JOHN TINER
4 FEBRUARY 2003

Good afternoon. May I begin by thanking the AITC for again inviting me to speak at its conference for directors. When I spoke last year, I referred to the dismal investment conditions with the FTSE 100 at a level of 5,167 and having reached a low of 4,400 following the attacks on 9/11. Well we in this room are fully aware of what has happened to world stock markets since this time last year - - on Friday the FTSE 100 closed at 3,567 having dipped below 3,400 for a few minutes last Wednesday morning. The outlook for investors and for firms continue to look worrying as the prolonged uncertainty about whether or when the US will declare war on Iraq and fears about the global economy have created a climate of nervousness among both institutional and private investors, keeping the buyers of stocks at bay. It has to be said, however, that many of the larger institutional investors appear to view the equity markets as good value at, and perhaps even quite a bit above, its current level.

In the UK equity market there is an important phenomenon, not replicated in most major markets around the world – that is the high level of equity weightings in the portfolios of UK life insurance firms. On Friday, I wrote to the Chief Executives of all UK life insurance firms setting out the FSA’s intentions for reforming the way regulatory capital is determined and inviting those firms whose financial position is sound to apply to the FSA for waivers for certain aspects of our rules, pending the introduction of the new methodology, planned for 1 January 2004. The FSA is aware of the dangers of pro-cyclicality and that is one of the reasons why we want to change the regime. Life insurance firms, like other financial firms, should hold capital sufficient to protect their customers, taking into account the risk profile of their assets, and the estimated levels of their liabilities and other financial uncertainties. If they judge that holding a certain level of equities in their portfolios represents good value and is in the best interests of their policyholders, then provided they have enough capital to support such asset allocations, the regulations alone should not force them to sell with a falling market, potentially creating a downward spiral. At this point you are probably thinking that I have become confused, believing that I am speaking to a life insurance audience – but no, that is tomorrow’s job – as investment professionals, I thought I should take this opportunity to give you a very brief outline of our thinking behind my letter to CEOs at the end of last week.

My remarks last year were also against a background of increasing interest in the investment trust sector - but, sadly, not for the right reasons.

It may seem strange to think now, but even a year ago, relatively few people outside the industry could have told you what a split capital investment trust was, let alone give any meaningful analysis of what the potential risks were of investing in them. My postbag suggests the term "split cap" has now become a byword for investors who feel – rightly or wrongly – that they have been conned out of their hard-earned savings. As a result, the investment trust industry has lost the confidence of those it is there to serve. This is in no one’s interest and so the question, which I propose to address today, is how to win it back?

As I have repeatedly pointed out to the industry's critics, in the media and elsewhere, the investment trust sector as a whole is an efficient investment vehicle for risk-aware customers who want to invest in equity markets. The problems that have infected one, relatively small, sector of the market must not be allowed to spread to the whole sector and any regulatory response to those localised problems has to take into account the possible impact elsewhere.

Perhaps it's worth re-capping on what has happened in the last year. At the time of last year's conference there were clear signs that a number of Split Capital Investment Trusts were coming under pressure. Here we are one year on and 19 Splits (including Highly Geared Ordinary Investment Trusts) have been suspended (of which 9 have also appointed receivers) and 50 trusts have either suspended or cut their dividends. Since 31 March 2002 the market cap of the Investment Trust sector has fallen by 31% to £34 billion and the Split Cap sector has fallen 47% to just £7 billion. Debt in the Split Cap sector halved last year with £2.3 billion being repaid.

What happened? Many of the investment managers with whom we discussed this problem attributed the collapse of the Splits market to market conditions following September 11. However, few suggested that perhaps the collapse was due to the weak structure of certain trusts, including the high levels of gearing and cross-holding.

That strikes me as a state of denial. I think it's fair to say that no one anticipated the speed with which the weaker trusts fell. But to blame those events purely on the market is, I think, to bury one's head in the sand about the real problem and the real causes. The inflated levels of gearing and cross-holding in the sector of the market created a dangerous cocktail, which the falling market exposed.

