UK: Supreme Court clarifies scope of principal’s liability under appointed representatives regime

Why should I read this?

In a landmark judgment, the Supreme Court has held that a principal firm, Kession Capital Ltd (Kession), was not responsible for the acts of its appointed representative (AR), Jacob Hopkins McKenzie Ltd (JHM), who dealt with retail clients despite being expressly prohibited from doing so under the terms of the AR agreement in place between the two parties.

The decision will be welcomed by principal firms as it confirms that they will not be held liable for the conduct of ARs who carry on activities, such as dealing with retail clients, that are outside the scope of their appointment.

What was the case about?

The AR regime

Section 39 of the Financial Services and Markets Act 2000 (FSMA) establishes the AR regime by creating an exemption from the general prohibition on carrying on regulated activities for an unauthorised person (the AR) who acts under the responsibility of an authorised firm (the principal).

Under section 39(1), the exemption applies where the AR is party to a contract with a principal which permits or requires the AR to carry on specified business, and the principal has accepted responsibility in writing for the AR’s activities in carrying on “the whole or part of” the specified business.  This means a principal may limit the scope of what the AR is permitted to do to only “part” of the specified business.

Under section 39(3), a principal is responsible, to the same extent as if it had expressly permitted it, for anything done or omitted by the AR in carrying on the business for which the principal has accepted responsibility.

Kession and JHM

Kession was an FCA-authorised firm with permission under Part 4A of FSMA to arrange deals in investments and advise on investments.  One or both of those permissions were subject to the limitation that the firm could not deal with retail clients.

In 2015, Kession appointed JHM as an AR to carry on “relevant business” on its behalf, which included arranging deals in investments and giving advice on investments.  The terms of the AR agreement between Kession and JHM expressly prohibited JHM from dealing with retail clients.

The dispute

JHM set up a number of property investment schemes, all of which failed.  Despite the terms of the AR agreement, all but one of the investors in the schemes were retail clients. The investors, who lost a total of £1.7 million, issued proceedings against JHM and others. Judgment in default was entered against JHM and the scheme companies, all of which are insolvent and from which no recovery is expected.  The investors then issued proceedings against Kession and applied for summary judgment.

Kession defended the claim on the basis that, in dealing with retail clients, JHM had acted outside the scope of the business for which Kession had assumed responsibility and, accordingly, the retail clients were not entitled to bring a claim against Kession.

At first instance, Paul Stanley KC (sitting as a Deputy High Court Judge) gave summary judgment against Kession, finding that under section 39(3) FSMA, Kession was responsible for JHM’s activity in arranging and advising on investments with the claimants.  This was despite the limitations on Kession’s Part 4A permission and the terms of the AR agreement.

The decision was upheld by the Court of Appeal.  Kession appealed to the Supreme Court.

What did the Supreme Court decide?

The decision

The issue considered by the Supreme Court was one of statutory construction, namely the meaning of the words “part of” in the phrase “the whole or part of” the specified business in section 39(1) FSMA.

In a unanimous decision, the Supreme Court allowed Kession’s appeal, holding that dealing with retail clients constitutes a “part” of a business in the context of section 39(1).  By restricting JHM’s permission to dealing only with professional clients, and not with retail clients, Kession had accepted responsibility only for JHM’s dealings with professional clients and not with retail clients. Accordingly, the investors’ claim failed.

Reasons for the decision

Lord Richards, who gave the judgment, noted that as a matter of ordinary language, there is no difficulty in describing dealing with retail clients as a “part” of a financial services business.  The distinction between retail and professional clients is an important feature of the financial services regulatory regime, due to differences in their protection needs.  This provides support for the view that dealing with a particular category of clients, such as retail clients, may properly be described as a distinct “part” of a financial services business.

Lord Richards also noted that the FCA may give an authorised firm permission to deal solely with professional clients.  Again, this suggests that dealing with retail clients is a distinct “part” of a business.

