One year ago – FCA bans the promotion of unregulated collective investment schemes and similar products to retail investors

The Financial Conduct Authority (FCA) has published a policy statement and final rules which ban the promotion of units in unregulated collective investment schemes (UCIS) and a broad range of “close substitutes” (collectively known as non-mainstream pooled investments – NMPIs) to the vast majority of retail investors in the UK from 1 January 2014. Whilst the FCA has taken account of some of the comments made by market participants to its earlier consultation paper, the final rules severely restrict the ability of firms to promote and/or give advice to retail clients on NMPIs and the precise scope of the rules remains unclear. Even where marketing is permitted, firms will be subject to a more onerous compliance burden, which will often require suitability assessments to be made and properly documented and recorded at the promotion stage.

This alert provides a high level summary of the final rules.

What is caught by the new rules?

The final rules, along with the current restriction in section 238 of FSMA, prohibit a regulated firm from making or approving the communication of a financial promotion of NMPIs to retail investors. In addition, the FCA states that personal recommendations (i.e. investment advice that is presented to investors as suitable for their needs) will normally include financial promotions. In its view, advice given by regulated firms to retail investors on buying an NMPI will also fall within scope of the ban.

The new rules are intended to capture units in UCIS and other products that provide access to the same investment strategies that are normally pursued by UCIS. The final rules identify these “close substitutes” as including traded life policy investments (even if not pooled), units in qualified investor schemes, and securities issued by special purpose vehicles (SPVs) and rights or interests in any of the foregoing.

The definition given for an SPV in the FCA rules was originally drafted to describe securitisation vehicles in the context of regulatory capital rules and is not entirely appropriate or easy to apply in the context of retail marketing. However, it would appear that the FCA intends to interpret the scope of securities issued by SPVs broadly since, as noted below, it deemed it necessary to carve out certain securities, which would otherwise, in the FCA’s view, fall within scope (e.g. shares in investment trusts, REITs and VCTs).

What is excluded from the new rules?

Securities issued by SPVs where the payment obligation is “wholly or predominantly linked to, contingent on, highly sensitive to or dependent on” the performance of shares, bonds, or government and public securities (whether measured directly or via a market index of indices) will fall outside the scope of the new restrictions. This will be the case even if the relevant underlying securities are unlisted but not if they are issued by other SPVs. How this test will actually apply in practice remains unclear and indeed there is no further guidance on this point in the policy statement. Nevertheless, it will mean that securities issued by SPVs that are directly or indirectly linked to more ‘exotic’ asset classes and products should normally fall within the scope of the new rules.

Other products listed as falling outside the scope of the restrictions are:

Certain exchange traded products, though the definition of relevant products is highly complex
UK listed investment trusts which are approved by HMRC
EEA or non-EEA overseas investment companies that would meet the criteria (including listing requirements) for investment trust status if based in the UK
HMRC approved real estate investment trusts
Venture capital trusts
Covered bonds
The specific exemptions given to certain types of investment companies suggest that the FCA considers that all other investment companies (e.g. those traded on AIM) will be caught by the new rules, though this is not clear from the definition of an SPV.

Which categories have been removed from permitted marketing?

The existing FCA rules contain a number of exemptions from the general restriction on regulated firms promoting (or approving the promotion of) units in UCIS. These are set out in COBS 4.12 and in the CIS Exemption Order. The final rules remove some of the current exemptions. This will have the effect of prohibiting regulated firms from promoting (or approving the promotion of) not only UCIS but the other NMPIs to:

Category 2 persons: existing clients of the firm for whom the firm has deemed the NMPI to be suitable
Category 8 persons: persons for whom the firm has undertaken an adequate assessment to determine whether the person has the relevant expertise, experience and knowledge to be capable of making their own investment decision (but only where certain disclosures have been made)
In practice the revisions made to the other categories of permitted marketing recreate quite similar exemptions.

Which categories are still permitted – and how have they been changed?

The new rules do not affect marketing to exempt persons in relation to their exempt business or to eligible counterparties and professional clients, including people who have properly “opted up” to that status. For these purposes the FCA will continue to allow firms to apply a qualitative test of expertise for “opting up”, rather than also requiring the MiFID quantitative tests to be met.

Regulated firms will be able to certify retail investors as sophisticated based on their own assessment and the client’s confirmation and acceptance of risks and then market NMPIs to those clients (rather than needing another regulated firm to carry out that certification).

It will also be possible not only to rely on the existing exemptions for promoting certain venture capital and private equity funds to self-certified high net worth and sophisticated investors but also to follow a similar certification procedure to promote any type of NMPI to such individuals – but only after conducting a preliminary assessment of suitability for that person, having considered his or her profile and objectives, and deciding the relevant NMPI is likely to be suitable.

Some scope is allowed for responding to requests from clients, but only when the promotion forms part of a personal recommendation given in response to a specific request from a client for advice on the merits of investing in a particular NMPI without having received any promotion or other communication from the firm, or a connected person, which is intended to influence the client in relation to that NMPI.

