Regulation of investment trusts
The Treasury's consultation paper on regulation of investment trust companies has identified not so much a gap in the rules as a yawning chasm. The Treasury is right to look at plugging that gap, but it needs to be done with care.
Investment trusts are not regulated in the same way as unit trusts and open-ended investment companies, and disgruntled investors have no recourse to the Financial Ombudsman scheme. This makes it well-nigh impossible for investors to claim compensation.
As the debacle over split capital trusts has shown, many buyers of these investment schemes are unaware of the differences in supervision. Cautious retail investors bought zero dividend preference shares and income shares in split trusts, regarding them as low-risk.
However, a combination of high levels of gearing and shareholdings in other splits led to the implosion of a small number of trusts two years ago. Regulators have since been trying to clear up the mess.
The Financial Services Authority is in negotiations with 22 companies over alleged collusion in the sector - specifically that trusts invested in each other to prop up share prices. It wants companies to agree to compensate investors rather than push them through its lengthy formal enforcement procedures.
The Treasury is now consulting about the need to beef up regulation in the sector. It suggests applying full-on unit trust rules to the industry. This would mean regulating investment trusts as products as well as the need for those running the trusts to be authorised by the FSA.
Investment trusts are companies and the FSA has indirect jurisdiction over them through its powers as the UK listing authority. It has already tightened up some of these rules by restricting the amount that trusts can invest in each other.
In addition, the industry has improved its disclosure so that investors should be more aware of what they are buying.
As companies, investment trusts can engage in gearing and invest in more illiquid assets than unit trusts. This can bring benefits for investors and it must not be forgotten that the sector has offered successful low-cost products for investors for many years.
The sector's reputation of that sector has been mired by a handful of ambitious companies eager for returns, which structured their investments in a way that did not allow for a market downturn. The industry rightly argues that many investors want to retain the flexibility of the investment trust structure, which could be lost if it were brought into the FSA's ambit.
The Treasury suggests two alternatives to full-on regulation. One would involve some restrictions on the sale of investment trusts or the creation of new rules to cover the sector. The requirement in all the options for those running trusts to seek FSA approval would bring these vehicles under the auspices of the ombudsman, which would be a good thing for investors.
However, either of these options would take a couple of years to put in place. Alternatively, the Treasury asks whether the listing rules should be tightened further. This has the merit of being a quick fix.
The Treasury's consultation is due to run until February, by which time the FSA may have settled with the split trust companies in negotiations. Whatever happens, investors should be given recourse to the ombudsman, if that can be done while still retaining some of the sector's unique features. However, if more draconian rules are applied, such as a ban on gearing, investment trusts know who to blame.
The decision by bondholders in MyTravel to take their battle to the Court of Appeal on Wednesday has implications for investors in a range of high-yield and junior debt. The troubled tour operator won a protracted and complex legal battle to implement a debt-for-equity swap that could leave the convertible bondholders with as little as 2 per cent.
But the bond investors vowed to fight on, specifically to gain clarity on a much-disputed point about whether they have any economic interest in the company. Since the debt they hold is subordinated, any wind-up of the company would leave them with nothing.
MyTravel is not in liquidation, but the judge has suggested that, to all intents and purposes its current situation is akin to liquidation and therefore the bondholders' interest in its assets is nil. Bondholders are increasingly asserting their rights over troubled companies no matter how far down the chain of investors they come.
MyTravel's bondholders number Fidelity, New Star Asset Management, Société Générale Asset Management and Lehman Brothers. These are heavyweights and prepared to take their fight to the House of Lords.
The bondholders argue that yesterday's ruling casts a shadow over all holders of mezzanine, high-yield and convertible debt. This desperately needs sorting out.
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