Welcome to Paper 3 in the Eversheds MiFID II Implementation series.

1. Background

1.1 The FCA is proposing to introduce a new Product Intervention and Product Governance sourcebook (“PROD”) to implement the MiFID II product governance requirements. This will sit alongside the ESMA Guidelines on Product Governance which are currently in consultation1.

The purpose of PROD is to improve firms’ product oversight and governance processes (the systems and controls firms have in place to design, approve, market and manage products throughout the products’ lifecycle to ensure that they meet legal and regulatory requirements) and to set out FCA’s statement of policy on making temporary product intervention rules.

1.2 Guidance in the current draft of PROD, as set out in the FCA’s third MiFID II implementation Consultation Paper, CP 16/29, states that good governance should result in products that:

  • meet the needs of one or more identifiable target markets
  • are sold to clients in the target markets by appropriate distribution channels
  • deliver appropriate client outcomes.

1.3 The MiFID II product governance rules in PROD will apply to MiFID investment firms and CRD credit institutions with respect to:

  • manufacturing financial instruments and structured deposits
  • distributing financial instruments, structured deposits and investment services.

1.4 A manufacturer is a firm which creates, issues and/or designs investments, including when advising corporate issuers on the launch of new investments. A distributor is a firm which offers, recommends or sells investments or provides investment services to clients.

1.5 Other firms which manufacture or distribute financial instruments or structured deposits will be required to take account of the PROD product governance rules as if they were guidance.

1.6 The draft ESMA Guidelines on Product Governance include, inter alia, the six categories that firms should use when identifying the target market for a particular financial instrument, structured deposit or investment service and include:

  • the type of client to whom the 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
  • clients’ needs

Annex 4 of the ESMA Guidelines on Product Governance include illustrative examples and case studies related to the application of certain aspects of the guidelines.

Firms will also need to consider whether the product is complex or non-complex. We expect to will issue a separate paper on this topic as part of our MiFID II series.

2. MiFID II requirements

2.1 All MiFID firms must:

  • establish procedures to assess the target market and risks for new products (or product re-issues) that the firm manufactures or distributes
  • ensure Board level accountability for the process
  • employ staff with relevant competence for the relevant roles
  • choose appropriate distribution channels
  • monitor existing products on an ongoing basis to check they function as expected; are sold to the expected target market and remain consistent with the needs of the target market
  • take action if problems are identified

2.2 MiFID firms involved in the manufacture of products must also:

  • design products that meet the needs of the target market
  • stress test the products
  • assess whether the charging structure is appropriate
  • provide relevant information to distributors

2.3 Under MiFID II distributors must also:

  • gather relevant information from manufacturers
  • provide information to manufacturers to help in the manufacturer’s regular product reviews
  • work together when several distributors are involved in the sale of a product

2.4 A summary of the above rules are contained within Appendix A which is available in a downloadable pdf below.

3. Changes to RPPD rules

The MiFID II rules go beyond the FCA’s existing product governance guidance (contained in the Responsibilities of Providers and Distributors for the Fair Treatment of Consumers (“RPPD”)) in a number of ways as summarised below

3.1 For firms involved in the manufacture of products:

  • product design, including product charges, should meet the needs of the target market and the firm should identify groups for whom the product is unlikely to be suitable
  • firms should consider the impact of new products on the orderly functioning of the market
  • the distribution strategy should meet the needs of the target market
  • firms working together to develop a single product should have a written agreement setting out their share of these responsibilities
  • the compliance function should monitor product governance and boards must have effective control and oversight over the process

3.2 For firms involved in the distribution of products:

  • before distributing a product, firms should consider for which target market it is likely to be suitable
  • the distribution should meet the needs of the target market
  • products should be reviewed regularly to confirm they remain consistent with the target market’s needs and make changes to the distribution strategy or other process if they identify problems
  • firms should provide product manufacturers with information on sales and, where appropriate, the regular reviews mentioned above
  • the firm’s compliance function should monitor product governance
  • Boards should have effective control and oversight over the process
  • firms working together to distribute a single product should share information with other firms in the chain

4. Future FCA Development of PROD

In future the FCA may also consider replacing the RPPD with guidance and rules in PROD for firms who are not subject to the MiFID II requirements.

5. Preparing to Comply with PROD

MiFID firms and CRD firms distributing financial instruments or structured deposits, who must comply with the rules in PROD, and other FCA firms involved in manufacturing or distributing financial instruments, whom must comply with PROD as if it was guidance should take the following steps before MiFID II comes into force on 3 January 2018:

  • ensure that they have procedures in place to assess the target market and risks for new products (or product re-issues) that the firm manufactures or distributes
  • establish procedures to ensure Board level accountability for the product oversight and product governance process
  • for manufacturers, review processes for distributor due diligence so as to choose appropriate distribution channels
  • for manufacturers establish procedures to provide relevant information to distributors
  • for manufacturers prepare agreements under which firms working together to develop a single product set out their respective shares of the product governance responsibilities
  • for distributors, establish procedures to provide information to manufacturers to help in the manufacturer’s regular product reviews
  • for distributors establish protocols to work together when several distributors are involved in the sale of a product

Distribution agreements will need to be amended to comply with PROD requirements as well as other MiFID II changes in areas such as suitability, appropriateness, commission payments and client categorisation.

Firms who have entered into large volumes of distribution agreements will need to consider how to update these in the time available, for example whether one way agreements can be used to update existing agreements. Firms will also need to have arrangements in place to deal with draft agreements and one way agreements that they receive.