Following the demise of Lehman Brothers, concerns arose globally relating to the suitability and business conduct standards employed in the sales of financial products, and in June 2009 the Technical Committee of International Organization of Securities Commissions (“IOSCO”) announced that it had mandated a standing committee (“TCSC3”) to review the suitability obligations that relate to intermediaries’ distribution to investors of complex financial products.
Since such time, TCSC3 has been considering such suitability standards in the context of both retail and professional investors and in furtherance of its objectives. It has entered into dialogue with groups of capital markets and industry associations, including the Institute of International Finance, the International Banking Federation, and the Joint Associations Committee on Retail Structured Products (referred to collectively as the “Associations”). At the request of TCSC3, the Associations submitted a written contribution in March 2011 outlining their views on developing common suitability standards for the sale of complex financial products.
Written Contribution and Suggested Principles
The written contribution urged IOSCO to take a careful, targeted, and proportionate approach to developing common standards on suitability. It also recommended that suitability not be defined by reference to the complexity of products, noting that complexity does not necessarily bear any relationship to risk — some noncomplex products can carry higher risks, and vice versa. Instead they recommended considering all securities, as well as collective investment schemes and their related derivative instruments and looking at the balance of risk and reward associated with them.
As set out in greater detail below, the written contribution also provided a list of 18 suggested principles (the “Principles”) which the Associations intend to serve as a guide for both conduct by market intermediaries, and the aims of regulators in this area. Such Principles do not focus solely on questions of suitability. Instead, they cover a broader range of issues including disclosure, client categorization, conflicts of interest, and best execution.
The suggested Principles are designed by the Associations to lead to three essential outcomes. First, an investor should be in a position to understand the relevant service or product in all material respects, including its risk/ reward profile, or should be represented by an agent who can understand the service or product. Second, the investor’s decision to buy a financial product or service should not be influenced by a material conflict of interest of the provider or adviser. Third, an investor being advised as to a financial product or service should be entitled to expect the adviser to take reasonable care in providing that advice.
Those relevant to all stages of the distribution process
- All customers should be fairly treated, which means the avoidance of conflicts of interest. If conflicts cannot be avoided, they should be mitigated through disclosure.
- Payments or benefits provided to intermediaries should be clearly disclosed to customers (both in terms of their nature and amount) and must not have a significant adverse effect on the discharge of the intermediary’s duties.
- Intermediaries must disclose all “relevant material information” in a way that is “clear, fair and not misleading.” They must respond appropriately to customer requests for information when received. They must make it clear whether or not a communication from them is an investment recommendation.
- Intermediaries must ensure their staff act in accordance with the Principles, and have resources and procedures in place that allow them to adequately perform their duties. This might include the provision of training and creation of an independent compliance function.
- Intermediaries must manage their relationships with other firms in the investment distribution chain. This will require giving consideration to whether other firms are “appropriate for their role,” ensuring that the roles and duties of each firm in the chain is clear and certain, and that any materials they produce are fair, balanced, clear, and consistent with their obligations.
Principles applicable presale
- Intermediaries must disclose sufficient information to allow customers to make an informed decision regarding their investment. Such information should include the nature of the service they will provide, the nature of the investments covered by the service, and the basis of their remuneration.
- Where appropriate, intermediaries should consider telling execution-only clients that it may be in their interests to seek advice.
- Intermediaries that market investments, or provide personal recommendations or discretionary management, must assess and understand the features, characteristics, and risk/reward profiles of the relevant investments.
- Intermediaries must seek all relevant information from their customers to help them assess and understand their financial needs, experience, and objectives (unless transacting on an execution-only basis).
Principles applicable at the point of transacting
- When making investment recommendations to customers, intermediaries should take “reasonable steps” to ensure they are suitable for customers.
- In taking reasonable steps under principle 10, intermediaries should ensure that: a) the relevant investment is consistent with the customer’s investment objectives, b) the investment will not generate an exposure that is not consistent with the customer’s financial situation, and c) the customer has enough knowledge and experience to understand the features, characteristics, and risks of the investment.
- Before transacting in respect of an investment with a customer, intermediaries should take “reasonable steps” to ensure that the customer has sufficient information (in a form the relevant customer is likely to understand) to understand the risk/reward profile and other material characteristics of the investment.
- Principle 12 will not apply when the intermediary is performing a discretionary investment management mandate in accordance with its terms.
- The basis of any investment recommendations should be communicated clearly to customers, and records of such recommendations should be maintained.
- If an intermediary is asked by a customer to undertake transactions where it is not providing a recommendation, it should still consider if there is anything that it knows about the customer that clearly suggests that the customer does not have sufficient knowledge or experience to assess the merits of that transaction. If it believes that to be the case, it should (but does not have to) consider whether to notify the customer that it would be prudent to take professional advice. However, if the customer (having been given sufficient time to consider the matter properly) decides to proceed, the intermediary can execute the transaction.
- Intermediaries should take all reasonable steps to ensure “best execution” on behalf of their customers, subject to complying with the customers’ express instructions. In this context, best execution is to be understood as a term of art, by reference to local usage of that expression.
Principles applicable post transaction
- Intermediaries should provide information on the performance and value of particular investments with as much frequency and in as much detail as is appropriate in the context of the services they have agreed to provide.
- In relation to investments acquired as a result of the intermediary’s recommendation, or exercise of discretion, where expressly agreed between intermediaries and their customers, intermediaries should make ongoing assessments of the suitability of investments at such intervals as have been agreed between them.
Simultaneously with the IOSCO review, the European Commission is currently formulating its proposed legislation in relation to Packaged Retail Investment Products, which will focus on the appropriateness of presale disclosures and the conduct of business obligations of the providers and distributors of financial products and services, based on the standards established in the Markets in Financial Instruments Directive. Many of the Principles bear a close resemblance to MiFID conduct of business obligations and the way in which those obligations have been developed by member state competent authorities, such as the FSA in the UK.
Similar to the PRIPs initiative,1 the Principles aim to apply those conduct of business obligations in a consistent (though not homogenous) way across different financial product and sector groups. It is also worth noting that the current MiFID review by the European Commission2 aims to extend certain conduct of business obligations (such as in relation to pre-trade transparency) that apply to equity securities, to other securities and derivatives products within the scope of MiFID. In Europe, the aim is clear — bringing disclosure and conduct of business requirements up to the highest standards that exist across all different sectors and products. We wait to see whether IOSCO will adopt a similarly broad-reaching aim.