SCARPs, sometimes referred to as 'precipice bonds', are products which typically offer consumers a high rate of return over a fixed investment period, commonly three to five years. The return of the initial capital invested at the end of the fixed period is determined by a formula based on the performance of an equity index, a combination of indices or a 'basket' of selected stocks.
The customer is therefore exposed to a range of outcomes in relation to the return of their initial capital sum. In addition, the amount of initial capital repaid may be 'geared ' e.g. consumers may lose 2% of their capital for every 1% fall in the market past a certain level – this is the ‘precipice’ element.
If the index/indices perform within certain thresholds, full repayment of the capital invested occurs (in addition to the income or growth on the capital). However, if the performance is outside these thresholds consumers could lose a substantial part, or even all, of the capital they invested.
Around 450,000 of these products were sold between April 1997 and February 2004, with most being sold from 1999 to 2002. Roughly 80% of all sales were by 'direct offer ' i.e. consumers received a financial promotion and invested their capital as a result of that promotion, without benefiting from advice from a financial adviser.
Our work established that the average individual investment was £16,000 and many consumers invested in more than one SCARP. Our work also established that SCARPs were often sold to consumers over the age of 60, often to generate income to supplement their pension.
In common with other stock market related products, many SCARPs have suffered capital losses in recent years. The FTSE 100 dropped from its peak of 6930 in December 1999 to the trough in March 2003 of 3230, a drop of 53%. The Eurostoxx-50 fell 63% from February 2000 to March 2003. The majority of SCARPs were linked to one of these indices, so any investment running over this period was likely to result in the consumer suffering a reduction in the capital returned. SCARPs that matured in 2003 and 2004 bore the brunt of these large falls.
From April 1997 to February 2004, £7.3 billion was invested in SCARPs. As at February 2004 we estimated that if the income on these products is taken into account (usually over 10%) the total returned to consumers is roughly the same as the amount invested i.e. £7.3 billion, based on all matured values and projected capital losses. The picture varies significantly across different products, so some products show a loss even after income is taken into account.
The gearing associated with some SCARPs means that some bonds have seen much larger losses than the equivalent fall in the market. From 2003 onward we have seen fewer products which include this gearing element. Bonds that are maturing now are likely to show either lower or no loss because consumers who bought bonds later did so when the market had already fallen. In addition, the later products tend to have greater downside protection.
Poor market performance is not an indication of mis-selling. However, we were concerned by reports that consumers had been sold these products without being made aware of the risks involved.
Our overall approach to regulating the sale of these products to retail investors has been based on the following elements:
- As the Financial Services and Markets Act (FSMA) makes clear, the senior management of regulated firms is responsible for carrying out the firm’s business in line with regulatory requirements, including treating their customers fairly.
- Regulatory requirements in these circumstances include the need for financial promotions to be clear, fair and not misleading.
- Where advice is given on the products, it should be suitable, taking into account the investor’s circumstances and risk appetite.
- The FSA is not a product regulator except in certain circumstances outlined in FSMA or under some EU regulations.
Consumers
Reflecting concern that consumers were purchasing SCARPs in search of higher returns, without fully understanding the risks associated with these products, we took a number of steps to warn consumers.
In December 1999 we issued a warning on our website 'High income products: Make sure you understand the risks', drawing specific attention to our concern that consumers needed to understand that their capital may be at risk. We backed this up with a press release aimed at encouraging the personal finance press to raise concerns about these products.
We followed this with a consumer factsheet 'High income products: Make sure you understand the risks' in February 2000 and issued further alerts in March 2001, August 2001 August 2002 and December 2002. On each occasion, these were accompanied by press releases which generated further warnings in the key media.
Firms
Guidance was issued to firms relating to SCARPs both by the Personal Investment Authority (PIA – one of the predecessor regulators) and the FSA. In Regulatory Update 85 (RU85) issued in March 2001, the PIA said that investment products were increasingly using financial instruments which are ‘less familiar to ordinary investors’. It said it was therefore important that ‘the structure of these products and the risks involved are carefully explained to customers before they commit themselves.’ RU85 also made it clear that customers should be given an adequate explanation of the product and its risks and that these should be explained in language that the customer is likely to understand.
We further emphasised these reminders and warnings in February 2003 by issuing FSA Guidance Note 7 (which was issued under an expedited procedure). This Guidance Note required firms to send relevant investors our factsheet 'High income products: Make sure you understand the risks' and to ensure that investors were given periodic information about the performance of their investment.
In December 2003, we established a central team to coordinate the work carried out across the FSA. The team developed the strategy for addressing the concerns identified, based on the need to develop an efficient and effective package of measures that took account of the likely costs and benefits that would result.
The team's considerations were based on a number of factors, including the scale of the problem, nature of the products involved, average loss per consumer, nature of the consumers affected, clarity of the mis-selling issue and the wider implications of redress.
A significant amount of information had been published about the risks associated with these products. However, the complaints being generated indicated some people had not understood the risks they were taking.
So the team devised a strategy to focus mainly on the major product providers and distributors. We contacted the providers to identify the number of different products available, the volumes of products sold and the potential liabilities of each product. We also asked who the biggest distributors or sellers of these products were.
The team then reviewed the sales and complaints of over 150 distributor firms. The top 25 firms accounted for 43% of total sales. We reviewed all these firms along with other significant sellers, or firms who had received a large number of complaints and/or had a significant number of complaints upheld by the FOS. In addition, we reviewed a number of smaller IFAs to ensure that we had sampled the whole of the market. We reviewed over 100 promotions, including those relating to the period when most SCARPs were sold and more recent promotions.
All the promotions reviewed contained a warning that capital was at risk and the vast majority of promotions were consistent with the standards in place at the time. Our work on direct offer promotions did lead to action against two firms: The FSA fined Chase de Vere and issued a private warning to another firm, for issuing a misleading direct offer financial promotion.
The team reviewed the quality of the sales process where consumers had received advice. We found some instances of mis-selling where it was neither evident that the product was suitable for the consumer; nor that the risks of the product had been explained; nor that other products had been considered.
We also reviewed the quality of firms' complaint handling. Again, we found some instances where the firm had failed to review the complaint adequately, or had rejected complaints even though the evidence on file did not support a rejection.
Our work focusing on SCARPs sales advice and complaints handling has led to three firms being fined; Lloyds TSB, Capita Trust Company and Bradford & Bingley. One firm, David M Aaron Ltd, was also banned from trading.
Redress of approximately £125 million has already been paid by firms with the Financial Services Compensation Scheme (FSCS) paying £9 million redress on SCARPs cases. A further £25 million is anticipated from firms.
We are interested to learn about how we might best anticipate and prevent such mis-selling from happening in the future and how we can deal better with any similar incidences that arise. We will be carrying out a review of the SCARPs project for internal purposes, but some of the things we are already doing following from the SCARPs project are:
- Giving greater priority to work to spot new and emerging risks, such as new products, or significant increases in sales of particular products. We have established a new team to take this work forward for us.
- Putting more emphasis on the quality of financial promotions. We now have a dedicated department responsible for financial promotions, with an emphasis on early identification of issues so we can prevent problems occurring.
- Improving complaint handling in firms. Complaint handling is a theme for our work on Treating Customers Fairly. We want to see an improvement in complaint handling and will encourage senior management to learn from the complaints they receive.
