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Compliance: Agent as Client – understanding the risks

11 May 2020

Many advice firms use discretionary investment managers to run client portfolios, often on an ‘Agent as Client’ basis. However, this can increase risks for advice firms, as explained by Steve Bailey, director ATEB Consulting.

This article was first published in the May 2020 issue of Professional Paraplanner.

The issue of Agent as Client (AaC) is one we have been raising with firms for several years as we have seen a continuing increase in advisers’ use of Discretionary Investment Managers (DIMs) for client portfolios. A significant number of the relationships between DIMs and adviser firms are based on the AaC operating model.

The AaC model is where the advisory firm arranges for the investment management to be carried out by the Discretionary Investment Manager (DIM) but on the basis the client (the investor) does not have a contractual relationship with the DIM. Instead, the DIM treats the advisory firm as the client, and considers that the firm is acting as the agent of the end investor.

The FCA’s Conduct of Business rules (COBS 2.4.3) allow for this model, if the adviser is acting in a genuine agency capacity and has been appointed by the client accordingly.

There are benefits of using the AaC model in that the adviser retains control of the client relationship, however, the model also carries risks for advisers – potentially more so than for the DFM.

Risks

However, this operating model carries a number of risks. A primary risk which advisers carry is that there is no direct relationship between the DIM and the client, so any complaints or claims from the end client would come to the advisory firm if something were to go wrong. If there was fault on the part of the DIM, then the adviser could theoretically make a claim against them for any losses but this is likely to be small comfort if they are facing a raft of Financial Ombudsman Service complaints and/or if the DIM fails.

Unsuitable investments

There are investment vehicles that can be promoted to professional clients, but which are not permitted to be used for retail clients. Under the AaC model, the adviser may be considered to be a per se ‘professional client’. This may result in the DIM including high risk and/or illiquid investments within the discretionary service that are incompatible with retail clients. Accordingly, the adviser firm has a duty of care to the end client to have appropriate controls and oversight in place, along with the capacity and expertise, to ensure that the discretionary service is, and continues to be, compatible with the actual investor/end client.

Authority to act as agent

It is the adviser, as agent for the underlying client, that is giving the DIM authority to act. This is fine where the adviser’s agreements with the end investor/end client have the necessary agency authority. However, in our experience, many adviser firms do not have wording in their client agreements/terms of business that authorises them to act as agent for the client.

Lack of clarity on responsibilities

The investor, i.e. the adviser firm’s client, does not have a contractual relationship with the DIM.

Potential liabilities of the AaC model

  • The AaC model can expose firms to complaints and claims if the portfolio does not perform as expected – especially if there are investments that are unsuitable for retail clients;
  • An additional difficulty arises from the end investor not being the client of the DIM in that the investor might not be considered an eligible complainant;
  • It is also possible that the adviser firm may struggle to discharge its responsibilities under this model – overseeing the changes that occur in the portfolios to ensure that the holdings are suitable for retail clients could be a significant piece of work.
  • The possibility of liabilities that could arise out of the AaC model might come as unwelcome news to adviser firms. But it is possible that these could also be a surprise to PI providers in the event of claims arising.

As a minimum, firms should identify the nature of any agreements they have with DIMs and, if AaC applies, should work closely with their PI Provider to make sure that cover is in place for such circumstances.

An alternative model – ‘reliance on others’

The ‘reliance on others’ rule (COBS 2.4.4) is an alternative operating model where the advisory firm arranges for the client to have a direct (contractual) relationship with the DIM.

Under this model, the DIM relies on the client information provided, and the suitability assessment being done, by the adviser, with the adviser being responsible for any liabilities arising from those aspects.

Responsibility and liability for the suitability of the portfolio construction, both initial and ongoing, lies with the DIM for a bespoke discretionary service.

Where there are pre-defined model portfolios, it is up to the adviser to select the suitable portfolio from the range of pre-defined strategies. The suitability of the transactions in that portfolio remains the responsibility of the DIM.

