The FCA Targets the Wealth Management Industry

Harvey Knight, Withers LLP, Partner, 1 October 2013


In this article Harvey Knight, a partner at the global law firm of Withers, gives us a blow-by-blow account of the financial regulators' attempts to lead the British private banking and asset management sector into the 21st Century.

In this article Harvey Knight, a partner at the global law firm of Withers, gives us a blow-by-blow account of the financial regulators' attempts to lead the British private banking and asset management sector into the 21st Century.

In March this year, Martin Wheatley (the Financial Conduct Authority's 'chief executive designate' at the time) fired the opening shot in a concerted campaign against 'customer detriment' in the wealth management industry. He said that wealth management firms were falling short in the service of their customers and were ignoring their preferences on the subject of 'risk'. He said that “the word we need in the back of our minds, at all times, is suitability. I want it pinned up on the walls of wealth management board rooms; meeting rooms; tea rooms. I want customer service to become institutionalised in this industry”.

The New Approach to Supervision

With the FSA closing its doors and the FCA opening for business in its place on 1 April, the new regime set out its stall at the beginning of July. Clive Adamson, the FCA’s supervision director, announced that there would be a specific FCA supervisory emphasis on the wealth management and private banking sector. The FCA would erect a new supervisory model that would focus on how its wealth management firms ran themselves, not on their controls. The business models, strategies, culture and front-line processes of these firms would be at the heart of the FCA's risk-assessments in relation to them. The FCA intended to change its mindset. It had decided to focus less on the minutiae of compliance and more on the big issues that affected such firms and their sector. As part of a continuing move towards more judgement-based regulation, the FCA would be use its judgment to make firms do what it considered to be 'the right thing' instead of just monitoring compliance with rules.

A New Department

The FCA also changed its internal structure to align this new supervisory approach with sector-focused departments. The FCA’s new Wealth Management and Private Banking Department (part of its long-term savings and pension division) opened for business on 15 July 2013 with the FCA spokesman saying: “previously, wealth management came under asset management and now there is a more targeted focus on wealth management”.

Use of Thematic Reviews

Thematic reviews are to be used as the most effective way of fulfilling the FCA’s 'conduct' priorities, with the FCA intending to become more open about where its interests lie before starting its work.

Although the FCA wants everybody to believe that this is a brave new world, there is a history of such thematic reviews in the wealth management sector since the regulators began reviewing it in 2010.

Suitability: The First Thematic Review

The first thematic review in the autumn of 2010 involved a number of retail client investment portfolios at a sample of 16 wealth management firms.

In a 'Dear CEO' letter dated 14 June 2011, the FSA (as it then was) said that this review, which looked at the suitability of portfolios, had exposed significant and widespread failings. The FSA was concerned that these failings could also be prevalent at firms outside the sample.

This FSA review indicated that nearly 90% of the firms in its sample review (14 out of the 16 firms) were posing a high or medium-high risk of 'detriment' to their customers. It based this allegation on the number of client files which displayed a high risk of unsuitability or from which suitability could not be determined. 67% of the files under review were not consistent with at least one of the following:

  • the firm’s house models;
  • the client’s documented attitude to risk; and
  • the client’s investment objectives.

CEO Attestations: The First Incarnation

Every CEO who received this letter was required to respond by 9 August 2011 with an acknowledgement that he or she had read and understood the content of this letter and had considered the implications for his or her firm.

The Enforcement Phase

Some two years later on 13 September 2013, AXA Wealth Services Limited was fined £1.8 million for failing to ensure that it was giving suitable investment advice to its customers. The FCA also found that AXA had failed to exercise effective control over the bonuses it had paid to sales advisers. There was an unacceptable risk of sales advisers making inappropriate investment recommendations to customers because they stood to qualify for bonus payments. (We discuss conflicts of interests below.)

Further Phrases of the First Thematic Review

The FCA decided to conduct a second phase of thematic work in 2012. It focused on six British retail banks in the knowledge that some of them had or were planning to have substantial wealth management offerings. The FCA teams interviewed a range of individuals including senior managers and front and back office staff . They looked through customers' files to assess the judgments those firms were making about whether the investments they recommended were 'suitable'.

The FCA still found a number of cases where 'suitability' could not be determined or where there was a high risk of 'unsuitability', with some firms’ descriptions of their wealth management offerings perhaps leading customers to misunderstand the services they were receiving. It remains to be seen whether this will also lead to enforcement action but there is no doubt that suitability will remain a central regulatory concern for the wealth management sector.

The Identification and Management of Conflicts of Interest: the Second Thematic Review

In his keynote speech in July, Mr Adamson said that wealth management firms’ identification and management of conflicts of interest was another vital regulatory concern. In November 2012, although he did not mention it, another 'Dear CEO' letter had warned of the FSA’s concerns about the potential for conflicts of interest between asset managers and their clients.

As a result of the FSA’s thematic review of the arrangements of asset management firms between June 2011 and February 2012, the regulator claimed that many firms had failed to set up adequate processes to identify and manage conflicts of interest. It also accused them of breaking its detailed rules that governed the use of customers’ commissions and the fair allocation of trades between customers. Most firms could not show it that their customers avoided inappropriate costs and had fair access to all suitable investment opportunities.

The FSA pointed the finger of blame at the senior managers and boards of these firms. In most cases, it said, these people had failed to review or update their arrangements for managing conflicts of interest since 2007. They had also failed to dedicate themselves to serving their customers' best interests. The FCA also found that many people at these firms were oblivious to the fact that their managers' short-term business goals were conflicting with the long-term interests of customers.

CEO Attestations: the Second Incarnation

The board of each assessment management firm was to discuss the issues raised in the 'CEO letter' of November 2012. Then, each firm’s CEO was to sign an attestation that his arrangements to manage conflicts of interest were effective. The deadline was 28 February 2013.

Further Phrases of the Second Thematic Review

The FCA then said that it was planning a second round of thematic visits on the subject of conflicts of interest and would use the responses to select firms for follow-up assessment visits. It is a fair assumption that it will find further misconduct, notwithstanding the explicit CEO attestations. Enforcement activity is likely to follow, though it remains to be seen whether the FCA will take on the senior managers as well as the firms in such cases.

Other Important Regulatory Concerns

In addition to suitability and the identification and management of conflicts of interest, Mr Adamson recommended that wealth management firms should:

  • ensure that their 'oversight arrangements' are suitable for their nature, size and complexity;
  • perform every service for which a customer has signed up, especially when the relevant agreement states from the outset the exact nature of the service and the customer's method of payment;
  • 'focus on' processes to prevent their businesses from being used to facilitate money-laundering and bribery;
  • send customers periodic reports to enable them to judge how well their investments were being managed, using appropriate benchmarks with adequate disclosure of relevant fees.

At the beginning of July, at the FCA’s financial crime conference, the regulators also said that they considered the adequacy of regulated firms’ anti-money-laundering and anti-bribery-and-corruption processes as vital to their aim to reduce financial crime. A number of banks have already been the subject of FSA/FCA enforcement activity for such processes that the regulators have judged defective.

A Stressful Time Ahead for CEOs?

Wealth management firms and their senior managers should also expect thematic reviews and sample exercises in relation to the other key regulatory concerns that Mr Adamson set out in the months and years to come. Their CEOs have already been required to attest to the adequacy of their suitability and conflicts arrangements. Those signed attestations will now be stress-tested.

Harvey Knight is a partner at the global law firm of Withers LLP. He can be reached on +44 207 597 6199 or at harvey.knight@withersworldwide.com

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