UK Reg CH 4 - The FCA's Conduct of Business and Client Assets Sourcebooks

Question 1

1. What is the impact of location on the application of the COBS rules?

Answer 1

The general application rule is based on geographical location and states that firms are subject to COBS if they carry on any of a range of activities from an establishment maintained by them or their appointed representative in the UK.

Question 2

2. What activities are subject to the COBS rules?

Answer 2

The activities that are subject to COBS are:
designated investment business
long-term insurance business in relation to life policies
accepting deposits – in part, eg, financial promotion rules, and rules on preparing and providing product information.

Question 3

3. Which COBS rules are disapplied for firms undertaking ECP business?

Answer 3

A range of COBS rules are disapplied, in certain cases, for firms carrying on eligible counterparty business). These include:
A large part of COBS 2 – general conduct of business obligations
Much of COBS 4 – communicating with clients (including financial promotions)
COBS 6.1 – provision of information about the firm, its services and its remuneration
COBS 8 – client agreements
COBS 10 – appropriateness (for non-advised services)
Certain parts of COBS 11 – best execution, client order handling and use of dealing commission
Parts of COBS 12 – labelling of non-independent research
COBS 14.3 – information relating to designated investments
COBS 16 – reporting requirements to clients.

Question 4

4. Do appointed representatives have to comply with the COBS rules?

Answer 4

The COBS rules also apply to firms in relation to the relevant activities carried on for them by their appointed representatives.

Appointed representatives are exempt; that is, they can carry out a range of regulated activity under the auspices of their principal firm, which has accepted responsibility for the activity. See Chapter 2 if you need to review the regulated activities that may or may not be conducted by appointed representatives.

Question 5

5. What types of conversations must be recorded?

Answer 5

Preventing, detecting and deterring market abuse is one of the FCA’s key priorities. However, market abuse is one of the most difficult offences to investigate and prosecute. Good quality recordings of voice recordings and electronic communications (taping) help firms and the FCA to detect and deter inappropriate behaviour.

Question 6

6. How will a MiFID firm classify its client in relation to non-MiFID business?

Answer 6

MiFID laid down rules as to how client categorisation has to be carried out for MiFID business. For non-MiFID business, the FCA uses the same client categorisation terminology but the rules on how the categories must be applied are modified in some cases.
If a firm provides a mix of MiFID and non-MiFID services, it must categorise clients in accordance with the MiFID requirements, unless the MiFID business is conducted separately from the non-MiFID business.
So, for example, if a firm were to advise a client on investing in a CIS (advice about which would fall within the scope of MiFID) and also about a life policy (which would not), it should use the MiFID client categorisation.

Question 7

7. What are the three client categories?

Answer 7

Under COBS, clients may be categorised as:
a retail client
a professional client, or
an eligible counterparty.

Question 8

8. What are the criteria for reclassifying a retail client as an elective professional client?

Answer 8

A retail client may be treated as an elective professional client when:
the firm has assessed his (or its) expertise, experience and knowledge and believes he can make his own investment decisions and understands the risks involved (this is called the qualitative test) and – additionally – for MiFID business
any two of the following are true (this is called the quantitative test):
the client carried out, on average, ten significantly sized transactions on the relevant market in each of the past four quarters
the size of the client’s financial portfolio exceeds e500,000 (defined as including cash deposits and financial instruments)
the client works or has worked as a professional in the financial services sector for at least a year on a basis which requires knowledge of the transactions envisaged.
Assuming the client passes the qualitative and, for MiFID business, the quantitative test, the client must put in writing to the firm their wish to be reclassified and the specific services and/or products that this will apply to. The firm has to respond with a clear written warning of the investor protections that will be lost, and the client must state in writing, separately, that they are aware of the consequences of losing such protections.

Question 9

9. Who are elective eligible counterparties?

Answer 9

A professional client may be treated as an elective ECP if it is a company and it is:
a per se professional client (other than one which is only a professional client because it is an institutional investor), or
it asks to be treated as such and is already an elective professional client (but only for the services for which it could be treated as a professional client), and
it expressly agrees with the firm to be treated as an ECP.

