How to Regulate Financial Advisors? I

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2 CONTENT

Sr. No. Document Page Number 1 Background 5 2 Tackling Conflict of Interest in Distribution of Financial Products 6 3 Structure of Proposed Regulations 8 4 Definitions 10 5 Coverage 11 6 Persons Exempt from the regulations 12 7 Registration Requirements 13 8 Obligations of an Investment Advisor 14 9 Execution Services 15 10 Outsourcing 16 11 Liability 17 12 Entities registered as Portfolio Managers 18 13 Public Comments 19 Exhibit I : Presentation made by FPSB India before High Level 14 21 Co-ordination Committee on Financial Markets (HLCCFM) - (2009) 15 Exhibit II : Paper on Service Tax on Mutual Fund Distribution - (2004) 37 16 Exhibit III : Consultation Paper by HLCCFM - (2009) 43 Exhibit IV : Discussion Draft [Investment Advisor Oversight Act of 17 75 2011] as presented in the U.S Congress - (2011) Exhibit V : FPSB India’s comments on SEBI (SRO Regulations), 2004, 18 105 and Draft SEBI (Investor Advisor Regulations), 2007 Exhibit VI : Regulation of Investment Advisors - Model for 19 141 Establishment of Self Regulatory Organization (SRO) - (2007) 20 Exhibit VII : About FPSB India 289

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4 1. Background

Paragraph No SEBI Concept Paper FPSB India’s Comments Section 11 (2)(b) of SEBI Act empowers SEBI to register and regulate working of Investment Advisors and such other 1.1 NC intermediaries who may be associated with securities market in any other manner. As decided by SEBI Board in its meeting dated March 22, 2007, SEBI had posted a consultative paper on the “Regulation of Investment Advisors” on its website inviting public comments. Based on public comments received on the consultative paper as also the USAID (Fire Project), a memorandum was placed before the SEBI Board proposing a regulatory approach for 1.2 NC Investment Advisors. It was proposed that the Regulations shall be implemented through an SRO. As Investment Advisors offer products across asset classes, it was felt that the respective regulators may take a view and formulate similar norms and code of conduct. Accordingly a reference was made to the HLCC on Financial and Capital Markets. FPSB India was invited by the “Swarup HLCCFM in its meeting held on December 22, 2008 set up the Committee” to give it’s comments on August D. Swarup Committee to re-examine the issue. The committee 5, 2009. FPSB India’s recommendations submitted its report to government in December 2009 which was included establishment of a Self Regulatory 1.3 discussed in the HLCCFM meeting in March 2010. Subsequently, Organization [SRO] for Investment Advisors regulatory issues relating to Wealth Management and / Private in the short term and enactment of a suitable Banking undertaken by banks were discussed by the FSDC Sub- legislation in the mid to long term. Kindly Committee in its meeting on March 4, 2011. refer Exhibit I for details. As submitted before the “Swarup Committee”, In this background, SEBI has developed a framework for establishment of Self Regulatory Organization 1.4 regulation of investment advisors through the SRO route. [SRO] for Advisors is a much needed reform.

5 2. Tackling Conflict of Interest in Distribution of Financial Products

Paragraph No SEBI Concept Paper FPSB India’s Comments It is axiomatic that any industry, in order to achieve scale and high productivity, must be free of internal contradictions and conflicts of interest. Financial sector is no exception. The financial product Unlicensed usage of the term/s has blurred distribution space is particularly fraught with these conflicts 2.1 the distinction between “Advisor” and between the manufacturers of financial products like banks, mutual “Seller” of the product. funds, and insurance companies, etc. and the distributors which sell these products who call themselves by various names like agents, financial advisors, financial planners, etc. It is necessary to resolve or at least mitigate these conflicts, especially in the case of financial products because of their two peculiar characteristics. Firstly, the products are intangible and This is what “Swarup Committee” has said conceptually more difficult to understand. Secondly, the pay-offs 2.2 and FPSB India entirely agrees with this are in a distant future and can be camouflaged by several factors prognosis. external to the product. It is in this context that the distributors occupy a key role; all the more so considering the low levels of financial literacy and awareness in India. Two major conflicts of interest in the financial product distribution space are the following:

a) Dual role played by distributors as an agent of investors as well By definition, under the law, the “Agents” as of the manufacturers. This is due to the fact that with respect are deemed to be Business Auxiliary to many financial products, agents receive their payments from Service providers to the principal [Asset two sources: commissions from the manufacturers (either Management Companies] they represent. directly or through deductions from the investment amount However to ensure that the clients’ interest of investors), and advisory fees or other charges received is protected, a new category of Professional from the investors. This immediately raises the question: Advisors will have to be created. whose interests do they represent: the manufacturers’ or the investors’? This question has also been raised in the Devendra The current reforms should aim towards Swaroop Committee report on ‘Minimum Common Standards the said objective as well. FPSB India in 2.3 for Financial Advisors and Financial Education’. This 2004 (formerly AFP, India) in the Paper on prevalence of divided loyalties may not be in the best interest “Service Tax on Mutual Fund Distribution” of all the stakeholders concerned. It often results in a situation presented before the Central Board of where the distributors are loyal to only themselves. They Excise and Customs [CBEC] and SEBI, would happily churn investors’ portfolio and also squeeze had recommended that the Mutual Fund more commission from the manufacturer. Distributors should collect fees from the investors who should pay the service tax. b) A situation might arise where distributors are likely to be This would make them serve in the investors’ partial to, and would sell more products of the manufacturer interest. The distinction between “Advisors” who is the best paymaster; and ultimately, other manufacturers and “Sellers” would be well established. would scramble to do the same, thus leading to a race to the Kindly refer Exhibit II for details. bottom. Thus, there is an inherent conflict in the activities of an agent/distributor distributing similar products of various manufacturers. Furthermore in addition to enhancing the There could be many possible solutions to these issues - the most levels of Financial literacy, attempt should obvious and the easiest being enhanced disclosures. However, in be made to ensure that the “Advisors” are 2.4 a country like India where levels of literacy are low and financial the service providers to the clients whom literacy even lower, disclosures have a limited effect. they represent in addition to the disclosures as prescribed.

6 Tackling Conflict of Interest in Distribution of Financial Products (Contd..)

Paragraph No SEBI Concept Paper FPSB India’s Comments The Financial Services Authority, UK, had outlined plans to ban commission payments for product providers and enforce financial advisors to agree on fee payments with clients upfront. It defined two categories of service: independent and restricted, on the basis of which advisors would charge the fee. Examples of restricted advice may be where advisors offer advice only about the products of a particular manufacturer; or about the products from a defined list of manufacturers. Independent advice would include unrestricted advice based on a comprehensive and fair analysis of the relevant market. However, there is a kind of restricted advice called ‘basic advice’. With Basic Advice, the consumer is asked some pre-scripted questions about their income, savings and other circumstances 2.5 NC to identify the consumer’s financial priorities and suitability for a stakeholder product, but a full assessment of their needs is not conducted nor is advice offered on whether a non-stakeholder product may be more suitable. ‘Basic advice’ is excluded from the new rules i.e. in case of basic advice, commissions can be paid and the new advisor charging rules are not applicable to the same. Also, nonadvised or execution only sales would be remunerated only by commission and would not fall within the ambit of the advisor charging rules. Thus, in the FSA model, the first conflict of interest as per para 2.3(a) seems to have been addressed by ensuring that the distributor/advisor owes allegiance to only one paymaster at a time- either the manufacturer or the investor. SEBI, with effect from August 01, 2009, had banned entry loads in mutual fund investments and had mandated that the upfront commission should be paid directly by the investors to the distributors 2.6 based on factors like assessment of the service of the distributor. NC However, the distributor continued to earn trail commissions from the Asset Management Company at the same time. Thus, the first conflict of interest was only partially mitigated in this model. In this paper, we are attempting to deal with only the first type of conflict of interest. The possible model for tackling this conflict of interests may be the following:

a) The person who interfaces with the customer should declare upfront whether he is a financial advisor or an agent of the manufacturer. Unlicensed usage of the nomenclature

i.e. “Advisor” should not be permitted. b) If he is an advisor, he would be subject to the Investment However, over a period the same should be Advisors Regulations; and would require a much higher level 2.7 applicable across all spectrum of financial of qualifications. He would act as an advisor to the investor on products i.e Banking, Commodities, all financial products. He would receive all payments from the Insurance, Mutual Fund, Post office investor and there would be no limits set on these payments. On deposits, Securities, etc. as well. the other hand, there will be agents who will be associated with the manufacturer and would receive their remuneration from them. However, they will be prevented from styling themselves as financial advisors and will have to call themselves as agents only.

c) This will resolve the first conflict of interest as in para 2.3 (a).

7 3. Structure of Proposed Regulations

Paragraph No SEBI Concept Paper FPSB India’s Comments FPSB India’s recommendations were part of the HLCCFM’s final report wherein the establishment of SRO was recommended. Kindly refer Exhibit III [Recommendation 9] for details. The recommended proposed Regulatory framework is well appreciated and would help financial consumers to a large extent.

The proposed nature of Self Regulatory Organization [SRO] viz. Non Profit/ Profit The proposed regulatory framework intends to regulate the activity proposed constituents/shareholding may be of providing investment advisory services in various forms by a specified. wide range of entities including independent financial advisors, banks, distributors, fund managers etc. The investment advice In case of latter the share holding pattern may be provided for investments in various financial products may be prescribed by SEBI, as deemed including but not limited to securities, insurance products, pension suitable. This would be similar to the Stock funds, etc. While the activity of giving investment advice will be Exchanges like National Stock Exchange 3.1 regulated under the proposed framework through an SRO, issues [NSE] and Bombay Stock Exchange [BSE] relating to financial products other than securities shall come under being private limited companies and also the jurisdiction of the respective sectoral regulators such as action being the de facto SROs for its members as for mis-selling, violation of code of conduct, conflict of interest well. etc. The SRO set up for the regulation of Investment Advisors shall follow the rules/regulations laid down by respective regulators for Furthermore, recently (September 11, 2011), products falling in their jurisdiction, including but not limited to proposal for the establishment of Investment suitability and appropriateness of the products. Advisor - Self Regulatory Organization (IA- SRO) has been tabled in the U.S. Congress. This is by virtue of amendment in the Investment Advisors Act of 1940, by passing a bill. This calls for all Retail Advisors to be the members of IA-SRO, which would report to Security and Exchange Commission (SEC). It further states that Advisors to the investment companies, institutional advisors, private and venture capital funds, and some others would be exempted. Kindly refer Exhibit IV for details.

8 Structure of Proposed Regulations (Contd..)

Paragraph No SEBI Concept Paper FPSB India’s Comments The SRO formed to regulate investment advisors will be registered under the SEBI (Self Regulatory Organization) Regulations, 2004. The SEBI (Self Regulatory Organization SRO will have sufficient resources to perform its functions. Its [SRO] Regulations) 2004 and SEBI duties would include registering and setting minimum professional (Investment Advisors Regulations) 2007 standards, including certification of investment advisors, laying may be modified with certain amendments. down rules and regulations and enforcing those; informing and 3.2 Kindly refer Exhibit V and Exhibit VI for educating the investing public; setting up and administering a details. In addition, SEBI Regulations, 2007 disputes resolution forum for investors and registered entities needs to be notified as well. Furthermore, etc. Persons desirous of registration as Investment Advisors shall grants/ funding by SEBI to the SRO may be obtain registration with the SRO established for the purpose. The stated, as SEBI had earlier suggested. SRO will be entitled to charge a fee for granting registration and an annual fee. Complaints / disputes arising out of investment advisory services will be taken up by the SRO with the respective regulatory authority, This would help to differentiate between 3.3 while the complaints regarding the financial products and their “Advisors” and “Sellers”. manufacturers will be handled by the respective regulators. This input should serve as a guideline Investment Advisors tend to call themselves by varied names for the proposed SRO. Furthermore, this viz. wealth managers, private bankers etc. This causes much should eventually cover across all financial confusion as to their role and responsibility. Hence the regulations products. will provide that no person can carry on the activity of offering 3.4 investment advice unless he is registered as an Investment Advisor In addition, sufficient scope should be given under the regulations. On the other hand any person who has to incorporate professionals who are offering obtained the certificate of registration as an Investment Advisor holistic Financial Planning like Certified must necessarily use the word “investment advisor” in his name. Financial PlannerCM [CFPCM] Certificants.

9 4. Definitions

Paragraph No SEBI Concept Paper FPSB India’s Comments Investment Advisor: Investment advisor for the purpose of the regulations shall be 4.1 any person or entity that provides investment advice directly or NC indirectly for a consideration, which may be received directly from the investor or who holds himself out as an investment advisor. Investment Advice: Investment advice shall be an advice written, oral or through any How the oral advice will be deemed to be other means of communication given regarding investment of the “Investment Advice” should be stated funds in financial products or products that are traded and settled and the evidence/s thereof: Lest it may be like financial products purportedly for the benefit of the investor. looked upon as a feedback / comment only. 4.2 It shall include: Secondly, whether the inputs /advice (Inter alia the circumstances) will fall under Indian (a) Financial advice; or Contract Act, 1872 will have to be specified (b) Financial planning service or as well. (c) Actions which would influence an investment decision and are incidental to making an investment/investment decision.

10 5. Coverage

Paragraph No SEBI Concept Paper FPSB India’s Comments Individuals The following set of individuals would need to get registered under the regulations to be able to provide Investment Advisory Services:-

a) Independent Investment Advisor– Independent Investment Advisors are professionals who offer independent advice on financial matters to their clients and recommend suitable It should be prescribed that for the products financial products or products that are traded and settled like to be “sold” by the agents, the accompanying financial products. specific financial advice should be prescribed b) Representatives of investment advisors or intermediaries 5.1 by the “Advisors” - Individuals and Non- who on behalf of the investment advisor or intermediary Individuals. However, certain exemptions provide investment advice to investors: Representative would may be given to specific class of products mean a person, in the direct employment of, or acting for, an as well. investment advisor, who performs on behalf of the investment advisor any investment advisory service, whether or not he is remunerated, and whether his remuneration, if any, is by way of salary, wages, commission or otherwise, and includes any officer of an investment advisor who performs for the investment advisor any investment advisory service whether or not he is remunerated, and whether his remuneration, if any, is by way of salary, wages, commission or otherwise; Non individuals The following set of non-individuals (corporate entities) would need to get registered under the regulations to be able to provide Investment Advisory Service:

a) Banks providing investment advisory/ wealth management services: In India Banks are allowed to perform only Investment Advisory Services. Those banks which provide similar services would be required to get registration under Certification and Rating by professional these regulations. organizations like the Ratings offered by b) Any entity, other than an individual person - representing Financial Planning Corporation (India) 5.2 investment advisor, who on behalf of the investment advisor Private Limited [FPCIL] and ISO should provides investment advice to investors: be encouraged as well, for firms and Representative would mean a person, acting for, an investment institutions. advisor, who performs on behalf of the investment advisor any investment advisory service, whether or not it is remunerated, and whether its remuneration, if any, is by way of, commission or otherwise, and includes any officer of such an entity who performs for the investment advisor any investment advisory service whether or not he is remunerated, and whether his remuneration, if any, is by way of salary, wages, commission or otherwise;

11 6. Persons Exempt from the regulations

Paragraph No SEBI Concept Paper FPSB India’s Comments A person shall be deemed not to be engaged in the business of providing investment advice, if the advice is solely incidental to some other business or profession and the advice is given only to clients of the person in the course of such other business or 6.1 NC profession and the advice does not specify particular securities and is limited to general comments made in good faith in regard to trends in the securities market, the economic situation of the country. The following shall be exempt from registration under these regulations: a) An advocate and solicitor or law firm, whose offer of financial advice is solely incidental to his legal practice. b) Chartered accountants who are registered under the Institute of Chartered Accountants of India providing of any investment advice is solely incidental to the accounting practice. c) Any person who publishes magazine/newspaper, where — i. the newspaper is distributed generally to the public in India; ii. the advice given, or analysis or report issued, is 1. Chartered Accountants [CAs] who promulgated only through that newspaper; offer advice for various Financial iii. that person receives no commission or other products should be under the ambit of consideration, apart from any fee received from the regulations notwithstanding the fact subscription to or purchase of the newspaper, for that the said advice may be incidental giving the advice, or for issuing or promulgating the to the accounting practice. analysis or report; and iv. the advice is given, or the analysis or report is issued This is on account of the fact that many or promulgated, solely as incidental to the conduct of individuals/households route their that person’s business as a newspaper proprietor. investments through CAs. d) Any person who owns, operates or provides an information service through an electronic, or a broadcasting or 2. Furthermore, not charging any 6.2 telecommunications medium, where — consideration for advice should not i. the service is generally available to the public in be the criteria for the exemption from India; the regulations as there is a very heavy ii. the advice given, or analysis or report issued is reliance on the advice being rendered promulgated only through that service; based on which several transactions are iii. that person receives no commission or other conducted. consideration, apart from any fee received from subscription to the service, for giving the advice, or 3. Hence, stock brokers or sub brokers as for issuing or promulgating the analysis or report; registered under SEBI (Stock Broker and and Sub-Broker) Regulations, 1992, iv. the advice is given, or the analysis or report is issued should be brought under the ambit of or promulgated, solely as incidental to that person’s the regulations as well. ownership, operation or provision of that service. e) Any stock broker or sub-broker as registered under SEBI (Stock Broker and Sub-Broker) Regulations, 1992, who provides any investment advice as per Regulation 7 read with Schedule II of SEBI (Stock Broker and Sub-broker) Regulation, 1992 and not charging any consideration for such advice. f) Any person offering exclusively insurance broking services under regulation of Insurance Development and Regulatory Authority.

12 7. Registration Requirements

Paragraph No SEBI Concept Paper FPSB India’s Comments Notwithstanding the fact that professional qualifications like ICAI, MBA in Finance, etc., are held in high esteem, persons undergoing these programs are not trained to offer investment advice. Hence, all persons who wish to get registered under the proposed Regulations should qualify themselves by virtue of certification standard The Individuals who wish to get registered under these which is specially designed for the said purpose i.e. regulations would need to satisfy the following criteria: rendering Financial Advisor /Financial Planning service. Accordingly certification from NISM or any a) Individuals should acquire a Professional such organization when is approved by SEBI/SRO for Qualification from a recognized institute for e.g. this purpose should only be considered. Chartered Accountancy form ICAI, MBA in Finance or similar qualification from a recognized Certified Financial Planner CM[CFP ] Certificants 7.1 university or should have at least 10 years of are trained for the said purpose, and hence may be relevant experience; and exempted as well. b) Certification from NISM or such other organization approved by SEBI for this purpose The minimum eligibility criteria of having 10 years c) The individuals should conform to the Fit and of experience for registration in lieu of qualifications Proper Criteria s laid down in Schedule II of SEBI should not be permitted as this may not necessarily (Intermediaries) Regulations, 2008. render a person qualified for giving financial advice.

Notwithstanding the minimum qualification requirements and/or exemption/s thereof, all individuals should be asked to undergo a Continuous Education [CE] program in the form of test/qualification/ examination by NISM and / or any other body as approved by SEBI / SRO. The capital adequacy requirement may be finalized by the proposed SRO. The requirement for number of key personnel in the entity offering “Investment Advice” Entities who wish to get registered under these should be a function, scope and the size of the business regulations would need to satisfy the following criteria: being conducted, which could be decided by the SRO. a) Capital Adequacy Requirement: Entities would Furthermore, to ensure effective service standards to need to maintain a minimum net worth which the investors, the “Certification and Rating” offered by would be separate from the net worth required for Financial Planning Corporation (India) Private Limited other activities. [FPCIL] should be recommended. The evaluation for b) Key personnel: Entities should have at least 2 the granting of Certification and Rating is based on the key personnel having the relevant experience following criteria: exclusively for such activity. Such key personnel 7.2 should also acquire the certification from NISM or 1. Approach to Financial Planning Process such other organization as approved by SEBI for 2. Policy on Investors’ interests this purpose and have minimum qualification as 3. Organization Structure and Corporate prescribed. Governance c) The entity should conform to the Fit and Proper 4. History / Background Criteria laid down in Schedule II of SEBI 5. Financials (Intermediaries) Regulations, 2008. 6. Firms Positioning and Offerings d) The applicant must have adequate infrastructure to 7. Resources & Infrastructure enable it to discharge its functions as an Investment 8. Organization’s Process and Procedures Advisor. 9. Risk Management Policy and System 10. Management Policy on Compliance and Disclosures

13 8. Obligations of an Investment Advisor

Paragraph No SEBI Concept Paper FPSB India’s Comments Fiduciary Responsibility to Investors: All information received and provided by the investment advisor would be in fiduciary capacity. The investment advisor will be 8.1 responsible to maintain confidentiality of the investment advice NC provided to the client and information provided by the client. Advice should be given by the advisor in the best interest of the investor. Suitability and Risk Profiling: The Investment Advisors or their representatives would be required to do adequate risk profiling of the client before any investment service is provided to them. Based upon the risk profiling 8.2 NC performed by the investment advisor or their representative suitable investment advice should be provided. The records of such risk profiling and investment advice should be maintained by the Investment Advisor. Advertising and Marketing Material: Investment Advisors should not use any advertisement that contains any untrue statement of material fact or that is otherwise misleading. They should not use or refer to testimonials (which include any statement of a client’s experience or endorsement). 8.3 NC Refer to past, specific recommendations made by the advisor that were profitable, unless the advertisement sets out a list of all recommendations made by the advisor within the preceding period of not less than one year and complies with other specified conditions. Conflict of Interest: No financial incentives/ consideration would be received from any person other than investors seeking advice. In case of advice 8.4 NC regarding investment in entities related to the investment advisor, adequate disclosures shall be made to investor regarding the relationship. Maintaining Records Records in support of every investment recommendation / Audio Records should be prescribed only transaction made which indicates the data, facts and opinion in lieu of written advice: in which case the 8.5 leading to that investment decision would be maintained by the documentation establishing the written Investment Advisor. Records should be retained for at least 5 years. advice should suffice. Systematic record of all advises provided would be kept including audio recording of any oral advice given. Fees and Charges The Investment Advisor would clearly indicate to its clients the fees and charges that are required to be paid by them. An investment advisor shall disclose to a prospective clients all material 8.6 information about itself, its businesses, its disciplinary history, NC the terms and conditions on which it offers advisory services, its affiliations with other intermediaries and such other information as is necessary him to take an informed decision whether to avail of its services.

14 9. Execution Services

Paragraph No SEBI Concept Paper FPSB India’s Comments 1. The Individual Investment Advisor (non corporate entities/ individuals) must also make appropriate disclosures Investment advisors shall not accept funds / securities and clarify that the investor is under from investors, except the fee for investment advice. If no obligation to use their services and Non-individual investment advisors (corporate entities) maintain arms length relationship, in offer assistance in execution services such as broking, case they offer allied services through custody services, DP services, accounting etc., they must associates, relatives etc. make appropriate disclosures, clarify that the investor is under no obligation to use their services and maintain Accordingly, the choice of opting arms length relationship through creation of Chinese for the execution services offered walls. The choice of opting for execution services offered by Investment Advisor should be by investment advisor should be left to the investors. left open to the investors directly / Fees and charges paid to service providers should be paid indirectly. Proper disclosures should, directly to them and not through investment advisors. however, be ensured.

2. Violation / penalty should be prescribed by the SRO.

15 10. Outsourcing

Paragraph No SEBI Concept Paper FPSB India’s Comments Other allied initiations like Marketing Other than sourcing of research reports, no other part of / PR etc may be permitted to be investment advisory activity can be outsourced. outsourced as well.

16 11. Liability

Paragraph No SEBI Concept Paper FPSB India’s Comments It may be advisable for the Investment Advisors to seek Professional Indemnity Cover. Furthermore the The investment advisors shall not be liable for civil or scope and conduct, Grievance Redressal criminal liability in respect of advice given unless the advice Mechanism should be established is negligent or mala-fide in nature. Any dispute between the under the aegis of the proposed SRO. investment advisor and his client would be resolved through Secondly, who shall be the authority grievance redressal mechanism or arbitration created by to judge whether the advice given is SEBI “negligent” or “malafide” under law, may be specified – viz. SEBI, SRO, and/or any other agency.

17 12. Entities registered as Portfolio Managers

Paragraph No SEBI Concept Paper FPSB India’s Comments Portfolio Managers who provide only investment advice would need to be registered only as investment advisors after their present registration expires. Portfolio Manager NC Regulations would be amended in view of the proposed AIF Regulations as well as the Investment Advisor Regulations.

18 13. Public Comments

Paragraph No SEBI Concept Paper FPSB India’s Comments Public Comments are invited on the Concept Paper on Regulation of Investment Advisors. All comments may be forwarded by e-mail to Shri Manish Tekriwal, Manager, NC Investment Management Department, Division of Funds - 1 at [email protected] latest by 1730 hours on October 31, 2011.

NC: Indicates “No Comments”

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20 EXHIBIT I

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22 Establishment of Self Regulatory Organization (SRO) for Financial Intermediaries (Advisors) Proposed Model: By FPSB India

Contents

I. Why to Regulate Financial Advisors? i. Current State of Financial Inclusion ii. Global Perspective & Regulatory Environment II. How to Regulate Financial Advisors? i. Understanding the current Financial Advisory Industry ii. Scope of Prevailing Financial Advisors’ Regulatory Infrastructure iii. Proposed Regulatory Mechanism for Financial Advisory Industry III. Who should Regulate Financial Advisors? IV. Role of FPSB India V. Action Plan & Discussion

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23 Why to Regulate Financial Advisors?

Financial Savings 2005-06 (P) 2006-07 (P) 2007-08 # (Rs In Crores) 5,97,867 7,68,967 7,34,699 % to GDP 16.7% 18.5% 15.6%

P : Provisional. # : Preliminary Estimates * Source: RBI Data, 2008 Slide 3 of 30

Current State of Financial Inclusion - How many will be benefited?

* Source: AMFI, RBI, SEBI, NSDL, CDSL & IIMS Dataworks Survey 2007 Slide 4 of 30

24 Attitudinal pre-dispositions of Indian earners regarding finance - Clear Need for Financial Inclusion

The above figures represent the percentage of total numbers in a class agreeing to a given premise. * Source: IIMS Dataworks Survey 2007 Slide 5 of 30

With whom would Indians trust their money?

* Source: IIMS Dataworks Survey 2007

Slide 6 of 30

25 Global Regulatory Environment

Sl. Country Regulations Notes No 3 Malaysia Capital Market and 1. Financial Planning is regulated by two authorities – the Services Act Securities Commission and the Central Bank. (CMSA), 2007 2. The Securities Commission provides under CMSA the definition for Financial Planning, whereas the Central Insurance Act 1996 Bank provides under the Insurance Act the guidelines for Financial Advisers. 3. CFP Certification is an eligible qualification. 4 New Financial Advisers 1. The Financial Advisers Act covers aspects of practice Zealand Act 2008 including authorization, definitions, registration, etc. under the supervision of Securities Commission. (NZ) 2. It is proposed that the key elements will be set by subsidiary legislation called Regulations and there will be a Code which will set out competency requirements and ethics and practice standards for the financial advisers. 5 South Financial Services 1. The Financial Services Board (FSB) an independent Africa Board Act, (Act 97 of institution established by statute to oversee the South 1990) (“FSB Act”) African Non-Banking Financial Services Industry, regulates the activities of all financial service providers who give advisory and intermediary service. 2. The Act requires licensing of such service providers and governing their conduct through a code of conduct and specific enforcement measures.

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Global Regulatory Environment

Sl. Country Regulations Notes No 6 UK Financial 1. Financial Services Authority (FSA), an independent body having Services and statutory powers under the Act, regulates business and requires that all investment businesses apply for authorization through their Markets Act respective SRO. (FSMA) 2000 2. FSA has wide ranging enforcement powers. It is accountable to Parliament, though it is operationally independent of Government and is funded entirely by the firms it regulates. 3. FSA has proposed to bring to an end the existing commission-based system of adviser remuneration. Coming into effect from the end of 2012, the charges would be decided by the consumers and would no longer be determined by the product providers. 7 USA Investment 1. The Act regulates investment advisers who furnish advice relating to Advisers securities. 2. It requires that firms or sole practitioners compensated for advising on Act,1940 and securities investments register with the SEC if assets under Investors management exceed $25 million. The advisers below this limit must Protection Act register at the state level. (Proposed), 3. The Financial Planning Coalition, consisting of CFP Board, the 2009 Financial Planning Association, and the National Association of Personal Financial Advisors, recommends the creation of a professional oversight board for financial planners that would set and enforce competency and ethical standards in the delivery of financial planning advice, subject to SEC oversight. 4. Investor Protection Act 2009 proposes consistent standards, disclosures amongst others. Slide 10 of 30

26 Need for Regulations

1. Prevent or restrict mis-selling

2. To establish suitable Grievance Redressal Mechanism for Investors Protection

3. To enhance the scope for higher penetration and Financial Inclusion

4. To create Certification Standards for Independent Financial Advisors

5. To create Job Opportunities, bring in new talent, and to establish credibility for the Financial Planning Profession

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Contents

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27 Understanding the current Financial Advisory Industry

Growth of Financial Intermediaries – MF & Insurance

The rapid increase in the number of intermediaries over a short span has the following concerns: . Moderate level of regulation or no regulation . Risks associated with unregulated selling sans any advisory . Tremendous scope for skill generation * Source: AMFI, IRDA Annual Reports 2004-05, 2007-08 Slide 13 of 30

Prevailing Financial Advisory Industry

. Minimal or no entry barriers for Financial Intermediaries . 100 Hrs of Training after passing Exam for Insurance Advisory . A single certification for Mutual Fund Distribution (AMFI)

. Conflicts of Interests and absence of any consistent approach to managing them

. No distinction between Advice and Selling

. Absence of Industry wide minimum certification standards

. Consumers’ inability to distinguish between variable quality standards of different intermediaries

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28 Present Regulatory Infrastructure - Diverse Regulations Exists !

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Proposed Regulatory Mechanism

Options Available:

. Enactment of a separate legislation by the Parliament for Financial Planning so as to define the profession and delegate authority to make regulations

. Any of the current Regulators may directly supervise the Investment Advisors

. Establishment of Self Regulatory Organization (SRO) under SEBI Regulations as the first level Regulator of Investment Advisors

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29 How to Regulate Financial Advisors?

Roadmap for a Self Regulatory Organization (SRO)

1. SRO to regulate Investment Advice relating to all financial products. This could be achieved by other regulators endorsing the SRO

2. SRO to define process for registration, entry and exit, market conduct, reporting, advertising

3. SRO to also define disclosure of services & fees, commissions, fair dealing and Conflict of Interest #Benefits of Establishment of Self Regulatory Organization (SRO)

. More responsive to a complex, fast-changing marketplace

. More efficient regulation

. Paid for by industry, not taxpayers

. Extended beyond statutory powers through contractual relationships

# Source: Indian Capital Market Reform by USAID & NISM, November 2007

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Establishment of Self Regulatory Organization

1. IOSCO Guidelines for SRO have been suitably incorporated 2. Blend of Principle-Based Regulations and Rule-Based Regulations 3. Certification Standards for Independent Financial Advisors and Rating Standards for Institutions proposed 4. Norms for Membership, Certification, and Obligations established 5. Establishment of Dispute Resolution body has been prescribed 6. An Independent Board should govern the functioning of SRO

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30 Scope of Proposed Financial Inclusion

Unrestrained access to public goods and services is the sine qua non of an open and efficient society

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31 Convergence of Regulations for Financial Advisors by a Single SRO

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Contents

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32 Industry Giants have come together to announce the Birth of a Revolution in Financial Planning Industry Over 12,000 Students Over 5,000 Certificants viz. CFPCM & AFP Spread across 29 Cities & Towns 50 Charter Members

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Who should Regulate Financial Advisors?

Developments & Updates at FPSB India

1. FPSB India Position Paper on SEBI’s Consultative Paper on “Regulation of Investment Advisors” submitted ……(July 2007)

2. Based on the recommendations from SEBI, FPSB India blocked the name –“Financial Planning Regulatory Board (FPRB)” ……..….(August 2007)

3. *Feedback on Draft SEBI (Investment Advisors) Regulations 2007 and SEBI (SRO) Regulations, 2004 submitted ……(October 2007)

4. Paper on “Regulation of Financial Advisors : Model for Establishment of Self Regulatory Organizations” submitted ……….…(December 2007)

5. Ongoing discussions and consultations with Government and Regulators

FPSB India (through FPCIL) has signed a MoU with NISM on 10th November 2008 to initiate joint certification programs in financial advisory, and financial education. * Paper prepared in consultation with M/s Amarchand Mangaldas & Suresh A Shroff & Company

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33 The Financial Planning Universe

FPSB India as a Standard Setting & CFP Certification Administration body will continue to strive in bringing best global Practice Standards & Certification Standards in the country

Financial Planning Financial Planning Corporation of India Regulatory Board (P) Ltd. (FPCIL) will Financial FPSBI Financial (FPRB) will regulate offer products & Planners Institutions the Financial services to Financial Planners in India Planners, Industry based on Code of and the Consumers to Ethics, Practice actualize those Standards and benchmarks FPCIL FPRB Disciplinary Rules & Procedures

Financial Consumers

FPSB, FPCIL and FPRB together will lead the Financial Planning Movement in India assuring WIN-WIN environment to all the stakeholders i.e. financial consumers, financial planners & financial institutions

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Contents

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34 Role of FPSB India

FPSB India has the requisite strong Membership base, Body of Knowledge and Global Expertise who shall be pleased to act as knowledge partner and facilitate the establishment of Financial Advisors’ Self Regulation Organization (SRO)

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Contents

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35 Action Plan and Discussions

1. Investor Advisors’ Draft Guidelines to be notified based on the inputs offered by FPSB India 2. SRO Regulations, 2004 should be amended by SEBI suitably 3. FPSB India may be mandated to facilitate the formation of SRO for Investment Advisors In the interim, the Certification Programs viz. Certificate for Financial Advisors and Certificate for Financial Educators should be initiated and prescribed as per the MoU signed.

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Thank You

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36 EXHIBIT II

37                                                                                                    

38   The responses are summarized as below:

Sr. No. Country Tax Payable by Consumption tax of 5% applies to the commission 1. Japan paid for investment trusts, mutual funds and This tax is paid by the clients / investors. securities brokerage. When VAT on commissions payments was introduced A value added tax (VAT) applies to all goods and it was done on a “add-on” basis. In other words the services. This tax also applies to fees charged commission payment was increased to include the 2. South Africa (including those charged by financial planners) VAT amount (at a rate of 14%) so the net amount and to commissions earned and paid by mutual of commission earned by the adviser remained the fund companies like insurers etc. same. Commission is payable on all products sold, but If planners are offering a fee service and invoicing doesn’t necessarily have to be taken by advisors their clients they also have to charge VAT (Value if they are offering a fee service. The commission 3. U.K. added tax) at 17.5% which of course is an extra rate varies from 3%+ 0.5% annual on mutual charge for the clients to funds to a variety of different rates on other bear. product types. Any taxes related to as a security investment (including mutual funds) are passed on to the The tax is deposited in deduction system which investor. 4. Austria means that capital gains, dividends and interest In no way a bank / mutual fund / financial planner payable are net sums i.e. (after tax). has to carry the tax burden for the investor. For the purposes of GST, financial planning fees, charged by financial advisers for services provided in planning, implementing and monitoring investment portfolios for their investor clients, are generally separated into seven categories.

(i) “Initial Planning fees’ are fees for services provided by the adviser for the initial interview, where the investor and the adviser discuss the Services relating to initial planning fees are subject investor’s to GST as they are not a “financial service” and investment goals, savings objectives and other payable by the investor. requirements. This category includes preparation of a draft portfolio plan for the investor and further 5. New Zealand discussions and adjustments to the draft plan that may follow until it is acceptable to the investor.

(ii) “Implementation fees” are for services associated with implementing the portfolio plan devised in the category above. They will include any one-off upfront fees or other charges made for Services relating to implementation fees come services by advisers, administrators, executors, under the definition of “financial services” for GST fund managers and so on, to purchase or acquire purposes and are therefore exempt from GST. the investments. They also include payments to custodians on implementation of the plan or charges by fund managers for entry into investments.

39 Sr. No. Country Tax Payable by

(iii) “Administration fees” are for services in maintaining records of the investor’s transactions Services relating to administration fees come with the adviser, and the costs of that. This category under the definition of “Financial Services” for 5. New Zealand (Contd) also includes charges relating to the handling of GST purposes and are therefore exempt from cash for the investor, and other administration GST. fees and any commissions charges for collecting income from investments and arranging payment or crediting to the investor. (iv) “Monitoring fees” are annual charges for services in monitoring and relaying information to Services relating to monitoring fees are subject the investor on the performance of the portfolio to GST as they are not a “financial service” (including the performance of the fund managers and the adviser) in terms of the investor’s goals. (v) “Evaluation fees” are for services relating to an evaluation of an existing portfolio involving a more detailed examination of performance of the Services relating to evaluation fees are subject portfolio than simply monitoring and reporting to to GST as they are not a “financial service”. the client. It may result in a recommendation from the adviser to make changes to investments within the portfolio to maintain the investor’s aims. (vi) “Replanning fees” are for services relating to the replanning of a portfolio sometimes due to changes to the investor’s objectives arising from the evaluation services in the preceding category. Replanning fees could also be for advice by an adviser to a new client who had Services relating to replanning fees are subject previously self-managed a portfolio or who to GST as they are not “Financial Services”. had previously engaged a different adviser. Included in this category are any other fees for services as described in the initial planning fees category above, when there has been a complete restructuring of investments. (vii) “Switching fees” are for services and costs involved in selling existing investments and/ or purchasing new investments, or otherwise changing or withdrawing investments, arising from a recommendation by the adviser relating to services in either of the preceding two Services relating to switching fees come under the categories. definition of “financial service” for GST purposes and If financial planners charge a global fee, it will are therefore exempt from GST. be necessary for that fee to be apportioned between the categories, based on the particular services provided for the fee, to ensure the fees and services are correctly treated. Also it may be noted that “financial services” are exempted from GST.

40 It is interesting to study that the law in New Zealand clearly differentiates the various components of Financial Planning and offers a holistic approach to the same: and depending on its various sub components the tax treatment is made accordingly.

It is pertinent to note at this point of time that with reference to the current scenario we refer to the "Implementation fee" (for services associated with implementing the portfolio plan devised in the category above. They will include any one-off upfront fees or other charges made for services by advisers, administrators, executors, fund managers and so on, to purchase or acquire the investments. They also include payments to custodians on implementation of the plan or charges by fund managers for entry into investments) which is not taxable in New Zealand. Also it may be noted that the tax in the similar situation is passed on to the investors in all other countries.

Communication / Meetings

Meetings and interactions were held with the following Government Departments (at the behest of Revenue Secretary’s Office), and the Regulator: (i) Chairman – CBEC (ii) Member – Service Tax Board/CBEC (iii) Director – CBEC (iv) Chairman – SEBI Also interactions/communications were held with some industry players.

Observations

While CBEC is clear on the fact that Service Tax has to be payable by agents & brokers, it is silent on the issue - whether it could be recovered from the Asset Management Companies/Investors? Hence pertinent questions are:

(1) Whether the Service Tax has to be eventually paid (or recovered) from the recipient of the service? Or Does the service provider reserves its right to recover the Service Tax from the recipient of the service? (2) Secondly in this case the definition of service recipient has not been clarified. For the purpose of this transaction is it the Asset Management Companies who are availing services of agents/brokers or the investors who are the ultimate beneficiaries of the whole set of transaction? According to the Service Tax authorities it is the AMCs who are the recipients of the service and not the Investors since AMCs are availing the services of the Service Providers. The Investor has not been considered !

Lest there is clear communications on these aspects by the authorities, the matter may remain unresolved: while in other countries it is clear that ultimate recipient has been well defined (Investor) and the Service Tax is passed on to the investor. But in India the issue is unclear. In case SEBI permits to increment the cap on the expense ratio the recipient would be the Investors else the beneficiary would remain (or deemed) as the Asset Management Companies who have appointed and are availing the services of the agents and the brokers/Financial Planners. Secondly the issue of right of recovery of Service Tax from the Service Recipient by the Service Provider needs clarification in the present scenario especially when the clarification on the notification dated 26/02/2003 has come on 05/11/2003 and the tax payable is effective from July 1, 2003 which is on retrospective basis, and the payments made to the Service Providers

(Financial Planners/Distribution Firms) are based on the mobilization amount, and the Service Providers normally do not charge the Investor. (Fee based Financial Planning practice is not much prevalent in India currently). Service tax should be excluded when calculating total expense ratio, says Cadogan Financial, a UK based consultant retained by Asian Development Bank on behalf of the Finance Ministry to suggest reforms to the India Mutual Fund industry. The Cadogan study points out: “The levying of service tax on mutual funds is presently regarded by SEBI as an expense which should be included with the total expense ratio limits established by SEBI; any excess of MF expenses over this level has to be borne by the trustees or AMC or sponsors (regulation 52.5). This in effect means that a tax that is mandated by Government to be paid by all entities using certain services may not be borne by that entity, but by one of its service providers – and the level of that tax is not insubstantial. This is irrational since mutual fund investors should be being taxed on a service that they do receive under Indian law”.

41 Recommendations - Short Term

(1) The beneficiary i.e. the investors of the services/transactions needs to be well defined and accepted. The service tax should be entirely levied by the beneficiary and not by the service provider (Expense Ratio should be incremented accordingly).

(2) To ensure minimum collection points & ensuring efficiency in collection Service Tax could be recovered from the Asset Management Companies on behalf of its agents/brokers/Financial Planners who are spread all over the country; which would otherwise create multiple collection points and tax evasion as well. And this in turn would create unhealthy competition in this situation wherein some Service Providers would pay the Service Tax, and some would not.

(3) The tax should be levied with effect from November 6, 2003 (i.e. after the clarification) and not on retrospective basis.

Recommendations - Long Term

The New Zealand Model could be adopted suitably in India wherein Financial Planning process has been well defined and structured (For the purposes of GST, financial planning fees charged by financial advisers for services provided in planning, implementing and monitoring investment portfolios for their investor clients are generally separated into seven categories i.e. the various components of Financial Planning and depending on its various sub components the tax treatment is made accordingly ).

This would eventually encompass other disciplines of financial services viz. retirement products, estate planning, etc. (Furthermore it is notable hat the life insurance services are specifically exempt from service tax vide notification No. 9/2002 dated August 1, 2002 in public interest). This would also promote fee based financial planning as well. Keeping this in view the current issue would fall in the area of “implementation fees” and accordingly the government in interest to develop & promote Fee based Financial Planning could exempt service tax on implementation. However tax on other services/components of Financial Planning may be levied accordingly (viz. Initial Planning Fees, Monitoring Fees, and Re-planning Fees).

42 EXHIBIT III

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74 EXHIBIT IV

75 This page is intentionally kept blank

76 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft]

[DISCUSSION DRAFT]

112TH CONGRESS 1ST SESSION H. R. ll

To amend the Investment Advisers Act of 1940 to provide for the registration and oversight of national investment adviser associations.

IN THE HOUSE OF REPRESENTATIVES

Mr. BACHUS introduced the following bill; which was referred to the Committee on llllllllllllll

A BILL To amend the Investment Advisers Act of 1940 to provide for the registration and oversight of national investment adviser associations.

1 Be it enacted by the Senate and House of Representa- 2 tives of the United States of America in Congress assembled,

3 SECTION 1. SHORT TITLE. 4 This Act may be cited as the ‘‘Investment Adviser 5 Oversight Act of 2011’’.

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77 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 2 1 SEC. 2. REGISTRATION AND OVERSIGHT OF NATIONAL IN-

2 VESTMENT ADVISER ASSOCIATIONS. 3 The Investment Advisers Act of 1940 (15 U.S.C. 4 80b–1 et seq.) is amended by inserting after section 203A 5 the following new sections:

6 ‘‘SEC. 203B. REGISTRATION OF NATIONAL INVESTMENT AD-

7 VISER ASSOCIATIONS.

8 ‘‘(a) REGISTRATION REQUIREMENT.—Except as pro- 9 vided in subsection (b), it shall be unlawful for any invest- 10 ment adviser registered under section 203 or that is sub- 11 ject to a state authority under section 203A(a) of this title 12 to make use of the mails or any means or instrumentality 13 of interstate commerce in connection with the person’s 14 business as an investment adviser unless the investment 15 adviser is a member of a registered national investment 16 adviser association.

17 ‘‘(b) EXEMPTIONS.—Except as provided in para- 18 graph (c), the provisions of subsection (a) shall not apply 19 to— 20 ‘‘(1) any investment adviser that has assets 21 under management 90 percent or more of which are 22 attributable to one or more of the following types of 23 clients: 24 ‘‘(A) investment companies registered 25 under the Investment Company Act of 1940;

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78 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 3 1 ‘‘(B) clients that are not ‘U.S. persons’ as 2 defined in rule 902(k) of regulation S under the 3 Securities Act of 1933; 4 ‘‘(C) clients that in the aggregate own not 5 less than $25,000,000 in investments; 6 ‘‘(D) entities defined in section 3(c)(10) of 7 the Investment Company Act of 1940; 8 ‘‘(E) entities defined in section 3(c)(11) of 9 the Investment Company Act of 1940; 10 ‘‘(F) private funds as defined in section 11 202(a)(29) of this title; and 12 ‘‘(G) venture capital funds, as that term is 13 defined by the Commission pursuant to section 14 203(l) of this title; 15 ‘‘(2) any investment adviser that is controlling, 16 controlled by, or under common control with an in- 17 vestment adviser described in subsection (b)(1), if 18 the Commission finds that the compliance programs, 19 operations and businesses of such investment advis- 20 ers are sufficiently integrated that membership in a 21 registered national investment adviser association 22 would necessitate inappropriate duplicative examina- 23 tion by the Commission and the association, or oth- 24 erwise would not be necessary in the public interest

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79 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 4 1 and for the protection of investors or in furtherance 2 of the purposes of this title; or 3 ‘‘(3) any other investment adviser or class of in- 4 vestment advisers that the Commission may exempt 5 by rule or regulation consistent with section 206A of 6 this title.

7 ‘‘(c) APPLICATION OF EXEMPTIONS.—The exemp- 8 tions in subsection (b) shall not apply to any investment 9 adviser that is registered as a broker-dealer under section 10 15 of the Securities Exchange Act of 1934 or that is con- 11 trolled by an officer, director, or employee of, or any other 12 natural person who is registered with, such a broker-deal- 13 er.

14 ‘‘(d) PROCEDURE FOR REGISTRATION.—An associa- 15 tion of investment advisers may be registered as a national 16 investment adviser association by filing with the Commis- 17 sion an application for registration in such form, and con- 18 taining the rules of the association and such other infor- 19 mation and documents, as the Commission, by rule, may 20 prescribe as necessary or appropriate in the public interest 21 or for the protection of investors or otherwise in further- 22 ance of the provisions of this title.

23 ‘‘(e) STAY PENDING APPROVAL.—No proposed rule 24 of any national investment adviser association, and no pro- 25 posed rule change of such an association, including any

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80 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 5 1 rule or proposed rule change concerning any assessment, 2 fee or other charge imposed by the association, shall take 3 effect unless approved by the Commission after publica- 4 tion and opportunity for public comment.

5 ‘‘(f) EFFECTIVE DATE.—Notwithstanding subsection 6 (e), no proposed rule of any national investment adviser 7 association shall take effect within 1 year after the date 8 of enactment of this section, unless the Commission deter- 9 mines that an earlier effective date is appropriate to facili- 10 tate the effective operation of the association’s examina- 11 tion or enforcement programs, the organization and man- 12 agement of the association, or the Commission’s oversight 13 of the association.

14 ‘‘(g) REQUIREMENTS FOR REGISTRATION.—An asso- 15 ciation of investment advisers shall not be registered as 16 a national investment adviser association unless the Com- 17 mission determines that— 18 ‘‘(1) such association is so organized and has 19 the capacity to be able to carry out the purposes of 20 this title and to enforce compliance by its members 21 and persons associated with its members with the 22 provisions of this title, the rules and regulations 23 thereunder, and the rules of the association; and 24 ‘‘(2) the rules of the association—

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81 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 6 1 ‘‘(A) assure a fair representation of the 2 public interest and the investment adviser in- 3 dustry in the selection of its directors and the 4 administration of its affairs and provide that a 5 majority of its directors shall not be associated 6 with any member of the association or any in- 7 vestment adviser or broker-dealer; 8 ‘‘(B) are designed to prevent fraudulent 9 and manipulative acts and practices and to pro- 10 tect investors and the public interest; 11 ‘‘(C) are necessary in furtherance of, and 12 are consistent with, the principles and provi- 13 sions of this title and the rules thereunder and 14 the fiduciary standards applicable to investment 15 advisers under this title or state law, and do 16 not unnecessarily duplicate, overlap or conflict 17 with any existing provision of this title or the 18 rules thereunder; 19 ‘‘(D) are necessary and appropriate in 20 light of the business of registered investment 21 advisers and do not impose any burden on the 22 business of investment advisers or on their abil- 23 ity to compete in the market for financial serv- 24 ices that is not necessary or appropriate in the 25 public interest or for the protection of investors

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82 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 7 1 or otherwise in furtherance of the provisions of 2 this title; 3 ‘‘(E) provide for periodic examinations of 4 its members and persons associated with its 5 members to determine compliance with the ap- 6 plicable provisions of this title, the rules and 7 regulations thereunder, and the rules of the as- 8 sociation, for consultation with the Commission 9 in the development of such an examination pro- 10 gram, and for the coordination of those exami- 11 nations with examinations by the Commission 12 and state securities regulatory authorities in a 13 manner that promotes efficiency and avoids un- 14 necessary burdens on its members; 15 ‘‘(F) provide for the equitable allocation of 16 reasonable dues, fees, and other charges among 17 members and other persons using any facility 18 or system that the association operates or con- 19 trols; 20 ‘‘(G) provide for the issuance of an annual 21 financial report, and for the submission of the 22 report to the Commission and to the Committee 23 on Banking, Housing, and Urban Affairs of the 24 Senate and the Committee on Financial Serv- 25 ices of the House of Representatives;

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83 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 8 1 ‘‘(H) establish appropriate procedures and 2 criteria for investment advisers to become mem- 3 bers of the association; and 4 ‘‘(I) establish appropriate procedures to 5 discipline its members and persons associated 6 with its members for violations of the provisions 7 of this title or the rules and regulations there- 8 under, and the rules of the association.

9 ‘‘(h) TIME PERIOD FOR MEMBERSHIP APPLICA-

10 TION.—A Commission determination to permit the reg- 11 istration of a national investment adviser association shall 12 establish a reasonable period of time following the effective 13 date of such registration for investment advisers to apply 14 for membership in accordance with the rules of the asso- 15 ciation.

16 ‘‘(i) RULE OF CONSTRUCTION.—Nothing in this Act 17 shall be construed to limit or detract from the authority 18 or the ability of any State to regulate any investment ad- 19 viser that is otherwise subject to state authority under sec- 20 tion 203A(a) of this title.

21 ‘‘SEC. 203C. OVERSIGHT OF NATIONAL INVESTMENT AD-

22 VISER ASSOCIATIONS.

23 ‘‘(a) PROCEDURES FOR APPROVAL OF REGISTRA-

24 TION.—

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84 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 9

1 ‘‘(1) PUBLICATION AND INITIAL DETERMINA-

2 TION.—The Commission shall, upon the filing of an 3 application for registration as a national investment 4 adviser association pursuant to section 203B of this 5 title, publish notice of the filing and afford inter- 6 ested persons an opportunity to submit written data, 7 views, and arguments concerning such application. 8 Within 90 days of the date of publication of such no- 9 tice (or within such longer period as to which the 10 applicant consents), the Commission shall— 11 ‘‘(A) by order grant such registration; or 12 ‘‘(B) institute proceedings to determine 13 whether registration should be denied.

14 ‘‘(2) PROCEEDINGS FOR DENIAL.—The pro- 15 ceedings to determine whether registration should be 16 denied shall include notice of the grounds for denial 17 under consideration and opportunity for hearing and 18 shall be concluded within 180 days of the date of 19 publication of notice of the filing of the application 20 for registration. At the conclusion of such pro- 21 ceedings, the Commission, by order, shall grant or 22 deny registration. The Commission may extend the 23 time for conclusion of such proceedings for up to 90 24 days if it finds good cause for such extension and 25 publishes its reasons for so finding or for such

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85 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 10 1 longer period as to which the applicant consents. 2 The Commission shall grant such registration if it 3 finds that the requirements of this title and the 4 rules and regulations thereunder with respect to the 5 applicant are satisfied. The Commission shall deny 6 such registration if it does not make such finding.

7 ‘‘(3) WITHDRAWAL.—A national investment ad- 8 viser association may, upon such terms and condi- 9 tions as the Commission, by rule, considers nec- 10 essary or appropriate in the public interest, for the 11 protection of investors or otherwise in furtherance of 12 the purposes of this title, withdraw from registration 13 by filing a written notice of withdrawal with the 14 Commission. If the Commission finds that any na- 15 tional investment adviser association is no longer in 16 existence or has ceased to do business in the capac- 17 ity specified in its application for registration, the 18 Commission, by order, shall cancel its registration.

19 ‘‘(b) PROCEDURES FOR APPROVAL OF RULES AND

20 RULE CHANGES.—

21 ‘‘(1) FILING AND PUBLICATION BY COMMIS-

22 SION.—Each national investment adviser association 23 shall file with the Commission, in accordance with 24 such rules as the Commission may prescribe, any 25 proposed rule or any proposed change in, addition

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86 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 11 1 to, or deletion from the rules of the association (in 2 this paragraph collectively referred to as a ‘proposed 3 rule change’) accompanied by a concise statement of 4 the basis and purpose of, and the terms of substance 5 of or a description of the subjects and issues in- 6 volved with, the proposed rule change. The Commis- 7 sion shall, upon the filing of any proposed rule 8 change, publish notice thereof together with the 9 terms of substance of the proposed rule change or 10 a description of the subjects and issues involved. The 11 Commission shall give interested persons an oppor- 12 tunity to submit written data, views, and arguments 13 concerning such proposed rule change. No proposed 14 rule change shall take effect unless approved by the 15 Commission or otherwise permitted in accordance 16 with the provisions of this subsection.

17 ‘‘(2) DETERMINATION.—Within 35 days of the 18 date of publication of notice of the filing of a pro- 19 posed rule change in accordance with paragraph (1) 20 of this subsection, or within such longer period as 21 the Commission may designate if it finds a longer 22 period to be appropriate and publishes its reasons 23 for so finding or as to which the national investment 24 adviser association consents, the Commission shall:

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87 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 12 1 ‘‘(A) by order approve the proposed rule 2 change; or 3 ‘‘(B) institute proceedings to determine 4 whether the proposed rule change should be dis- 5 approved.

6 ‘‘(3) PROCEEDINGS FOR DISAPPROVAL.—The 7 proceedings to determine whether the proposed rule 8 change should be disapproved shall include notice of 9 the grounds for disapproval under consideration and 10 opportunity for hearing and be concluded within 180 11 days of the date of publication of notice of the filing 12 of the proposed rule change. At the conclusion of the 13 proceedings, the Commission, by order, shall approve 14 or disapprove the proposed rule change. The Com- 15 mission may extend the time for conclusion of the 16 proceedings for up to 60 days if it finds good cause 17 for the extension and publishes its reasons for so 18 finding or for such longer period to which the na- 19 tional investment adviser association consents.

20 ‘‘(4) CRITERIA FOR APPROVAL.—The Commis- 21 sion shall approve a proposed rule change of a na- 22 tional investment adviser association if it finds that 23 the proposed rule change is consistent with the re- 24 quirements of this title and the rules and regulations 25 applicable to the national investment adviser associa-

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88 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 13 1 tion. The Commission shall disapprove a proposed 2 rule change of a national investment adviser associa- 3 tion if it does not make this finding. The Commis- 4 sion shall not approve any proposed rule change be- 5 fore the thirtieth day after the date of publication of 6 notice of its filing, unless the Commission finds good 7 cause for so doing and publishes its reasons for so 8 finding.

9 ‘‘(5) SUMMARY EFFECTIVENESS.—(A) Notwith- 10 standing any other provision of this subsection, a 11 proposed rule change may be put into effect sum- 12 marily if it appears to the Commission that such ac- 13 tion is necessary for the protection of investors or 14 the safeguarding of securities or funds. Any pro- 15 posed rule change so put into effect shall be filed 16 promptly thereafter in accordance with the provi- 17 sions of paragraph (1) of this subsection. 18 ‘‘(B) Any proposed rule change of a national in- 19 vestment adviser association which has taken effect 20 under subparagraph (A) may be enforced by the na- 21 tional investment adviser association to the extent it 22 is not inconsistent with the provisions of this title, 23 the rules and regulations thereunder, and applicable 24 Federal law. At any time within 60 days of the date 25 of filing of a proposed rule change in accordance

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89 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 14 1 with the provisions of paragraph (1) of this sub- 2 section, the Commission summarily may abrogate 3 the change in the rules of the association made 4 thereby and require that the proposed rule change 5 be refiled in accordance with the provisions of para- 6 graph (1) of this subsection, and reviewed in accord- 7 ance with the provisions of paragraph (2) of this 8 subsection, if it appears to the Commission that 9 such action is necessary or appropriate in the public 10 interest, for the protection of investors, or otherwise 11 in furtherance of the purposes of this title. Commis- 12 sion action pursuant to the preceding sentence shall 13 not affect the validity or force of the rule change 14 during the period it was in effect and shall not be 15 reviewable under section 213 of this title nor deemed 16 to be final agency action for purposes of section 704 17 of title 5, United States Code. The Commission, by 18 rule, may abrogate, add to, and delete from (in this 19 subsection collectively referred to as ‘amend’) the 20 rules of an association as the Commission deems 21 necessary or appropriate to ensure the fair adminis- 22 tration of the national investment adviser associa- 23 tion, to conform its rules to requirements of this 24 title and the rules and regulations applicable to such 25 national investment adviser association, or otherwise

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90 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 15 1 in furtherance of the purposes of this title, in the 2 manner provided for in paragraphs (6) through (8).

3 ‘‘(6) NOTIFICATION AND OPPORTUNITY TO

4 COMMENT.—The Commission shall notify the na- 5 tional investment adviser association and publish no- 6 tice of the proposed rulemaking in the Federal Reg- 7 ister. The notice shall include the text of the pro- 8 posed amendment to the rules of the association and 9 a statement of the Commission’s reasons, including 10 any pertinent facts, for commencing the proposed 11 rulemaking. The Commission may give interested 12 persons an opportunity for the oral presentation of 13 data, views, and arguments, in addition to an oppor- 14 tunity to make written submissions. A transcript 15 shall be kept of any oral presentation.

16 ‘‘(7) STATEMENT OF BASIS FOR DETERMINA-

17 TION.—A rule adopted under this subsection shall 18 incorporate the text of the amendment to the rules 19 of the association and a statement of the Commis- 20 sion’s basis for and purpose in amending such rules. 21 This statement shall include an identification of any 22 facts on which the Commission considers its deter- 23 mination to amend the rules of the association to be 24 based, including the reasons for the Commission’s

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91 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 16 1 conclusions as to any of such facts which were dis- 2 puted in the rulemaking.

3 ‘‘(8) ADA RULEMAKING PROCEDURES.—(A) 4 Except as provided in paragraphs (1) through (3) of 5 this subsection, rulemaking under this subsection 6 shall be in accordance with the procedures specified 7 in section 553 of title 5, United States Code, for 8 rulemaking not on the record. 9 ‘‘(B) Nothing in this subsection shall be con- 10 strued to impair or limit the Commission’s power to 11 make, or to modify or alter the procedures the Com- 12 mission may follow in making rules and regulations 13 pursuant to any other authority under this title. 14 ‘‘(C) Any amendment to the rules of an associa- 15 tion made by the Commission under this subsection 16 shall be considered for all purposes of this title to 17 be part of the rules of the association and shall not 18 be considered to be a rule of the Commission.

19 ‘‘(c) DISCIPLINE OF MEMBERS.—

20 ‘‘(1) IN GENERAL.—In any proceeding by a na- 21 tional investment adviser association to determine 22 whether a member or person associated with a mem- 23 ber should be disciplined (other than a summary 24 proceeding pursuant to paragraph (3)), the national 25 investment adviser association shall bring specific

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92 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 17 1 charges, notify the member or person associated 2 with a member of, and give the member or person 3 an opportunity to defend against, such charges, and 4 keep a record. A determination by the national in- 5 vestment adviser association to impose a disciplinary 6 sanction shall be supported by a statement setting 7 forth— 8 ‘‘(A) any act or practice in which the mem- 9 ber or person associated with a member has 10 been found to have engaged, or which the mem- 11 ber or person associated with a member has 12 been found to have omitted; 13 ‘‘(B) the specific provision of this title, the 14 rules or regulations thereunder, or the rules of 15 the association which any such act or practice, 16 or omission to act, is deemed to violate; and 17 ‘‘(C) the sanction imposed and the reason 18 for it.

19 ‘‘(2) PROCEDURES AND DETERMINATION.—In 20 any proceeding by a national investment adviser as- 21 sociation to determine whether a person shall be de- 22 nied membership, barred from becoming associated 23 with a member, or prohibited or limited with respect 24 to access to services offered by the national invest- 25 ment adviser association, the national investment

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93 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 18 1 adviser association shall notify the person of, and 2 give such person an opportunity to be heard on, the 3 specific grounds for denial, bar, prohibition or limi- 4 tation under consideration, and keep a record. A de- 5 termination by the national investment adviser asso- 6 ciation to deny membership, bar a person from be- 7 coming associated with a member, or prohibit or 8 limit a person with respect to access to services of- 9 fered by the national investment adviser association 10 shall be supported by a statement setting forth the 11 specific grounds on which the denial, bar, or prohibi- 12 tion or limitation is based.

