After studying this unit, you will be able to demonstrate a knowledge of:

• how other non-tax laws and regulations impact upon firms and the process of advising clients.

You should also be able to demonstrate an understanding of:

• the FSA’s approach to regulating firms and individuals;

• how the FSA’s rules affect the control structures of firms and their relationship with the FSA;

• how the FSA’s Conduct of Business rules apply to the process of advising customers/clients;

• how the Anti-Money Laundering rules apply to dealings with private and intermediate customers;

• the main features of the rules for dealing with complaints and compensation;

Section 1 covers parts K1, U1, U2 and U3 of the syllabus, including the aims and activities of the FSA; its approach to ethical conduct and to the regulation of firms and individuals; how its rules affect the control structures of firms; and how its Conduct of Business rules apply to the process of advising customers.

There was, in the latter part of the 20th century, a strong assertion, in Western societies, of the rights of the consumer. Many people believe that, as commercial organisations have grown through mergers and acquisitions, they have become more remote from their customers and more concerned with their own financial results than with customer satisfaction. This is reflected in the emergence of both government-sponsored organisations, such as the Office of Fair Trading and the Competition Commission, and openly consumerist bodies such as Which?.

Although some people believe that this trend to consumerism has gone too far – notably in the USA, there is a general acceptance that protection for the consumer is both necessary and appropriate.

One of the primary objectives pursued by most modern governments is an economic and legal environment in which a balance is established between the need for businesses to make a profit and the rights of customers to receive a fair deal. This has led to the regulation, to some degree, of most industries in the UK, but at the same time, the government recognises the right of companies to make a profit. Indeed, it recognises that it is essential that companies be permitted to make a reasonable profit; it would otherwise be impossible to attract the investment that sustains the industries on which the UK economy depends.

These twin objectives of a free market for business enterprise and the protection of the consumer are among the principles on which the European Union is based, and it is not surprising to discover that these objectives have been promoted largely through European legislation – most of which impacts, either directly or indirectly, on the UK. The force of European law can be seen in most recent major developments in the regulation of UK financial institutions.

Perhaps because it deals with money – a vital common denominator both in the lives of individuals and in the national economy – the financial services industry has become one of the most regulated business sectors of all. Following the government’s establishment in 1998, of the Financial Services Authority (FSA) as the single regulator of the financial services industry and the passing of the Financial Services and Markets Act 2000, there is no sign of a slowing down in the trend to greater supervision of the industry. Details of the nature and scope of the FSA as the regulator of the UK financial services industry are included later in this section.

Although governments try to foresee problems and to introduce legislation as a means of ‘prevention rather than cure’, it remains true that most regulatory legislation in the past has been reactive rather than proactive, ie it has been passed in response to problems, rather than designed to foresee and prevent them. Legislation has often resulted from:

Now, however, there is a strong move towards a culture of recognising and preventing problems before they arise, where possible, rather than simply picking up the pieces afterwards and allocating blame and punishment (although punishment has not been discarded). This approach is clearly illustrated by the Financial Services Authority’s stated objective of moving to a more proactive stance and, in particular, its plans to base regulation on an assessment of the risk posed to consumers and to the economy by financial organisations and their products.

Government policy on the regulation of the financial services industry in the UK has, since the late 1970s, displayed what appears to be something of a paradox. There have been specific moves in what seem to be two opposite directions: in some areas, deregulation has been a key development; at the same time, many aspects of the industry have become more closely regulated. The aims of developments in all areas have been to benefit the consumer through greater choice, better service and stronger protection.

Deregulation was experienced mainly in the worlds of banking and building societies. Traditionally, banks had not been active in the mortgage market because government credit controls had severely restricted their lending activities, while building societies – operating under legislation that dated, in some cases, from as far back as the nineteenth century – were restricted to lending on mortgages and to offering simple personal savings products. But the world had moved on: the increase in home ownership was creating a huge demand for mortgages and customers were demanding a much wider range of products and services from their chosen financial providers.

The deregulation introduced in the 1980s was designed to remove these barriers, enabling institutions to broaden their services and to move into new markets. The relevant changes were introduced largely through the Building Societies Act 1986 and the Banking Act 1987. Increased competition was beneficial for customers who, in addition to having a much wider choice of both products and providers, saw a reduction in the cost of many products. The increased size and complexity of the financial marketplace, however, quickly revealed the inadequate protection afforded to customers by existing legislation. Many existing laws, such as the Prevention of Fraud (Investments) Act 1958, were quite inadequate to deal with what was now a much more sophisticated and competitive industry.

One consequence of the charges described in the Introduction was, in the 1980s and 1990s, a number of new pieces of regulatory legislation, including the Financial Services Act 1986 which included an element of self-regulation.

By the mid-1990s, however, it was becoming clear that the self-regulatory aspects of the system had not been wholly successful and that the overall structure of regulation was too fragmented for the increasingly integrated world of financial services. For example, many large banking groups – now providing a wide range of financial products and services – were regulated by the Bank of England and also by several other organisations relating to fund management, investments and marketing. This sometimes led to confusion over where regulatory responsibility lay. The collapse of Barings Bank in 1992 highlighted many of these anomalies, with both the Bank of England and the body then regulating stock market organisations (the Securities and Futures Authority) being criticised.

The first major step in the development of a new regulatory regime came in June 1998, when responsibility for the regulation of the UK banking sector was transferred from the Bank of England to a new single regulator, the Financial Service Authority (FSA). The next stage was achieved in December 2001, when the FSA assumed regulatory responsibility for almost all of the financial services industry. A wide-ranging new Act, the Financial Services and Markets Act 2000, gave effect to the new regulatory regime.

This Act provides the legislative framework through which the FSA is able to regulate the professional and business behaviour of all parts of the industry, from the largest institutions (including around 800 insurance companies and 600 banks) to individual employees and sole traders. It covers a wide range of matters, including solvency, capital adequacy, sales and marketing practices, prevention of crime, competence of managers and sales staff, complaints and compensation.

Two sectors of the industry that did not come under the wing of the FSA in 2001, however, were mortgages and general insurance. Regulation of mortgage sales continued on a voluntary basis, overseen by the Mortgage Code Compliance Board (MCCB), until their regulation under the FSA in October 2004. Similarly, general insurance continued to be the responsibility of the General Insurance Standards Council (GISC), until their regulation under the FSA in January 2005.

The role of the FSA is to oversee the regulation of the financial services industry in the UK. To carry out this role requires a staff of well over 2,000 and an annual budget of over £200 million. It involves the publication of a Handbook so large that, as the Director of Policy of the Association of Independent Financial Advisers pointed out, a paper version would take up the entire shelf space in most financial advisers’ offices.

The FSA is not a government department – it is a limited company – but it does have statutory powers, given to it under the Banking Act 1987, the Financial Services and Markets Act 2000 and other legislation. The FSA’s board, which makes its policy decisions, is, however, appointed by the Treasury, which has overall responsibility for the UK financial services industry.

The FSA has also been given the following statutory objectives:

The performance of the FSA in regulating the industry will be judged against a set of ‘principles of good regulation’. It must be seen to be:

The FSA carries out its role by setting standards, developing rules and regulations, supervising their implementation, authorising firms and individuals, and providing guidance and training. These and other areas of FSA activity are covered in a range of Sourcebooks, which make up the Handbook. The Handbook is broadly divided into five sections, each of which is described below. More details of relevant key aspects of Sourcebook contents are given throughout Section 1.

The ‘High-level standards’ section of the FSA’s Handbook covers:

Business standards are described in:

The third section of the Handbook covers regulatory processes, including rules and guidance for firms wishing to seek authorisation, and the FSA’s enforcement powers. It also includes the Supervision Manual, which sets out the way that the FSA will regulate and monitor the compliance of authorised firms.

The two remaining sections of the Handbook cover:

The Handbook consists mainly of ‘rules’ and ‘guidance’, and it is important to understand the difference between them.

It would be impossible to explore every area in this text that is covered by the FSA Handbook. It will, however, cover the areas of greatest interest to financial advisers and mortgage advisers in sufficient detail to enable them to carry out their activities in an efficient, safe and well-regulated manner.

The FSA's regulatory regime is based on a set of 11 ‘Principles for Business’, from which all of the more precise rules and regulations follow. They apply to the behaviour of firms and of the individuals who carry out the firm’s activities and refer to:

There are seven further statements of principle for members of staff who are approved persons and are carrying out controlled functions (see Section 1.7.1 for a definition of approved persons and controlled functions). These principles specifically stress that approved persons must, while carrying out controlled functions:

These principles are taken straight from the list of ‘Principles for Business’.

In addition to these, there are three principles that apply to persons who are in positions of significant influence in a firm (ie those who carry out senior or supervisory functions). Such persons must:

In order to ensure that these principles are translated into a practical, properly controlled regulatory regime, the FSA has established a very large body of rules, many of which are found in the Sourcebooks listed in Section 1.2.2. A selection of the important rules affecting financial advisers and mortgage advisers is also included.

The establishment of rules and regulations can, however, carry with it one very serious drawback, which is that people and organisations make it their aim to comply with the letter of the law rather than to operate according to its spirit. There is also the danger that it is sometimes possible for firms to ‘hide behind’ the rules, using loopholes or technicalities to their own advantage.

The FSA quickly became aware of this potential drawback to their complex system of rules and has introduced an initiative known as Treating Customers Fairly (commonly referred to as TCF). The aim of the scheme, which is being treated very seriously by the FSA, is to develop a more ethical ‘frame of mind’ within the industry, leading to more ethical behaviour at every stage of firms’ and individuals’ relationships with their customers.

What exactly is meant by Treating Customers Fairly? Clearly, it depends on the definition of ‘fair’, but the FSA has declined to supply a definition, claiming that fairness is a concept that is ‘flexible and dynamic’ and that it can ‘vary with particular circumstances’. Instead, firms will have to decide for themselves exactly what TCF means within their own context. What is clear is that the FSA intends that TCF will apply at every stage throughout the life cycle of financial products, beginning with product design. All the stages that follow – including sales and marketing, advice and selling, administration – must also be carried out with TCF in mind, and this carries through into all post-sales activities such as claims handling and, where necessary, dealing with complaints. The FSA has stressed that firms and employees must ‘embed the principle of Treating Customers Fairly into the firm’s culture and day-to-day operations’.

Despite failing to specify what ‘fairness’ entails, the FSA has given some guidance on the types of behaviour it would wish to see and has suggested a number of areas that a firm should consider. These include: considering specific target markets when developing products; ensuring that communications are clear and do not mislead; honouring promises and commitments that it has made; identifying and eradicating root causes of complaints.

Responsibility for the introduction of TCF lies with a firm’s senior management, which is required to ensure that TCF is ‘built consistently into the operating model and culture of all aspects of the business’.

Individuals who wish to get fully to grips with this new FSA initiative, and to demonstrate their commitment to the principles of TCF, can take an appropriate examination such as the ifs Certificate in Regulated Customer Care (CeRCC).

Senior managers must take responsibility for a firm’s compliance with FSA regulations and there are three particular ways in which they are required to achieve this. The exact nature of the systems and controls used by a firm is left to its discretion but it must be able to demonstrate that these systems and controls are appropriate.

