The much-anticipated Balanced Scorecard Framework for determining the remuneration of representatives and supervisors in the financial advisory industry came into force on 1 January 2016. The framework is a major development and is likely to transform the industry. This article seeks to explain the framework and its challenges.

The Balanced Scorecard Framework for Financial Advisers:
A Pandora’s Box?



Introduction

It was some seven years ago when the collapse of Lehman Brothers led to the structured products crisis which impoverished countless investors around the globe. The ensuing years witnessed a slew of regulatory changes. In Singapore, the most significant of the changes so far as relates to conduct of business (“COB”) include, chronologically:

1.    the issuance of the Guidelines on Fair Dealing¹ by the Monetary Authority of Singapore (“MAS”);

2.    the extension of the Consumer Protection (Fair Trading) Act² to financial products;

3.    the issuance of the MAS Tenets of Effective Regulation;³

4.    the issuance of a new Notice on Recommendations on Investment Products⁴ to deal with, inter alia, clients’ investment knowledge and enhanced due diligence for complex products; and

5.    the addition of a regulation 18B to the Financial Advisers Regulations to deal with management responsibility for the approval of new products.

The Balanced Scorecard Framework (“BSF”), the culmination of a consultative process⁵ which began in October 2014, is the latest of the new regulatory measures.

The change is effected through four⁶ instruments:

1.    An amendment to the Financial Advisers Act⁷ (“FAA”);

2.    The Financial Advisers (Remuneration) Regulations 2015⁸ (“FARR”);

3.    MAS Notice FAA-N20⁹ (on BSF); and

4.    MAS Guideline FAA-G14¹⁰ (on BSF).

The FAA is amended by the introduction of s 22A, which requires financial advisers (“FA”s) to have remuneration systems (for their representatives and supervisors) which are in accordance with FARR and MAS regulations. The amendment adds a Division 5, on remuneration, wherein s 38 requires an FA to establish and maintain the said remuneration framework and s 39 requires an FA to have an independent sales audit unit (“ISA unit”). The contravention by an FA of its BSF obligations is a serious offence and attracts a fine not exceeding $25,000.¹¹

The FARR essentially says¹² that payment under remuneration systems other than the BSF is not allowed apart from exempted categories, namely FAs and representatives who are exempted from ss 25, 26, 27 and 36 FAA and the counterpart MAS Notices¹³ and service/sale to accredited investors, expert investors and institutional investors.¹⁴ Remuneration which is “not dependent, directly or indirectly” on the number or value of contracts, and thus not “variable income”,¹⁵ is also exempted¹⁶ as is remuneration in relation to the products within the Schedule.¹⁷

Notice N20 is one of the two key pieces of regulation (the Guidelines being the other) as to the BSF. It provides for the workings of the BSF (and the ISA Unit) and emphasises the responsibility of the senior management in relation to the BSF. The Notice has three annexes: Annex 1 which specifies the non-sales KPIs, Annex 2 which contains the Quarterly Report Form¹⁸ and Annex 3 which provides detailed worked examples of such a report.

The Guidelines reinforce and add to the Notice, providing details on the full workings of the BSF, including documentation review, client surveys, classification of infractions and the consequences of classification.

The Guidelines also have three annexes – Annex 1 on documentation reviews, Annex 2 on client surveys and Annex 3 on examples of Category 1 (or major) infractions.

BSF – Concept and Philosophy

The balanced scorecard is essentially a performance management tool or system.¹⁹ Popularised by Kaplan & Norton, it adds non-financial performance measures or indicators to the financial metrics in order to give a more “balanced” view of performance.²⁰

As explained by MAS in its consultative paper,²¹ the aim of the BSF:

… is to better align the interests of FA representatives and supervisors with that of their customers and minimize conflicts with customers’ interests that are inherent in volume-based remuneration arrangements (emphasis added).

A representative must take reasonable steps to conduct a sufficient fact-find to understand the circumstances and needs of his clients.

