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	England and Wales High Court (Chancery Division) Decisions
You are here: BAILII >> Databases >> England and Wales High Court (Chancery Division) Decisions >> Secretary of State for Business Innovation and Skills v Aaron & Ors [2009] EWHC 3263 (Ch) (10 December 2009) URL: http://www.bailii.org/ew/cases/EWHC/Ch/2009/3263.html Cite as: [2009] EWHC 3263 (Ch)

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IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION

		Royal Courts of Justice Strand, London, WC2A 2LL
		10/12/2009

Mrs Justice Proudman:

1. This is an application by the Secretary of State for Business Innovation and Skills under s. 7 of the Company Directors Disqualification Act 1986 ("CDDA") to disqualify the second and third defendants from acting as directors under s. 6 CDDA. The first defendant, Mr David Aaron, signed a disqualification undertaking in terms acceptable to the Secretary of State and did not attend the trial. I have not been told the length of his disqualification. He had sworn a witness statement in his own defence which was relied on in some respects by the other defendants although he was not cross-examined on it. The application before me proceeded against the second and third defendants alone.
2. The case centres on the alleged mis-selling of what have come to be known as Structured Capital at Risk Products, commonly called "SCARPS". It is founded on the conduct of the defendants Andrew Jones and Michael Aaron as directors of a company called David M Aaron (Personal Financial Planners) Limited ("DMA") which provided investment services and was regulated until November 2001 by the Personal Investment Authority ("PIA") and thereafter by the Financial Services Authority ("FSA") when the FSA became the UK's single financial services regulator. David Aaron was at all material times DMA's Chief Executive. DMA was authorised under the Financial Services and Markets Act 2000 ("FSMA") to advise on and enter into dealings in investments. The defendants were regulated by the FSA as Independent Financial Advisers ("IFAs").
3. DMA was incorporated in 1977 but the investment business was run by a partnership rather than the company until October 2000 when DMA took over the partnership business and assumed the partnership trading name. At that time both the second and third defendants were directors of DMA. Although DMA may have had some prior involvement in the partnership it is common ground that for present purposes it is the conduct of the defendants as directors of DMA from October 2000 that is relevant rather than what the same persons may have done as partners prior to that date.
4. DMA was included in the FSA's industry-wide review of the sale of SCARPS which began in March 2002. In 2003 the FSA investigated DMA's activities under FSMA s. 167-8. On 8^th December 2003 the Financial Ombudsman Service ("FOS") upheld four complaints against DMA relating to the mis-selling of SCARPS and awarded compensation. This triggered consultation with the FSA and KPMG LLP as a result of which the directors, with FSA approval, resolved that DMA should be put into administration. In the events which happened DMA's bankers appointed two partners of KPMG LLP as joint administrators on 22^nd December 2002. The FSA concluded its investigation with an Investigation Report dated 30^th April 2004 ("the Report") dealing with sales of SCARPS by the partnership and by DMA, compendiously referred to as "the Firm". FSA issued a Final Notice against DMA on 25^th April 2004 cancelling DMA's authority to carry on regulated activities.
5. In an application in this action the Court of Appeal decided that the Report was admissible in evidence for present purposes, although the weight to be attached to the FSA's findings and conclusions was a matter for the Judge hearing the disqualification application. Certain other matters, such as opinions of and findings of fact (other than those appearing in the Report) made by the FOS, are inadmissible and as such must be ignored for present purposes.
6. DMA's Statement of Affairs showed a deficiency of assets over liabilities of some £2.66m. Earlier this year the Financial Services Compensation Scheme updated previously supplied information, stating that it had received more than 4,000 claims against DMA relating to SCARPS of which 2,028 had been successful. £13.8m has been paid in compensation and there is a total deficiency of over £17m.

Disqualification under CDDA

7. The general provisions about disqualification orders are contained in s. 1 CDDA. By s.6 CDDA, disqualification of a defendant is mandatory if the Court is satisfied of two matters-:

"(a) that [which is not in dispute in this case] he is or has been a director of a company which has at any time become insolvent…and

(b) that his conduct as a director of that company…makes him unfit to be concerned in the management of a company."

8. S.9 prescribes certain matters for determining unfitness. In the circumstances of this case, where the company is insolvent, the Court is required to have regard in particular to the matters mentioned in Parts I and II of Schedule I to CDDA. Only two of those specific matters are relied on, one from each Part of the Schedule. The first (Part I paragraph 1) is "Any misfeasance or breach of any fiduciary or other duty by the director in relation to the company". It is the words "other duty" which are pertinent here as it is said that there was mis-selling of SCARPS in contravention of FSA rules.
9. I accept the submission of Mr Newey QC on behalf of the Secretary of State that in the case of a FSMA authorised company a director's duty to that company to exercise reasonable care skill and diligence extends to taking all reasonable steps to ensure that the company complies with its regulatory obligations. Failure to adhere to them may have the effect of exposing the company to substantial financial claims.
10. Secondly, there is Part II paragraph 6, which is "the extent of the director's responsibility for the causes of the company becoming insolvent".
11. The question for the Court is not whether there were regulatory breaches or as to the seriousness of any breaches. It is the question (one of fact) whether each defendant's conduct as director makes him unfit to be concerned in the management of a company, having regard to all relevant circumstances and in particular the matters specified in the Schedule.
12. I observe that as the Court has to have regard to all the specified matters in determining whether the director is unfit it is, or may be, relevant that none of the other specified matters is relied upon. Many of such matters relate to general company law obligations which would apply to a company conducting any type of business.
13. I keep in mind Dillon LJ's statement in In re Sevenoaks Stationers Ltd [1991] Ch 164 at 176 B-G as to the test contained in s.6 CDDA:

These are ordinary words of the English language and they should be simple to apply in most cases. It is important to hold to those words in each case…

[T]he true question to be tried is a question of fact-what used to be pejoratively described in the Chancery division as 'a jury question'.

