FCA commissions independent inquiry into whether they can pass the buck on London Capital and Finance

April 2, 2019 ~ Phoenix ~ Leave a comment

The FCA announced yesterday that an independent inquiry will be held into its supervision of the FCA-authorised Ponzi scheme London Capital and Finance.

The inquiry will cover two areas:

whether the existing regulatory system adequately protects retail purchasers of mini-bonds from unacceptable levels of harm
the FCA’s supervision of LC&F

The first area of investigation will essentially cover whether the FCA can pass the buck.

The regulatory system is not the FCA’s creation but the creation of the Government; it is the Government that writes securities legislation and the Government that periodically sets up, abolishes, merges and reshuffles the regulators.

The FCA has therefore decided that the most important question (the one they have listed first of the two) is whether they can blame the regulatory system rather than the regulator, i.e. themselves. As a famous social scientist once said, don’t hate the playa, hate the game. Not our fault guv, we don’t make the rules.

The FCA has wide powers of rule-making and interpretation but could not fundamentally alter the Financial Services and Markets Act, give itself new powers or make unregulated minibonds regulated.

I’ll give the FCA’s as-yet-unamed independent reviewer a clue: the answer to the first question is no. But that has absolutely nothing to do with whether the FCA should have:

paid more attention to the repeated warnings from both industry professionals and members of the public about LCF’s misselling from 2015 onwards
while processing LCF’s application for FCA authorisation, conducted a cursory Google search for its name; which would have revealed, among other evidence of potential harm, the now long-running Moneysavingexpert forum thread in which numerous potential investors were asking whether LCF was safe, providing ample evidence of potential misselling
taken action on LCF’s misleading financial promotions (and those of third parties to whom LCF paid commission) earlier than December 2018
demanded that LCF produced evidence that all its investors qualified as high net worth or sophisticated investors; and that they had not just ticked a box to say so, but provided evidence that they qualified as such, as required by FCA regulation COBS 4.12.9 onwards

A timescale for the inquiry has not been given, but the phrase “broad and comprehensive remit” provides a clue. The FCA is likely to have plenty of time to fish out its “lessons will be learned” stamp.

Who is to lead the inquiry is yet to be decided. Whoever it is, if they truly want to demonstrate that they are genuinely independent, they could start by insisting that the first question should be a completely separate inquiry, as it is a completely different area of investigation.

London Capital & Finance: Is Smith & Williamson’s softly-softly approach in the interests of investors?

February 6, 2019February 6, 2019 ~ Phoenix ~ 3 Comments

Link: All our London Capital & Finance articles

In Sunday’s interview between Smith & Williamson’s Finbarr O’Connell and Paul Lewis of BBC’s Money Box show, O’Connell made clear that the administrators would be treating London Capital & Finance’s underlying borrowers with kid gloves to ensure they didn’t damage the ability of the borrowers to repay.

PL: So again it depends on those 12 companies [the handful of companies which borrowed from LCF] succeeding in what they’re doing and not failing.

FO’C: Absolutely, and nobody amongst administrators or listening to this has any interest in those companies becoming distressed, so we want to work with them on a very co-operative basis to ensure we get back the bondholders’ money.

On the face of it, Smith & Williamson being “very co-operative” with LCF’s underlying borrowers makes sense. For starters, the administrators may not have the right to demand the money back anyway, as a term for repayment will have been agreed at outset. Even if it can call in LCF’s loans, it makes no sense to do so if the borrowers aren’t currently in a position to pay it back in full, as long as they will be later.

The other option on the table is to sell the loans to a third party, on which the administrators would certainly have to take a loss, which again makes little sense if the borrowers can be relied on to repay the capital and interest in time.

There is one glaring problem with this logic. For some of LCF’s borrowers, if they repay any capital or interest, it will be the first time they have ever done so. Research by Drew J of Damn Lies and Statistics showed that in at least one case, LCF loaned money to a dormant company, CV Resorts Limited, whose published financial results subsequently did not change for four years. This is only possible if the company was not trading, and paying no interest on its loan. Otherwise you would see movement in the balance sheet.

Smith & Williamson can be “very co-operative” with CV Resorts Limited by continuing to allow them to hold LCF investors’ money without paying anything back, and in doing so they can say that the loan is still performing. (If I’ve borrowed money on the basis that I don’t have to pay anything back for however long, and I don’t pay anything back in that time, then I’ve met my obligations and the loan is performing.) But it doesn’t recover anything for investors.

It is clearly in the borrowers’ interests for Smith & Williamson to be very cooperative with them (bearing in mind that the directors and ex-directors of many of LCF’s borrowers are ex-directors of LCF itself). Is it in the interests of investors? Only if being very co-operative means there is a realistic chance of the money eventually being paid back.

If on the other hand the money that LCF has loaned out on any particular loan is not recoverable, then it is in the interests of creditors for the loan to be written off as soon as possible, so that the administration can be brought to the swiftest conclusion possible, without the administrators racking up fees waiting for recoveries that never come, and the investors can move on with their lives.

