Income Trusts and Seniors

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Postby admin » Thu May 17, 2007 10:27 am

Here are some of the more interesting statements made in the final debate on income trusts in the House of Commons on May 16, 2007.

Mr. John Cannis (Scarborough Centre, Lib.)

I would like to quote some distinguished people on how they felt about the government's initiatives on income trusts. Allan Lanthier, a retired senior partner of Ernst and Young and the immediate past chairman of the Canadian Tax Foundation said it is the single most misguided proposal I have out of Ottawa in 35 years.

Claude Lamoureux of the Ontario Teachers' Pension Plan board, said the following: This is unbelievable. I do not know who in finance looked at this. I cannot believe any sensible person would do this.

Nancy Hughes Anthony, the president of the Canadian Chamber of Commerce, whom that party supports and we support as well, had this to say: The proposal appears to be driven by revenue enhancement rather than a desire to build a competitive advantage.

Mr. Pat Martin (Winnipeg Centre, NDP):

Mr. Speaker, there is a good reason why the United States, Great Britain, Japan, Australia, or any country in the European Union, such as Germany or France, do not allow income trusts. The United States does not allow them because they are disastrous economic policy, and I do not use the word disastrous lightly.

Income trusts are corporate greed gone wild. They are a corporate wet dream. No business likes to pay taxes, so these guys have discovered a way to pay none, not just lower taxes but no taxes. The guy who developed this got a promotion. Some young Turk somewhere on Bay Street or Wall Street got a bonus that year after inventing this. I cannot get over how we have allowed this disastrous policy to percolate and incubate until it has reached the magnitude that it has.

The NDP spoke out as soon as it noticed it. I took note when the Yellow Pages converted to an income trust. It was a good number of years ago. I met one of the lawyers who orchestrated the Yellow Pages conversion. He said to me, You are a socialist. He asked why we were not screaming bloody murder, that somebody should call the cops, that there was robbery going on. That was essentially his point of view. He asked how we could stay silent on it, did we not read the financial pages? In actual fact, sometimes I think we do not read the financial pages enough because stuff like goes on that deserves to be denounced in the strongest possible way.

Businesses do not like paying taxes, so they argue with government all the time that they should pay less and less. We balk sometimes at that, but they have managed to shift the tax burden successfully over the years. It used to be that roughly 50% of government's tax revenue came from individuals and the other 50% came from business. That has shifted dramatically to 80:20, to 85:15, to where individuals are assuming the overwhelming majority. With income trusts, businesses found a way to pay no taxes and shift all the burden on to the unit holder who would get the revenue.

A lot of people do not understand how simple the income trust concept is. Businesses are putting together a corporate structure where there are nothing more than shells, flow through entities. That is what is disastrous.

This was why our American colleagues, who know capitalism better than anyone in the world perhaps, balked at it. They recognized how devastating this would be for a business if the earnings simply flowed through to unit holders with no commitment to hang on to any of that money for research and development or to grow the business and hire more people.

The obligation is to meet this insatiable demand for increased revenue to the unit holders. They suck the life out of a corporation. They stuck it dry. It is corporate greed at its ugliest, at its worst embodiment. It is the manifestation of greed run wild for short term gain and long term pain. That is why no country in the world would allow it. That is what was wrong

Mr. Dean Del Mastro (Peterborough, CPC):

First of all, the member is probably aware that every single provincial finance treasurer came forward and said there was tax leakage, that it was substantial, that we could not afford to have it and we could not afford to let it keep on going. The governor of the Bank of Canada came forward and said there was tax leakage, and what is more, that corporations switching to income trusts was a bad structure.

I see the member for Mississauga South is counselling the member. That is good. The member for Mississauga South also knows nothing about this topic, but I will tell members something else.

Finn Poschmann from the C.D. Howe Institute said something had to be done, and better now than later. Kevin Dancey from the Canadian Institute of Chartered Accountants said that there was leakage and there was also severe reporting problems with income trusts.

That member stands in this House and says he stands for families. He should stand for them now. He should stand for tax fairness while he has a chance. The member for MarkhamUnionville has no idea. His friends on Bay Street are the ones who influence him. The thugs with CAITI are the ones who influence him.

Regular Canadians, people who pay taxes and rely on the people in this House to do their jobs and stand up for them, are the ones who need tax fairness. The member should stand up for them. I would like to know why he does not.

Mr. Rick Dykstra (St. Catharines, CPC):

Mr. Speaker, I appreciate the opportunity to speak to the bill.

I am a little surprised to see the member here. He and I had a good debate on Thursday of last week and he indicated that if I showed him where in the Liberal red book it said that the GST was going to be cancelled, scrapped and changed, he would resign, but he is here today to speak to his private member's motion. I took him up on his challenge, mano-a-mano, and, like the Liberal Party, he did not keep his commitment.

I take this opportunity to contribute to the debate on Motion No. 321, a proposal that represents another sorry chapter in the tale of Liberal mismanagement on the issue of income trusts. It is a book that is never going to become a best seller, and I would like to think, as probably all Canadians would, that the conclusion of the Liberal Party is actually being written as we speak.
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Postby admin » Thu Mar 01, 2007 12:30 pm

Detecting crookery
Al Rosen
From the February 12, 2007 issue of Canadian Business magazine
Over the past eight years I have avoided turning this column into an endless series of accounting lessons on how financial statements can be cooked. I fear now that this was to the detriment of investors. I originally believed that the perpetrators of the scams would stop performing certain tricks once they were exposed. Sadly, this was not the case

The situation really came into perspective when I saw the old "pro forma" financial reporting chicanery at the heart of the 2000–2001 tech meltdown get dusted off and used for many income trust scams.

Unfortunately, Canadian investors have not understood the main reason for the continued unravelling of many trusts. Unmistakable blame should be placed with certain underwriters, accountants, lawyers and regulators who promoted and allowed misleading distributable cash and yield figures that routinely misrepresented the ongoing costs of these businesses.

The lack of willingness of regulators and SROs to clean up these recycled shenanigans once and for all means that it’s back to teaching investors how to protect themselves. This column—the first in a small series this year—serves as an introduction for subsequent articles.

Step 1 in protecting your investments involves actually reading quarterly and annual financial reports. By doing this, you will quickly learn that financial statements can be at great odds with what someone has told you about a company. And, of course, after careful analysis you will also find that the financial reports of many companies are frequently incomplete and sometimes quite misleading.

Step 2 involves understanding the type of company you are analyzing. You must recognize that you have a better chance when a company follows U.S. or international accounting rules, and is regulated by the U.S. Securities and Exchange Commission. Canadian regulators are simply too feeble and have a long history of letting down investors.

Step 3 requires learning the nature of the company, especially its sources of revenue and income, including the countries of origin. Many corporate collapses have involved financial institutions (e.g., Canadian Commercial Bank, Northland Bank, Principal Group, Standard Trust, Confederation Life) and real estate operations (e.g., Bramalea, O&Y Real Estate Investment Trust, Castor Holdings). Monitoring cash inflows is vital, but financial statements can hide or obscure them. Likewise, the financial statements of resource industries can be of limited use because accounting doesn’t focus on valuing the assets in the ground.

Step 4 involves developing a skeptical attitude in general. Canadian regulators rarely prosecute financial reporting misrepresentations. Corporate managers know this better than anyone. They also know the specific tricks available under loose accounting rules that can be used to mislead investors.

Unlike the rest of the industrialized world, Canada has foolishly allowed its auditors to direct and influence the writing of auditing and accounting rules. This has resulted in the current financial reporting process being skewed in the interests of corporate issuers, instead of addressing the needs of investors.

Even worse, successful Canadian court cases against directors, officers and auditors are negligible. One reason is that the auditor-influenced rules are too weak to secure convictions. The fact that an annual report has been audited and approved by a provincial securities commission must be ignored; virtually all of Canada’s major financial failures over the past 25 years had financial statements that passed regulatory oversight.

Step 5 involves recognizing when something is too good to be true. An investment that boasts of tax efficiencies or superior returns must be viewed with a critical eye. Likewise, large gains in reported sales or income should have a good explanation. Any unexplained or windfall results could be a warning sign of financial games being played with your money.

Al Rosen is a forensic accountant and principal of Rosen & Associates in Toronto. He writes frequently for Canadian Business magazine.
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Postby admin » Thu Feb 08, 2007 11:55 pm

hers hoping we can get to the point one of these days

the point is that income trusts were the most abused, most hyped, most pushed, most often junky product that has been foisted on mostly unknowing clients in many a decade.

that the government had to step in and call a halt to having the investment industry attempt to convert nearly every single company in canada above the level of an ice cream vending cart, is simply symptomatic of the greed and desperation for revenue of todays banking and underwriting genius's. Billions and billions have been lost due to misrepresented, oversold, overpriced crap sold to trusting and vulnerable clients without proper disclosure, by an investment industry that stands on (and claims to represent fairly) both sides of the transaction while collecting underwriting fees in the billions.

they were just using the retail client as cannon fodder. Jack Layton should throw away the "ATM gouging" story, and look for hundreds of billions here
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Postby admin » Sun Feb 04, 2007 6:43 pm

