Ucis: an accident waiting to happen?

Ian, like most IFAs, I'm afraid you do not seem to understand the 'restriction' rules either. For example, the reference to having held a UCIS in the previous 30 months, is simply a "category 1" one exemption via COBS 4.12. It is not an absolute requirement. Most IFAs will effectively rely on a 'category 2' exemption (i.e. the product being suitable).

To explain...

The UK Regulatory regime under FSMA (2000) is based on the premise that things are prohibited unless expressly permitted (or exempted from that prohibition).

- s.19 (“the general prohibition”): “no person may carry on a regulated activity...unless” an authorised person or otherwise exempt.

- s.21 (“the financial promotion restriction”): “a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity.”

- Sub-section (2) dis-applies this restriction for an 'authorised person' (or for communications approved by an 'authorised person'). Sub-section (5) also enables the Treasury to make an Order specifying circumstances in which the restriction is dis-applied - this Order is currently the FSMA 2000 (Financial Promotions) Order 2005 SI 1529.

- s.238 (“the scheme promotion restriction”): “An authorised person must not communicate an invitation or inducement to participate in a collective investment scheme.”

- Sub-section (4) dis-applies this restriction in respect of Unit Trusts/Oeics that are authorised or 'recognised' (i.e. authorised in certain overseas jurisdictions)

- Sub-section (5) dis-applies this restriction where an 'authorised person' is acting in-line with FSA rules – these Rules are currently in COBS 4.12

- Sub-section (6) also enable the Treasury to make an Order specifying circumstances in which this restriction is dis-applied – this Order is current the FSMA 2000 (Promotion of Collective Investment Schemes)(Exemptions) Order 2001 SI 1060 (as amended).

Promotion By Unregulated Scheme Operators et al...

An unauthorised firm in the business of operating an unregulated collective, or indeed an unauthorised 'marketing' firm, can promote such schemes in certain limited circumstances.

Such activity is not usually 'regulated activity' as such – given the unregulated nature of the scheme – hence s.19 does not apply. By virtue of not requiring authorisation, the s.238 restriction (“scheme promotion restriction”) does not apply. Such a firm can then avoid the s.21 restriction if it limits its marketing activities to exemptions within the Financial Promotions Order: -

- Investment Professionals (Article 19) i.e. IFAs or Investment Managers

(It is effectively this exemption that has allowed Jon Maguire to resurface via Viola Asset Management)

Individuals who are: -

- Certified High Net Worth Individuals (Article 48)

- (Certified) Sophisticated Investors (Article 50)

- Self-Certified Sophisticated Investors (Article 50A)

The importance of the formal status of these individuals, and the certificates pertaining to them, needs to be understood in this context: without them the firm/person is committing an offence under s.25.

Financial Advisers & Investment Managers...

The situation for financial advisers and investment managers is somewhat different. We are not subject to the 'financial promotion' restriction by virtue of being FSA 'authorised persons'. Instead, we are subject to the 'scheme promotion restriction'. We are of course also subject to FSA's Conduct of Business Sourcebook and, specifically, to the COBS 9 rules on suitability and know-your-client.

Adviser firms have a choice between two sets of exemptions from the s.238 restriction: -

- s.238(6) and the Promotion of Collective Investment Schemes (Exemptions) Order 2001 SI 1060 (as amended). These provide exemptions to the promotion restriction for authorised firms that effectively mirror the exemptions to unauthorised persons (as above) i.e. Certified High Net Worth Individuals (Article 21), (Certified) Sophisticated Investors (Article 23), and Self-Certified Sophisticated Investors (Article 23A).

- s.238(5) and the COBS 4.12 rules. These create a number of (rather different) 'categories' to whom such schemes may be 'promoted', the pertinent ones for us to note being: -

- Category 1: those already holding investments in such schemes (or similar ones) or having done so in the previous 30 months; OR

- Category 2: clients of a firm for which it has taken 'reasonable steps' to ensure that investment in the particular scheme is suitable; OR

- Category 6: those classified as 'eligible counterparties' (i.e. other regulated firms) or 'professional investors' within the MiFID criteria; OR

- Category 8: those who have been assessed by the firm as having the expertise & knowledge to make their own decisions.

