Partner Bambos Tsiattalou examines London Capital & Finance in the FT Adviser

Partner Bambos Tsiattalou discusses the risk of investing in ethical or alternative investment schemes and the regulatory consequences of the collapse of London Capital & Finance, in FTAdviser.

Bambos’ article was published in FTAdviser, 7 October 2019, and can be found here.

Complex regulatory, statutory and criminal investigations are underway after some 11,600 members of the public suffered major losses following the collapse of mini-bond issuer London Capital & Finance (LCF) earlier this year. It is widely hoped that these investigations will ultimately lead to the establishment of an effective regulatory regime for mini-bond issuers.

On 18 March 2019, the Serious Fraud Office (SFO) made four arrests in connection with the collapse of the high-risk lender. At that stage, it was known that LCF’s sales agent Surge Financial was being paid 25% commission on the funds it raised for LCF. Administrators Smith and Williamson put the total commission paid at some £60 million. Last June, the CEO of Surge Financial, Paul Careless, was also arrested and questioned by SFO officers.

Investors in LCF mini-bonds were led to believe that their money was being invested in a large number of companies, which transpired not to be the case. In fact, the four arrests made last March were of individuals connected to the small number of businesses into which investor’s money was being suspiciously pumped. Investors were also told that the mini-bonds qualified to go into an ISA. Again, this proved not to be the case.

Mini-bonds can be risky. They allow companies to raise capital by borrowing directly from the public. In LCF’s case, customers were promised returns of 6.5-8% on their investment. Such high yields come at an inevitable cost, with investors typically exposing themselves to much higher risk.

The return on any investment depends upon the success of the company invested in. If that company fails, the investor may see no return at all. Furthermore, mini-bonds are not normally protected by the Financial Services Compensation Scheme (FSCS) and so if the issuer is unable to repay the capital, there is no guarantee that investors will get their money back.

Firms must be authorised by the FCA if they undertake any of the regulated activities listed in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001. Authorised firms have to comply with overarching principles and rules issued by the FCA when carrying on regulated activities in the UK. However, the Order excludes certain activities from its scope. Issuing mini-bonds is not a regulated activity and so firms issuing them do not need to be authorised by the FCA. LCF did not therefore need to be regulated to issue the mini-bonds. However, it did need to be regulated in order to promote them.

Shortly before LCF’s collapse, on 10 December 2018, the FCA ordered LCF to stop marketing its fixed-rate investment bonds and ISA products. Three days later it froze LCF’s assets. The concerns cited by FCA included LCF’s mini-bonds being marketed as ISA eligible, when they were not.

The regulator has the power to bring criminal charges when an investigation uncovers evidence suggesting a crime has been committed. In such cases, the FCA will usually undertake a twin-track approach, with both regulatory and criminal offences being considered. In this case, however, the FCA referred the LCF case to the National Economic Crime Centre (NECC) and the SFO. The NECC has launched an investigation into certain individuals connected with LCF. That investigation will run alongside the FCA’s own enquiries.

Following the collapse of LCF, the FCA issued warnings about the risks of investing in peer-to-peer lending or mini-bonds. Although the investigation into LCF was opened following a referral from the FCA, the regulatory authority itself has also been burnt by the scandal. It has emerged that the FCA had failed to adequately regulate the firm, despite receiving warnings some three years prior to LCF’s collapse.

In March of this year, the FCA Board launched an independent investigation into issues raised by the failure of LCF. The investigation is to examine whether the existing regulatory system adequately protects retail purchasers of mini-bonds from unacceptable levels of harm and the FCA’s supervision of LCF.

However, on 22 May 2019, the Treasury used its powers under the Financial Services Act, 2012 to direct the FCA to launch an independent investigation into the relevant events relating to the regulation of LCF. The Treasury stated that, “it is in the public interest that the Financial Conduct Authority (“the FCA”) should undertake an investigation into the relevant events relating to the regulation of London Capital Finance plc (“LCF”) and it does not appear to the Treasury that the FCA has undertaken or is undertaking into those events”.

