FAO Ms Jenny Frost Advice and Distribution Financial Conduct Authority 25 The North Colonnade Canary Wharf London E14 5HS 22 City Road Finsbury Square London EC1Y 2AJ Tel: +44 (0) 20 7448 7100 Email: info@thewma.co.uk Web: www.thewma.co.uk 3 rd November 2015 Dear Sirs WMA s 1 response to CP15/28 - Chapter 2 Offshore bonds Financial Ombudsman Service and the COBS suitability rules We understand the FCA s desire that consumers who have purchased an offshore life insurance bond should have access to the Financial Ombudsman Service and the protection of the COBS suitability rules when receiving advice or a discretionary investment management service in relation to assets within the bond. The proposal, however, raises a number of issues which we believe need further consideration. We attach as an appendix to this letter a paper produced by one of our member firms which provides further details. Yours faithfully Ian Cornwall Head of Regulation 1 1 The Wealth Management Association (WMA) is a trade association representing 186 Wealth Management firms and Associate Members. With formal contracted client relationships our firms deal in stocks and shares and other financial instruments for individuals, trusts and charities and offer a range of services across a spectrum spanning execution only through to full discretionary services. Our member firms act for over 4 million private investors and carry out around 20 million transactions a year in the marketplace. Our members also manage in excess of 670 billion of wealth in the UK, Ireland, Channel Islands and Isle of Man, operate across more than 580 sites and employ approximately 32 000 staff. Our aim is to ensure that any changes including operational, regulatory, tax and other business matters across Europe and the rest of the world are appropriate and proportionate for our wealth management community and, most importantly, their clients. Wealth Management Association (WMA) Company limited by guarantee Registered in England and Wales No. 2991400 VAT Registration No. 675 1363 26
Response to Chapter 2 (Offshore Bonds) of FCA Quarterly Consultation No. 10 (CP 15/28) relating to legal issues 1. Introduction The FCA has identified as an issue the fact that consumers who take out offshore bonds find the structure complex to understand and are not aware that they may lose some of the regulatory protections they would have with a directly owned portfolio. 2. Legal Structure and Relationships 2.1 The problems with offshore bond arrangements arise out of the necessarily complex legal structure and the fact that certain parties may be acting in more than one capacity. The policyholder often acts in two different capacities: firstly, in their own right as the person who took out the offshore bond (on which they were probably advised by an investment firm); and, secondly, as agent on behalf of the insurance undertaking on whose behalf they may be authorised to accept advice and give instructions to the firm that the insurance undertaking has appointed to manage the portfolio of assets that is linked to the offshore bond. The investment firm may also act in two different capacities: firstly, as adviser to the policyholder (acting in their own capacity) in relation to the taking out of the policy and, possibly, the on-going suitability of the policy; and, secondly, as adviser to the policyholder (acting as agent of the insurance undertaking) in relation to the investment of the underlying assets. But different investment firms may perform each of these functions. 2.2 These relationships are set out in the diagram below. 2
2.3 Each of these roles comes with different legal and regulatory rights and obligations and the following should be noted: Where the policyholder is appointed to give instructions on behalf of the insurance undertaking, the insurance undertaking remains at all times the client of the firm. The policyholder has no legal rights of their own when acting in this capacity, but is simply exercising those of the insurance undertaking. The authority of the policyholder to give instructions as to the investment of the underlying portfolio as agent of the insurance undertaking is normally limited and it is the right of the insurance undertaking to impose such limitations. Thus, in many cases the firm will be prohibited from taking instructions from the policyholder in relation to changes of the terms of appointment of the firm (including as to the investment objective according to which the portfolio of assets is to be managed) or making certain specified investments. These restrictions may be imposed in order to ensure that the insurance undertaking can comply with the terms on which the offshore bond was issued, its own regulatory obligations (to non FCA regulators) and its own risk management policies, as well as to ensure compliance with tax rules on the basis of which the bond was sold. Anything that interferes with such rights of the insurance undertaking fundamentally undermines the principles of the rule of law. The policyholder often has the power to request or direct the insurance undertaking to appoint a particular firm to manage the portfolio of assets, but that is often a right of the policyholder (acting in their own capacity) under the terms of the offshore bond, rather than the exercise of a right of the insurance undertaking by the policyholder as its agent. Where the same firm also advises the policyholder in their own capacity as to the terms on which the offshore bond was taken out, that firm should be treating the policyholder as a client in their own capacity. This is a separate advisory relationship which should be papered separately between the client and firm (as required by COBS 8.1.3 R (1)). 