What is the purpose of the guidelines?
The guidelines are part of the regulatory framework aimed at protecting investors across the EEA.
Under Directive 2014/65/EU on markets in financial instruments (MiFID 2), investment firms which manufacture financial instruments and structured deposits will be required to ensure that their products are made to meet the needs of an identified target market of clients within the relevant category of clients (Recital 71 of MiFID 2). Additionally, investments firms have to take into account the strategy for distribution of the financial instruments and the extent to which it is compatible with the identified target market, and take reasonable steps to ensure that the product is distributed to the identified target market (Article 24(2) of MiFID2). These obligations are referred to as product governance requirements but as can be seen, they are fairly broad and cover a number of different issues. As such, the guidelines focus on the "target market" aspect as this was identified by the European Securities and Market Authority (ESMA) as the most important one for ensuring the "common, uniform and consistent application" of MiFID 2 by Member States.
The guidelines also aim to establish an effective approach in the supervision of investment firms by National Competent Authorities (NCAs) as the requirements should be applied in a harmonised manner by Member States, meaning that non - compliance with the guidelines should be easier for NCAs to detect and enforce.
To assist investment firms, ESMA developed a list of six categories that it suggested manufacturers use to identify the target market for its products.
The list has been modified slightly and now comprises five categories:
- type of client to whom product is targeted
- knowledge and experience
- financial situation with a focus on the ability to bear losses
- risk tolerance and compatibility of the risk / reward profile of the product with the target market
- clients' objectives and needs.
With regards to manufacturers, ESMA has amended the guidelines so that if a manufacturer considers the 5 categories to be too restrictive to identify a meaningful target market, it can include additional categories. The guidelines also require manufacturers to clearly define concepts and terminology used when identifying the target market to avoid misinterpretation and misunderstandings.
ESMA has provided further guidance on the target market – saying that when refining the manufacturer's target market, distributors should not deviate from the fundamental decisions of the manufacturer but neither should they just rely on it without considering how it fits their client base.
It has also added guidance on inclusion of products in portfolios where individual products are sold outside the target market but, taken within the portfolio or combination of instrument and hedge, are suitable for the client.
What were the key issues raised in responses to the consultation, and how have they been addressed?
One of the key issues raised by some respondents was that the list should be a "closed list" so individual manufacturers should not add to the 6 categories although they would be happy to see sub categories addressing specific product features.
Other comments on this issue included that, ideally, concepts used by manufacturers in identifying their target market are clearly and commonly defined, but, recognising this may not be achievable in the short term, said that at least the guidelines should require the manufacturer to clearly define the concepts being used.
ESMA said it agreed with these two comments and has amended the guidelines (see "How do the guidelines differ from ESMA's consultation" above). However, as noted above, it has stated in the revised guidelines that manufacturers may add additional categories if they feel the five are too restrictive.
Respondents also made detailed observations on what each category would comprise. In many cases ESMA did not see the need to make any changes, but it has made some clarificatory adjustments without fundamentally changing the scope of the categories. Its decision to merge the objectives and needs category into one stemmed from observations that it was hard to understand what the distinction between them should be. It has also added some further clarification and case studies to illustrate how the guidelines apply to simple products.
Other comments focussed on identifying the respective obligations of manufacturers and distributors, including in reporting of sales outside the positive target market for the portfolio management and hedging purposes noted above, and ESMA has clarified what it expects to be reported in light of these.
What impact will the guidelines have on manufacturers and distributors of financial instruments?
The level of the impact will depend to a large extent on the current practices of manufacturers and distributors, and the complexity of their respective product and customer bases. For the riskier products, and those which have traditionally caused significant losses or mis-selling scandals, firm will have an extra reason to assess the circumstances in which it is safe to offer the products. For firms that manufacture and sell simpler products, the guidelines should be less onerous. What is clear is that both manufacturers and distributors will need to make required assessments in a co-ordinated way, but taking into account their own position in the distribution chain. The key will be to avoid un-necessary duplication while not placing blind reliance on what others have done.
The guidelines will be translated into the official EU languages and published on ESMA's website.
NCAs will have two months from the publication of the translations to notify ESMA whether they comply or intend to comply with the guidelines. Given the shortage of time between publication of the guidelines and the date by which firms should be complying with MiFID 2, firms would be best advised to assume their NCA will be applying the guidelines.
How should lawyers and their clients prepare for the proposed changes?
Preparing to comply with ESMA's guidelines should be factored into firms' MiFID 2 preparations. Most firms should by now have carried out a detailed gap analysis of their current policies and procedures against what MiFID 2 requires. Changes that go to the heart of the customer experience are likely to take significant time to plan and embed, to be ready for compliance in January 2018. In this, and in many other areas of compliance, firms can work with their professional advisers to assess how best to meet the testing time limits.