'Inquisitors' and 'gangsters': City watchdog savaged by splits broker

The Financial Services Authority has had a bad start to 2005. Now, in an exclusive interview with James Mawson, David 'Dotty' Thomas is making things worse. Meanwhile Miranda McLachlan hears growing calls for the FSA to be muzzled

ust when the Financial Services Authority thought that things couldn't get any worse, up pops the broker at the heart of the split-capital scandal to add to the City regulator's misery.

ust when the Financial Services Authority thought that things couldn't get any worse, up pops the broker at the heart of the split-capital scandal to add to the City regulator's misery.

David Thomas, a broker to many of the split-cap investment trusts that collapsed costing investors hundreds of millions of pounds, believes the FSA is out of its depth.

Speaking for the first time since 18 fund managers and stockbrokers involved in the scandal agreed a £194m compensation package with the FSA on Christmas Eve, the 71-year-old broker told The Independent on Sunday he had now been exonerated by the regulator, despite agreeing to retire from the City.

But in an angry and bitter series of interviews, he attacked his so-called "inquisitors" at the FSA, which he said was staffed by people acting like "gangsters" under an ill-drafted Act of Parliament.

He added: "You have 60 people [at the FSA] doing an investigation for two and a half years, and you find what? A pebble. Nothing else."

Thomas, who worked in the City for 30 years, latterly at brokers Brewin Dolphin, added: "They [the FSA investigators] are revoltingly ignorant and they jumped to the conclusion that they could use serious fraud police methods of looking at nothing but telephone conversations, which they would indict people on.

"Those telephone conversations are not worth the paper they are printed on. There isn't any way of using them to prove any wrongdoing. Particularly in my case. I spent four whole days in front of the inquisition ... and I think I have been given a clean bill of health."

The regulator had spent four days last June and July interviewing Thomas - known as "Dotty" by some in the City - but in December it said: "The FSA has agreed to take no regulatory action against Mr Thomas, and has confirmed that it has not made a finding of regulatory breach against Mr Thomas."

The regulator had been trying to stand up allegations of collusion by 22 fund managers and stockbrokers as a magic circle designed to mislead other investors in split-capital investment trusts.

Splits are closed-ended, listed collective investment schemes with at least two share classes. More than £9bn was invested in splits between 1999 and 2001 as new trusts were launched with increasing regularity. But by December 2002, 39 out of 140 splits had suspended their shares or lost more than 70 per cent of the initial money raised, according to trade body the Association of Investment Trust Companies.

However, after launching its biggest-ever investigation in February 2002, the regulator has so far been unable to prove allegations of malpractice. Callum McCarthy, chairman of the FSA, had previously told a parliamentary committee that City firms had committed financial crimes in managing splits.

In the settlement, the 18 splits managers and brokers made no admissions in providing the £194m compensation to just one share class: zero dividend preference shareholders. But the FSA added it was still investigating eight people and four firms.

For Thomas, the regulator dropped its investigation of him in return for retirement. He agreed to drop his appeal to an independent tribunal where he was trying to regain the financial licence lost when the FSA started its investigation.

Thomas explained he had not proceeded with his appeal because of the cost. "The reason the FSA was very worried about my tribunal was that it would become obvious it had absolutely no evidence against me. It costs a lot of money [to continue with the appeal]. The FSA has strung this out for two years. It has become very, very expensive legally for all the firms. And it has reached a stage where the firms will say, 'All right, we'll give you some money, anything to shut you up.'

"Every single solicitor in London knows it [the FSA] doesn't have a case. They [the firms] thought the payment today [the £194m] would be much the same as the amount of money they would spend on legal expense for the next three or four years."

The FSA's initial settlement target was £350m, and retail investor losses have been put at £650m for just the single share class, zero dividend preference shares, that the compensation pot will cover.

In a simple splits structure there will also be income and capital share classes, which rank behind zeros and any bank debt if there are claims on the trust's assets. The zeros and bank loans in effect act as gearing for a split - which means any rise or fall in the assets' value is magnified.

AberdeenPreferred, one of the worst-hit splits, lost 90 per cent of its assets in about six weeks. Mr Thomas, who had acted as its broker, said it had been affected by the falling prices in almost all splits. Investor panic had been caused by negative press articles, which warned people of the danger of these geared splits, which also had high levels of cross-holdings with other splits. AbPref had mainly held other splits in its portfolio, so when these trusts' values fell because no one wanted to buy their shares - apart from other splits managers - AbPref fell as well, which then infected other splits. Aberdeen Asset Management, which ran AbPref, declined to comment on its portfolio.

This fall in all trust prices had not been foreseen by Thomas, who had been the architect of a large number of them and had earned his firm £22m in five years in the late 1990s as a result. Thomas, who earned between £500,000 and £1m a year for 10 years, said: "One of the mistakes I made was to write off the security of assets in about three or four lines - to say they were so far diversified that no one asset disappearing would have any impact. I did not think of a systemic attack."

