Select Committee on Treasury Minutes of Evidence

Further memorandum from the Financial Services Authority


  1.  When the FSA gave evidence to the Committee on 22 October, we undertook to provide a further memorandum on two points: what information the FSA had received from the Guernsey regulator about split capital investment trusts; and the role of the UK Listing Authority in approving prospectuses for listing.

  2.  This note covers these areas and takes the opportunity to elaborate on our evidence on the issue of FSA's statutory immunity which was discussed on 22 October. It begins with a brief explanation of how splits are regulated.


  3.  The legal and regulatory framework for this sector is as follows:

    —  Split Capital Investment Trusts (splits) are listed companies, not regulated products (unlike unit trusts); they are therefore subject to FSA Listing Rules but not to specific product approval by the FSA.

    —  The managers of splits are subject to the FSA conduct of business and prudential rules, as are those who either advise consumers to invest in splits or who invest client portfolios in splits under discretionary management agreements.

    —  The FSA's rules on Financial Promotion also cover the contents of any marketing or promotional materials aimed at private clients (which must be "fair, clear and not misleading"). These rules do not apply to the initial prospectus, which is subject to the Listing Rules. See section D below for more details on this.

    —  The regulatory framework also provides for consumers to have recourse to the Financial Ombudsman Scheme and where appropriate to the Financial Services Compensation Scheme. This is subject to the limitations described in the FSA's original memorandum to the Committee.


  4.  The FSA and its predecessor organisations had been considering and acting on issues relating to split capital investment trusts from late 2000. In particular:

    (a)  IMRO's Risk Identification Group (RIG, set up in 1994 to review market developments from a risk perspective) discussed splits at two meetings in October and December 2000. IMRO had some concerns about splits and identified a need to establish more precisely what the problems were.

    (b)  At the end of January 2001 Peter Moffatt, the Guernsey Financial Services Commission's Director of Investment Business, visited the FSA. The meeting was one of a regular series, allowing an informal exchange of views on a range of issues and an opportunity to maintain relationships. Splits and the risk of incestuous investment were mentioned.

    (c)  Following a further RIG meeting in February 2001, IMRO decided to carry out a project to assess the risk concentration in the holdings of splits and to establish whether any regulatory action was required.

    (d)  In the light of IMRO's concerns, the Personal Investment Authority (the primary regulator concerned with marketing material) issued a regulatory update in March 2001 to its firms which included a warning on splits. See attachment one. It stressed, "It is important that the structure of these products and the risks involved are carefully explained to customers before they commit themselves".

    (e)  Around the same time the FSA began issuing general warnings about high income products linked to stock market and the dangers for consumers attracted to unsuitable products. For example, in March the FSA issued a consumer alert, warning consumers to "think twice before investing in exotic financial products that qualify for tax benefits as ISAs". These warnings received widespread press coverage throughout April to August 2001.

    (f)  On 9 April 2001 Peter Moffatt wrote to the FSA about a number of issues including splits.[11] 9 By this stage UK regulators had already issued a regulatory update and set up a project specifically to look in more detail at the issue. In addition, prospectuses issued with the approval of the United Kingdom Listing Authority (UKLA) explicitly stated before and after April 2001 that both gearing and cross holdings were elements of the investments involved (see attachment three as a representative example). "Systemic risk" is not included among the risk factors listed in prospectuses. The FSA considers systemic risk to mean a threat to the stability of the financial system. Problems in the splits sector were not expected to be, and have not turned out to be, a risk in this sense. The risk warnings did, however, specifically identify the risks of gearing, and the potential impact of the failure of one trust on others invested in it. Our understanding is that this was the kind of "systemic" risk, which also concerned the Guernsey regulator.

    (g)  The IMRO project on splits (c, above) reported in April 2001, having assessed risk concentrations in 38 trusts where information was in the public domain. Of these, 22 had no cross holdings while 16 did. IMRO's conclusions were that the risk concentrations did not indicate a problem for the splits sector as a whole, but that this exercise would need to be repeated periodically to maintain a watching brief on the sector.

    (h)  Two market developments led to the April exercise being repeated on a much bigger scale and earlier than previously planned, in August 2001. These developments were:

      —  in July 2001 one of the largest splits cut its dividend. This had not happened before; and

      —  the dividend cut led to a fall in the price of income shares and a number of splits with cross holdings began to have financial difficulties, as most cross holdings were in income shares.

    (i)  At this point the FSA directed greater resources to this work—a team of five people working full time for six to seven weeks. The team identified a list of 114 splits along with details on debt levels and individual cross holdings. They produced a model to analyse the interaction of debt and cross holdings to assess the likelihood of collateral damage to the whole splits sector.

    (j)  In October 2001 an internal FSA report concluded that there was risk to the splits sector as a whole due to cross holdings, but that the FTSE 100 would have to fall further for large numbers of funds to become insolvent. It recommended that the FSA investigate the selling practices and allegations of collusion. The FSA decided to publish a Discussion Paper on disclosure, corporate governance and the guidance offered to financial advisers who recommended these products. This was published in December 2001.

    (k)  In February 2002 the FSA announced that it was making enquiries into various aspects of the splits market, including through visits to a number of fund managers, brokers, banks and independent financial advisers. An update on all the elements of this work was published in May 2002.

