Fraser Kane

On 19 April 2021, the Treasury launched an open consultation concerning the future regulation of the issuance of non-transferable debt securities (NTDS), also commonly known as “mini-bonds” in the UK.

The issuance of NTDS has historically not been subject to regulation by the Financial Conduct Authority (FCA). However, the promotion of NTDS has been subject to the financial promotions regime. This means that (unless an exemption applies) marketing material concerning NTDS may only be communicated by an FCA authorised firm or where it has been approved by an FCA regulated firm.

Separately, the FCA in January 2020 temporarily banned the promotion of “speculative illiquid securities” to most retail consumers which includes NTDS where the issuers uses some or all of the funds raised to lend to a third party, buy or acquire investments, or buy or fund the development of property. The temporary ban was made permanent in January 2021 following a consultation process.

The Background to the Consultation

NTDS sharply arrived onto the regulatory agenda following the failure of London Capital & Finance (LCF) in early 2019, impacting over 11,000 investors with more than £230m invested. Most of LCF’s revenue was generated through its issuance of NTDS – a non-regulated form of debt security which paid interest of around 6-9 per cent and was only repayable on maturity. The funds raised were lent onto or invested into third party projects.

Most of the investors in LCF and similar schemes are retail investors with no specialist experience in investing. Despite this, research shows that a high proportion of investors (around 80 per cent) do not take financial advice prior to investing in the NTDS. As unregulated investments, NTDS are not covered by the Financial Services Compensation Scheme (FSCS) and investors have no ability to make a complaint to the Financial Ombudsman Service. This was confirmed by the High Court last month in a judicial review brought by LCF bondholders against the FSCS, albeit this decision may be appealed.

The collapse of LCF and subsequent FCA inquiry culminated in an independent investigation by Dame Elizabeth Gloster into the events relating to the FCA’s regulation of LCF. Dame Elizabeth Gloster’s report made a number of recommendations, including that the Treasury should consider extending the FCA’s regulatory perimeter to include NTDS.

The Treasury’s consultation is made in this context.

The Treasury Consultation

The consultation focuses on proposed regulation of NTDS where the proceeds are then used to on-lend or invest in third-party projects as opposed to instances where the proceeds are used by the issuing firm to invest in its own business. The Treasury is responsible for setting the FCA’s regulatory perimeter through the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO). The consultation does not contemplate bringing into the scope of regulation the issuance of NTDS via regulated intermediaries (eg. crowdfunding platforms who have been regulated since April 2014) and so thus only applies to so called “direct to market NTDS”.

Option 1 – Making the issuance of direct to market NTDS a regulated activity

The first option consulted on is a change in the regulatory perimeter to include the dealing in direct to market NTDS as a regulated activity subject to FCA authorisation. Firms who issue their own securities are generally excluded from the scope of the RAO, other than where the “MiFID Override” applies – ie. where the issuer issues certain transferrable securities. The consultation considers either (i) including NTDS in the scope of the RAO; or (ii) extending the scope of the MiFID Override to include NTDS, with the Treasury favouring the first option.

The consultation notes that such an approach would give direct oversight over relevant firms to the FCA, allowing compliance with the relevant rules to be supervised. Accordingly, firms would also require to meet certain minimum standards in respect of conduct of business, product governance and systems and controls. Ultimately, the consultation states that these “protections would, in the government’s view, lead to better designed products and enhanced investor protection for retail investors able to access these types of product”.

Option 2 – Extending the scope of the Prospectus Regulation to cover NTDS

The Treasury is also consulting on, as an alternative, extending the scope of the Prospectus Regulation to cover NTDS. The Prospectus Regulation currently only covers “transferable securities”. To extend the requirement to produce a prospectus to NTDS, potential investors would be provided substantially more information than is currently required under the financial promotions regime. A prospectus requires to be approved by the FCA, but only in respect of disclosure, not suitability. The Treasury also ask for views regarding extending whether the requirement for a prospectus should include issuances of NTDS, even where the current €8 million Prospectus Regulation threshold is not reached.

The consultation states that it is “the view of the government that the additional information provided within a prospectus would be of limited benefit to the typical retail investor”. This is due to the fact that the information in a prospectus is likely to be hard to understand for the average retail investor. The Prospectus Regulation provides a remedy for compensation to investors where information within the prospectus is untrue or misleading, or information is omitted. In practice this is likely to be of little comfort to investors where historically issuers have been prone to failure and the difficulty/cost of enforcement is likely to be prohibitive. Additionally, the fact that a prospectus is FCA approved, could give a sense of false reassurance to investors, given that it is not an endorsement of the business model, but merely the content.

Option 3 – Rely on other FCA and Treasury measures

The Treasury proposes a third alternative in its consultation. As discussed above, the FCA have already banned the promotion of speculative illiquid securities. This means that (unless an exemption applies) NTDS where the proceeds are used to on-lend or invest, or invest in property, cannot be marketed to most retail investors. In addition, the FCA is seeking to tighten its oversight in respect of the approval of financial promotions by way of the establishment of a regulatory “gateway”.

The consultation notes that the FCA’s intervention closes the highest risk part of the NTDS market for ordinary retail investors. However, it does not allow for regulatory oversight in the design, governance or functioning of NTDS, and does not apply to high net worth or sophisticated investors.

Comment

The market for direct to market NTDS has declined considerably from its peak. Notwithstanding the FCA’s recent marketing restriction, the potential for ordinary retail investors to participate in NTDS continues to expose investors to a high risk of detriment if left unchanged. It appears that providing additional disclosure through a prospectus or relying on existing powers, are both unlikely to give the level of protection that would be desirable through direct regulation.

Direct to market NTDS display many of the characteristics of a collective investment scheme which are regulated. Investors’ funds are collectively pooled to invest in a range of onward lending/investments. The key difference is that investors’ returns are fixed, and accordingly, not linked to the success of the investment.

However, in reality, as we have seen with the demise of LCF and others, the collective failure of the NTDS issuer’s investment strategy can result in a complete failure of the investment (ie. an inability to repay the interest and capital in terms of the NTDS). It therefore seems sensible that the Treasury is considering bringing the issuance of NTDS within the regulatory perimeter. It will be important that any regulation captures both point of sale and ongoing oversight throughout all stages of the products lifecycle.

Fraser Kane is a senior solicitor at Burness Paull