3. Definition of relevant offshore bond 3.1 Concerns expressed regarding the definition of relevant offshore bond are well made, in particular as regards paragraph (d) of the definition which reads, that firm is instructed to engage directly with the policyholder in relation to the provision of the firm s service. This terminology is indeed rather ambiguous, leaving it open to differing interpretation and failing to provide legal certainty. It would be clearer if it could be formulated to reflect the real legal relationships involved and clearly related to the firm s services regarding the investment of the portfolio of assets. 3.2 In addition, it is not clear that consideration has been given to the position relating to the management of life company internal funds. They may not be easy to distinguish in all cases, but at least have the capability of supporting more than one life policy. While the reference to the involvement of the policyholder may be enough exclude such situations from these rules, it is not certain. 3.3 To avoid these issues, it may be best to amend the definition of relevant offshore bond. Suggested amendments are: 3
paragraph (b) is amended by adding words such as: but are exclusively dedicated by the insurance undertaking to satisfying its obligations under that contract ; and paragraph (d) is amended to read, the insurance undertaking has appointed the policyholder to act on its behalf with the result that the firm is authorised to provide advice to and/or to take instructions from the policyholder in relation to the provision of the firm s services regarding the investment of the portfolio of assets dedicated by the insurance undertaking to satisfying its obligations under the terms of the relevant offshore bond. (A defined term for the dedicated portfolio might be used to make the drafting easier to read.) The related COBS 18.12.1 R (3) would also be amended accordingly. 3.4 These amendments should also make it clearer that the rules do not apply where the investment firm has no interaction with the policyholder in relation to the investment of the assets underlying the offshore bond. 4. Modification of the suitability rules: conflict of legal and regulatory obligations 4.1 Under the current suitability rules (and assuming the insurance undertaking is considered a per se professional client) the firm would need to assess that it was meeting the financial objectives against those set out in the terms of its appointment (which would reflect those of the offshore bond itself). It has no responsibility to assess either (i) financial circumstances or (ii) knowledge and experience in ensuring the investment is suitable. 4.2 Note however that if the firm has an ongoing advisory relationship directly with the policyholder regarding the offshore bond itself, the firm may have a separate ongoing obligation to the policyholder in that respect, depending on the terms upon which it provides advice to the policyholder in respect of the bond. This should of course have been clearly explained to the policyholder. 4.3 The essential requirement of the proposed COBS 18.12.3 R is, essentially, to look through to the policyholder in applying the suitability assessment. The effect of this is to require the firm to: assess the knowledge and experience of the policyholder as regards the individual investments in question (or those that may be invested under the relevant discretionary strategy); assess the financial situation of the policyholder; and assess the investment objectives of the policyholder (by-passing those specified in the terms upon which the firm has been appointed by the insurance undertaking). 4.4 The first is not unreasonable where the individual giving the instructions on behalf of the insurance undertaking. 4.5 The second and third points may reflect what many firms do at a practical level but by imposing a mandatory rule the potential for an irreconcilable conflict between the obligations of the firm at law and under this new regulatory obligation is created. To be more specific, the contractual terms upon which the firm has been appointed by the insurance undertaking to invest the portfolio of assets linked to the offshore bond (which will tend to remain static unless specifically amended) may not always be entirely consistent with the policyholder s financial situation 4
