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online technical resource

structured capital at risk products (SCARPs)

overview

This section of the website describes how we approach complaints involving disputes about “structured products”.

A “structured product” is an investment that combines elements of investing in a bond with investing in more complicated financial instruments – often known as “options” or “derivatives”. A structured product offers income, capital growth or a combination of both, and usually has an investment term of one to ten years. Investment professionals usually consider structured products to be “complex investments”.

what are the features of a structured product?

Typically, a structured product will have the following characteristics.

  1. Some form of capital protection, provided by the bond-like element issued by a counterparty (also called a note or debt security). The counterparty promises to pay the investor back some or all of the original investment at maturity (essentially, an ”IOU”). Some products guarantee return of capital, but most do not.
  2. Defined return at maturity, provided by the financial option. It will pay a pre-defined amount, which will be either be
  • a fixed amount - normally based on a percentage of the original investment; or
  • an amount calculated by reference to a change in the value of an underlying asset. The underlying asset could be a stock market index, a basket of shares or a basket of other financial products (such as life insurance policies).
  1. The inherent nature of the underlying asset will not change during the term of the investment. Consumers will usually receive only a share of the growth or income return achieved by the underlying asset.
  2. Restricted liquidity – the bond-like element and the financial option are combined into a security, which is a closed-end company, often held offshore. When consumers invest, they are buying shares in that company. The company only exists for the term of the investment, after which it is wound up. Its shares are not normally traded on an exchange and, in practice, can only be sold back to the issuer, usually on specific dealing days. The value of the sale proceeds may not fully reflect the value of the underlying investment. This means that the investor may not get back all of the initial capital they invested.

Most structured products can be held in an Individual Savings Account (ISA) wrapper.

This note will focus on structured capital at risk products (SCARPs) – a type of structured product.

what is a SCARP?

SCARPs generally aim to return the money invested at the end of the term if the underlying asset has not fallen below a predetermined level. But they do not guarantee to do so – hence the “capital at risk” part of the name.

They are also known as "precipice bonds". This is to reflect that, if the underlying asset performed poorly over the term of the bond, the product would "fall over the precipice" and return significantly less capital than was invested, or potentially no capital at all. The reduction in the initial capital repaid may be geared – for example, a 1% fall in the underlying asset’s value might lead to a 2% reduction in capital returned (also known as "downside gearing").

The investor may not benefit from the full extent of any growth associated with good market performance. In general the level of growth or income generated by the SCARP is set at the outset. So, if the market performs particularly well, although the consumer will receive back their initial capital and the agreed level of growth or income, their return will not reflect the full extent of the rise in the underlying asset. As a result, it may be argued that the SCARP was not suitable for a consumer with a higher risk profile. However, when we look into these cases, we will always take into account the particular circumstances involved.

Most SCARPs must be held for the full term of the investment. But an early redemption plan (or "kick-out" plan) can mature earlier than the full term (usually on any anniversary of the plan start date) if certain criteria are met.

We usually find that consumers have invested in a SCARP on the advice of an independent  financial adviser (IFA). Although we occasionally see that they have responded to a mailshot offer directly from a product provider.

what are the potential benefits of SCARPs?

  • they allow broader exposure to equity-based investments without direct equity investment 
  • they are a medium-term investment with a finite life
  • they may provide a higher level of income than is available from other products
  • they can allow for early maturity if certain criteria are reached (kick-out plans)
  • they may provide some limited capital protection

can we look at a complaint involving a SCARP?

Although a SCARP might involve an offshore company, we will usually still be able to consider the complaint, as long as the financial business concerned is regulated by the FCA.

non-regulated guaranteed bonds

Non-regulated guaranteed bonds (also known as guaranteed equity bonds or guaranteed capital bonds), are not the same as SCARPs.

Non-regulated guaranteed bonds have some similarities to SCARPs because their returns are linked to the performance of a stock market index or certain other assets over a specified period of time.

But there are key differences between non-regulated guaranteed bonds and SCARPs:

  • the capital is secure as the financial business is obliged to return the initial investment to the consumer, although there may be no interest added.
  • any return is added as interest to the initial investment.  
  • in essence, they are deposit accounts.

Because of the features involved – and the fact that they are essentially deposit accounts – complaints involving non-regulated guaranteed bonds will generally be considered by our banking area. However, that will largely depend on whether a consumer was given advice to invest in the guaranteed bond. If they were, and the complaint is about that advice, it is likely that the complaint will be considered by our investment area.

what complaints do we see involving SCARPs?

The complaints we see usually involve

  • consumers being advised to take out a product that does not match their attitude to risk
  • consumers being unaware that they might only get back some (or none) of their capital at the end of the term
  • consumers being unaware that it would be difficult to access their capital – or that it would heavily impact the value of the investment if they did
  • consumers being unaware of the involvement of a counterparty, who the counterparty was, or not fully understanding their role.

what we take into account when we investigate SCARPs complaints

Most SCARPs contain an element of risk. The risk is that the full capital the consumer has invested will not be returned to them at the end of the product term. This could be because of a counterparty failure, or because the underlying asset’s value falls below a certain level.

