Restrictions on the Sale of Subordinated Debt

Introduction

The FCA (Financial Conduct Authority) has highlighted the potential for the inappropriate distribution of regulatory capital investments – which are deeply subordinated (i.e. rank behind all other claims in the event of insolvency) and offer poor liquidity (i.e. may not be readily saleable in order to recover the amount invested) – as an area of high possible risk to consumers. Therefore it has applied increased consumer protection requirements to the sale of these capital instruments across the financial services industry, including subordinated debt and deferred shares  offered by credit unions.

The FCA’s rules restrict the amount a typical individual can invest in subordinated debt and other capital instruments and require firms to issue risk warnings when promoting the sale of subordinated debt to typical individual investors.

There are no additional requirements applied to sales to corporate and professional clients (broadly regulated firms and large companies) and reduced requirements for those individuals who are certified as sophisticated investors or high net worth individuals.

If you have any questions or comments on this information guide please contact your Member Relationship Manager by emailing them direct, on info@abcul.org or dialling 0161 832 3694.

New Requirements

The below requirements on subordinated debt will take effect 3 January 2017 and are held in CREDS 3A.5 here.

No obligation rule

The FCA explicitly states that credit unions must not require any of their members to purchase subordinated debt or purport to do so.

Investment cap of 10% of net investable assets

Ordinary individual members, small businesses, and small charities are limited to investing 10% of net assets into credit union subordinated debt, deferred shares and mutual society shares. Credit unions can still sell subordinated debt to professional and counterparty clients (e.g. a regulated financial firm or large company) without any additional requirements.

Exemptions for sophisticated and high net worth investors

The following categories of retail customers are – on meeting certain conditions – exempt from the 10% net asset restriction and the risk warning:

• Certified sophisticated investors – These are individuals who have been assessed by an FCA regulated firm within the last 36 months as sufficiently knowledgeable to understand the risks associated with engaging in investment activity in non-mainstream investments (such as subordinated debt). Such a person must present a certificate of assessment from an FCA approved firm and have signed a dedicated confirmation statement in the 12 months preceding an investment.

• Self-certified sophisticated investors – These are individuals who self-certify as a sophisticated investor, having met one of four criteria detailed in COBS 4.12.8R. The prescribed self-certification statement is contained at the bottom of this briefing which the individual must have signed in the 12 months preceding an investment.

• Certified high net worth investors – These are individuals with an annual income of more than £100,000 or net investable assets of more than £250,000. The firm will have to obtain a signed statement contained from the individual and carry out a preliminary assessment of suitability i.e. taking reasonable steps to acquaint itself with the members’ profile and objectives and ascertain whether or not the sale of subordinated debt would be suitable for that member. (see: COBS 4.12.5G 2. (c)).

Compliant versions of the self-certified sophisticated investor statement, certified investor statement and high net worth investor statement are provided in the appendices at the end of this guide.

Risk warning(s)

Credit unions must provide the prescribed risk warning in a durable medium in any promotion which invites a member purchase subordinated debt.

The credit union also needs to obtain written confirmation that the member has read it in good time before they have committed to buy the subordinated debt.

This warning covers the following points:

• All of the capital invested is at risk
• Income or distribution payments are entirely discretionary
• The instrument is perpetual and may be illiquid
• Investing more than 10% of the client’s net investable portfolio in this type of instrument is unlikely to be in their best interests

The risk warning firms must use is included at the bottom of this briefing . If selling to a non-advised individual credit unions also need to provide and obtain a signature for the statement.

N.B. Unless the member is receiving regulated advice it is a non-advised sale and will require the further risk statement in Appendix 5. Credit unions require specific permission to provide regulated advice.

Compliance and record keeping

Records must be maintained for all sales of deferred sales demonstrating compliance with the above for three years, including:

• signed investor statements in the case of self-certified high net worth and certified investors
• records of suitability assessments or any certifications issued by the credit union
• evidence that risk warnings have been issued.

Outsourcing

Where any of the activity of selling subordinated debt is outsourced to another firm it is the credit union’s responsibility to ensure that activity is compliant with FCA rules.

Conclusion

The requirements above relate to credit union subordinated debt and were added to the credit union sourcebook 3 January 2017. Whilst these requirements impact the potential for credit unions to raise capital from their individual members, they can continue to sell subordinated debt to most corporate members (i.e. professional and counterparty investors) without additional restrictions or requirements.

If you have any questions or comments on this information guide please contact your Member Relationship Manager by emailing them direct, on info@abcul.org or dialling 0161 832 3694.