So, what did the FSA do? Last year, at this conference, I announced that we were about to launch an enquiry into Split Capital Investment Trusts and to embark on a series of visits to investment managers, investment advisers, stockbrokers and banks. I added that during our visits to investment managers we would be examining transaction data and the way Splits were being marketed.

During our visits to intermediaries, it became apparent that they relied heavily on the marketing material provided by the managers, and I think it is fair to say that some of this promotional material glorified the product, using headline-grabbing claims, which I’m sure you will have all now seen, and describing Zeros as low risk (when, in some cases, the shares were anything but). Our concern has been to investigate whether this promotional material gave fair and clear warnings of the potential downside risk. It is important to remember that this is for a product which has often been sold as a savings vehicle for important occasions such as family education or simply to protect capital when a consumer has received a lump sum, perhaps for example, or redundancy.

Explaining risk is even more crucial where trusts introduce gearing on gearing or their main source of income is from other Split income shares held in the portfolio who in turn invest in other split income shares and so on. Concerns have also been raised about the practice of manufactured dividends, which can transfer value from zeros to income shares.

It is questionable whether all directors of these splits were fully conversant with the content of the underlying portfolios, the added risk factor, and whether they thought to query the structure. Stock swaps appeared to be an accepted practice in the industry but were they in the best interest of investors, and did anyone question the activity?

The FSA’s visits and information gathering were concluded in the first quarter of last year, and resulted in the FSA issuing a Policy Statement in May. In that statement, we announced that we planned to -

  • investigate specific cases relating to alleged collusive behaviour within or between managers of Splits; and
  • investigate the ways in which the products were sold to retail investors, including the marketing material produced.

Let me give you as much of an update as I can on that work. You'll appreciate that the Financial Services and Markets Act, quite rightly, prevents us from disclosing confidential information about any ongoing investigation. Those who are the subject of investigation are entitled to fair treatment, generally including confidentiality until the completion of the case. But I can make a few general comments.

On the allegations of collusion between fund managers to invest in each other's funds purely to sustain the price of those funds, our approach in this investigation has been very focused - starting small and growing bigger - following the spider’s web, if you like. A small number of firms were formally referred to our enforcement division for investigation last autumn. Last month the scale of that investigation was increased significantly to encompass many more firms, covering both managers and sponsors [brokers]. How many firms are being investigated? Well, when I was asked that question by the Treasury Select Committee last year I said the number could be counted on one hand. I have two hands and they are now both full. But it is still at the investigation stage. We have not reached concluded views about any breaches.

As you'll appreciate, this is a complex investigation, but it is an absolute priority for the FSA and resources being applied to it have been substantially increased. We have also brought in some external resources to work on the case. In terms of resources, this is our largest current investigation.

As for the timeframe - again, I'm sure you all know that our enforcement process is set out in the Financial Services and Markets Act and contains numerous checks and balances to ensure that the FSA cannot be judge, jury and executioner. That, inevitably, means that to the outside world there appears a long delay between the FSA beginning and concluding an investigation. In fact, once the forensic investigation and the case determination work is complete, the provisions of the Act mean there can be an interval of several months before final decisions can taken by the FSA’s Regulatory Decisions Committee or, if there is an appeal, by the Financial Services and Markets Tribunal, administered by the Lord Chancellor’s Office.

On allegations of misleading marketing material, our formal investigations have been in train since May of last year, focussing both on providers and intermediaries.

Of course, our Enforcement powers give us the ability to order restitution to consumers. Ensuring consumers receive compensation, where it is due, is a key and urgent aim for us. But the Enforcement route is not the only route for this to happen. Individual investors can, of course, complain to the Financial Ombudsman Service. Over 2000 investors have now complained to the FOS, and between 50 and 100 cases are notified each week. The FOS has made a preliminary ruling on a number of ‘lead’ cases. Those decisions have not been made public as it is open to the parties to make further representations. Of course, it is also open to firms to compensate investors without waiting to be ordered to do so, either by the regulator or the Ombudsman and we would encourage them to do so, without delay. Such an act of faith would go some way to restoring the sector’s tarnished image.