Textual Reference
Presentation on income trusts to the House of Commons Finance Committee
The TAMRIS Consultancy
30 January 2007
An income trust is a business entity that distributes all its cash flow after an allowance for
maintenance capital expenditure and interest payments on debt.
It is therefore a business entity that needs access to the capital markets and credit if it wants to
grow, expand or to invest in upgraded capital. And, most income trusts access the capital and
debt markets to do just that.
Traditional business entities retain a percentage of earnings to fund all or a portion of capital
growth, acquisitions and investment and use retained earnings to pay down debt used to fund
acquisitions and capital investment and to support their dividends.
Entities that retain earnings to fund growth and acquisition will have a lower yield and a higher
level of capital growth via the compounding of retained earnings. Entities that retain no
earnings and/or distribute capital will have a lower level of capital growth or a higher rate of
capital depletion.
The decision to buy an income trust is therefore primarily a decision between current and future
consumption and a decision between the rate of depletion and/or accumulation of capital.
Many trusts have been distributing not just the return on their capital but a good portion of their
capital itself. Many are also using debt and capital raised from new issuance to fund
distributions in excess of cash flow let alone earnings.
Accepting capital depletion in favour of higher expenditure is not a problem if the investment
decision and the price reflect the impact and the risks of this depletion.
It is a fact that the yield on cash, bonds and traditional equities are insufficient to meet the
financial needs of all but the very wealthy. Individuals are forced to meet lifetime expenditure,
to lesser or greater degree, by depleting investment capital. It is this problem of managing the
rate of depletion over time that has drawn the individual investor towards the income trust
Unfortunately, income trusts have not been valued as lower long term capital growth or capital
depleting investments that are exposed to the economic and market cycle for their return and
1 The TAMRIS Consultancy
8 Algo Court, Willowdale, Ontario, Canada, M2M 3P1
Telephone 416 730 8103, E mail
their access to capital. They have been valued as high growth, high yield investments
impervious to risk, which of course they are not.
With most income trusts having been launched from the bottom of the last business cycle and
up through the current commodity led boom, investors have been led to believe that they
provide both high yield and high rates of capital growth over the long term, which they do not.
Given this belief it is no wonder that the average income trust investor is up in arms. It would
appear to these investors that the government has indeed taken away the elixir of perpetual
yield and capital return.
Are income trusts of value to the economy?
Canada does not have a consumption problem. It has a productivity, a growth and an
investment problem.
An investment which leverages short term consumption at the expense of long term capital
accumulation will exacerbate short term inflationary problems and impact long term economic
Income trusts exacerbate the peaks and troughs of the economic cycle.
Income trusts are cash generative businesses that invest (with a few exceptions) in cash
generative activities and acquire cash generative businesses. With few exceptions, income
trusts are unlikely to invest capital in businesses that are not immediately accretive to cash flow.
Their investment objective is therefore short term.
Capital is therefore being allocated to businesses leveraged to current consumption as opposed
to long term investment and capital growth. This is raising the price of lower growth
businesses relative to their long term return, something which is contrary to financial theory.
Some have pointed out that sales, revenue and capital invested by income trusts have increased
at a far higher rate than the economy at large and use this to argue that income trusts have
generally positive economic benefits.
These figures ignore the fact that this sector of the market has grown strongly through IPO
issuance and post IPO acquisition and that much of this gain is due to the transfer of capital
from other business structures, economic sectors and asset classes.
Acquiring existing capital via acquisition is not investment, neither is the application of
resources to maintaining existing capital. Additionally excessive capital investment in any one
sector, something that could result from the business income trust model would also have a
negative impact on the efficient balance of economic growth.
At any one point in time resources are best allocated and managed by efficient, competitive and
informed markets without distortions.
2 The TAMRIS Consultancy
8 Algo Court, Willowdale, Ontario, Canada, M2M 3P1
Telephone 416 730 8103, E mail
The efficient allocation of capital within the Canadian market place has been negatively
impacted by tax distortions (for tax exempt investors) and by informational asymmetry;
individuals are unaware that part of their yield is a return of their capital and that a good portion
of their recent return is highly leveraged to the economic cycle and the demand for income
Tax distortions and the informational asymmetries have resulted in excessive demand for
income trusts, raising the price of certain productive assets while reducing the total long term
return on those same productive assets for income trust investors.
From the analysis I have conducted into this asset class income trusts focus on acquisitions that
provide cash flow and tend not to operate in the necessary growth sectors of the future. Instead
I see income trusts promoting amongst others Canada’s strengths in Casinos, telephone
directories and regional advertising, ice making, North America funeral homes, bleach and
propane, seafood and no name brand foods, budget music, DVD distribution, cheques and
chemicals’ businesses that nobody else wants. While these businesses are necessary to the
Canadian economy, they do not warrant the valuations attached and the capital being
Are they important to the Canadian resource sector?
As far as the resource sector is concerned, at a time when the world economy has been
overweight commodities and when global capital has been aggressively seeking exposure to
commodity investments it would seem absurd to state that the Canadian resource sector has
been dependent on income hungry Canadian investors.
Instead I see many examples of corporate structures selling off assets to income trusts at
valuations they would not be able to achieve elsewhere and could not afford to turn down.
The problem Canada has is in reallocating return from the resource sector to the rest of the
economy, not in allocating more capital to this sector.
Are they important sources of capital for small to medium
sized companies?
Over the last three months I have analysed the financial histories of 100 income trusts from pre
IPO and conversion to the current point in time.
• The majority of the business trusts at IPO were not businesses seeking capital for expansion
but private equity and institutional investors seeking exit strategies for business acquired.
• Another important source of income trusts were corporations spinning off non core
businesses or minority stakes to raise capital.
3 The TAMRIS Consultancy
8 Algo Court, Willowdale, Ontario, Canada, M2M 3P1
Telephone 416 730 8103, E mail
• Many of the genuine corporate conversions were companies that were growing well enough
prior to conversion, that were retaining earnings, acquiring businesses and investing and had
access to debt and equity capital.
• Companies with significant cash flow are also companies that are best able to finance their
own organic growth and are least likely to suffer from the end of the income trust model.
Is there a real, viable and valuable cost of capital benefit?
Many argue that income trusts provide a lower cost of capital. Unfortunately the lower cost of
capital argument only works if capital raised is not transferred to institutional or private equity
sellers but retained for organic growth or for an acquisition strategy that does not value its
targets on similar distributable cash multiples.
There is ample evidence that income trusts are paying higher multiples for their acquisitions
and that the benefit of higher unit prices is being felt by the sellers of assets and not the buyers
of those assets.
The cost of capital argument appears to be confusing the benefit that a higher share price
ordinarily bestows on a company, allowing it to raise capital for growth and acquisition. This
argument ignores the fact that a growth company with a high share price only pays out a portion
of current earnings as recompense for the capital issued. Clearly the cost of capital for an
income trust in the market place is so high that it can often only meet this cost through a return
of the investors’ own capital, a return the individual has already paid for.
Does an income trust structure impose greater fiscal
Why does Canada need its small to medium sized companies to go on cash generative
acquisition binges?
From my analysis it would appear that far too many income trusts have been raising capital far
too easily. In the presence of significant demand from small Canadian investors it would
appear that there is less financial discipline and constraint on income trust fund raising for
acquisition purposes.
At the same time with valuations and the ability to raise cash dependent on the maintenance of
high cash distributions many companies are forced to maintain their cash distributions at levels
well beyond those the business is capable of maintaining.
Are income trusts a business and investment model that we
want to see here in Canada?
An income trust model would only be a more efficient business and investment structure if
investors were better able to make the capital allocation decision than the managers of the
company and if investors were able to make similar judgements with regard to the issuance of
and application of capital.
4 The TAMRIS Consultancy
8 Algo Court, Willowdale, Ontario, Canada, M2M 3P1
Telephone 416 730 8103, E mail
To do this investors would need to know the business better than the managers and to be able to
model the long term impact of cash distributions on the ability of the business entity to grow its
capital base and its distributable cash or at least manage its depletion.
Income trusts risk distributing far too much of their earnings and capital and are far too reliant
on the whims of the market and the risks of the economic cycle. Examples of what happens to
income trusts when they encounter difficult business and economic conditions already litter the
financial landscape and examples of what happens to resource based income trusts are now
being seen.
The income trust model is a short term leveraged consumption driven economic and investment
model incompatible with long term investment/deferral of consumption. The impact of
leveraging consumption towards the short term, amongst others, has significance for immediate
investment, long term growth, short term inflation and interest rate policy. As the baby
boomers retire such a structure could cause significant economic problems.
As stated, Canada has a productivity problem; its natural rate of economic growth (the growth
rate that can be achieved without inflationary consequence) is low and sensitive to excess
consumption. Canada does not need to leverage current consumption.
Why have income trusts been sold?
Income trusts have not been sold to help the retired individual meet their financial security in
retirement. They were sold for the revenue they generated for the financial institutions and the
often phenomenal financially engineered returns for private equity and institutional investors
that used income trusts as exit routes.
Income trusts have been sold as stable mature cash generative businesses that require little or no
capital to for business operations. This is not the case. Also, contrary to the belief of some,
private investors have not been granted the same access to return as private equity and
institutional investors.
I would like to point out that the income trust IPO has been an exit strategy that has allowed
cash flows and leverage and hence valuations to be manipulated in favour of private equity,
corporate and institutional sellers. Private equity returns on an income trust IPO can be
between 3 and 7 times the initial equity investment.
In addition to the high and inappropriate cash valuations attached to these investments, many
were further leveraged at their issue with additional debt designed to enhance the yield and
attractiveness of the issue. Leverage has also been used to spin off partial holdings for a much
greater initial capital return than could have been obtained via other routes. In short, the private
investor has been used.
I believe that investor anger is genuine, but that it is misinformed and misguided with
regard to its direction.
5 The TAMRIS Consultancy
8 Algo Court, Willowdale, Ontario, Canada, M2M 3P1
Telephone 416 730 8103, E mail
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Postby admin » Fri Dec 22, 2006 1:40 pm

Barry Critchley columnist for the Financial Post writes a disturbing column today entitled "Yield debate continues 4 years later" about a senior corporate finance lawyer at the OSC writing in the attached 2002 Canadian Tax Journal ("CTJ") article that: "some investors may not grasp that part of the apparent yield represents a return of capital as opposed to a return on capital. If investors are being misled about the fundamental nature of their investments, then it may be argued that the [Income Tax] Act is complicit in the deception." The excerpts from the CTJ article reproduced below, show that there was considerable support given by the author for his conclusion that there is deception in the marketing of income trusts to the unsophisticated retail market and complicity by government in permitting the deception to occur.

