In September 2016 the European Parliament rejected the packaged retail and insurance-based investment products (PRIIPs) technical standards (first time ever for a financial services regulation), throwing the whole regulation into doubt and disarray. Rejecting the PRIIPS technical standards did not delay the regulation being implemented at the end of the year, something only the Commission can do. This left firms (primarily providers) not having the detailed guidance needed to implement the regulation in a consistent way across the EU. The result would have been numerous different interpretations, leaving clients with information that was at best inconsistent between companies and at worst dangerously misleading. However, on 27 October 2016 the Commission indicated that PRIIPS will be delayed until 2018 so this has been averted. For now. 

It is worth noting that the original reason for the European Parliament rejecting the standards is that it was considered misleading to clients. UK MEP Syed Kamall summed it up: "Unless we get this right it is consumers who will suffer. For example, the average high street investor looking to open a new individual savings account could have been given unclear misinformation because their provider was required to do so by this regulation. The European Commission will now have to go back to the drawing board and come up with something that will actually deliver."

One key aspect of PRIIPS was the issue to clients of a Key Information Document (KID), largely modelled around Undertakings for the Collective Investment in Transferable Securities (UCITS), and fund only, Key Investor Information Documents (KIIDs) with the latter due to come into line with the former in due course. However, that's where the similarity ends and the information contained in the KID is somewhat controversial for what it says and, just as importantly, what it doesn't say. The European Fund and Asset Management Association (EFAMA) published a paper earlier this year highlighting the shortcomings and making suggestions to fix the problems. In summary the concern areas are:

• Past performance (and benchmark) of a PRIIP is no longer disclosed to investors, even though future scenarios are based on them.
• Costs are shown only by their impact on return averaged over the recommended holding period of a PRIIP, making comparisons between products impossible and not showing to investors the actual costs.
• The calculation of transaction costs is based on improper assumptions and leads to false outcomes that will surely confuse investors.
• Two different disclosure documents will be presented to a retail investor when investing into the same fund through different means.
• Retail investors are provided with too much prescriptive narrative that inhibits detailed explanation of the actual product.

The extent of the issues and the challenges going forward should not be underestimated and the latest delay does nothing to solve the underlying problems.

3. Isssues exposed by open-ended property funds

In the wake of Brexit, concerns about the effect on property prices produced a surge in withdrawals from retail open-ended UK property funds. The result was approximately £18bn of assets locked up in funds closed to redemptions or imposing punitive costs, or the more palatable sounding 'dilution levy', for doing so. While the situation has subsequently calmed and most funds have gone back to some semblance of normal trading, this raises a couple of important questions. Firstly, whether the structure of these funds is even suitable for this type of investment and where this leaves model portfolios that make use of them.
When everything is operating 'normally', problems within a system rarely show themselves. It is only in extreme conditions that a particular system's integrity and resilience is really tested. Ironically, it is in these extreme conditions that clients and their investment managers most expect, want and need things to operate normally. One of the foundations of the open-ended structure is liquidity, and it is largely sold and held on this basis with that being the understanding of all but the most sophisticated retail clients. However, this simply doesn't work where the underlying assets are fundamentally illiquid and this contradiction lies at the heart of the issue. The response of funds is to hold a cash buffer and some are now proposing increasing this. But that only delays the inevitable in extreme conditions and where does that leave the purpose of the investment and balance in a client's portfolio? Perhaps it is time for investment managers and compliance officers to reflect on exactly how these funds are used. Are there times when it simply isn't appropriate or suitable for a portfolio, such as when a client is close to retirement or has indicated any need for liquidity (or been told their money is always available)?

For model portfolio services the situation is compounded. Liquidity is the lifeblood of these services because without this it becomes difficult or impossible to rebalance and maintain the correct (and possibly, contracted) asset allocation. Valuations and pricing of portfolios becomes problematic and where there are automated processes on internal and external platforms, for example, in the allocation of new client money, there will need to be manual interventions and/or adjustments to systems. If a model has suspended funds, do you suspend the model or accept there will effectively be two models running going forward, one for affected clients and one for new ones? And where does the client money intended for the affected asset go, cash or an alternative? All the firms involved with these services should be taking the opportunity to ask themselves whether the models and the documentation around them are robust enough, not least to defend against client complaints.

 

Given the systemic nature of the issues thrown up around these funds and the knock-on effects, it seems likely that the FCA will be taking a closer look. A closed-end fund anybody?

4. Markets in Financial Instruments Directive II consultation paper

On 29 September 2016 the FCA published a long-awaited MiFID II consultation paper covering areas of particular interest to private wealth management firms. While it did cover the key areas likely to have the most impact, including costs and charges disclosure, product governance, record-keeping and suitability, there is some disappointment amongst firms about the lack of detail. Work carried out by firms and the Wealth Management Association has highlighted numerous queries and questions in these areas, many of which fundamentally affect how the new rules will be implemented. Assuming the intention of the new rules is to get consistency between firms and the projected development time required, this is a problem that needs to be addressed sooner rather than later.

