Unit 1 IMC Passcards

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Investment Management Certificate Unit 1 – The Investment Environment Syllabus version 11


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Published November 2013 ISBN 9781 4727 0410 8 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd, BPP House, Aldine Place, 142-144 Uxbridge Road, London W12 8AA www.bpp.com/learningmedia

Printed in the United Kingdom by Ricoh Ricoh House Ullswater Crescent Coulsdon CR5 2HR

Your learning materials, published by BPP Learning Media Ltd, are printed on paper obtained from traceable sustainable sources. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media.

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The contents of this book are intended as a guide and not professional advice. Although every effort has been made to ensure that the contents of this book are correct at the time of going to press, BPP Learning Media makes no warranty that the information in this book is accurate or complete and accept no liability for any loss or damage suffered by any person acting or refraining from acting as a result of the material in this book. Every effort has been made to contact the copyright holders of any material reproduced within this publication. If any have been inadvertently overlooked, BPP Learning Media will be pleased to make the appropriate credits in any subsequent reprints or editions. © BPP Learning Media Ltd 2013


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Preface

Contents

Welcome to BPP Learning Media’s Investment Management Certificate Unit 1 Passcards. Passcards save you time. Important topics are summarised for you. Passcards include diagrams to kick start your memory. Passcards follow the overall structure of the BPP Learning Media Study Texts, but Passcards are not just a condensed book. Each card has been separately designed for clear presentation. Topics are self contained and can be grasped visually. Passcards are still just the right size for pockets, briefcases and bags. Passcards focus on the exam you will be facing. Run through the complete set of Passcards as often as you can during your final revision period. The day before the exam, try to go through the Passcards again. You will then be well on your way to passing your exams. Good luck!

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Preface

Page 1

Financial markets and institutions

2 3

Contents

Page

1

4

Legal concepts

109

Ethics and investment professionalism

27

5

Client advice

119

Financial regulation

33

6

Taxation

145

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1: Financial markets and institutions

Topic List Financial institutions Role of government Financial markets Listing & governance International markets The agency problem

The financial services industry plays a key role in the economic system. Here, we look at the institutions and markets within the industry. We also examine the roles of the national Government, and the status of EU legislation. The London Stock Exchange is a market place for trading bonds and other securities. The creation of Multilateral Trading Facilities (MTFs) since MiFID is a challenge to the mainstream exchanges, with MTFs taking a significant market share. The FCA operates as the UK Listing Authority (UKLA) to regulate company listings on the Exchange.


Financial institutions

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Financial markets

Functions of financial intermediaries Financial intermediaries bring together providers and users of finance, either as a broker facilitating a transaction, or in their own right, as principal. Source of funds for borrowers Aggregation of deposits (eg small savers) to lend on to borrowers (eg for mortgages) Maturity transformation: between for example depositors wanting instant access and borrowers needing a 25-year loan Pooling of collective funds, giving small investors access to diversified portfolios

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Listing & governance

International markets

The agency problem

UK financial intermediaries Banks Building societies Insurance companies, pension funds, collective funds National Savings & Investments (NS&I) – a Government agency Capital markets – for raising and investing largely long-term capital (eg the Stock Exchange) Money markets – for lending and borrowing largely short-term capital (eg banks’ short-term lending)

As well as its domestic market in equities (company shares) & bonds (interest-bearing securities), the UK is a major centre for the eurobond markets – for debt denominated in non-domestic currencies.



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The agency problem

Flow of funds in an open economy, showing the role of financial intermediation Page 3




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Financial markets

UK financial services industry


Clearing banks – operate the system for settling payments Retail banks – the ‘High Street’ banks Wholesale banks – lend in large amounts, to larger customers Investment banks – serve institutional investors and corporate customers Central bank – Bank of England (for UK)

Building societies – mutual organisations Main assets: mortgages of their members Main liabilities are to investor members

The agency problem

The central bank (BoE)

Employs over 1 million people in the UK Accounts for around 5% of national output

Banks


Functions of Bank of England

Banker to the central government Banknote-issuing authority Manager of the National Debt Manager of UK's foreign currency reserves Adviser to the government on monetary policy Monetary policy control (through MPC) Key role in prudential regulation (see Ch. 3) Banker to the commercial banks Lender of last resort to the banking system

Monetary Policy Committee (MPC) aims to meet UK’s 2% (CPI) inflation target.



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The agency problem




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Products and functions Banks and building societies

Current accounts: non- or low interest Deposit or savings accounts Trend towards e-banking and ATMs Overdrafts and personal loans Mortgages, including ‘buy-to-let’ Trustee services Portfolio management services FInancial planning services

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Financial markets

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The agency problem

Life offices provide protection on death and disability, long-term savings and lump sum investments, through the issue of term assurances, whole life assurances, endowments, pensions, investment bonds, annuities. Products are marketed by personal advice and by advertisements. Bancassurers are banks with their own life offices. Banks may establish independent subsidiaries employing independent financial advisers, who must advise on the most suitable product available in the whole market or market sector. Friendly societies: mutual organisations offering investment products.



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Financial markets

Brokers – buy and sell securities Individual clients Corporate clients

Services may include: Page 7

Unit trusts and OEICs Investment trust offers ISAs Discount share dealing Internet dealing services

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The agency problem

Functions may be combined in discretionary portfolio management: Manager makes buy/sell decisions Within parameters agreed with the client

Investment managers Portfolio management Research and analysis

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E-commerce: transacting business via the internet E-commerce has changed the industry, with: Internet banking & online share trading Real-time share price information services Marketing of products, with online completion of applications Funds supermarkets offer:

Various providers’ collective funds ‘Mix and match’ facility to combine different providers’ funds in an ISA Online dealing by credit or debit card Online account tracking facilities 1: Financial markets and institutions



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The agency problem

Legislation

Fiscal policy

EU law takes precedence over national laws, and UK lawmaking must follow the Treaty of Rome and EU Directives.

A government's fiscal policy concerns its plans for Government spending, taxation and Government borrowing.

The UK has a mixed economy – market-based with some State intervention

Monetary policy

is concerned with:

Changes in the amount of money in circulation – the money supply – and Changes in the price of money – interest rates These variables are linked with: Inflation in prices generally Exchange rates – the price of the domestic currency in terms of other currencies

Government spending is an injection into the economy, adding to demand for goods and services, whereas taxes are a withdrawal.

A government's fiscal stance may be neutral, expansionary or contractionary, according to its overall effect on national income.



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Easing of monetary policy

v

BoE reduces interest rates:

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The agency problem

Tightening of monetary policy BoE increases interest rates:

Loans are cheaper, and so people borrow & spend more. Companies find borrowing cheaper while consumer demand may rise, both factors boosting profits.

Loans cost more, property prices may be dampened & consumer demand may fall. Company profits could reduce through higher borrowing costs & lower demand.

Asset values rise. Eg, Government bonds (gilts) rise in price, since required returns are now lower.

Other asset prices may fall. Investors will require a higher return than before & so pay less for fixed interest stocks (eg gilts).

Those dependant on income from cash deposits will be worse off.

Those reliant on interest for income will be better off.

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Exchange rate policy The Government can try to influence exchange rates by buying & selling currency, to the extent that it has sufficient currency reserves.

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The agency problem

Changes in interest rates affect exchange rates: currencies with higher rates attract money inflow, and their values relative to other currencies rise.

The European Union

EU law

The EU seeks to remove barriers to the free movement of goods, persons, services and capital.

EU legislation takes three forms: Regulations have the force of law in every EU state without need of national legislation. Directives are issued to the governments of the EU member states requiring them within a specified period (usually two years) to alter the national laws of the state. Decisions of an administrative nature are made by the European Commission in Brussels.

The European Central Bank is the central bank for eurozone countries – which use the euro as their common currency.



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Asset types Tangible assets – eg, property, equipment, commodities – are real assets. Claims on a return such as interest or dividends are financial assets. Loans (debt) and shares (equity) represent the two main types of financial security. Ordinary shares (equities) offer the prospect of dividends and capital growth, if the company succeeds. Fixed income securities (debt, for the issuer) are often generally called bonds. Pooled or collective funds package securities, allowing diversification and index-tracking.

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The agency problem

Sell side and buy side Traders in financial markets can be categorised broadly into sell-side & buy-side. Sell-side firms comprise investment banks, brokers, & dealers who provide investment products & transaction services Buy-side firms are mainly investment managers (including pension funds, mutual funds, hedge funds & insurance companies) who purchase investment products & transaction services Many firms encompass market participants on the buy-side as well as the sell-side.




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The agency problem

Financial markets .... Mobilise people’s savings and put them to use in enabling firms to grow, thus contributing to the wealth of the economy .... Enable the transfer of risk. Eg, derivatives markets enable investors, entrepreneurs and market participants to hedge risks as well as to speculate on the prices for assets Attributes of an effective & efficient securities market Cost efficiency – electronic order systems lower costs (operational efficiency) Liquidity – the ability to enter or exit the market with reasonable price spread, on a transaction of a reasonable size (promotes operational efficiency). Contributing factors: effective IT & settlement systems, diverse membership & stock availability, stock lending facilities Price discovery – the process through which an equilibrium price for a financial instrument is revealed continuously through bid & offer prices, and trading (enabling informational efficiency) Transparency – investors knowing the price before, during & after a deal in order to be satisfied that they have a good deal (informational efficiency: prices reflect all relevant information)



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The agency problem

Round trip (purchase / sale) transaction costs include: bid / offer spread, broker’s commissions, Stamp Duty Reserve Tax (CREST, dematerialised transactions) or stamp duty (non-CREST), Takeover Panel levy (£1, on transactions over £10k). A less easily quantified element of transaction costs is the cost effect of the tendency for fluctuating order sizes to move prices: this is market impact or price impact. For major stocks with deep liquidity, bid-ask spread and potential price impact can be very low for typical transactions. Smaller issues may have high liquidity risk or marketability risk, which has to do with the ease with which an issue can be sold. This risk can become acute at times of market stress, and is built into the price of securities. Limit orders – only filled if price is better than the stated limit – compare with market orders, which are filled at the best available price when the order is placed.The opportunity cost of a limit order is that the price may move against the trader before the order is filled. More opaque (less transparent) markets will typically have larger bid-ask spreads because dealers will find it more difficult to judge demand for stock, and so know the equilibrium price (price discovery). Real-time pretrade & post-trade transparency are required for many securities (especially equities) under MiFID rules. Over-The-Counter markets are typically less transparent.

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Order- v quote-driven markets Order-driven: trading system matches willing buyers & sellers automatically. Prices of securities are driven by buyers & sellers. Quote-driven: market makers act as buyers & sellers to the market, quoting prices continuously.

Exchange trading v OTC Exchange-traded instruments: standardised in respect of (eg) contract size and dates, facilitating a liquid market in the instrument ‘Over the counter’ instruments: generally negotiated with a financial institution, to fit client needs

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The agency problem

London Stock Exchange plc Initially, companies issue securities to investors – the primary market. LSE also provides a secondary market for trading in already-issued securities.

Stock Exchange members LSE members are: Broker/dealers, who may act in dual capacity, ie broker a customer’s business (agent) or deal directly with them (principal) or Equity market makers / GEMMs, who quote 2-way prices



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Role of government

SETS

SETSqx

SEAQ

Combined order- Quoteand quote-driven driven No market makers 1+ market 2+ market makers per stock makers per stock ‘Liquid’ listed stocks as ‘Illiquid’ stocks No listed classified by MiFID, i.e. under MiFID stocks FTSE All Share stocks, ETFs, Exchange Traded Commodities & actively traded Irish stocks Most traded AIM stocks All AIM stocks in All AIM EURO remaining sectors not AIM stocks traded on SETS Page 15

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Financial markets

LSE trading platforms Order-driven

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The agency problem

SETS (Stock Exchange Electronic Trading Service) is called ‘The Order Book’. LCH.Clearnet is the central counterparty, keeping trades anonymous. Brokers’ orders: Match automatically with an order currently displayed, or May be matched later SETSqx (‘SETS – quotes & crosses’):

Market makers must quote buying & selling (two-way) prices up to Exchange Market Size (EMS)

Also, periodic auctions, where anonymous limit orders are placed

SEAQ (known as a quote display system): secondary system, used for fixed income securities and less frequently traded AIM stocks. 1: Financial markets and institutions



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Financial markets


The agency problem

Cum- and ex-div Shares trade cum div (with right to receive next dividend) until 2 business days before books close date.

Fixed interest: usually go ex-div 7 business days before coupon dates.

Company determines

Dividend announcement

LSE determines Ex-div date

Books close

2 business days

Cum div – buyer will receive next dividend

Ex div – seller will receive next dividend

Dividend payment date



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Alternative trading venues ‘Dark pools’: electronic trading platforms where

neither price nor identity of trading firm is revealed

Multilateral Trading Facilities (MTFs): electronic trading platforms functioning similarly to SETS, but generally cheaper than SETS trading

Systematic Internalisers (SIs): Investment banks executing client orders by trading for their own account, rather than with an exchange or MTF

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The agency problem

Automated & high frequency trading (HFT) Benefits Improved liquidity & bid/ask spreads Lower transaction costs More efficient market pricing Risks HFT traders may squeeze unfair price advantage Technical glitches could lead to erroneous orders & volatility (‘flash crashes’) Possible market manipulation




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Settlement conventions Equities Gilts/ US ‘T’-Bonds Eurobonds/ Corporate bonds Currencies/ German equities

T+3 T+1 T+3 T+2

Dual listing Corporations in different jurisdictions act as single operating business. Consequences: Access to a wider pool of investors Increased liquidity may reduce bid/offer spreads Greater compliance costs

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The agency problem

Gilts market Gilts settle via Euroclear UK & Ireland (EUI). Gilt Edged Market Makers (GEMMs) must quote firm two-way prices in all conventional gilts and/or all index-linked gilts. Inter Dealer Brokers (IDBs) arrange matched principal-to-principal anonymous trades between GEMMs, allowing GEMMs to unwind positions.

Order Book for Retail Bonds (ORB)

Electronic order-driven trading service for selection of gilts & UK corporate bonds Investors can enter orders directly, or via a broker with Direct Market Access (DMA)



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The agency problem

New gilts issues

Issuer: Debt Management Office (DMO), to fund Public Sector Net Cash Requirement (PSNCR) New issue

Tranche Large

Auction Competitive

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Pay bid price

Non-competitive

Tap

If small (tranchette) or failed auction, issued into secondary market

Maximum bid is £0.5 million nominal value Pay weighted average of successful bid prices in competitive auction 1: Financial markets and institutions



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Financial markets

UKLA and AIM rules Summary

AIM

3 years*

None

25%*

None

£700,000 for equity; £200,000 for debt

None

Free transferability

Yes

Yes

Prospectus requirement**

Yes

Yes***

UKLA

LSE

Percentage in public hands Minimum market value

Applicable rules


AIM Main List

Trading record

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*Not required for a Standard (non-Premium) listing. **Exemptions: qualified/larger investors; smaller offers/private placements. *** For AIM, a simplified Admission Document.


