Keydata, the FSCS and Kafka
Like many business owners managing or advising private wealth, I have found the last few days a bit Kafkaesque, confused and frustrated by the actions of our regulatory institutions.
As both an intermediary and a wealth management firm, we have two compensation levies to pay in relation to the total losses suffered by investors in Keydata products that were backed by investments in Lifemark, a Luxembourg Special Purposes Vehicle set up by Keydata. The bill arrived last week. Like everyone else, we had no idea how big it was going to be – 2% of revenues in our case.
The fact that consumers should be compensated against fraud and misselling is not at all objectionable to businesses, unless we are really myopic. We benefit from not having to carry capital to meet liabilities that are better pooled between us, and from not having to build, as our Victorian forebears did, grand temples in the High Street to indicate our financial strength and respectability. Kafka was not in the principle, only the implementation.
My initial focus was on getting my head round when a product provider is (for compensation purposes) actually an ‘intermediary’ or agent and why product literature is not an integral part of a product when testing for product failure. Moving on, we had to start thinking hard about how many other structured products that have proliferated under the eye of the FSA might similarly now represent a potential compensation liability for our type of firm, rather than for product providers. We have to do this, as part of our required stress testing of capital adequacy. But coming to terms with our ‘loss’ seemed to need something else. By the week end I was really keen to understand how the eligibility to compensation was itself determined, even before the question of how it was allocated.
Easier said than done – even with Google. I was exasperated by the lack of a clear narrative from the FSCS or the FSA about the Lifemark-related products. I wanted complete information, not little glimpses, that would satisfy me as an explanation of:
How the product literature gave rise to claims (other than in respect of the ISA issues already addressed by eligible claims)
Why the liability resulting in a legitimate claim to compensation lay with Keydata alone
What precise form the liability took (had the company not been insolvent would they have had misselling claims, or was the product failure itself covered by the FSCS?)
Exactly which products are covered by this claim – the applicability by categories listed by FSCS appears to relate to the tax liability issues, not the Lifemark failure as a whole.
The FSCS stated on 28th September 2010: ‘We are satisfied that the marketing materials produced by Keydata to promote the products did not comply with the Financial Services Authority’s rules. This means that Keydata may owe a legal liability to investors in these products, allowing us to pay compensation to anyone who is eligible under the FSCS’s compensation rules.’ Well, actually, that doesn’t satisfy me.
Is this a liability to put the investors back into the position they would have been in before investing, which (conventionally) ignores the performance of the product and looks only at how it was sold? I’m guessing it is, because the loss of value itself in the Lifemark bonds was explicitly ruled out by the FSCS as being protected. It also makes more sense in terms of the FSA’s directions to the FSCS (upheld after a judicial review) that the regulated activity involved was a distribution activity, not a management activity. The basis of the claim then looks like what we are familiar with as ‘misselling’. In this particular context, the only difference appears to be that it applies to all classes of investor, requiring no test of suitability case by case, as misselling usually does.
I can see why a failure in product literature might be a basis of a claim to FSCS compensation if it is because the provider is no longer around to sue (or refer to the FOS). But is that really what makes this an eligible claim and is that really the reason why it lies with Keydata rather than, say, the firms that gave advice on the strength of the literature, without adequate due diligence of their own? I would like to see that spelt out.
The obvious next step was to look to see what the failings in the literature were that would have made these products universally unsuitable. The FSA and FSCS don’t appear to have given any more details so I had to look at the offering documents myself. I wasn’t just looking for the mistakes about whether these were ISA-eligible, which we already knew about (and have already paid the FSCS so it could pay HMRC). I read one of the documents and would merely observe that it is not self-evident in what respects it was non-compliant, let alone why that might lead to universal unsuitability. I am not surprised, though, because if it was that obvious you would have expected some professional reader to have commented to the press or even to the FSA.
A detailed explanation would allow us to form a judgement ourselves as to whether the liability is really universal to all investors, regardless of how they bought (direct or through a regulated advisory firm) or whether the product literature failings rely on the assumption they were being read by a direct investor, not a professional firm. We might be expected to think this distinction matters because the claims might otherwise be made against the advisers rather than Keydata and reach back to professional indemnity insurers (or even be met by fines raised by the FSA from advisers at fault). After all, we know a high proportion of these products were placed by a very small number of firms.
Materiality would be important to our respect for the process leading to the levy. For instance, was a decision made that the underlying life insurance contracts were inherently unsuited to generating an income stream, as the product structure required? That would be pretty material. But it would also be quite different from the explanation given by Lifemark itself that it got the actuarial assumptions wrong – which sounds a bit like errors in investment assumptions, which we know are not covered by compensation.
Generic unsuitability, which sounds much more like product failure than literature shortcomings, would also imply that the FSA had plenty of opportunity to review this form of investment structure and deal with it generically, not necessarily singling out Keydata. Is the lack of explanation a cover for embarrassment, perhaps?
Though the focus of my questions, and search for answers, shifted over the past few days from the basis of allocation of the levy to the reasons for the liability itself, I have not lost sight of the allocation problem. I find it difficult to respect the FSA’s current procedures for determining apportionment, which are by narrow reference to the function being regulated where a firm has separate permitted business activities. Those different functions have origins and purposes that were designed for reasons unrelated to liabilities for compensation. When applied to product liability, they appear counter-intuitive and counter-factual. Judging by the outrage from my peers, they clearly do not command the respect of the industry generally. That is unhealthy and has to be addressed.
I realise that any new procedures will need to take into account EU developments, as we are impacted by changes the EU wants to see made to compensation arrangements. But it would be helpful to see a statement from the FSA that it at least recognises the present reliance on distinctions between separate regulated activities may not be fit for purpose.