A tale of tangled assets, toxic waste and the turkeys that couldn't see Christmas coming

Attempts to rescue split capital trusts ended up resembling backstreet used-car auctions. Sam Dunn and Jason Nissé unpick the financial knots

It was a case of turkeys voting for Christmas. Shareholders in the Aberdeen Preferred Income Trust, the flagship of Aberdeen Asset Management's portfolio of split capital trusts, voted by an overwhelming majority to back a £62m rescue rights issue in January last year. It could have been a New Year hangover or simply desperation that made them ignore the warnings from industry experts and back the fundraising. They were not long in discovering the error of their ways.

The £62m raised had soon disappeared as the Trust's value plummeted by £80m in just 10 weeks during 2002. By September, Aberdeen Preferred Income had followed other splits, such as Aberdeen's Media & Income and High Income trusts and BFS's Leveraged Income Trust, into oblivion. All in all, about 20 split capital trusts collapsed as the sector fell apart during 2001-02. Thousands of investors lost their savings, prompting resignations, legal actions, parliamentary inquiries and a probe by the Financial Services Authority.

The FSA's investigation is understood to be moving slowly, hampered by the fact that split capital trusts are technically companies and not "regulated investments" in the eyes of the law. However, The Independent on Sunday has discovered that much of the focus is now on the rescue rights issues, launched by the trusts as they desperately tried to avoid going bust.

"The FSA sees this as the most profitable line of enquiry," says one well-placed source. "It has the most likely breaches of the Companies Act - though that is a matter for the Department of Trade and Industry, and the FSA will be pretty disappointed if all it does is pass the file to the DTI. The FSA is looking at the regulatory issues, the question of whether there was an attempt by fund managers to artificially inflate values, and whether launching and backing these rights issues was really 'best execution' for clients of the fund manager."

The rights issues were supposed to raise money, but nothing in the split capital trust world is so simple. Many of the trusts held shares in each other, so that when one trust launched a fundraising, the others would give it shares they held. The problem was that these shares were usually in other trusts, often ones that were also running into trouble. The result was a downward spiral, in which the falling value of one trust brought down another and another, until only so-called "toxic waste" investments were left.

According to Richard Moon, who runs a capital management company for private clients: "Share exchanges between split capital trusts, of the type practised by some distressed trusts in late 2001 and early 2002, were really a means of fooling the bankers and share-buying public into believing that an artificial pyramid could continue and that the market would bail them out.

"The truth was that many of these shares being exchanged had little or no underlying economic value, certainly much less than the prices at which they were exchanged. It was a bit like an old-fashioned backstreet used-car auction, where a ring of dealers would push up the price of some old bangers, hoping that gullible buyers would take them off their hands."

Trusts that raised money through rights issues included Aberdeen's Media & Income, which secured £46m in April 2001, and Dartmoor Trust, managed by Exeter Fund Managers, which raised £42m from a rights issue backed by stockbrokers ABN Amro in September 2001.

The last, and most controversial, rescue rights issue was for the Aberdeen Preferred Income Trust. This had been one of the largest trusts in the sector, worth over £400m in 1999. It was managed by star fund manager Christopher Fishwick, who made more than £1.8m in 2001 but has since quit the company. Mr Fishwick sat on the board of the trust, along with two other senior Aberdeen stalwarts and a number of outside directors, including property developer Harry Hyman and Neil Osborn, a director of the financial publisher Euromoney.

When Preferred Income launched its money-raising, late in 2001, it gave the impression it would bring in £72m of cash or assets to bolster its flagging balance sheet. In fact, the prospectus, sponsored by Brewin Dolphin stockbrokers, made scant reference to the fact that "stock swaps" constituted the new capital raised.

In the event, Preferred Income's major shareholders, including trusts managed by Aberdeen, BFS, Exeter and Framlington, exchanged the stock they held - highly geared income split shares, in many cases - for new Stepped Preference shares, "bolstering both sides of the balance sheet without any cash changing hands," according to a senior source.

Of the £62m raised, over £50m was in the form of this stock. These assets soon collapsed in value. By April 2002, the trust's ordinary shares were trading at just 2p, down from 119p a year before. The trust called in the receivers that September.

William Hemmings of Aberdeen Asset Management, who now looks after many of the trusts formerly managed by Mr Fishwick, argues there was nothing wrong with the stock swaps in rescue rights issues such as Preferred Income. "Stock swaps have been a feature of the entire investment trust sector, both conventionals and splits, for as long as I have worked in the sector," he says. "Investors effectively sell shares they already own - not necessarily investment trusts - in return for the new shares being issued by a trust. All such transactions that we took part in were done at mid-market price. The reason a trust such as Aberdeen Preferred Income took the stock was because it wanted the stock."

But others argue that the mid-market prices of these trusts were unreliable. As the trusts were not heavily traded and prices often depended on disclosures about "net asset value" made by the fund manager, the mid-market prices were often a poor reflection of reality.

John Newlands, founder of Newlands Fund research company in Edinburgh and formerly head of investment trust research at stockbrokers Williams de Broë, says: "There is some suggestion that managers accepted stock in lieu of cash payments at mid-market prices, knowing that the mid-market price would have been extremely difficult - if not impossible - to achieve in the real market."

Grilled by MPs in October last year, Daniel Godfrey, director-general of the Association of Investment Trust Companies, said: "We were concerned about some of the rescue issues, but there were none that could not possibly strengthen the balance sheet."

But the evidence being unearthed by the FSA could undermine Mr Godfrey's confidence, and see the chickens coming home to roost for the architects of the split capital trust scandal.