The agency problem

– Alternative Investment Market

Applicants must: Appoint NOMAD (nominated adviser) Produce Admission Document

ISDX (previously PLUS Markets) ISDX Growth Market: for growing small- and medium-sized enterprises (SMEs) Rules for issuers include application & continuing obligations requirements Market makers Peel Hunt & Shore Capital make markets in ISDX's major stocks, ensuring its operation as a secondary & primary market



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Annual General Meeting (AGM) Listed company: must hold within 6 months of financial year end 21 days’ notice required (unless Articles specify longer) – can be waived if all members agree Member attends/sends proxy, to exercise member’s rights Private company (Ltd): AGM not required – most decisions can be made by written resolution

Other general meetings 14 days’ notice required – can be waived if 95% of members agree (90% for private company) Page 21



The agency problem

Standard AGM tasks

Approve accounts Approve dividend (Re)appoint directors (Re)appoint auditors

Resolutions Ordinary resolution needs 50% majority / 14 days’ notice. Special resolution needs 75% majority / 14 days’ notice. 1: Financial markets and institutions



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Disclosure/transparency Key rules Holders (including connected parties) of 3% of voting rights, & where holdings cross a % point up or down, must notify company by T + 2 (two business days) Directors and senior executives (PDMRs) must get clearance to deal in own company shares / derivatives, & notify company of such transactions by T+4 Company informs the market via Regulatory Information Service (RIS)/ Primary Information Provider (PIP) by T + 1

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The agency problem

Corporate Governance Code Key points

Chairman/Chief Executive split Non-executive directors balance Re-election every 3 years Audit & renumeration committees Service contracts & notice periods Review of internal controls Disclosures in annual accounts Encourages institutional shareholders to use votes

The 7 Principles of the FRC’s 2010 Stewardship Code aim to make fund managers and institutional investors more active and engaged in corporate governance, eg by monitoring investee companies and having clear voting policies. Like the FRC’s Corporate Governance Code, the code is based on a ‘comply or explain’ principle.



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USA US Government bonds: issued by Dutch auction, a form of tender Market makers on NYSE: known as ‘specialists’ Super Display Book System: the NYSE’s primary order processing system

France French bonds: longer dated OAT (T + 3) & shorter dated BTAN (T + 1) OATi: inflation-protected bond Bonds issued by Dutch auction

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The agency problem

Japan Japanese stocks settle at the Japanese Securities Depository Centre (JASDEC) Japanese Government bonds (JGBs): mostly traded over-the-counter (OTC) JGBs settle at Bank of Japan

Germany Government bonds are the Bund: stock exchange-traded & also OTC Equities settle T + 2, where counterparties are both German




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Role of government

Emerging markets Attractions Rapid economic growth Low correlations Potentially attractive valuations Inefficient pricing

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Financial markets

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The agency problem

Central securities depositories (CSDs) Most major markets have a CSD to hold securities, which will be either Immobilised (certificates held in depository), or Dematerialised (no physical certificate)

Possible drawbacks Transparency Volatility Regulation Liquidity Taxation

International CSDs (ICSDs) – such as Euroclear & Clearstream – provide clearance, settlement & custody in Euromarkets & in international equities.



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The agency problem

The principal-agent problem A small firm typically has a strong alignment between its ownership and its control. The enterprise will typically be run by owner-managers, who are perhaps within the same family. It is in the interests of the ownermanagers for the company to succeed, and for shareholder wealth to be maximised. In larger companies, professional managers may be hired who may have little or no shareholding in the company. There is then a separation of ownership & control. Agency theory sees employees of businesses, including managers, as individuals, each with their own objectives. Various people are involved as agents. The department of a business has its own departmental objectives. If achieving these various objectives leads also to achieving the organisation’s goals, there is goal congruence. In practice, this may not occur. Managers who work for the company (as agents) may have different objectives, such as gaining benefits (perks) for themselves, dealing on their own account (in a financial firm), pursuing pet projects or ‘empire-building’. Agency problems arise from the misalignment of goals, and this can make clients, including individuals, more reluctant to provide finance intermediaries in the investment industry: they might tend to prefer keeping their assets as cash, for example. This will limit market liquidity and makes it more difficult for firms to grow, potentially hurting growth prospects in the economy. Page 25




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The agency problem

Ways to reduce the agency problem One strategy aiming to enhance goal congruence and to mitigate the 'agency problem' is the use of remuneration incentives. Examples Profit-related/economic value-added pay Rewarding managers with shares Executive Share Options Plans In financial trading firms, the wrong remuneration structures could encourage short-term risk-taking by traders, potentially putting the future of the enterprise in jeopardy, if risks turn bad.

Other measures Separation of roles – one individual not to have too much power Accounting standards – auditied accounts an important source of 'post-decision' information for investors Corporate governance – a check on management power Regulation – in the financial services industry, rules & principles aim to ensure that financial services firms deal properly with conflicts of interest and treat customers fairly


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2: Ethics and investment professionalism

Topic List Ethics and compliance CFA Code of Ethics

Ethical conduct is a matter of continuing debate. The reputation of individuals and firms is at stake when there are shortcomings in professional behaviour. In business as in other areas of life, reputation must typically be built up over a long time, but it can be lost quickly.


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Ethics and compliance

Ethics in organisations Firms must follow law and regulations. Ethics in organisations relates to social responsibility & business practices. Personal ethics derive from a person's beliefs & opinions. Professional ethics – eg, the CFA’s Code of Ethics. Corporate culture – eg, 'Customer first'. Organisation systems. Ethics might be contained in a formal code. Possible problem: good ethics does not always save money, & there is a real cost to ethical decisions. Equally, there can be substantial risk, & costs, if poor ethics results in loss of reputation.

CFA Code of Ethics

Senior management’s role As the regulator stated (CP10/12), promoting standards of ethical behaviour improves outcomes for consumers & their perception of the financial services industry. Beyond mere compliance with rules, firms must – through their leaders – foster a corporate culture congruent with regulatory principles, if regulation is to work. Senior management must use their leadership positions to move the culture of their firm in the desired direction, with: Communication of the principles at all levels of the organisation, & possibly external stakeholder groups Leaders (senior management, and team leaders) setting an example Appropriate training of staff


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CFA Code of Ethics

Regulations

Ethics

A set of rules designed to control the behaviour of industries, firms, or individuals

A set of basic principles about how individuals and organisations should behave, for the benefit of all

The rules or principles that regulate behaviour of individuals and businesses derive from: The law The requirements of rules & regulations Regulatory guidance that is not mandatory Professional standards & codes of conduct Ethics & ethical values

The ethical environment refers to justice, respect for the law and a moral code. The conduct of an organisation, its management and its employees will be measured against ethical standards by customers, suppliers & other members of the public.

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The FCA expects firms to consider properly if their incentive schemes increase the risk of misselling. 2: Ethics and investment professionalism


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The principle of integrity Financial services is an important industry, affecting the lives of most people in some way. The industry needs not simply to provide the necessary expertise, but to do so with integrity and professionalism.

As we shall see in the next Chapter: The first FCA/PRA Principle for Businesses is Integrity: ‘A firm must conduct its business with integrity.’

& The first Statement of Principle for Approved Persons is also Integrity: ‘An approved person must act with integrity in carrying out his accountable functions.’

CFA Code of Ethics

Attributes of professional integrity Honesty: the person will not deliberately mislead another Reliability: the person can be relied upon to maintain appropriate levels of competence & skill in practice Impartiality: treating different people fairly, where the people involved could be customers, employees or others Openness: implying transparency, where appropriate & where justified confidentiality is not breached


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Compliance-based approach A rules-based compliance approach seeks to ensure that a firm acts within laws & regulations, & that violations are prevented, detected & punished. Some organisations, faced with the legal consequences of unethical behaviours, take legal precautions such as: Compliance procedures to detect misconduct Audits of contracts Systems for employees to report criminal misconduct without fear of retribution Disciplinary procedures to deal with transgressions A compliance-based approach suggests that bureaucratic control is necessary; an integrity-based or principles-based approach relies on cultural control. Page 31

CFA Code of Ethics

Integrity-based approach An integrity-based approach combines a concern for the law with emphasis on managerial responsibility for ethical behaviour. Integrity strategies define companies' guiding values, aspirations & patterns of thought & conduct: To prevent damaging ethical lapses, while Tapping into human impulses for moral thought & action This approach echoes the FCA’s principles-based approach to financial regulation – eg, the principlesbased approach requires firms to act with integrity and to treat customers fairly. Unlike rules, such principles require senior management to apply higher-level professional values in their business. 2: Ethics and investment professionalism


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CFA Code of Ethics 1. 2. 3. 4. 5. 6.

III. Duties to Clients A. Loyalty, Prudence & Care B. Fair Dealing Act with integrity, competence, diligence and respect, & in an ethical C. Suitability manner with others D. Performance Presentation Place the integrity of the investment profession & the interest of client E. Preservation of Confidentiality above personal interests Use reasonable care & exercise independent professional judgement IV. Duties to Employers A. Loyalty Practice & encourage others to practice in a professional & ethical B. Additional Compensation Arrangements manner C. Responsibilities of Supervisors Promote the integrity of, & uphold the rules governing, capital markets V. Investment Analysis, Recommendations & Actions Maintain & improve their own, & others’, professional competence A. Diligence & Reasonable Basis B. Communication with Clients & Prospective Clients C. Record Retention Professionalism VI. Conflicts of Interest A. Knowledge of the Law A. Disclosure of Conflicts B. Independence & Objectivity B. Priority of Transactions C. Misrepresentation C. Referral Fees D. Misconduct VII. Responsibilities as a CFA Institute Member or Candidate Integrity of Capital Markets D. Conduct as Members & Candidates in CFA program A. Material Non-Public Information E. Reference to CFA Institute, designation & program B. Market Manipulation

Standards of Professional Conduct I.

II.

CFA Code of Ethics


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3: Financial regulation

Topic List Regulatory framework FCA high level standards Exchanges & markets FCA business standards Supervision & redress Financial crime

The Financial Services Act 2012 (FSA 2012) amended the Financial Services and Markets Act 2000 (FSMA 2000) to reform the system of regulation of the UK financial services industry. Re-structuring of the UK regulatory framework with effect from 1 April 2013 has seen the establishment of the PRA and the FCA as twin regulators, to replace the FSA.


Regulatory framework

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FCA high level standards

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Exchanges & markets

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FCA business standards

Supervision & redress

Financial crime

European regulatory framework

Home State/ host State

The aims of the EU’s Financial Services Action Plan (FSAP) have been to create a single wholesale market, an open and secure retail financial services market, and state-of-the-art prudential rules and regulation. Various EU Directives have been issued to further these aims.

For a passporting firm (home-State authorised): Organisational matters regulated by the home State: eg authorisation, fitness & propriety, capital adequacy, Principles for Businesses, senior management arrangements, systems & controls, client assets, conflicts of interest, personal account dealing, transaction reporting & transparency, compensation Operational matters, eg conduct of business rules that are not ‘organisational matters’, regulated by: – The host State, for activities of a branch ‘within its territory’ – The home State, for cross-border services

Passporting ‘Passporting’ (under MiFID rules) enables firms to use their domestic authorisation to operate not only in their home state, but also in other host states within the European Economic Area (EEA) (EU + Norway, Iceland & Liechtenstein).



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Exchanges & markets

Role of ESMA



Financial crime

MiFID

European Securities & Markets Authority:

The Markets in Financial Instruments Directive:

Part of the FSAP, implemented November 2007

Applies to all investment firms, eg investment & retail banks, brokers, asset managers, securities & futures firms, securities issuers & hedge funds

1 of 3 European Supervisory Authorities To ensure integrity, transparency, efficiency, orderly functioning of securities markets, and Enhance consistent EU-wide investor protection. Works on laws to develop single EU rulebook, promoting equal competition, limiting regulatory arbitrage Standard setting, promoting international supervisory co-operation With ESRB, identifies & advises on systemic risks: short-, medium- and long-term Would co-ordinate emergency crisis measures Able to prohibit products that threaten stability Page 35

Instruments covered by MiFID

Transferable securities, eg shares & bonds Money market instruments Units in collective investment undertakings Derivatives of various types Financial contracts for differences (CFDs) 3: Financial regulation



Scope of MiFID

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Exchanges & markets

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Financial crime

MiFID applies to ‘core’ investment services and activities of: Investment firms (which are also regulated for ‘non-core’ ancillary services) Credit institutions including UK banks & building societies, for activities in MiFID’s scope Ancillary services

Investment services and activities


Receiving & transmitting orders Execution of orders on behalf of clients Dealing on own account Discretionary portfolio management Investment advice Underwriting financial instruments Placing financial instruments Operating MTF

Safekeeping & administration of financial instruments Credit / loans to an investor in a transaction involving the firm Advice on capital structure, industrial strategy, mergers & acquisitions Currency services connected with investments Investment research & financial analysis



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UCITS Directives

EMIR – European Market Infrastructure Regulation

Undertakings for Collective Investment in Transferable Securities (UCITS) – collective investment schemes (CISs) that can be marketed across the EEA. CIS must comply with marketing rules of host State & documentation requirements of Directive.

EMIR sets standards for OTC derivatives, central counterparties (CCPs) & trade repositories: Reporting obligations for OTC derivatives Obligations for eligible OTC derivatives to be cleared through CCPs New risk mitigation requirements for all OTC derivative trades that are not centrally cleared Common rules for CCPs and for trade repositories Rules on the establishment of interoperability between CCPs Under EMIR, all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through CCPs.

Permitted UCITS investments

Transferable securities Money market instruments Forward contracts & financial derivatives Deposits Units in other CISs [Not permitted: Commodity derivatives] Page 37




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The UK regulatory structure The Financial Services and Markets Act 2000 (FSMA 2000) is amended by the Financial Services Act 2012 (FSA 2012), which established: The independent Financial Policy Committee (FPC) at the Bank of England (BoE), and The Prudential Regulation Authority (PRA) – a subsidiary of the BoE The Financial Services Authority (FSA) legal entity became the Financial Conduct Authority (FCA). The BoE became supervisor of financial market infrastructure providers: regulated clearing houses (RCHs), payment systems & securities settlement systems.

PRA & FCA The late 2000s financial crisis brought into focus problems of financial instability affecting some banks and other financial sector institutions. In 2013, the UK's single-regulator system (under the old FSA) was abolished.

The PRA was established to oversee the stability of 'prudentially significant' firms. Regulation of conduct across the sector, including retail consumer advice, became the responsibility of the new FCA.



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‘Twin peaks’ regulation: since 1 April 2013 Prudential Regulation Authority Bank of England PRA is a BoE subsidiary. Objective: to promote safety and soundness of firms Prudential regulator of banks, larger firms (Dual-regulated) Makes prudential rules Recovery & resolution plans Authorisations, permissions, supervision, enforcement The ‘twin peaks’ are Prudential & Conduct regulation. Note the dual regulation of banks & other large ‘Prudentially Significant Firms’. Page 39

Role to protect & enhance stability of UK financial system, working with other bodies. Prudential regulator of clearing houses, and settlement & payment systems Special Resolution Unit to resolve failing banks The Bank’s Financial Policy Committee monitors stability & resilience, risk – and advises / directs PRA & FCA as appropriate


Financial crime

Financial Conduct Authority FCA is independent company.

Objective: ensuring that the relevant markets function well Oversees FOS, FSCS, Money Advice Service Conduct regulator of banks, larger firms (Dual-regulated) Conduct & prudential regulator of smaller firms and providers Powers over criminal market abuse Acts as UK Listing Authority 3: Financial regulation



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HM Treasury The Minister with overall responsibility for the Treasury, the Chancellor of the Exchequer, is ultimately responsible for the regulatory system for financial services under FSMA 2000. HM Treasury, to which the FCA is accountable, will judge the regulator against the requirements laid down in FSMA 2000 which includes a requirement to ensure that the burdens imposed on the regulated community are proportionate to the benefits it will provide. Accountability of the FCA to HM Treasury

HM Treasury has the power to appoint or to dismiss the Board and Chairman of the FCA.

HM Treasury requires that the FCA submit an annual report covering such matters as the discharge of its functions and the extent to which the regulatory objectives have been met.

