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structured products: are you aware of what is in your back book? december 2014 background The sale of structured products in firms’ back books have once again been thrust into the limelight, following the fining of two high-profile retail firms1. Although these firms are big industry players, the FCA is keen for the industry as a whole to sit up and take note when they issue fines and final notices. Therefore, the past sale of structured products is not just a potential issue for the larger firms, but one for any firm, even small intermediaries, that have previously recommended these products as part of a client portfolio. Critics suggest that structured investment products are risky investments that are highly complex and are unlikely to be understood in any depth by the average adviser, let alone the unsophisticated investors who have often ended up as the consumer. Conversely, many view them as a vital option for risk-averse investors who have little capacity for loss and argue that there are good and bad options, as with any financial product. Consumer detriment is usually uncovered years after the event, and so we are yet to confirm conclusively whether problems are still occurring and whether legacy issues have yet to be uncovered. This means that unsuitable sales of structured products may still be lurking in firms’ back books. Notional value Although the FCA does not seem to be proactively engaging in any interventionist activity, firms should be proactively examining past business to make certain that the past sale of structured products is not an area of concern for them. This white paper provides an exploration of the risks of structured investments and outlines where issues and failings have occurred in the past to provide advisers with food for thought when considering whether they need to consider reviewing any past business. Risks and rewards Structured investments, also frequently referred to as Guaranteed Equity Bonds or Protected Investment Bonds, are an investment where the returns are based on the performance of an instrument such as the FTSE 100. There are many varieties but, commonly, there are two underlying investments, one for capital protection and another to provide investment growth. The diagram below illustrates how a structured investment is generally arranged: Provides investment growth Equity Option Zero Coupon Bond Issue date 1 Provides capital protection Maturity date 3 years FCA http://www.fca.org.uk/news/fca-fines-credit-suisse-and-yorkshire-building-society-for-financial-promotions-failures Structured Products: Are you aware of what’s in your back book? 3 The combination of features available generally appeals to investors wanting to guarantee their initial investment yet also gain an element of growth. Structured investments may be especially attractive in today’s market due to low interest levels generating little return for traditional savings vehicles and low yields from many investment products. On paper, structured investment products sound highly attractive with most being able to boast capital protection as well as investment growth and flexibility; but as with any kind of investment, there is a gamble, delivering risks as well as rewards for investors. Detriment may have occurred in past business where these risks were not made clear, or where they were not understood by both adviser and client. As with any investment, there is a gamble delivering risk as well as reward for investors Capital protection In a structured investment, often a proportion of the initial capital is protected by investing it in a fixedinterest security, such as a zero coupon bond. With a fixed price at maturity, the investor can expect this part of the investment to be guaranteed. This is not always the case however, some products known as SCARPs (structured capital-at-risk products) will lose capital Structured Products: Are you aware of what’s in your back book? protection if the investment element falls below a certain percentage e.g. 60%, resulting in investors losing capital as well as investment growth. Most structured investments are distributed to market through a financial adviser, bank, building society or insurance company. In the majority of cases the distributor is not the product provider, rather the provider is another company that is simply using the third party to sell to the product. These companies are referred to as counterparties and if they fail, investors lose their capital. The collapse of Lehman Brothers (the counterparty) at the beginning of the financial crisis brought it home to investors that the ‘capital protection’ element of these products was vulnerable. To further compound this risk, counterparty failure is not covered by the Financial Services Compensation Scheme (FSCS) so if the counterparty goes bust, investors have no chance of obtaining compensation, unless they have been a victim if mis-selling. Advisers should ensure when reviewing past business that the extent of capital protection was clearly explained to customers, using illustrative aids to ensure that counterparty risk was made clear to the customer and was documented. Potential return on investment The remainder of the capital can then be used to pay requisite charges and distribution costs and be invested for growth, usually on the performance of an underlying asset or index such as the FTSE 100 or S&P 500. Although the gains will not be as high as investing directly in the stock market, this element provides the investor with potential growth. Obviously, investors could also be at risk of making no gain at all. It is also important to note that whether investors win or lose, administration and adviser charges still apply, which can eat into the gain, the capital or augment the loss further, and this must be clearly illustrated to the client. 