TCF in the wholesale sector [ June 2008 ]

1. Summary
   
2. Does TCF apply to firms operating in the wholesale sector?
   
3. Why does it matter?
   
4. What should wholesale firms be doing in relation to TCF?
   
5. FSA publications
   
6. Where can I find more information on TCF?
   
7. Appendix 1
   
8. Appendix 2

Summary

This briefing gives an outline of the TCF regime and how it applies to the wholesale sector.

It also contains two appendices. In the first appendix there is set out key parts of the FSA’s guidance on the responsibilities of providers and distributors of products and services for the fair treatment of customers.

The second appendix sets out some of the FSA’s good practice illustrations for managers of UK authorised collective investment schemes relating to provider responsibilities.

Does TCF apply to firms operating in the wholesale sector?

Yes.

The FSA has made it very clear that TCF applies to both commercial customers and retail customers. It has warned wholesale firms not to assume that TCF has no relevance to their business.

TCF will apply to a wholesale firm, where it:

1. interacts directly with retail clients;
2. develops products or contributes to the development of a product which is distributed by others to retail clients; and/or
   deals with professional clients.
3. The only situation where the FSA has acknowledged that TCF will not apply is where a firm deals only with eligible counterparties (assuming there are no underlying retail clients). In these circumstances, Principle 6 of the FSA’s Principles for Businesses (customers’ interests) is switched off.

Why does it matter?

1. The FSA set two deadlines in relation to TCF which apply in the same way to wholesale firms as they do to retail firms. By 31 March 2008, firms should have had appropriate evidence, in the form of management information (MI) or other measures, in place to test whether they are treating their customers fairly (the March deadline).
2. By 31 December 2008, firms must be able to demonstrate that they are consistently treating their customers fairly (the December deadline).
3. Wholesale firms which are the subject of an ARROW inspection or which interact with the FSA in any other way during 2008 can expect to be asked about their progress in relation to meeting the TCF deadlines. They are unlikely to receive a sympathetic response from the FSA if progress is limited or non-existent.

What should wholesale firms be doing in relation to TCF?

1. Wholesale firms will need to demonstrate to the FSA that they have thought about (and documented) the implications of the TCF regime on their businesses.
2. On a risk-based approach, firms dealing both directly and indirectly with only professional clients will generally not have to do as much work on TCF as those firms interacting directly with retail clients. However, the FSA expects all firms to which the TCF regime applies to take their obligations seriously. Firms should ensure that they can satisfy themselves (and the FSA) that their customers are being treated fairly.
3. Although it will depend on the precise nature of the business model of your firm, the following documents and processes are likely to need reviewing from a TCF perspective:

• • External facing documents eg, all customer communications (not just financial promotions), risk warning disclosures, best execution summaries, terms of business, newsletters and post sale documents.
  • Internal facing documents eg, compliance manuals, best execution policies, complaints handling procedures, conflicts of interest policies, HR policies on remuneration and recruitment.
  • Business processes eg, product design and development, documentation review processes, staff training, reporting lines and escalation procedures for managing TCF issues.

FSA publications

On 16 July 2008 the FSA published guidance on the responsibilities of providers and distributors of products and services for the fair treatment of customers.

• Key parts of the guidance are set out in appendix 1.

In the Policy Statement that accompanied the guidance the FSA stated that:

• “there may be some difficult or complex areas where case studies (or at least additional clarification of what we expect of firms) may be helpful. So we intend to consider on a case by case basis whether further clarification is required in any particular area, and if so, what the best form for that clarification is.”

In line with this commitment the FSA published good practice illustrations for managers of UK authorised collective investment schemes relating to provider responsibilities.

The good practice illustrations were published in January 2008. They cover identifying the target market and reviewing how what is occurring in practice corresponds to (or deviates from) what was originally planned or envisaged.

• Key parts of the good practice illustrations are set out in appendix 2.

Appendix 1

1. Key parts of guidance on the responsibilities of providers and distributors of products and services for the fair treatment of customers
   The responsibilities
2. Providers and distributors should consider the impact of their action (or inaction) on the customer in various stages of the product life-cycle, or the various stages of provision of the service. Depending on the precise nature of a firm’s business, this could mean addressing the fair treatment of customers at the following stages: design and governance; identifying target markets; marketing and promotion; sales and advice processes; after-sales information and service; and complaints handling.
3. The Guide gives the FSA’s view of the respective responsibilities of providers and distributors under the Principles during the product life cycle or while the service is provided.