Clearly, the Category 2 exemption is the key one for advisers/investment managers: -

Whilst a client can sign the declarations or be certified as HNW, sophisticated individuals et cetera, this does nothing to demonstrate that any advice is actually suitable for that client i.e. the fallout for the firm is not reduced by certification.

The suitability test for these purposes is the same as the general suitability test which in turn first requires the usual gathering of know-your-client and risk-profiling et cetera [COBS 9]

FSA tends to interpret this 'category 2' exemption very precisely: a client must become a client without having first been solicited on the back of promotions for an unregulated scheme; the KYC, research & suitability assessment should be seen as occurring before the recommendation is made and before there is actually any discussion about particular unregulated schemes.

It is important to note that any discussions or correspondence about a 'recommendation' by its nature involves some form of invitation or inducement to a client to invest i.e. technically, is covered by the 'scheme promotion restriction' (but then exempted under s.238(5) as long as the firm has previously established that the investment would be suitable). On the other hand, a discretionary decision by an investment manager is technically outside these restrictions.

Whilst headlines are given to the fact that FSA found that *some* IFAs were putting people 100% into niche schemes, or even gearing to finance such investments, this is not what is catching most IFAs.

From some of the 'skilled person' work and FSA audits I have reviewed, I would suggest that the main "trap" for IFAs is simply their approach to 'risk profiling'...

Since MiFID, it has been a requirement to assess a client's knowledge & experience of investments in order to be able to confirm that recommendations are commensurate to a client's ability to understand those risks. This is what IFAs are largely failing to do, it seems.

It is important to realise that most standard fact-finds or 'risk profiling' questionnaires do not do this adequately...

This is why FSA "only" claimed about 24% of UCIS sales appeared unsuitable...the other half of disputed cases were down to defective fact-find and risk-profiling documentation.

I hope that makes sense!

Thanks MIB - if this reply does not clarify things - nothing will!

I think you are right, but I'm still not aware that the FSA have tried to make it clear that it is primarily the 'suitability' process that is the issue, rather than the more headline grabbing 'Unregulated Collective' which is creating more heat than light!

Perhaps if they did, that would be useful!

The first question to be asked about any unregulated product must surely be why the provider hasn't sought regulation of it. Given that a number of products that are supposed to have fallen within the FSA's regulatory remit have gone wrong to varying degrees (Low Cost Endowments & Split Cap Investment Trusts spring readily to mind), to choose a product without even that dubious level of regulatory approval seems a trifle foolhardy.

If it looks too good to be true, then it almost certainly is. Why do so many people forget these ancient truisms?

Thank you so much MIB. At last, a reasonable explanation in plain English that even I can understand. I know it must have taken you a while to put all that info in but I'm very grateful that you did. I actually feel like I may now understand what the problem is.

MiB all i can say is you do a lot of reading and i am impressed! I think your explanation is great and if the FSA come knocking at my door then I might just refer them to you.

Unlike most of the small IFAs I did sign up to the MifiD regulation as I have a couple of clients resident in Europe which I did not want to give up, even though the returns are a pain. What it does make me wonder is, how many IFAs are breaking the rules regarding dealing with their clients not resident in the UK, particularly regarding emails?

The question of unregulated funds I have always dealt with on the basis of common sense. The Connaught Fund is one of those that I have recommended and all my clients get to read the inf. memo before they even consider investing and it is only provided to those who I feel it may be suitable for. This also applies to the Close Freeholding Income fund which has a track record of 15 years.

There are lots of others that i get details on but it is like lots of things in life, if you can't see why it would be good for you why would you consider it for your clients?

Interestingly, I have reservations about Structured Products and even ETFs.

Thanks MIB,

You are the first person to give any sensible dialogue to the discussion. I am disturbed not only by IFAs general understanding, but also the FSAs.

It seems their very mention makes the regulators and certain IFAs froth at the mouth. Clearly, there are UCIS and there are UCIS although some structural risks are throughout.

Unfortunately, it seems that most seem to focus on the highly risky, as opposed to well run funds- or are simply unable to distinguish to the two. I firmly believe that they deserve consideration in portfolio risk management.

The FSA is de facto pushing advisers in to backward looking asset allocation models, that had you invested would have had you and your clients licking your wounds in 2008. Clients certainly wouldn't have thanked you.

The FSAs message is, it's bascially fine to lose 40% in regulated funds prescribed by a model (so an adviser can abdicate regulatory risk and responsibility for investment management), but not ok to temper those losses by using UCIS as part of a portfolio.

