European Union: Financial Services Europe and International Update - November 2011 / Issue 13

Last Updated: 14 November 2011
Article by Martin Day, Karen L. Anderberg and Richard Frase

Regulatory Developments

This update summarises current regulatory developments in the European Union, the UK and internationally, focussing on the investment funds and a set manager and related sectors, during the past four weeks.

EU Regulatory Developments

A Financial Transaction Tax: The Commission's Latest Proposal

The European Commission released details either this month of their proposal to introduce a Financial Transactions Tax ("FTT"). This followed statements of support for the introduction of an EU-wide FTT from the French and German governments. The EU's proposal envisages that the tax would come into effect from 1 January 2014 onwards and it is the EU's hope that it will also serve as a platform for the introduction of a global FTT.

The Commission believes that the introduction of an FTT would be an appropriate way to ensure that the financial sector (which it currently believes is under-taxed) should make a fair contribution to the cost of the financial crisis having benefited from significant financial support from national governments since it began. In addition, the Commission is of the view that an EU-wide FTT would help avoid competitive distortions and discourage risky trading strategies.

The Commission also recommends that part of the revenue raised by an FTT should be paid directly to the EU rather than going entirely to the national governments within the territories of which the tax has been collected. The FTT is thus a major element of the Commission's proposals to reduce its reliance on national contributions for its own resources.

A FTT would apply to financial transactions carried out by financial institutions. Financial transactions would include the purchase and sale of shares, bonds, derivatives and structured financial products. However, the tax would exclude residential mortgages, bank loans, insurance contracts and "day to day" financial activities. The Commission has proposed a minimum tax rate for the trading of bonds and shares of 0.1 per cent, and 0.01 per cent for derivative products. This would be calculated by reference to the actual consideration paid (or market value when higher) or the "notional amount" in the case of a derivative contract. The tax would be paid by each EU-based financial institution which is a party to a transaction, and where there is more than one such financial institution the tax would be shared between them.

Financial institutions within the scope of the FTT would include investment firms, organised markets, banks, insurance companies, pension funds, collective investment schemes, leasing companies and special purpose vehicles (such as securitisation SPVs). As well as covering financial institutions incorporated in the EU or operating branches in the EU, the tax would include not only entities authorised in an EU member state, but also any non-EU entities which are a party (whether as principal or agent) to a financial transaction with an EU-based financial institution, for example, a US fund entering into a derivative transaction with a German company.

The FTT would be collected by banks, brokers or dealers, or alternatively by exchanges, central counterparties or central depositories. Every entity liable for the FTT would be required to submit monthly returns to its EU member state.

Comments: Although liability for the FTT would be that of the relevant financial institutions which are a party to the transaction, according to the International Monetary Fund, most of the burden of FTT is likely to ultimately fall on consumers.

The Commission estimates that depending upon market reactions the revenues of an EU FTT could be €57 billion per annum throughout the EU. However, if the FTT is only introduced on an EU-wide basis, there would inevitably be scope for securities and derivative trading to move outside the EU. There may also be opportunities to avoid the FTT by undertaking transactions which are economically equivalent to transactions which would otherwise be subject to FTT, or a higher amount of FTT, but which themselves are not within the scope of the Tax.

Although the Commission's present proposal is for an EU-wide FTT, it would also have a potential impact on non-EU financial institutions which are caught by the tax if a party to certain transactions. It would also catch dealings in non-EU shares, bonds etc if one of the parties to the transaction is EU-based. Further, non-financial institutions which are a party could also be jointly and severally liable for FTT, along with the relevant EU financial institution(s).

Most EU member states have stated that they are in favour of introducing the FTT but the UK, while not opposed to the introduction of a global FTT, is opposed to an EU only FTT (the introduction of which could require the abolition of UK stamp duty). Since the proposal requires unanimous approval of all EU member states, the UK is in a position to block the introduction of an EU-based FTT. However, there is an "enhanced co-operation procedure" under which a number of member states can be authorised to exercise EU non-exclusive competencies through the EU institutions, with the purpose of protecting the EU's interests and reinforcing its integration process. One potential risk here for the UK government is that if FTT was introduced in this manner without the UK participating it would still impact on UK financial institutions through trades with counterparties within the scope of FTT but the UK would not share in any of the revenue generated.

