A completely new set of Conduct of Business Rules will come into force on 1 November. All the existing rules are replaced.
The new rules are being introduced partly to implement the EU’s Markets in Financial Instruments Directive (MiFID) but also as part of the FSA’s move towards more principles-based regulation. The FSA wants regulation to focus on outcomes rather than detailed procedures.
The new rules extend the suitability rule to all clients, whereas previously it had only applied to private customers. The rules also introduce an entirely new concept of “appropriateness”.
The Suitability Rule has been at the heart of all mis-selling cases. The question is whether this endowment mortgage or that investment product is suitable for the particular customer. The new Conduct of Business Rules extend the suitability rules to all customers, private and professional. Whenever a firm makes a personal recommendation or decides to trade (within discretionary investment management) for any customer, it must take reasonable steps to ensure that the recommendation or trading decision is suitable. This even applies to trading for market counterparties because the relaxed regime for eligible counterparty business does not apply to making personal recommendations or managing investments. Thus, the suitability rule will apply where a fund manager handles the investments of a multi billion pound pension scheme. Before making a personal recommendation or managing investments, the firm must obtain the information regarding the client’s knowledge and experience, financial situation and investment objectives necessary to enable the firm to make the recommendation or take the investment decision. If the firm does not obtain the necessary information, it is prohibited from making any personal recommendations or trading on a discretionary basis.
The firm can still act on an execution only basis, but must ensure it receives written confirmation of its instructions to do so.
Having obtained the necessary information, the firm must then consider whether the proposed transaction meets the client’s investment objectives; whether the client is able to bear any related investment risks; and whether the client has the necessary experience and knowledge to understand the risks involved in the transaction. In the case of professional clients, the firm can assume a client has the necessary experience and knowledge, and in the case of per se professional clients (broadly large corporate clients), but not elective professional clients (the former expert private customers), the firm can assume the client is able financially to bear any related investment risks. The firm must always consider whether the investment meets the client’s investment objectives.
This includes the length of time for which the client wishes to hold the investment; his preferences regarding risk taking; his risk profile; and the purposes of the investment.
There will be fears that extending the suitability rule to commercial clients will make firms more exposed to potential claims. However, many will recall the litigation brought in 2001 by the trustees of the Unilever Pension Scheme against Merrill Lynch. At the time that claim was considered to be unprecedented. Now it would be brought with the additional allegation that the portfolio was unsuitable.
Appropriateness is an entirely new concept introduced by MiFID. It applies when firms are not making a personal recommendation (so the suitability rule does not apply). It then applies to all MiFID business by MiFID firms. This will cover all dealing by stockbrokers. It will not cover most independent financial advisers who are outside the scope of MiFID if they do not handle client monies. However, they will be covered if they have opted into MiFID to take advantage of the single European market. In such cases, they also assume the additional potential liabilities.
The appropriateness obligation does not apply where a firm is dealing in non-complex financial instruments (which include quoted company shares) at the initiative of the client. The appropriateness obligation therefore does not apply if a client finds a stockbroker on the internet or Yellow Pages and asks them to trade. It is less certain whether the obligation applies when the firm has acquired the client through advertising. The question is whether the transaction is at the initiative of the client. The appropriateness obligation would apply if it is in response to any personalised communication.
Direct mail may be a personalised communication depending on its content, unless it makes clear that the firm does not intend the communication to be personalised and the personal circumstances of the recipient have not been taken into account. From a compliance perspective, firms would be well advised to include such a warning in all their direct mail marketing, although this is unlikely to be attractive from an advertising point of view.
As with the suitability rule, the firm must obtain sufficient information from the client to determine whether the client has the necessary experience and knowledge to understand the risks involved in relation to the product or service offered or demanded. Firms must obtain information about the types of transaction with which the client is familiar; the nature and volume of transactions the client has previously carried out; and the client’s level of education or profession.
Where the client declines to provide such information, or the firm considers the product or service is not appropriate, then it must warn the client. Having warned the client, the Rules allow the firm to go ahead with the transaction, but that is in the firm’s discretion having regard to the circumstances.
If a firm fails to conduct the appropriateness test when it is required to do so, or wrongly fails to conclude that a transaction is inappropriate, it will be in breach of the FSA rules. S150 FSMA then provides that the private customer has a cause of action in damages against the firm for loss caused by that breach of the Rules.
Execution only stock-broking was previously viewed by many firms and their professional indemnity insurers as a low risk business. The new appropriateness rule means potentially onerous obligations now arise in this area.