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COB 5.4 Customers' understanding of risk

Application

COB 5.4.1R

This section applies to a firm that conducts designated investment business with or for a private customer but does not apply to a firm when providing basic advice on a stakeholder product.6

Purpose

COB 5.4.2G

Principle 7 (Communications with clients) requires a firm to pay due regard to the information needs of its clients and communicate information to them in a way that is clear, fair and not misleading. Principle 9 (Customers: relationships of trust) requires a firm to take reasonable care to ensure the suitability of its advice and discretionary decisions. The purpose of this section is to ensure that a firm takes reasonable steps to ensure that a private customer understands the nature of the risks inherent in certain transactions.

Requirement for risk warnings

COB 5.4.3R

A firm must not:

  1. (1)

    make a personal recommendation of a transaction; or

  2. (2)

    act as a discretionary investment manager; or

  3. (3)

    arrange (bring about) or execute a deal in a warrant or derivative; or

  4. (4)

    engage in stock lending activity;

with, to or for a private customer unless it has taken reasonable steps to ensure that the private customer understands the nature of the risks involved.1

COB 5.4.3AG

A securitised derivative (as defined in the Glossary) is a derivative, and COB rules relevant to derivatives therefore apply. Firms should note that the Glossary definition of securitised derivative is slightly different from the definition in chapter 24 of the listing rules.7 An instrument listed under that chapter, which is not an option or contract for differences,7 is not a securitised derivative for the purposes of COB.2

COB 5.4.4E

The reasonable steps in COB 5.4.3 R should include the steps set out in COB 5.4.6 E to COB 5.4.12 E as appropriate, in relation to transactions in the following types of investment or activity:4

  1. (1)

    warrants and derivatives (see COB 5.4.6 E, COB 5.4.6A E or COB 5.4.6C E as appropriate);

  2. (2)

    non-readily realisable investments (see COB 5.4.7 E);

  3. (3)

    penny shares (see COB 5.4.8 E);

  4. (4)

    securities subject to stabilisation (see COB 5.4.9 E);

  5. (5)

    stock lending activity (see COB 5.4.10 E);5

  6. (6)

    a security or an investment trust savings scheme which satisfies the conditions specified in COB 3.8.9 G (6) (see COB 5.4.11 E);4

  7. (7)

    structured capital-at-risk products (see COB 5.4.12 E).2

COB 5.4.5E

Contravention of COB 5.4.4 E may be relied on as tending to establish contravention of COB 5.4.3 R.

Risk warnings in respect of warrants and derivatives (other than retail securitised derivatives and certain EEA listed derivatives)

COB 5.4.6E
  1. (1)

    In relation to a transaction in a warrant or derivative (other than a retailsecuritised derivative or an option or contract for differences to which COB 5.4.6C E applies), the firm should:

    1. (a)

      provide the private customer with the notice in COB 5 Annex 1 E (Warrants and derivatives risk warning notice); and

    2. (b)

      require the private customer to acknowledge receipt of the notice and confirm acceptance of its contents, in writing.

  2. (2)

    A firm need not undertake steps COB 5.4.6 E (1) (a) and (b) in respect of a private customer who is ordinarily resident outside the United Kingdom, if it has taken reasonable steps to determine that the private customer does not wish to receive the notice.

  3. (3)

    The notice in COB 5 Annex 1 E (Warrants and derivatives risk warning notice) need not be sent in relation to the realisation of a warrant that is already held by the private customer, or of a warrant attached to another designated investment.

  4. (4)

    For a firm acting as an outgoing ECA provider, the exemption contained in COB 5.4.6 E (2) applies only if the private customer is ordinarily resident outside the EEA and if the outgoing ECA provider has taken reasonable steps to ensure that the private customer does not want to receive the notice.23

Risk warnings in respect of retail securitised derivatives

COB 5.4.6AE
  1. (1)

    2In relation to a transaction in a retail securitised derivative, the firm should provide the private customer with:

    1. (a)

      the notice in COB 5 Annex 1 E (Warrants and derivatives risk warning notice); or

    2. (b)

      a copy of the listing particulars prepared for the securitised derivative in accordance with chapter 24 of the listing rules, in a manner calculated to bring to the attention of the private customer the description of risk factors required by paragraphs 24.36 and 24.37 of the listing rules (Disclosure about risk factors); or

    3. (c)

      a notice containing a clear, fair and adequate description of the securitised derivative which is to be the subject of the transaction, in a manner calculated to bring to the attention of the private customer the risks involved, and in particular (and if applicable):

      1. (i)

        that the securitised derivative gives rise to risks similar to those arising when an investor buys or sells an option;

      2. (ii)

        that the securitised derivative is 'geared' or 'leveraged', which means that a relatively small movement in the price of the underlying instrument, whether favourable or adverse, could result in a larger movement in the price of the securitised derivative;

      3. (iii)

        that the price of the securitised derivative may therefore be volatile;

      4. (iv)

        that the securitised derivative has a limited life, and may expire worthless if the underlying instrument (such as a share or index) does not perform as expected;

      5. (v)

        that, consequently, the private customer should not enter into the transaction unless he is prepared to lose all of the money he has invested, plus any commission or other charges;

      6. (vi)

        that the private customer should satisfy himself that the securitised derivative is suitable for him, in the light of his circumstances and financial position, and if the private customer is in any doubt he should seek professional advice; and

      7. (vii)

        a clear, fair and adequate description of any other relevant risks affecting the value, trading price, and realisation of the value of the securitised derivative.

