the brokers face probe about selling of ex-dividend shares to splits
The FSA is investigating questionable activities by brokers and other companies within the split capital sector following revelations from AITC director-general Daniel Godfrey.
Godfrey told the Treasury Committee Inquiry into split capital trusts, chaired by John McFall MP, that he was aware of market-makers selling ex-dividend shares to splits with special cum dividends attached, which increased the sale price by an equal amount.
The broker would then rebate the dividend amount to the split, which would declare it as dividend income.
This arrangement meant the splits were effectively paying dividends to themselves, providing on-paper income at the expense of uncovered zeroholders, from whom value was effectively transferred to holders of income shares.
Godfrey also alleged a second questionable activity. He said some trusts marketed on the basis of models that included only cash subscriptions also accepted swaps for other splits' shares, thereby increasing cross-holdings and substantially altering the starting portfolio from the model.
He told the Treasury committee he had alerted the FSA to the 'alleged dubious conduct' and the FSA confirmed it is examining the allegations as part of its ongoing investigations into collusion and misleading marketing practices within the split-cap sector.
John Hall, chief executive of leading splits broker Brewin Dolphin, told the committee he had never told fund managers a subscription in a new split might be reciprocated and said he was unaware of any magic circle of brokers and fund managers operating in the market to support each other's trust launches.
'As far as I am concerned there is no magic circle,' he said. 'I would go to the stake saying that if there was one, we didn't know about it.'
Also appearing before the committee was Aberdeen Asset Management's former head of global closed-end funds Chris Fishwick, who apologised to investors who had suffered in the collapse of the splits sector.
'I'm very, very sorry people lost money,' he said.
Fishwick also apologised for his absence at a previous hearing, when Aberdeen drew flak from the committee for not bringing its most highly-paid executive and chief architect of its splits stable, the largest in the market.
Fishwick defended Aberdeen's marketing of zero dividend preference shares as low-risk investments that could weather downturns, saying the regulator, the media and the rest of the financial services industry were in agreement on the risks at the time.
However, he conceded that with hindsight they were wrong, and chief executive Martin Gilbert said that were they to market the same products now, they would not push them as low-risk.
'If we are found to have mis-sold zeros to anyone, we will compensate them,' Gilbert said.
He also reiterated his commitment to an uplift package for Aberdeen's Progressive Growth unit trust, which was invested in splits, to commence in 2005.
'We advertised Progressive Growth with a low-risk warning, and that is where we feel a certain obligation to unitholders,' he said.
However, he added at the time the trust was being sold, there was strong evidence to support the low-risk claim.
Gary Marshall, managing director of Aberdeen Unit Trust Managers, denied Aberdeen is getting out of the retail sector. He said he was aware of media speculation the unit trust and Oeic business was to be sold, but the board had no such plans.
Fishwick said he started to worry about the fate of splits around 18 months ago as the bear market started to gain pace, and blamed the high level of gearing in the trusts for amplifying the problem.
He said Aberdeen had acted as quickly as it could to de-gear its splits, but had been unable to do so quickly enough. Merging of distressed trusts also failed to arrest the decline.
Falling interest rates in the wake of the September 2001 terrorist attacks also increased loan breakage costs for trusts repaying bank debt, he said.
Fishwick forecast further woe for the sector, saying 10 to 15 more splits are likely to join the 19 already in suspension or administration unless markets recover in the near term.
Asked what he had learnt from the experience, Fishwick replied he did not previously realise the importance of confidence to the sector.
'I was surprised how confidence in this sector has been damaged so much,' he said.
'I have learnt a lot about the crisis of confidence, which we should probably have seen coming earlier. But I would not have believed you could have a situation where investors wouldn't buy any investment trusts and everyone was a seller.'
He attributed the impact on confidence to a lack of understanding on the part of investors. 'The lesson I've learnt is that there needs to be a mass education program for investors for all types of products. I'm astounded how little people understand,' he said.
Fishwick denied involvement in any corrupt activities and defended his remuneration ' the highest of any Aberdeen executive ' pointing out it was set by the company directors and approved by shareholders.
Asked whether he jumped or was pushed from his position when he announced his departure from Aberdeen in October, Fishwick said his career direction change was a mutual decision after the media attention centred on him became unbearable.
One particular area the committee focused on was the use of bank debt for gearing, which accelerated from early 1999 as interest rates fell to below the cost of zeros, making them a more attractive source of cash.
Fishwick conceded trust managers should have made it clearer that the decision to take on bank debt, which ranks ahead of zeros and could be called in the event a market downturn led to a breach of covenants, amounted to a fundamental change in the risk profile of splits.
David Thomas, head of the investment trust team at brokers Brewin Dolphin, said he didn't think the inclusion of bank debt fundamentally changed splits as the level of cover for the borrowings and the zeros appeared ample and not unsafe at the time.
Asked whether he realised that in opting for cheaper bank debt rather than zeros, managers were making the trusts vulnerable to having the loan called once markets started to fall, Thomas replied 'nobody noticed that ¦ including me.'
The AITC's Godfrey later said he doubted most advisers would have had the competence to spot the problem already missed by fund managers.
Market makers sold ex dividend shares to splits with cum-dividends attached.
Splits share swaps distorted portfolios investors thought they were buying.
Three funds to watch