The regulatory trend is only in one direction. Consumer
protection and enhanced disclosures. Mis-selling and mis-allocation are the
most often complained incidents observed by SFC. It is imminent that SFC is
going to come down heavily on such violations. It is better to take corrective
actions now. How to do that? Where to begin?
Regular and comprehensive due diligence is the key. The
Suitability Obligations (SO) apply both to solicitation and recommendation.
Generally, when a licensed person tries to sell its services either to existing
or prospective customer that is treated as solicitation. While a recommendation
happens when someone asks for something and the licensed person gives
suggestion in response.
The prerequisite to comply with SO for solicitation or
recommendation is to take steps or seek answers to the following queries:
1. Do I know the client? Do I understand the risk appetite of the
client?
The due
diligence of the client is an important and necessary step. The licensee should
ask for certain specific details on the client’s financial situation and
investment experience through a questionnaire. These questions should cover information
on income, savings, past investments, current investments, liquidity needs and
the timing, ability to bear financial loss and margin calls, one time or
regular investment preference, etc. It is suggested to collect supporting
documents on the assertions made by a client on her financial situation and
investment experience. It is also necessary to keep record for internal as well
as external audit that the licensed person understands the needs of the client.
The
information given by the client will help in evaluating the risk appetite of
the client and should be used to develop a conservative risk profile and the
possible investment portfolio. At the same time, it is important for the
licensed person to document the holistic assessment as to the accuracy and
currency of the information provided by the client. In case, there are doubts
either on the accuracy or currency or both, then further clarifications should
be taken before finalizing the investment portfolio. And this is critical. The
licensed person’s assessment should show an application of mind as a trained
person to the information provided. If there is no application of mind, the
whole exercise of conducting the due diligence on the client can be termed by
the regulator or the court as an exercise in deception.
2. Do I understand the technical features of the portfolio of
products proposed for the client?
Financial
markets are in a constant state of flux. Therefore, it is of paramount
importance to understand the impact of change in market conditions on a product
in an investment portfolio. Though this is difficult to foresee but the aim of
the due diligence is to evaluate variation in return / asset value with change
in market conditions. This is like a stress test. Therefore, due diligence of a product shall
cover a thorough analysis on the basis of the documentation provided by the
issuer, other third party recommendations on the same product, seeking
clarifications from the issuer and research houses and own analysis on the product
by the licensed person. Own analysis of the product is a critical factor.
Reasonableness of the assumptions have to be analyzed and, if necessary,
scenario analysis shall be conducted on revised assumptions. Further, the
investment climate might have changed since the issuance of the product due to
other economic and political factors which may have an impact on the returns
from it. Therefore, assessment whether a product will meet the needs of the
client has to be done on client specific situation and as and when solicitation
or recommendation is made. It is advisable to have a product approval committee
to approve licensed person’s portfolio of products. Further, the product
approval committee shall also set parameters for nature of further assessment
that needs to be done to determine suitability of a product for a client. An
audit trail shall be maintained for product approval.
3. Have I done a matching of the needs of the client and the features
of the products proposed for the client?
One prudent
approach for matching client profile and the investment risk is to select
portfolio of products on the basis of modern portfolio theory. The weight of
different securities in the portfolio can be determined on the basis of the
risk profile of the client. Such a portfolio, apart from being diversified,
will also be lower in risk. It is easier to defend such a portfolio as it will
be subject to broadly systematic risk and lower product specific risk. This
approach should be used in case of discretionary portfolio management with a
mandate. Even in other situations, it should be possible to suggest product on
the basis of efficient frontier.
4. Have I given sufficient information on the product and the
investment environment to enable the client to make a decision?
It is
necessary to give to the client the relevant literature and the risk-return
profile of the proposed product portfolio. Along with the product literature,
the client should also be given information on the portfolio construction,
diversification, and reduction of risk by diversification etc. as a support for
the selection of the portfolio vis-à-vis the risk profile of the client as
determined by the licensed person. Further, a realistic assessment of the
likely market scenarios during the investment horizon of the client and the
risk profile of the client should be shared.
Transactions
to build the portfolio should be undertaken only after sufficient time to
consider the information to assess its suitability and to seek clarification,
if any, has been given to the client. The trail of communication with the
client should be appropriately documented for any future audit purposes.
5. Have I been trained on conducting due diligence on clients and
understand the technicalities of the products?
Licensed
persons are advised to look into the existing training program and make a
judgement whether it is sufficient to meet the obligations imposed on them.
This should also be evaluated in the light of the new requirement of
identifying Manager In-Charge (MIC). Whosoever is identified as MIC will carry
heavy burden to prove the sufficiency of the training to meet the Suitability
Obligations. However, in my view, this is an area which goes beyond training.
This requires a relook at the transaction life-cycle from solicitation /
recommendation to transaction to product approval to close all the gaps, if
any.
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