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Investor protection

Investor protection

As discussed in “From MiFID I to MiFID II/MiFIR”, protecting the interests of investors is one of the key aspirations of the revised regulation. MiFID II/MiFIR introduce a number of provisions and extensively update existing ones that are understood to have significant impacts on the business models of asset and investment managers.

According to the multi-level implementation approach of MiFID II/MiFIR, the definite legal interpretation of these provisions will be adopted incrementally. While rules on the safeguarding of client assets, product governance and inducements exist at a mature level (a Delegated Act by the European Commission has been issued), other regimes will have to be detailed further. Please find an overview of the areas covered by the investor protection part of MiFID II/MiFIR and their explanations below:

  • safeguarding of client financial instruments and funds,
  • product governance requirements,
  • ban of inducements/unbundling of services,
  • best execution,
  • independent advice,
  • eligible counterparties/client classification,
  • client reporting, and
  • operations and compliance procedures (incl. telephone and electronic recording).

Safeguarding of client financial instruments and funds

In order to safeguard client financial instruments and funds, Member States shall require that investment firms

  • keep records and accounts enabling them to distinguish at any time assets they hold for one client from assets held for any other client and from their own assets,
  • maintain their records and accounts ensuring accuracy and usability as an audit trail,
  • regularly conduct reconciliations between their internal accounts and logs and third parties’ records (by whom those assets are held),
  • ensure that client financial instruments deposited with a third party are also identifiable separately from those belonging to the investment firm – and that this is also ensured for client funds deposited with a central bank, a credit institution or a bank authorised in a third country or a qualifying money market fund, and
  • adopt adequate organisational arrangements to minimise the risk of losses, diminution of client assets or associated rights, misuse, fraud, poor administration, inadequate record-keeping or negligence.

Member States shall also require that investment firms hold information ready for the national competent authorities, appointed insolvency practitioners and those responsible for the resolution of failed institutions to retrospectively track processes, responsibilities and activities in case of trouble. The Delegated Act is similarly explicit in the governance of depositing client financial instruments or funds and the use of which.

Product governance requirements

The Delegated Act distinguishes product governance obligations for investment firms manufacturing financial instruments from those for distributors of financial instruments. Manufacturers will be confronted with a significant level of obligations to make sure potential conflicts of interests will be avoided. They shall always be able to assess whether the financial instrument creates a situation where end clients may be adversely affected if they take

  • an exposure opposite to the one previously held by the firm itself, or
  • an exposure opposite to the one that the firm wants to hold after the sale of the product.

Firms shall assess whether a financial instrument may represent a threat to the orderly functioning or stability of financial markets before launching it. They have to ensure that staff involved in the manufacturing are sufficiently competent and that product information (including such on distribution) will be included in the compliance reporting to the management (whereby compliance has to periodically review the products and the entire development process).

Distributors are obliged to have in place “adequate product governance arrangements to ensure that products and services they intend to offer or recommend are compatible with the needs, characteristics and objectives of an identified target market and that the intended distribution strategy is consistent with the identified target market”. They must perform comprehensive periodic scenario analyses as to the eligibility of the product for the target market and for end clients; they must also review the charging structure and internal processes to be similarly restricted as those of manufacturers.

Ban of inducements/unbundling of services

Under MiFID I, Commission Sharing Arrangements (CSAs) have been breaking down the commission which asset/investment managers direct to their brokers into a distinct execution component and a distinct research component. This used to allow firms to use the CSAs accrued with brokers to pay for research from a provider of choice, including independent research houses.

Effectively, firms have several ways to pay for research – depending on their relationship with their broker. A firm that has a bundled approach pays one rate of commission to its broker and essentially receives its research as an add-on.

The Delegated Act issued in April 2016 provides that investment firms providing both execution and research services should price and supply them separately in order to enable compliance with Article 24(7)(8) of MiFID II prohibiting the acceptance/retention of commissions or fees from any third parties when providing portfolio management to clients.

Firms must also either pay for research from their own funds or, when paying for it through a dedicated research payment account, make sure that such account may “only be funded by a specific research charge to the client which should only be based on a research budget set by the investment firm and not linked to the volume and/or value of transactions executed on behalf of clients”.

