What does caveat emptor mean in the retail market for financial services?

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Callum McCarthy

Speech by Callum McCarthy, Chairman, FSA
Financial Services Forum
9 February 2006

Most times when I talk about FSA issues, I try – with varying degrees of success – to set out FSA policies, either clearly defined or emerging thinking. This evening, I intend to do something different, namely to explore an issue on which there is no agreement, namely the role of consumer responsibility in retail financial markets. There are a range of – important – questions under this heading. What should caveat emptor mean in the retail market for financial services? What is the meaning of consumer responsibilities? What should we expect of a responsible consumer? Does the consumer have responsibilities as well as rights? And if he or she fails to discharge those responsibilities, does he or she lose or weaken those rights?

These questions give rise to strong views, and very different answers, from different market participants. The questions, for all their apparent simplicity, raise issues which are complex. I am not surprised that there has not been complete agreement on aspects of these issues between our Consumer and Practitioner Panels in their debates on the issues, though the debate has been helpful in arriving at a more informed and thoughtful level of disagreement than occurred before – as well as some areas of agreement. Many of the points I'll be making this evening are drawn from those discussions.

Let me start by explaining why I think we need to make progress in our thinking on these issues. I start with an approach to regulation of any market activity with the belief that the best results – for both customers and providers of goods and services – are obtained by markets which work efficiently, not by regulation; that when markets do not operate efficiently, the first effort should be to improve their efficiency rather than to regulate them; and that regulation should be used only when there is both market failure and the prospect that regulatory intervention will produce benefits which outweigh the costs of that regulation. I would add that it is important to concentrate on the efficiency and effectiveness of any market, not on the existence of that near myth, "the perfect market". There are many effective markets which are clearly not perfect.

The difficulties in the retail market for financial services are well known. Many financial products are complex; they are bought infrequently; they have long duration, and the time between making a decision and finding out whether it has been a good decision is therefore protracted; and that decision involves an understanding both of the reward and of the risks involved – neither of which may be easy to assess. There is very often a massive imbalance between the knowledge of the vendor and that of the purchaser of the financial service – the information asymmetry problem.

Faced with these difficulties, there are various reactions. Some – I believe misguidedly – argue that these problems are so intractable that we should abandon the reliance on the market for retail financial products. Exactly what they would replace it with is unclear, as is how they believe they would provide incentives for profit seeking firms to provide the services, still less to invest in innovation. I suppose it is possible to envisage a world of heavily regulated and price controlled retail financial services – but it is not a world I would wish to live in, as consumer, provider or regulator of financial services.

Instead, I am concerned with how to make the market operate effectively: how to incentivise providers of retail financial services to act responsibly; how to ensure information that is useful is provided in an accessible and understandable form; and how to incentivise prospective customers to engage in the purchasing decision in a way that recognises the importance of that decision, and provides the dynamic needed to produce an adaptive market.

The statutory framework

So much by way of background. What is the statutory position? The Financial Services and Markets Act (FSMA) 2000 establishes "the protection of consumers" as one of the FSA's four statutory objectives. But it does not provide protection that is "absolute" or "all-encompassing" – for as FSMA further insists, regulatory protection of the consumer should be "appropriate". Specifically, FSMA directs that in assessing what protection is appropriate, the FSA must have regard to "the general principle that consumers should take responsibility for their decisions". After all, consumers can be disappointed with their experience of a service or product, but this is very likely to be the result of risk inherent in financial markets, such as movements in market prices. Were the FSA to aim to relieve consumers of all adverse consequences, an environment would be created in which they no longer needed to weigh up the reasonableness of their financial decisions. No market can work effectively without involved customers. To relieve consumers of retail financial services of the consequences of their actions would destroy this as an effective market.

Consumer responsibility is therefore vital to the effectiveness of financial markets (as indeed it is for all markets). This, however, is not to say that they must always bear such responsibility regardless of what was said or done to them by the seller. That view may have prevailed once, but the trend over 250 years of English law has been away from "caveat emptor". Case law and consumer legislation have spelled out with growing clarity that particular acts or omissions by sellers will reduce the buyers’ responsibility for an unhappy outcome.