It is therefore essential that the administrators are willing to make themselves unpopular with LCF’s borrowers if necessary, firstly to establish whether the loans are likely to be paid back, and secondly to ensure that repayment is not deferred indefinitely. Accepting their word is not good enough – accepting people’s word is what got LCF investors into this mess in the first place.

My old pa told me you could be someone’s creditor or their friend but not both. Clearly up until this point, LCF has been a very friendly creditor, given the number of close links that run between LCF and its borrowers via their directors and ex-directors. Following LCF’s admission that it was insolvent after becoming unable to raise new money from investors, this close friendship is no longer viable.

Does Smith & Williamson have the appetite to be unfriendly to the people that appointed it? Based on its public statements so far, that appears highly uncertain.

London Capital & Finance administrators get off to unpromising start

February 5, 2019February 6, 2019 ~ Phoenix ~ 2 Comments

Link: All our London Capital & Finance articles

It has only been a week since four practitioners at Smith & Williamson were appointed as administrators of London Capital & Finance – by London Capital & Finance itself – but already the administrators have made a poor start in reassuring creditors that they are on their side and not the people who appointed them.

First, on the second day of their appointment, Smith & Williamson referred to London Capital & Finance’s investors as “sophisticated or high net worth” in a statement to Professional Adviser.

Exactly how many of LCF’s investors qualify as high net worth or sophisticated will only become clear when the FCA or the administrators get round to reviewing what evidence LCF has retained on file that its investors did, in reality, meet those criteria. FCA regulations require them to hold such evidence for any investors who invested on that basis (COBS 4.12.9 onwards).

For the moment, however, it is clear from the FCA’s Second Supervisory Notice, and the personal statements of LCF investors on the Facebook action group and elsewhere, that a significant number of LCF’s investors did not qualify as high-net-worth or sophisticated. Given that this contributed to LCF calling in administrators in the first place, parroting the idea that LCF’s investors were mostly high-net-worth or sophisticated when the administrator has not had nearly enough time to establish that is a clear blunder.

Smith & Williamson has since rowed back from its claim that LCF investors were HNW/sophisticated, saying it should have been better worded.

This statement was then followed by an interview on the BBC’s Money Box programme on Sunday 3rd Fenruary between BBC presenter Paul Lewis and Smith & Williamson’s Finbar O’Connell. After a brief interview with an LCF investor (who made it very clear that he was not a sophisticated investor, and had invested money that he couldn’t afford to lose), and a brief overview of the numbers, O’Connell made an astonishing statement:

PL: How many companies are involved?

FO’C: It is actually only twelve companies, which is good in a way, becuase it means our focus on the borrowers we have to deal with is quite a small number.

PL: Ye-s, but the small number implies that the risk isn’t being spread […] These were supposed to be low risk, if you lend to twelve companies you’re entirely dependent on those twelve companies to get your money back.

FO’C: Yes, as you say, as regards spread, it is twelve companies, security is in place, we’re meeting those entities next week, and we’ll know more after that.

One of the most basic principles of investing (which Paul Lewis is clearly aware of) is that diversification reduces the risk of an investor losing money, without necessarily reducing the potential return. Other things being equal, the more individual companies invested in, the better. These should also be uncorrelated as far as possible – which does not apply if most of the companies you lend to are linked to your company.

It may well be understandable if Smith & Williamson are secretly quite pleased that LCF has very few underlying borrowers because it makes their job easier. It is however not what the creditors will want to hear – and remember that Smith & Williamson are working for the creditors. To go on national radio and state to the listeners (many of which will be LCF investors looking for more news) that it’s good that LCF’s loan book is chronically under-diversified because it gives them less work to do is an extraordinary self-serving gaffe.

O’Connell goes on to say that the administrators have already established that the money invested in LCF’s twelve borrowers matches the total invested by investors – “the numbers all add up”. Paul Lewis asks if this means that if investors will be safe if all these companies return interest and capital on time (acknowledging “that’s a lot of ifs”): O’Connell replies “that is the hope”.

The fact that the administrators have matched the amount invested by investors with the amount loaned out rather misses the point that LCF paid 20% of investors’ money to Surge Financial, who ran its call centres and comparison websites promoting LCF via misleading comparisons with deposit interest rates. (The 20% figure has been confirmed by the Evening Standard and is backed up by note 10 in LCF’s most recent accounts.)

To enable LCF to return all investors’ capital and interest, LCF’s borrowers therefore not only need to return capital to LCF with sufficient interest to cover the interest offered by LCF, but also cover the 20% commission, and any other costs incurred by LCF (such as those of its sponsorship).

Conclusion

Smith & Williamson has a statutory duty to work in the interests of creditors. When an administrator is appointed by the directors of the firm that has just become insolvent, they have extra work to do to convince creditors that they are working in their interest, not those of the people that appointed them.

Especially when you consider that S&W will spend the larger part of their time interacting with the directors, in order to establish the financial position of the company and any avenues for recovery. This means it is essential that creditors can be confident that the administrators will robustly challenge the directors.

