MiFID forms a central element of the EU’s highly ambitious Financial Services Action Plan. The sheer breadth and depth of its impact is unlike any change to fi nancial services regulation that the UK has ever seen. All FSA-regulated fi rms will need to be aware of, and plan how to meet, the changes it will bring. This guide is intended to help Legal and Compliance Offi cers to do just that.

This guide comprises the following sections:

  • An Executive Summary, which can act as both an introduction to the topic for the uninitiated and as a summary for management who need to be aware, at an overview level, of what MiFID means, and who will be looking to Legal and Compliance Offi cers to ensure proper implementation;
  • An explanation of the background to MiFID - like many regulatory changes, it often helps to understand what MiFID is trying to achieve to make sure that a fi rm can properly interpret the new rules;
  • A description of changes to the scope of MiFID when compared with the existing ISD regime; Detailed coverage of the key rule changes. These take the form of a “life cycle”, which uses, as an example, taking on and then doing business with a new client in order to illustrate the key changes. The guide highlights areas where systems, controls, procedures or documentation will need to be revised in order to give FSA-regulated fi rms a platform to achieve compliance;
  • A guide to MiFID project planning - what needs to be done, and when, and the role of a Nabarro Nathanson MiFID Opinion in this regard;
  • Finally, some refl ections on MiFID - in particular on the extent to which it might be expected to change regulatory attitudes going forward.

MiFID implementation will not be easy but, with proper planning, fi rms will be able to ensure that they minimise the burden of change, both to businesses and to Legal and Compliance teams. Section 5 describes in more detail the Nabarro Nathanson MiFID Opinion that we have designed to help in this regard.

Section 1

MiFID - an executive summary



MiFID will replace the Investment Services Directive (“ISD”). ISD currently gives certain FSAregulated fi rms so-called “passporting rights” - that is, the right to conduct business throughout the EU on the basis of a single licence granted by the FSA. However, the passport currently does not give fi rms the right to ignore local laws. In practice, this can make conducting cross-border business diffi cult. The activities for which the ISD passport is available are also somewhat limited.

MiFID is an attempt to deal with these two issues. First, following MiFID implementation, fi rms will not only be able to do crossborder business on the basis of a single FSA permission, but they will be able to do so solely in accordance with FSA’s rules. Second, it will be possible to get a passport for additional services. However, as the quid pro quo for these new rights, Member States have agreed what is, in effect, a common European rulebook, including FSA-style conduct of business requirements. Whilst very few of these rules cover areas which will be unfamiliar to FSAregulated fi rms, they do substantively change the majority of the existing conduct of business requirements.

The FSA published its fi nal rule proposals in November 2006 and must have the rules in fi nal form by 1 February 2007 in order for the rules to come into force in accordance with the MiFID timetable on 1 November 2007.


There are relatively few areas where MiFID will create structural change for many business lines. Indeed, for some fi rms, MiFID’s key impact will be to require an extensive review of existing policies and procedures and for revised compliance systems, documentation and controls to be put in place. For other fi rms, MiFID will bring about some changes to mid-offi ce systems and the way that the fi rm does business with its clients. Key impacts will be:

  • changes to the fi nancial promotion regime that govern the ways that fi rms advertise their services;
  • changes to the classifi cation of clients and the type of documentation that must be put in place before a fi rm can do business with a client;
  • new suitability and appropriateness requirements that apply both to retail and professional customers; new requirements relating to the management of confl icts of interest;
  • detailed new rules relating to handling of orders and, in particular, potential changes for fi rms that deal as principal in certain equities (these requirements are commonly referred to as “pre-trade transparency” or “systematic internalisation”);
  • new requirements relating to the use of client assets; and
  • changes to reporting requirements.


In a press release dated November 2005, FSA warned directors of FSA-regulated fi rms that “senior management are advised to earmark suffi cient resource to assess the likely impacts of MiFID on their fi rm, and to consider how to respond to the business, operational and compliance issues that will arise. Early planning will help identify implementation issues.” This was a clear early warning that, following MiFID implementation, the FSA did not expect fi rms to say that they had been unable to complete MiFID implementation on time. It is clear from the FSA’s consultations to date that, given the nature of the MiFID legislation, there is not a lot of scope for the FSA to take creative policy decisions on how to implement the legislation. The FSA have made it clear that they will largely be copying-out the relevant parts of the directive. Therefore, the FSA are right to say that fi rms already have all they need to start MiFID project planning.

However, a successful MiFID plan will need to overcome the following obstacles:

  • inter-dependencies between different parts of MiFID (for example, risk warning disclosures and terms of business requirements);
  • inter-dependencies between MiFID and other directives (for example, the Market Abuse Directive and its requirement relating to research, which overlap with some MiFID requirements);
  • potential early implementation of some aspects such as confl ict management (in order to comply with parallel obligations in other directives, such as the Capital Requirements Directive, which may bring some measures into force earlier in 2007);
  • the potential need for computer systems development, either to limit the impact of the new requirements or to demonstrate compliance with them;
  • the heavy documentation burden relating to procedures, processes and client-facing documents that will need to be revised.

Many fi rms will need to dedicate compliance resources to handle these implications, or to outsource some aspects of their MiFID implementation project. Firms may want to rely upon a Nabarro Nathanson MiFID Opinion (see Section 5) to demonstrate compliance.

Section 2

MiFID - background


The Investment Services Directive (“ISD”) came into force on 1 January 1996. At the time, it was seen as a great step forward in providing for mutual recognition of “investment fi rms”. The effect of ISD was that fi rms carrying on ISD core activities (broadly: dealing; arranging; managing; and underwriting transactions in securities, units, and certain derivative products) were, for the fi rst time, permitted to conduct business throughout the EU on the basis of a single licence. Therefore, a UK-regulated fi rm had the absolute right to do business, either on a cross-border or branch basis, in each EU jurisdiction without the need for any particular permission from the local regulator. In the past, there have been a variety of local rules requiring, for example, fi rms to establish local subsidiaries, or to gain permission to open a branch. The immediate effect was that an increased amount of business was done on a crossborder basis. In some cases, this manifested itself with a proliferation of local branches; in others, in a retrenchment to a single base (often London) from which business could be conducted on a pan-European basis. In particular, non-EU fi rms (such as American investment banks) incorporated UK subsidiary companies as a “front” for their European businesses.


However, conducting business on a cross-border basis was still not easy. ISD did not harmonise locally applicable laws. Therefore, in order to carry out business on a pan-European basis, fi rms still needed to comply with local laws that differed in their scope and application. The range of activities that gave rise to passporting rights was also limited - for example, fi nancial advisers could not get a licence as advice was not covered as a “core” ISD activity.

So, in many respects, ISD was only half a step-forward. In order to complete the process, and as part of the broader case for action across the fi nancial services sector (set out in the Financial Services Action Plan announced at the EU’s Lisbon European Council in 1999), the Commission put forward a proposal to revise ISD in order to combat two key fl aws. First, the Commission’s intention was to expand the range of services that could be provided under the European passport regime. Second, the Commission wanted to enable fi rms to conduct cross-border business on the basis of harmonised rules. There was a broad degree of support for the proposal, in particular political support from the Member States, coupled with some trepidation about the quality of, and philosophy that would underpin, any pan- European rulebook.

Of course, the project of creating a single European rulebook covering investment business was never going to be easy. Each of the regulators had their own idea about what they wanted the outcome to be, as did the

Commission, who, in the end, played a major role in the drafting. The outcome is undoubtedly a compromise - there are areas, such as rules relating to pre-trade transparency in equities, or best execution, or client classifi cation, which demonstrate that something of the original philosophy was lost in the midst of these compromises. However, fi rms will, at least, be able to conduct cross-border business on a simplifi ed, essentially home Member State, basis once MiFID is implemented.


The Financial Services Action Plan was an attempt to bring together around 50 directives in a single, coherent package. It was thought that this would bring the European legislative process grinding to a halt unless a new structure was put in place to bring the legislation into being. The new structure (the so-called “Lamfalussy Process”) was an attempt to streamline the way that this legislation was drafted, and it has had an important impact on the way that MiFID is being introduced.

