18 September 2019 - Article
Direct investment in real property is not regulated pursuant to the UK's financial services regulatory system (i.e. the Financial Services and Markets Act 2000 – ‘FSMA', regulations pursuant thereto and the rules of the Financial Services Authority – ‘FSA'). However, once real property is put into an investment fund or corporate vehicle, regulatory considerations arise. This can often cause a property fund project to stall and progress no further – though it need not, as the regulatory hurdles can, generally, be cleared.
Property investment vehicles such as limited partnerships, property unit trusts and open ended property investment companies are generally collective investment schemes (‘_CISs_'), and are subject to some specific regulatory considerations, primarily the FSMA regulated activity of ‘operating a CIS' and the restriction on FSA-authorised persons ‘promoting' a CIS (unless it is regulated).
Those established as closed-ended companies are treated, for regulatory purposes, as ‘normal' closed-ended companies, and are not subject to the provisions just mentioned (which are specific to CISs). However, closed-ended companies are subject (potentially) to the restrictions on ‘financial promotions' (which apply to communications regarding investments generally, including investments in both CISs and normal companies) and the prospectus provisions under FSMA.
The regulatory system is very detailed and extensive and this article aims to summarise briefly the aspects which need to be addressed when setting up a property fund.
FSMA – The regulatory framework
Regulated activities – the ‘General Prohibition'
Pursuant to section 19 FSMA, no person may carry on a ‘regulated activity' by way of business in the UK, or purport to do so, unless it is authorised by the FSA, or is exempt, or its activities fall within one of the exemptions contained in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the *‘*_RAO'_). This is sometimes referred to as the ‘General Prohibition'.
The RAO specifies the various activities which constitute ‘regulated activities' and also sets out the exclusions from those activities, which (in effect) operate as exemptions. These exclusions are either specific to one or more activities or apply generally across all regulated activities. The RAO also specifies the various classes of ‘investment' to which the specified activities relate. In broad terms, therefore, to constitute a ‘regulated activity' the activity concerned must in some way involve an ‘investment': hence, for example, ‘dealing in investments', ‘advising on investments', ‘arranging deals in investments' and ‘operating a collective investment scheme' (because interests in a CIS are ‘investments').
Section 21 FSMA provides that a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity, unless that person is authorised (generally speaking, by the FSA) or the content of the communication is approved by an authorised person. This prohibition is sometimes referred to as the ‘Financial Promotions Restriction'. Breach of this prohibition is a criminal offence and can lead to resulting investments being set aside.
However, communications relating to direct investments in real property or to participation in a LLP (provided care is taken to avoid it being a CIS: see below) will not involve ‘investments' and will therefore be outside the scope of FSMA. As with ‘regulated activities' therefore, the best way of avoiding infringing the prohibition is to ensure that either:
(a) no investments are made other than directly in real property; and
(b) to the extent investments are made through property investment vehicles the interests in which constitute ‘investments', an exemption is available.
Pursuant to the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, a number of exemptions from the Financial Promotions Restriction have been created. For practical purposes, the most relevant exemptions are those which provide for the ability to issue financial promotions to certain categories of person, as follows:
(a) FSMA authorised persons (such as banks, stockbrokers, insurance companies, investment managers, etc);
(b) a government, local authority or public authority (as defined by FSMA);
© a body corporate or an unincorporated association which either:
(1) if it is a body corporate and has more than 20 members or is the subsidiary of a holding company which has more than 20 members, it, or any of its holding companies or subsidiaries, has a called up share capital or net assets of not less than £500,000; or
(2) if it is a body corporate other than one described in sub-paragraph (1) above, it or any of its holding companies or subsidiaries has a called up share capital or net assets of not less than £5m; or
(3) if it is an unincorporated association, it has net assets of not less than £5m; and
(d) any trustee of a trust where the aggregate value of the cash and investments which form part of the trust's assets (before deducting the amount of its liabilities) is £10m or more or has been £10m or more at any time during the previous year. This would for instance cover most pension funds (although it is recommended that marketing materials are normally sent to their manager, who would typically be an FSMA authorised firm, who are the people who would make the investment decision in practice). There are in addition categories of individual ‘high net worth investors', ‘sophisticated investors' and ‘self-certified sophisticated investors'. These, however, rely on certification of the relevant status having been given prior to the financial promotion, and compliance with quite detailed conditions, and are not especially user-friendly for practical purposes.
