Special report: UK regulators face mounting concerns over their handling of multi-million pound fund collapse

April 4, 2014

By Alex Davidson, Compliance Complete

LONDON, Apr. 4, 2014 (Thomson Reuters Accelus) – Regulators face searching questions about whether they acted effectively in the multi-million pound collapse in 2012 of an unregulated collective investment scheme (UCIS). The then Financial Services Authority’s (FSA) decisions concerning the Connaught Income Fund, Series 1, a UK-domiciled fund based in London, will come under fresh scrutiny at a debate in Westminster Hall, between members of parliament and HM Treasury this month, subject to scheduling. The Financial Conduct Authority (FCA) has said that the FSA, its predecessor body, acquitted itself well in dealing with the situation. Detractors, including investors, MPs and independent financial advisers (IFAs), have said the regulator failed to act appropriately on warnings about the misappropriation of multiple millions of pounds from the fund.
Some have found fault with the regulator, fund operators and IFAs who sold the Connaught fund, but it remains to be seen who, if anyone, will be held broadly accountable. Critics of the regulator have said it failed to investigate effectively evidence of financial misappropriation and insolvency, at Tiuta Plc (Tiuta), a regulated mortgage lender, to which the fund was lending money. The evidence was provided by whistleblower George Patellis, chief executive of Tiuta, which, like its unregulated subsidiary,Tiuta International (TIL), was a specialist partner to the Connaught fund.

In March 2011, Patellis informed the FSA he had discovered fictitious secured loans in the loan book of the fund and that the books of Tiuta had been arranged to pretend it was solvent when it had a multi-million pound deficit. Notwithstanding his subsequent provision of evidence, seen by Compliance Complete, the FSA did not close down Tiuta or require the regulated fund operator, Blue Gate Capital, to suspend the fund’s operations. Tiuta continued to trade. Tamlyn Stone, director of compliance oversight at Blue Gate, declined to comment.

Action stations

“The regulator should have gone straight into Tiuta. I thought when I initially notified the FSA by telephone that it would go in the next day. I was CEO and not just a disgruntled clerk, but I ended up going in to see them, and that came to nothing,” said Patellis, a former managing director of Lehman Brothers who has held several controlled functions.

The reasons why the FSA did not immediately take action to close down Tiuta or stop money coming into the fund, given the evidence that Tiuta’s chief executive had provided, could not be ascertained. The FCA declined to comment in detail, citing confidentiality, but has defended its predecessor’s actions.

Speaking generally, Oliver Lodge, director of Owl Regulatory Consulting and a former senior official at the FSA, noted that, in any given case, the new and old regulators’ obligations in relation to suspected fraud were virtually identical.

“The new board would not be held culpable for failure of the old board, but if there is unfinished business in terms of investigation, the FCA takes over. If the FCA felt the old regulator had made a mess of things, it could say so,” he said.

Lodge said the FCA is the same legal entity as the FSA and many of the same personnel are involved.

In the Connaught case, the FCA is defending the FSA’s decisions in discussions with MPs who are formally raising concerns. In a January 2014 letter to Christopher Chope MP, Linda Woodall, director of mortgages and consumer lending, supervision division, FCA, said neither the regulator nor its forerunner was the lead prosecutor of fraud, but that it had not stopped or discouraged Patellis from approaching agencies himself, and that the regulator had since provided information received from numerous resources to law enforcement agencies and others.

Among the unanswered questions are what information was given to the agencies and, most importantly, when. The City of London Police told Compliance Complete it had no record of any contact from the FSA/FCA regarding Tiuta and Connaught. The Serious Fraud Office could not confirm or deny whether it had been approached.

Patellis said the FSA had not encouraged him to report his findings to any other authorities, although, as he noted, the regulator’s published whistle-blowing guidelines had provided for this.

20:20 hindsight

On Patellis’ evidence, the discrepancy between the representations and the reality was enormous. The Connaught Series 1 Fund had been promoted originally as “The Guaranteed Low-Risk Income Fund”. The investment memorandum for the fund said it would make short-term bridging loans to finance the purchase of existing properties on reasonable loan-to-value ratios by third parties. In every case the loan would be secured by a first fixed charge.

Critics believe that, had the regulator investigated the list of fictitious secured loans in the loan book of the fund provided by Patellis in March 2011, it would have had no option but to act immediately. According to Patellis, it would have taken the FSA only a couple of hours to ascertain that for the loans listed in his documentation given to the FSA, the redemption money had come into Tiuta, but had not gone back to the fund.

The FSA did take some action. Writing to MPs in November 2013, HM Treasury said the regulator had opened a case as a result of Patellis’ evidence, had started supervisory engagement with Tiuta in March 2011 and, two months later, had met with Tiuta and requested that the firm place itself in administration. The firm was also presented with aSection 165 request under the Financial Services and Markets Act 2000 for the preservation of documents.

In the event, Tiuta was not placed in administration until September 2012. The company’s subsidiary, TIL, had gone into administration in July 2012. According to the TIL administrator’s progress report of December 2013, TIL owes the fund £107 million and the administrators estimate the overall loan book collections will range between £36.2 million and £41.4 million.