The CTJ article is written by Paul Hayward, who was at the time and is now still an OSC lawyer in the corporate finance division of the OSC. While an OSC spokesperson tells Barry Critchley that Paul Hayward was not speaking in his role as an employee of the OSC at the time, the significance of Paul Hayward being the author of the CTJ article and being a senior corporate finance lawyer at the OSC, is that he too has been complicit to the cash yield deception in income trusts , while working at the OSC. Also at page 1 of the CTJ article, Paul Wayward says , "I wish to thank the following people for helpful comments in the preparation of this article: Margo Paul, Iva Vranic, Susan McCallum, Erez Blumberger, and Ilana Singer at the OSC"). Four of the five OSC colleagues are still in senior management or advisor positions at the OSC and one left recently who had been with OSC senior management too, after a 20 year career at the OSC. Here are the current roles of Paul Hayward's OSC colleagues mentioned to have provided helpful comments to him.
Margo Paul - Director, Corporate Finance

Iva Vranic - Manager, Corporate Finance Team 2

Erez Blumberger - Assistant Manager, Corporate Finance Team 1

Ilana Singer - Senior Advisor International Affairs

Susan McCallum - for more than 20 years, was a member of the staff of the Ontario Securities Commission. She is a former Director of the Corporate Finance Branch and Policy Advisor to the Chair of the Ontario Securities Commission. She was the Chair of the OSC Task Force on Small Business Financing. Ms. McCallum is now a private practictioner specialized in securities law.

The OSC's own complicity to the cash yield deception in income trusts has cost ordinary Canadians, mostly seniors at the 50 plus age, billions of dollars of capital losses since 2001. 1 in 3 of the 123 business income trust IPOs between January 1, 2001 and now is in capital loss of over 20%, with an average capital loss of 51% and total capital losses in this group of over $4 billion. About 3 in 10 of the 115 secondary offerings of business income trusts between January 1, 2001 and October 25, 2005 are in capital loss of over 20%, with an average capital loss of 45% and total capital losses in this group of close to $9 billion. A small proportion of these heavy % and absolute dollar losses is due to the Federal Government Income Trusts Tax Plan, with a significant amount of the balance due to the marketing deception known to Paul Hayward in 2002. Most of the business income trust torpedoing began well before the October 31, 2006 Federal Finance Minister income trusts tax announcement.

Did Paul Hayward personally sign off income trust prospectuses at the OSC that contained the misleading estimated distributable cash, that did not prominently disclose return of capital? Did he personally see and approve the Green Sheets containing the inaccurate and misleading cash yields used to value the income trust IPO and secondary offerings, that were sold to unsophisticated seniors and other retail investors since 2002? Did he show other OSC superiors, in addition to any of the ones who helped him prepare the article, the article he wrote in the CTJ in 2002 ? Did he ask these superiors to take actions so that the OSC was not complicit to the deception in income trusts in same manner he says the federal income tax act was? Why did Paul Hayward pass the buck to the federal government being complicit to the income trusts deception in the Federal income tax, when his own job at the OSC would squarely have personal responsibility for himself, or his colleagues in OSC Corporate Finance, not to approve prospectuses that contain the deception he describes in his CTJ article? Should Paul Hayward be terminated for being complicit in the income trusts deception he describes in his CTJ article? Why has he not resigned from his OSC position, if his employer forced him to be complicit to the income trusts deception in his capacity as senior corporate finance lawyer?

Why has David Wilson, current Chair of the OSC, not been asked to resign by his boss, Ontario Government Services Minister Gerry Phillips, due to him being personally complicit since November 1, 2005 to the OSC approval of income trusts prospectuses containing the described deception in the CTJ article prepared in 2002 by a senior corporate finance lawyer at the OSC and containing the same inaccurate and potentially misleading financial measures discussed in the attached May 3, 2006 decision summaries of the Canadian Accounting Standards Board?

Furthermore, since David Wilson has the conflict of interest of having personally supervised as a C.E.O. of Scotia Capital Markets , the co-lead in about 28% and the syndicate participation in about 64 % of the business income trusts IPOs and secondary offerings between January 1, 2001 and October 25, 2005, how can he be signing off the OSC guidelines for the definition of estimated distributable cash expected to be released in the first week of January 2007? The Scotia Capital Market income trusts' prospectuses and Green Sheets contained the noted inaccurate and misleading financial measures, just as all of them did? Why has David Wilson not called for any OSC investigation on any of the business income trusts that have torpedoed in the market, after financial advisors marketed these IPOs as having high cash yields from mature stable companies and as suitable investments for retirement accounts?

In light of the failures of the self-regulating Canadian Accounting Standards Board, the OSC and all the provincial securities commissions to protect the retirement savings of seniors by not stopping the acknowledged deceptions in the financial reporting and marketing of income trusts, it is now socially responsible for all the Federal political parties to add several new conditions to the federal government income trust tax plan designed to fix the accounting mess in income trusts . Seniors must no longer be duped by the sophisticated market players, who understand that the cash yield is not a measure of business performance and cannot be used to compare one income trust to another.

These conditions for example could be:

(1) income trusts must have financial reporting on Canadian Generally Accepted Accounting Standards (GAAP), and non-GAAP financial reporting measures are not permitted in marketing communications with seniors.

(2) regular distributions are restricted to income only, with excess cash = return of capital paid as special distributions from time to time; or at least, full and equally prominent public disclosure of the income distributions and return of capital distributions in all income trust public disclosure documents and in all financial advisors' marketing materials.

(3) market players must provide a variety of equally prominent financial measures to compare the valuation of income trusts with corporations on a pre tax equivalent basis.

(4) the calling of a federal government enquiry on why the system broke-down permitting the accounting mess and the inaccurate, inflated and misleading cash yields on income trusts sold to seniors and other unsophisticated conservative retail investors.

Diane Urquhart
Independent Consulting Analyst
Mississauga, Ontario
Telephone: (905) 822-7618
Cell: (416) 505-4832

Relevant Excerpts from Canadian Tax Journal: Income Trusts - A Tax Efficient Product or the Product of Tax Inefficiency - Paul Hayward:

Page 4
The tax policy goals of simplicity and neutrality may be undermined by the income trust form. Some investors, particularly retail investors, may not understand that the product they are purchasing is packaged to resemble a fixed-income product but in reality is closer to an equity claim.Similarly, some investors may not grasp that part of the apparent yield represents a return of capital as opposed to a return on capital. If investors are being misled about the fundamental nature of their investments, then it may be argued that the Act is complicit in the deception.

Page 32
The complexity of the income trust is of particular concern, since some investorsparticularly retail investorsmay not fully appreciate that income trusts, they are purchasing a product that is packaged as a fixed-income product but that in many cases resembles, in economic terms, an equity claim. If investors are being misled about the fundamental nature of their investment, then the Act is complicit in this deception.

Page 20

Some anecdotal evidence suggests that the growth in income trust products derives disproportionately from the retail investor market, and that institutional investor interest is limited. If it is true that demand resides principally with retail investorsthe least sophisticated segment of the marketone must ask whether retail investors fully understand that they are purchasing a product which, although it is packaged to resemble a fixed-income product, may in substance represent an equity claim. For example, Brussa has noted that in the current, arguably disflationary, environment characterized by a significant decline in short-term interest rates . . . the fact that this financing vehicle tends to produce high levels of periodic distributions not accompanied by a decline in unit value (by reference to trading price) causes investors to view units of royalty trusts or income trusts much in the same way as a bond. Therefore, units tend to trade at a high multiple of distributable cash flow which is analogous to a yield computation. They are therefore attractive to fixed-income investors. [Emphasis added.] The extent to which fixed-income investors understand that they are substituting low-risk and low-return income products (such as T-bills, GICs, and corporate bonds) for higher-risk and higher-return income products (such as equities) is questionable. Because fixed-income products have traditionally been highly secure, the act of clothing an equity product in the form of a fixed-income product may confer an unwarranted appearance of security on the product.

For example, one recent advertisement for an income trust fund reads as follows: I have good news for investors looking for an income product that can outperform T-Bills, GICs, bonds and many dividend mutual funds! When you look at the monthly income paid to investors from [the advertised fund] over the last three years compared to other investments, you might be really surprised. Its forward yield has been between 13% and 15% each of the past three years. The trust has a one-year trailing yield of 11.9%. . . .Compare our performance to what you would have earned on other income investments. The yield of the average Canadian bond fund has been under 5% over the past 12 months, and on the average dividend fund, it has been less than 2.5%. Note that the ad simply refers to the income trust as an income product, and suggests that its yield is to be measured against that of other income products. Although some cautionary language is used in the ad, the overall impression (in my view, at least) is that the income trust product on offer bears a risk profile similar to that of traditional fixed-income investments, but offers much higher returns. To the extent that an income trust unit simply represents a repackaged equity interest, it should be substantially riskier than a T-bill, GIC, or corporate bond. One hopes that all investors will see that additional yield comes at a priceadditional risk. A second element of possible misperception is inherent in an income trust product. Income trusts are widely promoted as being tax-advantaged investments: In a low interest rate environment, fixed income yields are not the only thing shrinking. So are dividend payouts, both on common shares and preferred shares. This leaves income-oriented equity investors increasingly looking beyond traditional sources. If you need tax-efficient income, income trusts are the only game in town, says John Priestman, managing director of Guardian Capital Inc. and co-manager with Kevin Hall of GGOF Guardian Monthly High Income Fund, the largest in the Canadian income trusts category. . . . What makes income trusts so tax-effective is that much of their returns are deemed a return of capital. . . . Return of capital is not a free lunch. Any such payments reduce the adjusted cost base of the fund units held, increasing the amount of capital gains investors will be taxed on when they eventually redeem their units at a profit.

The advantage is capital gains are taxed at the lowest rate for most investors, and the holder gets to decide when to realize the capital gain. You get the lowest tax rate, and at a time of your own choosing, Mr. Priestman says.Brussa has argued that in fact this does not represent a tax advantage per se, since it is based on a misperception: The fact that distributions from income trusts are either entirely or partially characterized as the return of capital for income tax purposes (usually as a result of deductions available at the distributing entity level), while considered yield in the eyes of income trusts, most investors, results in distributions being considered tax-advantaged when compared to traditional yield products (namely, bonds and certificates of deposit). . . . The tax advantages of receiving a return of capital which is misperceived by the investor as yield is not a tax advantage per se. [Emphasis added.]

