INFOCUS. Seller Beware: Managing the Product Lifecycle in a Changing Regulatory Climate BY DAVID THELANDER AND PIERRE DE SAINT PHALLE

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1 promontory.com NOVEMBER 15, 2012 INFOCUS BY DAVID THELANDER AND PIERRE DE SAINT PHALLE Seller Beware: Managing the Product Lifecycle in a Changing Regulatory Climate The era of buyer beware in the financial services industry is gone at least for now. Changes in public sentiment and policies prompted by the financial crisis have put the onus on companies to warrant that their customers purchase suitable products. Legislators, regulators, and enforcement authorities are all watching closely with the expectation that financial institutions will do their part to earn back consumers confidence. David Thelander is a managing director at Promontory and co-leader of its Asset Management Group. He advises clients on all aspects of investment management governance, risk management, and compliance oversight. Success in the seller beware era will require firms to focus on products that meet customers needs, rather than on creating products that are notable mostly for their high margins. Effective product lifecycle management is not just a compliance necessity to achieve this end; it is a business sustainability requirement, and an essential element in managing reputation risk. The increasing complexity of financial and investment products complicates the task of protecting purchasers. Banks, asset managers, insurers, building societies, and broker-dealers are responding to customer demand and their own bottom lines in shifting away from traditional long-only products to sophisticated, tailored products as they seek to broaden their global distribution channels. Leveraged and inverse exchange-traded funds, structured notes, futures and options, hybrid securities, and other types of complex products are well established in the marketplace, particularly as investors look for yield in a low-interest-rate environment. The notional amount of derivatives increased more than tenfold in the decade prior to 2007, according to the Bank for International Settlements, and hit a new high in Firms that have historically specialized in equity and investment-grade bond products are among those exploring alternatives, both in response to investor interest and also in an effort to increase revenue. Pierre de Saint Phalle is a managing director at Promontory and co-leader of its Asset Management Group. He advises banks, insurance companies, and asset management groups on governance, compliance risk management, and government regulation. Consumer protection has emerged as a global priority, and regulators are increasingly focused on whether investors understand the risks they ve assumed. Enforcement authorities are ramping up their efforts as complex products, once reserved for sophisticated clients, flood the broader retail market. Products that do not perform as expected or are ill-suited for customers can lead to regulatory censure and reputational damage. Financial companies therefore must emphasize business models that accommodate regulatory scrutiny and align performance goals with high standards of customer care. This article reviews heightened global regulatory expectations in product development, sales, and distribution, with the intention of helping firms strengthen their management during the project phase, or pre-launch, of the product lifecycle. A future article will review the appropriate vigilance in the post-delivery stages, WASHINGTON, D.C. ATLANTA BRUSSELS DUBAI HONG KONG LONDON MILAN NEW YORK PARIS SAN FRANCISCO SINGAPORE SYDNEY TOKYO TORONTO

2 including suitability, sales, investment monitoring, ongoing product review, oversight of marketing and disclosures, and consumer compliance. REGULATORY EXPECTATIONS GLOBALLY Expectations of regulators around the world have changed dramatically, and firms must devote significant attention to mitigating the risk of increasingly common, complex products. United States The Dodd-Frank Act has strengthened the Federal Reserve Board s powers to examine affiliates of banks functionally regulated by the Securities and Exchange Commission and the Financial Industry Regulatory Authority. Given the Federal Reserve s focus on governance and control frameworks, it is increasingly reviewing the adequacy of product-related controls in banks investment management, wealth management, and capital markets divisions. Finra recently released guidance on product due diligence and suitability reviews, and in recent years the SEC and Finra have brought increasing numbers of enforcement actions focused on ineffective controls in management of products. Some of the actions have involved well-known companies. Charles Schwab & Co. in 2011 paid $117 million to settle SEC charges that an affiliate made misleading statements regarding the Schwab YieldPlus Fund and had inadequate policies and procedures to prevent the misuse of material, nonpublic information. AXA Group in 2011 agreed to a $25 million penalty and restitution of $217 million to harmed clients after the SEC concluded that, upon discovery of a coding error that disabled a key risk-management component, senior managers declined to fix it and directed others to keep quiet. CHART 1: ONE MEASURE OF PRODUCT COMPLEXITY Notional amount of outstanding over-the-counter derivatives ($ trillions) /98 6/99 6/00 6/01 6/02 6/03 6/04 6/05 6/06 6/07 6/08 6/09 6/10 6/11 Source: BIS Quarterly Review, June 2012 PROMONTORY Sightlines InFocus NOVEMBER 15,

