MiFID II was implemented into Luxembourg law by the law of 30 May 2018 on markets in financial instruments (the “Law”), which was published in the Luxembourg Mémorial A under number 446 on 31 May 2018.
However, even before the implementation of MiFID II into Luxembourg law, which was due by 3 January 2018,the Luxembourg supervisory authority, the Commission de Surveillance du Secteur Financier (“CSSF”), stated in its press release 17/47 on 29 December 2017 that “in accordance with the fundamental principles of EU law (notably the principle of direct effect of EU law, the principle of precedence of EU law and the obligation to interpret national law in conformity with EU law), MiFID II provisions, which confer new rights or which are more favourable than the applicable national rules and regulations, shall apply from 3 January 2018 and existing provisions of inter alia the Luxembourg law of 5 April 1993 of the financial sector, as amended from time to time (“PSF Law”) shall be interpreted accordingly. This is notably the case for provisions of MiFID II which strengthen investor protection, such as the more stringent rules regarding organisational requirements, inducements and research”. Furthermore, the CSSF issued on 15 May 2018 a Q&A on MiFID II and Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (“MiFIR”) (the “CSSF Q&A”).
Background on the financial market: The financial crisis demonstrated that the legal framework according to Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments (“MiFID I”) was not suitable for creating transparent financial markets that provide a reasonable degree of investor protection. In addition, financial products have become increasingly complex, so much so that the European legislature decided to strengthen the existing legal provisions of MiFID I by enacting MiFID II.
All legislation related to MiFID II is defined in this summary as “MiFID II Rules” and takes into account the currently applicable legal situation in Luxembourg, including the Law and the CSSF Q&A.
In short, the MiFID II Rules concern “Investment Firms” regulated by the PSF Law (including inter alia investment advisers, brokers in financial instruments, portfolio managers, distributors of shares in investment funds, credit institutions when providing investment services and activities, investment firms and credit institutions when selling or advising clients in relation to structured deposits etc.) as well as so-called “Market Operators” and “Financial Instruments”. The MiFID II Rules target mainly:
financial intermediaries of Financial Instruments regarding the reception of fees, commissions and other benefits,
the financial markets and execution processes, i.e. trading venues, and
the issuers ( “manufacturers”) of Financial Instruments (i.e. product governance on creation and target market),
whereby it is understood that all these products / parties are those products / parties which are mainly covered by the PSF Law, which will mainly include the MiFID II Rules (in addition to the abrogation of the existing Luxembourg law of 13 July 2007 on markets in financial instruments).
Impact on the fund industry: In principle, the MiFID II Rules are not directly applicable to the fund industry, unregulated and/or regulated investment funds/entities and/or their respective management companies unless they provide services which are regulated under the PSF Law (i.e. MiFID-related services, for example, discretionary portfolio management). Indeed, the PSF Law (which will include the MiFID II Rules) expressly excludes regulated investment funds as well as their management companies, including alternative investment fund managers (together “Funds”), and the Law did not make any changes to the PSF Law which would result in the MiFID II Rules being directly applicable to Funds.
However, the provisions of the MiFID II Rules indirectly concern Funds in the case of use by persons who themselves fall under those rules. The Association of the Luxembourg Fund Industry (“ALFI”) issued on 20 December 2017 the first version of its FAQ “MIFID II: IMPACT ON INVESTMENT FUNDS”, which confirms that understanding. This FAQ aims at clarifying the obligations stemming from the MiFID II Rules which will be imposed directly or indirectly on Funds.
1. Receipt of fees, commissions and other benefits
The MiFID II Rules reshape the cost centres of Investment Firms and will lead to a consolidation of the financial market.
The general rules are set forth in the Law under articles 99 (amending article 37-2 of the PSF Law in relation to conflicts of interest), 100 (amending article 37-3 of the PSF Law with regard to information to be submitted to clients, assessment of suitability and appropriateness and reporting to clients) and 102 (amending article 37-5 of the PSF Law regarding the obligation to execute orders on terms most favourable to the client).
In addition, the Commission Delegated Directive 2017/593/EU of the European Parliament and of the Council of 7 April 2016 further supplements MiFID II with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or receipt of fees, commissions or any monetary or non-monetary benefits (“Directive 2017/593”). Directive 2017/593 was transposed into the Luxembourg legal framework by the Grand-ducal Regulation of 30 May 2018 relating to the safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits (the “Grand-ducal Regulation”), which was published in the Luxembourg Mémorial A under number 447 on 31 May 2018.