The Lamfalussy Process works on the basis of a number of “levels”:

[see diagram]

As a consequence, in order to assess their obligations under MiFID firms will need to consider four different “tiers” of legislation:

MiFID - this contains the core measures (in a way that is very broadly analogous to FSMA);

The MiFID Implementing Directive and Regulation - there are two implementing measures. The fi rst, which takes the form of a Regulation, largely looks at market-related issues (although it also contains important obligations for fi rms, such as those relating to pretrade transparency). FSA has no real fl exibility in implementing these measures. The second, contained in the Directive, contains the core conduct of business obligations relating to fi rms. FSA’s ability to gold-plate this measure is severely restricted by the Directive itself - such measures are only supposed to relate to matters of a UK-specifi c nature, or changes following the implementation of MiFID, and must be presented to CESR. In a change from recent financial services directives (e.g. the Market Abuse Directive) MiFID is “maximal” in approach - it seeks to achieve a common position by introducing maximum, not minimum, standards. The Commission has consistently reinforced this position by saying that it does not expect to see Member States gold plating MiFID. In FSA’s October 2006 Consultation on reforming Conduct of Business Regulation, FSA nonetheless identifi ed six area where it intended to acknowledge that its rules gold plated the directive. For retail providers, this includes rules on the use of Initial Disclosure Documents, Reason Why Letters, and polarisation disclosures. For fi rms in wholesale markets, FSA intends to retain its rules on the use of dealing commission. There are other areas where, as we shall see, FSA is not acknowledging that it is gold plating, but intends to retain its rules e.g. on fi nancial promotion of collective investment schemes). In practice, the two implementing measures are very broadly equivalent to a Statutory Instrument issued under FSMA;

FSA rules - firms should hope that everything that they need to know and do would actually be contained in FSA rules. FSA have suggested otherwise in their numerous consultation and guidance papers. However, it is fair to say that the core obligations set out in MiFID and the Implementing Regulation and Directive will fi nd their way into FSA’s detailed rules. Therefore, an undoubted effect of MiFID will be a whole scale rewriting of FSA’s rules relating to the operation of investment business. Even fi rms that are not caught by the scope of MiFID will be affected, as FSA’s broad approach is to ensure that rules are consistent for all fi rms, whether they are within or outside the scope of MiFID (FSA calls this the “Common Platform”). Further, FSA’s stated intention is to “intelligently copy-out” the MiFID implementing measures, although, as we will see, they have also been prepared to take the legislative initiative in certain areas and go beyond merely implementing MiFID;

Industry Guidance - FSA is constrained in its implementation and is therefore looking to make full use of the endorsement of industry guidance. Indeed, in some areas, guidance on FSA’s MiFID implementing requirements is being “outsourced” to industry groups such as “MiFID Connect” (a grouping of the major financial services trade associations), who can be more flexible and interpretive in their approach than can FSA. This gives fi rms an added challenge.

FSA’s rules may no longer contain all the answers. So it is fair to say that the structure of the legislation is complicated (although not signifi cantly more complicated than the existing regime).

However, it is nonetheless a wholesale change to the existing regime and one which is written in an unfamiliar way. One of the challenges facing fi rms is how to tie together all of the different requirements set out in the different levels of the legislation.


There are four key timing aspects to MiFID:

First, FSA was required to publish, in draft, its new rules by 1 November 2006, to be followed by a three month consultation process. FSA’s October 2006 consultation on reforming Conduct of Business regulation was the fi nal element of its MiFID implementation proposals. However, FSA also took the opportunity afforded by implementing MiFID to attempt to simplify the existing rules. This is part of FSA’s policy to move towards principles-based regulation. Indeed, FSA states in the October 2006 consultation that “mis-selling and mis-buying still happens too often. Our response to such conduct of business problems has frequently been to make more detailed rules. These have added to the cost of regulation but failed to address the root causes, which lie in fi rms’ failure to consider the reasonable information needs of their customer and to treat them fairly”. The result is to make changes to FSA’s rules even more wide-ranging that MiFID alone had intended.

Second, FSA’s fi nal measures need to be published on 1 February 2007. However, given the enormity of the exercise facing FSA, and the relatively short timescale, it is unlikely that there will be wholesale changes to what was proposed in November 2006, although FSA has indicated it may develop guidance on MiFID requirements after 1 February 2007.

Third, as well as implementing the requirement set out in MiFID, FSA is also grappling with implementing the Capital Requirements Directive (see section 5 below). As a result, some measures in the two directives overlap (for example, in relation to confl icts of interest). Therefore, some of these measures may come into effect during 2007 - we await further details from FSA.

Fourth, MiFID itself and FSA’s new rules come into place on 1 November 2007.

There has been much publicity about certain Member States (Germany, Italy, France and the Netherlands in particular) being “late” in implementing MiFID. A recent Commission investigation suggested that a majority of Member States would be late. There have even been suggestions, fuelled by the Commission, that Member States that are late will

lose passporting rights on behalf of their member fi rms. In our view, this is highly unlikely to materialise - any such decision would be down to Host Member States which will be unlikely to want to close cross-border business given the collective problems that implementing European directives are giving regulators in general. The UK is expected to be ready on time.

Therefore, in summary, we know the content of the majority of FSA’s new rules already. FSA has been making it clear for some time (in particular in its November 2005 “Dear Director” letter) that planning for MiFID implementation needs to start as soon as possible and, in particular, well in advance of the fi nal nine months preparation period. Coordinating implementation is a complex process requiring, potentially, new procedures, changes to business practices, and correspondence with clients. As an added complexity, certain MiFID measures will potentially come into effect early to fi t in with the timing of the Capital Requirements Directive, so fi rms need to act now.

Section 3

MiFID - scope

As we noted in Section 2.2 above, one of the main reasons to update ISD was to increase the scope of the instruments and services which benefi ted from the Passport. This section identifi es the new instruments and services for which fi rms can apply for cross-border passport permission, and also addresses the changing territorial scope of the passporting regime.

In structure, MiFID follows the approach of its predecessor, ISD, in that it identifi es specifi c instruments to which the Directive relates. It then goes on to identify both “core” and “ancillary” activities and services. A fi rm is only caught by MiFID if it provides “core” services and activities in relation to the identifi ed instruments (for example, dealing on own account in transferable securities). A fi rm that only provides “ancillary” services does not fall within the scope of MiFID, and therefore cannot benefi t from the passport. However, fi rms that provide “core” services and activities are allowed to also provide “ancillary” services using their passport. As we shall see in sections 3.1 and 3.2 below, MiFID changes the categorisation of some of the ISD services, and captures new instruments.


MiFID upgrades investment advice from an ancillary to a core investment service. Therefore, fi rms providing investment advice who had not previously been able to benefi t from a passport for their advice will now be able to do so. The defi nition of investment advice in MiFID is “the provision of personal recommendations to a client, either acting upon its request or at the initiative of the investment fi rm in respect of one or more transactions relating to fi nancial instruments”. The Implementing Directive makes it clear that generic advice is not caught as investment advice, although Recital 81 does point out that if such advice is presented as suitable for a particular client, fi rms will need to bear in mind the requirements relating to fair, clear and not misleading marketing communications, and a general requirement to act in accordance with the best interest of clients.

MiFID also contains a new core service of “operating a Multilateral Trading Facility”. An MTF is a system that brings together multiple third-party buyers and sellers in accordance with nondiscretionary rules - in other words, a rival to an exchange. It is distinguished from an investment fi rm that, on an ad-hoc basis, seeks to match orders with other “natural” orders from clients. FSA has indicated that fi rms currently subject to FSA’s Alternative Trading System rules will be the only fi rms likely to be operating an MTF. The provision of investment research is also caught as an ancillary service for the fi rst time. This will assist fi rms in providing research on a cross-border basis throughout the EU. However, as we will see in Section 4.6 below, new requirements overlapping those contained in the Market Abuse Directive, and FSA’s rules, will be introduced relating to the production of research.


MiFID expands the list of instruments compared to ISD. This will result in certain instruments being caught by the UK regulatory regime for the fi rst time. The most signifi cant is noncash settled commodity options (with the exception of precious metals, which are currently caught by FSA’s regime) where they are traded on a market.

The other instruments caught by MiFID that were not caught by ISD are already subject to regulation in the UK. These instruments are different types of commodity derivative. Under MiFID they will have a passport applied to them for the fi rst time. FSA has worked hard to make sure that its implementation maintains existing defi nitions of the type of instrument which is caught as a regulated derivative - for example, continuing to exclude spot foreign exchange. However, derivatives relating to intangible products such as climatic variables, freight rates, emission allowances, and economic statistics are caught by MiFID. Firms active in these markets will need to identify the type of business currently undertaken, and consider whether or not they need to vary their existing Scope of Permission (see Section 3.4 below), and whether a passport is available which might assist them to carry out business on a cross-border basis.

[see table]


The intention behind MiFID is to create pan-European rulebook. In many respects, the Commission has managed to maintain this principle in the detail of MiFID. Therefore, in future, most business will be subject to the regulation by the Home Member State. This will eliminate an existing diffi culty, whereby ISD fi rms need to pay careful attention to local rules when exercising their passport rights (see Section 2.1 above). The Host Member State will maintain rights in relation to conduct of business rules for business undertaken by a branch located in that Host Member State. However, there are at least two areas where the territorial scope of MiFID is not what might be expected, and which is contrary to the original intention of MiFID.

