COMISSÃO DO MERCADO DE VALORES MOBILIÁRIOS (CMVM) NEED FOR A COHERENT APPROACH TO PRODUCT TRANSPARENCY "SUBSTITUTE" RETAIL INVESTMENT PRODUCTS?

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1 COMISSÃO DO MERCADO DE VALORES MOBILIÁRIOS (CMVM) ANSWER TO THE EUROPEAN COMMISSION CALL FOR EVIDENCE * NEED FOR A COHERENT APPROACH TO PRODUCT TRANSPARENCY AND DISTRIBUTION REQUIREMENTS FOR "SUBSTITUTE" RETAIL INVESTMENT PRODUCTS? * -1-

2 We welcome the opportunity to respond to the Commission s call for evidence on "substitute" retail investment products. The Portuguese Securities Market Commission, also known by its initials "CMVM, supervises and regulates securities and other financial instruments markets in Portugal, as well as the activity of all those who operate within said markets. The CMVM pursues the following main goals: protecting investors maintain efficient and regular functioning markets, control the quality of the information in order to preserve the market confidence and prevent and reduce financial crimes. As explained further below, the question of substitute products is an area that deserved great attention from the part of the CMVM and in which Portugal has adopted a pragmatic approach that could serve as an example that other supervisors could follow, while no structural intervention is implemented at the European level. GENERAL REMARKS The "substitute products" issue has become visible in the recent years as a consequence of the development of the range of investment products available to retail customers coincident with an increase of their complexity. The emergence of financial conglomerates as well contributed to the dissemination of the known "wrappers". The disappearing of the classical limits between different saving products (banking deposits, pension funds and financial instruments), was not accompanied by a regulatory response at EU level, who maintains a sectoral approach on product regulation as recognized in the summary of this call for evidence. This sectoral approach led, in the past, to dissimilar regimes applicable to equivalent products that are substitutable by reason of their characteristics (in terms of investment objectives, expected return and risk). The obvious example is the insurance contracts related to investment funds (unit-linked) and the UCITS. Simultaneously to the product regulation, the rules governing the products providers and distributors are also truly different (in terms of capital requirements, conduct of business rules, conflicts of interests, organizational requirements, etc). These differences could contribute to distort the competition between these entities while they are competing for the same market, since substitute products are also competing products. In this matter, the bottom line is for now if the firm is subject to the MiFID requirements. The main difficulty that derives from the lack of European harmonization in this field concerns the nature of maximum harmonization of certain Directives which can unduly constrain legislative interventions, even at domestic level. For instance, Article 34 of the Life Insurance Directive is the paradigm of a rule that generates negative interferences at the possible legislative responses concerning ex ante disclosure obligations of unit linked contracts. If we think back 15 or 20 years ago, the bank and insurance products are acknowledged as lower or risk-free products and financial instruments as risky products. This crucial differentiation is not -2-

3 anymore valid; nevertheless, the product regulation prepared considering this risk and complexity differences remains the same. We consider this situation unsustainable in the long run. Recognizing the current need to remove several regulatory and supervisory asymmetries between substitute products and also enhancing the coherence of the financial legal system, we took the opportunity of MiFID transposition to the Portuguese legal framework to supplement the Directives with national rules aiming at bringing distribution and marketing rules closer. These additional rules brought in particular the information and advertising requirements for unit-linked insurance contracts and open-ended pension funds with individual adhesion at the same level as those applying to UCITS and extend, in a limited way, the rules of know your customer and suitability requirements to the firms when they sold this products to retail clients. On a conclusion note, we wish to highlight that the issue of "substitute" retail investment products must be undertaken to deliver, at least, a full harmonisation at EU level on key investor information in order to promote a greater degree of comparability of this products and contribute, as much as possible, to investors understanding of them. We believe this could be achieved if the information provided to investors on each substitute product allows them to make informed and full comparisons (information understandable to them), before the subscription or acquisition of the product and during its lifetime. In some situations, if the complexity of the products makes difficult to provide understandable information to retail investors, general know your customer and suitability requirements could prove to be a solution. RESPONSES TO THE SPECIFIC QUESTIONS Question 1: Do you see that different regulatory treatment of substitute products gives rise to problems? Please explain why you consider this to be the case. Yes. Like we said on the general remarks, the differences between traditional insurance, banking and investment products in terms of financial risk for the investor, which were likely to justify different regulatory regimes historically, have almost completely disappeared. This lack of convergence between these different regulatory regimes supports the coexistence of some different levels of retail client protection and do not allow a fair competition between the products themselves and their providers or distributers. One of our concerns is the difference between retail distribution rules applicable to the substitute products. These differences could generate undesirable outcomes in the investor s protection regime and distort the competition, because they don't contribute to increase the comparability between the economic characteristics of these products. These differences are often related to the authorization process and other selling restrictions, marketing and advertising campaigns and the extent and -3-

