The headlong rush to implement theMarkets in Financial Instruments Directive (MiFID) in time for its 1 November 2007 in force date has inevitably meant that those FSA regulated firms covered by the Directive1 have not had asmuch time as they would have liked to consider and debate some of the finer points of interpretation arising in relation to what is undoubtedly a very complex piece of legislation. TheMiFID inducement rule is perhaps one of the more obvious cases in point. In this briefing we set out the fundamentals of the new MiFID inducement rule that came into effect in the United Kingdom on 1 November 2007 and offer some thoughts on the potential road ahead for FSA regulated firms.
Where does the MiFID inducement rule come from?
The MiFID inducement rule is derived from Article 19(1) of the MiFID Level 1 Directive2:
“Member States shall require that, when providing investment services and/or, where appropriate, ancillary services to clients, an investment firmacts honestly, fairly and professionally in accordance with the best interests of its clients and comply, in particular, with the principles set out in paragraphs 2 to 8.”
This means that the MiFID inducement rule has its origins in a high-level conduct of business obligation requiring firms, in effect, to act in the best interests of clients whenever they provide investment services. This is something of a change of emphasis in the UK where the regulation of inducements has traditionally been regarded as a subset of the rules relating to the prevention and management of conflicts of interest.
What does the MiFID inducement rule look like?
The MiFID inducement rule can be found in Article 26 of the MiFID Level 2 Directive3 which reads as follows:
“Member States shall ensure that investment firms are not regarded as acting honestly, fairly and professionally in accordance with the best interests of a client if, in relation to the provision of an investment or ancillary service to the client, they pay or are paid any fee or commission, or provide or are provided with any non-monetary benefit, other than the following:
(a) a fee, commission or non-monetary benefit paid or provided to or by the client or a person on behalf of the client;
(b) a fee, commission or non-monetary benefit paid or provided to or by a third party or a person acting on behalf of a third party, where the following conditions are satisfied:
(i) the existence, nature and amount of the fee, commission or benefit, or, where the amount cannot be ascertained, themethod of calculating that amount,must be clearly disclosed to the client, in amanner that is comprehensive, accurate and understandable, prior to the provision of the relevant investment or ancillary service;
(ii) the payment of the fee or commission, or the provision of the non-monetary benefitmust be designed to enhance the quality of the relevant service to the client and not impair compliance with the firm’s duty to act in the best interests of the client;
(c) proper fees which enable or are necessary for the provision of investment services, such as custody costs, settlement and exchange fees, regulatory levies or legal fees, and which, by their nature, cannot give rise to conflicts with the firm’s duties to act honestly, fairly and professionally in accordance with the best interests of its clients.
Member States shall permit an investment firm, for the purposes of point (b)(i), to disclose the essential terms of the arrangements relating to the fee, commission or non-monetary benefit in summary form, provided that it undertakes to disclose further details at the request of the client and provided that it honours that undertaking.” TheMiFID inducement rule has been incorporated into the FSA’s new Conduct of Business Sourcebook at COBS 2.3. COBS 2.3 is effectively a copy out of Article 26 of the Level 2 Directive, albeit with additional colour to clarify the application of the rule to certain non-MiFID business, specifically as regards packaged products.
Does theMiFID inducement rule apply to all clients?
The MiFID inducement rule is potentially relevant to a client wherever Article 19(1) of theMiFID Level 1 Directive applies to their business. Article 19(1) of theMiFID Level 1 Directive will not apply to any client that has been correctly categorised by an FSA regulated firmas an eligible counterparty (ECP) as regards business covered by the ECP client status (this amounts to executing orders on behalf of clients, dealing on own account and the reception and transmission of orders). Thismeans that theMiFID inducement rulemay apply to any client categorised by an FSA regulated firmas a professional client or a retail client.
There may also be circumstances where theMiFID inducement rule is not relevant because the person being dealt with by an FSA regulated firmis not a “client” for the purposes of the FSA conduct of business rules. This would be the case, for example, where the firmwas dealing with a person who had been correctly categorised as a corporate finance contact in the context of the firm’s corporate finance business.
How should firms go about applying the MiFID inducement rule?
The Committee of European Securities Regulators (CESR) finalised its recommendations on inducements underMiFID inMay 20074. CESR’s recommendations form part of its Level 3 work onMiFID, the purpose of which is to produce guidance on keyMiFID requirements to ensure that they are consistently implemented and applied across Europeanmarkets. The recommendations should therefore be taken into account by FSA regulated firms when considering how to apply theMiFID inducement rule to their business arrangements.