This is not a good start.

Misleading statements by LCF is partly what got LCF investors into this situation in the first place (source: FCA’s Second Supervisory Notice). In which case you have to ask why S&W initially blindly accepted LCF’s assertions about the sophisticated / HNW status of their investors, and the idea that everything is hopefully fine because LCF’s borrowers will repay their loans on time (and with sufficient interest to cover not just LCF’s commitments but to recover the amounts paid out as commission).

Footnote

O’Connell does accurately state in the interview that the existence of a Security Trustee with security over LCF’s assets doesn’t actually help investors, as the investors have a claim against LCF anyway. This is an obvious point but you wouldn’t know it from the number of unregulated bond issuers that go big on the existence of a “Security Trustee” in their adverts.

London Capital & Finance: what happened and when?

February 1, 2019April 28, 2020 ~ Phoenix ~ 8 Comments

After London Capital & Finance recently admitted that it was insolvent and put itself into administration, bringing a three-year career of persistent misselling to an end, now seems a good time to look back upon its short life – and what the FCA did about it during that time.

July 2015: An obscure company called Sales Aid Finance (England) Limited renames itself London Capital & Finance, despite being based in Tunbridge Wells, about 20 miles away from Greater London’s outskirts. This appears to have signalled the launch of its new business model.

October 2015: A member of the public asks the Moneysavingexpert forum about LCF after coming across them while Googling for “investment ideas”. The forum is unanimous in advising them not to invest.

November 2015: A prominent financial adviser, after being asked about LCF by one of his clients, writes to the FCA to warn about their activities.

2016-19 (and ongoing): The FCA continues to expend hundreds of man hours a week on implementing the Mifid II directive, dubbed by one compliance expert “by far the worst piece of financial regulation ever in Europe”. Mifid disclosure requirements are so bad that the FCA itself advises firms that they should issue “additional explanation” when the documents that Mifid forces them to issue are misleading. All of this is for a directive that the UK no longer has any good reason to follow once it leaves the EU.

June 2016: After an application process which is likely to have taken at least six months, the Financial Conduct Authority approves London Capital & Finance (for corporate finance business only; its loan notes remain unregulated).

By authorising its business, the FCA allows LCF to target the ISA transfer market, using the new Innovative Finance ISA wrapper – notwithstanding that LCF’s bonds are not eligible for ISA status – as well as giving it the added cachet that comes from being able to display “Authorised and regulated by the Financial Conduct Authority” on your website.

Early 2017: The FCA spends £60,000 on a new logo (plus an unknown number of worker hours changing all its stationery). The new logo is identical to the old one, but swaps around the maroon/white colour scheme, ruining the genuinely clever spotlight effect in the old logo.

March 2017: Drew J of the Damn Lies & Statistics blog adds another complaint to the FCA’s pile of warnings against London Capital & Finance.

August 2017: The FCA pays an undisclosed amount to hang out with Arnold Schwarzenegger and get him to front a series of ads telling the two people who had PPI and haven’t yet made a claim to make one.

December 2017: Bond Review is founded and, in our first ever post, issues a warning about the high risk nature of London Capital & Finance bonds.

February 2018: London Capital & Finance finally files its annual accounts for 2017 four months late, having used the accounting-period-shortening loophole twice in a row.

Its auditors, Ernst & Young, do not identify any concerns or issues with the accounts, and state that they have not identified any misstatements in the Strategic Report or the Directors’ Report. The directors’ report states that LCF is a going concern, and makes no suggestion that this is dependent on continuing future investment.

March 2018: The FCA publishes a collection of 28 essays on “Transforming Culture in Financial Services” from “thought leading academics, industry leaders, international regulators and change practitioners”. Leading figures from centres of excellence such as the University of Greenwich pontificate on subjects such as “Creating a culture of learning through speak-up arrangements”, “The permafrost problem: from bad apples to excellent sheep” and “A New Dawn for Cultural Transformation as Organisations Make Stakeholder Interests a Reality”.

July 2018: The FCA launches a consultation into why most people still don’t switch their cash accounts for an extra 0.5% a year.

October 2018: The standard six-month deadline for London Capital & Finance to file its April 2018 accounts expires. London Capital & Finance again deploys the accounting-period-shortening trick to avoid being officially overdue.

December 2018: The FCA finally wakes up, orders LCF to remove all its marketing materials, followed swiftly by a second order to freeze all its assets including its bank accounts.

January 2019: LCF places itself into administration, stating that it is unable to raise money from new investors, and is insolvent.

Footnote

The only thing worse than realising that your spouse has been cheating on you for years is realising that you were literally the only person who didn’t know about it, and that you’re the laughing stock of the whole town. Unfortunately this is the reality that LCF investors are waking up to.

Some of the facts about London Capital & Finance, such as the lending to companies closely linked to LCF directors, have only come to light since the administration. However, it was always clear right from day one (i.e. late 2015) that LCF bonds were extremely high risk products that, like any unregulated loan to a small startup, carried a high risk of loss by their very nature. That risk has come to pass.

