How to Protect Investors: Lessons from the EC and the UK [1 ed.] 0521888700, 9780521888707

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How to Protect Investors: Lessons from the EC and the UK [1 ed.]
 0521888700, 9780521888707

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HOW TO PROTECT INVESTORS

As governments around the world withdraw from welfare provision and promote long-term savings by households through the financial markets, the protection of retail investors has become critically important. Taking as a case study the wide-ranging EC investor-protection regime which now governs EC retail markets after an intense reform period, this critical, contextual and comparative examination of the nature of investor protection explores why the retail investor should be protected, whether retail investor engagement with the markets should be encouraged and how investorprotection laws should be designed, particularly in light of the financial crisis. The book considers the implications of the EC’s investor-protection rules ‘on the books’ but also considers investor-protection law and policy ‘in action’, drawing on experience from the UK retail market and in particular the Financial Services Authority’s extensive retail market activities, including the recent Retail Distribution Review and the Treating Customers Fairly strategy. niamh moloney is a professor in the Law Department of the London School of Economics and Political Science.

international corporate law and financial market regulation Recent years have seen an upsurge of change and reform in corporate law and financial market regulation internationally as the corporate and institutional investor sector increasingly turns to the international financial markets. This follows large-scale institutional and regulatory reform after a series of international corporate governance and financial disclosure scandals exemplified by the collapse of Enron in the US. There is now a great demand for analysis in this area from the academic, practitioner, regulatory and policy sectors. The International Corporate Law and Financial Market Regulation series will respond to that demand by creating a critical mass of titles which will address the need for information and high-quality analysis in this fast developing area. Series Editors Professor Eilis Ferran, University of Cambridge Professor Niamh Moloney, London School of Economics and Political Science Professor Howell Jackson, Harvard Law School Editorial Board Professor Marco Becht, Professor of Finance and Economics at Universit´e Libre de Bruxelles and Executive Director of the European Corporate Governance Institute (ECGI). Professor Brian Cheffins, S. J. Berwin Professor of Corporate Law at the Faculty of Law, University of Cambridge. Professor Paul Davies, Cassel Professor of Commercial Law at the London School of Economics and Political Science. Professor Luca Enriques, Professor of Business Law in the Faculty of Law at the University of Bologna. Professor Guido Ferrarini, Professor of Law at the University of Genoa and Honorary Professor, Faculty of Law, University College London. Professor Jennifer Hill, Professor of Corporate Law at Sydney Law School. Professor Klaus J. Hopt, Director of the Max Planck Institute of Comparative and International Private Law, Hamburg. Professor Hideki Kanda, Professor of Law at the University of Tokyo. Professor Colin Mayer, Peter Moores Professor of Management Studies at the Sa¨ıd Business School and Director of the Oxford Financial Research Centre. James Palmer, Partner of Herbert Smith, London. Professor Michel Tison, Professor at the Financial Law Institute of the University of Ghent. Andrew Whittaker, General Counsel to the Board at the UK Financial Services Authority. Professor Eddy Wymeersch, Chairman of the Committee of European Securities Regulators (CESR); Co-Chair of the CESR-European Central Bank Working Group on Clearing and Settlement, and part-time Professor of Commercial Law, University of Ghent.

HOW TO PROTECT INVESTORS Lessons from the EC and the UK

NIAMH MOLONEY

CAMBRIDGE UNIVERSITY PRESS

Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Dubai, Tokyo Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521888707 © Niamh Moloney 2010 This publication is in copyright. Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published in print format 2010 ISBN-13

978-0-511-67557-7

eBook (NetLibrary)

ISBN-13

978-0-521-88870-7

Hardback

Cambridge University Press has no responsibility for the persistence or accuracy of urls for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

To Iain

CONTENTS

Preface and acknowledgments Table of cases xvii Table of treaties and legislation List of abbreviations xxv 1 I. II.

III.

IV.

The retail investor and the EC

page xiii xviii

1

The importance of the retail markets 1 The retail markets and the EC 5 1. The development of a retail market agenda 5 2. Scope: the reach of EC investor protection law and policy 13 3. Beyond the cross-border context 18 4. But room for local ‘law on the books’ and for ‘law in action’: the UK example 22 5. Examining retail investor protection through the EC lens 29 Who is the EC investor? 30 1. Characterizing the target of investor protection 30 2. The average EC investor: an elusive target? 31 3. Investors or consumers? 39 The financial crisis and EC retail market policy 41

2

Designing a retail investor protection regime

I.

Why intervene in the retail markets? Encouraging the empowered investor, shielding the irrational investor or supporting the trusting investor? 45 1. Characterizing investor protection 45 2. The retail investor as an agent of public policy and the empowered investor 47 3. The irrational and uninformed investor 67 4. The trusting investor 81 The risks of retail market intervention 92 1. Regulatory and retail market agenda risks 92

II.

vii

45

viii

contents

III.

2. Regulation and the retail markets: ‘laws on the books’ and ‘laws in action’ 95 3. Responding to the drivers of retail market engagement 97 4. Centralization risks 100 How to intervene on the retail markets? 102 1. The regulatory toolbox and self-regulation 102 2. Achieving retail market outcomes 106 3. Principles-based regulation and the retail markets 108 4. Evidence-based policy formation and rule-making 114 5. Controlling risk-taking and segmentation techniques 118 6. Diversification 122

3

Product regulation

I.

Product regulation and the retail markets 134 1. The EC and product regulation 134 2. The benefits of CIS product regulation 137 3. The risks of CIS product regulation 142 4. An integrated model 151 The UCITS investor protection regime and product regulation 152 1. Inbuilt diversification and liquidity 152 2. Inbuilt governance: the depositary and the management company 153 The UCITS III product and design risks 157 1. The UCITS III regime 157 2. UCITS III and the risks of facilitative product design 162 3. Beyond UCITS III: alternative investments and product design risks 168 4. Beyond product regulation: the product provider and the provider/distributor relationship 176 Structured and substitute products 179 1. The substitute product market and structured products 179 2. A segmented product regime and its risks 184 3. Developing a response 187

II.

III.

IV.

134

4

Investment advice and product distribution

I.

Intermediation, its risks and regulation 192 1. The benefits of advice 192 2. The risks 193 3. Regulating advice 196 Scope of the advice and product distribution regime 200 1. The advice and distribution regime 200 2. MiFID’s scope: a wide range of instruments and services

II.

192

202

contents

ix

3. MiFID’s scope: the pivotal investment advice definition 203 4. MiFID’s scope: supporting access to advice? 204 5. MiFID’s scope: the nature of investor protection ‘on the books’ 207 III. Regulatory design choices 209 1. Regulatory design choice (1): maximum harmonization 209 2. Regulatory design choice (2): principles-based regulation 212 3. Regulatory design choice (3): shaping firm conduct and the eclipsing of disclosure 213 IV. Regulatory technique (1): the fairness principle and ‘law in action’ 215 1. The fair treatment principle 215 2. The risks of ‘fairness’ 217 3. Fairness and the TCF model: ‘law in action’ 219 4. The implications of the TCF model 223 V. Regulatory technique (2): marketing risks 224 1. Marketing risks 224 2. Delivery-specific protection: online and distance contacts 226 3. Horizontal protection: consumer protection directives 227 4. Investment-specific protections: MiFID 231 VI. Regulatory technique (3): quality of advice and suitability 235 1. Suitability and objective advice 235 2. The suitability regime: suitability and appropriateness 237 3. Suitability ‘in action’ 240 VII. Regulatory technique (4): conflict-of-interest management 244 1. Conflict-of-interest risks 244 2. MiFID and retail market conflict-of-interest risk 245 VIII. Regulatory technique (5): the investment firm/investor contract 247 IX. Segmentation risks 250 1. The UCITS regime 250 2. Structured and substitute products 252 X. Advice or sales? Addressing the ‘right risks’ 256 1. Delivering high-quality investment advice 256 2. Incentive and commission risks: advice or sales? 257 3. MiFID and commission risk 263 XI. Fee-based investment advice: segmenting regulated advice 266 1. Delivering independent investment advice: the UK Retail Distribution Review and other international experience 266 2. An EC model? 273 XII. Access to mass market advice and the sales problem 278 1. Access to advice 278 2. A mass market advice regime and MiFID: generic advice 279 3. Access to advice and the UK experience 279 4. The EC and access to advice 285

x

contents

5

Disclosure

I.

Disclosure and EC investor protection 288 1. The retail market disclosure regime 288 2. The investor understanding problem 290 3. The risks of disclosure 296 4. Disclosure ‘in action’ 300 Investment product disclosure (1): the UCITS regime 304 1. Designing CIS disclosure: the challenge 304 2. The EC laboratory 312 Investment product disclosure (2): the substitute products challenge 322 1. A fragmented regime 322 2. Developing a response 330 Disclosure in the distribution and advice context 333 1. Marketing communications 333 2. General investment firm and services disclosure: MiFID Article 19(2) and (3) 334 3. Conflicts of interest and commissions 337

II.

III.

IV.

288

6

The trading process

I.

Promoting access to trading 345 1. Better diversification and lower trading costs 2. The risks and execution-only services 350 Investor protection in the trading process 354 1. A matrix of rules 354 2. Best execution 355 3. Trading and issuer disclosure 363

II.

345 345

7

Education and governance

I.

Investor education 374 1. Investor education 374 2. Building an investor education strategy: the UK example 384 3. Investor education and EC retail market policy 389 Retail investor involvement in policy formation and law-making 398 1. Retail investor involvement 398 2. Retail governance and the EC 399 3. Improving investor governance 413 4. CESR and the retail markets 419

II.

374

8

Supervision, enforcement and redress

I.

Public supervision and enforcement in the retail markets 1. Public supervision and enforcement in the retail markets

426 426 426

contents

II.

2. The EC regime 426 3. Risks to the retail markets 429 4. CESR, the retail markets and supervisory convergence 5. Investor compensation schemes 440 Investor redress 442 1. Access to justice and the retail investor 442 2. Direct retail investor action 444 3. Collective action 458

Index

464

xi

436

PREFACE AND ACKNOWLEDG MENTS

This book is concerned with the protection of retail or household investors. The retail markets can be something of a Cinderella in financial market regulation. The regulatory challenges can be humdrum but intractable, the retail constituency quiescent and unhelpful to the beleaguered regulator, and the empirical and analytical pyrotechnics of law and finance and of law and economics, typically applied to financial market regulation, often overlook this area; behavioural finance is, however, now taking up some of the empirical heavy lifting. But, as governments withdraw from welfare provision and promote stronger long-term household saving, the retail markets have become of central importance; to borrow a phrase from law and finance, they ‘matter’. So does investor protection regulation and how it is developed and designed. This book accordingly addresses three questions. Who is the retail investor (chapter 1)? Why should that investor be protected (chapter 2)? How should protection be designed (chapters 3–8)? It considers whether investors are best characterized as empowered, irrational or trusting, and considers the implications for regulatory design. Its case study is the massive EC harmonized regulatory regime for Member States’ retail investment markets which provides a rich case study of investor protection law ‘on the books’. But effective retail market protection depends heavily on ‘law in action’, which remains largely the preserve of the Member States. The book’s main case study for domestic ‘law in action’ is the UK and, in particular, the retail market activities of the Financial Services Authority. A note on the European terminology used is necessary. The book is largely concerned with the internal market aspect of the European Union and so generally refers to the European Community, the EC and the EC Treaty. At the time of writing, the Lisbon Treaty had not been ratified by all the Member States. If the Treaty comes into force, the relevant EC Treaty provisions will not change in substance, but will be incorporated into the new Treaty on the Functioning of the European Union, and references to xiii

xiv

preface and acknowledgments

the EC or European Community in this book should be read as references to the EU or European Union. This book entered its final stages against the backdrop of the financial crisis. In the maelstrom, as regulatory and governmental attention focused on safety and stabilization, retail investor interests have been largely overshadowed. Household wealth has, however, been destroyed, investor trust has been badly shaken and the policy drive to encourage stronger marketbased saving seems quixotic, at least at first glance. Nonetheless, as this book argues, the difficult task of designing an effective investor protection system and of supporting household engagement with the markets must go on. Much greater evidence is needed on how investors think and behave (chapter 2). Hard questions concerning the degree to which investors should be allowed to access more complex products must be answered, particularly given the losses related to structured products over the crisis (chapter 3). Disclosure, the great panacea of modern investor protection, seems all the more a troublesome device (chapter 5). As discussed in chapter 7, the voice of the retail investor, however ill-informed and erratic that voice may be, has been largely absent from the policy debate on the crisis. This must change. The book aims to state the law and major policy developments as at 31 May 2009 although it has been possible to make some very brief references to subsequent major developments. A number of these are revealing as to the direction of the policy debate on retail investor protection. Most notably, perhaps, the Obama Administration’s blueprint for regulatory reform (Department of the Treasury, Financial Regulatory Reform (2009)), which took as a key objective the protection of consumers and investors from financial abuse, includes significant institutional reform in the form of a new Consumer Financial Protection Agency which will share responsibility with the Securities and Exchange Commission for protecting consumers of financial services. From an EC perspective, much can be learned from the emphasis being placed on the Agency’s gathering of ‘actual data about how people make financial decisions’. Otherwise, there is dishearteningly little evidence of any attempts to gather meaningful data on how household investors reacted to the crisis; the European Commission’s 2009 Eurobarometer survey on the crisis was limited to a survey of reaction to the EU’s general efforts (Standard Eurobarometer (EB 71), Europeans and the Economic Crisis (2009)). Institutional reform has also been a major theme of the EC response to the crisis, although here the retail interest was not the driving factor (chapter 7). The Commission’s September 2009 proposals for a European

preface and acknowledgments

xv

System of Financial Supervisors and, in particular, for a central European Securities and Markets Authority (which followed the Commission’s May 2009 Communication on supervision and the agenda-setting de Larosi`ere Report) promise much for better pan-EC prudential supervision. But the impact on retail market law-making is not yet clear, although the proposed Authority will have the power to adopt binding technical standards (endorsed by the Commission). Some efforts are, however, being made to engage the retail sector with the Authority’s work through enhanced consultation procedures (via a Stakeholders Group). The proposed Joint Committee of European Supervisory Authorities may also lead to better cross-sectoral law-making, although institutional segmentation between the banking, insurance/pensions and securities sectors persists in the new model. The initial failure to engage with the retail sector during the important de Larosi`ere discussions remains disheartening (chapter 7). The crisis has, however, galvanized FIN-USE, the EC’s forum for the consumer interest in financial services, to produce a number of papers, significant by their very adoption, on the crisis (including FIN-USE, The Future of Financial Services Supervision (2009)). Otherwise, and perhaps reassuringly given persistent governance and evidence-gathering weaknesses, there was little in the way of knee-jerk reaction, with the 2009 Commission Communication on the treatment of substitute investment products emerging from a discussion which pre-dated the crisis, although the crisis may have encouraged the Commission to adopt what is a relatively radical reform agenda. Similarly, in the UK, prudential and stability matters have been to the fore, although the FSA did proceed with the next stage of its massive Retail Distribution Review in June 2009, presenting specific reform proposals designed to address persistent and entrenched conflicts of interest in the commission-based UK investment advice and product distribution industry (Consultation Paper 09/18). The proposals broadly reflect the FSA’s final thinking on the Review in 2008 (chapter 4). Investment advice concerning a broad range of substitute ‘retail investment products’ will be segmented into ‘independent advice’ and ‘restricted advice’. ‘Independent advice’ must be unbiased, unrestricted and based on a comprehensive and fair analysis of the relevant investment product market. Advice must otherwise be labelled as ‘restricted’, including where a firm advises only on proprietary products. A new adviser charging model will apply to all investment advice; the current commission-based system will be prohibited. A new professional standards regime for all investment advice will also be adopted.

xvi

preface and acknowledgments

Overall, however, there is little evidence of a policy concern, post-crisis, to rethink how investor protection is delivered. The dominant assumptions concerning investor empowerment, investor competence and the investor’s carrying of market risk remain in place. The completion of this book was supported by a Research Leave Award from the Arts and Humanities Research Council which I very gratefully acknowledge. Cambridge University Press, in particular Kim Hughes and Daniel Dunlavey, oversaw the book’s production with great courtesy and efficiency. I would also like to thank the many people from whose work I have learned; in particular, I owe a great deal to Professors Eil´ıs Ferran, Guido Ferrarini, Klaus Hopt, Howell Jackson, Donald Langevoort, Stephen Weatherill and Eddy Wymeersch, whose scholarship has inspired me. My greatest inspiration is my wonderful husband, Iain. This book is dedicated to him. Niamh Moloney 1 October 2009

TABLE OF CASES

Alpine Investments BV v. Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93) 91, 233 Antonio Testa and Lido Lazzeri v. Commissione Nazionale per la Societ`a e la Borsa (Consob) [2002] ECR I-10797 (Case C-365/00) 17 Commission of the European Communities v. Federal Republic of Germany [1986] ECR 3755 (Case 205/84) 91 Gut Springenheide GmbH and Rudolf Tusky v. Oberkreisdirektor des Kreises Steinfurt – Amt f¨ur Lebensmittel¨uberwachung [1998] ECR I-4657 (Case C-210/96) 92, 115 Est´ee Lauder Cosmetics GmbH & Co. OHG v. Lancaster Group GmbH [2000] ECR I-117 (Case C-220/98) 92 Soci´et´e Civile Immobili`ere Parodi v. Banque H. Albert de Bary et Cie [1997] ECR I-3899 (Case C-222/95) 91 Verein gegen Unwesen in Handel und Gewerbe K¨oln eV v. Mars GmbH [1995] ECR I-1923 (Case C-470/93) 446

xvii

TABLE OF TREATIES AND LEG ISLATION

EC Treaty and EC legislation EC Treaty Art. 3 . . . 5 Art. 5 . . . 10 Art. 10 . . . 446 Art. 14 . . . 5 Art. 43 . . . 5 Art. 44(2)(g) . . . 10 Art. 47(2) . . . 10 Art. 49 . . . 5 Art. 55 . . . 10 Art. 56 . . . 5 Art. 94 . . . 10 Art. 95 . . . 10 Art. 153(1) . . . 391 Art. 251 . . . 405 Art. 257 . . . 405 Consolidated Life Assurance Directive 2002/83/EC . . . 323 Deposit Guarantee Directive 1994/19/EC . . . 42, 442 Distance Marketing of Financial Services Directive 2002/65/EC . . . 201, 226, 228, 233, 249, 255, 289 Art. 3(1) . . . Art. 3(4) . . . Art. 12 . . . Art. 13 . . . Art. 14 . . . Art. 15 . . .

8, 14, 21, 40, 57,

450 450 209 459 454 445

E-Commerce Directive 2000/31/EC . . . 7, 227, 334 Injunctions in the Consumer Interest Directive 1998/27/EC . . .

xviii

459, 460

table of treaties and legislation Art. 2 . . . Art. 4 . . . Art. 5 . . .

xix

459 459 459

Insurance Mediation Directive 2002/92/EC . . . Art. 12(1) . . . Art. 12(2) . . . Art. 12(3) . . .

16, 201, 236, 253, 255, 276, 339

253, 339 254 254

Investment Services Directive 1993/22/EC . . . 7, 203 Investor Compensation Schemes Directive 1997/9/EC . . . 42, 63, 441, 442 Legal Aid Directive 2002/8/EC . . . 447 Market Abuse Directive 2003/6/EC . . . 364, 366, 369, 403 Art. 6 . . . 364 Art. 6(3) . . . 364 Markets in Financial Instruments Directive (MiFID) 2004/39/EC . . . 10, 13, 14, 15, 17, 19, 22, 24, 25, 27, 52, 57, 89, 102, 106, 110, 111, 112, 113, 114, 126, 130, 132, 133, 151, 186, 190, 195, 199, 200, 201, 202, 203, 204, 207, 209, 213, 223, 233, 236, 241, 252, 253, 254, 255, 256, 263, 265, 272, 286, 288, 293, 295, 315, 346, 357, 388, 389, 409, 419, 445, 450 Art. 1 . . . 13 Art. 2(1)(c) . . . 203 Art. 2(1)(h) . . . 201 Art. 2(1)(j) . . . 203 Art. 2(2) . . . 441 Art. 3 . . . 206, 275, 286 Art. 3(2) . . . 335 Art. 4(1)(4) . . . 203 Art. 5 . . . 13 Art. 5(5) . . . 276 Art. 6 . . . 207 Art. 7 . . . 207, 276 Art. 7(2) . . . 207 Art. 11 . . . 207 Art. 12 . . . 207 Art. 13 . . . 348 Art. 13(3) . . . 245 Art. 13(7) . . . 207

xx

table of treaties and legislation

Art. 13(8) . . . 207 Art. 18 . . . 245, 348, 353 Art. 18(1) . . . 245 Art. 18(2) . . . 245, 338 Art. 19 . . . 207, 209, 348 Art. 19(1) . . . 115, 213, 215, 216, 217, 220, 221, 230, 234, 236, 240, 245, 249, 263, 264, 354, 359 Art. 19(2) . . . 115, 213, 215, 230, 231, 233, 234, 254, 324, 326, 327, 335, 339, 341, 342 Art. 19(3) . . . 215, 230, 324, 325, 326, 334, 335, 339, 341, 342, 357 Art. 19(4) . . . 215, 237 Art. 19(5) . . . 127, 215, 237, 239 Art. 19(6) . . . 120, 126, 128, 215, 353 Art. 19(7) . . . 215, 249 Art. 19(8) . . . 215, 336 Art. 21 . . . 348, 355 Art. 21(1) . . . 356 Art. 21(2) . . . 356 Art. 21(3) . . . 356, 359 Art. 22(1) . . . 215 Art. 22(2) . . . 349 Art. 27 . . . 349 Art. 32(7) . . . 427, 435 Art. 48 . . . 428 Art. 50 . . . 428 Art. 51 . . . 429 Art. 52 . . . 459 Art. 53 . . . 454 Art. 56 . . . 428 Art. 57 . . . 428 Art. 58 . . . 428 Art. 59 . . . 428 Art. 62 . . . 427 MiFID Level 2 Directive 2006/73 . . . 15, 17, 200, 203, 207, 209, 215, 238, 245, 263, 315 Art. 4 . . . Art. 4(1) . . . Art. 5 . . . Art. 6 . . . Art. 7 . . . Art. 8 . . .

102, 210, 211, 247, 273, 278, 328, 329 15, 203 207 207 207 207

table of treaties and legislation Art. 9 . . . 207 Art. 10 . . . 207, 447 Art. 11 . . . 207 Art. 12 . . . 207 Art. 13 . . . 207, 348 Art. 14 . . . 207 Art. 15 . . . 207 Art. 16 . . . 207 Art. 17 . . . 207 Art. 18 . . . 207 Art. 19 . . . 207 Art. 20 . . . 207 Art. 21 . . . 263 Art. 22 . . . 263, 264 Art. 22(4) . . . 338 Art. 23(3) . . . 338 Art. 26 . . . 216, 264, 334 Art. 26(b) . . . 342 Art. 27 . . . 216, 231 Art. 27(2) . . . 231, 232 Art. 27(3) . . . 232, 325 Art. 27(4) . . . 232, 325 Art. 27(5) . . . 232, 325 Art. 27(6) . . . 232, 325 Art. 27(7) . . . 232 Art. 27(9) . . . 232 Art. 29 . . . 334 Art. 29(1) . . . 335 Art. 29(2) . . . 335 Art. 29(4) . . . 325, 335 Art. 29(8) . . . 232 Art. 30 . . . 334, 336, 338 Art. 30(1)(h) . . . 340 Art. 30(2) . . . 336 Art. 30(3) . . . 336 Art. 31 . . . 216, 334, 336 Art. 31(1) . . . 325 Art. 31(2) . . . 325 Art. 31(5) . . . 326 Art. 32 . . . 334, 336 Art. 33 . . . 326, 334, 340 Art. 34 . . . 216, 334

xxi

xxii

table of treaties and legislation

Art. 35(1) . . . 219 Art. 35(5) . . . 238 Art. 38 . . . 126 Art. 38(d) . . . 289 Art. 41 . . . 336 Art. 42 . . . 336 Art. 43 . . . 336 Art. 44(1) . . . 356 Art. 44(3) . . . 357 Art. 44(4) . . . 357 Art. 46(2) . . . 359 Art. 51 . . . 207 Art. 52 . . . 203 Prospectus Directive 2003/71/EC . . . 369, 444

9, 13, 52, 119, 120, 129, 289, 323, 363, 366,

Art. 5(1) . . . 370 Art. 5(2) . . . 445 Art. 6 . . . 364 Art. 6(1) . . . 444 Art. 6(2) . . . 444 Art. 13 . . . 324 Art. 14 . . . 324 Art. 14(2) . . . 366 Art. 19 . . . 370 Prospectus Regulation 2004/809 Art. 24 . . .

370

Transparency Directive 2004/109/EC . . . Art. 4 . . . Art. 5 . . . Art. 6 . . . Art. 9 . . . Art. 10 . . . Art. 11 . . . Art. 12 . . . Art. 13 . . . Art. 14 . . .

364 364 364 364 364 364 364 364 364

13, 364, 366, 369, 444

table of treaties and legislation Art. 15 Art. 16 Art. 20 Art. 21 Art. 22

... ... ... ... ...

xxiii

364 364 369 367 367

Undertakings for Collective Investment in Transferable Securities (UCITS) Directive 1985/611/EC . . . 7, 26, 121, 122, 126, 128, 134, 135, 142, 146, 149, 151, 152, 153, 156, 162, 163, 168, 176, 188, 189, 246, 250, 295, 302, 321 Art. 1 . . . 13 Art. 1(1) . . . 152 Art. 1(2) . . . 158 Art. 1(3) . . . 153 Art. 4 . . . 152 Art. 4(2) . . . 154 Art. 4(3) . . . 155 Art. 5 . . . 156 Art. 19 . . . 158 Art. 19(6) . . . 166, 167 Art. 27(1) . . . 313 Art. 28 . . . 313 Art. 28(1) . . . 314 Art. 28(2) . . . 313 Art. 28(3) . . . 312, 314 Art. 32 . . . 313 Art. 33 . . . 313 Art. 37(1) . . . 152 Art. 42 . . . 159 Art. 44 . . . 250, 426 Art. 44(2) . . . 250 Art. 47 . . . 313 Art. 49 . . . 428 Art. 52 . . . 427 Art. 77 . . . 251 Art. 79 . . . 445 Art. 91 . . . 427 Art. 97 . . . 427, 428 Art. 98 . . . 428 Art. 99 . . . 429 Art. 108 . . . 427 Sched. A . . . 313

xxiv Sched. B . . . Sched. C . . .

table of treaties and legislation 313 314

Unfair Commercial Practices Directive 2005/29/EC . . . 227, 255, 290

13, 14, 40, 106, 201, 216,

Annex I . . . 230 Art. 2(c) . . . 228 Art. 2(d) . . . 228 Art. 3(1) . . . 228 Art. 3(9) . . . 14 Art. 5 . . . 40, 228 Art. 6 . . . 106, 229 Art. 7 . . . 229 Art. 7(1) . . . 229 Art. 7(2) . . . 230 Art. 8 . . . 229 Art. 9 . . . 229 Art. 10 . . . 106, 459 Art. 11 . . . 459 Unfair Contract Terms Directive 1993/13/EC . . . Art. 3(1) . . . Art. 7(2) . . .

13, 216, 248, 249, 445

249 459

UK legislation Financial Services and Markets Act 2000 . . .

22, 26, 50, 54, 63, 255, 402

s. 2 . . . 50 s. 5(1) . . . 54 s. 21 . . . 23 s. 22(1) . . . 22 s. 59 . . . 23

US legislation Investment Advisers Act 1940 . . . Securities Exchange Act 1934 . . .

267 267

ABBREV IATIONS

3L3 ADR AFM AMF APCIMS ASIC BaFIN CDO CEBS CEIOPS CESR CFD CIS CNMV COBS CONSOB DMD ECOFIN ECON ECOSOC EEA EFAMA ESC ESME FESE FIN-NET

three Level 3 Committees (CESR, CEBS and CEIOPS) alternative dispute resolution Autoriteit Financi¨ele Markten (Dutch regulator) Autorit´e des March´es Financiers (French regulator) Association of Private Client Investment Managers Australian Securities and Investments Commission Bundesanstalt f¨ur Finanzdienstleistungsaufsicht (German regulator) collateralized debt obligation Committee of European Banking Supervisors Committee of European Insurance and Occupational Pensions Supervisors Committee of European Securities Regulators contract for difference collective investment scheme ´ Nacional del Mercado de Valores (Spanish Comision regulator) Conduct of Business Sourcebook Commissione Nazionale per le Societ`a e la Borsa (Italian regulator) Distance Marketing of Financial Services Directive Economic and Financial Affairs Council European Parliament Committee on Economic and Monetary Affairs European Economic and Social Committee European Economic Area European Fund and Asset Management Association European Securities Committee European Securities Market Expert Group Federation of European Securities Exchanges Financial Dispute Resolution Network xxv

xxvi

FIN-USE FINRA FoHF FOS FSA FSAP FSCG FSCP FSMA ICMA ICSA IDD IMD IOSCO ISA ISD ISDA KFD KID KII MiFID MPBR MTF NASD NAV NURS OAM OECD OTC PwC RDR RSP SCDD SEC TCF TER UCITS UCP

list of abbreviations

Forum of User Experts in the Area of Financial Services Financial Industry Regulatory Authority fund of hedge funds Financial Ombudsman Service Financial Services Authority (UK regulator) Financial Services Action Plan Financial Services Consumer Group Financial Services Consumer Panel Financial Services and Markets Act 2000 International Capital Market Association Institute of Chartered Secretaries and Administrators Initial Disclosure Document Insurance Mediation Directive International Organization of Securities Commissions Individual Savings Account Investment Services Directive International Swaps and Derivatives Association Key Features Document Key Information Document Key Investor Information Markets in Financial Instruments Directive more-principles-based regulation multilateral trading facility National Association of Securities Dealers net asset value Non-UCITS Regulated Scheme officially appointed storage mechanism Organization for Economic Co-operation and Development over the counter PricewaterhouseCoopers Retail Distribution Review retail service provider Services and Costs Disclosure Document Securities and Exchange Commission (US regulator) Treating Customers Fairly Total Expense Ratio Undertakings for Collective Investment in Transferable Securities Unfair Commercial Practices Directive

1 The retail investor and the EC

I. The importance of the retail markets This book examines the nature of retail investor protection. It considers the protections which do, and those which should, apply to individual, private investors1 who purchase investment products, take investment advice, carry out direct trading and, overall, engage in short-term speculation or long-term savings through market-based instruments.2 Its case study is the massive EC regulatory regime for the retail investment markets. This regime has grown exponentially in recent years and now dictates the nature of retail investor protection ‘on the books’ for the twenty-seven Member States of the European Union. But, as discussed throughout the book, retail market protection is not simply a function of ‘law on the books’. Effective retail market protection depends heavily on ‘law in action’.3 And ‘law in action’, in terms of, for example, innovative supervisory strategies, product design initiatives, retail market research, investor redress and investor education, is largely the preserve of the Member States. The book’s main case study for domestic ‘law in action’ is the UK and the Financial Services Authority’s increasingly strenuous efforts in the retail markets.4 But the book adopts a generally comparative approach, 1

2

3 4

Although the terms ‘consumer’ and ‘investor’ are sometimes used interchangeably in this area, notably by the UK Financial Services Authority (FSA), the distinction can be meaningful: sect. III below and ch. 2. It is not, accordingly, concerned with banking, insurance and pension-related services and products although, as discussed throughout the book, investment product innovation has placed considerable strains on the traditional regulatory segmentation between the banking, insurance and investment sectors. Ch. 2 considers ‘law in action’. These include: FSA implementation of the behemoth Markets in Financial Instruments Directive regime (Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’)) and Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating

1

2

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drawing on international experience and experience in the other Member States. Why consider the retail markets and retail market regulatory design? As discussed in chapter 2, the financial crisis has wreaked destruction on household market savings; it calls for careful consideration of the role of regulation in the retail markets. But, before the financial crisis, the retail markets were worthy of close attention. Greater responsibility for financial planning and welfare provision, including with respect to pension provision,5 is being imposed on individuals and households internationally;6 welfare is increasingly being privatized and governments are seeking stronger individual financial independence. Risk is accordingly being transferred from government to households.7 Direct household participation in the markets8 is increasing;9 IOSCO, for example, has

5

6

7

8 9

conditions for investment firms and defined terms for the purposes of that Directive, OJ 2006 No. L241/26 (‘MiFID Level 2 Directive’) and the related extensive reforms to the FSA’s retail market conduct-of-business regime, in particular (chs. 4 and 5); the FSA’s embrace of a ‘more-principles-based’ regulation strategy (chs. 2 and 4); continuing efforts on the pivotal ‘Key Features Document’ for retail investment products (ch. 5); burgeoning financial capability initiatives (ch. 7); ever-deepening research efforts (ch. 2); and radical and far-reaching reform of the investment product distribution and advice regime under the Retail Distribution Review (ch. 4). E.g. S. Benartzi and R. Thaler, ‘Naive Diversification Strategies in Defined Contribution Savings Plans’ (2001) 91 American Economic Review 79; and Ageing and Pension System Reform: Implications for Financial Markets and Economic Policies (2005) (a report prepared at the request of the Deputies of the G10 by an experts’ group chaired by I. Visco, Banca d’Italia) (‘G10 Report’), identifying the importance of savings products which are complementary to pension products and which provide diversification (pp. 15 and 17). E.g. C. Borio, Change and Constancy in the Financial System: Implications for Financial Distress and Policy (2007), ssrn abstractid=1022874 and European Commission, Minutes of First Meeting of the Expert Group on Financial Education, 7 October 2008. The Dutch financial market regulator (the AFM), for example, has highlighted that more responsibility is being placed on citizens and noted the ‘democratization’ of financial options: AFM, Policy and Priorities for the 2007–2009 Period (2007), pp. 11 and 12. This point has been made in a range of studies. E.g. J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government (2005) (‘Delmas Report’) and Subgroup (of the Council of the EU’s Financial Services Committee) on the Implications of ageing on financial markets, Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’). The rise in defined benefit schemes, for example, has been described as turning employees into investors and as underlining the importance of securities market regulation: M. Condon, ‘Rethinking Enforcement and Litigation in Ontario Securities Regulation’ (2006) 32 Queen’s Law Journal 1, 6. Other than the exposure to the markets which pension schemes and insurance products achieve. Particularly by older investors. ‘Baby boomers’ control more than US$13 trillion in household investable assets, or over 50 per cent of total US household investment assets: SEC,

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highlighted increased levels of retail investor participation internationally in collective investment schemes (CISs) and identified the securities markets as central to individual wealth. 10 And the financial markets have, as a result, become significant politically.11 In the UK, the retail investment markets have become the focus of close regulatory and policy attention. The FSA’s current attention to the effectiveness of investment advice ‘in action’ (chapter 4), for example, reflects FSA concern to support effective investment advice and product distribution structures given government withdrawal from welfare provision, changing spending and saving behaviour, shifting employment patterns and other socio-economic factors which are placing pressure on longterm savings.12 Its annual Financial Risk Outlooks repeatedly highlight the increased pressure being placed on individuals and households to become financially independent and the risks which arise from failure to do so. The 2005 Outlook, for example, identified increased longevity, health risks (including obesity risks), increased individual responsibility for financing education, changing patterns of employment (particularly an increase in part-time and self-employed workers) and the need for long-term savings in support of pension provision as significant trends that could (or should) influence individuals’ financial planning; it also highlighted the risks of over-reliance on property investments.13 In 2006, the FSA highlighted the risks posed by individuals’ failures to address pension provision as well as the stresses placed on financial planning by, amongst other factors, lifestyle changes and child-care; similar concerns were highlighted in 2007.14 The choices faced by individuals are also becoming increasingly complex as governments encourage market participation and as the industry reacts. Complex retail investment products are burgeoning,15 as are government

10 11

12 13 14 15

North American Securities Administrators Association and FINRA, Protecting Senior Investors: Compliance, Supervisory and other Practices Used by Financial Services Firms in Serving Senior Investors (2008) (‘SEC Senior Report’), p. 1. In the UK, three in eight families (with a member between the ages of 50 and 64) hold some form of investment, whether directly or through some form of wrapper: FSA, Asset Ownership, Portfolios and Retirement Saving Arrangements: Past Trends and Prospects for the Future (Consumer Research No. 74, 2008), p. 1. IOSCO, Objectives and Principles of Securities Regulation (IOSCO, 2008), p. 1. Zingales has suggested that the massive increase in the use of financial markets for retirement purposes has made them much more important politically: L. Zingales, The Future of Securities Regulation (2009), ssrn abstractid=1319648, p. 2. FSA, A Review of Retail Distribution (Discussion Paper No. 07/1, 2007) (‘2007 RDR’), p. 17. FSA, Financial Risk Outlook 2005, pp. 33–40 and 43. FSA, Financial Risk Outlook 2006, pp. 71–4 and Financial Risk Outlook 2007, pp. 77–82. See further ch. 3.

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initiatives to encourage long-term and market-based savings; the UK Child Trust Fund, for example, provides some limited exposure to the markets.16 The need for stronger financial independence, and for effective and responsive retail markets, has been repeatedly highlighted by the Community institutions. Political direction has come from the Council of the European Union, which has called on governments to strengthen the tools with which they monitor household savings and to increase their efforts to raise households’ awareness of financial education and information needs.17 The Council’s powerful Financial Services Committee has engaged in a wide-ranging review of the implications of ageing populations for financial markets, highlighting the macro-economic and demographic trends which are leading to pressure on households to increase marketbased savings;18 while governments and financial institutions (such as pension funds) have traditionally intermediated the risks of market investment, the Committee reported that they are now increasingly being carried directly by households.19 The European Parliament, often sceptical of the financial markets, has acknowledged that societal and lifestyle changes demand sound management of private finances and has related better financial literacy to lower levels of problem debt, increased savings and adequate retirement provision.20 A similar concern has come from the Community’s executive, the European Commission. In its 2007 Green Paper on Retail Financial Services it argued that ageing populations and increasing pressure on public finances presented ‘clear challenges for consumers and investors’ and highlighted the need for a ‘competitive, open and effective market for long-term savings’.21 Earlier, its 2005 White Paper on Financial Services called for a boost in the efficiency of pan-European markets for long-term savings products.22 The need for regulatory policy to support long-term savings through the markets has also emerged 16 17 18

19 20 21 22

See further ch. 2. ECOFIN Conclusions, 2798th Meeting, 8 May 2007, Press Release, pp. 10–11. FSC Report. The dependency ratio (or the proportion of the population aged over 65 as a proportion of the population aged 15–64) is expected to increase from 24 per cent in 2003 to 51 per cent in 2050 (p. 5) and substantial strain is accordingly expected on public pension schemes (pp. 5–10). The Report suggested that higher levels of savings may be required following changes to pension provision and to medical subsidies but that ‘investment in riskier assets’ may reduce the need for additional savings (p. 11). Ibid., pp. 14–16. European Parliament, Resolution on Improving Consumer Education and Awareness on Credit and Finance (P6–TA(2008)0539, 2008), paras. A and B. European Commission, Green Paper on Retail Financial Services in the Single Market (COM (2007) 226), p. 11. European Commission, White Paper on Financial Services (2005–2010) (COM (2005) 629), p. 4.

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as a marked theme of the current debate on the treatment of substitute investment products.23 Regulators internationally are also increasingly addressing the risks faced by older and retired investors. The FSA has reviewed how the financial services market operates for older consumers and highlighted poor understanding of retirement and associated products and services and difficulties with access to advice;24 it has also underlined the particular vulnerability of older investors to share scams.25 Internationally, the US Securities and Exchange Commission (SEC) has also focused closely on the protection of ‘senior investors’, adopting investor education programmes, highlighting and prosecuting frauds and scams to which senior investors may be vulnerable, and providing guidance to financial services firms.26 In this environment, the resilience of investor protection and the appropriateness of efforts to promote individual engagement with the markets become of central importance.

II. The retail markets and the EC 1. The development of a retail market agenda a) Early developments In pursuit of the EC Treaty objective of securing an internal market (Articles 3 and 14 EC) and in support of the Treaty free movement guarantees,27 the Community institutions have long been engaged in the construction of an integrated financial market within which market actors can freely access liberalized cross-border markets.28 Financial market integration is presumed to generate significant benefits in terms of choice, competition and easier access to capital and, ultimately, more 23

24

25 27

28

The Commission, for example, has acknowledged that the policy debate ‘assumes added importance’ given the need to create the right conditions to support market-driven solutions for private retirement provisioning: European Commission, Call for Evidence: Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitutive’ Retail Investment Products (2007), p. 21. FSA, Finance in and at Retirement – Results of Our Review (2007). Although the FSA did not find market failures, it highlighted difficulties concerning access to advice as well as widespread poor understanding of retirement and associated products and services. FSA, Press Release, 27 April 2009 (FSA/PN/055/2009). 26 SEC Senior Report. Particularly the freedom to provide services (Art. 49 EC), the freedom to establish (Art. 43 EC) and the free movement of capital (Art. 56 EC). Treaty references are to the EC Treaty, as the Treaty on the Functioning of the EU had not come into force at the time of writing (see Preface and acknowledgments). N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008), ch. 1.

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liquid and efficient markets and stronger economic growth.29 The legal technology used to achieve market integration30 has been based on, first, the liberalization of market access through de-regulation (or the removal of Member States’ ability to impose local regulatory requirements on cross-border actors) and, secondly, on the related re-regulation of those markets by a common harmonized rule base. Liberalization is achieved by the requirement for Member States to accept, or mutually recognize, the regulation (and often supervision) of cross-border actors by those actors’ home Member States (typically the State where the actor has its head office); mutual recognition is supported by re-regulation or the harmonization of Member States’ rules in order to remove the integration obstacles which protectionist or, more usually, diverging local rules represent, and to allow mutual trust between regulatory regimes. As part of this process of de-regulation, liberalization and re-regulation, the regulation of domestic financial markets has, over time, moved from the Member States to the EC and become a function of harmonized rules. But the Community’s embrace of retail investor protection regulation and policy is a relatively recent phenomenon. The seminal 1966 Segr´e Report, the opening salvo in what has since become a massive harmonized regulatory programme for financial services and markets, did not address retail investor protection in any detail.31 The early phases of EC financial market regulation (from the late 1970s) were concerned with supply-side market access. Integration was initially sought through, first, detailed rule harmonization (best exemplified by the early securities directives (now repealed) which addressed capital-raising, disclosure and issuer access to cross-border markets) and, secondly, in the wake of the 1985 Commission White Paper on the Internal Market,32 minimum harmonization (which allowed Member States to impose more stringent rules on their domestic actors and so accommodated some degree 29 30

31

32

E.g. London Economics, Quantification of the Macro-Economic Impact of Integration of EU Financial Markets: Final Report to the European Commission (2002). Whether or not law can drive market integration and change actors’ behaviour is a very large question. On the debate, see further Moloney, EC Securities Regulation, pp. 40–7 and, in the retail context, sect. II.3 below and ch. 2. Perhaps because at that time ‘in continental Europe stockbrokers and other dealers are not organized in such a way as to facilitate contacts with the public at large. As for investment consultants, they are still far removed from the developed stage they have attained on the capital markets of some non-member countries’: Report by a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (1966) (‘Segr´e Report’), p. 204. European Commission, Completing the Internal Market (COM (85) 310).

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of regulatory competition) and mutual recognition (best exemplified by the 1985 UCITS Directive33 on the UCITS CIS and the now-repealed 1993 Investment Services Directive (ISD) on investment services34 ). The ISD asserted in a recital reference that one of its objectives was to protect investors. But this assertion sat very uneasily in a Directive which was primarily focused on the investment firm, on the investment services passport and on achieving the minimum level of harmonization required to support home Member State control of cross-border investment firm activity. ISD harmonization was primarily directed to prudential and stability requirements; marketing and conduct-of-business regulation, touchstones for investor protection in the intermediation context, were not harmonized and were thus left to the control of host Member States. The first significant moves towards a harmonized investor protection regime came in the late 1990s when market integration became more closely associated with the demand-side, the support of investor confidence as a means of encouraging integration35 and, accordingly, the harmonization of investor protection rules. The first hint of an investorfacing approach came in 1996 when the Commission presented its Green Paper on Financial Services Consumers36 which highlighted a number of investor protection concerns including aggressive marketing by investment firms and poor disclosure. A separate development outside the financial market policy sphere, the adoption of the 2000 E-Commerce Directive,37 further sharpened the focus on investor protection. The Directive anchored cross-border e-commerce/online services (including online investment services) to the ‘Member State of origin’ (essentially the State of establishment) and removed the ability of host Member States to apply their protective rules to cross-border online services. The Directive’s striking innovation was to remove host State control without parallel rule harmonization. By such accidents, or at least by a lack of joined-up 33

34 35 36 37

Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administration provisions relating to undertakings for collective investment in transferable securities, OJ 1985 No. L375/3. Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field, OJ 1993 No. L141/27. N. Moloney, ‘Confidence and Competence: The Conundrum of EC Capital Markets Law’ (2004) 4 Journal of Corporate Law Studies 1. European Commission, Green Paper on Financial Services: Meeting Consumers’ Expectations (COM (96) 209). European Parliament and Council Directive 2000/31/EC of 8 June 2000 on certain legal aspects of information society services, in particular electronic commerce, in the single market, OJ 2000 No. L178/1.

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thinking across different Commission divisions, do major shifts in regulatory design occur. The subsequent 2001 Communication on E-Commerce and Financial Services38 called for further convergence of protective rules, including conduct-of-business rules, in order to address the danger that Member States would rely on the E-Commerce Directive’s derogations to the Member-State-of-origin principle to protect investors and consumers where the Member State of origin’s rules were not regarded as offering adequate protection. But the Communication also adopted an investorfacing agenda. It linked market integration to the demand side and noted that ‘consumer confidence’ depended on sufficiently harmonized levels of protection. An initial response came in the form of the 2002 Distance Marketing of Financial Services Directive (DMD),39 which addresses disclosure, marketing, contractual rights (including withdrawal rights) and redress in the distance marketing context and which applies to a range of financial services, including investment services. It was the EC’s first sustained attempt to grapple with investor protection. It also reinforced the emerging reliance on ‘confidence’ as a demand-side justification for harmonization and market-integration measures; it argued that a high degree of consumer protection was required to enhance consumer confidence in distance selling (recital 3), and that a high level of consumer protection should be guaranteed by the Directive (recital 13).

b) The FSAP and the retail interest Before the pivotal 1999 Financial Services Action Plan (FSAP),40 a massive regulatory agenda which was designed to complete the integration of financial markets and remedy years of slow development, had begun to gather steam, the establishment of the Lamfalussy structures for EC law-making in the financial market sphere brought another influence to bear on the developing retail market agenda. The seminal 2001 Lamfalussy Report41 was concerned with the establishment of a new EC law-making mechanism for delegated law-making (which empowers the Commission 38 39

40 41

European Commission, Communication on E-Commerce and Financial Services (COM (2001) 66). European Parliament and Council Directive 2002/65/EC of 23 September 2002 concerning the distance marketing of consumer financial services and amending Council Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No. L271/16 (‘Distance Marketing Directive’ or DMD). European Commission, Communication on Implementing the Framework for Financial Markets: Action Plan (COM (1999) 232) (FSAP). Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (2001) (‘Lamfalussy Report’).

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to adopt delegated rules, advised by the Committee of European Securities Regulators (CESR, composed of Member State regulators) and supervised by the European Securities Committee (ESC, composed of Member State representatives)).42 Financial market rules now take the form of ‘level 1’ measures (typically directives) adopted by the institutions under traditional Treaty law-making procedures, detailed ‘level 2’ rules adopted by the Commission and ‘level 3’ guidance adopted by CESR.43 But the Lamfalussy Report also prioritized retail investor protection. It highlighted the absence of ‘high and equivalent levels of consumer protection and no efficient methods for resolving cross-border consumer disputes’ and recommended that ‘the conceptual framework of overarching principles’, on which, it suggested, all EC financial market regulation should be based, include a commitment to ensuring ‘appropriate levels of consumer protection proportionate to the different degrees of risk involved’.44 Its lasting legacy to the retail market agenda, however, was the establishment of CESR, which has had a far-reaching influence on the EC retail market agenda.45 The explosive combination of the Lamfalussy law-making reforms and the FSAP regulatory reform agenda led to an exponential increase in the intensity of EC financial market regulation over the FSAP period (1999–2004). The FSAP also included a discrete retail market agenda46 and the retail market interest emerged strongly across a series of FSAP measures. The first indications of the adoption of a retail market agenda came with the 2003 Prospectus Directive.47 While designed to support crossborder capital-raising by issuers (by harmonizing prospectus requirements and clarifying the scope of private placements), it is also designed to build the confidence of ‘small investors’ in financial markets (recital 41) and has a strong retail orientation;48 recital 16 states that ‘one of the objectives of this Directive is to protect investors’.49 The most dramatic 42 44 46

47

48

49

See further ch. 7. 43 Ibid. Lamfalussy Report, pp. 12 and 22. 45 See further ch. 7. ‘Appropriate and progressive harmonization of marketing and information rules throughout the Union together with a pragmatic search for non-legislative solutions offers the prospect of a truly integrated retail market fully respecting the interests of consumers and suppliers’: FSAP, p. 10. Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’). The European Commission’s advisory European Securities Market Expert Group has described the principal objective of the Prospectus Directive as to protect the retail investor: ESME, Report on Directive 2003/71 (2007), p. 10. See further ch. 6. But investor protection runs across the Directive. E.g. recitals 10, 18, 19, 20 and 21.

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developments, however, occurred with MiFID.50 The massive MiFID regime, discussed throughout this book, is expressly designed to support investor protection (e.g. recital 31)51 and addresses conduct-of-business regulation (including marketing, disclosure and suitability requirements), best execution, conflict-of-interest management and order execution and market transparency. MiFID is also notable for the Commission’s related regulatory rhetoric which claims investor protection (domestically and cross-border) as a legitimate concern of EC financial market regulation52 and which appears to break the link between investor-protection-based harmonization and market integration;53 under MiFID, investor protection has become an end in itself. The MiFID Proposal was designed to address the failure of the precursor ISD to provide a ‘bedrock of harmonized investor protection’,54 while the pivotal conduct-of-business regime was described as a ‘mainstay of investor protection’.55 In one of the more striking of MiFID’s many retail market innovations, the regulation of investment advice has now become a function of EC law (chapter 4). But 50 51

52

53

54

It has been described as ‘the most significant directive in capital markets law of recent times’: BaFIN, Annual Report 2007–2008, p. 12. The FSA has described MiFID in investor protection terms: ‘One of the main objectives of MiFID is to provide a high level of investor protection’: Reforming Conduct of Business Regulation (Consultation Paper No. 06/19, 2006), p. 9. ‘There is a need for enlightened regulation to define the rules of the game and for strong policemen to enforce these rules . . . [MiFID] should equip regulators with a comprehensive set of regulatory disciplines to tackle the risks to which the modern retail investor is exposed . . . A high level of protection is crucial in its own right [emphasis added]. It is also a pre-condition for the effective operation of the ISD passport’: Speech by DirectorGeneral Schaub of the Internal Market Directorate General on ‘Economic and Regulatory Background to the Commission Proposal for Revision of the ISD’, 15 October 2002, available via http://europa.eu/rapid/searchAction.do. All EC legislative measures must meet subsidiarity and proportionality requirements and be based on a Treaty competence (Art. 5 EC). In the financial markets sphere, harmonization has typically been based in the free-movement- and barrier-removal-related competences set out in Art. 44(2)(g) EC (directives designed to co-ordinate the safeguards required by Member States of companies or firms for the protection of members and others), Art. 47(2) EC and Art. 55 EC (directives designed to co-ordinate Member States’ rules on the taking up and pursuit of activities as self-employed persons) and in the two general single market competences, Art. 94 EC (directives for the approximation of Member States’ rules which directly affect the establishment or functioning of the common market) and Art. 95 EC (measures for the approximation of Member States’ rules which have as their object the establishment and functioning of the internal market). The EC institutions do not enjoy a general power to regulate the internal market. Internal market measures must be based on the need to remove regulatory barriers or distortions to competition, although the Commission has rarely appeared troubled by this restriction: Moloney, ‘Confidence and Competence’. European Commission, MiFID Proposal (COM (2002) 625), p. 23. 55 Ibid., p. 25.

