Legal development

Retail Investment Strategy - Inducements 

11 July 2023

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    This client paper is the first in a series of client papers on the Retail Investment Package (RIP)1. Ashurst is at the forefront of these developments, providing interpretation and implementation advice and helping our clients to navigate the upcoming obstacles for their business. 

    Further RIP client papers will cover (in no particular order): 

    • Overview – the basics
    • Value for Money – pricing and corporate governance
    • Investment Advisory – changes, duties and responsibilities 
    • Digital distribution and finfluencers
    • Information disclosure
    • Changes to the fund industry
    • Changes to PRIIPs
    • Interpretations, market reactions and updates

    As an omnibus directive, the RIP will change several EU laws (including the Insurance Distribution Directive). The focus of this series of client papers is, however, on intended changes to MiFID, PRIIPs and investment fund rules.

    This series of client papers are accompanied by consolidated track changes versions of the intended changes to EU laws, which will over time serve as a repository including outlining changes to Level 2 and which can be found here: 

    Ashurst has established a dedicated Retail Investment Strategy core team across Europe and UK. Please feel free to contact any of these team members set out at the end of this client paper.

    1.The Essentials

    Changes to MiFID II (and IDD) introduce a partial extended ban on inducements:

    • Banning inducements for RTO and Execution of Orders where no advice is provided to the retail client, subject to very limited exemptions. Inducement ban for portfolio management and independent advisors remain.
    • For sales where advice is provided, replacing the current quality enhancement criteria et sqq. with a new uniform test specifying the duty for advisors to act in the best interest of the client.
    • Where inducements are permitted, requiring distributors to inform clients about what inducements are, as well as their costs and impact on investment returns.

    MiFID II-RIP's inducement rules will substantially affect Investment firms who are execution only distributors of structured products / funds / complex debt to retail and make and receive a payment from the third parties. The current distribution chains will need to be reviewed.

    Investment firms that are carrying out corporate finance (broadly) are out of scope as long as the product is not within PRIIPS i.e. vanilla equity / debt. 

    To the extent (member) states allow for third parties as introducers (such as UK), introducer payments may still be possible.

    2. The Details

    2.1 Background

    Inducements has long been an issue for the EU and its legal organisations, with the EU Commission noting that:: 

    "Inducements may cause conflicts of interest in the distribution of retail investment products, as they may influence the distributor's advice for a certain product. This may steer retail investors towards more costly or less performant investment products, impairing the efficiency of the retail investment market. Evidence shows that this has a considerable impact on retail investors' net return on investment."

    The potential conflict of interest when paying or receiving inducements was a constant subject of discussion even before the implementation of MiFID in 2007. While the initial  practical focus (and often solution and not a measure last resort) was on proper disclosures to the client, over time the quality enhancement, proportionality and benefit for the client  received more and more attention.  With the introduction of  MiFID II, portfolio managers and independent investment advisors were  no longer permitted to receive and retain relevant inducements. Some member states extended this limitation to any kind of investment advice. The UK Retail Distribution Review front ran these MiFID II reforms by placing restrictions on how advisors were paid by product manufacturers.

    Very closely linked to the recent question on how inducements may benefit the (retail) client (in particular on-going inducements for one-off transactions), the RIP-changes for MiFID II (and IDD) introduce a ban on relevant inducement for "non-advised sales". 

    2.2 Proposed Rules

    (a) Monetary Benefits

    Whereas the ban for monetary inducement for portfolio management services and independent investment advice remain unchanged (Art. Art. 24 (7) and (8) MiFID II and for portfolio management in future Art. 24a (1) MIFID II-RIP), MiFID II-RIP intends to broaden the scope of the ban to "non-advised sales" when servicing retail clients. 

    The proposed Art. 24a MiFID II-RIP translates this into: 

    "Member States shall ensure that investment firms, when providing reception and transmission of orders or execution of orders to or on behalf of retail clients, do not pay or receive any fee or commission, or provide or are provided with any non-monetary benefit in connection with the provision of such services, to or from any third-party responsible for the creation, development, issuance or design of any financial instrument on which the firm provides such execution or reception and transmission services, or any person acting on behalf of that third-party."

    This wording is interesting for several reasons : 

    • It is limited to sales services to retail clients, i.e. for sales services to(opt-up) professional clients this inducement ban will not be applicable. 
     

    Note: Will this result in a revival of client re-classifications? We expect so bearing in mind that in that case the investment services firm must establish parallel systems and procedures for retail and non-retail clients.


    • It is limited to pure RTO and execution services in connection with the provision of such services, to. Or from "any third party responsible for the creation, development, issuance or design of a financial instrument on which the firm provides such execution […] or any person acting on behalf of that third party". In this context, we note that the EU Commission's Q&A on RIP2 always speaks of "non-advised sales" which gives further insights into the gist of that rule but does not fully match the wording proposed. 

