EU Retail Investment Directive and Regulation

Elective professional opt-up

The only significant proposed liberalising measure is modifications to the qualitative and quantitative criteria required to effect an elective professional opt-up. These are set out in a separate Annex to the directive.

The changes are less ambitious than many trade associations (and Travers Smith) have previously called for. In relation to the current two out of three quantitative requirements:

• there is a reduction of the wealth criterion from EUR 500 000 to EUR 250 000, but this is now to be measured on average over the preceding three years;
• the criterion of having worked in the financial sector for at least one year is broadened to include people who have "undertaken capital market activities requiring to buy and sell financial instruments and/or to manage a portfolio of financial instruments";
• a fourth criterion is introduced where "the client can provide the firm with proof of a recognised education or training that evidences his/her understanding of the relevant transactions or services envisaged and his/her ability to evaluate adequately the risks".

These changes may not make it much easier to opt-up captains of industry, still less lawyers, doctors and businesspeople who compose the mass affluent and high net worth investor base targeted by private capital retailisation strategies.

New size and experience tests are introduced for legal entities which might be opted-up. They must meet two out of three requirements: EUR 10m balance sheet, EUR 20m net turnover, and EUR 1m own funds, and the natural person responsible for the transaction must understand the relevant transaction or services, be capable of making the relevant investment decisions and be able to evaluate the risks.

Enhanced product governance rules

The product governance provisions are strengthened with requirements on manufacturers for a clear identification of the target market's objectives and needs and assessment of the design of the financial instrument added to the product approval process. In addition, the target market assessment undertaken by PRIIPs manufacturers will need to include identification and quantification of all costs and charges and an assessment of whether these are justified and proportionate having regard to the product's characteristics, objectives and strategy.  

This assessment must include a comparison with the relevant benchmarks, where available, on costs and performance published by ESMA. A manufacturer should not approve products that deviate from the relevant benchmark, unless the manufacturer is able to establish through further testing and assessment that the costs and charges are justified and proportionate.

Distributors will also be subject to additional requirements including an obligation to perform their own costs and charges assessment against relevant cost and performance benchmarks. A product must not be offered to a retail client if its costs (together with the costs of the distributor's services) deviates from the relevant ESMA benchmark unless the distributor performs additional testing and assessment to confirm that the costs and charges are justified and proportionate.

Additional reporting requirements will also apply to PRIIPs manufacturers and distributors.

Inducements

The existing ban on fees, commissions and non-monetary benefits to or from MiFID portfolio managers will be extended to MiFID investment firms providing the services of execution-only dealing or reception and transmission of orders to retail clients where the payment is to or from any third-party responsible for the creation, development, issuance or design of the relevant financial instrument (or a person acting on its behalf). This is principally aimed at inducements from manufacturers to distributors.

Such inducements will remain permitted in a non-independent advisory setting. This appears to be a compromise designed to placate certain EU Member States.

There would also be a new exemption for fees or remuneration paid by an issuer for placement and underwriting services provided by the MiFID investment firm which is also providing execution-only or reception and transmission services to a retail client in respect of non-PRIIPs financial instruments subject to the placing or underwriting services.

There is also a new general exemption from the prohibitions on inducements for minor non-monetary benefits of a total value below EUR 100 per year or of a scale and nature such as not to impair compliance with the MiFID investment firm's duty to act in the best interest of the client.  In order to rely on this exemption the minor non-monetary benefits would need to be clearly disclosed to the client. This introduces a new financial threshold for minor non-monetary benefits and removes the concept of "quality enhancement".

Similarly, the overarching conditions for the receipt or payment of any non-prohibited fees or benefits have also been amended with the removal of the "quality enhancement" criterion.

Investment advice and suitability and appropriateness

In order to demonstrate that a MiFID investment firm is acting in the best interests of its client, when it provides advice to retail clients it must in future recommend the "most cost-efficient" financial instruments which are suitable. This is a significant change. It appears to be applicable both to independent and non-independent advisors.

There are also some amendments to the process around suitability and appropriateness assessments for portfolio management and investment advice, including additional information to be obtained such as the composition of existing portfolios and the need for portfolio diversification.  MiFID investment firms providing other services will need to obtain information from retail clients on the ability to bear losses and risk tolerance.

Certain provisions are eased for a new category of "well-diversified, non-complex and cost-efficient financial instruments". It will, for example, no longer be necessary to obtain information on the client's knowledge and experience about the financial instrument or on the client's existing portfolio composition when recommending them.  This concept may become important in future.

Marketing communications

A new concept of "marketing communication" is introduced into MiFID including (broadly) any disclosure of information other than those required by law or which are financial education materials or investment research that directly or indirectly promote or entice investment in financial instruments or the use of investment or ancillary services made by the investment firm or a third party on its behalf. 

This is not confined to communications between a firm and its MiFID client.  In this respect, it may be as broad as the UK financial promotion restriction. It could therefore be applicable in a range of unexpected circumstances, such as communications between MiFID investment firms and non-client placees in a corporate finance context, or communications from MiFID investment firms to members of management teams about securities in portfolio companies, in the context of private equity transactions.