And so before turning to the future, I will close my remarks on addressing the problems of the past by summarising the position on compensation. Consumers who have suffered financial loss due to wrongful acts by firms may be compensated by the firm itself or by order of the Ombudsman. If our enforcement actions are successful we can order firms to provide restitution to their customers. But it remains possible that some recurring cases do not find appropriate compensation, either because of the Ombudsman limit (£100,000) or because they bought direct through the market. As my Chairman said to the TSC in November, it is hard to tell at this stage whether there will be such cases. And he also noted that it is not an area for the FSA to intervene directly. We would urge the AITC and the investment trust industry to take steps to fill this gap, in the interests of restoring consumer confidence in this sector.

 

All this work is, of course, backward looking and dealing with problems that have already occurred. Looking forward, it is in all our interests to take whatever steps are necessary to reduce the likelihood that similar problems could occur in the future and to restore confidence in the investment trust sector. Key to this is ensuring that we have the right calibre of people on the Boards of investment trusts. Acting in the interests of investors, who are, need I remind you, the shareholders in their companies. They must not be influenced – and must be seen not to be influenced – by any other interests than those of their investors. In other words, they must be truly independent.

I told the TSC in October that I thought there might be a "gap in regulation" as regards Investment Trusts. We had said previously in May last year, that we would consider, in our fundamental review of the Listing rules, if any tightening is required in the definition of "independent", for the purposes of establishing a majority of independent directors of Investment Trust Companies. We can achieve a certain amount through amendments to the listing rules, but bringing Investment Trusts into the full panoply of product regulation along the lines of Open Ended Investment Companies would require legislative change and so is a matter for the Government.

While the current Listing Rules describe those that will be deemed not to be independent, there is a perception that the independence of some directors may be compromised where they have close links with the investment manager. Some commentators have raised concerns about independence where, for example, an individual is a director of a number of investment companies managed by the same investment manager. Our own investigations have led us to share these concerns. Our recently published consultation paper, CP164, notes that a real lack of independence may interfere with the judgement of the directors, or at least make conflicts of interest more common, and more difficult, than they need be.

To deal with the perception that the relationship between the directors of investment companies and their investment managers has become too close, we believe that some additional practical safeguards are necessary. The proposed changes aim to deal with the fall in market confidence that has partly been caused by market participants’ fears that directors do not always feel able to make objective decisions if these would conflict with the interests of the investment manager.

Although I have been unable to be here all day and to hear the debate on the AITC’s draft corporate governance Code, Daniel Godfrey was kind enough to send me a draft of what he was to be saying. He has argued that individuals sitting on more than one Board can be independent and can be valuable to each Board. This may well be true, but we believe that the perceptions of investors are an important factor here if confidence is to be restored and the current perception, right or wrong, is that multiple directorships create conflict. If a perception of conflict can be avoided, and it can, we believe that it should be.

Daniel has also discussed the differences between the AITC draft code and the proposals recently made by Derek Higgs for changes to the Combined Code. It is important to note that investment companies, and investment trusts, are slightly different animals to the standard quoted company and do not have the usual executive and non-executive director roles. Indeed, the different nature of the independent and non-independent directors of investment companies is something that Derek Higgs has recognised in conversations we at the FSA have had with him and his team. I see no reason why any differences between provisions of the AITC code, which supplement and back up the regime we propose to introduce, should not be perfectly acceptable to Higgs and satisfactorily explained and justified.

The introduction of the FSA’s proposals is likely to impact on existing listed investment companies where, for example, a representative from the investment manager is on the board. They may also result in the need to remove or appoint additional board members to re-balance the board to ensure that it contains the appropriate number of independent directors.

It is likely to take some time for existing listed companies to become compliant with this proposal in relation to the structure of the board. Therefore, we propose that any new rules will come into effect twelve months from the date that the rules are made.

The proposed changes to the Listing Rules are not restricted to dealing with the question of fund managers' independence. We also wish to achieve greater clarity in respect of investment policy to be followed, gearing, and other risks and how they will be mitigated. As part of the avoidance of inappropriate or excessive risk, we are proposing a limit on the percentage of total assets that can be invested in other funds.

And to mitigate the risk that the investor who puts his money into a trust with a low-risk strategy suddenly discovers that the strategy has changed and he is now in a high-risk venture, we propose a new rule requiring that shareholders approve any material change in investment policy. At present shareholders have to approve a change only in the first three years.

