The Financial Services Authority (“FSA”) has recently issued Consultation Paper CP12/19 which will have significant consequences for all FSA authorised firms that promote, offer or advise on unregulated collective investment schemes (“UCISs”) in the United Kingdom with retail clients. It is important to note here that, although the FSA refers to “ordinary retail investors” in the consultation paper, the term “retail client” in the FSA Rules is much wider than just unsophisticated small investors but extends to include most individual investors, even many high net worth sophisticated investors.
The Current Position
To appreciate what the FSA is proposing in this consultation, we need briefly to survey the current position.
Under the current FSA rules and UK legislation, UCISs may be promoted to investors only in limited circumstances. There is, helpfully, a blanket exemption for offers to FSA authorised firms (such as banks, brokers, and investment managers) and to high value corporates, partnerships and trusts.
The position for promotions to individuals is, however, more complex. In very broad terms, UCISs that consist mainly of securities issued by unlisted companies (in other words, effectively private equity funds) may be promoted to high net worth individuals (people with either an income of more than £100,000 or net assets of more than £250,000) and to certain sophisticated investors, provided that the certification and risk warning process set out in the legislation is followed. This is essentially a bureaucratic process but is not difficult to comply with.
Other UCISs, such as hedge funds and real estate funds, may be promoted to individuals only in circumstances where an FSA authorised firm confirms either that the investment is a suitable investment for that client or the firm confirms that the relevant investor understands the risks in investing in such schemes. It is this exemption set out in Rule 4.12 of the FSA COBS Rules that is the subject of this consultation (for the sake of convenience, these two exemptions are referred to as the “Suitability Exemptions” in this summary).
The FSA Proposals
The FSA has frequently warned firms that they seem either to misunderstand the operation of UK restrictions or to have inadequate compliance procedures to show that the relevant exemptions are available in relation to particular promotions. The FSA has undertaken a number of disciplinary actions against various firms recently for breaches of these rules.
These warnings do not appear to have been adequately followed by firms, as a result of which the FSA is now proposing:
- The deletion of the Suitability Exemptions. This will mean that, in relation to retail clients, firms will not be able to offer or advise on UCISs except using the private equity exemptions referred to above. It is not surprising that the FSA has taken some action in relation to UCISs since it gave warning that it would do so when issuing the recent guidance on the promotion of life settlements funds to UK investors. What is surprising here is that the FSA has gone further than it did in that guidance in not merely warning firms that such investments are usually not suitable for retail clients but has specifically now proposed banning such offers.
- Extending this ban to UCIS substitutes such as securities issued by SPVs where the SPV itself provides a broadly equivalent pooling investment to a UCIS. The current draft rules do not extend this restriction further to include, for example, securities issued, or derivatives offered, by banks that provide returns calculated by reference to a specific underlying fund. The specific extent of this prohibition is subject to review, though, and is subject to change.
- Requiring firms to improve compliance procedures when using the promotion exemptions that will continue to exist when making a promotion to retail clients. In particular, a record will need to be kept for all promotions showing how the complies with the exemptions.
ConsequencesClearly, the main consequence will be that many promotions to retail clients will be prohibited, and no relevant exemption will be available. Firms, however, that deal with sophisticated and high net worth individual investors will need to look carefully at the new draft rules to see to what extent promotions may continue to be made to them. There are certain possibilities:
- The FSA proposals do not affect promotions to professional clients. The FSA rules contain procedures for upgrading retail clients to professional client status. In very brief terms, whilst it will often be difficult to upgrade clients when carrying on MiFID services such as providing advice to clients (such as in the service provided by IFAs), firms providing non-MiFID services such as distributors may well be able to upgrade many of the more sophisticated individual investors.
- The statutory exemptions for high net worth and self-certified sophisticated investors in relation to private equity funds and the (FSA firm) certified sophisticated investor exemption for all UCISs will continue in place. This would allow, for example, a manager of a UCIS to market a fund to a potential investor whose IFA has certified him to be a sophisticated investor in accordance with the procedure set out in the Financial Promotion Order.
- Investment in UCISs where the investor has genuinely sought out the fund himself and where no promotion has been made will not be restricted by the FSA proposals. This will certainly be an important point for managers and distributors, although no firm will be able to build a business plan on it.
The consultation period ends on 14 November 2012, with the final rules expected during the course of the first quarter of 2013.