SIPP operators – due diligence after Carey

(2) the FCA’s Conduct of Business Sourcebook (COBS) Rules imposed an obligation (COBS 2.1.1) on the SIPP provider to act “honestly, fairly and professionally in accordance with the best interests its client”, which required the SIPP provider to advise the claimant against making the investment.

The Court concluded that in order to identify the extent of any duty imposed on a SIPP provider by COBS 2.1.1, one would have to look to the contract between the parties. In this case the contract made clear that the claimant was responsible for his own investment decisions and the SIPP provider did not owe any duty to advise on the underlying investment.  The judge stated that “that ‘[no] provision [was] drawn to my attention at trial to demonstrate that, so far as the COBS duties which I am considering are concerned, the regulatory regime is intended to take precedence over the contractual terms”.

The approach of the court to look at the actual contract, and to not accept arguments to extend duties that do not arise in the contract, is helpful in giving execution-only SIPP operators some level of certainty about their activities, at least from the perspective of the courts. Further, while the FOS does not need to follow legal precedent – case officers can base their decisions on what they consider to be fair and reasonable in the circumstances – one would expect the Carey case to inform FOS decisions. Well drafted SIPP documentation, with clearly crafted scope of duties and exclusions of liability clauses, will protect SIPP operators.

The Berkeley Burke case

The Carey case has been contrasted with the much discussed decision in Berkeley Burke SIPP Administration v Financial Ombudsman Services Ltd [2018] EWHC 2878 (the Berkeley Burke case). In this case, it transpired that there was no title to the land that was purported to be sold as part of an underlying investment. The investor brought a FOS claim against Berkeley Burke SIPP Administration Ltd (BBSAL), to recover the funds he had lost. FOS held that BBSAL should compensate the investor. FOS had decided that BBSAL should have:

• identified the investment as high-risk, speculative and non-standard;
• ensured that the investment was not fraudulent;
• independently verified the assets were real and secure, and the investment operated as claimed; and
• ensured that the investment could be independently valued.

BBSAL brought an unsuccessful legal challenge to the FOS decision. The judge in Carey stressed the very different facts from the Berkeley Burke case. In particular, Berkeley Burke was concerned with an investment into a scam and the key point at issue was whether sufficient due diligence had been carried out by the SIPP operator, something which the Judge considered Carey had undertaken appropriately according to the client agreement.

The FCA’s approach

Despite the Carey case, the FCA has since clarified that it still expects SIPP operators to comply with its expectations in the 2009 thematic review, Dear CEO letter and the 2013 finalised guidance for Self-Invested Personal Pensions (SIPP) operators (Finalised Guidance) which would impose obligations which go beyond those which the court expected of the SIPP operator in the Carey case. 

In its ‘Dear CEO’ letter published in October 2018, the FCA had referenced the Berkeley Burke case and reminded SIPP operators of its Finalised Guidance.

Due diligence

With reference to Principle 6 of the FCA’s Principles for Businesses which requires all firms to pay due regard to the interests of its customers and treat them fairly; and Principle 2 which requires all firms to conduct their business with due skill, care and diligence, the FCA expects SIPP operators to have procedures and controls in place to manage the risk of financial crime and consumer detriment.

The FCA states that “while they are not responsible for the advice, there is a reputational risk to SIPP operators that facilitate SIPP investments that are unsuited to their members”. The following are examples of relevant systems and controls as described by the FCA in the Finalised Guidance:

• assessing that investments are appropriate for personal pension schemes;
• ensuring that all investments permitted by the scheme are permitted by HMRC, or where a tax charge is incurred, that charge is identifiable, HMRC is informed and the tax charge paid;
• having a set of benchmarks, or minimum standards, with the purpose of setting the minimum standard the firm is prepared to accept to either deal with introducers or accept investments;
• recording and retaining records of the due diligence completed on investments not approved and collecting and analysing the Management Information (“MI”) this provides;
• collection of MI to identify trends in the business submitted by introducers;
• ability to identify the number of investments, the nature of those investments, the amount of funds under management, spread of introducers, the percentage of higher risk or non-standard investments;
• ability to identify any issues with the production of illustrations or benefit crystallization events;
• monitoring MI against established benchmarks linked to a firm’s risk tolerance and business model e.g. the level of non-standard investments within a scheme; and
• ensuring all third-party due diligence that the firm uses or relies on has been independently produced and verified.

An enhanced level of due diligence is expected in relation to Unregulated Collective Investment Schemes (UCIS).

