INVESTMENT CLUBS AND FINANCIAL SERVICES LAW
CONTENTS
Introduction ........................................................................................................................................................................ 1
The General Prohibition (“GP”) .......................................................................................................................................... 2
GP - The Business Test ........................................................................................................................................................ 2
GP - Regulated Activities ..................................................................................................................................................... 3
GP - Establishing or Operating a Collective Investment Scheme ........................................................................................ 4
GP – Group Exemption – a false hope ................................................................................................................................ 5
GP – Deposit taking............................................................................................................................................................. 6
GP - MiFID ........................................................................................................................................................................... 6
Financial Promotion ............................................................................................................................................................ 6
Conclusions ......................................................................................................................................................................... 7
INTRODUCTION
Recently I was asked about the law relating to Investment Clubs. The Investment Club had been going for many years,
with meetings arranged on a monthly basis, and had about 50 members each contributing a reasonably modest
amount per month. A problem arose when their broker, who supplied investment advice and not just execution only
services, sought legal advice. I have not seen this advice but the consequence was that the investment adviser
immediately resigned. Naturally this caused some consternation as the members of the club are pillars of the local
business community with reputations to protect. Could there be something illegal about an Investment Club?
There is no particular law or exemption relating to Investment Clubs. One has to do an analysis of financial services
law and see how it impacts on Investment Clubs. Perhaps there may be those of you reading this who are
unaccustomed to the UK financial services legislation and might be astonished at the tortuous regulatory maze that
has to be negotiated, in order to extract the answer(s) to what seems a simple question. Therefore let me give a short
background.
Unlike most legislation, which essentially starts from the idea that the citizen is allowed to do things unless prohibited,
with financial services law many activities are prohibited unless there is an exemption or an exclusion. Also much of
financial services law appears Delphic (e.g. what is the correct definition of a business, what exactly does arranging a
deal encompass or what does exercising day to day control really mean?). Years ago I had the good fortune to have a
brief discussion with Michael Heseltine who was the Government Minister in charge for a time of financial services
legislation and he indicated there was no stopping his officials who wanted to regulate everything and at any
opportunity he would relish in approving an exemption or exclusion. While we like to think the law is made by those
we elect to Parliament most laws are made by unelected officials but the law is the law and must be obeyed.
Before I go further, the sort of Investment Club this note is about is where friends, neighbours and others with an
interest in investing get together to discuss the best ways of investing particularly in the stock market. They want to
improve their knowledge of investing by exchanging news and views and they probably agree to put a reasonably
small monthly amount of say £50 into a pot which the Club as a whole will invest with each member having units in
the central pot. Also this note is intended to focus on investing in shares. There are separate laws that deal with say
insurance products and more esoteric products such as contracts for differences and any Club which wishes to invest
in anything other than straightforward shares ought to consider any legislation peculiar to that product.
THE GENERAL PROHIBITION (“GP”)
Breach of the General Prohibition, contained in section 19 of the Financial Services and Markets Act 2000 (“FiSMA”),
carries a possible two years in prison and an unlimited fine as well as making any agreements entered into or as a
result of the activities by a person in breach unenforceable. It states:
“(1) No person may carry on a regulated activity in the United Kingdom, or purport to do so, unless he is:
(a)
an authorised person; or
(b
an exempt person.”
We must next look for the meaning of regulated activity which is contained at s22 of FiSMA and states:
“(1) An activity is a regulated activity for the purposes of this Act if it is an activity of a specified kind which is carried
on by way of business and (a)
relates to an investment of a specified kind; or
(b) in the case of an activity of a kind which is also specified for the purposes of this paragraph, is carried on in
relation to property of any kind.”
GP - THE BUSINESS TEST
We see from s22 of FiSMA that to be caught by the General Prohibition the activity must be carried on by way of
business. Thus before looking at the detail of carrying on a regulated activity there has to be a discussion on whether
whatever was being carried on amounts to a business.
When we turn to the FSA Rules Perimeter Guidance PERG 2.3.3 it states:
“Whether or not an activity is carried on by way of business is ultimately a question of judgement that takes account of
several factors (none of which is likely to be conclusive). These include the degree of continuity, the existence of a
commercial element, the scale of the activity and the proportion which the activity bears to other activities carried on
by the same person but which are not regulated. The nature of the particular regulated activity that is carried on will
also be relevant to the factual analysis.”