Patellis now says that any of the regulator’s actions outlined by the Treasury would have been taken well after he had made his revelations, and that it was too little and misplaced, as well as too late. The losers were investors in Connaught, by some tens of millions of pounds.

Patellis says his evidence contradicted the mandatory quarterly mortgage lending and administration returns that Tiuta had submitted to the FSA, providing details of capital adequacy and other financial measures. In his view, a reasonable person investigating properly would have quickly realised those returns were false and removed Tiuta’s authorisation.

Behind closed doors

There is no clarity about what conversations took place between the FSA and some directors of Tiuta. The FSA, now the FCA, faces questions about why it failed to take stringent measures to stop investors from continuing to invest tens of millions of pounds into the fund which were subsequently lost, how much it had understood of the misappropriations, and whether it had checked the evidence. The fund was suspended in March 2012.

A spokesman for the FCA said the Connaught fund had not been subject to direct regulation because it was a UCIS. “We nonetheless monitored its situation as part of our ongoing supervisory work. We took action to warn consumers and raised our concerns with the parties we regulated as soon as we spotted potential problems.”

In her letter this year to Chope, Woodall said it was correct that the FSA relied on information from the sources given, but it “considered that to be a reasonable decision”.

Senior lawyers see it differently, although some have a commercial interest in the outcome. As one put it, Tiuta and many of its subsidiaries were insolvent in early 2011, caused by a multiplicity of factors, and Patellis had given the FSA relevant presentations from accountants, and letters from a firm of solicitors. By early 2011, the sole source of finance for the insolvent Tiuta was the fund.

The lawyer said the FSA — in its role as supervisor of the regulated operator of the fund — should have set in motion the suspension of the fund to redemptions, and should have supervised an orderly winding-up, once it had established that a large number of secured loans listed in the loan book of the fund did not exist. An operator is meant to keep the score and safeguard the assets of the fund, and the regulator should have required the operator to supervise the redemption/creation for shares pending the outcome of an investigation.

Available enforcement options

The consensus of the lawyers is that the FSA, acting on the whistleblower’s evidence under powers of investigation available to it, could have gone into Tiuta Plc as a regulated mortgage lender and checked the loans.

Lawyers agreed further if the FSA had uncovered sufficient evidence of wrongdoing, in a case such as this, it could have put significant pressure on a fund operator to suspend a UK-based UCIS, and that this was entirely within its remit. The FCA spokesman said requirements on the operator of a UCIS were very limited and, in this case, excluded responsibility for the underlying investment decisions made by the fund. Critics, however, said the operator had responsibility for ensuring the fund was managed in accordance with the investment memorandum, including that the flow of funds and property criteria used were as required.

Dan Morrison, senior partner at Grosvenor Law, a London law firm, who has knowledge of the case but has not advised any of the investors or the fund, said different staff at the regulator took different approaches. He said, however, that Patellis was a senior officer of Tiuta, and had set out his concerns in a cogent way.

“It is well established what the FSA should have done in a case like this. The regulator saw a statement from a senior person who was making very serious allegations of misconduct. The first thing to do is to take reasonable steps to verify its accuracy. This was pretty powerful stuff. It should want to go into the company, meet key people, see the underlying documents, the loan book and security arrangements, and review any money outflows,” Morrison said.

“If it had done this and it had come to the view that there was a reasonable prospect that Mr Patellis’ concerns had been made out, it could have suspended the fund, or at least taken some steps to try to stop the fraud from continuing. My understanding is that it did neither,” Morrison said.

Regulatory approaches by location

A lawyer said the FSA could not have put the same pressure on the operator of a fund not domiciled in the UK to suspend it. Tiuta’s Series 2 fund, which was distinct from Series 1, might have come into this category because it was domiciled in Guernsey. In this case, the lawyer said, the FSA would have had to go not through the operator but the local regulator, the Guernsey Financial Services Commission. The Series 2 fund eventually collapsed and the way it turned out, it was not where the majority of investors’ money was lost, and nor was it any substantial part of Patellis’ evidence.

The risk that Series 2 represented was important, however. According to Patellis, Tiuta had published press releases saying the fund aimed to raise £300 million from investors, and it would have access to wider resources on the basis of plans to list on an offshore exchange.

“I have no doubt that Tiuta would have carried on the same game with Series 2 that it was playing with Series 1. The scam could have escalated to very high levels,” Patellis said.

The problems involved more than one regulated entity. The FCA took no action against Capita Financial Managers, a regulated subsidiary of Capita, and which had been the operator of the Connaught Series 1 Fund until 2009, or against Blue Gate, which succeeded it. Capita had issued for distribution to investors an investment memorandum, written by Nigel Walter, who had been banned earlier as a company director in the High Court after he had operated a land banking scheme through UK Land Investments Group (UKLI). The document, which made reassuring claims about the level of risk undertaken for what was originally promoted as a low-risk fund, was subsequently reissued in new versions.

