29
Apr

FSLRC on Financial Consumer Protection

By Deepti George, IFMR Finance Foundation

This post is a continuation of our blog series on FSLRC report.

Keeping in mind the existing state of consumer protection measures in place for India, FSLRC has proposed a consumer protection framework for financial services, with the stated objectives being – to protect and further the interests of consumers of financial products and services; and to promote public awareness in financial matters. It is pertinent to mention here that the Commission has included, in its definition of retail consumer, not just individuals but also enterprises that avail a financial product or service whose value does not exceed a limit as prescribed by the regulator1, or who has less than a specified level of net asset value or turnover, also as prescribed by the regulator . The previous post mentioned the rights and protections that the draft Code sets out. Among these rights are the right against unfair contract terms and the right to redress of complaints.

The right against unfair contract terms

The Draft Code deems an unfair term of a non-negotiated contract2 to be void. A term is unfair if it causes a significant imbalance in the rights and obligations of the parties, to the detriment of the consumer, and is not reasonably necessary to protect the legitimate interests of the provider3. Further, the Draft Code enlists a set of factors that would be considered in determining whether a term is unfair or not – such as the nature of the service, the extent of transparency of the term, the extent to which the term allows comparison with other financial products or services, and the dependency of the term with the remaining contract and with other contracts under question. If a term was found to be unfair, the contract will continue to be enforced with the remaining terms as long as it can do so without the unfair term.

This is very much in line with the laws laid out in Australia, in as late as 2010, through the Competition and Consumer Act 2010. While Australia already had laws in place to protect consumers against unfairness in contractual dealings (ex: prohibition of unconscionable or misleading and deceptive conduct), this Act introduced a new ‘unfair contract terms’ regime to standard form consumer contracts4 under which courts can decide if a term in the contract is found to be unfair5, in which case the contract is void. However, the contract will continue to bind parties if it is capable of operating without the unfair term. Examples of unfair terms are set out in an indicative list in the law6.

The right to redress of complaints

The Commission addresses this right in two steps – the first, is by placing a requirement on providers to have in place an effective mechanism to redress complaints internally, to inform consumers about their right to redress, and the process to be followed for it; and the second, is by having a statutory body external to the provider, that will be a unified grievance redressal system to redress complaints. This body termed the Financial Redress Agency (FRA), will replace sector-specific Ombudsmans currently in existence such as those for banking and insurance. Whether or not the FRA will replace the Consumer Courts (instituted by the Consumer Protection Act, 1986), will be decided later based on how well the FRA succeeds in its task.

FSLRC_CP1

FSLRC has also created a niche for consumer advocates to contribute to the regulator’s functions, through the creation of an Advisory Council on Consumer Protection. This body, with adequate representation from experts in the fields of personal finance and consumer rights, is expected to advice, comment on, and review the effectiveness of regulator’s policies. The regulator in turn is held accountable to respond to such proposals made by the Council, thereby bringing in an element of transparency to the regulatory decision-making process.

  1. This is not uncommon. In Australia, for instance, retail consumer includes small businesses, which are defined by s761G of Corporations Act 2001, as a business employing fewer than 100 people (if the business manufactures goods or includes manufacture of goods), or 20 people (otherwise)
  2. A non-negotiated contract is one in which the provider has a substantially greater bargaining power relative to the customer in determining the terms of the contract; and it is a standard form contract
  3. This however does not include a term that is reasonably needed to protect the legitimate interests of the provider, is a basic term such as the price of a product, or is a term required under any law or regulations
  4. All contracts will be presumed to be standard form contracts unless otherwise established. It is typically one that has been prepared by one party to the contract (the supplier) and is not subject to negotiation between the parties
  5. A contract term is considered unfair if:
    • – It would cause a significant imbalance in the parties’ rights and obligations arising under the contract, and
    • – It is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term, and
    • – It would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.
  6. s25, CCA 2010. Some are given below: A term permitting one party (but not another party)
    • – to avoid or limit contractual performance or to terminate the contract
    • – to renew or not to renew the terms of the contract
    • – to unilaterally determine whether to determine whether the contract has been breached
    • – a term limiting one party’s vicarious liability for its agents

12
Apr

FSLRC moots shift in onus of consumer protection from consumer to provider

By Anand Sahasranaman, IFMR Finance Foundation

This post is a continuation of our blog series on the recently released FSLRC Report.