We generally consider SCARPs to be unsuitable for investors who do not want to take any risk with their capital, or for investors who are not in a position to sustain a financial loss.

Most of the things we take into account are the same as in any investment complaint, including:

  1. What level of investment risk was the consumer willing to accept at the point of sale?
  2. Did the product match the level of risk that the consumer was willing to take?
  3. Was the consumer given a clear and accurate description of the product’s features, including the level of risk it carried?
  4. What were the consumer’s financial needs and aims when they took out the product, and did the product meet those needs and aims?
  5. From the available evidence presented to us regarding disclosures made at the point of sale, did the consumer understand the product’s features, including the risks?
  6. Was the spread of risk between products appropriate for the consumer’s appetite for risk, or was too much capital concentrated into one product type?
  7. Would another type of investment have been more suitable?
  8. Did the adviser consider potential capital gains tax liabilities that could arise from investing in the product?

More detail about how we assess the suitability of investments can be found in our online technical resource.

counterparty risk

We used to see complaints about ”conventional” SCARPs from consumers who had lost capital, and who said they were not aware of the risk to their capital, or how much it would be affected by gearing when they entered the plan.

However, we now see fewer of these complaints, which suggests that consumers are being made more aware of the risks involved.

Now we tend to see more complaints about a different type of SCARP – which carries a degree of security that the capital will be returned. The ”guarantee” is based on the capital protection element issued by the counterparty (referred to earlier in the note).

The capital invested in the SCARP will be returned to the consumer at maturity, as long as the counterparty is able to honour the agreement to pay out on the "IOU". If the counterparty goes into liquidation, it is unlikely to be able to honour the agreement and the consumer is at risk of losing some or all of their original investment. Consumers have referred complaints to us where the counterparty was a bank which has now gone into liquidation – for example, Lehman Brothers.

what the regulator has said about counterparty risk

Following the collapse of Lehman Brothers in September 2008, SCARPs with Lehman Brothers as the counterparty were unable to repay capital to investors. In October 2009, the financial services regulator at the time, the Financial Services Authority (FSA) published reports on both the collapse of Lehman-backed SCARPs, and more generally on what it expected advisers and product providers to explain about counterparty risk at the point of sale. For more information on this  please see the additional resources section below – which also includes a more recent FSA review of structured products.

In the reports, the FSA said:

A firm’s communications with customers – including its suitability reports – should communicate the risks of investing in structured investment products in a way that is fair, clear and not misleading, including setting out any possible disadvantages for the customer. This includes, but is not limited to, explaining to the customer the nature of counterparty risk and the possibility that, if a counterparty failed, their capital could be lost.

We sometimes see complaints from investors that the risk of counterparty insolvency was not made clear to them – or even that the existence of a counterparty was not explained to them.

Where a complaint like this is made against an adviser, we will consider whether the adviser explained the counterparty’s role at all, and if so, how they did it.

For a complaint directly against the product provider, we will assess how the product brochures described counterparty risk. We will consider whether

  • the counterparty’s role was explained in a clear, fair and not misleading way; and
  • for advised sales only – whether counterparty risk made the product unsuitable for the individual consumer.

In its October 2009 reports on structured investment products, the FSA stated that for all sales:

we consider that advisers should have had regard to the financial strength of the underlying counterparties and whether this was appropriate given the customer’s attitude to risk.

But it distinguishes between the duties of an adviser before Lehman’s insolvency in September 2008, and their duties after that date: 

“However, we consider the due diligence it was reasonable for advisers to apply on the financial strength of the counterparty changed after Lehman’s collapse:

1. We have not applied the benefit of hindsight to the period before Lehman’s insolvency (in September 2008). Where a customer was willing to take counterparty risk we believe that it was not reasonable to expect advisers to distinguish between the financial strength of different counterparties that were rated A or above in this period.

2. However, from September 2008, given the failure of an investment grade counterparty, we expect advisers to have undertaken a higher degree of due diligence when recommending products with counterparty risk, and to consider more carefully how this may relate to each customer’s attitude to risk.

This due diligence includes: consideration of the number of counterparties underlying a single structured investment product; the location of the counterparties (eg UK-based, offshore, US etc); and the relative financial strength of counterparties.”

The regulator points out that counterparties with stronger credit and financial indicators might be more appropriate for consumers looking for a lower-risk investment, while less strong counterparties could be more appropriate for consumers looking for a higher-risk investment.

It goes on to explain what a product provider should state in its financial promotion literature about counterparties:

“Financial promotions for structured investment products must:

  1. be clear about where consumers’ money is invested, which may include explaining that it is not invested in an index but is loaned to a single financial company;
  2. clearly explain any relevant counterparty risk;
  3. prominently state that capital is at risk (if that is the case);
  4. use language that the target audience is likely to understand; and
  5. not describe a product as "protected" or "guaranteed" if this is an inaccurate or misleading description.”