HM Treasury also has powers to commission and publish an independent review of the economy, efficiency and effectiveness of the FCA's use of resources and to commission official enquiries into serious regulatory failures.



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Financial crime

Financial Policy Committee (FPC) The FPC includes the FCA Chief Executive and representatives from HM Treasury. The FPC will also have some external representation and will meet four times annually and at times of crisis. S9C Bank of England Act 1998 (as amended by FSA 2012) provides for the FPC to exercise its functions with a view to: Contributing to the achievement of the BoE’s Financial Stability Objective (to protect and enhance the stability of the financial system of the UK), and Subject to that, supporting the economic policy of the Government, including its objectives for growth and employment. The FPC will seek to identify, monitor, and remove or reduce, systemic risks, including: Systemic risks due to structural features of financial markets, eg connections between financial institutions

Systemic risks attributable to the distribution of risk within the financial sector, and

Unsustainable levels of leverage, debt or credit growth.

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Office of Fair Trading Investigates if combined entity > 25% market share or target’s UK turnover > £70m Refers matter to CC if ‘substantial lessening of competition’ Will report to FCA/PRA, HMT and CC if it believes that regulatory rules adversely impact competition

Competition Commission Ultimate power to block a takeover and fine for failure to comply with requests May take up to 24 weeks to investigate Appeals to rejection of the bid can be made to the Competition Appeal Tribunal

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Financial crime

Statutory merger control Office of Fair Trading Looks at current takeovers/mergers to ascertain if there has been a substantial lessening of competition May clear (ie, bid can go ahead) or refer the bid to CC Competition Commission CC investigates bid & recommends whether there has been substantial lessening of competition Bid is blocked

Bid is cleared



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Takeover Panel The Takeover Panel administers the Takeover Code (‘City Code’). The Panel:

Regulates offers for shares in public companies Is funded by a levy on share transactions

Department for Business, Innovation & Skills The Government’s Department for Business, Innovation & Skills (BIS) is responsible inter alia for business regulation, company law & consumer affairs.

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Financial crime

City Code – has statutory effect, under Companies Act 2006 Equal treatment for all shareholders of a particular class Reasonable period for bid to be considered Reduces defensive measures by target company Mandatory bid if shareholder acquires =/> 30% voting rights Minimum offer price = highest price paid to acquire shares in last 12 months Offer must remain open for =/> 21 days If =/> 90% acceptances, can compulsorily purchase remaining 10% Directors of target company should not deny shareholders opportunity to consider bid




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Data Protection Act 1998

Data Protection Register

Regulates the use of all personal data, placing obligations on the organisation, which may be taken to Court for a breach.

The DPA 1998 requires persons who process personal data to register (unless exempt) with the Information Commissioner (who maintains a public registry of data controllers).

Eight DPA 1998 Principles – personal data must be: 1: Processed lawfully and fairly The organisation must have 2: Obtained only for specific and lawful purposes a data protection policy. 3: Adequate, relevant and not excessive 4: Accurate and kept updated 5: Not kept longer than necessary 6: Processed in accordance with data subjects’ wishes 7: Protected against unauthorised or unlawful access, and damage 8: Not transferred outside the EEA unless to a territory with adequate data protections Recording sensitive personal data requires explicit consent.



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General prohibition FSMA 2000 establishes the authorisation of firms to carry out regulated activities – and the general prohibition: no person may carry on a regulated activity in the UK, unless they are either authorised or exempt. Sanctions may be civil and/or criminal.

Civil sanctions: Contracts voidable Compensation/damages Restitution Orders Regulator may seek injunctions Criminal sanctions: 6 month sentence and/or £5,000 fine 2 year sentence and/or unlimited fine Page 45

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Financial crime

FCA or PRA authorisation? Firm will apply to either FCA or PRA, depending on firm type.

Dual-regulated firms (banks & building societies, credit unions, insurers & some investment firms) are authorised by PRA but only with FCA approval. In the process, FCA will focus on conduct issues, while PRA will focus on a firm’s financial soundness.

FCA-only regulated firms (including independent financial advisers, investment exchanges, insurance brokers & fund managers) are authorised by FCA.

Passporting under MiFID is another authorisation route. 3: Financial regulation



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Is authorisation required? 1

Are regulated activities to be undertaken?

2

Covered by exceptions?

3

Covered by exemptions?

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Financial crime

Exceptions

Dealing as principal (for yourself) Newspapers/media (but not tipsheets) Acting as an unremunerated trustee Employee share schemes Certain overseas persons, for UK business

‘Passported’ EEA firms are authorised in their home State Exempt persons

Authorisation by FCA/PRA gives permission (Part 4A, FSMA 2000) to carry out regulated activities by way of business relating to specified investments.

Appointed (tied) representatives RIEs, ROIEs, RCHs, Lloyd’s members, Bank of England, National Savings & Investments, local government authorities Certain professions, eg lawyers, accountants, actuaries, for non-mainstream investment business (regulated by DPBs)



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Establishing/operating collective investment schemes, stakeholder pension schemes

Safekeeping/administering investments Lloyd’s insurance business Carrying out contracts of insurance Accepting deposits Regulated mortgage business Operating a Multilateral Trading Facility (MTF)

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Financial crime

Specified investments

Regulated activities Including: Dealing in, arranging deals in, managing, advising on investments


Including: Deposits and electronic money Contracts of insurance Shares, warrants, ADRs etc Debentures, loan stock, and govt/local authority securities

Units in collective investment schemes Options, futures, contracts for differences Lloyd’s syndicates Regulated mortgages




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Financial crime

Excluded activities The following activities are specifically excluded from the requirement for authorisation. Dealing as principal where the person is not holding themselves out to the market as willing to deal. The requirement to seek authorisation does not apply to the personal dealings of unauthorised individuals for their own account Trustees, nominees and personal representatives, if they do not hold themselves out to the general public as providing the service and are not separately remunerated for the regulated activity, are excluded from the authorisation requirement Employee share schemes. This exclusion applies to activities which further an employee share scheme Media, eg TV, radio and newspapers. Authorisation is not required if investment advice is not the primary purpose of the publication. 'Tip sheets' (written recommendations of investments) will however require authorisation Overseas persons – firms which do not carry on regulated activity from a permanent place within the UK. This exclusion covers: first, where the activity requires the direct involvement of an authorised or exempt firm; and, second, where the activity is carried on as a result of an unsolicited approach by a UK individual. Thus, if a UK individual asks a fund manager in Tokyo to buy a portfolio of Asian equities for them, the Japanese firm does not need to be authorised under FSMA 2000



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Financial crime

SYSC – in FCA/PRA Handbooks

Whistleblowing

Principle for Businesses 3: ‘A firm must take reasonable care to organise its affairs responsibly & effectively, with adequate risk management systems.’ SYSC requires firms to maintain Senior management arrangements, SYstems and Controls: a ‘common platform’ of requirements for almost all regulated firms.

Whistleblowers are protected by the Public Interest Disclosure Act 1998 if: A response from their firm was lacking, or they felt unable to raise the matter internally They reasonably believe matters raised to be substantially true

SYSC common platform

Business structure & contingency planning Training, competence & expertise Compliance, internal audit & financial crime Risk control Outsourcing Record keeping (5 years min., for MiFID business) Conflicts of interest

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Whistleblowing provisions are detailed in SYSC. Contracts must not prevent employee ‘blowing the whistle’: the legislation protects whistleblowing employees from unfair dismissal. Employees concerned about something may contact the regulator.




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Trustee Act 2000

Pensions Act 2004

Does the trust deed offer investment guidance?

Pensions Regulator – regulatory body for work-based UK pensions: – Adopts pro-active, risk-focused approach – Has powers to intervene in scheme affairs

Yes

Follow the deed

No

Follow TA 2000 Trustee Act 2000

A statutory duty of skill and care Functions may be delegated Invest in any asset except land overseas Keep investments under review

Work-based pension schemes may be defined benefit (DB) or defined contribution (DC).

Occupational (work-based) schemes:

Must have member-nominated trustees (except one-member schemes) Must have adequate liquidity Pensions Protection Fund for where an employer running a scheme becomes insolvent & unable to pay liabilities PPF provides compensation up to 100% of benefits to existing pensioners and 90% to those not yet retired, funded by charges on other DB pension schemes Trustees’ Statement of Investment Principles (SIP) gives members information about investment of pension scheme’s funds & investment returns received



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Financial crime

Financial Conduct Authority – objectives The FCA has a single statutory strategic objective (s1B(2) FSMA 2000) of:

The ‘relevant markets’ are:

The financial markets

Markets for regulated financial services, and

The markets for services that are provided by nonauthorised persons in carrying on regulated activities without contravening the general prohibition

Ensuring that the relevant markets function well.

FCA also has 3 supporting operational objectives:

Consumer protection objective: securing an appropriate degree of protection for consumers Integrity objective: protecting and enhancing the integrity of the UK financial system Competition objective: promoting effective competition in the interests of consumers in the market for regulated financial services and for services provided by a recognised investment exchange

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The regulator aims to ensure that firms put consumers at the heart of their business. The FCA’s duties to promote competition may involve analysing pricing. The FCA also has duties to address financial crime (broadly, following the existing approach to tackling such crime).




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FCA Handbook High Level Standards Principles for Businesses (PRIN) Training & Competence (TC) Statements of Principle & Code of Practice for Approved Persons (APER)

Business Standards Conduct of Business Sourcebooks (including COBS) Client Assets (CASS) Market Conduct (MAR)

Threshold Conditions (COND) Senior Management Arrangements, Systems & Controls (SYSC) Financial Stability and Market Confidence (FINMAR)

Regulatory Processes Decision Procedures & Penalties Manual (DEPP) Supervision (SUP)

Redress Dispute Resolution: Complaints (DISP) Compensation (COMP)

Fit & Proper Test for Approved Persons (FIT) Listing, Prospectus and Disclosure

Prudential Standards Prudential Sourcebooks for different types of firm

Listing rules (LR) Prospectus Rules (PR) Disclosure Rules & Transparency Rules (DTR)

Specialist Sourcebooks Cover certain specialised sectors of the industry



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The Principles for Businesses A firm must:

1 2 3

Conduct its business with integrity Conduct its business with due skill, care and diligence Take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems (management and control) 4 Maintain adequate financial resources (financial prudence) Treating Customers Fairly is 5 Observe proper standards of market conduct an important regulatory theme. 6 Pay due regard to customers’ interests & treat them fairly 7 Pay due regard to information needs of clients: communications with clients must be clear, fair, not misleading 8 Manage conflicts of interest fairly 9 Take reasonable care to ensure suitability of advice and discretionary decisions (customers: relationships of trust) 10 Arrange adequate protection for clients’ assets 11 Deal with regulators openly & cooperatively, making appropriate disclosures (relations with regulators) Page 53




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Scope of the Principles

Principles-based regulation

Some principles (eg, 10) refer to clients, while others (eg, 9) refer to customers.

This is regulation that is focused on the over-arching Principles, which firms must then apply. The regulator’s focus is not so much on the principles themselves, but on the actual outcomes and consequences of what firms do. Since the financial crisis, there has also been a shift to a more ‘intrusive’ style of regulation.

'Client' includes everyone from the smallest retail customer through to the largest investment firm (eligible counterparties, professional customers & retail customers). 'Customer' includes professional and retail clients but excludes eligible counterparties. Principles 6, 8 and 9, & parts of Principle 7, apply only to customers. Principle 3 would not be considered breached if the firm failed to prevent unforeseeable risks.

Breaches of the Principles, and of rules Breaching a Principle makes the firm liable to enforcement or disciplinary sanctions. A private person who suffers a loss from a rule breach may sue under s150 FSMA 2000, but not in respect of breach of a Principle.



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Approved persons Section 59 FSMA 2000 says that a person (that is a member of staff at an authorised firm) cannot carry out a controlled function in a firm unless the individual has been approved by the appropriate regulator

If a person carries out a controlled function but they not approved, this is a breach of statutory duty

Where such a breach of statutory duty occurs, a private person has the right to sue the firm for damages if they have suffered loss, using s71 FSMA 2000

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For all approved persons:

2 3 4

An approved person must act with integrity in carrying out his accountable (ie, regulated) functions And with due skill, care and diligence Must observe proper standards of market conduct


Financial crime

Code of Practice Examples of non-compliance

Statements of Principles

1

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Must deal with regulators openly and co-operatively Senior management only: 5 Must take reasonable steps to ensure business is organised so it can be controlled effectively 6 Exercise due skill, care and diligence in managing the business 7 Take reasonable steps to ensure compliance by business with regulatory requirements

Misleading or attempting to mislead customer/firm/regulator, eg about risks of investment or by falsifying documents Failing to give information to customer/firm/auditor/actuary when you know/should have known it should be provided, eg failing to disclose charges or surrender penalties Market abuse, eg trading on insider information, trading to distort the market, spreading false stories (FCA can impose unlimited fines under s123 FSMA 2000) Failure to report matters through internal reporting procedures



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Financial crime

Threshold conditions (for attaining Part 4A permission) Before it grants permission under FSMA Part 4A (formerly ‘Part IV’), the regulator must be satisfied that the firm meets and continue to satisfy the 'threshold conditions' for the activity concerned in order to be deemed fit and proper. General threshold conditions One condition relates to the location of the offices of the applicant. If the applicant is a UK company, its head and registered offices must be located in the UK. For an applicant that is not a company, if it has its head office in the UK, then it must carry on business in the UK. Firms will need to ensure that no impediment to their effective supervision arises from: the nature and complexity of regulated activities undertaken, products offered, and the business organisation. This condition also covers the effect of close links of the applicant with other entities, eg other members of the same group, and whether these have an effect on effective supervision by the regulator. An applicant for FCA authorisation must have adequate resources for the activities they seek to undertake. Such resources would not only include capital, but also nonfinancial resources such as personnel Another threshold condition relates to the suitability of the applicant. The firm must be considered to be 'fit and proper', ie it must have integrity, be competent and have appropriate procedures in place to comply with regulations. The management and staff of the firm must also be competent.

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Threshold conditions (for attaining Part 4A permission) FCA’s Business Model Threshold Condition

The FCA will apply the Business Model Threshold Condition, which refers to the risk that might be posed for a firm, for its customers and for the integrity of the UK financial system. The FCA has stated that this new threshold condition demonstrates the importance that the FCA will place on a firm’s ability to put forward an appropriate, viable and sustainable business model, given the nature and scale of business it intends to carry out. The regulator will expect firms to demonstrate adequate contingency planning in their business models. Firms will be expected to make clear how their business model meets the needs of clients and customers, not placing them at undue risk, or placing at risk the integrity of the wider UK financial services industry.

PRA’s Business to be Conducted in a Prudent Manner Threshold Condition

The PRA’s Business to be Conducted in a Prudent Manner Threshold Condition is closely equivalent to the FCA’s appropriate resources and business model conditions, which we have described above. PRA-authorised firms must hold appropriate financial and non-financial resources. Appropriate resources are evaluated by reference to complexity of activities, the liabilities of the firm, effective management, and the ability to reduce risks to the safety and soundness of the firm.



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Financial crime

Individuals carrying out controlled functions must have regulatory approval as fit and proper persons. ‘Fit and proper’ assessment

Controlled functions Governing functions (eg directors) Required functions (eg Money Laundering Reporting Officer) Systems and control functions (eg senior internal audit staff)

Honesty Integrity Reputation

Employment record Criminal record

Competence Capability

Experience Training and exams

Financial soundness

Court judgements? Bankruptcy?

