This alert highlights some of the risks arising from authorised firms failing to carry out appropriate due diligence on investment offerings. While aimed primarily at pension scheme operators, it will also be of interest to financial advisers and those providing discretionary fund management.
Scammers are becoming increasingly sophisticated in developing products designed to defeat firms’ due diligence efforts. We want firms to be aware of the current threats and encourage them to review the effectiveness of their systems and controls.
Previously, in our July 2014 Dear CEO letter[1], we raised concerns about:
- The due diligence procedures SIPP operators used to assess non-standard investments.
- How well firms were adhering to the relevant prudential rules.
Our new liquid capital requirement, imposed by IPRU(INV) 5.9.1 R[2], means these two concerns are now inseparable for personal pension scheme operators subject to that rule.
Scams are evolving
We have seen scams evolve to become increasingly sophisticated:
- First-generation scams offered unregulated physical assets – such as commercial property – for direct investment.
- Second-generation scams obscured those underlying unregulated physical assets by creating a special purpose vehicle (SPV) to acquire them using funding raised by the issue of corporate bonds.
- Third-generation scams now use the services of a discretionary fund manager to create an investment portfolio that does not require the direct input of the investor; this portfolio then invests in SPV bonds.
The reason for this evolutionary process appears to be to obscure the nature of the ultimate underlying investment.
Recognising non-standard assets
Our rules[2] say that a standard asset must appear on the list of standard assets, and ‘must be capable of being accurately and fairly valued on an ongoing basis and readily realised within 30 days, whenever required.’
A failure to understand which assets are non-standard may leave a firm vulnerable to exploitation by third parties, and we re-emphasise the need for firms to conduct – and retain – appropriate and sufficient due diligence. We have long advocated a financial crime risk assessment for newly introduced investment products as good practice; you can read our comments about investment fraud from the 2010 Small Firms Financial Crime Review in Part 2 of our Financial Crime Guide[3].
For those personal pension scheme operators which are subject to a liquid capital requirement where their schemes do not consist entirely of standard assets, failing to identify non-standard assets risks a capital shortfall. Other scheme operators may wish to consider whether their holding non-standard assets merits additional capital provision.
Assessing realisability has its own challenges. Despite this there can be signs that an asset appearing on the standard asset list may nevertheless be non-standard, for example by the questions which might be asked in the following two scenarios:
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Securities admitted to trading on a regulated venue
- How marketable are the securities? In the absence of systematic internalisers (‘market makers’) on a particular venue, is there a guarantee that securities can be sold at a particular price – or any price?
- If your holding of a particular security represents a material proportion of the issuance, will that have an impact on realisability?
- What are the implications of external events prompting many holders of a thinly-traded security all attempting to sell into the market at the same time? How likely is this to occur?
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Fixed interest stocks
Corporate bonds, including ‘mini bonds’, may be issued on terms where they are not redeemable before they mature. Despite this, some bonds are promoted – either generally, or to a particular group of investors – on the basis that there is a liquidity facility that means they can nevertheless be realised within 30 days, if necessary.
- How is this liquidity funded? How often has it been used?
- What is the identity and financial capacity of the counterparty? Has that capacity been tested?
Your firm is at risk
If your due diligence processes – both initial and ongoing – are not robust, there is a risk that you may become involved in an illegal scheme. Our intelligence and supervisory activities on pension scams are co-ordinated with our Project Bloom[4] partners and other agencies, and we will take action as necessary.
All authorised firms should contact us[5] to report concerns about investments offered to, or taken up by, scheme members.
If you are aware of money being lost to an investment fraud, you should report it to Action Fraud on:
- 0300 123 2040
- www.actionfraud.police.uk[6]
You should also consider whether suspicious activity reports – and, if appropriate, consent applications to transfer monies – should be submitted to the National Crime Agency[7].