When the Financial Services and Markets Act 2000 (FSMA) was still in the consultation process, it promised a regulatory system that would be flexible. Investors who needed protection would get it, while those who did not would be spared having to comply with prescriptive rules. Not surprisingly, however, what we have been given is still largely based around the notion that all investors – other than, perhaps, exceptional cases such as governments and large institutions – are in need of protection. Rules, regulations and regulatory policy all still pay homage to the holy writ that the poor old investor is the entity whose interests matter most. Yet, actually, life is not that simple.
It goes without saying that the sort of investor that purchases genuinely retail-type products may be considered to be among the more vulnerable, as the crisis over split-level investment trust shares has demonstrated. Sadly, the default position under the Financial Services Authority’s (FSA) rules and guidance would lead one to believe that there is something inherently frail about any individual investor, however wealthy or sophisticated they might be. Where this is most obstructive is in relation to liberating the investing power of a legion of wealthy private individuals, who would be happy to be shown, or find for themselves, opportunities to put some of their wealth at risk in venture capital projects.
We have to give a little credit where it is due: under the Financial Services Act regime, access for small entities seeking money from wealthy private individuals was nigh on impossible without involving an authorised investment firm at significant expense. Article 11 of the old Investment Advertisements (Exemptions) Order of 1996 was a basis for the issue of advertisements to “persons sufficiently expert to understand the risks involved”, yet it was limited always to authorised, governmental or institutional investors. As part of the FSMA, the Financial Promotion Order has created two promotion exemptions that do, by comparison, facilitate some level of exempt communication with individuals, although both of these are so badly flawed as to be practically useless.
First, there is the ‘certified high net worth individual’. Article 48 of the Financial Promotion Order requires that such a person holds a current certificate that is not more than 12 months old, issued by their employer or accountant. The certificate has to certify that in the last financial year, the person had gross income exceeding £100,000 or assets, net of their house, pension and certain other disqualifications, exceeding £250,000. That all sounds very simple, but that is precisely the problem.
Seriously high net worth investors are, perhaps not surprisingly, rather cagey about telling too many people about their money. Many do not even tell their accountants everything they would need to know to enable them to issue a certificate. Many more are not employed – they might be self-employed or retired – so that disenfranchises a large proportion of the community that this exemption was designed to assist.
Even supposing that getting a certificate is possible, how do the people who need to know find out that you have one? Imagine a conversation with somebody who might have a certificate. The opening gambit at present has to be something along the lines of: “I would like to know if you are a certified investor, but I can’t tell you why until you confirm that you are, because if I do and you aren’t then I’ve committed an offence under the FSMAâ€¦” Not a particularly shrewd way to sell an investment opportunity.
Article 48 goes on to say that you can only promote to individual investments that are “shares or debentures of an unquoted company”. It’s a bizarrely inept piece of drafting.
The other type of certificate attests, under Article 50, to the sophistication of an investor in specific investments, or, in theory, all investment types. That sort of certificate has a three-year life, and must be issued by a person authorised under the FSMA. Again, this all sounds extremely simple, and this type of certificate allows its holder to have pretty much any investment promoted to them, not merely shares in private companies. But the problems mount up here as well. Why, in principle, should an investment firm be prepared to issue such a certificate? And what criteria should it use, as no guidance is given? What is its liability if it issues a certificate when it should not have done? The answer to this is that, potentially, it commits the offence of making a false or misleading statement for the purposes of inducing persons to invest.
One might think that the investor would ask their financial adviser to certify them, simply because the two will know each other reasonably well. But actually, Article 50 stipulates that if an investment firm issues a certificate under this provision, it cannot then make related financial promotions to them.
There is, of course, a basis for an investment firm to classify customers and contacts as ‘expert’ and this has certain consequences, for example, that persons so classified can be shown particulars of unregulated collective investment schemes. However, the fact that somebody is expert-classified in this way, and treated as an intermediate customer under the FSA rules for investment firms, does not make them any more accessible to unregulated promoters of private investment opportunities.
When the Financial Promotion Order was under discussion, and for several months afterwards as the Treasury introduced amendments to it, there was pressure to create a more sensible regime where investors could self-certify, and the unworkable, or frankly embarrassing, features of these two certification processes could be corrected.
In the US, the concept of an ‘accredited investor’ has been in use for many years, and essentially it is up to the investors to declare their assets, net worth, experience and attitude to risk. We badly need that system in the UK.
And so I return to my opening observation, which was that it is simply not the case that all investors deserve intensive protection under the law. Where sophisticated, experienced, individual investors choose to invest money in a start-up venture run by moderately inexperienced entrepreneurs, the investors can take care of themselves – it is the entrepreneurs whom society most needs to protect. They may have a great idea, a sound business plan and a little money of their own, but no experience in converting all of this into a functioning business venture with third-party money injected and put to work. The entrepreneur needs tuition in running a company, liaison with investors and lenders. While tutoring investee entities and their managers in the art of working with third-party capital is largely a cultural thing, the shackles that inhibit investment opportunities in this sector can only be removed by amendment to the regulations. It ought to be made much simpler for small and developing businesses to be marketed to business angels and investment clubs, with the current regulatory obstacle course pared back to an acceptable minimum. To date, the FSMA regime in relation to informal investing has been an immense disappointment.
The past few years have seen a marked increase in the amount of data required of investors in order that those who handle their money comply with anti-money laundering rules and procedures. What this means is that at the point of investment, each investor must provide a significant amount of information about themselves, their means and the provenance of their money. This raises two interesting points in connection with financial promotion. First, disclosure for money laundering compliance purposes is effectively a self-certification exercise. Second, until the disclosure is given – which is an eleventh-hour aspect of most investment transactions – the parties negotiate entirely on trust that the investor’s identity and cash resources will pass muster. If so, why can they not also be trusted to have sufficient experience or resources to put their capital at risk if they want to?
Daniel Tunkel is a financial services partner at SJ Berwin