The ECON Report on the proposal for an EU Retail Investment Strategy

I. New rules for inducements

1. No prohibition of receiving inducements for non-advised order execution services

The Commission had suggested that investment firms should no longer be allowed to receive any inducements where it does not provide investment advice prior to the execution of an order. The Commission claimed that such prohibition would be necessary to avoid conflicts of interests detrimental to the investors. 

ECON, following a scathing critique by the Rapporteur, dropped this proposal, so that, in case of “execution-only” services, inducements can continue to be received. 

2. Abolition of Art. 24 para. 9 MiFID II Level I

Presently the provision or acceptance of inducements is permitted only if such inducements are disclosed to the client, do not prevent the firm offering or receiving such inducement to act in the best interest of the client and are designed to enhance the investment service. 

Ever since these criteria were introduced, it was clear that in particular the “designed to enhance” criterion was almost impossible to fulfil, and different Member State competent authorities (NCAs) have developed widely different views on how this criterion needs to be interpreted and applied, despite the European Securities and Markets Authority’s (ESMA) best efforts to ensure uniform application. 

Now, ECON, in line with the original proposal submitted by the Commission, acknowledges that the “designed to enhance” criterion has not achieved its investor protection purpose and suggests abolishing it. In its place will be stricter rules regarding the provision of investment advice, in particular by introducing a requirement to base financial advice on an appropriate range of financial products (see Section III for further details).

This will be welcome news in particular to online brokers who had some difficulties in justifying the receipt of inducements as they could not always demonstrate how this was designed to enhance the quality of their investment services.

3. Acceptance and retention of inducements by independent advisers and portfolio managers

Art. 24 paras. 7 and 8 of MiFID II presently forbid independent investment advisers and portfolio managers from accepting and retaining inducements. This allows them to receive inducements, provided such inducements are paid on to, for example, the investor. An investment firm that distributes investment funds through various sales channels (advised, non-advised, portfolio management) can thus receive retrocession fees from a management company for all of its assets under custody but pay on to investors the parts relating to independent investment advice and / or portfolio management. 

Now, ECON proposes that independent investment advisers shall not be allowed to accept or retain inducements (cf. Art. 24 para. 7 MiFID II), whereas a portfolio manager shall, according to Art. 24a MiFID II be allowed to accept such inducements if it does not retain them. One should hope that this discrepancy, for which no rational explanation can be found, will be amended in the final legislative text.  

4. More liberal rules on investment research

Ever since investment research received by an investment firm from a brokerage firm was explicitly declared to be an inducement, and since Art. 13 of Commission Delegated Directive (EU) 2017/593 of 7 April 2016 changed the regime for receiving such inducement, industry participants have declared such regime as non-practical and lobbied for its abolition. This is now going to happen if the EP-Position is adopted. 

Instead of having to agree on a research payment account with its client, an investment firm can, under the new Article 24a para. 6 MiFID II, opt for a system that requires it to take three steps:

Step 1: An agreement has to be entered into between the investment firm and the third-party provider of research and execution services, establishing a methodology for remuneration, including how the total cost of research is generally taken into account when establishing the total charges for investment services.

Step 2: The investment firm makes available to its clients its policy on separate or joint payments, as the case may be, for execution services and third-party research, as well as information on how the investment firm prevents or manages conflicts of interest when providing joint payments for execution services and research.

Step 3: On an annual basis, the investment firm assesses the quality of the research used, enabling it to make better investment decisions.

This proposal is clearly a step in the right direction and should make it easier for small asset managers that do not have large inhouse legal departments, to obtain valuable research for their portfolio management teams.

II. Product governance requirements for manufacturers and distributors

The Omnibus Directive implementing the Retail Investment Strategy not only amends MiFID II (cf. 1 and 2 below), but also the Alternative Investment Fund Managers Directive (AIFMD) and the UCITS Directive (cf. 3. below) with respect to product governance requirements. 

1. New MiFID II requirements for investment firms manufacturing financial instruments

a) Extension of product governance obligations

Art. 16 para. 3 sub-paras. 2-7 MiFID II contain relatively high-level requirements for investment firms that manufacture, as issuer or co-manufacturer of other issuers, financial instruments.

Now, ECON, in line with the Commission’s proposal, wishes to abolish these rules and see them replaced by a comprehensive new product manufacturing regime in Art. 16a MiFID II. This new regime implements some of the requirements so far contained in ESMA guidelines, only², but goes far beyond such requirements.

