On 3rd July 2017, and very much at the 11th hour, the FCA published its much awaited final Policy Statement on the implementation of MiFID II. This included, as it had to if the UK was to comply with its obligations under EU law, the made rules for many of the key areas of interest for firms. Publication had to be by 3rd July 2017 at the latest if the UK was going to achieve compliance with the transposition deadline. The FCA took it up to the wire, with publication coming after 5pm on the 3rd July. For those who are familiar with the FCA’s policy on change in control applications, for example, where anything received by them after 4pm is deemed to have been received the next working day, an eyebrow will be raised at this timing. In reality, it reflects quite how much the FCA had to do to meet the deadline. At over 1000 pages (1068 to be precise) it presents a challenge for firms to read and digest. It reflects quite how much is only now known by firms, that the FCA took the unusual step of telling firms that it expects them to take reasonable steps to meet the MiFID II implementation deadline of 3rd January 2018.
This article looks at some of the key areas of interest flowing from the policy announcements made by the FCA last week.
Not unexpectedly, the FCA has ploughed ahead with its policy of extending MiFID II’s rules restricting the use of dealing commission to fund research to all firms managing clients’ assets on a discretionary basis. This is despite no convergence on this point even within the EU since the FCA first announced it over 2 years ago, and certainly none outside the EU. The FCA feels that where it leads others will follow, but whether that proves to be so remains to be seen. The FCA did make a couple of policy changes from its original position. They have allowed greater flexibility regarding the timing around when research charge deductions must be passed to the Research Payment Account (RPA), with the final rules confirming that such deductions must be made without undue delay and in any event within 30 working days. FCA also clarified that, while they expect firms will find that maintaining a single RPA per research budget is the most appropriate policy, this is not mandatory and there may be cases where an alternative is legitimate.
For firms seeking clarification on the regulator’s expectations when it comes to ensuring they do not end up consuming free research in breach of the rules, the FCA recognised that this was needed after its previous position that firms needed to block such research. FCA pointed to ESMA’s subsequent guidance that firms have to have in place mechanisms to determine the nature of any service, benefit or material paid or provided by third parties to decide whether it can be deemed acceptable. If they do not wish to pay for it, firms should take reasonable steps to either stop receiving or cease benefiting from the content of this research. Ways to achieve this may include automatic filtering of senders and materials where practicable, or using the compliance function to monitor, assess and determine whether the incoming material can be consumed in compliance with the MiFID II rules. Training of front-office staff to recognise what research or other material can be accepted or not is also likely to be appropriate.
A further area of practical concern by firms related to what portfolio managers were expected to do when considering whether to engage with a new research provider. The rules, as drafted, may have meant that firms felt that they could not receive free “taster” research as part of the decision-making process; an outcome which the regulator recognised was not intended and would not operate in the best interests of clients. In order to address this point, the FCA came up with what is, in the circumstances, a pragmatic solution; namely that a firm:-
- can only receive a trial for up to three months;
- should not be required to provide any monetary or non-monetary consideration to the research provider for research received during the trial; and
- should not accept a new trial with the same provider within a 12 month period from the date on which a previous trial, or existing research agreement, ceased.
A firm must also ensure that receiving research for a trial period is consistent with the other conditions for acceptable minor non-monetary benefits and should keep adequate records to allow them to demonstrate that each research trial received is compliant with these conditions. At the end of a trial period, in order to avoid further research from a provider constituting an inducement, a firm would need to either cease receiving it or establish a research agreement and payment terms.
The FCA has clarified the position of brokers who provide execution services to third-country forms based outside the EEA. The FCA has confirmed that they are not required to price execution and research (or other) services separately, while at the same time pointing out that the obligation for separate pricing applies to all MiFID investment firms – regardless of the activity being carried out.
The FCA has listened to input received from the venture capital and private equity and commercial property markets who were concerned as to how the inducements and research provisions may apply to their industries. The FCA confirmed that AIFMs or collective investment scheme operators are exempt from the rules where their core investment policy does not generally include investing in financial instruments that can be registered in a financial instruments account which is either opened in the books of a depositary or physically delivered to the depositary or generally investing in issuers or non-listed companies in order to acquire control over such companies.
