Bonds in Luxembourg, investors in the UK

Catalyst was the primary UK distributor of the ARM Capital Growth Bond – issued by ARM, a securitisation company, in Luxembourg – and the ARM Assured Income Plan. The bonds were listed on the Irish Stock Exchange until November 2010. These products are a form of ‘traded life policy investment’ based on life insurance policies purchased in the United States. Securitisation firms typically purchase these policies from policyholders for a lump sum and take on the burden of paying them their regular premium. When an original policy holder dies, the firm receives the insurance payment.

All was going well at ARM until its internal compliance department 'formed a legal opinion' on 19 November 2007 that it had been issuing bonds in a non-compliant way. The FCA, at para 2.3, states this in the vaguest (and least grammatical) way possible, commenting that ARM thought that it needed a licence from the CSSF, Luxembourg's regulator, to continue to issue its bonds “as inter alia it fell within the CSSF's interpretation of 'issuing on a continuous basis.' With these mysterious words hanging in the air, the FCA mentions that Catalyst knew of this opinion at the time ARM formed it and then turns to ARM's application for a licence in July 2009.

The FCA takes up the subject of 'continuous issuance' again at para 4.15. Luxembourg law, it says, provides that securitisation undertakings which issue securities to the public on a continuous basis must be licensed by the Luxembourg financial regulator, the CSSF. Another piece of the jigsaw pops out at para 4.16 with ARM's opinion, formed on 19 November 2007, that it thought it needed a licence because it because it issued bonds more than three times a year – one wonders, but one is never told, whether this might have made it an 'issuer on a continuous basis' – and that this might make it a 'securitisation undertaking' in the eyes of the CSSF, with the implication that the CSSF's opinion on this was important in some way.

In the footnotes there are more tantalysing clues about the relationship between the CSSF and the law. Here, in a message to the FCA, (Annex B 1.1d) Catalyst states that, in its own eyes, “the position under Luxembourg law is unresolved as to whether ARM actually required a licence – if so this was only because the CSSF had changed the way it chose to interpret the 2004 Securitisation Law.” This throws up more questions than it answers. Why would anyone care what the CSSF thinks? (According to the FCA, it is not even ARM's regulator – at 4.8 it states baldly: “ARM is not regulated.”) Does it regulate securities firms at all, or does it merely grant them licences for various things? What powers does the CSSF have to interpret statutes? Is this not the job of a Luxembourg judge? Does the CSSF have any powers over bond-issuers other than the power to distribute licences? What are the Luxembourg courts' view of that doubtless important but unexplained phrase, 'issuing on a continuous basis'? The document does not bother to answer even one of these questions.

Openness about the regulatory situation

The FCA states that every firm in Catalyst's position is obliged under APER principles 1 and 7 (conducting business with integrity and meeting the information needs of clients) to point out anything that might be bad or unfavourable to investors about the bond-issuer's regulatory position. In this case the 'regulatory position' – a phrase it repeats over and over – was that ARM did not have a licence from the CSSF, but considered that it required one. We can extrapolate from this that, in the FCA's eyes, if any firm in the supply chain believes that regulatory trouble might affect business, the firm that deals with the high-net-worth investors is obliged to tell them that.

Dicing with death: the Luxembourg licence application process

The FCA makes a disconcerting observation about the CSSF licence-issuing process at para 2.4: “One consequence of the refusal of a licence under Luxembourg law is that the issuer of the bonds must be liquidated.” In other words, any Luxembourg securities firm that wants to issue bonds is taking its life in its hands every time it asks the CSSF for permission to do so – a very serious deterrent to business of this kind. CM asked the CSSF to comment on this, but had received no reply 24 hours later.

Catalyst clearly transgressed against APER principle 1 (“a firm must conduct its business with integrity”) by failing to point out the fact that ARM thought that it was staring liquidation in the face, something that ARM told it as soon as it had formed the opinion itself on 19 November 2007. Much later, on 20 November 2009, Catalyst knew that ARM would not issue any more bonds, at least until it had a licence, but also said nothing. Because of this and its secrecy about the aforementioned opinion it transgressed against principle 7 (paying due regard to the information needs of clients and passing information to them in a clear, fair and not misleading way) throughout the period of the censure.

