UK Supreme Court rules on the scope of liability of principals for their appointed representatives

Background

Under section 19 of the Financial Services and Markets Act 2000 (FSMA) no person may carry on a “regulated activity” in the UK unless they are either authorised by the Financial Conduct Authority (FCA) or an exempt person. Breach of this rule, which is known as the general prohibition, is a criminal offence and any transactions entered into as a consequence of such a breach are potentially unenforceable as against the other party

Section 39 of FSMA contains a mechanism under which a person who is not authorised by the FCA can become an exempt person and thus can perform certain regulated activities. If that person (i.e. the “AR”):

• enters into a contract with someone who is authorised by the FCA (his “principal”), which complies with certain prescribed requirements; and
• is someone “for whose activities in carrying on the whole or part of that business his principal has accepted responsibility in writing”,

that person is exempt from the need for FCA authorisation in relation to “any regulated activity comprised in the carrying on of that business for which the principal has accepted responsibility”.

AR arrangements are a relatively straightforward way for non-authorised persons to be able to carry out regulated activities – provided that they can find a principal willing to support them.

There are, however, legal limitations on what an AR can do. Under the FSMA regime, only certain specific types of regulated activity can be covered by an AR arrangement – the main ones being “advising on investments”, “arranging deals in investments” (e.g. acting as an intermediary to help bring about a transaction between two other parties), dealing as agent (but only in relation to certain types of insurance contract) and entering into various types of consumer lending agreement and/or providing certain debt-related services. An AR cannot be appointed to carry on regulated activities that are not listed in the relevant regulations (such as “managing investments” or operating collective investment schemes).

In addition, the FCA rules state that the principal can only appoint an AR to do regulated activities that fall within the scope of the principal’s own FCA permission. If, for example, a principal did not have permission from the FCA to carry on the regulated activity of advising on investments, it could not appoint an AR to carry on that activity.

The facts

In this case, Kession Capital Limited (KCL) was an authorised person that – acting as principal - entered into a contract to appoint Jacob Hopkins Mackenzie Limited (JHML) as its AR.

Under the terms of the AR contract, JHML was appointed to carry on the regulated activities of “advising on investments” and “arranging deals in investments”. However, the contract contained an express provision that the AR was “not permitted to conduct any business with retail clients”. This reflected the fact that KCL did not have permission from the FCA to do the “advising” activity for retail clients (although it did have permission to “arrange deals” for retail clients). There was also an express prohibition on the AR operating a collective investment scheme.

Notwithstanding these restrictions, JHML carried out a much broader range of activities than was permitted under the AR contract. JHML operated a series of property investment schemes, which the court found amounted to collective investment schemes. JHML also promoted these schemes to retail clients, who invested approximately £1.7 million into them. The schemes failed, and the investors lost their money. Having been unable to recover their losses from JHML given it had become insolvent and its director declared bankrupt, the investors sought to recover their losses from KCL, as the principal of JHML.

First instance and Court of Appeal decisions

At first instance, the court found in favour of the investors. Paul Stanley KC, sitting as Deputy High Court judge, found that the AR’s activity of “operating” the property schemes had been unlawful and was not covered by the AR contract. However, he held that, as the AR contract anticipated that the AR could “arrange deals” and “advise” on schemes of this nature, the activities of the AR in soliciting customers were within the scope of the AR arrangement – and so the principal could be liable for the investors’ losses. In relation to the prohibition in the AR contract on conducting business with retail clients, the judge said that that provision did not define “what” activities the AR could do but only defined “how” the AR went about doing the activities that it was allowed to do. On that basis, although JHML’s actions in marketing the schemes to retail clients were in breach of the AR contract, the judge held that those actions were within the scope of the authority given to JHML under the AR contract to carry on regulated activities – and KCL was therefore liable in respect of them.

KCL appealed that decision to the Court of Appeal. The Court of Appeal, by a 2:1 majority, rejected the appeal and decided that KCL was responsible for the losses suffered by JHML’s customers. The majority (Lord Justice Males and Sir Geoffrey Vos MR) endorsed the view of the judge at first instance that the contract term was a question of “how” the AR could perform activities, not “what” activities it was permitted to perform. (Lord Justice Levison gave a dissenting judgment as regards KCL’s responsibility for JHML’s dealings with retail clients as he was not of the view that KCL could permit its AR to carry on regulated activities which it was not permitted to carry on itself.)

KCL appealed to the Supreme Court on the question of whether it should be liable in respect of the business that its AR conducted with retail clients.

The Supreme Court decision

The Supreme Court unanimously upheld the appeal.

Section 39 of FSMA refers to the principal accepting responsibility for the “whole or part of” the business of an AR. In this case, Lord Richards, giving the leading judgment of the court, held that the restriction on conducting business with retail clients was a means by which KCL limited its responsibility so that it was only responsible for that “part of” the AR’s business that involved dealing with non-retail clients.

Lord Richards said it would defeat the purpose of the regime if a principal whose expertise lay in dealing with non-retail clients was required to assume responsibility for an AR’s conduct of retail business, notwithstanding that the permission given to the AR was limited to dealing with non-retail clients.

He also noted that, if the principal was liable in that situation, it would be likely to discourage the appointment of ARs unless both the principal and AR are qualified and competent to deal with all categories of client. If that was a result which the FCA considered appropriate, the FCA may well be able to achieve that through its rule-making powers.

Commentary

The decision will come as a relief to the principals of ARs, who would have been concerned about the risk of becoming liable for the acts of their ARs that even they themselves were not legally permitted to carry out. As the Supreme Court alluded to, the contrary approach could have had a chilling effect on the use of ARs in the context of wholesale and institutional business. As things stand, however, the Supreme Court has restored the orthodox view and the law has reverted to what most principals would have assumed the position to be.

Authored by Dominic Hill.