13 ‘‘(3) SUMMARY SUSPENSION AND SUBSEQUENT

14 PROCEDURES.—A national investment adviser asso- 15 ciation may summarily— 16 ‘‘(A) suspend a member or person associ- 17 ated with a member who has been and is ex- 18 pelled or suspended from any self-regulatory or- 19 ganization or barred or suspended from being 20 associated with a member of any self-regulatory 21 organization; 22 ‘‘(B) suspend a member who is in such fi- 23 nancial or operating difficulty that the national 24 investment adviser association determines and 25 so notifies the Commission that the member

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94 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 19 1 cannot be permitted to continue to do business 2 as a member and serve the interest of investors, 3 creditors, other members, or the national in- 4 vestment adviser association; or 5 ‘‘(C) limit or prohibit any person with re- 6 spect to access to services offered by the na- 7 tional investment adviser association if subpara- 8 graph (A) or (B) is applicable to such person 9 or, in the case of a person who is not a mem- 10 ber, if the national investment adviser associa- 11 tion determines that such person does not meet 12 the qualification requirements or other pre- 13 requisites for such access and such person can- 14 not be permitted to continue to have such ac- 15 cess and serve the interest of investors, credi- 16 tors, members, or the national investment ad- 17 viser association. 18 Any person aggrieved by any such summary action 19 shall be promptly afforded an opportunity for a 20 hearing by the national investment adviser associa- 21 tion in accordance with the provisions of paragraph 22 (1) or (2) of this subsection. The Commission, by 23 order, may stay any such summary action on its own 24 motion or upon application by any person aggrieved 25 thereby, if the Commission determines summarily or

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95 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 20 1 after notice and opportunity for hearing (which 2 hearing may consist solely of the submission of affi- 3 davits or presentation of oral arguments) that such 4 stay is consistent with the public interest and the 5 protection of investors.

6 ‘‘(d) FINAL DISCIPLINARY SANCTION.—(1) If any 7 national investment adviser association imposes any final 8 disciplinary sanction on any member, denies membership 9 to any applicant, or prohibits or limits any person in re- 10 spect to access to services offered by the national invest- 11 ment adviser association, or if any national investment ad- 12 viser association imposes any final disciplinary sanction on 13 any person associated with a member, or bars any person 14 from becoming associated with a member, the national in- 15 vestment adviser association shall promptly file notice 16 thereof with the Commission. The notice shall be in such 17 form and contain such information as the Commission, by 18 rule, may prescribe as necessary or appropriate in further- 19 ance of the purposes of this title. 20 ‘‘(2) Any action with respect to which a national in- 21 vestment adviser association is required by paragraph (1) 22 of this subsection to file notice shall be subject to review 23 by the Commission, on its own motion, or upon application 24 by any person aggrieved thereby filed within 30 days after 25 the date such notice was both filed with the Commission

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96 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 21 1 and received by such aggrieved person, or within such 2 longer period as the Commission may determine. Applica- 3 tion to the Commission for review, or the institution of 4 review by the Commission on its own motion, shall not 5 operate as a stay of the action unless the Commission oth- 6 erwise orders, summarily or after notice and opportunity 7 for hearing on the question of a stay (which hearing may 8 consist solely of the submission of affidavits or presen- 9 tation of oral arguments). The Commission may establish 10 for appropriate cases an expedited procedure for consider- 11 ation and determination of the question of a stay.

12 ‘‘(e) REVIEW OF FINAL SANCTION.—(1) In any pro- 13 ceeding to review a final disciplinary sanction imposed by 14 a national investment adviser association on a member or 15 a person associated with a member, after notice and op- 16 portunity for hearing (which hearing may consist solely 17 of consideration of the record before the national invest- 18 ment adviser association and opportunity for the presen- 19 tation of supporting reasons to affirm, modify, or set aside 20 the sanction)— 21 ‘‘(A) if the Commission finds that such member 22 or person associated with a member has engaged in 23 such acts or practices, or has omitted such acts, as 24 the national investment adviser association has 25 found him or her to have engaged in or omitted,

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97 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 22 1 that such acts or practices, or omissions to act, are 2 in violation of such provisions of this title, the rules 3 or regulations thereunder, or the rules of the asso- 4 ciation, as have been specified in the determination 5 of the national investment adviser association, and 6 that such provisions are, and were applied in a man- 7 ner, consistent with the purposes of this title, the 8 Commission, by order, shall so declare and, as ap- 9 propriate, affirm the sanction imposed by the na- 10 tional investment adviser association, modify the 11 sanction in accordance with paragraph (2) of this 12 subsection, or remand to the national investment ad- 13 viser association for further proceedings; or 14 ‘‘(B) if the Commission does not make any such 15 finding it shall, by order, set aside the sanction im- 16 posed by the national investment adviser association 17 and, if appropriate, remand to the national invest- 18 ment adviser association for further proceedings. 19 ‘‘(2) If the Commission, having due regard for the 20 public interest, the protection of investors, and the policies 21 and purposes of this title, finds after a proceeding in ac- 22 cordance with paragraph (1) that a sanction imposed by 23 a national investment adviser association on a member or 24 person associated with a member imposes any burden on 25 competition not necessary or appropriate in furtherance

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98 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 23 1 of the purposes of this title or is excessive or oppressive, 2 the Commission may cancel, reduce, or require the revoca- 3 tion of such sanction.

4 ‘‘(f) REVIEW OF DENIAL OF MEMBERSHIP.—In any 5 proceeding to review the denial of membership in a na- 6 tional investment adviser association to any applicant, the 7 barring of any person from becoming associated with a 8 member, or the prohibition or limitation by a national in- 9 vestment adviser association of any person with respect 10 to access to services offered by the national investment 11 adviser association, if the Commission, after notice and 12 opportunity for hearing (which hearing may consist solely 13 of consideration of the record before the national invest- 14 ment adviser association and opportunity for the presen- 15 tation of supporting reasons to dismiss the proceeding or 16 set aside the action of the national investment adviser as- 17 sociation) finds that the specific grounds on which the de- 18 nial, bar, prohibition or limitation is based exist in fact, 19 that the denial, bar, prohibition, or limitation is in accord- 20 ance with the rules of the association, and that the rules 21 are and were applied in a manner consistent with the pur- 22 poses of this title, the Commission, by order, shall dismiss 23 the proceeding. If the Commission does not make any such 24 finding or it finds that the denial, bar, prohibition or limi- 25 tation imposes any burden on competition not necessary

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99 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 24 1 or appropriate in furtherance of the purposes of this title, 2 the Commission, by order, shall set aside the action of the 3 national investment adviser association and require it to 4 admit the applicant to membership or participation, per- 5 mit the person to become associated with a member, or 6 grant the person access to services offered by the national 7 investment adviser association.

8 ‘‘(g) COMPLIANCE.—(1) Every registered national in- 9 vestment adviser association shall comply with the provi- 10 sions of this title, the rules and regulations thereunder, 11 and its own rules, and (subject to the provisions of para- 12 graph (2) and the rules thereunder) absent reasonable jus- 13 tification or excuse, enforce compliance with such provi- 14 sions by its members and persons associated with a mem- 15 ber. The Commission shall conduct regular and routine 16 inspections, at least annually, of the registered national 17 investment adviser association, to ensure that the associa- 18 tion complies with the provisions of this title and the rules 19 and regulations thereunder. 20 ‘‘(2) The Commission, by rule, consistent with the 21 public interest, the protection of investors, and the other 22 policies and purposes of this title, may relieve any national 23 investment adviser association of any responsibility under 24 this title to enforce compliance with any provision of this 25 title or the rules or regulations thereunder by any member

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100 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 25 1 of the national investment adviser association or any class 2 of such members or persons associated with a member.

3 ‘‘(h) ENFORCEMENT AUTHORITY OF THE COMMIS-

4 SION.—

5 ‘‘(1) SUSPENSION, CENSURE, LIMITATION ON

6 ASSOCIATIONS.—The Commission is authorized, by 7 order, if in its opinion such action is necessary or 8 appropriate in the public interest, for the protection 9 of investors, or otherwise in furtherance of the pur- 10 poses of this title, to suspend for a period not ex- 11 ceeding 12 months or revoke the registration of a 12 national investment adviser association, or to cen- 13 sure or impose limitations upon the activities, func- 14 tions, and operations of the national investment ad- 15 viser association, if the Commission finds, on the 16 record after notice and opportunity for hearing, that 17 the national investment adviser association has vio- 18 lated or is unable to comply with any provision of 19 this title, the rules or regulations thereunder, or its 20 own rules, or without reasonable justification or ex- 21 cuse has failed to enforce compliance with any such 22 provision by a member or a person associated with 23 a member.

24 ‘‘(2) SUSPENSION AND EXPULSION OF MEM-

25 BERS.—The Commission is authorized, by order, if

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101 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 26 1 in its opinion such action is necessary or appropriate 2 in the public interest, for the protection of investors, 3 or otherwise in furtherance of the purposes of this 4 title, to suspend for a period not exceeding 12 5 months or expel from a national investment adviser 6 association any member, if the member is subject to 7 an order of the Commission pursuant to section 8 203(e) of this title or if the Commission finds, on 9 the record after notice and opportunity for hearing, 10 that the member has willfully violated, or has par- 11 ticipated in any transaction with or for any other 12 person who the member had reason to believe was 13 violating with respect to such transaction, any provi- 14 sion of the Securities Act of 1933, the Securities Ex- 15 change Act of 1934, the Investment Company Act of 16 1940, this title, the Commodity Exchange Act, or 17 the rules or regulations under any of such statutes, 18 or the rules of the Municipal Securities Rulemaking 19 Board.

20 ‘‘(3) OTHER BARS.—The Commission is author- 21 ized, by order, if in its opinion, such action is nec- 22 essary or appropriate in the public interest, for the 23 protection of investors, or otherwise in furtherance 24 of the purposes of this title, to suspend for a period 25 not exceeding twelve months or to bar any person

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102 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 27 1 from being associated with a member of a national 2 investment adviser association, if the person is sub- 3 ject to an order of the Commission under section 4 203(f) of this title or if the Commission finds, on 5 the record after notice and opportunity for hearing, 6 that the person has willfully violated, or has partici- 7 pated in any transaction with any other person who 8 the person associated with a member had reason to 9 believe was violating with respect to the transaction, 10 any provision of the Securities Act of 1933, the Se- 11 curities Exchange Act of 1934, the Investment Com- 12 pany Act of 1940, this title, the Commodity Ex- 13 change Act, or the rules or regulations under any of 14 those statutes, or the rules of the Municipal Securi- 15 ties Rulemaking Board.

16 ‘‘(4) REMOVAL OR CENSURE OF OFFICERS AND

17 DIRECTORS.—The Commission is authorized, by 18 order, if in its opinion such action is necessary or 19 appropriate in the public interest, for the protection 20 of investors, or otherwise in furtherance of the pur- 21 poses of this title, to remove from office or censure 22 any officer, director or any person performing simi- 23 lar functions of a national investment adviser asso- 24 ciation, if the Commission finds, on the record after 25 notice and opportunity for hearing, that such person

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103 F:\M12\BACHUS\BACHUS_017.XML [Discussion Draft] 28 1 has willfully violated any provision of this title, the 2 rules or regulations thereunder, or the rules of the 3 national investment adviser association, willfully 4 abused his authority, or without reasonable justifica- 5 tion or excuse has failed to enforce compliance with 6 any such provision by any member or person associ- 7 ated with a member.’’.

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104 EXHIBIT V

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106 COMMENTS ON DRAFT SEBI (INVESTMENT ADVISERS) REGULATIONS, 2007 AND SEBI (SELF-REGULATORY ORGANIZATIONS) REGULATIONS, 2004 BY FINANCIAL PLANNING STANDARDS BOARD INDIA (FPSB INDIA)

A. BACKGROUND

1. SEBI has notified the draft SEBI (Investment Advisers) Regulations, 2007 (“Regulations”) for public comments.

2. The Financial Planning Standards Board India (“FPSBI”) is a not for profit company incorporated under section 25 of the Companies Act, 1956, with the object of promoting the growth of the financial planning profession in the country. Suitable regulation of entities providing financial advice to individuals forms one of the key objectives of FPSB India.

3. The purpose of this memorandum is to make certain suggestions to the Regulations with a view to achieving the said objective.

4. Further, as the Regulations envisage that investment advisers shall be members of, and shall abide by, the norms set out by a self-regulatory organization, certain amendments to the SEBI (Self Regulatory Organizations) Regulations, 2004 (“SRO Regulations”) have also been suggested here to enable the formation of an effective self regulatory organization for the investment advisers.

PART A

B. COMMENTS TO THE DRAFT SEBI (INVESTMENT ADVISERS REGULATIONS), 2007

I. Regulation 3(1) and Regulation 3(2) (a)

1. Regulation 3(1) of the Regulations defines an investment adviser to mean, “any person who for consideration is engaged in the business of providing investment advice to others, either directly or through publications or writings or electronic mails, or who, for consideration and as part of regular business, issues or publishes reports or analyses containing investment advice and includes any person who holds himself out as an investment adviser (by whatever name called) to others.”

2. The term “investment advice” is defined in Regulation 3(2) (a) of the Regulations to mean (unless the context otherwise requires), “advise as to the value of securities, or as to the advisability of investing in, purchasing, selling or otherwise dealing in securities.”

107 3. By way of a clarification, whilst we understand that the desire is to bring entities which advise on investments in any asset class within the purview of the Regulations, the jurisdiction of SEBI extends only to regulation of the securities markets and intermediaries connected with the same. Hence, in our view, the restriction of the definition of “investment advice” to matters pertaining to securities is warranted and SEBI may not have the jurisdiction to regulate other asset classes which are regulated by other regulators (one example being insurance products which are marketed by insurance agents and regulated by the Insurance Regulatory and Development Authority). Separate legislation would therefore be required in order to create a regulatory framework whereby investment advisers advising in relation to all asset classes were subject to the same regulations and governed by the same regulator.

4. Separately, the definition of “investment advisers” is in our view wide enough to cover instances of both mere marketing of products (selling) and offering tailored investment advice (eg: financial planning), and the same may therefore be retained in the interests of greater regulating of all persons offering any form of advice.

II. Regulation 3(2) (c) (i)

1. Regulation 3(2)(c) of the Regulations provides that a person shall not be deemed to be providing investment advice, if the advice is solely incidental to some other business or profession and the advice is given only to clients of the person in the course of such other business or profession.

2. Currently, both portfolio managers and stock brokers are permitted to offer investment advice provided they make suitable disclosures regarding their interests, including the interests of their family members, in such securities. A stock broker is further required to take into account his client’s position and obtain information in relation to the same in order to gauge the suitability of the recommendation before offering any such advice. However, under the current Regulations, neither intermediary would be required to register as an investment adviser as the advice offered may be deemed to be incidental to the primary business of stock broking/portfolio management and hence fall within the safe harbor provided by Regulation 3(2) (c).

3. Hence, stock brokers/portfolio managers and their employees who offer investment advise may be made to register as investment advisers under the Regulations. Alternately, entities which offer “investment advice” as an incidental activity to their main business, (including stock brokers/portfolio managers), may be required to undergo a limited certification requirement with the self-regulatory organization created to regulate investment advisers, in the

108 same manner that mutual fund employees who market mutual fund products and interact with clients are currently required to undergo AMFI certification.1

4. In light of the aforesaid, the moderation of the blanket exclusion contained in Regulation 3(2) (c) in the manner specified above may be considered.

III. Regulation 3(2) (c) (ii)

1. Regulation 3(2) (c) (ii) of the Regulations may be modified to read, “the advice does not specify particular securities or a class or type of securities”.

2. The above would bring within the fold of investment advice statements like “sell equity and invest in debt”, “invest in mutual funds” etc, which may equally be construed as investment advice and may equally induce people to change their financial position.

IV. Regulation 3(3) and Regulation 3(4)

1. Regulations 3(3) and Regulation 3(4) provide that advice contained in print media or through a radio broadcast, television, internet etc (“Medium”) shall not count as investment advice if the principal purpose of the Medium, taken as a whole, and including any advertisements or other promotional material contained therein, is not that of providing investment advice or of soliciting, leading or enabling persons to buy, sell or otherwise deal in securities.

2. The exemption contained in Regulations 3(3) and 3(4) above may be too broad and may permit individuals to offer investment advice without attracting the provisions of the Regulations, thereby defeating the purpose of the Regulations. One example of the above is the fact that a person offering financial advice in a general magazine (say India Today or Outlook) will not require registration although a person offering the same advice in Outlook Money may (this despite the fact that the general magazine is likely to be read by a larger number of people than the financial magazine).

3. Whilst there may be constitutional considerations in relation to the fundamental right to free speech at play, persons offering advice in a Medium that falls within the exceptions contained in Regulation 3(3) and 3(4) of the Regulations may be required, at the least, to insert a suitable disclaimer whilst offering such advice as a mandatory regulatory requirement.

V. Regulation 4(2)

1. Regulation 4(2) of the Regulations provides that a person who has been granted a certificate under Section 12 of the Securities and Exchange Board of India Act,

1 Note: Whether AMFI certification itself should be transferred to the self-regulatory organization created for the regulation of investment advisers is a broader issue that arises here.

109 1992, in any other capacity may provide investment advice to his clients in that capacity without obtaining a separate certificate under the Regulations.

2. We would recommend that such registered intermediaries be required to obtain a specific certification from the self-regulatory organization set up to regulate investment advisers, in order to be permitted to offer investment advice. Please also see our comments in Paragraph II above in this behalf.

VI. Regulation 4(3)

1. Regulation 4(3) of the Regulations provides that no certificate shall be granted to any person under the Regulations, unless he is a member of a self-regulatory organization. Regulation 2(d) defines a “self-regulatory organization” to mean, “any self-regulatory organization which is recognized by the Board under regulation 5 of the SEBI (Self Regulatory Organizations) Regulations, 2004 or any statutory amendment or re-enactment thereof.”

2. The above provisions create the impression that membership of any duly recognized self-regulatory organization is sufficient for the purposes of registration as an investment adviser. In our view two forms of regulatory models are possible:

i) multiple self-regulatory organizations, each of which exercise jurisdictions and supervise members falling within their sphere of activity. Thus for example, AMFI for mutual funds, a separate self-regulatory organization for stock brokers, a separate one for portfolio managers, a separate one for financial planners and so on; or ii) a single regulatory organization for investment advisers which may impose different certification requirements for persons based on their professional activities (thus for example whilst a financial planner would need certification across the Board, a mutual fund distribution agent need only obtain a certification equivalent to the current AMFI certification).

3. The second model described above may be preferable as it avoids multiplicity of regulators leading to the following inter alia benefits:

i) more coherent regulation of the market in relation to financial advice as a whole ii) greater simplicity in rules and procedures iii) convenience in registration/ acquisition of additional certifications by members as they expand their professional scope iv) ease of supervision and control of the self-regulatory organization by SEBI

4. In light of the above, and by way of abundant caution, the Regulations may expressly clarify that investment advisers are required to be registered with a

110 single specific self-regulatory organization created for the regulation of investment advisers, instead of any self-regulatory organization that is recognized by SEBI under the SRO Regulations. This self-regulatory organization may also be responsible for carrying on certification tests of other registered intermediaries as stated in our comments in Paragraph II above.

VII. Recognition and Registration of Institutions Offering Investment Advice.

1. Currently, the Regulations do not clearly provide for the registration of institutions as investment advisers. The same may be provided for based on the following (indicative) guidelines:

i) requirement of a minimum number of appropriately qualified promoters/directors/officers ii) track record, experience, competency etc iii) public interest

2. All employees of such institution which offer investment advice may be mandatorily required to obtain separate (individual) registration as investment advisers under the Regulations.

3. Based on the above, the self-regulatory organization for investment advisers would then have both institutional members and individuals as members. Such diverse membership would be in line with leading self-regulatory organizations throughout the world.

PART B

C. COMMENTS ON THE SEBI (SELF REGULATORY ORGANIZATIONS) REGULATIONS, 2004

I. Regulations 8 and 9

1. Regulations 8(2) of SRO Regulations provides that a certificate of recognition granted to a self-regulatory organization shall be valid for a period of 5 years. Regulation 9 sets out the procedure for renewal of the certificate of recognition.

2. In view of the fact that the self regulatory organization functions under constant SEBI supervision, it may be unnecessary to have a separate provision for renewal of the certificate of recognition and the same may be valid until revoked by SEBI or renounced by the self-regulatory organization. II. Regulation 12

1. Regulation 12(1)(c) of the SRO Regulations provides that the Board of Directors of the self- regulatory organization shall consist of nine directors out of which

111 five directors shall be nominated by SEBI and the remaining four shall be elected by the members of the self regulatory organization2.

2. As the very concept behind the creation of a self-regulatory organization is self- regulation by a group of market intermediaries who come together, the requirement of majority SEBI representation on the Board of such self-regulatory organizations may defeat the very purpose for their formation.

3. Regard may be had in this context to the Restated Certificate of Incorporation of the National Association of Securities Dealers Inc (“Certificate”).3 Article 8 of the Certificate, which provides for the election of the Board of Governors (akin to the Board of directors), lays down a procedure whereby the entire Board is elected by the members or nominated in the manner provided by the Board of Governors.

4. The SRO Regulations envisage adequate superintendence of self regulatory organizations as indicated by the following:

i) self-regulatory organizations are subject to SEBI supervision and are required to make periodic reports to SEBI ii) SEBI has the power to carry out inspections and audits of the self- regulatory organization and to give directions iii) SEBI has the power to reconstitute the Board of directors of the self- regulatory organization iv) The number of independent directors on the Board of the self- regulatory organization and all committees of the Board is required to exceed the number of non-independent directors v) self regulatory organizations have stringent compliance requirements and are required to comply with corporate governance norms as applicable to listed companies;

5. Hence, Regulations 12 and 5(2)(ii) of the Regulations may be amended so as to do away with the requirement of SEBI nominees on the Board of the self regulatory organization in the interests of greater autonomy and to create a regulatory framework bases on voluntary self regulation under broader SEBI supervision.

2 In this context Regulation 5(2)(ii) of the SRO Regulations also provides that the conditions which SEBI may prescribe for the grant of the certificate of recognition to the self regulatory organization may include SEBI representation on the Board of Directors of the self regulatory organization by such number of directors not exceeding four, as the Board may nominate in this behalf. Hence, there seems to be some inconsistency as regards the number of SEBI nominees on the Board of the self regulatory organization. 3 Now the Financial Industry Regulatory Authority which is the largest non-governmental regulator for all securities firms doing business in the United States of America.

112 Page 1 of 18

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THE GAZETTE OF INDIA

EXTRAORDINARY

PART – III – SECTION 4

PUBLISHED BY AUTHORITY

SECURITIES AND EXCHANGE BOARD OF INDIA

NOTIFICATION

Mumbai, the 19th day of February, 2004

SECURITIES AND EXCHANGE BOARD OF INDIA

(SELF REGULATORY ORGANIZATIONS) REGULATIONS, 2004

F. No. SEBI/LAD/DOP/3348/2004. In exercise of the powers conferred by section 30 read with clause (d) of sub-section (2) of section 11 of the Securities and Exchange Board of India Act, 1992 (15 of 1992), the Board hereby makes the following Regulations, namely: -

Chapter – I

Preliminary

Short title and commencement

1. (1) These Regulations may be called the Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2004.

(2) These Regulations shall come into force on such date as may be specified by the Board:

Provided that different dates may be specified for different provisions of these regulations and any reference in any such provision to the commencement of these regulations shall be construed as a reference to the commencement of that provision.

Definitions

2. (1) In these regulations, unless the context otherwise requires, -

(a) "Act" means the Securities and Exchange Board of India Act, 1992 (15 of 1992);

(b) "Board" means the Securities and Exchange Board of India established

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under section 3 of the Act;

(c) "agent" means any person who is associated with securities market and who conducts the business of distribution of securities products;

(d) "certificate" means a certificate of recognition granted to a Self Regulatory Organization by the Board under sub-regulation (1) of regulation 5 and includes a certificate renewed under regulation 9;

(e) "company" means a company which has been granted license under section 25 of the Companies Act, 1956 (1 of 1956);

(f) "economic offence" means an offence to which the Economic Offences (Inapplicability of Limitation) Act, 1974 (12 of 1974), is applicable for the time being and includes an offence under the Securities and Exchange Board of India Act, 1992, Securities Contracts (Regulation) Act, 1956 and Depositories Act, 1996;

(g) "governing norms" mean the governing norms of a Self Regulatory Organization made in accordance with sub-regulation (1) of regulation 15;

(h) "intermediary" means any person who is registered with the Board under section 12 of the Act;

(i) "member" means an intermediary who has been admitted as a member of a Self Regulatory Organization and includes an agent who has been so admitted;

(j) "office bearer" in relation to a Self Regulatory Organization means its Chairman, Managing Director, any whole time director or Chief Executive Officer, by whatever name called, and includes any person named as such by the Self Regulatory Organization in its application for grant or renewal of recognition made under these regulations;

(k) "Self Regulatory Organization" means an organization of intermediaries which is representing a particular segment of the securities market and which is duly recognised by the Board under these regulations, but excludes a stock exchange.

(2) Words and expressions used and not defined in the regulations, but defined in the Act, shall have the meanings respectively assigned to them in the Act.

Chapter II

Recognition of Self Regulatory Organization

3. (1) Any group or association of intermediaries, which is desirous of being recognized as a Self Regulatory Organization, may form a company registered under section 25 of the Companies Act, 1956 and such company may make an application to the Board for grant of certificate of recognition as a Self Regulatory Organization.

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(2) Every application made by such company under sub-regulation (1) shall contain such particulars as may be specified and shall be accompanied by a copy of the governing norms of Self Regulatory Organization and also a copy of the memorandum and articles of association relating in general to the constitution of the Self Regulatory Organization and in particular, to –

a. Board of Directors of Self Regulatory Organization, its constitution and powers of management and the manner in which its business would be transacted;

b. the powers and duties of the office bearers of Self Regulatory Organization;

c. the admission into the Self Regulatory Organization of members, agents, their qualifications for membership, and the exclusion, suspension, expulsion and readmission of members therefrom or thereinto;

(3) Every application under sub-regulation (1) shall be signed on behalf of the applicant under authority of its Board of Directors by its Chairman, Managing Director, Chief Executive Officer or whole time director.

(4) Every application under sub-regulation (1) shall be made to the Board in Form A of the first schedule and shall be accompanied by a non-refundable application fee, as specified in Part A of the second schedule, to be paid in the manner specified in Part B thereof.

Eligibility criteria

4. The Board shall not consider an application for grant of a certificate under regulation 3 unless the applicant satisfies the following conditions, namely:-

a. the applicant is a company which has been granted license under section 25 of Companies Act, 1956;

b. the applicant has, in its memorandum of association, specified admission of members and discharging the functions of Self Regulatory Organization as one of its main objects;

c. the applicant has a minimum networth of one crore rupees;

d. the applicant has adequate infrastructure, to enable it to discharge its functions as a Self Regulatory Organization in accordance with the provisions of the Act and these regulations;

e. the applicant referred to in regulation 3 and its directors have the professional competence, financial soundness and general reputation of fairness and integrity to the satisfaction of the Board;

f. neither the applicant, nor any director of the applicant is involved in any legal proceeding connected with the securities market, which may have an adverse impact on the interests of the investors;

g. neither the applicant, nor any director has at any time in the past been convicted of any offence involving moral turpitude or any economic offence;

h. the applicant has, in its employment, persons having adequate professional and other relevant experience to the satisfaction of the Board;

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i. the applicant, in all other respects, is a fit and proper person for the grant of a certificate;

j. grant of certificate to the applicant is in the interest of investors and the securities market.

Grant of recognition as a Self Regulatory Organization

5. (1) If the Board is satisfied, after making such inquiry as may be necessary in this behalf and after obtaining such further information, if any, as it may require, -

(a) that the articles and governing norms of the applicant applying for recognition are in conformity with such conditions as may be specified by the Board;

(b) that the applicant is willing to comply with any other conditions which the Board may impose for the purpose of carrying out the objects of these Regulations; and,

(c) that it would be in the interest of the trade and also in the public interest to grant recognition to the applicant as a Self Regulatory Organization;

the Board may grant certificate of recognition to the applicant as a Self Regulatory Organization in Form B1 of the First Schedule subject to such terms and conditions as the Board may deem fit and appropriate.

2. The conditions which the Board may specify under sub-regulation (1) for the grant of recognition to the applicant as a Self Regulatory Organization may include, among other matters, conditions relating to, -

i. the qualification for membership of the Self Regulatory Organization;

ii. the representation of the Board in the Board of Directors of the Self Regulatory Organization by such number of directors not exceeding four as the Board may nominate in this behalf; and

iii. the maintenance of accounts of members and their audit by chartered accountants whenever such audit is required by the Board.

2. No articles of Self Regulatory Organization relating to any of the matters specified in clauses (a), (b) and (c) of sub-regulation (2) of Regulation 3 shall be amended except with the prior written approval of the Board.

Application to conform to the requirements

6. Any application for a certificate, which is not complete in all respects or does not conform to the requirements of these regulations and particularly regulations 3, 4 and 5 or instructions specified in Form A shall be rejected by the Board.

Provided that, before rejecting any such application, the Board shall give an opportunity to the applicant to remove such objections as may be indicated by the Board, within 30 days of the date of receipt of relevant communication, from the Board.

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Provided further that the Board may, on sufficient cause being shown, extend the time for removal of objections by such further time, not exceeding 30 days as the Board may consider fit, to enable the applicant to remove such objections.

Furnishing of information, clarification and personal representation

7.(1) The Board may require the applicant to furnish such further information or clarification as it may consider necessary for the purpose of processing of the application.

(2) The Board, if it so desires, may require the applicant to appear before it through an authorized representative for personal representation in connection with the grant of a certificate of recognition.

Conditions of certificate and validity period

8. (1) The certificate granted under regulation 5 shall be, subject to the following conditions, namely: -

a. the applicant shall comply with the provisions of the Act, applicable regulations and guidelines, directions or circulars issued by the Board from time to time;

b. any information or particulars furnished to the Board by the applicant shall not be false or misleading in any material respect;

c. where any material information or particulars furnished to the Board by the applicant, in or in connection with the application for recognition, has undergone change subsequent to its furnishing, the applicant shall forthwith inform the fact to the Board in writing;

2. The certificate of recognition shall be valid for a period of five years.

Renewal of certificate

9. (1) Any Self Regulatory Organization desirous of obtaining renewal of the recognition granted to it, shall make to the Board an application for the renewal of the certificate of recognition in Form A of the First Schedule.

(2) Such application shall be made not less than three months before expiry of the period of validity of the certificate, specified in sub-regulation (2) of regulation 8.

(3) The application for renewal made under sub-regulation (1), -

(a) shall be accompanied by a renewal fee as specified in the second schedule; and,

(b) as far as may be, shall be dealt with in the same manner as if it were an application

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for the grant of a fresh certificate under regulation 3.

(4) If the Board is satisfied that the certificate of recognition already granted to the Self Regulatory Organization under sub-regulation (1) of regulation 5 or the certificate previously renewed under this regulation deserves to be renewed, the Board may renew such certificate in Form B2 of the First Schedule subject to such terms and conditions as it may deem fit and appropriate.

Procedure where certificate is not granted

10. (1) If, after considering an application made under regulation 3 or regulation 9, as the case may be, the Board is of the opinion that a certificate should not be granted or renewed, it may, after giving the applicant a reasonable opportunity of being heard, reject the application within a period of thirty days of receipt of such application complete in all respects or within thirty days of receipt of further information or clarification sought under regulation 7.

(2) If any application is rejected under sub-regulation (1), the fact shall be communicated to the applicant forthwith, stating the grounds for such rejection.

Effect of refusal to grant certificate

11. (1) An applicant referred to in sub regulation (1) of regulation 3 whose application for the grant of a certificate has been rejected under sub-regulation (1) of regulation 10 shall not undertake any activity as Self Regulatory Organization.

(2) A Self Regulatory Organization referred to in regulation 9 whose application for the renewal of certificate has been rejected by the Board shall on and from the date of the receipt of the communication from the Board under sub regulation (2) of regulation 10 cease to carry on any activity as Self Regulatory Organization.

(3) If the Board is satisfied that it is in the interests of investors to do so, it may permit the Self Regulatory Organization referred to under sub-regulation (2) to complete the functions or obligations already initiated or undertaken by it during the pendency of the application or during the period of validity of the certificate.

(4) The Board may in order to protect the interests of investors, issue directions with regard to the transfer of records, documents or reports relating to the functions of the Self Regulatory Organization, whose application for the grant or renewal of a certificate has been rejected.

(5) The Board may, in order to protect the interests of investors, appoint any person to take charge of the records, documents or reports relating to the organization referred to in sub-regulation (4) and for this purpose also determine the terms and conditions of such appointment.

CHAPTER III

Composition and functions of Self Regulatory Organizations

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Composition of Board of Directors

12. (1) The Articles of Association of a Self Regulatory Organization shall provide for the following: -

(a) There shall be a Board of Directors of the Self Regulatory Organization and majority of directors shall be independent directors.

(b) The independent directors shall not be required to hold any qualification shares.

(c) The Board of Directors shall consist of nine directors out of which five directors shall be nominated by the Board and the remaining four shall be elected by the members of the Self Regulatory Organization.

(d) The General Superintendence, direction and management of the affairs of the Self Regulatory Organization shall vest in its Board of Directors, which may exercise all powers and do all acts and things which may be exercised or done by the Self Regulatory Organization.

(e) There shall be a Chairman, who shall be an independent professional, appointed by Board of Directors, with the prior approval of the Board.

(f) The Chairman shall be responsible for day-to-day administration of Self Regulatory Organization and implementing the decisions of Board of Directors.

(g) The Board of Directors may establish committees including disciplinary committee, screening committee, arbitration committee or remuneration committee in order to carry out the purposes of these regulations.

Provided that the committees constituted under this regulation may consist wholly of other persons or partly of directors and partly of other persons.

Provided further that the majority of members of each such committee shall be independent.

(h) The office bearers of Board of Directors shall relinquish their office, when the Board passes an order under clause (c) of sub-section (4) of section 11 of the Act.

(i) The Board of Directors of the Self Regulatory Organization shall be reconstituted as and when required by the Board.

Membership of Self Regulatory Organization

13. (1) After commencement of these regulations, any application for registration or renewal of registration as an intermediary with the Board under the respective regulations applicable to such intermediaries, shall in case of any applicant who is a member of a Self Regulatory Organization or who ought to be a member of a Self Regulatory Organization, be made only through the Self Regulatory Organization of which he is a member, in the specified manner.

(2) The application under sub-regulation (1) shall be forwarded by the Self Regulatory Organization to the Board along with its recommendation for grant or refusal of certificate

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of registration not later than 30 days from the date of its receipt.

3. The Self Regulatory Organization shall also give the reasons for its recommendation either for granting certificate of recognition or for refusal of certificate of registration by the Board.

Functions and Obligations of Self Regulatory Organization

14. (1) A Self Regulatory Organization shall always abide by the directions of the Board.

(2) The Self Regulatory Organization shall be responsible for investor protection and education of investors or its members and shall ensure observance of Securities Laws by its members.

(3) The Self Regulatory Organization shall specify standard of conduct for its members and also shall be responsible for the implementation of the same by its members.

(4) The Self Regulatory Organization shall conduct inspection and audit of its members, on regular basis, through independent auditors.

(5) The Self Regulatory Organization shall submit its annual report to the Board.

(6) The Self Regulatory Organization shall treat all its members and the applications for membership in a fair and transparent manner.

(7) The Self Regulatory Organization may collect admission and membership fees from its members for carrying out the purposes of these regulations.

(8) The Self Regulatory Organization shall promptly inform the Board of violations of the provisions of the Act, the rules, the regulations, the directions, the circulars or the guidelines by any of its members.

(9) The Self Regulatory Organization shall conduct screening and certification tests for its members, agents and such other persons as it may determine.

(10) Self Regulatory Organization shall conduct training programmes for its members or agents and also conduct awareness programmes for securities market investors.

(11) The Self Regulatory Organization shall make endeavors for introduction of best business practices amongst its members.

(12) The Self Regulatory Organization shall act in utmost good faith and shall avoid conflict of interest in the conduct of its functions.

(13) The Self Regulatory Organization shall comply with the norms of corporate governance as applicable to listed companies.

(14) The Self Regulatory Organization may discharge such other functions and obligations as may be specified by the Board, from time to time.

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Governing norms of Self Regulatory Organization

15. (1) A Self Regulatory Organization may, subject to the previous approval of the Board, make governing norms and articles consistent with the provisions of the Act and these regulations.

(2) In particular, and without prejudice to the generality of the foregoing power, the governing norms or articles may provide for:-

(i) eligibility criteria for admission and removal of members from Self Regulatory Organization;

(ii) manner and the periodicity of furnishing information to the Board and to its members;

(iii) arbitration mechanism for resolving disputes between members and / or between members and their constituents;

(iv)procedure for proceeding against the member committing breach of the governing norms or articles including provisions for suspension or expulsion of members from the Self Regulatory Organization;

(v) internal control standards including procedure for inspection, auditing, reviewing, monitoring and surveillance of its members by Self Regulatory Organization;

(vi) code of conduct specifying standards for its members in the conduct of business;

(vii) procedure for conduct of election of the office bearers and members of the committees;

(viii) obligation of members to supply such information or explanation and to produce such documents relating to the business as Board of Directors may require;

(ix) manner of disciplinary action against its members by Self Regulatory Organization;

(x) contents and format of the annual report;

(xi) procedure for conduct of the meetings, quorum etc of Board of Directors;

(xii) manner of maintaining accounts or records of the Self Regulatory Organization; and,

(xiii) reporting requirements to the Board on monthly basis about various aspects of its functioning including policy initiatives, progress in certification, number of members admitted and disciplinary action taken against members, if any.

(3) The governing norms or articles shall also provide that the contravention of any of the governing norms shall render the member of Self Regulatory Organization concerned liable to one or more of the following punishments, namely:-

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(i) forfeiture of shares;

(ii) expulsion from membership;

(iii) suspension from membership for a specified period;

(iv) any other penalty of a like nature not involving the payment of money.

(4) Where the Board considers it expedient so to do, it may, by order in writing, direct a Self Regulatory Organization to make any governing norms or to amend or revoke any of them within such period as it may specify in this behalf.

(5) If a Self Regulatory Organization fails or neglects to comply with such order within the specified period, the Board may make, amend or revoke the governing norms either in the form specified in the order or with such modifications as the Board may think fit.

CHAPTER IV

Inspection and audit

Board’s right to inspect

16. (1) Where it appears to the Board so to do, it may appoint one or more persons as inspecting authority to undertake inspection of the books of accounts, other records and documents of the Self Regulatory Organization for any of the purposes specified in sub-regulation (2).

(2) The purposes referred to in sub-regulation (1) shall be as follows, namely: -

(a) to ensure that the provisions of the Act, the regulations, the directions and the circulars issued by the Board are being complied with;

(b) to inquire into the complaints received from members, investors, or any other person on any matter having a bearing on the activities of the Self Regulatory Organization; or,

(c) to inquire suo motu, in the interest of securities business or investors’ interest, into the affairs of the Self Regulatory Organization.

Procedure for inspection

17.(1) Before undertaking any inspection under regulation 16, the Board shall give a reasonable notice to the Self Regulatory Organization for that purpose.

(2) Notwithstanding anything contained in sub-regulation (1), where the Board is satisfied that in the interest of the investors or in public interest, no such notice should be given, it may by an order in writing, direct that the inspection of the

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affairs of the Self Regulatory Organization be taken up without such notice.

(3) On being empowered by the Board, the inspecting authority shall undertake the inspection and the Self Regulatory Organization against whom an inspection is being carried out shall be bound to discharge its obligations as provided under regulation 18.

Obligations of Self Regulatory Organization on inspection by the Board

18.(1) It shall be the duty of the Chairman, every Director, officer and employee of the Self Regulatory Organization, who is being inspected to produce to the inspecting authority or to any person authorized by him, such books, accounts and other documents in their custody or control and furnish to the Board the statements and information relating to the activities of Self Regulatory Organization in securities market within such time as the Board may require.

(2) The Self Regulatory Organization shall allow the inspecting authority or any person authorized by him to have reasonable access to the premises occupied by the Self Regulatory Organization or by any other person on its behalf and also extend reasonable facility for examining any books, records, documents and computer data in the possession of the Self Regulatory Organization or any other person and also provide copies of documents or other materials which, in the opinion of the inspecting authority are relevant.

(3) The inspecting authority in the course of inspection shall be entitled to examine or record statements of the Chairman, Director, any member and employee of the Self Regulatory Organization.

(4) It shall be the duty of the Chairman, every Director, officer and employee of the Self Regulatory Organization to give to the inspecting authority all assistance in connection with the inspection, which the Self Regulatory Organization may reasonably be expected to give.

Submission of report to the Board

19. The inspecting authority shall, as soon as possible, submit an inspection report to the Board.

Appointment of auditor

20. (1) Notwithstanding anything contained above, the Board may appoint a qualified auditor to inspect the books of account or the affairs of the Self Regulatory Organization.

Provided that the auditor so appointed shall have the same powers of the inspecting authority as mentioned in regulation 16 and the obligations of Self Regulatory Organization mentioned in regulation 18 shall be applicable to an inspection under this regulation.

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(2) The Board shall be entitled to recover the expenses of such audit or inspection as may be incurred by it, including fees paid to the auditors, from the concerned Self Regulatory Organization.

Power of the Board to call for periodical returns or direct inquiries to be made

21.(1) Every Self Regulatory Organization shall furnish to the Board such periodical returns relating to its affairs as may be specified.

(2) Every Self Regulatory Organization and every member thereof shall maintain and preserve for such periods such books of account and other documents as the Board after consultation with Board of Directors of Self Regulatory Organization concerned, may specify in the interests of the trade or in the public interest and such books of account and other documents shall be subject to inspection at all reasonable times by the Board.

(3) Without prejudice to the provisions contained in sub-regulation (1) and (2), if the Board is satisfied that it is in the interests of the trade or in the public interest so to do, it may, by order, in writing, -

(a) call upon Board of Directors of a Self Regulatory Organization or any member thereof to furnish in writing such information or explanation relating to the affairs of the Self Regulatory Organization or of the member in relation to the Self Regulatory Organization as the Board may require; or

(b) appoint one or more persons to make an inquiry in the prescribed manner in relation to the affairs of a Self Regulatory Organization or the affairs of any members of the Self Regulatory Organization in relation to the Self Regulatory Organization and submit a report of the result of such inquiry to the Board within such time as may be specified in the order or, in the case of inquiry in relation to the affairs of any of the members of a Self Regulatory Organization direct Board of Directors to make the inquiry and submit its report to the Board.

(4) Where an inquiry in relation to the affairs of a Self Regulatory Organization or the affairs of any of its members in relation to the Self Regulatory Organization has been undertaken under sub-regulation (3), -

(a) the Chairman, every director, manager, secretary, or other officer of the Self Regulatory Organization.

(b) every member of such Self Regulatory Organization.

(c) if the member of the Self Regulatory Organization is a firm, every partner, manager, secretary or other officer of the firm; and,

(d) every other person or body of persons who has had dealings in the course of business with any of the persons mentioned in clause (a), (b) or (c) whether directly or indirectly;

shall be bound to produce before the authority making the inquiry all such books of account, and other documents in his custody or power relating to or having a bearing on the subject matter of such inquiry and also furnish to the authority such

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statement or information as he may require within such time as may be specified by him.

Chapter V

Action in case of default

Obligation of Board of Directors to take disciplinary action against a member if so directed by the Board

22. (1) After receiving the report of an enquiry made under regulation 21, the Board may take such action as it deems proper and, in particular, may direct Board of Directors of the Self Regulatory Organization to take such disciplinary action against the delinquent member, including expulsion, suspension or any other penalty of a like nature not involving the levy of monetary penalty, as may be specified by it and thereupon, notwithstanding anything to the contrary contained in the articles or governing norms of the Self Regulatory Organization concerned, the Board of Directors of the Self Regulatory Organization shall give effect to the directions of the Board and shall not in any manner commute, revoke or modify the action taken in pursuance of such directions, without the prior written approval of the Board.

(2) The Board may either on its own motion or on representation of the member concerned, modify or withdraw any of its directions issued under sub-regulation (1), if it is satisfied that there are sufficient grounds for doing so.

Withdrawal of recognition

23. (1) If the Board is of the opinion that the recognition granted to a Self Regulatory Organization under the provisions of these Regulations should, in the interest of the trade or in the public interest, be withdrawn, it may serve a written notice in Form "C" on Board of Directors of the Self Regulatory Organization calling upon it to show cause as to why the recognition should not be withdrawn for the reasons stated in the notice.

(2) Where a notice is issued under sub-regulation (1), the Board may, after giving an opportunity to Board of Directors of the Self Regulatory Organization to be heard in the matter, withdraw, by passing an order, the recognition granted to the Self Regulatory Organization and thereupon sub-regulations (3), (4) and (5) of regulation 11 would apply as if the application of the Self Regulatory Organization for renewal of recognition has been rejected under regulation 10.

(3) The Board shall promptly communicate such order to the concerned Self Regulatory Organization.

(4) On receipt of the order passed under sub-regulation (2), the Self Regulatory Organization shall cease to carry on any activity as a Self Regulatory Organization and shall comply with such directions as may be issued by the Board under sub-regulation (2) read with sub-regulations (3), (4) or (5) of regulation 11, as the case may be.

Action in case of violation

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24. If any Self Regulatory Organization, any office bearer or member thereof violates any provisions of the Act or these regulations, it may be liable for –

(a) action under Chapter VIA of the Act;

(b) action under subsection (3) of section 12 of the Act;

(d) action under section 24 of the Act;

(e) such other action permissible under the Act which may be deemed appropriate in the facts and circumstances of the case.

FIRST SCHEDULE

FORMS

FORM A

(See Regulations 3 and 9)

Application for recognition / renewal of a Self Regulatory Organization under Regulation 3 of Securities and Exchange Board of India (Self Regulatory Organizations) Regulations 2003.

……………………

…………………..

Subject : Application for recognition / renewal of a Self Regulatory Organization under Regulation 3 of Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2003.

Sir,

1. I, being duly authorized for the purpose, hereby apply on behalf of …………. (name and address of the applicant) being a company eligible to be recognized as a Self Regulatory Organization as defined in Regulation 2(i) of Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2003 for recognition / renewal for the purpose of the said Regulations.

2. Four copies of the memorandum and articles of association of the Self Regulatory Organization and four copies of the governing norms are enclosed, alongwith the applicant’s Board resolution dated ______authorizing the undersigned to make this application on its behalf.

3. All the necessary information required in the Annexure to this Form is enclosed. Any additional information will be furnished as and when called for by the Securities and Exchange Board of India.

4. I on behalf the Self Regulatory Organization hereby undertake to comply with the

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requirements of Regulation 4 of the said Regulations and such other conditions and terms as may be contained in the certificate of recognition or be specified or imposed subsequently.

5. Demand Draft No …. dated ……..for Rs. ……… is attached.

Yours faithfully

Signature of authorized signatory

with name and designation

(On behalf of ______)

ANNEXURE TO FORM ‘A’

Part I – General

1. Name of the applicant. 2. Address. 3. Date of establishment.

Part II – Membership

1. State the number of members at the time of application. Also specify how many are inactive.

2. Do you insist on any minimum qualifications and experience before enrolling new members? If so give details.

3. Do you collect any admission / entrance fee from your member? If so, how much?

Part III – Board of Directors

1. What is the present strength of your Board of Directors? Give details of the constitution, powers of management, election and tenure of the office Board of Directors, and the manner in which its business is transacted.

2. How many SEBI’s representatives are there? Furnish their names.

3. Do you have any provision for the appointment of disciplinary committee, screening committee etc? If so, furnish the details of the method of their appointment, terms of office, powers and functions.

4. Give the designations, powers and duties of office-bearers of your organization. Are any of these office – bearers in the pay of the Self Regulatory Organization? If so, give details as to the mode of their appointment, tenure of office and remuneration.

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Part IV – Miscellaneous

1. Do you have any machinery for arbitration of disputes between members and / or between members and their constituents ? Give details.

2. Are you charging admission fees from your members ? If so, give details.

Form B1

Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2003

( See Regulation 5 )

Certificate of Recognition

1. In exercise of the powers conferred by regulation 5 of these regulations, the Board hereby grants a certificate of recognition No. ………… to M/s ______to act as a Self Regulatory Organization in accordance with these regulations and the conditions mentioned in the annexure.

2. Recognition Code for Self Regulatory Organization is ……………..

3. The certificate shall be valid from ………….. to ……………. and may be renewed as specified in Regulation 9 of Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2003.

Place : By order

Date : Sd/-

For and on behalf of

Securities and Exchange Board of India

Note: - Application for renewal of recognition shall be made so as to reach the Board not less than three months before the expiry of the period.

Form B2

Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2003

( See Regulation 9(4) )

Certificate of renewal of Recognition

1. In exercise of the powers conferred by sub-regulation (4) of regulation 9, the Board hereby renews the certificate of recognition No. ______dated ______, issued to M/s.______, to function as a Self Regulatory Organization, for a further period of ______years from ______.

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2. Recognition Code for Self Regulatory Organization is ……………..

Place : By order

Date : Sd/-

For and on behalf of

Securities and Exchange Board of India

Note: - Application for further renewal of recognition shall be made so as to reach the Board not less than three months before the expiry of the validity period of this certificate.

FORM C

(See Regulation 23)

Notice to show cause against the withdrawal of registration

THE SECURITIES AND EXCHANGE BOARD OF INDIA

Mumbai, the …..day of ….2003

To,

……………………………………………………

(name and address of the Self Regulatory Organization)

You are hereby called upon to show cause on or before …………………. at the office of ………………………. (designation of the officer) why the certificate of recognition No. …….. granted to you under Regulation 5 of Securities and Exchange Board of India (Self Regulatory Organizations) Regulations, 2003, should not be withdrawn for the reasons given below:

…………………………………………………….

Signature of the Officer

Designation

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SECOND SCHEDULE

PART ‘A’

Securities And Exchange Board Of India (Self Regulatory Organizations) Regulations, 2003

[ See Regulation 3 (4) and 9 (3) ]

FEES

PART A

AMOUNT TO BE PAID AS FEES

______(Rs.)

Application fee#9; 25, 000

Recognition fee for grant of certificate 5, 00, 000

Renewal fee 3, 00, 000

______

PART B

The fees specified above shall be paid by way of a demand draft in favour of ‘Securities and Exchange Board of India’ payable at Mumbai.

*****

G.N.BAJPAI

CHAIRMAN

[ADVT. III/IV/69ZB/2003/Exty.]

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Home Back

Draft SEBI (Investment Advisers) Regulations, 2007

SEBI has framed draft SEBI (Investment Advisers) Regulations, 2007 and the same are placed in public domain for comments and suggestions.

Comments on the draft Regulations annexed herewith may be sent on or before October 31, 2007 through email to [email protected] or to the address mentioned below:

Chief General Manager MIRSD – DPS III Securities and Exchange Board of India SEBI Bhavan, 2nd Floor, A- wing, Plot No: C – 4A, G Block, Bandra Kurla Complex, Mumbai 400 051.

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Draft SEBI (Investment Advisers) Regulations, 2007

THE GAZETTE OF INDIA

EXTRAORDINARY

PART – III – SECTION 4

PUBLISHED BY AUTHORITY

SECURITIES AND EXCHANGE BOARD OF INDIA

NOTIFICATION

Mumbai, the August, 2007

SECURITIES AND EXCHANGE BOARD OF INDIA

(INVESTMENT ADVISERS) REGULATIONS, 2007

F. No. . In exercise of the powers conferred by section 30, read with clause (b) of sub-section (2) of section 11 and sub-section (1) of section 12, of the Securities and Exchange Board of India Act, 1992 (15 of 1992) the Board hereby makes the following Regulations, namely: -

CHAPTER I

PRELIMINARY

Short title and 1. (1) These Regulations may be called the Securities and Exchange Board of commencement India (Investment Advisers) Regulations, 2007.

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They shall come into force on such date as may be specified by the Board by notification in the Official Gazette.

Definitions. 2. (1) In these Regulations, unless the context otherwise requires, -

(a) ‘Act’ means the Securities and Exchange Board of India Act, 1992 (15 of 1992);

(b) ‘Board’ means the Securities and Exchange Board of India established under section 3 of the Act;

(d) ‘self-regulatory organization’ means any self-regulatory organization which is recognised by the Board under regulation 5 of the Securities and Exchange Board of India (Self Regulatory Organisations) Regulations, 2004 or any statutory amendment or re-enactment thereof;

(2) Words and expressions not defined in these Regulations, but defined in or under the Act or the Securities Contracts (Regulation) Act, 1956 or the Companies Act, 1956, or any statutory modification or re-enactment thereof, shall have the same meaning as have been assigned to them by or under those enactments.

Investment adviser. 3. (1) For the purposes of these regulations, ‘investment adviser’ means any person who for consideration is engaged in the business of providing investment advice to others, either directly or through publications or writings or electronic mails, or who, for consideration and as part of regular business, issues or publishes reports or analyses containing investment advice and includes any person who holds himself out as an investment adviser (by whatever name called) to others.

(2) For the purposes of sub-regulation (1) and unless the context otherwise requires, other provisions of these regulations –

(a) ‘investment advice’ means advise as to value of securities, or as to the advisability of investing in, purchasing, selling or otherwise dealing in securities;

(b) ‘consideration’ means any form of economic benefit, and includes non-cash consideration in any form whatsoever, whether received or receivable directly or indirectly from any person;

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business of providing investment advice, if –

(i) the advice is solely incidental to some other business or profession and the advice is given only to clients of the person in the course of such other business or profession; and

(ii) the advice does not specify particular securities;

(3) Notwithstanding anything contained in sub-regulation (2), any advice given in writing or other legible form shall not be construed as ‘investment advice’ if the advice is contained in a newspaper, journal, magazine or other periodical publication and if the principal purpose of the publication, taken as a whole and including any advertisements or other promotional material contained therein is neither –

(a) that of providing ‘investment advice’ within the meaning of clause (a) of sub-regulation (2); nor

(b) that of soliciting, leading or enabling persons to buy, sell or otherwise deal in securities.

(4) Notwithstanding anything contained in sub-regulation (2), any advice given in any service consisting of radio broadcast or television transmission or a similar service in the internet or other electronic media shall not be construed as ‘investment advice’ if the principal purpose of the service, taken as a whole and including any advertisements or other promotional material contained therein is neither -

(a) that of providing ‘investment advice’ within the meaning of clause (a) of sub-regulation (2); nor

(b) that of soliciting, leading or enabling persons to buy, sell or otherwise deal in securities.

CHAPTER II

REGISTRATION OF INVESTMENT ADVISERS

Certificate of 4. (1) On and from the commencement of these regulations, no person shall act Registration. as an investment adviser or hold himself out as an investment adviser unless he has a certificate:

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Provided that a person acting as an investment adviser immediately before the commencement of these regulations may continue to do so for a period of six months from such commencement or, if he has made an application for a certificate under sub-regulation (3) within the said period of three months, till the disposal of such application.

(2) Notwithstanding anything contained in sub-regulation (1), a person who is holding a certificate granted by the Board under section 12 of the Act in any other capacity may provide investment advice to his clients in that capacity without obtaining a separate certificate under these regulations:

Provided that any person acting as an investment adviser under this sub- regulation shall comply with all other provisions of these regulations:

(3) No certificate shall be granted to any person under these regulations, unless he is a member of a self-regulatory organization.

(4) An application for grant of certificate shall be made in in such format as may be specified by the Board.

(5) The application shall be made to the self-regulatory organization of which the applicant is a member and forwarded by the self-regulatory organization to the Board with its recommendations in such format as may be specified by the Board.

(6) Where it is so decided, the Board shall grant a certificate to the applicant in such form as may be specified by the Board.

(7) Without prejudice to the powers of the Board to take any action under the Act or regulations made thereunder, the certificate shall be valid till the investment adviser continues to be a member of the self-regulatory organization on whose recommendation the certificate was granted.

Procedure where 5. (1) Where the Board is of the prima facie opinion that a certificate ought not to registration is refused. be granted to the applicant, it shall afford an opportunity of hearing to the applicant before taking a final decision.

(2) Where an application for a certificate is rejected by the Board, the order of rejection shall be communicated to the applicant as soon as may be.

(3) Where an application for a certificate is rejected by the Board, the applicant shall forthwith cease to act as an investment adviser:

Provided that nothing contained in this regulation shall affect the liability of the applicant towards its existing clients under law.

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CHAPTER III

GENERAL OBLIGATIONS AND RESPONSIBILITIES

General obligations of 6. (1) An investment adviser shall act in a fiduciary capacity towards its clients an investment adviser. and shall disclose all conflicts of interests as and when they arise or seem likely.

(2) An investment adviser shall not divulge to anybody, either orally or in writing, directly or indirectly, any confidential information about its clients, which has come to its knowledge, without taking prior permission of its clients except where such disclosures are required to be made in compliance with any law for the time being in force.

Disclosures to clients 7. (1) An investment adviser shall disclose to a prospective client all material information about itself, its business, its disciplinary history, the terms and conditions on which it offers advisory services, its affiliations with other intermediaries and such other information as is necessary him to take an informed decision on whether to avail its services.

(2) Before recommending a security, an investment adviser shall disclose all commissions and rewards, if any, that it will receive if the client chooses the recommended security.

(3) Before recommending the services of a stock broker or other intermediary to a client, an investment adviser shall disclose all commission and rewards, if any, that it will receive if the client chooses to avail the services of such intermediary.

Duty to comply with 8. An investment adviser shall comply with the bye-laws, rules and governing rules and bye-laws of norms of every self-regulatory organization of which it is a member. self regulatory organization.

CHAPTER IV

PROCEDURE FOR ACTION IN CASE OF DEFAULT

Liability for action in 9. (1) A investment adviser who - case of default. (a) contravenes any of the provisions of the Act, rules or regulations; or

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(b) contravenes any provision of the bye-laws of the self-regulatory organization of which it is a member -

may be dealt with in the manner provided under the Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer) Regulations, 2002.

(2) Sub-regulation (1) shall not prejudice the operation of sections 11, 11B, 11D or 24 or Chapter VIA of the Act or of any other law for the time being in force.

CHAPTER V

MISCELLANEOUS

Power of the Board to 9. In order to remove any difficulties in the application or interpretation of these issue clarifications. regulations, the Board may issue clarifications and guidelines in the form of circulars.

Delegation of powers 10. The powers exercisable by the Board under these regulations shall also be exercisable by any officer of the Board to whom such powers are delegated by the Board by means of an order made under section 19 of the Securities and Exchange Board of India Act, 1992 (15 of 1992).

Amendment of other 11. On and from the commencement of these regulations, the regulations regulations. mentioned in the Schedule shall stand amended to the extent mentioned therein.

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Schedule

Amendment to other Regulations

A. Amendment to the Securities and Exchange Board of India (Portfolio Managers) Regulations, 1993

1. In regulation 2, in clause (cb), the words “advises or” occurring after the words “contract or arrangement with a client” shall be omitted.

2. In regulation 16B, for sub-regulation (2), the following sub-regulation shall be substituted, namely:-

“(2) Nothing contained in this regulation shall apply to a portfolio manager who has total assets under management of value less than five hundred crore rupees.”

B. Amendment to the Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations, 2002

1. In regulation 4, after clause (s), the following clause shall be inserted, namely:-

“(t) the Securities and Exchange Board of India (Investment Advisers) Regulations, 2007.

[ADVT. III/IV/69ZB/2007/Exty.]

M. DAMODARAN

CHAIRMAN

SECURITIES AND EXCHANGE BOARD OF INDIA

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140 EXHIBIT VI

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142 Regulation of Investment Advisors

Cover Page

1 Interna AD Gandhi

2 Regulation of Investment Advisors

REGULATION OF INVESTMENT ADVISORS

TRANSPARENCY. TRANSFORMATION. EMPOWERMENT

Note:- The report “Regulation of Investment Advisors-Model for Establishment of Self Regulatory Organization (SRO) is based on secondary research carried out by FPSB India and is solely meant for internal circulation to its members and the stakeholders. The content in this publication are believed to be current as of this printing, but, overtime, legislative and regulatory changes, as well as new developments, may date this material.

3 4 Regulation of Investment Advisors Contents S No. Particulars Page No.

1 Background ------7

2 Executive Summary ------8

3 FPSB India: Certification Standards & Self Regulatory Organization ------10

4 Outline of our Approach ------12

5 Objectives and Outcomes ------13 • Objectives------13 • Extrinsic Stimuli: Transparency, Transformation and Empowerment ------13 • Does the process necessitate Structural Changes? ------14 • Global Standards ------14 • International Case Study ------15

6 Economic Context and Implications ------17 • Changing Financial Landscape ------18 • Market Trends in India ------18 • Financial Planning ------20 • Financial Planning in India ------20 • India in Investor Protection ------21 • India in Enforcing Contracts ------22

7 Developing Regulatory Framework: Key issues ------23 • Consumer Information related issues ------23 • Financial Intermediary Standards-Related Issues ------23 • Consumer Redressal Mechanisms, Sanctions & Enforcement issues ------23 • Better Information from the Intermediary ------24 • The Need for Industry Standards ------24 • Conflicts of Interests ------25 • Redressal, Sanctions and Enforcement------26 • Complaints/Disputes Resolution Mechanisms ------26

8 Regulating Financial Advisors: Key Elements ------27 • Distinction between Advice and Selling ------27 • Minimum Qualification for Advisors to be prescribed ------27 • Financial Advisors to be Certified and Regulated ------27 • Establishment of Regulatory Organization (RO) ------27

5 Contents S No. Particulars Page No.

9 Recommendations: Scope & Proposed Framework ------29 • Current Legal and Regulatory Framework – An Extract of the commentary by Amarchand and Mangaldas & Suresh A. Shroff & Co. ------29 • Financial Planning for wider scope of Regulations ------30 • Principles Based Regulations Vs Rules Based Regulations ------31 • Who should be registered as an Investment Advisor? ------32 • Establishment of a Third Party Administrator - (TPA) ------32 • Disclosure Obligations for Financial Intermediaries ------32 • The varying roles of a Financial Intermediary ------35 • Advertisement Code ------35 • Financial Advisory Roles and the Indian Market ------36 • Differentiation of “Advice” from “Selling” of Financial Products/Services ------37 • Specific Scope Issues ------38 • Self-Regulatory Model ------39 • Regulatory Framework Mapping, Proposed Policy Governance Model & Management Structures ------40 • Membership to the Self Regulatory Organization ------41 • Statutory Standards for Intermediaries ------41 • Disputes Resolution Body ------42 • Sanctions and Enforcement ------43 • Authorization Framework for Personal Financial Advisors ------44 • Establishment of the Ombudsman’s office ------45 • Rating for Organizations & Institutions ------46

10 Conclusion ------47

11 Annexures: ------• Annexure I: Democracy and the Evolution of Corporate Governance· ------48 • Annexure II: Regulation of Relationships – the Role of Self-Regulation in Building Trust·------66 • Annexure III: High Court Judgment: Hong Kong Special Administrative Region on Role of Investment Advisors ------75 • Annexure IV: Reforming Financial Regime Governance ------123 • Annexure V: Establishment of Rating Standards ------141

6 Regulation of Investment Advisors

BACKGROUNDBACKGROUND

Financial Planning Standards Board India (FPSB India) Charter Members was held, where in the need to establish has placed before itself two key items that it opines will Self Regulatory Organization for the Investment Advisors take the Financial Planning movement forward in the in India was reiterated and all were of the unanimous view country viz. establishment of path towards creating that FPSB India would be privileged to take the qualified Financial Advisors in the country and to seek opportunity to contribute, if given the prospect. suitable regulatory recognition for the Financial The said decision was made after due consideration Planning and Investment Advisory profession. and based on informed inputs from all the possible The endorsement from government & regulators like stakeholders within the community, keeping in view the RBI, SEBI, IRDA, & PFRDA for the Financial Planning fact that the proposed Self Regulatory Organization movement and Reforms in Financial Markets will propel would need to: the noble cause. The convergence of products & services a. Establish appropriate Governance Model and Best in the Financial Services industry is taking place at a fast Practices, pace. Banks are offering wealth management services, b. Resolve conflicts of interests issues within itself, Insurance companies are offering investment & c. Create maturity to establish suitable & scalable retirement products, Mutual Funds are offering outreach network within the country, commodity-linked products, and Equity Broking Houses d. Augment its membership base, have setup Financial Planning Divisions. The e. Be inclusive for all its stakeholders all across. convergence of regulations for financial intermediation Based on the above, we strongly believe that FPSB is imminent and has to happen. It’s just a matter of time. India’s constituents are well geared and positioned to Financial Planning is emerging as a profession and is participate in building up the proposed Self Regulatory getting its due respect from the consumers too. Financial Organization for the Investment Advisors in the country, Planners deal with almost all the financial products & especially keeping in view the guiding principles of Code services and are guided by a process rather than the of Ethics and Practice Standards that our Members product features. The current regulatory regime in India adhere to. The same has been institutionalized by virtue caters to the products & its sellers and not to the process of the establishment of Board of Professional Review as followers. This is where we see an inexcusable need for well. We appreciate that if given an opportunity, regulation of Financial Planners. The consumers need to Financial Planning Standards Board India’s constituents know what they can expect in terms of services & will have to play a dual role of a standard setting body professionalism, when they approach a Financial Planner. and a Self Regulatory Organization, and we would Taking forward the discussions on establishment of certainly be in a position to undertake the ownership of Self Regulatory Organization, a meeting of FPSBIndia’s these responsibilities.

