Every firm must take reasonable steps to ensure that a personal recommendation, or a decision to trade, that it makes is suitable for its client. So say the laws and rulebooks of all the major investment centres. The rules for Europe in this area come from the MiFID directives. Those for the Asia-Pacific region, like the Hong Kong Securities and Futures Commission (SFC) Code for Intermediaries, stem from the work of the International Organization of Securities Commissions or IOSCO, the world’s standard-setter for securities markets. Chris Hamblin of Compliance Matters provides a checklist for firms.

 Every firm must take reasonable steps to ensure that a personal recommendation, or a decision to trade, that it makes is suitable for its client. So say the laws and rulebooks of all the major investment centres. The rules for Europe in this area come from the MiFID directives. Those for the Asia-Pacific region, like the Hong Kong Securities and Futures Commission (SFC) Code for Intermediaries, stem from the work of the International Organization of Securities Commissions or IOSCO, the world’s standard-setter for securities markets. Chris Hamblin of Compliance Matters provides a checklist for firms.

For this refresher we take the UK conduct-of-business (COBS) rules as a template because they are the same throughout Europe through the MiFID connection and because Hong Kong and many other financial centres emulate them. MiFID is the Markets in Financial Instruments Directive. In fact there are two directives in operation here: the second is the confusingly named MIFID Implementing Directive. 

BASIC PHILOSOPHY 

When making a recommendation (COBS 9.2.1R) or managing investments, the relationship manager should ascertain the customer’s knowledge of and experience in the investment field in respect of the investment or service in question; his financial situation; and his investment objectives. This applies, of course, to investments of all types including those contained in life assurance policies. 

The idea is that the private bank or asset manager must have enough information about the customer as is reasonably necessary to help him meet his investment objectives; ensure that he is able financially to bear any related investment risks in a way that is consistent with those objectives; and ensure that he knows enough to understand those risks. 

WHAT TO ASK THE CUSTOMER 

The information the relationship manager or RM should draw from him (COBS 9.2.2R) must include, where relevant: 

• the length of time for which he wishes to hold the investment; 
• his preferences when it comes to taking risks; 
• his actual risk profile; 
• the purposes of the investment; 
• the source and extent of his regular income; 
• his assets, including liquid assets, investments and real property; and 
• his regular financial commitments. 

HOW SOPHISTICATED IS THE CUSTOMER? 

On the subject of the customer’s knowledge of and experience in the investment field (COBS 9.2.3R) the RM must find out: 

• the types of service, transaction and investment with which the customer is familiar; 
• the nature, volume and frequency of the customer’s previous transactions in the investments covered by the rules and the period over which they have been carried out; and 
• the customer’s level of education, his profession or his former profession, where relevant. 

COBS 9.2.4 bans the firm from encouraging the customer not to provide information. Having said that, COBS 9.2.5 allows the firm to rely on the information he provides as long as that information is not manifestly (Oxford English Dictionary: clear and obvious to eye or mind) out of date and/or wrong. If the information passes this test but still turns out to be wrong, the firm is officially held to be innocent but regulators play a dirty game in this area and the best advice, in the words of Ronald Reagan, is to “trust and verify.” 

THE GOLDEN RULE 

This brings us onto the subject of what happens when the RM cannot gather sufficient information. COBS 9.2.6R applies: “If a firm does not obtain the necessary information to assess suitability, it must not make a personal recommendation to the client or take a decision to trade for him.” In other words, the RM is not allowed to say “we took the decision without the information because the customer wouldn’t give it to me.” The private bank is not entitled to a free pass just because the customer is being difficult.

A MEAGRE EXEMPTION 

When recommending a small friendly society life policy (with a premium of £50 per annum or less or £1 a week or less if it is paid weekly) the only assessment of suitability the RM need do is to obtain details of the customer’s (and his dependants’) net income and expenditure. This, though, will not provide a defence against a claim for negligence. The exception is therefore quite useless. 

HOW TO ASSESS SUITABILITY: SOME GUIDANCE 

COBS 9.3.2 makes the obvious point that transactions that look suitable in isolation may not be so when taken together. It also encourages private banks to “have regard to the client’s agreed investment strategy.” COBS 9.3.3G deals with the things a firm should consider when making a personal recommendation to a retail customer about income withdrawals from a pension fund. These are: 

• his investment objectives; 
• his current and future income requirements, existing pension assets and the relative importance of the plan to him; and 
• his appetite for risk. 

WHEN IS A TRANSACTION BENEFICIAL? 

