MiFID2 update for investment managers - important details emerge on organisational and conduct rules

Almost two years after MiFID2 was finalised, the European Commission finally published on 25 April 2016 its Delegated Regulation supplementing MiFID2. The Delegated Regulation is a very important part of the “Level 2” measures which sit beneath MiFID2. It fleshes out much of the practical detail about how a MiFID investment firm must be organised and managed, and its day-to-day conduct of business and compliance obligations.

We set out in this note a summary of the key takeaway points from the Delegated Regulation, as it will affect investment managers. While the Delegated Regulation will apply to all types of MiFID investment firms, the commentary in this note focuses on its application to an EU investment manager authorised as a MiFID investment firm (for example a UK sub-investment manager within an international fund management group, or a firm providing managed account services), dealing with professional clients only.

This note will also be relevant to an authorised EU AIFM or UCITS management company, in respect of their “top-up” portfolio management activities governed by MiFID.

Overview

The Delegated Regulation is a substantial document (clocking in at almost 100 pages of complex rules with further annexes) which covers a disparate range of topics, including clarification of defined terms, organisational requirements, operating conditions for investment firms, operating obligations for trading venues, position reporting in relation to commodity derivatives, and data provision obligations for reporting service providers.

In effect (although it is not specifically framed in this way), the Delegated Regulation replaces the Implementing Directive under the current MiFID1 regime (Directive 2006/73/EC) (the MiFID Implementing Directive). By way of reminder, the MiFID Implementing Directive similarly specified key organisational and conduct rules, and was implemented into the national law and regulation of each EU and EEA member state. In the UK, the majority of the MiFID Implementing Directive was implemented into the FCA Handbook in 2007, in particular in the Conduct of Business Sourcebook (COBS) and in the “common platform rules” section of the Senior Management Arrangements & Systems and Controls Sourcebook (SYSC).

The key points to note are:

• The new Delegated Regulation replicates much of the existing organisational and conduct regime from the current MiFID Implementing Directive. As such, Legal & Compliance teams at investment managers will find much that feels very familiar in the Delegated Regulation, and we draw out these “continuing” rules below.

• However (as is often the case with the European legislative process) there are many subtle changes, and some very significant additions to the current regime, which Legal & Compliance teams will need to review and implement. One potential surprise for investment managers will be the extent to which the Delegated Regulation imposes current retail client conduct rules on a professional client business. We summarise below in this note certain of these and the potential challenges / pitfalls which arise out of them, including the following “Top 10” important changes:

1. form and content of marketing communications
2. telephone taping
3. outsourcing portfolio management to third countries
4. information disclosures to clients (pre-contractual and ongoing reporting)
5. remuneration policies
6. best execution policy summary for clients
7. information about the provision of investment advice services
8. record keeping
9. compliance monitoring and complaints handling, and
10. underwriting, placing and corporate finance activities.

Status of the Delegated Regulation

The European Commission has published these new rules in the form of a draft EU regulation. The European Council and Parliament now have three months in which to scrutinise the Act - which can be extended to six months on application of either of these institutions. If no objections are made, prior to or at the end of the scrutiny period, the Delegated Regulation will be published in the Official Journal and formally enter into force twenty days later.

The Delegated Regulation will apply from the date of the introduction of MiFID2, currently expected to be 03 January 2018.

As an EU regulation (and unlike a directive), the Delegated Regulation will not need to be implemented into the national law and regulation of EU member states. Instead, it applies directly across the EU to all MiFID investment firms on a harmonised basis as specified in the regulation (as is the case, for example, with the current Short Selling Regulation or the forthcoming Market Abuse Regulation). We anticipate that this means that any national regulation implementing the current MiFID Implementing Directive will need to be amended or (in many cases) removed from national rules. In the UK, for example, we expect that the FCA will need to re-write much of COBS and SYSC to remove the provisions which implement the MiFID Implementing Directive, and perhaps instead simply cross-refer to the relevant directly applicable part of the Delegated Regulation.

It’s worth emphasising that the Delegated Regulation is one of several different Level 2 measures which supplement the MiFID2 Directive and MiFIR. Other key Level 2 measures include:

• The regulatory technical standards (RTS) published in September 2015, in ESMA’s third final report. Of relevance to investment managers, this contained draft RTS on (among other issues) transaction reporting exemptions, post-trade transparency requirements, best execution and algorithmic trading.
• The draft Delegated Act published on 07 April 2016, dealing with (amongst other things) product governance and the inducements rules.