Significant management function (eg heads of divisions in larger firms) Customer functions, including: – Investment advice – Customer trading and investment management Page 59

Covers most personnel advising customers

In dual-regulated firms, significant influence functions (ie, excluding customer functions) are divided between PRA and FCA. 3: Financial regulation



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Training and competence

Page 60


For roles involving private customers (eg investment advice): Take account of individual’s knowledge and skill Find out about individual’s previous relevant activities and training

Financial crime

FCA’s T&C Sourcebook covers the retail sector.

Firm to determine training needs, and organise, monitor & record appropriate training Recruitment


Training

Appropriate examinations

Exams and supervision Attaining competence

Maintaining competence

Continuing Professional Development (CPD)

Required for advising retail clients, eg on retail investment products, securities & derivatives & for some specialist roles (eg: advice on mortgages, equity release, long-term care insurance, pensions transfers).



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Rules on training and competence The firm’s commitment to training & competence should be that employees:

Are competent Remain competent Are appropriately supervised Have competence reviewed regularly Have levels of competence appropriate to the business

Retail advisers must complete 35 hours of verifiable CPD annually, of which 21 hours must be structured (ie, with a defined learning outcome).

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“


Financial crime

The competent employees rule is the main FCA Handbook requirement on employee competence, and applies to both MiFID and non-MiFID firms: Firms must employ personnel with the skills, knowledge and expertise necessary for the discharge of the responsibilities allocated to them.

Professionalism requirements

”

Retail investment advisers (RIAs) need to hold a Statement of Professional Standing (SPS) issued by an accredited body to give independent advice or restricted advice. The SPS shows customers that the RIA subscribes to a Code of Ethics, is qualified, and has up-to-date knowledge.




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Financial crime

Recognised Investment Exchanges (RIEs) (but not their members) are exempt from regulatory authorisation.

Recognised Overseas Investment Exchanges (ROIEs) operate in the UK without FCA authorisation. ROIEs:

RIEs: ICE Futures Europe LIFFE London Stock Exchange ISDX London Metal Exchange

Australian Securities Exchange Ltd CBOT Eurex ICE Futures U.S., Inc NASDAQ NYMEX NYSE Liffe US SIX Swiss Exchange AG Chicago Mercantile Exchange

RIE requirements cover: Financial resources, Suitability, Systems & controls, Investor safeguards, Issuer disclosures, Complaints arrangements, Discipline, Member default.

RIEs

ROIEs

RCHs

DIEs

Recognised Clearing Houses (RCHs) may perform clearing and settlement for an exchange. RCHs: CME Clearing Europe Ltd Euroclear UK & Ireland European Central Counterparty Ltd ICE Clear Europe Limited

Designated Investment Exchange (DIE) status of overseas exchanges gives some assurance about local regulation but does not exempt from UK authorisation.

RCHs, along with recognised payments systems & securities settlement systems (collectively Financial Market Infrastructures (FMIs)) are supervised by the BoE.



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A contract for differences (CfD), a future or an option. (FCA definition)

UK derivatives markets members are regulated under FSMA 2000. MiFID applies to firms carrying out activities in relation to various derivative instruments Financial and commodity derivatives Derivatives relating to credit risk Financial CfDs Derivatives relating to climate, freight, carbon emissions, inflation & other economic statistics Page 63

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Exchanges & markets

Derivative UK

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Financial crime

IAS 39 states: (non-hedge) derivatives must be recorded in balance sheet at fair value.

Changes in fair value (ie, gains or losses) can be recognised in the income statement

For derivatives used as a hedge, gains and losses are recognised in reserves

EMIR standards for OTC derivatives – covered in Chapter 1.

USA

(Main law: Commodity Futures Modernization Act 2000)

In the USA, there are two key regulatory bodies:

Securities and Exchange Commission (SEC) – regulates derivatives on securities

Commodity Futures Trading Commissions (CFTC) – regulates derivatives on commodities 3: Financial regulation



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Financial crime

LCH.Clearnet LCH.Clearnet: Acts as guarantor in the derivatives market, honouring contracts in the event of a party defaulting Formerly, London Clearing House Owned by exchanges and their members Is central counterparty for all trades (‘novation’) Administers all margin cash flows Registers all matched trades for the market

Initial margin

Returnable ‘good faith’ deposit paid on opening positions Based on maximum probable one-day loss

Variation margin

Cash settlement of daily profits or losses based on closing price of each day Paid to or received from LCH.Clearnet the following morning



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Financial crime

Central Counterparty – novation Short – ‘seller to every buyer’

LCH.Clearnet

Long – ‘buyer to every seller’

Trade Long oil @ $80

Novation

Short oil @ $80

Novation eliminates counterparty risk

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Where? Activities in UK, and business brought into UK

Exchanges & markets

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Who? All authorised firms, but not professional firms in respect of nonmainstream regulated activities


Financial crime

Firms should ensure that inducements do not conflict with duty to customers

Communications by electronic media count as written communication

7:25 PM

Exclusion of liability

COBS

Communication must be clear, fair and not misleading (Principle 7)

Advising on investments Dealing in investments What? Generally, designated investment business

Firm may not exclude its duties or liabilities to customers under FSMA 2000 or the regulatory system ie Customers cannot sign away their rights under COBS

Designated investment business covers includes various regulated activities but excludes deposits, mortgages nor non-savings insurance contracts.



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Financial crime

Client Customer

Eligible counterparty* Per se

Elective Elect

*Only for eligible counterparty business: Receipt & transmission of orders Execution of orders Dealing on own account

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Professional client

Retail client

Authorised firms Large undertakings Elective professional clients

Individuals

Elect

Small businesses




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Client classifications

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Financial crime

Clients can opt up or down. Professional clients (eg large businesses, experts)

Retail clients (eg individuals, small businesses)

Eligible counterparties (eg government, other firms)

COBS applies More protection Firms must notify clients of: Categorisation Rights to request a different categorisation Resulting limitations to client protection

Retail clients A retail client is any client who is not a professional client or an eligible counterparty.

More knowledge/size

Client agreements If a firm carries on designated investment business, other than advising on investments, for a new retail client (eg, a discretionary investment management service), the firm must enter into a basic agreement with the client.



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Financial crime

For MiFID Business

An entity requiring authorisation or regulation to operate in financial markets, whether authorised in the EEA of by a third country A large undertaking meeting conditions:

2 out of three of: – €20m balance sheet total – €40m net turnover – €2m own funds

Per se Eligible counterparties

Non-MiFID Business

Per se Professional clients

Insurance company, investment firm or credit institution UCITS CIS or its management company Pension fund or its management company Another EEA-authorised financial institution National government, central bank or supranational organisation

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–

£5m called-up share capital or net assets, or 2 out of 3 of:

– – –

€12.5m balance sheet total €25m net turnover 250 average employees in year




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Exchanges & markets

Elective Professional clients


Firm carries out a ‘qualitative test’: & for MiFID business a ‘quantitative test’:

3

Firm gives a clear written warning of protections & investor compensation rights lost

4

Client states separately in writing that they are aware of consequences

2

Client makes requests in writing

Financial crime

Qualitative test

Firm undertakes assessment of client’s knowledge, expertise and experience. Assessment gives firm reasonable assurance that client is capable of making their own investment decisions & understanding risks.

To treat a retail client as an elective professional client:

1


Quantitative test – for MiFID business

At least 2 of the following 3 must be satisfied: Client has traded, in significant size, on relevant market at average 10 times per quarter over previous 4 quarters Financial instrument portfolio > €500,000 Client works/has worked in financial sector for at least 1 year in professional position requiring knowledge of transactions/services



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Financial promotion (FP) An invitation or inducement to engage in investment activity communicated in the course of business (s21(1), FSMA 2000). Means of communicating FPs: Product brochures, mailshots General advertising Telemarketing Written correspondence Sales aids, presentations Tip sheets Other publications containing non-personal recommendations Page 71

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Financial crime

There is a general prohibition on FPs (s21, FSMA 2000) unless issued or approved by an authorised person. Exemptions/exclusions Qualifying credit Home purchase plans & home reversion schemes Personal quotations & illustrations ‘One-off’ communication that is not a cold call Generic promotions (eg, of Investment Trusts) Communications to investment professionals Overseas recipients Deposits & insurance Certified high net worth individuals Sophisticated investors 3: Financial regulation



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Financial promotions

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Financial crime

Fair, clear and not misleading

A firm must ensure that a communication or FP is:

Fair, clear & not misleading, Appropriate & proportionate Considering the means of communication & the information to be conveyed.

FP addressed to a retail client & falling within the rules must be clearly identifiable as FP. The FCA’s rules are: media-neutral (print/fax/email/internet/phone etc) mainly directed at regulated activities

Guidance A firm should ensure: It is clear if a client’s capital is at risk Any yield figure quoted gives a balanced impression of short/long term prospects Complex charging structures are explained The regulator is named A clear impression is given of any third party packaged/ stakeholder product provider



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Financial crime

Unwritten promotions and cold calling Someone making an unwritten FP outside the firm's premises must: Do so at an appropriate time of day Identify self & firm, and make his purpose clear Clarify if client wants to continue or terminate communication, and terminate on request If appointment is arranged, gives a contact point

Direct offer financial promotions A direct offer FP is a FP: Containing an offer or invitation Which enables investors to purchase investments directly 'off the page' Without receiving further information. The promotion must include relevant disclosures for the product. Page 73

Firms may only make cold (unsolicited) calls: To a client having established relationship with the firm justifying such calls, or About a generally marketed packaged product (not based on a high volatility fund), or Relating to controlled activities by an authorised person or exempt person, involving only readily realisable securities (not warrants)




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Controls & approvals


Financial crime

Communicating with retail clients

SYSC requires that a firm communicating or approving FP has systems & controls or policies & procedures.

Requirements:

Approval of FP by an authorised firm enables it to be communicated by an unauthorised firm.

Understandable by target group Fair & prominent indication of relevant risks

Firm approving FP must confirm that it complies with the FP rules. Promotion made during a personal visit, phone conversation or other interactive dialogue cannot be approved. Firm’s approval may be ‘limited’, eg to communications to professional clients or eligible counterparties. In communicating FP, firm can rely on another firm’s confirmation of compliance. FP should only be communicated to types of recipients for whom intended.

Key items not disguised, diminished, obscured Must include name of firm Investment comparisons should specify sources, key facts, assumptions Firm should consider if omissions will make information insufficient, unclear, unfair or misleading



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Record keeping Records of FPs must be kept: Indefinitely for pension transfers 6 years for life policies & most pension schemes 5 years for MiFID business Three years in other cases

Distance contracts Firms must give clear information before a contract is concluded, including: Identity & address of supplier Product details (incl. price & fees) Contract details (incl. cancellation rights) Page 75

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Financial crime

Financial Promotions Power FCA has power (under FSA 2012) to ban misleading financial promotions. The regulator can give (and publish) a direction to firms requiring them immediately to withdraw or to modify promotions which it deems to be misleading. The firm will be able to make representations to the FCA to challenge its decision. The FCA may then amend or revoke its decision, or confirm its original decision. The FCA can then publish: (1) Its direction, (2) A copy of the promotion, and (3) The regulator's reasons for banning it. The FCA may publish details even if it has decided to revoke its decision.




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Financial crime

Past, simulated past and future information Past performance information

Simulated past performance information Past performance information should: Simulated past performance information Not normally be the most prominent must: feature of the communication Relate to an investment or a Include appropriate information financial index covering at least the five preceding Be based on actual past years, or the whole period performance of investments/indices Be based on and must show which are the same as, or underlie, complete 12-month periods the investment concerned State the reference period and Contain a prominent warning that source of the information figures refer to simulated past Contain a prominent warning that performance and that past the figures refer to the past performance is not a reliable If denominated in a foreign currency, indicator of future performance state the currency clearly If based on gross performance, disclose the effect of commissions

Future performance information Future performance information must:

Not be based on nor refer to simulated past performance Be based on reasonable assumptions supported by objective data If based on gross performance, disclose the effect of commissions, fees or other charges Contain a prominent warning that such forecasts are not a reliable indicator of future performance Only be provided if objective data can be obtained



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Financial crime

Ethical implications of misleading communications The pressure for short-term gain in a firm could encourage the use of a misleading financial promotion. This could have undesirable longer-term ethical and professional consequences:

When the misleading nature of the promotion comes to light, it may be that customers have lost money, while others may feel cheated. Many may feel aggrieved. Consumers may have diminished financial prospects and may view the firm unfavourably

Consumers coming to know about the firm’s actions, as well as those directly affected, may come to view the firm as unethical, and damage may be done to the reputation of the firm

Customers may become less loyal to the firm and the firm may find it more difficult to retain and acquire customers

Page 77




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Financial crime

Suitability

Appropriateness (for non-advised services)

Firm recommending designated investments must assess whether the recommendation is suitable for the client, based on client’s:

For investment services other than: personal recommendations & managing investments.

Knowledge & experience Investment objectives Financial situation Suitability report (letter) required following personal recommendation to retail client on:

Assessing appropriateness Client to provide information about relevant knowledge/ experience to enable firms to assess appropriateness.

Life policy Stakeholder pension scheme, & some other pensions transactions Regulated collective investment schemes

If the product/service is not appropriate, firm must warn the client If there is insufficient information to assess appropriateness, firm must notify the client



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Financial crime

Best execution

Order execution policy

The rules on best execution apply to retail & professional clients.

Clients must give prior consent to execution policy. Information must be given on the policy. For each class of financial instrument, policy should include: Information on different execution venues, & Factors affecting the choice of venue

When executing orders, a firm must take all reasonable steps to obtain the best possible result for clients, taking into account the execution factors A firm will satisfy this rule by executing a client order in accordance with the specific instructions of the client Execution factors are: price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order. Page 79

For retail clients, the following information must be given in advance: Relative importance of the execution factors List of execution venues Warning that specific instructions may prevent firm from following its policy to obtain the best possible result 3: Financial regulation



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Financial crime

Client order handling

Inducements

Rules cover retail & professional clients. Procedures must provide for prompt & fair execution of client orders Comparable orders to be executed according to time of receipt by the firm

A firm must act honestly, fairly and professionally in the best interests of their client (Client’s best interests rule.)

Use of dealing commission Investment manager must be satisfied that goods/services purchased with commission: Do not impair compliance with client’s best interest rule Relate to the execution of trades, or Comprise the provision of research

Any fee, commission or non-monetary benefit paid to or provided by a third party must be designed to enhance the quality of service to the client A firm must disclose to the client any fees, commissions or non-monetary benefits in summary form



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Churning and switching

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Financial crime

Personal account dealing Firms must have arrangements to:

Churning is prohibited: switching products in order to make more commission or fees regardless of the client’s interests. Customers must not be advised to switch products unless it is in their interests.

Prevent employees engaging in market abuse Ensure all relevant persons are aware of restrictions Ensure any deals are notified promptly to the firm Ensure adequate transaction records are kept

A series of transactions that are each suitable when viewed in isolation may be unsuitable if the recommendations or the decisions to trade are made with a frequency that is not in the best interests of the client.

A firm should have regard to the client's agreed investment strategy in determining the frequency of transactions. This would include, for example, the need to switch within or between packaged products.