14. As Hoffmann LJ put it in Re Grayan Limited[1995] Ch 241 at 253E, the Court must decide whether the conduct in question,

…viewed cumulatively and taking into account any extenuating circumstances, has fallen below the standards of probity and competence appropriate for persons fit to be directors of companies.

15. The primary purpose of the jurisdiction under s. 6 is the protection of the public against persons whose past records as directors show that the public needs such protection. Disqualification under s.6 is mandatory for at least two years which indicates the significance Parliament attached to the fact of unfitness where a company has become insolvent. However, as Jonathan Parker J observed in Re Barings plc (No 5) [1999] 1 BCLC 433 (at 484) the serious nature of a disqualification order also means that, where there is no dishonesty, the burden in establishing unfitness based on incompetence is a heavy one.

SCARPS

16. It is the essence of SCARPS, as the name implies, that capital invested is at risk. SCARPS were not given that label, or their other name, precipice bonds, until late 2002 or early 2003. Indeed there was some evidence that until those labels were applied SCARPS were not even considered by the industry as a generic type of product.
17. However I do not agree with Mr Jones's view that, because this type of product had not been separately defined for most of the time that he was marketing them, it is unfair to criticise him for having failed to take steps to deal with them differently from other types of investment. IFAs who recommended SCARPS to clients were always under a duty to analyse the nature of the products and the risks they posed. That duty applied whenever they were sold, that is to say both before and after labels indicating the fact that capital was at risk had been formally applied to them.
18. SCARPS are a relatively short term investment for a fixed period, potentially producing a high rate of return. Income-return SCARPS typically produce a guaranteed return of something in the region of 10%. Capital-growth SCARPS typically produce no income but provide for growth of 30% or more. Typically, again, SCARPS are linked to an index. If that index falls below a so-called safety zone at any time in the fixed term investment period, and does not fully recover, the capital return will be diminished. If the index does not so fall (or recovers fully), the investor will get a fixed contractual return. In the case of an income-return SCARP, he will get his capital back in full in addition to the contractual rate of interest. In the case of a capital-growth SCARP, he will get his capital enhanced by the contractual rate of growth. Those are the potential benefits.
19. The risk to capital depends on the type of product. Some SCARPS guarantee that the initial investment will be returned in one way or another, so that the investor will, at worst, receive income and capital payments totalling the initial investment, subject only to reduction for any tax and charges. Other SCARPS provide for a 1:1 gearing. That is to say, once the safety zone is breached the investor will lose £1 for every £1 by which the linked index falls. Whereas with an investment in equities the investor stands to gain on a 1:1 basis if the market rises, he may stand to lose more than the investor in 1:1 SCARPS since an equity investment contains no safety zone. However the investor also has to be aware that with SCARPS, unlike equities, he is locked into the investment for the duration of the term during which the SCARPS may be linked to a volatile index. Further, the terms are relatively short in the context of allowing for full recovery in the event of a fall in the market.
20. Another type of product involves a downside gearing of 2:1 or even 2.66:1 below a certain band. Much of the argument before me centred on the NDF Extra Income and Growth Plan 7 ("NDF 7") where there was such a level of gearing. In other words, the investor stands to lose £2.66p for every £1 by which the linked index has fallen below a certain level. Examples were given where the investor would lose 100% of his initial capital in circumstances where the linked index fell by only 50%. The investor would it is true have received income at the rate of 10.1% per annum for 3 years, a higher rate than the general market rate on deposits. However it was not so much higher that it made up for capital lost through downside gearing. There is a further wrinkle in that, as I have said, the safety zone was not simply applied at the end of the term. The investor would receive a reduced capital return if the linked Index fell by the relevant amount at any time during the investment term and failed to recover in full.
21. Properly analysed, the nature of a SCARP is that the investor obtains an interest bearing deposit combined with a put option, assuming the risk of a fall in the market in order to generate a higher return in terms of interest or capital growth. The product provider's terms relating to NDF 7 explained the income return investment as:

the equivalent of a put option on the Index and a normal-interest-bearing deposit, with the investor receiving a higher than normal rate of interest as compensation for accepting the risk of diminished capital return if there has been a Safety Zone Breach and the Final Index Level is below the Initial Index Level

22. The higher the guaranteed rate of interest or capital growth, the greater the risk that the investor would have to bear in order for the product provider to safeguard its own investment. The safety zone was likely to be linked to a volatile index to hedge against the chance of a safety zone breach. Thus from the provider's standpoint there was a sophisticated and delicate balance of various factors: the level of safety zone and downside gearing, the investment period, the volatility of the index and the rate of payment that the provider undertook to make in the event that there was no safety zone breach. It is evident that this balance was achieved against a background in which a safety zone breach which would trigger the put options was foreseen as a possibility and was being anticipated. In short, the provider was prepared to pay a premium for an option that would safeguard its investment.

The issues

23. The Secretary of State has enumerated seven allegations of unfitness in the same terms against each defendant. They are as follows:

a) He failed to ensure that he was sufficiently concerned with the regulatory responsibilities that applied to DMA.

b) He failed adequately to understand or take account of the risks associated with SCARPS.

c) He failed to ensure that advertisements and promotional material issued by or on behalf of DMA were clear, fair and not misleading.

d) He failed to use material provided by journalists in an appropriate manner within DMA's promotional literature.

e) He failed to make suitable recommendations to customers.

f) He failed to keep adequate records of the manner in which DMA assessed and discussed the risks of SCARPS and complete records of individual sales.

g) He failed to ensure that DMA's compliance procedures were adequate and properly recorded.

