By William Yonge
Brexit notwithstanding, the United Kingdom implemented MIFID II locally on time. FCA later clarified certain issues for global asset managers regarding the new payment for research regime.
The European Union’s Markets in Financial Instruments Directive (MiFID) II required all 28 EU member states to transpose the directive into local law by 3 July 2017. To achieve this in the UK, HM Treasury put in place, on time, the following implementing legislation:
- Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2017
- Financial Services and Markets Act 2000 (Markets in Financial Instruments) Regulations 2017
- Data Reporting Services Regulations 2017
Also, the Financial Conduct Authority (FCA) finalised its rules implementing MiFID II in two policy statements issued on 31 March 2017 (covering mainly trading venues, algorithmic and high-frequency trading, and certain firm organisational requirements) and 3 July 2017 (covering key areas of interest to investment managers, including inducements, payments for research, best execution, client categorisation, telephone taping, and client assets). By way of reminder, the obligations under MiFID II commence on 3 January 2018.
In its July policy statement, FCA reported back on its consultative process over five consultation documents. The third consultation document (which focused mainly on conduct issues, including inducements and payment for research) received 211 responses, while the other four consultation documents taken together received 69 responses. FCA noted that it received the majority of feedback on a small number of conduct areas, in response to which it has made “significant policy changes to some proposals”. This LawFlash gives an overview of those policy changes.
Inducements Regarding Research
Which firms are in scope?
FCA consulted on gold-plating these provisions by applying them to UK-based firms carrying out collective portfolio management but not doing so under MiFID II, namely Undertakings for Collective Investment in Transferable Securities (UCITS) fund management companies, full-scope alternative investment fund managers (AIFMs), most sub-threshold UK AIFMs, and residual collective investment scheme (CIS) operators. The FCA’s July policy statement confirms that approach despite concerns that UK-based fund managers may be disadvantaged and made less competitive than other EU member states that decline to follow suit, perhaps motivated by Brexit and a desire to win business from the UK.
However, in a move welcome to the private equity, venture capital, and real estate industries, FCA decided to exempt alternative investment funds whose core investment policy does not generally involve investing in financial instruments that can be registered in the books of a custodian (or delivered to one) or that generally invest in listed or non-listed issuers to acquire control over them. The British Private Equity and Venture Capital Association was successful in its representations that applying inducements rules to such firms was beyond MiFID II’s intended scope and could adversely impact market standard arrangements for due diligence payments.
Research payment accounts (RPAs) and funding models
The FCA has decided to amend its proposed guidance on the timing of transfers of deducted research charges. Charges must now be transferred to the RPA without “undue delay” but no later than within 30 calendar days of the relevant transaction.
The July policy statement also clarifies that portfolio managers may use a “virtual” RPA with multiple underlying RPAs, provided that each individual RPA is sufficiently protected in accordance with the rules.
Mixed funding models (such as the use of RPAs and payment out of the manager’s P&L) are permissible. However, firms will need to ensure that the use of differing methodologies does not create conflicts of interest.
Execution services cover certain related activities
The FCA treats certain activities as being part and parcel of the provision of execution services by brokers in return for execution fees, rather than a separate “benefit” to the manager that would be subject to the inducement rules. The July policy statement indicates that taking trades on risk, structuring a series of derivatives transactions, and working large orders would form part of the execution service.
Minor non-monetary benefits
Two new examples of potentially acceptable minor non-monetary benefits have been added:
- Free, short-term research trial periods (no longer than three months and subject to other conditions)
- Connected research in the context of a primary market capital raising
FCA also has confirmed that sell-side brokers will not be required to price execution and research services separately to non-European Economic Area (EEA) firms, but this obligation applies when providing execution services to all MiFID investment firms (and collective portfolio managers)—regardless of what activities they conduct. In practice, UK brokers will thereby be able to continue any existing “soft commission” arrangements in place with non-EEA managers.
FCA acknowledges the issues presented by the interaction between MiFID II and US regulation and, in particular, whether US broker-dealers will be willing to accept separate “hard cash” payments for research (due to the implications of the US Investment Advisers Act of 1940). Equally, FCA notes the European Securities and Markets Authority guidance that no exemption from the MiFID II inducements rules is available where EU managers obtain their asset research from providers in non-EU jurisdictions. However, FCA does not address the topic in substance—preferring instead to wait on a US solution.
