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In the dock: City watchdog accused of incompetence

The Sunday Times: Special Report: In the dock: City watchdog accused of incompetence

“When it adopted an American-style settlement formula last week and allowed Shell to pay its fine without admitting guilt, the regulator set a precedent.”

By Peter Koenig

Posted 1 August 04

The Financial Services Authority is under fire for failing to get compensation for victims of the split-capital scandal

DAVID “DOTTY” THOMAS limped into the tribunal in London on July 22. At 71 his belly sagged and his jowls quivered. He half resembled a City gent and half a sport looking to cadge a fiver.

Thomas was one of the architects of modern split-capital investment trusts — companies set up to buy shares in other companies that offer investors two categories of stock, one for high income, the other for safe returns. He was called Dotty partly because his technical pitches for split caps were often incomprehensible.

In the eyes of 50,000 small investors who lost some £650m between 2000 and 2003, Thomas is a villain. But he is just one of 30 individuals from 21 firms, including his former employer, the stockbroker Brewin Dolphin, under investigation for allegedly colluding in a “magic circle” to benefit themselves at the expense of their investors.

Between 1998 and 2001, Thomas earned £3.4m by helping to design eight split caps into which people looking to boost pensions or save for school fees sank £1.1 billion. After the stock market slumped in March 2000, two of Brewin Dolphin’s trusts failed and the others struggled. At a July 2002 Treasury select committee hearing, Andrew Tyrie MP likened Thomas to Professor Brainstorm, “sitting in his lab twiddling the dials and blowing us all up”.

In light of such allegations, it may seem surprising that Thomas emerged from the tribunal looking like a hero to many. But that was what happened.

The Financial Services Authority (FSA) had refused to authorise him to go to work for a new employer. It said it could not decide on Thomas’s fitness until it completed its investigation into split caps. Thomas cried foul, claiming that the other 29 individuals targeted by the FSA, who had not switched jobs, were still working.

Thomas’s solicitor said: “The FSA was accusing David of being guilty until he was proved innocent. He was fighting for his human rights.”

The Office of Constitutional Affairs tribunal will rule on FSA v Thomas before August 22. Already, however, the regulator’s handling of the matter is fueling a debate over its competence.

The FSA, which parliament established in 2000 as the City’s supercop, has thrown a good chunk of its £200m-a-year budget at the split-cap investigation, its biggest ever. A great deal now rides on the outcome. If the FSA wins, its credibility will benefit. But if — as many in the City are predicting — it fails, it could end up looking like a financial version of the Keystone Kops.

FSA critics characterise it as a Soviet-style bureaucracy — not only incompetent but bullying in its efforts to cover up that incompetence.

Rob McIvor, an FSA spokesman, dismissed the charge, saying: “Investors in split caps are facing losses. We are trying to get compensation for them. That is what we will be judged on. The rest is a sideshow.”

CRITICISM of the FSA’s competence dates back two years to claims by City firms that FSA staff visiting them did not understand their businesses. Recently, there has been more specific evidence of FSA incompetence.

On June 28, a tribunal hearing a dispute between the FSA and investor Paul “The Plumber” Davidson dismissed itself after Christopher Fitzgerald, chairman of the FSA’s enforcement committee, discussed Davidson’s case with tribunal panel member Terence Mowschenson, who happened to be his neighbour, while the FSA official was walking his dog at midnight.

Last week, Shell agreed to settle disputes with the FSA and its American counterpart, the Securities and Exchange Commission, over inflated petroleum reserve estimates. Shell agreed to pay the FSA a £17m fine. It paid the American regulator $120m (£66m).

Now the FSA must back up a bald assertion to parliament by its chairman, Callum McCarthy, that City firms committed financial crimes in connection with their management of split caps.

By the summer of 2001, as a result of the stock market imploding a year earlier, some 23 of 89 split caps launched over the previous decade were in crisis — cutting dividends, recapitalising themselves or simply going broke.

In May 2002, the regulator launched a formal investigation. Many in the City applauded. But the way the FSA handled it soon had professionals up in arms.

“The FSA misallocated resources,” said a leading City figure. “Its investigators misunderstood the evidence needed to prove wrongdoing.

