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Example One

Fund manager E is launching a new UK-based fund investing in a range of European listed equities. The new fund qualifies as a UCITS, and its investment strategy will involve hedging certain risks through the use of derivatives (primarily exchange-traded). The fund manager wishes to contact a wide range of its existing clients , through direct offer financial promotions, to offer them the chance to invest in the new fund. The fund manager is within the scope of MiFID.

Issues arising

Because the fund qualifies as a UCITS, for the purposes of the appropriateness test it can be treated as a ‘non-complex’ instrument (UCITS are specifically mentioned as such by MiFID and therefore in COBS). The fact that the fund may invest in derivatives does not affect the position, as long as it is doing so in line with the UCITS Directives. There is no obligation to look through a UCITS to discover whether the underlying instruments it invests in are themselves ‘complex’.

Because the proposed investment is non-complex for these purposes, the appropriateness test will only apply if the fund manager is marketing it to potential investors through ‘personalised communications’. But the manager’s chosen marketing strategy will deliberately employ a personalised approach in its direct offer promotions, so the test will need to be considered (as well as other applicable financial promotion rules).

The fund manager knows that some of the existing clients to whom the new fund is to be marketed are already investors in another of the manager’s equity funds which also uses derivatives. Given the similarities in the two funds’ investment strategies as well as asset class, the manager may conclude that it is reasonable to rely on the MiFID-derived exemption for clients who have already engaged in a course of dealings involving a specific type of product or investment service beginning before 1 November 2007. You can presume such clients have the necessary knowledge and experience in order to understand the risks involved in relation to that product or service. They will receive the fund prospectus anyway, as well as any further information about the nature and risks of the investment.

The fund manager has also established that some of its existing clients to whom the new fund is to be marketed have invested in its standard fixed income fund. Because the risk profiles of the two types of fund are not identical, the manager cannot reasonably presume that these clients already have the necessary knowledge and experience to understand the risks involved in the new fund. The manager may still market the fund to this group. But if any of them take up the offer and wish to invest, then to satisfy the appropriateness test the manager will need to ask each client for information about their knowledge and experience relevant to the new fund. This is so he can determine whether the client can understand the risks involved. There are several ways he could do this:

Example of good practice

Example of poor practice

All of the following: the manager provides potential investors with an adequate explanation of the fund and its risks, in language that the investor is likely to understand; and the manager includes some targeted questions in the direct offer application form it sends the client, designed to establish the client’s understanding of the key relevant risks. When the form is returned, the manager will need to review the answers. The manager will already hold some additional information about the client’s investment experience, which they can consider if it is relevant; and the firm encourages the client to call the manager for any further information about the investment, before investing.

The firm sends the potential investor a copy of the fund prospectus (maybe with additional written disclosure material) and simply asks them to confirm on the application form they return that "I have read and understood the information about the fund and the risks it involves". The firm then relies on this alone as satisfying its obligations under the appropriateness test.

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Questions a firm could ask itself

In either scenario, in the case of the new fund, examples of the types of specific questions include:

• Have you invested in an equity fund before?
• Do you understand that the equity markets can be volatile and that the value of investments in the market can increase or decrease in value? (If the market sector poses potential additional risks, other targeted questions could be helpful).
• Do you understand that the use of derivatives in an investment strategy (even for the purposes of hedging risk) could increase the returns on investments in it but also the risks to the fund?

With a higher risk fund, it may be necessary to ask about the client’s knowledge to understand relevant additional risks.

If the client has read and understood at least the simplified prospectus information for the fund (either the simplified prospectus itself or the contents incorporated into a direct offer, for example) before applying, this will give the manager additional grounds on which to base the assessment.

What happens next?

Some clients return the application form but do not answer the questions adequately or at all. The manager is unable to determine whether the service or product envisaged is appropriate for these clients. So he issues a written ‘warning’ to each that their decision will not allow the firm to determine whether the service or product envisaged is appropriate for them. Some clients then contact the firm with the requested information so they can invest.

One client still refuses to provide any further information but is adamant about investing in the fund. This client has invested not only in the fund manager’s standard fixed income fund, but also in two property funds. The fund manager considers carefully whether it is in the client’s interests to refuse the investment, or whether the risks involved in the new fund are sufficiently controlled to allow him to accept the investment after warning the client.

If a firm provides a warning and the client asks the firm to proceed with the transaction, it is for the firm to consider whether to do so, having regard to the circumstances. However, an example of poor practice on this point would be that a firm fails to ask each client for information about their knowledge and experience or to conduct an appropriateness assessment. Instead, it simply issues a warning to every client, along with the application form, stating it is unable to determine whether the product/investment is appropriate for the client. Not only is this poor practice: in our view, this approach does not comply with the requirement which clearly imposes a proactive requirement on the firm to carry out an assessment.