In the Guide the FSA has distinguished between providers and distributors.

1. While it considers the labels ‘provider’ and ‘distributor’ useful for the purposes of the Guide, it recognises that responsibilities flow from the actual roles or functions undertaken in a transaction, and firms should take this into account in considering their responsibilities under the Principles. In considering which responsibilities apply to it, a firm should consider the functions and roles that it undertakes in the product lifecycle.
2. Whether a particular role or function is fulfilled by the distributor or provider (or both) may vary based on the product or service, or particular arrangements in place, and it may be possible for a firm to act as both provider and distributor at the same time in respect of different products or services. For example:
3. It is possible that a provider creates a product or service to meet criteria or designs specified by a distributor. In such instances, many of the responsibilities fall to the commissioning distributor, as ‘retail manufacturer’ of the product or service, rather than the ‘pure manufacturer’ of the commissioned product or service. Of course, if what the pure manufacturer delivers fails to meet the agreed specification, the retail manufacturer may seek its own redress under the contract between them or the applicable law. That said, the pure manufacturer must act with due skill, care and diligence in accordance with Principle 2 and, where it conducts a regulated activity for the underlying customer (for example, it enters into a contract with a customer), must treat that customer fairly.

Other Principles and detailed rules may also apply.

1. It is also possible that a product manufacturer creates components that are later (and possibly without the component manufacturer’s knowledge) subsumed into retail products designed and marketed to customers by ‘retail manufacturers’.
2. In such instances, the pure manufacturer may not have a contractual or other relationship with the underlying customer. The pure manufacturer may not be aware (nor is it necessarily the case that it ought to be aware) of whether the retail manufacturer is using the product for itself or for an underlying customer.
3. However, the pure manufacturer should act with due skill, care and diligence in designing its products (Principle 2). The skill, care and diligence that are ‘due’ under Principle 2 will be determined taking all the circumstances into account.
4. These may include the manufacturer’s knowledge of whether the product or service is provided to a firm, rather than an underlying customer, and the information needs of the firm. In addition, the pure manufacturer will normally be obliged to communicate information to the retail manufacturer in a way that is not misleading (Principle 7).
5. Whether providers and distributors can agree between themselves how to apportion responsibilities between themselves will depend on the circumstances. In particular, it depends on the nature of the regulatory responsibility, the extent to which such an agreement would be reasonable, whether the arrangement is clear to both parties and properly recorded and the systems and controls used to monitor whether the agreement continues to be appropriate in the circumstances.

Provider responsibilities

When undertaking product or service design, Principles 2, 3 and 6 are particularly relevant. In particular, a firm:

1. should identify the target market, namely which types of customer the product or service is likely to be suitable (or not suitable) for
2. should stress-test the product or service to identify how it might perform in a range of market environments and how the customer could be affected
3. should have in place systems and controls to manage adequately the risks posed by product or service design.

When providing information to distributors, Principle 2 is particularly relevant. In particular, a firm:

1. should make clear if that information is not intended for customer use
2. should ensure the information is sufficient, appropriate and comprehensible in substance and form, including considering whether it will enable distributors to understand it enough to give suitable advice (where advice is given) and to extract any relevant information and communicate it to the end customer.
   • As part of meeting this standard, the provider may wish to consider, with regard to each distribution channel or type of distributor, what information distributors of that type already have, their likely level of knowledge and understanding, their information needs and what form or medium would best meet those needs (which could include discussions, written material or training as appropriate).

When providing information to customers Principles 3, 6 and 7 are particularly relevant. In particular, a firm:

1. should pay regard to its target market, including its likely level of financial capability
2. should take account of what information the customer needs to understand the product or service, its purpose and the risks, and communicate information in a way that is clear, fair and not misleading
3. should have in place systems and controls to manage effectively the risks posed by providing information to customers.

