For many years, financial sector firms and their advisers have sometimes struggled when different regulatory treatment applies to different activities. Often, the differences occur when business falls under several EU Directives which do not use consistent concepts or terms. Of course, this causes frustration in terms of time and cost.
This article looks the differences between a “qualified investor” under the Prospectus Directive (PD) and a “professional client”/”eligible counterparty” under the Markets in Financial Instruments Directive (MiFID). We consider whether it be possible to make the two terms more consistent.
1 Prospectus Directive: “Qualified investors”
1.1 What is a “Qualified Investor”?
The PD sets an EU-wide definition of an offer to the public of transferable securities. Anyone who makes such an offer must produce a prospectus containing set information and have it approved by the relevant competent authority, unless the offer falls within an exemption. There is an exemption for offers directed only at “qualified investors”. These are:
(a) authorised legal entities: financial markets professionals authorised or regulated anywhere (not just in the EU) including credit institutions, investment firms, insurance companies and collective investment schemes and commodity dealers. It also includes an unauthorised entity whose corporate purpose is solely to invest in securities;
(b) government and international bodies: national and regional governments, central banks, and international and supranational organisations such as the IMF or ECB;
(c) large undertakings: this is an undertaking that is not an SME. An SME is an undertaking that meets at least two of the following based on its last accounts:
(i) average number of employees of less than 250;
(ii) total balance sheet of not more than €43 million; and
(iii) annual net turnover of not more than €50 million.
(d) registered sophisticated individual investors: natural persons who meet the criteria below and ask to be included on a national register of qualified investors but only if their home Member State chooses to allow this. The criteria are that the individual:
(i) has carried out transactions of a significant size on securities markets averaging at least 10 per quarter over the previous year;
(ii) has a portfolio exceeding €0.5 million; and
(iii) works in the financial sector in a professional position that requires knowledge of securities investment;
(e) registered SMEs: SMEs may also ask to be included on the national register, if their home Member State has one in place.
1.2 Why does it matter?
Under the PD, issuers and intermediaries do not have to produce a prospectus vetted by the authorities if their securities offering is addressed solely to qualified investors. But other laws may to protect investors. In the UK, issuers and intermediaries have to comply FSMA requirements on financial promotions and misleading statements. In all countries, laws on misrepresentation will be relevant.
1.3 What are the problems?
The immediate problem is with registers for natural persons and SMEs. A report carried out by the European Securities Markets Expert Group (ESME) for the European Commission shows some Member States have chosen not to have a register, as is their right under the PD. Even the UK’s register, which is the largest ESME identified, holds just over 300 names, and FSA receives only around 4 requests a month to access it. For offerors, it is an advantage that registered qualified investors self-certify, so all the offeror has to do is check they are registered. However, whether it is worth the effort of accessing the register for so few names is another matter. Investors may be reluctant to register themselves because by doing so they leave themselves open to contact by all offerors – they cannot for example specify they are interested only in particular business sectors. They may also be concerned about confidentiality.
2 MiFID: Professional clients
MiFID is a wider-ranging and more complex Directive and so has to take a different approach to investor protection. Its approach is to give most protection to retail clients. A retail client is any client who is not a professional client or eligible counterparty. Professional clients are:
(a) authorised legal entities: similar to the PD, financial markets professional entities authorised or regulated with or without reference to a Directive within or outside the EU. This category, though, does not include entities that are not authorised but whose purpose is to deal in securities;
(b) government and international bodies: national and regional governments, public bodies that manage public debt, Central Banks, international and supranational organisations as in the PD. This goes slightly wider than the PD, in that it includes public bodies that manage public debt
(c) large undertakings: undertakings that meet at least two of the following criteria:
(i) balance sheet total of €20 million;
(ii) net turnover of €40 million; and
(iii) own funds of €2 million.
So in no respect do these criteria match the PD equivalent. Many undertakings will fall within the scope of one but not the other. The PD criterion based on number of employees is not replicated.
(d) other institutional investors: institutions whose main activity is to invest in financial instruments, including entities dedicated to the securitisation of assets or other financing transactions. This is similar, but not identical, to the catch all in the “authorised legal entities” head within the PD.
(e) “elective professionals”: This is the MiFID equivalent of the registered qualified investors categories. Some clients may be professional clients, but only if they meet set criteria and choose to be professionals. The criteria are:
(i) the client has carried out transactions in significant size, on the relevant market at an average frequency of 10 per quarter over the last year;
(ii) the client’s financial instrument portfolio (including deposits and financial instruments) exceeds €500,000; and
(iii) the client works in the financial sector in a professional position that requires knowledge of the transaction or services envisaged.
