MiFID II is Europe’s new financial regulation for investment business which came into effect on 3 January 2018. The banking and legal industries seem to be unsure about whether or not MiFID II treats both issuers and buy-side participants as “clients” in relation to issuances. If this were indeed the case, underwriters’ fees would best be disclosed to buy-side investors under MiFID II’s inducement rules. Traditionally, the United Kingdom has not followed such an approach, allowing underwriters and placing agents to regard themselves as acting only for the issuer or seller. Whilst MiFID II does introduce various new rules which are relevant to underwriting in general and disclosure in particular, the United Kingdom’s implementation has not repealed the United Kingdom’s “corporate finance contact” exemption, under which firms can make clear when underwriting that they are acting only for the issuer in connection with the issue and not for any purchasers of the issuer’s newly issued instruments. Firms may wish to disclose fees due to market developments or as a defensive step, but in our view this is not mandatory under MiFID II, either in debt or equity securities markets.
Introduction: The Corporate Finance Contact Exemption
Investment banks engaged in primary or secondary markets activities, such as acting as underwriters, arrangers, managers, placing agents or in other capacities on a deal, will typically have client relationships with a suite of buy-side firms as well as with the issuer (or selling shareholders). Buy-side firms may separately have prime brokerage, custody, lending, advisory, execution dealer, portfolio management or other relationships with the same bank. In addition, the issuer or seller on any deal will also clearly be a client of the investment bank for regulatory purposes.
The definition of “client” under MiFID I, MiFID II and the FCA’s Conduct of Business rules is rather wide, such that an investment bank could, without more, find itself treated for regulatory purposes as acting for both the issuer and the purchasers of securities, and owe regulatory duties to both. Such a situation would be untenable as a legal and regulatory matter: a client relationship on both the buy-side and the sell-side would give rise to irreconcilable conflicts of interest on the part of the investment bank. The investment bank would be obliged to its issuer client to obtain the highest possible pricing for the transaction while simultaneously being obliged to its buy-side clients to obtain the lowest possible pricing for the same transaction.
In order to address this issue, the FCA Handbook, since its inception as the FSA Handbook well before MiFID I, has always provided that a financial institution does not owe prospective purchasers of securities any regulatory duties if it “clearly indicates” that it is not acting for such persons and that such persons will not be treated as its clients. Essentially, the investment bank’s client in relation to any offering is the issuer and its sole obligation is to obtain the best possible pricing for the issuer. Its buy-side clients are instead treated as so-called “corporate finance contacts” in the context of any specific transaction and are exempt from being treated as clients in the context of the offering. In order to fall within this exemption, it is necessary to include language along the following lines in deal documentation, as is standard in EU capital markets documentation:
“In connection with the offering, the [underwriter[s]/name(s) of such persons] [is/are] not acting for anyone other than the [issuer] and will not be responsible to anyone other than the [issuer] for providing the protections afforded to [its/their] clients nor for providing advice in relation to the offering.”
It is also sometimes made explicit that the underwriters are not acting for any selling shareholders or guarantors or other involved parties. Where the person appointing the investment bank is a non-issuer seller, their name would be substituted for that of the issuer.
The corporate finance contact exemption has remained in the FCA rulebook after implementation of MiFID II.
Here We Go Again: 2007 and All That
When MiFID I was implemented in 2007, there were discussions as to whether the corporate finance contact exemption could still be relied upon. This is because there was no mention of this concept in MiFID I and certain elements of MiFID I seemed to apply across the board. Notably, article 19(2) of MiFID I required that “[a]ll information, including marketing communications, addressed by the investment firm to clients or potential clients shall be fair, clear and not misleading.” This standard applied (and continues to apply) to all communications, including those by investment banks to buy-side participants.
MiFID I also introduced new rules on conflicts of interest. Investment banks became comfortable that, in the context of primary and secondary markets activities, their conflicts of interest policies could provide that they would act solely for the issuer. Most banks disclosed this fact in policies and deal documentation and described any consequential related conflicts to buy-side clients in order to comply with MiFID I.
The New MiFID II Regime for Underwriting and Placings
MiFID II contains several new requirements relating to primary and secondary markets activities in this context. First, the conflicts of interest provisions are recast and expanded. Secondly, new and more detailed rules are applicable in the context of underwriting and placing, as regards the identification, disclosure and management of conflicts of interest. The intention is to “ensure that the underwriting and placing process is managed in a way which respects the interests of different actors. Investment firms should ensure that their own interests or interests of their other clients do not improperly influence the quality of services provided to the issuer client. Such arrangements should be explained to that client, along with other relevant information about the offering process, before the firm accepts to undertake the offering….Investment firms engaged in underwriting or placing activities should have appropriate arrangements in place to ensure that the pricing process, including book-building, is not detrimental to the issuer’s interests.”
