INCOME TRUSTS

Many small investors have already lost by investing in income trusts. In recent years many companies have converted to income trusts to raise money and these units were sold to investors who believed their investment was secure and they would receive a regular income stream. Unfortunately many of these new income trusts could not support the promised income stream (or distribution) and when distributions were suspended or cut the unit value deteriorated. So, anyone who wanted to cash out because of the reduced income found that they would be hit with a loss, which sometimes was quite significant.

There have been warnings since 2003 and this page was developed to alert investors to the risks associated with this type of product. As with any investment product investors should understand the fundamental principles and the related risks and rewards.  

A report released in November 2005 by Accountability Research Corporation is a must read for anyone contemplating an investment in income trusts. The report is available in SIPA's Library under Documents: The Worst is Yet to Come

The Ontario Securities Commission provides the following information on income trusts for investors:

What is an income trust?
An income trust offers units to the public. The money that the trust raises is used to purchase the common shares and debt of a business. As the business generates income, the combination of the trust's equity and debt holdings in the business allows the income to flow from the business through to investors essentially tax-free in the form of distributions. "Distributable cash" is the term that is used to describe the income that flows from the business to investors. In contrast, publicly listed companies usually retain and re-invest their earnings, and sometimes pay out a small portion of earnings to their shareholders as dividends.

Risk and Return
Income trusts are not conservative or fixed-income investments. They are equity-like investments that carry varying degrees of risk. Income trust distributions are not assured, and depend almost entirely on the financial performance of the underlying business. Just like any security, the quality of income trust investments can vary. Before you invest, make sure you look at a range of factors such as any business risks specific to the industry involved, and the management structure that is in place.

The investment industry continues to develop new products that seem designed more to generate earnings for the investment industry than to provide good investment vehicles for small investors, although it is not unusual that investors are offered results that seem too good to be true.

From humble beginnings mutual funds have proliferated to such an extent that it is almost impossible for average investors to understand the risks associated with many of them. Now there is a variety of new structured products, some of which have risks that are much greater than those related to standard mutual funds.

Reduced interest rates have caused many seniors and retirees, who depend upon their life savings to generate income to enable them to enjoy their golden years, to seek alternate types of investment that promise higher returns. Many have not wanted to take on the risk of investing in equities, but succumb to the offers of "secure" investments that offer a high rate of "return". 

Many "GIC refugees" invest in income trusts. Some of the initial trusts were based on mature companies with consistent cash flow and a high rate of earnings. By converting these mature companies to trusts the companies were able to pay out higher returns before taxes, than was possible with dividends paid after taxes. The tax liability is passed to the investor.

The investment industry was quick to realize that not only was this type of product easy to sell but there was a lot of money to be made in the conversion process. Companies whose shares were not saleable could easily be sold as a trust due to demand created by low interest rates. This resulted in many businesses being converted to income trusts.

Most Canadians trust their advisors and also do not have the knowledge or the time to conduct their own due diligence. That fact coupled with the failure of the industry to properly disclose the risks associated with income trusts and particularly business trusts has led to many seniors being invested in products that are not suitable for them.

Already there have been many income trusts that have reduced or suspended distributions or declared bankruptcy. Investors should review their any income trusts they hold and assess the related risks. Get a second opinion. 

MoneySense.ca is a good source for information with The All Canadian Trust Guide. This guide lists the top 100 Canadian Trusts and rates them to help you assess the risks with each fund. MoneySense suggests your risk of loss should be less with the A rated Trusts. 

All investors should become aware of the basics of any investment product and understand the risks associated with each investment product.

Are the products guaranteed? And if so by whom? And what if you need to cash out before maturity? Is there a possibility that you could lose all of your money? Is there any bankruptcy protection? What protection is there for investors? 

Is increased risk of loss worth the incremental increase of return on investment?  

Some investment experts suggest a maximum of 10% to 15% should be invested in income trusts. Business trusts may be particularly troublesome for investors if they, or their advisor, fail to to carry out their due diligence, and if investments are not appropriately diversified. 

Income trusts have become problematic for small investors because of lack of accountability and inadequate regulation. The investment industry has been selling business income trusts to small investors and for many they are unsuitable. 

