Select Committee on Treasury Third Report

C In what circumstances were zeros sold as low risk to investors?

32. Investors may have acquired an investment in a zero in a number of different ways, with different implications for possible redress. The FSA outlined four principal situations:

- purchase (generally on launch of the trust) on the basis of information in the trust's launch prospectus

- purchase (whether in the primary or secondary markets) without advice or use of promotional material of any kind ('execution only' purchase)

- purchase on advice from an authorised firm (IFA, stockbroker etc); this would include cases where funds were invested under a discretionary power

- purchase on the basis of promotional material issued by the fund manager.[44]

In the latter three cases, investors may have been influenced by general coverage of splits in the press and other media.

33. It should be noted that an investor might suffer without investing in a zero directly, but through an indirect investment, such as a unit trust which invested in splits (such as, for example, the Aberdeen Progressive Growth Unit Trust, which invested in zeros, including the Aberdeen Preferred Income split) or a traditional investment trust which invested in splits (such as Aberdeen's Enhanced Zero trust). The investment might come through a share scheme or be wrapped in an ISA.[45] The different routes through which an investment may have been made have to be kept in mind when considering how far investors may have been misled in their purchase of zeros. A key further distinction, it seems to us, lies in the difference between cases where purchase was by professional investors and those where purchase was by inexpert (often private) investors.

Institutional and professional investors

34. The vast majority of shares bought on the basis of the prospectus alone would have been bought by institutional investors on launch. Most witnesses have indicated to us that the prospectuses themselves generally met required standards.[46] Even Mr Alexander said that "in the prospectuses themselves the risks were generally spelled out".[47] Mr Tiner told us: "through the UK Listing Authority, which was not part of the FSA at the time, we have to approve all prospectuses, and we have done a trawl of past prospectuses and we think the disclosures about cross holdings, or the ability, within the investment mandate given to the managers, to invest in other trusts was clearly disclosed."[48] From the prospectuses we have seen, it is for consideration whether the Listing Rules failed to pick up the difference in the treatment in the prospectuses between income shares and zeros. Income holders were told they could lose all their money; zero shareholders were only told the rate at which the trust's assets needed to grow to generate the expected return.

Purchase of zeros on the basis of advice

35. The real issue is with the sale of zeros on the basis of some form of advice or encouragement—the FSA's third and fourth categories. These would often be individual investors who could not be expected to have understood all the details of financial products and whom it is the job of government and legislators to seek to protect.

36. Mr Piers Currie (Aberdeen's Marketing Director, Investment Trusts) told us that in the documentation for their share schemes, in respect of investments in zeros, "We did not describe it as low risk exclusively" and that the accompanying material—which investors would be required to read—described the characteristics of the zeros concerned.[49] The 'Key Features' document for the Aberdeen Investment Trust Share Plan (July 1999) stated for example that "We advise anyone contemplating the purchase of a split capital trust to take independent professional advice". The 'Risk Factors' section noted that "The substantial use of gearing by some Trusts, usually in the form of bank borrowings ... means that changes in the value of the investment portfolio of the company can be expected to result in exaggerated movements in the [Net Asset Value] which are potentially unfavourable as well as favourable"; in respect of zeros the section states "The repayment of zeros is not guaranteed and is dependent on the issuing investment trust having sufficient assets at wind-up date". The July 2000 version states that "An Investment Trust which 'gears' may well have a more volatile share price than one which does not".[50] In respect of zeros, the July 2000 version states that ZDPs "have a pre-determined redemption value ... This final redemption is not guaranteed, and will not be repaid in full if the investment trust, on liquidation of its portfolio, has insufficient assets. They however rank first in priority on a trust's assets after bank borrowings, and are therefore deemed less risky than other share classes". Similar statements feature in the June 2001 version of the Share Plan Key Features document, though the added statement appears "Shareholders should be aware that if any trust at wind-up does not have sufficient assets to repay ... [any] prior entitlements such as bank borrowings, then they will not receive any capital back at the winding up date."

