Regulation of Financial Services

Question 1

How are financial services regulated in the UK?

Answer 1

There are two regulators of financial services in the UK: the Prudential Regulation Authority (‘PRA’) and the Financial Conduct Authority (‘FCA’).

The PRA is currently a subsidiary of the Bank of England, responsible for the prudential supervision of deposit takers (such as banks and building societies), insurers and a small number of significant investment firms.

The FCA is responsible for the conduct of business, supervision of PRA and FCA firms, and the prudential regulation of firms not regulated by the PRA, amongst other things – this includes law firms carrying out work relating to financial services.

Question 2

Can a law firm give financial advice?

Answer 2

One of the key principles established by FSMA is that you may not carry out a ‘regulated activity’ in the UK unless you are authorised or exempt.

s 19(1) FSMA

No person may carry on a regulated activity in the United Kingdom … unless he is –

(a) an authorised person; or

(b) an exempt person.

IMPORTANT

It is a criminal offence to breach s 19(1) FSMA. In order to avoid criminal liability a solicitor must always assess whether or not the activity they are proposing to carry out for a client is governed by s 19(1) FSMA.

Question 3

Regulated Activities

Answer 3

The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (‘RAO’) contains a long list of regulated or ‘specified activities’. The list includes activities such as

• dealing in investments (which includes buying or selling investments)
• arranging deals in investments
• managing investments
• advising on the merits of investments

You can imagine then that there is plenty of potential for lawyers to be carrying out regulated activities for the purpose of s 19(1) FSMA.

IMPORTANT.

Few law firms have obtained direct FCA authorisation because FCA authorisation requires firms to comply with a lot of detailed regulations that are aimed at people giving financial advice to clients. In most cases law firms will try to avoid this additional regulatory burden if they can.

Question 4

Exceptions

Answer 4

There are exceptions to the rule in s 19 FSMA. However for the most part, solicitors take care to ensure that they do not provide financial advice to their clients, but refer the client to an independent financial advisor who is authorised by the FCA.

The prohibition in s 19 applies to everyone, not just solicitors. So FSMA and the statutory instruments arising out of FSMA are important not just from the perspective of a lawyer having to ensure that in they do not commit an offence, but also being aware of the statutory constraints which might be placed on their clients.

Question 5

FSMA applies – what now?

Answer 5

You will either need to be directly authorised by the FCA – OR (and to be honest, in practice, not many law firms are directly authorised by the FCA), the alternative, which is more likely, is that you are supervised by a designated professional body (or DPB for short) and the law firm complies with the rules of the DPB.

For solicitors the SRA is the designated professional body, so you would need to comply with the rules of the SRA in relation to that regulated activity.

Question 6

Step 1: Is there a specified investment?

Answer 6

The investments which are regulated are specified in Part III of the RAO and include:

Rights under a contract of insurance (Article 75)

Shares in a company (Article 76)

Instruments creating or acknowledging indebtedness (Article 77)

Government and public securities (Article 78)

Rights under a pension scheme (Article 82)

Regulated mortgage contracts (Article 88)

Step 1: Is there a specified investment?

All specified activities carried out in relation to regulated mortgage contracts are regulated under the RAO.

Article 61(3) RAO says a contract is a ‘regulated mortgage contract’ if, at the time it is entered into, the following conditions are met:

(i) the contract is one under which a person (the ‘lender’) provides credit to an individual or to trustees (the ‘borrower’);

(ii) the contract provides for the obligations of the borrower to repay to be secured by a mortgage on land in the EEA; and

(iii) at least 40% of that land is used, or intended to be used-

(aa) in the case of credit provided to an individual, as or in connection with a dwelling; or

(bb) in the case of credit provided to a trustee which is not an individual, as or in connection with a dwelling by an individual who is a beneficiary of the trust, or by a related person.

Regulated mortgage contract

Note that the definition of a regulated mortgage contract does cover a typical home buyer’s mortgage, but it does not cover:

• a loan to buy an office
• loans to companies

Question 7

Step 2: Is there a specified activity?

Answer 7

Specified activities listed in Part II RAO include:

• Dealing in investments as principal (Article 14) or as agent (Article 21).

This includes buying, selling, subscribing for or underwriting securities (eg shares, government and public securities, or rights under a pension scheme) or contractually based investments (eg rights under certain contracts of insurance).

