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Thursday 30 October 2008
How to avoid the perils of mis-selling
Over recent days, the media has been highlighting the tragic losses suffered by investors in buying structured notes, such as DBS High Notes, Lehman Mini Bonds and Pinacle Notes.
Over recent days, the media has been highlighting the tragic losses suffered by investors in buying structured notes, such as DBS High Notes, Lehman Mini Bonds and Pinacle Notes.
It is shocking to discover that such highly complex derivative products have been sold to so many retail customers, particularly the elderly, retirees and those who are not conversant with English (the so-called ‘vulnerable customers’). According to one newspaper report, more were sold to retail customers than institutional customers. The amounts invested by these ‘vulnerable’ customers have not been small. Many have invested $100,000. Some have put in as much as $600,000.
The common complaint by these investors, who have suffered heavy losses, is ‘mis-selling’. There would appear to be some validity to this complaint, at least in some cases.
There are currently certain Conduct of Business rules in our laws under the Financial Advisers Act (FAA) and MAS Notices etc, to protect the man in the street against mis-selling of investment products. First, there is the Disclosure of Product Information rule under Section 25 of the FAA. Under this rule, a representative (that is, the person who sells the investment product, such as the relationship manager) must, among other matters, disclose the benefits and risks of the product and also the ‘need-based sales process’ to the customer.
Secondly, there is the Recommendation rule under Section 27. Under this rule, when a representative recommends an investment product to a customer, he must have a reasonable basis for his recommendation (which must be documented in writing). This means that the representative must first ‘profile’ the customer (the ‘Know Your Customer’ rule) before he recommends a suitable investment product. To do this, the representative must know about the customer’s financial objectives, risk tolerance, employment status, financial situation and his current investment portfolio. This is also called the Need-based Sales Process to determine the needs of the customer - although this also depends on how much information the customer is prepared to disclose to the representative.
Having profiled the customer, the representative will then recommend an investment product that suits the customer’s needs. This is the ‘suitability’ rule. Whether a representative has mis-sold the structured notes to a vulnerable customer may depend on which option the customer chose in the needs-based sales process. For instance, if the customer has elected ‘full fact-find’, the representative will have a great responsibility in proving that he has recommended a product that is suitable to a ‘vulnerable’ customer’s needs.
However, full fact-find is rare in market practice. On the other hand, if the customer had opted for ‘product advice’, it means that the representative is merely expected to advise on the product itself (without consideration of the customer’s needs). This is common in market practice. If the customer had opted for ‘no advice’, the representative merely executes the transaction; he has no responsibility to advise on the suitability of that product for that customer.
So does this mean that it all boils down to a matter of ticking the right boxes in deciding whether there has been mis-selling? I believe this is the legalistic approach the Monetary Authority of Singapore (MAS) is persuading the financial institutions not to adopt. Considering the fact that many of the sales processes were conducted under circumstances that were disadvantageous to these vulnerable customers, the compensation route is a fairer form of resolution.
How can such financial tragedies be avoided in future? First, MAS should ban the sale of structured notes by financial institutions to retail customers (particularly ‘vulnerable’ customers) unless they are prepared to purchase them by signing an ‘exculpatory’ document (to absolve the financial institution from liability in selling the product to them) attested and explained by their own lawyers. In other words, as a general rule, such structured products should only be sold to sophisticated investors - otherwise known as ‘Accredited Investors’, which refers to individuals with net personal assets exceeding $2 million or personal income exceeding $300,000 per annum. It should be similar to the Restricted Schemes under the Securities & Futures Act, restricting such investment products to sophisticated investors, who can look after themselves.
Secondly, financial institutions must re-evaluate the way they remunerate their representatives. It is common knowledge that representatives are paid a minimal basic salary; hence the bulk of their take-home pay has to come from sales commissions. There is nothing wrong with that. However, to earn more, the representative will have to push more sales every month. If not, he will be hounded daily by his supervisor. If the representative is an underperformer, he might even be asked to leave.