Role of introducers

Where introducers are involved, the FCA expects:

• confirmation, both initially and on an ongoing basis, at least that: introducers that advise clients are authorised and regulated by the FCA with the appropriate permissions; ensuring that introducers have other appropriate qualifications and skills to introduce different types of business to the firm, and undertaking additional checks such as viewing Companies House records, identifying connected parties and visiting introducers;
• terms of business agreements that govern relationships and clarify the responsibilities of those introducers providing SIPP business to a firm;
• an understanding the nature of the introducers’ work to establish the nature of the firm, what their business objectives are, the types of clients they deal with, the levels of business they conduct and expect to introduce, the types of investments they recommend and whether they use other SIPP operators. Being satisfied that they are appropriate to deal with;
• an ability to identify irregular investments, often indicated by unusually small or large transactions; or higher risk investments such as unquoted shares which may be illiquid. This would enable the firm to seek appropriate clarification, for example from the prospective member or their adviser, if it has any concerns;
• identification of instances when prospective members waive their cancellation rights and the reasons for this; and
• independent verification checks on members to ensure the information they are being supplied with, or that they are providing the firm with, is authentic and meets the firm’s procedures and are not being used to launder money.

Non-standard assets – additional due diligence

The FCA’s prudential rules for SIPP operators require all asset types to be categorised by SIPP providers as either ‘standard’ or ‘non-standard’. Non-standard investments are those which do not fall within the category of standard investments found in the FCA Handbook (IPRU-INV). These are typically higher risk or speculative propositions, and the entire amount invested is at risk. These investments tend to be illiquid and difficult to value, and there may be little or no recourse to the FOS and FSCS, for example if the arrangement is mis-managed. Some may be outright scams.

The FCA considers that most non-standard investments, such as UCIS, unlisted shares and speculative overseas property schemes, are unlikely to be suitable for those retail investors of ordinary sophistication and means who make up the vast majority of the retail market in the UK.  However, more sophisticated investors may consider them to be appropriate investment opportunities. For this reason, the FCA has decided not to ban them (see FCA Policy Statement 14/12).

Clearly, a SIPP operator would need to decide if its risk appetite extended to non-standard investments and, if so, put in place additional due diligence processes which might include screening questionnaires for potential investors.

The SIPP operator may undertake additional due diligence on both the advisory / introducer firm and the potential investment including: the investment provider’s structure; key individuals; and analysis of the legal status and underlying structure of the investment. A further stage may be to consult an external due diligence specialist and / or law firm to give an opinion as to the status of the investment and prepare a report for the operator.

Appropriate governance mechanisms would follow such as approval by an investment committee which undertakes a final review of the proposed investment and any third party report.

Due diligence – one size does not fit all 

Clearly the FCA’s guidance and examples of good practice are not exhaustive, and, subject to the circumstances, a SIPP operator may decide to make further checks on the business of third party advisers and introducers e.g. the risk profile and history of success of the underlying investments and whether they fall within the contractual arrangements with the client. This is a difficult assessment as the SIPP operator will not want to collect data which is more properly collected by an investment advisory firm where it has otherwise satisfied itself as to the probity of that firm.

An important element in determining the scope of the SIPP  operator’s duties will be the extent to which the FCA rules on suitability and appropriateness apply.  SIPP operators inhabit varying structures – a group comprising a SIPP operator may have a mixture of MiFID; non-MiFID businesses; and insurance entities.  For instance, there may be a MiFID adviser or discretionary manager in the group;  and advice may be given in relation to the pension wrapper only and/or the underlying investments; or as in the Carey case there may just be an execution-only service. Such considerations will determine the appropriate systems and controls; and the nature of client documentation. 

In conclusion

While the Carey case stresses the importance of ensuring that the client agreement is properly drafted to protect the SIPP operator, the FCA’s clarification that it still expects SIPP operators to comply with its expectations in the 2009 thematic review, Dear CEO letter and Finalised Guidance mean that firms are still required to have in place robust due diligence processes to ensure that investments accepted into a SIPP comply with the FCA’s regulatory requirements. While an important protection, contractual disclaimers will be insufficient to release the SIPP operator from its obligations to undertake due diligence.

Although the judge in the Carey case took the view that the FCA’s 2009 “Thematic Review” document relating to SIPPs did not reflect binding requirements on SIPP operators actionable in court, the trend towards such FCA communications effectively becoming regulatory standards is likely to continue.

The Carey case is unlikely to stop SIPP clients whose investments underperformed taking their chances in legal action on the basis of a lack of due diligence by the SIPP operator on the underlying investment itself.

McDonnell Ellis has experience of:

• drafting client contracts for SIPP operators which correctly define the relationship and mitigate a firm’s risk consistent with the Carey case;
• advising on and designing due diligence programs for SIPP operators according to their particular circumstances; and
• offering health checks and reports on the scope of duties of the operator and legal opinions  / due diligence services on standard and non standard assets.

Please speak to Brian or David if you would like to discuss the issues raised by this briefing