and/or investment objectives (which will probably change from time to time). Given the likely limitations on the policyholder s power to agree changes to the insurance undertaking s appointment of the investment firm, the policyholder may not be permitted to agree any necessary change directly with the firm so as to resolve this conflict. 4.6 As a result two different situations could arise: (1) The firm is able to advise the client or determine on a discretionary basis what would be a suitable investment for the purposes of the (proposed) COBS requirement, but may be unable to implement that advice or decision without breaching the contractual terms of its appointment by the insurance undertaking. OR (2) The firm gives advice or makes discretionary investment decisions which are consistent with the terms of its appointment by the insurance undertaking but that advice or those decisions may not be suitable under the (proposed) COBS requirement. 4.7 Furthermore, in such a situation, these proposals would appear to conflict with the right of an insurance undertaking to have its investment objectives taken as the basis for the management of the assets, as provided for under the Markets in Financial Instruments Directive. This right is more clearly expressed in the proposals for MiFID II where the likely terms of the Level 2 implementing measures of MiFID II would require firms to base their suitability on the legal position (see proposed Article 60.6 of the proposed Level 2 MiFID II Implementing Directive). As a result there is a risk the proposals could be considered as a misimplementation of MiFID requirements and, if an insurance undertaking suffered as a result, the insurance undertaking might have a legal claim against the UK Government/FCA for such failure under EU legal principles. 4.8 It is probably unrealistic to expect this conflict to be resolved by investment firms negotiating clauses in their agreements with insurance undertakings to allow the terms set down by the insurance undertakings to be overridden to satisfy a rule of the FCA. This is because the restrictions on the policyholder s authority will have been set with the interests of the insurance undertaking in mind, such as the need to comply with the terms on which the offshore bond was issued, its own regulatory obligations (to non FCA regulators) and its own risk management policies, as well as to ensure compliance with tax rules on the basis of which the bond was sold. 4.9 Therefore the FCA rules should provide the mechanisms by which investment firms are not put in the position of being subject to irreconcilable legal obligations but which allow for the conflict to be resolved. 4.10 This could be done firstly by recognising that the terms of appointment of the firm by the insurance undertaking (its client) take precedence over the suitability assessment of the policyholder (i.e. they are not entirely supplanted the assessment of the client s financial situation and investment objectives). COBS 18.12.3 R would therefore read: To the extent that it is possible to do so while complying with the terms of its appointment by the insurance undertaking relating to the investment of the portfolio of assets related to the relevant offshore bond, the firm must apply the 5
suitability rules in COBS 9 as if the policyholder of the relevant offshore bond were its client. 4.11 To square the circle and address the underlying issue, the FCA could then also require firms facing a conflict such as that described above to take measures with a view to resolving the conflict. This might be achieved by having a new COBS 18.12.5 R along the following lines: Where a firm determines that there is a conflict between: (a) (b) the investments that would conform with the terms upon which the firm has been appointed by the insurance undertaking to manage the portfolio of assets related to the relevant offshore bond; and the investments that would be a suitable investment if the firm were to apply the suitability rules in COBS 9 as if the policyholder of the relevant offshore bond were its client, the firm must take reasonable steps with a view to resolving such conflict. 4.12 To allow flexibility according to the circumstances, rather than mandating the steps in detail, guidance might be given in a new 18.12.6 G along the following lines: The reasonable steps to be taken under COBS 18.12.5 R are likely to include: (i) (ii) informing the policyholder that the conflict exists and that as a result the firm is unable to undertake a transaction which would be considered suitable were it to apply the suitability rules in COBS 9 as if the policyholder of the relevant offshore bond were its client while also complying with both the terms of its appointment by the insurance undertaking; and taking one of the following courses of action: (A) (B) Where the policyholder is not authorised by the insurance undertaking to amend the terms of the firm s appointment on behalf of the insurance undertaking and the firm is not authorised to represent the policyholder in dealings with the insurance undertaking in relation to the relevant offshore bond, the firm informs the policyholder that, if the transaction is to be undertaken, the policyholder must obtain the agreement of the insurance undertaking to amend the terms of the policy and/or the terms of the firm s appointment by the insurance undertaking so as to permit the transaction to be undertaken. Where the policyholder is not authorised by the insurance undertaking to amend the terms of the firm s appointment on behalf of the insurance undertaking, but the firm is authorised to represent the policyholder in dealings with the insurance undertaking in relation to the relevant offshore bond, the firm obtains any necessary permission from the policyholder and then approaches the insurance undertaking with a view to obtaining the agreement of the insurance undertaking to amend the terms of the policy and/or the terms of the firm s appointment by the insurance undertaking so as to permit the transaction to be undertaken. 6