Senior managers will be held personally responsible for the firm’s activities but in many large firms it is not realistic for them to do everything themselves. They must therefore identify specific individuals within the firm to take responsibility for specific areas of activity. These individuals must be made aware of their areas of responsibility and records must be kept showing a clear chain of responsibility.

A firm must implement systems and controls that are ‘appropriate to its business’. These systems and controls must be clearly documented and regularly reviewed. They will relate to a wide range of the firm’s activities, including:

Firms should have whistle-blowing procedures in place to enable employees to report serious inappropriate circumstances or behaviour within the firm, which they believe are not being addressed. Workers who wish to report their knowledge or suspicions regarding, for example, a failure by the firm to comply with legislation, have a right to protection under the Public Interest Disclosure Act 1998. The firm’s procedures should assist staff and not hinder them in the whistle-blowing process.

The FSA has established a set of criteria for determining whether an individual is a ‘fit and proper’ person to be approved to undertake a controlled function. This refers to the need for individuals to be authorised under the terms of the Financial Services and Markets Act 2000 before they can undertake certain specified jobs or activities within the financial services industry. This is described in more detail in Section 1.7.1.

The criteria relate to a person’s:

The FSA is committed to reducing financial crime of all kinds, in particular:

Any financial services organisation carrying on business in the UK must be authorised by the FSA if it carries out regulated activities in relation to regulated investments. Regulated activities and regulated investments are defined in Sections 1.3.1 and 1.3.2. Similarly, individuals who carry out certain specified controlled functions also have to be authorised, as described in Section 1.7.1.

The activities for which firms must be authorised were first listed in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, often referred to simply as the Regulated Activities Order or RAO. These activities include:

Permission is given in the form of a list of regulated activities that the firm is allowed to carry out; it also shows the regulated investments with which the firm is allowed to deal. The relevant section of the FSMA 2000 under which permission is granted is Part IV – as a result, this form of permission is often referred to as Part IV permission.

The RAO (see above) also defines regulated investments. They include:

The FSA defines two key categories of regulated investments: securities (such as shares, debentures and gilts), and contractually based investments (including life policies, personal pensions, options and futures).

A vital element of the work of any industry regulator is to ensure that the firms operating in the industry are prudently managed. The aim is to protect the firms themselves, their customers, and the economy, by establishing rules and principles that should ensure the continuation of a safe and efficient market, able to withstand any foreseeable problems.

One of the key areas of prudential control for financial institutions relates to their capital adequacy. There are different rules for deposit-takers (eg banks and building societies), for investment firms and for life assurance companies.

Regulations about capital adequacy broadly state that institutions must have sufficient capital to make it very unlikely that deposits will be placed at risk. The meaning of ‘capital’ in this context is perhaps best illustrated by the fact that it is also sometimes referred to as own funds, ie the bank’s own capital base, obtained from shareholders and related sources, as distinct from funds deposited by customers.

Although a bank’s lending is generally financed by deposits, any losses made (for instance if a loan is written off because repayment cannot be obtained) should be borne by shareholders rather than by depositors. Minimum requirements for capital adequacy are set to protect a bank's depositors so that they do not lose money, whereas shareholders are expected to take risks.

The Basel Committee on Banking Supervision, a multinational body acting under the auspices of the Bank for International Settlements, first established an international framework for deposit-takers (ie principally banks) in 1988. This agreement, which – among other things – set out minimum capital requirements for banks, was commonly referred to as the Basel Accord. This has now been superseded by a new expanded Accord, commonly known as Basel II (see below), which is due to become fully operational in 2007.

These minimum capital requirements are specified in terms of a bank’s solvency ratio, which means that the capital required is denominated as a proportion of the bank’s assets (ie mainly its loans), with appropriate allowances made for the perceived risk level of different assets.

The solvency ratio is defined as own funds of the institution as a percentage of the risk-adjusted value of its assets. (This reflects the very reasonable principle that any losses made on traditional banking business – such as debts written off when borrowers default – should be carried by the institution’s shareholders and not by the investors whose deposits provide the funds that the institution lends out.) Current regulations require credit institutions to keep a solvency ratio of at least 8%. This means that their own funds must amount to at least 8% of their risk-weighted assets. In practice, institutions normally keep more than the required 8%.

‘Own funds’ means the bank’s paid-up share capital, plus any retained profits. The ‘risk weighting’ of assets is a process that is largely self-explanatory. Since the solvency ratio is designed, broadly speaking, to calculate how much an institution must hold to cover the risk of loss on its lending (its credit risk), each asset is categorised according to risk. The percentage contribution of the less risky assets to the risk-weighted total is less than that of the more risky assets, as in the following table of examples.

Under Basel II, the minimum capital requirements for credit risk remain broadly as described above, although there is more flexibility to reflect the business of individual institutions.

Capital requirements for operational risk are included for the first time in Basel II. Operational risk is the risk of loss from failed or inadequate internal processes, people and systems, or external events: this might include computer failure, a serious earthquake or staff fraud. The basic approach to calculating the capital required is to multiply the institution’s gross annual income (averaged over the past three years) by 0.15. Insurance held against the events happening cannot be offset against this. For large organisations with different business lines, a more sophisticated system (called the standardised approach) can be applied, using different multiplying factors for each line.

In addition to the traditional ‘capital requirements’ approaches, Basel II introduced a more robust system of supervision. This includes the requirement for banks to carry out ‘stress tests’ to ascertain the extent to which they would have sufficient capital if certain unexpected adverse economic conditions prevailed. These supervisory processes are backed by a set of disclosure requirements to ensure that banks publish sufficient information to enable market participants to assess a bank’s risk profile and the extent of its capitalisation.

In the early 1990s, it was recognised that investment firms that are not credit institutions should have the same freedom to provide services across the frontiers of the EU as is available to banks and other credit institutions. In order to achieve fair competition on investments, the European Directive on Investment Services in the Securities Field was issued in 1993 and came into force in 1996. It is commonly known as the Investment Services Directive (ISD). Under the ISD, firms based in one EU state can provide investment services in other states but are generally subject to conduct of business rules imposed in the states where the business is transacted.

The ISD does not cover all investment firms or all investment services. For instance it does not apply to:

The types of investment activity covered by the ISD include:

The specified investments covered by the ISD are:

The ISD has now been revised by a new directive, the Markets in Financial Instruments Directive (MiFID).This gives investment firms the right to operate throughout the EU on the basis of a single authorisation in its home state. The aim of the directive is to make life simpler by imposing a single set of rules across the EU. Firms affected will include securities and futures firms, banks conducting securities business, recognised investment exchanges and alternative trading systems. Implementation of MiFID in the UK is expected to take place in 2007.

While MiFID covers broadly the same range of investments as ISD, there is one significant addition in that regulation is extended to include investment advice. MiFID includes new standards for managing conflicts of interest, best execution and suitability requirements. ‘Best execution’ rules require that the best possible deal is obtained for clients, taking into account not only price but also speed and likelihood of execution and settlement.

In conjunction with the investment directives described above, the Capital Adequacy Directive (CAD) sets out the requirements for the capital adequacy of investment firms. The CAD established minimum capital requirements to cover market risks arising from debt, equity and related derivatives in the trading books of those credit institutions and investment companies that are subject to the provisions of MiFID.

Minimum initial capital requirements are split into two categories:

The authorities may sometimes permit firms in the first category, who only carry out transactions on behalf of clients, to hold investments temporarily on their own account, provided that the situation arises from a failure to match a client’s order precisely.

Determining whether a life assurance company is solvent is a more complex process than determining solvency for most other companies – more complex even than for other financial services companies such as credit institutions. This is because the liabilities of a life assurance company relate to payments that the company may or may not have to make at unknown dates in the future, eg as a result of a death claim on a life assurance policy. Determination of the current value of these future liabilities, based on estimates of future mortality rates and future interest rates, is the province of actuaries. Although the valuation liabilities –known in the Life Directive issued by the EU in 2002 as mathematical provisions – must continue to be assessed according to the professional judgment of the actuarial profession, the directive sets out principles designed to harmonise the sometimes very technical methods and calculations used.

The directive requires that a life assurance company must maintain an ‘adequate’ solvency margin at all times in respect of its entire business. The solvency margin is the excess of the company’s assets over its mathematical provisions (the discounted current value of its liabilities).

An ‘adequate’ solvency margin means a margin that is at least equal to that prescribed by the directive. The regulations are complex and the detail is beyond the scope of this text, but the basic rule is that, for policies that carry an investment risk (such as endowment assurances), the required minimum solvency margin is 4% of the mathematical provisions – in other words, the value of a life company’s assets must be at least 104% of the value of its liabilities. For policies with no investment risks (such as term assurance), the percentages are less. This reflects the fact that actuaries can be more confident about future mortality rates than about future yields on investments.

The ‘competent authorities’ in individual EU states (eg the FSA in the UK) can, in extreme circumstances, relax the rules on a temporary basis if they feel it is appropriate to do so. In early 2003, in the wake of a deep and continuing fall in the value of stock market securities, the FSA indicated that it would not take action against life assurance companies that had become, or were in danger of becoming, technically insolvent under the 4% rule, provided that they could show that they were taking steps to rectify the situation. This would normally mean taking action to reduce their prospective liabilities, for instance by reducing the levels of annual bonuses and terminal bonuses on with-profits policies.

The directive also sets out the types of assets that can be used to represent a company’s solvency margin, including:

The FSA has made it clear that its approach will be radically different from that of earlier regulators. In particular, it will:

It also recognises that regulation has to be built on realistic aims and has stated that it will not aim to prevent all failure. The FSA stresses not only the responsibilities of firms' own managements in this regard, but also the need for consumers to take some responsibility for their own decisions. This appears to be a tacit admission that there is a danger in the 21st century of consumerism going too far and eventually acting to the detriment both of providers and of consumers themselves.

The FSA claims that its new approach will ‘integrate and simplify’ the different approaches employed by its predecessors. Some practitioners and commentators, however, feel that simplicity has not been – and is unlikely to be – achieved.

The integrated approach is based on systems and controls that reflect the risk factors involved rather than the business sector from which the firm comes – reflecting the fact that many firms now operate across a wide range of product areas.

The FSA has listed the main risks that financial services consumers face:

The FSA aims to reduce prudential and bad faith risks, and possibly some aspects of complexity/unsuitability risk, but it is not responsible for protecting consumers from performance risk. This is reflected in the fact that the industry’s consumer protection schemes do not, for example, protect investors who have lost money because of a fall in stock market prices. The FSA will, however, aim to educate consumers about opportunities, risks and potential rewards.

The FSA's risk-based approach seeks to identify risks that may prevent it from achieving its objectives, to assess those risks and to prioritise them. The risks may arise from a number of different areas, ie firm-specific risks, product-specific risks and macroeconomic risks.

Assessment of risks is a complex process, but the following illustration may help to clarify the FSA's approach (which is set out in more detail in its booklet A new regulator for the new millennium). Consider a firm-specific risk, for instance the risk of a particular firm collapsing. The overall level of risk is defined by the FSA as being a combination of probability factors and impact factors. This reflects the fact that the seriousness of a problem depends both on the chance of it happening and on the effects of it happening.

