MiFID firms must handle client categorisation with care, as is clear from recent Central Bank settlement agreements. This is particularly relevant in view of the revised client categorisation framework provided for in the European Union (Markets in Financial Instruments) Regulations 2017 (the “MiFID II Regulations”), which came into operation on 3 January 2018.
MiFID Client Categorisation Requirements
Both the European Communities (Markets in Financial Instruments) Regulations 2007 (the "MiFID Regulations") and the MiFID II Regulations require investment firms to categorise their clients in order to determine the correct level of investor protection and transparency. The categorisation requirements under each of the Regulations are similar, although there is a number of differences.
Both the MiFID and the MiFID II Regulations categorise clients as eligible counterparties, professional clients and retail clients and clients can move between the three categories. In particular, it is possible for an investment firm to reclassify a retail client as a professional client, once certain qualitative, quantitative and procedural requirements are met.
Qualitative Requirements: under both the MiFID and MiFID II Regulations, an investment firm must conduct an assessment of the client’s expertise, experience and knowledge to ensure that the client is capable of making his/her own investment decisions and understands the risks involved.
Quantitative Requirements: the MiFID Regulations provided that an investment firm must take all reasonable steps to ensure that the client satisfied at least two of the following criteria:
- the client had carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter, over the previous four quarters;
- the size of the client’s financial instrument portfolio exceeded €500,000;
- the client worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.
These same requirements apply under the MiFID II Regulations.
Procedural Requirements: in order to be re-categorised as a professional client under the MiFID and MiFID II Regulations:
- a retail client must state in writing that he or she wishes to be treated as a professional client;
- the investment firm must give the client a clear written warning of the protections and investor compensation rights that he or she could lose; and
- the client must state in writing in a separate document from the contract, that he or she is aware of the consequences of losing such protection.
Moreover, investment firms must implement appropriate written internal policies and procedures to categorise clients.
The Settlement Agreements
Over the past 12 months the Central Bank of Ireland (“CBI”) has published two Settlement Agreements relating to fines imposed for client categorisation failings under the MiFID Regulations.
Both fines are associated with the re-categorisation of retail clients as opted-up professional clients. In both agreements the CBI identifies breaches relating to the relevant firm’s failure; a) to carry out adequate qualitative and quantitative assessments of retail clients who elected to be treated as professional clients, and b) to implement appropriate policies and procedures for client categorisation.
Each of the firms had failed to carry out the qualitative assessments to an adequate standard.
As part of its assessment process, one of the firms had issued prospective investors in structured investment products with an application pack containing a pro-forma client declaration (“Declaration”) which required the client to indicate which of the two quantitative criteria the client determined it satisfied. The Declaration also contained a statement confirming that the client understood that by being treated as a professional client, the client lost certain protections and investor compensation rights. In addition, the Declaration referred to an attached document which listed the protections and compensation rights lost (“Document”).
According to the CBI, the relevant Firm breached the assessment requirements by failing to conduct adequate due diligence by looking behind the self-certifications and placing undue reliance on the fact that the Declarations were transmitted to it by investment intermediaries. It had also failed to gather sufficient documentary evidence to establish the adequacy of the steps that it had taken to satisfy itself as to the relevant client’s expertise and experience and to verify that the client had received, read and understood the contents of the Document.
The CBI criticised the other Firm for its approach to determining whether a client had carried out transactions of a significant size over the relevant period. Specifically, according to the CBI, the relevant Firm had failed to ensure that transactions it considered eligible to satisfy the test were conducted at the discretion of the client and not an investment firm. In this respect, the CBI observed that “transactions conducted at the discretion of an investment firm do not demonstrate any market expertise or knowledge on the part of a client.”
Failure to Implement Policies and Procedures
In both cases, the CBI held that the relevant Firms had failed to implement appropriate written policies and procedures to categorise clients because they failed to:
- outline procedures for how the Firm would carry out an adequate assessment of the expertise, experience and knowledge of clients;
- address the reasonable steps that the Firm would be required to take before categorising elective Professional clients; and
- specify the documentary evidence which the Firm should require from clients prior to categorising them as elective Professionals.
In one of the cases, the CBI also referred to the fact that the Firm had failed to specify in its policies and procedures the type of investment account and/or the degree of client discretion which would be required in order for transactions to be eligible for consideration as transactions carried out by the client as opposed to the investment firm.
Implications for MiFID II Client Categorisation Requirements
While the Settlement Agreements relate to the client categorisation requirements under the MiFID Regulations, they have clear implications for client categorisation under the MiFID II Regulations.
Specifically, while certain details of the client categorisation requirements have changed under the MiFID II Regulations, the overall framework remains the same. Consequently, investment firms should ensure that their client assessments meet the CBI’s expectations, as well as their relevant policies and procedures. They must also ensure that they sufficiently document any client assessments they carry out together with their reasons for recategorising clients from one category to another.
According to the CBI, it expects investment firms to give high priority to compliance with client categorisation requirements as the consequences of miscategorisation are very serious for clients.