The Markets in Financial Instruments Directive (MiFID) was replaced by MiFID II on 3 January 2018, following an extensive period of consultation at both a European and domestic level. The extent to which MiFID II has impacted on firms operating within the investment management space has varied depending on regulatory classification, but there is little doubt that its presence has been, and will continue to be, keenly felt across the industry. In this article, we clarify some of the issues that remained unresolved in the months leading up to implementation.
How has MiFID II extended the reach of MiFID on implementation?
MiFID II has a broad scope and was intended in part to enhance investor protection, reduce systemic risks and address the increase in market efficiency.
The UK implementation of MiFID II extends the scope of some of its rules to fund managers. This note will focus on its impact in relation to: (1) telephone recording; (2) inducements and research; (3) client categorisation; and (4) best execution requirements.
As a result of MiFID II’s implementation, the FCA has limited its previous telephone recording exemption for discretionary investment managers. MiFID II’s record keeping rules require MiFID firms to record telephone conversations and other communications that relate to transactions concluded when a firm is ‘dealing on own account’ or is providing ‘client order services’ related to the ‘reception, transmission and execution of client orders’. However, following extensive industry lobbying, the final rules published by the FCA exclude AIFMs and MiFID portfolio managers from the new recording rules where their discretionary portfolio management activity relates to unlisted securities.
The FCA had no similar discretion to limit the application of the rules for CAD-exempt firms in relation to their arranging (bringing about) activities, so these firms are subject to the rules for activities relating to all types of securities, including unlisted securities. However the FCA has confirmed that it remains committed to proportionality and it remains to be seen whether written minutes of face-to-face meetings or saved emails will prove acceptable in place of taped telephone conversations.
Inducements and research
MiFID II has imposed substantial restrictions on the receipt of inducements by portfolio managers and independent investment advisers – effectively prohibiting them from receiving fees or non-monetary benefits from third parties in connection with their investment activities for clients (although they may receive some ‘minor’ non-monetary benefits).
Other firms, including non-independent advisers (which would include private equity and venture capital adviser/arrangers), may continue to receive third party benefits if they are satisfied that: i) the arrangement is designed to enhance the quality of the service received by the firm’s advisory client (i.e. the fund GP/manco); and ii) there are no other conflicts. The ‘quality enhancement’ test under MiFID II requires firms to identify a tangible benefit to the advisory client that is proportionate to the benefit received by the firm from a third party.
As a consequence of the inducements ban, buy-side portfolio managers may no longer receive free or bundled research but must instead either pay for it out of their firm’s resources or arrange a separate charge with their clients. Non-discretionary (non-independent) advisers can still accept free research if they satisfy the ‘quality enhancement’ test.
The FCA has extended the inducements ban and research payments rules to non-MiFID firms, including AIFMs when executing client orders or placing orders for execution. However, the FCA has specifically exempted from these requirements private equity/venture capital firms that do not generally invest in custody assets and/or which generally invest in issuers or non-listed companies in order to acquire control. Nonetheless, the BVCA remains concerned that the receipt of due diligence by private equity/venture capital firms on their potential acquisitions of unlisted companies may be considered a form of research benefit (although those firms should still be able to satisfy the ‘quality enhancement’ test).
MiFID II categorises local authorities as retail clients by default (ostensibly to protect their treasury portfolios from exposure to mis-sold complex products), although they may, if appropriate, ‘opt-up’ to ‘elective professional client’ status via a prescribed procedure led by the manager. This includes local authority pension schemes where these are not legally separate from the local authority itself.
The revised categorisation also affects AIFM marketing activities, as the definition of ‘professional investor’ for AIFMD purposes references back to the MiFID definition of ‘professional client’.
As a result, under the FCA’s revised rules, firms are now required to apply the following tests and procedural steps when opting-up UK local authority clients to professional client status:
- a qualitative test – reflecting the test ordinarily applied to retail clients and including an adequate assessment of the expertise, experience and knowledge of the client to give reasonable assurance, in light of the nature of the transactions or services envisaged, that the client is capable of making their own investment decisions and understanding the risks involved;
- a quantitative test – which requires that the size of the client’s financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds £10m and that at least one of the following criteria are also satisfied:
- the client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters;
- the person authorised to carry out transactions on behalf of the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the provision of services envisages; and / or
- the client is an administering authority of the Local Government Pension Scheme within the meaning of the version of Schedule 3 of the Local Government Pensions Scheme Regulations 2013 or, (in relation to Scotland) within the mean of the version of Schedule 3 of The Local Government Pension Scheme (Scotland) Regulations 2014, and is acting in that capacity.
If a local authority entity cannot satisfy the FCA’s opt-up procedures, firms will need to assess whether their permissions enable them to continue providing services to such entities or whether additional retail permissions are required. Fund managers should not need to ‘opt-up’ local authorities that are already invested in their funds (particularly where these are close-ended AIFs).
Although MiFID II does not significantly alter the best execution requirements, firms are now required to take “all sufficient steps” (rather than “reasonable steps”) to obtain the best possible result when executing orders. Firms are also subject to greatly enhanced disclosure obligations, including the annual publication of their top five execution venues and brokers in volume and the quality of the execution obtained specific to each class of instrument.
The FCA originally intended to apply these requirements to AIFMs in addition to MiFID firms but has since confirmed that its final rules do not apply to either full-scope or sub-threshold AIFMs. In relation to MiFID optionally exempt (Article 3) firms, the revised rules build upon their existing best execution obligations by applying the enhanced MiFID II requirements, excluding the requirement to produce an annual report on execution quality and order routing activities. However, (private equity) CAD-exempt adviser/arranger firms should typically fall outside the regime in practice due to the absence of an order or execution venue and because they usually only receive and transmit client orders in order to being together two or more specific investors.