The FSA is to embark on a wide-reaching review into the structured product market after uncovering significant advice failings in nine of the 11 advice firms sampled in its probe into Lehman-backed plans.
Three of the firms are facing enforcement for giving unsuitable advice and the FSA is instructing other advisers it looked at to review past sales of Lehman-backed structured products and to pay redress where appropriate.
It is instructing the biggest sellers/advisers to conduct wider reviews of all structured product sales and consider redress and a different sales/advice approach if appropriate. Over 2010, it will undertake follow-up assessments to ensure that firms are meeting these advice standards.
The regulator published detailed findings on quality of advice given to clients who invested in structured investment products backed by Lehman Brothers from November 2007 and August 2008. Counterparty risk has dominated debate over structured products since the demise of Lehman but failings outlined in the report are wide-ranging and damning for many of the firms.
The FSA reviewed 157 advised sales across 11 firms ranging in size, including national IFAs, networks and the bank sector. Almost a quarter of sales by value of the sample was of Lehman-backed structured products.
It found 73 cases (46 per cent) to be unsuitable, 36 unclear (23 per cent) and 48 per cases suitable (31 per cent). Reasons for unsuitability include failure to meet client needs and circumstances, inappropriate exposure to risk, including over concentration of assets in a single product or product type and failure on tax consideration.
Inappropriate risk exposure was the most significant advice failing, with 67 of the 73 cases rated as unsuitable for this reason. It highlights a case where the proportion of the client’s portfolio invested in a single structured investment product (and therefore exposed to a single counterparty) exceeded 85 per cent.
All firms failed to adequately disclose the risk of investing in structured products to their clients in suitability reports.
The regulator also found adviser understanding of the products to be poor across nearly half of the firms sampled. One deficiency highlighted is the inability to explain the difference between structured investment products and structured deposits. Another included failure to understand the implicit charges in structured products which led to client communication suggesting they had none.
The principal failure to appropriately consider client needs and circumstances was due to a lack of consideration of time- scales for investments, particularly where a kickout product was recommended.
The FSA says assessments found that literature issued by plan managers formed the core basis and, in some cases, only basis of firms’ and advisers’ research on specific products.
However it says failings identified suggest more “fundamental flaws in core principles of investment advice” and cannot be solely attributable to the product literature. It says only two firms had controls in place that met required standards.
The FSA’s review considered firms’ systems and controls for ensuring suitable advice both prior and following Lehman’s collapse, with the latter focusing on changes implemented in response to market events.
For controls in place before the collapse, the FSA says: “It is our view that it was reasonable for firms to rely on credit ratings and to have assumed that the risk of failure of counterparties rated A or above was low.”
Lehman’s collapse, it says, “should have prompted firms giving advice to recognise the potential for investment grade counterparties to fail” and “should have prompted a higher degree of due diligence within advisory firms”.
Though several firms made positive changes, most failed to do so, it says. Only two of nine firms where controls prior to Lehman’s failure were unacceptable made sufficient changes to reduce the risk of unsuitable sales to a satisfactory level.
Following the publication of the report, advisers expressed concern as to what judgment call on counterparties would be expected from firms. Baronworth Investments director Colin Jackson says: “Is there now an onus on the IFA to make sure that the counterparty is not going to go bust. How on earth can an IFA do that, how on earth can anyone do it?”
Aifa director Robert Sinclair says: “Where failures are identified we are sure that adviser firms will co-operate with the regulator and the Ombudsman. Consumers should be compensated where appropriate. Unfortunately, the specific circumstances surrounding the collapse of Lehman Brothers means that nobody, including the regulator, could have predicted its collapse and the detrimental effect it would have on the performance of structured products backed by the bank.”
The FSA is writing with complaint guidance to all other Lehman plan investors who will not be contacted as a result of the administration of plan managers NDFA, DRL and Arc Capital & Income.
Lowes Financial Management managing director Ian Lowes says: “Having and promoting a plan backed by Lehman Brothers was not a crime but having inappropriate literature is and not correctly assessing the risk of a plan or the suitability always has been.”