In addition to this broad legal basis for qualified consumer responsibility, FSMA goes further in recognising that, for financial services, it is only reasonable to expect consumers to exercise responsibility for their decisions if we accept and address some of the inherent difficulties in the market. Specifically, FSMA states that appropriate consumer protection must have regard not only to the principle of consumer responsibility, but also to:

the needs that consumers may have for advice and accurate information;
the differing degrees of experience and expertise that consumers may have in relation to different kinds of products or services;
the differing degrees of risk involved in investments or other transactions.

So how do we in the FSA reflect these requirements of FSMA when designing our regulatory framework?

Consumer protection

To answer this, allow me first to pick out relevant elements of that framework:

we require firms to Treat Customers Fairly – this is one of eleven high level principles that we apply to all regulated firms;
we support this and our other principles with rules and guidance setting out the standards we expect firms to observe;
we require firms to pay due regard to the information needs of clients and communicate information to them which is clear, fair and not misleading;
we assess and challenge firms’ compliance with our principles and requirements – our supervision and, if necessary, enforcement work aims to address serious detriment to markets or consumers;
we rely first on the firms themselves – either voluntarily or as a result of disciplinary action by the FSA – and then on the Financial Ombudsman Service and Financial Services Compensation Scheme to provide protection to those who may have suffered detriment from unfair treatment or from firms’ insolvency;
we support consumers through pursuit of our public awareness objective – market efficiency is heavily determined by the extent to which consumers are able to exercise informed choice; so we and our partners are pursuing a national strategy to help ensure that consumers are, over time, better able to take responsibility for their financial affairs.

Let me now consider the above elements from the particular perspective of what FSMA says about consumer responsibility.

To repeat, FSMA envisages that consumers often need some regulatory help in making the decisions which they take, and that some consumers will need more help than others, while some products will need to be bought with more assistance than others. So our regime is not uniform across the full spectrum of the retail market. Such uniformity would go against FSMA's insistence on "appropriateness" and would also be an inefficient use of our finite resources. Instead, we provide differing levels of protection in respect of various classes of consumer and types of product.

For example, we at present in practice prohibit firms from marketing certain products which we have determined to be high risk products directly to the mass market and restrict the number of consumers who have the opportunity to buy these products. Such opportunity is instead confined to clients who are willing and able to classify themselves justifiably as experienced "non-retail" investors. But as such, they do not need any additional regulatory protection, and this category of investors is not, for example, included in the scope of the FOS. On the other hand, what have been considered lower risk products have very little regulatory prescription around their sale or the information provided about them, so the purchase decision is unassisted and very much consumers' own responsibility.

I confess to considerable doubts about the analysis which underpins this differentiation. I am clear here, as elsewhere, that we should require information about a product to be clear, fair and not misleading; and that the general principles of Treating Customers Fairly and Know Your Customer should apply. But I am uneasy about the FSA, or any other regulator, decreeing that a particular product should not be sold to the retail market. Derivatives illustrate the point. We at present, insofar as we are able, prevent their direct distribution to the mass market. (I say, insofar as we are able, because they legally can be distributed electronically from EU member states which take a more relaxed stance; and many intermediaries invest in derivatives, or in hedge funds which extensively use derivatives, so that indirect investment is possible.) But I find it hard to justify why, when we allow other asset classes which include examples of products of a complexity which (although less mathematical than derivatives) is probably as great, and with risks as great, we should prohibit this asset class. The FSA is not and cannot be in the game of assessing, ex ante, all products for risk, return and suitability, and I have reservations about those occasions when we do so.

I do see more of a case for our helping firms identify the particular risks they should consider when assessing suitability, or should describe to prospective customers. For example, equity release products can be of value in a society of wide home ownership, but they involve risks that consumers need to understand and consider very carefully. We have established rules that specify in detail the things the firm should consider in assessing the potential suitability of the product for the consumer – life expectancy, future plans and needs, intentions for their estate – and we also require the firm to disclose specified key information about the product at various points in the advice and sales process. But this is very different from prohibition of the product. Even here, there is an argument as to whether specific rules are justified, or whether we should rely, as elsewhere, on general principles.

