THURSDAY 11 JULY 2002
Mr John McFall, in the Chair
Memorandum submitted by Aberdeen Asset Management
Examination of Witnesses
MR MARTIN GILBERT, Chief Executive, MR GARY MARSHALL, Managing Director of Aberdeen Unit Trust Managers, and MR PIERS CURRIE, Marketing Director, Investment Trusts (Aberdeen Asset Managers), Aberdeen Asset Management, examined.
(Mr Gilbert) I am Martin Gilbert, Chief Executive of Aberdeen Asset Management.
(Mr Marshall) I am Gary Marshall, Managing Director of Aberdeen Unit Trust Managers, which is the Group's retail division.
(Mr Currie) I am Piers Currie, Marketing Director of Investment Trusts at Aberdeen.
(Mr Gilbert) The structure of the company is I am the Chief Executive and Chris Fishwick is the Executive Director responsible globally for our closed end funds as we call them, or investment trusts as they call them in this country. He has overall responsibility for them. Then what happens is each individual fund or each individual company has its own investment remit, so the investment management of that part of the portfolio would be delegated to a particular fund manager within the fund management division.
(Mr Gilbert) Two reasons. One, I was asked to come and, two ----
Mr Fallon: By whom?
(Mr Gilbert) He is attending a number of meetings today with some of our funds because, as you are probably aware, the markets are in a very, very bad condition at the moment and we have a number of funds that are in difficulty and he is dealing with those today. I apologise. If you had wanted him here specifically we would have rearranged things and brought him here but I thought it would be adequate to bring the two gentlemen I have brought.
(Mr Gilbert) He sits on ten boards. I think we should elaborate that he does not sit on a board as an independent non-executive director, he sits on the board as a non-independent director. All our boards tend to have a management representative on each board.
(Mr Gilbert) Yes, that is correct.
(Mr Gilbert) That is correct.
(Mr Gilbert) I think he exercised the stock options but he held on to the stock so I suspect of that 2.3 million he would have probably lost about 2 million of it.
(Mr Gilbert) I think that is correct.
(Mr Gilbert) Yes, he is.
(Mr Gilbert) I do see your point.
(Mr Gilbert) But there are a number of other points, if you would not mind me making them. He is in charge of, as we call it, the closed end fund division of Aberdeen which ranges from Sydney right through to the US. It is one of our most successful divisions. It has contributed over the last ten years substantial profits to the group and he has been a very, very good profit generator for the group. Those particular trusts that you were speaking about for the three years before the last two were the best performing investment trusts in the UK.
(Mr Gilbert) I do not agree with that statement. He is not holding himself out to be independent on those boards, he is non-independent. He is the senior representative from Aberdeen management on those boards.
(Mr Gilbert) Much as I hate to disagree with the regulator, which is a very dangerous thing to do, I do disagree with his comments.
Chairman: We have the regulator later in the morning so we will certainly be asking those specific points.
(Mr Currie) Shelley O'Donnell works with me on investment trust sales and investor relations.
(Mr Currie) Yes.
(Mr Currie) There are a lot of articles on zero dividend preference shares.
(Mr Currie) Not specifically, but if you remind me I will try to clarify it.
(Mr Currie) I think that is very true.
(Mr Currie) I think she was correct.
(Mr Gilbert) I think at the time they were commonly perceived to be low risk, not just by us but by the market as a whole.
(Mr Currie) I would have to hear the source of the article. They share similar analytical characteristics to gilt edged securities. Typically zeros are compared to gilts in terms of redemption yields and so the characteristic of zeros as an asset class has been one which has been low risk over the last 15 years.
(Mr Currie) I think they are between ten and 20 pence. I would have to check the exact figures.
(Mr Currie) I think if we are looking at the redemption yield criteria written at the time and the analytical process that was saying Aberdeen preferred, I think you are saying, 2003 zeros, which is one zero out of 138, and expressed the properties at the time of offering a redemption yield of somewhere between 71/2 and 81/2 per cent. What that is telling you is at the time the market priced those zeros as a lower risk entity, otherwise it would have been priced at a 50 per cent gross redemption yield.
(Mr Currie) Thirty-nine.
(Mr Currie) No.
(Mr Gilbert) Can I just elaborate on one point. To correct a point you made, we did not offer those particular zero dividend preference shares for sale. What we have offered for sale, to use your terminology, is a unit trust which invests in zero dividend preference shares. I think, like any investment, we always advocate that people take a spread of investments rather than a particular single investment. I am prepared to concede that we sold the unit trust to the general public but that particular share you are talking about is one of many that the trusts that we manage and which are listed on the Stock Exchange.
(Mr Currie) We are looking at those figures. Some of those figures we are keen to go back to the FSA to have a look at. I think the other thing I would point out is that if there is more than one share class in a split capital share, the riskiest share classes are those typically called capital shares or income and residual capital shares. These shares are the highly geared shares which means if there is a movement in the market down, say, 20 per cent, they may be down 80 per cent or more. I think one of the elements of confusion here which Martin has been trying to clarify is that the zero share class, which is a preference share, is the lowest risk share class of the ones in the split capital trusts, the other share classes are higher risk, they are securities, they are not products. What we are trying to clarify is that zeros are the lowest risk share class and in particular the product offered in the main to the retail market is through a retail unit trust investing in zeros.
(Mr Currie) I think she tried to talk about zeros as a generic type in the same way as bonds. Many people think that government bonds are low risk, the safest securities, but in fact they dropped 20 per cent at one stage in 1993-94. Some people think Argentinian bonds might have been a safe bet. Because bonds are going to be backed by governments people believe them to be low risk but not all bonds are the same and not all zeros are the same in terms of their characteristics.
(Mr Gilbert) Mr Plaskitt, could I pick up your point on the zeros in the fund we offered to the public because it is the one fund that we actually retailed to the general public and, you are quite right, did market as a low risk product.
(Mr Gilbert) It was perceived at the time to be low risk, not just by us but by the whole industry.
(Mr Gilbert) Mr Plaskitt, I am going to ask my colleague, Gary Marshall, to tell you what we have done about it in a second. I do have to point out that we are suffering the longest bear market since the 1930s, not the deepest since the 1930s but the longest since the 1930s. Whatever happened, these bear markets are very, very tough and zeros as a whole have tended to lose on average 30/40 per cent of their value. Perhaps Mr Marshall could tell you what we are doing about it.
(Mr Gilbert) I do not think hindsight is a true measure or a true description of how we should judge it. At the time we believed they were low risk.
(Mr Gilbert) Unfortunately, everyone looks at it that way. Everyone judges things with hindsight. If we only had the benefit of hindsight I am sure we would all do things differently.
(Mr Gilbert) We were aware of that quote and, yes, it did affect our management practice. We did not agree with everything that was in the document, in fact we disagreed with a lot of it, as did a number of other analysts disagree. There were two opinions on that particular paper.
(Mr Gilbert) They did get worse because sentiment got worse. I think we have got to separate share prices into two aspects: market movement and sentiment. What we have got at the moment is poor markets driven by general market falls plus falls on sentiment specific to the sector. For instance, a zero which is worth 150 pence today and might have 200 pence of assets backing it would be priced at 75 pence today and that is the sentiment factor.
(Mr Currie) I am sorry, there is a typo on the last page.
(Mr Gilbert) My colleague is looking for the figure ----
(Mr Currie) From memory we ----
(Mr Currie) This (document) compiles it as a sector rather than by split----.
(Mr Currie) We have 19 split capital investment trusts, three of which are a fund of funds, which means their specific mandate is to invest in other split capital income shares. Three of them have no investment in other income shares at all and others have varying amounts between nought to ten and nought to 30. The reason why it is not off the top of my head is that they are all managed separately with different mandates, with different boards and with different instructions. There is also the fact that the ownership profile changes dramatically over time as managers invest into different areas. To answer your question, there are three fund of funds and there are four that would be described as barbell trusts that may typically have between ten and 30 per cent in income shares. The figures do change.
(Mr Gilbert) Three to four.
(Mr Currie) Three.
(Mr Currie) I will check my previous file if I have it with me.
(Mr Gilbert) Eight at present.
(Mr Gilbert) Nineteen.
