Both the FSA and ESMA have recently launched consultations on proposed guidance relating to firms' financial incentive schemes. Affected firms (see below) should now be taking steps to review their financial incentive schemes and to ensure that they are well-managed and structured in a way which enable the firm to treat customers fairly.
The FSA's consultation marks the beginning of a programme of work which will be taken forward by the Financial Conduct Authority (FCA). The UK regulator intends to monitor this area closely, and to take follow up action to assess what firms have done in response to this work. To assist firms in reviewing their financial incentive schemes, we have prepared a checklist based on the key points arising from the FSA and ESMA proposed guidelines.
Key actions for firms:
- Review financial incentive schemes, related controls and governance arrangements now – see checklist.
- Make changes to financial incentive schemes, controls or governance arrangements as necessary.
- If changes to schemes are necessary, re-negotiate and amend employee contracts to reflect changes.
- Consider effectiveness of current management information capture - IT systems may need to be updated.
- Communicate and train staff on incentive scheme changes.
- Investigate recurring problems, take action and consider whether redress is necessary where customers have suffered detriment.
- All firms: review guidance consultation 12/11 and send any comments to the FSA by 31 October 2012.
- MiFID firms: review ESMA Guidelines and send any comments to ESMA by 7 December 2012.
Which firms are affected?
Click here to view the table.
The key objective of the draft guidelines (ESMA Guidelines) is to improve the implementation of the existing conflicts of interest and conduct of business requirements found within the Markets in Financial Instruments Directive (MiFID) on remuneration practices across the EEA. When the European Commission consulted during the review of MiFID in December 2010, it discussed the need for remuneration policies and practices to be compatible with MiFID's conflicts of interest requirements. It noted in particular the need to consider the remuneration of sales forces and the structure of incentives for the distribution of financial products. Based on evidence gathered in its remuneration questionnaire to supervisors in July 2011, ESMA concluded that there were divergences in the way firms address conflicts of interest and conduct of business risks arising from their remuneration policies and practices. The proposed ESMA Guidelines aim to achieve a more consistent application of the relevant MiFID rules.
MiFID firms and competent authorities will need to apply the ESMA Guidelines once they are finalised – likely to be in Q2 2013. The FCA will be required to adopt the ESMA Guidelines in its supervisory practices on a comply or explain basis. The FSA is clearly anxious not to wait until next year to do so. The FSA guidance consultation (GC 12/11) makes no reference at all to the ESMA consultation, but appears to be closely aligned to the proposed ESMA Guidelines. Since at least one firm has already been the subject of FSA enforcement proceedings as a result of poorly managed incentive schemes, it might be suggested that the FSA is already applying the guidance in its supervisory practice, and to some extent front running the outcome of both its own and ESMA's consultation.
FSA financial incentives review: key driver of mis-selling
The FSA's financial incentives review marks the start of a programme which will be taken forward by the Financial Conduct Authority (FCA). Martin Wheatley, the managing director of the FSA who will head up the FCA next year, has made it clear in his speech that the review of financial incentives and other conduct issues will be a priority for the FCA. His statements follow on from a review of the financial incentive structures of 22 firms by the FSA. The FSA found that many firms do not adequately manage the risks arising from these schemes, and many schemes were overly complex and benefit sales staff rather than the customers.
GC 12/11 sets out the review's key findings, examples of unsuitable incentive structures, as well as guidance on some of the ways in which firms can comply with FSA requirements. The Herbert Smith Checklist is based on the examples and guidance set out in the ESMA Guidelines and GC 12/11.
FCA's new approach
There is also a link to the FCA's new approach. Martin Wheatley emphasised that the FCA will have a new approach to supervision and a new culture. The FCA will be considering issues from the consumer's perspective and dealing with conduct risks will be at the top of the FCA's agenda. To this end, the FCA will:
- intervene earlier to reduce the underlying causes of consumer detriment;
- focus on pre-emptive regulation and much less on the traditional model of setting standards and looking back at firms' actions;
- look for bigger issues, find them early and deal with them quickly once spotted;
- look at how firms make their money and whether or not they are "good profits"; and
- look at how firms pay their staff and whether or not they are designing and selling products with customers in mind.
Europe: ESMA is expected to publish its final guidelines by Q2 2013. However, the ESMA Guidelines do not take into account the on-going review of MiFID. ESMA will consider whether the ESMA Guidelines will need to be revised upon implementation of MiFID 2. At present, the Commission MiFID 2 proposals are being reviewed separately by both the European Parliament and European Council. MiFID 2 is unlikely to be agreed until next year at the earliest. The European Parliament has proposed the inclusion of rules relating to sales targets and incentive schemes to ensure that they do not impair the ability of firms and their employees to act in the best interest of clients. Whether or not these provisions will survive into the final draft remains to be seen. If they do, they will need to be implemented in the UK.
UK: Firms should not wait for GC 12/11 to be finalised before reviewing their incentives schemes. One firm has already been the subject of FSA enforcement proceedings. The FSA has promised more supervisory work involving a wider review of incentive schemes which will potentially result in more enforcement proceedings. The FSA has also said that it is likely that FSA rules in this area will be strengthened. In any case, MiFID 2 may end up containing rules on financial incentives which will need to be implemented in the UK in due course.
It is clear that both the FSA (and the future FCA) and regulators across Europe will continue to take an interest in firms' remuneration structures. The interaction between remuneration and how products and services are designed and sold seems set to remain a key area of focus for supervisors.