A representative must have a reasonable basis for any recommendation made to a client and must take into account the client’s financial objectives, investment horizon, risk profile, financial situation and particular circumstances and needs.

a.    meets the financial objectives of the client?

b.    is affordable to the client?

c.    is aligned with the client’s investment horizon?

d.    matches the client’s risk profile?

e.    takes into account the client’s concentration risk? or

f.    takes into account the particular needs of the client?

This set of questions is of great importance. In carrying out the review and assessment, the ISA Unit makes a judgment on whether the representative’s recommendation is suitable for the client. Does the recommendation/product meet the client’s objectives or does it not? Does it match the client’s risk profile or does it not? But the fundamental question is: does an inquiry into suitability necessarily lead to a binary result – that the recommendation/product is either suitable or unsuitable? For sure, there will be instances where this binary approach would work, such as where the client wishes to have a capital guaranteed product but the representative recommended a non-capital guaranteed product²⁹ or where a representative recommends an insurance plan where the monthly premium exceeds the client’s monthly disposable income.³⁰

But quite often, it may lead to a range or spectrum of results, such as clearly unsuitable/unsuitable/suitable/clearly suitable/most suitable? If so, then pushing for a binary result may lead to inaccuracy and unfairness.

Another difficult question is – are all representatives measured by one standard as to product suitability? Are all representatives held to the same standard of knowledge and expertise, or should the enquiry take into account their years of experience? There is no easy answer.

Annex 2 of the Guidelines follows up with this pertinent and very direct question for the client survey: “Did you understand the representative’s explanation as to why the product is suitable for you?”

Adequacy of Information Disclosure

KPI 3 is essentially a combination of the product disclosure requirements of s 25 and s 26 of FAA (and the relevant MAS Notices),³¹ namely that the representative must disclose all material product information and must not make false or misleading statements. Annex 1 of the Guidelines follows up with these matters with a checklist whilst Annex 2 goes into greater detail as to disclosure of key aspects of particular products such as structured deposits, unit trusts and bonds.

Professional and Ethical Conduct

KPI 4 is titled “Standards of professionalism and ethical conduct in relation to the provision of financial advisory services” and the text explains that unprofessional and unethical acts, other than those under non-sales KPIs refer to:

(a)    acts involving fraud, dishonesty, or other offences of a similar nature, misrepresentation, or acts involving non-compliance of regulatory requirements or serious breach of the FA’s internal policy or code of conduct which would render the representative liable to demotion, suspension or termination of the representative’s employment or arrangement with the FA; and

(b)    acts that impinge on the fitness and propriety of representatives set out in the Guidelines on Fit and Proper Criteria (FSG- G01).

The ambit of KPI 4 is certainly very wide. It is observed that the items in para (a) overlap substantially with KPIs 1 to 3.

Paragraph (b) in substance is similar to KPI 4, on professionalism and ethics. The specified³² fit and proper criteria cover a broad spectrum of qualities – honesty, integrity, reputation, competence, capability and financial soundness. It is worth adding, at the risk of repetition and overlap, that FA and his representatives are expected to perform their functions “efficiently, honestly and fairly” and “in the best interests of its clients”.³³

The ISA Unit’s mandate and task, in this regard, is extremely broad. Annex 3 of the Guidelines gives examples of unprofessional and unethical conduct and they include:

1.    Falsifying client’s responses in the fact-find form in order to place the client in higher risk category;

2.    Delaying an execution of a client’s instruction in order to accumulate the representative’s sales volume for the next quarter;

3.    Asking a client to pre-sign a blank fact-find form;

4.    Harassing a client who is not interested in purchasing any product; and

5.    Failing to meet a client but instead asking an unauthorised person to meet him.

Some guidance is also given in Annexes 1 and 2 of the Guidelines.³⁴

The Workings of the BSF

The BSF envisages a system whereby the sales transactions and performance of all representatives and supervisors are regularly checked and assessed by an independent sales audit unit (“ISA Unit”) and overseen and acted upon by the FA’s board and senior management.³⁵

As the name suggests, the ISA Unit has to be independent of the financial advisory services unit (or sales unit) which it audits; it must not directly or indirectly supervise or manage the conduct or performance of the representatives it is auditing.³⁶

