A regular briefing for the alternative asset management industry
Wealthy individuals want better access to private funds, and policymakers are (mostly) on-side. Meanwhile, larger alternative asset managers are building teams that know how to tap this growing pool. But the risks of adding retail investors to an asset class used to dealing with institutions are significant – and firms that manage those risks properly will thank their compliance teams in years to come.
Everyone agrees that sensible investor protection regulation is essential. Indeed, it is one of the primary objectives of regulators, and rightly so. In the UK, those protections have recently been reviewed and upgraded – the Consumer Duty now requires firms to deliver fair outcomes, not just good process. One of the aims of the EU's retail investment strategy is to increase consumer protection.
A UK court case last year demonstrated how tough the rules are, and the risks of getting it wrong. A regulated firm, Linear Investments, was ordered to compensate a client – an LSE professor – for selling him risky derivative investments which were only available to professional clients. The firm had followed a process to re-categorise the professor as a "professional". It had relied on his representations that he had experience in trading contracts for differences (CFDs, a type of derivative contract) of the kind being offered. But when the individual lost money, he complained to the Financial Ombudsman. In general, only retail clients can complain to the Ombudsman – so it was necessary for the Ombudsman to decide whether the client had been miscategorised as a professional investor.
The Ombudsman decided that he had been miscategorised. It held that some of the client's answers relating to his experience in the derivatives market were inconsistent, and Linear did not obtain supporting information or the documentary evidence requested by its application form. The Ombudsman said that Linear should not have relied solely on the representations the client had made on that form. It therefore found that the firm had failed to comply with its regulatory obligations, had mis-sold a product, and should pay compensation. On appeal, the court upheld that decision, agreeing that the firm had not done enough and ordering the firm to reimburse a proportion of the client's losses.
The ruling makes clear that robust procedures are vital and must be followed carefully in each case. Well-designed forms are not enough. As individual investors become more prevalent in private markets, the risk of litigation rises – and proper due diligence, thorough records, and robust opt-up processes will be worth their weight in gold.
It is also noteworthy that this ruling related to a period which preceded the UK's new Consumer Duty. Broadly, these rules apply to activities carried on in relation to retail clients. They also apply to firms when opting up individuals – by default retail clients – to professional client status. If individuals wish to challenge an opt-up process in future, they might therefore also claim that a firm has failed to comply with the Consumer Duty.
However, as well as being essential, regulation can also create unnecessary barriers. The UK's regulator, the FCA, has recently acknowledged that its own client categorisation rules, largely inherited from the EU, are cumbersome and unduly restrictive. It has been consulting on proposals to simplify them.
Under the FCA's proposals, there will be two main ways for a prospective client to gain “elective professional” status. First, the new “investable assets test” – requiring at least £10 million in regulated investments and cash. Second, a qualitative test focused on whether the investor is genuinely capable of assessing risks and making decisions, based on experience, knowledge, and financial resilience.
