A letter from the FCA, outlining how it expects certain MiFID2 requirements to be applied, signals a game-changing departure by the regulator, with potentially significant ramifications for the UK asset management industry.
In a letter to the Alternative Investment Management Association (AIMA), the UK Financial Conduct Authority (FCA) has outlined its expectations around the application of certain MIFID2 requirements, in particular regarding inducements and unbundling of research, to outsourcing arrangements where a UK investment manager delegates the provision of portfolio management services to a non-EEA entity.
In a departure from current industry practice under the existing MiFID1 regime, the FCA has adopted a “purposive reading” of the MiFID2 outsourcing requirements, concluding that a firm outsourcing portfolio management to a non-EEA delegate is expected to “secure an equivalent level of protection for its clients under a delegation arrangement”. Examples of an “an equivalent level of protection” are provided and indicate that a full contractual "push down" of the MiFID2 requirements onto non-EEA delegates is not necessarily required. However, UK investment managers will need to ensure that non-EEA delegates implement an appropriate policy, properly account for and value-assess research, and set a maximum research budget, as well as implementing controls to ensure the receipt of research does not lead to conflicts of interest.
This unexpected response from the FCA signals a game-changing departure from the status quo which has potentially very significant ramifications for the UK asset management industry.
Background to the FCA letter
The FCA has written to AIMA - copied to a number of other industry bodies participating in the MiFID2 implementation forum - by way of response to AIMA’s letter of April 2017 regarding the application of the MiFID2 framework where a UK investment manager has delegated the provision of portfolio management services to a non-EEA entity. Specifically, AIMA’s letter raised the issue of whether the outsourcing rules in MFID2 require the delegating investment manager to impose contractual obligations on its delegate to comply with certain investor protection requirements of MIFID2. Both AIMA’s and the FCA’s letters focus on the area of inducements and unbundling of research.
MiFID2 contains outsourcing requirements which are virtually identical to those already contained in MiFID1. These require that:
“[i]nvestment firms outsourcing critical or important operational functions shall remain fully responsible for discharging all of their obligations under [MiFID1/MiFID2]” and that such outsourcing must not “result in the delegation by [the MiFID firm’s] senior management of its responsibility”.
Traditionally, the market has not interpreted the MiFID1 requirements as obliging MiFID portfolio management firms to impose a contractual requirement on their non-EEA delegates to comply with the MiFID conduct of business rules when providing their delegated services. Rather, the MiFID1 requirements have been interpreted as obliging the investment firm to ensure that the effect of any delegation is not to put the MiFID firm in breach of its own, directly-owed obligations to its clients. Support for this interpretation is found in the European Commission’s MiFID1 Q&A website which contains the following question and answer:
“Outsourcing of portfolio management to third country investment firms - application of MiFID"
Where a MiFID investment firm, which provides portfolio management to professional clients, outsources some of that portfolio management to a third country investment firm, does that MiFID investment firm need to establish arrangements which require the third party to comply with MiFID for the provision of those services? In particular how does this affect the MiFID investment firm’s best execution obligations and transaction reporting obligations?
Comment or Answer
MiFID explicitly states that where investment firms outsource critical or important operational functions or any investment services or activities, the firms remain fully responsible for discharging all of their responsibility under MiFID. In particular, outsourcing arrangements must not result in the delegation by senior management of its responsibility, and must not alter the relationship and obligations of the firm towards its clients (see Article 14(1) of Directive 2006/73/EC (Directive 2006/73/EC)).
In other words, the fact that part of an investment service is outsourced to a third country firm does not alleviate the investment firm of its MiFID responsibilities, whether under best execution, transaction reporting or otherwise.
The firm to which the service is outsourced, if it is based in a third country, will not be subject to MiFID. MiFID does not require that firm to be made subject to MiFID obligations by way of the outsourcing agreement. However, the outsourcing arrangement must not result in the MiFID investment firm breaching its MiFID obligations. The contents of the outsourcing agreement must also conform with Article 14(2) of Directive 2006/73/EC, which is based on Articles 13(2) and 13(5) of the Level 1 Directive.”
