Examination of Witnesses (Questions 780-799)|
TUESDAY 29 OCTOBER 2002
780. You stated you had asked them to change
accounting practices. What did you mean by that?
(Mr Godfrey) We did not ask them to;
we asked them to consider whether the accounting practices they
started off with were still appropriate, and the sort of things
we were talking about in general were the amount of the expenses
that were being charged against capital. This is quite an esoteric
accounting point but I think you understand my angle.
781. What else?
(Mr Godfrey) That is the key thing.
782. But I read in your statement you gave the
Committee last time that that is actually a recommended practice.
Were they not carrying out recommended practice?
(Mr Godfrey) We felt that some of the
interpretation of recommended practice was rather aggressive.
783. Did they change?
(Mr Godfrey) Some of them did.
784. So some of them did not?
(Mr Godfrey) Some of them did change
their accounting practice.
785. If some of them did, it means some of them
(Mr Godfrey) Some did not, yes.
786. And did the Regulator show any interest?
(Mr Godfrey) The accounting policy of
the board would not be a matter for the Regulator.
787. On the circumstances that you have outlined,
charging the expenses to capital just adds to the debt and as
debt is one of the things that pulled them down, it has that effect,
so it was not esoterical or anything, it was important. It is
in your recommended practice, and yet how strongly is this recommended
practice? Is it just recommended so you please yourselves?
(Mr Godfrey) No, generally UK listed
investment trusts will follow the statements of recommended practice.
788. Again I note the word "generally".
(Mr Godfrey) We are not a regulator and
a statement of recommended practice is, as you say, just that,
but auditors, to my knowledge, do not like to sign off accounts
which do not comply with the SORP and we are going through the
final stages of issuing a new SORP, but the point on here is that
under our statement of recommended practice, it says either you
charge all your expenses to income or you split them by giving
thought to the way in which you expect the total returns to be
delivered. So if you expect half your total returns to come from
income and half from capital you can split 50/50.
789. I can read.
(Mr Godfrey) We felt that some of the
assumptions being made were overly aggressive. Of course, the
perceived benefit from the fund's perspective of doing this is
that they think the zeros are covered, so it is not hurting the
zeros and by charging expenses to capital you are enabling a higher
level of income to be paid out. That is all very well when the
zero is covered because although you may be robbing Peter to pay
Paul, at that moment in time Peter and Paul are one person.
790. It is also a way of disguising the fact
that you have not got the cover. If you have invested in technology
shares and they are going down and your other main investment
is other companies who have themselves invested in technology
shares, you are desperate for income, so if you charge your expenses
across the capital you can disguise this for a bit, but not forever.
(Mr Godfrey) This is why we wrote the
791. I think you have described very accurately
the lethal cocktail of gearing and risk which was introduced into
this sector which was newaggressive accounting, investment
in high tech stocks, high yielding stocks and cross investmentsbut
you have said that it was very difficult for anybody to spot this.
I am asking a very straight question. On the basis of the information
available, although you did not spot it, do you think it was reasonable
for professional investment advisers to have spotted it?
(Mr Godfrey) I doubt that most professional
investment advisers would have had the competence or experience
or level of knowledge to have dug into this and found that which
the product manufacturers themselves did not find.
792. We have a quote here from Alistair Mundy,
the Manager of Investec Capital Accumulater, the fund I compared
with Aberdeen earlier. When he was asked, "Can you explain
why your fund has managed to avoid the crisis?" he said,
"Back in February we made the decision to switch a large
part of the portfolio into lower risk zeros. We felt there were
three main elements that made a split level trust low quality:
a) a high (above 15 per cent) level cross shareholdings; b) aggressive
accounting policies; and c) a high level of bank debt. On their
own each element was highly toxic. Together they formed a lethal
cocktail." That was February 2001, so here we have an investment
manager making the very point, so that point has been made, Mr
(Mr Godfrey) Clearly Alistair Munday
was somewhat ahead of the curve. All credit to him and his performance,
which you quoted earlier, bears that out. By that point in 2001
we had already initiated the process to get all fund managers
to disclose (which we would then do through our monthly figures)
the extent to which they were investing in other split capital
investment trusts. That was in September 2000. You do not suddenly
go from a point of being absolutely relaxed to absolutely terrified;
there is a process, and we moved from a state of some nervousness
to sheer terror. That happened over a period of years. By the
point that you mention, February 2001, we had already started
undertaking initiatives which reflected a sense of unease. Had
I been managing money perhaps I would have arrived at the same
conclusion, that it just was not worth taking the risk, but we
certainly at that stage had not come to the view that there was
a likelihood that the zeros which had been sold as low risk would
not perform. Although we hear a lot of "well, low risk means
lower risk than the other shares in the portfolio", I can
tell you that is not what the consumers understand by that.