The first relates to client classifi cation. MiFID fails to produce a consistent defi nition of the three categories of client (Eligible Counterparties (ECs), Professional Clients (PCs) and Retail Clients (RCs) - see further Section 4.2 below). In particular, Member States have retained some discretion over whether particular categories of person can be categorised as an EC. This would be a minor difference were it not for the fact that the relevant country for classifi cation of a client is that in which the client is located, not the investment fi rm. Therefore, investment fi rms will need to be able to classify clients in accordance with the different national regimes.

Second, the rules that relate to overseas branch business are, again, not what would be expected. Clearly, when a fi rm undertakes business from its head offi ce with clients in the same jurisdiction, then local rules apply. Where branch undertakes business with people in the same jurisdiction as that branch, the conduct of business rules relevant to the Member State where the branch is located apply. So far, so good. However, if a branch does overseas business (for example, a German branch of a UK fi rm deals with Austrian clients) then the UK rules apply to the business undertaken by the German branch. Firms will need to identify whether or not any branches conduct signifi cant amount of cross-border business, and, if necessary, ensure that the business can be undertaken from the branch in accordance with both the local conduct of business rules, and those applicable in the Home Member State.


FSA and the Treasury are committed to a grandfathering regime to enable fi rms to be automatically authorised under MiFID on the basis of a sensible interpretation and application of their existing permissions. The experience of N2 suggests that fi rms will need to check very carefully that the existing permissions have been correctly transcribed into the MiFID regime. In addition, fi rms intending to apply for new categories of permission, or whose activities will be caught for the fi rst time, will clearly need to apply to vary the scope of their existing permissions and FSA is currently being asked to ensure that there is a fast-track process for handling such applications. Firms will need to consider the scope of their business in order to ensure that grandfathering is properly applied, and that any variation necessary is applied for in a timely fashion.

MiFID rule changes - life cycle

This section identifi es the key rule changes that will affect fi rms. In particular, its focus is on those areas currently covered in FSA’s Conduct of Business Rulebook. Our approach is to follow a client life-cycle, from the moment that a fi rm fi rst starts to promote its services to a potential client, through client take-on processes, to the rules that apply when the fi rm actually does business with a client. In this way, we hope to highlight the key changes in a manner that makes sense to fi rms thinking about how they deal with their clients - our analysis does not follow the layout of the legislation. Our methodology is based upon the theory that the most effective way of managing a MiFID implementation project is to consider it primarily to be a procedural burden falling upon the Compliance Department, rather than (as some commentators suggest) a piece of legislation which will fundamentally alter the dynamics of the interaction between investment fi rms and their clients.

Firms that take a different view, or intend to re-engineer their business to exploit MiFID opportunities to move into new markets, may fi nd other approaches more helpful.


[see table]

The client life-cycle

[see table]


The fi rst contact that a fi rm has with a client is likely to be promotional. This is the start of our “life cycle”.

Under ISD, advertising is subject to the rules in the Host Member State. One of the best known examples is language requirements in France when dealing with retail clients. MiFID takes a different view. A marketing communication is subject only to Home State rules. MiFID defi nes a “marketing communication” as “any form of information issued to… the public that advertises, makes a recommendation or is capable of acting as a solicitation regarding investment services, and/or fi nancial instruments”.

MiFID only applies to written communications. The existing UK regime applies to both written communications (non-real time fi nancial promotions) and oral promotions (real-time). One argument might be that, as MiFID is maximal in nature, the FSA cannot introduce any restriction upon real-time fi nancial promotions. It was always unlikely that they would take this view, and FSA intends to retain its existing fi nancial promotion restrictions relating to real-time promotions by arguing that as MiFID does not cover the point at all, FSA is free to introduce its own rules in this area.

However, MiFID could, if implemented in its purest form, make substantial changes to the existing UK regime. The marketing of collective investment schemes is restricted in a way not contemplated by MiFID. At the moment, collective investment schemes either have to be authorised by the FSA (in which case they can be promoted widely) or can only be promoted to restricted categories of investor. MiFID contains no similar restriction. Instead, it contains detailed rules relating to suitability and appropriateness (see Section 4.4 below). The Commission seems to think that there is no reason why a fi nancial product ought not to be promoted to any investor, provided that there is a sensible burden in demonstrating the suitability and appropriateness of the investment placed upon the investment fi rm. This is completely at odds with the FSA’s existing regime relating to the promotion of collective investment schemes. FSA is currently working hard behind the scenes to try to retain the basic elements of the existing regime, but it is diffi cult to see how they are compatible with MiFID and, if FSA does take this view, its rules might be challenged.

However FSA ends up tacking these diffi cult issues, there is clarity on one matter. MiFID’s key requirement in relation to marketing communications is that they be “fair, clear and not misleading”, a requirement familiar to all FSA-regulated fi rms. The Implementing Directive develops this theme with more detailed requirements. Appendix 4.1 contains a summary of this detail. If implemented in accordance with FSA’s stated “intelligent copy-out approach”, it will result in a signifi cant simplifi cation of the existing rules contained in COB3. None of the measures are likely to surprise fi rms who have lived with the existing FSA regime. However, fi rms will need to amend existing processes to ensure that they can demonstrate that the newlydefi ned requirements have been taken into account.


Once a fi rm has turned a prospective client into a new client, MiFID requires the fi rm to classify that client and issue it with a terms of business. This is the second step in our client lifecycle.

We have already observed, in Section 3.3 above, the extent to which the MiFID approach to client classifi cation is at odds with the overall philosophy of the directive. If there was one area where harmonisation would have helped investment fi rms, it was in the classifi cation of clients in order that fi rms could understand which clients received particular protections, and which did not. Unfortunately, MiFID has failed to achieve that objective and fi rms will need to be able to classify their clients in accordance with the rules applicable in the Member State of the client, not the firm.

The importance of the categorisation regime is primarily that the categorisation of the client determines the protections that they receive. One key difference is that in a number of cases, clients categorised as Professional Clients under MiFID receive more regulatory protection then they would have done as Intermediate Customers under the existing FSA rules. The best known example is in relation to best execution, where the current opt-out for Intermediate Customers is removed.

The key issues relating to classifi cation for MiFID business are as follows:

  • There are likely to be more Retail Clients, as the quantitative threshold for a “large undertaking” capable of being categorised as a Professional Client is higher than that in the existing FSA rules. In addition to a qualitative test for upgrading Retail Clients to Professional Client status, a quantitative test is also included for the fi rst time. This may make it more diffi cult for new clients to be upgraded, although existing clients who have been upgraded to Intermediate Customer status can be grandfathered as a Professional Client;
  • On occasions, MiFID requires notifi cations to be sent to clients highlighting their categorisation status and its implications;
  • Clients may only be treated as Eligible Counterparties in relation to order execution and transmission. Other activities undertaken with such parties,
  • such as advice, would be covered by the Professional Client regime;
  • FSA has retained its rules that permit a fi rm to treat an agent as its client, rather than the underlying principal of the agent; Firms will, in the future, need to apply size criteria on an entity, rather than a group basis although existing clients categorised on a group basis may be grandfathered to the equivalent category even if they would not meet the new size criteria on an entity basis;
  • The existing rules that result in “corporate fi nance contacts” not being clients are being retained on the basis that fi rms do not provide MiFID services to such clients;
  • Where a client is upgraded to EC status, a fi rm must send a notice to that client and receive an active demonstration of consent (as opposed to silence) from that client.

We set out in Appendix 4.2 the key boundary changes.

FSA will use the MiFID distinctions between EC, PC and RC for non- MiFID business. However, FSA will also allow more fl exibility in grandfathering existing client categorisations, and in “upgrading” retails clients by softening the quantitative criteria referred to above.

Firms will need to review their existing processes to make sure that, in the future, they can comply with requirements relating to categorisation. In particular, new areas that will need to be covered include categorisation in accordance with overseas defi nitions; new requirements for upgrading private clients; and new requirements for giving notices to professional clients of their new status.


FSA currently imposes detailed requirements relating to Terms of Business in COB 4.2, which apply both to Private Customers and Intermediate Customers. MiFID merely has a high-level obligation requiring that a document that is “agreed between the fi rm and the client that sets out the rights and obligations of the parties” is in place with Retail Clients. CESR had originally argued that further guidance was required, but the Commission disagreed, and FSA has taken this to its logical conclusion by stating that it will no longer require Terms of Business to be agreed between Professional Customers. Detailed requirements relating to Retail Clients remain in line with MiFID implementing requirements. In practice, there are a number of circumstances where two-way notifi cations are required, even with Professional Clients, and, in our view, fi rms are likely to continue to want to put in place Terms of Business with Professional Clients to meet these requirements and to manage legal risk more generally.


Once a fi rm has classifi ed its clients, it needs to gather information about that client. This is the next step in our client lifecycle.