Lord Richards noted that as the financial services regulatory regime “operates primarily on a prophylactic basis, seeking to prevent the occurrence of abuse”, FSMA should be construed with consumer protection in mind.  There are three reasons why consumer protection would be better served by construing dealing with retail clients as constituting “part” of a business:

• First, it would undermine effective regulation if a principal whose expertise is in dealing with professional clients is required to assume responsibility for an AR’s conduct of retail business.  This would mean that a principal whose Part 4A permission prevents it from dealing with retail clients would still be responsible for its ARs’ dealings with retail clients.  This would not serve the interests of consumers or be a sensible feature of an effective regulatory regime.
• Second, a principal may conclude that an AR is only qualified to deal with professional clients.  It would make little sense to require the principal to be responsible for the AR’s dealings with retail clients where the terms of the AR agreement limit the AR to dealing with professional clients.
• Third, if dealing with retail clients is not “part” of its permitted business, an AR whose terms of appointment prohibit it from dealing with retail clients will not incur any criminal or civil consequences flowing from breach of the general prohibition if it does in fact deal with retail clients.  This outcome would not improve consumer protection.

The judgment also notes that it would be unfair and “regulatory overkill” to make a principal responsible for an AR’s activities in dealing with retail clients when the AR is expressly prohibited from doing so by the terms of its appointment.

While the appeal arose from a summary judgment application, the case was argued in full before the Supreme Court.  In allowing the appeal, the Supreme Court ruled as a final decision that Kession had no responsibility under section 39(3) FSMA for anything done or omitted by JHM in carrying on business with retail clients.

What does this mean for principal firms?

The Supreme Court’s decision will be welcomed by principal firms as it gives certainty that their contractual arrangements with ARs can be relied upon to define the scope of their responsibility.  The now-overturned Court of Appeal decision created the troubling prospect of a situation in which a principal could be held responsible for activities by an AR which were outside the scope of the AR agreement or for which the principal did not have regulatory permission.

AR agreements

The case highlights the importance of principal firms ensuring that their AR agreements are well-constructed and drafted to clearly identify the scope of business their ARs are permitted to conduct and, crucially, any restrictions that apply (including restrictions on dealing with particular client types).  At a minimum, the restrictions on the AR’s activities should encompass any limitations on the principal’s Part 4A permission.

Principals should review their AR agreements on a periodic basis to ensure they remain fit for purpose.

Due diligence, supervision and monitoring

Principal firms should ensure they carry out thorough due diligence on their ARs and have robust processes in place to supervise and monitor their ARs’ activities once appointed.  Due diligence, and oversight and monitoring frameworks, should be reviewed on a periodic basis, as well as when any issues come to light, to ensure they remain adequate.

This is especially important in the age of the Consumer Duty and the FCA’s increasingly assertive approach to supervision: where the FCA has concerns about the conduct of an AR and potential harm to consumers, the principal will inevitably find itself under the regulatory spotlight.

Changes to the AR regime

HM Treasury recently consulted on wide-ranging changes to the AR regime, with the aim of improving standards of conduct and providing an appropriate level of consumer protection.  The proposals include the introduction of a new regulatory gateway for principal firms wishing to appoint ARs, extending the jurisdiction of the Financial Ombudsman Service to include ARs, and bringing ARs within the scope of the Senior Managers and Certification Regime.

Principal firms should keep watch for our updates to ensure they stay informed about future changes to the AR regime.

How ES can help

Eversheds Sutherland’s Financial Services sector teams have specialist knowledge of the AR regime.  We can advise principals and ARs on:

• the potential consequences of proposed changes to the regime and structural planning for the same;
• your regulatory obligations;
• compliance with FCA requirements;
• how to manage your relationship with the FCA; and
• what to do when things go wrong.

Further reading on the appointed representatives regime

HM Treasury consultation on the Appointed Representatives Regime

HMT policy statement on the appointed representatives regime