3 Regulators continue to focus attention on ETFs. Most recently, the SEC s Office of Investor Education and Advocacy in August issued a bulletin that discussed considerations prior to investing in ETFs 1, including how they differ from mutual funds, how they are traded and valued, and how they can be arbitraged. The bulletin referenced earlier agency guidance on leveraged ETFs 2 and contained a blunt warning: Do not invest in something that you do not understand. Finra has also issued its own warnings about nontraditional ETFs. 3 The Consumer Financial Protection Bureau does not have direct jurisdiction over broker-dealers and investment advisers, but is likely to influence the products they design and sell, particularly as it steps up enforcement activities. United Kingdom Martin Wheatley, the CEO-designate of the new Financial Conduct Authority, has made oversight of the product-management lifecycle a top priority. He has committed the FCA to greater involvement in preventive regulation, and expects firms to strengthen their product preapproval process. 4 Though he has not committed the FCA to product approval, the agency has new statutory powers to ban products and promotions on consumer-protection grounds. The FCA s approach to product regulation is likely to be much more aggressive than that of the Financial Services Authority, and standards for manufacturers and distributors will be significantly higher than those expected under the FSA s Treating Customers Fairly initiative. The new emphasis in part reflects the UK s long history of problems with retail market distribution, including pensions misselling, mortgage endowment mis-selling, split-capital investment trusts, precipice bonds, and, most recently, payment-protection insurance. The FSA has brought many enforcement actions against firms in the UK that have resulted in considerable fines and reputational damage. European Union Recent and proposed legislation has fundamentally changed expectations for product management. The European parliament s fourth directive on Undertakings for Collective Investments in Transferable Securities, which was implemented last year, imposed new obligations, including a requirement that UCITS manufacturers produce Key Investor Documents to replace simple prospectuses. UCITS V, likely to be effective in 2014, will add further retail customer safeguards and the ability to impose financial sanctions for violations of the UCITS legal framework. The European Commission through its Markets in Financial Instruments Directive is evaluating guidance to institutions on tailoring products appropriately for specific customers, and the European Securities and Markets Authority is focusing on whether new products pass reasonable-basis and customer-specific tests. Taken together, these efforts provide substantial new tools for national authorities throughout the EU to supervise and take enforcement action against firms with weaknesses in the product management process A New Focus to Financial Regulation: Building a Stronger System (CM8012), HM Treasury, February See also, My vision for the FCA, speech by Martin Wheatley at the British Bankers Association, January 25, PROMONTORY Sightlines InFocus NOVEMBER 15,