In light of certain comments made by FCA representatives at recent trade association meetings and the statement which appeared on the FCA website in March 2017 in relation to its recent thematic review of use of dealing commissions by asset managers, which appeared to be at odds with the Commission Q&A and the current industry approach (ie under MiFID1), AIMA wrote to the FCA to ask for confirmation that the current approach is still valid.
The FCA’s response signals a game-changing departure from the status quo which has potentially very significant ramifications for the UK asset management industry.
What does the FCA letter say?
As a general point, the FCA notes that it would be for the European Commission or ESMA to provide formal legal interpretation on the new outsourcing provisions, as these are contained in the MiFID2 Delegated Regulation, which has direct effect.
The FCA notes that the relevant legal provision under MiFID2 regarding outsourcing, in Article 31 of the MiFID2 Delegated Regulation, requires that “[i]nvestment firms outsourcing critical or important operational functions shall remain fully responsible for discharging all of their obligations under [MiFID2]” and that such outsourcing must not “result in the delegation by senior management of its responsibility”.
The FCA highlights that firms sub-delegating portfolio management must remain "fully responsible for discharging all of their obligations" under MIFID2 and ensuring that "the relationship and obligations of the investment firm towards its clients under the terms of [MiFID2] is not altered" [emphasis added by the FCA]. In applying these principles to the new inducements framework for portfolio managers, the FCA considers that a purposive reading of the MiFID2 reforms on inducements is necessary.
Article 24(8) of MiFID2 prohibits portfolio managers from receiving any material third party payment or benefits, which may lead the firm to act other than in the client's best interests. However, Article 13 of the MiFID2 Delegated Directive provides an exception that allows the receipt of third party research outside the inducements framework where a MiFID investment firm either:
- bears the costs directly from its own resources, or
- pays for research via a research payment account (RPA) that is funded by a separate research charge to the client that is disclosed upfront and based on a research budget set by the firm.
In the context of sub-delegation of portfolio management to a non-EEA manager, the FCA rejects any “narrow reading” that the MiFID2 inducements provisions fall away due to the fact that any third party benefits will be received by the delegate (which is not subject to MiFID) rather than the MiFID investment firm. In the FCA’s view, such an approach would remove the accountability and transparency that MiFID2 requires from a firm when offering portfolio management services where the costs of third party research are borne by its clients.
The FCA suggests that, under this “narrow reading”, clients would lose specific MiFID2 protections and would be exposed to the risk that the receipt of third party research by the delegate could influence investment and execution decisions in a way that is not in the clients’ best interests. In the FCA’s view, by treating the MiFID2 inducements provisions as inapplicable to the delegate, a MiFID investment firm would be altering its relationship and obligations towards its clients under MiFID2, which would be contrary to Article 31 of the MiFID2 Delegated Regulation.
Therefore, the FCA considers that, where a MiFID investment firm outsources part of the portfolio management service, it must take steps to “secure an equivalent level of protection for its clients under a delegation arrangement” and “secure for its clients substantively equivalent outcomes as they would expect to receive based on the relevant investor protection provisions in MiFID2”.
An “equivalent level of protection”
The FCA provides some detail on what amounts to an “equivalent level of protection” for clients. Where a firm permits a delegate to charge clients for third party research, the FCA would expect “similar controls to be in place, scrutiny to be exercised and transparency to be provided, to ensure that such arrangements are in the clients' best interests as set out in Article 13 of the Delegated Directive (and transposed in COBS 2.3B)”.
The FCA is clear that a MiFID investment firm may be able to satisfy itself that its delegate can deliver such accountability on behalf of its clients through other operational arrangements that are consistent with, without necessarily being precisely the same as, the MiFID2 provisions - as long as they achieve the same investor protection outcomes for the underlying clients.
This indicates that a full contractual "push down" of the MiFID2 requirements onto non-EEA delegates is not the only method by which a delegating MiFID firm can satisfy the FCA’s expectations. However, firms must “seek equivalent outcomes to MiFID” by contractually securing sufficient control, oversight and access to information on any third party research costs that the delegate will pass on to clients.
