27 October 2016

Ban paying - or feeding - the Piper: the MiFID II Inducements Regime

Regulators have grasped the force of the proverb that “He who pays the piper calls the tune”. The MiFID II rules on inducements are the latest in the long running series of regulatory attempts to ensure that it is only the firm’s client who can call the tune played - or service provided - by an investment firm. They impose a new prohibition on investment managers and investment advisers accepting and retaining third party payments or benefits, new rules on investment research and tighter conditions and disclosure rules for all types of investment firm.

The FCA in its third MiFID II Consultation Paper CP16/29 proposes to combine these stricter new rules with its RDR regime, to impose more onerous requirements than are necessary under MiFID II where retail clients are involved, and to extend some provisions to catch collective portfolio managers such as AIFMs and UCITS managers.

Ban for portfolio managers and independent advisers

From implementation of MiFID II on 3 January 2018, any MiFID portfolio management firm, or independent advisory firm, will not be allowed to accept and retain any payment or benefit from a third party in relation to the provision of those services, apart from “minor non-monetary benefits” that: (i) are capable of enhancing the quality of the service provided; (ii) do not impair compliance with the firm’s duty to act in the best interests of the client; and (iii) are clearly disclosed.

This ban is effectively on retention of the third party payment or benefit, not its mere receipt. Third party payments can be received by portfolio managers and independent advisers but must be transferred in full to the relevant client as soon as reasonably possible after receipt. This in turn means firms will have to establish new policies and records to ensure proper allocation and transfer of monetary benefits to each client. 

However, the near-final Level 2 measures go on to ban even the receipt of any non-monetary benefits other than those classified as “minor”.

The FCA fully supports the new ban. Moreover, in relation to business with retail clients it plans to go further. Where retail clients are involved the FCA intends to extend the ban to all investment advice, whether or not it is held out as independent. It also intends to forbid even the receipt of any third party payments (i.e. continue to require payment only by adviser charges and not allow receipt coupled with rebates to retail clients) by independent advisers, and to extend that ban to discretionary managers.

Generally the FCA will only apply the new rules to MiFID business, pending implementation of the Insurance Distribution Directive for other products. However, it also plans to tighten up its RDR adviser charging rules for all retail investment products by providing that these apply to the wider business of providing investment advice generally, not just to particular personal recommendations, and that only minor non-monetary benefits can be paid and accepted in relation to advice to retail clients on retail investment products. 

Obligations of other investment firms

All MiFID firms, not just managers and advisers, will be regarded as in breach of the client’s best interests and conflicts rules if they pay, provide or receive any fee, commission or non-monetary benefit in connection with the provision of an investment or ancillary service to or from anyone but the client or its representative, unless it:

  • is designed to enhance the quality of the relevant service provided to the client; and
  • does not impair compliance with the firm’s duty to act honestly, fairly and professionally in the best interests of its clients (client’s best interests rule).

Detailed disclosure obligations apply where any third party payment or benefit is paid, provided or received.

The basic rule on inducements is therefore substantially the same as the current rules. However, the Level 2 measures interpret it more strictly, and impose more procedural requirements, than many firms currently apply to third party payments and benefits. For instance, any firm providing execution services will be required to identify separately its charges for: (i) executing transactions; and (ii) all other services and benefits it provides (e.g. research), with the supply of and charges for the latter not being influenced or conditioned by the level of payment for execution services. 

What are minor non-monetary benefits?

The only types of non-monetary benefit which are listed in the Level 2 measures as being sufficiently “minor” to be allowable for independent advisers and managers, and generally subject only to generic disclosure are, in summary:

  • information or documentation about a financial instrument or investment service (including some short term market commentary, not involving substantive analysis);
  • written material paid for by the issuer promoting a corporate issue or issues, provided the relationship with the issuer is clearly disclosed in the material and it is made available at the same time to all interested investment firms or the general public;
  • conferences and training on specific financial instruments or investment services; and
  • reasonable de minimis hospitality, such as refreshments at such a conference or training course.

There is an overarching requirement that all such benefits, even when on this permitted list, must be reasonable and proportionate and of such a scale that they are unlikely to influence the investment firm in a way detrimental to its client. 

Member States are permitted to identify other types of permissible non-monetary benefit (subject to this overarching requirement and to the need for benefits to be both capable of enhancing the quality of service and unlikely to impair compliance with the client’s best interests rule). However, the FCA did not do so in CP16/29. 

