Regulating the Regulator: The FCA and the Collapse of London Capital & Finance By Rhys Rosser

The world of ‘mini-bonds’ is one which has not found itself in the limelight before. That changed in January of last year when London Capital & Finance entered into administration leaving over 11,500 investors out of pocket. The estimated loss so far is around £236m.

One of the unexpected consequences of the collapse is the scrutiny that the Financial Conduct Authority has faced for their role, or lack thereof. The ‘mini-bond’ product is largely unregulated; they are very different to Corporate/Institutional bonds due to both their size (with trading starting at around £1,000), and the absence of any need for rating. They are also different to retail bonds as they are not tradable; mini-bonds are held to maturity regardless of the performance of the underlying company. This means that the safeguards offered by rating companies such as Fitch and Standard & Poors is worryingly absent.

The lack of regulation allowed London Capital & Finance to promise returns of between 6.5% and 8%. The mini-bond was available in the Innovative Finance ISA wrapper, approved by HMRC, and London Capital & Finance was regulated by the FCA. This led to investors feeling that their funds would be safe. When one considers where the funds went, such as on a £58m commission payment to Surge Financial (Oil Exploration in the Faroe Islands) and a private Helicopter, the financial returns were clearly a myth and the confidence of investors was misplaced. One can draw similarities between the structure of London Capital & Finance and the Collateralised Debt Obligations that led to the downfall of Lehman Brothers in 2008.

The impact is already starting to be apparent with Junior Finance Minister John Glen writing to lawmakers, stating that there will be a consideration as to whether the current regulatory regime for these securities issued by companies to consumers is appropriate. The SFO, working closely with the FCA, are also taking a very close interest in London Capital & Finance’s conduct, with five individuals already arrested and released under investigation including Paul Careless: the founder of ‘Surge Financial’ that marketed the mini-bonds to investors and who took the commission referred to above.

The more striking effect may well end up being that on the FCA. Serious concerns have been raised over the fact that the FCA had been warned about the activities of London Capital & Finance as early as 2015. Neil Liversidge, a financial advisor based in Yorkshire who had become aware of London Capital & Finance through a client, had written to the FCA warning them about the safety and promotion of the bonds as investments, stating that the bonds were worth “the square root of bugger all” and that the investment was unsuitable. Despite this warning, no action was taken until a month before the collapse when the FCA warned London Capital & Finance to withdraw their marketing as it appeared misleading. It took until 13th December 2019 for the FCA to freeze assets due to concerns about the running of the business.

An investigation has now been ordered by the Government and is well underway. The investigation is being led by Dame Elizabeth Gloster and is expected to focus on what led to the FCA’s failure to act and the changes that ought to be made in light of this. The investigation will also consider the regulation of mini-bonds and the associated marketing that was permitted.

The current guidance on the FCA regulation of mini-bonds is limited to say the least. This is partly because they represent such a small volume, individually, of trades and investments that they have not posed any serious issue. The main rule change will likely relate to the ‘packaging’ of unregulated products in a regulated form; this will result in much greater scrutiny of what forms the makeup of a product. It is doubtful whether we will see the introduction of ratings, simply due to the sheer level of resources required to manage such an exercise.

The FCA have already taken some steps by issuing advice to investors on the nature of mini-bonds and the need to seek investment advice, and the internal and external reviews may result in changes to the regulatory landscape. The consequences may also be far reaching for products such as P2P lending and e-currencies (particularly in light of Facebook’s recent launch of ‘Libra’ currency). There have been concerns since the rise of Blockchain over the high volatility of the trading price and the absence of any physical asset that underlies the transaction. If Blockchain’s value were to crash, there would be no asset offering any form of security. There are further similarities between mini-bonds and e-currencies due to their accessibility, which means that ‘residential’ investors are able to gain profits or make losses.

Whilst there has been no clear indication as to what changes are being considered, the reviews may well result in the introduction of regulations as to the providers of trading platforms, in addition to requirements of the products themselves. These may not only be financial, but also consider the security of the platforms’ technology, both in respect of the hardware and software on which they operate.

It is worth noting that the only previous inquiry that was carried out into the FCA was when the FCA subjected itself to an independent external investigation following the Co-operative Bank scandal. This led to a review of the prudential supervision of the Co-operative Bank, by the FSA, between 2008 and 2013. This had far reaching consequences which were preceded by the establishment of the Prudential Regulation Authority (“PRA”), which the investigation ultimately recommended. It may be that the FCA takes a similar step following this investigation, by introducing an ‘Innovative Finance Regulator’ which would deal with those products which are driven by the technological changes of the past 20 years.

Beyond the FCA, HMRC’s decision to grant ISA status will likely come into question. Administrators considering London Capital & Finance have already stated that they view the qualification process as having “fairly limited” requirements and that the application process is “not rigorous”. There may well be wholesale changes that follow, both in the way that ISAs are initially considered for qualification and how they are reviewed on a continuing basis. The exact nature of this remains to be seen, but it may well be that metrics which operate in a similar way to Risk Weighted Assets (i.e. the value of an asset balanced against the risk of such an asset) are introduced.

12 months on, the Financial Services Compensation Scheme (“FSCS”) declared on 9th January 2020 that London Capital & Finance had ‘failed’. As of 17th February 2020, a total of just under £2.7m had been paid by the FSCS to consumers. This is scant compensation for those customers who invested prior to LCF being authorised to carry out financial services business.

The FCA meanwhile have provided a limited update. They confirm they are continuing to investigate alongside the SFO ensuring that all reasonable lines of enquiry are being pursued. This clearly provides limited comfort to both investors and those with an interest in the future legislative scheme for alternate financial products.