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Categorising Investment Advisors within an RDR Framework

Posted on 26 July 2018   

The FSCA published a discussion document on investment related matters in June 2018 and has asked industry for input in response to their thinking and proposals by 17 August 2018


­­­­In the first issue of this series, we had a look at the FSCA’s thinking about the different types of activities that discretionary financial services providers perform and how these could, potentially, be separated into different licence categories with a set of fit and proper requirements for each.

In this article we discuss the FSCA’s proposed approach to categorising investment advisors within an RDR framework.

In the initial RDR Discussion Document which was published in 2014, it was a clear objective of the Regulator to ensure that financial services customers are able to clearly understand what services are being provided by the advisor with whom they are dealing and in which capacity the advisor is acting (i.e. the nature of the relationship between the advisor and one or more product suppliers). In order to achieve this objective and address the risk of conflicted advice, the 2016 RDR Status Update confirmed that the Regulator was in favour of a two-tier advisor categorisation model, made up of:

  • Product Supplier Agents (PSAs); and
  • Registered Financial Advisors (RFAs).

It was very clear that an entity will not be allowed to operate as both a PSA and an RFA and will have to decide between the two. There are very clear implications/consequences that come with each designation, and it is therefore really important for advisors to understand and consider these in the set-up of their business models. We have summarised what it means to be a PSA in Figure 1.

Figure 1

In previous RDR Status Updates, the Regulator has questioned whether an investment advisor should be regarded as a PSA of an investment manager (currently a Category II FSP). However, if this approach were to be followed, then there are some regulatory challenges which would first have to be overcome. Currently, to be defined as a PSA, certain things need to be in place – there must be:

  1. a product supplier,
  2. an agent appointed to act as advisor for that product supplier, and
  3. financial products of that product supplier in respect of which the agent provides advice.

However, the first stumbling block is that neither a Category II nor a Category III FSP is a product supplier. They are regarded as intermediaries. The second stumbling block is that an “investment portfolio” (in the case of Category II) is not a financial product, while the bulking and platform services that Category III FSPs (LISPs) provide are also not defined as a financial product. So, if the regulators wish to apply the PSA definition to the investment sector, there needs to be some changes, with a few of these options being:

  1. Change the definition of PSA to include an “agent of a financial services provider” which will mean that an advisor who is acting as an agent of a Category II FSP can fall into the definition of a PSA;
  2. Change the definition of “advice” in the FAIS Act to include “advice on financial services”; or
  3. Change the definition of “financial product” to include “investment portfolios”.

Although there are a few challenges with each of these options, what is clear is that the FSCA is set on applying the PSA categorisation to the investment sector to address the objectives and risks which we set out above. This may have implications for FSPs such as Category II FSPs which either have an advice licence (Category I) combined with the Category II licence, or where they have set up a separate Category I FSP to provide advice on the investment portfolios or funds that it manages.

What does this mean for investment advisors?

For purposes of this section, let’s assume that an investment portfolio will fall into the definition of a “financial product”. That would mean that where an entity, for example a Category II FSP, has advisors acting as its agents (either through its own advice licence or through its own PSA entity) those advisors will be restricted to offering the products and services of that entity. In addition, since the Category II FSP, in this example, will be a product supplier with an advice licence too, it will then also be responsible for the advice which is given by those advisors.

It is possible for a financial group (whether large or small) to have both a PSA channel as well as have ownership in an RFA entity. However, where an investment manager or product supplier has some ownership interest in an RFA, to ensure transparency and fair customer outcomes, the FSCA will closely monitor the extent to which the RFA advisors promote the investment solutions of the investment Category II manager in its group. Category II FSPs that have set up separate Category I licences and wish for these Category I licences to operate as RFAs will have to be very careful to ensure that (1) there is no bias by those advisors towards its investment solutions, (2) there are no production targets and (3) there are no additional fees or benefits payable to the Category I advisor. In addition, they will likely have to report to the FSCA on the percentage of business placed with the Category II FSP in the group.

What are the implications for outsourced investment management arrangements by a CIS Management Company (CIS Manco)?

