Income Trusts and Seniors

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Postby Guest » Fri Nov 04, 2005 2:08 pm

The Investor Advocate
Ken Kivenko’s column is all about investor protection. Ken fights for investors’ rights and exposes violations and malpractices. He also runs an advisory business, FundBuster Analytics, assisting investors obtain restitution due to sales or broker abuses.

A Closer Look at Income Trust Issues

By Ken Kivenko | Thursday, November 03, 2005

A thirst for ultra-high yields has motivated the ever-creative mutual fund industry to create mutual funds primarily composed of income trusts. “The problem with income trusts is many small investors don’t realize how they operate. It’s not clearly explained that you can’t create money by magic. If people really understood what they were buying, a lot of the stuff wouldn’t be sold.” — Stan Buell, SIPA President

Source: International Herald Tribune on September 10, 2003 .

With interest rates near 30 year lows, income investors such as seniors, retirees and others are attracted to income trusts with their high “distribution yields” (this yield is NOT the same as dividend yield or GIC yield). Currently, the S&P /TSX Composite index yields about 1.8 % but the S&P Canadian income trust index yields over 4X that. Never forget that risk and yield are inversely related. This thirst for ultra-high yields has motivated the ever-creative mutual fund industry to create mutual funds primarily composed of income trusts.

Income trusts are available as open-ended mutual funds (a diversified holding of income trusts) or publicly traded on the TSX Exchange (symbol suffix “.un”). You’ll find these open-ended mutual funds under the Canadian High Income Balanced classification due to the fact they’re generally designed to deliver income that is above and beyond what regular bond or dividend funds offer. Income trusts have also made appearances in income, bond, dividend and balanced funds. Almost one third (333/1090) of Canadian Equity funds have at least a 5% trust holding. Income trusts are eligible for tax-deferred accounts including RRSP’s, RRIFs, RESP’s and DPSPs. as 100% eligible Canadian property. Main Street Canada is deep into income trusts one way or the other.

The trust cash cow is an “easy sell” for brokers and fund dealers, perhaps too easy, to retail investors. They have been vocal about Goodale’s supposedly destructive actions. But remember all these firms earned high fees when these trusts were issued as IPO’s. Price to earnings, barriers to entry, strength of the underlining businesses, leverage - all of these were ignored as Bay Street pushed “yield” upon its clients Critics argue that the newer trusts are of declining quality and not even suitable for a trust structure. i.e. risks are increasing and investors aren’t aware. Investor advocates are concerned about the way the Street has marketed the trusts.

Clearwater Seafoods Income Fund certainly illustrates the dangers seniors face when ‘investing’ in income trusts. When Clearwater announced it was suspending distributions and shelving plans to buy back units the market value of the units plunged from $5.61 to $2.25 before recovering to $3.55. Clearwater cannot blame the drop in the unit price because of uncertainty about income trusts due to Goodale’s comments. A year ago the Clearwater trust unit price was $9.90. By December 31 it was down to $8.78 (down 11%). By April 1 it was down to $8.20 (down 17%). By the end of June it was $6.50 (down 34%). On Oct. 19 it opened at $5.61, dropped as low as $2.25, and closed at $3.55 (down 64%). It is probable that some small investors who invested solely in Clearwater would have lost a bulk of their retirement nest egg. Recently, Heating Oil Partners became the first income trust to file for creditor protection. Atlas Cold Storage is being investigated by regulators for accounting fraud. Arriscraft International went public at the beginning of the year. By July, earnings crashed and the trust is down 60% and any mutual funds that owned it took a big hit.

On Sept. 19, Finance Minister Ralph Goodale said the Canada Revenue Agency would no longer grant advance tax rulings to help companies become trusts. He’s concerned that income trusts are providing too much tax leakage for the Government. There’s now widespread concern among investors that a distribution or capital tax targeting trusts may be coming early next year. But, it isn’t just or even primarily Goodale’s actions that could reduce the valuation of income trusts and the mutual funds that hold them. Income trusts have plenty of risks especially the business trusts. Don’t let the word “trust” give you a false sense of security. All trusts are risky to varying degrees. Income trusts do not offer preservation of capital or a guarantee of income. Research is essential when investing in income trusts. The risks include interest rate increases, debt, lucrative insider management contracts, governance, less than conservative accounting practices, the usual business risks and of course commodity price risks and resource depletion risks for royalty trusts. The emphasis to deliver “yield” has put pressure on trusts to have high payout ratios, which often meant trusts turned to the bank to meet their yield obligations. Investors, however, don’t always realize that the trust is often handing over borrowed cash.