• Arranging deals in investments (Article 25)
• Managing investments (Article 37)
• Advising on [the merits of] investments (Article 53)

Question 8

Advising on the merits of investments

Answer 8

For ‘advising on the merits’ under Article 53, the person has to be

• giving advice requiring an element of opinion, and
• a recommendation as to a course of action.

Giving generic advice (eg to invest in China, as opposed to Europe) is not a specified activity, nor is giving information as opposed to advice. Only advice relating to the merits of buying, selling, subscribing for or underwriting a particular investment which is a security or relevant investment is regulated. To be regulated, the advice requires an element of opinion on the part of the solicitor and a recommendation as to a course of action.

A solicitor giving generic advice on investments (for example, explaining the legal rights attaching to two different classes of shares) will not require FCA authorisation.

A solicitor recommending to his client to purchase ABC plc shares, or to take out an mortgage with XYZ Building Society will be advising on the merits and will require FCA authorisation.

Question 9

Step 3: is there an exclusion available?

Answer 9

This element focuses on the exclusions that are most relevant to the work of a solicitor, which are:

Regulated activities that are a necessary part of other services carried on in the course of a profession (Article 67)

Regulated activities in connection with the sale of a body corporate (article 70)

Authorised persons (Article 22/29)

Question 10

Article 67: ‘necessary part’ exclusion

Answer 10

Among other things, a solicitor will generally not be:

• ‘dealing as an agent’ – Article 21 RAO
• ‘arranging deals’ – Article 25 RAO or
• ‘advising [on the merits]’ – Article 53(1) RAO

in relation to investments for the purposes of FSMA and therefore will not be carrying on a specified activity, provided that these activities are:

(a) carried on in the course of carrying on any profession or business which does not otherwise consist of the carrying on of regulated activities in the UK; and

(b) may reasonably be regarded as a necessary part of other services provided in the course of that profession or business. (Article 67(1) RAO)

This exclusion will not apply if the specified activity is remunerated separately from the other services.

Article 67: ‘necessary part’ exclusion cont

What constitutes a ‘necessary part’ of other services is not specified in the RAO. The FCA’s view is that it must not be possible for the other services to be provided unless the dealing / arranging / advising is also provided.

For dealing as an agent and arranging deals in investments, it will rarely be necessary to rely on this exclusion as such work can usually be referred to an authorised person – see Articles 22 and 29 RAO respectively.

In fact cases where the Article 67 exclusion is used are quite rare in practice. However one example where it is commonly used is by property lawyers in relation to leasehold flats:

Example: when a client is selling a leasehold flat, the transaction might also involve the transfer of a share in a management company or the company that owns the freehold for the block of flats. Although shares are specified investments, arranging their sale would be a necessary part of the other property work the solicitor is carrying out. Therefore the solicitor will be able to arrange for the transfer of the share in the management company without being authorised by the FCA.

Question 11

Article 67: contracts of insurance

Answer 11

PLEASE NOTE: Article 67(3) states:

This article is subject to article 4(4), (4A)

What does this mean?

• ‘subject to article 4(4)’ means that the exclusion does NOT apply to certain investment firms or credit institutions.
• ‘subject to article 4(4A)’ means that the exclusion does NOT apply to contracts of insurance.

Question 12

Article 70: sale of a body corporate

Answer 12

A solicitor will not be:

• ‘dealing as principal’ – Article 14 RAO (which means the solicitor is acting on his own account)
• ‘dealing as an agent’ – Article 21 RAO (which means the solicitor is acting as though he was the client so the person he is dealing with is treated as dealing with the client)
• ‘arranging’ – Article 25 RAO or
• ‘advising [on the merits]’ – Article 53(1) RAO

if such activity is carried out in connection with the purchase or sale of shares in a company (if the transaction to buy or sell the shares is entered into for the purposes of buying or selling the shares), PROVIDED THAT: …

Article 70: sale of a body corporate cont

i) the shares consist of or include 50% or more of the voting shares in the company AND the acquisition or disposal is between parties each of whom is a body corporate, partnership, single individual or a group of connected individuals; or

ii) the shares, together with any shares already held by the purchaser, consist of or include 50% or more of the voting shares in the company AND the acquisition or disposal is between parties each of whom is a body corporate, partnership, single individual or a group of connected individuals; or

iii) the object of the transaction may reasonably be regarded as being the acquisition of day-to-day control of the affairs of the body corporate.

