The Financial Conduct Authority is in the news a lot these days. Andrew Bailey has been handpicked to head the agency but the chancellor George Osborne has come under fire for making the appointment without conducting a formal interview, thereby sidestepping the two candidates (Tracey McDermott and Greg Medcraft from Down Under) formally on the shortlist. However, the beleaguered FCA chairman John Griffith-Jones agreed with outgoing chief executive McDermott and both of them were “happy” with the chancellor’s appointment of Bailey – a beefy looking BoE insider who impressively holds a doctorate in economic history. As seen in the last post, Panama has been in the news a lot. The FCA had originally given 20 banks until 15 April 2016 to report on the extent, if any, of their involvement and links with Mossack Fonseca or firms serviced by them. But now it warns that prosecutions over the Panama Papers are not clear-cut. According to Mark Steward, head of enforcement, the media frenzy is “quite different from prosecutions – the two don’t necessarily go together”. This case involved a Panamanian corporation called Asset LI Inc trading as Asset Land Investment plc against which the FCA brought proceedings for carrying on “regulated activities” without authorisation contrary to the general prohibition in section 19 of the Financial Services and Markets Act 2000. Schemes for investing in land with development potential are commonly known as “land banks” and the operation of such initiatives first came into the regulatory perimeter under section 11 of the PERG Manual of the FCA Handbook.
In Financial Services Authority v Fradley  EWCA Civ 1183, the Court of Appeal had described the drafting of section 235 (collective investment schemes) of FSMA as “open-textured” by virtue of which words such as “arrangements” and “property of any description” are to be given “a wide meaning”. Arden LJ found in Fradley that section 235 must not be construed so as to include matters which are not fairly within it because contravening section 19 may result in the commission of criminal offences, subject to section 23(3) of FSMA. Lord Carnwath of Notting Hill found her Ladyship’s approach to be “helpful guidance”. On the other hand, he remained cautious of drawing analogies from comparative Commonwealth legislation presented to the court – such as the Australian Corporations Act 2001 – on the ground that differences in drafting warranted keeping the discussion strictly within the boundaries of UK statutes and authorities. Like the first instance judge, the Supreme Court referred to the English and the Panamanian company indiscriminately as “Asset Land”.
Agricultural land was acquired at various sites. The land was sub-divided into small plots. Individual investors then purchased hoping that it would be re-classified for residential use, allowing the land to then be resold at a profit. It was sold to savers for £7,500 to £24,000 with an assurance that it would go up in value once planning permission was obtained.
The Financial Services Authority (as the FCA was prior to 1 April 2013) became aware in early 2007 that Asset Land was selling land to investors. In the process, it was representing itself as responsible for seeking rezoning for residential development and for arranging a sale to a developer. However, the inquiry was closed in late 2008 on the basis of information supplied by Asset Land’s lawyers. Subsequently, in June 2011 the regulator decided that the agreed restrictions on the company’s method of working were not being observed and the inquiry was reopened and notice was given in relation to the appointment of investigators. The instant proceedings were brought in June 2012, following a worldwide freezing injunction against the company and Mr Banner-Eve.
The agreement between the companies and each investor disclaimed any intent by the companies to offer investment advice. It declared that the company would not itself be applying for planning permission or providing any other services amounting to regulated activities, which it had no authority to conduct. At first instance, at  EWHC 178 (Ch) Andrew Smith J found that the activities amounted to a collective investment scheme in breach of FSMA. Subsequently, the Court of Appeal (Rimer, Gloster and Sharp LJJ,  EWCA Civ 435) upheld the judge’s decision.
The Supreme Court found that a promotion of this nature needed FCA authorisation and upheld the High Court’s decision, which represents a blow to extravagant investment schemes and provides welcome success to the FCA, which faces harsh criticism for (a) being a lame duck enforcement agency (b) squandering public money and (c) falling well short of the high expectations it has of regulated firms. As noted above proceedings were brought against Asset Land, its principal owner and director Mr Banner-Eve and related parties by the FCA. In the Supreme Court the appellants raised four grounds and lost on all of them.
The section 235 provision relates to collective investment schemes constituting by arrangements respecting property which enable participants to receive profits or income arising from the acquisition, holding, management or disposal of the property. To fall within it, participants in the scheme must not have day-to day-control over the management of the property, and the property must be managed as a whole by or on behalf of the operator of the scheme.
In Secretary of State for Business Innovation and Skills v Chohan & Ors  EWHC 680 (Ch) the court said that in order to be safe, a “scheme” must ensure that the owners actually control the management of their property and the FCA argued that in many instances the wording of brochures, marketing material and contracts disregarded reality. It was objectionable that there was lack of any real involvement by investors in the management of the process allowing them to benefit from an increase in the collectivised value of the individual plots brought about by the operator’s supposed expertise and experience in the rezoning process.