(Mr Gilbert) When was that report?
(Mr Gilbert) I would like to correct the point that it is the cross-holdings that have caused the difficulties for capital investment trusts. It is not the cross-holdings, it is the gearing that has caused the problem. If there had been no gearing in funds at all they would not be in difficulty, to take the extreme case.
(Mr Gilbert) Gearing has added huge positive returns over the last, Piers?
(Mr Currie) Over the last 15 years.
(Mr Gilbert) The gearing has added about 11 per cent of the value.
(Mr Currie) I think what you are trying to get to, Mr Ruffley, is the supposed systemic ----
(Mr Currie) You can cut and slice the data with 400 different shares and class it a number of different ways. If I do not have immediate answers I will certainly come back and let you know the specifics. The issue that the FSA was raising in their report and what the Chairman appeared to be mentioning before was the question of the systemic risk affecting the sector. We now see about ten per cent of the split capital market is weak but as against that, identifying purely cross-holdings as the clear and present danger is one which is possibly over-expressed. Only about 15 per cent of the sector is invested in income shares. Investing in income shares per se is not necessarily a bad thing, income shares are priced according to how much income they can produce in the future. The problem that we see here with some of these structures that were being invented in the late 1990s was that bank debt proved to be a more inflexible form of gearing than zero dividend preference shares. Once assets fall sufficiently and fund managers effectively lose control to the bank because assets have fallen, you have an issue with income shares, This is because income shares that are unable to pay out their income fall in value quite dramatically. The sensitivity modelling is generally done by each trust and each board and each manager specific to that trust because they are all designed differently, some invest in different areas, different asset classes, some have bank debts, some do not have bank debt, some have a focus on the UK.
(Mr Currie) I think the reason with hindsight ----
(Mr Gilbert) No, he did not say that.
(Mr Currie) Who screwed up?
(Mr Currie) No, I do not think the managers did screw up.
(Mr Currie) I think one of the issues is that when these instruments are designed, and they have been designed by some of the best investment bankers and brokers in the UK, they actually build the product to try and withstand stress testing in certain market environments. As it is they stress tested it as if it was a car driving down a pretty bad rainy road and what ended up happening was that they hit a hurricane. We have seen fairly massive falls, let us not forget. A number of these trusts are exposed to the technology market which has been down about 80 per cent and a number of conventional investment trusts exposed to certain asset classes have also fallen dramatically. Geared instruments on falling asset classes do worse. That was the purpose of a number of these instruments and it is obvious what the instrument said it was going to do.
(Mr Gilbert) As far as I am aware no authorities are investigating us for collusive behaviour at the moment. The industry, including Aberdeen is working with the FSA in their overall review of the split sector.
(Mr Gilbert) I think that is a question you should ask Mr Tiner.
(Mr Gilbert) I am not expecting it but that is a question you have got to ask Mr Tiner. I would not dare speak on behalf of the FSA.
(Mr Gilbert) No, I do not agree because it is all written with hindsight, Chairman. Every comment there is with the benefit of hindsight.
Chairman: Fair enough.
(Mr Gilbert) I think it is very important to understand that some of the funds are set up as fund of funds so their specific investment remit is to hold shares of other investment trusts. That is what it was set up to do, that is what it has been described as doing and that is what it does.
(Mr Marshall) Was that Progressive Growth you mentioned or Aberdeen Preferred Income Trust?
(Mr Gilbert) Sorry, I thought you meant Aberdeen Preferred income Trust.
(Mr Marshall) If I could take that question. Progressive Growth is a unit trust which invests in split capital, the zero dividend preference shares which are shares of split capital trusts. It is, as Martin said, in this case designed to invest in zeros. It is very clear that it invests in zeros. That is its entire purpose and it is laid out that way.
(Mr Marshall) Since that point I think it is down at just over a 40 per cent fall.
(Mr Marshall) I think with the benefit of hindsight you can come back and say clearly that fund has not performed as we laid it out to do but you have to look back at the time the advertisement was run. The information out in the marketplace about zeros was very clearly pointing towards it being a low risk asset class. They had been around for a very long period of time, had performed exactly in line with the type of statement we were setting out. We were confident that was the correct position for the fund. We understand and recognise - and it is the only product that we as a group have marketed very explicitly as low risk - that statement has not been borne out in practice and therefore we have proposed an uplift package for investors which is designed to ensure they get their money back at a date in future.
(Mr Marshall) It varies depending on the fund. If you take any split capital fund, it is by definition geared by the existence of a zero because that is obviously a set liability against the fund. It would depend entirely upon the individual fund as to exactly how much gearing was involved. You also find clearly when the equity content has fallen and the shares have fallen that the gearing levels have increased significantly. If you look back at the levels of gearing that were around, say, in June last year, the gearing percentages were considerably lower because the markets have subsequently fallen.
(Mr Gilbert) When we launch a fund, or a trust I should say, you can compare it to a house and a mortgage. If you are buying a house and you have a mortgage of, say, about 70 or 80 per cent down against the value of the house, that gives you a geared exposure to the property market. When we launched the funds, the maximum they were ever geared was really about 50 per cent. As assets have fallen obviously the gearing rate has gone up. We have, of course, in the falls in the market sold down parts of the portfolio because, as Piers said, the banks and the banking covenants have forced us to reduce assets. Often with the gearing now you will get a fund where there might have been originally, say, 100 million of bank debt against it but there might be 40 million of cash sitting against it.
(Mr Gilbert) That is correct, yes.
(Mr Gilbert) No.
(Mr Gilbert) No. The unit trust has no gearing in it so.
(Mr Gilbert) Yes.
(Mr Marshall) If you look at the Progressive Growth unit trust, the fee on that unit trust is one and a quarter per cent which would be standard for a unit trust product in the marketplace. Where there are any zeros which are also managed by Aberdeen, and obviously as a larger player in the market you would expect to see some holdings in there, we do not double-charge. The charge is clear and it is laid out in the fund, that is the net charge which is paid by the investor as far as the products which we manage are concerned. The other holdings that are in that portfolio are shares in the market, that is no different from a holding of any other equity product in the marketplace. The charge that is laid out is clear and is not in excess of that, there is nothing hidden as far as I am concerned.
(Mr Gilbert) I think the key issue which Gary referred to on Progressive Growth is we realised that the adverts we had were not as good as they should have been when they were made and that is why we are proposing the guarantee to give the investors their money back, which is a key component in this guaranteed uplift package. I do not know where else people in this industry or in these markets at the moment are actually going out and guaranteeing that their investors get their money back.
Chairman: It is all down to hindsight though, is it not?
(Mr Currie) I do not think that construction is quite right. When any new issue comes to market, the stockbroker takes the prospectus to several hundred institutions who take equity and shares, so you may have 150 investing institutions putting cash in to buy income shares or capital shares or whatever is on offer. But institutions buying closed end funds is not in itself peculiar, that is how the stock market works. Some private investors then may take the view that they will buy shares in the after market.
(Mr Gilbert) I do not accept that. On one of the last trusts we launched, which was the European Technology and Income Fund, there were 95 institutions - I can check that figure later - invested in that. They invested £100 million of equity in that fund. I just do not accept those figures.
(Mr Currie) And then that portfolio gets invested --
(Mr Gilbert) That particular fund I think was less than 1 per cent of other funds. In fact, when it initially started it had no cross-holdings at all.
(Mr Currie) We have got the statistics here.
(Mr Gilbert) We have three that were funds of funds.
(Mr Currie) We have four AAA-rated which means they have no income shareholding at all; three AA-rated which means they have less than 5 per cent invested in income shares in their portfolio; and then eight which are A-rated which is less than 25 per cent; so 15 out of the 18 split capital trusts invested by Aberdeen have less than 25 per cent in income share ownership, four of which have none at all and three of which have less than 5 per cent, and each of those individual holdings in income shares - and I think the FSA report touches on this - is less than 2 per cent of the portfolio so the actual quantum of individual holdings into a particular trust is pretty small. What we have tried to cover in the paper is to say that, where cross-holdings become an issue, is if you have circular elements attached with fund A back to fund B back to fund A, and then you have a problem if there are falls. Nigel Sidebottom explains in the article for Credit Lyonnais that by the third iteration of a cross-holding its effect on NAV falls is de minimis. What matters, therefore, is whether investors are investing in the right type of income share, and income shares have become somewhat demonised generally. They do something very good that other equities cannot: they can offer high yield and capital appreciation in a way that corporate and government bonds cannot, and conventional equities cannot as well. Where you have a problem is if you have income shares falling generally because bank debt is then putting pressure on the portfolio that remains.
