TIGHTENING THE FINANCIAL PROMOTIONS FRAMEWORK IN THE UK

Striking a balance between investor protection and market development

The U.K. is assessing its financial promotion framework, and changes are being made or proposed to amend the laws and rules. Financial promotions are defined as “invitations or inducements to engage in investment activity” and cover a broad range of marketing communications relating to financial products. Such communications may, on the whole, only be made in the U.K. by regulated financial institutions. The rules are particularly relevant for retail investors since most wholesale activity is exempted.^[1]

Various issues with the rules have been noted recently, with reforms proposed by the Gloster Report^[2] or otherwise introduced by the U.K. Financial Conduct Authority (“FCA”), related to the fall-out from the London Capital & Finance Plc (“LC&F”) scandal. At the same time, the risk of retail investment in crypto-assets and an increase in scams and financial fraud, particularly through the pandemic, have resulted in policy intervention. This client note sets out the changes, some of which will be made through legislation, and others in changes to the FCA’s rules. Many of the changes would be a welcome enhancement to the U.K. financial promotions regime, and may reduce potential harm to retail investors.

The Financial Promotion Restriction

The Financial Services and Markets Act 2000 (“FSMA”)^[3] sets out a prohibition on communicating an “invitation or inducement to engage in investment activity” either in the U.K. or in a way that could have an effect in the U.K. (the “Financial Promotion Restriction”). Firms authorised in the U.K. are exempt from the Financial Promotion Restriction; however, they must still comply with the rules governing financial promotions when making any promotion or when approving a financial promotion of an unauthorised firm. All financial promotions must be fair, clear and not misleading. A wide range of communications are covered—including advertising, broadcasts, emails, websites, Facebook, tweets—and the rules apply regardless of whether the communication is made to one person or many people. Certain communications do not constitute a financial promotion because, for example, the communication does not relate to an “investment activity” or is not an inducement or invitation. In addition, there are various exemptions.

Exemptions for Promotions to Certain Individuals

Exemptions from the Financial Promotion Restriction are set out in the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 (the “FPO”).^[4] Exempt communications are not subject to the requirement that they be made by a regulated financial institution, and the FCA’s rules on financial promotions are inapplicable to exempt communications. These exemptions include certain financial promotions to self-certified sophisticated investors^[5] and to certified high net worth individuals.^[6]

HM Treasury is consulting^[7] on proposed changes to the financial promotion exemptions for high net worth individuals and sophisticated investors. The main aim of the proposals is to mitigate instances of misuse of certain exemptions by some firms who have marketed inappropriate products to retail customers. LC&F was one such firm, which encouraged retail bondholders to confirm they fell within sophisticated or high net worth investor categories without considering whether they in fact met the appropriate criteria. The Treasury Select Committee’s report on the failure of LC&F recommended that various financial promotion exemptions, including those for high net worth and sophisticated investors, be re-thought to ensure more effective consumer protection.

The main proposals or open items in the consultation include:

• Whether, and how, the financial thresholds for high net worth individuals should be recalibrated. Currently, high net worth individuals are individuals who certify that they have earned at least £100,000 in the previous year or hold net assets of at least £250,000, with certain assets being excluded from the calculation. These thresholds were first set over 20 years ago and may no longer be appropriate because of an increase in inflation and a general move to greater responsibility on consumers for their investment decisions.
• Amending the criteria for exempted self-certified sophisticated investors. Currently, these are individual investors who certify that they meet one of the following four criteria:
  1. They are a member of a network or syndicate of business angels and have been so for at least six months;
  2. They have made more than one investment in an unlisted company in the previous two years;
  3. They are working or have worked in the previous two years in a professional capacity in the private equity sector or in the provision of finance for SMEs; or
  4. They are currently or have been in the previous two years a director of a company with an annual turnover of at least £1 million.

HM Treasury proposes removing criterion 2. above because it does not consider it to be an indicator of investor sophistication. The availability of online investing makes it is a lot easier today for individuals to invest in unlisted companies than it was when first introduced in 2005. In addition, it is proposed that the threshold (in condition 4.) of £1 million should be increased to reflect inflation.