Question 10

10. What are the notification requirements to clients on their client categorisation?

Answer 10

New clients must be notified of how the firm has classified them. They must also, before services are provided, be advised of their rights to request recategorisation and of any limits in their protections that will arise from this.

Question 11

11. What information must be disclosed prior to providing services?

Answer 11

COBS 2.2 sets out high-level disclosure requirements. Firms carrying on MiFID business, or equivalent third country business, must provide clients with appropriate information in a comprehensible form about:
the firm and its services
designated investments and proposed investment strategies, including appropriate guidance on, and warnings of, risks associated with investments in those designated investments or in respect of particular investment strategies
whether methodologies for assessing the risk that a customer is willing and able to take with their money are fit for purpose, including the use of risk-profiling tools
whether descriptions firms use to reflect and check the level of risk a customer is assessed as being willing and able to take are fair, clear and not misleading
whether processes for choosing investments result in selections that are suitable for the risk a customer is willing and able to take, including the use of asset allocation tools
execution venues
costs and associated charges.

Question 12

12. When is a firm required to provide a client agreement?

Answer 12

A firm must provide a retail client with the following general information, if relevant:

The name and address of the firm and contact details necessary to enable the client to communicate effectively with the firm.
In respect of MiFID business or equivalent third-country business, the languages in which the client may communicate with the firm and receive documents and other information from the firm.
The methods of communication to be used between the firm and the client, including those for the sending and reception of orders.
A statement of the fact, that the firm is authorised and the name and contact details of the competent authority that has authorised it.
If the firm is acting through an appointed representative or, where applicable, a tied agent, a statement of this fact specifying in which EEA state the appointed representative or tied agent is registered.
The nature, frequency and timing of the reports on the performance of the service to be provided by the firm to the client in accordance with the rules on reporting to clients on the provision of services [COBS 16].
Information about the firm’s conflict of interest policy – a summary of the firm’s policy, including the manner in which the firm will ensure fair treatment of the client and that further details are available on request.
A firm must disclose in writing to a retail client, in good time before the provisions of its services in respect of a personal recommendation or basic advice in relation to a retail investment product, whether the advice will be independent advice or restricted advice.
Disclosure must be made in a durable medium or through a website. A firm is able to provide the disclosure by using a services and costs disclosure document or a combined initial disclosure document.
If a firm provides restricted advice and engages in spoken interaction with a retail client, the firm must disclose orally in good time before the provision of its services in respect of a personal recommendation that it provides restricted advice and the nature of that restriction.

Question 13

13. What is the purpose of the financial promotion rules?

Answer 13

The purpose of the financial promotion rules is to ensure that promotions are identified as such, and that they are fair, clear and not misleading.

Question 14

14. Which two of the Principles for Businesses are amplified by the financial promotion rules?

Answer 14

The financial promotion rules are consistent with Principles 6 and 7 of the Principles for Businesses:

Principle 6 – a firm must pay due regard to the interests of its customers and treat them fairly.
Principle 7 – a firm must pay due regard to the information needs of its clients and communicate information to them in a way which is clear, fair and not misleading.

Question 15

15. What types of communication are subject to the fair, clear and not misleading communication rule?

Answer 15

Firms must ensure that all communications relating to designated investment business, including financial promotions, are fair, clear and not misleading.

The way in which this is achieved should be appropriate and proportionate and take account of the means of communication and what information the communication is intended to convey. So, for example, communications aimed at professional clients may not need to include all the same information as those aimed at retail clients.

Question 16

16. List the main exceptions to the financial promotion rules.

Answer 16

The financial promotion rules are disapplied in certain cases, notably for excluded communications.

These are communications which:

are exempt under the financial promotion order (FPO – this is a Treasury order which allows unauthorised persons to communicate specified types of promotion, or, in specified circumstances, without the communication having to be approved by an authorised firm), or
originates outside the UK and cannot have an effect within the UK, or
an overseas communication that meets criteria for exemption under the FPO, or
are subject to (or exempted from) the Takeover Code or similar rules in another EEA state, or
are personal quotes or illustration forms, or
are one-off promotions that are not cold calls (subject to certain conditions), or
are promotions about unregulated CISs that are permitted because they fall within one of the exemptions in the FSMA 2000 (Promotion of Collective Investment Schemes (Exemptions) Order 2001).

