UK: MiFID 2: Advising Clients – Independence, Suitability And Appropriateness

Last Updated: 16 September 2015
Article by Emma Radmore and Rosali Pretorius

In the latest of Dentons' series of articles focusing on specific elements of MiFID 2, Emma Radmore looks at changes MiFID 2 will make to how firms give advice to clients. She also considers what changes the Financial Conduct Authority (FCA) will have to make to its rules to implement the relevant parts of MiFID 2. This article should be read alongside the article on communicating with clients.

MiFID 1

MiFID 1 now seems simplistic in terms of its provisions surrounding advice to clients, although, at the time it was agreed and implemented, it caused significant controversy and problems for firms. It was MiFID 1 that introduced the suitability and appropriateness requirements that stated:

  • Suitability: when providing investment advice or portfolio management, investment firms must obtain information on a client's (i) knowledge and experience in the relevant field, (ii) financial situation and (iii) investment objectives, to enable the firm to recommend services and investments that are suitable for the client; and
  • Appropriateness: when providing any investment service to which the suitability requirement does not apply, firms must ask the client for information on relevant knowledge and experience to enable the firm to assess whether the product or service is appropriate.

Both MiFID 1 and the MiFID 1 Level 2 Directive put some gloss on these requirements by providing certain exemptions (for example, in relation to execution-only services in non-complex instruments, and by setting out assumptions firms would be entitled to make in respect of certain clients).

What does MiFID 2 do?

MiFID 2 noted that increased awareness by investors of financial markets and the continuous development of products and services has led to the need for a high level of investor protection that is consistent across the EU. Not only does this cover product governance, covering development and distribution (on which the European Supervisory Authorities continue to carry out technical work), but also investment firms must:

  • disclose the cost of investment advice;
  • explain the basis on which they give advice, in particular on the range of products they consider and whether they provide advice on an independent basis;
  • tell clients if they will periodically assess suitability; and
  • explain to clients the reasons for advice the firm provides.

It also sets out the regulatory framework within which firms provide advice that is "independent", by requiring these firms to consider an appropriate range of providers and products.

MiFID 2 also introduces the requirement that firms that provide advice on an independent basis or portfolio management services must not accept and keep fees, commissions or any monetary and non-monetary benefits from third parties, and particularly from issuers or product providers. This would mean that any moneys or benefits the firm receives must be paid to the client, and the client informed whenever the firm receives them. Firms can keep only disclosed, minor, non-monetary benefits and even then only when they are capable of enhancing the quality of the service provided and cannot be judged to impair the ability of the firm to act in the best interest of its clients. This ban will form the subject of a separate article later in this series.

The key articles of MiFID 2 are in Section 2 of Chapter II, specifically:

  • Article 24, which addresses the general principles of investor protection and information for clients – so includes the provisions on informing clients about whether advice is independent and the ban on third-party payments, alongside the more general client disclosures, the product governance requirements and the ban on remunerating staff in a way that conflicts with the best interests of clients; and
  • Article 25, which addresses assessments of suitability and appropriateness, including also:
    • the requirement that relevant staff have the necessary knowledge and experience to fulfil their obligations under Articles 24 and 25;
    • that firms recommending a bundled package of investment must ensure the overall bundle is suitable;
    • the requirement for warnings to clients where either the firm does not consider a product appropriate or the client has not provided enough information for the firm to make that determination;
    • specifying the investments in relation to which firms may avoid the appropriateness assessment when a client deals on an execution-only basis, and including the requirement for firms to warn clients when there is no obligation on the firm to assess appropriateness; and
    • the need for client agreements and reports, including the requirement for a firm to provide a suitability statement in relation to advised sales before a transaction is made, except in limited circumstances where it may follow the agreement.

MiFID 2 allows the Commission to make delegated legislation including on the suitability and appropriateness assessment criteria, and allows the Commission and ESMA to opine on what instruments are non-complex. Article 25 itself specifies as non-complex (with certain limitations) shares, bonds and securitised debt traded on a regulated market, MTF or third country equivalent market, money market instruments and structured deposits. The limitations operate to exclude many instruments that embed a derivative or otherwise make it hard for a client to evaluate the risks of the product.