Concerns being raised by investors, investor advocates, SIPA, CARP, the CGA of Ontario and by respected forensic accountant Al Rosen suggest there may be a ticking time bomb in the business trust sector especially. Suggested problems include weak governance, dubious accounting practices, foggy misleading terminology, weak capital structure, conflicts-of –interest and tax treatment. According to Mr. Rosen the income trust underwriting bonanza, confusion over tax issues, and the lack of financial reporting regulation in Canada are shaping up to be a serious triple threat to investors. The following 10 Income Trusts suffer from either “unique ” accounting, relative overvaluation or questionable distributable cash reporting : Aeroplan, Artiscraft, The Brick Group, Cineplex, Galaxy, Clearwater Seafoods, Great Lakes Carbon, KCP, Priszm, Transforce, Yellow Pages, according to an article quoting him in Canadian Business (pg 60 Oct. 10- 23, 2005).

There are even some concerns that a number of trusts are effectively Ponzi schemes using debt or new stock issues to finance ongoing distributions –so called “distribution yield”. Shortly, S&P will be adding some trusts to the S&P/TSX index, a scary thought to some. In a Sept 2004 paper The Need for Regulating Income Trusts: A Bubble Theory, researcher Dirk Zetzsche concluded:

“The current income trust boom has striking similarities to the Tech Bubble of 1999/2000. Specifically, overstated marketing arguments induce unsophisticated retailers to invest in businesses which might not benefit from the income trust structure. As a consequence, the income trust boom shows phenomena associated with a Bubble: story leverage, opportunistic support by interested parties, and overoptimistic retail investors. In order to solve the problem, four steps need to be taken: (1) avoid tax incentives for investments in low-growth businesses, (2) trust law should require governance structures equivalent to those mandated by corporate law, if the units are issued to the public - investments in trust units that do not meet this condition should be restricted to sophisticated investors, (3) investors should be empowered to decide upon the distribution policy of a trust, and (4) avoid limitations of pension funds holdings in income trusts. Furthermore, a strict approach in regulating broker-dealers’ and mutual funds sale practices is apt to augment the aforementioned measures.”

Now that Ralph Goodale has made income trusts a public issue, perhaps the real issues will be debated and effective corrective action may be taken. If there is a meltdown, small investors, seniors and retirees would bear the brunt. CAVEAT EMPTOR

Ken Kivenko P.Eng.

President, Kenmar

Postby Guest » Sun Oct 16, 2005 9:32 pm

Dear Sir,

I am not an investor in income trusts, predominately because I do not understand the business model.

I have followed closely a couple of trusts; the figures do not add up. For example:

A trust that I followed was marketed on the basis of solid existing management, having signed 5 year agreements, plus non-trading provisions for management owned units.

After approx. 2 years, that management, en masse, takes ‘early retirement’, taking with them a further $1½ million in 'early retirement allowance'. The company claims to be saving great sums of money in future compensation.

A year ago, the company made $.42 per share, yet paid out $1.50. Current figures are (they ‘increased’ distribution) revenue of $.84 per share and distribution of $1.64. Yet, they claim, there is all sorts of ‘distributable cash’

The Board lets the President go. The Chair of the Board resigned. The company arranged for a new credit line of $90 million.

The market cap of this organization is $145 million. Investors get a distribution of 11.55% at present on their investments (At 11.55%, that amounts of a pay out of $16.75 million as far as I am concerned, yet they only make $6.3 million as per the latest financial report).

I would be ‘delighted’ to make 11.55%. In fact, you would be receiving this email from the Bahamas. However, none of the figures add up. Why did management ‘bail out’, despite having a contract to stick around for 5 years?