7 EXECUTIVEEXECUTIVE SUMMARYSUMMARY

The decisions consumers make about their finances, Establishment of a Self Regulatory Organization investments and retirement are critical. It is important (SRO) may be reasoned as an application of Tocqueville’s that we have a regime where consumers can have access Hypothesis on prevalence of true democracy in sphere to, and deal with, financial intermediaries with of organized activity, which will eventually evolve into a confidence. That in turn can assist consumers in making healthy regime of financial markets. Kindly refer to the quality and informed decisions and encourage greater article in Annexure I. use of financial intermediaries where it is appropriate The roadmap presented has been developed through to do so. Through this proposal, we are trying to present a series of stakeholder consultations & literature review a roadmap towards this regime. This regime, as and hence presents an all inclusive and eclectic strategy envisaged, is meant to engender a normative and towards establishing this regime. It is notable that there regulated environment for those who provide financial has been a high degree of convergence in views from advice or who market and promote financial products within the industry, consumers and other interested & services to consumers. parties as to the issues which should be addressed and It is envisaged that the proposed SRO will conduct our substantive reform proposals relating to redressal the regulatory oversight of all the Investment Advisory & enforcement, enhanced disclosure and enhanced Firms, Brokers and Individual Financial Advisors. It will standards. In formulating our recommendations, we be responsible for rule writing, firm examination, have very much been of the view that:- enforcement & arbitration and mediation functions, • This is not an industry in crisis currently, [but may along with other activities. The creation of the proposed turn if suitable mechanisms are not put into place] but SRO will be the most significant modernization of the the issues identified do undermine the market’s ability Self Regulatory regime addressing the financial markets to function effectively, and the confidence of consumers in India. With investor protection and market integrity in that market. A proper addressing of those issues as its overarching objectives, the proposed SRO will be would, in our view, significantly contribute to a better an investor-focused and more streamlined regulator that functioning industry and better opportunities for is better suited to the complexity and competitiveness consumers and intermediaries; of today’s global capital markets. By eliminating • Any reforms should be workable, proportionate and overlapping regulations and establishing a uniform set cost effective; of rules placing oversight responsibility in a single • In particular, we believe the regulations to be organization, it is proposed that regulations will enhance effective, should be broad in its coverage, but not take a investor protection while increasing the competitiveness ‘one size fits all’ approach in its application; And of our financial markets. • The regulations should be one best suited to India,

8 Regulation of Investment Advisors having regard to both domestic and international • The proposed SRO shall be established based on considerations. In essence, Transparency, Principle Based Regulations [PBR] Transformation and Empowerment are the key • The proposed SRO shall have a professional staff elements of our recommendations. As noted above, from with the appropriate training and resources. our consultation process there was a high degree of • The proposed SRO shall ensure that market convergence from industry and the public, as well as participants and qualified independent directors have a other interested parties, on the need for change instantly meaningful role in its governance. and also broadly, what that change should entail. If the • The proposed SRO shall establish and maintain an Securities & Exchange Board of India (SEBI) and the effective consultation program in order to ensure that Government accept our recommendations, we believe market participants and, when appropriate, members of it important that they be advanced and implemented the public have input into the design and implementation expeditiously so as to build on the support and of regulatory policies. momentum for reform that is now clearly evident in the • The proposed SRO shall establish and maintain industry and the public. appropriate structures, policies and procedures to ensure that potential conflicts of interest between its FPSB India believes that a workable Self Regulatory regulatory and commercial and/or advocacy activities Organizations should be dedicated to the public interest are appropriately managed. objectives of enhancing market integrity, investor The above said points have been attempted to be protection and market efficiency and accordingly shall incorporated in the proposal. incorporate the following salient points [with inputs from International Organization of Securities Commissions (IOSCO) guidelines]:- • The proposed SRO shall be a private non- governmental organization that should be dedicated to the public interest and shall establish rules and regulations that effectively promote market integrity, market efficiency and enhance investor protection. It should eventually lead to regulations which will help Investment Advisors in building trust among their clientele. Kindly refer Annexure II. • The proposed SRO shall monitor and enforce compliance with its rules and regulations and, where applicable, with other relevant governing regulations. • The proposed SRO should have statutory regulatory authority and/or regulatory authority that are delegated to it by the government regulator(s). [SEBI in this case.] • The relevant government regulator(s) should effectively supervise the proposed SRO. [SEBI in this case.] • The proposed SRO shall have a stable and an adequate funding base for its regulatory activities while also maintaining financial accountability and transparency.

9 FPSBFPSB INDIA:INDIA: CERTIFICATIONCERTIFICATION STANDARDSSTANDARDS && SELF-REGULATORYSELF-REGULATORY ORGANIZATIONORGANIZATION (SRO)(SRO)

Financial Planning Standards Board India (FPSB India) pursue their full time studies (if any) and working is a Public – Private Enterprise and a Professional executives to remain in employment or professionalize Standards Setting body that proactively guides the practice throughout the duration of study (through development and promotion of standards for Financial distance learning & online programs). Planning professionals to benefit and protect the public in the country. FPSB India closely works with all the ii. Examination: The CFPCM Certification stakeholder’s viz. the Government, the Regulators, the Examinations are conducted six times a year. The Industries/Associations, the Corporate, the Media and examinations are designed to assess the candidate’s the General Public to achieve its objectives. ability to apply the following Financial Planning It is a Professional Membership & Certification knowledge to real life situations. The examinations are organization-part of leading Global Confederation conducted for the following disciplines:- established by prominent financial service corporations • Introduction to Financial Planning with an objective to professionalize the concept of • Risk Management & Insurance Planning Financial Planning in India. FPSB India by the virtue of • Retirement Planning & Employee Benefits its 4 ‘E’s i.e. Education, Examination, Experience and • Investment Planning Ethics requirement for its Certification requirement fits • Tax & Estate Planning into the criteria as mentioned and is elucidated in detail • Advanced Financial Planning below:- i. Education: The initial education requirement is iii. Experience: Candidates must demonstrate three met by registering for the CFPCM Certification or the AFP years of relevant work experience in the Financial Certification Program. An individual can register in one Services Industry. The experience requirement centers of the two ways: Completion of FPSB India’s Authorized on work that involve personal Financial Planning. It is Education Program or through the Challenge Status to provide the public with the assurance that the Program. For meeting with the education requirements candidate understands the counseling nature of personal FPSB India has appointed 17 educational institutions Financial Planning. providing a curriculum that meets FPSB India’s education standards. The education methodology iv. Ethics: This is established by FPSB India’s Code of prescribed by FPSB India encourages independent Ethics and Rules of Professional Conduct. Code of Ethics thinking and provide a pathway for members to develop and Rules of Professional Conduct goes into the detail the necessary skills and knowledge to become successful how a Financial Planner is expected to interact with the Financial Planners. The program allows students to Financial Consumer as well as dwells into issues like

10 Regulation of Investment Advisors disclosures and written documentation of advice. v. Continuing Education (CE): Once Certified, CFPCM Certification must fulfill a continuing education requirement to stay current on planning strategies and financial trends affecting their clients. CE plays a vital role in the CFPCM Certificants pursuit of outgoing professional competence. FPSB India understands that the current governance structure of FPSB India may not be appropriate for the Regulators / Government of India to mandate FPSB India as Self Regulatory Organization. FPSB India intends to build an independent legal structure which will be best suited to the current regulatory architecture of India and will be incorporating the best global practices. FPSB India is of the view that the Establishment of the Self Regulatory Organization for the Investment Advisors will augment the market’s ability to function effectively, and will increase the confidence of consumers in that market. It would not only help in proper addressing of the issues in the interest of the investors thus giving them confidence in the markets but would also significantly contribute to a better functioning industry, and better opportunities for consumers and intermediaries. FPSB India believes the process of change & regulations should be advanced and implemented expeditiously, so as to build on the support and momentum for the reforms, which are now clearly evident in the industry and the public.

11 OUTLINEOUTLINE OFOF OUROUR APPROACHAPPROACH

The approach taken by FPSB India for developing a • Ensuring regulatory compliance. structure is:- • Ensuring a manageable regulatory burden. • Broad Understanding of the Indian Financial Sector • Examining how practical Principles Based and the Regulatory Framework incorporating the Regulation is versus Rules Based Regulation. changes which have happened in the last 10 years of • Setting up an infrastructure that checks and updates reforms keeping in mind the following:- members. Changing role of Banks. • Develop a rating system that periodically checks and Opening up of the product manufacturing sector. records member’s activities. Technology enhancements. Reducing the asymmetric information gap for the consumers. Policies that allow for competition and prevent cartelization. Reducing the asymmetric information gap for the consumer. Delivering consumer protection. Evaluating cost of regulation. Harmonizing rules across products. Transparency in drafting rules and regulations to get and accommodate industry views. • Credibility of the SRO – the most important objective. Structure. Separate from FPSB India.

Legally independent.

Board members (or as regulators desire/ mandate). Term. Financially independent. • SRO’s Development Role. • Managing conflicts of interests. • Maintenance of standards.

12 Regulation of Investment Advisors

OBJECTIVESOBJECTIVES ANDAND OUTCOMESOUTCOMES

Objectives behaviour; This proposal attempts to submit a roadmap on • Through the above, contributing to enhanced regulation of financial intermediaries, and suggest confidence both by domestic and external investors, in options for reform that will: India’s financial markets generally; And • Enhance the quality of financial information and • Having a regulatory regime, which is cost-effective advice provided to the public; And in achieving the above outcomes. • Assist the consumers to make the most of their savings & investments through Empowerment, Extrinsic Stimuli: Transparency, Education & Protection. Transformation and Empowerment The prevailing visage of financial intermediary industry The objectives entail identification of the following has the ability to catalyze the process towards creating a specific review outcomes: dynamic self regulated environment. In line with this, • Providing both the consumers and the financial the following points try to identify the stimulating intermediaries with reasonable grounds for participating factors within the present financial intermediary with confidence in the financial intermediary sector; industry which can effectively contribute towards • Encouraging consumers to increase their use of implementation of this process:- appropriately qualified financial intermediaries, • The presence of a substantial number of financial wherever it is suitable and cost-effective to do so; intermediaries with, by international standards, have • An appropriate baseline level of financial relatively loose ties to particular product generators; intermediary competency and ethical standards; • The reasonably broad geographical spread of • Effective disclosure of consumer relevant practices in India; information about the financial intermediary, in addition • A gradual shift away from product based “sales” to information about the financial products and product advice towards a consumer-focused “needs-based” advice; generators that the intermediary advises on or promotes; • The combined effect of the above providing rural and • Enhancing the general baseline financial literacy of urban India with choice about the type of services they the Indian public including the ability to raise questions wish to access; and about the appropriateness of information or advice • An overall emphasis on regulation and compliance provided by financial intermediaries and product procedures not becoming ends in themselves. Rather generators; they should be measured against their contribution to • Providing effective mechanisms for addressing poor an effective intermediary market, particularly, better quality information or advice and unethical or fraudulent consumer servicing and quality of outcome for

13 consumers. It is important that compliance costs are (actual and prospective) the role they undertake and the appropriate to their benefits. These features can limitations associated with that role. A further significant positively contribute to choice, innovation and and immediate outcome will be the obligation for all competition, all of which have benefits for consumers intermediaries to be part of enforcement regime with and which we consider any reform should facilitate. statutory backing and for those operating as personal Financial Advisors or as product marketers to have Does the process necessitate Structural Change? additional disclosure obligations. These measures are Findings of the stakeholder consultation process indicate not directed to any particular sector of the industry, but a consensus on the value attached to regulation though we do see changes generally resulting from them, it emanated two diverse schools of thought on the through higher standards and increased confidence. possible implications on the structure of industry. It is spelled out clearly that regulation has the potential of Global Standards engineering structural change in the financial The International Organization of Securities intermediary industry. The following two views were Commissions’ (IOSCO) Objectives and Principles of generated through the process: Securities Regulation set international standards for the a. At present the industry comprises of too many small regulation of securities, including for “market players existing on too narrow margins without the intermediaries”. For market intermediaries, the IOSCO ability to invest in quality training, advice and focus is on areas where capital, client money, and public compliance. This nature of industry will entail that the confidence in the market may most be put at risk. costs imposed by regulation forces rationalization by Investment Advisors are included within this definition, reducing the number of narrow margin operators, but importantly for those advisors who offer only leaving the field open for financial intermediaries who advisory services (as opposed to dealing in securities on are more able to invest in quality outcomes. behalf of clients, holding client assets or managing b. The regulation regime will reduce consumer choice portfolios) the requirements are less stringent. In and possibly geographical coverage, with little evidence relation to market intermediaries, the report that quality outcomes were any more likely to be recommended more comprehensive regulatory oversight achieved by larger players as opposed to small practices, of market intermediaries, through either a licensing as it has happened in Australia. Australia is an example regime, or, as a less costly option, the imposition of of rationalization in favor of large dealer groups, with a standards, with monitoring by the regulator. subsequent decline of small quasi-independent practices FPSB India has undertaken a review of financial and no significant discernable uplift in the overall quality intermediary regulation in comparable jurisdictions. We of advice. have looked at regulations in Australia, Canada, Hong This proposal tries to draw synergy from both the Kong, Singapore, South Africa, New Zealand and the view points. FPSB India is not seeking change in the United Kingdom. We have also considered some aspects structure or composition of the industry as an aim in of the US regulatory environment. Some of these itself. However, we are proposing better consumer jurisdictions have previously been used as a reference information and the establishment of baseline standards, point for commercial law reform, having similar legal enhanced redress mechanisms, enforcement and traditions and/or commercial regulatory traditions. A sanctions. Conversely, those intermediaries who will not number of these markets are also a source of wish to meet the higher standards associated with the international investment into India. As such, they personal Financial Adviser role will have to adjust their provide a basis for assessing international norms, trends practices so that they do not provide advice of that and expectations in relation to financial intermediary nature, and just as importantly, disclose to their clients regulation. The key conclusions from the international

14 Regulation of Investment Advisors review are:- further assets to provide such security, Ms. Field was • There is a consistent theme of greater regulation of eventually forced to encash certain assets to pay the financial intermediaries; required sums due under the loan, and practically lost • The norm is state regulation of financial her entire investment. intermediaries, but this is commonly coupled with The Court of First Instance: At first instance, in a recognition of self-regulatory initiatives; 92 page landmark judgment, Deputy High Court judge • Financial intermediaries are commonly required to Aarif Barma, SC, awarded Ms. Field damages for Barber meet:- Asia’s negligence a sum of £219,890.25 plus interest

- Entry standards, which consistently include and costs. It is now the case that in the modern era of requirements as to competence; And sophisticated and complex investment schemes, the

- Ongoing obligations, usually including reporting burden is upon investment advisors to ensure that and professional development requirements; products introduced by them heed to the real intention of which are generally applied by way of a licensing the investor. A mere general introduction of the products regime; And is no longer enough to discharge their duty of care. • Financial intermediary obligations are commonly Duty of Care for Investment Advisors: The court enforced by a state regulatory body, sometimes coupled found that an investment advisor owes a duty of care in with dispute resolution by self-regulatory bodies. tort to their client, the investor. It confirmed that where an investment advisor:- International Case Study “Assumes the responsibility of providing advice to In July 2004, the Hong Kong Court of Appeal dismissed a plaintiff (Ms. Field), and knows or ought to know that an appeal by Barber Asia Limited, an SFC-licensed the Plaintiff is likely to reply on that advice, a duty of professional investment advisor, to try to overturn an care is likely to arise. Pertinent factors to take into earlier Judgment where Barber Asia were found to have account will also include the relative skill and been negligent when advising an investor, Ms. Field. knowledge of the parties, the context in which the advice Introduction: The case of Field V Barber Asia Limited is given, whether the giver of the advice is doing so (HCA7119/2000) has a far - reaching impact on the completely gratuitously or is getting a reward, whether commercial relationship between investment advisors in some direct or indirect form, and whether or not there and investors. In this case, where Tanner De Witt acted are any express disclaimers of responsibility (which for the successful Plaintiff, the Hong Kong courts would negate any assumption of responsibility by the concluded and clarified a Financial Advisor’s duty of defendant).” care to investors. It was previously thought that so long as “There can be doubt that Barber Asia, as professional Financial Advisors complied with the regulatory rules that investment advisors, were in possession of special skills govern them, they would not be liable for losses an investor and knowledge which Ms. Field, a wholly inexperienced suffers in a fluctuating market. This is not the case. investor, did not have.” Background: Susan Field, an inexperienced investor, “It seems to me…that Mr. Barber and Barber Asia used the services of Barber Asia to advise and assist her considered themselves to be Financial Advisors to Ms. to set up a “conservative” investment portfolio. This was Field.” done initially with a Sterling dominated portfolio, “Barber Asia did fall short of the standard of care to however a few months later Barber Asia recommended be expected of them in a number of significant respects.” that she “gear up” her existing portfolio with a Japanese Barber Asia breached its duty of care, as it had failed Yen Loan. However, in the months that followed the Yen to warn Ms. Field of the particular risks involved in appreciated against the Sterling, and Ms. Field was gearing, which were seen to be contrary to Ms. Field’s required to provide added security for the loan. Without “conservative” investment strategy. The obligation to

15 warn of such risk is reasonably expected from a prudent investment adviser. It is not sufficient for investment adviser to merely bring such risk to the attention of the investor. This is so even when Barber Asia had complied with all the regulatory rules and Ms. Field signed all the application forms, explanatory document, declaration and risk disclosure statements. The court noted “…it seems to me unlikely that a detailed explanation of the various risks involved was provided…” The Appeal: Despite the findings of the Judge at first instance, Barber Asia proceeded to appeal the judgment and the hearing of the appeal took place. The court of Appeal unanimously dismissed Barber Asia’s appeal with costs. For detail Court Judgment, kindly refer to Annexure III.

16 Regulation of Investment Advisors

ECONOMICECONOMIC CONTEXTCONTEXT ANDAND IMPLICATIONSIMPLICATIONS

Financial reforms were central to India’s economic financial sector has seen major changes over the past liberalization program initiated in the early 1990s. After decade. The frontiers between banking, securities and more than a decade of reforms since 1991, India’s insurance sectors have become ever less clearly defined financial sector – including markets, institutions and as banks have begun to move towards universal banking products– have changed, in some respects, beyond structures and with recent reforms allowing banks to be recognition. Capital markets are deeper, more liquid and involved in the insurance and securities business. much more open. While the banking sector continues to Moreover, competitive pressures have resulted in a dominate the financial system and remains growing number of mergers, resulting in the emergence overwhelmingly Government-owned, competition has of financial conglomerates. increased. Private entry has also been progressively These changes affect the way financial services are allowed into mutual funds and insurance. A recent delivered. They have important implications for the development that is likely to stimulate the development players who deliver finance as also for the regulators who of pension managers, is the decision of the Government oversee the sector. As financial institutions become of India in 2003 to change the basis of pensions for new larger and more complex, and as they begin to operate civil service employees from an “un-funded pay as you across multiple national jurisdictions, risks become more go defined benefit system” to a “fully funded defined difficult to monitor and the challenge of financial contribution system”. These reforms have led to financial regulation – to achieve the dual objective of systemic integration at two levels. At one level, the trends towards efficiency and stability — becomes ever more daunting. universal banking and mergers between financial The three main challenges facing India’s financial institutions have led to integration between different regulations are:- segments of the domestic financial system. Traditional i. The challenge of streamlining regulatory frontiers between Banking, Capital Markets and oversight: Under the current financial regulatory Insurance have become less distinct. At another level, structure, multiple regulators, who do not always India’s financial system has become much more coordinate their activities, often supervise a single integrated with the global financial system. But financial institution properly. This can lead to regulatory important weaknesses remain, and need to be addressed. overlaps, the diffusion of regulatory power, and the lack Stock market scams, the UTI story and problems with of proper accountability, all of which can weaken cooperative banks, underline the importance of supervision and increase risks. enhancing supervision and governance. Moreover, as the ii. The challenge of addressing under- financial sector becomes more open, the challenge facing regulation: While some financial institutions suffer India’s regulators will become even greater. India’s from over-regulation by multiple regulators, others

17 appear to remain under-regulated. • Catering to the complex demands of consumers and iii. New regulatory challenges arising from the growth of financial volatility and risk in a globalized financial sector innovation and liberalization: financial market. Traditionally, the institutional arrangements for The focus of these objectives is at enhancing financial regulation in India have been function-based. international competitiveness & efficiency of market In this context, the emergence of financial conglomerates institutions, in which the ability of the financial poses a new and complex challenge for regulators. institutions and financial providers in ensuring high In the absence of consolidated supervision of standards of market conduct & integrity and access to conglomerates, opportunities may arise for regulatory their services, systems & products at comparable cost arbitrage, among other things, with serious implications and efficiency with international markets & standards for financial sector’s efficiency and stability. must be maintained, in view of market institutions worldwide facing greater global competition. Indian Changing Financial Landscape market intermediaries will need to be able to respond The financial services industry in India is facing an era effectively to the impact of changing consumer demands, of rapid changes in view of the globalization of financial technological developments, pressure of greater markets worldwide. In the face of anticipated challenges disintermediation and the increasing integration of of such globalization, the Indian financial sector is financial services. The Indian market intermediaries currently undergoing a lot of changes to remain resilient must also be able to offer a wide range of financial and competitive in the industry. products and services, in order to respond effectively to The objective is to evolve a competitive, resilient and increasing business opportunities both domestically and dynamic financial system, catering to the increasingly internationally. It must also be consistently and sophisticated demands of consumers and businesses, prudently managed, not only to withstand the vagaries and adapting to the rapid technological changes in the of volatile markets and changing competitive dynamics financial services markets through: - but also to effectively position themselves for future • A more diversified and internationally competitive growth and greater competition. There must always be financial market meeting the requirements of a a continued effort to ensure that market intermediation diversified economic structure and the demands of a services are anchored on appropriate prudent standards, globalized market; accompanied by high levels of business conduct and • Emergence of specialist providers of specialized professional skills through amongst others, partnership products and specifically tailored services; efforts with governmental agencies, relevant professional • Formulation of common rules and regulations, bodies and academia in key areas of training and strategic business focus and employment of prudent professional development. principles towards strengthening and development of financial institutions and efficiency of financial providers; Market Trends in India • Harmonization amongst the regulators to keep According to SEBI- NCAER survey “82% of urban abreast with the convergence (blurring of boundaries) households and 97% of the rural households have not between the financial service providers supported by a invested directly in Equity Shares and Debentures. The strong and facilitative regulatory framework; lack of awareness of about the Securities Market and • Enhancement of professionalism in the financial absence of a dependable infrastructure and distribution services industry in line with international best practices; network which could have facilitated the household’s • Ensuring quality financial advices rendered to access to the market coupled with their aversion to risk, clients through qualified and professional financial appears to have often inhibited the non- Investor service providers; And households from investing into the Securities Market.

18 Regulation of Investment Advisors

closely, from 1996 to 2000, when HNWI wealth Diagram 1 grew at an annual rate of 12.9%, and from 2003 to 2005, when it advanced by 8.1% annually, the world economy also experienced robust expansion. By contrast, the global recessionary pressures of mid-2000 to 2002 stalled HNWI’s wealth creation during that period (-0.6% annual growth). The BRIC nations of Brazil, Russia, India and China remained strong economic players in the competitive global arena, with three of the four represented in the top 10 fastest-growing HNWI Approximately 43% of the Investors do not invest in the populations in 2005. As we have noted in the past, Stock Market because of Lack of Confidence in the Goldman Sachs projects that the BRIC nations will Brokers or Lack of Awareness about the Market”. Apart leapfrog the G7 nations by 2040, in terms of total output. from the above, the following reasons would also Their most recent reports indicate that not only does this contribute to the need for Financial Planning growth potential still exist but also that the BRIC nations Regulations:- grew faster than expected from 2003 to 2005. Morgan a) Growing Income Levels and Affluence: This is Stanley’s Emerging Market Index is up 171% since the highlighted by a few revealing statistics. According to end of 2002, while its BRIC index has surged 262%. As Cap Gemini Merrill Lynch World Wealth Report 2006, a result, HNWI’s have not been disappointed. China, the no. of HNWI’s in India has risen from 70,000 to whose economy continued to grow at breakneck speed 83,000 in the year 2005 with a growth rate of 19.3 % in 2005, enjoyed real GDP gains of 9.9%. India was not (Kindly refer Diagram 1). According to McKinsey, far behind, with 8.0% real GDP growth. HNWI numbers nearly a million households in India will have assets of grew by 6.8% in China in 2005, while India posted a US$ 100,000 or more by 2010. surging 19.3% run-up. India’s growth is hardly surprising A brief look back at key findings of our earlier reports given current analyst projections. Also, according to the shows how far HNWI wealth, the global economy and most recent Goldman Sachs projections, India has the

HNWI Ranks Show 10 Years of steady Expansion Table 1 HNWI Global 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 CAGR 96-05 Financial Wealth 16.6 19.1 21.6 25.5 27 26.2 26.7 28.5 30.7 33.3 8.0% US $ Trillion Number of HNWI’s 4.5 5.2 5.9 7.0 7.2 7.1 7.3 7.7 8.2 8.7 7.6% (M) Source: Capgemini Lorenz curve analysis, 2006 the wealth management industry have advanced during potential to become the fourth largest economy by 2025 the past decade and how significant an effect global and the third largest by 2050, behind only the United economic forces have on them: Overall, from 1996 to States and China; 2005, HNWI wealth grew at an annual rate of 8.0%, b) Steady decline in personal income tax rates over the expanding from US$16.6 trillion in 1996 to US$33.3 last 10 years; trillion in 2005 (Kindly refer Table 1). Looking more c) Fluctuation in interest rate leading to active reshuffle

19 of financial assets to maintain the income balance; savings, investments and anticipated retirement or other d) Both wealth generation and wealth protection are (employee’s) benefits of an individual in order to provide becoming important; impartial assistance in analyzing and organizing that e) Portfolio management approach adopted by big individual’s personal financial affairs to achieve his banks abroad and in India is giving way to personal financial goals and objectives. Financial Planning counseling model; provides direction and meaning to financial decisions, f) Growing willingness of middle class to seek financial allowing the client to understand the manner and the advice from others and let others handle personal extent in which each of his financial decisions would finances; affect his financial state of affairs as a whole. g) Increasing complexity of financial products and their risk profile. The existing players in the market can be Financial Planning in India divided into three broad groups:- In these increasingly exuberant times, in a profession Banks and established Financial Institutions (FIs) where the term “Planning” stands out as its raison d’être, targeting high net worth individuals; the Financial Planning profession itself needs to be well Product advisors (MF distributors, insurance prepared to ride the peaks and troughs of the economic advisors etc.) tapping the retail end of the market; cycle, as investor’s confidence is tested, as it has been, Independent Financial Planners (emerging) time and time again by adverse economic events. For focusing on broad spectrum of clients. instance, the experience in Australia demonstrates the In absence of any value add services the Product importance of the orderly development of the Financial Advisors can offer, they are depending on rebates to lure Planning industry. Australian regulators were concerned customers. Banks and Financial Institutions attract with undesirable practices amongst Financial Planners customers based on their geographic spread and their in reaping hefty remuneration and fees regardless of the knowledge base. The success of Independent Financial effectiveness of the financial plan drawn for their clients. Planners would be essentially a function of Personal A survey of standards in Australia reveal that Financial Approach, Competency and Adoption to High Degree of Planner’s fees are often prioritized above client’s risk Ethics & Integrity. profiles, resulting in a deviation from the primary objective of ensuring that the client’s financial and life Financial Planning goals are met. Financial Planning is the process of meeting an The message here is that the mode of packaging individual’s life goals through the proper management financial advice in a “thinly disguised product selling” of his finances. Life goals can include buying a home, manner should be prohibited, if the integrity of the saving for a child’s education or planning for retirement. industry is to be preserved.

SCOPE OF FINANCIAL PLANNING / ADVISORY SERVICES Diagram 2

Investment Insurance Retirement Tax Estate Advisory Services Advisory Services Advisory Services Advisory Services Advisory Services

Financial Planning is a process that entails the The Financial Planning industry in India is still preparation of a financial program for a client based on considered to be in its nascent stage. In some form or the client’s financial position and intended objectives. another, Financial Planning is being practiced in India The process encompasses establishing the present and but each segment of the financial services industry in anticipated assets and liabilities, including insurance, India operates and functions separately and distinctly

20 Regulation of Investment Advisors from each other with its own regulatory bodies and independently of other financial decisions or vehicles of distribution of its services to the public commitments of the client and may not be consistent (see Diagram 2). with the client’s overall financial plans or in line towards With such financial service structure, an individual achieving the client’s true and ultimate financial goals intending to formulate his own financial plan would or objectives. have to engage the services of agents in each of the Although these recommendations are a form of respective financial services industry. For instance, an Financial Planning tailored to meet the client’s need at individual would require the services, advice or that particular moment in time and in that particular assistance of an insurance agent for insurance products aspect of the financial service but collectively these and likewise an agent or a stockbroker for investment recommendations do not form the true essence of the purposes. Financial Planning process in achieving the ultimate These agents may possess the knowledge and the financial objectives and goals of the client. understanding of the products in their respective industries but may not possess the knowledge or the India in Investor Protection understanding of the mechanics of each and every This topic measures the strength of minority shareholder financial services or products available in the market. protections against misuse of corporate assets by An insurance agent or a stockbroker may recommend directors for their personal gain. The Table 2 shows or structure their products for a client but these the main indicators. They include:- recommendations are not reflective of the client’s true • Transparency of transactions (Extent of Disclosure financial goals and objectives as a whole. These Index) ; recommendations are made separately and • Liability for self-dealing (Extent of Director Liability

Table 2 Region or Economy Disclosure Director Shareholder Investor Index Liability Index Suits Index Protection Index East Asia & Pacific 5.2 4.4 6.1 5.2 Europe & Central Asia 4.7 3.8 6 4.8 Latin America & Caribbean 4.3 5.1 5.8 5.1 Middle East & North Africa 5.8 4.6 3.5 4.6 OECD 6.3 5 6.6 6 South Asia 4.4 4.3 6.4 5 Sub-Saharan Africa 4.4 4.5 5.2 4.7 Country Australia 8 2 7 5.7 Brazil 5 7 4 5.3 Canada 8 9 8 8.3 China 10 1 4 5 Germany 5 5 5 5 Hong Kong, China 10 8 9 9 India 7 4 7 6 Indonesia 8 5 3 5.3 Japan 7 6 8 7 Korea 7 2 7 5.3 Malaysia 10 9 7 8.7 Netherlands 4 4 6 4.7 New Zealand 10 9 10 9.7 Singapore 10 9 9 9.3 South Africa 8 8 8 8 United Kingdom 10 7 7 8 United States 7 9 9 8.3

Source: http://www.doingbusiness.org/ExploreTopics/ProtectingInvestors/

21 Index) ; main indicators for enforcing contracts. They are:- • Shareholders ability to sue officers and directors for • Number of procedures from the moment the plaintiff misconduct (Ease of Shareholder Suit Index) ; files a lawsuit in court until the moment of payment; • Strength of Investor Protection Index (the average • Time in calendar days to resolve the dispute; And of the three index). • Cost in court fees and attorney fees, where the use It can be observed that India’s Investor of attorneys is mandatory or common, expressed as a Protection Index which is a combination of the percentage of the debt value. Disclosure Index, Director Liability Index and It can be observed that India’s position in the Shareholder Suits Index is above average when number of procedures from the moment the compared with that of South Asia but still lags plaintiff files a lawsuit in court until the behind other South Asian countries like moment of payment received and the number Singapore, Malaysia and Hong Kong etc. (see of days spent on a dispute to get resolved, is in Table 2) a very dismal state. Also the cost in court fees and attorney fees, where the use of attorneys is India in Enforcing Contracts mandatory or common, expressed as a This topic looks at the efficiency of contract enforcement percentage of the debt value is very high. by following the evolution of a sale of goods dispute and tracking the time, cost, and number of procedures Table 3 Region or Economy Procedures Time Cost (number) (days) (% of debt) East Asia & Pacific 31.5 477.3 52.7 Europe & Central Asia 31.5 408.8 15 Latin America & Caribbean 39.3 641.9 23.4 Middle East & North Africa 41.6 606.1 17.7 OECD 22.2 351.2 11.2 South Asia 38.7 968.9 26.4 Sub-Saharan Africa 38.1 581.1 42.2 Country Australia 19 181 12.8 Brazil 42 616 15.5 Canada 17 346 12 China 31 292 26.8 Germany 30 394 10.5 Hong Kong, China 16 211 14.2 India 56 1420 35.7 Indonesia 34 570 126.5 Japan 20 242 9.5 Korea 29 230 5.5 Malaysia 31 450 21.3 Netherlands 22 408 15.9 New Zealand 28 109 10.9 Singapore 29 120 14.6 South Africa 26 600 11.5 United Kingdom 19 229 16.8 United States 17 300 7.7 Source: http://www.doingbusiness.org/ExploreTopics/DealingLicenses/#ctl00_top

involved from the moment the plaintiff files the lawsuit until actual payment. The Table 3 shows the three

22 Regulation of Investment Advisors

DEVELOPINGDEVELOPING REGULATORYREGULATORY FRAMEWORKFRAMEWORK :: KEYKEY ISSUESISSUES

Currently in India, there are no laws or statutes, which Around actual and relative cost structures and govern the Financial Planning Industry per se. Financial performance of product manufacturers and Planning is a process that encompasses an array of associated financial intermediaries, and the financial products and services such as Insurance, Stocks, impact of charges and remuneration on actual Unit Trusts, Asset Management, Accounting Services, returns to consumers; Estate Planning services and so forth and where each of Around the actual and relative cost structures and this industry is governed by their own specific regulator performance of product manufacturers and established by respective legislations. Although the associated financial service providers (such as Financial Planning industry in India is relatively new, costs associated with custodian / administration India should seriously consider adopting similar approach services/commission) and the impact of those and direction as given in the countries mentioned. It costs on returns to the consumer. would be the ideal situation to ultimately have a single legislation / regulation and authority regulating and Financial Intermediary Standards-Related governing our Financial Planning Industry, and this could Issues:- be achieved gradually over a period of time. However, in • Lack of distinction between advice and selling; the interim, certain steps and measures ought to be taken • Lack of regulations for Financial Advisors; towards achieving this ideal situation and which should • The absence of mandatory minimum industry-wide not involve substantial amendments to the existing laws, standards; or the enactment of any new Acts but amendments to the • Variable quality of financial intermediary advice/ current regulations governing licensing procedures and service and consumer difficulties in understanding and requirements in their respective financial industries. Set distinguishing between quality standards; And out below are some of the proposed measures to develop • The presence of conflicts of interest and the absence the regulatory framework for Financial Planners in India. of any consistent approach to managing them.

Consumer Information related issues: - Consumer Redressal Mechanisms, Sanctions & • A general need to increase consumer financial literacy; Enforcement issues:- • Need for greater transparency :- • Variability of dispute resolution coverage and Around financial intermediary fees and redress for consumers; commissions, conflicts, obligations and standards, • Difficulties removing financial intermediaries from roles and history, and available redress the industry for dishonest, negligent, unethical or other mechanisms for consumers; misconduct, wherever appropriate to do so; And

23 • Shortcomings in current disciplinary, complaints obtaining the coverage or value they were seeking, then and enforcement mechanisms. this is relevant information for the consumer to assess These issues may in turn be impacting on overall market the impact of the commission; confidence in the financial intermediary industry. There •Whether the intermediary’s remuneration basis and are obvious overlaps between these issues, and it is the mix amount is variable; of issues that may have the most significant impact. • Poor transparency around the factors that contribute to deductions from a product manufacturer’s gross Better Information from the Intermediary investment return and the impact it has on a consumer’s FPSB India believes that there is insufficient and/or actual net return (for example, what costs and fees the ineffective disclosure by financial intermediaries of product manufacturer deducts post return, what matters, which are relevant to a consumer for deductions the intermediary makes post investment empowering them to make an assessment of the return, and what ancillary service providers deduct post suitability of the intermediary, the appropriateness of return). This lack of transparency can contribute to poor the advice given, and/or the ability to make comparisons consumer understanding of the value of the investment across intermediaries. Insufficient or ineffective they have made, and the costs of the various services disclosure covers some or all of the following:- they are using; • Relevant information about the financial • Just w ho is the intermediary’s client, and the duties intermediary’s character (for example, disclosures as to the intermediary owes to that client; And convictions of an offence, adjudged bankruptcy, whether •The parameters within which the advice is being the intermediary have been subject to professional body given (for example, an intermediary may have a practice censure or sanctions etc). While disclosure of convictions of only advising on investments in a particular range and bankruptcy has been a mandatory legal requirement of products, if the amount available for investment is for intermediaries who advise on the buying and selling of under a certain amount). securities, feedback suggests that compliance may be less Greater transparency around and increased extensive than it should be. Nor does the scope of the legal effectiveness of disclosure can assist consumers to requirement extend to all who advise on or promote financial compare financial intermediaries and contribute to products (for example, those who promote investment greater competition between intermediaries, more property, risk only products or consumer credit); innovation in relation to best practice standards and • Relevant information about the financial greater consumer choice. intermediary’s skills (for example, what relevant FPSB India is also conscious that long or complex qualifications they have, their experience etc); disclosure documentation can be counterproductive and, • Relevant information about the benefits the indeed, obscure the key material points relevant to a financial intermediary obtains from advising on or consumer’s decision. As much attention should go to promoting the product and the effect such benefits effective communication of disclosure obligations to could have on the advice and promotion, including consumers as to communication for marketing. Effective commissions, soft commissions etc . (see also the disclosure involves far more than compliance oriented, discussion on conflicts of interest). FPSB India believes “boiler-plate” approach. To this end, FPSB India believes that how the benefit might affect the information or it essential that disclosure is succinct and effective and advice provided is an important element of disclosure. facilitates ease of comparison across intermediaries. For example, if the total cost of insurance coverage resulted in the consumer reducing the value of the The Need for Industry Standards amount insured or the coverage of the insurance, and a In maintaining the appropriate prudent standards of the lower commission would have resulted in the consumer financial markets, Financial Planning will be in need more

24 Regulation of Investment Advisors than ever before. With the increasing demands to offer a value sales commitments; AND/OR wide range of financial products and services, qualified • The financial intermediary receives a commission, Financial Planners will be needed to educate and guide remuneration or other benefit from the product consumers in making informed financial decisions. manufacturer in relation to a sale. Volume and value Professional Financial Planning will eventually play incentives vary including:- an important role in every individual’s life. In a globalized • Formal contractual arrangements (minimum volume market, numerous financial products will be available to guarantees, minimum commission targets etc); consumers at large and along with these, the possibility • Loyalty based support services (office support, of the emergence of a tremendous quantity of persons product manufacturer based software and claiming to be “Financial Planners” without the proper technology services); And knowledge or understanding of the process of Financial • Loyalty based “soft” commission incentives and Planning is plausible, as a result of which, professionalism reward programmes [overseas trip credits (for in the industry will undoubtedly be compromised. To example, one week in Switzerland for top selling circumvent this, certain standards of professionalism intermediaries and their partners of that product must be set and regulated. Financial Planning, if practiced manufacturer’s products), goods, sponsorships professionally will assist in achieving and maintaining the etc]. appropriate prudent standards in the financial services industry but several core values must first be established Firm conflicts and which should encompass the following: - Firm conflicts can arise where the financial intermediary’s • Integrity firm is performing different, and potentially conflicting, • Objectivity functions. This may include where:- • Competence • The intermediary firm has, in addition to its advisory • Fairness services, other services that create incentives for the firm • Confidentiality to promote a product manufacturer’s product (for • Professionalism example, an advisory firm has been contracted as the • Diligence lead manager in the public offering of a manufacturer’s • Compliance products, or is a sub-underwriter of a public offer); • The firm is both an advisory service and a product Conflicts of Interests manufacturer, recommending its own products either Actual and potential conflicts of interests are a feature exclusively or with others; of the financial intermediary industry. There are a • The firm may be raising funds for investments that number of different conflicts, broadly categorized as:- it, or a related party, is also promoting; And/Or • Individual conflicts: where a financial • The advisory firm is owned by the product intermediary is performing two different and potentially manufacturer, though the association may not be conflicting functions; And apparent from the respective brands. • Firm conflicts: where a financial intermediary’s firm is performing different and potentially conflicting functions. Potential consequences of conflicts These conflicts can give rise to a number of consumer Individual Conflicts and broader market risks, such as:- This may arise because:- • The consumer is under the impression that he/she • The financial intermediary and product manufacturer is receiving broad impartial financial advice, but is in have arrangements in place which create incentives for, fact receiving advice limited to, or tailored around, and/or bind the intermediary to certain volume and/or specific products which the intermediary has strong

25 preferences for as a result of the relationship between How much the consumer already knows actually the intermediary and the product manufacturer; about the specific conflict. • The consumer is advised on a product which is not appropriate for the consumer (for example an elderly Redressal, Sanctions and Enforcement person who is recommended a fixed long term, illiquid, Redressal equity investment); The consumer’s ability to effectively seek redressal • The consumer is advised on an appropriate product against financial intermediaries was highlighted as an but there were other equally appropriate products in the issue in many submissions. Difficulties were identified market which were cheaper; in both complaints/disputes resolution processes, and • The consumer is advised on an appropriate product court proceedings. which is appropriate for the consumer but there were better products available for the same price; Complaints/Disputes Resolution Mechanisms • The consumer has an appropriate product but, The main constraints identified in the effectiveness of because of commission incentives, is encouraged by the these processes are: intermediary to switch to another product which is either • Membership of industry bodies is generally less appropriate, or where the marginal cost of switching voluntary (with exceptions, for example, lawyers and exceeds the marginal benefit. The practice of “churning” Chartered Accountants & CFP professionals), so if the is relevant to the risk industry. (For example, the financial intermediary is not a member, the consumer consumer is encouraged to switch over from an existing does not have access to dispute resolution; mutual fund to a new fund offer without being aware of • Lack of monitoring of internal complaints the risk involved); And procedures. Consumers may not have access to a clear • The perception that the above could occur, even if and understandable statement of the financial in most circumstances they do not, affects consumer intermediary’s core obligations; confidence in seeking out a financial intermediary. • Existing bodies are limited in their jurisdiction, so Moreover, it is not easy to ascertain with any certainty that even though the financial intermediary belongs to a the prevalence of these risks . While FPSB India received disputes resolution body, the particular complaint might some feedback on the presence of some of these matters, not be covered; they were either anecdotal or limited to a few generally • Compensation is not always available under the rules of known instances or a few consumer’s experiences. The the dispute resolution scheme, or is limited to a certain level; significance of these risks for consumers may also vary • A financial intermediary may be able to withdraw depending on:- from dispute resolution at any time, including when a Whether the financial intermediary is undertaking complaint is referred or when an adjudication is made; an information only role or is giving advice on the • With different disputes resolution bodies operating appropriateness of the product; in the industry and multiple membership by some How relevant the relationship between the intermediaries , consumers have difficulty determining intermediary and product manufacturer is to the where and how to lay a complaint. consumer’s particular needs; The benefits the intermediary will receive from the product manufacturer as a result of the advice given to the consumer; The extent to which the intermediary passes on some, or all, of the benefits received, to the consumer; And

26 Regulation of Investment Advisors

REGULATINGREGULATING FINANCIALFINANCIAL ADVISORS:KEYADVISORS:KEY ELEMENTSELEMENTS

Distinction between “Advice” and “Selling” Financial Advisors to be Certified and Regulated There must be a well-established distinction between the Financial Planning is a multi-discipline profession and terms “Advice” and “Selling” across all regulators. There one that should be practiced only by qualified must be separate certification requirements for “Advice” professionals, and as it affects the financial state of and “Selling”. There could be separate certification for affairs of an individual, Financial Planners and the “Selling” mandated by different regulators for different profession itself ought to be regulated. Keeping the products (as is prevalent today). However there should also consumer the Centrum, Code of Ethics and Rules of be a uniform certification that fulfills the requirements/ Professional Conduct should be formulated and a qualifications (such as Certified Financial Planner (CFPCM) Supervisory Mechanism should be established so that / Associate Financial Planner (AFP) Certification offered the Financial Planners/ Advisors are well regulated. by FPSB India for “Advising”, incorporating integrated Financial Consumers of India should be aware/made disciplines/facets of all financial products/services thus aware that a professional body regulates the giving a holistic perspective to the investor. It is recalled professional Financial Planner/ Advisor and the that there exists certification for Mutual Fund “sellers” regulatory authorities concerned have a direct mandated by the Securities & Exchange Board of India jurisdiction on the regulatory body and knows where (SEBI) & conducted by Association of Mutual Funds of to approach for Redressal of his/her grievances. A India (AMFI), and insurance “sellers” prescribed by the consumer should be aware of his/her rights as a Insurance Regulatory & Development Authority of India Financial Consumer as well as clearly understand what (IRDA). to expect from a Financial Planner/Advisor. This will aid towards the establishment of a Consumer centric Minimum Qualification for Advisors to be regulatory mechanism in India. FPSB India already has Prescribed an established forum through its Board of Professional Even though, with the proposed amendments above in Review to look after these issues. Appointed Regulatory place, professionalism in the Financial Planning industry Authority by SEBI could be entrusted with the would still be affected and so would consumer confidence responsibility for creating investor awareness programs in the industry, if there is no provision in law to curb under its support/supervision. unauthorized/unlicensed practice of Financial Planning activities by unqualified individuals. Hence a mandate Establishment of Regulatory Organization (RO) should be prescribed to all individual/s wanting to Further to the commentary by Amarchand & Mangaldas practice Financial Planning to possess a minimum & Suresh A. Shroff & Co. (for details kindly refer certification. page 27) it is observed that:

27 None of the laws and regulations in India explicitly recognize a separate category of Financial Planning professionals. Consequently, Financial Planners face the possible burden of being subject to regulatory oversight by numerous regulators in the discharge of their functions. In our view, separate recognition could be provided to Financial Planning professionals by either I) piecemeal amendments to each regulation by the respective regulator, or II) the enactment of a separate legislation by Parliament for Financial Planning which would define the profession and delegate rule making powers to specified authorities therein. In our view, ideally option II above would be the most efficient and surest means of legitimizing the profession because then the profession would draw its legitimacy from an act of Parliament and accordingly a single legislation would be the best way to regulate the Financial Planning profession as the functions of Financial Planners cut across various regulatory sectors. Consequently, the legislation would permit the profession to be regulated by a single regulator or as a Federal Self Regulatory Organization (to be created by the legislation or specified by it) avoiding multiple regulation and regulatory overlap. However, under the current situations to establish professionalism in the market place, it would be apt to at least regulate the Investment Advisors in the country who fall under SEBI. Consequently, one view provided by SEBI is that a private sector self-financing Regulating Organization (RO) should be created to be the first level regulator for investment advisors. The RO should develop Principles Based Regulations with Risk Based examinations and implement regulation of discrete market segments in phases. The RO should publish regulations defining the process for regulations and registration, entry and exit, reporting and market conduct. These should include regulations on advertising, performance reporting and presentation, disclosure of conduct, experience and conflict, disclosure of services and fees, prices and commissions and fair dealing. Most importantly, the RO should regulate investment advice relating to all the products.

28 Regulation of Investment Advisors

RECOMMEDATIONS:RECOMMEDATIONS: SCOPESCOPE && PROPOSEDPROPOSED FRAMEFRAME WORKWORK

Current Legal and Regulatory Framework Regulations, 1993 provides that no person shall act as a 1. By the very nature of their profession, Financial portfolio manager unless he holds a certificate granted Planners offer a holistic array of services, which by the Board under the regulations. Regulation 2(cb) of range from Insurance, Stocks, Unit Trusts, Asset the Regulations provides that a portfolio manager Management, Accounting services, Estate Planning means, “any person who pursuant to a contract or services etc. arrangement with a client, advises or directs or 2. Currently, there exists no single legal or undertakes on behalf of the client (whether as a regulatory framework in India for regulating the discretionary portfolio manager or otherwise) the activities of Financial Professionals in the country. management or administration of a portfolio of Financial Planners are not recognized explicitly as a securities or the funds of the client, as the case may be.” separate category of professionals in applicable laws, The regulations impose certain obligations on, and which govern various sectors. Consequently, prescribe a code of conduct for portfolio managers to follow. Financial Planners may find themselves being regulated piece-meal by diverse regulators depending iii.Stock-brokers and Sub-brokers are required to be on the nature of the services offered. A brief summary registered with SEBI in terms of the SEBI (Stockbrokers of some of the key laws and regulations, which may and Sub-brokers) Regulations, 1992. Regulation 2(gb) be applicable to Financial Planners, is given below:- defines a stock brokers to mean, “a member of a stock I. SEBI related laws and regulations: exchange”, whereas Regulation 2(gc) defines a sub- i. Section 12(1) of the Securities and Exchange broker to mean, “any person not being a member of a Board of India Act, 1992 (“SEBI Act”) states that, “no stock exchange who acts on behalf of a stock broker as stock-broker, sub-broker, share transfer agent, an agent or otherwise for assisting the investors in Banker to an issue, trustee of trust deed, registrar to buying, selling or dealing in securities through such stock an issue, merchant banker, underwriter, portfolio brokers.” The regulations impose certain obligations on, manager, investment adviser and such other and prescribe a code of conduct for stockbrokers and intermediary who may be associated with the sub-brokers to follow. securities market shall buy, sell or deal in securities except under, and in accordance with, the conditions iv. In terms of SEBI circulars MFD/CIR No-10/310/01 of a certificate of registration obtained from the dated September 25, 2001, MFD/CIR/20/23230/2002 Board in accordance with the regulations made under dated November 28, 2002, SEBI/MFD/CIR No. 01/ the Act (SEBI Act).” 6693/03 dated April 3, 2003 and SEBI/IMD/CIR No. ii. Regulation 3 of the SEBI (Portfolio Managers) 2/254/04 dated February 4, 2004, employees of Mutual

29 Funds who engage in marketing or interact with 2(2) provides that a member is deemed to be in practice investors as well as all intermediaries responsible for sale when, individually or in partnership with Chartered and marketing are required to complete a certificate Accountants in practice, he, in consideration of course offered by AMFI and be duly certified. remuneration received or to be received. —(i) engages Whilst there exists no specific SEBI regulations himself in the practice of accountancy; or (ii) offers to governing Financial Planners, they would nevertheless perform or performs services involving the auditing or be required to obtain the requisite registration/s and verification of financial transactions, books, accounts, would be governed by the above regulations depending or records or the preparation, verification or certification on their functions and scope of activity. of financial accounting and related statements or holds himself out to the public as an accountant; or (iii) renders II. Insurance related laws and regulations: professional services or assistance in or about matters i. Section 2(10) of the Insurance Act, 1938 defines an of principle or detail relating to accounting procedure “insurance agent” to mean, “an insurance agent or the recording, presentation or certification of financial licensed under Section 42 who receives or agrees to facts or data; or (iv) renders such other services as, in receive payment by way of commission or other the opinion of the Council, are or may be rendered by a remuneration in consideration of his soliciting or chartered accountant in practice. Penalties are procuring insurance business including business prescribed for violation of the Chartered Accountants relating to the continuance, renewal or revival of Act. policies of insurance.” Insurance agents are required to be licensed to act as such in the manner specified in ii. Section 2(1) (e) of the Pension Fund Regulatory and the IRDA (Licensing of Insurance Agents) Regulations, Development Authority Bill, 2005 (“Bill”) defines an 2000 and the IRDA (Licensing of Corporate Agents) intermediary to include a “retirement advisor”. Section Regulations, 2002 (applicable to corporate agents). 24(1) requires an intermediary to be appropriately These two sets of regulations prescribe qualification registered in terms of the act and the regulations before and other requirements as well as a code of conduct in order to act as such intermediary. Whilst the Bill is for such agents and certain employees. yet to be passed by Parliament, it is possible that Financial Planners who provide insurance related advice ii. The IRDA (Insurance Brokers) Regulations, 2002 may require to be duly registered under regulations provide for the licensing of insurance brokers. prescribed under the Pension Fund Regulatory and Regulation 2(1)(i) defines an “insurance broker” to Development Authority Act, 2005, in future once it is mean, “a person for the time being licensed by the enacted. iii) Finally, the RBI may regulate Financial Authority under Regulation 11, who for a remuneration Planners where they are involved in the dissemination/ arranges insurance contracts with insurance companies sale/ distribution of marketing products. and/or reinsurance companies on behalf of his clients.” Financial Planners would require to be appropriately Financial Planning for wider scope of qualified and licensed under the above regulations if Regulations they wish to discharge the functions of an insurance FPSB India is of the view that whoever interacts with agent, corporate agent or insurance broker. the general public whether an Individual or an Institution and gives Financial Advice irrespective of the III.Others mode of compensation should be made accountable for i. Section 6 of the Chartered Accountants Act, 1949 the advice given. Moreover it may be noted that not requires a member to obtain a “Certificate of Practice” withstanding the mode of compensation, the quality of in order to practice in India or elsewhere. Regulation advice is more important for which the regulations may

30 Regulation of Investment Advisors

Currently FPSB India’s Diagram 3 Members are offering advice in all areas depicted as portrayed in the Diagram 3. However the proposed Self Regulatory Authority will be established under SEBI Guidelines for SROs and will restrict itself at this current juncture any member who is registered with SEBI U/s 12 of the SEBI Act. be established by the proposed RO. The Financial Planning industry in India is still Principles Based Regulations Vs Rules Based considered to be in its nascent stage. In some form or Regulations:- another, Financial Planning is being practiced in India When we contemplate to regulate any but each segment of the financial services industry in profession it could be achieved by virtue of any India operates and functions separately and distinctly one of the following three approaches: from each other with its own regulatory bodies and • By regulating the firms and establishments vehicles of distribution of its services to the public. With which offer the services for e.g. Asset such financial service structure, an individual intending Management Companies, Banks and Insurance to formulate her/his own financial plan would have to Companies which are being regulated by their engage the services of agents in each of the respective respective regulators viz. SEBI, RBI and IRDA financial services industry. For instance, an individual respectively; would require the services, advice or assistance of an • By regulating the individual professionals insurance agent for insurance products and likewise an who offer the services; for e.g. Chartered agent or a stockbroker for investment purposes. These Accountants, Company Secretaries by their agents may possess the knowledge and the respective professional bodies; And understanding of the products in their respective • By regulating the process which governs the industries but may not possess the knowledge or the transactions itself. understanding of the mechanics of each and every While each of the above three approaches financial services or products available in the market. have their respective merits and demerits, An insurance agent or a stockbroker may recommend nevertheless, these cannot be looked upon in or structure their products for a client but these isolation without taking into consideration the recommendations are not reflective of the client’s true dynamics of the environment and the industry financial goals and objectives as a whole. These as well as the maturity prevailing in the sector. recommendations are made separately and Taking an informed view we believe that the outcome independently of other financial decisions or to essentially protect the consumer’s interest should have commitments of the client and may not be consistent the highest precedence than attempting to establish and with the client’s overall financial plans or in line towards / or defining the process of relationship between the achieving the client’s true and ultimate financial goals consumer and the advisor by the regulations. Hence the or objectives. outcome is more important than the process itself. Also

31 we need to establish a premise that competition and securities” element if the advice or reports relate to innovation in rapidly evolving markets are always driven securities. The Advisors providing one or more of the by technology and should not be inhibited by over following also could satisfy this element: advice about prescriptive regulations. market trends; advice in the form of statistical or historical While the proposed model rules out the regulations of data (unless the data is no more than an objective report processes and the regulation of individuals as advisors take of facts on a non-selective basis); advice about the the highest precedence, however the responsibility of the selection of an investment advisor; advice concerning the institutions in case of large institutions have also been advantages of investing in securities instead of other types considered relevant. Hence the model structure is essentially of investments; and a list of securities from which a client an evolution of Principle Based Regulations, (PBR) while can choose, even if the advisor does not make specific the laid down policies which would form the rules for the recommendations from the list. members of the proposed SRO could be deemed to be based on the Rules Based Regulations, (RBR). For more details Establishment of a Third Party Administrator (TPA) kindly refer to Box 1.3 of the Annexure IV. In order to enroll members for the SRO it is highly recommended that a TPA should be established. The TPA Who should be registered as an Investment shall enroll and monitor the activities of members Advisor? belonging to the various strata of the society, which We have drawn our understanding from US regulations includes Financial Service Companies, Educational which defines an “investment advisor” as any person or Institutes, IFA’s, Industry specialists etc. who deal with firm that: the end user. • For compensation; As the TPA is not an advisor to the consumer in the • Is engaged in the business of; selection process of an advisor, in our opinion, the • Providing advice, making recommendations, issuing disclosure options will not impact the business reports, or furnishing analyses on securities, either provided by the TPA that does not offer consulting directly or through publications. services. The onus for disclosure would rest with the A person or firm must satisfy all three elements to be advisor. regulated. For example, with respect to “compensation,” the receipt of any economic benefit suffices. To be Disclosure Obligations for Financial deemed compensation, a fee need not be separate from Intermediaries other fees charged, it need not be designated as an 1. Advisors who are covered by the Disclosure advisory fee, and it need not be received directly from a Obligations:- client. All intermediaries are covered by disclosure obligations With respect to the “business” element, an investment specific to their function. For example, those advisory business need not be the person or firm’s sole intermediaries who are offering personal financial or principal business activity. Rather, this element is advice or are marketing specific products have more satisfied under any of the following circumstances: the extensive obligations than those carrying out an person or firm holds himself or itself out as an information-only or execution-only function. investment advisor or as providing investment advice; the person or firm receives separate or additional 2. Details, which need to be disclosed:- compensation for providing advice about securities; or FPSB India recommends that, in general, the person or firm typically provides advice about the Investment Advisor disclosure regime should be specific securities or specific categories of securities. extended to cover: advice on or marketing of any Finally, a person or firm satisfies the “advice about financial product within the scope of the

32 Regulation of Investment Advisors recommendations, including risk, investment intermediaries carrying out a personal Financial property and credit. This will include most Financial Advisor function should be subject to a statutory Intermediaries providing financial advice without standard to agree with the consumer in writing the advising on financial products including some amount or formula for the intermediary’s Financial Planners. These are summarized in remuneration. Under FPSB India’s proposal, the the Table4, with the additional disclosures arrangement between the intermediary and the recommended by FPSB India. consumer to have some or all of the following features:- 3. Details of Remuneration, which need to be • All commission payable to the intermediary would disclosed :- belong to the consumer; All intermediaries regardless of function will be • The consumer and intermediary would agree the required to disclose the nature and level of any fee that amount or formula payable for the intermediary’s the intermediary will charge. services, (this could be an agreed fee, an hourly rate, a FPSB India defines remuneration to include “a proportion of funds under management, or some other commission, fee, or other benefit or advantage, whether agreed arrangement); pecuniary or not, and whether direct or indirect; but • That amount or formula is all the intermediary does not include a salary or wages of a fixed amount.” would be entitled to, unless agreed otherwise. The same section requires disclosure of, to the extent FPSB India recommends initial disclosure with an practicable, “the amount or rate of the remuneration obligation for subsequent transaction-related disclosures and the name of the person from whom the if there is a material change in the matters required to remuneration has been, or will or may be, received”. be disclosed. Further, work is required on which of the FPSB India supports extending this requirement to disclosure elements are suitable to initial and which to all intermediaries performing a personal financial ongoing disclosure. advice function or a product marketing function. 5. How Useful Is This Information to 4. How and when does one have to make the Consumers:- disclosure :- FPSB India agrees that disclosure needs to be consumer The final content and form of disclosure will need to focused, and analyzed from the perspective of benefit to be established. FPSB India recommends that all

Recommended Disclosure Requirements Table 4 Sr. Recommended disclosure Information Execution Product Financial No. requirements only only marketer Advisor function function function function 1 Experience No No No Yes 2 Qualifications No No No Yes 3 Membership of professional bodies No No No Yes 4 Nature and scope of any professional indemnity insurance No No No Yes 5 Whether dispute resolution facilities are available to consumers No Yes Yes Yes 6 In the previous five years before the service is provided: Relevant convictions No Yes Yes Yes Whether the adviser has been adjudicated bankrupt No Yes Yes Yes

