In the aftermath of the turmoil on the global financial markets which has become prominently known and felt since the year 2008, FINMA, first in its discussion paper on regulating the production and distribution of financial products to retail clients (Distribution Report) and now in its position paper on the regulation of the production and distribution of financial products (Position Paper on Distribution Rules) has made proposals on how to better protect clients investing in financial products. This article provides a summary overview over the 18 key points which FINMA makes in its Position Paper on Distribution Rules and, to some extent, puts them into perspective.

By Peter Ch. Hsu/Tina Balzli (Reference: CapLaw-2012-30)

1) Introduction

On 24 February 2012, FINMA published its Position Paper on Distribution Rules accompanied by an introductory note of Dr. Patrick Raaflaub (FINMA Director) and a speech of Urs Zulauf (General Counsel of FINMA). In addition, FINMA published a report on the consultation procedure (Consultation Report) regarding its Distribution Report, published in October 2010 essentially as a reaction to the general turmoil on the financial markets since the year 2008 (including Lehman Brothers bankruptcy, Madoff etc.). The Consultation Report summarizes the responses of the participants in the consultation procedure and the Position Paper on Distribution Rules is a result of such consultation procedure.

In 2010, FINMA’s overall conclusion was that the financial markets law as it stands does not adequately protect clients and that it needs to be changed accordingly. Given the fact that FINMA felt vindicated by the consultation procedure with regard to the majority of its regulation proposals, its overall conclusion remains the same in 2012 although there are some differences between the two papers.

The following is a summary of the 18 mutually complementary and generic key points set forth by FINMA in its Position Paper on Distribution Rules which should essentially be in line with international standards on the production and distribution of financial products such as the Principles on Point of Sale Disclosure published by the International Organization of Securities Commission (IOSCO), the EU Prospectus Directive and the EU Directive on Markets in Financial Instruments (MiFID). The three main areas of concern throughout the key points are:

1. Rules on financial products;
2. Stricter rules on business conduct and organization for financial services providers; and
3. Extension of supervision.

The majority of key points focus on area (3). Apart from this, FINMA also gives thought to enforcement of client claims (without actually proposing specific civil law measures which is outside its scope) as well as to the creation of a financial services act.

2) Rules for Financial Products

a) Problem

On the level of rules for financial products, FINMA concludes that there are currently insufficient and inconsistent rules on the obligation to provide information to the customer. This is particularly true with regard to the obligation to provide (i) prospectuses and (ii) information documents regarding the key characteristics and risks of a product. 

Against this background, FINMA proposes the following three key points on rules for financial products.

b) Key Point 1: Prospectus Requirement for all Standardized Financial Products

FINMA believes that client protection can be improved by introducing a uniform prospectus requirement for all standardized financial products offered in Switzerland (except for collective investment schemes, insurance products or pure savings products that should remain subject to specific regulation), irrespective of the domicile of the producer. The uniform prospectus shall be drawn up following a prescribed format and contain key information on the producer and the product itself, in particular the involved risks.

Further, (i) issuers issuing large numbers of similar products shall have the option to draw up a base prospectus, (ii) prospectuses shall generally require authorization before being published in order to ensure compliance with the legal requirements and (iii) the issuer shall be subject to a follow-up publicity whenever a financial products changes after its issuance.

c) Key Point 2: Product Description for Compound Financial Products

As regards compound financial products (i.e. products which are made up of different components and, thus, more complex), FINMA requires all clients to be provided with a product description before they acquire such product, irrespective of whether it is issued in standardized form or designed upon the client’s request. The product description shall set out the key product characteristics, including risks and costs.

For the sake of comparability between the different product types, FINMA asks the legislator to enact strict regulations governing the composition, sequence and length of the document. The Key Investor Information Document (KIID) for European Undertakings for Collective Investment in Transferable Securities (UCITS) funds may serve as a model for such product description.

d) Key Point 3: Standardized Rules to Better Protect Retail Clients

According to FINMA, the prospectus requirement as well as the obligation to provide a product description shall primarily apply to financial products to be distributed to retail clients (i.e. all natural persons irrespective of their financial situation and companies without special knowledge of the financial markets). Professional clients may “opt in” to the same level of protection as retail clients while the latter may “opt out” as far as they dispose of sufficient assets and demonstrate adequate professional skills regarding the concerned market segment.

