In January 2013, the IOSCO issued its final report, after comments from FINRA and others, entitled Suitability Requirements with Respect to the Distribution of Complex Financial Products (the “Consultation Report”). The purpose of the Consultation Report was to recommend principles focusing on customer protections, including suitability and disclosure requirements, relating to the distribution by intermediaries of complex financial products to retail and non-retail customers based on a review of its members’ existing regulatory frameworks, as well as the lessons learned from the 2008 financial crisis and relevant actions taken in response.
The IOSCO issued the following nine “principals” and implementation frameworks for utilization by its members:
Principle 1: Intermediaries, e.g. broker dealers, should be required to adopt and apply appropriate policies and procedures to distinguish between retail and non-retail customers when distributing complex financial products. The classification of customers (many types of complex financial products often have a “counterparty.” Accordingly, where the term customer is used in this report, the term is also deemed to refer to counterparties) should be based on a reasonable assessment of the customer concerned, taking into account the complexity and riskiness of different products. The regulator should consider providing guidance to intermediaries in relation to customer classification.
Regulators in implementing this principal should provide guidance on the process for intermediaries to independently and periodically distinguish between retail and non-retail customers. The suggested criteria included: nature of the customer (e.g. regulated or unregulated, and business or consumer); financial position; expertise in complex financial instruments, including the ability to assess independently the value, features, and risks of these products.
Principle 2: Irrespective of the classification of a customer as retail or non-retail, intermediaries should be required to act honestly, fairly and professionally and take reasonable steps to manage or mitigate conflicts of interest through implementing appropriate procedures in the distribution of complex financial products, and where there exists a potential risk of damage to the customer’s interest, the intermediaries should, where appropriate, be required to clearly disclose the risk.
Intermediaries should disclose to all of its customers any conflict of interest related to these instruments. Further, they should also have policies and procedures to assess whether the customer has sufficient knowledge and expertise to evaluate the transaction, and to evaluate any conflicts of interest that are inherent to the transaction.
Principle 3: Customers should receive or have access to material information to evaluate the features, costs and risks of the complex financial product. Any information communicated by intermediaries to their customers regarding a complex financial product should be communicated in a fair, comprehensible and balanced manner.
Intermediaries should exercise “reasonable care” in giving potential customers information about these instruments. This information includes: the specific risk-return profile; scenario presentations based on reasonable assumptions about the risks and benefits; a description of the different components of the products and how these components interact and affect the risks. Such disclosures should be tailored to the type of customer and their level of skill or knowledge of complex financial instruments.
Further, “customers should have reasonable access to information that allows them to identify costs and charges relating to the purchase of a complex financial product including, ideally, if practical and feasible, on an unbundled basis (i.e. a breakdown of the components of the total price). When a liquid secondary market for a complex financial product does not exist, the only prices available may be from the intermediary that sold the customer the product. The intermediary should know and disclose ahead of time how these prices will be computed (using models, other markets for similar products, etc.) and what the price represents (mid-market theoretical value, re-purchase prices, etc.). The customer should have access to enough information to know that the product is illiquid, including information about the means and range of timing for disinvestment (for instance, the customer should be informed if the intermediary or another entity belonging to the same group is the only source of liquidity for the instrument). Where practical and feasible, intermediaries should seek to provide customers with comparative information concerning appropriate alternative investment products, to the extent that such products are available.”
Principle 4: When an intermediary sells a complex financial product on an unsolicited basis (no management, advice or recommendation), the regulatory system should provide for adequate means to protect customers from associated risks.
It is recommended that regulators establish baseline disclosure and distribution requirements for these instruments. For example, supervisory approval before opening accounts; prohibiting trade execution-only services for complex financial products; and prohibiting these products for sale to retail customers.
Principle 5: Whenever an intermediary recommends the purchase of a particular complex financial product, including where the intermediary advises or otherwise exercises investment management discretion, the intermediary should be required to take reasonable steps to ensure that recommendations, advice or decisions to trade on behalf of such customer are based upon a reasonable assessment that the structure and risk-reward profile of the financial product is consistent with such customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.
The IOSCO stated that intermediaries should have a robust process to assess the profile of a customer and document how suitability determinations would apply on the basis of, among other things, the following factors relating to the customer: investment objectives, including the length of time for which they wish to hold the investment; age of the customer may be relevant for this factor; risk tolerance and relevant risk preferences, taking into account the purpose of the investment and the need for portfolio diversification; financial situation (e.g., the customer’s other assets, income and tax liabilities) and general capacity to withstand losses of trading complex financial products; investment experience and knowledge in relation to complex financial products, including the nature, volume and frequency of previous transactions and level of familiarity with relevant complex financial products and services. The customer’s profession, former professional experience, and level of financial education may also be relevant; liquidity needs; any other relevant information the customer may disclose to the intermediary in connection with the recommendation.