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Independent advice

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Financial crime

Retail investment advice rules Restricted advice

Advice must be either independent or restricted. If an adviser declares themselves to offer independent advice, they will need to consider a broader range of retail investment products (RIPs) – wider than the definition of ‘packaged products’. Independent advice Covers all retail investment products Unbiased, based on comprehensive & fair analysis of market

Advice that is not independent must be labelled as restricted advice, for example as advice on a limited range of products or providers. Retail investment advisers (RIAs) are still required to meet the regulator’s suitability requirements, even if they offer restricted advice. Restricted advice Covers limited products or providers Includes basic advice (stakeholder products) Suitability requirements still apply



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Retail investment products (RIPs)

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Financial crime

Packaged products definition

RIPs are defined to include:

Collective Investment Schemes (regulated)

Life policies

Life policies

Units/shares in collectives: ITs, UTs, OEICs

Investment trust savings schemes

IT savings scheme investments

Personal pensions

Personal and stakeholder pension schemes

Stakeholder pensions

Other packaged investments offering exposure to underlying financial assets

Adviser charging

Structured capital-at-risk products (SCARPs)

Adviser must not take any other benefit, even to pass on to client

Advice is paid for through an adviser charge.

Firm must account for any reasons for charges varying materially from its charging structure Page 83




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Financial crime

FCA’s product intervention power

Referring to specialists

The FCA’s product intervention power gives it the ‘flexibility to intervene quickly and decisively’, normally after public consultation, where it considers that a product or product feature is likely to result in significant consumer detriment.

If dealings with a client involve actions beyond adviser’s authority (because of firm’s or regulator’s rules), the adviser should seek authority from an appropriate person.

The FCA may impose temporary product intervention rules (TPIRs) for up to 12 months without the usual consultation process, eg where:

Products involve inappropriate consumer targeting Product access is restricted to boost firms’ profit Significant consumer detriment could result Inherently flawed products, from which consumers unlikely to benefit

Advisers should be able and willing to refer to other specialists within the firm. Advisers may also need to refer to specialists outside their business in certain areas & should explain to client when it would be necessary.



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Investment research Rules: Apply to investment research which is intended/ likely to be disseminated to clients/public Cover written & oral material Firms must manage conflicts of interest: No personal or firm transactions in unpublished research until clients have had a reasonable opportunity to act on it No personal transactions contrary to current recommendation No promises of favourable research No editorial control for subject of research No front running of trades by firm or its employees Page 85

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Financial crime

Required disclosures Firms should take reasonable care to ensure fair presentation of information: Disclose identity of person responsible for research Disclose relationships & circumstances which may impair objectivity Do not tie remuneration to specific transactions or recommendations Fact should be distinguished from opinion, analysis, interpretation etc




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Financial crime

Non-independent research

Conflicts of interest

Investment research is research described as investment research or in similar terms, or is otherwise presented as an objective or independent explanation of the matters contained in the recommendation. Otherwise, research is non-independent research.

Principle for Businesses 8: A firm must manage conflicts of interest fairly, both between itself & its customers & between a customer & another client.

Non-independent research must: Be clearly identified as a marketing communication Contain a clear & prominent statement that it does not follow the requirements of independent research and is not subject to prohibitions on dealing ahead of dissemination of research

Identify material conflicts that arise or may arise between: Firm & client Clients SYSC provisions:

Financial promotions (FP) rules apply to non-independent research as if it were a marketing communication.

Organisational & administrative arrangements Written conflicts policy Keeping records of the conflicts Disclosure of potential conflicts is the measure of last resort, if conflicts cannot be managed



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Financial crime

Disclosures From Principle 7 Communications with clients & Principle 9 Customers: relationships of trust comes a general obligation to disclose risks. Specific warnings may be needed – eg, for warrants, derivatives, non-readily realisable investments. Key Facts Document (KFD) must be given to a retail client when providing a recommendation on a packaged product, including: Details on nature & complexity of the product Complaints handling procedures Compensation schemes Cancellation rights

Page 87

Key Investor Information (KII) Managers of authorised UCITS funds must prepare short KII document, containing: Identification of the scheme The words ‘key investor information’ Investment objectives and policy Past performance presentation / scenarios Costs and charges Investment risk/reward profile, with guidance & risk warnings How to get more information




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Information on client transactions Immediately after executing a client order, an investment firm should record key details of the transaction. A firm must provide promptly in a durable medium the essential information on execution of orders to clients in the course of designated investment business (except where it is managing the investments ie, under a discretionary management agreement). The information may be sent to an agent of the client, nominated by the client in writing. For retail clients, a notice confirming execution (a confirmation) must be sent as soon as possible and no later than the first business day following receipt of confirmation from the third party.

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Financial crime

Cancellation rights The consumer must be informed of a right to cancel. The cancellation date is the date of dispatch by the consumer. Life policies & pensions (including stakeholder & personal) – 30 calendar days Other products – 14 calendar days



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Financial crime

Periodic reporting

Progress reports for funds

Firm managing investments must provide periodic reports showing:

Managers of authorised funds must report to unitholders:

Name of the firm Name / designation for a retail client’s account Statement of contents & valuation of portfolio, including details of: – Designated investments & their value – Cash balance at beginning & end of period – Performance of portfolio Total fees & charges, itemising management fees & execution costs Comparison of period performance with any agreed benchmark Dividends, interest & other payments received Information about corporate actions Page 89

Short report (send to all holders) & long report (available on request), half-annually & annually The reports must be available within 4 months of the year-end & within 2 months of the end of the half-year

Record keeping periods MiFID records – 5 years Non-MiFID – general rule: as long as is relevant for the purposes for which the records are made Pension transfers & pension opt-outs – indefinitely 3: Financial regulation



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Financial crime

Client assets

Client money

Make adequate arrangements to safeguard clients’ ownership rights in event of:

Client money is money the firm looks after which is not its own. Client money must be held on trust. Client bank account should be separately identifiable from firm’s own account. Adequate records and procedures must cover mandated accounts (eg direct debit mandates and credit card details held). A firm must reconcile its internal records with those of third parties: As regularly as necessary As soon as reasonably practicable after reconciliation date Correct any discrepancies promptly: If shortfall, top up account the same business day If excess, remove the same business day

Insolvency of firm Unauthorised use by the firm – client must give prior consent to their use in security transactions such as stocklending Firm should have adequate arrangements to minimise risk of loss or reduction of financial instruments, misuse, fraud, poor administration, inadequate record keeping or negligence. Custody reconciliations: Reconcile internal records with third parties’ regularly Correct any discrepancies promptly

Notify the regulator of any breaches without delay.



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Financial crime

Powers of the new regulators (FCA and PRA)

Granting authorisation & permission to firms (under Part 4A FSMA 2000) to undertake regulated activities Approving individuals to perform controlled functions Issuing rules which appear to be necessary or expedient to advance regulators’ objectives (Part 9A FSMA 2000) Supervision of authorised firm to ensure that they continue to meet the regulators’ authorisation requirements & that they comply with the regulatory rules and other obligations Powers to take enforcement action against authorised firms and approved persons Powers to discipline authorised firms & approved persons The FCA & PRA jointly oversee the Financial Services Compensation Scheme (FSCS) Applications for variations or cancellations of permissions: Dual-regulated firm will normally apply to PRA, which may determine an application to vary a permission only with FCA consent, and to cancel a permission only after consulting the FCA.

FCA-only regulated firm will apply to FCA. If the applicant firm is part of a group that includes a dual-regulated firm, the FCA must consult the PRA in making its decision

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Financial crime

FCA supervisory approach The FCA’s process for assessing conduct risks puts firms into categories C1 (larger firms with most consumer/market impact: most intensive supervision) to C4 (smaller firms). Firms are also put into prudential categories CP1 (firms whose failure has greatest impact) to CP3 (least impact). The FCA’s supervision approach: 1 – Firm Systematic Framework (FSF): analysing firms’ business models to assess sustainability from conduct perspective, and future risks; evaluating firm’s culture and ‘tone for the top’ regarding fair treatment of customers and market integrity 2 – Event-driven work: covering emerging issues, eg mergers, spikes in complaints, whistleblowing allegations 3 – Issues and products: analysis by FCA’s sector teams



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Complaints What is a complaint? Any oral or written expression of dissatisfaction whether justified or not, alleging loss, distress or inconvenience Eligible complainants for Ombudsman purposes: Consumers Enterprises with fewer than 10 employees and turnover or annual balance sheet not exceeding €2 million (‘micro-enterprises’) Charities with annual income < £1 million Trusts with net asset value < £1 million

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Financial crime

Firms must report to the regulator twice-yearly, on:

Complaints categories & product types Numbers of complaints closed: within 4 weeks; within 4-8 weeks; & more than 8 weeks Numbers of complaints: upheld; referred to & accepted by Ombudsman; outstanding Total amount of redress paid

To whom should customers complain? 1

Contact the provider firm, using the firm’s formal complaints procedures if necessary.

2

If complaint not resolved with the firm, use an independent scheme, eg the Financial Ombudsman Service (FOS), or the courts. 3: Financial regulation



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Complaints handling Effective and transparent complaints handling procedures Allow complaints to be made by any reasonable means Recognise complaints as requiring resolution Complaint must be: – Investigated competently, diligently, impartially – Assessed fairly, consistently, promptly Assessment must be explained in a fair, clear & not misleading way, & any appropriate redress or remedial action offered

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Financial crime

Financial Ombudsman Service (FOS) Firms must cooperate with FOS’s Compulsory Jurisdiction which applies to regulated activities: Where complaint not resolved after 8 weeks Max. FOS award: £150,000 (including any compensation for suffering, damage to reputation, distress, inconvenience), plus interest & costs

Financial Services Compensation Scheme For default/insolvency in respect of: Investments & home finance: 100% of 1st £50,000 Deposits: 100% of 1st £85,000 Long-term insurance: 90% of claim General insurance: 90% of claim, but 100% for compulsory insurance



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Complaints Procedures must be in place for complaints handling by a firm, and a complaints log must be maintained. Publish summary of procedure & refer eligible customers to it at the point of sale. An FOS decision is binding on the firm.


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Financial crime


Timeline

Receive complaint, within 6 years of event, or 3 years of when complainant should have been aware of it

Promptly on receiving a complaint, acknowledge it, providing ‘early assurance’ that it is being dealt with

By 8 weeks after receipt, send final response or holding response explaining why final response cannot be made, stating when it is expected to be made, and informing complainant of his right to go to Ombudsman

Final response ‘starts the clock’ on ...

... 6 month limitation period on using FOS

Records of the complaint and measures taken for its resolution must be kept for three years, but five years for MiFID business. Twice-yearly reports to regulator required.

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Exchanges & markets

Anti-money laundering (AML) provisions Three aspects to AML:

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Financial crime

Money laundering: conversion of money obtained illegally into apparently legitimate funds.

Deterrence Co-operation Detection

Proceeds of Crime Act 2002 Makes it a criminal offence to facilitate arrangements involving the proceeds of any crime (including, eg, tax evasion)

International & UK action

International Financial Action Task Force (FATF) UK Criminal Justice Act 1993 POCA 2002 (updated CJA 1993) Anti-drug trafficking & counter-terrorism financing (CTF) legislation



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Financial crime

Proceeds of Crime Act 2002 Three main offences:

Assistance – If any person knowingly helps another person to launder the proceeds of criminal conduct, he or she will be committing an offence

Failure to report – If a person discovers information during the course of his employment that makes him believe or suspect money laundering is occurring, & he fails to make the report as soon as is reasonably practicable, he is committing a criminal offence

Tipping off (s333A) – Even where suspicions are reported, the parties must generally be careful not to alert the suspicions of the alleged launderer since, within the regulated sector, this is an offence

Money laundering: Sequence Depositing funds in respectable investments (placement) Multiple transactions to conceal origins of funds (layering) Conversion of funds into a business (integration) Page 97




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Financial crime

Anti-money laundering regulation Money Laundering Regulations 2007 Risk-sensitive policies and procedures required Customer due diligence (CDD) means identifying customer or beneficial owner, if different, and verifying identities Enhanced due diligence (EDD) applies for higher-risk situations, such as non-UK politically exposed persons Simplified due diligence (SDD) means not having to apply the usual measures, eg for CTFs, listed companies and public authorities Penalty – Failure to implement MLR 2007 is a crime: 2 years imprisonment and/or fine

Joint Money Laundering Steering Group Guidance Notes Identity information may come from (in order of preference): Government department or Court Other public sector body Regulated financial services firms Other firms subject to MLR or similar regime Other organisations Keep records for five years.



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Criminal Justice Act 1993 Money laundering regulations (secondary legislation) Joint Money Laundering Steering Group guidance Identity checks are designed to prevent money laundering. To prevent financial exclusion, there is some flexibility on the evidence necessary.

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Financial crime


Money laundering: maximum penalties (POCA 2002) 14 years for knowingly assisting in laundering of criminal funds 5 years for failing to report knowledge or suspicion of money laundering 2 years for ‘tipping off’ a suspected launderer, in regulated sector (s333A POCA 2002)

The suspected launderer must not be alerted! Suspicions of laundering

report to

Money Laundering Reporting Officer

may report to

National Crime Agency

The regulator requires annual reporting by MLRO to senior management and training of staff. Page 99




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Financial crime

SYSC & financial crime

SYSC requires firms to:

Systems & controls need to identify, assess, monitor money laundering risk – the risk that firm is used to further financial crime

Allocate to a senior manager (could be the MLRO but does not have to be) responsibility for establishment & maintenance of AML systems and controls

Systems & controls should be comprehensive & proportionate to the nature, scale & complexity of the business

Provide appropriate training Appoint MLRO, who must provide a report at least annually to the governing body/senior management Appropriately document ML risk profile/policy Ensure ML risk is considered in day-to-day operations Ensure identification procedures do not unreasonably deny access to services



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Terrorism What is terrorism? – Terrorism 2000 Act definition encompasses violent actions designed to influence a government or intimidate the public. How does terrorism financing differ from money laundering?

Relatively small amounts may be involved Terrorists may be funded from legitimate income

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Financial crime

Terrorist offences

Fund raising Use & possession Funding arrangements Money laundering

Law on Counter-Terrorism Financing (CTF) The duty to report – Terrorism Act 2000 Regulated sector – Anti-Terrorism, Crime & Security Act 2001 Failure to disclose – 5 years in jail and/or fine Protected disclosures – Not a breach of client confidentiality 3: Financial regulation



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Who is an insider?

Page 102


FCA supervision & redress

Financial crime

Insider Inside Source

Inside Information

Price-sensitive Unpublished Specific or precise Particular issuer or security

Must not: Deal Encourage Disclose

Company Director Employee Office or duties Direct or indirect source

Insider dealing is a criminal offence under Part IV of the Criminal Justice Act 1993. Under CJA 1993, an insider is an individual who has information in her possession that she knows is inside information and knows is from an inside source – either directly from her own profession or indirectly from someone with access due to their own profession.



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Financial crime


Where are insider dealing restrictions found?

