On Thursday 17th, Dame Elizabeth’s Gloster’s long awaited report into the £237 million collapse of London Capital & Finance was published.
The report is damning and makes very clear that the FCA bears a large part of the blame for LCF accumulating, and losing, as much investor money as it did.
Furthermore, the following is, in the Investigation’s view, self-evident: had some or all of the FCA’s failures in regulation outlined in this Report not occurred, then it is, at the least, possible that the FCA’s actions would have prevented LCF from receiving the volume of investments in its bond programmes which it did. For instance, had possible irregularities by LCF been detected (and their significance appreciated) by the FCA42 sooner than late 2018, then the FCA should, in the Investigation’s view, have intervened (or taken other regulatory action) earlier.
This has been widely covered in the press, along with the apology from Andrew Bailey, who was head of the FCA throughout much of LCF’s lifespan, and was rewarded for its failure by being kicked upstairs to the job of Governor of the Bank of England.
Here are some edited highlights for those who want a bit more detail than the headlines, without reading the full 494 page report. This is not intended to be a full summary of the report (so you’ll have to forgive me for skimming over accounts of high-level supervision discussions at corporate away days, important as they are) but a list of the most interesting / juiciest bits for ordinary investors.
LCF was waving red flags from day 1, but its accountants didn’t notice
Accounting behemoth PriceWaterhouseCoopers told the FCA in November 2017, on being replaced by another firm of auditors, that there were no matters to bring to the FCA’s attention. The fact that LCF was paying 25% commissions and had no investments with a realistic hope of paying sufficient returns to fund 25% commissions and 8% interest to bondholders apparently wasn’t deemed worthy of notice.
A chartered accountant hired to review the historic information submitted by LCF to the FCA found “red flags” and inconsistencies in financial information that could have been spotted as early as 2016. It also found that the information provided to the FCA by LCF continually indicated that LCF could not meet its liabilities without raising further investment.
It noted that LCF had to charge up to 29% annual interest to its underlying borrowers to fund its commission and interest payments, and this made no sense considering LCF claimed to be engaged in secured lending with low loan-to-value ratios – such borrowers would have no need to pay such high interest. [A11]
The FCA told potential investors that LCF was not a fraud, and FSCS protected
An elderly (septuagenarian) investor was told by the FCA that LCF was “unlikely to be operating fraudulently” as it was FCA-authorised. This was not an isolated incident. [A6 4.2 and 6.7]
A call-centre worker who did advise a potential investor to be “very cautious” and report LCF to Action Fraud, having correctly identified the misleading nature of LCF’s promotions, and subsequently raised concerns with the FCA’s Supervision division, was slapped down as “in error”. They were told that there was already an article on the FCA’s intranet to say that they were “already aware of this issue” and that LCF was not in breach. [4.6-4.7]
A limited number of FCA call-handlers incorrectly advised LCF investors that they would be protected by the Financial Services Compensation Scheme. [6.2]
Potential investor: It does sound too good to be true doesn’t it?
FCA call handler: Let’s have a look… So that’s [London Capital and Finance] coming up as authorised and regulated, so that’s absolutely fine. That means if you wanted to invest with them, you’d be protected by up to £50,000 by the Financial Compensation Scheme.
Transcript of call between a potential LCF investor and an FCA call handler. [C12 2.36]
FCA action against LCF was limited to watering down their misleading advertising
The FCA first contacted LCF with concerns over how its bonds were being marketed in January 2016. At the time LCF’s website claimed LCF was “100% protected”. This was amended following the FCA’s intervention.
Despite LCF’s misleading promotions, the FCA took no follow-up action to verify a) that all LCF’s investors qualified as high-net-worth and sophisticated and that it could produce evidence to confirm this, and b) that it was lending investor money to a diverse portfolio of SMEs as it claimed. A cursory investigation would have revealed that neither was true, and led inevitably to LCF being shut down before it caused £237 million in investor losses.
The FCA’s previous intervention into LCF’s misleading financial promotions were not flagged up during LCF’s application for FCA authorisation. [A8 10/5/16]
Further FCA intervention into LCF’s misleading financial promotions took place in September 2016, this time over lack of past performance disclaimers and warnings about the illiquidity of the investment. Again there was no follow-up after LCF mollified the FCA by amending its website. [A8 Sep16]
In January 2017, LCF disclosed to the FCA that it paid 25% commission on funds invested by bondholders. This commission was not disclosed to bondholders. The FCA apparently didn’t see anything alarming about this. [A8 26/1/17]
In October 2016, LCF applied for permission from the FCA to hold client money. In a dim corner of the FCA’s collective mind, a lightbulb went on: “why would a firm dealing with corporate finance want to hold client money?” This led to LCF being subjected to an “Enhanced” risk assessment process (the 2nd most rigorous out of 4 classifications), during which the FCA asked detailed questions of LCF. In June 2017, LCF threw in the towel in its attempt to gain permission to hold client money.
