The MiFID 2 implementation deadline may still seem a long time away, but it is now less than 18 months until firms must be compliant with it. In amongst the uncertainties over the implementation date and the disputes between the European Commission and European Securities and Markets Authority (ESMA) over key technical standards, not to mention the curve-ball of Brexit, firms could be forgiven for having let their preparation for MiFID 2 slip. But it is clear the UK regulators are focussed on producing relevant consultations, law and rules (although we will not see the final form of many of these for nearly a year), and firms should by now be well advanced in their gap analyses to identify which aspects of MiFID 2 will trigger the most need for change in their policies, procedures and customer documentation.
In the UK, the regulators continue steadily to advance their implementation plans. Most recently we considered the Financial Conduct Authority (FCA's) consultation paper on changes to several parts of its Handbook. Previously it has consulted on the markets aspects of implementation. While there are major structural and scope change for markets, perhaps the trickiest area of implementation will be in conduct of business, on which we still await formal proposals for rule change.
In this article, Emma Radmore and Andrew Barber highlight the major areas of change that MiFID 2 brings to key conduct of business and closely related requirements, and what it means for firms in terms of likely change to FCA rules.
MiFID 2 does not bring structured deposits within the official scope of MiFID "financial instruments". However, it does apply many of the MiFID 2 standards to investment firms and credit institutions when they are selling these products. The Treasury has indicated its plans to include structured deposits within the Regulated Activities Order and provide for the activities of dealing as agent or arranging deals in, or managing or advising to apply to structured deposits. This will have a knock on effect to some of the Conduct of Business Sourcebook (COBS) and potentially other conduct sourcebook provisions. In its discussion paper on its COBS options in early 2015, the FCA indicated that it favoured continuing to apply a "level playing field" regime to insurance-based investments and pensions as well as to MiFID instruments, while appreciating that other EU initiatives might get in the way. But insofar as not inconsistent with the requirements of, particularly, the Insurance Distribution Directive and the Packed Retail Investment and Insurance-based Investment Products (PRIIPS) Regulation, we should expect the FCA to continue to apply MiFID requirements to non-MiFID products.
UK firms are, of course, used to FCA rules applying to their activities relating to structured deposits anyway, mainly through the Banking: Conduct of Business Sourcebook (BCOBS). The FCA needs to decide the best way to apply the relevant MiFID 2 rules to structured products – in its discussion paper it sought views on whether it should integrate appropriate MiFID 2 requirements into BCOBS, bring all regulation of structured deposits from BCOBS into COBS but apply only relevant COBS rules, or leave BCOBS broadly alone and apply relevant COBS rules to structured deposits. Whichever route it chooses, it will need to take care to apply the right rules in the right circumstances, and not to confuse or contradict within or between conduct modules.
The basic client categorisations – retail, professional and eligible counterparty (ECP) – remain, but there is a key change to the categorisation of municipal authorities. Under MiFID 2, these are not ECPs nor per se professionals. As a result, they will be retail clients unless they have been opted-up, which will require their consent.
Firms who number municipal authorities among their clients, especially those that have not traditionally dealt in the retail markets, will need to assess the basis on which they now wish to deal with them. The FCA has indicated a preference to strengthen in some way the current tests firms must apply when opting-up local authorities, but has not yet consulted on the precise nature of the changes.
The information requirements for clients, including the need for a written client agreement, remain broadly as under MiFID 1. However, there is some extension of certain information requirements and protections to cover ECPs and to apply certain rules relating to information provided to clients to communications to professional clients where MiFID 1 applies it only to retail clients. Most notably, MiFID 2 requires a written client agreement to be provided to professional clients as well as retail. In terms of specific information to be provided to clients, the basic MiFID 1 expectations remain, but with a renewed focus on the presentation and content of information on specific instruments, and on costs and charges. The most change, however, is in the disclosure requirements around investment advice (see "advice").
Many of the changes MiFID 2 makes will represent best and current practice to most firms. However, it, and particularly the Level 2 Delegated Regulation, set out details and checklists for firms to consider in the presentation of their customer communications, which all firms will need to build into their compliance procedures.
The key messages to firms, then, are to check their client base is still in line with their regulatory permissions, and to review their client documentation to assess whether any clients who do not currently receive certain communications will need to do so in future, and what structural and presentational changes they must make to standard client documents. We must also wait to see what, if any, standard form disclosure the FCA proposes to introduce.
