Tomorrow will mark four weeks since the FCA announced an independent inquiry to examine a) its supervision of the FCA-authorised Ponzi scheme London Capital & Finance, and b) whether the FCA can pass the buck and blame the system rather than itself. As yet we are still waiting to see who will be appointed to head the inquiry.
As I have previously argued, by conflating the two issues into one enquiry, the FCA is attempting to manoeuvre the inquiry into letting it off the hook. If the head of the inquiry is truly independent, they will insist on examining the FCA’s conduct only, and passing the second question on whether the current regulatory system is adequate to a separate inquiry.
The answer to the FCA’s question “whether the existing regulatory system adequately protects retail purchasers of mini-bonds from unacceptable levels of harm” is quite obviously “no”. It is a classic leading question. Even if the answer was actually “yes”, which it isn’t, nobody would dare say as much when 11,000 individuals are still dealing with the destruction of their life savings and financial security.
All that remains is for Parliament to decide how exactly the current system should be improved. Here is where they could start.
Why legislation must be improved and loopholes must be closed
A basic principle of law is that anyone who wants to take part in an activity that poses a high risk to the public should be regulated. If you want to own firearms for sport, drive a car, or offer investment securities to the public, you need to register yourself with the authorities. The law does not say you can’t do it, but if you are, you have a duty to show you are doing it responsibly.
But did you know there is a loophole in UK firearms legislation that allows you to own a high powered assault rifle, as long as you put a sticker on it saying “This Is Not An Assault Rifle”? And that even if you start walking around in public waving your not-an-assault-rifle in people’s faces, the police will take no action until people start getting hurt?
No there isn’t, because that would be utterly ridiculous. Yet this is the situation that UK legislation allows in the offering of unregulated investments to the public.
Unlike firearms, collapsed unregulated schemes do not kill people, but the impact on people’s lives is often comparable to losing a limb, losing a loved one or chronic illness.
Legislation is progressively improved over time, usually after a disaster has made the failings of the existing legislation clear. London Capital & Finance is one such disaster and legislation must be improved to prevent another one.
1. Any securities offering to the public should be registered with the FCA
UK financial services law is 86 years out of date and counting.
In the United States, all investment offerings to the public, such as LCF, are required to register with the Securities and Exchange Commission. As part of their registration they must provide accurate information on the investment offering and their financial position, certified by independent auditors. They must then file updates on a regular basis, also audited.
There are exemptions in US securities law, such as when you only offer an investment to a very small group of people and not the public (e.g. when someone buys shares in a family business). Even then, the company using the exemption must declare the fact that they are relying on the exemption to the SEC. The loopholes are much tighter than they are in the UK.
This does not make it impossible to run an illegal investment – nothing will. It does however make it a lot more difficult, because a) there are far fewer loopholes in what can be promoted to the public, and b) the requirement to publish accurate and timely information is more difficult to get around.
In the USA, LCF would never have been able to advertise its loan notes to the public via third-party websites without a relatively swift cease and desist from the SEC (long before the FCA creaked into gear after three and a half years).
In the USA, LCF would never have been able to get away with repeatedly deferring the date at which it published accounts. Nor would it have been able to conceal the fact that its claims to have security over £685 million worth of assets were completely bogus.
The UK Government should immediately introduce legislation requiring any body offering securities to the public, which is not already caught by the FSMA provisions on collective investments, or trading on a recognised exchange, to:
- Register their investment offering with the FCA.
- As part of that registration, provide comprehensive information regarding their business plan, existing financials, and projected cashflow, audited by an independent accountant.
- Provide full updated accounts to investors on a six-monthly basis. No company offering securities to the public should be allowed to use “small company” exemptions from publishing full accounts. Any failure to file accounts on time should trigger an immediate investigation.
The definition of a “security” should mirror that used in the US. Contrary to myth, the definition of what is and isn’t a security is well-defined, and has been since the “Howey Test” was established in law in 1946.
None of this is impossible, disproportionate or unaffordable, as this is how it has worked in the US for decades.
The “restricted investor” definition (people who can have ultra high risk unregulated investments advertised to them if they promise not to invest more than 10% of their capital) should be abolished. It is completely unenforceable.