Page 21

The use of a trust as a substitute for the corporate form also appears to allow the promoters of the offering to pick and choose the corporate attributes they wish to retain (including attributes that are intended to be mandatory attributes of the corporate form), such as a shareholders right to bring a derivative or oppression action.85 Similarly, when the identity of the issuer that makes the public offering (an overlying holding entity rather than the operating entity) is altered, certain basic securities law requirements applicable to public companies may be avoided, since the operating entity does not become a reporting issuer, and the multi-tier structure allows shareholders to disaggregate their holdings (and thereby potentially avoid rules relating to insider reporting, control block distributions, and takeover bids).

Diane Urquhart
Independent Consulting Analyst
Mississauga, Ontario
Telephone: (905) 822-7618
Cell: (416) 505-4832
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Postby admin » Fri Dec 22, 2006 1:39 pm

Yield debate Continues 4 Years Later

Earlier this year, OSC chairman David Wilson said the regulatory body
would have guidelines in place for defining distributable cash by the
end of 2006. Investors are still waiting.

Barry Critchley
Financial Post

Friday, December 22, 2006

Unless the Ontario Securities Commission makes an announcement soon, it will miss its self-imposed deadline of creating a definition of distributable cash by the end of the year. Distributable cash is, in effect, how much the issuer has available to pay out to the unit holders. Cash distribution, which represents a part of distributable cash, is the numerator that, when divided by the trading price of the units of an income trust, gives the yield. And yield is one of the key ingredients used in determining the offering price of income trusts.

A few months back, David Wilson, the OSC's chairman, said the country's senior regulator would "have guidelines for the definition of estimated distributable cash by the end of 2006."

Two other bodies, the Canadian Accounting Standards Board (CASB) and the Canadian Institute of Canadian Accountants (CICA), have already passed the matter to the OSC. Both have said that the problem of regulation of financial reporting of non-GAAP measures should be solved by the OSC. The reason: The CASB does not have legal authority to stop income trusts from providing financial reporting on non-GAAP measures.

And the CICA is a professional organization whose job is not to regulate accounting standards and financial reporting. It is not given over to regulation. Estimated distributable cash and cash yield are two such non-GAAP measures.

But in a sense, part of the answer to the OSC's search for a definition of distributable cash already lies within the intellectual capital of the OSC.

Four years back, Paul Hayward, then the legal counsel, corporate finance, at the OSC, penned a 40- page article in the Canadian Tax Journal, a most prestigious publication, called "Income Trusts: A 'tax efficient' product or the product of tax inefficiency?"

Hayward said that "the income trust structure effectively allows the owners of a taxable operating business to retain many of the non-tax advantages of the corporate form (such as limited liability) while largely avoiding certain tax disadvantages associated with the corporate form." Hayward, who is still with the OSC, said foremost among these disadvantages is the double taxation of income earned by the corporation: once at the corporate level and again at the individual shareholder level.

For this, Hayward blames the federal Income Tax Act. "The income trust structure represents a market response to the Income Tax Act's disparate tax treatment of legal entities, economic claims and cash flows, all of which may, in many cases, be economically equivalent or nearly equivalent."

But he adds a second dimension to that criticism, after noting investors should understand that they aren't purchasing a fixed-income product but a product that "in reality is closer to an equity claim. Similarly, some investors may not grasp that part of the apparent 'yield' represents a return of capital as opposed to a return on capital. If investors are being misled about the fundamental nature of their investments, then it may be argued that the [federal Income Tax] Act is complicit in the deception."

What's interesting about that comment is that the underwriters make no distinction between return of capital and return on capital when talking about return. They just talk about yield, a measure that combines the two. But there is a difference: The former amounts to the unit holders getting part of their original investment back, while the latter is the normal measure by which yield is determined.

But by combining the two measures, the return is made to be higher than the "real" return. It follows if the real-return measure was used, the returns would be lower, as would the demand for income trusts.

What's also interesting is that the comment was made four years back and was written after Hayward said that in preparing his paper he received "helpful comments" from a number of staff members at the OSC. Of the five people mentioned by Hayward, four are still employed at the OSC.

What's more interesting is that since then, the OSC has approved hundreds of prospectuses from income trust issuers. And those issues have raised billions of dollars from the public, much of it from the average retail mope.

Indeed, cash cannot be raised from the public until the OSC signs off and gives the issuer a final receipt. It's far easier to refuse the receipt of a prospectus than to get the federal government to change the Income Tax Act.

Aside from handing the problem to the federal government, the article is interesting for another reason: On numerous occasions, Ottawa has spoken about wanting to create a national securities commission, the idea being that such a body would be more efficient and apply rules in a more consistent manner and would allow Canada to present one voice to the world.

Jim Flaherty, the Finance Minister, has spoken on a number of occasions about such an initiative. He may have another reason: the desire to ensure that investors are fully informed about the investments they make.

The OSC said it is revising the current income trust policy. "The revisions clearly speak to the Commission's approach to distributable cash disclosure. We are expecting to publish at the end of the first week of January".

It added Hayward's article was done as part of his LLM and he was not speaking in his role as an employee of the OSC.

Financial Post

© National Post 2006
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Postby admin » Fri Nov 10, 2006 3:31 pm

The statements made by the OSC and RCMP in the attached coverage of today's Dialogue with the OSC 2006 Annual Conference make a good script for "This Hour Has 22 MInutes." Meanwhile , while David Wilson admits the OSC has much work to do, another one of his Scotia Capital Markets underwritten income trusts topedoed today.

This week's business income trusts torpedo is Granby Industries Income Fund, based in Granby, Quebec. Seniors and other conservative investors in the Granby Industries Income Fund have now lost $48 million since this income fund's initial public offering less than two years ago on December 16, 2004. The lead investment bankers were RBC Dominion and Scotia Capital Markets, who lead the five investment bank syndicate sharing $4 million of investment banking fees. Stikeman Elliot and Torys were the legal advisors on this IPO, who shared in the total additional fees of $4 million deducted from the proceeds of the IPO for the costs associated with the acquisition of the underlying business and for preparing the IPO. The percentage loss on the investment is now 65%, after falling 33% today upon the news that distributions are being suspended and top management is being changed.

Granby Industries Income Fund is 16th worst on the list of 45 business income trusts that are down more than 20% since their initial public offerings, falling in rank from the same list provided in my research reprot: Income Trusts: Heads I Win, Tails You Lose dated October 18, 2006.

It is interesting to note that this is yet another business income trust that paid distributions well in excess of net income. For the 9 months ending September 30, 2006, the net income was $1.294 million, estimated distributable cash was $4.075 million and the actual cash distributions were $6.222 million. In the year prior to the IPO, Granby Industries had net income of $4. 696 million and estimated distributable cash of $10.372. The initial distribution per unit on an annualized basis was $1.125, reduced to $0.90 on September 30, 2006 and suspended today.
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Diane tells it like it is. No self serving agenda. Adocate

Postby admin » Sat Oct 28, 2006 10:40 am

Who's got an agenda?
Re: Mintz Slammed Over Trust Stance, Oct. 24.

Diane Urquhart
Friday, October 27, 2006

Jeffrey Singer of Stikeman Elliot alleges that Jack Mintz, professor of business at the Rotman School of Business, is in pursuit of a larger agenda than informing the public about the impact of income trusts conversions on government revenues.

"Mr. Mintz seems to be using income funds as the thin edge of the wedge in his pursuit of a larger agenda of tax reform he has been chasing for years," said Jeffrey Singer, a senior partner at Stikeman Elliott LLP. "Income funds are essentially his convenient lever."

Mr. Singer can hardly criticize Mr. Mintz, when his employer, Stikeman Elliot, makes millions of dollars in fees as legal advisor to the income trusts or investment banking syndicates, who sell units of income trusts to seniors and other investors. Stikeman Elliot has made an estimated $16-million of legal fees on 16 business income trust offerings that are now down more than 10% from their offering prices.

The average capital loss on these 16 deals is minus 43% and the total capital losses is $1-billion. Investors lost while investment bankers earned $127-million and lawyers made $32-million on these deals. The worst deal on the list is Spinrite Income Fund, down 87%, where Stikeman Elliot was legal advisor for the investment banking syndicate.

Stikeman Elliot is among the sophisticated market players who are able to take advantage of unsophisticated retail buyers of income trusts by focusing them on inaccurate cash yields.

We cannot let Stikeman Elliot slam legitimate contributors to the public debate on income trusts, such as Jack Mintz.

Diane Urquhart,

Independent consulting analyst,

Mississauga, Ont.

Advocate "$16 million in legal fees on 16 income trusts. No wonder the good folks at Stikeman Eliot have public commentary to make. Now if they only had public interest............."

Keep up the good work Diane. You are changing the way Canadians think and act about income trusts, and doing it without personal gains at stake. Very admirable.
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Canadian Business Article on Spinrite

Postby urquhart » Wed Oct 25, 2006 8:02 pm

Location: Mississauga
Posted: Thu Oct 26, 2006 2:58 am Post subject: New Canadian Business Article on Spinrite Income Fund


Canadian Business Magazine
October 23 - November 5, 2006
Matthew McClearn

Knitting and crocheting enthusiasts will tell you that making sweaters and scarves is a great way to relieve stress. The same has sometimes also been said of income trusts: ideally, they¹re supposed to pay investors a predictable stream of income from a stable business. And calm is the defining characteristic of a small rural community like Listowel, Ont., with its 5,900 souls and surrounding farmland. Yet somehow, these three ingredients combined to create a nightmare for investors who bought into the Spinrite Income Fund.

Spinrite, a yarn manufacturer, has for decades been one of Listowel¹s largest employers, rivalled only by a Campbell¹s food plant. The town¹s tallest buildings are churches, and Mennonites move about in black horse-drawn buggies. That income trusts made it here is testament to just how pervasive they¹ve become. It¹s a world apart from the Byzantine wheeling and dealing of Wall Street and Bay Street, which paid the town several visits in recent years. Listowel may seem an unlikely destination for investment bankers, institutional investors and analysts‹but much is possible when stock markets and hobby fads converge.

