FREE CHAPTER from ‘A Practical Guide to the Financial Conduct Authority (FCA) Consumer Duty’ by Robert Bell

CHAPTER ONE – INTRODUCTION

1.1: About this book

This book is about compliance with the Consumer Duty as set out by the Financial Conduct Authority (FCA) in their Policy Statement 22/9, Final Guidance 22/5 and subsequent interventions up to and including the first quarter of 2024. It aims to highlight the greatest challenges that UK financial services firms have in implementing the Duty and presents key requirements in a way that is understandable for most readers. However, this book has been written on the assumption that the reader is already familiar with the Consumer Duty. As such it is focused on the more intricate, and therefore interesting, aspects of the Duty.

Terms defined in the FCA Handbook have the same meanings in this book. All publications referenced are published by the FCA unless otherwise specified. These include webpages and ‘documents’ such as Dear CEO letters, reports, investigations and enforcement action. Other types of FCA publication include Consultation Papers (CP), Discussion Papers (DP), Finalised Guidance (FG), Market Studies (MS) Policy Statements (PS) and Thematic Reviews (TR), where, in each case, the first two digits of the reference number are the publication year.

1.2: A Failure of Treating Customers Fairly

The FCA and Prudential Regulation Authority (PRA) were created following the 2008 financial crisis, also known colloquially as the credit crunch. Following a period of review by the Government elected in 2010 the Financial Services Act 2012 was passed, and the new regulatory regime was born.

Under the ‘twin-peaks’ model, the FCA is mainly concerned with the conduct of regulated firms whilst the PRA regulates the 1,500-2,000 firms undertaking higher risk activities, focusing on market stability. Both regulators began work in April 2013 with the FCA, in particular, acquiring its regulatory standards from the previous regulator, the Financial Services Authority (FSA).

Treating Customers Fairly (TCF) is one of the more well-known set of standards inherited by the FCA. Originally created by the FSA in 2006, the TCF initiative was continued by the FCA, with the new regulator embedding the six TCF outcomes in the sixth principle of businesses “Customers interests – A firm must pay due regard to the interests of its customers and treat them fairly”.[1]

However, during the tenure of both regulators, industry research has found instances of practices inconsistent with the TCF principles. The mis-selling of Payment Protection Insurance (PPI) highlights one of the more egregious examples of financial services firms prioritising income over customer needs or outcomes and therefore failing to treat customers fairly. This example also emphasises the role that different firms in the distribution chain can play in failing to treat customers properly. One tends to blame the introducer (the firm selling the product to the customer, often a retailer) for mis-selling, an understandable assumption as they were often the party disguising the true cost of the insurance, failing to check whether it was suitable and sometimes even signing on behalf of customers. However, the manufacturer (the insurer) was often at fault as well due to a failure in oversight and control of the distributor’s actions or knowingly allowing them to conduct such practices.

Poor practices were not limited to PPI, with several instances across a range of markets including poor affordability assessments undertaken by several high-cost-short-term-credit (HCSTL, otherwise known as payday loan) providers. This often resulted in customers borrowing again, or rolling over their loan, so the amount of credit borrowed grows – profitable for the lender but trapping the customer into a cycle of debt. Of course, there is also the expense of HCSTC loans. Payday lenders have been singled out as charging very high interest rates, which have been justified in part by the lenders due to the relatively small amount of credit involved and the risk to the firm, given that the customer base includes a large proportion of customers with low financial resilience. The FCA has, however, also criticised the high charges in unauthorised overdraft fees and the rent-to-own sector, among others.

Insurance pricing practices were criticised by the FCA in the General Insurance Pricing Practices Market Study (MS18/1.3)[2] for several reasons including ‘price walking’, the practice of charging loyal customers more to take advantage of a behavioural bias – inertia – where customers prioritise convenience and it is less likely that they will switch to a lower priced product. This and other failures led the regulator to believe that TCF had failed, and a new, stronger set of standards were required – which would form the Consumer Duty.

1.3: The Scope of the Duty

The importance of the Duty to the financial services industry is encapsulated by its wide scope; the Duty applies to all firms in the distribution chain where they have a material impact on the outcomes received by customers. However, there are a number of factors to take into consideration.

Regulatory perimeter

In its Final Guidance FG22/5 the FCA confirmed that the scope of the Duty is limited to the regulatory remit of the FCA meaning only firms conducting activities in the UK are in-scope. This means that only firms holding FCA permission, or temporary permissions under the post-Brexit temporary permissions regime, are subject to the Duty. It is accepted that in some cases it will mean the Duty does not apply to some firms in the distribution chain.

It should be noted that where the distribution chain involves a company operating out of Gibraltar, the Duty still applies. At the time of writing the aim is for a Gibraltar Authorisation Regime (GAR) to be established. This will enable UK market access for specified financial services firms and it is expected that the GAR will align its rules with the FCA’s.

The Duty generally only applies to activity under the FCA’s supervision, therefore activity falling outside of their remit, such as unregulated business lending, is not subject to the Duty.

Some unregulated activity can fall within the scope of the Duty. Where an unregulated activity is required as part of the delivery of a regulated activity (i.e. an ancillary activity) then it will be subject to the Duty. However, the sale of an unregulated product, separate and distinct from the regulated product, even if sold at the same time, is not subject to the Duty.

