23rd Feb 2011

Anticipate change rather than reacting to it

While some feel that this has come as a bolt out of the blue and is too much and too soon, advisors and distributors who participated in Wealth Forum's 2nd Annual Platinum Circle Conference in Dec 2010, were well prepared to accept this as an inevitable next step in regulation of distribution and advisory services.

In fact, the central theme of the conference was about understanding global best practices in sales processes. Here is what we said back in Dec 10 : "Wealth Forum believes the next wave of regulations in India will inevitably focus on establishing regulations for the distribution and wealth management business - which will include not just education and licensing norms, but a whole new set of sales process and documentation norms that advisors will need to adhere to - just as their counterparts in several other markets already do. This conference gave participating advisors a rare opportunity to understand this important input from across several geographies - to enable them to be ahead of the curve and anticipate regulatory change and be prepared for it - rather than reacting to change." For more details on the conference, click here :

www.wealthforumezine.net/WFPCAC041210.html

Who are "institutionalised distributors" ?

All banks, bank sponsored entities, national distributors and regional distributors fall into the ambit of "institutionalised distributors" for the purpose of these new regulations. They will have to comply with the new norms with immediate effect - or by such date that AMFI prescribes (which cannot be too far into the future).

There does not appear to be a clear definition of who is a regional distributor. If a firm has an office in more than one city in the same region, does it qualify as a regional distributor? For example, a firm has one office each in Mumbai and Pune, would it become a regional distributor? What about a firm that has 20 offices in Mumbai but none outside the city? And then what about a firm that has an office in Mumbai and another in Thane - which is technically outside Mumbai but practically considered its suburb? Would this firm be an IFA or an RD?

Probably the industry will need to come up with a definition of exactly who qualifies as a regional distributor.

Are IFAs exempt from these norms?

For the moment, yes. But, don't count on this situation lasting for too long. The regulator's intention is clear - that mutual fund distributors must follow a sales process that establishes product suitability before they sell any fund to their client. Or else, the client explicitly states in writing that he does not need advice and that he has asked for an "execution only" service from the distributor.

It is perhaps only from an implementation feasibility point of view that SEBI has chosen to mandate these processes for "institutionalised distributors". Once this system settles down, we would expect SEBI to extend these norms to cover all distributors. After all, if investor protection is the aim, we can't think of a situation where SEBI says that they need to protect only investors of large distribution houses.

IFAs across the country will do well to understand these norms and gear up for the day they become applicable for their segment too. There is little point in waiting for the eventuality to hit you and then start running - may as well get into action right now, and be prepared for it - when it comes.

What are the new sales process norms?

The new norms are at two levels :

   (1) Aspects that AMCs are expected to verify during their due diligence process when signing up a new distributor or during a periodic review of an existing distribution            relationship, and

   (2) Transaction level confirmations that AMCs are expected to obtain from these distributors on a weekly/fortnightly/monthly basis

Distributor due-diligence norms

Among other criteria, AMCs are expected to satisfy themselves on these aspects for each "institutionalised" distributor :

- That organizational controls are in place to ensure that the following processes are delinked from sales and relationship management processes and personnel:

   i. Customer risk / investment objective evaluation

   ii. MF scheme evaluation and defining its appropriateness by customer risk categories

- That customer relationship and transactions are categorized as either advisory or execution only. No third category is permitted.

   i. Advisory - where the institutional distributor commits to distributing only on the principle of 'appropriateness' of products to that customer category. Appropriateness is         defined as selling only that product categorization that is identified as best suited for investors within a defined upper ceiling of risk appetite. No exception can be made.

   ii. Execution Only - all transactions that are not booked as 'advisory' and, would therefore, mandatorily require:

1. In case of "execution only" transaction where the institutional distributor has information to believe that the transaction is not appropriate for the customer, then a written communication shall be made regarding 'inappropriateness' to investor, duly acknowledged and accepted by investor.

2. A customer confirmation to the effect that the transaction is 'execution only' notwithstanding the 'advice of appropriateness' from that distributor, is obtained prior to the execution of the transaction.

