UK: Client Categorisation - FSA Proposals For implementation

The FSA’s Information paper on its proposals for implementing MiFID’s client categorisation requirements recognises that the categorisation of clients is a fundamental issue and seeks to address this now, before issuing the formal proposals in October. Firms were invited to comment on the paper by 25 September 2006.

This Law-Now highlights the significant proposals in the Information paper and covers the following topics:

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MiFID adopts the following categories of client: retail clients, professional clients and eligible counter-parties, the retail client category being the default category. Although MiFID adopts the FSA’s three-tiered categorisation of client, the boundaries between the client categories will change as a result of the MiFID rules.

Professional clients under MiFID are corporates and authorised financial intuitions. Large undertakings that meet specific size criteria may also be classified as professional clients. Contrary to the current Conduct of Business ("COB") rules however, the size thresholds when determining whether a corporate is a professional client will apply on a company-by-company basis, rather than on a group basis. As a result, many corporates currently classified as intermediate customers will not be professional clients under MiFID.

Eligible counter-parties are considered to be sophisticated investors or capital market participants and are subject to fewer protections under MiFID. The MiFID eligible counter-party regime differs from existing rules as it only applies to specific types of business, namely: executing orders on behalf of a client; dealing on own account; and/or receiving and transmitting orders. Thus, when dealing with a client outside these specified activities, a firm will have to classify the client as a professional client. In addition, Member States will be given discretion to define eligible counter-parties in their jurisdictions, with the potential effect that an entity may be regarded as an eligible counter-party in jurisdiction A but a professional client in jurisdiction B. Firms will be required to carefully review their clients’ positions in light of the particular jurisdiction’s definition of eligible counter-party.

As is the case under existing COB rules, clients may upgrade (and lose certain protections) or downgrade (in order to gain more protection) from one category to another. This can be done generally, in respect of a particular service/investment (with respect to retail clients/professional clients) or on a trade-by-trade basis (with respect to eligible counter-parties). Upgrading from retail client to professional client is difficult under MiFID because of the requirement to meet both qualitative as well as quantitative criteria before a retail client becomes an ‘elective professional client’. (Existing rules only require a qualitative assessment to be made). As a result, it is probable that many more clients will be classified as retail clients under MiFID.

In any case, many of the benefits derived from upgrading clients under existing rules will not be carried forward under MiFID. Under the current FSA rules, for example, clients upgraded to intermediate customer are able waive many protections, such as best execution and client money protection. These waivers will not be available to professional clients. Thus, although the new rules will make it more difficult to move from retail to professional client, it is not as crucial under MiFID to require this upgrade as in many cases, similar protections will apply to both categories of client.

The FSA proposes to copy out the MiFID requirements and the FSA Handbook will be amended to reflect this new terminology for MiFID business.

While clients dealing with firms after 1 November 2007 will be classified using the above categories, FSA has proposed comprehensive transitional arrangements in order to minimise the issues discussed above for existing clients. These arrangements are welcomed as they will allay the industry’s concerns that implementing MiFID’s client categorisation will cost considerable time and resource in re-papering existing clients. The FSA produces a helpful ‘map’ in Annex D, which gives a good indication of how clients may be transitioned from the existing COB categories to the MiFID categories.

The FSA considers that most private clients will automatically classify as retail clients without the need to repaper or notify them.

The FSA proposes to allow firms to classify existing expert private customers as professional clients under MiFID under the transitional grandfathering provisions, notwithstanding the fact that they will not meet the new MiFID requirements. The FSA justifies this by stating that existing COB procedures to upgrade a private client to intermediate customer status are similar to the procedures required under MiFID (i.e. a client requests the upgrade in writing, is given a clear warning of the protections that may be lost and the client states in a separate document that they are aware of the consequences of losing such protections). FSA has asked the industry to state whether they would choose to notify such clients of the categorisation even though the rules do not require it.

Those clients currently classified as intermediate customers will be permitted to be classified as professional clients as FSA considers that an adequate assessment of their experience, knowledge and expertise has already been made under existing rules. This is notwithstanding the fact that they may not meet the new size requirements under MiFID. Again, FSA has left it to the industry to determine whether these clients should be notified of their classification under MiFID.

It is likely, however, that parties that are currently classified as market counterparties will have to be repapered, as the eligible counter party regime is very different to the existing regime, as discussed above. Many of these clients will now be professional clients and will have to be notified of this change and the protections now afforded to them.

Clients that cannot be grandfathered will need to be newly categorised and notified under MiFID.

3. Client categorisation for non-MiFID business

As concerns those firms that do not fall within the scope of MiFID and firms that carry out both MiFID and non-MiFID activities, FSA has indicated that it plans to adopt the MiFID categorisation for both MiFID and non-MiFID business but provide modified definitions or criteria and use of grandfathering, where appropriate.

This preferred route avoids the need for two sets of parallel requirements and provides some flexibility at the same time. FSA also recognises that a single set of categories would be more appealing to consumers.

The cost benefit analysis carried out on behalf of FSA also indicates that this option would be preferable as the reclassification of clients and the maintenance a dual system is likely to have cost implications. These costs are minimised by adopting a single system and by allowing for grandfathering.

The FSA considers that the existing COB 4.1.5R, whereby an investment firm can treat a mediating firm as an agent (thus complying with the conduct of business requirements that apply to that agent as opposed to the underlying customer) is not inconsistent with MiFID. It proposes to retain this rule and justifies this by saying that MiFID contemplates such an approach.

As the categorisation of a client directly affects the protections afforded to the client (i.e. best execution), firms will have to ensure that existing clients and future clients are appropriately classified. Client categories will have to be reviewed in order to establish what MiFID protections are to be afforded to the client. This cannot be assumed as the MiFID boundaries do not match the existing COB boundaries.

FSA has also indicated that the MiFID categorisation changes should be reflected in the Financial Ombudsman’s jurisdiction by amending the definition of ‘eligible complainant’. This is because the MiFID category of ‘retail’ client is now likely to include persons that will not fall under the definition of eligible complainants. FSA is currently considering this issue with FOS. (Note that this does not affect the Financial Services Compensation Scheme as the definition for a claimant under the latter is not linked to the existing COB classification system).

The proposed rules will be published in the Reforming COB Regulation Consultation Paper (the COB CP), which is due to be published in October 2006. As concerns those firms carrying out non-MiFID business, the CP will only deal with proposals in relation to their retail clients. Rules that apply to firms carrying out non-MiFID business in relation to non-retail clients will be covered separately in the summer of 2007.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 26/09/2006.