As for those facts that have only come to light in the last few weeks, they were never hidden; they have been public knowledge for months available via Companies House, but it took the FCA orders to spark enough interest in people with enough expertise to uncover them.

As always the investors are last to find out. And the cost of the FCA’s failure to act on LCF’s misselling before stands at anything up to £225 million of life savings, depending on what is eventually recovered in the administration.

Dear Brevdre: how can loan note investors ensure the company does what they say they will?

October 16, 2018October 10, 2018 ~ Phoenix ~ 5 Comments

A reader writes:

Dear Bond Review,

Thank you for drawing my attention to the Financial Ombudsman ruling on the IPM case.

I have read the Decision Note you link through to. What is particularly interesting to me, as an investor in loan notes, is these points:

And the Security did not have any mechanism to enable the Security Trustee to prevent SEB from disposing of secured property which was a fundamental flaw. It meant the Security Trustee could not prevent SEB from paying most of the money raised for investing in solar projects in the UK to its parent in Australia – who then went bust.

What would be interesting to me would be to learn of example paragraphs in loan documentation that would have secured against this particular risk.

The short answer is that I don’t believe there is any way you can secure against this particular risk on an individual loan note basis, and certainly not by inserting paragraphs in the Information Memorandum.

When you hand over money to a company to be invested on your behalf, there is always a risk that they won’t do with it what they said they would.

Once your money is in the hands of a company, the default position is that the directors can do with it as they see fit. What is there to stop them misusing it? There is no regulator or bondholder-appointed governess looking over their shoulder. The answer is mainly the threat of legal action against the company or the directors themselves if misuse results in a loss.

However, legal action is expensive and difficult, and the possibility of an investor recovering their money from the company or its directors may be slim. And, of course, legal action can only take place after the fact.

Let us say that back in 2013 the Secured Energy Bonds documentation included the line “Investor funds will be invested solely for the purposes described in this Information Memorandum and will not be invested in the parent company or any other third party”. SEB then goes ahead and transfers money to the Australian parent anyway. What can investors or the Security Trustee do about it? Not a lot. They probably wouldn’t have even found out until SEB went bust.

It is important to bear in mind that the risk of the company not doing what they said they would is only a small subset of a much larger risk – default risk. A company can do exactly what it said it would with investors’ money, and still fail to make sufficient returns to pay bondholders, because it does it badly, or has sheer bad luck. Any loan note is subject to default risk.

The vast majority of investors secure their investments against default risk by diversifying across hundreds or thousands of companies listed on regulated exchanges worldwide. The risk of any one company on a regulated exchange going bust is small, and diversification ensures that even though a small number inevitably will go bust during the course of a long-term investment, it will only have a negligible effect on the investor’s portfolio.

Some of those busts will be due to mismanagement, some incompetence, some bad luck and often a combination of all three. The investor doesn’t have any reason to care why a company went bust if it only means an imperceptible blip in their portfolio of less than 1%.

diversified portfolio — If I have a diversified basket of investments, I’m not going to be up all night worrying about any blue circle in particular.

The vast majority of investors should not be put in a position where they have to worry about such things.

Have a question about investments? Worried about risk? Problems in the bedroom? Send your questions to the usual address, unless they’re about the last one.

Is the FSCS about to make all unregulated investments risk-free?

September 28, 2018September 28, 2018 ~ Phoenix ~ Leave a comment

Betteridge’s Law of Headlines: Any headline that ends in a question mark can be answered with the word “No”.

As I noted earlier this week, in July and August Independent Portfolio Managers had what is bound to be the first of many Financial Ombudsman complaints awarded against it, for its role in approving the literature for the collapsed Secured Energy Bond investment.

It looks highly likely that similar awards against it will follow for its role in Providence Bonds.

In June 2018, the Financial Conduct Authority cancelled IPM’s permissions over an unpaid regulatory fee of £1,660 and 23 pence. The chance of IPM being able to meet the slew of claims against it, which could run into the millions, appears minimal.

Secured Energy investors still however appear confident that they’ll get their money back – on the basis that the Financial Services Compensation Scheme will pay up when/if IPM goes bankrupt.

At time of writing, the two test case investors have accepted the ruling, so IPM has now been ordered to pay. IPM is no longer an FCA-regulated company. If it fails to pay, investors have to go to the Financial Services Compensation Scheme. More delays, but eventually I should see my money back.

I hate to be ‘that guy’ towards investors who have suffered enough already, but if the FSCS compensates Secured Energy investors for their unregulated, ultra high risk investment, it will effectively turn the entire UK financial system on its head and mean that any unregulated capital-at-risk investment can be rendered risk-free for any investment below £50,000 (£100,000 for couples).

(This point appears to have been missed by the Guardian and other outlets which have covered this story; understandably, they have focused on the long emotional struggle of investors and not the detail of financial services regulation.)

