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

Sell-side pricing

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.

Global implications

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.

Best Execution

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.

Client Categorisation

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.

Telephone Taping

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.

By Shannett Thompson

Williams and Solicitors Regulation Authority [2017] EWHC 1478 (Admin)

Overview

Mr Peter Williams (the Applicant), a former solicitor, lodged an appeal against the findings of misconduct against him by a Tribunal of the Solicitors Disciplinary Tribunal (SDT). In short, the issues were in respect of representations made by the Applicant which were alleged to amount to dishonesty or a want of integrity.

Background to the representations

The referral to the Solicitors Regulation Authority (SRA) about the Applicant had been made by Wilson Solicitors LLP (Wilsons), whom in the course of reviewing the Applicant’s files noted concerns. It is of note that the report made by Wilsons was done in the course of court proceedings involving an Involuntary Notice of Retirement which was acrimonious. The crux of the report made by Wilsons to the SRA was that the Applicant had planned and sought to implement a scheme to defraud the client’s creditors, and in this attempt, misled, or cause his client to mislead, third parties.

The client for whom the Applicant was acting was made bankrupt in April 2009, which was discharged in April 2011. The client owned a property which was mortgaged by Northern Rock Asset Management PLC (NR). The mortgage debt was in the region of £2.9 to £3m. A gentleman known to the client, JD, was presented to the Applicant as being interested in purchasing the property for the sum of £3.9m. The Applicant met JD for the first time on 18 February 2010, but he decided not to act, informing the client of this in a letter dated 2 March 2010. It is of note that the Applicant was concerned with the role he was being asked to play; essentially to negotiate with NR to achieve the lowest price for the property, although he had knowledge that a higher price was already available.

The client returned to the Applicant in April 2011, and at a meeting on 27 April 2011, the client instructed the Applicant to act in relation to a proposed transaction involving the purchase of the property from, or with the agreement of, NR, at a price consistent with the market value. The client had a connection with the purchasing entity, and therefore hoped to profit from the sale of the property to JD. The Applicant advised that he was prepared to act if:

• The purchase from NR was at market value;
• The client obtained a proper valuation which would be disclosed to NR;
• The connection between the client and JD was disclosed; and
• JD instructed an independent solicitor (which was duly done).

On 16 June 2011, the Applicant obtained an open market valuation of the property to the sum of £2.3m. On 22 June 2011, the Applicant advised NR of his client’s connection with JD, and that “our client will seek to negotiate with the Purchaser in order to try to obtain an increase in the offer, ideally to £2.3 million”. A written report confirming the valuation was provided by the company instructed by the Applicant on 26 July 2011. NR responded on 13 July 2011 to the effect that it would not be prepared to sell unless the price was fully supported by independent valuation evidence due to the connection between the client and JD. Following this, NR obtained two valuations, and agreed to the sale of the property for £2.2m.

On 16 August 2011, during a telephone conversation, the Applicant advised NR that he was “engaged in the process of trying to get a firm increased offer”. On 1 November 2011, the Applicant advised NR that the offer of £2.2m had not been made by the client, it was an offer made to the client by a prospective purchaser.  On 9 November 2011, NR wrote to the Applicant agreeing to sell the property at £2.2m; however the sale did not proceed despite various communications.

On 8 March 2012, the Applicant wrote to two banks, in the same terms as mentioned above, regarding the possibility of a loan to the purchaser. The Applicant stated that his firm acted for the purchaser.

On 13 April 2012, the Applicant sent a letter to the solicitors acting for the client’s trustee in bankruptcy stating that the client did not have a valuation of the property for £3.9m. In November 2013, an order was made authorising the sale of the property at £2.25m, and the sale was finally made by NR to a third party for £2.4m in July 2014.

Regulatory proceedings

The SRA served a statement in accordance with Rule 5(2) of the Solicitors (Disciplinary Proceedings) Rules 2007 on 22 August 2015; this statement did not include dishonesty. An amended statement was served on 1 December 2015 which included dishonesty by the Applicant, and also that he had deceived the court at a possession hearing on 22 September 2011. This allegation rested on statements made by the Applicant to the effect that there was negative equity in the property in respect of which NR had obtained a valuation confirming the market value at £2.2m.

The SRA’s case, up until closing submissions, included an allegation that the Applicant had lied about the value of the property. The SRA withdrew its case in this respect, and the Tribunal ordered the SRA to re-amend the Rule 5 statement.

The Tribunal found that the Applicant had made the following false representations:

“i) The £3.9m representation: [the Applicant] had acted dishonestly, failed to act with integrity, failed to behave in a way that maintained the trust the public placed in him and the provision of legal services and took unfair advantage of third parties in his professional capacity;

ii) The F Ltd representations: [the Applicant] had failed to act with integrity and failed to behave in a way that maintained the trust the public placed in him and the provision of legal services; and

iii) The negotiation representations: [the Applicant] had failed to act with integrity and failed to behave in a way that maintained the trust the public placed in him and the provision of legal services” (para 35).

The Tribunal found all of the representations demonstrated a “manifest” lack of integrity. As to dishonesty, the Tribunal took account of the test in Twinsectra Ltd v Yardley and others [2002] UKHL 12; [2002] 2 AC 164. The Tribunal found the £3.9m representation to be both objectively and subjectively dishonest.

