This paper proposes to analyse the structure of an income trust as a starting point from which recent broker/dealer decisions will be discussed.1 It is also the hope of the authors that we might provide some useful insight into avoiding the pitfalls we envision will be faced by dealer/brokers in the event of a failure of an income trust.
"Arriscraft Wipeout Shouldn't Happen"- so read the headline of Andrew Willis' Globe and Mail column of July 28, 2005.2 The wipeout which shouldn't have happened was the almost 60% drop in value of Arriscraft International's unit price, from $9.80 to $4.03. The loss stemmed from Arriscraft's announcement that its second quarter sales were down 18% from the previous year due in part to a "carryover of large dealer inventories… from the winter booking program."3
In and of itself, the market's reaction to Arriscraft's news is not shocking - especially in a market that is now little surprised by meteoric rises and stunning drops in listed companies' perceived fortunes/valuation.4 What prompted Mr. Willis' admonition, however, was the fact that the investment in question was an income trust - an investment vehicle which the market assumed provided a constant, comforting rate of return.
Whether one can assume that the income trust sector will continue on its steady path is a matter of some uncertainty. Clearly, Al Rosen of The Accountability Research Corporation does not believe the sector can sustain its current pace. According to its report of November 16, 2005, entitled "The Worst is Yet to Come", the analysts at Accountability believe that the Canadian business income trust sector is overvalued by 28% or a total of $20 billion.5 While Mr. Rosen appears to be a vocal minority in the income trust debate, his warnings and the Arriscraft International experience presage the fact that, regardless of how well the income trust sector does as a whole, it is likely that there will be at least a few income trust failures. Further, some of those who invest in such failures are apt to blame their broker/dealer and, of those who are apt to blame, some of them are likely to sue.
The Income Trust Phenomenon
The collapse of the tech bubble in the spring of 2000 (the fallout from which is still being litigated to this day) coincided with the emergence of the Income Trust in Canada as a preferred investment structure. The surge in the popularity of income trusts is made readily apparent through a review of the TSX publication: "Income Trusts on Toronto Stock Exchange (TSX)".6 Some interesting facts to be gleaned from this publication are as follows:
- income trusts represent 10% ($176.2 billion) of the Quoted Market Value (QMV) of all securities listed on the TSX and 15% (229) by number of issuers.
- 62% ($110.8 billion) of income trusts by QMV are based in Alberta; 22% in Ontario, 9% in Quebec, 6% in the rest of Canada, and 1% in the US.
- 37% (84) of income trusts by number are based in Alberta and 10% (22) in British Columbia.
- As of September 2005, income trusts represented 39% of equity capital raised on the TSX, 33% of IPO dollars, and 22% of new listings.
- In 2004, it is estimated that income trusts paid out distributions of $6.98 billion to unitholders.
- The number of income trusts listed on the TSX has more than tripled over 5 years.
- Trading Volume in income trusts has increased 6 times over the last 5 years.
The Structure of an Income Trust
While we don't propose to spend more space than is necessary discussing the nuances of the structure of an income trust, some description is required for the purposes of understanding the potential basis for a broker/dealer negligence suit.7 An income trust, in its most simplified form, is composed of three layers: the business, the trust, and the unitholders. The business generates a stream of revenue which is transferred, directly or indirectly, to the trust in accordance with the terms of a "note indenture". The trust owns, directly or indirectly, the equity of the business and usually most of the debt. The administration of the trust is overseen by trustees in accordance with the terms of an indenture. The unitholders, through their trust units, are the owners of the trust and hence are owners of a beneficial interest in the stream of revenue generated by the underlying business.
Benefit of the Income Trust Structure
The benefit of adopting an income trust structure is quite simple: a greater realization of after-tax income by investors in the business.
This greater realization of after-tax income is accomplished through the avoidance of "double taxation". When the profits of a business are paid to investors through other means, such as dividends, they are paid by the business using the business' after tax profits. The dividends are in turn taxed in the hands of the investor (subject to a federal dividend tax credit). At current corporate and personal tax rates, taking into account the dividend tax credit, this "double taxation" results in less after-tax income finding its way to the investor when compared to cash distributions made by income trusts directly to the unitholders.8 Thus, the benefit derived by the use of an income trust results from the shifting of the tax burden from the business directly to the owners of the equity.9
An income trust minimizes the tax paid at a business level because the business is able to deduct all of its debt financing charges and royalty payments from its gross income before applying the corporate tax rate. In turn, if the trust distributes all of its taxable income to the unitholders, there is no tax payable by the trust. Ultimately, the tax burden falls to the unitholders, who are taxed at a rate dependent upon their unique circumstances.