FSA’s existing rules contain detailed suitability protections relating to Private Customers. However, they also assume a working knowledge of fi nancial instruments on the part of Intermediate Customers, who consequently get much less protection.

MiFID takes a different view. Certain suitability and appropriateness requirements are applied to Professional Customers, and the extent to which execution-only business can be used to justify the nonapplication of such rules is restricted.

We address each of these topics below.

Know your customer requirements

MiFID does not amend the money laundering regime requiring fi rms to take steps to identify customers. However, there is an overlap between the MiFID requirements on suitability and appropriateness and the existing money laundering regime. This is because the existing money laundering regime requires fi rms to gather information relating to each client, and to understand something about each client’s business in order to be able to notify potentially suspicious transactions. One way of looking at MiFID’s suitability and appropriateness requirements is an expansion of the information required at the client take-on stage, particularly in relation to Professional Clients.


MiFID distinguishes between the requirements that apply to different types of business.

MiFID imposes a suitability requirement where fi rms are providing investment advice or fund management services. In these cases, fi rms are required to “obtain the necessary information regarding the client’s knowledge and experience…fi nancial situation…and investment objectives so as to enable the fi rm to recommend…the investment services and…investments that are suitable for him”.

The Implementing Directive extends this requirement in the following way. When dealing with a Retail Client, the firm must gather sufficient information to demonstrate that their services “meet the investment objectives of the client in question… that the client is able fi nancially to bear…the risks…and has the necessary experience and knowledge in order to understand the risks involved”.

Where a firm is dealing with a Professional Client, it can presume that the client has necessary level of experience and knowledge, but still needs to understand the investment objectives of the client and that they are fi nancially able to bear the investment risks. This is the reason why, in relation to Professional Clients, the new requirements can be looked on as an extension of existing practices relating to understanding a client’s commercial objectives and preventing money laundering. Investment fi rms generally want to understand the objectives of their clients and, if for no other reason than their own credit risk, to understand that the client can bear the fi nancial risks of the transactions they are entering into. So, in relation to professional markets, complying with the suitability obligation may be looked upon primarily as a documentation burden.

It is difficult to be so optimistic in relation to Retail Clients. Firms currently have to deal with FSA’s detailed requirements which often end up with lengthy fact-fi nd documentation and, in addition, Reason Why Letters to justify courses of action. It is likely that these requirements will continue, but they will need to be amended in order to fi t in with MiFID’s view on the importance to be attached to particular types of information, and also of the steps to be taken if a client will not provide information. That is because, when providing investment advice or portfolio management, a fi rm that does not obtain the “necessary” information required cannot provide services or deal in instruments with that client. FSA has made it clear that this requirement does not mean that fi rms cannot act, but that they must tailor their service to ensure it is appropriate given the level of (or lack of) information received.

Appendix 4.4 contains a list of information that must be required in order to meet the suitability test.


Where the service being provided is not fund management or advice, fi rms are required to assess the appropriateness of their activities. This is a lesser test than suitability but nevertheless will require changes to existing procedures. The MiFID requirement is that a fi rm must obtain “information regarding the client’s knowledge and experience so as to enable… the fi rm to assess whether… the service or product is appropriate for the client… [and if not] the fi rm shall warn the client”. The Implementing Directive effectively narrows this obligation merely to Retail Clients, on the basis that investment fi rms can assume that professional clients have the necessary experience and knowledge.

When dealing with retail or professional clients, and whether a suitability or an appropriateness test applies, fi rms are not permitted to not encourage clients to provide them with the required information.

Firms can rely upon the information provided by clients unless they are aware or ought to be aware that the information is manifestly out of date, inaccurate or incomplete. The extent to which FSA genuinely sees this as a requirement to commit to updating client information is not yet clear. Many fi rms do attempt to carry out client reviews on, for example, an annual basis for their own commercial purposes and it may be that the MiFID requirements will fi t in with such reviews - which may, nevertheless, need to be amended to show that they are aimed at MiFID compliance. FSA is currently being encouraged not to take a strict view of this wording so as to give some fl exibility to large fi rms who may come into contact with information in a variety of ways. For example, a bank may receive information in relation to bank lending which would not be known to a different division of the fi rm entering into a fi nancial transaction with that client.

Appendix 4.4 contains the information required to assess appropriateness for Retail Clients.

Execution-only business

The suitability and appropriateness requirements do not apply where a customer is transacting on an execution-only basis. In some ways, the defi nition of execution-only business is liberal, in that MiFID makes that a personalised communication to the client is required before a service can be considered to be provided at the initiative of the fi rm, rather than the client. In the past, general marketing might have been considered suffi cient to prevent business from being classifi ed as execution-only.

However, in another way, the new regime is very illiberal, in that there are restrictions on the type of business which can be treated as execution-only. The key restriction is that such business can only be undertaken in relation to “non-complex instruments”, and the defi nition of a non-complex instrument is very restrictive. All derivatives are excluded from being non-complex per se. In addition, there must be a level of liquidity in any instrument before it can be considered non-complex, and the liability of the client must be limited to the cost of acquiring the instrument itself. Finally, to be classifi ed as non-complex, an instrument must be such that information on its characteristics is “likely to be understood so as to enable the average retail client to make an informed judgment about it”. Given the research on the lack of knowledge of retail clients about fi nancial products in general, it is questionable whether any product would pass this test. It is likely that fi rms will take a sensible approach to this topic and concentrate on the ability of their client base to understand the types of product involved, in particular where products are not generally available to the public.

Other matters

FSA intends to retain its rules requiring fi rms to provide retail clients investing in particular products to be provided with a Reason Why Letter.

FSA will apply the new suitability and appropriateness rules to non- MiFID business.


Conflicts of interest have long been a focus for regulators. FSA regulated fi rms will already be familiar with a variety of requirements aimed at ensuring that fi rms manage confl icts of interest appropriately. In some ways, the MiFID requirements have similarities, but there are important differences which fi rms will need to take into account.

MiFID contains a general obligation in relation to confl ict management, that fi rms must “maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps designed to prevent confl icts of interest…[and] to identify confl icts of interest…[and] clearly disclose” potential confl icts if they cannot otherwise be avoided. Downgrading disclosure to an option of last resort is different to FSA’s, and the English common law’s position and will require existing processes to be reassessed.

MiFID contains a convoluted defi nition of a confl ict of interest and there is probably little to be gained from reproducing it here because it does not bring any particular clarity around what is and is not a confl ict (it is set out in Appendix 4.5). However, MiFID’s recitals make it clear that a confl ict only exists where a fi rm owes a duty to a client.

The Implementing Directive requires fi rms to have a confl ict of interest policy in order to try to identify potential confl icts and to set out confl ict management methods. The policy must be disclosed to clients. In our view, this is likely to lead to fi rms writing high-level confl ict policies and making them available to clients either in a terms of business or on a website, and backing that disclosure up with more detailed internal provisions, for example relating to wallcrossing procedures, that are not disclosed to clients.

So the key action point for fi rms is likely to be that they will need to document their existing confl ict procedures more carefully, reassess their use of disclosure as a primary means of managing a confl ict of interest, and to ensure that existing processes are now written in MiFID compliant language in order to demonstrate that the correct factors are being taken into account.

Appendix 4.5 sets out the factors that should be included within a confl ict management policy.


Research is another topic which has received considerable regulatory scrutiny for some time. Despite the fact that research was covered in great detail in the Market Abuse Directive (“MAD”), the drafters of MiFID have felt it necessary to add additional restrictions. Firms will need to review existing procedures in order to deal with the additional level of complexity introduced by MiFID whilst maintaining compliance with the MAD requirements.

Investment research is the subject of another regulatory defi nition in MiFID. It is “research or other information recommending or suggesting an investment strategy, explicitly or implicitly, concerning… fi nancial instruments… including any opinion as to the present or future value or price of such instruments, intended for distribution channels or for the public… [provided that] research which is labelled or described as investment research or in similar terms, or is otherwise presented as an objective or independent explanation of the matters contained in the recommendation” will also be “research”.

In some ways, the defi nition is similar to that used in MAD. However, there are some important differences. Anything labelled as investment research will fall within the investment research requirements (which, as we will see, will mean that the current distinction between objective and non-objective research is no longer sustainable - firms will not be able to call a product research and merely note that it has not been produced in an objective manner, it will need instead to be identifi ed as a “marketing communication”).

The Implementing Directive makes it clear that the confl ict of interest policy must be applied to research analysts, and there are restrictions on the activities of analysts which are similar to those already contained in FSA’s rules. Analysts must not undertake personal transactions where they have knowledge of the timing or content of research. They cannot undertake personal account transactions contrary to their own current recommendation except in exceptional circumstances and with prior compliance approval. Firms must not accept inducements relating to the subject matter of research, nor promise favourable research coverage, nor permit the object of the research to review it other than to verify the accuracy of factual statements.