37. But such formal warnings, whether in respect of Aberdeen or other fund managers, are not the whole story. A significant part of the problem was that a whole climate of opinion appeared to have developed[51] that zeros had never failed and were therefore low risk.[52] This impression permeated the general coverage of the subject and meant that what may have been technically correct statements about risk in the formal documents did not have a great impact compared to what investors were being told in the wider context. There is a string of quotations from press coverage and advertisements illustrating this.[53] A newspaper advertisement in September 1999 described zeros as "lower risk investments similar to bonds" which offer "quasi-guaranteed annual growth".[54] Mr Currie, of Aberdeen, was quoted in the Glasgow Herald on 11 February 1999 as stating that investment in the Enhanced Zero Trust was "a no-brainer. It is a banking decision really. You are able to borrow cheap, invest high.", implying that there was no significant risk of not getting the envisaged return.[55] Mr Fishwick was quoted by Reuters in connection with zeros as extolling their reliability "even in the most volatile of equity markets. Their prices do not fall back sharply even when equities are in decline".[56] Aberdeen's Progressive Growth Unit Trust notoriously promoted its investment in zeros in 2001 with the message "The one year old who lets you sleep at night".[57] The AITC itself was suggesting to investors in August 2001 that zeros "might prove to be the best choice" for someone seeking "only a minimal amount of risk".[58] All five of these statements have proved to be false. We consider that Aberdeen's promotion material and statements, in particular, were recklessly misleading.

38. Mr Alexander supported the idea that there had been negligence among advisers and that the most common failing was "that they failed to understand the structural differences between those split capital trusts that were sound and/or of relatively low risk and those ... that were highly geared and with cross-holdings ... that were clearly of much higher risk. In many cases, it is quite clear that the advisers merely relied upon a leaflet or marketing documents from the fund managers rather than reading the prospectuses, which would in most cases have shown the risks involved";[59] similarly, "it was this mismatch of prospectuses as against marketing material that is the cause of concern, because, after all, the public, particularly the smaller investor, is only ever going to receive the marketing material, the application to put their money into an ISA, they are not going to go and read any underlying documentation".[60] He cited evidence from an Aberdeen statement to the Financial Times in 1997 that the newer splits were only suitable for the professional investor or someone with an adviser, suggesting that Aberdeen knew then that there were risks and should not have been marketing them to the public.[61] Advisers continued straight through the events of September 11th 2001 to take the attitude that zeros were "a good thing, and they never focus on the fact that these particular zeros were not the same as those they had previously looked at".[62]

39. The risks of zeros were noted by Cazenoves for example in their January 2001 Annual Review noted "The wider issue is whether there is systemic risk to the whole split sector resulting from the poor performance of some of the recently launched funds ... Sophisticated investors know that splits create high income through the use of 'smoke and mirrors' and high charges to capital account. We suspect that most private clients and IFAs do not."[63]

40. One of the firms against which Mr Alexander said there were particular complaints was Brewin Dolphin. Brewin Dolphin told us that zeros "had been widely sold by advisers, through fund managers' advertising campaigns, and have been generally recommended in the press" but that it was not their practice to distribute fund managers' marketing material to any private investor.[64] They said that they advised over 80,000 private investors and that for some of these they had recommended zero shares, but that "Each and every one of our clients's portfolios is different and each has been invested to achieve the client's objectives ... With all the information we had at the time we believe we gave sound advice to our clients".[65] When questioned whether the advice being given about zeros changed in the late 1990s as splits began to change character, Mrs Bowden for Brewin Dolphin said "I do not think there was a huge shift in perception at the time ... Across the industry I think the market professionals as a whole did not see a huge shift ...".[66]

41. It seems clear to us that those primarily responsible for the development of the 'newer' splits—the board members themselves, some trust fund managers and some sponsoring brokers—did not take the steps they could and should have taken to bring the true nature of the risks in zeros to the attention of the wider investment community. We deplore the fact that many investors in the 'newer' zeros were not adequately warned by trust fund managers of the risk to their investment, especially as the managers subsequently increased that risk by substantially increasing gearing.