4 structure of the information to be supplied to the investors. Due to these regulatory arbitrage consumers might take it for granted that products offering the same economic benefits are submitted to the same protection rules (in terms of information duties, conflicts of interests, suitability, etc), and feel abused when discovering this is not the case. The confusion is even greater when substitute products are sold through the same distribution channels. Definitely, there are no economic reasons for treating substitute investment products differently because it causes confusion in retail investors and affects their reliance on the markets and regulators. Otherwise, differential regimes in such circumstances run the risk of competitive distortion, because a different treatment of substitute products may create artificial markets and promote particular financial products affecting consumer perceptions. For example, if it is difficult investors made comparisons between substitute products or, due the different selling rules, the firm decide advertise only products with poor rules (with less costs of compliance), this might misrepresent the products that are available in the market and pervert the consumer's awareness. In a similar way the coexistence of distinct product rules leads to an excessive and apparent product differentiation, suggesting that similar products are different and cannot be compared. This kind of asymmetric information creates obstacles for the investor s best choices and contributes to distort the competition. Likewise, the absence of suitability and know your customers rules applicable to all the distributors of these products (and not only those subject to MiFID) do not ensure the protection of those investors that are more risk adverse and do not have experience and expertise in complex products. This also induces distortions in competition between products and distributors and it is currently the case with the MiFID rules that are not applicable to life insurance products and structured deposits are extremely difficult to cover with MiFID rules. Question 2: Do you regard the perceived concerns relating to different levels of product transparency and intermediary regulation as a threat to the further development of EU markets for retail investment products? x strongly agree somewhat agree no opinion somewhat disagree strongly disagree Question 3: Is it appropriate to regard different retail investment products as substitutable - regardless of the legal form in which they are placed on the market? Which of the products listed below should be considered as substitute investment products? - UCITS funds yes no -4-

5 - nationally regulated retail funds yes no - exchange traded or listed funds yes no - unit-linked life insurance (especially which mortality risk level is small or nil) yes no - retail tranches of structured notes yes no - some annuities; yes no - some bank term deposits (e.g. with embedded optionality or structured deposits) yes no - others (please list and describe) open-ended pension funds with individual adhesion yes no What are the features/functionalities (holding period, exposure to financial/other risk, capital protection, diversification) that lead you to regard them as interchangeable? Have you encountered any legal or other definition which would encompass the range of 'substitute investment products'? The definition of 'substitute investment products' comprises all those products which are perceived as interchangeable by the consumer, taking in account his investment objectives in terms of set-off between expected return, risk and holding period. Taking this into account, we can define a substitute investment product as product which gives essentially the same economic benefit for investors, under three conditions: (a) it assume the legal form of an already existing instrument but have certain characteristics which are not directly identifiable with that existing instrument, namely in terms of factors affecting its return and risk; (b) have his value dependent, fully or partially, on the performance of other underlying assets or financial instruments; and c) have the investor bearing the risk fully or partially. Question 4: Which factors in your opinion drive the promotion and sales of particular investment products? Please use the table below to rank these factors in terms of importance ( ; ; no opinion; in) for each of the different products. In addition to completing the table, we would welcome further explanation of your view as to which factors are particularly important for each product. UCITS funds Nonharmonised Unitlinked life insurance products Retail structured products Annuities (Structured) Term deposits Others -5-

6 Taxation in in in - in - Financial innovation - - Cultural preferences no opinion no opinion no opinion no opinion - - Distribution models - - Regulatory treatment (*) - - Others (*) The regulatory arbitrage between UCITS and Unit-linked life insurance products was recently reduced (please see our response to question 10 below). Question 5: Product disclosures: Do pre-contractual product disclosures provide enough information to help investors understand the cost and possible outcomes of the proposed investment? Please use the attached tables to provide your evaluation of the adequacy of the information provided with regard to the following items for each category of investment product. Nature of information provided UCITS Nonharmonised funds Unit-linked life insurance products Retail structured products Annuities (Structured) term deposits Others Product features Yes Yes Yes Yes - Yes - Direct costs Yes Yes Yes Yes - Yes - Indirect costs (or foregone Yes Yes Yes Yes - No - performance) Risks Yes Yes Yes partial information - partial information - -6-