Firms will need to review their existing policies in light of these amendments.


At this stage of the client lifecycle, the rules around how a fi rm actually deals with clients (handling client orders; protecting client assets and so on) became relevant.

One of the most important aspects of MiFID is the way that it changes the best execution regime. FSA rules currently apply when a fi rm owes an agency or similar obligation, and require a fi rm to take “reasonable care to ascertain the price which is best available”. There is an important safe harbour for fi rms when trading on LSE.

MiFID makes a number of important changes to this existing regime (which had themselves been anticipated by FSA in its October 2002 Consultation Paper 154). The key aspects of the new best execution regime relate to the factors to be taken into account in achieving best execution, and the circumstances in which the requirement applies.

Best execution is no longer primarily about price. Firms are required to take into account “price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration [although] whenever there is a specifi c instruction from the client the fi rm shall [follow] the specifi c instruction”. The Implementing Directive, and FSA guidance on it, makes it clear that, when dealing with Retail Clients, fi rms are expected to give particular emphasis to the price requirement - price is likely to be the most important factor for Retail Clients.

One area which is very confused in MiFID is precisely when the best execution requirements apply. On the one hand, Recital 33 of MiFID states that it applies “to the fi rm which owes contractual or agency obligations to clients”. However, fi rms always owe contractual obligations on some basis or other, as there is likely to be a contract between the parties. The Implementing Directive appears to contradict this recital in its own Recital 69, which states that “dealing on own account with clients by an investment fi rm should be considered as the execution of client orders, and therefore subject to the requirements… in relation to best execution”. FSA have added to the confusion by stating that, in their opinion, best execution applies when a fi rm is carrying out an investment service, rather than an investment activity. FSA’s rationale is that services are provided on behalf of clients, whereas activities are conducted with clients. However, as the only investment activity in MiFID is “dealing on own account”, if best execution applies in those circumstances (Recital 69) then there is no other “activity” that could be undertaken when the best execution obligation would not apply.

FSA has also stated that it will look to three factors: the nature of the client relationship; whether a fi rm is executing an order; and whether it is providing a service, in determining whether best execution applies.

So what are regulated firms to make of all this confusion?

Firms will need to seek a sensible way through all these contradictions. In our view, fi rms will have diffi culty justifying the non-application of the best execution requirement where they are dealing as principal unless they can demonstrate that the client was not looking to the fi rm to act on its behalf. For example, when acting in a risktaking capacity, a fi rm might need to make it clear to its client that it was the counterparty to the transaction, rather than acting in a riskless principal capacity on the client’s behalf. This may prove diffi cult for fi rms who only decide to commit capital part way through handling a client’s order to make sure that the order can be fulfi lled in accordance with the client’s requirements. Such fi rms might be required to revert to the client if they intend to dis-apply best execution to the risk-taking elements of the trade. Further, fi rms who intend to argue that their trading is not caught by the best execution requirement because they are responding to a request from a client will need to be able to show that they have made it clear to the client that, if the client proceeds with the trade, the client has chosen the fi rm as the venue, rather than that the client is looking to the fi rm to act on the client’s behalf. FSA’s guidance suggests that fi rms will be able to make it a term of their dealing with Professional Clients that transactions will be on a “request for quote” basis without best execution applying, although in practice fi rms will need to be careful that sales activities do not mean that the “quote” came before the “request”, as FSA state that the existence of an order “cannot be determined solely by reference to a terms of business”.

Ultimately, this debate may prove academic as firms will have to act in the way agreed with their clients. Experience at N2 suggests that investment managers are likely to ask broker/dealers to contract to provide best execution, and under MiFID it is diffi cult for them to decline to do so - there is no specifi c opt-out. Firms are required to document execution policies and are likely to include compliance with these policies as part of their terms of business. Therefore, the entire basis upon which a fi rm intends to trade will be negotiated between (say) the investment manager and the broker/dealer, and in such a competitive market, it is likely that the “buy” side is going to gets its way over the “sell” side - there will always be other brokers prepared to offer best execution to professional clients (indeed, some have done so since N2). As with many areas of MiFID, there has been a lot of time and effort expended on the debate at the detailed rule level, but it may be that, ultimately, commercial factors are far more important.

Dealing with Retail Clients is likely to be a different matter - fi rms are going to fi nd it very diffi cult to persuade FSA that trading with retail clients is not subject to a best execution obligation no matter what the capacity of the client or the contractual provisions put in place with the client.

No matter what the outcome of the above debate may be, fi rms will be required to agree an order execution policy with clients and review that policy at least annually.


One of the most controversial aspects of MiFID is the pre-trade transparency requirements applicable in the equity market (please note - the rest of this subsection applies only to equity trading). The original basis of this obligation was as a balance for the abolition of concentration requirements - ISD had permitted Member States to require all trading to be conducted on a local exchange, but MiFID abolished this option. Therefore, investment fi rms would be free to compete with investment exchanges for business. However, one perceived benefi t of concentrated market environments related to best execution - requiring fi rms to consider different price venues is more problematic than having all trading undertaken on, or by reference to the price of, one exchange. It seems that no party is actually satisfi ed with the fi nal MiFID position on pre-trade transparency, and investment fi rms should not look for any particular logic or philosophy behind the measures described in this subsection.

What is a Systematic Internaliser?

MiFID defi nes a Systematic Internaliser as “an investment fi rm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or MTF”. There are a number of elements to this defi nition.

The Implementing Regulation contains (not particularly illuminating) guidance on the meaning of “organised frequent and systematic”. Its suggestion is that these words require the activity: to have a material commercial role for the fi rm; to be carried on in accordance with non-discretionary rules and procedures; to be carried on by personnel or technological system; and to be available to clients on a regular or continuous basis. In our view, it would be diffi cult for many fi rms to say that they carry on business in a disorganised, infrequent or unsystematic ways if they see themselves as being in the market for trading shares. The Implementing Regulation does use the same language as MiFID itself in stating that fi rms will not be acting on an “organised, frequent and systematic basis” where their activity is performed on an ad-hoc and irregular basis with wholesale counterparties as part of a business relationship characterised by dealing above standard market size (on which more below) and where the transactions are carried on outside any systems are habitually used to systematically internalise.

Dealing on account is also not necessarily a straight-forward concept. MiFID defi nes it as “trading against proprietary capital resulting in the conclusion of transactions in fi nancial instruments”. FSA’s guidance is that there is a distinction between matched back-to-back trading (which does not amount to dealing on own account) and trading resulting in an unmatched position, with subsequent action to hedge exposure, which does amount to dealing on own account.

Further, the transactions must be executed outside a regulated market or MTF. FSA’s analysis here seems to be closely linked with the above description of FSA’s view on what constitutes dealing on own account, in that such transactions, where on a matched principle basis, might be said to be executed inside the regulated markets.

Obligations of Systematic Internalisers

If a fi rm is a Systematic Internaliser as defi ned above, it has certain obligations. These obligations only apply if there is a liquid market in the share in question (and it is estimated that this will cover 500 of the most liquid shares in Europe, plus certain other shares nominated by Member States as being liquid), and the fi rm deals in such shares below standard market size (there is a complicated method for calculating this but it is likely to vary from between around €100,000 for the most liquid shares to €7,500 for the least liquid). If this is the case, the fi rm is required to act as a market maker. In other words, it must hold itself out as willing to deal at fi rm prices and will be bound by clients who want to deal in the size and at the price quoted by the fi rm.

There is some protection for fi rms acting as market maker in that they can quote one-way prices, and in exceptional circumstances withdraw quotes altogether.

Firms are given fl exibility by MiFID over how they make their quotes public. It can be done by using a regulated market (and LSE has been active in promoting a future service in this area), using a third party (and FSA has been active in promoting the use of a new concept, that of a Trade Data Monitor, in this area) or through proprietary arrangements (and all parties involved except investment fi rms themselves seem to want to limit the ability of investment fi rms to use their own arrangements to publicise prices - FSA’s view seems to be that such data must be readily consolidatable).

Price improvement by systematic internalisers is banned when dealing with Retail Clients or in retail size (which is defi ned as being below €7,500). Price improvement for Professional

Clients is also restricted - it is only available in relation to orders that are not limit or market orders, and only then if justifi able in the circumstances. FSA’s defi nitions of what constitute limit and market orders is helpful to fi rms. Limit orders do not include contingent orders (where a transaction is dependent upon the price of another security being at a particular level) or stop orders (and the defi nition of a stop order is very similar to that which is generally called a limit order). So it may be that fi rms will document in their order execution policy an approach based on these defi nitions that gives the fi rm more fl exibility than might otherwise have been expected. Systematic Internalisation will be a major concern for fi rms.

