It is being called by some the largest single fraud against small UK investors in decades.

Against a background of recent high profile financial collapses and frauds, the administration of Keydata is yet another concern for insurers as desperate investors seek to recover their losses, often putting IFAs in the front line.

The collapse of Keydata Investment Services Limited (Keydata) in June 2009 has given rise to an increase in claims against IFAs and others involved in its Keydata Secure Income Bond (the Bond), a number of which Mills & Reeve is currently defending. The different compensation tests applied by the courts and the regulatory compensation schemes – the Financial Ombudsman Scheme (FOS) and the Financial Services Compensation Scheme (FSCS) – can make it difficult for insurers to assess the likelihood of liability and accurately set reserves.  

In this, the second of two articles looking at IFA claims, we look in greater detail at the risks and pitfalls of the regulatory regime and its impact on reserving.  

FSCS Compensation

In our first article (Covernote Issue 2 2010) we noted that FOS plays a quasi-judicial role and is empowered to order IFAs and other regulated persons to pay up to £100,000 in compensation where in the Ombudsman’s opinion it is “fair and reasonable in all the circumstances” to do so, despite any legal defences that would defeat the claim in court.  

In contrast, FSCS is the statutory compensation fund of last resort and compensates investors who have lost funds when a regulated entity (in this case Keydata) is “in default” (ie, no longer able to meet its obligations). Compensation for Keydata investors is capped at £48,000 and is only payable if the investor can prove that Keydata somehow breached a contractual or legal obligation that would sound in damages if the matter went to court. Any losses above the cap are not compensated.  

Because FSCS is the fund of last resort, if an investor has a claim against another party, they are normally not entitled to FSCS compensation until they have exhausted all avenues of recovery.  

FSCS’s restricted discretion in deciding whether compensation should be paid (it does not have the wider discretion conferred on FOS to decide what is “fair and reasonable”) has led it to distinguish between non-ISA investors (who are required to provide evidence that Keydata breached a contractual or legal obligation) and the automatic compensation that has been paid to ISA investors (who were told that the Bond was ISA compliant, when it was not).

This has provoked significant criticism, particularly since it contrasts with the treatment of Icelandic bank depositors who recovered their full investments from jointly FSCS, the Icelandic equivalent, and the UK Treasury. (In contrast, Madoff and Stanford victims have not received FSCS compensation since the investments were not UK regulated.)  

Many IFAs have been shocked to discover that FSCS’s questionnaire appears designed to identify others against whom claims can be made. For example, FSCS’s questionnaire asks investors whether they received and relied on advice from an IFA. Ironically, many IFAs believed when their clients invested in the Bond that FSCS compensation would be readily available if anything went wrong.  

It is therefore not surprising that many IFAs have wanted to help investors complete their forms. Unfortunately, few IFAs are qualified to give such advice, which is likely to be beyond the duties that they owe and outside their expertise since it affects investors’ legal rights. If they do and future claims arise, these may not be insured.  

The current uncertainty about whether FSCS will compensate non-ISA investors has made it difficult to accurately reserve. Since the majority of Keydata investments appear to have been small (meaning FSCS compensation would extinguish the loss), any failure by FSCS to compensate will undoubtedly increase the number of claims brought against IFAs through FOS and the courts.  

Referrals between the FSA, FOS and FSCS

Although the Financial Services Authority (FSA), FOS and FSCS are discrete bodies, they sometimes share information. FOS and FSCS have a reciprocal arrangement whereby claims that are incorrectly sent to one are automatically forwarded to the other. For example, where a complaint against an IFA is sent to FSCS, FSCS will automatically send it to FOS so that it can be dealt with as a complaint.  

Likewise, in the past FOS has alerted FSA where it received a number of complaints against the same IFA alleging mis-selling (which resulted in a fine).  

In responding to claims, the risks of creating a presumption that the IFA did not comply with the FSA’s rules needs to be carefully considered, since this could make it more difficult to defend future claims.

For example, if FSCS or FOS receive numerous allegations of mis-selling by the same IFA and trigger a FSA finding that the IFA breached its regulatory obligations, it may prove difficult to defend future claims even if the IFA complied with FSA’s requirements in placing those other investments.  

Likewise, where FSCS sees numerous complaints about the same IFA, this could lead FSCS to handle future claims involving that IFA with a degree of scepticism, making it more difficult to successfully recover compensation. This could, in turn, trigger more claims against the IFA as investors seek to recover their investments.  

A shorter version of this article appeared in Insurance Day on 18 December 2009.