1. Investors protection and MIFID
EU Financial Law – Lesson April 3, 2019
Dott.ssa Benedetta Barmann

2. (Retail, institutional – hedge funds – insurance companies, etc.)
INTERMEDIARIES
COMPANIES
INVESTORS
(Retail, institutional – hedge funds – insurance companies, etc.)
CAPITAL MARKETS
Raise funds to finance their investments
Allocate capital => expectation of a future return

3. Why we need a Financial regulation?
the influence of Finance on money supply;
the possible impact of malpractice or fraud on public confidence in the correct functioning of the financial markets;
the need to protect individual investors in order to encourage their financing/funding role to firm;
the risk that a financial crisis could affect the economic system;
the influence which can be exercised through finance on the economic system in terms of economic planning and as a public policy tool.
HOW DO WE PROTECT INVESTORS?

4. BASIC PARADIGM => rationale behaviour.
PROBLEM => asymmetries of information and transaction costs.
Bitter lemon paradigm («Market for lemons», Akerlof): shows that informational asymmetries may lead to an inefficient offer of only low quality products in a market when buyers are not able to assess the quality of a product and sellers of high quality products suffer from these asymmetries.
Asymmetries of information do not constitute a problem limited to the investors, but instead is a problem that may influence the entire market: the adverse selection problem drives the high-quality products out of themarket > Adverse selection is a market mechanism that can lead to a market collapse.

5. The instruments to overcome market failures: information disclosure
Introduce obligations to inform in order to enhance the information basis of investors.
European and national legislations lay the accent on delivering to clients almost all possible information by means of general publicity and transparency or by means of mandatory individual consultation of the client by the bank (or the financial intermediaries).
The most important rules influence the conduct of the investment firms.

6. The Markets in Financial Instruments Directive: MIFID
MiFID is the markets in financial instruments directive (Directive 2004/39/EC). In force from 31 January to 2 January 2018, it is a cornerstone of the EU's regulation of financial markets.
Significant harmonisation of the conduct rules and the organisational requirements.

7. MIFID II and MIFIR
Financial crisis: weaknesses in the functioning and transparency of financial markets; excessive risk; incorrect conducts; complex financial prodcuts; etc.
Recital 7 of Mifid II (Directive 2014/65): Directive /39/EC (Mifid) should therefore now partly be recast as this Directive and partly replaced by Regulation (EU) No 600/2014 of the European Parliament and the Council.
Relevant intervention: product governance, investment advice.

8. Investors categories
Recital 31 MIFID (2004) states that “One of the objectives of this Directive is to protect investors. Measures to protect investors should be adapted to the particularities of each category of investors (retail, professional and counterparties)”.
ELIGIBLE COUNTERPARTIES
PROFESSIONAL INVESTORS
RETAIL INVESTORS

9. 1. Eligible counterparties
Article 24 MIFID I: «Member States shall ensure that investment firms authorised to execute orders on behalf of clients and/or to deal on own account and/or to receive and transmit orders, may bring about or enter into transactions with eligible counterparties without being obliged to comply with the obligations under Articles 19, 21 and 22(1) in respect of those transactions or in respect of any ancillary service directly related to those transactions».
This means that, when operating with eligible counterparties, an investment firm is not bound to the conduct of business obligations and the best execution principle. This also means that the conduct of business rules should be enforced in respect of those investors most in need of protection.

10. 2. Professional investors
Annex II of MIFID II states that “Professional client is a client who possesses the experience, knowledge and expertise to make its own investment decisions and properly assess the risks that it incurs”

11. Professional investors by law: credit institution, investment firms, large undertakings that meet certain size requirements, etc.
Professional investors on request:
1) the size of the client’s financial instrument portfolio, defined as including cash deposits and financial instruments exceeds EUR ;
2) the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.

12. 3. Retail investors
All the investors not included in the past categories;
This notion mainly corresponds with the consumer’s one

13. Conduct rules and organisational requirements

14. Section 2 of MIFID II contains the provisions to ensure investor protection.
These provisions are divided in two different level: (1) provisions which apply to all financial services; (2) provisions which apply to single services or activities.
In order to protect investors the EU directive identifies 4 main instruments:
General principles regarding intermediaries conduct;
Duty to inform;
Organisational requirements;
Conflicts of interests.

15. 1. Conduct of business rules
Article 24 MIFID II states that: «Member states shall require that, when providing investment services or, where appropriate, ancillary services to clients, an investment firm act honestly, fairly and professionally in accordance with the best interests of its clients and comply, in particular, with the principles set out in this Article and in Article 25».

16. 2. Duty to inform the client or duty of disclosure
Article 24, par. 3, provides that “All information, including marketing communications, addressed by the investment firm to clients or potential clients shall be fair, clear and not misleading. Marketing communications shall be identifiable as such”.
Traditionally, a double flow of information is considered: information transmitted from the client to the investment firm and information imparted by the latter to the client.
Specific rules for investment advice service (innovation of MIFID II).

17. Par. 4: «Appropriate information shall be provided in good time to clients or potential clients with regard to the investment firm and its services, the financial instruments and proposed investment strategies, execution venues and all costs and related charges».
Par. 5: «(…) shall be provided in a comprehensible form in such a manner that clients or potential clients are reasonably able to understand the nature and risks of the investment service and of the specific type of financial instrument that is being offered and, consequently, to take investment decisions on an informed basis».