24. In the light of the way in which the evidence emerged I would paraphrase the issues, which to some extent overlap, as follows. The first is whether, as alleged, the defendants grossly and incompetently underrated the risks of the SCARPS which they sold. Dishonesty is not alleged and it is accepted that the defendants genuinely, if wrongly, held the view that the SCARPS which they sold carried the low risk ratings which they assigned to them.
25. The second issue is whether the products and their attendant risks were presented to clients appropriately, clearly and fairly in accordance with FSA requirements. This comprises the questions whether the products were properly explained to potential clients in a way that was not misleading and whether there were regulatory breaches of the rules as to how such risks should and should not be presented in advertising and other written materials. It overlaps with the third issue whether recommendations and advice took into account the suitability of the client to the product.
26. Fourthly, there is the issue whether the defendants were in breach of FSA standards of record-keeping.
27. Fifthly, if all or any of these matters are established, there is the question of whether the respective defendants are responsible for them, embracing the allegation at 23 (a) above.
28. Mr Hantusch submits that all these questions should be answered in the negative but that, in any event, these defendants' conduct was not such as to render them unfit to act as directors of a company for the purposes of s. 6 of CDDA. Whether either or both of the defendants are unfit within s. 6 CDDA is the ultimate question for decision when the other issues have been determined.

Assessment of risk: risk ratings

29. I turn to the first issue, namely whether the defendants failed adequately to understand or take account of the risks associated with SCARPS. It was put by Mr Newey as a matter of gross incompetence in obviously understating obvious risks. The risk ratings were ones which, to quote Mr Newey, "could not sensibly be arrived at".
30. DMA's risk ratings of the SCARPS it sold were typically "cautious to realistic" or "medium to low". Numerical ratings were typically 4/5 out of 10 for the income option and 2/3 out of 10 for the growth option where 10 was DMA's highest risk rating in relation to return of final capital. The ratings were the same for 1:1 geared SCARPS as for those with a band of as much as 2.66:1.
31. It was clear from the defendants' evidence that they still believe that their risk ratings were justified at the time and that it is only with the hindsight of the market crash that the risks have proved not to be worth taking. Mr Jones said that his evaluation was an honest and considered one based on reasonable market expectation at the relevant times. The Secretary of State admits that the opinions were honestly held, but it was submitted that this does not avail the defendants since the opinions were manifestly unreasonable, giving "probability risk" undue preference over "impact risk" and thus skewing the perception of risk overall.
32. Both defendants accepted that they were aware of the PIA Regulatory Update 38 of August 1997 and the PIA Regulatory Update 85 of March 2001. Those updates showed that the regulatory authority regarded SCARPS (as they afterwards came to be known) as inherently risky products. The defendants further accepted that they would have read the Sunday Times Guide to Investing for Income (September 2001) which DMA sponsored, but which was produced independently of DMA's views. That Guide expressed the view that SCARPS were extremely risky products unsuitable for all but those investors prepared to take significant risk with their capital.
33. The Report stated that DMA took a number of factors into consideration in assessing risk, including the product features, (the term, safety zones and relevant gearing), market forecasts, current market conditions, historic market performance, the financial strength of the underlying company and the worth and stability of the custodian of the assets of the underlying fund. However the Report made a number of adverse findings about DMA's risk assessment process. The FSA's view was that the risk categorisation was flawed in that it did not give sufficient weight to aggravating factors such as increased downside gearings and the fixed term nature of the product.
34. It was also said against the defendants that what they considered to be reasonable market expectation was largely based on past performance, emphasising probability at the expense of impact and blurring the distinction between the two. It was said that in any event these defendants only considered recent performance and closed their eyes to the market crashes of the 1930s and 1970s.
35. From the investor's point of view the assumption of the risks associated with the put option could be viewed, as Mr Newey submitted, as a gamble. To adopt the racing metaphor, one question is to what extent that gamble was based largely and illegitimately on recent past form.
36. While Mr Jones accepted, as he must, that past performance was no guide to future performance, he believed that it could not be ignored altogether. It was one of many factors relevant in determining the future market risks attaching to an investment.
37. It seems to me that past performance has considerably less relevance in evaluating an investment of this kind than, for example, the market for a particular product or service supplied by a company whose shares are being considered as an investment. However the issue of how impact risk (that is to say, the risk of a disaster) should be balanced against probability risk is largely a matter of expert judgment. I take into account the fact that eminent financial journalists, some admittedly paid to promote the product, but some, it appears, not so paid, also believed the risk to be smaller than it turned out to be. Mr Michael Aaron gave evidence, which I accept, that DMA sought advice from several sources of outside experts and analysts before ascribing ratings to the SCARPS. Indeed Mr Garwood, the expert instructed by the defendants, observed that SCARPS have been widely used by retail investors for many years. I conclude that DMA's view on risk was therefore a judgment shared by some respectable advisers at the relevant times.
38. It emerged from the defendants' evidence that the primary basis for considering SCARPs to present a low risk was the safety zone. They had felt that the probability risk of breaching the zone was small with the result that the investment in a SCARP was inherently safer than investment in, for example, a tracker fund.
39. The evaluation of risk is to some extent a subjective matter. I take into account the warning given by Sir Nicolas Browne-Wilkinson V-C in Re Lo-Line Electric Motors Limited [1988] Ch 477 at 486

Ordinary commercial misjudgement is in itself not sufficient to justify disqualification. In the normal case, the conduct complained of must display a lack of commercial probity, although I have no doubt in an extreme case of gross negligence or total incompetence disqualification could be appropriate.

40. I note and take into account Dillon LJ's stricture in Sevenoaks (at 176) when commenting on that passage. Each case must be considered on its own facts and I must not construe such judicial pronouncements as though they were paraphrases of the statute itself.
41. It seems to me that DMA's evaluation of the SCARPS risks (whether in assessment or categorisation) was wrong for all the reasons given in the Report. However I do not have to decide whether or not the defendants were negligent. The question is whether their risk ratings were so flawed that they could not sensibly be arrived at. I do not think that DMA's evaluation can be considered to have been so obviously incompetent that it would by itself render these defendants unfit to be concerned in the management of a company. I say 'by itself' because risk ratings must be considered in context. That context is the manner in which they are presented to the consumer and in which the rating and the risk itself are arrived at and explained. I would add that this is not a case where DMA's directors did not understand the products DMA was selling. On the evidence before me it appears that they did. However it is plain that they badly misjudged the effect of the risks attached to them. There may therefore be a difference between me and the Secretary of State (and the FSA) in the way the word 'understand' is used.
42. I add the caveat that in failing to keep written records of the meetings at which they ascribed risk ratings to the various types of SCARPS, and the reasons for those ratings, they laid themselves open to the criticism that they did not give proper consideration to such matters.