This risk assessment process will be applied to all firms and will determine how closely supervised each firm will be. The FSA allocates each institution to one of four ‘impact’ bands: Category A is high risk; Categories B and C are medium risk; Category D is low risk. Initial investigations suggest that less than 1% of institutions fall into Category A (high risk), whereas the great majority are Category D. It has been estimated that – not surprisingly – high impact firms have, on average, about 65% of market share; the collapse of a large organisation clearly has greater overall impact than the collapse of a small one.

Although the FSA has said that it aims to be proactive rather than reactive in its activities, there will undoubtedly be occasions when it needs to investigate situations in which it believes that the regulations have been broken and possibly to discipline organisations or individuals.

The FSA is empowered to undertake general investigations into the business of authorised persons by looking at the business as a whole or at particular aspects of that business.

The FSA is also empowered to undertake specific investigations if it has specific suspicions about the activities or behaviour of an authorised person. The circumstances under which this might occur cover a wide range of situations including, for example, suspicion of an authorised person:

The person who is appointed to carry out the investigation on the FSA’s behalf has the power to:

If there are reasonable grounds for believing that someone has not complied with the requirement to provide information or documents, the FSA can apply to a Justice of the Peace for a search warrant to enter a property and seize documents or take copies.

If the FSA is satisfied that it has discovered a contravention of its rules, it has a number of steps that it can take, depending on its view of the nature and/or the severity of the contravention. Some of these are described below.

The Conduct of Business Sourcebook is part of the FSA Handbook. It draws on the principles established in the FSA’s ‘Principles for Business’ (and elsewhere) and sets out, in more detail, the rules by which approved persons must operate when carrying out their controlled functions.

There is a very wide range of rules covered in the Sourcebook (and in others) and this test will look only at these.

Any person working in an authorised firm who carries out a controlled function must be approved by the FSA. Approved persons are always approved to carry out a specific controlled function or functions.

The concept of approved persons is designed to cover all areas of financial services and all types of functions, so some controlled functions will not apply in all areas. For completeness, however, the full list of controlled functions is set out below. They are sub-divided into five categories.

A required function relates to:

A financial promotion is defined as an ‘invitation or inducement to engage in investment activity’. This includes:

Financial promotions can be ‘communicated’ only if they have been prepared, or approved, by an authorised person.

There is a distinction between:

Examples of the rules applying to advertisements and other financial promotions are as follows:

There are particular rules about unsolicited real time promotions, for instance:

The maintenance of clear and readily accessible records is vital at all stages of the relationship between financial services professionals, their clients and the FSA, from details of advertisements to information collected in factfinds, to the reasons for advice given and beyond. Record-keeping requirements for the different stages can be found at appropriate points within the Conduct of Business Sourcebook, with details of what must be kept and the minimum period for which it must be retained.

There are many business reasons for maintaining good records. From a regulatory point of view, the most important reason is to be able to demonstrate compliance with the regulations. Records can be kept in any appropriate format, which includes storage on computer, although the rules say that records stored on computer must be ‘capable of being reproduced on paper in English’.

Firms are expected to take reasonable steps to protect their records from destruction, unauthorised access and alteration.

The FSA’s philosophy of regulation is to be proactive rather than reactive and there is little doubt that one of the major steps towards the achievement of this objective lies achieving high levels of knowledge and ability among financial services staff. This is reflected in the importance that the FSA places on training and competence.

The FSA has published a Training and Competence Sourcebook (as part of its overall Handbook) that requires firms to make certain commitments regarding the competence of all persons who are employed in controlled functions (see Section 1.7.1). It is particularly prescriptive in relation to three types of employees, for whom it sets out detailed training and competence rules:

These training and competence rules fall into the following categories.

Firms must check that individuals being recruited for a particular post have the knowledge, skills, and qualifications appropriate to that particular post. This means, for instance, that firms must research the applicant’s background, in addition to preparing a clear job description for the post, specifying the knowledge, skills, and qualification achievement required for the job.

If a new recruit has no industry background, then full training must be given. If, on the other hand, he has been assessed as competent by a recent previous employer, there are transition rules allowing recognition of this prior competence. This means that he can initially be assessed as competent by his new employer on the basis of his existing skills and experience, provided that he will be carrying out substantially the same role as before.

Firms must, at appropriate intervals, determine each employee’s training needs and must organise training that is both appropriate and timely. The success of the training in achieving its objectives must be evaluated.

Employees must not be allowed to engage in carrying out any of the activities covered by these rules unless they have been assessed as competent in that activity. This means that the employer must be satisfied that the employee has:

An employee may only engage in such an activity before being assessed as competent if they act under appropriate supervision. In this case, the firm must ensure that the employee has:

Approved persons who carry out certain controlled functions are required to achieve a pass in an appropriate examination as demonstration of their competence. Lists of appropriate examinations for different functions are held by the Financial Services Skills Council (FSSC). The FSSC sets the standards for appropriate examinations: awarding bodies submit proposals for particular examinations; when these are accredited, they are added to the lists.

The ifs’ Certificate for Financial Advisers (CeFA^®) and the Certificate in Mortgage Advice and Practice (CeMAP^®) are examples of appropriate examinations for financial advisers and for mortgage advisers respectively.

As well as ensuring that employees become competent, firms must have definite arrangements in place for ensuring that they maintain that competence. Although there is no specified minimum for the time that should be spent on continuing professional development (CPD), employees should take steps to refresh and expand their knowledge and skills levels. Some practitioners suggest that around 50 hours per annum is appropriate.

Firms must maintain records showing how and when employees’ competence has been and is being assessed. All records relating to the training and competence of individual employees must be retained for at least three years after they leave the firm. For pensions transfer specialists, records must be kept indefinitely.

Typical records might include some, or all, of the following:

The FSA’s Conduct of Business Sourcebook covers a variety of aspects of business behaviour within the financial services industry, but one particular section of the Sourcebook is of special relevance to financial advisers: Part 5, which relates to advising and selling.

Part 5 covers the relationship between the adviser and the client, the independence (or not) of the adviser, the collecting of information, the requirement to give suitable advice and to describe clearly the nature of the products, the opportunity to withdraw from the contract and the question of the adviser’s remuneration.

These topics are dealt with in the next subsection.

There are three defined categories of customer, which can be broadly described as follows.

All advisers are required to have a written agreement with the client, which sets out the basis of their business relationship. In most cases this takes the form of a terms of business letter, issued separately or included as part of an initial disclosure document (IDD – see Section 1.7.5.2.3).

All new clients must be informed of the terms of business before any information is sought or advice given. If the business transaction results from an off-the-page advertisement, the terms of business can be sent with the first response.

A terms of business letter is not required if:

The terms of business will typically address the following key issues:

• the status of the adviser (see Section 1.7.5.2);
• the services offered by the adviser;
• the full name of the regulator;
• summary of the client’s responsibilities;
• details of complaints procedures;
• details of payment for the services provided;
• the firm’s authorisation in relation to the handling of clients’ money:
• the duty to disclose details of any ‘connected persons’ before transacting the client’s business with them;
• the locum arrangements to ensure continuity of service in the event of the adviser’s absence;
• whether or not professional indemnity insurance is held.

The agreement reflects the fact that the customer is placing an increased reliance on the adviser’s advice and service. Issues that it addresses may include:

It is a customer agreement with additional features. In particular it must specify the limits of discretion within which the adviser can operate in his capacity as investment manager.

One of the significant concepts introduced by the Financial Services Act 1986 was polarisation, which meant that all advisers had to be either independent or tied, and that they must make their status clear to clients before giving any advice.

By the end of the 1990s, however, it was becoming clear that the polarisation regime was no longer an ideal way of protecting the customer against the danger of commission bias ie the tendency of advisers to recommend those products that pay larger commissions.

In January 2002, the FSA issued a consultation paper (‘Reforming Polarisation – Making the Market Work for the Consumer’) that effectively signalled the end of polarisation by proposing that the status of advisers should simply be a matter of disclosure to the customer. A broader range of types of status as to be permitted, provided that customers are made aware of precisely what products are available, where they are being sourced from, exactly how the adviser will be remunerated and what the level of that remuneration might be.

The new regime, known as depolarisation, was fully operative from 1 June 2005, and is designed to make the process of buying financial products clearer. The two major innovations of the new system are:

Under the new rules, advisers are permitted to operate in one of three categories:

Advisers are obliged to specify to their clients, before any business is discussed, the category in which they operate.

Customers will receive two important disclosure documents that the FSA have branded as key facts documents. The first, Key facts about our services, is the initial disclosure document described in Section 1.7.5.2.3, and tells the customer about the type of advice offered and the range of products available. The second document, Key facts about the cost of our services is commonly known as the menu, and is described below.

Advisers who class themselves as independent will have to be a whole-of-market firm (ie offer advice across the whole market or a specified sector of the market) and will have to offer (but not necessarily insist on) a fee-based option. Whole-of-market firms are technically supposed to select products from the whole range of product providers; in practice, however, they are permitted to select from a panel of companies, provided that they can show that the panel is representative of the whole market.

Advisers who are tied to a particular product provider are, of course, still required to give advice as to what they believe is the most suitable type of product for the client, based on the client’s circumstances and needs. If the most suitable type of product is not one that is available from the provider to which they are tied, it is not permissible to recommend or sell the product from the provider’s range that is ‘next best’. If the provider does not offer a fully suitable product it is permissible, although not mandatory, to recommend that the client seeks independent advice to obtain a suitable product.

The menu document described above will be provided to customers alongside an initial disclosure document (IDD), which will set out the key facts about the firm and its services in a standard format. The information contained in this document will include:

Under ‘Know your customer’ rules, An adviser must not give advice to a client unless he has fully ascertained the client’s personal and financial circumstances relevant to the services that the adviser has agreed to provide.

This process is carried out by the completion of a confidential client information questionnaire, commonly known as a factfind. There is no prescribed format for this document. The information gathered normally includes the following details about the client, spouse, children and other dependants:

The ‘Know your customer’ rules specifically require advisers to take all reasonable steps to ensure that the client understands the nature of any risks implicit in the product proposed. Examples are whether or not the customer’s capital will be returned in full or whether or not the level of life cover is sustainable for the duration of the term without an increase in premiums. The extent of these requirements will depend on the client’s experience and knowledge of the type of product under consideration.

Advisers must also determine the customer’s risk profile: in other words, how much risk, if any, is the customer willing to take with his capital?

The information obtained through the factfind must be retained for a specified period of time, depending on the nature of the product recommended. These periods are:

In practice advisers will wish to retain the information in all cases for as long as they believe they may be required to justify the advice and recommendations given.

Advisers must recommend the product or service that is most suitable for the client, based on the information supplied by the client and on anything else about the client of which the adviser should reasonably be aware. The recommendation must be solely in the best interests of the client and no account should ever be taken of the commission that might be payable to the adviser.

