CESR paper on Markets in Financial Instruments Directive inducements regime – good and bad practices
The Committee of European Securities Regulators (“CESR”) has published a consultation paper on the Markets in Financial Instruments Directive (“MiFID”) inducements regime setting out its views on industry practices to comply with the inducements regime, including examples of good and bad practices. CESR has based its views on responses given to a CESR questionnaire distributed to investment firms. It is inviting comments on its views by 22 December 2009.
The inducements regime was an aspect of MiFID that caused difficulties for some firms when applying the rules to their business prior to the implementation of MiFID in November 2007. This was due in part to the fact that the inducements regime casts its net widely, and prohibits firms from paying or being paid any fee, commission or non-monetary benefit in relation to the provision of investment services to a client, unless they fall within one of the categories of permitted payment set out in the MiFID implementing directive. The categories of permitted payment are themselves quite narrowly drawn and their application is subject to satisfying a number of convoluted conditions. As firms found, the regime therefore bites on a number of fees, commissions and non-monetary benefits that would not previously have been regulated in this way- a particularly controversial example being underwriting fees paid by issuers in the debt and equity capital markets to investment banks when providing underwriting and other related services to the issuer.
CESR says that the main objective of this consultation is to help firms to “benchmark themselves against industry compliance practices under the MiFID inducements rules, with the additional comfort of knowing whether securities regulators encourage or discourage particular instances of behaviour by firms”.
With that in mind, and given that some of the guidance in the paper represents new guidance on key areas under the inducements regime, such as processes for complying with the regime and the content of summary disclosures, firms would be advised to perform a benchmarking exercise against this new guidance.
A short summary of interesting aspects of the paper for firms is set out below.
2. Arrangements and procedures to categories payments and benefits under the inducements rules
CESR provides some helpful guidance to firms on the processes that it would expect to see in place to ensure that a firm is complying on an on-going basis with the inducements rules. Of the approach that firms need to take in this respect, CESR says:
“In this context, firms enjoy a certain degree of flexibility in the approach to be adopted according to the nature, scale and complexity of their business and the nature and range of investment services and activities undertaken in the course of that business”
CESR says that procedures should:
“(1) identify relevant payments and benefits or types of payments and benefits occurring in relation to the provision of an investment or ancillary service to the client for the purposes of the MiFID inducements rules (identification). Once relevant payments and benefits or types of payments and benefits have been identified, a firm should be able to (2) classify them under Article 26 of the Level 2 Directive (classification). For a payment or non-monetary benefit flowing between a firm and a third party (Article 26(b) of the Level 2 Directive) the firm should (3) assess how the payment or benefit fulfils the conditions for the MiFID inducements rules to be admissible (evaluation).”
CESR also says that procedures should prevent any payment or benefit from taking place if it does not meet the requirements of Article 26 of the Level 2 Directive, and the compliance function should be involved in these procedures to ensure that payments and benefits the firm provides or receives adhere to the rules.
CESR helpfully confirms that recurring payments once assessed may only need to be reviewed periodically to ensure that they continue to comply with the rules. Any new relationship originating payments or non-monetary benefits should be subject to an appropriate assessment of payments and benefits under the rules, and procedures should ensure that this happens.
CESR is of the view that the senior management of the firm should approve the general approach that the firm is going to undertake with respect to inducements. The compliance function of the investment firm should also assess on an ongoing basis the adequacy and effectiveness of the measures and procedures, with the support of the senior management of the firm to enable it to challenge decisions made by the business. The compliance function should consider inducements in its compliance reports to senior management.
3. Permitted payment- “Proper fees”
A category of permitted payment under the inducements regime is so called “proper fees”. Prior to implementation of MiFID there was some industry debate as to what types of fees were caught by this category, with some parties taking a wider view of its interpretation than others. For example it was discussed whether underwriting fees in a debt/equity capital markets context fell within this category, although this was subsequently for the most part decided against. CESR has taken a narrow interpretation of the category, and has now clarified that the following kinds of fees are “proper fees” within the exception,
- fees paid by an investment firm in order to access and operate on a given execution venue (under the general category of settlement and exchange fees);
- specific types of custody-related fees in connection with certain corporate events can be eligible for the proper fees regime.