Mis-selling marketing material

43. I therefore turn to the second issue, namely whether the products and their attendant risks were properly explained to potential clients. This also embraces the question whether there were regulatory breaches of the rules as to how such risks should and should not be presented in advertising and other materials provided to clients.
44. The need for an explanation of risk is particularly acute in relation to SCARPS. This is partly because, as the defendants were at all times aware, there was an important body of opinion, including that of the regulators, that SCARPS were risky products unfamiliar to the average investor.
45. All investments carry a risk outside the express terms of the investment itself, namely the risk that the company, bank or counterparty involved may become insolvent. Many market risks, for example that a company may perform badly because of poor products or a downturn in a particular sector, are readily understood in general terms by the average investor. It is appreciated that the investment may go down as well as up for those sorts of reasons.
46. With SCARPS however there are risks to capital spelt out in the terms of the investment itself, and each type of SCARP carries different types of risk. The returns offered are easily understood. It is perhaps also understood that there is a degree of risk that the index will not perform, in the same way that there are risks associated with a tracker fund. However the underlying mechanics of the investments are complex. Investors are unlikely, without proper explanation, to understand what it is that they are taking on and what enables the potentially high return to be offered.
47. The evidence centred on sales of SCARPS through direct marketing. While it is true that those targeted were encouraged to seek advice from DMA, mail shots were designed to enable potential investors to invest simply by signing the forms supplied. Mr Jones found it difficult to accept that those targeted would not understand what was on offer, but it was plain that DMA's whole client base was targeted without any regard either to the suitability of the product to each client or to each client's level of sophistication in understanding the product.
48. Direct marketing of investments comprises a number of elements. One is information about investment opportunities of which the clients might not otherwise be aware. A second is explanation of the investment in terms which enable the clients, whoever they may be, to understand the risks involved and make an informed decision as to whether the investment is suitable for them. A third is recommendation, which (although this was disavowed by Mr Jones) necessarily involves an element of advice, implied if not express. To my mind it is only common sense that material used for direct selling purposes should not conflate explanation with recommendation. The person who receives the mail shot must not be led into thinking either that any views expressed are fact rather than opinion, (or an opinion that is so generally held as practically to be fact), or that he is being advised that the investment is a suitable one for him.
49. DMA was required under the terms of its authorisation by PIA and then FSA to comply with Conduct of Business Principles and Rules from time to time in operation. The three relevant over-arching principles are (principle 2) "a firm must conduct its business with due care, skill and diligence"; (principle 3) it "must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems" and (principle 7) "a firm must pay due regard to the information need of its clients and communicate information to them in a way that is clear, fair and not misleading". Those principles are distilled into the rules.
50. PIA Regulatory Update 38, issued as long ago as August 1997, (some time before SCARPs received that name or the name precipice bonds), dealt specifically with products which offered consumers an equity type exposure combined with an underlying guarantee of a particular rate of income or capital growth. Rules were prescribed about descriptions of such products in marketing materials. Although references to Key Features documents (used by product providers) suggest that those rules were aimed at providers, the references to Lautro and Fimbra and the more general references to marketing material show that they were not confined to providers. Indeed, Mr Jones and Mr Michael Aaron were aware of the requirements of the rules and appeared in their evidence to accept that DMA was bound to observe them.
51. Update 38 required that firms should ensure that certain points were taken into account in developing their literature. One was that the explanation of the risk factors must contain a clear warning that, if such were the case, there might be a capital shortfall at the end of the term. Another was that the minimum amount of capital repayable at the end of the period must be clearly stated. A third was that consumers should not be led by information about past performance, "back-testing", to the mistaken belief that favourable returns were always guaranteed.
52. In March 2001 Update 85 prescribed in more detail the steps that firms should take to ensure that consumers received a proper explanation of the products and their risks. The update aimed at SCARPS started with an introduction containing the following rubric:

Investment products are increasingly using financial instruments which are less familiar to ordinary investors. Typically, their marketing highlights the high returns that may be achieved. These products may well be designed to be available within an ISA wrapper. It is important that the structure of these products and the risks involved are carefully explained to customers before they commit themselves.

53. The introduction then went on to identify three main bullet points, as follows:

Care must be taken to ensure that in advertising and other promotional material the structure of the product is described and the risks to which the customer will be exposed are explained clearly and in words that the ordinary consumer is likely to be in a position to understand;

In particular, it is important that there is an explanation of how the rate of return has been calculated and the factors that will influence whether it is achieved must be explained, again in words that the ordinary consumer will understand;

…where advice is given, particular care must be taken to ensure that the risk profile of the product is carefully assessed in relation to the investment needs and aspirations of the customer. This is specially important where the customer is not familiar with either the type of product or the kind of risks to which he or she would be exposed. To achieve the necessarily high standards, it should go without saying that the adviser must be fully conversant with the type of product on which he is advising and the nature of the risks involved.

54. Update 85 then set out in an appendix the PIA detailed guidance for the advertising of structured products. First, firms were required to ensure that investors were given all the information necessary to understand the nature of the product, involving an explanation of the factors affecting the return. Secondly, firms were required to provide an explanation of the risk profile of a product in terms that investors would understand. A number of specific matters were identified. Thus,

…in general terms the PIA would expect more prominent and more detailed explanations of risk to be disclosed in advertisements for products offering higher fixed payments.

