UK Court of Appeal considers the FCA’s Conduct of Business (COBS) rules on client categorisation of elective professional clients

Under the FCA’s COBS rules, regulated firms are required to categorise their clients into one of three categories: retail clients, professional clients or eligible counterparties. Each category receives different levels of protection under the FCA rules, with retail clients receiving the highest level of protection.

Some clients who would ordinarily be retail clients can be recategorised as professional clients if they meet certain criteria – which include (i) a “qualitative assessment” – i.e. that the firm undertakes an adequate assessment of the expertise, experience and knowledge of the client that gives reasonable assurance, in light of the nature of the transactions or services envisaged, that the client is capable of making his own investment decisions and understanding the risks involved and (ii) a “quantitative assessment”, to determine whether the client meets certain criteria - one of which involves the client having carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters. Clients who are categorised in this way are known as elective professional clients.

In its recent decision in Linear Investments Limited v Financial Ombudsman Service Limited, the UK Court of Appeal considered the adequacy of the processes that a regulated firm had undertaken when categorising an individual client as an elective professional client.

The regulated firm, Linear Investments, was marketing a strategy that involved trading in contracts for differences (CFDs), a type of derivative that are usually considered to be a form of high-risk investment. The firm had determined that that strategy should be for eligible counterparties and professional clients only, and would not be made available to retail clients.

The firm’s client was asked to complete a form to confirm that he met the criteria to be categorised as an elective professional client. The client ticked a box which said that he had traded CFDs on an execution-only and advisory basis for over two years, with 40-80 transactions conducted per year. The form also contained another box in which the client was invited to set out his knowledge and experience of the kinds of transactions which were being proposed. The client wrote “Have invested for +15 years in blue chip stocks”.

The client invested approximately £100,000 into the proposed strategy, and within about a year the value of his investment had halved. He brought a claim to the Financial Ombudsman Service (FOS) in respect of his losses.

The FOS awarded the client compensation, concluding (amongst other things) that he should not have been treated as an elective professional client. In reaching this conclusion, the FOS noted that the client’s handwritten explanation of his knowledge and experience referred only to his investment in blue chip stocks and said nothing about investing in CFDs. The FOS also said that the Account Opening Form was inadequate, because merely requiring a client to indicate the number of transactions that they had carried out over the last two years would not enable the regulated firm to determine whether those transactions were of significant size, or that they were on the relevant market; to make the assessment, the firm would also require details of the market on which the trades had taken place and the size of the lots.

Having at one point contemplated reducing the amount of the award by 25% for contributory negligence (to reflect the client having ticked the box saying that he had traded in CFDs), the FOS ultimately did not reduce the award on this basis, saying that the regulated firm should not have relied on what was in effect self-certification by the client without properly assessing his knowledge and experience.

The regulated firm applied for judicial review of the FOS decision. The court at first instance rejected the application, and the matter went to the Court of Appeal. The question at issue was whether the FOS had acted irrationally in reaching the conclusions that it had.

In relation to the adequacy of the regulated firm’s assessment process, the Court of Appeal noted that:

• It is unlikely to be enough to satisfy the FCA rule requirement (COBS 3.5.3(1)R) for a firm simply to require a client to complete a few very general tick boxes containing bald statements in relation to their trading experience and do nothing more.
• The application form itself had anticipated that the client would provide further information on his knowledge and experience. However, for the client to have mentioned blue chip stocks but to say nothing about his experience of trading CFDs was a “glaring omission”. It was right, and certainly not irrational, for the FOS to conclude that the regulated firm was put on further inquiry and not entitled simply to rely upon the tick box answers that the client had been given.
• In relation to the quantitative tests, the regulated firm had not done enough to determine whether the client had carried out the specified number of transactions “in significant size, on the relevant market”.

The Court of Appeal, however, disagreed with the FOS about the question of contributory negligence. It said that if the client had not ticked the box saying that he had experience of trading in CFDs, he would not have been categorised as an elective professional client and so would not have been able to access the relevant trading strategy. His own misrepresentations to the regulated firm were plainly an operative cause of his loss. The Court of Appeal therefore remitted the matter back to the FOS to reconsider whether a deduction should be made.

Implications

The decision has some important implications for investment firms who have processes for categorising certain clients as professional clients:

• Firms cannot simply rely on boxes being ticked by the clients. The client should have to provide proper evidence demonstrating that they have knowledge and experience, including by providing evidence of actual trading history.
• In cases of ambiguity or inconsistent information, firms are likely to be “on notice” and required to make further enquiries.
• While the decision was specifically in the context of the client categorisation requirements there are a number of other COBS requirements which require firms to consider information provided by the client, including in relation to their knowledge and experience. For example, the rules on appropriateness and suitability. This decision provides guidance that should be considered in the context of similar processes, particularly where they relate to consideration of a client’s knowledge and experience.

In the light of the decision, firms would consider the following practical questions:

• Are their staff are sufficiently well trained and able to identify inconsistencies or ambiguities that might require them to make further enquiries?
• Are their client categorisation processes sufficiently rigorous? Are similar processes for assessing a client’s knowledge and experience sufficiently rigorous?
• Do they have proper records of the basis on which each decision to categorise a client as an elective professional client was made?

If you would like to discuss any of the issues raised in this article, please get in touch with one of the contacts listed or your usual contact at Hogan Lovells.

Authored by Anahita Patwardhan and Dominic Hill.