Further, before recommending complex financial products to customers, intermediaries should themselves develop a thorough understanding of the features of the relevant product and its complexity and associated risks taking into account, when providing individual portfolio management or advice, the composition of the customer’s portfolio. Which includes; how the complex financial products are structured and priced; the nature and complexity of a product’s pay-off and underlying components, if any; the relevant level of risk (with, if appropriate, a separate assessment of counterparty, liquidity and market risks); the experience and reputation of the issuers and product providers/manufacturers; – any fees, charges or any other costs associated with the product; the level of liquidity; the lock-in periods and relevant termination conditions exit options and associated costs; how the product performs under abnormal or extreme conditions; and, the nature of any guarantees.
Care should be given to the different components of a complex financial product in order to foster customer understanding of the risks associated with them. The complex financial products selected by intermediaries for distribution to their customers should in general meet the needs of the customer group at which the intermediary aims its services.
Finally, intermediaries should keep written evidence of the information required by the regulator to be gathered from customers as part of the suitability determination. In addition, regulators should require intermediaries to retain documentation to the extent that such written documentation is created, to evidence any inquiries and analysis they made when carrying out the product and customer due diligence.
Principle 6: An intermediary should have sufficient information in order to have a reasonable basis for any recommendation, advice or exercise of investment discretion made to a customer in connection with the distribution of a complex financial product.
The intermediary should not sell the product to the customer if they do not have sufficient information to determine suitability, or should immediately inform customer that their recommendation to purchase the product is based on limited suitability information.
Principle 7: Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability requirements, including when developing or selecting new complex financial products for customers.
Principle 8: Intermediaries should be required to develop and apply appropriate incentive policies designed to ensure that only suitable complex financial products are recommended to customers.
The IOSCO recommended that senior management should be responsible for regularly reviewing incentive schemes and distribution practices by sales staff. And remuneration structures and related sales staff incentive programs should not conflict with the duty to act honestly, fairly and professionally, and consistent with the best interests of the customer. Regulators should consider taking steps to require disclosure of remuneration structures and policies (e.g., commissions received by the distributors from the product issuers) as a means to reduce the risks of financial incentives that could lead to unsuitable advice or recommendations.
Principle 9: Regulators should supervise and examine intermediaries on a regular and ongoing basis to help ensure firm compliance with suitability and other customer protection requirements relating to the distribution of complex financial products. The competent authority should take enforcement actions, as appropriate. Regulators should consider the value of making enforcement actions public in order to protect customers and enhance market integrity.
The IOSCO defined “complex financial products” as financial products, whose terms, features and risks are not reasonably likely to be understood by a retail customer (as that term is defined in individual jurisdictions) because of their complex structure (as opposed to more traditional or plain vanilla investment instruments), and which are also difficult to value (i.e., their valuations require specific skills and/or systems, particularly when there is a very limited or no secondary market). The term generally includes, but is not necessarily limited to, structured instruments, credit linked notes, hybrid instruments, equity-linked instruments and instruments whose potential pay-off is linked to market parameters, asset-backed securities (“ABSs”), mortgage-backed securities (“MBSs”), collateralized debt securities, and other financial derivative instruments (including credit default swaps and covered warrants). The term does not include conventional equities, conventional bonds, plain vanilla unit trusts and mutual funds and exchange-traded standardized derivatives contracts. The list is intended to be illustrative and non-exhaustive. The above criteria should be taken into account when determining the level of complexity of a financial product.
Further, they listed the following issues which may be considered by intermediaries when carrying out product due diligence in assessing suitability of a complex financial product
- For whom is the product intended, e.g., limited or general retail distribution? If limited, how will the firm prevent distribution beyond the targeted customer group?
- What is the product’s investment objective and how does the product improve upon the firm’s current offerings? Are less complex, less costly, and/or less risky products available to accomplish the same investment objective(s)? Are the product’s costs transparent to investors to allow independent cost comparison with other products?
- What key assumptions underlie the product’s performance over time, e.g., market behavior, interest rate changes, market volatility and market liquidity? What are the qualifications of the persons making the assumptions that underlie projections of the product’s performance?
- How a complex financial product is structured and priced, its underlying components, its functions, and how it is described to the customer. In other words, does the complexity of the product impair understanding and transparency of the product? If so, what are the implications for the training requirements for the sales staff? Will the product require development or refinement of in-house training programs for sales personnel and their supervisors? In what respects?
- What promotional or sales materials will be used to market the product? What risks must be disclosed and how will those disclosures be made? What sorts of disclosures are needed to achieve a balanced promotion of the product to the targeted customer group?
- The relevant level of risk (with, if appropriate, a separate assessment of counterparty, liquidity and market risks). For example, what are the product’s principal risk factors? Do they include any currency, legal, tax, market, or credit risks?
- The experience and reputation of the issuers;
- Any fees, charges or any other costs associated with the product;
- How liquid is the product? Will there be an active secondary market for the product, e.g., with liquidity providers? How will the fact that a particular product is illiquid impact its valuation during its life span? Will the product be marginable?
- The lock-in periods, exit options and associated costs; and
- The nature of any guarantees.