42. We accept that not all individual investors in zeros over the last five or more years are automatically entitled to compensation, even if their investment was made using some form of adviser or intermediary. The circumstances of each case must be examined—initially by the adviser or company concerned but if necessary by the Financial Ombudsman Service—but we are in little doubt that there is a wide range of cases in which it will be found that compensation is justified. In some cases it may appear that the promotional material contained phrases and statements which appear to convey adequate warnings of the risks involved. But these statements—even assuming that in themselves they accurately describe the extent of risk—are not the full story. The statements of risk in the promotional material must be assessed in the wider context of the way in which clients were led to believe that zeros were, overall, a safe investment. The greater was the general belief among inexpert investors that investments were 'low risk' when they were not, the greater was the onus on those advising them—or on those designing the products and promoting them through advisers—to make clear what the risks were. It was insufficient for the warnings to be little more than small print. Of course, the level of compensation must take into account the fact that any alternative investments —had the investors not invested in zeros—might also not have fared very well.

43. In many cases an independent financial adviser or broker would have been involved. In coming to a view as to whether fault lies with the adviser or with the firms supplying the information to the adviser, the question which needs to be addressed is whether the adviser could have been expected to have spotted the real nature of the 'newer' splits. Mr Alexander, arguing that all the players in the field held some responsibility for what had happened, suggested in respect of IFAs that some had simply relied on their previous confidence in splits and in managers such as Aberdeen rather than examining the underlying information properly.[67] He noted also that some advisers had looked at investing in some of the splits and had rejected them as desirable investments.[68] He felt therefore that there were grounds for negligence claims against advisers who had recommended these products to clients who had asked for low risk products, and against any brokers who had sold products directly to clients where the clients had received misleading marketing material.[69]

44. The Association of Private Client Investment Managers and Stockbrokers (APCIMS) and individual professionals have cited to us instances where disclosure from the boards and fund managers to investment advisers about investment portfolios etc may have been incomplete or misleading.[70] Mr Godfrey, when asked whether professional investment advisers should have spotted the risk, replied "I doubt whether most professional investment advisers would have had the competence or experience or level of knowledge to have dug into this and found that which the product manufacturers themselves did not find."[71]

Future developments and financial redress

45. Brewin Dolphin told us that they had "put in place a dedicated team to examine complaints" from their clients.[72] We note that Aberdeen accepted that, in the case of its Aberdeen Progressive Growth Unit Trust, some compensation was appropriate.[73] Mr Gilbert told us "... we marketed that as a low risk product ... and while we can look at the marketing literature we produced for the unit trust and legally it stands up ... we have taken the view that we are not happy with the performance of that fund. Therefore we are proposing and are still committed to an uplift package for all the people who have bought ... not just those who have bought directly from us, but everyone who has bought."[74] When challenged in October 2002, following press reports that Aberdeen might be reconsidering their proposed 'uplift package', Mr Gilbert stated that the story was "absolutely untrue";[75] in January 2003 Aberdeen told us that their "commitment to the ... uplift package remains unchanged—we continue to work towards its finalisation".[76]

46. What has happened has caused harm not only to the splits directly affected but to the whole splits sector and possibly to the whole investment trust sector. The damage could be even wider still, reducing confidence in the whole savings process. It is important that confidence is restored and this will not be achieved—nor will justice be delivered to those who have suffered losses—if the issue of compensation is fought at length through the courts.[77] We look to the various firms involved—trust fund managers and sponsoring brokers—to be as positive and accommodating as possible in their approach to compensating investors who may have been mis-sold investments based on zeros in new-style splits. We note that some steps have already been taken by the companies involved. It may be in the interests of the investment trust industry to go beyond what they might regard as their legal obligations. Given the delays which some investors may inevitably face in obtaining redress through the formal mechanisms already in train, one possibility would be for the investment trust industry speedily to establish a compensation fund for small investors who have suffered losses from zeros; sums paid from the fund could in part be recovered from the firms responsible if and when a compensation liability is established.[78] Measures such as this could go a long way to restore the reputation of the industry. This is an issue to which we will continue to pay attention and to which we may wish to return if there is evidence that firms involved are not responding as they should.

