Promotion of Unregulated Collective Investment Schemes (UCIS) and close substitutes in the UK
Our brief article below is not intended as a comprehensive guide as to the rules and regulations that apply to UK financial advisers advising on NMPIs, it merely aims to set out certain points that should be considered when developing a compliant advice process.
Please contact us if you require more detailed guidance.
Regulated or Unregulated?
The FCA register contains a database of collective investment schemes that are regulated for promotion to UK Retail Clients. In the UK, ‘authorised’ funds will be either UK domiciled ‘regulated’ by the FCA, or offshore funds that the FCA lists as ‘recognised’.
If a fund is a Collective Investment Scheme but does not appear on the FCA CIS database, then it will be an Unregulated Collective Investment Scheme (UCIS), and must only be promoted to suitable clients after appropriate procedures have been followed.
"...and close substitutes"
Prior to June 2013, it was apparent that certain investment schemes were managing to skirt the UCIS rules by setting up structures that were not legally defined as Collective Investment Schemes. So, by definition, they could not be Unregulated Collective Investment Schemes and therefore were not caught by the rules governing promotion of UCIS.
PS13/3 extended the rules to cover such schemes and introduced the term NMPI.
There is a diverse spectrum of unregulated funds. They range from well-managed, transparent funds that invest in traditional asset classes, all the way through to highly speculative, opaque funds investing in all manner of obscure assets.
Some key reasons for funds choosing the ‘unregulated’ route are generally:
The costs of setting up and running a UK authorised or a recognised offshore fund often prove to be prohibitive for a scheme that may be starting from scratch, even though it may represent a sound investment opportunity. Launching under the umbrella of, say, an existing Protected Cell Company in Guernsey may make the fund viable due to lower start-up and running costs.
Similarly, the requirement for authorised funds to diversify their percentage exposure to individual assets would mean that, for example, a ‘bricks-and-mortar’ property fund would require a large amount of seed capital investment in order to present a sufficiently diversified portfolio at launch. An unregulated fund could raise investor equity and then buy a single property, acquiring further properties as additional equity flowed in.
The unregulated route allows a fund to accelerate acquisition of assets through borrowing capital alongside equity investment. This does have a positive effect on returns if the cost of borrowing is favourable and asset prices are increasing. However, gearing will accentuate any falls in the underlying assets, and could also present a problem if the servicing cost causes significant drag on returns, any debt covenants are breached, or refinancing cannot be achieved at some point in the future.
NMPIs can be recommended by UK financial advisers as long as they have a clear understanding of the rules governing promotion of such schemes, and a robust process is in place.
Remember that all of the restrictions placed on authorised and recognised funds aim to achieve one thing: Investor Protection. As unregulated schemes are not bound by all of these restrictions, they do not offer the same levels of investor protection (e.g. No FSCS, exposure to a limited range of assets, high gearing, etc.) and therefore represent a high level of risk to the average investor. Although UCIS funds and other products classed as NMPIs are not regulated by the FCA, promotion of and advising to invest in them is.
As an adviser, you will need to be able to demonstrate the following as part of your NMPI process:
Knowing how to establish whether the product in question is a NMPI or not.
Clearly documented evidence that you have researched the fund in order to establish the credibility of the investment strategy, the parties involved in the fund, the risks involved, etc and whether you have found this to represent a viable investment opportunity. Due diligence should be updated at regular intervals.
The term ‘Promotion’ is wide ranging and applies to regulated and unregulated funds. Rules governing the promotion of UCIS had been in place for many years, and these have been updated with effect from 1st Jan 2014 . These rules restrict promotion of UCIS and close substitutes ('NMPIs') to specific categories of clients.
Articles 21, 23, and 23A of the PCIS Order, and COBS Section 4.12 provide a number of exemptions that enable an adviser to legitimately promote NMPIs to qualifying clients. The FCA require you to be able to demonstrate your understanding of, and compliance with these rules. As ever, documentation of the process having been followed is essential, and the appropriate exemption must be in place before promoting an NMPI to a potential investor. There were a number of changes to COBS 4.12 in January 2014 which firms should make themselves familiar with.
Potential investors must be made aware of the risks involved with regard to the NMPI. Typically these would include the fact that investors would not have protection from the Financial Services Compensation Scheme in the UK, or the equivalent in the jurisdiction where the fund is domiciled. There may also be risks associated with illiquidity of assets, risks associated with high gearing, the reliance on the performance of one particular company, and so on. These will have been identified as part of your due diligence, but the client file must show that they have been drawn to the clients attention.
MiFID: This EEA directive has implications for Advisers sending application forms (‘transmitting orders’) to UCIS operators. As many UCIS funds are operated outside of the EEA, an Article 3 MiFID Exempt Firm may breach their regulatory permissions if they send application forms to a UCIS operator outside the EEA. The FSA require firms to ‘self-report’ any breaches, so it is extremely important to understand these issues.
Being able to quickly identify which NMPIs have been reviewed, promoted, and the relevant clients involved will help to demonstrate that a robust process is in place.
Particularly for multi-RI firms, there should be a suitable process in place to ensure that only those advisers who are able to demonstrate their competence in promoting NMPIs are allowed to engage with clients for that function.
Although mainstream, regulated funds will satisfy the needs of the majority of an adviser’s clients, carefully selected NMPIs may represent legitimate investment opportunities for some investors. Such investors will be more financially astute, wealthier, and have a higher tolerance for risk than the average UK investor or ordinary retail client. NMPI investors would also typically have other capital to call upon should the scheme fail or become illiquid.
NMPIs can provide these types of clients with the opportunity to further diversify their investment portfolios, and gain exposure to assets that would not usually be available via more mainstream funds.
Not all NMPIs are the ‘get-rich-quick-doomed-to-fail’ propositions that some commentators would have you believe. There are many financially sound unregulated funds available that can make a valuable addition already diversified investment portfolios for suitable investors.
As with all financial advice, knowing the rules and following them are key constituents in keeping on the right side of the regulator. Knowing your client, your client understanding what you have recommended to them and why, and documenting this advice is simply business as usual.
Incorporating a robust NMPI process into your existing advice process need not be an onerous task and may enhance your proposition for high net worth and sophisticated investors.