The regulator has stated that terms that imply security should only be used where they are accurate descriptions of the risk to capital within the product. Examples of these types of words are secure/safe/protected/guaranteed. The regulator says that literature needs to be clear, fair and not misleading, and that it expects

“promotions to name the counterparty in order to be able to describe the counterparty risk fairly. So, it would not be sufficient to simply state that the counterparty is a ‘major financial institution’. In addition, any description of the counterparty must be fair, clear and not misleading.”

The regulator distinguishes between sales that took place before and after September 2008 for due diligence purposes. We will look at each case individually and make an assessment based on its own individual circumstances. 

other factors

We may also need to take the following factors into account when we investigate a complaint about SCARPs:

  1. Which index or basket of assets did the SCARP track and how appropriate was this for the consumer’s circumstances? For example, tracking the FTSE100 is likely to be less risky than tracking an index with fewer shares (for example, the Eurostoxx 50), or an index covering a comparatively volatile sector of shares, or one exposed to exchange rate fluctuations. Also, tracking an index rather than a basket of assets is likely to be less risky as it will be more diversified, particularly as the basket of assets cannot be altered during the term of the SCARP. 
  2. Did the product have “downside gearing”? For example, a 1% fall in the underlying asset results in a 2% fall in the capital and/or income returned. If it does, did this increase the SCARP’s risk profile?
  3. What was the term of the product? Generally, the shorter the term, the greater the risk to the capital and/or income.
  4. Did the consumer have the opportunity to replace any capital losses they might suffer? Many of these products were taken out by elderly consumers looking to increase their retirement income. 
  5. How large was the “safety net”? In other words, to what extent could the value of the underlying asset fall without threatening the return of capital? The smaller the safety net, the riskier the SCARP.
  6. How does income drawn from the SCARP affect the capital returned at maturity? The amount of capital returned at the end of the product term may be affected by how much income has been paid out already. We will consider whether this was clear to the consumer when they invested – and whether it provided them with sufficient capital ”protection” for their risk profile.
  7. If the complaint is against the product provider, how was the risk to capital explained in its documentation? Were comments about the security of capital in any way misleading?

putting things right

If we decide that the SCARP was not suitable for a consumer, we will need to consider carefully what the consumer would have done if they had not invested in the SCARP. The starting point is to put the consumer in the position they would have been in if they had not received unsuitable advice.

Calculating compensation is done in two stages:

Stage 1 – alternative return

If we are satisfied that a consumer would have invested in a different scheme, and we know what that that scheme would have been, we can calculate what the return would have been.

If we are satisfied the consumer would have invested elsewhere for the opportunity of a reasonable return, but we cannot be sure where they would have invested, we are likely to use a fair benchmark to calculate an award. This may be based on a return linked to the Bank of England (BOE) base rate (traditionally BOE +1%). However, a lot will depend on the individual circumstances involved – and we  might tell the business to pay compensation based on a different approach.

If we conclude that the consumer would have left their money in a deposit account, we will apply a reasonable rate of interest to the capital amount – which in some instances will be reflected by the Bank of England base rate. But again, some circumstances may require us to take a different approach.

Stage 2 – reduction in value

Once we have calculated the amount of alternative return that the consumer would have received, we need to deduct the benefit that the consumer has already received from the SCARP. This will be the maturity/surrender value of the SCARP, along with any withdrawals that have been made.

We might see a situation where the SCARP has no value at all – for example, if the counterparty is in liquidation.

distress and inconvenience

We will often consider whether an award for distress and inconvenience is appropriate. This could happen where, for example, an elderly consumer has taken out a SCARP to increase their retirement income, and something has gone wrong with the SCARP.

We may also make an award if a financial business has handled a consumer’s complaint poorly. You can find more information about our approach to awarding compensation for distress, inconvenience and other non-financial loss in our online technical resource.

additional resources

ISA allowances – our approach to compensation where a consumer misses their annual ISA allowance because of a business error.

Structured Product Review – Carried out by FSA and published March 2012.

Treating customers fairly – structure investment products – published by the FSA in October 2009.

Quality of advice on structured investment products – findings of a review of advice given to consumer to invest in structured investment products backed by Lehman Brothers from November 2007 to August 2008. Published by the FSA in October 2009.

help for businesses and consumer advisers

contact our technical advice desk on 020 7964 1400

This is part of our online technical resource which sets out our general approach to complaints about a wide range of financial products and issues. We would like your feedback on how helpful you found it. Please also use the feedback form below to tell us about anything you think we could clarify or explain better.

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  • The law requires us to decide each case on the basis of our existing powers and what is fair in the circumstances of that particular case.
    We take into account the law, regulators' rules and guidance, relevant codes and good industry practice at the relevant time.
    We do not have power to make rules for financial businesses.
    Our current approach may develop in the light of circumstances disclosed by further cases we receive.
    We may decide that fairness requires a different approach in a particular case.