Strengthening the compliance function within firms is a key focus of MiFID 2. In an article for World Securities Law Report, Christina Pope and Emma Radmore look at the changes firms will see.
MiFID 2: Comply or Die?
Previous articles in our MiFID 2 series have considered the effects of MiFID 2 on dealings with customers, and on transparency. This third article, by Christina Pope and Emma Radmore, looks at how MiFID 2 will affect how firms organise their compliance.
Strengthening the compliance function within firms is a key focus of MiFID 2. The reason is clear - a strong compliance function reduces risk.
The compliance function within an investment firm is responsible for identifying, assessing, monitoring and reporting on the firm's compliance risk. Compliance risk is the risk a firm fails to comply with its obligations under MiFID and other applicable laws.
Senior management is responsible for ensuring the compliance function is adequate. We have already seen the regulatory appetite for levying penalties against individuals in senior positions and this is unlikely to reduce under MiFID 2. In the UK at least, the new domestic Senior Managers and Certification Regime will focus the minds of all individuals categorised as senior management. Hopefully, this will have the effect of supporting a strong compliance function.
While MiFID requires firms to have a clear set of systems and controls in place, the principle of proportionality applies. Firms are free to tailor their compliance function to the nature, size and complexity of the business.
What is the compliance function under MiFID?
The compliance requirement under the current MiFID is in Article 13(2). It states:
"An investment firm shall establish adequate policies and procedures sufficient to ensure compliance of the firm including its managers, employees and tied agents, with its obligations under the provisions of this Directive as well as appropriate rules governing personal transactions by such persons".
The detailed compliance requirements are in Article 6 of the MiFID Implementing Directive. Firms must have in place a permanent and independent compliance function. This function must
- regularly monitor and assess the adequacy and effectiveness of the firm's compliance measures and procedures; and
- advise and assist the persons responsible for carrying out the investment business in how to comply with MiFID.
In order to do this, under MiFID, firms must equip their compliance function with the necessary authority, expertise and resources and access to information which allows them to carry out their function.
Firms must have a compliance officer who is responsible for the compliance function and related reporting obligations. The compliance officer must be independent of the firm's investment business activity and the compliance officer's remuneration must not be linked to the performance of the investment business activity. These principles apply unless the firm can show that the nature and complexity of the business is such that it would be disproportionate for the firm to comply with them.
In 2012, the European Securities and Markets Authority (ESMA) produced a set of guidelines for firms to follow and for Member State regulators to incorporate into their supervision. ESMA's intention was to clarify firm's responsibilities, promote pan-European consistency, and boost investor protection.
ESMA's general guidelines are that:
- firms should take a risk-based approach to allocating compliance resources, and carry out a risk assessment regularly;
- the compliance function should establish a monitoring programme that covers all aspects of the firm's investment business. The monitoring programme should have priorities built in to it in line with the compliance risk assessment;
- the compliance function should provide written reports to senior management at appropriate intervals and no less frequently than once a year. The report should outline the effectiveness of the overall compliance control of the investment business activity and a summary of identified risks and subsequent remedies.
- to fulfil its advisory and assistance responsibility, the compliance function should provide training, day-to-day assistance and participate in the development of new practices and procedures.
- firms should make adequate arrangements for when the compliance officer is absent to ensure the compliance function is permanent and on-going.
- the compliance officer should be independent within the organisational structure, have sufficiently broad knowledge, experience and expertise and should be appointed and replaced by senior management.
ESMA also set out guidelines on what to consider when assigning resources. Where a firm considers a particular form of compliance is disproportionate, firms must assess whether they properly fall within the exemption the MiFID Implementing Directive provides and whether making use of it has an impact on the overall compliance function.
What does FCA require?
Authorised firms in the UK must comply with the rules set out in 6.1 of the Senior Management Arrangements, Systems and Controls sourcebook (SYSC) of the FCA Handbook. The rules in SYSC 6.1, insofar as they apply to UK firms that are MiFID investment firms, mirror Article 6 of the MiFID Implementing Directive. As FCA's regulated community goes wider than firms that derive their authorisation from MiFID, there are sometimes slight differences in requirements and expectations depending on, for example, whether the firm is a credit institution or a fund manager. Completely separate rules apply to insurers.
