To get the industry in the mood for summer, the FCA released CP 16/19, its second consultation paper on the implementation of the Market in Financial Instruments Directive II.
CP 16/19 focuses on organisational requirements for investment firms. The final, and probably most comprehensive CP, on changes to the Conduct of Business Sourcebook and Perimeter Guidance Manual, has still to be issued. The changes involve proposed deletions and additions to the FCA Handbook of Rules and Guidance.
The main focus for CP 16/19 has been on mere implementation of the MiFID II requirements, however there are some areas where the FCA is seeking to impose more than is strictly required to implement MiFID II. Three of the more noteworthy areas, which we discuss below, are the following:
- conflicts of interest
- the Article 3 opt-out from MiFID II
- additional CASS rules.
In keeping with the tone and content of the statement which it issued on the morning of the UK Referendum result (see our previous briefing, The FCA's Brexit statement: An incomplete explanation of the short term legal impact on UK financial services?), the FCA highlights at the beginning of CP 16/19 that, as far as MiFID II implementation is concerned, it is business as usual. Whether the UK’s eventual exit from the EU has emboldened the FCA to impose additional requirements, including the application of MiFID II standards to firms not otherwise captured, is hard to tell. Certainly, the FCA never needed the Brexit spectre to ‘gold plate’ MiFID both as to content of rules and scope of application.
The FCA has invited comment by 28 October 2016. Eversheds plans to respond and we would be happy to discuss any of the issues with our clients or any other interested parties.
The proposed changes
The FCA sets out the proposed changes in the following order:
The FCA proposes a new section of the Market Conduct Sourcebook to set out guidance and directions on MiFID II’s regime of position limits, position management and position reporting for commodity derivatives contracts. This section will be split into five sections:
- position limit requirements
- position management controls
- other reporting, notification and information requirements.
The supervision manual
The FCA proposes updates of requirements to notify the FCA of breaches of requirements and provide information to the FCA that is accurate and complete to take account of the introduction of the Markets in Financial Instruments Regulation and non-FSMA Treasury implementing regulations; transitional provisions for transaction reporting to take account of the revocation of the existing MiFID implementing regulation; and changes, building on those proposed in CP15/43, to passporting requirements (see our previous briefing, The FCA's MiFID II consultation: a let off for fund managers?).
The FCA proposes changes to the FCA’s prudential sourcebooks to reflect MiFID II’s introduction of the new investment service of operating an Organised Trading Facility, the abolition of the exemption for a local firm, and the movement of certain provisions from the scope of MiFID II to the Credit Requirements Regulation
Senior management arrangements, systems and controls
The FCA has set out changes designed to enhance governance through new management body requirements, key organisational requirements which are in SYSC and in an EU directly applicable regulation. The FCA also sets out its proposed approach to how the management body and organisational requirements will apply to branches of non-EU firms and firms exempt under Article 3 of MiFID II. A firm is exempt under Article 3 if it:
- does not hold client funds or securities
- only receives and transmits client orders in relation to transferable securities and collective investment schemes units and/or provides related investment advice, and is only allowed to transmit such orders to identified firms or funds
- does not do business outside of its home member state (i.e., as far as the FCA is concerned, the United Kingdom).
The FCA also deals with changes to the rules on conflicts of interest which we comment on further below.
In addition, in Annex 2 of CP16/19, the FCA has included a MiFID II navigation guide for systems and controls which is intended to help firms navigate the organisational requirements in SYSC and the MiFID II regulation.
Remuneration requirements for sales staff
The FCA proposes a new section in SYSC, designed to ensure sales staff are not incentivised to act in ways which are detrimental to the best interests of clients, for example not remunerating staff in a way that creates incentives to sell products inappropriately. The FCA does not propose cross-cutting standards applicable to firms regulated under other EU directives.
There are provisions in several EU directives which deal with the protection of whistleblowers. The FCA proposes a single chapter in SYSC which implements the MiFID II requirements alongside existing domestic obligations, as well as signposting for ease of reference other related single market whistleblowing legislation.
The FCA is advocating incremental changes are required to the Client Asset Sourcebook to implement MiFID II, many of which are already part of the FCA’s rules. The FCA proposes to continue the FCA’s single rulebook approach and make the changes for all designated investment business.
The FCA proposes a new section in Dispute Resolution: Complaints to set out the enhanced complaint handling rules in MiFID II which will extend to a wider range of clients than is currently the case.
The FCA proposes the initial and ongoing costs for firms who wish to apply to operate an OTF or vary their permission to do so, or to operate a Multilateral Trading Facility, and the onboarding fee for firms who connect to the FCA’s Market Data Processor.