Investors expect that their principal is not at risk and that the rate of return would be much higher than traditional secure investments. Many have found that the distributions have been reduced or eliminated and that if they wish to access their capital they may face a substantial loss. The British Columbia Securities Commission has placed an investor alert on their website to alert investors. This alert can be accessed on the BCSC website at Investor Alert Income Trusts.

The following articles may help you to understand there are risks associated with all income trusts, and that some of them are unsuitable for most investors. 

March 20, 2003 - "The pros and cons of income trusts" - Larry MacDonald, MoneySense. Legislative responses seem likely. Few other countries are as accommodating. Many of the Canadian IPOs have been originated by cash-staved U.S. firms unable to set up trusts in their home country. Beside the policy risk, it must be kept in mind that income trusts are more like equities than bonds. Their yields are not based on a legal commitment but on management projections for the underlying assets. Given that free cash flow is subject to interpretation, there is a potential for distributions to be cut back. In short, inherent subjectivity provides fertile grounds for accounting and governance flexibility, which can lead to investor disappointment. 

September 10, 2003 - Early Warning - "Yellow flag on trusts in Canada" - International Herald Tribune. Atlas Cold Storage was found by auditors to have booked $3.6 million expenses as addition to capital assets. Stan Buell says "The problem with income trusts is many small investors don't realize how they operate. It's not clearly explained that you can't create money by magic. If people really understood what they were buying, a lot of the stuff wouldn't be sold."

September 2004 - September 2004 Warning - "Distributions dwindle at some income trusts" - Canadian Press. Specialty Foods Group and General Donlee unit values dropped when they announced distributions would be reduced.

May 18, 2005 - May 2005 Warning - "Many trusts will turn out to be scams, Rosen predicts" Advisor.ca. Outspoken forensic accountant Al Rosen has a bit of a reputation in the industry. And it's no wonder. Rosen claims cooking the books is practically a national sport in Canada, laws make it impossible for investors to seek redress and because there are no big lawsuits, the issues are largely ignored by the media. Right now, Rosen has his sights set on income trusts. He says the market is running the same scam Nortel executives used in the late 1990s, only this time around the accounting tricks are being used by companies who are targeting retired people.

May 23, 2005 - "Who do you trust?" - Canadian Business. Al Rosen says "The calculation of distributable cash can be very confusing for investors to grasp."

May 27, 2005 - "CFAs taken to task over trust accounting" - Globe and Mail. Mr. Rosen is one of the more credible trust critics. The sector is now a major component of the capital markets, with more than $120-billion worth of units outstanding. There should be acknowledged, understood rules in place for the ways companies report their numbers.

July 27, 2005 - "Arriscraft wipeout shouldn't happen" - Andrew Willis writes in the Globe: "Wipeouts like this shouldn't happen to income trusts. This sector is supposed to be predictable in its ability to crank out cash. Trusts are supposed to carry modest leverage, so one bad quarter doesn't make creditors nervous. The mess at Arriscraft should provoke soul-searching. Was this a suitable trust candidate? Was management up to snuff? Where were the internal controls?"

August 15, 2005 - "Wild West Accounting" - Canadian Business. Al Rosen says "Con men are fleecing complacent Canadian investors. Where's the sheriff when you need him?"

September 9, 2005 - "Feds reviewing popular income trusts" - Linda Leatherdale, Canoe Money. Linda says "Although income trusts appear safe, they can be risky business."

September 12, 2005 - "Investing in the Dark" - Al Rosen, forensic accountant and principla of Rosen & Associates writes in Canadian Business "Much of the risk associated with income trusts is produced directly as a result of poor disclosure." 

September 25, 2005 - "Income Trust Seeks Creditor Protection" - Grant Robertson reports in the Globe: "Heating Oil Partners Income Fund became the first member of the hot income trust sector to seek bankruptcy protection Monday, announcing that its operating subsidiary has filed for shelter from creditors amid deepening financial woes.