Equally important, the persons in the ISA Unit need to be competent (a point to which we will return). They must be able to review the quality of the services against the non-sales KPIs and determine (correctly and fairly) if infractions have been committed.³⁷ The ISA Unit’s responsibilities can be done internally, such as by its compliance or risk management department/unit, or outsourced to a third party provider.³⁸

The role of the ISA Unit is to perform quarterly review and assessment on representatives and supervisors. The tasks are:

1.    To carry out post-transactions checks on sampled³⁹ transactions, using documentation reviews and client surveys (via phone calls, face-to-face interviews, written surveys and electronic surveys);⁴⁰

2.    To classify infractions uncovered by the post-transaction checks as either Category 1 infractions or Category 2 infractions; and

3.    To report to the FA.

In addition to infractions uncovered by the ISA Unit’s post-transaction checks, the FA is also required to act on findings from mystery shopping exercises conducted and complaints it has received.⁴¹ Where the FA’s review and assessment conclude that infractions have been committed, such infractions must also be included in the BSF report.

Classification of Infractions

The BSF is concerned with uncovering infractions in relation to the non-sales KPIs. The Notice classifies the infractions into Category 1 infractions, Category 2 infractions and “disregardable” infractions.

A Category 1 infraction is one which has “a material impact on the interests of the client” or which impinges on the fitness and propriety of the representative.⁴² So the infraction can be regarded as serious either in terms of how it affects the client or how it reflects on the conduct of the representative. The Notice gives five examples of Category 1 infractions:⁴³

1.    Recommending a product that is “clearly unsuitable” for the client;

2.    Unnecessary switching of products and for the representative’s benefit;

3.    Failure to provide or explain information which, if had been disclosed to the client  “would have resulted” in the client not purchasing the product;

4.    Failing to execute a client’s instructions without valid cause and the failure resulted in the client incurring “material losses”; and

5.    Where the representative has carried out any act of “misrepresentation, gross negligence or serious misconduct”.

Some observations are in order here.

Example (1) speaks of a “clearly unsuitable” recommendation. Does this suggest that a borderline unsuitable recommendation is not a Category 1 infraction?

Examples (3) and (4) encapsulate the concept of causation – the infraction must cause⁴⁴ loss to the client. This is an interesting concession towards the representative. Note, in contrast, that a failure to disclose material product information is an offence under s 25(5) FAA even if it did not result in loss to the client.

Example (5) lists misrepresentation, gross negligence and serious misconduct as Category 1 infractions. The terms appear to suggest that only grave errors – gross negligence in contrast to ordinary negligence and serious misconduct as opposed to not so serious conduct – are Category 1 infractions. However, misrepresentation covers a spectrum of culpability – fraudulent, negligent and innocent. Arguably, only fraudulent and grossly negligent misrepresentations should count as Category 1 infractions. Negligent and innocent misrepresentations should perhaps be Category 2 infractions.

Category 2 infractions are infractions in relation to the four non-sales KPIs but in circumstances where the infractions are not so serious.⁴⁵

Apart from Category 1 and Category 2 infractions, there is a category of “disregardable” infractions. These are “minor lapses or administrative oversights … which [do] not affect client’s interest or impinge on the fitness and propriety of a representative”.⁴⁶ In such cases, the FA “may allow” the ISA Unit to not consider them as infractions. The Notice gives a simple example of the representative not filling in the name of the client’s dependants where such failure did not affect the result of the needs analysis.⁴⁷

Just as the line between Category 1 and Category 2 infractions is difficult to draw, it can also be challenging trying to distinguish between Category 2 infractions and disregardable infractions.

Grading of Representatives and Supervisors

The framework also envisages that each representative is assigned⁴⁸ a grade ranging from A to E, and that his entitlement to remuneration will be correspondingly affected by the grade. For example, an A grade representative is entitled to 100 per cent of his “specified”⁴⁹ variable income whilst an E grade representative will receive 0 per cent to 25 per cent.⁵⁰ An E grade representative is one who is guilty of one or more Category 1 infractions or 30 per cent or five cases (or more) of Category 2 infractions. Grade A to B representatives are those who may have varying lesser degrees of Category 2 infractions.⁵¹

An E grade also attracts the dire consequence of being placed under close supervision by the FA’s CEO or his designate; this close supervision includes being accompanied by a supervisor for at least five closed sales and being subject to full-scale post-transaction checks by the ISA Unit for every transaction for at least three months.⁵² The representative is also not allowed to perform any supervisory or managerial role for at least a year.⁵³ It is also possible that prosecution and regulatory sanctions may follow.

