What is section 21 approval and when is it needed?

Any company who wants to market an investment opportunity to investors through making an offer or an invitation to them to subscribe for shares or securities in the UK must comply with the Financial Services and Markets Act 2000 (“FSMA”). Specifically, section 21 of FSMA states that “a person must not in the course of business communicate an invitation to engage in investment activity unless he is an authorised person, or the content of the communication has been approved by an authorised person, or the communication is covered by an exemption.”

A section 21 approval allows businesses to promote investment opportunities to potential investors who aren’t certified as high net worth individuals or sophisticated investors, expanding the potential pool of investors dramatically which should increase the chances of further investment.

What are Financial Promotions?

Financial promotions can involve any types of communication employed by individuals, whether that be through written or oral means. Essentially any marketing material that is used to invite or induce individuals to invest in a business will constitute a financial promotion. This can include communications made on a telephone conversation, business meeting, a presentation to attract investment and even information on the company’s website.

Exemptions

Where the communication is covered by an exemption under the Financial Promotions Order (“FPO”) the financial promotion restrictions won’t apply. There are around seventy different exemptions but some of the useful exemptions to be aware of include:

1. Communications to overseas recipients that are not aimed at persons in the UK (Article 12 of the FPO).
2. Introductions of clients by unauthorised persons to an authorised person. (Article 15 of the FPO)
3. Generic promotions that do not identify either the provider of the investment or any of the persons carrying on the activity in relation to the investment. Such promotions can involve promoting particular products without specifically mentioning any brands. (Article 17 of the FPO)
4. The recipients of the communication are investment professionals and are expert enough to understand the risks involved with investments, and do not require any additional statutory protection. In order to rely on this exemption, it is necessary that the communication contains a clear indication that the communication is directed only at investment professionals.  In addition, you will need to have in place proper systems and procedures to prevent recipients other than investment professionals (or investors permitted under one of the other exemptions) engaging in the investment activity to which the communication relates. (Article 19 of the FPO)
5. One-off communication exemption. This requires the communication to be tailored to the circumstances of the recipient and individual in nature (it must not be a personalised letter sent out as part of a general mail campaign). (Articles 28 and 28A of the FPO)
6. Making company statements or briefings to members of the press. (Article 47 of the FPO)
7. Any communication made to certified high net worth individuals and self-certified sophisticated investors. Communications made to any of these individuals must also be accompanied by a warning that the communication has not been approved by an authorised person and that reliance on the communication for the purpose of engaging in any investment activity may expose an individual to a significant risk of losing all of the property or other assets invested. Such a warning must either be given to the recipient at the beginning of the communication or, if this is not possible in light of the means of communication used, the individual must be given an oral warning at the beginning of the communication and be provided with a legible copy of the warning within two business days. (Articles 48 and 50A of the FPO)

Who are Investment Professionals, Certified High Net-Worth Individuals and Self-Certified Sophisticated Investors?

Investment Professionals include:

1. an FCA authorised firm;
2. any other person whose ordinary activities involve carrying on the activity to which the communication relates for the purpose of business carried on by them or where it is reasonable to expect that individual to carry on such an activity for their business;
3. a government, local authority or international organisation; or
4. any person who is a director, employee or officer of a person falling to a person within 1) to 3) and the communication was made to that person in their capacity

Certified High Net-Worth Individuals are individuals who have signed, within 12 months ending on the day with which the communication was made, an FCA prescribed statement/form certifying that, in the preceding financial year, at least one of the following statements applies to them:

1. they had an annual income of £100,000 or more; or
2. they had net assets to the value of £250,000 or more, where net assets do not include property that is the individual’s primary residence or any loan secured on this residence, rights under an insurance contract, or benefits in the form of pensions or otherwise that are payable on the termination of service, death or retirement.

Self-Certified Sophisticated Investors are individuals who have signed, within 12 months ending on the day with which the communication was made, an FCA prescribed statement/form certifying that, in the preceding financial year, at least one of the following statements applies to them:

1. they are a member of a network or syndicate of business angels and have been for at least six months prior to the date of the statement;
2. they have made more than one investment in an unlisted company within the two years preceding the date of the statement;
3. they are working, or have worked in the two years preceding the date of the statement, in a professional capacity in the private equity sector, or in the provision of finance for small and medium enterprises; or
4. they are currently, or have been in the two years preceding the date of the statement, a director of a company with an annual turnover of £1million.

