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Capital Markets- United Kingdom

Background

Back in September 2006 the Financial Services Authority (FSA) published Discussion Paper 06/4, entitled "The Responsibilities of Providers and Distributors for the Fair Treatment of Customers". The paper is part of the FSA's continuing initiative on treating customers fairly and contains a statement of the respective responsibilities of providers and distributors of financial products to their ultimate customers in Annex 1. The FSA notes that the statement does not add new regulatory responsibilities for providers or distributors. Rather, it merely captures existing responsibilities under the principles and the detailed rules and guidance contained in the FSA's Handbook.

 

The FSA clearly believes that the statement, once finalized, will be a useful tool for supervisors, but will not change its approach to supervising the fair treatment of customers or other issues. As far as enforcement is concerned, the FSA cannot take action under the principles unless, at the time the breach occurred, it was reasonably predictable that the conduct in question was in breach of the principles. The FSA accepts that it will be unable to use this statement as evidence of predictability for conduct that occurs before the statement is published in final form. However, the FSA presumably intends to use the statement for this purpose in relation to conduct which occurs after it has been finalized.

 

The FSA accepts that the statement must be read in conjunction with other legislation and case law when considering the nature and scope of the duties owed to customers. The statement does not purport to be a complete exposition of the responsibilities owed by providers or distributors to their customers or to each other. Instead, it is intended to give the FSA's view on what the combination of the principles and the detailed Handbook rules requires of firms.

 

Responsibilities of Providers and Distributors

The statement uses the term 'providers' to include firms which offer services such as portfolio management through distributors, as well as those which develop, manage or package products. The term 'distributors' covers the firms which make up the rest of the supply chain and present the product or service to the customer, including financial advisers, appointed representatives, banks and fund supermarkets.

 

The provider's primary obligation is to ensure that products:

 

  • are soundly designed for the target market;
  • are sold through appropriate distribution channels with clear, comprehensible information for distributors and, where relevant, customers; and
  • perform as the provider promised.

 

The provider's specific responsibilities include:

  • designing and testing products and broadly assessing their suitability for different types of customer;
  • selecting appropriate distribution channels;
  • providing appropriate information to distributors and, where relevant, customers;
  • monitoring the end result (ie, determining whether products end up with the right type of customer and continue to deliver what the provider promised, and taking action if they do not); and
  • delivering prompt post-sale service (eg, claims handling).

 

The distributor's primary obligation is to ensure that:

  • customers have the information they need;
  • the product is suitable for the customer (in the case of an advised sale); and
  • post-sale service meets the expectations created.

 

The distributor's specific responsibilities include:

  • ensuring that the distributor understands the provider's information about the product and, if the distributor is unclear about the information, questioning the provider and considering whether to distribute the product;
  • fully considering the customer's needs and circumstances (where advised) so that the product can be properly matched to the customer; and
  • ensuring that post-sale service meets the standard that the customer was led to expect.

 

The statement also takes account of more complex arrangements, such as those which may arise when:

  • multiple distributors act in a chain;
  • distributors commission products in order to take responsibility for product design; and
  • 'pure' manufacturers create components which are later subsumed into retail products designed and marketed to customers by 'retail' manufacturers.

Responsibilities in Practice

Annex 2 to the discussion paper illustrates the responsibilities of providers and distributors in specific circumstances. One illustration involves the production and sale of a structured retail product. The illustration unbundles the product and traces its components back up the chain.

 

A retail bank decides to offer a variety of structured retail products, including a three-year product linked to a basket of indices and five and seven-year products linked to the Financial Times Stock Exchange Index. It purchases the requisite amount of zero coupon bonds from investment bank B and the necessary derivatives to help it assemble the product from investment bank A. The retail bank decides on a marketing campaign split between technical marketing to financial advisers and internal marketing to its own branch staff on one hand, and a less technical campaign targeting mid to high-sophistication consumers on the other. The illustration examines the various responsibilities of the firms in the scenario based on the summaries contained in the statement.

 

The illustration notes that product manufacturers sometimes create components which are later subsumed into retail products without the component manufacturer's knowledge. Where such components are subsumed, the manufacturer has no contractual or other relationship with the ultimate customer.

 

In the case of the product in the illustration, there are three identifiable product providers: investment bank A, which provides the structure; investment bank B, which provides the bonds; and the retail bank, which packages them as a product.