When selecting distribution channels, Principles 2, 6 and 7 are particularly relevant. In particular, a firm:

1. should decide whether this is a product where customers would be wise to seek advice
2. should review how what is occurring in practice corresponds to (or deviates from) what was originally planned or envisaged for the distribution of its products or services given the target market. This involves collecting and analysing appropriate Management Information (MI) such that the firm can detect patterns in distribution as compared with the planned target market, and can assess the performance of the distribution channels through which its products or services are being distributed
3. should act when it has concerns, for example by ceasing to use a particular distribution channel.

In the area of post-sale responsibility, Principles 2, 6 and 7 are particularly important. In particular, a firm:

1. in supplying information direct to the customer, must ensure that the information is communicated in a way which is clear, fair and not misleading
   should periodically review products whose performance may vary materially to check whether the product is continuing to meet the general needs of the target audience that it was designed for, or whether the product’s performance will be significantly different from what the provider originally expected and communicated to the distributor or customer at the time of the sale. If this occurs, the provider should consider what action to take, such as whether and how to inform the customer of this (to the extent the customer could not reasonably have been aware) and of their option to seek advice, and whether to cease selling the product
2. should communicate to the customer contractual ‘breakpoints’ such as the end of a long tie-in period that may have a material impact on a customer that the customer cannot reasonably be expected to recall or know about already
3. should act fairly and promptly when handling claims or when paying out on a product that has been surrendered or reached maturity. In doing this, the provider should meet any reasonable customer expectations that it may have created with regard to the outcomes or how the process would be handled must establish, implement and maintain effective and transparent customer complaint-handling systems.

Distributor responsibilities

In the area of financial promotions, Principles 3, 6 and 7 are particularly relevant. In particular, a firm:

1. should have in place systems and controls to manage effectively the risks posed by financial promotions in passing on a promotion created by a provider, must act with due skill, care and diligence. A firm will not contravene the financial promotions rules where it communicates a promotion produced by another person provided the firm takes reasonable care to establish that another firm has confirmed compliance with the relevant detailed rules, amongst other matters.

When providing information at or before the point of sale to a customer, Principles 2, 6 and 7 are particularly relevant. In particular, a firm:

1. should consider, when passing provider materials to customers, whether it understands the information provided
   should ask the provider to supply additional information or training where that seems necessary to understand the product or service adequately
2. should not distribute the product or service if it does not understand it sufficiently, especially if it intends to provide advice when providing information to another distributor in a distribution chain, should consider how the further distributor will use the information, such as whether it will be given to customers. Firms should consider what information the further distributor requires and the likely level of knowledge and understanding of the further distributor and what medium may suit it best for the transmission of information.

When advising on selection of a provider, Principles 2 and 6 are particularly relevant. In particular, a firm:

1. should consider the nature of the products or services offered by the provider and how they fit with the customer’s needs and risk appetite
2. should consider what impact the selection of a given provider could have on the customer in terms of charges or the financial strength of the provider, or possibly, where information is available to the distributor, how efficiently and reliably the provider will deal with the distributor or customer at the point of sale (or subsequently, such as when queries/ complaints arise, claims are made, or a product reaches maturity).

In the area of post-sale responsibility, Principles 3 and 6 are particularly relevant. In particular, a firm:

1. should comply with any contractual obligation it has to the customer, for example to provide ongoing advice or periodic reviews. In connection with this, it should also consider its responsibility to maintain adequate systems and controls to deliver on such reviews
2. should consider any implied or express representation it made (during meetings, correspondence or promotional material, for example).

• Where a customer has reasonable expectations based on the prior statements of a distributor, for example that performance will be monitored, the distributor should meet these expectations where involved in handling claims or paying out on a product that has been surrendered or reached maturity, should meet any reasonable expectations that the distributor has created in the customer’s mind with regard to how the process would be handled must establish, implement and maintain effective and transparent customer complaint-handling systems should pass any communications received from customers (intended for or suited to providers to act upon) to providers in a timely and accurate way.

Appendix 2

Good practice illustrations for managers of UK authorised collective investment schemes relating to provider responsibilities
Target Market – Good Practice for the Guidance ‘When undertaking product or service design a firm should identify the target market, namely which types of customer the product or service is likely to be suitable (or not suitable) for.’

Good practice includes:

The target market of a particular fund being characterised by identifying certain criteria or parameters which could include risk characteristics and likely investor usage/needs that the fund would fulfil – eg, around likely investment viewpoint; risk appetite; proportion of portfolio; and time horizon.
This is more than just describing the fund characteristics and risks, but it does not require targeting to a particular demographic profile.