In 2001, in a vain effort to save these trusts, new investors were sought and rescue rights issued to raise more money from existing investors. But by early 2002, "we all realised the game was up," says Thomas, and the money was lost. For pensioners and investors who have also lost their life savings, he has few words of comfort - just "caveat emptor. I don't think we conspired to wreck the bloody sector."

Rocked by reverses, disrupted by departures, 'the world's most powerful regulator' fights for credibility

Callum McCarthy and John Tiner, the men at the top of the FSA, have not had a happy new year. Incessant attacks on the way Europe's leading financial regulator operates have left the organisation feeling battered and bruised.

Criticism of the FSA's handling of the protracted split-cap trust debacle has not been sated by the regulator's Christmas Eve settlement. Mr Tiner, much criticised for failing to aggressively pursue and penalise the split-cap parties, plumped for a £194m deal which was much lower than the earlier target of £350m. And, as our exclusive interview with David Thomas shows, these attacks will not abate.

Then early last week, the Financial Services and Markets Tribunal unleashed a judgment critical of the FSA, and one that is expected to force it to overhaul its practices.

The tribunal's partial upholding of Legal & General's appeal against charges that it engaged in the mis-selling of endowment policies is another setback. It found that there was only mis-selling of policies in eight cases, dismissing charges of gross mis-selling due to lack of evidence.

The FSA will also have to deal swiftly with disruptions following the departure of senior staff. These include enforcement chief Andrew Procter, now at Deutsche Bank, itself in potential hot water over allegations that it favoured hedge funds in a bond issue for French group Vivendi Universal. It is still seeking Mr Procter's replacement.

The FSA is already gearing up for a challenging year: it has just taken over regulation of insurance and mortgage broking companies, and has to enforce a swathe of new regulation.

Tim House, a partner at lawyers Allen & Overy, believes L&G's action reflects growing resentment over "regulatory activism": "I detect a sense among the financial institutions that they are not guaranteed a fair and vigorous evaluation of the evidence." He predicts L&G's success will encourage others.

This is the second time the tribunal has criticised the FSA. In 2003, it dismissed many findings against broker Hoodless Brennan and censured the actions of FSA staff.

The tribunal has put the FSA on notice that it is prepared to recommend procedural reforms, and L&G's chief executive, David Prosser, has already called for reform after the FSA ruled out a full review.

Martin Saunders at lawyers Clifford Chance believes the "embarrassing" judgment will lead to changes to the Regulatory Decisions Committee (RDC): "It would be very dangerous not to take the criticisms on board."

The committee, which reviews FSA findings, consists of paid industry and interest group representatives. The tribunal criticised the RDC's review of L&G evidence, which failed to stand up to the tribunal's scrutiny. "There is sometimes a feeling that the FSA stretches evidence to use it to support charges that are more serious than it can really support," says Mr Saunders.

The FSA has failed to act on tribunal advice that the RDC cross-reference every allegation against the evidence relied upon to prove that allegation.

Another Allen & Overy partner, Sidney Myers, also backs a review: "This is a very significant decision." He questions whether this is just an isolated case. However, lawyer Tim Herrington, who is to become RDC chairman next month, is expected "to take a hard look at this". He replaces Christopher FitzGerald, who admitted discussing the details of a tribunal case with one of the judges.

Despite the criticisms, the industry appears largely happy with the FSA's performance under Mr Tiner. Two key challenges he will face this year are the rolling out of EU directives and expanded responsibilities in insurance and mortgage broking. The FSA warns that financial institutions face significant risks due to the sheer volume of regulation coming from overseas.

Angela Knight, chief executive of the Association of Private Client Investment Managers and Stockbrokers, believes the increasing range of activities and rules that the FSA has to cover has become "a real challenge. It's not easy - the FSA has more powers than any other regulator in the world," she says.

The authority, which has a budget of £202m, relies on the fees paid by firms for funding. However, complaints over compliance costs have prompted Mr Tiner to review the burden. Enforcement requires a lot of funding: the FSA initiated 175 probes last year. It faces further costly appeals from the likes of the former Shell chairman, Sir Philip Watts.

Martin Mankabady at lawyers Lawrence Graham believes the FSA is entering a new era after its start-up period: "It's moving into a different phase in its existence: monitoring and enforcing. " He says the FSA has already experiencedproblems with its authorisation of another 20,000 insurance and mortgage brokers. "It's going to put a massive strain on resources."

Many failed to apply for full authorisation in time and the FSA has been handing out temporary authorisations.

The watchdog will also be under pressure to act as Eliot Spitzer, the New York Attorney-General, steps up an investigation of insurers over conflicts of interest. "There's going to be pressure on the FSA to be seen to be doing something," says Mr Mankabady.

The FSA has followed overseas regulators in forcing banks to take greater responsibility in monitoring customers. Its head of financial crime, Philip Robinson, has told the City it should be working towards a "risk-based approach" in its systems to detect fraud and prevent money laundering. This means that some customers and products are deemed "low risk" and a lower level of checks is made.

"A number of people are twitchy about this," says Giles Williams, a money laundering expert at accountants KPMG. The FSA has threatened to enforce tougher measures if firms oppose this approach.