It also appears that the FSA is unclear between direct promotion and promotion as part of a discretionary portfolio..

Philosophically, why it is fine for retail clients to purchase some regulated 'absolute return' funds pitched as 'cautious' which contain UCIS, but not ok to have direct holdings under a discretionary portfolio (and relevent authorisations) I'm not sure...

Clearly, some reform is needed to provider better clients outcomes, not only in terms of reducing poor advice, but also in improving investment performance through a change in attitude to investment management. This would be a good step in reducing the failings of the wider fund management industry.

@Julian Stevens

Hi Julian, firstly, believe it or not, Split-Capital (or any other) Investment Trusts are not regulated as Collective Investment Schemes [Reg.22, SI 2001/1062] but are exempted by virtue of being listed companies. As such, they are not covered by the Scheme Promotion Restriction etc. There was a discussion (CP164) some years ago about requiring them to become regulated collectives, but this did not happen.

To answer your question, however, this is arguably a case of the FSA regulation not keeping up with the market...

The point about FSA's regulation of Collectives is that FSA regulate the scheme's choice of investments, borrowing etc and this might not be conducive to perfectly legitimate investment strategies.

With regards to the Connaught Fund, for example, I cannot see that this would be possible as an authroised scheme: "None of the money in the scheme property of an authorised fund may be lent and, for the purposes of this prohibition, money is lent by an authorised fund if it is paid to a person ("the payee") on the basis that it should be repaid, whether or not by the payee" [COLL 5.5.6 R]

Likewise, a fund of hedge funds (e.g. Absolute's Absolute Fund) has historically been unable to operate as an authorised fund simply by virtue of a 20% restriction on investing in underlying hedge funds [COLL 5.6.10 R (1)(e)]. This is changing with the introduction of the FAIF rules [COLL 5.7] though I'm hearing that potential providers are finding these cumbersome.

Then there is the small matter of gearing. This might be a legitimate investment strategy (to a degree!), but as every school boy knows, a Unit Trust or OEIC is only allowed a temporary 10% borrowing [COLL 5.5.5 R(1)]. A similar 10% cap applies to actual physical Gold [COLL 5.6.4 R (3)(G)]. And so on and so forth....

This is all in addition to the actual costs of being regulated for a smaller niche scheme - just using a 3rd party ACD, for example, cn add 30-40bps on to the TER.

And I haven't even started on Tax treatment of offshore funds versus UK authorised colelctives...

Am I making sense?

There are plenty of legitimate reasons for not getting a collective investment scheme authorised. Mind you, I wouldn't suggest that 99.9% would want to use these funds for the bulk of their portfolios - they're better used as a diversifier!!!

@Mr Blue

I'm wondering whether we know each other??

The thrust of what FSA is doing is probably in line with what you are suggesting: pushing investors into mainstream portfolios with little diversification to alternatives.

It certainly hasn't escaped my notice that a song-and-dance gets made about the Compensation Scheme, yet the compensation scheme does nothing to underwrite or mitigate the main causes of investor losses: simple market fluctuations.

There's also a small point that if you invest 10% of your portfolio in an unregulated scheme, 90% of your underlying investments are covered via the Compensation Scheme. Whereas if you invest 100% in authroised schemes via an authorised Fund of Funds, you have 0% FSCS coverage in respect of your underlying collectives!! (The FoF being excluded as an 'eligible claimant' under DISP 4.2.2. R(3)).

However, I'm not sure what you're saying about FSA and suitability of portfolios is correct.

Firstly, FSA simply excluded discretionary purchases from its thematic work on UCIS where they found trasnactions had been made on this basis.

Secondly, FSA's concern was with concentration limits being outside a client's ATR i.e. a cautious investor with 60%+ in an unregulated scheme. On the otherhand, it seemed to praise as 'good practice' firms including a portion of assets in unregulated schemes i.e. where the firm had said strict limits.

Or have you had any interesting experiences with FSA and UCIS of late?

I have always been wary of these funds and have never recommended them as a result, I assume the article relates to life settlement funds, ppi funds etc?

One question I have is do you have to be an ifa to sale these? I have come across bdm who promote these to mortgage brokers to sale as they are unregulated surely this cannot be allowed?