Systematic Internalisers need to change the way in which they currently do business (from a passive to an active market making role), and use of variety of systems to enable them to meet the various publication and record keeping requirements. But who will actually be Systematic Internalisers?

At a recent ISITC conference, the views of the attendees varied between fi rms that thought there would be less than fi ve, to fi rms that thought there would be more than 50. Systematic Internalisers. In our view, fi rms are likely to take every step possible to avoid being defi ned as a Systematic Internaliser, and some major players may yet avoid doing so. There are a number of means to conduct business to avoid being caught by the requirement.

The fi rst is not to deal as a risktaking principal below standard market size. It is quite clear from the Directive that all pure agency dealing is excluded from the best execution requirement. FSA is also attempting to make it clear (although it remains to be seen what the Commission and CESR will make of this) that riskless principal trading is also not caught (see above). For fi rms generally dealing in large sizes with sophisticated players, this may be one way out. Clearly it will not help fi rms for whom their basic operating model is to deal on-risk in smaller sizes - but how may fi rms actually do this? Most of the retail service providers are either matching orders (and might therefore be caught by the MTF requirements - see 4.9 below) or acting in a riskless capacity. The position remains far from clear.

One thing is certain. Firms with equity trading business will need to document very carefully either why they do not think they are a Systematic Internaliser, or document how they will comply with the onerous obligations applying to such fi rms.

Appendix 4.8 contains a fl ow chart setting out when a fi rm might be considered to be a Systematic Internaliser.


MiFID introduces a new investment activity of operating a multilateral trading facility, or MTF for short. MiFID defi nes an MTF as “a multilateral system, operated by an investment fi rm or market operator, which brings together multiple third-party buying and selling interests in fi nancial instruments, in the system in accordance with nondiscretionary rules, in a way that results in a contract”. FSA has given guidance to say that it thinks this defi nition is, in essence, the same as the existing Alternative Trading System (ATS) defi nition. The outcome is that the firms that are currently subject to FSA rules on operating ATSs will, in future, be subject to revised rules on operating MTFs. There is little public information on how many ATSs exist.

However, suffi ce to say that fi rms not currently operating an ATS should take comfort that they will not in future be considered to be operating an MTF, and in particular that attempting on an ad-hoc basis to match client orders as a trading effi ciency mechanism will not amount to the more systematic operation of holding oneself out as being a market venue which would be caught by the MTF defi nition. Firms that are operating as an ATS at present will need to be aware of and comply with the new requirements relating to operating an MTF, in particular in relation to pre- and post-trade transparency.


FSA intends to retain its new rules restricting the ability of fi rms to use dealing commission to pay for other services on behalf of their clients. In our view there is no justifi cation for this gold-plating as the issue is neither unique to the UK nor new. FSA has had rules to this effect for some time, and MiFID contains anti-inducement requirements that cover the same ground. This is the only wholesale markets measure where FSA will seek permission to gold-plate, and it is likely to come under pressure not to do so.


FSA’s existing CASS rules governing client money and assets will be largely replaced by the MiFID requirements, which FSA, in its Consultation Paper 06/14 entitled “Implementing MiFID for Firms and Markets”, describes as being “broadly equivalent”. There are some key differences highlighted below.

MiFID does not contain a detailed defi nition of “client money”. It merely requires fi rms to “make adequate arrangements to safeguard clients’ ownership rights”. FSA has said that it intends to retain its existing defi nition of client money, and to include a carve-out refl ecting the effect of the existing banking exemption which means that a bank accepting a deposit does not have to place the deposit with anyone else.

The key change in the new MiFID regime will be that there will no longer be an opt-out for Professional Clients. At the moment, under FSA rules, when dealing with an Intermediate Customer, the two parties can agree that client money protections will not apply. FSA takes considerable comfort from the ability of fi rms to opt-up Professional Clients to Eligible Counterparty status if this is likely to prove a problem. However, history suggests (and we discussed the history in 4.7 above) that, when it comes to discussions between the “buy” and “sell” sides, the buy side is unlikely to want to opt-up and out of regulatory protection. So, in practice, fi rms are likely to have to carry out an extensive review of existing client money provisions to ensure that professional clients who do not agree to opt out of the client money regime get the required protection.

FSA has given some guidance on the tricky areas not directly covered by MiFID. For instance, when holding commission rebates in accordance with FSA’s commission rebate rules, commission will not be client money until its ownership has been determined. FSA also intends to make express the option for fi rms to place client money in a qualifying money market fund. FSA has also made it clear that there is no way around the MiFID restrictions on depositing client funds with unregulated custodians, and therefore fi rms that use such custodians in third countries will need to review their arrangements. A summary of the MiFID implementing regulation requirements is set out in Appendix 4.10.


Once the fi rm has undertaken business with clients, the next stage of our life-cycle is for the fi rm to meet MiFID’s requirements relating to reporting on that business.

FSA rules currently contain detailed requirements relating to the contents of confi rmations, contract notes, and portfolio performance statements. MiFID merely has a high level requirement for the fi rm to send “adequate reports on the services provided to its clients including… the costs”. The Implementing Directive contains more detail in relation to both confi rmations and reports on portfolio performance.

In relation to confi rmations, fi rms must provide confi rmations containing the information set out in the first part of Appendix 4.11.

In relation to portfolio management, fi rms must provide the information set out in the second part of Appendix 4.11.


FSA rules contain detailed requirements on inducements, particularly in relation to packaged products. MiFID contains broadly similar requirements, although there is one important distinction in that, under MiFID, payments of fees or commission or the provision of non-monetary benefi ts must be “designed to enhance the quality of the relevant service to the client”. Some jurisdictions have talked about this term in a very broad sense - for example, arguing that payments of commission for the sale of products are designed to enhance the quality of the service to the client by fi nancing the provision of advice. We do not expect FSA to take such a broad view. Firms will need to consider whether their practices can meet this requirement.


MiFID contains requirements relating to personal transactions that will require fi rms to reassess existing procedures. Firms are required to: publicise restrictions on personal account transactions; be informed by employees of all transactions that they enter into; and to keep a record of such transactions (although these requirements do not apply to decisions under a discretionary portfolio mandate, or transactions in UCITS or their equivalents).

Firms are also required to prevent employees from entering into personal account transactions involving the misuse of confi dential information or similar breaches of the Market Abuse Directive.

FSA is to delete its existing requirement that fi rms provide employees with a written notice of the personal account dealing restrictions. However, we expect fi rms to continue to retain some evidence of the awareness of their staff of these restrictions.


Regulators have long noted the importance of controls on outsourcing in order to ensure that a fi rm is able to comply with its obligations, both to clients and to the regulator. FSA’s detailed requirements relate to “material outsourcing”, where FSA expects to be notifi ed and to be given audit rights over the outsourcee.

MiFID takes a similar view. It requires fi rms to “ensure, when relying on a third party for the performance of operational functions which are critical for the provision of continuous and satisfactory service…[to] take reasonable steps to avoid undue operational risk. Outsourcing of important operational functions may not be undertaken in such a way as to impair materially the quality of its internal control and the ability of the supervisor to monitor the fi rm’s compliance with all obligations”. The Implementing Directive makes it clear that a function is only critical or important if “a defect or failure in its performance would materially impair the continuing compliance of a fi rm… or its fi nancial performance, or the soundness or the continuity of its services”. It also makes it clear that the receipt of advice from third parties and the purchase of standardised services such as market information and price feeds is not “critical or important”. Firms are required to take into account the factors set out in Appendix 4.13.

Where the service being outsourced is the investment management of retail client portfolios, the outsourcing fi rm must ensure that the third party is authorised in another state and that there is a co-operation agreement between FSA and that third party state. If this is not the case, the proposed outsourcing must be notifi ed to FSA and FSA given the chance to object.


The fi nal stage of our life-cycle is the maintenance of records to demonstrate compliance.

Firms are already required to keep records for a variety of different purposes, from money laundering to tax. MiFID contains additional requirements which, whilst not out of line with the general law and litigation risk management (for example, the six year limitation period for general court claims), fi rms will need to show that they have taken the new rules into account and integrated them into the fi rm’s existing procedures.

MiFID requires fi rms to arrange for records to be kept which are “suffi cient to enable the competent authority to monitor compliance with the requirements under this Directive”. The basic retention period is fi ve years.

The MiFID requirement applies to all services and transactions, including advice and telephone orders. There is no guidance on the method by which fi rms can demonstrate compliance for this period of time, nor what is “suffi cient” for these purposes. If it is possible to tape a conversation, then that would be a perfect record to keep - but it would not often be practical. Is a contemporaneous note equivalent? Firms will need to be able to justify their view.

