CFM13130 - Understanding corporate finance: derivatives: types of derivative: limits to the regulatory definitions

Limiting the scope of the FSMA 2000 definitions

As they stand, the FSMA 2000 definitions - particularly those of ‘future’ and ‘contract for differences’ - are so wide that they would bring into the regulatory regime all sorts of contracts that no one would normally think of as investments.

For example, someone buying a house will usually sign a purchase contract, pay the purchase price, and take possession of the property at a later date. So between exchange of contracts and completion, the house buyer could be seen as holding a ‘future’ - rights under a contract for the sale of property, where delivery is to be made at a future date. Unless qualified, this might lead to the conclusion that all estate agents ought to be authorised by the FSA! The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI2001/544) limits the scope of these definitions for regulatory purposes.

Futures

A contract is not a future if it is made for commercial, rather than investment, purposes. A contract traded on a recognised investment exchange, or an OTC contract couched in the same terms, is automatically regarded as being for investment purposes. Any other sort of contract will generally be regarded as having a commercial purpose if it is intended to result in something being delivered.

Options

Options are limited to those which acquire or dispose of (broadly) financial assets, currency, or precious metals. It does not include, for example, an option held by a builder to acquire land.

Contracts for differences

Contracts which are intended to result in delivery, deposits of money, and insurance contracts are all specifically excluded from being CFDs. Unlike futures, there is no investment versus commercial purpose test - all CFDs are regarded as investments.

The FSMA 2000 definition of contract for differences refers to a contract ‘the purpose, or pretended purpose, of which is to secure a profit or avoid a loss. ‘Pretended’ in this sense means ‘aimed for’ or ‘aspiring to’. It does not imply any fraud or deception.

“Contract for differences” is a term that has an ordinary commercial meaning and one that has been considered in the Courts. The essence this is a contract whose value depends on something else, but is not simply a wager. So a loss under a contract for differences should be legally enforceable.

The issues were considered by the Court of Appeal in the case of City Index Ltd. v Leslie (1991, 3 All ER 180). Mr Leslie entered into “spread bets” over share price indices and after some initial profits, rapidly lost a considerable amount of money. He tried to escape liability by claiming that his debt to City Index Ltd was a non-enforceable gaming loss. However the Courts concluded that the spread bets were “contracts for differences”, either under their commercial meaning or by virtue of their ‘pretended purpose’ of securing a profit or avoiding a loss. This the applicable regulatory legislation, then in Financial Services Act 1986 overrode S18 of the Gaming Act 1845.

The court found the reference to the “purpose or pretended purpose” of a contract, difficult. It could be traced back to earlier legislation relating to the prevention of financial fraud. Possibly this wording was used because, historically, the legal status of an arrangement might have depended upon whether it was entered into avoid a loss (hedging) or to make a profit (speculation). The reference to ‘pretended purpose’ should allow the same treatment to apply, whichever of the two was the ‘real’ purpose for entering into the arrangement. This had the effect of legitimising, as commercial, contracts that could not be settled by delivery as a method of seeking profit or protecting from loss, and ensuring that they came within the ambit of the regulatory regime.

In recent years, the term ‘contract for differences’ has come to refer to a particular derivative product which is sold mainly to individual investors. Such CFDs are based on the price movements of individual shares or bonds, stock market indices, or futures contracts. The customer agrees with the provider that for each day that the contract is open, the customer will pay the provider, or receive from the provider, a sum based on the upward or downward movement in the index or other reference indicator. Confusion can arise between this narrow sense of ‘contract for differences’ and the very wide sense in which the expression is used in FSMA 2000. Where the expression is used in this guidance, it is in the statutory sense. ‘New style’ CFDs will, of course, fall squarely within the statutory definition.

Gaming or wagering

In the 19th century, the term ‘contract for differences’ was used to differentiate contracts which were, in effect, bets on stock market movements from genuine transactions in shares. Until 1986 (when the predecessor legislation to FSMA 2000 came in) debts arising on the former were unenforceable because they were regarded as wagering contracts. Now such debts are enforceable provided the contract was entered into by way of business.

Case law (such as Morgan Grenfell and Co Ltd v Welwyn Hatfield District Council [1995] 1 All ER 1) and CIR v Leslie, referred to above, has established that, although contracts for differences can be entered into speculatively, and may be capable of being wagers, they are not necessarily so. It will depend on the intentions of the parties. Since a company will normally enter into a derivative contract to hedge or to invest, rather than to wager its shareholders’ money, it would be unusual for a CFD entered into by a company to be a wager, and the point is irrelevant if the contract falls within CRA09/PT7 for tax purposes.