Sarah Jane Leake | Bloomberg Law Suitability Requirements with respect to the Distribution of Complex Financial Product – Technical Committee of the International Organization of Securities Commissions Consultation Paper CR03/12 of 21 Feb. 2012 In the wake of the financial crisis, there has been a sharp increase across the globe of complaints made by consumers that they have been sold complex financial products (CFPs) without being made fully aware of the risks associated with them. In the UK, for example, the Financial Services Authority (FSA) found, in a review of the sale of structured investment products backed by Lehman Brothers, high levels of unsuitable advice and systems and controls failings across a spectrum of regulated firms.1 While many jurisdictions have since taken steps to increase the level of protection afforded to investors, particularly those on the retail side, the International Organization of Securities Commissions (IOSCO) considers that much still needs to be done, particularly in terms of harmonisation. To this end, on 21 February, IOSCO's Technical Committee (IOSCO TC) launched a consultation paper seeking views on a number of proposed principles it is considering adopting in order to strengthen investor protection over the distribution2 of CFPs.
Complex Financial ProductsCFPs are, essentially, financial products whose features are unlikely to be understood by less sophisticated investors (unlike plain vanilla investment instruments), that have a complex structure, are difficult to value, and/or have no, or a very limited, secondary market. Products generally considered to be complex include structured instruments, credit-linked notes, hybrid instruments, equity-linked instruments, and instruments linked to market parameters, asset-backed securities, mortgage-backed securities, collateralised debt securities, and other derivative instruments, including credit default swaps and covered warrants. Conventional equities and bonds, as well as exchange-traded standardised derivative contracts do not fall within this category. Significantly, certain CFPs may be illiquid and therefore difficult to sell, subject to the issuer's credit risk (as was the case with Lehman's mini-bonds, which were sold to retail investors in a number of jurisdictions, including the UK, Spain, Germany, Hong Kong, and Singapore), and/or involve a leveraged element that may multiply the risk.
Existing Suitability RequirementsIOSCO-member jurisdictions have implemented suitability standards though a mixture of regulation, case law and/or rules of self-regulatory organisations, depending on whether a jurisdiction is a civil or common law country. The UK represents an exception among the common law jurisdictions, as its existing suitability requirements primarily derive from Directive 2004/39/EC on markets in financial instruments (MiFID), which have been transposed into UK law largely through the FSA's Conduct of Business sourcebook (COBS). In the U.S., suitability obligations arise out of federal anti-fraud general provisions, supplemented by case law under the "shingle theory," as well as fair dealing obligations and self-regulatory organisations' rules and interpretative guidance. According to the IOSCO TF, in the majority of member jurisdictions, the suitability requirements applicable to CFPs are generally the same as those applicable to other securities. In the IOSCO TF's view, however, the more complex the financial instrument, the stricter the suitability requirements should be. In most countries, suitability requirements differ depending on the type of investment service provided. Generally, a full suitability assessment is only required where an intermediary provides advisory services. Suitability obligations in connection with non-advisory services, on the other hand, vary. As is the case in Mexico, China, and the U.S., there are, usually, no suitability obligations if no recommendation or advice is actually made. Some countries, however, still provide for some degree of investor protection where non-advisory services are sought by imposing "appropriateness requirements" on firms. These are narrower than the suitability requirements, as the intermediary is generally only required to assess the knowledge and experience of the client with regard to the particular asset or service, but not the client's financial situation and investment objectives. Other countries, though, do not impose any suitability/appropriateness requirements on firms offering execution-only services. These firms are, however, required to warn the customer that they do not benefit from any suitability or appropriateness protection. Yet, to the IOSCO TF, all regulatory systems should provide for adequate minimum protection, calibrated to the complexity and riskiness of the product and level of sophistication of the customer, even where products are purchased on an unsolicited basis.