Supervisors are also graded. The grading of a supervisor considers the total percentage of variable income of all the representatives under his charge and assigns a grade according to the band of percentage. The range is as follows: Good (75 per cent to 100 per cent), Satisfactory (50 per cent to 74 per cent), Fair (25 per cent to 49 per cent) and Unsatisfactory (0 per cent to 24 per cent).⁵⁴ In short, a supervisor’s grading correlates with the balanced scorecard performance of his representatives. Likewise, the supervisor is entitled to the same percentage of variable income as his representatives.⁵⁵

The consequence of obtaining an Unsatisfactory rating is that the FA must review the supervisor’s oversight of his representatives to ascertain if it is adequate and, where appropriate, reduce the number of representatives under his supervision or impose a moratorium on the supervisor’s recruitment of new representatives.⁵⁶ The FA’s CEO is responsible for this review.⁵⁷

Further, where a direct supervisor of an E representative is assigned an Unsatisfactory grade in the same quarter as the E representative, the role of supervising that E representative must be performed by a supervisor in a higher tier who has not been assigned an Unsatisfactory grade.⁵⁸

In addition, the FA must assess the fitness and propriety of every E representative and every Unsatisfactory supervisor and, if necessary, take appropriate disciplinary action against him.⁵⁹

In summary, the FA has the responsibility to set up, maintain and oversee a BSF. Through and with the ISA Unit, the board and senior management have to:

1.    regularly review and assess the transactions of representatives;

2.    classify infractions uncovered by the review (as well as by mystery shopping exercises and complaints);

3.    grade the representatives and supervisors;

4.    determine the percentage of variable income they are entitled to and recover unentitled amounts from them;

5.    take remedial action on transactions affected by infractions;

6.    scrutinise and watch over representatives and supervisors with poor grading; and

7.    submit regular reports to MAS.



Quarterly Balanced Scorecard Report

The BSF and all its workings culminate in comprehensive and detailed quarterly reports in the format set out in Annex 2 of the Notice, from the FAs to the MAS. The compendious quarterly report should include the following data and information:⁶⁰

1.    Number of representatives and their grades, number placed under closed supervision, number with grades of B and lower, amount of variable income that representatives were not entitled to, details of infractions by E representatives, appeals and results of appeals;

2.    Number of supervisors and their grades, details of supervisors grade Satisfactory or worse, amount of variable income not entitled, appeals and results of appeals; and

3.    Statistics of client surveys, method of sampling, and number of cases of infractions uncovered through various processes.

The reports are to be submitted within two calendar quarters of the quarter being measured.⁶¹ The time lag is sensible as no doubt an immense amount of effort and time will go into the preparation of the quarterly BSF reports by FAs and to the scrutiny of and response to these reports by MAS.

As might be expected, the board and senior management of the FA are accountable for the implementation and workings of the BSF.

The Role of Pre-transaction Checks

Fully cognizant of the severe consequences of infractions (especially Category 1 infractions) being uncovered by the BSF, the MAS counsels, in the Guidelines, the use of pre-transaction checks by supervisors. Paragraph 26 suggests in clear and strong terms:

… a financial adviser should require its supervisors to review all the documentation and basis of every recommendation made or transaction handled by its representatives during the pre-transaction stage (emphasis added).

Pre-transaction checks would help to minimise the impact of the (BSF) as any infraction uncovered by a supervisor during pre-transaction checks will not be factored into the (BSF) and will not affect the remuneration of the representatives as well as that of their supervisors.

It appears that pre-emption, through the conscientious use of pre-transaction checks, may be the key to the smooth operation of the BSF.

