Insurers fear a surge in claims from fund managers who advised private investors to put money into split capital trusts. Matthew Allen explains how these investment vehicles work
Liability insurers may face a surge of claims from fund managers if private investors successfully sue over the split capital investment trusts scandal. Many disgruntled investors are forming action groups to seek compensation.
Last week the FSA's John Tiner defended accusations from MPs and Class Law lawyer Stephen Alexander that the regulator was not taking action. The FSA is understood to have broadened its investigation into the troubled sector and has promised to "dig deeper" to find out exactly what has happened and why. But what are splits?
Splits are investment trusts that issue various classes of shares carrying different rights, risks and rewards. Shares in splits were launched more than 100 years ago, but the number of new issues has accelerated during the past few years. As at March this year there were 134 issued splits, with a combined market capitalisation of £13.2bn.
The three main types of share issued by splits are zero dividend preference shares (zeros), income shares and capital shares. Zeros do not pay dividends, but have a predetermined value paid to shareholders on a set date in the future as long as the split has enough net assets. Income shares pay dividends, but the repayment of capital ranks after zeros.
Capital shares do not pay dividends and do not have a predetermined value, but take any assets remaining at maturity, after zeros and income shares have been accounted for.
The problems in the splits sector have been widely reported. Investment managers feel the fall in splits' value in the past two years is due to the decline in underlying stock markets, rather than any unusual or inappropriate investment or financing arrangements.
Growing numbers of investors feel the losses were caused by fundamental structural problems that left the sector open to systemic collapse in a bear market. The problems are essentially cross-holdings (investment of one split in another); excessive gearing that has magnified the effect of falling stock markets, and misleading promotion and distribution.
Of the 134 splits in issue as at 31 March of this year, 83 had cross-holdings in other splits, of which 51 had holdings which represented in excess of 20% of the investment portfolio. Eleven splits had cross-holdings in other splits of more than 70% of their portfolio. Of these, ten had total borrowings of 74% or more of gross assets.
The FSA says: "The impact is that interest charges -based on borrowings - and management charges - based on the level of gross assets - are substantially greater than would otherwise be the case, the effect of falling stock markets is magnified and the ability to unwind positions is hampered."
Stock swaps have been common among some splits with cross-holdings in their portfolio. These are transactions where a management firm has exchanged shares from one split portfolio for shares in another. These were sometimes done to support in-house or external share issues or restructuring of the split.
While there is nothing fundamentally wrong with this, managers must make investment decisions that are consistent with the investment mandate and the investment policy stated in the prospectus.
The corporate governance of splits has also come under scrutiny. Investigations by the FSA have identified instances of individuals holding directorships in a number of different splits at the same time. Most of these individuals are there in a non-executive capacity and have been appointed as investment professionals with the necessary gravitas to influence the board. But the FSA notes that where stock is swapped between splits, and individuals sit on the board of two or more of these splits, it must be hard for those concerned to manage conflicts of interest.
Ultimately, the success or failure of compensation claims in the splits sector will depend upon how individual trusts were marketed. Unfortunately, splits, including those with cross-holdings and substantial borrowings, habitually have been described as "low risk" in product providers' marketing materials, with zeros compared to building society accounts, national savings and gilts.
The regulator's inquiries have led to the interim conclusion that "in many cases marketing material given to investors and advisers has not adequately disclosed or explained the risks of investing in certain splits".
The pensions mis-selling review and other financial scandals have given rise to a new breed of investor that is willing to second guess the advice given and the decisions made on their behalf. Financial institutions and their insurers are judged on expectations raised by sales literature or contractual terms of engagement, the level of education given to the client and transparency of decision making. When judged against short-term performance in a bear market, these factors give rise to a potentially explosive mix.