How to make an unregulated investment risk-free (if the FSCS pays out over IPM)

I launch Company X offering unregulated bonds offering returns of 8% per year for investing in whatever (let’s say crypto mining).
Simultaneously my friend sets up Company Y and applies for FCA authorisation to conduct whatever regulated activity is the easiest to get FCA authorisation for.
Once FCA registration is secured, my friend rubber-stamps my investment literature with the words “approved for the purposes of Section 21 of the FSMA by Company Y, which is authorised and regulated by etc etc”.
Both of us ensure we are careless enough that there is a clear error in the investment literature – such as overegging “security features” to make the bonds appear less risky than they are (as with IPM).
A few years later Company X goes bust. Investors complain to the Financial Ombudsman that the literature was misleading and Company Y should have spotted it.
The Ombudsman upholds the complaints and awards redress against Company Y. Company Y goes bust.
Investors claim to the Financial Services Compensation Scheme and get their money back (up to £50,000 per person).

There are, of course, already a total of three ways in which you can transfer liability for an investment scheme to the FSCS.

Set up an authorised deposit-taker and issue retail deposits or cash ISAs (which are FSCS-protected). Problem: getting authorised as a deposit-taker involves extremely stringent regulation and capital adequacy requirements. Difficulty: Extreme.
Set up a SIPP (Self Invested Personal Pension) firm and have investors invest in Company X via Company Y SIPPs, while failing to do adequate due diligence. (Note: rulings from the Ombudsman have been contradictory, but the recent direction of travel seems to be that the SIPP provider can be held liable.) Problem: getting authorisation to run a SIPP provider also involves stringent regulation and capital adequacy. Difficulty: Extreme.
Set up a financial adviser and have it advise investors to invest in Company X. Problem: Getting authorisation to give advice requires passing a series of exams and obtaining professional indemnity insurance. Difficulty: Much lower than setting up a bank or a SIPP provider, but still high enough to prove a deterrent.

The crucial difference between these three types of firm and Independent Portfolio Managers is that they all involve a specific type of FCA permission that is quite hard to get.

However, any FCA authorised firm, regardless of what it is authorised to do, is permitted by the Financial Services And Markets Act to authorise financial promotions. There is no specific FCA permission for “authorising financial promotions”. If you’ve got any other FCA authorisation, you get that one chucked in as a freebie.

In turn, following the recent precedent, any FCA-authorised firm can be ordered by the Ombudsman to pay for authorising promotions that they shouldn’t have.

Lowering the bar

There are FCA permissions that are really not that difficult to acquire – for example, insurance mediation (which has been a favourite of firms illegally holding themselves out as financial advisers when they don’t have the specific authorisation) or debt counselling.

You still have to wait six months to a year for the FCA to consider your application, but if you are in the unregulated investment bond business, a waiting period of six months to a year is not much of a problem.

According to the FCA’s website, “positive indicators” which would make authorisation more likely include:

reading information on our website
making enquiries of the contact centre
seeking legal/compliance advice
being able to clearly articulate their regulatory obligations

This sounds not dissimilar to the basic requirements for passing a job interview.

You get the point. Getting FCA authorisation is not difficult as long as you pick the right kind of authorisation. The authorisation of firms like Independent Portfolio Managers rather proves as much.

This means that allowing any FCA-authorised firm to effectively transfer the liability of an unregulated investment to the Financial Services Compensation Scheme, by way of authorising a misleading or flawed promotion on its behalf which investors could then complain about, would represent an astonishing lowering of the bar to obtain FSCS coverage.

It is such a low bar that I can’t see why you wouldn’t do it, and make your investment far more attractive by lowering the risk at no cost to yourself. Hence my rather clickbaity headline.

Protected claims

But is it even likely? By my reading of the Financial Services Compensation Scheme rules, the answer is no.

As I have banged on about before, the liability of the Financial Services Compensation Scheme is strictly defined by the definition of a “protected claim”. All FSCS claims involve FCA-authorised firms but not all claims against FCA-authorised firms are covered by the FSCS. If I run an FCA-authorised company and commission my friend’s company to build me a £1 million solid gold swimming pool on the roof, and go bust without paying, my friend’s company has a claim against an FCA-authorised firm but not against the FSCS.

A complaint about a regulated adviser’s bad advice is a protected claim. So is a deposit-taker or a SIPP provider going bust. A claim arising from a complaint over the authorisation of investment literature is, as far as I can see, not included anywhere in the list of protected claims.

At this point of course, this is just my interpretation. It will be the Financial Services Compensation Scheme that decides when/if Independent Portfolio Managers eventually goes to the wall.

The regulated financial industry has long chafed against the cost of FSCS levies, on the grounds that the good guys have to pay for the bad. Making it much easier to get unregulated investments covered by the FSCS would inevitably lead to higher FSCS levies, and increase costs for the vast majority of consumers who use mainstream regulated financial services (who always pay in the end when investors in unregulated investments are bailed out).

If the FSCS does pay out over Secured Energy Bonds and Providence Bonds – even where no SIPPs were involved and no financial advice was involved – we can expect a huge backlash from the regulated world.

