Does a mini-bond have to be approved by an FCA authorised firm?
What are mini-bonds?
While having no legal definition, a ‘mini-bond’ can be best described as a type of debt security that is marketed to retail investors.
One of the characteristics of a mini-bond is that it is illiquid. The reason for them being illiquid is due to the fact that mini-bonds do not have a secondary market, meaning that once an investor has agreed to invest money and purchase a mini-bond, they are ‘locked in’ until maturity of that bond and cannot put the bond up for sale on a secondary market. This is what distinguishes mini-bonds from ordinary retail bonds, as there is a secondary market for the latter.
A mini-bond functions as an IOU whereby the investor gives money to a company (called the ‘issuer’ as it ‘issues’ the mini-bond), in exchange for a fixed rate of interest over the duration of the bond (i.e. the investment term). Once the bond reaches maturity at the end of the investment term, the investors’ money becomes repayable.
As with all bonds there is a level of risk involved and therefore investors that are thinking about diversifying their investment portfolio to include mini-bonds should always seek professional financial advice before making such a decision.
Mini-bonds are typically offered by small or start-up companies or companies that find it difficult to raise capital from institutional investors (i.e. banks). This is the reason for the underlying risk inherent in mini-bonds in that the return of the investors’ capital almost entirely depends on the issuer’s business becoming (or continuing to be) a success. If the business fails, the investors may get nothing back at all. For this reason, the Financial Conduct Authority (“FCA”) (one of the UK’s financial regulatory bodies which is responsible for the regulation and supervision of promotions relating to financial services and products) advises investors that they should not invest more than 10% of their net financial assets in these kinds of bonds.
You can find more information about mini-bonds on the FCA website by following this link.
How are mini-bonds regulated and what protections are in place for investors?
Pre-November 2019 position
A business did not (generally speaking) need to be regulated by the FCA in order to raise capital by issuing shares or debt securities (such as mini-bonds) before November 2019. However, any investment services provided in relation to these investments were regulated in the usual way. For example, if an FCA authorised firm provided investment advice about mini-bonds then it had to make sure that it was suitable (i.e. that it had the necessary level of expertise to be able to give such investment advice).
Where mini-bonds were distributed by an FCA authorised person (such as an online investment platform) then that authorised person was subject to regulation by the FCA and was responsible for complying with its rules.
Any kind of financial promotion needs to be approved by an FCA authorised person to ensure that the promotion complies with the FCA’s rules – fundamentally the promotion must be clear, fair and not misleading (this is detailed further below).
The general risks surrounding mini-bonds highlighted above are compounded by the fact that the Financial Services Compensation Scheme (“FSCS”) offers no protection to the investor if the issuer is unable to repay any capital – increasing the likelihood that if the issuer goes bust, the investor will not receive any of their investment back.
If you receive a regulated investment service, such as investment advice, relating to the mini-bond from an authorised person and that individual failed to meet the FCA’s standards, you may be entitled to complain to the Financial Ombudsman Service (“FOS”). If the authorised firm has subsequently gone out of business since the investment advice was given, you may still be able to bring a claim to the FOS.
If you received no service from an authorised person but still entered into a mini-bond with an issuer and the issuer has subsequently gone bust (meaning you have lost your entire investment), it is unlikely that you will have recourse to either the FOS or the FSCS.
Therefore, the pre-November 2019 position was that a mini-bond did not generally need to be approved by an FCA authorised firm. However, any investment services provided in relation to such investments were regulated.
Post-November 2019 (and current) position
On 26 November 2019, the FCA announced that it will ban the mass marketing of speculative mini-bonds to retail customers. The FCA introduced this restriction without consultation (meaning that the FCA found the risk to consumers was sufficiently “serious and immediate”), using its product intervention powers. The restriction came into force on 1 January 2020 and lasts for 12 months, while the FCA consults on making permanent rules relating to mini-bonds (the FCA is expected to consult on permanent rules during the first half of 2020).