793. So your considered view is that it would
have been unreasonable for most of the specialists to have spotted
(Mr Godfrey) You asked about financial
advisers. To expect advisers to have spotted it, I would not have
expected them to, given what I know.
794. Therefore it was clearly totally impossible
for private investors.
(Mr Godfrey) For the vast majority, yes.
795. That brings us back to my first question,
that brings us back to the manufacturers. We have had before us
in David Thomas the Henry Ford of split capital trust manufacturing,
have we not, the brains behind the whole thing, and he said that
he did not notice the increased risks even though he was inventing
them and designing them. Do you think it was reasonable that he
should have known what he was designing?
(Mr Godfrey) Well, I wish he had.
796. Could you try and have a go at answering
(Mr Godfrey) It is a very difficult question
which is why I pause and the reason is that I do not have his
knowledge. I did not design them and it is very, very difficult
for me to put myself in that position and look back and say should
I have known because I wish I had known and I am sure he wishes
he had, but we have heard he and others today saying that they
did not and I can only echo that; they say they did not know.
797. But we have had someone create something
who thought it would be some useful chemical product and in fact
he has created this lethal cocktail which has blown us all up.
(Mr Godfrey) That is the point. The point
is not whether they should have known or not. The point is
798. It is a "Professor Brainstorm"
job, somebody sitting in his laboratory twiddling dials and doing
various tests and ending up blowing us all up. Two questions.
What are the obligations towards their clients from not having
known and the results that have transpired from that? It seems
to me the key question, which is my second question, is, of course
we cannot eliminate this ever happening again, we want innovation
in the market, we want all people after having listened to advice
to buy products, we do not want to start forbidding people from
buying products, we want to be in a free and flexible market,
but at the same time we want to think about what we can do to
restrict this happening again, to limit the scope for such a crisis
happening again. What kind of transparency, what kind of rules,
what kind of systems, can we put in place which can make it more
difficult for manufacturers to engage in these back room Professor
(Mr Godfrey) We have two areas of activity
which we think will prevent this happening again and indeed strengthen
the industry going forward, because we very much appreciate the
Committee's approach to this in wanting to help the industry and
restore its good name. On the one side there is transparency and
disclosure, and we have written to the boards of all split capital
trustsand you have a copy of that lettersetting
out our proposals on this. They are, to disclose very clearly
the full list of investments in other split capital trusts, the
full details of their borrowings and the banking covenants attached
to that, and also to provide investors with a tool that they can
use to plug in potential returns from different aspects of the
portfolio and see what would happen in those circumstances. So
investors and their advisers would be able to, if they want to
buy shares, go into them with an intelligent understanding of
what the risk/reward trade-offs are and how sensitive that share
might be to a relatively small movement in the value of the underlying
portfolio, effectively the effect of the gearing and the underlying
portfolio. If they see that, they can either say, "I like
the idea of that reward but the risk is not for me" or "I
do not like the idea of it, I am not buying that one". So
I think it would give them the information they require between
themselves and their advisers to understand whether something
is appropriate for them. The other element is corporate governance
which perhaps we will come on to later.
799. What you said is, we need to provide the
specialist advisers with far more information than they at present
have because at the moment they cannot do their job because the
manufacturers are not giving them what is required; that there
was a veil between this product and even the specialist advisers
which prevented them from understanding it.
(Mr Godfrey) There has certainly been
a period of time during which advisers did not have sufficient
information to make intelligent decisions.