A spokeswoman for Capita said it had not identified the link between Walter and UKLI during initial due diligence but on finding out, ensured that Walter resigned, requiring him to surrender his shares in Connaught Asset Management, the unregulated party that managed the fund on the basis of advice from Tiuta. Capita instructed staff to cease dealings with him.

The FCA’s publicised actions focused on other areas. The regulator had issued a statement in May 2011, saying the fund was not as safe as it claimed to be and investors should consult with their financial adviser before investing.

“The FSA took a non-threatening step and put this notice on Tiuta’s FSA page, announcing this in the financial press, but the statement barely touched the surface of what was going on at Tiuta. The FSA had already met with me and had seen my evidence,” Patellis said.

Variations to Tiuta’s permissions

Patellis told Compliance Complete it was still more significant that the FSA varied Tiuta’s permission and added a requirement. The change of permission ruled that Tiuta could not arrange the sale of any new regulated mortgage contracts. Tiuta and Connaught issued press releases suggesting this was a voluntary withdrawal from the market, and this was reported in the national financial press, giving an impression that could be misinterpreted but that nobody corrected. The regulator’s requirement of Tiuta was that, on redemption of any loan, it should return the money immediately to the fund.

“Returning redemption money when a loan pays off is basic. By adding this as a requirement to Tiuta’s permissions, the FSA was demonstrating that it knew something about how the company was operating,” Patellis said.

The variation of permissions and the requirement could only be accessed from the FSA’s web site after five clicks or more and were not announced separately in the financial press. If they had, new money might have not flowed into the fund, Patellis said.

Some investors have made claims against the IFAs who, in some cases, had broken financial promotion rules by selling the UCIS to them without a proper assessment of its suitability. The IFAs have claimed they were misled by the statements in the investment memorandum, which went through several versions, some of which are understood to have been circulating simultaneously.

The regulator’s overall treatment of Capita has come under scrutiny as a result of another, unrelated case. In November 2012, Capital Financial Managers had received a public censure from the FSA. As part of its settlement with the regulator, the company had agreed to make a voluntary contribution of £32 million towards a scheme to compensate investors in a fund managed by Arch cru. The FSA had decided not to impose a material financial penalty on Capital Financial Managers, taking into account, among other things, its financial circumstances.

Powers and accountability of the regulator

According to lawyers and parties representing IFAs, the Connaught case, and, to some extent, Arch cru, raise wider issues. Under fresh debate are the powers of the regulator and its willingness to act, its accountability, and the broader efficiency of the system, including its resourcing.

Morrison, for one, said the regulator had a tough job. “This case demonstrates that the regulator was ineffective on this occasion. Perhaps this issue was too complicated to handle, particularly when a regulator is understaffed. It is difficult to fathom why no steps were taken.

“To expect the FCA now to admit [the FSA] made a mistake is naive. No government agency would do that, and it opens the door to litigation,” Morrison said.

Jonathan Herbst, partner at Norton Rose Fulbright, declined to discuss any particular case, but said generally: “The FCA has emergency powers and can apply certain tests, including around consumer detriment, and so can act immediately to close down a fund, for example, and then order an inquiry. But this is unusual.

“The FCA is supposed to act in a proper way, but it is very difficult for anyone to argue it has not taken the action it should have done. The regulator has statutory immunity, although that does not cover bad faith. One can take a judicial review of the regulator’s decisions, and there is the internal complaints process, but people don’t want things coming out in public; if they did you would open the floodgates,” Herbst said.

Another complication is the frequent gap between industry and the regulator, and blowing the whistle on wrongdoing will not necessarily bridge it. In the case of the Connaught fund, Patellis said senior staff in regulated functions could learn from his own experience of dealing with the regulator.

“After I submitted my evidence to them, I never heard a word. The regulator bangs on about approved persons working closely with them but there is no reciprocity,” Patellis said.

Regulators and whistleblowers

This is the whistleblower’s dilemma. The FCA is committed to providing better arrangements for whistleblowers, and when it consults on the subject later this year, the subject of how it treats them may arise. The existing unspoken rules are not, however, so far removed from Patellis’ experience.

Lodge, of Owl Regulatory Consulting, said those who made revelations to the regulator under Principle 11 should not expect to hear back from it. “An approved person doing a controlled function in passing information to the regulator is also passing on responsibility. Not to talk is to put oneself in an untenable position, but it is rare that whistleblowers get feedback privately and it can be a personally unsatisfying experience.”

The value of top grade whistle-blowing to the regulator can be vast, which argues for more careful treatment. Morrison said encouraging people inside the market to raise concerns in a way that would not prejudice their own interests was an important route for regulators and law enforcement to find out about misuse early.

“Money laundering and bribery laws make it compulsory to report suspicion and this is the way regulatory law is going. Whistle-blowing is a softer version, but is part of the same underlying approach of encouraging individuals to raise their concerns confidentially and without exposing themselves to litigation.

“George Patellis was a senior guy with an unblemished past, and about as credible a whistleblower as you could get. He gave detailed information and documents to the FSA that would have cost it much time and money to get on its own. I’d like to think regulators won’t make the same mistake again,” he added.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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