CESR’s view is that theMiFID inducement rule applies to all fees, commissions and non-monetary benefits paid or provided to or by a firmin relation to the provision of an investment or ancillary service5 to a client. Rather surprisingly, it is not necessary for there to be an underlying purpose or intent to influence the actions of the recipient, this being whatmost people would understand to be the hallmark of an inducement. This means that the term“inducement” becomes something of amisnomer in the context of Article 26 of theMiFID Level 2 Directive, at least as regards determining whether theMiFID inducement rule applies in the first place. Instead, the questions to ask when determining whether the rule applies (assuming, for these purposes, that the clients in question have been categorised as professional or retail clients) are as follows:
- Is a fee, commission or non-monetary benefit being paid or provided by or to the firm?
- If the answer to the first question is yes, is the payment made or benefit provided in the context of the provision of an investment or ancillary service to a client?
TheMiFID inducement rule would only apply where the answer to both questions is positive. Thismeans that, for example, a payment in the formof a “spread” ought to fall outside the scope of theMiFID inducement rule on the grounds that it is neither a fee nor a commission (although it is doubtful whether this logic would apply where the “spread” had been inflated to conceal what was in reality an inducement). There is also an argument that an underwriting fee paid by an issuer to an FSA regulated firm in the context of the underwriting of a primarymarket issue should not trigger an inducement question as regards the investors in the securities being issued, because the investment service in question (namely underwriting) would be provided to the issuer and not the investors.
Assuming the answer to both questions is positive so that theMiFID inducement rule applies, the next stage is to determine whether the fee, commission or non-monetary benefit is capable of falling within one of the three exceptions set out in paragraphs (a), (b) and (c) of Article 26 of theMiFID Level 2 Directive. Failure to satisfy the requirements of one of these exceptions wouldmean that the fee, commission or non-monetary benefit was a prohibited inducement for the purposes ofMiFID.
The exception in Article 26(a)
The wording of the Article 26(a) exception is such that it would cover any fee, commission or non-monetary benefit paid or provided to or by the client itself. Onemight think on a plain reading of the words that this exception would apply whenever an agent made a payment on behalf of a client (for example, where an introducing broker acting on behalf of an underlying client received an introduction fee froman FSA regulated firm). Unfortunately, CESR has construed this aspect of the Article 26(a) exception in such a way that the clientmust be aware that a payment has actually beenmade or received on its behalf. Clearly, the client would be fully aware where it had issued a separate, specific instruction to a third party to make or receive a payment on its behalf.
The exception in Article 26(b)
The Article 26(b) exception authorises payments or non-monetary benefits paid or provided to or by a third party where the following requirements are satisfied:
- clear, prior disclosure of the payment or non-monetary benefit has beenmade to the client of the UK regulated firm(Condition 1)
- the payment or non-monetary benefit has been designed to enhance the quality of the service to the client (Condition 2)
- the payment or non-monetary benefit does not impair compliance with the firm’s duty to act in the best interests of the client (Condition 3)
The client disclosure required underCondition 1 extends to the existence, nature and amount of the payment or non-monetary benefit, or,where the amount cannot be ascertained, themethod of its calculation.Byway of a concession, it is possible to satisfyCondition 1 by disclosing the essential terms of the arrangements in summary formon the basis that the firmundertakes to disclose further details at the client’s request and subsequently honours that undertaking.CESRhas said that the summary disclosure must contain enough information to enable the client tomake an informed decision and that a generic disclosure that a firm may receive a payment or non-monetary benefitwill not be sufficient. There is currently nomarket practice regarding the content of any such summary disclosure and, in particular, it remains unsettledwhether the amount of the payment or non-monetary benefit (or,where appropriate, themethod of its calculation)must always be disclosed to the underlying client.
In relation toCondition 2,CESR has clarified that the use of theword “designed”means that the arrangement should be judged at the time it is proposed rather than at the time the payment ismade or non-monetary benefit is provided. Further, the requirement to enhance service qualitywill bemet at the level of the service,meaning thatmore than one client may benefit fromthe payment or non-monetary benefit. CESR’s recommendations include a list of factors that should be considered when determining whether an arrangement satisfies Conditions 2 and 3. These factors are as follows:
- the type of the service provided by the firmto the client and any specific duties it owes to the client in addition to those under theMiFID inducement rule
- the expected benefit to the client (including its nature and extent) and any expected benefit to the firm
- whether there will be an incentive for the firmto act other than in the client’s best interests and whether this incentive is likely to change the firm’s behaviour
- the relationship between the firmand the entity receiving or providing the benefit
- the nature of the benefit, the circumstances in which it is paid or provided and whether any conditions attach to it
The point to note here is that these factors go verymuch to the heart of what FSA regulated firms have previously understood to be the characteristics of an inducement, albeit that the analysis required under theMiFID inducement rule operates at the level of the Article 26(b) exception rather than at the level of determining the payments and non-monetary benefits that fall within the scope of the rule.