33 Sr. Recommended disclosure Information Execution Product Financial No. requirements only only marketer Advisor function function function function Prohibitions from managing a company or business No Yes Yes Yes Any successful court action taken against the financial intermediary in the intermediary’s professional or business capacity No Yes Yes Yes Whether the intermediary has been expelled from or prohibited from being a member of a professional body No Yes Yes Yes 7 The nature and level of the fee the intermediary will charge (if any) Yes Yes Yes Yes 8 Other interests and relationships reasonably likely to influence the intermediary in performing their function, such as relevant remuneration received from someone other than the consumer, and the amount or rate of remuneration No No Yes Yes 9 Details of the types of products about which the intermediary gives advice or markets and, if the intermediary only advises or markets in relation to products of a particular product generator or generators, a statement to that effect and the name of each of those product generators No No Yes Yes 10 Disclosure in Rupee terms, on a periodic basis, of the difference between the aggregate gross returns on all investments organized though the financial intermediary, and the actual net return received by the consumer, with an explanation of the difference No No Yes Yes 11 To the extent practicable, total benefits to the intermediary of the consumer’s business (including “Soft Rupee” benefits) where those benefits are not already disclosed as part of the actual gross and net gross return disclosure above No No Yes Yes 12 The role being undertaken by the intermediary, including a statement as to whose interests the intermediary is acting in and a description of those interests, and for product marketers, a “health warning” about the limitations in the information provided (for example, “I have not considered your personal circumstances, and accordingly, the product may not suit your needs”) No No Yes Yes 13 Remuneration options, if any (that is, hourly rate, fee only, commission rebate) and whether any components of the remuneration are variable Yes Yes Yes Yes 14 Where advice or marketing relates to switching products, disclosure of remuneration to the intermediary, the cost to the client (for example, exit fees, entry fees and implementation fees), and the benefits of the alternative as against the existing product No Yes Yes Yes 15 Code of Conduct for Marketing, Advertising & Promotional activities Yes No No Yes

34 Regulation of Investment Advisors the consumer. Consistent with this, FPSB India thinks Institution who promote financial products, and provide that before determining the final content and form of more than factual information (for example, marketing disclosure there is considerable value in researching aspects of the product) but do not advise on the consumer views on what consumers would consider suitability or appropriateness of the product for the useful information and what form of disclosure would consumer’s personal circumstances (a “product be most effective in conveying that information. marketer role”). For example, this would include an Asset Management Company etc. Overall, FPSB India views disclosure of fees and remuneration as contributing to two positive outcomes, 4) Financial Advisor function: Any Individual or namely:- Institution who provide broad Financial Planning advice • Assisting the management of conflicts of interest; or advice on financial products, and implicitly or explicitly And advise the consumer on the suitability or appropriateness • Facilitating a better-informed market providing for the consumer’s personal circumstances (a “personal opportunities for competition between suppliers in Financial Advice role”). Typically, this would include respect of fee structures and fee amounts. Financial Planners and product advisors who advice on the suitability of investment, risk or credit options for The varying roles of a financial intermediary: - the individual consumer. A focus on both advice and promotion recognizes that in India, as in many other markets, financial Advertisement Code intermediaries could cover four conceptually distinct Investment advisors should be prohibited from using any roles namely, advertisement that contains any untrue statement of The investment advisor as stated above shall fall into material fact or that is otherwise misleading. any of the four categories:- “Advertisement” should include any notice, circular, 1) Information only function: Any Individual or letter, or other written communication addressed to Institution, those who undertake factual information (an more than one person, or any notice or other “information only” role). For example this would cover a announcement in any publication or by radio or share broker who provided information on the current buy television, that offers any investment advisory service. and sell price for a listed company share, or the employee In addition, an advertisement may not:- who provided a consumer with a factual description of the • Use or refer to testimonials (which include any various products that business had on offer. statement of a client’s experience or endorsement); • Refer to past, specific recommendations made by the 2) Execution only function: Any Individual or advisor that were profitable, unless the advertisement Institution who execute client instructions, where that sets out a list of all recommendations made by the execution function is linked to a personal financial advice advisor within the preceding period of not less than one or product marketer role (an “execution only” year, and complies with other, specified conditions; role).These roles move along a continuum from least to • Represent that any graph, chart, formula, or other greatest involvement with the consumer. Generally device can, in and of itself, be used to determine which speaking FPSB India believes that the level of securities to buy or sell, or when to buy or sell such consumer reliance, the required intermediary skill securities, or can assist persons in making those level, and potential consumer risk increases along the decisions, unless the advertisement prominently continuum. discloses the limitations thereof and the difficulties regarding its use; and 3) Product marketer function: Any Individual or • Represent that any report, analysis, or other service

35 will be provided without charge unless the report, exceed the remuneration a planner could obtain from analysis, or other service will be provided without any the consumer or, conversely, the amount a consumer obligation whatsoever. would consider it reasonable to pay; and An advisor may be allowed to advertise its past • There was less scope for comprehensive planning performance (both actual performance and hypothetical services the smaller the sums available. or model results) only if the advertisement meets certain While some of the banks indicated greater flexibility in conditions and restrictions. An advertisement using relation to the range of services provided, as they make an performance data must disclose all material facts assessment on the total value of a consumer’s services necessary to avoid any unwarranted inference. Among (including debt), nonetheless they indicated that their full other things, an investment advisor may not advertise Financial Planning service would have similar preferences. its performance data if the advisor:- (1) fails to disclose As a result, the “less than Rs. 500000” part of the the effect of material market or economic conditions on market was more likely to be serviced by those who the results advertised; (2) fails to disclose whether and market products or provide information only. While a to what extent the advertised results reflect the product marketer may incur lower costs, some reinvestment of dividends or other earnings; or (3) experienced product generator observe that expensive suggests or makes claims about the potential for profit products tend to get sold to those who can least afford without also disclosing the potential for loss. In addition, it. In part this arises because the product marketer’s cost generally an advisor may not advertise gross of transacting will still constitute a high proportion of performance data (i.e., performance data that does not the typical savings available. reflect the deduction of various fees, commissions, and Accordingly, a product marketer may look to promote expenses that a client would pay) unless the advisor also products that recover the cost of transacting. includes net performance information in an equally Some respondents noted that those who had prominent manner. However, an advisor may provide substantial funds to invest tended to be more financially gross performance information, accompanied by literate, and as a result were less dependant on their appropriate disclosure regarding the impact of fees and financial intermediary. Some responses described this expenses, in certain limited circumstances that present category as more likely to be “validation seekers” rather minimal risk that the client will not understand the than pure advice takers. While FPSB India has little impact of fees and expenses, such as when the client is a empirical evidence to assess the observations made sophisticated institution, and the advisor presents the above at a general level, these features have been information to the client “one-on-one”. considered by FPSB India in formulating its recommendations. In particular: Financial Advisory roles and the Indian market • If regulatory intervention is too heavily focused on A recurring theme in a number of responses to FPSB India the Financial Planner role without generating equivalent was that Financial Planning services were focused on benefits for the Financial Planner it could lead to a shift Indians who had significant funds (in addition to home in advisory roles away from Financial Planning into equity) to invest. The cut off figure varied, depending on product marketing and information only roles. In the intermediary, ranging from around Rs.500, 000 to addition, it could result in limited consumer protection amounts in excess of Rs.250, 0000. Some Financial for large no. of Indian consumers who are serviced (if at Planners are willing to advice those who had lesser sums all) by product marketers. Neither outcome would be to invest if there was obvious potential for the person to desirable given the review objectives; generate further investment funds over time. • If regulatory intervention places too high a This approach was due to two factors:- compliance cost on product marketers, it could • The cost of servicing a smaller amount would likely contribute to increased product costs for those

36 Regulation of Investment Advisors consumers who can least afford it (those with limited an industry standards setting body, compulsory sums to invest); And registration and appropriate qualification and/ • While there may be some general reforms that would or experience requirements, those who do not apply to all financial intermediaries, a uniform “one size meet these requirements will not be able to hold fits all” approach is difficult to justify, particularly in themselves out as providing personal tailored relation to information only roles, given the limited financial advice and will be required to issue a significance of this role for the review objectives. “health warning” to the consumer as to the limits of the role that they undertake. Differentiation of “Advice” from “Selling” of Further an individual is said to be giving advice if he Financial Products/Services meets the following definition of advice as given below. In India, as in many other jurisdictions, the advice and The definitions of “Advice” and “Selling” may be marketing functions, in particular, can become blurred, elucidated as follows:- with consumers having difficulty in distinguishing “Advice”: Any recommendation, guidance Or between financial and product advice that is primarily proposal of a financial nature furnished, by any means designed to advance the interests of the consumer and or medium, to any client or group of clients: product marketing that is primarily designed to advance • In respect of purchase of any financial product; or the interests of the intermediary as a product distributor. • In respect of the investment in any financial product; or FPSB India considered whether its reform • On the conclusion of any other transaction, including recommendations should be limited to the personal a loan, aimed at the incurring of any liability or the Financial Advisor role, with regulation of product acquisition of any right or benefits in respect of any marketers and information only advisers being left to financial products; Or the Government to address as part of its product review. • On the variation of any term or condition applying However FPSB India is conscious that significant groups to a financial product, on the replacement of any such of Indians seek and/or obtain product advice from product, on the termination of any purchase of or product marketers and excluding product marketers investment in any such product, and irrespective of from the regime would impact on the overall efficacy of whether or not such advice – is furnished in the course the reform recommendations in achieving the FPSB of or incidental to Financial Planning in connection with India’s outcome. FPSB India is recommending changes the affairs of the client; Or that distinguish between the personal financial advice • Results in any purchase, investment, transaction, role, and the product marketer role, with different variation, replacement or termination, as the case may obligations attaching to an intermediary depending on be, being affected. the role the intermediary is undertaking. FPSB India is conscious that placing greater “Selling”: Offer for sale of any financial product obligations on the personal Financial Advisor Effectively, this will require a substantial number of role, without compensating benefits, could existing intermediaries who purport to, or do, provide result in a shift away from personal advisory advice tailored to the need of the individual consumer, roles into the product marketing and to make a choice, namely, whether they wish to continue information only roles. This would not be a providing personalized financial advice with the desirable consequence given the review corresponding duties (in some cases this may require outcomes. To address this, FPSB India is up-skilling) and with the corresponding benefits, or proposing that while the personal Financial whether, going forward, they confine their role to Advisor role should be subject to higher product marketing and disclose that role and its standards, including compulsory membership of limitations to the consumer.

37 FPSB India believes these requirements should regulatory regime should only capture intermediaries contribute to the following positive outcomes for who are providing financial advice or marketing to select consumers and the industry:- members of the public. • Providing consumers with the confidence that FPSB India believes that in the context of Financial appropriate competency standards, higher ethical Advisors, wealth exclusions are an arbitrary distinction. standards and closer industry examination. For example, FPSB India does not believe the objectives • Enabling consumers to more easily identify the of the review would be advanced, if an individual is difference between the financial advice and product deemed to have the protection of the regime for marketing roles, roles which currently are closely investment advice which they receive, until they intertwined and difficult for consumers to distinguish accumulate an investment sum in excess of (in part because the intermediary is not incentivised to Rs.10,00, 000. But once they achieve that (that is, they make that distinction clear); have made good use of their savings) the protection of • Enabling personal Financial Advisors to more actively the regime does not attach to the next piece of “brand” themselves as a class or profession and promote investment advice if it is in relation to the whole to consumers the benefits of dealing with a personal investment sum. Financial Advisor when seeking financial advice; • Enabling industry bodies and other third parties to 3. Product coverage respond, with greater confidence, to consumer enquiries FPSB India has also taken a broad approach to the about who they should go to for financial advice, now definition of “financial products”. The FPSB India views having available the personal Financial Advisor for a financial product as any product having an investment referral; And (including investment property) risk or credit • Enabling product marketer intermediaries to component. The reasons for FPSB India’s preference for function with obligations that are consistent with the role covering the complete range of financial advice include: they undertake, while enabling the consumer to have • That investment, risk and credit advice can all greater awareness of the limitations of that role. contribute to Indians making the most of their savings; • Financial Planning itself views all three components Specific scope issues as being essential considerations for the provision of 1. Occupational group coverage comprehensive Financial Planning advice; FPSB India recommends that (with the exception of • From a consumer perspective a holistic approach is journalists and authors) particular occupational more comprehensive. Over a consumer’s lifetime, one groups should not be excluded from its can expect to see a shift from an initial heavy emphasis recommendations. Rather, FPSB India is keen to on credit and risk products, to a growing emphasis on ensure that the same standards apply across investment and risk products. Financial advice is an occupations, that the specialist redress bodies important constant over this life cycle and distinguishing proposed for addressing consumer complaints in this between financial intermediaries on the basis of the area should apply to practitioners regardless of their category of financial product/s on which they advise occupation, but that the implementation design seems arbitrary from a consumer perspective; should be sufficiently flexible to recognize appropriate • In practice, investment, risk and credit choices are leverage off the standards, rules and processes of not distinct, and indeed within some products are fused; existing occupational bodies. • There is no obvious principled basis for a distinction between those who promote and/or advise on the asset 2. Consumer coverage side of the balance sheet from those who advise on the FPSB India thinks that as a general proposition, the credit side. In addition, financial intermediaries may be

38 Regulation of Investment Advisors promoting to the same consumer both investment and to deal with disciplinary matters. These limitations are credit products of the same product generator. less relevant to an enhanced self-regulatory model with However, we also want to avoid the costs that canaries mandatory membership, where sanctions and with a “one size fits all” approach. enforcement are backed up by, or delivered by, statutory With reference to the proposed SRO to be established empowered agencies; And under SEBI guidelines, products advice could cover • The broad scope of the recommended regulatory anything that fall under the preview of SEBI. regime would include a wide variety of product distributors and advisors (across the risk, investment Self-Regulatory Model and credit spectrum) with the inevitable need for Broadly, enhanced self-regulation refers to a voluntary flexibility as to operational requirements depending on system where industry develops its own standards and the type of intermediary, function and even product dispute resolution and enforcement mechanisms, but type in question. Industry involvement in a regulatory these are backed by legislation (for instance, legislative model could deliver some benefits given these name protection for a brand developed by the industry). characteristics. An example of this type of regime is the Chartered Accountant title. Any enhanced Self–Regulatory Model needs to A Self Regulatory system would allow the industry to address:- develop its own standards, dispute resolution and • The potential costs and interface complexities for disciplinary procedures, but this would be backed up consumers, industry participants and the state itself if through the oversight of a Government appointed body. there are a significant number of industry bodies The body would monitor industry activity, could approve involved in a regulatory role; industry-developed rules, and step in where it considers • Industry capture risks, for example the risk of the that the industry has not effectively regulated itself. industry regulatory bodies acting as “closed shops” State responsibility would involve a Central deterring innovation and competition, and/or that the Government or Appointed Regulator administering a interests of all relevant stakeholders (for example regulatory regime. Standards could be developed, consumers) would not be taken into account when administered and enforced by the body in consultation carrying out their regulatory functions; with industry. State responsibility would give greater • How the model would work in less developed assurance that standards and administration took segments of the market, where either there was no account of the interests of all parties (including established industry body coverage or it represented a consumers), and that any objectives specified for the reasonably new market segment, had little expertise regime flow through to its operation. and/or experience in carrying out the functions of a regulator; And The Self Regulation would be targeting at:- • The need for clear distinctions between the role of • Leveraging on existing industry bodies, knowledge the industry bodies and any state oversight (for example and practices would enhance the overall effectiveness through SEBI) so that on the one hand the industry and efficiency of any regulatory reform; bodies can function without the static and dynamic • Addressing the limitations with the existing self- efficiency costs that can arise where there is state regulatory approach, which arise out of the voluntary “second guessing” of industry body administrative nature of the regime, the inability for industry bodies to decisions, while conversely such state oversight is not effectively sanction poor behaviour (members can simply limited to “rubber stamping” with the structure leave the industry body but continue to practice) and implying a higher level of state assurance than is the fact that existing industry bodies are not well set up actually delivered.

39 Regulatory Framework Mapping, and the Chief Executive Officer would be vested with all the Proposed Policy Governance Model & Executive powers to run the Company (implementation). Management Structures 2. Since the Board of Directors and Committee would Governance Model be Non-Executive bodies, the ownership of responsibility To facilitate the delegation of responsibilities, to of all activities /initiatives shall be vested with the Chief establish role clarity on responsibility of the Chief Executive Officer/appropriate staff, who shall be the Executive Officer & the Committees to facilitate effective Executives of the Company. The authority that would working relationship and to establish professionalism be required for any execution shall also be vested with of the highest order in the functioning of Company , the him /her accordingly. following guidelines for Governance for conducting the 3. The following extract from Carver’s Policy business affairs of the Company (Based on Carver’s Governance Model would serve as a guideline to Policy Governance Model) shall be adopted:- establish the role of Chairman, and his/her relationship 1. The Board of Directors involvement would be an extent with the Chief Executive Officer/Company staff and of providing Vision, Mission and broad guidelines (policy), other Board of Directors: “In taking responsibility for its own performance, the board confronts the difficulty of acting responsibly as a group of equals . Since the board is, by definition a group of peers, no one has authority over anyone else. The first action of a group of peers is to create a position of Chairperson, a first among equals, to help it stay on task . Although it is important that each board member continue to take responsibility for the board ‘s

4groups behavior, the board grants Diagram 4 the Chair extra authority required to make rulings that keep the board on track . To stay consistent with the superior role of the board as a Diagram 5 group, however in policy Governance the Chair only has authority that is within a reasonable interpretation of the board ‘s policies on Governance Process and Board Staff Linkage. Hence, the Chair is truly the servant leader of the board. It is usual for non profit boards to expect the Chair to supervise the CEO, but in policy Governance there is no need

40 Regulation of Investment Advisors to have Chair to have authority over the CEO. Only the board has authority over staff operations, and it exercises Maintaining the title “Registered investment the authority through carefully crafted policies. It is not Advisor”: only unnecessary, but harmful for the Chair to tell the 1) Meet the continuous education requirements; CEO what the board wants, for the board speaks for 2) Pass renewal test conducted by SRO. itself.” “…Consequently both the Chair and the CEO work for the board as a whole, but their roles do not overlap Exclusion from taking Investment Advisory because they are given authorities in different domains. Test:- The Chair‘s job is to see that the board gets its job done, 1) Certified Financial Planner (CFP) from FPSB India as described in Governance Process and Board -Staff 2) Chartered Financial Analyst (CFA) from CFA Linkage Policies . The CEO‘s job is to see that the staff Institute, USA organization gets its job done, as described in the Ends achieving adequate redress and compensation; and Executive Limitations policies..…” • What best fits with standard business practice, with • What best enhances effective enforcement. A. Membership to the SRO Types of Membership B. Statuary Standards for Intermediaries SRO will enroll two kinds of Members namely: FPSB India believes that the minimum core standards Institutional Members: Indicates any person who set out in its reform recommendations should be set carries on “a business” that provides investment advice outin industry specific regulations/ legislation. What to the members of the public by employing Registered these statutory standards will entail in practice should Investment Advisors. be a matter best addressed by industry organisations Individual Members: Indicates any person who and ultimately determined by Disciplinary Body and provides investment advisory to the members of the judicial decisions. FPSB India does not support a pubic by being a Registered Investment Advisor. detailed and prescriptive approach to determining the operational consequences arising out of these general Eligibility for Enrolling as Member of SRO standards (whether in primary or secondary legislation Institutional Member: or through notification issued by a statutory regulator). 1) Any business entity established as firm/company; Overly prescriptive legislative guidelines may lead to 2) Employing 2 or more Registered Investment inflexibility over time, a loss of innovation in carrying Advisors; out advice and marketing functions, and compliance 3) Agree to abide by SRO rules and regulations. costs that may not deliver tangible benefits to Membership validity and fee every 3 years consumers.

Individual Member: Firm and / or individual obligations 1) Any individual ; A key choice for FPSB India was whether obligations 2) Has to be Registered Investment Advisor; should be placed on:- 3) Agree to abide by SRO rules and regulations. • Each person who provides financial advice or who Membership validity and fee every 3 years advises on, or markets a financial product to a member of the public (“individual obligations”); Registered Investment Advisor (RIA): • Each person who carries on a business that includes Awarding the title “Registered Investment Advisor” the providing of financial advice, or who advises on, or 1) Pass the Investment Advisory Test conducted by SRO; markets, a financial product to a member of the public 2) Minimum 10th pass. (“business obligations”); Or

41 • Both the individual and the business. breach of that employee’s obligations (i.e. the employee would not ordinarily have liability for such compensation In assessing these choices, FPSB India has considered unless the employee would be liable under existing the following:- statutory and common law). Employees could still be • Where are the incentives best placed to enhance liable for financial penalties awarded by the Disciplinary higher standards; Body as a disciplinary sanction. In other words, remedies • What most effectively achieves removal of non- for compensation/loss in dispute resolution and court compliant performers from the industry; proceedings would continue to generally be the • What provides the greatest chance of consumers responsibility of the entity carrying on the business. achieving adequate redress and compensation; Individuals (if not carrying on business in their own • What best fits with standard business practice, with name) however would be accountable for breach of their a view to minimising business compliance costs and obligations in terms of liability for disciplinary sanctions, encouraging compliance; including fines and removal from the register. • What best minimises regulatory (administrative) costs; And C. Disputes Resolution Body • What best enhances effective enforcement. FPSB India recommends the statutory establishment of a single dispute’s resolution body that has jurisdiction FPSB India believes that there are clear benefits if to consider, and make binding decisions on, any obligations relating to statutory standards are attached consumer complaint in relation to all intermediaries and to both, those who carry on business and the individual all financial intermediary businesses. intermediary. This conclusion is an “on balance” one, as Complaints would need to be based on a breach of a it recognises that a dual obligation in relation to statutory standard or, in relation to personal Financial standards could increase the overall complexity and cost Advisor statutory standards. of the regime. As the statutory standards attach both to the person Conversely, if obligations are placed only on the carrying on the business of providing advice/marketing individual, then the following limitations may arise:- and the individual who carries out the advice/marketing, • Consumers may have less access to compensation - the Disputes Resolution Body would have jurisdiction their statutory rights will be against the individual not over both persons. This may necessitate some procedural the firm (recourse against the firm will require rules for dealing with proceedings against one or both establishing a contractual or tortuous remedy), an of the individuals and the persons carrying out the outcome which may be counter-intuitive for consumers business. who may reasonably assume they were dealing with the While FPSB India has not formed detailed views on firm and not the individual; the design features of the Disputes Resolution Body and • There may be less incentives for firms to invest in believes there would be considerable value in consulting compliance than if the firm had a direct obligation; And with, and drawing on the considerable expertise and • There may be difficulties with enforcement – an knowledge already present within the Banking individual may be more difficult to locate than a Ombudsmen, FPSB India has a preference for the significant employer of that individual especially in the following:- Indian Context. • The Disputes Resolution Body should be, and be FPSB India recommends that financial intermediary seen to be independent of the industry. This could be businesses would be liable in the Dispute Resolution achieved, in part, by the governing body of the Disputes Body and in Court proceedings for any compensation Resolution Body being composed of persons who have awarded to a consumer in relation to any employee’s experience of the perspectives of consumers and industry

42 Regulation of Investment Advisors

(who could be appointed or approved by the Regulator); where compensation is awarded in favour of a consumer • The rules governing the jurisdiction and procedures by the Disputes Resolution Body, and the business is of the Disputes Resolution Body being subject to unable to pay. FPSB India would expect that failure by Regulatory approval/veto; any individual or business that undertakes a personal • To reduce the incidence of parties to the disputes Financial Advisor role to pay compensation would be process taking an overly formal approach:- grounds for revoking the license, thus precluding that Evidence adduced in the dispute proceedings which intermediary or business from being able to provide is relevant to the dispute would not be admissible personal financial advice. This should, in most instances, in any other forum (including the Disciplinary provide strong incentives for the intermediary or Body and/or the statutory regulator) though; business to pay compensation or manage the risk of The decision of the Disputes Resolution Body compensation through insurance. In addition, the would be made available, on written request, to Regulatory Authority can, if they wish, develop rules the disciplinary body and/or the statutory around members taking out insurance or the provision regulator; of fidelity funds. The jurisdiction of the Disputes Resolution Body would be limited to claims below a specified D. Sanctions and Enforcement amount (for example, Rs. 10,00,000) – any claims The Disciplinary Body should be, and be seen to be, above that would be a matter for the Courts. independent of the industry. This could be achieved, in part, by the governing body of the Disciplinary Body • The Disputes Resolution Body in conjunction with being composed of persons who have experience of the the Regulator would be responsible for promoting to perspectives of consumers and industry (who could be consumers the presence and role of the Disputes appointed or approved by the Regulatory Authority). Resolution Body; And Sanctions available to the Disciplinary Body would • The Disputes Resolution Body, in conjunction with include:- the Regulator, may wish to agree a process for • Temporary and permanent banning orders; considering the complaint at the first instance at the • Orders for supervision or management of practice; Regulator or member level to see if satisfactory • Orders for correction of information; resolution can be achieved without the need to • Orders for reimbursement of fees to consumers; And commence a dispute resolution process. Such “first line • Fines. of resolution” processes should seek to minimize Rules will need to be developed around any double administrative and time demands on the consumer e.g. jeopardy risks, for example, if criminal proceedings have the consumer only has to interface with the Disputes already been brought in relation to the same conduct. Resolution Body, with the first line of resolution being FPSB India recommends that the regulations should addressed directly between the Disputes Resolution include:- Body and the Regulator. • A threshold for bringing proceedings, for example, FPSB India recognizes that the ability to obtain that there has been a significant breach of the compensation is an important part of any complaints obligations; and process and recommends that the Disputes Resolution • Effective safe harbours to excuse behaviour that is Body be able to award compensation to consumers. reasonable in the circumstances, although technically a FPSB India is conscious that a significant number of breach of the regulations, for example, that “the breach financial intermediary businesses in India comprise one is immaterial or, in all the circumstances, ought or two practitioners, operating on reasonably low profit reasonably to be excused”. margins. This raises the risk that there may be instances FPSB India recommends that the regulations should

43 provide consumers bring actions for relief (including be able to revoke SRO status on failure to satisfy one or seeking compensation) in relation to statutory breaches. both of the above grounds, or if the Regulator is satisfied FPSB India’s strong preference is that regulations that the SRO had failed to carry out one or more of its (whether primary or secondary) should seek to prescribe statutory functions in a satisfactory manner. what the minimum statutory standards entail. However While current industry bodies may establish SROs, it should be flexible and should have provision for review these new bodies will be subject to Regulatory approval, which FPSB India believes that in the longer term, this their own governance arrangements, and constrained to will enable a more flexible and innovative approach to the functions set down in statute. The statutory role of practice requirements, with boundaries being the SRO would be: determined by the Disciplinary Body or the Courts. • To consider, and if thought appropriate, make rules An important feature of this approach is that the for those statutory standards that relate to its members disciplinary and Court decisions are available to the and such other rules as the SRO thinks appropriate, industry and consumers. This needs to be balanced having regard to the statutory principles including against the desire to not publicise individual information establishing what are appropriate qualifications and/or in relation to Disciplinary Body decisions in order to experience for advising in particular segments of the encourage, wherever appropriate, a less formal/ market, whether ongoing competency requirements adversarial approach to Disciplinary Body matters. A need to be satisfied and if so, what they might be; pragmatic solution to these competing objectives might • To monitor compliance by members; be for the Disciplinary Body also to issue guidance notes • To resolve low level disciplinary and consumer based on decisions which have significant precedent value dispute matters; for the industry, without including personal details about • To fund a disputes resolution body and disciplinary body; the specific disciplinary decision to which they relate. • To report material breaches of standards to the Disciplinary Body and bring disciplinary proceedings E. Authorisation framework for personal against members when there has been a material breach; Financial Advisors • Either collectively with other SROs or individually, i. Statutory Functions for SRO promote to consumers their rights and the role of the FPSB India recommends that every individual and SRO; And business that undertakes a personal Financial Advisor • To consider, and if thought appropriate, make rules role must belong to an SRO. An SRO would be a body relating to the financial capacity of businesses to provide approved by the statutory regulator to undertake certain for consumer redress for established breaches of statutory functions. To be approved, the body must standards and rules. satisfy criteria relevant to the role the SRO will In order to have some assurance that the SRO rules undertake, for example: are consistent with the statutory objectives of the • The Regulator being satisfied that the SRO has regulatory regime, FPSB India recommends that the SRO sufficient resourcing and expertise to discharge its rules be subject to a Regulatory approval/ Veto process. statutory functions; and FPSB India considers it important that the SRO • The SRO represents a sufficient number of take into account the interests of consumers in individuals and businesses, which undertake a personal developing standards and discharging other statutory Financial Advisor role to justify the potential increase functions. To achieve this, the legislation could in marginal costs and complexities in the operation of address governance structures for SRO, including the regulatory regime that may arise as a result of the requirements for consumer representation at a SRO being a regulator. governance level. The Regulatory Authority on an ongoing basis would FPSB India notes that withdrawing membership of

44 Regulation of Investment Advisors an SRO could preclude an intermediary from practising to also include experience requirements) of their SRO. (depending on whether there were other SROs the An intermediary business or individual could be removed intermediary could join). Accordingly, SROs should not from the register for a serious breach of standards. be able to exercise the power to withdraw membership The purposes of the register are to:- other than in relation to breaches of statutory standards • Ensure that there is a clear public record of all and rules developed in relation to those statutory individuals or businesses undertaking a personal standards. In addition, if SROs are given a statutory Financial Advisor role; power to levy members to undertake their statutory • Give details that enable a consumer to locate an roles, this funding would need to be applied only to the intermediary and know which SRO’s they belong to. This SROs statutory role. could assist if the consumer wants to understand what a For these reasons, it may be advisable for the SROs role particular intermediary’s obligations are and/or report to be limited to its statutory functions, with other functions a matter for disciplinary action; And (for example, lobbying or developing non-statutory • Enable consumers and employers to determine if a standards) dealt with by separate industry bodies (which registered intermediary has been subject to disciplinary can include product marketers as part of their membership sanction. if they choose). Hence it is recommended that a separate The register would contain the following details about legal entity shall be established to function as a SRO. In each registered individual financial intermediary:- establishing SRO, FPSB India does not intend to limit the • Their name; role of industry bodies. We view these as able to exist in • A contact address (which could be their business parallel with SROs. address); FPSB India believes that there is the potential for • Their qualifications; interface costs and administrative complexities if there • Any disciplinary sanctions imposed on them. are a significant number of SROs. FPSB India also believes that there are benefits in an SRO not F. Establishment of the Ombudsman’s office: consisting of a single employer. For these reasons, The Ombudsman responds to inquiries, assists in the FPSB India’s preference is that SROs be representative resolution of complaints in a fair, impartial, confidential, of employers and individuals across various and timely manner; gathers information to ensure that businesses, rather than single business based SRO’s regulations and procedures are clear, consistent, organisations. and current, works to influence systemic change, wherever necessary, to improve SRO operations and ii. Registration customer service and encourages the use of effective FPSB India recommends that there be a register of all alternative dispute resolution practices throughout the individuals or businesses undertaking a personal Financial Office of Thrift Supervision. The Ombudsman strives to Advisor role. No individual or business will be permitted accomplish this mission by providing high quality to undertake such a role unless they are on the register. customer service, seeking continuous improvement, and The title “Registered” in relation to roles undertaken by inviting meaningful customer involvement:- financial intermediaries, would be reserved in regulation • To facilitate communication between SRO staff and to those intermediaries who are on the register. interested parties in the resolution of regulatory issues; The register would be administered centrally (for • To serve as a confidential, designated neutral to example, by Third Party Agency (TPA) and would be whom customers may raise concerns and from whom available to the public (including being available on the customers may request assistance to informally resolve internet). No individual intermediary can register unless conflicts and problems; they have satisfied the qualification requirements (defined • To develop implement, evaluate and provide an

45 independent, neutral, problem resolution service for Diagram 6 financial institutions and the general public; • To promote an effective conflict management program throughout SRO to facilitate effective and efficient operations.

H. Rating for Organizations In view of the developments that are taking place in the Financial Planning field, the need to constantly upgrade and improve systems and procedures in operation as well as skill sets has gained considerable importance. Besides compliance with regulatory requirements both in letter and spirit has assumed significance so as to mitigate risk and ensure adequate protection of investors’ interest. In light of these developments, quality, competence, professionalism and standards of ethics being adopted by financial firms have become all the more necessary. These developments underpin the need to measure and would measure these Financial Planners on laid down compare the relative competencies and standards of criteria and will be an indication of the relative strength services of the Financial Planners on these and other of the financials and other parameters of the Financial parameters in order to provide investors necessary Planning firm. The proposed SRO could endorse ratings information to compare the Financial Planners. on similar lines. One of the tools with which these parameters can be For more details on rating for organizations, kindly refer measured and indexed is the professional rating of to Annexure V. Financial Planners by FPSB India. The rating index Diagram 7

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CONCLUSIONCONCLUSION

Regulatory Framework • To resolve low level disciplinary and consumer FPSB India recommends that there should be a Self- dispute matters; Regulatory framework for the regulation of financial • To fund a Disputes Resolution Body and intermediaries. Disciplinary Body; • To report material breaches of standards to the Obligations on business and individual Disciplinary Body and bring disciplinary proceedings FPSB India recommends that the obligations against members when there has been a material breach; recommended in this proposal (which differ depending • Either collectively or with other regulators or on the intermediary’s function) be placed on:- individually, to promote to consumers their rights and • Each person who provides Financial Advice or who the role of other Self Regulatory Organisations (SRO’s), advices on, or markets a financial product to a member which shall be encouraged; And of the public (“individual obligations”); And • To consider, and if thought appropriate, make rules • Each person who carries on a business advice, or who relating to the financial capacity of businesses to provide advises on, or markets, a financial product to a member for consumer redress for established breaches of of the public (“business obligations”). standards and rules. Lastly but not the least, FPSB India with its objective Authorisation framework for Financial Advisors of promoting Financial Planning in the country would FPSB India recommends that every individual and be glad to initiate the process of establishment of a Self business who undertakes a personal Financial Adviser Regulatory Organization. role must be a member of the proposed Self-Regulatory Organization. FPSB India recommends that the SRO should have the following roles: • To consider and if thought appropriate make rules for those statutory standards that relate to its members and such other rules as the SRO thinks appropriate, having regard to the statutory objectives including establishing what are appropriate qualifications and/or experience for advising in particular segments of the market, whether ongoing competency requirements need to be satisfied and if so, what they might be; • To monitor compliance by members;

47 ANNEXURE - I

DEMOCRACY AND THE EVOLUTION OF CORPORATE GOVERNANCE PIERRE-PIERRE-PIERRE-YVES GOMEZ AND HARRY KORINE

48 Regulation of Investment Advisors

Under what conditions do stakeholders consent to a regime of corporate governance? We propose that consent by the governed in corporate governance cannot be satisfactorily explained without reference to the collective value of procedural fairness that underlies markets. Drawing on the social psychology of justice and the political economy of social choice, we highlight the critical role played by democratic procedures in achieving consent by the governed in modern society. This line of reasoning leads us to suggest that the evolution of corporate governance, too, can be understood in terms of Tocqueville’s well-known hypothesis that democracy eventually prevails in all spheres of organised activity. Examining the historical record of institutional reform in France, Germany, the United Kingdom and the United States, we find that corporate governance has indeed evolved to make increasing use of democratic procedures. Viewed over the long-term of two centuries of capitalist development, corporate governance is seen to have successively incorporated enfranchisement, separation of powers and representation. In conclusion, we consider the implications of basing the study of corporate governance on the question of stakeholder consent and the practice of corporate governance on the procedures of democracy.

INTRODUCTION on the voluntary contractual triad of sovereign, governed Under what conditions do stakeholders consent to a and governing, and equally embedded in a society of regime of corporate governance? The dominant natural law, corporate governance shares with modern orientation in research on corporate governance, agency political governance a common root in consent by the theory, is built on the premise that corporate profit governed. satisfies individual preferences and thereby ensures Consistent with the perspective articulated in the general consent. While agency theory relies purely on the political economy of social choice, we propose that market in resolving the question of consent, influential consent by the governed in corporate governance cannot scholars in contemporary political economy stress that be satisfactorily explained without reference to the social choice depends upon collective values (cf. collective value of procedural fairness that underlies Harsanyi, 1955; Sen, 1970; Rawls, 1971; Etzioni, 1990). markets. Drawing on the social psychology of justice In this view, markets still constitute the ultimate selection (Thibaut and Walker, 1975; Soltan, 1987; Lind and Tyler, mechanism for (corporate) governance forms, but the 1988; Tyler, 1990) and the political economy of social collective values of society create the context within which choice (Rawls, 1971; Sen, 1989; Mackie, 2003), we markets operate and choices are made. highlight the critical role played by the procedures of Corporate governance can be understood as a set of democracy in achieving consent by the governed in contracts that defines the relationships among the three modern society. This line of reasoning leads us to suggest principal actors in the corporation: the sovereign,1 who that the evolution of corporate governance, too, can be in the vast majority of modern legal systems is the understood in terms of Tocqueville’s well-known shareowner; the governed, namely all stakeholders, hypothesis that democracy eventually prevails in all including owners of shares; and the governing, who spheres of organised activity (Part 1). Examining the direct and/or control the corporation. Analogously based historical record of institutional reform in France,

49 Germany, the United Kingdom and the United States, we the social choice of consent is based upon the find that corporate governance has indeed evolved to stakeholders’ acceptance of profit maximisation as the make increasing use of democratic procedures. Viewed rationally legitimate framework of their behaviours (cf. over the longterm of two centuries of capitalist Weber, 1947 [1922]). development, corporate governance is seen to have slowly Agency theoretic research in corporate governance and successively incorporated the fundamental has been subject to multiple criticisms of its ideological democratic procedures of enfranchisement, separation foundations (Ellerman, 1992; Engelen, 2002), of the of powers and representation (Part 2). In conclusion, we importance it accords to ownership (Blair, 1995; consider the implications of basing the study of corporate Donaldson and Preston, 1995), of the realism of its governance on the question of stakeholder consent and assumptions (Canella and Monroe, 1997; Davis and the practice of corporate governance on the procedures Greve, 1997), and of its neglect of political and social of democracy. contexts (Pound, 1989; Whitley, 1999; Roe, 1994, 2000). In many of the critiques, agency theoretic research is Part 1. CONSENT BY THE GOVERNED, reproached for being too narrowly economic and not COLLECTIVE VALUES AND CORPORATE taking the points of view of other social sciences into GOVERNANCE account (Fligstein, 1990; Turnbull, 1997). Reversing the The question of consent in the agency common thread of these critiques, we argue that theoretical treatment of corporate governance corporate governance research based upon agency theory Most economic research in corporate governance occurs is not too narrowly economic, but, rather, represents only within agency theory (cf. Aguilera and Jackson, 2003), a narrow slice of economic theory on questions of social and a large proportion of sociological and political choice. research in corporate governance positions itself in reference to and indeed against agency theory (cf. Roe, The importance of collective values in the 1991; Davis and Thompson, 1994). Agency theoretic economics of social choice research in corporate governance is a specific application The process whereby free individuals with different of a broader theory of the firm built around information preference functions reach collective choices has for a economics (Jensen and Meckling, 1976; Fama, 1980; long time been an important subject of study in Holmstrom and Tirole, 1989) and property rights economics (see Mandeville’s Fable of the Bees [1714] for (Alchian and Demsetz, 1972; Alessi, 1983). By the general a very early discussion and Arrow (1951), March (1978) hypothesis that individuals are self-interested and can for overviews). From the Paradox of Condorcet to the be opportunistic, efficiency in controlling information research of Arrow (1951), economists have recognised and reducing transaction costs is posited as the selection that socially acceptable order does not emerge mechanism that determines both the forms of spontaneously from individual choices. Running across organisation and the forms of corporate governance the intellectual spectrum from the strict individualism (Jensen and Meckling, 1976; Jensen 2001). Corporate of Gary Becker (Becker and Murphy, 2001) to the social governance forms in place then represent a successful, welfarism of Amartya Sen (1970, 1989, 1997), economists market-rational adaptation of corporate institutions share a profound interest in under-standing how (Fama and Jensen, 1983a, 1983b). The same criterion collective decisions emerge. In Sen’s words, the aim of which applies to managerial decisions - profit- social choice theory is to find a “rational basis for making maximising efficiency also applies to the choice of such aggre-gative judgments as ‘the society prefers this corporate governance forms (Hayek, 1960). This view of to that,’ or ‘the society should choose this over that,’ or governance posits that the search for profit renders the ‘this is socially right’” (1989, p. 349). The common thread diverging individual interests of the governed compatible; in the study of social choice is the importance of collective

50 Regulation of Investment Advisors values in enabling decisions for society while maintaining Procedural fairness and the procedures of individual freedom. Thus, whether collective values are democracy described as ex ante “ethical preferences” (Harsanyi, A fair process of governance (1) preserves individual 1975,1978,1982) or as ex post “principles of justice” freedom of behaviour and (2) makes possible the (Rawls, 1971), they constitute a necessary set of promotion of individual choices. Procedural fairness thus conditions for collective decisions and mitigate the implies equal treatment and protects voice. Although the anarchical tendency of social systems (Arrow, 1951). meanings given to procedural fairness in law, social Collective values ensure that institutions are compatible psychology and other applications differ in their nuances with individual freedom and support the constitution of (cf. Greenberg, 1986; Lind and Tyler, 1988), equal modern (economic) society (Charkham and Simpson, treatment and voice are consistently seen as the 1999; Arrow, 1974; Rawls, 1971; Sen, 1970).2 fundamental building blocks. In the context of modern governance, it is the procedures of democracy that ensure Collective values, procedural fairness and the maintenance of equal treatment and the protection consent by the governed of voice (i.e. Mackie, 2003). On the definition of the Surprisingly, research in corporate governance has to procedures of democracy, if not on their merit or date paid only limited attention to the findings of the effectiveness, there is a strong consensus in the literature economics of social choice. Emphasis has been placed of political science. Authors as far apart in time and space on the study of the efficiency of corporate governance as early thinkers Rousseau, Madison and Tocqueville, on forms, to the detriment of careful inquiry on the collective the one hand, and contemporary theorists such as Dahl values that underlie markets and enable the social choice (1956), Gastil (1986) and Mackie (2003), on the other of consent by the governed. What are these collective hand, agree that the procedures of democracy cover values? In the social psychology of justice, consent by free enfranchisement, separation of powers and individuals is seen to require agreement on the essential representation with (public) debate. elements of what makes a particular form of governance Enfranchisement: in accordance with the fair and just (cf. Thibaut and Walker, 1975; Soltan, 1987; Enlightenment’s philosophy of equal treatment and Tyler, 1990). The perceived fairness of any system individual freedom (Locke), the law is the same for every depends on both procedural and distributive citizen, and every citizen has the freedom to act considerations, in other words, procedures and independently, within the limits set by private property outcomes. Since fair procedures ensure a fair distribution rights. of outcomes over the long term, regardless of initial Separation of powers: again in the tradition position, traditions as diverse as social psychology, established by the Enlightenment (Montesquieu), a economic philosophy and legal studies (i.e. Thibaut and separation obtains between the powers of direction (the Walker, 1975; Rawls, 1971; Lind and Tyler, 1988) accord executive) and control (the legislature and the judiciary) prime importance to the fairness of procedures in the to prevent the abuses of autocracy and to ensure the achievement of consent (Dahl, 1971). Perhaps just as protection of individual freedom. importantly from the point of view of identifying Representation with public debate: in a system where collective values, a large body of empirical research sovereignty is delegated to representatives, in contrast demonstrates that procedural fairness concerns are to authoritarian regimes built on secrecy and information widely shared, both across contexts and across cultures monopoly, democracy welcomes differences of opinion, (Lind et al. 1978; Leung and Lind, 1986). We therefore and the expression of differences reinforces consent to propose that procedural fairness can also provide a basis decisions made by strengthening individual freedom. for understanding consent by the governed in corporate It is important to note that what we call the procedures governance research. of democracy are not seen as a system of moral values

51 but rather as a technique of governance, or what Foucault on them. (DA, Introduction, p. 7). It appears to me called a “political technology” (1980, pp. 440-52). The beyond doubt that sooner or later we shall arrive, like procedures of democracy are techniques that ensure the the Americans, at an almost complete equality (DA, fairness of the decision-making process. Introduction, p. 12). Faithful to the traditions of the Enlightenment and Tocqueville’s democracy hypothesis 3 analogous to Foucault (1980), Tocqueville views If consent by the governed can be achieved through the democratic governance as a technique for procedures of democracy, the question to be asked of the institutionalising the practices of power and supporting evolution of modern governance is to what extent consent: democracy “draws a formidable circle around different spheres of organised activity, including thought” (DA I, 2, 7, p. 244). It is important to note that corporations, have incorporated these procedures over Tocqueville’s hypothesis is not presented as a moral time. The temporal relationship between governance and judgement, but as an analytic result (cf. DA, democracy was described most memorably (if not Introduction, p. 12). Accordingly, we also find in uniquely) in Tocqueville’s wellknown democracy Tocqueville the same three basic procedures of hypothesis. Much like Kant’s famous peace hypothesis democracy identified by classical and modern writers- (cf. Hess and Orphanides, 2001), Tocqueville’s enfranchisement, separation of powers and democracy hypothesis has stood as a longterm reference representation. for scholarly inquiry (cf. Mar-shall, 1987 [1949]; Enfranchisement: Then with none differing from Rueschmeyer et al., 1993). those like him, no one will be able to exercise a To Tocqueville, all of history can be read as the slow, tyrannical power; men will be perfectly free because but inexorable struggle of the collective values underlying they will all be entirely equal and they will be perfectly democracy, namely the values of fairness and equality of equal because they will be free. This is the ideal toward condition, to assert themselves. It is Tocqueville’s central which democratic people tend (DA II, 2, 1, p. 479). Each hypothesis that democracy constitutes the sole model of one, having a particular good to defend, recognizes acceptable governance in modern society and will the right of property in principle (DA 1,2, 6, pp. 227- eventually prevail in all spheres of organised activity. 228). When one runs through the pages of our [European] Separation of powers: The right of direct the history, one finds so to speak no great event in seven official presumes the right to discharge him if he does hundred years that has not turned to the profit of not follow the orders that one transmits to him, or to equality (DA, Introduction, p. 5). In whichever raise him in grade if he zealously fulfills all his duties direction we cast a glance we perceive the same [...] One should indeed be careful, for an elective revolution continuing in all the Christian universe. power that is not to be subject to a judicial power Everywhere the various incidents in the lives of sooner or later escapes from all control or is peoples are seen to turn to the profit of democracy destroyed (DA I, 1, 5, pp. 69-70). (DA, Introduction, p. 6).... The gradual development Representation: In America, the people name those of equality of conditions is, therefore, a providential who made the law and those who execute it; they fact and it has all the principal characteristics of one: themselves form a jury that punishes infractions of it is universal, enduring, each day escapes human the law. Not only are institutions democratic in their power; all events, like all men serve its development principle, but also in all their developments; thus the (DA, Introduction, p. 6). To wish to stop democracy people name their representatives directly and would then appear to be to struggle against God itself generally choose them every year in order to keep and it would only remain for nations to accommodate them more completely under their dependence (DA II, themselves to the social state that Providence imposes 1,1, p. 165).

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Tocqueville’s hypothesis in historical acceptability of the exercise of authority and power in perspective most spheres of organised activity (Huntington, 1991). Tocqueville’s hypothesis did not meet with unanimous If democratic procedures are essential for consent by approval, particularly in the 19th and early 20th the governed in modern society, and if these procedures centuries. Reactionaries regularly denied the inevitability are extending to all spheres of organised life, then the of democracy and appealed for new authoritarian forms question of their relevance to the evolution of corpo-rate (Schmitt, 1988 [1927]). The resistance of the old order governance merits examination.4 Should Tocqueville’s was often countered by ideologues who believed that hypothesis hold true, we ought to be able to observe, democracy could not be truly achieved by history and the over time, the incorporation of democratic procedures will of God (cf. DA, Introduction, p. 7) alone and sought as points of reference for evaluating the fairness of to impose a popular democracy by revolution. As a result corporate governance forms. The following section of these struggles, the world has seen ups and downs of reconsiders the evolution of corporate governance over democracy, corruptions of democratic governance and the last two centuries in light of Tocqueville’s at least temporary reversals of it. hypothesis. However, over the long term, the empirical validity of Tocqueville’s hypothesis is difficult to refute. Marshall’s Part 2. RECONSIDERING THE EVOLUTION OF seminal essay (1987 [1949]) showed that equal treatment CORPORATE GOVERNANCE and its corollary, democratic decision-making, had Based on the seminal summary of Berle and Means (1932) become the main reference points: first in civic life from and extensions made by institutionalists and agency the end of the 18th century onwards, with the principle theorists, scholars describe the evolution of corporate of equality before the law; then in political life from the governance in terms of changes in the relationship first third of the 19th century, with the principle of one between ownership and control (Chandler 1962, 1977; person/ one vote; and, finally, in social life from the first Galbraith, 1967; Fligstein, 1990). One speaks of three half of the 20th century, with the principle of equal social major periods, each with its own model of reference for rights. Since Marshall’s corroboration of Tocqueville’s corporate governance, a model that comes to be accepted hypothesis some 100 years after the publication of as standard for the times and is generally adopted, “Democracy in America”, democratic decision-making whether a company is large, or small, listed, or unlisted has continued its expansion, spreading into many other (Frentrop, 2003). The first period is typified by the areas of social life, as pushed by an “iron law of dominance of the founding family and stretches from the democratization”. In terms of political governance, Industrial Revolution to the 1920s; the second period is Gastil’s benchmark surveys (1986, 1996) show that the marked by the rise of the professional manager and proportion of what he calls “free” (democratically prevails from the 1920s to the 1970s; and the third period, governed) countries has increased significantly in recent with its origins in the 1970s, is characterised by increasing years, reaching a very high level (1996: 40 per cent free; accountability to society. These three periods are 72 per cent partially free). Indeed, although scholars may presented as distinct stages in the history of the not agree on the nature, the salience or the desirability corporation, each with its own model of reference for of democratic values, the spread of the procedures of corporate governance. By examining the historical record democracy in the political and social spheres is generally in the four largest Western economies, France, Germany, seen as critical to the development of capitalism as a the United Kingdom and the United States, we will show whole (Schum-peter, 1987 [1942]; Rueschmeyer, 1993). that each period can be interpreted as a further step in In our time, democratic procedures - enfranchisement, the deployment of the procedures of democracy in separation of powers and representation - have come to corporate governance. Although far from exhaustive, this represent the ultimate standard for judging the sample of four countries has the benefit of theoretical

53 variety (cf. Yin, 1984). Corporate governance research sell shares of ownership in a corporation. We can say situates the United Kingdom and the United States at one that corporate governance in the 19th century puts in end of a market-society continuum and Germany at the place the first defining element of democratic procedure other, with France located somewhere in between, - economic enfranchisement. depending on the institutions under study (cf. La Porta However, that is not to say that the corporation of the et al., 1999). If Tocqueville’s hypothesis can be validated 19th and early 20th centuries is governed by the in such diverse contexts, then our proposition’s claim to procedures of democracy -equal rights to ownership only generality is significantly strengthened. establish economic enfranchisement. If we trace the beginnings of capitalism as we know it today to the FAMILIAL GOVERNANCE AND ECONOMIC Industrial Revolution, the most striking characteristic ENFRANCHISEMENT from a corporate governance point of view is the lengthy The primary distinction between pre-capitalist and dominance of the founding family. Apart from very few capitalist forms is private ownership of the means of exceptions, and across nations, the family firm production (North, 1973; Furubotn and Pejovich, 1974). represented the model of reference for corporate The birth of the new economic order involves two steps: governance throughout the 19th and the early 20th first, the establishment of property rights for industry; centuries (cf. Bourguignon and Levy-Leboyer, 1998; and, subsequently, the removal of the requirement of Kaeble, 1990; Coffee, 2001). Since the family both owns public authorisation for incorporation. The French Code and manages the assets of the corporation, there is no du Commerce (1808), the American legislation on separation of powers in the corporation. And since General Incorporation (1811 for New York) and the decisions are made in secret family council, there is no English joint Stock Company Regulation and representation of stakeholders outside the family and Registration Act (1844), represent the first step in a no public debate. Indeed, the new entrepreneurs who fundamental reshaping of the notion of economic more often than not are commoners benefiting from the sovereignty. These acts of legislation open the right to new legal order, appear to recreate the institutions of the ownership of a business corporation to any individual the old regime, constituting veritable dynasties of who can afford it, independently of social status, class or industry: the Dupont de Nemours in the US, the heredity and establish that each owner of property has Siemens or the Haniel in Germany, the De Wendel or equal rights before the law. the Boussac in France, and the Courtaulds in the United However, until the second part of the 19th century, Kingdom, to name just a few of the most prominent the incorporation of the limited liability company is business families. subject to public authorisation and therefore remains In a pattern that we will see repeats itself through the highly restrictive in practice. The removal of the different periods of capitalism, the establishment and requirement of public authorisation for incorporation practice of democratic procedures in corporate takes place over a 20-year period commencing around governance temporally lags the practice in political 1860 (United Kingdom 1856; France 1867; Germany governance. Whereas the major upheavals of the late 18th 1870; but also, Spain 1869; Belgium 1873, Hungary 1875 century lead to the political institutionalisation of and Italy 1882). This latter development in property enfranchisement, separation of powers and rights represents what has been called the “Magna representation in much of 19th century America and Carta” of emerging shareowner power (Ripert, 1951, p. Europe, business adopts a form of governance that is 63): individuals are definitively emancipated from the much closer to aristocracy, with a concentration of power public authority, and shareowners acquire full and a lack of representation and public debate. As lucidly sovereignty over the corporation. This is indeed a noted by Tocqueville at the very beginning of this new revolution. Individuals may now freely create, buy and era.