Possibly all is well, I simply cannot figure out how that could be.

If ‘income trusts’ are permitted to state as their largest asset ‘good will’, I logically have to stay away from that asset class.


example of the misunderstanding on trusts at client level

Postby Guest » Tue Oct 04, 2005 1:42 am

I recall one retired gentleman, in his 70's, who came to me to manage his account.
His broker in Calgary was retiring, and would I look after his account?

I looked at his holdings, and they consisted of between 90% and 100% in income trusts. 100% of these trusts were resource based and 100% of the resource was oil and gas. Nothing particularly wrong with this strategy, just that it lacks a bit of diveristy.
When I filled out the KYC (suitability, Know Your Client) form I put him down (and wrote him a letter to sign) suggesting that his account was on the higher risk side.
He disagreed, saying at his age, he could not afford to take any risks. Therein lies the problem.

This gentleman had no idea whatsoever, of the level and or type of risks he was taking. The only thing he understood was the income coming from them was high, and nothing else seemed to matter in a declining interest rate environ.
It was not the first, nor the last time I would be faced with clients who had no desire to accept risk, wanting to have the "high, safe", returns from trusts. It was also not uncommon for clients of some brokers to be inder the impression that "trusts" were something guaranteed, or something akin to a GIC.
For the sake of my own sanity, I had to politely decline the account of the 70 year old, depite it being just under a million dollars in size. The risks of assuming responsibility for this man's rates of returns was too large to do under the guise of low risk.

I think he has done OK, and I hope his income still survives and thrives.

Postby Guest » Tue Oct 04, 2005 1:30 am

good comments. well worth the discussion.
I never understtod income trusts well enough to invest in them, and the smart money says to never invest in anything you do not understand.

This, as you correctly point out, however, does not stop the underwriting firms from collecting fees from sellers wishing to try and unload certain assets, nor does it prevent them from also representing them as sound investments to their trusting clients. One wonders how large the liability might be to the firms if a severe crash in income trusts were to occur.

I also never understood how trusts could maintain the magic of paying out more than they earned, or paying out an unsustainable income based on the corporate strategy of, "burning the furniture" to heat ones home. It struck me as unsustainable at best, and unethical at worst.

I was told by an old Rich Green broker of this story. He told me that Rich Green had been working with the principles of Luscar Coal for years and years to try and sell the assets. Coal was back then (1990's I think) not a very glamorous fuel when compared to natural gas and the owners wanted to unload it. They had absolutely no buyers and no interested parties. When some enterprising soul in the investment industry decided to package it up as an income trust, paying out some higher than normal (pick a number) rate of return to unitholders, they were easily able to sell off the assets to the public at several times the former asking price. This I simply did not understand, or if I did, i never really got my mind wrapped around the suitability of it as an investment.
Is it a suitable investment to recommend to your clients just because you can manage to sell it? It appeared to me to be a case of not giving trusted investment advice, but rather using the smarts of the industry and the trust of the clients to unload bad assets.

Now I could be wrong, and I have been before. History has shown some trusts to be very strong income earners, and market performers. I know that some of this would result from high resource prices, so they have had some wind in some sails. Overall, I have to admit ignorance and misunderstanding of them in general, and I appreciate the informed comments about them from all sides.
No trusts for me. None for my clients.

Income Trusts and Seniors

Postby urquhart » Mon Oct 03, 2005 1:55 pm

I sent the following e-mail to Federal Finance Minister Ralph Goodale today expressing my support for a new income trust tax and advocating a new Federal Investor Protection Agency to enforce fair valuations and full public disclosure on the sustainability of cash distributions of income trusts. The new Federal Investor Protection Agency would be the single national securities commission, if the provinces would agree to create one, or would be a new Federal Agency to supercede the work of the provincial securities commissions in the field of investor protection.

