Regulating the Unregulated?

Restrictions on the promotion of UCIS and close substitutes

Originally published in the July 2013 issue

Following on from the Financial Services Authority’s (FSA) Consultation Paper on the promotion of unregulated collective investment schemes (UCIS) and close business substitutes, its successor the Financial Conduct Authority (FCA), has issued a Policy Statement (4 June 2013) outlining the restrictions on the distribution of what it terms “riskier and often very complex fund structures” to retail investors.

The new rules are effective from 1 January 2014 and aim to protect ordinary retail investors from both inappropriate promotion and the provision of unsuitable advice, problems the FCA has identified and characterised as being serious.

Presently, UCIS may not be promoted to the general public and marketing of such is only allowed where an exemption is available. Following related supervisory and enforcement work, the FCA concluded that existing rules were “widely misinterpreted, poorly understood and sometimes simply ignored”. The regulator has taken steps to clarify those rules and, effectively, banned the promotion of such products to retail investors.

Products subject to the new marketing restrictions
As investment strategies often seen in UCIS are being replicated in a variety of other legal structures the scope of the general prohibition on marketing has been extended through the concept of ‘non-mainstream pooled investments’ (NMPI). An NMPI encompasses:

  • Units in a UCIS;
  • Units in a qualified investor scheme (QIS);
  • Securities issued by special purpose vehicles (SPVs) (other than excluded securities);
  • Traded life policy investments (TLPIs); and
  • Rights to or interests in investments in any of the above.

An SPV takes the FCA glossary definition which requires it to be:

  • A body corporate
  • Explicitly established for the purpose of securitising assets
  • With the sole purpose (either generally or when acting in a particular capacity) of carrying out one or more of the following functions:

   – Issuing investments;
   – Redeeming, terminating or repurchasing investments;
   – Entering into or terminating transactions involving investments in connection with the issue, redemption, termination or repurchase of investments.

Products falling outside of the restriction
As this definition is fairly broad, a number of products have been confirmed to lie out of scope and are specifically excluded from the new rules, including:

  • A security whereby an issuer’s payment obligations are linked to the performance of shares, debentures or government and public securities (providing the underlying asset is not itself issued by a SPV);
  • A covered bond;
  • A share in an investment trust;
  • Overseas investment companies that would meet the criteria for investment trust status if based in the UK;
  • A share in a venture capital trust;
  • A share in a real estate investment trust;
  • An exchange-traded product (admitted to trading on an exchange or evidence of trading);
  • Enterprise investment schemes funds (unless structured as a UCIS);
  • Seed enterprise investment scheme funds (unless structured as a UCIS);
  • Arrangements that are fund-like but do not take the legal form of an NMPI; and
  • Trading companies (businesses set up for commercial purposes rather than the securitisation of assets).

Retail investors afforded greater protection
As previously outlined, the purpose of the revisions is to afford greater protection to retail investors and the changes do not affect the marketing of NMPIs to professional and institutional investors.
Under the new rules firms will not be able to market NMPIs to ‘ordinary retail investors’, being retail investors that do not meet the definition of a ‘sophisticated investor’ or ‘high-net-worth individual’ which are defined as follows:

  • Sophisticated investors (certified or self-certified) – generally speaking these are considered to be retail clients with extensive investment experience and knowledge of complex instruments who are better able to understand and evaluate the risks and potential rewards of unusual, complex and/or illiquid investments such as NMPIs.
  • High-net-worth individuals (certified) – amongst other factors, having an annual income of more than £100,000 or having investable net assets of more than £250,000 (these thresholds are subject to review by the FCA).

Key changes to the exemptions
The existing categories of exemptions will be removed and replaced by COBS 4.12.4R which states that the restriction on marketing NMPIs will not apply if the promotion falls within one of 13 exemptions set out therein. The categories primarily seen to accommodate the promotion of UCIS to retail investors have been removed or severely restricted. Category 2 (advised sales) and category 8 (knowledge, experience and expertise) have therefore been removed, and category 1 (existing participants) will only be available to promote a product intended to replace or absorb an existing scheme which is being liquidated, wound down or undergoing a rights issue.

Category 3 (charitable funds) remains but has been extended to include arrangements constituted under the Regulation on European Venture Capital Funds (EuVECAs) and the Regulation on European Social Entrepreneurship Funds (EuSEFs).

The exemptions previously set out in COBS 4.12.1(5) relating to eligible employees, members of Lloyds Society, exempt persons and the promotion to non-retail clients remain. It is important to note that firms will still be able to ‘opt up’ retail clients to professional status, meaning that the exemption under category 7 (promotion to non-retail clients) will then apply. For the purposes of marketing, whether or not the resulting business transacted is MiFID activity, the non-MiFID criteria can be applied (quantitative assessment and requisite procedures followed).

In addition to the sophisticated investor and high-net-worth exemptions, set out above, the promotion of NMPIs is also permitted in relation to solicited advice, excluded communications, non-recognised UCITS (product information requirement) and the promotion of US mutual funds to US citizens temporarily resident in the UK.

Implications on the marketing process
It should be noted that a ‘preliminary assessment of suitability’ must be completed when reliance is placed on exemptions 2 (certified high-net-worth investors), 9 (self-certified sophisticated investors) and 12 (non-recognised UCITS). This requires a firm to take reasonable steps to acquaint itself with the client’s profile and objectives in order to ascertain whether the NMPI under contemplation is likely to be suitable for that client. There is no duty to communicate the preliminary assessment of suitability to the client.

However, if the firm does so it must be careful not to stray into the realms of a making a personal recommendation, unless the rules in COBS 9 on suitability are complied with.

The compliance officer (CF10) must ensure that each promotion complies with the permissible exemption to the general prohibitions. This responsibility, however, can be delegated to other members of the compliance team who report to and are supervised by the CF10. The CF10 must retain oversight responsibility and is required to complete an annual review of the standards and procedures being undertaken to certify compliance.

The firm will be under a duty to record which exemption was relied upon when promoting the NMPI with the reason noted as to why the firm is satisfied that the exemption applies. Where the firm relies on an exemption that requires investor certification, warnings to investors or a preliminary assessment of suitability the relevant documentary evidence must be retained.

Action required by firms
Firms will need to identify the products that will fall within the definition of an NMPI and ensure that those responsible for marketing are aware of the new exemptions and, where applicable, the requirement for a preliminary assessment of suitability to be undertaken. Whilst the rules do not require retrospective categorisation in accordance with the new exemptions, firms may benefit from reviewing their current investor base in light of the revisions, with particular reference to those previously falling within category 8 (knowledge, experience and expertise) and consideration given as to whether those individuals could meet the definition of sophisticated or high-net-worth investors, or be opted up to professional status.

The rules will not take effect until 1 January 2014. However, we recommend firms use the next six months to consider the changes that will need to be made to their systems and controls in order to ensure compliance.

Cordium (the new name for The IMS Group and HedgeOp Compliance) is a global provider of regulatory compliance consulting services and software to the asset management and securities industry. It has offices in London, New York, Boston, San Francisco and Hong Kong and employs more than 100 experienced professionals who support more than 800 investment businesses. Its clients range from start-ups to large firms with well-established track records and utilise a broad array of investment strategies and styles such as: long only, long/short equities, global macro, credit, distressed, bank debt, fixed income, private equity, venture capital, real estate-related and fund of funds strategies.