Given that the term mini-bond refers to a range of investments, the FCA explained in their press release that the ban will apply to more complex and opaque arrangements where the funds raised are used to lend to a third party, invest in other companies or purchase or develop properties. There are various exemptions including for listed mini-bonds, companies which raise funds for their own activities (other than the ones above) or to fund a single UK property investment.
The press release states that the FCA has limited powers over the, usually unauthorised, issuers of speculative mini-bonds but can take action when an FCA authorised firm approves or communicates a financial promotion, or directly advises on or sells, such products. Alongside this activity, the FCA states that there is evidence of a growing incidence of promotions which are frauds or scams and involve no attempt to meet financial promotion rules. The FCA confirms that the marketing ban does not apply to such frauds and scams because they are illegal in any event.
The FCA states that it had undertaken an extensive programme of work (over the course of 2019) to tackle the risks for investors from mini-bonds, reflecting the real risk of consumer harm. This included:
- Investigating more than 80 cases of regulated activities potentially being carried out without having the right FCA authorisation.
- Assessing over 200 cases of financial promotions that appeared not to have complied with the FCA rules.
- Seeking to persuade the internet service providers, particularly Google, to take more action, for instance to take down websites promptly where they are likely to involve a breach of law or regulations.
- Contact with the Departure of Culture, Media and Sport to urge inclusion of financial harm in the proposed legislation on online harms.
- Developing tools for data analysis, for instance introducing web scraping to assist in the identification of mini-bond promotions.
The FCA ban means that unlisted speculative mini-bonds can only be promoted to investors that firms know are sophisticated or high net worth. Marketing material produced or approved by an FCA authorised firm will also have to include a specific risk warning and disclose any costs or payments to third parties that are deducted from the money raised from investors.
A sophisticated investor refers to an individual who has sufficient knowledge and experience of relevant investments, and has attested that they understand the risks involved and significant risk of losing all their investment. This can either be assessed by a firm, or can be self-certified (subject to slight variations in the attestations required).
A high net worth investor is one who has an annual income of £100,000 or more, or has net assets of £250,000 or more, excluding the value of their main residence, insurance rights or benefits, or withdrawals from pension savings (unless this is used to provide an income in retirement), and who also signs a declaration acknowledging the high-risk nature of the investments, the possibility of losing all their funds, and that they could seek professional advice.
The temporary rules apply to unlisted debentures and preference shares where the issuer uses the funds raised to lend to a third party, invest in other company, or purchase or develop property. The FCA refers to them as “speculative illiquid securities” for the purposes of their rules. There are exemptions to the definition, which are set out in the FCA’s rules. The new restrictions are set out in this section of the FCA’s rules.
“Speculative illiquid securities” are a type of mini-bond which take the legal form of a debenture or preference share, with a denomination or minimum investment of £100,000 or less, where the issuer (or a member of the issuer’s group) will use (or purports to use) the proceeds of the issue to:
- make loans to, or provide finance to any person outside the issuer’s group; or
- to acquire financial investments or an interest in property (whether directly or indirectly) or to fund the construction of property.
The FCA has come under increased scrutiny in this area of the market since 2019 following the high-profile collapse of mini-bond provider London Capital & Finance (“LCF”), which fell into administration in January 2019 putting the funds of more than 14,000 bondholders at risk. LCF allegedly signed clients up to fixed-rate ISAs promoting an 8% interest rate, with investors’ capital then invested into mini-bonds used to issue loans to small businesses.
HM Treasury issued a direction to the FCA to conduct an independent investigation into the circumstances surrounding LCF’s collapse, as well as the regulator’s supervision of LCF and compliance with its statutory objectives, and this is likely to have been one of the catalysts for the temporary intervention. The Treasury’s direction was accompanied by an announcement that it would conduct a wider policy review in response to LCF’s failure, including a review of the regulatory regime for ‘mini-bonds’. This demonstrates an apparent perception in Government that the regulatory regime for these investments may not be fit for purpose.
