A look of disapproval: the FCA’s new discussion paper on financial promotions rules for high-risk investments and firms approving financial promotions

On 29 April 2021, the Financial Conduct Authority (“FCA”) published a Discussion Paper DP21/1 concerning the proposed strengthening of the financial promotion rules for high-risk investments and firms approving financial promotions (the “Discussion Paper”). The Discussion Paper relates to:

1. the FCA’s classification of high-risk investments;
2. further segmentation of the high-risk investments market; and
3. the role of an authorised firm that approves a financial promotion.

1. Classification of high-risk investments

Background

At present, the FCA rules relating to financial promotion classify investments into the following categories:

• readily realisable securities (“RRSs”), which are generally marketed to retail investors without restrictions;
• non-readily realisable securities (“NRRSs”) and peer-to-peer (“P2P”) agreements, which carry restrictions on the direct offer of financial promotions; and
• non-mainstream pooled investments (“NMPIs”) and speculative illiquid securities (“SISs”), which cannot be mass-marketed to retail investors.

Questions by FCA

The FCA is considering changing these classifications and is seeking views on the following two questions:

1. are there any investments which are not currently subject to marketing restrictions which should be?
2. should the FCA change how certain types of investments are currently classified under the financial promotion rules, consequently changing the level of restrictions that apply?

Potential arbitrage relating to SISs

The rules for SISs are in place to target and regulate the financial promotion of speculative investments. The FCA states that it considers the use of the proceeds to be the key to the classification of the investment, not the legal structure that is adopted. However, at present, the rules for SISs only apply to debentures and preference shares, which the FCA believes leads to other possible routes for arbitrage.

In this respect, the FCA proposes the following two changes:

• SISs to include equity shares – this aims to prevent ordinary shares being offered as a route of regulatory arbitrage and for the categorisation of investments according to the use of proceeds, rather than the structure of the investment; and
• SISs to extend definition of P2P agreement – this aims to prevent P2P agreements which have similar features to SISs (e.g. where it is a loan to a property developer) from being able to market to retail customers in order to prevent regulatory arbitrage.

RRSs

The Discussion Paper also proposes changes to the definition of an RRS, which is currently as follows:

“(a) a government or public security denominated in the currency of the country of its issuer;

(b) any other security which is:

(i) admitted to official listing on an exchange in the UK; or

(ii) regularly traded on or under the rules of such an exchange; or

(iii) regularly traded on or under the rules of a recognised investment exchange or (except in relation to unsolicited real time financial promotions) designated investment exchange;

(c) a newly issued security which can reasonably be expected to fall within (b) when it begins to be traded.”

The FCA has not set out any new definition for an RRS, but it has identified two issues with this definition:

1. the regulation of listed securities vary state to state in the EEA. Different states require varying levels of due diligence and admission standards and are subject to varying levels of regulation. Therefore, the risk level associated with such securities will vary state to state; and
2. some EEA state definitions of “official listing” include securities traded on multilateral trading facilities (MTFs), which present a further risk of arbitrage.

In response to these issues, the FCA proposes to change the definition of RRSs by:

• extending the permanent mass-marketing ban for SISs to listed debentures which otherwise meet the definition of a SIS but are not regularly traded;
• treat exchanges in EEA member states the same as other third countries (rather than the same as the UK) from the RRS definition; and
• removing any fixed income securities traded on an “exchange-regulated MTF” (a term which is undefined) from the definition.

The FCA is also seeking views on how to amend the definition of an RRS in the context of the financial promotion rules and considering whether the focus on liquidity by reference to a list of investment exchanges would be the right way to distinguish securities appropriate for mass-marketing without restrictions to retail investors.

2. Further segmenting the high-risk investments market

The FCA is proposing new rules to:

1. strengthen the categorisation of retail investors (as high net worth, sophisticated or restricted investors) where rules restrict the communication of financial promotions to retail investors who meet the relevant criteria;
2. improve risk warnings to help consumers better understand and engage with them; and
3. add “positive friction” to the consumer journey when making high‑risk investments that will lead to more effective decisions.

