Compensating LCF investors

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Compensating LCF investors

The recent collapse of London Capital & Finance poses some challenging questions for the financial services industry, particularly whether the Financial Services Compensation Scheme should be required to pick up the tab.

Reports state 11,625 bondholders invested approximately £237m into LCF mini-bonds.

The company was established in July 2012 and became a Financial Conduct Authority regulated entity in 2016. However, the regulation did not extend to the issuing of the bonds.

The LCF information memorandum claimed that its investment strategy was to issue secured bonds and then lend the proceeds of these to a wide portfolio of UK small and medium-sized enterprises on a secured basis.

Key Points

  • The LCF collapse poses questions of who should pick up the tab
  • The FSCS is not making it easy to make a claim
  • Investors could claim if they went through an unregulated introducer

The information memorandum set out the various risk controls and due diligence that LCF would undertake to minimise risk.  

Unfortunately, the memorandum failed to point out that the borrowers were not a diverse spread of SMEs, but a small number of businesses connected to the individuals behind LCF, with risky profiles that were often concentrated in offshore and/or exotic assets (oil and gas).

While the mini-bonds were purportedly restricted to only high-net-worth and sophisticated investors, LCF aimed its marketing squarely at retail clients through the use of an unregulated introducer company and slick online adverts promising high returns.

In December 2018, the FCA issued a supervisory notice directing LCF to immediately withdraw its promotional material, on the basis that the manner in which the company was marketing its bonds was “misleading, unfair and unclear”.

In January 2019, a second supervisory notice was issued by the FCA, confirming that:

• The LCF Isas were not HM Revenue & Customs qualifying investments.

• Undue prominence was given by LCF to the company’s FCA authorisation.

Following the second supervisory notice, LCF promptly collapsed and administrators Smith & Williamson were appointed.

The Serious Fraud Office has commenced an investigation leading to several individuals at LCF being arrested.  

Independent investigation

The FCA has been the subject of sustained criticism for its regulation of LCF.

The government has ordered an independent investigation into the regulatory supervision of LCF and the regulation of mini-bonds.

The investigation will be led by an independent person appointed by the FCA, with the approval of the Treasury. We await the outcome.

So, where does that leave the bondholders?

The administrators Smith & Williamson have been working hard to protect the interests of the creditors. Unfortunately, they estimate the investors may only get 20 per cent of their investment back.

One cannot help but have sympathy for reputable financial services companies faced with ever increasing FSCS levies to fund compensation payments to the victims of disreputable companies. On the other hand, is it not the purpose of the FSCS to act as a lifeboat fund for such victims?

As unregulated investments the FSCS protection does not cover the failure of mini-bonds.

Valid claims

On March 6 2019 the FSCS opened the door advising that: “Should we determine that there are circumstances that give rise to potentially valid claims, we’ll begin to accept claims against [LCF]. If this happens, we’ll communicate this to customers on our website. We’re working closely with the administrators to understand more about how the firm carried out its regulated activities.”

The question is what will constitute a ‘valid claim’?

The FSCS must be satisfied that an eligible claimant has made an application for compensation in respect of a protected claim (as defined in the compensation rules in the FCA handbook).

In order for the FSCS to pay compensation in relation to a claim in connection with protected investment business, it must be satisfied that:

• The claim involves a designated investment (as defined in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001); and

• The claim is made in connection with designated investment business.

Section 138D of the Financial Services and Markets Act 2000 sets out the circumstances in which a private person who suffers loss as a result of a breach of a rule made by the FCA or Prudential Regulation Authority may have a right of action for damages in respect of those losses.

However, only certain FCA rule breaches are actionable and the FSCS will only compensate for breach of an actionable rule.

The FSCS appears to be willing to consider compensation if the investors can demonstrate that LCF provided “advice” to invest in the mini-bonds.

The mini-bonds would fall within the definition of a “designated investment” as an instrument creating indebtedness under the regulated activities order. Advising on investments is a regulated activity.

This will be a fact sensitive issue and will depend on what each investor was told at the point of sale about the merits of investing in the bond.

But, what if LCF did not give advice, will the FSCS compensate the victims?

Financial promotions

It may seem a little strange that the FSCS is unlikely to compensate the investors on the basis that the LCF marketing literature was not a “clear, fair and not misleading” promotion.   

Financial promotions are required to be approved by an authorised person under section 21 of the Financial Services and Markets Act 2000.

LCF was an authorised company and the FCA has confirmed that the promotional material was misleading. If an investor could prove that it relied upon the promotion, one might expect that this would automatically lead to a compensation award.

Unfortunately for the bondholders, the definition of “designated investment business” in the regulated activities order does not include financial promotion. Accordingly, it could be that compensation will not be payable in relation to a claim solely on the basis of a misleading financial promotion.

The FCA recently issued “Dear CEO” letters on January 9 and April 11. The latest letter makes it abundantly clear that the FCA considers that companies engaged in approving financial promotions are under an obligation to conduct sufficient due diligence before approving a promotion. 

It therefore appears odd that if a company has failed in this regard and the promotion does not comply with the ‘clear, fair and not misleading’ rule, that the consumer cannot claim redress from the FSCS even if they relied upon this promotion.  

It is worth contrasting the position of the FSCS with that of the Financial Ombudsman Service. The Fos has been able to find approving companies liable for failures and misleading assurances in the product literature.

Perhaps another avenue to redress can be found in section 27 of the Financial Services and Markets Act 2000.  

Section 27 exists to provide a cause of action against authorised companies who have wrongly utilised the services of unregulated third parties.

In theory, if the unregulated introducer engaged by LCF conducted an activity, such as arranging the investment, that required authorisation (in breach of the general prohibition in section 19) that caused the client to invest in the mini-bond, the client can be entitled to a return of the sum invested and compensation.  

Pradeep Oliver is a partner in the professional negligence team at Cripps Pemberton Greenish