HL Deb 23 May 1991 vol 529 cc395-402

3.36 p.m.

Viscount Astor rose to move, That the order laid before the House on 30th April be approved [18th Report from the Joint Committee].

The noble Viscount said: My Lords, with permission, I shall take the two orders together. The two orders have been laid under separate powers in the Financial Services Act and are subject to slightly different procedures.

The delegation order has been laid in draft under Section 114 of the Act, which gives the Secretary of State power to transfer certain functions, either in whole or in part, to a designated agency. Under Section 114 no delegation order shall be made unless it is approved in draft by a resolution of each House. Under Section 81 of the Act the Secretary of State may make regulations as to the constitution and management of authorised unit trust schemes, the powers and duties of managers of such schemes and the rights and obligations of participants in them.

The purpose of the draft order before the House today is to transfer to the Securities and Investments Board powers to restrict or regulate the investment and borrowing powers exercisable in relation to certain types of authorised unit trusts. Because they restrict the kind of property in which authorised unit trust schemes may invest, the investment and borrowing powers regulations effectively limit the categories of collective investment schemes which may be sold to the general public.

Powers to make regulations dealing with other aspects of authorised unit trusts were transferred to the SIB in 1988. Last September the Minister for Corporate Affairs announced that the SIB would draft new investment and borrowing powers regulations for certain classes of authorised unit trusts in parallel with developing its product regulation and marketing rules.

The SIB has consulted extensively. Its proposals are set out in its comprehensive proposed regulations for collective investment schemes, copies of which have been placed in the Library. They cover pricing arrangements and scheme particulars as well as the powers which are the subject of the draft order. Those regulations include detailed provisions as to investment objectives and as to the investment limits imposed on each category of fund. They also extend the scope of the existing regulations by allowing funds to employ efficient portfolio management and stocklending techniques.

The draft delegation order covers existing categories of funds and four new categories of funds: futures and option funds, geared futures and options funds, property funds and warrant funds. The new categories of funds are intended to increase customer choice while providing an adequate level of protection for investors. They will also enable managers to utilise the sophisticated facilities now available in London to the benefit of a wider range of private investors.

The Secretary of State is satisfied, as required by Section 114 of the Financial Services Act, that the SIB is able and willing to discharge the functions being transferred and that the detailed proposals will afford investors an adequate level of protection. In accordance with Sections 121 and 122 of the Act, and having regard to a report by the Director General of Fair Trading, the Secretary of State is also satisfied there are no significant competition problems.

The second order, the Financial Services Act 1986 (Extension of Scope of Act) Order 1991, has been laid under Section 2 of the Act. Because it extends the meaning of investment for the purposes of the Act it has been laid before Parliament after being made. It would cease to have effect if it were not approved by a resolution of each House within 28 days of being made. The order was made on 30th April and, provided that it is approved, it will come into force on 1st June, with the effect that building society deferred shares will then be an investment falling within the scope of the Financial Services Act 1986.

Most building society shares are similar to interest bearing savings deposits repayable to the investors by the society. Because these shares are in substance deposits rather than risk bearing equity, it is not thought appropriate that they should fall within the scope of the Financial Services Act. Investors are protected by the Building Societies Act and the building societies investor protection scheme.

Deferred shares are a special type of building society share, originally used to capitalise new societies. The concept has now been extended by the Building Societies Commission in two orders to come into force on 1st June. Established societies will be allowed to issue deferred shares to strengthen their capital position in the more competitive and risky market conditions that they face and to give additional protection to their ordinary shareholders.

The first order made by the Building Societies Commission defines deferred shares. They may be repaid only on the winding up of a society after all other shareholders and creditors have been paid or with the prior consent of the Building Societies Commission; and holders of deferred shares are not protected by the building societies investor protection scheme.

The second order specifies a class of deferred share called a permanent interest bearing share (PIBS) which societies may count as part of their capital. PIBS will to all intents and purposes be risk bearing equity share capital analogous to company preference shares and they may be transferred. The Government therefore believe that it must be right to give investors in them and all other building society deferred shares the same protection afforded by the Financial Services Act to investors in company shares.

The effect of the order will be that anyone carrying on an investment business in building society deferred shares, unless an exempt person, must be authorised by the Securities and Investments Board, by a self-regulating organisation or by a recognised professional body and will be subject to rules made under the Financial Services Act. I beg to move.

Moved, That the order laid before the House on 30th April be approved [18th Report from the Joint Committee].—(Viscount Astor.)

Lord Clinton-Davis

My Lords, I thank the noble Viscount for that explanation of what is undoubtedly an extremely complicated matter. I fear that I shall detain the House for more than a few moments in order to raise a number of points that are highly germane to the issue. My anxieties relate primarily to the geared futures and options funds—otherwise known by the delicious acronym of GFOFs—and to the warrant funds.

The gravamen of the Minister's case appears to be that the order paves the way for the provision of "an adequate level of protection" as and when the additional funds achieve their unit trust authorised status. Is that right? The Minister is being far too bland, if not complacent, in reaching that conclusion. I contend that, far from necessarily providing that adequate level of protection, the new instruments could well involve investors in additional risks because of the way in which the Government have dealt with the situation. The Minister seems to discount that possibility.

