Legal Updates

Earlier this year, on 24 May 2023, the European Commission published its highly-anticipated Retail Investment Strategy (Strategy) which proposes extensive changes to existing European legislation governing retail investor protection.

The proposed changes have been presented by the European Commission in the form of i) an “Omnibus Directive” (Omnibus Directive) which collectively amends the MiFID II Directive[1], the Insurance Distribution Directive[2], the Solvency II Directive[3], UCITS[4] and AIFMD[5]; and ii) a Regulation amending the Packaged Retail and Insurance-based Investment Products Regulation (PRIIPs Regulation)[6].

The Strategy provides for wide-sweeping changes to MiFID II however, in this briefing, we discuss the proposed amendments to i) the product governance requirements and ii) the cost and charges disclosure requirements under MiFID II, which, if implemented, will significantly impact the operations and obligations of in-scope firms.

Background

The proposed changes to MiFID II reflect the overarching aim of the Strategy to empower retail investors in EU capital markets.

As part of its investor protection framework, MiFID II, which has been in effect since 3 January 2018, introduced product governance requirements for firms which manufacture and/or distribute MiFID type financial instruments or who sell or advise on structured deposits (investment products). MiFID II requires manufacturers and distributors of investment products to act in the investor’s best interests throughout the life-cycle of products and services. In accordance with Article 16(3) and Article 24(2) of MiFID II, in-scope firms that manufacture investment products for sale to clients or distribute products to clients are required to maintain, operate and review adequate product governance arrangements.

Furthermore, MiFID II clarified and expanded the scope of the costs and charges disclosure requirements for investment products, providing for a regime of “full” ex-ante (i.e. before the event) disclosure as well as a regime of ex-post (i.e. after the event) disclosure.

On 29 April 2022, the European Securities and Markets Authority (ESMA) published its Final Report on the European Commission mandate on certain aspects relating to retail investor protection (Final Report). In its Final Report, ESMA made various recommendations concerned with costs and charges disclosure requirements. For instance, ESMA advised that a standard EU format for costs and charges disclosures should be developed and suggested that the MiFID II costs and charges requirements should be further clarified and aligned with the approach as required under the PRIIPs Regulation.

The Strategy seeks to build on this previous work by EESMA and to strengthen existing product governance rules and in particular to ensure that financial products are only manufactured and/or distributed to retail investors when they provide value for money.

Pricing Process Requirements

Flowing from the Strategy’s objective to improve “value for money” for retail investors on investment products, the proposed revisions to MiFID II include a new “Article 16a” which elaborates on product governance requirements.

These amendments will seek to strengthen the product approval process by requiring manufacturers to clearly identify the target market’s objectives (as well as needs as currently provided for) and to conduct “an assessment of whether the financial instrument is designed appropriately to meet the target market’s objectives and needs”.

In addition, the proposed amendments will include a new requirement for both manufacturers and distributors to adopt a pricing process (Pricing Process) for packaged retail and insurance-based investment products distributed to retail clients (PRIIPs). This Pricing Process will involve the clear identification and quantification of all costs and charges related to the financial instrument and an assessment of the costs and charges against both internal and external criteria, before the product is marketed or distributed to clients.

The manufacturer and distributor will each be required to determine whether the costs and charges related to the PRIIPs investment product (which shall include the costs of distribution) are justified and proportionate. The manufacturer will be responsible for identifying and quantifying the costs and charges related to the PRIIPs and the distributor will be required to identify and quantify the costs of distribution and other costs or charges not taken into account by the manufacturer.

The assessment of costs and charges against external criteria will involve cost and performance benchmarks which are to be established by ESMA (in consultation with EIOPA) on the basis of comparative data feedback provided by manufacturers and distributors. Article 16a provides for the adoption of secondary legislation to establish criteria to determine whether costs and charges are justified and proportionate.

If justification and proportionality of costs and charges cannot be demonstrated, the financial instrument shall not be approved by the manufacturer and the financial instrument must not be offered or recommended by the distributors to retail investors.

The proposal also includes new reporting obligations for manufacturers and distributors to national competent authorities (NCAs) in respect of the costs and charges destined for retail investors.

Associated Miscellaneous Changes

The proposed revisions to MiFID II will introduce a new “Article 24(b)” to incorporate new requirements for investment firms relating to both ex-ante and ex-post disclosure of inducements, costs and charges.

The proposals will include revisions to required content of ex-ante disclosures, including requirements upon firms to disclose information on implicit and explicit costs and associated charges, as well as third-party payments paid or received by the firm. The proposals will also introduce changes to the presentation of costs, for example by requiring that the overall costs should be expressed in percentage terms (as well as monetary terms as currently specified under MIFID II) and to specify that such percentages shall be calculated up to the maturity date of the financial instrument, or for financial instruments without a maturity date, the holding period recommended by the investment firm, or in the absence thereof, holding periods of 1, 3 and 5 years. Additional disclosure requirements are proposed in respect of third-party payments (such as the requirement to provide an itemised breakdown). ESMA will be mandated to develop draft regulatory technical standards to expand further on the cost disclosure requirements.

New ex-post disclosure obligations will be introduced concerning the form of, and contents of, the annual statement of costs and charges to be provided to a retail client. The proposals will provide for differing requirements depending on the type of service provided. In addition, ESMA will be mandated to develop draft regulatory technical standards concerning the relevant format and the standard terminology and related explanations to be used for such information.

The focus on “value-for money” theme also underlies the proposal to introduce a new “Article 24 (1a)” which will set out new requirements for Investment Advisors, including the requirement for Advisors: (a) to recommend “the most cost-efficient investment” and (b) in addition, to recommend, amongst the options, “a product or products without additional features that are not necessary to the achievement of the client’s investment objectives and that give rise to extra costs”.

Timeline for Legislative Changes

The European Commission public consultation on the proposed measures closed on 28 August 2023 and thereafter interinstitutional negotiations between the European Commission, the European Parliament and the Council of Europe on the proposed legislation commenced. It is anticipated that such negotiations will be ongoing for at least a year, which could be further delayed by the European Parliament elections in June 2024.

Once a finalised text is agreed, ESMA will be then responsible for drafting related regulatory technical standards (also known as “Level 2” texts) which will provide detailed rules on the processes provided for within the agreed amended legislation, such as the methodology to be used by ESMA to develop cost and performance benchmarks.

Conclusion

The proposed changes discussed, if enacted, would undoubtedly impact the operations of in-scope firms, mandating intricate cost-analysis processes of the investment products offered. Furthermore, the proposed changes discussed are only one aspect of the significant overhaul that is proposed by the Strategy to the MiFID II framework.

If you have any questions arising from this briefing, please get in touch with the Financial Regulation team or your usual contact in Dillon Eustace.

The author would like to thank Aoife Grugan for her contribution to this article.

Footnotes:

[1] Directive 2014/65/EC

[2] Directive 2016/97/EC

[3] Directive 2009/138/EC as amended

[4] Directive 2009/65/EC as amended

[5] Directive 2011/61/EU

[6] Regulation (EU) No 1286/2014 as amended