4 Flexibility Due to the wide range of options and products available, the investor has the option to match their market exposure to their attitude to risk, allowing an element of control over the balance of risk and reward. On the other hand, investors are invariably locked into a structured investment for a fixed-term, where redemption penalties can be high. Investors also lose out by not being able to take dividends, which can be a significant part of an investment. This lack of liquidity can be attractive for some investors and there are potential tax advantages to be gained, such as qualification for capital gains tax rather than income tax. Structured investments are also designed to pay out at a fixed date. This means that if, on maturity, the market is not favourable, the investor cannot wait for more agreeable times, they have to take what is paid out on that date. Once again, it is imperative that the client is made aware of both the risks and rewards of investing in a structured product. Although many structured investments are designed to protect against fluctuations in the market, they do not protect against catastrophic events such as those occurring during the financial crisis. In these events, financial firms considered stable by the consumer have in the past failed and could do so in the future. Counterparty failure is therefore a real risk and there have been well documented instances of this in the past. Advisers should have explained to clients the risk of counter-party failure and to mitigate this risk should have used one or more of the following three guards: • Invested only in products where the credit rating of the counterparty was BBB (investment-grade) or above; • Carried out effective due diligence on the counterparties; • Spread the risk over a multitude of counterparties or a range of Structured Investments backed by different counterparties. Market risk Structured investments rely on the volatility of the markets to produce the expected return. Of course, markets can go down as well as up and so there is vulnerability as with any kind of investment. Structured investments commonly use a barrier level, below which investors stand to lose out financially. This means that if the index used e.g. FTSE 100 drops below, say 50% of its initial level, then investors will lose all or a proportion of their capital. Although the likelihood of the FTSE falling below 50% is slim, it is not an inconceivable event and if the barrier level is set higher, at 75% for example, the risk is much higher. Structured Products: Are you aware of what’s in your back book? Counterparty failure is a real risk and there have been well documented instances in the past 5 Structured Investment Issues There have been some well documented problems with Structured Investments over the past 15 years, leading to consumer detriment and regulatory intervention: 1999-2006 Eurolife/Nvesta Capital Secure Bonds Counterparty Failure 1999-2003 Precipice Bonds Mis-selling Considering where firms have gone wrong in the past and the common themes that have emerged from the above cases is a good place to start when considering where issues may have occurred in past business. Complexity Structured investments are often regarded as complex due to the number of different product options and the way in which they are structured. The term ‘structured products’ is a wide catchall and to the unsophisticated investor it can be difficult to distinguish between what are mainstream retail derived products and the more complex structures designed to hedge risk in and out of complex investment arrangements. There have been concerns in the past that structured products have been discounted due to miscomprehension and there is potential for mis-selling should they have been misunderstood and recommended to clients 2005-2009 2007-2008 2007-2009 Lehman Brothers Credit Suisse UK Counterparty Failure & Mis-selling Counterparty Failure & Mis-selling Inadequate Systems & Controls Keydata unsuitably. This was a key issue in the Keydata scandal whereby the FSCS ruled that the product was largely mis-sold by advisers, reasoning that any competent adviser would realise that Keydata was a high-risk and complex product. With this in mind, when assessing past business it is imperative that advisers are certain that they received the level of information and/or training needed from the provider to enable them to describe complex product features clearly and make them understandable to investors. The information provided for advisers should have been more comprehensive than the financial promotions intended for investors. Moreover, firms should ensure that suitable training and competence procedures were in place to ensure that advisers were aware of structured products, their advantages and risks. Ultimately, where advisers did not understand the features and structure of a product, they should not have recommended it. 2008-2010 6 Santander UK Credit Suisse International Disclosure Breach Misleading Promotions Understanding whether there was adequate comprehension of products can be difficult to assess retrospectively, and so, to remove doubt, advisers should initially consider reviewing a sample of cases and examining adviser training records to assess the level of competence. Target market & distribution In the FSA’s review of structured product development and governance2 in March 2012, they discovered that firms were unable to articulate a clear strategic purpose in the manufacturing of structured products and placed too much emphasis on commercial factors. In adherence to TCF Outcome 2: Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly, providers should ensure that they are designing products that meet an identified need and distribute them through appropriate channels. 