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investor protection, not market integration, is the concern; recital 3 does not justify the inclusion of advice by reference to the integration of the advice industry. It notes instead that ‘due to the increasing dependence of investors on personal recommendations’ it was appropriate to include investment advice as a service requiring authorization. On its application on the markets in November 2007 the Commission greeted MiFID as a robust and comprehensive framework for ensuring high levels of investor protection.56 The investor protection rhetoric has also been taken up by CESR which described the harmonization of ‘investor protection throughout Europe and increase[ing] consumers’ confidence that the products they are being sold are actually appropriate for their needs’ as ‘one of the main purposes’ of MiFID.57

c) Post-FSAP Post-FSAP, the policy focus on the retail markets has continued. Integration has often been a subsidiary concern in this period which has seen a focus on effective regulatory design for the retail markets. In the UCITS investment products sphere,58 for example, radical reforms to the design of UCITS disclosure are taking place; the EC is also grappling with the difficulties raised by substitute investment products and the retailization of alternative investments.59 This period is also strongly associated with a more holistic appreciation of retail market policy and with a concern to promote financial literacy, stronger retail involvement in the law-making process and access to redress.60 Belated efforts are also being made to understand retail investor behaviour, with the publication of important reports on long-term retail saving patterns61 and on retail market disclosures.62 The Commission’s 2007 Green Paper on Retail Financial Services63 points to the entrenchment of the retail market agenda. Its earlier 2005 56 57 58 59 61

62 63

European Commission, Press Release, IP/07/1625. Press Release Accompanying the Retail Investor Guide to MiFID (CESR/08-209, 2008), p. 1. The EC’s collective investment regime focuses on the UCITS product. Chs. 3 and 5. 60 Chs. 7 and 8. BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007) (‘BME Report’). Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’). European Commission, Green Paper on Retail Financial Services.

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White Paper on Financial Services Policy had identified the retail market as a key element of the 2005–10 financial services agenda and committed to a series of investor-facing initiatives, including with respect to investor education initiatives, investor governance and redress.64 The 2007 Green Paper was concerned with ensuring that the integrated financial services market (including investment services) delivered products that met consumer needs, enhancing consumer confidence by ensuring consumers were properly protected and empowering consumers to take the right decisions.65 Retail financial services markets (including investment services) were also a theme of the Commission’s wider 2007 internal market policy initiative which addressed the distribution of investment products, financial education and redress.66 By late 2007, the retail interest in financial services generally had become a major policy priority.67 The shift in emphasis is well illustrated by the minutes of the Commission’s then newly constituted consultative Financial Services Consumer Group which, in December 2007, noted that transparency, the provision of information and education were all key elements of the current policy debate.68 None of these elements was a feature of the EC policy debate prior to the FSAP. Why did retail investor protection acquire such prominence, particularly given the absence of retail stakeholders from the policy debate (chapter 7)? Traditional integration concerns are certainly a factor, as is the internal momentum which the FSAP and the Lamfalussy model generated.69 But regulatory empire-building by the Commission, the engine of policy development in the EC, cannot be discounted given the political power of the retail market agenda and its association with regulation. Member States have become increasingly willing to devolve retail market regulation to the EC (section II.2.c below). And, perhaps above all, the Commission has embraced the investor empowerment and ‘marketing the markets’ agenda which is becoming associated with retail investor policy internationally (chapter 2).

64 65 66 67

68 69

European Commission, White Paper on Financial Services, pp. 7–8. European Commission, Green Paper on Retail Financial Services, pp. 2–3. European Commission, A Single Market for 21st Century Europe (COM (2007) 725), Staff Working Paper on Initiatives in the Area of Retail Financial Services. The Commission argued that ‘consumer information and protection are at the heart of EU financial services legislation’: European Commission, Communication from the Commission, Financial Education (2007), p. 1. Financial Services Consumer Group, Minutes, 12 December 2007. See further Moloney, EC Securities Regulation, pp. 19–22.

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2. Scope: the reach of EC investor protection law and policy a) Main elements The main concerns of investor protection regulation – investment product regulation, disclosure, distribution and advice and trading rules70 – are now all governed by the harmonized EC regime, albeit to varying degrees; the scope of the investor protection regime has been further extended by CESR’s quasi-law-making activities.71 The EC regime is not limited to cross-border activity but applies to local activity. The UCITS regime, for example, applies to all UCITS schemes, whether or not they avail themselves of the Directive’s passporting opportunities (Article 1). MiFID similarly applies to all investment firms within its scope, whether or not they engage in cross-border activity (Articles 1 and 5). Investment product regulation (chapter 3) is addressed by the UCITS regime. Disclosure (chapter 5) forms a large component of the retail market regime and is governed by the UCITS regime (UCITS disclosure), the Prospectus and Transparency72 Directives (issuer disclosure) and MiFID and the DMD (disclosure related to product distribution and to investment services). The distribution of investment products and investment advice (chapter 4) is addressed by MiFID and the DMD; a limited regime applies to the distribution of investment-related unit-linked insurance products under the Insurance Mediation Directive.73 MiFID also addresses the trading process. Retail investors additionally benefit from a range of contractual and marketing protections under the harmonized consumer protection regime, notably the 1993 Unfair Contract Terms Directive74 and the 2005 Unfair Commercial Practices Directive.75 Despite its reach, the EC’s investor protection regime is, as discussed in subsequent chapters, segmented and does not always capture the reality of mass market investment. MiFID, for example, does not cover the 70 72

73 74 75

Ch. 2 considers the main tools for intervening in the retail markets. 71 Ch. 7. Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2000/34/EC, OJ 2004 No. L390/38 (‘Transparency Directive’). European Parliament and Council Directive 2002/92/EC of 9 December 2002 on insurance mediation, OJ 2003 No. L9/3. Council Directive 93/13/EEC of 5 April 1993 on unfair terms in consumer contracts, OJ 1993 No. L95/29. Directive 2005/29/EC of the European Parliament and of the Council of 11 May 2005 concerning unfair business-to-consumer commercial practices in the internal market, OJ 2005 No. L149/22 (‘Unfair Commercial Practices Directive’).

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distribution of unit-linked insurance-related investments or structured retail products with deposit elements,76 both of which are popular retail market investments but both of which are vulnerable to regulatory arbitrage risks with respect to distribution requirements and product design and disclosure rules.

b) A prescriptive regime The harmonized retail markets regime has become highly prescriptive. This is in part related to the Lamfalussy model and to the adoption of detailed level 2 rules77 and the accretion of CESR guidance at level 3; the crisis, and related EC institutional reforms, will also likely lead to an increase in the volume of technical rules (chapter 7). But it is also a function of the extent to which a maximum harmonization model, which ousts Member States’ ability to apply additional rules in the harmonized area to domestic actors,78 has been adopted for retail market rules. The DMD contained an augury of what was to come by employing a maximum harmonization model and removing Member State ability to apply additional local rules to domestic actors.79 Recital 13 of the Directive provides that Member States should not be able to adopt provisions other than those laid down by the Directive in the field it harmonizes. The prospectus regime, while not formally a maximum harmonization regime, severely limits, given the scale of the harmonization, the extent to which Member States can use the prospectus regime to address local retail markets risks, including with respect to the offering of retail structured products, a current preoccupation of retail market policy (chapter 3). In the consumer protection field, the Unfair Commercial Practices Directive adopts a maximum harmonization model, although financial services, given their complexity and the risks to consumers (recital 9), are subject to a specific derogation which permits super-equivalent rules (Article 3(9)). The consumer protection field has also seen some enthusiasm for consumer protection directives (including the Unfair Contract Terms Directive) to be recast as maximum harmonization measures.80 76 78 79

80

See further ch. 4. 77 Notably the MiFID Level 2 Directive. Applying additional rules to passporting actors would be in breach of the relevant directives as well as, potentially, the Treaty free movement guarantees. Member States are, pending further harmonization, allowed to impose more stringent disclosure requirements to those imposed on distance marketing by the Directive (Art. 4(2)). MiFID, however, means that Member States have very limited discretion with respect to investment services disclosure. The Commission’s review of the consumer acquis highlighted the fragmentation risks consequent on minimum harmonization measures and canvassed whether a horizontal,

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But the MiFID Level 2 Directive, which is pivotal to the regulation of product distribution and advice as well as to trading regulation, provides in Article 4 the clearest example of the extent to which Member States’ regulatory discretion over the retail markets has been restricted. Article 4(1) addresses ‘gold-plating’ (or the imposition of local super-equivalent rules, additional to directive requirements, on domestic actors) and severely limits the extent to which Member States can impose additional obligations on local markets and actors. Member States may only do so in ‘exceptional cases’ where the rules in question are objectively justified and proportionate so as to address specific risks to investor protection or to market integrity which are not adequately addressed by the Directive.81 The additional rules must also either address a specific risk of particular importance given the Member State’s market structure or address risks or issues that emerge or become evident after the coming into force of MiFID and are not otherwise regulated by the Community. This ‘gold-plating’ ban represents a political consensus during the MiFID level 1 negotiations that uniform solutions be adopted.82 As discussed in chapter 2, harmonization of this intensity and the ousting of Member State discretion in purely local markets potentially poses considerable risks to investor protection given the heterogeneous nature of the Community retail market. The extent of the EC’s influence is well illustrated by its impact on the UK regime ‘on the books’. The FSA has acknowledged that its rules are now based on EC requirements,83 that implementation of the MiFID conduct-of-business regime would ‘over-write’ many of the pre-existing

81

82

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maximum harmonization measure should be adopted and/or earlier measures tightened: European Commission, Green Paper on Review of the Consumer Acquis (COM (2006) 744). Industry stakeholders were supportive of more extensive harmonization although consumer stakeholders were more sceptical: European Commission, Report on the Outcome of the Public Consultation on the Green Paper on the Review of the Consumer Acquis (2007). The Commission has now proceeded with a proposal for an omnibus directive on consumer rights (COM (2008) 614) which updates and strengthens earlier measures (including the Unfair Contract Terms Directive) and adopts a maximum harmonization model. Applications have not been common. As at September 2009, only France, Ireland and the UK had made Art. 4 applications: European Commission, MiFID Transposition State of Play Table. Ch. 4 considers the UK experience. The Art. 19(10) level 2 delegation for conduct-of-business rules, for example, refers to the ‘uniform application’ of Art. 19, as does the Art. 18(3) delegation for conflict-of-interest management. ‘Uniform application’ is also a concern of the best-execution delegation (Art. 21(6)) and the order-handling delegation (Art. 22(3)). E.g. ‘For the most part, our rules reflect the standards set out in Directives’: FSA, Consumer Responsibility (Discussion Paper No. 08/5, 2008), p. 25.

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FSA conduct-of-business requirements84 and that its Conduct of Business sourcebook (COBS), central to investor protection in the UK retail market, is now governed by the requirements of MiFID, the Insurance Mediation Directive and other EC measures and that these requirement are often, in a form of quasi-harmonization, applied by the FSA to local activities and instruments outside the scope of these measures.85 The Retail Distribution Review, central to the UK’s current efforts in the retail market, has also highlighted that EC measures, as well as the Commission’s overall policy direction with respect to retail financial services, have the potential to influence how the UK distribution and advice market works.86

c) The movement of retail market issues from the Member States to the EC The reach of the EC over local and cross-border retail markets is also clear from the growing tendency of the Member States, notwithstanding the sensitivities of local retail markets, to view retail market policy and reaction to new developments in terms of a co-ordinated Community response. The highly sensitive question of retail investor access to alternative investments, for example, saw the FSA acknowledge the need to co-ordinate with the Community.87 Although regulators have been struggling domestically with how to design effective investment product disclosure, there appears to have been little resistance to the current UCITS ‘Key Investor Information’ (KII) reform, although it removes Member State discretion in this area (chapter 5). The current debate on substitute investment products (chapter 3) has also seen support for a co-ordinated response.88 The industry also appears conscious of the likelihood but also the potential value of EC intervention. The FSA’s massive Retail Distribution Review generated some resistance to the FSA’s reforms given the risk that 84 85

86 87

88

Consultation Paper No. 06/19, p. 7. FSA, Response to the European Commission’s Call for Evidence on Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008) (‘FSA Substitute Products Response’), p. 2. 2007 RDR, p. 5. FSA, Wider Range Retail Investment Products (Discussion Paper No. 05/3, 2005), noting that ‘any enduring solution will need to take account of, and preferably influence, the developing European and international debate’ (p. 7). European Commission, Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products: Feedback Statement on Contributions to the Call for Evidence (2008), pp. 29–30 and 35. The Retail Distribution Review reforms have been extended to reflect the scope of the Commission’s proposals: FSA, Distribution of Retail Investments: Delivering the RDR (Consultation Paper No. 09118, 2009), p. 11.

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the FSA’s radical plans might be overtaken by EC developments.89 In a notable example of the industry using EC influence on domestic policy, the substitute product debate saw two leading UK trade associations raise their concerns with respect to the local regulatory treatment of a domestic product before the Commission.90 The recent concern in the UK to address the risks posed by ‘boiler rooms’91 has also seen a leading trade association call for co-ordinated action between the UK, the Commission and national regulators.92 MiFID, in particular, marked a greater willingness to address retail market regulatory issues centrally and through maximum harmonization measures. The earlier Council negotiations on the DMD were difficult and focused in particular on the Directive’s ‘abandonment of the minimum harmonization principle’93 and the extent to which local consumer-protection (particularly disclosure) regimes could be accommodated within the Directive’s maximum harmonization structure. The MiFID level 2 negotiations, however, appear to have been more concerned with preventing gold-plating than with addressing the retail market risks generated by a removal of Member State flexibility. There is also evidence of Member State reliance on MiFID as a template for wider national retail market reforms;94 the European Court has confirmed the intuition that Member States can expand the scope of EC measures domestically as long as the national measure makes clear that it does not implement a Community rule.95 89

90

91 93 94

95

The Association of Private Client Investment Managers (APCIMS) warned that the FSA’s determination to lead the way might result in their wasting time and resources on domestic regulatory initiatives which were subsequently taken over by European requirements: APCIMS, Response to DP 07/1 (2007), p. 1. The Investment Management Association (IMA) raised its concern (which it had already expressed domestically) as to the UK regulatory treatment of the Global Equity Bond (issued by the UK’s National Savings and Investments body, which is backed by HM Treasury) which is not subject to the full application of the FSA’s disclosure and marketing regime. The IMA argued that it was inappropriately marketed as a substitute product for equity market investments although, based on the IMA’s research, it under-performs the market and is not a safe substitute for stock investments: (IMA), Response to Commission Call for Evidence on Substitute Products (2008), pp. 1–2 and Annex. See further ch. 4. 92 APCIMS, Press Release, 14 May 2008. European Commission, Report on the Common Position (SEC (2002) 30), p. 3. Portugal, for example, has applied MiFID-style disclosure and suitability obligations to the sale of insurance and pension products (which are outside the scope of MiFID): Comiss˜ao do Mercado de Valores Mobili´arios (CMVM) Regulation No. 8/2007. See n. 139 below on the FSA position. Testa and Lazzeri [2002] ECR I-10797 (Case C-356/00).

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It may be that CESR’s burgeoning influence on policy development, the opportunities it provides for strengthening trust between regulators and its recent adoption of a retail market agenda have contributed to a greater degree of comfort with EC initiatives.96 It may also be that the recent enhancement to the policy and regulatory design process under the Lamfalussy process and the Better Regulation agenda,97 including more extensive consultation procedures, better cost/benefit analysis and the recent striking attempts to locate policy developments in a better understanding of the nature of the retail market,98 are leading Member States to give more weight to the economy of scale benefits of EC intervention than to the restrictions posed by harmonized rules. Given that retail market measures are often associated with higher industry costs, the EC may also provide useful political cover for Member States seeking retail market reforms to emerging risks. Although retail investors do not yet act as a coherent group in policy-making, intriguing evidence has emerged of investors’ regarding the Commission as their champion against the financial services industry; this enthusiasm for EC action extends to those traditionally more eurosceptic Member States, such as the UK.99 Member States may therefore find it more palatable to adopt EC-driven solutions to emerging problems.

3. Beyond the cross-border context While the harmonized retail market regime applies to local as well as crossborder activity, the regime’s roots are in the construction of an internal market. But the construction of the retail integrated market has proved to be highly troublesome; integration is proceeding very slowly, and the impact of harmonization has not been significant. But this has not affected 96 97

98 99

Ch. 7 considers CESR. Which the Commission committed itself to follow in the financial services sphere: White Paper on Financial Services Policy, pp. 4–8. See generally R. Haythornthwaite, ‘Better Regulation in Europe’ in S. Weatherill (ed.), Better Regulation (Oxford and Portland, OR: Hart Publishing, 2007), p. 19. See further chs. 2 and 7. Optem Report, p. 16. The Report found that ‘in a number of countries (Eastern European Member States, Italy, Ireland and the UK), the Commission was seen as the institution that was most capable of regulating a sector that has been dogged by scandal’ (p. 117). Comments included ‘I think it’s great that they [the EC] are trying to do something to help the consumer’ (from the UK) and ‘It’s very positive that the [Commission] pays attention to a sector of the financial market where – at least in Italy – so many frauds have damaged thousands of honest citizens who were simply looking to protect their life’s savings’ (from Italy) (p. 117).

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the reach of the regulatory regime into local markets or the ambition of the EC’s regulatory strategy for the retail markets, underlining the regulatory quality of the harmonized regime. Poor levels of cross-border activity in retail financial services generally were reported in the Commission’s first (2004) Financial Integration Monitor;100 direct cross-border offers of retail financial products were the exception and product delivery to the end-investor was typically through local distribution networks.101 In 2005, there was little change: ‘the degree of fragmentation in retail markets is still considerable’.102 The 2006 Monitor focused on the CIS sector and reported significant differences in investors’ preferences for cross-border schemes.103 Since then, MiFID has come into force, but progress has remained very slow. The 2007 review reported continuing fragmentation in the retail markets,104 as did the 2008 review which found that a single retail financial market was ‘far from being achieved’.105 Cross-border transactions by individuals were limited and prices, products and distribution channels all varied across local markets. To the extent integration was taking place, it was on the supply side and through firms, particularly retail banks (which typically take the form of multi-service ‘financial supermarkets’ in continental Europe), establishing cross-border subsidiaries and branches,106 reflecting strong demand-side preference for local suppliers.107

100 101 102

103 104 105 106

107

European Commission, Financial Integration Monitor 2004 (SEC (2004) 559). Ibid., pp. 5 and 17. European Commission, Financial Integration Monitor 2005 (SEC (2005) 927) (‘2005 Monitor’), p. 12. It reported that only 5 per cent of EU citizens had bought a financial product from another Member State (and these purchases were usually related to migration) (p. 10). European Commission, Financial Integration Monitor 2006 (SEC (2006) 1057) (‘2006 Monitor’), pp. 21–2. European Commission, European Financial Integration Report 2007 (SEC (2007) 1696) (‘2007 Monitor’), pp. 13 and 17. European Commission, European Financial Integration Report 2008 (SEC (2009) 19) (‘2008 Monitor’), p. 14. Ibid., pp. 10 and 14. The 2007 Monitor reported an increasing number of cross-border bank branches, although subsidiaries were the dominant form of cross-border establishment with their assets amounting to 10.5 per cent of the EU-25 market as compared to an 8.5 per cent share by branches (p. 15). The 2005 Monitor noted that consumers do not appear to distinguish between foreign and domestic providers where they are both established locally (p. 10), while the 2006 Monitor also emphasized local establishment (p. 5). The 2003 preparatory Monitor had previously highlighted the importance of proximity in the retail markets: Tracking EU Financial Integration (2003) (SEC (2003) 628), p. 5.

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Close attention was given to cross-border activity in the important 2007 BME Report on long-term savings in the EC. It found that retail consumers were participating in the integration process indirectly through CISs which invested in cross-border assets, but that the market in long-term savings products was highly fragmented.108 It reported modest levels of crossborder activity, wide variations in prices, restricted product diversity and choice, variations in the performance of intermediaries109 and a strong preference for local providers.110 It also reported on the extensive evidence of national segmentation in the distribution of investment products and the delivery of investment advice (chapters 3 and 4).111 Reluctance to engage with cross-border services and products is also clear from the Commission’s Eurobarometer surveys of public opinion. In 2005, it reported high levels of reluctance to obtain cross-border financial services and that 85 per cent of respondents had not purchased financial services from firms situated in other Member States.112 An integrated retail investment services market could offer retail investors significant benefits in terms of product and services competition, wider choice, cost discipline and better diversification – although this assumption makes significant demands on the retail investor’s ability to exercise choice effectively.113 But whether or not a cross-border market can be driven by regulation is highly doubtful. Cross-border activity in the retail markets, on the demand side,114 depends on a range of factors, few of which are amenable to regulation. Language difficulties are a significant inhibitor. So too is the tendency of retail investors to prefer local suppliers and to exhibit a strong home bias in investments.115 Cultural factors can affect the extent to which investors operate 108 112

113 114

115

BME Report, p. 11. 109 Ibid., p. 26. 110 Ibid., p. 15. 111 Ibid., pp. 100–47. European Commission, Special Eurobarometer No. 230, Public Opinion in Europe on Financial Services (2005), p. 10. Enthusiasm for future cross-border purchases varied, however. 87 per cent of Greek respondents would not purchase cross-border in future but respondents in France, Ireland, Malta and Slovakia were more open to cross-border purchases (p. 11). Consumers in the new Member States, however, appear more open to crossborder financial services, suggesting some lack of trust in domestic institutions: European Commission, Eurobarometer 2003:5 (published in 2004) Financial Services and Consumer Protection: Summary Report (2004), p. 4. Discussed further in chs. 2, 3 and 5. The supply side will have limited incentives to engage without investor demand. The supply side also faces other obstacles including with respect to diverging non-harmonized rules, litigation and supervisory risks, taxation, personnel, payment/credit assessment and other infrastructure difficulties and the need to adapt products, business models and pricing strategies: European Commission, Green Paper on Retail Financial Services, p. 6. See further ch. 2.

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cross-border.116 Market infrastructure can cause difficulties;117 fragmentation in clearing and settlement increases the cost of retail trading.118 Taxation remains a significant obstacle. Although the BME Report suggested that investment (and banking) products had greater potential for integration than pension and insurance products, it highlighted a wide range of obstacles, including wide variations in investment behaviour (section III below), a home bias and preference for familiar products and services, information failures, language difficulties, national product segmentation (including the local distribution of government bonds), higher fees for cross-border investments, higher investment thresholds for cross-border investments, switching penalties, lack of transparency and diverging welfare systems which generate different incentives to purchase investment products.119 The fate of the DMD provides a vivid example of the limitations of law. Two extensive 2008 studies on the Directive’s impact on the construction of a cross-border market in distance financial services point to a signal failure. One found that there was no significant cross-border activity in the distance marketing of financial services and that the failure of the market to develop was linked not to legal difficulties but to language, cultural factors and the nature of financial services.120 The second reported that there was no meaningful cross-border provision of distance marketing of financial services either before or after the Directive, which had little or no impact. It highlighted the difficulties caused by taxation, electronic contracts, cultural and language difficulties and consumer preferences for local providers.121 There now appears to be a policy realization that harmonization is a limited tool for driving cross-border activity in the retail sector. The Commission’s 2007 Green Paper on retail financial services acknowledged that integration had not reached its potential with only modest cross-border activity, wide variations in price, restricted product diversity and choice and large variations in the profitability of retail providers.122 Stakeholders are also doubtful.123 The Commission now appears to accept that most 116 118 120 121

122 123

2007 Monitor, p. 13 and 2008 Monitor, p. 14. 117 2007 Monitor, p. 13. See further ch. 6. 119 BME Report, pp. 211–14. U. Reifner et al., Final Report: Part I: General Analysis: Impact of Directive 2002/65/EC. Project No. SANCO/2006/B4/034 (2008). As well as factors related to understanding local markets, payment structures, credit assessment and recovery and diverging rules, particularly on money-laundering: Civic Consulting, Analysis of the Economic Impact of Directive 2002/65/EC: Final Report (2008). European Commission, Green Paper on Retail Financial Services, pp. 4–5. The consultation on the 2007 Green Paper revealed that most respondents saw retail markets remaining local for the foreseeable future given the importance of language,

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consumers of retail financial services are likely to remain domestically focused. Although it has suggested that further reforms may be necessary, it will only proceed where appropriate and where there is evidence of clear and concrete benefits.124 This realization of the limits of harmonization in driving cross-border activity coupled with the ever-increasing ambition of EC retail market policy points, however, to the importance of the regime as a regulatory system.

4. But room for local ‘law on the books’ and for ‘law in action’: the UK example The EC regime is not, however, monolithic. Some room remains for regulation to reflect the different features and risks of Member States’ markets. MiFID and the related UK investment advice and product distribution regime provides a useful illustration of the ability of Member States to retain discrete rules ‘on the books’ which respond to local risks. Investor protection in the UK retail investment markets125 is primarily a function of the Financial Services and Markets Act 2000 (FSMA) under which the FSA operates and which, under section 2, imposes a series of statutory objectives, including consumer protection and public awareness, with which FSA activities must be compatible (chapter 2); the harmonized regime, by contrast, does not engage with the over-arching principles with which local regulators should act and which could lend coherence to ‘law in action’ strategies in particular. FSMA also imposes the central authorization obligation for ‘regulated activities’ in the financial services sector; a person may not engage in ‘regulated activities’ unless that person is authorized or exempt (section 19). ‘Regulated activities’ essentially relate to ‘specified activities’ and ‘specified investments’ (section 22(1)) which are set out in the related Regulated Activities Order126 which covers

124 125

126

culture and the familiarity of consumers with local providers. A senior FSA official has similarly suggested that stakeholders need to be realistic in their expectations as to what can be done through regulation to encourage consumers to do more cross-border business: D. Waters (FSA), Speech on ‘MiFID, Threats and Opportunities’, 9 January 2008, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml. European Commission, Green Paper on Retail Financial Services, p. 6. This section is an outline discussion only. See further I. MacNeill, An Introduction to the Law on Financial Investment (Oxford and Portland, OR: Hart Publishing, 2004), pp. 59–78, 91–135 and 165–85. Financial Services and Markets Act 2000 (Regulated Activities) Order 2001.

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EC requirements as well as those additional activities specified by the Order. ‘Specified activities’ in the investment services sphere include advising on investments as an agent of the investor as well as the other central retail market activities covered by MiFID127 (such as managing investments and safeguarding and administering investments) and exMiFID activities such as establishing, operating and winding up collective investment schemes; ‘specified investments’ extend to a wide range of investments.128 By contrast with the MiFID regime, FSMA also imposes an additional discrete authorization requirement on particular individuals through the ‘approved persons’ regime which limits ‘controlled functions’ to ‘approved persons’ (section 59) and which reinforces both ex ante investor protection regulation and ex post enforcement.129 Alongside the authorization regime, FSMA also imposes a financial promotions regime which prohibits financial promotions by persons who are not authorized (section 21). In addition to these local features which strengthen MiFID’s authorization requirements for advice and distribution, the local regime also responds to specific UK market features. Investment advice in the UK is largely delivered by smaller, notionally ‘independent’ investment advice firms, often termed personal investment firms, which do not manage investments or hold client assets or funds and which do not deal in investments; these firms simply advise on investments (primarily the ‘packaged products’ discussed below) and transmit orders in investments to other regulated entities.130 They are at the heart of the UK investment advice industry.131 Their limited range of activities, however, means that MiFID’s 127 128 129

130

131

See further ch. 4. Including government and public securities, shares, debt instruments, derivatives, collective investment schemes, contracts related to life assurance and deposits. A function may be designated by the FSA as ‘controlled’ where it is likely to enable the individual responsible for its performance to exercise a significant influence on the conduct of an authorized person’s affairs (with respect to the regulated activity), where the function will involve the individual performing it in dealing with customers of the authorized person in a manner substantially connected with the carrying on of the regulated activity or where the function will involve the individual performing it in dealing with the property of customers of the authorized person in a manner substantially connected with the carrying on of the regulated activity. Over 5,000 personal investment firms (representing 28,000 investment advisers) provide advice in the UK market. 83 per cent of these firms have fewer than five advisers, although firms are increasingly becoming organized in networks and, in some cases, are owned by product providers: FSA, Review of the Prudential Rules for Personal Investment Firms (Discussion Paper No. 07/4, 2007), pp. 8–9. These advisers account for more than 75 per cent of all sales of CISs, for example, and are seen, based on consumer surveys, as the ‘key conduit between consumers and products’:

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weighty authorization and regulatory regime, which responds to a wide range of investment firm risks, would be costly. But one of MiFID’s more notable exemptions from investment services authorization (and regulation) relates to ‘Article 3 firms’ which only advise on investments or receive or transmit orders in transferable securities and units in collective investment undertakings and do not hold investor assets.132 This exemption has been applied by the UK to its personal investment firm industry. ‘Article 3 firms’ nonetheless carry out ‘regulated activities’ and are subject to FSA authorization and to a discrete regulatory regime which – in an attempt to avoid regulatory arbitrage – is closely based on MiFID requirements where cost benefit requirements have been met.133 But the FSA also has the freedom to apply a more nuanced regime to the sector, although arbitrage risks between MiFID and non-MiFID advice firms134 must be managed. Recent FSA retail reforms have focused closely on this sector and, in particular, on the mis-selling risks with which it is associated (which arise from a combination of commission-based remuneration, poor investor discipline and product competition at the distribution level (with respect to product commissions) rather than at the investor level135 ). The FSA has engaged in an extensive review of the prudential requirements imposed on these firms, particularly to limit the impact of latent liabilities where these firms fail and outstanding liabilities in terms of mis-selling claims must be met by the industry through the Financial Services Compensation Scheme,136 and has had the freedom to develop a targeted capital resources regime for non-MiFID ‘Article 3 firms’.137 The FSA has also addressed misselling risks in this sector through its massive Retail Distribution Review,

132 134

135 136

137

HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC (2007) (‘UK Article 4 Application’), pp. 12–13. MiFID, Art. 3. 133 See also ch. 4. In particular as not all personal investment firms fitting the ‘Article 3’ profile are MiFIDexempt as they have ‘opted in’ to MiFID authorization in order to benefit from the MiFID ‘passport’ (FSA, Review of the Prudential Rules for Personal Investment Firms (Consultation Paper No. 08/20, 2008), p. 5. See further ch. 4. FSA, Discussion Paper No. 07/4, FSA, Review of the Prudential Rules for Personal Investment Firms (Feedback Statement No. 08/2, 2008) and FSA, Consultation Paper No. 08/20. The reforms followed concerns that the pre-existing and complex regime was no longer fit for purpose given failures in the sector and that a new and clearer risk-based model was required. The reforms apply only to non-MiFID ‘Article 3 firms’ (FSA, Consultation Paper No. 08/20). Where ‘Article 3 firms’ do not benefit from the exemption, MiFID applies a lighter capital resources regime, based on insurance cover (see further ch. 4). The FSA’s approach,

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although the scale of the review, which covers the whole investment advice industry and not simply the ‘Article 3’ sector, has led to difficulties with MiFID (chapter 4). The tailoring of EC rules to local market features is also evident in the detailed rules which support the statutory regime and which are set out in the FSA’s extensive rulebook or Handbook. The Handbook, which also implements EC requirements, has a number of different sourcebooks which contain the detailed regulation for the retail markets.138 The COBS (conduct of business) sourcebook, in particular, is pivotal to investment advice and distribution, addressing investor classification, investment firm disclosures, advice and know your client rules, client agreements, marketing, product disclosure and reporting. While it implements MiFID with respect to investment firms and MiFID investments, it is wider than MiFID in its scope,139 reflecting the cross-sector nature of product distribution in the UK and the extent to which ex-MiFID pension products, ex-MiFID unit-linked insurance products and MiFID investment products substitute for each other and are sold by advisers. In extending the MiFID regime, the FSA’s concern has been to meet local concerns by seeking a level playing

138

139

however, is expressly designed to address market failures and mis-selling in the UK personal investment firm sector and is based on a minimum capital level for all firms (£20,000) and an ongoing Expenditure Based Requirement which is designed to be risk-based. The High-Level Standards Block, for example, includes PRIN (the principles for business, including Principle 6 on fair treatment, which supports the FSA’s important Treating Customers Fairly regime), SYSC (senior management arrangements, systems and controls), COND (threshold conditions for authorization) and FIT (the approved persons regime and the related ‘fit and proper’ test). The Prudential Standards Block includes GENPRU (general prudential requirements), BIPRU (prudential requirements for banks, building societies and investment firms) and UPRU (prudential requirements for UCITS). The Business Standards Block includes COBS (conduct of business), CASS (client asset requirements) and MAR (market conduct and the control of market abuse). The Listing, Prospectus and Disclosure Block includes LR (the Listing Rules), while the Redress Block includes DISP (redress) and COMP (compensation). The COLL sourcebook addresses collective investment. Unlike the MiFID conduct-of-business regime, the COBS sourcebook applies in principle to firms with respect to their deposit-taking, designated investment business and long-term insurance business activities (COBS 1.1.1). But the main retail investment market rules apply broadly to ‘designated investment business’, which business reflects the definition in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 of investment business. By contrast with MiFID’s narrower approach, advice business (which comes within ‘designated investment business’) is subject to COBS where the advice concerns ‘designated investments’; these cover a wide range of retail investments, including life policies, personal pensions and stakeholder pensions, which are excluded from MiFID. MiFID’s suitability regime, for example, provided the ‘nucleus’ of the COBS suitability regime for non-MiFID products including life insurance policies, pensions and other packaged products: FSA, Consultation Paper No. 06/19, p. 76.

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field where firms carrying out investment business deal with retail clients, not differentiating between firms, and ensuring the same standards apply to competing products.140 The regulation of investment products also illustrates how tailored domestic regimes can co-exist with the harmonized EC regime. The main focus of the EC investment product regime, such as it is, is on UCITS disclosure, UCITS product design and, to a more limited extent, UCITS governance requirements. The FSMA regime, however, is wider, addressing ‘open-ended’ (in that schemes must redeem investors’ investments on demand) CISs generally141 and imposing promotion restrictions unless a scheme is an authorized unit trust, an authorized open-ended investment company or other recognized scheme142 (or essentially a regulated UCITS scheme or ‘non-UCITS retail scheme’ (NURS)). The FSA’s Handbook imposes detailed regulation on regulated schemes which are authorized for distribution to the public.143 This regime is both deeper and wider than the UCITS regime. The FSMA/FSA regime for regulated UCITS schemes is considerably more sophisticated and extensive than the harmonized UCITS regime.144 But the FSMA/FSA regime is also wider. The nonUCITS NURS regime (which includes future and options schemes and property schemes145 ) has allowed the FSA to respond to the requirements of the UK retail market. In implementing a policy decision to expand retail investor choice with respect to the range of NURS marketed to the public146 the FSA has, for example, expanded the NURS regime to allow NURS to invest in funds of hedge funds.147 The UK investment product market also includes ‘closed-end’ investment schemes (which do not redeem investor units or investments on 140

141 144

145

146 147

E.g. FSA Substitute Products Response, p. 2 and Consultation Paper No. 06/19, pp. 79–80 (with respect to the extension of the MiFID suitability rules to ex-MiFID unit-linked products and ex-MiFID ‘Article 3’ firms). Defined in FSMA, sect. 235. 142 FSMA, sect. 238. 143 Through the COLL sourcebook. For a discussion of how the detailed FSA Handbook applies to collective investment schemes (including UCITS) see E. Lomnicka, ‘Collective Investment Schemes’ in W. Blair and G. Walker (eds.), Financial Services Law (Oxford: Oxford University Press, 2006), p. 659 and J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), pp. 211–12. NURS have wider investment powers than UCITS schemes. Although the NURS regime is not segmented into different schemes and adopts a framework approach, specific rules apply (with respect to, for example, concentration, borrowing, and spread of assets) to particular schemes, including property schemes and funds of hedge funds. FSA, Discussion Paper No. 05/3 and FSA, Funds of Alternative Investment Funds: Feedback on Consultation Paper 07/6 and Further Consultation (Consultation Paper No. 08/4, 2008). See further chs. 2 and 3.

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demand and so fall outside the UCITS and NURS regime) in the form of (typically) listed companies which engage in investment business (or ‘investment trusts’) in which investors hold a shareholding. These corporate vehicles, which have a venerable history,148 although they came under severe pressure over the financial crisis,149 are, for the most part, primarily addressed by company law, by the disclosure and other requirements which the Prospectus and Transparency Directives impose on listed issuers and by the Listing Rules applied by the FSA.150 Although domestic issuer disclosure requirements are a function of the directives, the domestic listing regime has allowed the FSA to tailor the local regulatory regime to the particular risks of the UK marketplace and to the popularity of these investments.151 The losses incurred by retail investors following the failure of the split-capital investment trust sector, for example, led to reforms to the listing regime and, in particular, to a requirement that investment trust boards be independent from investment managers given the possibility for conflicts of interest.152 While MiFID imposes high-level admission to trading requirements on transferable securities (including shares in investment companies and trusts),153 the Listing Rules for closed-end schemes/investment trusts are considerably more tailored.154 The UK investment product regime also responds to the particular risks which arise from local industry structures and retail investor behaviour. 148 149 150

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152 153

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The Foreign & Colonial Investment Trust, for example, was established in 1868. S. Johnson, ‘Rescue Plan for Investment Trusts’, Financial Times, Fund Management Supplement, 9 February 2009, p. 1. Listing Rule 15. Listing requirements also apply to open-ended schemes (Listing Rule 16) but these are much less extensive as open-ended schemes marketed to the public are subject to the detailed FSMA/FSA regime. Over 430 investment entities are represented on the UK Official List (amounting to £66 billion): J. Tiner (FSA), Speech on ‘Listing Rules Reform and the FSA’s Approach to Better Regulation’, 20 March 2006, available via www.fsa.gov.uk/Pages/Library/index.shtml. Although retail investment in this sector is significant, wholesale institutions remain dominant, with two-thirds of the investment institutional in nature: Benjamin, Financial Law, p. 212. FSA, Investment Companies: Proposed Changes to the Listing Rules and the Conduct of Business Rules: Changes to the Model Code (Consultation Paper No. 164, 2003). Through MiFID, Art. 40(1) (financial instruments generally must be capable of being traded in a fair, orderly and efficient manner and transferable securities must be freely negotiable) and the related level 2 (delegated rules) regime. Listing Rule 15 includes the requirements that closed-end investment schemes must: invest and manage assets in a way consistent with their objective of spreading risk; avoid cross-financing between the businesses which form part of their portfolios; invest no more than 10 per cent of assets in other listed closed-end schemes; publish an investment policy which covers asset allocation, risk diversification and gearing; and meet board independence requirements.

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In principle, FSA regulation of the retail investment services and products market seeks to ensure a level playing field between firms which deal with retail clients and investments and does not generally distinguish between firms or with respect to different products, thereby limiting the scope of regulatory arbitrage in the UK. But the popularity of substitutable, cross-sector investment products in the UK (including UCITS, NURS, investment trusts, pension products and unit-linked insurance products),155 well-documented evidence of poor investor decisionmaking156 and reliance on commission-based advisers157 has also led the UK regime to focus sharply on the cross-sector risks of product sales and to attach discrete regulation to particular products. By contrast with the segmented EC approach, the FSA has developed a specific and targeted cross-sector regime for the distribution of, and advice with respect to, ‘packaged products’ or complex and long-term investment products which are sold to the mass market, typically by commissionbased (usually ‘Article 3’) advisers. Personal pension products, units in regulated CISs (including UCITS), investments in investment trust saving schemes (not all investment trusts) and unit-linked life insurance products, and whether or not they are held within tax wrappers or constructed as ‘stakeholder products’ (see chapter 3),158 are all packaged products and so are subject to tailored distribution and disclosure requirements under COBS. These products have in common generally complex structures, commission-based sales and a mass market orientation – the packaged products regime is designed to be calibrated to the investing patterns of the UK retail investor. The regime does not include equities, in part as they are less opaque and as they are not generally actively traded by retail investors.159 Shares in investment trusts are not, accordingly, included within the regime. But, where a trust provides a regular savings mechanism and competes with other investment and savings products, it is treated as a packaged product as, under the FSA’s analysis, it then becomes substitutable with other mass market savings and investment products.160 The additional packaged product requirements include disclosure obligations, in that a ‘Key Features Document’, which is similar in design to the UCITS simplified prospectus, must be prepared by product providers 155 158 159 160

Sect. III below. 156 See further ch. 2. 157 See further ch. 4. Definition of packaged product, FSA Handbook, Glossary. Stakeholder and personal pensions are also packaged products. FSA Substitute Products Response, p. 3. Investment Trust Savings Plans represented only 10,000 of the 844,000 investment products sold in 2007–8: FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 8 (a 50 per cent drop from 2006–7).

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and provided at the point of sale, a requirement to disclose commissions and commission equivalents prior to a sale, a requirement to explain recommendations in writing and controls on when a firm can describe itself as independent.161 Because the FSA’s packaged product regime imposes requirements additional to the MiFID distribution regime for MiFID investments and services, it necessitated an Article 4 application to the Commission.162 Regulation aside, as discussed further in chapter 2, effective retail market intervention depends heavily on ‘law in action’ techniques as well as on ‘law on the books’. But EC investor protection law and policy is primarily based on regulatory strategies. ‘Law in action’, in the form of supervisory and enforcement practices, remains the preserve of the Member States. The FSA has made full use of this distinction with its innovative ‘Treating Customers Fairly’ (TCF) strategy. Based on Principle 6 of the FSA’s high-level Principles for Business,163 it addresses the product life-cycle and the fair treatment of investors through product design, distribution/advice and redress initiatives. The different TCF initiatives sit within the EC rule framework but are designed to drill below the regulatory regime and to support the delivery of its objectives and outcomes.164

5. Examining retail investor protection through the EC lens Regulatory design ‘on the books’ for retail markets in the Community has, accordingly, become in large part a function of EC intervention, although 161

162 163 164

A Key Features Document (and other disclosures – the Key Features Illustration) must, in principle (exemptions apply), be prepared by firms for the packaged products they produce (COBS 13.1.1) and it must be provided when a firm sells packaged products to retail clients (COBS 14.2). Commission and commission equivalents must be disclosed in cash terms when a firm sells, personally recommends or arranges the sale of a packaged product to a retail client (COBS 6.4.3). A record of the suitability assessment (explaining why certain recommendations were made) must also be kept with respect to advice concerning certain products, including CIS units, certain investment trust shares (including those related to savings schemes), life insurance products and pension products (COBS 9.4.1). The regime also provides that a firm may not hold itself out as independent in relation to advice (or personal recommendations) on packaged products unless it intends to look across the ‘whole of the market’ (or the whole of a sector of the market) in making a recommendation and offers a client a fee (rather than commission) option with respect to the packaged product transaction (COBS 6.2.15 and 6.2.16). See further chs. 4 and 5. Principle 6 of the Principles for Business (set out in the PRIN sourcebook) requires firms to pay due regard to the interests of their customers and to treat them fairly. See further chs. 3 and 4.

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practical ‘in action’ strategies remain the preserve of the Member States and there is some room for local flexibility with respect to ‘law on the books’. The scale of the influence of EC investor protection regulation and policy on domestic regulation alone calls for close attention.165 But the regime also provides a rich case study for wider examination of the purpose of intervention in the retail market and the risks (chapter 2), for assessing the main regulatory levers used to deliver retail market objectives (chapters 3 (product design), 4 (distribution), 5 (disclosure) and 6 (trading)) and for assessing education, investor governance and supervision and redress in the retail markets (chapters 7 and 8). The relationship between the EC regime ‘on the books’ and local supervisory and other efforts ‘in action’ similarly provides a useful case study for illustrating the distinction between ‘on the books’ and ‘in action’ intervention. But a threshold question must first be asked: who is the retail investor who is the subject of the EC investor protection regime?

III. Who is the EC investor? 1. Characterizing the target of investor protection The complexities and risks of retail market regulatory intervention, discussed in chapter 2, are exacerbated by a fundamental difficulty: who is the retail investor? Descriptive but ultimately meaningless references to the retail investor,166 the small investor167 and the average investor168 are scattered across the harmonized regime. In practice, however, ‘the “retail investor” can be a very hard character or set of characters to pin down’.169 The Commission’s 2007 Green Paper on Retail Financial Services exposed related differences on the nature of the consumer of financial services,170 while CESR has identified the difficulties in building a model of the retail

165 168 169 170

Ch. 2. 166 MiFID, Art. 4(1)(12). 167 Prospectus Directive, recital 41. UCITS Directive, Art. 28(3) and MiFID Level 2 Directive, Arts. 27(2) and 38(c). J. Black, Involving Consumers in Securities Regulation: Research Study for the Taskforce to Modernize Securities Legislation in Canada (2006), p. 28. How best to classify the consumer of retail financial services arose during the Commission’s consultation. There was some support for the consumer as a reasonable, well-informed and circumspect consumer, although this model was regarded as setting too high a threshold for consumer protection by user stakeholders: European Commission, A Summary of the Written Contributions Received on the Green Paper on Retail Financial Services (2007), p. 21.

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investor.171 But pinned down the retail investor must be if intervention is to respond effectively to real risks and not to be a function of regulatory empire-building or driven by woolly regulator perceptions of the nature of the retail investor.172 In the EC context, failure to conceptualize the retail investor carefully raises the additional risk of poorly designed rules which remove local flexibility.

2. The average EC investor: an elusive target? a) Investment patterns The ‘EC investor’ does not exist,173 for the moment at least.174 Evidence must be drawn from national markets on the investment preferences of retail investors.175 But, notwithstanding the current policy focus on the retail markets, only limited evidence has hitherto been available, gathered either nationally or on a pan-EC basis, to inform EC policy and regulatory design.176 As discussed in chapter 2, one of the more striking recent trends in retail market policy internationally is regulators’ probing 171

172

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174

175 176

CESR’s 2005 Retail Investor Workshop highlighted that ‘retail investors’ vary considerably with respect to their levels of understanding, experience, needs and concerns and underlined the difficulties in capturing the diversity of investors: CESR, Annual Report 2005, p. 37. The French regulator, the AMF, for example, has acknowledged the need for its actions to ‘be based on what savers really want, rather than on what it thinks they want’: AMF, Promoting Better Regulation: Outcome of the Consultation – The AMF’s Commitments (2006), p. 8. The hearings on the Commission’s Green Paper on Retail Financial Services also saw some concern that information ‘be aimed at what best serves the average retail investor rather than what a regulator thinks’: European Commission, Report of Hearing on Green Paper on Retail Financial Services (2007), p. 3. Although one analysis has suggested that the standard French equity holder is similar to holders in other European countries in that ‘he’ is usually ‘a member of the workforce, middle-aged . . . and belongs to one of the higher net-worth categories, meaning that some diversification across several asset types is assumed’, has a superior education and is receptive to financial information: B. S´ejourn´e, Why Is the Behaviour of French Savers So Inconsistent with Standard Portfolio Theory? (AMF Working Papers, 2006) (‘French Savers’), p. 7. As acknowledged by CESR Chairman Wymeersch, although he suggested that the ‘European consumer’ might emerge: Presentation on Financial Education, Commission Hearing on Retail Financial Services (2007). Ch. 2 considers the behavioural vulnerabilities of retail investors. This section addresses their investment preferences. Studies can be hard to reconcile. See, for example, V. Corragio and A. Franzosi, Household Portfolio and Demand for Equity: An International Comparison (Blt Notes No. 19, Borsa Italiana, 2008), p. 26, which illustrates how domestic data on equity holdings varies across the EC according to whether the data collected is for direct or indirect holdings, that

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of retail market behaviour. The EC’s failure to model the retail investor must be placed in the context of the grip of the market integration priority as well as the long dominance of supply-side interests. A significant step forward was taken, however, with the important 2007 BME Report on long-term, EC retail savings patterns (the report focused on banking products (deposits), pension products (funded pension policies) and investment products (securities, CISs and life insurance policies with a savings/investment component)).177 It is now clear that the EC investor protection regime applies to a set of retail investors who are largely inexperienced with market investments. The FSAP was adopted at a time of general stock market exuberance and policy enthusiasm for market investments.178 But retail investor activity has not developed across the Community in the way expected at the height of the dotcom/day-trading boom of the late 1990s179 and when the FSAP was adopted.180 Pension products and unit-linked life insurance products181 together represent nearly half of total household longterm savings.182 Unit-linked insurance products sit uneasily within EC investor protection policy. Although they provide some exposure to market

177 178

179

180

181

182

the entities collating this data vary (private and public entities are involved) and that the regularity with which it is collected varies. It focused in particular on eight Member States deemed to provide a representative sample: the UK, Germany, Italy, France, Spain, the Netherlands, Sweden and Poland. Best expressed, perhaps, in the 2000 Lisbon Council Conclusions: ‘Efficient and transparent financial markets foster growth and employment by better allocation of capital and reducing costs. They therefore play an essential role in fuelling new ideas, in supporting entrepreneurial culture and promoting access to the use of new technologies’: Council Conclusions, para. 20. Similarly, Internal Market Commissioner Bolkestein’s speech on ‘Making the Most of the Internal Market after Enlargement’, 13 May 2004 (available via http://europa.eu/rapid/searchAction.do) highlighted the importance of ‘a full integrated financial market which is capable of channelling our savings into productive investments at the lowest cost. Financial services is the oil in the machine.’ The Community did not experience mass retail market exuberance over the dotcom period. Investment research risks, for example, were seen as lower in the UK given the dominance of institutional investors who were less susceptible to the ‘cult of the star analyst’ which distorted the US market: FSA, Investment Research: Conflicts and other Issues (Discussion Paper No. 15, 2002). US broker Schwab entered the retail market in 1999 but was sold in 2003 following low levels of retail market activity: P. Coggan, ‘Disillusioned Followers Desert Cult of Equity’, Financial Times, 21 February 2003, p. 10. The premium for unit-linked life insurance policies is in part used to purchase life cover and in part invested in an investment scheme; the return on the policy reflects the performance of the scheme. Unit-linked policies do not typically offer guaranteed lump sum payments but reflect the performance of the investments. BME Report, p. 23. They represented 42 per cent of total long-term savings in 1999 and 47 per cent in 2005.

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returns, and despite their complexity and risks, they are treated, for the most part, as insurance, rather than investment, products and largely fall outside the harmonized investor protection regime. Pension and unitlinked insurance products are followed by bank deposits, at 21% of total household savings.183 Collective investment schemes come in third place at 15%.184 Direct investments in shares and bonds are ranked fourth; bonds (fixedincome investments) represent 10% of EC household savings.185 Direct equity investment by the retail sector is not common186 and – even leaving aside the effect of the ‘credit crunch’ market convulsions187 – is dropping. The initial growth of market finance across the Community in the 1980s and 1990s was reflected in an increase in riskier retail equity investments in continental portfolios in particular, although UK household equity participation also increased.188 Household share portfolios increased, as a percentage of GDP and between 1980 and 2003, from 8.7% to 49.3% in Italy, from 15.7% to 49.8% in France and from 4.8% to 18.5% in Germany.189 183

184 186

187 188

189

Ibid., pp. 11, 23 and 34. For a similar finding on the dominance of bank savings, although based on a smaller sample, see W. de Bondt, ‘The Values and Beliefs of European Investors’ in K. Knorr Cetina and A. Preda, The Sociology of Financial Markets (Oxford: Oxford University Press, 2005), p. 163, p. 169. In France, for example, short-term bank deposits and government-supported savings schemes represent 41 per cent of households’ financial assets, while insurance products represent 41.3 per cent (Delmas Report, Annex IV, p. 1), while 2005 data shows UK households holding 25.7 per cent of assets in the form of deposits and 53.8 per cent in insurance and pension reserves: Corragio and Franzosi, Household Portfolio, p. 19. BME Report, p. 11. 185 Ibid., pp. 23 and 41. Limited direct retail investor involvement in the equity markets relates in part to the more limited embrace of market finance in continental Europe (C. Van der Elst, ‘The Equity Markets, Ownership Structures and Control: Towards an International Harmonization’ in K. Hopt and E. Wymeersch (eds.), Capital Markets and Company Law (Oxford: Oxford University Press, 2003), p. 3), although UK retail investors, in a market characterized by market-based financing, tend to prefer packaged products to direct investments, as noted below. Discussed in ch. 2. UK retail investor holdings in equity increased in the 1980s and 1990s, reflecting the privatization and demutualization waves. Growth in direct equity-ownership was rapid during the 1980s, with UK equity levels growing faster than those in the US: J. Banks, R. Blundell and J. Smith, ‘Understanding Differences in Household Financial Wealth Between the US and Great Britain’ (2003) 38 Journal of Human Resources 241, 259. Ownership grew from 2 million in 1979 to 12 million in 1990 and peaked at 15 million in 1997. But most small investors sold their holdings for a quick return and the ‘anticipated rise in the number of consumers proactively engaged in the stock market has not materialized’: FSA, Towards Understanding Consumer Needs (Consumer Research No. 33, 2005), p. 20. I. Ert¨urk, J. Froud, S. Solari and K. Williams, The Reinvention of Prudence: Household Savings, Financialization, and Forms of Capitalism (University of Manchester, Centre for Research on SocioCultural Change, 2005), pp. 10–11.