A suitability letter explains why the particular product recommended is suitable for the client based on his particular personal and financial circumstances, his needs and priorities as identified through the fact-finding process and his attitude to risk (both in general terms and in relation to the specific recommendation made). It should be clear and concise and written in plain English, and must be signed by a person who is authorised to advise on the type of product recommended.

Suitability letters are required for:

A suitability letter should be provided as soon as possible after the transaction has been effected, and no later than the date when the cancellation notice is issued to the client (see Section 1.7.5.8).

Some transactions with some customers may be carried out on an execution-only basis, which means that, rather than wanting an adviser to make recommendations, the customer instructs him to effect a specific transaction on his behalf detailing in full the nature of the product required.

For an execution-only transaction, the adviser’s duty of care to fully explain the nature of the transaction and risks involved does not apply. The customer is acting entirely on his own responsibility.

Advisers who deal with this type of client are required to obtain the client’s signature confirming that the transaction is execution-only. Similarly, where a non-execution-only client wishes to effect a transaction that contravenes any advice given, the adviser will commonly require the client to sign to that effect.

It is expected that only a very small proportion of any adviser’s cases would be on an execution-only basis.

The rules specifically require that charges to clients must not be excessive. In determining what constitutes excessive charges, advisers should consider:

When an adviser transacts designated investment business for a client, the basis or amount of the charges must be disclosed in writing before the business is transacted. This is normally done in the terms of business letter.

Advisers who advise on or sell packaged products (eg life policies, pension policies, unit trusts and investment trusts) must provide clients with written details of the key features of a product before the sale is concluded. Although it is the adviser’s responsibility to provide the documents, the product providers usually prepare the papers. It is a requirement that key features documents should be of the same quality as the materials used for marketing purposes.

The format for supplying the information is specified by the FSA and cannot normally be changed. The rules on what must be included are very detailed but, as a broad guide, a key features document will cover the following issues:

Sometimes known as a cooling-off notice, the statutory cancellation notice reminds clients of their right to withdraw from the contract within a specified period of receiving the notice. This time period is most commonly 14 days and runs from the date on which the client received the cancellation notice. The notice must be sent by post direct from the product provider to the client.

The customer can withdraw from the contact at any time during the cooling-off period, without any commitment or loss, by returning the signed cancellation notice to the product provider.

Generally the customer will receive a full refund of any premiums paid if they cancel the contract during this period. The exception to this is where the customer cancels a lump-sum unit-linked investment where the money has been invested and the value of the investment has fallen. Under these circumstances, the customer is entitled to a refund of the reduced investment: no charges can be taken but an adjustment can be made to reflect the fact that the value of the lump sum has fallen. This risk should be explained to the customer before the contract is effected.

In 2001, the government asked Ron Sandler to:

The Sandler report suggested that there were three main reasons why the industry seemed to be failing to serve large portions of the population who have urgent and genuine financial needs. The government are particularly concerned about the so-called savings gap, ie the failure of many people to provide adequate funds for their retirement. The report mentioned:

A simplified selling model applies to these products, with the exception of the smoothed investment fund. The rules for this simplified selling process are included in a new chapter (5A) in the Conduct of Business Sourcebook, and can be summarised as follows.

The FSA took over the regulation of mortgage advice and sales with effect from 31 October 2004.

The FSA’s rules relate to loans taken out by individuals or trustees, which are subject to a first charge on the borrower’s property. This includes not only mortgages but also other loans where the security is a first charge on a residential property.

Second mortgages and other second-charge loans are not covered. The property must be in the UK and it must be residential to the extent that the borrower or their immediate family must occupy at least 40% of the property. This means that the new regime will cover home improvement loans, debt consolidation loans and equity-release schemes such as home income plans, but not normally buy-to-let mortgages.

The rules cover lending, administration, advice and the arranging of loans; banks, building societies, specialist lenders and mortgage intermediaries will need authorisation.

The sales process must distinguish between cases where advice is given and those where only information is given and a series of pre-determined questions is used as a ‘filter’ through which a client can narrow down the selection of mortgages. In the latter case, sales staff will have to ensure that they have not strayed into the area of giving advice.

Where advice is given, it must be based not only on a consideration of which mortgage best suits the client’s needs, but also on the affordability of the scheme for that client. This might include, for instance, recognising the impact of any possible increase in interest rates on a variable-rate mortgage. Determination of the suitability of a mortgage involves three stages:

There is no requirement to issue a suitability letter to the client but advisers may do so if they wish. It is important for advisers to keep their own record of why a recommendation made meets the FSA’s suitability requirements.

The FSA’s detailed rules for mortgage regulation are contained in the Mortgage Conduct of Business (MCOB) Rulebook. A brief summary of the contents of the MCOB rules is given below and a more detailed summary is included in an Appendix.

The MCOB rules specify that information about mortgages must be set out clearly and in a prescribed format to enable clients both to understand the terms of the mortgage and to compare it with other mortgages.

KFIs will also be issued if the client asks for a further advance or for the addition or removal of a party to the mortgage. For other variations to the mortgage (eg changing the term), certain specified items of key information must be given out but not necessarily in a standard KFI format.

For lifetime mortgages (the FSA’s new name for home income plans), there are additional elements in the sales process, designed to ensure that the client understands the nature of the product and the additional risks it entails. An adviser must consider, for example, whether taking out a lifetime mortgage will adversely affect a customer’s entitlement to means-tested benefits or to age-related personal allowances. The adviser must also check whether a customer has plans to leave his property to his family.

The MCOB rules also contain other elements designed to protect the client from unfair practices such as excessive charges and misleading advertising:

There are detailed rules for non-real time promotions (ie by letter, e-mail or in advertisements in the press, on the Internet or on television or radio). They must be clear, fair and not misleading. If they include comparisons with competitors, they must show a realistic like-for-like comparison and must not create confusion or denigrate the competitor.

Mortgage advisers must meet the FSA’s normal training and competence requirements (see Section 1.7.4). These are found in the Training and Competence Sourcebook rather than the MCOB rules, but they apply equally to mortgage advisers. Firms must ensure that their employees are competent for the work they do and that they remain so.

Advisers who met the training and competence requirements of the previous voluntary regulatory regime (under the Mortgage Code Compliance Board) are permitted to continue advising on standard mortgages under the new FSA rules.

For advisers dealing with lifetime mortgages, however, there are additional training and competence requirements.

In relation to complaints and compensation, mortgage advisers, arrangers and lenders now come under the scope of the Financial Ombudsman Service (see Section 3.2) and the Financial Services Compensation Scheme (see Section 3.3).

With effect from January 2005, the FSA assumed responsibility for regulating activities relating to general insurance and other protection products. This move was prompted in part by the need to implement the terms of the EU Directive on Insurance Mediation, which was designed to open and standardise the market for insurance intermediaries across the European Union. The new FSA regulatory regime does, however, apply to product providers (insurance companies) as well as intermediaries.

The new regime is similar to the existing regulation of long-term insurance contracts (ie life policies). Firms and individuals working in the areas of general insurance, protection, critical illness, long-term care and permanent health insurance have to be authorised through the same processes of permission and approval as apply to the rest of the industry.

Rules applicable to intermediaries who sell, administer or advise on general insurance are contained in a new FSA rulebook known as the Insurance Conduct of Business (ICOB) Sourcebook. The ICOB rules are split into a number of sections, the contents of which are summarised below.

Advertisements must be clear, fair and not misleading. This means, among other things, that expressions of opinion should be fair representations, and it should be clear if the person quoted has a connection with the firm. It should be made clear if price quotations are estimates only and not precise figures, and any mention of reduced premiums should make it clear in what circumstances the reduction is available and what limitations are involved.

A policy summary must be given to all customers. It must include the ‘Keyfacts’ logo, the main features of the policy, and any significant exclusions or limitations.

If a customer cancels, the insurance company must return any sums paid to it within 30 days of cancellation. For general insurance contracts, the company can deduct any reasonable and genuinely incurred costs, including a charge for time on risk, but the company must not make a profit and the amount retained must not be capable of being interpreted as a penalty.

If the intermediary acts on behalf of the insurance company in handling a claim on their behalf, the insurance company is responsible for ensuring that the rules are complied with. If the intermediary were to act on behalf of both the insurance company and the customer for whom he arranged the policy, that would be construed as a conflict of interest. In the event of a conflict of interest, it is necessary for the intermediary to tell the customer and ask for their consent to continue acting for them. If this is not possible, or the consent is not given, then the intermediary must withdraw from acting for one of the parties.

Few people today hold their financial wealth in cash. While we still sometimes read of people with large quantities of notes and coins stored in their homes, this is increasingly rare. At the very least they generally keep their money mainly in bank and building society accounts. Many people have wealth stored in the form of property, such as houses or works of art.

When people have more money than they need to spend immediately, they lend to invest it with a view to making a profit, thus becoming part of the chain of intermediation described in Section 1.1.1.

Section 2 looks at a range of what might be described as direct investments, as distinct from indirect investments in financial assets (eg collective investments such as unit trusts), which are covered in Section 3.

Section 2 covers part 2 of the syllabus for Unit 1. The assets covered in Section 2 are deposit-type investments, fixed-interest securities such as gilts and corporate bonds, shares (and other forms of corporate financing) and property. We describe the nature of each type of asset, with its features and benefits, its advantages and drawbacks, and how it is affected by taxation of income and capital gains.

Deposit-based investments are those in which the capital element is fixed but the income from the investment may vary.

Investors place money in deposit-based savings accounts for a number of reasons. Some consider their capital to be secure. In one respect this is true, ie the amount of capital invested remains intact, but inflation reduces the value of capital and, in times of high inflation, the value of their deposits can quickly be eroded in real terms.

There is also the risk of loss of capital if the institution becomes insolvent. This is rare with banks and building societies, but is not unknown. In the event of insolvency, investors may be able to reclaim some of their funds through the Financial Services Compensation Scheme.

The convenience of the ready accessibility of banks and building societies is a strong reason for investors to deposit money with them; it is believed that, to some extent, inertia inhibits an investor’s search for a more rewarding home for their deposits.

If the reason for saving or investing money is for a short-term purpose (next year’s holiday or a new car, perhaps) then few would argue that a deposit-based savings account is a sensible place in which to invest the money. It is prudent to have a part of an investment portfolio that is easily accessible in, for example, a no-notice deposit account; this is often referred to as money put by for a ‘rainy day’. Institutional investors maintain a part of each of their funds in readily accessible form.

In general, banks offer three types of interest-bearing account:

These are among the most straightforward types of account that banks offer. Depositors (whether individuals or corporate bodies) can invest from as little as £1 with no maximum, and receive a return on their investment in the form of interest.

Interest is normally variable and is usually linked to the bank’s base lending rate. It is calculated daily and added to the account on a periodic basis (ie quarterly, half-yearly or yearly).

Some deposit accounts offer higher interest rates provided that a certain minimum investment is made. Deposits can be subject to notice of withdrawal, with the typical notice period being seven days. Often the requirement for notice will be waived subject to a penalty, which is normally equal to the amount of interest that could be earned over the notice period.

Deposit accounts may be considered as an investment of funds kept for an emergency or otherwise in case of need. Over the longer term, however, they have proved to be unattractive when compared with asset-backed investments.

