UK: MiFID and Outsourcing in the UK

MiFID is the Markets in Financial Instruments Directive 2004/39/EC¹ and replaces the Investment Services Directive (which was adopted in 1993). It is part of the European Union’s ongoing Financial Services Action Plan², which aims to harmonize all Financial Services in the European Internal Market. MiFID seeks to regulate investment firms and provide a level playing field, thus ensuring greater consumer choice and protection. However, its regulations on outsourcing have caused a degree of concern, as the regulations place a potentially cost-heavy burden on investment firms to ensure that any such outsourcing does not jeopardise their quality of services.

What Is an Investment Firm?

Investment firms are defined at article 4 of MiFID, as any legal person who does the following:

• receives and transmits an order,

• executes an order,

• manages a portfolio,

• gives investment advice,

• underwrites,

• places the below with or without a firm commitment basis, and

• operates multilateral trading facilities,

with regard to the following Financial Instruments:

• transferable securities,

• money-market instruments,

• units in collective investment undertakings,

• derivative contracts,

• derivative instruments, and

• financial contracts for differences.

MiFID sets out the legislative measures for regulation of investment firms (what is known as Level 1 Measures). The European Commission (the Commission) has now published the Level 2 Measures³: these set out the technical measures that Member States must adopt in order to fully implement MiFID. The Financial Services Authority (FSA)⁴ is the UK regulatory body with responsibility to implement MiFID. This will be done by updating the FSA Handbook⁵ of rules and guidance.

The MiFID implementation date for Member States is 31 January 2007 and the compliance date for investment firms is 1 November 2007.

MiFID regulates investment firms seeking to outsource any of their ‘critical operational functions’. Article 13(5) says:

The Level 2 Measures state that "an operational function shall be regarded as critical if a defect or failure in its performance would materially impair the continuing compliance of an investment firm with the conditions and obligations of its authorization, or its financial performance, or the soundness or the continuity of its investment services and activities."

The Level 2 Measures go on to specify 11 conditions that an investment firm must ensure are complied with in order to take reasonable steps to outsource critical operational functions. These are:

1. the service provider must have the ability, capacity, and any authorization required by law to perform the outsourced functions, services or activities reliably and professionally;
2. the service provider must carry out the outsourced services effectively, and to this end the firm must establish methods for assessing the standard of performance of the service provider;
3. the service provider must properly supervise the carrying out of the outsourced functions, and adequately manage the risks associated with the outsourcing;
4. appropriate action must be taken if it appears that the service provider may not be carrying out the functions effectively and in compliance with applicable laws and regulatory requirements;
5. the investment firm must retain the necessary expertise to supervise the outsourced functions effectively and manage the risks associated with the outsourcing and must supervise those functions and manage those risks;
6. the service provider must disclose to the investment firm any development that may have a material impact on its ability to carry out the outsourced functions effectively and in compliance with applicable laws and regulatory requirements;
7. the investment firm must be able to terminate the arrangement for outsourcing where necessary without detriment to the continuity and quality of its provision of services to clients;
8. the service provider must cooperate with the competent authorities of the investment firm in connection with the outsourced activities;
9. the investment firm, its auditors and the relevant competent authorities must have effective access to data related to the outsourced activities, as well as to the business premises of the service provider; and the competent authorities must be able to exercise those rights of access;
10. the service provider must protect any confidential information relating to the investment firm and its clients; and
11. the investment firm and the service provider must establish, implement and maintain a contingency plan for disaster recovery and periodic testing of backup facilities, where that is necessary having regard to the function, service or activity that has been outsourced.

Investment firms should note the following two points in particular: they retain responsibility at all times for compliance with the above conditions, and they must ensure that at all times they retain the expertise to bring the outsourced functions back in-house.

The Level 2 Measures go on to define operational functions that will not be considered as critical: "the provision to the firm of advisory services, and other services which do not form part of the investment business of the firm, including the provision of legal advice to the firm, the training of personnel of the firm, billing services and the security of the firm’s premises and personnel, the purchase of standardized services, including market information services and the provision of price feeds."

Chapter 3 of the Senior Management Arrangements, Systems and Controls Sourcebook (SYSC)⁶ of the FSA handbook covers outsourcing by regulated firms. 3A.9.1 and 2 state that a regulated firm should take reasonable care to supervise the discharge of outsourcing functions, and particular care to manage material outsourcing arrangements, and that a firm should notify the FSA when it intends to enter into a material outsourcing arrangement.

