On 22 August 2012 the FSA published its consultation paper CP12/19 on restrictions on the retail distribution of unregulated collective investment schemes (“UCIS”) and close substitutes.
The FSA considers that the majority of retail promotions and sales of UCIS that it has reviewed fail to meet the required regulatory standards, exposing ordinary investors to significant potential for detriment. Therefore, the FSA is proposing to intervene in the market by changing its rules to ban the promotion of UCIS and close substitutes to ordinary retail investors in the UK.
The FSA is proposing to extend the current regime to cover what it considers to be close substitutes of UCIS, which would include qualified investor schemes, traded life policies and securities issued by SPVs (other than investment trusts, covered bonds, or securities whose return is closely linked to shares or bonds admitted to a regulated market).
The FSA’s determination to implement an outright ban on the sale of UCIS to retail investors marks a shift in policy from that under the existing secondary legislation. The secondary legislation permits the promotion of UCIS to high net worth and sophisticated individuals, but only where those UCIS invest predominantly in unlisted securities or unlisted debt. These exemptions are seemingly aimed at encouraging investment in early stage and venture capital type investments. Conversely, the FSA seems to consider the only safe harbour for close substitute products to be those that invest predominantly in listed equities or bonds.
Proposed removal of COBS 4.12 categories
COBS 4.12.1R provides that a firm will not breach the restriction on financial promotions in the Financial Services and Markets Act 2000 (“FSMA”) if the invitation or inducement is aimed at a person who falls within one of eight categories of person. The consultation proposes to restrict this provision by removing the following three categories:
- Existing investors (category 1) – If a client is invested in (or has recently been invested in) similar UCIS, then a firm can promote that type of UCIS to them. This category will be removed, except that a client who is invested in a UCIS may be offered the opportunity to go into another scheme that merges with the one he is invested in, or to go into a new UCIS at the end of the term of the current one (i.e. rather than receive the cash proceeds).
- UCIS that are suitable for the individual (category 2) – Currently, firms can promote UCIS to retail investors if they deem that the product is suitable for the recipients. The FSA considers this category has been abused by firms and would, therefore, be removed entirely.
- Clients with requisite expertise and knowledge (category 8) – If a firm carries out an assessment that the client has the requisite expertise and knowledge to invest in a particular UCIS, they are permitted to promote that UCIS to them. The FSA seems to be concerned that firms might abuse this category once category 2 is removed, and so this category would also be removed.
The consequence of the above changes to COBS 4.12 would be that firms can no longer promote any UCIS (or close substitutes) to ordinary retail investors under COBS 4.12. Firms would instead only be able to promote to retail clients if they fall within the category of person exempted from the financial promotion restriction under current secondary legislation (i.e. FSMA (Financial Promotion) Order 2005 (the “FPO”) and FSMA (Promotion of Collective Investment Schemes) Order 2001). The relevant categories of person are:
- high net worth individuals;
- sophisticated investors; and
- self-certified sophisticated investors.
These categories of person are the same as apply to unregulated firms making a financial promotion, except that the FSA is proposing, in its consultation, to set the bar higher for authorised firms than for unauthorised firms. The FSA is proposing to introduce guidance into COBS 4.12 to the effect that, even where one of the above exemptions apply, the firm must also carry out an analysis that the product is in the best interests of that person, that it is suitable for that person, and that the person has a requisite level of relevant experience.
Extension to close substitutes
The FSA is proposing to bring the close substitutes of UCIS under the framework of COBS 4.12 because it is concerned that firms might employ regulatory arbitrage to sell products that have a similar risk profile as UCIS to retail investors. By bringing these products into COBS 4.12, the FSA would also be preventing their sale to retail investors.
Again, these proposals would apply only to authorised firms, so that unauthorised firms would continue to be able to rely on the exemption in the FPO which are available for products that are not UCIS.
These proposals raise a number of questions on what is included in the proposed list of close substitutes and on what is excluded. For example, there are valid reasons for asking why qualified investor schemes, which are regulated funds and usually only attract institutional money, should be included in the list. Also, given investment trusts are not considered close substitutes, should their overseas equivalents be treated in the same way?
If structured products (or other SPVs) that invest predominantly in listed equities or bonds are not considered close substitutes, why does that safe harbour not also apply to qualified investor schemes?
Given the current list of close substitutes and the FSA’s policy position, it is curious why Enterprise Investment Scheme (“EIS”) funds are not also included. They are not UCIS (but operate in a very similar way) and they invest in early stage and venture capital type businesses. On the other hand, the Government encourages investment in EIS funds by individuals by offering them tax incentives to invest in these structures. This apparent contradiction underlines the policy shift we referred to above, and it is not clear if this is the reason why EIS funds have not been included as close substitutes.
What about advisers?
The FSA is critical of advisers as it believes that advisers have wrongly assumed that there is no simultaneous financial promotion when they have given personal recommendations.
The FSA is proposing to amend the guidance on the regulatory system as it applies to UCIS in its Perimeter Guidance Manual. The proposed amendments will set out that personal recommendations generally also constitute a financial promotion and, as a result, firms will also need to rely on a relevant exemption to the financial promotion restriction. Firms would also need to assess suitability under COBS 9.
We would question the FSA’s assertion that all personal recommendations invariably include a financial promotion. This appears to be out of step with the market position in the UK over the last 20 years.
Additional record keeping requirements
The FSA is proposing to introduce a rule into COBS 4.11 requiring firms to document and retain records setting out the basis on which promotions have been made. Distribution forms requiring firms’ compliance oversight function (CF10) to verify the compliance of each financial promotion for products within the scope of the consultation are also proposed. This will include verification of financial promotion in the context of advised sales. Records will need to be kept for the same amount of time as other client records.
Responses to the consultation are due by 14 November 2012. We think there are a number of unsatisfactory aspects to the proposal and will be putting in a response. Given the scope of the proposal, firms and industry bodies might also consider responding.