Split capital investment trusts: A case of déjà vu?

Many older clients and some trusts will have had portfolios containing split capital investment trusts. But, investment webs and debts brought some values tumbling down. Peter Cherry, a barrister at Chancery House Chambers, examines the legal issues of the debacle and contrasts it with other similar situations of a decade earlier. He addresses mis-selling as a concept and conflict-related issues, as well as how a quantum of loss might be assessed. He also considers why the position of the individual has much improved and how legal fees have been saved.

Over recent months, the latest chapter in the saga of mis-selling of financial products has quietly closed. The problem of split capital trusts has largely been resolved, not in a high-profile bloodbath of litigation, but in a pragmatic settlement process brokered by the Financial Services Authority.

This can be contrasted with two of the major financial issues of the 1990s: home-income plans and the position of names in the Lloyd’s of London insurance market, where litigation clogged the courts for years, and involved taking appeals to the House of Lords in both cases.

What are split capital investment trusts?

The concept of an investment trust, under which an investor/beneficiary benefits from the spreading of risk profile gained by a collective pool of investments, is well known. Split capital investment trusts (splits) take the concept one stage further. They are not new, having been around for about 100 years, and (provided that their nature is properly understood) pose no inherent additional problems for investors.

Shares in splits fall into three basic categories – zero dividend preference shares, income shares and capital shares:

Zero dividend preference shares, or zeros, pay no dividends but have a limited life and a predetermined capital return on maturity. This return, however, assumes that the investment trust has enough net assets at the maturity date. They were often sold as a school-fee savings plan to parents and grandparents;
Income shares are higher risk. They pay dividends and repay capital at maturity if there are sufficient net assets after zeros have been paid out;
Capital shares pay no dividends. They have no predetermined capital return, but take any assets remaining at maturity after both zeros and income shares are paid out.

The nature of the problem

In a climate of rising stock markets and falling interest rates in the late 1990s, everything seemed quite straightforward and low risk. However, a small group of splits began during this period to do two things that, with hindsight, were very unwise:

They began to invest in each other’s shares, creating a web of cross holdings;
They began to borrow money against the asset values of their portfolios in order to invest more in the then current bull market to increase available returns.

It is difficult now to recall the investment atmosphere of the late 1990s, when the dotcom boom was at its peak. There was talk of a ‘new paradigm’ in Western economies. Widget makers were no more. The whole concept of boom and bust had been consigned to history by technology. The possibilities were endless… All largely hype and nonsense, as we now realise all too well, but it was very seductive nevertheless.

When the bubble burst, the unwise splits were rapidly exposed. As the value of their portfolios tumbled, they were locked in a downward spiral because of the extent of cross holdings, and those that had borrowed were left struggling not merely to service the loans from their diminished asset bases, but to avoid breaching banking covenants. The demise of any one split had a domino effect on those that held its shares. Splits were left with insufficient net assets to pay out zeros, let alone income or capital shares. Large numbers of investors who thought their money was safe were in for a rude shock.

Those investors did not take their losses lying down. Many alleged that they had been mis-sold their investments and that a small cabal of market professionals had acted in concert to manipulate the market to their own advantage, extracting large fees while small investors lost out. This had echoes of the Lloyds of London scandals of the 1990s, both in the hideous dangers of a spiral of cross liabilities, and in the allegation of manipulation by insiders.

The legal issues

The problem does not lie with the inherent nature of splits. Properly used, they are a perfectly acceptable structure for investment. It is also fair to say that the courts do not expect investors to take no responsibility for their investment decisions. All investment carries some degree of risk, and the role of investment advisers is not to insure investors against risk.

The legal arguments over splits fall into two areas – mis-selling and conflict of interest:

Mis-selling. There is no doubt that many investors who lost money believed that their investments had been ‘as safe as houses’. However, in order to claim, they must show either that the financial adviser who sold them the investment misrepresented the level of risk involved, or that the advice given was negligent, such that no reasonable financial adviser (knowing his client as required) could have advised that investment. This requires a detailed consideration of exactly what was said between the parties, possibly many years previously. In addition, all surviving marketing literature will need to be gone through, searching for statements that might constitute misrepresentations. Rarely will the results of a review of the available evidence allow clear-cut advice that a claim is likely to succeed;
Conflict of interest. The question of conflict of interest arises in connection with the allegations that the market in splits was manipulated by a small group of ‘insiders’ who took handsome fees for their efforts, but failed to have proper regard for the interests of investors. Such claims lie in breach of fiduciary duty, or breach of trust. Not surprisingly, hard evidence is difficult to come by. At best, a prospective litigant might construct a case based on inference, and hope that the process of disclosure of documents in litigation might reveal something supportive.

Quantum

If a claim succeeds, the measure of damages is far from simple. It is not enough simply to argue that an investment in splits would not have been made if the true risks had been properly explained at the outset. The court must consider what would have been done with the money instead. Alternative investments may also have lost value over the same period.

A different approach to a solution?

The outraged Lloyd’s Names rushed to court. They faced huge liabilities and had no choice. Rightly or wrongly, many had believed that their position was relatively low risk, and that they had been misled.

The Commercial Court was tied up with the litigation for years. Monstrous, document-heavy cases rumbled inexorably to trial and the trials dragged on for months and years. Appeal after appeal followed each judgement obtained. Staid concepts of common-law liability were tested to their limits. Overall, legal costs were in the hundreds of millions. Hundreds went bankrupt and the reputational damage to the London market was immense.

To many people, the splits scandal must have seemed like history repeating itself. However, while that might be said about the nature of the problem, it cannot be said about the nature of the solution. The position of investors has changed in two important respects:

Better regulation. This time around, the Financial Services Authority (FSA) (created by the Financial Services and Markets Act 2000) has been able to act. It has no direct regulatory responsibility for the unwise splits themselves. Nevertheless, it now has regulatory responsibility for the firms involved in selling splits, and, most importantly, regulatory power over the relevant individuals at those firms. Thus, pressure has been brought to bear on those individuals and firms to recognise their potential responsibilities without litigation. The result has been that a significant number of firms perceived to be ‘in the firing line’ have been prevailed upon to pay substantial sums to a claims-handling company, Fund Distribution Limited, which then assesses individual claims for compensation and makes payments;
No cost investigations. On an individual level, complaints about the firms involved in marketing splits can now be made to the Financial Services Ombudsman, resulting in an investigation at no cost to the consumer. While consumers still retain the ability to go to court if they wish, if they do so then it will be on the usual basis as to costs, namely, that if they lose, they risk having to pay not only their own costs, but those of the successful defendant. This is not surprisingly a major deterrent to commencing court action.

It remains to be seen how well the settlement process through Fund Distribution Limited will work in practice. Nevertheless, individual investors now have two potential avenues by which to get some level of redress without having the costs risk and evidential difficulties of litigation. That has to represent a measure of progress in resolving generic issues in the financial-services industry and can serve as a model in other areas.

Peter Cherry is a barrister at Chancery House Chambers. He can be contacted at peter.cherry@chanceryhouse.co.uk