The pre-transaction checks should include documentation review and client call-backs.⁶² The checks can be carried out by internal non-sales staff or by third party providers or by a system-based method and should be completed by the effective date of the transaction or within a short time thereafter.⁶³

Where a product is found to be unsuitable during the pre-transaction checks, the FA must allow the client to modify or cancel his transaction without any loss or cost to the client.⁶⁴

Comments

The BSF is a major development in the regulation of financial advisers. Conceptually and philosophically, it is sound – it is right that performance and the reward for performance of representatives and supervisors should be assessed holistically. Pragmatically, it is sensible and effective as it targets misconduct by representatives and their supervisors. But there are challenges.

In the first place, the BSF depends on the quantitative assessment of qualitative performance, which is always a difficult thing. We have seen, for example, that a recommendation may not be simply suitable or unsuitable but instead involve a spectrum, such as clearly unsuitable/unsuitable/suitable/ clearly suitable/most suitable.

We see a similar struggle as the line between Category 1 and Category 2 infractions is sought to be drawn through the thresholds of “material” impact, “gross” negligence and “serious” misconduct. But the law always has to grapple with the issue of threshold, resorting to the aforementioned terms as well as others such as “major”, “grave” or “excessive”.

Further, a KPI such as fitness and propriety is inherently general and vague and lends itself to discretion and subjectivity.

So the competence of the persons within the ISA Unit is critical. They need to have a very good grasp of the legal and regulatory COB framework in general and of the conceptual framework and criteria of the BSF in particular. Next, they have to have good appreciation of the dynamics of the due diligence and sales process within which representatives and supervisors work in order to know what is actionable and practical and what is not. Third, as they carry out their checks and fact-finding, they need to be adept in seeking out and ascertaining the veracity of evidence. Finally, as they apply their understanding of the legal and regulatory requirements to the facts as ascertained, they need the skill and judiciousness to accurately and fairly classify the infractions uncovered and, if its their assigned task, to fairly grade the representatives and supervisors and assign the appropriate percentage of remuneration entitlement.

One result of the BSF is that infractions, including serious infractions will be uncovered and that negative consequences will follow. The conscientious implementation of pre-transaction checks will go a long way to reduce and soften the fear and apprehension of those who are subject to the system. Prevention is a lot less painful than cure.

It is clear that a very substantial amount of resources and time will be expended for the purposes of the BSF. The challenge is to not impose an inordinately huge burden without reaping corresponding benefit.

Concluding Remarks

The introduction of a balanced scorecard framework into the financial advisory industry is a laudable and ambitious initiative. The move, however, is not a simple one and may be likened to the opening of a Pandora’s box. If implemented with the requisite skill, reasonableness and good sense, the BSF can turn out to be a positive and desirable development and a significant and concrete step in the aspiration towards fair dealing.



►    Low Kee Yang
       Associate Professor of Law
       Singapore Management University
       E-mail: [email protected]

