December 31, 2005
Popular Canadian Investment Runs Into Politics and Hints of Scandal
By IAN AUSTEN, NY TIMES

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OTTAWA, Dec. 30 - Income trusts, the delight of many Canadian investors and a source of concern to corporate governance experts, became yet another thing this week: the heart of a political scandal.

Little known outside of Canada, the trusts have been booming here, offering a way to tap directly into a company's earnings, even for the smallest investors. The trusts also pay virtually no taxes, spurring a stampede of corporate conversions from ordinary stock into trusts.

But late Wednesday the Royal Canadian Mounted Police confirmed that it was investigating whether possible leaks from the Department of Finance on planned tax changes to the trusts may have benefited some investors. The statement comes amid a campaign for federal elections on Jan. 23, with the now disbanded Liberal government in a very tight race.

Canada's opposition parties, which were already campaigning on allegations of Liberal Party corruption, were quick to capitalize on the inquiry. But there was considerable skepticism in the investment community about the police ever laying charges.

"My gut feel is that by the time the smoke clears and a lot of money's wasted, I don't think you're going to find any clear villains," Thomas S. Caldwell, the chairman of Caldwell Securities, told The Globe and Mail of Toronto.

The criminal investigation is major news in Canada. While investors have flocked to the trusts, which now make up almost 10 percent of the Toronto Stock Exchange's capitalization, analysts have questioned the amounts the trusts distribute and the inflated valuations of their units.

Canada's finance minister, Ralph Goodale, has brought up other qualms. In September, Mr. Goodale noted that in paying out most of their income, many trusts were not retaining cash for expansion or to respond to future market changes. "You could be embedding a kind of sluggishness in the economy," he said at the time.

Adding in estimates that trusts were costing the government 300 million Canadian dollars in lost taxes, Mr. Goodale went further: he froze trust conversions while the government studied their future.

An investor outcry produced a series of events leading to Wednesday's investigation. In the ensuing weeks, trust units lost 10 billion to 20 billion Canadian dollars in market value; the investment community swiftly mounted a campaign against the freeze in conversions, prominently featuring the impact on retirees.

With the governing Liberal Party already severely weakened, Mr. Goodale reversed course, and ended the review of the trusts and the freeze on conversions in late November, and instead introduced cuts to dividend taxes to make traditional stocks more attractive. The government nonetheless lost a vote of confidence on other issues at the end of the month.

But in the hours leading up to Mr. Goodale's announcement, trading volume in trust units spiked about 50 percent and the sector rallied 2 percent.

That unlikely trading pattern prompted Judy Wasylycia-Leis, a member of Parliament from the left-leaning New Democratic Party, to ask the mounted police, Ontario's securities regulator and the Securities and Exchange Commission to investigate the possibility of insider trading.

The income trusts began to take off about four years ago in oil and gas companies in Alberta. Since then, they have expanded to involve nearly every sector of Canada's economy, from a sardine canner to the country's largest newspaper chain. While there are no statistics on who owns the trusts, it is believed that individual investors are the largest single group, with about a million Canadians holding part of a trust.

"After the tech bubble burst, many Canadian investors were afraid of stocks; bonds were anemic," said Lewis Johnson, a professor of finance at Queen's University in Kingston, Ontario. "And people started hearing about income trusts."

What they heard was appealing. Like leveraged buyouts, income trusts provide a way for investors to get part of a company's earnings, paid out in regular, usually monthly, distributions. Unlike leveraged buyouts, income trusts let even the smallest investor in on the action.

Since trusts pay little or no corporate income tax and retain only enough earnings to cover depreciation, they are able to offer returns generally in the range of 7 percent to 8 percent, with some hitting double digits. At a time when traditional income-generating investments are offering Canadians returns of only 1 percent to 4 percent, trusts swiftly became the investment of choice for retirees and others on fixed incomes.

As a result, Canadian companies with lagging share prices or low dividend payments now find themselves under shareholder pressure to become trusts.

The conversion process is relatively straightforward. A corporation delists its traditional equity and transforms itself into a partnership held by the previous stockholders. An initial public offering relists the company's partnership units on the Toronto Stock Exchange. A crucial factor in pricing those units is the company's estimate of its profit distributions.

But it is how those cash distributions are set and how the units are priced that worry some critics. Some argue that trust holders may see their investment diminished, or even wiped out, by a long-term decline in the value of overpriced trust units.

In a study released last month of Canada's 50 largest trusts, the Accountability Research Corporation based in Toronto concluded that many trusts units are overvalued at the outset.

One method of inflating the unit value, Accountability Research argues, is to offer cash distributions that exceed a company's actual net income. According to the study, three quarters of the largest trusts are paying out more than their net income. One common technique is to underestimate the amount of profit that must be held back to cover depreciation and future investment.

In a separate report, Accountability Research noted that when ACE Aviation Holdings, the parent company of Air Canada, first looked at spinning off its Aeroplan points rewards program in 2004, the operation was given an assessed market value of 532 million Canadian dollars. Today, as a trust, the Aeroplan Income Fund has a market capitalization of about 2.5 billion Canadian dollars. In an e-mail message, a spokeswoman for Aeroplan declined to comment.

In a telephone interview, Ms. Wasylycia-Leis said that she had no specific evidence of a leak and that the police have not uncovered anything either.

While Mr. Goodale's change of heart was sudden, it was not without hints. The day before his announcement, Mr. Goodale told reporters he would be clarifying his position on trusts before any election. And Canadian newspapers and investor Web sites were filled with speculation that the government was unlikely to impose taxes or otherwise limit the trusts with an election looming.

"It may be that they can't find anything specific," Ms. Wasylycia-Leis said of the police inquiry. "The pattern may be the result of general speculation and the fact that the government did this in such a hurry. But we have to know if in this country some people were able to take advantage of government information."

Unfortunately for Mr. Goodale, the police say it is unlikely those answers will come before election day.