The European Commission published a wide ranging consultation (the “Consultation”) on its review of the Markets in Financial Instruments Directive (“MiFID”) in December 2010. The Consultation, which closed on 2 February 2011, sought views of market participants, regulators and other stakeholders on a range of potential changes to the existing MiFID legislation. The responses submitted to the Commission will be used to inform its formal proposal to amend MiFID, which is expected to be published in June.
In advance of the formal Commission proposal, this paper considers some of the issues raised by the Consultation in relation to the regulation of inducements under MiFID.
Background and overview of changes
The current MiFID inducement rule set out in Article 26 of the Level 2 Implementing Directive1 prohibits firms from making or receiving payments or other non-monetary benefits in connection with any investment or ancillary services provided to professional clients or retail clients, unless those payments or benefits fall into one or more of three specified exceptions. The rule is derived from Article 19(1) of MiFID, a high-level duty requiring firms to act honestly, fairly and professionally in accordance with the best interests of their clients. See our briefing “The MiFID inducement rule: has Pandora’s box been opened?” for further detail on the current MiFID inducement rule.
While the Consultation does not suggest any alterations to the scope of this broad framework for the regulation of inducements, it does include a number of suggested changes to the exception under Article 26(b) of the Level 2 Implementing Directive, including the disclosure requirements and the separate “enhancement” requirement. Notably, the Consultation is inclined to introduce outright bans on third party inducements for portfolio managers and intermediaries providing investment advice on an independent basis.
The Commission proposals
Changes to the Article 26(b) exception
Under Article 26(b) of the Level 2 Implementing Directive, inducements paid by a firm to a third party or received by a firm from a third party are not prohibited where the following three conditions are satisfied:
- Condition 1 – clear, prior disclosure of the inducement has been made to the underlying client of the firm;
- Condition 2 – the inducement has been designed to enhance the quality of the service to the underlying client of the firm; and
- Condition 3 – the payment or non-monetary benefit does not impair compliance with the firm’s duty to act in the best interests of the underlying client.
The Commission is proposing further prescription in relation to the way in which disclosure is made by firms.
It is currently possible to satisfy Condition 1 by disclosing the essential terms of the inducement arrangements in summary form, on the basis that the firm undertakes to disclose further details at the client’s request and subsequently meets any such request. The Commission is minded to remove the option of making this summary form of disclosure, and to mandate detailed disclosure on a pretransaction basis in all instances. While this undoubtedly reflects the stated difficulties in distinguishing between summary and detailed disclosures, we imagine it also has something to do with concerns about the overall quality of summary disclosures and a lack of follow up requests by clients.
The proposed abolition of summary form disclosure is accompanied by a suggested new post-transaction reporting obligation which would apply where it was impossible to calculate the amount of fee or benefit on a pre-transaction basis (so that only the calculation method could be disclosed upfront).
The Commission has observed differing standards in relation to the details provided in inducement disclosures and has suggested greater prescription of the technical details of the items to be disclosed in order to harmonise the way in which inducements are presented to clients. Disclosure templates are specifically mentioned as a possible way forward.
Condition 2 is sometimes referred to as the “enhancement” requirement. The Commission is minded to facilitate further convergence of the practical aspects of this requirement. For instance, in assessing whether a third party payment or non-monetary benefit has been designed to enhance the quality of the service to the underlying client, regulators may be expected to take into account the long term assistance provided by firms to their clients over the course of a relationship.
Independent investment advice
In the case of intermediaries providing investment advice on an independent basis, the Commission has suggested an outright ban on the receipt of third party inducements. This reflects concerns that the receipt of these inducements would be incompatible with the independent nature of the advice provided by the intermediary and appears to assume that this would result in any recommendations being biased.
This aspect of the Consultation has clearly been influenced by the FSA’s policy thinking developed under its Retail Distribution Review (“RDR”) initiative. In particular, one of the cornerstones of the RDR is a ban on product providers paying fees or commission to advisers in conjunction with any personal recommendation relating to a retail investment product provided to a retail client. Instead the adviser will have to be remunerated for his advice through adviser charges paid by the client. This ban applies regardless of whether the advice provided is “independent” or “restricted” in nature. It remains to be seen whether the Commission will retain the current scope of the suggested ban or whether it will be extended to include all types of investment advice. It is also unclear if any future ban would be limited to investment advice provided to retail clients. See our briefing here on the MiFID review proposals in relation to investment advice and the potential conflicts with the RDR.
The Commission appears minded to impose a similar ban on portfolio managers receiving or providing third party inducements. The justification provided for this ban is the discretionary nature of portfolio management, the prevailing assumption again being that any recommendations would be biased wherever inducements have been received from brokers and other third parties.
In the UK, the FSA’s existing use of dealing commission rules2 limit the circumstances in which a portfolio manager can accept goods or services from brokers in conjunction with the execution of orders relating to underlying fund clients. In broad terms, any goods or services so provided must relate to the execution of those orders or involve the provision of research. Compliance by a fund manager with the use of dealing commission rules would ordinarily mean that he is in compliance with the MiFID inducement rule.
The use of dealing commission rules have been notified by the FSA to the Commission under Article 4 of the Level 2 Implementing Directive, a provision that allows individual Member States to impose local requirements that go above and beyond those specified in the Level 2 Implementing Directive in certain limited circumstances. The Commission has suggested in the Consultation that this right of Member States to impose local “gold plating” of the Level 2 Implementing Directive should be withdrawn. Assuming this is what happens in practice, it will be crucial to understand if existing “gold plating” notified to the Commission – like the use of dealing commission rules – will be allowed to remain in place. It would certainly be unfortunate if the UK market, which adjusted some years ago to the introduction of the use of dealing commission rules, had to adjust again as a result of the rules being withdrawn.
A missed opportunity
The Consultation does not address a number of significant problems arising from the current treatment of inducements under MiFID, a position that can only be described as a missed opportunity.
In particular, the fact that the term “inducement” is not itself defined in the Level 2 Implementing Directive means that the MiFID inducement rule is capable of applying to a seemingly limitless range of payments and non-monetary benefits paid, provided or received in the context of a client relationship. This omission means that there is no room for traditional thinking on inducements based on conflicts of interests, under which the question of whether an inducement was permitted ultimately turned on whether it was likely to conflict to a material extent with any duties that a firm owed to its clients3. Indeed the absence of any concept of materiality seems to defy the ordinary natural meaning of the term “inducement”.
One other problem with the current MiFID inducement rule is its failure to calibrate the application of its requirements as between professional clients and retail clients. Logic suggests that these requirements should be mitigated in the case of professional clients who are treated under MiFID as having the experience, knowledge and expertise to make their own investment decisions and properly assess the associated risks. While unquestionably logical, this approach may be running against the tide of some of the other potential changes suggested in the Consultation, including the apparent question mark placed over the current presumption regarding the knowledge and experience of professional clients, the suggested limitations in the scope of the eligible counterparty regime and the threatened extension of the range of regulatory requirements applicable to eligible counterparty business4. It seems to us that any extension of the MiFID inducement rule to eligible counterparty business would make it even more important to introduce appropriate levels of calibration of its requirements as between different types of client.