The newly appointed CEO of the FCA starts in October and has to bring about much needed improvements in the protection of retail investors as this is one of the FCA’s top priorities. Glaring weaknesses in the current investor protection regime have seen scandals such as the promotion by FCA firms of low-quality, high-risk mini-bonds. This alert comments on four initiatives to protect retail investors:
- The FCA’s ‘consumer harm campaign’
- An HM Treasury consultation paper proposing restrictions on the financial promotions regime
- A permanent ban on the promotion of speculative illiquid securities to retail investors
- A consultation paper proposing to bring certain unregulated cryptoassets within the financial promotion perimeter
Consumer harm campaign
In its 2020/21 business plan, the FCA sets out plans to help consumers make effective investment decisions and to prevent exposure to risky, poor value investment products.
The FCA has decided to raise over £11 million from authorised firms over a five year period to fund its consumer harm campaign, which will involve communicating information to educate retail investors on what a good investment proposition looks like.
Education is doubtless needed and this campaign will be supported by interventions to protect consumers from high risk investments (HRIs).
HM Treasury consultation on the financial promotions approval regime
HM Treasury’s consultation paper seeks to strengthen the current financial promotions approval regime, under which the only protection from an unregulated financial product offered by an unregulated provider is via the authorised firm that ‘approves’ the promotional material describing the financial product. Too many firms have proved to be inadequate in their approach to this important protection. The proposal is to establish a regulatory ‘gateway’ through which the authorised firm must pass before it can approve such a financial promotion.
Financial promotions are communications that contain an invitation or inducement to access a financial product or service; they can take many forms, including hard and soft copy advertising, marketing brochures, direct mail or social media engagement. Digital marketing of financial products quickly reaches investors hungry for yield in a low interest rate environment and the regulators have decided that they need to increase their control.
Under the current marketing regime, unauthorised firms wishing to promote a financial product need to seek approval of the promotion by an authorised firm (or else ensure that the financial promotion is exempt). The rationale for this approval is that authorised firms are regulated by the FCA and so should have the necessary expertise to check that a financial promotion meets certain standards.
Recent experience shows that extra safeguards are needed to ensure that such approval is an effective method of investor protection. Some FCA firms have provided approval without conducting adequate due diligence to ensure compliance with FCA requirements; other firms have approved financial promotions for products which they do not understand and which fall beyond their normal areas of expertise. HM Treasury highlights that such financial promotions are likely to be misleading, unclear or unfair and can result in consumer detriment.
The problem is therefore that any FCA firm can approve any type of financial promotion for any type of product offered by any unauthorised firm. The FCA often discovers failings only after losses have occurred and so their role is typically reactive and too late. The current regime is too broad and permissive in the view of the Treasury and so two options are proposed to implement a new regulatory gateway:
- Option 1 would require authorised firms to obtain specific consent from the FCA to provide approval for financial promotions of unauthorised firms.
- Option 2 would involve making the approval of such financial promotions a new ‘regulated activity’ under the Financial Services and Markets Act 2000 (FSMA).
Option 1 would empower the FCA to impose a requirement on all existing authorised firms, preventing them from approving the financial promotions of unauthorised persons. Existing authorised firms would then need to apply to the FCA to have this requirement varied or cancelled. Regardless of which option is chosen, HM Treasury highlights that consumers who invest in a product issued by an unauthorised person on the basis of that person’s communication would remain unprotected by the Financial Services Compensation Scheme for losses arising solely as a result of the issuer’s failure.
The consultation closes on 25 October 2020.
Ban on promotion of speculative illiquid securities to retail investors
The FCA’s temporary product intervention (TPI) came into force on 1 January 2020 and was prompted by the collapse of the notorious mini-bond firm London Capital & Finance, which had issued over £200 million of mini-bonds to thousands of investors. Mini-bond marketing typically promises high returns but downplays the risks of speculative illiquid securities (SIS). Financial promotions for these products, which were often mass-marketed, lacked sufficient risk warnings and there was no transparency around the scale of fees deducted from the proceeds of the issue. The FCA has launched a consultation paper on making the TPI provisions permanent; the consultation period closes on 1 October 2020.
What is a speculative illiquid security?
The FCA ban refers to SIS rather than mini-bonds. Broadly, SIS are unlisted debentures or preference shares (with an investment investment of £100,000 or less) where the issuer uses all or some of the proceeds to:
- lend to a third party (that is, a person other than a member of the issuer’s group);
- buy or acquire investments; or
- buy or fund the construction of property.
Often these SIS include one or more of the following characteristics:
- they are issued by an unauthorised person who is not subject to FCA oversight and will generally not be covered by the Financial Services Compensation Scheme;
- they are issued through a special purchase vehicle (SPV);
- they offer a high fixed rate of interest (often 8 per cent or more) to investors if they commit to invest for a fixed period (e.g., three to five years), with little or no opportunity to sell or transfer the investment before the end of that period; and
- investors are subject to high costs or third-party payments made from the proceeds of the bond issue.