In response, the FCA downgraded LCF to the “Standard” risk channel (the 2nd least rigorous out of 4) and from then on accepted all LCF statements and responses at face value in regard to its application for regulatory permissions, including in relation to the security of its loans. [C9 6.9]
The FCA consistently treated LCF’s unregulated bonds as not its problem
The report finds that, in the multiple times that the LCF crossed FCA desks, it repeatedly failed to examine LCF’s unregulated business or consider the investment scheme holistically (as a whole). [C2]
In the wording of the report, the “FCA’s approach to its regulatory perimeter was unduly limited” and “the FCA did not sufficiently encourage its staff to look outside the Perimeter when dealing with FCA-authorised firms such as LCF”.
The “regulatory perimeter” is internal code for the FCA’s cultural attitude of “if it’s unregulated it’s not our problem”. As per the statutory objectives given to the FCA, unregulated investment schemes promoted to the public very much are the FCA’s problem, and the Financial Services and Markets Act specifically empowers the FCA to act on such schemes, using court action if necessary where its statutory powers are insufficient.
FCA staff members responsible for reviewing LCF’s application for regulatory status had no accountancy qualifications, and training to analyse company accounts was “on-the-job”. (I.e. non-existent; when it comes to authorising financial firms so they can promote themselves directly to the public, doing the job with no training is not training.) [C2 2.6a]
According to a supervisor, there is little training on how to identify financial crime within the FCA’s Supervision division. [C2 2.6b]
LCF partly fell through the net because responsibility for its regulation had been transferred from the Office of Fair Trading (which formerly regulated consumer credit) to the FCA. 50,000 such firms were subject to a “limited strategy”. As a result, from 2014 to early 2019, LCF was subject to no proactive supervision by the FCA. [C2 3.5]
The FCA failed to see anything untoward about the fact that LCF was generating no revenue from the regulatory activities it had applied for permission to do. (This was, of course, because LCF applied for FCA authorisation purely to use it as a “seal of approval”, and to allow it to access the ISA market.) [C2 3.2]
The FCA treated LCF’s repeated breaches of financial promotion rules as separate cases, rather than considering whether these repeated breaches could indicate poor systems and controls or even misconduct. [C2 3.7b]
A number of members of the public contacted the FCA identified correctly
- that LCF’s literature was misleading
- that LCF’s published accounts raised questions over its financial viability, contradicted LCF’s claims to have loaned money to numerous SMEs,
- that LCF had conflicts of interest between itself and connected companies
Whenever these reports from the public were escalated, they continually foundered against the FCA’s “it’s unregulated so it’s not our problem” regulatory perimeter.
An internal FCA report from 2013 identified that there was a risk of minibonds such as LCF’s slipping through the cracks. “In addition, if they [are] not sold on an advised basis, it seems that it would not be a sector team issue. This is a risk as there is a possibility that this issue is overlooked as each sector might consider it beyond the scope of their remit.” [Translation: nobody’s been given the job of looking at minibonds so every FCA team will say “more than my job’s worth”.]
The report also noted the increasing amount of money that was going into minibonds, and that misselling of minibonds via lack of risk warnings was endemic. It is unclear whether this report was ever acted on by or even reached senior FCA management. [C7 2.2]
There is no evidence that the FCA took any steps to check whether LCF’s bonds were sold only to high-net-worth and sophisticated investors. [C7 2.6]
FCA senior bureaucrats shirk responsibility
In its response to the Investigation, the FCA claimed that the Investigation was unfairly using the benefit of hindsight. [C1 10.3b]
As the Investigation notes, this is of course false, as per its accountant’s report which showed that there was more than sufficient cause for further investigation and intervention as early as 2016.
The FCA also claimed that it would have taken a forensic accountant to spot the red flags in LCF’s financial information. [C9 6.21]
As the Investigation notes, this is also patently incorrect. Plenty of lay members of the public managed to spot the issues in what little financial information LCF released, including the lack of evidence for its claim to have loaned out hundreds of millions to SMEs with asset security. Many took their concerns to the FCA.