Why does consumer protection assume so much more significance in financial services, more so than perhaps for other services? Financial services don’t have fixed characteristics. They can have almost infinite variations and in a sense, can be synthesised on the spot by the provider varying one or more features. They are also constantly interacting with the context of the user. Given the complexity in designing products to suit diverse consumer situations, there exists a gap in information and understanding between the providers and the consumers; a gap that has been widening over time and is only expected to widen further. The nature of financial services therefore points to consumer protection as the central objective that should drive financial sector regulation. India’s consumer protection regime has been built on the doctrine of caveat emptor or ‘buyer beware’, which holds that, since the buyer has been given all information relating to a product, the buyer is to be responsible for all risks associated with the product after its purchase. The FSLRC rightly recognises that there needs to be a shift in the approach to consumer protection and that a higher standard is required.

The ‘buyer beware’ doctrine has translated into several pages of legal and technical documentation which a customer signs on, and which the representative of the seller is usually unclear about. The real risk here is the chance that the product sold is unsuitable and therefore will result in bad customer outcomes. This is further exacerbated by industry-level sales-incentives such as commissions and soft-benefits given to agents to push product uptake. The ULIP controversy involved the commission driven mis-sale of equity-linked investment product to customers seeking an insurance cover. Entry loads in mutual funds is another example of mis-sale where agents get unsuspecting customers to churn their portfolios in order to cash in on the entry-loads each time the customer bought into a new mutual fund. Since agent incentives do not reward maintenance of customers, this has inevitably led to lapsed insurance policies, clearly making a massive portion of the customer base worse-off with the policy.

In this context, it is heartening that the FSLRC “marks a break with the tradition of caveat emptor, and moves towards a position where a significant burden of consumer protection is placed upon financial firms.” The draft code establishes basic rights for financial consumers:

  1. Financial service providers must act with professional diligence;
  2. Protection against unfair contract terms;
  3. Protection against unfair conduct;
  4. Protection of personal information;
  5. Requirement of fair disclosure;
  6. Redress of complaints by financial service providers.

Retail consumers have three additional protections:

  1. The right to receive suitable advice;
  2. Protection from conflicts of interest of advisors;
  3. Access to the redress agency for redress of grievances.

It is especially significant that the Commission has decided that retail consumers have the right to receive suitable advice in relation to the purchase of a financial product or service, and that the provider must collect all relevant information on the needs and situation of the consumer in making its recommendation. It could be argued that this decisively shifts the onus of consumer protection from the consumer to the financial services provider.

Since providers have greater expertise on financial products and can get the household-level information they need to make an informed judgment on the suitability of a product for a particular consumer, it is only appropriate that the onus of consumer protection be placed on the provider. Enshrining this right in the law will mean that financial service providers will be legally required to act in the best interest of consumers and that consumers will have legal recourse in case they have been sold unsuitable products or given unsuitable advice. While the penalties for errant financial service providers are not clear yet, enacting legal liability on providers to ensure suitability is possibly the single most powerful step to align the incentives of providers with those of consumers.

It is useful to take a moment to consider how a “Suitability” based consumer protection framework could actually work. “Suitability” should be seen as a process that covers all aspects of consumer interactions, right from the time of enrolment, data collection and analysis, through to the communication of product recommendation or advice, and follow-up with consumers on recommendations made. The financial services provider needs to ensure through the implementation of the “Suitability” process that the design and sale of services meets the needs of the consumer. The provider should be held legally liable on the implementation of this process of “suitability”, and not the intentions of the provider or consumer outcomes (which are difficult to objectively measure).

Such a provider-led regime might seem alien to many but it is the standard being followed in corporate banking and investment products in most countries. While insurance and credit providers are not being held to this standard, it is only a matter of time before this anomaly gets corrected.

The principles-based approach of law-making suggested by the FSLRC also indicates that while the right to suitable contract is enshrined in law, it is possible to meaningfully interpret “Suitability” only through the development of case law over time, reflecting the evolution of ground-level realities of consumer protection in the Indian context.

The application of ex-ante firm-level “Suitability” processes combined with the creation of a credible ex-post redressal mechanism such as the proposed Financial Redressal Agency (FRA) together can create a robust framework to meaningfully protect the interests of financial consumers.

Read our previous posts on Suitability: A Paradigm for Suitability

7
Mar

Regulator Supervision of the Suitability process: An example from UK

By Deepti George, IFMR Finance Foundation

We have presented Suitability as the paradigm of choice for India’s financial system and have put forward the idea of Suitability as a board-approved process that each financial services provider develops and adheres to across all functions of the firm. This ex-ante liability for the firm is complemented by increased supervisory responsibilities for the regulator, in addition to an ex-post redressal mechanism to handle complaints arising from wrongful advice and sale. We share results of such a supervisory effort by UK’s regulator, the Financial Services Authority (FSA).