Insider dealing: Criminal Justice Act 1993

Many rules and regulations:

Individuals who are ‘insiders’ Regulated market/ professional intermediary

Financial Services & Markets Act 2000 Criminal Justice Act Principles for Businesses Exchange rules Civil offence

Not all investments covered Various bodies involved

Special defences

General defences Did not expect to profit Believed on resonable grounds that information was in public domain Would have dealt anyway Page 103

Defences

Market maker Market information including bid facilitation Price stabilisation rules 3: Financial regulation



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FCA supervision & redress

Financial crime

Market abuse

Market manipulation

Market abuse: due diligence defence

Behaviour by any person occuring in relation to qualifying investments traded on a prescribed market

Manipulating devices

Section 123 FSMA 2000 Person believed on reasonable grounds that he was not committing market abuse, or

Insider dealing Insider dealing Improper disclosure Misuse of information

Manipulating transactions Dissemination of false or misleading information Misleading behaviour & distortion

Person took all reasonable precautions and exercised due diligence to avoid committing market abuse No financial penalty

Safe harbours – if acting within one of these safe harbours, a person is not committing market abuse: Regulators’ rules The Takeover Code Buy-back programmes and stabilisation Due diligence defence – see above



1

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Insider dealing

Improper disclosure

Where an insider discloses inside information to another person otherwise than in the proper course of the exercise of her employment, profession or duties

3

Misuse of information

Where a transaction is based upon information not generally available, which a . regular market user would regard as relevant and would cause them view the person’s behaviour as being below reasonable market standards

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Exchanges & markets

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6

Where behaviour Is likely to give a regular market user a false or misleading impression as to the supply of, demand for, or price or value of, qualifying investments; or cause a distortion of the market

Market abuse offences 4

Dissemination

Dissemination of information which gives, or is likely to give, a false or misleading impression as to a qualifying investment by a person who knew it was false or misleading

5

(detail set out in the Code of Market Conduct)

Financial crime


7 Misleading behaviour & distortion

Where an insider deals, or attempts to deal, in a qualifying investment or related investment on the basis of inside information

2

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Manipulating devices

Effecting transactions or orders to trade which employ fictitious devices or any other form of deception

Manipulating transactions

Where a transaction or orders to trade (are effected otherwise than for legitimate reasons and in conformity with accepted market practices) which: Give, or are likely to give a false or misleading impression as to the supply, demand or price of one or more qualifying investments; or Secure the price of one or more such investments at an abnormal or artificial level




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Financial crime

Enforcement of market abuse – The FCA may impose one or more of the following penalties on those found to have committed market abuse: An unlimited fine Issue a public statement Apply to the court to seek an injunction or restitution order Disciplinary proceedings, which could result in withdrawal of authorisation/approval where an authorised/approved person is guilty of market abuse as they will also be guilty of a breach of the Principles for Businesses Note that the regulator has criminal prosecution powers to enforce insider dealing and Part 7 Financial Services Act 2012 (see below). The regulator has indicated that it will not pursue both the civil and criminal regime. Part 7 Financial Services Act 2012 has created criminal offences relating to:

Misleading statements Misleading impressions, and Misleading statements relating to benchmarks (including LIBOR)

There will also be new provisions relating to regulated activities that are connected with setting benchmarks.



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Exchanges & markets

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Financial crime

Bribery Act 2010 The Bribery Act 2010 (BA 2010) replaces existing anti-corruption legislation and introduces a new offence for commercial organisations of negligently failing to prevent bribery.

Bribery offences There are four main offences under BA 2010: Section 1: Active bribery – Offering, promising or giving a bribe Section 2: Passive bribery – Requesting, agreeing to receive or accepting a bribe (passive bribery) Section 6: Bribing a foreign public official – A breach of this section may also breach s1 BA 2010, and prosecutors will need to decide which is the more appropriate offence for the case Section 7: Failure of firms to prevent bribery – Failure by a commercial organisation to prevent persons associated with it from bribing another person on its behalf. An organisation has a defence against the s7 offence (failure to prevent bribery) if it can prove that, despite a particular instance of bribery having occurred, the organisation had adequate procedures in place to prevent persons associated with the organisation from committing bribery. Page 107



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Notes

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4: Legal concepts

Topic List

Those working in the financial sector must operate within various regulations, laws and statutes.

Legal persons

As in any business, the law of contract has a bearing, and the law on power of attorney, wills and trusts needs to be understood.

Power of attorney Contracts & agency Property Bankruptcy & insolvency Trusts & wills


Legal persons

Power of attorney

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Contracts & agency

Page 110

Property

Bankruptcy & insolvency

Trusts & wills

Legal personality

Companies

Legal persons include:

A company is a legal person. A creditor cannot demand payment of company debts from its shareholders. The company is liable without limit for its own debts.

Companies Nations Co-operatives Individuals

Legal persons can: Enter into contracts Sue & be sued Incur debt Own property

Sole traders For a self-employed trader, there is no legal distinction between individual & business. The trader is personally liable for debts of the business.

An individual human being is a natural person A corporation (eg, a company) is an artificial person A public company (plc) has a nominal share capital of at least £50,000 – & may be Stock Exchange-listed Others are private companies (Limited or ‘Ltd’) – not permitted to offer their securities to the public


Legal persons

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Power of attorney

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Contracts & agency

Page 111

Property


Trusts & wills

Powers of attorney

Lasting power of attorney

Power of attorney: formal document made by ‘donor’ which appoints ‘attorney’ or ‘donee’ to act for donor in legal matters (eg, to sign documents).

A lasting power of attorney (LPA) under the Mental Capacity Act 2005 can take effect if the donor becomes mentally incapable, and can cover Personal Welfare as well as Property & Affairs.

General power of attorney allows donee to act for donor in all matters Power may be restricted to specific act, eg to execute a specific document

To take effect, LPA must be registered with the Office of the Public Guardian.

Ordinary power of attorney: Valid while donor capable of giving instructions Revoked by death or bankruptcy of donor or attorney, or at choice of donor Existing enduring powers of attorney (EPAs) are still effective, but new EPAs cannot be set up. Page 111

If no replacement attorney, LPA is cancelled if: Attorney cannot or will not act, or dies Married attorney & donor divorce For a Property & Affairs LPA, if attorney or donor become bankrupt 4: Legal concepts


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Power of attorney

Legal persons

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Contracts & agency

Page 112

Property


Trusts & wills

Elements of a contract A contract is a legally binding agreement between persons in any form (eg, inferred, written or oral). Offer

Intention to create legal relations Consideration

Acceptance

eg A life assurance proposal form constitutes an offer Other factors affecting validity of a contract:

Capacity. Some people have restricted capacity to enter into contracts, eg, minors (under 18) Form. Some contracts must follow a particular form Content. There may be some implied terms in a contract. Express terms may be unlawful Genuine consent. There may be undue influence or duress, or misrepresentation or mistake Legality. The courts will not enforce a contract which is illegal or contrary to public policy Effect of failure to satisfy the validity tests: Void contract. This is no contract Voidable contract. This contract can be avoided by one party Unenforceable contract. This contract is valid but performance by one party cannot be enforced


Power of attorney

Legal persons

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Page 113

Contracts & agency

Property


Trusts & wills

Agency The agent-principal relationship forms a contract between the principal & a third party.

Principal Agent (eg broker, appointed representative) Third party

Contract discharge Agent’s obligations

Ways in which a contract can come to an end:

Breach Performance Agreement Frustration

A verbal contract is legally binding, except for sale of property, and tenancy agreements. Page 113

Performance & obedience Skill & accountability No conflict of interest Keep confidence Benefit only as agreed

4: Legal concepts


Legal persons

Power of attorney

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Contracts & agency

Page 114

Property


Trusts & wills

Real property

Co-ownership

In legal terminology, land includes buildings & anything else permanently attached to the land. Real property (also called 'realty') is land owned in perpetuity – ie, freehold property. With leasehold property, the right of the rentpaying tenant (or lessee) to possession ends either by expiry of a fixed period or by notice. A lease is a form of contract. If granted for a term of more than three years, it must generally be in the form of a deed.

2+ persons may own land. (Applies to owning freehold land outright, in spite of the word ‘tenant’.) Joint tenancy – a common form of ownership of a house by a couple. The transfer does not state what share in the land each person has. The land is 'held by X and Y'.

Personal property Personal property (‘personalty’) is anything that is not real property (freehold land).

If a joint tenant dies, his interest lapses & the land is owned wholly by the survivor(s). Tenants in common. A conveyance may state that the land should go to 'P, Q and R equally' – each then owns one-third part of the interest. With a tenancy in common, each tenant can bequeath his interest.


Legal persons

Power of attorney

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7:25 PM

Contracts & agency

Bankruptcy Bankruptcy: when an individual is no longer able to pay debts and his or her financial affairs are taken over by a court. The assets are transferred into a trust. Bankruptcy proceedings start with a Bankruptcy Order to the court. Court will decide whether to declare the individual bankrupt. The Official Receiver takes control of assets, as receiver & manager. A bankruptcy order is normally discharged automatically one year after the date of the order, unless the bankrupt is culpable (Enterprise Act 2002). Page 115

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Property


Trusts & wills

Receiver & manager protects bankrupt's property until trustee in bankruptcy is appointed to get possession of bankrupt’s assets & realise their value.

Trustee is entitled to the excess income above what is needed to support bankrupt and his/her family.

If the debtor owns their own home, & lives alone, lives with a co-habitee or lives with adult children, interest in the home normally passes to the trustee.

4: Legal concepts


Legal persons

Power of attorney

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7:25 PM

Contracts & agency

Insolvency procedures Three types of corporate insolvency: Administration – to provide a better way of realising company's assets than could be achieved by liquidation or receivership Receivership – concerned principally with interests of secured creditors who want to take control of charged assets Liquidation – mainly for the interests of unsecured creditors and members (shareholders) of the company. The company is dissolved and its affairs 'wound up'.

A voluntary liquidation cannot be initiated by shareholders if a company is insolvent.

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Property


Trusts & wills

If there was intent to defraud creditors or others, the court may decide that persons (usually, directors) who were knowingly parties to the fraud shall be personally responsible for debts and other liabilities of the company.

Aims of insolvency law Protect the creditors of the company Balance the interests of competing groups Control or punish directors responsible for company's financial collapse Encourage 'rescue' operations


Legal persons

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Power of attorney

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Page 117

Contracts & agency

Property


Trusts & wills

Valid will Signed by testator Witnessed by two people Not made under pressure

Intestacy Yes

Is there a valid will?

Administrators deal with the estate.

No

Types of trust Executors carry out the terms of a will, to distribute estate in accordance with testator’s wishes. A witness or their spouse cannot be a beneficiary. Marriage invalidates a will, unless the will states it is made in ‘contemplation of marriage’.

Trusts A trust is an equitable obligation in which trustees are bound to deal with property they control (as legal owners) for the benefit of the trust beneficiaries. Page 117

Bare Trust Interest in Possession Trust Discretionary Trust Charitable Trust

Some uses of trusts: will trusts, life trusts, family settlements, unincorporated associations, land gifted to children, protecting the identity of a beneficial owner 4: Legal concepts


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Notes

Page 118


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5: Client advice

Topic List The retail consumer Advising clients Institutional funds Client interaction

A client’s life stage, employment status and current financial position all influence the client’s needs in the financial planning context. Just as important are the client’s future prospects and aspirations. Planning is by definition forwardlooking and it is what the client can make of their current situation that matters. Different factors shape asset allocation for a client portfolio and for a fund. Accurate recording of information is of course vital, to help the financial planning process as well as to demonstrate compliance with regulatory provisions.


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The retail consumer

Page 120

Advising clients

Institutional funds

Client interaction

Consumers’ perceptions

Treating Customers Fairly (TCF)

In DP 18 An Ethical Framework for Financial Services (2002), the previous regulator (FSA) recognised that consumers increasingly understand an ethical stance.

The FCA’s TCF initiative identifies 6 improved outcomes to achieve for retail customers.

Professional conduct & ethical behaviour could strengthen confidence in the industry, but If consumers have diminishing trust in the sector & in firms, they will hesitate to use products & services

1.

Customer confident of receiving fair treatment (TCF is viewed as a matter of corporate culture)

2.

Products/services designed to meet the needs of specific consumer groups

3.

Customers are provided with clear (ie, simple & understandable) information

4.

Advice given to retail customers takes account of their circumstances

5.

Products perform as customers expect

6.

No unreasonable post-sale barriers imposed by firms (eg, when switching provider, making a complaint, etc)

There is also pressure from consumers & government for the sector to ‘put something back’, eg combating social exclusion.

TCF outcomes


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The retail consumer

Trust and confidentiality The consumer must have every reason to trust a financial adviser. Trust is gained through respect, through the way advisers deal with customers. The adviser must always treat personal information with the utmost confidentiality.

RDR The Retail Distribution Review (RDR) set up arrangements (since end of 2012) to enhance consumers’ confidence in using financial services.

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Page 121

Advising clients

Institutional funds

Client interaction

The adviser’s fiduciary duty An adviser's fiduciary responsibility implies that the adviser (or firm) acts in the best interests of the client (Client’s Best Interests Rule), to the exclusion of his or her own interests.

Firms’ obligations to consumers Authorised firms have an obligation to abide by the FCA Principles for Businesses and detailed rules, as set out in the FCA Handbook, in their dealings with consumers.

5: Client advice


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Page 122

The retail consumer

Advising clients

Institutional funds

Client interaction

Stages in giving advice Obtain relevant information Establish & agree client’s financial objectives Process & analyse information – identify & analyse client’s needs Formulate recommendations in a plan Implement recommendations, as agreed with client Review & regularly update the plan

Fact-find (questionnaire) Detailed in the fact-find

Analysing client circumstances, eg:

Structure of liabilities might be re-arranged Are protection arrangements adequate? Consider changes in circumstances: house, job, children Assess client’s disposable income – to determine affordability of a recommended product

Factors in formulating recommendations

Regulation & compliance Economic conditions Taxation State benefits Savings & investments Protection Client’s attitude to & understanding of risk


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The retail consumer

Page 123

Advising clients

Client objectives Two potential client requirements: To maximise returns, eg positive net worth individuals looking for a portfolio to match their risk/return preferences To match liabilities, eg pension funds, where aim is to match assets & liabilities or to minimise a mismatch Private clients could have objectives that mix liability matching (eg to pay school fees) & returns maximisation (for other funds, say). Maximising returns. Given the choice, investors would elect for high performance with minimal risk. In practice, this is not achievable: a risk/reward trade-off applies. Matching liabilities. Investments in government bonds can match income & capital inflows precisely with liabilities. Extending into more risky assets means that liabilities might not be met. Page 123

Institutional funds

Client interaction

Types of investor risk

Capital risk – potential variability in investment values Inflation risk – potential variability in inflation rates Interest rate risk – the risk of changes in bank base rates on asset returns Shortfall risk – the risk of a fund failing to meet any specified liabilities Liabilities can be nominal (eg bank loan) or real (eg living costs, which will rise with inflation). 5: Client advice


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The retail consumer

Page 124

Advising clients

Institutional funds

Client interaction

‘Know your customer’: collect information using the fact-find.

Typical fact-find Personal details: ‘hard’ facts

Family details

Employment details

Advisers

Financial details (‘hard’ facts) Assets

Liabilities

Name, address, date of birth, contact details, NI number/tax reference marital status, state of health country of domicile Dependants, other immediate family Occupation, employer time with employer, previous employer Bank, accountant, stockbroker, solicitor Property, belongings, antiques, stocks and shares, unit trusts, savings accounts, cash, other assets Mortgages, other loans and debts Get letter of authority for information needed from third parties.


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The retail consumer

Typical fact-find Income

Expenditure

Protection

Pensions

Wills and legacies

Customer’s attitudes (‘soft’ facts) Customer’s views on savings/ investment/protection

Customer’s objectives

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Advising clients

Institutional funds

Client interaction

Pay, bonus, benefits profits, if self-employed, investment income, pensions Living expenses, mortgage payments, school fees, regular savings, life assurance Life cover, disability insurance details Occupational schemes, personal pension schemes, preserved benefits Current will – when last reviewed? gifts in last seven years, anticipated legacies Attitude to risk, ethical investments? perceived needs? Moving/children’s education/retirement plans?