Suitability reports explain, among other things, why this-or-that private bank has concluded that a recommended transaction is suitable for the customer. Fund management firms need not compile these but any private bank that is giving advice (i.e. a “personal recommendation”) to the customer ought to take heed of COBS 9.4.1R, which calls on such a firm to give him a suitability report if he: 

• buys or sells a holding in a regulated collective investment scheme; or 
• buys or sells a holding in an investment trust where the relevant shares have been or are to be acquired in a regulated collective investment scheme; or 
• buys or sells a holding in an investment trust where the relevant shares are to be held within an ISA which has been promoted as the means for investing in one or more specific investment trusts; or 
• buys, sells, surrenders, converts or cancels rights under, or suspends contributions to, a personal pension scheme or a stakeholder pension scheme; or 
• elects to make income withdrawals or purchase a short-term annuity; or 
• signs a pension transfer or pension opt-out. 

If the private bank is making a personal recommendation (i.e. giving advice) about a life policy, it must automatically give the customer a suitability report (COBS 9.4.2R). 

WHEN ARE SUITABILITY REPORTS NOT NEEDED? 

No report is needed at all if the bank is managing a client’s funds and its advice relates to a regulated collective investment scheme. There are other peripheral exemptions from this requirement in COBS 9.4.3R. In most cases the bank must hand the report over to the customer when – or as soon as possible after – the transaction is done (COBS 9.4.4R). In respect of a life policy, the report must be presented in a durable medium, such as paper, immediately after the contract is concluded (COBS 9.4.5R and 9.4.6R). 

Professional clients receive much less protection from the regulators in this area. Firms do not have to provide them with suitability reports. Having said that, a “professional” can always sue the private bank for negligence with much the same results for the institution. RMs always have to remember their obligation under the FCA “principles for business” and APER “principles for approved persons” to “use due care and diligence” in this area. They cannot be too careful in ensuring that professional investors are correctly classified as such. 

WHAT IS A PROFESSIONAL? 

Only a commodity dealer or commodity derivatives dealer, or a “local” (a dealer on an exchange such as LIFFE, trading on his own account) can automatically qualify as “professional.” Otherwise, the customer can only qualify if the firm subjects him to a battery of stringent tests (COBS 3.5.2R). It must undertake a “reasonable” assessment of his expertise to ensure that he is capable of making his own investment decisions and understanding the risks involved. It must certify that at least two of the following three criteria are true: 

• the client has €500,000 in his portfolio; 
• he has carried out transactions of “significant size” on a market at an average frequency of 10 per quarter over the previous four quarters; 
• he works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged. 

There is a third hurdle, once again with a threefold procedure: 

• the customer must state in writing to the firm that he wishes to be treated as a professional client, perhaps only in relation to one particular service or transaction or type of transaction or product, perhaps in relation to them all; 
• the firm must give him a clear written warning of the rights he might lose; and 
• the customer must state in writing, in a separate document from the contract, that he is aware of the consequences of losing such protection. 

SUITABILITY REPORTS FOR INCOME WITHDRAWALS 

When a firm is advising a customer about income withdrawals or the purchase of shot-term annuities, the report should contain such warnings as the following. 

• The capital value of the fund may be eroded. 
• The investment returns may be less than those shown in the illustrations. 
• Annuity or pension scheme rates may deteriorate. 
• If the maximum short-term annuity is to be bought, the resultant high levels of income might not last. 

RECORD-KEEPING: THE RULES 

The private bank (COBS 9.5.2R) must retain its records relating to suitability for a minimum of the following periods: 

• if they relate to a pension transfer, pension opt-out or FSAVC (free-standing additional voluntary contribution) scheme, indefinitely; 
• if they relate to a life policy, personal pension scheme or stake holder pension scheme, five years; 
• if they relate to MIFID business, five years; and 
• in any other case, three years. 

The bank need not keep its records that related to suitability if the customer does not proceed with its recommendation or if the records do not relate to MIFID business (COBS 9.5.3R). 

THE SECOND GOLDEN RULE: THROW NOTHING AWAY! 

Despite these apparent safeguards, when private banks throw away records on this subject they expose themselves to the risk of litigation and to the referral of complaints by eligible parties (individuals, micro-enterprises and reasonably small trusts) to the Financial Ombudsman Service and this is not only true in the UK. Hong Kong now has a dispute resolution service to deal with such complaints. New Zealand and Australia have ombudsman schemes on the British model. Elsewhere, similar arrangements (sometimes not binding) are springing up.