Section 5

MiFID - project planning

So far, we have reviewed the background to MiFID and identifi ed the key changes to the perimeter, and the conduct of business rules, that MiFID will entail. The practical challenge for fi rms is to determine how to deal with myriad of issues set out in this paper. We addressed in Section 1 a number of obstacles relating to implementation. These were:

inter-dependencies between different parts of MiFID (for example, risk warning disclosures and terms of business requirements);

inter-dependencies between MiFID and other directives (for example, the Market Abuse Directive and its requirement relating to research, which overlap with some MiFID requirements);

potential early implementation of some aspects such as confl ict management (in order to comply with parallel obligations in other directives, such as the Capital Requirements Directive, which may bring some measures into force earlier in 2007);

the potential need for computer systems development, either to limit the impact of the new requirements or to demonstrate compliance with them;

the heavy documentation burden relating to procedures, processes and client-facing documents that will need to be revised.

This section sets out some practical steps on managing the diffi culties of planning for MiFID implementation.


This, at least, is an easy question. The answer is now. FSA has already warned fi rms of the need to plan for MiFID, and not to underestimate the diffi culties involved. We now have not only the Directive but its implementing measures in fi nal form, and FSA has consulted extensively on its proposed new rules. The work of MiFID Connect, a group of trade associations, in supplementing these rules with “industry”

guidance is well underway, and in almost all areas fi rms have suffi cient materials to start reviewing their existing processes.


In our view, much of the discussion about MiFID has been on the extent to which it will fundamentally alter business processes within investment fi rms. From spending hundreds of millions of pounds on new IT systems, to completely undermining existing business models in the equity market, different commentators have emphasised the scale of the problem. For some fi rms, it is clear that IT costs may be substantial; management time may have been, and may continue to be, eaten up by MiFID preparation; and some business will be fundamentally altered following MiFID’s implementation. However, for many businesses, the key burden of MiFID is in relation to changes to existing processes and procedures. Investment fi rms are already highly regulated by FSA -

they will continue to be so once MiFID has been implemented. There will need to be extensive reviews of those processes and procedures, but in many cases, the burden of MiFID implementation can largely be contained within a Legal and Compliance Department. For fi rms who agree that MiFID is likely to affect existing processes more than business practices, the starting point is likely to be an analysis of their existing processes against MiFID’s requirements. By taking the “life-cycle” approach, fi rms should be able to identify all of their existing processes (What rules do we have around fi nancial promotions and other advertising? What are our client take-on and AML procedures? Does our compliance manual contain all of our conduct of business obligations, or are some kept elsewhere e.g. a separate confl icts management policy? What are our record keeping policies? and so on. A gap analysis will not be an easy task - it may require expert outside assistance as it is often diffi cult to add together the requirement of MiFID itself, the relevant Implementing Measure, FSA’s guidance, and the important work being undertaken by MiFID Connect. However, once an initial gap analysis has been undertaken, fi rms should then be able to identify key areas of change; get management and business by-into proposed action points; and proceed to implement those changes. Training on new requirements may be necessary; and fi rms may feel some frustration at the lack of clear rules in some areas where preference has been given to a principalsbased regime; but ultimately fi rms will need to show that they took reasonable steps to achieve compliance with MiFID’s requirements.


Following a thorough MiFID review and practical implementation project, fi rms will have a record of what has changed. They will be able to compare old procedures against existing procedures. However, fi rms should not be fooled into thinking that this alone would be suffi cient to show FSA that they took reasonable steps to achieve compliance. For example, on occasions it may be that a fi rm decided that no change was necessary, and it would be important to be able to show why, and how, this decision was reached. Further, a fi rm on its own will struggle to benchmark its own processes and decisions against others taken in the industry.

One service which Nabarro Nathanson intends to provide is that of a “Nabarro Nathanson MiFID Opinion”. The Nabarro Nathanson MiFID Opinion will provide justifi cation for a fi rm having taken reasonable steps to achieve compliance. It will document the methodology of the review; the various decisions that were taken; the changes to existing processes and procedures that were made; and provide comfort that the steps were in line not only with the various legal requirements but also with the rest of the industry. We hope that a MiFID Opinion will give comfort to senior management, as well as Legal and Compliance Offi cers, and prove a helpful record should FSA decide to review MiFID implementation at a fi rm or across the industry.


[see diagram]

Section 6

MiFID - reflections

Firms have enough on their hands preparing for MiFID implementation without needing to concern themselves with what MiFID might mean for the future of the regulation of fi nancial services in Europe. However, there are important messages for those prepared to read between the lines, so we have included this section to set out our thoughts on key refl ections on MiFID and beyond.


At a high-level, whilst all FSA rules apply to retail clients, rule application is very limited in professional market - Intermediate Customers can opt out of protections such as client money and best execution. The “bar”, so to speak, for general protection is currently placed between Private Customers and Intermediate Customers.

MiFID will change all of this. MiFID views Professional Clients as being at a signifi cant disadvantage to the investment fi rms with whom they deal, and worthy of extensive regulatory protection. Be it the application of suitability standards to advice given to professional parties, or the application of best execution requirements, MiFID tends to prefer regulation to competition as a means of protecting consumers. The “bar” for protection has been raised - arguably it now rests between Professional Clients and Eligible Counterparties.

What are fi rms intended to read into this development? Given the principles - led nature of regulation, in particular in the post-MiFID environment, fi rms should be slower to presume the professional clients can look after themselves. This may seem strange in a world where a fund manager with billions of assets under management and sophisticated systems to monitor execution quality is considered to be so disadvantaged when dealing with a broker/dealer that they require best execution protection. However, fi rms will need to view their new responsibilities in light of MiFID’s philosophy. The fact that, in practice, such a fund manager would withdraw business from any broker/dealer who is not providing the right price does not affect either fi rm’s regulatory responsibilities.


There is no doubt in our minds that FSA will not give a very sympathetic hearing to fi rms who fail to prepare adequately for MiFID and then fi nd themselves not in compliance with its requirements. But on the basis that most industry players will try to take reasonable steps, what is FSA’s approach to enforcement action likely to be?

The history of N2 suggest that, in the short term, FSA is unlikely to bring a series of actions against fi rms for breaches of the new requirements. 2008 is unlikely to see lots of enforcement cases for technical breaches of MiFID’s requirements. FSA is much more likely to act with the industry in order to help fi rms who have been seen to take reasonable steps to prepare for MiFID to improve performance in any areas that may, nonetheless, still be lacking. However, the same history suggests that, in the medium term, FSA will run out of patience with fi rms who have not been adept enough to identify areas where their MiFID implementation approach is out of line with either the industry’s, or FSA’s, thinking. It is almost inevitable that FSA enforcement actions will include reference to a failure to prepare adequately for MiFID as both a senior management and a systems and controls issue, and no fi rm will want to be the fi rst to gain this dubious honour.


At first glance, MiFID looks like the logical conclusion to a series of steps that started with ISD over ten years ago. The introduction of mutual recognition based upon minimum standards was a great step forward at the time, but suffered from the diffi culties discussed in Section 1 above. The Financial Services Action Plan was an attempt to co-ordinate action to produce a single market. Certain directives, such as the Market Abuse Directive, agreed common offences would apply throughout the EU, but allowed national governments the option to continue to prohibit other activities - in other words, to gold plate MAD. This situation would never do in relation to a directive such as MiFID that was intended to produce a single European rulebook. Therefore, the Commission originally envisaged MiFID being implemented by means of two Regulations that would be directly effective on the Member States. When the Commission was eventually persuaded to change its mind and, for legal reasons relevant to certain Member States which it remains diffi cult to properly comprehend, use a Directive to implement some of the measures (which means that Member States potentially have some leeway in implementation) the Commission introduced anti-gold plating measures. These are discussed in more detail in Section 2.3 above. There is no doubt that the Commission intends MiFID to be the last word in the areas that it covers.

However FSA has issued hundreds of pages of consultations on implementing MiFID. This cannot have been how the Commission envisaged at the outset things would be. FSA is attempting to retain elements of its existing regime, such as requirements restricting sales of collective investment schemes. It remains to be seen whether FSA will “win the day”. However, the long-term message may be this. If MiFID was intended to create a level playing fi eld by introducing maximum standards, and there remain differences between Member States, then the only logical conclusion for the Commission must be that a single European regulator is the only way to achieve its aim. There are no more legislative tricks to try - the Commission will need to look at the structure of the regulators, rather than the regulations.

A single European regulator is certainly not on the agenda of Member States. FSA has consistently said, with HM Treasury’s support, that Member States should compete on the basis of the effi ciency and practicality of their rules, and that competition on this point should be encouraged, not outlawed. The Commission clearly do not agree. Ultimately, their appetite to tackle this issue may depend upon the approach of fi rms - only if fi rms start to be frustrated by differences in interpretation, and the failure to complete the single market in fi nancial services, will the Commission gain an ally.

What is the view of your fi rm on the prospect of a single European regulator?

