For portfolio management firms and independent advisers, MiFID II is a significant departure from MiFID I standards on the types and size of inducements firms can accept and retain.
While restrictions on inducements applying to investment firms more generally remain substantively unchanged, from MiFID II's implementation date (expected to be 3 January 2017), portfolio management and independent advisory firms will only be able to accept and retain minor, non-material benefits subject to certain criteria being satisfied. The rules apply to both retail and professional clients.
So what does this mean for you?
- Investment firms may accept and retain inducements in similar conditions as under MiFID I.
- Independent advisers and portfolio management (discretionary investment management) firms may no longer accept and retain any inducements, unless they are minor, non-monetary benefits. These firms must implement policies and mechanisms to transfer on to clients any other inducements as soon as received.
- Increased record-keeping and disclosure requirements.
- If third parties provide research services to the firm, consider whether these could constitute inducements.
- As the ban under MiFID II applies to both professional and retail clients (unlike under RDR, which applies only to retail clients), firms should consider their current practices carefully.
Summary table of position on inducements under MiFID II
Click here to view the table.
What is the basic position for investment firms?
Under MiFID II, investment firms that are not portfolio management firms or independent advisers may not pay or be paid any fee or commission, or provide or be provided with any non-monetary benefit (together, "inducements" or "third party payments") in connection with the provision of an investment service or an ancillary service, to or by any party except the client or a person on behalf of the client, unless the payment or benefit:
- is designed to enhance the quality of the relevant service to the client (the "quality enhancement test"); and
- does not impair compliance with the investment firm's duty to act honestly, fairly and professionally in accordance with the best interests of the client.
While there will be no substantive changes for many FCA-regulated investment firms, it is worth firms noting that MiFID II removes the option to disclose the essential terms of the inducement arrangements in summary form. Nevertheless, ESMA considers that minor non-monetary benefits can still be disclosed in a generic way (see below).
The FCA has previously applied MiFID I inducement rules to the sale of insurance-based investments and pension products, and it seems highly likely that the FCA will continue this policy in its implementation of MiFID II. Indeed, in its Discussion Paper DP15/3 Developing our approach to implementing MiFID II conduct of business and organisational requirements("Discussion Paper DP15/3)", the FCA states:
"To ensure strong, clear and consistent standards for the sale of substitutable products and to minimise the risk of arbitrage, we believe it is appropriate to continue to preserve consistency between the sale of MiFID II products and insurance-based investments and pensions for both advised and non-advised business."
Investment firms: how do they meet the quality enhancement test?
Investment firms (not, for the avoidance of doubt, portfolio management or independent advisers) may retain inducements where they enhance the quality of the relevant service to the client. ESMA's December 2014 Technical Advice (the "ESMA Advice") sets out a non-exhaustive list of conditions which, if any one of them were satisfied, would mean that the quality enhancement test was not met.
In summary, these "negative conditions" are that the inducement:
- is not justified by the provision of an additional service to the client, proportional to the level of inducements received; or
- directly benefits the recipient firm, its shareholders or employees without tangible benefit to the relevant client; or
- in relation to an on-going inducement, is not justified by the provision of an ongoing benefit to the client.
Even when the quality enhancement test is satisfied and inducements are retained, investment and ancillary services must remain bias-free. Once firms have met the quality enhancement test, they should maintain that level of quality, although it does not need to continuously increase over time.
Investment firms must be able to demonstrate that any third party payments received are designed to enhance the quality of the service. Firms should consider: (i) keeping an internal list of all third party payments; (ii) recording how these payments will be used to enhance the quality of services; and (iii) recording steps taken not to impair the firm's duty to act honestly, fairly and professionally in accordance with the best interests of the client.
Firms providing independent investment advice or portfolio management
The substantive changes under MiFID II will affect portfolio management firms and investment firms that provide advice on an independent basis. The rules for these firms are tougher, and they may not accept and retain third party payments in relation to the provision of the service to clients unless these are minor, non-monetary benefits, and the following conditions apply:
- they are capable of enhancing the quality of the service provided to a client;
- they are of a scale and nature such that they could not be judged to impair compliance with the firm's duty to act in the best interests of the client (please note the slight variance in wording between this test and that in respect of investment firms more generally, which explicitly mentions the firm's duty to act "honestly, fairly and professionally"); and
- they are clearly disclosed.