The European Commission still seems extremely keen to implement an FTT on one basis or another despite its potential negative impact on GDP. Further, European policymakers have put this issue firmly on the political agenda before the next meeting of the G20, scheduled for early November. Accordingly, the proposal is one that needs to be taken seriously. Clients who are potentially adversely affected by the introduction of the FFT should consider lobbying against its introduction on a national and/or EU-wide basis.

EU Contract Law: Draft Regulation

The European Commission issued a Green Paper on policy options for progress towards a European Contract Law for consumers and businesses in July 2010, with a deadline of 31 January 2011, under the responsibility of EU Commissioner Reding (DG Justice), who has previously referred to her wish to create a European civil code and to harmonise EU contract law to provide a higher level of consumer protection.

A legislative proposal issued by the Commission on 11 October 2011 for an optional European contract law is now due to be approved shortly and is expected to take the form of a Draft Regulation, focusing on the sale of goods. Its issue has been accompanied by Member State-specific factsheets which seek to identify the current problems in the area of cross-border sales and purchases and highlight the improvements for both consumers and business (especially small firms) that the proposal will bring, in particular in comparison with existing national laws. The proposed Common European Sales Law is optional, and is currently aimed at cross border transactions, but will allow Member States the option to extend it to domestic contracts. It covers both business to business and business to consumer contracts. According to the Commission, it will give consumers more choice and a high level of consumer protection. The Commission also claims that "at least €26 billion" is forgone in intra-EU trade each year due to contract law obstacles. An Impact Assessment has also been published which accompanies the proposal.

Comments: Across the Member States this proposal continues to divide opinion. In their responses to the earlier consultations several Member States (including the UK) have expressed their concern that the Commission has failed to make the case for the introduction of an EU contract law. In addition, the proposal has been issued under Article 114, which allows the decision to be taken by Qualified Majority Voting. This choice of legal base for the proposal is also causing concern amongst a number of Member States.

The EMIR Proposal

Derivatives were brought to the forefront of regulatory concerns as the financial crisis developed, from the near-collapse of Bear Stearns to the default of Lehman Brothers and the bail-out of AIG. In October 2009, the Commission published a Communication outlining the range of legislative measures that it has now published as a draft regulation, and on 15 September 2011 the Commission issued its formal Proposal for a Regulation on OTC derivatives, central counterparties and trade repositories (known as "EMIR").

On 30 September 2011 several EU-wide trade associations sent an open letter to Commissioner Barnier expressing concerns about non-discriminatory clearing access to market infrastructure providers. They believed that choice and efficiency in clearing services in the EU may diminish dramatically if the current trend towards concentration in the provision of clearing (and trading services) continues. They also expressed concern at the lack of safeguards within EMIR to deal with this issue, including the fact that EMIR is currently restricted in scope to cover only OTC derivatives. Combined with the anticipated requirements from MiFID II, choice for users between clearing houses was in their view likely to be severely limited, as is the choice of trading venues. The associations urged the Commission to introduce explicit and detailed open access requirements into EMIR which would cover the clearing of all financial instruments.

On 4 October 2011 EU Finance Ministers agreed their general approach to the EMIR proposal. Contrary to expectations the agreed position includes the reinstatement of an article ensuring that venues of execution have access to any CCP to clear OTC derivatives transactions and subject to certain conditions, for CCPs to have access to the trade flows from trading venues. (This brings the EU into line with the Dodd-Frank proposals in this area). The UK also succeeded in inserting the option for a national competent authority to challenge a negative opinion from ESMA on the authorisation of a CCP. The agreed draft also stipulated that no member state can be discriminated against as a venue for clearing services. Finally it allows room for further technical work in the area of arrangements with third countries. The scope however remains OTC, rather than all derivatives, including those traded on exchanges (for which the UK had been pushing).

Now the Council of Ministers has agreed its general approach, trialogue discussions on EMIR will begin with the European Parliament.