Appendix 4.1 Advertising

Article 27 of the Implementing Directive sets out the following requirements:

  • The communication must include the name of the investment firm;
  • The communication must not emphasise potential benefi ts without also giving a fair and prominent indication of risks.
  • The communication must be presented in a way likely to be understood by the average member of the group to whom it is directed, or by whom it is likely to be received. (This requirement is likely to be problematic - are any fi nancial products understood by the average member of the public? It is hoped that FSA will give further guidance on this point, or that MiFID Connect will do some instead);
  • Comparisons must be meaningful; presented in a fair and balanced way; with sources used for the comparison specifi ed; and key assumptions made clear;
  • Where the information contains an indication on past performance, that indication must not be the most prominent feature of the communication. Past performance information must cover the immediately preceding fi ve years or the whole of the period for which the instrument has been offered (if shorter), or a longer period provided it is for a full twelve month period. The fact that past performance is not a reliable indication of future results should be made clear. Currency risks must be stated. Information based on gross performance must include an explanation of the effect of commissions;
  • Where a comparison relations to a simulated past performance, the comparison must be with an instrument or index which is the same as, or underlie, the relevant financial instrument. The fact that past performance has been simulated must be made clear;
  • Where the information relates to future performance, it may not be based upon or refer to simulated past performance, it must be based on reasonable assumptions supported by objective data, it must disclose the effect of commissions if based upon gross performance, and it must contain warning about the reliability of future performance indicators;
  • Where the information relates to tax treatment, it must also explain that treatment depends upon individual circumstances and may change in the future;
  • The information must not name a competent authority in a way that would suggest it is approving the product or the fi rm issuing the communication.

Appendix 4.2

Client classifi cation boundaries 


The below parties are Eligible Counterparties when the investment fi rm is dealing (as agent or principal) or transmitting orders on behalf of such parties. On other occasions, they are Professional Clients:

  • Investment firms;
  • Credit institutions;
  • Insurance companies;
  • UCITS and their management companies;
  • Pension funds and their management companies; Other fi nancial institutions authorised and regulated by a Member State;
  • Unregulated commodity derivatives undertakings;
  • National governments;
  • Central banks and supranational institutions.


In addition to the parties set out above who would be Eligible Counterparties but for the fact that the business involved is not dealing or transmitting orders, undertakings meeting two of the following size requirements are Professional Clients:

  • Balance sheet total of €20 million;
  • Net turnover of €40 million;
  • Own funds of €2 million.
  • In addition, regional governments and public bodies are included as Professional Clients, as are institutional investors such as entities dedicated to securitisation or fi nancing transactions.

All other clients are, by default, Retail Clients unless they can be expertised (see below).


All other clients unless the client can meet the qualitative and quantitative criteria.

The qualitative criteria is that the fi rm has suffi cient “experience, expertise and knowledge… that the client is capable of making its own investment decisions and understanding the risks involved”.

The quantitative criteria is that the client satisfi es at least two of the following:

  • At least ten transactions per quarter over the previous four quarters;
  • Financial instrument portfolio exceeding €500,000;
  • Working in the fi nancial sector for at least a year in a position requiring knowledge of the transactions or services involved.

FSA is being asked to give clear advice on how the above criteria might work where no such quantitative data is likely to exist. For example, even a major private equity investor is unlikely to have carried out suffi cient transactions. As it currently stands, it looks as though sophisticated private equity investors might have to be categorised as retail clients.

Appendix 4.4

Suitability and appropriateness


  • What are the investment objectives of the client?
  • For how long does the client want to hold the investment?
  • What is the client’s preference regarding risk taking?
  • What is the client’s risk profi le?
  • What are the purposes of the investment to the client?
  • What is the client’s fi nancial situation and can they bear the risks of the investment?
  • What is the source and extent of the client’s regular income?
  • What assets does the client own?
  • What are the client’s regular fi nancial commitments?
  • What experience and knowledge does the client have of the risks involved in the transaction?
  • What types of service,  transaction and instrument is the client familiar with?
  • What is the nature, volume, and frequency of previous transactions?
  • What is the level of education, professional qualifi cation etc. of the client?


  • What types of service, transaction and instrument is the client familiar with?
  • What is the nature, volume, and frequency of previous transactions?
  • What is the level of education, professional qualifi cation etc. of the client?

Appendix 4.5

Conflicts of interest


A confl ict of interest will exist only where a fi rm owes a duty to a client. In assessing whether a conflict exists, firms must take into account the following factors:

  • Whether the firm is likely to make a financial gain, or avoid a loss, at the expense of the client (guidance makes it clear that normal business operation in order to achieve a profi t is not caught);
  • Whether the firm has an interest in the outcome of a service distinct from the client’s interest;
  • Whether the firm has a financial or other incentive to favour the interest of another client over the interest of this client;
  • Whether the firm carries on the same business as the client;
  • Whether the firm receives an inducement relating to any particular service.


The policy must identify, with reference to specifi c investment services and activities, circumstances that may give rise  to a confl ict and specify the procedures to be followed to manage the confl ict.

The policy must cover such of the following factors as necessary to ensure the requisite degree of independence:

  • Procedures to control flows of information;
  • Separate supervision of persons carrying out separate functions for clients whose interests may conflict;
  • Removal of direct links between remuneration of persons engaged in one activity and remuneration of other persons where the interests of their clients conflict;
  • Measures to limit persons from exercising inappropriate infl uence over the way any other person carries out their business;
  • Measures to prevent or control the simultaneous or sequential involvement of a person in different activities where the interest of clients may differ.

Appendix 4.8

Systematic internaliser definition

[see table]

Appendix 4.10

Client assets

Firms must keep records and accounts as necessary to distinguish assets held for one client from assets held for another client or of the firm.

Firms must maintain records and accounts in a way that ensures their accuracy.

Firms must conduct regular reconciliations between their internal accounts and those of any third parties holding assets. Firms must take the necessary steps to ensure that instruments deposited with the third party are identifi able separately from instruments belonging to that third party.

Firms must introduce procedures to minimise the risk of loss to client assets.

Firms must exercise due skill, care and diligence in the selection, appointment and periodic review of the performance of third parties who hold client assets, in particular taking into account the expertise and market reputation of the third party.

Firms must ensure that if assets will be held in a country which regulates custody and client asset holding, that the instruments are deposited with an authorised institution in that third party country.

If a firm receives client monies, they must be placed in an account with a bank authorised in the EU or in a third country, or into a qualifying money market fund. A fund will be a qualifying money market fund if its primary objective is to maintain the net asset value of the capital, it invests exclusively in high quality money market instruments with a maturity of no more than 397 days, and provides liquidity through same day or next day settlement. The instrument must have been awarded the highest available credit rating by each relevant agency.

Firms must ensure that instruments belonging to a client are not used by the fi rm without the client’s consent.

Firms must ensure that instruments are not held in an omnibus account unless each client has given their express permission.

Firms must get an external audit report at least annually to confi rm compliance with these standards.

Appendix 4.11

Reporting to clients


  • Reporting firm identification;
  • Name or designation of the client;
  • Trading day;
  • Trading time;
  • Type of order;
  • Venue identifi cation;
  • Instrument identifi cation;
  • Buy/sell indicator, or nature of the order if other than buy/sell;
  • Quantity;
  • Unit price;
  • Total consideration;
  • Total commission;
  • Client’s settlement responsibilities;
  • Whether the firm, or anyone in its group, was dealing as principal.


Where dealing with retails clients, the fi rm must, on a six monthly basis (unless either three months or twelve months is agreed) provide the following information: Name of the investment fi rm; Name of the retail client’s account; Statement of the contents of the account, including market value of each instrument and cash balance;

  • Total fees charged during the period;
  • Comparison of performance against any agreed benchmark;
  • Total amount of dividends etc received;
  • Information relating to corporate actions.

Appendix 4.13


  • The following conditions must be satisfied:
  • The service provider must have the ability, capacity, and any necessary authorisation to perform the services;
  • The investment firm must have a means to assess the standard of performance of the service provider;
  • The service provider must agree to properly supervise the outsourced function and to manage the risk associated with the outsourcing;
  • The service should be monitored such that appropriate action can be taken if the service provider is not carrying out its functions effectively;
  • The investment firm must retain the necessary expertise to supervise the outsourced function and manage the risks associated with the outsourcing;
  • The service provider must agree to disclose to the investment firm any development that may have a material impact on its ability to carry out its functions;
  • The investment firm must be able to terminate the arrangement for outsourcing without detriment to continuity and quality of provision of services to clients;
  • The service provider must agree to co-operate with FSA;
  • The investment firm, its auditors and FSA must have access to data relating to outsourced activities and to the business premises of the service provider;
  • The service provider must agree appropriate protections around confi dential information provided by the investment firm about its clients;
  • The investment fi rm and the service provider must maintain contingency and disaster recovery plans.