Select Committee on Treasury Third Report

D Was there more than just 'mis-selling': was there improper management?

52. There are a number of different bodies involved in the launch and management of an investment trust. In addition to the fund manager, who may have made the initial proposal for the trust, a broker will be involved to act as sponsor for companies seeking listing, advising on such matters as capital structure, the Listing Rules and the prospectus.[90] The board appointed for the trust will enter into a management agreement with a fund manager and will be responsible for the trust's affairs. There will also of course be auditors. We have received suggestions that firms amongst all these groups have questions to answer in respect of what has happened in the split sector in recent years, beyond questions of risk and mis-selling alone. At their worst, the suggestions paint a picture of a network of improper conduct amounting to corruption of which both professional and private investors have been the victims.

Collusion and conflicts of interest

53. The AITC noted that it had heard "numerous rumours and anecdotes about collusion where managers and sponsoring brokers are alleged to have agreed to support each other's new issues ... The charge is that they agreed to invest their client funds in each other's launches on a quid pro quo basis. In other words, the motivation behind certain investment decisions was not what was in the best interests of the investors who has entrusted their money to the fund manager, but was rather what was in the best commercial interests of the fund management house."[91] APCIMS also drew to our attention a number of cases in which the actions of particular boards and fund managers in respect of particular trusts raised questions as to the proper motivations for the investment decisions taken. We received similar suggestions from others also.

54. The core of these suggestions is that professionals in the splits sector worked with each other in some form of 'magic circle' to devise new splits in which others involved (fund managers, brokers, boards) would invest—to ensure a successful launch—before the shares were then sold on in the secondary market to individual investors. The players in this 'magic circle' were so encouraged by the success (and thus financial rewards) of earlier splits during a period of rising markets that they sought to develop the market further without proper care as to the risks involved. There have been particular concerns and allegations about mutual share support operations occurring after launch, as fund managers sought to shore up the position of funds facing difficulties in response to market falls.

   55. The directors forming the board of the investment trust will generally comprise people put up by the fund managers and brokers.[92] Mr Alexander provided evidence of the extent of cross-relationships between directors on the different boards investing in each others's funds, also suggesting that the extent of directors sitting on different boards gave rise to conflicts of interest questions and implied collusive behaviour;[93] He did not provide direct evidence of such behaviour but felt it was very clearly implied and that "you have seriously to question their motivation".[94] Mr Alexander claimed that there were higher cross-holdings where there were common directors than where there were not.[95] He accepted that there was nothing wrong or unlawful in itself about directors sitting on each other's boards and investing in each other's companies, but argued that there was a threat to the independence of the decision-taking by the directors (since their fiduciary duty was towards the shareholders, not to other companies) and there was a danger that the situation was not made clear to investors.[96] The FSA noted in its evidence to us that the Listing Rules require "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."[97]

56. Aberdeen sent the Committee details of the board membership of the 19 splits managed by them. While some boards had no, or only one, member who sat on other Aberdeen-managed boards, some other boards were all, or nearly all, composed of members who sat on other boards.[98] Mr Chris Fishwick was a member of 8 of the boards. We questioned Mr Fishwick about the extent of cross-membership of boards (both of Aberdeen-managed trusts and others) and about his contacts with other fund managers. He argued that his level of contacts was nothing out of the ordinary and that it was common—even desirable, in terms of expertise—for the same people to sit on different boards.[99] Aberdeen denied participating in mutual support operations.[100]

57. Brewin Dolphin denied any knowledge of a 'magic circle'[101] Mr Alexander referred to Brewin Dolphin and BFS (another fund manager broker) putting their discretionary client funds disproportionately into splits in which they were involved.[102] Mr Hall, for Brewin Dolphin, rejected this categorically, saying that "the two ... divisions of the business are kept totally separate" and that the side of the business, headed by Mr Thomas, which worked up the design of a new trust and prepared the prospectus for listing in effect dealt only with institutional investors, not private investors.[103] He also stated in respect of decisions to place funds of discretionary clients in zeros "I am totally clear ... that whether or not we were brokers to those companies had no effect on the decision".[104]

58. For Collins Stewart, Mr Crawford indicated that there might be a 'magic circle' if all it meant was that there was a small number of fund managers who ran funds of funds. He added that there would in the normal course of events be discussions between brokers and clients as to the correct time to launch a new trust, relative to the launch of other trusts, in order "to decide whether we want to compete head on with them or do we want to try and go before them or after them".[105]

59. Mr Godfrey said that the AITC had had some concerns about the likely effectiveness of some of the rescue issues, particularly where no real cash was raised but instead there were stock swaps in other splits, though he was not aware of any such issues which "could not possibly" have been effective in strengthening the company's finances. He stated that he had heard some examples of possibly dubious conduct, relating to treatment of dividends in sales of stock between different splits, which he had reported to the FSA.[106]

