The FCA has today announced the introduction of temporary product intervention measures for 12 months from 1 January 2020 to address risks of consumer harm from the promotion of speculative mini-bonds to retail investors. The intervention reflects the FCA’s concerns with the widespread marketing of mini-bonds in spite of their high risk nature and difficulty for retail investors to understand, and responds to the failure of London Capital and Finance as well as the regulator’s wider work relating to high-risk investments.
The FCA defines speculative mini-bonds as debentures or preference shares which include one or more of the following features:
- they are typically issued by an authorised person who is not subject to FCA oversight, and therefore generally not covered by the Financial Services Compensation Scheme;
- they are unlisted and commonly issued through a special purpose vehicle;
- the investment offers a high fixed rate of interest (8% or more) to investors, if they commit to invest for a specific period of time (eg 3 or 5 years), with limited or no opportunity to sell or transfer the investment before the end of that period;
- the issuer uses the capital raised to fund speculative and high-risk activities; and
- they often involve high costs or third-party payments being made from the proceeds of the bond issuance.
It is important to recognise that the FCA’s temporary measure is applicable to a specific sub-sector within the mini-bond market: securities which are defined as ‘speculative illiquid securities’.
The UK remains a leading jurisdiction for crowdfunding in a range of forms, including investment-based crowdfunding of which mini-bonds are a component. The FCA’s actions target unlisted debentures and preference shares where the issuer uses the funds raised to lend to a third party, invest in other companies, or to purchase or develop property. Importantly, the issuance of mini-bonds by unregulated companies in order to generate working capital for deployment in the business remains a viable funding structure provided that it is conducted in accordance with existing provisions for the promotion of ‘non-readily realisable securities’, although the impact which the temporary intervention has on market appetite for such investments remains to be seen.
The FCA highlights the dangers of less sophisticated investors or less wealthy investors being drawn to these products by promotions that appear as the top result of an online search when entering ‘high investment returns’ or similar phrases. The FCA is concerned that investors may be attracted to the lucrative returns offered, but that such promotions down-play the key risks and imply that these products are ‘safer’ than they are in practice.
As a result, the FCA is acting to strengthen its financial promotions rules, on a temporary basis, by:
- restricting the marketing of speculative illiquid securities to ensure they can only be promoted to individual retail investors who have been pre-categorised as either sophisticated or high net worth, and where the product has been initially assessed as likely to be suitable for them; and
- mandating the inclusion of a specific risk warning, as well as disclosure of any costs or payments to third parties that are deducted from the money raised by an issuer, in any financial promotion for these products.
In overview, the temporary intervention will effectively harmonise the treatment of ‘speculative illiquid securities’ with ‘non-mainstream pooled investments’. The FCA is explicit that the intended effect of the intervention is to limit access of most retail investors to these products.
The FCA acknowledges it has limited powers in dealing with unauthorised issuers, however, it states that it “can take action in relation to the marketing of products when an authorised firm approves or communicates a financial promotion, or directly advises on or sells these products”. The FCA warns that it is actively investigating firms where breaches of its rules linked to financial promotions for, or the distribution of, speculative illiquid securities have been observed and reminds unauthorised firms of the criminal liability attaching to the communication of financial promotions which are neither ‘exempt’ nor approved by an authorised firm.
Revised financial promotions
The FCA also recognises that unauthorised issuers may still rely on exemptions under the Financial Services and Markets Act 2000 (Financial Promotions) Order 2005 (the FPO) to promote mini-bonds to high net worth or sophisticated retail investors. Rather than casting a wide net to mass market these speculative investment opportunities to the general public, communications under certain exemptions must only be ‘made to’ individual investors who have been previously categorised as meeting the appropriate conditions. The FCA reminds unauthorised businesses that it will enforce against firms who issue communications amounting to a financial promotion which are made outside of the scope of an FPO exemption and without approval from an authorised firm.
The FCA also notes that the quality of promotions approved by many firms for speculative illiquid securities and the associated scrutiny of these investments has been extremely poor. On a related webpage, the FCA has set out guidance under its existing rules on approving the financial promotions of unauthorised persons, with a heightened focus on issuers of mini-bonds.
Firms who engage in the promotion of investment products or services to retail clients should take note of the FCA’s amended guidance and ensure that the various lessons being communicated by the FCA are effectively incorporated into their financial promotion approvals processes.
FCA’s rationale for intervention
The administration of London Capital and Finance (LCF), an issuer of mini-bonds, was a catalyst for the implementation of these measures. The collapse of LCF in January 2019 prompted an investigation by the FCA into the circumstances surrounding its potential failings. For further information, see our previous blog here.
Among other things, the FCA is concerned that speculative mini-bonds are marketed as investments eligible to be held in a tax incentivised wrapper (eg ISAs or SIPPs) when in fact they do not meet the qualifying criteria. In addition, the FCA has seen misleading promotions using the role of HMRC in its general oversight of tax wrappers to imply that these investments have government endorsement and therefore there is additional protection or scrutiny attached to these products.
In light of this, the FCA intends to put these measures into place before the end of the current tax year in April 2020, when retail investors would usually look for new ISAs or ISA-eligible investment opportunities, and would likely be vulnerable targets for further marketing of speculative illiquid securities.
The FCA will consult on permanent rules in the first half of 2020, meanwhile HM Treasury is currently undertaking a review on the regulatory regime for the issuance of non-transferable debt securities. HM Treasury expects to complete its assessment next year as to whether there should be any reform to the legislative framework.