The definition of a “high net worth” investor should be changed from £200,000 in assets excluding one’s home to £1 million. This is in line with the widely-accepted definition of a HNW investor. One-off windfalls such as an inheritance or pension lump-sum should be excluded.
2. The FCA must be reformed from the top down.
£230 million of life savings have been lost and 11,000 lives wrecked. Most of this damage was preventable had the FCA done their job. Heads must roll. The third statement follows the first two just as night follows day.
New legislation is pointless if nobody enforces it, and as it stands, the FCA will not enforce it.
At present, the FCA shows virtually no interest in shutting down investment schemes that ignore existing legislation. It has often been said that the FCA was slow to act on LCF, and of course it was. But by its own standards the FCA reacted quickly. Normally the FCA takes no action on an unregulated investment scheme until it collapses.
The FCA has shown zero appetite for investigating unregulated investment schemes, even when they are committing blatant violations of existing law by openly advertising to unsophisticated investors via the Internet or TV and encouraging them to post reviews on Trustpilot or Feefo. The FCA shows far more interest in investigating regulated and legitimate firms over minor differences in price.
At present the FCA is a vicar, not a sheriff. Its comfort zone is sending regulators to visit legitimate businesses that serve them tea and biscuits and nod attentively when the FCA lectures them. It does not like investigating schemes that refuse to let the FCA in without a court order. This represents a huge misallocation of priorities, as it is the latter that cause the most damage.
With the support of unambiguous securities legislation, a revamped FCA could investigate potential violations on a risk-targeted basis. If an unregistered securities offering is brought to its investigation, it would assess whether the potential violation merited action. If so, it would demand evidence that the scheme qualified for an exemption (e.g. by producing evidence that all its investors qualified as high-net-worth). If the scheme failed to do so, it would petition the courts to shut it down, freeze assets as necessary, and wind it up in an orderly fashion to minimise further losses to investors.
But the FCA will not do this without a culture change, without an active desire to investigate the schemes that aren’t going to let it in. It needs to become a sheriff instead of a vicar. This will only happen with top-down reform. Senior management must be sacked and new directors brought in with a mandate to target those who don’t play by the rules.
3. The Innovative Finance ISA should be immediately closed down.
Rightly or wrongly the Individual Savings Account is viewed as a “CAT standard” by UK investors. You can hardly blame them because the Government actively encourages them to save in ISAs via a tax break.
Until the introduction of the IFISA, ISAs were also restricted to authorised deposits (cash ISAs), regulated collective investments or securities traded on a regulated exchange. This gave a further level of assurance that an ISA-eligible investment was legitimate and not unduly risky. Technically you could invest your entire stocks & shares ISA in Patisserie Valerie and lose the lot, but it took some doing (and nobody launched comparison sites encouraging you to do so for 20% commission).
The introduction of the IFISA allowed providers such as London Capital & Finance to exploit this market.
This blunder should be reversed immediately. Any existing IFISAs should remain tax free, but no new money should be permitted into IFISAs.
Any legitimate P2P providers that are upset about the loss of this source of funding have a simple solution – follow Funding Circle and list on the London Stock Exchange. If they can’t meet the financial and disclosure requirements for a successful IPO, tough.
The clock is ticking
The UK Parliament is, to say the least, somewhat pre-occupied at present. It has time to ask a few searching questions of the FCA but not for an overhaul of financial legislation. But regardless of whether the UK leaves the EU, stays in the EU or undergoes economic collapse, at some point the crisis du jour will fizzle out and MPs will have time on their hands again.
At present the remaining unregulated schemes who were formerly most active in advertising are retreating into their shells and waiting for the storm to pass. This will not last.
At present the media are printing lots of stories warning their readers of the dangers of chasing returns that seem higher than usual. This will not last.
If nothing is done, then in between five and ten years time, there will be another London Capital & Finance. Why wouldn’t there be? If nothing changes, then in 5-10 years time there’ll be a £250m prize on offer for whoever can next capture the imagination of the public. Another generation will retire and receive pension lump sums, another generation will die and leave 5-6 figure sums to their heirs. The pool of victims will be replenished.
Over the last month politicians have started asking questions. Soon we will see whether they will act. Asking questions from a committee chair is not enough.