Background:

The Financial Services Authority (FSA) undertook a mystery shopping review of the quality of investment advice in the retail banking sector between March-September 2012, specifically to check whether firms were giving their customers suitable investment advice. Mystery shopping is a supervisory tool used by regulators across the world, and is considered to be among the more intrusive approaches to supervision of market players. The exercise spanned 231 mystery shops across 6 large firms in UK. The representatives of the exercise posed as customers looking to invest a lump sum and were seeking investment advice.

Results:

While three-fourths of the mystery shop customers received good advice, the quality of advice was under question for the remaining one-fourth. All 6 firms exhibited some form of ‘poor advice’ – where customers were at a risk of suffering detriment as a result of being recommended products that were not suitable for their needs and circumstances. Poor advice reflects a breach of FSA’s Conduct of Business (COBS) Rules and the FSA’s Principles for Businesses. The table below summarises the cases1 of poor advice:

 Nature of poor advice  Instances observed in the mystery shopping exercise
Poor risk-profiling
Risk profiling tools with complex and limited questions • Questions within a tool that required customers to use percentages to calculate potential investment losses based on different scenarios and then confirm the level of loss they were willing to accept.
• Advisor failing to check whether customers understood a question from the tool even when the customer was struggling to answer it, and instead proceeding to execute the advice.
Unclear customer risk category descriptions The middle-risk category at a firm highlighted the potential to lose money but did not indicate the extent of potential losses; this was further exacerbated by advisors failing to give further clarifications to customers.
Failing to check whether the results from risk-profiling tool are correct Advisor failing to check whether the customer’s ‘self-selected’ risk profile accurately reflected the actual level of risk he was willing and able to take with his investment. This was in spite of the advisor having identified that the customer had no previous investment experience and limited financial knowledge. (This is especially so because firms relying on risk-profiling tools need to ensure they manage any of its limitations through the suitability and ‘know your customer’ process2)
 Failing to consider customers’ needs and circumstances
Failing to consider customers’ financial circumstances and needs (13%3)  • Advisor failing to gather enough information on the customer’s income, current and future tax status, existing assets and regular financial commitments.
• Advisor failing to recommend the customer repay the existing credit card debt (that was accruing significant interest), and instead recommending investment in a collective investment scheme.
Failing to consider the length of time customers wanted to hold the investment (6%) Advisors recommending medium to long-term investments (product feature requiring customer to remain invested for 5 years) even though customers made it clear they needed their money after 3-4 years (in time for the customer to purchase a house for her son).
Failing to give customers the correct information
 Failure to describe or giving a misleading description of initial disclosure on the firm, its services and remuneration (13%) Advisor telling the customer ‘you don’t pay me a penny and you don’t pay the bank a penny for this advice’, while in reality the service was not free. Although the customer was not paying anything upfront, he would be paying indirectly through product charges. 
 Advisor making statements that were unclear, unfair or misleading (15%) • Advisor incorrectly stating, and reinforcing that the customer would ‘always get a return’ for a product and that the potential returns would be 3.5 times the achievable maximum return.
• Advisor making incorrect statements about how a fund was managed and failing to give risk warnings.
 Issues with suitability reports (17%) The suitability report mentions that customer wants to invest for ‘at least 5 years’ and was keen to follow a medium to long-term strategy, when in reality the customer had clearly stated she wanted to invest for 3 years and use the money for a holiday.(Such reports can cause further problems as it would be relied on by business monitoring and compliant-handling functions within the firm, and would go undetected as a case of poor advice)
Inappropriate use of investment sales aids • Advisor emphasising potential returns from investment without mentioning the potential for losses.
• Undervaluing the returns on cash deposits in sales aids in order to make other investment options look more attractive.
• Sales aid indicating a positive return on a medium-risk investment portfolio, and advisor emphasising the same, while in reality the medium risk portfolio did not guarantee a positive return.
Weaknesses in firms’ controls Unable to override the firm’s advice processes/systems, advisor deliberately entering inaccurate customer information (income or investment term) to overcome the system constraints. (This also had the added danger of generating inaccurate suitability reports which would be difficult for customer to use to complain if needed; nor would this manipulation be detected by monitoring teams)
Other factors causing poor advice may be at play for the following instances (possibly incentives, sales targets, performance management) • In spite of collecting all relevant information, advisor recommending an investment product when a deposit product should have been advised.
• Recommendations that appeared to be at odds with the firm’s advice policy.



