With the publication of MiFID II and MiFIR in the Official Journal of the European Union the clock has now started ticking and firms need to familiarise themselves with the new requirements and prepare themselves for regulatory change. Whilst the headline changes to the MiFID regime focus on market infrastructure there are also a number of important changes which are designed to enhance the protection afforded to retail clients.

Best interests of clients

When providing investment services to retail (and professional) clients, a firm must act honestly, fairly and professionally in accordance with the best interests of its clients. MiFID II continues this policy and firms are expected to establish and review effective policies and arrangements to identify the category of clients to whom products and services are to be provided. The obligation to act in the best interests of the client is developed in MiFID II in the following ways:

  • a firm that manufactures financial instruments for sale to clients must ensure that: (i) those products are manufactured to meet the needs of an identified target market of end clients within the relevant category of clients; (ii) the strategy for distribution of the financial instruments is compatible with the identified target market; and (iii) it takes reasonable steps to ensure that the financial instruments are distributed to the identified target market; and
  • a firm which offers or recommends financial instruments must: (i) understand those financial instruments; (ii) assess the compatibility of the financial instruments with the needs of the clients to whom it provides investment services; (iii) take into account the identified target market of end clients; and (iv) ensure that the financial instruments are only offered or recommended when this is in the interests of the client.

In its recent consultation paper of 22 May 2014 (the consultation paper) ESMA proposes to introduce two sets of policy proposals for product governance arrangements for:

  • investment firms to adopt when manufacturing products (product governance obligations for manufacturers); and
  • investment firms to adopt when deciding the range of products and services they intend to offer to clients (product governance obligations for distributors).

ESMA proposes that where an investment firm acts as both a manufacturer and a distributor of investment products it should be required to fulfil all the relevant obligations set out for both manufacturers and distributors. In a group context, where the product is developed by one entity and distributed by another, the product governance requirements for manufacturers and distributors apply to each entity depending on the activities undertaken.

Also, ESMA proposes to impose on investment firms a positive duty to check that products function as intended rather than only requiring them to react when detriment becomes apparent or at issuance or re-launch of the same product. The frequency of the review is considered further in the consultation paper.

It is also worth remembering that MiFIR gives ESMA, the EBA and national competent authorities powers to temporarily or (in the case of Member States) permanently prohibit or restrict the marketing, distribution or sale of certain financial instruments or financial activity where there is a significant investor protection concern or a threat to the orderly functioning and integrity of the financial or commodity markets or financial stability. For the UK product intervention powers have already been given to the FCA under the Financial Services Act 2012.

Independent advice

The reference to the provision of investment advice “on an independent basis” has been introduced for the first time by MiFID II.

Where a firm informs the client that investment advice is provided on an independent basis, it must assess a sufficient range of financial instruments available on the market which must be sufficiently diverse with regard to their type and issuers or product providers to ensure that the client’s investment objectives can be suitably met and should not be limited to financial instruments provided either by:

  • the firm itself; or
  • other entities that have close links with the firm or such close legal or economic relationships with the firm, such as contractual relationships, as to pose a risk of impairing the independence of the advice.

In the consultation paper ESMA makes a number of points as to when advice can be considered to be given on an independent basis. Two key points in ESMA’s analysis are:

  • a crucial requirement for the identification of investment advice provided on an independent basis is the investment firm’s ability to assess a sufficiently diversified range of financial instruments available on the market. In this context ESMA believes that it is not appropriate to set a specific or minimum number of financial instruments or product providers to be considered when selecting the products that may be recommended to a client. The number, types and product providers to be compared will depend on the scope of the advice given, client preferences and needs and the circumstance that the service provider is including or excluding products; and
  • the scope of investment advice can range from broad and general to specialist and specific. The scope of advice offered by investment firms providing advice on an independent basis depends on the business model. A firm could specialise in particular financial instruments and still hold itself out as being independent.

Inducements and commission

MiFID II creates a complete ban on inducements being received in certain circumstances (see below). In addition, other than where a firm is providing independent advice or portfolio management, any fees, commission or other monetary benefits must comply with the rules on inducements as set out in MiFID and its implementing measures (these are moved into the Level 1 text of MiFID II). Firms must also, where applicable, inform clients on how the fee/commission/non-monetary benefit can be transferred to them.

Firms providing investment advice on an independent basis or portfolio management, will in most circumstances, be prohibited from retaining any fees, commission, monetary or non-monetary benefits received from third parties. Such payments / benefits can be received and passed onto clients but cannot be received and retained by firms. Minor non-monetary benefits are excluded from the ban. Firms need to accurately and, where relevant, periodically inform clients about all the fees, commissions and benefits that have been received in connection with the investment services provided.

In the consultation paper ESMA considers the following areas:

  • the conditions under which investment firms providing investment advice on an independent basis and portfolio management fulfil the requirement to not accept and retain any monetary or non-monetary third party payments;
  • the definition and conditions for ‘minor non-monetary benefits’ that can be received when providing independent advice or portfolio management;
  • the use of payments and non-monetary benefits that meet the requirement of enhancing the quality of the relevant service to the client; and
  • requirements for the disclosure to the client in relation to the existence, nature and amount of the third party payment or benefit.

In relation to minor non-monetary benefits ESMA believes that this exemption should be strictly interpreted, such that non-monetary benefits likely to influence the behaviour of the recipient should not be allowed. ESMA also discusses the potential for research to be permissible as a minor non-monetary benefit. In particular ESMA proposes that for financial analysis to come within the exemption it would need to be intended for distribution so that it is, or is likely to become, accessible by a large number of persons, or for the public at the same time. The simultaneous widespread distribution of research on a single financial instrument or issuer of financial instruments, or generic economic commentary, is given as an example that may meet the requirement. In contrast ESMA states that it considers any research which involves a third party allocating valuable resources to a specific portfolio manager would not constitute a minor non-monetary benefit and could be judged to impair compliance with the portfolio manager’s duty to act in their client’s best interest.