Though the official line places Spinrite¹s founding in 1952, a trip to the Stratford-Perth Archives reveals that the company¹s roots stretch back to just before the First World War. According to local history and folklore, German immigrant Max Becker was on his way to set up a wool-spinning and dyeing shop on the shores of Lake Huron. But a fateful encounter with six Listowel businessmen, each of whom offered him $1,000 to set up in their town instead, convinced him to found Perfect Knit Mills on the banks of the Maitland River. He was just in time to capitalize on massive wartime demand for wool to manufacture soldiers¹s uniforms. That made Becker rich. As a local newspaper noted decades later: ³Mr. Becker was a man whose timing was good.²

Becker sold out in 1933, and the new owner renamed the company Maitland Mills. It again enjoyed strong demand during the Second World War, but subsequently suffered three unprofitable years and eventually folded. A member of a prominent local family, David Hay, came to the rescue. He cobbled together new investors, bought Maitland¹s assets and founded Spinrite Yarn and Dyers Ltd., in 1952.

Through a combination of workaholism and constant investment in new technology, Hay built Spinrite into one of North America¹s largest yarn manufacturers. Hay explained to a local newspaper in his later years: ³We have taken out machines only four or five years old and replaced them with better, more efficient models.² But toward the end of his life, he despaired as his customers in the Canadian textile business faltered. They couldn¹t keep up with American competitors, let alone those in developing countries.

Upon Hay¹s death in 1985, his two sons, Robert and Douglas Hay, took over. The latter presided over Spinrite¹s declining commercial yarn business, which dried up during the 1990s as clothing manufacturers moved offshore to reduce labour costs. Robert Hay, meanwhile, rescued the company yet again by diversifying into craft yarn‹basically the balls of yarn you see at craft and department stores. He bought up or licensed brands such as Phentex, Patons, Bernat and Lily during the 1990s.

In 2002, the company consolidated its dispersed warehouses in a new manufacturing and distribution centre. Henceforth, it concentrated on craft yarns, pitting itself against U.S. competitors such as Caron International, Coats & Clark and Lion Brand Yarn Co. (Commercial yarn operations ended in 2003, by which time Douglas Hay had left‹leaving his brother as the lone
shareholder.) Spinrite became Canada¹s yarn leader by buying out competitors, and grew its U.S. market share to nearly one-fifth.

By early 2004, Robert Hay wanted out. His two adult children showed no interest in running the business, and he hoped to retire. So that January, he sold Spinrite for about $81 million to a partnership led by New York based private equity firm Sentinel Capital Partners. (Sentinel invested US$19 million.) Hay said at the time: We are confident that by working together with Sentinel we will be able to further develop our business. As to how exactly the business would be developed, however, little was said.

Private equity firms make some people nervous. For decades, detractors have accused them of hijacking weak companies, boosting their short-term cash flow, piling on debt and then flipping them to unwary public investors. But academic studies consistently found evidence that reverse leveraged buyouts (a popular private-equity maneuver, and one Spinrite was about to experience) actually performed as well as‹or better than‹other types of transactions. This year, a study by Harvard University professor Josh Lerner and Boston College¹s Jerry Cao argued private equity firms get a bad rap, but offered one caveat: firms held by private equity for less than a year before being spun out performed far worse than average thereafter.

Sentinel certainly saddled Spinrite with debt. Whereas Spinrite had just $4.8 million of it in January 2004, the leveraged buyout increased that more than eightfold. Scotiabank provided most of the credit; Norwest Mezzanine Partners, a Minneapolis-based debt provider, contributed $10 million.

Short-term cash flow also surged, thanks to Sentinel¹s timing‹which was as uncanny as Becker¹s had been nine decades earlier. It so happened that the purchase coincided with a knitting and crocheting craze across North America. Celebrities such as Cameron Diaz and Sarah Jessica Parker came out as knitters, providing much-needed publicity. Young women across North America did, too. They were partly attracted by so-called fancy yarns‹jazzier products featuring unique colours and unusual textures like feather and bouclé‹that even novices could use. We had so many people making these very easy scarf projects as Christmas gifts, says Mary Colucci, executive director of the Craft Yarn Council of America, an industry trade association. It drove sales tremendously. Retailers rejoiced; for example, Michaels Stores Inc., based in Irving, Texas, enjoyed a surge in same-store sales of yarn during 2004.

Fancy yarns generated higher margins, so Spinrite enjoyed a remarkable recovery through 2004. Our focus went to just being able to ship product, says CFO Ryan Newell. We ran a lot of overtime at the facility trying to keep up with demand. All told, Spinrite earned record revenue of $105 million that year.

Hay¹s replacement as CEO was Dario Margve. A graduate of the United States Military Academy at West Point, N.Y., Margve built his career with various management positions at Nestle S.A. in the 1980s. During the 1990s, he worked with a private equity firm to develop the business of J. B. Williams Co., a purveyor of personal products including fading brands like Aqua Velva and Brylcreem. Brands play an important role in the craft-yarns business, says Margve. My entire background is in consumer products, primarily in sales and marketing, so I thought I could bring some expertise in that regard. He started at Spinrite in August 2004 with a base salary of $500,000.

By then, Sentinel already had a plan for Spinrite. It had been in discussions with underwriters about spinning off the company as an income trust. Sentinel had held some investments for more than seven years, but not this one. Was this the dreaded ³buy and flip² that investment bankers warn their children about?

The conventional wisdom is that mature businesses with stable cash flows and little need for capital expenditures are ideal candidates to become income trusts. Highly cyclical or seasonal businesses‹or ones requiring extensive capital expenditures‹need not apply. Spinrite's prospectus emphasized the yarn industry¹s even-footedness, and observed that there hadn¹t been a downturn in 10 years. Indeed, between 2000 and 2003, its craft yarn sales consistently ranged between $55 million to $56 million. The brands had been around a long time, says Margve. The competitive base was limited‹the same players had been there for years. Barriers to entry were high. And unlike the commercial yarn equipment David Hay had upgraded often, Newell says craft yarn machinery hasn¹t changed much in 20 years. Capital expenditures would be small, they believed.

Had everyone followed the above logic, things mightn't have turned out so badly. But Spinrite also predicted its unprecedented surge in revenues would continue. Why? For one thing, North America¹s population was aging. That meant more knitters, management reasoned, because ³the average knitter is female and over 50 years old. Meanwhile, young women‹including college students‹flocked to the craft thanks to the sudden popularity of fancy yarns. And due to deteriorating global security, North Americans claimed to be spending more time with family and friends. This cocooning trend, the prospectus posited, meant that individuals are also spending more time on crafting activities such as hand knitting and crocheting.

A great deal rode on these assertions. Income trusts pay their distributions out of a vaguely defined concept called distributable cash. This generally refers to the cash generated by the underlying business minus typical expenses like operating costs, taxes and capital expenditures, though there¹s no standard method of calculating it. Management claimed Spinrite could generate more than $25 million a year in distributable cash. That assumption helped drive Spinrite¹s enterprise value to about $301 million, almost four times what Sentinel paid a year earlier.

But in arriving at that calculation, Spinrite plugged in the 2004 sales of $105 million, which were unprecedented in the company's history. Most of the metrics or financial aspects of the IPO were negotiated between [Sentinel] and the underwriters, says CFO Ryan Newell. But I can say that it was normal for an income trust being marketed at the time to take the most recent 12-month activity and reflect that in the prospectus as the basis for valuation. Some critics, however, condemn that approach as unduly aggressive. They set the distribution too high, says Diane Urquhart, an independent analyst.

Urquhart (who once worked for Spinrite¹s lead underwriter, Scotia Capital Inc., and is now one of its most vocal critics) says the underwriters shouldn¹t have allowed it. In my years in the business, if a company produced a hockey stick forecast, you didn¹t price it on the hockey-stick high, she says. If a company sets an aggressive distribution and then has to cut it, it's going to suffer damages to the stock Spinrite is symptomatic of a very serious structural problem with income trusts, and the high risks in that structure.

Robin Schwill, a lawyer with the Toronto firm Osler, Hoskin & Harcourt, says such decisions ultimately must lie with management, not the underwriters. Who's best to know? It's going to be management of the enterprise, he says. As long as they're putting forward prospectuses that comply with securities legislation and make full, true and plain disclosure of the circumstances, I don't think there's any requirement for‹nor would the market want‹somebody to step in as an intermediary.

Scotia spokesman Frank Switzer agrees. People looked at the industry and the solid history of this company, looked at who its customers were, and made decisions based on that, he adds. Everybody has to remember that income funds are still equity investments subject to a company¹s performance. It's not like a bond.

Prospectuses are often dismissed by investors, partly because prospectuses read a lot like technical manuals. But investors ignore them at their peril. In addition to the usual boilerplate warnings about unforeseeable events, Spinrite's revealed specific concerns. One was that nearly two-thirds of Spinrite¹s recent revenue gains came from two customers. If either of them fell on hard times, Spinrite's growth spurt could end in a hurry.

Spinrite¹s prospectus also mentioned that most of the growth came from fancy yarns. But it pointed out that consumer tastes and fashion trends are fickle. An employee of one Toronto yarn shop (who requested anonymity) explained that manufacturers risk their products falling out of favour. It's all about fads, he said. Knitting will become a fad, and then it will go into crochet, and this year felting is very popular. Either you get lucky and it¹s still in, or you¹re very unlucky and you¹re stuck with warehouses full of stuff.²

Perhaps the biggest risk was that the IPO saw Spinrite pile on even more debt. It intended to pay off its outstanding loans and enter into a new credit agreement with a syndicate that included Scotiabank, CIBC and the Bank of Montreal. Total debt would rise to $67.7 million‹the highest on public record. Of course, that money came with strings attached. One debt covenant proved particularly significant: Spinrite promised to maintain its ratio of debt to earnings before interest, taxes, depreciation and amortization (EBITDA) below 2.5:1. (This ratio theoretically shows how many years of operational earnings are needed to pay off company debt.) We were leveraged very similarly to other income trusts that went to market around the same time we did, which was 1.5 times EBITDA, says Newell. In other words, at the time of the IPO, Spinrite was well under the 2.5:1 limit. As long as the business is operating the way it's supposed to, that¹s an acceptable ratio. If the business encounters difficulties, there's not a lot of leeway there.