Although the temporary intervention only applies to promotions in respect of “speculative illiquid securities”, it is worth noting that most mini-bonds which are promoted to the general public are likely to be within the scope of the existing financial promotion rules.
Importantly, the issuance of mini-bonds by unregulated companies in order to generate working capital for deployment in its business remains a viable funding structure provided that it is conducted in accordance with existing legal and regulatory requirements, such as those for the promotion of ‘non-readily realisable securities’.
Given the significant detriment to consumers stemming from LCF’s failure, it is not surprising that the FCA has now intervened in this area. However, tightening rules in this sub-sector of the mini-bond market could curb investor appetite for mini-bonds in the wider market, and so the ripple effect of this intervention remains to be seen.
The FCA has used its temporary product intervention powers to enhance consumer protection for potential investors.
Any firms who communicate financial promotions relating to mini-bonds in scope of the intervention, in reliance on ‘exemptions’ from the financial promotion restriction should expect heightened scrutiny from the FCA. Any firms found to operate unlawfully outside such exemptions could face enforcement action.
The interventions place restrictions on the persons to whom financial promotions can be made in respect of “speculative illiquid securities”, as well as new requirements on authorised firms approving or communicating financial promotions to the limited categories of retail client (i.e. sophisticated investors (whether self-certified or not)and high net worth investors) to whom such promotions may now be made.
The FCA’s expectation appears to be that the temporary intervention will substantially restrict the persons to whom promotions of certain mini-bonds can be made, but again this remains to be seen.
Please also click here to also read about Blackmore Bond PLC, which issued high-risk mini-bonds between 2016 and 2019 to raise money to develop properties, and collapsed into administration in April 2020 having collected approximately £45 million from investors.
In what circumstances will financial promotions need to be approved by an FCA authorised person / firm and is it possible to avoid the need for such financial promotions to be approved?
Ordinarily, companies that offer financial services and products will need to make sure that its promotions and adverts comply with the FCA’s rules and that the promotions treat customers fairly (by ensuring that any promotions / adverts issued by the company are clear, fair and not misleading).
A ‘financial promotion’ is construed widely and doesn’t just include actual adverts on television or radio. A financial promotion can take the form of a website, Facebook post or even a tweet.
Because financial promotions can form a significant part of a consumer’s product knowledge and can ultimately influence a consumer’s decision making when choosing a product, the FCA require these promotions to be clear, fair and not misleading so as to allow consumers to make informed decisions.
The FCA regulates advertising for most financial services, including products such as:
- loans (e.g. payday loans, guarantor loans, car finance);
- cash savings and bank accounts;
- mortgages; and
- insurance (e.g. home, motor, travel)
This link will take you to the FCA’s website on this topic which includes a more comprehensive list of the types of products which, if advertised, the FCA will regulate.
The FCA takes a media-neutral stance meaning that regardless of the media type being used, all financial promotions must be clear, fair and not misleading.
Consumers and businesses can report misleading financial promotions to the FCA by filling out an online reporting form (you can access the reporting form by clicking this link).
The FCA’s powers when they find that a financial promotion is misleading include:
- asking the firm the change or remove the advert;
- asking the firm to write to customers who may have been misled;
- warn or fine the firm; and / or
- ban the promotion
Part 8 of the FCA’s Perimeter Guidance manual (PERG 8) contains detailed guidance on financial promotions and related activities.
Specifically, PERG 8.3 states that the basic restriction on the communication of financial promotions by unauthorised persons / firms is contained within section 21(1) of the Financial Services and Markets Act 2000 (“FSMA”). Section 21(1) states as follows: – “A person (“A”) must not, in the course of business, communicate an invitation or inducement to engage in investment activity”.
Section 21(2) states that subsection (1) does not apply if –
a) A is an authorised person; or
b) the content of the communication is approved for the purposes of this section by an authorised person.
Section 25(1) of the FSMA states that a person who contravenes the restriction contained within section 21 is guilty of an offence and is liable to imprisonment and / or a fine.
