Following a public consultation conducted by its predecessor, the Financial Services Authority (FSA), the Financial Conduct Authority (FCA) of the UK has published new, final rules1 restricting the distribution of unregulated collective investment schemes and "close substitutes" to certain retail investors.
Unregulated collective investment schemes (UCIS) are collective investment schemes (as defined in Section 235 of the Financial Services and Markets Act 2000), the operator of which has not applied for or obtained authorised or recognised scheme status from the FCA. These CIS are not generally subject to the FCA rules on the operation of collective investment schemes, such as in relation to a CIS’ investment and borrowing powers, its management of risk, information to investors and provisions regarding fees and other investor protection measures.
In addition to UCIS, the new rules focus also on schemes that the FCA regards as close substitutes to UCIS and that, together with UCIS, it terms "non-mainstream pooled investments" (NMPIs). Expressly within the scope of the NMPI definition are units in qualified investor schemes (QIS), non-excluded securities issued by special purpose vehicles (SPVs) and traded life policy investments (TLPIs).
Background. The FSA had previously concluded that most retail promotions and sales of UCIS that they had reviewed were inappropriate and exposed ordinary retail investors to significant risk of detriment. The rules are intended to enhance consumer protection by restricting the promotion of NMPIs to those consumers for whom these products are likely to be unsuitable.
Ban on marketing NMPIs to certain investors. The FCA distinguishes between three different types of retail investor: sophisticated investors, high net worth individuals and "other retail investors." The FCA’s rules are designed to protect the "other retail investors," who are the vast majority of the UK retail market, by a complete ban on promoting NMPIs to them, except in very limited circumstances.
Beginning 1 January 2014, firms must comply with this new communications ban. The means that a firm must not communicate or approve an invitation or inducement to participate in, acquire or underwrite a non-mainstream pooled investment when that communication is likely to be received by a retail client, unless the relevant promotion falls within one of a number of exemptions, such as a promotion to a sophisticated investor or to a high net worth individual.
The FCA is particularly concerned about a number of different investment types, including traded life policy investments (investments in second-hand life insurance policies of US citizens—sometimes known as traded life settlements or senior life settlements). The FCA has found these TLPIs to be "higher risk, complex and opaque products, yet often marketed as low risk on the basis of being uncorrelated with mainstream investments, and many of these products have failed and caused significant consumer detriment." Also of concern to the FCA are schemes based on investments in land, overseas forestry and crops, property/hotel developments and wine.
The FSA’s consultation paper made clear that, despite the reference to securities issued by SPVs, structured products were not the focus of its intervention action. However, since the FSA had encountered securities issued by SPVs that were used to facilitate retail investment in TLPIs, the FCA’s final rules provide that securities issued by SPVs should not automatically be excluded from the definition of NMPI. When the SPV invests in non-mainstream assets, it could be subject to the NMPI restrictions.
Therefore the final rules generally include securities issued by an SPV in the restrictions, subject to a list of exclusions. Among other things, covered bonds, investment trusts, venture capital trusts and REITs and exchange traded products are excluded. Also excluded are securities "wholly or predominantly linked to, contingent on, highly sensitive to or dependent on, the performance of or changes in the value of shares, debentures or government and public securities, whether or not such performance or changes in value are measured directly or via a market index or indices, and provided the relevant shares and debentures are not themselves issued by SPVs."
Of particular interest to US persons resident in the UK: funds registered under the US Investment Company Act of 1940 are excluded from the prohibition. That is, broker-dealers may promote US registered investment companies in the UK to any person who is classified as a United States person for tax purposes under US legislation, or who owns a US qualified retirement plan. This exemption was crafted by the FCA in response to comments that, in the case of US citizens temporarily resident in the UK and expecting to return to the USA, regulated US mutual funds are likely to be more suitable than EEA-regulated funds, and therefore should not be subject to marketing restrictions to which the EEA funds were not.
The FCA has also provided further guidance to firms wishing to rely on the exemptions for promotions to certified high net worth investors, self-certified sophisticated investors and for non-recognised UCITs (i.e. funds which have been approved by an EEA regulator in accordance with the UCITS legislation, but where the fund manager has not applied for the fund to be recognised in the UK). It notes that a preliminary assessment of suitability is required before the promotion of NMPIs to clients, although this preliminary assessment does not extend to a full suitability assessment, unless the NMPI is being promoted on an advised basis. However, it states that the preliminary assessment of suitability requires the firm to take reasonable steps to acquaint itself with the client’s profile and objectives in order to ascertain whether the particular NMPI is likely to be suitable for that client.
One more item of interest in the FCA’s policy statement that contained the final rules is an indication that the FCA is planning to consult on other possible new marketing restrictions. In particular, it is concerned that the new Basel III and (in Europe) CRD4 requirements for banks and building societies to raise loss-absorbing capital will lead to firms offering these types of regulatory capital instruments, and similar instruments such as contingent capital securities (CoCos), to retail consumers who do not have the necessary experience and understanding to evaluate them. It therefore plans to consult on a new restriction for the marketing of these products only to sophisticated or high net worth retail investors, as well as professional investors. In the meantime, it expects issuers to distribute these sorts of instruments in a way that prevents ordinary retail investors from buying them, and it does not rule out using its temporary product intervention powers2 to address these risks in the short term if necessary.
Also on the FCA’s radar are the criteria used to determine when a retail client qualifies as a "high net worth individual." Currently the criteria are that the person must have an annual income of more than £100,000 or investable net assets of £250,000. These criteria were determined back in 2001, and the FCA plans to consult on whether they are still set at an appropriate level, or whether they should be raised.