7 Capital guarantee Likely performance Conflicts of interest Yes Yes Yes Yes - Yes - Yes Yes Yes Yes - No - Yes Yes No No - No - Compensation or fee Yes Yes No No - No - retrocession Question 6: Conduct of business rules: Do differences in conduct of business regulation result in tangible differences in the level of care that different types of intermediary (bank, insurance broker, investment advisor/firm) offer to their clients? For which conduct of business rules (know-your-customer, suitability, information/risk warnings) are differences the most pronounced and most likely to result in investor detriment? UCITS funds Nonharmonised Unitlinked life insurance products Retail structured products Annuities (Structured) Term deposits Others Know your customer Suitability or appropriateness X - X - X - X - Risk warnings X - X - Examples - information Others In our opinion, only the products covered in the MiFID scope provide a complete conduct of business regime. As a consequence, the same distributor is subject to ly different conduct of business rules depending on the product he is selling (for example, a MiFID or Insurance Mediation Directive -7-

8 product). In this issue we support the analysis made by the European Commission in the Call for Evidence Paper. Question 7: Conflicts of interest: Are there effective rules in place to ensure effective management/disclosure of conflicts of interest (and/or compensation arrangements) by the different categories of product originators and/or intermediaries for the different types of investment product? For which type of product do you see a regulatory gap in terms of the coverage of conflict of interest rules? Please explain According to the MiFID, investment firms (and credit institutions providing investment services) shall provide clients with appropriate information about the general nature and/or sources of conflicts of interest to the client, before undertaking business on its behalf, where organisational administrative arrangements made by the investment firm in accordance with the Directive to manage conflicts of interest are not sufficient to ensure, with reasonable confidence, that risks of damage to client interests will be prevented. Insurance intermediaries are not submitted to any obligation to adopt and disclose rules on the management of conflicts of interest. Question 8: unfair marketing / misleading advertising: Is the risk of unfair marketing / misleading advertising more pronounced for some product types than for others? If so, why? Can you point to concrete examples of the mis-selling of the different types of investment product resulting from unfair marketing / misleading advertising?" We believe that the major factor is the influence of the distribution channel taking in account the power of major distributors, especially banks, through advertising and marketing campaigns or instructions given to their sale-forces, to bring retail investors to choose massively the substitute product they decided to promote. But the risk of unfair marketing / misleading advertising could arise in result of differences in the regulatory regimes of the different products, because only for the UCITS is required an approval of marketing and advertising material by the competent authority. Question 9: Is a horizontal approach to product disclosures and/or to regulation of sale and distribution appropriate and proportionate to address the problems that you have identified? Can you specify how this objective of coherence between different frameworks would address the problems? What are the potential drawbacks of such an approach? -8-

9 We are favourable to a convergence between the different rules governing the sale and distribution of substitute products if this could deliver a greater degree of comparability between them before the subscription of the product and during its lifetime. One possible solution could be the obligation to provide to the retail clients key product information in standardized format and set specific rules to calculate the risks and return measures in order to increase the comparability among substitutable products. We also support the introduction of suitability and know your customer rules in order to increase the coherence of the investors' protection regimes. Question 10: Can market forces solve the problems that you identified (fully/partially)? Are there examples of successful self-regulatory initiatives in respect of investment disclosures or point of sale regulations? Are there any constraints to their effectiveness and/or enforceability? Are you aware of effective national approaches to tackle the issues identified in this call for evidence? Should it be left to national authorities to determine the best approach to tackling this problem in their jurisdiction? Is there a case for EU level involvement? Please explain. Differences between distribution rules applicable to the substitute products are recently recognized as a regulatory concern of the Portuguese financial legal system, with undesirable outcomes in the investor s protection and competition, because they didn t follow the trend to increase the comparability between the financial characteristics of these products 1. These differences are often related to authorization and selling restrictions, approval of marketing and advertising campaigns, extent and structure of the information to be supplied to the investors. 1 These are also European concerns. «As the debate on the European legislative framework for UCITS evolves, it will be important to consider the wider asset management landscape. UCITS compete with many other products for the private savings of European investors. Products, such as unit-linked life insurance or certain structured products, replicate some UCITS features. They are, however, subject to different regulatory or tax treatment and are sold through different sales processes. In some Member States such competing products enjoy wide acceptance. The Commission is concerned that this different regulatory treatment may distort investment decisions. It believes that it would be a retrograde step for investors if UCITS disclosures were scaled back as a result of regulatory competition». In Green paper on the enhancement of the EU framework for investment funds (SEC(2005) 947). -9-

