Community bond issues
The impact of the FCA's new rules on what they term 'Speculative Illiquid Securities'
Financial promotions are any communication of an invitation or inducement to engage in investment activity. Section 21 of FSMA 2000 prohibits a person from issuing a financial promotion unless it has been approved by an (FCA) authorised person, or is exempt from the prohibition. The exemptions are set out in the Financial Promotion Order 2005 (FPO).
In addition to the above, the FCA uses powers to impose rules on the communication of financial promotions through its Conduct of Business Sourcebook (known as COBS). These rules include what the FCA expects to see in relation to financial promotions which require approval by an authorised person (e.g. financial promotions must be fair, clear and not misleading), and rules relating to certain investments.
The collapse of London Capital & Finance
The regulation of financial promotions has been subject to recent scrutiny, following the high profile collapse of London Capital & Finance. LCF went into administration in January 2019 after taking around £236 million from over 11,600 ordinary savers who invested in a total of about 14,000 mini-bond/ISA financial products. Having determined that LCF failed to comply with the regulations in promoting its investment products (amongst other things, the communications were found to be "misleading, not fair and not clear" in claiming the bonds were ISA qualifying), the review looked at whether the existing system adequately protected retail investors (crudely, ordinary members of the public) of mini-bonds, from unacceptable levels of harm.
As a consequence of that review, the FCA has inserted a new rule COBS 4.14 relating to the promotion of speculative illiquid securities into COBS from 1 January 2020 to 31 December 2020 under the FCA's temporary product intervention measures. A consultation on permanent rule changes is due to take place in the first half of 2020, with the intention that the new rules will come into effect at the end of the temporary period. The new rules greatly restrict the ability for organisations to promote investments in these type of products.
We work with many community organisations that seek to raise finance by issuing debt (bonds etc.) investments to members of the public. This article considers the effect of the new rules relating to the promotion of speculative illiquid securities on community bond raises by community organisations.
What type of promotions do the new rules affect?
COBS 4.14 applies to financial promotions which promote speculative illiquid securities, to retail investors. Speculative illiquid securities are defined as:
A debenture (a bond) or preference share which has a denomination/minimum investment of £100,000 or less; and has been issued/will be issued in circumstances where the issuer (or a member of the issuer's group) will use or purports to use some or all of the proceeds of the issue directly or indirectly for one or more of the following: (a) the provision of loans or finance to any person other than a member of the issuer's group; (b) buying/acquiring investments (whether to be held directly or indirectly); (c) buying property or an interest in property; or (d) paying for, or funding, the construction of property.
There are some products which will not fall within the above definition (such as products issued to buy or develop property for the issuer/its group's own use for a general commercial or industrial purpose).
What do the new rules restrict?
The new rules will prevent regulated firms from approving/issuing financial promotions in respect of speculative illiquid securities where the promotion is addressed/likely to be disseminated to a retail investor unless the promotions are only made to high net worth and sophisticated investors and contain additional risk warnings.
Are there any exemptions?
However, the regulations state that a promotion which is an excluded communication is not affected by the above restriction. An excluded communication includes a communication which benefits from a financial promotion exemption if it were communicated by an unauthorised person.
Exemptions that tend to apply to financial promotions issued by community organisations to retail investors include:
o FPO Art 35 – industrial and provident societies (now registered societies, i.e. co-operative or community benefit societies);
o FPO Art 48 - certified high net worth individuals (financial promotions to);
o FPO Art 50 - sophisticated investors (financial promotions to);
o FPO Art 50A - self-certified sophisticated investors (financial promotions to); and
o FPO Art 52 - common interest group of a company (financial promotions to).
In order to see how the exemptions work, we look at community organisations that are structured as registered societies and which benefit from the Industrial and Provident Societies exemption. This allows registered societies to issue financial promotions (to retail and other investors) provided that they are:
o a non-real time communication or a solicited real time communication;
Non-real time communications include postal communications, web pages and similar communications without a dialogue with the potential investor.
A real time communication is any communication made in the course of a personal visit, telephone conversation or other interactive dialogue.
A real time communication is treated as having been solicited if the call/visit/dialogue was:initiated by the recipient of the communication; orin response to an express request from the recipient of the communication.
o communicated by the industrial & provident society; and
Note that this would not permit a third party to issue the communication on the registered society's behalf – similarly the common interest group exemption (see above) can only be relied upon by the issuer, not a third party.
o relates only to an investment falling within paragraph 15 of Schedule 1 (of the FPO) issued, or to be issued, by the society in question.
This includes debenture/loan stock, bonds and "any other instrument creating or acknowledging a present or future indebtedness". It is worth noting that financial promotions relating to the withdrawable share capital of a registered society are not prohibited by the financial promotion prohibition because they are not regulated investments – hence they do not have their own financial promotion exemption, as there is no need for one!
The above highlights the importance of having a firm knowledge of the parameters of each financial promotion exemption (in terms of what can be issued, in what media, to whom and by whom).
Community organisations seeking to undertake a community bond issue should take into account the following:
o It is important to check whether an investment constitutes a speculative illiquid investment. The new rules only apply to investments meeting this definition.
o For organisations that previously relied on a financial promotion exemption to promote a community bond issue, they can still do so without adhering to the rules (provided they stick to the strict letter of the exemption).
For organisations that could not previously rely on a financial promotion exemption to promote a community issue of speculative illiquid securities (and would therefore need to have had their promotions approved by an authorised person), they will need to adhere to the new rules. This will be the case for many third parties who are promoting a bond issue on behalf of a community organisation.