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Higher equity market participation rates were also recorded in the 1990s190 with an increase in the number of households holding equities.191 But this trend was not sustained.192 The Federation of European Securities Exchanges’ 2006 share ownership report reported that households represented 15% of total share ownership and that participation had declined between 1999 and 2005.193 Its 2007 Report similarly reported a ‘continuous decline in the participation of individual investors’ between 1999 and 2007, down to 14% in 2007.194 Similarly, household equity holdings, as a proportion of household savings, reduced from 12.6% of households’ long-term savings in 1999 to 8.8% in 2005.195 The pan-EC downturn in equity investments has been related, in part, to the dotcom/Enron-era market crash and to a wider loss in household confidence in equity market investment as well as to structural market features, including the growth of intermediated investments.196 The FSAP policy discovery of the retail investor appears, therefore, to have coincided with the retreat of a ‘first cycle’ of direct retail equity investors.197 This has been exacerbated by the recent severe turbulence in financial markets which has seen some retail investors revert to intermediated, capital-protected products. But patterns vary across the EC; Poland, Belgium, Italy and Denmark all experienced increases in household/individual equity investments prior to the financial crisis.198 The Dutch market conduct regulator (the AFM) has also reported 190

191

192 193 194 196

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This period saw a movement towards high-return, riskier assets and away from safer and more liquid assets such as government bonds: L. Guiso, M. Haliassos and T. Japelli, Household Stockholding in Europe: Where Do We Stand and Where Do We Go? (CEPR, Discussion Paper No. 3694, 2003) (‘CEPR Household Stockholding’), p. 7. The percentage of households holding direct equity investments increased from 9 per cent (1987) to 22 per cent (1998) in the UK, from 4 per cent (1989) to 7.3 per cent (1998) in Italy and from 10 per cent (1989) to 17 per cent (1998) in Germany: ibid., p. 10. The BME Report noted that European households experienced a pronounced decline in the weight of quoted stocks in their portfolios between 1999 and 2005: p. 45. Federation of European Securities Exchanges (FESE), Share Ownership Structure in Europe (2006), p. 17. FESE, Share Ownership Structure in Europe (2007), p. 7. 195 BME Report, p. 45. FESE, Share Ownership 2006, p. 17 and BME Report, pp. 47 and 48 (noting that, while markets fell by 8.5 per cent over 1999–2005, total household losses were in the order of 18.5 per cent); and (in the Italian context) A. Franzosi, E. Grasso and E. Pellizzoni, Retail Investors and the Stock Market: Second Report on Shareholding in Italy (Blt No. 12, Borsa Italiana, 2004). In a number of Member States, notably Poland and Greece, shares became a ‘fashionable’ investment for the first time in the 1990s but investors dramatically revised their assumptions as to the wisdom of equity investments following substantial losses: BME Report, p. 89. FESE, Share Ownership 2007, p. 21.

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that a slight downturn experienced after the bursting of the dotcom bubble was followed by a steady rise in the number of private investors (who invest primarily in collective investment schemes and equities).199 Derivatives are only of marginal importance in the retail market,200 although demand has grown for structured products based on derivatives,201 particularly in Germany,202 and retail investors are increasingly being exposed to derivative risk through the UCITS III product, discussed in chapter 3. Overall, however, evidence is emerging of greater long-term savings through the markets;203 households and individuals are moving away from a largely deposit-based/government-securities-based savings culture.204 There is a striking move towards ‘institutionalized’ savings, or savings through pension funds, insurance companies or collective investment schemes. Between 1970 and 2003, for example, household savings in bank deposits as a proportion of household portfolios dropped from 54%, 60%, 49% and 34% in Italy, Germany, France and the UK, respectively, to 27%, 36%, 30% and 26%. Over the same period, institutionalized savings increased from 8%, 15%, 6% and 23% in Italy, Germany, France and the UK, respectively, to 28%, 41%, 39% and 54%.205 While pension savings must account for a very considerable share of this increase, investors have also become more exposed to direct market investments; appetite for investments in often complex, risky and opaque structured products, and in similarly troublesome unit-linked insurance products, is also increasing (chapter 3). In the future, household savings patterns are likely to reflect 199 200

201

202

203 204

205

AFM, Policy and Priorities, p. 11. BME Report, p. 77. Although 6 per cent of Italian trades in standard equity derivative contracts are made online by retail investors: B. Alemanni and A. Franzosi, Portfolio and Psychology of High Frequency Online Traders: Second Report on the Italian Market (Blt No. 16, Borsa Italiana, 2006). In the late 1990s, European exchanges and intermediaries began to develop structured products based on derivatives which are designed to respond to retail investor needs. The Warsaw stock exchange, in particular, is regarded as a pioneer of retail derivatives – 70 per cent of investors in listed derivatives in Poland are individuals: BME Report, pp. 77 and 79. Deutsche Bank, Retail Certificates: A German Success Story (Deutsche Bank Research, EU Monitor 43, 2007). More than 6 per cent of German retail investors hold derivatives in their portfolios (BME Report, pp. 80–1). E.g. Coraggio and Franzosi, Household Portfolio, p. 19, pointing to a general reduction in banking intermediation and to an increase in equity and investment fund investments. Oxera, Description and Assessment of the National Compensation Schemes Established in Accordance with Directive 97/9: A Report Prepared for the European Commission (2005), p. 106. G10 Report, p. 18. A similar study over the 1995–2005 period reports a similar shift in household portfolios: Coraggio and Franzosi, Household Portfolio, p. 18.

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increased reliance on market instruments, whether directly or through collective investment schemes;206 the potential for the market for private pensions, but also for direct investment in market instruments, is certainly considerable.207

b) Diverging investment patterns But retail investment patterns are very far from homogeneous and risk appetites vary considerably across the Community.208 Packaged products, and particularly pension and life-insurancerelated (unit-linked) packaged investments, dominate in the UK and are considerably more popular than direct investments in shares and bonds.209 Of the 3 million retail investment products sold between April 2007 and March 2008, 1.5 million represented pension products and almost 850,000 represented ‘investment products’.210 Most investments in these investment products were in the form of ‘investment bonds’ or investment products which often have an insurance component.211 Insurance-based ‘with profits’ products,212 which are akin to unit-linked 206 207 208 209

210

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Oxera, Description and Assessment, pp. 104 and 105. Some estimates place the size of the market at €4,000 billion by 2010 and €11,000 billion by 2030: ibid., p. 104. ‘[T]here are pronounced differences among Member States for virtually every type of long-term savings instrument’: BME Report, p. 87. The FSA’s ‘packaged products’ regulatory regime is based on the popularity of these investments. Packaged products far outstrip direct investments in shares and bonds: UK Article 4 Application, pp. 10–11. The application highlighted that, while ISAs (Individual Savings Accounts – a structure which provides tax benefits) can be used as tax shelters for direct share and bond investments, they are much more commonly used to hold investments in packaged products. It has also been reported that half of the average personal spend on financial products relates to pension and superannuation funds and life assurance premiums: HM Treasury, Financial Capability: The Government’s Long-Term Approach (2007), p. 9. Including investment trusts, structured capital-at-risk products, unit trusts, open-ended investment companies and different bond products: FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 2; almost 540,000 sales took the form of tax-wrapped investments in the form of an ISA. Ibid., pp. 2 and 8, also reporting that a minority 300,000 of the products sold in the previous year were collective investments in the form of unit trusts and open-ended investment companies. Bond products include: distribution bonds, unit-linked bonds (which represented almost 50 per cent of all bond sales), guaranteed bonds and withprofit bonds. These products, which are often complex and opaque, and which generate risks with respect to how the life assurer exercises its discretion, are based on the allocation of investment returns (from the fund represented by the premiums paid by ‘with profits’ policy-holders) in the form of bonuses which provide ‘smoothed’ investment returns

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products,213 have been particularly popular,214 although they are becoming less common.215 Insurance-related investments vary in popularity across the EC, however. While they are popular in France,216 where their growth has been related to the wider movement of risk from intermediaries to retail investors,217 the Netherlands218 and Poland,219 they are less common in Germany.220 Reflecting a marked trend to wrap products, which is often related to regulatory arbitrage dynamics, life insurance wrappers are, however, widely used across the EC to distribute CIS investments.221 UK investors lag behind their continental counterparts with respect to CIS investments. Most EU-15 Member States display CIS to GDP ratios of over 20%, while the UK ratio of CISs held by households to GDP is below 15%.222 But participation rates vary. One study, based on 2005 data, has identified CIS participation as ranging from a low of 2.5% of household savings in the Netherlands to a high of 17.1% in Belgium.223 CIS asset allocation preferences also vary considerably with northern households (Netherlands, Sweden and the UK) tending to prefer equity schemes and Southern households (Italy and Spain) preferring less risky bond schemes.224 Patterns of UCITS CIS investments, at the heart of the EC investment product regime, vary considerably. Holdings as a proportion of household savings now range from 4.1% in the UK to 26.1% in Sweden.225

213

214

215 216

217 220 221

222 224 225

through guaranteed (usually conservative) annual bonuses which are paid when the policy matures. Terminal bonuses, allocated and paid when the policy matures, reflect the fund’s actual investment return: MacNeill, An Introduction, pp. 126–7. Unit-linked products were developed to provide a more transparent form of investmentrelated life assurance and are based not on bonuses but on investment returns linked to the units in the relevant fund which are allocated to the policy-holder: ibid., p. 127. The FSA has highlighted the importance of UK cultural preferences in product selection, pointing to the importance of ‘with-profits’ bonds in the UK market: FSA Substitute Products Response, p. 9. Ibid., p. 5. Delmas Report, p. 7 and Annex IV, p. 2. One-third of insurance investments in 2007 were unit-linked (AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings (2007), p. 61). Delmas Report, p. 7. 218 AFM, Annual Report 2006, p. 44. 219 BME Report, pp. 97–8. BME Report, p. 67 (linked to local risk-aversion factors). PricewaterhouseCoopers, The Retailization of Non-Harmonised Investment Funds in the European Union (2008) (‘2008 PwC Retailization Report’), pp. 9 and 12 (representing 18 per cent of non-UCITS sales in 2007). BME Report, p. 55. 223 Coraggio and Franzosi, Household Portfolio, p. 18. BME Report, p. 58. European Commission, Impact Assessment of the Legislative Proposal Amending the UCITS Directive (SEC (2008) 2236), p. 7.

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Non-UCITS CIS investment patterns also vary, with non-UCITS investment considerably stronger in Germany (which represents 46% of the total EC non-UCITS sector) and in Luxembourg (14%).226 Divergences also exist with respect to preferences for cross-border investments. The Commission’s 2006 Financial Integration Monitor, for example, reported that only 3% of French investor assets were placed in schemes registered abroad, while 41% and 36% of German and Belgian assets, respectively, were placed in non-domestic schemes.227 Particularly sharp differences arise with respect to bond/fixed-income investments. Germany and Italy together represent more than two-thirds of total fixed-income investments by Community households: German households hold 13% of their long-term savings in bonds while Italian households, strikingly, so hold 32%;228 government debt securities are the most common Italian household investment.229 Bond investments are also popular in Denmark, with direct household investment in bonds accounting for nearly 20% of Danish retail savings and investments in 2003.230 Elsewhere, however, bond investment patterns vary sharply.231 Equity investment patterns also diverge sharply.232 This was clear from an early stage from the initial equity ‘spurt’ between the early 1980s and late 1990s which saw marked differences in household enthusiasm for equity investment across the Member States, reflecting a range of factors 226

227 228

229 231

232

2008 PwC Retailization Report, pp. 6 and 29. By contrast, the non-UCITS sector is very small in Belgium (0.36 per cent of the EC non-UCITS sector). The UK non-UCITS sector represents 6.67 per cent. These figures include institutional investment. 2006 Monitor, pp. 21–2. BME Report, p. 42. The FSA has similarly suggested that, in 2004, Italian households’ direct investments in bonds accounted for 42 per cent of total Italian retail savings, making Italian investors the ‘biggest direct retail investors in bonds in Europe’: Trading Transparency in UK Secondary Bond Markets (Discussion Paper No. 05/5, 2005), p. 14. CONSOB, Annual Report 2007, p. 82. 230 FSA, Discussion Paper No. 05/5, p. 14. BME Report, p. 42. In 2004, the average Italian household held more than €12,000 in fixed income securities, the average German household held €5,800, while the average British, French and Spanish holding was in the order of €1,000: Centre for Economic Policy Research (B. Biais, F. Declerck, J. Dow, R. Portes and E.-L. von-Thadden), European Corporate Bond Markets: Transparency, Liquidity and Efficiency (CEPR, 2006), p. 32. One report has suggested that direct investment in listed shares is strongest in Germany, Spain and the Netherlands, followed by the UK: AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings (2008), p. 60. Similarly, the FESE has reported that only in Spain and Italy do individual investors hold more than 20 per cent of the market value of listed shares and that, in seven Member States, individual investors’ holdings represent under 10 per cent of market value: FESE, Share Ownership 2007, pp. 7 and 21. Although the UK is the largest market by capitalization, individual investors’ holdings represent only 12.8 per cent of market value (p. 21).

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including education, household wealth, pension provision and the relative importance of CISs and other institutional investors.233 Direct and indirect holding patterns also vary, with indirect holdings favoured in the UK (through packaged products), Denmark and the Netherlands, but direct holdings more common in Spain and Italy.234 Investors have also differed in their response to the financial crisis. While demand across Europe seems to have shifted from UCITS investments into deposits and structured products, UCITS outflows have varied across the Member States with Greece and Portugal recording very strong outflows, but Sweden reporting inflows for 2008.235 The stakes are, accordingly, high for EC retail market policy. The evidence suggests that investors are generally inexperienced with market investments and that investment patterns vary sharply across the EC, increasing the risks of intervention in the retail markets.

3. Investors or consumers? The emerging evidence points to a retail market which is embryonic and strongly characterized by the sale of investment products. As discussed in chapter 2, levels of investor competence are low. Reflecting these themes, the Commission’s second major empirical study of pan-EC retail investment, the 2008 Optem Report on disclosure, classified investors as either prudent ‘savers’, who sought ‘safe’ investments, or ‘gamblers’, who were prepared to take risks.236 It seems reasonable, accordingly, and, given the policy concern to promote stronger welfare provision by households and more effective long-term savings, to suggest that prudent, welfare-driven investment, as well as more discretionary, risk-tolerant investment, should be reflected in regulatory design. One way of achieving this is for the regulatory system to ensure it captures the investor as a consumer of mass 233 234 235 236

CEPR Household Stockholding, pp. 11–13. Corragio and Franzosi, Household Portfolio, p. 26. Slightly different findings are noted in n. 232 above. European Fund and Asset Management Association (EFAMA), Quarterly Statistical Release No. 36 (2008). Optem Report, pp. 8 and 88. Similarly, the French TNS-Sofres Report on regulated disclosures distinguished between ‘savvy investors’, able to control risk through diversification, and ‘small investors’, who were unwilling to take risks and were concerned to purchase safe products: TNS-Sofres, Report for the AMF: Investigation of Investment Information and Management Processes and Analysis of Disclosure Documents for Retail Investors (2006), p. 8.

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market investment products, as well as the investor as a sophisticated risk-taker.237 There are signs that the retail investor is becoming characterized in the EC regime as a consumer of investment products and is being subsumed within the wider consumer policy agenda – although investment services remain the responsibility of the Commission’s Internal Market Directorate General and not the Health and Consumer Protection Directorate General (SANCO) which drives consumer policy and has responsibility for overlapping areas, notably the DMD.238 Financial services policy is addressed in the Commission’s 2007 general consumer policy strategy.239 Retail financial market policy discussions in the Commission’s Financial Services Consumer Group tend to focus on financial products and on distribution; they only rarely engage with the direct investment and asset management risks associated with more sophisticated investors. Current major policy initiatives are also concerned with the investor as consumer of investment products, notably the substitute products debate and the UCITS product disclosure reforms (chapters 3 and 5). There are, however, dangers in adopting a consumer-oriented approach to investor protection. EC consumer protection policy is strongly associated with consumer choice and consumer empowerment240 and with a robust model of consumer competence. The Unfair Commercial Practices Directive, for example, relies on whether the economic behaviour of the ‘average consumer’ would be materially distorted in determining whether a breach has occurred (Article 5); but the ‘average consumer’ is related to the consumer law jurisprudence of the Court of Justice and to a ‘reasonably well-informed and reasonably observant and circumspect consumer’. Characterizing the retail investor as a robust consumer of products, to whom investment is simply one of a series of consumption decisions and choices,241 may risk over-emphasizing informed choice and disclosure and risk that firm-facing protections are de-emphasized. It may 237

238 239 240 241

R. Karmel, ‘Reconciling Federal and State Interests in Securities Regulation in the US and Europe’ (2003) 28 Brooklyn Journal of International Law 495, examining how the investor as consumer tends to dominate how the US states view investors, while a more robust, capital-driven approach is taken by the federal system. SANCO also deals with consumer credit, mortgages, consumer education on financial services, the payments system and euro-related matters. European Commission, Communication on EU Consumer Policy Strategy 2007–2013 (COM (2007) 99). E.g. European Commission, Communication on Monitoring Outcomes in the Single Market: The Consumer Markets Scoreboard (COM (2008) 31). As noted in ch. 2, the use of the term ‘consumer’, rather than ‘investor’, in FSMA has been associated with a normalization of investment activity: J. Gray and J. Hamilton,

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also risk that too much is expected of the retail investor. A robust model of investor behaviour is certainly fast becoming associated with EC retail market policy which is increasingly concerned to empower and to engage retail investors (chapter 2). The empowerment model is, however, poorly equipped to address the risks which are faced by vulnerable investors, seeking to address welfare needs. As discussed in the next chapter, a careful balance between empowerment strategies and those designed to support engaged but vulnerable investors, characterized in chapter 2 as trusting investors, is required when intervening on the retail markets.

IV. The financial crisis and EC retail market policy The international and EC response to the ‘credit crunch’, which has led to the deepest world financial crisis since the Great Depression, is evolving at the time of writing. The reform movement and the policy debates, so far, have been strongly associated with systemic stability, the credit and banking system and macro-prudential regulation.242 They have focused on those actors most closely implicated in the crisis, namely, credit rating agencies, investment banks and credit institutions, and, perhaps unfairly, hedge funds and on those rules which, either by failing to support strong internal risk management, or by reinforcing procyclicality (notably the Basel capital rules and the mark-to-market principle followed by current accounting standards), have been linked to the crisis.243 But there are also important implications for the retail markets as retail market protections have been placed under pressure in conditions of acute market stress and as losses in the retail sector have intensified (chapter 2). The search for yield prompted by historically low interest rates, which led, in part, to the crisis, was mirrored in the retail markets with increased demand for alternative investments and complex structured products (chapter 3) and with heightened regulatory arbitrage and mis-selling risks (chapter 4). So too was the failure of internal risk management associated with the banking crisis, with risk management difficulties arising with investment

242 243

Implementing Financial Regulation: Theory and Practice (Chichester: John Wiley & Sons, 2006), p. 192. E.g. S. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown (2008), ssrn abstractid=1056241. E.g. W. Buiter, Lessons from the 2007 Financial Crisis (CEPR Policy Insight No. 18, CEPR, 2007); M. Brunnermeier, A. Crocket, C. Goodhart, A. Persaud and H. Shin, The Fundamental Principles of Financial Regulation. Geneva Reports on the World Economy 11. Preliminary Conference Draft (ICMB International Center for Monetary and Banking Studies, 2009) and High-Level Group on Financial Supervision, Report (2009) (‘de Larosi`ere Report’).

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schemes and asset custody (chapter 3). Disclosure – always a troublesome retail market tool – appears all the more so given the severe risks to retail investors from new products, mis-selling and market risks, which the crisis exposed, none of which can easily be captured by information techniques (chapter 5). In the maelstrom and with the overwhelming preoccupation to stabilize the world financial system, retail investor interests have not been to the fore.244 As discussed in chapter 7, regulators have been slow to respond to retail market risks, and in particular to the crystallization of losses, through investor education, while the policy debate in the EC has not engaged with retail stakeholders for the most part, neither have assessments been made of how households reacted to the crisis. But the picture is not entirely bleak. Despite the risk that reforms to the institutional markets and to the international supervisory architecture would overwhelm all other initiatives, work has continued apace in the EC on key retail market measures, notably the UCITS Key Investor Information disclosure reform (chapter 5). At Member State level ‘in action’, the FSA completed its massive consultation on its Review of Retail Distribution over the worst of the ‘credit crunch’ convulsions in 2008 and consulted on reform proposals in June 2009, although the important Treating Customers Fairly initiative appears to have been something of a casualty (chapters 2 and 4). Specific retail market reforms to the harmonized regime have been limited and have focused, thus far, on reforms to the Investor Compensation Schemes Directive245 (in part to reflect the autumn 2008 reforms to the parallel Deposit Guarantee Directive246 as the banking system came under severe strain).247 On the other hand, and although formal reform proposals are still some way off, the Commission’s enthusiasm in its April 2009 Communication on packaged products for what might be a radical recasting of the harmonized disclosure and investment advice/product distribution regime in order to capture the risks of investment product sales, 244

245 246 247

A notable exception being the summer 2009 Obama Administration proposal for a Consumer Financial Protection Agency. Scholarship has also been preoccupied with prudential matters, although. Zingales, Future of Securities Regulation, considers the retail market agenda. Directive 97/9/EC of the European Parliament and the Council of 3 March 1997 on investor compensation schemes, OJ 1997 No. L84/22. Directive 94/19/EC of the European Parliament and Council of 30 May 1994 on deposit guarantee schemes, OJ 1994 No. L135/5. European Commission, Directive 1997/9/EC on Investor Compensation Schemes: Call for Evidence (2009), p. 8.

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in response to the substitute products question, appears to reflect concern as to the risks to which retail investors were exposed over the crisis by structured products in particular.248 While it remains to be seen whether the Commission’s radical and wide-ranging, but still tentative, proposals will take root, there is no doubting the ambition of the reforms or the Commission’s confidence in asserting its role as the main guardian of Europe’s retail markets; the crisis may also have encouraged the Commission to present relatively radical reforms. Institutionally, CESR’s growing attachment to the retail cause has not abated over the crisis; its ‘credit crunch’ activities included an assessment of the implications of the Lehman Brothers insolvency for retail investors.249 In a welcome appearance of the retail interest, the controversial debt markets transparency debate has also been reopened following liquidity pressures in the debt markets, with CESR appearing unhappy at the market’s efforts to promote stronger transparency in the retail markets.250 The most important implications, however, are likely to be indirect and to follow from the 2009 de Larosi`ere Report which recommended that a decentralized, networked European Financial System of Supervision be developed, based on home Member State supervision but also on a transformation of the current Lamfalussy ‘level 3’ committees, including CESR, into independent Authorities with a significantly enhanced range of supervisory powers, particularly with respect to crossborder and systemic stability risks, and with powers to adopt binding standards (chapters 7 and 8). The Report was broadly accepted by the Commission in May 2009. Although the reform is directed towards systemic stability, it is likely to lead to a significant recharacterization of CESR’s role and, potentially, prejudice to its retail market agenda (chapter 7) and may also, in the longer term, have important implications for retail market supervision with the hint that pan-EC supervision take the form of a ‘twin peaks’ model, with conduct of business and prudential supervision in distinct EC institutions.251 248

249 250 251

European Commission, Communication from the Commission to the European Parliament and the Council: Packaged Retail Investment Products (COM (2009) 204). See further ch. 3. The Communication was also highlighted in the Commission’s financial crisis submission to the European Council: European Commission, Communication for the Spring European Council: Driving European Recovery (COM (2009) 114), p. 7. CESR, The Lehman Brothers Default: An Assessment of the Market Impact (CESR/09-255, 2009) which focused in particular on the sale of structured products. CESR, Transparency of Corporate Bond, Structured Finance Product, and Credit Derivatives Markets: Consultation Paper (2008) (CESR/08-1014, 2008). De Larosi`ere Report, p. 58.

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But, overall, the EC’s attachment to the empowered investor, discussed in chapter 2, and its scant attention to market risk, have continued in the face of the titanic market upheavals and widespread destruction of household wealth, although it is not alone internationally in this regard, and despite the frequent protestations to rethink regulation. It is this failure to address whether the ‘why’ and ‘how’ of investor protection, discussed in the next chapter, should be reconsidered, that raises most concern.

2 Designing a retail investor protection regime

I. Why intervene in the retail markets? Encouraging the empowered investor, shielding the irrational investor or supporting the trusting investor? 1. Characterizing investor protection The EC investor protection regime is ultimately a creature of political compromise1 and is closely tied to market integration priorities. But it also forms an extensive regulatory regime which demands challenge and contextualization. This chapter uses the EC regime and aspects of UK implementation, in particular, ‘in action’ to examine the nature of retail investor protection regulation. Chapter 1 considered the ‘who’ of EC investor protection; this chapter considers the ‘why’ (section I), ‘why not’ (or the risks of intervention) (section II) and the ‘how’ (section III). ‘Investor protection’ has considerable intuitive appeal and dominates as a regulatory objective internationally.2 But it remains a controversial justification for intervention. Sharp distinctions arise between characterizations of investor protection as, for example, a threat to entrepreneurialism and efficient capital-raising,3 as an expression of social virtues4 and as 1

2

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4

As in the related consumer protection sphere: ‘aspects [of the regime] are, like many areas of any legislature’s output, the result of political expediency rather than considered selection among available regulatory techniques’: S. Weatherill, EU Consumer Law and Policy (2nd edn, Cheltenham: Edward Elgar, 2005), p. 85. IOSCO’s by-laws state that securities regulators should ‘be guided by a constant concern for investor protection’: IOSCO, Objectives and Principles of Securities Regulation (IOSCO, 2008), p. 1. ‘It has become something of an intellectual gaffe for a serious securities scholar to suggest that investors might actually need some investor protection to prevent their exploitation’: L. Stout, ‘The Investor Confidence Game’ (2002–3) 68 Brooklyn Law Review 407, 413. Similarly, tension has been identified between competing characterizations of securities regulation as threatening entrepreneurialism and as addressing abuses of economic power: D. Langevoort, Managing the Expectations Gap in Investor Protection: The SEC and the Post-Enron Reform Agenda (2002), ssrn abstractid=328080, pp. 4–5. D. Langevoort, ‘Re-reading Cady Roberts: The Ideology and Practice of Insider Trading Regulation’ (1999) 99 Columbia Law Review 1319, 1326–9.

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a moral imperative.5 The retail investor has been cast as a central figure in contemporary capitalism, forming part of a wider cultural legacy which dates to nineteenth-century globalization.6 But the retail investor can also be regarded as a disruptive force.7 Investor protection has traditionally been concerned with the defensive protection of the vulnerable investor against unscrupulous market participants.8 Under neo-classical economics regulatory analysis,9 however, protection is necessary only where market failures, primarily related to information asymmetries, arise. This analysis typically characterizes the appropriate regulatory response as information-based and as allowing investors to engage in efficient bargains.10 Information failures are exacerbated by the credence nature of often complex investment services and products and by investors’ difficulties in comparing investments and assessing long-term performance.11 Information risks also flow from the significant potential for incentive misalignment in the principal/agent relationship which characterizes the investor/intermediary relationship.12 Retail investors also have limited ability to bargain for protections and to monitor intermediaries. Adverse selection becomes likely with investors differentiating on price rather than on quality, ‘lemons’ (or poor-quality products or services) dominating13 and the market becoming less efficient.14 Market failure analysis, with its emphasis on the correction of information asymmetries, is strongly associated with the preservation of individual autonomy and tends to promote minimal intervention. But 5 6

7 8 9

10

11 12 13 14

B. Black, Are Retail Investors Better Off Today? (2008), ssrn abstractid=1085744. A. Preda, ‘The Investor as a Cultural Figure of Global Capitalism’ in K. Knorr Cetina and A. Preda, The Sociology of Financial Markets (Oxford: Oxford University Press, 2005), p. 141. C. Bradley, ‘Disorderly Conduct and the Ideology of “Fair and Orderly Markets”’ (2000) 26 Journal of Corporation Law 63. R. Clark, ‘The Soundness of Financial Intermediaries’ (1976) 86 Yale Law Journal 1, 26. Which is increasingly used by regulators: for example, DG Internal Market and Services Working Document, Report on Non-Equities Market Transparency Pursuant to Article 65(1) of Directive 2004/39/EC on Markets in Financial Instruments (2008) (one of the first clear examples of market failure analysis by the European Commission). Consumer policy has taken a similar journey from assuming malpractice and abuse to addressing information failures: G. Howells, ‘The Potential and Limits of Consumer Empowerment by Information’ (2005) 32 Journal of Law and Society 349. H. Garten, ‘The Consumerization of Financial Regulation’ (1999) 77 Washington University Law Quarterly 287. See further ch. 4. G. Akerlof, ‘The Market for “Lemons”: Qualitative Uncertainty and the Market Mechanism’ (1970) 84 Quarterly Journal of Economics 488. J. Black, Rules and Regulators (Oxford: Oxford University Press, 1997), p. 141.

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paternalism,15 long regarded with hostility by the efficiency school,16 is also associated with investor protection. It is less concerned with information and more associated with intervention for the individual’s ‘own good’.17 This more defensive approach to investor protection tends to lead to heavier intervention in the investor/investment firm relationship and in the design and distribution of investment products.18 Models of paternalism have, however, become more nuanced with the advent of the behavioural finance school of analysis.19 But investor protection is increasingly becoming a proxy in the policy debate for a more muscular and transformative rationale for intervention; it is now closely concerned with the promotion of market-based savings. This development suggests that, as discussed below, the ‘why’ of investor protection now has three interlinked elements: should retail market regulation encourage the empowered investor, shield the irrational investor or support the trusting investor?20

2. The retail investor as an agent of public policy and the empowered investor a) Public policy and marketing the markets Long-established US scholarship relates investor protection to capitalraising;21 investor protection is justified where it supports issuers by reducing the cost of capital, particularly by signalling issuer quality to 15

16 17

18 19 20

21

A. Ogus, ‘Regulatory Paternalism: When Is It Justified’ in K. Hopt, E. Wymeersch, H. Kanda and H. Baum (eds.), Corporate Governance in Context (Oxford: Oxford University Press, 2005), p. 303. J. Arlen, ‘Comment: The Future of Behavioral Economic Analysis of Law’ (1998) 51 Vanderbilt Law Review 1765; and Ogus, ‘Regulatory Paternalism’, p. 304. C. Camerer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin, ‘Regulation for Conservatives: Behavioral Economics and the Case for Asymmetric Paternalism’ (2002–3) 151 University of Pennsylvania Law Review 1211. J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 18. Leading contributions include R. Thaler and C. Sunstein, ‘Libertarian Paternalism’ (2003) 93 American Economic Review 175. One vivid characterization has described the potential identities of the retail investor as variously: ‘an independent risk-taker . . . a prudent saver simply requiring regulatory assistance in the form of enforced information disclosure, a hapless, relatively uninformed victim in need of regulatory protectiveness . . . and . . . as a risk-averse individual who wants something for nothing’: M. Condon, Making Disclosure: Ideas and Interests in Ontario Securities Regulation (Toronto, Buffalo and London: University of Toronto Press, 1998), p. 231. E.g. F. Easterbrook and D. Fischel, ‘Mandatory Disclosure and the Protection of Investors’ (1984) 70 Virginia Law Review 669; and R. Romano, ‘Empowering Investors: A Market Approach to Securities Regulation’ (1998) 107 Yale Law Journal 2359.

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the marketplace and by standardizing disclosure. Market-facing concerns are also evident in the related investor confidence rationale which has been strongly associated in the US market with a positive view of market investment22 and with wider market efficiency and capital allocation goals.23 The massive US issuer disclosure system, in particular, has been linked to the risk that small investors might withdraw their capital.24 Under this model, the ‘confident’ retail investor is a public policy agent of the capital-raising process and an instrument of regulatory efforts to promote market efficiency.25 Although it has had immense influence on the US debate, this analysis is closely associated with issuer disclosure policy, capital-raising and direct market investing; it has limited direct resonances with the Community retail market which is dominated by intermediation and by indirect investment in investment products. But there are echoes of this instrumental approach to investor protection in the initial association between harmonization and market integration in EC securities regulation. The pre-FSAP phase of EC securities regulation did not address the retail markets in any detail; nonetheless, it characterized the investor as a capital supplier and integration agent, and regarded investor confidence, built on harmonization, as a driver of market integration and cross-border investment.26 This theme recurred in the FSAP and post-FSAP periods with the policy arguments including that ‘private sector savings in Europe amount to some 20% of GDP – a valuable asset, if efficiently used, to stimulate growth and job creation’,27 the importance of ‘access to the widest possible pool of potential investors’ and the need to ‘mobilise household savings’28 and the link between market participation and wider economic growth.29 22 23 24 25 26 27 28 29

D. Langevoort, ‘Selling Hope. Selling Risk. Some Lessons from Behavioral Economics about Stockbrokers and Sophisticated Investors’ (1996) 84 California Law Review 627, 674. D. Ruder, ‘Balancing Investor Protections with Capital Formation Needs after the SEC Chamber of Commerce Case’ (2005) 26 Pace Law Review 39. F. Easterbrook and D. Fischel, The Economic Structure of Corporate Law (Cambridge, MA: Harvard University Press, 1991), p. 226. Similar concerns have motivated the regulation of securities markets in Ontario: Condon, Making Disclosure, pp. 59 and 169. E.g. European Commission Recommendation 77/534/EEC concerning a European code of conduct relating to transactions in transferable securities, OJ 1977 No. L212/37, para. 2. European Commission, Second FSAP Report May 2000, p. 3. European Commission, Communication on Upgrading the Investment Services Directive (COM (2000) 727), pp. 5–6. The 2007 Financial Education Communication assumed that ‘[c]itizens who become confident in investing can provide additional liquidity to capital markets, which can be fed

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A market-facing and instrumental approach to investor protection is now, however, closely associated with the retail investment markets. Governments have begun to promote stronger household market engagement and to identify the retail investor as an agent of a public policy commitment to financial independence. Investor protection law and policy is accordingly embracing a related ‘marketing’ or transformative dimension. Internationally, the US Securities and Exchange Commission (SEC) has been characterized as promoting widespread market participation30 by ‘marketing’ the markets as safe and fair,31 while ASIC, the Australian market conduct regulator, has characterized regulation as a means of promoting retail investor market participation.32 In Europe, France’s Delmas Report warned that mis-selling and poor product design could see a flight from equities and, in consequence, poor capital allocation, prejudice to long-term saving and ‘prompt [an] aversion’ to the market,33 while the French AMF has suggested that limited household exposure to the financial markets suggests poor household diversification, inappropriate investment horizons and inefficient asset allocation.34 In the UK, government and regulatory initiatives, related to the withdrawal from welfare provision, have sought to promote market savings.35 The Treasury has recently supported the FSA’s ground-breaking Retail Distribution Review (RDR) as a means of supporting stronger engagement with financial services.36 Earlier, the 1980s privatizations attempted

30

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33 34 35 36

through to small-business financing in the EU, a key element in supporting growth and jobs’: European Commission, Communication from the Commission, Financial Education (2007), p. 4. R. Karmel, ‘Reconciling Federal and State Interests in Securities Regulation in the US and Europe’ (2003) 28 Brooklyn Journal of International Law 495 and L. Stout, ‘The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation’ (1988) 87 Michigan Law Review 613. Langevoort, ‘Re-reading Cady Roberts’ and D. Langevoort, ‘Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation’ (2002) 97 Northwestern University Law Review 135. ASIC’s deputy chairman has highlighted the importance of considering the ‘steps towards the virtuous centre that retail investors need to complete the journey, to get to the centre where they invest confidently and have adequate long term savings’: J. Cooper (Deputy Chairman ASIC), ‘Retail Investors – What More Can or Should We Do to Help Retail Investors Build Long-Term Wealth?’, ASIC Summer School July 2008 Papers, p. 5. J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government (2005) (‘Delmas Report’), p. 12. AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings (2008), p. 83. J. Gray and J. Hamilton, Implementing Financial Regulation: Theory and Practice (Chichester: John Wiley & Sons, 2006), pp. 187–8. HM Treasury, Financial Capability: The Government’s Long-Term Approach (2007), p. 17.

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to promote wider stock market participation.37 The cornerstone Financial Services and Markets Act 2000 has been described as forming part of a wider government strategy for ‘enticing’ investors into the marketplace.38 FSMA can certainly be read without too much difficulty as promoting an essentially benign view of the markets. The adoption of consumer protection, public awareness and market confidence as statutory objectives for the FSA by FSMA,39 the Act’s highlighting of proportionality, innovation and competition in the principles of good regulation which the FSA must follow40 and the FSA’s heavy reliance on disclosure (often reflecting EC requirements) and on financial capability techniques,41 have been assessed as amounting to a commitment to the markets as wealth creators and as promoting informed and competent retail investor engagement with the financial markets.42 Major policy reviews, such as the 2002 Sandler Review on investment product distribution, which was designed to support greater mass participation through a suite of simple investment products,43 have a similar orientation. The FSA’s major recent retail market initiatives (including its financial capability strategy44 and the Retail Distribution Review45 ) and retail market discussions in its recent Financial 37

38 39

40 41

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The British Telecom and British Gas campaigns have been described as communicating a belief that share ownership was not only a game played by the rich and famous: FSA, Towards Understanding Consumers’ Needs (Consumer Research No. 35, 2005), p. 31. Gray and Hamilton, Implementing Financial Regulation, pp. 192–7. FSMA, sect. 2(1) and (2). The market confidence objective has been interpreted by the FSA in terms of a strategic aim to ensure that consumers (and other market participants) have confidence that markets are efficient, orderly and clean: FSA, Annual Report 2002–2003, p. 61. FSMA, sect. 2(3). See further chs. 5 and 7. These strategies reflect FSMA’s public awareness objective (sects. 2(1) and 2(2)(b)) and the connection made in the Act between ‘appropriate’ consumer protection and the needs consumers may have for advice and accurate information (sects. 5(1) and 5(2)(c)). Gray and Hamilton, Implementing Financial Regulation, p. 194. The FSA has been analyzed as carrying out a ‘social marketing’ function: J. Devlin, ‘Monitoring the Success of Policy Initiatives to Increase Consumer Understanding of Financial Services’ (2003) 11 Journal of Financial Regulation and Compliance 151. The Sandler Report, Medium and Long-Term Retail Savings in the UK: A Review (2002) (‘Sandler Report’), p. 35. It was supported by a Basic Advice regime which was designed in part to encourage consumers to buy products: FSA, A Basic Advice Regime for the Sale of Stakeholder Products (Policy Statement No. 04/22, 2004), p. 7. The FSA has linked its capability initiatives to people buying more products: FSA, Towards a Strategy for Financial Capability (2003). See further ch. 4. During the RDR, the FSA pointed to the importance of generic advice services in encouraging savings (A Review of Retail Distribution (Discussion Paper No. 07/1, 2007) (‘2007 RDR’), p. 31), argued that sales services (as distinct from advised services) could encourage higher levels of savings (Retail Distribution Review – Interim Report (2008)

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Risk Outlooks are accompanied by a broadly positive rhetoric on market investments. In its 2003 Risk Outlook, for example, the FSA warned that, notwithstanding volatile equity markets, diversified investment strategies should include equities and that investors would face opportunity costs from an unwarranted loss of confidence in equities.46 The 2006 Outlook noted the risk that, given the need for individual financial responsibility for long-term savings, consumers might invest less and be less likely to take advantage of financial services.47 The 2007 Outlook similarly pointed to deterrence risks and to the risks related to any reduction in the availability of financial advice.48 As discussed in section I.2.d below, the financial crisis has not noticeably blunted FSA concern to promote market engagement. This recasting of investor protection regulation from being defensive to amounting to a quasi-marketing strategy can also be seen in the recent evolution of EC law and policy. At an early stage of the FSAP, a senior Commission official suggested that, post-Enron, ‘the prospect of a European retail equity culture has been dealt a severe blow’.49 Post-FSAP, the 2005 White Paper on Financial Services linked regulation to more effective engagement with financial products as governments limited social security.50 The 2007 Green Paper on Retail Financial Services included investment products among the savings products ‘essential for the everyday lives of EU citizens’ and necessary for long-term planning and protection against unforeseen circumstances.51 Similarly, the European Parliament’s response to the Commission’s 2007 Communication on consumer policy52 assumed that some encouragement to use financial products was appropriate.53 Support of market investment is implicit across the FSAP,

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(‘2008 Interim RDR’), p. 2) and suggested that the majority of consumers of investment products needed help to identify needs and ‘to encourage them to take action’ (Feedback Statement No. 08/6 (Feedback Statement No. 08/6, 2008) (‘2008 RDR Feedback Statement’), pp. 26 and 56). FSA, Financial Risk Outlook 2003, p. 10. 47 FSA, Financial Risk Outlook 2006, p. 80. FSA, Financial Risk Outlook 2007, pp. 10 and 90. Speech by Director-General Schaub of the Internal Market Directorate General on ‘Economic and Regulatory Background to the Commission Proposal for Revision of the ISD’, 15 October 2002, available via http://europa.eu/rapid/searchAction.do. European Commission, White Paper on Financial Services Policy 2005–2010 (COM (2005) 629), p. 7 and Annex III, pp. 10–11. European Commission, Green Paper on Retail Financial Services in the Single Market (COM (2007) 226), p. 4. European Commission, Communication on EU Consumer Policy Strategy 2007–2013 (COM (2007) 99). European Parliament, Committee on the Internal Market and Consumer Protection, Report on EU Consumer Policy Strategy 2007–2013 (A6-0155/2008), para. 28.

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but particularly in two cornerstone measures: the Prospectus Directive54 (direct investment and disclosure in the primary markets); and MiFID55 (advice and distribution of investment products in the secondary markets). The Prospectus Directive ambitiously promotes a pan-European retail equity market;56 in consequence, it is not unreasonable to assume that, on the demand side, it is also designed to support wider retail engagement. The Commission placed MiFID, which has been associated with stronger investment activity,57 in the context of ‘investors turn[ing] to marketbased investments as a means of bolstering risk-adjusted returns on savings and for provisioning for retirement’.58 It was described by the European Parliament’s powerful ECON Committee as designed to encourage market savings.59 On its market application in November 2007, the Commission similarly argued that MiFID would support investors in maximizing returns on savings and help to guarantee a higher standard of living.60 This pro-market perspective, and the related characterization of investor protection regulation as a means of promoting the markets, is also evident in the pervasive investor confidence rhetoric,61 which has survived the

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Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’). Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’) and European Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ 2006 No. L241/26 (‘MiFID Level 2 Directive’). E.g. L. Burn and B. Wells, ‘The Pan-European Retail Market – Are We There Yet?’ (2007) 2 Capital Markets Law Journal 263 and ICMA (International Capital Markets Association), Letter to the Commission on Review of the Prospectus Directive and Regulation, 8 April 2008, Annex (available via www.icmagroup.org), para. 2.1. See further chs. 1 and 6. More extensive regulation under MiFID has been related to an increase in consumer confidence and the volume of trade in financial markets: Europe Economics, The Benefits of MiFID: A Report for the Financial Services Authority (2006) (annexed to FSA, Overall Impact of MiFID (2006)), pp. 13 and 15. European Commission, MiFID Proposal (COM (2002) 625), Explanatory Memorandum, p. 3. A5-0287/2003. European Commission, MiFID: Frequently Asked Questions (2007) (MEMO 07/439), p. 4. The wealth of policy and regulatory examples includes the Prospectus Directive, which associates disclosure regulation with increasing confidence in securities (recital 18), and the Commission’s Explanatory Memorandum to MiFID which emphasized the need to

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financial crisis.62 In its 2009 Communication on packaged products, the Commission highlighted the collapse in investor confidence and the need to rebuild confidence, and argued that ‘the foundations for future investor re-engagement with packaged retail investment products will need to be laid; people will continue to need to save and invest’.63

b) The empowered investor Allied to this pro-market and instrumental approach, investor empowerment (typically in terms of informed and active investor decision-making, investor autonomy, wider investor choice and deeper investor engagement) is increasingly a concern of investor-protection-driven intervention. Investor empowerment reflects a long-standing tradition of investor autonomy, caveat emptor 64 and individual risk assessment in financial market regulation.65 But, in its developing form, empowerment is concerned with equipping and encouraging the retail investor to navigate the financial markets. It focuses in particular on investor-facing disclosure, financial capability and choice strategies which are designed to support the achievement by investors of their savings and investment preferences.66 Internationally, empowerment has, for example, been associated with the recent SEC initiative to ease access by foreign brokers and exchanges to the US market under a new mutual recognition model.67 Liberalization through mutual recognition is designed in part to accommodate wider access by the empowered retail investor to the international markets.68

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support investor confidence in the wake of the dotcom era scandals: Commission, MiFID Proposal, p. 4. The European Parliament in late 2008 noted that ‘educated and confident investors’ can provide additional liquidity to the capital markets: European Parliament, Resolution on Protecting the Consumer: Improving Consumer Education and Awareness on Credit and Finance (P6 TA-PROV(2008)0539, 2008), para. 4. European Commission, Communication from the Commission to the European Parliament and the Council: Packaged Retail Investment Products (COM (2009) 204) (‘Packaged Products Communication’), pp. 1 and 12. J. Black, Involving Consumers in Securities Regulation: Research Study for the Taskforce to Modernize Securities Legislation in Canada (2006), p. 15. H. Jackson, ‘Regulation in a Multisectored Financial Services Industry: An Exploration Essay’ (1999) 77 Washington University Law Quarterly 319, 333. T. Williams, ‘Empowerment of Whom and for What? Financial Literacy Education and the New Regulation of Consumer Financial Services’ (2007) 29 Law and Policy 226. Although, following a change in SEC leadership and the financial crisis, there have been few developments since the SEC’s initial efforts in 2008 (e.g. SEC Press Release 2008-49, 24 March 2008, available via www.sec.gov/news/press/2008/2008-49.htm). The debate was opened in an important article by two senior SEC officials (E. Tafara and R. Peterson, ‘A Blueprint for Cross-Border Access to US Investors: A New International

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The interests of retail investors were traditionally regarded as being compromised by, or in tension with, those of foreign firms. But the acceptance of mutual recognition suggests a reorientation of the SEC’s view of investor protection and a concern to deliver enhanced diversification opportunities and lower transaction costs to retail investors.69 Empowerment has also become strongly associated with the FSA’s retail market strategy.70 The consumer protection objective which, under FSMA,71 should inform FSA action, is characterized in terms of securing only the ‘appropriate’ degree of protection for consumers (FSMA section 5(1)).72 An empowerment agenda can also be implied in the inclusion of public awareness73 among FSMA’s objectives for FSA action. The reliance by FSMA on the term ‘consumer’ rather than on ‘investor’ has been associated with an empowerment agenda and with a ‘normalization’ of financial product decisions.74 Since 2002, the FSA’s major strategic aim for the retail markets has been to help consumers achieve a ‘fair deal’.75 The ‘fair deal’ agenda is based on four pillars, two of which (capable and confident consumers; and clear, simple and understandable information76 )

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Framework’ (2007) 48 Harvard International Law Journal 31) which argued that, as retail investors were increasingly pursuing international investment opportunities, changes in investor demand suggested that viewing the US markets in isolation was ‘no longer the best approach to protecting our investors’ (at 32). The SEC’s March 2008 Press Release similarly emphasizes diversification and lower transaction cost benefits. H. Jackson, ‘A System of Selective Substitute Compliance’ (2007) 48 Harvard International Law Journal 105, 110–13. The National Consumer Council has also supported confident and capable consumers as being able to plan more effectively for the future and less likely to face mis-selling risks, capable of making informed choices and promoting effective competition and more likely to engage willingly with financial services: National Consumer Council, Financial Capability: The NCC Response to the Treasury Consultation – Financial Capability: The Government’s Long-Term Approach (2007), p. 4. FSMA, sects. 2(1) and 2(2)(c). The FSA must have regard to a series of factors including: the differing degrees of risk in investment transactions and of consumer experience and expertise; consumer needs for advice and accurate information; and the general principle that consumers should take responsibility for their decisions (FSMA, sect. 5(2)). Including promoting awareness of the benefits and risks associated with different kinds of investment or other financial dealings, as well as the provision of appropriate information and advice: FSMA, sects. 2(1) and 2(2)(b) and 4. Gray and Hamilton, Implementing Financial Regulation, p. 192, suggesting that consumers are ‘individualistic and acquisitive participants in a market exchange looking after their own interests and taking responsibility for their choices’. E.g. FSA, Plan and Budget 2002–2003, p. 11 and, more recently, FSA, Business Plan 2008– 2009, p. 23. The other two pillars relate to soundly managed and well-resourced firms who treat customers fairly and to proportionate, risk-based and principles-based regulation.

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rely significantly on disclosure (chapter 5) and education (chapter 7) techniques. They accordingly reflect a concern to empower investors which has been implicit in the ‘fair deal’ strategy from the outset.77 Recent FSA strategic initiatives also suggest support for the empowered investor. The RDR (chapter 4) is based, in part, on supporting ‘capable and confident consumers’ and on consumers acting as a ‘stronger force’ on the markets, demanding services appropriate to their needs.78 A robust approach has also been adopted in the products sphere; the new fundsof-hedge-funds regime places a premium on investor choice,79 as does the FSA’s recent review of the listing rules which apply to investment entities.80 Consumer responsibility has also emerged as an FSA concern. An FSA suggestion that retail investors sign an explicit acceptance of risk, in an attempt to communicate a ‘stronger caveat emptor message’ with respect to riskier products,81 was rejected by the FSA’s consultative Financial Services Consumer Panel (FSCP) given poor levels of investor understanding.82 So too was the FSA’s suggestion that specific responsibilities could be imposed on investors.83 In 2008, the FSA returned to the fray84 with a generally measured discussion of consumer responsibility and of the balance between consumers’ and firms’ responsibilities.85 While acknowledging that decision-making weaknesses and market complexity limit the extent to which responsibility can be expected of consumers, it nonetheless suggested that in a ‘better world’ consumers would be able to 77

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The FSA’s initial strategic outcomes for the ‘fair deal’ aim related to consumers: understanding their rights and responsibilities better; demanding high standards and suitable financial products; undertaking more responsibility for their financial affairs and understanding the financial environment; and understanding the risk/reward trade-off (FSA, Business Plan 2002–2003, p. 17). 2007 RDR, pp. 3 and 5. 79 See further ch. 3. The FSA argued that product proliferation should be addressed through greater reliance on consumer awareness and education strategies rather than on restrictions on the variety of products available: Implementation of the Transparency Directive: Investment Entities Listing Review (Consultation Paper No. 06/4, 2006), p. 68. FSA, Wider Range Retail Investment Products: Consumer Protection in a Rapidly Changing World (Discussion Paper No. 05/3, 2005), p. 26. Financial Services Consumer Panel (FSCP), Opinion on Discussion Paper 05/3 (2005), pp. 2–3. FSCP, Annual Report 2004–2005, p. 14. The FSA canvassed in the RDR whether a cross-stakeholder statement of consumers’, distributors’ and providers’ responsibilities could be agreed: 2007 RDR, pp. 46–7. The FSCP was hostile, warning that a ‘significant sea change’ in investor competence and ability to understand disclosure would be required before any such move could be countenanced: FSCP: Response to Review of Retail Distribution (2007), p. 16. FSA, Consumer Responsibility (Discussion Paper No. 08/5, 2008).

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act in their own best interests86 and that ‘markets will work more effectively if consumers are involved and empowered’.87 It set out actions which the FSA could take in support of greater consumer responsibility and the ‘sensible actions’ which consumers might take. While clearly accepting limitations to empowerment, the discussion represents a significant statement of intent as to the role of empowered retail investors in a ‘better world’. This robust approach to retail investor engagement is not confined to the UK. The Dutch market conduct regulator has pointed to ‘assertive consumers’ as a key component of its market regulation strategy and has emphasized consumer responsibility.88 France’s Delmas Report was similarly concerned with the transfer of ‘risk and responsibility’ to retail investors and with ‘teach[ing] consumers to ask the right questions’,89 while empowerment also appears to be a feature of the French regulator’s thinking.90 EC law and policy has also embraced the empowerment model. The policy concern to ‘strengthen the demand side’91 has been accompanied by an ambitious model of the retail investor as autonomous, rational and empowered,92 driving competition, exerting discipline on the market and exercising informed choice.93 The Commission’s 2007 Green Paper on Retail Financial Services committed to empowering consumers of 86

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‘Better world’ consumers would be financially capable and confident, stay engaged postsale, be willing and able to find the most relevant services and understand and be prepared to accept the consequences were they not to do so: ibid., p. 29. Ibid., p. 7. AFM, Policy and Priorities for the 2007–2009 Period (2007), pp. 6 and 16; ‘when communicating with consumers, the AFM will continue to tell them about their own responsibility’ (at 24). Delmas Report, pp. 7 and 42. The AMF has highlighted its role in equipping investors to make informed choices (Response to Commission Green Paper on Retail Financial Services (2007), p. 1) and that it seeks to ensure that savers get the information necessary to assess market risk and to make free choices (Promoting Better Regulation: Outcome of the Consultation – The AMF’s Commitments (2006), p. 8). European Commission, White Paper on Financial Services, p. 7. The Parliament has suggested that ‘empowered and educated consumers’ can help to foster competition, quality and innovation within the banking and financial services industries: European Parliament, Resolution on Protecting the Consumer, para. 4. ‘By helping to develop better informed, better educated and more confident citizens we can enable them to take better responsibility for their financial affairs and play an active role in strengthening the consumer demand side of financial services markets’: Commissioner McCreevy, Speech on ‘Increasing Financial Capability’, 28 March 2007, available via http://europa.eu/rapid/searchAction.do.

