Recently I was asked about the law relating to investment clubs. The investment club had been going for many years, with meetings arranged on a monthly basis, and had about 50 members each contributing a reasonably modest amount per month. A problem arose when their broker, who supplied investment advice and not just execution-only services, sought legal advice. I have not seen this advice but the consequence was that the investment adviser immediately resigned. Naturally this caused some consternation as the members of the club are pillars of the local business community with reputations to protect. Could there be something illegal about an investment club?
There is no particular law or exemption relating to investment clubs. One has to do an analysis of financial services law and see how it impacts on investment clubs. Perhaps there may be those of you reading this who are unaccustomed to the UK financial services legislation and might be astonished at the tortuous regulatory maze that has to be negotiated, in order to extract the answer(s) to what seems a simple question. Therefore let me give a short background.
Unlike most legislation, which essentially starts from the idea that the citizen is allowed to do things unless prohibited, with financial services law many activities are prohibited unless there is an exemption or exclusion. Also much of financial services law appears Delphic (e.g. what is the correct definition of a business, what exactly does arranging a deal encompass or what does exercising day to day control really mean?).
Years ago I had the good fortune to have a brief discussion with Michael Heseltine who was the government minister in charge for a time of financial services legislation and he indicated there was no stopping his officials who wanted to regulate everything and at any opportunity he would relish in approving an exemption or exclusion. While we like to think the law is made by those we elect to parliament most laws are made by unelected officials but the law is the law and must be obeyed.
Before I go further, the sort of investment club this note is about is where friends, neighbours and others with an interest in investing get together to discuss the best ways of investing particularly in the stock market. They want to improve their knowledge of investing by exchanging news and views and they probably agree to put a reasonably small monthly amount of say £50 into a pot which the club as a whole will invest with each member having units in the central pot.
Also this note is intended to focus on investing in shares. There are separate laws that deal with say insurance products and more esoteric products such as contracts for differences and any club which wishes to invest in anything other than straightforward shares ought to consider any legislation peculiar to that product.
The general prohibition
Breach of the general prohibition, contained in section 19 of the Financial Services and Markets Act 2000 (the act), carries a possible two years in prison and an unlimited fine as well as making any agreements entered into or as a result of the activities by a person in breach unenforceable. It states:
'(1) No person may carry on a regulated activity in the UK, or purport to do so, unless he is:(a) an authorised person; or(b) an exempt person.'
We must next look for the meaning of regulated activity which is contained at section 22 of the act and states:
'(1) An activity is a regulated activity for the purposes of this act if it is an activity of a specified kind which is carried on by way of business and -(a) relates to an investment of a specified kind; or(b) in the case of an activity of a kind which is also specified for the purposes of this paragraph, is carried on in relation to property of any kind.'
GP - the business test
We see from section 22 of the act that to be caught by the general prohibition the activity must be carried on by way of business. Thus before looking at the detail of carrying on a regulated activity there has to be a discussion on whether whatever was being carried on amounts to a business. When we turn to the Finanical Services Authority Rules Perimeter Guidance (perg) 2.3.3 it states: 'Whether or not an activity is carried on by way of business is ultimately a question of judgement that takes account of several factors (none of which is likely to be conclusive). These include the degree of continuity, the existence of a commercial element, the scale of the activity and the proportion which the activity bears to other activities carried on by the same person but which are not regulated. The nature of the particular regulated activity that is carried on will also be relevant to the factual analysis.'
If a court was considering whether you as a member of an investment club were carrying on a regulated activity by way of business the judge would consider the FSA guidance and then in my view apply common sense and put considerable emphasis on whether you were involved in the activity of arranging etc. in return for remuneration. It is clear that you can carry on a business with or without a view to profit but it would be perverse for a judge to decide you were carrying on a regulated activity as a business when you were not receiving any form of remuneration for your work.