This part of SYSC is the only part of FCA's Handbook that relates specifically to the compliance function. However, under the current rules, one of the many "controlled functions" to which firms must appoint an individual as an "approved person" (which means that individual, as well as the firm, is directly accountable to the regulator, and subject to enforcement proceedings) is that of "compliance oversight", known as a CF10. This is the person allocated the function set out in SYSC. The person will work closely with a number of other individuals approved in different functions, particularly the money laundering reporting function and the CASS oversight function (for firms that hold client money and assets). Indeed, in smaller firms, the same individual may hold all three functions as well, often, as being approved as a director. There is no absolute requirement the individual be a director, provided the individual, and the compliance function, meet the MiFID and FCA requirements on experience, resource and independence.
Given the wide-ranging scope of the SYSC requirements, and FCA's Principles for Business (in particular Principle 3, which states that "A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems"), the majority of FCA's enforcement actions and fines will refer to compliance failings, whether or not FCA includes the CF10 or any directors or other approved persons in its actions. In this way, FCA embeds compliance within the firm, while not always placing blame on the compliance function.
What's new under MiFID 2?
Article 16(1) of MiFID 2, which sets out the compliance function requirement, is identical to Article 13(2) of the current MiFID.
The detail of the compliance function's obligations will come in the form of delegated acts and technical standards. The European Commission ("Commission") relies on ESMA for advice on what these should be. In its advice to the Commission ESMA stated that MiFID 2 should adopt a form of the "Level 2" procedures set out in its compliance guidelines in 2012. ESMA has advised the Commission to modify Article 6 and transpose it into MiFID 2.
What does ESMA think?
ESMA considers that the existing Level 2 measures in Article 6 above should form the basis of the requirements under MiFID 2 but should be enhanced by incorporating the ESMA guidelines set out in their guidance paper in 2012. The modifications that ESMA recommends are as follows:
- firms must have in place adequate policies and procedures designed to detect and minimise any risk of failure of the firm in complying with its obligations under MiFID 2;
- the compliance function would have added responsibilities which include:
- carrying out a risk assessment of the firm. From that, the firm must set up a risk-based monitoring programme;
- monitoring must be permanent and regular assessments of the adopted measures must be carried out;
- to advise and help persons responsible for carrying out investment business in relation to MiFID compliance;
- report at least annually on the overall control environment for investment business;
- monitor the operations of the complaints process and use the complaints as a source of information.
- as there is under MiFID, ESMA provides for an exemption for firms for which some implementing measures would be disproportionate to the size, nature and complexity of the business.
- to equip the compliance function in carrying out its duties, ESMA's advice is to require that:
- firms have the necessary authority, resources, expertise and access to information;
- the compliance officer is appointed and replaced by the management body, and will be responsible for the compliance function and any reporting under MiFID 2;
- the compliance function can report on an ad hoc basis whenever it has detected a significant risk of failure;
- the persons within the compliance function are separate from the performance of services or activities they monitor; and
- they are remunerated in a way which means their objectivity isn't compromised.
What key changes will firms have to make?
Compliance and therefore a compliance function is a critical element of firms' risk management systems and controls already. MiFID 2 seeks to emphasise this. Some firms may need to make few changes to comply with MiFID 2 standards, while others, who may previously have adopted a more fragmented approach to compliance, perhaps housing it within relevant business units, may have to do more. MiFID 2 (and, if introduced the Level 2 measures ESMA calls for) does not represent a fundamental change from MiFID, but nevertheless will require firms to reassess how they manage their compliance function and how other key risk and audit activities within the firm interact with compliance.
Risk detection remains a vital component of the compliance function. The risk-based monitoring programme must stem from the risk assessment, and it must identify areas of priority. Firms must ensure that the risk assessment itself covers all relevant areas of the investment business and information sources. Firms' annual reports will be among the best indicators of a firm's compliance performance. These should also be used in helping to form the risk assessment and monitoring.
As part of its monitoring programme, the compliance function should oversee the complaints process. It should have access to all complaints received. The compliance function is not required to determine the outcome of complaints but monitor the subject of complaints. This represents a change, certainly, for UK firms, from anything previously expressed as a function of the compliance department and should, in turn, lead to better risk detection and management.
Firms will liable if staff are not adequately trained. Staff must be fully trained for the role they are responsible for. After that, training must be regular and staff must provided with updates and be reminded of their obligations.
Independence and permanence are key. Senior management must provide the compliance function with the resources necessary to meet this requirement. Any absences in the compliance function must be covered by persons with the necessary level of expertise and experience.