The Average Investor's Understanding of the Income Trust Structure
The popularity of the income trust as an investment vehicle is phenomenal. As with most investment phenomena, it is not merely the sophisticated investor who is attracted by the potential gains. According to Bill Gleberzon, director of government and media relations for the Canadian Association of Retired Persons ("CARP"), "An estimated one to two million Canadians directly or indirectly (through mutual funds) rely on the income from [income] trusts. They're the people who would traditionally have been invested in GICs (Guaranteed Investment Certificates) but who were attracted by the average six to eight percent returns of the trusts. They rely on those distributions for cash flow."10
George Kestevan, head of the Canadian Association of Income Funds ("CAIF"), further specifies that 75% to 80% of the trusts are held by "Ma and Pa retail investors". Mr. Kestevan agrees with Mr. Gleberzon that such investors "are people who are using the trusts as part of a retirement strategy or who are living off the distributions."11
The fact that the bulk of the investment in income trusts is by "Ma and Pa retail investors" should be a clear sign to broker/dealers that extra care should be taken when dealing with this form of investment, especially given that the structure of an income trust is more complicated than that of other securities owned by the average investor (i.e. shares and bonds). This complexity may lead (and has likely led) to investor assumptions, ignorance and misconceptions, which in turn may lead to litigation when such assumptions prove unfounded.
As indicated earlier, it is not the purpose of this paper to provide a detailed discussion of broker/dealer case law. However, it should be noted that broker suits generally involve one of the following: breach of fiduciary duty, breach of duty of care, or breach of contract. Given the unsophisticated nature of the typical investor in income trusts, we will focus our discussion on possible breaches of fiduciary duty; but, reference will be made to other types of breaches when warranted.
Breach of Fiduciary Duty
Case law has long since established that professionals such as brokers can owe a fiduciary duty to investors. In order to establish a fiduciary relationship an investor must establish that a broker: exercised a discretionary form of power; exercised such power unilaterally in such a way that it affected the investor's interest; and the investor was vulnerable to the exercise of such power.12
It does not seem much of a leap to suppose at least a subset of the Ma and Pa investors in income trusts could be categorized as vulnerable to the exercise of a broker's power over their investments. Regardless of the client, it is a broker's job to look after client accounts, provide advice and follow trading instructions; but, in the case of retirees who are depending upon the expertise of an investment advisor to protect their monthly retirement income, one can only imagine plaintiff counsel's arguments concerning the vulnerability and weakness of this unsophisticated group of investors.
Further, while most brokers understand the seriousness of having a Court determine that a relationship is one in which the broker owes a fiduciary duty to his or her client, the effects of being found in breach of such a duty bear repeating: in the event an investor establishes that the purchase of income trust units would not have been made but for the wrongful conduct of the dealer, then the investor is entitled to be returned to the position that he or she would have been had the conduct not occurred and the investment in the income trust not been made. That is, the investor is to be made whole.
In order for a broker to avoid this spectre of liability, he or she must follow the well-tested practice of "knowing your client" . The know your client rule is quite simple: brokers must determine whether an investment is appropriate for a particular client, which depends upon a client's objectives, investment knowledge and experience. To the extent that a client is part of the decision making process, the broker must provide all material that is relevant to allow each particular investor to make fully informed decisions.13 A determination of whether a broker/dealer fulfilled his or her duty depends upon a finding of fact and often involves expert evidence.
Communication is the clearly the key to any broker/client relationship. In order for a broker to understand an investor's objective, knowledge and experience, the broker must ask the proper questions. One means of ensuring the proper questions are asked is to consider in advance potential pitfalls, assumptions and misconceptions as they relate to a particular investment. When dealing with an unsophisticated client, it is important to provide a balanced presentation regarding prospective investments and to warn an investor of the associated risks.14 We therefore provide a brief discussion of issues to be considered by brokers in relation to investments in income trusts.
Be clear in determining a client's objectives
- A client may indicate that he or she has a specific objective in mind and does not wish to 'know the nuances' of the investments in question, as he or she is content to leave that to the broker/dealer. Statements such as "that's why I hired a professional" will invariably float to the surface when the investments fail to provide the desired results.