For instance if one member of the club helps another member make up his mind on which investment to buy or sell, common sense (without the need for much legal analysis) can in most circumstances tell whether that member is carrying on a business when doing so. Thus if one or more members are charging for their services to others then more detailed analysis is required. But if it is a regular club where members do not charge one another it is unlikely that any one member is carrying on a regulated activity by way of business.
The position would be different if the club was incorporated as a company or an LLP or was in fact treated as a general partnership. There would have to be an analysis of the activity of the entity and in particular an LLP or a general partnership can only be set up as a business with a view to profit. There are also complications if it is an investment club for private equity. These clubs might be formal groupings run by a firm authorised by FSA or an exempt body (such as The Oxfordshire Investment Opportunity Network Limited which is better known as OION and/or Thames Valley Investment Network) which has as its principal object the promotion of commercial activity in the UK so long as it does not carry on that activity for or with the prospect of direct or indirect pecuniary gain (2000 act (Exemption) Order 2001, schedule, part IV paragraph 40).
However, private equity investment clubs are often just informal groupings of wealthy individuals whose members generally take it in turn to investigate likely investment opportunities and no one member gains an advantage over other members for his or her efforts. A problem might arise in those private equity clubs where one individual spends much effort in negotiating and structuring a transaction. In those circumstances the negotiator may justifiably be tempted to seek recompense from his fellow members. My view is he ought to resist and look only to the terms of his investment (and perhaps directorship) with the investee company.
The question of whether you are carrying on the regulated activity by way of business is vital as it is your first line of defence and only if that line of defence is crossed do you need to consider the detail of the exclusions from the various regulated activities.
GP - regulated activities
The second line of defence is whether you are carrying on a regulated activity at all under section 22. The interpretation of section 22 is assisted by the 2000 act's (Carrying on Regulated Activities by Way of Business) Order 2001 where article 3, inter alia states, with my comments in square brackets:
'(1) A person is not to be regarded as carrying on by way of business an activity to which paragraph 2 applies, unless he carries on the business of engaging in one or more such activities.'(2) This paragraph applies to an activity of the kind specified by any of the following provisions of the Regulated Activities Order, namely - '(a) article 14 (dealing in investments as principal); [Under article 15 this is disapplied unless essentially you are market making and so it is difficult to see how it is applicable to investment clubs.] '(b) article 21 (dealing in investments as agent); [Under article 22 this does not apply if you are making the arrangements for the other members with or through an authorised person, it is clear no one at your club has sought advice from you (and if they have you declined to give it and recommended they seek the advice from an authorised person) and if you receive a pecuniary reward or advantage from anyone (other than from your fellow members for whom you are making arrangements) you must account to your fellow members for whom you are making arrangements. Investment clubs normally deal in listed shares and so dealing is through a securities broker (who will require to be authorised).
'Remuneration is not a problem with normal investment clubs where there is no payment to members except to cover expenses. An issue might arise with advice, given that investment clubs rely on individual members doing research on particular opportunities and then reporting back to members who take the decision as a unit and then delegates a member to implement the decision of the club. Questions that arise include is the person implementing the decision of the club an agent of individual members and if so was he or she the person who reported back on the particular share and did that report amount to advice. Let us not lose sight though that here we are talking of the second line of defence and the first line of defence (the activity of dealing in investments as an agent was not being carried on as a business) ought to hold firm in almost all normal situations for an investment club.]
'(c) article 25 (arranging deals in investments); [Article 25 is the one that catches many activities connected with investments. There is an exclusion at article 28 which essentially says article 25 shall not apply if the person making the arrangements is to enter the transaction himself or as agent for another person. Another exclusion is at article 29 when arranging a deal through an authorised person, which is similar to article 22 mentioned above, so I do not repeat it here. However whether an exclusion applies depends on the exact circumstance and an exclusion may not always apply. It might be appropriate to mention that many investment clubs have members whose day job is in part to arrange deals in investments such as lawyers, accountants, bankers, corporate brokers and investment advisers. In their day jobs some may be authorised or use the exclusion at article 67 which refers to any activity which "is carried on in the course of carrying on any profession or business which does not otherwise consist of regulated activities; and may reasonably be regarded as a necessary part of other services provided in the course of that profession or business". This exclusion is useful to lawyers and accountants acting in the course of their day to day business but does not help them when acting as a member of an investment club.]