@Popsy

Strictly speaking it depends what's in them, but it's usually advice on investments - an unregulated collective is still a collective for these purposes and an (authorised) mortgage broker will be committing a Grade A rule breach if he advises on them without having the requisite permission scope.

I have a concern about the term "suitability".

When I was a boy, the term was "best advice". To me, anything less than "best advice" is logically "not best advice".

This industry is it's own worst enemy at times.

I appreciate that I am cynical, but in my opinion "suitability" and "best advice" could simply be replaced or at least enhanced by "common sense".

Surely that's more sensible than cynical?

Man in Black (MIB) - thanks for your thorough reply.

I based my blog article on the facts as presented to me by compliance as well as my understanding of the rules. Further, the word count meant not being able to expand fully - otherwise I could have easily written a 50 page book!

The purpose was to bring this subject out in the open and so advisers will seek clarity from the regulator over what the rules are and thus can avoid breaking them.

The Edinburgh SIPP client I came across who had been sold many unregulated investments (and was the inspiration for my blog) certainly wasn't an 'investment professional' nor met these categories:

- Certified High Net Worth Individuals (Article 48)

- (Certified) Sophisticated Investors (Article 50)

- Self-Certified Sophisticated Investors (Article 50A)

Clearly, where an investment is not regulated by anyone, the IFA needs to check out what FSA rules do and don't apply and then carry out careful due diligence.

Even where the IFA is authorised to place the deal, and considers the product a useful diversifier in the client portfolio, PI insurers recommend that the RWL needs to make reference to:

- liquidity

- safekeeping of assets

- exit route

- investment spread

There needs to be confidence in the sponsors of these schemes. If the proverbial does hit the fan - will they still be around?

@ MIB - it is possible we know eachother ; )

I can tell you from 1st hand experience that the FSAs original position regarding their use in discretionary portfolios was that they were not allowed, period. They did not simply 'exclude' them.

A sudden shiver went down my spine, as the entire discretionary management industry would be implicated in such a thing....

Only after some considerable time and legal opinion did they back down....or perhaps 'chose not to pursue' would be their way of putting it.

The disquieting element appeared to me to be the lack of communication between FSA teams investigating, and individuals lack of knowledge. Only once a more senior member took control of the situation, did we find resolution.

I would be interested to see the correlation between the business cycle and FSA rulings against firms - my bet is that it's negative.

@Mr Blue

That's extremely interesting. The irony being that a discretionary purchase does not involve any form of "promotion"...

I would be very interested in knowing whether you have any original correspondence or an explanation of their original rationale? How did you come into contact with FSA on this initially? TCF visit. Thematic work? Is there a chance your cases were the ones referred to in the Project Findings?

Am interested in discussing offline if possible: mib@watersidegate.com

Speaking with IFAs who have had 'visits', the low level of understanding of some of the relatively junior FSA staff is a key concern - the personnel in question often disappearing to telephone the legal department. In one case, the woman had apparently joined just 3 months earlier having previously worked for a charity involved in fertility treatments?!?

Colours aside - where have we met??

@Iain Wishart

I can certainly accept how an normal investor having the bulk of their portfolio loaded into weird and wonderful schemes like you mention is probably not suitable advice.

But this will be primarily because of the suitability issues you (rightly) raise in the second half of your email Re liquidity, safeguarding of assets, overall investment spread and how these profile against most client's investment objectives, financial capacity for risk and understanding...

The details you list with regards to certification, however, are completely collateral to the issue. Firstly, if this client has picked these investments up having dealt with an authorised firm (as you imply), the exemptions you list are the wrong set!! Secondly, whether a client is or can be certified as a HNWI blah blah is pretty much irrelevant if the advice is unsuitable for the reasons you've identified. The client still has a claim against the adviser, whether via FoS or (for larger cases) actionable under s.150 in the Courts.

As Phil Billingham summarised it, this issue is primarily one of suitability and audit trail - not certificates or supposed blanket bans.

Excellent debate and thanks to Iain for raising this and to MIB for explaining it so well (as usual). It's such a pity the FSA doesn't employ more people like MIB!

I agree, as Phil Billingham summarised it, this issue is primarily one of suitability and audit trail.