The prominence given to the information about risk should reflect the degree of risk posed by the product and the prominence given to marketing information about the benefits. For example, with any product where the investor faces capital loss, PIA's view is that any…advertisement…should disclose the possibility of capital loss as one of the main points in the advertisement. Any brochure or leaflet will probably require disclosure of the possibility of loss on the front cover. In any direct offer pack, the possibility of loss should be disclosed in any covering letter. The wording used in each case should specifically address the possibility of capital loss…

…PIA would view with concern any presentation which might lead investors to assess the risk profile of an investment by reference to 'back testing'. Advertisements risk this inference being drawn unless there is a clear separation of the 'back testing' information from the assessment of risk, and unless the 'back testing' information is accompanied by suitable text to warn investors that the information should not be used for assessing the risk profile of the investment.

55. Mr Hantusch submitted that any breaches of the Updates were matters of mere regulation which should not be capable of affecting the defendants' suitability to act as directors. I do not agree. The Updates were there to provide guidance as to how firms could ensure that their marketing material was indeed clear, fair and not misleading in accordance with the rules. They provided for circumstances where there was potential for playing down the risks of a product and conflating the functions of the explanatory material in the ways I have mentioned. They were concerned to ensure that the nature and extent of the "impact risk", that is to say, the circumstances in which the worst case scenario would arise and the extent to which capital could be lost in those circumstances, should be clear to the consumer. It seems to me that these were matters of substance and that the regulatory guidelines were ignored at the peril of firms and their directors.
56. I must therefore turn to the material provided to clients to investigate whether it satisfied the requirements of the Updates or whether it otherwise complied with the principle that it should be "clear, fair and not misleading".
57. For this purpose I will refer to the NDF 7 "write-up" letter of 9^th July 2001 (beginning "Dear Investor") and brochure, although I was taken to several types of SCARPS marketed by DMA at which similar criticisms could be levelled.
58. The letter emphasised high return in the same sentence as what was described as "low downside risk". The plan was described several times throughout the literature as a "strictly limited offer". Nowhere in the letter was there any express mention of the risk that the initial capital invested might be substantially reduced or even lost altogether. On the contrary, in capital letters the letter declared that "THE DAVID AARON PARTNERSHIP BELIEVE IT TO BE AN IDEAL INVESTMENT FOR THOSE WHO WISH TO BUILD UP CAPITAL…THE POTENTIAL PROFIT OF 33% (OR AN INCOME OF 10.10% A YEAR) IS OUTSTANDING". A warning was then given in general terms in a box at the end of the letter, but it required the addressee to read the detailed warnings "in the following write-up".
59. Risk ratings were given in the main body of the brochure. The high returns and the risk ratings were more prominently displayed in the brochure than any explanation of the risks themselves. All the references to risk were overshadowed by various statements extolling the perceived advantages of the products.
60. The section entitled "How secure is your capital and how is your money invested?" explained how capital return was calculated and the circumstances in which a reduced capital return would result. However the explanation was formulaic and did not set out in clear or simple terms the impact risk by reason of the downside gearing and the fixed investment term.
61. The section about reduced return highlighted what would happen on the basis of past performance. Although this section included a warning that "This "information alone should not in itself be used as an indication for assessing the real risk profile of the investment", it is notable that there was no separation (as required by Update 85) of back testing and risk assessment. So far from making it clear that no reliance should be placed on back testing in terms of risk assessment, it is impossible to avoid the conclusion that the information as to past performance was included for the very purpose of minimising the clients' perception of risk, and that the warning was there to pay lip service to compliance.
62. While risk warnings were included at the foot of the letter and on the brochure's back cover, which may be considered a prominent place, they were not comprised in the provisions about return of capital. The impression given was of generic warnings of the 'your investment may go down as well as up' nature. The investor was adjured to read the whole of the brochure rather than told in straightforward terms of the risk that he might lose all his capital. There was no description in the risk warnings of the method by which capital return was calculated and no statement anywhere of the minimum return (zero in the case of NDF 7). The circumstances which would give rise to such a worst case scenario were explained only in technical terms.
63. The Product Providers' document was also furnished with the letter and brochure. However, that contained the relevant information in small print and highly technical wording, very far from the "terms investors will understand" required by the Updates.
64. The categorisation as low risk was presented as information without the explanation of the risk which would enable the investor to make up his own mind whether the investment was suitable for him. Certain statements of opinion, for example "better than a tracker fund" were inadequately qualified and presented almost as though they were fact. Back-testing information was located in the section dealing with the return of capital. Block letters were used only to promote the advantages of the product. Risk warnings were mainly generalised and in any event diluted by the way they were presented.
65. In its promotional literature DMA also relied on expressions of opinion provided by journalists. In the context of aggressive marketing it is my view that these opinions were presented inappropriately, for two reasons. The first is that although the journalists were described as 'independent', they were in fact paid for providing their comments. While the journalists may have been independent in the sense that they were not in-house to DMA and their views were not pre-written for them, the impression was nevertheless potentially misleading to the recipient. Secondly, the risk ratings provided by the journalists were different, and lower in terms of short-term risk, than those of DMA. The effect was confusing and the material did not therefore comply with the regulatory requirement that the assessment of risk should be clearly explained.
66. The information in the mail shots was not presented in such a way that consumers receiving it were enabled to make an informed decision whether to invest. While it is true that some of the client base may have been familiar with SCARPS, or have had a sophisticated perception of investments, that does not avail the defendants since the mailings were sent out indiscriminately to a wide customer database.
67. For the reasons I have given, I do not accept Mr Hantusch's submission, reflecting what is obviously still the view of Mr Jones at any rate, that DMA's advertisements were consistently fair, clear and not misleading. In my judgment marketing considerations took precedence over the requirement for a full and fair explanation of the products and their risks. I have concentrated on NDF7 but I was shown other examples of this type of marketing strategy, downplaying the risks or highlighting the advantages, in relation to other products also. The words "secure investment" were a constant theme.
68. My firm finding, taking all the above matters into account, is that these directly marketed SCARPS were mis-sold. I have come to this conclusion independently of the findings in the Report on the direct evidence that I have seen and heard.
69. There were also serious irregularities in respect of those SCARPS for which advice was directly given to individual clients. Update RU 85 reminded firms of their obligation only to make recommendations to clients whose risk profile matched the risk profile of the product. The Report shows several cases, including cases in and after October 2000, where the client's attitude to risk was documented as being more cautious than DMA's own assessment of risk. The defendants were cross-examined about these incidents but were to my mind unable to give any satisfactory answer.
70. Allied to the mis-match of risk was the fact that DMA's record-keeping was woefully inadequate. This included record-keeping about discussions and assessment of risks, which sales were achieved through direct selling and which through advised sales, and about client profiles. The Report's review of customer files contains a running thread of findings that inadequate customer information was documented on file and that there was reliance only on what was described as 'brief manuscript notes'.
71. The defendants said in oral evidence that the reason for the thin files in some cases was or may have been that there was more than one file for each client. In some instances but not others the client invested jointly with his or her spouse and two or three files would therefore be opened. Mr Michael Aaron was able to give some information about one of persons named in the Report because he had been the person advising that client. Although he insisted that he would have had all the relevant information as the client was well-known to him, he was unable to demonstrate any kind of coherent system to support his statement. The defendants could not explain any rational system for examining all relevant files before advising the client. In answer to a question from the court it emerged that there was no database, computer or manual, which held or cross-referenced all relevant information.
72. These breaches as to client information were not trivial matters. They have to be seen in the context of the firm's cavalier attitude to the recording of decisions about risk rating, the explanation of risk and the indiscriminate targeting of customers with promotional material about products they were unlikely to understand. Moreover there was no specific monitoring in relation to SCARPS sales and it would have been very difficult, if not impossible, to ascertain any trends in relation to sales of SCARPS in view of the way in which the client files were maintained.
73. It was in my judgment the mis-selling which ultimately exposed DMA to the financial claims which brought about its insolvency. Mr Hantusch argued that the insolvency was largely caused by claims in respect of earlier investments sold by the partnership (maturing before the FSA investigation) which DMA agreed to take over. He submitted that there was thus no direct link between the defendants' acts as directors and the failure of the company. It is true that the Report deals with the failures of the partnership and the company as a seamless 'Firm'. However DMA carried on the policy, unchanged in any way, which the partnership had adopted prior to October 2000. If I leave out of account, as it is agreed that I must, SCARPS advertised and sold prior to October 2000, there were still a very large number of SCARPS for which DMA took responsibility and which substantially contributed to its downfall.