(Mr Gilbert) At the time they were launched the market was significantly higher and the projections from all the experts were of continuing stock markets going up at rates of 7 to 9 per cent per annum. It is very easy sitting here today with the market down 200 points and 100 points this morning to laugh at that but that was the reality at the time. Not only are we caught by surprise but so are pension funds, insurance companies - the whole industry is caught out by a fall of this magnitude.
(Mr Gilbert) Yes. Absolutely clear.
(Mr Currie) They were not as high as that. They were 1 per cent of gross assets.
(Mr Gilbert) 1.2 per cent of gross assets.
(Mr Gilbert) And no fees charged on holdings in other Aberdeen funds either.
(Mr Gilbert) No.
(Mr Currie) Yes, and relative to initial distribution costs, say, of a unit trust of 5 per cent or 3 per cent, such charges are not unusual. After all, you are investing one hundred per cent of the portfolio not just 50 per cent of it, so the charging structures which apply to these trusts and which have been set for all investment trusts are pretty much the industry standard.
(Mr Gilbert) Yes, I think they are. They are the industry standard.
(Mr Currie) Unless they run into difficulties, which I think some of them have. We have been the first to waive fees on distressed funds - we were the first manager to do so - although we appreciate that was not much consolation given the extent of the sector's difficulties. People have lost a lot of money. But the important thing is how we as an industry, and we as Aberdeen, can make best efforts to try to restore investor confidence and produce information that is genuinely helpful and that people can understand, and we are taking a number of initiatives with the AITC and others to try to achieve that end.
(Mr Gilbert) We stress-tested these products to a 30 per cent fall in the market; we did not expect the falls to be greater than that. Now, you may say, "You should have known that the market was going to fall to the extent it did", but I either was not clever enough or did not know enough to foresee that the market was going to fall to those levels
(Mr Gilbert) We would be delighted to do so, Chairman.
Chairman: Then maybe we will have you and others back at a later time so we can go over it at leisure.
(Mr Marshall) If I could start, there are basically three broad initiatives we have been looking at. As far as the retail investors are concerned there is the Progressive Growth Unit Trust which has the widest retail exposure and there, as I mentioned previously, what we are aiming to do is put an uplift package together which will ensure that investors receive their original investment back at a future date. Some of the details of that are still in the course of being finalised and we will be discussing those with the regulators and others. I am not in a position to give you all the details right now but that is the broad thrust of it. Elsewhere we have mentioned the fact that we are waiving fees on a number of the distressed investment trusts that are having specific issues - we are looking to waive fees in order to allow those funds the opportunity to recover - and in a particular instance we have also invested in a particular fund which has been in trouble in order to try and secure that fund's future; we will perhaps be a participant in the recovery of that fund. So there are a number of things we are doing there, plus I think the document you have in front of you, the monthly monitor document which we produced, is really all about trying to give as much information and be as open to the market as we possibly can so that the issues are understood, because there clearly is evidence in the marketplace of misperception, of generalisations going out, whereas when you draw down to the detail the problem is much more localised and much more specific and we have tried to be clear on that. I think there are various initiatives we are trying to do there.
(Mr Currie) I think why we are putting this into two different boxes is because the ownership pattern of split capital investment trusts is different from the ownership of unit trusts. Investment trusts generally have an ownership of about 1 per cent of the adult population - about 600,000. On split capital investment trusts as a universe, as far as we can calculate it, there may be about 50,000 owners. A lot of conventional trusts became split capital trusts in the early 1990s. But drilling down into the type of trusts we have, as far as we can tell, of the trusts launched in the last three or four years there may be about 10,000 or so private investors, many of them direct investors who know what they are doing, DIY investors, but we cannot keep track of the registers because quite a lot of names are buying through nominee accounts. We know more about the unit trust ones because the names are all coming through the unit trust on which Aberdeen itself maintains the register. With an investment trust, in terms of the buying and selling of nominee accounts, it is really very difficult to keep track of who owns it, so the 19 that are managed are all very different with different histories. Three or four of them came with the acquisition of Murray Johnstone in Glasgow so they arrived with their own shareholders and their own history. Two or three others came from a Jersey-based company, Graham Investment Managers, acquired by Aberdeen, so trying to know the shape and the structure is quite difficult but we monitor the registers as best we can. Zero holders typically are more owned by the private investors than geared, ordinary or capital shares, and therefore to generalise with the 19 it is quite difficult to say which is more retail than the other. What I can tell you is that a unit trust is a retail-focussed vehicle and generally split capitals and the higher risk share classes are owned by less people but generally wealthier people with bigger sums, who are using them as part of an overall portfolio.
(Mr Currie) Correct. These are independently quoted listed companies.
(Mr Marshall) The split capital funds, the zeros we are referring to, are individual shares. The Progressive Growth unit trust is a managed fund of zeros.
(Mr Gilbert) Marketed as low risk. It is the marketing aspect that is the important aspect on a split capital investment trust and it is wrong to talk of the split capital as one class of share - it has very different classes of shares and the low risk class of share is the zeros. If someone bought a geared ordinary income share that tells you that there is gearing in that, and that it is not a low risk product.
(Mr Currie) The FSA have given guidance on this area and from the individual investor's perspective it is, "How is it you came to acquire either your share or investment? What happened in the process? How were you advised to make an investment in this case? If you were advised and came in and were misled saying 'Buy this share and it is going to be as safe as gold bars' or whatever, you go to the person who told you that and raise your issue with them for the complaints procedure", because we are all regulated firms and by going through the authorised procedures it means that we are able to identify how somebody came to buy something. If I want to go off and buy Japanese warrants because I have a dead cert belief that the market is going to go up and gamble my way to whatever it is and they go down, I did it, if I did it through my own execution-only broker saying that that was a great thing for me to invest in, on my own cognisance and if I come back afterwards and the Japanese market underperforms, the position on that if I have made my own decision is pretty clear - that was done on my own expectation and my own cognisance. So we are turning back to talk about how things were perceived because what we have with the issue of the zero funds in particular is that private investors saw this as an asset classed as low risk and that is the one which we have the most concerns about - not the capital shareholders. I myself invested in a technology capital share which was a bit of a gamble and it did not work, but I am not writing to the FSA or yourselves to say I have lost my money on it. Do you understand why I am trying to differentiate?
(Mr Currie) The Ombudsman has looked at some of these cases and has pretty clear guidance on his website.
(Mr Currie) No. What I am saying is look at the sales process because there is an issue to do with how people bought and sold things, and if people made their own decisions and they elected to buy an equity or a share or whatever it is, then I think you would find they made their own decision and that is their responsibility.
(Mr Currie) I think that is FSA's guidance on that and that is quite right. If they are a customer of ours, they should come back to us.
(Mr Gilbert) It is more complex than that. I think that is over-simplifying it. We have examples of people who have read in the newspaper that zeros were a good thing and they went and bought through an execution-only stockbroker and now they are reading that zeros are not such a good thing, and it is very difficult to say to that person "Well, look...". And then there are clear examples where people have bought zeros - and we have to keep this to zeros rather than shares, if I might say so, because the zeros are the low risk shares - and where they have been advised to buy it by advisers, obviously the first stage to go back to is the person who advised them to buy the share.
(Mr Gilbert) I do not think that is correct. I think those are words that have been put in our mouth.
(Mr Gilbert) We are doing all we can to restore confidence in the zero share market. As I said, we are giving a guaranteed uplift on the unit trust: we have injected cash into one of our investment trusts that invests in zeros - we are doing all we can to restore confidence in that sector of the market because that sector underpins the rest of it.
(Mr Gilbert) We would be delighted, yes.
(Mr Currie) Yes.
(Mr Gilbert) We would be delighted to do so, yes.
(Mr Currie) The vast majority.
