Risk Mitigation
   Overview: Risk Control
   Overview: Capital Adequacy
   Overview: Regulatory Co-operation
   Overview: Sales Practices
   Overview: Netting and Insolvency
   Overview: Accounting and Disclosure


Risk Mitigation

Overview: Sales Practices

The drafting of a code of sales ethics, i.e. a set of appropriate rules to ensure fair dealing between firms and their customers, has always been dealt with in documents relating to customer protection. It was never the focus of regulatory attention, as a standalone subject, prior to 1994. A seachange occurred in that year when many well-known firms announced multi-million losses resulting from derivative transactions in which, they claimed, they were misled. The most infamous of these were Gibson Greetings, Procter & Gamble, and Orange County. There followed a plethora of law suits, most of which were settled out of court. But these high-profile stories thrust the need for a code of marketing standards into the regulatory forefront.

Events in the Procter & Gamble and Gibson cases brought home the need for an appropriate set of transaction-specific rules. (It goes without saying that a code of sales practices is part of customer protection.) In December 1994, the New York Federal Reserve Bank of New York and Bankers Trust signed a written agreement in which the New York bank agreed to a rigid set of policies and procedures for its leveraged derivative business.

To pre-empt further regulatory initiatives on derivatives, the Derivatives Policy Group comprising senior officials from six of the United States' largest broker-dealers (Goldman Sachs, Merrill Lynch, CS First Boston, Salomon Brothers, Morgan Stanley and Lehman Brothers) released a code of conduct in "Framework for Voluntary Oversight (1995). " The code deals with the issues of transaction disclosure and valuation. It attempts to codify the basic principles espoused in the Federal Reserve - Bankers Trust agreement, i.e. that the major risks of a transaction are explained clearly to the customer, and sensitivity and scenario analyses of complex transactions offered unsolicited to customers. These analyses should be done as objectively as possible; so should the valuations provided to the customer. The DPG states in black and white that a professional intermediary should not provide valuations to a non-professional intermediary with a view to misleading the counterparty, and that the latter should be told whether the valuations it receives are firm or indicative price quotations.

At an official level, only the International Organisation of Securities Commissions, has produced a set of principles of ethical conduct for all its member countries. The Technical Committee defines ethical conduct as "rules applying to financial intermediaries designed to promote the primacy of the interests of the client and the integrity of the market. "International Conduct of Business Principles" (1990)outlines these rules of conduct. They are:

  • In conducting its business activities, a firm should act honestly and fairly in the best interests of its customers and the integrity of the market.
  • In conducting its business activities, a firm should act with due skill, care and diligence, in the best interests of its customers and the integrity of the market.
  • A firm should have and employ effectively the resources and procedures which are needed for the proper performance of its business activities.
  • A firm should seek from its customers information about their financial situation, investment experience and investment objectives relevant to the services to be provided.
  • A firm should make adequate disclosure of relevant material information in its dealings with its customers.
  • A firm should try to avoid conflicts of interests, and when they cannot be avoided, should ensure that its customers are fairly treated.
  • A firm should comply with all regulatory requirements applicable to the conduct of its business activities so as to promote the best interests of customers and the integrity of the market.

These rules have also formed the core of business principles currently being drawn up in emerging markets.

An IOSCO report released in July 1995 sets out a code for selling collective investment schemes (CIS). A CIS is an open-end collective investment scheme that issues redeemable units and invests primarily in transferable securities or money market instruments. Of the 10 core principles considered important for the regulation of CIS in "Report on Investment Management", six deal with sales practices. They are: eligibility to act as an operator, delegation, conflicts of interest, asset valuation and pricing, investor rights and marketing and disclosure.

An operator has to observe high standards of integrity and fair dealing while acting in the best interest of the CIS. In situations where there is a possible conflict of interest, the regulatory regime may impose sanctions for self-dealing, such as revoking the operator's licence, taking action to withdraw a CIS's authorisation, freezing the assets of the operator, instituting administrative or civil proceedings, and recommending criminal action where appropriate. Assets of CIS must be marked to market while the rules of asset valuation and calculation of the unit price laid down in the CIS's rules or public disclosure documents. Units of CIS must be repurchased or redeemed at the request of any unit holder, in a manner, which does not give an unfair advantage to one investor in the CIS over any other investor. Regulators of CIS schemes also insist on full, accurate and timely disclosure so that prospective investors have all the information necessary to make informed decisions.

Part II of the report contains details of how major countries around the world put into practice these 10 general core principles.

Because collective investment schemes are a major investment vehicle for millions of people worldwide, IOSCO released "Principles for the Supervision of Operators of Collective Investment Schemes" in September 1997. To promote high standards of conduct from CIS operators, the paper sets out 10 supervisory principles, singling out activities that are considered sufficiently important to warrant supervision. Principle 1 which deals with 'conduct of business' has guidelines on timely and best execution, and allocation; churning to generate more income for the operator; cash commission rebates; soft commission arrangements and inducements. For example, the guidelines stipulate that where brokerage rebates are common, supervisors must ensure that such rebates, unless explicitly authorised by and disclosed in the CIS documentation, are credited to the CIS rather than retained by the operator.

Principle 2 tackles the issue of connected party transactions. Supervisors have to ensure that where an operator is connected to a company in which non-fund management activities are carried out, that appropriate protective arrangements such as 'Chinese walls', are in place to limit and disclose any conflicts of interest. Supervisors should also ensure that CIS transactions executed through a connected broker are carried out at arms' length. The CIS should also have a code of ethics with regards to personal dealing activity - operators' employees should not make transactions on their own account which may conflict with the operator's obligations as a CIS.

Underwriting and participation by CISs in initial public offerings (IPOs) is also covered in the principles. Supervisors must determine whether it is appropriate for a CIS to participate in sub-underwriting. This is because sub-underwriting can give rise to a number of risks, which include participating to support an issue which has been organised by the corporate finance arm of the group, or retention of the best underwriting business for itself or another customer, to the detriment of a CIS. Other risks include not receiving underwriting commission or undue exposure if the IPO is unsuccessful.

See also overview on customer protection

  • International Conduct of Business Principles (1990)
  • Framework for Voluntary Oversight (1995)
  • Report on Investment Management (1995)
  • Principles for the Supervision of Operators of Collective Investment Schemes (1997)

Updated 3/16/98


Key Risk Concepts * Risk Mitigation