Compliance procedures

74. I now turn to the history of compliance procedures at DMA. Mr Jones's title at DMA was 'Investment Director' but he was also the compliance manager until September 2000 when a Miss Sarah Bailey (then known as Mrs Cleaver) was appointed as compliance manager, and he resumed those duties after she left. He retained the supervisory role and title of Compliance Officer after she joined DMA.
75. Although by training and experience she was also very knowledgeable about investment matters, compliance was Miss Bailey's only responsibility. She attended marketing meetings as part of her role. As she was not a director she reported to Mr David Aaron and Mr Jones. Miss Bailey gave evidence and she was evidently predisposed in favour of Mr Michael Aaron and, in particular, Mr Jones. She had a good relationship with Mr Jones with whom she worked in close physical proximity at DMA's premises. Her evidence was that he always took her concerns seriously and sympathetically and he was her first port of call when she experienced any difficulties. As time went on, her relationship with Mr Jones remained excellent but her relationship with Mr David Aaron deteriorated. She felt he brushed aside her concerns and she left DMA in March 2002, when Mr Jones again took over the main compliance role.
76. Miss Bailey noted that when she joined DMA there were few procedures in place, and in particular written procedures. On 10^th July 2001 she sent a memorandum to the directors, expressing concern that advisers were not following correct procedures and that there were some serious shortcomings in relation to the recording of fact finding information and the contents of 'reason why' letters. Her evidence was that advisers who had been working for DMA for some time acted as if compliance procedures did not apply to them. There was resentment at the rapid recruitment of new advisers.
77. When she joined DMA, Miss Bailey and Mr Jones (who undertook responsibility between them for maintaining compliance records) decided that 10% of all sales should be subjected to compliance checks. However checks were not in fact undertaken at that level because Mr Jones was always in arrears with them. He was the most prolific of all DMA's salesmen; indeed the Report attributes certain deficiencies in compliance to the burden of his work with customers. In her report of 30^th November 2001 Miss Bailey stated that lack of resources had again meant that it had proved impossible to adhere to file checking and monitoring procedures.
78. Her interview with the FSA showed that DMA's directors did not share her concerns about compliance. It was plain from her oral evidence that she ascribed most of the blame to David Aaron. Nevertheless it is hard to escape the conclusion that among the directors as a body there was a culture whereby Miss Bailey's concerns were only superficially addressed and then dismissed.
79. Miss Bailey prepared a compliance report and plan which she circulated to the directors on 28^th February 2002. She criticised DMA's failure to record the manner in which it selected investments. She reiterated the backlog on checking files, noting that,

The system has failed because Andrew [Mr Jones] has not got time to check the files, so they build up and then he does lots together…This breakdown has led to several problems, difficulties in reconciling the advisers' earnings, inadequate evidence of monitoring, advisers are not getting regular one-to-one meetings each month, increased pressure and backlogs in the filing department, many permanent files are incomplete, the file checks are carried out too late to have maximum input in terms of remedial action, and instead of problems or trends being nipped in the bud, they continue unchecked for many months.

