More than three years after its implementation, the European Commission published its consultation on the review of the Markets in Financial Instruments Directive (“MiFID”)1 on 8 December 2010. In light of lessons learnt from the recent financial crisis, it was considered that a revision of several key investor protection provisions was necessary, including the specific conduct of business obligations relating to “execution-only” business. The consultation closed on 2 February 2011, with final proposals expected to be published later this year. This briefing comments on the Commission’s recent regulatory proposals for execution-only business.
Background – the current “execution‑only” regime
The appropriateness test
Article 19 of MiFID includes several conduct of business obligations which apply where investment firms provide investment services to clients. One of these obligations – the appropriateness test set out in Article 19(5) of MiFID – applies where a firm intends to provide an investment service other than investment advice or portfolio management to a client. In these circumstances, the firm must obtain information regarding its client’s knowledge and experience in the investment field relevant to the specific type of product or service being offered, in order to allow it to assess whether this service or product is appropriate for the client. The firm must provide a warning if the product or service is considered to be inappropriate for the client or the client fails to provide enough information to allow the firm to undertake an assessment.
Currently the appropriateness test has no relevance to eligible counterparties as regards business involving the execution of orders on behalf of clients, dealing on own account and/or the reception and transmission of orders. The test is also effectively irrelevant in relation to professional clients for whom it is currently possible to assume the necessary knowledge and experience2. This means that the appropriateness test is limited in its current application to retail client business.
Exemption under Article 19(6) of MiFID
Under the current MiFID regime when a firm is providing investment services that consist only of execution and/or the reception and transmission of client orders (whether with or without ancillary services), it is not required to undertake an appropriateness assessment where certain conditions are satisfied. These conditions are that:
- the service relates to shares admitted to trading on a regulated market or an equivalent third country market, money market instruments, bonds or other forms of securitised debt (excluding bonds or securitised debt that embed a derivative), UCITS and other “non‑complex” financial instruments;
- the service is provided at the initiative of the client or potential client (ie there is no solicitation by the firm);
- the client or potential client has been clearly informed that the investment firm will not be required to assess the suitability of the instrument offered or service provided or offered and that he will not benefit from the protection of relevant conduct of business rules; and
- the firm complies with its obligations relating to conflicts of interest under Article 18 of MiFID.
Proposals for execution-only business
The effect of Article 19(6) of MiFID is to allow investment firms to provide a retail client with a way of buying and selling non-complex financial instruments without any assessment being undertaken of their appropriateness based on the client’s level of knowledge and experience.
As the Commission notes in its consultation, there is a degree of uncertainty as to the range of products that can qualify as “non-complex” and the services that can be covered by the execution-only regime. The Commission suggested two options to clarify the position:
This would involve the amendment of Article 19(6) of MiFID as follows:
- Clarifying that the shares that may be treated as automatically non-complex are those company shares which have been admitted to trading on a regulated market, Multilateral Trading Facility or equivalent third country market. Shares in collective investment undertakings, convertible shares and other shares that embed a derivative would be ineligible for automatic classification as non-complex.
- Limiting the categories of money market instruments, bonds and securitised debt qualifying as non-complex to those which have been admitted to trading on a regulated market or equivalent third country market. Asset backed securities, convertible bonds, exchangeable bonds and other products “incorporating a structure which makes it difficult for the client to understand the risk involved” would be ineligible for automatic classification as non-complex.
- Excluding the provision of execution-only services where the ancillary service of granting credit or loans to the client is provided to allow the client to carry out a transaction in one or more financial instruments. The stated reasoning behind this suggested change is to reflect the increased risk exposure and complexity that arises as a result of a credit or loan being granted in these circumstances.
- Introducing a differentiated approach for UCITS products to further refine the categories of UCITS which would be eligible for inclusion in the execution-only regime.
The overall effect of these suggested changes would be to limit the circumstances in which the execution-only regime could be invoked in practice. There would also appear to be potential for further uncertainty in relation to the determination of whether a product was eligible for inclusion under the regime, notably as regards the determination of whether it incorporated a structure which made it difficult for a client to understand the associated risks.
This would involve the removal of Article 19(6) of MiFID, a change that would clearly have a significant impact on those firms which currently operate a business model involving the provision of execution-only services to retail clients.
Options 1 and 2
It seems to us that abolition of the execution-only regime under the Commission’s suggested Option 2 would be a disproportionate response, bearing in mind the inevitable additional cost that retail clients would face in accessing investment products and services, the potential delays that could occur to the execution of their transactions while appropriateness assessments are undertaken by firms and the unproven benefits that would accrue to them in exchange. No obvious justification has been made for a change that would effectively ban retail clients from directly accessing products and services at their own initiative and thereby restrict the choice of services available to them in European markets.
A far more proportionate approach would be for the Commission to adopt its suggested Option 1 and retain a modified form of execution-only regime in Article 19(6) of MiFID. That said, we do not think it would be helpful for the Commission to use a reform of a MiFID conduct of business requirement to divide UCITS products into separate “complex” and “non-complex” categories. If it is indeed appropriate to make such a division, it must surely fall to be undertaken through amendments to the underlying UCITS legislation.
Future scope of the appropriateness test
Of perhaps more concern is the suggestion throughout the consultation of the possibility of additional obligations being applied to clients categorised as professional clients or eligible counterparties. Of particular note is the suggestion that the current presumption that professional clients have the necessary level of experience, knowledge and expertise to make their own investment decisions and properly assess the associated risks should be abolished or else limited in its application. It is easy to see how such a change could lead to the removal of the existing assumption that a professional client has the necessary experience and knowledge for the purposes of the appropriateness test.
On a similar note, the Commission appears minded to alter the boundaries of the existing eligible counterparty regime to exclude transactions in certain “complex” products and particular client types from the scope of the regime and to apply some of the high level principle-based requirements of MiFID to eligible counterparty business. This would appear to include the duty of a firm under Article 19(1) of MiFID to act honestly, fairly and professionally in accordance with the best interests of its clients (from which the appropriateness test is itself derived). Whether this would extend to the application to eligible counterparty business of the appropriateness test and other detailed conduct of business requirements based on Article 19(1) of MiFID remains to be seen. However, it is easy to see the logic of such an extension. Furthermore, any reduction in the scope of the eligible counterparty client category will only increase the population of professional clients and focus attention on how they should be treated under the appropriateness test.
It remains to be seen how the Commission will move on these scope issues. However, it would clearly be an unfortunate and indeed disproportionate outcome if appropriateness assessments became necessary under Article 19(5) of MiFID for some or all professional clients and eligible counterparties.