The current ban
The FCA’s TPI measures include:
- restricting the promotion of SIS to sophisticated investors or high-net-worth retail investors. This also introduced a requirement to conduct a preliminary assessment of the suitability of the SIS for the recipients of such promotions; and
- making it mandatory for marketing materials to include the date of approval together with prominent risk warnings which address:
- the high-risk nature of the SIS, including the risk of losing the entire capital invested and, where appropriate, the risk that ISA eligibility does not protect consumers from losing their invested money; and
- a summary of costs and charges, including any third-party payments made by the issuer that are deducted from the capital raised.
The restrictions on the financial promotion of SIS were implemented by Chapter 4.14 of the FCA Conduct of Business Sourcebook.
For more detail on the FCA’s TPI please read our previous alert at reedsmith.com.
Proposed changes to the current ban
Making the TPI rules permanent
The FCA proposes that firms will be permanently banned from approving or communicating financial promotions for SIS that are addressed to or likely to be received by a retail client. There are exceptions for promotions to certified/self-certified sophisticated investors or to certified high-net-worth retail investors, and for certain excluded communications.
Where a firm communicates promotions to certified/self-certified sophisticated investors or certified high-net-worth retail investors, it will be required to comply with the TPI measures relating to the promotion of SIS.
Expanding the scope to listed bonds which are not regularly traded
The FCA has noted that the damage caused by speculative mini-bonds can also occur in the case of some listed bonds that are very illiquid and have similar features to SIS. The FCA is concerned about the increasing prevalence of HRIs often being marketed to retail investors by small or start-up companies that are unable to raise funds through traditional routes (banks or institutional investors). In order to tackle this issue, the FCA has proposed expanding the scope of the permanent ban to include listed bonds that are not regularly traded and have similar features to SIS.
Clarification of how promotions are restricted for SIS
In response to some confusion among market participants as to the nature of the marketing restriction and how promotions can be made, the FCA has confirmed that preliminary suitability assessments must be conducted before the potential investor receives any promotional material. Practically, this means firms should not display promotional material relating to SIS on a webpage which is accessible to potential investors prior to a ‘vetting’ of the investor. Prospective retail investors must be identified as falling into an exempt category (certified/self-certified sophisticated or certified high-net-worth retail) before being able to access promotional material.
Proposal to introduce an exclusion for SPV structures for single-company investments
The TPI rules contain a number of exemptions relating to issues of securities used to purchase or develop property. The FCA has proposed an additional carve-out for SPV structures for single-company investments as the TPI rules were not intended to capture single-company debt or equity investments where the company is funding its own commercial or industrial business, or that of a group entity. This carve-out benefits issuers which do not use funds to lend to third parties, buy or acquire investments, or buy or fund the construction of property (subject to limited exemptions). The carve-out applies to structures that involve an investment firm facilitating investment in a single company by using a separate SPV to hold investors’ funds – where the SPV then makes a single investment in the company, thereby funding its commercial or industrial activity. Such structures will only be exempt where the function of the SPV is purely to hold the investment in the underlying company while giving investors a ‘look-through’ exposure to the underlying company.
Clarifications to the TPI rules and next steps
In response to feedback, the consultation paper also seeks to clarify the exemptions to the SIS definition and other technical aspects.The FCA aims to publish a policy statement before the end of 2020 so it can make the TPI rules permanent from 1 January 2021.
Cryptoassets to fall within expanded financial promotions perimeter?
HM Treasury has launched a consultation which seeks to address consumer protection concerns about unregulated cryptoassets (broadly speaking, these are exchange or utility tokens which do not fall within the scope of FSMA). HM Treasury argues that promotion of such assets often overstates the benefits and underplays the risk of loss and the absence of regulatory protections. Such misleading advertising has led the government to decide that intervention is necessary in this market. The proposal, in short, is that unregulated cryptoassets should become controlled investments, which would mean that any financial promotion of such assets would need to be communicated or approved by an FCA authorised firm (absent an exemption). In principle, it might seem odd to ban the promotion of an unlisted debt security to a retail investor but permit the promotion of unregulated cryptoassets; however, the regulators are clearly trying hard not to kill off a nascent and innovative sector and are aiming for a balanced approach, which inevitably involves a degree of compromise. This consultation closes on 25 October 2020.
For further information on the financial promotion of cryptoassets please see the following article from Crypto AM: Talking Legal in the City AM of 28 July.
Please get in touch with your usual Reed Smith contact if you have any questions or concerns regarding this alert.Client Alert 2020-460