 

Both investment banks sell their products to a market counterparty and neither is responsible for treating customers fairly with respect to product design; they are both pure manufacturers of component products. However, they have obligations to the retail bank under Principle 7, which requires them to communicate information that is not misleading. Duties also exist under general law.

 

The retail bank is responsible for the design of the product and - in the FSA's terminology - is a retail manufacturer. The retail bank must identify the target market. As its product is relatively complex, it must identify the characteristics that will make up the target market; this may include potential customers' knowledge of the risks involved. The retail bank must stress-test the product.

 

In relation to the selection of a distribution channel, the investment banks again play no role. The retail bank has various obligations (eg, under Principles 2, 6 and 7). Among other things, it must undertake a risk assessment and consider whether ultimate customers would be wise to seek independent advice or whether it should choose another channel through which it can communicate complex information effectively. It should also consider whether to monitor financial advisers at a strategic level - higher than expected volumes could indicate misselling. The retail bank will be responsible for financial promotions issued to the retail market and should use care and skill when preparing information for distributor use (Principle 2). Lastly, the retail bank has clear responsibilities to the customer after the sale has been completed; Principles 6 and 7 are particularly relevant here.

 

FSA Speeches

Two speeches given to coincide with the publication of the discussion paper shed further light on the FSA's approach to treating customers fairly. John Tiner's speech to the FSA Asset Management Conference on September 21 2006 preceded the publication of the discussion paper and looked at how the initiative is linked to the FSA's drive towards more principles-based regulation. Tiner stated that the issue of treating customers fairly is spearheading the new approach, as it looks towards outcomes for consumers, not detailed rules and guidance. Given the nature of his audience, Tiner focused specifically on the responsibilities of product providers, anticipating many of the points raised in the discussion paper. He also examined how the FSA intends to assess the initiative's success or failure, noting that it could be gauged at several points in the market. The FSA will gauge success primarily by the difference the initiative makes to consumers; the regulator will look for (i) products which have been designed to meet the needs of identified consumer groups and have been targeted accordingly, and (ii) clear information provided to consumers along with suitable advice which takes account of their circumstances. The FSA will also look for products which perform as promised and for associated services that meet the acceptable standard which consumers have been led to expect.

 

In addition, the FSA will build the initiative into the core of its regulatory approach to the retail market and will expect firms to demonstrate that they are building the aim of treating customers fairly into their strategy and approach. Lastly, Tiner noted that the FSA is developing ways to identify firms' progress towards such outcomes. He warned that, although the FSA does not regard high numbers of enforcement cases on fair treatment of customers as a sign of success, it will take action where necessary.

 

Sarah Wilson's speech was given on September 28 2006, the day on which the discussion paper was published. She used her speech to emphasize the idea of the product lifecycle which, she believes, has helped many firms think through what it means to treat customers fairly. Most of the speech examined the discussion paper itself, but she added a number of comments on how the regulator expects the industry to respond. She emphasized that, at a working level, firms and the FSA must become more comfortable with regulatory material that requires interpretation and judgement (ie, principles-based regulation). She hoped that firms would avoid the tendency to over-interpret regulatory requirements and would respond to the discussion paper with this in mind. Although it is acceptable to point out where the FSA has not expressed itself clearly, she stated that firms should remember that the paper contains a statement about desirable outcomes, not detailed instructions for achieving them.

 

Wilson used a further speech on March 19 2007 to highlight the FSA's March deadline for firms. The FSA has said that all firms should have reached the implementing stage of their work on treating customers fairly in a substantial part of their business by the end of March 2007. This means that they should be developing plans and processes, allocating resources and responsibilities and training their staff.

 

In the months following the publication of its discussion paper, the FSA undertook assessments of whether firms were likely to meet the deadline. This was done in the case of larger, relationship-managed firms through individual assessments based on information gained through Advanced Risk Responsive Operating Framework visits or specific visits.

 

Wilson emphasized that there are a range of supervisory tools that the FSA can consider for firms which missed the deadline, including the creation of risk mitigation programmes and the use of skilled persons. She also specifically mentioned enforcement action in appropriate cases, although this would be on the basis of alleged actual or potential customer detriment, not failure to meet the deadline.

 

Firms which met the deadline are saying only that they are implementing appropriate plans. The FSA will encourage them to complete their implementation work and embed change. This will require sustained leadership from senior management, as well as the production and use of targeted intelligent management information to demonstrate that new systems are translating into improved outcomes for customers.

 

International Law Office