In previous RDR publications, the Regulator made it clear that it intended to prohibit a CIS Manco from outsourcing its investment management activities to an FSP that is also authorised for advice. The FSCA has now stated that it no longer intends to prohibit these arrangements but is still looking to introduce measures to mitigate the risks to customers. Some of the proposed measures are as follows:

  1. It needs to be clear that the investment manager acts as the agent of the CIS Manco, specifically in relation to the investment management activities, but not in relation to the advice provided. Obviously, this can be different if the CIS Manco specifically enters into an agreement to appoint a PSA to provide investment advice as its agent, which could include appointing the investment manager that also has a Category I licence, to act as its PSA in relation to the co-branded portfolios concerned.
  2. A CIS Manco will only be able to enter into an outsourced investment management arrangement with an FSP that is categorised as an “investment manager” (see the previous article). This would mean that any current Category II FSP that performs the activities of a “model portfolio provider”, for example, and does not fall into the proposed definition of “investment manager”, would no longer be able to act as an outsourced investment manager for a CIS Manco. This could impact the business model and remuneration structures of these types of FSPs.
  3. The CIS Manco will retain full responsibility (which will also extend to any LISP in respect of the co-branded third-party portfolios) for governance and oversight, operational requirements and data sharing requirements of the management functions performed by the FSP.

What happens if a PSA does not have a LISP and/or a life licence in the group?

One of the consequences of being designated as a PSA is that a PSA is limited to providing advice on the products or services within its group only, which could include third party co-branded portfolios managed by the investment manager for a CIS Manco and segregated portfolios managed by the investment manager for its own clients. So, if a PSA is limited in this way, it may be quite restrictive, particularly where there is no LISP (Category III FSP) or life licence within the group that would enable the Category I PSA to advise on products that are linked to a life insurance licence, like living annuities. Given these concerns expressed by industry, the FSCA is considering a few alternatives such as:

  1. Maintain a strict “no gap filling” approach to PSAs which will disallow a PSA from offering any products or portfolios through a LISP platform outside of its group. The FSCA has recognised that this approach could be problematic for “model portfolio providers” that would like their advisors to offer their own model portfolio solutions but use an external LISP for annuities or retirement products. If this ‘strict’ approach is followed, these FSPs would still be able to enter into referral agreements with other investment managers or advisors.
  2. Allow the PSA advisor to provide advice on products or portfolios on an external LISP but only in those cases where there is no LISP in the group and provided that the products and portfolios on which the advice is provided are managed by the group “model portfolio provider” or “investment manager”. In addition, the group must undertake adequate due diligence on the LISP concerned and must accept full responsibility for that advice.
  3. The last option being considered is that a PSA advisor is only allowed to give advice on products or portfolios on an external LISP where the requirements of point (2) above have been met and the group is below a certain size. The reason for this is to encourage those groups that have the capacity to set up their own LISP, to do so.

We believe that there are still a lot of questions to be answered to practically understand how this will work, particularly considering those FSPs that offer advice across a wide range of financial products such as medical aid, life insurance, short-term insurance etc. If an FSP is a PSA in respect of its investment business, will this apply to all its other lines of business as well. Based on the current definition, this seems to the case as an entity cannot act as both a PSA and an RFA.

Due diligence

The FSCA has confirmed that it intends to set clear requirements for due diligence reviews to be carried out before agreements are concluded between parties in the investment value chain. The due diligence which an entity will be expected to carry out will be more than just confirming that an entity has the necessary licence or authorisation – it must also take into account the “fit” with the business model and investment offerings of the entity or FSP, specifically to ensure delivery of fair outcomes to customers. The responsibility to conduct due diligence will fall on CIS Mancos, investment managers, advisors, LISPs and model portfolio providers alike and in particular, CIS Mancos, model portfolio providers and investment managers will need to satisfy themselves that their selected distribution channels are suitable.

Conclusion

The proposals relating to investment advisor categorisation will have an impact on many business models, particularly those where advice is provided to customers as part of the business’ value proposition and the investment solutions are structured and modelled by investment managers or discretionary FSPs within the group. The proposals are complex and each FSP must consider these within its own business structure to understand the potential risks.

We recommend that you read the full Discussion Document and invite you to provide us with your input which we will take into consideration when consolidating our response to the FSCA.

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