More likely is that the FSCS will reject the claims, and the Secured Energy and Providence investors will finally be allowed to come to terms with the loss of their investments.

Bond Review Komix Korner: “Do Your Research”

April 13, 2018April 11, 2018 ~ Phoenix ~ Leave a comment

One of my pet hates at the moment is the phrase “Do Your Own Research” (DYOR) – most commonly seen in discussions of day-trading, higher-risk “pick-your-own” P2P, and lately cryptocurrency.

How can I be against people being informed before they invest money? Clearly I’m not. The problem is that research is worthless if you don’t know what you’re looking for; all it achieves is to instill a false sense of security and one’s own insight.

I’m not a great believer in the Dunning-Kruger effect (the theory that most people significantly overestimate their intelligence), but it applies here. Otherwise we wouldn’t see so many people lose money in day-trading or other speculative investments despite having spent long hours on the computer looking at Google Finance. Either their research would allow them to avoid poor investments, or they would pull out before investing.

For a professional who does know what they’re looking for, these are the kind of things that would be considered research / due diligence into an individual security:

drilling down exhaustively into a company’s projections, checking that the assumptions behind them are sound, even making sure all the formulae add up correctly
auditing the monthly management accounts to ensure they are consistent
site visits to check that everything is as the company management claim it is
reading through a company’s contracts, with a legal expert if necessary, to ensure their contracts are watertight

These are the kind of steps that a corporate lender would require its due diligence accountants to take before they handed over a large sum of money (in the good days when banks used to lend to companies).

By contrast, here is what research typically means to a retail investor labouring under the Dunning-Kruger effect:

Reading the information memorandum cover-to-cover (for cryptocurrency, substitute the whitepaper for the IM)
Speaking to the management or their representatives on the phone
Reading through data which is already known to the market, or broker reports that regurgitate data already known to the market and add some guesses

All of these are essentially equivalent to staring really really hard at the back of the opponent’s cards. Without independent verification of the claims made by the potential investment opportunity, using professionals paid by you (not the people you are giving money to) if necessary, they mean almost nothing.

Most retail investors should invest using regulated mainstream diversified funds. While these still require some research, it is mostly to check that their funds are actually those three things. This is trivial compared to the research necessary to invest with any genuine confidence in an ultra-high-risk investment with a risk of total loss.

The risk scales used by the regulated financial sector are broken. Here’s why

March 15, 2018June 3, 2019 ~ Phoenix ~ Leave a comment

For many years now, the regulated investment industry has attempted to classify both investment products and investors on a scale of risk – sometimes 1 to 5, sometimes 1 to 7 and sometimes 1 to 10.

The idea is simple and uncontroversial enough – a very cautious investor who cannot stomach any fluctuations in value would be a 1/10, and should only buy products that are 1/10 on the risk scale. While very-high-risk products that are 10/10 for risk (or 5/5 or 7/7 depending on whose scale you used) would only be purchased by investors willing to take that risk. Most people fall somewhere in the middle.

This idea of a risk scale found its way into regulation; everyone who offers investment products to the public in the European Union has to issue a Key Investor Information Document which shows where its product sits on a scale of 1 to 7, determined by its volatility (how much its product goes up and down on a daily basis).

KID and DT risk scales — Two common risk scales: the first is used by Distribution Technology (a leading risk profiling firm), the second is the risk scale mandated for use in Key Investor Documents by EU law. The third is the scale they are measured against; the investment’s volatility (how much it goes up and down).

Here is the problem with these risk scales: whether the scale tops out at 5, 7 or 10, they only consider products available via the regulated investment sector, and whose moving parts are listed on mainstream stock markets. This means a 10/10 risk investment is considered something like an emerging markets or smaller companies fund.

But there are quite obviously many investments which are higher risk than an emerging markets fund – many of which are routinely held by retail investors, such as individual shares or buy-to-let residential properties. These investments can not only fluctuate by more than 10/10 risk-rated funds; they can generate permanent and total losses.

Why is this a problem? Because promoters of unregulated investments have been known to hand-wave away the risk of losing money by saying something along the lines of “all investments have risk”. Logically, this is like chucking a novice swimmer in the deep end of the pool and then saying “all swimming pools have water”. They are denying that there is such a thing as a scale at all.

But if the experts routinely use a risk scale that can’t accommodate even commonplace investments like individual blue-chip shares and residential properties, how is the investor supposed to know which end of the pool they’re about to jump into when they’re offered an investment that doesn’t sit on the scale?

Instead of focusing on volatility (which falls apart at the higher end of the risk scale where volatility cannot be measured), the following risk scale measures investments by what retail investors actually want to know, which is a) can I get my money out? b) can I lose money?