In particular, MiFID II requires new disclosures to the issuer of:
“(a) the various financing alternatives available with the firm, and an indication of the amount of transaction fees associated with each alternative;
(b) the timing and the process with regard to the corporate finance advice on pricing of the offer;
(c) the timing and the process with regard to the corporate finance advice on placing of the offering;
(d) details of the targeted investors, to whom the firm intends to offer the financial instruments;
(e) the job titles and departments of the relevant individuals involved in the provision of corporate finance advice on the price and allotment of financial instruments; and
(f) firm’s arrangements to prevent or manage conflicts of interest that may arise where the firm places the relevant financial instruments with its investment clients or with its own proprietary book.”
Specifically, in relation to conflicts of interest, the rules on underwriting and placing require that: “[f]irms shall identify all potential conflicts of interest arising from other activities of the investment firm, or group, and implement appropriate management procedures. In cases where an investment firm cannot manage a conflict of interest by way of implementing appropriate procedures, the investment firm shall not engage in the operation. … Investment firms providing execution and research services as well as carrying out underwriting and placing activities shall ensure adequate controls are in place to manage any potential conflicts of interest between these activities and between their different clients receiving those services.”
Firms are required to maintain systems, controls and procedures to identify and prevent or manage conflicts of interest that arise in the specific context of the risk that they might under-price an issue by having regard to the interests of investors, not their issuer clients. These rules serve only to strengthen the status quo treatment of corporate finance contact relationships in securities offerings, which provide a clear path towards compliance with these new rules.
MiFID II also introduces other important new rules, notably on allocation policies and product governance, which are not addressed in this paper.
Disclosure of Underwriting Fees by the Back Door? The Impact of the MiFID II Inducements Rule
Arguably the most difficult aspect of the entire MiFID II package has been the new inducements rule. We have published separate client notes on this topic concerning both fund management and investment banking.
MiFID II restricts the payment or receipt of all fees, commissions and non-monetary benefits (which are defined as so-called “inducements”) unless these enhance the quality of service provided to a client and do not impair an EU investment firm’s duty to act in the best interests of its client. EU investment firms are obliged to disclose to each client all fees, commissions and non-monetary benefits received by them in connection with any investment service provided by them to that client.
Article 24(9) of MiFID II requires Member States to “ensure that investment firms are regarded as not fulfilling their obligations” in relation to conflicts of interest “where they pay or are paid any fee or commission … 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 a client,” unless (i) it is designed to enhance the quality of service to the client and (ii) it does not impair compliance with the investment firm’s obligation to act honestly, fairly and professionally in accordance with the best interest of its clients.
In our view, underwriting fees pass the generic tests for fees to be permitted under the general inducements rule, even if it applies, since a specific regime under MiFID II allows for underwriting and provides for conflicts to be managed in that context. However, the same article goes further, to require that: “[t]he existence, nature and amount of the payment or benefit … or, where the amount cannot be ascertained, the method of calculating that amount, must be clearly disclosed to the client, in a manner that is comprehensive, accurate and understandable, prior to the provision of the relevant investment or ancillary service.”
These inducement-related disclosure rules are further detailed under a Commission Delegated Directive, applicable to “investment firms paying or being paid any fee or commission …. in connection with the provision of an investment service or ancillary service to the client.” Such firms must “ensure that all the conditions set out in Article 24(9) of Directive 2014/65/EU and requirements set out in paragraphs 2-5 are met at all times.” These further requirements are more detailed concerning the way in which fees or commissions should be disclosed:
“Investment firms shall disclose to the client the following information:
(a) prior to the provision of the relevant investment or ancillary service, the investment firm shall disclose to the client information on the payment or benefit concerned …;
(b) where an investment firm was unable to ascertain on an ex-ante basis the amount of any payment or benefit to be received or paid, and instead disclosed to the client the method of calculating that amount, the firm shall also provide its clients with information of the exact amount of the payment or benefit received or paid on an ex-post basis; and
(c) at least once a year, as long as (on-going) inducements are received by the investment firm in relation to the investment services provided to the relevant clients, the investment firm shall inform its clients on an individual basis about the actual amount of payments or benefits received or paid. Minor non-monetary benefits may be described in a generic way.”
So, the argument goes, even though the specific rules on underwriting and placing impose no requirements for underwriting fee disclosure to the buy-side, the inducement rules do require such disclosure. Such persons might be clients “in connection with” the offer if the securities are purchased pursuant to an advisory or management mandate or where the securities are received into a custody account at the same institution. Under this line of argument, the fee arrangements would require disclosures: (i) generally speaking, that the bank may receive underwriting commission, whether based on a percentage fee or otherwise; (ii) specifically, in relation to particular proposed transactions, with details of the basis for the commission; and (iii) as to total amounts of commissions received in respect of transactions placed with the particular investor on a periodic basis.