MiFID 2 brings a fundamental change to the retail markets on the requirements surrounding investment advice, key among which is the introduction of the independence requirement. MiFID 1 does not differentiate between advice which is independent or is not. MiFID 2 introduces a definition of "independent" advice, by listing several criteria which, if met, mean the advice is independent. It also addresses the possibility that advice will be independent yet focus only on certain categories or a particular range of investments. In these cases, firms must be careful to ensure they attract clients who are only interested in the restricted range (and must also ensure the service is appropriate). It requires firms to:
- disclose to clients the basis on which they give advice – that is, whether it is independent or not, and the range of products they take into account when giving the advice. Where the advice is independent, firms must explain how it satisfies the independence conditions. The explanation must be clear and concise. However, firms may give the same client both independent and non-independent advice, but must explain the scope of each service clearly;
- disclose the cost of the advice;
- disclose any interests the firm has in any relevant product or other potential conflict;
- explain whether the firm will periodically assess suitability; and
- explain the reasons for the advice the firm will provide.
The MiFID 1 suitability and appropriateness tests remain, with firms being required to assess suitability for advised services and portfolio management, and appropriateness otherwise. However, within the basic requirements, some key factors have changed, most notably the narrowing of the scope of "non-complex" instruments. Firms do not have to conduct an appropriateness analysis on specified non-complex instruments so the effect of the change will be to require a greater number of products to be assessed for appropriateness. The FCA noted this could have a significant impact on firms that make direct offer financial promotions of products that may now need to be categorised as complex.
UK firms are luckier than many, because they had to make significant changes to their business models to comply with the Retail Distribution Review (RDR) requirements a few years ago. However, they should not be complacent, because the MiFID 2 regime does not completely overlap the RDR requirements, and certain product-specific rules are also different. Although they will face less fundamental changes than firms from other EU jurisdictions, they will nevertheless have to focus significant compliance resource on adapting their policies, procedures and documentation to comply with MiFID 2.
Firms will need to conduct a detailed mapping exercise to be clear as to how their advisory activities will be categorised under MiFID 2, and the extent to which MiFID 2 requirements apply to the products on which they advise. A further technical exercise will be to assess whether the firm sells any products that it counted as non-complex under MiFID 1 but which will no longer qualify as such under MiFID 2. There will be other adjustments, including in the way firms must disclose all costs and charges associated with an investment service and financial instrument that are not caused by underlying market risk. For UK firms, FCA also said it would consider whether to apply the MiFID 2 standards to insurance-based investments and pensions, but, at the time of its 2015 discussion paper, was minded not to do so.
The FCA was interested in views on whether its views on independence differ significantly from the MiFID 2 standards, while noting that there is only a small overlap in products covered by both sets of rules – broadly, only structured products, UCITS and some other collective investment vehicles fall within both sets. MiFID 2 also covers securities, structured deposits and derivatives, while FCA's RDR standards cover a wider range of collective investment products as well as insurance and pension based products. The FCA is aware it would be disproportionate to apply its full independence rules to most of the securities and derivatives-based MiFID 2 products (although it may include structured deposits), and will need to consider very carefully what standards to apply and what requirements to place on firms to ensure they meet all relevant expectations without regulating disproportionately or confusing the consumer.
Another major area of change is on product governance and intervention. MiFID 1 had general organisational requirements, but nothing specific to products. MiFID 2 has more detailed organisational requirements and includes:
- a requirement on product manufacturers to have a process for approving each instruments before it is marketed or distributed to clients, with details of what the process should include – for example identifying the target market and ensuring the distribution strategy is in line with the identified targets;
- a requirement on investment firms to review regularly financial instruments they offer or market, again to ensure the product and the distribution strategy are suitable for the target market;
- a duty on the manufacturer to make available to the distributor appropriate information about the product and the approval process, and a duty on the distributor to get this information and to understand it;
- an extension of the obligations to distributors when they offer or recommend financial instruments manufactured by non-MiFID entities; and
- part of the overarching obligation to avoid conflicts of interest requires firms to have in place effective arrangements to prevent any conflicts from adversely affecting their clients.
While MiFID 2 and its delegated legislation impact on the manufacturing and distribution process, MiFIR includes the new regulatory powers to restrict or completely ban marketing, distribution and sale of products under specific circumstances. Although the use of these powers will be tightly controlled, and are powers for regulators to use rather than firms to build into their processes, firms should be building into their product manufacture, design and distribution processes (as appropriate) a consideration of the factors that may lead a regulator to intervene.
