Failings and foreseeability

FSA claims second wealth management scalp in two weeks

On 8 November, the FSA fined Coutts & Company ("Coutts") £6.3m for advice and compliance failings relating to the sale of the AIG Enhanced Variable Rate Fund ("the Fund"). This followed on from the 25 October fine of £5.95m of Credit Suisse’s private bank for the misselling of SCARPs.

The FSA found that Coutts, facing complaints by 427 high net worth customers who had invested in the Fund between December 2003 and September 2008, had breached Principle 9 of the FSA’s Principles for Business in failing to take reasonable care to ensure the suitability of its advice and discretionary decisions.

Main heads of criticism

Risk assessment and diversification

• There was a lack of precision about the risk the client was assuming, with Coutts advising that the Fund was a cash fund invested in money market instruments, akin to a bank or building society account. In fact, a material proportion of the Fund was invested in complex non-cash assets with longer maturity dates than money market assets. Customers should have been advised that this exposed them to higher capital and liquidity risk and suitability letters should have highlighted and explained the risks as well as the benefits of the Fund in a balanced way.
• The product recommended did not match the customer’s attitude to risk. In particular, Coutts’ advisers should have drawn customers’ attention to any apparent mismatch in investment objectives i.e. where customers sought high levels of return but had a limited appetite for investment risk.
• There was an inappropriate lack of diversification of investments. Many customers were advised to invest a large proportion of their total investible assets in the Fund leading to overexposure to risks associated with a single fund provider and the risk of the Fund failing to be able to meet withdrawal requests because of the long dated nature of some of its assets.

Inadequate sales process

• There was a failure to provide appropriate training for advisers as to the nature of the products being sold. Coutts relied on its advisers to actively seek out information themselves as to the features and risks of the Fund and did not give product specific guidance. This would have enabled advisers to understand the detailed but important characteristics of the Fund, adequately explain the associated risks to customers and identify when other suitable Coutts’ products should be recommended instead.
• Sales documentation was held to be inaccurate in relation to its description of the product in question and the associated risks, and, importantly, to ensure that sales documentation and advice given was updated to reflect any change in market conditions.

Failure to respond to changing market conditions

• The FSA accepted that Coutts had initiated discussions with the Fund provider, a subsidiary of AIG, in response to the changing market conditions in 2007, taking comfort from the decision to increase the overall cash composition of the Fund. Coutts had also investigated and reconfirmed the ringfencing of customer investments in the Fund from the financial position of AIG, notifying sales advisers of this.
• The FSA held, however, that these actions, although appropriate, were an insufficient response to the risks to Fund which Coutts had identified. Coutts did not properly explain the risks or their impact to its advisers, to ensure that advisers were in a position to take their new risks into account when advising new or existing customers.

Failure to respond to and address staff concerns

• Coutts did not carry out a review of past sales to determine whether risks had been highlighted to customers until after the suspension of the Fund, or ensure that its advisers understood that the Fund was not like a fund that invested in short term, highly rated government debt, despite the fact that these issues were flagged by members of staff as being of concern prior to that date.

Failure to undertake and quickly complete an effective compliance review following suspension of the Fund and complaints by customers

• Although a compliance review was undertaken by Coutts between 2008 and 2009, it did not adequately address suitability and disclosure failures by Coutts’ advisers, was based on a poor quality checklist and was slow.

A point of interest - foreseeability

The FSA considered that Coutts failed to respond adequately to the changing market conditions in late 2007 and 2008 when there was a greater risk of the Fund suspending redemptions and customers suffering a loss and what that meant for the advice they had given, and were continuing to give to their customers. Not only did Coutts fail to ensure that its advisers stopped selling the Fund or were in a position to explain any increase in risk adequately to new investors, they failed to ensure that an adequate explanation of the risks was given to existing customers as those risks evolved or became apparent.

It is interesting to consider in this context whether Coutts should have predicted the run on the Fund. The FSA’s reasoning does not quite go this far but such an implication could be read into the sub-text. In the recent case of Rubenstein v HSBC [2011] EWCA 2304, also concerning the sale of the Fund, the court did not consider whether HSBC had a specific duty to respond appropriately to changing market conditions. Although HSBC was held to have been negligent when advising Mr Rubinstein that the Fund was akin to cash, it ultimately avoided liability for his losses on the basis that those losses had been incurred following a run on the fund which was not foreseeable. The court held that the substantial withdrawals of investor funds in the wake of the Lehman collapse based on the rumour that AIG was also going to go bankrupt, was "so remote that no financial adviser would have been required to point it out as posing a risk to capital". No doubt, these foreseeability issues will be revisited in the barrage of civil claims Coutts is likely to face on the back of its fine.

Solutions

Not all the messages in Credit Suisse and Coutts are novel. Both actions highlight the perennial problem of adequate record keeping as the private wealth industry’s Achilles heel. There is little point in giving the right advice if it cannot be proven when the FSA conducts a file review. In addition, although there may be a natural tendency to avoid highlighting the downsides, careful analysis at the point of sale of the suitability of a product, and, crucially, its level of concentration in the portfolio, is a constant challenge. Neither of these issues are likely to ever be perfectly resolved but given the FSA’s searchlight on the industry, private banks and wealth managers should be working with their legal advisers now to spot the flaws in their own processes in order to remedy them.

Lawyers Laurence Lieberman, Julie Simpson Day