ESMA's MiFID Suitability Guidelines and sustainability preferences

On 23 September 2022 ESMA published its final report on its updated Guidelines on certain aspects of the MiFID II suitability requirements.

This follows from its consultation paper published in January which we commented on here.

The update to the Guidelines takes into account

• the amendments made to the MiFID II Delegated Regulation to integrate sustainability factors, risk and preferences into investment firms' organisational requirements and operating conditions. These changes came into effect on 2 August 2022. For more information, please see our summary here
• the “good and bad practices” identified in ESMA's 2020 Common Supervisory Action (CSA) on progress made by intermediaries in applying the MiFID II suitability rules across the EU (which have been added to the Guidelines as an Annex) and
• the amendments introduced to Article 25(2) of MiFID II by the Capital Markets Recovery Package (notably in relation to an assessment of the costs and benefits of switching investments)

This note focuses on the first item and in particular the integration of sustainability preferences in the suitability assessment as required under the MiFID II Delegated Regulation.

Who should read this and why?

EU MiFID firms who provide investment advice or portfolio management have had to amend their suitability assessment procedures and policies for 2 August 2022 to comply with the amendments to the MiFID II Delegated Regulation. In particular such firms need to ask clients about their sustainability preferences as part of the suitability assessment and ensure that investment advice and investment decisions match those preferences. This has proved a substantial uplift to policies and procedures for which to date firms have only had ESMA’s consultation paper as guidance.

In addition any firm selling products via EU MiFID intermediaries are keen to identify how their products may be sold and what they will need to do in order to ensure their products are best positioned to take advantage of the changes to suitability assessments.

What’s the next step?

First the Guidelines need to be translated into the EU official languages and such translations published on the ESMA website. This triggers a two-month period for national competent authorities to notify ESMA whether they comply or intend to comply with the Guidelines.

In a change to the draft Guidelines, the Guidelines will only apply as from six months from the date that the translations are published on ESMA’s website. This is an increase from the 2 months compliance deadline in the draft Guidelines in light of the “challenges firms are facing to implement the EU sustainability legal framework”.

It is important to note that this is not a delay to the amendments to the MiFID II Delegated Regulation which came into force on 2 August 2022 – firms have had to comply with the legal requirements to consider client’s sustainability preferences as part of the suitability assessment since that date.

Firms are required to “make every effort to comply” with the Guidelines. Firms should start work now to integrate the Guidelines into their suitability processes and client on-boarding procedures. As mentioned below, firms also need to start the process for inviting existing clients to submit their sustainability preferences to ensure that all clients have been invited to do this by 2 August 2023 at the latest.

What has changed in the final Guidelines?

Many of the Guidelines remain unchanged since the consultation paper (which we reported on here).

We have set out below the key changes that firms should be aware of:

Providing information on a firm’s products with sustainable features: The Guidelines are clear that firms must adopt a neutral and unbiased approach during the suitability assessment so as not to influence a client’s answers in relation to their sustainability preferences. ESMA has amended the Guidelines to allow for firms, when providing investment advice, to disclose to a client its offering of products with sustainability features only after a client has “expressed their intention” to amend their original sustainability preferences. Firms may welcome this ability to refer to its sustainable product offerings (albeit in limited circumstances) to assist with client on boarding.

Minimum proportion: The definition of sustainability preferences in the Delegated Regulation refers to a “minimum proportion” being invested in taxonomy-aligned investments or sustainable investments. The draft Guidelines allowed for this to be minimum proportion to be collected as particular percentages, ranges or sizes. The Guidelines have been amended to state that this does not have to be collected as an exact percentage but by minimum percentages (for example “minimum 20%, minimum 25%, minimum 30% etc”). ESMA has stated that this is to align with the approach taken by EIOPA for the equivalent amendments to its suitability assessment guidelines under the Insurance Distribution Directive. However in its feedback on the consultation paper, ESMA confirms the possibility for firms to obtain information on the customer’s preferences in terms of the minimum proportion through the use of a particular “range” or “size”, despite the amendments to the Guidelines deleting these particular terms.

Consideration of PAI: ESMA has confirmed that, where a client’s sustainability preference is for financial instruments that consider principal adverse impacts (PAI) it is possible to collect information on the consideration of PAI on either quantitative or qualitative elements (rather than both quantitative and qualitative). This is a welcome correction to the Guidelines which aligns with the Delegated Regulation. ESMA has also added further guidance to state that “firms could also ask the client if there are specific economic activities that, on the basis of relevant PAIs, it wishes to exclude from its investments (for example, specific economic activities that are considered as significantly harmful under the EU taxonomy framework and/or that are opposed to the environmental and ethical views held by the client and that are linked to certain principal adverse impacts on sustainability factors)”.

Combination of sustainability preferences: ESMA has removed provisions in its Guidelines referring to the approach to be taken when a client expresses a combination of sustainability preferences, following feedback that this guidance was overly complex and onerous. In the event that a client does express a combination of sustainability preferences, firms can interpret these as alternatives when matching the client’s preferences to a particular investment (ie meeting just one limb of the client’s sustainability preferences), unless specifically expressed by the client.