There are further specific exceptions from the ban on promotion to allow firms to promote:

Rights issues and replacement products offered as an alternative to cash on liquidation
The new European Venture Capital Funds and European Social Entrepreneurship Funds as well as certain pooled charity and church funds to relevant types of investors
Some types of NMPIs to employees and related persons, broadly intended to continue to enable incentive and co-investment schemes in the same way as is currently allowed for UCIS
EEA UCITS which have not yet gone through the passporting notification process to allow general promotion as a “recognised scheme”, provided that a preliminary suitability assessment is conducted and full product information is provided
US registered mutual funds to US citizens even if they are temporarily resident in the UK
In addition, the FCA intends to consult on whether the current criteria identifying sophisticated and high net worth investors, as set out in COBS 4.12 as well as the CIS Promotions Order and the Financial Promotions Order, remain appropriate and specifically whether the financial threshold in the high net worth individuals test should be higher. The impact of any proposed change to the definition of sophisticated investors or high net worth individuals in the Financial Promotions Order will not only affect communications made by regulated firms but also communications made by unregulated firms, who wish to rely upon the relevant exemption.

What else do firms have to do?

In practice, firms will need to go through their whole product range in order to identify which investments will be NMPIs whose promotion will need to be made subject to extra compliance procedures. Product development will also need to introduce a new step to identify NMPIs. Marketing and investor relations teams will need to be made aware of the new restrictions. In many cases new “preliminary suitability” assessments will need to be made – presumably falling somewhere between an “appropriateness” test and a full advisory suitability assessment.

Many firms will also need to review their client base to see whether some retail clients may be reclassified as “professional” or, even if still retail, whether they are “sophisticated”. Carrying out such reclassifications would need to be done with considerable care.

The final rules require the compliance oversight officer (CF10) to certify the regulated firm’s compliance with the rules in relation to each marketing communication made. However, the original proposals have been relaxed so that day-to-day compliance with this requirement can be delegated to other compliance staff, provided that the certification process is reviewed annually by the compliance oversight officer. Regulated firms will be required to retain full records of the exemptions relied upon for each financial promotion, together with an explanation of why the exemption applies and copies of any investor certificates and warning notices.

Even if an exemption is technically available, firms will need to ensure that promotional materials regarding these products are fair, clear and not misleading, and if advice is given, a full suitability assessment must be made by the firm and the outcome of each assessment must be properly documented and adequate records retained. Generally it is clear from the policy statement that the FCA expects regulated firms to act in the best interests of its clients and fit the new rules into their Treating Customers Fairly (TCF) and Retail Distribution Review projects and procedures. So, as with all investments, regulated firms should still consider the target market and whether the investor has the capacity to understand the NMPI that is being promoted and its associated risks.

Does this only apply to regulated firms and financial promotions?

The new rules will apply to regulated firms who promote or approve the promotion of NMPIs to retail investors. This will be the case for EEA firms marketing into the UK as well as for UK firms.

Unregulated firms who require a regulated firm to approve their marketing/financial promotions will also be heavily affected by the new rules. Further, any subsequent amendments to the definition of self-certified sophisticated investors or high net worth individuals in the Financial Promotions Order will affect the ability of unregulated firms to promote NMPIs – and other investments – directly to these types of retail investors.

The rules will also apply in certain cases to regulated firms when they make personal recommendations which, in the FCA’s view, include a promotional element. The FCA states that not all investment advice relating to NMPIs will include a promotional element. Advice to sell an NMPI would not involve a promotional element and generic advice in relation to asset classes will normally be neither investment advice nor financial promotion since particular investments are not recommended. In practice promotions made in the course of of giving advice often benefit from the “one off” exemptions.

Discretionary managers who manage NMPIs for retail clients will have to consider the impact of the new rules on their business. Indeed, the FCA specifically states that such managers should “exercise particular care when placing ordinary retail investors’ money into these products [i.e. NMPIs], to satisfy themselves that they are suitable for each particular client and are in the best interests of that client”.

How does it relate to AIFMD/RDR?

Firms operating in the ‘alternative fund’ and retail investment product space have been, and continue to be, bombarded with new and ever increasingly complex and burdensome rules and regulations both at a UK and EU wide level. From 22 July 2013, firms marketing alternative investment funds will be subject to the marketing restrictions in the Alternative Investment Fund Managers Directive. The AIFMD only addresses marketing to professional investors in the EEA with firms being required to apply the full MiFID tests to identify professional clients. Most, though not all, AIFs will also be NMPIs. So any review of marketing compliance procedures undertaken by regulated firms will therefore need to consider both new regimes.

Most regulated firms doing business in this sector are also subject to the detailed rules and requirements that were introduced late last year as part of the UK’s retail distribution review. The RDR requirements are principally designed to improve the quality of information that is being provided to retail investors about investment products, outlaw commission, and ensure that investment products sold to investors are suitable. It is unclear why the FCA is unwilling to give these new changes a chance to work before adding yet another layer of regulatory complexity and confusion into the mix. However, the policy statement clearly states that it considers that the RDR will do no more than “mitigate aspects of the problem”. The key question is whether the FCA will be able to enforce the new rules any better than it has done the old, or whether it will simply rush to impose further bans.

What next?

The final rules will come into effect on 1 January 2014 but the FCA is encouraging firms to take steps to comply with the new requirements as soon as possible. Firms who fail to do so may well find action taken against them under the current rules and principles. The FCA will continue to review progress in this area and warns firms that it will extend the scope of the ban to cover more of the ‘excluded products’ if similar consumer detriment issues arise.

The FCA has indicated that it will consult on new rules restricting the promotion of other types of investments, such as contingent convertibles (CoCos) and building society deferred shares. The FCA says that it is concerned that these products are being marketed to retail investors who are unfamiliar with their complexity and unable to evaluate their risk.

Overall it looks likely that this will be a first step of a more interventionist regulator rather than the last one.