Finance Minister Ralph Goodale is preparing Liberal Party Members of Parliament and Senators with talking points to address income trust concerns from investors and the public.  Financial experts and the media are being routed by MPs to the Department of Finance.  But Canadians have to wonder: How best to address the lack of information Mr. Goodale is feeding his allies to defend the Party’s stance on income trusts? -

Finance Minister Ralph Goodale is preparing Liberal Party Members of Parliament and Senators with talking points to address income trust concerns from investors and the public.  Financial experts and media are being routed by MPs to the Department of Finance.

Current Situation

Mr. Goodale has written Party members with points to “address the concerns of your constituents” including “Key Facts for Basic Oral Responses” along with his analysis of recent changes in the trust market. He lays a backdrop to say that while investors “and their brokers are extolling the benefits of trusts these days, they’re not the only ones making their views known.”

Similar to Mr. Goodale’s general response letter to citizens who contacted him about the issue, his note to Liberals says “I have also heard from other equally conscientious Canadians (including—among others—some of Canada’s leading entrepreneurs, traditionally incorporated enterprises, and several provincial governments) who take the opposite perspective. They are concerned about the potential long-term consequences of an extensive proliferation of income trusts.”

No doubt, both Liberal MPs and those from other parties as well as the Prime Minister’s Office have been flooded with calls and letters of complaint. Many investors feel there is a problem with the Ottawa freeze on tax rulings for income trusts and its consideration of further taxation or severe policy that could further damage the income trust market.

Early estimates showed that $10 billion in unit values occurred after the stop in tax rulings. Recent estimates by Canaccord Capital suggested that more than $20 billion in market capitalization was lost in the following 6 weeks to the end of October.

Key Points for Discussion from Minister of Finance

The package of information delivered by the Finance Minister is said to include:

(1) A chart and graph seems to show that a decline in trust market value is similar to a drop in prices in the equities market in general;

(2) Suggestion is made that key factors in dropping prices include “lower oil prices” and “concerns about higher interest rates”.

(3) Recognition is given that, in the broadest sense, “The announcement has done nothing to affect the level of distributions received by investors from income trusts,”

(4) Simple logic says that distribution “determines the value of trust investments.”

(5) Summary arguments are made that “Clearly, the decline in the trust index (which is heavily weighted in energy) cannot be attributed solely to the [government] announcement.”

What Really Needs to Be Discussed?

Some considerations required to understand the situation and the consequence of government actions to date:

(1) Uncertainty caused by policy changes in the income trust market may well have caused concerns about the equity market in general. 

If the trust and broader equity markets appear to be moving in synch then this provides short-term evidence that government actions have added significant risk to the income trust market.  In past years, prices in the income trust market have tended to be less volatile relative to returns than those in the equity market in general. Conclusions from statistical studies published in July 2005 by BMO Nesbitt burns can support this fact.

Large investors have said that they perceive Canadian government actions in regard to trusts to be market meddling. Policy setters are seen to be the ones introducing otherwise uncontrollable risk into a significant income sector of the equities market.

The results of government actions on income trusts are potentially catastrophic: Sophisticated investors including American fund managers have pulled capital from Canadian equities markets because of the new added risk determined by our government with actions on trusts.

(2) Market factors identified in the proposed talking points are relatively inconsequential in causing the precipitous decline in the financial markets.

Oil prices are not significantly lower at the end of October than they were months earlier, before the Department made its moves.  People also need to remember that prior to the release of the Consultation Paper in September many fund managers indicated that they had already taken profits from the energy sector during the temporary price spike caused by supply concerns during Hurricane Katrina. 

A concern about higher interest rates does not explain the massive market sell-off in October.  Since early 2005, investors have been learning to expect a tempered rise in interest rates to control inflation.  Recent small changes short term interest rates by the Bank of Canada and the U.S. Federal Reserve did not cause the kind of surprise and the degree of reaction by income trust investors this year compared to prior years.

(3) Changes in policy do not affect the underlying business fundamentals of an enterprise including its ability to pay distributions. However, there is evidence that thoughtful managers of both income trusts and corporations have responded to government actions by changing company financial policies or plans. In effect, they are acting as if addressing a new risk as a company with securities in a public market.

For example, A&W Income Fund decided to hold its distribution rate steady and retain cash rather than increase its distribution rate to pay investors excess cash that would otherwise have been paid to unit owners. And companies seeking new investment capital at the time of government actions, planning the conversion of traditional equities into trust units or the new public offering of trust units, have changed their plans due to government policies. Many potential new issuers sought professional advice and paid unexpected costs to adapt their plans to concerns about pending government policy changes.

(4) The idea that cash distribution “determines the value of trust investments” fails to acknowledge other considerations in valuation that depend on critical factors other than just cash payout.

The quality of business, equity and trust, alike, needs to be valued in terms that include the quality of underlying assets: Oil and gas reserves; Properties and tangible assets; Long term contracts to secure income; Exploration and discovery capacity, etc.

As important, the valuation of security depends on returns relative to risk.  And in the case of Canadian markets, Mr. Goodale’s leading words and government actions following release of the Consultation Paper all increased the level of market risk due to government policy risk, in a very real way.

(5) Reasonable investors might conclude that the largest change in market valuation of income trusts can be seen as relating directly to the most significant change in market conditions: The addition of government-driven policy-related risk.

A starting point for discussion with parliamentarians might include due consideration of the fact that a direct consequence of government actions and official statements is significant uncertainty about the stability of investments in entirely legal enterprises and about the continued viability of the income segment of the Canadian equity market. 

Government actions have not had minimal impact on a small market.  Millions of investors, brokers and analysts are observing first and second-hand that there is painful damage to equity markets in general as a result of Mr. Goodale?s actions through the Department of Finance in regard to the income trust class of security.

Investors and observers have witnessed a new policy of risk-propagation by the Canadian government in its own financial markets, subsequent to the release of a Consultation Paper originally intended to put a process in place to inform policy formulation. 

Retirement savings have been hurt to the extent that capital gains have been destroyed by sellers large and small due to risk aversion.  And as a result, Government actions have diminished the Canadian tax base as reasonable investors have been forced to re-evaluate their investments in Canada.

Key Questions

One might ask their members of Parliament and talk with one another about more fundamental questions such as:

What do we think about the agenda for discussion set by the Consultation Paper? Points for discussion include retirement savings, taxation, corporate structures and productivity.

Whether it is new government representatives or existing powers that are responsible for policy formulation, how can we restore market values and faith in our markets?

Who in Canada will respect the values we have created in our equities market by starting to understand the nature of our innovation? 

Who can demonstrate leadership by committing to stated government intentions and by working to realize the potential benefits of public participation in and contribution to informed policy making?

Significant Response in Respect of Government Intent & Consultation Paper

Members of TrustInvestor felt that it would be most productive to respect the Government?s stated intent to explore issues raised in its Consultation on Flow-through Entities and gather information prior to making changes in policy. Such policy affects investments that determine the quality of so many lives that it deserves attention and thoughtful consideration.

To this end, members have initiated the establishment of iTrustInstitute. We invite participation in our first annual Roundtable on December 14, in Toronto and on the Web. Bringing together people from all sides of the market and society, we expect that our Roundtable will be the first that is truly round.

Non-partisan and not-for-profit, the Institute aims to foster equitable participation in financial markets and an understanding of the fundamental values underlying productive capital and real growth. Our work is distinguished by focus on the unique qualities of income securities based on legal trust, particularly as they relate to broader notions of sustainable capitalism, market integrity and democracy.

This matters because this is where Bay Street meets Main Street and we find opportunity to shape our future, together.