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The Corporate Financier and the Tricky Matter of its Client Classifications
At a glance
Following a series of complex pieces of regulatory advice to some of the firm’s corporate finance clients, it seemed like a good idea to summarise some of the key issues as we see them for general readership.
This piece cannot cover the whole of this area of FS regulation, and specific firms will have attributes to their business models which will need more careful analysis, however Partner and Head of Financial Regulation, Daniel Tunkel provides a summary below.
First, what is corporate finance “advice” and is it regulated at all?
It is well understood that “advising … on investments” is a regulated activity. But what is missing from that ellipsis? The word investors. In the UK, we regulate the provision of investment advice to persons in their capacity as investors on the merits of a particular investment.
First of all, this excludes generic advice, such as whether a given market may go up or down in the light of economic events.
Secondly, the person advised must be an investor; and the corporate client seeking advice in this case is typically an issuer (or wishes to be).
Original UK law therefore never regarded this sort of advice as regulated, and a great many businesses provide this advice wholly outside regulation.
However, there is an ancillary classification of advice under the Markets in Financial Instruments Directive (“MiFID”), meaning that it is available as a service to a firm that is already registered to undertake primary investment activities such as to deal in or manage investments. But that is about the sum of it.
When does corporate finance “advice” enlarge into wider forms of e.g. fund-raising activity?
This point should not be too difficult to pin down. It is one thing to generate a paper to the board of a company concerning its potential to raise capital in the market or by promotion to family offices. It is quite another to then engage in that capital-raising exercise.
(a) Assisting the company to raise capital is, at the very least, the regulated activity of making arrangements for persons to subscribe (which is a regulated activity under the non-MiFID regime);
(b) But, it may be the activity of arranging deals in investments (which is treated as the same as the MiFID activity of “reception and transmission of orders” in investments).
The MiFID/non-MiFID business distinction is actually important for its relevance to client classification, considered lower down.
Are there any work-arounds:
(a) First, it bears confirming that both of these arrangement activities can be carried on by an appointed representative. We encounter a lot of firms where this is happening. However, the appointed representative model has come under regulatory scrutiny in a variety of recent FCA work, so that it is no longer an automatic choice for the corporate finance provider that it once was.
(b) There are some piecemeal exclusions from regulation that might be relevant. For example:
- Arrangement of a transaction to which one is also party as a principal is not generally regulated; and
- Certain transactions where at least 50% of a company is for sale, and certain other conditions as to transaction purpose, or as to sellers and buyers, are met, are also excluded from regulation. This is complex set of interlocking provisions and specific guidance should always be sought on applicability. This said, this set of exclusions is unlikely to apply to a flotation or capital-raising exercise.
Where does the regulated firm sit in relation to the company and the potential investors?
In principle, the simple answer should be that the company (seeking finance) is the firm’s client and the investors fend for themselves. However, these aspects of financial regulation are not that simple.
Clearly, the company seeking finance is the client. It will sign an engagement letter with the regulated firm and the terms of that letter will outline the firm’s client classification responsibilities (which are considered below).
What of the investors?
(a) They are not clients in the same way as the company seeking finance. The firm is at liberty to disclaim client-facing responsibilities to them.
(b) But there is a residual requirement to classify them as clients for the purposes of their receipt of communications or financial promotions from the firm. They will be treated under FCA Rules as “corporate finance contacts”.
Position where the firm has retail client permissions
Many firms retain a permission for retail client classification just for corporate finance activities; others have the full suite of retail permissions.
However, in essence, the investors in such a case will be retail classified (and the firm is under an obligation to tell them so, of course). This means that:
(a) They do not have to evince any experience or expertise in financial transactions as a condition of being registered as clients even in the limited “corporate finance contact” context noted above.
(a) But in order to receive actual promotions (which are assumed to be “direct offer financial promotions”, i.e. promotions from which an application to invest is possible), FCA Rules will require that they are classified further into one of four “certified” categories. Commonest are:
- Certified high net worth individual – in essence, this person has gross income before tax of £100,000 or net qualifying assets of £250,000 in the last UK fiscal year; or
- Certified restricted investors – here the individual commits that in the last fiscal year he/she did not, and in this year he/she will not, commit over 10% of capital for investment in the type of security in question.
The firm can also classify the corporate client as retail, and for reasons that are addressed in the next paragraph, this may be highly significant.
What if the firm can only work with professional clients?
This raises a number of difficulties, and it is likely that many firms are not operating correctly here.
With respect to the investors, these (again, even as corporate finance contacts) must be classified as elective professional clients.
(a) There is first of all a requirement that the investor in question has sufficient experience and expertise in relation to the transaction in question: the firm must find or devise a satisfactory basis for this assessment.
(b) The investor must be offered the classification, warned of the protections lost if he/she accepts and sign formally to accept the classification.
(c) In other words, even if the firm knows that the individual concerned is a multi-millionaire, this alone is not sufficient to base the classification. The steps above are needed to be addressed and properly recorded in the firm’s records and refreshed from time to time.
(d) Fortunately, further MiFID-driven requirements are not needed to be satisfied (see below), as these will prove very difficult if not impossible to address.
However, once investors have been classified as elective professional clients, the requirement for “certified investor” status under the FCA Rules goes away, as this in principle only applies to communications with retail clients.
The firm’s corporate client is in the same position, but the process here is rather trickier.
(a) The outline above for registering the investors can be replicated for the company (must be replicated) if the firm’s services to the company are non-MiFID.
(b) MiFID investment arranging involves:
- The literal taking of an order to invest and passing it on to the company to issue the stock; or
- Though probably not relevant in this case, the introduction of two or more investors to each other to transact a deal (this has secondary rather than primary market resonance).
(c) In short, if the firm’s style is to accept investors’ applications and to relay them to its corporate client, this is MiFID business. If the firm merely presents investors with the opportunity and it is up to them to liaise with the company from there onward, this is non-MiFID business. But this may be more nuanced than this summary suggests and firms should seek advice on their models if in doubt.
Classifying a company as a per se professional client involves it exceeding a range of value thresholds (capital, net assets etc.) which are prescribed in the FCA Rules. Many smaller companies seeking finance will not meet these. Classifying the company as an elective professional client will, if MiFID criteria are relevant, mean that as well as demonstrating experience and expertise, it has to pass two of these tests:
(a) 10 like-for-like transactions per quarter for the last year: a clear non-starter;
(b) A portfolio of €500,000 minimum for investment: also not promising; and/or
(c) Involvement for 2+ years in the financial services sector: will not apply to most.
So it becomes very important to avoid these and for the firm to ensure its business model is non-MiFID.
Even then, the firm must classify the company as an elective professional client based upon the “experience and expertise” test. The firm has to be satisfied that the company, by reason of its record and the records of its directors etc., can demonstrate this to be the case. And again, it will be very important for the firm to keep a competent compliance record of how it reached this decision.
This is a very quick tour of some complex regulation, and many firms should be considering carefully whether their classification systems are correct or in need of a compliance-led overhaul. This is not definitive advice to any firm or person, and most firms will need to take specific advice on their circumstances.
We at Memery Crystal (and our parent company RBG Holdings plc) support and encourage free/independent thinking in relation to issues which are sometimes considered to be controversial subject matters. However, the views and opinions of the authors of articles published on our website(s) do not necessarily reflect the opinions, views, practices and policies of either Memery Crystal or RBG Holdings plc.
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