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MARKET COMMENT
The Lesson From The Split Capital Debacle

By James Carlisle
October 30, 2002

The Treasury Select Committee's inquiry into the split-capital trust debacle reveals greed and incompetence in the fund management industry.

At the centre of the debacle are the supposedly safe zero-dividend preference shares. As the name suggests, these 'ZDPs' or 'Zeros' traditionally worked by giving their holders preference over other investors. That meant that even if a split capital trust's assets fell below the level required to pay out ZDP holders in full, they could still expect to share what's left between them.

Unfortunately, this apparent safety was substantially undermined by the introduction of borrowings in the late 1990s (apparently to boost returns in the rising market). The effect was that the ZDPs had moved from having first dibs on the trusts' assets, to following second after the banks. Where the borrowings were substantial, it raised the possibility of a complete wipe-out of the ZDP holders' interests if the market fell a certain amount -- which is, unfortunatley, is just what's happened.

Chris Fishwick, the former head of investment trusts at Aberdeen Asset Mangement, said yesterday that 10 to 15 more trusts could get into trouble if the market fell further and apparently used the warning to support a claim that he hadn't "bogged it up more than anyone else in the sector". This sort of "I wasn't the only one" defence doesn't do Fishwick or the industry any favours, but you can see his motivation for the comment, after he's been turned into the industry's number one scapegoat. I'm very happy to accept that there hasn't been any corruption (as Fishwick also said yesterday) but, given the millions that Fishwick and others have taken in pay and bonuses over the years, it's hard to resist the allegation that the problems are founded in the industry's greed.

If greed isn't enough, then the industry has also shown itself to be incompetent in its failure to warn investors about the increasing risks. Part of the problem is that, in many cases, there was no ongoing client relationship that obliged advisers to go back to clients and explain things. Even where there was such a client relationship, though, it appears that the industry itself didn't understand the increasing risks. David Thomas, the man in charge of splits at Brewin Dolphin, said yesterday that "in common with everyone" (barring one chap from Henderson Crosthwaite apparently), he had failed to work out that increasing the gearing of these trusts would increase risk.

The lesson for investors is that you can't rely on the financial services industry to look after your interests. You simply have to look after your own. That means getting eductated about financial matters and steering clear of anything you don't understand.