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financial services to make the right financial decisions for their circumstances, and highlighted the importance of transparency and comparability in strengthening demand and in promoting good investment choices.94 MiFID saw ECOSOC call for the MiFID level 2 regime to be based on a model of an autonomous, ‘far-sighted, well-informed consumer’95 and the European Parliament’s ECON Committee repeatedly emphasize investor autonomy and choice.96 The empowered investor is also regarded as an agent of market discipline; MiFID’s best execution disclosure regime is based on the assumption that retail investors will use execution disclosure to monitor the quality of execution (chapter 6), while the 2006 Investment Funds White Paper called for strong demand-side discipline on the fund industry.97 The promotion of informed choice has been a particular concern.98 The Distance Marketing of Financial Services Directive (DMD), the first sustained expression of the EC’s retail market policy, for example, argued that it was in the interests of consumers to have access without discrimination to the widest possible range of financial services (recital 3) and assumes that consumers benefit from easier access to crossborder goods and services.99 The UCITS III investment product regime (chapter 3) is similarly based on the assumption that empowered investors benefit from a wide range of investment products; so too are the UCITS IV reforms.100 The rhetoric of empowerment and choice is already well established in the related Commission consumer policy.101 If the trend towards characterizing investor protection in terms of products and mass market savings102 continues, and if consumer and investor protection policy continues to align, this dynamic (and its risks) can be expected to become more entrenched. Empowerment has certainly cascaded down through the level 2 and 3 committees, suggesting local political and regulatory 94 95 97 98 99 100

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European Commission, Green Paper on Retail Financial Services, p. 15. 96 2003 OJ No. C220/1, para. 4.10. E.g. A5-0287/2003. European Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (COM (2006) 686) (‘Investment Funds White Paper’), para. 2. E.g. European Commission, Staff Working Document, White Paper Impact Assessment (SEC (2005) 1574), pp. 16–19. European Commission, Green Paper on European Union Consumer Protection (COM (2001) 531). The Commission has highlighted the need for UCITS disclosure reforms which would empower investors, help them to compare products and strengthen their ability to push for more competition: European Commission, Staff Working Document, Impact Assessment of the Legislative Proposal Amending the UCITS Directive (SEC (2008) 2236), p. 34. See further ch. 1. 102 See further ch. 1.

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support. The level 2 European Securities Committee has supported an empowerment-based approach.103 So too has CESR at level 3.104 Its 2008 Retail Investor Guide to MiFID, for example, highlighted as its ‘key message’ that the degree of protection received was ‘directly related to the reliance that [you] place on the firm and on yourself’.105

c) The attractions of the empowerment model The empowerment model is in many respects attractive and efficient. It may imply a reduction in regulatory intervention and in the related risks,106 including those flowing from the assumption that the regulator ‘knows best’. Investor-facing empowerment strategies, typically disclosure- and education-based, can support investors in achieving individual preferences.107 Disclosure, choice-, and education-based aids can also be customized by empowered investors who can choose the supports they need to reflect their needs and preferences. Empowering strategies, together with ‘marketing the markets’ efforts, can also be used to lead the investor to exercise sovereignty to achieve particular regulatory and governmental goals. The ‘responsibilization’ literature examines regulatory policy in terms of government and regulatory efforts to withdraw from the provision of services and of protection, to foster greater self-reliance and to make demands of individuals.108 Under this model, investor protection policy strives to build capable, independent and informed investors who can take on responsibility for welfare provision.109 The regulatory regime is not neutral as to the merits of market investment; it assumes and drives active participation by informed and capable investors. Sovereignty and choice are not simply a function of the investor’s decision; law and policy seek to direct the exercise of sovereignty and choice to the achievement of policy goals.110 This model also has strong resonances with the characterization of ‘smarter’ or more efficient financial market regulation as being decentred 103 105 106 108 109

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ESC, Minutes, 11 October 2007. 104 See further ch. 7. Accompanying Press Release to the Retail Investor Guide (CESR/08-209, 2008), pp. 1–2. Sect. II below. 107 Williams, ‘Empowerment’, 232. E.g. Williams, ‘Empowerment’; and I. Ramsay, ‘Consumer Law, Regulatory Capitalism and New Learning in Regulation’ (2006) 28 Sydney Law Review 9. The FSA’s approach has been related to its fostering the ‘financial citizen’ as a ‘knowledgeable, competent, confident, self-reliant, and willing market participant’ and a ‘strong commitment to markets as wealth creators, to competition and innovation, and to the concept of the individual as a “responsibilized citizen”’: Gray and Hamilton, Implementing Financial Regulation, pp. 188 and 192–4. Ramsay, ‘Consumer Law’, 13.

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in that it embraces a range of disciplining techniques, beyond traditional command and control regulation.111 Capable and informed investors can be enrolled as disciplining actors in the regulatory process, monitoring the market, exerting competitive pressures and accepting responsibility for their actions; regulation becomes concerned with building ‘responsibilized’ actors who can regulate themselves and the marketplace.112 Regulators can accordingly define the regulated environment and transfer responsibility for managing risks and market monitoring to the individual; regulators’ responsibility and regulatory risk in an increasingly complex environment can be reduced.113 Empowered and informed investors can also become agents for the regulator, providing from their market interactions valuable information which allows the regulator to take more effective action and to strengthen its position.114 As responsibility is passed to the investor, the retail investor might also be regarded as becoming the object of blame, and as not taking sufficient efforts to become informed, rather than as the beneficiary of public protective intervention.115 Mis-selling becomes an occasion of investor imprudence rather than of regulatory failure.116 The appeal of empowerment-based, investor-facing, disclosure and capability strategies is considerable to the beleaguered regulator. As discussed in subsequent chapters and in section II below, optimal retail market regulatory design is extremely difficult to achieve, particularly on the supply side. Product design is an unwieldy retail market lever and the distribution and advice lever is obstructed by conflict-of-interest difficulties. The strains are increased by the traditional segmented approach to financial market regulation as investment products cross the insurance, banking and investment sectors. Retail investor input into the law-making process is minimal, but supply-side interests are well organized and typically ferocious in defending their turf. Demand-side, empowerment-related 111 112 113 114 115

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E.g. J. Black, ‘Decentring Regulation: Understanding the Role of Regulation and Self Regulation in a “Post Regulatory World”’ (2001) 54 Current Legal Problems 103. Williams, ‘Empowerment’, 243; and Gray and Hamilton, Implementing Financial Regulation, pp. 49–50. Williams, ‘Empowerment’, 242. The FSA’s exhortations on its ‘moneymadeclear’ website to retail investors to provide it with instances of unfair contract terms might fall into this category. L. Willis, Against Financial Literacy Education (2008), ssrn abstractid=1105384, pp. 43–7. Faint echoes of this approach might be identified in the FSA’s suggestion that consumers be made aware of the consequence of not reading regulated disclosures: Discussion Paper No. 08/5, p. 31. Williams, ‘Empowerment’, 238.

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measures may represent the path of least resistance (and certainly do in the context of harmonization) and may distract attention from difficult supply-side reforms,117 particularly during periods where the retail constituency is politically quiescent118 – usually the status quo for much of Europe. In these circumstances, and although regulators are unlikely to yield significant power over the retail markets, the relative attraction of strategies which place more responsibility on the retail investor, as compared with the relentless difficulties of achieving retail market outcomes through supply-side intervention, are understandable, if not desirable.

d) The risks of the empowerment model and of ‘marketing the markets’: retail investors and the financial crisis The empowerment model makes significant assumptions as to investor competence which are difficult to reconcile with the evidence on retail investor decision-making (section I. 3 below). The ‘marketing’ dimension of the empowerment model is also perilous.119 Market investment entails significant costs for retail investors which may represent a considerable misallocation of resources given the costs investors incur in trying to ‘beat the market’ or in investing in actively managed but under-performing collective investment schemes (CISs).120 Market investment also carries significant market or investment risks. The observation that markets are volatile, often irrational, and can be inefficient in allocating resources, and that investor welfare may accordingly be prejudiced, is uncontroversial. A well-established literature argues that markets are inefficient given ‘noise traders’ who trade on the basis of irrelevant information,121 and a weight of evidence suggests that irrational 117

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In the 2003 US Congressional session, consumer-related financial services bills, including a bill to protect home buyers from predatory mortgage practices, failed, but in the same period a bill establishing the Financial Literacy and Education Commission became law in less than three months: Willis, Against Financial Literacy, p. 50. L. Bebchuk and Z. Neeman, Investor Protection and Interest Group Politics (2007), ssrn abstractid=1030355. J. Gray, ‘The Sandler Review of Medium and Long-Term Retail Savings in the UK: Dilemmas for Financial Regulation’ (2002) 10 Journal of Financial Regulation and Compliance 385. K. French, ‘Presidential Address: The Cost of Active Investing’ (2008) 63 Journal of Finance 1537, highlighting that, on average, the US spends 0.79 per cent of the aggregate value of the US equity market to invest each year and that active investors spend 0.67 per cent of total market capitalization each year in a ‘futile search for superior returns’ (at 1558–9). E.g. F. Black, ‘Noise’ (1986) 41 Journal of Finance 529 and J. Bradford De Long, A. Shleifer, L. Summers and R. Waldmann, ‘Noise Trader Risk in Financial Markets’ (1990) 98 Journal of Political Economy 703.

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momentum, herding and irrelevant information can distort prices122 – vividly illustrated by the dotcom crash and the Enron-era scandals.123 Market risks appear to be entrenching as markets become increasingly complex.124 The financial crisis has placed further pressure on market efficiency theories.125 It has also wreaked destruction on household market savings. Equities,126 bond investments,127 investment trusts,128 structured products129 and CISs130 (although by the end of 2008 investors were 122 123 124 125

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E.g. Langevoort, ‘Animal Spirits’. E.g. L. Ribstein, ‘Market vs Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes–Oxley Act 2002’ (2002) 28 Journal of Corporation Law 1. Modern financial management techniques may have led to markets coming to resemble casinos: L. Mitchell, The Morals of the Marketplace (2008), ssrn abstractid=1129340. The Turner Review, for example, summarized the challenges to market efficiency as including that: market efficiency does not imply market rationality; individual rationality does not ensure collective rationality; individual behaviour is not entirely rational; there are limits to allocative efficiency benefits; and empirical evidence illustrates large-scale herd effects and market overshoots: FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009) (‘Turner Review’), pp. 39–42. One year after the start of the credit crunch, and before the most dramatic market plunges, UK private shareholders were estimated to have lost £48 billion: C. Seib, ‘Private Shareholders Have Lost £48bn on Investments since Credit Crunch Started’, The Times, 25 August 2008, p. 36. The market capitalization of European stock exchanges fell by €5.6 trillion in the twelve months prior to October 2008: Federation of European Securities Exchanges, Share Ownership Structure in Europe (2008), p. 5, noting ‘the loss of financial wealth has been massive’. One report has highlighted the drop of more than 60 per cent in the value of US stocks since 2000 and a ‘broad sense of betrayal among the [US] populace that the faith all had been told to put in equities had been misplaced’: J. Authers, ‘Is It Back to the Fifties?’, Financial Times, 25 March 2009, p. 9. Including where issuers defaulted or delayed (as did Deutsche Bank) on redemption obligations: P. Davies and J. Wilson, ‘Deutsche Bank Faces Buyer Strike Over Decision Not to Redeem Bond’, Financial Times, 19 December 2008, p. 15. Trusts suffered steep share price reductions and a widening of the discount to net asset value to which they typically trade: S. Johnson, ‘UK Investment Trusts Hit Hardest’, Financial Times, Fund Management Supplement, 8 December 2008, p. 1. Major failures included two UK (Legal & General) capital-protected products, linked to the Lehman bankruptcy: K. Burgess and A. Ross, ‘L&G investors will pay price of Lehman collapse’, Financial Times, 16 December 2008, p. 17. Retail investors in the EC fled from CISs in all asset classes in the third quarter of 2007, moving into cash or high-interest deposit accounts; net redemptions amounted to €61 billion for the quarter ending September 2007, representing 1 per cent of the asset base of Europe’s fund industry: J. Saft, ‘Banks Benefit as European Investors Flee Financial Markets’, International Herald Tribune, 17 December 2007, available via www.iht.com. Matters worsened significantly in 2008. Equity schemes, for example, shrank dramatically, reducing from €350 billion to €188 billion over 2008, and massive withdrawals took place in the first and third quarters of 2008: S. Johnson, ‘Hopes of Return to Calmer Times’, Financial Times, Fund Management Supplement, 5 January 2009, p. 1; and S. Johnson, ‘UCITS Outflows Soar in Q3’, Financial Times, Fund Management Supplement,

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returning to more stable money-market schemes131 ) have all been affected. The massive withdrawals from the European CIS industry alone suggest the scale of investor losses.132 The Commission has estimated that assets invested in the most common retail packaged products (CIS, insurance products and structured products) fell in value from €10 trillion at the end of 2007 to around €8 trillion at the end of 2008.133 But the empowerment and responsibilization models appear resilient to major market shocks. Regulators generally regard general market risk as a burden to be borne by the investor,134 even though this risk deters engagement,135 and this tendency has persisted over the crisis. It took some time for the financial crisis to be addressed on the education sites of major international regulators136 and retail interests have not featured largely in the international debate.137 In particular, recent UK and EC policy debates have not engaged closely with retail investor exposure to general market risk.138 The FSA is, however, notable for its regular highlighting of the risks from market volatility in its annual Financial Risk

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1 December 2008, p. 2. The picture became significantly worse in the final quarter, reflecting the autumn 2008 market convulsions. Outflows reached €142 billion, making that quarter the worst in the sector’s history; almost 40 per cent of the year’s outflows occurred in October, reflecting the massive market instability: European Fund and Asset Management Association, Quarterly Statistical Release No. 36 (2008), pp. 2 and 5. In the US, investors withdrew €237 billion from mutual funds in 2008, the biggest ever exodus of funds from professional management: D. Brewster, ‘Retail Investor Behaviour’, Financial Times, 25 March 2009, p. 9. D. Ricketts, ‘Mutual Funds Move Back into the Black’, Financial Times, Fund Management Supplement, 19 January 2009, p. 11, reporting a ‘cautious return by retail investors’. Between June 2007 and September 2008, €416 billion was withdrawn from CISs, although much of this represents institutional investment: Johnson, ‘Hopes of Return’. Packaged Products Communication, p. 1. G. Pearson, ‘Risk and the Consumer in Australian Financial Services Reform’ (2006) 28 Sydney Law Review 99. FSA research has consistently found market risk to be a key inhibitor: for example, FSA, Accessing Investment Products, Consumer Perceptions of a Simplified Advice Process (Consumer Research No. 73, 2008), p. 7. Recent research on household reaction to the ‘credit crunch’ has similarly found that low levels of trust in December 2008 (and, as discussed later in this chapter, disengagement from the markets) were primarily related to a ‘brutal loss in stock market valuations’: P. Sapienza and L. Zingales, A Trust Crisis (2009), p. 6. See further ch. 7. Although the April 2009 G20 statement makes a vague reference to the effect that regulators and supervisors must protect consumers and investors: London Summit – Leaders’ Statement, 2 April 2009, para. 14. Retail investor exposure to market risk is absent from the FSA’s RDR (although it might be argued to be implicit in the Turner Review’s acceptance of the limits of market efficiency) and, for the most part, from the EC’s recent consideration of retail market policy in its discussion of substitute products.

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Outlooks.139 But, and reflecting the empowerment objectives embedded in FSMA, Outlooks typically associate market volatility with potential damage to investor confidence, a widening of the savings gap and the risks of a flight to riskier products.140 The FSA’s identification of market risk accordingly reflects a concern to ensure that investors do not leave the markets.141 Although the FSA’s 2008 Financial Risk Outlook noted that the financial crisis might require it to change its consumer information priorities,142 it was more concerned by the risk of potential disengagement from financial services.143 The 2009 Risk Outlook similarly highlighted the risk of prejudice to consumer willingness to engage with financial services and of savings behaviour being embedded which would be difficult to reverse in more stable conditions.144 Although the FSA’s 2009–10 Business Plan links the financial crisis to its retail market activities, its focus is on empowerment-related concerns to improve marketing and strengthen capability as well as on strengthening firms and embedding the TCF strategy;145 wider reconsideration of how investors should engage with the market does not, unsurprisingly, feature. The Commission has been similarly reluctant to address general market risks. In its 2009 consultation on reform of the Investor Compensation Scheme Directive, it was still confidently asserting, notwithstanding the destruction of retail investor value, that ‘it has been a mainstay of our approach to financial regulation that investors in financial investments should not be protected from investment risk’.146 The April 2009 Packaged Products

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The 2005 Outlook, for example, warned that weaker equity market performance would lead to financial losses for some consumers, that volatility in equity and bond prices would lead to sharp movements in the value of many investment products and that rising interest rates could lead to significant capital losses for consumers holding bond-related investment products. The 2005 Financial Risk Outlook warned of a widening in the savings gap and longterm opportunity losses: Financial Risk Outlook 2005, p. 27. The 2006 Outlook was also concerned that market volatility could lead to a loss of confidence in financial instruments and a flight to alternative investments: Financial Risk Outlook 2006, pp. 21 and 23. E.g. Financial Risk Outlook 2005, pp. 27 and 28 and Financial Risk Outlook 2006, pp. 21–3 and 80. FSA, Financial Risk Outlook 2008, p. 13. 143 Ibid., pp. 28 and 29. FSA, Financial Risk Outlook 2009, pp. 68–9. It noted, for example, consumer caution with respect to equity-based products and the relative popularity of deposit accounts given their security. Business Plan 2009–2010, p. 25. European Commission, Directive 1997/9/EC on Investor Compensation Schemes: Call for Evidence (2009), p. 8. The related impact assessment suggested that market or investment risk is ‘the price that needs to be paid to gain the potential for greater performance’: SEC (2009) 556, p. 6.

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Communication similarly underlined that regulation could not protect against adverse outcomes given the market risk integral to most products.147 But it is well time to reconsider the assumption that regulation is powerless to address general market risk. It is based on the traditional view that regulation is a function of the prevention of fraud and malfeasance and not a device for protecting retail investors against macro-economic shocks, and reflects the caveat emptor principle. But the caveat emptor principle has its roots in a time when widespread engagement with the markets was not promoted and when markets were simpler; it is now in need of recharacterization. The empowerment movement also seems to be resilient to what now appears to be recurring evidence of regulatory failure and of its impact on investor welfare. The scale of the regulatory failure associated with the financial crisis is only now emerging. The market mechanisms on which the regulatory framework relied certainly failed.148 It also appears that preexisting regulation, particularly in the form of the Basel II capital regime and the fair value/mark-to-market accounting approach, has contributed by reinforcing procyclicality. Regulators have also failed to address the macro-prudential risks to overall systemic stability which arise when major financial institutions act in a similar manner, have overlooked the linkage between regulation, markets and wider macro-economic policy and do not appear to have engaged with the risks which arose from the transmission of debt from the banking system into securities markets.149 They have also struggled with the burgeoning complexity of markets.150 The risks to retail investors can be exacerbated as market turbulence can lead to a diversion of regulatory and supervisory resources from the retail markets when financial-market architecture and systemic issues become pressing; this might explain, in part, the very limited response to investor education and advice needs as markets plunged in the second half of 2008. The risks are also evident from the FSA’s decision in late 2008 to scale back

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Packaged Products Communication, p. 5. E.g. S. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown (2008), ssrn abstractid=1056241; and Turner Review, pp. 45–7. E.g. W. Buiter, Lessons from the 2007 Financial Crisis (CEPR Policy Insight No. 18, CEPR, 2007); M. Brunnermeier, A. Crocket, C. Goodhart, A. Persaud and H. Shin, The Fundamental Principles of Financial Regulation. Geneva Reports on the World Economy 11. Preliminary Conference Draft (International Center for Monetary and Banking Studies (ICMB), 2009) and High-Level Group on Financial Supervision, Report (2009) (‘de Larosi`ere Report’). S. Schwarcz, Regulating Complexity in Financial Markets (2009), ssrn abstractid=1240863.

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its TCF supervisory initiatives,151 which led to considerable concern from the FSCP.152 Retail investors cannot be insulated from complexity and from regulatory failures which lead to systemic market losses. All the indications are that the reform process will be wide-ranging, that the assumption (which drove much of recent wholesale market regulation) that markets are self-correcting and that market discipline can often be more effective than regulation, is being challenged and that attempts are being made to protect the financial system against future failures.153 The catastrophic transmission of wholesale market risks into the retail markets which occurred might be avoided. But the scale of recent events, and the increasing difficulties posed by market complexity, suggests that another major regulatory failure154 leading to systemic losses cannot be ruled out. It may be time therefore to think more closely about how general market risks can be managed and to recalibrate the empowerment rhetoric and policy. General market risk is not easily managed by regulation, not least because of flawed regulator incentives. Where regulatory power depends on the championing of widespread participation in the markets, the regulator has few incentives to highlight investment risks, whether explicitly or through tougher regulation, without risking a reduction in retail investor activity and corresponding damage to its position.155 The world’s major regulator, the SEC, can be examined as having adopted, through its massive issuer disclosure regime, a ‘brand’ of securities regulation which empowers retail investors and promotes market investments.156 But it has been criticized for trumpeting market efficiency (described as a ‘Noble Lie’157 ), implicitly marketing direct investments while failing to take into account poor retail market awareness of the impact of diversification and

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J. Hughes, ‘FSA lowers the customer fairness bar’, Financial Times, 13 November 2008. FSCP, Press Release, 12 November 2008. Although it should be acknowledged that the FSA proceeded with its massive RDR over this period. E.g. the Turner Review, which argued that the susceptibility of financial markets to irrational momentum called for regulation to be based on striking a balance between the benefits of market liquidity and the disadvantages of instability (p. 42). Schwarcz has suggested that prescriptive regulation will struggle in protecting increasingly complex markets from failure and that measures are therefore needed to ensure that failure in one sector does not trigger a failure elsewhere: Schwarcz, Regulating Complexity. Langevoort, Expectations Gap, p. 6. 156 Langevoort, ‘Animal Spirits’, 173–4. G. La Blanc and J. Rachlinski, In Praise of Investor Irrationality (2005), ssrn abstractid=700710, p. 45.

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transaction costs158 and for adopting a ‘fair and orderly’ markets rhetoric which does not reflect the unfairness generated by limited financial resources and financial literacy.159 But better attempts must be made to manage market risk. Regulation should focus on diversification as a means of mitigating market risk. Leverage controls, which can dull the impact of market volatility, are already built into the UCITS product160 but the impact of leverage on the design of other retail products, notably structured, non-UCITS products, could also be considered. Procyclicality could be addressed more carefully; product design measures, on the lines of the FSA’s product life-cycle and risk assessment requirements,161 and disclosure reforms, in the form of a prohibition on past performance disclosures,162 while likely to be limited, could be considered by the EC. Closer attention must be given to guarantees; more radical product-based strategies might be employed to incentivize providers to provide guarantees, but at the very least the resilience of disclosure strategies must be tested as must the risk management procedures which govern the strength of guarantees. Given that EC retail investment is strongly based on the bond and equity asset classes which proved so volatile,163 stronger engagement with alternative investments might be useful,164 even allowing for alternative classes having under-performed during the crisis and posed liquidity and redemption risks. While the severe losses sustained by all asset classes over the financial crisis, and the removal of the buffering effect normally provided by bond investments,165 may not recur, the complexities and speed of financial market innovation, and the regular exposing of regulatory failures, suggest that future periods of large-scale, cross-asset instability will recur. As discussed in chapter 3, alternative investments are being opened to the retail sector. But closer regulatory engagement, not only with respect to product design but also with respect to the resilience of distribution and advice structures, is required. 158

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Langevoort, Expectations Gap, p. 35; and H. Jackson, ‘To What Extent Should Individual Investors Rely on the Mechanisms of Market Efficiency: A Preliminary Investigation of Dispersion in Investor Returns’ (2003) 28 Journal of Corporation Law 671. Bradley, ‘Disorderly Conduct’. 160 See further ch. 3. See further ch. 3. 162 See further ch. 5. 40 per cent and 39 per cent of assets under management in the European fund management industry represent bond and equity classes, respectively: EFAMA, Annual Asset Management Report: Facts and Figures (2008), p. 3. E.g. A Report Prepared at the Request of the Deputies of the Group of Ten by an Experts’ Group Chaired by Ignazio Visco, Banca d’Italia, Ageing and Pension System Reform: Implications for Financial Markets and Economic Policies (2005), p. 34. EFAMA, Annual Report 2007–2008, pp. 8–9.

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Particular care must also be taken in designing a regulatory response to the growth of structured retail products given their potential for delivering diversified returns and capital protection.

3. The irrational and uninformed investor a) The irrational and uninformed investor: the evidence Market risk therefore challenges the empowerment model. So too does the evidence outlined in chapter 1 of limited investor experience with investments. Above all, perhaps, so does the emerging evidence on how investors behave. With its emphasis on autonomy and informed choice, and its attachment to disclosure and investor education strategies, investor empowerment is closely associated with the rational behaviour model espoused by the law and economics, efficiency-driven school of analysis166 which has exerted such a profound influence on research and policy in law and economics. The empowerment model reflects the assumptions of law and economics that investors act as self-interested rational agents, seek to maximize utility and are capable of acquiring and assessing relevant information, and that sporadic divergences from rationality will be removed by arbitrage mechanisms.167 But, while law and economics has provided powerful tools for analysis, and in particular for exposing principal/agent risks,168 it is now clear that rational homo economicus is, if not extinct, then certainly a very rare character; homo sapiens, with all her flaws and complexities, is in the ascendant.169 The persistence nonetheless of homo economicus, in the face of mounting evidence of irrationality, points to the relative simplicity of rationality as a means of modelling human behaviour when designing rules170 and to the difficulties posed by alternative models.171 It might also point to the attractiveness of 166

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E.g. L. Stout, Taking Conscience Seriously (2006), ssrn abstractid=929048; and R. Korobkin, ‘The Endowment Effect and Legal Analysis’ (2003) 97 Northwestern University Law Review 1227. E.g. Easterbrook and Fischel, ‘Mandatory Disclosure’; and R. Ippolito, ‘Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry’ (1995) 35 Journal of Law and Economics 45. E.g. P. Mahoney, ‘Manager–Investor Conflicts in Mutual Funds’ (2004) 18 Journal of Economic Perspectives 161. R. Thaler, ‘From Homo Economicus to Homo Sapiens’ (2000) 14 Journal of Economic Perspectives 133. Thaler, ibid. (noting that it is easier to build a model of a rational, unemotional agent); and Stout, ‘Taking Conscience’. Arlen, ‘Future of Behavioral Economic Analysis’.

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the law and economics model for the deregulatory movement which, until the financial crisis, had been associated with financial market regulation. The burgeoning behavioural finance literature and the related behavioural analysis of securities regulation, which has recently focused on the retail investor, exposes a different reality. Many households make financial decisions that are hard to reconcile with the advice they may receive or with standard finance models.172 A rich legal literature on investment decision-making has developed,173 drawing on the findings of behavioural finance,174 which supports a more nuanced model of retail investor behaviour and regulation. Much of the evidence is concerned with direct market investments, trading and issuer disclosure, rather than with the purchase of investment products which strongly characterizes the EC and UK markets, as outlined in chapter 1. Nonetheless, it suggests that the investment markets are a challenging environment for a nascent retail investor constituency and that empowerment-based, investor-facing strategies generate significant risks. A considerable weight of evidence, reflecting the early insight that individuals are only ‘boundedly rational’,175 points to systematic, poor decision-making.176 This research builds on the seminal work of Kahneman and Tversky on the prevalence of systematic biases and deviations from rationality in decision-making,177 with the 1980s seeing two of the

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J. Campbell, ‘Household Finance’ (2006) 61 Journal of Finance 1553, 1554. E.g. S. Bainbridge, ‘Mandatory Disclosure: A Behavioral Analysis’ (2000) 68 University of Cincinnati Law Review 1023; S. Bainbridge, ‘Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for Its Future’ (2002) 51 Duke Law Journal 1397; Langevoort, ‘Animal Spirits’; L. Stout, ‘The Mechanisms of Market Efficiency: An Introduction to the New Finance’ (2003) 28 Journal of Corporation Law 635; R. Gilson and R. Kraakman, ‘The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias’ (2003) 28 Journal of Corporation Law 215; and E. Augouleas, ‘Reforming Investor Protection Regulation: The Impact of Cognitive Biases’ in M. Faure and F. Stephen (eds.), Essays in the Law and Economics of Regulation In Honour of Anthony Ogus (Antwerp: Intersentia, 2008). For summaries of the main findings see, for example, Prentice, ‘Whither Securities Regulation’, 1454–89; La Blanc and Rachlinski, In Praise, pp. 17–21; and R. Deaves, C. Dine and W. Horton, How Are Investment Decisions Made?, Research study prepared for the Task Force to Modernize Securities Legislation in Canada (2006) (‘Deaves Report’), pp. 252–6. Developed by Herbert Simon: H. Simon, ‘A Behavioral Model of Rational Choice’ (1955) 69 Quarterly Journal of Economics 99. Generally, R. Shiller, Irrational Exuberance (Princeton and Oxford: Princeton University Press, 2000). E.g. D. Kahneman and A. Tversky, ‘Prospect Theory: An Analysis of Decision under Risk’ (1979) 47 Econometrica 263.

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early applications of behavioural finance to financial decision-making.178 Since then, a voluminous financial economics and legal literature has developed on the evidence on and implications of significant and systematic defects in investor decision-making. Rules of thumb are used to ease complex decisions and lead to poor decision-making.179 The status-quo bias, which means that decision-makers are reluctant to make changes and undervalue the risks of the status quo and the benefits of choice,180 leads investors to hold investments for too long181 and to a related tendency not to ‘shop around’. The endowment effect, or the tendency to demand more to surrender an asset than its acquisition cost,182 leads to investors assessing risks in terms of loss aversion rather than in terms of final return.183 Cognitive conservatism also limits the extent to which investors change their decisions, even in the face of evidence that change is optimal. The framing effect means that investor vulnerability to marketing is significant; the way in which an investment choice is framed (in terms of the loss of an investment opportunity, for example) can drive the investment decision.184 The hindsight bias increases investor vulnerability to past performance information. The limitations of disclosure are borne out by the confirmation bias, which leads investors to rely on evidence or disclosures which reinforce their decisions, and by the availability shortcut, which leads investors to rely on information which is most easily brought to mind.185 Biases can also be contrarian. While loss aversion and the status quo bias suggest conservative decision-making, over-confidence186 is a particularly well-documented bias.187 It leads to investors being overoptimistic as to their skill, discounting the impact of chance (save with 178

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H. Shefrin and M. Statman, ‘Explaining Investor Preference for Cash Dividends’ (1984) 13 Journal of Financial Economics 253; and W. de Bondt and R. Thaler, ‘Does the Stock Market Overreact?’ (1985) 40 Journal of Finance 793. S. Benartzi and R. Thaler, ‘Naive Diversification Strategies in Defined Contribution Savings Plans’ (2001) 91 American Economic Review 79. E.g. Ogus, Regulatory Paternalism, p. 307. T. Odean, ‘Are Investors Reluctant to Realize Their Losses?’ (1998) 53 Journal of Finance 1775. Korobkin, ‘The Endowment Effect’. Arlen, ‘Future of Behavioral Economic Analysis’, 1771. A. Tversky and D. Kahneman, ‘Rational Choice and the Framing of Decisions’ (1986) 59 Journal of Business 251; and D. Langevoort, ‘Towards a More Effective Risk Disclosure for Technology-Enhanced Investing’ (1997) 75 Washington University Law Quarterly 753. C. Sunstein, ‘What’s Available? Social Influences and Behavioral Influences’ (2003) 97 Northwestern University Law Review 1295. R. Korobkin and T. Ulen, ‘Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics’ (2000) 88 California Law Review 1051. It has been supported by some hundreds of studies (C. Jolls, ‘Behavioral Economics Analysis of Redistributive Legal Rules’ (1998) 51 Vanderbilt Law Review 1653) and is

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respect to losses), over-emphasizing positive returns and underestimating risk levels.188 Ultimately, poor decision-making based on over-confidence can lead to a wider misallocation of resources.189 Trend-chasing is also common, as is herding behaviour.190 As a result, investor decision-making is far from the model of rational, self-interested, utility-maximization assumed by efficiency theory and implicit in the empowerment model. Decision-making failures make the direct trading process particularly problematic (chapter 6). But poor decision-making also relates to choice of investment products191 (chapter 3), particularly with respect to how disclosure is processed (chapter 5), and is reflected in over-reliance on investment advice and in investor difficulties in assessing conflicts-of-interest disclosure (chapters 4 and 5). Choice, strongly associated with investor empowerment, is accordingly something of a siren’s call in the retail markets,192 particularly with respect to investment products.193 Overall, retail investors simply tend to make bad decisions.194 These findings are increasingly being confirmed by industry studies195 and by regulator-sponsored surveys which point to poor decision-making

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described as ‘the most robust finding in the psychology of judgment’: Langevoort, ‘Animal Spirits’, 146, citing an ‘oft repeated’ finding from W. de Bondt and R. Thaler, ‘Financial Decision-Making in Markets and Firms: A Behavioral Perspective on Finance’ (1995) 9 Handbook of Operations Research and Management Science. Langevoort, ‘Animal Spirits’, 146–7. La Blanc and Rachlinski, In Praise, pp. 2 and 17. Shiller, Irrational Exuberance, pp. 157–62. L. Costanzo and J. Ashton, ‘Product Innovation and Consumer Choice in the UK Financial Services Industry’ (2006) 14 Journal of Financial Regulation and Compliance 285. A leading study has found that most participants did not have the skill to pick portfolios aligned with their attitude to risk and, accordingly, has questioned the presumption that adding choice makes consumers better off: S. Benartzi and R. Thaler, ‘How Much Is Investor Autonomy Worth?’ (2002) 57 Journal of Finance 1593. As has been acknowledged by the FSA, for example in Financial Risk Outlook 2007, p. 10. In the EC context, FIN-USE, the Commission’s representative group on the retail markets, has repeatedly pointed to the risks of increased choice and investor confusion. E.g. FIN-USE, Financial Services, Consumers and Small Businesses: A User Perspective on the Reports on Banking, Asset Management, Securities and Insurance of the Post FSAP Stock Taking Groups (2004), p. 1 and 4. ‘[M]any do not begin to save till very late and do not save enough once they start. Risk is not well understood: it is common to believe that an individual security is less risky than a market index. People become increasingly hesitant and even paralyzed when offered additional asset choices. Ignoring the most basic lessons of diversification, future retirees put far too much money into company stock, and fall prey to recency and representativeness in chasing winners’: Deaves Report, pp. 256–7. E.g. ANZ, Adult Financial Literacy, Personal Debt and Financial Difficulty in Australia (2005); and NASD, NASD Investor Literacy Research: Executive Summary (2003).

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as well as limited understanding of the investment process. The 2005 Canadian Deaves study, for example, which characterized evidence on how investors behave as a ‘needed piece of the puzzle’ when designing regulatory reforms,196 summarized its survey findings as follows: ‘knowledge levels are often low and decisions are tainted by behavioural bias. Some are over confident, subject to emotion and chase winners.’197 Investors displayed over-confidence,198 relied on gut feelings and instinct199 and relied inappropriately on past performance.200 In the EC, the 2007 BME Report provides (for the first time on a pan-EC basis) a picture of retail investor capability significantly at odds with the investor-facing, empowerment model; the Council’s Financial Services Committee has similarly bleakly identified a ‘currently unsophisticated and unprepared retail mass market’.201 As outlined in chapter 1, experience with investments is limited. But diversification is also weak. Household equity portfolios are generally limited to a small number of shares and display a strong home bias,202 clear from the evidence from France,203 the Nordic countries204 and Italy.205 There is, however, some evidence of 196 198 199 200 201 202

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Deaves Report, p. 250. 197 Ibid., p. 247. Particularly with respect to their ability to ‘beat the market’: ibid., p. 278. One-quarter of investors stated that intuition drove investment decisions: ibid. Ibid., p. 279. Subgroup on the Implications of Ageing on Financial Markets, Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’), p. 21. BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007) (‘BME Report’), p. 49, reporting that ‘retail equity investments are almost completely limited to domestic shares’ and that this trend did not change over 1999–2005. More generally, the Commission has reported that EC investors continue to demonstrate a home bias in equity investments, although it suggested that the bias effect was declining and that the increase in investments in other Member States (from 52 per cent to 55 per cent between 2001 and 2005) pointed to the emergence of a regional EU bias: European Commission, Financial Integration Monitor 2007 (SEC (2007) 1696), p. 9. French households are generally under-diversified with 80 per cent of shareholders in privatized companies holding fewer than five stocks and only 26 per cent of equities held by French households representing foreign issuers: B. S´ejourn´e, Why Is the Behaviour of French Savers So Inconsistent with Standard Portfolio Theory? (AMF Working Papers, 2006) (‘French Savers’), pp. 6, 8 and 9. Less than 10 per cent of Nordic investors hold securities of foreign issuers: Centre for Strategy and Evaluation Services, Study in the Impact of the Prospectus Regime on EU Financial Markets (2008) (commissioned by the European Commission) (‘CSES Report’), p. 18. Although the Swedish market represents one of the important retail stock markets in the Community in relative terms, household investments are heavily concentrated in Ericsson and TeliaSonera shares (although diversification is improved by indirect CIS investment: BME Report, p. 46). Fifty per cent of Italian shareholders have a portfolio composed of no more than two shares: ibid., p. 47.

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retail investor appetite for cross-border investments.206 Bond investments are similarly locally based; cross-border activity in the debt market is very limited.207 Exacerbating the home bias, understanding of the process of market investment is limited, although understanding levels vary.208 Knowledge of different investments is poor; knowledge concerning bonds is particularly low in some Member States and knowledge of CISs is variable.209 The pan-EC 2008 Optem Report on disclosure similarly found low levels of understanding of terms such as ‘leveraged’ and ‘derivative’ and difficulties with percentage disclosure.210 Similar findings have been reported by the Council’s Financial Services Committee which concluded that current levels of understanding were too low.211 Once investment decisions are made, they tend not to be revisited very often; investment performance is reviewed only infrequently.212 These findings are mirrored both internationally213 and in national studies. The FSA has engaged in an extensive series of studies on financial capability and on attitudes to investment and risk.214 They suggest low levels of understanding and have led to financial capability being persistently

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Retail investors have doubled their holding of equities issued in another Euro-zone Member State to 29 per cent, although the vast majority of portfolios are composed of domestic shares: ibid., p. 27. In the Netherlands, 15 per cent of private investors invest on foreign stock markets: AFM, Policy and Priorities, p. 11. BME Report, p. 26. Bonds, shares and investment funds are not seen as long-term investments, particularly in France and the UK, although Poland and Italy show stronger understanding: ibid., p. 194. Ibid., p. 195. Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’), p. 108. FSC Report, p. 21. 212 BME Report, p. 196. Australian investors, for example, have poor understanding of the risk/return relationship: ANZ, Adult Financial Literacy, p. 3. An NASD survey of US investors found that only 35 per cent answered at least seven of ten basic market knowledge questions correctly: NASD, Investor Literacy, pp. 6 and 9. See generally, for example, A. Lusardi and O. Mitchell, ‘Financial Literacy and Retirement Preparedness: Evidence and Implications for Financial Education’ (2007) 42 Business Economics 35. Including: studies of risk appetite in annual Financial Risk Outlooks; studies on investor behaviour (e.g. Consumer Understanding of Financial Risk (Consumer Research No. 33, 2004); Levels of Financial Capability in the UK: Results of a Baseline Survey (Consumer Research No. 47, 2006); and Consumer Purchasing and Outcomes Survey (Consumer Research No. 76, 2009)); a series of studies on disclosure (chs. 3 and 5); and a series of studies on awareness of the FSA and regulation (e.g. FSA, Consumer Awareness of the FSA and Financial Regulation (Consumer Research No. 67, 2008) and Consumer Awareness of the FSA and Financial Regulation (Consumer Research No. 62, 2007)).

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highlighted by the FSA as a risk to the achievement of its objectives.215 Understanding of risk is poor;216 there is considerable misalignment between investors’ risk appetites and their investment choices.217 Many investors do not understand which products are linked to the stock market and what is meant by equity;218 in one study, 40 per cent of those holding an equity-based Individual Savings Account (a structure for holding investments which provides tax benefits) were not aware that its value fluctuates with stock market performance.219 Investment monitoring is weak,220 with shares typically being held for eleven years,221 and financial management is reactive rather than proactive.222 ‘Shopping around’ is limited.223 The 2002 Sandler Review earlier described investor choices of financial product as characterized by an excessive focus on past performance, insufficient attention to asset allocation, a preference for costly active management and a tendency to use inappropriate timescales over which to assess performance.224 This troublesome profile repeats across the Member States. The French TNS-Sofres Report, for example, reported that, while the retail investors canvassed understood, in principle, the concept of risk, they associated CISs and equities with lower levels of risk.225 It also found that intuition plays a major role in share investments, evidence of herding behaviour 215 216

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E.g. Financial Risk Outlook 2007, p. 90. An earlier study found a deep-seated consumer belief in the long-term performance of the stock market and that, while risk was accepted on a rational level, it was not personalized: FSA, Report of the Task Force on Past Performance Information (2001), p. 9. The 2008 report on awareness of the FSA and regulation, for example, found that 32 per cent of those holding unit trusts and equity-based products, and 36 per cent of direct share owners, were not willing to take any risks: FSA, Consumer Research No. 67. FSA, Towards a Strategy for Financial Capability, p. 6. FSA, Financial Capability in the UK: Establishing a Baseline (2006), p. 18. Some ISA investors also erroneously believe that returns are government-guaranteed: FSA, Consumer Research No. 35, p. 18. Twenty-two per cent of investors canvassed never monitored their investments: FSA, Consumer Research No. 47, p. 93. In a subsequent study, the FSA found that only 63 per cent of investors monitored their investments, although 81 per cent recognized that monitoring was appropriate: FSA, Investment Disclosure Research (Consumer Research No. 55. 2006), p. 3. Seib, ‘Private Shareholders’. 222 FSA, Towards a Strategy for Financial Capability, p. 6. FSA, Losing Interest: How Much Can Consumers Save by Shopping Around for Financial Products? (Occasional Paper No. 19, 2002); and, more recently, FSA, Consumer Research No. 76, p. 12. Sandler Report, pp. 13–14. TNS-Sofres, Report for the AMF, Investigation of Investment Information and Management Processes and Analysis of Disclosure Documents for Retail Investors (2006) (‘TNS-Sofres Report’), p. 8.

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(particularly in privatizations) and that the ‘thrill of speculation’226 influences investment decisions.227 The Delmas Report highlighted the procyclical tendency of household investments;228 procyclicality and poor diversification have also been repeatedly highlighted as a risk to households by the French AMF.229 Italian investors also show low levels of understanding of the financial markets and investments.230 Research from the Netherlands has yielded similar results.231 The Commission’s 2007 Communication on financial education also pointed to low levels of understanding on financial matters more generally.232

b) The implications of the irrational investor The behavioural finance analysis and the problem of investor irrationality and limited understanding produces some elegant puzzles concerning the nature of regulation and, in particular, the dynamics of issuer disclosure, market efficiency and price formation.233 But the potentially mitigating effects of the market efficiency mechanisms associated with issuer disclosure are not directly relevant to individual retail investor decision-making. The policy implications are, therefore, particularly significant in the retail sphere and with respect to the often intermediated sale of investment products and individual decision-making.234 One response might be that, far from retail market regulation following an investor-facing empowerment or responsibilization agenda, 226

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The attractions of speculation have also been identified as a significant driver of the Taiwanese retail market: B. Barber, Y.-T. Lee, Y.-J. Liu and T. Odean, ‘Just How Much Do Individual Investors Lose by Trading?’ (2009) 22 Review of Financial Studies 609. TNS-Sofres Report, p. 37. 228 Delmas Report, Annex V. E.g. AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings (2008), p. 65. L. Enriques, ‘Conflicts of Interest in Investment Services: The Price and Unfair Impact of MiFID’s Regulatory Framework’ in G. Ferrarini and E. Wymeersch (eds.), Investor Protection in Europe: Corporate Law Making, the MiFID and Beyond (Oxford: Oxford University Press, 2006), p. 321, pp. 334–7. M. van Rooij, A. Lusardi and R. Alessie, Financial Literacy and Stock Market Participation (2007), ssrn abstractid=1014994, showing that households do not understand the difference between stock and bonds, risk diversification or how financial markets work. Commission, Financial Literacy. E.g. Bainbridge, ‘Mandatory Disclosure’ and the articles examining the Efficient Capital Markets Hypothesis on the twentieth anniversary of Gilson and Kraakman’s seminal analysis of the mechanisms of market efficiency in (2003) 28 Journal of Corporation Law, summer issue. Gilson and Kraakman suggest that behavioural finance, while not convincing in its attempts to dismantle market efficiency, might justify intervention concerning poor individual decision-making and diversification: ‘Twenty Years Later’, 738–9.

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restrictive strategies which seek to protect investors from themselves may be more appropriate, particularly with growing product complexity.235 Retail market intervention might be better concerned with limiting choice or with excluding retail investors,236 whether through taxation237 or testing238 strategies, than with autonomy, market access and choice. It may also be that, in the interests of wider market and regulatory efficiency, and regarding investors as agents of public policy, retail investor access to the markets should be controlled given the potential risk of damage by irrational and disruptive investors.239 Retail investors certainly have the capacity to influence financial markets.240 Stock market volatility seems to increase along with wider market participation.241 Mass market and irrational investing can lead to asset prices drifting from fundamental values242 as arbitrageurs can find it too risky to trade against a tide of investor sentiment.243 Over-investment and poor resource allocation 235 236

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T. Hu, ‘Illiteracy and Intervention: Wholesale Derivatives, Retail Mutual Funds, and the Matter of Asset Class’ (1996) 84 Georgetown Law Journal 2319, 2364. La Blanc and Rachlinski query whether, if investors make ‘bad choices’, the sensible response is to stop them from doing so (In Praise, p. 21), while Rachlinski has suggested that, ‘instead of encouraging cheap access to the markets and information for all investors, the cognitive error story suggests placing significant restrictions on access to the markets’: J. Rachlinski, ‘The Uncertain Psychological Case for Paternalism’ (2003) 97 Northwestern University Law Review 1165, 1185. E.g. J. Stiglitz, ‘Using Tax Policy to Curb Speculative Short-Term Trading’ (1989) 3 Journal of Financial Services Research 101; and Stout, asking whether taxation measures or prohibitions could be used to restrict speculative trading: L. Stout, ‘Are Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation’ (1995) 81 Virginia Law Review 611. E.g. S. Choi, ‘Regulating Investors Not Issuers: A Market-Based Proposal’ (2000) 88 California Law Review 279, suggesting that retail investors be restricted to passive investment funds and that the segmentation of investors be based on some form of investor test. A ‘driving licence’ model has also been suggested, which would require that investors show some level of competence before accessing certain products: J. Kozup and J. Hogarth, ‘Financial Literacy, Public Policy and Consumers’ Self Protection – More Questions, Fewer Answers’ (2008) 42 Journal of Consumer Affairs 127, 134. On retail investors as a ‘bad influence’, see Bradley, ‘Disorderly Conduct’; Langevoort, ‘Animal Spirits’: and Hu, ‘Illiteracy and Intervention’. Yen volatility has been related to large volumes of purchases of foreign currency bonds by Japanese retail investors in an attempt to take advantage of yen appreciation: Bank for International Settlements, 77th Annual Report 2006–2007, pp. 84–5. L. Guiso, M. Haliassos and T. Japelli, CEPR Discussion Paper No. 3694, Household Stockholding in Europe: Where Do We Stand and Where Do We Go? (CEPR, 2003), pp. 21–2. Shiller, ‘Irrational Exuberance’, 203. A. Shleifer, Inefficient Markets: An Introduction to Behavioural Finance (Oxford: Oxford University Press, 2000), pp. 28–52.

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can follow.244 Ultimately, markets may crash as a result of investor irrationality and error.245 Taken to its extreme, this might suggest that retail investors be either excluded from the markets or somehow restricted, perhaps through marketing restrictions, to a limited series of regulatorsponsored products.246 At the very least, it might suggest that regulatory efforts in support of wider participation should be constrained.247 Faint echoes of this approach have emerged amidst the empowerment rhetoric. The Delmas Report, for example, noted the risk to the financial system as a whole were poor decision-making and inadequate regulation to damage the financial system by accentuating the procyclical behaviour of households.248 The FSA has also expressed concern that wider risks to market disruption may arise where retail investors, with limited understanding of more complex investment products, withdraw en masse from particular products, such as illiquid property funds.249 The market disruption argument should not be over-played, however, given limited household involvement250 and the dominance of institutional investors in direct investments in the Community marketplace. But the fact remains that the retail investor’s contribution to asset pricing is often contrarian,251 that retail investors act as liquidity suppliers to professional investors who often trade against the direction of retail trading252 and that they sustain significant losses. Issuers may also benefit from investor irrationality 244 245 246

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P. Mahoney, ‘Is There a Cure for Excessive Trading?’ (1995) 81 Virginia Law Review 713. F. Partnoy, ‘Why Markets Crash and What Law Can Do About It’ (2001) 61 University of Pittsburgh Law Review 741. E.g. La Blanc and Rachlinski, suggesting that collective investment be incentivized and calling for restrictions on online trading, investor education strategies and marketing controls: In Praise, p. 3. This argument was made in the US in the context of Regulation FD and the risk that ‘mindless and erratic price movements’ might follow easier retail investor access to issuer disclosure: Langevoort, ‘Animal Spirits’, 165. Delmas Report, p. 12. Financial Risk Outlook 2008, p. 51. 250 Guiso et al., Household Stockholding, pp. 21–2. A study on Finnish investor behaviour, for example, has found that domestic investors, particularly households, pursued contrarian strategies and showed significant negative performance, cashing in winning stocks and holding losing stocks: M. Grinblatt and M. Keloharju, ‘The Investment Behaviour and Performance of Various Investor Types: A Study of Finland’s Unique Data Set’ (2000) 55 Journal of Financial Economics 43. In the mutual fund context, see A. Frazzini and O. Lamont, ‘Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns’ (2008) Journal of Financial Economics 299. R. Kaniel, G. Saar and S. Titman, ‘Individual Investor Trading and Stock Return’ (2008) 63 Journal of Finance 273.

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by exploiting sentiment through equity offerings, stock-financed mergers and other issuance mechanisms.253 Any attempts to deal with investor irrationality through exclusionary policies would, however, be highly paternalistic.254 Exclusionary policies could also damage liquidity255 and asset pricing.256 While it may be sacrificial, widespread market participation has been found to contribute to asset pricing,257 while retail investor sentiment has been studied given its impact on pricing and resource allocation.258 Less aggressive strategies which channel retail investors towards particular assets or products, and which adopt a ‘merit’ approach by requiring the regulator to attest to their relative ‘safety’ (however this might be captured – perhaps in terms of returns, protection against market risk and capital protection), could be canvassed. But merit strategies have become unpopular259 and the prejudicial implications for innovation and competition are considerable. Intervention of this nature would also significantly increase the risks of regulatory intervention; market risks may simply be replaced by regulatory risk. It would also be a long way from the market integration and choice-supporting principles on which the post-FSAP regime is based, place considerable strain on the internal market competences on which the investor protection regime is based and be politically fanciful. There are echoes of this approach, however, in the segmentation and product

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Frazzini and Lamont, ‘Dumb Money’. R. Romano, ‘A Comment on Information Overload, Cognitive Illusion, and Their Implications for Public Policy’ (1986) 59 Southern California Law Review 313, 325. E.g. Shleifer, Inefficient Markets, pp. 190–4; and Kaniel et al., ‘Individual Investor Trading’, suggesting (at 296) that individual traders are ‘natural liquidity providers’. The liquidity provided by retail investors has, for example, been noted by the London Stock Exchange in its information on the Alternative Investment Market (AIM): available via www.londonstockexchange.com. E.g. La Blanc and Rachlinski, In Praise. French, ‘Cost of Investing’, 1538, noting that active investors ‘almost certainly’ improve the accuracy of financial prices. E.g. Kaniel et al., ‘Individual Investor Trading’, finding that individual trading on the New York Stock Exchange can, over a short term, predict future returns; and, in the European context, M. Burghardt, M. Czink and R. Riordan, Retail Investor Sentiment and the Stock Market (2008), ssrn abstractid=110038. More generally, see M. Baker and J. Wurgler, Investor Sentiment in the Stock Market (2007), ssrn abstractid=962706. E.g. H. Pitt, Written Testimony Concerning Accounting and Investor Protection Issues Raised by Enron and Other Public Companies, Testimony before the Committee on Banking, Housing, and Urban Affairs of the US Senate, available via www.sec.gov/news/testimony/.