47. In practice, many cases are now coming before the Financial Ombudsman Service (FOS) and are being resolved. A case can only be dealt with by the Ombudsman once the complainant has already raised the matter with the company concerned and failed to receive satisfaction. As at 22 October 2002, the Ombudsman (Mr Walter Merricks) had received 1054 complaints.[79] At that time, he suggested that the reason he had not received a greater number of cases, given the wide publicity surrounding the issue, may have been that people were uncertain whom to complain against: people were not clear whether their complaint lay against their financial adviser, or against a fund manager, or someone else. He indicated that they were having "to assist complainants, in explaining to them against whom it is possible for them sensibly to make a complaint, if that is what they wish to do".[80] Since then, the number of cases has risen to 2097, with cases continuing to come in at a rate of 50-100 per week.[81] The Ombudsman came to preliminary findings on some of the cases in December 2002, but has not yet come to final conclusions.

48. The FSA told us in July 2002 that enforcement investigations by them into the promotional and marketing material issued by authorised firms were under way. In October 2002 we were told that these inquiries were continuing,[82] and that it was hoped it would be possible to bring the first cases on possibly misleading marketing material before the Authority's Regulatory Decisions Committee around the end of 2002.[83] We understand that in fact the first cases are now expected to reach this stage in the near future. It is important that both the Financial Ombudsman Service and the FSA complete their zeros mis-selling investigations quickly.

49. It is not fully clear to us how these parallel sets of inquiries relate to each other. The FSA explained in a note to us that while its "investigations cover the conduct and behaviour of the firm generally", the FOS's inquiries "will be limited to considering only those complaints it has received from customers ... In particular, it is limited to considering each case on its own merits"; the FSA therefore did "not see a significant amount of duplication between the FSA's current investigation ... and the FOS's inquiries".[84] It explained that it was able to make material available to the FOS in certain circumstances under a Memorandum of Understanding.

50. While we accept that the two bodies are performing different roles, we can nevertheless see areas of difficulty. First, the two bodies might in practice form different judgements as to what constitutes an appropriate risk warning on what are basically the same facts, albeit one is generalised and one is specific. Secondly, in dealing with the large number of complaints in a related field, the FOS has-quite properly—grouped together similar cases. In adjudicating on these he is in practice likely to set down general principles as to expected behaviour, and in doing so there is the possibility of overlap or conflict with the role of the FSA. APCIMS noted that the "FSA and the regulatory bodies which it superseded always refused to provide a definition of risk" and expressed concern that the FOS would be making decisions on risk "without having a regulatory definition of risk [with] the clear consequence that there is potential for defining risk by hindsight".[85] Thirdly, their inquiries are pursued on different timescales, so that clarity of outcome is lacking. As APCIMS have noted "The Ombudsman timetable and the FSA's timetable are mismatched. The FSA's investigation on the marketing material is unlikely to be published until summer 2003. The Ombudsman is under pressure to decide much earlier on the cases that have been referred to [him]".[86] It could be problematic, for example, if the FSA were to find that a company had in effect been guilty of mis-selling, whereas the FOS had already found in favour of the company in the individual cases referred to him. There is a need for greater clarity as to the relationship between the different inquiries being carried out by the FSA and the Financial Services Ombudsman into the problems of mis-selling in relation to splits. We recommend that the FSA publishes a fuller statement, as a matter of urgency, explaining how the apparent conflicts between the FSA's inquiries and those of the Ombudsman can be reconciled. These problems are compounded by the fact that the FSA is also pursuing inquiries (as we discuss below) into even more serious allegations of misconduct which go beyond simple mis-selling.