Review client information each time he/she seeks advice Page 125

5: Client advice


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The retail consumer

Clients’ typical life stages Minors (under 18) Young and single Married or cohabiting

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Advising clients

Institutional funds

Client interaction

Clients’ employment status Employed Self-employed Non-employed

Both working, no dependants One working, no dependants One working, with dependants Married or cohabiting, older children Children left home Retired

Client needs

Protection of financial stability Protection against adverse events Provision for future financial needs Pension provision Maintenance of living standards Ability to pass wealth on


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The retail consumer

Page 127

Advising clients

Institutional funds

Client interaction

Protection products Protection products help to protect financial stability from the potential adverse effects of common life events. Possible adverse events Death

Illness

Incapacity

Redundancy

Protection needs If there are dependants State benefits are limited

Emergency funds can act as a temporary cushion.

Page 127

CAPITAL

INCOME

Financial stability If the unexpected happens: What is the likely loss of earnings? What are the housing & mortgage implications? For a self-employed person, what are the likely effects for the business? 5: Client advice


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Page 128

The retail consumer

Advising clients

Institutional funds

Client interaction

Typical protection needs at different ages Age

Death

Sickness

Redundancy

Under 18

None

None

None

18-25

If married or in debt

If employed or self-employed

If employed

25-40

Significant: marriage, children, mortgage

Significant

Mortgage cover needed?

40-50

Less significant if children growing up

Increasing age increases risk Mortgage cover needed?

50-60

Less significant unless there is a second family

Long-term care cover may be If there is still mortgage considered debt

60+

Protection of assets, IHT liabilities

Health protection and longterm care

Some possible needs are shown above, but every case is different.

Not usually significant


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The retail consumer

Page 129

Advising clients

Institutional funds

Client interaction

Mortgages: loans secured on property. Lending sources

1

Capital and interest (or ‘repayment’) mortgage Borrower’s payments

Banks

Interest Lender

Capital

Building societies Insurance companies

2

Investment-related (or ‘interest only’) mortgage Borrower’s payments Capital

Interest Lender Savings vehicle

On maturity

eg: ISAs, pension lump sum, endowment policy Page 129

Mortgage corporations Credit companies (mainly unsecured loans) Islamic mortgages avoid interest, since interest is against Islamic (Sharia) law. The homebuyer may pay rent to the bank, with part of it going towards buying out the bank’s share in the property.

5: Client advice


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The retail consumer

Page 130

Advising clients

Institutional funds

Client interaction

Planning for retirement What age am I now? How much can I afford from income? What investment returns can I expect? Tax relief is available on pension provision

At what age will I retire? What income do I want in retirement? How will inflation erode the value of savings? Pensions in payment are taxed

Planning points

In retirement

Evaluate existing provision

State provision is limited

Consider PP or stakeholder

Housing costs can be significant

Consider additional contributions

What are the client’s aspirations?

Consider ISAs as alternative


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The retail consumer

Investment risks The adviser must: Understand investment risks Ensure that the client understands investment risks, before the recommendation or transaction

Advising clients

Institutional funds

Client interaction

The investor risks: Loss of income

Eg variable interest

Loss of capital

Assets which rise or fall in value, eg shares

Information on risks is included in the Key Features Document.

RISK

SAFETY

Risky investments

Safe investments

Investments with high potential return come with the risk of low or negative returns and loss of capital (eg: shares, collective investments, options, warrants).

Investments with low risk of loss of capital come with lower potential returns (eg: bank deposits, NS&I).

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5: Client advice


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The retail consumer

Diversification

– two sorts of risk:

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Advising clients

Institutional funds

Client interaction

Attitude to risk

The general market (systematic) risk of A client’s attitude to risk may be influenced by: investing in shares or bonds Investment timescales. Eg: in managing a pension fund, The specific (non-systematic) risk of any attitude to risk may depend on how far out in time liabilities fall individual investment Client’s risk tolerance. Standard fact-find approach: ask client to select a mix of, say, equities & bonds, to give an idea Diversification by asset class – portfolio of the normal mix (& hence risk) that the client wishes to face possibly spread across: cash, fixed interest (bonds), equities, property, & other assets Diversification within asset classes – a variety of investments, possibly spread The trade-off between risk & potential reward: across different geographical markets Low-risk investments offer low returns, but low probability Diversification by manager – to reduce of loss risk from a manager performing poorly (as in 'manager of manager' and 'fund of High-risk investments offer the possibility of high returns, with higher probability of loss fund' structures)

Investment risk & rewards


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The retail consumer

Risk profiles Rational Emotional decision making decision making High risk Methodical Cautious aversity Low risk Individualist Spontaneous aversity Based on Bronson, Scanlan, Squire Cautious investors Highly loss averse Need for security Want low-risk investments with safe capital Typically do not like making decisions but do not listen to others Tend not to use advisers Portfolios are low risk & with low turnover Page 133

Page 133

Advising clients

Institutional funds

Client interaction

Methodical investors Analytical & factual Make decisions slowly Little emotional attachment to investments & decisions Tend to be conservative in investment approach Spontaneous investors High portfolio turnover Do not trust the advice of others Some are successful investors, but most do less well, given high transaction costs Make decisions quickly & fearful of missing opportunities Individualist investors Self-confident Prepared to do analysis and & expect to achieve their long-term goals 5: Client advice


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The retail consumer

Page 134

Advising clients

Maintaining wealth

Institutional funds

Client interaction

Passing on wealth

Employees An employer may meet some protection needs Economic conditions affect What form of Is the remuneration package flexible? values of shares and other assets investment is most On pensions, salary sacrifice, additional and investments tax-efficient? contributions & stakeholder pensions Inflation erodes the real value of Non-housing assets might be considered assets expressed in money terms might be gifted to Self-employed reduce IHT liabilities House price inflation boosts Spouse might be employed to use equity but it may need to remain Life assurance personal allowance policies (usually tied up in housing No S2P (2nd State pension) entitlement whole of life) can be Own pension provision is necessary Future inheritances may change used to cover an IHT a client’s position Non-employed liability Are all benefits due being claimed? Can any expenses be met from capital? Personal pension contributions can be up Clients who have actively accumulated their to £3,600 p.a. for non-earners wealth typically have higher risk tolerance


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The retail consumer

Page 135

Advising clients

Institutional funds

Client interaction

Affordability

Client review

Affordability of investments & protection policies to be recommended for the client must be considered.

The adviser is concerned with identifying and satisfying client needs. This is not just a ‘one-off’ process. Clients will have a continuing need for financial advice. Their circumstances will change, & there may need to be a review of whether products initially recommended continue to be suitable.

The client's prospective disposable income should be ascertained in order to assess the affordability of regular contributions to policies & investment plans. Existing assets & policies, such as life assurance contracts & other savings need to be taken into account in quantifying the sizes of investments needed to meet client needs.

Page 135

Regular reviews of client circumstances will enable the adviser to make best use of future business opportunities with that client. For the client, there are benefits of advice arising from the review.

5: Client advice

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Client interaction Institutional funds Advising clients The retail consumer

Risk spectrum of investments

Low/ medium risk

Low risk

Gilts (pre-redemption capital) With-profits funds

Bank deposits Building society deposits Cash ISAs Annuities

Negligible NS&I deposit products risk Gilts (income) Gilts (redemption)

Medium risk Unit-linked managed funds Unit trusts & OEICs/ICVCs (UK funds) Investment trusts (UK) Residential and commercial property

Medium/ Unit-linked overseas high risk Unit trusts & OEICs/ICVCs (overseas funds) UK single equities Commodities High risk Venture capital trusts Unlisted shares Warrants Futures & options when used to speculate Enterprise Investment Scheme Enterprise Zone Property


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The retail consumer

Approach to fund management Evaluation performance

Strategies

Advising clients

Institutional funds

Client interaction

Strategic asset allocation

Objectives Establish investment policy

Page 137

Stock Selection

Allocation of the fund between various: Asset classes (shares/bonds etc) Currencies Based on:

Fund selection criteria Past performance Charges Entry (initial) & exit charges, annual management charges Financial stability of provider Stability, independence & standing of trustees, auditors & fund custodians Page 137

Objectives of fund & client Assets available for investment

Concept: the objectives & constraints direct you towards certain asset classes and away from others

5: Client advice


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The retail consumer

Active and passive management An active investment manager tries to use individual expertise to enhance the overall return of the fund.

v

Passive investment management, on the other hand, establishes a strategy which, once established, should guarantee the appropriate level of return for the fund.

Indexation The index fund manager selects an appropriate index and builds a portfolio to mimic the index. Index funds typically based on a sampling approach, and thus exhibit some tracking error. Transaction costs will typically be low, although the portfolio must change to accommodate changes in index constituents.

Page 138

Advising clients

Institutional funds

Client interaction

a range of criteria to meet Ethical funds cover client ethical preferences.

Fund review Fund performance should be reviewed at least annually to evaluate whether fund is achieving its objectives. Client circumstances – any changes, which might require a change in strategy? Performance review – monitor against fund’s selected benchmark Portfolio rebalancing – consider potential changes to agreed asset allocations


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The retail consumer

Page 139

Advising clients

Institutional funds

Client interaction

Benchmarks

Risk profile of funds

Three forms of analysis of a fund's performance:

Each type of institutional fund has its own particular risk/reward profile stemming from:

Comparison to relevant stock/index, eg a published market index Comparison to similar funds, ie performance of other similar fund managers, measuring: – Short and long-term investment return – Asset distribution of funds – Performance against peer groups, market indices & medians Comparison with customised benchmark for funds with a unique constraint, eg ethical funds that cannot invest in arms/tobacco (standardised FTSE4Good indices meeting ethical criteria are available) Page 139

Its initial objectives, return maximising/liability matching The value and time horizons of the liabilities it has to meet (if any) The assets it can invest in The liquidity required within the fund The risk that can be tolerated Its tax status Legislation governing its powers 5: Client advice


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The retail consumer

Page 140

Advising clients

Institutional funds

Client interaction

Pension funds – liability matching

Funds:Tax

A pension fund is a pool of money to be invested now, to achieve either:

Approved pension funds pay no UK tax on either fund income or capital gains.

A specific return based on the employee's salary & number of years' service with the company – a defined benefit (DB)/ final salary scheme, or A general increase in value of the contributions paid on behalf of the employee – a defined contribution (DC)/ money purchase scheme

Life funds: all fund income & capital gains are taxable, so the investment manager will tend to select more tax-efficient investment vehicles.

General insurance: business profits are subject to normal corporation tax rates.

Reasons for decline in DB schemes and rise of DC schemes – Pressure on DB schemes from: Increased longevity Flling returns on scheme assets Poor financial position of schemes Requirements to disclose scheme funding position in company’s financial statements


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Page 141

The retail consumer

Advising clients

The time horizon for the attainment of the return, or the matching of liabilities, will influence types of investment selected. A fund with a long-term time horizon can probably stand a higher risk: poor returns in some years will tend to be cancelled by high returns in other years. Pension funds & life assurance companies will have statistical projections of their liabilities into the future & the fund must attempt to achieve these. Currency risk. A pension fund may have all its liabilities denominated in sterling. If the fund were to invest heavily in overseas assets, this would expose it to additional risk, other than the risk inherent in the assets themselves. Page 141

Institutional funds

Client interaction

Liquidity needs. Within any fund, there needs to be a degree of liquidity, to respond to changing events. Risk aversion & risk tolerances. The risk/reward trade-off impacts on ways in which the fund’s requirements can be achieved.

Constraints on funds Asset allocation

The fund or portfolio manager has legal & professional duty to base the asset allocation on client's wishes with particular regard to:

Matching liabilities Meeting any ethical considerations Remaining within risk tolerances Maximising fund performance 5: Client advice


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The retail consumer

Page 142

Advising clients

Institutional funds

Client interaction

Asset and liability matching Constraints Time

Young pension fund Long-term

Mature pension fund Short-term

Life assurances fund Long-term

General insurance fund Short-term

Liability Liquidity

Real Very low

Real High

Nominal Low

Nominal Very high

Risk tolerance Tax status

High Low Medium/high Gross fund, no tax on Gross fund, no tax on Tax on income and income or gains income or gains gains

Very low Tax on income and gains

Possible asset allocation Equities Property

60% - 80% 5% - 10%

20% - 30% 0% (illiquid)

55% - 65% 0% - 5%

0% 0%

Bonds

15% - 25%

55% - 65%

15% - 30%

100%

Cash

0% - 5%

15% - 25%

5% - 15%

100%


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The retail consumer

Advising clients

Institutional funds

Client interaction

Factual v evaluative statements

Closed and open questions

Factual information is distinct from evaluative statements about someone’s hopes, wants, plans, opinions or feelings.

Closed questions ask for specific information, & typically the answer is very short, or is ‘Yes’ or ‘No’.

Examples Closed questions

Factual information

Disregarding dividends, the fund has grown in value by more than the FTSE 100 index over the 3-year period. Brenda has fallen into two months' arrears on her mortgage payments.

Could you please tell me your address? Do you have any ISAs? Open questions give the client more opportunity to express views or feelings in a longer response.

Non-factual statements

Graham thinks that he should invest more of his portfolio in foreign stocks, in order to diversify risk. Matilda was disappointed by the service provided by her previous financial adviser.

Page 143

Open questions

How do you feel about taking risks with your investments? What do you think are the most immediate financial needs to be addressed? 5: Client advice


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The retail consumer

‘Know your customer’ (KYC) To know your customer – basic requirement of the regulatory regime and part of adviser’s fiduciary duty.

Page 144

Advising clients

Institutional funds

Client interaction

Written reports to clients Parts of a financial planning report

Obtain sufficient information about a customer's personal & financial situation, before giving advice or (if applicable) before constructing a portfolio for the customer.

Statement of client's objectives Summary of client's income & assets; other relevant circumstances/ problems

Know the customer’s capabilities, adapting both spoken & written communication to suit the customer. Such adaptation should cover technical terminology & quantitative analysis presented.

Appendices, if appropriate

In presentations to clients, continually check (eg, by asking open questions) for indications that the client understands, explaining points again & more simply as necessary.

Recommendations, including any proposals for immediate action as well as longer-term suggestions

The language in the report should be phrased concisely with explanations to suit capabilities of client, avoiding unnecessary jargon.


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6: Taxation

Topic List Income tax National insurance Capital gains tax IHT & trusts Other taxes Tax on investments

In covering the tax element of the syllabus, we examine various aspects of the taxation of individuals. Different products suit clients with different tax situations, and there may be a financial advantage in careful tax planning. Inheritance tax (IHT) is charged on lifetime gifts and on an individual’s estate at death. Same-sex civil partnerships established under the Civil Partnership Act 2004 follow the same tax treatment as married couples.


Income tax

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National insurance

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Capital gains tax

Page 146

IHT & trusts

Other taxes

Tax on investments

Residence If an individual ... 1

Satisfies automatic overseas test > then, non-resident

2

Satisfies automatic UK test (eg, spending 183+* days of tax year in UK) > then, UKresident

3

If neither, then a sufficient ties test is applied.

*Counting days when person is in UK at midnight.

Domicile An individual is domiciled in the country which is his permanent home. Someone can only change domicile by severing ties with old country & establishing a permanent life in a new one.

UK residents are taxable on worldwide income. Non-residents are taxable on UK-derived income.

A remittance basis charge may be payable if claiming remittance basis: £30,000 for ‘nondoms’ who were UK-resident for 7 of the last 9 tax years; £50,000 if resident for 12 of last 14 tax years. Non-UK domiciled UK residents are only taxable on overseas income if it is remitted to the UK or if it is from employment.


Income tax

National insurance

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Capital gains tax

UK income tax system Pay as you earn (PAYE): tax on employment earnings, deducted at source Self-assessment: where additional tax is payable Payments on account: 31 January & 31 July (if self-employed or < 80% of last year’s tax paid at source) The fiscal year runs from 6 April to 5 April.