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regulation techniques currently associated with EC retail market intervention but which, unless carefully executed, risk poor returns for retail investors and a proliferation of poorly designed products.260 Caution is certainly required in engaging with the behavioural finance agenda. Behavioural finance remains a shaky basis for radical reforms without considerably more evidence.261 The range of biases, the lack of a consistent underlying theory,262 uncertainty as to the extent to which biases impact on the market, the importance of context in decision-making263 and the troublesome policy loop – if biases exist, how can they be corrected given bias in policy-makers and regulators?264 – all call for care.265 Biases, rather than representing irrationality, have been described in terms of an evolutionary model, and as being consistent with individuals’ efforts to adapt to their environment, and to learn from their mistakes, using short-cuts.266 Other factors, including poor incentive alignment in the firm/investor relationship, may drive seemingly irrational decisions.267 In the absence of large-scale evidence on how different types of investors behave under different conditions and with different asset classes, retail investors might prejudicially be regarded as a homogeneous group. The rationality model remains useful for identifying the particular choices which would maximize wealth and for informing investor education.268 Biases may be dulled by investor learning269 and minimized by advice.270

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See further ch. 3. Camerer et al., ‘Asymmetric Paternalism’, 1214; and Arlen, ‘Future of Behavioral Economic Analysis’, cautioning that behavioural finance ‘cannot provide a coherent alternative model of human behaviour capable of generating testable predictions and policy conclusions in a wide range of areas’ (at 1777) and warning that rational choice remains a reasonable description of individual choice as individuals learn (at 1768). For an attempt at a unifying theory (from a financial economics perspective), see H. Hong and J. Stein, ‘A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets’ (1999) 54 Journal of Finance 2143. One of the most high-profile efforts concerns the evolutionary theory developed by Lo: for example, A. Lo, Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis (2005), ssrn abstractid=728864. E.g. Korobkin, ‘The Endowment Effect’, considering how context impacts on the endowment effect and the implications for policy recommendations. Bainbridge, ‘Mandatory Disclosure’. S. Choi and A. Pritchard, ‘Behavioral Economics and the SEC’ (2003) 56 Stanford Law Review 1. Lo, Adaptive Markets. 267 Mahoney, ‘Manager-Investor’. Campbell, ‘Household Finance’, 1554. Arlen, ‘Future of Behavioral Economic Analysis’, 1769. E.g. Romano, ‘Information Overload’, 326.

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Market efficiency and competition dynamics are such that it is not necessary that all investors are rational at all times.271 Institutional investors are active in the European retail CIS products market,272 for example, and can exert discipline on CISs, particularly with respect to costs.273 It might also be suggested that irrational behaviour is simply the outcome of a market failure and a reasonable response by the investor to a lack of information and/or the costs of becoming informed;274 disclosure reforms might, accordingly, address the failure. On the other hand, the empirical evidence is burgeoning, investor learning opportunities are limited as retail investors tend not to be repeat players, advisers can be of doubtful effectiveness275 and the real difficulties generated by retail market irrationality are at the level of the individual decision;276 market efficiency, competition and institutional investor discipline are of little support in the mis-selling context or where the retail investor does not appreciate the costs and diversification effects which can prejudice returns even where a security’s price reflects efficient market dynamics. Disclosure’s ability to manage irrationality risks is doubtful; mounting empirical evidence points to its limitations in improving retail investor decision-making (chapter 5). There is also little direct evidence that financial capability strategies can substantially improve decisionmaking as poor financial capability appears to be related more to psychological factors than to a lack of information.277 At the very least, the evidence of irrationality and related evidence on poor understanding gives investor-protection arguments an overdue degree of scholarly respectability and the empirical heft which is essential given the policy concern to empower and/or responsibilize the retail sector. Capital-raising, and the related efficiency school of analysis, has (arguably for too long) traditionally been the main concern of securities regulation scholarship.278 Behavioural finance, however, which is often 271

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Ibid., pointing to the protection provided by efficiency dynamics; and Choi, ‘Regulating Issuers Not Investors’, arguing that market efficiency dynamics can compensate for a lack of knowledge. EFAMA, Annual Asset Management Report: Facts and Figures (2008), pp. 16–17. E.g. J. Coates and R. Hubbard, ‘Competition in the Mutual Fund Industry: Evidence and Implications for Policy’ (2007) 33 Journal of Corporation Law 151. E.g. U. Malmendier and D. Shanthikumar, ‘Are Small Investors Naive about Incentives?’ (2007) 85 Journal of Financial Economics 457. See further ch. 4. 276 Gilson and Kraakman, ‘Twenty Years Later’, 742. FSA, Report by D. De Meza, B. Irlenbusch and D. Reyniers, Financial Capability: A Behavioural Economists’ Perspective (Consumer Research No. 69, 2008). Although this argument perhaps is best confined to US securities scholarship (e.g. J. O’Hare, Retail Investor Remedies under Rule 10b-5 (2007), ssrn abstractid=1019295,

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associated with regulatory intervention,279 has invigorated the regulation/deregulation debate, challenging law and economics’ traditional hostility to restrictions on autonomy, trumping market dynamics with institutional/supervisory decision-making280 and generating an important debate on the nature of the appropriate regulatory response. The ‘libertarian paternalism’ model,281 for example, preserves freedom of choice. But it assumes that individuals can be influenced to make choices which reflect those which would have been made had individuals complete information, unlimited cognitive abilities and no lack of will power.282 It supports individuals being steered in directions which promote their welfare, typically by opt-out options from default opt-in choices.283 In the investor protection sphere, it might be associated with a closer focus on product regulation and on the difficult question of how the industry can be incentivized to design products which meet investor needs (chapter 3). Alternatively, a less interventionist approach to irrationality emphasizes freedom of choice, focuses on effective decision-making, suggests that individuals be educated to recognize and deal with irrationality284 and has strong resonances with disclosure and investor education (chapters 5 and 7). So too has ‘asymmetric paternalism’ which suggests that intervention should be designed so that it creates large benefits for those who make decision-making errors but imposes little or no harm on those who are fully rational.285 But disclosure imposes costs and requires sophisticated regulatory technology (chapter 5). Effective decision-making has, however, also been regularly associated with the delegation of decision-making to experts.286 Reforms might therefore focus on the quality of advice and product distribution287

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pp. 37–8, highlighting the limited attention retail direct investors have received in US scholarship). UK scholarship has been sensitive to the consumer protection aspects of financial market regulation (e.g. Gray and Hamilton, Implementing Financial Regulation). Langevoort, ‘Animal Spirits’, 187. Rachlinski, ‘Uncertain Psychological Case’, 1165–6 and 1175, suggesting that those inclined to distrust law and economics and inclined to favour institutional mechanisms have found in behavioural finance an ‘appealing source of support’. Thaler and Sunstein, ‘Libertarian Paternalism’. 282 Ibid. 283 Ibid. G. Mitchell, ‘Libertarian Paternalism Is an Oxymoron’ (2005) 99 Northwestern University Law Review 1245, 1258 and 1261, highlighting the importance of ‘inoculating’ individuals against irrational influences. Camerer et al., ‘Asymmetric Paternalism’, 1233. E.g. Romano, ‘Information Overload’, 326; and Rachlinski, ‘Uncertain Psychological Case’, 1168. Thaler and Sunstein suggest that individuals benefit from being required to make their choices explicit (Thaler and Sunstein, ‘Libertarian Paternalism’, 178), while Mitchell has argued that requiring individuals to give reasons for their choices can reduce the influence of framing effects (Mitchell, ‘Oxymoron’, 1256).

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or even require that advice be taken288 (an assumption implicit in the restrictions placed on execution-only advice under MiFID), although the severe conflict-of-interest risks in the advice process calls for caution (chapter 4). The three main regulatory levers for the retail market – design, distribution and disclosure – could therefore all be employed to address the challenges irrationality poses to the empowerment model. But the evidence of irrationality and poor understanding still sits uncomfortably with empowerment, responsibilization-based strategies and the concern to promote the markets. The next section suggests that investor vulnerability and poor decision-making is better characterized in terms of the vulnerable but engaged ‘trusting investor’, rather than in terms of the irrational investor. It suggests that a regime which reflects the vulnerabilities of the engaged but trusting investor, particularly through supply-side reforms, and which allows that investor to become empowered, while accommodating and supporting the robust, informed and empowered investor, might represent the best way forward.

4. The trusting investor a) The trusting investor The financial crisis convulsions should not obscure the reality that imaginative intervention which strengthens investor decision-making while acknowledging investor vulnerability, which facilitates investment while addressing market risk and which engages robustly with the supply side as well as with the demand side, remains necessary. Governments are withdrawing from welfare provision, retirement needs are acute and the need for long-term market-based savings is intensifying, not least as interest rates remain historically low and even if this is a temporary phenomenon. Stronger financial independence can yield society-wide benefits.289 Households’ tendency not to participate in the stock markets has generated an extensive financial economics literature290 on the ‘non-participation’ or stock-holding puzzle.291 It considers why households forego potentially 288 290

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Rachlinski, ‘Uncertain Psychological Case’, 1224. 289 Deaves Report, p. 309. E.g. L. Guiso, P. Sapienza and L. Zingales, Household Portfolios (Cambridge: Cambridge University Press, 2001); and M. Haliassos and C. Bertaut, ‘Why Do So Few Hold Stocks?’ (1995) The Economic Journal 1110. E.g. Rooij et al., Financial Literacy; L. Guiso and T. Japelli, ‘Awareness and Stock Market Participation’ (2005) 9 Review of Financial Studies 537; and French Savers, noting ‘surprisingly low’ rates of ownership of risky securities in France, far beyond standard risk-aversion levels (at p. 3).

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higher stock market returns292 and the associated equity premium293 and why they risk poor asset allocation in not diversifying beyond deposit and insurance instruments.294 The welfare loss can be sizeable;295 one study has calculated it as between 1.5 per cent and 2 per cent of consumption.296 The annual return shortfall from retail investor trading, reflecting limited knowledge of the trading process and poor diversification, is also potentially significant.297 So too are the potential losses to households where risk aversion levels increase significantly in the wake of market turbulence.298 While market and regulatory risks are real, nonparticipation is also a problem. Investors may also not always be as irrational or as financially illiterate as usually assumed.299 There is some evidence that the retail investor home bias might reflect investors’ exploitation of local knowledge300 and that retail investors seek301 and achieve better diversification.302 Research on whether investors’ choice of CISs exhibits a ‘smart money’ effect, in that 292

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The Council’s Financial Services Committee has highlighted that ‘investment in riskier assets’ may reduce the pressure on additional savings to cover welfare provision: FSC Report, p. 11. P. Shum and M. Faig, ‘What Explains Household Stock Holdings’ (2006) 30 Journal of Banking and Finance 2579. AMF, Risks and Trends 2008 Report, p. 83. 295 Rooij et al., Financial Literacy. J. Cocco, F. Gomes and P. Maenhout, ‘Consumption and Portfolio Choice over the LifeCycle’ (2005) 18 Review of Financial Studies 491. A Federal Reserve study has pointed to the economy-wide effects, with consumption increased by 5–15 per cent per dollar of stock market capital gain: K. Dynan and D. Maki, Does Stock Market Wealth Matter for Consumption? (2001), ssrn abstractid=270190. One study has suggested an annual return shortfall of 2–2.3 per cent which, over a 20-year savings horizon, is significant: Barber et al., ‘Just how Much’. As appears to have happened with UK investors as the financial crisis intensified. The proportion of respondents willing to take risks with their investments fell from 61 per cent in 2007 to 56 per cent in 2008 (FSA, Consumer Research No. 67, p. 22) and they became more cautious concerning equity-based products (Financial Risk Outlook 2009, p. 60). A. Jackson, The Aggregate Behaviour of Individual Investors (2003), ssrn abstractid=536942; and J. Coval, D. Hirshleifer and T. Shumway, Can Individual Investors Beat the Market? (2005), ssrn abstractid=364000. Z. Ivkovich and S. Weisbenner, ‘Local Does as Local Is: Information Content of the Geography of Individual Investors’ Common Stock Investments’ (2005) 60 Journal of Finance 267. Increasing retail demand for alternative investments has been linked to a desire to diversify and for stronger returns: PricewaterhouseCoopers, The Retailisation of Non-Harmonised Investment Funds in the European Union (2008) (‘2008 PwC Retailization Report’), p. 23. L. Calvet, J. Campbell and P. Sodini, Fight or Flight? Portfolio Rebalancing by Individual Investors (2007), ssrn abstractid=971062; and L. Calvet, J. Campbell and P. Sodini, Down or Out: Assessing the Welfare Costs of Household Investment Mistakes, NBER Working Paper 12030 (NBER, 2006) (drawing on evidence from the Swedish stock market).

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investors choose schemes which subsequently perform well, is inconclusive; but it provides some evidence of effective decision-making.303 Retail investors also seem to learn from experience,304 as suggested by retail market reaction to the turn-of-the-century equity market downturn,305 although learning typically follows significant losses. Amidst the stark evidence of household losses, there is also some evidence of shrewd retail investment over the financial crisis,306 including retail investor recourse to capital-protected products.307 ASIC’s initial examinations of retail market trading, for example, did not find uniquely high levels of volatility and, in January 2008, found an even distribution of buy and sell orders.308 Ultimately, and however uncomfortable a reality it may be given poor investor decision-making and the bleak evidence of market turbulence, governments are imposing more financial responsibility on individuals. 303

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A recent study of ‘smart money’ in the UK market, which also reconsiders the contrary US evidence, suggests that individual (and institutional) investors in actively managed funds display ‘smart money’ effects: K. Aneel and D. Stoli, ‘Which Money Is Smart? Mutual Fund Buys and Sells of Individual Investors’ (2008) 63 Journal of Finance 85. The more products consumers buy, the better they become at exercising choice: FSA, Establishing a Baseline, p. 18. The FSA has also reported improvements in sensitivity to disclosure, in that investors were able to differentiate between the Total Expense Ratio (TER) recommended under the UCITS regime (which does not include entry or exit charges), and the additional Reduction in Yield (RIY) criteria used by the FSA which shows the effect of total charges on returns: FSA, UCITS: Charges Disclosure – Presenting Changes to Customers (Consumer Research No. 34, 2005). A US study has similarly found that investors learned, over time, to assess front-loaded mutual fund fees, although they were slower to realize the impact of ongoing expense-related fees: B. Barber and T. Odean, ‘Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows’ (2005) 78 Journal of Business 2095. The FSA, for example, pointed to greater diversification by retail investors into bonds following the dotcom-era equity market crash: Financial Risk Outlook 2006, p. 50. Retail investors began to get nervous about an economic downturn in 2006, selling cyclical stocks and leading one commentator to suggest that ‘far too often private investors are derided for simply following market trends. Time and again our research shows this isn’t true’: Seib, ‘Private Shareholders’. As the credit crunch effects intensified, particularly in late summer/autumn 2008, UK retail investors were described as holding their nerve and not offloading equities: R. Wachman and T. Webb, ‘Week of Utter Carnage Moves the Crunch into the Real World’, The Observer, 12 October 2008, Business, p. 4. Retail investors also appear to have been alert to liquidity risks, deferring investments in CISs: D. Ricketts, ‘Mutual Funds Move Back into the Black’, Financial Times, Fund Management Supplement, 19 January 2009, p. 11. Significant losses were, of course, sustained by the significant volume of investors who off-loaded CIS investments in the last quarter of 2008. See further ch. 3. A. Erskine, ‘Retail Investors – Who Are They? What Do They Invest in?’, ASIC Summer School July 2008 Papers, p. 7, p. 8.

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In these circumstances, it is an abdication of responsibility to despair of the retail markets or to suggest exclusionary measures. The empowerment model is not misguided in attempting to support stronger market engagement. Empowerment-related and investor-facing disclosure and capability strategies should also not be dismissed. As discussed in chapters 5 and 7, they may reduce the risks of regulatory intervention and lead to more effective retail investor monitoring. But they have a long horizon. They do not respond well to retail market risks in the short term. The empowerment model also does not engage sufficiently closely with poor decision-making and the reality that the retail investor will often be a ‘novice investor’ and significantly vulnerable to decision-making errors as well as to market risk.309 Adding the vulnerable, often irrational, but, importantly, engaged ‘trusting investor’ into regulatory design, however, may bring better balance, particularly as it implies a focus on imaginative supply-side measures, and may provide an appropriate rationale for more robust intervention which, unlike the irrationality model, also engages well with the empowerment agenda. The effect of trust310 and of social capital more widely311 on economic transactions has become the subject of a burgeoning312 scholarship313 and prompted attempts to quantify the impact of trust, including the 309

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E.g. Campbell, ‘Household Finance’, 1591, warning of the greater likelihood of mistakes by households when they are asked to take on more financial planning responsibilities; and J. Kozup, E. Howlett and M. Pagano, ‘The Effects of Summary Information on Consumer Perceptions of Mutual Fund Characteristics’ (2008) 42 Journal of Consumer Affairs 37, warning of the risks welfare privatization holds for the novice investor. Definitions of trust include ‘the expectation that a person (or institution) will perform actions that are beneficial or at least not detrimental to others’: Chicago Booth/Kellogg School Financial Trust Index. Or the ‘shared habits, values and trusting relationships that unite a society’: Kellogg Insight, Focus on Research, Measuring Trust: Introducing the Financial Trust Index (2009). Trust has also been defined as the subjective probability individuals attribute to the possibility of being cheated: L. Guiso, P. Sapienza and L. Zingales, Trusting the Stock Market (2007), ssrn abstractid=811545. The nature of trust is contested, with different models being used in the social science and financial economics spheres: C. Mayer, ‘Trust in Financial Markets’ (2008) 14 European Financial Management 617. One study has suggested that more than 7,000 studies have assessed the economic effects of trust: P. Sapienza, A. Toldra and L Zingales, Understanding Trust (2007), ssrn abstractid=1008943. E.g.: finding a relationship between trust and higher economic performance, S. Knack and P. Keefer, ‘Does Social Capital Have an Economic Pay-Off? A Cross-Country Investigation’ (1997) 112 Quarterly Journal of Economics 1251; and S. Knack and P. Zak, ‘Trust and Growth’ (2001) 111 Economic Journal 295; finding a relationship between the early development of securities markets and informal relations of trust, Mayer,

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Chicago Booth/Kellogg School ‘Financial Trust Index’.314 Trust has been identified as a key driver of financing and investment315 and a lack of trust has been associated with the intensifying of the ‘credit crunch’.316 The retail investor fits well with this analysis; faith is required of illinformed and vulnerable retail investors in entrusting funds to markets and intermediaries.317 Trust is increasingly regarded as a determinant of retail investor activity.318 Lack of trust in financial markets has been identified as among the causes of household failure to participate in the financial markets.319 Guiso, Sapienza and Zingales have suggested that ‘trusting individuals’, who are prepared to make an ‘act of faith’320 that disclosure is reliable and that the system is fair, are significantly more likely to buy stocks and risk assets and to invest a large share of household wealth.321 But the study

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‘Trust in Financial Markets’; in the financial markets context, L. Bottazzini, M. da Rin and T. Hellman, The Importance of Trust for Investment: Evidence from Venture Capital (2007), ssrn abstractid=997934; and, in the corporate law context, M. Blair and L. Stout, Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law (2000), ssrn abstractid=241403. Based on household survey evidence, it measures investors’ trust in stock markets, banks, mutual funds and large corporations on a quarterly basis. On the other drivers, see sect. III.3 below. ‘Without trust, co-operation breaks down, financing breaks down and investment stops’: Sapienza and Zingales, Trust Crisis, commenting on the Financial Trust Index findings from December 2008. More generally, the April G20 meeting also highlighted the importance of strengthening financial regulation to rebuild trust: London Summit – Leaders’ Statement, 2 April 2009, paras. 4 and 13. E.g. Stout, ‘Investor Confidence Game’. And has been emphasized by the slowly emerging retail constituency in the EC in CESR discussions: CESR, Annual Report 2005, p. 37. E.g. Campbell, ‘Household Finance’, 1569; S. Tanner, The Role of Information in Savings Decisions, Briefing Note 7 (London: Institute for Fiscal Studies, 2000) (arguing that trust is a determinant of stronger long-term saving); and Deaves Report, pp. 265–6. Trust was also highlighted as a determinant of investor behaviour by the BME Report (p. 48). Similarly, the FSA has frequently identified a lack of trust as a barrier to retail market engagement (e.g. FSA, Treating Customers Fairly – Progress and Next Steps (2004), p. 8, FSA, Consumer Research No. 35, p. 21 and Financial Risk Outlook 2009, p. 68, noting that the financial crisis has damaged trust in financial services). In an earlier study, which pointed to the relationship between levels of trust in Italy and stock market versus cash holdings, the authors suggested that ‘financial contracts are the ultimate “trust-intensive” contracts’: L. Guiso, P. Sapienza and L. Zingales, ‘The Role of Social Capital in Financial Development’ (2004) 94 American Economic Review 526, 527. Guiso et al., Trusting the Stock Market. The study was based on an examination of Dutch households under the Dutch National Bank Household Survey.

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found that, where an investor believes there is a 3 per cent probability of being cheated, the threshold level of wealth beyond which stock market investments are made increases five-fold. The study related stock market participation to levels of trust in the fairness of the ‘rules of the game’, and warned that, if trust is sufficiently low, very few will participate in markets. Similarly, Sapienza and Zingales have related withdrawal from the market over the ‘credit crunch’ to levels of trust; those who planned to withdraw from the stock markets in December 2008 had the lowest levels of trust. Higher levels of trust were reported among those prepared to leave investments unchanged. The highest trust levels were found among those who planned to increase investments.322 Low levels of trust can also exaggerate the deterrent effect of the costs of participation.323 Once trust has been damaged, it is not easily reclaimed, further inhibiting retail market participation.324 More defensively, and reflecting the vulnerabilities of the retail investor, the retail investor resonances are also strong in that trust, rather than rational reliance, has been identified as the basis of the investor/investment adviser relationship,325 as is underlined by the repeated reforms to the UK advice and distribution sector, discussed in chapter 4. The polarization system (which was reformed in 2005) was designed, in part, to support independent investment advice by ‘polarizing’ the investment advice and product distribution system into tied agents and independent advisers. But investors remained reluctant to choose independent investment advisers and chose familiar and trusted tied advisers over unknown independent advisers.326 Investor trust in market actors is common, notwithstanding conflicts of interest; investors tend, for example, 322 323

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Sapienza and Zingales, Trust Crisis, p. 2. The existence of trust has been associated with some alleviation of the deterrent effect of investment costs. M. Mayer, ‘Comments on Lynn Stout’s The Investor Confidence Game’ (2002–3) 68 Brooklyn Law Review 449. The late 1980s/early 1990s personal pension mis-selling saga in the UK cast a long shadow, with approximately 15 per cent of surveyed consumers still distrusting their advisers in 2005: Basel Committee on Banking Supervision, International Organization of Securities Commissions, International Association of Insurance Supervisors, Customer Suitability in the Retail Sale of Financial Products and Services (Bank for International Settlements, 2008) (‘Joint Forum Report’), p. 77. Rand Institute for Civil Justice, Report on Investor and Industry Perspectives on Investment Advisers and Broker-Dealers: Sponsored by the SEC (2008) and Langevoort, ‘Selling Hope’. See also ch. 4, n. 16, on levels of trust in advisers in the EC and the UK. FSA, Reforming Polarisation – Making the Market Work for Consumers (Consultation Paper No. 121, 2002), p. 4.

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to follow the ‘buy’ recommendations of research analysts.327 There is also some evidence of trust in compliance,328 although entrenched conflictof-interest risks suggests that this trust might be misplaced. Trust has also been associated with retail investors of limited sophistication;329 the pan-EC Optem Report found that ‘prudent savers’, who, unlike ‘gamblers’, were inclined to rely on investment advice, were driven by trust when seeking advice.330 What might be termed the irrational tendency of investors to trust the markets chimes well with the evidence on irrationality and investor behaviour. But the assumption that trusting investors, while vulnerable and often irrational, also engage with the markets responds more effectively than the irrational investor model to the need for household market engagement. What are the implications of the trust analysis for investor protection policy? There are resonances between investor trust, engagement and regulation. Retail investor trust appears to be related in part to regulation;331 the US Financial Trust Index suggests a relationship between regulation, trust and engagement.332 The need to support trust and engagement, but also to reflect the risks of investor trust, through law is also gathering support.333 In a leading analysis, Professor Stout has proposed that regulation should reflect the needs of the trusting investor; regulation must acknowledge that retail investors neither expect market participants to defraud them nor have the resources or inclination to monitor.334 Protecting trust, and ensuring that trust is not abused, suggests, in particular, that robust supply-side intervention is necessary. While investors may trust intermediaries, they are not in a position to monitor whether 327 328 329

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E.g. Malmendier and Shanthikumar, ‘Small Investors’. The FSA has reported that 67 per cent of consumers were very or fairly confident that firms complied with their regulatory obligations: FSA, Consumer Research No. 67. FSA research has identified ‘trusters’ as consumers with low levels of financial sophistication and high dependence on advisers: FSA, Consumer Understanding of Financial Risk (Consumer Research No. 33, 2004), p. 2. Optem Report, p. 88. B. Carlin, F. Dorobantu and S. Viswanathan, Public Trust, the Law, and Financial Investment (2007), ssrn abstractid=1033102, suggesting that intervention can improve public trust. Sapienza and Zingales, Trust Crisis, finding the lowest levels of trust among those who thought the crisis was due to a lack of oversight and regulation: p. 2. E.g. L. Zingales, The Future of Securities Regulation (2009), ssrn abstractid=1319648; P. Huang, How Do Securities Laws Influence Affect, Happiness and Trust? (2008), ssrn abstractid=1082590; Stout, ‘Investor Confidence Game’; and A. Pritchard, ‘Self Regulation and Securities Markets’ (2003) Regulation 32. Stout, ‘Investor Confidence Game’.

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that trust is warranted. But intervention is necessary not simply to protect vulnerable investors from abuse; it is also necessary because a failure of trust may lead to investors leaving the market. Regulatory support of trust through supply-side reforms therefore also chimes well with the empowerment agenda335 as well as with the need to protect vulnerable and often irrational investors. As discussed in subsequent chapters, the sharpening focus on robust supply-side reforms in the EC regime, but also in UK implementation ‘in action’, points to a policy awareness of the need to bolster investorfacing, empowerment-based measures with more robust strategies if market engagement is to be safely promoted. A warning as to the need for supply-side regulatory efforts to support the vulnerable but engaged trusting investor might therefore seem otiose. It may seem all the more so given the regulatory power associated with supply-side intervention, the current hostility to deregulation, self-regulation or lighter-touch regulation engendered by the financial crisis, and, in the EC context, the Commission’s traditional enthusiasm for regulatory solutions. But supply-side reforms are difficult. Industry enthusiasm for placing more responsibility on investors is considerable.336 Retail investor involvement in lawmaking and policy formation is limited. There is also intense resource pressure on regulators concerning the banking system and wholesale markets. All this may create the conditions within which too much responsibility is placed on investors or, less malignly but no less prejudicially, not enough attention is given to the hard work of supporting vulnerable but engaged trusting investors with imaginative supply-side strategies ‘in action’.

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E.g. ‘[we are] working to secure the trust in our markets that undergirds our nation’s continuing prosperity’ (SEC, 2007 Performance and Accountability Report, p. 2). The 2004 UK Parliamentary Review into long-term savings similarly suggested that, while there was no clear definition of the ‘right’ degree of consumer protection, a regulatory framework that left consumers distrustful of the industry might be considered as failing to meet its core objectives: Select Committee on Treasury, Eighth Report, Restoring Confidence in Long Term Savings (2004), sect. 8, para. 75. E.g. Joint Associations Committee (representing a group of trade associations), Retail Structured Products: Principles for Managing the Distributor–Individual Investor Relationship (2008). The FSA’s consultation on its guidance for product provider/distributor responsibilities also saw some sections of the industry question why the FSA had not considered consumers’ responsibilities (FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Policy Statement No. 07/11 (2007), p. 6), while the FSA’s consumer responsibility paper noted the belief in some quarters that responsibilities should be imposed on consumers: Discussion Paper No. 08/5, p. 5.

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b) Blending empowerment-based and trust-based strategies As discussed in subsequent chapters, the empowered investor and the trusting investor can both be identified in current EC policy and regulation and in UK implementation ‘in action’; concerns to fine-tune supply-side regulation are growing and the attractions of disclosure, while persistent, are waning. The FSA has linked empowerment to supply-side as well as to investorfacing initiatives, acknowledged the limitations of empowerment-based, investor-facing strategies337 and engaged with the importance of trust.338 The FSA’s support of empowerment-based disclosure and financial capability initiatives is designed to equip investors to navigate the markets. But its muscular supply-side measures,339 particularly under the TCF initiative (chapters 3 (products) and 4 (advice)) and the RDR (chapter 4), expressly engage with investor trust340 and acknowledge that empowered investors also need supply-side support. The trusting investor, engaged with the markets but suffering from poor decision-making and vulnerable, can also be traced through current EC law and policy and is increasingly appearing in the policy rhetoric.341 As discussed in chapter 4, interventionist distribution-related rules, rather than empowerment-related disclosure rules, are in the ascendant;342 MiFID favours firm-facing, fiduciary-style obligations over disclosure. The Commission has rejected suggestions that disclosure requirements, which remain an important element of the regulatory regime, are based on a 337

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E.g. FSA chairman Lord Turner, Speech on ‘Helping Consumers Through the Recession’, 15 July 2009, available via www.fsa.gov.uk/Library/Communications/Speeches/index. shtml. E.g. Financial Risk Outlook 2007, p. 96. The 2009–2010 Business Plan is based on empowerment-related capability strategies (it identified consumer capability and responsibility as essential to consumers achieving a fair deal) but also on firms being well governed and meeting TCF obligations: FSA, 2009–2010 Business Plan, p. 25. The 2007 RDR, for example, argued that regulation should support market efforts to generate greater trust (p. 6). Similarly, the FSA’s emerging consumer responsibility strategy is based on encouraging consumers to act in their best interests but acknowledges the primary role played by firm regulation. ESC discussions on the Commission’s 2007 Green Paper on Financial Services, for example, note a common view that confidence and trust are key for competitive and efficient retail markets: ESC, Minutes, 11 October 2007. The Commission has highlighted that consumers must be properly protected where appropriate and that providers must be financially sound and trustworthy, in addition to consumer empowerment: European Commission, Green Paper on Retail Financial Services, pp. 2–3.

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caveat emptor approach to the retail markets.343 Choice, the poster-child of the empowerment model and closely linked to integration, appears to be on the wane.344 Trust also has particular resonances in the EC retail market given the heavy reliance on intermediation, whether through advisers or sales channels (chapter 4) or in the form of the pan-EC preference for investment products rather than direct investments (chapter 3). Given that trust appears to account for different participation levels across countries345 and appears to vary across the Member States,346 measures which support trust may also encourage investors to embrace the crossborder market and thereby achieve more effective diversification and protection against market risk. It is not only the EC’s law-making and policy institutions which must carefully balance empowered and trusting investor models. So too must the European Court of Justice, particularly when interpreting the harmonized regime. The scale of the post-FSAP regulatory regime and the increasing proliferation of CESR guidance and other soft law suggests the Court will be called on to adjudicate on the new regime. The question therefore arises as to how the Court might characterize the EC retail investor. There is little evidence, thus far, of the Court’s approach to retail investor protection. It has only rarely considered the interpretation of harmonized rules in the financial markets sphere and this case law sheds little light on the Court’s approach to investor protection, being largely concerned with technical, scope-related matters. But some indications can be drawn from the limited, pre-FSAP case law which addresses the extent to which Member States can impose national rules in the financial services and markets 343 344

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Financial Services Consumer Group, Minutes, 3 July 2007, p. 4. The European Parliament recently warned that ‘more is involved in the creation of an integrated European financial market than just providing consumers with more choice’ (European Parliament, Resolution on Financial Services Policy (2005–2010) (P6 TA(2007)0338, 2007) (‘Van den Burg II Resolution’), para. 36), while the Commission has accepted that ‘consumers often express the concern that a too wide choice of products may distract or confuse them, complicating their selection of the product best suited to their needs’: Green Paper on Retail Financial Services, p. 9. E.g. R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘Trust in Large Organisations’ (1997) 87 American Economic Review 333 (finding cross-country variations, related to trust levels, in, inter alia, government efficiency and economic performance). A Eurobarometer study, for example, pointed to only 17 per cent of consumers of financial services trusting advice from financial institutions in Greece, while 75 per cent and 71 per cent of consumers trusted advice in Finland and Belgium: European Commission, Special Eurobarometer No. 230, Public Opinion in Europe on Financial Services (2005), p. 21.

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sphere which are restrictive of the Treaty freedoms in order to protect consumers of financial services.347 In the German Insurance case, the Court examined the extent to which local consumer protection objectives could justify restrictions on the provision of insurance by cross-border providers in Germany in the form of, inter alia, establishment and authorization requirements.348 The Court accepted that there was a public interest in protecting the consumer given that insurance was a ‘mass phenomenon’, the difficulties faced by consumers in assessing whether payments would be made and the ‘precarious position’ in which consumers would be placed were there a failure to pay.349 Although the Court did not accept that all the German restrictions were valid, considerable sensitivity to the risks faced by the consumer of complex financial products is clear. In the investment context, in Alpine Investments,350 the Court accepted that the Netherlands could impose a prohibition on cold-calling with respect to off-market commodity futures (following a series of scandals) although this restricted the ability of Netherlands-regulated firms to engage in cold calls cross-border. Although investor protection was not directly at issue in the case (the Netherlands’ public interest argument was based on the need to protect the reputation of the Netherlands’ financial market), the Court was again sensitive to the risks posed to retail investors by complex investments and, in particular, argued that investors were particularly reliant on the competence and trustworthiness of financial intermediaries.351 The Parodi ruling352 addressed banking and the restriction represented by a French authorization requirement imposed before a Netherlands bank could grant a Deutschmark mortgage to a French client. Although the ruling was concerned with the extent to which limited prior harmonization in the banking field prevented France from imposing its authorization requirements, the Court accepted that the banking sector was ‘particularly sensitive’ from a consumer protection perspective, given the need to protect consumers from institutions which did not meet appropriate solvency criteria or whose management did not possess the necessary integrity or 347

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Reflecting the ‘general good’ jurisprudence which accommodates the interests of Member States in imposing non-discriminatory but restrictive regulation, which furthers legitimate social and public interests, with the Treaty freedoms. Commission v. Germany [1986] ECR 3755 (Case 205/84). Ruling of the Court, paras. 30–2. Alpine Investments v. Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93). Ruling of the Court, paras. 42 and 46. Soci´et´e Civile Immobili`ere Parodi v. Banque H. Albert de Bary et Cie [1997] ECR I-3899 (Case C-222/95).

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professional qualifications. This case law suggests that the Court may be somewhat reluctant to adopt an empowered approach to the investor, although it has already accepted an empowerment-based model in the consumer protection sphere.353 Ultimately, the lesson seems to be the obvious one. A careful blend of both supply- and demand-side measures, and of trust- and empowermentbased strategies,354 is required in designing a retail market regime which seeks to promote market engagement but responds to investor vulnerabilities and poor decision-making.355 The trusting investor may, over time, and with empowerment-driven disclosure and education strategies, become more independent. Independent, competent and empowered investors, benefiting from a secure and well-designed foundation of supply-side protections, can use disclosure and education strategies to navigate the financial markets more confidently. But, even if it carefully blends the needs of vulnerable trusting investors and competent empowered investors, retail market intervention carries considerable risks. These risks, and the strategies which can be used in mitigation, are considered in the remaining two sections of this chapter.

II. The risks of retail market intervention 1. Regulatory and retail market agenda risks The development of ‘good’ rules, or at least rules which do not have malign effects, is difficult. The FSA’s move to outcomes-based and 353

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The Court has generally supported consumer choice and the primacy of free trade over protective national rules, and, in particular, favoured disclosure requirements over marketing restrictions, adopting a robust model of an informed, ‘reasonably circumspect’ and rational consumer (e.g. Mars [1995] ECR I-1923 (Case C-470/93); Gut Springenheide GmbH [1998] ECR I-4657 (Case C-210/96); and Est´ee Lauder [2000] ECR I-117 (Case C-220/98)). For an extensive discussion of the jurisprudence and of how the Court developed a model of a ‘rather robust self-reliant consumer’, see Weatherill, EU Consumer Law, pp. 34–59. In particular, ‘the presence of a large block of prudent consumers who will not be duped by a particular practice undermines the legitimacy of national measures designed to suppress that practice, even where some gullible consumers would be prejudiced’: ibid., p. 57. As appears to be acknowledged by Commissioner McCreevy: ‘if you look at the range of our financial services policies, consumer protection, consumer empowerment, and consumer choice is at the very core’: Commissioner McCreevy, Speech on ‘Increasing Financial Capability’, 28 March 2007, available via http://europa.eu/rapid/searchAction.do. La Blanc and Rachlinski, for example, argue for a multi-layered response, including firmfacing rules and investor education: In Praise, p. 22.

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more-principles-based regulation, for example, reflects its recognition that earlier detailed retail market regulation, often in response to particular mis-selling crises, has not been successful in preventing investor detriment.356 Regulators are vulnerable to monopoly risk and behavioural weaknesses357 and operate in conditions of very considerable opacity with respect to investor behaviour and the impact of law (as discussed in section II.2 below); but the choices they must make are complex. The mechanisms for delivering retail market outcomes are many, extending from regulation to include a multiplicity of institutions and market actors.358 Rules which appear reasonable in isolation can have prejudicial effects; regulatory arbitrage risk in the retail markets is now considerable as investors are faced with a range of competing investment products which can have investment, deposit and insurance components and the risks from which are often not wholly captured by traditional segmented regulation.359 Incentive risks, which are entrenched in the retail markets, can be exacerbated by poor regulatory design; capital rules can skew product design and distribution incentives.360 Badly designed and costly regulation, notionally in support of the retail markets, can damage innovation,361 generate incentives for firms to disengage from the retail markets and limit retail investor returns; internationally, the SEC has faced the criticism that its concern to promote fairness and equal access by retail investors to issuer disclosure, which led to Regulation Fair Disclosure, risked damage to market efficiency by ‘chilling’ the supply of information.362 The retail market agenda has certainly driven poor regulatory design in the EC. The controversial prohibition on price improvement for retail investors under MiFID’s equity market 356

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FSA, Reforming Conduct of Business Regulation (Consultation Paper No. 06/19, 2006), p. 13. FSA Chief Executive Tiner noted that prescriptive rules had ‘not produced the vibrant, customer-oriented market needed’: Keynote Speech to FSA More PrinciplesBased Regulation Conference, 23 April 2007, available via www.fsa.gov.uk/Pages/Library/ Communications/Speeches/index.shtml. Choi and Pritchard, ‘Behavioral Economics’. J. Black, ‘Mapping the Contours of Contemporary Financial Services Regulation’ (2002) 2 Journal of Corporate Law Studies 253. See further ch. 4. 360 See further ch. 4. E.g. L. Zingales, The Costs and Benefits of Financial Market Regulation (2004), ssrn abstractid=536682. E.g. Z. Goshen and K. Parchomosky, ‘On Insider Trading, Markets and Negative Property Rights in Information’ (2001) 87 Virginia Law Review 1229 and S. Choi, ‘Selective Disclosure in the Public Capital Markets’ (2002) 35 University of California (Davis) Law Review 533.

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transparency regime,363 for example, has been associated with an illconsidered investor protection justification.364 The risks and complexities are compounded by the rapid pace of innovation and the repeated failure of regulation to capture evolving retail market risks. In the UK, this was earlier made clear by the mis-selling of splitcapital investment trusts (chapter 3). The 2008 Lehman collapse has since led the FSA to focus not only on the marketing of those structured products which were backed by a failed Lehman guarantee but on the retail structured products industry more generally;365 the FSA was, however, initially somewhat sanguine, despite its 2004 Financial Risk Outlook earlier pointing to the risks to investors from guaranteed structured products.366 And it is not complex product regulation which appears to have failed in these cases, but core disciplines concerning marketing and the quality of advice. The risks of political over-reaction are also considerable.367 The personal finance agenda is now of some political importance and regulation may come under pressure to deliver unrealistic outcomes.368 Although the retail markets have not featured prominently in the financial crisis reform agenda, wider public engagement with the markets has led to the financial crisis being examined as exposing the ‘too many to fail’ problem.369 The pressure on regulation is further increased by an unhelpful retail cohort with only limited ability to monitor firms, decode disclosures and mitigate the risks of poor regulatory design. An investor protection/retail market mandate might focus regulator attention on retail market interests, drive better regulation and create a public perception of a regulator not captured by industry interests;370 this might also support stronger market engagement. But there are risks to the retail market agenda. Investor confidence, which is closely associated with retail market intervention, is a challenge to capture in cost/benefit analysis and, as a regulatory objective, risks passing excessive powers to the 363 364

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Art. 27(3). As was suggested by a London Stock Exchange Chairman: D. Cruikshank, Speech on ‘The Impact of the EU Financial Services Action Plan on the Regulation of EU Securities Markets’, 6 March 2003, available via www.londonstockexchange.com. J. Hughes, ‘Products Backed by Lehman Spark FSA Probe’, Financial Times, 8 May 2009, p. 3. FSA, Financial Risk Outlook 2004, p. 64. E.g. R. Romano, ‘The Sarbanes–Oxley Act and the Making of Quack Corporate Governance’ (2005) 114 Yale Law Journal 1521. J. Gray, ‘Personal Finance and Corporate Governance: The Missing Link: Product Regulation and Policy Conflict’ (2004) 4 Journal of Corporate Law Studies 187, 190. Zingales, Future of Securities Regulation, pp. 9 and 18. Hamilton and Gray, Implementing Financial Regulation, p. 193.

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regulator.371 Productive competition between regulators may be dulled by retail market mandates.372 A retail market mandate may also lead to an undue and potentially risky ‘consumerization’ of financial market regulation. Wholesale market regulation may as a result be inadequate and consequent failures in the wholesale markets may ultimately prejudice retail investors.373 Weaknesses in the SEC’s treatment of speculative trading by institutional investors over the dotcom period, for example, have been related to the SEC’s being ‘stuck in a paradigm of investor protection’.374 In its response to the financial crisis, the FSA has suggested that its balancing of conduct-of-business regulation (strongly associated with the retail markets) and prudential regulation may have been wrong, with insufficient attention paid to prudential regulation.375 On the other hand, it is doubtful whether the attractions of the retail agenda can be blamed for the international failure to focus sufficiently closely on the wholesale markets; it is much more likely that the long-standing assumption as to the resilience of market discipline in certain segments has been more influential and that the danger that the retail interest is insufficiently considered in the reform process is real.376 But it is also clear that failures to address the wholesale markets can have catastrophic effects for retail investors.

2. Regulation and the retail markets: ‘laws on the books’ and ‘laws in action’ The extent to which regulatory strategies can deliver retail market objectives is also unclear. The relationship between law and financial 371

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Although efforts have been made to quantify investor confidence (e.g. J. Hochberg, P. Sapienza and A. Vissing-Jørgensen, ‘A Lobbying Approach to Evaluating the Sarbanes– Oxley Act of 2002’ (2009) 47 Journal of Accounting Research 519), it is a nebulous objective and can mask regulatory aggrandizement. CSES Report, suggesting that regulators, such as the AMF, with an express mandate to protect individual investors’ savings, are less inclined to compete with respect to issuer prospectus matters than other regulators: p. 20. Garten, ‘Consumerization’, 304–7. R. Karmel, ‘Mutual Funds, Pension Funds and Stock Market Volatility – What Regulation by the Securities and Exchange Commission Is Appropriate?’ (2004–5) 80 Notre Dame Law Review 909, 912. Turner Review, p. 87. The FSCP took issue with the Turner Review’s suggestion as to over-reliance on conductof-business regulation, suggesting that repeated failures in the banking industry show that the ‘FSA cannot be allowed to think that it has the regulation of the consumer facing side of financial services under control’: FSCP, Press Release, 18 March 2009. The FSA has now established a Conduct Risk Division to ensure sufficient attention to conduct matters while prudential matters dominate.

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market development has become the subject of an innovative and vibrant scholarship over the last decade or so. Significantly for the transformative ambitions of retail market policy, it asks whether ‘law matters’ to financial market development.377 It models the relationship between capital market rules (particularly on informational and agency problems in the public securities markets) and indicators of economic development and financial sector growth (such as the value of stock markets, numbers of listed firms and levels of dividend payouts).378 The initial research focused on ‘laws on the books’379 and suggested that strong securities markets and lower costs of capital are related to strong investor protection laws. But, even if a correlation could be drawn between this research and the impact of law on retail market behaviour, the causal relationship between law and strong markets is fiercely contested.380 Recent scholarship suggests, however, that enforcement (and so ‘law in action’) is a driver of strong markets.381 This line of scholarship, perhaps, holds the most important lesson for retail market regulation.382 The strenuous efforts expended in shaping the disclosure provided to retail investors and its limited effects (chapter 5), and the difficulties regulation faces in dealing with entrenched 377

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It is spearheaded by the work of financial economists La Porta, Lopez de Silanes, Shleifer and Vishny (e.g. R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘Law and Finance’ (1998) 106 Journal of Political Economy 1113), reviewed in S. Choi, ‘Law, Finance, and Path Dependence: Developing Strong Securities Markets’ (2002) 80 Texas Law Review 1657; and J. Coffee, ‘Law and the Market: The Impact of Enforcement’ (2007), ssrn abstractid=967482. E.g. R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘Legal Determinants of External Finance’ (1997) 52 Journal of Finance 1131. Although the research has now turned to address enforcement, for example R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘What Works in Securities Laws’ (2006) 61 Journal of Finance 1. E.g. L. Guiso, P. Sapienza and L. Zingales, ‘Does Culture Affect Economic Outcomes?’ (2006) 20 Journal of Economic Perspectives 23; R. Rajan and L. Zingales, ‘The Great Reversals: The Politics of Financial Development in the Twentieth Century’ (2003) 69 Journal of Financial Economics 5; J. Coffee, ‘The Rise of Dispersed Ownership: The Roles of Law and the State in the Separation of Ownership and Control’ (2001) 111 Yale Law Journal 1; and B. Cheffins, ‘Does Law Matter?: The Separation of Ownership and Control in the United Kingdom’ (2001) 30 Journal of Legal Studies 459. E.g. E. Ferran and K. Cearns, ‘Non-Enforcement-Led Public Oversight of Financial and Corporate Governance Disclosure and of Auditors’ (2008) 8 Journal of Corporate Law Studies 191; H. Jackson and M. Roe, Public and Private Enforcement of Securities Laws: Resource-Based Evidence (2008), ssrn abstractid=1000086; Coffee, Law and the Market; and H. Jackson, ‘Variations in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications’ (2007) 24 Yale Journal on Regulation 253. ‘[S]imply because something is enacted into law, clearly or not, does not tell us much about how strongly it will influence economic behaviour’: D. Langevoort, The Social Construction of Sarbanes–Oxley (2006), ssrn abstractid=930642, p. 2.

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commission-based conflict-of-interest risks (chapter 4), certainly caution against expecting too much of regulation ‘on the books’. The FSA provides an instructive example of the distinction between ‘laws on the books’ and ‘laws in action’. Its retail market activities currently include the supply-side, non-regulatory TCF initiative and the RDR.383 As discussed in chapter 4, the TCF strategy is designed to translate regulatory fairness requirements into operational outcomes ‘in action’. While the RDR is concerned with regulatory reform, as discussed in chapter 4 it extends far beyond the traditional process-based concerns of advice regulation; regulation is used to re-engineer the structure of the advice and sales market and to simplify the advice environment. This ‘in action’ model is rooted in the UK market and reflects the dynamics of FSA culture and decision-making.384 But it is not unreasonable to suggest that regulation ‘on the books’ alone is unlikely to deliver retail market objectives. The EC’s regulatory retail market efforts therefore represent only a partial strategy and its success is likely to depend heavily on the effectiveness of local ancillary strategies ‘in action’.

3. Responding to the drivers of retail market engagement Much remains to be done before regulators will have a deep understanding of retail investor behaviour; until knowledge improves, regulation remains risk-laden. Much also remains to be done with respect to understanding of the drivers of retail market engagement. Trust-based and empowermentbased retail market strategies are both concerned with investor engagement with the markets. But the drivers of investor behaviour and of household market engagement are not well understood.385 Why investors invest is straightforward – to make money;386 investments might similarly be characterized in terms of their ability to increase the investor’s financial resources.387 But this masks the range of factors (including trust in the 383

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FSA, Major Retail Thematic Work Plan for 2007–2008, p. 1; and FSA, Business Plan 2008– 2009, p. 23. The retail market strategy also includes demand-side, non-regulatory financial capability initiatives. The TCF initiative is related to the FSA’s identification of the retail market as of ‘greatest structural concern’: Speech by FSA Chief Executive Sants on ‘Judgments on Judgments – Retail Firms and Principles-Based Regulation’, 27 February 2008, available via www.fsa.gov.uk/Pages/Library/index.shtml. Relatively little is known about individual investors’ money management and there is a shortage of high-quality data: Ivkovich and Weisbenner, ‘Local Does as Local Is’. Stout, ‘Investor Confidence Game’, although this covers a range of other motivations given the different drivers for seeking personal wealth: Langevoort, ‘Selling Hope’. Oxera, Towards Evaluating Consumer Outcomes in the Retail Investment Products Markets: A Methodology: Prepared for the Financial Services Authority (2008), p. 1.

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markets and in regulation) which drive investment.388 If non-participation is a function of factors which are amenable to regulation (as trust appears to be) then law may be able to support engagement.389 In practice, however, not all the factors which appear to drive participation390 are easily susceptible to intervention. They range from the tendency of households to follow other households391 and the influence of neighbours, peers392 and family,393 to tax incentives,394 behavioural factors,395 age396 and cultural factors.397 Participation is also related to household wealth398 and education,399 different savings motivations,400 financial literacy401 and the costs of investing.402 It is influenced by house price volatility and pressure to become a homeowner,403 the impact of privatization programmes404 and the availability of pension provision.405 Economic stability, as the financial crisis has made graphically clear, is also strongly associated with retail investor engagement with the markets.406

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Investment has been described as displaying utilitarian (low risk and high returns) and expressive (status, patriotism and social responsibility) benefits: M. Statman, ‘What Do Investors Want?’ (2004) Journal of Portfolio Management 153. H. Hong, J. Kubik and J. Stein, ‘Social Interaction and Stock-Market Participation’ (2004) 59 Journal of Finance 137. For a review of the evidence, see V. Corragio and A. Franzosi, Household Portfolio and Demand for Equity: An International Comparison (Blt Notes No. 19, Borsa Italiana, 2008), pp. 5–6. The range of influences on limited French household participation, for example, have been identified as including loss aversion, tax disincentives, high participation (including information) costs and transaction costs: French Savers, p. 1. Campbell, ‘Household Finance’, 1569. 392 Hong et al., ‘Social Interaction’. French Savers, p. 15. 394 Campbell, ‘Household Finance’, 1569. Including loss aversion, optimism and subjective expectations as to stock market performance: Guiso and Zingales, Trusting the Stock Market, p. 3. Shum and Faig, ‘What Explains’. W. de Bondt, ‘The Values and Beliefs of European Investors’ in Cetina and Preda, Sociology of Financial Markets, p. 163. AMF, L’´education financi`ere des Franc¸ais (2004). E.g. Guiso et al., Household Stockholding, pp. 11–13. 400 Shum and Faig, ‘What Explains’. E.g. Guiso and Japelli, ‘Awareness’; and Haliassos and Bertaut. ‘Why Do So Few Hold Stocks?’ Shum and Faig, ‘What Explains’; and Guiso et al., Household Stockholding. J. Banks, R. Blundell and J. Smith, ‘Understanding Differences in Household Financial Wealth Between the US and Great Britain’ (2003) 38 Journal of Human Resources 241. Guiso et al., Household Stockholding. Repeated French privatizations, for example, have led to significant small household equity portfolios: French Savers, pp. 12–13. Guiso et al., Household Stockholding, p. 16. As EFAMA noted in its analysis of the massive outflows from the UCITS industry in the final quarter of 2008: EFAMA, Quarterly Statistical Release No. 36 (2008), p. 2.

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Policy attention is increasingly turning to understanding why households do not engage with the markets. The Deaves review of investor behaviour for Canada’s securities regulation reform, for example, highlighted the deterrent effect of transaction costs.407 The 2008 Rand Report, commissioned by the SEC, highlighted limited resources, the fear of losing money, lack of knowledge, a perception that large amounts of disposable income are required for investment activity and the complexity of the financial service industry as deterrents to investment.408 FSA research, as part of the RDR, has identified a range of factors which may deter low to middle incomes from market savings,409 while other FSA research has identified the range of environmental factors which may influence consumer behaviour with respect to financial services, including investment services.410 The AMF has also examined the drivers of investment.411 These findings are echoed in the 2007 BME Report. It reported a strong relationship between GDP per capita and the aggregate volume of household financial assets.412 It linked the initial 1980s move towards equity investment to (then) high stock returns, privatizations413 and the growth of CISs.414 It also related investment patterns to taxation,415 cultural factors and market structure factors (such as the importance of listed investment trusts (or companies) in the UK market).416 It highlighted occupational pension provision as a significant local driver of investment,417 contrasting the comparatively low levels of direct CIS investment in the UK and the Netherlands with very high levels of investment in those 407 409 410

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Deaves Report, pp. 264–5 and 281. 408 Rand Report. Including age, employment status, education, housing, ability to save and pension provision: Volterra Consulting, The Market for Basic Advice: A Report for the FSA (2008). FSA, Consumer Research No. 35, pp. 13–27. More recently, FSA research has linked the likelihood of households holding investment products to higher income and education levels, home ownership and higher overall wealth: FSA, Asset Ownership, Portfolios and Retirement Saving Arrangements: Past Trends and Prospects for the Future (Consumer Research No. 74, 2008), p. 3. Highlighting insufficient resources (65 per cent of respondents) and being overwhelmed and poorly informed (21 per cent): AMF, L’´education financi`ere des Franc¸ais. BME Report, p. 21. Ibid., pp. 167–8. Successive privatization rounds in France, for example, created a large number of small household equity portfolios (French Savers), as they did in the UK. Also, Guiso et al., Household Stockholdings, p. 2. Also, FSA, Response to the European Commission’s Call for Evidence on the Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Products (2008) (‘FSA Structured Products Response’), p. 9 (although tax incentives appear to have only limited impact in practice: BME Report, p. 155). And the availability of ‘with profits’ insurance products: ibid., p. 9. BME Report, pp. 151–4 and 163–5.