The FCA provides a worked example of delegation to a US manager that (for US regulatory reasons) is unable to make separate research payments to US brokers in the precise manner that MiFID2 would require. The FCA states that, in such cases, the MiFID investment firm should secure the most comparable standards possible from the US manager by requiring it to:
- set a budget for the maximum research costs it will incur on behalf of the delegated funds, and provide a policy for how that budget will be used;
- fully account for the research inputs it receives in relation to managing the delegated funds, the value of the research inputs used (using objective benchmarks or metrics to make this value-assessment), and control payments made to research providers in line with the valuation of services, and
- have systems and controls to ensure the receipt of research does not influence order routing and best execution decisions, or give rise to any other conflicts of interest that risks material detriment to the delegated clients' funds.
The FCA provides these measures as examples of an arrangement that, in its view, could provide a level of protection for underlying clients equivalent to those in the MiFID2 provisions, despite not being precisely the same. Therefore, although the FCA’s worked example is in the context of a US manager, it is reasonable to conclude that for any non-EEA delegation, these measures represent an “equivalent level of protection” for clients and are sufficient for MiFID2 compliance.
MiFID firms wishing to adopt this approach will need to ensure (presumably via a combination of contractual provisions and ongoing oversight/reporting) that their non-EEA delegates set a research budget for the research that they intend to use to make investment decisions for the relevant MiFID firm’s clients and that they have commission sharing agreements (CSAs) or similar arrangements in place under which executing brokers allocate a portion of the clients’ dealing commissions as representing research costs. This will allow the non-EEA delegate to systematically account for research received and charged to clients under the delegation arrangements. Presumably, in order to manage spend in accordance with the budget, the CSA or similar arrangements would need to allow the non-EEA delegate to switch off the research element of the composite commission once the research element generated for the period has reached the budgeted amount. In addition, firms will need to ensure that non-EEA delegates have a robust process and methodology for objectively valuing the relevant research received and paid for.
It is not entirely clear how this alternative model could be used in the context of fixed income, currencies and commodities (FICC) research. These are markets where commissions are not used and where brokers fund their research activities from the bid-offer spread. The alternative approach proposed by the FCA, therefore, does not appear to fit with the fixed income model, which begs the question what the FCA’s expectations are for MiFID firms delegating portfolio management for FICC instruments to non-EEA delegates, particularly where those delegates are unable (because of local regulatory requirements) to pay their brokers directly for research, as would, for example, currently be the case in the US.
An alternative solution suggested by the FCA is for the MiFID firm to pay (from its own resources) for the research consumed by the non-EEA delegate. However, it is not clear how this solution would work if, as would commonly be the case, the non-EEA delegate has multiple clients only one of which is a MiFID firm. Would the MiFID firm have to pay for all research used by the delegate (or at least all of the research used to make decisions for the MiFID firm’s clients) even though the delegate’s other clients also benefit from that research?
The FCA’s (unexpected) response to AIMA’s letter has generated many more questions than it has answered.
Application to AIFMs and UCITS management companies
The FCA has made clear in its response that it expects UK AIFMs and UK UCITS management companies (to whom the MiFID inducements and research rules are applicable as the result of UK gold-plating) to adopt the same approach as MiFID firms when they delegate portfolio management to non-EEA delegates.
Application beyond inducements and research
The focus of the FCA’s letter (and the AIMA letter to which it was responding) is inducements and, in particular, unbundling research and dealing commissions. However, the view expressed by the FCA in the letter does leave open the question whether the principle set out in the letter has relevance to a wider range of MiFID requirements in the context of outsourcing.
Our current view (taking into account the “political” context, specifically, the FCA’s general antipathy towards bundled brokerage and its consequent role as the main driving force behind the MiFID2 research and inducements rules) is that the FCA did not intend to create an obligation on MiFID firms to “push down” contractually to their non-EEA delegates the full suite of MiFID2 obligations and that the specific requirement established in the letter should be interpreted as confined to the MiFID2 research and inducements rules.
Ahead of 03 January 2018, UK MiFID firms, AIFMs and UCITS management companies will need to review any existing arrangements where they have delegated portfolio management to non-EEA delegates to ensure that any such delegates which pass the cost of third party research on to delegated clients’ portfolios will have in place the policy and procedures outlined above (or consider alternative arrangements, for example, direct appointment of the relevant delegates by their clients).
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.