1 – These are not mutually exclusive; a mystery shop may exhibit more than one of the instances below
2 – As per http://www.fsa.gov.uk/pubs/guidance/fg11_05.pdf
3 – % implies percentage of mystery shops

6
Jan

A Paradigm for Suitability: Part III

By Deepti George, IFMR Finance Foundation

The previous post covered the process of “Suitability” in financial services. Here, we cover aspects of the legal and regulatory structure that will aid in establishing an effective Suitability regime in India.

The primary objective of finance is to improve the financial well-being of consumers. For this to happen in India, there needs to be a shift towards a higher-trust-equilibrium between the consumers, financial service providers and the regulators. However, this is not possible to achieve under the following two scenarios:

  1. A disclosure-based approach to financial intermediation, which has inadvertently ended up as a way for providers to absolve themselves of their responsibilities to their consumers.
  2. A purely rule-based regime in which product approval is left in the hands of the regulator, absolves the provider of the responsibility of creating products that are truly welfare-enhancing for the consumer.

The “Suitability” regime seeks to reach this higher trust equilibrium by placing a direct responsibility, through legal liability, on the financial services provider for its advice or recommendation. To give teeth to this responsibility, it becomes a prerequisite to insert into law the Right to Suitability. The Approach paper recently put out by the Financial Sector Legislative Reforms Commission seeks to enshrine this right in the law. Every citizen must have the right to be provided suitable advice or recommended suitable products. By incorporating this, consumers would be empowered to move a court of law in case this right is denied. Its introduction into primary law would be followed by changes to subordinated legislation which the regulators have the mandate to execute and supervise. This will shape the behavior of financial services providers, who will evolve the suitability process and practices that are consistent with subordinated legislation. The suitability regime places a very strong burden on everyday behaviour of the provider.The interpretation of suitability will emerge from the building up of case laws and judicial precedents, ensuring that our understanding of suitability comes from the reality and evolution of the market over time.

The Suitability regime would require the regulator to take a more non-interventionist approach towards product approvals for providers; providers should be free to develop products based on the needs of the market. This will ensure that both providers as well as regulators will have more leeway and will enable the creation of incentives that push the providers to innovate on socially useful product development. This does not however, in any way, indicate that the Suitability Regime would be a ‘light-touch’ one solely characterized by completely unrestrained market participants let loose on unsuspecting consumers. While the regulator steps back from product approvals, it would have greater supervisory responsibilities. This ex-ante regulatory oversight, coupled with a strong, unified ex-post redressal mechanism that also gives ‘real-time’ feedback to all regulators to aid in their monitoring, would provide severe disincentives for providers to offer bad advice or recommend inappropriate products to consumers. The redressal mechanism must include penalties that are not just compensatory in nature (to cover the losses incurred by the aggrieved), but also heavily punitive for non-compliance, which would act as a severe deterrent for the future. This could be in the form of direct liability on the heads of financial institutions, product recalls, and the like.

Coordination among regulators would assume tremendous importance in this regime. The Financial Stability and Development Council (FSDC) plays a big role in facilitating this. The agenda for development of the financial sector must be decided solely by the FSDC and the Finance Ministry. Keeping the regulators responsible only for their respective domains will help remove any conflicting objectives the regulators might have faced otherwise.

How can suitability be enforced in a country like India where vast majority of the population have only limited or no access to basic financial services? If a consumer has access to only one product provider, should the provider sell the consumer a product that it has concluded to be unsuitable for her? Is Unsuitable access better or worse than no access? This situation, of a single product in low-access environments, can be overcome by getting the provider to develop natural suitability guidelines – which indicate a class of consumers for whom the product is automatically suitable; and serving the product to only those consumers. Besides, the provider can come up with natural “unsuitability” guidelines which, at the very least, stand by the principle of ‘do no harm’. This framework will automatically push for a bias in favour of distributors who can offer a single yet perfectly suitable product, and going forward, offer multiple products. It is likely that the Suitability equilibrium will shift the market from single product providers to multiple product providers.

The regulatory costs of implementing the Suitability paradigm need to be considered in greater detail. Further work will need to be carried out to arrive at a conclusion of whether the costs would be lesser or greater both in the short term and in the long term.

Also, greater thought will need to be given to develop a framework for supervising the Suitability regime. We can however learn from experiences from other countries which have already covered considerable ground in this aspect. The box below looks briefly at how Australia has been enforcing Suitability.

Enforcing Suitability – Lessons from Australia

Australia has a single market conduct regulator, the Australian Securities and Investments Commission (ASIC), whose mandate is to ensure that Australia’s financial markets are fair and transparent, and are supported by confident and informed investors and consumers. ASIC administers the Financial Services Reform Act 2001 (FSR Act), which requires persons who provide financial product advice to retail consumers to comply with certain conduct and disclosure obligations. More details can be found here.