Note: On 6 October 2011, the Financial Markets Law Committee (the "FMLC") published a paper based on the latest Presidency compromise proposal on EMIR dated 23 September 2011. The technical standards, through which much of the detail on EMIR implementation will be given effect, are not due to be submitted to the Commission until 30 June 2012.

Whilst the FMLC accepts it will not be possible to fully assess the legal uncertainty issues associated with EMIR until the technical standards are published, it has nevertheless identified a number of key legal uncertainties arising from EMIR. It notes that legal uncertainty is a particular issue for market infrastructure, notably for CCPs, and that it is therefore important to ensure that EMIR does not adversely affect the existing robust aspects of the market infrastructure.

In the paper, the FMLC considers key legal uncertainties and makes a number of recommendations in the following areas:

  • the scope of EMIR as it relates to parties and eligible contracts;
  • the civil law consequences of breach of the obligations to clear derivatives;
  • frontloading, segregation and different client clearing models;
  • default procedures and portability;
  • different methods of taking collateral and the need to amend the Collateral Directive (2002/47/EC);
  • deficiencies arising from the Settlement Finality Directive (98/26/EC) and issues relating to CCP insolvency;
  • interference with the automatic early termination election under an ISDA's Master Agreement; and
  • regulatory capital.

Although the FMLC does not comment in the paper on policy issues (other than relating to issues of legal uncertainty or misunderstanding), it notes that the imposition of the clearing requirement in EMIR will have a major impact in that it will result in a concentration of risk in CCPs, which may in turn give rise to an increased risk or even CCP failure, notwithstanding the various measures in EMIR which have been designed to prevent this.

EMIR is intended to apply throughout the European Union from the end of 2012.

CRD4: ECON Committee

On 20 July 2011, the Commission adopted a legislative package to strengthen the regulation of the banking sector which replaces the current Capital Requirements Directives with a Directive and a Regulation. The new Directive governs the access to deposit-taking activities whilst the Regulation establishes the prudential requirements institutions need to follow.

In an exchange of view in the ECON Committee recently, the rapporteur on CRD4 stated that the European Parliament should adapt the Basel III agreement to the specifics of EU banking. This position was supported by some MEPs but was challenged by others who cautioned against introducing unnecessary differences with Basel III which could be interpreted as the EU taking a lighter approach to regulation. Sharon Bowles, a UK MEP, highlighted a number of areas in the Commission proposal which needed further attention, such as the issue of how to consider sovereign bonds, third country equivalence and the need for harmonisation of risk models, and also stressed the need to consider how CRD4 would interact with other legislation. The rapporteur on CRD4 also expressed concern about the number of areas delegated to the European Banking Authority (the "EBA") given the resource constraints which the EBA has been experiencing.

The draft report is now expected to be presented late in January 2012 with a vote in ECON expected at the end of April 2012. Once the European Parliament's position is agreed, negotiations with the Member States will then begin with a view to reaching agreement on the Directive by summer 2012.

ESMA Opinion on Practical Arrangements for Late Transposition of UCITS IV

On 13 October 2011, the European Securities and Markets Authority ("ESMA") published an opinion on practical arrangements for the late transposition of the UCITS IV Directive (2009/65/EC) ("the Opinion").

The deadline for transposition of UCITS IV into national legislation was 1 July 2011. However, most Member States have not yet fully transposed the Directive and its implementing measures. ESMA notes in the Opinion that late transposition can create difficult situations where some authorities may not have the legislative framework in place to allow for proper UCITS IV implementation. It intends to address this situation at an operational level to minimise, as far as possible, the impact of late transposition on both the industry and investors.

The Opinion sets out practical arrangements for cross-border operations where one Member State has not transposed UCITS IV. However, ESMA advises that it is not possible for all situations arising from non-transposition to be "accommodated by way of practical arrangements that are legally sound". ESMA explains that the arrangements it has proposed are based on the jurisprudence of the Court of Justice of the European Union (ECJ) on direct applicability of the self-executing provisions contained in the relevant directives. The Opinion covers the following areas:

  • UCITS notifications;
  • use of the management company passport;
  • mergers (both cross-border mergers and mergers between UCITS established in the same Member State); and
  • master feeder structures.