In particular, Investment Firms cannot pay or be paid any fee or commission, or provide or be provided with any non-monetary benefit in connection with the provision of investment services or ancillary services, to or by any party except their client or persons on behalf of their client, other than where the relevant payment or benefit:
is designed to enhance the quality of the relevant service to the client; in this respect, in accordance with article 10 (Inducements) of the Grand-ducal Regulation, a fee, commission or non-monetary benefit shall be considered to be designed to enhance the quality of the relevant service to the client if (a) it is justified by the provision of an additional or higher level of service to the relevant client, proportional to the level of inducements received, (b) does not directly benefit the recipient Investment Firm or its shareholders or employees without tangible benefit to the relevant client and (c) it is justified by the provision of an on-going benefit to the relevant client in relation to an ongoing inducement; and does not impair compliance with the duty of the Investment Firm to act honestly, fairly and professionally in accordance with the best interests of its clients; in particular, pursuant to article 10 (Inducements) of the Grand-ducal Regulation, a fee, commission, or non-monetary benefit will not be considered acceptable if the provision of relevant services to the client is biased or distorted as a result of the fee, commission or non-monetary benefit.
However, Investment Firms will be able to pay or be paid a payment or benefit which enables or is necessary for the provision of investment services, such as custody costs, settlement and exchange fees, regulatory levies or legal fees, and which by its nature cannot give rise to conflicts with the Investment Firm’s duties to act honestly, fairly and professionally in accordance with the best interests of its clients.
In addition, a specific duty of disclosure falls to the Investment Firm, i.e. the existence, nature and amount of the payment or benefit or, where the amount cannot be ascertained, the method of calculating that amount, must be clearly disclosed to the client in a manner that is comprehensive, accurate and understandable, prior to the provision of the relevant investment or ancillary service. Furthermore, the Investment Firm must also inform the client regarding mechanisms for transferring to the client, where applicable, the fee, commission, monetary or non-monetary benefit received in relation to the provision of the investment or ancillary service.
A further important revolution is also made to portfolio management versus investment advice services. As far as the activity of investment advice is specifically concerned, an Investment Firm must inform the client in advance whether the advice is provided, or not, on an independent basis. Only if the advice is provided on a non-independent basis, after providing information to the clients the Investment Firm can accept and retain a fee, commission or non-monetary benefit, provided that the general principles and rules described above are respected. On the contrary, when the advice is provided on an independent basis, or in the case that an Investment Firms is providing portfolio management services to a client, such Investment Firm shall not accept or retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party(ies) or person(s) acting on behalf of third party(ies) in relation to the provision of the service to their clients, except for ‘minor’ non-monetary benefits. In this respect, article 11 of the Grand-ducal Regulation (i) further specifies that all fees, commissions or monetary or non-monetary benefits (which do not qualify as ‘minor’) received from third parties in relation to the provision of independent investment advice and portfolio management shall be transferred in full to the clients and (ii) clarifies the meaning of ‘minor’ non-monetary benefits, which might be retained (such as inter alia written material or participation in conferences, seminars or other training events and related hospitality).
In addition, pursuant to article 12 of the Grand-ducal Regulation, Investment Firms can receive researches from third parties and this does not qualify as an inducement if (a) the relevant Investment Firm directly pays the third party(ies) out of its own resources, or (b) third party(ies) are paid for the researches out of separate research account(s), provided that in such case the clients are duly informed in advance about the budgeted amount for research and the costs of the estimated research and, on an annual basis, the total costs that each of them has incurred for third party research.
Furthermore, article 100 of the Law inserted under the amended article 37-3 of the PSF Law new paragraphs regarding inter alia the so-called ‘cross-selling’ practices, defined as the offering of investment services together with other services or products as part of packages or as conditions for the same agreements or packages, which were also the subject of tailored guidelines issued by ESMA on 11 July 2016 (ESMA/2016/574).
In such cases, the Investment Firm shall inform the client whether it is possible to buy the different components separately and shall provide separate evidence of the costs and charges associated with each component. Where the risks resulting from such an agreement or package offered to a retail client are likely to be different from the risks associated with the components taken separately, the Investment Firm shall provide an adequate description of the different components of the agreement or package and the way in which their interaction modifies the risks.
Finally, when making the link to the fund industry, in accordance with the rules set it out in the Law, the clients of Investment Firms will have the right to inter alia receive tailored information on all costs and charges relating to investment and ancillary services, including the cost of advice, the cost of the Financial Instruments which are recommended or marketed and how the costs will be paid. In light of that, it could be advisable for Funds to ensure that the relevant offering documents are updated to properly disclose the various fees and payments to Investment Firms, if any.
1. Trading venues
A further reshape by the MiFID II Rules concerns the infrastructure on which Financial Instruments are traded. It is the express intention to move as much trading as possible to regulated facilities.
Trading venues under the MiFID II Rules are defined as facilities in which multiple third-party buying and selling interests interact in the system. Functionally, trading venues include so-called “Regulated Markets”, multilateral trading facilities (“MTF”) and organised trading facilities (“OTF”).
