CALGARY and OTTAWA -- Marcel Tremblay and John Brussa had no idea what they'd unleashed when they hatched a plan in the fall of 1984 to sell portfolios of aging oil wells to retail investors.
Neither did Ottawa, for 19 years. Over those two decades, the ripples from that plan -- to create the legal foundation for income trusts -- have swept through entire industries and have now left the federal government scrambling to contain the rising tide.
The history of this investment vehicle, and business income trusts in particular, is a tale of a child of the private sector that has never been formally adopted by Ottawa. The anger over the federal government changing the rules for trusts ignores the fact that Ottawa had almost no role in creating them -- other than a technical tax ruling two decades ago.
In the beginning, income trusts were simply a maverick idea from a pension fund manager at Royal Trust who wanted to build up his client list. In the fall of 1984, Mr. Tremblay began to work on a pitch to his bosses, hoping to convince them to let him sell bundles of oil and gas assets to individual investors.
After months of legal legwork with Mr. Brussa, a Calgary lawyer, Mr. Tremblay made the pitch to the board of Royal Trust. It was an utter flop. Mr. Tremblay was told to stop dreaming about the retail market and go back to his desk. No one believed he would make good on his vow to set up shop on his own.
"They laughed at me. They never thought the fourth-best-paid officer of Royal Trust would suddenly slam the door in their face," Mr. Tremblay said.
Two months later, he did just that, and by December, 1985, Enerplus Resources Fund was born. The first income trust hardly got off to a promising start. In January, 1986, oil prices began to crash, bottoming out below $10 (U.S.) a barrel by Easter. In those first few months, Mr. Tremblay was forced to cash in his personal RRSPs to pay his staff. But by August, oil prices had rebounded enough to allow Enerplus to go ahead with its first offering, of $9.15-million (Canadian).
The income trust snowball had started to roll, with retail investors flocking to the offering. Even so, neither Mr. Tremblay nor Mr. Brussa thought they had triggered a corporate revolution. There was no grand policy debate in Ottawa, only a technical tax ruling that allowed cash to be paid to directly to investors.
"It was a small thing, it was a small thing," said Mr. Brussa, now a partner at Burnet Duckworth & Palmer LLP in Calgary, who describes the original trust tax ruling as a "sideshow."
The main event came 10 years later, starting with the 1995 deal to spin off Labrador Iron Ore Royalty Trust from the holdings of Norcen Energy Resources Ltd., a deal stick-handled by Jim MacDonald, then an investment banker with Scotia Capital. Mr. MacDonald knew Mr. Tremblay -- and his efforts in the energy trust market. What started as a conventional deal to spin off Norcen's iron ore interests quickly morphed into the first mining trust. Tax advantages were a factor, but Mr. MacDonald said he also had a gut feeling that a mining trust would be a hit with Canadians.
"After Labrador, we turned our attention and the market turned its attention to how the same concept could be put to work for appropriate corporate entities," said Mr. MacDonald, now chairman and managing partner of Enterprise Capital Management Inc.
The first full-blown corporate conversion -- whose proliferation now has Ottawa so worried -- came just two months later. Mr. Tremblay again played a central role, as he stepped into the midst of a takeover battle for a firm called Mark Resources Inc. He trumped a hostile bid with a proposal to turn the entire company into an income trust, Enermark Income Fund. Mr. Tremblay and Mr. Brussa say that deal, much more than the tax ruling a decade earlier, set the stage for the current explosion in trusts. And Mr. Tremblay said he cannot understand why no one in the federal government in the 1990s understood the implications of the trust structure, particularly after the Mark Resources deal. "They should have realized 10 or 12 years ago."
However momentous those deals, they didn't show up on the federal Finance Department's radar, with the entire trust sector a low priority. "It wasn't that big a thing," a senior Finance official said.
Part of that attitude of official indifference came from the minor role that income trusts played in the wider equity markets. The fledgling energy, real estate and business trust market reached a market capitalization of just $8.8-billion in 1996. For the next five years, trusts were largely the domain of energy and real estate entrepreneurs. "Trust vehicles seemed to be a vehicle that worked reasonably well for them and didn't cause a hell of a lot of concern," the Finance official said.
The other factor lulling Ottawa to sleep was that no one in the federal government was consulted about the conversion of Mark Resources into Enermark; Mr. Tremblay simply used the original -- and still obscure -- decade-old ruling authorizing the income trust structure. His belief was that the original ruling was enough, and that the conversion was no different in principle than earlier and much smaller deals to create income trusts from collections of oil wells. And events bore him out: The federal government did not protest, and Enermark carried on for five years, until it was folded into Enerplus.
But today, nine years after the fact, the precedent has come back to haunt Ottawa, as whole companies disappear into the shadow of the income-trust tax shelter. In the Finance department's view, the business income trust is a creation it never explicitly approved and that has gotten out of hand.
There are precedents, officials say, where the market invents a new vehicle using existing rules and its rampant growth prompts Ottawa to clamp down. Several years ago, the federal government shut down film tax shelters, replacing them with a credit for film producers. The parallels with the debate over business income trusts are striking, as the senior Finance official describes it. No authorizing legislation had been passed, and the film investment craze, which started slowly, suddenly exploded. "It was on nobody's radar screen, until they got a little bit more aggressive."
The Canada Revenue Agency asked Finance to take a look at the phenomenon, and the accounting. The tax shelter was scrapped, and replaced with a tax credit.
That doesn't mean that income trusts will share the same fate, the official emphasized but it shows there are precedents where the market has invented new investment vehicles using existing rules and their rampant growth has prompted Ottawa to intervene.
"There wasn't any specific government program for it. They just used rules of general application," the Finance official said. "But then it got to a point where it was getting out of hand."
Income trusts hardly seemed likely to be a major public policy concern at the end of the 1990s. The collapse of oil prices in 1998 left the energy trust sector reeling. Then came March, 2000, and the tech market crash. Canadian investors watched their equity portfolios evaporate, souring them on growth stocks. Interest rates headed toward 50-year lows, leaving bonds equally unappealing. And the market for traditional initial public offerings dried up, leaving investment bankers searching for a new source of fees. By 2002, trusts accounted for 79 cents out of every dollar raised through IPOs in Canada.
Alarm bells started to ring in Finance, as Canada's income trust market not only accelerated, but took off in much different direction. Energy trusts and real estate trusts were being elbowed aside by a new dominant player: the business income trust, which offered investors cash payouts from sectors other than oil and gas, and property. By 2002, trusts for industries other than petroleum and real estate made up 38 per cent of the market.
The sudden transformation caught Ottawa off guard.
The income trust runup continued unabated in 2003, but sources outside of Finance say serious concern took a long time to percolate to the upper echelons of the department. Even in the fall of 2003, trusts were still "a very low-grade concern," people familiar with deliberations said. "The consensus at the time was it was something to pay attention to, but nobody was sure what to do about it," another official from the era recalls.
In Canada we trust
A four-part Report on Business special investigation.
Tuesday: Why Ottawa turned its back on income trusts
Yesterday: Retail investors dominate the trust market
Today: Why does Canada have income trusts?
Tomorrow: Can trusts be good for the economy?
© The Globe and Mail
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