    (l)  In July 2002 we confirmed that we had commenced enforcement investigations in a number of cases relating to misleading marketing. In October 2002 we also confirmed that investigations into alleged collusion had begun. In addition, FOS is looking at a number of cases. As at 22 October the Ombudsman had received 1,054 cases.

  5.  The regime described above is based closely on the regime in place under the Financial Services Act 1986, though FSMA strengthened the FSA's powers in relation to market abuse and financial promotion. Issues of regulatory scope are for Ministers and Parliament, but the FSA Board is willing to consider, in the light of experience, whether their powers remain appropriate for changing conditions.


  6.  The United Kingdom Listing Authority (UKLA) was transferred from the London Stock Exchange (LSE) to the FSA on 1 May 2000. The FSA is therefore now responsible for a number of activities including the approval of listing particulars, the approval of prospectuses published by issuers for those securities in respect of which an application for admission for listing is to be made or has been made, and the making of the listing rules. These responsibilities remained unchanged on the transfer of the UKLA from the LSE to the FSA and on the coming into force of FSMA. The objectives of the FSA acting in its capacity as the UKLA are agreed with the Treasury each year and published.

  7.  The Listing Rules implement the requirements of the European Directive on the admission of securities to official stock exchange listing and on information to be published on those securities. The rules set out which shares can be listed and the minimum disclosures, which the issuing companies must make. Almost all splits are listed on the London Stock Exchange.

  8.  A prospectus must contain all the information that investors and their professional advisors would reasonably require and reasonably expect to find there for the purpose of making an informed assessment of: the assets and liabilities, financial information, profits and losses and prospects of the company; and the rights attaching to the securities. Under FSMA, the directors of the company are responsible for ensuring that this information is included. The Listing Rules require that they make a statement in the prospectus certifying that they have done this. Like the legislation it replaced (the Financial Services Act 1986), FSMA creates a cause of action before the courts for those who have acquired securities to which the document relates if they suffer loss as a result of any untrue or misleading statement in the document or from the omission of information otherwise required to be included. In such a case any person responsible under FSMA is liable to pay compensation.

  9.  Under FSMA, if the UKLA considers that an issuer of listed securities or an applicant for listing has contravened any provision of the Listing Rules, it can impose a financial penalty. In addition, if it considers that any director was concerned in a breach, the UKLA can impose a financial penalty on that director. These sanctions were not available to the UKLA under the previous legislation. If a breach occurred prior to the implementation of FSMA, the sanction available is to publish a statement of censure.

  10.  More specifically, the Listing Rules require:

    —  investment trusts to include a list of their 10 largest investments, in their listing prospectus and in their annual report and accounts. Listed investment companies are required to include a list of all investments with a value of greater than 5 per cent of the gross assets of the company;

    —  disclosure of an investment company's investment policy. We would expect this to include whether it could invest in the shares of other splits (and, if so, to what extent) and also whether it could raise borrowings from banks. Shareholder approval must be sought for any material change in investment strategy within three years of listing; and

    —  an investment company's board of directors to be able to demonstrate that it will act independently of any investment manager. The majority of the board must not be directors or employees of the investment manager.

  11.  If a company meets the listing rules, the UKLA has an obligation to list that company's securities. The UKLA does not assess whether a company is attractive or not to investors. This is not part of its statutory function.

  12.  In approving a prospectus, the role of UKLA is to assess whether its rules on disclosure have been complied with. The UKLA does not seek to investigate or verify the accuracy or completeness of the information set out in a draft prospectus, nor does it check the sources of information.

  13.  The UKLA is currently undertaking a review of the listing rules. A Discussion Paper was published in July this year. Among other things, the paper states that we will review whether the Listing Rules should provide guidance in relation to conflicts of interest on trust Boards and that we will review the disclosure requirements of such entities.


  14.  Questions were raised during the session on 22 October about the FSA's statutory immunity. Below we provide some factual background to that discussion.

  15.  The FSA's exemption from liability in damages is not new. It carries forward the exemptions previously available to SIB, the SROs, the Bank of England, and the Stock Exchange as competent authority for listing. Recognised investment exchanges and clearing houses have a similar exemption in relation to their regulatory functions, as does OPRA under the Pensions Act 1995. The principle of an exemption has therefore been supported by both the current and previous Governments, and confirmed by Parliament in both the Financial Services Act 1986 and the Financial Services and Markets Act 2000. The Joint Committee chaired by Lord Burns examined the issue of statutory immunity in some depth. The Committee confirmed that the immunity should be retained provided that there was an appropriate complaints procedure. These provisions were included in the Act.

  16.  There are recognised international precedents for the exemption. The Basel principles for banking supervision recognise the need for immunity of banking supervisors in order to allow them to take effective regulatory action in the public interest. In accordance with this principle legal protection is also available for banking supervisors in Australia, Canada, Germany, India, Ireland, Malaysia, New Zealand, Philippines, Singapore, South Africa, Sweden, Switzerland and the US.

  17.  The exemption is not absolute. It does not apply if the FSA acts in bad faith or in respect of a claim under the Human Rights Act 1998. Unlike Crown bodies, there is no immunity from prosecution. The FSA is also subject to judicial review. The FSA has established a complaints scheme with an independent complaints commissioner who can publicly recommend that the FSA pays compensation to a complainant.

8 November 2002

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