Committee of European Securities Regulators consults on client classification under MiFID

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1 July 2010 Stop Press Committee of European Securities Regulators consults on client classification under MiFID The Committee of European Securities Regulators ( CESR ) published on 12 July a consultation paper seeking views on client classification issues under the Markets in Financial Instruments Directive 1 ( MiFID ). The European Commission (the Commission ) wrote to CESR in March 2010 asking for CESR s advice on certain aspects of MiFID, as part of the MiFID review being conducted this year. CESR has now opened up for public consultation client classification issues on which its advice is sought. In particular, and controversially, CESR is seeking views on whether the current client classification regime under MiFID that automatically classifies certain types or sizes of entities as per se professional clients or eligible counterparties ( ECPs ) should be changed so that an assessment of a specific client s knowledge and experience is required to be made when categorising them. CESR is also concerned by the number of mis-selling cases to have emerged out of the financial crisis concerning highly complex products, and is considering whether the client classification rules in respect of such products needs to be changed to afford greater client protection. Specifically, CESR is consulting on: > possible technical criteria to distinguish within the current broad categories of per se professional clients as set out in MiFID 2 : "other authorised or regulated financial institutions", "locals", and "other institutional investors"; 1 2 The Level 1 Directive- 2004/39/EC Per se professional clients are defined in MiFID [2004/39/EC], Annex II.I (1) as: Entities which are required to be authorised or regulated to operate in the financial markets. The list below should be understood as including all authorised entities carrying out the characteristic activities of the entities mentioned: entities authorised by a Member State under a Directive, entities authorised or regulated by a Member State without reference to a Directive, and entities authorised or regulated by a non Member State: (a) Credit institutions (b) Investment firms (c) Other authorised or regulated financial institutions (d) Insurance companies (e) Collective investment schemes and management companies of such schemes (f) Pension funds and management companies of such funds (g) Commodity and commodity derivatives dealers (h) Locals (i) Other institutional investors MiFID Client Classification July

2 > the meaning of "public debt body" as referred to in MiFID 3 ; > other client categorisation issues, including: > Knowledge and experience: whether there should be more use of tests of a potential client's knowledge and experience when assessing categorisation (particularly for per se professional and per se eligible counterparties); > Complex products: whether the MiFID categorisation rules for very complex products should be changed (e.g. including that ECP status should either not be available, or that there should be a new "Super ECP" status for highly complex products); > Business standards for ECPs: the standards that apply when business is done with ECPs. The consultation has a very short period in which to respond - consultation closes on 9 August A summary of the points raised in the consultation is below. 1 Possible technical criteria to distinguish within the current broad categories of per se professional clients: "other authorised or regulated financial institutions", "locals", and "other institutional investors" As the definition of per se professional client currently stands in MiFID, it refers to some broad categories of entities, including: other authorised or regulated financial institutions", "locals", and "other institutional investors. None of these terms are currently defined in MiFID, and the Commission has asked for CESR s assistance in preparing criteria to help define these categories further. CESR concludes that: > the category other authorised or regulated financial institutions, should be interpreted by reference to the definition of a financial institution in the Capital Requirements Directive 2006/48/EC (the CRD ) as an undertaking other than a credit institution, the principal activity of which is to acquire holdings or to carry on one or more of the activities listed in points 2 to 12 of Annex I, so as to include entities not covered by the CRD or MiFID who meet this definition, e.g. non-eea regulated banking and investment entities; > it understands locals, a term that is not defined in MiFID, as including regulated/authorised persons within article 2(1)(l) of MiFID: firms which provide investment services and/or perform investment activities consisting exclusively in dealing on own account on markets in 3 Public bodies that manage public debt can be classified under MiFID as per se professional clients (Annex II.I (3)), and also ECPs (Article 24(2) of MiFID) Main Title Issue 1 2

