MiFID review: Authorisation and organisational requirements

The consultation paper addresses a number of issues under this section. The common theme is senior management responsibility (more particularly, board responsibility). Most of the proposals for change stem from perceived weaknesses in the organisational arrangements within firms that contributed to some of the problems that arose during the financial crisis. The Commission hopes to strengthen the quality of firms’ organisational arrangements so that similar problems can be avoided or mitigated in the future.

There are seven areas where the Commission has asked for responses to its proposals.

The current requirement under MiFID is that persons who effectively direct a firm’s business must be of sufficiently good repute and sufficiently experienced to ensure sound and prudent management of the firm. This “fit and proper” test has been applied differently in the member states and the Commission considers that corporate governance frameworks can be clarified and strengthened by:

• Extending the fit and proper criteria to all board members (not just those who “effectively direct the business”) and include an assessment of the time commitment of non-executive directors in the criteria;
• Competent authorities to satisfy themselves through ongoing monitoring that all board members remain fit and proper;
• Implementing measures to adapt the fit and proper criteria to specific roles; and
• Clarifying that the definitions of “senior management” and the “supervisory function” in the MiFID implementing directive explicitly includes executive directors and non-executive directors respectively.

The Commission considers that there should be greater board involvement with these functions. All three functions should report directly to the board and the removal of any officers responsible for these internal control functions should be subject to board approval and notification to the supervisor.

In addition, the Commission considers that the compliance function should be specifically involved in the handling of any complaints received, irrespective of the category of the client. The periodic report from compliance could summarise complaints and their treatment.

The Commission is concerned that existing organisational requirements are too high level to address potential detriment to clients where new products, operations and services are launched by firms. The specific obligations which could be imposed in this area are:

• An assessment of the compatibility of the product, operation or service with the characteristics of the firm’s clients;
• Compliance must make certain that procedures are in place to ensure that the product etc. complies with all relevant rules (e.g. disclosure; suitability/appropriateness; inducements; conflicts).
• Risk management to ensure that risks to the firm are adequately managed;
• Stress testing of the product etc.
• Periodic reviews of the distribution and performance of the product etc.
• Firm must ensure staff have the necessary expertise and receive training;
• Board, or corresponding governing body, must have effective control of the above processes. Information about new products and services could be included in compliance reports to senior management and, possibly, to supervisors.

Although authorisation is required to conduct this activity, and the firm will be subject to COBS rules, the actual management of portfolios by firms is not subject to any specific rules. The Commission considers that some specific requirements could be introduced in the context of organisational requirements.

The Commission proposes that firms:

• Formally document how they define and implement their investment strategies (and retain the document);
• Ensure the strategy fits the profile of their investors over the whole life of the mandate in accordance with suitability requirements;
• Ensure they are able to implement the strategy efficiently and consistently without diverging from the original parameters
• Senior management approve, and check on a regular basis, the general investment policies and the relevant systems and controls for implementing and monitoring the management of portfolios.

The Commission believes that the existing provisions for dealing with conflicts of interest is still suitable for preventing failures in the sales process provided it is applied consistently in member states. It restates the key element of the current framework, which is that conflicts must be managed. Disclosure is a measure of last resort and does not amount to the management of a conflict. The creation of a conflict of interest, where a firm provides strong incentives to staff to sell particular products (e.g. through a bonus scheme), is cited as an example of potential non-compliance with MiFID.

The Commission is concerned to ensure a consistent level of investor protection throughout the member states and asks for views on whether implementing measures are required in this area.

In the Commission’s view, recent cases where ownership of asserts has been in dispute, have emphasised the need for strong requirements. It proposes some modifications in the following areas:

• The use of title transfer collateral (TTC) should be prohibited for retail clients. Member states would have an option to allow TTC for professional clients and eligible counterparties (subject to a warning being given);
• Where retail clients’ assets are borrowed as part of a securities financing transaction, the firm must ensure that appropriate collateral is taken and monitor the continuing appropriateness of the collateral to ensure that the balance with the value of the assets is maintained;
• Information which is currently required to be provided to retail clients on the use that can be made of their assets should be required for all client types; and
• The criteria for selecting an institution to deposit client assets with should include the need for diversification in placement of client funds; this is to address the risk of contagion when assets are placed with an intra-group entity where intra-group insolvency occurs.

The Commission considers that more detailed and tailored requirements could be introduced into the corporate finance area. The following options are under consideration:

• Firms must establish specific organisational arrangements concerning all the different steps of the underwriting process and maintain records (preliminary contacts with the issuer; formation of the syndicate; pricing; actual issue of the securities and risk mitigation);
• Specific rules could be introduced to deal with allotment, including conduct of business rules (e.g. information requirements towards issuers and investors regarding procedures and criteria adopted by the firm in distributing the securities; record keeping should include the overall allotment where more than investment firm is involved);
• Specific conflicts of interest rules could be introduced to deal with underwriting and placing activities (similar to the model used for investment research conflicts).

There are two further areas which will impact the authorisation and organisational requirements of firms, if proposals by the European Commission find their way into law. The first concerns dealing on own account and the execution of client orders, which is discussed in an earlier section of the consultation paper (“Dealing on Own Account”). The second concerns the activity of providing custody services, which is discussed in the Commission’s consultation paper on legal certainty of securities holding and dispositions (“Account Provider Status”).

MiFID currently permits exemption from the requirement to be authorised where a person does not provide any investment services or activities other than dealing on own account, unless the person is a market maker or deals outside a regulated market or MTF in an organised, frequent and systematic manner. The Commission is concerned that member states have applied the exemption differently, with some confusion arising where firms execute client orders against proprietary capital. The Commission suggests that the exemption should be clarified so that it is applied consistently and an exemption will apply only where the person concerned is not executing client orders and is neither a market maker nor a systematic internaliser.

A second issue which the Commission believes requires clarification is the treatment of matched principal trades in relation to both capital requirements and the application of the systematic internaliser regime.

Where both legs of a trade are precisely matched, this type of trading could be considered as, either, the execution of client orders or, dealing on own account (as the firm’s capital is put at risk if one of the trades fails). The Commission believes that this activity should regarded as dealing on own account but the treatment of the trading for regulatory capital purposes should be unaffected. Currently, these positions are not regarded as attracting capital charges where they are precisely matched.

The application of the systematic internaliser regime to these types of trades is less clear as the substance of the transaction is a trade between the two clients, even if legally the trades are with the firm as principal.

The Commission is seeking industry views as to capital treatment and also how matched principal trading should be treated for the purposes of the systematic internaliser regime.

The Commission is proposing that an entity providing securities account services (a custodian) should be regulated on a European level. This will involve an upgrade of the current ancillary service of “safeguarding and administering assets” to an investment service in its own right. Anyone providing this service will require authorisation by the relevant competent authority and be subject to its ongoing supervision. If the provider is already an authorised investment firm, no additional authorisation will be required. However, firms which currently provide this service only, and who are not required to be regulated at present, will require authorisation and be subject to supervision should the proposal become law.

Whilst at first glance the proposals for change appear to have something of the scattergun approach to them, in fact they show the depth of the review that has been undertaken. The Commission has clearly examined the existing organisational requirements placed on firms and, using the lessons learned from the financial crisis, tried to see where potential gaps in the rules can be strengthened. None of the proposals are particularly extravagant and most will have been expected following the work of CESR in this area.

The details relating to the proposals for organisational changes are found in section seven of the Commission’s consultation paper.