Further information on the key impact of the MiFID2 measures on investment managers can be found on our MiFID2 Tracker.

Familiar rules continuing in force

Let’s start with the good news!

As mentioned above, much of the Delegated Regulation retains in place existing organisational and conduct rules in largely the same manner as is currently the case in SYSC and COBS. We expect that an investment manager’s familiarity and existing compliance with this set of “continuing” rules will help mitigate the burden of MiFID2 implementation.

In particular, the rules which will (post-January 2018) remain largely in their current form include:

• high level organisational rules around reporting lines, internal controls, skilled personnel, and internal reporting
• the requirement to have a compliance function and compliance policies, an internal risk management function and (on a proportionate basis only) an internal audit function
• the obligations of senior management
• personal account dealing rules
• outsourcing rules, including the requirements when outsourcing critical or important functions (although see below re changes to the rules on outsourcing to third countries)
• conflicts of interest rules, including the rules on identification of conflicts and the content of a conflicts policy (although there are stricter rules around the use of disclosure as a means of managing conflicts)
• notifying clients of client classification status
• risk warnings
• suitability and appropriateness rules, and
• the extension of the best execution rules (as specified in MiFID2) to the services of reception and transmission of orders and portfolio management (although see below re the enhanced requirements for a best execution policy).

Top 10: enhancements or changes to existing regimes

And now, onto the bad news.

Despite the large number of rules which will remain in a similar format, the Delegated Regulation includes various enhancements or changes to existing regimes. We summarise these changes, and how they may impact on an investment manager’s business, below. (For clarity, references below to “client” mean the fund entity or managed account client, or the primary investment manager delegating to the UK firm, and not (except at point 1) the investor in a fund.)

1. Form and content of marketing communications

Under the MiFID1 regime in force today, when communicating with clients and issuing financial promotions to investors, investment managers are subject to a requirement to issue communications which are “fair, clear and not misleading”. Under MiFID1, there is also a set of detailed form and content rules which apply only when communicating with retail investors (but which do not apply when communicating with professional investors).

However, under the Delegated Regulation, the existing form and content rules for retail client communication are also expressly extended to cover communications with professional investors. This includes the rules on balance, presentation of risks, prominence of important information, fair comparisons, and past / simulated past / simulated future performance information. While many firms dealing with only professional investors might today look to those prescriptive rules as a guide when seeking to ensure that communications are “fair, clear and not misleading”, they are not mandatory requirements. This will be a significant change for investment managers which produce and disseminate promotional materials only to professional investors.

Investment managers will therefore need to ensure that all client / investor communications to be used post-January 2018 comply with these detailed form and content rules, and that their internal approval / sign-off processes are updated as needed for future communications. Depending on the range of promotional material published by a firm, this could be a significant undertaking. We anticipate that investment managers may also wish to consider to what extent marketing processes could be updated to fall outside the scope of these rules, such as procuring that an offshore (non-EU regulated) affiliate issues promotional material into the EU.

2. Telephone taping

The MiFID2 Directive introduced a new pan-EU telephone taping requirement. MiFID2 will require all MiFID firms to record telephone conversations and electronic communications relating to (as a minimum) transactions concluded when dealing on own account and the provision of “client order services that relate to the reception, transmission and execution of client orders”. The obligation applies to conversations and electronic communications relating to transactions that are concluded and to those which are intended to result in a concluded transaction (even if not ultimately concluded). The resultant records are required to be retained for a period of five years, or up to seven years if requested by a competent authority.

The Delegated Regulation provides more of the detail around the practical expectations of this rule. Investment managers will need to implement a new telephone taping policy, and the Delegated Regulation specifies the content requirements for that policy, as well as requirements that it should be “technology neutral” and information disclosure requirements for clients.