The Treasury considers “relevant events” to be the events and circumstances surrounding the failure of LCF and the supervision of LCF by the FCA during the relevant period.

The Treasury has directed that the independent investigation “must focus on whether the FCA discharged its functions in respect of LCF in a manner which enabled it to effectively fulfil its statutory objectives”. Amongst several specified issues, the investigation is required to look into whether “the FCA adequately supervised LCF’s compliance with its rules and policies” and “whether the FCA had in place appropriate rules and policies relating to the communication of financial promotions by LCF.” The investigation must also examine whether the FCA received relevant third party information relating to LCF; whether the FCA had “appropriate policies” to respond to such third party information and whether any processes were properly applied.

The Treasury’s direction also sets out detail as to how the investigation should be conducted. In particular, it specifies that the investigator must liaise with the SFO and the FCA to ensure that the investigation does note prejudice the ongoing joint investigation and any subsequent prosecutions or regulatory actions by the SFO and FCA.

The Treasury’s direction specifies that the final report should include the investigators findings, conclusions and the FCA’s response to those findings, conclusions and recommendations – including any lessons the FCA considers it should learn from the investigation. The Treasury directs that this report be completed within twelve months, in the absence of satisfactory reasons for its delay.

All these investigations are undoubtedly in the public interest. However, the specific interests of the thousands of people who may have lost their life savings as a result of the collapse of LCF must also be carefully considered. For these investors, perhaps the most important question is whether any of the relevant companies will be in a position to repay the loans.

Earlier this year, LCF’s administrators Smith and Williamson warned that most of the businesses LCF invested in had been unable to provide proof that they would be able to repay their loans. Only one company, Independent Oil & Gas, looked like it would be able to repay a substantial part of its loan. The administrators estimate that investors can only expect to get around 20% of their investment back.

Investors’ hopes of being able to recoup their losses from the Financial Services Compensation Scheme (FSCS) were initially dashed as a result of mini-bonds not being regulated investments. However, despite originally stating that it would not accept claims from investors in the collapsed scheme, the FSCS has more recently been exploring possible grounds for compensation for those affected.

The scheme – which can pay up to £85,000 per eligible person – has now indicated that it may pay compensation to investors if LCF is found to have provided advice when it was not regulated to do so. To that end, the FSCS issued a fact-finding questionnaire last July, which has already been completed by thousands of investors.

The scheme’s focus is on whether there was any “regulated advising, arrangement or other activities which may trigger compensation.” As part of that investigation, the FSCS says it wants to “better understand” the relationship between LCF and the company founded by Surge Financial’s CEO, Paul Careless. The authorities will need to carefully consider whether customers were actively advised that the mini-bonds were a suitable investment for them, or whether they simply took the orders.

LCF paid Surge Financial £58 million to develop its online comparison sites promoting mini-bonds. Although not charged or subject to bail, the recent arrest of its founder demonstrates the robust approach being taken by the SFO in ensuring a thorough investigation takes place. Given Surge’s reported turnover of £50 million last year, the extent of Surge’s involvement in LCF will no doubt be of particular importance to those investors unable to make a case to the FSCS.

Some might say that regulators did too little, too late, to protect the investors. It is certainly proper that those involved in the wrongdoing which caused such devastating losses for investors should be held to account. However, it is also perhaps welcome news that the regulatory bodies which are supposed protect people against such wrongdoing will also face investigations when they fail in their duties.

The scandal is unlikely to end with LCF’s demise. For example, mini-bond investment firm Asset Life  – which has links to LCF – went into administration in July 2019, with administrators unable to locate several million in funds. It had sold over 700 mini-bonds to some 500 investors. Even celebrity home-makeover guru Kevin McCloud recently hit the headlines when it emerged that some 200 investors in mini-bonds issued by his company now face significant losses.

It is clear that mini-bonds schemes have operated without effective regulation for some time. The consequences for many investors are only now becoming clear. While it will be cold comfort for those investors shouldering losses, it does appear that the government and the regulators are now determined to thoroughly investigate and – most importantly – learn hard lessons in the wake of the collapse of LCF and other mini-bond schemes.