The decision in the recent High Court case of The Queen on the application of Donegan, Ellis-Clarke, Considine and Brown v the Financial Services Compensation Scheme Limited will have surprised nobody familiar with financial services regulation. Over some 20-odd pages of close legal reasoning, the court reached the less than astonishing conclusion that securities which were not transferable were not transferable securities.
However, the judgment is interesting both as a footnote to the controversies around the failures of the regulatory regime to protect the investors in London Capital & Finance plc (LCF), and as a reminder that the regulatory perimeter does have some sharply defined edges. It is perhaps no coincidence that shortly after this decision was made, HM Treasury (HMT) published its own consultation paper (the HMT CP) setting out proposals for the tighter regulation of non-transferable securities.
This case was a judicial review hearing challenging a decision of the Financial Services Compensation Scheme Ltd (FSCS) not to compensate investors who had bought securitised bonds from LCF. The case turned on whether these bonds were "transferable securities". If the bonds were not transferable securities, then LCF's activity in issuing these bonds was not a regulated activity, and if there was no regulated activity then the FSCS compensation scheme did not apply. The issue was important not just for LCF investors but also generally in relation to offerings of so-called "mini-bonds" i.e. typically illiquid debt securities marketed to retail investors – like an IOU issued by a company (the issuer) to an investor, in exchange for a fixed rate of interest over a set period (this is the FCA 's description).
The claimants clearly had an uphill struggle with this case. The bonds in question very clearly stated within the contractual documentation that they were not transferable. However, with impressive creativity, a case was assembled which went something like this:
- the bonds were properly classified in accordance with definitions in the RAO as "securities", because this is defined to include instruments issued by a company creating or acknowledging indebtedness such as debentures, loans, stocks, bonds or certificates of deposit;
- under article 14 RAO, selling securities is a specified activity (with the result that if it is undertaken by way of business it becomes a regulated activity) and "selling" is given an extended meaning in the RAO to include issuing the security;
- although there was an exclusion under article 18 of the RAO which excludes article 14 applying to the issue by any person of his own debentures or debenture warrants, this exclusion was subject to what is often referred to as the "MiFID override" if the securities are transferable securities: the effect of this was to disapply exclusions where an "investment firm" as defined in MiFID "provides or performs investment services and activities (as defined in MiFID) on a professional basis";
- although the securities were stated not to be transferable:
- on a proper construction of MiFID the phrase "transferable securities", despite the definition being prefaced by reference to securities that are "negotiable on the financial markets" covered all bonds whether or not transferable;
- alternatively, the contractual restriction on the bonds on transfer was unfair and therefore fell to be struck out under provisions in the Consumer Rights Act 2015 so that the bonds should be dealt with as if they were transferable.
These ingenious arguments were not enough to convince the Judge. The Judge disagreed with the interpretation that even non-negotiable bonds were transferable securities. Although he did find that the contractual term rendering the bonds non-negotiable was an unfair term, he drew a distinction between the contract to acquire the bonds, and the terms of the bond itself, and found that the existence of such an unfair term in any case did not turn the bonds into negotiable instruments. He also dismissed the argument that even if the bonds were not transferable, LCF should be regarded as having agreed to sell transferable securities, because the subscription agreement selling the bonds should be read disapplying the unfair provision restricting transfer, with the result that even if it had not undertaken an activity under article 14 RAO, it had undertaken the separate specified activity of "agreeing to" undertake one of various regulated activities specified in the RAO (including that under article 14).
The result, therefore, was the one that might have been expected: non-transferable securities are not transferable securities and activities relating to them are generally outside the RAO.
The judgment will be welcomed by those who are structuring financing arrangements which are intended to operate outside the regulatory perimeter. If this had been decided differently this might have cast doubt on what is meant by "transferable securities" creating confusion and uncertainty.
The judgment, however, does need to be read with some caution as elements of it were not entirely accurate. In particular, the court's apparent acceptance that if the securities had been properly labelled as "transferable securities" the MiFID override would automatically have been engaged, is questionable. This would depend on the issuer also being characterised as a MiFID investment firm i.e. a firm 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”.
It was always going to be a long shot to convince a court that non-transferable securities are in fact transferable securities. But one can understand why the case was brought. It was the last chance to obtain some compensation for LCF investors who were left without redress. It was also a valiant attempt to extend the scope of regulation to protect future investors in mini-bonds – and certainly there has been, and remains, a case for better regulation in this area. The HMT CP referred to above makes a good case for further regulation, citing academic research that shows how the market in mini-bonds has developed and the risks that it poses to investors, particularly retail investors, who it appears have little understanding of the risks.
Since LCF's demise the FCA has already taken action to restrict "speculative illiquid securities" from being marketed to "ordinary retail investors" when the sale proceeds are used to on-lend or to on invest in third-party projects. However, these restrictions do not apply to high net worth, sophisticated or professional investors. As the HMT CP somewhat damningly remarks "Although these investors should be better placed to understand the risks presented by these products, there is limited evidence that they do."
HMT is therefore consulting on a number of possible options to tighten regulation in this area including:
- making the issuance of non-transferable debt securities a regulated activity where the proceeds are used to invest in third party businesses or projects;
- extending the scope of Prospectus Regulation as it applies in the UK post-Brexit to cover non-transferable debt securities (and reconsidering the €8 million threshold for application of the regulation in relation to this type of security).
- Relying on other FCA measures, such as building on the existing FCA ban on the mass-marketing of speculative illiquid securities.
The consultation is running to 12 July 2021. Anyone with an involvement or interest in this area should consider the proposals put forward in the HMT CP and whether they would like to respond to them.
  EWHC 760 (Admin).
 The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544).
 That is the provision in in article 4(4) RAO.
 specified in articles 69 RAO.
 Also the Judge seemed unaware that the MiFID override had not been introduced in 2018 (i.e. as part of the implementation of MiFID II) but in fact had been in place ever since the original implementation of MiFID I many years earlier.
Sign up to our email digest