Potential liabilities of ‘reliance on others’

This model helps adviser firms to de-risk their businesses. However, it is possible that the DIM could struggle to discharge its duties to the individual investor in terms of ensuring a suitable portfolio and transactions – especially bearing in mind that it is likely that the adviser will hold all suitability information. Regardless of whether the roles and responsibilities are clearly articulated to the client, it’s a difficult conversation to have with an end investor / end client in the event of a complaint (i.e. it’s not my fault – its theirs!).

Equally, under this model the DIM could face the risk of ‘bulk complaint’ from all the adviser’s clients if issues arise.

Ongoing review

There is an obligation, both initially and ongoing, to assess the suitability of a discretionary service for the end investor/end client. This suitability assessment should happen at least annually.

This means that clients cannot enter a discretionary service without a suitability assessment being undertaken. Equally, either the DIM, or the adviser, must assess ongoing suitability. It should be made clear in the terms of business with the client, and in the adviser / DIM agreement, where the responsibilities and liabilities lie between the adviser and the DIM for assessments of suitability and for other aspects.

Where the DIM undertakes the ongoing suitability assessment, advisers should consider the value that their own ongoing service is adding to the client, where one is offered.

Where the DIM doesn’t provide the ongoing assessment, then the adviser must. Clients should be made aware of the need / importance of engaging with the ongoing suitability assessment. Continued lack of engagement could result in one of several outcomes, including the discretionary element of the service being stopped by the DIM for the client, and the need for the adviser to consider whether continuing to take an ongoing adviser charge is justified.

DIM and independence

COBS 6.2B, which requires firms to disclose their regulatory status as independent or otherwise, only applies to investment advice on Retail Investment Products & Financial Instruments. DIM is a service and so, strictly, a referral to a DIM is not subject to COBS 6.2B. That said, the now retired FSA guidance paper (Final Guidance – June 2012 ‘Independent and restricted advice’) made clear that, if a discretionary service is ‘predictable’, including model portfolios, then it would be considered investment advice, as the adviser is effectively recommending particular funds offered by the DIM.

The Independence paper also indicated that although a referral to a DIM does not need to be based on “comprehensive or fair analysis of the market” (MiFID II updated this definition to “a sufficient range that is sufficiently diverse”), firms still have an obligation to undertake adequate due diligence.

“However, the firm should undertake sufficient due diligence on a DIM before recommending it to a client, so that it can make a judgment about whether it is the right solution for the client.”

As mentioned above, the independence guide has been retired, following a number of updates to the definition of advice and the definition of independence. However, none of these updates appear to include anything which brings a recommendation of using a DIM into the Investment Advice definition (unless ‘predictable’). Therefore, in the absence of updated guidance from FCA, ATEB believes that the guidance provided in the Independence paper holds good.

Our view and action points

DIM solutions are widely used by adviser firms, yet we believe that the risks highlighted here are not widely understood. Attention to the following aspects when next reviewing the firm’s investment process would be prudent.

  • Check all DIM / intermediary agreements that are in place to identify any that are on the ‘Agent as Client’ basis;
  • If AaC applies and the firm is not comfortable with the risks and issues we have highlighted here, the DIM should be asked to amend the agreement and to treat the underlying investor as their client;
  • Check client agreements – many do not go as far as giving firms the ability to commit and bind the client to a discretionary management agreement on an AaC basis.
  • Full due diligence on the DFM has been undertaken (and a record kept of it), which should be updated periodically.
  • Ensure PI insurers know that this model of business is being used. PI policies frequently contain exclusions for certain types of product or investment which could be contained within a portfolio; hence
  • Advice firms should keep an eye on the construction of model portfolios to ensure that they match the risk profile of the customers.

Firms that retain the agent as client operating model should ensure that:

  • Appropriate systems and controls are in place, along with capacity and expertise, to be able to monitor any risks for the investor;
  • PI Insurance covers this arrangement
  • Ask the DFM to reclassify you as a ‘retail client’, so placing an appropriate restriction on the DIM’s use of investments that are not compatible with retail clients.

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