ESMA advises that its work in this area is also subject to any initiatives taken by the Commission relating to the late transposition of UCITS IV by any Member State.

MiFID 2

In force since November 2007, the original Markets in Financial Instruments Directive ("MiFID") governs the provision of investment services in financial instruments by banks and investment firms and the operation of traditional stock exchanges and alternative trading venues (the so-called "multilateral trading facilities" or "MTFs"). Whilst MiFID created competition between these services and brought more choice and lower prices for investors, shortcomings were exposed in the wake of the financial crisis. Drawing lessons from the crisis, the G20 agreed at the 2009 Pittsburgh summit on the need to improve the transparency and oversight of the less regulated markets, including the derivatives markets, and to address the issue of excessive price volatility in the commodity derivatives markets. The Commission published its consultation on the MiFID Review in December 2010.

The European Commission in October 2011 published its previously widely-leaked proposals to revise MiFID. These proposals consist of a Directive and a Regulation and aim to make financial markets more efficient, resilient and transparent, and to strengthen the protection of investors. The new framework also aims to increase the supervisory powers of regulators and provide clear operating rules for all trading activities. Key elements of the proposal are:

  • Market structures: MiFID already covered MTFs and regulated markets, but the revision will now bring a new type of trading venue into its regulatory framework: the Organised Trading Facility ("OTF"). These are organised platforms which are currently not regulated but are playing an increasingly important role. The proposals will also introduce the creation of a specific label for SME markets. This will provide a quality label for platforms that aim to meet SMEs' needs;
  • Algorithmic trading: firms, which use computer-driven automatic trading formulas, will have to become fully regulated and provide national regulators with details of their trading strategies. There will be limits placed on the number of orders per transaction and on how far trading venues can go to attract order flow. The venues will also be obliged to operate the algorithmic strategies continuously throughout their trading hours in order to reduce volatility;
  • Increased transparency: according to the Commission, the introduction of the OTF category will improve the transparency of trading activities in equity markets, including dark pools - exemptions will only be allowed under prescribed circumstances. The proposals also introduce a new trade transparency regime for non-equities markets (i.e. bonds, structured finance products and derivatives);
  • Reinforced supervisory powers and a stricter framework for commodity derivatives markets: the proposals will reinforce the role and powers of regulators. In co-ordination with the European Securities and Markets Authority ("ESMA") and under defined circumstances, supervisors will be able to ban specific products, services or practices in case of threats to investor protection, financial stability or the orderly functioning of markets. The proposals also foresee stronger supervision of the commodity derivatives markets. They introduce a position reporting obligation by category of trader. In addition, the Commission proposes to empower financial regulators to monitor and intervene at any stage in trading activity in all commodity derivatives, including the shape of position limits if there are concerns about disorderly markets;
  • Third countries: the Commission's proposals contained in both the Directive and the Regulation, introduce a harmonised approach across Europe in the treatment of third country firms. Third countries will need to be deemed as being equivalent by the Commission before access to firms from the third country is allowed. (ESMA is to maintain a central list of the relevant countries). Third country firms will have to establish branches in order to provide services to retail clients; however they may continue to provide services to eligible counterparties provided they are supervised in their own countries and are registered with ESMA. It is not clear how this regime will apply to clients categorised as "professionals" and whether firms supervised outside the EU would also be subject to checks by regulators local to the markets they are seeking to operate in. Existing third country firms will have four years to comply with new requirements set out in the Regulation from its entry into force;
  • Investor protection: the revised MiFID also sets stricter requirements for portfolio management, investment advice and offers of complex financial products such as structured products. In order to prevent potential conflicts of interest, independent advisers and portfolio managers will be prohibited from making or receiving third-party payments or other monetary gains. Rules on corporate governance and managers' responsibility are also introduced for all investment firms.

The proposals will now pass to the European Parliament and the Council for negotiation and adoption.

The G20 Summit in Cannes on 3 and 4 November 2011 will also address the issue of commodity derivatives.

