Liability for principals for failure to adequately supervise: key developments in regulatory hosting services

The authorised representative regime has been trending in both the regulatory and litigation spaces.  On the regulatory side, the FCA recently toughened its rules for principals.  On the litigation side, the Court of Appeal recently refused to allow a principal to escape liability in the KVB Consultants Limited v Jacob Hopkins McKenzie Limited [2024] EWCA 76 decision.  We outline these key recent developments in this article.

New rules for principals

While the Financial Services and Markets Act 2000 (“FSMA”) contains a general prohibition on unauthorised persons carrying out regulated activities, unauthorised persons can be exempt from this prohibition by becoming the appointed representative (an “AR”) of an authorised person (a “principal”) under section 39.  As at the end of 2023, there were just under 3,000 principals and around 35,000 ARs in the marketplace.

In essence, the principal takes on regulatory responsibility (or engages in “regulatory hosting”) for the AR.  As stated in one of the leading cases on the AR regime [1], “Regulation of ARs may thus be said to be outsourced by the FCA to the relevant authorised person. It is designed to reduce the regulatory burden on both the FCA and the large number of tied agents and independent financial advisors whose activities are conducted on a relatively modest scale.”  This outsourcing by the FCA, whereby the principal is responsible for ensuring regulatory compliance by the AR, results in the FCA looking to the principal when harm occurs as a result of an AR’s actions or inactions.  In effect, it is a statutory principal-agent relationship giving rise to four broad areas of potential liability for principals. Under the statutory regime: (i) vicarious liability for breaches by the AR; and (ii) primary liability for failure to supervise or implement proper systems and controls.  Under the common law; (i) liability where the agent has implied (and therefore actual) authority for acts incidental to their express authority; and (ii) liability where the agent has ostensible or apparent authority.

As a consequence, it is perhaps no surprise that the FCA noted in 2022 that “principals and ARs account for more than 60% of the total value of recent claims to the Financial Services Compensation Scheme. They also generate up to 400% more supervisory cases and complaints than other directly authorised firms.” [2] Nor is it a surprise that the FCA introduced new rules and enhanced expectations for principal firms effective from the end of 2022, requiring principals to provide more information on ARs, and clarifying and strengthening the responsibilities and expectations of principals. These were mainly around self-assessment, annual reviews, monitoring and oversight.

Last month the FCA released results from a survey (via telephone questionnaire) of just over 250 principals, and an in-depth assessment of around 10% of those, looking at their compliance with these new regulations. While it found general improvement and compliance from principals, some of the statistics are interesting. With regard to self-assessments, while the survey showed 95% had completed these, the in-depth assessment found only 83% had and, of those, that only 52% were “of a good quality”. Similarly, with regard to annual reviews, while the survey showed that 90% had completed these, the in-depth assessment found 82% had and, of those, only 43% were “of a good quality”. Other findings around monitoring, oversight, acting out of scope, onboarding, offboarding and termination did not include statistics but the FCA commented on “tick-box” approaches which needed to improve before concluding that it would take “swift action” where it sees principals not meeting its standards in the future.

The Court of Appeal’s most recent view on the AR regime

In KVB Consultants v Jacob Hopkins McKenzie, decided in late summer, the courts were (yet again) tasked with the question of when a principal is responsible for the acts of one of its ARs.  In this case, having lost money in residential property schemes promoted by a now insolvent AR, the investors sought to sue the principal and requested summary judgment on the question of the principal’s liability.

The agreement between the principal and the AR restricted the AR to carrying out only certain activities including “advising on investments” and “arranging deals in investments”.  It also contained an express prohibition on the AR conducting business with retail clients and on operating collective investment schemes.  Despite these restrictions, the AR carried out those activities: it operated a property investment scheme that the Court found was consistent with a “collective investment scheme” and promoted it to retail clients who made significant investments (totalling circa £2 million). The main question for the Court was whether the principal could be liable for activities (i.e. operating a collective investment scheme and dealing with retail clients) that the AR agreement appeared to exclude.

Since Anderson, the Courts make a distinction between “what” the AR is permitted to do (i.e. what activity may be carried on by the AR) and “how” the AR carries on that permitted activity.  A principal can limit its liability through restrictions on “what” an AR can do, but not through “how” an AR does it.

Here, the lower Court held that the AR was not allowed (under the AR agreement) to operate collective investment schemes and, indeed, that KVB was not allowed to under its own authorisation. This being a “what” prohibition, KVB could not be responsible for it. However, the AR was allowed to promote and advise on such schemes and the lower Court determined that the restriction on promoting them to retail clients was a “how” prohibition (i.e. it could promote and advise on such schemes generally, with subsequent specification as to who could be a candidate for investment) and therefore the principal could be liable. The lower Court further held that the retrospective realisation that the property schemes were collective investment schemes did not assist the principal claim that these were prohibited, because the investments had in fact been operated as the principal and AR understood they would be (they had just not appreciated that they would qualify as collective investment schemes). The Court then went on to consider whether the AR had been in breach of FCA Conduct of Business rules and, if so, when, granting partial summary judgment. On appeal, the Court agreed that the principal was liable for the ARs’ losses.  It endorsed the view that this was a question of “how” the AR could perform activities and not “what” activities it was permitted to perform. The majority then held that the restriction on sales to retail clients was a contractual term that did not affect the scope of permission given by the principal to the AR, even though the principal itself did not have permission from the FCA to advise retail clients (Lewison LJ disagreed on this point).

Comment on trends

It is clear from the above that there is continued regulatory concern as to the adequacy of AR supervision as well as continued judicial willingness to find ways to ensure retail investors are not left out-of-pocket where there have been breaches by ARs.  This will be welcome for investors dealing with ARs, particularly as it illustrates that there are both regulatory and litigation avenues for recovery against principals that are not adequately supervising their representatives.

Similar trends towards ensuring closer supervision, and compensation, in other principal-agent, delegatory and outsourcing-type relationships can be seen in other areas of financial services.  By way of example, in the “Authorised Corporate Director” space, earlier this year the FCA found Link Fund Solutions liable for failing to act with due skill, care and diligence in carrying out its role in respect of the Woodford funds at almost the same time as, on the judicial side, the Courts approved the related scheme of arrangement [3] providing redress. It seems evident from these recent developments that regulatory bodies and Courts are trending towards tightening the reins of principals in principal-agent relationships.

Footnotes

[1] Anderson v Sense Networks [2019] EWCA Civ 1395, at [13].
[2] FCA confirms new rules to improve oversight of Appointed Representatives | FCA
[3] Re Link Fund Solutions Ltd [2024] EWHC 250 (Ch)