If a court was considering whether you as a member of an Investment Club were carrying on a regulated activity by
way of business the judge would consider the FSA guidance and then in my view apply common sense and put
considerable emphasis on whether you were involved in the activity of arranging etc. in return for remuneration. It is
clear that you can carry on a business with or without a view to profit but it would be perverse for a judge to decide
you were carrying on a regulated activity as a business when you were not receiving any form of remuneration for
your work. For instance if one member of the club helps another member make up his mind on which investment to
buy or sell, common sense (without the need for much legal analysis) can in most circumstances tell whether that
member is carrying on a business when doing so. Thus if one or more members are charging for their services to
others then more detailed analysis is required. But if it is a regular club where members do not charge one another it
is unlikely that any one member is carrying on a regulated activity by way of business.
The position would be different if the club was incorporated as a company or an LLP or was in fact treated as a general
partnership. There would have to be an analysis of the activity of the entity and in particular an LLP or a general
partnership can only be set up as a business with a view to profit.
There are also complications if it is an Investment Club for private equity. These clubs might be formal groupings run
by a firm authorised by FSA or run by a body corporate which has as its principal object the promotion of commercial
activity in the UK so long as it does not carry on that activity for or with the prospect of direct or indirect pecuniary
gain (FiSMA 2000 (Exemption) Order 2001, Sch, Part IV para 40). However such Clubs are often just informal
groupings of wealthy individuals whose members generally take it in turn to investigate likely investment
opportunities and no one member gains an advantage over other members for his or her efforts. A problem might
arise in those private equity clubs where one individual spends much effort in negotiating and structuring a
transaction. In those circumstances the negotiator may justifiably be tempted to seek recompense from his fellow
members. My view is he ought to resist and look only to the terms of his investment (and perhaps directorship) with
the investee company.
The question of whether you are carrying on the regulated activity by way of business is vital as it is your first line of
defence and only if that line of defence is crossed do you need to consider the detail of the exclusions from the
various regulated activities.
GP - REGULATED ACTIVITIES
The interpretation of s22 is assisted by FiSMA (Carrying on Regulated Activities by Way of Business) Order 2001 where
article 3 inter alia states, with my comments in square brackets:
“(1) A person is not to be regarded as carrying on by way of business an activity to which paragraph 2 applies, unless
he carries on the business of engaging in one or more such activities.
(2) This paragraph applies to an activity of the kind specified by any of the following provisions of the Regulated
Activities Order, namely—
(a) article 14 (dealing in investments as principal); [Under article 15 this is disapplied unless essentially you are market
making and so it is difficult to see how it is applicable to Investment Clubs.]
(b) article 21 (dealing in investments as agent); [Under article 22 this does not apply if you are making the
arrangements for the other members with or through an authorised person, it is clear no one at your club has sought
advice from you (and if they have you declined to give it and recommended they seek the advice from an authorised
person) and if you receive a pecuniary reward or advantage from anyone (other than from your fellow members for
whom you are making arrangements) you must account to your fellow members for whom you are making
arrangements. Investment Clubs normally deal in listed shares and so dealing is through a securities broker (who will
require to be authorised). Remuneration is not a problem with normal Investment Clubs where there is no payment
to members except to cover expenses. An issue might arise with advice, given that Investment Clubs rely on
individual members doing research on particular opportunities and then reporting back to members who take the
decision as a unit and then delegates a member to implement the decision of the Club. Questions that arise include is
the person implementing the decision of the Club an agent of individual members and if so was he or she the person
who reported back on the particular share and did that report amount to advice. Let us not lose sight though that
here we are talking of the second line of defence and the first line of defence (the activity of dealing in investments as
an agent was not being carried on as a business) ought to hold firm in almost all normal situations for an Investment
Club.]