	Short term risk	Long term risk
Low risk e.g. Easy-access deposit guaranteed by FSCS or other depositor protection scheme	Negligible risk of loss	Negligible risk of loss
Medium risk e.g. Globally diversified portfolio of mainstream regulated equity funds	Fluctuates in value; bought and sold daily	Negligible risk of permanent loss if held throughout the market cycle
High risk e.g. Single-sector or single-country regulated equity fund	Fluctuates in value; bought and sold daily	Risk of long-term loss even if held throughout the market cycle
Extra high risk type A e.g. Individual buy-to-let residential property	Fluctuates in value; may be difficult to sell quickly	Risk of permanent loss
Extra high risk type B e.g. Individual S&P 500 or FTSE Main Market equity	Fluctuates in value; bought and sold daily	Risk of total and permanent loss
Ultra high risk e.g. Unlisted individual loan notes, unregulated fund which can borrow to invest	Fluctuates in value; may be illiquid; may be impossible to sell quickly	Risk of total and permanent loss
Scam e.g. Ponzi scheme, advance fee fraud, binary options scam, etc	Near-certainty of total and permanent loss	Near-certainty of total and permanent loss

There are investments which do not sit comfortably in the above table, such as FSCS-protected fixed term deposits (low risk but illiquid) or bricks and mortar funds (generally considered medium risk but illiquid at times of crisis). However, these are niche solutions and the above table shows the progression of risk through the more common investments.

For those less familiar with the investment market, a little more explanation:

By a medium-risk “globally diversified portfolio” we mean a portfolio holding thousands of securities representing all global stockmarkets. This could be a single highly diversified multi-asset fund or a mixture of single-sector funds. Although such a portfolio will at times experience severe falls in value (in the last major crash in 2008, a typical fall was 30-40%), as long as the portfolio is properly diversified, the investment will recover when global stockmarkets recover.

By a high-risk investent we mean those which can lose money in the long term even after global stockmarkets have recovered. There were Japanese funds at the end of the 1980s which never recovered from the “lost decade”, even though they were diversified across lots of Japanese companies. This is why no-one should have all their money invested in Japan, or any single country, even if you live in it.

An extra high risk investment has no diversification, and is different from a plain high risk investment in one of two ways. Either a) it is illiquid and difficult to sell, or b) it is liquid but presents a risk of total and permanent loss (like S&P 500 or FTSE Main Market shares).

Residential property falls under type a), despite being considered by many laypeople as “safe”, because the reality is that residential properties can and do lose money if you get a bad tenant and have to spend money repairing the house instead of making money, and if the house fails to appreciate in value. (House price indices generally go up, but individual houses don’t always.)

An investment which has both illiquidity and risk of permanent and total loss is an ultra-high-risk investment.

A total loss is by its nature permanent.

People often make mistakes when managing medium- and high-risk investments (like betting too heavily on Japan or cashing out at the wrong moment) but as these investments have very little risk of total loss, these mistakes are usually fixable. And because these investments are generally liquid, the investor can correct their mistake as soon as they recognise it, albeit at a cost.

By contrast, someone who mistakenly invests in an ultra-high-risk investment does not usually realise their error until the money is already gone. And there is nothing to switch into a more diversified portfolio, and no way of correcting their error.

This is why developed regulatory systems have at their core the belief that unregistered securities should not be sold to the general public. There is no point saying “caveat emptor“ if the emptor has no way of knowing they should cavere until their wallet has already been emptied.

This is of course all a little academic: ultra-high-risk investments are generally exempted by the EU regulatory system from any requirement to hand investors a document which might show that they are being offered a maroon-level ultra-high-risk investment (as opposed to a “secured” “asset-backed” “insured” “bond”). But we can dream.

Trustpilot lays bare how many unsophisticated investors have invested in high-risk unregulated bonds

February 7, 2018March 12, 2018 ~ Phoenix ~ Leave a comment

Under UK law and regulations, unregulated corporate loan notes should only be offered to high-net-worth or sophisticated investors. (In the regulatory jargon, they are considered non-mainstream pooled investments, being debentures issued by “special purpose vehicles”, an issuer whose objects and purposes are primarily the issue of securities.)

“Sophisticated” does not mean “clever”. It has a specific definition, meaning a member of an angel investment network, a previous investor in unlisted companies, a private equity professional, or a director of a company with a turnover over £1 million.

Leaving the regulations aside, it is a basic principle that inexperienced investors should not be investing significant amounts of their capital in an investment which has a material risk of total and permanent loss.

Many unregulated firms are currently very keen to promote their high ratings on Trustpilot. Often they display 5-star Trustpilot icons on the home page of their website.

example — Typical Trustpilot link on the website of an unregulated issuer

When reading the reviews left on Trustpilot for the issuers of unregulated loan notes, it is clear just how many are highly unlikely to be sophisticated or high-net-worth investors.

In an unscientific survey, I have read through around 300 reviews left for one particular issuer and counted those which showed strong evidence that the reviewer was neither a high net worth investor or sophisticated investor.

I marked a review as definitely unsophisticated if it stated explicitly that they did not have much experience of investing, appeared to believe they had invested in a deposit account or that the investment was otherwise capital protected, used very broken English, or were under the impression that they had been given advice by the issuer (which they are not authorised to do).