60. Dr Adams described what happened in this way: "As a result of splits investing in the income shares of other splits ... a so-called 'magic circle' of fund managers whose splits hold shares in one another developed. Initially, this consisted of just a handful of fund management groups subscribing for each other's shares but it widened as others joined in during the splits boom. Apart from the problem of accountability and transparency, this raised the serious question of what the inter-related structure of cross-holdings could lead to in a bear market."[107]

61. Any assessment of what has happened must take into account the fact that investments in other splits were a natural course of action, and one openly set out in their trust objectives, for a split seeking high income yields. A very great deal of the concern arises in the context of the actions taken by the various parties to maintain yields in response to the difficulties which began to arise as markets fell. Dr Adams noted that the choice faced by fund managers as to how to split burdens between zero and income shareholders gave rise to "a temptation to treat the ordinary income shareholders more favourably if they are predominantly members of the so-called 'magic circle'."[108] APCIMS argued "hindsight suggests that a small group of fund managers took advantage of the lack of transparency in the disclosure requirements, initially to conduct a price-smoothing exercise in what they perceived to be a temporary market setback, but which the FSA's investigations may show became a support operation ... This seems to have led to a systematic destruction of portfolio quality within the splits' portfolios, possibly carried out by fund managers with conflicts of interest."[109]

The questions to be answered

62. The suggestions of collusion and conflicts of interest are not the only allegations of improper conduct which have been made. The AITC also drew attention to funds allocating an inappropriate proportion of their charges to the capital account of the fund rather than the income account in possible contravention of their SORP (Statement of Recommended Accounting Practice), which requires the allocation to be in proportion to the expected returns. As noted earlier, such a practice can artificially maintain the income returns while eroding the capital base at the expense of zero shareholders (and others with an interest in the capital).

63. APCIMS noted that the board of the trust and the fund managers "are the only people with ongoing responsibilities to the trust once it has been launched and the shares placed".[110] Although the board of an investment trust might thus be expected to prevent any improper activity, there are in practice weaknesses in its position. Quite apart from the fact that many or all of the directors will initially have been put on the board at the instance of those initiating the trust—i.e. the fund manager or the broker—the fund manager would normally provide the management contract for the board to agree, and this would often contain provisions making "it difficult or expensive to sack a fund manager".[111]

64. We have been left in little doubt that there is substance in the suggestions that there was a form of 'magic circle' operating in a manner harmful to the interests of shareholders.[112] It may be that only a relatively small number of people in a small number of companies were actively involved. A range of questions must be addressed about the way in which splits were established and managed in the late 1990s and subsequently, in order to establish more clearly what improper practices went on. The questions need to be put to each fund manager, trust board, auditor and other adviser for each split, and they involve complex professional accounting and other issues. The exercise should help to reveal not only where there was misconduct, but also to identify those splits and advisers which were well managed.

65. Suggestions put to us for the kinds of question which need to be answered include:

For the fund managers of each split:

-   did the percentage of investments made in other splits remain within the guidance given to investors at all times?

-   at its peak, what proportion of the trust's assets were invested in other trusts (a) managed by you (b) managed by other companies with investments in your trust?

-   how did you assess proposed restructurings in other trusts in which your trust held investments; which ones did you (a) support and (b) oppose? What steps did you take to avoid conflicts of interest when the proposed restructuring was in another trust managed by you?

-   where the trust invested in other trusts managed by you, what steps were taken to avoid double charging?

-   were there any occasions on which you were led to understand that not supporting an issue or a restructuring would have any implications for your dealings in other areas?

-   on what occasions did you support new issues or restructurings by using investments already held or by issuing new securities (rather than cash)? In such cases, what assessment was made of whether the price was the most attractive available?

-   on what occasions did you receive securities rather than cash to support your trust's new issues or restructurings?

-   on what occasions did you engage in securities transactions on a special ex-dividend or special cum-dividend basis, and in each case what assessment was made of the effect on the capital account?

For the boards of each split capital investment trust:

-   how many of your board members are/were (a) employed by or directors of your fund manager (b) involved with companies in which your trust invested (c) neither? To what extent were different stances on major investment policy taken by the different categories of director? What steps were taken to avoid conflicts of interest for directors discussing other companies in which they had an interest?

-   where a proposed restructuring of your trust or one in which you invested was being considered, what consideration did you give to the different effects on your different classes of shareholder?

-   (for trusts with zeros) what discussions did you hold on the changing risk factors facing your zero holders as asset values fell?