It is important to bear in mind however that the availability of an exemption from the Financial Promotions Restriction does not imply any exclusion from the ‘General Prohibition'. In practice, it is very difficult to ‘promote' an investment without, incidentally, also giving investment advice or arranging a deal. As a result, the main practical use of the above exemptions is for people selling investments into the UK from overseas, in reliance on the ‘overseas person' exemption (ie for people who do not maintain a permanent place of business in the UK).
What is a CIS?
A CIS refers to any arrangement with respect to property of any description, including real estate, the purpose of which is to enable persons taking part in the arrangement to receive profits or income from the acquisition, holding, management or disposal of such property.
The arrangements must be such that the participants in them do not have any day-to-day control over the management of the property, regardless of whether they have the right to be consulted to give directions.
The arrangements must have either or both of the following characteristics: (i) the contributions of the participants and the profits or income out of which payments are to be made to them are pooled; and/or (ii) the property is managed as a whole by or on behalf of the operator of the scheme (the term ‘operator' is described in more detail below).
There is a potential opening therefore where a small number of people come together to form a limited liability partnership (‘LLP'), all of whose members are involved in controlling the LLP's management.
As mentioned above, direct investments in real property are not ‘investments' and therefore have no FSMA implications, nor will the management (or promotion to potential members) of the LLP itself have any FSMA implications as long as it is structured (and managed) in such a way as to avoid being a CIS. However, where the LLP invests in property not directly but through a company or a CIS (e.g. a property unit trust or limited partnership) then it will be carrying out activities which are in principle capable of being ‘regulated activities' (for instance, dealing in investments or, to the extent it seeks to counsel other parties to co-invest, advising on investments).
Although any such activity needs to be carried out ‘by way of business' in order to potentially infringe FSMA, in practice this phrase is very widely construed and the argument that an activity is not being carried on ‘by way of business' should not generally be regarded as a safe one to rely on. Where any property investment involves a corporate or CIS vehicle, it will therefore be necessary to consider whether an exclusion is available. As mentioned above, these exclusions are typically activity-specific and therefore we need to consider what regulated activities the LLP may be carrying on.
Generally speaking, the LLP could be carrying on the activities of dealing as principal in investments, advising on investments, or arranging deals in investments. The position should be considered on a case-by-case basis for each deal, where an ‘investment' is involved in the deal structure.
What is an ‘Operator' and does one need to be FSA Authorised?
There is no statutory definition of the word ‘operator' or ‘operating' in the general CIS context. Consequently, there is no complete certainty as to the correct interpretation of what it means to ‘operate' a CIS. The key factor that will render a person an operator is generally considered to be the notion of responsibility. Therefore, the person most likely to be the operator is the person with overall responsibility for the management of the fund. The most prudent course would be to consider that a person responsible for the management of the fund might potentially be an operator (and there may be more than one operator in respect of the same CIS).
FSMA prohibits the operator from establishing, operating or winding up a CIS in the UK unless FSA authorised or exempt. In addition, a CIS is operated in the UK if the activities which take place in the UK are a significant part of the business activity of operating the CIS. Note that operating an offshore CIS will therefore, generally (unless carried out in the UK), fall outside UK regulation, though it may of course be covered by local regulatory requirements in the relevant jurisdiction.
Promoting a CIS (in other words, inviting investors to participate in the CIS) in the UK is also regulated by FSMA, as the CIS ‘units' (however termed) are ‘investments'. Similarly, advising on investment in, or arranging deals in (ie, in effect, placing or distributing) ‘units' of, a CIS will be a regulated activities.
