The appropriateness test

The appropriateness test is a requirement introduced by MiFID which aims to increase investor protection in the non-advised market. Where it applies, it requires an investment firm to seek information from a client or potential client to enable the firm to determine whether the client has the knowledge and experience, to the extent appropriate to the nature of the client, service and product, to understand the risks involved in the transaction or service that is envisaged.

The appropriateness test applies to a firm that is performing MiFID (or equivalent third country) business which involves providing any of the following as an investment service with or for clients ("non-advised services"):

• receiving or transmitting orders;
• executing orders on behalf of clients;
• dealing on own account;
• underwriting; and
• placing.

Chapter 13 of the Perimeter Guidance Manual (PERG) contains further information to help you determine whether your firm is performing MiFID business and to understand what is covered by these particular investment services.

In limited circumstances, the appropriateness test also applies to non-MiFID firms and to non-MIFID instruments (including additional non-MiFID derivatives such as sports and other 'leisure' spread bets). The effect of this is that for MiFID firms the test also applies in respect of arranging or dealing in relation to a non-MiFID derivative or warrant with, or for, a retail client where the firm is aware or ought reasonably to be aware that the application or order is in response to a direct offer financial promotion. And for non-MiFID firms, the test applies to any firm that arranges or deals in relation to a derivative or a warrant (MiFID-scope or not) with, or for, a retail client where the firm is aware or ought reasonably to be aware that the application or order is in response to a direct offer financial promotion.

Outside of such direct offer business, the appropriateness test does not apply in relation to business that is not MiFID (or equivalent third country) business. So it does not apply to non-MiFID products such as insurance policies, deposits (including structured deposits) and pensions. If a firm is not doing MiFID business (i.e. it is a non-MiFID firm), the test does not apply except in respect of the direct offer business described above; although the rules allow non-MiFID firms to choose to carry out the test so that a MiFID firm can rely on this assessment (for example as part of an order chain) - see COBS 10.1.3R.

The appropriateness test also does not apply where a firm gives investment advice (referred to in our rules as ‘personal recommendations’) or provides discretionary portfolio management services. In such cases, the suitability requirements in COBS 9 apply.

There are also a number of particular circumstances when an appropriateness test is not required. We have set these out in COBS 10. For instance, existing client business could be ‘grandfathered’ - a client who has engaged in a course of dealings involving a specific type of product or service beginning before the appropriateness requirement comes into force on 1 November 2007 is presumed to have the necessary experience and knowledge in order to understand the risks involved for those specific types of product or services. In addition, an appropriateness assessment does not need to be repeated for a client if it has already been done for that product or service (for example, where the client is an existing holder of an equity ISA). However, it might still be necessary for an existing client who would like to start dealing in a different type of instrument.

There is also an exemption for certain types of ‘execution-only’ business. However, this is only available if the conditions in COBS 10.4.1R are satisfied. Some of these conditions are set out below and are considered in more detail in later Q&As:

• the service consists only of the execution and/or the reception and transmission of orders;
• the service relates only to ‘non-complex financial instruments’;
• the service is provided ‘at the initiative of the client’;
• a required warning has been provided to the client; and
• the firm complies with its obligations in relation to conflicts of interest.

While the test applies to both retail and professional clients (though not eligible counterparties), the rules allow firms to assume that professional clients have the necessary knowledge and experience to understand the risks related to the specific product or service for which they are classified as professional. Provided that a firm has categorised a professional client in line with the relevant requirements, we do not envisage it generally needing to obtain additional information from the client (or maintain additional records) for the purposes of the appropriateness test.

Not all ISAs are within MiFID scope. However, the determining factor for assessing appropriateness will be the instruments that are within the ISA wrapper. So, an ISA that invests in a MiFID financial instrument (as defined in the Handbook glossary) will be within the directive’s scope and the requirements that implement it. This includes, for example, ISAs investing in equities, bonds, unit trusts, funds, or contracts for differences; but not cash-only ISAs or ISAs investing solely in property.

The question of what is a complex or non-complex instrument may be subject to further consideration in Europe in the future.

Also see Case study 1

We give guidance on what ‘at the initiative of the client’ might mean at COBS 10.5.1G - 10.5.2G. These and other points are considered in this Q&A and case study material.

Communications that are ‘by their very nature general’ will lead to services that are ‘at the initiative of the client’. If the other conditions for providing ‘execution only’ business described above are met, those services will not trigger an appropriateness test.

In our view, such general communications include material in newspapers and magazines or on TV, radio or billboards (see COBS 10.5.3G). Other communication methods (such as websites and internet search results) might also fall into this category, but only if they are ‘by their very nature general’, which may depend on the individual circumstances. For example, unrestricted website content is likely to be by its very nature general. However, this will not necessarily be the case if the user has to log on to the website before they can use it (for example, if the user has to register for a password). That said, whether or not the content of the material accessed following the log on is personalised or not may vary from case to case.

Other methods of communication, such as mail shots, emails and mass text messages, may in practice be general but they are not ‘by their very nature general’. This is because they are directed to individuals rather than available to the public generally or to a larger group of clients. However, such communications may still result in services at the initiative of the client if they are not ‘personalised communications’.

Also see Case study 2

COBS 10.5.3G provides important guidance on personalised communications. Regardless of medium (electronic, telephone, or paper-based), we see content as the factor that will determine whether a communication should be regarded as personalised or not.

The fact that a directed communication contains the name and address of the recipient will not, on its own, be sufficient to make it personalised for the purposes of the appropriateness test. However, this may change if other elements of the communication give the impression that it has been personalised.

Also, we do not believe that the simple filtering of a mailing list will automatically make the communication 'personalised' if, for example, this is not apparent to the recipient from the content of the communication.