Moreover, representatives are expected to sell the entire range of financial products in the basket. To avoid the penalty of not selling certain financial products in the basket, representatives are forced to aggressively push ‘slow-moving’ products to their customers, even though such products may not be suitable for the customers.
Thus many financial institutions are turning their representatives into better ‘product-pushers’ rather than better ‘financial advisers’. This needs to change. Financial institutions must find ways to properly remunerate representatives who are good ‘financial advisers’ and not merely good at pushing products.
Thirdly, let us learn some lessons from Lloyds TSB’s mis-selling of endowment policies and bonds in the UK. Lloyds TSB was fined £pounds;1 million (S$2.35 million) in 2002 by the Financial Services Authority (FSA) of the UK and had to set aside £pounds;165 million to compensate claims relating to mis-sold endowment policies, involving 45,000 policyholders.
Then, in 2003, Lloyds TSB was further fined £pounds;1.9 million and had to compensate £pounds;98 million to 22,500 investors, many of them pensioners. This was related to the mis-selling of high-income ‘precipice’ bonds touted as an ‘Extra Income and Growth Plan’. These bonds promised a return of 9.75-10.25 per cent over three years (twice the bank deposit rates then) and were linked to 30 stocks. They were called ‘precipice’ bonds because the investors’ capital returns could ‘fall off a cliff’ if the markets fell below a pre-set trigger point.
The markets linked to the 30 stocks did indeed fall. These high-risk bonds, which were highly leveraged, were sold to inexperienced investors. Some 16,500 investors had never purchased equity-related investment products before. 22,500 sales out of 51,000 (that is, 44 per cent) of the total sold were deemed to have been mis-sold. Howard Davies, outgoing chairman of FSA, said that the products sold by Lloyds were ‘inherently wicked’ (because they were highly leveraged) and they were sold to unsuitable people. Andrew Proctor, FSA director of enforcement, said: ‘There was nothing wrong with the product itself. The problem was that too much of it was sold to the wrong people.’
The writer, a partner of SL Tan & Co, is a compliance lawyer specialising in regulatory compliance relating to financial institutions
How to avoid the perils of mis-selling
ReplyDeleteBy TAN SIN LIANG
29 October 2008
Over recent days, the media has been highlighting the tragic losses suffered by investors in buying structured notes, such as DBS High Notes, Lehman Mini Bonds and Pinacle Notes.
It is shocking to discover that such highly complex derivative products have been sold to so many retail customers, particularly the elderly, retirees and those who are not conversant with English (the so-called ‘vulnerable customers’). According to one newspaper report, more were sold to retail customers than institutional customers. The amounts invested by these ‘vulnerable’ customers have not been small. Many have invested $100,000. Some have put in as much as $600,000.
The common complaint by these investors, who have suffered heavy losses, is ‘mis-selling’. There would appear to be some validity to this complaint, at least in some cases.
There are currently certain Conduct of Business rules in our laws under the Financial Advisers Act (FAA) and MAS Notices etc, to protect the man in the street against mis-selling of investment products. First, there is the Disclosure of Product Information rule under Section 25 of the FAA. Under this rule, a representative (that is, the person who sells the investment product, such as the relationship manager) must, among other matters, disclose the benefits and risks of the product and also the ‘need-based sales process’ to the customer.
Secondly, there is the Recommendation rule under Section 27. Under this rule, when a representative recommends an investment product to a customer, he must have a reasonable basis for his recommendation (which must be documented in writing). This means that the representative must first ‘profile’ the customer (the ‘Know Your Customer’ rule) before he recommends a suitable investment product. To do this, the representative must know about the customer’s financial objectives, risk tolerance, employment status, financial situation and his current investment portfolio. This is also called the Need-based Sales Process to determine the needs of the customer - although this also depends on how much information the customer is prepared to disclose to the representative.
Having profiled the customer, the representative will then recommend an investment product that suits the customer’s needs. This is the ‘suitability’ rule. Whether a representative has mis-sold the structured notes to a vulnerable customer may depend on which option the customer chose in the needs-based sales process. For instance, if the customer has elected ‘full fact-find’, the representative will have a great responsibility in proving that he has recommended a product that is suitable to a ‘vulnerable’ customer’s needs.