Alternatives to becoming an FSA authorised operator or promoter yourself
The lengthy process of obtaining authorisation from the FSA for the operation and/or promotion of a fund may not be practicable. Authorisation by the FSA takes time to obtain (typically some six months from starting work on the application to virtually obtaining authorisation) and entails very significant ongoing regulatory capital and compliance obligations.
There are two main alternatives, each of which necessitates the involvement of an FSA-authorised third party:
1. the unauthorised person wishing to establish a property fund could become an appointed representative of an FSA-authorised firm, for the purposes of promoting the CIS and advising on potential investors; or
2. the unauthorised firm could restrict itself to the property management/advisory aspect, which is unregulated, and involve an FSA-authorised person for promoting and placing the fund interests, advising prospective investors and (if the fund is ‘operated' onshore the UK) any CIS operating functions.
For practical purposes an FSA-authorised person will generally need to be involved in the process of setting up and marketing a property fund unless:
(a) the structure used is a limited liability partnership (“LLP”), in which all partners are involved in the management of the structure (this is a common holding structure in real property deals, but is not suitable where there are a significant number of investors or where the investors, or any of them, are passive investors);
(b) the fund is set up offshore and an offshore entity makes all approaches to investors, keeping within the scope of the so-called ‘overseas persons' exemption mentioned above: this is a fairly commonly used route but needs to be very carefully managed; or
© all activities related to the fund and the solicitation of investors are carried out offshore (in accordance with applicable local requirements) and not in (or into) the UK- this is only practicable generally where there are no investors in the UK, therefore no activities touch the UK other than the direct property investment aspect (which is not regulated by FSMA).
Becoming an Appointed Representative of an FSA authorised firm
Under section 19 FSMA no person may carry on regulated activity in the UK unless he is authorised or exempt. A person will be exempt if he satisfies the conditions in section 39(1) FSMA, and becomes an appointed representative.
The conditions under section 39(1) are:
1. The person must not be an authorised person, i.e. he must not have permission to carry on regulated activities in his own right.
2. The person must have entered into a contract with an authorised person (the principal). The principal must permit him to carry on business of a description prescribed in the appointed representatives regulations, and also comply with any requirements prescribed in these regulations.
3. The principal must have accepted responsibility in writing for the activities of the person carrying on the business specified in the contract.
4. Where the appointed representative is also a tied agent, he must also be listed on a register of tied agents in order to be exempt. In the UK this is the FSA's register.
Being appointed as an appointed representative avoids the need for FSA authorisation and the attendant requirements to satisfy minimum solvency requirements and take out professional indemnity cover. However, the FSA-authorised principal has significant compliance obligations, and must in effect take regulatory responsibility for the appointed representative: consequently, it must implement monitoring measures to ensure the representative is not causing it to be in breach of the FSA rules. It must also ensure that the regulated activities covered by the appointment fall within the principal's permission to carry out regulated activities.
There is therefore a heavy onus on the principal to ensure that the prospective appointed representative is suitable to act in that capacity and that there are supervisory controls in place. There must also be resources to monitor and enforce compliance by the appointed representative with any relevant requirements. There are also administrative requirements that firms who appoint appointed representatives must comply with in relation to notifying the FSA, as well as record keeping requirements.
Becoming an appointed representative therefore does entail significant responsibilities on both sides, which the business case will need to justify.
Contracting with an FSA authorised Person
In some instances, neither the authorised third party nor the property fund adviser may want the compliance and supervisory burdens of the appointed representative relationship. Thus, an alternative may be for the property adviser to restrict its activities to the non-FSMA ones, i.e. direct property investment and advice, and to involve an FSMA authorised person for the CIS promotion and ‘investment' advisory (and any CIS operating) aspects.
Currently there are certain firms on the market which offer this service to people wanting to establish property (or other unregulated private) funds. Again, the compliance requirements on the FSA-authorised person are significant, but it will not be required, in this structure, to accept supervisory responsibility (and indeed liability) for the non-authorised person's actions. Naturally, this structure can only work if the non authorised property manager/adviser is careful not to become involved in any promotional or advisory activities in relation to the fund.