However, the fact that a communication does not include a name and address may not prevent it from being regarded as personalised. It will be necessary to look at the content of the communication as a whole. For example, a generic ‘flyer’ which might otherwise be non-personal could become part of a personalised communication if accompanied by a covering letter which clearly referred to the recipient’s personal circumstances.

Also the fact that the same communication has been sent to a number of target investors will not prevent it being personalised if its content has been designed to make it look as though it has been personalised.

A communication that refers to the characteristics of a group of target investors (as opposed to the individual recipient’s personal circumstances) would not necessarily be personalised. So, the nature of the communication could be affected by how its content is phrased.

MiFID makes clear that the personalised communication restriction only applies where the communication contains an invitation or is intended to influence a client about a specific financial instrument or specific transaction (see COBS 10.5.1G). So it may be possible for a service to be provided at the client’s initiative following a communication that promotes a specific service (such as an execution only dealing service) but does not make an invitation or attempt to influence the client regarding a specific transaction or financial instrument.

Also see Case study 2

In our view, it is the response to the first of a series of communications leading up to a transaction in a non-complex product that will determine whether the client has responded to a personalised communication and therefore whether an appropriateness test is required (also see COBS 10.4.2R). For example, if the original communication a client responded to was a newspaper advertisement, we would not see an appropriateness test as being triggered by any later personalised communication relating to the transaction that follows the client’s original response to that general advert.

Also see Case study 2

How the appropriateness obligations can best be integrated into a firm’s particular business model and processes will of course be for each firm to determine. You could do it online, or you may prefer to assess appropriateness face to face, over the telephone or in hard copy.

Overall, firms are likely to need processes to distinguish between ‘complex’ and ‘non-complex’ MiFID products (which may already have been done at the product design stage), whether contact with the client is at the initiative of the firm and whether the necessary warnings have been provided.

In certain cases, you may need to do little more than establish or confirm that the client is a sufficiently experienced investor in the type of product envisaged. However, we would expect an appropriateness assessment to be particularly rigorous if you were offering more complex products to less experienced clients who may be less likely to understand the risks.

You may also wish to use targeted questions designed to establish the client’s knowledge in order to understand the risks relevant to the specific type of product or transaction envisaged. Or you may seek to increase the client’s level of knowledge about a product or service through providing pertinent information to the client before assessing appropriateness. In doing so, however, a firm would of course need to avoid acting in a way that amounts to making a personal recommendation (unless it complies with the requirements in COBS 9 on suitability).

In principle, the assessment could work online; for instance a firm could use electronic application forms which automatically process clients’ answers to targeted questions to help the firm come to a decision.

In other cases, your commercial relationship with a client may mean you have sufficient information to determine their knowledge and experience in relation to the product or service without requesting further information. This is unless you are aware that the information is manifestly out of date, inaccurate or incomplete.

Also see Case study 1

Our rules (in COBS 10.2.2R) indicate what information may be relevant. This includes:

• the types of services and products with which the client is familiar;
• the nature, volume and frequency of the client’s previous transactions;
• the client’s level of education; and
• the client’s profession or former profession.

However, we do not see this as a definitive list of information-gathering requirements and do not therefore expect a simple tick-box approach to compliance from firms. Indeed, MiFID envisages that the precise components and rigour of the information gathering and assessment will vary according to the nature of the client, the nature and extent of the service to be provided and the type of product or transaction envisaged, including their complexity and the risks involved. For example, sophisticated clients or simpler, low risk products may require less rigour than inexperienced retail clients or products with higher risk profiles.

So, the types of information mentioned above should not be seen as an exhaustive list. The key thing is the objective: to determine a client’s knowledge and experience in order to understand the risks involved in relation to the product or service offered or demanded. It is open to firms to ask other relevant questions and not to gather irrelevant information. If you do not see how the client’s level of education can be used to assess an understanding of the risks involved in the product or service, there may be no need to gather this information. But you may find circumstances where the information is relevant; for example, if the client has an obviously poor level of literacy/numeracy. Their former profession could be relevant if the client is retired. Firms will need to determine what information is relevant according to the circumstances.

You may also use existing information (unless you are aware that the information is manifestly out of date, inaccurate or incomplete) without requesting more from the client if you are satisfied you have the necessary information to satisfy the appropriateness test.

Also see Case study 1

Depending on the circumstances, you may decide that the client’s knowledge alone is enough for them to understand the risks involved in a product or service. Where reasonable, you may infer knowledge from experience (see COBS 10.2.6G).

If you believe the client does not have the necessary knowledge and experience, you must warn them (COBS 10.3). If the client does not provide information, or gives insufficient information, you must warn the client that on this basis you are unable to make a determination.

If the client wishes to proceed in spite of the warning, our rules do not prohibit this. You would need to consider whether you want to proceed in the circumstances, taking into account the client, the nature of the service, the type of product or transaction envisaged, the particular risks for the client etc. You would wish to be satisfied that your chosen course was consistent with relevant general obligations under the Principles (such as the firm’s duty to pay due regard to the interests of its customers and treat them fairly) or, for example, the general COBS duty that a firm must act honestly, fairly and professionally in accordance with the best interests of its client (COBS 2.1.1R).

MiFID Connect has developed examples of possible wording that you might consider using when warning clients in these circumstances.

Also see Case study 1

It is up to you to decide when to assess appropriateness in the sales process. So, a firm may carry out the test at any point before providing the service (e.g. before executing the transaction). What is key is that doing so is in the best interests of the client and that the desired outcome is achieved: to determine a client’s knowledge and experience in order to understand the risks involved in relation to the product or service offered or demanded.