The FCA ignored red flags in LCF’s provided financial information, ignored its own interventions into LCF’s misleading advertising, and has then had the nerve to claim nobody could have seen it coming at the time. It’s a bit like running your car over someone and then claiming “well it’s easy to say I should have seen them now they’re in the rear view mirror”.
The FCA claimed “the draft report had not adequately recognised that the FCA must necessarily prioritise and take a risk-based approach”. Or, to translate, “what’s all the fuss about? It’s only a piddly £237 million.” [C1 10.3]
In a paragraph straight out of an episode of Yes Minister, the FCA told the Investigation that it would be wrong to assign responsibility for the failings over the FCA to individuals, on the grounds that a) it might deter people from wanting to be FCA senior bureaucrats, b) that investigations such as these are supposed to focus on institutional failures and not individual ones, c) the very concept of responsibility is ambiguous. [C1 11]
As the Investigation pointed out, this attitude is at odds with the FCA’s own “Statements of Responsibility” and “Management Responsibilities Map”, implemented in 2016 after the Treasury recommended that the FCA should apply the same framework to itself that it applies to the senior management of banks.
For all the failings in the report, the most glaring paragraph to me is the one where it was claimed to the FCA that the concept of “responsibility” is some kind of ambiguous, philosophical concept, ignoring its own Responsibilities Map and the principles it (somehow) expects the UK finance industry to follow.
And where exactly did this come from? A footnote to the report reveals it came from the submission to the Investigation made by erstwhile head of the FCA, current head of the Bank of England, Andrew Bailey. It came from the top.
It appears to be lost on FCA senior management that responsibility and accountability is what they pay you the big bucks for. For many people it is what they pay you minimum wage for (ask any carer).
The FCA’s 2018 intervention into LCF was delayed by fears of being met with a hail of bullets
The FCA’s belated intervention in late 2018, which resulted in LCF being closed to new investment and immediately collapsing, only happened by chance, as a result of an unrelated search on an external database while looking for something else, which turned up a report which identified significant concerns about LCF. The FCA staff member who stumbled upon the document stated “if the document didn’t mention LCF, it’s entirely possible that nobody would have looked at it”.
The report was circulated by the FCA’s Intelligence Team, ultimately resulting to an unannounced site visit in late 2018. [C13 7.12f]
The site visit was initially due to take place on 21-22 November, but was delayed for three weeks because the FCA team responsible felt there was a risk of being met with armed resistance, and stated they would not proceed without police support. The local police force refused to attend as they concluded the risk of LCF meeting FCA bureaucrats with a volley of gunfire was insignificant. Consequently the site visit eventually took place on 10 December. An FCA team member described the delay as “frustrating”. [C13 7.12f]
The FCA failed to consider taking action to freeze the accounts of LCF, and companies and individuals connected to it, prior to its December 2018 site visit. [C2 3.23e]
Conclusion
Dame Gloster makes a number of sensible recommendations as to how the FCA should reduce the chance of similar scandals happening in the future, and limit the damage when it does. These include better training for FCA call handlers, more effort to consider the whole of a regulated firm’s business when supervising it, more effort by senior management to identify emerging risks, etc etc.
What Dame Gloster does not address, most likely due to limitations placed on her by the Government which commissioned the report, is how we can expect the FCA to follow such recommendations.
When you consider:
- the lamely defensive response of the FCA to the Investigation, which suggests that despite a change in leadership, the FCA has been more concerned about loss of face than using the Investigation to identify ways in which it can do better
- the repeated and systematic way in which the FCA contrived reasons to file reports and screaming red flags about LCF in the circular filing cabinet under the desk
- an environment where members of the Supervision division receive no training in financial crime, and where FCA call centre staff were so poorly coached that they actively endorsed LCF to potential investors
…we have a clear picture of an organisation that is so infested by the cultural attitude of “if it’s unregulated it’s not our problem” that I fail to see how anyone can be confident the FCA will follow the Gloster recommendations, no matter how many mea culpas the FCA and Bailey give.
If the Government had replaced Andrew Bailey with an outsider with a reputation for a pro-active and activist approach, we might have grounds for optimism that change could come from there. But they went with a lifelong mandarin in Nikhil Rathi, so we’ll have to hope he has hidden depths.
Change needs to come from the top as part of a full overhaul of the UK’s 80-years-out-of-date securities laws, and it can’t come soon enough.