Short Selling and Certain Aspects of Credit Default Swaps

In the summer of 2010, the Commission came under significant political pressure, notably from Germany and France, to accelerate its work or short selling. In 2009, the Commission had included in its consultation on the review of the Market Abuse Directive questions on the possible elaboration of a European short selling regime. In September 2010 the EU Commission published a proposal for a regulation on short selling and certain aspects of credit default swaps ("CDSs"). The Commission did not recommend any prohibition of naked short selling, but focused on enhanced transparency requirements, with low thresholds for notifications to the regulator and higher ones for disclosure to the market.

Representatives of the EU Parliament, the Council of Ministers and the EU Commission have now reached agreement on the proposed Regulation on short selling and certain aspects of CDSs. The Regulation will contain a ban on uncovered sovereign CDSs, i.e., buying CDS protection otherwise than for hedging purposes, but subject to a limited power for national regulators temporarily to suspend the ban when it interferes with sovereign debt markets.

The proposed Regulation also includes new rules on reporting of net short positions to regulators and to the market and new powers for ESMA to co-ordinate short-selling bans and flag up risks.

The EU Parliament expects to hold a plenary vote on the agreed text at the end of November 2011, which will also need to be endorsed by the Council of Ministers before the new Regulation is brought into force.

Market Abuse Directive: The Commission's Amendment Proposals

The Market Abuse Directive (the "MAD") was one of the main measures in the EU Financial Services Action Plan, designed to help complete a single market in financial services for the EU. The implementation of the MAD resulted in an EU-wide market abuse regime and a framework for establishing a proper flow of information to the market. The Commission had proposed a Market Abuse Directive because it considered the former Insider Dealing Directive to be out of date and incomplete (since it did not also deal with market manipulation). Furthermore, the approaches in Member States to tackling market abuse were very diverse, with different systems and powers existing across the EU. (The MAD was implemented on 1 July 2005 and affects all firms and individuals who participate in a regulated market.)

The European Commission on 20 October 2011 published a proposal for a regulation on insider dealing and market manipulation, which updates the existing framework provided by the MAD following its consultations in April 2009 and June 2010. This contains drafts of:

  • a revised version of the 2003 Market Abuse Directive (the "MAD Proposal"); and
  • a new Market Abuse Regulation (the "MAR Proposal").

(A Regulation is directly applicable in all Member States and once approved, there is no need for further implementing measures. A Directive, however, must be transposed into national legislation, providing room for national regulators to consider how to best implement the provisions bearing in mind their own existing rules and regulations.)

The main aims of the MAD Proposal and the MAR Proposal are threefold:

  • to keep pace with developments in the market;
  • to enhance the powers of competent authorities to investigate and punish market abuse; and
  • to reduce the regulatory onus in this area on SME issuers.

Key points to note in relation to the MAD Proposal and the MAR Proposal are:

  • Scope: the MAR Proposal will significantly extend the scope of the current market abuse regime by bringing within it financial instruments traded over-the-counter ("OTC") which might have an effect on the covered underlying market, as well as financial instruments admitted to trading on a regulated market, multilateral trading facility or the new type of trading facility, the Organised Trading Facility ("OTF") (proposed under MiFID 2).
  • Commodities trading: the market abuse regime as it applies to commodities and commodity derivatives trading will be more closely aligned with the rest of the regime.
  • Market manipulation: the MAR Proposal introduces the new offence of attempted market manipulation, where a person intends to manipulate the market but does not place an order or execute a transaction, and also provides a wider set of examples of what would be presumed to be manipulative behaviour, including a number centred on algorithmic and high frequency trading.
  • Investigative powers of competent authorities: the MAD Proposal and the MAR Proposal also provide competent authorities with specified powers to enhance their ability to tackle and investigate market abuse, which include the power to enter private premises, to seize documents and to access telephone records.
  • Harmonised criminal and administrative sanctions: the MAD Proposal and the MAR Proposal aim to establish a more harmonised regime in respect of criminal and administrative sanctions across the EU Member States, in order to reduce the possibility of regulatory arbitrage, and includes persons being held liable where their lack of supervision or control has enabled market abuse to be carried out for their benefit by someone acting under their authority.

These proposals will now pass to the European Parliament and to the Council for negotiation and adoption. Once adopted, the Regulation will apply from twenty-four months after its entry into force, and Member States would have two years to transpose the Directive into national law.