The FCA has proceeded to implement its policy of extending MiFID II’s rules regarding the categorisation of local public authorities and municipalities to non-MiFID business. At the same time, they have made an amendment to its proposed set of tests for opting up a local public authority or municipality from retail client to professional client status. Under the change, the portfolio size - which was previously set at £15m – is now set at £10m. While this amendment may be helpful to some firms, it does not alter the fact that, by extending the re-calibrated quantitative test to non-MiFID business, the regulator has imposed what might be an unworkable opt-up process for firms who may, for example, assist local authorities in fundraising for special development projects.
Here, the 40 trades a year threshold is meaningless, and so such firms will only be able to treat the local authority as a professional client where they are represented by an investment professional. While this may be the case in many instances, it might also provide likely that firms assisting in the raising of finance, and who do not traditionally deal with retail clients, might decide they are no longer in a position to assist local authorities on such projects.
The FCA did offer some useful guidance as to how firms should interpret the third limb of the quantitative test, namely the requirement to have worked in the financial sector for at least one year. FCA confirmed that the test was to be applied to “the person authorised to carry out transactions on behalf of the client” and that the requirement was that this individual works, or has worked, in the financial sector for at least a year in a professional position which requires knowledge of the provision of the services envisaged.
The FCA confirmed that it does not interpret “the financial sector” in a limited way so that only persons working in the regulated financial sector firms counted. Instead, the FCA reminded firms that the purpose of the test is to ensure that the person acting on behalf of the client has the expertise, experience and knowledge necessary in relation to the investment or service being sold and of the risks involved.
The FCA reminded firms that MiFID II’s categorisation rules do not provide for any form of transitional arrangements for the categorisation of local authorities and so firms will have to comply with these rules at the implementation deadline of 3rd January 2018.
FCA also pointed out to firms that this is an area where national policies are permitted and so, while the new COBS 3.5.3B rules reflect the FCA’s policy, other EU member states are entitled to make their own rules. For this reason, firms seeking to provide services to a non-UK EU local public authority or municipality must both comply with the FCA’s rules as well as whatever rules there are in the member state of the local public authority or municipality.
In a significant move for collective portfolio management firms the FCA has decided not to follow through with its policy of applying MiFID II’s best execution standards to Alternative Investment Management Firms and, instead, to await the European Commission’s forthcoming review of the AIFMD. The FCA did warn, though, that the regulator is prepared to take action if it finds evidence of poor outcomes linked to execution practices at AIFMs. This leaves the MiFID II portfolio manager, UCITS ManCo and Article 3 firm subject to MiFID II’s best execution regime. This example of different rules covering the same activity is a good illustration of why a fresh approach by policy-makers to create a unified regime should be a priority – not that it is going to happen any time soon. Indeed, as we see below in the context of disclosure requirements, the FCA is warning firms that applying MiFID II’s standards to non-MiFID business will not necessarily be compliant. (see the section on Disclosure Requirements below).
The FCA has decided against creating a single unified regime for complaints-handling which applies MiFID II’s standards across the board. It is likely that this will present operational challenges for firms providing both MiFID and non-MiFID services to clients while, no doubt, alleviating the concerns of firms who do not undertake MiFID business. FCA has also confirmed that the extension of MiFID II’s complaints-handling standards to both Professional Clients and Eligible Counterparties did not bring with it an extension in the jurisdiction of the Financial Ombudsman Service; which remains unchanged.
The FCA has, as planned, decided to apply MiFID II’s ban on inducements when dealing with retail clients by banning both the receipt and retention and receipt and rebating of inducements when advising retail clients, irrespective of whether the advice is independent or restricted and, of course, whenever providing portfolio management. However, the FCA has added a layer of operational complexity that will be welcomed by some, but not all, by restricting the extension of MiFID II’s standards banning the receipt and rebating of inducements for non-MiFID business only to retail clients in the UK. This will leaveretail clients outside the UK in the same position as professional clients and eligible counterparties. Of course, it is open to firms to adopt the MiFID II standard (as enhanced by FCA) across all services and clients but this places them at a potential disadvantage against those firms who decide to adopt a policy of minimum compliance.
The FCA has issued what is probably welcome clarification regarding the position of trail commission under COBS 2.3A and stated that the inducements ban only applies to inducements paid, provided or received in respect of services that are provided to clients on or after 3rd January 2018.