'(d) article 37 (managing investments); [This is managing assets involving the exercise of discretion. Thus where you are asked to buy or sell specific securities following a meeting of the club you will not be caught by this activity. An issue might arise where an absent member gives authority for the committee or another member to act on his behalf. This is not a problem providing the first line of defence holds firm.]
'(e) article 40 (safeguarding and administering investments); [This does not apply where you are providing information on the number of units or value of assets safeguarded or receiving documents for passing on. However it might apply if you held on to the documents and dealt in the income arising from the investment. There is also the problem that the wording of the regulated activity includes: "arranging for one or more other persons to carry on" the safeguarding and administration of assets belonging to another. Normally a member of the club arranges a brokerage account where the assets are kept and there seems no exclusion is available except of course this is only relevant if the activity is carried on by way of business.]
'(f) article 45 (sending dematerialised instructions); [This is to do with the Crest system and I believe the ordinary member of the public only has the ability to send these instructions through an authorised person so this article should not be of concern to investment clubs.]
'(g) article 51 (establishing etc. a collective investment scheme); [Probably this is the regulated activity giving rise to the greatest frisson within investment clubs and given its importance I comment on it in a separate section below.] '(h) article 52 (establishing etc. a stakeholder pension scheme); [It would be an obscure set of circumstances that made this relevant to investment clubs.]'(i) article 53 (advising on investments); and [This refers to giving advice to members of your club on the merits of buying, selling etc. a particular investment. Given the nature of investment clubs each member is expected to research particular shares and report back. Simply giving information to fellow members "without any comment or value judgement on its relevance to decisions which an investor may make is not advice" (FSA Handbook perg 8.28.2). However, the member doing the research is expected by his colleagues to report back with an opinion and in effect while he or she might try and avoid it there will in effect in many cases be a recommendation and so it seems investment advice is an inescapable issue for investment clubs.
'There is no exclusion from the regulated activity of carrying on business of giving investment advice. I emphasise that to be guilty of an offence it would have to be shown you were carrying on the business of advising on investments which, in a normal investment club where no one is paid (other than expenses), is unlikely. Perhaps it is worth mentioning that business consultants who advise companies avoid this regulated activity by ensuring that their advice is always to the directors in their capacity as directors and not (unless they are authorised) in their capacity as shareholders). I do not see though how this route could be made to apply to say the chairman and officers of the investment clubs as democracy and everyone having a vote is so essential to the nature of investment clubs (even if we were not concerned with day to day control issues discussed below in relation to collective investment schemes)].'(j) article 64 (agreeing), so far as relevant to any of the articles mentioned in sub-paragraphs (a) to (i).'
I emphasise again that these activities are only relevant if you can be shown to be carrying any of them on by way of business. The first line of defence in any investment club ought to be that none of these activities is carried on by way of business and the second line of defence is that an exclusion applies.
GP - establishing or operating a collective investment scheme
A collective investment scheme is defined at section 235 of the 2000 act. Subject to the business test an investment club will involve a collective investment scheme if there is a pool of money or other property where the arrangements are '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 give directions' (section 235(2) of the act). Thus theoretically you may have a problem if you are in an investment club where the decisions are effectively taken by one or a few members. However, with a little planning it ought to be possible to organise the club into a democratic organisation with power over the management of the investment firmly in the hands of the members rather than a central clique.