  2. (2)

    A firm should either:

    1. (a)

      require the private customer to acknowledge receipt of the documentprovided in accordance with (1)(a), (b) or (c) and confirm acceptance of its contents, in writing; or

    2. (b)

      be otherwise able to demonstrate that the private customer has received the documentand had a proper opportunity to consider its terms.

  3. (3)

    A firm need not undertake steps (1) and (2) in respect of a private customer who is ordinarily resident outside the United Kingdom, if it has taken reasonable steps to determine that the private customer does not wish to receive the notice.

COB 5.4.6BG
  1. (1)

    2It is appropriate for a notice provided to a private customer in accordance with COB 5.4.6A E (1)(c) to explain, where applicable, the existence and extent of any factors that reduce the risks to which the private customer is exposed (for example, the fact that the securitised derivative is listed, or subject to some form of guarantee), but the firm should ensure that any such statement does not, obscure or diminish the significance of the notice taken as a whole.

  2. (2)

    The document provided to a private customer in accordance with COB 5.4.6A E (1) (b) or (c) may use another term (such as "covered warrant") to describe a securitised derivative, if it is generally accepted market practice to do so.

  3. (3)

    In relation to (1) and (2), firms are also reminded of the requirements of COB 2.1 (Clear, fair and not misleading communication).

Risk warnings in respect of certain derivatives listed in other EEA States

COB 5.4.6CE

2In relation to an option or contract for differences which is included on the official list of an EEA State other than the United Kingdom, a firm should comply with COB 5.4.6A E if:

  1. (1)

    the investment is not a contingent liability investment; and

  2. (2)

    (if it provides a right of exercise) the investment would comply with paragraph 24.7 of the listing rules (Method of exercising retail securitised derivatives), if it were listed on the UK official list.

Risk warnings in respect of non readily realisable investments

COB 5.4.7E

In relation to a transaction in a designated investment that is not a readily realisable investment, a firm should:

  1. (1)

    warn the private customer that there is a restricted market for such designated investments, and that it may therefore be difficult to deal in the designated investment or to obtain reliable information about its value; and

  2. (2)

    disclose any position knowingly held by the firm or any of its associates in the designated investment or in a related designated investment.

Risk warnings in respect of penny shares

COB 5.4.8E

In respect of penny shares, a firm should provide the risk warnings required by COB 3.9.17 G (12) (Investments that can fluctuate in value).

Risk warnings in respect of securities that may be subject to stabilisation

COB 5.4.9E

In respect of securities that may be subject to stabilisation, a firm should send to the private customer the notice in COB 5 Annex 2 E (Dealing in securities which may be subject to stabilisation) unless it has taken reasonable steps to establish that the customer requires an oral explanation only.

Stock lending activity

COB 5.4.10E

A firm should not engage in stock lending activity with or for a private customer unless it has notified him:

  1. (1)

    that this may affect his tax position and that he should consult a tax adviser before proceeding; and

  2. (2)

    of the consequences of the stock lending activity, including what impact it may have on the rights of the holder of the designated investments concerned.

4Risk warnings in respect of listed securities where gearing is involved

COB 5.4.11E

4In relation to a transaction in a security or an investment trust savings scheme for dealing in securities which satisfies the conditions specified in COB 3.8.9 G (6) a firm should provide to the private customer a notice to warn the private customer that the strategy which the issuer of securities uses or proposes to use may result in:

  1. (1)

    movements in the price of the securities being more volatile than the movements in the price of underlying investments;

  2. (2)

    the investment being subject to sudden and large falls in value; and

  3. (3)

    the private customer getting back nothing at all if there is a sufficiently large fall in value in the investment.

COB 5.4.12E
  1. (1)

    5Unless (2) applies, in relation to a transaction in a structured capital-at-risk product, the firm should provide the private customer with a notice containing a clear, fair and adequate description of the structured capital-at-risk product which is to be the subject of the transaction, in a manner calculated to bring to the attention of the private customer the risks involved, in particular (and if applicable):

    1. (a)

      that the return of initial capital invested at the end of the investment period is not guaranteed and therefore the private customer may get back less then what was originally invested;

    2. (b)

      that the amount of initial capital repaid may be geared, which means that a small percentage fall in the related index may result in a larger reduction in the amount paid out to the private customer;

    3. (c)

      that any maximum benefit advertised to the private customer is only available after a set period, indicating how long that period is;

    4. (d)

      that redeeming a product early may result in redemption penalties and a poor return;

    5. (e)

      that the initial capital invested may be placed into high risk investments, such as non-investment grade bonds;

    6. (f)

      that the rate of income or growth advertised to private customers may depend on specified conditions being met, indicating what these conditions are;

    7. (g)

      that the private customer should not enter into the transaction unless he is prepared to lose some or all of the money he has invested;

    8. (h)

      that the private customer should satisfy himself that the structured capital-at-risk product is suitable for him, in the light of his circumstances and financial position, and if the private customer is in any doubt he should seek professional advice; and

    9. (i)

      a clear, fair and adequate description of any other relevant risks affecting the value, trading price, and realisation of the value of the structured capital-at-risk product.

  2. (2)

    If the firm is acting as an investment manager, it should provide the notice referred to in (1) as part of its terms of business, but need not provide a notice before each transaction in a structured capital-at-risk product, provided that the structured capital-at-risk product is within the range of structured capital-at-risk products described in the terms of business.

COB 5.4.13G

In relation to a transaction in a structured capital-at-risk product, if it is relevant, firms should comply with COB 5.4.7 E.5