51. We note that much greater information about splits than was typically the case in the past, including crucially their levels of bank borrowing and of investments in other splits, is now regularly placed in the public domain. This is due in part to the work of the AITC, as part of the sector's efforts to restore confidence, though they are dependant on cooperation from all the companies concerned.[87] Details of this work are given in the AITC's written evidence. Aberdeen themselves have also taken steps to place more information in the public domain regularly.[88] The FSA has been supporting these initiatives.[89] We commend the steps, albeit belated, taken by the investment trust industry to improve the level of information publicly available about splits' affairs, including borrowings and holdings, and the frankness of the evidence given by Mr Godfrey of the AITC in explaining the shortcomings of the splits sector.

44   Ev 136, para 18ff Back

45   Dr Adams noted that there "was a rise in the number of unit trusts investing in ZDPs" in 2001 and 2002, citing also unit trusts managed by Exeter, Framlington and Gartmore [Appendix 3]. Back

46   Though we received evidence from Mr R Plummer arguing that the warnings should not have been accepted by the FSA (as the UK Listing Authority) as adequate, and Mr P Challens noted one case where the risk warnings in the original prospectus were not repeated in the formal offer letter for a subsequent issue of shares [memoranda not printed]. Back

47   Q 266; see also Q 820 [AITC.]. Back

48   Q 317 Back

49   Q 386ff; see also documentation for Aberdeen's Enhanced Zero Trust, Ev 205. Back

50   It also contains an entry in respect of the effects of management charges, stating "Certain trusts deduct part of their management charge from capital, which increase distributable income, at the expense of capital, which will either be eroded or future growth constrained ." Back

51   Though our attention was drawn to an analysis from Smith New Court as early as 1992 which cast doubt on the adequacy of the traditional ways in which the safety of zeros were measured (see Appendix 3 [Dr Adams]). Back

52   It is important to note that the same analysis does not apply to non-zero share classes in splits which were, as noted earlier, always recognised as involving higher risk (see for example Q 597). Back

53   For a selection of such quotations, see Ev 207. Back

54   Q 375 Back

55   Q 482ff. Back

56   See Q 490ff. Back

57   Appendix 3 [Dr Adams] Back

58   Q 817 ff. and Ev 207 Back

59   Ev 126, para 3; Q 266 Back

60   Q 270 Back

61   Q 260 Back

62   Q 266 Back

63   Investment Trust Companies Annual Review, 10 January 2001. Back

64   Ev 175, para 9 Back

65   Ev 175, para 11 Back

66   Qq 686-687 Back

67   Qq 273-274 Back

68   Q 277 Back

69   Q 279 Back

70   Appendix 2, para 3.1; see also evidence from Mr P Challens [Memorandum not printed]. Back

71   Q 791; see also Q 847 ff. Back

72   Ev 175, para 12 Back

73   Aberdeen saw this as being in addition to any obligation it might be found to have to compensate anyone who had been mis-sold a zero (Q 531). Back

74   Q 395 Back

75   Q 537 Back

76   Information supplied by Aberdeen (24 January 2003) Back

77   Q 365 [FSA] Back

78   The level of losses refunded might be weighted to reflect overall market falls. Back

79   Q 368 Back

80   Q 370 Back

81   Figures as at 23 Jan 2003 (see Appendix 6) Back

82   Ev 134, para 1 Back

83   Q 337 Back

84   Appendix 5 Back

85   Appendix 2, paras 6.4-6.5 Back

86   Appendix 2, paras 6.1-6.3 Back

87   Ev 190 ff. Back

88   Aberdeen sponsor the monthly Split Capital Closed End Funds Monitor, prepared by Fundamental Data Ltd. Back

89   Q 200 Back

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