A couple of cases, Russell-Cooke Trust Co v Elliott's  and Financial Services Authority v Fradley , give guidance on the language at 235(2). However they are not fully on point. There does seem to be an argument over the meaning of 'persons' in section 235(2) based on the fact that the Interpretation Act 1978 allows that unless the contrary intention appears the plural can include the singular. This creates the argument that it is unclear whether the participants collectively or individually must have day-to-day control. It would make nonsense of the wording at section 235(2) if each single participant actually had to have day-to-day control over the management of the property (on the basis that only one person at a time can have proper control).
I have faith in the common sense of our judges and I believe any almost all our judges would interpret the sub-section to mean that the participants as a group must have that day-to-day control - although you ought to expect any judge to be difficult if he or she finds that even one participant has actually handed over discretionary management to a third party. There are also questions on why the words 'whether or not they have the right to be consulted or give directions' have been added at the end of section 253(2). It seems to emphasise that not only must the participants have the right to exercise day-to-day control but they must in addition actually exercise that right.
This begs the question how regularly a member must actually exercise control for his control to constitute 'day-to-day control' for the purposes of section 235(2).
Another question is how many can you have in the club. Is there a magic number where you can have day-to-day control in the hands of the participants but above that number the judge would say it is not feasible for so many participants to have day- to-day control? If there is a number is it 20 or 50 or more per club? My view is that the number of participants might well be a factor in determining whether the participants had day-to-day control but it would be a strange judge who decided on an actual number as it all depends on the detailed way in which the club is organised and managed.
ProShare Investment Clubs suggests the number of members of a club should be restricted to 20. The number 20 I believe is based on a sensible maximum for ensuring all can participate in a discussion at a meeting and is not based on a legal requirement. If meetings are held electronically then, given modern means of communications, I suspect many more than 20 could participate in decisions.
The FSA’s Handbook at perg 11 has useful guidance on property investment clubs (e.g. buy-to-let syndicates). However although it refers several times to 'day-to-day' control it does not really address questions in relation to normal investment clubs. A property club normally has a property manager (who will be earning remuneration) at its heart and so it is easier to point the finger at a likely operator of a collective investment scheme. With a normal investment club it is more difficult to point the finger and find an actual operator of a scheme and if there is no obvious operator it is more difficult if not absurd for the prosecutor to argue that there was illegal 'operating' of a collective investment scheme.
The above discussion on collective investment schemes ought to be irrelevant to almost all investment clubs as the relevant legislation only applies to establishing or operating a collective investment scheme 'which is carried on by way of business'. It will be a peculiar judgment that decides an investment club is a business where it does not pay remuneration to anyone involved in running the club.
GP - group exemption: a false hope
There are various group exclusions in article 69. The question arises as to whether an investment club is a group for the purposes of the legislation. The definition of group at section 421 of the 2000 act includes you and any person who is an undertaking in which you have a participating interest. An undertaking may be an unincorporated body such as a club carrying on a business with or without a view to profit. However a participating interest is generally intended to refer to holdings of 20% or more of the undertaking. Thus it is difficult to see how the group exclusion can be of assistance to an investment club.
GP - deposit taking
The above only deals with regulated activities for the purpose of assessing whether a business is being carried on. There are other articles in the Regulated Activities Order which are relevant to investment clubs. For instance many investment clubs have members investing £20 or £50 a month into a central pool. The law is that accepting deposits is a regulated activity if:'(a) money received by way of deposit is lent to others; or(b) any other activity of the person accepting the deposit is financed wholly, or to a material extent, out of the capital of or interest on money received by way of deposit.' (Article 5)
I have difficulty believing a judge would find that the monthly payment was a loan - given that individual members regard it as a subscription for shares. As regards (b) it ought not to apply to investment clubs as monthly subscriptions will normally be paid to a bank or a broker who have appropriate authorisation to accept deposits.