We also think a warning should only be provided once a client has declined to give information. It would be inconsistent with the rules for a firm to request information and to also include the warning in that request; particularly if the firm’s request also gives the impression that it could proceed with the order without further information, as this would be implicitly encouraging the client not to provide information.

The manager decides to widen the scope of potential investors by publicising the new fund in the specialist investor press. He will not be obliged to carry out an appropriateness test in respect of potential investors who respond to this advertisement, as the clients would not be responding to a personalised communication.

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Example Two

A bank offers an execution-only service to clients in structured notes. The particular notes are structured so that returns on the contract are determined by the performance of the FTSE Eurofirst 300 index. Most are capital-protected if the index falls below a certain level (i.e. the investor cannot lose their original investment), though some issues are structured capital-at-risk (the investor can lose their original investment, though not more). The notes in question are structured to return capital in full after five years, in addition to the regular 'interest' payments linked to the performance of the index. If investors wish to surrender the investment before the end of the term, this can be done at market prices, during monthly dealing periods.

Issues arising

Our understanding is that these notes are ‘complex’ instruments under MiFID for the purposes of the appropriateness requirement. Although they may be structured as a bond and regarded as a form of debt security, they also involve features of a financial contract for differences (a MiFID derivative). Each note will have to be considered separately to identify the derivative element and consider, among other things, its impact on risk profile and pricing. (As noted earlier, however, the question of what is a complex or non-complex instrument may be subject to further consideration in Europe.)

As complex instruments, the bank does not need to consider whether transactions originate from the initiative of the client or the firm. The appropriateness test will always be relevant where the investor is a retail client, unless the transaction is within an exemption from that test.

If any of the bank’s clients have already engaged in a course of dealings involving this type of structured product, the bank can presume they have the necessary experience and knowledge to understand the risks involved. (This may be because the client has been ‘grandfathered’ for the business in question; or because the client’s knowledge and experience has already been assessed on a ‘holistic’ basis (e.g. at account-opening stage); or because the firm has used the client’s past transactions as an indication of understanding.) For other clients, the bank will need to ask each client for information about their knowledge and experience relevant to the structured product, in order to determine whether the client can understand the risks involved.

The bank may seek to obtain this information and use it to assess appropriateness in several ways:

Example of good practice

Example of poor practice

All of the following: The bank provides potential investors with an adequate explanation of the product and its risks, in language that the investor is likely to understand; and if the bank chooses to seek answers (either orally or in writing) to targeted questions designed to focus on the key risks involved in the product, it could ask the client questions such as: Have you invested in a structured product before? Do you understand that the equity markets can be volatile and the returns you receive will depend on whether the particular index of European shares increases or decreases in value? Do you understand that you could receive little return on your investment, both regularly and at the end of the five-year period? If the note is capital-at-risk: do you understand that you could lose some or all of your original investment, though not more than this? Or (if applicable): do you understand that you could lose more than your original investment? Do you understand that you may not be able to cash-in your investment immediately if you wish to do early? There are monthly dealing periods. and if the bank concludes - even after providing information to the client - that a client does not have the necessary experience and knowledge in order to understand the risks involved, it warns the client of this conclusion, and makes a considered decision whether to facilitate the client’s investment if the client wishes to do so in the light of the warning. If the note is capital-at-risk, the bank is more likely to conclude that it is not in the client’s best interests to proceed, even more so if a degree of gearing is built into that risk of loss.

All of the following: The firm sends the potential investor a lot of hard-to-digest technical written material about the product and simply asks them to confirm that they have read and understood the information. The firm then relies on this as satisfying its obligations under the appropriateness test; and the firm does not seek to establish the client’s level of understanding of the key risks and features of the product; and even though the firm concludes that a client does not have the necessary experience and knowledge in order to understand the risks involved, and has warned the client of this conclusion, it readily processes the client’s investment when the client so asks without consideration of any implications for the client.

Record keeping

The bank wishes to be able to demonstrate, if asked, that it has complied with all relevant obligations with respect to its clients. It therefore chooses to keep records of the client information it has obtained, together with the questions it asked to elicit the information, and a record of any additional information provided to the client for the purposes of the appropriateness test. The bank also keeps a note of how the information informed the determination it reached as to the client's experience and knowledge to understand the risks involved in the product. If it had needed to issue a warning to the client, it would have kept a copy of this warning too, together with any subsequent instruction from the client and any further decision taken by the bank.

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