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Caveat Venditor 

(Article published in the May 30, 2007 issue of Manila Standard Today)  

This coming 8th of June, the Board of Directors of the Trust Officers Association of the Philippines will have a Mission/Vision/Planning session, which is expected to determine the trust industry’s directions in the near future.  TOAP President Marily De Vera, trust officer of Banco de Oro, invited me and she says “other industry elders”, to contribute our two cents’ worth to the enterprise. 

I am perversely delighted with the opportunity of saying what I think the future will bring from my vantage point of a tempus laudator acti and so I plan to attend.  However, since my presence is subject, of course, to the approval of the light of my life, Maria Angela Beatriz, I take this opportunity to share in advance how I think the industry winds will be blowing in the months and years to come.

The radical change (“paradigm shift”, used to be the buzz word) that is now going on in the Philippine financial regulatory scene is the departure from the rule of “caveat emptor” into a new principle I dare tag as “caveat venditor.  It is, and will continue to be, a free market out there; but buyers are no longer left on their own and exclusive look out; sellers are now and, by law and regulation, will be asked more and more to also look after the buyers of their wares. 

This per se ought not to worry local trust departments.  Philippine trust entities are not strangers at looking after their clients.  From the time trust was formally accepted in a big way in Philippine law, way back in 1906 as part of the Corporation Code, trust entities have been understood to be companies holding property “in behoof of others”.  The word “behoof” is very old English for “for the benefit of” and, to the best of my knowledge, is not found in any other Philippine statute currently in force. 

But, somehow, the quality of being devoted to acting “in behoof of others” was trodden underfoot by the modern and global practice of commoditizing banking services.  Presently, the fiduciary idea is beneath the hooves of commercialization.  But, it is still there. And fortunately, the trends in the entire market place are themselves shifting, their direction becoming clear. 

Accordingly, like competitors in a regatta who look at other vessels in the race to read the conditions of the sea, players in the trust industry will benefit from observing what developments are affecting their colleagues in the other regions of the financial seascape.  And when they do, they certainly will not miss what is going on in the securities industry, namely, the serious  imposition on vendors of the obligation to adopt the “Suitability Test” in the marketing of their instruments.

The suitability test first appeared in rudimentary form in Rule No. 30.2, Item 4 of the SEC implementing rules of Section 30 of Securities Regulation Code.  The rule requires that before “recommending to a customer the purchase, sale or exchange of any security, a Broker Dealer or an associated person or salesman of a Broker Dealer shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts disclosed by such customer as to his other security holdings and as to his financial situation and needs.”  Just precisely how, the players are left to their own prudent devices, up to now.

But, very soon, the suitability test will be seen again in the first half of what the BSP is almost certain to issue as Appendix 26 and 26A of the Manuals of Regulations for Banks relating to Section X602 on the sale of derivatives by banks.  This time, the guidelines are more detailed and demanding.

The guidelines on suitability, as to be found in Appendix 26, are premised on a two-fold reality: first, that the banks are to “act honestly, fairly, and in the best interest of its clients”; and, second, that “the complex nature of derivatives and the increasingly sophisticated products being developed…[are] not readily understood by all client types.” 

The previous response to the phenomenon of lack of understanding by the customers, which response is still acceptable to some legislators, is to ban the product, thereby keeping the public safe, but, unfortunately, remaining immature and ignorant.  The improved practice in the recent past was to allow the product, but to require prior disclosures, in the hope that the buyer, having been adequately informed, hopefully makes an informed decision to act or not, as his own appreciation of his interest dictates. That is the regime of caveat emptor. The most recent regulatory attitude further improves on that and, in addition wants to ensure that the vendor makes a parallel determination, requiring in the process that the vendor chooses, not the margin of his profit, but the interest of his client.  Caveat venditor.

The suitability test guidelines in the coming Appendix 26 stand on three legs. First is the obligation of gathering by the vendor of sufficient information about his intended client, i.e. his financial condition, investment experience and expertise, specific objectives.  It is the same as the unwritten mandate to a blade manufacturer to know who the buyers of his knives are.  Obviously, common sense dictates he may not sell a butcher’s knife to a seven year old child.

The second leg is the requirement that the vendor, based on the information gathered through the first leg, make a systematic classification of acceptable buyers, according to the buyer’s general profile, i.e. whether the buyer is market counterparty, a sophisticated institutional investor, a sophisticated private (or individual) customer, or, a “non-sophisticated” investor.  This leg determines how extensive and intensive the efforts of the vendor ought to be in determining that the product that he will offer is suited to the particular buyer.

The third leg is the most crucial and this is the vendor’s determination of the suitability of his particular product to the needs and wants of the specific buyer.  This is obviously a judgment call, based on limited information, but one that the vendor must make through a verifiable process that reasonably justifies the decision to sell to the client or not.  To ensure that the vendor goes through the required process, he is encouraged to put things in writing, in clear and understandable language, his pitch to the client and the agreement of the client on the precise point of suitability.

         I intend to give more space to Appendix 26 when it eventually comes out.  All I want to do for now, is, like my ever patient instructor and friend Benny Legarda teaching me how to manage my dinghy, to point to the spot in the water where the waves say there is a strong wind coming our way.  The imposition of the suitability test, in a more detailed and demanding fashion, I am almost certain will come the trust industry’s way in the marketing of its services.  It is time for the players, like those on a dependable Laser, to hold their tillers firm with their right and the rope that controls the boom on their left, and prepare to shift, sway, and even bend when and as the wind finally arrives.