Client categorisation is an area where many people (including FSA authorised firms) are still confused. To be fair to them, it has changed a few times and there are several complications and clashing concepts.
For instance, it’s common to confuse concepts like ‘High Net Worth Individual‘ and ‘Sophisticated Investor‘ with client categorisation as retail, professional or eligible counterparty. In fact they are nothing to do with one another – many investors are both High Net Worth and Sophisticated but still retail investors.
Client categorisation is particularly important when an authorised firm does not have the permissions to deal with retail investors. If client categorisation isn’t handled properly, the firm can end up on the wrong side of the law.
All authorised firms must categorise their clients, so to start at the beginning; who is the client? A client is any person to whom the firm provides, or may potentially provide, a service in the course of carrying out a regulated activity. Even if services aren’t provided to them, a person to whom a firm communicates, or for whom a firm approves, a financial promotion is also a client (but a different kind of client and slightly different rules apply).
How a client is initially categorised depends on what sort of entity they are. Starting at the top and working down…
Eligible counterparties include investment firms, insurance companies, authorised collective investment schemes, pension funds, governments, central banks and supranational institutions (like the World Bank and IMF).
Professional clients include many of these same entities because eligible counterparties are only counted as such in respect of eligible counterparty business, the rest of the time, they are professional clients. This category also includes large businesses (how large depends on the services provided), trusts with asssets of more than €10m, and pension funds with more than 50 members.
Retail clients are everybody else – most SMEs and all individuals will be retail clients.
However, a retail client can ask to be treated as an ‘elective’ professional client. This means that they will be less well protected by the FSA’s rules and so authorised firms are required to ensure that such people qualify to make the change. The criteria for that qualification again depend on what kind of service is being provided.
For non-MiFID business, the firm must assess the expertise, experience and knowledge of the client to ensure that they are capable of making investment decisions and understanding the risks involved. Firms must have in place procedures and training to ensure such an assessment is adequate and must keep appropriate records. There must also be an exchange of correspondence between the client and the firm in order to effect the change.
For MiFID business, as well as the above, the client must be able to satisfy two of the following quantitative tests:
- they have carried out an average of 40 significant transactions on the relevant market in the last year;
- they have a cash and financial instrument portfolio of over €500,000;
- they have worked in the financial sector for at least one year in a professional position which requires knowledge of the transactions or services envisaged.
For many types of regulated activity, the first of these quantitative tests is highly unlikely to be met by even the most active investor. If so, for an authorised firm carrying out MiFID business that does not have permission to take on retail clients, the only individuals they can work with are essentially financial services professionals with portfolios over €500,000… and there just aren’t as many hedge fund managers as there once were!
Retail clients who choose to recategorise as professional always have the right to return to being retail clients. Indeed, all professional clients and eligible counterparties have the right to downgrade their categorisations and increase their potections.
As well as in relation to the provision of regulated services, client categorisation is important to financial promotions where communications which are likely to be received by retail clients must meet higher standards than others. If a promotion is approved so that it can be circulated by unauthorised firms, the approval must be limited to the client categories for which it is written. It is an offence under FSMA for a communication approved for professional clients to be distributed to retail clients.
If you are at all unclear about client categorisation, StypersonPOPEcan prepare a clear and straightforward procedure for you to follow. Please contact Simon Webber for an initial discussion on 07710 260 717 or firstname.lastname@example.org.