The Financial Conduct Authority (FCA) recently published the third Markets in Financial Instruments Directive 2014/65/EU (MiFID II) consultation. Michael McKee, financial services regulatory partner, along with Chris Whittaker, associate, and Georgia Karamani, trainee at DLA Piper UK LLP, consider the proposals of the consultation and potential implications.
Transposing MiFID II in the UK—the third FCA consultation
The FCA has published consultation paper CP16/29 ‘Markets in Financial Instruments Directive II implementation—Consultation Paper III’ on the implementation of the revised MiFID II. The consultation seeks views on the proposed changes to the FCA Handbook and makes key proposals concerning conduct of business issues, product governance, telephone taping for financial advisers and knowledge and competence requirements. The consultation closes on 4 January 2017.
What are the FCA’s proposals in this consultation?
On 29 September 2016, the FCA took another step in the implementation process of the second MiFID II and Regulation (EU) 600/2014 on Markets in Financial Instruments (MiFIR) by publishing its third Consultation Paper (CP16/29).
The FCA focuses on conduct of business issues, including:
- inducements (such as adviser charging)
- inducements and research
- client categorisation
- disclosure requirements
- dealing and managing
- underwriting and placing
- investment research, as well as other conduct matters
The FCA’s proposals also touch on:
- product governance
- knowledge and competence requirements
- recording of telephone conversations and electronic communications (taping)
- supervision manual, authorisation and approved persons and perimeter guidance (PERG)
What is the purpose of the proposals?
FCA CP16/29 is a necessary step for the Directive’s implementation. Covering conduct of business issues, as well as certain issues that remained outside the scope of the previous consultation, the FCA and the UK government proposals are published to work towards implementation of MiFID II so that the UK is compliant with the legal obligations deriving from EU law on the implementation date of 3 January 2018.
The FCA also is considering exercising its discretion to regulate further than what is required by MiFID II in some respects. As MiFID II is a Directive there is scope in certain respects for ‘super-equivalence’ (see the requirements on taping discussed further below).
How does the FCA plan to treat the following topics?
In CP16/29, the FCA proposes a new Conduct of Business sourcebook (COBS) rule 2.3B which transposes article 13 of the Commission Delegated Directive C(2016) 2031 supplementing Directive 2014/65/EU (the MiFID II Delegated Directive). It will also transpose (as guidance) certain recitals of the MiFID II Delegated Directive on how firms should operate a research payment account and collect charges. Firms that wish to use client funds to obtain client-specific research reports should pay close attention to these requirements in COBS 2.3B, in particular the requirements of oversight, audit and controls regarding any research payment account. Clients must agree to any charges on the account and arrangements must be put in place to remit any unused funds back to the relevant clients.
The FCA proposes to incorporate the MiFID II investment research provisions into a single COBS chapter as well as adding guidance to clarify that the new rules will apply to both investment research and non-independent research. The current rules require firms to manage conflicts of interest in relation to the financial analysts involved in the production of investment research and other relevant persons whose responsibilities or business interests may conflict with the interests of the persons to whom research is disseminated. A particular change in MIFID II is a requirement not just to manage conflicts but also to prevent them.
The new rules put in place a number of requirements that require firms to put in place safeguards and arrangements on the production of investment research. For example, an investment firm will need to ensure that:
- financial analysts do not undertake personal trades in the investment to which the research relates
- a physical separation exists between financial analysts who produce the investment research and others whose responsibilities may conflict with the interests of the recipients of the research putting in place appropriate information barriers
- the firm itself as well as analysts do not accept any inducements from those with a material interest in the subject-matter of the research
- the firm itself, financial analysts, and other relevant persons involved in the production of the investment research do not promise issues favourable research coverage
- before dissemination of investment research issuers, relevant persons other than financial analysts, and any other persons, are not permitted to review a draft of the investment research for the purpose of verifying the accuracy of factual statements made in that research, or for any purpose other than verifying compliance with the firm’s legal obligations where the draft includes a recommendation or a target price
Costs and charges disclosure
The FCA proposes to amend COBS in line with the provisions in MiFID II and the MiFID II Delegated Directive. These changes will:
- require the disclosure of appropriate information to clients with regard to the investment firm and its services, the financial instruments and proposed investment strategies, execution venues and all costs and related charges (see new COBS 2.2A), and
- require additional disclosures in respect of safeguarding client instruments and funds as well as information about costs and associated charges
The new disclosure requirements are primarily applicable to firms doing MiFID business.
Fair treatment of customers
Fair treatment of customers constitutes an overarching theme for both MiFID II and CP16/29 and as such it can be traced throughout the FCA consultation.
