UK: Split Capital Investment Trusts

The Financial Services Authority has released an update initial report on its enquiry into the split capital investment trust market. On the whole this response has been a measured and thoughtful one. In particular, the FSA has not responded to the "knee jerk" call for immediate extension of regulation and appears to recognise that many of the problems affecting certain splits stem from adverse market conditions.

Nevertheless, the FSA has highlighted a number of areas where it is undertaking further investigation and has raised a number of issues which are pertinent to the splits industry going forward.

Mis-selling

The FSA has indicated that it is investigating a number of individual cases of mis-selling. Mis-selling can, in theory, arise at any point throughout the life of a split, from initial public offering by way of prospectus, to activities of IFAs and private client brokers at initial public offering or thereafter, to marketing documentation produced by investment managers. The FSA appears to be focussing its attention primarily on the latter two situations.

Firms which are the subject of FSA investigation will need to ensure that they are appropriately advised. Our experience suggests that it is generally beneficial to engage with the FSA at the earliest possible time, even prior to the commencement of a formal investigation. The FSA may use its broad powers under FSMA 2000 to require the production of information or documents or it may appoint persons to investigate on its behalf and prepare a report of their findings. It will then decide whether to instigate disciplinary proceedings. Investigations can be lengthy and dealing with the FSA is not always straightforward. The disciplinary measures available to the FSA include the power to publicly censure or fine authorised or approved persons, listed companies and directors of listed companies. Other measures available to the FSA include the variation or cancellation of permission, the withdrawal of authorisation, the withdrawal of an individual's status as an authorised person and, in the case of listed companies, suspension or cancellation of listing. Further complexity is added by the potential overlap between investigation and enforcement by the FSA and litigation by disappointed investors. Herbert Smith already has experience of dealing with FSA investigations under the new regime to add to its extensive experience of handling contentious regulatory matters.

Going forward, how can procedures be improved? Boards of investment trust companies should be mindful that marketing material produced by the company's investment manager will be seen to speak on behalf of their company whether or not the company has itself been involved in producing it. They may, therefore, wish to provide in their management agreement that marketing material is to be produced in accordance with guidelines agreed with the board. This would allow the board to seek their own advice should they have any concerns over consistency of content as compared with the company's own documentation, being principally their prospectus and report and accounts.

Boards may also give greater thought to how risk factors pertinent to their company and the finer detail of their company’s investment policy are disclosed in their public documentation. While this is often an area where the company's investment manager and financial advisers, assisted by the legal advisers, take the lead, directors can play a valuable role here in assessing the content of investor information from a slightly more detached standpoint.

The FSA is also concerned about the level of information which IFAs and private client brokers are giving to their clients when recommending shares in splits. This, it is suggested, may have resulted in IFAs/brokers failing to meet their obligations to ensure suitability when recommending products as a result of their own failure properly to appreciate the particular risk profile of the product. While this is a difficult issue for any one investment trust to deal with, investment managers may wish to think again about how information is disseminated to IFAs and private clients, given the adverse publicity that can result. A number of investment managers have sought to introduce “risk ratings” for their investment trusts but should investment managers be giving more explicit information about the risk profile of each product marketed by them to IFAs?

Management of splits

The FSA has been looking in some detail at the implications of "stock swaps" in particular and the suggestion of collusive behaviour between certain investment managers generally. No firm conclusions have been reached and further investigation is underway. The FSA has, however, accepted that where swaps are undertaken at market value and in accordance with the current investment policy, such practices are unlikely to be considered problematic.

When advising companies wishing to enter stock swaps and receive stock as part of a money raising, best practice is: (1) no stock swap should ever be undertaken unless the quality of the stocks to be acquired is acceptable to the investment manager, (2) stocks should be acquired at a market value and (3) the managers should explain to the board what stocks are proposed to be acquired in this way and why. For companies prepared to take new shares on a stock swap basis the advice is the same: do not accept shares under a stock swap where you would not have acquired such shares had you had the cash to do so.

To these we would add one further point. Boards should give consideration to amending the terms of their existing management agreement to require the prior consent of the board to the use of stock swaps or the acquisition of shares issued by other investment companies with cross-holdings above a specified level. This would place such activities in the same category as, for example, the use of derivatives which is generally under stricter supervision by the board.

Corporate governance

The surprise of the current FSA statement is the extent to which corporate governance has taken prominence. This reflects wider concerns on governance arising out of the collapse of Enron and other high profile failures

The FSA has identified independence as a particular cause for concern. Respondents to the discussion paper appear to be mixed in their views as to whether or not boards are currently independent. It is, however, undoubtedly the case that a number of directors do sit on more than one split board. Where these are spread over companies managed by a number of investment managers the FSA seems to be less concerned but it is concerned where a director sits on the boards of a number of companies managed by one manager. Our view on this is that this latter situation is actually less likely to be problematic since such a director will almost always be a representative of the investment manager and as such is clearly conflicted, and should therefore abstain, on issues relating to the investment manager and its stable of investment trusts. Such an individual would not be expected to take part in discussions relating to the investment manager unless invited to do so by the independent directors.

The FSA is also concerned that the particular complexities of managing a split may not, in all cases, be properly addressed by board composition. A point not addressed, however, and one which is a significant issue, particularly in light of the recent slump in performance, is the difficulties which many boards have in fairly balancing the interests of the various classes of share within their company. This is indeed a highly complicated legal issue and one on which we have been asked to advise a number of boards recently. The exact response can only be arrived at having regard to the term of the initial prospectus, specific rights of the shares concerned, the current balance sheet position and the length of time remaining before the scheduled winding-up.

We believe that in the current climate, it is opportune for boards to consider a number of these issues in greater detail. If, as the FSA has indicated, the role of directors of investment trust companies is to be brought to the attention of Derek Higgs in the context of his more wide-ranging investigation of corporate governance practices in the UK, boards may consider it appropriate to identify and address areas for concern at this stage. A legal and regulatory "audit" may be appropriate.

Conclusions

The problems in the splits sector would not appear to be fully resolved yet. While the FSA's initial view is, perhaps, less alarmist than might have been feared, a number of significant investigations remain in place. However, the threat of increased regulation appears, for the moment, to have receded.

Nevertheless the sector remains becalmed. Until such time as asset values begin to recover, we anticipate that further restructurings of capital and debt will be inevitable in order to enable some splits to go forward and seek to rebuild shareholder value.

We await with interest the further reports of the FSA, and in particular to see whether the FSA considers "splits mis-selling" does indeed compare with the previous pensions and with-profits endowment issues, with which it as been grouped by some commentators.

© Herbert Smith 2002

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