Here we re-examine the risks of opting up retail clients after Linear Investments v FOS.
Clients have differing levels of knowledge, sophistication, and risk appetite. Rules in many jurisdictions allow for this by having different categories. For investment business in the UK this is covered by the Conduct of Business Rules (COBS). In particular COBS 3.
The vast majority of clients in the UK and globally are not sophisticated. They are hence given higher levels of protection, in the UK (and EU). These are called Retail Clients.
Regulatory Framework: COBS 3 Overview
Regulators recognise that there are individuals and companies who are sophisticated and the retail client’s requirements can be somewhat burdensome. To accommodate this the COBS 3 rules, allow firms and clients the opportunity for a Retail Client to ‘opt up’ to be an Elective Professional Client, or a Per Se Professional Client. The latter category is more aimed at larger companies with sufficient balance sheet and turnover. It is not the focus here. We are instead looking at the individuals and small companies that might opt up to Elective Professional Client(‘EPC’) status.
Linear Investments v Financial Ombudsman Service
Let’s start by looking at the recent case of Linear Investments Ltd (‘Linear’) v Financial Ombudsman Service Ltd (‘FOS’). The Court of Appeal in England and Wales heard the case.
Whilst Linear had a partial victory regarding how the FOS should have taken more account of the client’s role in the issue. On the other two grounds, and in particular client classification the Court found in favour of the FOS and hence the client.
The background to the case is that Linear had sold Professor Leslie Willcocks (‘Willcocks’) a high risk and leveraged CFD portfolio built around a computer-generated trading strategy. In turn Willcocks lost money in these investments. Crucial to this case is that Linear had classified Willcocks as an EPC before embarking on this investment strategy with him. And they relied on this in their defence of his complaint.
The Court looked at the process that Linear followed in opting up Willcocks to an EPC and the facts they relied upon.
COBS 3 requires that qualitative and quantitative tests must be followed to opt up a client to EPC. These quantitative criteria require clients to satisfy 2 of the 3 following qualifications:
(a) the client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters.
(b) the size of the client‘s financial instrument portfolio, defined as including cash deposits and financial, exceeds EUR 500,000; or
(c) the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.
Key Findings from the Court of Appeal
Whilst the evidence presented suggests Willcocks had an investment portfolio of in the region of GBP 800,000 (approximately EUR 900,000) and hence comfortable to meet point (b), Linear also relied on his trading experience in point (a).
Here the Court found against Linear for process and evidence reasons. In particular, Willcocks had ticked a box saying he had experience of CFDs (40 plus CFD trades per year and 20 lots per trade). Yet he then made a potentially contradictory statement around having invested in ‘Blue Chip Stocks’. The opt up form used by Linear also required evidence of trading experience to be attached. Which was not done in the case of the opt up for Willcocks. These were flags that Linear ought to have spotted and investigated further as part of the onboarding process. As such they were key in the findings of the Court in favour of the FOS and ultimately Wilcocks.
Lessons for Firms: Avoiding Common Pitfalls
So, what can firms learn from this and do differently to avoid these types of extremely expensive situations?
- Understand that opting Retail Clients up to EPC is the highest risk action that firms can take under the client classification rules. Create a sufficiently robust process to govern and oversee such opt ups.
- Seriously consider having a check and sign off process involving a business senior manager (i.e. SMF or business MRT) and possibly an experienced compliance officer.
- Provide data to a senior governance meeting (e.g. a Risk meeting) of the number of clients opted up. Along with trends in these numbers and other relevant data such as complaints from these EPCs.
- Compliance or Internal Audit to undertake assurance reviews of opt ups to check the quality and completeness.
Recommendations for Robust EPC Procedures
As we infer, the gap between the protections given to Retail Clients and Professional Clients such as EPCs is easily the biggest gap between classifications and hence where the biggest risks lie. This is effectively the boundary between Retail and Wholesale.
Next Steps: Health Check and Contact Information
We have extensive experience at Leaman Crellin of operating and reviewing client classification processes at banks, brokers, and wealth managers. We have also seen examples of where this has gone wrong.