September 25, 2005 - "Painful lessons in structured products" - National Post. In 2002, a small investor invested in Pro-AMS U.S. Trust, a structured product, that invested in S&P 500 companies and wrote covered call options on these shares to generate more income. The fund offered an attractive monthly yield of 9% on the original issue price of $25 a unit. But distributions were halved a few months later, then halved again, then cut to zero. The units currently trade around $21.50.

October 12, 2005 - SIPA letter to the Honourable Ralph Goodale Minister of Finance, Canada - "We are particularly concerned about income trusts because the very name causes seniors to believe these are safe investments. It is only when they see their distributions being reduced and learn that if they want to cash in before maturity that the current value of their capital is much reduced, that they realize they may not have such a safe investment."

October 14, 2005 - "Regulators push for more income trust disclosure on distributable cash" - The Canadian Press. - Income trusts, perhaps the most fashionable investment vehicles on the Canadian market today, need to step up and give a better account of just how much cash they plan to distribute to investors, the Canadian Securities Administrators said Friday.

October 23, 2005 - "Lessons to learn from Bloodbath" - Bill Carrigan, Toronto Star, defines income trusts and offers some advice: "Suitability is the real issue; many of these small business trusts should have been classed in the "junk" category suitable for sophisticated investors who understood the risk associated with the higher yields they promised."

November 11, 2005 - "BMO comes out swinging on trusts" - BMO became the first bank to issue a formal response on the trust issue Thursday, warning Ottawa that any attempts to meddle with these wildly popular investment vehicles could have “significant repercussions on the Canadian economy.”

November 11, 2005 - "Red Flags Can Guide Investors'" - WebBroker Select - One of the easiest ways to lose money in the Canadian equity market is to own a trust that cuts its distribution. So Calgary-based McLean & Partners Wealth Management Ltd. has come up with a way to determine which Canadian income trusts could be the next to cut their distributions.

November 11, 2005 - "Business Income Trust Dangers" - While Income Trusts are the latest investment rage, critics are alerting unwary investors about Business Income Trusts. Will they heed? "Although some good business income funds and trusts exist, many carry significant risks that you will lose much or all of your investment.  Business income trusts are not the same as the oil and gas or real estate trusts.  A trust that is not involved with oil, gas, real estate or public utility (e.g., power, water heaters, etc.) might be very high risk."

November 16, 2004 "The Worst is Yet to Come - The $20 billion deception that dwarfs the tax debate"  - The Accountability Research Corporation Report states "Business income trusts could easily be overvalued by 28% on average, or by $20 billion across the entire business trust market." Reprinted with permission.

November 18, 2005 - "OSC needs to look at FMF"  - Barry Critchley writes in the Financial Post "The desire by retail investors for some regulatory response to the dramatic meltdown in the unit price of FMF Capital Group continues. The company was taken public last March in a $197.5-million offering by a syndicate led by BMO Nesbitt Burns at $10 a unit. The same units were changing hands yesterday at 93 cents, a few days after FMF Capital suspended distributions."

November 20, 2005 - "Pulling Back from Income Trust Mania" - Bill Carrigan writes in the Toronto Star: "Suitability is the real issue; many of these small business trusts should have been classed in the "junk" category suitable for sophisticated investors who understood the risk associated with the higher yields they promised."

November 24, 2005 - "Trusts' share values to fall further: Study" - James Daw of the Toronto Star provides some insight into the Accountability Research Report that analyses the 50 largest business trusts. Daw writes: "On average, those trusts pay cash distributions that are 158 per cent of reported net income. If they only distributed their net income, then their share values would likely drop by 20 per cent."  

November 24, 2005 - "Ottawa cuts dividend tax" - CBC News announces the federal government is reducing tax on dividends to help level the playing field and quotes Finance Minister Goodale as saying: "Reducing the tax individuals pay on dividends will encourage savings and investment and will help establish a better balance between the tax treatment of large corporations and that of income trusts." 

December 5, 2005 - "Wicked Curveballs - Want to recoup your business trust losses?" - Al Rosen, forensic accountant and principal of Rosen & Associates writes in Canadian Business and names 14 business income trusts that "have all lost between 50% to 100% of their value since their IPO". Dr. Rosen says "it doesn't stop there. In fact, 15 other business trusts have dropped between 20% and 50% in value from their IPO price." 