However, the exemption for excluded communications does not generally apply in relation to MiFID business.

Question 17

17. When do the prospectus advertisements rules apply?

Answer 17

Prospectus Rule PR 3.3 applies to offers, or admission to trading, of transferable securities in respect of which:

a prospectus is required under s.85 of the FSMA, or
where an election to produce a prospectus has been made under s.87 of FSMA.

A prospectus advertisement is any type of communication (eg, TV, press, email, letter, text, brochure) that specifically promotes the offer to subscribe or acquire securities.

Question 18

18. When is a firm permitted to cold call retail clients?

Answer 18

Firms must not cold call unless:

the recipient has an existing client relationship with the firm and would envisage receiving such a call or

the call relates to a generally marketable packaged product, which is neither a higher-volatility fund, nor a life policy linked to such a fund or

it relates to a controlled activity relating to a limited range of investments, including deposits and readily realisable investments other than warrants or generally marketable non-geared packaged products

Question 19

19. What are the rules on churning and who they do they apply to?

Answer 19

Churning is the activity of over dealing/trading more frequently for a client in order to generate additional fees/commissions for the firm. It is relevant where, for example, a firm manages a client’s portfolio on a discretionary basis. Switching is the activity of selling one investment and replacing it with another.

Question 20

20. What is the purpose of the suitability rules?

Answer 20

The suitability rules exist to ensure that firms take reasonable steps to ensure that personal recommendations (or decisions to trade) are suitable for their clients’ needs.

When a firm makes a personal recommendation or is managing a client’s investments, it should obtain the necessary information regarding the client’s:

knowledge and experience in the investment field relevant to the specific type of designated investment business
financial situation and
investment objectives.

Question 21

21. What is the appropriateness test?

Answer 21

In assessing appropriateness, the firm:

must determine whether the client has the experience and knowledge to understand the risks involved
may assume that a client, classified as a professional client for certain services/products, has the necessary knowledge and experience in that field for which it is classified as a professional client.

In terms of a client’s knowledge and experience, a firm should obtain information (to the extent appropriate to the circumstances) on:

the types of service/transaction/investment with which they are familiar
the nature, volume, frequency and period of their involvement in such transactions/investments
the level of education, profession or relevant former profession.

Question 22

22. What is the purpose of the cancellation rules?

Answer 22

The rules on cancellation apply to:

most firms providing retail financial products based on designated investments or deposits and
firms entering into distance contracts with consumers, relating to deposits or designated investments.

They are intended to ensure that clients entering into the relevant range of transactions have the opportunity to reconsider, within a certain period of time and to cancel the transaction. When a consumer does so, the effect is that the contract is terminated.

Question 23

23. State four steps firms could take to prevent or manage conflicts of interest.

Answer 23

A firm should:

maintain and operate effective organisational and administrative arrangements, designed to prevent conflicts of interest from adversely affecting the interests of its clients

for those producing externally facing investment research, have appropriate information controls and barriers to stop information from these research activities from flowing to the rest of the firm’s business

if a conflict arises the firm must disclose the interest to the client before undertaking business for the client – the disclosure must be in a durable medium and be in sufficient detail to allow the client to make an informed decision as to the provision of the service. (Note that disclosure alone is insufficient to meet the rules; the firm’s arrangements should be designed to prevent conflicts arising in the first place)

prepare, maintain and implement an effective conflicts policy

provide retail clients and potential retail clients with a description of that policy and

keep records of those of its activities where a conflict has arisen.

Question 24

24. What is the difference between investment research and research recommendations?

Answer 24

There are particular conduct of business rules for managing conflicts of interest, when a firm produces investment research. Investment research is information recommending or suggesting an investment strategy, including opinion as to the present or future value/price of the investments, and intended for distribution to the public as opposed to just for use within the firm or the firm’s group.
It has to be clearly labelled as investment research and presented as an objective or independent explanation of the matters that are the subject of the research. It must not be presented in such a way that it constitutes a personal recommendation to a client of an investment firm.
The rules are different if a firm produces non-independent research. That is, in summary, research that includes a research recommendation; this being a recommended strategy or a particular investment recommendation and the research does not otherwise comply with the conditions to ensure the independence of the research.
Firms that prepare or disseminate research recommendations have to comply with detailed standards for presentation and disclosure of certain information.