- The Court may not impose liability upon a broker if an investor's account as a whole has been managed professionally and has performed within the range of "reasonable profitability".15 "Reasonable profitability" is to be assessed taking into account an investor's stated investment objectives.
- Make certain that the investment objectives to be met are clearly laid out.
- Make certain that objectives can be reasonably met. For instance, if the investor requests a guaranteed high yield, explain that such an objective cannot be met - address the internal inconsistency of the requested objectives. This saves the broker from having to respond to the allegation that the investor valued safety above all else and would never have purchased anything other than a GIC had he or she known of the risks associated with income trusts.
An Income Trust Unit is not a Bond
- The most common misconception, which also appears likely to have the gravest consequences, is the belief that an income trust is some form of bond that provides a guaranteed fixed high yield without the risk associated with owning equity.16
- The belief that income trusts provide a guaranteed high yield appears to form the basis for the average investor's retirement strategy to purchase an income trust as a substitute for GICs. Address this misperception.
- Wilful blindness appears to prevent investors from seeking to understand the discrepancy between the cash distributions provided by income trusts and the much lower yields offered by fixed-income securities such as GICs. Use this fact to help explain the difference in risk between these two types of investments.
- There is little doubt that some of the investors who wind up on the wrong end of an income trust collapse will point to the broker/dealer as having indicated that the two types of investment vehicles were interchangeable. Or perhaps, in a less aggressive fashion, an investor might lament the fact that he or she had informed his or her broker of the need for a secure investment with a constant yield and had agreed to invest in income trusts based upon the understanding that he or she was investing in a safe form of income generation suitable for retirement. DO NOT ALLOW THIS CONFUSION TO PERSIST.
- Make certain that investors understand that even though income trusts are now included in the S&P/TSX Composite Index, this does not alter the underlying fact that an income trust is not a bond or a share in a corporation.
- Consider buying a guaranteed income generating investment if the investor's stated risk tolerance is low.
- Do not rely upon the media to educate investors. The media does not have the expertise of brokers/dealers to properly educate investors on the risk associated with income investments. The media does not owe the same duties to investors as do brokers/dealers.
Other Characteristics of Income Trusts to be Discussed
The following are points of discussion that should also be raised with a potential investor in income trusts to ensure that he or she is aware of the risks associated with his or her investment.
There is no guarantee that an income trust will pay out a cash distribution
- Trustees must act in the best interest of the beneficiaries of the trust (i.e. the unitholders); however, distribution promises are at the discretion of the trustees administering the trust and trustees may decide, for a variety of valid reasons, that a cash distribution is not appropriate.17
Not all income trusts are equal
- An income trust's ability to consistently make cash distributions depends upon the health of the underlying business.
- Certain sectors make better income trust candidates due to the certainty of costs associated with the business.
- If purchasing an oil and gas trust, cash distributions depend upon the life of the underlying reserves and the price of oil.
The price of income trusts depends upon interest rates
- The yield of an income trust should be compared to other cash generating investments such as bonds.
- If interest rates go up, the yield in bonds will be greater, thus decreasing the relative value of the trust and, as a result, its pricing.18
Unitholders are potentially at some risk of unlimited liability
- Theoretically, if a unitholder is determined to have control over the actions of a trustee, then the unitholder could be found liable for amounts beyond his or her original investment.
- At present, Alberta, Quebec and Ontario have enacted legislation to limit the liability of income trust unitholders.19
The valuation of an income trust is inextricably linked to its perceived tax advantage
- If it is perceived that the tax advantages are precarious, the valuation of the income trust as a sector will fall.20
- There is currently an ongoing debate as to the tax benefits to Canada of the income trust structure.21
- There is no guarantee that the Government of Canada will maintain the tax laws to the benefit of income trusts. For instance, the Government may decrease the tax rate payable on dividends.
The rights of unitholders vary by income trust and are not the same as the rights of shareholders
- Each income trust provides a unique set of rights to its unitholders as defined by the underlying trust indenture, whereas shareholders are granted rights and are protected through the various business corporation acts.
- As a class, income trusts generally do not provide for shareholder dissent rights.22
- As a class, income trusts generally do not allow for oppression remedies or derivative actions as against their trustees or external managers.23
Breach of Duty of Care and Breach of Contract
As indicated previously, this paper focuses upon the possible breach of broker/dealer's fiduciary duty. However, a few points regarding the duty of care and contractual obligations are worth mentioning.