Disclosure requirements, as well as independence requirements both serve the policy aim of fair treatment of customers.
Firms providing independent advice will have to ‘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’. The FCA states that it intends to implement the MiFID II standards to all retail investment products for UK retail clients. Rules in the MiFID II Delegated Directive in relation to the robustness of a firm’s product selection process, will also be applied to non-MiFID II business. For professional clients and non-UK retail clients, the FCA will only apply the MiFID independence standard on MiFID financial instruments and structured deposits.
Moreover, both the suitability and the appropriateness requirements support the fair treatment of customers and ensure that they are not misled or confused when choosing a financial product.
Rules transposing the MiFID II suitability requirements will be set out in a new COBS 9A. The new rules include more specific requirements to ensure suitability of personal recommendations, such as the obligation to ensure information about the client is up-to-date where the firm is providing ongoing advice or a discretionary management service. Additionally, the rules clarify that, where advice or a discretionary management service is provided wholly or partly through an automated system, the firm remains responsible for the suitability assessment. Responsibility is not diminished by use of an automated system.
The FCA proposes to add two new criteria to the list of non-complex criteria in COBS 10.4.1 R (3), namely that the product does not:
- contain a clause, condition or trigger that could fundamentally alter the nature or risk of the investment or pay out profile and
- include exit charges that have the effect of marking the investment illiquid even though the client may have frequent opportunity to dispose, redeem or realise the product
The FCA will also include in COBS 10:
- a rule that where a bundle of services or products is envisaged, the firm must consider whether the overall bundled package is appropriate, and
- a specific requirement for firms to keep records of appropriateness assessments, including, where a warning was given to a client, whether the client decided to go ahead despite the warning and whether the firm accepted the client’s request to go ahead with the transaction
MiFID II introduces for the first time an EU-wide requirement for firms to record telephone conversations and electronic communications when providing specific client order services that relate to the reception, transmission and execution of orders, or dealing on their own account. The FCA will consolidate the rules into Senior Management Arrangements System.
The FCA proposes to apply the MiFID II taping regime to a wider range of situations than those required by MiFID II, namely:
- the service of portfolio management, including removing the current qualified exemption for discretionary investment managers
- corporate finance business
- energy market activity or oil market activity
- the activities of collective portfolio managers (full-scope UK alternative investment fund managers (AIFMs), small authorised UK AIFMs and residual collective investment scheme operators, incoming EEA AIFM branches and undertakings for collective investment in transferable securities management companies)
How do these proposals differ from existing FCA practice?
Many of the concepts introduced by the FCA consultation are familiar to its existing practice and some are not expected to drastically change the regulatory requirements for firms. However, there are also certain proposals that will have significant practical implications.
Third party research, being an important tool for investment firms, will still be available, but firms wishing to use client funds to obtain client-specific research reports should pay close attention to requirements in COBS 2.3B—in particular the requirements of oversight, audit and controls regarding any research payment account. There is considerable concern among fund managers about the practicality of the requirement for research payment accounts.
The appropriateness test is introduced for a wider range of products than at present.
Product governance also reflects a revised approach by the FCA, with the regulator being more willing to directly intervene in the market in cases of potential customer harm.
A significant change is proposed regarding perimeter guidance. The FCA introduces the scope of the expanded financial derivatives category, notably in relation to FX products, as provided in article 10 of the MiFID II Delegated Regulation. In particular FX forwards will now fall within MiFID II in the UK. The FCA has, up to now, treated FX forwards as out of scope of the current MiFID requirement.
Do any of these proposals go beyond what is required by MiFID II?
The FCA explicitly states that in most areas the regulator is not convinced of the need to extend the MiFID approach beyond the scope of MiFID. Unless the new MiFID provisions have broadly the same effect as existing non-MiFID provisions, the FCA is not proposing a wider application.
An exception to the above is the limited extension of the MiFID II rules to non-MiFID business, when the same risks apply in the provision of designated investment business, whether for MiFID or non-MiFID business.
What are the next steps?
The FCA is planning to publish a fourth consultation later in 2016. All investment firms are expected to be ‘MiFID II ready’ by 3 January 2018 and compliant with the enhanced regulatory regime.
How should lawyers and their clients prepare for the proposed changes?
Both lawyers and their clients should establish a deep understanding of both the currently applicable provisions, as well as the suggested amendments. It is important that firms remain compliant to their regulatory obligations, but it is also crucial that they achieve that in the most cost and time-efficient way. MiFID II and MiFIR require significant changes to systems and procedures, so it is vital that firms analyse how the requirements affect their own business and take legal advice as part of a MiFID II implementation project.
Interviewed by Alex Heshmaty.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.