Court of Appeal spotlights principal's liability for appointed representatives in the UK

The recent Court of Appeal decision in KVB Consultants Limited v Jacob Hopkins Mckenzie Ltd has raised concerns for regulatory hosts, as it continues the recent line of decisions interpreting the scope of section 39 of the Financial Services and Markets Act 2000 (FSMA) and what hosts have "accepted responsibility" for in respect of the conduct of their appointed representatives (AR).

Although the split decision is expected to lead to an appeal to the Supreme Court, in the meantime, many risk and compliance officers are likely to consider reviewing their contractual arrangements with ARs, increasing supervision and audit activity and checking their insurance coverage.

'Accepted responsibility'

The decision under appeal was a finding that Kession Capital Ltd (KCL) had accepted responsibility for the actions of its AR, Jacob Hopkins McKenzie (JHM), in promoting and marketing collective investment schemes to retail customers.

The decision was on an application for summary judgment, meaning that the High Court judge was satisfied, without the need for a full trial, that KCL had no real prospects of defending the claim.

Section 39 deals with the exemption of ARs from the general prohibition on regulated activities, providing that that exemption applies "in relation to any regulated activity comprised in the carrying on of that business for which his principal has accepted responsibility."

It is established law that the principal's liability for the regulatory misconduct of the AR is co-extensive with that exemption: if the principal has "accepted responsibility", they can be held directly liable under section 39.

Underlying misconduct

KCL was authorised to carry on designated investment business and appointed JHM under an AR agreement (ARA) to conduct "relevant business".  

The ARA provided that the schemes that JHM operated were not to be collective investment schemes (CISs) and should not be marketed to retail clients. KCL was not authorised to operate CISs or market to retail clients. 

The schemes were CISs, however, and JHM had marketed and sold them to retail clients; inevitably, the investors lost their money and JHM went into insolvency when the investment schemes failed – and the claimants sought to recover from KCL as the principal.

KCL argued that, as was made clear from the terms of the ARA, it had not accepted responsibility for the conduct of JHM, as the contract excluded the promotion or operation of CISs and the advising on or arranging deals for retail clients.

The High Court disagreed in part. Applying the established test, the High Court distinguished between "what" activities KCL had accepted responsibility for and "how" those activities were carried out (for which it has sought to restrict its responsibility). In simple terms, KCL,  under section 39(3) of the FSMA, had accepted responsibility for promotion and marketing activities – the "what" – and that it could not contractually limit its responsibility for "how" JHM undertook those marketing activities (that is, marketing CISs or to retail clients) in breach of contract.

KCL's appeal

KCL appealed on two grounds – that it had excluded all CIS activity in the ARA and that it had excluded all activity with retail clients – and, therefore, had not accepted liability for this conduct.

The leading judgment noted the precedent case law distinguishing "what" and "how". However, it noted that, while this was a useful judicial tool, the wording in section 39 was "accept responsibility for part of the business". The key question was, therefore, to establish what "part" of the business the principal had accepted responsibility for; and, once accepted, it could not limit its liability of that part through contractual drafting.

Section 39's application

The majority were satisfied that the part of the business (or the type of the business) was distinct from the question for whom that business could be undertaken and from an assessment of whether a client is professional or retail is part of the business process. If a client is mistakenly classified as a professional client or eligible counterparty, the principal should be responsible for the representative's error. The court also noted that section 39 fulfils a consumer-protection objective that would be undermined if such matters could be excluded by contractual drafting.

Although the ARA was clear that JHM was prohibited from giving advice to or arranging deals for retail clients, the prohibition did not limit the scope of the permission given by KCL or the responsibility accepted for the purposes of section 39.

In a brief dissent, Lord Justice Lewison expressed concern that a result could arise in which KCL itself had no authorisation in relation to the activity that JHM had improperly undertaken. He stated that, in his view, "if an ARA purports to appoint a representative to carry on business which the principal is not authorised to carry on, that agreement is not, to that extent, an agreement with an 'authorised person'" for the purposes of section 39. 

Permission is understood to have been sought for appeal to the Supreme Court, which would bring much need clarity to the position.

Osborne Clarke comment

This line of case law, for the moment, raises a number of risks to principals. It is clear that the court – as the regulator has sought to do over recent years – was at pains to place responsibility for any regulatory misconduct, as far as possible, on the activities' principal.

For the time being, not only should regulatory hosts look to review their contractual arrangements with their ARs to make sure that the demarcation of which "part" of the business they have taken responsibility for is contractually clear.

Hosts should make sure, in light of the Court of Appeal's approach, that any risk for any regulatory misconduct in terms of the "how" is contractually constrained. They should also ensure that there are contractual and practical measures in place to allow them to supervise and audit of the AR to ensure compliance with the contractual terms.

Where the scope of the host's own authorisations are limited, it may be helpful to require ARs to inform their own customers of restrictions; for example, on their website and promotional or contractual documents. This would allow potential customers to be made aware of the restrictions on the AR, as well as dovetailing with the objectives of the Consumer Duty – and may already be an approach firms are considering.

Principals should also check their insurance policies: in respect of the regulatory misconduct of ARs, an insurance policy is likely to only cover the activities for which the principal has accepted responsibility. Almost by definition, if a principal is seeking to argue that the AR's conduct falls outside the scope of what it has accepted responsibility for, then the insurance policy might also not bite – including any clauses that provide for the coverage of investigation cost or legal fees. 

Our recent breakfast roundtable discussed this development alongside other issues for regulatory hosts. If you are interested in attending future roundtable discussion events for regulatory hosts, please get in touch.