10 The differences in the distribution rules applicable to substitute products are, in predominance, not a result of the dissimilar characteristics of the products (in terms of their risks and complexity), but a consequence of divergent approaches of the regulators in the past, alongside three different groups of saving products: financial instruments, bank deposits and insurance products. Historically, the bank and insurance products are acknowledged by retail investors as lower or risk-free products and financial instruments as risky products. One of the reasons for this confusion is because the banks and insurance companies are mainly risk takers and capital markets are identified with risk or hazardous uncertainty. Indeed, in the classical deposits the client is seeking for a guaranteed capital with a small return (whilst the bank undertakes the risk for applying this amounts in lending activities) and in insurance contracts the client objective is transferring the risk of something. On the opposite side, when the client invests his money in capital markets he accepts more risk as a balance of a larger return expectancy, but he needs to be aware (be informed) of the risk of losing the amount invested. Besides these historical reasons for these differences, we can also find that the substitute products are regulated (or not regulated) under several Directives providing an unharmonious legal framework for authorization, distribution, marketing and disclosure. The last of these Directives, the MiFID (which covers a wide range of products - all financial instruments listed in Section C of MiFID), magnified the current differences between the substitute products, due their prescriptive regime of disclosure and conduct of business rules (v.g. suitability and know your customer requirements) in the distribution of financial instruments when compared with the other Directives: - In the securities sector there are, at least, other three Directives that regulate the financial instruments: the UCITS Directive, the Prospectus Directive and the Transparency Directive. The UCITS Directive is the only that regulates the product itself, - Unit-linked insurance contracts are covered by the Directive on Life Insurance and their distribution is regulated under the Directive on insurance mediation; - Bank term deposits are not regulated at UE level. The Portuguese regulatory approach The differences between national distribution rules are now a regulatory concern and that was primarily due to the complexity and opacity of a wide range of saving products that are sold as insurance or bank products, alone or in a package. These differences among the rules governing the substitute products have a direct effect on the comparability between the degrees of risk involved in the investment and their correspondent return. Notwithstanding the difficulties in comparing substitute s products, the sellers don t watch out the differing degrees of experience and expertise of the investors. The needs of great comparability and accurate information among substitute products and a sound protection of investors linked with their experience and expertise, justifies the adoption -10-

11 of national rules aiming at bringing distribution rules closer to the MiFID regime and in particular for unit-linked insurance contracts and open-ended pension funds whit individual adhesion at the same level as those applying to UCITS. In fact, there are no economic reasons for treating comparable in-scope and out-of scope investment products and firms differently because it causes confusion in retail investors and affects his reliance on the markets and regulators. Otherwise, differential regimes in such circumstances run the risk of competitive distortion, because a different treatment of substitute products may create artificial markets and promote particular financial products affecting consumer perceptions. For example, if it is difficult investors made comparisons between substitute products or, due the different selling rules, the firm decide advertise only products whit poor rules (with less costs of compliance), this might misrepresent the products that are available in the market and pervert the consumer's awareness. In a similar way the proliferation of distinct product rules may lead to an excessive and apparent product differentiation, suggesting that similar products are different and cannot be compared. This kind of asymmetric information creates obstacles for the investor s best choices and contributes to distort the competition. Recognizing the need of minimizing these market failures and eliminate regulatory and supervisory asymmetries between substitute products, and also enhancing the coherence of the financial legal system, Portugal took the opportunity to extend a part of the Securities Code s regime to: insurance contracts related to investment funds (unit-linked); and to open-ended pension funds with individual adhesion, considering its material similarity to the category of financial instruments, in general, and to investment funds, in particular. The Decree-Law that operated MiFID s transposition to the Portuguese legal framework also operated the transfer of legal, supervisory and regulatory competences from the Portuguese Insurance Institute (ISP) to the Portuguese Securities Commission (CMVM) as regards insurance contracts related to investment funds and openended pension funds with individual adhesion, in what concerns to conduct of business rules (information duties). Making use of the new regulatory competences, the CMVM approach was supplementing the existent requirements for unit-linked insurance contracts and open-ended pension funds with some relevant MiFID provisions. One example was the obligation to provide retail clients key product information in the format of a simplified prospectus similar to required for UCITS 2. We believe that the consumers 2 These solution is consistent with the opinion of the European Economic and Social Committee on the Green Paper on the Enhancement of the EU Framework for Investment Funds (COM(2005) 314 final): -11-

