MiFID II Series #16 - The time for talking is almost over: FCA publishes MiFID II papers (PS17/14 and CP 17/19)

On 3 July 2017, the FCA published its second Policy Statement (PS 17/14) (second PS) on the implementation of MiFID II, alongside a sixth Consultation Paper (17/19) dealing with a number of residual issues. In a move which will generally be welcomed by industry and as a result of feedback to its consultations, the FCA has made significant policy changes to some of its proposals pertaining to inducements in relation to research, client categorisation, best execution and taping. In general, the changes are to the industry's advantage. But to say that MiFID II implementation is now a done deal, would be a step too far. Some uncertainty remains where European guidance is to be relied upon such as on the definition of multilateral system. But otherwise, this publication should be generally welcomed.

The second PS follows the publication of the FCA's first Policy Statement (PS 17/5) issued in March 2017 (which we covered in our newsflash "The FCA publishes first MiFID II policy statement and fifth consultation paper"). It summarises feedback received to its proposals set out in CP15/43, CP16/19, CP16/29, CP 16/43 and CP17/08 (which we covered in #7, #10 and #11 of our briefings series). The near final rules that the FCA published in the PS 17/5 have also been finalised in the second PS.

Scope – beyond MiFID II requirements

The FCA has clearly outlined some broad categories where it has gone further by applying the MiFID II standards to non-MiFID businesses. These include:

• Inducements in relation to research. The FCA will apply the MiFID II research and inducement rules to non-MiFID discretionary investment management business, it considers similar issues arise in relation to the consumption of research to discretionary investment managers, whether or not they or their business is covered by MiFID II.
• Client categorisation. The same criteria establishing the scope of clients who can be classified as eligible counterparties and the same client categorisation of local authorities will apply to both MiFID and non-MiFID designated investment business.
• Disclosure requirements. Aspects of the MiFID II rules on communicating with clients will apply to non-MiFID designated investment business where these can be inferred from the existing provisions and do not impose an additional burden.
• Independence. The FCA will adopt the MiFID II independence standard for personal recommendations to retail clients in relation to MiFID financial instruments or non-MiFID retail investment products (such as insurance-based investments and personal pensions).
• Best execution. MiFID II best execution standards will apply to UCITS firms and, with the exception of the reporting obligation in RTS 28, to Article 3 firms. However, the FCA has moved back from requiring AIFMs to comply with such.
• Investment research. MiFID II provisions on the production and dissemination of investment research will apply to certain types of non-MiFID firms.
• Product governance. The FCA will apply the MiFID II rules on product governance "as guidance" to firms undertaking non-MiFID designated investment business.

Research and inducements

Third country firms

The scope of COBS 2.3C, i.e. the requirement placed on brokers to price execution and research services separately, does not apply where the broker is facing third country firms. The FCA will, however, proceed with its approach that separate pricing should be provided to all MiFID investment firms, regardless of the activity that the MiFID firm is carrying out.

RPAs

The FCA has changed its position on the length of time that funds should be transferred into a research payment accounts (RPAs). Previously, the FCA proposed a "sweep period" of two days. In this second PS, the FCA confirms that the transfer to an RPA should be carried out "without undue delay, but in any case, within 30 calendar days from a transaction taking place." Where firms have agreements in place with research providers prior to receiving substantive services, the FCA states that these should allow for services and payment levels to be reviewed on a regular basis (e.g. in-year) to ensure that research procured remains in the best interests of the clients. This is a more practical approach taken by the regulator.

Minor non-monetary benefits extend

Connected research written by a bank analyst on an issuer in the context of primary market capital raising should be acceptable as a minor non-monetary benefit where it is clearly circulated to inform potential investors about the specific issuance prior to a deal being completed. The FCA considers this as comparable to issuer-commissioned research coverage (which is already permitted in the MiFID delegated directive). The FCA has, therefore, created an additional "minor non-monetary benefit" provision in COBS 2.3A.19R which indicates that "connected" research can be provided and accepted without being considered as material research that would not be receivable by firms subject to the enhanced inducements regime, or be required to be paid for separately. This limited exemption does not extend to any on-going provision of research outside a specific capital-raising context.

