Legislative Framework and Background

Under Article 51ZE of the Financial Services and Markets Act 2000 (“FSMA”) (Regulated Activities) Order 2001 (FSMA RAO), establishing, operating or winding up a collective investment scheme (“CIS”) is a regulated activity. Therefore, to enable a person to continue this activity they must be authorised, or be an exempt person, or be able to rely on an applicable exclusion. A CIS is an arrangement by which individuals collectively invest in property with a view to sharing any residual profits or income. A comprehensive definition of what constitutes a ‘CIS’ is set out in s.235 of FSMA. This definition has recently been examined and interpreted by the Supreme Court in the case FCA v Asset LI Inc (“FCA v Asset LI”), which considered the scope of s.235 in conjunction with a land-banking scheme.

Section 235 FSMA 2000

The definition of ‘CIS’ under s.235 FSMA is as follows:

“(1) In this Part “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.

(2) The arrangements must be 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 to give directions.

(3) The arrangements must also have either or both of the following characteristics—
(a) the contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
(b) the property is managed as a whole by or on behalf of the operator of the scheme.

(4) If arrangements provide for such pooling as is mentioned in subsection (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single collective investment scheme unless the participants are entitled to exchange rights in one part for rights in another.

(5) The Treasury may by order provide that arrangements do not amount to a collective investment scheme—
(a) in specified circumstances; or
(b) if the arrangements fall within a specified category of arrangement.”

Previous case law already identified that the drafting of s.235 had been done in an open textured manner; it adopts a high level of generality by using words such as ‘arrangement’ and ‘property of any description.’ The Supreme Court considered the scope of this definition in the context of a land-banking scheme by determining whether such a type of arrangement fell within the ambit of s.235.

Facts of the Case

A company (Asset LI) had acquired some large agricultural sites and then divided the sites into small individual plots of land, which where then offered for sale to investors. Once sold, the company prepared the site for development by: re-zoning, assisting in converting the use of the land from agriculture to residential and progressing planning applications for planning permissions with a view to selling the whole site to a third party, most likely a developer, on behalf of the investors. The investors, as owners of the land, would each receive a part of sale proceeds that corresponded to their respective plots.

It was noted that the schemes had evolved over time in a concerted effort to bring the scheme outside of the scope of s.235. Despite these steps the FCA still deemed the schemes within the ambit of s.235 since the true object of the scheme was for investors to benefit from an increase in the collectivised value of individuals plots with minimal input from the investors themselves. In forming this conclusion the FCA considered that the investors were being offered rights under a scheme that provided for someone else to manage the property, which amounted to a CIS.

Prior to the investor acquiring an individual plot of land, they were required to sign a document confirming a number of disclaimers, namely that the company did not offer investment advice or offer regulated investment products to the public. The document also included a representation clause that excluded the investor from relying on any representations made outside of the contract. Furthermore, the contract also stated that the company would not be involved in re-zoning the land or applying for planning permission.
The company sought to rely on these various representations and disclaimers as proof that they did not intend, nor did they operate a CIS.

The judge found the reality to be inconsistent with these representations particularly the latter one; the general understanding was that the company would progress the planning procedure and then procure their sale of the site as a whole, probably to developers, to which the land owners would then see a return on their investments. Although the investors had legal protections in which they could refuse a sale; the judge noted that it would make no financial sense to do so and therefore, in reality the investors would inevitably accept such an offer.

As a side point, the judge found the various disclaimer clauses to be of no effect because of the application of the Unfair Terms in Consumer Contracts Regulation 1999 and the Misrepresentation Act 1967. The key representations had been made before the provision of legal documentation and it was these representations that the investors had relied upon and considered the true agreement between the parties. In this way, these representations, disclaimers and contract were not part of the arrangement.

In formulating this conclusion, the judge at the first instance made the following observation:

“people do not live their lives only by reference to their legal rights, and often manage their affairs, and make arrangements, on the basis that the legal framework in which they operate will not be invoked…Non legal arrangements are commonly made in parallel with legal contracts…they operate on different levels.”

Additionally, the language of s.235(2) referred to ‘actual control’ and was not limited purely to what legal rights each investor had.

On appeal, the Company sought a conservative interpretation of s.235 given the serious consequences of a breach, and an interpretation that would promote certainty. Their key points of appeal was that legally the investors held their property outright and merely had a right to opt-in to a potential sale of the whole site. Consequently, the final decision was reserved for the investors. The Company cautioned that an incorrect interpretation would interfere with a wide range of legitimate business arrangements that should not be characterised as a CIS. Whilst judges appreciated the contention that s.235 should not be stretched, they considered that its application in these circumstances did not distort its natural meaning or its intended purpose.

The issues to be considered under s.235 were noted as:

(i) Were there arrangements within s.235(1)?
(ii) Were the arrangements such that the investors did not have day-to-day control?
(iii) Were the arrangements such that the property was managed as a whole by or on behalf of the ‘operator’?