Also, considering the criteria of those risk characteristics and investor usage/needs that the fund would not fulfil can be useful in demarcating the appropriate ‘target market’ (eg, an emerging markets smaller cap long-only fund is unlikely to fulfil the needs of investors with low risk appetite).

The following factors are considered in creating the fund, and subsequently, the main elements of any characterisation will typically be described in the Simplified Prospectus, or equivalent disclosure material. But ancillary marketing and training material might also usefully capture some of these factors, including a description of:

1. what the fund is for, the investment viewpoint that is encapsulated in the fund strategy (which will typically vary according to investor’s time-horizon), the nature and scale of risks presented by the fund that might be relevant to its selection such as liquidity, volatility and/or risk of capital loss and a realistic typical investment time-horizon
2. whether the fund would best be incorporated as part of a portfolio of investments.
3. Considering, and if appropriate limiting the means of distribution of the fund.
4. Firms have strong relationships with their key distributors that are based on regular contact including product knowledge training and marketing to those firms, which will include platforms and advisers amongst others. A firm has a good understanding of the business models (including typical client base) of those distributors when determining how it will actively distribute, for example, a fund that has been designed to express an unusual or esoteric investment viewpoint. We expect firms to consider whether the nature of the fund is such that it might be necessary to limit or otherwise restrict its active distribution, including:
   • to direct retail customers – not issuing direct offer financial promotions, asking direct investors whether they have received advice and suggesting that they do so to a subset of the distribution population via a fund supermarket or wrap platform.
   • Reviewing how what is occurring in practice corresponds to (or deviates from) what was originally planned or envisaged – Good practice for the Guidance.
     • ‘When selecting distribution channels, a firm should review how what is occurring in practice corresponds to (or deviates from) what was originally planned or envisaged for the distribution of its products or services given the target market. This involves collecting and analysing appropriate Management Information (MI) such that the firm can detect patterns in distribution as compared with the planned target market, and can assess the performance of the distribution channels through which its products or services are being distributed’.

Good practice includes:

Considering the information needs of distributors, such as:

1. building an understanding of key distributors, including through training processes and other contact (eg sales & marketing and client relationship management activities), as appropriate for particular funds
2. taking steps to ensure understanding of the information needs of distributors and how performance characteristics and investment risks can be explained in a way that distributors are capable of understanding and using effectively during the sales and advice process considering the aggregate level of understanding of its distributors when they are determining the appropriate type and extent of distribution for the fund (eg, as a result of feedback from product knowledge training), and taking action accordingly (eg, not actively distributing through them, or adjusting their communications with the distributor accordingly).

Assessing the accuracy of the characterisation of the fund and its generic suitability on an ongoing basis, such as:

1. keeping the distributors and customers informed on an ongoing basis of developments relating to the fund
2. considering if the suggested original usage of the fund remains appropriate and that the performance of the fund is continuously compared to the initial/current characterisation of the fund.
3. In this regard, a firm might:
   • ensure that any disparity is reflected in changes to the relevant disclosure and marketing material assess whether any disparity or development is so material that this should be communicated to investors and/or distributors (eg, if documentation describes a fund as low risk, movements in the underlying asset type, strategy, sector or market which call this characterisation into question)
     assessing feedback on the content of marketing and training material related to funds, and amending material as appropriate to ensure it remains relevant and comprehensible.

Collecting evidence that enables the monitoring of sales volumes and trends against projections, such as:

1. tracking sales volumes/trends to identify unusual trends in terms of sales volumes (including through particular distribution channels), so that a firm might, for example, investigate instances of particularly high sales volumes through individual intermediaries:
   1. this might be based on comparison with the average volume from individual intermediaries or based on a firm’s past experience of that distributor even though this might be more difficult in cases where sales are aggregated through the use of nominee accounts, whether on platform or by wealth managers, firms utilise any available information (quantitative or qualitative) to check disproportionately high level of sales proactively considering whether there are particularly useful measures to assess outcome against expectation, such as:
      • comparison of firm experience against market-wide statistics
      • redemption patterns evidenced via directly invested holdings and any other data (eg, qualitative) available from intermediaries;
      • complaints data, including analysing ‘root causes’ of complaints.