Exemption from the applicability of MiFID for persons providing an investment service in an incidental manner
The section on investor protection begins with a brief discussion on the exemption from the applicability of MiFID II for persons providing an investment service in an incidental manner. This exemption is contained in article 2(1)(c) of MiFID II. The wording of the exemption is identical to that contained in MiFID.
Interestingly, ESMA states that common criteria for the exemption should be developed noting that the word “incidental” should not solely be defined through temporal criteria (i.e. frequency or duration of services) but rather that the provision of the investment service should have an inherent connection to the main area of the professional activity and be of minor and subordinated scope in comparison. In addition, ESMA states that an investment service would not be considered as being provided in an incidental manner if the person who provides the investment service markets its ability to provide investment services. A positive and negative example of how the exemption could apply are given by ESMA.
Article 16(2) of MiFID II consists of an identical recast of article 13(2) of MIFID. It provides that:
“An investment firm shall establish adequate policies and procedures sufficient to ensure compliance of the firm including its managers, employees and tied agents with its obligations under this Directive as well as appropriate rules governing personal transactions by such persons.”
In September 2012, ESMA published guidelines on certain aspects of the MiFID compliance function which focused on, among other things, the organisational requirements of the compliance function for the standards of effectiveness, permanence and independence. In the consultation paper ESMA states that improvements could be made to the MiFID Implementing Directive by implementing some of the principles set out in the guidelines.
Record keeping (other than recording of telephone conversations or other electronic communications)
MiFID II does not make any substantial changes to MiFID in respect of general record keeping obligations, other than emphasising that records should enable national competent authorities (NCAs) to fulfil supervisory tasks and perform enforcement actions.
The MiFID Implementing Directive and the MiFID Implementing Regulation currently provide for a number of record-keeping requirements. ESMA acknowledges this and states in the consultation paper that article 51 of the MiFID Implementing Directive and articles 7 and 8 of the MiFID Implementing Regulation should be confirmed in the implementing measures of MiFID II. However, ESMA also advocates transposing a list of minimum records into the MiFID II implementing measures. This list would be largely based on the 2007 CESR Level 3 recommendations that list the minimum records that NCAs need to draw up according to article 51(3) of the MiFID Implementing Directive.
Recording of telephone conversations and electronic communications
ESMA discusses article 16(7) of MiFID II which introduces organisational requirements for investment firms, which requires them to record telephone conversations or electronic communications relating to the following investment services: reception and transmission of orders, execution of orders on behalf of clients, and dealing on own account.
The specific conversations and communications that should be recorded in relation to these investment services are: (i) the receipt of an order from a client; (ii) the transmission of an order (both where the investment firm will transmit the order, and where it will execute it); (iii) the conclusion of a transaction when executing orders on behalf of clients; and (iv) the conclusion of a transaction when dealing on own account regardless of whether a client is involved in the transaction.
Among the many points that ESMA makes on this obligation is one concerning internal calls. ESMA states that some internal calls will be subject to the MiFID II recording requirement where the internal call in question “relates to or is intended to result in transactions” in the provision of investment services subject to the telephone recording requirement. According to ESMA this view aligns with recital 57 of MiFID II.
In the consultation paper ESMA discusses the relevant product governance provisions in MiFID II, being recital 71 and articles 16 and 24. In its analysis 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.
Safeguarding client assets
Article 16 of MiFID II concerns the safeguarding of client assets. Articles 16 to 20 of the MiFID Implementing Directive also deal with the safeguarding of client assets. Having reviewed these articles ESMA sets out draft advice on a number of related issues including the indiscriminate use of Title Transfer Collateral Arrangements (TTCA), segregation of client financial instruments in third country jurisdictions and securities financing and TTCA and collateralisation.
Noticeably ESMA proposes to introduce additional requirements in respect of both client instruments and client funds. ESMA proposes that investment firms should have proper and specific governance in place to ensure the safeguarding of client assets. More specifically, ESMA proposes addressing concerns around inappropriate lending of, and liens over, client assets; and restricting any inappropriate activity in this area; increasing disclosure to clients; and addressing, through diversification, the contagion risk to client funds that occurs when held exclusively in group banks.
Conflicts of 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 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 NCAs 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.
Whilst MiFID and its implementing measures do not specifically mention remuneration issues MiFID II changes the position by inserting a new explicit requirement in article 9(3)(c) that management bodies of investment firms:
“define, approve and oversee [….] a remuneration policy of persons involved in the provision of services to clients aimed at encouraging responsible business conduct, fair treatment of clients as well as avoiding conflicts of interest in the relationships with clients.”
The basis of ESMA’s draft advice are the principles contained in its 2013 guidelines on remuneration (in particular the definition of remuneration). ESMA believes that MiFID II should specify requirements in the following areas:
- governance – before approving remuneration policies, management bodies should seek advice from the compliance function;
- general criteria for the design of remuneration policies – such criteria should avoid creating incentives for relevant persons to favour their own interest or the firm’s interest over the interest of clients; and
- variable remuneration – an appropriate balance between fixed and variable remuneration to be maintained at all times and variable remuneration to be based on qualitative criteria.
Legitimacy of inducements to be paid to/by a third person
MiFID contains requirements for third party payments in the context of article 26(b) of the MiFID Implementing Directive. Article 24 of MiFID II seeks to strengthen these requirements by distinguishing between rules that apply to: (i) the investment services of portfolio management and investment advice on an independent basis; and (ii) all other investment services.
In the consultation paper ESMA considers the following areas which were set out in the Commission’s mandate:
- 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.
ESMA’s draft advice covers the general suitability provision in article 25(2) and the contents of the suitability report in article 25(6) of MiFID II.
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.
ESMA’s draft advice 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&A statement 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.
MiFID II does not set out major changes to the best execution requirements although ESMA’s advice provides a few additional requirements and clarifications covering:
- detail of execution policies;
- disclosure and consent;
- content of disclosure;
- third party payments;
- transparency of venue selection;
- factors that may constitute a ‘material change’; and
- use of a single venue or entity for execution.
In relation to material change 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).