In particular, the product approval process for packaged retail and insurance-based investment products (PRIIPs) shall contain 

“a clear assessment and description of both quantitative and qualitative features of the financial product, including:

i) all costs and charges related to the financial instrument,

ii) whether those costs and charges are justified and proportionate, having regard to the target market’s objectives and needs, and the product’s characteristics, objectives, strategy and performance (‘pricing process’),

iii) additional product features and services that could impact the value and benefits provided to investors”

While the costs of a financial product already play a limited role under the ESMA guidelines, they will be essential elements of the manufacturer’s analysis and need to be justified: 

“The product approval process shall ensure that the investment firm takes the clients’ best interest into consideration in the manufacturing of the financial instruments and takes into account the intended monetary and non-monetary benefits to the customer.”

The investment firm that manufactures PRIIPs must conduct a peer review of its products with those of its competitors, but it remains unclear how large the control group has to be:

“An investment firm which manufactures financial instruments shall in addition perform a peer analysis of historical performance when performing a product review of packaged retail investment products as defined in Article 4, point (1), of Regulation (EU) No 1286/2014.

An investment firm that offers or recommends financial instruments shall in addition perform a peer analysis of service costs based on an internal analysis of relevant peers in the market. (…)

An investment firm shall document all assessments made and shall, upon request, provide such assessments to a relevant competent authority, including the justification and demonstration of the proportionality of costs and charges of the financial instrument.”

Finally, the investment firm must make available detailed information about costs and charges as well the performance (presumably both historical and projected performance) not only to the NCAs, but also to distributors of its products. The latter shall also receive detailed information about other “features, objectives and strategy” of the financial product. 

b) Benchmarking

Based on information from product manufacturers (both MiFID firms and fund management companies), ESMA shall establish benchmarks for the costs and benefits of financial products.

The benchmark concept was already included in the Commission’s proposal. The Rapporteur was very sceptical that ESMA would be in a position to establish such benchmarks and suggested to first require a proof of concept before including benchmarking provisions in the text of the Omnibus Directive. 

However, ECON seems to think that ESMA may be able to deliver meaningful benchmarks that assist the objective that investment products should offer value for money. ECON stresses that benchmarks should not lead to price regulation, but

“should allow for better supervision of the products on the market, with the aim to identify potential outliers and ensure the rectification for the benefit of customers and clients.”

c) Assessment

The importance of these changes for the product governance process cannot be over-emphasized.

Manufacturers will be obliged to justify all implicit and explicit costs which investors in a financial product have to bear. To conduct the peer group review, they have to obtain information from their competitors which at least for now are not all in the public domain. They must provide their distributors with information that is much more detailed than is presently the case. And finally, they operate under the spectre that ESMA intervenes as it considers the manufacturer’s product as not providing sufficient value for money, according to its benchmarks. 

As if all this were not difficult enough, ESMA will, for investment products, not disclose the benchmarks against which the financial instruments will be compared: 

“ESMA and EIOPA should, after consulting the national competent authorities and on the basis of industry testing, develop common European benchmarks for products manufactured and distributed in more than one Member State. The benchmarks should be used solely by national competent authorities as a supervisory tool to perform the assessment of the qualitative and quantitative features of the products and to identify potential outliers on the market. As a supervisory tool, those benchmarks should not be disclosed publicly and should take into account the qualitative and quantitative features of financial instruments and insurance-based investment products. However, in order to ensure that the supervisory process is transparent and to facilitate insurance manufacturers’ value-for-money assessment, national competent authorities are allowed to share with insurance manufacturers and distributors the relevant benchmarks for that market.” (Recital 13)

Why the manufacturers of insurance products shall know in advance which benchmarks are relevant for them, but manufacturers of financial products will be kept in the dark, is difficult to understand. One would hope that if the benchmark concept is maintained, there will be a level playing field for all manufacturers and distributors of financial products.

2. New MiFID II product governance requirements for investment firms distributing financial instruments

a) Extended obligations of distributors

The new Article 16a paras. 4 and 4a MiFID II of the EP-Position provides for significant new obligations of MiFID investment firms that distribute financial instruments: 

“An investment firm that offers or recommends financial instruments shall regularly review them, taking into account any event or risk that could materially affect the identified target market, to assess whether the financial instrument remains consistent with the objectives and needs of the identified target market and whether the monetary and non-monetary benefits are still relevant for the identified target market and reasonable compared to the costs and charges. The firm shall also consider whether the intended distribution strategy remains appropriate” (…)

The above requirement to analyse, compare and evaluate costs at product level applies not only in case the investment firm provides investment advice, but also to non-advised offerings of financial products and even its execution-only business:

“Where an investment firm manufactures or distributes financial instruments falling under the definition of packaged retail investment products in Article 4, point (1), of Regulation (EU) No 1286/2014, it shall perform a peer grouping analysis (…). “

However, 

“In their assessment, distributors may rely on the manufacturer’s peer grouping analysis.”