Controversial points and ESMA's technical advice

Understanding the changes MiFID 2 brings in this area is tricky. When providing its technical advice to the Commission, ESMA relied on existing measures in MiFID 1 Level 2 and commented only where it thought they needed change or embellishment. This made its consultation and ultimate technical advice appear short and surprisingly lacking in some respects – but in fact this is because it recommends continuing the existing detailed guidance.

Independence

The Commission had asked ESMA to advise on appropriate measures for the selection process to assess a sufficient range of instruments and the conditions under which firms can offer advice on an independent and a non-independent basis. In ESMA's consultation paper of May 2014 it had set out proposals for its technical advice, outlining how firms should explain whether advice is independent, and how they should explain to clients the basis of their services where one firm intends to provide both independent and non-independent advice to the same client. The technical advice that followed in December 2014 stated that any assessment should be based on an "adequate number" of financial instruments available on the market, which should make the test proportionate to the product. Some respondents to its consultation said firms should not be allowed to leave certain products out of consideration simply because they were, for example, cheaper. ESMA decided this practice would not meet overarching principles of business so did not need specifically to be banned.

ESMA's proposal that, if a firm's business model did not match the client's, the firm should refer the client to another firm did not go down well. ESMA stuck to its belief that firms must not provide services if they cannot meet the client's objectives and its final technical advice merely stated this.

The final controversial issue on advice was ESMA's proposal that one individual could not provide both independent and non-independent advice. Again, ESMA did not change its views after reviewing the responses it received to its consultation.

Its final advice on independence stressed that:

  • a firm's selection process when providing independent advice should (i) focus on a diversified selection of instruments, (ii) consider a number and variety of these instruments proportionate to the service it offers and what is available on the market and taking account of any relevant instruments it, or a linked firm, offers and (iii) assess all relevant aspects and ultimately ensure there is no bias in the recommendations made;
  • if a firm cannot make an appropriate comparison because of the business model or the specific scope of the service the firm provides, then it cannot say it is "independent";
  • firms that say they are independent but focus on certain categories or a specified range of instruments should ensure they market themselves on this basis. Additionally, clients should indicate they are only interested in investing in these products and should be able to identify a preference for the products and self-select them accurately. Finally, firms must be able to confirm that their business model matches the client's needs and objectives, and must not provide a service to the client if this is not the case; and
  • firms offering a mix of independent and non-independent advice (i) must tell retail clients whether the advice will be independent or non-independent, (ii) must not hold themselves out as being independent for their business as a whole but may claim independence in relation to particular services and (iii) must have adequate procedures to separate those who give independent advice from those who do not, such that no individual can give both types of advice and clients are not confused or given inappropriate advice.

Suitability

The Commission had asked ESMA to advise on what information firms should get from clients in order to be able to assess appropriateness and suitability, and particularly to consider any updates or improvements to the suitability assessment and report provisions carried over from MiFID 1. ESMA's proposals drew some criticism, and most respondents thought the existing guidance should not be embellished. However, ESMA thought otherwise and its final technical advice to the Commission states:

  • firms must ensure clients understand that it is the firm that is responsible for undertaking the suitability assessment so it can ensure it acts in the client's best interests;
  • firms must appreciate that the suitability requirement applies to all personal recommendations, not just those to buy;
  • firms must have, and be able to show they have, policies and procedures that enable them to understand the instruments they select and whether any alternatives might be suitable for the client;
  • firms must not make a recommendation if none of the investments they offer is suitable;
  • if recommending switching, firms must ensure they have all relevant information to analyse the costs and benefits of the switch;
  • firms must have in place systems to keep information about ongoing clients up to date;
  • the information firms need will depend on all the circumstances;
  • firms should take reasonable steps to ensure the information they collect is reliable (and the advice suggests how they might do this);
  • firms must ensure they correctly identify the person to whom they should apply the suitability requirement, if the client is a legal person or a group of individuals – again, ESMA gives guidance on this and how firms can ensure the client knows the basis on which it is carrying out the assessment; and
  • when providing suitability reports to retail clients, firms must include an outline of the advice given and explain why recommendations are suitable. Firms must tell retail clients if the recommended instruments are likely to require periodic review (but any periodic report would cover only changes since the last report).