(Mr Gilbert) As long as markets do not go down. If markets go down further from here, others will get into difficulty. If markets go up, a lot will recover. We are heavily dependent on stock markets.
(Mr Gilbert) The problem is everyone is getting more and more depressed on markets now. Six months ago everyone thought markets would recover in three months; now people are speaking about two to three years and that makes lenders nervous - everyone more nervous.
(Mr Gilbert) I could not say really. We would need to do a more detailed assessment of that. I could not answer that now. I could come back to you on that though.
(Mr Gilbert) One hundred per cent, if they bought through us or bought our unit trust.
(Mr Gilbert) Through us or bought our unit trust, so not only are we compensating retail investors who bought the unit trust, but anyone who bought our unit trust.
Chairman: I think Mr Marshall wanted to come in on the previous point as well.
(Mr Marshall) To clarify, the package we have proposed for the unit trust applies to all investors in the unit trust. What I think Martin is explaining is if there were a case of a zero dividend preference share having been mis-sold in any way by us to a retail investor outside the unit trust then obviously we would compensate for that, but our package applies for the unit trust and is only for the unit trust.
(Mr Gilbert) I do not think they bought on the back of our reassurances - I do not believe that. There were numerous, hundreds of articles on zeros at that time saying they were a safe investment and they have not turned out to be as safe as we thought. "Low risk" does not mean "no risk". "Low risk" does not mean that you cannot lose money.
(Mr Gilbert) No one has lost money yet. Most people are still in their zeros so they have not lost any money yet. They have not sold.
(Mr Gilbert) Then they are being naive, Mr Laws. We all know that until we sell an investment we have not lost money on that investment. You may think otherwise but -
Mr Laws: I think most people will view it otherwise. If you have lost 95 per cent of your assets -
(Mr Currie) We have covered the risk profile made on page 11 of the document submitted to you which tries to take forward the attributes of zeros as an asset class and how it was being written by various other investment managers at the time. We have the data on redemption yields on zeros going back to July last year and before that, and if the market had seen the risk in these shares it would have priced them accordingly.
(Mr Currie) A low risk share class.
(Mr Gilbert) There is a very good statistic at the time. When we were marketing these as low risk, some could have lost 11 per cent of their assets per annum over the remaining time of the zeros for them still to pay out, so we were looking at a situation where we could see that they could lose on some zeros 11 per cent per annum, say, over seven years and still pay. Now, obviously the markets have fallen further than we expected and everyone else expected.
(Mr Currie) I think we must distinguish between us and the boards running the companies themselves - that is the first point. If there is any substantive change the boards of directors write to the shareholders for shareholder approval; shareholder democracy kicks in; people vote if there are going to be any substantive changes to capital structures or reconstructions, and that is done by the board. You can go to AGMs and EGMs and you can vote against these things - and actually we would like more shareholders turning up because often shareholder apathy is a bit of a problem. Boards meet and put out annual and interim reports, we put out monthly fact sheets - investors are getting information on the structure of the company all the time.
(Mr Gilbert) That is nothing like the case.
(Mr Marshall) The fund you are referring to is our High Income Trust and the position there is that all of the registered holders of that fund are entitled to receive a notice of the meeting. We have one registered holder on there which is the Aberdeen share plan which contains within it a whole raft of other people, and unfortunately they were not mailed. In fact, the position was that the meeting was for information only and there were no votes involved and we did --
(Mr Marshall) We offered everybody the opportunity to attend a subsequent meeting, and that was available to them. So they had the opportunity to put any issues and concerns to the board quite shortly thereafter.
(Mr Marshall) It was administrative error. You have one shareholding and the shareholding represents all of the subholders.
(Mr Gilbert) They were not obliged to be told but we normally out of courtesy tell them. They were in the Share Plan basically but, Mr Laws, I accept it was not acceptable practice and it is not something we are proud of.
(Mr Gilbert) Yes.
(Mr Currie) Which information?
(Mr Gilbert) I think it is in the performance monitor.
(Mr Currie) In the monitor we supplied, which also includes pages on the income shareholdings that you were asking us about, each individual trust in the split capital market is covered.
(Mr Gilbert) We also provided that. I am sorry - we should have included it.
(Mr Gilbert) I do not think it was provided after the meeting started - well, I am sorry. I apologise, Chairman.
(Mr Gilbert) No, I do not.
(Mr Gilbert) Well, (a) there are 36 other fund managers in the split capital sector - I know from reading the press you might think there was only one but there are 35/36 others - and (b) this has happened before. This happened in the 30s and in the 70s so this is history repeating itself. I know that causes general mirth, but that is the case: this is caused by a prolonged bear market. Now we cannot ignore that.
(Mr Gilbert) There is 100 per cent integrity behind everything we have done.
(Mr Gilbert) Thank you very much.
Memorandum submitted by the Association of Investment Trust Companies
Examination of Witnesses
MR ANTHONY TOWNSEND, Chairman, and MR DANIEL GODFREY, Director General, the Association of Investment Trust Companies, examined.
(Mr Godfrey) I am the director general of the Association of Investment Trust Companies.
(Mr Townsend) I am the chairman.
(Mr Godfrey) Clearly the split capital trust sector has been having a very difficult time, and the managers of that sector are under a great deal of pressure. I think that was evidenced in the session we have just witnessed.
(Mr Godfrey) The Association of Investment Trust Companies' mission is to work with our member investment trust companies to add value for shareholders. We are an organisation funded by the shareholders' funds of investment trust companies so we regard our primary objective as being to work in their interests, and we share this with the boards. In the context of that, therefore, we are deeply distressed by the losses that they have experienced.
(Mr Godfrey) I think it is a matter of the greatest possible regret that the good name of the investment trust industry --
(Mr Godfrey) I would agree with it in part.
(Mr Godfrey) I would agree that the good name of the investment trust sector, certainly of the split capital sector, has been blackened and that the stain has started to spread through the investment trust industry as a whole.
(Mr Godfrey) Yes, I do agree with that. I thought you were asking me whether I had any sympathy for Aberdeen Asset Management or not as well.
(Mr Godfrey) There was a long period of time during which I believe it was entirely appropriate for zero dividend preference shares to have been marketed as low risk investments. One of the things we heard in the previous session was that they were low risk, and one of the statistics mentioned was that some of the zeros issue could suffer a fall in the value of supporting assets by 11 per cent per annum and still pay out. That is only one of the methods of analysis. Clearly what one also has to look at is the quality of the assets underlying that structure and then take a view as to how risky one thinks it is that those assets will fall by 11 per cent per annum. The assets are not necessarily related to the market as a whole, so if you feel that you have assets which are vulnerable to falling considerably then clearly the chances of them falling by 11 per cent a year become much greater.
(Mr Godfrey) I think an ordinary investor understands by the phrase "low risk" that they are not likely to lose very much money. If they lose anything at all it will not be very much.
(Mr Godfrey) It is not what happened.
(Mr Godfrey) From that perspective they were not low risk but if I can please just return for a moment --
(Mr Godfrey) I could not agree with you more that the industry should not hide behind its own definition of "low risk" which may not accord with that of its customers. I think it is incumbent on us to make sure we understand what the customers believe and make sure we inform them accurately about what they are getting but the fact is that zeros, up until a few years ago, could suffer big falls in value and were backed by fairly conservative portfolios as well so the chances of them suffering any catastrophic loss were infinitesimally small. What happened over the last few years was that the portfolios backing that supposedly low risk investment started to change because of the introduction of investment in other split capital trusts - what we have referred to today as cross-holdings - and it started to change also because of the introduction of bank debt which destabilised the whole structure in the event of serious falls in the market. So I do believe that the risk profile was changing, and it is also my belief that the industry did not go out of its way to communicate with potential investors that the risk profile was changing.
(Mr Godfrey) Investors were not in receipt of sufficient information.
(Mr Godfrey) It depends what you mean by "misled". If you mean that they were being told something proactively that was wrong, I think probably not; if they were not being told something that perhaps they should have been told, then yes.
(Mr Godfrey) They were not given crucial information.
(Mr Godfrey) No, I do not.
(Mr Godfrey) I cannot go to the motivation of the people who did not give them the information so it is impossible for me to say "withheld". It would depend on whether they recognised it themselves or not.