GP - Markets in Financial Instruments Directive
More difficult to comprehend properly is the possibility that what is generally called the MiFID override might apply to investment clubs. For those not familiar with the term, MiFID refers to the Markets in Financial Instruments Directive 2004/39/EC as subsequently amended which seeks to harmonise investment services across the European Economic Area and which inevitably has had a complicating impact on existing financial services law. Basically the law now says that where an investment firm 'provides or performs investment services and activities on a professional basis' and in so doing would be regarded as carrying on as a regulated activity then most of the exclusions are to be disregarded (the MiFID override).
Almost all members of an investment club would scratch their heads and wonder what on earth has this law to do with investment clubs. An investment firm is defined as 'any person 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'. The thought that an investment club consisting of the butcher, the baker, the candlestick maker and their modern equivalents could be carrying on investment activities on a professional basis is incredulous.
However, remember that these exclusions only become relevant when your first line of defence is breached and it is found you were carrying on a regulated activity by way of business. Essentially the point is that once you are shown to be carrying on regulated activity by way a business it is but a short step for a judge also to decide you were providing investment services on a professional basis and so the MiFID override is triggered. It does seem absurd that an amateur investment club could trigger the MiFID override but the problem is that if it happened almost none of the exclusions work. Therefore given this theoretical possibility the firm focus of any investment club must therefore be to ensure no member can be regarded as carrying on a regulated activity within the club as a business.
There are two main statutory instruments supporting the 2000 act that concern investment clubs. One is the Regulated Activities Order, which is discussed above, and the other is (Financial Promotion) Order 2005. The basic restriction on financial promotion is contained at section 21 of the act which states a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity. Many people who have spent their careers in the financial services industry get muddled up between the Regulated Activities Order and the Financial Promotion Order so it is not feasible to think of the average member of an investment club having a proper grasp of the finer intricacies of these two Orders.
The first thing for you to notice though with the Financial Promotion Order is that it only catches you 'in the course of business'. As seen above there is a statutory interpretation of carrying on by way of business when dealing with the Regulated Activities Order but there is as yet no equivalent interpretation for the Financial Promotion Order. For the latter the phrase therefore has its ordinary or natural meaning. It is clear that it is intended to exclude discussions within the family or with friends in the pub.
If though a judge was considering whether you were making a financial inducement during a meeting at your investment club in the course of business he would consider all the circumstances but the most important factor is probably your commercial interest in communicating the financial promotion. For instance it might be you are promoting a business where you already have a considerable stake.
Let us suppose though that the complainant gets through your first line of defence (which seems easier to do than for the Regulated Activities Order) and somehow shows you are communicating a financial promotion in the course of business (in the ordinary sense of those words). Do you have any exclusions or exemptions that are relevant?
An obvious exemption is at article 28 which states:'(1) The financial promotion restriction does not apply to a one off communication which is either a non-real-time communication or a solicited real time communication.'(2) If all the conditions set out in paragraph (3) are met in relation to a communication it is to be regarded as a one off communication. In any other case in which one or more of those conditions are met, that fact is to be taken into account in determining whether the communication is a one off communication (but a communication may still be regarded as a one off communication even if none of the conditions in paragraph (3) is met).'(3) The conditions are that -'(a) the communication is made only to one recipient or only to one group of recipients in the expectation that they would engage in any investment activity jointly; '(b) the identity of the product or service to which the communication relates has been determined having regard to the particular circumstances of the recipient; '(c) the communication is not part of an organised marketing campaign.'
I suspect the above has unusual clarity for financial services legislation as it applies to investment clubs and there are only three additional points I shall make:
1. The reference to a group engaging in any investment activity jointly clearly seems to apply to members of an investment club;2. A one-off communication can be made several times on different occasions relating to the same investment;3. The reference to solicited real-time communications refers to solicited interactive dialogues which you would normally expect at a meeting of the investment club but an email is not regarded as real time. As regards the interpretation of 'solicited' suffice it to say that a properly organised investment club ought not to have a problem particularly as the legislation states that where a real time communication is solicited by one recipient it is treated as having been solicited by any other person to whom it is made at the same time if that recipient is 'expected to engage in any investment activity jointly with' the original intended recipient. For once this seems a piece of financial services legislation that is deliberately helpful to investment clubs.
