UK’s financial regulator rapped following LCF collapse – Paul Brehony, Abdulali Jiwaji and Johnny Shearman

By Paul Brehony & Abdulali Jiwaji

Partners Paul Brehony and Abdulali Jiwaji, and Head of Knowledge and Legal Services Johnny Shearman examine the report into the FCA / London Capital & Finance (LC&F) and its failures to effectively regulate and supervise LC&F and what this means for the FCA.

Paul, Abdulali and Johnny’s article was published in Global Restructuring Review, 22 January 2021, and can be found here.

The independent review of the regulator was instigated by the FCA at the direction of the UK’s Treasury and was carried out by the former Court of Appeal Judge, Dame Elizabeth Gloster.

Tasked with determining whether the FCA discharged its functions in respect of LCF in a manner that enabled it to effectively fulfil its statutory objectives, Dame Elizabeth concluded that it had not and, in doing so, she did not pull her punches. Overall, she found that the regulator failed to provide the protection that LCF’s bondholders were entitled to expect and receive.

The collapse of LCF

LCF’s primary business was lending funded by issuing various non-transferable securities, known as mini-bonds. These mini-bonds were issued for up to five years and at rates of interest that varied depending on the terms of the bond and bond issue. Prior to its collapse, LCF had raised over £237 million (US$325.31 million) from approximately 16,700 investment products issued to some 11,625 bondholders. In November 2017, the UK’s tax authority HMRC approved LCF to manage Individual Savings Accounts (ISAs). LCF promptly started to offer products that it claimed to be ISAs, alongside its non-ISA products (such as its pre-existing mini-bond offering).

In December 2018, because of serious concerns regarding the LCF’s conduct, including issues with the accuracy of its financial promotions, the FCA conducted an unannounced site visit at LCF’s premises. The FCA then imposed various restrictions preventing LCF from issuing any further financial products. Subsequently, the FCA raised concerns as to the viability of LCF’s business, resulting in a suggestion by the FCA that the firm should obtain advice regarding its solvency. Shortly after, on 30 January 2019, LCF’s directors appointed administrators with the consent of the FCA, among other stakeholders.

In March 2019, the administrators’ first report stated that there were several highly suspicious transactions involving a small group of connected people that led to large sums of bondholder money ending up in their personal possession or control. A subsequent report estimated that the return to LCF bondholders from the company’s assets could be as low as 25% of their original investment.

The collapse of LCF was well publicised at the time, receiving significant media and political attention because of its impact on retail investors and concerns about the regulatory framework that the events raised. This culminated with the UK Treasury directing the FCA to commission an investigation into the regulation of LCF. Dame Elizabeth was appointed to lead the investigation in July 2019.

Investigation into the FCA’s flawed approach

The direction from the Treasury required Dame Elizabeth’s investigation to determine whether the FCA had discharged its functions in a way that enabled it to fulfil its statutory objectives. Dame Elizabeth found that the FCA had failed in this respect. The root cause of the its failures to regulate LCF was significant gaps and weaknesses in the its policies regarding the analysis of the business activities of regulated firms. Dame Elizabeth identified three broad categories of deficiency underlying the FCA’s inadequate regulation of LCF.

First, the FCA’s approach to its “regulatory perimeter” was unduly limited. The FCA did not encourage its staff to look outside its regulatory perimeter when dealing with FCA-authorised firms, such as LCF. This made it possible for LCF to use its authorised status to promote risky, and potentially fraudulent, non-regulated investment products to unsophisticated investors.

While LCF was a regulated firm the majority (if not all) of its revenue was generated from non-regulated activities. LCF’s mini-bond business, for example, did not constitute regulated activity. As a result, the FCA’s approach to this wider aspect of LCF’s business was not subject to sufficient scrutiny. This flawed approach meant that LCF was able to use its FCA-regulated status to present an appearance of respectability to the market, even in relation to its non-regulated mini-bond business.

Second, the FCA failed to consider LCF’s business holistically. FCA staff focused on LCF’s breaches as though they were isolated issues. Notably, they did not consider whether, and if so how, these issues were indicative of broader concerns with LCF’s business. Where supervision was carried out it was limited and ineffective.

Finally, FCA staff members who reviewed material submitted by LCF had not been trained sufficiently to analyse a firm’s financial information to detect indicators of fraud or other serious irregularity. Despite having the appropriate powers to monitor LCF, this weakness in skill set permeated various aspects of the FCA’s regulation of the firm, rendering its powers ineffectual.

Dame Elizabeth found that the cumulative result of these failures was that the FCA had not appreciated the true nature of LCF’s business or the risks that it posed to consumers. Neither did the FCA appreciate the significance of an ever-growing number of red flags, which were indicative of serious irregularity in LCF’s business. To exacerbate matters, this occurred at a time when LCF’s unregulated mini-bond business was growing at a rapid pace and substantial funds were being invested by bondholders.


