On 26 November 2019, the Financial Conduct Authority (FCA) announced it was imposing a temporary ban on the promotion of mini-bonds to certain retail investors for an entire year, beginning from 1 January 2020 until 31 December 2020. During the period of the ban, the FCA will consult on introducing permanent measures to enhance consumer protection and in the meantime, authorised firms approving the promotions of these products are required to comply with revised FCA marketing rules. In the light of the FCA’s concerns regarding the promotion of unlisted debt securities or 'mini-bonds it issued a separate release providing further guidance for firms on approving financial promotions.'
Over the last ten years a number of companies have issued ‘mini-bonds’ to raise capital for their own purposes. In more recent years there has been a trend for entities issuing mini-bonds to onward lend, make investments and/or buy or construct property. Although these products are structured like a bond, the FCA believes the risks associated with them are more similar to unauthorised collective investment schemes. These products have been made attractive to retail investors by including a high ‘fixed’ interest rate (6-8%), which compares favourably to the rates obtainable from prevailing cash saving products. This has made them popular with retail investors seeking a regular income from investments, such as retirees who may have drawn down their pension savings following the pension freedoms. The FCA noted that many of these products involved complex legal structures that are difficult for retail investors to understand and the products themselves were issued by SPVs without a trading history.
The FCA is concerned that there are a number of aspects of the SPV issued mini-bonds that make them a high-risk investment. For instance, these types of mini-bonds are usually highly illiquid securities, as many are not tradable, which means that the investor will need to wait until the maturity of the bond (usually between two to five years) to get their money back. If in the meantime the issuer gets into financial difficultly, the bonds are not normally protected by the Financial Services Compensation Scheme, which often means the investors lose their investment if the issuer is unable to repay.
The FCA is concerned that retail investors are not able to appreciate the risks and harm they may suffer by investing in mini-bonds. They are also conscious that they have observed the open mass marketing (particularly on the internet) of mini-bonds where the high returns are emphasised and there are insufficient risk warnings and a lack of transparency around fees being deducted from the proceeds. In particular, the recent collapse into insolvency of London Capital and Finance Plc (LCF) on 30 January 2019 highlighted issues associated with these products. Despite the FCA intervening to ban certain LCF promotions, it was still able to issue mini-bonds to 11,625 investors, with a value of £237.2 million. In the wake of this scandal, the FCA had, on 9 January 2019, written to CEOs of all FCA-regulated firms to remind them of their responsibilities relating to the approval of financial promotions. This did not achieve the desired effect and on 11 April 2019 the FCA wrote again to CEOs observing that it had identified a number of examples where the due diligence carried out on certain financial promotion had fallen well short of the standard the FCA expects. The letter also reminded firms how seriously the FCA treats this issue and warned firms that it would consider limiting a firm’s activities if it approved non-compliant promotions and/or bring civil or criminal proceedings against them. This too has clearly had insufficient impact on the market and, given the ongoing independent investigation into the FCA’s regulation of LCF, it is not a surprise that the FCA has sought to take further action to halt market activity it views as a threat to consumers.
FCA's market intervention
On 26 November 2019 the FCA announced its intention to temporarily ban the marketing and sale of ‘speculative illiquid securities’ to retail investors without any consultation. It is rare that dramatic action of this sort is taken without consultation but the FCA felt it was necessary and expedient to introduce immediate temporary intervention measures in order to protect consumers, especially given that the average investment in speculative illiquid securities is over £25,000. The ban comes into effect on 1 January 2020 and lasts until 31 December 2020, after which time the changes will lapse as the FCA is not able to renew temporary intervention measures beyond 12 months.
This temporary restriction limits who ‘speculative illiquid securities’ can be promoted to and how they can be promoted. The FCA regards both debentures (including mini-bonds) and preference shares, as speculative illiquid securities provided that they are denominated, or have a minimum investment of less than £100,000 and the issuer uses or purports to use some or all of the funds raised to (i) lend to third parties, (ii) buy or acquire investments or (iii) purchase interest in or fund the construction of property. This legislation is not intended to capture (i) companies raising debt or equity for the purposes of its group, (ii) credit institutions, (iii) listed debt or (iv) peer-to-peer lending (which is covered by the non-readily realisable securities regime).
Who can receive speculative illiquid securities?