“It’s sad. Here you have a number of small investors who have lost millions and deserve some compensation. And what happens? The FSA screws it up.”

Kicking off its investigation, the regulator visited 34 firms. It reviewed split-cap prospectuses, 40 split-cap company websites and the activities of 60 independent financial advisers. It analysed information on the way 18 firms had swapped shares in 80 funds. In publicising such figures, it built up expectations of a result.

The regulator soon found evidence that split caps were mis-sold. A March 2001 Exeter Investment Group marketing brochure declared that split caps “currently display more safety features than a Volvo”.

The FSA had a harder time getting evidence of what it regarded as a more serious crime — collusion by the magic circle. During the bull market, firms may have bought shares in each others’ split caps not only as pure investments, but also to guarantee the successful launches of each others’ funds, an investment-trust expert said.

Then, when the split-cap sector collapsed, managers may have engaged in stratagems, including double counting of dividends and swapping stocks at non-market prices, to try to save themselves.

“If the FSA had obtained evidence showing that shares were bought at the launches of new funds to benefit firms, it could have built a case of maladministration,” the expert said. “If it had obtained evidence that firms traded shares at non-market prices, it could have built a case of market abuse.”

Instead, according to firms being investigated, the FSA concentrated on proving collusion while the split-cap sector tried to rescue itself through a 2001 recapitalisation programme.

“The FSA was fixated on our rescue operation,” a banker said. “It found 20 to 30 phone calls out of 27,000 where traders promised to do each other favours, and thought it had made its case. It was wrong.”

EARLIER THIS YEAR, John Tiner, FSA chief executive, sought to wrap up the split-cap investigation. On March 2, he called the heads of Brewin Dolphin, Aberdeen Asset Management, Exeter, HSBC, UBS and the rest of the 21 firms under investigation to a meeting at the FSA’s headquarters.

“The FSA has gathered evidence of shocking practice, an appalling financial scandal and wholesale disregard for obligation,” Tiner said, according to a person at the meeting.

The FSA chief then put a selection of quotes from traders’ phone calls and e-mails up on a screen, but the split-cap executives dismissed them as banter.

Giving the firms until March 16 to make up their minds on “collective settlement negotiations”, the FSA circulated a 78-page outline settlement with summary charges against each firm. When none of the firms signed and returned the FSA’s statements, which would have committed them to mediation, the FSA extended its deadline to June 18, and then to July 2.

At the FSA’s July 15 annual public meeting, Tiner said that five of the 21 firms “have said they are willing to enter into discussions”. But an executive at one of the 21 firms said that none had sent signed commitments to the regulator.

The FSA proposed that firms pay £350m in compensation at a meeting in May, according to a banker present. The firms countered with an offer of £120m in exchange for no admittance of guilt.

Tiner and the FSA enforcement chief Andrew Procter then visited John Duffield, chief executive of fund manager New Star at Duffield’s office in London’s West End. Shortly after the meeting, Procter made two calls to Duffield’s office, leaving the names of eight people who might be punished by the FSA, a banker said. They include: David Thomas, Chris Fishwick, ex-Aberdeen, Tony Reid, chief executive of BFS Investments, Alan Kerr from Legg Mason, Laurie Petar at Jupiter Asset Management, and Chris Whittingslow of Exeter. The FSA has made clear that these people are being pursued for civil rather than criminal offences.

A few City professionals said the FSA could yet emerge from the battle smelling like roses. “If it has the evidence, it could be free in one bound,” said a senior investment-trust figure.

Most said the FSA has a choice: go to court for years or agree to a weak settlement that disappoints investors and their supporters in parliament.

The FSA may be searching for a third way. When it adopted an American-style settlement formula last week and allowed Shell to pay its fine without admitting guilt, the regulator set a precedent. Industry sources said the FSA wants to use a similar formula to obtain compensation for split-cap investors and punish individuals, while shielding firms from shareholder lawsuits.

However it turns out, pressure on the FSA is likely to mount. Last month John McFall, chairman of the Treasury select committee, said he would hold hearings in the autumn if no settlement is reached before then.

Increasingly, it seems the FSA is in the dock as much as the people it is investigating.

Additional reporting by Louise Armitstead

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