Retail Market Business

Principle 12 and 2A apply to a firm’s retail market business in respect of both open and closed products. In this case, the term ’retail market business’ means products and services which are offered to ‘retail customers’. The FCA has chosen to align the definition of retail customers with the FCA Handbook, it therefore differs depending on the sector the organisation operates in. The FCA offer the following summary in FG 22/5:

For consumer credit, the Duty applies to all regulated credit-related activities.
For deposit-taking activities, the Duty applies to consumers, micro-enterprises, charities with a turnover of less than £1 million and a natural person acting in a capacity as a trustee if acting for purposes outside their trade, business or profession (in line with the ‘banking customer’ test in the Banking Conduct of Business Sourcebook (BCOBS)).
For insurance, the scope follows the position in the Insurance Conduct of Business Sourcebook (ICOBS). The Duty does not apply to reinsurance, contracts of large risk sold to commercial customers or other contracts of large risk where the risk is located outside the UK. Nor does it apply to activities connected to the distribution of group insurance policies or the extension of these policies to new members.
For investments, the Duty applies to business conducted with a customer who is not a professional client, as set out in the Conduct of Business Sourcebook (COBS).
For mortgages, the Duty follows the position in the Mortgage Conduct Business Sourcebook (MCOB). The Duty therefore applies to all regulated mortgage contracts within the perimeter but not, for example, unregulated buy-to-let contracts or commercial lending. Where the owner of a mortgage book is unregulated and the regulated party is an administrator, the Duty would apply in an appropriate and proportionate manner to the administrator’s function.
For payment service or e-money providers, the Duty applies to business conducted with consumers, micro-enterprises and small charities (where the definitions of these terms are the same as for deposit takers, as noted above).[3]

It is, then, clear that the scope of the Duty goes beyond customers who have purchased or used a product or service. Firms providing information to or answering questions of a prospective customer, handling an application or even a complaint, will need to comply with the Duty.

It is more difficult to ascertain whether financial promotions are within the scope of the Duty in so far as they don’t necessarily result in the onboarding of a retail customer. Therefore, the test which must be applied, under PRIN 3.2.6, is whether the promotion is likely to be received by a retail customer.

Where products are sold to both retail and non-retail customers, and it is impossible for the firm to separate the two in the design or delivery of that product, the FCA have confirmed that the Duty should be applied and, in this situation, products sold to non-retail customers are not excluded.

Distribution chain

Throughout the Duty the terms ‘distribution chain’, ‘manufacturer’ and ‘distributor’ are used repeatedly. The purpose of the regulator’s use of the terms is to make it clear that adherence to the Duty is not reliant on the organisation having a direct relationship with the retail customer, instead any organisation which has a material impact on the service received by the retail customer falls within scope.

The FCA define the distribution chain as “from product and service origination through to distribution and post-sale activities. By the ‘distribution chain’, we mean all firms involved in the manufacture, provision, sale and ongoing administration and management of a product or service to the end retail customer” (FG 22/5). Only those who do not have a ‘material influence’ will be out of scope. Firms that have a material influence are those which determine the design or operation of retail products or services, including their price and value, distribute the product or service, prepare and/or approve communications that are to be issued to retail customers, or those that engage in customer support for retail customers.

See Chapter 2 for further information on the different roles in the distribution chain.

Wholesale markets

The FCA, in Final Guidance FG22/5 state “the Duty applies to all firms that can determine or have a material influence over retail customer outcomes. This could include firms in the wholesale market, even if they do not have a direct relationship with retail customers.”^[4]

Instead, firms need to look at their role in designing products. A wholesaler that creates a structured product for distribution in the market will fall under the scope of the Duty, whereas one that provides only elements of a product, which are then pieced together by an independent third party to form a product, will not be subject.

In the guidance document the FCA lists the following as excluded from the Duty:

Manufacture of products or services only for wholesale purposes, where they meet the conditions in the ‘retail market business’ definition.
Activities relating to non-retail financial instruments.
Market activities for certain financial instruments meeting the criteria in the ‘retail market business’ definition.
Activities relating to insurance contracts of large risks for commercial customers or where the risk is located outside the UK.
Activities connected to the distribution of group insurance policies or the extension of these policies to new members.
The regulated activity of administering a benchmark, any ancillary activity to that activity and any activities undertaken by a benchmark administrator for the purpose of complying with the Benchmarks Regulation.[5]

Other points to note

While the Duty is not retrospective in so far as it does not apply to activities that took place prior to July 2023, it does apply to products and services already created and sold to customers or those still on sale. Such products are captured by the product review requirement under the products and services outcome, this will be explained in later chapters.

Where the manufacturer or distributor are already subject to product governance requirements those requirements will continue, the Duty does not intend to over-ride such requirements. For example, PRIN 2A.3.1G states “The product governance obligations on firms under Principle 12 are general in nature and should be considered alongside any other legal or regulatory obligations that may apply, for example any marketing restrictions in relation to the product”. In other words, the Duty applies in addition to existing requirements, and will not impact on those requirements, although the firm will need to ensure the expectations of the Duty are fully met.