The changes will cause many firms to put in place new, or significantly updated, policies and procedures, and be clear on their responsibilities and what they expect of others.
MiFID 2 has not just beefed up and extended in scope the requirements to prevent conflicts of interest, it has also made the rules on permitted inducements more restrictive. MiFID 2 prohibits firms that provide independent advice or portfolio management from receiving and retaining any payments or non-monetary benefits from third parties. Any other firm may receive and retain the benefit only where it is both designed to enhance the quality of the relevant service to the client and where it does not impair the firm's duty to act honestly, fairly and professionally in accordance with its clients' best interests. Much of this is familiar from MiFID 1 but the guidance is now tighter and also where appropriate firms must tell clients how the benefit can be transferred to them.
From what is now in MiFID 2 and the embellishments in the MiFID 2 Delegated Directive, firms will find themselves significantly restricted in what can be done between advisers and providers. Provision of research is likely normally to be acceptable, but meeting the tests for other forms of benefits could prove too dangerous. Also, the MiFID 2 rules apply to business with both retail and professional clients.
How does this relate to commissions? Firms that provide independent advice or portfolio management will almost always be banned from keeping any commissions. In other circumstances, the tests described above must be met. Firms must also tell clients accurately and at appropriate times about all fees, commissions and benefits the firm receives in relation to the services it provides to the client.
The impact of these changes on manufacturers and distributors in many EU countries will be huge. UK firms will see less change, but will still need to assess the new rules carefully as, for example, they ban firms from setting off any payments received against fees due to the firm, which is not a current requirement. For UK and other firms, there is also the likelihood that structured deposits will fall within the restrictions.
In the FCA's 2015 discussion paper, it noted that MiFID 2 allows firms carrying on portfolio management to rebate payments back to the client, whereas the RDR rules impose an outright ban – but RDR standards apply only to personal recommendations given to retail clients in respect of the FCA concept of retail investment products (which is not a concept mirrored in MiFID 2 or the PRIIPS Regulation). It sought views on whether there is a benefit in it putting in place the RDR standards (which it has also put in place in relation to platforms). The paper suggested its clear view was to impose an outright ban, for the same reasons as it has imposed the current bans – mainly customer confusion. Moreover, the FCA's initial preference is to apply similar standards across all relevant products, not just MiFID ones.
Staff incentives and remuneration
Allied to many of the changes above is the question of how sales staff are incentivised and remunerated. MiFID 2 prevents sales staff being remunerated in a way that creates incentives for them to sell products inappropriately. The UK regulators have actively addressed many of these issues over recent years, including in implementing other single market directives, and mainly through principles and the relevant remuneration codes in the Senior Management Systems and Controls Sourcebook.
In its 2015 discussion paper, the FCA sought views on the possible benefits of cross-cutting the MiFID 2 standards to non-MiFID business, to improve consumer outcomes. Clearly, if it does so, this will bring changes to the rules (if not the high level expectations) for sales and advice in a wide range of products, and the regulators will need to ensure nothing they do conflicts with rules put in place to reflect other single market standards.
Our article on the FCA's most recent consultation looked at the position of "article 3" firms, and the rules national regulators are required to impose on them. Telephone taping is one example of an area where the FCA may have to expand the scope of its rules so as to meet the requirement of imposing "broadly analogous" requirements on article 3 firms as on MiFID firms. It sees benefits in imposing consistent taping requirements across all firms subject to the relevant COBS provisions, including also removing the current "duplication" exemption from which discretionary fund managers benefit.
The other part of COBS that is likely to be directly impacted by the MiFID 2 changes are the rules on best execution. MiFID 2 does not make fundamental changes to the MiFID 1 requirements, but it does strengthen certain obligations and require additional notifications and reporting.
COBS is a complex set of rules. It contains 21 chapters. Some of these may be almost untouched by MiFID 2, or subject only to minor consequential amendments. Others will be subject to greater change and potentially a fundamental restructuring. The FCA's third consultation paper on MiFID 2 implementation, including COBS, is due in "autumn 2016" and is the last scheduled consultation before the FCA starts to feedback on consultations already published.
UK firms, as ever, should not await any finality of domestic regulatory requirements before preparing their gap analyses and planning for changes they will need to make and have in place by the beginning of 2018.