My mind started ticking on the whole Keydata/Lifemark SIB issue as many people purchased these directly having had them "promoted", by someone (KIS) who, in their own literature, described themselves as a promoter (hence why the F-pack argue it was not a "product" and hence are lumping the costs in the intermediation section of the FSCS levy) via an FSA authorised firm, Keydata. If that is the case, then it appears that Keydata have "promoted" an unregulated product contrary to these rules, which would make them liable for claims in law and hence as they are in administration the claim would fall in due course to the FSCS,. If this logic is correct, then the FSCS should stop it's delaying tactics in paying out investors and do it now so everyone can move on.

It is my understanding that unregulated collectives will be classed as retail investments post-RDR so advisers will be expected to consider them for their clients as part of their 'whole of market' approach. Is this the case? If so firms really need to be considering how they will integrate these products into their mainstream recommendation processes and how they will research and perform due diligence on these products. It will not be ok just to ignore them!

The KeyData fiasco boggles the mind. How breaches of 'safeguarding and administration of assets' and 'dealing as agent' permissions fall in line with standard IFA advising and arranging permission I'll never know.

One other thing perhaps MIB could clarify is the role of nominee companies such as a wrap provider in the promotion of UCIS.

Whether advisory or discretionary, technically the nominee company is the client of the asset management firm, not the IFA. The nominee fulfils the role of counterparty, authorised professional/sophisticated investor as they purchase the funds.

The IFA is merely an account designation underneath, and they may or may not be exempt in their own right via being advisory or discretionary. The asset manager has no idea who Mrs Bloggs is, they are just a deal number.

So the question is: can the use of a wrap exempt an advisory firm from the promotion of UCIS rule breach?

Interesting. As it happens I am just beginning to do some work for the unfortunate investors in Cameron Farley, who, themselves unauthorised, ran a UCIS. They were closed down by the FSA in 2008.

The law on promotion of UCIS is, as MiB says, clear enough, if fairly complex. The issue is to find someone to pay up when it all goes wrong. This may be tough, especially if the PI insurers walk away, or (as in Cameron Farley) were never there in the first place. The FOS and FSCS won't help.

The FSA has a reputation for being very lax about enforcing the rules on unauthorised business, but is itself immune from legal action unless you use the Human Rights Act (where the limitation period is only 1 year, and the connection with the issues sometimes tenuous).

I think I have a solution in Cameron Farley, and answers may be found in some other cases, but there will be cases where investors in unauthorised schemes have been left empty handed.

Robert Morfee

@ Chris Kilner:

I've spoken to the FSA RDR team about this. (My fear was that a literal reading of COBS 6.2A.3R would mean that any restriction to investment advice would disqualify a firm from describing themselves as independent).

The FSA confirmed they included products type like UCIS and other into the new definition of retail investment product to stop people getting around the Adviser Charging rules.

The answer to our fears is the guidance notes COBS 6.2A.18G to 21G, which talk about the use of panels. The key points are:

• You can exclude a type or class of retail investment product provided there is a valid reason consistent with the client’s best interests.

• The panel is sufficiently broad.

• Use of the panel does not materially disadvantage any retail client (of the firm).

• This is documented.

• This is reviewed regularly.

I hope this helps you as much as it did me.

Ian,

You say that 'a firm that is not opted into Mifid for the placing of orders for unregulated collectives can only place Ucis business with a Mifid firm'. Does that mean a non mifid arranger authorised by the FSA can not handle orders for UCIS. If yes, can you please guide to the relevant rules which prohibit this.

Great article Iain. Whilst I do not agree with your your view it has obviously stimulated some interesting discussion.

I am firmly of the view that UCIS play a very important role in providing clients with a diversified portfolio of investments. Like Mr Blue pointed out there sure are countless regulated schemes that have lost money in the last couple of years.

With regards to MiFID there are some confused comments on this page. MiFID is a European Directive. There are some elements that have now been incorporated into UK law such as the suitability requirements. However, importantly, a MiFID passport is not required for a UK domestic transaction.

However the issue of requiring a firm to be opted into MiFID to be able to place an order for an unregulated collective is not correct. MiFID only applies to IFAs that either hold client monies or transact cross border with other EU states.

So in answer to MK's question a passport is only required for cross border transactions (or between the UK, Channel Islands or the Isle of Man to which the directive does not apply).

JP Morgan has a good easy guide to MiFID:

http://www.financialplanning.org.uk/planners/files/jpm_mifid_explained.pdf