There are several key clarifications and additional detail specified in the Delegated Regulation:

• In a useful development for firms looking to procure the necessary recording technology, the parameters of the record keeping requirement are now clearer. The phone recordings and electronic communications must be kept in a “durable medium” which allows them to be replayed or copied, and must be retained in a format that does not allow the original record to be altered or deleted. Records must be “readily accessible” and available to clients on request. Firms also have to ensure the “quality, accuracy and completeness” of records. An investment manager which is engaging with external providers to supply technology to satisfy this rule should bear in mind these specific requirements.
• The scope of the recording rule is now expressly extended to include internal telephone conversations (for example, when a portfolio manager employed by an investment firm calls a trader on the same firm’s trading desk).
• In addition to the record keeping requirements, firms are also now subject to an express new requirement to periodically monitor the electronic records and also the telephone conversations. This monitoring must be “risk based and proportionate”, Many investment managers already carry out spot-checks and key-word monitoring on email records and chatroom logs (so that aspect of the rule may not be unduly onerous) but the requirement to manually listen to even a small sample of telephone recordings could be a difficult burden for some investment managers, Firms may wish to start engaging now with the cost and headcount implications of this monitoring requirement.
• The telephone taping and electronic communications policy must be reviewed each time a new medium of communication is accepted or permitted for use by the firm.
• Firms must keep a record of those members of staff who have a privately owned device which they are permitted to use for the firm’s business (and by way of reminder, MiFID2 requires a firm to prevent employees from using privately owned devices unless they are recorded too).
• There is a specific new training requirement, which states that firms must educate and train employees about these new requirements.

Many UK-based investment managers today rely on a FCA exemption from the telephone taping requirement, and so this new MiFID2 rule will post a potentially significant technological and operational challenge for firms required to record telephone calls for the first time. Firms may wish to engage with external providers sooner rather than later, to begin the implementation process.

3. Outsourcing portfolio management to third countries

The MiFID Implementing Directive already contains a detailed set of rules around the outsourcing of portfolio management for retail clients on a delegated basis to a sub-investment manager in a third country (ie a country not in the EU or EEA). These rules do not apply today to portfolio managers delegating outside the EU in respect of a client arrangement for a professional client. However, that will be changing under the Delegated Regulation, and so delegation by an EU firm to a sub-investment manager outside of the EU, including in respect of professional clients, will be caught by these rules. This may catch, for example, a UK manager delegating to a sub-investment manager in the US, Hong Kong or Switzerland (as is the case for many of our clients).

Under the Delegated Regulation, such outsourcing will be subject to the requirement that the sub-IM is authorised in its home country and is appropriately supervised, and that there are appropriate cooperation agreements in place between the EU state and the home country. As such, investment managers which outsource to a non-EU sub-IM will need to review those delegation arrangements well in advance of January 2018 for compliance with the new rules.

4. Information disclosures to clients (pre-contractual and ongoing reporting)

Similarly to the rules for marketing communications, the current MiFID1 rules contain a detailed set of rules about pre-contractual disclosures, the majority of which apply only when providing services to retail clients. However, under the Delegated Regulation, detailed rules around information disclosure to clients will also apply when providing services to professional clients. This includes disclosures about the firm, its services, and prescriptive disclosures around costs and charges. Investment managers will need to review their documentation and procedures around information disclosure, including both up-front disclosure to clients (perhaps by way of an annex to an investment management agreement), and ongoing disclosures.

In terms of ongoing reporting, MiFID1 contains today an obligation for a portfolio manager to provide a periodic statement to its clients. In the fund management context, this is perhaps a rule which some firms do not put at the very top of their priority list… However, post-MiFID2, this will become a more onerous obligation. Firms will be subject to much more granular content requirements for the report, as well as a specified minimum reporting frequency of every three months (with the reporting frequency increased to monthly reporting for a portfolio involving leverage). The reporting requirement can be satisfied by giving the client access to an online valuation system, provided that it is up-to-date and provided the client actually accesses it during the reporting period. The option to use an online system to provide periodic reports may be helpful in an intra-group sub-investment management relationship (for example, a UK MiFID firm acting as sub-investment manager to its US affiliate) where there is already a shared portfolio management or trading system used across the group. However, this is unlikely to be practical for a managed account relationship, and investment managers would in that situation need to implement new monthly or quarterly reports.

5. Remuneration policies

Almost all MiFID investment managers will already today be subject to a formal set of EU remuneration rules, as implemented in the UK in SYSC 19A to SYSC 19E. Most UK MiFID investment managers (not authorised under UCITS or AIFMD) will be subject to the SYSC 19C BIPRU remuneration code. The Delegated Regulation will require firms to further update and enhance remuneration policies, beyond the existing rules.