(c) article 25 (arranging deals in investments); [Article 25 is the one that catches many activities connected with
investments. There is an exclusion at 28 which essential says 25 shall not apply if the person making the
arrangements is to enter the transaction himself or as agent for another person. Another exclusion is at 29 when
arranging a deal through an authorised person, which is similar to article 22 mentioned above, so I do not repeat it
here. However whether an exclusion applies depends on the exact circumstance and an exclusion may not always
apply. It might be appropriate to mention that many Investment Clubs have members whose day job is in part to
arrange deals in investments such as lawyers, accountants, bankers, corporate brokers and investment advisers. In
their day jobs some may be authorised or use the exclusion at article 67 which refers to any activity which “is carried
on in the course of carrying on any profession or business which does not otherwise consist of regulated activities; and
may reasonably be regarded as a necessary part of other services provided in the course of that profession or
business.” This exclusion is useful to lawyers and accountants acting in the course of their day to day business but
does not help them when acting as a member of an Investment Club.]
(d) article 37 (managing investments); [This is managing assets involving the exercise of discretion. Thus where you
are asked to buy or sell specific securities following a meeting of the club you will not be caught by this activity. An
issue might arise where an absent member gives authority for the committee or another member to act on his behalf.
This is not a problem providing the first line of defence holds firm.]
(e) article 40 (safeguarding and administering investments); [This does not apply where you are providing information
on the number of units or value of assets safeguarded or receiving documents for passing on. However it might apply
if you held on to the documents and dealt in the income arising from the investment. There is also the problem that
the wording of the regulated activity includes: “arranging for one or more other persons to carry on” the safeguarding
and administration of assets belonging to another. Normally a member of the club arranges a brokerage account
where the assets are kept and there seems no exclusion is available except of course this is only relevant if the activity
is carried on by way of business.]
(f) article 45 (sending dematerialised instructions); [This is to do with the Crest system and I believe the ordinary
member of the public only has the ability to send these instructions through an authorised person.]
(g) article 51 (establishing etc. a collective investment scheme); [Probably this is the regulated activity giving rise to the
greatest frisson within Investment Clubs and given its importance I comment on it in a separate section below.]
(h) article 52 (establishing etc. a stakeholder pension scheme); [It would be an obscure set of circumstances that made
this relevant to Investment Clubs.]
(i) article 53 (advising on investments); and [This refers to giving advice to members of your club on the merits of
buying, selling etc. a particular investment. Given the nature of Investment Clubs each member is expected to
research particular shares and report back. Simply giving information to fellow members “without any comment or
value judgement on its relevance to decisions which an investor may make is not advice” (FSA Handbook Perg 8.28.2).
However the member doing the research is expected by his colleagues to report back with an opinion and in effect
while he or she might try and avoid it there will in effect in many cases be a recommendation and so it seems
investment advice is an inescapable issue for Investment Clubs. There is no exclusion from the regulated activity of
carrying on business of giving investment advice. I emphasise that to be guilty of an offence it would have to be
shown you were carrying on the business of advising on investments which, in a normal Investment Club where no
one is paid (other than expenses), is unlikely. Perhaps it is worth mentioning that business consultants who advise
companies avoid this regulated activity by ensuring that their advice is always to the directors in their capacity as
directors and not (unless they are authorised) in their capacity as shareholders). I do not see though how this route
could be made to apply to say the Chairman and officers of the Investment Clubs as democracy and everyone having a
vote is so essential to the nature of Investment Clubs (even if we were not concerned with day to day control issues
discussed below in relation to Collective Investment Schemes)].
(j) article 64 (agreeing), so far as relevant to any of the articles mentioned in sub-paragraphs (a) to (i).”
I emphasise again that these activities are only relevant if you can be shown to be carrying any of them on by way of
business. The first line of defence in any Investment Club ought to be that none of these activities are carried on by
way of business and the second line of defence is that an exclusion applies.
GP - ESTABLISHING OR OPERATING A COLLECTIVE INVESTMENT SCHEME
A collective investment scheme is defined at s235 FiSMA. Subject to the business test an Investment Club will involve
a collective investment scheme if there is a pool of money or other property where the arrangements are “such that
the persons who are to participate (“participants”) do not have day to day control over the management of the
property, whether or not they have the right to be consulted or give directions” (S235(2) of FiSMA). Thus theoretically
you may have a problem if you are in an Investment Club where the decisions are effectively taken by one or a few
members. However with a little planning it ought to be possible to organise the Club into a democratic organisation
with power over the management of the investment firmly in the hands of the members rather than a central clique.