I marked a review as possibly unsophisticated if they seemed to place excessive importance on customer service and the friendliness of the customer representatives, or on receiving their first interest payments promptly.

How efficient and customer-friendly an investment company is should really be of very little interest to a high-net-worth or sophisticated investor. Many of them will be using intermediaries or assistants to deal with their investments on their behalf. Even if they are managing their investments personally, they only have to deal with the company twice over a period of several years – at the beginning, and when they withdraw their money.

Many of these firms have been in operation for less than five years and the fact that they have so far dealt promptly with applications and made interest payments on time is of very little significance.

I found that out of 300 reviews, 32 displayed definite evidence of being from an unsophisticated investor, and a further 40 were possibly unsophisticated.

Most of the reviews were too short to draw any conclusions from.

72 out of 300 may be a minority, but it is a very high amount given the unsuitability of these investments for retail investors. It is likely to represent several millions of pounds worth of life savings at risk. Only 7 reviews showed clear awareness that their capital was at risk.

example review — Not a real review, but a mockup of a typical Trustpilot review for an unsophisticated bond. Names and the text have been changed to protect the unsophisticated.

Two Trustpilot reviewers even left reviews to say that they were not happy about being repeatedly asked by the issuer to leave a review on Trustpilot when they had only been invested for a week.

I have not named the company for two reasons. Firstly, because this survey is inherently subjective. Secondly, because of the possibility that the company’s bonds were sold by unrelated third parties and the issuer itself is blameless for any particular review.

To make it a bit more scientific, I looked up the Trustpilot page for a regulated firm, Octopus Investments, which also invests in asset-backed lending and property finance, but offers its products almost entirely via regulated financial advisers. In statistics, this is known as a “control group”. It had no reviews whatsoever on Trustpilot.

I tried two of its larger rivals, TIME Investments and Foresight Group: they also had no reviews on Trustpilot. So from my control group I draw the conclusion that firms that do not offer their products to retail investors do not get reviewed on Trustpilot, even if they have been around for many years with a good track record.

Conclusion

This is a highly unscientific survey and does not constitute evidence that any individual investor should not have taken out an unregulated corporate loan note.

And there is no reason whatsoever to believe that the 72 people who are or may possibly have invested without understanding the risks will not in due course receive their original capital on time and be perfectly satisfied.

We will keep our fingers crossed.

FCA confirms it is investigating unauthorised binary trading firms – but has the horse already bolted?

January 18, 2018October 4, 2018 ~ Phoenix ~ Leave a comment

On Friday the Financial Conduct Authority issued a list of firms known to be offering binary options in the UK without regulatory authorisation. Offering binary options has required FCA authorisation in the UK since 3 January.

COME ON RAINDROP! GO ON MY SON! GO ON… oh… oh well, shouldn’t invest money I couldn’t afford to lose.

Binary options is a form of gambling in which punters place bets on whether a stock, commodity or other security will go up or down within a very short space of time, often 15 minutes or less.

It is the 21st century equivalent of gambling on which of two raindrops will reach the bottom of a window first.

Adverts for binary options bookmakers have been ubiquitous on local news media and other websites for some time, for those of us who don’t use an ad-blocker.

The adverts follow the well-worn pattern of an ordinary punter talking about how they were struggling with debt but have now found financial freedom. After several paragraphs of talking about how great it is to be able to provide security for their family and go on holidays when they want, they reveal the secret was binary options.

And how they were initially sceptical, wagered a few quid “as they had nothing to lose”, and then swiftly progressed to making 4 figures in one month and 5 figures in the next month as their returns multiplied.

The reality is that as with all forms of gambling, the house always wins. And many people have lost their savings even more quickly than if they had bet in a legitimate casino, as many binary platforms rig the trades, refuse to process withdrawals and simply steal punters’ money.

According to the police, £50m has been lost in binary options scams. Assessing the true scale of losses is almost impossible, as Google searches about binary options are drowned out by fake review sites and fake forums.

So the FCA’s action is welcome. Any firm offering binary options in the UK without authorisation is now committing a crime, and the FCA’s press release suggests that further action may be forthcoming against the firms on the list.

There is likely to be little the FCA can do against binary options firms operating outside the UK. Analysis of the FCA’s list reveals a surprisingly high number – around half – claim to be based in the UK. But it wouldn’t be at all surprising if many of these are virtual office addresses.

And the prospect of the FCA recovering funds on behalf of defrauded binary options investors is pretty slim even when the firms and their money are still in the UK. (If you weren’t defrauded, and just made a bad bet, then the chance of recovery is nil.)

But most of all, this may be yet another stable door that the FCA has shut after the horse has bolted. The binary options ads have already been swiftly disappearing from the local news sites over the past few months.

And what is being flogged by the ads that have replaced them? Cryptocurrency – or to be more accurate, contracts for difference allowing you to bet on whether cryptocurrencies will move up or down. Advertised to UK investors via UK local news sites, with no indication that the advertiser is authorised by the FCA to offer contracts for difference in the UK.

As it is written, as one door closes, another one opens.