(Mr Godfrey) They may not have recognised it themselves --
(Mr Godfrey) -- And that is a separate issue, whether they should have done or not.
(Mr Godfrey) The concerns that were being raised in 1998 were concerns about what has become known as the "magic circle". We started to hear rumours about the magic circle; we were reading reports in the press; we looked into those rumours and we could not find any corroborating evidence. Again, there is a big issue of intent here and intent is always the hardest thing to prove. The fact that a number of managers issue new funds and invest in each other's shares is not of itself evidence of collusion. They may think that those shares are the most wonderful thing since sliced bread and may want to invest in them without any collaboration between them, and that is something that is quite difficult to prove. The rumours we were hearing were only of the nature that managers who were not participating in this were being invited to participate, and that in itself does not represent a misdeed being done - just an attempt to purloin them. We then, I think perhaps wrongly, after that period began to get more comfortable and the reason was that the argument was being made - and I think to a certain extent we accepted it - that the fact that more managers were coming into this sector and more of these holdings with other splits were being launched was leading to diversification which was reducing risk. The other factor which made us more comfortable was that increasingly the new issues were being issued purely into the institutional market place by way of placing. What we were not picking up on was that the intent was to push them out into the secondary market over time so I think we may have been wrong in buying that argument.
(Mr Godfrey) I am not going to use the word "hindsight": I think we made a mistake.
(Mr Godfrey) Again, we are getting into slightly technical grounds here.
(Mr Godfrey) Well, the income shares and the capital shares were always marketed as being higher risk. Now, I believe that even in the income shares and capital shares the quality was to a certain extent deteriorating and the risks were increasing.
(Mr Godfrey) Well, this is where we are not the rocket scientists. It is clear now to me that the introduction of bank debt has caused the destabilisation of the zeros in that, when they become uncovered, what previously was a degeared asset exhibiting low risk qualities suddenly became geared and started falling off the cliff pretty rapidly.
(Mr Godfrey) The changeover came when bank debt started being introduced in a big way, which is probably 1999/2000. It became clear to us the impact this was having, as people who were not the designers of the product, really only as things deteriorated very severely towards the back end of this year.
(Mr Godfrey) I am not sure I would go that far. What I would say is that probably they should have been marketed with a clear explanation if they understood at the time that the existence of the bank debt gave new characteristics to the zeros that investors should be aware of.
(Mr Godfrey) They were not.
(Mr Godfrey) We are not the regulator -
(Mr Godfrey) Well, I will tell you what we are doing because it may not fit exactly into that --
(Mr Godfrey) Well, we are not going looking but we are keeping our eyes and ears open.
(Mr Godfrey) I think you can put what we find into a number of different categories. Firstly, you have rumour and speculation, which comes to you as hearsay evidence: secondly, you have circumstantial evidence that we can see for ourselves by looking at facts and figures as to what has happened in the past; and, thirdly, we have what I would describe as being soft evidence in that it comes to us from people who claim to have been in meetings and heard what was said but which has not been given to us in the form of written deposition or corroborated by a second person at that meeting. Now, all of these we have passed on to the Financial Services Authority, who clearly are the appropriate agency to deal with that information.
(Mr Godfrey) Yes.
(Mr Godfrey) I would say three and a half years.
(Mr Godfrey) I think it would be inappropriate for me to do that in the context of the Financial Services Authority having an investigation about to start or already being in the midst of an investigation into the facts that we passed to them. I think it would probably be prejudicial to people who may be innocent in this, so if the Committee would allow me I would rather not answer that.
(Mr Godfrey) The Association of Investment Trust Companies is a trade association and we represent companies that are eligible by our rules to be members, and those rules are that the companies should be eligible for listing as closed-end investment companies and so forth. Under the Competition Act you can be deemed to be acting anti-competitively if you try to keep people out so we do not have a formal structure of sanction against members.
(Mr Godfrey) Firstly, on behalf of the industry as a whole I want to apologise to shareholders who have lost so very much money. It is something that the industry collectively deeply regrets. I would have to say again that, clearly, it is individuals who do things and they do not just happen by a process of osmosis, but we have passed all the information that we have to the Financial Services Authority. There has been a combination of development and circumstances which has brought us to this position, which is a combination of development in the product in terms of introduction of bank debt, in terms of investing in technology companies or high yielding bonds or in shares of other splits, combined with what was to them the unexpected behaviour of stock markets globally that has made this happen, as I am sure anyone will tell you. If markets have gone up about 20 per cent in each of the last two years we would be congratulating them all on having won the awards again.
(Mr Godfrey) Some things are self-regulating and others need a push. What we are doing proactively is trying to improve transparency and understanding so that people who perhaps have a very significant appetite for risk know what they are getting into and may still want to buy shares, and people can take a more informed judgment about what they are getting when they buy a share. So we have encouraged both members and non members - we think it is so important for the industry as a whole that we have made this facility open to members as well as non members - to supply details of their holdings in other splits that we will then put up on our website so that people can take an educated view about not just the extent of the holdings in other splits but the quality of those holdings as well. Secondly, we have a very significant and costly data project going on at the moment where we have asked every split trust to supply us with their entire portfolio, albeit in confidence, so we can run some very detailed analytical work to understand just exactly what non split assets are underpinning the value of the whole sector, and we think that will provide boards with information that they currently cannot get. One of the difficulties about holding splits that hold splits that hold splits is that, once you go beyond a second layer, it becomes impossible for the director or the manager at the top to know exactly what their effective holdings are, what their effective level of gearing is, and what their effective expense ratios are.
(Mr Godfrey) Yes. We will publish the broad conclusions but not details about individual trusts.
(Mr Godfrey) I think that in itself is not beyond reasonable doubt evidence. When combined with other circumstantial evidence and the soft evidence that I referred to earlier, I do not believe that the whole sector of split capital managers and every player in it were all colluding with each other but I think there is no doubt that there have been some instances of bad practice by some individuals.
(Mr Godfrey) No, not wholly. It is always a question of the quantum, is it not? If it looks as though there is a lower charge because you are saying it is only, say, 1 per cent on the gross assets but the shareholders only amount to 50 per cent of that and the income shareholders only 33 per cent of the total, then the effective cost against the income shareholders is no longer 1 per cent but 3 per cent, and I think that needs to be made clear.
(Mr Godfrey) We are not investment managers or investment experts, so I do not think we are the best people necessarily to make that sort of judgment. What we have tried to do is increase transparency so that people who know more about it than us can analyse it and take a view and communicate that view.
(Mr Godfrey) I am not sure that someone should be stopping it; I think it is probably the other way round. I think people should have sufficient information that they do not buy it if it is not for them.
(Mr Godfrey) Yes, absolutely. I think some people might say, "This has a three year timeframe; there is a risk that these premiums may prove unsustainable but if markets go up by 6 per cent a year it will shoot the lights out and I will have some of that- not all my money but some of it". I think it is dangerous territory to start saying, "Let's stop it happening". What we have to be absolutely sure about is that people understand what they are getting and what the risks are so they can take an informed decision for themselves, or their advisers can, about whether it is the right thing to buy.
(Mr Godfrey) Although we have had letters directly from people who have invested directly, we have not had letters of complaint against advisers and we have not seen what advisers were saying to them so I can only give you a hypothetical response. If an adviser was simply following the information that they received from the promoters of the product in the first place, personally I do not think I would hold them to blame. They are reasonably entitled to expect that the information they get is accurate and sufficient. If, however, they go further than they have been told by the promoter, if for instance they were to write to a client and say, "You should buy these; they are as safe as gilts", then I think they might be held up to have gone too far in their communication with their client.
(Mr Godfrey) Given that it is our statement of recommended practice I could hardly do otherwise than say I would like everyone to follow it, absolutely.
(Mr Godfrey) No, they do not all do so, but they do follow the international generally accepted accounting principles.
(Mr Godfrey) Yes.
(Mr Godfrey) It is our recommended practice. I do not know whether any of the offshore funds that have not followed that practice are our members but we will include that in our additional information for you.