A couple of cases, Russell-Cooke Trust Co v Elliott's 2001 and Financial Services Authority v Fradley 2005, give guidance
on the language at 235(2). However they are not fully on point.
There does seem to be an argument over the meaning of “persons” in s235(2) based on the fact that the
Interpretation Act 1978 allows that unless the contrary intention appears the plural can include the singular. This
creates the argument that it is unclear whether the participants collectively or individually must have day-to-day
control. It would make nonsense of the wording at s235 (2) if each single participant actually had to have day-to-day
control over the management of the property (on the basis that only one person at a time can have proper control). I
have faith in the common sense of our judges and I believe any almost all our judges would interpret the sub-section
to mean that the participants as a group must have that day-to-day control – although you ought to expect any judge
to be difficult if he or she finds that even one participant has actually handed over discretionary management to a
third party.
There are also questions on why the words “whether or not they have the right to be consulted or give directions”
have been added at the end of s253(2). It seems to emphasise that not only must the participants have the right to
exercise day to day control but they must in addition actually exercise that right. This begs the question how regularly
a client must actually exercise control for his control to constitute "day-to-the control" for the purposes of s235 (2).
Another question is how many can you have in the Club. Is there a magic number where you can have day to day
control in the hands of the participants but above that number the judge would say it is not feasible for so man y
participants to have day to day control? If there is a number is it 20 or 50 or more per Club? My view is that the
number of participants might well be a factor in determining whether the participants had day to day control but it
would be a strange judge who decided on an actual number as it all depends on the detailed way in which the Club is
organised and managed.
ProShare Investment Clubs suggests the number of members of a Club should be restricted to 20. The number 20 I
believe is based on a sensible maximum for ensuring all can participate in a discussion at a meeting and is not based
on a legal requirement. If meetings are held electronically then, given modern means of communications, I suspect
many more than 20 could participate in decisions.
The FSA’s Handbook at PERG 11 has useful guidance on Property Investment Clubs (e.g. buy-to-let syndicates).
However although it refers several times to “day to day” control it does not really address questions in relation to
normal Investment Clubs. A Property Club normally has a property manager (who will be earning remuneration) at its
heart and so it is easier to point the finger at a likely operator of a collective investment scheme. With a normal
Investment Club it is more difficult to point the finger and find an actual operator of a scheme and if there is no
obvious operator it is more difficult if not absurd for the prosecutor to argue that there was illegal “operating” of a
collective investment scheme .
The above discussion on collective investment schemes ought to be irrelevant to almost all Investment Clubs as the
relevant legislation only applies to establishing or operating a collective investment scheme “which is carried on by
way of business”. It will be a peculiar judgment that decides an Investment Club is a business where it does not pay
remuneration to anyone involved in running the Club.
GP – GROUP EXEMPTION – A FALSE HOPE
There are various Group exclusions in article 69. The question arises as to whether an Investment Club is a Group for
the purposes of the legislation. The definition of Group at s421 of FiSMA includes you and any person who is an
undertaking in which you have a participating interest. An undertaking may be an unincorporated body such as a club
carrying on a business with or without a view to profit. However a participating interest is generally intended to refer
to holdings of 20% or more of the undertaking. Thus it is difficult to see how the Group exclusion can be of assistance
to an Investment Club.
GP – DEPOSIT TAKING
The above only deals with regulated activities for the purpose of assessing whether a business is being carried on.
There are other articles in the Regulated Activities Order which are relevant to Investment Clubs.
For instance many Investment Clubs have members investing £20 or £50 a month into a central pool. The law is that
accepting deposits is a regulated activity if:
“(a) money received by way of deposit is lent to others; or
(b) any other activity of the person accepting the deposit is financed wholly, or to a material extent, out of the capital
of or interest on money received by way of deposit.” (Article 5)
I have difficulty believing a judge would find that the monthly payment was a loan – given that individual members
regard it as a subscription for shares. As regards (b) it ought not to apply to Investment Clubs as monthly
subscriptions will normally be paid to a bank or a broker who have appropriate authorisation to accept deposits.