Quite apart from giving the GFOFs and the warrant funds the status of being unit trusts—and I am not satisfied that that should happen—they have not been satisfactorily or properly integrated into the marketing rules introduced by the Life Assurance & Unit Trust Regulatory Organisation, LAUTRO. Am I right in supposing that the GFOFs and the warrant funds may be sold in the retail market in the same way as unit trusts? If so, that could mean that small investors, who may not appreciate the risks and the higher volatility involved with GFOFs, being exposed to greater risks. Associated with the question of greater risk is the danger that the GFOFs may prejudice the unit trust industry as a whole.

The unit trust industry is highly respected. On the whole it has worked remarkably well and the Opposition believes that that standing should not be exposed to unnecessary risk. That I fear is what will happen. Why should the GFOFs and the warrant funds be treated alongside conventional unit trusts? Why not treat them alongside investment trusts? That would be far more appropriate. After all, if one examines the Security and Investments Board's own consultative document, No. 49, one sees that the funds are offshore and unregulated. Paragraph 9 of the consultative document specifically poses the question as to whether the unit trust is an appropriate vehicle for investment in derivatives. The reason for asking that question is that unit trusts which invest in derivatives could be perceived as being high risk and could therefore damage the unit trust industry's image.

The consultative document was concerned that a futures and options unit trust might well incur liabilities in excess of its assets with the corresponding risk for investors that they might lose their investment altogether. Those are important issues but were not addressed in another place and have not been addressed today by the Minister.

I believe that the SIB sympathises with the point of view that I express. It has asserted that the only vehicle now available that provides the possibility of a significant tax advantage for collective investment is the authorised unit trust. The real question posed by the SIB is how that vehicle can be best adapted to enable new products to be developed. In addition, the collective vehicles that are available are not regulated by the Financial Services Act 1986. That is an Act which led to massive confusion and monumental difficulties.

Another matter which gives rise for concern is that, despite what the Minister said this afternoon, there has been no proper co-ordination in the way that negotiations have been conducted between the Department of Trade and Industry, LAUTRO and the SIB. In consequence we have two separate consultative documents issued by the SIB. LAUTRO conducted its consultations on the marketing process over a period of 10 days while the SIB did not publish its final proposals until after that. That is an extraordinary way to conduct these affairs. In fact the industry had only one day during which it had before it in a properly documented form the final proposals and the market mechanisms by which they were to be applied. That is thoroughly unsatisfactory.

The Minister will be glad to know that I raise no complaint about the efficient portfolio management format, the EPM. It is good for the industry that contracts and derivatives should be used to reduce risks arising from the fluctuation of prices, interest rates and cash flow rather than simply leaving that to speculation. That is not due to the Government. It results from the Directive on Undertakings for Collective Investment in Transferable Securities. The directive allowed investment in contracts and derivatives if they were in the format of the EPM. So the Government cannot congratulate themselves on that situation.

There are a number of other matters on which I ask the Minister to offer further explanation to the House when he responds. The first point relates to the initial outlay involved with the GFOFs. It seems that the amour: that may be invested in margins on future contracts or on premiums on options was set initially by the SIB at 10 per cent. Then it was resolved that it should be 20 per cent. That means that at least 80 per cent. of the fund becomes available for direct investment in securities, liquid assets and so on. The second point is that at the same time as the limit of the initial margin outlay is raised to 20 per cent., the rules on diversification are removed. That will lead to a further increase in volatility and risk for the investor. It is critically important that the rules which are still being discussed by LAUTRO should take note of that fact.

In SIB Consultative Paper No. 49 it was suggested that no more than 2 per cent. of the total value of the fund should relate to initial outlay regarding any single derivative contract. No more than 4 per cent. of the total value should be allocated to any single category of derivative contract. That could relate to shares, commodities and so on. Moreover, limits on diversification were to apply, thereby offering a balance against the initial outlay. We now know that all that is to go. What is left is a simple requirement that the fund manager should ensure that investment in derivatives is "suitably diversified". Does not the Minister appreciate that the term "suitably diversified" is likely to lead to enormous problems in terms of legal interpretation? That is a matter which needs to be addressed. I hope that the LAUTRO rules which are still under negotiation will take the point fully into account.

The third point that I raise relates to commodities. The SIB regulations will permit the geared futures and options funds to invest in derivatives relating to the commodities market. These are extremely problematical when it comes to predictions. The fact is that the final SIB regulations have no requirement for funds to diversify their initial outlay into different types of derivative contracts. Therefore one finds that a GFOF could hold the full 20 per cent. in commodities contracts. Bearing in mind the risks attaching to that, is it really sensible that that should be the case?

If one wants experience in the matter one does not need to look further than the United States and the Securities and Exchange Commission, which does not allow that to happen. A person there who wants to follow that particular route can operate in partnership. Why not apply the considerable experience and expertise of the SEC when dealing with the position in the United Kingdom, which is unquestionably far more lax than in the United States?