The proposals also include enhanced requirements for marketing communications including ensuring that they:

• clearly identify the MiFID investment firm responsible for their content and distribution;
• are balanced in presentation of risks and benefits; and
• set out the essential characteristics of the financial instrument or service so that retail clients can easily understand the key features of the product as well as the main risks associated with it.

In addition, the proposed changes set out the respective responsibilities of manufacturers and distributors.

MiFID investment firms must also have a policy on marketing communications, approved and overseen by the management body and effective organisational arrangements with a view to taking all reasonable steps to ensure marketing communications and practices comply with the relevant requirements. Reporting and record keeping requirements will also apply.

Marketing communications and other information materials will be required to display appropriate risk warnings concerning "particularly risky financial instruments".   ESMA is to develop guidelines on the concept of "particularly risky financial instruments" and technical standards specifying the content and format of the risk warnings.

Costs and charges

There will be new, enhanced requirements for MiFID investment firms in terms of disclosures on costs and charges.    

These include a requirement to disclose information on costs, associated charges and third-party payments prior to the provision of any investment services or the conclusion of a transaction.  The information to be disclosed will also be more detailed than previously.  

These requirements may be waived by professional clients, except where the relevant investment service is portfolio management or investment advice or the relevant financial instruments embed a derivative.

MiFID investment firms will have to provide all retail clients with a detailed annual statement. The content of reporting varies depending on the services provided and more details are required where a firm provides safekeeping services. Retail clients will be able to request a detailed breakdown information on certain elements included in the reports.

ESMA is to develop technical standards on the format, terminology and explanations that should be used.

Knowledge and competence

Natural persons giving investment advice or information about financial instruments, investment services or ancillary services to clients will have to meet new criteria for knowledge and competence, including undertaking regular professional development and training. Member States must set a criteria for determining this.

Investment advisors will have to undertake at least 15 hours of professional development and training each year and meet certain minimum professional knowledge and competence requirements set out in a new Annex. MiFID investment firms must issue them with a certificate of competence. When similar requirements were introduced in the UK, significant numbers of investment advisors left the industry.

Notably, investment advisors must understand the concept of sustainable investment, and be able to integrate clients’ sustainability factors and preferences in the advisory process.

Reporting of cross-border activities

MiFID investment firms which provide services to more than 50 clients on a cross-border basis will be required to report certain information annually to their home member state's competent authorities including the scope of activities, number and categories of clients, number of complaints and type of marketing communications used.

The existing AIF and UCITS regimes impose obligations on AIFMs and ManCos to ensure that funds and investors are not charged "undue costs". The proposed Retail Investment Directive will clarify and enhance these obligations. 

Under the proposals, costs (including but not confined to management and performance fees) will only be considered to be "due" if they:

• are in line with disclosures in the prospectus, any fund documents and any Key Information Document or Key Investor Information Document;
  
  
• are necessary for the AIF or UCITS to operate in line with its investment strategy and objective or to fulfil regulatory requirements (it remains to be seen what will count as "necessary" – presumably some profit margin is to be allowed!);
  
  
• are borne by investors in a way that ensures fair treatment of investors (except, in the case of AIFs, certain cases where AIF rules or instruments of incorporation provide for preferential treatment).

Costs borne by retail investors must be justified and proportionate having regard to the characteristics of the AIF or UCITS. Managers will be required to maintain and operate an effective pricing process designed to ensure that this is the case and also that no "undue costs" are charged. The pricing process must include an assessment of costs based on objective criteria including comparison with market standards. 

AIFMs and ManCos will have to conduct an annual review to determine if undue costs have been charged and there will be an obligation to reimburse the fund or investors for undue costs.  AIFMs and ManCos will also be required to report to regulators, the depositary and auditors if undue costs have been charged.

ESMA will also be empowered to create public benchmarks to facilitate comparative assessment of costs and performance of AIFs and UCITS. 

Much of the detail will be left to delegated legislation, including minimum requirements for the pricing process, the criteria to determine whether costs are justified and proportionate and the process for taking corrective action. 

It is particularly unclear how the benchmarking idea would work for private markets retailisation products with diverse investment strategies.

In its Opinion, ESMA has identified a lack of supervisory convergence in this area and made various recommendations to the Commission. There is broad consistency between the Opinion and the proposed Retail Investment Directive but there are some nuances.  For example, ESMA suggests using the PRIIPS KID list of costs as the starting point for determining whether a cost is eligible to be charged to the fund.  ESMA doesn't reference benchmarking but suggests that costs should be in line with, or better than, market standards.

The Retail Investment Regulation introduces some amendments to the scope of the PRIIPs Regulation including a new exemption for "pension products, including immediate annuities without a redemption phase which, under national law, are recognised as having the primary purpose of providing the investor with an income in retirement and which entitle the investor to certain benefits" and clarification that certain types of bonds with make-whole clauses are out of scope.

Other changes include changes to the way the PRIIPS KIDs will be prepared and provided to investors including the introduction of a new sustainability section, a new "Product at a glance" section and updates to the provisions on making PRIIPs KIDs available in electronic format.

If you would like further information or assistance in understanding the impact of the EU Retail Investment Strategy on your firm, please speak to your usual Travers Smith contact or any of the individuals below.