Question 25

25. What payments are permitted under the inducements rules?

Answer 25

In relation to MiFID business, firms are prohibited from paying or accepting any fees or commissions, or providing or receiving non-money benefits, other than:

fees, commissions or non-monetary benefits paid to or by the client, or someone on his behalf (such as management fees), or
proper fees which are necessary for the provision of the service (eg, custody costs, legal fees, settlement fees) and which cannot by their nature give rise to conflicts
fees, commissions or non-monetary benefits paid to/by a third party (or someone on their behalf). These are permissible only if:
they do not impair compliance with the firm’s duty to act in the client’s best interests
they are designed to enhance the quality of the service to the client, and
they are disclosed in accordance with set standards prior to the provisions of the service to the client.

Question 26

26. What is the purpose of the best execution requirements?

Answer 26

The best execution rules under COBS require firms to execute orders on the terms that are most favourable to their client. Broadly, they apply if a firm owes contractual or agency obligations to its client and is acting on behalf of that client.

Specifically, they require that firms take all reasonable steps to obtain, when executing orders, the best possible result for their clients, taking into account the execution factors. These factors are price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order.

Question 27

27. What is an order execution policy?

Answer 27

Firms are required to establish an order execution policy to enable them to obtain the best possible results for their clients. This must include, for each class of financial instrument in which the firm deals, information about the different execution venues where the firm executes its client orders, and the factors that will affect the choice of venue used.

The policy must include those venues that enable the firm to obtain the best possible result for its clients consistently.

Firms must give their clients appropriate information about their execution policies; this needs to be more detailed for retail clients. Firms must obtain their clients’ prior consent to their order execution policies (although this may be tacit).

Question 28

28. What is the purpose of the personal account dealing rules?

Answer 28

Firms must have arrangements in place to prevent their employees who are relevant persons (directors, partners of the firm or its appointed representatives, and other personnel involved in regulated activities either directly or via an outsourcing arrangement) from:

entering into a personal transaction that is contrary to the MAD; involves misuse or improper disclosure of confidential information; or conflicts with the firm’s duties to a customer
improperly advising or procuring that anyone else enters into a transaction that (if it had been done by the employee himself) would have fallen foul of 1. above or of a relevant provision or
improperly disclosing information or opinion, if he knows or should know that the person to whom he has disclosed it is likely to enter into a transaction that (if it had been done by the employee himself) would have fallen foul of 1. above or of a relevant provision, or encouraging someone else to do so.

Question 29

29. What is trade confirmation information?

Answer 29

If a firm (other than one managing investments) carries out an order for a client it must:

provide the essential information on the execution of the order, promptly and in a durable medium
for retail clients only, send the trade confirmation information as soon as possible (but no later than on the next business day); if the confirmation is received from a third party, the firm must pass the details on no later than the business day following receipt
provide clients with information about the status of their orders on request.

Question 30

30. How frequently must a periodic statement be sent to a retail client?

Answer 30

Periodic statements must be sent to the retail client at least quarterly, with the following exceptions:

the retail client may request statements three-monthly instead (the firm must advise the client of this right)
if the client receives deal-by-deal confirmations, and certain higher-risk investments are excluded, the statement may be sent every 12 months
if the client has authorised that their portfolio be leveraged, the statement must be provided monthly.

Question 31

31. What is the purpose of the client money segregation and trust rules?

Answer 31

Within CASS, there is a requirement to segregate client money from any other money held by the firm. This aims to ensure that, if the firm fails, money will not be used to repay its creditors. Usually, this is done by ensuring that it is placed promptly in a separately designated client money account with a bank and ensuring that the bank treats it as separate from the firm’s own.

Question 32

32. What are the reconciliation requirements for safe custody investments and client money?

Answer 32

Firms must keep such records and accounts as necessary to enable them at any time and without delay to distinguish safe custody assets held for one client from safe custody assets held for any other client, and from the firm’s own assets.

This means cross-checking the internal client money accounts against the records of third parties (for example, banks) with whom client money is held. Firms must perform external reconciliations as often as is necessary and as soon as reasonably practicable after the date to which the reconciliation relates.