(Mr Godfrey) We have two exercises, one of which is to supply data to the website of holdings in other splits, and we have probably about 80 per cent co-operation with that. We have not aggressively pursued that over the last couple of months because of the second exercise we are engaged in which is to collect the full portfolio for the data exercise that we have, and that we have had complete co-operation on, or virtually. The reason why we have not pursued the former is that my feeling is that once we have gone through that data exercise we will establish probably a new way forward for what would be the optimum form and frequency of disclosure of holdings, so there is not much point in going back and asking people to co-operate with something which was likely to become redundant fairly quickly.
(Mr Godfrey) 80 per cent of the universe. As I said, we regard this as such a significant problem for the industry as a whole that we have opened our doors, if you like, even to those who are not members offering to put their information up on our website, and I do not have a breakdown of the 20 per cent that has failed to co-operate between members and non members, but I can include that in the data as well. I do not regard this as just a problem for my members if people are losing money in investment trusts but a problem for the whole industry, and we have to tackle it as such.
(Mr Godfrey) Generally, yes.
(Mr Godfrey) I am sorry, I could not break it down by value, but I would imagine it is fairly representative of the sector as a whole.
(Mr Godfrey) I think in the format we have presented here that is not being done at the moment but to be fair to -
(Mr Godfrey) Not in this format, no, but to be fair to the managers --
(Mr Townsend) To be fair, there are no new issues taking place in the current market so the opportunity just has not arisen.
(Mr Godfrey) I think it is a very good point you are making: that the recommendations we are making there are something that we would like to see appearing in prospecti of new issues, but certainly the projections we refer to could be put out on a regular basis by managers. There is no reason why they could not be.
(Mr Godfrey) No one is doing it to this extent; it is something we would like to see. This is something we have only recently proposed, however, and in fact it is fleshed out in more detail in this document than we have yet been able to do elsewhere. It was first mentioned in our submission to the Financial Services Authority's consultation document that was due in at the beginning of this year. Of course one spends a good deal of time racking one's brains to think about what one can do to improve disclosure and information for shareholders going forward, so I would say this is a new idea and therefore we have not had the chance to get it adopted by people as yet.
(Mr Godfrey) This is a matter of judgment but I will give you my opinion. We have about 136 trusts in this universe altogether. My guess is that the number of trusts who are unlikely ever to return anything to shareholders, even zero dividend preference shareholders, is probably in the order of just below ten. Depending on what happens to the market, it may rise to as many as twenty. The group which in the previous session was referred to as possibly working themselves out if markets go up in the sense that they may return monies to zero dividend preference shareholders, and may even return some to shareholders but probably significantly less for the shareholders than they invested in the first place, probably numbers up to in total 40 between those two categories. Then we have perhaps another twenty who have had to take some action to avoid getting into further difficulties such as cutting bank debt, and then we have about half the sector which I believe will recover given any reasonable market returns over the next few years.
(Mr Godfrey) No. I think probably more than half is sustainable. The last twenty who have had to take some action I think are not in deep difficulties and may well recover. I think we probably have about forty, or about a third, which stand either to lose everything or a very significant proportion of their assets.
(Mr Godfrey) Up to a third or it could be as little as, say, a sixth. As I said, it is very much dependent on what happens in the future, but it could be up to a third or it could be as little as a sixth.
(Mr Godfrey) It would be difficult for a private shareholder unless they did a lot of research work and educated themselves as to how they work, but there are advisers and analysts, the same as those who analyse any plc, who are making judgments about what category these trusts are in and giving ratings to them as such. One of the outcomes we hope to achieve from the data exercise that we are undergoing is to be able to develop a more robust system - not saying, "This is good", "This is bad", "This is risky", "This is low risk" but giving people a measure of to what extent this particular trust is exposed to bank debt or is exposed to other splits and also some measure potentially of the quality of the exposure to other splits.
(Mr Godfrey) We do have coherent ratings systems; I think they could be improved. I think the primary one is an analyst called David McFadyen with ABN Amro, who has a rating which measures the amount of bank debt and the quantity of exposure to other splits which is a very good starting point and very useful. I hope that with our data project we can perhaps add something which will speak to the quality of the split portfolio not just the quantity, because clearly that is very important.
(Mr Godfrey) One might ask just how much influence we might have over the conduct of any firm given that we are not a regulator, but there are advantages to being in the Channel Islands, both with a more flexible accounting regime but also with the tax advantages. You have heard about barbell trusts already from Aberdeen, and barbells as part of their structure are often invested in high yielding bonds to provide the income part of the portfolio with shares in other splits and, on the zippy side, shares in technology and so forth, and there is a tax disadvantage to holding bonds through being in the United Kingdom compared with being in the Channel Islands, so there is more than one reason for being offshore and it is not just a more flexible accounting regime.
(Mr Godfrey) The companies are listed on the United Kingdom Stock Exchange so they have to fulfil the United Kingdom requirements in the same way as if they were United Kingdom domiciled. There is the same amount of transparency required.
(Mr Godfrey) I have no concerns about that element, no.
(Mr Godfrey) Only to the extent that our view was that some of the accounting policies went too far.
Chairman: You heard us extend an invitation to Aberdeen Asset Management at another stage. We are very much aware that the investment trust sector itself is worth £50 billion but the split capital sector accounts for just £13 million of that and, as we mentioned at the beginning of this session, we do not want the stain to cover the whole of the investment trust sector so I think all of us have to work on that issue. You have been very helpful to us this morning and constructive in your evidence but we would like to keep a link with you, and if you feel you can inform the Committee on the way forward then we will be very grateful for any advice you can give us. Thank you very much for your appearance and your evidence this morning.
Memorandum submitted by the Financial Services Authority
Examination of Witnesses
MR JOHN TINER, Managing Director, and MR KEN RUSHTON, Director, Listings, the Financial Services Authority, examined.
(Mr Tiner) I am the managing director of the Financial Services Authority and on my right I have Mr Rushton, director of the United Kingdom Listing Authority.
(Mr Tiner) Chairman, I think this sector has got itself into a mess. I think that is self-evident not just from the evidence we have heard this morning but from what we have learnt from the work that we have been doing over the last several months. Our concern now is to determine firstly whether there have been breaches of regulatory rules and, if there are, to investigate those and pursue enforcement proceedings but at the same time, and not waiting for those proceedings to come to a conclusion, to make sure that arrangements are put in place to enable consumers to get redress where that is warranted.
(Mr Tiner) I would not disagree with that assessment overall. From the update report in May that we published, you can infer that there are those kinds of numbers of trusts which are facing more severe difficulty and will probably for their investors result in very significant write-offs of their investments. What we are doing about that is to make sure that investors are fully apprised of their rights to complain to the relevant firms - and that is not a straightforward matter and I can talk about that, if you like, Mr Chairman - and if those firms do not deal satisfactorily with those complaints they will go to the ombudsman who will hear those complaints in the proper course.
(Mr Tiner) As has been said this morning, we do live in very volatile stock markets and the state of a number of those trusts is clearly stock market sensitive and, whilst we read overnight that there has been another one that has got into difficulty, if we have markets sliding further we could see more trusts getting into difficulty. Mr Godfrey suggests that there are 10-20 in the category where there may be almost a total loss to all classes of shareholder but we have not got 10-20 reported yet - it is a much smaller number than that - which suggests that, if markets go lower, there could be more coming into the pipeline.
(Mr Tiner) As I understand it, the debt side of these trusts is fairly concentrated into a small number of banks. The two you have mentioned are significant lenders and there are I think, as I understand it, a small number of other banks who are lenders, but their actions and when they decide to call in their debt or push for reconstructions or whatever of course is a judgment call for them.
(Mr Tiner) On the debt side?
(Mr Tiner) I suppose it could be something like £4 billion in total, perhaps £3.5 billion. I think that is what we said in our report.