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Thus, as a mass of the nation turns to democracy, 1932; Burnham, 1941). The limited liability corporation the particular class occupied with industry becomes becomes the dominant legal form in all Western more aristocratic. Men show themselves more and economies, and a series of laws are enacted to more more alike in the one, and more and more different in strictly define and circumscribe corporate institutions the other, and the inequality increases in the small (Bourguignon and Levy-Leboyer, 1998; Cheffins, 2002; society as it decreases in the great. Thus, when one Frentrop, 2003). goes back to the source, it seems that one sees In the era of managerial governance, laws are passed aristocracy issue by a natural effort from within the and codes are written that favour the separation of very heart of democracy. (DA, II, 3, 20, p. 532) ownership and managerial control: for example, securities laws concerning the obligation of disclosure in the US, 1933 Managerial governance and the separation of and 1934; company laws making a board of directors powers compulsory in France, 1940 and 1943; and laws Towards the end of the 19th century already in some establishing the two-tier board in Germany, 1947 and 1957. industries and ever more widely after World War I, With this type of legislation in place, corporate governance familial governance starts to reach its limits. Firms are takes on many of the practices of political democracy. Thus, becoming bigger and more complex, requiring greater the most general structure for a publicly held company financial resources to continue growth than single includes an annual shareholder’s meeting that votes on families can provide and broader managerial skills than major corporate issues, an elected board of directors that possessed by the typical owner/manager and his oversees professional management, and, in some offspring. Great corporations grow out of once small jurisdictions like Germany, owner and worker family businesses and need professional management to representatives on the board (Roe et a\., 1993). Most deal with the new challenges of size, product diversity significantly, the power of the board to hire and fire and modern manufacturing, even in those cases in which managers is supposed to put in place a counterweight to ownership remains in family hands. managerial authority (cf. on the US, David and Soref, 1981; These developments are now very well documented, Mizruchi, 1983; on Germany, Joly, 1996). with substantial research to show by when the large-scale These historical changes notwithstanding, one cannot transition to managerial governance is accomplished in describe the adoption of the procedures of democracy in the different countries under consideration: the late corporate governance as a straightforward process (cf. 1920s in the United States and in France (Levy-Leboyer, Kaufman and Zacharias, 1992). In effect, the managerial 1985), somewhat earlier in Germany (Stahl, 1973) and revolution leads to the replacement of the old capitalist only after World War II in the United Kingdom (Florence, aristocracy by a new capitalist technocracy (Stanworth 1961; Hannah, 1976). In many, if not all cases, familial and Giddens, 1974). Although in theory independent of governance cannot cope with the changed economic management, in practice, the corporate board is often conditions of the 20th century and managerial controlled by a “managerial technocracy” (Galbraith, governance arises to take its place (cf. Berle and Means, 1967; Bourdieu, 1998). Shareowners and other 1932; Chandler, 1962, 1977).5 stakeholders are typically excluded from the board in With the takeover of the professional manager in the favour of managers from other companies (Jensen and early 20th century, corporate governance integrates the Meekling, 1973; Monks and Minow, 1995). separation of powers, the second defining element of democratic procedure. Under managerial governance, Popular governance and representation ownership and control are separated, with owners Demonstrated economic efficiency not with standing, providing capital and leaving managers to control the managerial governance begins to meet resistance. The business of the firm (Veblen, 1921; Berle and Means, great business challenges of the last decades of the 20th

55 century -technology, deregulation and globalisation - management (Gilbert, 1956; Pound, 1988,1989; Monks reveal the limitations of a system that put too much and Minow, 1995; Monks, 1998).7 Laws enacted in the control in the hands of managers. On the one hand, United States since the 1970s to protect the individual’s centralisation of managerial authority proves inefficient pension fund savings require institutional investors to in farflung multinational corporations that need to be actively monitor and vote their holdings (i.e. Erisa 1974, able to act swiftly in global markets (Bartlett and Ghoshal, Avon Letter 1986). As a consequence, engaged 1989; Korine and Gomez, 2002). On the other hand, the institutional investors have fought to gain more withdrawal of the state from large swathes of activity and information from and rights over management - the concentration of economic weight in a few, very large, sometimes even engaging in a public debate that has corporations, raises new questions about corporate social engulfed the courts, the legislatures and the press (cf. responsibility in decision making (Wartick and Cochran, Davis and Thompson, 1994; Brancato, 1996). Engaged 1985; Freeman, 1986; McGuire et al., 1988).6 The investment reached a first peak in the United States with manager is called upon to both decentralise authority the 1980s battle over corporate control. The movement inside the corporation and respond to a broader set of has since spread to Europe where individual pension demands from stakeholders outside the corporation. funds such as Hermes in the United Kingdom and These developments go to the heart of the definition of shareholder rights organisations such as the the manager’s job and undermine the technocratic claim Institu-tional Shareholders Committee in the United to authority and specialised expertise (Useem, 1984). Kingdom, ADAM in France or Association of Critical At the same time as the professional manager is Shareholders (Dachverband der Kritischen grappling with major challenges, the nature of ownership Aktionarinnen und Aktionare) in Germany have played, is also undergoing a fundamental shift. With the increase amongst others, a major role in its expansion. of equity-based retirement financing, with the In general, the form taken by engaged investment develop-ment of employee stock plans, and with the and the influence it yields depend on the possibilities privatisation of numerous large enterprises around the inherent in pension law and shareholder rights. Studies world, the number of individuals who own shares has have shown that although institutional investor grown approximately tenfold to 250 million over the last engagement is increasing, its effect on corporate 20 years (to 2002). This increase is not limited to the conduct and performance is not straightforward (for an United States (85 million), but extends also to such non- overview, see Romano, 2002). The practice of offering traditional homes of individual share ownership as proposals to the general assembly has no significant Germany (18 million), and France (6 million, of which 2 effect (Del Guercio and Hawkins, 1999; Gillan and million are shareholding employees). Share-owning Starks, 2000); by contrast, engagement has a positive individuals in such large numbers signify a new force in effect when institutional investors use non proxy corporate governance, a force we call mass ownership techniques such as threats to sell and direct negotiations and wish to differentiate from dispersed ownership as with executives (Smith, 1996; Wahal, 1996). Further described by Berle and Means and assumed by many studies based on data from the 1990s until today should agency theorists (cf. Fama and Jensen, 1983a). show that the impact of investor engagement is If mass ownership led merely to a further dilution of increasing, as indicated by the number and public reach shareholdings, its consequences for managerial of recently contested cases (i.e. Eurotunnel, 2003, in governance in the publicly held company would be France and the UK; Mannesmann, 2004 in Germany; negligible. However, mass ownership and pension reform and Disney, 2004, in the United States). have given birth to a new class of institutional However, shareowners are not the only actors in the share-holders that is sufficiently well organised and emerging popular governance. Stakeholders as diverse intrinsically motivated to take its concerns to as unions, churches, NGOs and multilateral institutions

56 Regulation of Investment Advisors

The evolution of corporate governance and the procedures of democracy

19th century-1920s 1920s-1970s 1970s-21st century

Model of reference for Familial Managerial Popular corporate governance Economic Implementation. Reinforcement. Reinforcement. enfranchisement Creation of rights to Strengthened by law Strengthened by new ownership independent and corporate practice. rules on the right to vote; of social standing Public general meetings protection of minority become standard interests Separation of ownership/ No Implementation. Reinforcement. control Generalisation of the limited Increasing board liability form, with boards supervision over and disclosure requirements managers Representation No No Implementation. Mass with public ownership; stakeholder debate activism such as the United Nations Organisation are becoming market) and hedge funds can have radically different actively involved in the governance of corporations and opinions on how shareholder value ought to be created their views are of concern to both publicly owned and (Goodstein and Boeker, 1991; Sherman et al, 1998). Mass privately held businesses. In many cases, these ownership and stakeholder activism imply a diversity of stakeholders are reoccupying the space abandoned by expectations regarding the performance of the national governments in the successive waves of trade corporation, and managers need to address the different liberalisation and industry deregulation that concerns of stakeholder groups to gain and maintain the characterised the half-century following World War II consent that could be taken for granted in the heyday of (O’Sullivan, 2001). Non-shareowner stakeholders draw managerial governance. the legitimacy to speak out on corporate affairs from a Over the last 30 years, then, we can observe a struggle variety of sources: moral, political and also professional. for the right of representation and public debate in Whether shareowner or not, activist stakeholders share corporate governance. Characterised by mass ownership two characteristics: (a) they are vitally interested in the and growing stakeholder activism in all four of the future of corporations and (b) they are large enough in countries under consideration in this study, capitalism number and well organised enough to seek today makes much more open and intensive use of representation in corporate deliberations. debates and contests than it did in the past (Romano, As the visionary Peter Drucker foresaw many years 2002; Turnbull, 2002), and differences of opinion are ago (1976), managerial governance faces a crisis: how can subject to increasing media attention. managers whose very jobs are being redefined pretend Recent actions to raise the number and enlarge the to understand and act for the interests of many thousands role of independent directors (Higgs Report, UK, 2003; of increasingly well organised shareowners and other Bouton Report, France, 1999), to require funds to declare stakeholders? A view maintained by many in the 1990s how they vote in shareholders’ meetings (SEC, 2002; Loi suggested that the creation of shareholder value de modernisation, France, 2003) and to make the (managing for a higher share price) could reconcile the responsibilities of the executive versus shareholders and interests of all the different stakeholders of the third parties explicit (Sarbanes-Oxley, US, 2002), all go corporation (Jensen, 2001). The problem with this view in the direction of opening the institutions of corporate is that shareowners as diverse in character as employees, governance to the representation of different stakeholder pension funds, responsible funds (10 per cent of the US interests and to debate, especially in cases where major

57 strategic decisions are being contemplated. Executives underlie acceptable governance in modern society, are put under pressure by shareholders, analysts and Tocqueville hypothesised that democracy would become journalists to explain their actions (reports, road shows the model form of governance for all spheres of organised and interviews), not only in the United States, but also in activity. We have built on Tocqueville’s hypothesis, France, Germany and the United Kingdom. If executives demonstrating that corporate governance forms appear and members of the board make significant errors of to evolve in relation to the procedures of democracy and judgement, they are today increasingly likely to be are accepted (or contested) by the governed in reference questioned and, if they cannot prove that their choices to these procedures. Our review of how laws and practices were based on clear information and open debate of have developed over the last two centuries in the four different points of view, to be removed from office. In largest Western economies shows that corporate this questioning of executives and members of the board, governance has come to incorporate economic the extent to which decision-making procedures that enfranchisement, separation of powers and guarantee a separation of powers and an open, representation. In this sense, the procedures of democracy representative contest of ideas have been respected often can be said to constitute the deep structure (Gomez and carries as much, if not more weight than the outcome of Jones, 2000) of modern corporate governance. the decision itself. Considering the procedures of democracy as points of reference in the long-term evolution of corporate Democracy and corporate governance: governance forms opens new avenues for understanding An Overview differences and convergences among countries. From our In summary, we can say that the evolution of corporate conclusions, we can draw the contours of a research governance models with reference to Tocqueville’s programme in corporate governance that articulates a democracy hypothesis in the four countries under study comparative perspective around the procedures of has been accomplished in stages, with each new stage democracy. By comparing corporate governance forms integrating one more of the three defining elements of first within countries, then across countries, and finally democratic procedure and reinforcing what was in practice along the dimensions of enfranchisement, established in the previous stage (see Table 1 and separation of powers and representation, it will be accompanying explanatory footnote). The diachronic possible to elaborate on Tocqueville’s hypothesis and lens of analysis we have adopted demonstrates a link identify the boundary conditions of our approach. Three between the evolution of corporate governance and the specific research directions are suggested. application of democratic procedures. This is consistent Research direction 1: Diachronic analysis, country with Tocqueville’s hypothesis. A long-term view suggests by country. Implicit in our argument is the proposition that the need to achieve consent by the governed has that corporate governance co-evolves with political served to orient not only political and social governance, democracy. This is a hypothesis that can be tested and but also corporate governance. further developed by means of country-specific study. Indeed, it is necessary to tackle the question country by CONCLUSION country, taking into account not only the passing of Corporate governance depends upon consent by the formal laws and directives concerning corporate governed. If one contends with political economy that governance (Roe, 1991; Albert, 1993), but also the actual consent depends upon collective values centred upon practice of corporate governance in general meetings and fairness, then one cannot assume with agency theory that board rooms. It will be particularly interesting to compare profit is a sufficient condition for consent by the governed the different categories of ownership (entrepreneur, (although it is a necessary condition). Consistent with family, state, public, investment, etc.) with reference to modern research evidence that fair decision procedures the same social environment. The procedures of

58 Regulation of Investment Advisors democracy are likely to play out quite differently in the choices and corporations more likely to adopt solutions different categories, thus shedding light on alternative that have the robustness to stand the test of time. meanings and differential rates of adoption over time. Research conducted along the three directions Research direction 2: Synchronic analysis, across suggested here takes the procedures of democracy as the countries. Our development of Tocqueville’s hypothesis basis of comparing different forms of corporate suggests a way of reconciling different points of view on governance. Our research plan complements the the critical question of convergence of corporate traditional comparison by economic performance, governance forms across countries (Bratton and explicitly incorporating the country-specific collective McCahery, 2002; Guillen, 2000; Boyer, 1996). In our values necessary for consent by the governed. Reference view, convergence is a reality, because modern societies to the procedures of democracy also grounds the study all implicitly (or explicitly) build on the procedures of of corporate governance in a long-term, historical democracy as the model for fair governance. Functional perspective. In building the basis for objective convergence (Coffee, 1999) may have its proximate cause comparison along the dimensions of space and time, we in the imitation of fundraising practices (Davis and are proposing a return to the methodology that Marquis, 2002), but we would look for its underlying Tocqueville used to such powerful effect. drivers in the spread of democracy accompanying the It appears to me beyond doubt that sooner or later globalisation of capitalism. Conversely, profound, we shall arrive, like Americans, at an almost complete persistent differences in corporate governance between equality of conditions. I do not conclude from this that countries (i.e. Laporta et al., 1999) may not merely be we are destined one day necessarily to draw the the result of contingent path dependencies (Licht, 2000), political consequences the Americans have drawn but might be traced to country-specific differences in the from a similar social state. 1 am very far from relationship between political democracy and the believing that they have found the only form of adoption of democratic procedures in corporate government that democracy can give itself; but it is governance. enough that in the two countries the generative cause Research direction 3: Study of current corporate of laws and mores be the same, for us to have an governance reforms. The larger part of policy-oriented immense interest of knowing what has produced in discussion takes the extant form of institutions as given each of them. (DA intro. 12) and revolves around designing structural improvements. If such discussion were embedded in a broader historical Notes appreciation of the adoption of democratic procedures, 1. The shareowner’s claim to sovereignty has been advisors and policymakers alike might revise their called into question in socialist (Ellerman, 1992) and approach. The composition and functioning of the stakeholder (Turnbull, 1997) critiques. In capitalistic corporate board, for example, could not be reduced to economies, the owner of capital is granted property questions of expertise and (committee) independence. rights and sovereignty over the corporation by Rather, the role of the board, and with its role, also definition. We do not discuss the merits of this composition and functioning, would need to be examined definition, but take it as a starting point for this paper. in light of the board’s responsibility to the governed. The 2. The very fact that economists have deep divergences more pressure for democracy exerted by the governed at over what forms the basis of collective (ethical) a particular moment in time, the more representative the values, human nature (Hayek, 1960) or community board likely needs to be. In general, if corporate (Etzioni, 2003) underlines the salience of this governance were understood to evolve in the long term discussion in economics. with reference to the procedures of democracy, then 3. All citations are taken from the Mansfield and advisors and policymakers might be more likely to offer Winthrop edition (2000) of Democracy in America,

59 The University of Chicago Press, Chicago. DA stands a large block holder and differs from the large block for Democracy in America, followed by the book in holder traditionally seen in Germany and France in Roman numerals, the part, the chapter and the page several important ways: (1) is not associated with number. management; (2) is not represented on the board; 4. It is common to argue that the business corporation and (3) has no commercial relations with the cannot be governed by the techniques of democracy. corporation. These differences allow the engaged The distinctive character of the corporation in this investor to take a more independent view, but imply view is based on two premises: greater difficulty in making its voice heard. first, that the corporation, unlike other institutions 8. In interpreting the table, it is important to of society, is exclusively profit oriented and that remember the distinction between governance model stakeholders (i.e. shareholders) in the corporation, and ownership form. Over the last 200 years, unlike citizens, participate by choice and are always multiple ownership forms (family, partnership, free to exit. This view ignores that the profit-oriented cooperative, government, listed, etc.) have co-existed corporation exists only within the 1. limits of the and will undoubtedly continue to do so in the future. collective values accepted by individuals. Moreover, In fact, family-owned firms far outnumber all the it underestimates both the possibility of exit in civic other forms put together. However, the model of society (i.e. emigration) and the importance of voice reference for corporate governance for all these in all types of governance (Hirshman, 1970), different ownership forms has changed over time. including corporate governance. Thus, for example, the family-owned firm of today is 5. It is important to distinguish between form of not governed in the same way as it was in the 19th ownership and governance model. Evidence from century. Instead, corporate governance in the France and Germany (cf. Bourguignon and Levy- familyowned firm of the 21st century is likely to Leboyer, 1988; Berghahn, 1985) shows that the integrate separation of ownership and (nonfamily) managerial model (strong management; professional management, a board of directors uninvolved ownership) also obtains under conditions including non-family members, a significant of concentrated shareholdings. In France and amount of disclosure, and an explicit policy for Germany, the most typical case has been that of large responsiveness to stakeholders. (block) holdings that do not exert their influence, either because the individual firm is only one of many References in a bank or insurance company’s vast portfolio, or Aguilera, R. V. and Jackson, G. (2003) The Cross because the owners have no competence or interest National Diversity of Corporate Governance: in the management of the companies they hold (e.g. Dimensions and Determinants, The Academy of stateowned companies). Management Review, July. 6.It is worth noting that national governments have Albert, M. (1993) Capitalism vs. Capitalism. New York: played a central role in shaping the institutions of Four Walls Eight Windows. managerial governance, as shown by Roe (1994) and Alchian, A. A. and Demsetz, H. (1972) Production, Coffee (2001) for the case of the Anglo-Saxon Information Costs, and Economic Organization, economies, Gomez (2002) for the French, and American Economic Revieiw, 62, 777-795. Berghahn (1985) for the German. As the nation state Alessi de, L. (1983) Property Rights, Transaction Costs has come under pressure from globalisation, so have and the X-efficiency, American Economic Revieiv, the institutions of managerial governance that the 73, 64-81. nation state helped create. Arrow, K. J. (1951) Social Choice and Individual Value. 7. The engaged (institutional) investor is typically not New York: John Wiley.

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Corporation. New York: McGraw-Hill, 97-117. Licht, A. (2000) The Mother of all Path Dependencies: Hess, G. D. and Orphanides, A. (2001) War and Toward a Cross-Cultural Theory of Corporate Democracy, Journal of Political Economy, 109, 776-809. Governance Systems, Delaware Journal of Hirschman, A. O. (1970) Exit, voice, and loyalty: Corporate Law, 26, 147. Responses to decline in firms, organizations, and Lind, E. A., Erickson, B. E., Friedland, N. and states. Cambridge: Harvard University Press. Dickenberger, M. (1978) Reactions to Procedural Holmstrom, B. and Tirole, J. (1989) The theory of the Models for Adjudicative Conflict Resolution: A Cross- firm. In R. Schmalensee and R. Willig (eds) National Study, Journal of Conflict Resolution, 22, Handbook of Industrial Organization. Amsterdam: 318-341. North-Holland, 61-133. Lind, E. A. and Tyler, T. R. (1988) The Social Huntington, S. (1991) The Third Wave. Democra-tization Psychology of Procedural Justice. “New York: in the Late Twentieth Century. Norman, OK, and Plenum Press. London: University of Oklahoma Press. Mackie, G. (2003) Democracy Defended. Cambridge: Jensen, M. (2001) Value Maximization, Stakeholder Cambridge University Press. Theory, and the Corporate Objective Function. Mandeville, B. (1723) The fable of the bees, or, Private Working paper, Harvard University. vices, publick benefits. London: Edmund Parker. Jensen, M. C. and Meckling, W. H. (1976) Theory of March, J. G. (1978) Decision in organizations and the Firm: Managerial Behavior, Agency Costs, and theories of choice. In A. Van de Ven and W. Joyce Ownership Structure, Journal of Financial (eds) Perspective on Organization Design and Economics, 3, 305-360. Be-havior. New York: John Wiley, 205-244. Joly, H. (1996) Patrons Allemands. Paris: Presses de Marshall, T. M. (1987 [1949]) Citizenship and Social Sciences Politiques. Class. New York: Pluto Press. Kaeble, H. (1990) Sozialstruktur und Lebensweisen McGuire, J., Sundgren, A. and Schneeweis, T. (1988) deutscher Unternehmer 1907-1927, Scripta Corporate Social Responsibility and Firm Financial Mercaturae, 24,151. Performance, Academy of Management Journal, 31, Kaufman, A. and Zacharias, L. (1992) From Trust to 854-872. Contract: The Legal Language of Managerial Mizruchi, M. (1983) Who Controls Whom? An Ideology, 1920-1980, Business History Review, 66, Examination of the Relation Between Management 523-560. and Boards of Directors in Large American Korine, H. and Gomez, P.-Y. (2002) The Leap to Corporations, The Academy of Management Globalization: Creating New Value from Business Review, 8, 433. without Borders. San Francisco: Jossey-Bass. Monks, R. (1998) The Emperor’s Nightingale: La Porta, R., Lopez de Silanes, F. and Shleifer, A. (1999) Restoring the Integrity of the Corporation in the Age Corporate Governance Around the World, journal of of Shareholder Activism. Reading, MA: Addison- Finance, 54, 471-517. Wesley. Leung, K. and Lind, E. A. (1986) Procedural Justice Monks, R. and Minow, N. (1995) Corporate and Culture: Effects of Culture, Gender, and Gover-nance. Cambridge, MA: Blackwell. Investigator Status on Procedural Preferences, North, D. C. (1973) The Rise of the Western World. Journal of Personality and Social Psychology, 50, Cambridge: Cambridge University Press. 1134-1140. O’Sullivan, M. (2001) Contests for Corporate Control Levy-Leboyer, M. (1985) Le patronat a-t-il echappe a - Corporate Governance and Economic la loi des trios generations?, Le Mouvement Social, Performance in the United States and Germany. 132, 3-7. Oxford: Oxford University Press.

63 Pound, J. (1988) Proxy Contests and the Efficiency of (1998) Institutional Investor Heterogeneity: Shareholder Oversight, Journal of Financial Implications for Strategic Decisions, Corporate Economics, 20, 237-265. Governance, 6,166-173. Pound, J. (1989) Shareholder Activism and Share Smith,M. (1996) Shareholder Activism by Institutional Values: The Causes and Consequences of Counter Investors: Evidence from CalPERs, Journal of Solicitations Against Management Anti-takeover Finance, 51, 227. Proposals, Journal of Law and Economics, 32, 357-379. Soltan, K. E. (1987) The Causal Theory of justice. Rawls, J. (1971) A Theory of Justice. Cambridge, MA: Berkeley, CA: University of California Press. Harvard University Press. Stahl, W. (1973) Der Elitekreislauf in der Rippert, G. (1951) Aspects juridiques du capitalisme Unternehmen-schaft. Frankfurt: Harri Deutsch. moderne, Presse Universitaire de France: Paris. Stanworth, P. and Giddens, A. (1974) An economic Roe, M. J. (1991) A Political Theory of American elite: a demographic profile of company chairmen. Corporate Finance, Columbia Law Review, 91, 10-67. In Elites and Power in British Society, 81,101. Roe, M. J. (1994) Strong Managers, Weak Owners: Cambridge: Cambridge University Press. The Political Roots of American Corporate Finance. Thibaut, J. and Walker, L. (1975) Procedural Justice: Princeton, NJ: Princeton University Press. A Psychological Analysis. Hillsdale, NJ: Erlbaum. Roe, M. J. (2000) Political Foundations for Separating Tocqueville, A. de (2000 [1830]) Democracy in Ownership from Corporate Control, Stanford Law America, edited by H. Mansfield and D. Winthrop, Review, 53, 539. Chicago: The University of Chicago Press. Roe, M. J., Ramseyer, J. M. and Romano, R. (1993) Turnbull, S. (1997) Corporate Governance: Its Scope, Some Differences in Corporate Structure in Concerns and Theories, Corporate Governance, 5, Germany, Japan, and the United States, Yale Law 180-205. Journal, 102,1927-1950. Turnbull, S. (2002) New Way to Govern: Organization Romano, R. (2002) Political foundations for separating and Society after Enron. London: NEF. ownership from corporate control. In J. McCahery, Tyler, T. (1990) Why People Obey the Law. New P. Moerland, T. Raaijmakers and L. Renneboogal Haven: Yale University Press. (eds) Corporate Governance Regimes: Convergence Useem, M. (1984) The Inner Circle: Large and Diversity. Oxford: Oxford University Press, 507- Corporations at the Rise of Business Political 566. Activity in the U.S. and U.K. Oxford: Oxford Rueschrneyer, D., Stephens, E. H. and Stephens, J. D. University Press. (1993) Capitalist Development and Democracy. Veblen, T. (1921) The Engineers and the Price System. Chicago: University of Chicago Press. New York: Viking. Schmitt, C. (1988 [1927]) Crisis of Parliamentary Wahal, S. (1996) Pension Fund Activism and Firm Democracy. Cambridge, MA: MIT Press. Performance, Journal of Financial and Quantitative Schumpeter, J. (1987 [1942]) Capitalism, Socialism, Analysis, 31, 1-23. and Democracy. New York: HarperPerennial. Wartick, S. and Cochran, P. (1985) The Evolution of Sen, A. (1970) Collective Choice and Social Welfare. the Corporate Social Performance Model, The San Francisco: Holden-Day. Academy of Management Review, 10, 758-769. Sen, A. (1989) On Ethics and Economics. London: Weber, M. (1947 [1922]) The Theory of Social and Blackwell. Eco-nomic Organization. New York: Tr. Henderson Sen, A. (1997) Choice, Welfare and Measurement. and Parsons. Cambridge, MA: Harvard University Press. Whitley, R. (1999) Divergent Capitalisms: The Social Sherman, H., Beldona, S. and Maheshkumar, J. P. Structuring and Change of Business World, Journal

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of Finance, 54, 471-517. Yin, R. (1984) Case Study Research. Glendale, CA: Sage.

Pierre-Yves Gomez is a full professor of Strategic Management at EM Lyon (France). He is director of the French Corporate Governance Institute. His research focuses on micro-economic and political foundations of management science. He has been conducting research on new micro-economic models on collective utility functions and their application to strategy and organization. He is currently working on the links between corporate governance and strategy. He has published several books in French and English including Trust, Firm and Society (1997) and The Leap to Globalization (2002) and articles on economics and strategy.

Harry Korine is a Teaching Fellow in Strategic and International Management at the London Business School and a Senior Research Fellow at the French Corporate Governance Institute. His academic research and investment management practice bridge the fields of corporate governance and strategic management. Together with Pierre-Yves Gomez, he is currently working on a new book “A General Theory of Corporate Governance”, scheduled for publication in 2006 by Cambridge University Press.

65 ANNEXURE - II REGULATION OF RELATIONSHIPS - THE ROLE OF SELF-REGULATION IN BUILDING TRUST PAUL C. BOURQUE, SENIOR VICE-PRESIDENT, MEMBER REGULATION INVESTMENT DEALERS ASSOCIATION OF CANADA

MAY 30, 2005

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THE NEED FOR EXCELLENT INVESTMENT enforcement action. The broad application of the rules, ADVISORS combined with limited enforcement resources ensures that If the goal of the excellent investment advisor is to create only the most serious misconduct, conduct that is wealth for their clients through relationships based on undeniably not in the public interest or is beyond any doubt trust, then it seems obvious that regulators should do “conduct unbecoming” is dealt with by regulators. whatever falls within their mandate to promote excellent On the other hand, self-regulators can set standards investment advisors. While investment firms seek to for their members that exceed the provincial minimum employ excellent investment advisors to distinguish standards. To the extent that that these standards are themselves from the competition, and clients look to voluntarily imposed and informed by close and intimate excellent investment advisors to help them achieve their knowledge of financial markets and client needs, they can life financial goals, regulators should examine the tools attract a higher level of adherence than those imposed they have to support the excellent investment advisor as by provincial legislation. The highest and best role for well, because it is entirely in their interests to do so. self-regulation is to bridge the gap between the The excellent investment advisor achieves trusting journeyman and the excellent investment advisor - relationships with his or her clients by acting with integrity between what is merely required to stay out of trouble and proficiency. Trust is earned in a relationship forged over and what is required to enable clients to achieve their time. This standard of behavior is not essential in order to financial goals through a relationship based on trust. survive in the investment industry. Saintly behavior is not Regulators often speak about public confidence and required to avoid regulatory sanction, however, the their role in restoring lost confidence in the capital avoidance of regulatory sanction is hardly a commendation1. markets. While this is an important issue, what the Between the merely competent (the journeyman), and public expects from the regulator and from their advisor the excellent investment advisor, there is a chasm of are quite different. The public wants to be assured that ethical and proficient behavior which regulators and the regulator is able to detect and discipline misconduct especially self-regulators should strive to bridge. in a timely and effective way. The clients’ expectations Excellence is not essential to avoid censure, however, of their advisor are significantly higher and more investors are best protected and markets most efficient personal. In the same way that firms do not recruit when those on the front line, in their day to day dealing “average” advisors, clients do not seek “mediocre” with their clients do so in relationships of trust. advice. Very simply, it is the advisor the investor has entrusted with his or her life savings, not the regulator. THE LIMITS OF REGULATION The public expectation of the excellent investment The objectives of regulation are limited. Regulation seeks advisor is that their capital will be put to work in the to protect investors by providing market participants with most advantageous way possible in order to achieve clear expectations, consistent regulatory processes and their financial goals. The public is not primarily predictable regulatory results. The regulators seek to achieve interested in the arcane world of securities regulation, these outcomes with compliance (rules and examinations) nor should they be. This indifference can easily turn to and enforcement (investigations and prosecutions). The alarm, however, if something goes wrong. rules, consisting of provincial laws and regulation, describe a minimum level of ethical and competent behavior for all THE EXCELLENT INVESTMENT ADVISOR market participants and intermediaries. When behavior falls AND THE JOURNEYMAN below the minimum standards, regulators may take What distinguishes the excellent investment advisor from

1We know from the analysis of client complaints reported to the IDA on ComSet that 93% of all registrants have no complaints made against them. We know that 98% of registrants have less than two complaints. This leaves 2% of registrants with two or more complaints. In addition client surveys have consistently demonstrated a high level of overall satisfaction with financial advisors. In the past nine years the Securities Industry Association annual survey has shown that 85% to 96% of clients are somewhat satisfied or very satisfied with their advisor. Securities Industry Association - 2004 Annual Investor Survey, http://www.sia.com/research/

67 the journeyman? The Excellent advisor knows that: (1) “Its where her work ethic, her courage, her deep money management and investment advice is not a knowledge of the business and ofmarkets, and her product, it’s a service, (2) investments are a means to an passionate commitment to underselling all get to end, not an end in themselves, and (3) no future shine Just as the journeyman’s all-roses-no-thorns investment outcome can be guaranteed. The excellent presentation instantly arouses a good prospect’s advisor provides professional advice to achieve the clients suspicions, the excellent advisor’s straight-arrow, long-term financial objectives and in so doing, both the no-holds-barred presentation convinces the prospect client and investor are committed to assuming some level to trust her.2" of risk. The excellent advisor knows that the client’s long If the excellent advisor is to thrive in a competitive term financial goals cannot be achieved without risk, and environment, then their commitment to high standards that the client will not make the commitment to risk in of ethics and proficiency must be supported by their self- the absence of a relationship of trust. The degree of regulator. The standards must describe behavior beyond commitment to risk is a personal decision by the client the minimum and enforcement of those standards must that only comes after a careful and knowledgeable demonstrate the value of excellence. The excellent advisor discussion of what the nature and level of risk is presented not only expects their self-regulator to protect clients by any particular investment. The excellent investment generally from misconduct, but also their business from advisor knows that obtaining the client’s commitment to the damage caused by rogue advisors and firms. risk and obtaining the clients trust go hand in hand. According to one advisor, “Some people do bad things Because of this understanding, the excellent and find ways to get away with it, and the rest of us pay. investment advisor behaves differently than the It is almost impossible to do business.3” journeyman. Where the excellent investment advisor is If this is the kind of behavior that distinguishes the focused on building relationships, the journeyman is excellent investment advisor from the journeyman, what content to focus on transactions. The excellent can self regulators do to promote this type of behavior? investment advisor follows his clients’ lives while the journeyman follows markets. The excellent investment THE ROLE OF SELF-REGULATION IN advisor listens to his client to ensure sufficient capital PROMOTING EXCELLENCE has been invested in order to make their goals a reality. Self-regulation, to be effective, requires significant The journeyman spends his time picking the “right” voluntary compliance by market participants. Self- mutual funds. The excellent investment advisor returns Regulators rely on the firm to supervise its employees, calls promptly and prefers face-to-face meetings. The report client complaints, maintain adequate capital and journeyman communicates with his clients infrequently hire proficient and honest employees. Voluntary and then usually by phone. compliance with high standards is premised on an The excellent investment advisor genuinely assumption that the industry and the public have shared distinguishes themselves from the journeyman when they objectives: the public’s requirement to be protected from explain how the long term financial goals of his client unscrupulous individuals, and the industry’s need to run will be achieved, how particular investments “fit” into the profitable, effective, ethical businesses. This alignment plan, how particular investments work and the risks. The creates strong incentives to comply where firms and most difficult discussion concerns risk. Where the individuals are concerned about their reputation. journeyman is afraid that if he’s candid, the client may Self-regulatory standards are developed with walk, the excellent investment advisor uses this extensive and early industry consultation and review. The discussion as an opportunity to build trust: standards are approved by the SRO board which has high-

2 Nick Murray, The Excellent Investment Advisor, 1996, at p.245 3 Investment Executive, Brokerage Report Card, May 2005, p. C14.

68 Regulation of Investment Advisors level industry participation. This role in policy variety of ways: by setting high proficiency and ethical development gives the standards a high level of legitimacy standards, by providing effective client compensation and “buy-in” that is essential for self-policing. If the rules systems, ensuring effective supervision and by enforcing are seen as practical and fair, they will command a high the rules in a clear, consistent and predictable fashion. level of respect resulting in wide-spread voluntary compliance. PROFICIENCY STANDARDS One of the primary justifications for self regulation is SRO’s have identified the need for higher proficiency the ability to set and monitor higher standards than are standards for their members than those prescribed in provided for in securities legislation. Take for example, provincial securities legislation.5 These standards are the the requirement to update client account information. subject of ongoing review and development by the SRO’s. There are no legislative requirements in this regard. The They are a key component in assessing whether an Mutual Fund Dealers Association has a rule that requires advisor is suitable for approval. updating of know-your-client information to include any All new advisors must take the Canadian Securities material changes in circumstances and to annually ask Course as well as the Conduct and Practices Handbook each client if the know-your-client information is up to course. Once on the job, all new advisors must take a 90 date.4 The IDA has no similar rule, however, many IDA day in-house training program, be under supervision for firms voluntarily update client account information six months and successfully complete the Professional according to a variety of criteria. The IDA, as part of Fair Financial Planning Course within thirty months. On the Dealing Model implementation, will bring in a rule to compliance side, there are minimum experience correspond to the MFDA rule in order to harmonize this requirements as well as a mandatory course for all higher standard for SRO members. Another good partners, directors and officers of investment dealers, for example of the value SRO’s can bring to policy making is Branch Managers, Assistant Branch Managers, Co- in the area of prospectus disclosure. The prospectus is a Branch Managers and Sales Managers. In addition, complex document and difficult for the average investor traders and Chief Financial Officers must successfully to understand. It is, however, the cornerstone of the complete a course of study and pass a qualifying exam. legislative disclosure scheme. There are other less In addition, an advisor who is primarily engaged in complex but unsanctioned summaries of the prospectus providing continuous investment advice to clients must provided by the fund company to the advisors. These complete the Canadian Investment Management would probably be far more useful to investors but Program and the Chartered Financial Analyst course. All advisors run a regulatory risk in providing them to clients. of these programs are developed and sponsored by SRO’s Thus, prescriptive regulation in some ways drives the or their related organizations.6 excellent advisor into non-compliance in order to assist The work of industry supported education providers their clients. Not only should self regulators be identifying like the Canadian Securities Institute has been enhanced and implementing higher standards, but they should also by the key involvement of the SROs in setting and identify where current standards actually reduce overseeing proficiency standards development and compliance and investor protection. implementation. The SROs ongoing consultation process Self-regulation promotes voluntary compliance in a with the industry and its cooperation with the various

4 2.2.4 Updating Know-Your-Client Information (a) The Form documenting know-your-client information must be updated to include any material change in client information whenever a Member or Approved Person or other employee or agent becomes aware of such change pursuant to Rule 2.2.4(b). (b) Without reducing the responsibility of Members in Rule 2.2.1, all Members must at least annually, in writing, request each client to notify the Member if the know-your-client information previously provided to the Member or the client’s circumstances have materially changed. The date of such request and the date upon which any such client information is received and recorded or amended must be retained. 5 IDA Policy 6 – Proficiency and Education sets out the proficiency requirements for al categories of approved persons. 6 For example the Canadian Securities Institute, Assoc. for Investment Management and Research Investment Funds Institute and Institute of Canadian Bankers.

69 provincial commissions has enabled a more harmonized its reputation. Recently market timing of mutual funds approach and a gradual increasing of standards.7 enforcement actions were brought by the IDA, OSC and MFDA. There is no rule that specifically prohibits market ETHICS timing of mutual funds, nor is it illegal per se as for Everyone knows that ethical behavior cannot be imposed instance insider trading or market manipulation. The by rules alone. It can, however, be identified, rewarded reaction of some firms, when challenged concerning this and ultimately made part of a firm’s culture and practice was “show me the rule.” 9 reputation. SRO’s can provide critical support for firm Here is another way to look at it: efforts to manage reputation risk through continued “Say you are examining a new financing technique, development of ethics training. a novel financial instrument or an innovative trading Compliance failures occur when ethical dilemmas go strategy. Your firm is going to profit handsomely and unrecognized or unresolved in the firm. Typically, ethical perhaps a few selected clients as well. But the bulk of dilemmas arise in the absence of clear standards that investors will be disadvantaged, your interests will require advisors to call upon underlying values and ethics: come ahead of most of your clients, and you have “Recognizing uncertainty is both realistic and been repeatedly warned that the activity is harmful healthy. The question must be asked then, what do to unit holders or shareholders. Well my advice is to individuals and firms do when no clear regulatory pause. Then ask yourself whether you are doing the answer exists? It may well be that an individual is right thing and whether your self-regulator will faced with a customer and has to make a decision agree.” 10 without time to refer to rules online or to seek the The difference between the excellent investment opinion of others. In moments of pressure they are advisor and journeyman is their response to ethical very much alone. In such situations the author decisions in the absence of a black letter standard. The suggests that individuals fall back on a distillation excellent investment advisor views all such decisions in of the regulation that they are aware of and the context of their relationship with their client; will this comfortable with - a general impression or be beneficial or corrosive of the trust I have developed instinctive reaction about the general philosophy and with my client? Will this activity strengthen or weaken course of FSA ‘s thinking. Resort to underlying values my client’s commitment to risk? and ethics will help sort our priorities and decisions. The difference between excellent firms that are Value judgments are made far more often than is concerned about their reputation and those that are not is admitted, and are very influential in steering in their commitment to helping their employees understand individual decisions. The questions may be very when they may be confronting an ethical dilemma where basic, e.g., on commission income or best advice, it the rules don’t help, and then providing them with a is how dilemmas are resolved which has tremendous straightforward construct to help them work through the impact on the quality of regulation and the delivery dilemma. Firms with a commitment to their reputations of consumer protection, market confidence, the and providing an environment within which the excellent reduction of financial crime and the improvement investment advisor can thrive, provide the framework within of consumer awareness.”8 which ethical dilemmas can be resolved: Is the activity legal? Resolving ethical dilemmas in the absence of a black Is the activity fair? Am I prepared to disclose the activity to letter rule is the litmus test of a firm’s ability to protect my supervisor, my client, or my family?

7 Canadian Securities Institute, Discussion Paper on Competency, December 2004, at p.5 8 David Jackman, Why Comply? Volume 9, Journal of Financial Regulation and Compliance, p.211 at p.212 9 Unnamed sources claim – “we didn’t actually do anything illegal,” and “we didn’t actually breach any securities laws or rules,” that the OSC and IDA are trying to extract confessions from fund firms and brokers for a crime “that does not exist” and pay fines or restitution to investors “for having committed non-existent crimes - National Post, November 27, 2004 – “IDA targets firms over moral duty”; National Post, December 1, 2004 – “Brokerages reach $30M settlement with regulator” 10 Joe Oliver, “Partners in Compliance”, Opening remarks to SRO Conference, Toronto, January 2005.

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Firms committed to excellent employees provide SUPERVISION consequences for both ethical and unethical behavior. No matter what proficiency requirements self regulators Firms that worry about their reputation identify the impose to help shape individual ethical sensibility, they behavior it wants to encourage. They provide positive will not - by themselves - be sufficient. Regulation is not reinforcement for ethical conduct. They provide negative just a matter of pointing in a direction; it is also a matter consequences for unethical behavior. It is not enough to of ensuring we get there. Supervision infrastructure is do this at the annual performance review. It has to be essential to confirm to the management, employees and done every day with every employee. the public that ethical standards are being reinforced. This process of day-to-day reinforcement of ethical The IDA has implemented accountability by the firm behavior is in fact what defines a firm’s reputation for for compliance with a “reporting up” compliance excellence. If a firm has a reputation for unethical framework. The objective is to identify compliance behavior that is because, as an organization, the firm responsibility with senior management personnel. Every reinforces unethical behavior either actively by perverse member firm must designate its CEO, President, COO or financial incentives or inactively by simply failing to CFO to act as the Ultimate Designated Person (the UDP) recognize and reward ethical behavior. Ultimately every who is responsible for the conduct of the firm and the firm depending on the behavior it reinforces will develop supervision of its employees. In addition, every member and maintain its reputation among its peers and the firm must appoint an Alternate Designated Person (the public. The firm’s reputation will be a key factor in ADP) who shall be approved to act as Chief Compliance attracting excellent investment advisors.11 Officer (CCO). The CCO must also report to the board of In 1994, as the securities industry began to transition directors of the member as necessary, but at least from a transaction-based to an advice-based business, the annually, concerning the status of compliance.13 The IDA introduced a Code of Ethics and new content about board of directors must review the compliance report, the evolving nature of the broker/client relationship, determine what action is necessary to address any featuring case studies. Industry entrants were taught that deficiencies and ensure those directions are carried out.14 rules and regulations are based on important ethical The mandate of the CCO is to provide to the board of concepts - that the client comes first, advice must be directors reasonable assurance that standards of the suitable, and disclosure should be fulsome. These are rules applicable self-regulatory organization are met.15 based on the principles of trust, integrity, honesty and In this way, the IDA seeks to support the Chief fairness. In 2003, the Canadian Securities Institute Compliance Officer as an important internal gatekeeper. strengthened their program regarding ethical education. In “Understanding Enron: Its About Gatekeepers, A new examinable course in Applied Ethics in the Stupid”, John C. Coffee, Jr. describes the failure of Enron Securities Industry was developed by separating the ethics as the failure of independent auditors and securities content from the Conduct and Practices Handbook. This analysts to perform their gatekeeper function, but his course uses examples from the industry and has its own comments about the role of gatekeepers is directly separate, case-based examination. applicable to securities firm compliance officers: In the year 2000, the IDA introduced mandatory “Inherently, gatekeepers are reputation continuing education requirements, which, for the intermediaries who provide verification and compliance requirement includes ethics training.12 certification service to investors. These services can

11 In this year’s survey of advisors the most important attribute of their firm was the firm’s ethics. Investment Executive, Brokerage Report Card, May 2005. Interestingly compensation ranked only seventh. 12 IDA Policy 6 – Part III – The Continuing Education Program 13 Ibid, s.38.8 14 Ibid, s.38.9 15 An alternative approach to the IDA structure of two levels of compliance reporting up to the board is contained in the recently published NASD Rule 3010 that would require the CEO and CCO certify annually the adequacy of compliance systems in achieving compliance with all applicable NASD rules, MSRB rules and federal securities laws and rules. In its comments on the proposal, the Securities Industry Association recommends the adoption of a requirement for mandatory meetings with senior management similar to the provisions in IDA By-Law 38.

71 consist of verifying a company’s financial statements cheaper, faster process for achieving a binding resolution (as the independent auditor does), evaluating the to a dispute than can be provided by the courts. creditworthiness of the company (as the debt rating In 2003, the Mutual Fund Dealers Association and agency does), assessing the company’s business and the Investment Dealers Association mandated their financial prospects vis-a-vis its rivals (as the members to participate in the Ombudsman for Banking securities analyst does), or appraising the fairness and Investment Services (OBSI). The OBSI is a national, of a specific transaction (as the investment banker independent, free service which will investigate client does in delivering a fairness opinion). Compliance complaints and prepare a non-binding recommendation officers are gatekeepers who verify the firm ‘s that is made public if the firm declines to follow it. compliance status. 16” Finally, the industry has developed a comprehensive If an SRO is to fulfill its objective of promoting high fund for the protection of client assets in the event of a standards, it must be able to not only monitor those member’s insolvency. The protection covers all accounts standards through firm compliance reviews, but provide at member firms and all assets in those accounts up to $ incentives for setting and supervising high standards. 1 million per account. Again, this far exceeds any Take for example the requirement to keep client account provincial or federally sponsored financial services client information updated. The firm may set a standard that protection fund. exceeds both the provincial and SRO standard. The SRO, The Canadian Securities Institute, the Ombudsman when it monitors compliance with internal firm standards for Banking and Investment Services, the National that exceed both provincial and SRO standards should Arbitration System and the Canadian Investor Protection incorporate this information in its overall risk assessment Fund are all industry-developed and funded solutions to of the firm. Higher standards, effectively supervised, issues relating to investor protection and compensation reduce risk. The overall risk score of the firm should and demonstrate a commitment to excellence and high determine the frequency and intensity of the on-site standards. These institutions are integral to the ultimate examinations. The lower the risk, the less frequent and commitment to risk by the client. intensive the regulatory intervention. This should reduce the cost of regulation for the firm. The SRO risk RULES AND CONSEQUENCES assessment process should continually feed back to the It is important to have high standards, but the public is firm incentives for setting high standards and result in interested in how those standards are enforced when reduced regulatory burden. things go wrong. The value of self-regulation in this If however, supervision fails, there have to be respect is the use of peer discipline in upholding remedies for clients and consequences for the advisor standards. who fail to achieve appropriate standards. Effective and The standards that regulate the advisor/client timely client compensation and consequences for relationship describe principled behavior. One of the misconduct represent the costs avoided by the excellent objects of the IDA, as described in the Constitution, is to investment advisor and confirm his or her commitment “encourage through self-discipline and self-regulation a to high standards. high standard of business conduct among Members and to adopt, and enforce compliance with, such practices and CLIENT COMPENSATION requirements as may be necessary and desirable to guard In 1996, the Investment Dealers Association mandated against conduct contrary to the interests of Members, participation by their members in the IDA’s national their clients or the public.” At a more detailed level, the arbitration program. The program is mandatory for by-laws require members to “observe high standards of member firms but not for their clients and provides a ethics and conduct in the transaction of their business, 16 John C. Coffee Jr, “Understanding Enron: Its About Gatekeepers, Stupid”, at p.5, Social Science Research Network, http://ssrn.com/abstract_ID=325240

72 Regulation of Investment Advisors not to engage in any business conduct or practice which A RENEWED FOCUS ON THE REGULATION is unbecoming or detrimental to the public interest17 and OF RELATIONSHIPS supervisors to ensure the handling of client business is In January 2004, the Ontario Securities Commission within the bounds of ethical conduct, consistent with just published their Fair Dealing Model Concept Paper. While and equitable principles of trade.18 The opening section the editorial tone of the Concept Paper elicited much of the IDA Disciplinary Sanctions Guidelines states,. comment and controversy, there was no disagreement with “Approved persons must above all conduct themselves the underlying assumption upon which the with trustworthiness and integrity and act in an honest recommendations were based - firms have shifted from and fair manner in all their dealings with the public, their transaction-based business models to advisory business clients, and the securities industry as a whole.” models. Most major financial services firms have Employees are expected to behave in a principled developed similar strategies of expanding their client fashion, and firms are expected to supervise their relationships as widely as possible to manage a broad range employees to ensure they are living up to these standards. of the client’s financial needs.19 This conclusion was not When either fails, administrative discipline is appropriate. new. The excellent investment advisors were already there: Discipline is administered at the IDA by panels “Make no mistake about it: in the future, success in composed of two industry panelists (frequently retired this business will be a pure function of the openness, from the industry) and a public chair (a legally trained candor and mutual respect between the advisor and person, often a retired judge). The allegations are his client. This was always supposed to be a business published and notice of the time and place of the hearing of relationships, and for many it was. But now its no are distributed to the media. The hearings to determine longer an option: he who forges the best relationship the merits of the allegations, or to approve a settlement, - that is engenders the most trust - will control the are public. Transparency is essential not only to assure account... ..for a long, long time20 the public that the rules are being enforced but also to The latest industry statistics support this slow but steady make sure that honest market participants know that trend: breaking the rules does not result in a competitive “Back in 1995, the average broker had less than $34 advantage. Peer discipline ensures the standards used to million in assets under management and was impose sanctions are administered by a tribunal that has managing a roster of about 375 clients. Today, the both industry and legal expertise to sort out the facts and client list is shorter, but the asset base is much bigger. principles. When discipline is meted out by a panel that The average broker now has more than $68 million understands the business, the decisions achieve a higher in AUM, more than double what it was a decade ago. level of understanding and respect. But the client roster is much shorter, with an average The public is naturally skeptical about the dedication of 305 clients on the books.21” of a self regulator to producing enforcement results. The Fair Dealing Model Concept Paper argues that if the Preconceived notions.of self regulatory discipline business model is based on relationships, then the role consisting of some informal private process of light of regulation is to support the creation of relationship reprimands are easily answered by the actual results. For based on trust by implementing rules based upon the example, the IDA discipline statistics for 2004: 74 public following principles: discipline hearings resulting in $41 million in fines • Roles and responsibilities should be clearly defined, against firms, $5.5 million in fines against individuals • All dealings should be transparent, and and 17 permanent bars. • Any conflicts of interest should be managed to avoid

17 IDA By Law 29 – Business Conduct 18 IDA Regulation 1300.2 (a) – Supervision of Accounts 19 Fair Dealing Model Concept Paper, January 2004 at p.8 20 Nick Murray, The Excellent Investment Advisor, 1996, at p.18

73 self serving outcomes.22 The CSA has recognized the essential role that SRO’s must play in the implementation of standards that will serve to further strengthen the ability of the excellent advisor to build relationships based on trust. In September 2004, the CSA made the implementation of the key principles of the Fair Dealing Project a national initiative. In an unprecedented move the CSA project steering committee selected steering committee members from the SRO’s and industry as well as the CSA. In addition, the final rule drafting will be done by a committee of the IDA and MFDA (with CSA observers). The SRO committee will determine how the key concepts of the Fair Dealing Model can be crafted into SRO rules, and in the process, achieve higher standards.

CONCLUSIONS The goal of the excellent investment advisor to obtain client commitment to risk in a relationship based on trust is entirely consistent with the goal and rationale of SRO’s: to develop and support standards that exceed those provided for in provincial legislation of market participants generally. SRO’s are well positioned to carry out this task through rule making informed by practical industry knowledge, sophisticated proficiency standards, effective client redress, risk-based compliance and public discipline. Excellence is a much overused attribute. It is sometimes applied to mundane and inconsequential tasks, however, in building relationships of trust and assisting investors achieve their financial goals, nothing less will serve. Self-regulators should do everything they can within their mandate to support excellent investment advisors.

21 Investment Executive, May 2005 p.C6 22 Fair Dealing Model Concept Paper January 2004 at p.18

74 Regulation of Investment Advisors

ANNEXURE - III HIGH COURT JUDGMENT: HONG KONG SPECIAL ADMINISTRATIVE REGION ON ROLE OF INVESTMENT ADVISORS

75 CACV 194/2003 IN THE

HIGH COURT OF THE HONG KONG SPECIAL

ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO. 194 OF 2003

(ON APPEAL FROM HCA NO. 7119 OF 2000)

BETWEEN

SUSAN FIELD Plaintiff

AND

BARBER ASIA LIMITED Defendant

Coram: Hon Rogers VP, Le Pichon JA and Sakhrani J in Court

Date of Hearing: 15 July 2004

Date of Judgment: 15 July 2004

Date of Handing Down Reasons for Judgment: 1 September 2004

REASONS FOR JUDGMENT

76 Regulation of Investment Advisors

Hon Rogers VP: changed over time, and that by the time that the 1. I agree with the judgment of LEPICHON JA investment now complained of was entered into, Ms Field wanted (or at least was prepared to accept) a Hon Le Pichon JA: strategy that was much riskier in order to obtain the 2. This is an appeal from the judgment of the Deputy High prospect of better returns. Court Judge Barma SC (as he then was) dated 17 June 2003 6. Barber Asia was of the view that it had whereby damages of GBP219,890.25 together with interest complied with all relevant regulatory requirements were awarded to the plaintiff. At the conclusion of the and codes of practice, and owed Ms Field no further hearing, the appeal was dismissed with costs with written duties. In any event, Barber Asia denied having acted reasons to be handed down later. This we now do. negligently, whether as alleged in Ms Field’s Amended Statement of Claim or at all. Barber Asia further Background emphasised the fact that Ms Field entered into direct 3. The plaintiff (“Ms Field”) brought an action against contractual relationships only with the financial Barber Asia Ltd (“Barber Asia”) for damages in respect institutions from which she acquired investment of negligent financial advice rendered to her. Ms Field products or loans. Its position was that any losses sought to recover losses sustained as a result of relying which Ms Field suffered were caused (wholly, or at on such advice. Her claim was based in contract and, in least in part) by her own acts and decisions, in the alternative, in tort. particular her decision not to continue with the investment and loan arrangement at the time of the 4. The judge summarised the parties’ respective cases second demand for further security, and not by any in the following terms: default on its part.” “4. In essence, Ms Field’s complaint is that she was an inexperienced investor, and from the outset The judgment below made it clear to Mr Barber that she wanted to invest 5. The judge dealt meticulously with the evidence and her savings, which represented substantially all of the submissions of the parties in his very comprehensive her capital, in a conservative way. She says that she judgment of over 90 pages. Whilst Ms Field was legally did not change these guidelines at any material time. represented, Mr Barber conducted the defence for Barber Notwithstanding this, Mr Barber advised her to enter Asia. The judge remarked that he had had the opportunity into an investment structure which was unsuitable of observing the principal protagonists in the action give for her and inconsistent with her objectives, in that evidence during the course of the trial and had concluded it involved risk of a significant loss of her capital, that to the extent that Ms Field’s evidence conflicted with without explaining to her the nature of the risk that of Mr Barber, he generally had little hesitation in involved. preferring Ms Field’s evidence to that of Mr Barber. 5. Barber Asia’s position was that Ms Field was a fairly sophisticated investor, who wished to retain 6. The judge made a large number of factual findings. control of her investments, and chose not to enter into For the purposes of this appeal, it is only necessary to any formal contractual relationship with Barber Asia, refer to the following. Ms Field first met Mr Barber, the but simply wished to obtain from Barber Asia principal of Barber Asia, in June 1997. She told him that information as to investment opportunities which she wanted to invest her money conservatively, with the might suit her needs, and to make her own decisions objective of doing better than placing money on deposit as to such investments. While accepting that Ms in a bank. The money represented many years of hard Field’s initial request had been for a conservative work and Mr Barber knew that Ms Field did not want to investment strategy, Barber Asia claimed that this had lose any of her savings. Mr Barber’s contemporaneous

77 notes and memo recorded that a “conservative risk” Field switched her Old Mutual funds to a sterling money strategy was to be adopted. The judge found that Ms Field market fund. Whilst the assets securing the loan would was not a sophisticated investor and had never had any be denominated in sterling, the loan itself would be in other form of investment. She trusted and relied Japanese Yen, a low-interest rate currency. An implicitly on the advice that she was given, without important aspect of the strategy was the expectation that questioning. Whilst Mr Barber did explain to Ms Field the sterling assets would produce a return higher than the discretionary investment service and the advisory the rate of interest payable on the Japanese Yen. It was investment service offered by Barber Asia which entailed envisaged that this, coupled with gearing at a ratio of a formal written contract and the payment of a fee 2.5 times, would significantly enhance the rate of return charged by reference to the value of the client’s portfolio, on Ms Field’s initial investment. Barber Asia stood to Barber Asia also acted on an execution basis and in this gain GBP28,000 by way of commission from case it would be remunerated not by the client but the Rothschilds. organizations in which the assets were invested. Ms Field never entered into an agreement with Barber Asia and 9. The judge found that Ms Field had not been provided never paid them any fees. Nevertheless Mr Barber with the introductory brochure to the scheme which had proffered advice from time to time which Ms Field outlined the features of the scheme. The judge found that accepted and Barber Asia received commissions or fees the combination of gearing, interest risk, the possibility from the organizations into whose products Ms Field of premature crystallisation of the loss and mismatch invested. between currencies meant that the scheme recommended to Ms Field was an investment with a high level of risk 7. Some 9 months after the first meeting, in March which did not conform to the type of investment Ms Field 1998, Ms Field followed Mr Barber’s recommendation wanted. and invested substantially the whole of her savings of approximately US$300,000 into an insurance product 10. On the question whether the risks had been explained offered by Old Mutual International (“Old Mutual”). The to Ms Field, the judge found that Mr Barber had not funds were allocated between different investment supplied Ms Field with the Rothschilds documents which sectors and invested into professionally managed introduced the scheme and the concept of gearing which investment funds. Barber Asia stood to earn GBP9,127 contained clear references to risk. So despite some over 5 years as a result. references to risks on the application form itself, the judge concluded that it was unlikely that a detailed explanation 8. Mr Barber introduced Ms Field to a scheme offered of the various risks involved was provided at the time Mr by N M Rothschild & Sons (C.I.) Ltd (“Rothschilds”) on Barber was with Ms Field in her office completing the 10 July 1998. They met over lunch and, by that forms with her. He accepted Ms Field’s evidence that afternoon, Ms Field had entered into the scheme by whilst she understood that there might be some risks signing the relevant forms. The strategy involved involved in the investment, she believed that any risks gearing up Ms Field’s existing investments which she that there might be, would be in line with her stated desire had acquired earlier on Mr Barber’s advice. Under the for the conservative investment strategy. As there was strategy, the initial investments were to be used as no requirement to provide projections showing a negative collateral for a loan in Japanese Yen being the equivalent outcome even in relation to matters covered by the of GBP468,000 for acquiring a product from Securities and Futures Commission’s Code of Conduct, Scottish Life International Insurance Company Mr Barber did not consider that investors should be (“Scottish Life”) which would also be pledged as security provided by way of illustration of the possible outcomes for the loan. On Barber Asia’s recommendation, Ms of a given investment strategy.

78 Regulation of Investment Advisors

The judge made the following findings: explained that the problem lay with the appreciation “112. Given this approach, I conclude that it is more of the Yen against sterling. likely than not that Mr Barber did not explain to Ms Field the possibility that the investment strategy 13. The Yen continued to strengthen and by late August which he was proposing carried with it the risk of a 1999 Ms Field was again in breach of the minimum loss of a significant part of her capital, or the reasons collateral cover requirements. On 2 September 1999, for this. Rothschilds warned that it might take steps to switch the 113. Ms Field said that had it been explained to her currency of the loan to sterling if the breach was not that the investment strategy being recommended rectified. The switch occurred on 15 September 1995 and carried such a risk of loss of capital, she would not the effect was that the loan then stood at about have entered into. Having regard to the fact that her GBP210,000 more than its value at the date of the investments represented the fruits of many years of drawdown. Mr Barber suggested that Ms Field should hard work, I accept that evidence.” continue to service the loan rather than cashing out and crystallising her losses. In early December 1999, Ms Field 11. On 2 December 1998, Barber Asia provided Ms Field closed out her whole position. The policies were with information regarding her investment in the surrendered, attracting penalties. The Rothschilds loan scheme. The judge found that this information was far was to be paid out of the proceeds. What was left for Ms from accurate. In claiming a net return of 7.7% on the Field was some GBP44,000. initial investment with Old Mutual, it had failed to factor in the strengthening of the Japanese Yen and the 14. The judge found that Barber Asia owed Ms Field a corresponding increase in liability under the Yen loan. duty of care in tort based on a voluntary assumption of Had this been done, in arriving at the net assets, it would responsibility by Barber Asia. In short, the judge found have been necessary to deduct approximately that the investment was unsuitable for Ms Field and GBP90,000. A further memo from Barber Asia dated 4 should not have been recommended to her. He concluded February 1999 adopted a similar approach. By this time, that Barber Asia fell short of the standard of care to be despite Barber Asia’s claim of net return of 6.2%, the expected of them in a number of significant respects. reality was that Ms Field had already lost more than half of her original investment. 15. The judge rejected Barber Asia’s defence that the losses were caused, not by their negligence, but by Ms 12. Rothschilds made a first margin call on 26 Field’s decision to close out her investments in December February 1999. The judge found that Barber Asia’s 1999. The judge found that Ms Field had acted reasonably recommendation to Ms Field was to maintain the loan in closing out her investments and her decision was one in Yen and provide Rothschilds with the security. that was reasonably made in the light of adverse They even introduced Ms Field to a banker with HSBC circumstances then prevailing such that it did not sever who arranged a loan of HK$650,000 at 11.75%. Apart the causal connection between Barber Asia’s negligence from this loan, Ms Field also borrowed from another and her losses. source. The total amount borrowed to meet the first margin call was GBP76,000. Over the next few 16. The judge also rejected any suggestion of months, Ms Field sought reassurance from Barber contributory negligence on the part of Ms Field. Mr Asia that the strategy was the right one for her. In Barber had argued that Ms Field had failed to take legal response, in July 1998, Barber Asia reiterated the low advice and had failed to pay sufficient regard to the risk level attached to the security and suggested that acknowledgements of risk she made when signing the a gearing of 2.5 times was not unreasonable and Rothschilds loan application form.

79 This appeal my view it does not necessarily follow that they would Causation not have invested in the package if the required 17. At the outset of his submissions, Mr Clifford Smith warnings had been given or the ‘risk free’ SC informed the court that he was not challenging the representation not been made...” primary findings of fact made by the judge. The main thrust of his attack was that the judge had applied the 20. It is clear from the passage cited from Allied Maples wrong test on the issue of causation. He submitted that that whether or not Ms Field would have invested in the the correct test was whether Ms Field would still have scheme had the right advice been given “can only be a gone ahead with the scheme had the right advice been matter of inference to be determined from all the given and that the burden was on Ms Field to show that circumstances”. Ms Field gave evidence to the effect that she would not have entered into the transaction had the she would not have invested in the scheme had she nature of the scheme been made clear. appreciated that she risked losing a significant part of her capital which the judge accepted. See paragraph 113 18. In support of the test put forward, reference was of his judgment quoted in paragraph 10 above. It was made to Allied Maples Group Ltd v Simmons & also entirely consistent with her conservative low risk Simmons (a firm) [1995] 4 All ER 907 where, at page investment strategy made clear to Mr Barber from the 915c-d, Stuart-Smith LJ observed that: start. Whilst an appellate court might more readily “ (2) If the defendant’s negligence consists of an interfere with a judge’s findings where it is a matter of omission, for example ... to give proper instructions inference than one of primary fact, nevertheless the or advice, causation depends, not upon a question of finding in question “depends to a considerable extent on historical fact, but on the answer to the hypothetical the judge’s assessment of [Ms Field and Mr Barber], both question, what would the plaintiff have done if the of whom he saw and heard give evidence for a equipment had been provided or the instruction or considerable time.” See per Stuart-Smith LJ at 915j. As advice given. This can only be a matter of inference to noted above, the judge had little hesitation in preferring be determined from all the circumstances. The Ms Field’s evidence to that of Mr Barber. Further, there plaintiffs own evidence that he would have acted to was no evidence, much less compelling evidence, to obtain the benefit or avoid the risk, while important, support any inference that Ms Field would have found may not be believed by the judge, especially if there is the level of risk acceptable. compelling evidence that he would not...” 21. Mr Smith’s complaint that the judge had applied the 19. Mr Smith also relied on NMFM Property Pty Ltd wrong test in that he failed to appreciate that it was Ms and Others v Citibank Ltd (No. 10) 186 ALR 442. At Field who had the burden of proving that she would not [454-455], it was stated that: have entered into the scheme had Mr Barber properly “[454] The investors did not testify, either on advised her flies in the face of the judge’s finding in affidavit or orally, as to what he or she would have paragraph 113 of his judgment cited in paragraph 10 done if the required warnings had been given, or if above. In my view, what Mr Smith was seeking to do was some had been given but not others, or if the investors to reopen the judge’s factual findings despite his initial had not been told that the package was ‘risk free’... protestations that that was not what this appeal was [455] The investors did testify in general terms that about. This was apparent from the way the matter was they decided to invest ‘as a result of the put. Mr Smith referred to the adequacy of the cushion representations made to them by the advisers, and built into the scheme, in particular, to the fact that the would not, but for these representations, have taken judge had found that there was a margin of GBP57,000. out a Mortgage Power loan or purchased units. But in Mr Smith also referred to the volatility of the underlying

80 Regulation of Investment Advisors currency as being no more than 5.7%. Thus, it was said time of the first margin call, Ms Field was fully aware of that there had to be an appreciation of 23% in the Yen the volatility of the Yen. Nevertheless, she was willing to before there would be any loss, suggesting that the invest in investments that required the taking of a view investment was not as risky as the judge said it was and on future currency movement. It was suggested that the that Ms Field would not necessarily have found that level fact that Ms Field carried on with the scheme after the of risk unacceptable. But that submission overlooked the full nature of the risk had been brought home to her judge’s acceptance of the evidence of Ms Field’s expert indicated that she was not adverse to the level of risk (at paragraph 106 of his judgment) whose assessment involved in the scheme, a point also relevant to the was that the strategy causation issue. By not cutting her losses and electing to “carried at least a high level of risk of loss, and could “gamble” on the future movement of the Yen at the time not be described as conservative, and did not, of the first margin call, Ms Field should be held liable for therefore, comply with the type of investment strategy contributory negligence and/or a failure to mitigate her requested by Ms Field.” losses.

22. Mr Smith then complained that Ms Field had not 25. Mr Smith acknowledged that Barber Asia did advise been tackled on the basis of actual risk. His submissions Ms Field to meet the first margin call. In those came to this: had Mr Barber been more astute or had the circumstances, Barber Asia can hardly complain about defendant had legal representation, Ms Field might have Ms Field’s decision to meet the margin call. The fact that been asked different questions and the judge might she chose to stay invested does not assist Mr Smith’s have reached a different conclusion. In essence, all his arguments on causation since the circumstances arguments on causation were veiled attempts at prevailing at the time of the first margin call were very circumventing the judge’s findings of fact. It should be different from those that pertained on 10 July 1998 when borne in mind that from the outset of Ms Field’s she entered into the scheme. By the date of the margin relationship with Barber Asia, she had made it clear that call, she had been locked into this investment. The her investment strategy had to be a conservative low risk options then open to her were limited. Unless her decision strategy. She should never have been offered the was not one that a reasonable person would have taken, scheme which Mr Smith initially readily she cannot be faulted for it. The arguments based on acknowledged was a “high risk” investment. In the course contributory negligence and/or failure to mitigate were of the hearing, he attempted to resile from that by accordingly misconceived. suggesting that had the true nature of the risk been explained in full terms, Ms Field might have found that Scope of duty level of risk acceptable because of the potential upside, 26. Mr Smith approached this point with diffidence. He and that, therefore, the “high risk” investment was in fact made no oral submissions on this point and chose to rely not that risky. Without overturning the judge’s factual on his written submissions. In brief, it was said that as findings, that contention could not possibly succeed and the level of service selected by Ms Field was the execution no case has been made out to displace the findings made. basis service, Barber Asia had discharged its duty by ensuring that Ms Field was aware of the overall nature of 23. I will now refer briefly to the other subsidiary points the scheme. Reliance was also placed on the warning raised in the appeal. notice which recommended that she seek independent legal advice. Contributory negligence 24. The point here was no different from that argued 27. The basis of Barber Asia’s liability was the voluntary before the judge. In essence, it was submitted that by the assumption of responsibility which gave rise to a duty of

81 care to Ms Field. It is a question of fact in each case whether there was such a voluntary assumption of responsibility. The different services offered by Barber Asia were irrelevant. What mattered was whether irrespective of the level chosen, it preferred investment advice which gave rise to a duty of care. Indisputably the advice rendered did not conform to the client’s request. In my view, there is no reason for interfering with the judge’s finding of a duty of care and its breach by Barber Asia.

Hon Sakhrani J: 28. I agree with the reasons given by Le Pichon JA.

(Anthony Rogers) (Doreen Le Pichon) (Arjan H Sakhrani) Vice-President Justice of Judge of the Court of Appeal First Instance

Representation:

Mr Jose-Antonio Maurellet, instructed by Messrs Tanner De Witt, for the Plaintiff/Respondent

Mr Clifford Smith SC and Mr Douglas Lam, instructed by Messrs John M Pickavant & Co., for the Defendant/ Appellant

82 Regulation of Investment Advisors

HCA007119/2000 HCA 7119/2000

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 7119 OF 2000

BETWEEN

SUSAN FIELD Plaintiff

AND BARBER ASIA LIMITED Defendant

Coram: Deputy High Court Judge Barma, SC in Court

Dates of Hearing: 17-21, 24-26 March and 1 April 2003

Date of Handing Down Judgment: 17 June 2003

JUDGMENT

83 Introduction to her, but this represented only a small part of her initial 1. This was the trial of an action by Susan Field (“Ms investment and she thus incurred a substantial loss overall. Field”) against Barber Asia Limited (“Barber Asia”) in which Ms Field claims damages in respect of financial The Parties’ Cases Summarised advice given to her by Barber Asia. Ms Field alleges that 4. In essence, Ms Field’s complaint is that she was an the advice that she was given was negligent, and that inexperienced In essence, Ms Field’s complaint is that losses which she suffered as a result of relying on such she was an inexperienced investor, and from the outset advice are recoverable either on the basis of a breach of made it clear to Mr Barber that she wanted to invest her contract by Barber Asia or because Barber Asia owed her savings, which represented substantially all of her capital, a duty of care in tort in relation to such advice. in a conservative way. She says that she did not change these guidelines at any material time. Notwithstanding 2. Ms Field’s complaints relate to an investment this, Mr Barber advised her to enter into an investment strategy which she says was recommended to her by Mr structure which was unsuitable for her and inconsistent Andrew Barber (“Mr Barber”) of Barber Asia in July 1998. with her objectives, in that it involved risk of a significant I shall deal with the facts underlying Ms Field’s claim in loss of her capital, without explaining to her the nature more detail below, but, in brief, this strategy involved of the risk involved. gearing up Ms Field’s existing investments (which she had acquired earlier on Mr Barber’s advice) by using them 5. Barber Asia’s position was that Ms Field was a fairly as collateral for a loan to be used to acquire further sophisticated investor, who wished to retain control of investments, which would also be pledged as security for her investments, and chose not to enter into any formal the loan. The loan would be in a low- interest rate contractual relationship with Barber Asia, but simply currency (in this case, Japanese Yen), but the assets wished to obtain from Barber Asia information as to securing the loan would be denominated in Sterling, and investment opportunities which might suit her needs, and were expected to produce a return that was rather higher to make her own decisions as to such investments. While than the rate of interest payable on the loan. With the accepting that Ms Field’s initial request had been for a effect of the gearing, it was envisaged that the rate of conservative investment strategy, Barber Asia claimed return on Ms Field’s initial investment could be that this had changed over time, and that by the time considerably enhanced. that the investment now complained of was entered into, Ms Field wanted (or at least was prepared to accept) a 3. Unfortunately, as a result of a sharp appreciation of strategy that was much riskier in order to obtain the the Yen against Sterling, Ms Field was faced with prospect of better returns. demands to top up the security provided for the loan in substantial amounts on two occasions within a just over 6. Barber Asia was of the view that it had complied with a year after this arrangement was entered into. On the all relevant regulatory requirements and codes of first occasion, about seven months after entering into the practice, and owed Ms Field no further duties. In any arrangement, Ms Field was able to provide the additional event, Barber Asia denied having acted negligently, security demanded, wholly or partly from further loans whether as alleged in Ms Field’s Amended Statement of (from different sources).On the second occasion, some 6 Claim or at all. Barber Asia further emphasised the fact months later, Ms Field did not provide further security, that Ms Field entered into direct contractual relationships and as a result the lender switched the loan into sterling, only with the financial institutions from which she crystallising the exchange loss. Shortly afterwards, Ms acquired investment products or loans. Its position was Field repaid the loan by realising the assets against which that any losses which Ms Field suffered were caused it was secured. The balance of the security was returned (wholly, or at least in part) by her own acts and decisions,

84 Regulation of Investment Advisors in particular her decision not to continue with the statements, which stood as their evidence in chief. investment and loan arrangement at the time of the However, both gave further evidence in chief by way of second demand for further security, and not by any amplification of their witness statements and in response default on its part. to some of the matters raised in the other party’s evidence. Although a witness statement was also made by another 7. At the trial, Ms Field was represented by Mr employee of Barber Asia, Mr Chris Barber (“Chris Maurellet of counsel. Barber Asia’s defence was Barber”), he was not called to give evidence, and conducted by Mr Barber, leave for him to do so having accordingly his witness statement was not referred to been granted prior to the commencement of the trial. during the trial.