Honourable Federal Minister of Finance Ralph Goodale:

I am e-mailing you today to support your efforts to make adjustments in the Canadian tax system, so that there is neutrality between income trusts and corporations. I agree that there should not be an incentive for Canadian corporations to convert to income trusts, solely for the purpose of tax savings. The Federal Government may need to both tax the income of income trusts and increase the dividend tax credit to achieve neutrality. I strongly urge that this is also the opportune time for the Federal Government to introduce a new Federal Investor Protection Agency to fix the slack accounting and securities rules governing trusts and to address the abysmal provincial securities commission enforcement of investor abuses. There should be a comprehensive package of federal reforms to protect seniors from fraud and investment abuses, so that the seniors who might feel they are hurt by a new tax on income trusts, are actually being made better off overall. It is easy to illustrate to seniors that an increase in income trust tax would be more than offset by: lower purchase prices for income trusts, where there is proper accounting and proper public disclosure on the sustainability of current cash distributions; lower losses from bankruptcies of bad businesses, businesses allowed to be run down and businesses overwhelm by fraud; and, less legal costs and other damages in seniors' efforts to gain redress for fraud and other investment abuses.

It appears to me that seniors relying upon income trusts for their retirement income and writing letters of support for income trusts are not fully apprised of the potential landmines in the income trust sector. These landmines have been well-publicized for some time, but for the most part seniors have yet to be harmed by them. The day of reckoning, however, always follows all investment manias. Current cash distributions are being inflated by numerous sources: (a) declining resource reserves; (b) underinvestment in plant and equipment necessary to sustain future cash generation; (c) cash payments exceeding cash flow from operations funded by debt and new equity financings; (d) cyclical businesses operating in the up phase of their cycle; (e) financially unhealthy businesses with poor future prospects being dumped into a financially illiterate retail marketplace, and (f) plain old fraud in trust structures and funds of income trusts, without adequate corporate governance and government enforcement. The investment dealers are making up to 5% upfront underwriting fees. The money managers are making up to 2.5% annual investment management fees, and of this amount the fund distributors are earning up to 4% upfront fees and 0.5% retainer fees. Selling corporate shareowners are making very significant upfront gains due to both the tax free status, and in many cases, the current inflated cash distributions of income trusts. Naturally, the financial intermediaries would like the Federal Government to leave income trusts alone. These financial intermediaries are only to happy to have seniors buy all the income trust product they offer, without accepting accountability for thorough due diligence and for full and timely disclosure on the true cash flow generating capabilities of these income trusts over the long term.

I personally know about the abysmal enforcement of fraud and illegal securities activities being carried out by the provincial securities commissions. I have attached a letter I wrote recently to Susan Wolburgh Jenah, the Acting Chairwoman of the Ontario Securities Commission, which describes the negligence and corruption I witnessed in the OSC's handling of illegal issuer bids, failure to file insider trading reports and lying by corporate lawyers and controlling shareowners of a B.C. public company, where I was a director. The C.E.O and director of this company was removed from his position by the British Columbia Securities Commission for continuous disclosure misrepresentation and stock trading manipulation, but the OSC spent hundreds of hours to protect the Ontario lawyers, chartered accountants and senior executives who took illegal payoffs not to complain about the securities violations occurring at the public company. The message for honest directors in Canada is clear, take a payoff and run. I have no confidence that income trusts are properly governed by their directors/trustees and that the provincial securities commissions are providing enforcement support to the honest gatekeepers who find illegal securities conduct.

The Federal Government should not be providing the tax free fuel for today's income trust mania, that offers so many opportunities for fraud and unsuitable investment claims from seniors in the future. Furthermore, as you have correctly pointed out, seniors also need to be more aware of the long term implications of virtually all Canadian corporations converting to income trusts. The Federal Government needs to protect total tax revenues and provide fair taxation; to promote investment in research and modern technologies to improve productivity; and to ensure private sector investment in high risk capital exploration and development projects, such as the Mackenzie Valley Pipeline and Voisey Bay. Individual investors are not suited to making these high risk investments. We need corporations with deep and diversified capital bases to do so. Our children and grandchildren need to be left a growing and prosperous country, not one where our economic engines are rusting and spewing out outdated products and decreasing cash flow.

Yours sincerely,

Diane Urquhart
Mississauga, Ontario
Telephone: 905-822-7618
Posts: 125
Joined: Tue Jun 14, 2005 3:43 pm
Location: Mississauga


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