Strengthening the process for categorising retail investors

At the current time, client classification is often a self-certification process, for example, with the investor confirming that they meet certain criteria. The Discussion Paper outlines the FCA’s view that further obligations should be placed on firms during the categorisation process in order to ensure the accurate categorisation of investors. The FCA proposes that such obligations could include requiring firms to:

• take reasonable steps to independently verify that a retail investor meets the relevant requirements to be characterised as a high net worth or sophisticated investor, or to verify that restricted investors are not investing more than 10% of their net assets;
• have grounds to reasonably believe that an investor meets the relevant requirements (and to document those grounds);
• have regard to any information that they hold about the relevant individual from other interactions, or collect as part of the appropriateness or preliminary suitability assessment, when considering whether to question a declaration; and
• question or verify declarations where there are certain “red flags”, for example where an investor attempts to invest an amount over a certain threshold.

The Discussion Paper also proposes that consumers should receive better help to categorise themselves and that this might be done by:

• introducing a requirement for a clearer and more prominent risk warning;
• giving a clearer risk warning which could be designed to directly address social and emotional drivers of investment choice; and
• considering other changes to the format of the declaration to require a consumer to make a more active choice, for example:

1. banning the use of pre‑ticked tick boxes and reframing passive declaration statements as explicit questions;
2. changing the format of the declaration so that an investor needs to provide additional relevant self‑declared information; and
3. introducing positive frictions into the declaration process to encourage reflection and more mindful interaction.

Improving risk warnings

The FCA presents evidence that risk warnings are most successfully heeded by consumers when they are conveyed in a particular manner. Therefore, rather than focusing on the amount of information provided to the consumer, the FCA has suggested the following improvements to the format of risk warnings:

• disclosures should be shorter, sharper and written in plain English;
• disclosures should be focused on visual based warnings, such as a traffic light system; and
• warnings should be specific and prominent, as is required for SISs, such as a standardised warning stating that investors could lose all their money or a warning that the products are high risk.

Positive frictions in consumer journeys

The FCA is concerned with striking a balance between allowing investors who have the financial resources to accept higher risk to do so, and ensuring that such investors understand the risk they are taking. The FCA proposes the following measures to create positive friction for consumers investing in higher risk products:

• introducing deposit collection and investment frictions, such as cooling off periods or requiring SMS confirmations before investments are made;
• requiring consumers to watch “just in time” education videos on investment risks, the benefits of diversification and regulatory protections; and
• requiring consumers to demonstrate sufficient knowledge about financial products, for example passing an online test.

3. The role of an authorised firm that approves a financial promotion

In the Discussion Paper, the FCA considers whether the role of a so-called “section 21 approver” should be changed. The FCA proposes that the scope of the role of a section 21 approver should be widened to include:

1. ongoing obligations; and
2. involvement in client categorisation and appropriateness/suitability assessments.

Ongoing obligations

At present, a section 21 approver must withdraw its approval if it becomes aware that the financial promotion no longer complies the FCA rules (for example, the financial promotion is no longer fair, clear and not misleading). The FCA proposes that this passive obligation should instead become an active obligation, which would require the section 21 approver to monitor the financial promotion after approval has been given. The FCA suggests monitoring:

• whether any amendments which would require the financial promotion to be re‑approved have been made to the promotion;
• whether there have been any changes, including changes in the matters covered by the due diligence which the section 21 approver undertook on the issuer and the investment, which may affect whether the promotion continues to be fair, clear and not misleading;
• whether the funds raised through the issue of an investment are being used for the purposes described in the financial promotion; and
• whether any other relevant requirements imposed by the financial promotion rules, and any new requirements introduced, are being complied with.

Involvement in client categorisation and appropriateness/suitability assessments

For NMPIs and SISs, a retail investor must be certified as either high net worth or sophisticated and the firm must take reasonable steps to acquaint itself with the investor’s profile and objectives to determine the suitability of NMPIs and SISs for a particular retail investor. Therefore, the FCA states when a section 21 approver approves a financial promotion in relation to an NMPI or a SIS, they should also have the expertise to understand whether an investment is suitable for any given investor.

Furthermore, for NRRSs and P2P agreements, a retail investor must be certified as a high net worth, sophisticated or “restricted” investor and certain rules must be complied with, including determining the appropriateness of NRRSs and P2P agreement for a particular retail investor. Compliance with such rules is often carried out by an automated online system. It is the section 21 approver’s role to ensure that these systems comply with the rules and at present the approver is only required to confirm compliance at the point of approval. Therefore, the FCA proposes that section 21 approvers should be required to confirm the compliance of such automated systems on an ongoing basis.

Next Steps

The FCA welcomes all comments on its proposed changes by 1st July 2021. After this period has elapsed, it will consider the feedback and consult on proposed rule changes later this year.

Co-authored by Isabella Ramsay.