The Issues 11. I had the opportunity to observe both Ms Field and 8. The broad issues which arise for decision are as Mr Barber give evidence during the course of the trial. I follows:- have borne in mind that they are the principal (1) Whether Barber Asia owed Ms Field any duties protagonists in this action. in contract, and if so what those duties were. (2) Whether Barber Asia owed Ms Field any duty of 12. In the case of Ms Field, I have taken into account the care in tort in relation to the investment information fact that given the sense of grievance which she clearly or recommendations which it provided to her. felt, her evidence may have been coloured by this. That (3) If Barber Asia owed any duties to Ms Field, said, however, I found Ms Field to be a straightforward whether in contract or in tort, whether Barber Asia witness. She readily admitted that her recollection was were in breach of such duties. in some respects limited. She was also prepared to accept (4) If so, whether any losses which Ms Field contemporaneous documents at face value. There were suffered were caused by such breach or breaches occasions when she appeared quite willing to accept of duty, or whether they were attributable (in whole matters which were put to her which might be thought to or in part) to Ms Field’s own actions. be damaging to her position. Although Mr Barber levelled (5) The quantum of the loss (if any) for which a number of criticisms at her evidence and the manner Barber Asia might be liable. in which she gave it, which I shall touch on when examining the evidence in question below, I should say 9. In the course of the trial, a number of factual issues that I did not consider such criticisms to be justified, and arose on which the parties’ evidence was contradictory. I am satisfied that Ms Field was a generally truthful The most important of these was whether or not Ms Field witness, who was doing her best to recollect matters as had, between the time she first had dealings with Barber they had occurred. Asia and the time when she entered into the investment structure complained of, changed her investment 13. So far as Mr Barber is concerned, I have made objectives by being prepared to accept much higher levels allowance for the fact that, apart from the strain which of risk than she had been at the outset. There were also any witness is likely to be under, he was giving his several other areas of factual dispute. I shall deal with evidence under the additional burden of having to these issues when considering the evidence and stating conduct Barber Asia’s case on his own without the benefit the facts as I find them to be. of legal representation. I have also allowed for the fact that there would be additional stress arising from the fact The Witnesses that it was his conduct and advice that was the subject of 10. At the trial, factual oral evidence was given by Ms criticism in these proceedings. However, that said, I did Field and by Mr Barber. Both of them had made witness find that there were a number of respects in which his

85 evidence was difficult to accept, and did not sit 17. Although it is fair to say (and Mr Green readily particularly well with contemporaneous documents. It accepted) that he had no experience of acting as a financial seemed to me that he was, on several occasions, anxious advisor to expatriates, or in Hong Kong, I do not consider to deflect responsibility away from himself, and onto Ms that these limitations impinged significantly on Mr Green’s Field. ability to express an opinion on what I consider, at the end of the day, to be reasonably straightforward matters 14. As will be apparent from my findings as to the facts, to of investment and financial advice. the extent that Ms Field’s evidence has conflicted with that given by Mr Barber, I have generally had little hesitation in 18. Mr Green gave his evidence in a careful manner. He preferring Ms Field’s evidence to that of Mr Barber. was, as I have indicated, ready to accept the limitations of his experience and knowledge. I found him to be a 15. Expert reports in relation to investments, investment satisfactory witness, and have no hesitation in accepting advice and quantum were also lodged by both parties. his evidence. However, at the trial, only the Plaintiffs expert, Mr Green, attended to give evidence. His report was admitted as The Evidence his evidence in chief, subject to some clarification Ms Field’s Background and expansion. As the Defendant’s expert, Mr Rigby, 19. I turn now to consider the evidence. In doing this, it was not called to give evidence and was unavailable for is necessary first to consider the position of Ms Field in cross-examination, his report, like the witness statement about mid-1997, when she met Mr Barber. Her evidence of Chris Barber, was not referred to at trial, and I have as to her own working experience was uncontroversial. not had regard to any of the matters contained in it. She said that she first came to Hong Kong in the mid- 1980s. Prior to coming to Hong Kong, she had worked in 16. Mr Green’s qualifications were attacked by Mr the United Kingdom, first as a receptionist, and then Barber, who suggested that Mr Green had had little working for Grand Metropolitan plc, a company with relevant experience, and that his involvement in interests in the hospitality field. After coming to Hong investment advice and financial advisory services was out Kong, she worked for a time with an Australian company, of date. I do not accept this criticism. Mr Green’s Goodman Fielder Wattie, where her principal role was curriculum vitae is impressive. Having trained as an to work on a tender to retain certain concessions at the actuary, he worked with a number of substantial Hong Kong airport. In this connection, her work involved companies as Pensions Secretary, Pensions and an element of lobbying or liaison with the Hong Kong Investment Manager, and Investment Manager. This Government (in particular the Civil Aviation included a period in the 1960s with what is now British Department). She was not, however, required to prepare Airways, where he had responsibility for its pension financial projections or budgets. She also worked for a scheme’s investments, which at the time totalled some time with the Ramada hotel group, in their public £500 million (and which would be many times that relations department, having responsibility for regional amount in current terms). In 1971 he formed his own public relations, but also dealing with those matters in investment management firm, in partnership with others, Hong Kong when the local hotel’s public relations and when his partners sold their shareholding to Nikko manager left. Securities Ltd in 1985, he remained with the firm until 1992 on a full-time basis, after which he continued as a 20. Thereafter, in about 1990, she set up her own consultant until 1995. He has given expert evidence in a marketing and communications business through a firm large number of cases, and is and has been a member of called Susan Field and Associates. At the same time she several committees of professional associations. had an interest in a hospitality industry publication called

86 Regulation of Investment Advisors

“Asian Hotelier”. Both proved to be successful ventures. US$300,000 by early 1998 when she made her first By 1997, the marketing and communications business investment through Barber Asia. However, in cross was being operated through a company called The Impact examination, she agreed with Mr Barber that she might Group Limited (“Impact Group”), of which she was have been mistaken, and that there was probably the major shareholder (a small passive shareholding in US$300,000 by the time she first met him in June 1997, that company being held by a friend) and for the business but that she had initially been inclined to invest only part of which she was the main driving force. By this time, of it through Barber Asia. Given that Impact Group at that she had, through her own efforts, built up the turnover time had a turnover of some HK$3 million, it seems unlikely of Impact Group to some HK$3 million per annum. that she would have been able to effect savings of nearly Impact Group provided media relations and public HK$800,000 (or US$100,000) in the space of some 9 relations services and advice, including graphic design months, and I conclude that it is more likely that Ms Field and event management services for a range of clients had some US$300,000 in savings by around June 1997. which were primarily international companies in the travel and hospitality businesses, such as hotel groups 23. So far as her experience in investing was concerned, and airlines, but which also included from time to time Ms Field’s evidence (which was not challenged) was that, some other consumer companies, such as San Pellegrino as at June 1997, she had never owned any stocks, shares, and Toppy Fashions. bonds or unit trusts. She did not own property, and did not have a mortgage. She had only ever had bank 21. Ms Field said that the business depended largely on accounts, these being maintained with the Hongkong and her relationships with the clients whom she serviced. She Shanghai Banking Corporation (“HSBC”), with whom said that the business had been profitable, although both she and Impact Group banked. She had an account margins have declined substantially in recent years. She known as an AssetVantage account, which provided said that while she expected to make a profit, she multi-currency savings accounts facilities, and allowed conducted her business without preparing budgets and for time deposits to be made in various currencies. She financial forecasts or targets, instead relying on a sense said that she found that the AssetVantage account was of the general level of the expenses, and working out rather complicated, and later terminated it, replacing it quotations on the basis of experience and a sense of what with a slightly simpler account known as a PowerVantage the job would bear. Her personal expenses were mostly account, which provided similar multi-currency savings put through the company, and although she drew a and time deposit facilities. She said that Impact Group modest salary, surpluses were generally kept in the bank, found it useful to have foreign currency accounts, since and ploughed back into the business, as there was usually this enabled it to make payments to foreign suppliers some money owing to its bankers at any given time. conveniently, and also provided its clients with the facility of being able to remit foreign currency in settlement of 22. By 1997, the Asian Hotelier publication business had Impact Group’s fees and charges. Ms Field said that she been sold for some HK$2 million to a publishing group, kept any spare money on time deposit, usually for fairly generating about HK$1 million for Ms Field. Together short periods (a month or so), and only in Sterling or US with her savings over her years working in Hong Kong Dollars, deciding between the two having regard to which and from the business of Impact Group, Ms Field had currency offered a higher rate of interest at the time. built up some US$300,000 in total assets. There was some uncertainty about the exact amount available to Ms 24. Ms Field’s personal life is also relevant to some of Field for investment at this point in time - in her witness the evidential issues arising in this matter. As at June statement she had said that she had some US$190,000 1997, Ms Field had a relationship with Frank Van available for investment, which had increased to some Amelsvoort (“Mr Van Amelsvoort”), a Dutch gentleman

87 who was working at the time in the United Kingdom. Her of an exploratory one, with Ms Field explaining her mother was also living in the United Kingdom. Although personal situation and the financial objectives which she she was happy working in Hong Kong, she had in the had in mind, and Mr Barber explaining the background back of her mind an idea that she might return to the of Barber Asia, and the ways in which Barber Asia might United Kingdom in about 5 years’ time. This is a time be able to assist Ms Field to attain those objectives. frame which has been extended over the years, and she says that even now she envisages returning to the United 28. Although there are some differences of recollection in Kingdom in 5 years from now. relation to some of the matters discussed or mentioned at this meeting, it was common ground that at this meeting, 25. Ms Field’s background is important, as it will be Ms Field told Mr Barber that she had saved up some money necessary to have regard to her personal situation and which she wished to invest, and that she wanted to invest her experience in investing and financial matters when it in a conservative way, with the objective of doing better considering the advice that she received from Barber Asia. than leaving the money in the bank. Ms Field’s desire for a conservative investment strategy is reflected in Mr Barber’s background handwritten notes made by Mr Barber at or shortly after 26. By comparison, Mr Barber’s background is of less the meeting. It is also recorded in a memorandum which relevance, and can be more briefly summarised. Having Mr Barber sent to Mr Field the same day, when, having resigned his commission from the British Army in 1984, recorded that she had told him that she had some he joined the financial services industry in the United US$190,000 which she wished to invest using a Kingdom, where he worked for Towry Law, and then “conservative risk” strategy, Mr Barber went on to joined the Mannin International Bank, where he started recommend an insurance product offered by Old Mutual working in Asia. Mannin International Bank having been International (“Old Mutual”), which was known as the taken over by the Royal Bank of Canada, he became an Alpha Capital Investment Plan. This essentially involved employee of the Royal Bank of Canada, eventually a single-premium investment, which could be allocated becoming head of their private banking operation in the between different investment sectors, where it would be Asia Pacific region in 1991. He then joined Coutts & Co invested into professionally managed investment funds. in 1993, setting up their private banking operations in Hong Kong and Singapore, and leaving in 1995 to form 29. It is clear from Mr Barber’s notes of the meeting that Barber Asia, as his own investment advisory company to there was some discussion of Ms Field’s business and service clients with whom he had built up a relationship personal background, and that Mr Barber obtained over the years. Apart from dealing with clients of Barber information as to the nature and financial position of Ms Asia, for a period from sometime in 1996 or thereabouts Field’s business, as well as of her own financial position. until about 2000, he was involved with assisting a Canadian I note that the figures in Mr Barber’s notes (both in client, the Zi Corporation, in setting up an office in Hong respect of Impact Group and Ms Field’s personal worth) Kong, something which took up perhaps half his time. are slightly higher than those which Ms Field mentioned during her evidence at trial, but neither party suggested The first meeting that much turns on this. 27. Ms Field and Mr Barber met for the first time on 19 June 1997. The meeting took place in the Clipper Lounge 30. I have noted that Mr Barber’s note does not contain at the Mandarin Hotel. Ms Field had been introduced to any information as to whether or not Ms Field had any Mr Barber by a friend of hers, Ms Jane Wild, who was at previous investment experience. There is no reference this time also involved, on something of a trial basis, with to any other investments which she held at the time (no Impact Group’s business. The meeting was in the nature doubt because she did not have any). I therefore conclude

88 Regulation of Investment Advisors that Mr Barber knew that Ms Field did not have any other and Mr Green agreed that a return of approximately 10% form of investment, beyond the bank accounts to which was something which could reasonably be regarded as I have referred, at this time. While it is not clear from the achievable consistently with Ms Field’s objectives, as notes whether Mr Barber knew that Ms Field had never although the range of risk involved might move slightly had any other form of investment, Ms Field said in her upwards, from low to low-medium, a strategy of this sort statement that she told him that she had no previous could still be described as conservative, despite the slight experience of investing, a statement which was not increase in the level of risk. challenged. I therefore conclude that Mr Barber knew this. 34. Mr Barber also explained that his practice is to define 31. Ms Field said that at this meeting, she told Mr Barber risk by reference to the level of returns in excess of base that she had accumulated some savings over the years rates for the currency in which the investment is to be which she wished to invest. She says that she made it clear denominated, and that he explained this to Ms Field. Ms to him that she did not wish to lose any of these savings, Field said that she did not recollect this. This is not as they represented virtually the entirety of what she had recorded in Mr Barber’s memorandum to Ms Field, to show for many years of hard work. Ms Field says that although it is consistent with his handwritten note (which she told Mr Barber this on a number of occasions. This was not sent to Ms Field at the time). While it may be that evidence was not challenged by Mr Barber. Mr Barber gave Ms Field an explanation along these lines, it is an explanation that is not, in my view, likely to have 32. Mr Barber did, however, say that apart from the meant a great deal to Ms Field, given her lack of experience amounts which Ms Field had told him that she had in relation to investments. In any event, given that an available (some US$300,000 for investment, with a investment strategy could be regarded as conservative relatively small amount left over for emergencies), he also whether it carried with it low or low-medium risk, it seems had regard to the fact that Ms Field’s business was worth to me that this is again a difference of no great significance. something. On the basis of a turnover of about HK$3 million a year, he said that her business would be worth 35. Mr Barber says that he went on to explain the way in approximately HK$6 million. Ms Field said that the value which Barber Asia could assist Ms Field with her of her business was never discussed - Mr Barber accepted investments. He outlined two main ways in which Barber this, but took the view that it was appropriate for him to Asia serviced its clients. One approach, known as a make an assessment of the value of the business of Impact discretionary investment service, was for the client to Group, and to take it into account when considering Ms hand over control of his or her investments to Barber Asia, Field’s overall net worth. who would make all investments on behalf of the client at their discretion, based on a mutually agreed set of 33. Ms Field says also that she had in mind a return of guidelines which would be determined at the outset, and about 10%, as she had been told by friends (who were reviewed from time to time. The other approach, known not investment advisors) that this would be something as an advisory investment service, involved Barber Asia that could be achieved given her desire to invest in a in providing advice and recommendations to its client, conservative way. She said that she mentioned this to Mr but not having the authority to make investments on the Barber, and that he agreed that such a return was client’s behalf. Under this approach, the client made the consistent with a conservative investment strategy. Mr decisions, based on the advice or suggestions which had Barber’s evidence was to the effect that Ms Field was been received. Both the discretionary and advisory initially looking for a return that was slightly lower, but services involved the entering into of a formal written that she increased it to 10% subsequently. This difference contract, under which Barber Asia would be entitled to is not one which is to my mind critical, as both Mr Barber payment of a fee based on the value of the client’s assets

89 under management. Apart from these two services, experience of preparing budgets, costings and Barber Asia would also act on an execution basis, where financial projections. no fee was payable by the client, but Barber Asia would (2) She had a number of multi-currency accounts implement investment decisions of the client by assisting which she used to manage Impact Group’s currency the client in investing in the investment products that exposure in various currencies. the client had decided upon, perhaps in the light of advice (3) She did not raise any objections or concerns or suggestions which had been provided by Barber Asia. prior to making her investments. In this case, Barber Asia would receive no remuneration (4) She signed various declarations in from the client, but would receive payment from the connection with her investments and financial organisations with whom investments were placed. arrangements entered into on Barber Asia’s advice, to the effect that she had read the product literature 36. Mr Barber said that from the outset, Ms Field did and understood the risks involved as well as the not seem to be interested in a discretionary service. applicable charges and fees. Initially, he had in mind that she might become a client of Barber Asia’s advisory investment services. As things 38. As to these matters, while it is undoubtedly correct turned out, Ms Field never signed any client agreement to say that Ms Field was an experienced and successful or other formal contract with Barber Asia, and never businesswoman, it is important to bear in mind the herself paid them any fees. Instead, Mr Barber provided limitations of such a statement. Ms Field’s expertise lay her with investment advice on occasion, which Ms Field in the area of public and media relations, and while appears to have accepted, acquiring the investments that managing the business of Impact Group and running it she did through Barber Asia, which was thus enabled to on a profitable basis undoubtedly called for business earn commissions from the companies whose investment skills, those skills are not necessarily those which equip products were acquired. Ms Field did not, I think, dispute the business owner with the ability to understand and any of this. While accepting that she did not herself wish appreciate the merits and risks involved in the types of to have to pay any fees to Barber Asia, she said that Barber investments which Ms Field was recommended by Barber Asia would of course have to earn its income from Asia. Accordingly, I do not think that it was reasonable somewhere, and she realised that commissions or fees for Mr Barber to conclude solely on the basis of Ms Field’s would be earned from the insurance or fund management business background that she was a sophisticated companies in whose products she invested. investor with a good understanding of the investments which he might recommend to her. Further, I do not see Whether Ms Field was a sophisticated investor that the possession of a multi-currency account is 37. Finally, in relation to the first meeting, I should deal necessarily an indicator of sophistication or acumen so far with Mr Barber’s suggestion that Ms Field was not a naive as investments generally are concerned. Multi-currency or inexperienced investor, but a fairly sophisticated one. accounts of the type which she held were common in Hong Mr Barber appeared to base this contention on two factors Kong by the mid-1990s, and the movement of funds few factors some of which would have arisen from the between currencies to obtain better interest rates is not, first meeting, and two others which would have arisen to my mind, evidence of great financial sophistication later. These were as follows:- (indeed, if anything, it may betray a lack of awareness of (1) Ms Field was a financially astute business risks in the movement of exchange rates). woman (not a widow or nurse or other person who might have no or little experience of business or 39. As to the suggestion that Ms Field did not raise finance), running her own company, in the course concerns or objections to the investments suggested by of which she must have built up considerable Barber Asia, this would seem to me to be more likely to

90 Regulation of Investment Advisors be evidence of the fact that she trusted and relied filling in substantially the whole of the application form implicitly on the advice that she was being given - for her to sign. Mr Barber also made recommendations sophistication and awareness of the factors involved in as to the mix of funds offered through Old Mutual into making an investment of the magnitude that Ms Field which Ms Field should put her funds for investment. was making would, to my mind, be better demonstrated These comprised five separate funds, to each of which by a questioning attitude as to the merits or otherwise of between 10% and 30% of the total sum invested was particular investments, which is conspicuous by its allocated. It does not appear that Ms Field played any absence in this case. Equally, the making by Ms Field of active role in the choice of funds - rather, she seems declarations as to having received and understood simply to have accepted the recommendations that were documentation supplied by investment product providers made by Mr Barber. Ms Field said that she did not really does not, in my view, assist Barber Asia, since such understand the various funds that were offered under the declarations are clearly designed to provide comfort and Old Mutual product, but that she simply trusted Mr protection to the investment product provider, who will Barber, whom she regarded as the expert, to make choices generally be unaware of the circumstances of the person for her which would be in line with the conservative acquiring the investment product, of the information investment strategy which she had asked for. supplied to him and his ability to understand it. Barber Asia, through Mr Barber, were well acquainted with Ms 42. Mr Barber said that he went through the Old Mutual Field and her personal situation and attributes, and to the documentation with Ms Field before it was signed. He extent that they knew or ought to have known that she did took issue with Ms Field’s statement that she trusted his not or might not understand the risks involved, they advice, pointing out that she apparently did not trust him cannot, in my judgment, improve their position by and Barber Asia enough to enter into a discretionary reference to the declarations which she signed. investment service agreement with Barber Asia, under which Barber Asia would have authority to make The second meeting - Ms Field’s first investment investment decisions on her behalf. I do not think that through Barber Asia this point is a valid one - in saying that she trusted Mr 40. Following the initial meeting with Mr Barber, Ms Barber, I think that Ms Field was doing no more than Field did not in fact make an immediate investment. It saying that she relied on his advice, which she believed was not until some 9 months later, in March 1998, that to have been given to her in good faith, and in accordance she made her first investment through Barber Asia. At with the investment strategy or objective which she had this time, Ms Field made an investment in the Old told Mr Barber about. I have no doubt that in this sense, Mutual product which had been recommended by Mr Ms Field trusted Mr Barber, and relied on his advice. Barber in his memorandum of 19 June 1997. As she felt There was no suggestion that Ms Field was, at this time, comfortable with Mr Barber, she invested substantially consulting other investment advisers (or for that matter, the whole of her available funds - a total of some anyone else) as to possible investments that she might US$306,380. She said that following this investment, she make. Although Mr Barber suggested in his submissions still had some money in reserve, to cover unexpected that she did take advice from others, relying on later expenses or contingencies. She was unable to recollect correspondence and e-mail messages, I do not think that the exact amount available, but thought that it was in the this detracts from Ms Field’s evidence, as the time frame region of US$20,000 or perhaps £20,000. is quite different - the later correspondence relating to a period after problems had arisen in respect of Ms Field’s 41. The decision to invest was made following a meeting investments. Further, it was not suggested by Mr Barber between Ms Field and Mr Barber, at which Mr Barber that he ever provided Ms Field with a recommendation assisted Ms Field with the application to Old Mutual, by which she did not accept and follow on the evidence

91 before me, on each of the occasions when Mr Barber made did say also that the fact that the investment was into a recommendation as to a particular course of action, Ms pooled funds meant that it was less risky than a direct Field simply accepted his advice. investment into the underlying securities or markets in question. As I have pointed out, Ms Field said that she 43. Mr Barber also emphasised that the investment did not really understand the nature of the funds in which contract was between Ms Field and Old Mutual, and that her investment was being made, and assumed that the Barber Asia were not parties to this contract. This is mix of funds was in accordance with her objective of undoubtedly correct. However, if Mr Barber was seeking making a conservative investment. Mr Green’s evidence to suggest by this that Ms Field did not rely (or was not was that taken as a whole, the mix of funds was one which entitled to rely) on his advice, I would reject such a he would regard as carrying a low-medium level of risk, suggestion. Far from excluding the possibility of any and compatible with Ms Field’s instructions to invest in reliance by Ms Field on Mr Barber’s advice, this simply a conservative manner. Mr Green also pointed out illustrates the manner in which she relied on his advice - (agreeing in this respect with Mr Barber) that there would by entering into the contract with Old Mutual on the usually be some scope for differences of categorisation strength of it. of risk levels in respect of particular investments, so that what one investment professional regarded as low risk 44. Although Barber Asia did not receive any fees from Ms might be regarded by another of low-medium risk, Field in connection with this investment, it did receive although he thought that this would be the case only as commissions from Old Mutual. The existence and rate of between one level and the next, in the case of investments commissions was disclosed Ms Field (who, as I have said, that could be regarded as being on the borderline between readily accepted that Barber Asia would have to earn the two levels. In these circumstances, I conclude that remuneration from somewhere). It appears that the amount the initial Old Mutual investment was one which could of commission to be earned by Barber Asia from the sale of be regarded as being in line with Ms Field’s objective of this product was some £9,127, spread over five years. having a conservative investment, which she had made clear at the outset. Indeed, no complaint is made by Ms 45. Although the commission paid to Barber Asia by Old Field as to this investment. Mutual was met by Old Mutual as part of its general selling and administrative costs, and was not therefore borne by 47. From this point onwards, it appears that Ms Field Ms Field, whose entire investment was placed into the and Mr Barber also developed a personal friendship, and various funds selected, it is pertinent to note that the met from time to time on social occasions. Mr Barber investment with Old Mutual was subject to surrender said, and Ms Field agreed, that he assisted her with a penalties which reduced on a sliding scale over the first number of personal problems, including the withdrawal five years of the investment. In other words, there was a of Ms Wild from the business of Impact Group, which penalty attaching to early withdrawal from the investment, did not, it seems, take place on particularly friendly terms, which would be borne by Ms Field, which might well be and the resolution of problems which had arisen with Ms regarded as going some way towards covering the costs to Field’s landlord following a fire at her home, which had Old Mutual of administering the investment, including the rendered it uninhabitable for a time. commission payable by it to Mr Barber. The third meeting 46. In the course of his evidence, Mr Barber produced a 48. Towards of the end of May 1998, there was a further document published by Old Mutual which indicated that meeting between Ms Field and Mr Barber. It appears that the particular funds into which Ms Field’s investment was Ms Field had been hearing positive things about the made were mostly rated as medium risk. However, he European stock markets, and wanted to consider the

92 Regulation of Investment Advisors possibility of adjusting the mix of funds under her the year, and had recommended to a number of his other investment with Old Mutual to take advantage of this. clients. He said that after the meeting he sent Ms Field a Following a meeting between them, it appears that a form full set of documentation concerning the scheme, authorising a switch of part of the investment mix was including a brochure produced by Rothschild describing prepared, altering what had been a 20% allocation of Ms the Scheme and giving information as to its features, a Field’s investment to an international stock market fund document which specifically discussed the gearing so that 10% of the original investment remained in that options available in connection with the scheme, and fund, with the remaining 10% being switched to a an application form for a loan pursuant to the Scheme. European stockmarket fund. In the event, it seems that These were, according to Mr Barber, in Ms Field’s although the switch form was signed, it was never acted possession for some weeks (perhaps four or five weeks), upon, perhaps because it was overtaken by the events to after which there was a further meeting on 10 July 1998, which I now turn. when Ms Field, having decided to go ahead with an investment strategy using the Scheme, met Mr Barber The making of the investments complained of again and Mr Barber, as he had done in relation to the 49. Mr Barber said that just a week after the meeting at investment with Old Mutual, assisted Ms Field by filling which the switch of part of the Old Mutual investment was in the relevant forms. Mr Barber said that he explained discussed, Ms Field called him and asked for another the Scheme in detail to Ms Field, and that he went over meeting, at which she told him that as a result of changes in the application form, which included a number of her personal situation (relating principally to her declarations by the applicant acknowledging the relationship with Mr Van Amelsvoort, and her mother’s opportunity to take legal advice, and the risks involved situation), she wished to make her money work harder, to in entering into the Scheme, with her in some detail. facilitate the possibility of relocating to the United Kingdom slightly sooner than she had previously had in mind. Mr 52. Mr Barber’s version of events was disputed by Ms Barber said in the course of giving evidence that he Field. According to Ms Field, there was no meeting a week understood this to mean that Ms Field wished to move to a after the meeting at the end of May when the switch in higher risk strategy, with a view to enhancing her returns. the Old Mutual investments was discussed. Ms Field said that there were a number of social occasions at which 50. Mr Barber went on to say that on being told this, they she and Mr Barber met, but that the first occasion on discussed various options within the Old Mutual which the Scheme was mentioned by Mr Barber was on investment structure, examining funds which had better about 10 July 1998. She said that Mr Barber called her recent performances such as Latin American stockmarket either on 10 July 1998 or the day before, and told her funds. These, however, were considered and rejected that there was an exciting new investment opportunity because of their volatility - while they had shown high that he wanted to discuss with her. They therefore growth in the recent past, there had been periods when arranged to have lunch on 10 July 1998. It was at this they had suffered substantial losses as well. Mr Barber lunch that Mr Barber described the Scheme to her. She says that he then mentioned the existence of an said that he explained what was meant by gearing, and investment structure that was offered by N M Rothschild that she understood from his explanation that it involved & Sons (C.I.) Ltd (“Rothschild”), a part of the well-known taking out a loan so as to have additional funds with which banking and investment house. This was called the Loan to make a further investment. She said that he explained and Guarantee Scheme (“the Scheme”) that the idea was to borrow money in a low interest currency (in this case Yen), and invest it in assets in a 51. Mr Barber said that he briefly described the Scheme, different currency which would produce a rate of return which he said he had studied after its launch earlier in substantially in excess of the interest costs. As she

93 understood his explanation, the Scheme was a sure not expected to last more than two years. Moreover, her winner. She said that he did not explain to her the risks mother was in good health, and young for her age, and involved in gearing. Nor did he explain to her the risks there was no change in her mother’s situation that would involved in borrowing in one currency and investing in have necessitated any earlier return to the United another. All that he mentioned concerning borrowing in Kingdom. She said that in 1998, just as in 1997 (and Yen was to say that if anything were to happen to the indeed today), her time frame for a possible return to the Yen, the Scheme provided for a currency switching United Kingdom was about five years, not a shorter facility, which could be exercised so as to switch the loan period, as suggested by Mr Barber. into another low interest rate currency. 55. Although Ms Field accepted that she might at some 53. She said that having heard the explanation, in the light point in the course of her dealings with Mr Barber have of which she did not envisage that there were any said something to the effect that she wanted her money significant risks involved in the Scheme, she agreed to go to work harder for her, she regarded these as just “general ahead with it, as she was at this point entirely happy with words”. She also said that she could not have said this in the advice that she had received from Barber Asia so far, June 1998 at the meeting alleged by Mr Barber, as there and given her friendship with Mr Barber, was content to was no such meeting. She said that throughout her rely on his recommendation. At the end of the lunch, Mr dealings with Mr Barber, she did not at any time tell him Barber returned to his office to get the Rothschild that she wished to depart from her original instructions application forms, and came with them to her office, where for a conservative investment strategy in favour of a they went through the forms fairly quickly together, and higher risk strategy, and that she throughout believed that he filled them in for her signature. He also had with him the advice that she was being given was given with her forms relating to an insurance product from the Scottish original instructions in mind. In any event, I would have Life International Insurance Company (“Scottish Life”), been of the view that even if Ms Field had said, at some which provided a capital protected investment scheme, 54. point during her dealings with Mr Barber, that she offering a range of options from 95% to 100% capital would like her money to work harder for her, this would protection, with potential returns based on the movement not have been understood by her to have been an of identified stock markets, the rate of return being affected instruction to increase the risk level of her investments - by the amount of capital protection desired. These were it seems to me that when used by a lay person, a phrase also completed by Mr Barber and signed by Ms Field. In such as this is likely to be simply an indication of a desire various places in these forms, Barber Asia and Mr Barber to achieve somewhat better returns, without implying a were described as Ms Field’s financial adviser, and Mr desire to move further out on the risk spectrum. Barber also signed the application forms for the Scheme and the Scottish Life product in that capacity. Was there a meeting in early June 1998? 56. Before turning to the details of the Scheme, and its 54. Ms Field was adamant that there had been no relevant terms and conditions, it is necessary to resolve meeting at about the beginning of June 1997. She said the conflict of evidence as to whether or not there was a that none of the factors which Mr Barber put forward as meeting in early June 1998, as Mr Barber suggests, or reasons which she had given for a change of investment whether the position is that Ms Field’s entry into the strategy were valid, in that her relationship with Mr Van Scheme took, place in the manner she described - Amelsvoort was at the time (and remains) perfectly solid, effectively in the course of a single day. that it was not the case that he would have asked her to return to the United Kingdom, since he was himself there 57. I start with the oral evidence. Ms Field’s evidence as only on a temporary basis, on an assignment which was to the absence of any meeting in June 1998 was firm.

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She was not, in fact questioned about such a meeting 1998. The body of the memorandum contains an during her initial cross-examination. However, when, as explanation of the mechanics by which the various a result of Mr Barber’s oral evidence, it became clear that components of the Scheme would be put into place. there was a significant divergence between his evidence However, the first paragraph of the memorandum states: and that of Ms Field on this point, I drew Mr Barber’s “Further to our lunch meeting today I have returned attention to the fact that he had not challenged Ms Field’s to you copies of the various applications and evidence that she had come to invest in the Scheme declarations for your files and confirmed a number following a single meeting with Mr Barber on 10 July of important details.” 1998. As Ms Field was still available for further cross- It seems to me that this reference suggests that the date examination, I allowed Mr Barber the opportunity to of the meeting was indeed 10 July 1998, as Ms Field says. cross-examine her further, specifically to deal with this There is no doubt that the relevant application forms were point, and one other matter that had arisen. However, not completed until that date, and the reference to such further cross-examination proved fruitless, as Ms returning copies for Ms Field’s files is, to my mind, a clear Field remained unshaken in her evidence that there had indication that this memorandum is referable to a been no meeting in early June 1998. She was adamant meeting on 10 July 1998, and not to an earlier meeting. that she was only shown the application form, and not the general information concerning the Scheme or the 60. The memorandum further refers, at the end of the additional sheet relating to the effects and risks involved second page, to a number of documents which are in gearing, and the levels of gearing permitted under the described as having been left with Ms Field for her Scheme. She denied having suppressed any perusal. Although they include reference to some documentation, insisting that she had turned over all the documents which Ms Field said that she did not receive documents in her possession to her legal advisers, and (she says in her statement that she only received the that these did not include either of the documents which standard policy terms and conditions for the Scottish Life I have just mentioned. She said that the first time she product), it seems to me that the relevance of this passage saw either of these documents was when they were for present purposes is that it too is, as Mr Maurellet produced by Mr Barber during his evidence. suggested, consistent with there having been a meeting on 10 July 1998, and not earlier. There is no suggestion 58. Mr Barber’s cross-examination of Ms Field on this point in the memorandum that such documents were provided was somewhat brief. When confronted with her firm denial to Ms Field prior to the meeting to which the of any meeting in early June 1998, and her denial that he memorandum refers. had provided her with any documents or information concerning the Scheme prior to 10 July 1998, he fell back 61. These points were put to Mr Barber in the course of on an alternative suggestion that this still left her with a his being cross-examined by Mr Maurellet. Mr Barber period of some five weeks before the loan was actually drawn sought to suggest first that the memorandum might have down, during which she could have read the documents been wrongly dated, in that it might in fact have been which she was given more closely, and reconsidered her first written following the early June meeting, but printed position if she thought it necessary to do so. out again after the July meeting, and, because of the vagaries of the word processing programme used, had 59. Apart from Ms Field’s evidence, and her having the current date inserted in place of the actual date on effectively dispelled the reasons which Mr Barber gave which it was written. I must confess that I found that for her having wanted a further meeting in early June explanation unconvincing. Quite apart from the fact that 1998, I have also had regard to a memorandum which the memorandum makes perfectly good sense on the Mr Barber prepared for Ms Field, which is dated 10 July basis that it refers to a meeting which both witnesses

95 agreed did take place - that on 10 July 1998, there are a conservative/medium risk strategy, and that the several other references in the memorandum which are Scheme was, for reasons which were given, a strategy that inconsistent with it having been written at an earlier date. met that description. Thus, for example, there is a reference to Ms Field having to complete a switch form for the Old Mutual investment, 63. Having regard to all of these factors, I conclude that and more significantly, an acknowledgment of receipt of Ms Field’s evidence as to the Scheme having been the Old Mutual policy documents for assignment to introduced to her on about 10 July 1998, the same day Rothschild as security for the loan to be granted under on which she signed the various documents to put it into the Scheme. I cannot see any reason why this would have effect, is to be preferred to that of Mr Barber. That being been provided to Mr Barber for handling some weeks so, I accept also Ms Field’s evidence that she did not before any decision had been made to go ahead with the receive a copy of the two documents that Mr Barber Scheme. It is far more likely that it would have been produced during the course of her evidence. While it is provided to him after a decision had been made to enter fair to say that there was little reason for Mr Barber not into an investment structure based on the Scheme, which to have given copies of these documents to Ms Field, it did not take place until 10 July 1998. Mr Barber also seems to me that, given that everything took place on suggested that he might have given Ms Field two copies one day, it is on balance more likely that Mr Barber would of the documentation referred to on the second page of have seen no need to provide that material to Ms Field, the memorandum, one set shortly after the June meeting, and did not do so, since she had already agreed to go and another set at the meeting on 10 July 1998. Again, I ahead with the scheme. find this suggestion unconvincing. It seems to me much more likely that the memorandum was correctly dated, The structure of the investment complained of and on this basis, it is inconsistent with Mr Barber’s case 64. I turn now to consider the nature of the investment that there had been an additional meeting in the early involved in the Scheme, as proposed by Mr Barber to Ms part of June 1998. Field. As I have indicated, in broad outline the Scheme involved assigning Ms Field’s existing investments with 62. Further, and to my mind more importantly, bearing Old Mutual as security for a loan from Rothschild, the in mind that the principal significance of the alleged proceeds of which would be used to acquire an investment meeting between Mr Barber and Ms Field in early June from Scottish Life, which would also be assigned to 1998 is that Ms Field is alleged, at this meeting, to have Rothschild as security for the loan. The loan was to be indicated a desire to make a significant modification of denominated in Yen, and would carry a low rate of interest. the level of risk that she was prepared to accept in order to attempt to achieve better returns on her investment, 65. The introductory brochure to the Scheme (which was it is strange that when Ms Field complained (about a year headed “The Loan and Guarantee Scheme”), which I have later) of the level of risk to which she had been exposed, found was not in fact supplied to Ms Field, set out in point Mr Barber and Barber Asia did not, despite several form what were said to be the benefits and main features opportunities to do so, ever suggest that there was no of the Scheme. One of the benefits was said to be that cause for complaint, since the level of risk involved in investment returns could be maximised by introducing the Scheme was commensurate which the increased level an element of gearing into an investment portfolio. It of risk that she had, in June 1998, instructed Barber Asia would seem that this was the reason for which Barber she was prepared to accept. As will become apparent Asia introduced the Scheme to Ms Field. The document when that correspondence is looked at, Barber Asia’s explained that the size of the loan that could be obtained response (through Mr Barber) was to affirm that Ms under the scheme depended on the nature of the Field’s instructions had been that she wished to invest in investments offered as collateral. This aspect of the

96 Regulation of Investment Advisors

Scheme was further explained in the additional without any further notice realise the collateral and document which commented on the effect of gearing apply the proceeds to repay the loan and/or cash (which I have found was also not supplied to Ms Field), collateralise its guarantee liability. In such which I shall consider below. Thus, for example, where circumstances, any surplus would be paid to you money market funds in the same currency as the loan and should a shortfall arise, such outstanding were offered as security, the maximum loan that could amount (including accrued interest) would be be drawn down would be 85% of the value of the immediately due and repayable by you to security. The maximum loan drawdown would drop to [Rothschild]. The enforcement by [Rothschild] of its lower percentages of the security value for other forms rights thereunder may result in the loss of part or of security. Where money market funds in a different all of the collateral.” currency to the loan were offered as security, the maximum loan would be 70% of the value of the security, 69. There was also a further section headed “Risk and where mixed bond and equity market funds were Considerations”, which stated:- offered as security, the maximum loan was 60% of the “The value of the collateral, and the income value of the security. therefrom, can fall as well as rise and fluctuations in currency exchange rates can affect performance 66. The brochure went on to explain that following returns. ...” drawdown of the loan, the borrower would be required to maintain a minimum level of security cover. This 70. The separate document which explained the effect allowed for some erosion of the margin of cover that was of gearing (which, as I have found, was also not provided provided at the initial drawdown, but the borrower was to Ms Field), contained the following statements :- required to ensure that the amount outstanding did not “[The Scheme] has been used ... to introduce an at any time exceed this higher percentage of the value of element of gearing into ... investment portfolios with the security available. the intention of enhancing investment returns. ... your exposure to investment markets increases, thus 67. Interest payable on the loan could either be paid off offering the opportunity to enhance your investment as it fell due, or rolled up and added to the amount of the returns through greater capital and/or currency loan at each interest payment date. If interest were rolled gains.” up, the amount of the interest would result in an increase “It should be noted, however, that gearing your in the amount outstanding under the loan, and would investments is only beneficial when the return gained only be possible if the increased amount was within the from your investments exceeds the interest incurred limits of the minimum security cover required. on your loan ...” [an example was then given, illustrating the beneficial effect of gearing based on 68. At page 4 of this document, reference was made to assumed returns and interest rates (which were what were described as “Important Notes”. These lower than the assumed returns)]” recommended that, as the loan agreement was legally “Gearing, however, can be a high risk strategy and binding, clients should consider seeking independent hence is certainly not for every investor. Whereas legal advice on the application form and the terms and gearing can increase potential gains, any losses are conditions before signing the application form, as this likewise magnified ...” [revised figures were then would bind them to the terms of the loan. The notes went provided, based on less favourable assumptions, on to point out that:- which nonetheless provided net returns (although at “Should the Maximum Maintained Drawdown a lower rate than the returns without gearing)]” levels be breached at any time [Rothschild] may “It is therefore essential to understand these risks

97 before arranging such a facility and then, having not recollect actually having gone through the detailed done so, to ensure that the geared investment is terms and conditions (which were in a separate regularly monitered by you, your financial adviser document), either with Mr Barber or later. She did not and/or your trustees taking investment recollect having received a copy of these. performance, interest rate exposure and currency rate exposure into account.” 74. The Application form itself set out a number of declarations by the applicant. These included the following:- 71. The Rothschild application form, which was signed “(e) I/We understand that I am/we are required to by Ms Field at the meeting on 10 July 1998, contained on maintain a minimum level of Collateral as security the front a prominent warning. It was headed “Important for the Facility as set out more fully in paragraph 8 Notice” and read as follows:- of the Terms and Conditions and in the event of my/ “This Application form together with the Terms and our failure to comply with this or any of the other Conditions set out the basis upon which the Bank will Terms and Conditions the Bank may realise the provide a credit facility under [the Scheme]. Their Collateral as set out in paragraph 12.7 of the Terms contents are important and should be read carefully and Conditions.” before completing and signing the Application Form “(f) I/We understand that the value of the Collateral as together they constitute the Client’s contract with can fall as well as rise, fluctuations in currency the Bank.” exchange rates can affect performance returns and “Private individuals are advised to seek independent that the Bank makes no recommendation whatsoever legal advice before signing and where the Client as to the suitability, quality or future performance consists of more than one person, each individual is of any of the Assets which either form part of the advised to seek such legal advice independently of Collateral or are listed in the List of Approved Funds, the other.” nor does it in any way make any representation or “The enforcement by the Bank of its rights hereunder give any warranties that those funds isted under the may result in the loss of part or all of the Collateral.” same category in the List of Approved Funds are subject to the same risks.” 72. Ms Field acknowledged having seen the notice on the “(g) I/we understand that this agreement is an front of the application form. She said, however, that important document, that the enforcement by the rightly or wrongly, she did not take legal advice before Bank of its rights hereunder may result in the loss of signing it. She explained that so far as she was concerned, part or all of the Collateral and that I am/we are she did not feel that a legal adviser could have told her hereby advised to seek independent legal advice whether or not she should be investing in the manner before signing.” that was being recommended. As Mr Barber was with her and had gone through the form with her, it did not 75. Under the Application form, the amount of the loan seem to her that there was any question of getting legal applied for was the Yen equivalent of £468,000. The advice. She thought that it was not so much a question of period of the loan was to be five years. An election was the forms being legally binding, which she accepted, but made to have interest payments rolled up over the life of of whether the product was the right one for her the loan, so that interest would not have to be kept circumstances, a question which would not be affected current, but would simply be capitalised (thus increasing by the legal position. the size of the loan) on each interest payment date.

73. Ms Field also acknowledged having gone through the 76. So far as the detailed terms and conditions are contents of the form with Mr Barber, although she did concerned, the most relevant are the following:-

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“8. UTILISATION were despatched by Mr Barber on Ms Field’s behalf. 8.1 Within the total amount of the Facility, utilisation will be limited so that the total amount 78. As at 10 July 1998, Ms Field’s investment with Old drawn, including capitalised and accrued interest, Mutual was split among five funds (the switch may not exceed the Maximum Maintained Facility contemplated at the end of May 1998 not having been Drawdwon from time to time ... processed at this point), which included both equity and money market funds. In his memorandum of 10 July 8.2 In the event that at any time utilisation under 1998, Mr Barber had recommended that Ms Field should the Facility exceeds the amount permitted under sub- switch all of her Old Mutual Investments (which were paragraph 8.1 above, the Client undertakes worth approximately £187,000) into the Sterling Money immediately on demand from the Bank to repay such Market Fund. He explained that this was to provide excess to the Bank or to provide the Bank with maximum security, and a better interest rate than US additional security satisfactory to the Bank of dollar money market rates. It appears from a letter dated sufficient value to remedy the excess and to provide a 16 July 1998 from Old Mutual to Rothschild that this was margin of security therefor satisfactory to the Bank.” done on or about 14 July 1998.

“12. SECURITY INTEREST AGREEMENT 79. The loan applied for under the Scheme was the Yen 12.7 Enforcement of Security equivalent of £468,000, which was expected to be some The security created by this Agreement shall 106,704,000 Yen (an exchange rate of 228 Yen to the immediately become enforceable at any time after notice pound). This figure was based on a gearing factor of 2.5 demanding payment of any sum secured by this times applied to the value of the original Old Mutual Agreement has been given by the Bank to the Client and investment. The loan proceeds would be converted into at any time thereafter the Bank may without prior notice Sterling and remitted to Scottish Life, for investment into to the Client redeem, exchange, switch, convert, sell, their International Secure Investment Portfolio, using the transfer and/or apply all or part of the Collateral in such 100% Capital Protected Deposit Bonus Fund. The policy manner and for such consideration (whether payable issued by Scottish Life, together with the Old Mutual or deliverable immediately or by instalments) as the Policy would be assigned to Rothschild as security for Bank in its absolute discretion may determine. ...” the loan to be made by them.

“13. VALUATION OF THE COLLATERAL 80. Thus, what was envisaged was that Ms Field would 13.2 Valuation of any life assurance policies borrow the equivalent of £468,000 from Rothschild. The comprised within the Collateral shall be by reference loan would be secured against the two policies (from Old to the latest surrender values available to the Bank Mutual and Scottish Life respectively) which had a converted into the currency of the Facility at the combined value of £655,000. The amount of the loan prevailing spot rate of exchange where appropriate. would be 2.5 times Ms Field’s original investment (it was in fact some £500 more than this amount, but that is, I 13.3 In the event of any dispute regarding the think, immaterial). After the entire structure was put into valuation of all or part of the Collateral the Bank’s place, the loan would represent some 71.45% of the decision will be final.” available security. The maximum maintained amount of the loan does not appear to have been stated in the 77. Having signed the Scheme Application form, and the application form. However, it is clear from other application form for the Scottish Life investment that was correspondence that this was set at 85%, so that Ms Field to be acquired with the loan proceeds, these documents was obliged to ensure that at all times, the value of the

99 loan did not exceed 85% of the value of the security which the then exchange rate of 238.14 Yen to the pound), and had been provided. This was equivalent to a security cover had effected a drawdown of 107,520,210 Yen by remitting requirement of about 117.76%. its Sterling equivalent (£451,500) to Scottish Life, to be invested into the Scottish Life investment product. A 81. I note in passing that the figures for initial and facility arrangement fee of a further 155,000 Yen had been ongoing security cover do not match any of the categories added to the loan balance, leaving some 2,324,790 Yen in either of the Rothschild explanatory documents. Mr (£9,762.28) available to cover the interest on the loan that Barber explained that this was probably due to the use of would be capitalised from time to time. The interest rate the Scottish Life product, which provided a higher level applicable to the loan was 2.1875% per annum. of security than money market funds because of the capital guarantee feature, so that Rothschild was The risks and level of risk involved in the Scheme prepared to offer greater gearing on a specially tailored 84. I pause here to consider the risks attaching to the basis. Mr Barber said that it was in fact Barber Asia who investment structure into which Ms Field had now had asked Rothschild to consider permitting the use of entered. These included the following:- this product, which a number of Barber Asia’s clients had (1) The element of gearing gave rise to increased risk, invested in, as security for loans under the Scheme. in that while it was designed to enhance the returns available on an ungeared investment, it would also 82. Although there was a switch of the Old Mutual amplify any decreases in value, and losses which might investment from the original five funds to the Sterling be suffered. Mr Green illustrated this with a simple Money Market Fund, this change appears to have escaped example. If an investor invested £100, it would be the attention of Rothschild, notwithstanding that it was necessary for the value of the investment to fall by mentioned in Old Mutual’s letter to Rothschild dated 16 £100 (or 100%) before he would lose everything. If, July 1998. On 3 August 1998, Rothschild wrote to Charles however, the same investor had the same capital Dunford, a colleague of Mr Barber at Barber Asia, saying (£100) and borrowed a further £100, and invested that on the basis of the original five funds (which were a the total, the total investment would be £200. mixture of major market equity funds and major and However, in such a case, a 50% fall in the value of the other market bond funds), it would not be possible to investment would result in the loss of £100, or the lend as much as £468,000, but only some £367,500, whole of the investor’s own money. Thus, with gearing, based on Old Mutual’s valuation as at 16 July 1998. a smaller percentage fall in the value of the underlying Rothschild suggested that in order to obtain investment can result in the loss of the investment. The approximately the loan applied for, the Old Mutual greater the amount of the gearing, the smaller the investments should all be switched into major money percentage fall required to result in loss of the investor’s market funds. It was also indicated that a slightly larger own (as opposed to borrowed) funds. loan could be obtained if the entire investment were (2) By utilising gearing in the form of the loan from switched to the Scottish Life product, probably because of Rothschild, there was a further element of risk arising the capital guarantee feature attaching to that investment. from the possibility that it might be necessary for Ms Field to put up further security if called upon by 83. In fact, as I have noted, the Old Mutual investments Rothschild to do so, and that if she could not or did had already been switched. Although not in the evidence not do so, Rothschild might realise the existing before me, it seems probable that this was brought to security, and perhaps demand immediate repayment Rothschild’s attention, as by 13 August 1998, Rothschild of the loan, thus crystallising any loss which might had approved a loan facility for Ms Field of some exist on paper. Although this might not result in the 110,000,000 Yen (which was equivalent to £461,913.16 at loss of the whole of Ms Field’s capital, it might result

100 Regulation of Investment Advisors

in a loss being incurred as a result of the premature 87. Mr Barber sought to explain the basis on which he termination of the investment, since it would preclude evaluated the investment structure under the Scheme by the possibility to holding on to the investment and reference to a document which he produced at trial, which waiting for a hoped for recovery to materialise. he said represented the sort of analysis which would have (3) The mismatch between the currency of the loan been done by Barber Asia in relation to that investment and the currency of the assets to be invested in structure. In brief, Mr Barber said that consideration was introduced an element of currency or exchange rate given to the amount of collateral cover taking account of risk - the risk that there might be a movement in the the initial collateral cover, the minimum collateral cover relative exchange rates of the two currencies that required after drawdown, and the income surplus that might adversely affect the returns on the investment. was expected to be earned over the course of a year, For example, if an investor borrowed in Yen to make having regard to the interest differential between the cost an investment in Sterling, and the value of the of borrowing and the yield on the investments securing investment increased by 10%, but Sterling fell by 20% the loan. For the purposes of the example, Mr Barber against the Yen, the investor would suffer a net loss assumed an initial investment of £100,000, gearing of in Yen terms. 2.5 times to produce a loan of £250,000, resulting in total (4) There was also, I think, an element of interest funds available for investment of £350,000. The excess rate risk - i.e., that the interest rate applicable to the of collateral over loan was therefore £100,000 (the loan might rise, in the event that the LIBOR rate for amount of the investor’s own funds). As the loan could Yen moved upwards. not exceed 85% of the value of the security during its life, Mr Barber assessed the minimum margin cover at 115% 85. In subsequent correspondence with Ms Field, Mr of the value of the loan, so that a minimum of £287,500 Barber had suggested that her investments as a whole under of security would be required during the life of the loan. this structure were consistent with her stated desire for a As there was in fact security of £350,000, there was an conservative/medium risk investment strategy. However, excess of collateral to the extent of £62,500, which in the course of cross-examination, he stated that he would provided a cushion against the possibility that the consider the investment strategy entered into on the basis collateral might, for whatever reason, decline in value. of the Scheme to be of medium to high risk, a risk level that Mr Barber then made a projection as to the likely growth was not, in my view, consistent with such a strategy. rate of the investments (net of annual fees assumed to be 1% for both Old Mutual and Scottish Life), and the likely 86. Mr Green disagreed with this assessment. While interest costs. On the basis that the Old Mutual accepting that there would be some investments which investment would return 5% net per annum on £ might fall on the borderline between different risk levels, 100,000, and the Scottish Life investment would return and which might reasonably be thought to fall within 9% net per annum on £250,000, total returns would be either of two adjoining categories of risk, Mr Green was some £27,500 per annum. From this would have to be of the view that the investment strategy entered into on deducted the borrowing cost, which at an interest rate of the basis of the Scheme was of at least high risk, possibly 2.2% per annum would be £5,500. Thus, over the course very high risk. He explained that while the underlying of a year, the investments would produce net income of Old Mutual and Scottish Life investments were in £22,000, a return of 22% on the original investment. This themselves compatible with a conservative/medium risk £22,000 would also be available to augment the security strategy, the addition of the elements of leverage and the cover, so that at the end of a year, assuming that exchange currency mismatch rendered the investment structure as rates did not move, there would be excess collateral cover a whole one which carried a high to very high level of of £84,500 in total, which would be available as a cushion risk. against a decline in the value of the security.

101 88. Mr Barber says that he then made some calculations Adding this to the excess of security, there was a cushion in order to assess the currency volatility of the Yen against of some £74,000, as opposed to Mr Barber’s figure of Sterling. Based on research which was available at the £84,500. time, he concluded that there had been six periods in the preceding three years in which the Yen had strengthened 91. More importantly, Mr Green drew attention to clause against Sterling, and the average appreciation was some 13.2 of the Terms and Conditions of the loan, which I 5.7%. Applying this figure to the loan, Mr Barber have set out above. The significance of this is that it makes estimated that on any single strengthening of the Yen, it clear that for valuation purposes, Rothschild would the loan principal amount might increase by some have reference to current surrender values where their £14,000 (5.7% of the loan amount of £250,000). This security took the form of insurance policies. Given that was, he said covered by the net investment return over there is typically a surrender penalty of in the region of the year, apart from which there was the excess collateral 5% applying to insurance products in the early years of of £62,500 available as a cushion. His assessment was the investment (usually the first five years, at least), the that the Yen was, on the basis of his research, not an value of the total investment of £350,000 for collateral excessively volatile currency, and he therefore thought purposes was reduced to some £322,500, so that the that the investment structure was not unduly risky. cushion available was significantly reduced. Mr Green therefore considered that the amount of leeway available 89. Mr Green made a number of comments on this to cover adverse currency movements was significantly analysis. First, he said that the minimum collateral cover less than Mr Barber had calculated (some £57,000, was not 115%, but 117.6%, since the calculation had to instead of the £84,500 which Mr Barber had arrived at). be done by reference to the ratio of collateral to loan. This is clearly correct. Collateral cover of 117.6% produces a 92. While not accepting that it was necessarily correct, loan to collateral ratio of 85% (which was the maximum Mr Green did not comment on Mr Barber’s analysis of ratio which Rothschild had agreed to), whereas collateral the volatility of the Yen against Sterling. cover of 115% produces a loan to collateral ratio of just under 87% (which is higher than the maximum ratio 93. I did not understand Mr Barber to disagree with the which Rothschilds would accept). The figure put forward qualifications which Mr Green indicated should be made by Mr Green also coincides with the figures put forward in relation to either the calculation of minimum collateral by Rothschild later, when the issue of collateral cover cover (and there could, I think, realistically be no arose in the course of 1999. This increased the minimum disagreement as to this), or the returns on the amount of security required to £294,000, reducing the investments (which was in any event a relatively small cushion to £56,000. adjustment). However, Mr Barber took issue with the question of using current surrender values as the basis 90. Mr Green also took issue with the assumptions as to of valuing the security for the loan. He asserted that returns on the investment, pointing out that the fees were Rothschild had, after Ms Field (and other clients of Barber in fact higher than had been assumed by Mr Barber. In Asia) had taken up loans under the Scheme, “moved the the case of the Old Mutual product, Mr Green thought goalposts” by valuing the security which had been the difference was immaterial, but he pointed out that provided on the basis of surrender values, and on the there was a set up charge of 1.6% per annum for the first basis of current values, rather than the value at the end five years of the Scottish Life investment, which would of the loan term, whereas it had been Barber Asia’s clear reduce the return to 7.4%, or £18,500 per annum on that understanding that security would throughout be valued investment. This would reduce the net return from the on the basis of its value at the end of the loan term (at two investments after interest costs to £18,000, or 18%. which time there would not be surrender penalties).

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94. In support of this point, Mr Barber drew attention to term (although he does suggest that such an approach the fact that the calculation by Rothschild of the was somewhat inflexible). maximum loan amount appeared to have been predicated not on surrender values, but on the (higher) policy values 101. In any event, I find it difficult to see how such the of the investments. approach suggested by Mr Barber would work in practice. It would appear to involve a forecast by Rothschild of the 95. However, apart from this, there is no evidence to future value of the security, which would be a difficult support either of these suggestions. To the contrary, such exercise to carry out, particular in the case of securities such evidence as there is points the other way. as equity or bond funds, the value of which will fluctuate from time to time. It is also difficult to see why such an 96. So far as the point on policy values as against surrender approach would have been agreed to by Rothschild, since it values is concerned, I start with the observation that the could not be in their interests to have to proceed on the terms of Clause 13.2 of the loan Terms and Conditions are basis of an assessment of future values which might turn unambiguous, and state that valuations of insurance out to be wrong, leaving them with the risk of an increased products will be based on latest surrender values. exposure to the borrower at the end of the day. Moreover, in a letter dated 26 February 1999, written at a time when the collateral cover for Ms Field’s loan was 102. For all of these reasons, I conclude that in this under close scrutiny, Rothschild stated that it had always respect, too, there was no change of stance by Rothschild. been their policy to value securities such as those provided by Ms Field on the basis of their surrender values. 103. I therefore conclude that Mr Green’s qualifications to Mr Barber’s analysis are well founded, and that the 97. I am therefore unable to accept that there was any amount of cushion available in respect of the security for change of stance by Rothschild in this respect, and am of the loans was significantly less than that suggested by the view that throughout, the relevant value of the Mr Barber. It would, I think, follow that the level of risk insurance investments for security purposes were their involved in the investment strategy was at least somewhat surrender values. higher than that which Mr Barber suggested.