Although note that under section 25(2) of the FSMA, it is a defence for the accused to show that they had reasonable grounds to believe that the content of the communication was prepared, or approved for the purposes of s.21, by an authorised person, or that they took all reasonable precautions and exercised all due diligence to avoid committing the offence.
So, under the relevant legislation, an FCA authorised person / firm does not have to comply with the requirements of section 21(1) of FSMA 2000. Furthermore, a non-FCA authorised person / firm can avoid the restriction contained within section 21(1) of FSMA if the content of the promotion / advertisement is approved by an FCA authorised person (in accordance with section 21 (2)(b) of FSMA outlined above). You will note that the legislation refers to a ‘communication’ rather than a ‘financial promotion’.
Please follow this link which will take you to the legislation.gov.uk website containing the relevant sections of the FSMA highlighted above.
The upshot of the legislation discussed above is that unless you are an FCA authorised person / firm or the content of your communication is approved by such a person, you must not communicate an invitation or inducement to engage in investment activity (in accordance with the restriction in clause 21(1) of the FSMA).
PERG 8.9 sets out the circumstances where the restriction in section 21 of the FSMA does not apply. The point to note is that when an authorised person makes a financial promotion, he or she is not subject to the restriction in section 21 and so financial promotions made by authorised persons / firms do not need to be ‘approved’. Where an unauthorised person wishes to make a financial promotion however, the legislation states that the content of the communication must be approved by an FCA authorised person / firm for the purpose of section 21 of FSMA.
Exemptions from the financial promotion restriction are available under the key piece of secondary legislation, the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (SI 2005/1529) (“FPO”). There are over 70 exemptions in total in the FPO that may be used in order to exempt a financial promotion from the otherwise stringent effect of section 21 of the FSMA 2000. These exemptions include permissible communications to:
- investment professionals;
- high net worth individuals;
- high net worth companies and certain other entities; and
- sophisticated investors.
Articles 48 and 50 of the FPO define what is meant by ‘sophisticated’ or ‘high net worth’ investors and are the exemptions most commonly relied upon. Please click this link to access the FPO.
When considering whether a communication by an unauthorised person is caught by the financial promotion regime it may be helpful to ask the following questions, which stem from the restriction in section 21 of FSMA:
- Is a communication being made or caused to be made?
- Is the communication an invitation or inducement to engage in investment activity or to engage in claims management activity?
- Is the communication made in the course of business?
- Does the communication originate from outside the UK and, if so, is it capable of having an effect in the UK?
- Does the communication fall within one of the exemptions contained in the FPO, bearing in mind that these exemptions are not available to promotions by firms carrying on business under the Markets in Financial Instruments Directive (“MiFID”)?
If the communication satisfies the first four criteria listed above, and there is no exemption available, the promotion will have to be communicated or approved by an authorised person in accordance with the financial promotion rules.
Firms which approve financial promotions are already required to ensure that those promotions comply with FCA rules. Please click here for the FCA’s published guidance on the requirements on firms when approving the financial promotions of unauthorised persons. The FCA believes that many promotions still fall short of existing requirements and firms which approve the financial promotions of unauthorised persons may not be taking adequate steps to ensure that they comply with the FCA’s rules before approving them.
The FCA also intends to launch a communications campaign to improve consumer awareness of risks and to inform consumers about what they should consider before investing in high-risk investments. The FCA continues to work with HM Treasury on its review into the regulatory framework for the issuance of non-transferable debt securities (“NTDS”).
Please note that this is a very complex and highly regulated area and so you should always seek professional advice where you are considering making a financial promotion or ‘communication’ which could potentially invite or induce consumers to engage in investment activity.
The Companies Act 2006 prohibition
Under section 755(1) of the Companies Act 2006 (“CA 2006”) a private limited company must not:
- offer to the public any securities (i.e. shares or debentures) of the company, or
- allot or agree to allot any securities of the company with a view to their being offered to the public.
However, section 756(3) of the CA 2006 provides that an offer is not regarded as an offer to the public if it can properly be regarded, in all circumstances, as:
- not being calculated to result, directly or indirectly, in securities for the company becoming available to persons other than those receiving the offer.