2 Structured Products: Are you aware of what’s in your back book? 2009-2012 2009-2012 Yorkshire Building Society Misleading Promotions 2013 Lloyds Bank Mis-selling It is thought that lack of targeting places a disproportionate responsibility on those distributing the products, potentially allowing the products to be mis-sold to unsuitable consumers. With the responsibility of ensuring that structured products distributed by the intermediary market land in the hands of those consumers for which it is suitable on advisers, it is imperative that advisers obtain a clear brief from the provider outlining who the intended target market is. Advisers should ensure that they truly understand who the product is intended for and that they feed back to the provider if they find that investors are not able to understand the product features or if they seem inappropriate for the target market. In the high-profile Keydata case, the distributor Norwich and Peterborough Building Society (N&P) was found to have sold to older consumers approaching retirement who were looking for, and should have been advised, low risk products. This is despite the product being FCA http://www.fca.org.uk/static/pubs/guidance/fg12-09.pdf Structured Products: Are you aware of what’s in your back book? 7 deemed high-risk. More recently Lloyds Bank has been reported to be paying thousands in compensation to the ‘vulnerable and elderly’ customers to which it sold complicated structured investments. Both these cases demonstrate the necessity of clearly designing products for a particular market and articulating it clearly so that products are not available to whom it was not intended. Advisers should investigate whether the structured products they sold in the past were targeted towards a specific consumer group and review a selection of past cases to determine whether they were indeed sold to the correct consumers. Systems and controls In a 2009 review3 the FSA found systems and controls failings in the quality of advice of structured products, stating that firms failed to: • Consider the individual features of structured investment products and their suitability for different customers • Ensure advisers were competent enough in their understanding to advise on structured investment products • Ensure appropriate compliance monitoring and oversight arrangements were in place. Subsequently, Credit Suisse UK was fined in 2011 for failing to establish and maintain effective and resilient systems and controls overseeing the advice suitability of structured products, resulting in a £198.2m consumer loss. Since then there have been no reported failings in oversight of advice suitability however this does not mean the issues have been entirely remedied. Firms should consider testing systems and controls around sales practices against specified outcomes to ensure they accurately identify unsuitability risks. A review of past business will also provide insight into how effective firms’ systems and controls were at the time, particularly around the sales process and 3 unsuitability. If failings in systems and controls are uncovered, this could signify there may have been failings across the board. Firms should test systems and controls to ensure accurate identification of suitability risks Suitability As suitability continues to be an issue for the industry, in the past nowhere was this more evident than with structured investments. In the review into the suitability of advice of structured investment products, conducted in 2009, the regulator found that 46% cases were advised unsuitably. The reasons stipulated for this view were: • Failing to meet the customer’s needs and circumstances. • Exposing the customer to an inappropriate level of risk including over-concentration of assets in a single product or product type. • Failing to meet the customer’s tax needs. Two areas of concern that crop up frequently in investment advice across the board are matching attitude to risk (ATR) with investment recommendation and portfolio diversification. In the FSA’s assessment of Credit Suisse UK, they said there was ‘little to no evidence’ of how attitude to FSA http://www.fsa.gov.uk/pubs/other/qa_structured.pdf Structured Products: Are you aware of what’s in your back book? 8 risk was met, highlighting a number of damning cases where customers’ risk profiles had been increased for no apparent reason. Advisers need to ensure that they are clearly establishing the risk that a customer is willing to take, taking into account their capacity for loss as well as their attitude to risk. If firms are using risk-profiling tools they should recognise their limitations and ensure there are effective controls to identify and mitigate arising risks. Many of the IFAs that sold Lehman Brothers backed structured investment products were found not to have taken into account customers’ financial circumstances and objectives and recommended products that did not match ATR. There have clearly, in the past, been issues with advisers misunderstanding or underestimating a structured investment product’s risk, leading to unsuitability. Firms should ensure that they have a clear view of a structured investment’s risk-rating and document comprehensively how that matches the client’s risk profile, taking into account the risk of the underlying investments and the additional features as well as counterparty risk. The regulator stipulates that ‘Advisers should always seek to diversify a customer’s investment portfolio.’4, considering both product and portfolio concentration. If an adviser has deemed a structured product to be a suitable recommendation for a client’s need and circumstances, they should reflect on the concentration of this product as part of the portfolio. The regulator has only set guidelines rather than prescribed rules as to what proportion of a portfolio should be allocated to structured products, it is widely accepted that no more than 25% should be invested in this way and no more than 10% in a single structured product. In the Lehman case, unsuitable advice given by the IFA distributors was attributed in part to the excessive concentration of one structured product in the investment portfolio. With any portfolio, whether containing structured products or not, spreading the risk is imperative and a basic component of financial planning. There is potential that this could be a common issue in structured product past business. Therefore, firms should review a sample of past cases to determine whether customers were recommended a product that matched ATR and whether their portfolio was sufficiently diverse. 