These accounts usually attract a higher rate of interest than ordinary deposit accounts. The rate of interest reflects current money-market interest rates and may vary according to the amount invested. There are two basic types of money-market account: fixed accounts and notice accounts.

Money-market deposit accounts may be suitable for individuals with very large amounts of cash to place on short-term deposit until they commit the cash to other purposes.

Interest-bearing current accounts provide an investor with immediate access to his funds without loss of interest. These accounts provide a range of services such as a cheque book and guarantee card, cashpoint facilities and overdrafts.

Interest-bearing current accounts for the mass market are a relatively recent phenomenon and have developed as a result of increased competition between the banks and building societies. Interest rates on current accounts are generally very low although higher rates may be available on accounts processed through telephone call centres or the Internet.

Many banks have for several years, offered high-interest cheque accounts. As the name implies, higher rates of interest are available with these accounts that, as a consequence, have higher minimum levels of investment, typically from £1,000 to £10,000. These accounts are normally free of charges subject to the minimum balance being maintained. Some accounts, however, allow only a limited number of cheques to be drawn in a given period without charge.

Interest paid on bank deposit accounts has tax deducted at a rate of 20%. If the gross interest rate is, for example 4%, the actual net rate received is 3.2%. Lower and basic rate taxpayers have no further liability. Higher rate taxpayers will be liable for an additional 20%.

Interest can be paid gross if the depositor declares that he is a non-taxpayer by completing form R85. Alternatively, non-taxpayers can reclaim any tax deducted and 10% taxpayers can reclaim the additional 10%.

Building society accounts have long been the home for investors’ surplus funds. They have offered competitive rates of interest in various types of account such as ordinary share accounts, high-interest-bearing accounts and term accounts. The main difference between a bank and a building society is in their legal structure. Building societies are mutual organisations and are owned by their members (investors with share accounts and borrowers), whereas banks are limited companies owned by their shareholders.

Tiered interest rates are often available on building society accounts. Basically, the larger the investment, the higher the rate paid, but should the investment level fall into a lower tier, the interest rate will be reduced.

In addition, building societies may offer monthly income facilities on all their accounts. For this facility, it is a usual requirement to have a higher minimum level of investment.

Building societies, along with banks, provide the appropriate investment for those investors who have short-term investment needs but also require immediate access to their funds.

Currently, all building society deposit accounts subject to tax are taxed the same way as bank deposit accounts (see Section 2.1.1.4).

The term ‘offshore’ is usually applied to any investment medium, whether bank or building society account or other form of investment, which is based outside the UK in countries that offer a more advantageous taxation of investments. Such countries, sometimes referred to as tax havens, include the Channel Islands, Luxembourg and the Cayman Islands.

Offshore investment can potentially expose the investor to greater risk than a similar onshore investment. Firstly, the account may not be denominated in sterling and will therefore be at risk of adverse currency movements if the investment is to be converted back to sterling at some point. Secondly, not all offshore accounts are protected by investor protection schemes. Investors should check what protection is available through local regulatory regimes.

Offshore investments may be useful to an investor who needs money to be available outside the UK, eg someone who owns a property abroad or who plans to move abroad in the future.

The interest on an offshore deposit will be paid gross. A UK resident must declare the income to HM Revenue and Customs. A person who is UK resident when they invest their money can avoid paying tax on their overseas investments if they let the returns roll up and withdraw the money at a point in the future when they have become non-resident. An example of this might be someone who retires and goes to live abroad.

There are specific rules governing whether or not an individual is resident or non-resident as far as his liability to UK taxation is concerned (see Section 1.3.3.1). Care should be taken to determine an investor’s residential status.

One form of ISA is the cash ISA: it is basically a means of obtaining tax-free interest on a bank or building society deposit account, subject to certain limits and regulations. National Savings and Investments also offer a cash ISA.

The maximum investment in a cash ISA is currently £3,000 per tax year. For further details, see Section 3.2.4.

There are NS&I products to suit most types of investors, with different terms, interest rates and taxation. Full details of the range of deposit-based savings and investments offered can be obtained from the Post Office or by visiting the National Savings and Investments website at www.nsandi.co.uk.

A brief summary of the main products is included below.

This is a ‘card and PIN’ based account. It has a tiered interest-rate structure and interest is paid gross but is taxable. It is available to anyone aged 11 or over, subject to a minimum balance of £100.

This account may be opened by anyone over the age of seven and, for those under this age, a parent or legal guardian may open the account.

The account pays a variable rate of interest at rates that are tiered in seven levels, from under £500 to £50,000 and beyond. The interest is paid gross but is liable to income tax.

Income bonds offer regular monthly income. The income bond has no term and capital can be withdrawn at any time, but subject to three months’ notice or loss of interest in lieu.

The interest rates are variable and are tiered according to the amount of money invested. Interest is paid gross but is liable to income tax and must be declared.

This is a lump-sum investment on which the interest rate is guaranteed for one, two or five years at a time. The bonds offer a monthly income that is paid gross but which is liable to tax. They are available to men and women over the age of 60.

The capital bond is a lump-sum investment with a five-year term.

Interest is added to the capital at rates guaranteed at the time of the initial investment. The interest rates increase over the five years so, in order to obtain the maximum guaranteed rate, it is necessary to hold the bond for the full five years.

Interest is paid gross but is taxable and should be declared each year on the investor’s tax return. The investor is liable for income tax on the interest each during those years that the bond is not cashed in.

These bonds carry a fixed rate of interest over a choice of terms: currently one, three or five years.

The interest rate is guaranteed for the term chosen at the outset and will then be reset at the end of the term; the investor can choose whether to withdraw their money or leave it invested for a further term. Interest is paid net of basic rate tax at 20%. Higher rate taxpayers will have to pay an additional 20% tax.

Savings certificates are of two main types: fixed-interest and index-linked. The fixed-interest certificates pay a fixed rate of interest throughout the chosen term of two years or five years. The index-linked certificates (currently available in three-year and five-year terms) differ in that their value increases with inflation as well as offering interest.

The certificates are available for investments of between £100 and £15,000.

Premium bonds provide investors with a regular draw for tax-free prizes, while they retain the right to cash in the bond.

The minimum purchase price is £100 and the maximum is £30,000 per person. Prizes are drawn each month and can be worth up to £1 million. Winnings from premium bonds are tax-free.

The bonds can be encashed at any time, subject to eight working days’ notice.

The children’s bonus bond is a single premium investment intended to be retained for at least five years. Anyone over 16 may purchase a bond for anyone under 16. The bond should be encashed no later than the child’s 21st birthday because no interest is payable after that age.

The interest rate is fixed for the first five years and a bonus is added on the fifth anniversary. A final bonus is added on the child’s 21st birthday.

Gilt-edged securities (commonly known as gilts) are British government securities and represent borrowing by the government. Gilts are safe investments because the government will not default on interest or capital repayments.

A gilt is categorised primarily according to the length of time left to run until its redemption. The redemption date is the date on which the government must buy back the gilt at its original issue value or par value, normally quoted as a nominal £100. Each gilt pays interest on the par value at a fixed interest rate known as the coupon.

Most gilts have a specific redemption date; some have two dates between which there will be redemption on a date selected by the government, at its discretion.

The categories are as follows:

Index-linked gilts are gilts where the interest payments and the capital value move in line with inflation. The redemption value and the interest paid are therefore index-linked. For the investor this means that the purchasing power of his capital and interest received will remain constant, unlike all other fixed-interest stock where inflation erodes the purchasing power of fixed-interest payments.

A gilt-edged stock with a coupon of 5% and a redemption date in 2021 might be designated as ‘Treasury 5% 2021’.

Interest on gilts is normally paid half-yearly, so the holder of £10,000 nominal of Treasury 5% 2021 would receive £250 in interest every six months. The interest is paid gross, but is subject to income tax at the investor’s highest rate.

Gilts cannot be redeemed by investors prior to the redemption date but can be sold to other investors. The price at which they are sold depends on a number of factors: the level of market rates of interest; nearness to the redemption date; supply and demand.

Gilt prices are quoted either cum dividend or ex dividend. If a stock is bought cum dividend, the buyer acquires the stock itself and the entitlement to the next interest payment. If, however, the stock is bought ex dividend, then while the buyer acquires the stock itself, the forthcoming interest payment will be payable to the previous owner of the stock (ie the seller).

Any capital gains made on the sale of gilts are entirely free of capital gains tax (CGT).

Like the government, local authorities can borrow money by issuing stocks or bonds, which are fixed-term, fixed-interest securities. They are secured on local authority assets and offer a guaranteed rate of interest, paid half-yearly. The interest is paid net of the basic rate of income tax (20%). Higher rate taxpayers are liable for a further 20% tax and non-taxpayers can reclaim any tax paid. The bonds are not negotiable and have a fixed return at maturity.

Return of capital on maturity is guaranteed but these are not quite as secure as gilts since there is no government guarantee.

Interest is paid net of 20% tax. Basic and lower rate taxpayers have no further liability; higher rate taxpayers are liable for an additional 20%; non-taxpayers can reclaim.

PIBS are irredeemable and are bought and sold on the Stock Exchange. It is possible for investors to make capital gains and losses and there is no certainty that investors will get all their capital back. There is no capital gains tax payable on any gains made.

Investors should also note that PIBS rank below ordinary accounts in priority of payment, should a society become insolvent.

They are considered higher risk than gilts because they do not have government backing, and they therefore tend to offer higher yields.

When companies need to raise money in order to commence or to expand their business, there are various ways in which this can be done. Section 2.2.4 above introduced corporate bonds, which are one way of borrowing money for a fixed period at a fixed rate of interest. Other types of loan, either secured or unsecured, can also be used and the most common way for companies to be funded is through the issue of shares. These methods of company financing are described in the following sections.

Holders of ordinary shares (shareholders) are in effect the owners of the company. The two main rights that they have are:

The rights attaching to shares of the same class can sometimes differ from company to company, even though the shares normally have the same major characteristics. It is therefore prudent for investors to find out precisely what rights attach to a particular share. These rights are given in the company’s Articles of Association, which is a public document and can be examined at the registered office of the company or at Companies House.

Direct investment in shares is considered to be high risk because the failure of the company can result in the loss of all the capital invested. This risk can be mitigated by investing across a range of shares and the products available to facilitate this (such as unit trusts and investment trusts) are described in Section 3.2.

In the short term, share prices can fluctuate both up and down – sometimes quite spectacularly – but in the long term, investment in equities and equity-linked markets has outpaced inflation and has provided higher growth than deposit-type investments.

The Stock Exchange has been London’s market for stocks and shares for hundreds of years. Government stock, share capital and loan capital, overseas shares and options are all traded on this market.

There are two markets for shares: the main market (for which full listing is required) and the Alternative Investment Market.

The main market allows companies to be quoted on the Exchange if they conform to the stringent requirements of the Listing Rules laid down by the FSA, acting in its capacity as the UK Listing Authority (UKLA).