ECON is not only concerned about excessive product costs, but also service costs of the distributor. In the future, an investment firm that offers PRIIPS (but not plain vanilla shares or bonds), shall:

“assess whether the total costs and charges incurred for the distribution of the product, including those associated with the investment advice provided to the client, are justified and proportionate, having regard to the characteristics of the instrument, to the service provided and the target market’s objectives and needs (pricing process).”

All of the assessments made by the investment firm in its role as distributor of financial products shall be documented and made available, upon request, to its NCA, which can forward such information to ESMA. 

b) Assessment

The impact of these new rules is best demonstrated if one takes the example of a firm that offers shares of several thousand investment funds and several thousand warrants / certificates to its retail investors via the internet. 

For each of these instruments, the investment firm must obtain information about implicit and explicit costs charged at product level and ensure that a peer review has taken place at manufacturer level. 

As regards its own costs, it shall also evaluate whether such costs are justified and proportionate compared to what its competitors are charging for similar services. At a time where “zero-cost brokers” are winning market share, this will inevitably impact the revenues of the more traditional online brokers.

This reduction of revenues, in an already highly competitive market, is exactly what the Commission and ECON want, and ESMA will execute this objective:

“ESMA shall, by ... [12 months after the entry into force of the amending Directive], develop guidelines to specify criteria to determine whether costs and charges are justified and proportionate, and it shall periodically update those guidelines.”

3. New product governance requirements for UCITS and AIF management companies

According to Recital 20 of the Omnibus Directive: 

“The pricing process under Directives 2009/65/EC and 2011/61/EU should ensure that costs borne by retail investors are justified and proportionate in the context of the overall value delivered to unit -holders and having regard to the characteristics of the product, and in particular to the investment objective, policy and strategy, level of risk and expected returns of the funds, so that UCITS and AIFs deliver value for money to investors.”

Again, just like MiFID investment firms, management companies shall conduct a peer review:

“UCITS and AIFs management companies should remain responsible for the quality of their pricing process. In particular, they should ensure that costs are comparable to similar market products, including by comparing the costs of funds with similar characteristics in terms of investment strategies, objectives, level of risk and other characteristics.” 

Art. 14 para. 1b UCITS-D as well as Art. 12 para. 1b AIFMD in the revised version of the Omnibus Directive requires that costs borne by retail investors are justified and proportionate. The criteria used to judge whether this is the case are manifold, and they include:

“investment objective, strategy, expected returns, level of risks and other relevant characteristics”

In the case of UCITS, also the investment policy must be taken into account. 

There are several problems that fund managers need to overcome when trying to comply with these requirements:

Firstly, the terms “investment objective”, investment strategy” and “investment policy” are not clearly defined, and managers interpret them differently, which makes a comparison difficult. 

Secondly, what conclusion does one draw, as to the proportionality of costs, e.g. from different investment strategies: suppose Manager 1 pursues a global equity strategy, the fund is denominated in USD and it is unhedged. Manager 2 pursues an APAC equity strategy; the fund strategy provides for a hedging of local currency risk into USD. Which manager “deserves” a higher remuneration? 

If the unhedged strategy performs better, as the manager reaped the benefits of currencies appreciating against the USD and did not have to bear hedging costs, does this in hindsight justify higher costs? This last question is not only academic, as:

“Member States shall require management companies to assess annually whether undue costs have been charged to the UCITS or its unit-holders.³”

and

“Member States shall require management companies to reimburse investors¸ without undue delay, where undue costs have been charged to the UCITS or its unit-holders, or where costs have been miscalculated to the detriment of the UCITS or its unit-holders.”

In the case of funds with a track record, shall past performance be an indication of future performance, contrary to typical disclaimers in marketing information? Shall the fund manager therefore be allowed to charge more if the fund performed well in the past?

What if a strategy did not pay off in Year 1, so that lower costs would have been appropriate, but then in Year 2 and later, the performance markedly improves?

Similar questions arise with respect to other criteria, such as the level of risk. Does a higher level of risk justify higher costs or lower costs? Should it not be the risk-return-profile that counts, so that fund managers that construct the most efficient portfolios are rewarded? But if so, how do you take into account that no fund and thus no fund manager is protected against unforeseeable macro-events such as Covid-19 or war in Ukraine? Should a fund manager be “punished” because it did not foresee these events, which have cost it already heavily in terms of loss of assets under management? 

