FIDLEG SOLUTION - News 11/2018

Rules on retrocessions under MIFID II

This issue of FIDLEG SOLUTION - News 11/2018 brings closer to you the provisions of MiFID II on retrocessions (also called inducements) which can also apply to Swiss financial services providers. In the next issue of FIDLEG SOLUTION - News we will then analyse the rules on retrocessions according to Swiss law, in particular the new Swiss Financial Services Act (FinSA) and the new Financial Institutions Act (FinIA).

WHAT ARE RETROCESSIONS AND WHAT IS THE PROBLEM WITH THEM?

The term "retrocession" is neither used nor defined in MiFID II / MiFIR. There is also no definition in FinSA / FinIA or in the Swiss Code of Obligations (CO). A definition can only be found in the so-called Transparency Guidelines of the Swiss Funds and Asset Management Association SFAMA, which will be discussed in our next FIDLEG Solution - News. Nevertheless, this term is on everyone's lips.

MiFID II / MiFIR rather use the term "inducements". It is generally understood as monetary and non-monetary benefits received by a person because he or she provides a financial service to a third party, such as managing the latter's assets, offering him / her a financial product or advising him / her on financial matters. A typical feature of retrocessions is that they are not paid to the recipient of the financial service but rather to the provider of the financial service. In practice, retrocessions are also called distribution fees, kickbacks, commissions or similar. In any case, retrocessions do not necessarily have to be in the form of money, also so-called non-monetary benefits are included.

Even if retrocessions have caused some attention in the financial sector, they can occur in any business sector.

Retrocessions are not problematic per se and they are not generally prohibited under MiFID II. However, they are problematic if they trigger a conflict of interests at the recipient, i.e. the financial services provider. This can be the case as the financial services provider must act in the best interest of its client (art. 23 (1) MiFID II), but the possibility to receive retrocessions can motivate the provider to focus its activities rather on the increase of the retrocessions which does not necessarily is aligned with the interest of the client.

WHERE ARE THE RULES ON RETROCESSIONS?

As retrocessions can lead to a conflict of interest, the handling of retrocessions is regulated in MiFID II / MiFIR in the chapter on conflicts of interest rules, i.e.

STARTING POINT OF MIFID II / MIFIR

MiFID II requires that financial services providers act "honestly, fairly and professionally and in the best interests of their clients" (art. 24 (1) MiFID II).

This is specified in art. 24 (9) MiFID II with regards to retrocessions. In general, this provision makes it clear that art. 24 (1) of MiFID II is violated by anyone who pays or receives fees or commissions or grants or receives non-monetary benefits in connection with a financial service.

The existence, nature and amount of the fee, commission or, if the amount cannot be established, the way in which this amount is calculated must be disclosed to the client in a comprehensive, accurate and comprehensible manner prior to the provision of the financial service (art. 24 (9)(2) MiFID II).

Actually, this means that any retrocession, whether monetary or non-monetary, must be disclosed and released "as soon as reasonably possible upon receipt" (art. 12 MiFIR).

AND WHEN CAN RETROCESSIONS BE RECEIVED AND RETAINED?

However, art. 24 (9) MiFID II also provides an exception. The payment or receipt of fees, commissions or non-monetary benefits is permitted, if cumulative:

  1. they are intended to improve the quality of the financial service provided to the client.
    The quality of the service provided will be improved if all three of the following criteria are met (art. 11 (1) MiFIR):
      ­
    • ­The fees, commissions or non-monetary benefits are justified by the provision to the client of an additional or higher-ranking service which is proportionate to the extent of the incentives received;
    • They do not directly benefit the financial service provider, its shareholders or employees;
    • They are justified by the granting of a continuing advantage to the customer in relation to a buying incentive.
      and
  2. it does not prejudice the performance of the obligation to act in the best interests of the client.

Where the financial services provider relies on this exemption, it shall be required to provide evidence. It must retain evidence that the fees, commissions or non-monetary benefits it pays or receives meet the above conditions. For this purpose, a list of all fees, commissions and non-monetary benefits received shall be kept.

APPLICATION TO INVESTMENT ADVICE

There is a special regulation for investment advice (art. 24 (7) MiFID II). Whoever provides investment advisory services can decide whether to provide them in a dependent or independent manner.

Only those who provide independent investment advice are bound by the obligation to disclose and issue retrocessions (art. 12 (1) MiIFIR), with the exceptions for minor, non-monetary benefits (art. 12 (2) MiFIR). What can be considered a minor non-monetary advantage is listed in art. 12 (3) MiFIR as an example.

On the other hand, those who provide dependent investment advice may accept and retain fees, commissions and non-monetary benefits.

APPLICATION TO PORTFOLIO MANAGEMENT

Art. 24 (8) MiFID II applies the provisions on retrocessions to portfolio management. The portfolio manager - in contrast to the investment advisor - has no choice between dependent and independent portfolio management service. The portfolio manager is independent per se and the rules on retrocessions apply to him in any case (art. 12 MiFIR).

This means that a portfolio manager is not permitted to accept and retain fees, commissions or other monetary or non-monetary advantages from a third party or a person acting on behalf of a third party. Only minor non-monetary advantages, which are listed as examples in art. 12 (3) MiFIR. These may be retained if they can improve the quality of service for the client and do not, by their scope and nature, suggest that they would impair compliance with the obligation to act in the client's best interests.

However, the rule, stating that retained, smaller non-monetary benefits must be disclosed, applies in this case.

APPLICATION IN THE CONTEXT OF ANALYSES / RESEARCH

The delivery of analyses / research material has long been a known application of non-monetary retrocession. Finally, by providing research material, an attempt was made to persuade the recipient to trade via the entity producing the research material.

The rules of art. 23 and 24 MiFID II clearly state that research material cannot be accepted tel-quel anymore. Art. 13 MiFIR rather provides special rules for the handling of research material. Financial service providers, for example, have two options:

  1. A financial services provider either pays for the research material itself, i.e. from its own assets. In this case, the research material does not give rise to a conflict of interest for the financial services provider, as he himself pays for it (art. 13 (1)(a) MiFIR).
  2. Or the financial services provider maintains an analysis so called “Research Payment Account” (RPA) with which it finances the research material (art. 13 (1)(b) MiFIR). Such an RPA must meet the following requirements:
    1. ­The RPA is funded by the client.
    2. The financial services provider sets and regularly assesses a research budget as an internal administrative measure.
    3. The financial services provider is liable for the RPA.
    4. The financial service provider regularly assesses the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions.

These rules must also be observed when receiving unsolicited research (point 7 Question 3 of ESMA Q&A on MiFID II and MiFIR investor protection and intermediaries topics; ­here). Since one cannot pay for unsolicited research, this means that unsolicited research must not be accepted.

AND TO WHAT EXTENT DOES THIS AFFECT SWISS FINANCIAL SERVICES PROVIDERS?

As it is generally true with MiFID II rules, the question arises as to why the rules also affect a Swiss financial services provider, since Switzerland is not in the European Union and MiFID II is not applicable in Switzerland.

However, the provisions on retrocessions also apply to Swiss financial services providers because they have to comply with MiFID II when they provide financial services to clients in the European Union.

THERE IS MORE TO COME…

The next issue of FIDLEG SOLUTION – News will deal with the provisions on retrocessions under FIDLEG and FINIG.

Your FIDLEG SOLUTION Team
www.fidlegsolution.ch


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