Any would-be elective professional must ask the firm to treat them as a professional client. Firms may agree to do so only if they are satisfied the criteria apply, the client knows what protections they will lose, and the client has agreed in writing it is happy to lose them. Clients may also be professional clients under transitional rules, if firms treated them as the pre-MiFID equivalent and they continue to qualify under those pre-MiFID rules.
These criteria are similar to the PD requirements for individuals. But the key differences are that:
(i) under the PD, the investors can self-certify. Under MiFID, the investment firm must make the judgement; and
(ii) MiFID does not provide for national registers.
(f) eligible counterparties: many, but not all, professional clients may also be eligible counterparties under MiFID. Eligible counterparties are:
(i) investment firms, credit institutions, insurance companies, UCITS and managers, pension funds and managers and other financial institutions authorised under Community law or national law of a Member State;
(ii) institutions exempted from MiFID because they are commodity or own account derivatives dealers;
(iii) national governments and their corresponding offices (including central banks etc);
(iv) “elective ECPs”: if Member States choose, they may also treat as ECPs undertakings that meet set thresholds and undertakings from outside the EU. But, if the counterparty is from elsewhere within the EU, the investment firm in question must look at whether they are an ECP under their local law.
2.2 Why does it matter?
Many of MiFID’s demanding protective requirements do not apply when firms deal with clients that are not retail clients. Even fewer requirements apply to business with ECPs. So, many sophisticated investors who do not automatically meet the professional client criteria are happy to “elect” the status, so their chosen investment firm is not bound to hold their hand and offer them protections they feel hamper their investment strategy.
2.3 What are the problems?
The first problem is the mechanism for electing professional status, which means the client must be pro-active. Although this is in part a protection mechanism so clients do not find themselves treated as professionals without realising the results, it is annoyingly bureaucratic for some.
Next is whether the client meets the relevant criteria. Some clients may be familiar with the markets and understand the regulatory environment well, but if they do not meet MiFID’s criteria, no firm is allowed to treat them as professional clients.
There is no concept of self-certification in MiFID. This is in contrast to the UK’s financial promotion regime, which has a self-certification process for HNWIs and sophisticated investors – this regime would, say, allow an unauthorised offeror to send an unapproved prospectus to a select number of rich individuals without breaching FSMA restrictions on offers to the public or financial promotion. However, it would not follow that any investment firm engaging in business with the individual could apply professional client status.
Then there is the problem of horses for courses. Because some clients may be, or consider themselves, experts in one sector or market, they may want more guidance and protection in others. So, under MiFID, firms may have clients that are professional clients (maybe even ECPs) for some purposes, and retail for others. Again, this is in keeping with the overarching MiFID concept of acting in clients’ best interests and giving protections to those who need them.
3 Could we minimise the differences?
Perhaps. But since the PD is purely product driven, and MiFID is service- and client-driven, it may make sense to keep some (if not all) distinctions.
An individual who chooses to appear on the qualified investor register under the PD cannot pick and choose what sorts of securities offers he is happy to receive. His only choice is whether to be on the register or not. On the other hand, it is logical for investment firms to treat certain individuals as professional clients for some purposes and retail for others. It would not benefit the firm and may not benefit the investor to be a retail client for all purposes. If this is right, it would not be sensible to change the MiFID approach in respect of “expert” individuals.
But to change the PD approach to make it consistent with MiFID would not work. Offerors are not in a position to make the assessments MiFID requires investment firms to do, and a register that lists qualified investors by sector or product would be expensive to set up and maintain, and would clearly not be worth it given the current use of existing registers.
ESME has made a practical suggestion that investment firms should be able to send “offers to the public” to existing clients which the firm treats as “professional” clients, regardless of whether they meet the qualified investor tests. This seems sensible.
ESME sees no reason not to align the categories of “per se” qualified investor with those for “per se” professionals, and favours using the MiFID tests.
There is no immediate explanation for the differences in criteria that make companies “large enterprises”. ESME notes, though, the PD may have some flexibility that MiFID does not, and the Commission should consider whether there might be any benefit in keeping both definitions for PD purposes rather than just substituting the MiFID criteria for the PD ones. This would presumably allow MiFID firms to rely solely on their client categorisations if they wanted, and might otherwise give a little more flexibility.
ESME has made powerful arguments for harmonising some of the definitions from the PD and MiFID. That said, because of the differing focus of the Directives, it is likely there will always be some differences. The Commission needs to think carefully about ESME’s recommendations and consult on proposed changes to definitions and consider whether it is worth keeping the PD’s qualified investor register, given Member State experiences so far.