All of this leaves ECON unfazed. It wants an ex-ante and ex-post justification of fees, and if the fees are ex-post not justifiable, it wants fund managers to establish:

“a procedure to determine the level of compensation in case undue costs have been charged to investors; establishing a procedure which will be triggered when the amount unduly charged is material and exceeds a threshold to be determined on the basis of existing guidelines from national competent authorities on indemnification procedures⁴”

This in itself is quite a daunting exercise considering that for instance Germany has been unable to establish a compensation procedure in line with UCITS requirements since 2011! The problems that have dogged the establishment of such a procedure for the erroneous calculation of the NAV per share will be even bigger for costs that were supposedly excessive, in hindsight.

III. New requirements for non-advised services and investment advice

1. Non-advised services

Investment firms can under MiFID II decide to distribute PRIIPS on an execution-only basis. Only in the case of so-called “complex financial instruments” they have to conduct an appropriateness test. This test shall establish whether the investor has the right level of knowledge and experience to understand the risk associated with an investment. If the investor, despite lacking for instance experience, still wishes to go ahead with the transaction, it can overrule the firm that conducted the appropriateness test and have his transaction executed. 

If a client wants a more comprehensive assessment as to whether he or she should invest in a product, for example taking into account the risk tolerance or financial objectives, it can always ask for investment advice, be it from another firm. 

Now, this “third way” (between execution-only and investment advice) shall be fundamentally changed, at least according to Recital 35:

“To ensure that appropriateness tests enable investment firms, insurance undertakings and insurance intermediaries to effectively assess if a financial product or service is appropriate for their clients and customers, those firms, insurance undertakings and insurance intermediaries should obtain from them information not only about their knowledge and experience on such financial instruments or services, but for retail clients or customers also about their capacity to bear full or partial losses, their risk tolerance, investment needs and objectives, including sustainability preferences. In the case of a negative appropriateness assessment, an investment firm, insurance undertaking or insurance intermediary distributor should, in addition to the obligation to provide a warning to the client or customer, only be allowed to proceed with the transaction where the client or customer concerned explicitly request so.”

Interestingly, while the Omnibus Directive picks up on the above point with respect to the distribution of insurance products, the amended MiFID II provisions do not provide for a change of the appropriateness test – and this is most welcome given that there is absolutely no need to fix a system that is not broken in a way that blurs the line between non-advised and advised services.

2. Investment Advice

a) Duty to recommend the “most efficient product”

As mentioned in I. above, the criteria for accepting inducements shall, according to ECON, be significantly revised. ECON correctly understands, however, that inducements play a large role when investment firms decide which products they recommend to their clients in the context of providing investment advice. Thus, investment advisors shall operate under a new regime proposed in Art. 24 para. 1a MiFID II, and they shall be obliged to

(a) inform the client of the range of financial instruments assessed by the investment firm, and to provide advice on the basis of an assessment of an appropriate range of financial instruments suited to the client’s needs, whereby the range of financial instruments is adapted to the business model of the investment firm;

(b) recommend the most efficient financial instruments among financial instruments identified as suitable to the client pursuant to Article 25(2) and offering similar features, taking into consideration its performance, level of risk, qualitative elements, costs and charges reported pursuant to Article 16-a, and, if an equivalent product with higher costs is recommended, to justify this on objective grounds and keep records of that justification;

These requirements lead to some interesting questions. For example:

When the “range of financial instruments [can be] adapted to the business model of the investment firm”, does this mean that a firm could for, instance, exclude ETFs from its product range? When a firm wishes to recommend a European large cap equity fund, does the range of financial products it has to assess have to comprise all of such products on offer in the respective market? 

Staying for a moment with the example of European equity funds, what “qualitative elements” could it have other than its risk-return profile? Shall the investment firm be allowed to refer to past performance as a criterion that justifies higher costs? 

b) Special rules for independent advisors

“Independent” investment advisers that are subject to an inducement ban are subject to another regime:

“Where investment firms are subject to an inducement ban, the conditions of this Article shall be presumed to be fulfilled. The national competent authority may reverse this presumption if an investment firm does not comply with the provisions in this Article.”

ESMA may organise and conduct a mandatory peer review in cooperation with national competent authorities regarding the implementation of the obligations described in this Article.”