3. That on all such 'execution only' transactions, the customer is not required to pay the distributor anything other than a standard flat transaction fee, that is not ad valorem or percentage of value and is consistent across all investors irrespective of the transaction value.

For execution only services, distributors can only charge a flat transaction fee, which cannot be linked to value of the transaction and which must be consistent across all investors. This means that distributors who wanted to charge say 0.25% cannot now do so and must now publish a flat fee which they will charge irrespective of whether the transaction is for Rs. 10,000 or Rs. 10 lakhs.

By issuing this guideline, SEBI has dealt a body blow to the industry's efforts of seeking a review of the variable entry load proposal. If all execution only trades can only carry a flat transaction fee, its no longer a variable fee that gets mutually negotiated between the distributor and the investor. It has to be a uniform flat fee - which will obviously be very low.

Advisors vs distributors : now the distinction is real

With these guidelines, SEBI has also clearly demarcated what it defines as advice and what it defines as distribution. There is little scope for a distributor masquerading as an advisor in the new circumstances.

If you want to call yourself an advisor, you will need to conduct client risk assessment, product evaluation, define appropriateness of product to each client type and maintain documentary evidence of the processes you have undertaken for each transaction. You can charge a mutually acceptable fee for your service.

If you do not wish to take on these responsibilities of ensuring product suitability, you will need to get an "Execution Only" sign off from your clients for each transaction - where the client explicitly states that he has not availed of any advice from you and is only asking you to execute his orders.

The days of informal and unstructured advice seem over. The days of verbal advice also seem numbered - documentation of risk profile and appropriateness of advice given will become necessary.

Transaction level confirmations

AMCs have been asked to seek from their institutionalised distributors, weekly/fortnightly/monthly confirmations (depending on volumes) which must include confirmations :

that all transactions executed on 'advisory' basis were only on the principle of 'appropriateness' and no product was sold to any investor whose risk appetite and categorization was inappropriate for that product.

1. that all transactions on 'execution only' basis include
   
      i. a confirmation from the customer that it was done on 'execution only'



  ii. a confirmation from the distributor that only a standard flat transaction fee (not ad valorem or percent of value) was applied

2. that on all transactions, full disclosures of all fees and commissions earned by the distributor has been made.

3. The certificate shall be annexed with a list of all transactions under each category during that week/fortnight/month that is covered by the certificate of declaration/confirmation.

4. The transactions list shall include a column to reflect the name and ARN of the employee who dealt with the customer for that transaction

The last stipulation seeks to plug a gaping compliance hole. Several NDs and RDs having branches in multiple cities and towns, have only a handful of employees who have cleared the AMFI exams. There are umpteen cases of large distribution houses who are not monitoring whether all their sales persons are indeed AMFI certified - a clear violation of existing regulations.

Incidentally, this periodic confirmation also requires distributors to confirm that they have disclosed commissions - something that very few distributors are actually doing.

Will distributors actually implement these norms or will life continue as before?

The big question is whether these periodic certifications that distributors will now have to furnish, will materially change the current business practices. We have seen far too many confirmations that are given, without actual implementation and without any mechanism to confirm actual compliance.

For years, distributors have been giving annual confirmations that they have been abiding by the code of conduct, even as many continued to practice rebating. Rebating died a natural death because loads were abolished - not because of the code of conduct.

Commission disclosures is something that few distributors are actually complying with - but most see no problems in giving periodic confirmations to AMCs on this aspect.

In the present scenario, an AMC sees itself as discharging its responsibility by seeking and filing distributor confirmations. Nobody seems to be actively verifying whether these confirmations are correct. There is no regulator for the distribution industry.

So, will all these new sales process guidelines also go the same way - will it mean that distributors now give more lengthy confirmations, but little changes on the ground? SEBI has sought to plug this gap as well, by asking AMCs to independently verify a sample of investors each month to revalidate the declarations made by their distributors.

What do you think of these new sales process norms? How effective will they be in curbing mis-selling? Will your life change for better or for worse? Post your comments below - its YOUR forum !