Catalyst sent letters to independent financial advisers in December 2009 and to investors in March 2010. These were, indeed, misleading about ARM's predicament. They intimated that the Luxembourg firm's application for a licence was voluntary and steered clear of any mention of liquidation.

The Irish escape-hatch that never opened

There were also plans afoot from early 2010 for ARM to relocate to Ireland. Here it would not need clearance from the regulator to operate, although regulatory approval would have been necessary for the prospectus and other odds and ends. A shell company was set up for this purpose but the crossover from Luxembourg never happened. In the letter to investors of March 2010 (para 4.31) Catalyst told investors that a move to Ireland would be 'advantageous' if it could not be 'regulated in Luxembourg.' The FCA thought that this was a disingenuous understatement.

In making its representation to the FCA, Catalyst wrote: “Catalyst reasonably believed at all times that either the CSSF licence would be granted or the re-domicile to Ireland would succeed, but believed that knowledge of those difficulties could cause a run on the bonds by consumers.” This may have been so – the FCA paper is unclear about what happened to the Irish escape plan and never states that it was not viable. It does not even state that ARM was right to believe that it needed a licence from the Luxembourg regulator.

Causing undue alarm to future victims

Catalyst's proposition that its decision to keep information away from the investors was legitimate, however, does seem far-fetched as principles 1 and 7 make it obvious that investors must be put in full possession of all the material facts. In another representation in Annex B 1.5a, the FCA remembers that Catalyst made the rather rum suggestion that a disclosure about the CSSF application was best avoided because it might cause “undue alarm to...pending investors,” a phrase that sounds remarkably close to an admission of mis-selling.

It also, however, refused to do so to avoid causing alarm to existing investors and causing a run on the ARM bonds. Here it was on firmer ground. The FCA itself states at Annex B 1.9b: “Catalyst was never required by the Authority (and ARM was never required by the CSSF) to write to investors regarding CSSF authorisation of ARM. This was clearly because nothing positive would have been achieved by doing so and there was a serious risk of precipitating a run on the bonds if that explicit message had been given.” Nonetheless, it is a different story when the FCA evaluates Catalyst's decision to keep quiet to the investors at 1.10b by saying “...the Supervisory Notice is not relevant to the case against Catalyst. Further, the prospect of a run on the bonds would not have been a legitimate reason to issue misleading promotions.”

Other holes exist in the document. For one thing, at paragraph 2.10 the FCA states that “any loss is currently unknown.” In other words, the FCA has not tracked down even one loss. Despite the general soundness of its conclusion, the tricky puzzles and blind alleyways that the Catalyst censure document presents to the reader are noticeable.

The FCA's interpretation of recklessness

In previous final notices the FCA and its predecessor-body have struggled with the definition of 'recklessness', a word that often justifies a fine. In the final notice the regulator often states that Catalyst's continuing promotion of bonds throughout the long crisis showed “a reckless disregard for the interests of investors.” Its decision whether a firm acts recklessly (Annex A 3.8) rests on “giving consideration to factors such as whether the person has given no apparent consideration to the consequences of the behaviour that constitutes the breach.” Expressing itself differently, it states at Annex B 1.6b: “Catalyst acted recklessly in closing its mind to the risks to investors when sending the letter.” It imposes even heavier penalties if it thinks that the behaviour it is punishing was deliberate.

A generous penalty...in principle

The award of penalties, in view of Catalyst's inability to pay, are largely academic. The FCA does, however, say that since most of the conduct it is censuring occurred before the new and more stringent penalty regime began operating on 5 March 2010, it would only have charged Catalyst a fine of £450,000 in accordance with the old regime. This might have repercussions for other persons whose misdeeds straddle the two periods and who are able to pay.