The requirement that investment firms should not over-rely on disclosure or use it as a self-standing measure to manage conflicts is, according to ESMA, implicit in article 22 of the MiFID Implementing Directive.

To address any uncertainty over interpretation in its consultation paper ESMA proposes to make this principle explicit. ESMA considers that before relying on disclosure, investment firms should first consider whether other reasonable measures effectively mitigate the conflict of interest and prevent potential detriment. It believes that in this regard it would be reasonable for national competent authorities to request evidence from investment firms to demonstrate compliance with this requirement.

ESMA also notes that under MiFID whilst there is no explicit obligation requiring investment firms to periodically review conflicts of interest policies it is normal business practice for them to do so. ESMA proposes to formalise this process by requiring investment firms to assess and periodically review at least annually their conflicts of interest policy.

Suitability and appropriateness

Suitability requirements apply to advised services and portfolio management. MIFID II provides for more onerous obligations on investment firms to determine suitability (including of bundled packages of products). Firms giving investment advice will be required to disclose whether they will provide the client with an on-going assessment of suitability of the product. Clients must also be provided with periodic reports including an assessment of the suitability of the portfolio (unless, in the case of investment advisers, the firm is not carrying out a periodic assessment of suitability). Firms providing investment advice must provide clients with a statement specifying the basis on which the investment recommended is suitable for the client.

ESMA considers that the suitability provisions in article 35 of the MIFID Implementing Directive are a good basis for the development of the MiFID II implementing measures and proposes to leave them as drafted except for article 35(1). This provision is to be updated to reflect that MiFID II explicitly requires investment firms, when undertaking a suitability assessment, to assess both a client’s ability to bear losses and a client’s risk tolerance. ESMA’s advice also covers the position that MiFID II requires investment firms to provide a client with a suitability report specifying how the advice given meets the retail client’s circumstances and needs.

Appropriateness requirements apply to non-advised services. MiFID II narrows the categories of ‘non-complex’ products. The ‘appropriateness’ test will apply to:

  • shares unless they are traded on a regulated market (or third country equivalent) or MTF;
  • shares in a non-UCITS collective investment undertaking or that embed a derivative;
  • structured UCITS;
  • bonds and other forms of securitised debt unless they are traded on a regulated market (or third country equivalent) or MTF;
  • all debt instruments that embed a derivative or ‘incorporate a structure which make it difficult for the client to understand the risk involved’; and
  • structured deposits that ‘incorporate a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before term’.

ESMA’s draft advice in the consultation paper on appropriateness covers article 25(3) and (4) of MiFID II, which includes the definition of a non-complex financial instrument. This includes advice in relation to the criteria to assess non-complex financial instruments for the purposes of article 25(4)(a)(vi) of MiFID II. ESMA considers that the criteria in article 38 of the MiFID Implementing Directive and the 2009 CESR Q&Astatement on MiFID complex and non-complex instruments to be a useful starting point when analysing “other non-complex financial instruments” but has added additional criteria.

Best execution

MiFID II does not set out wholesale changes to the best execution requirements. However, two important additional requirements are inserted for investment firms executing client orders:

  • the execution policy must be provided in sufficient detail and in clear, easy to understand language; and
  • firms must summarise and make public, for each class of financial instrument, the top five execution venues where they executed client orders in the preceding year, on an annual basis.

ESMA’s draft advice in the consultation paper covers certain key elements including disclosure and consent, third party payments, transparency of venue selection and factors that may constitute a ‘material change’. On this latter point investment firms are required to review their execution policy at least annually and whenever there is a material change that affects its ability to obtain the best possible results for the execution of its client orders. ESMA states that what is material will depend on the nature and scope of any change and the nature and size of a firm’s business. Nevertheless, ESMA also states that a material change could be understood as a significant event of internal or external change that could impact parameters of best execution (cost, price, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order).


Firms are required to provide clients with adequate reports on the service they provide. MiFID II will require reporting to be carried out in a durable manner and to include periodic communications taking into account the type and complexity of the financial instruments involved and the nature of the service provided as well as the associated transaction and service costs.

When providing investment advice to retail clients and before the transaction is made, firms will be required to report personally, and in a durable medium, on suitability to their clients specifying the advice given and how it meets the preferences, objectives and other characteristics of the retail client.

Where a firm provides portfolio management services to retail clients or has informed its retail client that it will carry out a periodic suitability assessment, the periodic report must contain an updated statement of how the investment meets the client’s preferences, objectives and other characteristics.

Where distance communication is used to conclude the agreement to buy or sell a financial instrument which prevents the prior delivery of a suitability statement, the firm can provide this statement in a durable medium immediately after the client is bound by the agreement, provided that the following two conditions are met:

  • the client has consented to receiving the suitability statement without undue delay after the transaction is concluded; and
  • the firm has given the client the option to delay the transaction in order to receive the statement on suitability in advance.

Information to clients

MiFID II introduces more onerous information requirements for investment firms. MiFID II requires firms to provide existing clients or potential clients with appropriate information in good time about:

  • whether the financial instrument is intended for retail or professional clients, taking into account the intended target market; and
  • all costs and charges related to both investment or ancillary services including the cost of advice, where relevant, the cost of the financial instrument recommended or marketed to the client and how the client may pay for it, and including any third party payments.

The consultation paper published by ESMA covers both information to clients about investment advice and financial instruments and information to clients on costs and charges. On the latter firms will be particularly interested in the examples that ESMA provides which illustrate how aggregated costs and charges could be disclosed.