This summary of TR 15/12 picks out four practical ways firms can respond to the FCA’s latest review of the wealth management sector.
The Financial Conduct Authority (FCA) released its Thematic Review “Wealth management firms and private banks: suitability of investment portfolios” (TR 15/12) on 9 December 2015.
Firms are still falling short of the FCA’s expected standards on suitability in several areas including:
- inability to demonstrate suitability;
- a risk of unsuitability due to inconsistent customer responses to information requests not being identified and challenged effectively;
- portfolio turnover (or churn) and the management of associated inherent conflicts of interest;
- mis-aligned risk appetite, investment objectives and portfolio composition; and
- inadequate governance, monitoring and assessment arrangements.
TR 15/12 is relevant to all firms providing discretionary portfolio management and/or investment advisory services, particularly to those with clients with a retail classification. Front office staff, senior managers and compliance officers need to address the FCA’s findings.
Tip 1 – Take action
While there has been an improvement in standards since the 2010 review, a third of firms assessed still fell substantially short of the FCA’s expected standards. With 23% of 150 files reviewed indicating a high risk of unsuitability, the FCA states unequivocally, in paragraph 1.14 of the Thematic Review report, that firms need to benchmark their own performance against the good and poor practices the FCA sets out in Annex 2 of the report and review their practices and customer outcomes accordingly.
Tip 2 – Maintain effective records
The FCA found that 37% of files were unclear, meaning there was insufficient evidence to determine whether the suitability assessment had been properly carried out or whether the client’s portfolio met their needs. Record keeping to evidence compliance is important but it also forms a vital part of the process by which a manager understands which investments to buy for a client.
A recent case in point is the High Court’s judicial commentary in Worthing v Lloyds Bank  EWHC 2836, which underlined the importance of completing a thorough customer fact finding investigation and maintaining comprehensive file notes of meetings and decisions made. In this case the investment advice was found not to have been negligently provided. In reaching its decision the High Court was able to place significant reliance on the information recorded in the client file maintained by the private banker at the defendant financial institution.
In TR15/12, the FCA reminds firms of existing regulatory requirements (as an example, see requirements in SYSC 3, SYSC 9 or COBS 9), which suggest an iterative three-step approach is used – (i) ask questions and note responses; (ii) consider the information obtained; and (iii) file the record in a way that allows for retrieval and review.
Tip 3 – Update customer information
The FCA identified in a number of files subject to the Thematic Review that either there was limited information to show whether customer information had been updated, or that the information had not been updated for a number of years. This results in inadequate and out-of-date information creating a risk that firms cannot ensure that individual decisions to trade continue to be suitable.
The FCA expects firms providing advisory and discretionary portfolio management services to be able to show that the key customer information they use to assess suitability has been kept up to date (and is not manifestly out of date).
A firm should have a policy to address situations where new information suggests a strategic change is needed to on-going investment decisions and whether existing holdings should be reviewed. This should also address what a firm should do if the client does not respond to requests to refresh suitability information.
In any event, many firms will need to adopt a tighter approach to suitability assessment and information collection with the advent of the more stringent requirements of MiFID II (Directive 2014/65/EU).
Tip 4 – Monitor customer portfolios
Ancillary to the need to ensure that customer information is up-to-date is the FCA’s expectation that firms ensure that the customer information they gather and record matches the customer’s underlying investment portfolio. Firms should be in a position to be able to demonstrate this.
Key failings the FCA identified in this regard include:
- investment managers using their own risk categorisation methodology, in conflict with the firm’s proprietary customer risk profiling procedures;
- investment allocations that did not accord with customer expectations or risk appetite;
- poor records, in terms of the rationale for certain customer investment allocations; and
- no evidence to explain the lack of diversification in customer portfolios.
The FCA suggests that it expects firms to modify their approach to control against these failings as they pose a high potential risk for unsuitability and customer detriment. A potential solution would be to design and implement a periodic client report indicating differences in the client’s actual portfolio against the relevant in-house target model and note why these deviations occurred and any risk mitigation mechanism in place.
As many of the suitability requirements are codified through the implementation of the Markets in Financial Instruments Directive framework, the implementation of the recast and expanded MiFID II will necessitate change (from 3 January 2017, although a delay is expected).
The FCA published CP 15/43 on MiFID II implementation on 15 December 2015 and plans a further paper in the first half of 2016. Although the precise approach the FCA will take is still emerging, firms should be planning how they will address the revised regulatory changes, including those relating to suitability.
A firm’s response to TR 15/12 will be an integral part of preparedness. For example, as part of its response to the FCA’s findings in this TR, the way in which the firm approaches the more prescriptive approach to adviser knowledge and competency requirements (see MiFID II article 25(1)) will be of relevance.
Following a review of 150 files from 15 firms, the FCA extrapolates that 59% of advisory client files do not meet expected standards. This places a high proportion of clients at risk of holding an investment product or portfolio that is not suitable for them. As TR 15/12 follows previous thematic work in 2010 as well as a Dear CEO Letter and a clarifying approach document and several high profile, firm-specific enforcement cases, the FCA is clear that these results mean all firms and their senior managers really do need to heed this warning shot. It is clear that where there has been a significant amount of related activity by the regulator this will be considered as an aggravating factor, which will be taken into account during any enforcement process.