The What, the How, and the Responsibility – Liability of Principals for actions of Appointed Representatives under FSMA s39

The Court of Appeal has recently affirmed the views of the lower court on the liability of principals for their appointed representatives' actions in KVB Consultants Limited v Jacob Hopkins McKenzie Limited and others.

We first reported on the case of KVB Consultants Limited v Jacob Hopkins McKenzie Limited and others after the original decision on summary judgment came out last year. The defendant principal appealed the summary judgment and the Court of Appeal has now dismissed the appeal, affirming the lower court's view.  Principals must therefore ensure that their appointed representative agreements are carefully drafted and must consider the risks of "how" an appointed representative might carry out regulated activities, not simply "what" activities are being carried out. 

Jacob Hopkins McKenzie Ltd (JHM) was an appointed representative (AR) of Kession Capital Limited (KCL), under the Financial Services and Markets Act 2000 (FSMA).  KCL became the target of a number of claims concerning losses incurred on certain collective investment scheme (CIS) investments which JHM promoted.  

Under s39 of FSMA, an authorised person can effectively lend their FCA authorisation to other firms. Despite being unauthorised themselves, these firms will then be able to use the principals' authorisations in order to undertake regulated activities.  The scope of what activities the AR is able to perform on behalf of the principal will be set out in an Authorised Representative Agreement (ARA).   In this case, the Claimants sought to hold KCL liable for the losses they incurred as a result of the CIS investments which JHM promoted.  The Claimants sought summary judgment against KCL, arguing that it was so clear that KCL was responsible for JHM's activities that summary judgment was warranted on that specific issue.  The lower court agreed.

The two primary issues to be heard by the Court of Appeal were (1) whether promoting the CIS investments fell under the 'Relevant Business' section of the ARA and (2) whether a prohibition in the ARA on promoting CIS to retail investors was a restriction on 'what' could be done or 'how' it could be done.  Under FSMA s39, liability of principals for the activities of ARs hinges upon what they have agreed to be responsible for in writing.   As such, the Court of Appeal considered the content of the ARA closely, and further considered how the ARA terms fit in with the language and overall aims of the relevant legislation.

As to the first issue, KCL submitted that the distinction the lower court drew between 'promoting/marketing' and 'operating' a CIS was too fine of a distinction and that the ARA, properly read, stated that JHM was to have nothing at all do to with CIS.

The Court of Appeal was unconvinced, noting that the distinction between promoting/marketing and operating is recognised within the legislation, and so it is only right to draw the same distinction in interpreting the ARA.  As such, the fact that the ARA expressly excluded operating a CIS did not mean that KCL did not accept responsibility for JHM promoting CIS.

The Relevant Business JHM was to carry out under the ARA was to "offer advisory and arranging services to third-party investors with regard to residential property investment." The CIS JHM had promoted was indeed a residential property investment, and so the Court of Appeal agreed that the ARA envisioned JHM carrying out precisely the activities it actually carried out. 

The Court of Appeal further agreed with the lower court that the attempt to exclude CIS by a clause in the ARA stating "there is no pooling of capital and no CIS" was a reflection of the parties' (mistaken) understanding of what constituted a CIS, not the legal reality of it, akin to parties' deeming an agreement to be a license, despite it legally being a lease.

As to the relevance of KCL's own FCA permissions, it is interesting that at the lower court, KCL argued that they themselves were not regulated to promote CISs.  However, at the Court of Appeal, they accepted that they were, in fact, regulated to promote CISs, by virtue of the inclusion of the word 'unit' in the list of authorised investment types. Therefore, this further strengthened the Court of Appeal's conclusion that promoting CISs did form part of the Relevant Business under the ARA and so was business KCL could be responsible under s.39 of FSMA dependant on the terms of the ARA.

As to the second issue, KCL submitted that the prohibition on advising retail clients contained within the ARA caused JHM's activities to fall outside the Relevant Business of the ARA, and KCL had therefore not agreed to accept responsibility for those activities for the purposes of s39 of FSMA.  This issue arose because it transpired that, although JHM classified all of its customers as sophisticated or professional, many of these classifications were incorrect, and the customer ought to have been classed as retail and so JHM should not have advised them.   