Appropriateness

Again, ESMA had MiFID 1 implementing measures and existing guidance to review and rely upon when drafting its technical advice to the Commission. ESMA's main focus was how instruments not specified in MiFID 2 as complex or non-complex should be assessed for complexity (that is, what other instruments might be considered non-complex for the purposes of the execution-only exemption from the appropriateness requirement). ESMA had proposed that instruments that were explicitly excluded from the list of non-complex instruments within MiFID 2 could not be assessed again for complexity against any other criteria. Despite criticism, it has stuck to this view, so that instruments such as units in structured UCITS that embed derivatives, and any interest in a non-UCITS collective investment undertaking, will always and automatically be complex. ESMA has acknowledged that, because MiFID 2 covers more instruments than MiFID 1, more instruments will be considered complex. It may undertake further work on this, in particular on warnings clients receive on whether a service or product is appropriate. For the time being, though, its technical advice is:

  • to add two criteria to the existing guidance on when an instrument is non-complex – that (i) it does not incorporate anything that could fundamentally alter its risk or payout profile and (ii) it has no exit charges that would have the effect of making the instrument illiquid even if there are technically redemption opportunities;
  • to clarify that no instrument that MiFID 2 excludes from the list of non-complex instruments can be reassessed; and
  • to require firms to keep records of appropriateness assessments and of warnings firms gave where a client had not given enough information or the firm had considered a product or investment inappropriate – and of what happened after the firm gave the warning.

Effect on UK firms

UK firms will see changes resulting from MiFID 2's provisions on independent advice, suitability and appropriateness, but arguably the changes will be less significant for them than for many of their continental counterparts as a result of the Retail Distribution Review (RDR), which introduced fundamental change to how UK-regulated firms advise their retail clients back in December 2012. The rules went significantly further than MiFID 1 and have to that extent gold-plated it. The cornerstones of the RDR rules are:

  • adviser charging;
  • advice models that must be either independent or restricted; and
  • professionalism.

All these are covered by MiFID 2. The RDR "independence" test caused many firms to rethink their business models, as did the adviser charging rules. Firms that say they give independent advice will have to give unbiased, unrestricted advice on a broad range of products (wider than just packaged products) and must base that advice on a comprehensive and fair analysis of the market. Firms that cannot show this will be giving "restricted" advice. FCA rules already state that firms that provide restricted advice must not recommend a product from their range that closely matches a customer's needs but is not suitable for them, simply because they do not advise on products that would be more likely to be suitable.

The RDR rules constantly need to adapt to change from the EU. The Packaged Retail Investment and Insurance-based Investment Products (PRIIPs) Regulation and the nearly-adopted Insurance Distribution Directive affect it, as well as the MiFID 2 and MiFIR requirements on product governance and the charging and commission restrictions mentioned above.

FCA has so far issued only a discussion paper on how these aspects of MiFID 2 will affect its rules. It notes that in some ways the RDR regime goes further than MiFID 2 but in others does not cover some of the new requirements. It notes there could be conflict between its concept of "independence" and ESMA's, and that its range of "retail investment products" to which the RDR regime applies includes many products that are outside the scope of MiFID 2 but does not include several which are within scope – and moreover, which FCA does not consider it appropriate to include within its definition (such as shares, bonds and derivatives).

The overlap is mainly in collective investment and structured products. FCA is clearly reluctant to change a regime that it thinks is beginning to work well and has given consumers clarity, but it will undoubtedly have to do so. In its discussion paper, FCA sought views on how it could marry together the two regimes in the best way.

Conclusion

The independence concept, and the increased focus on the suitability and appropriateness assessments, will mean significant change for some firms, and will inevitably bring some change to all firms. UK firms, many of which had to change their business structure to accommodate the RDR, have probably already made the most significant changes, but those that give independent advice will need to adapt to new rules that FCA will have to make – much as it will undoubtedly try to miminise the changes.

© 2015 Dentons. This publication is not designed to provide legal or other advice and you should not take, or refrain from taking, action based on its content. Attorney Advertising. Please see dentons.com for Legal Notices. Dentons is an international legal practice providing client services worldwide through its member firms and affiliates. Dentons UKMEA LLP is a limited liability partnership registered in England and Wales under no. OC322045. It is authorised and regulated by the Solicitors Regulation Authority. A list of its members is open for inspection at its registered office: One Fleet Place, London EC4M 7WS. Any reference to a "partner" means a person who is a partner, member, consultant or employee with equivalent standing and qualifications in one of Dentons' affiliates.

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