Intermediaries: Watch Who You’re Calling Sophisticated

Regulatory 03 Feb 2013

The International Organization of Securities Commissions published a report recently (January 21) on the principles that national authorities ought to apply to the distribution of complex financial products by intermediaries.

IOSCO’s recommendations might be taken to formalize the death of what remained of the principle of “caveat emptor.” Even if the buyer is an institution with some resources – even if it is, say, a municipality – it is the seller, the distributor, the intermediary of complex products who must beware.

IOSCO, in the imaginatively titled paper, “Suitability Requirements with respect to the Distribution of Complex Financial Products,” understands the term “intermediary” quite broadly, to mean any firm that manages individual portfolios, provides investment advice, executes orders for third parties, distributes securities, or carries derivatives positions. This of course includes banks “to the extent they are providing such services.”

It also understands “complex financial products” broadly to refer in essence to any financial products the valuation of which requires “technical skills and sophisticated computer models,” especially those with little or no secondary market.

IOSCO tells us that it has surveyed the existing suitability requirements, and in general they involve three elements: obligations imposed upon intermediaries to gather information both on the products and on the customers, and to warn customers when certain products are unsuitable; internal control rules such as bookkeeping requirements; enforcement tools – at a minimum civil and administrative, although in some jurisdictions criminal as well.

Down Memory Lane

This was enough to send me down memory lane, to a big news item concerning the City of Springfield, Massachusetts in late 2007 and early 2008. A Wall Street Journal story in January 2008 noted that as of July 2007 the city had owned a stake in three CDO portfolios with a combined value of $13.9 million, but that by November, the intermediary, Merrill Lynch, was valuing these assets at a markdown of 91 percent, or at $1.2 million.

City officials were ticked off at this. Predictably, though, they chose not to blame themselves. The WSJ story reported no example of any responsible city official kicking the furniture in his office at frustration concerning his own ineptitude in matters financial. Instead, it quoted Christopher Gabrielli, the very man whose furniture ought to have been most in danger, to a very different effect.

Gabrielli, the chairman of the city’s Finance Control Board, said:  “I believe Merrill Lynch is responsible and will be obliged, in the end, to restore the city’s money.”

He was right. Or, at any rate, Merrill chose not to fight to render him wrong. A month after the WSJ headline Merrill settled.

Back to the Present

But I return now to the present, and to IOSCO’s findings on suitability.  A key point is that intermediaries “should be required to adopt and apply appropriate policies and procedures to distinguish between retail and non-retail customers when distributing complex financial products.” The non-retail customers are those who might otherwise be called “sophisticated” or “qualified.” Retail investors? – anybody else.

IOSCO cautions both intermediaries and their regulators against developing “an overly broad presumption or definition of non-retail customer that could inappropriately limit the reach of suitability protections.” It mentions in this connection that during the financial crisis of 2007-08 “local authorities and municipalities” – ahem, Springfield – sometimes appeared “not to have understood the risks to which they were exposed.” Any classification that keeps such naïfs on the hook is, then, suspect.

In a footnote, intermediaries are reminded that they “may make the reasonable choice of treating all customers as retail because doing so may be more cost-effective than establishing separate categories for customers….”

Further, if an intermediary has an ongoing relationship or open account with a particular customer, then the fact that this customer is validly categorized as non-retail in year X should not imply that it will still be non-retail in year X+1 or X+2.  The intermediary ought to have – and ought to be required to have – a process in place to keep track.

As IOSCO puts it, the intermediary should be required “to take reasonable steps to obtain updated or additional information from [its] customers on a periodic basis” and should it become aware in this way “that a customer no longer fulfills the criteria that made him eligible for classification as a non-retail customer, the intermediary should be required to take appropriate action with respect to any subsequent transactions.”

Be Sociable, Share!

Leave A Reply

← Portfolio Risk: The Case for Outsourcing Risk Management versus Risk Mitigation & Absolute Return versus Hedge Funds →