FSA delves deeper into split cap sector's Magic Circle and mis-selling scandal

Thousands may be in line for compensation over products sold as being safe as houses

Internal links

Outlook

The City watchdog turned up the heat on the troubled split capital investment trust sector yesterday, declaring that thousands of investors had been mis-sold products and may be in line for compensation.

For the last couple of months, the Financial Services Authority has been having gentle chats with companies to work out why split caps have come so unstuck. Yesterday, the softly, softly approach ended and the regulator began an official investigation into whether split cap companies have committed some serious misdemeanours.

John Tiner, the managing director of the FSA and this project's chief inquisitor, said: "We have not just launched this investigation on a whim. We have gathered evidence and information to support the view that a minority of funds have created a contagious cocktail of cross-holdings and high borrowings."

The two main areas of concern that the FSA has identified are selling practices, by companies themselves and by financial advisers, and the way split caps have been managed, by directors who frequently sit on a web of boards in the sector and who have overseen increasing cross-investment between funds and burgeoning amounts of borrowing.

The FSA has already concluded that there is evidence of inappropriate selling, where investors were led to believe they were exposing themselves to low-risk funds ­ investments which, in the words of one split cap expert, "have more safety features than a Volvo".

The recent performance of split caps, which are a type of investment trust and contain three different types of shares, has highlighted the fact that the truth is very different. The share prices of most splits has plummeted in the last few months and out of 134 splits currently on the market, 11 have suspended their dividend, five have been forced to restructure due to burgeoning bank debt and one has gone bust. As well as triggering an investigation by the FSA, the downwards trend has also led some investors to consider legal action against split cap companies.

The regulator's team of investigators is in the process of visiting 34 firms in order to try to gain a clearer picture of the level of mis-selling. Of the 34, 20 companies to be visited are independent financial advisers, indicating that the FSA's fears are just as focused on the sales practices of brokers as on the official brochures produced by the split cap companies.

Mr Tiner said: "Sadly, our inquiries reveal that in many cases marketing material provided to investors and advisers has not adequately disclosed or explained the risks of investing in certain splits. We are also concerned that advisers have not always given their clients a detailed explanation of the risk."

Mr Tiner's team will now put their forensic hats on and, if they believe split cap companies have breached the FSA's conduct of business rules, they will exert their penalising powers.

These could include imposing unlimited fines on both companies and individual directors, plus a public rebuke. The regulator may also order offending companies to pay compensation to thousands of disgruntled investors.

The other prong of the FSA's investigation is to question the competence and independence of directors of split caps. One potential problem it has highlighted is that a relatively small number of directors sit on numerous boards, the so-called "magic circle".

One such director is Tony Reid, chief executive of BFS Investment. Mr Reid was not named by the FSA but his record ­ of sitting on 15 different boards ­ was held up by the regulator as an example of potential conflict of interest.

Another director with a large number of positions is Chris Fishwick, at Aberdeen Asset Management, who sits on about half of the 19 split cap funds managed by his company. The FSA also said that 16 people are on the board of more than one split.

Mr Tiner believes that more evidence is required to prove the allegation of critics of split caps that members of the magic circle have colluded in order to inflate their funds' share prices.

But he says there is cause for concern: "We need more data on what actually is happening when directors are on several boards within one group and when that group is swapping stock between the funds. We also need to know whether there is collusion between companies."

In terms of what can be done, the FSA is considering a "fundamental review" of the Listing Rules to tighten up definitions of what constitutes an independent director, possibly to ensure that those calling themselves independent have no connection with the company managing the split's assets.

Another approach the regulator is thinking of taking is to try to force split cap boards to be more open about their investments. This might discourage some of the heavy cross-holding, and it would alert investors who do opt for these funds to the fact that they are buying an investment where more than half of its assets could be held in similar funds.

The FSA has found that 11 splits have more than 70 per cent of their assets in other splits and others also have very significant cross-holdings. This feature has already caused a domino effect of funds not paying dividends because they have suffered cuts in dividends on their own investments ­ and could possibly knock fund after fund into insolvency.

The FSA endorses the proposal of the Association of Investment Trusts, that splits should disclose holdings of 0.5 per cent and more. This would hike up the level of disclose from the current 3 per cent, which is what the Listing Rules require of all quoted companies, and would expose many cross-holdings that currently hover just below that mark.

A number of funds already disclose most of their holdings, with the information being published on the AITC's website. If the rest do not, the FSA said in its report, it will consider making it compulsory.

The regulator may also make it compulsory for splits to disclose their level of bank debt on a regular basis and to highlight potential danger areas for investors such as holdings in highly illiquid stocks.

Daniel Godfrey represents split caps as director general of the investment trust trade body, the AITC, but is also pushing for certain funds to clean up their acts. "We are not a regulator, so we can't predict the outcome of the FSA's investigation. But if it transpires that some people have misled shareholders and funds that have invested, we would expect them to receive redress," Mr Godfrey said.

Unsurprisingly, most companies involved in the sector do not see the need for radical change. Aberdeen already discloses its holdings, but Piers Currie, marketing director of Aberdeen's investment trusts, defended the principle of a manager sitting on a number of boards. "Split caps are complicated mechanisms that require someone with expertise to advise on issues like the level of debt and it does not compromise the independence of the other directors," Mr Currie said.

Mr Reid of BFS was not in the country to respond to the FSA's report. But it and Aberdeen are confident that they have not mis-sold split caps.

Exeter Investment, the author of the Volvo comment, pointed out that the quote has been taken from an article written by its marketing manager that also points out that investors should pay attention to how much gearing they are exposing themselves to.

Split cap companies feel the scrutiny by the FSA is unfair, because while investors may have had a rough ride, no one is actually to blame because no one knew when many of the funds were launched in the late 1990s that the stock market would perform so badly.

Mr Tiner is sympathetic to an extent, but will not allow this as an excuse for all to wriggle off the hook. Warning companies about the investigation to come, he said: "Where splits have fallen because the market has fallen ­ that is life. But where companies sold the products portraying them as very safe when they had characteristics that are very volatile ­ investors who complain about that have got a point."