In case firms establish a research payment account they will have to apply far-reaching quality assessments and, upon request by clients or the competent authorities, must provide details including who is being paid what from the account over which period, total payment against the research budget and the services received.

Payments and non-monetary benefits are required to be assessed to ensure that they do not impair the firm’s duty to act in the best interests of the client, that they are “designed to enhance the quality” of the service being provided to the client and that they are disclosed to the client.

Investment firms must take all appropriate steps to identify and to prevent or manage conflicts of interest. They must ensure that inducements paid or received are designed to enhance the quality of the relevant service to the client. Inducements must be justified by the provision of an additional, or higher, level of service, must not directly benefit the firm (or its shareholders or employees) without tangible benefit to the client; and for ongoing inducements, there must be ongoing benefits to the client.

In addition, firms must keep records of inducements, how they were paid or received, how they enhance the quality of service to the client; and disclose certain information in relation to inducements to clients. Firms that provide investment advice on an independent basis, or portfolio management, must return or transfer related inducements to clients, put a policy in place to manage those transfers, and only accept “minor non-monetary benefits” that meet certain conditions and are unlikely to influence the firm’s behaviour in a manner detrimental to clients.

Best execution

Investment firms executing (or arranging for the execution of) trades on behalf of clients must take all reasonable steps to obtain the best possible result for their clients when executing orders (known as “best execution”). MiFID II builds upon the existing requirements in MiFID I in a number of ways, including the requirements expressly stated therein to

  • explain their execution policies in sufficient detail to allow clients to easily understand how orders will be executed,
  • disclose the top five execution venues used,
  • disclose on at least an annual basis the quality of execution,
  • avoid the use of payments for order flow, and
  • achieve the best result to make sure that “all sufficient steps” have been taken.

Independent advice

Under MiFID I, investment advice constitutes a personal recommendation made to an investor – with no distinction being made between different types of advice (e.g. independent or non-independent). However, a personal recommendation has not been made where it has been given exclusively through distribution channels or to the public.

MiFID II makes no changes to the definition of “investment advice” from that contained in MiFID but does introduce the concept of “independent advice” (as opposed to non-independent (i.e. restricted) advice). MiFID II requires the following to be satisfied in order for advice to be considered “independent”:

  • A sufficiently wide range of financial instruments available on the market must be considered.
  • A sufficiently diverse range of financial instruments must be considered (e.g. by type, issuer, product provider).
  • The financial instruments considered should not be provided solely by the firm or other entities that have close links with the firm, or entities with close legal/economic relationships (such as contractual relationships) such that independence is at risk of being impaired.
  • The firm should not receive and keep any inducements/commission/monetary or non-monetary benefits from any third party (e.g. product providers) – minor non-monetary benefits are permitted to be received/kept (see “Ban of inducements” discussed above).

Client reporting

Under MiFID II/MiFIR, the frequency with which asset managers must provide clients with portfolio statements will be increased from semi-annually to quarterly.

The report must include valuations, if necessary on a best efforts basis, a review of activities and performance during the relevant period, any depreciation in the value of the portfolio that exceeds 10 per cent, and certain prescribed information on ownership issues such as assets subject to title transfer or security arrangements.

Operations and compliance procedures

Prescriptive complaint handling rules are extended to complaints by professional clients and potential clients. New requirements include a formal obligation to establish a complaints management policy function, the publication of details of the policy and the provision of reports to national regulators. More detailed record-keeping requirements were introduced with records of decisions to deal becoming more detailed with the initial decision covered by 16 fields and another 40 thereafter.

Record-keeping requirements for telephone and electronic communications relating to client orders will be strengthened while records will have to include relevant internal communications; there is also a new requirement for written records to be kept of face-to-face client meetings.

Existing exemptions under MiFID I are discontinued and there is a new requirement to monitor call recordings. Plus, new requirements on governance and the design of remuneration policies were introduced including a balance between fixed and variable remuneration, applicable to all persons who may have a material impact, directly or indirectly, on the firm’s services.