Investment clubs that do not pay remuneration for any regulated activity to its members ought to be safe from the general prohibition on the basis that neither the club nor individual members (in their capacity as members) are carrying on a regulated activity by way of business. If there is a member of the club who does have a business carrying on a regulated activity as his or her regular day job then they ought to wear a separate hat when acting as a member of the club.
I guessed when I started on this review I would find that even if there was a business then each regulated activity would have an applicable exclusion. However, the basic function of an investment club is to have individual members research different shares and report back to other members. The reporting back may not amount to investment advice but it may well do so (and there is no exclusion from the offence of unauthorised advising on investments as a business). Thus there is a possible breach in the second line defence which spills over to mess with the exclusions for dealing as agent or arranging deals in investments.
The message therefore is to ensure that no member of the club is carrying on a business of a regulated activity within the club. Personally I have difficulty seeing a judge deciding there is a business for such an activity within a normal investment club unless there is remuneration being paid for the activity.
As regards the Financial Promotion Order again you must be carrying on a business before it becomes worrisome. If that defence is lost then my view is that the exemptions in the Order are designed to permit the normal activities of an investment club.
Reverting to the case which started this analysis I did not see the brief to the advisers nor their advice. My guess though is the advice related to the peculiar status of their client who was a member of the club and who worked for an FSA authorised firm who was not only providing execution services but also giving investment advice to the members. In particular FSA Rules are onerous on such firms who give investment advice to investment clubs rather than just act as executing broker. There is an increased focus on firms meeting their suitability obligations in respect of investment advice and the cost of meeting the suitability obligations can outweigh the income from an investment club.
There are issues to be faced by investment clubs interfacing with their professional advisers - such as is the client one person or the whole association? Also what will be the unintended consequences of the Retail Distribution Review (which essentially are more FSA rules for professional advisers)? Equally there are issues about possible Market Abuse where the club wishes to sell a sizeable stake in, say, an AIM illiquid stock. Such issues though are beyond the scope of this note.
After writing the draft of this note (which I did while reading through say 100 or 200 pages of legislation) I thought it would be useful to review it against a hard copy of the Perimeter Guidance Manual which forms one of the 67 or so manuals and sourcebooks of the FSA Handbook. At a guess printing out that one manual consumed about 800 pages. As I waited regretting pressing the print button I had a vision of our great-grandchildren shaking their heads in disbelief as they read about the sacrifices in the 20th century of our people to fight for freedom only to allow their liberties, a few decades later, to be so constrained by such complex financial services legislation. One can only hope things will improve after the FSA is split but that depends on leadership having a clear goal of simplification for the private investor (who was not responsible for causing the current financial crisis).
One feels that many politicians and most officials at the FSA believe that the world has not yet invented a problem that cannot be fixed by yet another rule. One of the problems with this approach is that rules are made to reflect past experiences and almost inevitably will lead to an unpredictable change in behaviour which may have a negative effect on the economy such as making us all less entrepreneurial. We all know we need financial regulation but it would be nice to think that in the future more of our politicians and government officials used their common sense and focused less on giving us more regulation and more on better regulation.
Finally, I see that ProShare Investment Clubs indicate some years ago there were over 60,000 investment clubs in America and over 12,000 in Britain. It is often difficult for a single investor on his or her own to arrange a sensible spread of risk and pooling resources with a few like-minded individuals ought to help the spread of risk and improve decision-making. It seems clear investment clubs are a powerful force for good in a developed economy and there is nothing inherently wrong with them. In particular provided they are organised to ensure they are not carrying on the business of a regulated activity they ought not to break financial services law.
Tom Mackay is a partner at Mackay Carter Shaw LLP