4. Payments “designed to enhance the quality of the relevant service to the client and not impair compliance with the firm's duty to act in the best interests of the client”
MiFID provides an exception to the inducements rules for payments/benefits that are “designed to enhance the quality of the relevant service to the client and not impair compliance with the firm's duty to act in the best interests of the client”.
In summary, CESR's view is that:
- product distribution and order handling services are two highly important instances where payments and non-monetary benefits provided or received can give rise to very significant potential conflicts;
- where a payment covers costs that would otherwise have to be charged to the client, this is not sufficient for a payment to be judged to be designed to enhance the quality of the service;
- measures such as an effective compliance function should be backed up with appropriate monitoring and controls to deal with the specific conflicts that payments and non-monetary benefits provided or received by an investment firm can give rise to.
5. Content of summary disclosures
CESR provides some clear and helpful guidance concerning the content of summary disclosures. Given the relative lack of guidance prior to implementation of MiFID on this subject, firms would be advised to revisit their summary disclosures to perform a benchmarking exercise against this new guidance.
5.1 “Essential terms”
MiFID permits a firm to disclose the “essential” terms of the arrangements relating to third party payments and non-monetary benefits in summary form. CESR clarifies that in relation to each service provided to the client, “the client should be provided with sufficient details in order to understand readily how the firm is incentivised to act in a specific manner. For example, if an investment firm receives different levels of rebates for distributing UCITS investing in bonds and UCITS investing in shares or in-house (including in-group) products in comparison with third party products, this should be stated.”
5.2 Level of inducement payments received
CESR says that in order for summary information to be clear and comprehensive, the information should include a reasonable band of payments, so that the client will be ware of the level of inducements. Also, if the exact amount varies depending on the class of instrument, then the information should be given per service and per class. If the level of payments received depend on the provider (e.g. third party or in-house), the information should set out material differences.
5.3 Good and poor practices
CESR is clearly in favour of detailed disclosure, even in summary information. It lists as examples of “poor practice” summary disclosures that are generic in nature. For example, the following is too generic in CESR’s view:
“An investment firm which provides and receives third party payments and non-monetary benefits discloses to a client prior to the provision of a service that it may provide to or receive from third parties fees, commissions or non-monetary benefits (the firm provides no other disclosure under the MiFID inducements rules prior to the provision of the service).”
In a firm’s general terms of business covering all investment services and activities provided by the firm and sent out to all clients, CESR says that the following is an example of a “good” summary disclosure:
“it makes payments to third parties that help to start, conclude or maintain a business relationship between the firm and clients (introducing fees). It specifies that these payments are one-off payments, representing a maximum of 1.25% of the assets brought to the firm for portfolio management, and that on-going payments of a maximum of 0.30% of the assets under portfolio management can also be made;
that it receives third party payments from CIS providers and that these payments consist of rebates of the management fees due to the relevant CIS. To indicate the size of these payments (including variations depending on the CIS provider or CIS family where relevant and material), a reasonable band range is provided.”
5.4 Use of bands
CESR makes a number of detailed comments concerning the use of bands to present information on levels of payments where the exact amount cannot be ascertained in advance. The general message is that firms must present the information in a clear, easy to understand way, and must not be misleading. For example, CESR says:
“firms should not give their clients a false impression by using maximum levels where in fact the minimum level of third party payment is not 0. For example, if the firm says that it receives third party payments of a maximum 50% of the management fee due to the provider of a CIS and in practice it receives between 20% to 50%, CESR believes that it is a poor practice for the firm to make such a disclosure and it should instead say that it receives from 20% to 50% of the management fee due to the CIS provider”
6. Form of disclosure
MiFID does not provide how firms should make disclosure of third party payments and non-monetary benefits to their clients. CESR provides the following guidance in this respect:
“There is no one-size-fits-all approach regarding disclosures and CESR believes that when choosing the documentation through which disclosures are made, investment firms should take into account elements such as the type(s) of service(s) provided to their clients or the way they provide services to clients. For example: investment firms distributing a large number of financial instruments could decide to adopt a "two step approach" regarding disclosures: a summary disclosure to be provided to all clients in the initial client information pack, the general terms and conditions or the contract concluded with the client, and detailed disclosure to be provided to the client at the point of sale, through the product fact sheet given to the client before any transaction”.
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