    Note: Will this amount to more trades being executed as own account dealer? Can custodians still receive and retain inducements (as they do today) – this would at least help the platform custodians for their custody business.
    • As the Quality Enhancement Test currently defined in Art. 24 (9) MiFID II will be replaced by enhanced investment advisory obligations, this test should not be applicable any longer even in those cases where the investment firm receives inducements for its sales business with non-retail clients.
     

    Note: If this holds true and the "Quality Enhancement Test" is not re-introduced by the obligation to "act in the best interest", there would be substantial administrative relieve as the relevant quality enhancement registers must not be maintained any longer.

    It is also worth mentioning that the "Quality Enhancement Test" should also be no longer applicable to minor non-monetary benefits – these will be limited to certain values which will give sufficient protection, cf. below ‎2.2(b). We note, however, that according to the MIFID II-RIP proposal, Art. 24 (7) lit. b MIFID II will not be altered and would still refer to the Quality Enhancement Test. We expect that this is an oversight to be deleted in the final version.

    The increased inducement ban will be subject to certain exemptions which may give at least some (in particular  digital/online retail investment firms) room to keep the current inducement regime:

    • Inducement can still be received and retained for RTO/Execution where that RTO/Execution is relating to prior non-independent investment advice (Art. 24a (3) MIFID II-RIP).

    Note: It will need to be discussed how long the effects of a prior investment advice can be factored into. Is an order which relates to a financial instrument advised upon the week before still "related"? – surely it would. But what about 6 months? What if there have been substantial changes to the product or its value in the meantime?

    We further expect that the topic of "automated/robo investment advice" will take an uplift as it is easy to implement prior to an order and MiFID II-RIP and the broad interpretation which the NCAs applied in the past for "investment advice" can now become an advantage to the advised retail investor journey. However, for the large scale execution-only-brokers, this will not help their business case and other means of financing their business will need to be discussed.

     

    • Inducements can be received for underwriting and placement business in non-PRIIPs financial instruments.

     

    Note: Art. 24a (4) MiFID II-RIP creates an exemption from the inducement ban for placement and underwriting fees received from the issuer where the financial instrument is placed or underwritten for retail clients. We note that so far some member states – including Germany – have taken a different approach as the underwriter / placement agent is also providing RTO/Execution services to the investor. With this exemption, the EU adopts a position that was already common in the UK.

     

    This exemption is, however, limited (by way of counter-exemption) to non-PRIIPs financial instruments. In practice, this will be limited to share and plain bond issuers.

     

    (b) Minor Non-Monetary Benefits

    Art. 24a (1) MIFID II-RIP (ban on inducements for portfolio managers) and (2) (ban on inducements for RTO/Execution services provided to retail clients) will not apply to the minor non-monetary benefits of a total value below EUR 100 per annum, or of a scale and nature such that they could not be judged to impair compliance with the investment firm’s duty to act in the best interest of the client, provided that they have been clearly disclosed to the client. Independent investment advisors will also be allowed to receive and retain minor non-monetary benefits as per the current provision.

     

     

    Note: Minor non-monetary benefits are not as essential as the monetary ones. However, they have proved to be very useful for the provision of items like: better IT tools..

    In the UK the above threshold is based on per annum per client calculation which does make sense also for the interpretation of the MiFID II-RIP provision. We expect that any amount exceeding the EUR 100 value p.a. and per client will need to be explained to the regulator in some detail. Depending on the basis of calculations, however, this might be of less importance.

     


    Overall, the above can be summarised as follows (as overview and flow chart): 

     

    (c) Ashurst.LLP

     

     

    (c) Ashurst.LLP

     

    2.3 Things to think about

    The intended further ban on inducements will change the distribution landscape and distribution chains in the EU. In particular the large scale custodian banks with their execution-only business will need to start thinking about financing their business in future. How will your firm finance the distribution?

    Some market players may consider shifting to placement/underwriting of non-PRIIPs instruments and ultimately very plain vanilla non-PRIIPs instruments for their retail client business. Whether such a move would maintain the interest of  retail clients is another matter

    There is even the chance that some larger players will distribute their own products to a larger extend and rely on (increased) internal distribution sources – though not triggering the inducement rules. However, this goes against the idea of openness and transparency  which has been sought by the industry and championed  over the last few years.

    Can (very basic) investment advisory tools be established in the mass retail market to be able to make use of the RTO/Execution following investment advice exemption? 

    Our Retail Investment Strategy team stand readily available to discuss structures, economics and solutions for your further business.

    References

    1. COM(2023) 279 final, Retail investment – new package of measures to increase consumer participation in capital markets (europa.eu). 

    2. https://ec.europa.eu/commission/presscorner/detail/en/qanda_23_2869. 

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.

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