A Regulated Market is a market in the sense of the European Capital Markets Regulations.
An MTF is a multilateral system operated by an investment firm or a market operator which brings together multiple third-party buying and selling interests in financial instruments – within the system and in accordance with non-discretionary rules – in a way that results in a contract.
As an excurse to the European Capital Markets Regulations and its implementations in Luxembourg, it should be noted that these regulations provide basically for these two different markets, also being existent and successfully operating in Luxembourg since years:
- The first one, which is in compliance with the European Capital Markets Regulations and therefore grants easy access to other European markets, concerns offers of securities to the public and admissions of securities on the Regulated Market. Within such a market, issuers of Financial Instruments are subject to more severe criteria, such as regular reporting concerning the financial year, International Financial Reporting Standards (“IFRS”) accounting rules, transparency requirements etc. In general, prospectuses must contain such details as are necessary for the investors’ understanding regarding the issuer’s property holdings, debts, financial positions, risks etc. Issuers must also prepare yearly and half-yearly annual accounts which must comply with IFRS. The supervisory authority for the Regulated Market is the CSSF.
- A second regime sets up a Luxembourg-specific regime that applies to admissions of Financial Instruments to a market which is not included in the list of Regulated Markets published by the European Commission. This market is the (EURO) MTF and is regulated by the Luxembourg Stock Exchange (“LSE”) itself.
The European Capital Markets Regulations do not apply to the MTF. The MTF is operated independently of the Regulated Market, i.e. the relatively strict requirements of the European Capital Markets Regulations do not apply. As the LSE acts as the competent authority, the prospectus must be drawn up in particular on the basis of the Rules and Regulations of the LSE itself. From an investor’s perspective, the MTF is considered an unregulated market – any investor who seeks listed Financial Instruments might therefore invest in securities listed on the MTF. Listing on the MTF is generally sufficient in projects where no Europe-wide marketing activity for the sale of the Financial Instruments is envisaged.
An OTF is a multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract. As of today, no OTF has been set up in Luxembourg.
The organisational requirements for all trading venues governed by the MiFID II Rules, namely Regulated Markets, MTFs and the new OTFs, are generally analogous (in contrast to bilateral systems, such as for example systematic internalisers (“SI”)). However, while Regulated Markets and MTFs under the MiFID II Rules continue to be subject to similar transparency and non-discrimination requirements regarding whom they may admit as members or participants, OTFs are able to determine and restrict access based inter alia on their role and obligations in relation to their clients.
Looking more deeply at the new OTF, it is a multilateral system, i.e. “a system or facility in which multiple third-party buying and selling interests in financial instruments are able to interact in the system”, in accordance with article 1(8) of the Law. Only buying and selling interests in bonds, structured finance products, emission allowances and derivatives may interact on an OTF in a way that results in a contract and the execution of orders must be carried out on a discretionary basis.
The operation of an OTF is an investment activity that requires prior authorization wherein:
trading is conducted on a multilateral basis,
the established trading arrangements have the characteristics of a system and
the execution of the orders takes place on a discretionary basis through the systems or under the rules of the system.
Moreover, OTFs share features in common with MTFs: they can both be operated by an Investment Firm or a Market Operator (such as the national stock exchanges) that is required to establish, publish, maintain and implement transparent and non-discriminatory rules, based on objective criteria, governing access to its facility.
The main specific features of OTFs are as follows:
they may only trade in bonds, structured finance products, derivatives and emission allowance (non-equity instruments);
there are less stringent limitations on the type of activities that the operator of the OTF may undertake, both in relation to matched principal trading and trading on own account. Additional restrictions apply as an OTF and an SI cannot be operated by the same legal entity;
as opposed to Regulated Markets and MTFs governed by non-discretionary rules, the OTF operator must exercise discretion when deciding to place or retract an order on the OTF and/or when deciding not to match potential matching orders available in the system;
as opposed to Regulated Markets and MTFs, which have members or participants, OTFs have clients. As a consequence, transactions concluded on OTFs must comply with client-facing rules, including best execution rules, regardless of whether the OTF is operated by an Investment Firm or a Market Operator.
Finally, taking a deeper look at SIs, these are, according to the MiFID II Rules, Investment Firms which, on an organised, frequent, systematic and substantial basis, deal on their own account when executing client orders outside a Regulated Market, an MTF or an OTF, without operating a multilateral system. SIs are therefore not trading venues but are subject to similar rules. In contrast to the definition under MiFID I, MiFID II enacts significant changes which extend the SI regime. It is also important to note that the operation of an OTF and of a SI to take place within the same legal entity will not be allowed. Likewise, an OTF shall not connect with an SI in a way which enables orders in an OTF and orders or quotes in an SI to interact.