The Proposed PrinciplesThe nine high-level principles proposed by the IOSCO TF are outlined below. — Client Classification Intermediaries should be required to adopt and apply policies and procedures to distinguish between retail and non-retail customers when distributing CFPs. Moreover, client classification should be based on a reasonable assessment of each individual customer, taking into consideration the complexity and riskiness of the products and services. Criteria for the qualification of a customer as retail or non-retail should be based on objective indicators, including financial status, financial experience etc. — General Duties Regardless of whether a customer is classified as retail or non-retail, intermediaries should be required to act in an honest, fair, and professional fashion, and take reasonable steps to manage conflicts of interest that arise in the distribution of CFPs, including, where appropriate, through disclosure. Intermediaries should also have policies and procedures in place to assess whether the customer has sufficient knowledge to evaluate the transaction and identify and review any conflicts of interest that may be inherent to it. — Disclosure Requirements Investors should be given, or have access to, material information that allows them to evaluate the costs and specific risks of a CFP. Moreover, any information communicated by intermediaries to their customers regarding these products should be communicated in a fair, comprehensible, and balanced manner. Given the inherently intricate nature of CFPs, regulation should, opines the IOSCO TF, require enhanced disclosure in order that all actual and potential risks are made clear to the customer. Importantly, they should not be presented as if they were non-complex plain vanilla securities. Stricter disclosure requirements should apply when the intermediary advises on, or recommends the purchase of, a CFP to a retail customer. For the IOSCO TC, proper disclosure should include any compensation and/or fees that the intermediary may earn as the result of the distribution of the product, and other non-financial benefits that might otherwise accrue. Ideally, intermediates should also seek to provide customers with comparative information on appropriate alternative investment products. — Non-advisory Services Where an intermediary distributes a CFP on an execution-only basis, the regulatory system should still, maintains the IOSCO TF, seek to protect customers from risk. At a minimum, it should require the intermediary to collect relevant information from the customer to enable it to make an informed decision as to whether certain types of transaction should be restricted, or if additional warnings or enhanced disclosure should be given for certain customers, regardless of whether advice is given or a recommendation made. — Advisory Services Where an intermediary provides advisory services in relation to a particular CFP, it should be required to take reasonable steps to ensure that any recommendation made or advice given is based on a reasonable assessment that the structure and risk-reward profile of the CFP in question is consistent with the customer's experience, knowledge, investment objectives, risk appetite etc. To be able to make such an assessment, the intermediary should itself, before distributing a CFP, develop an in-depth understanding of the features of the relevant CFP, including liquidity levels, lock-in periods etc. It should also gather and retain detailed information from each customer, relevant to the specific CFP recommended, on their investment knowledge and experience, risk tolerance etc. — Information The intermediary should have sufficient information at hand to be able to make a suitable recommendation, or give appropriate advice, in relation to the distribution of a CFP before recommending, or advising on, a particular CFP. Where a customer fails to provide all information requested, the intermediary should be required to consider whether it has sufficient information to make a reasonably-based recommendation. If not, as is the case in the EU and the U.S., the intermediary should be prohibited from making recommendations, or giving advice, to this customer. Alternatively, as is the case in many Asian jurisdictions, the intermediary could make recommendations or give advice, but on the condition that such recommendation or advice is based on limited information. — Compliance Function Going further than Principle 31 of IOSCO's Objectives and Principles of Securities Regulation,3 the IOSCO TF maintains that intermediaries should be required to establish and maintain a compliance function and develop appropriate internal policies and procedures to support compliance with suitability requirements when developing and selecting new CFPs for customers. The compliance function should be proportionate to the scale and type of a firm's business, and must be able to operate on its own initiative without improper influence from other departments. The compliance function should, in particular, put in place and enforce written strategies, policies, and procedures for the distribution of CFPs, to ensure that any such products intended for distribution are suitable for the type of customer the firm wishes to solicit. — Incentives The distribution of CFPs can be significantly more lucrative than the distribution of plain vanilla securities. The ISOCO TF therefore recommends that intermediaries should be required to develop and apply proper policies that seek to eliminate any incentives for staff to recommend unsuitable CFPs. To this end, intermediary and staff compensation policies should actively discourage the recommending of unsuitable CFPs, and senior management should be responsible for regularly reviewing the sales teams' incentive schemes and distribution practices. — Enforcement Regulators should supervise and examine intermediaries on a regular, ongoing basis to help ensure compliance with suitability and other consumer protection requirements pertaining to the distribution of CFPs. Both on-site and off-site visits should be undertaken, together with thematic reviews, for compliance monitoring purposes. Enforcement action should be taken as appropriate, and regulators should consider making enforcement actions public to send out a message to potential perpetrators and, in consequence, heighten investor protection.
Next StepsSeveral jurisdictions, notably the EU4 and the U.S.5 are currently in the process of reviewing their rules applicable to the distribution of CFPs with a view to introducing more stringent requirements. The IOSCO TF hopes that its proposed principles, once finalised, will, where relevant, be woven into the EU and U.S. revised regulatory regimes and also assist those member-jurisdictions with weaker regulation in this area. The consultation closes for comment on 21 May. -------------------------------------------------------------------------------- 1 See Quality of advice on structured investment products: The findings of a review of advice given to customers to invest in structured investment products backed by Lehman Brothers from November 2007 to August 2008 – FSA Report, 27 Oct. 2009. 2 The term "distribution" in this context has a broad, functional meaning. It includes advising, recommending, and managing discretionary accounts and/or individual portfolios, which results in investors holding complex financial products. 3 Principle 31 provides that market intermediaries should "be required to establish an internal function that delivers compliance with standards for internal organization and operational conduct, with the aim of protecting the interests of clients and their assets and ensuring proper management of risk, through which management of the intermediary accepts primary responsibility for these matters." 4 Proposal for a Directive on markets in financial instruments repealing Directive 2004/39/EC of the Parliament and of the Council (Recast), COM(2011) 656 final of 20 Oct. 2011; Proposal for a Regulation on markets in financial instruments and amending Regulation [EMIR] on OTC derivatives, central counterparties and trade repositories, COM(2011) 652 final of 20 Oct. 2011. 5 Sections 731 and 764 of the Dodd-Frank and Wall Street Reform and Consumer Act of 2010, Pub. L. No.111-203, § 124 Stat. 1376, provide the Securities and Exchange Commission and the Commodity Futures Trading Commission with, amongst other things, rule-making authority to impose conduct of business standards for swap dealers and major swap participants and major security-based swap dealers/participants dealing with counterparties generally. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.
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