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Compliance: Research and due diligence – not the same thing

18 February 2020

Research and due diligence form part of the requirements to ensure good client outcomes, but they are separate requirements that need their own robust systems and controls, says ATEB’s Steve Bailey

The FCA undertook a thematic review back in 2016 (TR16/1), which set out their findings on the research and due diligence processes carried out by advisory firms on the products and services they recommend to retail clients.  This project followed previous thematic work that had exposed instances of consumer harm and shown that the poor quality research and due diligence is one of the three root causes for poor consumer outcomes. Firms were reminded that research and due diligence form part of a wider range of requirements which, together, combine to ensure firms deliver good client outcomes. These include:

  • Competence – the advisory firm must ensure its advisers are adequately competent on the subject of the product or service concerned. Advisers are required to be competent in the regulated activities they undertake, such as advising on investments;
  • Research and due diligence –the process carried out by the firm to assess (a) the nature of the investment, (b) its risks and benefits, and (c) the provider (to establish whether the advisory firm believes it appropriate to entrust the provider with client assets). Firms need to understand these factors in order to judge whether the solution is suitable;
  • Assessing suitability – once advisers are competent in the nature of the investments and understand the individual product or service, they should be able to judge for each client if the solution is suitable.

So here we are, another four years on and the above aspects remain as relevant as ever. Research and due diligence need robust systems and controls in order to be effective.

For most firms, file reviews are the primary form of control. To be effective, file reviews should involve a genuine assessment of the recommendation rather than simply checking the presence of research and due diligence, regardless of its quality or relevance to the client.

Research and due diligence are separate requirements – they are not the same thing. In short, research is about understanding and evaluating a product or service; due diligence is about checking out specific providers. A product might pass all your research criteria but if it is offered by a questionable provider, it is unlikely to pass the suitability test.

Along with MiFID II came PROD, which added new requirements for documenting the assessment and ongoing monitoring of recommendations. The core research and due diligence requirements remained effectively unchanged but were upgraded from guidance to rules.

Our view

There are two aspects that firms need to address, namely challenge and the PROD rules.

Challenge

The FCA identified that firms that demonstrated good practice had research and due diligence as a central function of the advice process, clearly showed they had the client’s best interests at heart and put this into practice.

A key driver of good research and due diligence was a corporate culture of challenge. The better firms had challenge built into the process and/or individuals who were knowledgeable, enthusiastic and who challenged the firm’s approach. Where there was no culture of challenge within the firm, the research and due diligence process showed weaknesses.  We believe that firms and investment committees should be evidencing constructive challenge in their investment process.

Once firms have undertaken the ‘research’ identifying which DFMs and platforms they wish to use, and have carried out ‘Due Diligence’ on the selected DFMs and platforms to ensure they meet the criteria set, they will need to drill down further with regard to the due diligence on the underlying funds to ensure that they are suitable for the target market.  Again, challenge to anything that looks ‘out of kilter’ will need to be evidenced.  Firms need to ‘get comfortable’ with the funds included within its solutions or consider not using them.

PROD

A key point to remember is that, prior to MiFIDII, the regulatory pronouncements on research and due diligence were mostly in the form of guidance. PROD carried that guidance forward, added some new requirements and framed it all as rules. We know the FCA have monitoring of adherence to PROD rules on the radar and we know that failure to satisfy the PROD rules has already figured in some supervisory notices leading to firms being prohibited from doing any new business. We would expect to see a thematic project at some point. At time of writing, some commentators have suggested that fewer than 5% of firms are properly complying with PROD rules.
The principle PROD requirements for distributors (PROD 3.3.1) can be summarised as follows:

A distributor is required to:

1. understand the financial instruments its distributes to clients;
2. assess the compatibility of the financial instruments with its clients’ needs;
3. take into account the manufacturer’s identified target market of end clients; an
4. distribute only when this is in the best interests of the client.

As an example
If using DFM solutions, firms would need to have PROD data that identifies clients that are compatible with a DFM solution. So, the process would be:

1. Is client compatible with a DFM solution?
2. If yes, which DFMs match the client type criteria.
3. Periodically, undertake DD on the DFMs used.
4. Finally, keep under regular review to identify relevant market changes.

Recommended action

  • Firms should consider whether they can evidence that they have research and due diligence as a central function of the advice process, which embraces constructive challenge;
  • Firms should also ensure that they have PROD data relating to the funds/DFM solution being recommended, which identifies that they are suitable for the target market;
  • Furthermore, the firm’s file checking process should include a genuine assessment of the recommendation rather than simply checking the presence of research and due diligence.

 

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