FINANCIAL PLANNING

FS FOCUS July/August 201016

DEALING WITH NOVATION

IFA FIRM BUYOUTS

Mark Dennison considers some of the challenges and pitfalls of acquiring an IFA business

A storm erupted recently when an acquisitive adviser attempted to block novate clients without getting letters of authority from those clients. In the circumstance of the case the selling adviser had assets on the same platform as the buying adviser. The purchaser attempted to change the agencies by novation only to be informed by the platform that explicit client agreement was required.

Forgetting the particular issues of this case for a moment, there are tangential considerations that can be raised in all buying and selling situations.

Pivotal to the discussion, the Financial Services Authority (FSA), in its March Retail Distribution Review (RDR) paper (PS 10/6 ‘Distribution of retail investments: Delivering the RDR –feedback to CP09/18 and final rules’) confirms ‘where commission can be switched we would expect it to be paid to the client, given that the new adviser did not provide the service for which the service was payable’.

Advisers and the market have reacted in a knee-jerk fashion, saying it makes business sales very difficult at best and probably impossible. We would interpret it slightly differently. Our view is that this is the FSA saying that in relation to Treating Customers Fairly (TCF), (Principle 6, PRIN2.1, FSA Handbook) clients need to be offered a service from a buying firm, and explicitly agreeing to it, before the trail can be re-directed. Again in relation to TCF, we are of the view this goes directly to consumer outcomes 3, ‘Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale’ which relates to the service a client is paying for, and outcome 6, ‘Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint’ (Sarah Wilson, FSA speech, August 2007), which relates to barriers to freedom of asset movement.

Reverting back to the case in question, in considering the FSA’s stance as set out above, it can be argued that the platform provider is operating within FSA parameters even without a view of the legal contractual issues which remain unresolved to date as far as we are aware.

FINANCIAL PLANNING

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The novation waters and the FSA’s views of them are to some extent muddied because elsewhere in the FSA handbook there is apparently explicit acceptance of the principle of novation as an efficient means of transfer. In its Policy Statement on prudential regulation in January 2001, the FSA said at section 5.2 para 4, that it regarded novation in the transfer of assets as ‘a clean transfer’ and the ‘cleanest transfer of risk’. This was accepted as made text in the prudential sourcebook for banks at the time.

It would seem then, that the FSA may not be averse to novation per se, but that where it happens, the operational procedures need to be client TCF- centric.

A knock on effect of the regulator’s position is the methodology of buying and selling firms. Currently the perceived best practice is to carve out client banks and pay for the recurring income identified therein, then let the selling firm fall away. A key incentive for this process from the seller’s point of view is the speed and efficiency of transfer of clients through block novation

Under the FSA’s RDR proposals, this would be more difficult, and would certainly be more costly, given the implicit requirement to obtain explicit client consent. This would indubitably bear down on valuations, and in extreme cases could cause deals to collapse.

The simplest way to avoid the problem would be for the acquisitor to buy the selling firm (instead of client bank) in which case there is no novation. There are potentially a whole lot of problems that come with such a purchase though, the largest of which is the past service liability issue, which is far more difficult to carve out under this method.

Selling / buying transactions, if we are blunt, tend to primarily consider the financials of the deal, with the goal of the acquisition vehicle to gain as large a pool of assets under influence as possible. The clients get left in the vacuum. The FSA’s latest direction seeks to re-address that balance. The underlying principle, it seems to us, is that clients must get continuity of service that they understand and buy into at a known price.

One way to do that (if the selling firm is not to be bought intact) is for a buying firm to take the advisers of the selling firm on-board for a transition period. This alleviates the continuity issues. It probably allows for a better end result as settlements to the advisers can be staggered and paid on successful transfer, to some extent obviating cash flow short outs. There is also scope for accumulating discovery assets not included in any novation (because there is no trail). Some might argue that that is diluting value, because it is an exercise for the buyer and part of the reason for the purchase in the first place.

To return one last time to the case we considered at the beginning of this piece. It focuses our minds on the issue of platforms / wraps in a sell / buy situation. Our expectation would be for most sellers to be old model advisers (without platforms), while buyers are far more likely to be new model adviser firms with platform(s) in situ. Again referring to the FSA March papers, in this case Discussion Paper 10/2 ‘Platforms: delivering the RDR and other issues for discussion’, it is clear to see that a transition model that transfers assets on to a platform without due consideration to suitability issues, is bound to encounter justification problems. At the very least a client categorisation project is advised.

To sum up then, this note is aimed at buying and selling firms. It has its genesis in the FSA’s direction with regard to trail income post 31.12.12 (RDR

implementation). It suggests that novation is at the heart of any buy / sell transaction and that there is a right way and a wrong way to novate. Going forward novation implications will impact on the buy / sell price, and probably the initial margins for buying firms. Broadly, in our view, novation should be accompanied by a letter of acquiescence by the client (probably in the form of a novation agreement), following an invitation and a description of the buying firms’ services and costs. Where the intention is to novate on to a platform it should be done in two stages, one to move agencies, the second to move to platform (if appropriate).

The novation process should be handled as a project with sufficient resources (human) allocated to it together with a documented policy and process. Our view is that is should have a run period of at least six weeks before transfer, to avoid unnecessary cash flow and time lags. Novations can be unwound for transactions that fail at the 11th hour.

The avoidance of the novation conundrum seems to us to force IFAs potentially to purchase selling firms rather than ‘asset books’. This has implications for valuations and liability carve out.

Mark Dennison STC

www.wlcholdings-ltd.co.uk