Collective Investment schemes, regulatory enforcement and the criminal law

If it looks like a Collective Investment Scheme and smells like a Collective Investment Scheme, what is it?

Overview

Many criminal practitioners will be quietly confident they could spot a Collective Investment Scheme (“CIS”) at thirty paces, but the Supreme Court case of Financial Conduct Authority v Asset LI Inc. (trading as Asset Land Investment Inc.) & Others [2016] UKSC 17, considered important issues over the legal definition of such schemes.

It is a criminal offence, contrary to sections 19, 22and 23 of FSMA 2000, in conjunction with the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, to run an unregulated CIS. In addition to any criminal sanction, section 26 of FSMA 2000 provides that any contract made in relation to such activity is unenforceable, in addition to compensation and restitution being available remedies to the participant. In Asset LI, the Supreme Court recognised that these serious consequences are sufficient to warrant a cautious approach being taken towards the consideration of the statutory requirements for a CIS.

The common elements to a CIS, derived from section 235 of FSMA 2000, are:

  1. Any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
  2. The arrangements must be 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 to give directions.
  3. The arrangements must also have either or both of the following characteristics-
    • (A) The contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
    • (B) The property is managed as a whole by or on behalf of the operator of the scheme.

The nature of the scheme in Asset LI

Unlike early land-banking schemes, where the operator would often be under a contractual obligation to negotiate the sale of the entire site to a developer, in the Asset LI case, the written contracts explicitly stated that Asset LI would not be pursuing “rezoning” or applying for planning permission. Importantly, however, numerous oral representations were made by third party telesales brokers to give the participants a contrary impression.

Following contact between Asset LI and the FCA (as now is), amendments were made to the scheme so that, instead of dividing the site into a simple grid model common to such investments, the plots were arguably large enough to allow a small dwelling to exist inside each plot and the overall site had spaces for access roads, which were retained by Asset LI.

On appeal, Asset LI submitted that the final decision lay with the participant, who could decide how to dispose of his plot, as he was the legal owner. On the contrary, the FCA’s position was that, in reality, a participant would follow the general direction he understood to be coming from Asset LI, otherwise his own parcel would be rendered valueless. To confuse matters, there was also a suggestion at one point that a sale to a developer would proceed if 50% of the participants agreed, which would prevent individual participants from holding a developer to ransom over their plot, thereby frustrating the success of the scheme.

As had been the position in In re Sky Land Consultants plc. [2010] EWHC 399 (Ch) (“Sky Land“), in the Asset LI case, it was held not to be enough for a company to stipulate in writing that it will not progress the site as a whole when, in fact, oral representations had given the participants the impression that this would be the case. In this respect, as with many appeals, the findings of fact made by the judge at first instance, who heard the investors’ evidence, were crucial to the determination of the appeal.

“Arrangements”

The Supreme Court held that “arrangements” comprises not only contractual or other legally binding arrangements, but any understanding shared between the parties to the transaction about how the scheme would operate, whether legally binding or not. “Arrangements” also includes consequences which necessarily follow from that understanding, or from the commercial context in which it was made.

It should be noted that simply selling parcels of land is not a CIS as land is not a specified asset. Similarly, if an estate agent and planning consultant had come in after the investors had acquired their plots and assumed the functions of negotiating with the planning authority and a potential developer, they would not be operating a CIS. The Supreme Court rejected the argument that the fact Asset LI offered the whole package made this scheme a CIS as the Act does not regulate the establishment or promotion of schemes, unless they are collective investment schemes. Accordingly, the statutory requirements of section 235 are what matters.

“Property”

In relation to “property,” the case for Asset LI was that this should be construed as the collection of plots sold to investors, rather than the entirety of the original site purchased by the operator.

As was the case in Sky Land, the court rejected the argument that “property” for the purpose of section 235 was to be the individual plots as, although an individual could legally sell his individual plot, that was not what was intended or likely to happen. On this point, the Supreme Court held that “property” was defined as the whole site in the context of a land-banking scheme such as the one being offered by Asset LI.

This finding is extremely important as it affects the remaining requirements under section 235. In relation to this, Asset LI retaining the common parts for use as access roads counted against them as this suggested the “property” was to be rezoned and promoted as a complete site.

“Day-to-day control over the management of the property”

In terms of “day-to-day control over the management of the property,” once the Supreme Court determined that the “property” is the whole site and not the individual plots, in a land-banking context, it quickly follows that the individual investors do not have control of this. In any event, the finding was that the investors did not have actual control of the individual plots, in light of the nature of this scheme.

The court held that “control” of property means the ability to decide what is to happen to it but that this is not limited to the legal ability to decide and it was was extended to the situation where the arrangements are such that the investor will in practice be able to do so. The court recognised the “strictly legal” position, which was that the investors had complete dominion over their plots, but found that, in light of the findings at first-instance, the practical consequences of the arrangements went further than the express representations and the investors would rely on Asset LI to control the “property” in order to enhance the value of the whole site.

The court held that the test for “day-to-day control” was prospective and should be viewed from when the arrangements were made. It was further confirmed that this should not depend on what happens after the arrangements have been made, nor should it be based on the actual exercise of control. In essence, the question must necessarily be: In whom would control be vested were control to be required?

“Pooling”

If an arrangement has been made for the “pooling” of money in relation to separate parts of the property, section 235 provides that the arrangements are not to be regarded as constituting a single CIS unless the other participants are entitled to exchange rights in one part for rights in another.

It should be noted that the pooling and management requirements within section 235(3) operate entirely separately from one another and they are treated as alternative criteria for recognising a collective scheme as they are deemed to be functionally equivalent.

Is the property is managed as a whole?

In relation to the management criterion, the correct approach is to look at the type of scheme involved. In a land-banking case, this is likely to be taking steps towards planning permission and the longer-term investment goals, rather than the use of the land in the meantime.

It is in this context that there is a danger to an operator trying to tread too cleverly around this criterion, in order to avoid committing an offence under ss. 19 and 23 of FSMA 2000. The difficulty arises when plots are being sold by third party sales companies, who are making oral representations that the operator will pursue planning permission, in order to sell plots and receive their commission, when the operator has no intention of doing so for fear of contravening the general prohibition under section 19. The inconsistency between the two can easily lead to a suggestion that the scheme is fraudulent as its prospects of success are likely to be speculative (as is almost always the case in a land-banking context) and the participants may have been misled about the nature and intentions of the scheme. Given the Supreme Court’s clear view that the arrangements for a CIS are not limited to the “strictly legal” obligations, but also include the understanding of the participants, who may have relied on misrepresentations from telephone salesmen and not concentrated on the written contracts from the operator, this requires the operator to be clear and transparent about the scheme it is operating.

Thomas Daniel was junior counsel for the principal defendant in criminal proceedings arising out of the Asset LI case.


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