Non-MiFID firms. The Consultation Paper 06/9 Organisational Systems and Controls (the Consultation Paper)⁷ effectively states at chapter 7.6 that the requirement for regulated firms to take reasonable care to outsource their operational functions and particular care to outsource their material operational functions will be ongoing but will be applied by the FSA through the revised Banking Consolidation Directive 2000/12/EC (BCD)⁸ article 22 (which comes into force on 1 January 2007). Basically, the article requires firms to have robust governance arrangements and adequate internal control mechanisms. Failure by a regulated firm to take care to outsource its operational functions will be interpreted by the FSA as a failure to comply with article 22.

MiFID firms. Annex 4 of the Consultation Paper sets out the new SYSC regime. Chapter 8 implements the outsourcing requirements of the MiFID Level 1 and 2 measures. It will come into force on 1 January 2007. Investment firms will need to comply from 1 November 2007.

MiFID requires reasonable steps to be taken when outsourcing operational functions that are critical for the provision of investment services and activities. The FSA is going to require reasonable steps to be taken with regard to the provision of investment services and activities and ancillary services.

These are defined in MiFID at Section B of Annex I and, by way of example, include the provision of investment research and financial analysis or other forms of general recommendation relating to transactions in Financial Instruments.

The Proposal for Re-casting Directive 2000/12/EC relating to the taking up and pursuit of the business of credit institutions and Council Directive 93/6/EEC of 15 March 1993 on the capital adequacy of investment firms and credit institutions⁹ (CRD) applies to Credit Institutions (defined as an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account) and is, like MiFID, part of the EU’s ongoing Financial Services Action Plan. It was formally adopted on 7 June 2006, and must be implemented by EU Member States before 1 January 2007.

The FSA has decided that there is considerable overlap between the CRD and MiFID regimes and that many firms will be affected by both. It has dubbed such firms "common platform" firms. The FSA has decided that the new SYSC regime will apply to Credit Institutions, common platform firms and investment firms. Credit Institutions will need to comply with the outsourcing requirements of the new SYSC regime from 1 January 2007. Common platform firms do not have to comply with the new SYSC regime before 1 November but may opt to do so.

Prior to the publication of the Level 2 Measures the FSA had criticised the Commission for failing to provide a cost analysis at any level. The FSA recognises that the initial implementation costs in the UK for firms implementing or upgrading their outsourcing procedures to comply with the new SYSC regime could be significant. Financial markets analysts suggest that capital market participants will have to spend up to €1 billion on technology to comply with the new rules. The FSA is in the process of compiling a cost benefit analysis which it plans to publish shortly.

Currently, 3A.9.3 of SYSC states that a regulated firm should not assume that, simply because a service provider is an intra-group entity, any outsourcing arrangement with that provider will necessarily imply a reduction in operational risk.

Chapter 8 of the new SYSC regime puts this the other way round. It says that where a common platform firm and the service provider are members of the same group, the firm may take into account the extent to which they control the service provider or have the ability to influence its actions. However, although the firm may take into account the extent of their control they must not abuse this provision and assume that because they control the service provider they are necessarily in compliance with the MiFID provisions.

For FSA regulated firms not affected by MiFID and CRD, the situation is business as usual. Such firms must continue to take care when outsourcing their operational functions and particular care when outsourcing a material operational function.

Credit Institutions not affected by MiFID will need to comply with the new SYSC regime from 1 January 2007.

Investment firms not affected by CRD will need to comply with the new SYSC regime from 1 November 2007.

Common platform firms may decide whether to comply with the new SYSC regime from 1 January 2007, or from 1 November 2007.

The FSA have stated that they are not going to provide any guidance further to the Level 2 Measures on what constitutes a critical or important function; furthermore, they have not yet released their cost benefit analysis. Therefore, it is currently not possible to assess in detail the steps a regulated firm should be taking now and the potential cost of those steps, beyond a recommendation that such firms should at least be seen to be taking steps, in order to rely on a workable defence in the event of any FSA investigation into their outsourcing arrangements.

Fortunately, the Level 2 measures are largely a re-statement of current best practice and whilst internal policies and practices will require review, and maybe some refinement, it is likely that already sophisticated buyers of outsourced services, and their advisers (internal or external), will have many of these bases covered in their existing outsourcing contract documentation and practices.