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.
B. OUR REGULATORY
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.
THE FSA FROM
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
(f) On 9 April 2001 Peter Moffatt wrote to
the FSA about a number of issues including splits.
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
(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 worka 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
(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.
D. ROLE OF
THE UK LISTING
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
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.
E. THE FSA'S
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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