It is currently anticipated that the MAD Proposal and the MAR Proposal will be implemented throughout the EU at the same time, but that this will not occur before 1 July 2014. However, the final implementation date will depend on how negotiations between the European institutions and the drafting of a number of technical standards, which have been left for consideration proceed.

UCITS Classification

In a briefing issued in October 2011 the European Fund Classification Forum (the "EFCF") (which is a working group of the EFAMA (the European Fund and Asset Management Association)) has issued a high level classification under which detailed sector classifications will be grouped, each primary asset class being defined by three or four of the following characteristics:

  • nature of the asset class;
  • geographical focus of investments;
  • a characteristic that may vary from asset class to asset class; and
  • the currency of investments.

The EFCF is now holding discussions with the EFAMA members associations to encourage the promotion of this classification with their member firms and with third party data service providers to encourage the incorporation of the new fund categories within their data services.

IOSCO's Final Report on Regulatory Issues Relating to Impact of Technological Changes on Markets

On 20 October 2011, the International Organisation of Securities Commissions ("IOSCO") published its final report on regulatory issues raised by the impact of technological changes on market integrity and efficiency (FR08/11).

The report analyses significant technological developments (including high frequency trading ("HFT") and algorithmic trading) that have arisen in financial markets and their impact on market integrity and efficiency. It contains the following recommendations to assist securities markets regulators in mitigating potential risks:

  • regulators should require trading venue operators to provide fair, transparent and non-discriminatory access to their markets (and associated products and services);
  • regulators should seek to ensure that trading venues have in place suitable trading control mechanisms to deal with volatile market conditions; trading systems and algorithms should be robust and flexible so that they can deal with, and adjust to, evolving market conditions;
  • the order flow of trading participants must be subject to appropriate controls (including automated pre-trade controls) and regulators should also identify risks arising from unregulated members and participants of trading venues;
  • regulators should continue to assess the impact on market integrity and efficiency of HFT and algorithmic trading and there should be suitable measures to mitigate risks, including risks to price formation or market stability; and
  • regulators should monitor novel forms or variations of market abuse that may arise as a result of technological developments, and take action as necessary. The arrangements and capabilities for the continuous monitoring of trading should also be reviewed to ensure they remain effective.

(IOSCO consulted in relation to this report in July 2011, following a request made by the G20 at its November 2010 Seoul summit to report on these issues.)

An accompanying press release states that to support the recommendations, IOSCO will now carry out work on developing recommendations on market surveillance and analysing new market structures and their impact on market efficiency and integrity and will provide an update on this work in mid-2012.

G20 Finance Ministers and Central Bank Governors' October 2011 Communiqué

The G20 finance ministers and central bank governors have published a communiqué following their meeting in Paris on 14 and 15 October 2011, at which amongst other things, they:

  • agreed to take all necessary actions to protect the stability of banking systems and financial markets, including by ensuring banks are adequately capitalised and have sufficient access to funding to deal with current risks;
  • reaffirmed their commitment to implementing fully, consistently and in a non-discriminatory way agreed reforms on over-the-counter ("OTC") derivatives, the Basel agreements on banking regulation and reducing over-reliance on external credit ratings;
  • endorsed a comprehensive framework to reduce the risks posed by systemically important financial institutions ("SIFIs") and urged the Financial Stability Board (the "FSB") to extend the agreed framework for globally SIFIs ("G-SIFIs") to all SIFIs;
  • agreed initial recommendations and a work plan to strengthen regulation and the oversight of shadow banking;
  • endorsed the FSB's report and common principles on financial consumer protection prepared by the Organisation for Economic Co-operation and Development ("OECD") with the FSB and called for further work on implementation issues;
  • endorsed the progress report of the FSB OTC derivatives working group to ensure proper co-ordination and sequencing, and agreed on the importance of the work to set margining standards on non-centrally cleared OTC derivatives;
  • endorsed the International Organisation of Securities Commissions' ("IOSCO") report on commodity derivatives markets and called on IOSCO to report on implementation of its recommendations by the end of 2012;
  • endorsed IOSCO's recommendations on market integrity and called for further work by mid-2012;
  • welcomed initial work by the FSB, the International Monetary Fund ("IMF") and the Bank for International Settlements ("BIS") on macro-prudential policy and noted they would look forward to further work in 2012;
  • emphasised their support for a global legal entity identifier system which uniquely identifies parties to financial transactions, with an appropriate governance structure representing the public interest;
  • agreed on a co-ordinated framework for monitoring implementation of the G20's financial regulation agenda and reviewed a scoreboard to track progress for G20 leaders; and
  • committed to strengthen the FSB's capacity, resources and governance, to ensure it keeps pace with the G20's financial regulation agenda, (the first steps to be implemented by the end of 2011).