The appeal also raised the broader question of whether the FCA correctly understood the law as applicable to the instant case. Observing that the court’s decision was rather important to correctly understand the application of FSMA in this and similar cases, Lord Carnwath found it useful to discuss earlier authorities such as FCA v Capital Alternatives Ltd  EWCA Civ 284 relating to land exploitation schemes. His Lordship also found value in the judgment of David Richards J in In re Sky Land Consultants plc  EWHC 399 (Ch) which held that a land-banking arrangement, resembling the present matter, amounted to a collective investment scheme within the meaning of section 235.
The Supreme Court
Sitting as Lord Mance, Lord Clarke, Lord Sumption, Lord Carnwath and Lord Hodge, the court unanimously dismissed the appeal. Both Lord Carnwath and Lord Sumption gave judgments.
Quarrelling with the Court of Appeal’s judgment, the appellants submitted that (i) it erred in its identification of the component parts of the arrangements, and gave inadequate weight to an essential feature, namely that each investor intended to, and did own his plot(s) outright (ii) it erred in treating “the property” under section 235(2) and (3) as each of the sites acquired by the company, rather than the aggregate of all the plots sold to individual investors, and should have held that the arrangements left investors with the necessary control (iii) the critical question under section 235(3)(b) was whether the arrangements reserved to the investor the final decision as to the exploitation of the property pursuant to the arrangements, the correct answer to which was yes and (iv) that the court’s interpretation would potentially interfere with a wide range of legitimate business arrangements which should not be characterised as collective investment schemes.
Rejecting the purported distinction between the arrangements made by the operator and how they were perceived by others as “artificial and unrealistic”, Lord Carnwath held at para 54 that the judge was entitled to take the view that the investors’ understandings conformed to what was intended by the operator, and was not required to give special weight to contractual or other documents, without regard to their context. Dealing with the second and third grounds together, at paras 57-60, Lord Carnwath held that:
- the relevant “property” for the purposes of section 235(1) is the whole site, but that management control of the property under section 235(2) and (3) may be achieved in different ways, and may not be by legal mechanisms or legal control; “have control” in subsection 2 refers to “the reality” of how the arrangements are to be operated.
- the judge was entitled to find that the relevant management of the property as a whole comprised the steps necessary to obtain planning permission and secure a sale to a developer, and it was no part of the arrangement that the investors should have any part in or control over those management activities.
No issue arose as regards the fourth ground because the judge’s application of section 235 on the facts as found by him involved no distortion of its natural meaning or intended purpose.
Lord Carnwath acknowledged at para 63 “that section 235 should not be stretched to cover matters covered by other legal remedies, under common law or statute.”
The Supreme Court’s historian judge did not quarrel with Lord Carnwath’s reasoning and agreed that the appeal should be dismissed. Yet, as he said at para 65, he proposed to express his own views in a judgment “because this is the first case to reach this court or the Appellate Committee of the House of Lords about one of the more problematic features of the United Kingdom’s system of statutory investor protection, namely the regulation of collective investment schemes.”
After conducting a painstaking review – with an analytical focus on things such as the Prevention of Fraud (Investments) Act 1939, Professor LCB Gower’s Review of Investor Protection, Part I, (Cmnd 9215) 1984, Financial Services in the United Kingdom: A New Framework for Investor Protection (Cmnd 9432) 1985 and the more recent Consumer Rights Act 2015 and UCITS – of the policy underlying the regulation of collective investment schemes, Lord Sumption found at para 91 that whether a scheme is a collective investment scheme depends on what was objectively intended at the time the arrangements are made, and not on what later happens. Like Lord Carnwath, Lord Sumption traced section 235 to Fradley and remarked at para 88 that “Arden LJ was surely right” in her treatment of the provision.
Describing management as a “protean” word capable of embracing “a wide range of activities involving varying degrees of control over the property being managed” but which “has a specific purpose” within the meaning of section 235, his Lordship made the following points at paras 98 and 99. First of all, the essence of such a scheme is a lack of legal or practical control by the investor of the profit-generating investment which is the subject of the scheme. Moreover, the investor exchanges property over which he has entire dominion for units in a larger property over which he has more limited rights. Accordingly, a distinction must be made between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can be either pooled or managed in common, in return for a share of the profits generated by the collective fund.
