Assessing Suitability

The FSA sounds a warning

JOHNATHON WATSON and DAVID ENGEL, ADDLESHAW GODDARD

For many investment advisers and discretionary investment managers, there has been a substantial increase in the number of complaints by clients who have suffered losses on their investments since the start of the financial crisis. Such claims are often triggered by poor investment performance, but frequently involve assertions that investments were “unsuitable”. Many firms have found that defending themselves against such claims has been difficult, and the FSA’s latest announcements in this area are unlikely to make the situation easier for investment firms that do not have a well thought out approach to investment risk profiling and robust controls around their investment advisory and investment management processes.

At the start of 2010, the FSA highlighted a concern over high numbers of unsuitable investment selections (in both advised and discretionary services) and they placed a high level of focus on this area throughout 2010, including active reviews of investment advisers and managers by its Conduct Risk team and “thematic work” on, for example, Lehman-backed structured products and investment advice involving platforms.

The FSA recently published a report aimed at firms providing investment advice or discretionary management services to retail customers, outlining its findings from that work. The report is issued as a Guidance Consultation paper (the Guidance), proposing guidance on the FSA’s Conduct of Business Sourcebook (COBS) rule 9.2.1 which requires that firms take “reasonable steps to ensure that a personal recommendation, or a decision to trade, is suitable for its client.” The report suggests that many firms have further work to do in properly managing their risks in relation to investment suitability. It is recommended that all firms providing investment advice or discretionary management services to retail customers consider the report and the good and poor practices described. It is clear that future failings in this area will lead not only to increased liability risk towards clients, but also increasingly to risk of action against firms by the FSA.

The FSA’s findings and key issues raised
The FSA’s findings are based on reviews of the investment portfolios and client records of a number of different investment advisers and managers, with a focus on “higher risk” firms. Between March 2008 and September 2010 the FSA rated 366 of the investment files they reviewed in the course of their work as “unsuitable.” 199 of these failed because the investment selection did not meet the customer’s “attitude to risk.” Key reasons for this included the following:

• Failing to collect and account for the information relevant to assessing the risk a customer is willing to take. Specifically, some firms have taken “inappropriately simple” approaches, including not considering a customer’s capacity for loss, making assumptions about preparedness to take the risk of capital loss and failing to recognise that some customers may be best suited to place their money in cash deposits rather than other forms of investment.

• Using poor questions in risk assessment questionnaires. The FSA found a number of firms using unclear or excessively complicated risk profiling questionnaires. However, they also criticised those with fewer questions, where the FSA says there is a “greater probability of making an inaccurate assessment.” Cases where risk categorisation is effectively determined by the answer to one question as a result of weighting or scoring systems are also criticised.

• Failures to update customers’ risk profiles over time.

• Unclear or misleading customer risk category descriptions. Examples given include descriptions not clearly quantifying the level of risk; being “inconsistent with most customer’s understanding of that term”; or the language used being “emotive” or having “judgemental connotations” (terms criticised include “progressive”, “risk aware”, and “realistic”). Good practices included having fair and balanced summary descriptions of what each category means, charts showing the “shape” of annual returns and descriptions of risk of capital loss and typical investments in a category.

• Inappropriate or “missing” risk categories – where firms have extremely wide categories or there are significant differences in the proportions of underlying investments in consecutive risk categories.

• Insufficiently robust investment selection processes which failed properly to take all relevant suitability factors into account. The FSA reminds firms that “if none of the investment selections that are available to the firm are suitable for the customer, no recommendation or transaction should be made.”

• Over-reliance on automated investment selection tools and model portfolios. This may be a particularly important point for many firms to consider, with the FSA citing as good practice where a firm “had standardised initial asset allocations” but also gave portfolio managers the “flexibility to tailor solutions to individual customer circumstances.”

• Failing to ensure that investment selection was consistent with the customer’s risk category description. The FSA says that whilst they “do not necessarily expect descriptions to outline specific asset allocations”, “it is important that an investment selection matches the customer’s risk expectations.”

• Relying on volatility as a proxy for investment risk and failing sufficiently to consider diversification. The FSA highlighted cases where diversification across investments or asset classes was not (or only insufficiently) considered in portfolio construction.

• Use of third-party tools for suitability assessment. The FSA emphasises that use of a third-party tool to assess suitability does not absolve the user of the responsibility to effect the suitability assessment in compliance with the FSA’s rules. Further, firms using third-party tools must ensure they are suitable for their clients, understand the tool fully and mitigate known limitations.

Conclusions
Based on their findings, the FSA conclude that “the level of failure in this area is unacceptable” and say that they “have taken, and will continue to take, tough action to address these failings with individual firms.”

Whilst offering suitable investments to customers is at the heart of every investment adviser’s or manager’s business, it can be difficult to define and deliver suitability in every case. Every client has different aims and circumstances and it can be challenging to ensure that these particularities are fully recognised in an area where there is scope for subjectivity and assessment of performance through a lens of perfect hindsight. The Guidance is helpful for all firms. It allows an opportunity to firms to consider good and poor practices from across the industry. Firms should consider it, take this opportunity to review their own practices against those described and assess whether (and if so how) practices may be improved. Recording that review, conclusions reached and actions taken as a result will also be key. Importantly however, and subject to responses that the FSA receives to its consultation, it is clear that the Guidance will frame the standards that the FSA expects from firms in future. In the Guidance, the FSA states that “as we apply our intrusive and intensive supervisory approach, we will be looking to see how firms have acted on this report. We will consider, for example, whether firms have robust procedures, tools and risk category descriptions (where used) to establish and check the level of risk a customer is willing and able to take, as well as assessing the suitability of investment selections. We expect to see improvements in the standards of advice and private client discretionary management, and will continue to take tough action where we identify poor practice.”

Additionally, whilst assessing their suitability processes, firms should also consider the related monitoring and control framework. The FSA mentions that they did not make judgement on the effectiveness of reviewed firms’ controls in this area. However, it can be expected that for individual firms, supervisory teams will consider these aspects with equally high levels of scrutiny in the future.

The report is issued as a Guidance Consultation paper (GC11/01) and can be accessed at http://www.fsa.gov.uk/pages/Library/Policy/guidance_consultations/2011/11_01.shtml.