The broad scope of Dame Elizabeth’s investigation meant she was entitled to make recommendations in light of her findings. In total, she made nine recommendations that targeted both the FCA’s policies and practices and the regulatory regime in general. Among the recommendations were the following:

  1. FCA staff responsible for authorising and supervising firms should consider a firm’s business holistically.
  2. The FCA’s policies should clearly state that call-handlers: (i) should escalate allegations of fraud or serious irregularity, even when the allegations concern the non-regulated activities of an authorised firm; (ii) should not reassure consumers about the non-regulated activities of a firm based on its regulated status; and (iii) should not inform consumers (incorrectly) that all investments in FCA-regulated firms benefit from protection under the UK’s financial services compensation scheme (FSCS)..
  3. The FCA should provide appropriate training to relevant teams on: (i) how to analyse a firm’s financial information to recognise circumstances suggesting fraud or other serious irregularity; and (ii) when to escalate cases to specialist teams within the FCA.
  4. FCA senior management should ensure that product and business model risks, which are identified in its policy statements as being emerging, and are of sufficient seriousness to require ongoing monitoring, are communicated to staff involved in the day-to-day supervision and authorisation of firms.
  5. The FCA should have appropriate policies in place which clearly state what steps should be taken or considered following repeat breaches by firms of the financial promotion rules.
  6. The FCA should ensure that its training and culture reflect the importance of its role in combatting fraud by authorised firms.
  7. The FCA should take steps to ensure that: (i) all information and data relevant to the supervision of a firm is available in a single electronic system such that any red flags can be easily accessed and cross-referenced; and (ii) that system uses automated artificial intelligence / machine learning to generate alerts for staff when there are red flags.
  8. The FCA should take urgent steps to ensure that all key aspects of its “Delivering Effective Supervision” programme, which envisions supervision as a pre-emptive and collaborative tool, are fully embedded and operating effectively.
  9. The FCA should consider whether it can improve its use of regulated firms as a source of market intelligence.

“Use it or lose it”

As part of its response to this public rebuke, the FCA has accepted all nine recommendations made in the LCF review. Nikhil Rathi, Chief Executive of the FCA, who joined the regulator only last October, referred to the historic events as sobering. Mr Rathi emphasised the FCA’s commitment to implementing the recommendations and lessons learned but acknowledged that significant changes were needed to the way the regulator operates, in particular on the way the FCA approaches information and data sharing.

Among other key actions, in the next six months the FCA plans to undertake a “use it or lose it” exercise. Firms that have not used their regulatory permission to earn any regulated income for the last 12 months are at risk of having their authorisation revoked. The desired effect is to reduce the risk of firms having permission to carry out regulated activity simply to add credibility to their unregulated activities.

Further regulatory reform?

The FCA’s handling of LCF fell well below the standard expected of it and it would be wrong to simply consign these events to the history books. Clearly, lessons must be learned and changes must be made to ensure that investors are protected against similar events in the future. However, one danger for authorised firms is the risk of a knee jerk reaction from the regulator.

The announcement of the “use it or lose it” exercise comes at a time when the economy is gripped by the covid-19 pandemic. The result is that there may well be legitimate instances where firms have not used their regulatory authorisation to earn income in the past 12 months. Those authorised firms will need to be ready for an interaction with the regulator in the next six months about permission.

Concerns regarding the conduct of LCF’s business have resulted in criminal investigations by the regulator and the Serious Fraud Office, both of which remain afoot.

In addition, independent liquidators have been appointed to review possible claims against LCF’s auditors, which include EY and PwC. At the same time, the administrators of LCF are pursuing claims against the former directors of the company in an effort to recoup money that they allege was misappropriated. In this regard, it will be interesting to see if the FCA decides to involve itself in the insolvency proceedings by issuing warning notices against LCF in a similar way that it did recently against the construction and facilities giant, Carillion.

Given that enforcement activity against directors and senior managers has been relatively light in recent years, we may see the FCA taking a more robust approach in light of this recent criticism, which follows soon after heavy criticism of its failure to hold anyone to account for the scandal that saw the collapse of UK fund, Woodford Equity Income.

However, with the full impact of the UK’s withdrawal from EU on the financial services sector still to come, it is unlikely there will be much appetite for further regulatory reform at this time. With that said, given the number of independent reviews that are considering the regulatory framework (including the LCF review, the review carried out by Raj Parker into the FCA’s handling of the Connaught fund and the long-awaited investigation by Dame Linda Dobbs into the HBOS Reading fraud) it is right to question whether consumers and unsophisticated investors are being afforded adequate protection.

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