12 are more likely to compare information laid out in a clear and succinct manner and in a standardized format. Establishing similar disclosure requirements, the same format, and the alignment of the instructions to calculate the risks and return measures will increase the comparability among substitutable products. We also have introduced a rule of suitability and know your customer (also applicable to the investment advice) but not as prescriptive as the related MiFID rules. This rule will increase the protection of those investors that are more risk adverse and do not have experience and expertise in more complex or risky products. The partial convergence with the MiFID rules of suitability and know your customer is justified by the need to establish a prudent equilibrium between these products (that are investment products in substance, but insurance products in their legal form) and other insurance products. The table below makes a detailed picture of our regulatory approach: CMVM Regulation n. º 8/ Selling open-ended pension funds with individual adhesion and insurance contracts related to investment funds 3 Source Duty Article 2. Article 3. Article 4. Present a simplified prospectus to the potential investor before the subscription transaction Rules for preparation of the simplified prospectus: -"using language which is clear, concise and easily comprehensible by the common investor"; - The simplified prospectus must adopt a standardized format in accordance with a defined model; - The simplified prospectus is available on the CMVM website Sets the minimum content of the simplified prospectus of the pension fund (which is similar to the required for UCITS). It includes the following gist information: (i) general presentation of the management company, the investment «Investment funds compete against financial products such as unit-linked policies, perceived as comparable by investors, despite the fact that they are governed by a different legal framework. This can distort investors' choices with negative repercussions on cost and risk levels in the investments concerned. The EESC believes that this problem cannot be addressed with reduced competition or by easing the restrictions and guarantees imposed on investment funds. We would call instead for an upward adjustment of standards so that financial products that are perceived as being a direct alternative to investment funds are subject to regulatory requirements that are comparable to those pertaining to such funds.» 3 This Regulation could be found in: (only available in Portuguese). -12-

13 Article 5. consultants, the custodian, the auditors and the supervision authority; (ii) a concise description of the pension fund investment policy; (iii) the risks associated with the pension fund investments (such as the risk of price variation, credit risk, interest rate risk, foreign exchange risk or country risk), including those related with derivatives investments; (iv) the profile of the investor to which the pension fund is targeted (particularly their level of risk aversion and tolerance for oscillations in the value of capital invested, their investment goals and also the advisable period of investment); (v) historic yield and risk, which must be presented by means of a graph showing the change in value of the unit and the yield of the pension fund in the last 10 financial years or, if not applicable, in the financial years that have elapsed since it began its activities; (vi) the table of costs and the global rate of costs; (vii) the means of determining the value of the unit for the purposes of subscription and redemption and the respective conditions of subscription, redemption and transfer and (viii) tax regime applicable. Sets the minimum content of the simplified prospectus of the insurance contracts related to investment funds. It includes the following gist information: (i) general presentation of the insurance company and the supervision authority; (ii) complaints policy; (iii) the possible existence of a risk of total or partial loss of capital invested, as well as the possible existence of any guarantee of return; (iv) the investing profile at which the unit-link is aimed; (v) the maturity of the investment and the period recommended for the investment (vi) the return on the capital invested, including information on its calculation method, on the factors determining the return, on the periodicity and method of liquidation of the earnings and on the existence of a guaranteed rate of return; (vii) historic yield and risk, which must be presented by means of a graph showing the change in value of the unit and the yield of the unit-link in the last 10 financial years or, if not applicable, in the financial years that have elapsed since it began its activities; (viii) the table of costs and the global rate of costs; -13-

14 Article 6. Article 8. and 9. Article 10. and 11. (ix) tax regime applicable. The "Global Costs Rate" method Rules governing the advertising material. Formulas for calculation of yield and publication of yields rules. These rules stated also that only annually adjusted measures of yield may be published. These rules are equal to those applicable for the UCITS. Formulas for calculation of risk and risk scale. These rules are equal to those applicable for the UCITS, and they include the same risk scale: Article 12. Article 14. Article 17. Article 18. Annually adjusted standard deviation (%) [0 ; 1,5[ Low risk Scale of risk [1,5 ; 5[ Medium to low risk [5 ; 10[ Medium risk [10 ; 15[ Medium to high risk [15 ; 20[ High risk >= 20 Very high risk Assessment of appropriateness. The distribution entities should assess if the product is appropriate for a client, determining whether that client has the necessary experience and knowledge in order to understand the risks involved in relation to the product offered. This duty applies also to the investment advisers of this kind of products. This rule is an extension to this products of the MIFID appropriateness regime (article 36.º Directive 2006/73/CE) Management companies or the distributor needs to send, at least once a quarter, to each client for whom they hold pension funds or unit-links, a statement in a durable medium. Record-keeping obligations. -14-