80. Miss Bailey also noted that there was a risk of clients receiving unsuitable advice, a risk to the business in terms of complaints, redress and the increased costs of professional indemnity insurance, and the risk of disciplinary action by the Regulators. She made detailed proposals to regularise matters.
81. Her report stressed the need for her to see the final version of marketing material before it was passed to clients, noting that some changes had been made in final versions without her prior approval. She made three important points in relation to marketing material and FSA regulation, as follows:

Be aware that we might need to revise any existing 'formulaic approaches which might not comply with the new regime. For example, where risk warnings are contained separately in small print at the end of the document…

Be careful when promoting our belief that market recovery will happen in the short term, balance is given to other possibilities. For example, what would happen in a fairly static market, in a volatile market, or a recession?

Consider that many of the products we promote are FSA 'Hot Spots'. This does not mean that we should not promote them, but where any contentious issues or controversy surround a product provider or product this should be covered clearly in the literature. The new regime will require risks to be equally contrasted with advantages, both within financial promotions and suitability letters.

82. A formal response was prepared by the directors to Miss Bailey's report and compliance plan. It was short and somewhat perfunctory, even complacent, in dealing with her concerns. As events have turned out, many of Miss Bailey's concerns and warnings have proved to be entirely justified.
83. However, I note that the directors' response was said to have been "discussed, and agreed with Sarah Cleaver at a meeting between Andrew Jones, Ewan Boyle [brought in to assist with compliance issues] and Sarah Cleaver on 13^th March [2002]." Further, Miss Bailey did on every occasion formally approve promotional material for compliance purposes (although sometimes she was only given a very short time to consider it) and at no stage did she report DMA to the FSA for any regulatory breaches. It can only be inferred that her better judgment was overborne by DMA's directors, and in particular David Aaron, the Chief Executive, and Mr Jones, to whom Miss Bailey reported directly.
84. I therefore turn to the question of whether the defendants should take responsibility for the mis-selling and associated regulatory breaches which I have identified.

Responsibility for ensuring compliance with regulatory requirements

85. The Secretary of State's allegation that the defendants failed to ensure that they were sufficiently concerned with DMA's regulatory responsibilities lies at the root of this application. It is said that the failure to comply with regulatory requirements provided the context in which the mis-selling and consequent insolvency took place.
86. While the court is required to consider the extent of an individual director's responsibility for the company's deficiencies, a director cannot simply leave the management of the company's affairs to others. Jonathan Parker J summarised the position in Barings (No 5) at 483g and 484c-g, where he said:

In considering the question of unfitness, the respondent's conduct must be evaluated in context- 'taken in its setting'…

It follows…that the court will assess the competence or otherwise of the respondent in the context of and by reference to the role in the management of the company which was in fact assigned to him or which he in fact assumed, and by reference to his duties and responsibilities in that role. Thus the existence and extent of any particular duty will depend upon how the particular business is organised and upon what part in the management of that business the respondent could reasonably be expected play (see Bishopsgate Investment Management Ltd (in liq) v. Maxwell (No 2) [1993] BCLC 1282 at 1285 per Hoffmann LJ)…

Thus while the requisite standard of competence does not vary according to the nature of the company's business or to the respondent's role in the management of that business- and in that sense it may be said that there is a 'universal standard- that standard must be applied to the facts of each particular case. Hence to say that the Act envisages a 'universal' standard of competence applicable in all circumstances takes the matter little further since it says nothing about whether the requisite standard has been met in any particular case. What can be said is that the court, whilst taking full account of the demands made upon a respondent by his management role, will recognise incompetence in whatever circumstances and at whatever level of management it occurs, from the chairman of the board down to the most junior director.

Mr Andrew Jones

87. With this passage in mind I turn to the position of the defendants.
88. I have no doubt that the mis-selling and indeed the regulatory failures fell squarely within Mr Jones's area of responsibility. He retained the title Compliance Officer during Miss Bailey's employment, and, in any event, he oversaw compliance in practice. His conduct as compliance officer prior to October 2000 informed his attitude and that of the directors generally, to record-keeping and the priority of marketing considerations in promotional material. While many of his sins were those of omission because he simply did not have the support to deal properly with compliance as well as sales, his judgment was faulty in giving preference to sales at a time when he was, or ought to have been, heavily involved in compliance matters.

Mr Michael Aaron

89. Mr Michael Aaron's title at DMA was "Technical Director", a term used to mean the director responsible for taxation and trust matters. He sometimes attended marketing meetings and vetted promotional material, but only for the purpose of checking that information given about taxation and other so-called technical matters was accurate.
90. It has not been suggested by anyone in these proceedings that Miss Bailey was otherwise than a knowledgeable, conscientious and competent compliance manager, or that she was not a fit and proper person for appointment to that post. Mr Michael Aaron's view is that it was right to delegate compliance functions to her and that as far as he was concerned she was the ultimate arbiter on all such matters. Provided she gave formal approval, for example to promotional material, he believed (and continues to feel) that he could not reasonably be criticised for thinking that nothing was seriously wrong.
91. Mr Newey described this attitude as an attempt by Mr Aaron to throw blame for his actions on to Miss Bailey. I do not think this is quite fair, particularly as Mr Aaron does not accept that blame attaches at all. The question for my purposes is whether Mr Aaron's responsibilities extended beyond delegation of compliance matters to a fit and proper person. In other words, did he himself have a responsibility to ensure that DMA's products were not mis-sold?
92. I have to consider his duties and responsibilities in the context of his role at DMA. On a narrow view that role was merely one of Technical Director. However, two special factors apply to him.
93. The first is that he was an acknowledged expert on SCARPS and the mechanics of how they worked. It emerged that he advised investment banks (negotiating with life companies) on how best to structure such products. The second is that he was himself a registered IFA actively involved in advised sales of SCARPS.
94. Of course a director's specific responsibilities within a company provide an important context within which to consider his conduct. However the fact that Mr Aaron was a tax and trust specialist with particular responsibility for fiscal matters does not confine his duties to that narrow focus. As a director he could not, with his expertise, close his eyes to regulatory matters of which he was admittedly aware. Although he was not an expert on regulation Miss Bailey raised her concerns with him. He was a party in name to correspondence in which her carefully expressed concerns were patently being side-lined.
95. In all the circumstances I do not consider the fact that Miss Bailey signed off advertisements exonerates Mr Aaron from blame in acceding to the views of Mr David Aaron and Mr Jones that her concerns were groundless. He was in a position to know that they were not. As an expert on SCARPS, it ought to have been evident to him that the marketing material used for the products sold by DMA was neither clear nor fair but was instead misleading.
96. There is also the question of the risk ratings. Miss Bailey emphasised the fact, which he already knew, that SCARPS were FSA 'Hot Spots'. In those circumstances he should have been especially vigilant about the manner in which DMA's lower perception of risk was explained and communicated to its clients.
97. I add to this that delegation to Miss Bailey could not exonerate Mr Aaron from his regulatory obligations to ensure that DMA kept proper records for the protection of its clients.
98. In summary, it is my view that Mr Aaron's familiarity with the nature of SCARPS and with selling them means that he could not simply rely on the delegation to Miss Bailey of ultimate approval. That approval ought in all the circumstances of this case to be described as only an artificial tick.
99. Having regard to the particular skills and experience of Mr Jones and Mr Michael Aaron, their fundamental duties as directors included the duty to be alert to the failures of delegated responsibilities which ought to have been evident to them. If they were not so evident, it can only be because they turned a blind eye to those duties under a misconception of the role and responsibilities of directors.