The Court of Appeal considered a similar issue in Anderson v Sense finding that there are boundaries as to the limitations principals can place within ARAs in order to avoid liability for certain activities.  More specifically, a principal may restrict what activities the AR carries out (by reference to the authorised activities), but it cannot restrict how those activities are carried out, at least for the purposes of s39 responsibility.  'How' limitations will still be effective as between the AR and the principal for the purposes of a claim by the principal against the AR for a breach of any appointed representative agreement, but they will not be effective as between the consumer and the principal. 

When determining whether the restriction on JHM to only deal with retail customers was a 'what' or a 'how' restriction, the Court of Appeal considered whether the activity of advising could be broken into parts – ie advising retail customers as a separate activity to advising professional or sophisticated customers.

Following a review of the relevant authorities, the Court of Appeal drew particular attention to four principles:

"78. First, the appointed representative’s exemption and the principal’s responsibility are co-extensive.

79. Second, the permission given to the appointed representative, and the corresponding acceptance of responsibility by the principal, may be limited to the carrying on of only part of the generic business for which the principal is authorised.

80. Third, it was in this context that [the Court of Appeal in Sense] drew a distinction between ‘what’ and ‘how’. The point of the distinction was to enable the principal’s acceptance of responsibility to be limited to certain kinds of business (the ‘what’, i.e. ‘what activity may be carried on’), while preventing the principal from drafting its way out of responsibility by limiting its permission by reference to the way in which the permitted business was to be carried on (the ‘how’, i.e. ‘how a permitted activity is carried on’). For example, a grant of permission which is conditional on the business being carried on properly will be ineffective to limit the principal’s responsibility to investors. If I may say so, the distinction between ‘what’ and ‘how’ sheds valuable light on section 39, although it is always necessary to ensure that such a striking phrase does not come to replace the statutory language. The statutory
language refers to ‘part of that business’, i.e. part of the business of a prescribed description which the principal is authorised to conduct.

81. Fourth, it is significant that Lord Justice David Richards referred to ‘the underlying regulatory and protective purposes of the legislation’."

In applying these principles, the Court of Appeal concluded first that the issue of what type of business an AR carries out is very different from the question of for whom that business is carried out.  Second, the court concluded that determining whether a client is retail, professional, or otherwise, requires an assessment which is very similar to the type of assessment required in advising on suitability.

"It is common ground that an assessment of suitability is concerned with how the business is conducted, so that if an appointed representative recommends an unsuitable investment, the principal is responsible. That responsibility cannot be avoided by a contract term purporting to limit the permission given to the appointed representative to recommending investments which are suitable for the investor."

Similarly, the court concluded that a principal ought not to be able to avoid liability for the incorrect classification of a customer as professional or sophisticated.  For a principal to impose a prohibition on dealing with retail clients necessarily entrusts to the AR the task of determining which clients are retail and which are not, just as it entrusts the task of assessing suitability.  Viewed this way, "it makes no legal or commercial sense to say that the principal entrusts that decision to the representative when the representative gets it right, but not when it gets it wrong."

Third, the court concluded that to allow a principal to limit their responsibility only to an AR advising non-retail clients would be against the consumer protection aims of FSMA s39.  It would result in professional clients dealing with ARs having greater protections that misclassified retail clients: a perverse result indeed.

The court did note that KCL's own FCA permissions did not permit it to deal with retail clients, and that this might seem contradictory to the conclusion that KCL was responsible for JHM advising retail clients, despite a prohibition on it in the ARA.  However, KCL finds itself in the same position as JHM, in that if it were to misclassify a retail client as a professional client, it would have to take responsibility for the consequences of doing so, just as it would have to take responsibility for providing unsuitable advice. 

As with the original judgment in this case, the conclusion here does not drastically alter the landscape of principal liability for AR activities.  However, it does provide some useful nuance and explanation for the tests employed in differentiating 'what' and 'how' restrictions and serves as a stark reminder to principals to ensure AR agreements are carefully drafted and that they fully understand what they are taking responsibility for.