Section 235 of the Financial Services and Markets Act 2000 (FSMA) defines a “collective investment scheme” (CIS), but it can be difficult to interpret and apply in practice. It will be much easier to interpret and apply now the Court of Appeal has handed down its decision in The Financial Conduct Authority -v- Capital Alternatives Limited.

In this case, there were two types of potential CIS:

  1. The African Land Scheme. Here, the scheme operator took a 50 year lease of 3,000 acres of uncultivated land. It built a village, a farmhouse and roads, and began to clear the land ready for cultivation. The operator also sold plots to investors on a sub-lease basis. The investors were free to sell their plots and take a profit, if the value of the land increased as it was brought into cultivation. Alternatively, they could keep their plots and take a share of the profits from each rice harvest grown on their land; and
  2. The Carbon Credits Scheme. Here, the scheme operator planned to acquire the lease of a forest. Some of the forest would be sold to investors on a sub-lease basis. These investors would be entitled to the proceeds of the carbon credits generated by their plots. In at least one case, the plot(s) and the carbon credits would actually be owned by the scheme operator, and the investors would be the beneficial owners of the credits attributable to their plot(s). Some of these arrangements were reflected in the scheme documents, but the rest were not.

Section 235 of FSMA defines a CIS as:

“(1) … any arrangements with respect to property of any description … the purpose or effect of which is to enable persons taking part in the arrangements … to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.

(2) … the persons who are to participate [must] not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions.

(3) The arrangements must also have … the following characteristics (a) the contributions of the participants and the profits or income out of which payments are to be made to them are pooled; [and/or] (b) the property is managed as a whole by or on behalf of the operator of the scheme.

(4) If arrangements provide for such pooling as is mentioned in … (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single [CIS] unless the participants are entitled to exchange rights in one part for rights in another“.

The lead judgment in the Court of Appeal was given by Lord Justice Christopher Clarke; and he found that:

  1. In the African land case, contributions were pooled; but income and profits were not, because the rice from each demarcated plot was harvested separately, and the investors were paid for the rice actually grown on their plot(s). It didn’t matter that the rice was then aggregated, processed and sold in bulk for a standard price. So, the test in section 235(3)(a) was not met.
  2. The “property” referred to in section 235(3)(b) was the same as the property referred to in section 235(1), and that was not restricted to the property acquired by the individual investor(s) (in this case, the plots). It extended to the property acquired by the operator which generated profit for the investors (so it included the roads, buildings and irrigation areas of the land as well). And whether that “property” was “managed as a whole” depended on what the scheme required the operator or his agent to do. In this case, the operator was required to “manage the property as a whole“, so the test in section 235(3)(b) was met, and there was a CIS. “It is not necessary that there should be no individual management activity – only that the nature of the scheme is that, in essence, the property is managed as a whole…”
  3. In the Carbon Credits cases, the Court of Appeal found that “If a scheme provides for the distribution of income/profit, which would mean that there was no pooling, but it is in fact operated in such a way that there is … pooling, it is the actual method of operation that will … determine its nature. The same applies if the scheme does not, by its express terms, specificy how the sharing is to be effected. It is … the way in which it is intended to operate (or, when the time comes, does operate) that will determine its nature“. On the facts of this case, it was “open to the judge to find that there was to be individual accreditation, and that that formed part of the arrangements [referred to in section] 235“, even if these things weren’t reflected in the contractual documents or sales brochures. So, the Carbon Credit Schemes were also CISs.

The second Court of Appeal judgment was given by Lord Justice Vos. Vos LJ’s judgment appears to be a supplement to Christopher Clarke LJ’s judgment:

  1. When section 235(3) refers to the “the property [that] is managed as a whole by or on behalf of the operator of the scheme“, it is referring “not [to] the individual plot … but the whole of the property in respect of which the arrangements alleged to be a collective investment scheme are made“; and
  2. The “arrangements that need to have the characteristic of being “managed as a whole” are those relating to one or more of the acquisition, holding, management or disposal of the property. The question of whether the property is managed as a whole may be answered differently depending on which of these types of arrangements have been made in order to produce the intended profits or income…” (if any).

The final judgment of the Court of Appeal was given by the Chancellor of the High Court, Sir Terence Etherton, who merely agrees (presumably) with Christopher Clarke LJ and Vos LJ.

These judgments answer some of the questions that have made it difficult to interpret and apply section 235 in practice. Some of these difficulties will now fall away. It’s not yet clear whether the FCA will update its perimeter guidance to reflect these findings; or even if one or more of the parties will appeal. We’ll see.