This includes new requirements that remuneration policies must take into account the interests of all clients, that remuneration should not be judged solely on quantitative criteria, and providing a “balance” between fixed and variable remuneration, so as not to favour the interests of the firm and its staff against the interests of any client. Investment managers will therefore need to review existing remuneration arrangements against this new set of standards. The FCA and other EU regulators may also need to provide formal guidance about how these rules interact with for example the BIPRU remuneration code.

6. Best execution policy summary for clients

The Delegated Regulation contains very detailed rules about the content of the best execution summary as provided to a firm’s clients (as opposed to the policy itself to be used internally by the firm). The required level of detail goes significantly beyond that which is currently specified for the purposes of the MiFID1 regime. Investment managers will need to review and update their execution policy summary, to ensure that the appropriate level of detail can be provided to clients.

Given these new rules, we expect that investment managers may consider giving clients the full execution policy, rather than going through the expense and time of preparing a summary which is almost as detailed as the full policy.

7. Information about the provision of investment advice services

The MiFID2 Directive introduced the concept of “independent” versus “non-independent” advice, for firms which provide the service of investment advice to their clients. The Delegated Regulation provides a considerable amount of detail for firms about what it means to be an “independent” or a “non-independent” adviser, and the related disclosures, policies and processes that are required, depending on the status selected by the firm.

The MiFID2 rules on investment advice pose an interesting challenge for investment management firms. Most UK investment managers will ordinarily have permission to advise on investments, and most IMAs will include the option for the manager to provide non-discretionary advice to the fund or other client, as needed. However, in practice, an investment manager will only very rarely give specific advice to its client (as opposed to making discretionary trading decisions), at least in the open-ended hedge fund world. For a typical hedge fund manager, this may raise the question of whether the cost of complying with the new rules on investment advice merits retaining the ability to give investment advice under the IMA. This will be a cost / benefit analysis for the manager.

For investment managers which have an advisory model as a core part of their business (for example in the private funds / infrastructure funds / real estate funds context, where the manager might give advice to an offshore investment committee which makes the investment decision) it will be important to consider the impact of the Delegated Regulation on their business and update the advisory model and client disclosures accordingly.

As an incidental point, these new rules on investment advisory services will likely reinforce the already widespread practice of an investment manager instructing its IR and marketing teams not to give investment advice to potential investors in a fund (to avoid triggering these obligations in the context of fund marketing).

8. Record keeping

There are of course already detailed record keeping requirements under MiFID1 and the prevailing national regimes. The Annex to the Delegated Regulation sets out a prescriptive list of detailed record keeping requirements, and firms will need to review these requirements and ensure that their procedures are updated as needed.

9. Compliance monitoring and complaints handling

In a codification of what is already widely seen as good practice, investment managers will need to have a risk-based compliance monitoring programme, and the compliance function will also need to take responsibility for complaints handling. There are also new detailed requirements around preparing and publishing to clients a complaints handling policy. Investment managers will need to review and update their CMP and complaints procedures for compliance with the new rules.

10. Underwriting, placing and corporate finance activities

The Delegated Regulation contains detailed new rules relating to firms carrying out underwriting, placing and corporate finance activities, principally to manage the institutional conflicts of interest which occur when a firm is carrying out this amongst a broader range of financial services. While very few investment managers provide corporate finance, underwriting or placing services, these new rules will impact on managers when interacting with a sell-side firm running for example a placing service for a client. Investment managers should be aware that sell-side firms will be subject to much stricter rules in providing such services, and so the ability of a manager to participate on a preferential basis may be curtailed.

What to do next?

For much of 2015 and the first part of 2016, the most commonly heard answer to the question “What next on MiFID2” was “Wait and see….”. Wait to see if the delay to January 2018 would be confirmed (which it almost now has been) and wait for the delegated acts (the key pieces of which have now fallen into place).

If they have not already done so, we suggest that in Q2 / Q3 2016, all investment managers should kick-off or re-start their MiFID2 implementation projects (subject to perhaps waiting to see the outcome of the Brexit vote on 23 June). The workstreams and issues identified in this note are just a small piece of the MiFID2 puzzle, and managers will want to ensure that they have fully benchmarked and captured how MiFID2 affects their business, and what steps they need to take to reach full compliance by January 2018.

Firms may also wish to consider using the Simmons & Simmons MiFID2 Manager tool. The MiFID2 Manager is a practical tool to guide you through the steps that need to be taken to stay on top of the requirements of MiFID2/MiFIR and its implementing legislation.