Minor non-monetary benefits
In its May 2014 Consultation Paper, ESMA initially proposed an exhaustive list of examples of minor, non-monetary benefits. This met with strong resistance from respondents, however, and has resulted in ESMA making a notional revision to its Advice and stating that the list (detailed below) should be viewed as exhaustive but "could be supplemented".
In summary, minor non-monetary benefits include:
- information relating to a financial instrument or investment service;
- participation in training events on the benefits and features of a specific financial instrument or investment service;
- hospitality of a reasonable de minimis value; and
- other non-monetary benefits that are reasonable and proportionate and of such a scale that they are unlikely to influence the recipient's behaviour in any way that is detrimental to the interests of the relevant client.
Minor non-monetary benefits should be disclosed by investment firms before providing investment or ancillary services to clients.
Can portfolio managers and independent advisers accept third party benefits?
Rules under MiFID II
Under the ESMA Advice and MiFID II, independent investment advisers and portfolio managers can accept, but must rebate to clients, any monetary third party payments or non-minor, non-monetary benefits, received in relation to the services. The ESMA Advice places specific obligations on portfolio managers and independent advisers in respect of passing on inducements. In particular, firms should:
- set up a policy to ensure that third party payments received are allocated and transferred to the relevant individual client;
- return any such payments to their clients as soon as possible after receipt by transferring the monies received into their client money account;
- inform clients about monetary amounts transferred to them through regular bank account statements; and
- make the additional disclosures described below.
The FCA's proposed approach
The approach under MiFID II can be contrasted with that of the FCA in its Discussion Paper DP15/3, which notes that:
"unlike our RDR [Retail Distribution Review] rules applicable for investment advisers, MiFID II allows discretionary managers to receive payments from third parties if these are passed to clients in full (in effect allowing rebating)."
Although it is seeking feedback on this point, it appears from the Discussion Paper that the FCA intends to maintain its position as set out in the RDR. The FCA sees rebates as having the potential to distort customer outcomes and provide incentives for advisers and platforms to sell commission-paying funds as opposed to funds with no in-built commission. This could give the impression of "discounted" charges, when compared to non-commission paying (and potentially cheaper) products. The FCA moreover points to the risk that, should it disapply the RDR rebate ban for certain firms in certain areas, this could create different standards with additional costs and complexities for firms.
If a firm wishes to retain the inducement, what disclosures must it make?
Investment firms are required to make a number of disclosures in relation to inducements received from or paid to third parties. In summary, the firm should declare:
- prior to the provision of the service, the existence, nature and amount of the third party payment;
- if the amount of payments cannot be ascertained, the method of calculating that amount must be clearly disclosed to the client. Once this has been determined, the firm should provide this information to its clients;
- minor non-monetary benefits should only be described in a generic way (i.e. a summary description can be provided). Other non-monetary benefits should be priced and disclosed separately; and
- at least once a year the firm should inform its clients on an individual basis about the actual amount of payments or non-monetary benefits received. Minor non-monetary benefits are excluded from this obligation.
Is the provision of research by third parties to investment firms an inducement?
There has been considerable debate over the question of whether the provision of research to investment firms would be considered an inducement and would therefore be caught by these provisions. This was also the subject of the FCA's Discussion Paper DP14/3 Discussion on the use of dealing commission regime, and subsequent Feedback Statement FS15/1.
In its Advice, ESMA states that the provision of research by third parties should not be regarded as an inducement if it is received in return for (in brief) direct payments by the firm out of its own resources, or by payments from a separate research payment account controlled by the investment firm but funded by the clients (the latter option is subject to the satisfaction of a number of operational and disclosure requirements). Firms providing execution services should identify separate charges for these services that only reflect the cost of executing the transaction – this effectively "unbundles" research costs from the costs of the transaction itself.
The FCA broadly supports ESMA's position, stating that:
"We believe ESMA’s proposals will better align investment managers’ incentives to control costs and be transparent with their customers over charges for external research, and remove the inducement and conflicts of interest created by bundling research into execution arrangements with brokers. It will lead to pricing for research by brokers and other providers, encouraging a focus on quality and value for money in this market that will result in more effective competition in the interests of consumers." (FS15/1)