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A suitable case

The regulator’s Dear CEO letter to wealth management firms is a reminder of the importance of suitability of advice

Many of you will have seen, or at least be aware of, the recent June 14) “Dear CEO” letter issued by the FSA to the heads of wealth management businesses.

The letter’s basic theme is an apparent “uncovering” of a potentially widespread lack of “suitability” underpinning many portfolio choices for investors.

What did the FSA letter say? Well, it opened like this:

“We have recently reviewed the suitability of client portfolios in a sample of firms in the wealth management industry. We have identified significant, widespread failings, which we are concerned may also be prevalent in firms outside our sample. In this letter we explain the issues we have identified and ask you to consider whether your firm meets – and can demonstrate that it meets – our suitability requirements.
Results from our review

14 out of 16 firms were judged to pose a high or medium-high risk of detriment to their customers, based on the number of client files which had a high risk of unsuitability or where the suitability could not be determined.

Overall, 79 per cent of files reviewed had a high risk of unsuitability or the suitability could not be determined.

Sixty-seven per cent of the files reviewed were not consistent with one or more of the following – the firm’s house models; the client’s documented attitude to risk, and the client’s investment objectives.

We are involved in ongoing regulatory action with these firms to mitigate these risks. However, as a result of our findings some firms have already put in place major rectification programmes.”

The letter went on to quote some examples of the key concerns, stemming from their review, that firms had an “inability to demonstrate that client portfolios and/or portfolio holdings were suitable”.

The examples included the following:

“An inability to demonstrate suitability because of:

  • an absence of basic know-your-customer (KYC) information;
  • out-of-date KYC information;
  • inadequate risk-profiling;
  • some firms not implementing Mifid client classification requirements;
  • the lack of a record of clients’ financial situation (assets, source and extent of income, financial commitments); and
  • the failure to obtain sufficient (or any) information on client knowledge, experience and objectives.”

The risk of unsuitability was stated to be, in summary, due to:

  • “inconsistencies between portfolios and the client’s attitude to risk; and
  • inconsistencies between portfolios and the client’s investment objective, investment horizon and/or agreed mandate.”

The FSA also stated: “We also had concerns that firms were not taking reasonable care to organise and control their affairs responsibly and effectively, using adequate risk management systems.

’Overall, 79 per cent of files reviewed had a high risk of unsuitability or the suitability could not be determined’

“We expect firms to take reasonable steps to ensure that a personal recommendation, or a decision to trade, is suitable (for further details on this and related requirements, Appendix 1 contains a summary of some of the relevant handbook obligations). These findings give rise to concerns that there is an unacceptable risk of customers of wealth management firms experiencing unfavourable outcomes. While underlying drivers of poor outcomes have not been a major focus of our work to date, the failings we have seen may point to deficiencies in the management and control architecture of firms.”

So, all a bit of a worry. A worry that will lead, no doubt, to a mass of “rectification exercises”, file and system/process reviews.

But is that where it all stops? Are there any other areas of potential concern in relation to suitability and investment recommendations?

Mention has been made of the principles of this initiative extending to more than wealth managers – basically, anyone, including financial advisers who advise on portfolio construction and appropriateness. The “suitability” principle is presumably just as important in any area of advice where there is a risk of adverse consumer/investor outcomes.

That is not to say that I have any particular inside knowledge or insight into what’s next for the FSA, just that the “Dear CEO” letter serves as a reminder of the absolute (and completely understandable) importance of putting suitability and “non-deficient” outcomes at the heart of the advice process.

What other aspect of the investment advice process could the “Dear CEO” principles of suitability and good outcomes be applied to? Well, try portfolio product wrapper selection. This is the subject that I will look into in detail over the coming weeks.

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