4 At this stage, it is worth considering whether the distribution of structured products through non-advised sales channels is appropriate. Clearly, those products that are complex and carry a high degree of risk should only be distributed through advice from a qualified professional. This largely occurs in practice, however whilst those that carry little capital risk and are fairly simple in structure may be appropriate to distribute through non-advised channels, care must be taken to ensure that these traditionally financially unsophisticated consumers are provided with enough clear information to enable them to assess the compatibility of the product to their needs and circumstances. Financial promotions & information Financial promotions are identified as a particular risk in financial services because of the complexity of products, their long-term nature and the potential for considerable detriment to consumers. Therefore, providing consumers with clear, fair and not misleading information at every stage of the purchasing process is imperative to ensure that consumers are not becoming victims of mis-selling and to enable them to make informed, sound decisions. In response to the market trend of consumers seeking higher yielding products than currently available, firms responded by creating products that deliver higher returns and marketing them as such. TCF outcome 5 stipulates: Customers are provided with products that perform as firms have led them to expect, putting in focus the need for firms to ensure their financial promotions are fair and balanced and that unrealistic expectations have not been fostered. Since 2009 the regulator has witnessed significant improvement in the quality and level of information provided in firms’ financial promotions and the systems and controls governing them. However they noted a propensity to overstate the maximum rates of return achievable and developed concern about the difficulty for firms to explain complex product features in a way that is fair, clear and not misleading. This is a concern that has been echoed in the recent Credit Suisse International (CSI) and Yorkshire Building Society (YBS) sanctions. FSA http://www.fsa.gov.uk/pubs/other/qa_structured.pdf Structured Products: Are you aware of what’s in your back book? 9 CSI were found to have given undue prominence to the maximum return of a structured investment to over 83,000 customers. This warranted penalty from the regulator because their promotions presented unfairly the information of the maximum return (of which the probability of achieving was close to 0%) leading to a disparity between what the customers were led to expect and what was actually achievable. In addition, they also failed to explain early termination charges and conduct periodic review of their processes to ensure compliance with regulatory requirements. CSI distributed their products through third parties, typically building societies on a non-advised basis, meaning that investors were generally unsophisticated and conservative, unlikely to understand structured products in general and the likelihood of achieving the maximum return. The third parties were not off-the-hook however, as is evidenced in the penalty imparted on YBS, where they too gave the maximum return undue prominence in their product literature and financial promotions. These examples demonstrate that both providers and distributors are responsible for the way in which they promote structured products. Firms should take care to scrutinise the promotions and product literature they receive from providers to ensure that it provides a balanced view of the product and will not influence the customer unfairly by placing emphasis on unachievable outcomes. In turn, advisers should ensure that the information they provide to customers from point of sale through to post-sale, fulfils their information needs. This Structured Products: Are you aware of what’s in your back book? means highlighting the risks and disadvantages as well as the reasons for recommendation or purchase. The key is to ensure that a product ‘does what it says on the tin’. As part of a review of past business, firms should review their financial promotions, taking care to ensure that the aforementioned issues are not present. Assessing past financial promotions of structured products can be a challenge if they have not been retained past the required retention period. As part of a review of past business, firms should look at financial promotions 10 Summary Structured products are often complex investments that have the potential to yield a return higher than traditional savings deposits, whilst offering a degree of capital protection. It is easy to see why these are an attractive option for the risk averse, conservative consumer, however there are complicated associated risks which need to be evaluated by independent advisers who must consider these as part of their appraisal of the whole market. Although suitability, attitude to risk and portfolio diversification remain continuing issues across markets, advisers also need to take into account counterparty risk, the complexity of added features and above all, how this is communicated and explained to the investor in a way that makes them understand what is generally a complex product with many layers of management. Advisers should ensure that these products are reaching the target markets for which they were intended and if there is any doubt as to the integrity or credibility of the underlying counterparties that they choose to discount them. The sanctions against CSI and YBS demonstrate that there may still be mis-selling or unsuitability issues in firms back books. Advisers should be proactive now to assure themselves that their past business does not contain any skeletons by heeding the above advice and reviewing a small sample. If you think this could be an issue of concern for you, or just to gain peace of mind that it isn’t, please discuss with your TCC Intermediary consultant or get in touch with the team on 0800 970 9757. Structured Products: Are you aware of what’s in your back book? 11 Head Office TCC Intermediary The Consulting Consortium Ltd 6th Floor 10 Lower Thames Street London EC3R 6EN Tel: +44 (0) 800 970 9757 www.tccintermediary.com This document was produced by The Consulting Consortium Ltd © 2014