• Placing more responsibility on firms to ensure that individuals do, in fact, meet the criteria to be deemed high net worth or sophisticated. Currently, a firm must ‘believe on reasonable grounds’ that the individual to which a communication is directed has signed the high net worth individual or self-certified sophisticated investor statement. In the LC&F case, 12,000 individual investors lost their savings. Hundreds of persons whose only experience of investing was via a bank account were assessed as sophisticated or experienced for purposes of the firm selling its high-risk bonds. HM Treasury proposes to reduce the risk of future mis-selling by providing that a firm is required to reasonably believe that an individual is a high net worth individual or self-certified sophisticated investor and not merely to rely on the signed investor statement. Investors will still need to sign the investor statement.
• Updating the prescribed formats of high net worth individual and self-certified sophisticated investor statements. To address the risk of an investor incorrectly certifying themselves and/or not comprehending the regulatory protections they are giving up when receiving promotions subject to the exemptions, HM Treasury is proposing to: (i) update the format of the statement to highlight the conditions that are needed for an investor to be classed as a high net worth individual and self-certified sophisticated investor; (ii) simplify the language; and (iii) require the investor to state which conditions are met and how.
• Removing “certified” from the name of the high net worth individual exemption since third-party certification is no longer required.

High Risk Investments

High-risk investments are those to which marketing restrictions apply. These include Non-Readily Realisable Securities (“NRRS”), peer to peer (“P2P”) (loan) agreements, Non-Mainstream Pooled Investments (“NMPI”) and speculative illiquid securities (“SIS”). Since January 2020, the marketing of SIS to retail investors has been banned (by the FCA), first under a temporary product intervention measure, then made permanent from 1 January 2021.^[8] The measure prohibits the mass-marketing of non-transferable bonds^[9] (sometimes referred to as “mini-bonds”) and preference shares to retail investors, subject to certain exemptions, and requires improved disclosure to be made to high net worth and sophisticated investors.

Re-classifying Securities

The FCA is proposing^[10] to organize its rules for marketing securities into three different categories:

• Readily Realisable Securities, which are listed and/or exchange traded securities, for which no additional marketing restrictions apply.
• Restricted Mass Market Investments, which are NRRS, P2P agreements and qualifying crypto-assets (which HM Treasury has confirmed will be brought within the Financial Promotion regime), and for which marketing to retail investors will be allowed subject to restrictions.
• Non-Mass Market Investments, which are NMPI and SIS (i.e., including speculative mini-bonds) for which marketing to retail investors will be prohibited. The FCA states that it is not, at this stage, taking forward its proposals to extend the speculative illiquid category to include equity shares or P2P agreements with similar characteristics to a speculative mini-bond. The FCA will revisit the issue later in the year.

Strengthening Rules to Enhance Consumer Protection

The FCA is also proposing^[11] to amend the financial promotion rules for Restricted Mass Market Investments and Non-Mass Market Investments. It is proposed that firms would have three months from publication of the final rules to comply with the new rules. The proposed changes include:

• Improving risk warnings by introducing rules for how risk warnings should be displayed, introducing a new text for all financial promotions^[12] and prescribing risk information requirements for different types of high risk investments.
• Prohibiting inducements to invest from all financial promotions for high risk investments, which will include banning the promotions from having any monetary and non-monetary benefits that incentivize investment activity.
• Adding two “positive frictions,” the first being a personalized risk warning pop up for first time investors with a firm, and the second a 24-hour cooling off period for first time investors with a firm.
• To align the rules with HM Treasury’s proposal to change the requirement for a firm to “believe on reasonable grounds” that the individual has signed the relevant investor statement to one where a firm is required to reasonably believe that an individual is a high net worth individual or self-certified sophisticated investor.
• Enhancing the appropriateness tests for Restricted Mass Market Investments by introducing guidance on the types of questions to be covered by appropriateness assessments and to discourage binary answers.

Financial Promotions of Qualifying Crypto-Assets

HM Treasury recently confirmed^[13] a tightening of the rules for financial promotions of certain unregulated crypto-assets. These crypto-assets, called “qualifying crypto-assets,” will be brought within scope of the U.K.’s financial promotion rules by bringing them within the scope of the FPO as controlled investments. This will not change the FCA’s current guidance^[14] on where certain crypto-assets are within the financial regulatory perimeter and for which authorisation would be required. HM Treasury is only concerned with the promotion of unregulated crypto-assets.

Qualifying crypto-assets are defined as being fungible (i.e. freely replaceable by another of a similar nature or kind) and transferable (which excludes crypto-assets in closed systems). E-money and central bank digital currencies will be excluded from the definition. In a change from the original proposal, the government has decided to remove the reference to distributed ledger technology from the definition of a qualifying crypto-asset. This is to future-proof the definition for technological innovation.