This very useful exclusion is commonly used by solicitors working on corporate transactions.

Note: the two entities do not each have to have the same legal status to fall within paragraphs i) or ii) eg a company can sell its shares to an LLP; a company can sell its shares to an individual and still fall within i) or ii) above.

Question 13

Dealing in investments as agent: authorised persons

Answer 13

Further exclusions apply where the solicitor refers the client to an authorised person:

Article 22 RAO: Dealing with or through authorised persons

A solicitor [who is not an FCA authorised person] will not be ‘dealing in investments as agent’ [for the client] for the purposes of FSMA and therefore will not be carrying on a specified activity, if he enters into a transaction as agent for his client with or through an authorised person, provided:

(a) the transaction is entered into on the advice of the authorised person;

OR

(b) it is clear that the client is not seeking and has not sought advice from the solicitor as to the merits of entering into the transaction.

This exclusion applies to the specified activity of ‘dealing in investments as agent’ under Article 21 RAO.

Question 14

Arranging deals through authorised persons

Answer 14

Article 29 RAO: Arranging deals with or through authorised persons

A solicitor [who is not an authorised person] will not be ‘arranging deals in investments’ [for the client] for the purposes of FSMA and therefore will not be carrying on a specified activity, if he enters into a transaction as agent for his client with or through an authorised person, provided:

(a) the transaction is entered into on the advice of the authorised person;

OR

(b) it is clear that the client is not seeking and has not sought advice from the solicitor as to the merits of entering into the transaction (or if the client has sought such advice the solicitor refused to give it and instead recommended the client seeks advice from an authorised person).

This exclusion applies to the specified activity of ‘arranging deals in investments’ under Articles 25(1) and (2) RAO.

Question 15

Authorised persons exclusions

Answer 15

Note: the exclusions under Articles 22 and 29 RAO do not apply:

• if the transaction relates to a contract of insurance or investment services or activities; NOR
• if the solicitor receives a commission (or any other advantage) from any other person (e.g. the authorised person) for which he does not account to the client.

Question 16

S4: Can both s 327 FSMA and SRA Scope Rule 2 be satisfied?

Answer 16

If the answer is yes, you can satisfy s, 327 and Scope Rule 2 – then the activity is an exempt regulated activity – that means that you are exempt from s. 19 – you don’t need to be authorised by the FCA PROVIDED you comply with the rules set by the SRA which for a solicitor is the designated professional body – those rules are the SRA Scope Rules and the SRA COB rules.

If however the answer is no – you cannot satisfy s. 327 and SRA Scope Rule 2, than you must be authorised by the FCA to carry out the activity otherwise you will be guilty of a criminal offence.

Question 17

General exemption (s 327 FSMA)

Answer 17

Section 327 FSMA provides that where members of a professional body (such as the SRA) are only carrying on ‘exempt regulated activities’ they will be exempted from the general prohibition set out in s 19(1) FSMA and will not be required to obtain authorisation from the FCA directly. Instead, the firm will be subject to rules prescribed by the SRA in relation to such exempt regulated activities.

The main rules prescribed by the SRA are the SRA Financial Services (Scope) Rules 2019 (‘SRA Scope Rules’) and the SRA Financial Services (Conduct of Business) Rules 2019 (‘SRA COB Rules’).

However, if a firm is carrying out regulated activities which do not fall within the s 327 exemption, it will need to obtain authorisation from the FCA directly and have to comply with the FCA Handbook.

Question 18

Section 327 FSMA

Answer 18

Solicitors may carry on exempt regulated activities without being directly regulated by the FCA provided they can meet the conditions specified in s 327 of FSMA. All the conditions set out in s 327(2) – (7) FSMA must be satisfied. The key conditions are:

• the person carrying on the regulated activities must be a member of a profession (such as practising as a solicitor (s 325(2));
• that person must not receive a ‘pecuniary reward’ [eg commission] from a third party in respect of the regulated activities, unless he accounts to his client for the commission (s 327(3));
• the specified activity must be provided in a way that is incidental to the provision of professional services (s 327(4)); and
• the person must only carry out regulated activities which he is permitted to carry out as a result of s 332(3) (i.e. he has to comply with the rules set by his relevant designated professional body - for the SRA, the Scope Rules) (s 327(5)).