If these risks kept investors awake at night, it didn't show. On Feb. 8 2005, the oversubscribed offering raised $202.9 million, $181 million of which was used to buy 80% of the operating company, Spinrite Inc. Sentinel retained a 13% interest.

This transaction was highly lucrative for its backers. Sentinel made a
killing: it received US$109 million in cash, a 474% return on its original investment, making this, by far, the most lucrative of the five deals it had executed the preceding year.

Transaction costs totalled nearly $14.7 million. Much of that went to the underwriting syndicate (along with Scotia Capital, the other members included CIBC World Markets, BMO Nesbitt Burns, RBC Dominion Securities and TD Securities). Riches flowed into management's pockets, too. Margve received nearly $2 million in cash‹plus another $1.5-million worth of subordinated units‹from Sentinel. The justification was his performance, but he¹d been on the job just six months. And he was promised $3.1 million more in cash, and more subordinated units, during the following three years if he stayed on as CEO. Other executives received lesser amounts.

That left investors. They received trust units at $10 a pop, and the prospect of receiving $1 of income per unit each year derived from Spinrite¹s future yarn sales. Though a significant number were retail investors, institutional investors also jumped on board. Bloom Investment Counsel, once described by investment guru Gordon Pape as one of Canada¹s leading experts on income trusts, bought significant amounts for funds it managed, such as the Citadel Diversified Investment Trust. Manulife Financial Corp. bought several of its Elliott & Page mutual funds. The Globe and Mail dubbed it the strangest offering of 2005. It only remained to be seen whether Spinrite could deliver on its promises.

Just after the February 2005 offering, American domesticity maven Martha Stewart walked out of a federal prison camp in Alderson, W.Va. wearing a poncho knitted by a fellow inmate. Spinrite and Lion Brand both speculated publicly that the inmate had used their yarns. She actually used Lion¹s product, but Spinrite declared ³Martha Poncho Madness Month and produced a pattern so that customers could make a similar item using its Bernat Galaxy yarn.

It was indeed a time of madness. Spinrite¹s sales continued at a frenetic pace during the first nine months of 2005, as retailers stocked up on yarns in preparation for a blockbuster Christmas. Spinrite had to fly in raw materials and outsource some production to other manufacturers. Investors drove its units to a high of nearly $14 that summer. Scotia Capital equity analyst Chris Blake was gung-ho, issuing reports that consistently forecast increases in the value of Spinrite¹s units. In September 2005, Margve increased distributions by 6%, to $1.06 a year. Everything seemed to be going as planned.

But they were all mistaken.

In the fall, craft retailers soon discovered that sales during the crucial Christmas season weren't nearly as buoyant as anticipated. For example, A.C. Moore Arts & Crafts Inc., based in Berlin, N.J., saw yarn sales plummet by 30% in the second half of 2005. Jo-Ann Stores Inc., based in Hudson, Ohio, also noticed unsold yarn piling up. They responded by slashing orders‹and dumping the stuff at liquidation prices.

One of Spinrite¹s smaller customers, Lewiscraft Corp., based in Brampton, Ont., couldn¹t handle it. The 90-store chain applied for court protection from creditors at the beginning of this year. Of Lewiscraft's nearly 150 suppliers, it owed Spinrite the most‹some $600,000. Meanwhile, turmoil at Spinrite¹s other customers continued. In the three months ended April 29, Michaels' yarn sales were down 38% from the same period a year earlier. Jo-Ann lamented a significant deterioration in yarn and quickly replaced top executives.

Manufacturers felt the sting immediately. Spinrite's sales for the final quarter of 2005 plummeted by more than a quarter compared to the previous year. Margve ushered in 2006 by cutting 51 jobs and trimming production. Scotia's Blake, however, remained upbeat. And another analyst, Duff Kovacs of Clarus Securities, commenced coverage in January. Spinrite's units then traded at $6.90, but Kovacs thought they would return to $10. He called it a speculative buy. Bloom Investment Counsel was apparently in a speculative
mood: during the first three months of 2006, it acquired more Spinrite units for its Citadel HYTES Fund, even as its existing holdings dwindled in value. Nobody saw what was coming. I guess we shouldn¹t have been surprised says Colucci at the Craft Yarn Council. But our industry had never experienced this before.

Finally, horror set in. When Spinrite revealed its first-quarter results that spring, sales were just more than half what they had been a year earlier. There was no way its cash flow could cover the generous monthly distributions, so those were cut in half. The unit price imploded, and the analysts slashed their price targets.

Remember the debt? Spinrite quickly ran afoul of its covenants, forcing management to renegotiate them with bankers. In May, they reached an agreement that included a reduced credit limit, relaxed debt-to-EBITDA covenants and a one-year extension to repay borrowed money. Spinrite sold all of its foreign exchange hedge contracts for $5.1 million and used the proceeds to reduce debt. Management figured this would provide enough breathing room.

But it wasn¹t enough. In June, Spinrite eliminated distributions entirely. By September, its units traded at an all-time low of 80¢. Since its units had lost most of their value, Spinrite¹s market capitalization was grossly out of whack with the enterprise value on the company¹s books. Spinrite decided to revise in August, writing down its assets by $160 million. Simultaneously, management revealed that Spinrite was again in danger of violating its debt covenants. During a conference call, Kovacs asked whether management would seek protection from creditors under the Companies¹ Creditors Arrangement Act. Newell denied that. 'We feel it can generate enough cash flow to service the debt and be able to offer a proposal to the banks to get our debt down to what they believe is an acceptable level,' he said. But with unit prices around $1, Kovacs wasn¹t alone in wondering about Spinrite's future. In an August report, Scotia's Blake fretted about how little cash Spinrite had left. The most encouraging thing he could say was that the company is worth more as a going concern than broken up and liquidated. At press time, negotiations continued.

In a Lewiscraft store in a drab subterranean mall in downtown Toronto, a wall of brightly coloured Patons and Bernat yarns sells at half price. Lewiscraft is no more; a receiver liquidated it this summer and 595 employees lost their jobs. Now in the hands of an agent, its few remaining stores are just one venue where knitting and crocheting enthusiasts can pick up yarn dirt cheap. Colucci says members of the Craft Yarn Council expect sluggish sales to continue until next fall.

Spinrite's ownership structure changed in recent months. Bloom Investment Counsel bailed out, while Royal Capital Management Corp. (not affiliated with RBC Royal Bank) began purchasing units in July. By the end of September, RoyCap had acquired a 16.75% stake, making it Spinrite's largest shareholder. It claims this is for investment purposes only, and that it hasn't reached any agreement with management. A RoyCap spokesman declined to comment on the company's intentions. Notably, however, on its website, RoyCap calls itself an expert in financial reengineering for companies in crisis.

What the hell happened? Looking back, Margve believes one contributing factor was that the yarn business failed to convince newcomers to stick to their knitting. For whatever reason, they didn¹t continue to the next level, he says. They didn't make sweaters and afghans. They got bored, and they left. He doesn¹t think his team was to blame. But having experienced both the knitting craze and its implosion, Margve and Newell agree the income trust structure proved inappropriate for Spinrite. In hindsight, should a business experiencing that kind of fluctuation be an income trust? Newell says. No. That's a given.
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Income Trusts: Heads I Win, Tails You Lose

Postby urquhart » Wed Oct 25, 2006 7:45 pm

The full research report, Income Trusts: Heads I Win, Tails You Lose, is available for reading and download at the Small Investors Protection website


Heads I Win, Tails You Lose

Business income trusts will likely suffer a 25% to 35% correction as an asset class. This
“accident” can happen at any time and is most likely to occur when Canada enters its next recession in the normal business cycle.

Income trusts are too risky for seniors and other conservative investors because the business model is flawed and rife with financial reporting problems. They are marketed on a cash yield measure that is inaccurate, misleading and inflated, in most cases.

Corporate conversions into income trusts will continue as long as income trusts are over-valued. These conversions will take place even if Canada moves to complete tax parity for non-taxable pension funds and foreign investors, as well as for taxable individual investors because: (a) the majority of income trusts pay distributions in excess of income, without public disclosure to distinguish between income and return of capital distributions; and (b) market players are not doing pre-tax equivalent adjustments to accurately compare income trusts with corporations.

63% of a sample of 135 business income trusts (from Reuters Trader Workstation) currently pay distributions above income. The current average distribution to income ratio is 160%. The published cash yield is inaccurate when it contains return of capital.

Return of capital does not add value of the trust unit, but when investors are unaware of the return of capital in distributions, they pay too much for them.

Corporations pay dividends that are less than income, except in exceptional
circumstances. Special corporation dividends for the return of capital, are clearly understood not to be sourced from income. Corporations face restrictions on dividend payments, while provincial trusts have no such restrictions.

On the basis of pre-tax equivalent income, 135 business income trusts are trading at a 53% premium to large Canadian public corporations. On the basis of pre tax equivalent cash flow from operations, 110 business income trusts are trading at a 39% premium to large Canadian public corporations.

The structural flaws of income trusts are already causing losses for seniors and other
conservative investors in income trusts. There are 54 business income trusts, or 44% of all the business income trust IPOs issued within the past five and three quarter years, that are in a capital loss relative to their initial public offering prices.

The average percentage capital loss amongst these losing business income trust IPOs is 36%. Total capital losses are estimated to be $3.8 billion in these 54 IPO names, of which $3.0 billion is in the IPO public float.

Close to three dozen business income trusts have lost more than 20% of their capital value since their IPOs, with an average loss of 51% amongst these.


These catastrophic capital losses are from business income trusts that were sold to seniors as mature stable businesses paying a very good cash yield are occurring in prosperous economic conditions. Total future business income trust capital losses may reach $18 to $25 billion.

The 135 business income trusts in our sample have an average cash yield calculation of 8.4%. This includes undisclosed return of capital.

