The FCA have issued a report on their findings of a review of conflicts of interest arising from wealth management and private banking firms’ use of in-house investment products (“IHPs”) in retail discretionary and advisory investment portfolios. The regulator’s review was based on a sample of 18 wealth management and private banking firms with a total of £146 billion of customers’ assets under management. Throughout the review the FCA also engaged with the Wealth Management Association and the British Bankers Association in order to obtain their views on the information being sought from firms.
Below we have provided a summary of the FCA’s key findings and a brief explanation of them.
The FCA were pleased to observe that:
1) There was a heightened focus by senior management within firms on conflicts of interest in relation to IHPs and they had taken steps to identify and manage weaknesses in their controls. Senior management are responsible for ensuring that the firm has systems and controls set in place to identify and manage potential conflicts of interests, which could arise due to the firm’s business model. Good practice example:
“ Some firms engaged third parties to report on the effectiveness of their conflicts of interest arrangements and identify any gaps. ”
2) We found no evidence of remuneration structures that could have biased investment decisions unfairly towards IHPs. Remuneration schemes can incentivise individuals to place their own interests above those of their customers, which would lead to a conflict of interests. Good practice example:
“ Remuneration structures within distribution channels, for example in the front office and portfolio construction units, appeared to be neutral towards investment in IHPs. ”
3) Due diligence processes in selecting investment products and monitoring their subsequent performance appeared to be consistent between IHPs and third party products. Firms should ensure that they deliver services as described to their customers and act in their best interests. Good practice example:
“ Due diligence on product selection, reviews and monitoring appeared neutral between IHP and third-party products. There was evidence of firms terminating IHPs if the product failed to meet the defined criteria. One firm provided evidence of termination of an IHP within 24 hours of initial selection approval when one of the key components of the product had changed. ”
However, the regulator also observed a number of shortcomings and lack of consistency in several areas:
1) Firms did not articulate clearly enough how IHPs fitted within their business model and strategy, and were aligned with customers’ interests. Poor practice example:
“ Several firms, including some with high levels of assets under management invested in IHPs, were unable to explain how the use of IHPs was linked to their business strategy. There is a risk that these firms may not have fully considered how the use of IHPs was aligned with customers’ interests, nor adopted a strategic approach to managing conflicts of interests in this area. ”
2) Not all firms monitor the level of IHPs in customer portfolios, which could help to indicate how effectively they are managing conflicts. Poor practice example:
“ In one firm, we observed numerous committees with responsibility for due diligence on product selection, but there was ambiguity in overall responsibility for conflicts of interest in the use of IHPs. “
3) Communications with customers were not always clear about the nature of the firm’s services and the extent to which IHPs might feature in customer portfolios. Firms are required to pay due regard to the information needs of their customers and to communicate information to them in a clear manner, which is not misleading. Poor practice example:
“ Terms were inconsistent and ambiguous with some firms stating they were ‘restricted’ but also that they were ‘scanning the universe’ for ‘best of class’ products.
While there was information about the relationship between the manufacturer and distributor, it was unclear whether customers would understand what the exact service offering was and the likely level of IHPs in portfolios. “
The FCA’s concern can be explained by the commercial reality of the investment industry. Investment firms act as agents for their customers when making discretionary investment decisions on their behalf or advising them. While they have a duty to be acting in the best interest of these customers, there is an inherent risk of conflict of interest when they invest customers’ assets into IHPs. This is so because investment firms are commercial entities and as such they naturally seek to maximise their revenue and profits, in turn this could often lead to situations where decisions are guided not by a client’s best interests but by profit maximisation. However, based on the findings of this review the FCA have concluded that there isn’t any evidence of significant failures by firms to identify and manage conflicts of interest in their use of IHPs. Therefore, the regulator has not proposed to undertake any further thematic work on this topic.
Regardless of the regulator’s generally positive findings on this matter, all firms (including distributing and manufacturing entities) that are using IHPs in providing retail discretionary and advisory investment management services should consider how their arrangements for identifying and managing conflicts of interest measure up against the specific FCA Rules and the examples of good and poor practice provided above. Firms should also consider reviewing the full report for an extensive list of good and poor practice examples. A link to the full report including a full list of applicable FCA Rules can be found here.
Should you require any further advice or information on the above, Cleveland & Co, your external in-house counsel, are here to help.