In our view, the better analysis is that these arguments, whilst plausible, are incorrect as an EU law matter. Moreover and in any event, as a matter of UK regulation we are of the view that disclosure is not mandatory. First, on the basis of the natural meaning of the wording, Article 24(9) of MiFID II does not apply to underwriting or placing at all so as to require disclosures. The provision only applies to payments or receipts by a firm “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 a client.” The underwriting fee is not being paid to or by any person “except the client.” It is paid by the client (or a person on the client’s behalf). Further, in our view the service for the issuer is unconnected with any services provided to clients who may become purchasers of the issue. In other words, the provision of custody, lending or other services to other clients has no connection with the underwriting or placing and the restriction in Article 24(9) therefore does not apply in the context of payments received by the underwriter from the issuer against the backdrop of that separate relationship. This is indeed the very basis for the United Kingdom’s implementation. Were it not the case then, analytically, the conflict between the firm’s obligation to the issuer to obtain the best price and the countervailing obligation to its other clients to reduce that price would be irreconcilable and could hardly be said to be satisfied merely by disclosure of the fee level to those other clients. The dual role held by the underwriter would likely only be capable of being managed by stepping away from the transaction entirely. This is exactly why the UK corporate finance exemption exists—to make clear to purchasers that the firm as underwriter has not taken account of their interests. If the firm has at the same time a fiduciary (for instance advisory) relationship with some of the purchasers, this should in principle be exercised behind an ethical wall, such that the firm operates in that context independently from its underwriting function.
The position is made absolutely clear in the United Kingdom: where the United Kingdom’s corporate finance contact exemption applies, the buy-side participant will not be a “client” in connection with the offering and there will therefore be no “investment service or ancillary service” provided to the buy-side participant for purposes of this provision. The investment bank’s only client will be the issuer.
The UK Implementation
It should be noted that article 24(9) of MiFID II does not impose a directly applicable legal requirement of disclosure; instead, it is a mandate on member states. An understanding of the implementation of Article 24(9) in each member state is therefore required to comprehend the scope of the requirements.
On 3 July 2017, the FCA published Policy Statement PS 17/14 “Markets in Financial Instruments Directive II Implementation – Policy Statement II.” The FCA largely copied out the new requirements in relation to underwriting and placing and also applied them to UK branches of non-EU firms, in order to maintain a level playing field between MiFID firms and third country firms. Prior to the implementation of MiFID I, the FSA Handbook contained (in the Conduct of Business sourcebook) detailed guidance on underwriting and placing activities. This guidance was replaced on MiFID I implementation with guidance in SYSC 10.1.13 – SYSC 10.1.15. However, the FCA’s regulatory expectations around underwriting and placing remained unchanged. In its review of the MiFID II requirements, the FCA confirmed that the new requirements did not change the status quo. The FCA proposed deleting the specific guidance in SYSC 10.1.13–SYSC 10.1.15, as the the new MiFID II provisions are more thorough than the existing guidance in SYSC 10. It has stated, however, that “[m]any of the new underwriting and placing requirements introduced under MiFID II now add rigour to what is expected by of firms but are fully consistent with SYSC 10.”
Notably, the FCA has retained the Handbook glossary definition of “corporate finance contact” and has not changed any use of the definition in its final rules for MiFID II implementation, meaning that the exemption continues in force.
A more difficult question may arise, if article 24(9) of MiFID II do actually apply to buy side participants on underwritings (despite the interpretative, purposive and other arguments above), as to whether MiFID II would then override a contradictory member state law, such as the FCA Handbook provisions which give effect to the corporate finance contact exemption. However, in our view, under the EU treaties and EU case law, even if new disclosure requirements were mandated by MiFID II for underwriting, this would not override the UK regulators’ rulebooks.
MiFID II, which is a directive and contains the troublesome provisions on inducements, can have direct effect in some circumstances, if the United Kingdom were to be found to have failed to implement MiFID II into national laws or to have implemented it incorrectly. The first principle in interpreting apparently contradictory EU directives and member state laws is to attempt to reconcile them so as to achieve the purpose of the directive. However, national courts cannot apply such an interpretative approach where a member state law and EU directive are in direct, irreconcilable conflict, as would be the case in the scenario discussed here. Where there is a direct conflict, the EU directive cannot prevail over national laws so as to impose an obligation on individuals. This principle has been somewhat eroded in recent case law as regards civil obligations. However, it remains a cornerstone of EU law that an untransposed directive cannot have the effect of imposing or exacerbating criminal liability. The EU courts have omitted to interpret EU laws so as to impose tax code breaches and the same principle should apply to regulatory breaches, meaning that the United Kingdom’s corporate finance contact exemption will prevail as a matter of UK law and regulation.
For the reasons above, in our view, the corporate finance contact exemption remains good law in the United Kingdom and means that disclosures for investment banks active in the primary or secondary markets in most situations will not be mandatory. This does depend, however, on the relevant investment bank being able to make the statement set out in the first section of the memorandum accurately: that it is indeed only acting for the issuer and for no-one else in connection with the offering. If the bank is acting for buyers in a discretionary portfolio management capacity and purchases bonds that it is underwriting in that capacity, then it would need to establish additional processes to address conflicts of interest.
We understand that various market associations and market participants have been looking into this topic. ESMA has, to date, issued no relevant guidance on this topic.
It may be that more or less defensive approaches to this question arise in different markets, or that the approach of continental EU banks with less comfort on this topic (due to the absence of an equivalent to the corporate finance contact exemption in their local law) results in market changes. MiFID II has clearly led to enhancements as regards client disclosures and some firms may choose to go beyond the strict limits of what is required under UK regulation. We are only commenting here on what the position is as a matter of law.