4 Asia Pacific Hong Kong s Securities and Futures Commission responded to the minibond mis-selling scandal of 2008 and 2009 by issuing comprehensive rules last year that defined acceptable behavior for the distribution and sales of complex products. The regulator s public statements have articulated a strengthened commitment to enforcement actions relating to product and distribution breaches, and its resolve has likely been stiffened by a Hong Kong Legislative Council subcommittee that warned that regulatory failures in this area will no longer be tolerated. The Monetary Authority of Singapore has also clarified higher standards for product-lifecycle management of retail products, and the Australian Securities and Investment Commission continues to focus on disclosure and advertising requirements. Indonesia is among the countries currently revamping their entire financial rules framework to impose stricter requirements for retail investor protection, and the Japan Financial Services Agency has been far more active in its recent enforcement efforts in this area. The days of lax standards and little enforcement in Asian jurisdictions are clearly over. Global The International Organization of Securities Commissions has proposed revised best-practice guidelines to help identify customer groups and tailor products. The guidelines assign responsibility to the originator and intermediary to ensure that financial products are used as intended. The guidance has no legal force, but IOSCO best practices help shape regulatory approaches in developed and developing markets alike. The global regulatory theme is clear: All financial firms banks, insurers, investment advisers, brokerdealers, and building societies must evidence strong, effective product management lifecycle controls and processes. The preapproval phase of the product lifecycle is the most critical. RISK MANAGEMENT DURING DEVELOPMENT Firms must be able to demonstrate that they have strong governance and risk-management processes for new products beginning with the design stage. Investment firms must have a committee or governing body with all risk functions participating to vet risk, including identifying hazards that cannot be fully offset and assessing the potential impact of those hazards in worst-case scenarios. Distributors should also assess the products it intends to sell and the customers who will purchase them, including whether additional product-specific controls are necessary and whether sales representatives require guidance in meeting customer needs and suitability requirements. One firm recently contemplating a new product targeted at retail consumers supplemented the product-vetting process by appointing a band of skeptics a group of senior business executives tapped to identify potential flaws in the potential product. The group was essential in resolving potential difficulties prior to the product s approval, marketing, and sale, and should also make it less likely that the firm will experience post-launch issues with the product. Such an approach also sends a message to regulators that the firm takes seriously its product-lifecycle management responsibilities. VALUE TO INVESTORS Regulators are focusing on whether products in development pass reasonable-basis and customerspecific tests. Matching product to investor classes during the early stages, rather than relying on heightened suitability obligations and due diligence at the point of sale, is critical. Manufacturers PROMONTORY Sightlines InFocus NOVEMBER 15,

5 should target groups of customer and tailor products accordingly; regulators may also expect to see testing protocols on product matching. Several firms have discovered during testing that distributors sold products intended for sophisticated investors into the broad retail market, which invited significantly greater regulatory scrutiny. Most jurisdictions make sharp distinctions between retail and institutional investors, and firms should recognize those distinctions in product design, development, and governance efforts. STRONG APPROVAL PROCESS Firms should put in place a robust and well-documented approval process by the end of the first half of the product lifecycle and before the new products are subjected to suitability and sales analysis. The introduction of the new Finra suitability and know-your-customer rules may compel advisers and broker-dealers handling complex products to adopt a more rigorous due-diligence process for matching customers and suitable products. HANDOFF CONTROLS Product design and development due diligence should continue throughout the development stage. Firms can no longer design, develop, and approve a product without taking steps to ensure that, as Martin Wheatley put it, the sales process gets your product in the right people s hands. Regulators expect firms to monitor who is buying the product, how it is performing, and whether market changes are creating gaps between actual and predicted product behavior. Regulators also expect forwardlooking product stress testing. Firms must make sure that controls and processes envisioned in the approval process are put in place in time for launch, with clear accountabilities for ongoing product management. Many firms integrate handoffs from the project management required for product approval to back-end compliance and risk monitoring to review effectiveness of the controls after launch. IMPROVING CULTURE New-product vetting and approval are only as effective as a firm s culture requires. Senior executives run the risk of dominating the process and creating a culture in which mid-level staff, especially in operational areas, finds it hard to raise concerns that could delay product launch. Executives in firms that greenlight the vast majority of products without delay should ask themselves whether the effective rubber-stamping of new products reflects superior product innovation or possibly indicates that the firm s culture inhibits staff from raising legitimate concerns. A collaborative new-product environment that brings together all elements of a firm, including operations and information technology, is a culture far more conducive to satisfying regulatory expectations. SUITABILITY AND CUSTOMER COMPREHENSION Suitability remains a key area of concern and risk. US and UK regulators have made it clear that sellers are responsible when customers end up with products they don t understand. Firms in several large jurisdictions face a wave of suitability requirements in the sales process. The average adult in the United States reads at the eighth- or ninth-grade level; how many firms design their retail materials with that perspective in mind? Have firms developed thorough processes for assessing customer risk appetite and anticipating how that might change over time? DE FACTO FIDUCIARY RESPONSIBILITY? Fiduciary responsibility is obviously a controversial topic, but firms are facing extensive requirements PROMONTORY Sightlines InFocus NOVEMBER 15,

