From the FSA website:
“Any money in an open-ended investment fund is protected by a trustee or depository who ensures the management company is acting in the investors’ best interests at all times.”
From the Treasury’s briefing on the introduction of Oeic regulations in November 1996:
“The Treasury’s policy objective in establishing powers for Oeics is to provide their shareholders with the same standard of protection as is available to investors in authorised unit trusts.”
We are about to find out if either of these official statements is still true. I fear they are not.
Over the years since I wrote the first book on unit trusts in 1975, I have often made the statement – one that nobody has so far contradicted – that no UK investor has ever lost money though fraud or mismanagement as a result of investing in a UK unit trust (excluding losses caused by poor investments). There have been frauds and there have been technical glitches but, as far as I know, in every case, investors’ potential losses have been made good by either the manager or the trustee.
The robustness of the system created by the 1959 Prevention of Fraud (Investments) Act is undisputed. American investors must wish regulation of their mutual fund industry had been as effective. But the Arch Cru case could destroy this record and inflict huge damage on the UK fund management industry.
Investors in the Arch Cru funds face losses which are the direct result of an authorised fund following an investment policy that was usually prohibited for unit trusts and Oeics.
The private equity holdings in the Arch Cru funds were held in cell funds listed on the Channel Islands Stock Exchange. This was a device to enable investments to be held within an Oeic structure that would otherwise be allowed to constitute only a small fraction of a fund’s assets. The Cru funds held almost all the units in the cells. The value of the private equity investments was determined on a mark-to-model basis – not unusual with private equity – but there was no liquidity. Effectively, the cell company structure permitted Arch to put into an Oeic a far higher percentage of illiquid private equity investments (and other illiquid investments) than the regulations would normally permit.
What of the authorised corporate director, Capita Financial Managers? It is a subsidiary of a FTSE100 company and runs 291 funds for 100 investment management companies. Its pitch to investment managers is that it handles all the technical issues and lets them get on with investing and marketing. It enabled and signed off on the structure of the Arch Cru funds. It could be concluded that CFM was instrumental in enabling the Arch Cru funds and that without Capita’s backing it is unlikely they would have been authorised.
The big issue is who should make up investors’ losses of up to 40 per cent in the supposedly low-risk Arch Cru funds? The potential liability of advisers for giving bad advice is a red herring. No doubt some did but the prime cause of investors’ losses was not bad advice but a fund structure that should never have been authorised in the first place.
The purpose of “two-way” investment fund regulations (manager and independent custodian/trustee) is to ensure thatwhere the investment manager and distributor fail, there are deeper pockets to draw on to meet investors’ reasonable expectations. If the regulations do not achieve this objective, then it is legitimate to ask what purpose they do serve.
It could be argued that the FSA was, once again, asleep at the wheel in permitting the Arch Cru structure to be authorised as an Oeic. I have been told that as many as six senior fund management CEOs and CIOs wrote to the FSA querying the basis of the Arch Cru funds – to meet
the usual wall of silence.
The FSA has in previous cases shown itself willing to permit authorised firms to dump liabilities into the Financial Services Compensation Scheme. I fear it will do the same in this case, arguing that investors can achieve redress against advisers and permitting the manager’s and custodian’s roles to go unquestioned.
In this event, the FSA will do something nobody has achieved since 1959 – permit investors in an authorised UK fund to suffer losses arising not purely from market movements but out of the actions (or inactions) of the managers and/or custodians.
The damage for the whole UK fund management industry would be colossal. Investors’ confidence in UK-authorised funds will be seriously eroded. To be effective, a regulator needs to know when to be brutal. Capita has announced it expects costs of £30m for the Arch Cru debacle. I believe it should pay up in full. If Arch Cru investors lose out, all fund managers will suffer too.
Chris Gilchrist is director of Churchill Investments and editor of The IRS Report