A second extension to the list of minor non-monetary benefits relates to trial periods. Helpfully, the FCA is clear that free trial periods can be provided (for a period of three months) subject to conditions. These are that the firm: (i) should not be required to provide any monetary or non-monetary consideration to the research provider for research received during the trial; and (ii) 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.

The investment 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 it 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. On the other hand, investment firms providing free research trials are also advised to consider their own inducement obligations and where a firm is subject to COBS 2.3.C, it should ensure that the supply of a free trial is not influenced or conditioned by levels of payment for execution services.

Adviser charging

The proposal to ban firms that provide independent or restricted advice or portfolio management services to retail clients from accepting and rebating monetary benefits to such clients will be implemented. These rules will only apply where the retail client is in the UK. 

Firms will not be required to comply with the adviser charging rules for advice on structured deposits, although the MiFID II inducement rules will apply to firms when selling, or advising on, a structured deposit. However, the FCA goes on to state that firms are free to go further than FCA rules in order to have a single process for selling investments if they wish, and treat structured deposits as if they were within the scope of the adviser charging rules.

Execution related services clarification

In relation to acceptable non-monetary benefits, post trade delegated reported services could be considered as part of the overall execution service provided, rather than be treated as a separate benefit.

Trade analytics tools, RPA administration service, would, however, not be considered as linked to an execution service.

Large orders, taking trades on risk or structuring services however can be viewed as inherent to the provision of execution services and received by the underlying client in return for execution costs and charges. The FCA notes that this would not cover order transmission systems used by a broker.

Physical separation

The requirement for firms to maintain physical separation between analysts and other persons, as well as the provision stating that analysts should not participate in investment banking activities, apply only to producers of independent investment research. Producers of non-independent research are, however, reminded to consider their general conflicts of interest obligations under SYSC 10.

Product governance

The product governance sourcebook (PROD) will apply to firms providing portfolio management. The FCA noted that ESMA has produced guidance on target market assessment and so it will not be providing additional guidance on target market assessment in PROD 3.2.12G.

In relation to information sharing, the FCA emphasises that firms should take a proportionate and appropriate approach to meeting requirements. We view this as a clear prompt from the FCA that this could be used to firms' advantage in non-complex situations.

Taping

Importantly, the FCA will not extend the taping regime in MiFID II to capture all aspects of corporate finance business, but communications occurring during corporate finance business would be in the scope of the taping requirement insofar as they are automatically captured by MiFID II (i.e. that they relate to order execution type services). The FCA also sets out its views in relation to what may or may not be recorded in respect of corporate finance related business, as well as the type of phone calls that need to be recorded in respect of portfolio management.

Client categorisation

The FCA provides clarification for firms in relation to its rules on "opting up" local authority clients from retail status to professional status where the local authority has satisfied a set of qualitative and quantitative criteria. The qualitative test, which is unchanged from MiFID I, requires firms to undertake an adequate assessment of the expertise, experience and knowledge of the client regarding the types of investment or service being offered and the risks involved. The requirement in COBS 3.5.4 for the qualitative test is to be applied to the person authorised to carry out transactions on behalf of the legal entity can apply to a single person or a group of persons within the local authority. Persons within a local authority investing on behalf of pension funds are often elected officials acting as part of a pensions committee and states that, where this is the case, firms may take a collective view of the expertise, experience and knowledge of committee members, taking into account any assistance from local authority officers and external advisers of a local authority (where this contributes to the expertise, experience and knowledge of those making the decisions).