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countries in pension funds and life insurance products; but countries which have not moved significantly from the ‘pay as you go’ pension model had higher levels of CIS investment.418 Local home ownership patterns have also been identified as relevant; high levels of home ownership in the UK and the related concern to repay mortgages have been associated with high levels of UK investment in packaged products.419 Economy-specific effects have also been highlighted; the Italian experience with inflation has been associated with a retail investor concern for high returns.420 Crafting retail market regulation is accordingly a challenge. Retail market intervention carries risks, the impact of regulation remains unclear and, when it comes to engaging investors, many of the relevant factors are not susceptible to regulation. The difficulties are all the greater in the EC context.

4. Centralization risks An even cursory review of retail market policy in different markets internationally leads to the intuitive conclusion that it is deeply rooted in the risks posed by, and reflects long-standing investment cultures within, local markets. Internationally, Australian regulatory priorities, for example, reflect the innovative Australian compulsory superannuation regime which requires employees to save for retirement through superannuation funds and which allows employees to choose the fund in which employer pension contributions are invested;421 retail market policy is accordingly closely concerned with the quality of investment advice on fund choice, product disclosure and financial literacy.422 In Europe, debt market risks to retail investors are of particular concern to the Italian regulator, 418 419

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Ibid., p. 90. HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC (2007) (‘UK Article 4 Application’). Response to Commission’s Call for Evidence on Debt Market Transparency by a group of thirteen leading trade associations, September 2006, p. 13. It has prompted very high levels of pension contributions: J. Shingleton, ‘Australia Acts to Reassure Pensioners’, Financial Times, Fund Management Supplement, 1 December 2008, p. 11. E.g. Speech by ASIC Chairman Lucy on ‘ASIC’s Super Strategies 2006–2007’, 6 September 2007, available via www.asic.gov.au.

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CONSOB.423 The Dutch financial regulator has recently focused on structured product risks, reflecting their popularity in the Dutch market.424 The UK FSA, by contrast, was initially more sanguine given their more limited penetration in the UK market.425 Conversely, the FSA is focusing closely on the design of the distribution and advice industry, reflecting the importance of commission-based advisers in the UK market.426 In principle, therefore, extensive harmonization of retail market rules, and the apparently inexorable movement of the Community into the management of emerging retail market risks, gives some pause for thought. As discussed in chapter 1, the scope of the post-FSAP investor protection regime and its increasing degree of prescription suggest that the EC is fast becoming the monopoly supplier of retail market regulation. A range of risks accordingly arise, related to the wider debate on the merits of regulatory competition and harmonization.427 Specific retail market risks include industry interest-group pressures given poor retail governance (chapter 7). The EC’s response to retail market risk may also become less informed by local rules and innovations. Systemic regulatory risks may be increased as EC regulatory decisions are injected into all local markets. Greater centralization also jars with wide variations in investment patterns428 and in investor competence, different distribution structures429 and varying attitudes towards financial services,430 all of which suggest that a flexible regulatory approach is required.431

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Sect. III.6 below. 424 E.g. AFM, Exploratory Analysis of Structured Products (2007). FSA Structured Products Response. It has since opened a review into the retail structured products market: Hughes, ‘Products’. See further ch. 4. E.g. L. Enriques and M. Gatti, ‘The Uneasy Case for Top-Down Corporate Law Harmonization in the European Union’ (2006) 27 University of Pennsylvania Journal of International Economic Law 939. See further ch. 1. 429 Ch. 4 sect. X. The Eurobarometer has reported significant differences in the extent to which consumers of financial services regard consumer rights to be adequately protected, ranging from significant agreement with the statement that consumer rights are adequately protected by Finnish (60 per cent), Luxembourg (58 per cent), Belgian (44 per cent) and Danish (43 per cent) respondents, to disagreement by Greek (56 per cent), Swedish (53 per cent), Italian (50 per cent) and French (49 per cent) respondents: European Commission, Special Eurobarometer No. 202, Public Opinion in Europe: Financial Services, and Eurobarometer Highlights (2004), p. 12. FIN-USE, the Commission’s retail market forum, has repeatedly cautioned against the removal of local consumer protection rules: for example, FIN-USE, Financial Services, Consumers and Small Businesses: A User Perspective on the Reports on Banking, Asset Management, Securities and Insurance of the Post FSAP Stock Taking Groups (2004), p. 5.

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Local innovations may also be obstructed by EC requirements. In the UK, the FSA sought and received confirmation from the Commission that the Child Trust Fund (CTF), a tax wrapper which holds savings and investments and into which the government makes a contribution per child, and which has distinct product features, does not come within MiFID’s scope.432 This exclusion has allowed the FSA to retain a tailored disclosure regime for CTFs.433 The ‘stakeholder’ products regime also operates outside MiFID as does, for the most part, the personal investment firm regime. But national initiatives and harmonized rules do not always fit easily together. As discussed in chapter 4, MiFID may pose an obstacle to the development of more limited advice regimes designed to promote wider access to advice. The constraints posed by the UCITS summary prospectus have also been associated with obstructing Member States in adopting more innovative prospectus formats for fund disclosure.434 There are countervailing factors. The EC regime is not monolithic (chapter 1); local variation is possible with respect to rules on the books and supervisory techniques ‘in action’. MiFID’s principles-based model (chapters 4 and 5) also allows supervisors considerable freedom should they choose to proceed by way of guidance and supervisory practices. Evidenced-based policy formation and rule-making is on the increase (section III below), and CESR provides a forum through which national expertise can inform policy-making (chapter 7). Safety valves are also built into the regime. Member States can notify the Commission of additional local rules under the MiFID Article 4 ‘goldplating’ regime, for example, while the Prospectus Directive leaves significant room to Member States to impose advertising requirements on the public offer of securities.

III. How to intervene on the retail markets? 1. The regulatory toolbox and self-regulation The challenge for retail design is therefore considerable. Regulation must blend trust-based and empowerment-based strategies, effectively support

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FSA, Child Trust Funds and MiFID (2005). Firms selling CTFs are subject to a ‘balanced comparison’ rule which requires them to disclose which of the three types of CTF are being sold and which is designed to ‘reflect the unique nature of this product (which is uniquely marketed to many who will not have previously engaged in financial services)’: FSA, Consultation Paper No. 06/19, p. 122. See further ch. 5.

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stronger engagement and contain the risks of regulatory design. Sophisticated regulatory technology is called for. The main retail market regulatory mechanisms can be placed on a spectrum which extends from interventionist supply-side product design and advice/distribution rules, to techniques which support private ordering (typically disclosure-based), to non-regulatory techniques, typically investor education strategies.435 This spectrum is reflected in the EC investor protection regime. In addition to disclosure (chapter 5) and investor education (chapter 7), it relies on product regulation (primarily through the UCITS regime (chapter 3)) and on horizontal distribution/advice measures (primarily through MiFID (chapter 4)), as well as on specific rules for order execution (chapter 6) and education strategies (chapter 7). All of these levers must be manipulated simultaneously. But they are of varying utility. Disclosure is receding in significance but, reflecting empowerment priorities, remains a prominent mechanism in the retail markets; ‘processability’ reforms account for significant regulatory resources. It has long-term potential as an investor education tool. But investor difficulties with disclosure are of such a scale that it is poorly suited to addressing immediate risks. Investor education is similarly limited. Product regulation can mitigate understanding and disclosure risks as well as the conflict-of-interest risks associated with advice. But it is a particularly interventionist form of regulation and carries considerable risks. Since MiFID’s adoption, the horizontal advice and product distribution process,436 and the management of quality of advice risks, has moved to the centre of retail market policy, as discussed in chapter 4. Reliance on the distribution lever is efficient. Heavy reliance on advisers recurs across the Member States.437 The 2008 Optem Report438 found that those investors who can be characterized as consumers of investment products and prudent ‘savers’,439 and who dominate in the EC market, tend to rely heavily 435 436

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S. Choi, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1 Berkeley Business Law Journal 45. The FSA regime, which, post-MiFID, is now closely based on EC requirements, has long been associated with a focus on advice rather than on products: Black, Rules and Regulators, pp. 139–40. Intermediaries are the main information source for investors in Spain, Italy and France: BME Report, p. 175. Optem Report, pp. 88 and 93–4. As compared with more experienced direct and more risk-tolerant investors (or ‘gamblers’).

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and passively on advice.440 This reflects national studies which suggest retail investor reluctance to engage with disclosure and to exercise independent choice.441 It also reflects wider evidence on investor behaviour442 and on investor trust in intermediaries. As outlined in chapter 4, the horizontal advice lever can also carry heavier loads than the design and disclosure levers. Nonetheless, the distribution lever is awkward. The management of commission risk has proved elusive, while the translation of suitability rules ‘on the books’ to high-quality advice ‘in action’ can be very difficult to achieve. Market solutions can also be called on. The post-FSAP retail market regulatory regime is strongly characterized by traditional ‘command and control’ regulation.443 But EC financial market regulation more generally was showing some signs of a more decentred approach and beginning to involve market actors in disciplining markets.444 Self-regulation appears, however, to be on the wane in the wake of the financial crisis.445 Selfregulation in the retail markets is, in principle, problematic. Investors are poorly equipped to monitor market actors and to price protections.

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As do inexperienced consumers. The TNS-Sofres Report found that French CIS investors relied heavily on banks or financial advisers: pp. 7 and 10. The FSA has frequently highlighted the failure of investors to read disclosures and their preference for advisers (64 per cent of all reported retail investment products were sold on an advised basis in 2007/8 (68 per cent in 2006/7): FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 2): for example, Consumer Research No. 76, p. 12 and Consumer Research No. 41, p. 8. It has identified advisers as a ‘key interface between the financial services industry and its consumers’: Financial Risk Outlook 2005, p. 88. FSA research into the simplified Basic Advice regime, for example, found that transactions were adviser-driven and that there was little evidence of active decision-making: Consumer Perceptions of Basic Advice (Consumer Research No. 70, 2008), p. 6. Deaves Report, pp. 247 and 262; and Investment Company Institute, Understanding Investor Preferences for Mutual Fund Disclosure (2006), p. 6. By contrast, soft law techniques are increasingly being employed in the consumer sector more generally: C. Poncibo, The Challenges of EC Consumer Law (2007), ssrn abstractid=1028218. N. Moloney, ‘Law-Making Risks in EC Financial Market Regulation after the Financial Service Action Plan’ in S. Weatherill (ed.), Better Regulation (Oxford and Portland, OR, Hart Publishing, 2007), p. 321. Best exemplified by the Commission’s change of position on credit rating agencies and its adoption of a regulatory model (COM (2008) 704; a Regulation was adopted in April 2009) in preference to its previous reliance on the self-regulatory IOSCO Code of Conduct (2004). The de Larosi`ere Report, however, was ‘mindful of the usefulness of selfregulation’ and suggested that ‘public and self-regulation should complement each other’ (p. 15).

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Retail stakeholders are often hostile.446 But self-regulation has flexibility, speed and innovation benefits and some retail market potential – not least because the wider the range of tools used, the more likely it is that an effective response will emerge. There is some evidence that the FSA is increasingly sceptical of selfregulation in the retail markets with its recent extension of conduct-ofbusiness regulation to the deposit-taking activities of banks.447 Nonetheless, it has engaged firms and market solutions in its retail market activities,448 particularly through the TCF initiative and related industry actions;449 it has suggested that a combination of the TCF agenda and industry initiatives should lead to fairer consumer outcomes.450 It has supported trade associations in developing best practice disclosure guides.451 The RDR, which is designed to achieve outcomes in partnership with the industry,452 ‘challenged the industry’ to develop an enhanced framework for professional standards453 and called for an enhanced role for professional bodies.454 In its extensive review of bundling and soft commissions 446 447

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‘[I]t can easily come to mean nothing more than unconstrained action by suppliers’: FIN-USE, User Perspective, p. 14. It has proposed that the current self-regulatory regime, based on the voluntary Banking Code and the Business Banking Code, which applies to the conduct of business in the retail banking area and with respect to the sale of current and savings accounts, be replaced by a regulatory approach and a new BCOBS sourcebook which will include the fair treatment principle and disclosure requirements: Regulating Retail Banking Conduct of Business (Consultation Paper No. 08/19, 2008). A new BCOBS will come into force at the end of 2009. It has identified the ‘different levels of market solution’ in the UK regulatory regime as including FSA reliance on high-level principles, FSA endorsement of industry guidance and the involvement of professional bodies in the delivery of high standards of adviser competence and professionalism: FSA Substitute Products Response, p. 19. The Association of British Insurers’ multi-faceted ‘Customer Impact Scheme’, which reflects the TCF initiative and is designed to focus firms on consumer outcomes (ABI, Customer Impact Scheme (2006)), was developed in consultation with the FSA (Speech by A. Sykes, FSA KFD Seminar, 6 May 2008, available via www.fsa.gov.uk/ Pages/Library/index.shtml). FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Policy Statement No. 07/11, 2007), p. 15 (although the FSA also highlighted that industry efforts alone would not bring the necessary changes to firms’ behaviour). Consultation Paper No. 06/19, p. 124; and FSA, Good and Poor Practices in Key Features Documents (2007). The FSA’s preference was ‘for market- not regulatory-led ideas’ and to facilitate industry ideas: 2007 RDR, pp. 12 and 15. 2008 Interim RDR, p. 2. The FSA suggested that the industry should lead the way on professionalism and competence standards: 2007 RDR, pp. 38–40. The final 2008 Feedback Statement suggests that the industry will be closely involved in the design of a new Professional Standards Board.

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in the CIS industry, the FSA eschewed a regulatory response in favour of allowing the industry to develop techniques which would show that customers were being treated fairly with respect to soft commissions.455 Attempts to incorporate market solutions are not confined to the UK. France’s Delmas Report, for example, called for industry initiatives on investment adviser competence and for its recommended conduct-ofbusiness reforms to be implemented as trade association rules approved by the regulator.456 Self-regulatory initiatives by trade associations have been incorporated by the Dutch regulator in its response to the risks of structured products.457 Although self-regulation strategies are not yet of notable importance in the EC retail investor regime, elements of self-regulation do appear. The empowerment model for retail market intervention suggests that the retail investor is, to some degree, being engaged as a self-regulating, risk-aware participant in the marketplace. Principles-based regulation is associated with self-regulation and MiFID’s principles-based approach is likely to see industry guidance become more prominent. A threat of intervention dynamic is also injecting a hybrid form of self-regulation under which industry responses are dictated by Commission priorities. Retail debt market transparency is based on industry compliance with a voluntary standard which was developed under the threat of Commission intervention (section III.6 below). The structured products debate has seen a group of leading trade associations develop a code of practice which may be, in part, an attempt to forestall regulatory intervention.458 The Unfair Commercial Practices Directive, which expressly refers to the possibility of unfair commercial practices being addressed by codes of conduct (Article 10), provides a useful model for how self-regulation can be ‘hardened’ by linking failure to comply with a code of conduct to a determination that a commercial practice is misleading (Article 6).

2. Achieving retail market outcomes The risks of intervention, and better achievement of retail market objectives, can be mitigated by a focus on the particular outcomes 455

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FSA, Bundled Brokerage and Soft Commission Arrangements for Investment Funds (Policy Statement No. 06/5, 2006). The FSA also relies on the industry standards adopted by leading fund management trade associations in assessing whether firms’ soft commissions disclosure is ‘adequate’, as required under the FSA’s COBS sourcebook. Delmas Report, pp. 48–9. It has also relied on the Financial Services Foundation (the StFD). 458 See further ch. 3.

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sought.459 Clear identification of outcomes is also essential to effective principles-based regulation, as discussed below. The FSA’s retail market activities are based on the achievement of the outcomes identified in its annual Business Plan460 and in its Major Retail Thematic Work Plan.461 This approach cascades down to specific initiatives. The TCF initiative is based on the achievement of specified outcomes which describe the characteristics of the retail market sought by the FSA.462 The RDR is designed to support a market in which consumers are capable and confident, information is clear, simple and understandable, and firms are soundly managed and treat customers fairly.463 The Commission supported an ‘impact-driven approach’ and ‘making markets deliver more effectively’ in the 2007 Single Market Review,464 and is to ‘shift the focus of regulation towards citizen-focused outcomes’ in its consumer policy.465 It is also, slowly, turning to the outcomes of retail market intervention in specific measures466 and more generally. The 2007 Green Paper on Retail Financial Services suggests that the Commission seeks a market in which: properly regulated markets and strong competition deliver products that meet consumers’ needs; consumer confidence is enhanced through protective measures; and consumers are empowered 459

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The Sandler Report, for example, suggested that, in a well-functioning retail savings market, there would be: reasonable understanding of retail savings products; a properly functioning advice market; alignment of advisers and consumer incentives; simple and straightforward products; downward pressure on price and upward pressure on quality; clear price identification; and easy access to products and services, particularly for the low-to-middle-income group: p. 22. The 2008–2009 Business Plan focused in particular on the TCF initiative, the sound resourcing and management of firms, the RDR, and financial capability: FSA, Business Plan 2008–2009, p. 23. Similar outcomes were specified in the 2009–2010 Business Plan. Areas of concern identified for thematic review are typically assessed through file reviews, discussions with firms, consumer surveys and research, and mystery-shopping surveys: FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008), p. 41. See further ch. 4. 2007 RDR, p. 3. The final 2008 report stated the outcomes as: an industry that engages with consumers in a way that delivers more clarity; a market which allows consumers’ needs and wants to be addressed; standards of professionalism that inspire consumer confidence and build trust; remuneration arrangements that allow competitive forces to work for consumers; sufficient industry viability to deliver long-term commitments and firms which treat customers fairly; and a supportive regulatory framework which does not inhibit future innovation beneficial to consumers: 2008 RDR Feedback Statement, p. 5. European Commission, A Single Market for 21st Century Europe (COM (2007) 724), para. 1. European Commission, Communication on EU Consumer Policy Strategy 2007–2013, p. 3. The UCITS Key Investor Information (KII) reform, for example, recognizes the importance of clarifying outcomes (ch. 5).

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to make the right decisions for their financial circumstances.467 The ability of the EC to articulate clear outcomes for retail market intervention, particularly in the absence of an institutional statement on the objectives of EC intervention in the financial markets,468 will become all the more important as policy questions of central importance to the retail markets are addressed by the EC.

3. Principles-based regulation and the retail markets Closely associated with the identification of retail market outcomes, principles-based regulation has become one of the more striking features of the EC retail market regime. It applies in particular to the regulation of distribution/advice (chapter 4) and of disclosure (chapter 5). Principles-based regulation469 has a number of characterizations.470 It typically involves: the articulation of regulatory objectives and outcomes through high-level principles which are supported, where necessary, by rules but also by guidance; a commitment to paring back unnecessary or ambiguous rules; a focus on the achievement of outcomes;471 and better engagement by industry and senior management with the delivery of outcomes.472 Prior to the financial crisis, principles-based regulation had become somewhat fashionable in regulatory design. The FSA was the standardbearer with its ‘more-principles-based’ regulation (MPBR) strategy.473 But principles-based regulation became popular internationally,474 even being 467 468 469

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European Commission, Green Paper on Retail Financial Services, pp. 2–3. N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008), pp. 1095–7. This discussion of a complex area is necessarily brief. See, for example, J. Black, ‘Forms and Paradoxes of Principles-Based Regulation’ (2008) 2 Capital Markets Law Journal 425; S. Schwarcz, The Principles Paradox (2008), ssrn abstractid=1121454; C. Ford, ‘New Governance, Compliance, and Principles-Based Securities Regulation’ (2008) 45 American Business Law Journal 1; and L. Cunningham, A Prescription to Retire the Rhetoric of ‘Principles-Based Systems’ in Corporate Law, Securities Regulation, and Accounting (2007), ssrn abstractid=970646. E.g. D. Kershaw, ‘Evading Enron: Taking Principles Too Seriously in Accounting Regulation’ (2005) 68 Modern Law Review 594. J. Black, M. Hopper and C. Band, ‘Making a Success of Principles-Based Regulation’ (2007) 1 Law and Financial Markets Review 191. Ford, ‘New Governance’. FSA, Principles-Based Regulation: Focusing on the Outcomes That Matter (2007). E.g. the adoption of a principles-based approach by the Japanese Financial Services Agency: Financial Services Agency, The Principles in the Financial Services Industry (2008), available

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associated with international regulatory competitiveness.475 The financial crisis has seen principles-based regulation recede from the regulatory scene, amidst concerns that it led to a prejudicially light-touch supervisory style.476 The 2009 Turner Review has committed the FSA to more intervention in the wholesale securities and banking markets in particular, significantly less reliance on market discipline, and more intrusive supervision. Although the Review does not focus directly on principlesbased regulation, it is associated with a withdrawal from principles-based regulation.477 But the FSA has not rejected principles-based regulation. While it has acknowledged its limitations, the FSA appears committed to moving from prescriptive rules to a higher level of articulation of what the FSA expects of firms and to deterring ‘box-ticking’.478 It appears concerned, however, to recharacterize ‘principles-based regulation’, with its connotations of lighter touch supervision, as ‘outcomes-based regulation’ and to emphasize that regulation cannot operate on principles alone.479 The financial crisis has also significantly strengthened the FSA’s supervisory approach to principles and to the monitoring of outcomes, with its Supervisory Enhancement Programme and its ‘intensive supervision’ model. But the basic commitment, in terms of regulatory design, to regulatory principles appears to remain in place.480 Principles may also provide a way for capturing the severe complexity risk which the crisis has exposed.481 It may therefore be too early to abandon principles-based

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via www.fsa.go.jp. In the EC, the Dutch AFM, for example, follows a principles-based approach: AFM, Policy and Priorities for the 2007–2009 Period (2007), p. 15. Cunningham, Prescription, pp. 55–62. The Paulson Report called for a more-principlesbased regulation approach to strengthen the weakening competitive position of the US market: Interim Report on the Committee on Capital Market Regulation (2006) (‘Paulson Report’), pp. 63–5. It suggested that ‘prescriptive rules should be fashioned, where sensible, more in terms of outcomes, performance and results rather than inputs and mandated processes’ (p. 8). The failure of Northern Rock led to criticisms of the FSA’s reliance on principles-based regulation. House of Commons, Treasury Committee, The Run on the Rock: Fifth Report of Session 2007–2008 (2008). P. Thal Larsen, ‘FSA Faces Fight to Regain Global Reputation’, Financial Times, 19 March 2009, p. 3, suggesting that the Review ‘provides a clear break with the FSA’s previous philosophy of principles-based regulation’. Speech by FSA Chief Executive Sants on ‘Delivering Intensive Supervision and Credible Deterrence’, 12 March 2009, available via www.fsa.gov.uk/Pages/Library/index.shtml. Ibid. The emerging conduct-of-business regime for banking is based on a principles-based model: Consultation Paper No. 08/19. Schwarcz, Complexity, pp. 65–6, but warning of the need for common agreement on what principles mean.

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regulation, although principles are likely to be accompanied by significantly more intrusive supervision. Certainly, the EC retail market rulebook contains a number of principles-based requirements. While some concerns have been raised as to principles-based regulation,482 the Parliament, at least, appears convinced of its flexibility benefits.483 A recasting of the MiFID regime also seems very unlikely given current regulatory and supervisory strain. Principles-based regulatory design has benefits in the retail market where the risks of regulatory intervention are significant and the outcomes sought are ambitious. Broad-based principles484 may focus regulators more closely on the achievement of core regulatory objectives485 and reduce the risks of regulatory capture.486 Principles can capture innovation. The FSA’s application of MiFID’s principles-based rules to wraps and platforms has been welcomed.487 MiFID’s disclosure and distribution principles may also provide a basis for managing the cross-sector risks of substitute products.488 Principles-based regulation promises much in terms of better firm compliance, the mitigation of ‘tick-the-box’ practices,489 and thus the achievement of stronger retail market outcomes ‘in action’.490 The FSA has, for example, linked MPBR to a series of stronger consumer outcomes including a more innovative and competitive financial services industry, more efficient markets and firms better attuned to consumers’ needs.491 If firms are required to engage with how to achieve high-level outcomes in their

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J. William, B. Sherwod and S. Scholtes, ‘Queues Outside Bank Damaged Case for LightTouch Regulation’, Financial Times, 21 January 2008, p. 1; and Clifford Chance, PrinciplesBased Regulation – Problems of Uncertainty (2007), p. 2. European Parliament, Resolution with Recommendations to the Commission on Hedge Funds and Private Equity (P6–TA(2008)0425, 2008), suggesting, at the height of the autumn 2008 market turbulence, that principles-based regulation provided the flexibility needed in financial market regulation. An extensive scholarship addresses the nature of principles and rules and considers the related certainty, flexibility and effectiveness issues. E.g. L. Kaplow, ‘Rules v. Principles. An Economic Analysis’ (1992) 42 Duke Law Journal 557. W. Bratton, ‘Enron, Sarbanes–Oxley, and Accounting: Rules versus Principles versus Rents’ (2003) 48 Villanova Law Review 1023, 1037. P. Mahoney and C. Sanchirico, General and Specific Legal Rules (2004), ssrn abstractid=566201. FSA, Platforms and More Principles Based Regulation (Feedback Statement No. 08/11, 2008), pp. 6 and 10. See further ch. 4. 489 E.g. Kershaw, ‘Evading Enron’, 596. FSA, Focusing on the Outcomes That Matter, p. 6. 491 Ibid., pp. 2 and 7.

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particular business environments, the potential exists for substantive compliance and investor welfare to improve; this process may also lead to better firm ownership of the compliance process.492 Allowing greater innovation by firms may also strengthen investor welfare. As discussed in chapter 5, MiFID’s principles-based approach has led to significantly less prescription in retail market disclosures in the UK market, and more room for firm innovation, although the regime’s effectiveness is not yet clear. Better investor outcomes may also be supported by stronger industry sustainability; a principles-based approach should lead to reduced regulatory costs as firms can develop tailored responses to regulatory requirements. In the EC context, principles can also mitigate centralization risks. Innovative supervisory practices in support of the achievement of outcomes may also follow. The FSA’s high-level Principles for Business, and particularly Principle 6 on fair treatment,493 underpin its flagship ‘law in action’ TCF strategy.494 But principles-based regulation is not without risks, particularly in the EC context. Effective principles-based regulation is not a proxy for thinner or lighter rules. It operates on a continuum from regulation to supervision and to enforcement; its different elements are connected by the need to deliver clearly identified outcomes. This demands sophisticated regulatory design and supervision. But there was little discussion of what principles-based regulation involves during MiFID discussions, although the EC is not alone in this regard.495 While principles-based regulation has been associated with the Commission’s Better Regulation agenda,496 its

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Ford, ‘New Governance’. Principle 6 (fair treatment) requires that a firm must pay due regard to the interests of its customers and treat them fairly. Principle 7 (clear disclosure) requires that a firm must pay due regard to the information needs of its clients and communicate information in a way which is clear, fair and not misleading. Other key retail market principles include Principle 9 on suitability and Principle 8 on conflicts of interests. The other principles, all of which impact directly or indirectly on the retail markets, cover integrity (Principle 1), acting with skill, care and diligence (Principle 2), management and control systems (Principle 4), financial prudence and financial resources (Principle 4), market conduct (Principle 5), client assets (Principle 10) and the firm’s relationship with regulators (Principle 11). See further ch. 4. E.g. I. MacNeill, ‘The Evolution of Regulatory Enforcement Action in the UK Capital Markets: A Case of “Less Is More”’? (2007) 2 Capital Markets Law Journal 345, critiquing the FSA’s failure to assess the costs and benefits of more-principles-based regulation. Commissioner McCreevy, Speech on ‘Regulators: Help or Hindrance’, International Corporate Governance Network, 6 July 2007, available via http://europa.eu/rapid/ searchAction.do.

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adoption seems to have been driven by exhaustion with the FSAP497 rather than by a reasoned assessment of its risks and benefits and an appreciation of what it requires. As a result, investor welfare may be prejudiced by MiFID’s placing of firm judgment and firm responsibility to achieve outcomes at the heart of its pivotal disclosure and advice regime. The potential for firm/investor incentive misalignment is already considerable; high-level principles, unless carefully policed, may provide flawed incentives for firms to neglect typically costly investor-facing procedures in the prevailing difficult market conditions.498 The FSA’s FSCP has highlighted the risks of placing significant emphasis on a firm’s judgment, and has called for a review of the new model.499 The risks of excessive discretion can be managed with clear guidance on what is expected from firms, robust supervision and ex post enforcement. Under the TCF initiative, for example, the FSA has deployed an arsenal of weapons to drive firm compliance; but even it has struggled.500 But the risks may be considerable on a pan-EC basis given limited supervisory experience and resource strain. In practice, guidance is strongly associated with principles-based regulation and is necessary to ensure a common market understanding of the relevant outcomes and how they might be achieved. The Commission has published an innovative MiFID ‘Q and A’,501 as have CESR502 and other European regulators.503 So too has the FSA,504 exercising its wide

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Principles-based regulation has been related to ‘the legislative fatigue experienced by Member States and industry’ and the Commission’s consequent concern to avoid overregulation: ESC, Minutes, 23 February 2005. The FSA warned during the financial crisis that weaker economic conditions may lead investment firms to focus on short-term business survival and to neglect retail market conduct-of-business requirements: FSA, Financial Risk Outlook 2008, pp. 25 and 47. FSCP, Annual Report 2006–2007, p. 3. See further ch. 4. 501 European Commission, ‘Your Questions on MiFID’ website. CESR. Questions and Answers on MiFID: Common Positions Agreed by CESR Members (December 2008 version) (CESR/08-943, 2008). The AMF has produced a MiFID Q and A, while CONSOB has produced guidance on the MiFID inducements regime. It has, at times, declined to provide guidance. It was, for example, reluctant to issue guidance on the MiFID Level 2 Directive’s operational rules given that ‘it is for a firm’s management to decide how best their firm might meet [MiFID] requirements and it is more appropriate for a firm to discuss issues or concerns bilaterally with its supervisors’: FSA, Organisational Systems and Controls: Common Platform for Firms: Feedback (Policy Statement No. 06/13, 2006), p. 4.

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discretion to adopt guidance,505 particularly in those areas where MiFID’s rules have brought significant change.506 It has also clarified the status of FSA guidance507 and of the industry guidance508 which has become a feature of the MiFID landscape.509 But this proliferation of guidance carries risks. Regulators may use ‘softer’ measures to reverse-engineer into prescription without the checks and balances imposed on formal lawmaking. The FSA experience points to an exponential increase in quasiprescription through softer measures, including TCF progress reports, case studies, speeches, and examples of best practice which are not subject to the formalities of FSA rule-making510 but which nonetheless have drilled deep into firms’ practices. Retail investors are unlikely to be aware of the risks which arise from the voluntary nature of guidance.511 The retail interest will also not be well served by a more opaque regulatory environment in which softer quasi-regulation proliferates and becomes less readily available512 and which may prejudice the achievement of key MiFID outcomes.513 Neither will it be well served by the heightened risk of retail investor exclusion from the guidance-setting process (chapter 7).

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FSMA, sect. 157. Guidance can be adopted within the FSA Handbook, accompanied by supporting materials (FSA, Confirmation of Industry Guidance (Policy Statement No. 07/16, 2007), p. 4), and take the form of separate regulatory guides (e.g. Regulatory Guide on the Application of TCF Principles to Product Providers: Regulatory Guide, annexed to FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Policy Statement No. 07/11, 2007) (see further ch. 3). E.g. its guidance on the new appropriateness regime: FSA, Reforming Conduct of Business Regulation (Policy Statement No. 07/6, 2007), pp. 57–61; and COBS 10.2.5–COBS 10.2.8. FSA, Reader’s Guide: An Introduction to the FSA Handbook, p. 24. Where industry guidance has been through the FSA’s confirmation process, firms which follow it are regarded as complying with the relevant rules, but failure to comply is not treated as indicating a rule breach as, according to the FSA, in many cases, there will be more than one way to comply: Policy Statement No. 07/16, p. 7. E.g. MiFID Connect, Information Memorandum on the Application of the Conflicts of Interest Requirements under the FSA Rules Implementing MiFID and the CRD in the UK (2007); and MiFID Connect, Guideline on the Application of the Suitability and Appropriateness Requirements under the FSA Rules Implementing MiFID in the UK (2007). FSMA imposes a number of requirements on FSA rule-making (sects. 152–156), including impact assessment requirements. FSA, FSA Confirmation of Industry Guidance (Discussion Paper No. 06/5, 2006), p. 17. M. Hopper and J. Stainsby, ‘Pause for Thought: The FSA Needs to Decide What Status It Intends to Ascribe to Industry Guidance’ (2007) 26(1) International Financial Law Review 40. E.g. Black et al., ‘Making a Success’, highlighting the risks as including prejudice to certainty, a proliferation of interpretive guidance, a blurring of the distinction between standards and best practice, and supervisory and regulatory uncertainty.

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Principles-based regulation also poses a considerable challenge to the EC’s currently networked supervision model514 and to often inexperienced and ill-equipped supervisors. Successful principles-based regulation requires a fundamental reconsideration of how supervision is carried out, how the regulator communicates with the industry, and how firms can legitimately protect themselves against supervisory action; failing which, the ‘principles paradox’ arises.515 Principles-based regulation may also not be sufficiently detailed to support relatively inexperienced supervisors in dealing with complex retail market risks. While more established supervisors have a wealth of experience on which they can draw in applying MiFID, or on which to base ‘Article 4’ applications for more detailed rules, others will be required to rely heavily on MiFID’s core principles. The advanced technology developed by the FSA in this area certainly underlines the considerable resources, experience and expertise required to deliver results under a principles-based model and the challenges it poses in a pan-EC context.

4. Evidence-based policy formation and rule-making Effective regulatory risk management and stronger achievement of retail market objectives is more likely when intervention is based on evidence.516 It is not new to call for testing;517 Coase’s seminal examination of the nature of government intervention and of the management of social costs called for the impact of rules on actors’ behaviour to be examined.518 The 514 515

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The financial crisis is likely to lead to significant reforms to the supervisory structure (chs. 7 and 8). Schwarcz, Principles Paradox, suggesting that, while principles-based regulation can achieve normative goals more effectively than rules, a regulated actor who faces unpredictable liability is likely to act as if it were subject to a rule, even where the rule is unintended. In a recent example, in the context of the FSA’s RDR, the FSA’s FSCP challenged the FSA’s assumption that retail investors would not be willing to pay for higher-cost independent investment advice, particularly where appropriate education was made available, and rejected the FSA’s related assumption that the advice regime be segmented according to the level of complexity and cost of the investment advice required as overly simplistic: Response to a Review of Retail Distribution (2007), p. 10. Calls for better data collection by the SEC are a regular feature of US investor protection scholarship, for example, D. Langevoort, The SEC as a Lawmaker: Choices about Investor Protection in the Face of Uncertainty (2006), ssrn abstractid=947510, arguing that the SEC has ‘never shown much interest’ in whether disclosure can lead to better decision-making (p. 20). J. Coase, ‘Problems of Social Cost’ (1960) 3 Journal of Law and Economics 1. The Coasian efficiency model accordingly shares a common heritage with behavioural finance although

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stakes have, however, become significantly higher with the policy concern to promote stronger engagement and as the extent to which investor behaviour diverges from rationality becomes clear. Principles-based regulation also demands evidence. Supervisory and judicial determinations519 as to whether or not firm communications are ‘misleading’ or investment firms act ‘fairly’ (MiFID, Article 19(1) and (2)) must be informed by some evidence as to how investors behave. The financial crisis has also exposed the need for better retail market research. The crisis has highlighted the serious systemic risks which flow from failure to recognize the link between wider macro-economic policy (notably low interest rates leading to an injection of funds into the financial system) and market reaction (the catastrophic search for yield and a recycling of debt from the banking sector into the securities market). But retail investors have also formed part of this dynamic, investing more heavily in higher yield alternative investments and structured products520 and then withdrawing into capital-protected structured products. Regulatory policy with serious ambitions in the retail markets must stand ready to identify and respond to shifts in investment patterns. Without evidence, regulators will not be able to capture emerging weaknesses in, for example, execution-only/advicefree regimes when new products begin to press heavily on the boundaries of investor competence. Until recently, hard evidence on investor decision-making has been limited, partly given the rationality assumption but also given the difficulties in gathering data.521 But change is underway. Industry efforts are intensifying. US research, for example, is being spearheaded by the NASD (now FINRA),522 while the powerful Investment Company Institute has examined mutual fund disclosures ‘in action’.523 Demand-side perceptions of intermediaries and of fair treatment have been examined by the UK insurance industry.524 The 2006 call from the President of the American Finance Association for economists to focus more closely on

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it diverges from it with its rationality assumptions: Arlen, ‘Future of Behavioral Economics Analysis’, 1765–6. In Gut Springenheide GmbH [1998] ECR I-4657 (Case C-210/96), the Court noted that national courts were not prohibited from taking into account consumer research polls or experts’ judgments when assessing whether or not consumers were misled where there was a particular difficulty in assessing the misleading nature of the communication. FSA Financial Risk Outlook 2005, p. 86. 521 Campbell, ‘Household Finance’, p. 1557. Its 2003 investor literacy study was the first national US study of its kind. E.g. Investment Company Institute, Understanding Investor Preferences for Mutual Fund Information (2006). The ABI’s Customer Impact Scheme initiative includes annual assessments of consumers’ perceptions of how they are treated.

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the dynamics of household investment525 also reflects growing academic interest in household financial decision-making.526 Regulators are also engaging in large-scale efforts to understand investor behaviour527 and to test regulation, particularly disclosure rules.528 Leading recent examples include the Canadian Deaves Report, the SEC’s recent Rand Report on investment advice and brokerage, the AMF’s 2004 study of French financial literacy and its regular research into retail market trends,529 and the FSA’s studies of financial capability. The latter’s extensive research also includes efforts to understand the key ‘life events’ which trigger interaction with financial services, to quantify the impact of reforms to distribution and advice,530 to understand the retail investment products market,531 and to track retail investment patterns.532 But the EC’s post-FSAP rule base was developed without evidence on investor behaviour533 and without evidence on the structure of the retail market. Given the Commission resources expended on Eurobarometer, which has examined financial services but could be used more intensively,534 it does not seem unreasonable that a retail investor index be constructed which would regularly gauge investor competence, experience and investment attitudes.535 Although the 2007 BME Report 525 526 527

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Campbell, ‘Household Finance’, suggesting that ‘the possibility that household finance may be able to improve welfare is an inspiring one’. R. Bluethgen, A. Gintschel, A. Hackethal and A. Mueller, Financial Advice and Individual Investors’ Portfolios (2008), ssrn abstractid=968197. The Australian regulator, ASIC, for example, has highlighted the importance of regulatory understanding of what consumers of products are doing, what they are thinking, and how they are behaving: Cooper, Retail Investors. See further ch. 5. AMF, L’´education financi`ere des Franc¸ais (summarized in French Savers) and its regular Risks and Trends Mapping for Financial Markets and Retail Savings reports. A series of studies were undertaken in relation to the RDR. E.g. Oxera, Towards Evaluating Consumer Outcomes in the Retail Investment Products Markets: A Methodology: Prepared for the Financial Services Authority (2008). Including through its annual Financial Risk Outlook and its Retail Investments Product Sales Data (PSD) Trends Report. For an early criticism of this failure, see FIN-USE, User Perspective, p. 16. E.g. European Commission, Special Eurobarometer No. 230; Special Eurobarometer No. 202; and Eurobarometer 2003:5 Public Opinion in the Candidate Countries: Financial Services and Consumer Protection: Summary Report (2004). They provide some limited evidence about investor behaviour and sentiment on a pan-EC scale, particularly with respect to confidence in dispute resolution (low), satisfaction with disclosure (low) and perception of marketing by financial institutions (often seen as aggressive). The 2009 ‘crisis Eurobarometer’, however, did not address investor decision-making: Standard Eurobarometer (EB71), Europeans and the Economic Crisis (2009). An Investor Index project has been developed for the Canadian market: Black, Involving Consumers, pp. 34–5.

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marks an important staging post, it is limited and largely based on secondary sources. Tests of investor behaviour are complex and expensive. Questionnaires can be unreliable, proprietary data-sets can be limited and reliable information hard to come by.536 Regulators, despite the resources they can wield, are not immune from criticism; the FSA’s strenuous efforts have, for example, been criticized as being overly general.537 But CESR provides a vehicle through which national initiatives can be collated, priorities for evidence-gathering established, and experience shared;538 it is increasingly probing the structure of the retail markets.539 The FIN-NET dispute resolution mechanism (chapter 8) provides another potentially important resource on retail market behaviour in that analysis of the major types of complaint which recur across the Member States could usefully be integrated into the law-making process. Some signs augur well. The Commission’s 2005 White Paper on postFSAP policy included a commitment to evidence-based policy-making, based on wide consultation and impact assessment,540 and a commitment to ex post assessment.541 New rules are being subject to ex ante impact assessment testing, best illustrated by the extensive efforts expended on the UCITS Key Investor Information model (chapter 5). An extensive panEC study (the 2008 Optem Report) has been carried out on consumer reaction to a range of financial services disclosure, including investment disclosure.542 The influence of EC consumer policy may also come to bear. SANCO, the Directorate General for Health and Consumer Protection, appears to have expended considerably more resources on research than the Internal Market Directorate General, which is responsible for financial services.543 SANCO is concerned to develop a ‘richer understanding of 536 537

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Campbell, ‘Household Finance’, 1555–8. National Consumer Council, Financial Capability: The NCC’s Response to the Treasury Consultation – Financial Capability: The Government’s Long-Term Approach (2007), pp. 11–13. CESR’s potential for acting as a clearing-house can be seen in its 2006 Factbook: CESR, The European Single Market in Securities in 2006: A Factbook on Markets and Supervision (2006). E.g. CESR, Call for Evidence on UCITS Distribution (2007) (CESR/07-205, 2007). European Commission, White Paper on Financial Services Policy, p. 4. Ibid., p. 6. The Commission set 2009 as the deadline for a full legal and economic assessment of the FSAP. Optem Report. See further ch. 5. Its website states that ‘[r]eliable and up-to-date information (quantitative and qualitative) is essential for better policy-making . . . It is a cornerstone of Consumer Policy Strategy. Convincing policy-makers and stakeholders of consumer concerns and demands depends on a clear and defined “problem statement” and a fair and balanced assessment of all the impacts.’

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consumer behaviour [and] to understand how rational consumers are in practice’.544 Notably, the 2008 Optem Study took place under its aegis, and it has also developed a Consumer Scoreboard to assess the performance of consumer markets.545 But the crisis did not lead to greater efforts to understand investor behaviour. By contrast, the proposed new US Consumer Financial Protection Agency will be charged with evidence-gathering.

5. Controlling risk-taking and segmentation techniques The risks of regulation may also be contained, and the achievement of retail market objectives supported, by investor segmentation (or what might be called ‘investor regulation’546 ) strategies which reflect different levels of investor experience and sophistication. Segmentation can be restrictive and protect vulnerable investors from excessive risk. Professor Choi’s oftcited proposal to restrict unsophisticated retail investors to passive index funds is an elegant, if extreme, articulation of segmentation.547 But it has resonances in the decisions regularly taken by regulators as to which investments can be marketed to the public548 and with the restrictions placed on the products which can be sold execution-only. But, where it allows investors some degree of freedom in moving between segments, segmentation can also accommodate growing levels of empowerment and competence and mitigate the risks of over- or poor regulation. Segmentation also reflects a concern not to impose unwarranted regulatory costs on the wholesale sector,549 and not to obstruct innovation which may benefit 544 545 546 547 548

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European Commission, Consumer Policy 2007–2013, p. 9. European Commission, Communication on Monitoring Outcomes in the Single Market: The Consumer Markets Scoreboard (COM (2008) 31), pp. 4–7. T. Paredes, Hedge Funds and the SEC: Observations on the How and Why of Securities Regulation (2007), ssrn abstractid=984450. Choi, ‘Regulating Issuers Not Investors’. Member State regulators generally restrict retail investor access to investment strategies which are considered to be ‘too risky’ and/or ‘too complex’, particularly in the form of hedge funds and private equity/venture capital funds: PwC Retailization Report, p. 7. On hedge fund segmentation, see, for example, Report of the Alternative Investment Expert Group, Managing, Servicing, and Marketing Hedge Funds in Europe (2006); IOSCO, The Regulatory Environment for Hedge Funds: A Survey and Comparison (IOSCO, 2006); and PricewaterhouseCoopers, The Regulation and Distribution of Hedge Funds in Europe (2005), p. 5. ‘Sensible principles of good regulation, including efficiency, economy, and proportionality, suggest that rules reflect the differing needs for protection, both in types and amount, of various investors whose knowledge, sophistication and understanding varies’: Paulson Report, p. 65.

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the retail markets, typically by lifting protections for particular categories of investors. Segmentation appears in EC investor protection policy. Under the Prospectus Directive, an extensive range of securities offerings are exempted from the requirement to publish an approved prospectus but are closed to retail investors. The Directive’s many exemptions are broadly designed to carve out the institutional market and include offers addressed to ‘qualified investors’,550 as well as offers with denominations of at least €50,000 or requiring consideration of at least €50,000 (Article 3(2)). But, as befits a regime with strong empowerment overtones, the Prospectus Directive allows private investors to ‘opt in’ to ‘qualified investor’ status, as long as they meet certain conditions.551 This self-certification regime contrasts with MiFID, which subjects any ‘opt in’ decisions to investment firm oversight. MiFID segmentation includes relaxations on the application of MiFID’s cornerstone conduct-of-business regime for more sophisticated investors; its application is governed by whether the investor is a retail investor,552 who benefits from the full range of protections, a professional investor,553 who may opt out of the retail protections, or an eligible counterparty.554 When eligible persons seek to ‘opt in’ to professional investor status,555 extensive classification and notification requirements apply.556 In a tightening of the Prospectus Directive, its ‘self-certification’ 550

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‘Qualified investors’ include institutional and regulated actors (such as investment firms, CISs and credit institutions), governmental and public bodies, and large companies (Art. 2(1)(e)). Two of the following criteria must be met: they have carried out transactions of a significant size on securities markets at an average frequency of at least ten per quarter over the previous four quarters; the investor’s portfolio exceeds €500,000; and the investor has worked for at least one year in the financial sector in a professional position which requires broad knowledge of securities investment (Art. 2(1)(e)(iv) and (2)). Defined by default as a client who is not a professional client: Art. 4(1)(12). A professional client is one who falls within the criteria specified in Annex II to the Directive (MiFID, Art. 4(1)(11)) which reflects the Prospectus Directive. The MiFID Level 2 Directive specifies how the different conduct-of-business rules apply to the retail and professional sectors. The firm must be satisfied that the client meets two of the following criteria: the client has carried out transactions, in significant size, on the relevant market at an average frequency of ten per quarter over the previous four quarters; the client’s investment portfolio exceeds €500,000; and the client works or has worked in the financial sector for at least one year in a professional position which required knowledge of the transactions or services envisaged. Any waiver of conduct-of-business protections is valid only where an adequate assessment of the expertise, knowledge and experience of the client, undertaken by the investment firm, gives reasonable assurance, in light of the nature of the transactions or services involved,

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model is to be aligned to MiFID’s approach.557 MiFID segmentation also includes restrictions on the products which can be sold execution-only. Segmentation is also common in the UK regime. Only regulated CISs (largely based on the EC UCITS product but also including domestic, regulated non-UCITS funds (NURS) and FSA-recognized overseas schemes (including passporting UCITS)), for example, may be marketed to the public.558 Non-regulated schemes may only be marketed to those who have already invested in similar schemes559 or where suitability requirements are met.560 Restricting retail market access to particular products, whether through industry discipline or regulatory fiat, was also highlighted as an appropriate response to retail market risks by France’s Delmas Report.561 Segmentation can be a problematic regulatory device and must be carefully deployed. It is associated with troublesome regulatory determinations that certain products or markets are ‘too risky’ for direct retail market access or as to the design of ‘appropriate’ retail market products. The restriction of MiFID’s execution-only regime to ‘non-complex’ products (Article 19(6)), and the exclusion of derivatives, for example, risks imposing additional advice costs on the sale of products which may deliver stronger returns and protect against general market risks. The line between safe and risky products is also particularly difficult to draw,562 not least given the untested and often confused regulator assumptions as to the degree of risk which investors should carry. Unintended effects may follow; the segmentation by the Prospectus Directive of retail and professional markets has reduced retail market access to the debt markets (section III.6 below).563 Segmentation may also not take sufficient account of

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that the client is capable of making his own investment decisions and understands the risks. European Commission, Background Document: Review of Directive 2003/71 (2009). FSMA, Part XVII. See E. Lomnicka, The Financial Services and Markets Act: An Annotated Guide (London: Sweet & Maxwell, 2002), pp. 375–445. The combined effect of the marketing regime and the extensive product requirements imposed on regulated schemes is that the CIS industry is divided into publicly offered and heavily regulated funds, and private funds which are privately placed and largely unregulated: Benjamin, Financial Law, p. 248. Non-regulated CISs may be recommended to investors in the course of an advice relationship and where suitability requirements are met: COBS 4.12. Delmas Report, pp. 25 and 30. The Commission has warned that national experience across the EC suggests that ‘there is no fully satisfactory basis’ for distinguishing between safe and risky products for the retail markets: European Commission, Investment Funds White Paper, p. 13. In the US market, some unease has been expressed as to the potential prejudice to retail investors from the scale of the US private placement regime and the institutionalization

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institutional investor monitoring of traditionally riskier investments.564 While both the Prospectus and MiFID regimes allow retail investors to progress to professional/qualified investor status, the stringency of the conditions suggests that very few retail investors will be in a position to make the transition – where they do, the risks could be considerable as determinations of contributory negligence may follow.565 Conversely, segmentation can be a blunt instrument and fail to control the sale of risky and complex products in the retail sector. Effective segmentation through product regulation is very difficult to achieve; the reach of the UCITS III regime suggests considerable policy tolerance for the extent to which the retail market should be allowed to take on risks. Segmentation in the form of limitations on the assets which can be purchased through execution-only channels is also of limited use if the regulatory regime for the eligible products supports the proliferation of a vast range of complex products. Where segmentation is based on classifying investors, nuanced decisions are required. It is difficult to choose appropriate proxies for sophistication, competence and risk appetite; it is all the more so as regulators have only recently embraced research into investor decision-making. Inadequate proxies can mean that the investment freedom of more sophisticated investors is curtailed566 but that affluent but unsophisticated investors may be exposed to overly risky products without adequate protection. Net worth, the easiest and most common proxy,567 might suggest that

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of the securities markets: R. Karmel, Regulation by Exemption: The Changing Definition of an Accredited Investor (2008), ssrn abstractid=1115409. It has been suggested that the stringent regulation imposed on US mutual funds contributed to the growth of hedge funds and deprived retail investors of the opportunity to invest alongside sophisticated investors who would carry the monitoring burden: P. Mahoney, ‘The Development of Securities Law in the United States’ (2009) 47 Journal of Accounting Research 325. The English High Court has determined that an investor who opted to move from ‘private’ to ‘intermediate’ status under the FSA regime was contributorily negligent with respect to spread-betting losses: J. Gray, ‘High Court Rules Customer Who Opted from Private to Intermediate Customer Status to Have Been Contributorily Negligent to His Spread Betting Losses’ (2008) 16 Journal of Financial Regulation and Compliance 414. The FSA appeared concerned not to obstruct natural persons who were ‘qualified investors’ from investing in private placements under the prospectus regime in designing the qualified investor register and in providing for a self-certification regime: FSA, Implementation of the Prospectus Directive (Policy Statement No. 05/7, 2005), p. 10. Used, along with experience tests, in the EC regime.