Question 19

s 327(3): Pecuniary reward

Answer 19

‘P must not receive from a person other than his client any pecuniary reward or other advantage for which he does not account to his client, arising out of the carrying on of any of any of the activities’ (section 327(3) FSMA).

The FCA has stated in guidance notes that any commission must be held to the client’s order.

The requirement to account to the for any commission does not mean just informing the client that the firm will receive commission. You must hold the commission to the client’s order and may only keep it if the client gives you informed consent to do so.

Question 20

s 327(4): Incidental

Answer 20

‘The manner of the provision by P of any service in the course of carrying on the activities must be incidental to the provision by him of professional services’ (emphasis added) (section 327(4) FSMA).

The FCA has provided the following guidance on s 327(4) in its handbook:

‘The FCA considers that to satisfy the condition in section 327(4) regulated activities cannot be a major part of the practice of the firm. The FCA also considers the following further factors to be among those that are relevant:

the scale of regulated activity in proportion to other professional services provided;

whether and to what extent activities that are regulated activities are held out as separate services; and

(3) the impression given of how the firm provides regulated activities, for example through its advertising or other promotions of its services.’

It is important to note that the FCA considers that to satisfy s 327(4) the regulated activities cannot be a major part of the practice of the firm.

To work out whether or not the activity in question is incidental you need to look at the overall work the firm does - is the specified activity the solicitor is being asked to do a small part of what the firm does for clients overall? If so, it will be incidental.

It is worth noting that in most cases the answer to this question will be ‘yes’ – the specified activity the solicitor is being asked to do will be a small part of what the firm does for clients overall.

Question 21

SRA Scope Rule 2

Answer 21

Rule 2 of the SRA Scope Rules sets out the basic conditions that solicitors must satisfy when carrying out any exempt regulated activities:

Basic Conditions

2.1 If you carry on any regulated financial services activities you must ensure that:

(a) You satisfy the conditions in section 327(2) to (5) of FSMA;

(b) The activities arise out of, or are complementary to, the provision of a particular professional service to a particular client;

(c) There is not in force any order or direction of the FCA under sections 328 or 329 of FSMA which prevents you from carrying on the activities; and

(d) The activities are not otherwise prohibited by these rules.

The conditions contained in Rule 2 of the SRA Scope Rules incorporate those contained in s 327(2) to (5) of FSMA.

Question 22

SRA Scope Rule 2: complementary

Answer 22

To be classified as carrying on exempt regulated activities only, a firm must ensure that:

The activity arises out of OR is complementary to the provision of a particular professional service to a particular client (emphasis added) (Scope Rule 2.1(b)).

When does the activity ‘arise out of’ non-regulated work?

To work out whether or not the activity arises out of the (non-regulated) work the solicitor is doing for the client you need to ask what has happened to prompt the activity in question.

If, for example, you are acting for a client on the sale of a company and the client asks for advice as to how best to invest in a personal pension, the advice would not arise out of the work being done for the client because it is completely unrelated to the non-regulated work.

Question 23

SRA Scope Rule 2: complementary

Answer 23

To work out whether or not the activity is complementary you need to ask yourself if the specified activity arises naturally out of the work the solicitor is doing for the client - if it does not, then the work is not complementary.

Examples of legal work where regulated activities might arise out of or be complementary to such work are as follows:

Property work: giving legal advice, drafting documents and undertaking a conveyancing transaction involving a regulated mortgage.

Corporate work: giving legal or tax advice, drafting documents to effect the sale of shares or other (specified) investments.

Litigation work: giving legal or tax advice, drafting documents and dealing with court proceedings where regulatory matters are involved.

It is not possible for a solicitor to undertake a regulated activity in isolation for a client and still have complied with 2.1(b).

Question 24

SRA Scope Rules and SRA COB Rules

Answer 24

The SRA Scope Rules contain other restrictions imposed on firms carrying on certain exempt regulated activities. For a solicitor to carry out a regulated activity without the need for authorisation by the FCA, they must comply with all the other provisions of the SRA Scope Rules and the provisions of the SRA COB Rules.