Page 147

IHT & trusts

Other taxes

Tax on investments

Income tax rates (2013/14) Rate

Taxable income

Salary and Dividends interest

Basic

£0 to £32,010

20%

10%

Higher

£32,011 to £150,000

40%

32.5%

Additional

>£150,000

45%

37.5%

Tax avoidance v.Tax evasion Tax avoidance: the taxpayer uses tax rules to his/her advantage Tax evasion: the taxpayer does not pay all tax due, eg by under-reporting his/her income Page 147

There is also a 10% starting rate for savings income only, with a limit of £2,790 of taxable earnings. The starting rate is not available if taxable non-savings income exceeds £2,790. 6: Taxation


Income tax

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National insurance

7:26 PM

Capital gains tax

Gross taxable income less Personal allowance Qualifying pension contributions Allowable gifts to charity equals Taxable income

Allowances (2013/14) There is a personal allowance of £9,440* The personal allowance is reduced by £1 for every £2 excess income above £100,000 (thus falling to zero for incomes over £118,880) Those born before 6 April 1948 may get a higher personal allowance, subject to an income limit.

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IHT & trusts

Other taxes

Tax on investments

Pension contributions Contributions to personal or stakeholder pension plan are paid net of basic rate tax, even for eligible non-taxpayers. Higher/ additional rate taxpayers can reclaim more, to get tax relief at marginal rate. Annual allowance cap on tax-relievable contributions is the lower of 100% of income and £50,000 (2013/14), with carry forward rules. Low or non-earners can make up to £3,600 gross contributions and still get tax relief. Contributions to an occupational pension scheme are deductible from earnings for tax purposes.


Income tax

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National insurance

7:26 PM

Capital gains tax

Page 149

IHT & trusts

Other taxes

Tax on investments

A basic principle of income tax is the aggregation of income. Income from all sources is aggregated in a personal tax computation. Income taxed at source Exempt income

Taxing income

Non-savings income is taxed first, then savings (excl. dividend) income then dividend income is taxed last. Non-savings income is taxed at 20% (basic rate), then 40%, & 45%. Savings income starting rate of 10% (only where savings income falls below starting rate limit), then 20% (in basic rate band), then 40%, & 45%. Dividend income is taxed at 10% (not 20%) in basic rate tax band, at effective total rate of 32.5% for higher rate, & 37.5% for additional rate taxpayers. Page 149

Bank/building society interest: received net of 20% tax Debenture interest: received net of 20% tax Dividends: received net of 10% tax credit Include GROSS income in computation

Premium Bond prizes Returns on NS&I Savings Certs. Income in ISAs Betting/gaming winnings Do not include in computation

Tax credits on dividends can be offset to reduce tax but are never repaid to taxpayer.Tax suffered on other taxed income can be repaid. 6: Taxation


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IHT & trusts

Other taxes

Tax on investments

Dividends taxation

Planning points

Higher rate (40%) taxpayers’ liability for tax at 32.5% on dividends. This equates to: 10% of gross dividend + 25% of net dividend

Transfer assets? Transfer income yielding assets to the spouse with the lower marginal tax rate. To be effective, such transfers should be unfettered rights.

Example A higher rate taxpayer is paid a gross dividend of £400 He receives £360 after withholding tax (£40 collected at source) He has to pay 25% of £360 = £90 further to meet his liability Total tax paid = £130 (32.5% of £400 = £130) Additional rate (45%) taxpayers pay 37.5% on dividends.

Children If parent gives income (or assets which generate income) to a child, the income is treated as the parent’s if the child is under 18 and unmarried.

Does not apply if the income is £100 a year or less Does not apply to gifts from grandparents, uncles etc


Income tax

National insurance

Class

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Other taxes

Tax on investments

National insurance contributions

1

Payable by employees on their earnings above the ‘primary threshold’ Amount payable depends on an individual’s income

1A

Payable by employers on certain types of non-monetary benefits given to employees (eg, a company car)

1B

Payable by employers on an employee’s earnings

2

Payable by self-employed persons If earnings below the small earnings exemption, no NICs payable

3

Voluntary – usually to fill gaps in contributions

4

Payable by self-employed, if profits exceed a threshold

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IHT & trusts

Other taxes

Tax on investments

Capital Gains Tax: rates For individuals, taxable gains are taxed at 18%, but at 28% for gains (after the annual exemption) that fall in the higher rate band.

Married couples / civil partners 1

Disposals between spouses / civil partners living together do not give rise to gains or losses.

2

Spouses / civil partners are taxed as separate people, each with an annual exemption.

Capital gain calculation Disposal consideration (or market value) Less disposal costs Less costs of acquisition / enhancement Equals Capital gain

Annual CGT exemption of £10,900 (2013/14) is deducted when computing individual’s total taxable gains.


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Chargeable persons, disposals and assets Three elements are needed for a chargeable gain to arise.

1

A chargeable disposal: this includes sales, gifts and the destruction of assets.

2

A chargeable person: individuals.

3

A chargeable asset: most assets are chargeable, but see exempt list.

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Other taxes

Tax on investments

Exempt assets Exempt from capital gains tax: NS&I Savings Certificates & Premium Bonds Betting & lottery winnings Foreign currency, for private use Gilts (Government stocks) Qualifying corporate bonds Tangible movable property up to £6,000 per item Wasting assets (life of 50 years or less) Private cars Investments in ISAs, Enterprise Investment Scheme & Seed EIS Own home (principal private residence) 6: Taxation


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Capital gains tax

Example Donna has taxable income of £22,000. In 2013/14, she sold shares for £42,000 that she had bought five years ago for £28,000. The annual CGT exemption is £10,900. What CGT must Donna pay? Solution £42,000 – £28,000 = £14,000 net gain. £14,000 – £10,900 = £3,100 taxable gain. £22,000 [income] + £3,100 = £25,100, within the basic rate band. Donna must pay CGT of 18% x £3,100 = £558.

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IHT & trusts

Other taxes

Tax on investments

CGT planning Ways to mitigate extent of CGT liabilities: Spread ownership of assets among family members Phased encashments Realise paper loss Sell shares & repurchase other shares as substitutes Use ISAs


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Tax on investments

Deduct allowable capital losses from chargeable gains in the tax year in which they arise. Any loss which cannot be set off is carried forward to set against future chargeable gains. Allowable losses brought forward are only set off to reduce current year chargeable gains less current year allowable losses to the annual exempt amount.

Example Zoë made chargeable gains of £12,200 in 2013/14. She had brought forward capital losses of £7,000.

Matching gains on shares Disposals by individual shareholders are matched with acquisitions in the following order. Same day acquisitions Acquisitions within the following 30 days Other shares: the ‘share pool’

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Brought forward capital losses of £12,200 – £10,900 = £1,300 will be set off in 2013/14. The remaining losses will be carried forward to 2014/15.

Stops ‘bed and breakfasting’

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Capital gains tax

Inheritance tax (IHT) is charged: (1) on death, (2) on gifts within 7 years of death, (3) on chargeable lifetime transfers

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IHT & trusts

Other taxes

Tax on investments

Exemptions for lifetime transfers only

Small gifts £250 or less per donee per tax year

Annual exemption £3,000: 1 yr carry forward possible

Potentially Exempt Transfers

Normal expenditure out of income

PETs include lifetime transfers to individuals and to trusts for the disabled PETs are initially assumed to be exempt They are chargeable if the donor dies within 7 years

Marriage exemptions

Most lifetime transfers into trusts not covered by an exemption are immediately liable to IHT (chargeable lifetime transfers (CLTs)).

£5,000 from parent £2,500 from remoter ancestor £1,000 from anyone else

Exemptions for lifetime and death transfers Transfers between spouses/ civil partners Transfers to charities, political parties or for national purposes Transfers of land to housing associations


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IHT planning Potentially Exempt Transfers (PETs). Gift made by individual in lifetime is potentially exempt IHT provided not made in last 7 years of life Gifts to trusts. Transfer to a discretionary trust will attract IHT rate of 20% if transfer not made in last 7 years of life Gifts with reservation of benefit (GWR) – A gift with strings attached. Still considered part of individual’s estate for IHT purposes.

Example: transfer of nil rate band Eric McMullan dies & leaves his entire estate to his wife. 100% of his nil rate band has been unused. This transfers to his wife. If the individual nil rate band is £350,000 when his wife dies then her nil rate band will be: = £350,000 + 100% of £350,000 = £350,000 + £350,000 = £700,000

Nil rate band. Transfer of nil rate band between spouses / civil partners. Transfer is on percentage basis, not on a cash basis (see Example).

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6: Taxation


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Other taxes

Tax on investments

Inheritance tax on death

IHT on the estate is found by taking into account all transfers in 7 years before death. IHT on each lifetime transfer made in 7 years before death is found as follows: 1 Take into account all chargeable transfers (including PETs which have become chargeable) in 7 years before the transfer 2 Find the tax at full rates: £325,000 at 0% (2013/14); remainder at 40% – then deduct any taper relief (percentage reduction in IHT charge given if transfer was made more than 3 years before death) 3 Deduct any tax already paid on the transfer

Trusts and beneficiaries: tax Tax

Non-dividend income

Dividend income

1st £1,000

20% (‘basic rate’)

10% (dividend ordinary rate)

Income > £1,000

45% (‘trust rate’)

37.5% (dividend trust rate)

Beneficiary may be able to reclaim tax charged on income received from a trust (if nontaxpayer or basic rate taxpayer)


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Stamp Duty Land Tax

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Capital gains tax

– payable on buying property

Value (residential property) Up to £125,000 Over £125,000 up to £250,000 Over £250,000 up to £500,000 Over £500,000 up to £1,000,000 Over £1,000,000 up to £2,000,000 Over £2,000,000

SDLT rate 0% 1% 3% 4% 5% 7%

Value (non-residential property) Up to £250,000 * Over £250,000 up to £500,000 Over £500,000

SDLT rate 1% 3% 4%

* SDLT is 0% on non-residential property up to £150,000 if it earns annual rent of less than £1,000. Page 159

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Tax on investments

Stamp duty reserve tax (SDRT) ½% rate of tax (rounded to nearest 1p) Payable (in a paperless transaction) by buyer of: Shares in a UK company Shares in a foreign company with UK share register An option to buy shares Rights arising from shares already owned An interest in shares, ie an interest in the money made from selling shares Payments are made through CREST. For unit trusts & OEICs, the fund manager pays SDRT when units are surrendered. 6: Taxation


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Corporation tax (FY 2013)

IHT & trusts

Other taxes

Tax on investments

Value Added Tax (VAT)

Corporation tax is payable by: Companies resident in the UK on worldwide profits Overseas companies on UK-derived profits Companies pay main rate in quarterly instalments, based on the estimated corporation tax liability. Other companies pay whole amount 9 months & 1 day after end of accounting period.

Main rate

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Company profits

FY 2013 rate

> £1.5m

23%

Chargeable on supply of goods & services in the course of business – a tax on turnover, not profits VAT rates 0% – eg, books & children’s clothing 5% – energy services & products 20% – ‘standard rate’ on most other goods

Small profits rate

< £300k 20% Companies with profits falling between £300k & £1.5m pay on a sliding scale to give an effective rate between 20% and 23%. Losses can be offset against: This year’s profits Last year’s profits, or Future years’ profits from same trade

VAT on investment services Commissions – exempt (not the same as 0%) Advisory services – standard rate, if invoiced separately (otherwise, exempt) Nominee services – exempt Portfolio management – standard rate


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Tax on investments Direct investments are taxed based on relevant income tax or CGT rate. Indirect investment

Pension funds Individual Savings Accounts (ISAs) Existing Child Trust Funds (CTFs) Real Estate Investment Trusts (REITs) Collective Investment Schemes (CISs) & investment companies Life insurance funds Venture Capital Trusts (VCTs) Enterprise Investment Schemes (EISs) Page 161

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Other taxes

Tax on investments

Tax treatment of pension benefits Key points Tax-free lump sum (up to 25% of accumulated funds) can be taken from age 55. Remainder used to produce an income, subject to income tax. Lifetime limit of £1.5m (2013/14) A lifetime allowance charge applies on any excess: 25% for funds taken as income 55% for funds taken as a lump sum

6: Taxation


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Other taxes

Tax on investments

ISAs

Junior ISA

Key points Not an investment, but rather a tax ‘wrapper’ Cash ISA or Stocks & Shares ISA Annual limit on how much can be invested in ISA (£11,520 for 2013/14) Up to 50% of this can be invested in a Cash ISA Investments within ISA not subject to income tax or CGT Tax paid at source (eg, 10% tax credit on dividends) is not recoverable Withdrawals allowed at any time

Available since 1 November 2011: Max. £3,720 can be invested for a child per tax year in cash, stocks & shares (2013/14) Holdings are not subject to income tax or CGT Replaces the Child Trust Fund

Real Estate Investment Trusts (REITs) Rental income and capital gains exempt within fund, but REITs are required to distribute most rental income. Investors are subject to income tax on distributions, which are subject to 20% withholding tax. Investors are also subject to CGT.


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Tax on investments

Collective investments Unit Trusts & OEICs In general, an authorised unit trust is treated as an investment company, with its units being treated as shares in the company & any distribution as a dividend. Basic principle: to make the unit trust effectively transparent for tax purposes, with no additional tax borne solely, because assets are held within a unit trust. Income Authorised and unauthorised unit trusts and OEICs pay corporation tax at 20%. Franked income is not subject to corporation tax. Capital gains Authorised unit trusts & OEICs are exempt from CGT on disposals of investments & are thus able to switch investments free of tax. Page 163

Investment trusts (ITs) Income Income for an investment trust is divided into franked investment income (largely dividends received from other UK companies) & unfranked income. Franked income is not chargeable to corporation tax, while corporation tax is payable on unfranked income. Capital gains Capital gains are free from tax for HMRC-approved ITs.

6: Taxation


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Other taxes

Tax on investments

Distributions

Life funds

Dividend distributions from a collective investment fund are treated like dividends for income tax purposes. Interest distributions are taxed as yearly interest of the share or unit holder & tax is deducted for UK residents. On sale, the investor is subject to CGT (unless the holding is within a tax wrapper).

Proceeds from a qualifying life assurance policy are usually free of income tax & CGT. Requirements: Premiums paid for at least 10 years Premiums paid at least annually One-off or regular payments from single premium UK life assurance policy (or life assurance bond) usually lead to no income tax. Up to 5% of original premium can be withdrawn per year without incurring additional income tax liability.


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Other taxes

Tax on investments

Enterprise Investment Scheme (EIS) Venture Capital Trusts Investor’s tax liability is reduced by 30% of the invested amount (subject to £200,000 investment maximum). If shares are not held for 5 years, the relief is clawed back Dividend income is tax-free No CGT (both within VCT and for investor)

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Offers tax incentives to individuals to invest in new & growing businesses

Certain unquoted shares & AIM shares

Gains on disposals are not taxed (if held for 3 years)

Income tax relief given at 30% of investment (£1,000,000 max. investment – 2013/14)

6: Taxation


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IHT & trusts

Other taxes

Tax on investments

Offshore funds Reporting funds

Non-reporting funds

Must notify HMRC annually of reportable income as well as distributed income

A fund without ‘reporting’ status

Income Income tax on their share of income* Gains

18%/28% CGT on realised gains * Even if not distributed

Income tax** Income tax on realised gains ** When distributed

Like earlier rules they replace, the current Offshore Funds (Taxation) Regulations 2009 seek (as above) to: Stop investors accumulating untaxed income offshore while only paying tax on realised capital gains Apply income tax on gains by investors in funds that roll up income


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Notes

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Unit 1 IMC Passcards

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