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wealthy investors making more substantial investments have greater incentives to monitor their investments. But it is not an effective proxy for sophistication.568 Investor testing offers intriguing possibilities.569 But, and aside from resource and design difficulties,570 it sits uneasily with the wider empowerment and choice dynamic of the current policy debate. The risks of blunt segmentation may be contained where the segmenting decision moves from the regulator and becomes the responsibility of the adviser; suitability assessments can replace regulatory segmentation determinations. Segmentation could also take the form of an industry requirement that products and services be appropriately targeted. But the UCITS product regime remains some considerable distance behind the UK model which requires product producers to consider whether products respond to investors’ needs and abilities.571

6. Diversification a) Diversification and the retail markets The prevalence of general market risk, and the threat it poses to trusting and empowered investors, calls for a careful regulatory response if retail market objectives are to be achieved. Effective diversification572 is key to strong returns and to protecting investors against market risk.573 It may also provide some protection against issuer fraud risks.574 But it is 568

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H. Parry, ‘Hedge Funds, Hot Markets, and the High Net Worth Investor: A Case for Greater Protection’ (2001) 21 Northwestern Journal of International Business Law 703. The FSA acknowledged during its wider range products review that a threshold-based approach, based on net worth or investability criteria, would be based on ‘admittedly rough and ready criteria’: FSA, Discussion Paper No. 05/3, pp. 27–8. Choi, ‘Regulating Issuers Not Investors’. Notably, MiFID saw an attempt to introduce investor testing with respect to the application of disclosure requirements: see further ch. 5. Although online tests are being used in practice by investment firms to assess whether particular complex products are appropriate for investors as required under MiFID, Art. 19(5): M. Vincent, ‘Private Clients Will Face Tests’, Financial Times, 30 October 2007, p. 21. See further ch. 3. For a celebration of the benefits of diversification theory, including for ‘ordinary investors’, see M. Rubinstein, ‘Markowitz’s “Portfolio Selection”: A Fifty Year Retrospective’ (2002) 57 Journal of Finance 1041. E.g. FSA, Financial Risk Outlook 2005, p. 28. F. Easterbrook and D. Fischel, ‘Optimal Damages in Securities Cases’ (1985) 52 University of Chicago Law Review 611; R. Booth, ‘The End of Securities Fraud Class Action’ (2006) 29 Regulation 46; and, contra, E. Evans, ‘The Investor Compensation Fund’ (2007–8) 33 Journal of Corporation Law 223.

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regularly highlighted as a common retail investor weakness.575 Retail investors display a strong home bias576 and exit investments inefficiently.577 As outlined in section II above, diversification within asset classes, particularly equity, is generally poor across the EC and there is a strong home bias. Calls are frequently made for diversification to be incorporated into investor education strategies.578 But diversification should not simply be regarded in terms of financial literacy. A focus on diversification can facilitate regulators in deciding on the extent to which regulation should empower vulnerable investors and support easier access to the markets. Failure to address diversification risks while promoting an empowerment agenda also represents an abdication of responsibility to investors with respect to market risk.579 Diversification should be integrated into regulation and supervision, including in the suitability sphere (chapter 4). Diversification is, however, increasingly becoming associated with retail market policy. Internationally, the post-Enron reform movement in the US has been associated with the management of diversification risk,580 while the SEC’s developing mutual recognition model has been linked to better retail investor diversification.581 The FSA has also become concerned 575

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E.g. Campbell, ‘Household Finance’, 1570–1. Much of the evidence concerns poor asset selection in US pension funds (e.g. Benartzi and Thaler, ‘Naive Diversification’). Poor diversification has also been identified in US brokerage accounts (Jackson, ‘To What Extent?’), while evidence from the US Federal Reserve suggests that almost 60 per cent of individual investors surveyed hold stock in three or fewer companies and that approximately 35 per cent hold stock in only one company (Evans, ‘Investor Compensation Fund’, 234). E.g. W. Goetzmann and K. Kumar, Equity Portfolio Diversification (2008), ssrn abstractid=1081787; W. Bailey, A. Kumar and D. Ng, Foreign Investments of US Individual Investors: Causes and Consequences (2007), ssrn abstractid=633902; J. Coval and T. Moskowitz, ‘Home Bias at Home: Local Equity Preference in Domestic Portfolios’ (1999) 54 Journal of Finance 2045; and K. Lewis, ‘Trying to Explain Home Bias in Equities and Consumption’ (1997) 37 Journal of Economics Literature 571. Calvet et al., ‘Fight or Flight’. 578 See further ch. 7. ASIC has been urged to focus on diversification given in part that diversification is ‘modern financial theory at its most practical for retail investors’: Erskine, Retail Investors, pp. 7 and 9. Langevoort, Social Construction, p. 16; and Camerer et al., ‘Asymmetric Paternalism’, 1236 (many Enron employees had invested all or a significant proportion of their 401(k) employee pensions in Enron shares). The Enron-related Pensions Right to Know Act, which was not adopted, would have required 401(k) plan sponsors to advise participants on the importance of diversification. Jackson, ‘System of Selective Substitute Compliance’, 111; and Tafara and Peterson, ‘Blueprint’, 41. The SEC’s June 2007 Roundtable on Mutual Recognition also saw support for easier retail investor access to the international markets given the potential for better diversification: SEC, Unofficial Transcript of the Roundtable Discussion on Mutual Recognition (12 June 2002), p. 26 (comments by Karmel).

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with diversification.582 Its 2005 review of retail investor access to widerrange products suggested that the regulated CIS regime583 did not support wide choice and that a blanket prohibition on the public marketing of unregulated CISs (mainly non-UCITS alternative investment schemes) was restricting investors in developing their knowledge of investment products584 and did not adequately support risk-taking and wider access to diversification opportunities.585 The FSA ultimately supported an extension of the regulated product universe to allow non-UCITS regulated CISs to invest 100 per cent of their assets in unregulated CISs (this allows the public marketing of funds-of-hedge funds) in order to widen access to the greater risk-taking and diversification opportunities represented by these investments.586 Support of stronger retail market diversification can also be implied from the FSA’s recent review of the listing rules which apply to listed investment entities.587 The new approach liberalizes asset allocation588 and eschews prescriptive asset allocation rules589 in favour of a single-platform regime based on the exercise of board discretion and disclosure. It is designed to facilitate the listing of investment entities which pursue a wider range of strategies and more modern investment techniques.590

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Its review of financial capability, for example, addressed the importance of diversification (Establishing a Baseline, p. 17). See further ch. 1. 584 FSA, Discussion Paper No. 05/3, p. 23. Thereby contrasting sharply with the SEC’s tendency to weigh investor protection far more heavily than opportunity costs: J. Bethel and A. Ferrell, Policy Issues Raised by Structured Products (2007), ssrn abstractid=941720, p. 29. FSA, Funds of Alternative Investment Funds: Feedback on Consultation Paper 07/6 and Further Consultation (Consultation Paper No. 08/4, 2008), pp. 5 and 6; and FSA, Press Release, 22 February 2008 (FSA/PN/01(2008)), noting that the new regime would support greater consumer choice and create better opportunities for risk diversification. Including Implementation of the Transparency Directive/Investment Entities Listing Review (Consultation Paper No. 06/4, 2004); Investment Entities Listing Review (Consultation Paper No. 06/21, 2006) and Investment Entities Listing Review – Further Consultation (Consultation Paper No. 07/12, 2007). Consultation Paper No. 06/4, p. 61. The review was based on the premise that boards should not be constrained in undertaking investments they believe are in shareholders’ interests and should be permitted to adopt more sophisticated strategies. The earlier regime imposed a 20 per cent limit on single issuer investments and segmented the regime into five types of fund, including venture capital and property companies. The new regime is designed to accommodate more modern investment techniques, as well as private equity funds and single strategy hedge funds: FSA, Consultation Paper No. 06/21, pp. 4 and 8; Consultation Paper No. 07/12, p. 8; and FSA, Investment Entities Listing Review – Feedback on CP 07/12 and Final Handbook text (Policy Statement No. 07/20, 2007), p. 3.

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b) A patchy commitment to diversification: public offers, UCITS and the execution-only regime While diversification has been highlighted in the EC policy debate,591 it is pursued in a somewhat haphazard manner. More effective diversification has regularly been associated with integration.592 The combined effect of the Prospectus Directive, the E-Commerce Directive and the DMD is that traditional securities as well as investment products, including structured products, approved in one Member State, can now be marketed across the EC. The Prospectus Directive’s standardization of disclosure may also support stronger diversification practices, if investors accordingly become more familiar with cross-border issuers,593 although disclosure’s transformative abilities are limited. But there is little evidence that a pan-EC retail market for primary market offers has developed594 or of the Directive supporting stronger diversification.595 Issuer resistance,596 given the attractions of private placements, difficulties with the retail market summary prospectus,597 multiple opacities in the Directive,598 persistent retail investor difficulties with disclosure and the costs of cross-border trading, all represent considerable obstacles to the development of a cross-border retail market.599 591 592

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FSC Report, p. 20, noting household demand for diversified or less correlated asset classes. E.g. European Commission, European Financial Integration Report 2007, p. 7 and European Financial Integration Report 2008 (SEC (2009) 19), p. 6. The FSA’s Europe Economics MiFID study also pointed to the reduction in diversification costs which MiFID could generate: Europe Economics, The Benefits of MiFID: A Report for the Financial Services Authority (2006). T. Baums, Changing Patterns of Corporate Disclosure in Continental Europe: The Example of Germany, ssrn abstractid=345020; and C. Villiers, Corporate Reporting and Company Law (Cambridge: Cambridge University Press, 2006), p. 199. E.g. ICMA, Response to CESR’s Consultation on the Supervisory Functioning of the Prospectus Regime (2007), pp. 2 and 3; Sullivan and Cromwell, Response to CESR’s Consultation on the Supervisory Functioning of the Prospectus Regime (2007); and CSES Report, p. 22. CSES Report, pp. 18, 21 and 52, pointing to the still dominant home bias among retail investors, and suggesting that better portfolio diversification for retail investors was not among the Directive’s benefits. E.g. P. Ondrej, ‘ICMA’s Response to CESR on the Prospectus Directive and the Regulation’, ICMA Regulatory Policy Newsletters No. 5, April 2007, p. 2. See further ch. 6. Which have been the subject of three key reports: CSES Report; CESR, CESR’s Report on the Supervisory Functioning of the Prospectus Directive and Regulation (CESR/07-225, 2007); and ESME, Report on Directive 2003/71/EC (2007). E.g. S. Revell and E. Cole, ‘Practical Issues Arising from the Implementation of the Prospectus Directive – What Are the Equity Capital Markets Worrying About?’ (2006) 1 Capital Markets Law Journal 77; K. Craven, ‘Assessing the Impact of the Prospectus

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These weaknesses are mitigated by MiFID’s liberalization of order execution which facilitates investor access to the securities of issuers listed outside the investor’s domestic market. But third-country issuers face significant obstacles in accessing the Community capital market,600 limiting retail market diversification opportunities, and trading costs remain high.601 The UCITS regime is of central importance to effective diversification in that most retail investors engage with the markets through products. Effective diversification therefore often depends on product design. The UCITS regime (chapter 3) supports stronger investor diversification given the range of investments which a UCITS may make. But, as discussed in chapter 3, products remain complex, are proliferating and can often perform poorly. UCITS diversification rules are limited and product providers are not subject to any obligation to design products which are appropriate for the retail market. Distribution weaknesses and weak retail market competition dynamics are also hampering the construction of a pan-EC UCITS market; UCITS design is thus often closely related to long-standing local market asset preferences and so is less effective in delivering real diversification. Execution-only regimes play a key role in supporting investors in achieving low-cost diversification. MiFID’s Article 19(6) execution-only regime applies to a wide range of identified instruments, including shares admitted to trading on a regulated market or on an equivalent third-country market, bonds or other securitized debt (but excluding debt instruments which embed a derivative and are accordingly ‘complex instruments’ outside the scope of Article 19(6)), UCITS units, money-market instruments and other ‘non-complex instruments’. An instrument is ‘non-complex’ and eligible for execution-only sales where it is a non-derivative financial instrument, is liquid and easily realizable and does not involve any actual or potential liability for the client that exceeds the costs of acquiring the instrument (MiFID Level 2 Directive, Article 38). Disclosure is also used to govern the scope of the execution-only regime; ‘adequately comprehensive’ information on the instrument’s characteristics must be publicly available and must be likely to be readily understood so as to enable the ‘average

600 601

Directive’, ICMA Regulatory Policy Newsletters No. 5, April 2007; E. Ferran, Cross-Border Offers of Securities in the EU: The Standard Life Flotation (2006), ssrn abstractid=955252; and Moloney, EC Securities Regulation, pp. 128–31. E. Ferran, Building an EU Securities Market (Cambridge: Cambridge University Press, 2004), pp. 205–6. See further ch. 6.

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retail client’ to make an informed judgment as to whether to enter into a transaction in that instrument. The wide range of products which can be sold execution-only and the reliance on disclosure implies a facilitative approach to market access and to diversification opportunities.602 But there are difficulties with the regime. The exclusion of derivatives, which was strongly resisted by the industry during the level 2 negotiations,603 is problematic. Investors’ opportunities to manage risk and diversify and their learning opportunities are limited by this broad exclusion604 which reflects a traditional and paternalistic approach to investor protection.605 MiFID acknowledges that some Member States have developed active execution-only retail markets in derivatives and that, in certain circumstances, the ‘appropriateness’ suitability test (which would otherwise apply under MiFID Article 19(5) to the sale) is assumed to be met.606 The industry may also be willing to reduce the costs of the appropriateness test. Spread-betting products and contracts for differences (CFDs),607 which have enjoyed strong retail market growth in the UK,608 come within MiFID’s scope609 but are complex products under

602

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CESR’s advice (reflected in Art. 38) was designed to provide the necessary flexibility for a wide range of existing and innovative financial instruments: CESR, Technical Advice on Level 2 Implementing Measures on the First Set of Mandates Where the Deadline Was Extended and the Second Set of Mandates: Markets in Financial Instruments Directive: Feedback Statement (2005, CESR/05-291b) (‘Second Mandate Advice Feedback Statement’), p. 26. Further guidance on the complex/non-complex distinction is being provided by the Commission through its MiFID Q and A which takes a more conservative approach. The Commission has suggested, for example, that warrants and convertible bonds are complex products: European Commission, ‘Your Questions on MiFID’ website. Second Mandate Advice Feedback Statement, p. 26. Bethel and Ferrell caution against over-regulating derivative-based products given the benefits they offer in terms of low transaction costs: Policy Issues, p. 23. It has been suggested that MiFID ‘demonizes derivatives’ and adopts an ‘overly crude and generalized’ approach: A. Knight, ‘MiFID’s Impact upon the Retail Investment Services Markets’ in C. Skinner (ed.), The Future of Investing in Europe’s Markets after MiFID (Chichester: John Wiley & Sons, 2007), p. 207. MiFID Level 2 Directive, recital 59. Spread-betting products and CFDs, which are developed by specialist firms, allow investors to bet on price movements in the financial markets without taking delivery of the underlying assets: C. Brady and R. Ramyar, White Paper on Spread Betting (2007), pp. 9–10. Annual growth rates of between 20 per cent and 26 per cent have been predicted: ibid., p. 11. The FSA has also reported strong retail activity in the spread-betting market: FSA, Implementing MiFID’s Best Execution Requirements (Discussion Paper No. 06/3, 2006). Under MiFID, Annex I, sect. C. The importance of MiFID’s application to this sector is reflected in the series of questions on the Commission’s ‘Your Questions on MiFID’ website which ask whether CFDs come within its scope (the Commission has responded

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Article 19(6).610 But, rather than retreat from the retail market, the industry response appears to have been to develop appropriateness questionnaires and tests.611 Nonetheless, the regime remains conceptually untidy, it is likely to entrench local market preferences and it does not support investor learning. Neither does the exclusion of derivatives reflect the injection of derivatives into the UCITS III regime and the tacit acceptance that the retail market should be exposed to opportunities to take on higher levels of risk. UCITS do support diversified access to derivatives. But it is also the case that the UCITS spectrum includes high-risk CISs designed for the institutional sector but which can trickle down to the retail markets. These products can be sold execution-only. The regime will appear all the more clumsy if the level 2 requirements for ‘non-complex’ investments do not adequately capture the potential liquidity, insolvency and transparency risks of structured retail products,612 which became clear over the ‘credit crunch’ and particularly with respect to the Lehman insolvency.613

b) Supporting access to different asset classes: the debt markets example The pursuit of retail market diversification demands nuanced decisions as to how far regulatory policy should go in easing investor access to different asset classes. Two notable examples arise from current EC policy: the treatment of alternative investments (chapter 3); and the debt markets. Bond investments can provide investors with relatively stable returns and some protection against market risk.614 But they are sensitive to interest rate movements, are exposed to default risk (as the ‘credit crunch’ made

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in the affirmative, unless the underlying instrument does not come within MiFID, such as a contract which relates to a political or sports event). Which has been confirmed by the Commission on its ‘Your Questions on MiFID’ website. D. Thomas, ‘Regulation: The Day of the MiFID Approaches’, Financial Times, 28 September 2007, available via www.ft.com. The mis-selling of precipice bonds in the UK, for example, saw the FSA express concern as to the quality of disclosure in direct offer mailings: FSA, Press Release (FSA/PN/026/2003). CESR has raised concerns as to whether the criteria according to which structured products are determined to be ‘non-complex’ are adequate and is to prepare level 3 guidance: CESR, The Lehman Brothers Default: An Assessment of the Market Impact (2009) (CESR/09-255, 2009), p. 3. The autumn 2008 convulsions in world stock markets saw some support for bond investments in the media. E.g. H. Connon, ‘Don’t Put It under the Floorboards – There Are Still Safer Places for Cash’, The Observer, 12 October 2008, Cash, p. 13.

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clear615 ) and emerging market and high-yield bonds can pose significant risks.616 Retail investors are increasingly becoming exposed to the bond markets,617 not least as governments improve the distribution of sovereign bonds618 and following retail investor aversion to the equity markets in the wake of the dotcom crash,619 and they are popular investments in some parts of the EC market.620 Although the Commission appears to support wider access to the debt markets,621 the EC’s approach to debt market access has been quixotic. The Prospectus Directive seems, albeit unintentionally, to have reduced the retail debt market and so limited diversification opportunities.622 Issuers have avoided retail market offerings, as an approved prospectus is not required for debt offerings with denominations of at least €50,000.623 Confusion over the application of prospectus requirements to the ‘retail 615

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Dramatic inflows of retail investor funds into corporate bond funds in the UK, based on falling prices as spreads widened and on expectations that prices would rise if the risk premium eventually fell, raised some industry concern in early 2009 given higher default risks: S. Johnson, ‘Bond “Hype” Causing Concern’, Financial Times, Fund Management Supplement, 26 January 2009, p. 2. F. Salmon, ‘Stop Selling Bonds to Retail Investors’ (2004) 35 Georgetown Journal of International Law 837. IOSCO, Transparency of Corporate Bond Markets (IOSCO, 2004), p. 4. The 2007 IOSCO prospectus standards for debt offerings reflect the increased participation of retail investors in the debt markets: IOSCO, International Disclosure Principles for Cross-Border Offerings and Listings of Debt Securities by Foreign Issuers (IOSCO, 2007), p. 1. In the US, the TRACE reporting system shows that 65 per cent of the reported trades are below US$100,000 in value and associated with retail investment: FSA, Trading Transparency in UK Secondary Bond Markets (Discussion Paper No. 05/5, 2005), p. 14. Initiatives to improve direct access by retail investors have been undertaken in Spain, France, and the UK: BME Report, p. 109 (including the Private Investor’s Guide to Gilts (2006), issued by the UK Debt Management Office). FSA, Financial Risk Outlook 2006, p. 50. 620 See further ch. 1. European Commission, Call for Evidence: Pre- and Post-Trade Transparency Provisions of MiFID in Relation to Transactions in Classes of Financial Instruments Other Than Shares (2006), p. 5. ICMA reported that the ‘failure to create more investment opportunities’ was particularly disappointing given growing demand for a pan-EC retail market in debt securities: ICMA, Response to CESR’s Consultation on the Supervisory Functioning of the Prospectus Regime (2007), p. 6. CSES Report, suggesting that the exemption has led to a reduction in the retail debt market from €147.4 billion (2003) to €97.6 billion (2007), with significant effects in the traditionally large retail debt markets in France, Italy and Germany (DaimlerChrysler has stopped issuing bonds below €50,000) (pp. 55–6, 59 and 62). ESME had earlier reported that, while only 8 per cent of bonds listed in Stuttgart (a major debt venue) had a denomination of €50,000 in 2005, this had risen to 42 per cent in 2006: ESME, Report on Directive 2003/71/EC, p. 14.

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cascades’ typically used to distribute private placements of debt securities in the retail sector is also restricting retail access.624 It must be acknowledged that the Directive was negotiated in the cauldron of industry agitation and political compromise and that the Commission appears to be responding to the debt market problem.625 But the Directive’s unintended effects provide, nonetheless, an important lesson for future regulatory design and suggest that diversification should be a guiding principle for law-makers. Retail market interests and diversification were more to the fore during the Commission’s 2007–8 consultations on whether MiFID’s controversial equity-market trading transparency requirements should be extended to the debt markets. Although wholesale market concerns dominated (reflecting concerns as to damage to liquidity were transparency requirements imposed), the consultation process revealed considerable evidence that bond-market transparency information cannot easily be accessed by retail investors and that they have difficulties in accessing the bond markets.626 But the promotion through transparency regulation of easier access to the debt market is risky given the wider liquidity risk which greater transparency poses. It is also risky as retail investor familiarity with the debt markets varies very considerably across the EC.627 Retail market diversification can also be achieved indirectly through the UCITS product and exchange-traded funds. FIN-USE, however, trenchantly supported a widening of investment horizons beyond the equities markets and a ‘MiFID-like’ mandatory transparency regime.628 While the FSA accepted the possibility that enhanced transparency rules might support easier retail access, it was less convinced that ‘it had a role to promote retail participation as an end in itself’ although 624 625

626

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CSES Report, pp. 62–3 and 64. Its 2009 agenda for prospectus reform proposed that issuer choice of prospectus supervisor be allowed for all non-equity offerings and that subsequent prospectuses not be required at each stage of a placement of securities: European Commission, Background Document: Review of Directive 2003/71. Centre for Economic Policy Research (B. Biais, F. Declerck, J. Dow, R. Portes and E.-L. von-Thadden), European Corporate Bond Markets: Transparency, Liquidity and Efficiency (CEPR, 2006); CESR, Non Equity Market Transparency, Consultation Paper (CESR/07-284, 2007; and ESME, Non-Equity Market Transparency (2007). See further ch. 1. The FSA’s FSCP warned that the large majority of UK retail consumers would not necessarily appreciate bond market risks: FSCP, Response to FSA Discussion Paper 05/5 (2005), p. 1. FIN-USE, Response to Call for Evidence: Pre- and Post-Trade Transparency Provisions of MiFID in Relation to Transactions in Classes of Financial Instruments Other Than Shares (2006).

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it was concerned as to whether aspects of the bond markets’ operation might deter retail involvement.629 It also found no hard evidence that transparency difficulties were frustrating retail investor involvement;630 an interesting choice might have arisen had the evidence been different, given earlier FSA support for the retail debt market during prospectus regime reforms.631 In a very different market context,632 by contrast,633 a CONSOB official suggested that, if higher transparency levels were to reduce transaction costs, wider participation in the bond markets might follow634 and CONSOB supported a harmonized regime. CESR, which has adopted a retail market agenda (chapter 7), suggested that greater retail participation in the bond markets might follow from an increase in transparency levels.635 But it supported a market-driven solution to transparency risks. The high profile of retail-market-access difficulties during the consultation process and the implicit threat of intervention appears to have prompted a self-regulatory response from the industry. The International Capital Market Association (ICMA) adopted in September 2007 a Standard on bond market transparency which is designed to improve the quantity and accessibility of price and liquidity information for retail investors concerning liquid and highly rated bonds.636 Industry investor education 629 630 631 632 633

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FSA, Discussion Paper No. 05/5, pp. 5 and 7. FSA, Trading Transparency in the UK Secondary Bond Markets (Feedback Statement No. 06/4, 2006), pp. 22 and 24. FSA, Implementation of the Prospectus Directive (Policy Statement No. 05/7, 2005), p. 14. Bond investments are popular in Italy. See further ch. 1. Support for retail market access was stronger in those markets where retail investors are active. The Danish Shareholders’ Association (in their response to CESR’s consultation), for example, argued that, if retail investors were persistently excluded from the bond markets, the Commission should intervene to ensure market access and access to transparency. The Italian Banking Association similarly argued that limited transparency could seriously hamper retail investors’ direct participation in the market: European Commission, Feedback Statement, Pre- and Post-Transparency Provisions of MiFID in Relation to Transactions in Classes of Financial Instruments Other Than Shares (2006), p. 10. C. Salini (Head of Markets and Economic Research Division – CONSOB), Contribution at ABI Conference on ‘Bond Markets in Italy: Transparency and Regulatory Issues’, 19 March 2007, available via www.consob.it, para. 1.1. CESR, Response to the Commission on Non-Equities Transparency (CESR/07-284b, 2007) (‘CESR Bond Market Advice’). ICMA, European Financial Services Industry Standard of Good Practice on Bond Market Transparency for Retail Investors (2007). The ICMA regime supports ‘BondMarketPrices.com’ which provides free data on higher quality investment grade bonds with a large issue size. Bond market transparency data is also provided by SIFMA through its www.investinginbondsEurope.com site.

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measures were also taken.637 The Commission’s final report on debt market transparency, delivered in April 2008,638 acknowledged some problems with retail investor access to bond market prices but decided against regulatory intervention. While retail market transparency remained an ‘area of potential concern’, it concluded that market participants were well placed to enhance retail investor access to bond prices and ‘for the time being’ supported self-regulatory measures.639 The debt market access debate ultimately delivered a relatively nuanced response to access and diversification risks. The commitment to industry monitoring appears real. Following a series of difficulties in the debt markets over the ‘credit crunch’, including a contraction of liquidity, a widening of spreads, valuation difficulties and a lack of post-trade information, CESR has reopened the transparency debate and asked whether greater transparency would ease the market difficulties.640 But the consultation also addresses retail market risks. While CESR still appears committed to a self-regulatory solution, it is unhappy with the industry’s efforts to promote retail market transparency and concerned as to delays in the data provided, its limited coverage and a failure to provide trade-by-trade data. It has called for the content and timing of the data supplied to be enhanced. Member States also remain empowered to adopt retail market debt market transparency rules (MiFID, recital 46). But the risks of a ‘one-sizefits-all’ approach, considerable given sharply diverging bond investment patterns, are avoided; Italy’s adoption of a transparency regime in 2008, which responds to its large retail market, can be accommodated under the current approach. The debt market issue also underlines the importance of framing the regulatory question in the right way. Given the nascent state of the retail markets and the availability of indirect bond investments, the key regulatory question seems to be whether investors are appropriately advised on debt market risks, not whether transparency might support better access. As the losses sustained by retail investors in the Parmalat corporate bond collapse641 and the Argentine government bond default made clear, bond 637 638 639 640 641

See further ch. 7. European Commission, Report on Non-Equities Market Transparency Pursuant to Article 65(1) of Directive 2004/39/EC on Markets in Financial Instruments (2008). Ibid., pp. 10 and 12–13. CESR, Transparency of Corporate Bond, Structured Finance Product, and Credit Derivatives Markets: Consultation Paper (CESR/08-1014, 2008). The Parmalat scandal concerned a massive bankruptcy involving looting by controlling shareholders (through off-balance sheet transactions via special purpose vehicles) and

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market risk to retail investors is often a function of conflict-of-interest642 and suitability risks in the advice relationship.643 Retail investors tend to hold debt securities long-term and do not typically trade in these securities; the initial investment advice relationship (where advice is taken) is therefore the critical point for targeted investor protection measures, not transparency information. Investor protection in the bond markets therefore depends heavily on the effectiveness of MiFID’s suitability/appropriateness and best execution regimes. It also depends on whether the execution-only regime ensures that only non-complex debt instruments are sold without advice; the MiFID advice regime may have what could be the salutary effect of reducing sales of complex bonds and increasing sales of diversified UCITS bond schemes.644

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failures in financial reporting which broke towards the end of 2003. Parmalat engaged in a final and worthless €150 million bond issue, a substantial proportion of which flowed to the retail sector: G. Ferrarini and P. Guidici, Financial Scandals and the Role of Private Enforcement: The Parmalat Case (2005), ssrn abstractid=730403. Conflict-of-interest management was a strong feature of the policy debate on Parmalat: for example, European Commission, Preventing and Combating Financial Malpractice (2004) (COM (2004) 611); and ESC, Minutes, 17 February 2004. ESME, Non-Equity Market Transparency, p. 10; and CESR Bond Market Transparency Advice, p. 15. CESR Bond Market Advice, p. 14. Although bond schemes are popular in Southern Europe, UK CIS bond investments are increasing. Between 2001 and 2004, unit trusts and openended investment companies increased their investments in UK corporate bonds from £12.9 billion to £23 billion: FSA, Discussion Paper No. 05/5, p. 14.

3 Product regulation

I. Product regulation and the retail markets 1. The EC and product regulation Retail investment products (sometimes termed ‘packaged products’1 ) can take myriad forms. They include mutual funds or collective investment schemes (CISs) which pool investor assets (whether held in a corporate or other form and whether represented by a share or other unit), are managed according to investment mandates and redeem investors’ investments on demand (or are ‘open-ended’); these structures are the main concern of EC product regulation. Investment trusts or companies which engage in investment business and in which investors hold often listed shares, unitlinked insurance products and a burgeoning array of structured retail investment products are also popular retail market products.2 Product design regulation, typically linked to the authorization of the product for public marketing and so associated with segmentation-based regulation, is one of the three arcs of retail market protection along with the regulation of distribution and disclosure. Product regulation in the EC regime is largely a function of the ‘UCITS’ regime which provides a cross-border marketing passport for CISs in the form of UCITS and their management companies.3 Major reforms in 2002 (the UCITS III reforms) significantly increased the range of UCITS investable assets. The UCITS IV reforms,4 currently in train, are designed to bring efficiencies to the 1

2 3

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A term strongly associated with UK Financial Services Authority (FSA) regulation but which the European Commission adopted in its April 2009 Communication which responded to the substitute products debate: European Commission, Communication from the Commission to the European Parliament and the Council: Packaged Retail Investment Products (COM (2009) 204). Sect. IV below. Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities, OJ 1985 No. L375/3. The UCITS IV Proposal to reform and recast the UCITS regime has been through its Parliamentary reading. References to the reform (the ‘UCITS Recast’ or ‘UCITS IV’) are

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UCITS market and to reform the UCITS disclosure regime (chapter 5). But, and mitigating the harmonization risks, the EC product regime is by no means monolithic, certainly by comparison with MiFID. Many different forms of investment product are marketed and regulated domestically and respond to local market preferences and regulatory requirements.5 But, as discussed in section IV below, regulatory arbitrage risks, particularly between heavily regulated UCITS and other products, are considerable. The 1985 UCITS CIS regime was designed as a supply-side measure and to support cross-border UCITS marketing; it was crafted long before the retail market had impinged seriously on EC policy and regulation.6 The 2002 UCITS III reforms were also adopted without institutional engagement with retail market investments patterns, distribution and advice risks, and the role of product regulation in supporting investment and risk-taking.7 More recently, however, the UCITS regime has become closely tied to EC retail market policy, the promotion of long-term savings8 and the market engagement movement.9 The 2005 Commission Investment Funds Green Paper identified the UCITS as part of the solution to the

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to the European Parliament text: European Parliament, Legislative Resolution of 13 January 2009 on the Proposal for a Directive of the European Parliament and of the Council on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (2009) (P6 TA-PROV(2009)0012, 2009). Non-UCITS domestic regulation tends to be diverse. It ranges from no recognition for nonUCITS schemes (Poland) to detailed local regulation (e.g. Germany, Italy, Luxembourg and Ireland): PricewaterhouseCoopers, The Retailisation of Non-Harmonised Investment Funds in the European Union (2008) (‘2008 PwC Retailization Report’), p. 7. Ch. 1 outlines the UK domestic regime. J. Gray, ‘Personal Finance and Corporate Governance: The Missing Link: Product Regulation and Policy Conflict’ (2004) 4 Journal of Corporate Law Studies 187, 201. The Commission’s proposals (COM (93) 37, COM (94) 329 and COM (98) 449) do not grapple with UCITS policy as a mechanism for promoting investment. ECOSOC only tentatively suggested that the UCITS regime should support ‘small investors’ in achieving diversification (1999 OJ No. C116/44, paras. 1.1 and 3.6.5), while the European Parliament (A4-0232/99, 1999) suggested the regime could ‘inspir[e] confidence in listed shares and bonds’ (Opinion of the Committee on Economic and Monetary Affairs, para. 1). The Council was primarily concerned with market integration and cross-border UCITS marketing: Council Common Position (2001 OJ No. C297/35), Statement of Reasons, II, Aim of Proposal. Commissioner McCreevy has highlighted the potential of CISs as the ‘vehicle of choice for private retirement provisioning’: Speech to Commission Hearing on Investment Funds, 13 October 2005, available via http://europa.eu/rapid/searchAction.do. ‘If widespread retail investment in investment funds is to be encouraged, then a sound regulatory framework is needed’: Commissioner McCreevy, Speech on ‘Retail Financial Services and the Consumer’, 26 January 2005, available via http://europa.eu/rapid/searchAction.do.

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EC’s pension deficit,10 while the 2006 White Paper characterized CISs in benign terms as providing ‘small investors’ with access to professionally managed and diversified investments.11 Empowerment and responsibilization themes can be identified in the policy and industry rhetoric, which often characterizes the UCITS as a ‘household product’ with risk levels appropriate for retail investors,12 and in the related ‘branding’ of the UCITS product,13 which enjoys some retail stakeholder support.14 The European asset management industry has frequently argued that the industry can foster financial independence and generate better returns for retirement provisioning.15 Reflecting a wider institutionalization of the retail markets and a shift from direct investments,16 CIS investments (dominated by UCITS) rank ahead of direct investments in popularity across the EC, although behind bank deposits and, significantly for regulatory arbitrage risks, insurancerelated investment products.17 The industry is, nonetheless, significant.

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European Commission, Green Paper on the Enhancement of the EU Framework for Investment Funds (COM (2005) 314) (‘Investment Funds Green Paper’), pp. 3 and 16. European Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (COM (2006) 686) (‘Investment Funds White Paper’), p. 2. Deutsche Bank Research, EU Asset Management (EU Monitor No. 37, 2006), p. 6, describing the UCITS as an investment with a degree of risk and complexity that ordinary investors can be expected to bear. Well illustrated by the concern of the European Fund and Asset Management Association (EFAMA) that the Madoff scandal might damage the UCITS brand and its assertion that the UCITS Directive provided extensive investor protection: EFAMA, Press Release, 15 January 2009. The UK FSA’s Financial Services Consumer Panel (FSCP) has suggested that, with respect to UCITS, ‘product regulation has been a clear success’: FSCP, Response to the FSA on DP05/3 Wider Range Retail Investment Products (2005), p. 3. An early 2009 industry report, for example, called for the UCITS to become the primary vehicle for retirement savings: P. Skypala, ‘Squabbling over Pan-European Funds’, Financial Times, Fund Management Supplement, 9 February 2009, p. 6. E.g. W. Gerke, M. Bank and M. Steiger, ‘The Changing Role of Institutional Investors – A German Perspective’ in K. Hopt and E. Wymeersch (eds.), Capital Markets and Company Law (Oxford: Oxford University Press, 2003), p. 357; L. Zingales, The Future of Securities Regulation (2009), ssrn abstractid=1319648; R. Deaves, C. Dine and W. Horton, How Are Investment Decisions Made?, Research Study prepared for the Task Force to Modernize Securities Legislation in Canada (2006) (‘Deaves Report’), p. 263 (reporting that 81 per cent of Canadian retail investors hold mutual funds and 57 per cent hold stock). Institutional investors, including CISs, have ‘enhanced their role as collectors of savings’: Ageing and Pension System Reform: Implications for Financial Markets and Economic Policies (2005) (a report prepared at the request of the Deputies of the G10 by an experts’ group chaired by I. Visco, Banca d’Italia), p. 17. See also n. 80 below. See further ch. 1.

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UCITS represent 80 per cent of the total EC CIS market.18 The UCITS has established a global reputation,19 overtaking US mutual funds as the leading international fund investment.20 But the extent to which the UCITS has become a template for CIS design and investor protection across the Member States, the prevalence of retail investment in UCITS,21 and its status as the preferred EC policy vehicle for supporting long-term savings, means that the risks are significant if its regulatory design is weak.

2. The benefits of CIS product regulation The regulation of investment products, and in particular of CISs, has long been a component of retail market regulation, although it has recently become less fashionable.22 Regulation, certainly in the Anglo-American context, has traditionally been associated with the agency costs and conflict-of-interest risks which follow when investor funds are entrusted to the CIS.23 The potential of schemes for concentrating corporate control has also been associated with the development of the US regulatory regime.24 The stakes have become higher, however, as the CIS industry has burgeoned,25 as CIS policy becomes more central to retail market 18

19 20 21

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Deutsche Bank, EU Asset Management, p. 1. Assets under management have been estimated at €7.6 trillion: PricewaterhouseCoopers, Investment Funds in the European Union: Comparative Analysis of Use of Investment Powers, Investment Outcomes and Related Risk Features in Both UCITS and Non-Harmonised Markets (2008) (‘2008 PwC Investment Powers Report’), p. 13. EFAMA, Annual Asset Management Report: Facts and Figures (2008), p. 9. S. Johnson, ‘How UCITS Became a Runaway Success’, Financial Times, Fund Management Supplement, 27 November 2006, p. 3. EFAMA, Annual Asset Management Report 2008, p. 12. This reflects the US market where first-time equity investors, ‘the ones on training wheels and especially deserving of regulatory attention’, are far more likely to invest in equity mutual funds than in individual shares: H. Hu, ‘The New Portfolio Society, SEC Mutual Fund Disclosure and the Public Corporation Model’ (2005) 60 Business Lawyer 1303, 1307. FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009) (‘Turner Review’), p. 87. T. Frankel and L. Cunningham, ‘The Mysterious Ways of Mutual Funds: Market Timing’ (2006) 25 Annual Review of Banking and Financial Law 235; and A. Page and R. Ferguson, Investor Protection (London: Weidenfeld and Nicolson, 1992), pp. 182–3. M. Roe, ‘Political Elements in the Creation of a Mutual Fund Industry’ (1991) 139 University of Pennsylvania Law Review 1469. A. Khorana, H. Servaes and P. Tufano, Explaining the Size of the Mutual Fund Industry Around the World (2004), ssrn abstractid=573503. In the US context, Mahoney, for example, has pointed to the dramatic increase in mutual fund investment between World War II (US$1.2 billion) and 2002 (US$6 trillion) (P. Mahoney, ‘Manager–Investor Conflicts

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regulation26 and as CIS regulation has become more closely associated with regulatory efforts to engineer stronger market engagement. A recurring feature of the CIS debate is the argument that retail investors should (and should be encouraged or even compelled to27 ) access the markets through lower-cost,28 diversified, passive (index-tracking) CISs;29 this reflects engagement concerns but, in steering the investor towards collective rather than direct investments, also has strong resonances with the need to protect vulnerable trusting investors. Reflecting EC policy enthusiasm for the UCITS product, the FSA, for example, has supported collective investment as allowing retail investors to achieve higher returns than those available from deposits.30 Related to this, product-based regulation of CISs can be regarded as, in effect, ‘quasi-marketing’ these investment products as being somehow ‘appropriate’ for the retail markets. This has some intuitive appeal, particularly for vulnerable, but engaged and trusting, investors. CIS investment may address behavioural defects31 given the delegation of decisionmaking to an expert scheme manager and may mitigate the risks of poor

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in Mutual Funds’ (2004) 18 Journal of Economic Perspectives 161), while Choi and Kahan highlight the 20,000 per cent growth in assets under management between 1965 and 2004 (S. Choi and M. Kahan, ‘The Market Penalty for Mutual Fund Scandals’ (2007) 87 Boston University Law Review 1021). The US SEC’s regular monitoring of household mutual fund investment has been characterized as a proxy for the relative effectiveness of its enforcement policy as well as an indicator for market confidence: Frankel and Cunningham, ‘Mysterious Ways’, 255. In an oft-cited proposal, Choi has suggested that retail investors be corralled into tracker funds: S. Choi, ‘Regulating Investors Not Issuers: A Market-Based Proposal’ (2000) 88 California Law Review 279. Less radically, Zingales has suggested that the benefits of CIS investment are such that broker/investor contracts for direct investment should contain a risk warning as to the risks of direct investment: Zingales, The Future of Securities Regulation, p. 28. Although retail investors are poor at choosing low cost funds: sect. I.3.b below. From an extensive and primarily US scholarship, see, for example, H. Jackson, ‘To What Extent Should Individual Investors Rely on the Mechanisms of Market Efficiency: A Preliminary Investigation of Dispersion in Investor Returns’ (2003) 28 Journal of Corporation Law 671; L. Ribstein, ‘Bubble Laws’ (2003) 40 Houston Law Review 77; D. Langevoort, ‘Rereading Cady Roberts: The Ideology and Practice of Insider Trading Regulation’ (1999) 99 Columbia Law Review 1319; and D. Langevoort, ‘Selling Hope, Selling Risk: Some Lessons from Behavioral Economics about Stockbrokers and Sophisticated Investors’ (1996) 84 California Law Review 627. FSA, Informing Consumers at the Point of Sale (Consultation Paper No. 170, 2003), p. 5 (while also acknowledging the risks). G. La Blanc and J. Rachlinski, In Praise of Investor Irrationality (2005), ssrn abstractid=700170, p. 22.

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decision-making in the direct trading context.32 Collective investment trading costs, particularly for passive schemes, are lower than direct trading costs.33 Schemes, and their supporting regulatory regimes, can, as is often highlighted,34 support stronger diversification35 (although equity-marketindexed schemes can be less effective than balanced funds36 ), particularly through international portfolios,37 and so manage general market risks.38 Intermediation through a CIS can mitigate the risks of counterparty failure; the ‘credit crunch’ saw exchange-traded funds (ETFs), and particularly bond schemes, increase in popularity.39 CIS investment and CIS regulation can facilitate retail investor access to higher-risk/higher-return schemes. The FSA’s development in 2008 of a fund-of-hedge-funds vehicle (within the domestic non-UCITS regime), in order to support stronger retail returns and better diversification, saw close attention to product design,40 including the liquidity and valuation risks of scheme investment in hedge funds assets.41 Liquidity and easy redemption, typically sought by retail investors42 but also protections against general market risk, can 32

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E.g. B. Barber, Y.-T. Lee, Y.-J. Liu and T. Odean, ‘Just How Much do Individual Investors Lose by Trading?’ (2009) 22 Review of Financial Studies 609, finding that individual portfolios suffered an annual performance penalty of 3.8 per cent. See further ch. 6. A major survey into the cost of active investment in US equity has found that the costs of active trading amounted to 0.82 per cent of the value of all NYSE, Amex and Nasdaq stocks in 1980 and 0.75 per cent in 2006. Passive investment represented only 0.18 per cent of the aggregate market capitalization in 1980 and 0.09 per cent in 2006: K. French, ‘Presidential Address: The Cost of Active Investing’ (2008) 63 Journal of Finance 1537. E.g. Mahoney, ‘Manager–Investor Conflicts’, 162–3; and J. Freeman and S. Brown, ‘Mutual Fund Advisory Fees: The Costs of Conflicts of Interests’ (2001) 26 Journal of Corporation Law 609, 614. E.g. Jackson, ‘To What Extent’ (finding substantially higher rates of return for diversified equity and bond mutual funds than for employee 401(k) pension funds). Nonetheless, one financial crisis analysis has suggested that conservative index funds, traded on an exchange, could become ‘building blocks for new retirement savings products’: J. Authers, ‘Is It Back to the Fifties?’, Financial Times, 25 March 2009, p. 9. W. Bailey, A. Kumar and D. Ng, Foreign Investments of US Individual Investors: Causes and Consequences (2007), ssrn abstractid=633902. EC investors increasingly seek diversification through CISs and exchange-traded funds: Centre for Strategy and Evaluation Services, Study on the Impact of the Prospectus Regime on EU Financial Markets (2008) (commissioned by the European Commission) (‘CSES Report’), p. 21. R. Sullivan, ‘Passive Fund Sector Ticks All the Boxes for Growth’, Financial Times, Fund Management Supplement, 19 January 2009, p. 3. FSA, Press Release, 22 February 2008 (FSA/PN/01(2008), noting that the new regime would maintain consumer protection through product controls. FSA, Funds of Alternative Investment Funds (Consultation Paper No. 07/6, 2006) and Funds of Alternative Investment Funds (Consultation Paper No. 08/4, 2008). J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 189.

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also be supported as open-ended CISs allow redemption on request by investors at a price related to the scheme’s net asset value (NAV). Overall, CISs can facilitate mass market access to market investments43 and may mitigate the market risks faced by retail investors. Product regulation of this type also presents multiple design possibilities and, in its potential for commoditizing the retail product market, may represent a more appealing expression of consumerism in retail market regulation than the empowerment model with its over-emphasis on autonomy and choice. It allows the creative regulator to steer retail investors towards preferred outcomes and, in particular, asset allocations which hedge against market risk.44 By combining protection with support of diversification and access to a range of investment strategies, CIS product design strategies can address a range of abilities and risk appetites. They can also address product clarity, simplicity and costs. Product regulation can also mitigate regulatory risks. The risks of disclosure regulation may be countered by asset allocation and governance requirements which transfer much of the risk decision from the investor to the scheme.45 CIS product regulation can also ease some of the immense pressure on distribution and advice regulation by simplifying schemes and by embedding advice elements within schemes (through product design and related labelling techniques).46 This model has been attempted by the UK stakeholder/Sandler products regime, which also highlights how product regulation can be used ‘in action’ to support wider engagement with the financial markets. The 2002 Sandler Report into failures in the long-term savings market,47 which recommended that a suite of low-cost savings and investment 43

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The US mutual fund industry has been described as ‘democratizing capitalism’: E. Roiter, ‘Delivering Fiduciary Services to Middle and Working Class Investors’ (2004) 23 Annual Review of Banking and Financial Law 851, 852. H. Hu, ‘Illiteracy and Intervention: Wholesale Derivatives, Retail Mutual Funds, and the Matter of Asset Class’ (1996) 84 Georgetown Law Journal 2319, 2378. H. Jackson, ‘Regulation in a Multi-sectored Financial Services Industry: An Exploration Essay’ (1999) 77 Washington University Law Quarterly 319; and A. Palmiter, ‘The Mutual Fund Board: A Failed Experiment in Regulatory Outsourcing’ (2006) 1 Brooklyn Journal of Corporate, Financial, and Commercial Law 165. ASIC’s deputy Chairman, for example, has suggested that regulation should consider whether advice could be embedded within investment products given that the more functional and well designed a product is, the more limited the advice needs: J. Cooper, Deputy Chairman ASIC, ‘Retail Investors – What More Can or Should We Do to Help Retail Investors Build Long-Term Wealth?’, ASIC Summer School July 2008 Papers, p. 5. The Sandler Report, Medium and Long-Term Retail Savings in the UK: A Review (2002) (‘Sandler Report’).

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products be developed to overcome consumer reluctance to save, to reduce product costs and complexity and to address the commission risks posed by distribution, relied heavily on product design.48 The ‘stakeholder’ products regime which followed is based on a suite of simple, low-cost and price-capped and risk-controlled49 products; the medium-term investment product, which includes a CIS,50 is subject to a principles-based asset allocation regime which includes a 60 per cent limit on equity and property-related investments.51 The regime has been regarded as a key element of the UK strategy for delivering investor protection and supporting long-term savings,52 although its success has been questioned and it came under review as part of the FSA’s Retail Distribution Review.53 Product regulation does not, however, have to be associated with product design. It can also be used as a means of attaching specific disclosure and advice/distribution rules to sales of retail investment products which are particularly risk-prone. The FSA’s ‘packaged products’ regime is designed to ensure that particular distribution/advice, disclosure and conflict-ofinterest protections apply to the sale of nominated investment products (including CISs) which are widely sold in the mass market but which are often opaque and complex, are prone to investor misunderstanding and confusion and the sale of which can be prone to commission risk.54 The EC investment product regime, such as it is, has not taken this approach, focusing on product design. But a change of approach may be in the offing. The Commission’s radical April 2009 Communication on packaged products, in which it set out its response to the substitute products 48

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‘[T]he heart of the solution lies in product regulation . . . [P]roduct regulation provides an embedded means of protection that does not rely on advice and so minimizes the fixed cost element of interacting with the consumer’: ibid., p. 23. These features define the regime: HM Treasury, ‘Stakeholder’ Savings and Investment Products Regulation: Government Response (2004), p. 5. The suite encompasses: a cash deposit account; a medium-term investment product (either a CIS or a unit-linked life insurance product and including a ‘smoothed’ investment product option); a long-term stakeholder pension; and an equity-based Child Trust Fund. The smoothed product is designed to provide smoothed equity market exposure for entrylevel investors who want to avoid the highs and lows of equity investment (HM Treasury, Consultation on ‘Stakeholder’ Savings and Investment Product Regulations (2004), pp. 9–11). General asset allocation principles apply, including that assets be selected with regard to the need to achieve a balance between growth and the risk of a loss of value and that the manager have regard to diversification and the suitability of the investment strategy: Financial Services and Markets Act 2000 (Stakeholder Products) Regulations 2004, reg. 7. HM Treasury, Financial Capability: The Government’s Long-Term Approach (2007), p. 6. FSA, Retail Distribution Review: Feedback Statement No. 08/6 (2008) (‘2008 RDR Feedback Statement’), pp. 65–6. See sect. I.3.a below. See further ch. 1.

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debate, suggests that it will attempt to reorient the harmonized disclosure and advice/distribution regime away from its current segmented approach and to construct a new disclosure and selling regime which will apply to the sale of nominated packaged products.55

3. The risks of CIS product regulation a) Design risks CISs pose significant difficulties in terms of their ability to manage market risk and support effective diversification (section III.2.a below), conflictof-interest risks (section II.2 below) and their ability to support investor learning.56 But a host of other regulatory design challenges arise. Commoditization of investor protection through product regulation can represent a misallocation of regulatory resources. Characterizing CISs as products might imply a light-touch approach which leaves monitoring to competitive market forces and product choice dynamics.57 But, under the UCITS regime, commoditization has led to close regulatory intervention in product design and to regulatory determinations as to the appropriateness of particular investment strategies for the retail market. By contrast, the massive US mutual fund industry is regulated through an essentially corporate-law-based strategy, based (with respect to openended mutual funds) on fund oversight by its board and disclosure.58 Intervention UCITS-style carries a number of risks. CIS product regulation requires the regulator to make choices concerning the structure and engineering of financial products59 which are likely to be made more efficiently by the industry.60 The FSA has generally 55 56

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Packaged Products Communication (sect. IV below). Shiller has suggested that investor learning is limited given high costs and as investors tend to switch and choose poorly performing funds: R. Shiller, Irrational Exuberance (Princeton and Oxford: Princeton University Press, 2000), pp. 197–200. D. Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty (2006), ssrn abstractid=885970, p. 21, suggesting that, once a scheme is regarded ‘as a product to be marketed within liberal societal expectations as to fair advertising like another’, ‘the transaction is . . . simply embedded in the morals of the marketplace’. Palmiter, ‘Mutual Fund Board’. Palmiter has observed that the ‘buck stops’ with the regulator in a product-based system but with the board in the US regime: ibid., 207. R. Karmel, ‘Mutual Funds, Pension Funds and Stock Market Volatility – What Regulation by the Securities and Exchange Commission Is Appropriate?’ (2004–5) 80 Notre Dame Law Review 909, 918.

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(aside from the UCITS regime) eschewed detailed product regulation. It has been concerned as to the innovation risks which can flow from product regulation and has assumed that the market is better placed to judge whether products deliver value.61 Evidence from the UCITS III industry, for example, points to some industry discipline in the design of complex CISs (section III below). Close regulatory engagement in the structure of schemes increases the more general risks of regulatory intervention and may lead to regulation which responds to ill-defined or poorly evidenced risks;62 the assumptions on which the disclosure and conflict-of-interests regulation of the US open-ended mutual fund industry is based have, for example, been challenged.63 Regulatory intervention is also likely to experience multiplier effects: more risky products will demand more in terms of supporting risk management requirements, as has been the case with the UCITS III product. The risks of regulatory over-reaction are high, given that CISs are associated with household savings.64 Industry-facing moral hazard risks arise where regulation/public marketing provides a notional quality label for particular CISs.65 The risks are also investor-facing. Labelling dynamics are strong in the retail investment product market generally.66 Moral hazard difficulties can therefore arise where ‘authorized’ or ‘retail market’ CISs are regarded as being somehow ‘safe’, particularly by vulnerable but trusting investors. Investors may misunderstand the nature of government intervention, as has happened with the UK’s equity Individual Savings Account (ISA) tax wrapper67 and was acknowledged by the FSA with respect to alternative investment 61 62 63

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Turner Review, p. 106. R. Romano, ‘A Comment on Information Overload, Cognitive Illusions, and Their Implications for Public Policy’ (1986) 59 Southern California Law Review 313, 320. J. Coates and R. Hubbard, ‘Competition in the Mutual Fund Industry: Evidence and Implications for Policy’ (2007) 33 Journal of Corporation Law 151; and Choi and Kahan, ‘Market Penalty’. Roiter, ‘Delivering Fiduciary Services’, 865. Gray, ‘Personal Finance’, 215–16; and J. Gray, ‘The Sandler Review of Medium and LongTerm Retail Savings in the UK: Dilemmas for Financial Regulation’ (2002) 10 Journal of Financial Regulation and Compliance 385, 391. Sandler Report, p. 18. Extensive US research has also found that investment decisions are often made on the basis of popular brands: for example, A. Hortacsu and C. Syverson, ‘Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds’ (2004) 119 Quarterly Journal of Economics 403. It has been wrongly assumed to provide government-guaranteed returns: FSA, Towards Understanding Consumers’ Needs (Consumer Research No. 35, 2005), p. 18.