Unfitness

100. Mr Hantusch submitted that it would be unfair to disqualify directors who had committed FSA regulatory breaches unrelated to the general management of a company since that would result in disqualification from acting as a director of any company.
101. There are two answers to this. First, I bear in mind the observations of Jonathan Parker J in Barings (No 5) at 485, where he said,

In my judgment it can be no defence to a charge of unfitness based on incompetence for a respondent to contend that even if he was grossly incompetent in discharging the management role in fact assigned to him, or which he in fact assumed, nevertheless he has not been shown to be unfit to be concerned in the management of any company, since it is possible to conceive of a management role (whether in the company or companies in question or in some other company altogether-real or imagined) which he could have performed competently-what I might call the 'lowest common denominator' approach. In the context of an issue as to unfitness it is neither here nor there whether a respondent could have performed some other management role competently. That is not the test of 'unfitness' for the purposes of s 6 (although of course it may be a relevant factor in the context of an application for leave under s. 17 of the Act…). Under s. 6 the court is concerned only with the conduct in respect of which complaint is made, set in the context of the respondent's actual management role in the company. If in his conduct in that role the respondent was guilty of incompetence to the requisite degree, then a finding of unfitness will be made and (under s 6) a disqualification order must follow…

102. Although in that passage Jonathan Parker J was considering the issue of conduct of a particular management role, his remarks are also susceptible of covering the director's conduct in managing the particular business with which he is concerned. The fact that he has not shown himself unfit to manage any business, or to undertake a different management role, is, like the likelihood or otherwise of offending again (see 483 g) a matter which goes to leave to be concerned in the management of a company under s. 17 CDDA and to length of disqualification. It is not a matter which goes to disqualification itself.
103. Secondly, there is the simple fact that the abnegation of responsibility by a director is a matter affecting the ability to conduct ordinary corporate governance. A director's failure to ensure that he was sufficiently concerned with relevant responsibilities is a grass roots failure.
104. I must also deal with the allegation that the defendants have been disadvantaged in defending themselves because of lack of availability of DMA's documents. The defendants were given the opportunity by KPMG LLP to inspect documents but decided not to do so. However the defendants said that it was unlikely that all relevant documents would have been in KPMG LLP's possession owing to a take-over of DMA's business, and it was also unlikely that any relevant documents would be organised in such a way that they were readily accessible.
105. The fact remains that no efforts were made by or on behalf of the defendants to see what was in fact available or how it was organised. Indeed Mr Jones accepted under cross-examination that access to DMA's records would not have made a material difference to the defendants' case. He said, "From the records we had and from our own memory we feel that we were able to put across as good a case as we possibly could."
106. It was also submitted that the defendants were never given a proper opportunity to present their case about the failure of DMA to the FSA. However in my judgment they were given that opportunity and they took it. Much of the case they have advanced in these proceedings replicates the case they put to the FSA. Again, under cross-examination, Mr Jones accepted that the defendants did not pursue their statutory rights (for example to make a reference to the Financial Services and Markets Tribunal) because of a conscious decision "…not to put ourselves through what we felt was the case that we were just not being listened to…" He said, "so we took the view that in terms of life decision we would try and move forward."
107. At the time those decisions were taken the defendants did not realise that disqualification proceedings might ensue, but that does not seem to me to be relevant. The reality is not that the FSA did not listen to the directors, but that the FSA did not accept their arguments. Unfortunately the defendants cannot come to terms with that fact and still, despite all the client claims that have been made and all the sums paid in compensation, believe that they were justified in what they did.
108. In summary I find that these SCARPS were mis-sold for the reasons I have given. Both the defendants must share responsibility for the mis-selling, the lack of proper record-keeping, the failure in corporate governance and the demise of DMA. The defendants did not take all reasonable steps (taking into account the context of their respective roles at DMA) to ensure that DMA complied with its regulatory responsibilities. Regulatory guidance cannot be dismissed as bureaucratic detail; it is there to protect the consumer. Moreover, IFAs who comply with it know that they are also protected.

Conclusion

109. It flies in the face of common sense to say that these two individuals were, despite all this, fit to act as directors. While I stress that there was no dishonesty, it seems to me that the wrong balance was struck between marketing considerations and the interests of the consumer. That is where lack of commercial probity comes in and that is the conduct from which the public needs to be protected.
110. In these circumstances a disqualification order is mandatory under CDDA s. 6. I will hear further submissions as to the appropriate length of the disqualification period in each case.