For a full listing (ie a listing of the main market), a considerable amount of financial and other information is required to be disclosed accurately. In addition:

The Alternative Investment Market, which started in 1995, is an additional, separate market on the London Stock Exchange. It is mainly intended for new, small companies with the potential for growth.

Its purpose is to enable suitable companies to raise capital by issuing shares and it allows those shares to be traded. In addition to the benefit of access to public finance, companies will enjoy a wider public audience and enhance their profiles by joining the AIM.

Rules for joining the AIM are fewer and less rigorous than those necessary to join the official list (the main market) and were designed with smaller companies in mind.

Shareholders in a limited liability company do not have a liability for the debts of the company. The company has a separate legal identity and is itself liable for its debts. Shareholders do, however, run the risk that the value of their investment in the company could go down or even, in the event of a liquidation, be lost altogether. In line with the broad rules of risk and return, therefore, it might be expected that the potential for high returns would also be a feature of the share market. It is certainly true that, on average and over the longer term, equity markets have far outpaced the returns available on secure deposit-based investments.

The financial returns that shareholders hope to receive from their shares are of two forms: the growth in the share price (capital growth) and the dividends they receive as their share of the company’s distributable profits (income). There are a number of measures that can be used to assess the success of investment in a company’s shares and to predict future performance. Some of these measures are as follows.

Dividends are received by shareholders net of 10%, with a tax credit equal to the amount deducted. Non-taxpayers cannot reclaim this deduction; lower rate and basic rate taxpayers have no further liability, but higher rate taxpayers have to pay sufficient additional tax to bring their tax paid up to the special higher rate applicable to dividends (32.5% of the grossed-up dividend).

This extraordinary system was introduced to smooth out the effect of the abolition of advance corporation tax (ACT) from 6 April 1999.

Gains realised on the sale of shares are subject to capital gains tax (CGT), although investors may be able to offset the gain against their annual CGT exemption allowance.

Dividends are usually paid half-yearly. Because of the administration involved in ensuring that all shareholders receive their dividends on time, the payment process has to begin some weeks before the dividend dates. A ‘snapshot’ of the list of shareholders is made at that point, and anyone who purchases shares between then and the dividend date will not receive the next dividend (which will be paid to the previous owner of the shares). During that period, the shares are said to be ex-dividend (or xd). The share price would normally be expected to fall by approximately the dividend amount on the day it becomes xd.

The Stock Exchange Daily Official List gives the closing prices of all listed securities on the previous day. The Financial Times produces daily lists of the share prices of most companies, making it easy to check up-to-date share prices.

It is possible to measure the overall performance of shares by using one or more of the various indices that are produced. These include, among others:

In the event of winding up a company, preference shares rank behind loans but ahead of ordinary shareholders' claims.

As well as issuing shares, companies can seek loans for use in their business. They can borrow from banks or other lenders. They can also issue what are known as loan stocks and debentures. These types of borrowing are usually over the longer term, which helps the company to make long-term business plans. Loan stocks and debentures are issued on specified terms, including the rate of interest payable by the issuing company (and when that interest is payable) and the redemption date. They are usually issued at a fixed rate of interest.

Loan stocks and debentures are essentially the same, that is, borrowings by the company on certain terms, but, as is the case with shares, it is important to ascertain the precise rights and obligations of a particular borrowing. Broadly speaking, loans that are secured in some way – perhaps on the company’s property – are normally referred to as debentures, while those that are not are simply called loan stocks.

Some loan stocks are issued that give the holder the right to convert the loan into ordinary shares of the issuing company. There is no obligation to do so and if the option is not exercised the loan continues unchanged.

Interest rather than dividends is payable on both types of debt and normally should be payable whether or not sufficient profit has been made by the company. The holders of these types of debt are creditors of the issuing company and so, in a winding-up, take priority over the shareholders. On the other hand, the loan stock and debenture holders do not have the right to vote at company meetings.

The interest on stock is paid net of 20% tax. Basic and lower rate taxpayers have no further liability; higher rate taxpayers are liable for a further 20%; and non-taxpayers can reclaim.

The risk inherent in these types of debt is related to the viability of the issuing company, its prospects and strength. Loan stocks have a greater level of risk than debentures because they do not have the backing of security.

In broad terms, investment in property falls into three categories:

The vast majority of investors will only ever be involved in residential property. For most people this does not extend beyond the purchase of their own home, although an increasing number of people are buying residential properties specifically as an investment.

Property investment has a number of benefits and advantages, including:

On the other hand, there are a number of pitfalls and disadvantages of which inexperienced investors in particular should be made aware, including:

As with direct investment in shares, direct investment in property can be a risky business for the small investor, although the advent of buy-to-let mortgages (see Section 2.4.2 below) has made it easier. For smaller amounts of capital and for those who wish to spread the risk, there are property bonds where the underlying fund is invested in a range of properties and shares in property companies.

Despite some dramatic falls from time to time, the overall trend in UK house prices over the last 30 years has been strongly upwards. The early 2000s saw dramatic rises in the price of property in the UK. One unfortunate consequence of this is that young people and other first-time buyers now find it difficult to afford to purchase a property, especially in the South-East of England, which has seen significant increases. In times of economic downturn, this effect is worsened by an uncertain job market that makes it difficult for people to commit to large mortgages.

The situation can be eased if there is a reasonable supply of good quality properties to rent but, traditionally, the UK has had a shortage of private rental property – much less than in most other European countries, for instance. There are a number of reasons for this, not least of which are:

Buy-to-let is an initiative designed to stimulate growth in the private sector of the rental market. The aim is to encourage private investors to borrow at competitive interest rates with a view to investing in rental property that should give them a reasonable expectation of sustained income and capital growth. Lenders involved in this scheme will now take potential rental income into account and will charge interest rates broadly in line with those for owner-occupation mortgages.

The scheme is the result of a joint initiative by the Association of Residential Letting Agents (ARLA) and mortgage lenders. Alliance and Leicester, Halifax and NatWest were instrumental in the early stages, although many more banks and building societies now offer buy-to-let mortgages.

This change in policy results from the knowledge that a buy-to-let scheme will be professionally managed. For many schemes, it is a requirement that an agent who is a member of ARLA should be involved in:

Gross rents for buy-to-let properties are typically 150% of the monthly mortgage payments. There are of course other costs, such as agents' commission/fees, insurance and maintenance costs.

Rental income is subject to income tax but the cost of insurance, agents’ fees, maintenance etc, can be offset as a deduction against tax. The initial cost of furniture, fixtures and fittings cannot be deducted, but a wear and tear allowance of 10% per year may be allowed.

Investment in commercial property covers almost anything that is not defined as wholly ‘residential’. This includes:

Commercial property tends to provide reasonably high rental income together with, in general, steady growth in capital value.

The main advantages are:

Drawbacks may include the following:

Lenders often carry out detailed investigations before lending for the purchase of commercial property, checking on:

One of the FSA’s statutory objectives (see Section 1.2) is to ‘secure an appropriate level of protection’ for consumers of financial services and products. One step towards the achievement of this objective has been the FSA’s attempt to make it easier for customers to know how to complain when they feel that they have been badly treated by a financial institution or by an individual working in the industry. Customers who are not satisfied with a firm’s response to their complaint can refer the matter to a dedicated independent ombudsman bureau. In some circumstances, customers who have lost money can receive compensation.

Section 3 deals with the practical aspects of these consumer rights, as specified in part U5 of the syllabus, with particular reference to complaints procedures, arbitration schemes (ombudsmen), and compensation arrangements.

The Financial Services and Markets Act 2000, consolidating and enhancing the arrangements under the previous regulatory regime, introduced new rules on complaint-handling arrangements. The rules require firms to deal properly and promptly with consumer complaints. The key requirements for firms' complaints procedures are that firms must:

Complaints may be received orally (in person or by telephone) or in writing. In either case, the complaint should be acknowledged in writing within five working days. Complaints covered by the FSA rules are those that are received from eligible complainants, which means:

It is also necessary to distinguish between soft and hard complaints. Hard complaints are those involving ‘an allegation that the complainant has suffered financial loss, material distress or material inconvenience’. Soft complaints are any other complaints and are, for the most part, subject to the same rules as hard complaints – the only differences are that they are not subject to the usual deadlines and they do not have to be reported to the FSA.

All complaints must be promptly and thoroughly investigated by a person of sufficient competence who, wherever possible, was not directly involved in the matter under complaint. The overall aim should be to ensure that any specific problem identified by the complainant is remedied.

The firm’s response to the complainant is in the form of a final response letter, which must ‘adequately address the subject matter of the complaint’. It must also inform the complainant that if he is not satisfied, he can refer his complaint to the Financial Ombudsman Service within six months of the date of the letter.

If the final response letter cannot be issued within four weeks of receiving the complaint, an interim letter must be sent explaining the cause of the delay. If after eight weeks, a final response still cannot be given, a further letter must be sent, this time also telling the client that he can refer the matter to the Financial Ombudsman Service if he is dissatisfied with the delay.

Records of hard complaints have to be retained for at least three years.

Six-monthly reports about the progress of hard complaints are required, showing how many were satisfactorily concluded within four weeks, between four and eight weeks, and after more than eight weeks.

The FSMA 2000 provides for a mechanism under which ‘certain disputes may be resolved quickly and with the minimum of formality by an independent person’. The concept of an ombudsman, as a person or organisation providing an independent facility for the resolution of complaints and disputes relating to public bodies and commercial organisations, has been with us for many years. Indeed, in the past, a number of separate ombudsman bureaux have operated in the financial services marketplace, each of them dealing with problems arising in a particular sector. These included the Banking Ombudsman, the Building Societies Ombudsman and many more relating to insurance, investment, pensions and other areas.

The FSA recognised that such a fragmented system was neither helpful nor efficient, and the framework for an integrated body, the Financial Ombudsman Service (FOS), was established by the FSMA 2000.

The FOS took over from the existing financial services ombudsman schemes in December 2001, with the aim of being a single organisation with a consistent set of rules that would deal with complaints and disputes arising from almost any aspect of financial services. Note that the rules mentioned here are rules about dealing with complaints – the FOS stresses that it does not make the rules under which firms are authorised, nor can it give advice about financial matters or debt problems.

Although now a single organisation, the FOS does acknowledge that different types of problems may arise from different areas, so it has established three different divisions within the service:

The FOS has not, however, taken over the responsibilities of the Pensions Ombudsman, which deals with complaints about occupational pension schemes (see Section 3.4).

The Financial Ombudsman Service is free to customers and is open to all private individuals and small businesses. It is funded by the firms who are members of the FOS and membership is compulsory for all firms authorised under the FSMA 2000.

Complainants must first complain to the firm itself; the FOS will become involved only when a firm's internal complaints procedures have been exhausted without the customer obtaining satisfaction. Complaints to the FOS must be made within six years of the event that gives rise to the complaint, or within three years of the time when the complainant should have become aware that he had cause for complaint, whichever is the later. The FOS will not usually consider any complaint that is the subject of a court case.

The FOS can make awards of up to £100,000, plus the complainant’s reasonable costs, which are binding on the firm but not on the complainant, who is free to pursue the matter further in the courts if he wishes. The award is not intended to punish the firm, but to put the complainant back into the same financial position in which he would have been had the event complained about not taken place.