Currently where speculative illiquid securities are likely to fall within the regime for non-readily realisable securities, which can be broadly advertised to retail investors provided the promotion is approved by an FCA-authorised firm and the eligibility of a retail investor is assessed before they receive a direct offer to invest.
The new rules mean that a firm must not approve financial promotions of speculative illiquid securities that are going to retail investors unless (a) the promotion is made only to persons who the firm has taken reasonable steps to establish are:
- certified high-net-worth investor;
- self-certified sophisticated investor; or
- self-certified sophisticated investors.
or (b) the promotion is directed at recipients in a way that may reasonably be regarded as designed to reduce, so far as possible, the risk of acquisition of a speculative illiquid security by persons who are not in the above categories (i) to (iii). This effectively bans the promotion of speculative illiquid security to retail investors who cannot afford to lose the money they invest and/or are not sufficiently knowledgeable to understand the risks related to the investment.
How can speculative illiquid securities be marketed?
In its announcement, the FCA noted that the scrutiny by firms of financial promotions in respect of speculative illiquid securities that those firms were approving had been ‘extremely poor’ to date. Therefore the FCA measures introduce additional requirements to be included for financial promotions of speculative illiquid securities. These are:
- A requirement to include additional risk warnings that the investor may lose all their money and that the investment is higher risk and much higher risk than a savings account (save where there is a character limit).
- Clear disclosure concerning the costs or third-party fees deducted from amounts invested.
This change was in part brought about by the FCA’s observation that it had seen mini products in the marketplace that did not disclose the costs and charges to the investor or embed them in the arranging or structuring of the product, which could be 20% or more of funds raised in some cases. This is in the FCA’s view often undermined the likelihood of the issuer being able to deliver the advertised rates of return.
Additional guidance on financial promotions
The mini-bond issue seems to have caused the FCA to focus on the approval of financial promotions more generally. It is clear that the FCA views current practices to be below the standards it expects and this led the FCA to announce, alongside the ban on mini-bonds, non-handbook guidance to firms on the existing financial promotion rules explaining its expectations and the practical implications for firms that approve financial promotions for unauthorised persons. In particular this guidance focuses on how to ensure a promotion is fair, clear and not misleading, but also covers the extent to which firms can rely on information provided by unauthorised persons and also refers to the FCA’s guidance on the use of digital communications to promote unauthorised retail investment products. It also reminds firms of their obligation under Principal 11 to deal with the FCA in an open and co-operative way, and disclose to it anything relating to the firm of which that regulator would reasonably expect notice. It also encourages firms to consider if their approval of promotions to date, and any prospective approvals before our temporary rules apply, have met these standards. It is also worthy of note that senior management will need to ensure their firm's compliance with the mini-bond ban and have regard to their responsibilities under the senior managers and certification regime, which applied to most authorised forms from 9 December 2019.
The FCA intends to consult in the first half of 2020 on the whether the financial promotions rules need to be strengthened to (i) protect retail investors from the risks inherent in high-risk investments and (ii) ensure firms are meeting appropriate standards when promoting or distributing financial promotions to retail investors. This consultation will also be likely to seek views on whether the FCA temporary measures should be made permanent. The FCA’s aim is to finalise the new rules by the end of 2020, before the temporary measures cease.
The new rules are a targeted at a narrow type of product, which is the sort of product that led to LCF’s downfall. The ban could have been imposed on a wider range of mini-bonds including those issued by smaller companies or charitable organisations and, in time, the FCA may seek to impose similar restrictions on those products. However, it is certain that the FCA is going to be paying very close attention to all approved financial promotions and that firms are going to need to raise their game in this area. Firms in particular should consider whether there are any bonds that they have been involved in that should be brought to the FCA’s attention. This is particularly the case as the new rules are likely to hamper the refinancing of those bonds, which may lead to issues on maturity.
Also, the FCA has stated that it will seek to actively monitor for, and take action against, any increase in scams that seeks to exploit retail investors once the ban is implemented. This may mean that the FCA will seek to scrutinise those firms that have been particularly active in this market segment and also be alive to promoters repackaging their offering to avoid being classified as a 'speculative illiquid securities.'
In any case it is likely that the temporary ban will be made permanent and, if anything, expanded to other retail products where the FCA feels the current protection is inadequate.