OTC Derivatives Client Suitability Assessment: AFCA’s Approach

Posted On: 4 November, 2019 Xiaoshu Liu

An Australian Financial Services Licence (‘AFSL’) holder that is authorised to deal with retail clients is generally required to maintain a membership with the Australian Financial Complaints Authority (‘AFCA’). It is therefore important to understand how AFCA approaches its work when dealing with disputes between financial services organisations and their clients.

We reviewed approximately 30 AFCA determinations in relation to over-the-counter (‘OTC’) Contracts for Difference (‘CFDs’) that have been issued in the last 18 months. Almost half of the cases involved the issue of adequacy of client suitability assessment. AFCA appears to take the view that client suitability is an obligation imposed on OTC CFDs issuers, and a failure to conduct adequate client suitability assessment may result in an issuer’s liability for the losses incurred by retail clients. We share our observations on this issue below. A reference to AFCA includes a reference to its predecessors.  

Background: RG 227 Benchmark 1 Client Qualification

Regulatory Guide 227 Over-the-counter Contracts for Difference: Improving Disclosure for Retail Investors(‘RG 227’) was published in August 2011. It was addressed to OTC CFDs issuers in general and was intended to improve disclosure for retail clients. It provides seven benchmarks that should be addressed in an issuer’s Product Disclosure Statement (‘PDS’), the first benchmark being client qualification.

RG 227.37 provides that an issuer should maintain and enforce a written client qualification policy. RG 227.40 further provides the areas that issuers should consider to include in a suitability assessment, including prior trading experience, understanding of leverage, margin and volatility, the nature of CFDs, the risks involved in trading and the relevant processes and technology.

The disclosure against the RG 227 benchmarks is not mandatory, but rather, on an ‘if not, why not’ basis. It means that an issuer is either to state in its PDS that it meets a particular benchmark, or, if it does not meet a particular benchmark, it should explain the reasons for not meeting the benchmark and how it deals with the “business factor or concern underlying the benchmark” (see RG 227.19-20).

AFCA’s Approach

Our review indicates that AFCA appears to take the view that client suitability assessment is an obligation. A mere statement in a PDS that an issuer does not intend to meet the benchmark may not be sufficient. An issuer cannot ‘disclaim’ itself out of the “obligation”. Non-financial losses were awarded in the vast majority of the cases to compensate for “emotional and financial distress”.

Client suitability assessment an obligation

AFCA appears to consider that OTC CFDs issuers have an obligation to adequately assess the suitability of prospective retail clients before they can allow the clients to trade, despite the “if not, why not” approach taken in RG 227. The majority of the reviewed determinations made no reference to the issuer’s PDS, nor did they state whether the issuer committed to meeting this particular benchmark in its PDS. The overall approach observed has been the following:

If

      • a licensee failed to “meet its obligation” to conduct adequate assessment of a prospective client’s suitability to trade CFDs, to keep records of the assessments, and only to allow those who are experienced and understand the risks associated with CFD trading to open accounts; and
      • if the licensee had met its “obligations” and not opened an account for the client, the client would not have suffered a financial loss,

Then the issuer would generally be liable for the losses incurred by the client. See cases 527159,  514332 and 532717.

“If not, why not” disclosure may be insufficient

There was only one instance where the issuer attempted to not meet the client suitability assessment benchmark. In case 525459, AFCA described the issuer’s PDS as effectively stating that the “RG 227 benchmarks were not a requirement for the financial firm to follow but provided ‘helpful information to assist’ with a consumer’s decision-making process in relation to the product.” The determination went on to state that the issuer “had an obligation to assess the complainant’s understanding of CFDs”, and in the circumstances of that case, the issuer had failed to adequately assess the complainant’s experience.  

It is not clear from the determination whether the PDS in question provided the reasons for not meeting the benchmark and the issuer’s systems and controls to deal with the concern addressed by this particular benchmark (See RG 227.19-20). It is also unclear whether such disclosure if provided would be sufficient to allow the issuer not to meet the benchmark in the opinion of AFCA.

Disclaimer insufficient

In the event that an issuer has assessed a particular retail client as unsuitable, some issuers may show the client a warning to the effect that the issuer does not consider the client as having an adequate understanding of the product. At the same time, the client is given an option to acknowledge such a warning and to proceed to complete the account application process. AFCA appears to consider that an issuer cannot rely on such a disclaimer to comply with RG 227. See case 539507.

Non-financial losses awarded

AFCA has the power to award up to $5,000 for non-financial losses per claim and has exercised such a power in almost every single case we have reviewed to compensate for retail clients’ “the emotional and financial distress” as a result of losing money.

Takeaway

The key takeaway from the review process:

Client suitability assessment policy and records

Not all is lost for OTC CFDs issuers. Good record keeping of the client suitability assessment policy and properly conducted suitability assessments have saved the day.

For example, in case 510248, a prospective client completed a suitability questionnaire prior to the opening of his CFD trading account and obtained a 90% overall score. The test result indicated that the client largely understood the margin requirements at the time of the account opening. The client also accepted the issuer’s terms and conditions. As a result, AFCA held that the issuer adequately complied with its client suitability assessment obligations.

Another example is case 513104. Here the issuer’s records demonstrated that the complainant completed an online assessment of 15 questions covering all key elements as set out in RG 227.40. She obtained a score of 86.67% by correctly answering 13 questions. AFCA held that the issuer adequately assessed her suitability in this case.   

Clients with no prior experience

Where a prospective client has no prior trading experience and/or has failed the suitability assessment, some issuers require that the client practices CFDs trading in a demo environment for a period of time before they are allowed to open an account. It may be desirable to require these clients to pass the issuer’s suitability assessment before they can be allowed to trade real CFDs.

Further Note

We have also observed a practice, through our own work, where a sales representative may “educate” a prospective client almost immediately before the client would be required to complete a suitability test. The content of such “client education” would in substance provide the client with the correct answers to the questions they would be required to answer. Given the concerns that the suitability assessment is attempting to address, such a practice defeats the purpose of having a such a process in place in the first place and goes against the very spirit of RG 227. The practice should, therefore, be discouraged. Also, see a case study on page 5 of the April AFCA Newsletter.

Qualification

The above are our observations in relation to the issue of client suitability assessment only. Many of the cases involved more than one issue, such as misleading or deceptive conduct, a failure to provide financial services efficiently, honestly and fairly (s 912A(1)(a) of the Corporations Act 2001(Cth)), margin call procedures and so on. Our comments are not directed to the overall results of the determinations, but rather are restricted to client suitability assessment issue alone.

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Thank you for taking the time to read this article. Please get in touch if you have any questions, comments or if you need assistance. Please also see AFSL Compliance for details on how we can assist you with your AFSL compliance requirements.

Note: Xiaoshuis not a legal practitioner. This article has been provided for general information purposes only and cannot be construed as legal advice.