According to Lord Sumption, the judge was right to say that the mutual understanding based on the core representations made by Asset Land to the investors constituted “arrangements” under section 235, and that so far as the contract, disclaimer and publicity material were inconsistent with those representations, they were not part of the “arrangements”. He went on to hold at para 93 that the core representations were consistent only with the “property” the subject of the arrangements being the whole of a site. It was the whole site which was to be rezoned and sold to a developer, and the profit which each investor would derive would be derived from an aliquot share of the entire sale price for the site.
As regards “day-to-day control”, his Lordship reasoned at paras 94-95 that the question must be “in whom would control be vested were control to be required” – section 235(2) must refer to the control exercisable by the investors collectively. He found that:
95. The question is therefore whether the arrangements were such that the investors had day-to-day control of the management of the whole site. This cannot refer to the powers of control exercisable by any individual investor. It is hard to conceive of a case in which an individual investor could ever have day-to-day control of any more than his own plot. The subsection must therefore refer to the control exercisable by the investors collectively. In the case of Asset Land’s sites, the investors collectively did not have the relevant control for two reasons. First, they were not in a position to exercise control of the management of the whole site because the roadways, access points and other common parts were retained by Asset Land. The investors had only easements in respect of those parts. Secondly, even if the investors had been for practical purposes in a position to control the management of the whole site by organising themselves to that end, there were no arrangements to that effect.
Whether the property was “managed as a whole” remained the critical question and Lord Sumption held at para 97 that that depended on whether, objectively, the functions which the arrangements assigned to Asset Land after the investor’s acquisition of his plot constituted management of the site.
His Lordship concluded that it was not possible to purely view the transaction through the prism of the law and he said that it was inappropriate for the Supreme Court to substitute a different view instead of the judge’s finding that the dominion of the investors over their plots was in reality an illusion.
In conclusion, he said at para 102:
On that ground, which is substantially narrower than the submissions addressed to us by the Financial Conduct Authority, but enough for the resolution of this appeal, I agree that the schemes with which we are concerned are collective investment schemes.
As seen above, the outgoing FCA chief executive Tracey McDermott is hardly an iron lady and says she does not want her job. She has timidly chosen not to irritate the chancellor – who was unimpressed with Martin Wheatley’s infamous cowboy “shoot first” strategy and clashed with his overall tactics – and preferred to quietly exit to a sweeter life in the evergreen pastures of the private sector, leaving the regulatory ruckus for Bailey to sort out. As an economic historian, the new FCA boss will no doubt be familiar with the concept of history repeating itself. Hopefully, he will be able to set higher standards than some of his predecessors who have generally adopted a strategy of hoodwinking the public about how well they have done to solve the problems posed by financial misconduct.
The truth is that the FCA decided to drop its important review of culture which presents somewhat of a paradox because the City watchdog continues to insist in its latest business plan that “poor culture and control continues to threaten market integrity, including conflicts of interest.” (Big Bailey also blames bad culture for laying “the ground for bad outcomes”, he warns against senior management’s “hubris risk, the risk of blinding over-confidence.”) It has also abandoned reviewing the activities of HSBC’s Swiss banking arm, which allegedly helped the rich to dodge taxes. When added together, i.e. drop by drop leading to an ocean, these things matter and unsurprisingly Andrew Tyrie MP (chairman of the Treasury Select Committee) summoned both McDermott and John Griffith-Jones for a dressing down over these affairs. Small wonder, McDermott is eager to leave her job and find a comfy place in private sector!
In any event, adopting a sanguine tone as regards the Supreme Court’s decision, Mark Steward continued to talk tough but as usual he ultimately passed over the buck to consumers and advised them to protect themselves rather than expecting regulators to solve their problems. In a press release, he said on behalf of the shambolic agency:
This decision should sound a clear warning to those selling dubious investments. We will do what it takes to shut down firms trying to exploit loopholes and take advantage of consumers.
However, while this is an important victory from a legal point of view, we are acutely aware from experience that the risk to investors who deal with unauthorised firms is that most, if not all, investors are likely only to get a fraction of their money back.
Consumers should therefore recognise that there are huge risks involved when investing with unauthorised businesses.
Yet limited hope may be found in Bailey’s recent Culture in financial services speech, partially drawn on above, where he attacked management’s excesses and self-perceived invincibility by arguing that high-flyers “are so convinced of their rightness that they hurtle for the cliff without questioning the direction of travel.” Quite rightly, he emphasises that the culture of firms “matters a great deal” and “is of the utmost importance to financial regulators.” Nonetheless, despite these attractive maxims, as members of the public, we can only hope Bailey can change the culture of shirking responsibility and negligence at the FCA itself. It will be interesting to see whether or not he tries to hide behind the Bailey “there is no magic bullet to change culture” adage which he also articulated in his speech.