Enough already: do the FCA’s new rules on UCIS risk inducing compliance fatigue?

The UK Financial Conduct Authority has set out new rules on unregulated collective investment schemes (UCIS) and ‘close substitutes’ in relation to ordinary retail investors in the UK. Tamasin Little, Partner in the Financial Markets team at SJ Berwin, considers the impact of so many overlapping regulations in this area.

Promotions of risky and complex fund structures will be restricted to knowledgeable investors and high net worth individuals under new rules from the FCA banning the promotion of UCIS and certain close substitutes—together to be known as Non-Mainstream Pooled Investments (NMPIs)—to the vast majority of retail investors in the UK. The ban follows work undertaken by the Financial Services Authority (FSA) which found only one in every four advised sales of UCIS to retail customers was suitable, and many promotions breached the existing UCIS marketing restrictions.

What are the main changes being made in this area?

The changes made in PS 13/3 will restrict marketing to retail investors even more tightly and extend the restrictions to a wider range of products which the FCA is calling ‘non-mainstream pooled investments’ (NMPI).

The new category of NMPI will include, in addition to all UCIS, units in qualified investor schemes (QIS), traded life policy investments, securities issued by special purpose vehicles (SPVs) and any form of rights to or interests in any of these types of investment. As well as the well-known and longstanding difficulty of the definition of a UCIS the FCA is now adding new uncertainties since its definition of a ‘special purpose vehicle’ was originally designed to refer to securitisation vehicles in a regulatory capital context rather than to define products in a retail investor protection context.

There have, however, been significant changes to the original proposals made by the FSA. Shares in venture capital trusts, REITs, companies which would qualify as investment trusts if they were based in the UK and a restricted range of exchange traded products have been excluded from the definition of NMPIs as well as the original exclusion of shares in investment trusts, covered bonds and securities where payment obligations are linked to movements in the prices of shares or debt securities.

The new restrictions mean FCA regulated firms must not promote NMPIs to retail investors—nor approve promotions to be made by unauthorised firms—except in very limited circumstances. Authorised firms will also 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 to those clients. 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 decided 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, for instance, rights issues and replacement products offered as an alternative to cash on liquidation (and other vehicles).

What have been the problems in this area and to what extent are the rule changes likely to address these concerns?

There have been a string of cases, such as Keydata, where enforcement action has been taken and/or there have been claims on the FSCS with considerable costs first to investors and then to those firms who are called on to contribute to the FSCS compensation pool. According to the FCA it has also seen widespread bad practice among both advisers and wealth mangers; and it considers that none of the enforcement actions and public pronouncements by its predecessor the FSA were having the desired effect in changing the behaviour of firms.

The interesting question is whether the FCA will be able to enforce the new rules any better.

It seems to me most unclear whether imposing further restrictions will deter the unscrupulous from seeking to find ways round the new restrictions. It also seems fairly clear that the complexity of the new rules will leave a number of others unable to understand whether a product is or is not an NMPI or the precise extent of the promotion restrictions.

Could there be any unintended consequences of the change?

The new rules on NMPI are being layered on top of the already complex financial promotion and scheme promotion regimes; preparing for implementation of the Alternative Investment Fund Managers Directive 2011/61/EU in July 2013 and changes are also due to be made to the Markets in Financial Instruments Directive 2004/39/EC.

It is hard to assimilate so many new overlapping regimes. There seems to be a real risk of firms either incurring excessive compliance time and costs which are focussed more on understanding the new rules than on active investor protection or suffering regulatory fatigue and failing to navigate all the new rules.

Retail investors who have longer term investment horizons may increase their already strong tendency to invest directly in real property and also move into direct investment in other illiquid assets outside the scope of regulation where none of the usual investor protections apply.

More investors may be ‘opted up’ into professional status, losing retail client protections. It is also possible that the compliance failures and lack of understanding the FCA has seen in this field will simply continue when the same firms go about certification of ‘sophisticated’ investors or carrying out preliminary suitability assessments.

What should lawyers and their clients do next?

Firms will need to go through their whole product range in order to identify which investments will be NMPI whose promotion will need to be made subject to extra compliance procedures. Product development will also need a new step identifying NMPI.

Marketing and investor relations teams will need to be made aware of the new restrictions, and financial promotions of NMPI will require sign off from the head of compliance (or approved delegate) with records kept of the reason the promotion is permitted and supporting materials. 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.

Are there any trends emerging in the law in this area?

The many different forms of new regulation in this area testify to the level of regulatory concern. The NMPI promotion restrictions may be followed by further restrictions, in fact it looks likely that this will be a first step of a more interventionist regulator rather than the last one.

Tamasin Little was interviewed by Nicola Laver of LexisNexis. This interview was first published as a Legal Analysis news item on LexisPSL Financial Services

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Filed Under: UCIS

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