The City watchdog has been ordered by the government to launch an independent review of how it handled the collapse of London Capital & Finance, the investment firm at the centre of a growing £236m financial scandal.

LC&F sold £236m worth of bonds which promised returns of 6.5% to 8% a year, but the company has collapsed with more than 11,000 investors expected to receive little more than a fifth of their money back.

The board of the Financial Conduct Authority has agreed to subject itself to an independent investigation, which will examine the FCA’s supervision of LC&F, and the regulation of the “mini-bonds” at the heart of the scandal. The independent person who will lead the process has not yet been appointed.

Confirming that an investigation has been ordered by the government, the economic secretary to the Treasury, John Glen, said: “The recent stories of those affected by the collapse of LC&F are incredibly concerning. I want to make sure we have the strongest and safest financial system possible. By ordering this investigation, we will better understand the circumstances around the collapse and make sure we are properly protecting those who invest their money in the future.”

The investigation could prove deeply embarrassing for the regulator after it emerged that the FCA’s enforcement team were warned three years ago about LC&F but failed to act.

It may also throw a lifeline to the victims of the collapse – some of whom sunk their entire pensions into the scheme – who currently have no recourse to the Financial Services Compensation Scheme.

A spokeswoman for a Facebook group representing the bond investors said: “We see this as the power of the collective voice raising concerns and excellent news. We hope that we will be able to provide impact statements.” She said some investors had lost six figure sums.

The review follows a demand by Nicky Morgan MP, chair of the Treasury select committee. She said: “The FCA and the Treasury must think innovatively about how the investigation can report and publish as quickly as possible. Investors will want answers.

LC&F is also under investigation by the Serious Fraud Office which two weeks ago arrested and later released four individuals in the Kent and Sussex area as part of its probe.

The LC&F products were structured as “mini-bonds” that carry zero protection from the Financial Services Compensation Scheme, but which have in recent years been heavily promoted to investors.

The investigation will determine if mini-bonds should come under the supervision of the FCA – and maybe also qualify for protection under the Financial Services Compensation Scheme.

The bonds on offer from LC&F were marketed heavily during 2016 and 2017 with the promise of interest at a table-topping 6.5% to 8%. LC&F became an FCA-regulated entity on 7 June 2016, and was granted tax-free ISA status by HMRC.

But little of the money ploughed into the bonds by investors went into safe interest-bearing investments. About £58m was taken as commission by the Brighton-based marketing company, Surge Financial, which promoted the bonds.

As the administrators set out in clinical detail last week, much of the rest went into highly speculative property developments, some in the Dominican Republic, oil exploration off the Faroe Islands, and even a helicopter bought for a company controlled by LC&F.

It was not until 10 December 2018 that the FCA ordered LC&F to stop promoting the bonds because it deemed the investments ineligible for ISAs – which allow savers to shelter up to £20,000 a year from tax – and on 13 December froze its assets because of “serious concerns about the way the firm was conducting its business”.

In a report last month the administrators Smith & Williamson said: “There are a number of highly suspicious transactions involving a small group of connected people which have led to large sums of bondholders’ money ending up in their personal possession or control.”

The Yorkshire-based financial adviser Neil Liversidge was an early whistleblower about LC&F after a client asked his advice. He wrote to the client saying underlying investments in the bond were worth “the square root of bugger all” and immediately contacted the FCA with his concerns.

In a letter to the FCA dated 29 November 2015 – before the bulk of investors had placed their money with LC&F – Liversidge called the bond’s promoters unprofessional, and the investment unsuitable. “This promotion gives me cause for concern as to how safe or otherwise will be any funds placed with them.” The FCA did not respond.

The only previous time that the FCA has subjected itself to an independent external investigation followed the Cooperative Bank scandal.

The role of HMRC in granting ISA status is also likely to come under the spotlight. In their report, the administrators said: “Our understanding is that the necessary requirements to qualify for ISA manager status are fairly limited and that it is not a rigorous application process. We understand that ISA managers are not routinely monitored by HMRC.”

HMRC said it does not approve any ISA investment that an ISA manager may offer.