Appendix 1

Self-certified sophisticated investor statement:

“SELF-CERTIFIED SOPHISTICATED INVESTOR STATEMENT

I declare that I am a self-certified sophisticated investor for the purposes of the restriction on promotion of subordinated debt. I understand that this means:

(i)  I can receive promotional communications made by a person who is authorised by the Financial Conduct Authority which relate to investment activity in subordinated debt;

(ii) the investments to which the promotions will relate may expose me to a significant risk of losing all of the property invested.

I am a self-certified sophisticated investor because at least one of the following applies:

(a)  I am a member of a network or syndicate of business angels and have been so for at least the last six months prior to the date below;

(b)  I have made more than one investment in an unlisted company in the two years prior to the date below;

(c)  I am working, or have worked in the two years prior to the date below, in a professional capacity in the private equity sector, or in the provision of finance for small and medium enterprises;

(d) I am currently, or have been in the two years prior to the date below, a director of a company with an annual turnover of at least £1 million.

I accept that the investments to which the promotions will relate may expose me to a significant risk of losing all of the money or other property invested. I am aware that it is open to me seek advice from someone who specialises in advising on subordinated debt.

Signature:

Date:”

Appendix 2

Certified investor statement:

“SOPHISTICATED INVESTOR STATEMENT

I make this statement so that I can receive promotional communications which are exempt from the restriction on promotion of subordinated debt. The exemption relates to certified sophisticated investors and I declare that I qualify as such.

I accept that the investments to which the promotions will relate may expose me to a significant risk of losing all of the money or other property invested. I am aware that it is open to me to seek advice from an authorised person who specialises in advising on subordinated debt.

Signature:

Date:”

Appendix 3

High net worth investor statement:

“HIGH NET WORTH INVESTOR STATEMENT

I make this statement so that I can receive promotional communications which are exempt from the restriction on promotion of subordinated debt. The exemption relates to certified high net worth investors and I declare that I qualify as such because at least one of the following applies to me:

– I had, throughout the financial year immediately preceding the date below, an annual income to the value of £100,000 or more;

– I held, throughout the financial year immediately preceding the date below, net assets to the value of £250,000 or more. Net assets for these purposes do not include:

(a)  the property which is my primary residence or any money raised through a loan secured on that property;

(b)  any rights of mine under a qualifying contract of insurance; or

(c) any benefits (in the form of pensions or otherwise) which are payable on the termination of my service or on my death or retirement and to which I am (or my dependants are), or may be, entitled.

I accept that the investments to which the promotions will relate may expose me to a significant risk of losing all of the money or other property invested. I am aware that it is open to me to seek advice from an authorised person who specialises in advising on subordinated debt.

Signature:

Date:”

Appendix 4

Subordinated Debt Risk statement (link):

“The investment to which this financial promotion relates is credit union subordinated debt. Making a subordinated loan to a credit union can be high risk and is very different to investment in deposit accounts or other savings products. In particular you should note that:

(a)  the entire amount you lend is at risk;

(b)  the loan will not be repaid to you until at least five years from the date on which you lend the amount to the credit union;

(c)  if the credit union is wound up the sum you lend is only repayable to you if there are funds remaining after all creditors (excluding holders of deferred shares) have been repaid;

(d)  the entire amount you lend is not covered by the Financial Services Compensation Scheme;

(e)  to the fullest extent possible, you will be required to waive any right to set off any amount you owe to the credit union against any amount the credit union owes to you under the subordinated loan; and

(f)   investing more than 10% of your savings or net investment portfolio in credit union subordinated debt, deferred shares issued by a credit union and mutual society shares is unlikely to be in your best interests.”

Appendix 5

Further risk statement for non-advised sales

“I make this statement in connection with my proposed making of a subordinated loan to a credit union. I have been made aware that investing more than 10% of my net assets in credit union subordinated debt, deferred shares issued by a credit union and mutual society shares is unlikely to be in my best interests. I declare that the proposed investment would not result in more than 10% of my net assets being invested in credit union subordinated debt, deferred shares issued by a credit union and mutual society shares. Net assets for these purposes mean my financial assets after deduction of any debts I have. My debts for these purposes do not include the outstanding balance of any mortgage I have on my home, unless this is more than the current value of my home, in which case the debts include the amount above the current value. My financial assets for these purposes do not include:

(a)  the property which is my primary residence or any money raised through a loan secured on that property;

(b)  any rights of mine under a contract of insurance; or

(c)  any benefits (in the form of pensions or otherwise) which are payable on the termination of my service or on my death or retirement and to which I am (or my dependants are) or may be entitled.

I accept that the investment to which this statement relates will expose me to a significant risk of losing all the money invested.

Signature:

Date:”

[1] A partnership, body corporate, unincorporated association or association with an annual turnover of less than £1 million

[2] A charity with an annual income of less than £1 million 

[3] Net investable assets exclude the value of the client’s home, pension funds and any benefits under insurance policies. Any debt that the client owes should be subtracted from the value of assets held by the investor.