Partner Bambos Tsiattalou writes in FT Adviser regarding FCA ban on speculative mini-bonds

Partner Bambos Tsiattalou examines the Financial Conduct Authority’s ban on speculative mini-bonds from January 2020 in FTAdviser.

Bambos’ article was published in FTAdviser, 5 December 2019, and can be found here.

The FCA will ban the promotion of speculative mini-bonds to retail investors for a year from 1 January 2020. The move is a welcome one, however, it comes too late to protect the 11,600 people who suffered devastating losses in the collapse of mini-bond issuer London Capital & Finance (LCF) earlier this year.

Announcing the ban, the Financial Conduct Authority’s (FCA) Chief Executive Andrew Bailey said, “We remain concerned at the scope for promotion of mini-bonds to retail investors who do not have the experience to assess and manage the risks involved. This risk is heightened by the arrival of the ISA season at the end of the tax year, since it is quite common for mini-bonds to have ISA status, or to claim such even though they do not have the status.”

The FCA’s move comes amid the ongoing fallout of the LCF scandal. LCF had promoted some £236 million mini-bonds to small investors on the basis of false claims that they had ISA status and would be invested in a broad range of companies.

Complex parallel regulatory, statutory and criminal investigations are underway following LCF’s collapse earlier his year. The FCA’s own handling of the matter will be examined closely by the government’s inquiry, led by High Court judge, Dame Elizabeth Gloster. A number of MPs have even called for Mr Bailey to resign, after it emerged that the FCA was warned about LCF three years ago.  We can only hope that these investigations will ultimately lead to the establishment of an effective regulatory regime for mini-bond issuers.

Of course, the term “mini-bonds” is used by promoters to refer to a wide range of investments, some of which are far riskier than others. The FCA’s ban is in respect of “speculative mini-bonds” which it calls “more complex and opaque arrangements where the funds raised are used to lend to a third party, invest in other companies or purchase or develop properties.” There are exemptions to permit the promotion of speculative mini-bonds in respect of less risky investments.

The FCA has also announced a communications campaign to help better inform consumers about the risks of certain investments. It has also warned of an increase in investment scams. The FCA has also singled out Google for its alleged slowness in taking down promotional websites which are breaching FCA regulations.

The new guidance will be set out in the FCA Handbook at COBS 4.14. The amending instrument, the Conduct of Business (Speculative Illiquid Securities) Instrument 2019 has been published online. What are colloquially referred to as “speculative mini bonds” are referred to as “speculative illiquid investments” within the instrument. The instrument is issued under the provisions of the Financial Services and Markets Act, 2000.

Speculative illiquid investments are defined in COBS 4.14.17R. These are defined as a “debenture or preference share” which “has a denomination or minimum investment of £100,000 or less” and which is issued for:

“(a)  the provision of loans or finance to any person other than a member of the issuer’ s group;

(b)  buying or acquiring investments (whether they are to be held directly or indirectly);

(c)  buying property or an interest in property (whether it is to be held directly or indirectly);

(d)  paying for or funding the construction of property.”

The exceptions are set out at COBS 4.14.18R. These include where “the relevant property is or will be used by the issuer or a member of the issuer’s group for a general commercial or industrial purpose which it carries on”.

At COBS 4.14.20(5) this exception is elucidated further by way of two examples. The guidance states that “where a retailer issues a [mini bond] and uses the proceeds to build a shop, the debenture or preference share will benefit from the exemption because the property is used by the retailer for its own commercial activities”.

However, the guidance also states that, by contrast, “where a property developer issues a [mini bond] and uses the proceeds to fund the costs of a property development or construction of property, which is intended to be sold, it will not benefit from the exemption because the development will not be used by the developer itself, and property development and construction services are excluded from the definition of general commercial or industrial purpose.”

However property developers can avail of a further exemption. This is where mini bonds are issued by a property holding vehicle to purchase or construct an income generating property in the UK. For the purposes of this exception, an “income generating property” is defined as “a single property or multiple properties within a single development” in the UK, which “is actually used, or is intended to be used, for residential or commercial purposes” and is rented by persons unrelated to the company’s directors at a commercial rate.

There is also an exception as regards promoting speculative mini bonds to high net worth individuals and sophisticated investors. However, this is subject to a preliminary assessment of suitability and the use of prescribed risk warnings.

Those promoting investments which avail of an exception under the new rules will need to tread carefully. In light of the recent strident criticism of the FCA as regards mini-bond regulation, it is reasonable to assume that the FCA will stringently enforce the new rules. Indeed, the FCA is currently assessing over 200 cases where financial promotions may not have complied with its rules.

The LCF mini-bond scandal shows that the consequences for wrongdoers can go far beyond regulatory enforcement. On 18 March 2019, the Serious Fraud Office (SFO) made four arrests in connection with the case. The four arrests were of individuals connected to the small number of companies into which investor’s money was being pumped.

LCF’s sales agent Surge Financial was paid 25% commission on the funds it raised, totalling some £58 million. Last June, the CEO of Surge Financial, Paul Careless, was also arrested and questioned by SFO officers. It’s no co-incidence that the new FCA rules require that any payments to third parties be disclosed on promotional material, in certain cases.

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. However, issuing mini-bonds is not a regulated activity and so issuers 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.

The FCA has the power to bring criminal charges when an investigation reveals evidence that 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 a parallel investigation into certain individuals connected with LCF.

On 22 May 2019, the Treasury also 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 has directed that the 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”.

While their findings may prove useful, the various ongoing investigations will not recompense those who may have lost their life savings as a result of the scandal. LCF’s administrators Smith and Williamson estimate that investors can only expect to get around 20% of their investment back.

Investors’ hopes of receiving compensation from the Financial Services Compensation Scheme (FSCS) were initially dashed as mini-bonds are not regulated investments. The scheme can pay up to £85,000 per eligible person. Despite initially stating that it would not accept claims from LCF investors, the FSCS has begun exploring possible grounds for compensation.

The FSCS has indicated that it may pay compensation if LCF is found to have provided advice when not regulated to do so. The FSCS issued a fact-finding questionnaire last July. The focus is on whether there was any “regulated advising, arrangement or other activities which may trigger compensation.” The essential question is whether customers were actively advised that mini-bonds were a suitable investment.

LCF paid Surge Financial £58 million to develop its online comparison sites promoting mini-bonds. Given Surge’s reported turnover of £50 million last year, the extent of Surge’s involvement may be of interest to those investors unable to gain compensation from the FSCS.

For investors in LCF, the ban on retail sales of speculative mini-bonds comes too late. It is welcome news that robust action is proposed against those responsible for such devastating losses. Closer scrutiny of the actions of regulatory bodies which are supposed protect people is also welcome.

However, the mini-bond scandal is not over yet. Mini-bond investment firm Asset Life  – which has links to LCF – went into administration in July 2019, with several million pounds missing, leaving 500 investors out of pocket.

The devastating consequences of the ineffective regulation of mini bond schemes are now clear. At last, it seems that the government and regulators are determined to intervene robustly in the sector. Yet the warning signs were there for years. The real shame is that it took a scandal involving almost a quarter of a billion pounds of ordinary people’s money to prompt effective action.