What this means in practice is unclear and it would be well worth following the drafting in case it evolves over the summer. On a literal interpretation the wording adopted by the EP-Position seems to suggest that investment firms subject to an inducement ban may be forced by their NCA to comply with the requirements of Article 24 MiFID II even though they are not operating under a conflict of interest. Whether an ESMA mandatory peer review shines a further light into all of this remains to be seen but such review will take time and there may be some uncertainty for firms in the short time.

c) No general duty to analyse diversification of investor portfolio

One of the most heavily criticised proposals of the Commission’s original proposal was the requirement for an investment adviser to take into account the diversification of the investor’s overall portfolio, whether kept with the adviser or with another firm. 

ECON thankfully clarified that this obligation only exists where the investment firm expressly asks for information about the investor’s assets and if the investor provides such information.

d) Training requirements for financial advisors

ECON agrees with the Commission’s assessment that financial advisers providing investment advice to retail clients are often not sufficiently trained and thus proposes the introduction of a uniform new training regime to be rolled out in the EU in Art. 24d MiFID II:

“Member States shall require investment firms to ensure and demonstrate to competent authorities on request that natural persons giving investment advice to clients on behalf of the investment firm possess and maintain at least the knowledge and competence set out in Annex V and undertake at least 15 hours of professional training and development per year, during work hours. Member States shall have in place and publish mechanisms to control effectively and assess the knowledge and competence of natural persons giving investment advice to clients on behalf of investment firms. (…) Member States may require that compliance with the criteria set out in Annex V as well as the yearly successful completion of the continuous professional training and development shall be proven by a certificate or any other document recognised by the Union or a Member State.”

e) Assessment

The EP-Position leaves a number of important questions open and would benefit from the deletion of some “fuzzy” expressions (cf. “qualitative elements”) that make the daily implementation at the investment firm level easier and more uniform.

IV. Miscellaneous proposals

1. Information on costs and charges

Delegated Regulation (EU) 2017/565 contains detailed rules on how investment firms must disclose to their investors, ex ante, costs and charges levied at product level and for their services. 

Now, ECON proposes some additional requirements in a new Article 24b MiFID II, some of which will be challenging to implement. For instance: 

“The third-party payments paid or received by the investment firm in connection with the investment service provided to the client shall be itemised separately. The investment firm shall disclose the cumulative impact of such third-party payments, including any recurring third-party payments, on the net return over the holding period as mentioned in the preceding subparagraph. The purpose of the third-party payments and their impact on the net return shall be explained in a standardised way and in a comprehensible language for a retail client.”

It is not immediately obvious which benefit an itemised(!) ex ante breakdown of inducements paid and received has for the investor. Also, it remains to be seen whether the technical advice that ESMA will be required to provide on the format and terminology required for ex ante cost disclosure is more helpful than its last attempt, which led to significant legal uncertainty.

2. Record-keeping of marketing materials

Art. 24c MiFID II on marketing communication on practices shows what happens when a legislator tries to impose new rules without giving any thought to their practical consequences and the principle of proportionality. 

Para. 7 of said Article provides that records shall be kept of all marketing communications provided or made accessible to (potential) retail clients, by either the investment firm or a third party acting on its behalf. 

The records shall be retained “for at least the duration of the relationship between the investment firm and the customer” – i.e. practically forever, as the firm will never know which of its clients has actually been exposed to which marketing material. 

The record shall contain all of:

(a) the content of the marketing communication;

(b) details about the medium used for the marketing communication;

(c) the date and duration of the marketing communication including relevant starting and end times;

(d) the targeted retail client segments or profiling determinants;

(e) the Member States where the marketing communication is made available;

(f) the identity of any third party involved in the dissemination of the marketing communication.

Imagine a fund supermarket that sells third party investment funds online and through its B2B2C distributors, each of which uses hundreds or thousands of so-called “independent financial advisors” (IFAs). 

For each of those IFAs, the EP-Position requires that their legal names, registered addresses, contact details etc. shall be recorded, in perpetuity, if they use marketing materials provided by the investment firm. At least ECON does not yet require that the relevant information shall be kept up to date – but this in turn makes such records completely worthless after a few years.

V. Overall assessment and looking ahead

The head of the German financial services regulator BaFin, in a widely observed interview, recently asked for “simpler and more proportionate regulation⁵” . The EP-Position does certainly not simplify the work of investment firms and asset managers. 

Hopefully, the summer break will be used by the parties of the trilogue to amend some of the shortcomings, in particular where the benefits for investors are either non-existent or very small compared to the additional workload of the affected firms.

The final text of the Omnibus Directive is expected to be released in Q1 of 2025. Until such time, a lot of work remains to be done.