INTRODUCTION

On 5 September 2012, Martin Wheatley, the managing director of the FSA and CEO designate of the Financial

Conduct Authority1, announced the findings of the FSA's review of financial incentivisation of sales staff and the risk

of mis-selling to customers at UK firms. The document incorporates findings from a thematic review of incentive

schemes and incorporates draft guidance on which the FSA is consulting. The review also provides important insight

into the FSA's robust expectations of firm conduct in this area, a focus for the regulator moving forward.

Following on from the review, the FSA expects that firms who incentivise their sale staff:

1. assess their incentive schemes for the risk of mis-selling;

2. review the monitoring and control mechanisms in place around the schemes; and

3. change any schemes or monitoring processes that do not comply with the FSA's expectations.

BACKGROUND

The Principles of Business of the FSA2 require firms to design incentive schemes in such a way as to align them with

the requirements of the Principles and minimise the risk of mis-selling products to customers.

Martin Wheatley noted that incentive schemes used by firms involved in PPI mis-selling3 to motivate their staff were

"rotten to the core" and that this had led to a deficit of trust between the public and the financial services industry. To

address this, the FSA investigated 22 firms of various sizes and found that in almost all cases4 incentive schemes

were driving mis-selling of products and around half of the firms were not mitigating this risk correctly5.

FSA PUBLISHES GUIDANCE CONSULTATION ON RISKS TO CUSTOMERS FROM FINANCIAL INCENTIVES

1 Any reference to the FSA in this document may be read as a reference to the FCA when it assumes its conduct regulating role in early 2013. 2 Principle 3 provides that "a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management

systems." 3 The FSA considers mis-selling as an unfair outcome for the customer in terms of their treatment, lack of understanding of the product, being supplied with

misleading information or being recommended unsuitable products on an advice basis. 4 20 out of 22 firms had incentives in place that "increased the risk of mis-selling". 5 11 out of the 20 firms with an increased risk of mis-selling were not "properly addressing" this risk.

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GUIDANCE: SCHEMES THAT INCREASE MIS-SELLING RISK

The FSA found that mis-selling was more likely where the value of the incentive increases with sales and/or where the

incentive makes up a high proportion of the remuneration package staff receive. Across all types of schemes, the features

that presented the highest risk of customer detriment were in schemes where one or more of the following was true:

1. the incentive was calculated on fee or sale volume;

2. the structure of the incentive was complicated;

3. senior management did not understand the complexity of the scheme; and/ or

4. there was an insufficient link between detected mis-selling and eligibility for the scheme.

The FSA also gives non-exhaustive examples of incentive structures that it found to pose the highest risk of driving mis-

selling. The table below outlines these examples:

The FSA describes taking strong action against poor sales quality or mis-selling as good practice in respect of structuring

and managing incentive schemes. This includes excluding non-compliant staff from incentives altogether or deducting

bonus payments. This deterrent can also be combined with rewarding sales that are compliant and meet the needs of the

customer with an overall focus on sales quality and good customer outcomes. This is as distinct from schemes that reward

on volume of sales alone.

Scheme Mechanism Issues/Risks

Retrospective Accelerator Achieving sales targets

increases incentive earned

for the whole period rather

than only those sales above

the target.

The reward can be disproportionate, as in the case of one firm

which offered up to eight times bonus once the threshold was

reached which created a strong incentive for staff to mis-sell

payment protection products.

Accelerators (Stepped

Payments)

Incentive is only earned for

sales over a target.

As with retrospective accelerators, the reward can be

disproportionate and drive poor quality sales.

Incentive Bias Incentive is exclusively

earned on (or weighted in

favour of) certain product

sales with higher profit

margins.

The potential to earn more incentive may drive staff to sell

products that are not appropriate for the customers.

Variable Salary Salary levels are varied up or

down depending on

achievement of sales targets.

This may seriously impact the income that staff receive

depending on how much salaries vary. This may drive

inappropriate sales, for instance where staff are on the cusp of

going down a pay-band.

Thresholds Incentive is achieved only

where a percentage of

customers are sold a certain

product or products.

The FSA noted a firm where staff could earn 100% of their

salary as an incentive if they sold PPI to 50% of their customers,

which drove mis-selling to achieve that percentage.

Cross Selling Selling "add-ons" with

primary products is

incentivised.

This provides an opportunity for mis-selling where the primary

product sold may meet all the requirements of the customer.

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GOVERNANCE OF INCENTIVE SCHEMES AND MANAGING RISK

Martin Wheatley's announcement noted that the FSA is not seeking to ban incentivisation of staff outright but that it expects

firms to consider if their incentive schemes will drive mis-selling and inappropriate behaviour and put strategies in place to

address this.

The report outlines by example the following ways that this may be achieved and the expectations of the FSA:

Use of Management Information

Management should have access to sales data to allow monitoring of high risk staff and schemes and this data should be

used to assist with business quality monitoring (see below). An example of good practice given is a firm where a wide range

of detailed information was available to management for analysis. Poor practice may include insufficiently detailed

management information or failing to act on trends or spikes in sales patterns that indicate mis-selling.

Business Quality Monitoring

Firms should act on the management information they have to actively monitor staff and incentives. This should be

accompanied by appropriate action to address mis-selling where detected such as re-training or incentive exclusion. The

review notes that monitoring and assessment of sales and customer feedback should look at the outcomes for the customers

as well as the sales process.

Sales Managers' Conflicts of Interests

Sales managers who are incentivised on the performance of their staff should have any quality monitoring they undertake

checked independently to manage the resulting conflict of interest.

Governance

Senior management should have both visibility and understanding of incentive schemes with regular reviews being

undertaken to ensure that poor customer outcomes are minimised. Senior management should also approve incentive

schemes with this in mind with good practice being described as a firm where a senior manager was formally accountable

for representing customer interests in the design and review of incentive schemes.

FINAL THOUGHTS AND NEXT STEPS

Martin Wheatley's speech clearly warns that the FCA will be taking this issue and the general concern for treating

customers fairly forward as points of focus. There is therefore a clear expectation that all firms that incentivise their sales

staff should take heed and look inward to their processes and risk management.

In his announcement Martin Wheatley described a "cultural shift" towards considering issues form a consumer perspective,

indicating that a dim view will continue to be taken of mis-selling of investment products. This also suggests further, more

explicit regulation of how firms can incentivise their staff being implemented following the consultation. Firms should

therefore be prepared for tougher rules and more supervision by the industry regulator which may threaten to bring down

sales volumes and profits.

The consultation closes on 31 October 2012 with the FSA inviting any firm or person with an opinion on the management

of incentive schemes to provide feedback to financial.incentives@fsa.gov.uk.

If you have any questions about this briefing, implications for your business or would like to find out more about our

Financial Services Regulatory expertise, please contact:

Philip McEachen

Solicitor

T +44 20 7153 7713

philip.mceachen@dlapiper.com

Michael McKee

Partner

T +44 (0)20 7153 7468

michael.mckee@dlapiper.com

www.dlapiper.com

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