For firms providing independent advice or portfolio management to professional clients, the FCA has decided to push ahead with its policy of not extending MiFID II’s inducements ban to restricted advice to professional clients and to allow the rebating of inducements when providing independent advice, or portfolio management, to professional Clients.
The FCA addressed the often contentious issue of corporate hospitality in the context of the wholesale market and makes the point that MiFID II states that hospitality is acceptable if it is of a reasonable de minimis value, such as food and drink during a business meeting or a conference, seminar or other training events. In addition, firms are reminded of their general obligations to identify, prevent, or manage conflicts of interest – including those caused by third party inducements.
The FCA has provided what is probably welcome confirmation that brokers can offer transaction reporting services as part of execution services – provided this does not influence best execution and that it is offered as a standard service by the broker; that is not selectively free for some clients but chargeable to others. As additional guidance, FCA warns that firms cannot adopt this approach to services such as third-party trade analytic tools, order management systems and RPA administration as these do not meet the test of being inextricably linked to an execution service.
The FCA has followed through with its policy of not imposing MiFID II’s requirements in respect of costs and charges to clients in relation to non-MiFID business. This is despite recognising that this might cause operational problems for firms undertaking both MiFID and non-MiFID business. The FCA has added to this complexity by saying that, while firms may wish to adopt a policy of complying with MiFID II’s disclosure rules in relation to both MiFID and non-MiFID business, they should only do so where they are satisfied that the adoption of the MiFID standard imposes an equivalent or higher requirement compared to the otherwise applicable non-MiFID disclosure requirement. It is likely that this obligation will only add to the difficulties faced by firms conducting both MiFID and non-MiFID business - in some cases for the same client - in determining what the regulatory expectations are.
The FCA has followed through with its proposals to apply MiFID II’s standards of independent advice on financial instruments to structured deposits and nonMiFID Retail Investment Products (RIPs). The FCA has responded to concerns that MiFID II’s insistence that the same adviser cannot provide both independent and restricted advice. In an unspoken questioning of the approach taken by MiFID II’s policymakers, the FCA confirmed that, while the policy behind MiFID II’s ban was intended to reduce potential customer confusion about the type of advice they are receiving, it is, in its view, possible to ensure that the client is aware of the type of advice being provided. The FCA is not going to impose this prohibition to non-MiFID business.
The FCA has recognised that there is uncertainty within the industry as to how to comply with the new switching of provisions in MiFID II. While the FCA has not provided any guidance in this Policy Statement, it has explained that this is because ESMA is expected to do so shortly. While it would have been useful to have the FCA’s guidance at this stage, it is understandable that the regulator has decided to await ESMA’s guidance which, it must be hoped, will be provided shortly.
In response to several requests the FCA has confirmed that the requirement for the physical separation of analysts applies to investment research; that is independent research; but does not apply to a nonindependent research i.e. a marketing communication. At the same time firms are reminded that the production of non-independent research is still subject to the requirements regarding conflicts of interest. FCA responded to firms who had requested guidance on when it might not be proportionate for a firm to maintain a physical separation of analysts by saying that this was a matter for firms to exercise judgement.
The FCA has proceeded with its policy of applying MiFID II’s product governance regime as guidance to non-MiFID firms who manufacture and/or distribute MiFID II products. The FCA has also provided helpful clarification to confirm, as was the intention all along, that the proper role of the compliance function in the product governance regime is to is to monitor the product governance arrangements of the firm. The FCA had proposed to refer to this as an oversight role but which the regulator has recognised, quite properly, is inappropriate.
FCA’s proposals to extend MiFID II’s requirements regarding the taping of telephone conversations to firms conducting corporate finance business generated considerable interest in that market. In the end, the FCA reconsidered its proposals and decided against extending the taping obligation to all corporate finance business, but reminded corporate finance firms that they will be subject to the requirements when providing client order services relating to the receipt and transmission or execution of client orders, or when dealing on their own account. The FCA also provided a useful summary of the nature of the taping obligation in the context of such corporate finance business; namely its focus being on conversations resulting in, or intended to result in, transactions concluded when dealing on their own account and the provision of client order services which relate to the reception, transmission and execution of client orders; and that the focus of the recording requirement is on the end of the process leading to a transaction where the transaction is agreed or there is a reasonable prospect of the transaction being agreed.