98. The suggestion that Rothschild would have regard 104. Further, it seems to me that in considering the not to current values, but the value of the security at the analysis carried out by Mr Barber, prudence would end of the loan term is equally one which is unsupported indicate that allowance should be made for the possibility by evidence. that the assumptions as to returns and calculations of currency volatility might turn out to be wrong, since it is 99. Further, it seems to me that Clause 13.2 is also not uncommon for unexpected movements in relation inconsistent with such a suggestion, referring as it does to such matters to occur. to the latest surrender values available to Rothschild. This clearly implies that current valuations will be used, and 105. Mr Green also emphasised that the use of gearing not some valuation based on the likely value of the always gives rise to the second form of risk identified security at the end of the loan term. above. The lender will almost inevitably stipulate for an element of margin cover, which means that there is a risk 100. Moreover, I note that in an e-mail message to Ms that additional margin will have to be found at some point Field of 21 September 1999, Mr Barber appears to during the period during which the investment is held, recognise that Rothschild were entitled to use current and if this is not done, the result is likely to be that the values, notwithstanding that the loan was for a five year lender will foreclose on the loan at an unfortunate time,

103 causing loss of capital to the borrower/investor. There is Scheme, and the concept of gearing, which contained thus always a risk of loss of capital, which means that clear references to risk (particularly in the case of the such a strategy cannot properly be described as latter document, which indicates that the use of gearing conservative, a term which implies an approach that has can be a high risk strategy). However, it is fair to say that as one of its main objectives the conservation of the some references to risks can also be found in the original investment. Application Form itself. That said, however, given that I have accepted Ms Field’s account of the manner in which 106. For all of these reasons, I would accept Mr Green’s the investment was entered into, it seems to me unlikely assessment of the level of risk associated with the that a detailed explanation of the various risks involved investment strategy which was embarked upon on 10 July was provided in the time during which Mr Barber was at 1998 - i.e. that it carried at least a high level of risk of Ms Field’s office, completing the forms with her. In any loss, and could not for that reason be described as event, Ms Field said that although she understood that conservative, and did not, therefore, comply with the type there might be some risks involved in the investment (as of investment strategy requested by Ms Field. with any investment), she believed that any risks that there might be would be in line with her stated desire for 107. I would also mention briefly at this point a a conservative investment strategy. suggestion which Mr Barber made (in later correspondence and in the course of his testimony) that 110. Moreover, there is nothing in the documentation to gearing of 2.5 times could be considered to be suggest that any explanation of the nature of the risks conservative in the Hong Kong context, where, he said, involved was given to Ms Field. This is perhaps it was not uncommon for foreign exchange and futures unsurprising, given the suggestion in later correspondence dealers and financiers to offer leverage of up to 20 times that the strategy was in fact one which met her the investor’s investment. It seems to me that this is not a requirements. If this was what Mr Barber believed, there particularly helpful approach to take. While there are would have been no obvious reason why he would have undoubtedly extremely high risk investment strategies thought it necessary to highlight such risks to Ms Field. available in the marketplace, their existence does not render a less risky, but still high risk strategy, any the less 111. It is also, I think, instructive to note Mr Barber’s one which carries a high degree of risk for the investor. approach to the question of what information should be provided to investors by way of illustration of the possible Whether the risks were explained to Ms Field outcomes of a given investment strategy. Although there 108. It was Ms Field’s evidence that, apart from telling her is some doubt as to whether or not the illustrative that the Scheme offered a currency switching option for the document said to have been appended to his loan, so that if anything happened to the Yen, the loan could memorandum to Ms Field dated 10 July 1998 was in fact be switched to another low interest rate currency such as attached to it, it is to be noted that it projected a highly the Swiss Franc, Mr Barber did not explain to her the nature satisfactory rate of return. Even the examples provided of the risks involved. She said that she was left with the by Rothschild in their document on gearing, which I have impression that the proposed investment structure was a found was not seen by Ms Field at the material time, safe one, which carried with it little or no risk of loss of which provided two calculations, resulted in a positive capital. Mr Barber, on the other hand, said that he explained return in both cases (albeit the worse of the two cases all the relevant risks to Ms Field. shown involved a return that was less than that which could have been achieved without gearing). Mr Barber 109. I have found that Mr Barber did not supply Ms Field was asked whether projections were ever produced by with the Rothschild documents which introduced the him which showed a loss arising. He said that no such

104 Regulation of Investment Advisors projections were ever provided. When asked why this was, indicated that it was considered that the Yen was likely he explained that there was no requirement to do so, saying to weaken again in due course, and recommended that that even in relation to matters governed by the Securities existing loans in Yen be maintained. Ms Field said that and Future Commission’s Code of Conduct (which he did she was not unduly concerned by this letter. A few weeks not accept applied to this case) there was no requirement later, on 28 October, Ms Field received a further letter to provide projections showing a negative outcome. from Barber Asia, commenting on the Scottish Life investment, and mentioning that the Yen had weakened 112. Given this approach, I conclude that it is more likely somewhat, and that there was evidence to suggest that than not that Mr Barber did not explain to Ms Field the this trend would continue. possibility that the investment strategy which he was proposing carried with it the risk of a loss of a significant 117. In October 1998, the Yen resumed its upward trend part of her capital, or the reasons for this. against Sterling. Ms Field says that during October, she met Mr Barber at a social event in Macau, at which the 113. Ms Field said that had it been explained to her that subject of the strengthening Yen came up, and she asked the investment strategy being recommended carried such him about it. Mr Barber’s recommendation was to keep a risk of loss of capital, she would not have entered into. the Rothschild loan in Yen. Subsequently, on 26 October Having regard to the fact that her investments represented 1998, Mr Barber sent a memorandum to Ms Field, stating the fruits of many years of hard work, I accept that evidence. that the Yen had unexpectedly strengthened sharply against Sterling, to the surprise of the market. Mr Barber 114. At this point, it is pertinent to note that as a result indicated that it was still thought that the Yen would of the entering into of the arrangements under the weaken again, and recommended that no changes should Scheme, Barber Asia stood to receive some £22,575 in be made to the Rothschild loan currency. commissions from Scottish Life over five years, and annual fees from Rothschild of some 268,800 Yen, or in 118. It seems that during November 1998, Ms Field excess of £1,200 per year. Thus, although Barber Asia requested a further review of her position. This resulted were not earning any fees from Ms Field herself, the in a further memorandum being prepared by Mr Barber, business which she had placed through them was dated 2 December 1998. For reasons which were not producing fees of over £7,000 per year for Barber Asia. entirely clear, further copies of this memorandum, bearing later dates (in March and April 1999) also appear The period up to the first margin call to exist. However, it seems reasonably clear from the 115. The loan from Rothschild having been drawn down terms of the memorandum that it was in fact produced and the investment in the Scottish Life product having on or about 2 December 1998. This memorandum been obtained on 13 August 1998, the Yen almost purported to provide an overview of Ms Field’s immediately began to strengthen against Sterling. I investment position as at the end of November 1998. It should make it clear that no complaint is made by Ms commented on the assets which Ms Field owned (the Old Field in relation to Barber Asia’s failure to predict the Mutual and Scottish Life policies which were pledged as actual extent to which the Yen was to strengthen against security for the Rothschild loan), both of which it Sterling over the course of the next year or so. described as “Low Risk”. This description was accurate, so far as the investments underlying the policies 116. On 4 September 1998, Ms Field received a letter themselves were concerned, The memorandum stated that from Barber Asia referring to the fact that the Yen had in US dollar terms, the Old Mutual investment had strengthened, although this was more in relation to the increased by 4.4% and the Scottish Life investment by 2.2% US dollar than in relation to Sterling. However, the letter since they had been acquired. The overall increase for both

105 investments taken together was 2.8%, which was said to loan was secured. be equivalent to a gross return of some 9.8% over Ms Field’s original investment with Old Mutual. These figures 121. A similar report titled “Fourth Quarter 1998 did not take account of the interest cost associated with Investment Report” was provided by Mr Barber to Ms the Yen loan, and the memorandum went on to say that Field in a letter dated 4 February 1999. This indicated taking those costs into account, there had been a net return slightly lower returns than had been recorded in the of some 7.7% on the initial investment with Old Mutual. report of 2 December 1998. However, it still suggested that there had been a net return (in US dollar terms) of 119. The report ended by commenting on the recent 6.21% on the original investment which had been placed strength of the Yen against Sterling, expressing with Old Mutual in March 1998. The total value of Ms confidence that this was a short term phenomenon, and Field’s investment was stated to be some £651,687.45 (or that the Yen would weaken back to levels close to those US$1,081,801). It seems likely that this value was based prevailing when Ms Field took out the Yen loan. on the investment value of the Old Mutual and Scottish Life policies, and not their then surrender values. 120. Although this purported to be an general overview However, as with the 2 December 1998 report, this report of Ms Field’s various investments, it seems to me that in did not indicate the current level of the Rothschild loan failing to factor in the current liability under the Yen loan, either in Sterling or US dollar terms. As at 1 February in the light of the Yen’s strenghening, it did not provide a 1998, the Yen/Sterling exchange rate was approximately complete picture as to Ms Field’s position. The 187 Yen to the pound (I have again taken this figure from strengthening of the Yen had the effect of significantly the chart annexed to Mr Green’s report). On this basis, increasing Ms Field’s liability to Rothschild at this point the Rothschild loan (again ignoring the arrangement fee in time. In order to provide an accurate picture of the and accumulated interest, which would increase it position and the return (if any) which she had achieved somewhat), would have been equivalent to some at this point, it seems to me that it was necessary to deduct £574,000, leaving Ms Field with a net investment of just from the value of the investments (whether their face or under £78,000, less than half of her original investment. surrender values) the amount of the Yen loan. Only after I note that at these levels, Ms Field would at this point this was done would Ms Field have a true picture of have been in breach of the minimum collateral cover whether she was ahead or behind on her original requirements under the Rothschild loan. investment at this stage. Although no calculation was provided to me of the amount of the Yen loan (in Sterling The first margin call. or US Dollar terms) at this point, it would appear, based 122. On 18 February 1999, Rothschild wrote to Barber on the drawdown amount, and an exchange rate of 198 Asia to say that Ms Field was in breach of the minimum about Yen to the pound (which I have taken from a graph collateral cover requirements under the loan, and to call depicting the movement of the Yen against sterling for the position to be rectified immediately. A number of between between July 1998 and January 2002 appended options were suggested as ways of achieving this. These to Mr Green’s report), the amount drawn down under included a switch to a higher rated category of security the Rothschild loan to acquire the Scottish Life (which would decrease the amount of cover required), investment, in Sterling terms, had increased to some the provision of further security in the form of cash or £543,031, more than £90,000 over its original amount other investments, the repayment of part of the loan, or (this does not take account of the facility fee and accrued the full repayment of the loan (in the latter two cases, interest, which would increase the outstanding amount repayment being made either from the assets or some further). This was an increase which exceeded by many other source). Rothschild indicated in the letter that it times the return earned on the assets against which the was its intention to write to Ms Field shortly.

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123. Ms Field was not immediately informed of the mentioned as an “option” the possibility of switching the problem. Instead, it seems that Barber Asia discussed the loan to sterling, so as to reduce the collateral cover position with Rothschild, with a view to obtaining some required (by putting the loan and security into the same time. It appears from a letter dated 25 February 1999 that currency, thus eliminating the currency mismatch). Rothschild had been told that action would be taken, but However, he made it clear that this would have the none had yet been. Rothschild therefore said that it would unsatisfactory consequences of locking in the exchange write to Ms Field if nothing were done by the next morning. loss of some £115,000, and moving to a higher interest rate on the loan. He suggested that Ms Field should look 124. Nothing was in fact done within that time frame, into the possibility of obtaining a loan from her local and Rothschild accordingly wrote to Ms Field on 26 bankers (HSBC), on the basis that even though the February 1999, informing her that her security for her interest rate might be higher, the total amount of interest loan was some way short of the minimum cover payable would be less than would be the case if the requirements, and indicating that they wished to speak Rothschild loan were redenominated into Sterling. He to her about this. Ms Field said that prior to receiving also emphasised that this would eliminate the exchange this letter, she had been unaware of the problem that had loss, and that when the Yen weakened (as he thought it arisen, as Barber Asia had not been in touch with her. would), it would be possible to withdraw some security On the same day, Rothschild wrote to Barber Asia to and so repay the additional loan. A later letter the same indicate that in fact, the position was worse than they day provided Ms Field with Mr Barber’s reasons for had previously thought, as their valuations of the security thinking that the Yen would indeed weaken in due course. had been made on a partially erroneous basis, in that their valuations of the Scottish Life policy did not take account 126. Although Mr Barber sought to suggest that his first of the surrender penalty attaching to that investment. As letter of 3 March 1999 simply offered Ms Field options I have mentioned previously, it was in this letter that as to what could be done to remedy the situation in Rothschild confirmed that it had always been their respect of the Rothschild loan, it is clear from the tenor practice to value security on the basis of surrender values. of that letter that his firm recommendation was to It seems that Barber Asia agreed that if necessary, it maintain the loan in Yen, and to seek to provide would cover the surrender penalty in order to persuade Rothschild with further security, by obtaining a loan from Rothschild not to take immediate action to switch the HSBC. This is clear from the first and last paragraphs of loan into Sterling, thereby crystallising a substantial the letter. I note also that the fact that Mr Barber appears exchange loss to Ms Field. to have assumed that a loan would be necessary to enable the further security to be provided is indicative of an 125. Rothschild continued to press for action to be taken, awareness on his part that Ms Field might not have ready and on 3 March 1999, Mr Barber wrote to Ms Field to access to additional funds. explain the problem which had arisen. Mr Barber said, correctly, that the problem had arisen as a result of 127. Mr Green was critical of this advice, saying that it the strengthening of the Yen, which had resulted in the resulted in Ms Field being subjected to an even higher Sterling equivalent of the loan increasing from its original level of gearing, and hence to even greater risks. It seems amount of £451,500 (wrongly stated by Mr Barber to be to me that this is a fair criticism. £450,000) to £566,610. Mr Barber said that this meant that the value of the collateral cover was short by some 128. It seems that (perhaps because of a £115,666 (in fact this was not strictly accurate - this was misunderstanding) Ms Field thought that the branch of actually the approximate amount by which the loan HSBC with whom she and Impact Group banked would principal had increased in Sterling terms). Mr Barber not assist. In the result, Mr Barber introduced her to a

107 Mr Cho, the manager of another branch of HSBC with loan been switched to Sterling. Further exchanges took whom Barber Asia banked. Following a number of place in April 1999, in which Ms Field continued to press meetings between Ms Field and Mr Cho (Mr Barber did for explanations as to the rationale underlying the not take part in these negotiations), HSBC agreed to grant Scheme, and Mr Barber continued to say that Ms Field a term loan of HK$650,000 to Ms Field, at an interest was still making net positive returns each year. However, rate of some 11.75%. This was much higher than the rate it is again pertinent to note that such returns were of interest which Mr Barber had thought might be calculated only by deducting interest costs from assumed available (see his letter to Ms Field of 3 March 1999, which returns on the security placed with Rothschild (by this indicated an interest rate of 7-8%). The principal of the time, the two insurance products and the deposit from the loan was to be paid off in 11 instalments of HK$55,000 further funds lodged in March 1999), and did not reflect and a final instalment of HK$45,000, with interest on Ms Field’s net asset position having regard to the amount the outstanding amount being debited to Ms Field’s of the outstanding loan in Sterling terms. current account every month. Apart from the proceeds of the HSBC loan, Ms Field also had recourse to further 131. By late July 1999, Ms Field was still seeking funds from another loan source, and was able to provide explanations. In an e-mail message of 27 July, she a total of about £76,000 by way of fortification of the reminded Mr Barber of his statement that should security for the Rothschild loan. This was placed on anything happen to the Yen, the loan currency could be monthly deposit with Rothschild, earning a small amount switched to a safer option, and asked for a clear of monthly interest. explanation of her position. In his replies to these queries, Mr Barber reiterated the low risk level attaching to the The period up to the second margin call security and suggested that gearing of 2.5 times was not 129. Ms Field was, understandably, somewhat unhappy unreasonable given the use of low risk collateral, and the at this turn of events, and sought an explanation from existence of much higher levels of gearing available in Mr Barber, and reassurance that the strategy was still Hong Kong. Mr Barber suggested that the problem lay the right one for her. By an e-mail message of 17 March with the appreciation of the Yen against Sterling. In 1999, Mr Barber sought to explain the rationale behind saying this, he was undoubtedly correct, however, this the scheme, and to make the point that when (as he still was clearly one of the components of the risk involved in expected) the Yen weakened back to its level at the time the Scheme, as I have explained above. of the loan, the structure would have produced satisfactory results. This analysis did not, however, The second margin call appear to take account of the possibility that the Yen 132. Unfortunately, the Yen strengthened further during might strengthen further so as to result in Ms Field facing late July and August 1999, and on 25 August 1999, a further margin call. Rothschild wrote to Barber Asia advising that Ms Field’s loan was once again in breach of the minimum collateral 130. Ms Field pressed for further clarification on about cover requirements. No immediate action having been 13 April 1999, asking how the Scheme was benefitting taken to rectify the breach, Rothschild wrote to Ms Field her, particularly given the substantial additional on 2 September 1999, warning that Rothschild would be commitments she had undertaken with the loan from entitled to take such steps as they thought necessary if HSBC, and asking how it was helping her meet her the breach was not remedied, indicating that this might objective of a small return on her investments. Mr Barber well include switching the currency of the loan to Sterling replied the same day, saying that in fact, the interest and switching the Scottish Life investment to a more payable on the HSBC loan was significantly less than the secure one. Ms Field says that she tried to contact Mr interest which would have been payable had the Rothschild Barber, but was unable to do so, as he was out of Hong

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Kong. She managed to contact Chris Barber, but he was been partially obscured. However, she was sure that she only able to suggest putting up further security. This was did not ask for this to be done, and thought that it might not done, and on 14 September 1999, Rothschild wrote simply have been something that her secretary had done to Ms Field demanding immediate payment of the loan, without asking her. Mr Maurellet also drew my attention which then stood at 110,112,357 Yen. The next day, 15 to the fact that the bundle of documents did, in any case, September 1999, Rothschild wrote to say that it had contain a letter from Messrs Johnson Stokes & Master, decided to switch the loan into Sterling, although leaving Ms Field’s former solicitors, addressed to both open the possibility of a subsequent switch back into Yen Rothschild and Barber Asia and in which complaints should the position be rectified to their satisfaction. were addressed to both of them.. He suggested that this was inconsistent with any attempt to create the impression 133. The switch was effected at the then current exchange alleged by Mr Barber. I think that this is right indeed, in rate of 166.25 Yen to the pound. The effect was that the addition to the letter from her former solicitors, it is clear loan then stood at £662,330, nearly £210,000 more than from several e-mail messages sent by Ms Field to its value at the date of drawdown. Ms Field e-mailed Mr Mr Barber or Chris Barber at this time that she considered Barber at this time, asking why he had taken such risks that they had let her down as well. Her unhappiness with with her money, leaving her with very substantial losses, Barber Asia at this time is also, I think, evidenced by the when she had reminded him many times how complaint which she was to lodge with the Securities & conservative she was. Mr Barber replied suggesting that Futures Commission in October 1999 against Barber Asia. the best course might still be to service the loans and hope I therefore reject Mr Barber’s suggestion that the partial to hold on long enough to avoid what was still at that obscuring of this document was deliberate, or due to stage a paper loss, rather than cashing out and sinister motives on Ms Field’s part. crystallising Ms Field’s losses. In fact, at this point, unless the switch into Sterling could be reversed at no cost, Ms 135. E-mail correspondence between Ms Field and Mr Field had already suffered a substantial exchange loss. Barber and Chris Barber continued. On 20 September 1999, Ms Field wrote to Mr Barber, demanding a strategy The period up to the closing out of Ms Field’s to deal with the situation. In this e-mail, she summarised investments her grievances in these terms :- 134. It seems that Ms Field subsequently faxed a copy of “... my grievance right now is two-fold: the Rothschild letter of 14 September 1999 demanding a) I told you I was a ‘conservative investor’ right repayment of the loan to Mr Barber on 21 September from the start. Was it wise to put all my eggs in 1999, expressing her indignation at Rothschild’s one basket and ‘over-gear’ me so much (I have attitude, and indicating that she was minded to complain sought independent advice on this - and been told to the press about them. However, the copy of this letter I was overgeared given the amount of the than was produced in the bundles of documents had these investment and the fact that my entire savings handwritten comments blanked out. Mr Barber were put into one scheme) suggested that this had been done deliberately by Ms b) Why didn’t you take remedial action to Field, in order to create the impression that she had all change the loan currency and prevent this as soon along blamed Barber Asia for the losses which she as the yen started it[s] mammoth slide? ...” suffered, whereas the truth was that she initially blamed only Rothschild. Ms Field said that this had not been her 136. It will be clear from this that Ms Field was by now intention. She was unable to explain how it was that the consulting others as well. She said in her evidence that copy of the document which was sent to her solicitors by this point, she had enlisted the assistance of Mr Van (which found its way into the bundle of documents) had Amelsvoort, and also a friend in the United Kingdom who

109 was a banker. I also note that the second complaint is Barber suggested that he did not respond to the complaint not one that is pursued in these proceedings. as it would have been impolite to do so - an explanation which I found weak, to say the least. 137. So far as the first complaint is concerned, Mr Barber responded in the following terms in his e-mail to Ms Field 139. At about the same time, on 22 September 1999, of 21 September 1999:- Chris Barber provided Ms Field with a number of options “7. Eggs in one basket issue: Your investments are to consider, ranging from putting up additional security spread between Rothschild, Scottish Life and Old to enable the Rothschild loan to be redenominated back Mutual, they are not in ‘one basket’. In addition, the to Yen, to closing out all the investments and paying off underlying Scottish Life investments are spread the loan in full. Ms Field consulted Mr Van Amelsvoort between several different stock market indices and at about these options, and it appears to have been his advice varying levels of capital protection. The underlying that although closing out would crystallise substantial (and collateral investments are all sound conservative perhaps total) losses, staying in the loan structure would investments, which are still worth in excess of carry the risk of further losses, particularly if it were £750,000. It is the foreign exchange position that has redenominated back into Yen, an the Yen did not weaken, caused the problems.” or strengthened further against Sterling. Ms Field also “8. ‘Over-geared’: When we originaly discussed this consulted a friend, a Mr Temple, who also advised her to type of investment, I outlined that 2-2.5 times gearing close out her positions, since there was no guarantee that was considered conservative gearing, particularly she would ever be able to recover her losses, and he felt it when compared to many private banks who offer 5- unsatisfactory for her to have to remain in a relationship 10 times gearing (I have even seen 20 times gearing with Barber Asia for what might be a substantial period of FX trading programmes). Taking into account the low time, in the hope of recovering her losses. interest rate on Yen borrowing; the Scottish Life growth track record plus the capital guarantee structure, the 140. Ms Field continued to consider the various options reasons for this gearing strategy were sound and, at which Chris Barber had suggested to her. Chris Barber that time, acceptable to you because you were looking was, it seems, pressing her to continue with the loan for conservative/medium risk growth. If for one and investments, although he did suggest reducing the moment we had been able to predict the rapid and loans and investments in various ways. This continued historic appreciation of the yen, then obviously we until December 1999. During this time, Ms Field also would not have commenced this strategy.” lodged a complaint about Barber Asia with the Securities & Futures Commission on 11 October 1999. It seems that 138. As I have noted earlier, this e-mail message is this did not result in any action being taken against significant as much for what is not said, as for what is Barber Asia. said. In particular, it is instructive to observe that Mr Barber confirmed that Ms Field’s objective at the time 141. On 15 October 1999, Barber Asia wrote to Scottish the Scheme was entered into was to achieve conservative/ Life to instruct them to cease paying the management medium risk growth, and that there is no suggestion that fee of 1% per annum payable to Barber Asia for managing her investment objectives had changed since her initial Ms Field’s investments with Scottish Life. As I understand dealings with Barber Asia. I have already considered it, this would have had the effect of reducing the charges above the suggestion that the Scheme was consistent with payable by Ms Field to Scottish Life on this investment, conservative/medium risk growth - as I have concluded, thus increasing slightly the value of the investment. On the Scheme in fact involved a significantly higher degree the same day, Chris Barber wrote to inform Ms Field that of risk than was compatible with such a strategy. Mr this had been done.

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142. Thereafter, Ms Field instructed her former Was There a Contract Between the Parties? solicitors, Messrs Johnson Stokes & Master to write to 146. I turn first to the question of whether or not Barber Rothschild and Barber Asia setting out her complaints Asia owed any duties to Ms Field as a matter of contract, about the Scheme - this was done by letter dated 12 and if so, what the scope of those duties were. This raises November 1999, in which the unsuitability of the the issue of whether there was any contract at all between investment for Ms Field, and its incompatibility with her Ms Field and Barber Asia. It is only if there was a contract objectives and instructions was complained of Rothschild between them that the scope of any duties owed pursuant instructed solicitors to respond denying liability. As I have to it will arise for consideration. noted earlier in this judgment, no response to this letter was forthcoming from Barber Asia. 147. Mr Barber submitted that there was no contract between Ms Field and Barber Asia. He drew attention to The closing out of the investments the fact that although he had explained the different 143. Finally, in early December 1999, Ms Field decided services available, in particular the discretionary and to close out her whole position, and instructed Chris advisory client services offered by Barber Asia, Ms Field Barber to do so on 8 December 1999. The Old Mutual ultimately opted for neither of these. He stressed also and Scottish Life policies were therefore surrendered, that at no time during the period in which Ms Field had attracting penalties for early surrender, and the cash dealings with Barber Asia did Ms Field pay any fees deposit with Rothschild was realised. The Rothschild loan directly to Barber Asia for its services. Barber Asia was, was repaid out of the proceeds, and it was common as he pointed out, remunerated by the commissions ground that Ms Field eventually received a total of and payments that it received from the companies whose £44,152.36. products Ms Field acquired through Barber Asia. Mr Barber also pointed to the fact that all contracts in relation 144. Mr Barber made the point that it was not reasonable to the investments which Ms Field acquired, and in for Ms Field to have chosen to close out her whole respect of the loan from Rothschild, were made between position, when there were other options available, which Ms Field and the company concerned. could have resulted in a recovery of some (or perhaps all) of her losses. However, Ms Field explained that by 148. Mr Maurellet, however, submitted that the evidence this point, quite apart from the advice which she had (particularly some of the application forms filled in for received from Mr Van Amelsvoort and Mr Temple, she Ms Field by Mr Barber, and other information provided simply did not feel able to continue in any form of by Mr Barber to parties such as Rothschild and Scottish relationship with Barber Asia. Mr Green also commented Life, in which he described himself and Barber Asia as on Ms Field’s decision to close out her investments and Ms Field’s financial adviser) disclosed a relationship of effectively endorsed it, saying that in his view, there was adviser and advisee, and that this, coupled with the fact little clear upside to her in staying in, and by closing out, that Barber Asia earned commissions, or were enabled she eliminated the possibility of any further losses. He to do so, was sufficient to give rise to an implied contract considered that on the whole, closing out the entire between Ms Field and Barber Asia. position was the less risky option to take, and that it was therefore a reasonable one. 149. It seems to me that the evidence clearly indicates that Mr Barber and Barber Asia considered themselves 145. Having set out the facts as I find them to be, and to be financial advisers to Ms Field. I do not think the the reasons for my findings, in some detail above, it will, fact that the actual investment or loan contracts were I think, be possible to resolve the issues which I identified entered into by Ms Field in her own right would negative, at the beginning of my judgment reasonably briefly. or be inconsistent with, the existence of a contract

111 between her and Barber Asia. It seems to me that even if between the parties (although the existence of a contract there were such a contract (certainly if it were a contract may, in some cases, negative or restrict the scope of any to provide an advisory service, and perhaps also if it were duty of care that might otherwise arise). one for the provision of a discretionary service), it would still be necessary for investments to be acquired by Ms 153. Mr Barber sought, I think, to suggest that Barber Field herself (in the absence of some form of nominee Asia was under no relevant duty in the circumstances of arrangements). this case. As I understood his argument, he submitted that having regard to the regulatory framework applying 150. That said however, in my view, the relationship to the financial services industry in Hong Kong, the between Ms Field and Barber Asia was not a contractual obligations applicable to persons providing financial one. In order for a contract between them to have existed, advice were governed by the codes of conduct imposed apart from the provision and acceptance of services in by the Securities & Futures Commission, in the case of the nature of investment, it would be necessary for there investments in securities, and by the Confederation of to be some consideration passing between the parties. It Insurance Brokers, in the case of investments in is not difficult to see consideration passing from Barber insurance products. Mr Barber explained that Barber Asia Asia, in the form of provision of services. However, in would be subject to the Confederation of Insurance my view, Ms Field provided no consideration to Barber Brokers’ code of practice in relation to the selling of the Asia for its services. She did not herself agree to Old Mutual and Scottish Life policies, and subject to the remunerate Barber Asia for its services. The fact that Securities & Futures Commission code in relation to the Barber Asia earned remuneration from other sources as selection of securities or funds into which the investment a result of Ms Field’s acting on its advice does not, in my was to be channelled under the Old Mutual policy. So far view, amount to consideration moving from her. The as the loan from Rothschild was concerned, however, Mr position might have been different had there been an Barber indicated that this would not be covered by either obligation on Ms Field’s part to make her investments code of conduct, since it was a loan, and not a securities through Barber Asia, or even to take advice from Barber or insurance investment. Asia exclusively, but it was not suggested that either of these situations was the case here. 154. This may well be correct in terms of the applicability or otherwise of the different codes of conduct, and may 151. I therefore conclude that there was no contractual be one of the reason why Ms Field’s complaint to the relationship between Ms Field and Barber Asia. In the Securities & Futures Commission came to nothing. light of this conclusion, I do not propose to consider what However, it does not, in my view, exclude the possibility duties might have arisen on the part of Barber Asia by of a tortious duty of care arising, since such a duty is one way of contract had a contract existed. In particular, it is which is imposed as a matter of law, in the light of the not, I think, necessary to consider whether any of the relationship between the parties. implied terms pleaded in the Amended Statement of Claim arose. 155. The principle on which liability in tort in respect of advice given, whether by an investment adviser or some Was There a Duty of Care in Tort? other professional, is now quite well established. In 152. I turn to consider whether Barber Asia owed Ms Field general, where a defendant assumes the responsibility a duty of care in tort, to act with reasonable care and skill of providing advice to a plaintiff, and knows or ought to in relation to the advice which they gave her from time to know that the plaintiff is likely to rely on that advice, a time. It is well established that a tortious duty of care can duty of care is likely to arise. Pertinent factors to take into arise irrespective of the existence or otherwise of a contract account will also include the relative skill and knowledge

112 Regulation of Investment Advisors of the parties, the context in which the advice is given, responsibility should be held to have been assumed whether the giver of the advice is doing so completely by the defendant to the plaintiff. ... In addition, the gratuitously or is getting a reward, whether in some direct concept provides its own explanation as to why there or indirect form, and whether or not there are any express is no problem in cases of this kind about liability for disclaimers of responsibility (which would negative any pure economic loss; for if a person assumes assumption of responsibility by a defendant). responsibility to another in respect of certain services, there is no reason why he should not be liable in 156. A recent statement of the principle may be found in damages to that other in respect of economic loss the speech of Lord Goff in Henderson v Merrett which flows from the negligent performance of those Syndicates Ltd [1995] 2 AC 145 at 180C-181D, where services. It follows that, once the case is identified as Lord Goff had this to say, when discussing the effect of the falling within the Hedley Byrne principle, there decision of the House of Lords in Hedley Byrne & Co. should be no need to embark upon any further enquiry Ltd v Heller & Partners Ltd [1964] AC 465, which is whether it is “fair, just and reasonable” to impose the starting point when considering the principle liability for economic loss ...” underlying liability for negligent advice or mis-statement:- “... We can see that it rests upon a relationship 157. Applying these principles, it seems to me clear that between the parties, which may be general or specific in this case, there was the necessary voluntary to the particular transaction, and which may or may assumption of responsibility by Barber Asia. There can not be contractural in nature. All of their Lordships be no doubt that Barber Asia, as professional investment spoke in terms of one party having assumed or advisers, were in possession of special skills or undertaken a responsibility towards the other. On this knowledge which Ms Field, a wholly inexperienced point, Lord Devlin spoke in particularly clear terms investor, did not have. Further, the circumstances in ... Further, Lord Morris spoke of that party being which Barber Asia, through Mr Barber, provided possessed of a “special Skill” which he undertakes to investment and financial advice to Ms Field negative the “apply for the assistance of another who relies upon possibility that such advice was provided in a social or such skill”. But the facts of Hedley Byrne itself, which other setting that might indicate that there was no was concerned with the liability of a banker to the assumption of responsibility on their part. The advice was recipient for negligence in the provision of a reference clearly provided as part of their business, and it was, I gratuitously supplied, show that the concept of a think, clearly in Barber Asia’s contemplation that it would “special skill” must be understood broadly, certainly be rewarded for those services, although not by Ms Field, broadly enough to include special knowledge. ... by being put in a position to earn fees and commissions although, in the case of the provision of information from the investment products which Ms Field would and advice, reliance upon it by the other party will be acquire as a result of following its advice. There were not, necessary to establish a cause of action (because so far as I can see, any express disclaimers of otherwise the negligence will have no causative effect), responsibility by Barber Asia in respect of the advice nevertheless there may be other circumstances in rendered to Ms Field. In these circumstances, I have no which there will be the necessary reliance to give rise doubt that looked at objectively, Barber Asia should be to the application of the principle.... regarded as having assumed responsibility to provide Ms “... Furthermore, especially in a context concerned Field with financial advice. with a liability which may arise under a contract or in a situation “equivalent to contract”, it must be 158. Moreover, it seems to me just as clear that Barber expected that an objective test will be applied when Asia realised, or must have realised, that Ms Field would asking the question whether, in a particular case, rely on its advice. From Barber Asia’s point of view, it

113 was undoubtedly the expectation that Ms Field would rely to Mr Barber (no such investments having been recorded on the advice tendered by accepting it and acquiring the in his notes of his initial meeting with Ms Field), or which investment products which had been recommended, as would have been known to him had he but asked (as Mr this was the means by which Barber Asia would be Green pointed out that a competent financial adviser enabled to earn fees and commissions from the suppliers should have done). of such investment products. Quite apart from this, it must have been clear to Barber Asia that Ms Field was 163. Further, so far as Ms Field’s financial position is seeking its advice with a view to entering into an concerned, I have found that she told Mr Barber, as was investment strategy on which to employ her savings. It the case, that the investment which she was proposing to seems to me also that the various references in the make in about March 1998 represented virtually the documents and application forms in which Barber Asia whole of her available assets for investment, leaving only described itself as Ms Field’s financial adviser are a a relatively small amount over for emergencies or recognition by Barber Asia that it was acting in that contingencies. This is, I think, something that it was capacity vis-a-vis Ms Field, a capacity which to my mind incumbent on Mr Barber to have in mind in advising Ms inevitably suggests that the advisee is likely to rely upon Field as to an investment strategy. Mr Barber indicated the advice of the adviser. that he took account also of the value of Ms Field’s business in assessing her overall worth. So far as this is 159. I therefore have little hesitation in concluding that concerned, Ms Field said, and Mr Barber agreed, that Barber Asia’s relationship with Ms Field was one which there was no actual discussion of the valuation of her imposed upon it a duty of care in her favour. business. The approach which Mr Barber took was to value the business at twice its annual turnover. It seems Were Barber Asia Negligent? to me that this is at best a rough and ready, and rather 160. This leads on to the question of whether or not, on unscientific approach to the valuation of a business, so the facts of this case, that duty has been breached. In other that any valuation made on this basis, without a closer words, did Barber Asia fall short of the standard of care examination of the nature of the business and the factors which is to be expected of a reasonably competent financial affecting its valuation can only be of very limited value. adviser, advising a person in the position of Ms Field. Moreover, it seems to me that it is also important to have regard to the undoubted fact that the nature of Ms Field’s 161. In considering this, it is necessary to bear in mind business was such that her personal involvement in it was Ms Field’s inexperience in investing, her personal likely to be responsible for a significant part of its value, (and particularly financial) circumstances, and the as her clients were likely to deal with her company on objectives which she had communicated to Barber Asia. the basis that she was there to execute and manage their media management and public relations plans. To realise 162. I have already found that Ms Field was, at the time the value of the business might therefore require some she approached Barber Asia, an inexperienced investor. commitment on the part of Ms Field to continue to It seems to me that Mr Barber knew, or ought to have operate it for some period of time. It does not seem that known this. I have rejected the suggestion that Ms Field Mr Barber took this into account. Finally, it is important was, by reason of her having held a bank account with to bear in mind that, if Mr Barber was considering Ms multi-currency deposit facilities, to be regarded as a Field’s overall worth with a view to ascertaining her ability sophisticated investor. Much more pertinent is her to carry an investment strategy involving gearing through apparently total lack of experience in investment in to its conclusion, it would (as Mr Green pointed out) have stocks, shares, bonds, unit trusts, mortgages, or other been incumbent on him to have regard to Ms Field’s forms of investment, a matter which was either known available or readily realisable assets, since it is likely that

114 Regulation of Investment Advisors at times when additional security or funding is required, invest in conservative or conservative/medium risk it is likely to be required to be provided promptly in order strategies, it seems to me that simply on the basis of Mr to stave off adverse action being taken by a lender. Viewed Barber’s acceptance that the strategy using the Scheme from this perspective, it does not seem to me to be was a medium to high risk strategy, it would be open to appropriate or reasonable to place much, if any, weight me to find this allegation proved. However, I would go on the valuation of a business being run by the investor, further, and hold that the strategy using the Scheme was since such a business is rarely likely to be readily in fact, as Mr Green opined, a high risk strategy that could realisable, and will often prove to be a questionable source not be described as conservative, for the reasons which I of additional funding, whether by loans secured against have given, and I therefore consider that this allegation it, or some other means. For all of these reasons, I do not is made out, as I cannot see any basis on which a consider that a reasonably competent financial advisor reasonably competent investment adviser could properly would have set much store by a valuation of Ms Field’s give advice which was or should have been known to be business, and in so far as Mr Barber did so, it is my view inconsistent with an advisee’s stated desires or objectives. that he fell short of the standard to be expected of him. I am satisfied that a reasonably competent investment adviser would have realised that the investment structure 164. So far as Ms Field’s objectives are concerned, I have into which Ms Field was recommended to enter involved found that throughout her relationship with Barber Asia, a high level of risk, and could not properly be described she had made it known to Barber Asia that she desired a as conservative. Mr Green has suggested that Mr Barber conservative investment strategy. I do not think that it may have been influenced by the prospect of higher makes much difference for present purposes whether this commissions being earned by Barber Asia through this is described as conservative, low to medium risk, or structure. As I indicate below, I am not persuaded that conservative/medium risk. It seems to me that any level this is necessarily correct. However, it may be that Mr of risk of loss of capital that went beyond the lower end Barber, having (in my view, negligently) concluded that of the medium risk band would not accord with Ms Field’s the investment structure was of medium to high risk, stated objectives. I have also found, on the basis of the thought that this was nonetheless a suitable investment evidence to which I have referred above (and in particular for Ms Field, given that he appears to have thought it Mr Barber’s own correspondence, and his failure to unlikely that the Yen would appreciate significantly suggest that Ms Field had changed her objectives to a against Sterling. higher risk and non-conservative strategy when complaints were made as to the strategy adopted on a 167. The second complaint (paragraphs 37(2) and (3)) number of occasions in late 1999), that Mr Barber was is effectively that no sufficient consideration was given throughout aware of this. to the fact that Ms Field was investing the whole of her available capital. This, too, is something that I consider 165. Against this background, I turn to consider the that a reasonably competent investment adviser would allegations of breach of the duty of care which are pleaded have borne in mind. Although Ms Field accepted that she in paragraph 37 of the Amended Statement of Claim. had some modest reserves left over after making the initial investment with Barber Asia in the Old Mutual 166. The first allegation (paragraph 37(1)) is that Barber product, I think that it is fair to say that she had invested Asia failed sufficiently to heed Ms Field’s stated the whole or substantially the whole of her available desire to invest in conservative investments. This is capital. On this basis, it seems to me that this complaint clearly something to which a reasonably competent too is made out, in that the fact that what was being investment advisor would have had regard. Having invested was substantially the whole of her capital made regard to my findings as to Ms Field’s instructions to the geared investment under the scheme one which was

115 incompatible with Ms Field’s instructions, and unsuitable 170. The fourth area of complaint relates to the for her, since it gave rise to a significant risk of loss of her collateral risk inherent in the currency mismatch capital in the event of a call being made (as it was) by (paragraphs 37(6) and (7)). In my view, given Rothschild for further security to be provided. the miscalculations by Mr Barber of the amount of security cover actually available, there was a failure on 168. The third area of complaint (paragraphs 37(4) and the part of Barber Asia to appreciate the extent of the (5)) relates to the currency risk involved in the mismatch collateral risk involved in the currency mismatch. On of currencies between the loan and the investment, which balance, I think that the errors made were such as was also to serve as security for it. It seems to me that it would not have been made by a reasonable investment is clear that Barber Asia appreciated that there was a adviser. The miscalculation of the minimum collateral currency risk involved in the structure which they were cover percentage (which Mr Barber put at 115% instead recommending. They sought to assess the level of that of 117.6%) was a straightforward arithmetic error, risk. Mr Green did not criticise (although he did not accept which should not have been made had reasonable care the correctness of) the assessment of the volatility of the been exercised. The errors in relation to the assumed Yen, which was part of the assessment of the currency risk. costs in respect of the investments are also He did, however, criticise the manner in which Barber Asia surprising, but perhaps not as signficant. The major assessed the sufficiency of the cushion of collateral problem, however, was the failure to factor in available to cover this risk. In my view, while there are surrender values. It seems to me that a reasonably legitimate criticisms to be made of Barber Asia’s careful 169. investment adviser would have read assessment of the level of cushion that was available, it through and obtained an understanding of the terms seems to me that on balance the existence of this risk was and conditions of the Rothschild loan, and having done adverted to by Barber Asia, and I therefore do not think so, would have appreciated that security valuations that the complaint in paragraph 37(4) is established. would be based on surrender values. I have rejected Mr Barber’s suggestion that Rothschild had “moved the 169. I find, however, that Barber Asia (acting through goalposts” in this regard. I do not regard the fact that Mr Barber) did not in fact sufficiently warn Ms Field of Rothschild appear to have miscalculated the amount the existence or nature of this risk, as it should have done, of cover when indicating the level of loan that might had it acted with reasonable care and skill. As I have be available, or in the early stages of monitoring the stated, I have accepted Ms Field’s account of the meeting loan as excusing this. The fact that Rothschild, who on 10 July 1998, and therefore accept that Mr Barber dealt were unfamiliar with the Scottish Life product, may with the question of risks associated with currencies at have made such an error does not, to my mind, excuse best in a cursory fashion, by referring to the possibility Barber Asia for doing so, particularly when, according of a switch in the currency of the loan. I do not think that to Mr Barber, it was Barber Asia who were seeking to this was sufficient to bring to Ms Field’s attention the risks persuade Rothschild to accept the product as security. associated with the currency mismatch, which it was It seems to me that in these circumstances, Barber Asia incumbent on Mr Barber to do if he were to deviate (as he could be expected to have a better understanding of did) from Ms Field’s instructions to provide her with a the product than Rothschilds. Further, an error on conservative or conservative/medium risk investment Rothschild’s part could not, in my view, justify Barber strategy. The obligation to warn of particular risks is, I Asia in thinking that Rothschild were intending to vary think one which a reasonably prudent investment advisor the terms and conditions of the loan without at least would be expected to comply with (see e.g. NMFM making enquiries to ascertain that this was what was Property Pty Ltd v Citibank Ltd (No. 10) (2001) 186 intended. I therefore consider that the complaint in ALR 442, at paras 423 to 443 of the judgment). paragraph 37(6) is made out.

116 Regulation of Investment Advisors

171. So far as paragraph 37(7) is concerned, having be expected of a reasonably competent investment accepted Ms Field’s account of the circumstances in which adviser, it seems to me to be permissible to have regard she embarked upon the investment strategy using the to them, and for Ms Field to frame her claims by reference Rothschild loan, it follows that I am satisfied that Mr to them, so far as appropriate. I therefore turn to consider Barber did not warn Ms Field as to this risk, as he should these further complaints. have done, and accordingly I find this complaint to be established. Ms Field also gave evidence, which I accept, 175. I do not think that the allegation in paragraph that had the nature of the risks to which she was exposed 37(10), that Barber Asia failed to act fairly and in the best been explained to her so that she understood that there interests of the Plaintiff adds a great deal to the allegations was a risk of loss of her capital, she would not have gone which I have already considered. It will be apparent from ahead with this investment strategy. my conclusions that I consider that Barber Asia did not, in all the circumstances, give Ms Field advice that was in 172. Paragraph 37(8) was not explored to any great extent her best interests. However, to the extent that there is a during the course of the trial, and I therefore decline to make suggestion that there was some unfairness in the way that any findings in respect of the complaint there set out. Barber Asia dealt with Ms Field, it was not entirely clear to me how the Plaintiffs case was being put, and I 173. Having regard to the findings which I have made therefore make no finding in that respect. above, it follows that the complaint in paragraph 37(9) that Ms Field was advised to invest in a manner which 176. I do not think that the complaint in paragraph 37(11) was attended by inappropriate risks is made out. Like is made out. It is clear from the evidence that Mr Barber the firsttwo complaints, this is, I think, in essence an did obtain information from Ms Field about her financial allegation that the investment was unsuitable for Ms situation, investment experience and investment Field, and should not have been recommended to her. I objectives. The complaint is that he failed to take accept that the recommendation of an investment which appropriate account of her objectives, and failed to have is or should be known to be unsuitable for the sufficient regard to relevant features of her financial prospective investor will amount to a breach of the duty situation and investment experience (although there might of care owed by an investment adviser to those to whom be some room for criticism of his appraisal of these matters). he gives advice (see e.g. Martin v Brittania Life Ltd[2000] Lloyds Rep PN 412; NMFM Property Pty 177. I did not understand the complaints in paragraphs Ltd v Citibank Ltd (No. 10)(supra) at paras 444 et 37(12) and (13) to be pressed, and make no findings in seq. of the judgment). respect of them.

174. The complaints pleaded in paragraphs 37(10) to (19) 178. The complaint in paragraph 37(14) appears to be are predicated largely on the terms of the Securities and broadly similar to that in paragraph 37(9), relating as it Futures Commission’s Code of Conduct applicable to does to the suitability of the investment for the investor. investment advisers regulated by that body. As I have Accordingly, I find that this allegation is made out. noted, although accepting that Barber Asia was subject to regulation by that body, Mr Barber contended that the 179. Having regard to my findings as to what Mr Barber Code of Conduct did not apply in this case, since the loan knew or should have known about Ms Field’s financial from Rothschild (which underpins Ms Field’s complaints) position, and my finding that he did not sufficiently was not something that fell within the purview of the explain to her the risks involved in gearing her Securities & Futures Commission. That may well be right. investments with a currency mismatch, I conclude that However, in so far as the complaints reflect standards to the complaint in paragraph 37(15) is made out.

117 180. The allegations in paragraphs 37(16) and (17) a number of significant respects. In principle, therefore, concerning failure to enter into a client agreement are, the losses which Ms Field suffered as a result of the in my view, inappropriate to a claim in tort, and I investment advice rendered to her by Barber Asia would therefore do not consider that Barber Asia were negligent be recoverable by her as damages for their negligence. in failing to enter into a client agreement with Ms Field. This was not, it seems to me, something that they could Causation and Contributory Negligence have insisted on Ms Field doing. 184. Before considering the quantum of loss, however, it is necessary to deal with two further matters - one raises 181. The complaint about failure to provide quarterly questions of causation, and the other issues of statements (paragraph 37(18)) is also, to my mind, one contributory negligence. which is inapt for a negligence claim. Absent some obligation to do so, I can see no reason why Barber Asia 185. So far as causation is concerned, paragraphs 32 and should have provided such quarterly statements to Ms 34(2)(b) of Barber Asia’s Amended Defence alleges, in Field, with whom they did not stand in a contractual effect, that Ms Field’s losses were caused, not by any relationship. Moreover, I have some difficulty in seeing negligence on their part, but by her decision to close out how, even if established, this allegation would have her investments in December 1999. It is true that that caused Ms Field loss. I therefore decline to make any decision resulted in the crystallisation of the losses which finding against Barber Asia in this respect. might hitherto be regarded as paper losses, since it involved the realisation of the investments in order to 182. Finally, the complaint in paragraph 37(19) alleges pay off the Rothschild loan, which had by that point been that Barber Asia acted in conflict of interest. This appears redenominated into Sterling. However, it seems to me to be based on the fact that Barber Asia stood to earn that so long as the decision was one which was reasonably significantly higher commissions and fees from the made, in the light of the circumstances then prevailing, investment structure which Ms Field entered into on 10 Barber Asia can have no cause for complaint. July 1998 than they would have earned from the investment with Old Mutual. It is undoubtedly true that 186. In my view, the decision on Ms Field’s part to close Barber Asia stood to earn significantly higher fees as a out her position was a reasonable one, for the reasons result of the change in investment strategy (as much as which she gave. I accept that there was no certainty that in excess of £40,000, as compared to just under £ 10,000, the position would have improved in the future, and that over a period of five years). However, Mr Barber having regard to her experiences to that point, it was strenuously denied that the advice he gave Ms Field was reasonable for her to wish to terminate her relationship motivated by this factor. Although Mr Green was of the with Barber Asia, rather than to try to continue dealing view that the level of commissions might have been a with them in the hope of recouping her losses. motivating factor in Barber Asia recommending the Scheme to Ms Field, and was, at any rate, something that 187. I would also add that given the redenomination of should have been disclosed to Ms Field, the complaint the loan into Sterling, it would seem that the currency is, as pleaded, one of actually acting in conflict of interest loss was already crystallised, and in that sense incurred. rather than non-disclosure of matters that might suggest So long as the loan remained in Sterling, the only way for the existence of a conflict of interest. On balance, I am Ms Field’s losses to be reduced would be by achieving not persuaded that this allegation to be established. gains on her investments. However, had there been such gains, but no currency loss, the effect of the gains would 183. In conclusion therefore, I find that Barber Asia did have been to enhance her returns, so that she would have fall short of the standard of care to be expected of them in had greater profits. I therefore tend to think that the

118 Regulation of Investment Advisors substantial cause of Ms Field’s losses was the currency into the investments and investment strategy which she loss occasioned when the loan was switched to Sterling undertook had it not been for Barber Asia’s advice. by Rothschild. The only way this currency loss could have Further, as I have noted, there is no evidence that Ms been reversed would have been to secure a switching of Field was at the material time in receipt of advice from the loan back into Yen, in the hope that there would be a any other advisers, or that she ever rejected any significant weakening of the Yen in future. However, it suggestions for investments which were tendered to her seems to me that it would not have been reasonable to by Mr Barber. Given that Barber Asia was dependent on expect Ms Field to have taken such a course, as it would her accepting (and thus relying on) its advice in order to have involved a fresh assumption of the various risks earn fees and commissions from the insurance companies which I have already concluded were incompatible with and banks whose products they had recommended, it lies her investment objectives. ill in its mouth to suggest that Ms Field did not in fact rely on such advice, and I reject any such suggestion. 188. I therefore reject the contention that Ms Field’s decision to close out her position in December 1998 192. I turn now to deal with an allegation of contributory severed the causal connection between Barber Asia’s negligence that I permitted to be made by a reamendment negligence and her losses. to Barber Asia’s Amended Defence shortly before closing submissions at the trial. It had become apparent that Mr 189. I should not leave the topic of causation without Barber was complaining that Ms Field had failed to take briefly commenting on some points which Mr Barber legal advice, and had failed to pay sufficient regard to made in his closing submissions, which appeared to me the acknowledgments of risk which she made when to be directed to an argument that Ms Field did not in signing the Rothschild loan application form. As these fact rely on Barber Asia’s advice to her. This is also, I matters had been explored in the evidence, and as Mr Barber think, an argument of causation, since it is the reliance was unrepresented, I thought it right to draw to his attention on the negligent advice which provides the causal link the possibility that a plea of contributory negligence on Ms between the advice and the damage which is suffered. Field’s part might be open to him. Mr Maurellet very properly did not object to the amendment preferred by Mr 190. Mr Barber made the point that it appeared from the Barber, and I accordingly gave leave for it to be made on evidence that Ms Field was in fact conducting her own the usual terms as to costs - that Barber Asia should pay to research, and obtaining and acting on the advice of others, Ms Field the costs thrown away by the amendment (which such as Mr Van Amelsvoort and Mr Temple. He also referred were likely, in any event, to be slight, limited effectively to to various pieces of evidence which he said suggested that the cost of the amendment). she was making her own decisions as to how to deal with the situation. With respect, I do not see that this is relevant, 193. The amendment raised a number of different points, particularly since all of the evidence to which Mr Barber which I shall deal with in turn. referred related to the period after the investment strategy complained of had been embarked upon. 194. The first three points made relate to the entering into of the Rothschild loan agreement. It is suggested that 191. Equally, I do not think that the fact that Barber Asia Ms Field agreed to the terms of the loan, that she fully were only providing advice to Ms Field, which she could understood the risks involved, and that (to the extent that accept or reject as she chose, is indicative of a lack of she did not) she failed to ask any questions which would reliance on her part. There can be little doubt that Ms have brought the risks to her attention. In my view, each Field relied on Barber Asia’s advice. As I have indicated, of these points is without foundation. It is of course true there is no suggestion that Ms Field would have entered that Ms Field agreed to the terms of the loan - that is the

119 basis of her complaint. Had it not been for Barber Asia’s Field reposed in Mr Barber at that time, it would be harsh advice and recommendation that she should do so, she to fault her for this failure. I therefore conclude that it would not have done so. I have rejected the suggestion would not be right for me to find her guilty of contributory that Ms Field was fully aware of the risks that she was negligence for failing to seek independent legal advice in undertaking. Even if it might be said that in signing relation to the Rothschild loan. the Rothschild Agreement Form, she acknowledged the existence of risk, this has, I think, to be looked at in 197. Mr Barber then suggests that Ms Field should have the context of her reliance on the advice of Barber Asia re-read the documents in the period between signing the that this was an appropriate investment structure for her loan agreement and the drawdown of the loan. While Ms to enter into. In other word’s, there was, to my mind, no Field said when asked about this that perhaps she should reason for her to think that the risks that she was have done, I think that this does not amount to contributory undertaking were inconsistent with the investment negligence on her part, for much the same reasons as I have objectives which she had communicated to Barber Asia. given in relation to the preceding paragraph. For the same reason, I see no substance in the suggestion that she should have asked questions if she did not 198. It is next suggested that Ms Field failed to give clear understand anything - given the confidence which, at that and concise instructions to Barber Asia about her investment stage, she reposed in Mr Barber, it is not surprising that objectives. I reject this allegation - on the findings which I she did not ask many questions. have made, Ms Field in fact gave clear instructions about this vital topic, which were not adhered to by Barber Asia. 195. It is next suggested that Ms Field is partly to blame for her own losses because she did not cede full control 199. The final three numbered paragraphs of the of her investments to Barber Asia. I fail to see how this amendment are, to my mind, somewhat inconsistent with argument can be made good. There is nothing to suggest each other, as Mr Barber complains both that Ms Field that had she done so, Barber Asia would not have caused stayed in the investment structure at the time of the first her to enter into the investment complained of. To the margin call and thereafter, and that she chose ultimately extent that this is a suggestion that she did not fully trust, to close out her position. Be that as it may, I can see no and therefore did not rely on, Barber Asia, I reject it for basis for complaint by Barber Asia in relation to Ms Field’s reasons which I have already explained. decision to stay invested in the Scheme at the time of the first margin call, particularly since it is clear that this was 196. It is then suggested that Ms Field should have had Mr Barbers recommendation to her, as is apparent from regard to the prominent recommendation to take legal the terms of his memorandum to her of 3 March 1999. advice on the front of the Rothschild Application Form. Thereafter, there would appear to have been no particular Ms Field readily admitted that she did not do this, but reason for her to close out her position before the second thought that since the question was one of suitability of demand by Rothschild for further security. So far as the the investment rather than the legality of the contract, complaint about liquidating her investments is there was little reason for her to do so. To my mind, it is concerned, I have already rejected the suggestion that perhaps unfortunate that Ms Field did not heed this she was at fault in doing so when dealing with Barber recommendation, since I think it very likely that had she Asia’s case on causation, and for the same reasons, I reject done so, her attention would have been drawn to the risks the suggestion that this decision should be viewed as which I have found that Barber Asia should have, but did contributory negligence on her part. not, bring to her attention. That said, however, I have come to the conclusion that in all the circumstances, 200. The second page of the document handed up as particularly having regard to the confidence which Ms containing the amendments make the following further

120 Regulation of Investment Advisors points:- (3) The costs of the HSBC loan and other loan btained (1) That there were also unforeseeable factors which to provide such top up security, including interest and contributed to the market events (viz. the annual fee, totalling £4,699.99 from which is to be strengthening of the Yen) which caused or increased deducted the sum of £44,152.36 recovered on about Ms Field’s losses; 21 December 1999 after surrendering the Old Mutual (2) That Ms Field herself chose to increase her risk by and Scottish Life policies and terminating the cash entering upon this investment strategy, well aware deposit with Rothschild. of the limitations on her resources; and (3) That failure to sign a client agreement was not a 204. It seems to me that this method of quantifying Ms contributing factor in relation to her losses. Field’s loss is appropriate. There can be no quarrel with including her original investment with Old Mutual. So 201. I do not consider that the first of these points is a far as the amount of top up security and the costs involved good one. While there may have been unforeseen market in providing it are concerned, it seems to me that these, events that affected the relevant exchange rate (and I note too, are properly recoverable, particularly having regard again that Ms Field does not suggest that Barber Asia are to the fact that the risk of having to put up further security to be held liable for failing to foresee the extent to which is a necessary part of a geared investment, and also that the Yen strengthened against Sterling), this does not, to it was reasonable for Ms Field to have incurred these my mind, excuse Barber Asia in relation to the various further amounts of investment or expenditure, given that respects in which I have found that they fell short of the it was Mr Barber’s advice that she should do so. So far as standards to be expected of them. The second point is in the amounts recovered at the end of the day, it is obviously my view devoid of merit, in the light of the findings which appropriate for credit to be given for these. I have made. Finally, although the third point is, I think, correct, it does not assist Barber Asia in any way. 205. I should mention, finally, one point that arose in the course of Mr Green’s evidence. As a result of a 202. I therefore conclude that no deduction should be suggestion by Mr Green (at paragraph 7.04 of his report, made to the damages to be awarded to Ms Field by reason but which was not pleaded and which I have therefore of contributory negligence on her part. not had regard to) that it might be appropriate to have regard to the fact that the Old Mutual policy had increased Quantum in value at the time when Ms Field entered into the new 203. I turn finally to the quantum of the loss suffered by investment strategy on 10 July 1998, I enquired whether Ms Field. This is dealt with in Mr Green’s report at it might not be relevant to have regard to what the paragraphs 7.01 to 7.05. The quantum of loss was not, I position would have been had the new investment think, seriously in dispute, apart from one point to which strategy never been embarked on. Although the parties I shall refer below. Although Mr Green put forward three endeavoured to ascertain the value at various points in alternative bases on which her loss might be calculated, time of the original Old Mutual portfolio, it proved only the first of these is pleaded in Ms Field’s Amended impossible to do this fully since some of the funds in Statement of Claim. This is a net loss of £219,890.25, which Ms Field had invested were no longer in operation. arrived at by taking the total amount spent by Ms Field On reflection, I am satisfied that it would not be of £264,042.61, made up of:- appropriate to attempt such an inquiry, since it would (1) The original investment in the Old Mutual policy involve an attempt to ascertain what Ms Field would have of £ 182,541.35; been advised to do, or would have done, over a (2) The further sum of £76,801.27 put up by way of considerable period of time, during which there were top up security in March 1999; many changes in the various markets in which such

121 investments were made, which would inevitably render the attempt to do so speculative.

Conclusion 206. Accordingly, I award Ms Field damages in the sum of £219,890.25 against Barber Asia. I also award interest pursuant to section 48 of the Supreme Court Ordinance (Cap. 4) at a commercial rate (of say 1% above HSBC’s prime lending rate from time to time) from 21 December 1999, when the losses were crystallised, down to the date of judgment, and interest at the judgment rate thereafter. I also make an order nisi that Barber Asia should pay Ms Field her costs of this action, to be taxed on the party and party basis if not agreed.

(Aarif Barma, SC) Deputy High Court Judge Representation: Mr Jose-Antonio Maurellet, instructed by Messrs Tanner De Witt, for the Plaintiff

Defendant: Barber Asia Limited, represented by Mr. Andrew Nicholas Barber, in person, present

Remarks: Appeal by Defendant to Court of Appeal appeal dismissed. Please refer to the appeal judgment of CACV194/2003.

122 Regulation of Investment Advisors

ANNEXURE - IV REFORMING FINANCIAL REGIME GOVERNANCE

- EXTRACTS FROM THE REPORT BY HIGH POWERED EXPERT COMMITTEE ON MAKING MUMBAI AN INTERNATIONAL FINANCIAL CENTRE.

Ministry of Finance, Govt. of India, New Delhi

123 1. A SHIFT TOWARD PRINCIPLES-BASED woods from the trees. This leads to reduced REGULATION awareness and inferior perceptions about financial India’s strategy for financial regulation deploys rules firms in the minds of supervisors. based regulation - the same strategy used in continental 3. Rules-based regulation inhibits innovation. Europe and, to a significant extent, in the US. It consists Every new idea on products, services, markets or of building up a large repository of subordinate law even new ways of doing business requires going to through codification of detailed rules and regulations by the regulator requesting a modification of rules. specialised regulators. These define the permissible This tends to eliminate the temporary profits features of financial products and services and the obtained by innovative firms who obtain an edge functioning of financial markets in detail. Such a over their competitors by coming up with new prescriptive approach avoids legal ambiguity through ideas, which (in turn) tends to reduce investments precise codification. Rules-based regulation has two into research and development. strengths. First, it provides greater legal certainty to 4. Rules-based regulation induces corrosive political market players, who are able to abide by clear rules economy, where firms seek to influence the governing all aspects of their business. Second, it enables evolution of rules into pathways which favour financial regulators and supervisors to operate in a non- themselves. discretionary manner. As the manual of rules defines all High quality regulation and supervision is a sine qua permissible activities, the act of supervision reduces to non for IFS. It determines the competitiveness of an IFC. ticking off a long checklist, and objectively verifying If an IFC lags in innovation, through slow governance whether specific rules have been complied with or not. processes, and through weak incentives for firms to invest However, over the decades, important weaknesses of in innovation, then that IFC will lose competitiveness and rules-based regulation have become visible: global market share. If regulators and supervisors at an 1. Sophisticated compliance officers of finance IFC are unable to block fraudulent or unfair behaviour companies are frequently able to find ways of by firms, and are ineffective in setting up a sound risk pushing the edge of the envelope while not violating management system for markets and firms, then the IFC the letter of the law. Supervisors focused on will lose reputation as well as global market share by codified rules cannot look beyond the letter of the becoming a pariah. law to its spirit. In recent years, many large The alternative to rules-based regulation - i.e., financial firms in New York engaged in activities ‘principles-based regulation’ or PBR - was first which were unfair to customers and did not meet introduced in the UK in 1997. It involves less detailed minimum ethical standards. However, most of prescription of what is allowed and what is not in every these firms were still able to argue that no laws had activity or market, less codification, less rigidity of rule been violated and supervisors could not disagree book interpretation, and a greater reliance on practice though both knew that the spirit and intent of the and precedent. The prime exponents of this approach are law had not been honoured. the UK, Ireland and Australia. However, the ideas 2. From the viewpoint of detection of fraud, or of underlying this new regulatory approach are being impending firm failure, supervisors need to have applied all over the world, including in established IFCs an overall understanding of the business of the like Singapore. The same ideas have been adopted in firm. They need to understand its business plan Japan. But they have been less effectively implemented and its sources of profit, to form a judgment about there. Japan has had difficulty erasing the legacy of US- the incidence of malpractice or probability of style rules-based regulation with the meticulous default. Rules-based regulation requires application to detail that Japan’s supervisors appear loath supervisors to focus on minutiae. It obscures the to relinquish. That stance has inhibited Tokyo’s role as

124 Regulation of Investment Advisors an IFC. It serves as a lesson for Mumbai as well. system of transparency and checks-and-balances, in The bedrock of PBR is that the regulator articulates order to prevent abuse. No approach is perfect. Rules- broad principles and avoids codifying details of allowable based regulation poses no such risk for supervisory staff products, markets or business plans. Under PBR, the top apart from the risk of performance failure. PBR, on the management of financial firms is held accountable for other hand, places greater burdens of knowledge, ensuring that the business plan of the firm, and all its responsibility and accountability on supervisory staff. activities, are consistent with the principles defined by PBR runs the risk that: (a) supervisory staff might misuse the regulator - i.e., not just with the broad letter of the their discretion; and (b) they may need to be shielded law but with its intent and spirit. It removes incentives sufficiently to be confident about exercising discretion for financial firms to play an adversarial game (induced and not become convenient political scapegoats when by rules-based regulation) of ‘beat-the-regulator’ to things go wrong. become competitive. Under PBR unsavoury business Applying a historical perspective, the use of PBR at plans for financial market operations cannot be rendered the FSA is not that unique. As Jayanth Varma has pointed palatable by clever compliance officers. By its very nature out, it is only in modern times that regulation by the US- PBR ensures that such game-playing does not take place. SEC has turned into de facto over-prescription. In its With PBR, supervisors are inevitably called upon not to early years, the US-SEC had enormous flexibility and think of supervision in terms of checklist compliance. competence, with a more flexible, accommodating They are required instead to understand a financial philosophy much like PBR. The SEC was a product of firm’s: sources of profit; core businesses processes; the civil law era in US administration (the New Deal). corporate adherence to ‘principles’ based on its But Chairman Douglas made the SEC the most successful management commitment, its corporate culture and the and least prescriptively oriented of all the New Deal corporate sanctions applied to rule-breakers; as well as agencies. The US-SEC in its heyday- the Douglas and the strength and depth of its compliance processes. Landis eras -stands out as an exemplar of the flexible PBR Principles-based supervisors engage in broader and approach. This period probably laid the foundations of deeper continuous interaction with the financial firms the enormously successful US financial system. It would being regulated to understand their businesses and to probably not have emerged as such if the existing US anticipate how they are evolving as markets change. They approach of over-prescription and harmfully intrusive are often consulted by the firms they supervise about new legislation had been applied in the formative years. products and ideas informally but do not have the powers The European Commission has also become an to block those ideas from being tried out. Their influence outpost of excessively prescriptive approaches to financial is through relationship and persuasion rather than regulation. It stands out in sharp contrast with the FSA. through policing. The shift at the SEC and on the continent towards over- The main strength of PBR is that it fosters innovation. prescriptive rules-based regulation has helped London It encourages greater competition among financial firms to achieve success as the world’s premier IFC 1. that are able to introduce new ideas into markets rapidly. PBR requires a regulator to make informed The malpractices that occur when supervisors focus on judgements based on an understanding of firms, their checklist compliance are avoided. However, PBR imposes customers, and the markets in which they operate. In onerous demands on, and requires adequate protection making judge-ments about outcomes, and about what for, the staff of supervisory agencies. They are required con-stitutes minimum standards, PBR requires a broad to understand each regulated firm, and make 1 Across the Irish sea is and even more remarkable financial regulator discretionary judgments about whether its business plan in Ireland (IFSRA). It has a reputation excveeding that of the FSA in and modus opetandi are consistent with the principles terms of appluing the rule of common sense alongside common law. It is increasingly seen as one of the smartest and most flexible secutities established by the regulator. This requires an elaborate regulators in the world.