2) Stricter Rules on Business Conduct and Organization for Financial Services Providers

a) Problem

Moving on to the level of financial services providers, FINMA observes insufficient regulation on their business conduct. FINMA in particular criticizes (i) the general lack of information on financial services providers (in particular as to their authorization status), (ii) insufficient knowledge of the subject matter of the service and the motivation of financial services providers (inter alia regarding remuneration from third parties) as well as (iii) inconsistent and incomplete rules on how and to which extent financial services providers must obtain information on the experience and knowledge of their clients and provide them with information and warnings about financial products.

The subsequent key points 4 to 11 aim at rectifying this state of affairs.

b) Key Point 4: Information on the Financial Services Provider’s Authorization Status and Area of Activity

FINMA proposes that financial services providers must inform clients about their area of business activity and their authorization status before carrying out any financial transactions. In particular, financial services providers shall inform clients in writing (which may take a standardized form) about their authorization status and the activities which are allowed under such authorization. Only service providers who are supervised on a constant basis shall be allowed to refer to themselves as “supervised”.

c) Key Point 5: Disclosure of the Service and Interests of the Financial Services Provider

FINMA envisions that financial services providers must inform clients about (i) the content of their specific service, (ii) the interests involved in providing such service and (iii) the costs which their services entail. Further, financial services providers shall disclose whether they only distribute their own products and whether they receive remunerations from third parties or group companies for the distribution of certain products. They shall only be allowed to call themselves “independent” if they do not accept incentives or inducements from third parties when performing services for their clients and are not tied to third parties in any other way. In our view, this would e.g. include payments such as retrocessions paid to asset managers or commissions paid by insurers to insurance brokers.

d) Key Point 6: Information on the Characteristics, Risks and Costs of Products

FINMA wants financial services providers to inform clients about the characteristics, risks and costs of the respective type of business transaction before they perform the service in question. Such information must enable the client to make an informed investment decision, particularly with regard to the risks involved and may be provided in standardized form as far as it is suitable for the client’s level of expertise. However, such information must go beyond the current self-regulatory standards e.g. in the securities trading business (cf. the Swiss Bankers Association brochure on special risks in securities trading of 2008).

e) Key Point 7: Providing the Product Documentation

As a correlative of the product producers’ duty to draw up prospectuses and product descriptions (see key points 1 and 2), FINMA wants to oblige financial services providers to provide the product documentation to their clients whenever they offer productsto them. In particular, they shall provide retail clients with a product description for compound financial products. Prospectus documents, however, shall only have to be made available on request. Also, advertising material shall clearly be separated from the documents required under supervisory law.

f) Key Point 8: Checking the Appropriateness of Financial Products

Before carrying out financial transactions for a retail client, FINMA wants to oblige financial services providers to determine the client’s experience with and knowledge of the respective type of product or the service to be provided. Whenever a service provider concludes that a transaction is inappropriate for a certain client, it shall warn the client accordingly who is then free to decide whether or not to execute the transaction. The appropriateness test shall, in principle, only apply to retail clients and not to professional investors which is along the lines of MiFID.

g) Key Point 9: Providing Information on the Suitability of Investments

Before giving advice to clients (compared to advice addressed to the general public), FINMA wants financial services providers to determine whether a transaction is suitable for the client by asserting such client’s experience and knowledge, investment objectives and financial situation and to take into account the risk diversification of the client’s portfolio. Before taking on portfolio management mandates, they shall further ascertain whether the client has understood the significance of issuing the order and whether the chosen investment strategy is suitable for the client. If a financial services provider does not receive sufficient information to check the suitability of a financial product for a client, it must inform the client of this situation. In such case, it may not render the client any personal advice on a specific product. As far as a portfolio management mandate exists, the individual transactions shall usually be deemed suitable for the respective client as far as they are in particular in line with the chosen investment strategy. The service provider shall further constantly monitor the client’s portfolio.

h) Key Point 10: Restriction of Execution-only Services for Retail Clients

FINMA suggests that financial services providers may carry out financial transactions for retail clients without an appropriateness test (see key point 8), if the client instructs the provider to carry out the transaction on his/her own initiative and the products in question qualify as simple financial products (e.g. exchange-traded equities or bonds, but per se no products with derivative components). Consequently, financial products that do not qualify as simple financial products may not be sold without advice on an execution-only basis to a retail client.

i) Key Point 11: Documentation on the Service Provided

In order to avoid uncertainties and misunderstandings, FINMA proposes to oblige financial services providers to document the scope and subject matter of the agreed service. Further, they shall duly account for the services provided.

3) Extension of Supervision

a) Problem

On the level of supervision of financial service providers, FINMA criticizes the incomplete coverage of financial services providers under current supervisory law. The detected deficits in particular concern (i) gaps in the supervision of portfolio managers,(ii) insufficient qualification requirements for persons who enter into contact with clients and (iii) insufficient client protection in the case of cross-border financial services.