What would be the situation concerning liability in the event of a GFOF insolvency? The SIB regulations provide that no investor in a GFOF can lose more than his initial investment. But the gearing effect on trading on the margin is that price movements in the underlying asset can have a disproportionate effect. It can lead to the investor owing more on a derivative contract than his initial outlay. The Minister must reply to this point: who is responsible for the liabilities of a GFOF in circumstances of the kind that I have just postulated?

Is it the trustees? Is it the fund manager? Is there a joint and collective responsibility as far as both are concerned? What the Government are doing here—of course I exculpate the noble Viscount from all this—is to eschew any responsibility, simply passing it on to the SIB. They are passing the buck. The competence of the SIB depends on the powers delegated to it by the Government. That is a thoroughly unsatisfactory state of affairs.

The next point I want to raise relates to something called cold calling. The Minister will know what that means. On paper it is prohibited. We know from experience that in practice prohibition simply does not stop it from taking place. It does go on. I know that there are denials, but the experience of many people illustrates that it goes on. The rules relating to cold calling are far too lax. This laxity in the marketing regulations brings the unit trust industry into disrepute.

In conclusion, I would say yes, we are anxious about the nature of investor protection as far as concerns GFOF when it is put on to the market. We do not accept the bland reassurances of the Minister in another place, in particular the reassurances contained in his press release of 30th April when he said that customer choice is to be increased without detracting from investor protection. He is increasing customer choice, but he is detracting from investor protection. In our judgment too much depends on the discretion of the individual manager. One has to take human frailty into account. Not all managers are good managers. In my judgment the Government should think again about this. The reputation of the unit trust industry is far too important to be tampered with in the way now envisaged by the Government. I believe that the measures the Government are seeking to put before us today—or at least some of them are essentially misconceived.

3.57 p.m.

Viscount Astor

Before I answer some of the more detailed points made by the noble Lord, Lord Clinton-Davis, I should like to say that the points he has made were correctly raised in another place; the Minister for Corporate Affairs answered them. It is important to remember that the Secretary of State is satisfied that there will be adequate investor protection. That is an important point.

I shall now deal with some of the specific points raised. The Unit Trust Association is concerned about geared futures and options funds. There is no requirement on the industry to set up such funds; nor is there a requirement that any investor should invest in them. Investors should be free to choose, provided that they are made aware through clear warnings of the risks involved. The Unit Trust Association's concern is that potentially risky funds should not be marketed as unit trusts and that they should have some other name. The underlying characteristics of GFOFs and warrant funds are those of a traditional authorised unit trust. That is how they fall to be categorised under the Act. I understand that some regard open ended investment companies as offering a more appropriate vehicle for these funds. At present UK legislation does not provide for these kinds of companies. The Department of Trade and Industry are considering the issue and have asked the Unit Trust Association for its considered views on the form any future legislation might take.

The noble Lord, Lord Clinton-Davis, mentioned marketing rules. These marketing rules are for the SIB and LAUTRO. In reaching his decision on the transfer of the powers the Secretary of State took into account the broad objectives of the marketing proposals published by LAUTRO on 19th April. The Department of Trade and Industry has kept in touch with with progress. The SIB and LAUTRO understand that the high standards of disclosure and other protections appropriate to the new products must be maintained. The noble Lord is absolutely right that the SIB's proposed marking arrangements will prohibit the cold calling of geared futures and options funds. Moreover, the marketing regimes for these funds will be strengthened to ensure that investors are fully aware of the risk characteristics. In a way the firm will be required to make clear the degree of risk involved, the potential volatility and the way this affects the return to the investor if he decides to cancel. The SIB and LAUTRO are aware of the need to act swiftly and surely if any breaches of the marketing arrangements are suspected.

The SIB consulted widely on increasing the initial outlay from 10 per cent. to 20 per cent. It concluded that by increasing the level to 20 per cent. wider diversification will be achieved together with a potential of lowering volatility. Comments received by the SIB suggested that detailed diversification requirements could force managers to invest in areas in which they did not have full expertise. The SIB proposal is for a simple requirement that the manager should ensure that investments are prudently diversified. This will, like other duties imposed on the manager of a fund, be monitored in the first instance by the trustees.

The noble Lord asked what will happen if things go wrong. The investors compensation scheme would compensate unit holders who are private investors if they are owed money by the manager or the trustee and the firm has gone into liquidation and is unable to pay their claim. A claim cannot be met, however, if it relates to a failure of an investment or a failure to meet or match a guarantee given or representations made.

There has been close co-ordination at every stage, including on the proposed LAUTRO marketing rules. In the light of the concerns of the Unit Trust Association, LAUTRO extended its consultation period well beyond the end of March.

4 p.m.

Lord Clinton-Davis

My Lords, before the noble Viscount sits down, he will appreciate that he has not been in a position to respond to a large number of the points that I have made. I do not blame him for that. He rather anticipated that in any event. I ask him to ensure that, after reading my remarks, he responds in writing to the various points that are still outstanding and perhaps even put the reply in the Library because I think the matter is of more general interest than to me alone.

Viscount Astor: My Lords, I am happy to give an assurance that I shall certainly respond to the points that I have been unable to cover in detail today and that I shall put a copy of my reply in the Library.

On Question, Motion agreed to.