In its comment on changes to CASS to implement the safeguarding of client assets provisions in MiFID II, the FCA noted that the proposals would not mean significant changes to the existing CASS regime as MiFID II requirements are broadly implemented already. There are, however new standards for client consent in MiFID II, which will require repapering client agreements. Other significant issues of note as follows:
Prohibition on TTCAs with retail clients - Firms must terminate existing TTCAs with retail clients – retaining them is contrary to MiFID II.
Inappropriate use of TTCAs with non-retail clients - compliance with the relevant rules will be determined on a per client basis as individual clients within a class may have varied obligations to the firm.
Custody and client money liens – FCA expects firms to record any security interest, lien or right of set-off in client contracts and in their books and records, ultimately in a way that allows ownership rights to be readily established on insolvency. FCA also expects records to evidence that the client has agreed to the firm being able to grant a third party a lien over the client’s assets (and not necessarily list all the terms in the client contracts) and to allow the firm to identify all the client assets that are subject to a lien (including where this involves the firm being informed by a third party) at all times.
Delegation of safekeeping duties to a third party – The FCA expects firms subject to CASS to ensure that its custody agreements only provide for further delegation that complies with MiFID II on where assets can be held. MiFID II continues the existing MiFID requirement to ensure the custody chain comprises only regulated custodians subject to existing exceptions.
Internal firm assessments of Qualifying Money Market Funds (”QMMFs”) and express client consent - No change, however when a firm places client money in a QMMF as part of its requirement to comply with segregation, the firm will need to have the relevant permissions to hold any units pursuant to CASS 6. There is no allowance for firms to grandfather clients who did not opt out of QMMFs previously as though they have given ‘express client consent’, as MiFID II does not permit this. However, if a firm’s agreements with clients amounted to the firm having obtained express consent then repapering may not be required.
Depositing client money in a group bank - Firms meeting the “small balance” threshold should be able to make use of the exemption from the prohibition on depositing over 20% of client money in a group bank provided they also meet the remaining MiFID II conditions.
Preventing unauthorised use of assets - A firm should ensure it takes ‘appropriate measures’, which may include more than those listed in new CASS 6.4.1CR. FCA expects firms to be able to evidence that they are taking appropriate measures which may, for example, include having a policy for dealing with trades that do not settle as expected. The rules have been amended to make it clear that the requirement on remedial measures applies if the firm cannot deliver on the settlement date.
The FCA expects firms to evidence their appropriate measures to prevent unauthorised use of client assets. This could, for example, include a policy to address unintended consequences occurring in omnibus account structures. The use of one client’s assets for other clients’ transactions is a breach of the rules.
Taking collateral when arranging securities lending - MiFID II places responsibility on the firm for ensuring that a borrower of safe custody assets provides appropriate collateral and that the firm monitors the continued appropriateness of such collateral.
Appointment of a single officer for safeguarding of client assets – FCA will consider the interaction of the CASS single officer requirement with the SMCR in the context of investment firms when this is consulted on in the future.
MiFID II has expanded the scope and level of prescription of investment firms’ transaction reporting obligations. Transaction reporting will therefore apply to a much wider range of financial instruments and require the disclosure of additional mandatory data, and imposes an obligation on firms that receive and transmit orders, but which do not execute orders, to transmit certain required details of such orders to the receiving investment firm, or to report the order themselves.
The obligation to report transactions will apply to:
Financial instruments which are admitted to trading or traded on a trading venue (now including MTFs and OTFs) or for which a request for admission to trading has been made;
Financial instruments where the underlying is a financial instrument traded on a trading venue; and
Financial instruments where the underlying is an index or basket composed of financial instruments traded on a trading venue.
The transaction need not have been executed on an EU trading venue. Derivatives, for example, traded outside the EU, where the underlying is traded on an EU trading venue, will have to be reported.
The reports shall be made to the FCA either by the investment firm itself, an ARM acting on its behalf or by the trading venue through whose system the transaction was completed.
The obligation to transaction report applies to all investment firms, including investment managers providing investment advice and portfolio management on a client-by-client basis (e.g. managed accounts).
MiFID II does not apply to investment managers who purely carry out collective portfolio management of Alternative Investment Funds (“AIF”) and UCITS. So a CPM firm is out of scope, whereas a CPMI firm is in scope, but only in respect of its MiFID managed account activities.