So to sum up so far:

from the perspective of general law and FSMA, both firms and consumers bear a responsibility for successful and effective dealing with one another;
the regulatory framework imposes requirements on firms and challenges breaches;
the extent of regulatory intervention varies in a mostly proportionate way across different parts of the market;
we help consumers to varying degrees to help themselves.

Industry and consumer views

We believe that this approach and its foundation in FSMA provide a coherent high-level approach to consumer responsibility. However, we also recognise that it’s not always easy to specify what exactly consumers can and should be doing when they buy. So we invited the Consumer Panel and Practitioner Panel to debate this in the context of an advised sale of an investment product and to draw up a more consolidated perspective on firm and consumer responsibilities that might serve as "standing advice" to the FSA and be useful to other stakeholders.

I am grateful to the Panels for the work they put into this and should like to summarize some of the key outcomes.

First, there was substantial agreement between the Panels on the nature of firms' responsibilities. This was perhaps unsurprising, given that many of these responsibilities are reflected in our handbook and have in most cases been consulted upon. What was gratifying, however, was that there were several things that the FSA does not prescribe in detail, but which both Panels agreed were important responsibilities of firms that contribute to the fair treatment of consumers in an advised sale of an investment.

For example, they agreed that firms should:

take into account, when designing products, the broad needs, capabilities and risk appetites of the general types of consumers to whom the product is targeted;
make clear to their own sales staff, and to others who distribute their products, the category and risk appetite of consumers for which the products have been designed;
avoid remunerating staff or intermediaries in ways likely to result in pressurised or unsuitable sales;
take particular care when they are aware they are dealing with those of limited financial capability or experience; and
provide adequate opportunity for the customer to ask their own questions.

There was also a high level of agreement about what it was sensible for consumers to do to protect their own best interests when potentially making a financial decision during an advised sale. This included to:

read advertisements and other material, particularly that required by regulation, carefully and with reasonable caution, being alert to offers that seem too good to be true and being clear as to the commitment they are taking on;
engage, with appropriate assistance from the firm, actively and attentively in the fact finding process;
provide openly, and as accurately as they can, material facts and attitudinal information as the adviser requests;
ask questions where they feel uncertain, including about the purpose and risks of the products and services recommended;
read and reflect upon the suitability letter and statement of demands and needs provided by the firm to ensure that it properly reflects the discussion;
make the most of the protection provided by the right to cancel the purchase during any "cooling off" period;
continue to review their financial needs and position on a regular basis and to consider obtaining further advice where there has been a material change in personal circumstances; and
complain to a firm and seek redress where they believe they have not been fairly treated at any stage in the process, and, if necessary, go to the FOS or courts.

The Panels agreed that if consumers do all these things, then they will have maximised their chances of:

making a good decision that is in their own best interests;
protecting themselves against any improper or poor quality behaviour by the firm; and
putting themselves in a position to tell as good and persuasive an account as possible of their own actions and thoughtfulness to a court or ombudsman, should any dispute over the transaction go that far.

The difficulty of assigning consumer responsibilities

Where this consensus began to fray, however, was when the Panels considered:

whether what were considered sensible consumer actions could or should be described as responsibilities for the consumer; and
the consequences if a consumer fails to do these things.

In particular, practitioners wanted to designate the suggested consumer actions as "responsibilities", in order to convey a greater sense of symmetry between firms' behaviour and that of consumers. This reflected these practitioners' perception that many unhappy transactions reflected at least an element of "mis-buying" as well as mis-selling but that regulatory "blame" only attached to the firms' shortcomings. So they wished, by designating consumer "responsibilities", to establish a world in which any failings by the consumer were taken into account on those occasions when things go wrong, such that any redress (or regulatory action) against the firm was suitably reduced - ie the blame was shared.