(Mr Tiner) Yes. Perhaps I should explain that. The source of recourse initially is always to the firm. The question is which firm, and there are a number of ways in which investors have been put into these split capital investment trusts. In some cases the investors have bought on the basis of marketing material promoting these trusts that has been sent to them, and they have been persuaded by that information to buy on the basis that there were comments such as some of those that were raised this morning about their very low risk characteristics --
(Mr Tiner) That has been mentioned in a newspaper article, and the baby that sleeps at night has been mentioned in marketing material more specifically, so those investors who have bought on the basis of that promotional material that promoted the trust would have recourse to that firm to complain. Investors that have bought on the basis of advice from a financial adviser would also have recourse to complain to that adviser if they felt they had been given misleading advice. Now, the advisers may be relying on that promotional material themselves in giving that advice to the customer, so there is an issue there about against which firm does the client have a case - the adviser or the fund manager, the promoter. The third area is where stockbroking firms have run discretionary portfolios for clients which have certain risk mandates/limitations on them, and they have been put into instruments which do not follow those mandates. Again, they would have a case. But in all those situations the investors' first port of call is the firm. If the firm do not deal with that adequately within eight weeks, then they go to the Ombudsman.
(Mr Tiner) What the Financial Services Authority did when it was set up was to put in place a structural arrangement to cope with mis-selling of this kind and that is the Ombudsman service, so the important thing from the Financial Services Authority's point of view here is that we are able to give consumers enough information to make sure they know what they can do and what their rights are, and then it is for the complaints system we have set up to deal with this.
(Mr Tiner) No, I do not. It is important to draw a distinction here between those trusts that have got what I called in my report a contagious cocktail of high gearing and high cross-holdings. It seems quite self-evident to me that those kinds of arrangements cannot be low risk to the investor because, as I explained in the report, they have an exponential kind of risk profile so when markets are going up they do terribly well and, when they go down, they do badly indeed. That is not a low risk product, to my mind.
(Mr Tiner) I think that has to be an issue for the Ombudsman to consider.
(Mr Tiner) I think the Ombudsman will consider them properly --
(Mr Tiner) Absolutely, yes.
(Mr Tiner) No, not yet. The letter from the consumer panel makes a comparison to the information we have asked firms in the mortgage endowments market to give to the policy holders in those firms, and we think this is quite different. The only way you can get information on mortgage endowments at all is from the firm. Here there is a lot of information in the public domain; these investment trusts are quoted shares; you can look them up in the newspaper; and there is quite a lot of information that is out there. You have to remember these shares are listed companies and I am not sure that it would be right for us just to take a selection of the listed Stock Exchange market and put those on our website.
(Mr Tiner) We will have a think about it further - we have only just got the letter - but my initial reaction is it could be quite difficult. What we are trying to do is to encourage, through the offices of the AITC, the industry itself to get much better quality information to consumers.
(Mr Rushton) Can I add a comment? Back in April, on this question of disclosure, I wrote to all the sponsors of investment companies and investment trusts reminding them, first of all, of their obligations under the listings rules to ensure that any price-sensitive information is communicated in a timely way but, more importantly, I asked them if they would advise their clients to co-operate with the AITC in their disclosure initiative which you heard about. I then called a meeting of some of those sponsors who are particularly representative in this sector and suggested to them that this would be a good thing in terms of restoring and protecting the reputation of the sector and I believe, although you did not go into this with the AITC, that the figures show that there has been pretty good co-operation on that. If there is not good co-operation with an AITC voluntary initiative, then I think it is reasonable for us to consider whether the disclosure rules we have for investment entities should be reconsidered.
(Mr Tiner) I accept that. I think there is an issue and people are confused about whether they have a bad or good one - people are confused about quite what these instruments mean, quite frankly. We did put a consumer information bulletin on our website some months ago to help consumers try and work through what kind of trust they are in, and we provided advice in terms of who to talk to about their own particular position.
(Mr Tiner) I cannot tell you who made it although I can find out and let the Committee know, and I cannot tell you how widely that term was used. We put these in to give a flavour, quite frankly, of the sort of material that we have observed as being out there, or which has been.
(Mr Tiner) Well, particularly where you have this combination of gearing and cross-holding. That is what makes that statement particularly unreliable.
(Mr Tiner) If you like, yes.
(Mr Tiner) As we have said in the section of the report that deals with what we will be doing in the future, we have said that we have found enough data to cause us to go on and investigate this issue of collusive behaviour but without at that point progressing with enforcement proceedings against any particular firm. We have collected a lot of data about what is referred to as stock swaps, where one trust will swap stocks with another, and a lot of analysis of I cannot tell you right now how many trusts but quite a number and quite a number of managers --
(Mr Tiner) We are talking probably more about a handful than three dozen.
(Mr Tiner) No, a handful. One hand!
(Mr Tiner) No, because it is a relatively concentrated industry and there are a small number of firms who have quite a big market share.
(Mr Tiner) As a regulator, under our normal rights we can call for information we require for the purposes of fulfulling our regulatory responsibilities. When we commence an enforcement investigation then we have rights to call for information which is relevant to that particular investigation, and so I think we do have the necessary powers to pursue this if we think we have a case to pursue.
(Mr Tiner) I really would not want to speculate on that now. I think we have to look at the evidence we have gathered: we have said here that we have commenced enforcement proceedings in a number of cases in relation to misleading marketing information --
(Mr Tiner) On the collusive side we are still gathering data, and I would not want to be drawn on how many cases we will then pursue.
(Mr Tiner) Do you mean just on the collusion issue?
(Mr Tiner) The first point I should make is that we do not know when we will commence any action because we will not do that until we decide we have the evidence, so I cannot tell you whether we will at all if we do not get sufficient evidence to suggest that we should pursue a formal enforcement investigation. If we then do commence an enforcement investigation against any firm, under the enforcement procedures established in the Financial Services and Markets Act it could be a matter of possibly twelve months from the time at which that investigation commences to the time at which a decision would be taken. It could stretch even longer than that if the firm concerned, if there is such a case, then takes the issue to the Financial Services Tribunal.
(Mr Tiner) It is quite wide: it is a range of fines. We can change firms' permissions to do business in particular sectors and we are able to ban individuals.
(Mr Tiner) Yes, we can.
(Mr Tiner) Of course, the entire system here is a voluntary system, even in the United Kingdom, because investment trusts are not regulated. They are regulated through the United Kingdom Listing Authority but not as investment products by the Financial Services Authority. I would suggest, therefore, certainly in the light of what has emerged in this sector that it would be in the interests of all jurisdictions that have these products which have been sponsored from those jurisdictions to adopt a code of best practice.
(Mr Tiner) I would like to see if the market, through the work of the AITC, could deliver the necessary standards themselves first without necessarily making it mandatory.
(Mr Tiner) No. In that case, if there was that kind of dispute between the adviser and the promoter, in essence the complaint would not have been dealt with to the customer's satisfaction and the customer would go to the Ombudsman and the Ombudsman would decide who is at fault.
(Mr Tiner) We are in quite close touch to see how their information-gathering efforts have been progressing. I think they had one go at this at the end of last year which was, as I reported in a speech at the beginning of February, relatively unsuccessful but I think since then the determination of the sector to clean this up has been much greater and they have been much more successful more recently, so I am minded to give the AITC the time, perhaps a few months, to see if they can get the information they need and put it in a format which is of use to the market, advisers and consumers and to be able to put more relevant, more timely information out there into the market place.
(Mr Tiner) Yes.
(Mr Tiner) The Ombudsman has a service standard which we have set for him which is to hear all cases within six months, but in fact the average period by which he has judged a case is rather less than that. It is about four months.
(Mr Tiner) You need to do a daily evaluation of this given that the market is down sharply overnight. This was in May --
(Mr Tiner) I am sorry. I suppose the stock markets have probably fallen 10 per cent since then. I have not done an up-to-date valuation but my guess would be that it has probably fallen by more than 10 per cent because of the collateral damage that has been done throughout the whole sector from the bad splits, if I can put it that way, but the work would need to be done.
(Mr Rushton) Regrettably some of those splits are no longer in existence, of course. They have gone into liquidation since March. It is a small number, but --
(Mr Rushton) I have not got a figure either. As John Tiner says, you would have to calculate that day-to-day with the market moving as it is.
(Mr Tiner) No. I do not think there is a systemic risk here through the contagion that might take place within the investment trust sector itself because, as has been discussed several times this morning, the problem is restricted to a minority of trusts, albeit quite a significant minority. On the banking issues, not all of the debt - whatever the right number today is in terms of the level, £3.5 billion or whatever - is at risk because much of it is in trusts which are not on the hospital list. Some of it is, of course, but also the banks get paid out first. This is the problem for the investor - the banks get their money first - so I think it is not right to assume that the banks are going to pick up a hit of that sort, or anywhere near it.