GP - MIFID
More difficult to comprehend properly is the possibility that what is generally called the MiFID override might apply to
Investment Clubs. For those not familiar with the term, MiFID refers to the Markets in Financial Instruments Directive
2004/39/EC as subsequently amended which seeks to harmonise investment services across the EEA and which
inevitably has had a complicating impact on existing financial services law. Basically the law now says that where an
investment firm “provides or performs investment services and activities on a professional basis“ and in so doing
would be regarded as carrying on as a regulated activity then most of the exclusions are to be disregarded. Almost all
members of an Investment Club would scratch their heads and wonder what on earth has this law to do with
Investment Clubs. An investment firm is defined as “any person whose regular occupation or business is the provision
of one or more investment services to third parties and/or the performance of one or more investment activities on a
professional basis.” The thought that an Investment Club consisting of the butcher, the baker, the candle stick maker
and their modern equivalents could be carrying on investment activities on a professional basis is incredulous.
However remember that these exclusions only become relevant when your first line of defence is breached and it is
found you were carrying on a regulated activity by way of business. Essentially the point is that once you are shown to
be carrying on regulated activity by way a business it is but a short step for a judge also to decide you were providing
investment services on a professional basis and so the MiFID override is triggered. It does seem absurd that an
amateur Investment Club could trigger the MiFID override but the problem is that if it happened almost none of the
exclusions work. Therefore given this theoretical possibility the firm focus of any Investment Club must therefore be
to ensure no member can be regarded as carrying on a regulated activity within the Club as a business.
FINANCIAL PROMOTION
There are two main statutory instruments supporting FiSMA that concern Investment Clubs. One is the Regulated
Activities Order, which is discussed above, and the other is FiSMA (Financial Promotion) Order 2005. The basic
restriction on financial promotion is contained at s21 FiSMA which states a person must not, in the course of business,
communicate an invitation or inducement to engage in investment activity. Many people who have spent their
careers in the financial services industry get muddled up between the Regulated Activities Order and the Financial
Promotion Order so it is not feasible to think of the average member of an Investment Club having a proper grasp of
the finer intricacies of these two Orders.
The first thing for you to notice though with the Financial Promotion Order is that it only catches you “in the course of
business”. As seen above there is a statutory interpretation of carrying on by way of business when dealing with the
Regulated Activities Order but there is as yet no equivalent interpretation for the Financial Promotion Order. The
phrase therefore has its ordinary or natural meaning. It is clear that it is intended to exclude discussions within the
family or with friends in the pub. If though a judge was considering whether you were making a financial inducement
during a meeting at your Investment Club in the course of business he would consider all the circumstances but the
most important factor is probably your commercial interest in communicating the financial promotion. For instance it
might be you are promoting a business where you already have a considerable stake.
Let us suppose though that the complainant gets through your first line of defence (which seems easier to do than for
the Regulated Activities Order) and somehow shows you are communicating a financial promotion in the course of
business. Do you have any exclusions or exemptions that are relevant?
An obvious exemption is at article 28 which states:
“(1) The financial promotion restriction does not apply to a one off communication which is either a non-real time
communication or a solicited real time communication.
(2) If all the conditions set out in paragraph (3) are met in relation to a communication it is to be regarded as a one off
communication. In any other case in which one or more of those conditions are met, that fact is to be taken into
account in determining whether the communication is a one off communication (but a communication may still be
regarded as a one off communication even if none of the conditions in paragraph (3) is met).
(3) The conditions are that—
(a) the communication is made only to one recipient or only to one group of recipients in the expectation that they
would engage in any investment activity jointly;
(b) the identity of the product or service to which the communication relates has been determined having regard to the
particular circumstances of the recipient;
(c) the communication is not part of an organised marketing campaign.”
I suspect the above has unusual clarity for financial services legislation as it applies to Investment Clubs and there are
only three additional points I shall make:
1.
2.
3.
The reference to a group engaging in any investment activity jointly clearly seems to apply to members of an
Investment Club;
A one-off communication can be made several times on different occasions relating to the same investment;
The reference to solicited real time communications refers to solicited interactive dialogues which you would
normally expect at a meeting of the Investment Club but an email is not regarded as real time. As regards the
interpretation of “solicited” suffice it to say that a properly organised Investment Club ought not to have a
problem particularly as the legislation states that where a real time communication is solicited by one
recipient it is treated as having been solicited by any other person to whom it is made at the same time if that
recipient is “expected to engage in any investment activity jointly with” the original intended recipient. For
once this seems a piece of financial services legislation that is deliberately helpful to Investment Clubs.