Against this, the Consumer Panel suggested that consumers did not have "responsibilities" in the same sense firms had, because regulation did not apply to consumers and could not impose requirements on them. Moreover, they believed that any implication of symmetry would, in any case, be inappropriate because of the "real world" imbalance in power and knowledge between firms and consumers.

Sadly, it became increasingly clear that it was simply not possible to provide a summary that both Panels would support.

Let me attempt to set out the position as I see it.

if a firm fulfils all its obligations and treats the customer fairly, then even if the transaction turns out to be a disappointment to the consumer this should not be blamed upon the firm, whatever the consumer may or may not have done. It is important that this should be the case. Were it not, the fear of unpreventable liabilities would deter firms from classes of business – to the detriment of the customers of those classes of business.
the absence of reasonable care on the part of the customer is relevant. The courts have often accepted various arguments from firms that customers have displayed "contributory negligence" because, for example: they withheld important or provided inaccurate information; omitted to read product particulars or implement fully a package of interrelated investment proposals; or failed to take into account relevant advice simultaneously being received from other professional advisers, such as accountants or lawyers. As features of the law, these are things to which the Financial Ombudsman Service must also have regard. And indeed, FOS does frequently accept similar arguments and evidence as fair and reasonable in the particular circumstances of the case, and so rejects the consumer's investment complaint. They are things to which consumers should also have regard. Put simply, they can act in ways which reduce or eliminate the protection they can otherwise expect from the FSA, FOS or courts.
On the other hand, in a strictly legal sense, consumer actions are not prescribed or codified anywhere and so cannot legally be described as "responsibilities". We will, of course, have regard to what FSMA says about consumer responsibility in discharging our own FSA responsibilities.
FOS, like the courts, has to take into account the circumstances of any case, so that an attempt to shift responsibility to the consumer on the simple basis, for example, that he or she had not read the written contract will often prove simplistic. In practice - and particularly in the context of disputes - the actual "contract in force" may be complex to assess, as it potentially also includes written or verbal promises or representations made outside the formal contract, or terms implied into the contract by the courts. So whether or not the consumer has read a contract will often not be the decisive or determining question in assessing liability.

Conclusion

From this, you will perhaps see why the Consumer and Practitioner Panels failed to agree on certain matters – which leaves me free to express some views of my own.

I go back to my starting point: a belief in market solutions as the best solution, and a wish to concentrate on making markets work effectively. I am concerned to see a retail market for financial services in which there are informed and responsible customers; information that is, as well as clear, fair and not misleading, accessible and accessed; and providers who treat their customers fairly. What I do not want to see is a system where we demand more and more data to be provided to prospective customers without evidence that those data are accessed and used. That would have deeply undesirable results: the obvious result that, by pushing up the costs of providing financial services, the business which would remain profitable would be increasingly confined to higher net worth customers, with all the problems of social exclusion exacerbated. But there are other, less obvious consequences. An emphasis on the duty of the financial provider to furnish information can run completely counter to consumer protection unless it is accompanied by a sense of what is useful to and used by the prospective customer. The US prospectus requirements illustrate only too clearly the dangers of this: massive, largely boiler plate amounts of data; arguably little information as to the real risks; certainly extensive protection for the issuer, but very doubtful protection for the investor. I would find it hard to argue for further information requirements unless there is evidence of information actually being used. Indeed, were it clear that information was not being used, I would worry about requiring it at all.

The FSA has placed – and continues to place – great emphasis on the need for firms and advisers to treat their customers fairly. I am sure we are right to do so. But I would also like to see a greater sense of how consumers can best make use of the better information now being made available to them through, for example, key facts indicators. If, as I hope, we make the information available to consumers clearer, less jargon ridden, and shorter, the onus on them to consider it carefully grows. And the more they use it, the more strong will become the argument for requiring that information. So I hope that both Consumer and Practitioner Panel can agree on the need to encourage much greater involvement by consumers. In a strictly non legal, but nevertheless important, sense, consumers have responsibilities. And they certainly have a self interest in discharging them.

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