Based on this analysis, FINMA proposes the following measures in the area of extension of supervision.

b) Key Point 12: Introduction of Supervision to all Portfolio Managers

FINMA claims that all portfolio managers which are currently not subject to prudential supervision such as in particular external asset managers (compared to banks or securities dealers) should be supervised. Under this supervision, the portfolio managers shall comply with the rules of business conduct (see above section 2) and must have an appropriate organization and adequate capital. It is not clear whether financial intermediaries providing asset advisory services only (opposed to asset management services) should also be subject to supervision.

c) Key Point 13: Quality Test for all Client Advisors and Product Distributors

Apart from extending supervision to institutions, FINMA wishes to ensure that client advisors and product distributors entering into contact with clients meet certain minimum requirements. Accordingly, FINMA wants them to prove their knowledge of the rules of business conduct, the principles of financial planning and the products distributed in a test. They shall further be required to improve their skills by way of regular training courses. A publicly accessible register shall enable clients to check whether their client advisor or product distributor meets the required quality standards.

d) Key Point 14: Client Protection in the Case of Offers from Financial Service Providers based Abroad

FINMA plans to substantially change the current liberal cross-border services regime into Switzerland. In the future, cross-border services to clients in Switzerland shall only be permissible from other countries if the same level of protection is guaranteed as with a Swiss provider (i.e. requirement of an appropriate supervision of the service provider, cooperation agreement between the respective foreign supervisory authority and FINMA and, normally, a branch or subsidiary of the service provider in Switzerland). Further, Swiss rules on business conduct and staff quality standards shall also apply to foreign service providers conducting business in Switzerland.

4) Key Point 15: Improved Enforcement of Client Claims

FINMA points out that retail clients typically refrain from asserting their legal claims against financial services providers before court due to the high costs and uncertain outcome of the trial. FINMA believes that civil law measures can provide a sensible complement to the supervisory instruments available and therefore proposes that the enforcement of retail client claims against financial services providers should be improved.

5) Creation of a Swiss Federal Financial Services Act

a) Key Point 16: Financial Services Act Covering the Products, Business Conduct and Knowledge of Financial Service Providers

In order to ensure a coherent and comprehensive application of the suggested conduct and product rules across all sectors at the point of sale, FINMA proposes to incorporate them in a new act (i.e. a financial services act) and not to include them by amendment into the existing financial market legislation.

b) Key Point 17: Supervision of Portfolio Managers via an Amendment to the Stock Exchange Act

Given the fact that portfolio managers regularly engage in securities trading, FINMA proposes to include the rules on the authorization and supervision of portfolio managers into the Stock Exchange Act and thus, to adhere to the sector-specific approach in this regard.

c) Key Point 18: Amendments to the existing Financial Market Legislation of the Code of Obligations

FINMA notes that whilst introducing cross-sector business conduct and product regulations in a new financial services act, changes will have to be made to the applicable financial market laws and the Code of Obligations. To the extent that sector-specific circumstances require special arrangements, existing provisions on the documentation and distribution of financial products should nevertheless continue to apply.

6) Appraisal

In its Position Paper on Distribution Rules, FINMA altogether puts forth far reaching proposals for the purpose of improving client protection which are inspired by international standards. If adopted by the legislator, such proposals will lead to a significant expansion of FINMA’s current powers which, in our view, will require the provision of additional resources. At this stage, there is also considerable lack of clarity on how the FINMA proposals should actually be put into practice (e.g. approval of prospectuses, criteria for client segmentation, conditions for opting in and out of retail client protection, definition of simple financial products, supervision of pure advisors). We would also expect MiFID II to have an important influence on the future legislative development (see in particular the requirement of equivalence in article 41 no. 3 of the Proposal for a Directive of the European Parliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC of the European Parliament and the Council (MiFID II) of 20 October 2011, 2011/0298 [COD]). Nevertheless, the market environment and standard of regulation of jurisdictions outside the EEA should also be considered in order to remain internationally competitive. In any case, the Position Paper on Distribution Rules is certainly a starting point in a future legislation process and several of FINMA’s proposals are already being implemented in the current revision of the Collective Investment Schemes Act as far as collective investment schemes are concerned. Also, the Federal Council has instructed the Federal Finance Department to elaborate the required legal basis for improving client protection as regards the distribution of financial products, namely to examine in cooperation with the Federal Department of Justice and FINMA the potential need for action and to elaborate a consultation draft (see press release of the Federal Council dated 28 March 2012, http://www.news.admin.ch/message/index.html?lang=de&msg-id=43953).