In this week’s post I would like to discuss the concept of Investment Advice. Unfortunately there is a big misconception on what a financial advisor’s role is in modern financial markets. Some investors have the incorrect idea that a financial advisor is there to tell you exactly what to do with your money and that every time they speak to an advisor it means that they have received advice.
In reality most investors do not even receive advice from their advisor but information. From a legal point of view there is a specific definition for what financial advice is and just because your broker told you that he/she has been selling the bond of XYZ limited lately it does not mean that he/she gave you advice to buy that financial product. Just because the features and characteristics of the product are explained to a client it does not mean that such client received advice to buy that product.
To go a step further, even if the advisor carries out an appropriateness test on a client whereby the advisor asks the client certain question to establish the knowledge and experience of the client in relation to a particular product, it still does not qualify as giving financial advice.
Financial services providers in Malta and across the EU are subject to the Market in Financial Instruments Directive or MiFID in short. This directive defines investment advice as follows:
“‘Investment advice’ means the provision of personal recommendations to a client, either upon its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments”
Thus, the directive is quite specific in what actually amounts to investment advice as opposed to other things such as promotion and sell or simply the provision of information. In order to clarify the concept further, the CESR (Committee of European Securities Regulators) in October of 2009 had published a consultation paper entitled “Understanding the definition of advice under MiFID” (Ref. CESR/09-665). In this paper it was established that for a service to amount to investment advice ALL of the following 5 tests had to be met:
- Does the service being offered constitute a recommendation?
- Is the recommendation in relation to one or more transactions in financial instruments?
- Is the recommendation at least one of the following: a) presented as suitable?; b) based on a consideration of the person’s circumstances?
- Is the recommendation issued otherwise than exclusively through distribution channels or to the public?
- Is the recommendation made to a person in his capacity as one of the following: a) an investor or potential investor?; b) an agent for an investor or potential investor?
In the rest of the post I will be going through the above 5 tests to elaborate more on what is being meant in more detail.
Test 1: Does the service being offered constitute a recommendation?
In specifying that a service will only amount to investment advice if it constitutes a recommendation, the Directive draws a distinction between providing advice and simply providing information. Advice requires an element of opinion, in contrast to the provision of information that does not make any comment or value judgement on its relevance to decisions which an investor may make.
Hence, when an advisor simply provides facts about a product such as the interest being promised, the maturity date, who the issuer is and what its business is, there is no element of advice yet. Even if an advisor explains to a client that the current interest rate scenario is one where investing into a long dated bond makes the investment more risky than investing into a short dated bond, this is still an element of fact and not an opinion.
In theory a recommendation not to buy a particular financial instrument could also amount to investment advice. However, all of the 5 tests mentioned also have to be met. Moreover, the recommendation not to buy a product has to be based on an opinion and not simply facts. Case in point, the recent Bank of Valletta Notes that are being issued at a rate of 3.50% fixed for 15 years. As I explained in a previous post (see link here), the fact that the bond is likely to be illiquid, and is long dated with a low fixed interest rate means that based on facts, and not simply an opinion, the bond presents a big liquidity and interest rate risk.
Test 2: Is the recommendation in relation to one or more transactions in financial instruments?
Both generic advice and general recommendations are not investment advice under the Directive. In the case of generic advice, the consultation paper explained that this is owing to the fact that they do not relate to a particular financial instrument. So as an example, if a financial advisors tells a client that based on what the client has explained to the advisor such client should invest in bonds – no financial advice has been given. The terms bonds, shares, commodities are too generic in nature and can relate to many different instruments at once. For example, buying a bond issued by the government of Venezuela and a bond issued by the Republic of Germany are both transactions in bonds, but it is easy to understand that they are quite different in terms of risk.
In contrast, general recommendations are not investment advice because, being addressed to the public in general, they are not by definition presented as suitable for, or based on an evaluation of the personal circumstances of, a particular investor. So if a client sees a billboard on the side of the road that is promoting the sale of a particular financial product this cannot be construed as being advice.
Test 3a: Is the recommendation presented as suitable?
If the presentation of the information seeks to influence the client’s choice then the firm might be making an implied personal recommendation. If a disclaimer does not change the nature of a communication, meaning that the communication would still create a reasonable expectation by the client that he/she is being advised, the firm may be viewed as providing investment advice. Thus, disclaimers cannot be relied upon, on their own, to ensure that a service does not involve presenting a recommendation as suitable.
If a person places special emphasis on the advantages of one product over others for a client, in a way that would tend to influence the decision of the recipient to select that particular product over others presented, this could well amount to investment advice. Again, it must be stressed that all the other 4 test must also be satisfied for the service to be deemed as being classified as investment advice. So if an elderly client who is retired and is reasonably assumed to be interested in fixed income products is presented with a product that offers a fixed income, this alone does not mean that investment advice has been given.
Test 3b: Is the recommendation based on a consideration of the person’s circumstances?
If a firm has information about a client’s circumstances, including information on areas like his investment objectives or financial situation (i.e. investment advice or the service of discretionary portfolio management had previously been given to the client), it might reasonably be expected that the information is being used to create a picture of the client’s needs and wants to form the basis of a recommendation.
In some cases, it would not be reasonable to expect that a firm will access and use all of the information that it may happen to hold about a client’s circumstances. However, if information on a client was collected recently, or indeed over time as part of an established relationship, a client returning to the firm for follow-on advice can reasonably expect his previous information to be taken into account.
A related issue is that some marketing activities could be inappropriately classified as investment advice, if they are distributed to existing clients on whom the firm holds information. In situations where those activities either involve the presentation of a financial instrument as suitable for an investor or where the firm is making a recommendation based on the consideration of a person’s circumstances, investment advice would have been provided.
It has to be stressed here that the recommendation must relate to something specific. So if for example all the clients of a firm who have previously invested in bonds are sent a mailshot about a new bond that is coming to the market, this alone does not necessarily classify as investment advice. If a letter is sent specifically to a client there would for sure have been a solicitation of the product by the investment service provider to the client. Thus an appropriateness test would need to be filled in since the service would not have been at the initiative of the client. However, this does not necessarily mean that investment advice was given.
Test 4: Is the recommendation issued otherwise than exclusively through distribution channels or to the public?
Not all messages to multiple clients would automatically constitute advice, but there are circumstances in which they could. Three elements that should be taken into account:
- the target audience (if the personal circumstances that led the individual to be contacted are highlighted);
- the content of the message (e.g. if it contains a solicitation or judgement regarding the advisability of the transaction); and
- the language used (e.g. the tone and the way it could be understood by the client).
Test 5: Is the recommendation made to a person in his capacity as an investor or potential investor?
Where the client’s primary purpose for seeking advice is in order to generate a financial return or hedge a risk, the client’s objective is patrimonial in nature and if advice is provided such advice would be deemed investment advice. Conversely, where the client’s primary purpose for requesting the advice is for an industrial, strategic or entrepreneurial purpose, the objective of the client is industrial, entrepreneurial and strategic in nature and the advice provided would be corporate finance advice and not investment advice.
The Bottom Line
The aim of this post is to clarify what is understood as investment advice from the perspective of MiFID. There is a big misconception about this topic in the local market and I hope this post helped to clarify issues that might not have been known to investors. As always please refer to my general disclaimer and note that this post was neither investment, legal or any other form of advice. Anyone interested in further discussions about this or any other topic covered in my posts can contact me on kd@financebykd.com.
KD