Appeal

The material appeal points were that the Rule 5 statement was deficient, the allegations underlying the findings on the £3.9m and the F Ltd representations were not put to him and that “each finding was in any event irrational, perverse, unsupported by the evidence given before the Tribunal and inadequately analysed and considered by the Tribunal” (para 45).

The appeal in relation to the F Ltd representations was not opposed by the SRA on the basis that they were not pleaded as any part of the SRA’s case.

As to dishonesty versus want of integrity, the court noted that the SRA was seeking permission to appeal Malins v SRA [2017] EWHC 835 (Admin); [2017] 4 WLR 85 (as well as the permission already granted in SRA v Wingate and Evans). By way of background, In Newell-Austin v SRA [2017] EWHC 411 (Admin), Morris J opined that dishonesty and integrity were mutually distinct concepts; specifically that lack of integrity does not require conscious transgression. Our previous blog on this case can be accessed here. In Malins, Mostyn J concluded that the two concepts are synonymous stating:

“It is elementary, and supported by abundant authority, that if you are accused of dishonesty, then that must be spelt out against you with pitiless clarity. In my judgment, you cannot circumvent this obligation by pleading the same facts and matters as want of integrity. We do not have in our system dishonesty in the first degree and dishonesty in the second degree.”

As to the comments by Mostyn J, Sir Brian Leveson stated as follows:

“…..I ought to make it clear that, in the absence of compelling justification, I would reject Mostyn J’s description of the concept of want of integrity as second degree dishonesty. Honesty, i.e. a lack of dishonesty, is a base standard which society requires everyone to meet. Professional standards, however, rightly impose on those who aspire to them a higher obligation to demonstrate integrity in all of their work. There is a real difference between them” (para 130)

Having noted the potential appeals, the court proceeded on the basis that in respect of solicitors’ regulation, the concepts of dishonesty and want of integrity are “separate and distinct”, in that want of integrity “does not require the subjective element of conscious wrongdoing” thereby rejecting Mostyn J’s description in Malins.

The decision

In relation to the £3.9m representation, the court considered whether the Tribunal’s finding was one which was open to it on the basis of the SRA’s pleadings, and the hearing that followed.

The court commenced by considering the Rule 5 statement. Considering paragraphs 82 to 86 of the Rule 5 statement, the court stated: “On one view, the natural and proper reading is that each of paragraphs 83, 84 and 85 form part of the particulars of the first element of that cornerstone” (para 83) and on other view “a possible alternative reading of paragraphs 82 to 86 is that the allegations of deceitful misrepresentation were those set out in paragraph 85, and that there was no self-standing allegation of deceitful misrepresentation based on the letter of 13th April 2012 alone” (para 85).

The court noted that the Applicant was not cross-examined on the £3.9m representation, by reference to the documents leading up to it, or at all. Further, no mention was made of the representation in closing, although the letter of 13 April 2012 was referred to as “finely crafted”. Moreover, the Tribunal did not press the issue when the representation was described as “a very minor error” (para 91).

The court clarified that the key issue was whether the failure to cross-examine the Applicant in respect of the £3.9m representation, even though he had addressed the letter of 13 April 2012 at some length in his witness statement, was sufficiently unfair in all the circumstances. The key section of the judgement on this issue is at paragraph 95:

“There was ambiguity in the pleaded case. In all the circumstances, it was necessary for [the Applicant] to be challenged directly on the point so that his evidence could be tested properly before a finding of dishonesty could be made. The Tribunal could not fairly find him to be dishonest without the most careful consideration of what he said in his defence (as it was put by Lewison LJ, in Clydesdale Bank (supra) at [52])”.

In essence, the case was pleaded with some ambiguity, there was a failure to challenge evidence in cross-examination, there was no “meaningful reference” to the £3.9m representation in closing submissions, and that the combination of these matters rendered the Tribunal’s findings of dishonesty unfair. Notwithstanding, the court did not accept a submission by the Applicant that the entire judgement was “infected as a whole” (para 102). This was on the basis that the Tribunal carefully considered each of the allegations, deciding some of them in the Applicant’s favour. Whilst the Tribunal made a finding of dishonesty and two findings of want of integrity, these findings arose out of separate conduct, and therefore could not be considered to “infect” each other.

The appeal was therefore allowed on the basis that there had been serious procedural irregularity in relation to the finding of dishonesty on the £3.9m representation, and in relation to the finding of a want of integrity based on the F Ltd representations. The court invited the parties to make written representations as to how the appeal should proceed and as a means of resolving the outstanding issues.

Commentary

The first striking feature is that the case law in respect of dishonesty and a want of integrity remains unsettled. My colleague Iain Miller addressed the decision in Malins in a previous blog which you can access here. We will be keenly awaiting the decisions in Wingate and potentially Mailns as to dishonesty versus a want of integrity.

The decision in this case demonstrates the critical importance of clear and unambiguous pleadings. It also demonstrates that a failure to test each element of misconduct in cross examination and/or closing submissions can potentially lead to a decision on the facts which is unsustainable.

Website: www.kingsleynapley.co.uk