Reforming Corporate Retail Investor Protection

Regulating to Avert Mis-Selling

Diane Bugeja

• Publisher: Hart Publishing
• Year: 2019
• ISBN:
  9781509925889
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

The spate of mis-selling episodes that have plagued the financial services industries in recent years has caused widespread detriment to investors. Notwithstanding numerous regulatory interventions, curtailing the incidence of poor investment advice remains a challenge for regulators, particularly because these measures are taken in a 'fire-fighting' fashion without adequate consideration being given to the root causes of mis-selling. Against this backdrop, this book focuses on the sale of complex investment products to corporate retail investors by drawing upon the widespread mis-selling of interest rate hedging products (IRHP) in the UK and beyond. It brings to the fore the relatively understudied field concerning the different degrees of investor protection mechanisms applicable to individual retail investors – as opposed to corporate retail investors – by taking stock of past regulatory reforms and forthcoming regulatory initiatives as well as, more importantly, the conclusions reached by the judiciary in IRHP mis-selling claims. The conclusions are particularly interesting: corporate retail investors are in a vulnerable position when compared to individual retail investors. The former are exposed to a heightened risk of mis-selling, meaning that regulatory intervention should be targeted accordingly. The recommendations made as a result of these findings are further supported by insights emerging from behavioural law and economic theories. This book is aimed at researchers, lawyers and students with an interest in the financial regulation field who are keen to explore potential regulatory reforms to the investment services regime that address the root causes of mis-selling, and restore a level playing field amongst all retail investors.

PART I

The Illusion of Uniformity

The regulatory model … failed. The standard orthodoxy was that… people make rational decisions when given sufficient information; that markets are self-correcting organisms; and … that if you oversee distribution channels … the right products get to the right people. All three orthodoxies failed.¹

¹FSA, ‘My vision for the FCA’ Speech by Martin Wheatley (British Bankers’ Association, London, 25 January 2012): www.fsa.gov.uk/library/communication/speeches/2012/0125-mw.shtml, accessed 25 August 2015.

1

Breadth of Investor Protection Regulation

I.Why Regulate to Protect Retail Investors?

The history of financial services regulation has shown, albeit with the benefit of hindsight, that law and regulation are unlikely to evolve as rapidly as market practices and therefore swiftly become obsolete. This, together with the magnitude of investor detriment that has been registered in recent years, suggests that the need for more effective investor protection regulation has become ‘self-evident’.²

Both the common law and the regulatory framework for investment services are rooted in the neo-classical economic theory. This model is based on the assumption that investors act rationally such that, as long as they are supplied with accurate information, investors are presumed ‘willing and able to use it wisely’.³ Seen from this perspective, investor protection only becomes necessary where market failures arise, which failures are commonly attributed to information asymmetries such that disclosure is used as a central regulatory tool to support better decision-making and stronger market-based investing.⁴ The effectiveness of this approach, which is founded on the notion of caveat emptor,⁵ is dampened in the present climate marked due to the ever-increasing number of mis-selling scandals that have caused widespread investor detriment. Although regulators seem to have acknowledged the need for more paternalistic interventionist tools, elements of caveat emptor are still evident in the UK’s regulatory framework as well as in the deliberations of the English judiciary, particularly where certain categories of investors are concerned.

At a macroeconomic level, mis-selling poses a risk to financial stability and can have a de-stabilising effect on the balance sheets of investment firms, which in turn makes the economy prone to systemic risk.⁶ At a micro level, retail investors may also suffer from significant financial detriment. Indeed, since the pensions mis-selling scandal in the late 1980s, the UK has witnessed numerous incidences of investment products’ mis-selling.⁷ These episodes have caused widespread investor detriment and have contributed towards driving the overhaul of the UK’s regulatory system throughout the years. Amongst these reforms, one finds the abolition of the concept of self-regulation in the wake of structural changes that led to the establishment of the Financial Services Authority (FSA) in the late 1990s, and, subsequently, the restructuring of the FSA that resulted in the adoption of a ‘twin peaks’ model of regulation during 2013. The latter was implemented by the Financial Services Act 2012 (FSA 2012) and had the effect of splitting the then FSA into the FCA and the Prudential Regulatory Authority (PRA). The establishment of the FCA meant that investor protection concerns took on a more prominent role on the agenda of a regulator that focuses on conduct regulation and pursues objectives which include the protection of consumers and, therefore, retail investors.⁸ More recently, the increasing use of new interventionist tools by the FCA suggests that the regulatory mind-set that previously promoted caveat emptor is shifting towards a more paternalistic approach.

Reforms were also evident at an EU level to the MiFID regime,⁹ in response to the investor detriment caused by the global financial crisis as well as numerous other incidences of retail market detriment. These measures were dominated by the introduction of regulatory reforms aimed at enhancing the safety of financial products as well as improving their transparency and accessibility.

