Mortgage Strategy, December 2011 – Stephen Gilchrist looks at the trouble with Collective Investment Schemes

The trouble with collective investments

Land banking has attracted the regulator's attention as it can come under the banner of collective investment schemes, the sale of which requires authorisation. So it's worth knowing where the dangers lie

Readers will be well aware that the Financial Services Authority has sharp teeth in dealing with unfair treatment of mortgage customers. For example, in September 2011 the FSA fined Essex-based mortgage lender Swift 1st Limited lb630,000 for unfair treatment of some customers facing mortgage arrears.

However, mortgages are just one of many specified investments, dealing in which amounts to a regulated activity requiring authorisation by the FSA under the Financial Services and Markets Act 2000. These are fully defined in Order 2001 of the act.

In 2011 the FSA stepped up action against unauthorised so-called land banking operations, pursuing seven separate cases in the High Court. On November 16 2011 the press reported the FSA had arrested five people over allegations relating to land banking investments sold through an unauthorised collective investment scheme.

Land banking involves the purchase of land with a view to selling it on at a later date for profit, often as a result of planning permission being obtained.

The FSA does not regulate the sale of land but land banking may amount to a collective investment, something that does require FSA authorisation.

In a judgment against one Stephen Watkins in June 2011, the court held that he sold land illegally to consumers and ordered him to make an interim repayment of lb920,000, via the FSA, to his victims. Watkins has also been banned from selling plots of land.

The FSA is determined to close down operations which involve the sale of products which are not otherwise specified investments, which broadly speaking include financial products, but which are being sold in a way which contravenes the FSMA.

While entrepreneurs are constantly looking at new products and markets the role of the FSA is often forgotten or a blind eye is turned.

Carrying on a regulated activity without authorisation

Section 19 of the FSMA provides that no person may carry on a regulated activity in the UK, or purport to do so, unless they are an authorised or exempt person. The prohibition is referred to in this act as the 'general prohibition'.

It is also a criminal offence to contravene the general prohibition and is punishable by up to two years imprisonment.

For the purposes of this act, an activity is one of a specified kind that is carried on by way of business and relates to an investment of a specified kind or is carried on in relation to property of any kind (section 22).

Generally speaking, specified investments are those pertaining to financial products which include, for instance, shares, deposits, futures, options, and rights under regulated mortgage contracts.

Regulated activities can include the management of, advising on and promotion of those specified investments. Significantly, it also includes - together with section 22 of the FSMA - the establishment, operation or winding up of a collective investment scheme.

How is it that Watkins & Co fell foul of FSMA and the FSA? Land is not a specified investment and so the sale of land, even at prices which produce disproportionate profits for the operator, is not in itself a regulated activity.

The FSA's interest in these activities arises as a result of the suggested operation of a collective investment scheme, or of someone purporting to operate one.

What is a collective investment scheme?

In essence a collective investment scheme arises when the people who are to participate do not have day-to-day control over the management of the property, and either the contributions of the participants and the profits - or income out of which payments are to be made to them - are pooled or the property is managed as a whole by or on behalf of the scheme operator.

Essentially the FSA claimed Watkins' sales staff told his customers that he would seek planning permission for them and also help them resell the land at a profit.

The FSA claimed that the promise of his business to apply for planning permission and manage a resale of the land brought the mechanics of his operation within the definition of a collective investment scheme - there was no day-to-day control by the participants of the scheme and management of the investment was undertaken only by Watkins' business.

In fact the FSA claimed Watkins had no intention of seeking permission or helping his purchasers, many of whom paid him their life savings. Unfortunately for Watkins, it is not only unlawful to operate a collective investment scheme, but also to purport to operate one.

Consequences of breaching the prohibition

Under the FSMA an agreement made by a person in the course of carrying on any regulated activity in contravention of the general prohibition is unenforceable against the other party. This includes, among many other examples, running a collective investment scheme or a deposit-taking business. The other party can recover any money or other property paid or transferred by him, and compensation for any loss sustained by him as a result of having parted with it. The FSA can close the offender down, freeze his assets and seek recovery of all monies paid in. Bankruptcy proceedings may follow.

More pertinently, at the outset of proceedings, the FSA may apply for injunctive relief against the operator, stopping them from operating and freezing his assets. Even when the scheme is operated by a limited liability company, the principles behind it may also be joined in these proceedings. Reference has also been made to the criminal consequences of carrying on a regulated activity without authorisation.

The moral for entrepreneurial businesses is to ensure that whatever product they may be selling to the retail market, the product is not sold via any mechanism which could be construed as a collective investment scheme and thus attract the attention of one of the UK's fiercest regulators.

Link to article on Mortgage Strategy