MIFID II Quick fix: Slowly cutting the red tape
On 26 February 2021, the so-called MiFID II “quick fix” measures (the Directive), were published in the EU Official Journal.[1] The aim of this Directive is to reduce the administrative burden on investment firms following the economic shock caused by the COVID-19 pandemic. To this effect, the Directive makes a number of targeted and limited changes to existing EU laws on financial services.
Belgium transposed this Directive into the Law of 23 February 2022 transposing the Crowdfunding Regulation and the Directive (NL/FR) (the Law). The Law is a faithful transposition of the directive, and the provisions came into effect on 28 February 2022.
The amendments concern four areas:
- Research requirements with regard to unbundling;
- Information and reporting requirements;
- Product governance; and
- Position limits in relation to commodity derivatives.
As the focus of this note is on investor protection measures, we will not cover the commodity derivatives requirements in any detail. We will also not cover the crowdfunding provisions of the Law.
1. Limited re-bundling
The European Commission made targeted changes to the research unbundling rules under MiFID II. The MiFID II provisions require portfolio managers to pay for the research that they obtain, either by paying for it themselves or by passing on that charge to their clients. This rule was introduced to increase fee transparency in situations where a broker provides both research and execution services to a portfolio manager and charges a single sum, rather than provide an itemized breakdown of the fees. Such a practice can give rise to inducement concerns in circumstances where a portfolio manager’s access to research from a broker increases commensurately with the volume of orders it submits to the broker. Paying separately for research, or “unbundling” these fees from execution fees, was thought to mitigate this concern.
Limited re-bundling of research and execution fees will be allowed with respect to certain small and mid-cap companies, as it was felt they were disproportionately impacted by the COVID-19 pandemic. The changes are arguably also a response to frequently expressed industry criticism that the unbundling rules resulted in a reduced research offering for this segment of the market.
As such, the provision of third-party research to investment firms that provide portfolio management or other investment or ancillary services to clients will no longer be treated as an inducement if (i) a prior agreement is concluded between the investment firm and the third party specifying the portion of combined fees or joint payments attributable to the research, (ii) clients are informed of these joint payments and (iii) the relevant research concerns issuers with a market capitalization of less than EUR 1 billion (for the 36-month period preceding the provision of the research).
Research providers will have to review and amend (as necessary) their existing research agreements if they want to benefit from this additional flexibility.
2. Information and reporting requirements
a. The new default: electronic communication
There is a reversal of the default position that communication needs to take place in a paper format (subject to the client’s consenting to receive information electronically): investment firms can now provide the information they are required to provide to (potential) clients in electronic format, unless the (potential) client has requested receiving this information on paper, in which case the information should still be provided in paper form, free of charge.
However, investment firms must inform existing or potential retail clients that they can receive the information in paper form.
In addition, investment firms must inform their existing retail clients, who currently receive the information on paper, that they will switch to electronic communication at least eight weeks before making the change. Such clients have the option of continuing to receive information on paper if they inform the investment firm of their preference within this period. This obligation does not apply to existing retail clients, who already receive the information in electronic format.
b. Information requirements for professional clients and eligible counterparties
Various information requirements under MiFID have not proven their ability to generate much added value for professional clients or eligible counterparties. In this section, we discuss which of these information requirements the Directive removes for these categories of clients.
- Product switching and cost benefit analysis
When providing investment advice or portfolio management services that involve switching financial instruments, investment firms are required to obtain the necessary information about the client’s investments and analyze the costs and benefits of changing financial instruments. When providing investment advice, investment firms have to advise the client whether or not the benefits of changing financial instruments outweigh the costs of doing so.
As a result of the MiFID II quick fix, these requirements no longer apply to services provided to professional clients, unless those clients inform the investment firm that they wish to benefit from the rights provided for therein. Investment firms will maintain a record of such communications with their customers.
- Costs and charges
The call for evidence by the European Securities and Markets Authority (ESMA) on the impact of inducements and costs and charges disclosure requirements, under MiFID and the public consultation of the European Commission, both confirmed that professional clients and eligible counterparties do not need standardized and mandatory costs information, as they already receive the necessary details when they negotiate with their service provider. The information provided to professional clients and eligible counterparties is tailored to their needs and often more detailed.
Services provided to professional clients and eligible counterparties are therefore exempted from the costs and charges disclosure requirements. There is one carve-out from this exemption: firms providing investment advice and portfolio management to professional clients still need to make costs and charges disclosures to such clients.
- Client reports
MiFID requires investment firms to provide clients with adequate reports on the service in a durable medium. Those reports include periodic communications to clients, taking into account the type and the complexity of the financial instruments involved, and the nature of the service provided to the client. They shall also include, where applicable, the costs associated with the transactions and services undertaken on behalf of the client. These reports will no longer need to be provided to professional clients and eligible counterparties, although professional clients retain an opt-in right to request these reports.
We note that the Directive did not amend the provisions implementing the client reporting requirements in the relevant level 2 legislation (i.e. Commission Delegated Regulation (EU) 2017/565) (the Delegated Regulation). The Delegated Regulation specifies the types of reporting owed to clients, including reporting relating to the execution of orders, periodic statements with respect to portfolio management, loss reporting for portfolio managers and statements of client financial instruments or client funds for custodians. While it stands to reason that these reporting obligations are no longer owed to professional clients (subject to an opt-in) and eligible counterparties as the relevant level 1 provision is switched off for them, the absence of modifications to the level 2 text is regrettable as this gives rise to a degree of legal uncertainty.
3. Distance communication
Another change to the costs and charges regime is the new exception for distance communication. Where an agreement to buy or sell financial instruments was concluded with a retail client through distance communication (e.g. telephone), which prevents the provision of costs and charges information before the conclusion of the agreement, the investment firm is permitted to provide this information afterwards without unreasonable delay provided that the retail client has agreed to this and the investment firm offered to delay the conclusion of the contract until the client received the information.
4. Product governance
There is a new exemption for product governance requirements (e.g. establishing a target market and associated requirements for products manufactured or distributed by an investment firm) when the investment service provided concerns bonds that do not incorporate a derivative instrument other than a make-whole redemption clause, or when the financial instruments are marketed exclusively to eligible counterparties. The exemption for financial instruments marketed exclusively to eligible counterparties does not appear to extend to professional clients. While the Law tracks the language of the Directive on this point, it is not clear whether professional clients were intentionally excluded from this exemption, or whether this was an oversight or drafting error. It is not immediately obvious to us on which policy grounds lawmakers would have wanted to distinguish between eligible counterparties and professional clients for this purpose. We suspect that, in practice, the exclusion of professional clients will significantly reduce the usefulness of this exemption.
A make-whole redemption clause is a clause that aims to protect investors by ensuring that, in the event of an early redemption of a bond, the issuer is required to pay the investor holding the bond an amount equal to the sum of the net present value of the remaining coupon payments expected to be made until the maturity date and the principal amount of the bond to be redeemed. These clauses protect investors against losses by ensuring that those investors are provided with a payment equal to the sum of the net present value of the remaining coupon payments and the principal amount of the bond that they would have received if the bond had not been called.
[1] Directive 2021/338 of 16 February 2021 amending MiFID II as regards information requirements, product governance and position limits, and CRD IV and Directive 2019/878 as regards their application to investment firms, to help the recovery from the COVID-19 crisis.