Despite these regulatory reforms and the imposition of hefty penalties on the industry the familiar cycle of investment product mis-selling, massive investor detriment, and the problems of securing redress for corporate retail investors, has proved particularly hard to break. Rather than simply being reduced to ‘coincidental cocktail of circumstances’,¹⁰ these events can be described as classic characteristics of mis-selling driven by the complexities of regulation and the novelty surrounding certain intricate investment products. Further, these episodes also have one common fact at their core – the retail investor being sold a product that could place him at an actual or potential financial disadvantage primarily triggered by a mismatch between the product’s complexity and the investor’s financial acumen, circumstances, and risk appetite.

Investor protection, as one of the core objectives of investment services regulation, remains dominated by a ‘complex blend of statutory and non-statutory’¹¹ instruments, primarily inspired by reactions to major market events. These measures however do not fully address the disparities between investor protection frameworks applicable to different categories of retail investors (and which render corporate retail investors more vulnerable to registering financial losses as a result of mis-selling, in comparison to individual retail investors). Indeed, as also acknowledged by the FCA itself, these regulatory developments have come about as a ‘mechanistic response’¹² to scandals and crises, as regulators were more concerned with fighting fires rather than analysing the root causes giving rise to mis-selling. In consequence, the combination of opaque products, a competitive selling environment, and increasing retail investor participation in financial markets, remains an intractable challenge that requires the regulators’ attention and that has put to the test the robustness of past and present regulatory frameworks, particularly insofar as corporate retail investors are concerned.

Against this backdrop, the diverging treatment of different categories of retail investors emerges as one of the primary root causes of the mis-selling of complex investment products. Indeed, the position of corporate retail investors underlines a number of lacunae in the application of the investor protection framework to the needs and circumstances of this category of retail investors, as their exposure to the risk of mis-selling is further exacerbated by the principles underpinning the common law regime.

II.Categorising Retail Investors

A.Individual v Corporate Retail Investors

A ‘retail’ investor’ is defined in MiFID II by opposition to, or exclusion of, a ‘professional investor’.¹³ For the purposes of this definition, retail investors include both natural persons (what this book terms ‘individual retail investors’) as well as corporate entities (referred to in this book as ‘corporate retail investors’), unless these fall within the de facto definition of ‘professional’ investor,¹⁴ or otherwise request to waive some of the protections afforded by the conduct of business rules by electing to be treated as professional investors subject to meeting certain criteria (known as ‘elective professional investors’).¹⁵

Professional investors typically include institutional investors whose main activity is to invest in financial instruments, as well as large undertakings meeting specific size requirements. The size-based thresholds set out in the MiFID definition of ‘professional investors’ are lower than those set out in the Commission’s definition of micro, small and medium-sized enterprises (SMEs),¹⁶ meaning that corporate entities that do not meet the thresholds attached to the ‘professional investor’ definition under MiFID are small, unsophisticated entities that are presumed to have the same (relatively low) level of financial acumen and sophistication, that generally lack access to financial and professional resources, and that do not engage in complex investment transactions on a regular and habitual basis.

It is pertinent to note that, prior to the MiFID regime coming into force in the UK on 1 November 2007,¹⁷ UK investors were categorised in a different manner. The client classification provisions in the then FSA’s Conduct of Business Sourcebook (COB)¹⁸ provided for three categories of clients, being private customers, intermediate customers, and market counterparties. Private customers included the least sophisticated investors who were accordingly entitled to the greatest degree of regulatory protection; intermediate customers comprised the more experienced investors generally having either appropriate expertise in-house or the means to pay for professional advice when needed;¹⁹ and market counterparties included those investors who were experienced in financial products and markets (and hence sufficiently sophisticated to operate within a ‘light-touch’ regime without the application of most regulatory protections) as well as authorised counterparties operating within the inter-professional regime. Once the MiFID classification took effect, private customers were generally grandfathered to the retail category under MiFID; intermediate customers were classified as either retail or professional clients depending on the applicable quantitative thresholds; and market counterparties were mapped onto the eligible counterparty category under MiFID²⁰ (with some being classified as professional clients in certain circumstances).

B.Uneven Retail Investor Protection

It has been established that the MiFID regime only distinguishes between the broad categories of ‘retail’ investors and ‘professional’ investors and does not provide for more granular sub-divisions within the ‘retail’ category itself. Any investor falling within the definition of ‘retail’ investor is hence entitled to the same level of protection irrespective of whether the investor is an individual or a corporate. Yet, the protection extended to the corporate sub-set of retail investors through the MiFID regime is diluted by domestic UK legislation that exists alongside the MiFID framework and which has a restricted scope that operates to the exclusion of corporate retail investors.

When individual retail investors purchase investment products, they enjoy certain rights and protections under the UK general consumer protection legislation and also under financial services-specific regulation, which are designe...

Table of contents

• Cover
• Title Page
• Preface and Acknowledgements
• Table of Contents
• List of Acronyms and Abbreviations
• Table of Cases
• Table of Legislation
• PART I: THE ILLUSION OF UNIFORMITY
• PART II: THE REGULATORY AND LEGAL INTERPRETATION OF ‘INFORMATION’ AND ‘INVESTMENT ADVICE’
• PART III: CONCLUDING REMARKS AND RECOMMENDATIONS
• Bibliography
• Index
• Copyright Page