The G20 will meet in Cannes for its next summit on 3 and 4 November 2011.

UK Regulatory Developments

The FSA's Guidance on Prominence of Financial Promotions

At the end of September 2011, the FSA published its finalised guidance on the prominence of financial promotions (FG11/13).

Prominence of relevant information plays a key role in ensuring that a communication is clear, fair and not misleading. The FSA is aware from monitoring financial promotions that prominence can be interpreted in many different ways, which often leads to inconsistent standards. It is trying to clarify some of these inconsistencies in the final guidance, which appears to be in the same form as that consulted on in July 2011.

HM Treasury's Timetable for Introducing a Legislative Reform Order on Protected Cell Regime for UK OEICs

Also at the end of September 2011, HM Treasury published a statement, the first of what will become twice-yearly lists of regulations that have been, or will be, introduced by HM Treasury and which fall

within the scope of the Coalition Government's "one-in-one-out" regulatory policy.

The statement focuses on measures introduced between July 2011 and December 2011 and includes details of the following measure: "The Protected Cell Regime for UK open-ended investment companies". HM Treasury confirms that this measure is due to come into force in November 2011.

(HM Treasury and the FSA published a joint consultation paper on a protected cell regime for UK OEICs in July 2009).

The FSA's Phone Taping Rules

On 2 October 2011 the Alternative Investment Management Association ("AIMA") drew attention in guidance to the change in the FSA's phone taping rules which take effect on 14 November 2011. Currently, firms are required to take reasonable steps to record and store relevant telephone conversations and relevant electronic communications made with, sent from, or received on landlines. This obligation will be extended to cover mobile phones as well.

AIMA's guidance sets out:

  • the current FSA rules on phone taping;
  • what rule changes will apply from 14 November 2011;
  • what exemptions are available to discretionary investment managers;
  • guidance on some of the key terms used in the FSA rules;
  • practical steps which its members might wish to consider in complying with the new rules;
  • advantages and disadvantages of some of the types of product currently being offered for recording mobile phone calls, as well as a non-exhaustive list of vendors currently active in this area.

Although the contents of this guidance have been seen by the FSA prior to its publication, AIMA has not sought (and, consequently, has not obtained) FSA approval of its contents. This guidance therefore does not constitute formal industry guidance for the purposes of the regulatory regime.

FSA Consultation on Modernising Guidance on Financial Resources Requirements for Recognised Bodies

On 5 October 2011, the FSA published a consultation on modifying its guidance on the financial resources requirements for recognised bodies (i.e. recognised investment exchanges ("RIEs") and recognised clearing houses ("RCHs")) (CP11/19).

It will be recalled that the financial resources requirements for recognised bodies are set by HM Treasury through a recognition requirement. The FSA has adopted guidance, set out in Chapter 2.3 of its Recognised Investment Exchange and Clearing House sourcebook ("REC"), that elaborates on the requirement. The guidance sets out the principles the FSA will take into account when determining whether the recognition requirement has been satisfied. REC establishes the principle that the holding of financial resources equal to six months operating costs will ordinarily be deemed sufficient to meet the recognition requirement. This is known as the "standard approach".

The FSA believes that the guidance in REC needs to be modernised in response to significant market and regulatory developments since its introduction. This is underlined by the contrast between REC and other prudential regimes. The FSA wants to ensure that the guidance remains appropriate and, in the case of a UK RIE, that it continues to reflect the obligations of a regulated market under the Markets in Financial Instruments Directive (2004/39/EC). The FSA also believes there is an opportunity to enhance REC to help central counterparties (CCPs) prepare for their future obligations under the European Market Infrastructure Regulation (EMIR).