125 degree of consistency in terms of the quality of outcomes LCFIs have reaped competitive advantage in the global that firms deliver; rather than consistency in detailed IFS market as a consequence. In some jurisdictions, such requirements about processes. Firms are expected to as the UK, the integration of all financial regulation under adopt approaches to delivering outcomes that meet high a single regulator has facilitated the integration of a range regulatory objectives. of financial activities in unified financial firms. But many There has been some movement towards principles- countries have fragmented regulatory architecture, as in based regulation in the US also. For example, in 1974 the India. In such instances corporate structures need to be US Congress created the Commodity Futures Trading contrived to support the creation of a virtual unified Commission (CFTC) for oversight of derivatives financial firm that is able to operate in any or all areas of exchanges. This resulted in regulatory bifurcation in the the financial services business. The most expedient of US, with spot markets being regulated by the SEC and these is the “holding company structure”. If the structure futures markets being regulated by the CFTC. A key of regulation prohibits commercial banks from fund milestone for the CFTC was the Commodity Futures management, then the solution involves a mother Modernisation Act (CFMA) of December 2000. This law corporation that has two wholly owned-subsidiaries, one radically changed the approach of the CFTC, away from a commercial bank and the other a fund manager. The a rules-based system towards a principles-based system. virtual financial firm would then be engaged in both The CFMA defines 8 ‘designation criteria’ and 18 ‘core businesses while satisfying the separate regulators principles’. Under the CFMA, a futures exchange only has covering each area of business. to certify to the regulator that it is starting a new product In the most refined case, the holding company would or rule, with a notice of at least one day in advance. If the be a listed company, with a corporate HQ engaging in exchange wants to request an approval, the agency has pursuing the business strategy of a unified financial 45 days to give it. conglomerate. From the viewpoint of the shareholder and In contrast, stock exchanges in the US cannot change the CEO, the firm is a unified multi-product financial products or rules without a notoriously slow approval firm, with a series of wholly-owned subsidiaries present process at the SEC. In a speech in June 2006, in areas as required by regulatory rules. The CEO and Commissioner Walt L. Lukken said the CFMA gave the board of the holding company would make decisions exchanges the flexibility required to foster innovation, about allocating capital and forming business strategy saying: for the virtual firm. The strategy would be executed by “While the CFTC monitors whether a core principle multiple subsidiaries. The CEO of eachsubsidiary would is ultimately met, the exchanges with their hands-on then be roughly equivalent to the chief of each major experience are given discretion to tailor their rules to operating business division of the virtual unified firm. their special circumstances”. In order to achieve these goals, the holding company must be required to comply only with the Companies Act and with exchange listing requirements; in the event that 2. REDUCING THE ARTIFICIAL it is listed. It should be subject to no financial regulation SEGMENTATION OF FINANCIAL FIRMS, from any regulator. The fact that a subsidiary of the PRODUCTS, SERVICES AND MARKETS holding company may be a bank should give the banking How can the problem of segmentation in Indian finance regulator no power over the owner of the bank, i.e., the be addressed? In four ways. holding company. Further, regulations governing banks, 2.1. The holding company approach insurance companies, etc. need to accept 100% ownership In an international setting, financial firms exploit in the hands of holding companies that can have economies of scope and scale by operating in all sub- dispersed shareholding and public listing requirements segments of financial product/services markets. Global along the lines applied to any other company in any other

126 Regulation of Investment Advisors

BOX 1.1: PRINCIPLES-HASED REGULATION IN THE UK appropriate degree of protection for consumers; and The way in which the FSA operates in regulating the (4) Combating financial crime. The law codifies little City of London is important in understanding about markets and products. It focuses on broad regulatory issues surrounding IFS provision owing to principles. It is interesting to see that that the objective innovations in regulatory strategy, PBR was pioneered of the FSA is one of securing appropriate consumer in the uk. But it appears to have taken root in several protection, not infinite consumer protection at any cost.

OECD countries. It is now a well respected regulatory The FSA is tasked with making markets work to doctrine around the world. The us is also likely to apply deliver benefits to firms and consumers. It accepts that it before too long if the initiatives now in train come to some failures neither can, nor should, be avoided. fruition. Failures are part and parcel of what makes markets In May 1997, fundamental financial reforms were work and provide an important source of future announced in the UK. The Bank of England was made learning. an independent central bank with the sole objective of The mandate of the FSA is designed to avoid the loss setting the short-term (base) interest rate with of efficiency from the conservative instinct of setting accountability for hitting a publicly stated inflation target up a license-permit raj, or the periodic heavy handed (of keeping inflation under 2%) through an open and front-page-headlines crackdown on finance which transparent process. All functions other than setting the happens with populist regulators. short rate were removed from the Bank of England. The integration of all financial system regulation at All financial regulation that was previously FSA makes it easier to transmit knowledge on success undertaken by nine separate agencies was unified under from one part of the FSA (say banking) to another a new single regulatory/supervisory agency called the (insurance). Internationally, most banking regulators Financial Services Authority (FSA). It was seeded with view securities markets with suspicion or hostility. the 500 people from the Bank of England who used to However, the global economy is shifting away from do banking supervision from there, and the staff of all banks to securities-market dominated financial other existing financial regulators. systems. The merger of banking and securities into the By 2006, it is increasingly clear that the FSA FSA has ensured that FSA-regulated banks are not approach has worked in the UK. The FSA has managed hindered from deep integration with securities markets. to steer clear of three kinds of problems: the populist Instead of discouraging integrated LCFIS, the FSA is regulator who likes to play to the gallery by currying perfectly happy to see them bloom. favour with ordinary citizens; the conservative regulator ‘Principles-based’ or light-touch’ regulation was where the default answer to all questions concerning originally conceived at the Bank of England prior to the innovation is ‘no’; and the US-style approach of 1997 reforms. The main insight it applied is that it is introducing enormous legal-overheads on the neither feasible nor desirable to write down detailed production of financial services. Whereas the UK was rules governing every market and every product. Under afflicted by recurring failures and crises concerning this philosophy, it is simply not possible, nor even foreign banks in the financial system in the 1970s and necessary, for regulators to try to anticipate every 1980s, these have been conspicuous by their absence change or innovation that might occur in financial since 1997. markets; especially given the sheer size of the number The first innovation of the FSA is its mandate. The of participants, the changing needs of an even greater law asks FSA to attain four equally important objectives: number of sovereign, corporate and individual users of (1) Maintaining market confidence (2) Promoting public financial services, and the inexorable global integration understanding of the financial system (3) Securing an of national financial systems. Attempting to do so

127 simply inhibits innovation and detracts from verifying that the processes of the firm perform competition. Instead it is important to focus on broader satisfactorily and that risk is being managed properly strategic issues and let firms worry about regulating in the broadest and narrowest senses. The FSA team themselves on points of detail - but under the makes regular presentations to the board of the regulated continuous watchful eye of friendly and co-operative company about their understanding of the areas of FSA supervisors, should things go pear-shaped. concern. This improves the pressure on the FSA team to Debate about light-touch’ vs. traditional regulation have a sound understanding of the regulated firm. is essentially an argument about the relative costs and This approach makes two kinds of demands upon benefits of over-prescription vs. flexibility. The the staff of the FSA. They are required to understand contrasting US approach on the part of all regulators, the regulated firm in a manner akin to a strategic except those for derivatives markets where most management consultant, a responsibility not replicated financial innovation takes place, attempts to codify a or attempted at a conventional regulator in India. full set of rules covering every product and market Further, FSA staff are empowered to act based on their mechanism in fine detail. The alternative strategy, own discretionary judgment. adopted by the FSA, is one of articulating broad There is an interesting contrast between a principles, and leaving market players to continually principles-based approach and a rules-based approach. innovate on the details through which these broad In a rules-based approach, as is practiced in India or in principles will be achieved. the US, it is all too easy to have rigid checklists that A conceptual goal of the FSA is that the top RBI or SEBI staff must verify by ticking boxes on long management of a financial firm must primarily look at laundry lists when they interact with a firm. This gives markets and innovate, without worrying about the supervisory staff plausible deniability when anything regulator. This is strikingly reminiscent of India’s goes wrong. This, of course, does not uncover or solve experience with dismantling the control raj in underlying problems. manufacturing, where the reforms were about turning The FSA approach emphasises the need for the gaze of the CEO away from the government towards intelligence and judgment on the part of regulatory the market. PBR consists of applying that approach to staff, not just a mechanical checklist of rules. The FSA finance. The FSA places a complex burden upon the approach requires top quality professional staff, that financial firm and upon its own staff: that of have considerable operating experience in financial understanding broad principles and adhering to them firms, and are capable and senior enough to apply their in spirit. In return, detailed rules governing every own judgement independently without fear or favour. minute detail of every activity in finance have been In order to help achieve this, FSA wages are decoupled eliminated. CEOS of financial firms in London innovate from civil service wages, and linked to median wages on an everyday basis without needing to continually in the private sector. More than half of FSA’S staff comes approach the regulator for permission associated with from the financial industry, through a continuous two- every change in the business plan. way flow between the FSA and the industry. Large complex firms (LCFIS) are linked to With the concentration of monopoly regulatory specialised relationship-management teams in the FSA power at the FSA, there is enormous concern about which provide a single point of contact. The team at accountability and checks on the power of FSA and FSA that deals with the large firm is given three tasks: about the possibility of regulatory capture. This has (i) understanding the sources of profit of the firm; (ii) been accommodated through numerous checks-and- understanding that the business plan and processes are balances. The first is that of having staff that understand consistent with the principles of the FSA; and (iii) fully real world finance, and hence avoid automatically

128 Regulation of Investment Advisors

falling back on saying ‘no’ as the default option when is at risk, have an interest in keeping abreast of what faced with any complex idea. A statutory ‘practitioner hedge funds are doing. panel’ watches the FSA and writes reports about areas This approach relies on the self-interest of, and where things are going wrong. There is a tribunal for intelligence from, prime brokers, instead of trying to appeal on enforcement matters, much like the Indian write down rules and send out government employees Securities Appellate Tribunal (SAT). Finally, when there to visit hedge funds and comprehend what each of the are policy disputes between the industry and the FSA, 8,000 hedge funds of the world is doing. the UK Treasury (its Ministry of Finance) plays the role The FSA approach is both instantly appealing and of a tribunal. attractive, yet extremely challenging in implementation. The UK finance industry accounts for 8% of its GDP. The idea that CEOs of financial firms can think about If FSA stifles the innovation or competitiveness of this innovation and not undertake regular pilgrimages to industry, it impacts directly upon GDP growth. Apart the Treasury, the Bank of England, the FSA, and other from that, the City of London is extremely influential offices of government agencies to further their firm’s politically and government takes its interests very business interests is enormously attractive. seriously. This generates incentives for top policy At the same time, the UK approach is daunting on makers and politicians running for election to take many fronts. The principles based approach can reduce interest in sound financial regulation, and ensures the the legal certainty on which firms operate, it places global competitiveness of London as an IFC. It also discretionary power in the hands of regulators and constitutes an effective feedback loop between export supervisors all the way down the line.a It requires these orientation and high quality provision of the ‘public officials to have high quality understanding, judgment good’ of regulation. and probity. And, it requires that they be shielded from One practical example of the debate between a rules- a witch-hunt when discretion is exercised and things based approach and a principles-based approach go wrong. concerns the operations of hedge funds. The FSA The most important testimony about the UK approach emphasises the enormous positive approach is the fact that in the last decade, London has contribution that hedge funds’to market liquidity and emerged as the world premier financial centre, once market efficiency. The FSA has emphasised supervising again overtaking New York after a 50-year hiatus. That hedge funds through prime brokers. Prime brokers are process has, of course, been assisted by other factors such typically arms of (regulated) investment banks, and as terrorism in New York, Sarbanes-Oxley, and the civil provide hedge funds with a range of services, including law approach of the EU. However, there is little doubt securities lending, leveraged-trade transactions, and that the far-reaching decisions of 1997 in reforming the cash management. They are close to the market, so they Bank of England and the FSA transformed the position can keep regulators informed; and, because their money of London on the global financial stage.

a“In the classification scheme of Pritchett. and Woolcock (2004), the hardest problems of governance are those where there are many interactions between civil servants and private citizens, and there is discretion in the hands of the civil servant. line of business. Apart from regulatory constraints, the GAAP, a listed holding company has to present stand- other constraints faced with a holding company structure alone and consolidated accounts. However, for income- in the Indian environment are: tax purposes, such a consolidation of accounts is not A. Tax consolidation of accounts. Under Indian presently permitted. At a conceptual level, it would be

129 BOX 1.2: CASE STUDY-PRINCIPLES-BASED REGULATION consistent with their commercial objectives, FSA argues IN THE UK FOR TREATING CUSTOMERS FAIRLY that providing flexibility rather than prescribing detailed As an example of how PBR works, consider consumer processes enables firms to compete and innovate more protection, or what the FSA calls ‘’Treating Customers effectively in product design, in the quality of customer Fairly” (TFC)a. The FSA has defined six desired service, and in achieving economic efficiency. outcomes from its work in the TFC area:- FSA works on improving financial capability and 1. Consumers can be confident that they are dealing awareness of consumers, and the provision of clear with firms where the fair treatment of customers is information by firms and by the FSA to consumers, to central to corporate culture; help consumers to pursue their own best interests by 2. Products and services marketed and sold in the retail playing an active and informed role in the markets for market are designed to meet the needs of identified financial products and services. Enforcement actions consumer groups and are targeted accordingly; are taken against firms and their senior management 3. Consumers are provided with clear information and when they fail to achieve high level outcomes. are kept appropriately informed before, during and As part of the move to a more principles-based after the point of sale; approach, FSA is working on removing a significant 4. When consumers receive financial advice, the advice volume of detailed rules on consumer protection. must be suitable and tailored to take explicit account Detailed rules on money laundering, and on training and of their circumstances; competence for wholesale business have been removed. 5. Consumers are provided with products that, The Authorisation Manual is being dismantled. It intends perform as firms have led them to expect, and the to further implement a radical simplification of associated service is both of an acceptable standard and investment Conduct of Business rules, rules on financial also as they have been led to expect; promotions and rules on complaints handling. 6. Consumers do not face unreasonable post-sale When firms ask FSA to define minimum standards, in barriers imposed by firms to change product, switch the quest for legal certainty and predictability, the FSA provider, submit a claim or make a complaint. response is that the Principles and other high level rules These six principles define what the FSA requires are themselves minimum standards and that FSA sees the financial industry to do for consumer protection. these minimum standards primarily in terms of outcomes, FSA emphasises the responsibility of the senior not of prescribing detailed inputs and processes. management of finance firms - and not just their Predictability is enhanced by statements of good and poor compliance departments - to embed these objectives practice and through case studies illustrating ways in which within the business strategy, culture and behaviour of firms have succerssfully met requirements. Such statements their firms. The FSA holds the top management of each of good and poor practice help senior managements of firms firm accountable for meeting these six desired to think for themselves about how best to meet high level outcomes, and not seek to micro-manage firms on how requirements within the specific circumstances of their own these outcomes are achieved. activities and business models. By publishing examples of This principles-based approach provides financial good and poor practice on either side of an acceptable firms with more flexibility to decide how best to run their standard, FSA indicates to firms both where the minimum businesses, while meeting FSA regulatory objectives. standards lie, and that there are alternative ways of delivering Firms are better placed to judge the detail of how best to them. In doing this, FSA respects the confidentiality of deliver those outcomes in the marketplace, and thus ‘proprietary’ good practice that firms have developed to give deliver fair treatment to their customers in a way that is themselves a competitive advantage.

aSee http://www.fsa.gov.uk/pages/library/Communicatin/Speeches/2006/0724_cb.shtml

130 Regulation of Investment Advisors desirable to tax a group on the basis of its overall financial of jurisdictions, such as the US, UK and others that tax a performance incorporating the performance of all corporate group as a single unit. Although the scope and subsidiaries put together. Worldwide there are a number approach may vary from one jurisdiction to another, tax

Box 1.3: Principles Based vs. Rules Based Regulations necessarily or automatically instill or encourage high (PBR vs. RBR) standards of ethics or governance to be applied in any 1. Principles Based Regulation (PBR) is outcome particular environment. oriented. 13. What RBR appears to encourage is the 2. It differs from Rule Based Regulation (RBR) which development of capabilities aimed at evading rules is process driven. through technicalities and loopholes. This weakens 3. PBR is based on the idea that the regulator is not incentives for better self-regulation within the always best placed, or better placed than market regulated industry and induces a tendency for market participants, to judge what is best, or what is right and competition to be driven by a propensity for cleverly what is wrong in terms of products,instruments, evading rules faster than the competitor. services, practices or market functioning. 14. The key to determining the regulatory tone in a 4. PBR is based on the premise that competition and particular environment, and deciding whether PBR is innovation in rapidly evolving markets driven by more suitable than RBR in a particular country technology should not be inhibited by over-prescriptive circumstance, depends on the standards applied by the regulation. regulated industry in: monitoring itself, ensuring that 5. PBR allows for greater flexibility in devising internal all players in the industry conform to rules that protect corporate business and compliance processes to cope the reputation and integrity of that industry; and with changes in rapidly evolving markets. ensuring that the best global standards of corporate 6. RBR invariably prescribes permissible business ethics and governance are applied by all players. processes in micro-detail and changes too slowly in 15. PBR is particularly well suited to the regulation of response to market changes. securities markets, which regulators that are RBR 7. The overall effectiveness of PBR is critically driven (such as in the US) have now explicitly dependent on the ethical and governance standards that recognized. prevail in the financial and corporate worlds in any 16. PBR does not mean lax regulation and supervision. country. Compliance under PBR depends as much on the spirit 8. The higher such standards are in a given operating as the letter of the law. For that reason, compliance environment, the better is compliance with PBR and with PBR is different and more demanding than the the better its overall outcome. “checkbox” compliance under RBR. 9. In an environment accustomed to RBR, regulators 17. Violation of rigid but specific rules is much easier see PBR as posing high regulatory risks. to establish than broader principles that are more open 10. They fear that the operating flexibility that PBR to subjective interpretation. permits could be misused in environments with 18. PBR requires greater knowledge on the part of insufficiently high standards of internal corporate regulators, an obligation to remain up to date with ethics, compliance and governance. changes in rapidly evolving markets, as well as more 11. With RBR, market participants leave it to regulators accountability and responsibility to be exercised by to specify what those standards should be through supervisors in exercising judgments than RBR which detailed rules. focuses too much on the use of detailed checklists for 12. But experience suggests that RBR does not compliance assessment.

131 BOX 1.4 : THE POLITICS OF US REGULATORY ARCHITECTURE

In the US, regulation of all derivatives -financial or commodities - is placed under one agency (the CFTC). Regulation of financial spot markets is under another (the SEC). This separation is derived from history and sustained by political economy. The CFTC is overseen by the House and Senate Agricultural Committees, owing to the historical origins of the CFTC. In 1974, when the agency was created, futures trading was synonymous with agricultural commodity futures trading. That world is, of course, long gone; US derivatives exchanges trade every manner of derivatives imaginable including currencies, interest rates, energy, weather, etc. The members of the House and Senate Agricultural Committees tend to obtain significant political funding from the derivatives exchanges. The Chicago exchanges in general, and the Chicago Mercantile Exchange in particular, are top donors. In the 2006 election cycle in the us, four exchanges appear on the list of the top 20 securities

industry donors. All but one of the four are futures exchanges. The CME has been on the top 20 list for the last three election cycles.

grouping allows offset of profits and losses within the B. Dividend tax credit. When a subsidiary company group, with a few countries extending the concept to cover pays dividend to its holding company, it pays a dividend foreign subsidiaries. Hence, there is a case for introducing tax of 14.025% in India. A dividend payout by the holding a group tax regime, that is simple to administer, and company to shareholders incurs a second dividend tax involves low compliance costs. Flexible rules need to be of 14.025%. This vitiates the viability of the holding specified governing intra-group transactions and company structure. corporate reorganizations. The regime can prescribe conditions, such as minimum holding periods and C Leverage by the holding company. Section 293 condition for qualifying for group level consolidation, of the Companies Act, 1956, specifies that, without consistency of financial years, entry and exit issues etc consent of shareholders, a company cannot borrow more

BOX 1.5 : COSTS OF COMPARTMENTAIISATION, AND BENEFITS OF UNIFICATION, IN THE ‘EXCHANGE ECOSYSTEM’ Segmented model All 8-10 exchanges would compete in trading all products. (This Equity Fixed income Currency Commodities assumes NDS will be put out as one more exchange). Exchange NSE, BSE NDS, Clearcorp Clearcorp Dealing NCDEX, MCX, All three clearing corporations Dealing Systems Systems, Reuters, IBS NMCE etc would compete in offering clearing services for all products Clearing NSCC, BSE CCIL CCIL None All three depositories would Corporation Clearing compete for all demat services. House (This assumes that SGL will be put out as one more depository). Depository NSDL, CDSL SGL n.a NSDL Benefits: More competition, economies of scope and scale for Problems: Lack of competition, lack of economies of scale, lack of economies both exchange institutions and of scope. Conflicts of interest owing to functions held within the State at NDS member firms. Improved and SGL. Heightened costs for financial firms. functioning of NDS, SGL and the State, owing to elimination of conflicts of interest.

132 Regulation of Investment Advisors than the total amount of its share capital and free not eliminate them. reserves. This restriction is archaic. It needs to be Alternatively, India could choose to integrate all removed, particularly for listed companies where mature financial regulation into a single FSA-style agency. The corporate governance processes are in place. At the experience of London suggests that that IFS provision is minimum, this restriction needs to be rephrased to make encouraged by the unification of all financial regulation a link to the share capital and free reserves of the into the FSA. The principle of the FSA is that it is able to consolidated balance sheet. take a complete view of all activities of all finance companies and a holistic view of trends in financial D Restrictions on intra-group transactions. The market development. At the same time, there are ultimate goal of a holding company structure is to support problems of accountability and governance as well as listing and running a corporate headquarters for a set of regulatory monopoly associated with creating an FSA- finance companies, each of which complies with the style agency. requirement of a separate regulator. The ultimate objective is to create a virtual financial firm that spans 2.3. Shift away from “entity-based the financial services universe. However, Section 297 of regulation” towards domain based the Companies Act constrains the utilisation of the regulation services of any group company by another group Until an FS A-style agency comes about, care needs to be company. When group companies have a common taken in identifying rules that induce segmentation in directorship, prior approval of the central government is Indian finance and removing them. For India to succeed required prior to availing such services. This requirement in IFS provision, it has to be understood that the end goal needs to be reconsidered in a modern corporate is for India to have efficient, globally competitive financial governance environment. firms which are able to do what is needed to compete effectively in all IFS markets. The goal is not to make 2.2. Reforms in financial system regulatory life less complicated by maintaining the tidy regulatory architecture status quo of segmented financial firms that fall neatly One important source of segmentation in Indian finance within current regulatory domains, and are easy to is the turf separation created by having multiple control, supervise and regulate. This requires, for regulators. Reforms to regulatory architecture could be example, treating a ‘primary dealership’ as one of the undertaken to mitigate these problems. India needs to many business activities of a financial firm, and not choose between two paths. One is to consolidate down to requiring that standalone firms be created which do four regulators covering finance with one each for: (a) nothing but primary dealership. The strategy for banking with a regulator separate from the monetary regulation needs to be one where the banking regulator authority; (b) capital markets, with a merger of regulates the business of banking, but does not regulate securities markets functions on the fixed income, all the activities of a financial firm that chooses to call currency and commodity markets into a single securities itself a “bank”. and derivatives market regulator; (c) pensions with the consolidation of pension regulation into a single pensions 2.4. Organisation of the asset regulator; and (d) the insurance regulator.2 Such a quartet management industry might reduce the extant degree of segmentation and The very nature of the asset management industry regulatory turf protection in Indian finance; but it would enables large economies of scale to be captured. The costs of managing a bond portfolio of Rs. 1 trillion are not a 2 While the PFRDA is not yet a statutory regulator, the present direction thousand times larger than those of managing a bond of policy thiking in the field of prnsions envisages such a role for it (Shah and Patel, 2005) portfolio of Rs. 1 billion. They may not even be ten times

133 larger. Hence, when a firm manages a larger quantum of outsourcing should be removed, so that the in-house assets, it is able to quote lower prices when expressed as versus outsourcing decision is made by every financial

basis points of assets under management (AUM). AS an firm in India on the grounds of pure economic efficiency. example, in the world market, the price for index fund It is important to maintain a distinction between the management for $1 billion of assets is roughly 1 basis regulatory structure that applies to an insurance company point or 0.01%. At present in India, there is no index fund and the regulatory structure that applies for the wholesale with a size of $1 billion, and hence index funds in India AMC. The insurance regulator has a legitimate focus on cost much more than 1 basis point. the risk profile of the portfolio of the insurance company. Asset management functions are per-formed in However, the relationship between the AMC and the almost every subsegment of finance: banking, insurance, insurance company has no link to the complex obligations pensions, mutual funds, hedge funds, etc. The of the insurance company. fragmentation of finance owing to regulatory architecture As an example, an insurance company might place induces huge diseconomies of scale in asset management. Rs. 1 billion with an AMC for managing an equity index That will hamper the competitiveness of Indian firms in fund. The regulatory focus on the AMC would then be an international setting. restricted to verifying that the index fund is being Considerable progress can be made on this problem correctly managed. As an example, in a mutual fund by separating out the ‘front end’ through which assets setting, the costs associated with retail investor are sourced for management, from the back-end ‘factory’ protection should be concentrated into the mutual fund. where assets are managed. The front ends embed specific When the MF outsources to an AMC, this contract contractual structures, and regulations, such as insurance should be struck at the low prices seen in wholesale fund companies as opposed to mutual funds. However, the task management, and the burden of regulation associated of fund management that takes place in each of these with retail investor protection should not fall upon the firms is done in the same kind of factory. The difference AMC . between a mutual fund and a pension fund lies in the With such a structure, wholesale AMCs could achieve front-end, not in actual asset management. significant economies of scale by tapping into assets from This suggests the creation of a new industry of Asset many institutional funding sources. In such an Management Companies (AMCs) that are wholesale fund environment, when an insurance company evaluates the managers. This industry should be regulated by SEBI. decision of managing assets internally, as opposed to The customers of AMCs might be restricted to wholesale outsourcing that activity, it is likely to find that the customers who put up a minimum of (say) Rs. 100 million charges of the wholesale AMC are much lower than the (or Rs. 10 crores or USS 2.25 million equivalent) for costs of internal asset management. This would management. A small set of professional trustee encourage the outsourcing of assets for management companies - perhaps three to five -should supply from a large number of financial firms to save their own supervisory functions over an industry composed of costs and achieve economies of scale in the AMC industry. perhaps 50-200 AMCs. Such a move would immediately make asset management Once this industry is in place, it should be possible in India globally competitive. Asset management for banks, insurance companies, mutual funds, hedge companies in India with over $5 billion in assets under funds, FIIs, pension funds, EPFO, etc- to outsource their management would be cost-efficient by the standards of asset management to one or more of these companies. the global money management industry. But, for that to What is envisaged, of course, is a market-driven process. happen, appropriate institutional structures for There should be no compulsion that an insurance wholesale AMCs would need to be created and economies company must outsource fund management to an AMC. of scale captured in the domestic market before such However, any regulatory barriers that impede services could be globalised.

134 Regulation of Investment Advisors

3. CREATING AN ENVIRONMENT Clearing Corporation of India (CCI). The scope of CONDUCIVE TO EXIT these institutions, and the competitive market As argued above, the foundation of competition policy is a structure of the clearing corporation business, need ceaseless process of creative destruction, where every year, to be steadily extended. some financial firms fail and exit from the business, while 3.A host of sophisticated finance activities can be new financial firms enter into the business every year. This encouraged under firms organised like hedge ceaseless churning appears messy since newspaper funds, where customers are restricted to headlines dwell on firm failure. However, it is the only way sophisticated investors. Once this is done, the death to achieve a globally competitive financial sector. of such firms imposes no political problems upon This requires a corresponding paradigm shift on the the government. attitude towards both entry and exit. Financial regulators in India today are often fearful of exit. The death of a financial firm is seen as a failure of the financial governance 4. RETAIL VS. WHOLESALE MARKETS regime. This attitude needs to shift towards an approach Financial regulators around the world are concerned where the death of financial firms is seen as proof that a about investor protection of “small households”. properly competitive environment is actually in place. Ordinary households lack the specialised financial There is ample international experience on how a knowledge or incentive to understand complex financial sound approach towards exit can be constructed. It products that might be mis-sold or embed dubious comprises the following key elements:- practices encoded in fine print. If the regulator does not 1. Regulatory concerns about the failure of financial protect the interests of ordinary households, then the flow firms are focused only on banking, insurance and of savings from millions of households into modern defined benefit pensions. In these areas, a finance will not take place. This legitimate concern framework of deposit insurance - withsound induces regulators to be particularly cautious before pricing of the insurance and administration in a permitting products to be sold to retail investors. This, way that avoids moral hazard - is of the essence. in turn, induces a bias toward caution and conservatism This needs to be coupled with a prompt corrective and slows down innovation. action (PCA) framework, where strictures are This problem has traditionally been seen as a difficult placed upon weak firms well before failure; such trade-off faced by the regulator. On one hand, financial as a prohibition on accepting new business when innovation produces superior products for end- underlying risk capital is too low. Listing is a consumers. Yet, along the way, new products need to be powerful tool through which stock market screened carefully by the authorities to avoid episodes speculators monitor firms, and produce daily where households are defrauded and bolster public estimates of their failure probabilities. A policy of confidence in modern finance. One way of dealing with requiring listing, and the establishment of this issue, and fostering innovation without sacrificing procedures within regulators of monitoring stock the protection of small investors, is to cultivate a separate prices, would help generate early warnings about policy stance for sophisticated ‘wholesale’ players in the distress based on which PCA can be taken. financial markets who do not have the same knowledge 2.In the securities markets, clearing corporations deficits as retail investors and do not need the same which manage counterparty risk are a powerful tool degree of protection. In India, a threshold of Rs.1 crore for preventing firm failure from having systemic (or Rs.10 million) might be appropriate in defining a repercussions. India has made excellent progress ‘wholesale’ transaction. Once this is done, in a broad through the establishment of the National range of settings, the stance of regulators should be to Securities Clearing Corporation (NSCC) and the permit a free flow of innovation.

135 The best example of this approach is the hedge fund. retail’ differentiation has been successfully applied is in Mutual funds are specifically designed for retail investors the exchange industry in the US. There the CFTC has eased and they are regulated and supervised intensively. This the entry criteria and softened considerably the regulatory level of scrutiny imposes costs of compliance and regime for exchanges in which only large financial firms, opportunity cost of trading strategies which are prohibited and not small individual investors or ordinary households, by the government. The hedge fund is the unregulated are permitted to participate. This two-track approach alternative to the mutual fund. But it can be restricted to makes entry possible for a range of internetoriented start- deal only with customers who put up more than Rs.io ups which compete against the established exchanges, million of assets for money management. The argument without needing to incur all the costs and particularly the is that any customer who has more than Rs.io million of regulatory burdens associated with the established assets under management with a hedge fund has the exchanges. knowledge and capability to understand what the hedge A fast-paced, globally competitive financial sector, in fund manager is doing before investing in it. The which rapid innovation occurs, can be a useful laboratory government does not need to protect such a customer. where new products and services can be quickly tested Once such a separation is created between mutual funds in wholesale markets restricted to transaction sizes of at and hedge funds, there will be healthy competition in the least Rs.io million. Successful ideas from such tests can capital market. Large investors will have a choice between later be approved for the retail market by the regulator. mutual funds and hedge funds. If the benefits of regulation From an IFS perspective, almost all IFS transactions are outweigh the costs, then large investors will continue to likely to be bigger than Rs.io million. Hence, a rapid pace patronise mutual funds. If the costs of regulation of mutual of innovation in wholesale markets is quite consistent funds are larger than the consequent benefits, then large with a focus on export of IFS. But this approach has an investors will shift to hedge funds. The economy would important downside, in the context of organised arms- then benefit from a low cost organisation of money length financial markets, where secondary market management and from increased competition. liquidity is formed by pooling millions of orders, small Hedge funds are appealing when it comes to exit in the and large. The fragmentation of liquidity between event of failure. If a money manager such as a mutual fund segregated retail and wholesale markets would reduce has a large number of small retail customers, then the liquidity. government inevitably gets involved in the resolution of India’s key strength - i.e., its vast retail market - will failure. In contrast, hedge funds will have only a small not be able to play in areas where retail participation is number of wealthy customers. That makes it politically prevented. Hence, while this wholesale versus retail feasible for the government to watch impassively when a approach has merit in some areas such as money hedge fund fails. The hedge fund manager goes out of management, there is a need of caution when it comes to business and a few rich customers get hurt. Government the securities markets, where unification of all orders into is not obliged to intervene on their behalf and no issue of a single order book yields maximum liquidity and thus public interest policy arises. Under such a framework - international competitiveness. that distinguishes between the capabilities and interests of wholesale vs. retail investors - the principle of caveat emptor applies to the former and strong regulatory 5. THE ROLE OF EXCHANGE-TRADED VS. safeguards protect the latter permitting financial markets OTC DERIVATIVES IN THE BCD NEXUS to be regulated in a manner that encourages aggressive Derivatives can be traded on an exchange or bilaterally competition, with free entry and exit of different kinds of negotiated on the ‘over the counter’ (OTC) market. financial firms while protecting those that need protection. Trading on exchange requires standardised ‘plain vanilla’ Another well-known recent example where ‘wholesale- products, is anonymous, utilises a clearing corporation

136 Regulation of Investment Advisors to eliminate credit risk, and is fully transparent. The transparent futures market. A transparent trading trading computer ensures that each buy order is matched venue seems to matter disproportionately for with the lowest priced sell order. OTC trading permits overall price discovery, even if the turnover at unlimited flexibility in the contract, lacks anonymity, this public marketplace is relatively small. generally involves counterparty credit risk, and is Similar evidence for the role of exchange-traded generally non-transparent. There is never a certainty that futures on the interest rate market is found in one privately negotiated purchase was contracted at the Mizrach and Neely (2005) who estimate that over best price available on the non-transparent market. 50% of the price discovery on the US long bond Currency futures were the first situation where the market takes place in the exchange-traded product idea of the exchange-traded futures market was applied in the period after 1998. to a financial underlying. For many years, currency 3.Exchange-traded derivatives have become futures were not particularly successful when particularly important in the new world of compared with OTC currency forwards which algorithmic trading and internet trading, both of dovetailed well with the primarily inter-bank character which dovetail better with electronic exchange- of currency trading. With interest-rate derivatives, traded products. The new order flow that is created while exchange-traded interest rate derivatives are owing to these two channels tends to be enormous worldwide, they continue to be smaller than concentrated on exchange-traded products. their OTC counterparts. 4.In an environment where India’s regulatory and Despite these international empirical regularities, supervisory capacity in the derivatives market is the following seven factors suggest a greater role for still nascent but evolving, exchange-traded exchange-traded derivatives in an Indian IFC: markets pose a simpler problem with full 1. The present OTC market in India largely trades transparency, with standardised contracts being plain vanilla products. For trading plain vanilla traded, and where credit risk is removed by the products, the exchange traded environment clearing corporation. In comparison, sound induces transparency and liquidity at no cost in regulation and supervision of more opaque OTC flexibility. Indian currency forward trading is markets makes greater demands upon regulation already halfway to the exchange-traded and governance. framework, with the Clearing Corporation of India In particular, public sector financial firms are Ltd (CCII.) performing the services of a centra vulnerable to questions about lowest-price counterparty. The only further step required in procurement when a transaction takes place on an shifting from a forward market to a futures OTC market. In contrast, when a computer does market is the introduction of transparent trading order-matching, lowest-price execution is at an exchange venue. guaranteed. As long as public sector financial firms 2.Even though the global currency futures market is are important in India, an emphasis on exchange small when compared with the global currency traded derivatives will elicit greater participation. forward market, recent research has shown that it 5.Apart from filling a major gap in the structure of plays a disproportionate role in price discovery. its financial system, another key reason for building Rosenberg and Traub (2006) find that the currency a BCD nexus in India is to enter the export market futures market might contribute as much as 85% for IFS: i.e. attract global order flow into: (a) the of the price discovery. This reflects the role of INR yield curve; (b) trades in contracts of the INR transparency in price formation. Traders who vs. other global currencies; and (c) credit risk might place orders on the opaque OTC market find management products trading in India. The clubby it advantageous to constantly watch the world of the global forward market - where

137 counterparties know each other, face credit risk India needs both exchange-traded derivatives and from each other, and have conversations on OTC derivatives. However, these arguments suggest that telephone - will be more difficult for India to break particularly in the early years, a special focus should be into, given that these human relationships are well placed on obtaining world-class liquidity on the exchange established at the three established GFCs and other platform. This is where India’s IFS export opportunity IFCs like Tokyo, Frankfurt and Paris. lies, and this is the ‘raw material’ using which OTC It is more feasible for India to compete in the derivatives are made. The right sequencing is to first have world market for order flow into exchange-traded a liquid electronic trading screen, after which an OTC derivatives. This is a more meritocratic market, market can spring up based on utilisation of the prices where transaction charges and impact cost are all and liquidity produced on this screen. that matters; being plugged into certain human networks matters less. As an example, it appears more feasible to attract users of currency futures 6 REGULATORY IMPACT ASSESSMENTS and currency forwards trading all over the world In the foreseeable future, India could be headed for a to send orders electronically into an order- four-way separation of financial regulation, with separate matching system operating in Mumbai, rather than agencies performing regulatory and supervisory seeking to obtain market share in the global OTC functions for Banking, Securities, Insurance, and market. Pensions. The merits of a larger all-inclusive unification 6.Exchange-traded derivatives fit well with non- - such as emulating the UK-FSA - can be debated ad institutional customers, who are not able to access nauseam in the Indian context. The HPEC would prefer the telephone networks through which OTC not to trigger or indulge in that debate as it diverts from trading takes place. This issue is not unique to its main concern — i.e., that of establishing a successful India: e.g. in Japan, individuals have come to IFC in Mumbai as swiftly as possible. Regardless of play a substantial role in currency trading in recent whether FSA-style unification is attempted or another years, through the currency futures market. Given form of regulatory architecture is applied, an IFC in the importance of non-institutional players in Mumbai will still require world-class financial regulation Indian finance, an emphasis on exchange-traded and supervision (in terms of policy, approach, attitude derivatives will help in harnessing their and practice) in either case. participation and thus liquidity. One tool for improving the quality of regulatory 7. Finally, exchange-traded derivatives trading plays agencies is a periodic process of “Regulatory Impact

to India’s strengths in running exchange Assessments” (RIA). These are now commonplace in institutions. NSE, BSE, NSCC, CCIL are a strong OECD countries. Each RIA is essentially a cost-benefit set of institutions, and can compete in the global analysis carried out independently every 3-5 years to market for exchange-traded derivatives. review regulatory architecture and implementation. The Some of these seven issues are unique to India. However, term ‘architecture’ describes the boundaries of the some of these issues are presently at work in reshaping the agency, its legal foundations, and its mandate, while the international derivatives market. As a consequence, term ‘implementation’ refers to how the agency translates currency futures have experienced considerable growth. BIS these goals and conceptual framework into successful, data shows currency futures turnover has grown from $2.8 globally competitive regulation and supervision. Each trillion in Q3 2005 to $4 trillion in Q2 2006. RIA needs periodically to compare Mumbai against peer IFCs, and examine how architecture and implementation On the subject of individuals in the Japanese currency futures market, see http: can be evolved so as to improve India’s ability to produce //tinyurl. com/ ycgbm2 on the web. IFS for the global market.

138 Regulation of Investment Advisors

7. STRENGTHENING THE LEGAL SYSTEM enabling and strengthening this channel5. However, two SUPPORTING AN IFC decisions of the Supreme Court have dealt severe blows The legal system comprises legislature, laws, courts and to the 1996 Act: (1) the Oil & Natural Gas Corporation v judges. In a finance setting with independent regulators, Saw Pipes (2003) 5 SCC 705[3]36 and (2) SBP& Co. v an appeals mechanism is required for all actions of the Patel Engineering (2005) 8 SCC 6187. regulator. The difficulties confronted by the Indian legal As a response to these problems, the Arbitration and system in tackling sophisticated IFS are well known. The Conciliation (Amendment) Bill, 2003, currently pending system lacks specialised domain knowledge. Legal before Parliament, proposes to introduce a new section processes are drawn out over excessively elongated that would allow an award to be set aside “where there is periods of time. Recent reports indicate that over 30 an error apparent on the face of the arbitration award million cases are currently pending resolution in India. giving rise to a substantial question of law”. Although this From an IFC perspective, the most useful strategy may new ground for challenge is narrower in definition than be the creation of specialised courts that combine (a) the Saw Pipes ruling, it still affords losing parties an highly experienced arbitrators equipped with specific IFS opportunity to approach the courts in an attempt to domain knowledge, and (b) streamlined workflow leading second-guess arbitral tribunals. This could lead to a to minimal delays. Extending the scope of the present po-sition not dissimilar to that under the 1940 Act and Securities Appellate Tribunal (SAT) might be a useful way complete a full circle for Indian arbitration. The problems of addressing these concerns. SAT already has judicial of Patel Engineering case prima facie, do not appear to capacity with specialised domain knowledge in securities have been addressed in this Bill. markets. It processes cases with obvious efficiency at an The last (but not least) component of the legal system impressive pace. Going beyond SEBI, there is a possibility is lawyers. At present, there are some significant of utilising SAT for processing appeals against FMC and weaknesses in the development of legal skills by the PFRDA also. present Indian education system, particularly when it Applying the same logic, SAT’s scope and remit could comes to the legal aspects of sophisticated finance. The be extended to covering IFS as well with SAT adding an 5The 1996 Act was designed primarily to implement the UNCITRAL Model Law IFS Appeals Tribunal (IFSAT) to its extant role. SAT could on International Commercial Arbitration and create a pro-arbitration legal regime in India. Prior to its enactment, there was widespread discontent over have its remit expanded to deal with appeals not just for the excessive judicial intervention allowed by its predecessor, the 1940 Act. The 1996 Act attempted to rectify this problem by narrowing the basis on which capital markets transactions but cover banking, awards could be challenged, thereby minimising the supervisory role of courts, securities, insurance and pensions as well. A larger role ensuring finality of arbitral awards and expediting the arbitration process. for arbitration would help strengthen the legal system4. 6Saw Pipes addressed a challenge to an Indian arbitral award on the ground that it was “in conflict with the public policy of India”. Despite precedenls Arbitration is a key mechanism through which faster and suggesting that “public policy” be interpreted in a restrictive manner and that a breach of “public policy” involves something more than a mere violation of Indian superior contract enforcement can be achieved between law, the Court interpreted public policy in the broadest terms possible. The Court held that any arbitral award which violates Indian statutory provisions is private agents who have disputes about private contracts. “patently illegal” and contrary to “public policy”. By equating “patent illegality” to an “error of law”, the Court effectively paved the way for losing parlies in the From the viewpoint of a global participant utilising arbitral process to have their day in Indian courts on the basis of any alleged contraventions of Indian law, thereby resurrecting the potentially limitless Indian financial services, legal risk induces a risk judicial review which the 1996 Act was designed to eliminate. premium; it reduces the competitiveness of India as a 7ln Patel Engineering, the Supreme Court subsequently sanctioned further court intervention in the arbitral process. The case concerned the appointment of an venue for IFS production. Effective arbitration arbitrator by the Chief Justice in circumstances where the parties’ chosen method for constituting the tribunal had failed. The Court held that the Chief lustice , procedures give private agents a way to bypass the while discharging this function, is entitled to adjudicate on contentious preliminary issues such as the existence of a valid arbitration agreement and is constraints of the courts. The Indian Arbitration and entitled to call for evidence to resolve iurisdictional issues. Significantly, the Conciliation Act was passed in 1996, with the intent of Court ruled that the Chief Justice’s findings on these preliminary issues would be final and binding on the arbitral tribunal, making a mockery of the well established principle of Kompetenz-Kompctenz - the power of an arbitral 4 The ideas and facts here greatly draws upon “What next for Indian tribunal to determine its own jurisdiction - enshrined in section 16 of the 1996 arbitration?” by A. Ray and D Sabharwal, of the International Arbitration Act. This encourages parties to sabotage the appointment process of arbitrators, Practice Group at White & Case, London, which appeared in Economic Times, make spurious arguments about preliminary issues and use evideniiary hearings 29 August 2006. in courts to delay arbitral proceedings.

139 intcrnationalisation of Indian finance will induce new kinds of pressures upon the legal fraternity. On one hand, legal skills will be demanded in global finance that go well beyond the skills developed in dealing with Indian financial law. In addition, many global financial firms might feel comfortable utilising the services of the same global law firms they use in other IFCS when doing certain transactions out of India. This is perhaps analogous to Ells favouring foreign brokerage firms when operating in India. This suggests that India needs to open up on the issue of foreign law firms operating in India. Such measures will help simultaneously in three directions. It will improve the legal knowledge available in the country, particularly on the interfaces between finance and law. It will help global financial firms feel comfortable with operating in Mumbai, since they would find familiar global legal firms. It would have the same impact on improving the skills, technology and competitiveness of the Indian legal services industry that permitting FDI in manufacturing had on Indian industrial firms. Developments along these lines are already taking place. On 6th October, 2006, the Minister for Commerce and Industry said that a panel of lawyers had been constituted under the UK-India Joint Economic and Trade Committee (JETCO) to work with a similar group in the UK to deliberate on opening up the legal services sector.

140 Regulation of Investment Advisors

ANNEXURE - V ESTABLISHMENT OF RATING STANDARDS

- By Team FPSB INDIA

141 NEED FOR RATINGS STANDARDS as a result. In view of the developments that are taking place in the In a nutshell, the product may accrue significant Financial Planning field, the need to constantly upgrade benefits to all stakeholders including the investors, and improve systems and procedures in operation as Financial Planners themselves, the regulator and others well as skill sets has gained considerable importance. who will benefit from the transparency and the Besides compliance with regulatory requirements both consequential focus on efficiency. in letter and spirit has assumed significance so as to mitigate risk and ensure adequate protection of RATING- OPTIONAL OR MANDATORY investors’ interest. While the product for rating of Financial Planners should In light of these developments, quality, competence, be encouraged to be introduced in the market, it is felt professionalism and standards of ethics being adopted that the demand for the product should come from the by financial firms have become all the more necessary. market itself instead of any imposed obligation on the These developments underpin the need to measure and industry to go for it. Further with the relative maturity of compare the relative competencies and standards of the markets and self imposed code of discipline, which services of the Financial Planners on these and other arises out of such maturity, the demand for product is parameters in order to provide investors necessary expected to rise as more and more players would like to information to compare the Financial Planners. get themselves rated and measured, both for internal One of the tools with which these parameters can be evaluation and introspection and for giving an insight into measured and indexed is the professional rating of Financial its affairs to the outside world and for marketing its Planners by FPSB India. The rating index would measure services. these Financial Planners on laid down criteria and will be It is further observed that a similar approach has been an indication of the relative strength of the financials and followed by the rating agencies while introducing other parameters of the Financial Planning firm. Corporate Governance and Wealth Creation and Management Index. While the index has not been RATING OBJECTIVES/BENEFITS mandated initially, companies in their pursuit to achieve The intended objectives of rating as well as benefits higher and higher levels of governance standards are on accruing from the exercise are thought of as below: their own getting themselves rated. Similarly, for 1) It is expected to spur growth of professionally managed Financial Planners also as the process of consolidation entities as business development and opportunities and need to shape up gains momentum, the role and would result from such an exercise. significance of such an index would be felt more and more 2) Investors interest may gain more importance as this by them. The rating product is also expected to shore up would be a factor to be considered while taking a rating the interests of investors in the markets as a highly rated decision. Investors would be knowledge investors and will entity is expected to be more concerned with protection be informed about the standing of the entity. of investor’s interests in all its dealings. 3) Rated entity would be in a position to brand its image and capitalize the same for generating more business. RATING PARAMETERS 4) Benchmarking with others in the field is expected to Application of scientific analysis to recommend financial constantly improve and upgrade the performance. products (in-house or out-sourced) requires an 5) Risk management systems and procedures are organization to put in place adequate systems, processes expected to improve as this will be vital rating criteria. & procedures. It is expected that rating methodology 6) Process of consolidation of entities is expected to start should invariably should address the following as focus would be either to shape up or ship out. parameters of a Financial Planning services 7) Overall compliance standards are expected to improve establishements while taking a rating decision:

142 Regulation of Investment Advisors

1. Organization Structure & Corporate non-repetition of the same, dealing with arbitration Governance: matters, promptness in attending to such matters, Legal structure of the firm, ownership pattern, quantitative assessment of the organization’s approach organization structure which would include adequacy and towards investor’s protection by also maintaining competence of personnel, qualification and confidentiality of client data and documents.

4. Organization’s Processes and Procedures: The flow of work pattern in the organization, possible bottlenecks which may affect the performance of functions, procedures adopted by the entity in dealing with different facets of operations including opening of new accounts, executing trades, issuance of contract notes/bills to clients, executing agreements, obtaining clients information, operating bank accounts, DP account, dealing with agents, brokers, sub brokers etc.

5. Management Policy on Compliance & Disclosures: The importance attached to the concept of compliance in the organization, role and relative importance of the compliance officer, information flow from/to compliance officer, actual compliance with various rules/regulations/ professionalism of the top management who are at the circulars/bye laws of SEBI/stock exchanges/Regulators helm of affairs, checks and balances built into the system, etc., steps taken by the management to ensure that flow pattern of information, clear definition of job problematic areas are addressed promptly etc. The firm is profiles, proper delegation of authority and well laid down also expected to meet the disclosure norms of regulators. accountability and responsibility statement. 6. Financials: 2. Risk Management Policy and System: The financial strength of the entity as judged from its net The risk management practices and risk appetite of the worth, capital structure, gearing and other operating entity, systems and procedures for managing different types ratios, exposure taken by the entity based on financials, of risk including market risk, systemic risk, credit risk, policy on short term and long term borrowing, extent of operational risk, policy on giving exposure to and collection leveraging for proprietary trading, transparency and of margin and payins from clients, sub brokers etc. This quality in disclosures relating to operations, quality of would also include analysis of clients’ mix (retail/ disclosure in Directors reports, any adverse reporting by institutional), extent of proprietary trading, day trading, etc. the auditors and steps taken to rectify the same etc.

3. Policy on Investors’ interest: 7. History / Background: The Management policy on ensuring fair dealing for Factors would include an analysis of factors like clients, time taken to make payout of money as well as imposition of fines/penalties etc. by Regulators/stock securities to clients including the end clients of sub- exchanges/ courts/others, action taken by government brokers, policy on handling investors grievances, time authorities, repetition of violations, which resulted in taken to settle the complaints and steps taken to ensure such imposition/ action etc.

143 8. Firm’s Positioning & Sr. Score Levels Competency Levels of Offerings: Financial Planning Organisation Factors which may be analyzed would 1. > 40 < 50 FPCL1 Initilal Level - Processes are disorganized. include the market structure, size of points Success is likely to depend on Financial the market and level of competition, Planner’s relationships & knowledge base number of players in the field, core which may or may not be repeatable as the competence of the entity, dominance number of Planners/ Clents grow. of players, market share, trend in 2. > 50 < 60 FPCL2 Repeatable Lever - Basic FP Process of Sales, operations & client services are market size and market share, established. Successes could be repeated as comparative analysis with others firms processes could be established & defined on different parameters. The firm’s 3. > 60 > 75 FPCL3 Define Level - The organisation has basket product offerings may also be developed its won “Delivery System” of analysed to find the comprehensivenes Financial Planning Services through of Financial Planning services. documentation, standrdization & integration 9. Resources & Infrastructure: 4. > 75 < 90 FPCL4 Managed Level - The organisation The infrastructure especially IT monitors and controls its own processes. mechanisms & systems of the Will add the entire gamut of Financial organization, number of branches, Palnning gprducts under advice like loans, investors’ access points etc. which equity broking, estate planning etc. support the efficiency and effectiveness 5. > 90 FPCL5 Optimizing Level - Processes are of the Financial Planning process and constantly being improved through helps in the day-to-day operations of monitoring feedback from current processes & introducing innovative processes to better the firm. The qualification, certification serve the client’s particual needs & experience of the personnel employed shall also be analysed. (Table 1.2) various components of the Financial Planning process 10. Approach to Financial Planning Process: that may be rated are given in the next paragraph. The approach and depth of the Financial Planning process adopted may be given the highest weithtages as Rating Weightages: this directly addresses the client expectations. The It may be noted that the above factors are only illustartive and not exhaustive, the rating agency may devise its own Rating Weightages (Table 1.1) models and methodologies for rating of orgnizations. Parameters Weights Appropriate weightages may be given to these and other Financial Planning Processes Adopted 40 factors as may be deemed fit to provide for a level playing Policy on Investors Interest 15 field to smaller as well as big Financial Planning Organizational Structure 10 establishments while undergoing rating exercise. History/Background 5 Risk management Policy & System 5 Organization Processes & Procedures 5 Components for Rating Standards - Financial Management Policy on Compliance 5 Planning Process Financials 5 Definition Firm’s Positioning 5 A process that helps consumers to take control of their Infrastructure 5 financial situation by:

144 Regulation of Investment Advisors

oriented, not product oriented Objective • Seeks optimum products and services Presents alternative strategies/solutions

Dynamic • Proactive, ongoing and interactive...client regularly self- monitors and reviews • Oriented to inspire action, to “implement” (Fig. 1.3) Comprehensive • Formulating one’s own specific goals and concerns • Views all significant financially • Defining financial implications of the goals & concerns related aspects of client’s life • Developing realistic alternative strategies to better Integrated control one’s income, assets, liabilities, risks & opportunities • Links to several different professional discipline/ • Encouraging decisive implementation of a strategy service categories • Ongoing management of finance, legal and related • Changes in one area trigger corresponding changing areas to be more successful in achieving one’s goals changes in other relevant areas

Process - A process to serve the consumer which includes Quality Assurance in the Process • Establishing and defining the client-planner relationship The Financial Planning firms to ensure & enhance quality • Gathering client data, defining (Table 1.4) goals and concerns Competency Quality Management Techniques • Evaluating client’s financial status, risk and profile • Financial Plannig • Education, examination for course • Developing and presenting concepts completion; designations Financial Planning • Product konwledge • Quality of advice programs recommendations • Financial Plan preparation • Coaching, “covered” client meetings • Implementation of the selected • Laws/ regulations • Education; licensing; supervisory recommendations examinations; analysis of claims • Monitoring progress and • Compliance/ Suitability • Direct communication with clients updating the plan/revising strategy • Making and sales • Training, client relationship mgt. systems • Client relationship • Client satisfaction surveys, complaint Characteristics and management handling; Dispute resolution Overiew of Financial • Results; retention, referrals, repeat business Planning Process • Technology/ operation • Training, error analysis and remedies Client-focused systems • Driven by client’s desires and • Practice management/ • Coaching; benchmarking; best practices needs - financial, social and running a business emotional • Practice succession/ • Consumer and relationship transfer support

145 Value Propositions: Elements Role Creates Value By Captures Value By Consumer • Paying service fees for plannng, • better money / risk management accont management • More desired outcomes • Buying products to implement plans • Sense of control / satisfaction Professional • Information / advice / alternative • Planning fees from consumers Financial Planner Scenario analysis • Commissions from product Portfolio tracking/ analysis/ reporting manucaturers (if also a distributos) • Access to network of services • Proud professional career Financial Product • Education of marketplace • Commissions form product manufacturers Distributos • Client acquisition • Sales commissions from consumers • Product marketing • Client accoutn relation shipment • Product origination/ servicing Third-Party • Introduction of info./ products/ advice • Referral fees Intermediating to consumers in their affinity group • Enhanced satisfaction within their affinity group Entity • Subsidiesfor costs of products/ advice • Fulfilling moral or regla requiremetns service Financial Product • Product design/ fabrication • Money management fees Manufacturers • Investment/ risk management • Asset-liability spreads

(Table 1.5)

of operations, client service, knowledge base, according to the benchmark set above would find the compliances & practice model may adopt appropriate services a key differentiator among the competition. In a management techniques & control systems. The following distant long term objective of providing Financial competency areas of the Financial Planning business Planning services to all, all Financial Supermarkets as shall be considered: (See Table 1.4). well as the Kiosks (Intermediaries) would be forced to adopt the Financial Planning Process as mentioned in Value Proposition Elements Fig. 1.3 in one way or the other. Each of the stakeholders involved in the Financial If one goes through the value proposition, everyone Planning process from creation of a financial product by benefits and for a change the ‘Consumer’ is the biggest the manufacturers to its consumption by consumers beneficiary. The consumer takes decisions based on the create value and capture value, thus creating a win-win advice of the Financial Planner based on needs rather than situation for each other by adhering to the standard the gullible sales spiel of an agent. The benchmarking and processes (See Table. 1.5). the ratings of the Financial Planning process would herald a new chapter in terms of service delivery and will help Conclusion organizations to go for an advisory mode rather than the As mentioned earlier, adoption of the Financial Planning current ‘sales’ mode and will force the players in the process by an organization would require not just marketplace to pull up their socks and offer better services. changing the moniker but putting the systems and Though the discussion paper has set out the detailed procedure in operations as well as changes in the current parameters for ratings of an Organization in the Financial offerings. Financial Services organizations who would like Services industry, each points mentioned is open to to benchmark their services and position their services debate and further crystallization.

146 EXHIBIT VII

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144 About FPSB India

Financial Planning Standards Board India (FPSB India)

FPSB India is a Not For Profit establishment, which focuses on Financial Planning, investment advisory and improvements in the distribution of Financial Products with full disclosures and regulated practices. It is established by leading financial institutions across both sectors viz. public and private from various disciplines including Asset Management, Banks, Financial Planners, Insurance Companies etc. The establishment is governed and managed by professionals. The details on the Board of Directors are as given below:

Sr. No. Name Designation Job Title & Organization Former Chairman 1 Mr. D. Swarup Chairman Pension Fund Regulatory and Development Authority (PFRDA) Vice Chairman & Chief Executive Officer 2 Mr. Ranjeet S Mudholkar Vice Chairman & CEO FPSB India Managing Director & Chief Executive Officer 3 Mr. Amitabh Chaturvedi Director Dhanlaxmi Bank Managing Director & CEO 4 Mr. Anup Bagchi Director ICICI Securities Ltd. Executive Editor – Business 5 Mr. Gautam Chikermane Director Hindustan Times Director 6 Mr. Jaydeep M Kashikar Director Brain Point Investment Centre Pvt. Ltd. Secretary 7 Dr. K. P. Krishnan Director Economic Advisory Council to the Prime Minister of India Partner 8 Mr. Kedar Desai Director Desai Desai Carrimjee & Mulla, Advocates & Solicitors Managing Director 9 Mr. Mukesh D Dedhia Director Ghalla & Bhansali Securities Pvt. Ltd. Managing Director 10 Mr. Rajan Ghotgalkar Director Principal PNB Asset Management Company Pvt. Ltd. Country Head- Wealth Management, India, 11 Mr. Sharad Sharma Director BNP Paribas President & CEO 12 Mr. Sundeep Sikka Director Reliance Capital Asset Management Ltd. Managing Director 13 Mr. Suresh Mahalingam Director TATA AIG Life Insurance Co. Ltd Chief General Manager (New Businesses), 14 Mr. Venkatraman Murali Director State Bank of India Editor 15 Mr. Vivek Law Director Bloomberg UTV

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