- Internal broker/dealer policies are looked at by the Court as evidence in establishing the broker/dealer's standard of care.24 Failure to meet these policies may be evidence of the failure to meet the duty of care. Examine your policies to determine which are relevant to investments in income trusts.
- Know how other broker/dealers deal with income trusts. Experts will be hired by plaintiff's counsel to provide evidence as to the industry standard. Failure to meet the industry standard is strong evidence of the failure to meet the duty of care.
- Predictions are not actionable; the same cannot be said of "unwritten guarantees".25 Be cognizant of the choice of words used when discussing the benefits of investing in income trusts, especially as such benefits may relate to "fixed" or "guaranteed" cash distributions.
- Broker/dealer representations may include brochures. Be aware of statements made in promotional material and include qualifications where appropriate.
- The evidence of a broker/dealer consists of the collective memories of all employees and ex-employees - a broker/dealer's approach to income trust litigation must take into account this fact.
Given what appears to be an inevitable progression towards some type of income trust litigation, it is advisable that broker/dealers consider their position now so that steps can be taken to address potential liability.
- A small proportion of the income trust sales force may be either overzealous or underinformed to the extent that they do not provide information to investors sufficient to allow investors to make properly informed decisions when considering purchasing units in an income trust.26 Make certain that brokers understand the risk associated with income trusts and that such risks are being explained to clients.
- Do not wait for a problem to arise. If it is believed that investors purchased income trusts without having been provided the material that is relevant to allow such investors to make fully informed decisions, provide such information now. It will then be up to the investor to determine the direction of his or her portfolio.
- It is suggested that broker/dealers conduct a "litigation review" in conjunction with a lawyer (in-house or otherwise) to determine what information has been provided to investors who have purchased income trusts.
- Make certain that a lawyer is directly involved in any litigation review. Aside from the clear benefit of having a legal expert's input, the involvement of a lawyer is also necessary as the basis for any claim by the broker/dealer of privilege over any information resulting from such review.
The rush of excitement associated with any investing phenomenon eventually gives way to a sober examination of the costs and benefits which underlie the euphoria. The income trust phenomenon will prove no different. This warning is not meant to indicate that income trusts are, in and of themselves, poor investments. We only wish to emphasize that care must be taken to advise unsophisticated investors that, like any investment, there are no guarantees.
1 This paper does not propose to go into broker/dealer decisions in great detail as this topic is the subject of a separate paper to be presented at this session.
2 Andrew Willis, The Globe and Mail, July 28, 2005.
4 At the close of market on January 17, 2006 Arriscraft's unit price has made a recovery to $6.59.
5 THE WORST IS YET TO COME THE $20 BILLION DECEPTION THAT DWARFS THE TAX DEBATE, Accountability Research Corporation November 16, 2005. In the alternative read one of the many articles that cite this report such as Jay Byan's article in the Calgary Herald, November 24, 2005 "Rosen Report shows trust dangers."
6 Income trusts on the Toronto Stock Exchange (TSX), published by the TSX, amended November 9, 2005.
7 Dirk Zetsche describes the structure of an income trust in his article "The Need for Regulating Income Trusts" (2005), 63 V. Toronto Fac. L. Rev. 45. We repeat his description for the reader's ease of reference as follows: Two contracts connect the three layers: a "declaration of trust" or "trust indenture" sets out the terms of the trust, and is applicable to all three layers; a "note indenture" sets out the terms of the debt and is an agreement between the trustee and the operating firm. Together these documents set out a complex division of functions. The operating firm generates the distributable cash that is transferred to the trust as a combination of interest, dividends, lease interest or royalty payments, and return on equity payments. The trust is a special-purpose entity that is created to act as a fiduciary on behalf of the unitholders, and it is typically administered by multiple trustees, acting like a board of directors. In order to make trust units eligible investments for deferred income plans such as RRSPs, the trusts is incorporated as a "mutual fund trust" under section 132 of the Income Tax Act. The trust may fulfil five purposes: (1) bundling debt, royalties, and equity by securitization into a single "unit"; (2) issuing these units; (3) paying out the income generated by the operating firm to the unitholders on a monthly or quarterly basis; (4) exercising shareholder and creditor rights in the operating entity; and (5) owning the operating assets which were formerly owned by the firm. Through their direct investments in trust units, unitholders, who are for the most part public investors, each hold a beneficial interest in the operating firm. An income trust unit represents a share in the combination of debt or royalty interests and equity in the entity owning or operating the business (52-53).