ASIC places legal obligations on financial services firms to meet specific conduct, disclosure, skills as well as professional indemnity insurance requirements, amongst others, to implement the Suitability requirement. Potential breaches of the law are brought to ASIC’s notice through reports of misconduct from the public, through referrals from other regulators, statutory reports from auditors and the licensees themselves, and through ASIC’s own monitoring and surveillance work (through regular surveillance visits and shadow shopping studies, the results of which are shared in the public domain). ASIC is empowered to take a variety of actions such as:

  • Punitive actions such as court order, prison terms, criminal and civil financial penalties;
  • Administrative actions (without going to court) such as ban on providing financial services, revocation, suspension or variation of conditions of licenses, public warning notices;
  • Preservative actions such as injunctions; and
  • Negotiated resolutions such as through enforceable undertakings, and others

ASIC can decide on which remedy to take depending on various factors such as the severity of the suspected misconduct, the extent of losses, the compliance history of the individual or firm in question, and so on. The table lists major deterrence outcomes by type of action taken

(Source: ASIC Annual Reports):

7
Dec

A Paradigm for Suitability: Part II

By Vishnu Prasad, IFMR Finance Foundation

The previous post delineated the Indian context for finance and suitability as part of our Consumer Protection series. This post delves deeper into the conceptual discussions on suitability as the new paradigm for financial sector regulation in India.

Suitability as a process

It would be erroneous to think of suitability in the context of the intention of the financial services providers or customer outcomes. Instead, suitability should be seen as a process. As a part of this process, every financial services provider should be required to have a board approved suitability policy that the company must follow. This process must cover all aspects of consumer interactions, right from the time of enrolment, data collection and analysis, communication of recommendation or advice, and follow-up with consumers on recommendations made. The financial services provider needs to ensure through the ex-ante implementation of the suitability process that the design and sale of services meets the needs of the consumer. The financial services provider will be held accountable on the implementation of this process of “suitability”, and not the intentions of the provider or consumer outcomes.

It is in this view of “suitability”, as an on-going process that the provider implements in every interaction with every consumer (driven by the incentive of acting in the consumer’s best interests), that the true power of the “suitability” paradigm becomes apparent. The suitability policy can be legally challenged by regulators, consumers and consumer advocates and should be subject to regulatory audit and disclosure requirements.

Legal Liability

In order for any framework of suitability to have teeth, there is a need for the imposition of legal liability on the financial services provider. The only way to incentivise the financial services provider to act in the best interest of the customer is to hold them legally responsible for the suitability process. In a “suitability” framework, it is in the firms’ self-interest that their behaviour in situations of conflicted remuneration and sales models will be aligned with the best interests of the consumer. . For instance, the threat of product recall in case of unsuitable behaviour provides a strong dis-incentive from mis-selling.

Further, in the face of binding legal liability, competition will drive each provider to differentiate itself as the purveyor of the most suitable products and services to consumers. To meet the qualitative dimensions of the suitability criterion, they will be induced to offer a higher quality of service through a combination of:

  • Continuous product design to meet ever evolving consumer requirements;
  • Tighter training of their agents and representatives to better assess consumer situation, needs and prescribe customised solutions; and
  • Re-configuration of incentive structures so that the main criterion is the delivery of suitable service for the consumer, thus aligning provider’s incentives to those of the consumer.

The Consumer’s Right to Choose

It is important to clarify at this juncture that “suitability” does not compromise the right of the consumer to choose. The objective of “suitability” is to ensure that the financial services provider is always incentivised to act on the best interest of the consumer, not to ensure that the consumer abides by the advice of the provider.

In the suitability regime, every financial services provider will need to develop internal processes to assess and determine the suitability of their products for clients. On the basis of these internally developed processes, they will advise their clients on the appropriateness of products and services for them. At this point, it is completely up to the consumer to heed or reject the advice given – the final decision on accepting the advice and buying the product will always lie with the consumer. There can be no compromise on the fundamental right of consumers to choose the products and services they want to buy.

For every transaction where the consumer chooses to reject the advice of the financial services provider, she should be required to officially attest to the fact that she has been given expert advice that she has rejected. Beyond this, the financial services provider can then sell the product the consumer demands, and will not be held liable for “suitability”. Only in the case that the consumer accepts the provider’s expert advice and buys the products and services recommended will the provider be held liable under the “suitability” regime.

”Suitability” will drive financial services providers to act in the best interest of the consumer, thereby ensuring consumer protection, while the consumer will have the option to accept or reject the provider’s advice, thus safeguarding her autonomy.