The conflicts of interest rules are more onerous but still unclear
MiFID II imposes a generally more onerous regime for handling conflicts of interest than was previously the case. In particular, firms must take “appropriate” steps to prevent conflicts, rather than just manage conflicts which arise. The FCA’s use of the word “appropriate” in this context is designed to imply that firms now have the onus to ensure compliance against a higher bar than was previously the case, where firms had to take “reasonable” steps.
It is not yet clear how “appropriate” should be interpreted in practice in comparison to “reasonable”, and there is a question whether there is a meaningful distinction between the two tests. Appropriateness requires a rational connection between the steps a firm takes and the conflict which the firms seeks to prevent, yet this is similar to the reasonableness requirement, which denotes a reasoned matching between a conflict and the steps taken to avert it. There is scope to argue that the reasonableness test allows asset management firms greater discretion in being able to argue that the way in which they deal with conflicts is within a range of reasonable steps, whereas the appropriateness requirement limits this discretion to a more narrowly defined set of outcomes which are deemed “appropriate”. However, it is not clear that this is the case, it may be that the distinction is more theoretical than practical, encouraging asset managers to change their behaviour but without giving real guidance as to what should change.
Another potential issue for asset managers is that, if they make many conflicts disclosures, there is a danger of this being taken as evidence that they have not taken appropriate measures to prevent conflicts. In effect, these firms would face a reversed burden of proof, to show that they took adequate steps to prevent conflicts even though they are making high levels of disclosures. This could, in the worst-case scenario, lead to asset managers refusing to undertake new business for new or existing client, if the view is taken that it is too risky to act at all. As such, further clarity is required to determine the steps asset managers need to take to show compliance, and to avoid the requirement having unintended consequences, such as making it more difficult for potential investors to actually invest. In this respect, it would be useful to have regulatory guidance regarding what is deemed appropriate, so that asset managers may update their conflicts of interest policies accordingly. This could include creating a check-list of steps to prevent conflicts, for example as part of the take-on procedures for a new client.
The opt out from MiFID for certain “Article 3” firms has been narrowed
CP 16/19 also clarifies that Article 3 firms, which only operate within the UK, are required to comply with the substance of the MiFID II rules, which means, for example, that sales staff must be remunerated in a way that does not conflict with the best interest of the client. Although there is an opt out in MiFID II for these firms, the FCA notes that in reality the scope of this opt out is limited by the requirement that these firms be subject to at least analogous requirements for a range of authorisations, conduct of business and organisational requirements. The consequence of this is that there may be a simpler Handbook, with one set of requirements for all firms, however the effect may also be to create more onerous regime for Article 3 firms. On the other hand, the FCA does note that impact of the ‘at least analogous’ requirements is limited in the UK as Article 3 firms are already subject to very similar regulations to firms regulated under MiFID I.
The FCA has “gold plated” MiFID II client money requirements
CP 16/19, in addition to implementing MiFID II, also adds some further CASS obligations on asset management firms, for example a requirement that clients using a prime broker service have a daily report on the value and location for client assets held by the prime broker. This forms part of a recent focus by the FCA on the protection of client money, having imposed various fines on firms for failure to comply with their CASS obligations.
MiFID II for AIFMs and UCITS Management Companies
Article 6(4) of the AIFMD and Article 6(6) of the UCITS Directive require AIFMS and UCITS Management Companies respectively to apply parts of MiFID where they carry on portfolio management and the other permitted non-AIFM investment services identified in the AIFMD and UCITS Directive.
The MiFID II Directive indicates that references to MiFID should be now be read as references to MiFID II. An AIFM or UCITS Management Company will now have need to review MiFID II to understand the MiFID II provisions, including those which the FCA seeks to transpose, which Common Platform Requirements rules apply to its non-AIFM investment services.
The proposed SYSC provisions seek to make it clear the MiFID Organisational Regulation will not “apply to a collective portfolio management investment firm in relation to the firm’s business other than its MiFID business.”
The FCA is proposing that the rules on conflicts of interest should apply as guidance (as opposed to a rule) to AIFM or UCITS Management Company whether or not they undertake MiFID business. There is, however, an exemption from the whistleblowing and remuneration requirements for collective portfolio management firms.
It is anticipated that the FCA will publish its third and final CP on MiFID II implementation in the autumn of 2016. Although the FCA previously indicated that it hoped to publish a policy statement on the matters covered by CP15/43 in the first half of 2016, the FCA has stated in CP16/19 that is now likely it will publish a single policy statement covering all aspects of its MiFID II implementation in 2017.
HMT consulted in March 2015 on MiFID II implementation and plans to produce a policy statement in due course before presenting the legislation to Parliament. In the meantime, the proposals in CP16/19 are based on the draft legislation in HMT’s March 2015 consultation paper.
The PRA published its initial CP in March 2016, which covered passporting and algorithmic trading (see our previous briefing, The PRA and MiFID II: Sell-side impacts for the Buy-side). It plans to consult on the remainder of its proposals in due course.