Adviser knowledge gap at heart of struc prod failings

Advisers’ fundamental lack of understanding of how structured products work and their suitability for different clients has been identified by the FSA as a key factor behind inappropriate sales of Lehman-backed products to consumers.

Its report, Quality of advice on structured investment products, paves the way for consumer complaints against advisers as it highlights a catalogue of failings around how the risk of the products was assessed.

The regulator was also highly critical of the fact most firms failed to make improvements to their systems and controls following Lehman’s collapse.
 
Its report found the level of advisers’ understanding of structured products to be poor across nearly half of the firms surveyed, which accounted for 24% of Lehman-backed structured product sales by value. This included firms of different sizes and across distribution channels.

There was a clear failure to understand counterparty risk; an inability to differentiate between structured investment products and structured deposits and issues around client suitability. There was also a lack of understanding of charges, which even led to communications to customers suggesting these products had no charges.

The report found firms placed heavy reliance upon a plan manager’s literature as a source of research and there was often no firm-level strategy in this area. Where research was left solely to individual advisers, there was a failure to consistently recommend suitable products to all customers.

One firm only considered the strength of the plan manager and failed to look at the financial strength of counterparties.

Some firms also had faulty processes for assessing risk including a lack of category for identifying customers who wish to take to risk with their capital.

The FSA says: “We take the view that structured investment products are unsuitable for customers who do not want to take any risk with their capital or have no capacity for loss.”

It highlighted good practice at a firm which analysed a counterparty’s credit default spreads, credit outlook and financial reporting. This enabled the firm to move out of Lehman-backed products before the bank collapsed. The firm also did not recommend products when the counterparty was not disclosed. However, the FSA said this action was more than it would have expected of advisers at the time.

Although several firms made positive changes, most failed to do so after the collapse of Lehmans. Positive action included increasing the minimum credit rating of counterparties to 'AA' or above and introducing adviser competence testing on structured products.

All firms in the sample failed (in some or all cases) to adequately disclose the risk of
investing in structured investment products to their customers.

This included:

• failure to explain counterparty risk;
• misleading explanation of counterparty risk;
• failure to provide information on the product recommended, or information provided on the wrong product
• factually incorrect information within suitability reports.

Two firms in the sample displayed systemic failures around counterparty
risk disclosure, the FSA says.

On counterparty risk, the FSA says advisers should have had regard to the
financial strength of the underlying counterparties and whether this was
appropriate given the customer’s attitude to risk.

“However, we consider the due diligence it was reasonable for advisers to apply on the financial strength of the counterparty changed after Lehman’s collapse: so we have not applied the benefit of hindsight to the period before Lehman’s
insolvency (in September 2008).”

“Where a customer was willing to take counterparty risk we believe that it was not reasonable to expect advisers to distinguish between the financial strength of different counterparties that were rated ‘A’ or above in this period.”

However, from September 2008, given the failure of an investment grade
counterparty, the FSA expected advisers to have undertaken a higher degree of
due diligence when recommending products with counterparty risk, and to
consider more carefully how this may relate to each customer’s attitude to risk.

In other areas, the FSA found the advice given did not adequately consider and meet customer needs and circumstances. The main reason for the failings in this area was lack of consideration of timescales for investments, particularly where a ‘kick-out’ product was recommended.

It also found failure by advisers to ensure an appropriate degree of diversification of customers’ investment portfolios was a significant issue across its sample.

“In many unsuitable cases, the level of investment placed in either a single structured investment product, or structured investment products as a product type, was not justified given the customer’s attitude to investment risk or needs and objectives. In one case, the proportion of the customer’s portfolio invested in a single structured investment product – and therefore exposed to a single counterparty – exceeded 85%.”

When referring to good practice in this area, the FSA said one adviser set himself initial guidelines of 10% (single product) and 25% (multiple products) for the maximum exposure his customers should normally have to this product type, taking into account the customer’s wider circumstances.

In most cases, the FSA found advisers had also failed to address the customer’s tax needs adequately.