18. Investment advice service.
Article 24 par. 4:
(a) when investment advice is provided, the investment firm must, in good time before it provides investment advice, inform the client:
(i) whether or not the advice is provided on an independent basis;
(ii) whether the advice is based on a broad or on a more restricted analysis of different types of financial instruments and, in particular, whether the range is limited to financial instruments issued or provided by entities having close links with the investment firm or any other legal or economic relationships, such as contractual relationships, so close as to pose a risk of impairing the independent basis of the advice provided;
(iii) whether the investment firm will provide the client with a periodic assessment of the suitability of the financial instruments recommended to that client.

19. Further specific provisions have been introduced by Regulation n
Further specific provisions have been introduced by Regulation n. 565/2017 (Commission delegated regulation), supplementing MIFID II.
Detailed rules related to the contents of the information duties – once provided by national legislation - are now specified by the Commission’s Regulation => maximum harmonisation.
Common standard of rules.

20. 3. Conflicts of interests
Issue: the term conflict of interests is widely used to identify behaviour or circumstances where a party involved in many interests finds that two or more of them conflict.
In the provision of financial services are identified specif areas in which a conflict of interests may arise: client/firm – client/client – intra group conflicts.
In such cases, the investment firm (or other intermediary) may not pursue the client’s best interest

21. Conflicts of interests
Mifid regulatory framework rests on 4 pillars:
1) Organisational duties
2) The duty to identify the conflict of interests
3) The duty to disclose the conflict
4) A general duty of honesty and fairness

22. Article 23 MIFID II: «Member States shall require investment firms to take all appropriate steps to identify and to prevent or manage conflicts of interest between themselves, including their managers, employees and tied agents, or any person directly or indirectly linked to them by control and their clients or between one client and another that arise in the course of providing any investment and ancillary services, or combinations thereof, including those caused by the receipt of inducements from third parties or by the investment firm’s own remuneration and other incentive structures».
Par. 2: «Where organizational o administrative arrangements made by the investment to prevent conflicts of interest from adversely affecting the interest of its client are not sufficient to ensure, with reasonable confidence, that risks of damage to client interests will be prevented, the investment firm shall clearly disclose to the client the general nature and/or sources of conflicts of interest and the steps taken to mitigate those risks before undertaking business on its behalf».

23. 4. Suitability, appropriateness and best execution
Such rules influence the intermediaries behaviour in the provision of financial services, in order to comply with the general rules set out in article 24.

24. The suitability rule.
Article 25 MIFID II: «When providing investment advice or portfolio management the investment firm shall obtain the necessary information regarding the client’s or potential client’s knowledge and experience in the investment field relevant to the specific type of product or service, that person’s financial situation including his ability to bear losses, and his investment objectives including his risk tolerance».
The suitability rule is known since the early 90s and mainly consists in evaluating whether or not an operation is suitable for a client.
With the implementation of MIFID I it became un – waivable: so, if an operation is not considered suitable, the intermediary must abstain itself from carrying out it, even if the client has itself authorized it.
Due to the severity of the rule, the European legislator has limited its application only to 2 financial services: investment advice and portfolio management.

25. The appropriateness rule.
Article 25, par. 3: «Member States shall ensure that investment firms, when providing investment services other than those referred to in paragraph 2, ask the client or potential client to provide information regarding that person’s knowledge and experience in the investment field relevant to the specific type of product or service offered or demanded so as to enable the investment firm to assess whether the investment service or product envisaged is appropriate for the client».
The appropriateness rule has a different field of application => only to investment services different from the portfolio management and investment advice
The appropriateness judgement is evaluated only having regard to the client’s knowledge and experience

26. Execution only services.
Article 25, par. 4: investment firms are not obliged to apply the appropriateness rule when providing investment services that only consist of execution or reception and transmission of client orders with or without ancillary services.
Some conditions must being met: i.e. the service regards shares that are admitted to trading on regulated markets (non complex financial instruments).

27. 5. Best execution rule
Article 27 MIFID II «Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order».

28. Article 27 par. 5 «The order execution policy shall include, in respect of each class of financial instruments, information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue».
«Member States shall require that investment firm provide appropriate information to their clients on their order execution policy. That information shall explain clearly, in a sufficient detail and in a way that can be easily understood by clients, how orders will be executed by the investment firm, Member States shall require that investment firms obtain the prior consent of their clients to the order execution policy».

29. 6. Product Governance
Most relevant innovation introduced with MIFID II.
Expression of a significant reconsideration of the investor protection discipline:
MIFID I => focus on the selling/distribution of financial instruments process;
MIFID II => manufacturing process, focus on the genesis of financial products.

30. Article 16, par. 3: «An investment firm which manufactures financial instruments for sale to clients shall maintain, operate and review a process for the approval of each financial instrument and significant adaptations of existing financial instruments before it is marketed or distributed to clients. The product approval process shall specify an identified target market of end clients within the relevant category of clients for each financial instrument and shall ensure that all relevant risks to such identified target market are assessed and that the intended distribution strategy is consistent with the identified target market».
Article 24: “Investment firms which manufacture financial instruments for sale to clients shall ensure that those financial instruments are designed to meet the needs of an identical target market of end clients within the relevant category of clients, the strategy for distribution of the financial instruments is compatible with the identified target market, and the investment firm takes reasonable steps to ensure that the financial instrument is distributed to the identified target market”

31. Product intervention
MIFID II and MIFIR empower both national competent authorities and ESMA to prohibit or restrict the marketing, distribution and sale of certain financial instruments, if specific conditions are met.

32. Further tools for investor protection.
Investment contract discipline: written agreement with the client setting out the essential rights and obligations of the parties.
Civil liability for the violation of conduct rules.
Administrative sanctions.

33. Thank you!