The Financial Conduct Authority (the FCA) has now published Policy Statement PS17/14 on the implementation in the UK of MiFID II, together with the final rules that will take effect from 3 January 2018. We now have final clarity on what managers will need to do to comply with the new rules.
The EU Regulatory Regime
MiFID II (which is merely an update of MiFID I and does not extend the scope of regulation in the management sector) regulates various investment services and activities. For the purposes of the investment management sector, these include:
- portfolio management
- receipt and transmission of orders
- investment advice
Article 2(1)(i) of MiFID II specifically exempts funds and fund managers (AIFMs) from the scope of MiFID II, but only when acting as such – it is not a blanket exemption. The FCA has, in a few cases, decided to apply the MiFID II rules to AIFMs’ activities to ensure a level playing field across the management sector.
The main rule changes for managers are noted below.
The rules on inducements applicable to MiFID portfolio managers have been tightened. The previous rules allowed firms to pay and receive inducements largely subject only to disclosure and a general requirement that the payments improved the quality of the service to the client. This will now be replaced by a requirement that firms must be more rigorous in establishing benefit for clients (COBS 2.3A.8) and that only “minor non-monetary benefits” will be acceptable (COBS 2.3A.15) when dealing with retail clients or providing portfolio management services to professional clients. This list of acceptable inducements is very short and includes only limited hospitality and participation at conferences. In particular, portfolio managers will not be able to receive investment research other than when they pay for it themselves or their clients pay from a specific research payment account.
AIFMs will be subject to a similar but slightly lighter regime in COBS 18.
Local authorities will no longer automatically be professional clients, although they will be eligible for categorisation as elective professional clients subject to a modified upgrade process set out in COBS 3.5.3A and 3.5.3B. To be upgraded to professional client status, a local authority must have a portfolio of at least £10 million and at least one of the following must apply:
- it has carried out least 10 similar transactions per quarter for the previous four quarters;
- the person acting on behalf of the authority has worked in the financial sector for at least one year; or
- the authority is an “administering authority of the Local Government Pension Scheme within The Local Government Pension Scheme Regulations 2013.
This is important because many managers are unable to act for retail clients under their FCA permission and must either upgrade local authorities to professional client status or extend their FCA permission to allow them to deal with retail clients. In relation to AIFMs, there is nothing they need to do, since they do not provide any investment service to fund investors; the AIFM’s sole client is the fund itself. It will matter, however, in relation to any future marketing. The Alternative Investment Fund Managers Directive (AIFMD) grants a passport to market only to professional investors (which copies the MiFID II definition, including upgraded professional clients). Marketing may be made to retail investors only at national discretion. The upgrade criteria in other member states may differ from the above.
Managers will be required to “take all sufficient steps” to obtain the best possible result for clients when carrying out decisions to deal on their behalf in investments. Although the FCA notes that this is an enhancement over the existing requirement to “take all reasonable steps,” it is difficult to see how this has any consequences in practice. There are, however, some minor changes for portfolio managers:
- When executing orders in OTC products, the firm must check the fairness of the price proposed to the client by gathering market data used in the estimation of the price of such product and, where possible, by comparing with similar or comparable products (COBS 11.2A.8). Portfolio managers will not be able to rely on the fact that their broker is an EU broker that is itself obliged to ensure best execution.
- Managers must also summarise and make public on an annual basis for each class of financial instruments the top five investment firms in terms of trading volumes where it has placed client orders for execution in the preceding year. This information needs to be set out in a standard format.
- Each firm’s execution policy needs to set out more detail than under the current rules. In particular, it must set out the factors affecting the choice of different execution venues (COBS 11.2A.30) and set out an account of the relative importance the investment firm assigns to the relevant execution criteria (COBS 11.2A.36). There is guidance on these relevant factors in COBS 11.2A.38.
The FCA had considered extending these new MiFID II best execution requirements to AIFMs and but has chosen, for the time being and subject to further consultation, not to do so. This means that fund managers will continue to be subject to the best execution requirements set out in the AIFMD and the Level 2 Regulation.
The frequency with which portfolio managers must provide clients with statements will be increased from every six months to every four months. The report must include valuations, a review of activities and performance during the relevant period. Any depreciation in the value of the portfolio that exceeds 10% must be notified to the client within one working day (COBS 16A.4.1). This will not be materially different from the client reporting that managers undertake, although there will be small modifications.
These rule changes do not affect AIFMs.
There are no material changes to the suitability rules that apply to portfolio managers, although there are a couple of minor amendments that should be incorporated within their suitability policy:
- COBS 9A.2.1 now specifically mandates firms to obtain necessary information about both the client’s ability to bear losses and the client’s risk tolerance in making suitability assessments. Although this was implicit in the previous rules, it is now explicit, and firms’ suitability questionnaires should be updated to reflect this.
- COBS 9A.2.15 now requires firms to have a policy regarding the subject of a suitability assessment where the client is (as it will normally be) a legal person. Although the FCA does not give any guidance on this, we would normally expect the relevant person to be the individual who gives the instructions.
Portfolio managers will be required under COBS 11.5A.4 to record more granular details in relation to investment transactions. AIFMs are already required to record this information under the AIFMD regulation and are therefore not subject to this new rule.
The MiFID Product Governance Rules (PROD) apply to firms that manufacture and/or distribute investments; although they do not apply directly to AIFMs, PROD 1.3.2 states that other firms which manufacture financial instruments should take account of the rules as though they were guidance on the FCA Principles for Businesses. They will not apply to portfolio managers who simply manage a segregated account since this is not a manufactured investment.
AIFMs will need to consider their scope in creating new AIFs, though. PROD 3.1.2 provides that a firm is entitled to comply with the rules (or guidance) in a way that is proportionate, bearing in mind the target market for the relevant fund. Given the nature of the investors in private funds, therefore, the application of PROD will be light, but AIFMs should ensure they document the new fund creation process in accordance with the new rules.
Under the directive, any firm that is carrying on MiFID business is obliged to record telephone conversations and electronic communications that are intended to result in any investment transaction. This means that, in relation to the MiFID advisory or portfolio management business, all communications with third-party banks and brokers and with clients must be recorded where they relate to investments. MiFID managers may find it easier to record all conversations rather than trying to distinguish between conversations that relate to investments and those which do not.
The FCA has chosen to extend this obligation to record conversations to include AIFMs. In this case, however, there is only an obligation to record conversations where the subject matter of the conversation is listed or traded on a trading venue (a regulated market, multilateral trading facility or an organised trading facility). This will assist AIFMs who manage most types of private funds, although they will need to be careful to ensure that they are able to capture conversations concerning both listed shares and any hedging derivative contract that is on-exchange. The FCA very deliberately repealed the previous exemption that allowed managers not to record such conversations where they were recorded by the other party to the conversation.
Recordings need to be kept for a minimum of five years. Firms are required to inform clients and counterparties that the calls are being recorded.
Under the current rules, portfolio managers and AIFMs are obliged to report transactions in financial instruments admitted to trading on a regulated market unless they are able to rely on a third party (such as the executing broker) to report on their behalf.
MiFID II extends the transaction reporting requirements, not only in relation to the widened scope of financial instruments now covered by the directive, but also in relation to the amount of information that needs to be provided to the FCA in relation to each trade. The exemption referred to above has been repealed; portfolio managers may still employ brokers to report transactions, but they will remain responsible for complying with their own regulatory responsibilities.
The FCA has specifically chosen not to extend these reporting requirements to AIFMs. Since brokers will, however, need to report the transactions to the FCA, they will need the AIFM to provide it with much of the information that it would otherwise have needed to report to the FCA.