(C) Where the policyholder has been authorised to agree changes to the terms of the firm s appointment, request the policyholder to authorise the transactions or terms of the form s appointment in order to permit the transaction in question. 4.13 Broadly speaking, the above suggested course of action would reflect the current practical processes firms go through (or should go through) when dealing with these situations with a view to both respecting the legal rights and obligations of all parties and seeking the right outcomes for the underlying policyholder. 5. Modification of the suitability rules: tax risks for the policyholder 5.1 It is not clear that any consideration been given as to whether this altered suitability obligation increases the risk to clients that they will not obtain the favourable tax treatment they would have been seeking when they took the bond out. There are rules limiting the amount of influence policyholders should have over the investment of the portfolio, and if the firm is forced to engage directly with policyholders in a more intrusive way than to date in order to comply with the suitability rules, it may make it more likely that compliance with those rules is called into question. The FCA s proposals appear to be aimed at reducing the legal structure to an irrelevance in certain respects and may strengthen the argument that it is in in fact a sham for tax purposes. It would be ironic if rules designed to assist consumers actually helped to undermine the whole reason that the product was purchased in the first instance. 5.2 In any event firms advising on the taking out of offshore bonds in future may wish to take this heightened risk into account as part of their advice and risk warnings given to clients. 6. Right of complaint 6.1 The conferring on policyholders of a direct right to complain also raises challenges. It must be presumed that this right is conferred on the policyholder in their capacity as agent of the insurance undertaking, i.e. it is a right for the policyholder to make a complaint on behalf of the insurance undertaking. This is because only the insurance undertaking has any legal standing to make a claim against the firm as regards the investment of the portfolio of assets that belongs to it. Furthermore, if the policyholder has the power to make the complaint, the policyholder should also have the right to settle that complaint, which it would be doing on behalf of the insurance undertaking. 6.2 The insurance undertaking may of course authorise the policyholder as its agent to make complaints on its behalf, but it seems unlikely that they would do this because it would expect to reserve the right to decide to settle any claims to itself, because the interest of the insurance undertaking may differ from those of the policyholder (e.g. the policyholder will have no interest in whether the insurance undertaking is complying with its regulatory rules). 6.3 For the proposal to work, the FCA would have to oblige the insurance undertaking to authorise the policyholder to make and settle complaints on its behalf. Unfortunately, the FCA cannot oblige the insurance undertaking to do this as in cases such as these it will be outside the FCA s territorial jurisdiction. 6.4 If the above is not the case, and this is intended to be a stand-alone right of complaint of the policyholder (acting in their own capacity), it must be questionable whether there is power under FSMA to confer on a person a right to complain in respect of matter in which they have no legal standing in their own right. The clear 7
assumption on which the enabling provisions for the ombudsman scheme are based is that there must be at least a basis for a cause of action between the complainant and respondent in the first place. 6.5 However, in either case, any FOS determination will not be in full and final settlement of the underlying issue of the complaint because there must be doubt as to whether it would bind the insurance undertaking which has not agreed to accept the FOS jurisdiction, especially where the insurance undertaking can take action in its home courts which would do not recognise the binding nature of an FOS determination under FSMA. That appears manifestly unfair on investment firms who will have no certainty that an issue has been settled (which it is the clear intention of Parliament should be the case) and could also as a result be subject to dual liability (which appears manifestly unfair). 6.6 While it might be possible in theory to address this through changing the terms of appointment of the firm so that the insurance undertakings are contractually bound by any resolution of a complaint, there is no guarantee of that as the insurance undertakings are unlikely to wish to accept such a limitation on their rights. 6.7 Unfortunately it is difficult to see how this can be resolved through FCA rules as the insurance undertakings would need to be bound into any such solution and they will by definition be outside the jurisdiction of the FCA. 7. Cost-benefit analysis If amendments are not made to the proposals as they stand, investment firms would probably be obliged at least to enter into negotiations with insurance undertakings with a view to mitigating the legal risks imposed on them by the proposals (although the prospects of successfully doing so seem limited). No account has been taken of this in the cost benefit analysis. 8