It is inaccurate to include the return of capital distributions in the cash yield calculation because a prudent cash flow analysis over a 10 year horizon assumes that the return of capital to unit holders has an equal reduction of the unit's terminal value or long term sale price.

The Canadian Accounting Standards Board Decision Summaries, May 3, 2006 says:

“’The AcSB does not provide standards for financial information,
such as yields, provided outside of financial statements or for any
of the numerous non-GAAP measures, such as distributable cash,
found in published disclosures. Such disclosures are subject to
securities regulation. However, the AcSB is concerned that the
failure to distinguish clearly between returns on capital and returns
of capital is inaccurate and potentially misleading, particularly when
terms such as “yield” are used to describe the amount distributed.”

Accountability Research, Standard & Poor's, and the Canadian Securities Administrators have found income trusts are funding the return of capital primarily from funds saved by not maintaining and replacing depreciating capital assets. The worn down capital assets will reduce the future value of the business, since future managements will need to cut distributions or raise new equity to fix up and replace the worn out capital assets.

Strategic buyers for the income trust would pay a lower price to account for the need to
invest in upgrading and replacing the buildings, machinery, equipment, or software.
Other sources for the excess distributions are debt financing, cash reserves from prior
equity issuances and accumulated retained earnings, changes in working capital and
customer purchase goodwill. The accumulating debt used to fund excess distributions must be repaid and depletes the future equity value of the business.

There is even evidence that business income trusts raise credit ahead of time to fund return of capital distributions, such as the Teranet Income Fund $70 million credit facility, to be used in part to normalize distributions.

The high sales of income trusts to seniors and other conservative investors using flawed
accounting and inaccurate cash yield has been greased by the enormous bonuses and
fees paid to management and the investment banks, banks, auditors and lawyers involved in selling them.


The trustees for the income trusts and the financial advisors at the front end of the retail sales process appear not to be exercising their duties of care on behalf of the seniors and other conservative investors. If they were, the trusts would not be placed in the public markets on such flawed accounting and financial reporting, which mean many income trusts will be unable to produce adequate investment returns for seniors and other conservative investors in the long term.

Here is the list of everyone making money on income trust conversions:

(a) Income trust vendors are walking with hundreds of millions cash upfront. For
example, in the Spinrite Income Fund, Sentinel Capital made an upfront cash
profit of $107 million on its $31 million investment, while the Spinrite Income
Fund buyers have lost $186 million within eighteen months of its IPO.

(b) Management takes exorbitant restructuring bonuses upfront. For example, 15
Teranet Income Fund management was paid $156 million upfront, of which close
to half was paid to the CEO, who did not create the Ontario Land Registry
business. Similarly, six (6) Spinrite Income Fund management is being paid $15
million over three years, despite the collapse of sales, profits and the unit price
after the company's IPO.

(c) Investment bankers receive average income trust equity offering fees of 5.4%
compared to 4% for public corporations. Financial advisors for the investment
banks get close to half of these underwriting fees for placing income trust IPOs and secondary offerings into their clients' accounts.

(d) Lawyers receive an additional average 1.4% fees for income trust conversions and

(e) Creditors add debt and appear to unnecessarily restructure current credit
facilities with high fees. For example, there was $54 million of “break fees” for
existing debt repayment and “new credit fees” in the restructuring of the Teranet
Income Fund on a public offering size of $700 million (another 7.7% on top of 6.4% underwriting and legal fees).

We need a transparent income trust marketplace, since a bifurcated market where
sophisticated market players take advantage of trusting, old or ill, and unsophisticated retail investors is not acceptable.

We cannot have seniors and other unsophisticated retail investors being advised to buy income trusts on a cash yield measure that is an inaccurate measure of the return on investment and has no meaning compared to other income trusts.

Provincial trust laws governing income trusts should restrict distributions to income.
Income trusts wishing to return capital should from time to time make transparent special
return of capital distributions.


The CAcSB should require income trusts to report both income distributions and return
of capital distributions. Both of these terms should be defined in the Accounting
Handbook, and the Accounting Handbook should prohibit use of the term “distributions” as the sum of income distributions plus return of capital distributions.

The provincial securities commissions must set and enforce a new requirement for income trust prospectuses and other public disclosure documents - and for investment bank marketing materials estimate distributable cash and cash distributions show the
breakdown between income and return of capital. The income yield for income trusts
should be calculated and clearly provided.

The Federal Income Tax Act should add a prescribed condition for a mutual fund trust to
report income and return of capital distributions, and not the combined distributions without disclosure. The income yield must be calculated and clearly provided.

Prepared by:
Diane Urquhart, Consulting Analyst
Telephone: (905) 822-7618
Cellular Phone: (416) 505-4832

October 16, 2006
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Postby admin » Thu Sep 21, 2006 9:51 pm

I sure have to agree with the point:

2) Eliminate self-regulation.............

My experience with financial services tells me that self regulation results in self serving behavior. If the principle applies to the accounting industry as well as finance, then we are doing our own country's financial health great harm in allowing people who look after the money of others to also look after themselves.

It is time for a change.

Keep telling it like it is Diane.

Larry Elford
Lethbridge, alberta
Site Admin
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Location: Canada

Toronto Star - Financial disclosure a matter for trusts

Postby urquhart » Mon Sep 18, 2006 6:54 am

Financial disclosure a matter for trusts
Sep. 16, 2006. 01:00 AM
Regulators, credit analysts, and investor advocates continue to sound the alarm on
financial reporting by income trusts.
Two recent reports draw attention to the information — or lack of it — that is made
public by these popular investments. The Canadian market is now home to more
than 140 income trusts — investments that are designed to spin off a regular cash
distribution to unitholders. As a whole, the industry is worth some $120 billion. To
date, about three dozen trusts have cut or suspended their payouts, leaving
investors stranded.
The Canadian Securities Administrators, an umbrella group of provincial securities
regulators, issued its latest report in August. It examined financial reporting and
disclosure by a small sample of trusts — just 45 of them — but found some big
In total, 84 per cent of the issuers didn't meet required standards for financial
According to the report, 31 agreed to make improvements in future
communications to investors. Another seven were actually required to refile disclosure documents. Just seven "had
no identifiable deficiencies," the CSA found.
The crux of the problem lies with what's known as "distributable cash," or how much cash the trust has available to
pay the monthly or quarterly yields it has promised to unitholders.
There's no standard definition — nor is this figure included in annual audits. That can make it hard to figure out just
how the trust generates its cash flow, and how reliable it is.
"You have this distributable cash figure that not only does everybody calculate it differently, but it's not an audited
number, and there's no link between it and any of the audited financials," said mutual-fund industry expert Dan
In fact, trusts don't even use the same term to talk about their cash flow. In a two-part report issued by Standard &
Poor's in January, the credit-rating agency looked at 40 trusts and found 19 different names used for the concept
"generating and making cash available for distribution."
Troubles at some income trusts have made headlines. Auditors first alleged in 2003 that Atlas Cold Storage was
improperly booking expenses as capital assets, an accounting tactic that seemed to improve its earnings and cash
Heating Oil Partners Income fund stunned investors when it filed for bankruptcy protection in September 2005; and
units of FMF Capital Group plummeted from more than $10 apiece to less than $1 in November 2005 when it
suspended distributions.
When it comes to finding a solution, some look to the regulators.
But despite its findings, the CSA didn't bring sanctions against any trusts.
Investor advocate and independent analyst Diane Urquhart believes the CSA has breached its duty to investors —
particularly seniors — by not sanctioning trusts or instituting new regulations.
Hallett agrees that regulators need to take a closer look.

"I think something should be done, whether it's coming up with a standard definition or making it an audited figure,"
he said. "Either would be better than the status quo."
Kevin Hibbert, primary credit analyst and co-author of the S&P report on income trusts, agrees. "I think it really
comes down to the regulators taking a more proactive response to this."
If you're an investor who holds income trusts, do some homework on the risks involved. The Small Investor
Protection Association website ( has a whole section on income trusts.
Wade through the financial statements to get a handle on how the trust generates cash and how it plans to
consistently pay out what it has promised.
Most investors seem to be pretty familiar with concepts like earnings per share and price/earnings ratios, Hibbert
said. The same is needed for accounting. "We don't have to all be chartered accountants, but we should at least try
to get the accounting knowledge up to snuff as compared to the market metrics."
Madhavi Acharya-Tom Yew writes about mutual funds every other Saturday. She can be reached at
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Another S & P Warning, But No New Income Trust Rules Yet

Postby urquhart » Fri Sep 08, 2006 7:03 am

There is clear evidence of serious financial reporting deficiencies and misrepresentations in the marketing materials of the Canadian income trusts and the Canadian investment banks. The evidence is provided in the published research of the S & P, Accountability Research Corporation, Strategic Analysis Corporation, Edward Jones, Blackmont Capital, Peters & Co. , and now the second Canadian Securities Administrators Review of Income Trusts. Yet, there have been no remedial actions taken by the Canadian Accounting Standards Board, who acknowledges there are inaccurate and potentially misleading financial measures being provided in the marketplace. The CAcSB is unwilling to make recommended changes in accounting standards for income trusts and it passes the buck for remedial actions to the provincial securities commissions and the Canadian Securites Administrators. We have seen the CSA release its latest negative review of income trusts in a mid-summer Friday evening, without naming any names, or making any enforcement penalties for serious infractions. These infractions include not disclosing that distributions are being paid above the income trust's cash flow from operations and are being funded from credit facilities or prior reserves (not unlike ponzis) or not disclosing that there are breaches of bank covenants causing distribution cuts. There are no new rules to stop the inaccurate and misleading cash distributions, cash yields and their use in inflated valuations, despite many such rules applying to public corporations under Canadian company laws.

Meanwhile, seniors and other conservative investors have $3 billion of capital losses on 54 business income trusts, that have an average capital loss of 33% since their IPOs during the past 5 years. The worst 15 names are down more than 50%: Heating Oil Partners, Specialty Foods, FMF Capital, Spinrite Income, Associated Brands, Boyd Group Income, Entertainment One, Madacy Entertainment, Art In Motion Income, Somerset Entertainment, Hot House Growers, Advanced Fiber Technologies, SFK Pulp Fund, Arriscraft International, and Granby Industries.