8 See Phillips, Hager & North Investment Management Ltd.'s, "Understanding Income Trusts", report of July 21, 2005 at p. 2 for a simple and understandable diagram comparing taxation of corporate dividends versus income trust distributions.
9 Please note there is an ongoing debate as to whether there exists an overall tax advantage to the income trust structure. For instance, Sandy McIntyre, vice president of Sentry Select Capital Corp., states in the Calgary Herald, Special Section of November 22, 2005 entitled "Income Trusts An Investor's Guide" that Penn West Energy Trust will pay an increase in its taxes from $17 to 210 million due to accelerated taxes following conversion to an income trusts. He cites this as evidence that the Government of Canada's white paper of September 6, 2005 is erroneous in its suggestion that income trusts have an unfair tax advantage, siphon government revenue and drain the productivity of the nation. We do not purport to be tax lawyers and therefore provide no opinion with respect to this issue.
10 See Jim Bentein's article "Canadian seniors bring in 'heavy hitter'" in the Calgary Herald, Special Section of November 22, 2005 entitled "Income Trusts An Investor's Guide" at p. 19.
11 See Jim Bentein's article "Energy trusts- a bargain hunter's dream" in the Calgary Herald, Special Section of November 22, 2005 entitled "Income Trusts An Investor's Guide" at p. 12.
12 Hodgkinson v. Simms,  3 S.C.R. 377.
13 Lamoureux, Re (2001), W.L. 1756302 (Alta. Securities Commission), affirmed in Appeal: (2002), A.B.C.A. 253.
14 Abrams v. Sprott Securities Ltd. (2003), 67 O.R. (3d) 368 (C.A.); affirming (2001), 13 B.L.R. (3d) 78 (Ont. S.C.J.).
15 Hawkenson v. Rogers,  B.C.J. No. 456 (S.C.) at para. 50.
16 See Keystone Financial's Income Trust Report of October, 2005 at p.2 in which it is stated: One of the most common misconceptions regarding Income Trusts is that they are a fixed income investment. Like a bond, a trust offers investors a cash yield … The difference is that although most bonds are required to pay out a predetermined cash flow, Income Trusts have no such requirement…
17 Zetsche, supra, note 6.
18 Bill Maclean, "The ins and outs of income trusts", Benefits Canada September 2003.
19 See, for instance, Income Trusts Liability Act, S.A. 2004, c. I-1.5.
20 See Brian Burton's article, "Buy now. And buy value" in the Calgary Herald, Special Section of November 22, 2005 entitled "Income Trusts An Investor's Guide" at p. 19.
21 See note 8.
22 Goodmans LLP Memorandum To: Industry Canada Subject: Governance of Income Trusts in Canada, December 31, 2005.
24 In addition to actions against broker/dealers, compliance officers may also be sued for failure to meet compliance requirements. See for instance, Andersen v. Fortune Financial Corp.,  O.J. No. 2849 (S.C.J.).
25 White Tower Burgers Ltd. v. TD Securities Inc.,  O.J. No. 2986 (S.C.J.) at para. 16.
26 As evidenced by the following blog posted to billcara.com:
Hi Bill, At the beginning of the year I ask [sic] my financial advisor about a trust he bought for my account. I didn't know much about the income trust structure at the time but was concerned about these units because:
1. It appeared to me it was paying out more then it was taking in and it was funding the deficit with the issuance of more units.
2. The company's expenses had shot up over the last few quarters with no equal increase in profits or expectations of future profits.
3. The company operates in the financial sector with interest rate risks a part of their model and being an income trust compounds the risk.
It also was not a case of this stock/unit falling in price and the client asking what is wrong, the units in question had been moderately rising in price with the rest of the trusts. His answer was basically, "No nothing wrong with it". He did not even attempt to give me a real answer. I then sent him an e-mail after looking at the company reports again to look in to it again but received no response. This and other things caused me to take over my own account. He either did not care or did not know the answers; this surprised me because I am sure he had the same trust units in many of his customer accounts. To me it was a sign of a manager who was told by some one else what to buy but did not look at it himself before placing his customers[sic] capital at risk. Anyways, I am glad I left. Andrew
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.