-   where a restructuring in a trust in which you held investments was under consideration, to what extent were the board consulted by the fund manager?

For the brokers for each split:

-   were there any occasions on which you were involved in or learnt about agreements between individuals to support each other's issues?

-   what consideration was given in any prospectuses in which you were involved (a) to including information on 'wipe out' rates for zeros as a result of introducing bank borrowing (b) renaming zeros as 'geared' or 'subordinate' zeros in cases where there was prior bank debt or (c) giving more prominence within the documentation to the risk statements?

-   where brokers received a fee based on the total money raised (ie including bank debt) to what extent was this a change from past practice of receiving a fee only on money raised from shareholders?

For the auditors of each split

-   to what extent was the SORP governing practice on allocation of charges between capital and current accounts followed at all times?

-   to what extent did you have discussions with fund managers and brokers about charging policy before the launch of a split? Do you have any evidence of trusts being launched offshore as a way of avoiding the application of the SORP?

-   what assessment did you make of the validity of the assumptions about growth etc on which charging allocations were decided?

-   on what occasions did you come across securities transactions on a special ex-dividend or special cum-dividend basis, and what was the accounting treatment in each case? Are you aware of any case in which the same dividend was recorded as income in the accounts of two separate trusts?

-   what steps did you take to assess whether the actual starting portfolio of a split corresponded with the model portfolio described in the prospectus?

66. We considered whether we might conduct such an investigation ourselves, but we take the view that a select committee of the House is not the appropriate vehicle for such an exercise: the kind of investigation we are calling for here is more of a close examination of possible malpractice in a professional field, rather than an assessment of the political accountability of a public body. The issues involved require forensic research among competing claims.[113]

67. The FSA indicated in July 2002 that its own investigations into allegations of collusive behaviour had revealed enough information for it to be worth investigating further. They mentioned specifically stock swaps and suggested that half a dozen firms might be involved.[114] In October 2002 they indicated that a formal enforcement investigation "into the issue of collusion in the splits market" had been commenced. While they indicated that at the early stages of the investigation they were looking at relatively few firms (all fund managers) they would not say which companies were involved and that the position could change as the inquiry progressed; they could not say how long the process would take.[115] The FSA emphasised that the issues were complex and their investigation had to be detailed and thorough, with "thousands of transactions to get through".[116] Since then, the FSA has indicated that its inquiries have widened significantly, covering more than ten firms; outside external resources have been brought in and the inquiry is now the FSA's largest current investigation.[117]

68. Although the events relating to splits do give rise to issues of accountability for the Financial Services Authority in the exercise of its functions (and indirectly therefore for the Treasury), which we turn to later in this report, nonetheless we conclude that the investigations currently being undertaken by the FSA should cover all the issues on which we have called for an inquiry. We request that it publish a timetable by which this will be completed. The results of the inquiry should be published. We trust that AITC, APCIMS and all those with evidence of any possible wrongdoing, will discuss their suspicions with the FSA and make their evidence available to it. If, because of limitations in the Authority's statutory powers and responsibilities in respect of investment trusts themselves,[118] the FSA cannot perform the task, then it is for the Treasury to establish a vehicle which can.

69. The FSA set out to us their powers should they find there has been misconduct of a significant kind. These include criminal prosecutions, financial penalties, and withdrawal of a firm's or individuals' authorisation. They could also include restitution orders, if these are more appropriate than awards by the Financial Ombudsman Service or a scheme under section 404 of the Financial Services and Markets Act 2000.[119] Clearly, if there are findings that individual firms or practitioners have been guilty of any significant misconduct, then very severe penalties would be appropriate and the case for redress for investors who have suffered losses will go beyond simple compensation for possible mis-selling. Not only those who invested in risky products without adequate warning but also those who invested in products knowing (or who should have known) there was risk, such as investors in the income shares in splits and professional investors in zeros, may also be entitled to redress. Again, however, there are questions about how these inquiries by the FSA are to link in with those being conducted both by the FSA itself and the Financial Ombudsman Service into mis-selling.

Reform of corporate governance

70. The events relating to splits, and the fact that questions about possible corruption have had to be asked, raise the question of whether the existing rules on corporate governance are satisfactory. APCIMS suggested that "Governance issues have not always been addressed appropriately by managers and boards. From fee-charging to the over-seeing of illiquid or connected investments, from the response to rapidly changing market conditions to risk assessment and guidance, investors' realistic expectations have not been met. Defining what a board's job entails, and who should in future be regarded as truly independent, is merely the necessary start to this process."[120] They proposed a number of measures for reform of corporate governance, including the creation of a legal obligation on boards and fund managers to act in accordance with "the reasonable expectations of an independent investor."[121]

71. The AITC also have recognised the importance of governance issues, and have been giving active consideration to the question of what reforms are necessary. They note some of the unusual features of investment trusts compared to other companies, including the fact that the shareholders and customers of the company are the same, and the fact that the fund manager can have a disproportionate influence over the board compared to the position of shareholders.