3 financial futures or options or other derivatives and on cash markets for the sole purpose of hedging positions on derivatives markets or which deal for the accounts of other members of those markets or make prices for them and which are guaranteed by clearing members of the same markets, where responsibility for ensuring the performance of contracts entered into by such firms is assumed by clearing members of the same markets CESR is proposing that locals be defined in MiFID with reference to the language in this article; > other institutional investors should cover entities whose main activity is investing in financial instruments. CESR reaches this conclusion on the basis that it believes the category is intended to cover institutional investors not covered by (d), (e) and (f) of the definition (e.g. insurance companies, collective investment schemes, managers of such schemes, pension funds and management companies of such funds). CESR says in contrast to the language used in Annex II.I(4), there is no specific reference to the investors investing in financial instruments as their main activity. However, one would expect the concept of institutional investors in a MiFID context to be mainly focused on investing in financial instruments. other institutional investors should cover entities whose main activity is investing in financial instruments 2 Public debt bodies Public debt bodies as a category of client can be classified under MiFID as per se professional clients 4, or as ECPs 5, but currently there is no definition in MiFID of the types of entity that are covered by the term public debt body. The Commission in particular has concerns that local authorities in some Member States are being classified inappropriately as per se professional clients on the basis that they are a public debt body, particulary since the ability of local authorities to engage in the financial markets varies from Member State to Member State. Although there exists some guidance in the form of a Commission Q and A 6 that confirms that local authorities do not fall within the per se professional client category 7, CESR is of the view that the term public debt body could benefit from some clarification to put it beyond doubt that local authorities do not fall within its scope. CESR is of the view that the term public debt body could benefit from some clarification to put it beyond doubt that local authorities do not fall within its scope 3 Other client categorisation issues Against the backdrop of a number of cases of alleged mis-selling of complex products that have emerged out of the financial crisis, CESR is looking at policy proposals to enhance client protection through changes to the client classification regime, in particular by looking at: > introducing a knowledge and experience test: certain types and sizes of client under MiFID are currently automatically classified as per se professional clients or ECPs. The Commission is concerned that See Annex II.I (3) of MiFID (defining professional clients) Article 24 of MiFID See 7 In Annex II.I (3) of MiFID Main Title Issue 1 3

4 the broad brush approach could potentially mean that there are some clients considered to be professional clients or eligible counterparties who do not in fact have the knowledge and experience implied by their categorisation either generally or in relation to certain financial instruments. CESR is therefore considering whether investment firms should be required to assess the knowledge and experience of a wider range of entities before they could be considered to be professionals including certain entities who are currently per se professionals under MiFID. > changing the client classification process for very complex products: the Commission is concerned by the plethora of cases alleging the mis-selling of complex securities and complex derivative products, and where investment advice is not provided, CESR is considering changing the way client categorisation works under MiFID for highly complex products (asset backed securities and non standard OTC derivatives are expressly mentioned), including making ECP status unavailable for transactions in highly complex products; defining a super ECP status subject to stricter requirements for highly complex products (e.g. large financial institutions only); requiring undertakings to request to be considered as an ECP, and making firms undertake an assessment of their knowledge, experience, etc to undertake transactions in highly complex products and requiring firms that know or have reason to know that an ECP is unlikely to have the requisite knowledge or experience to properly assess the risks of the product to treat that investor as a professional client for the transaction. > clarifying the standards that apply to business with ECPs: certain client protections in MiFID 8 that require the firm to act honestly, fairly and professionally in accordance with the best interests of the client do not apply to business with ECPs. CESR is of the view that since ECPs are deemed to be able to look after their own interests, there is no need to have a long list of standards applying to business with them. However, CESR is proposing that firms: The proposals > act honestly, fairly and professionally; and have the potential to add an extra > communicate with ECPs in a way that is fair, clear and not compliance hurdle misleading. to be crossed at the inception of a client relationship and more fundamentally, have the potential to change the nature of the relationship between firms and clients when conducting 8 business in Article 19 of MiFID complex products Main Title Issue 1 4

5 The proposals to introduce a knowledge and experience test and to change the client classification process for very complex products, if they see the light of day, have the potential to impact the way that firms currently deal with per se professional clients and ECPs. The proposals have the potential to add an extra compliance hurdle to be crossed at the inception of a client relationship and more fundamentally, have the potential to change the nature of the relationship between firms and clients when conducting business in complex products. This is therefore a significant consultation. It is disappointing that so little time has been given to the industry to respond. Main Title Issue 1 5

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