However, full fact-find is rare in market practice. On the other hand, if the customer had opted for ‘product advice’, it means that the representative is merely expected to advise on the product itself (without consideration of the customer’s needs). This is common in market practice. If the customer had opted for ‘no advice’, the representative merely executes the transaction; he has no responsibility to advise on the suitability of that product for that customer.
So does this mean that it all boils down to a matter of ticking the right boxes in deciding whether there has been mis-selling? I believe this is the legalistic approach the Monetary Authority of Singapore (MAS) is persuading the financial institutions not to adopt. Considering the fact that many of the sales processes were conducted under circumstances that were disadvantageous to these vulnerable customers, the compensation route is a fairer form of resolution.
How can such financial tragedies be avoided in future? First, MAS should ban the sale of structured notes by financial institutions to retail customers (particularly ‘vulnerable’ customers) unless they are prepared to purchase them by signing an ‘exculpatory’ document (to absolve the financial institution from liability in selling the product to them) attested and explained by their own lawyers. In other words, as a general rule, such structured products should only be sold to sophisticated investors - otherwise known as ‘Accredited Investors’, which refers to individuals with net personal assets exceeding $2 million or personal income exceeding $300,000 per annum. It should be similar to the Restricted Schemes under the Securities & Futures Act, restricting such investment products to sophisticated investors, who can look after themselves.
Secondly, financial institutions must re-evaluate the way they remunerate their representatives. It is common knowledge that representatives are paid a minimal basic salary; hence the bulk of their take-home pay has to come from sales commissions. There is nothing wrong with that. However, to earn more, the representative will have to push more sales every month. If not, he will be hounded daily by his supervisor. If the representative is an underperformer, he might even be asked to leave.
Moreover, representatives are expected to sell the entire range of financial products in the basket. To avoid the penalty of not selling certain financial products in the basket, representatives are forced to aggressively push ‘slow-moving’ products to their customers, even though such products may not be suitable for the customers.
Thus many financial institutions are turning their representatives into better ‘product-pushers’ rather than better ‘financial advisers’. This needs to change. Financial institutions must find ways to properly remunerate representatives who are good ‘financial advisers’ and not merely good at pushing products.
Thirdly, let us learn some lessons from Lloyds TSB’s mis-selling of endowment policies and bonds in the UK. Lloyds TSB was fined £pounds;1 million (S$2.35 million) in 2002 by the Financial Services Authority (FSA) of the UK and had to set aside £pounds;165 million to compensate claims relating to mis-sold endowment policies, involving 45,000 policyholders.
Then, in 2003, Lloyds TSB was further fined £pounds;1.9 million and had to compensate £pounds;98 million to 22,500 investors, many of them pensioners. This was related to the mis-selling of high-income ‘precipice’ bonds touted as an ‘Extra Income and Growth Plan’. These bonds promised a return of 9.75-10.25 per cent over three years (twice the bank deposit rates then) and were linked to 30 stocks. They were called ‘precipice’ bonds because the investors’ capital returns could ‘fall off a cliff’ if the markets fell below a pre-set trigger point.
The markets linked to the 30 stocks did indeed fall. These high-risk bonds, which were highly leveraged, were sold to inexperienced investors. Some 16,500 investors had never purchased equity-related investment products before. 22,500 sales out of 51,000 (that is, 44 per cent) of the total sold were deemed to have been mis-sold. Howard Davies, outgoing chairman of FSA, said that the products sold by Lloyds were ‘inherently wicked’ (because they were highly leveraged) and they were sold to unsuitable people. Andrew Proctor, FSA director of enforcement, said: ‘There was nothing wrong with the product itself. The problem was that too much of it was sold to the wrong people.’
The writer, a partner of SL Tan & Co, is a compliance lawyer specialising in regulatory compliance relating to financial institutions