Penalties for breaching the Financial Promotion Rules

Where a person who is not authorised by the FCA markets a financial promotion to potential investors who aren’t either high net worth individuals or sophisticated investors, or where such a financial promotion is not covered under one of the exemptions, they will be committing a criminal offence and will be liable for a fine and / or up to two years imprisonment.

In addition any agreement entered into with an individual becomes unenforceable against the individual if the agreement was as a result of the financial promotion.

The FCA may also take disciplinary action against the communicator, if the financial promotion involves misleading or inaccurate information, including a potential misrepresentation claim, as well as holding the power to ban financial promotions and publishing details relating to the promotion to protect consumers.

The Section 21 Approval Process

In order to market investments to the wider public the investment must get approved by an FCA authorised firm, or the FCA itself, and marketed under the FCA Conduct of Business.

This will involve the firm carrying out extensive due diligence on any statements you intend to make or will make in the documentation to be used as part of the financial promotion (this will usually be an information memorandum or prospectus). Each statement will be checked and verified against supporting documentation and / or third-party evidence which means the process is often a time consuming and expensive one.

Usually getting Section 21 approval takes between two to three weeks, but can take longer depending on the number of representations being made by the management within the documentation as well as the size of the documents involved.

Every director should carry out an extensive verification process (as explained below) to ensure that any information communicated is both accurate and not misleading, and that any forecasts or statements of opinion are reasonably based.

Documents that the FCA or an FCA approved firm will look into as part of the due diligence process include contracts, the company’s constitution (i.e. articles of association and shareholder agreements), detailed checks on management’s history, accounts, bank statements and any coverage publicised on the news or through the media.

Once the process has been completed, the documents that will have to be section 21 approved can vary from each investment. It is usually the private company offer document (sometimes called an information memorandum or prospectus) but can also often include presentations, representations made over the phone, YouTube or social media videos, emails and any other way of communicating the financial promotion.

What a section 21 approved private company offer document (otherwise known as an information memorandum or prospectus) typically contains

• required language in respect of compliance with relevant exemptions;
• information on the market and opportunity;
• risk factors applicable to the business;
• details of the offer;
• information on the company/group;
• appropriate notice and risk warnings depending on nature of offering and jurisdictions; and
• financial information.

What is the process of verification?

Each director has a duty to ensure that offer documents are issued so as not to be misleading. This duty is discharged through a process called “verification”. Whilst verification can often seem long winded, it is designed to ensure the accuracy of all factual statements and where statements of opinion or belief are included, to confirm that such opinions are reasonable. Each director cannot be expected to know every fact relating to the issuer and its business. With respect to some statements, a director may rely on other people, including the company’s advisers, to check particular aspects of the relevant document.

Verification requires the production of verification notes for which each director takes responsibility. In preparing verification notes and conducting a verification exercise, the following key points should be noted:

1. the name of the source for the verification of the statement of fact must be recorded in writing;
2. a record in writing should be kept with a reasonable basis for each statement of opinion;
3. each of the directors (including non-executive directors) must be given sufficient time to consider and comment upon the prospectus or admission document and the verification notes so that they are each given time to correct and amplify statements, if necessary;
4. it is not sufficient for directors to simply record that each statement is ‘confirmed’, supporting evidence must be asked for and kept in an indexed ringbinder as an annexure to the verification notes; and
5. if statements cannot be verified they must be deleted or amended so that they can be verified.

Conclusion

It is vital that where you wish to market an investment opportunity to the wider public you make sure that it is covered under an exemption or you are marketing the opportunity after gaining section 21 approval.

Although due diligence can be particularly painstaking for individuals to be involved in, the long-term benefits from gaining a section 21 approval completely outweigh potentially falling foul of the FSMA rules. You are more likely to receive investment and you are less likely to receive criminal and civil penalties from the FCA. On the balance of play that should encourage you to seek section 21 approval wherever possible and is a win-win situation (as most would say).

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.