Many securities firms have some variation of the basic requirement that clients be treated “fairly, honestly and in good faith” on their books. Yet they often fail to live up to this ideal, and regulators realize they would be overwhelmed it they tried to enforce the requirement.

This kind of realization has prompted Britain’s Financial Services Authority to improve retail regulation with its treating customers fairly (TCF) initiative.

In theory, all firms should treat clients fairly. Most regulators demand it, and market forces should ensure it happens. Firms that don’t treat clients properly should quickly lose customers to competitors, which either drives the sloppy firms out of business or forces them to pull up their socks. Indeed, regulators often fall back on such a market theory when they are accused of failing to provide adequate investor protection.

Reality is much messier. For market
enforcement to work, clients must have genuine alternatives. They must also have good information about the alternatives, and the cost of switching firms should not be prohibitive.

Such conditions typically exist in the institutional world. Buy-side investors will deal with a number of sell-side firms, so they’ll have insight into the level of service they can expect. There’ll be aggressive cost competition between the sell-side firms for the business and, because the investors deal with a number of firms, there is no administrative hassle in choosing with whom to trade on any given day. Sell-side firms have an overwhelming incentive to behave or they will quickly find themselves marginalized.

The market doesn’t work nearly as well at the retail level. Retail investors don’t have as much comparative information, or the market power, that institutional investors enjoy. Even if they did, moving portfolios is a costly and administratively complex manoeuvre, compared with a fund manager cutting off a predatory institutional salesman.

Given that markets alone aren’t enough to protect investors, securities regulators have typically tried to give investors some protection with rules. However, the firms’ informational advantage means these very rules can be turned against investors. With firms’ knowledge of what can and can’t be done, and how to skirt the rules, they can stay onside with regulators and still take advantage of their clients. The only way regulators are likely to intervene on behalf of clients is in a case in which the rules have been breached. Without that, clients are left to fend for themselves.

Not only is the information disparity between retail investors and the Street often huge, but the gap in resources is also large. Given the legal and financial resources at their disposal, firms are well equipped to fend off small investors’ attempts to hold them to account for their actions.

Given such realities, the best regulators can
hope to do is narrow the information gap and make the system harder to game.

In Britain, the FSA is attempting to do so by moving to principles-based retail regulation with its TCF initiative — a move that should make it easier for investors to get a fair shake.

Robin Gordon-Walker, press officer at the FSA, says the TCF initiative grew out of the belief that retail investment regulation was too polarized. At one end were prescriptive, detailed rules, which only compliance officers really know. At the other end was the general principle of treating customers fairly, “which most people had forgotten.”

The goal, he says, is to “put some flesh on the principle, and then we can get rid of the detailed rules,” while making the principle of fairness a holistic part of firms’ culture.

TCF essentially involves taking the general principle that clients should be treated fairly and honestly, and pushing firms’ senior management to build that into the corporate culture by offering a mix of carrot (the prospect of fewer detailed rules) and stick (the threat of enforcement action for ignoring TCF). The promise of fewer detailed rules is an incentive to most firms because, even though rules work to firms’ advantage in some sense, complying with them represents a large, unwanted cost.

The regulator first enunciated its plans to push TCF in a July 2004 paper. Early this month, it published a follow-up report, which essentially found that, although progress has been made, there is still much left to be done.

@page_break@At some firms, the FSA found, senior management hasn’t gone much beyond thinking about how to implement the TCF principle. In response, the FSA is pushing management to make more concrete changes. Ît has pledged to make the application of TCF a core part of its regular risk-assessment process. It also pledges to help firms address shortfalls, possibly provide redress when investors have lost money because of a firm’s failure to adhere to TCF and threatens enforcement action for significant TCF shirkers.

The goal is nothing less than to change the culture of the financial services industry. As the British arm of the accounting and consulting firm Deloitte & Touche LLP declared in a paper it published earlier this year, the FSA essentially wants firms’ senior management to inculcate the principle of treating customers fairly “into their cultures, day-to-day operations, and for firms to consider fair treatment for customers at each stage of the product life cycle.” It notes that this includes product design, sales force incentives and complaint handling.

The recent update report from the FSA suggests, for example, that firms could use more focus on TCF in their product-design process by stress-testing new products from the customer’s point of view, doing a better job of clearly communicating the risks and benefits of new products and using after-sale surveys to test whether consumers have really understood what they have bought.

The Deloitte report suggests that as firms adopt TCF, their products will become more transparent, service will improve and “significant changes in culture and behaviour” will be required.

“We want firms to challenge ways of doing business that may be very familiar,” the FSA says. “Most firms in the financial services industry aim to treat their customers fairly.
They recognize the commercial importance of satisfied customers. But, even in these firms, there are often practices that have grown up over time, or have not kept pace with other changes in the financial services market, [that] need to be reviewed against the principle of TCF.”

Gordon-Walker characterizes TCF as a process that will be ongoing, as the regulator encourages firms to practise the religion of treating customers fairly, and make it part of the firm’s underlying spirit.

Deloitte suggests the slew of new regulatory initiatives, including TCF, currently facing the British financial industry will be the biggest regulatory catalyst for change in that country’s financial services industry since the 1980s. It calls 2005 a “watershed” for the industry, noting it will probably look much different in five years as a result of regulatory initiatives.

It projects that the changes will probably lead to larger firms selling more standardized products. This, in turn, may lead to less consumer choice and greater client segmentation, along with greater assurance of a fair deal. In some sense, the British government has endorsed this change by introducing a regime allowing firms to offer “basic ad” — a limited menu of simple, low-cost products that can be sold with a minimum amount of advice. So far, few companies have seized this opportunity.

Notwithstanding the fear that large firms could be the beneficiaries and consumer choice a casualty of initiatives such as TCF, the FSA’s latest report insists that customers stand to benefit from the efforts.
“The objective of our program is to bring about a change to the retail marketplace that will benefit consumers. We have never intended that TCF should become an exercise in form-filling or an unwelcome distraction for management,” it states in its latest report.

How well the move to a principles-based, fairness-focused approach to retail regulation works should be instructive for Canadian regulators. Canada has seen its own share of efforts to tackle the power imbalance between retail investors and dealers.

The B.C. Securities Commission is aiming to slash the size of its rule book and shift to more principles-based regulation, at the same time beefing up investors’ ability to seek private enforcement of disputes through the courts. Firms generally applaud the idea, but worry about how it would be executed. The BCSC is still waiting to reintroduce its new securities act based on these ideas.

Ontario has pioneered its own effort to ensure retail investors get a fair deal.
Somewhat modelled on Britain’s experience, it was initially known as the fair-dealing model. Faced with criticism from the industry and a desire to get the FDM implemented nationally, the initiative has morphed into the registration reform project, with its own branded Web site within the Ontario Securities Commission’s site. The project has essentially shifted to the self-regulatory organizations for implementation.

Broadly, it promises to narrow some of the gaps between retail investors and the industry by improving performance reporting and beefing up transparency of costs, conflicts and compensation. However, its chief objective now is merely to “create a flexible registration regime leading to administrative efficiencies and a reduced regulatory burden.”

It remains to be seen whether clients will see themselves being dealt with fairly and honestly, or if broader cultural change is needed. IE