Comments on the FSA's proposals can be made until 6 January 2012.

FSA Finalised Guidance on Issues Relating to Remuneration

On 5 October 2011, the FSA published finalised guidance on issues relating to remuneration (FG11/16), following its August 2011 guidance consultation (GC11/19).

This finalised guidance relates to the FSA's remuneration code in Chapter 19A of the Senior Management, Systems and Controls sourcebook ("SYSC"). A revised version of the code came into force on 1 January 2011. The guidance sets out the FSA's plans for monitoring implementation of the code up to and during the 2011/12 annual remuneration review. It also outlines the action the FSA is asking firms to take in this respect.

On 18 October 2011, the FSA published finalised guidance on "buy out awards" to new staff (FG11/18), following its July 2011 guidance consultation (GC11/14). Buy out awards can be made by a firm to compensate a new recruit for the outstanding deferred remuneration that he or she may have forfeited by joining the firm. This guidance also relates to the FSA's remuneration code set out in Chapter 19A of SYSC, in particular, to SYSC 19A.3.40R and 19A.3.41E. It aims to provide clarity on when buy out awards may normally be made without contravening the requirements of the code.

Guidance for Auditors in Providing Client Assets Reports to the FSA

On 13 October 2011, the Auditing Practices Board (which is part of the Financial Reporting Council) published its Bulletin 2011/2 for auditors involved in providing client assets reports to the FSA.

The Bulletin provides guidance on the revised rules in the FSA's Supervision manual ("SUP") relating to the duties of auditors to report to the FSA on firms' compliance with the Client Assets sourcebook ("CASS"). The FSA revised these rules to enhance the quality of client assets reports produced by auditors. Auditors have to comply with the revised rules for periods ending 30 September 2011 onwards.

The Bulletin emphasises that:

  • determination of whether assets are to be treated properly as client assets is a complex issue requiring a thorough understanding of a firm's business model, and its internal processes and controls;
  • auditors are required to approach evaluation of a firm's CASS compliance from the perspective of the position if the firm becomes insolvent;
  • auditors should focus on whether controls are designed and operated to ensure CASS compliance, rather than focusing on whether controls will subsequently detect any non-compliance; and
  • the auditor's client assets report to the FSA must report any and all breaches (irrespective of materiality) of the rules that the auditor becomes aware of.

This Bulletin has been prepared with advice and assistance from the FSA. However, it does not constitute formal FSA guidance.

FSA Guidance Consultation on Payment for Order Flow Arrangements

On 12 October 2011, the FSA published a guidance consultation (GC11/23) containing proposed guidance on payment for order flow ("PFOF") arrangements.

The guidance consultation sets out the FSA's views on PFOF, which it defines as arrangements under which a broker receives payment from market makers, in exchange for sending order flow to them. Specifically, the guidance consultation:

  • explains the practice of PFOF and its possible advantages and disadvantages;
  • details the relevant provisions in the FSA's Conduct of Business sourcebook ("COBS") and Senior Management Arrangements, Systems and Controls ("SYSC"); and
  • provides guidance on the consistency of PFOF arrangements with the relevant COBS and SYSC provisions.

In the FSA's view, PFOF arrangements create a clear conflict of interest between the broker's clients and the broker itself. These arrangements are therefore considered unlikely to be compatible with the FSA's rules on inducements. They also risk compromising brokers' compliance with best execution requirements.

The guidance consultation is concerned with payments between market intermediaries. It is not intended to affect the ability of a trading venue to operate particular forms of fee structure (such as a maker/taker fee structure) and incentive schemes which are designed to reward certain types of behaviour by market participants.

Specific questions are raised in the guidance consultation, addressed to both brokers and market makers. However, the FSA states that it is equally interested in hearing general industry views on PFOF arrangements, including their prevalence (that is, which markets are affected and to what extent) and the effect on the allocation of order flow and market prices.

Responses can be provided to the FSA until 9 November 2011.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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