The SRA COB Rules contain a number of obligations for firms carrying out exempt regulated activities, including regarding disclosure of information about the solicitor’s status, keeping records of transactions, records of commissions, safekeeping of clients’ investments. There are also a number of rules for solicitors involved in insurance activities.

Question 25

3.Selling shares in companies

Answer 25

The Financial Conduct Authority (‘FCA’) is concerned to ensure that prospective buyers of shares are properly advised and have accurate information about the investments they make. A number of restrictions are imposed on solicitors involved in advising sellers, and buyers of shares, under FSMA. Many activities can only be carried out by people authorised by the FCA.

If you are acting for a client selling shares, you should be aware of two restrictions in particular:

The restriction on financial promotions under s 21 Financial Services and Markets Act 2000 (‘FSMA’); and

The requirement for an approved prospectus where shares are to be offered to the public, under s 85 FSMA.

Question 26

4.Restriction on financial promotions

Answer 26

Section 21 FSMA provides that it is a criminal offence for an unauthorised person to communicate a financial promotion unless an authorised person has approved its contents or a relevant exemption applies.

Following text is in a box:

‘s 21 FSMA

(1) A person (‘A’) must not, in the course of business, communicate an invitation to inducement to …engage in investment activity.

(2) But subsection (1) does not apply if –

A is an authorised person; or

The content of the communication is approved…by an authorised person’

Question 27

Restriction on financial promotions – exceptions

Answer 27

Solicitors advising sellers on share sales are often involved in producing documents that constitute an invitation to engage in investment activity – for example an information memorandum where the shares are being sold at an auction.

Getting the content of the information memorandum approved by a person authorised by the FCA can be time consuming and expensive for the client.

There are three exemptions to the restriction on financial promotions that are useful for company solicitors in practice:

Sale of a body corporate – very useful.

Investment professionals – can be useful

High net worth – can be useful.

Question 28

Sale of a body corporate exemption

Answer 28

Article 62 of the FSMA 2000 (Financial Promotions) Order 2005 (‘FPO’) provides an exemption from s 21 FSMA where the communication relates to a transaction to acquire 50% or more of the shares or day to day control of the company provided certain conditions are met.

Question 29

Article 62 FPO – sale of a body corporate exemption

Answer 29

‘The transaction is to acquire or dispose of shares in a body corporate’

AND

The shares consist of 50% or more of the voting shares in the body corporate; OR

the shares together with those already held by the purchaser consist of at least 50% of such shares; AND

the acquisition or disposal is between parties each of whom is a body corporate, partnership, single individual or group of connected individuals. (NB the buyer and seller do not need to be the same type of entity).

OR

the object of the transaction is to acquire day to day control of the company; AND

the acquisition or disposal is between parties each of whom is a body corporate, partnership, single individual or group of connected individuals. (NB the buyer and seller do not need to be the same type of entity).

Question 30

Other exemptions from s 21 FSMA

Answer 30

There are other exemptions which may also apply if a solicitor is selling shares in a company. They include ensuring that the information memorandum (or other documentation) is only distributed to persons believed to fall within one of other exemptions. These include:

Investment Professionals: For example:

A person authorised by the FCA

(art 19 FPO)

High net worth companies:

For example: a company with a called up share capital of not less than £5 million (or £500,000 for a body corporate with more than 20 members) (art 49 FPO)

High net worth individuals:

Certified high net worth individuals (art 48 FPO)

Certified sophisticated investors (art 50)

Question 31

Requirement for an approved prospectus

Answer 31

Under section 85 FSMA it is a criminal offence to offer shares to the public in the United Kingdom without a prospectus.

The prospectus must be approved by the relevant regulatory authority, ie the FCA.

The following text is in a box:

‘s 85 FSMA

(1) It is unlawful for transferable securities to which this subsection applies [ie shares] to be offered to the public in the United Kingdom unless an approved prospectus has been made available to the public before the offer is made. ‘

Question 32

Prospectus – exemptions

Answer 32

Getting a prospectus approved by the FCA can be time consuming and expensive for the client.

There are two exemptions that can be useful in practice:

Text in a box: the offer is made to or directed at fewer than 150 persons. – Very useful

Text in a box: The offer is sent only to ‘qualified investors’ (eg banks, investment institutions and national and regional governments) – Can be useful.