Notes

1 FAA-G11.
2 Cap 52A.
3 Issued in June 2010 and revised in April 2013.
4 FAA-N16.
5 See Consultation Paper P022-2014: “Consultation on: (1) Draft Legislation and Proposed Legislative Amendments to Effect the Policy Proposals under the Financial Advisory Industry Review; and (2) Proposed Legislative Amendments to Authorise Inspections by Foreign Regulatory Authorities under the Financial Advisers Act and the MAS ‘Response to Feedback Received…’ issued on 11 May 2015”. The BSF was one of the many matters which the Consultation dealt with.
6 A point may fairly be made that the changes could have been effected through fewer instruments.
7 Cap 110.
8 S 816/2015.
9 Issued on 31 December 2015.
10 Issued on 31 December 2015.
11 Section 38(7). It is also an offence to have terms in a representative’s or supervisor’s remuneration arrangement which are inconsistent with the BSF: s 38(3).
12 The FARR does not specifically mention the BSF; instead it refers to s 22A(1) of the FAA: reg 3(1).
13 Regulation 3(2).
14 Regulation 3(3).
15 The term “variable income” is defined in para 2.1 of the Notice as remuneration which “varies and is directly dependent, wholly or partly” on the number or value of investment products provided to the client.
16 Regulation 3(4).
17 Regulation 3(5)(a). Pure protection policies are also exempted: reg 3(5)(c).
18 The Annex includes many tables that need to be prepared. There are three sections to the Report – Section A (Representatives), Section B (Supervisors) and Section 3 (General)
19 For many companies and institutions, it has evolved into something bigger – a total strategy management system.
20 See eg Robert S. Kaplan & David P. Norton, “Using the Balanced Scorecard as a Strategic Management System” (Jan-Feb 1996) 76 Harvard Business Review.
21 At para 26.
22 Paragraph 10.1 of Notice. It would be more accurate to say that it disincentivises unfair dealing.
23 Paragraph 10.2 of Notice.
24 Paragraph 4.2.2 of Notice.
25 Notice No. FAA-N16, more specifically, in para 11.
26 The third option is “Not applicable”.
27 This concern extends to the client survey in general.
28 It should be noted that, for “selected clients” (clients who are vulnerable on account of age, language or educational qualifications: see para 4 of Guidelines), the Annex suggests additional safeguards of call-back (by the supervisor) and closer scrutiny.
29 Scenario (a) of Example 2 of Annex 3 of the Guidelines.
30 Scenario (c) of Example 2 of Annex 3 of the Guidelines.
31 Annex 1 of the Notice refers to the Notice on Information to Clients and Product Disclosure (FAA-N03), the Notice on Dual Currency Investments (FAA-N11) and the Guidelines to Structured Deposits (FAA-G09).
32 Paragraph 8 of the Guidelines on Fit and Proper Criteria, FSG-G01, says they “include but are not limited to” the stated qualities.
33 See s 9(1)(j) and (n) of the FAA.
34 The very general question in Annex 2 – “Were there any aspects of the sales process that you were dissatisfied with?” may invite responses which are unintended, such as those which are excessive, unreasonable or unfair. Presumably, the ISA Unit will deal with them appropriately.
35 The term “senior management” refers to executive directors: see reg 18B(9) of the FAR. The Notice adopts the same meaning as the FAR: para 2.2 of Notice.
36 Paragraph 3.1.1 of Notice.
37 Paragraph 3.1.1(c) of Notice.
38 Paragraph 3.1.2 of Notice.
39 According to the sampling methodologies specified in para 4.4.2 of the Notice.
40 Paragraph 3.2 of Notice and paras 7, 9 and 10 of Guidelines.
41 Paragraph 4.4.3 and 4.4.4 of Notice.
42 Paragraph 4.5.3.1 of Notice.
43 Paragraph 4.5.3.2 of Notice.
44 Quare: what if in example (3) the client would have purchased less of the product? Would the infraction then be a Category 2 infraction?
45 It is observed that the Notice and the Guidelines avoid giving examples of Category 2 infractions.
46 Paragraph 4.5.5.1 of Notice.
47 Paragraph 4.5.5.1 proceeds to say that where such lapses are prevalent, the FA should assess whether they impinge on the fitness and propriety of the representative.
48 Although it is not clear from the Notice or the Guidelines whether this grading should be performed by the ISA Unit or by the board and senior management.
49 The Notice specifies the proportion of variable income which is to be measured against the non-sales KPIs for representatives and supervisors. A representative who is remunerated by variable income only shall have only 60 per cent of his variable income measure against the non-sales KPIs whereas one who has a fixed salary and variable income shall have all of his variable income measured against the non-sales KPIs: para 4.3.1. The proportion for supervisors is broadly similar: see para 5.2.
50 See the table at para 4.6.1 for the full details.
51 See the table at para 4.6.1 of Notice.
52 Paragraphs 15 and 16 of Guidelines.
53 Paragraph 18 of Guidelines.
54 See para 5.5 of Notice.
55 Paragraph 5.3.1 of Notice.
56 Paragraph 19 of Guidelines.
57 Paragraph 20 of Guidelines.
58 Paragraph 17 of Guidelines.
59 Paragraphs 14 and 20 of Guidelines.
60 Paragraph 9.2 of Notice.
61 Paragraph 11.1 of Notice.
62 There are additional controls in respect of “selected” clients and “selected” representatives: see para 27(b).
63 See paras 29 and 30 for details.
64 Paragraph 31.