72. The FSA, as part of its response to events, has been examining what steps it might take, in its capacity as the UK Listing Authority, to improve regulation of this area. In January 2003 it issued a Consultation Paper of which the main proposals are:

- a limit of 10% on the amount of a listed investment company's gross assets that can be invested in other investment companies which themselves invest in a portfolio of investments and whose investment policies allow investing in other such companies or funds;

- mandating the inclusion of risk warnings in listing documents for investment companies and identifying some of the specific issues with which they should deal;

- enhancements to the Conduct of Business risk warnings provided to those investors proposing to acquire holdings in geared investment companies or investment companies that propose to invest in geared investment companies themselves;

- monthly disclosure of any investment that exceeds a given percentage of the value of the portfolio of an investment company, together with 100% disclosure of all funds invested in other investment entities;

- changes to the relationship between an investment company and its manager;

- a requirement for all material changes to the company's investment policy to receive prior shareholder approval.[122]

73. The consultation period runs until April 2003. These proposals, and the more detailed suggestions from APCIMS and the AITC came out after we had completed taking evidence for this inquiry, so we have not had an opportunity to question affected parties on them. Nevertheless, we welcome the swift preparation and issue of a consultation paper by the FSA on improvements to the Listing Rules as they affect investment companies. We think it likely that changes in the areas and directions suggested will be appropriate. We think that the issues discussed in this Report, including in particular the dangers of cross-membership of boards and issues of transparency, should be taken into account. It may be that some improvements can be made by voluntary agreement with the industry, so long as there is complete participation in any agreement from the whole of the sector. We trust that the FSA will receive constructive cooperation from all sides (both representatives of splits and of the individual investor) in refining and implementing any changes in the Listing Rules which take place. We would expect swift action after the consultation period is over. Of course, in some respects the measures will amount to shutting the stable door after the horse has bolted.

90   Ev 175, para 6 [Brewin Dolphin]; Qq 646, 652 ff. Back

91   Ev 33, para 4.23; Qq 149-156 Back

92   Appendix 3, paras 2.4, 2.6 Back

93   Ev 127; Q 258 Back

94   Qq 258-259 Back

95   Qq 261-3 Back

96   Q 290 Back

97   Ev 149, para 9 Back

98   Ev 150 ff. There is no clear correlation between the degree of cross­membership of boards and the extent to which trusts are in difficulties, or between those splits set up in/since the late 90s and those with high cross­memberships. Further information on the extent of cross-membership of boards, managed by different fund managers, is given at para 3.10 of the FSA's May 2002 Update report on splits. Back

99   Q 423 ff. Back

100   Q 624 ff. Back

101   Q 743 ff. Back

102   Ev 126 Back

103   Qq 663, 674 ff. Back

104   Q 757. In respect of the taking up by Brewin Dolphin's clients of Brewin Dolphin-sponsored zeros at the time of launch, the figures involved were relatively small (only 577 clients, investing sums representing 0.07% of total funds) though we note that the rate amongst discretionary clients was nearly four times that amongst advisory clients (0.15% of discretionary client funds against 0.04% of advisory client funds) (Ev 217, paras 3-5). Back

105   Q 748 Back

106   Q 821 ff; Q 850 Back

107   Appendix 3 [Dr Adams] Back

108   Ibid. Back

109   Appendix 2, para 9.2 Back

110   Appendix 2, para 2.10 Back

111   Appendix 2, para 2.6 Back

112   See for example Appendix 7. Back

113   We note for example claims by Limbort Ltd against Collins Stewart in connection with the CI Income Fund, a split managed by Collins Stewart which has since had its shares suspended [Memorandum not printed]; these claims are challenged by Collins Stewart in a memorandum to the Committee (Ev 218). Back

114   Qq 205-208 Back

115   Ev 134, para 2 ff. and Qq 301-303 Back

116   Q 303 Back

117   Speech by Mr John Tiner to AITC 4 February 2003. Back

118   We discuss this below at paragraphs 75-78. Back

119   Ev 134, paras 6-9; section 404 allows for the setting up of a scheme for systematically reviewing past business of authorised persons and establishing amounts payable by way of compensation. Back

120   Appendix 2, para 3.2 Back

121   Appendix 2 (paras 9.4-9.5 and appendix 3) Back

122   FSA Consultation Paper No 164 January 2003 Back

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