Consumer protection and reforming the financial promotion regime: Part 1

3rd February 2022

HM Treasury and the Financial Conduct Authority (FCA) have intensified their efforts in recent months to address various consumer protection issues, in particular around financial promotions. A package of measures is being consulted on.

In the first of two briefings on this topic, Walker Morris financial services experts Jeanette Burgess and Andrew Northage consider HM Treasury’s consultation on financial promotion exemptions for high net worth individuals and sophisticated investors, and highlight other recent consumer protection initiatives.

In Part 2, to be published shortly, our experts will focus on the FCA’s consultation on strengthening its financial promotion rules for high risk investments, including cryptoassets. This is an important step forward in creating a robust regulatory framework that will foster innovation while ensuring consumer protection.

How we can help

Please contact Jeanette or Andrew if you have queries about any of the points raised in this briefing, need assistance with responding to the consultation or advice on how it may affect you, or have concerns over any other regulatory or compliance issue.

What is happening?

HM Treasury is consulting until 9 March 2022 on proposals to amend the financial promotion exemptions in the Financial Promotion Order for high net worth individuals and sophisticated investors. The exemptions disapply the effect of the financial promotion restriction in section 21 of the Financial Services and Markets Act 2000 that an unauthorised person must have its financial promotions approved by an authorised person before they are communicated.

Why?

HM Treasury explains that the exemptions were introduced in 2001 and expanded/updated in 2005 to enable small and medium sized enterprises (SMEs) to raise finance from sophisticated private investors – so-called ‘business angels’ – without the cost of having to comply with the financial promotion regime. Since then, however, economic, social and technological changes – such as the development of the online retail investment market (including the emergence of crowdfunding), price inflation and pensions freedoms – mean that a significant number of additional consumers now technically fall within the definitions for high net worth individuals and sophisticated investors.

The exemptions have also been misused in some cases, so that investors who are not high net worth or sophisticated are being marketed products without the proper regulatory protections. Unauthorised firms using the high net worth individual and self-certified sophisticated investor exemptions have no touch point with the regulatory system, either through an authorised person approving their communication or through FCA supervision directly, which makes it difficult for the FCA to proactively identify such behaviour.

HM Treasury notes that it may be difficult to prove the misuse given that the current drafting of the Financial Promotion Order provides that firms are only required to ‘believe on reasonable grounds’ that the individual has signed the requisite statement outlining they are high net worth or sophisticated as opposed to believing on reasonable grounds that they meet the criteria to be a high net worth individual or sophisticated investor. This places the evidential burden on the investor.

HM Treasury also points to a lack of engagement with the exemption requirements among investors so that they may not understand the regulatory protections they are giving up or the criteria to meet the exemptions – instead relying on their own subjective judgement about whether they are high net worth or sophisticated.

‘High net worth individuals’ and ‘sophisticated investors’

A certified high net worth individual is an investor who has signed a statement within the past 12 months confirming they have an annual income of at least £100,000 or net assets of at least £250,000 (excluding their primary residence, rights under a qualifying contract of insurance, or pensions).

A certified sophisticated investor is an investor that holds a certificate signed within the past 12 months by an authorised person confirming that they are sufficiently knowledgeable to undertake an investment in that type of investment.

A self-certified sophisticated investor is an individual who has signed a statement setting out that at least one of the following applies:

• They are a member of a network or syndicate of business angels (and have been for at least six months prior)

• They have made more than one investment in an unlisted company in the previous two years

• 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

• 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.

What are the reform proposals?

Subject to the criteria being calibrated correctly, the government believes that high net worth and sophisticated investors are better placed than ordinary retail investors to manage without the regulatory protections afforded by the financial promotion regime and to absorb any losses resulting from their investments. By acting as long-term investors, they can play a significant role in getting innovative businesses’ ideas off the ground. HM Treasury proposes the following five changes:

• Increasing the financial thresholds for high net worth individuals: As a minimum, increase the net income and net asset thresholds in line with inflation to £150,000 and £385,000 respectively; or go further and capture the top 1% of earners and asset owners, increasing the thresholds to £175,000 and £900,000 (this net asset threshold could, however, have a significant effect on the ability of firms to raise money using the high net worth individual exemption).

• Amending the criteria for self-certified sophisticated investors: Remove the criteria that more than one investment has been made in an unlisted company in the previous two years as the rise in online investing means this is no longer an indicator of investor sophistication; update the fourth criteria so that the minimum annual turnover figure is increased in line with inflation to £1.4 million.

• Placing a greater degree of responsibility on firms to ensure individuals meet the criteria to be deemed high net worth or sophisticated: Shift the ‘reasonable belief’ emphasis so that firms communicating the financial promotion must have a reasonable belief that an individual meets the criteria, not simply that they have signed a relevant statement; firms to provide certain details about themselves in any communications made using the exemptions, including address, contact details and Companies House number.

• Updating the high net worth individual and self-certified sophisticated investor statements: Update the format so that the criteria to be met are more prominent; simplify the language, with fewer references to other pieces of financial services legislation; require the investor to select which specific criteria they meet in order to be classified as high net worth or sophisticated, and to set out how they meet them. Suggestions are welcomed as to how the statements can work more effectively as part of the digital journey.

• Updating the name of the high net worth individual exemption: Change from ‘certified high net worth individual’ to ‘high net worth individual’ to reflect the fact that since 2005 the investor’s high net worth status does not have to be certified by a third party.

Other consumer protection initiatives

There is a significant amount of consumer protection work ongoing, including the following:

• The FCA has conducted behavioural testing on how best to influence consumer behaviour to make effective investment decisions. The results were shared with HM Treasury to support its financial promotion exemptions consultation. The FCA recently published the research notes on improving outcomes for consumers considering investing in high risk investments. This research has informed the range of measures proposed in its consultation on strengthening the financial promotion rules for high risk investments – the subject of our second briefing to follow shortly.

• The government intends to establish a regulatory ‘gateway’ which a firm must pass through before it is able to approve the financial promotions of unauthorised firms. There is currently no specific process through which a firm must be assessed as suitable and competent to do so. Legislation will be brought forward ‘when parliamentary time allows’. In its consultation on strengthening the financial promotion rules for high risk investments, the FCA sets out policy proposals to complement the proposed gateway when introduced and will consult on draft guidance for firms applying the gateway when the legislation has been published.

• The FCA is consulting until 3 March 2022 on improving the Appointed Representatives (AR) regime to reduce potential harm to consumers and markets. The regime was created primarily to allow self-employed representatives to engage in regulated activities without having to be authorised. For example, insurers and other product providers used it to distribute products through ARs. It has since evolved to include a wider range of models such as regulatory hosting and networks, with principals and their ARs also offering a wider set of products and services across many different sectors. The FCA is seeing a wide range of harm across all the sectors where firms have ARs. The harm often occurs because principals fail to perform enough due diligence before appointing an AR, or from inadequate oversight and control after appointment. The FCA is also collaborating with HM Treasury to explore whether legislative change is needed in this area.