Did the arrangement fall within s.235(1)? and what constituted the ‘property’?

As indicated above, given the generality of the wording of s.235(1) it was not difficult for the land-banking scheme to fall within the scope of s.235(1). Despite this, whether or not it did correctly fall within the scope required an examination of the true meaning of the term ‘property’. Did it amount to each individual plot or the site as a whole?

A previous judgment in Re Sky Land Consultants plc had already held that in such circumstances where a large site was split into smaller plots, the term ‘property’ referred to the land as a whole (which comprised the individual plots sold to investors) rather than each individual plot in circumstances where the income or profits would be derived from the sale of a whole. This reasoning was adopted despite it being legally possible for each investor to sell their individual plot because it was determined that in reality selling each individual plot was neither the intention of the investors, nor likely to happen in a context where the return to investors would be enhanced through a sale of the whole site. The true arrangement therefore related to the site as a whole.

‘Day to day control’

The judge confirmed that determining control extended beyond an identification of who had the legal ability to decide what happened to the property. To determine ‘control’ an assessment was required on whether the arrangement conferred or afforded the investors control, and to that end ‘day to day’ control. The judge concluded that the investors did not have either individually or collectively since:

i. the ‘property’ in question referred to the whole site and the investors could only exercise control of their own individual plots; and
ii. the investors did not have collective control of the property as the Company retained control of the common parts and access points and there were no arrangements that existed by which the investors were granted collective control.

Management

A significant feature of s.235 is the reference to ‘management of the property’. The judge considered that the necessary question to consider is, whether the functions that were assigned to the Company after the investors acquired their plot constituted the management of the site. In this way, the term ‘management’ should be focused on the management functions, which the investors were concerned with – i.e. those management functions that would lead to the intended profits, which therefore concentrated on the steps being taken to enhance the development of the land. Fundamentally, the term must be read in the context of the particular types of scheme in issue and in relation to land-banking. This was focused on taking actions to prepare the site for an application for planning permission, as this would be how the investors would realize the value of their investment, the purpose being to make a profit from the change of use of land from agricultural to residential or other use. It was confirmed, consistent with previous case law that enhancing the development value of land constituted ‘management functions’. Following this interpretation, the actions of the Company where related to the ‘management of the property.’

Notwithstanding that these functions could be considered management functions, this was not enough by itself to satisfy the test; the management function had to be carried out by the operator of a scheme. Therefore, a distinction needed to be made between circumstances where the intermediaries supply professional services to enhance value, and cases where investors surrender control over their property to the operator of a scheme so that it can be pooled or managed in common. This was a question of fact and the judges determined that the role of the Company did not amount to offering professional services as the actions of the Company went beyond merely putting a proposal forward to the investors in which they were free to either approve or reject as they saw fit.

Fixing the pieces of the puzzle together; application of this interpretation

Lord Sumption recognised that the issue of the definition of a ‘CIS’ was a longstanding one:

“the definition and its predecessor of 1986 have been regarded as highly unsatisfactory provisions by professional advisers ever since they were first enacted, mainly because of their generality, lack of definition and dependence on secondary legislation to take transactions out of the scope of the legislation which ought not to be there.”

The judge noted that most of the difficulty centered on considering schemes that were not covered by this secondary legislation. The judge identified that there was an important difference, which runs throughout FSMA 2000, between financial instruments and physical assets, but unhelpfully ‘CIS’ are the exception to this. The difficulty therein encompasses the difficulty with all regulatory legislation, which has to find the right compromise between protecting consumers and avoiding regulatory overkill.

The judge noted that the construction and use of sub-sections in s.235 were of fundamental importance; (1) provides a wholly general description of collective investment schemes which would virtually cover all cooperative arrangements for deriving profits or income from assets whereas (2), (3) and (4) narrows the breadth of that description which render (2), (3) and (4) to be at the heart of the definition. Considering what amounted to the ‘property’ required, given the wording of (1), determining where the income or profit would derive from; in this circumstance it was the sale of the whole site. Following on from this, day-to-day control referred to in (2) must equally refer to the property and therefore vis a vis the whole site. Similarly where the scheme involves physical asset, s.235 (3)(b) requires the arrangement to involve the operator managing the physical assets. Therefore, (2) and (3) provide two allied functions in that they restrict the scope of the definition to focus on circumstances where investor exchanges the property over which he has control in exchange for larger property within which he has limited rights. In essence, a CIS would exist where property owners are, despite individual rights they may possess, nevertheless limited by the collective nature of the scheme.

In a helpful summary the judge stated:

“the fundamental distinction which underlies the whole of s.235 is between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value; and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can either be pooled or managed in common, in return for a share of the profits generated by the collective fund.”

Jennifer Gray