Compensation arrangements for customers who have lost money through the insolvency of an authorised firm have been co-ordinated under a single scheme with effect from December 2001. The Financial Services Compensation Scheme is made up of a number of sub-schemes relating to different default situations, as follows:

Claims cannot be made against the Financial Services Compensation Scheme for other losses, ie losses due to negligence, poor advice or simply due to a fall in stock market values. In some cases, however, the customer may be able to sue for compensation through the civil courts.

The Pensions Ombudsman was created by the Social Security Act 1990 to deal with complaints relating to occupational pension schemes and certain aspects of personal pension schemes. The Secretary of State for Work and Pensions appoints the Ombudsman.

The Pensions Ombudsman can decide about complaints and disputes relating to the running of pension schemes. He does not deal with complaints about the sales and marketing of pension schemes – these are the province of the Financial Ombudsman Service (see Section 3.2) – or with complaints about state pensions.

Complaints are related to cases of maladministration, and it must be shown that this has led to injustice (financial loss, distress, delay or inconvenience). Disputes are disagreements about facts or about law.

Complaints and disputes can be made by a wide range of people: individuals, managers, trustees or employers. They are commonly made by:

Complaints or disputes should first be addressed to the pension scheme’s managers or trustees. If this does not result in agreement, the next point of reference should be to the Office of the Pensions Advisory Service (OPAS), who try to resolve the dispute through conciliation and mediation. OPAS decisions are not legally binding and cases that cannot be agreed are normally then referred to the Pension Ombudsman.

Complaints and disputes must be communicated to the Ombudsman in writing within three years of the event being complained about. Any time spent trying to resolve the matter using the scheme’s internal complaints procedures, or through OPAS, is normally excluded from this time period.

The Ombudsman’s decision is binding on all parties and can be enforced in the courts.

This section covers part U6 of the syllabus for Unit 2, incorporating details of how the Data Protection Act 1998 affects the provision of financial advice and the general conduct of financial firms.

The Data Protection Act 1998 replaced an earlier Act (the Data Protection Act 1984) when it became necessary for UK law in this area to comply with an EU data protection directive issued in 1995. The 1998 Act is much wider in its scope than the earlier Act: in particular, it extends the regulations to cover not only computerised data (as in the 1984 Act) but also ‘any structured set of personal data’. It can therefore include data held in manual filing systems.

The purpose of the legislation is, broadly speaking, to give private individuals control over the use of personal data about themselves held by commercial (and other) organisations. It does so by establishing a series of data protection principles, together with enforcement processes.

The basis of the Data Protection Act is a set of eight data protection principles. These are described below; they all relate to the processing of personal data (as defined in Section 4.1.1).

The Information Commissioner oversees the application of the Data Protection Act. The Commissioner’s responsibilities are:

The Commissioner can issue one of two types of notice to a data controller if he believes that there has been an infringement of the terms of the Act:

The enforcement powers of the Information Commissioner include the power to prosecute a data controller who fails to comply with an information notice or enforcement notice. This is a criminal offence and there are two further criminal offences under the Act:

The maximum penalty for these offences is £5,000, unless the case goes to the Crown Court, in which case there is no limit on the possible fine.

In addition to the legislation already described, the interests of financial services customers are safeguarded by aspects of a range of other laws and regulations. Some of these relate closely to financial services, while others are aimed more broadly at the rights of consumers in general.

Section 5 covers part K2 of the Syllabus for Unit 2, showing how a range of non-tax laws and regulatory schemes affect different aspects of financial services including consumer credit, pensions, and advertising.

The purpose of the Consumer Credit Act 1974 is to regulate, supervise and control certain types of lending to individuals, and to provide borrowers with protection from unscrupulous lenders. The provisions of the Act are regulated by the Office of Fair Trading (not the FSA).

There are many types of lender in the market for financial services, ranging from large multinational banks to individual moneylenders. The Act sets out standards by which all lenders must conduct their business. It includes a number of safeguards under which potential borrowers must be made aware of the nature and conditions of a loan, and of their rights and their obligations.

The Act affects most aspects of a bank’s lending activities, including personal loans and revolving credit such as credit cards. Not all loans are covered by the Act:

The main elements of the Act's provisions are:

One of the Act's most significant innovations was a system for comparing the price of lending. This is the annual percentage rate (APR), which must be quoted for all regulated loans. The APR represents a measure of the total cost of borrowing and its aim is to allow a fair comparison, between different lenders, of the overall cost of borrowing.

The calculation of APR is specified under the terms of the Consumer Credit Act 1974 and it takes account of two main factors:

The result is that the APR is higher than the actual rate being charged on the loan.

The government has previously recently carried out a three-year review of consumer credit law, which led to the decision to reform the Consumer Credit Act 1974 in order to better protect consumers and to create a fairer and more competitive credit market. It aims to make improvements in three broad areas, described by the Department of Trade and Industry as follows:

This reform is being implemented through primary and secondary legislation. The primary legislation is in the form the Consumer Credit Act 2006. The date for this Act to be implemented has yet to be appointed. Prior to this, however, a number of pieces of secondary legislation came into force.

The Supply of Goods and Services Act 1982 applies to all contracts (except those entered into before 1995) involving the supply of services, including those for the supply of financial services. Its terms mean that, in the absence of anything specific, the following provisions are automatically deemed to be included in all such contracts:

The Unfair Terms in Consumer Contacts Regulations 1999 apply to any term in a contract between a supplier of goods and services and a consumer, where the supplier is acting on the behalf of their business and the contract has not been negotiated on an individual basis. The Office of Fair Trading is responsible for considering any complaint brought about because of the regulations.

A contract that has been drafted in advance and which does not offer the consumer an opportunity to influence the terms of the contract is regarded as one that has not been individually negotiated and will therefore fall under the terms of the regulations. Contracts for the sale of land, tenancy agreements and mortgages can fall under the remit of the regulations where the supplier is not an individual and is acting in the course of business: a person selling his own home would be excluded from the regulations but the legistlation would cover a builder selling new houses.

The main areas covered by the regulations are as follows.

The main requirements are that all terms in regulated contracts should:

The written terms of a contract should be expressed in clear, easily understood language. If there is any doubt about the meaning of a written term, then the interpretation most favourable to the customer will be adopted.

A term that causes a significant imbalance between the rights and obligations of the various parties to the contract to the detriment of the consumer will be deemed to be in breach of good faith.

It should be noted that any part of a contract that defines the main subject matter of the contract does not fall under the regulations, as long as it meets the plain language requirement. So, for instance, in the case of house purchase, the regulations cannot be used to determine whether the price being charged for a property is fair.

Examples of unfair terms might be:

If an element of a contract is found to be unfair, the whole contract is not necessarily invalidated. The contract may be allowed to continue if it is can do so without the unfair term. The term that is deemed to be unfair will not be binding on the consumer.

The regulation of occupational pension schemes remains quite separate from the regulation of other financial services, separate even from the regulation of private pension arrangements such as personal pensions and stakeholder pensions. Nevertheless, financial advisers should clearly have a good knowledge of matters relating to occupational schemes, in order to be able to advise, for instance, individuals who are members of such schemes or employers who may be considering establishing a scheme.

The Pensions Act 1995 introduced changes to several aspects of pension provision and supervision, not least of which related to concern about the security of occupational pensions. Public confidence in occupational pension scheme security had been severely dented by the Maxwell affair, where pensioners' funds were used to meet the companies' general obligations. The government sought to restore confidence with measures designed to prevent fraud and to improve the administration of occupational schemes.

The later Pensions Act 2004 was, in part, a response to the worsening pensions crisis in the UK. Two particularly important elements of the 2004 Act are the establishment of the Pension Protection Fund (see Section 5.3.1.2) and the transfer of regulatory responsibility for occupational pension schemes from the Occupational Pensions Regulatory Authority (OPRA) to the newly created Pensions Regulator.

The Pensions Regulator has wider powers than its predecessor and will take a proactive and risk-focused approach to regulation. Its mission statement is that it will work ‘to improve confidence in work-based pensions by protecting the benefits of scheme members and encouraging high standards and good practice in running pension schemes’.

Like the FSA, the Pensions Regulator has a set of statutory objectives:

The Pensions Regulator aims to identify and prevent potential problems rather than to deal with problems that have arisen. It will do so by assessing the risks that may prevent it from meeting its statutory objectives. These risks might include inadequate funding, inaccurate record-keeping, lack of knowledge or understanding by the trustees, or even dishonesty or fraud. The Pensions Regulator will consider the combined effect of two factors related to each risk: the likelihood of the event occurring and the impact of the event on the scheme and its members. Schemes that are judged to have a higher risk profile will be more closely monitored than those with lower risk. This is similar to the principles and process adopted by the FSA.

The Regulator has a range of powers that enable it to protect the security of members’ benefits.

The Regulator’s powers fall broadly into three categories:

The Pensions Act 2004 requires the Pensions Regulator to issue voluntary codes of practice on a range of subjects. The codes provide practical guidelines for trustees, employers, administrators and others on complying with pensions legislation, and set out the expected standards of conduct.

The Act also introduces new requirements for trustees to have a sufficient knowledge and understanding of pension and trust law, and of scheme funding and investment. Trustees also must be familiar with the trust deed and other important documents such as the scheme rules and the statement of investment principles. These requirements came into force in April 2006.

The Pensions Act 2004 established the Pension Protection Fund (PPF) to protect members of private sector final salary (defined-benefit) pension schemes whose firms become insolvent with insufficient funds to maintain full benefits for all the members.

In addition to this responsibility, the PPF also assumes the existing responsibilities of the Pensions Compensation Board, which compensates members of both defined-benefit and defined-contribution (money-purchase) schemes in cases of fraud and misappropriation.

The PPF will ensure that, where a company with an eligible defined-benefit scheme becomes insolvent, with an insufficiently funded scheme, members of that scheme will still receive the core of the benefits to which they are entitled. The PPF will provide compensation of:

To ensure that PPF compensation retains its value over time, pensions in payment will be increased in line with the retail price index (RPI) up to a maximum of 2.5%.

Compensation will be funded in two ways: firstly, by taking over the assets of pension schemes with insolvent employers, and secondly, by means of a levy on all private sector defined-benefit schemes and the defined-benefit element of hybrid schemes.

The levy is split into five parts:

As mentioned in Section 1.1, directives issued by the European Union are binding, as to the result to be achieved, upon each member state to which they are addressed. What this means is that the objectives of the directive have to be achieved but the choice as to exactly how they are achieved is left to national authorities in each state. As a result, much of the UK regulation about financial services is derived from European directives. Some examples are given below.

A significant EU directive issued in March 2000 (known as the Second Banking Directive) consolidated the earlier directives that gave institutions the freedom to establish and pursue the business of credit institutions (banks, building societies and similar organisations) throughout the European Union. It describes:

Credit institutions (see Section 5.4.1) also provide investment services, in direct competition with firms whose primary business is investment. In 1993, the EU recognised that ‘in order to guarantee fair competition, it must be ensured that investment firms that are not credit institutions have the same freedom to create branches and provide services across frontiers’ as that which is provided by the Second Banking Directive.