Portfolio management or investment advice with a portfolio approach: ESMA has simplified the process of collection of client information by deleting the guidance which stated that a firm (including in the case of a portfolio approach) would ask the client “to what extent” financial instruments matching their sustainability preferences should be included in the client’s portfolio. In the case of a “portfolio approach” the quantitative indication of a client’s sustainability preferences will be collected when gathering information on the minimum proportion of sustainable investments or taxonomy-aligned investments and when collecting information on which PAI should be considered. In the context of the portfolio approach, ESMA has confirmed that client’s sustainability preferences can be applied in different ways. For example, a firm could assess suitability as regards the sustainability preferences on average at the level of the portfolio as a whole or at the level of the part/percentage of the portfolio the client wants to be invested in products with sustainability features. When adopting a portfolio approach, firms should ask which part or percentage (if any) of the portfolio the client wants to be invested in products meeting the client’s sustainability preferences.

Sustainability preferences for existing clients: ESMA has stated that it expects firms to have had new client questionnaires prepared for 2 August 2022 such that existing clients can update their profile to express their sustainability preferences if they so wish. However ESMA has amended the Guidelines to clarify that sustainability preferences for existing clients need to be updated at the latest through the next regular update of client information – not necessarily at the first meeting with the client or the first investment advice following 2 August 2022. In its feedback to the consultation, ESMA is clear that it expects firms to “launch the campaign to proactively invite clients to update their profiles with regard to sustainability preferences (unless they have already done so) no later than 12 months after the entry into application of the rules” – ie by 2 August 2023 at the latest. Until such time as the firm has obtained information on a client’s sustainability preferences the client is to be considered as “sustainability-neutral” and can be recommended products both with and without sustainability related features.

Clients with no sustainability preferences: Where clients do not have sustainability preferences (including where they do not answer the question) ESMA has amended the Guidelines to clarify that firms are not required to explain a products sustainability features (if relevant) to the client. That client will be deemed “sustainability-neutral” and be recommended products both with and without sustainability related features.

Other key points of interest from ESMA’s feedback on its consultation paper include:

Status of the Guidelines: ESMA is keen to emphasise that elements of the Guidelines (in particular the information gathering section) are not intended to be prescriptive but rather provide “practical examples” in which the requirements of the Delegated Regulation can be implemented. This is indicated where the Guidelines use the term “could” instead of “should”.

Professional clients: ESMA acknowledges the needs of professional clients can be significantly different from those of retail clients and emphasises that the Guidelines “principally address situations where services are provided to retail clients” and would apply to professional clients “only to the extent they are relevant”. That said the requirements under the Delegated Directive relating to sustainability preferences apply equally to retail and professional clients. ESMA believes it may be more efficient to deal with specific application of suitability requirements to professional clients would be better dealt with in Q&A rather than in the Guidelines.

Possible exemptions: ESMA was asked whether sustainability preferences would still need to be considered in respect of derivatives contracts used for hedging purposes or profiting from price movements without funding a particular economic activity. ESMA has confirmed that a suitability assessment (including sustainability preferences) should always be performed, regardless of the financial instrument. ESMA recognises that clients will always have specific objectives and needs (which could include hedging) and it is the firm’s responsibility to identify the suitable investments.

Collection of information: While sustainability preferences should not take precedence over a client’s personal investment objective, ESMA does not believe that this would prevent sustainability preferences being captured in the same questionnaire to collect other suitability related information from clients. However if this approach is used, questions on sustainability preferences should not be given precedence over questions on a clients financial objectives.

Where a client does not specific granular sustainability preferences: in such circumstances the Guidelines state that firms could consider any of the limbs of sustainability preferences provided that they explain this to clients and inform them of the sustainability features of the investments recommended or made on the client’s behalf as well as documenting the lack of granularity in the client’s sustainability preferences in the suitability report. The Guidelines have been amended to state that firms offering robo-advice should ensure similar arrangements are in place “given the limited human interaction”.

Where a firm cannot meet a client’s sustainability preferences: despite pushback from respondents to the consultation, ESMA has confirmed the approach in the Guidelines that a firm cannot recommend a financial instrument that does not meet a client’s sustainability preferences, unless the client adapts his/her sustainability preferences. ESMA states that it has confirmed this interpretation with the European Commission. ESMA does note that in the context of advice with a portfolio approach, the flexibility under the Guidelines to apply the suitability preferences on average at the portfolio level (or the part of the portfolio to be invested in products with sustainability features) should mitigate the risk of frequent adaptations of sustainability preferences by clients. Finally ESMA is conscious that this approach to adaptation of a client’s sustainability preferences has been designed having in mind the novelty of the regime and may be amended during the next review of the Guidelines once the new rules have bedded in.

We have also prepared a document showing the changes in the Guidelines compared to the original Guidelines published in 2018 – available here.