Furthermore (and disappointingly), the July policy statement is silent on (1) the approaches that may be adopted in the context of global asset management groups where research consumed by a UK manager is sourced through its non-EU affiliate, and (2) how the MiFID II research payment regime is intended to apply in the context of a UK manager delegating some of its investment management functions to a non-EU firm.
Its consultation process would have left FCA well aware of the practical significance of these issues. In addition, the global trade association and representative for the alternative investment industry, the Alternative Investment Management Association or AIMA, made a key intervention in writing to FCA in April 2017 for a steer. In a letter since made public, FCA replied in June with some constructive views in a letter since made public. The letter was positive on the limited issues that it addressed, at least, as compared to the prospect of the FCA requiring full MIFID II compliance when there has been a contractual delegation. The guidance likely fell short in the eyes of much of the industry. The FCA did give clarity in an area which was becoming fraught with uncertainty in the lead up to the MIFID II go live date of 3 January 2018. The FCA did make clear that FCA regulated UK asset managers delegating day to day asset management functions to non-EU (eg US) delegates would not be able to address compliance with their obligations under the new MIFID II payment for research regime by mere disclosure or oversight of delegate’s compliance with its own local regulatory regime governing the purchase of research with client commissions.
However, the FCA also made clear that that UK delegators could stop short of seeking to impose contractually full fat MIFID II payment for research compliance on the non-EU delegate. Instead, UK delegators may rely on a concept of the UK delegator securing for its client “substantively equivalent outcomes as they would expect to receive based on the relevant investor protection provisions in MIFID II. So, say US managers could continue to purchase research in compliance with US norms, but then voluntarily overlay the various range of budgeting and evaluation techniques as mapped across from MIFID II. This should enable a US delegate to persist with a modified commission sharing agreement, or CSA, model, which has become prevalent in the US market. Alternatively, FCA makes clear that the UK delegator could simply step in and pay for the research received by its non-EU delegate so as to “unequivocally” ensure that it complies with the MIFID II payment for research regime. Given the number of UK houses that are opting to pay for research out of their own resources, this suggestion is not as outlandish as it might appear.
It would be overstating the case to say FCA has provided asset managers with a “get-out” clause, as cross-border effects of MIFID II remain difficult and confused, but true to say FCA has been reasonably helpful in its guidance on the narrow issue of delegation. Given the reality of MIFID II and the obligations it imposes on EU asset managers to discharge their obligations under MIFID II even where delegating away, the FCA guidance provides a valuable tool to those seeking to harmonize MIFID II requirements with current US law. There are plenty of other areas remaining where harmonisation with US law would benefit from positive FCA guidance.
Unexpectedly, FCA has rowed back on its proposal to apply the enhanced best execution regime under MiFID II to investment managers not covered by MiFID II, i.e., to full-scope UK AIFMs, FCA authorised sub-threshold UK AIFMs, and residual fund operators. As a result, such investment managers will not be required to publish data relating to their top five execution venues or brokers on an annual basis and will remain subject to the existing best execution standard under the Alternative Investment Fund Managers Directive.
MiFID II best execution rules will be extended to UCITS management companies, with minor modifications to tailor these requirements for the provision of collective portfolio management services.
FCA has decided to water down its original proposals which would have made it more difficult for UK investment firms to classify certain local authorities as professional clients rather than retail clients. The revised criteria have a lower threshold for the size of portfolio that a local authority has to have.
FCA confirms that the existing exemption for investment managers from telephone taping requirements will be removed. As a result, all UK managers will become subject to MiFID II telephone taping requirements, which require recording of telephone conversations and electronic communications relating to all actual or intended transactions.
The FCA has clarified that the focus of this regime is on the transactional side of portfolio management. The taping requirements only will cover calls either directly related to the conclusion of a transaction or intended to result in a transaction.
FCA also has rowed back on their proposal to gold-plate the scope of the taping obligation by extending it to all aspects of corporate finance business—even those aspects not strictly covered by MiFID II’s scope (e.g., corporate finance advice and underwriting). As a result, regarding corporate finance, the taping obligation will apply to communications occurring during corporate finance business which involves providing client services relating to the reception, transmission, or execution of client orders, or when dealing on an account.