The quantitative test has been adjusted; previously it was proposed that the client must satisfy the requirement of having a portfolio of a certain size and satisfy one of the two criteria relating to: the number of transactions carried out by the client in a year; and the length of experience in the financial sector (one year). The FCA has now:

• added a fourth criterion that the local authority is using investment services as part of administration of a pension fund within the local government pension scheme;
• reduced the mandatory portfolio size requirement from £15 million to £10 million (and confirmed that the local authority's own assets and its pension scheme cannot be combined for this purpose); and
• amended the proposed drafting in COBS 3.5.3BR(b)(ii) to note that "the person authorised to carry out transactions on behalf of the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the provision of services envisaged" (financial sector is not interpreted by the FCA in a limited way and so a firm can decide that a that a professional treasury manager has worked in the financial sector for at least one year).

Despite feedback, the FCA will not introduce its own definition of local public authority or municipality, as this is not defined in MiFID II.

Disclosure requirement

Broadly speaking, the FCA will not provide standardised formats in relation to point of sale or point of sale disclosures (including costs and charges disclosures – at least at the current time).

PERG

In CP15/43, the FCA outlined proposals in relation to updating Chapter 13 of its perimeter guidance manual (PERG) to take account of MiFID related scope changes in a number of areas including the new service of operating an organised trading facility and the associated definition of "multilateral system". Since then ESMA has issued guidance in the form of Q&As on market structures which address the definition of multilateral and bilateral systems, and as such, the FCA considers it is best to rely on the ESMA Q&As in order to achieve a convergent approach. The FCA may, however, issue perimeter guidance on the on the definition of "multilateral system" in the future.

The FCA retains the view that any system that merely receives, pools, aggregates and broadcasts indications of interest, bids and offers or prices should not be considered a multilateral system, although this may amount to activity under Article 25(2) of the Regulated Activities Order.

Client assets

The FCA is proceeding with its proposal to prohibit title transfer collateral arrangements (TTCAs) with retail clients and require firms to consider the appropriateness of TTCAs for non-retail clients. It also provides its views on inappropriate use of TTCAs with non-retail clients.

Points raised by the FCA in relation to custody and client money liens include:

• the final drafting of the rules is not intended to disrupt the use of omnibus accounts in custody chains;
• the FCA agrees that the MiFID II rules on client money liens are already implemented in the CASS 7 acknowledgement letter rules and has deleted the client money lien rules on which it consulted; and
• firms are expected 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.

Appropriateness

No substantive changes have been made to the draft rules consulted on in CP16/29. It is worth noting though that the distributor and the product provider should be responsible for ensuring compliance with the relevant rules (whether a product is complex or not). PROD 3.3.1R states that the distributor must understand the financial instrument it distributes to clients and assess the compatibility of the financial instruments with the needs of the clients to whom it distributes investment services, taking into account the manufacturer’s identified target market of end clients.

Dealing and managing - best execution

As proposed, MiFID II best execution provisions will be extended to UCITS management companies. UCITS management companies must provide information in their execution policies to explain any differences in fees applied to different execution venues such that the advantages and disadvantages of a particular choice of venue are clear. Annual reporting requirements in line with RTS 28 under Article 65(6) of the MiFID II delegated regulation and Article 27(6) will also apply (as a result of COBS 11.2B.36R) where the firm itself performs portfolio management activities.

The FCA has decided not to apply the MIFID II RTS 28 reports and other aspects of the enhancements of the best execution rules to full-scope UK AIFMs and incoming EEA branches, at this present time. Therefore, full-scope UK AIFMs and incoming EEA AIFM branches will remain subject to the existing best execution standards as set out in the AIFMD delegated regulations and supplemented by the existing COBS 18.5.4AR (which will be moved to COBS 18.5A.8R).

FCA Consultation Paper CP 17/9

This consultation contains proposed amendments to FCA Handbook that were not previously consulted on including:

• bringing recognised investment exchanges operating multilateral trading facilities and organised trading facilities into the scope of the Financial Services Compensation Scheme;
• proposed amendments to the Decision Procedure and Penalties Manual and Enforcement Guide as result of changes introduced by legislation implementing MiFID II; and
• technical changes to the Prospectus Rules and Handbook glossary arising out of legislative changes implementing MiFID.