Finally, we propose the introduction of a further requirement for appropriate disclosures to be included in a prominent place in any prospectus or listing particulars. This would be in a language that investors will clearly understand.

This requirement is to ensure that retail investors and their advisers have the fullest possible information about potential risks before they invest. The present Listing Rules require the inclusion of risk factors in prospectuses only in very limited circumstances. These are primarily in respect of start-up companies with no real track record which, because of the nature of their business and their need to raise capital at an early stage of their development, are particularly high-risk.

To minimise the legal risk to themselves, issuers and their sponsors are, typically, anxious to describe in considerable detail the important features of their product. As part of our work, we reviewed a sample of investment company prospectuses issued in the UK between 1998 and 2002, together with those of trusts that had been suspended by Autumn of 2002. As is typical, as issuers became aware of and developed their understanding of the main issues, their description of particular features and risks of their offering also changed.

We found that information was consistently provided in prospectuses by issuers which (a) proposed to borrow (i.e. gear up) and (b) intended to use the company’s funds to buy the shares of other investment companies. Issuers also regularly indicated that there were risks to capital. But, looking ahead, we judge that the FSA could require more to be done than now to ensure that the implications of these strategies and the risks involved are described in plain English.

The first time a "systemic risk" warning relating to cross-holdings was included in a UK prospectus was on 23 February 2001. This prospectus was for a dual listing – i.e. for issue simultaneously in London and Guernsey. This warning did not become a standard feature of prospectuses approved solely in London, though it was included in one such prospectus. The warning was repeated in subsequent dual listings of companies issued in Guernsey and London.

We are aware of eight companies that carried this "more explicit" risk warning in their listing particulars. Three of these companies, each of which was fully subscribed, have since been suspended. One company, which has also suspended its shares, withdrew its restructuring document due to material deterioration in the net asset values of the shares held in its portfolio. Another company issued a prospectus in order to reconstruct and effect a merger with an investment company managed by the same fund manager. The remaining three companies – whose shares are still being traded – were also fully subscribed.

Our analysis raises the question of whether investors do, in fact, take sufficient notice of risk warnings in complex documents. Some may conclude, from the fact that even offers that were promoted with appropriate warnings were well-subscribed, that they do not. That is no reason for not including them. Ultimately, investors must take responsibility for their own decisions, but those decisions must be informed ones, made with the benefit of the fullest and most realistic assessment possible of potential risk and reward. Caveat emptor must not absolve company directors and sponsors from responsibility for the prospectus contents.

Needless to say, the FSA welcomes comments on the Consultation Paper. By 14 April, please. We do not expect all of our proposals to be welcomed with open arms, but we do believe that their introduction is necessary to return confidence to the investment company sector as a whole and to the Splits sub-sector in particular. Not all Splits are bad and the better ones will be helped by these proposals. We will listen to objections and suggestions, but they will have to be very convincing if we are to be persuaded to change our plans.

So, to conclude. The saga of the Splits sector over the past couple of years has been a sorry one, and many investors have lost money.

It was not just the market fell. All the falling markets did was - to borrow an analogy from Warren Buffet - draw out the tide and expose those who had apparently been swimming without any shorts on.

No one would suggest that there should be compensation solely because the stock market has lost value over the last few years. The fact that some participants in the market appear to have made their activities somewhat opaque, and the suggestions that some of them may have acted in their own interests rather than in the clear interest of their investors, has, however, made a difficult situation for investors worse and has led to the good being infected by the bad.

We are continuing to investigate the activities of certain firms and people and will take appropriate action against them. We are not proposing changes only to rules affecting Splits in a somewhat simplistic response to the apparent behaviour of a few players in that sub-sector; we are proposing changes to the rules affecting the sector as a whole because we believe that the need to do so is a feature of the whole sector and that the changes will increase confidence in that sector.

I am sure you will agree that, as I said before, it is in all our interests to restore confidence to this very important and, traditionally, innovative sector of the financial markets. I hope that we will all be able to work together to achieve this.

Thank you.

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