December 6, 2005 - "FMF investors target BMO in suit - Michigan class action alleges underwriter conspired with firm to underplay risks". Derek DeCLOET writes in Report on Business, Tuesday, December 6, 2005:  "A U.S. law firm is targeting BMO Nesbitt Burns Inc. in a class-action suit by investors in FMF Capital Group Ltd., a failed income trust that went public nine months ago. The lawsuit, filed yesterday in a Michigan court, accuses Bank of Montreal's investment banking unit and a U.S. subsidiary, Harris Nesbitt Corp., of conspiring with FMF management to perpetrate a fraud during the marketing of the $197-million initial public offering." 

December 7, 2005 - "FMF claim could reach $1.3-billion - Class-action suit" - Barry Critchley writes in the Financial Post "Juroviesky and Ricci LLP, the law firm that launched a class-action lawsuit on behalf of unitholders of FMF Capital Group Inc., said yesterday that the claim could reach $1.3-billion. 'Our intention is to make the unitholders whole for the $200-million that they have lost,' said Henry Juroviesky, the Brooklyn-born lawyer whose lawsuit also covers the Canadian underwriters, the analyst at the lead underwriter, BMO Nesbitt Burns, FMF's senior management and trustees at the Canadian issuer. On top of that amount, Juroviesky and Ricci LLP will also be seeking punitive damages for willful and wanton misconduct."

December 7, 2005 - "After FMF questions about BMO - Bank shows low returns in business trusts over past four years, Globe study finds" - By SINCLAIR STEWART and DEREK DECLOET and ANDREW WILLIS. "When FMF Capital Group Ltd. spiraled into its precipitous slide a few weeks ago, shedding more than 90 per cent of its value virtually overnight, outraged investors began to ask some tough questions. How could a company plunge from $10 a share to penny-stock indignity in less than eight months of trading? Why was a company with a heavy dependency on low interest rates brought to market as an income trust in the first place? And just what was BMO Nesbitt Burns Inc. thinking?"

December 8, 2005 - "Red tape in getting to bottom of FMF - Barry Critchley writes in the Financial Post: "A group of disgruntled unitholders in FMF Capital Group -- who have seen their original $10 investment become a penny stock in less than eight months -- are working on two different approaches to seek their version of justice. A vast number have responded to the class-action lawsuit filed this week by the firm Juroviesky and Ricci LLP. That suit was filed on behalf of LIMBC Acceptance Corp. and so-called class-action engagement letters have been circulated to investors. A smaller group has launched complaints with Bank of Montreal, the parent company of lead underwriter BMO Nesbitt Burns."

December 8, 2005 - "CARP says it got notice of Goodale announcement" Kathy Tomlinson of CTV News reports: "Finance Minister Ralph Goodale denies anyone in his office leaked word of changes to income trust policy, even as one man told CTV News he was tipped off in a phone call from one of the minister's senior advisors. In the hours before Goodale announced that the federal government was increasing the tax credit on corporate dividends two weeks ago, there was heavier-than-usual trading in income trusts and dividend-paying stocks. That has fuelled speculation that some investors profited from an early warning. Goodale has insisted all along that no advance word came from his office. "The Finance Department is very meticulous about these matters," he said Tuesday. "There was no specific advance notice whatsoever." But a representative of Canada's most influential seniors' lobby group says he got a phone call on the morning of Nov. 23, several hours before the markets closed, and before Goodale made his announcement."

May 24, 2006 - Teranet Income Fund IPO - Do Not Be Deceived By the Cash Yield and Intensive Marketing - Research Report by Diane Urquhart. Ms Urquhart is a research analyst, and an investor advocate actively supporting better investor protection laws, enforcement and adjudication in Canada. She communicates regularly with provincial securities commissions, federal and provincial legislators, the media, the legal community and associations, such as the Small Investor Protection Association, Consumer Council of Canada, Canadian Association of Retired Persons, KAIROS and Canadian Coalition of Good Governance. Ms Urquhart is also an equities representative on the United Church Investment Committee. From 1994 to 1998 she was Managing Director of Equity Research and Equity Strategist with Scotia Capital Markets.