The Article 26(b) exception is likely to be relevant to any FSA regulated firmthat acts as an introducing broker or enters into an introduction or referral arrangementwith an introducing broker. It is also particularly relevant to distribution arrangements forwhich an FSA regulated firmacts as product provider or distributor. In this regard,CESR has helpfully clarified that payment by a product provider or issuer to a distributor can be viewed as satisfyingCondition 2 as regards the end clients investing in the product in question, on the basis that no servicewould be provided to the end clients in the absence of a payment to the distributor. Further, in the case of a distribution arrangement,CESR has stated that each firmshould satisfyCondition 1 in relation to its own client,meaning that a product provider or a distributor6 having no relationshipwith end investor clients need not satisfy Condition 1 as regards those clients7.
The exception in Article 26(c)
This exception permits the payment of fees that satisfy the following conditions:
- the fee paymentmust enable the provision of the service or be necessary for it to be provided (Condition 1)
- the fee paymentmust by its nature be something that cannot give rise to conflicts with the firm’s duty to act honestly, fairly and professionally in accordance with the best interests of the client (Condition 2)
The effect of Condition 2 is to require FSA regulated firms to determine whether the nature of the arrangement is such that it cannot give rise to conflicts of interest. This is another example of how theMiFID inducement rule appliesmore traditional thinking on inducements at the level of an exception rather than at the level of determining whether the rule applies in the first place. Logic suggests that fees set at an inflated level as compared to the normin the relevant market are unlikely to satisfy Condition 2. There is clearly a significant degree of overlap between Condition 2 above and Condition 3 of the Article 26(b) exception, meaning that the factors specified by CESR as being relevant to the Article 26(b) exception ought also to be relevant to the Article 26(c) exception.
What has happened to the FSA’s use of dealing commission rules?
The FSA’s use of dealing commission (or unbundling) rules were brought into effect in 2006 as a replacement to the previous FSA rules on soft commission arrangements. The use of dealing commission rules limit the range of goods and services that FSA regulated fundmanagers can receive out of brokerage commissions paid to brokers for order execution in circumstances where those commissions are borne by the underlying funds. The goods and services permitted under the use of dealing commission rules include those related to the execution of trades on behalf of the underlying funds and the provision of research. Any FSA regulated fundmanager adhering to the use of dealing commission rules in the period before 1 November 2007 benefited froma “safe harbour” fromthe pre-MiFID FSA inducement rule.
The FSA had to decidewhat to do with the use of dealing commission rules in the run up toMiFID implementation, bearing inmind that they are similar in a number of respects to theMiFID inducement rule8. Its conclusionwas that the rules went above and beyond the requirements of theMiFID inducement rule (so called “gold-plating”) and that they could be justified in the post-MiFID rulebook on the grounds that they satisfied the test applied under Article 4 of theMiFID Level 2 Directive9. The use of dealing commission rules now appear at COBS 11.6 and are stated as building upon the requirements of the new FSA inducement rule in COBS 2.3. What is different is that there is now no “safe harbour” from the FSA inducement rule where an FSA regulated fund manager adheres to the use of dealing commission rules. Instead, there is guidance stating that FSA regulated fund managers should complywith both sets of rules.
So what does thismean in practice? Ultimately, FSA regulated fundmanagers and their brokers will have to get comfortable that any arrangement entered into in reliance on the use of dealing commission rules in COBS 11.6 also complies with the inducement rule in COBS 2.3. There has to be a strong argument that, absent any express statement to the contrary fromthe FSA, compliance with the former shouldmean that the latter is also complied with.
Some final observations
It is hard to ignore the fact that there has been a shift in the UK froman inducement rule based on conflicts of interest (to which an inbuilt yardstick ofmaterialitywas applied) to a muchmore sweeping inducement rule having its basis in high-level, open-ended conduct of business principles. The fact that theMiFID inducement rule catches every fee, commission or non-monetary benefit paid or provided to or by an FSA regulated firmin relation to the provision of investment or ancillary services to a client has naturally raised concerns among firms that there may be arrangements that need to be reviewed afresh or considered for the first time froman inducement perspective in light of the rule changes introduced on 1 November 2007. Any such review will inevitably amount in large part to establishing whether an arrangement can benefit fromone of the three exceptions available under theMiFID inducement rule, this being the natural consequence of having a rule with seemingly unlimited scope.
In light of this climate of regulatory change and the absence of FSA or industry guidance on the subject of theMiFID inducement rule, theremust be a case for FSA regulated firms working together in the short term(whether through the promulgation of formal industry guidance or the development of informal guidelines) to establish amore uniformand consistent approach to some of themore problematic aspects of the new rule. An obvious example of a potentially problematic area on which there currently appears to be littlemarket consensus is theminimum content of the summary disclosure permitted under the terms of the Article 26(b) exception. Greater uniformity of approach should give rise to a potential “safety in numbers” benefit for firms andmay also influence the FSA’s upcoming supervisory and policy work on firms’ compliance with the requirements of theMiFID inducement rule. The argument for firms coming together in the first quarter of 2008 to close the lid on Pandora’s boxmust surely be a good one.