What is capable of enhancing the quality of service to the client?

It has always been difficult to establish what amounts to quality enhancement sufficient to justify inducements. A little light is shed by the Level 2 measures, which now say that all of the following conditions must be met before an inducement is regarded as designed to enhance the quality of the relevant service:

  • justification by provision of an additional or higher level of service to the relevant client, proportional to the level of inducement;
  • no direct benefit to the firm, its shareholders or employees without tangible benefit to the relevant client; and
  • provision of an ongoing benefit to the relevant client if there is an on-going inducement.

There is also an overriding requirement that the provision of the relevant services to the client is not biased or distorted by reason of the inducement. The Level 2 stress on the relevant client is noteworthy, as is the ongoing nature of the test if the firm continues to receive a third party payment or benefit. The Level 2 measures also include non-exhaustive examples of services that are considered “additional” or “higher level”. 

A firm’s judgment on why it considers a particular payment or benefit is permissible will be much easier for regulators to test in future because MiFID II lays down new obligations for firms to keep evidence that whatever is paid, provided or received does enhance the quality of service to clients and the steps it has taken in order not to impair compliance with the client’s best interests rule. 

Fulfilling these obligations will require firms to review, and extend, their policies, systems and controls. It is also worth noting that the FCA regards the MiFID II rules as supporting its current position on banning practices such as payment for order flow (PFOF) and plans to take the opportunity to include in its rules a link to its PFOF guidance.

What are the changes to disclosure obligations?

Generally MiFID II ramps up disclosure obligations and this is certainly the case for inducements. MiFID I requires disclosure, in advance of providing the service, of the existence, nature and amount of the third party payment or benefit, or of the method of calculation where the amount cannot be ascertained. MiFID II adds the following obligations:

  • to disclose methods of payment including third party payments;
  • to disclose mechanisms for transferring monetary or non-monetary benefits received by the firm;
  • where the amount cannot be determined in advance and only the method of calculating is disclosed in advance, the firm must subsequently disclose the exact amount;
  • if inducements are ongoing, the firm must report at least annually to clients on an individual basis on the actual amount received or paid; and
  • independent advisers and portfolio managers must report on the payments received and transferred to clients.

How can investment research be given and received?

MiFID II has completely new provisions on investment research which apply to all investment firms, though they are particularly important for managers and independent advisers since they cannot receive third party research at all unless they comply with these provisions (apart from the very limited types of “non-substantive" commentary on financial instruments and services which are regarded as minor non-monetary benefits). Other firms can follow either these special rules for investment research or the general rules on inducements outlined above.

In summary, research provided to an investment firm will not be regarded as an inducement at all if it is either directly paid for by the firm out of its own resources or if it is received in return for payments from a special "research payment account" which is funded by charges to clients, not by third parties. This is a major shift from the previous treatment of investment research and soft commission. The MiFID II inducements provisions will replace the FCA's previous rules on the use of dealing commission.

Research payment accounts must be funded by a specific research charge made to and agreed with the client, in accordance with a research budget set by the firm. The Level 2 measures contain detailed provisions on setting these budgets and charges (which must be by reference to research needs, not the volume/value of transactions executed), the way in which they are charged and disclosed to the client and the ongoing operation of the accounts. Research charges must be separately identified from transaction commission, any excess charges must be rebated to the relevant clients and the research payment account cannot be used for internal research.

The complexity of the research payment account provisions have led to considerable doubt over how many, if any, industry participants will think it worthwhile to operate such accounts.

Operating a research payment account, if a firm decides to undertake this substantial new procedure, will require new policies, systems and controls, as well as additional disclosures, including:

  • regular assessment of the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions; 
  • detailed policies (which are provided to clients) for assessing quality and the benefit to client portfolios and for the fair allocation of costs to clients;
  • appropriate controls and senior management oversight of assessment of the need for third party research and the allocation of the budget to ensure that it is managed and used in the best interests of clients, with a clear audit trail of payments made to research providers and how these were determined with reference to the quality criteria; and
  • reporting to clients both in advance and on at least an annual basis.

What is the impact on AIFMs and UCITS managers?

The FCA proposes to extend a number of the MiFID II inducements rules, notably those on payment for research, to collective portfolio managers executing orders for funds they manage. The extension of MiFID II obligations to non-MiFID firms is in fact a theme of CP16/29 in many areas, not just inducements.

Please do get in touch with a member of the Financial Regulation team to discuss how we can assist you with MiFID II implementation.

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