What does it take to get our accounting standard setters and securities regulators to do their job of providing the most basic investor protection for our highest contributing, yet most vulnerable citizens_ our seniors? Enough of the Flying Circus and Wild West! We have our young people in Afghanistan fighting for justice and democracy, while our Canadian legislators and government administrators, who espouse these principles, are permitting the pillaging of Canadian retirement accounts by a few greedy people and organizations.

Diane Urquhart

Independent Consulting Analyst

Telephone: (905) 822-7618
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Sept 5, 2006 S & P Report Says Trust Reporting Getting W

Postby urquhart » Fri Sep 08, 2006 7:01 am

CSA Report Finds Income Trust
Reporting Still Leaves Room For
On Aug. 4, 2006, the Canadian Securities Administrators (CSA), which includes the Alberta, British
Columbia, and Ontario securities commissions, released its second report on the continuous disclosure
practices of income trust issuers (see CSA Staff Notice 51-319 “Report on Staff’s Second Continuous
Disclosure Review of Income Trust Issuers”, available at Here, Standard &
Poor’s Ratings Services summarizes the more salient points of the CSA report and underscores the
financial reporting issues mentioned earlier this year (see “Canadian Income Funds And The
Perceptions Of Distributable Cash: Part 1”, and “Canadian Income Funds And The Perceptions Of
Distributable Cash: Part 2”, on
CSA Finds Trouble Spots
In summarizing its 2006 findings, the CSA said “…income trust issuers need to significantly improve
the nature and extent of their disclosure. In particular, they need to improve the distributable cash
disclosure in MD&As.” The CSA did not disclose the names of the income trusts reviewed. Below are
the more notable findings.
�� The CSA report indicates that 84% of the 45 trusts examined had “identifiable deficiencies” in their
disclosures and 16% of them had to re-file disclosure documents or file disclosure documents that
they did not previously file. This is a significant turn of events, given that in 2004 only two of the
40 trusts sampled by the CSA had to re-file their disclosure documents as a result of the review.
�� Liquidity disclosures appear to have been quite poor. In many cases issuers apparently did not
provide disclosures about their sources of funding related to current and future cash distributions.
The financial statements revealed that, often, some portion of distributions was funded from sources
other than cash flow from operations, yet this fact was not mentioned by the income trusts. The
CSA Report Finds Income Trust Reporting Still Leaves Room For Improvement
Standard & Poor’s | COMMENTARY 2
CSA specifically noted the use of operating lines, long-term credit facilities, and reserves held back from
previous periods as ways in which the sampled trusts funded distributions.
�� Lack of timely disclosure was often consequential. The CSA identified some events at the operating entity
level of certain trusts that appeared to meet the definition of a “material change” for the trusts but for which
the trust did not file material change reports. For example, certain trusts breached financial covenants under
their credit facilities in three different instances, resulting in the trusts either suspending or significantly
reducing distributions. Surprisingly, when discussing the matter with the CSA, the issuers argued that these
events did not meet the definition of a material change.
�� Three trusts obtained waivers for financial covenants and made amendments to their credit facilities, but did
not file the amended credit agreements on SEDAR. In one instance, the trust did not file the original credit
facility agreement, or the amendments to it. We continue to view the filing of credit facilities on SEDAR as a
critically important practice in ensuring a sufficiently protected and well-informed investor.
�� In some cases, the adjustments made by management, ironically, had limited cash flow impact. In those
instances, the CSA points out that distributable cash did not accurately reflect the amount of cash that was
available for distribution.
Financial Reporting Quality Has Deteriorated Since 2004
There is compelling evidence that the financial reporting risks we have identified this year are indeed quite
meaningful and have increased in significance since the CSA’s 2004 staff review. Provided below are what we
view as key trends and patterns in the CSA’s findings from 2004 to 2006.
�� In 2006, three times as many income trusts had to re-file disclosure documents or file disclosure documents
that they did not previously file compared with 2004.
�� The 2006 report mentions that covenant breaches and financial waivers occurred for which sufficient
appropriate disclosure was lacking by certain trusts. This issue was not mentioned by the CSA in the 2004
report. This is of critical importance to investors given the potential for distributions to be cut or suspended as
a result of a financial covenant breach.
�� We believe that the lack of improvement in distributable cash presentation between 2004 and 2006 has been
the motivating factor behind the CSA’s amendment and revision of Staff Notice 52-306 “Non-GAAP
Financial Measures” to more explicitly state that distributable cash is fairly presented only when reconciled
to GAAP cash flows from operating activities. The CSA also mentioned that it is not appropriate to present
non-GAAP measures in the GAAP financial statements (which includes the notes to the financial
statements). This is a potentially misleading practice that 48% of trusts sampled in the CSA’s 2004 review
engaged in when reporting distributable cash. Specifically, this practice creates the misconception that the
distributable cash figure was subject to an audit or interim financial statement review, which is typically not
the case.
Notwithstanding the CSA findings, Standard & Poor’s employs several measures we believe can reasonably
mitigate the potential effect of information risk and reporting distortions on the ratings process. For instance,
ongoing access to management of rated income fund issuers provides the opportunity to discuss issues and
events such as covenant breaches or other material events that might otherwise go undisclosed in publicly filed
documents. Furthermore, our analytical process focuses on distributable cash metrics that consider, but are not
dictated by the as-reported numbers of management. This is most evident in the analytical adjustments we make, which often result in the reversal or amendment of certain adjustments made by management. We
include those adjustments along with meaningful discussion regarding our rationale, in issuer-specific stability
rating reports available at
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National Post - What went wrong at Spinrite? 08232006

Postby urquhart » Thu Aug 24, 2006 5:45 am

What went wrong at Spinrite?
Barry Critchley, Financial Post
Published: Wednesday, August 23, 2006
The next time a broker at Scotia Capital calls with a great new investing idea, the would-be investor could say: "Let me
give that idea some thought. But before I decide, can you tell me about Spinrite Income Fund?"
The broker may not be that interested in finding out, given that in the past week the units of Spinrite hit a level that
allows them to be bought in a dollar store -- a mere 18 months after the fund was taken public. In baseball, the mendoza
line is regarded as the low water mark; in public markets, ending up a penny stock is the equivalent.
If the broker does some research, what will emerge is the many roles played by Bank of Nova Scotia and its securities
unit, Scotia Capital, in the life and times of Spinrite.
The conclusion: How good was the due diligence given that last week Spinrite recorded $96-million in non-cash
impairment losses and a $64-million charge against goodwill? Spinrite also indicated "it will be difficult for the fund to
comply with certain of its bank covenants," a situation that may end up with it in default.
Clearly, Spinrite was taken public at too high a price. And clearly, Spinrite's best-ever results, posted just before it went
public, were unsustainable -- a not-too-surprising result.
A spokesman for Scotia Capital said, "It's our policy not to discuss clients."
- January, 2004. Sentinel Capital Partners, a New York-based private-equity firm, and Spinrite management complete a
recapitalization of Spinrite, a Listowel, Ont.-based yarn manufacturer and distributor. The purchase price was $80.955-
million, of which $78.768-million was paid in cash; the rest was for assumed debt.
Sentinel got senior debt financing from Bank of Nova Scotia and subordinated debt financing from Norwest Mezzanine
Partners. (Norwest kicked in US$10-million.) The debt portion of the transaction was $48-million -- which presumably
means the equity portion was about $32-million. (Norwest invested US$750,000 in the equity.) Norwest no longer has
a stake. It cashed in its investment last year.
- February, 2005. Spinrite is taken public via the sale of 20.3 million units at $10 per unit.
Scotia Capital was the lead underwriter. CIBC, BMO, RBC and TD were also in the syndicate. The underwriters
pocketed $12-million for their work.
The prospectus noted that a bank affiliate of Scotia Capital was a lender to Spinrite. It also indicated that part of the
proceeds from the offering were to be used to repay bank debt.
Proceeds from the offering were used to acquire 80% of Spinrite's business. (Virtually none of the proceeds went to the
company.) Spinrite's existing shareholders retained a 20% stake via a subordinated limited partnership unit. Sentinel
pocketed about $186-million from the offering and retained a $35-million stake in the income fund by way of units.
One year earlier, Sentinel anted up about $30-million of equity to purchase all of Spinrite.
When the initial public offering closed, Spinrite received a new $67.7-million credit facility. Of the facility, $47.7-
million was for a three-year term while the rest was a one-year revolver.
- After taking over in 2004, the new owners boosted revenue and net income. For instance, in fiscal 2000, 2001, 2002
and 2003, sales were in the $62-million-to-$66 -million range. But for the 12 months ended March, 2004, revenue was
$79-million. A similar trend was underway for net income: Over the four previous years net income was between $1.5-million and $4.8-million; for fiscal 2004 it was $12.4-million.
When data for the 52 weeks ended Sept. 25, 2004, were presented, the results were even better: Revenue was $105-
million; net income was $23.6-million. And the results are even better when the 26 weeks ended Sept. 25, 2004, are
compared with the 26 weeks ended Sept. 27 2003: There was a 82% increase in sales and a 117% increase in gross
profit; net income was up by 317%.
The prospectus noted Spinrite's management "expects that the North American craft yarn segment will continue to
grow over the next several years." The prospectus added Spinrite is positioned "as a low-cost producer ... and will
allow Spinrite to capitalize on the future growth of the craft yarn industry." The prospectus also indicated Spinrite had
focused its product offerings on "higher margin, value added fancy yarns."
So what went wrong?
For a while it seemed there were no problems: The company continued to pay its distributions and the units rose in
value. Last fall it upped the distribution to $1.06 from $1. This year -- or a year after going public -- things turned very
negative: In April it cut its monthly distribution by more than 50% to 4 cents a month (it is now zero) and spoke of
softening sales and inventory backlogs in its Dec. 31, 2005, MD&A report. In May it announced its senior credit
facility had been amended so that it could borrow $10-million less under its former operating facility and $7-million
less under its previous term facility.
© National Post 2006
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