III. The issuers (“manufacturers”) of Financial Instruments (i.e. product governance on creation and target market)
MiFID II imposes new rules on so-called manufacturers and distributors to ensure that all financial instruments (including structured deposits) are directed at an adequate target market and are subject to a product approval process.
The rules apply to Financial Instruments manufactured within the European Economic Areas (“EEA”), independently of where they are distributed.
The rules clearly show the different roles of the manufacturer and the distributor with respect to the end client. Indeed, the manufacturer typically does not interact with the end client and therefore can, in principle, only see a theoretical target market, whereas the distributor’s obligations relate to the actual target market and, in some cases, to the end clients with which it interacts.
It should be noted that the determination of a target market as one of the main achievements of MiFID II is not tantamount to carrying out an assessment of suitability of a client (as it was under MiFID I) as the determination of a target market is not about the specificities of an individual client while the assessment of suitability is about the specificities of an individual client.
A manufacturer is defined, taking into account article 8(1) of the Grand-ducal Regulation, a firm that manufactures an investment product, including the creation, development, issuance or design of that product, including when advising corporate issuers on the launch of a new product. It is worth mentioning that the MiFID II Rules are referring to Investment Firms only when speaking about product manufacturing, except for article 16.3 paragraph 6 of MiFID II, which states that “where an investment firm offers or recommends financial instruments which it does not manufacture, it shall have in place adequate arrangements to obtain the information referred to in the fifth subparagraph and to understand the characteristics and identified target market of each financial instrument”.
According to ESMA, for the purpose of product governance requirements, Investment Firms that create, develop, issue and/or design Financial Instruments, including when advising corporate issuers on the launch of new Financial Instruments, should be considered as manufacturers while Investment Firms that offer or sell Financial Instruments and services to clients should be considered distributors.
The following Financial Instruments are mentioned in the PSF Law: investment advisers, brokers in financial instruments, commission agents, private portfolio managers, professionals acting on behalf of their own account, market makers, underwriters of financial instruments, distributors of units/shares in undertakings for collective investment and investment firms operating an MTF in Luxembourg.
However, from a practical perspective, only a limited number of Investment Firms will be considered to be manufacturers as not all Investment Firms create, develop, issue and/or design financial instruments. It can be expected that Investment Firms that may qualify as manufacturers will typically be investment advisers, brokers in financial instruments and private portfolio managers.
In addition, the MiFID II Rules also apply to non-EEA firms providing investment services or performing investment activities through the establishment of a branch in the EEA.
What are the new rules applicable to manufacturers?
The new rules require manufacturers to:
identify at a sufficiently granular level the potential target market for each Financial Instrument and specify the type(s) of client with whose needs, characteristics and objectives the Financial Instrument is compatible;
implement for each Financial Instrument a product approval procedure which addresses conflicts of interest (including on remuneration), market integrity, adequate expertise of the staff involved and threats to the orderly functioning or stability of financial markets;
make available to any distributor all appropriate information on the Financial Instrument and the product approval process, including the identified target market of the Financial Instrument.
The compliance function must monitor the development and periodic review of product governance arrangements in order to detect any risk of failure by the firm to comply with its obligations.
What are the new rules applicable to distributors?
The new rules require distributors to:
determine the target market for the respective Financial Instrument, even if the target market was not defined by the manufacturer;
have in place adequate product governance arrangements to ensure that the products and services they intend to offer or recommend are compatible with the needs, characteristics and objectives of an identified target market and that the intended distribution strategy is consistent with the identified target market;
have in place effective arrangements to ensure that they obtain sufficient information about these Financial Instruments from the manufacturers;
maintain procedures and measures to ensure compliance with all applicable requirements under MiFID II, including those relating to disclosure, assessment of suitability or appropriateness, inducements and proper management of conflicts of interest.
As an excurse to the Fund industry, Funds, respectively management companies of retail and regulated alternative investment funds (“UCITS management companies and AIFMs”) (carrying out their core business and who do not have an MiFID extension) may also be indirectly impacted by these rules as distributors, who may require information that is not publicly or otherwise made available to them, may choose not to distribute the shares/units of Funds if these do not provide to the distributor such information. It should therefore be expected that distributors will seek to amend existing agreements or enter into new agreements with UCITS management companies and AIFMs which will enable them to obtain any information that they require in order to comply with the new rules. Moreover, in accordance with the FAQ “MIFID II: IMPACT ON INVESTMENT FUNDS”, ALFI recommends that UCITS management companies and AIFMs, even if not directly being impacted by the MiFID II Rules as long as they are carrying out their core business, shall at least review the regulatory status of their distributors and identify any Investment Firm accordingly. In order to comply with their duty to ensure oversight of their delegates, those players should obtain assurance/confirmation that the distributors, which in turn are covered by the MiFID II Rules, comply with their own requirements, for example inducement requirements and corporate governance.