It is our understanding that the UK’s crowdfunding platforms rely on the section 756(3) qualification in order to validate their business models.
Therefore private limited companies cannot issue mini-bonds (as they will fall under the term ‘debentures’ in the CA 2006) unless the offer falls within the qualification contained within section 756(3) of the CA 2006.
Examples of enforcement action taken by the FCA
We have highlighted above the powers that the FCA has at its disposal where it finds a financial promotion to be misleading.
It is of course impossible for the FCA to monitor and pursue all breaches of the FSMA and there will only be a limited number of cases they can take on at any one time. Therefore the FCA is only likely to prosecute the most serious violations of its regulatory regime.
By way of example, the following are two well known cases where the FCA have taken action:
a) On 1 March 2010, the Upper Tribunal (Tax and Chancery Chamber) issued a decision in relation to the case of Andrew Greystoke and Atlantic Law LLP v FSA (note that the preceding agency of the FCA was the Financial Services Authority, or FSA). Mr Greystoke and his firm were each fined £200,000, with the solicitor also banned from working in the financial services sector indefinitely, after they were found to have approved boiler room financial promotions.
b) On 24 June 2011, the FSA issued a Final Notice imposing substantial financial penalties in respect of a Solicitors firm named Fox Hayes. The action related to the approval of at least 20 financial promotions for five overseas unauthorised entities between February 2003 and June 2004. 670 UK customers purchased shares totalling approximately US $20 million which were subsequently determined to be of little or no value. THE FSA alleged (in essence) that Fox Hayes had not taken reasonable steps to ensure that these financial promotions were clear, fair and not misleading.
Offer documents and the verification process
When a company is planning to issue mini-bonds, it will need to produce a decent offer document in order to attract investment and ensure that such document includes the relevant legal aspects.
A mini-bond offer document should include:
- required language in respect of compliance with relevant exemptions;
- information on the market and investment opportunity;
- risk factors applicable to the business;
- details of the offer (interest, repayment etc);
- information on the company / group;
- appropriate notice and risk warnings depending on the nature of the offering and jurisdictions involved; and
- financial information relating to the company.
An approved offer document by an FCA regulated firm would have to be thoroughly verified, usually by a law firm. Although not necessary for an unapproved offer document, it could still prove worthwhile to carry out a verification exercise, not only to protect against any possible legal action but more so to increase the trust and confidence in the debt offering.
“Verification” is the process whereby a prospectus or admission document is fact checked and analysed so as to ensure that its contents are as clear and fair as possible and most fundamentally that the document is not misleading in any way. This is one of the duties of disclosure that a director of the issuing company has and it is their responsibility to ensure that any prospectus / admission document is verified before being communicated (or ‘offered’) to the public.
The verification process can (understandably) take a significant amount of time, particularly where the offer document is lengthy. However, it is important to note that this process is essential in ensuring the accuracy of all factual statements and determining the reasonableness of any statement of opinion or belief that are included within the offer document.
Each director of the issuing company cannot be expected to know every fact relating to the issuer and its business and therefore with respect to some statements, a director may rely on other people (for example a company’s advisers) to check particular aspects of the offer document.
What will happen contemporaneously with the verification process is the production of so called ‘verification notes’ for which each director will take responsibility. The following key points should be noted during the preparation of verification notes and the conduct of the verification exercise:
- names of sources for the verification of statements of fact must be recorded in writing;
- a written record should be kept and there should be a reasonable basis for each statement of opinion or belief;
- each director (and non-executive director) of the issuing company must be given ample opportunity and time to consider and comment upon the prospectus or admission/offer document and the verification notes in order to give them time to correct and amplify statements where appropriate / necessary;
- directors cannot simply record each statement as being ‘confirmed’ – they will be required to provide supporting evidence in an indexed ring binder which will be appended to the verification notes produced; and
- if any statement cannot be verified then it must either be amended so that it can be verified or, if this is not possible, the statement must be deleted entirely.