HM Treasury does not intend to add any controlled activities to the FPO based on its view that the current list of controlled activities reflect the activities that crypto-asset businesses conduct in the U.K. However, not all the controlled activities are relevant to qualifying crypto-assets and the FPO will be amended to apply the financial promotion restriction to the following controlled activities undertaken in relation to qualifying crypto-assets:

• dealing in securities and contractually based investments;
• arranging deals in investments;
• managing investments;
• advising on investments;
• agreeing to carry on specified kinds of activity.

HM Treasury has indicated the types of exemptions that would apply to qualifying crypto-assets. The exemptions in Part IV of the FPO, which include exemptions for promotions made to investment professionals, journalists and overseas recipients, apply to all controlled activities and will apply to all qualifying crypto-assets. The exemptions in Part V, which only apply to relevant insurance activity, would not apply to qualifying crypto-assets. Only some of the Part VI exemptions, which include promotions to self-certified sophisticated investors, high net worth companies, governments and central banks, would apply to qualifying crypto-assets. HM Treasury states that the Part VI exemptions for high net worth individuals and self-certified sophisticated investors would not apply to qualifying crypto-assets because the exemptions only apply to the specified investments listed in the FPO.

A proposed additional exemption for a vendor stating that it is willing to accept or offer qualifying crypto-assets in exchange for goods and services is being dropped. HM Treasury has opted not to add any such exemption because such a statement would not constitute an inducement to enter into an investment activity and would therefore not fall within the scope of the FPO.

Classifying Crypto-Assets as Restricted Mass Market Investments

The FCA is proposing to apply to qualifying crypto-assets the same rules proposed for other high risk investments classed as Restricted Mass Market Investments. This is a more lenient approach than that taken in other jurisdictions, such as Singapore.^[15] The FCA proposes that the new rules would apply from the date qualifying crypto-assets are brought within the financial promotion regime. The FCA intends to publish its final rules in summer 2022. Following feedback, HM Treasury has decided to implement a six-month transitional period from the finalization of the legislative measure and the publication of the FCA’s final rules.

Approving the Financial Promotions of Unauthorised Firms

The U.K. financial promotion rules provide that a person may not communicate a financial promotion—an invitation or inducement to engage in an investment activity—unless the communication is exempt, the firm is authorised to carry on a regulated activity or the communication is approved by an authorised firm. Only financial promotions that are not “real-time” (e.g. spoken on calls, personal meetings or online chat services) may be approved by an authorised person, and any approval must comply with the FCA’s financial promotion rules.

A Regulatory Gateway

HM Treasury has confirmed^[16] that it will be implementing the regulatory gateway for the approval of financial promotions of unauthorised firms. This will mean that authorised firms will generally be banned from approving financial promotions of unregulated firms and will need to apply to have the prohibition removed in whole or part before they are able to approve financial promotions of unauthorised firms. The change will be made through legislation amending the FSMA. There will be exemptions: first, for authorised firms approving financial promotions of unregulated firms within their group; and secondly, for principals approving financial promotions for their appointed representatives for regulated activities, for which the principal has agreed to accept responsibility.

Proposals to Strengthen Regulatory Rules

The FCA is proposing^[17] to amend its rules on the approval of financial promotions of unauthorised firms by authorised firms, including, among other things, to:

• Require all relevant financial promotions to include a date stamp. The FCA also intends to bring in stronger guidance on adding the name of the approving firm to financial promotions.
• Introduce a new rule requiring firms to self assess whether they have the necessary competence and expertise in an investment product or service before approving or communicating a financial promotion. A firm would need to consider whether it has the relevant experience and/or qualifications in the sector as well as the previous employment history and qualifications of the individuals responsible for approving promotions.

Firms would be required to keep records of how they meet the requirement for each approved financial promotion. The FCA is considering how these changes may be linked into the Senior Managers and Certification Regime, but has not yet made any proposals in that regard.

The FCA is also considering stronger rules for ensuring financial promotions remain compliant, including requiring firms to take reasonable steps to monitor the continuing compliance of approved promotions and requiring firms to collect, every three months, attestations of “no material change” from clients with approved promotions. These proposed obligations will be fairly onerous for firms, although will benefit retail investors.

The FCA is proposing to allow firms three months from the publication of the final rules to comply.