In order to achieve fair competition on investments, the 1993 Directive on Investment Services in the Securities Field, commonly known as the Investment Services Directive (ISD), was established and came into force at the beginning of 1996 (see Section 1.4.2). Investment firms could now operate in different European states in much the same way as banks (see Section 5.4.1) and the insurance industry (see Section 5.4.3), for which other directives had provided direct access to well-regulated markets across the EU.

In the same way as with credit institutions, firms that provide certain specified investment services must first be authorised in their own home state. They can then operate in the other member states without requiring further authorisation from the authorities in those other states.

The ISD does not cover all investment firms or all investment services: in particular, it does not apply to insurance and reinsurance companies. Section 1.4.2 describes the types of investment activity and the types of investments covered by the ISD and by the subsequent Markets in Financial Instruments Directive (MiFID).

In order to obtain and retain authorisation in their home state, investment firms must comply with certain prudential rules drawn up by the authorities in the home state. The general nature of these prudential rules is specified in the directives; they state that the authorities in each member state (eg the FSA in the UK) must require that investment firms take the following steps:

The regulatory authorities are also required to draw up a code of conduct that investment firms and their employees must observe. This code of conduct must, as a minimum standard, include the obligations that the firm will:

Many of these requirements will be recognised as elements of the FSA’s regulatory regime in the UK.

The two main objectives of a European single market for insurance are:

In setting out to achieve these objectives, the EU has always dealt with life assurance and non-life insurance separately, in order to take account of their different characteristics and also in acknowledgment of the close ties that life assurance has with the long-term savings industry.

The first directive relevant specifically to life assurance was adopted in 1979 with the aim of setting out how the right of establishment included in the Treaty of Rome might be put into effect for life assurance companies. The 1979 Life Directive defined life assurance as including the following categories:

The second Life Directive, issued in 1990, laid down special rules relating to the freedom to provide cross-frontier services in the life assurance field. It covers individual policies and group life, but not group pension funds.

Arrangements for regulation and supervision of the insurance fall into two categories, depending on the reason why the applicant is taking out the policy.

In 1992, the third Life Directive – sometimes also known as the Life Framework Directive – was adopted. Like all EU directives, its provisions had to be incorporated into the legislation of all the member states. In the UK, for example, its provisions were incorporated into insurance legislation (based largely on the Insurance Companies Act 1982) through the Insurance Companies (Third Insurance Directive) Regulations 1994.

In order to obtain authorisation, a company must:

The financial supervision of an insurer is the responsibility of its home state; this supervision includes valuation of assets and liabilities, and the consequent verification of solvency. Local legislation may apply, in the states where the insurance is sold, in relation to advertising, marketing and contract matters. Similarly, any premium taxes applied are those of the state in which the insurance is sold (at present, in the UK, insurance premium tax applies to general insurance but not to life assurance).

The directive requires the harmonisation of national laws where this is necessary for its principles to work smoothly throughout the EU. These principles include:

Policyholders must be able to withdraw from the contract within a ‘cooling-off’ period of between 14 and 30 days from the time when they are informed that the contract has been made. This rule is reflected in the UK through the issuing to customers, by the insurance company, of a statutory cancellation notice. Customers who then have 14 days in which to return the notice to the company and cancel the policy with a refund of any premium paid.

Policyholders must also be provided with clear and accurate information about the essential characteristics of the products offered to them, to assist them in choosing an appropriate product. This requirement is met in the UK by the issue of a key features document (see Section 1.7.5.6).

In 2002, a fourth Life Directive was issued: the previous three Life Directives (and certain other directives) were repealed and replaced by this single directive that covers all aspects of life assurance. It is largely a consolidation directive, bringing together the provisions of earlier directives concerning the concept of a single licence and harmonising local rules on authorisation and the regulation that is required to make the single-licence system work.

In 1988, the Second Non-Life Council Directive laid down rules for cross-frontier non-life insurance that balance the needs of freedom of service and consumer protection. This allowed companies to supply insurance in another member state without having to establish a branch or subsidiary in the other state.

The Third Non-Life Council Directive, issued in 1992, completed the process and now any insurance company whose head office is in one of the member states can establish branches, and carry on non-life insurance business, in any other state. That activity will be under the supervision of the competent authorities of the member state in which the insurance company’s head office is situated.

Authorisation to carry out insurance business under the terms of this Directive is granted for a particular class of insurance (or even, sometimes, for some of the risks relating to a particular class). Companies can, of course, be authorised for two or more classes. General insurance risks are classified into a large number of categories, including: accident; sickness; land vehicles; railway rolling stock; ships; aircraft; property; and a range of types of liability.

In some cases, authorisation can be given for more than one class together: the accident and sickness classes can be authorised as ‘accident and health insurance’. There are, however, specific rules on compulsory insurances against accidents at work, such as employers’ liability insurance in the UK.

As well as ensuring that insurance companies can operate throughout the community, the EU also wants to ensure that retail markets in insurance are accessible and secure. To this end, a Directive on Insurance Mediation came into force in January 2003, the purpose of which is to establish the freedom for insurance intermediaries to provide services in all states throughout the EU. It was felt that, prior to the development of this Directive, the liberalisation of the insurance sector had benefited the wholesale market (large industrial and commercial risks) to the detriment of the retail market (insurance for private individuals). The 2003 directive replaces an earlier (1977) directive, that first introduced plans to give insurance brokers and agents the freedom to operate across the community, and a 1992 recommendation from the European Commission about qualifications to be required of insurance intermediaries. It is now the sole European statute governing insurance intermediaries.

The directive establishes a system of registration for all independent insurance (and reinsurance) intermediaries. They must be registered with a competent authority in their home state: independent financial advisers based in the UK who are selling life assurance or general insurance must be registered with the FSA, but tied agents are authorised by the company to which they are tied and do not have to be authorised directly by the FSA.

Registration is subject to strict requirements regarding professionalism and competence; intermediaries must have the necessary general, commercial and professional knowledge and skills. Exactly what this means depends on the relevant national authority, but it will almost certainly include a requirement for appropriate training and a specified level of qualification, and possibly a programme of continuing professional development. In the UK, the FSA have set out their requirements in considerable detail in their Training and Competence Sourcebook.

Insurance intermediaries are also required to be ‘of good repute’. Again, local interpretations of this may vary, but minimum requirements are that an intermediary must not have been:

The directive also requires that insurance intermediaries should hold professional indemnity insurance of at least €1m per case and €1.5m in total per annum. The whole question of professional indemnity insurance in the UK has become very difficult in recent years: problems such as the ‘pensions mis-selling scandal’, and the failure of some mortgage-related endowments to provide sufficient funds to repay policyholders’ loans, have made professional indemnity insurance more difficult to obtain and more expensive.

Rules are also included to protect clients’ funds, including the requirement to keep client money in strictly segregated accounts. This is backed up by a requirement for intermediaries to have financial capacity of an amount equal to at least 4% of premiums received per annum, subject to a minimum of €15,000.

The regulations specify in some detail what information an intermediary must give to a customer. In relation to the intermediary, the following information must be supplied:

In relation to the advice offered and products recommended:

All information provided by an intermediary to a customer must be set out in a clear and accurate manner, and must be comprehensible to the customer.

The requirements of this directive are closely reflected by rules in the FSA’s Conduct of Business Sourcebook.

The government has for long been concerned that many financial products are:

They have tried to counteract this by introducing a set of cost, access, and terms or standards (CAT standards) intended to help less knowledgeable investors choose a suitable deal.

Originally, CAT standards were applicable to ISAs (at the product provider’s discretion) but, following the introduction of the ‘Sandler suite’ of simplified products (see Section 1.7.6), CAT standards for new ISAs have been withdrawn.

CAT standards for mortgages remain in force. These are standards that can be applied to mortgage products, although lenders are not obliged to offer CAT-standard mortgages and there is no guarantee by either the government or the lender that a CAT-standard mortgage will be the most suitable product for a particular borrower.

CAT-standard mortgages are likely to appeal to borrowers who wish to have clearly stated limits on charges. Examples of the limits set on charges and other costs are that:

Other rules relating to access and terms include:

In addition to abiding by the rules laid down in industry-specific regulations, advertisements for financial services and financial products must meet the standards laid down in the British Code of Advertising under the supervision of the Advertising Standards Authority (ASA).

The ASA was set up in 1962 and is an independent self-regulatory body, which administers the British Codes of Advertising and Sales Promotion.

It covers all non-broadcast advertisements, ie those that appear in:

The ASA can take action against individuals and organisations whose advertising contravenes the code. The first step is usually to discuss the offending advertisement with the advertiser and – if an acceptable explanation is not given – to require that the advertisement is changed or withdrawn.

A number of sanctions are used against offenders, ranging from the adverse publicity generated by its adjudications to legal proceedings in the case of persistent or deliberate offenders. This legal action is available through a referral of the advertiser, agency or publisher to the Office of Fair Trading.

The Advertising Code requires that advertisements should be prepared with a sense of responsibility to consumers and society, and should respect the generally accepted principles of fair competition in business. Specifically, the code requires that all advertisements should be:

Advertisers are permitted to express opinions, including opinions about the desirability of their products, provided that it is clear that it is opinion and not a statement of fact. Assertions or comparisons that go beyond subjective opinion must be able to be objectively substantiated.

It is a voluntary code of practice but almost all banks and building societies subscribe to the code. The aim of the code is to set out good standards of banking practice. It is not considered to be best practice: subscribers can, if they wish, adopt different standards if they believe them to be better than those in the code.

The code relates to dealings with personal customers, which covers private individuals, executors and trustees, but not clubs, societies, companies, sole traders or partnerships. A separate Business Banking Code covers small businesses with a turnover of up to £1 million. Both codes are reviewed every two years by an independent body – the Banking Code Standards Board – and updated versions of the codes came into force on 1 March 2005. The Banking Code Standards Board also checks on compliance with the code and, if it receives complaints about non-compliance, it takes the matter up with the bank or building society concerned.

The Banking Code covers the following products and services:

The standards of the code are set out in a series of key commitments that apply to the conduct of business for banking products and services. These commitments specify that banks and other organisations that subscribe to the code will:

• make sure that advertising and promotional literature is clear and not misleading and that the customer is given clear information about products and services;
• when a customer has chosen an account or service, give clear information about how the account or service works, its terms and conditions and the interest rates that apply to it;
• help the customer to use his/her account or service by sending him/her regular statements (where appropriate) and keep the customer informed about changes to the interest rates, charges or terms and conditions;
• deal quickly and sympathetically with things that go wrong and consider all cases of financial difficulty sympathetically and positively;
• treat all customers’ personal information as private and confidential, and operate secure and reliable banking and payment systems;
• publicise the Code, have copies available and make sure that the organisation’s staff are trained to put it into practice.

The Banking Code covers the following areas of business operation:

• the supply of information to other banks when customers decide to change;

Some of the requirements described in the code are open to interpretation – for instance, different banks may give different meanings to certain technical terminology. The code suggests that a ‘common sense’ approach should be applied in cases of doubt.