6 and even broader regulatory expectations pushing them in the direction of that threshold. Indeed, the Dodd-Frank Act allows the SEC to adopt conduct standards that are substantially more stringent than current KYC and suitability obligations. Finra has indicated that the new rules set forth are not inconsistent with the addition of a fiduciary duty obligation at some future time. 5 HOW TO IMPROVE PRODUCT DEVELOPMENT Firms preparing for the seller beware era should reassess their product-management lifecycle, paying particular attention to the newly established responsibilities, and consider: Conducting a refreshed across the enterprise self-assessment of the product-management lifecycle, paying particular attention to the development stage, examining whether the right people have been involved across all areas, and assuring that executive dominance has not distorted an otherwise sound process. The self-assessment should include all affiliates investment advisers, broker-dealers, and other distributors involved in the product-management lifecycle. Reviewing how current governance, risk management, operational, and compliance processes are working, and whether the firm s culture supports a rigorous process. Does the process assign clear ownership of the product or concept to a particular business unit, product group, or department? Does the signoff process provide adequate opportunity for challenge? Assessing whether culture and product management encourages contributions from every function at every level, and accounts for all material risks vetted in the design, development, approval, and distribution cycles. Does the identification of material risks in new-product development include investment, operational, legal and compliance risks? Is there a feedback loop that permits changes to fix problems identified during the process? Tracking and monitoring the process to ensure appropriate handoffs of all material risks to the appropriate business unit or operational, legal, or compliance group, as appropriate. Taking these steps will help firms understand their customers better and create better products for them. A clear articulation of the benefits and risks of the product will also effectively target sales and marketing activity in the most effective distribution channel. Consumers who understand what they are buying are more likely to hold a product in adverse market conditions, which in turn increases long-term fee income for the provider. Strong governance and risk management during product design is good for the firm and for the customer. A second article will review post-delivery vigilance in the second half of the productmanagement lifecycle: suitability, sales, investment monitoring and ongoing product review, oversight of marketing and disclosures, and consumer complaint handling. Thoughtful planning for both halves of the product-lifecycle management process will help firms meet regulatory requirements around the globe and give them the best possibility of commercial success. Ron Gould, Stuart King, Daniel Narbonne, Adam Shapiro, and Sam Ten Cate contributed to this article. 5 PROMONTORY Sightlines InFocus NOVEMBER 15,

7 For more information, please call or your usual Promontory contact, or one of those listed below: Pierre de Saint Phalle, Managing Director, (New York) Ron Gould, Managing Director, (Hong Kong) Stuart King, Managing Director, (London) Adam Shapiro, Director, (San Francisco) David Thelander, Managing Director, (San Francisco) To subscribe to Promontory s publications, please visit promontory.com/subscribe2.aspx Promontory is a leading strategy, risk management, and regulatory compliance consulting firm for the financial services industry. Promontory s professionals have deep and varied expertise gained through decades of experience as senior leaders of regulatory bodies and financial institutions. Promontory assists clients in meeting regulatory requirements and in enhancing governance, risk management, strategic plans, and compliance programs. Promontory Financial Group, LLC th Street, NW, Suite 1100, Washington, DC Telephone Fax promontory.com 2012 Promontory Financial Group, LLC. All Rights Reserved. PROMONTORY Sightlines InFocus NOVEMBER 15,