
trust industry to go beyond what they might regard as their legal
obligations. Given the delays which some investors may inevitably
face in obtaining redress through the formal mechanisms already
in train, one possibility would be for the investment trust industry
speedily to establish a compensation fund for small investors
who have suffered losses from zeros; sums paid from the fund could
in part be recovered from the firms responsible if and when a
compensation liability is established. Measures such as this could
go a long way to restore the reputation of the industry. This
is an issue to which we will continue to pay attention and to
which we may wish to return if there is evidence that firms involved
are not responding as they should (paragraph 46).
Mis-selling: FSA and FOS inquiries; and provision
of information by the industry
(k) It is important that both the Financial
Ombudsman Service and the FSA complete their zeros mis-selling
investigations quickly (paragraph 48).
(l) There is a need for greater clarity as
to the relationship between the different inquiries being carried
out by the FSA and the Financial Services Ombudsman into the problems
of mis-selling in relation to splits. We recommend that the FSA
publishes a fuller statement, as a matter of urgency, explaining
how the apparent conflicts between the FSA's inquiries and those
of the Ombudsman can be reconciled (paragraph 50).
(m) We commend the steps, albeit belated,
taken by the investment trust industry to improve the level of
information publicly available about splits' affairs, including
borrowings and holdings, and the frankness of the evidence given
by Mr Godfrey of the AITC in explaining the shortcomings of the
splits sector (paragraph 51).
Inquiry into improper behaviour
(n) 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 (paragraph 64).
(o) We conclude that 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. 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 (paragraph 68).
(p) 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
(paragraph 69).
Corporate governance
(q) 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 (paragraph
73).
The regulatory response
(r) We recommend bringing investment trusts
directly within the scope of investment product regulation by
the FSA (paragraph 78).
(s) The FSA has always had a general overarching
responsibility for the proper conduct of affairs in the financial
world. Against this background, our judgement is that the FSA
was not as pro-active as it might have been in identifying and
responding to the developing dangers. This was partly because
the FSA was not responsible for looking at direct investment in
new issues in investment trusts. This may have led to it being
less alert than it might have been to those problems associated
with such investments which did fall within its remit (paragraph
91).
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