Costs and charges disclosure is one area of particular concern and has the potential for unintended consequences. The proposed rules are essentially a repeat of technical and other guidance coming from the European Securities and Markets Authority, so lack real detail. While the FCA has indicated it may provide further guidance in the future, firms need to start work on this now. It is almost inevitable that inconsistencies will develop and even regulatory arbitrage appear as firms seek to take a path that involves less work but notionally complies with the requirements. As an example, the total costs of funds used by the investment manager must be included in calculations, arguably going beyond the total expense ratio. As noted by the FCA, they can effectively force the disclosure from funds in their direct control and it can be presumed this will also be reflected across EU-based funds, but what about those in other jurisdictions? The FCA has said: "We take the view that cost information is usually available for these investments, even if an investment firm may need to undertake some work to include this in aggregated MiFID disclosure, and require its disclosure from its counterparties.” It is going to be a difficult task getting UK/EU based funds to disclose the required data in a standardised form that is easily accessible. Add in other types of products and geographical complexity, and in practice firms may substantially restrict the universe of available investments to clients out of necessity. It is difficult to see how this can benefit clients. And this is just one example. On the other hand the FCA's hands are tied: "We appreciate the challenges. However, as these overriding requirements are outlined in MiFID, these requirements need to be addressed by firms." Clients will also end up paying for it.
5. Financial Ombudsman Service decisions where two regulated firms are involvedThe first case (DRN9422601) considers where the 'end point' of liability occurs when a client transfers to another adviser or investment manager. Towergate Financial (West) purchased an unregulated collective investment scheme for a client which it acknowledged was unsuitable. However, the client subsequently transferred to another investment manager and in the time it took to review the client’s existing investments and decide to sell the offending fund, the fund became illiquid. Towergate claimed their liability ended on transfer and so the cost of redress should be calculated at the date of transfer and not treated as if it were illiquid (a more onerous calculation). The delay between the client transferring and the fund becoming illiquid was two months, plenty of time, said Towergate, for the new firm to have assessed the suitability of the fund and sold out. Ombudsman Roy Kuku acknowledged that a change of financial adviser creates grounds for considering an 'end point' for the previous adviser’s liability. However, he went on to say that allowance must be given for the time reasonably needed by the investor and new adviser to review, consider and execute changes. Clearly this will depend on individual circumstances, but this case sets a marker at 2–3 months. The service provided may also have a bearing. For example, the Ombudsman may not have been so generous if the investment had been left in a discretionary account for the same period.

The second case (DRN8510743 and DRN4771772) looks at the question of responsibility for transactions in a self-invested personal pension. In summary, the client received advice to invest in a land fund from a firm that went into administration before the transactions from that advice were completed. It is accepted that the advice was unsuitable. A new firm, Mentor Financial, took over as the adviser and completed the transactions on an administrative, execution only basis, seemingly confirming this in writing. A claim to the Financial Services Compensation Scheme was rejected as the transaction was completed after the original firm ceased advising the client, who subsequently claimed against Mentor. This raises some interesting legal points but was not material to the subsequent Ombudsman decision. The Ombudsman, Adrian Hudson, upheld the complaint on the basis Mentor should have advised on the offending fund. Having been appointed as adviser, the Ombudsman considered there was a duty to advise and it was not acceptable to act as a processor relying on the previous advice. It was also acknowledged that Mentor advised the client to get further professional advice on the fund but in the Ombudsman's view that meant they should have refused to transact the business before this was done. There seem to be two key learning points here. Firstly, the Ombudsman will, quite reasonably, look at the entirety, and context, of a situation when coming to a decision. Secondly, notwithstanding the ephemeral comfort of supporting documentation, attempting to segregate out a single transaction as execution only in the context of acting as an adviser (or investment manager?) is a risky activity.

 

Regulation in brief

Impact of low interest rates

The recent lowering of interest rates by the Bank of England (BoE) is having an effect on wealth managers and custodians. In many cases the cost of keeping and managing client cash can no longer be paid for by a margin taken from interest received. It would appear that firms are doing their best to absorb these costs with a correspondent drop in revenue noted in published accounts. Another fall in rates, already indicated by the BoE, will almost certainly see most firms start to charge clients for holding client cash (many are doing this already for other currencies).

FCA looking at suitability reports

The Personal Finance Society and Association of Professional Financial Advisers have been in talks with the FCA and Financial Ombudsman Service (FOS) on the issue of suitability reports. The FCA has flagged this as an area for improvement but there is a lot of confusion and frustration around the whole subject on all sides. The FCA believes that suitability letters are over-engineered by including information aimed at protecting the adviser rather than adding value to the client. On the other hand, concern about future complaints and the way they are perceived to be dealt with by the FOS drives this behaviour. Clarification and guidance that can be truly relied upon would benefit everyone, especially clients. 

Robo-advice and suitability

CP16/29, covering MiFID II, makes specific reference to automated and part-automated systems where advice or discretionary management services are provided. It makes clear that the firm remains responsible for the suitability assessment. Its responsibility is not reduced by use of the automated system to make personal recommendations or decisions to trade. This is an interesting area of development and it remains to be seen whether a de facto two tier system of requirements develops in practice between robo and face-to-face services, particularly when it comes to assessing risk.

FCA concern about introducers

In August the FCA published a warning about introducers, in particular those that are unauthorised and/or lead generators. In short, the FCA concern centres on any advice given by the introducer, with the regulated firm being held responsible for that advice. This also covers situations where the regulated firm outsources parts of the advice process, including selection of investments. The FCA warning is detailed and practical, covering six 'areas of concern identified' and listing seven 'warning signs' for firms to watch for.

Retail investors and peer-to-peer

The FCA is looking closely at the peer-to-peer (P2P) market and has expressed concern about the new opportunities for P2P via innovative finance individual savings accounts (IFISAs) and pensions. Not surprisingly this centres on client lack of understanding of what they are getting into and whether it matches their risk profile. The FCA has said: "There is anecdotal evidence that suggests P2P investors in the past were relatively wealthy or knowledgeable." Wider availability through the 'trusted route' of ISAs and pensions could result in a large potential client base invested in something they don't understand and where they have little appreciation of the risks.