Battle lines drawn as High Court supports FCA collective investment scheme finding
Further judicial guidance has been provided on unauthorised collective investment schemes ("CISs").
In FCA v Capital Alternatives Limited and others, the FCA alleged that a farming scheme in Sierra Leone and multi-jurisdiction carbon credit schemes were unauthorised CISs and therefore regulated activities which could not be carried out lawfully by unauthorised persons (none of the defendants were appropriately authorised). The High Court was asked to assess the characteristics of the schemes and to rule upon whether they amounted to CISs as defined by s.235 of FSMA.
The legal framework
An investment scheme will be classed as a CIS only if participants in the scheme do not exercise day-to-day control over the management of the investment property and one or both of the following criteria is satisfied: (i) the contributions to and profits or income from the investment scheme are pooled together by the scheme operator; or (ii) the investment property "as a whole" is managed by the scheme operator.
In arriving at its 111 page judgment as to why the investment vehicles were indeed CISs the court delivered some potentially wide-reaching guidance that ought to give operators in the alternative investments market pause for thought.
The farming scheme in Sierra Leone (which was the focus of the court's attention) concerned a rice farm called Yoni Farm. Investors were invited to buy sub-leases of plots of land at the farm on the basis that they would receive profits from the sale of the rice cultivated on them.
The carbon credit schemes involved the sale to investors of sub-leases or licences relating to forest areas in various jurisdictions on the basis that the operators would seek accreditation by the relevant body, resulting in tradable carbon credits which could be re-sold at a profit. The two types of scheme together attracted over 200 investors and investments totalling £16.9m.
The court had little difficulty in finding that day-to-day control of the schemes vested with the operators. Whilst some investors contracted on terms entitling them to appoint their own managers, or to even manage their own plot of land themselves, no investor had in fact done so. This was key. When analysing this characteristic of a scheme the courts will consider what control was in fact actually exercised – not whether the investors had a contractual right to exercise it. That control must have been exercised by the investors as a whole – something which the court regarded as "inconceivable" in the instant case.
Interestingly, the court held in favour of the scheme operators when it came to the question of pooling. Although it found that investors' contributions to the farming scheme in Sierra Leone had been pooled (monies were used not only for expenditure with respect to their own plots of land but also to meet the general running costs of the farm) it did not find that income or profits had been similarly intermingled. Rice on investors' plots had been separately harvested, set aside and weighed and sold for sums that represented the price for the precise amount of rice grown. It was not therefore pooled for the purposes of FSMA. The fact that the rice grown generally on the farm was subject to standard percentage deductions by the operators for drying and milling did not alter this.
Management of the "whole property"
However, a scheme can still be classed as a CIS absent a finding that profits or income have been pooled if the investment property "as a whole" is managed by the scheme operator. This is what occupied the majority of the court's time during the eight day hearing and involved a forensic analysis of both the schemes' operation and the statutory framework.
The court held that all of the investment property – in the case of the farming scheme in Sierra Leone this was the entirety of Yoni Farm (and not the individual plots) – was managed by or on behalf of the operator as one entity for the collective benefit of all investors. There was no substantial regard for the individual interests of any of the investors. Most of the management activities necessary to create a viable farm, without which investors would not benefit from their individual plots, were carried out "as a whole" (for example the creation of roads, farm buildings, construction of wells and the creation of irrigation areas). The only aspect of management that was undertaken on an individual basis was the actual harvesting and weighing of the rice for each of the investors' plot. This was not enough to alter the characteristics of the CIS.
Furthermore, the court found that the object of the division of the property into separate plots so as to generate individual returns was simply an attempt to avoid the scheme being classed as a regulated activity. This did not benefit investors and more importantly did not involve any substantial individual, as opposed to collective, management.
Difficulties facing alternative investments scheme operators
Some of the defendants in Capital Alternatives Limited have already stated their intention to appeal the findings of the High Court and operators of alternative investment schemes will take a keen interest in the outcome of any such appeal. Irrespective of the final outcome upon appeal, the High Court decision serves as a stark warning as to the difficulties facing alternative investment operators. Significantly, a number of the defendants had relied on guidance given to them on various similar projects by teams at the FSA. The court stated that such informal guidance could not be relied upon and that the onus was very much on the scheme operators themselves to satisfy themselves as to the legality of their schemes.
Finally, whilst the FCA heralded this decision as a fillip for its goal to enhance the integrity of the financial services system it is noteworthy that the regulator itself was censured for the manner in which it conducted its investigation. The regulator was criticised for both the length of its 3 year investigation and its quality (it had failed to interview a key witness and did not respond to an invitation to view Yoni Farm to see the operations for itself). The court noted these criticisms had "some force".