(Mr Tiner) Yes, and I think the reason that they have fallen in value further since the report in March is because the stock market has gone down, not because new structures have been created that have created some new dangerous financial scenario. What is happening now is market-related, not structure-related. The structure bit happened before because there is no new gearing or anything like that coming into this sector.
(Mr Tiner) No. There has been quite a lot of trusts issued since 1999. I think we have said in our paper that there were about fifty.
(Mr Tiner) Yes, but I have also said there has been an acceleration in the last three years which is the period during which we have had the bear market, so I do not think all of these have been just launched in an upward only market. They have been launched since the market has started to turn, as these figures suggest.
(Mr Tiner) I would not say that. I think there is a difference between concerns about prudential regulation and systemic concerns. I think there is a difference there and it is an important difference to point out. There are issues here that are concerned, of course, with consumers, as we discussed, and there are issues here relating to whether firms are able to deal with the consequences of any redress that may be due to those consumers. They will have to be dealt with and we are monitoring that and watching that very closely indeed. I do not believe, however, that that will then become a systemic crisis for the sector or for the financial services industry.
(Mr Tiner) I do not think I would agree with that. I think that we have been working very hard to identify the breaches of conduct of business rules - the mis-selling and the misleading information that has been given to the consumers - and that is why we have started to pursue enforcement proceedings. Unfortunately, because of the provisions of the Act, we cannot wrap up those proceedings very quickly. We have to go through quite a lengthy process, which is not one that has been determined by us but is determined in the Act, which can delay the outcome for quite some months, but we are moving as fast as we can.
(Mr Tiner) It could be that, yes. The process could take that long.
(Mr Tiner) We have to follow due process. We cannot and should not cut due process. I would hope that we can get it done, frankly speaking, quicker than twelve months but I would not be able to promise that. In the meantime what is important for consumers is that they do have a right of access to the Ombudsman so that this process that we might take against firms does not slow up consumers getting redress, because it is the Ombudsman who will hear their complaint and who is able to deal with those complaints while those enforcement investigations continue.
(Mr Tiner) The Ombudsman incidentally at the moment has not got very many complaints, which is an interesting statistic. He only has 280 at the moment out of 50,000 people investing in this sector, but my belief is that quite a number of those will be relatively straightforward because people will have bought them through advisers or off promotional material. There will be some where it is a little bit unclear and it may take the Ombudsman a little bit longer, but he still has to deal with it within six months.
(Mr Rushton) A number of investors will be claiming redress against their independent advisers before going to the Ombudsman.
(Mr Rushton) It is all right if they get compensation.
(Mr Rushton) If the intermediary is at fault, he should.
(Mr Tiner) I think we are. I think we are pursuing the cases with real vigour and, if we can get these cases completed within the process established within the Act, then we will do that. We have made this a clear priority within the Financial Services Authority and we are progressing as fast as we possibly can. That is the only assurance I can give you - we are literally pursuing it as hard as we can.
(Mr Tiner) I think the prudential issues emerge if and when firms are required to pay redress to the consumers, and the issue for those firms is whether they can afford to pay that redress, either because they choose of their own will to make those payments to consumers or because they are instructed to do so by the Ombudsman.
(Mr Tiner) That is the system that has been set up. The way in which investors get compensation for breaches of conduct of business is through the Ombudsman - that is the system. We have put the system in place and we will make sure that firms deal with the complaints according to our rules, but the backstop is the Ombudsman.
(Mr Tiner) I am afraid that where there is secure bank debt they are always first in the queue - that is the nature of a lot of bank lending.
(Mr Tiner) No, I do not. I think the responsibility, if there has been irresponsible gearing, if that is the right term, falls with the firms that have raised that gearing. I think the banks need to look at whether they are able to judge the risk from their perspective and it may well be that the banks will be out of pocket as well, but I think it is those who are structuring the fund that you have to look to to make sure that you are happy that there is consideration of the interests of the different groups of shareholders vis-a-vis the banks, and that the banks need to make sure that they have got sufficient protection to get their money back.
(Mr Tiner) I would have thought so.
(Mr Tiner) I think as it turns out, if the banks lose money because a fund has been over-geared with their borrowings, then history will tell you it has been an unwise lending decision but that is the same as --
(Mr Tiner) I do agree.
(Mr Tiner) No, I am not. This is an issue for the banks. If the banks want to take that kind of risk with their shareholders' money and we think from a prudential point of view, going back to Mr Cousins' question --
(Mr Tiner) I think it is.
(Mr Tiner) If I was a banker, I would think twice about it.
(Mr Tiner) Maybe.
(Mr Tiner) Yes. I would like to respond to that by reading a note I have written because I think the precision of words is rather important.
(Mr Tiner) On 28 June 2002 the Financial Services Authority issued revised guidance to the life insurance industry on the stress testing of their portfolios, generally referred to as the resilience test. The resilience test is an important element in the prudential framework which is designed to protect policyholders as it helps to determine the appropriate mix in risk assets to the term, size and nature of policyholder liabilities. Recent events in the markets have revealed some problems with the formula which tapers down the stress test from a maximum of 25 per cent to a minimum of 10 per cent. We have been considering for some time possible changes to the resilience test which would take into account recent stock market movements in anticipation of the new Integrated Prudential Sourcebook that comes into effect in 2004. In the light of market conditions and the problems identified with the resilience test, we considered it appropriate to make this amendment at an earlier stage such that there would not be market distortions created by the problems that may be inherent in the current test. Our research among life insurance firms suggests that the significant majority were not close to being sellers of equities at the FTSE 100 level on 28 June of 4,540, based purely on the application of that resilience test. Of course there may have been some sellers, and buyers, depending on their analysis of the market. Hence the change to the resilience test was not made with any immediate pressure to sell in mind. As we have said, the suspension of the test on 24 September last year was under very different circumstances and we have seen no need to further suspend the test in recent market conditions. Based on stock market movements over the last three months, the new test will require firms to stress their equity portfolios as a decline in the FTSE Actuaries All Share of approximately 15 per cent or a 650 point fall. This new test will remain in force, as temporary guidance, until 31 May 2003 when, having consulted, we anticipate that it will become permanent. The financial returns of life insurance firms show that their free asset ratios have fallen in each of the last two years. However, as is suggested by my earlier remark on firms' resilience to equity price movements, the insurance sector continues to meet the minimum solvency requirements we have set, and this is in the light of a 33 per cent fall in equity markets over the last 22 months. This also takes into account the guarantees made to policyholders in with-profits funds which make up the majority of insurance company funds and which, of course, are not provided within unit-linked products. It is also useful to remember that whilst, of course, changes in asset prices on a day-to-day basis must be monitored closely, the liabilities of insurance firms are over the longer term. Of course, these are nervous markets and we continue to monitor closely the impact of market movements on the life insurance sector as a whole, and on individual firms. Members of the Committee may recall that the Financial Services Authority is rolling out its risk-based approach to regulation across all sectors of the financial services market, including insurance. We will perform risk assessments on some 200 insurance firms, being the larger firms in both the life and non-life sectors. These assessments are presently in progress and we will write to firms with our findings and conclusions. A recent report by the rating agency Fitch that the Financial Services Authority has 200 insurance firms on its high-risk list is wrong as the risk assessments have not even been completed. It is true to say that the Financial Services Authority is engaging in a much more intensive relationship with these 200 firms, as this is part of the risk-based approach. We have taken the opportunity during the last two or three months to meet with CEOs of the major insurance firms to explain this new approach, to explain the proposed policy reforms we propose in insurance regulation, and to discuss matters of current interest. We have also written to CEOs of insurance firms to remind them that they should be proactive in the management of their firms' financial resources.
(Mr Tiner) I think that we have been hungry for data, information and market intelligence on this sector and, as Daniel Godfrey said, he has given us some and we have had other types of information from other sources and without, frankly, wanting to go into specifics I have heard some information this morning which is quite interesting.
(Mr Tiner) If you like.
Chairman: Good. Thank you very much.