Independent financial advisers often operate as small businesses. They are regulated under the Financial Services and Markets Act 2000 and must be authorised to advise on investments.
Due to their size, smaller firms do not typically have the resources to employ someone responsible for compliance. In that situation, they can use external sources such as compliance consultancy firms. The other option is to join a ‘network’. Many IFAs become ‘authorised representatives’ of a much larger organisation providing adviser support services, in return for an annual fee.
Broadly speaking, the network organisation (the principal) the authorisation from the FCA. The individual businesses underneath the principal have their obligations to the regulator monitored and supervised and covered by the umbrella arrangement in the network. Financial intermediary networks have grown over the years and the largest currently has approximately 3,500 individual financial advisers.
The legal effect is that the network assumes regulatory responsibility for its IFAs. Can that lead to legal liability in all circumstances though? Two recent cases have examined where the line is drawn as to when a network should be liable if an adviser goes ‘rogue’.
Tenet v Financial Ombudsman Service (March 2018)
In the first case an IFA defrauded 37 of his clients of £2.9m in a scheme by which he persuaded them to buy apartments in Goa and lend him money, in place of their existing investments. He helped them to sell their investments and pay monies to him, ostensibly to invest in Goa but which he in fact used to gamble or pay his gambling debts.
The fraudster was an authorised representative of the Tenet network of financial advisers. The clients claimed against Tenet via the Financial Ombudsman (FOS), which found for them. FOS exercised its regulatory redress function looking at what was fair and reasonable, as it is required to do, rather than deciding strictly in accordance with the law of negligence. FOS decided that it would be fair and reasonable for Tenet to compensate for the loss caused by the fraudulent activities of the IFA.
Tenet’s view was that, although the IFA was undertaking a regulated activity when advising the clients to sell investments, and was doing so as its appointed representative, he was not undertaking a regulated activity, nor was he acting as Tenet's appointed representative, when he advised them on what to do with the money realised from the sale of assets. It was that advice, to invest in Goan property and/or lend monies to the fraudster, which caused the losses.
The court case was a judicial review of whether FOS had jurisdiction to award compensation in this situation. Only if the activity was regulated could FOS order compensation. The court agreed with FOS that the decision to sell the investments was intrinsically linked to the advice to invest in Goa. The advice to invest elsewhere was directly linked to the sale of regulated investments. Since they could not sensibly be separated it was decided that the advice as a whole was regulated.
The other issue was whether, under FSMA s39(3) Tenet, as the principal of the IFA, was responsible for the advice given by its authorised representative, in relation to the "unregulated" investments. The court agreed with FOS again in deciding that fraud in the course of giving "regulated" advice comes within s39(3). The IFA was not acting in a personal capacity when he gave the advice and therefore he was representing Tenet.
Anderson v Sense (October 2018)
In this similar case an IFA in Aberdeen set up a scheme which involved his clients paying monies to him, purportedly to invest in high return short term deposits. However, the IFA received the cash personally. He was able to make the interest payments to the first investors out of new subscriptions by later investors. The scheme continued until the total invested was £27m, with payments out amounting to £26.6m.
The IFA was an appointed representative of the Sense network. Sense were kept in the dark about the scheme and carried on their regulatory file reviews and oversight, ignorant of the fraud.
The fraud was brought down by a whistle blower reporting the existence of the scheme to Sense, although that person had no idea that the scheme was a free-standing account run by the IFA with no underlying investment.
It was immediately clear that the receipt of deposits by the IFA was not authorised and was manifestly in breach of FSMA.
A group of 95 clients made a claim against Sense seeking to hold them liable as principal by a variety of routes. Claims were made under section 39 of FSMA, actual or apparent authority, breach of supervisory obligations by attribution of knowledge, or failure to monitor, or failure to investigate, and under vicarious liability.
Overall the court considered that the scheme, and advice in connection with the scheme, were well beyond the scope of the "business" for which Sense accepted responsibility pursuant to the authorised representative agreement. It was considered clear that the activities of the fraudster in relation to the scheme, both in terms of operating it and advising on it, were wholly unauthorised.
The court also noted that taking deposits is not the normal activity of a financial adviser, which strengthened the view that there could not have been actual or ostensible authority from Sense to receive client funds.
The claims were made by various legal routes, but they all failed; it remains to be seen whether they will appeal on any aspect.
Sense avoided being held liable, a situation Tenet may find difficult to reconcile when they were found liable for a similarly ‘rogue’ adviser operating a fraudulent scheme.
In both cases there were no evident failings in the network’s level of supervision or compliance systems. Had there been any failings the outcome could have been very different for Sense.
Nonetheless there is a distinction between these types of fraud and all networks and clients need to take note if and when fraud is detected. It would appear that fraud carried out using the proceeds of regulated investments is liable to be compensated, but if loss is caused by a fraud using fresh subscriptions it is less likely to be recovered.
That might sound like an unfortunately technical distinction, since both schemes at their heart had a dishonest IFA and clients will consider they ought to be compensated if regulatory protection has any meaning. FOS has greater latitude to compensate based on principles of ‘fairness’ rather than the letter of the law and it is at least possible that, had each of the 95 Sense claimants applied there, they might have benefitted from a more sympathetic ear than that of Mr Justice Jacobs.
The FOS compensation limit looks likely to rise from £150,000 to £350,000 on 1 April 2019 and that is an unpalatable prospect for networks in light of the Tenet case.