CONCLUSIONS
Investment Clubs that do not pay remuneration for any regulated activity to its members ought to be safe from the
General Prohibition on the basis that neither the club nor individual members (in their capacity as members) are
carrying on a regulated activity by way of business. If there is a member of the Club who does have a business
carrying on a regulated activity as his or her regular day job then they ought to wear a separate hat when acting as a
member of the Club.
I guessed when I started on this review I would find that even if there was a business then each regulated activity
would have an applicable exclusion. However the basic function of an Investment Club is to have individual members
research different shares and report back to other members. The reporting back may not amount to investment
advice but it may well do so (and there is no exclusion from the offence of unauthorised advising on investments as a
business). Thus there is a possible breach in the second line defence which spills over to mess with the exclusions for
dealing as agent or arranging deals in investments.
The message therefore is to ensure that no member of the Club is carrying on a business of a regulated activity within
the Club. Personally I have difficulty seeing a judge deciding there is a business for such an activity within a normal
Investment Club unless there is remuneration being paid for the activity.
As regards the Financial Promotion Order again you must be carrying on a business before it becomes worrisome. If
that defence is lost then my view is that the exemptions in the Order are designed to permit the normal activities of
an Investment Club.
Reverting to the case which started this analysis I did not see the brief to the advisers nor their advice. My guess
though is the advice related to the peculiar status of their client who was a member of the Club and who worked for
an FSA authorised firm who was not only providing execution services but also giving investment advice to the
members. In particular FSA Rules are onerous on such firms who give investment advice to Investment Clubs rather
than just act as executing broker. There is an increased focus on firms meeting their suitability obligations in respect
of investment advice and the cost of meeting the suitability obligations can outweigh the income from an Investment
Club.
There are issues to be faced by Investment Clubs interfacing with their professional advisers – such as is the client one
person or the whole association? Also what will be the unintended consequences of the Retail Distribution Review
(which essentially are more FSA rules for professional advisers)? Equally there are issues about possible Market Abuse
where the Club wishes to sell a sizeable stake in say an AIM illiquid stock. Such issues though are beyond the scope of
this note.
After writing the draft of this note (which I did while reading through say 100 or 200 pages of legislation) I thought it
would be useful to review it against a hard copy of the Perimeter Guidance Manual which forms one of the 67 or so
manuals and sourcebooks of the FSA Handbook. At a guess printing out that one manual consumed about 800 pages.
As I waited regretting pressing the print button I had a vision of our great-grandchildren shaking their heads in
disbelief as they read about the sacrifices in the 20th century of our people to fight for freedom only to allow their
liberties, a few decades later, to be so constrained by such complex financial services legislation. One can only hope
things will improve after the FSA is split but that depends on leadership having a clear goal of simplification for the
private investor (who was not responsible for causing the current financial crisis).
One feels that many politicians and most officials at the FSA believe that the world has not yet invented a problem
that cannot be fixed by yet another rule. One of the problems with this approach is that rules are made to reflect past
experiences and almost inevitably will lead to an unpredictable change in behaviour which may have a negative effect
on the economy such as making us all less entrepreneurial. We all know we need financial regulation but it would be
nice to think that in the future more of our politicians and government officials used their common sense and
focussed less on giving us more regulation and more on better regulation.
Finally I see that ProShare Investment Clubs indicate some years ago there were over 60,000 Investment Clubs in
America and over 12,000 in Britain. It is often difficult for a single investor on his or her own to arrange a sensible
spread of risk and pooling resources with a few like-minded individuals ought to help the spread of risk and improve
decision-making. It seems clear Investment Clubs are a powerful force for good in a developed economy and there is
nothing inherently wrong with them. In particular provided they are organised to ensure they are not carrying on the
business of a regulated activity they ought not to break financial services law.
Tom Mackay, Partner, Mackay Carter Shaw LLP, Solicitors
Lorton, Toys Hill, Kent, TN16 1QG
Office (0) 1732 750 503
www.mackaycartershaw.com Skype: mackaytom