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products.68 Where product regulation reforms facilitate riskier strategies but do not change the regulatory label, investor confusion risks can arise. The UCITS label has become strongly associated with the retail markets and high levels of investor protection, both in the EC69 and internationally.70 Changes to its risk profile may not, as a result, be appreciated by the retail market, and mis-selling risks may arise.71 Product-based regulation is also complex. The UK experiment with the ‘stakeholder’ products is not regarded as particularly successful, partly because of the price caps which have limited industry enthusiasm. The effectiveness of product design is also closely related to the related distribution and advice risks ‘in action’ which are difficult to manage (chapter 4); the limited success of the stakeholder regime is also a function of perceived weaknesses in the related Basic Advice regime.72 Low levels of investor demand, linked to the limited product range, the poor return for firms and perceived high regulatory risk to firms from the limited Basic Advice regime all led the FSA to consult on withdrawing the stakeholder products regime.73 The FSA’s attempts in its Retail Distribution Review to link a more limited advice regime (Primary Advice) to the sale of a limited range of products also foundered in the face of a hostile reception; the FSA itself showed limited enthusiasm for vetting and pre-approving products for Primary Advice given the risks of product regulation.74 Product regulation also carries the risk of obsolescence and of obstructing innovation; stronger investor returns and investors’ ability to manage 68

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FSA, Wider-Range Retail Investment Products: Consumer Protection in a Rapidly Changing World (Feedback Statement No. 06/3, 2006), pp. 5–6. The FSCP has also warned that, if a wider range of non-UCITS alternative investment schemes were to be publicly marketed, investors might unwisely derive security from their public marketing: Annual Report 2005– 2006, p. 16. In France, the UCITS ‘brand name’ enjoys high recognition among savers (and distributors): Commission, Feedback Statement to the Green Paper on Enhancing the European Framework for Investment Funds (2006), p. iii, while in the UK the FSCP has highlighted wide consumer understanding of the UCITS product and highlighted the importance of maintaining this ‘brand awareness’: FSCP, Response to Discussion Paper 05/3, p. 1. 2008 PwC Investment Powers Report, p. 8. ‘Trust takes years to build but can be lost very quickly if a scandal breaks . . . [T]he debate about whether to extend the UCITS label to alternative investment funds is an important one’: P. Skypala, ‘Careful Handling Needed to Safeguard UCITS’ Reputation’, Financial Times, Fund Management Supplement, 14 April 2008, p. 6. See further ch. 4. 2008 RDR Feedback Statement, pp. 65–6, although it has since decided to retain it (chapter 4). FSA, A Review of Retail Distribution (Discussion Paper 07/1, 2007) (‘2007 RDR’), p. 63.

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general market risk may be prejudiced. It may also be too blunt. Retail investors, whether empowered or trusting, are not homogeneous;75 they display different levels of sophistication, competence and risk appetite.76 Where regulation reflects a ‘one-size-fits-all’, mass market approach to product regulation,77 the retail market may become dominated by generic mass market products which do little to support investor learning, varying degrees of risk appetite, and, ultimately, stronger returns.78 Conversely, the pendulum can swing in the other direction, as is suggested by experience with the UCITS III product (section III below). The risks of regulatory arbitrage are also considerable when regulation becomes segmented across different product lines, as is underlined by the EC’s experience with substitute products (section IV below). The resources expended on CIS regulation may also be misallocated given that the extent to which product regulation can drive investor behaviour is doubtful. Factors such as investor education and wealth, over which the regulatory regime has limited traction, appear to drive CIS industry growth.79 Although household participation seems, over time, to shift from direct to indirect participation in the equity markets,80 the long-established US retail market points to the persistence of direct investment in the markets, despite the relative benefits of fund-based investments and the risks and costs of direct market trading.81 EC households have also been generally slow to invest in market instruments through heavily regulated CISs, preferring often opaque and complex insurance-related products and structured products which are less heavily regulated.82

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As evidenced, for example, by the Optem Report’s characterization of its data-set in terms of savers and gamblers: Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’). The FSA has, for example, acknowledged that only a ‘minority subset’ of investors are likely to be equipped to engage with alternative investment products: FSA, Financial Risk Outlook 2005, p. 46. P. Ring, ‘A Critical Analysis of Depolarization’ (2004) 12 Journal of Financial Regulation and Compliance 248, 256, levelling this criticism at the stakeholder products regime. Gray, ‘Personal Finance’, 216. 79 Khorana et al., Explaining the Size, pp. 3 and 15. Individual holdings in the US equity market fell from 47.9 per cent in 1980 to 21.5 per cent in 2007, but holdings in open-ended mutual funds increased from 4.6 per cent to 32.4 per cent over this period (French, ‘Cost of Active Investing’, 1539), leading to an institutionalization of the market (e.g. J. O’Hare, Retail Investor Remedies under Rule 10b-5 (2007), ssrn abstractid=1019295, p. 4). Langevoort, ‘Re-reading Cady Roberts’, 1328; and Ribstein, ‘Bubble Laws’, 97. See further ch. 1 and sect. IV below.

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b) The investor choice assumption Reflecting empowerment concerns, the UCITS product regime is preoccupied with investor choice.83 The Commission has warned generally that product diversity is patchy and has targeted domestic rules which prohibit cross-border product sales.84 The choice rhetoric has persisted in the UCITS IV reforms which are designed to facilitate cross-border UCITS activity through more efficient cross-border notification procedures, asset pooling and scheme mergers, a more effective UCITS business chain (and in particular a passport for management companies) and more efficient supervision.85 The UCITS IV reforms are designed to deliver a more integrated UCITS market with ‘enlarged choice of better performing funds’;86 the rationalization of schemes through the new mergers process, for example, is designed to make investor choice easier and to reduce confusion.87 The emphasis on increasing investor choice and, through the earlier UCITS III regime, on facilitating industry innovation, suggests that the UCITS regime is designed to support an ever-increasing supply of schemes, already numbered at some 30,000.88 In all this, the retail investor is assumed to benefit from greater choice and efficiencies; the projected UCITS IV cost reductions are, for example, predicted to increase scheme returns by 3 per cent.89 But investor prejudice can follow where an essentially facilitative and choice-based strategy combines with poor investor choice and monitoring and with limited industry incentives to produce investor-driven products. CISs may fall within the regulatory parameters but be poorly distinguished, complex and not responsive to investor needs. They may proliferate, confusing investors and increasing the mis-selling risks already posed by distribution and advice. 83 84 85

86 87 88

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See also ch. 2 on the choice rhetoric and ch. 5 on comparability. European Commission, A Single Market for 21st Century Europe (COM (2007) 725), Staff Working Paper on Initiatives in the Area of Retail Financial Services, p. 3. European Commission, Proposal for a Directive of the European Parliament and of the Council on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (COM (2008) 458/3) (‘Commission UCITS IV Proposal’). Ibid., p. 4. European Commission, UCITS IV Proposal, Impact Assessment (SEC (2008) 2236), p. 32. At the end of 2005, some 44,489 investment funds were recorded in Europe, of which almost 80 per cent (31,181) were UCITS schemes: 2008 PwC Investment Powers Report, p. 17. In October 2007, 542 schemes were launched, although a sharp decrease occurred as the ‘credit crunch’ intensified: B. Aboulian, ‘Product Development Falls off Agenda’, Financial Times, Fund Management Supplement, 5 January 2009, p. 11. Investment Funds White Paper, p. 3.

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The evidence of poor decision-making in CIS selection is considerable. Investors tend to over-trade, buy high and sell low, over-react to market volatility and display herding behaviour.90 They over-rely on brands, over-react to past performance disclosure and under-react to the costs of schemes and the impact of expenses.91 They consistently choose more costly, under-performing managed schemes rather than cheaper passive/index schemes.92 Choice of index scheme is also poor;93 investors do not readily identify that costs are the determinative factor in choosing between index schemes and do not search for the lowest cost schemes.94 The wealth of evidence on the massive US mutual fund market suggests that those funds which receive most investment do not perform significantly better than other funds,95 that high levels of investor support predict low future returns96 and that, while investors tend to reallocate their funds actively across different funds, they reduce their wealth in the long term.97 There is, however, some evidence to the contrary which points to investor discipline on fees98 and to a ‘smart money’ effect, whereby investors’ fund choice predicts funds with a strong future performance, although the evidence is not conclusive.99 Investors are acutely vulnerable to marketing, which is exploited by schemes,100 and to how providers 90 91 92

93 94 95 96 98 99

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A. Frazzini and O. Lamont, ‘Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns’ (2008) 88 Journal of Financial Economics 299, 319. Palmiter, ‘Mutual Fund Board’, 196–200. Ch. 5 considers cost disclosure weaknesses. R. Otten and D. Bams, ‘European Mutual Fund Performance’ (2002) 8 European Financial Management 75 (based on schemes in the UK, France, Germany, Italy and the Netherlands) (it found, however, some evidence of a correlation between management fees and scheme performance). In the UK, the Sandler Report suggested that the CIS industry under-performed the market by 2.5 per cent as a result of charges and unsuccessful active management strategies which were not monitored by investors: Sandler Report, p. 2. A weight of US evidence also points to this dynamic, for example, J. Cox and J. Payne, ‘Mutual Fund Expense Disclosures: A Behavioral Perspective’ (2005) 83 Washington University Law Quarterly 907. E. Elton, M. Gruber and J. Busse, ‘Are Investors Rational? Choices Among Index Funds’ (2004) 59 Journal of Finance 261. J. Choi, D. Laibson and B. Madrian, Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds (2008), ssrn abstractid=1125023. L. Zheng, ‘Is Money Smart?: A Study of Mutual Fund Investors’ Fund Selection Ability’ (1999) 54 Journal of Finance 901. 97 Frazzini and Lamont, ‘Dumb Money’. Ibid. Coates and Hubbard, ‘Competition in the Mutual Fund Industry’, 183–4. T. Sapp and A. Tiwari, ‘Does Stock Return Momentum Explain the “Smart Money” Effect?’ (2004) 59 Journal of Finance 2605; and K. Aneel and D. Stoli, ‘Which Money Is Smart?: Mutual Fund Buys and Sells of Individual Investors’ (2008) 63 Journal of Finance 85. P. Jain and J. Wu, ‘Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows’ (2000) 55 Journal of Finance 937.

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label schemes.101 One troubling study has found that investors react to cosmetic name changes which suggest a particular investment orientation (for example, ‘value’ as opposed to ‘growth’) although the composition of the fund portfolio has not changed.102 The EC evidence suggests that ‘shopping around’ is limited across the Community103 and that investors have very limited ability to extend downward pressure on costs, despite the benefits predicted from the UCITS IV reforms.104 Failure to choose on the basis of quality, and an inability to exert pressure on costs, not only leads to poor individual resource allocation. It removes a driver of competition and discipline from the CIS industry,105 as suggested by the evidence from Australia,106 and can lead to systemic inefficiencies. Product differences can arise which are designed only to differentiate the product from competitors’ products. Providers may be driven by a concern to be ‘first to market’, rather than by a concern to produce competitive products tailored to investor needs.107 Conversely, and particularly in times of market stress, herding dynamics may be strong as the industry, with limited investor discipline, may follow trends, as occurred in the structured product sector;108 pressure is also currently on providers to produce high-margin products.109 Poor choice is exacerbated 101

102 103 104

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Investor confusion risks concerning capital protection and guarantees have, for example, been raised with respect to the use of the ‘cash-plus’ label by CISs: K. Nickerson and S. Grene, ‘IMA Concern over “Cash-Plus” Label’, Financial Times, Fund Management Supplement, 12 January 2009, p. 2. M. Cooper, H. Gulen and R. Raghavendra, ‘Changing Names with Style: Mutual Fund Name Changes and Their Effects on Fund Flows’ (2005) 60 Journal of Finance 2825. Oxera, Current Trends in Asset Management: Prepared for the European Commission: Executive Summary (2006), p. v; and see further ch. 2. One study has warned that, in part because of product complexity and poor financial capability, cost savings would be only slowly passed on to consumers: CRA International, Potential Cost Savings in a Fully Integrated European Investment Fund Market (2006), p. 14. Sandler Report, p. 46. The lack of downward pressure on the Australian fund market, notwithstanding its size (the world’s largest per capita), has been linked to investor inability to assess complex product disclosures: R. Bollen, ‘A Case Study of Bounded Rationality in the Market for Superannuation Products’ (2007) 4 Macquarie Journal of Business Law 49. L. Costanzo and J. Ashton, ‘Product Innovation and Consumer Choice in the UK Financial Services Industry’ (2006) 14 Journal of Financial Regulation and Compliance 285 (in the context of deposit products). E. Avgouleas, What Future for Disclosure as a Regulatory Technique? Lessons from the Global Financial Crisis and Beyond (2009), ssrn abstractid=1369004, p. 13. US mutual funds were among the purchasers of collateralized debt obligations (CDOs) and residential mortgagebacked securities (RMBSs), leading to significant litigation in the US: A. Ferrell, J. Bethel and G. Hu, Legal and Economic Issues in Litigation after the 2007–2008 Credit Crisis (2008), ssrn abstractid=1096582. FSA, Financial Risk Outlook 2009, p. 65.

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by the related potential for the CIS industry to be segmented,110 with inferior products marketed to less discerning retail investors and insulated from market monitoring by more sophisticated investors. In the absence of investor monitoring, product provider discipline becomes a function of the problematic distribution process. Increasing product complexity has been associated in the UK open distribution context (which is slowly becoming more widespread across the EC) with incentives for product providers to create complex products which can justify higher commissions111 given the competition for ‘shelf space’. Already severe commission risks can be deepened. The structure of the UCITS industry suggests limited investor discipline and poor choice. The Commission has charged the industry with delivering sound CISs which deliver the highest possible returns consistent with investors’ financial capacity and risk appetite112 and the UCITS III regime has supported a vast range of UCITS products. But concerns remain that investors are not provided with appropriate products.113 Investor confusion is considerable as UCITS III products proliferate.114 Products have become very difficult to compare. CISs still lag some way behind bank deposits and often complex and risky unit-linked insurance products in investor popularity;115 while German households have increased their CIS holdings, reductions have occurred in the Netherlands and Italy.116 A wide range of factors drive investment decisions; but it is probably not unreasonable to suggest that the relative popularity of generally lowerreturn bank accounts, even prior to the ‘credit crunch’, points to the failure of the CIS/UCITS industry to deliver appropriate and clear products, as well as to the deterrent effects of investor confusion. The market turbulence related to the ‘credit crunch’, which led to serious investor losses,117 has also seen some criticism of the CIS industry for the failure of high-cost 110 111 113

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Mahoney, ‘Manager–Investor Conflicts’. Sandler Report, pp. 17 and 19. 112 Investment Funds Green Paper, pp. 2–3. One report has suggested that many UCITS are unfit for purpose with unclear risk/return characteristics, excessive volatility and poor liquidity: Skypala, ‘Squabbling’. The Council’s Financial Services Committee has called for ‘simple and transparent products and products that automatically take into account the changing investment needs of an ageing population’: Subgroup on the Implications of Ageing on Financial Markets, Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’), p. 21. Expert Group on Investment Fund Market Efficiency, Report (2006), p. 10. See further ch. 1. BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007) (‘BME Report’), p. 54. See further ch. 2.

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and complex schemes, including absolute-return schemes, to perform118 (CESR, in particular, has questioned the relationship between fees and performance119 ). Investor confusion and product complexity risks are increasingly a policy concern in the highly developed UK product market in which more than 2,000 retail market CISs (including UCITS) are sold,120 not least as these risks are aggravated by commission-based sales. The FSA has repeatedly highlighted the risks in its annual Financial Risk Outlooks, which suggest increasing FSA scepticism as to the benefits of choice,121 while its major 2006 review of financial capability highlighted poor product choice in general, limited awareness of risk and little shopping around for products.122 In its recent review of alternative investment policy, the FSA similarly warned that product innovation was only beneficial where it resulted in useful products123 and that a wider product range could simply confuse investors.124 Notably, some limited restrictions on choice have been incorporated into the advice regime for stakeholder products. The regime restricts investor choice by limiting Basic Advisers to presenting only one CIS or unit-linked insurance product at the point of sale, partly in order to prevent advisers from engaging in judgments as to the relative merits of different products.125 But the risks posed by excessive choice are also reflected in this model, which is expressly designed to support the most inexperienced investors. Although the UK market is strongly characterized by investment product sales, product proliferation, complexity and confusion risks are also a concern in other Member States.126 The UCITS regime has yet, however, to engage with the very difficult problem ‘in action’ of how to incentivize providers to produce clear products which meet investor needs; the developing policy on alternative 118 119 121 122 123 124 125 126

CESR, Annual Report 2007, p. 19. Absolute return funds were under-performing before the major market shocks in autumn 2008. Ibid. 120 HM Treasury, Financial Capability (2007), p. 10. The FSA’s 2007 Financial Risk Outlook, for example, argued that, while increased product choice was generally positive, some consumers did not understand the risks: p. 9. FSA, Financial Capability in the UK: Establishing a Baseline (2006), p. 17. FSA, Consultation Paper No. 07/6, p. 7. FSA, Wider Range Retail Investment Products: Consumer Protection in a Rapidly Changing World (Discussion Paper No. 05/3, 2005), p. 7. COBS 9.6.3. E.g. J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government (2005) (‘Delmas Report’), p, 29. The German BaFIN has also pointed to the risks of confusion (Annual Report 2006, p. 27), while the Dutch AFM has pointed to the importance of comparability across different products (AFM, Annual Report 2006, p. 52).

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investment products (section III below) suggests, however, that some nuance may be emerging.

4. An integrated model So where do product design risks leave CIS product regulation and the UCITS model? One response might be that more and not less product regulation is required given that market forces do not seem to be delivering appropriate products.127 But the risks of greater EC intervention are considerable, not least given centralization risks, and retail market commoditization is not a complete strategy. Multiple and unwieldy regulatory levers must instead be manipulated to achieve outcomes ‘in action’ and to incentivize the industry to deliver products which, while within the regulatory product parameters, respond to investor needs. A careful interplay is required between relatively untested distribution/advice suitability, conflict-of-interest and inducement rules under MiFID (chapter 4) and the UCITS disclosure regime (chapter 5). Considerably heavy lifting is also required of financial literacy if empowered and trusting retail investors are to place themselves correctly on the UCITS risk spectrum. The need for an integrated strategy has been highlighted by two important national reviews: the UK Retail Distribution Review; and the 2005 French Delmas Report. The Retail Distribution Review identified a series of risks leading to inefficiencies and mis-selling in the product market generally (including CISs), including product complexity, poor investor understanding and inability to exert discipline on product design and a consequent reliance on commission-based independent advisers.128 The Delmas Report highlighted information and disclosure weaknesses, the increasing complexity of often poorly targeted products and the risks posed by the distribution of proprietary products.129 The UK’s Retail Distribution Review efforts to address the risks of the advice industry, discussed in chapter 4, are supported by attempts to improve product design, marketing and distribution under the Treating Customers Fairly (TCF) initiative (section III below). The Delmas Report also called for a series of intersecting reforms addressing disclosure

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The Turner Review suggests greater FSA openness, in the wake of the financial crisis and the weaknesses it exposed in market discipline, to retail market product regulation, albeit in the context of mortgage products: Turner Review, pp. 106–8. 2007 RDR, pp. 3–4. 129 Delmas Report, pp. 10–11.

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design, marketing and distribution risks, and the design of appropriate products.130 The lesson from the UCITS regime for retail market design seems to be that prescriptive asset allocation and design rules are unlikely to provide industry incentives to respond to investor needs and that excessive product choice may be a pernicious risk. The product orientation of the detailed EC regulatory regime may, as a result, be both flawed and liable to mask underlying risks. The following sections, after an overview of the UCITS regime, consider the troublesome design lever and whether it can be finetuned to achieve positive retail market outcomes.

II. The UCITS investor protection regime and product regulation 1. Inbuilt diversification and liquidity In the UCITS regime, product design has three dimensions: structure and investment policy; authorization and supervision of the scheme manager and depositary; and a public marketing restriction – only UCITS schemes authorized under the Directive can be publicly marketed (Article 4).131 Specific requirements support diversification and liquidity. The Directive applies to undertakings for collective investment in transferable securities, the sole object of which is the collective investment of public capital in transferable securities and/or in other ‘liquid financial assets’ and which operate on risk-spreading principles (Article 1). This core diversification requirement is supported by a liquidity rule; UCITS units must, at the unit-holder’s request, be capable of repurchase or redemption, directly or indirectly, out of UCITS assets (Article 37(1)). This requirement also underpins the extensive asset allocation and diversification regime (section III) and is at the heart of UCITS product design. Redemption on demand protects retail investors against liquidity risks; it allowed retail investors to move in large numbers to deposits over the worst of the 2008 market turbulence.132 But it also provides investors with a powerful mechanism for monitoring schemes or, at least, exiting under-performing schemes, with ease,133 although retail investors typically do not closely monitor performance.134 The UCITS Directive leaves, however, the management 130 131 132 133

Ibid., pp. 20–44. Authorization also supports the cross-border passport (Arts. 4 and 44). Although large losses were also crystallized. See further ch. 2. Coates and Hubbard, ‘Competition in the Mutual Fund Industry’. 134 See further ch. 2.

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of related valuation and redemption risks135 to the scheme and/or the Member States.136 Redemption is also supported by the requirement that, while a UCITS may be constituted according to the law of contract, trust law or under statute (in corporate form), it must be open-ended (Article 1(3)) and so capable of supporting redemption on demand. Closed-end schemes (or schemes which can apply redemption restrictions) are accordingly excluded. These include closed-end corporate structures (including UK ‘investment trusts’) in which the investor holds a share and is exposed to the usual equity and trading risk, as well as the risk that these structures typically trade at a discount to net asset value (NAV).137 The EC regime for these schemes is limited to the Prospectus Directive’s disclosure regime (chapter 5) and, where the securities are admitted to trading, the skeletal admission to trading regime (section IV). Although the importance of liquidity protection became clear over the ‘credit crunch’,138 the Directive’s restriction to open-ended schemes simply reflected the popularity of open-ended schemes at the time, and concern as to their susceptibility to failure unless careful portfolio management addressed redemption risks, rather than a considered consideration of the relative risks of different structures.139 The distinction exposes, however, the risks of segmented product regulation. Closed-end products have, as discussed in section IV below, become a target for regulatory arbitrage.

2. Inbuilt governance: the depositary and the management company Authorization and operational/conduct-of-business rules, embedded within the UCITS product, apply to the different entities which constitute 135

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In the US, a range of factors, including increased reliance on derivatives and the globalization of trading, sharpened the NAV measurement risks to investors and led to the market timing scandal (n. 160 below): Frankel and Cunningham, ‘Mysterious Ways’, 240–9. Art. 38. A. Shleifer, Inefficient Markets: An Introduction to Behavioural Finance (Oxford: Oxford University Press, 2000), pp. 53–88. The credit crunch saw non-UCITS funds apply for exemptions to redemption requirements as liquidity dried up, but retail UCITS funds remained subject to on-demand redemption: B. Aboulian, ‘Liquidity Tightening Now on the Agenda’, Financial Times, Fund Management Supplement, 12 January 2009, p. 11. UK investment trusts, for example, came under severe pressure over the credit crunch, experiencing very steep discounts to NAV and severe liquidity difficulties: S. Johnson, ‘Rescue Plan for Investment Trusts’, Financial Times, Fund Management Supplement, 9 February 2009, p. 1. The Directive simply noted that extending the regime to other funds ‘poses a variety of problems’ which were to be dealt with through later co-ordination: recital 16.

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the UCITS, namely, for UCITS in the form of a unit trust, the management company which manages the assets and markets the trust and the depositary which holds the assets and, for UCITS in corporate form, the (investment) company, which may also be the management company or a separate management company may be designated, and the depositary. Competent authorities must approve the unit trust management company, scheme rules and the choice of depositary and the investment company’s instruments of incorporation and the choice of depositary (Article 4(2)). The depositary, to which scheme assets must be ‘entrusted for safekeeping’140 and which is subject to high-level rules,141 is key to the Directive’s embedded investor protection and conflict-of-interest management regime. It acts as the custodian of scheme assets and is responsible for essential technical procedures relating to asset administration142 and for ensuring they are carried out in accordance with the law and the UCITS’ rules. The depositary is not subject to extensive authorization requirements, given that depositaries will often be regulated credit institutions. The directors must, however, be of sufficiently good repute and sufficiently experienced in relation to the type of UCITS to be managed,143 and the depositary must take the form of an institution subject to public control, be situated so as to ease supervision144 and furnish sufficient financial and professional guarantees that it can effectively pursue its business and meet its commitments.145 Independence is supported by the requirement that a single company may not act as both a management company and a depositary; the depositary (and the management company) are also required to act independently and solely in the interests of unit-holders.146 The centrality of the depositary to investor protection and to the strength of the UCITS brand became clear as the Madoff scandal unfolded amidst concerns that Luxembourg and Ireland, the two centres with schemes exposed to the Madoff fraud, had not imposed sufficiently 140 141 142

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Arts. 7(1) (unit trusts) and 14(1) (investment companies). Arts. 7 (unit trusts) and 14 (investment companies). Arts. 7(3) (unit trusts) and 14(3) (investment companies – valuation requirements do not apply). Investment company depositaries are subject to broadly the same regime as unit trust depositaries, subject to some slight differences, including lighter duties, given the notional role of shareholder discipline (Art. 14(3)). Art. 4(3). Under Art. 8(1) (Art. 15 for investment companies), the unit trust depositary must either have its registered office in the same Member State as that of the management company or be established in that Member State where its registered office is elsewhere. Arts. 8 (unit trusts) and 15 (investment companies). Arts. 10 (unit trusts) and 17 (investment companies).

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rigorous controls on UCITS depositaries who had outsourced custodian functions147 to Madoff affiliates and who had not confirmed the existence of the underlying assets.148 Concern as to potential damage to the UCITS brand led to a Commission review of Member State implementation of the depositary requirements.149 While only a very small number of schemes was affected,150 and the UCITS brand does not appear to be significantly damaged,151 the outsourcing of custodianship functions, permitted under the Directive, represents a significant risk in times of acute market volatility152 and was highlighted by the 2009 de Larosi`ere Report.153 Authorization requirements also apply to the management company or investment company (Article 4(3)) which manages the assets.154 So too do operational requirements,155 but the conduct-of-business and conflict-ofinterest regime156 is more notable for its exclusions than for its coverage. 147

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Depositaries’ liability under Arts. 9 and 16 (which impose liability towards unit-holders for any loss suffered by them as a result of ‘unjustifiable failure to perform its obligations’ or ‘improper performance’) is not affected where the depositary has entrusted assets to a third party: Arts. 7(2) and 14(2). E.g. S. Grene, ‘Luxembourg Called on to “Brush up” Governance’, Financial Times, Fund Management Supplement, 26 January 2009, p. 3, highlighting the risks to the UCITS brand as over 30 per cent of UCITS funds are domiciled in Luxembourg. Stricter French rules and French investor losses led to France demanding a Commission review of pan-EC implementation of the depositary requirements, amidst confusion as to the scope of the Directive’s asset protection rules. European Commission, Press Release IP/09/126, 29 January 2009. Four UCITS funds entrusted assets to Madoff affiliates: Commission Press Release IP/09/126, 29 January 2009. Hedge fund investors appear to want to use UCITS III structures, and benefit from stronger custody arrangements, in the wake of the Madoff fraud: S. Johnson, ‘Hedge Funds March Towards UCITS’, Financial Times, Fund Management Supplement, 23 February 2009, p. 1. FSA, Financial Risk Outlook 2009, p. 66. The High-Level Group on Financial Supervision in the EU, Report (2009) (‘de Larosi`ere Report’), p. 26. It called for tighter harmonized regulation of delegation and warned that the separation between asset management and custody, required by the UCITS regime, should be respected whatever delegation model was used. Arts. 5, 5a and 5b govern the authorization process and cover capital requirements, scope of activities, management suitability, prudential requirements concerning close links with other entities and qualifying shareholders. A similar regime applies to investment companies (Arts. 12–13a). Where a management company engages in MiFID activities, notably investment advice and discretionary portfolio management (as permitted by Art. 5(3)), the MiFID regime applies in respect of those activities (Art. 5(4)). Prudential requirements concerning ongoing capital requirements, qualifying shareholdings and operational prudential rules (particularly with respect to administrative procedures and transaction reconstruction) also apply (Arts. 5(d)–(f)) (Arts. 13b and 13c for investment companies).

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The conflict-of-interest regime, central to managing investor protection risks, is considerably less sophisticated than that which governs discretionary asset management under MiFID and does not reflect international best practice.157 The rules include the general requirement that a management company be structured and organized in such a way as to minimize the risk of UCITS’ (or clients’) interests being prejudiced by conflicts (Article 5f(1)).158 Conduct-wise, Article 5(h), a now-outdated provision, simply requires Member States to draw up conduct rules which management companies authorized in that Member State are to observe at all times and which must implement the skeletal Article 5h principles. Conflict-of-interest management is central to retail investor protection in the CIS context given the agency costs and risks which arise between ill-informed and passive investors and CIS managers.159 While ease of redemption means that investors can exit, in practice they are unlikely to monitor schemes closely and will rarely have sufficient influence to hold the scheme to account. Conflicts of interests and incentive misalignment can result in the extraction of benefits through excessive costs, which have proved very difficult to deal with through disclosure (chapter 5), in abusive trading practices, as evidenced by the US market timing scandal,160 incompetence in CIS management and fraudulent diversion of assets from the CIS. These risks are exacerbated as the disciplines imposed by marketpricing dynamics are weakened as CIS pricing (with respect to non-traded CISs) is closely related to NAV.161 But the UCITS regime does not address in any detail conflict-of-interest and governance risks. The particular conflicts of interests generated by the UCITS industry and, in particular, by the management, depositary and sales/distribution function all being carried out within a single, typically 157

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The IOSCO Objectives and Principles of Securities Regulation (IOSCO, 2008), for example, call for rules governing best execution, timely allocation of transactions, commissions and fees, related-party transactions, underwriting arrangements and delegation. It is supported by the requirement that investment management mandates may not be delegated to the depositary or any other undertaking whose interests may conflict with those of the management company or unit-holders (Art. 5g(1)) and the requirement that the management company must try to avoid conflicts of interest and, when they cannot be avoided, ensure that the UCITS it manages are fairly treated (Art. 5h). The same regime applies to investment companies (Art. 13b). Langevoort, Private Litigation; and Mahoney, ‘Manager–Investor Conflicts’. The US market timing scandal which broke in 2003 saw the uncovering of widespread abuses with particular investors (mainly hedge funds) being given preferential pricing and wider opportunities to trade, leading to prejudice to other investors: J. McCallum, ‘Mutual Fund Market Timing: A Tale of Systemic Abuse and Executive Malfeasance’ (2004) 12 Journal of Financial Regulation and Compliance 170. Langevoort, Private Litigation.

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banking, group have also not been addressed.162 As outlined in chapter 4, mis-selling risks remain significant where investors are advised on/sold proprietary CISs. Collective portfolio management also raises the risk that ‘soft commissions’ and ‘bundling’ arrangements generate conflicts of interests and increase costs. Commission structures of this nature may bias portfolio managers towards particular brokers and threaten best execution, risk that scheme assets are ‘churned’ to generate commissions and lead to less discrimination in the use of research where research is provided under commission arrangements.163 While the generic UCITS conflicts regime provides some protection (depending on how it is enforced), Community retail market policy has not (as discussed in chapter 4) directly tackled the difficult market structure questions raised by product distribution, commission structures, and bundling and softing arrangements. Member States have, of course, imposed national rules on CIS governance and trading practices.164 But, while market timing abuses, in particular, have not been a feature of the European industry,165 the policy priority afforded to asset allocation in the UCITS regime, combined with market integration priorities, may have driven an unwarranted EC focus on extending the boundaries of the UCITS product. On the other hand, it might also be argued that the absence of major concern with respect to conflicts of interests and excessive fees points to this issue being more effectively dealt with at Member State level and to the UCITS regime appropriately managing centralization risks and identifying those issues which require harmonized intervention.

III. The UCITS III product and design risks 1. The UCITS III regime Radical reforms to the original 1985 UCITS asset allocation regime under the UCITS III regime have allowed UCITS to extend their investment 162 163

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E. Wymeersch, Conflicts of Interest – Especially in Asset Management (Financial Law Institute Gent, Working Paper No. 2006-14), 2006), available via www.law.ugent.be/fli/WP/. E. Pinciss, ‘Sunlight is Still the Best Disinfectant: Why the Federal Securities Law Should Prohibit Soft Dollar Arrangements in the Mutual Fund Industry’ (2004) 23 Annual Review of Banking and Financial Law 864. The Dutch regulator, the AFM, for example, carried out an extensive examination into the fund market, governance and trading practices and introduced a series of reforms: for example, AFM, Monitoring Collective Investment Schemes (2004). CESR Chairman Docters van Leeuwen, Speech on ‘Management of Conflicts of Interest – Is There a European Way?’, 24 September 2004 (CESR/04-483, 2004), reporting that CESR members had not found major evidence of mispractices concerning late trading or market timing.

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horizons from listed shares and bonds to a range of ‘liquid financial instruments’ (Articles 1(2) and 19), including bank deposits,166 moneymarket instruments (listed (in the Community and elsewhere) and OTC (where liquidity requirements are met)),167 units of non-UCITS CISs (where they are ‘equivalent’ to UCITS),168 and financial derivatives (listed and OTC).169 Investment strategies associated with cost reduction and diversification, such as index-tracking170 and fund-of-funds structure,171 are also supported. Specific diversification requirements apply, including that a UCITS may invest no more than 5 per cent of its assets in the transferable securities or money-market instruments of a single issuer (Member States may raise this limit in certain circumstances);172 similar limits apply to deposits and financial derivatives.173 UCITS are also prohibited from investing more than 10 per cent of assets in transferable securities and money-market instruments other than those covered by the Directive.174 The regime is also supported by maximum derivatives exposure limits, controls on leverage and risk management requirements (designed to ensure that assets, and particularly OTC derivatives, are sufficiently liquid and accurately monitored, measured and managed), which are amplified by the Commission’s 2004 Recommendation.175 The leverage controls, in particular, provide some protection against general market risk by limiting the product’s exposure.176 Specific capital requirements do not

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Art. 19(f). 167 Art. 19(1)(a)–(c) and (h). Art. 19(1)(e). Some protection is provided against opaque cascades of CIS investments by the requirement that a UCITS may not invest in units of another UCITS or CIS which itself invests more than 10 per cent of its assets in units of other UCITS and/or CISs. Art. 19(1)(g). 170 Art. 22a. Art. 24(1); ‘feeder’ funds which invest all their assets exclusively in the units of one UCITS (the ‘master’ fund) are not currently permitted, although they are provided for under the UCITS IV reforms. Art. 22(1). A UCITS may not invest more than 20 per cent of its assets in deposits made with the same body, while the risk exposure to a UCITS counterparty in an OTC derivative transaction may not exceed 10 per cent of assets when the counterparty is a credit institution or, in all other cases, 5 per cent of assets (Art. 22(1)). Art. 19(2)(a). European Commission Recommendation 2004/383/EC of 27 April 2004 on the use of financial derivative instruments for undertakings for collective investment in transferable securities, OJ 2004 No. L144/33. Art. 36 prevents investment companies and management companies and depositaries acting on behalf of a UCITS from borrowing, while global exposure to financial derivative instruments is limited to 100 per cent of the UCITS’ net asset value and the UCITS’ overall

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apply.177 Short-selling, a strategy strongly associated with hedge funds but which has become associated with the ‘credit crunch’ convulsions, is permitted, but is limited by the restrictions placed on the use of derivatives as well as by the prohibition on uncovered short sales (Article 42).178 Although the UCITS remains strongly characterized as a retail market product institutionally,179 the UCITS III reforms have seen the UCITS change from a conservative investment vehicle to something of a bellwether for innovation. This is particularly the case at levels 2 and 3180 of the UCITS regime which have amplified ‘liquid financial instruments’ and ‘transferable securities’ to include a range of riskier and less liquid assets including the structured debt products which caused so much difficulties in the banking market,181 credit derivatives, closed-end funds, financial indices and transferable securities and money-market instruments which embed derivatives. Structured financial instruments, for example, may be inappropriate for a retail investment vehicle,182 but CESR’s approach was broadly facilitative. In an eye-catching CESR decision, hedge fund indices

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risk exposure is limited to 200 per cent of net asset value (Art. 21(3) and Recommendation, para. 2.1). The European Parliament, however, has called for all financial institutions, including UCITS, to comply with risk-based capital requirements: European Parliament, Resolution with Recommendations to the Commission on Hedge Funds and Private Equity (2008) (P6 TA(2008)0425, 2008), Annex, recital 1. CESR’s level 3 guidance on UCITS-eligible assets was amended in September 2008 as prohibitions were placed on short-selling across Europe to clarify that physical shortselling, whether or not backed by stock borrowing, is not permitted under the UCITS Directive (CESR/07-044b, 2007, p. 12). Recommendation 7 of the 2004 Recommendation addresses covered sales. Commissioner McCreevy, for example, has warned that ‘we must be careful not to undermine the pretensions of UCITS to be a retail investor product’: Commissioner McCreevy, Speech on ‘The EU Framework for Investment Funds: A Facilitator – Not a Strait Jacket’, Commission Hearing on Investment Funds, 13 October 2005, available via http://europa.eu/rapid/searchAction.do. European Commission Directive 2007/16/EC of 19 March 2007 implementing Directive 85/611/EC as regards certain definitions, OJ 2007 No. L79/11 (‘Level 2 Eligible Assets Directive’) (CESR’s Level 2 Advice is at CESR/06-005 (‘CESR Level 2 Advice’) and the earlier consultation papers are at CESR/05-064b and CESR/05-490b) and CESR, 2007 Level 3 Guidance on Eligible Assets (CESR/07-044, 2007). Such as collateralized debt obligations and structured investment vehicles. CESR adopted the general principle that investments in the form of transferable securities (such as structured investments) should be allowed (CESR Level 2 Advice), subject to, for example, valuation, liquidity, disclosure and risk management requirements (Level 2 Eligible Assets Directive, Art. 2). ‘[These products] could potentially pose a threat to the liquidity of the UCITS making it difficult for investors to redeem their units at a price that fairly reflects the value of the investment or . . . at all’: CESR/05-064b, 2005, p. 9.

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are also eligible, albeit following difficult CESR discussions.183 CESR’s willingness to embrace a robust approach towards the retail markets has had multiplier effects; the inclusion of hedge fund indices has since been used as an argument for either bringing funds-of-hedge-funds within the UCITS regime or for establishing a discrete EC product regime for hedgefund-like investments. It has also supported Member State moves to widen retail access to hedge fund investments through funds-of-hedge-funds.184 Overall, the UCITS III regime reflects an enabling characterization of the investor as empowered and risk-tolerant185 and supports investor choice of higher risk levels for higher reward. There was, however, little discussion of the link between the UCITS III regime and the nature of the EC retail market in CESR’s discussions or in European Securities Committee (ESC) minutes. It is doubtful that the new regime reflects a considered stance on the level of risk which should be contained within the UCITS III product. The risks may be mitigated in that there appears to be some degree of industry discipline with respect to the risk profile of UCITS III schemes. Although UCITS III schemes are burgeoning and, in particular, adopting derivative-based strategies,186 the 2008 PricewaterhouseCoopers study of the UCITS III sector187 produced some heartening results. It found that, while reliance on derivatives had increased,188 UCITS III investment powers were being used effectively and market risk levels were not significantly higher as compared to other CISs.189 Derivatives were generally relied 183

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CESR raised a number of concerns with respect to hedge fund indices, including survivor bias (under-performing hedge funds are not included in indices as they usually close down) and selection bias (CESR Level 2 Advice, p. 53), and originally excluded them from its level 2 Commission advice (p. 57). It reopened the issue through consultations in 2006 (CESR/06-530, 2006) and 2007 (CESR/07-045, 2007) and agreed to limited UCITS investment in particular hedge fund indices, subject to a series of eligibility conditions (CESR, Level 3 Guidelines on Classification of Hedge Fund Indices as Financial Indices (CESR/07-434, 2007)). The FSA’s widening of retail investor access to funds-of-hedge-funds was based in part on the exposure being gained by investors through UCITS III structures: Consultation Paper No. 07/6, p. 7. The Commission suggested that, while consumers would be faced with ‘some very complex retail products’ and exposed to risks beyond market risk and including operational and counterparty risks, ‘this is not a problem of itself’: European Commission, Simplified Prospectus Workshops 15 May 2006 and 11 July 2006: Issues Paper (2006), p. 14. S. Johnson, ‘New Products Make Use of UCITS Power’, Financial Times, Fund Management Supplement, 12 March 2007, p. 3. 2008 PwC Investment Powers Report. Growth in the rate of derivative use has been estimated at 10 per cent per annum. 2008 PwC Investment Powers Report, pp. 75 and 94.

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on for hedging purposes; reliance on derivatives for leveraging was very limited.190 Valuation risk was not regarded as significant.191 Liquidity risks did not appear to be troubling,192 although liquidity and valuation risks have increased with UCITS investing in non-liquid OTC derivatives.193 Asset managers also appear to be exercising some restraint and considering retail market suitability, as well as appropriate risk management processes, before launching UCITS III schemes.194 The UCITS III product is also capable of decreasing retail investors’ exposure to market risk through hedging techniques.195 On the other hand, the PwC study acknowledged that many UCITS schemes are using alternative investment strategies and ‘to a certain extent, have come to resemble hedge funds’ and highlighted that, as innovative and sophisticated products are developed, the risks of mis-selling increase.196 Hedge-fund-like strategies are increasingly being imported into the UCITS III product.197 Summer 2007 saw the first French UCITS scheme to replicate a hedge fund,198 while 2007 also saw UK schemes offering returns based on equity market volatility through a UCITS III structure.199 In early 2008, the Irish regulator authorized schemes based on the FTSE Hedge Global Index and the FTSE Hedge Momentum Index.200 Exchange-traded schemes which track indices through derivatives have also increased.201 The flexibility of the UCITS III structure is well illustrated by the reported move by hedge funds into UCITS III structures in early 2009 following hedge fund investor demand for higher standards of investor protection, liquidity and transparency.202 The perception of the UCITS as a low-risk 190 191 192

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Derivatives exposure was generally linked to hedging (92 per cent of funds) and trading/arbitrage purposes (almost 50 per cent of funds): ibid., p. 71. Ibid., p. 4. The Report noted that fund-of-fund structures did not appear to have impacted on liquidity risk (ibid., p. 66) although it noted the increased liquidity risk attendant on investment in asset-backed securities in the wake of the subprime crisis (ibid., p. 69). Ibid., p. 67. 194 Ibid., p. 7. Over 2,000 schemes were developed which were designed to bet on, or insure against, extreme volatility levels: K. Burgess, ‘Product Does More Than It Says on the Tin’, Financial Times, Fund Management Supplement, 3 March 2008, p. 20. 2008 PwC Investment Powers Report, pp. 13 and 67. S. Johnson, ‘Sophistication Goes Mass Market’, Financial Times, Fund Management Supplement, 5 November 2007, p. 1; and S. Johnson, ‘FSA Warns on Derivatives Danger’, Financial Times, Fund Management Supplement, 11 February 2008, p. 1. 2008 PwC Investment Powers Report, p. 73. 199 Ibid., p. 74. S. Johnson, ‘Dublin “Approves” Hedge Fund Indices’, Financial Times, Fund Management Supplement, 25 February 2008, p. 2. 2008 PwC Investment Powers Report, p. 74. 202 Johnson, ‘Hedge Funds March’.

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investment product is changing internationally, with UCITS facing some difficulties in those markets where UCITS are considerably more aggressive in their investment strategies than local schemes.203 While, in practice, UCITS III products are often used as investment vehicles by the sophisticated investors204 who influenced the widening of investment powers under the UCITS III regime,205 UCITS III schemes can be marketed to the public and retailization can occur.

2. UCITS III and the risks of facilitative product design a) Diversification Diversification is of central importance in product regulation, given its role in addressing general market risk and given that retail investors typically achieve diversification through products rather than through wider asset allocation. Diversification benefits were repeatedly raised during the UCITS III process. But the difficulties in achieving effective diversification through regulatory fiat (and the risks of regulatory promotion of the UCITS) should not be overlooked as the UCITS product range becomes more esoteric. The relatively crude UCITS diversification rules are linked to limiting exposure to single issuers and to identifying the very wide range of assets in which a UCITS can invest. They are not linked to factors more likely to impact on diversification and returns, such as the degree of concentration in particular industry sectors206 or in particular asset classes;207 UCITS asset allocation rules would not have protected investors from exposure to the dotcom sector during the early twenty-first-century market crash.208 Neither did the UCITS regime protect investors from market risk related to over-exposure to the bond or money markets through specialist bond schemes as the ‘credit crunch’ deepened, although overall the UCITS sector proved reasonably resilient, as discussed below. Considerable scepticism as to the value of prescriptive asset allocation rules can be seen in the FSA’s recent review of the listing rules which 203 204

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S. Johnson, ‘How UCITS Became a Runaway Success’, Financial Times, Fund Management Supplement, 27 November 2006, p. 3. EFAMA, Annual Asset Management Report 2008, pp. 16–17. PwC also reported that UCITS vehicles are extensively distributed to institutional investors (2008 PwC Investment Powers Report, p. 96). Asset managers in France and elsewhere pressed for the wider UCITS III powers in part to meet the needs of the institutional market: R. Saunders, ‘What’s Right or Not for Ordinary Investors’, Financial Times, Fund Management Supplement, 14 January 2008, p. 6. Roe, ‘Political Elements’. Hu, ‘Illiteracy and Intervention’. 208 Deutsche Bank, EU Asset Management, p. 6.

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apply to domestic, non-UCITS, listed investment companies or trusts. It removed a previous ceiling of 20 per cent on investments in securities of another issuer on the grounds that the ceiling restricted effective investment strategies, led to an over-emphasis on portfolio risk and that rigid asset allocation rules were a ‘crude proxy’ for the adequacy of portfolio diversification.209 It instead adopted a principles-based approach, based on general risk-spreading requirements,210 the retention of governance requirements in the form of board independence rules and disclosure requirements.211 A similar, manager-centric, principles-based approach was adopted in the 2008 reforms to the FSA’s domestic, non-UCITS, regulated CIS (NURS) regime to accommodate funds-of-hedge-funds. The risks raised by investment in hedge fund assets were not addressed by asset allocation requirements but, in the interests of supporting flexibility, innovation and effective retail investor diversification opportunities, by investment manager competence and diligence requirements.212 In an area of less potential toxicity, the ‘stakeholder’ CIS product is based on a principles-based approach to asset allocation, rather than on prescriptive rules, in an attempt to support innovation and avoid a rigid, rule-based approach.213 Diversification and protection against general market risk is also prejudiced by the vulnerability of investment managers to bias, herding and noise-trading and the risk that asset allocation can become too closely allied to the benchmarks against which schemes are assessed.214 CIS managers are not immune from market mania and diversification rules will provide little protection against poor asset allocation.215 UCITS managers are not, through the UCITS regime at least, placed under any fiduciary obligation to the UCITS investor (the depositary is the focus for investor protection, although, even there, the regime does not construct a 209 210 211

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FSA, Transparency Directive Implementation and Investment Entities Listing Review (Consultation Paper No. 06/4, 2004), pp. 66–7. Listing Rule 15 requires that the trust or fund must invest and manage its assets in a way which is consistent with its object of spreading investment risk (Rule 15.2.2). The FSA argued that, once a vehicle is properly governed, transparent and actually delivers a spread of investment risk, rules should not prescribe the investment strategies which should or should not be pursued: FSA, Investment Entities Listing Review (Consultation Paper No. 07/12, 2007), pp. 8–9. The FSA proposed high-level ‘due diligence’ principles for the fund manager (linked to FSA guidance and industry and international (including IOSCO) standards), particularly with respect to hedge fund valuation: FSA, Consultation Paper No. 07/6, pp. 10–11 and Consultation Paper No. 08/4, pp. 18–19. HM Treasury, Consultation on ‘Stakeholder’ Savings and Investment Product Regulations, p. 9. Shleifer, Inefficient Markets, pp. 12–13. 215 Karmel, ‘Mutual Funds’, 926–7.

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relationship between the depositary and investors216 ), whether through a best-interests-type obligation or otherwise. National rules, of course, may impose such an obligation on the manager,217 and its application seems to be accepted by the industry,218 but the weak tradition of investor action through the courts (chapter 8) limits the extent to which investors can seek redress where fiduciary rules and principles are breached. Equity schemes remain dominant among UCITS schemes, representing 41 per cent of all UCITS schemes in 2005.219 Retail UCITS investors exposed to equities accordingly suffered heavy market losses over the ‘credit crunch’.220 Nonetheless, the UCITS industry appears to have weathered the crisis without serious failures,221 despite the exposure of some UCITS to money-market instruments, CDOs and derivatives. Although scheme losses and outflows were significant,222 and the money-market schemes which represent 15 per cent of UCITS assets were, like their US counterparts, heavily affected,223 very few European schemes closed 216

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Although the depositary is liable to UCITS unit-holders (and the management/investment company) for any loss suffered by them as a result of an unjustifiable failure to perform its obligations or for improper performance of obligations (Arts. 9 and 16). On the UK position, which, with respect to the duty owed to investors in unit trusts (shareholders in corporate schemes benefit from the fiduciary duties imposed on company directors), is contested, see Benjamin, Financial Law, pp. 224–5. EFAMA, A Code of Conduct of the European Investment Management Industry: High-Level Principles and Best Practice Recommendations: A Discussion Paper (2006), p. 7 (recommending that the management company accept a fiduciary duty to the investor, although vague as to its contours). 2008 PwC Investment Powers Report, p. 18. 22.8 per cent of schemes were balanced and 21.3 per cent were bond schemes. While market losses were responsible for 77 per cent of the losses sustained by the European UCITS industry, this proportion increased to 84 per cent for equity schemes: EFAMA, Quarterly Statistical Release No. 36 (2008), p. 2. An admittedly partisan Commission suggested that the UCITS regulatory framework had ‘proved very resilient’ and that no more than a handful of schemes closed or suspended trading: European Commission, Press Release IP/09/126, 29 January 2008. Similarly, bar those few UCITS associated with the Madoff fraud, ‘the UCITS structure has proved scandal-free during the severe ructions of the past 18 months’: S. Johnson and B. Aboulian, ‘Convergence Strategy under Threat’, Financial Times, Fund Management Supplement, 16 March 2009, p. 1. The BaFIN noted limited impact on retail schemes (BaFIN, Annual Report 2007–2008, p. 164), although the French AMF focused on risk controls and the quality of disclosure (Annual Report 2007, p. 3). By the third quarter of 2007, net outflows represented one-third of total sales from the beginning of the year, with bond funds most heavily affected: CESR, Annual Report 2007, p. 19. See also ch. 2. EFAMA, Annual Report 2007–2008, p. 12. The de Larosi`ere Report also noted the contraction of liquidity and the redemption difficulties faced by CISs invested in short-term banking paper (and asset-backed commercial paper): de Larosi`ere Report, p. 26.

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(four),224 only a few suspended redemption (twelve, of which four reopened) and the investors affected were predominantly institutions and high net worth individuals.225 The ‘credit crunch’ also saw schemes raise liquidity levels, focus on counterparty risk and operational resilience, particularly with respect to depositary functions, and shift to less risky assets in certain cases; reaction and intervention by EC regulators were generally limited.226 But, while the scale of the ‘credit crunch’ and its impact on all asset classes would have placed strains on any diversification strategy, requirements to diversify across different asset classes might have provided stronger protection against market risks; so too might have a closer focus on product provider responsibilities (section III.4 below).

b) Allied risk management risks Some heavy lifting is required of regulation which ‘markets’ more complex retail market products with respect to effective ancillary risk management. Although the 2008 PwC study seems positive, and while the ‘credit crunch’ does not seem to have caused undue difficulties, more aggressive strategies place more strain on internal controls and risk management. The extent to which regulation can capture the complex and rapidly evolving valuation and liquidity risks raised by derivatives and hedge-fund strategies is unclear227 and a particular risk for unsophisticated investors.228 Implementation of the 2004 Recommendation has been variable,229 particularly with respect to the measurement of the market and leverage risks of sophisticated and ‘plain vanilla’ schemes,230 in respect of which Member States have adopted different approaches.231 This has led to some 224

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S. Johnson, ‘UCITS Outflows Soar in Q3’, Financial Times, Fund Management Supplement, 1 December 2008, p. 2, reporting some rationalization and cost-cutting but that the industry remained broadly robust. EFAMA, Annual Report 2007–2008, p. 9. 226 Ibid., pp. 10 and 11. The FSA earlier warned that UCITS III management companies may not implement appropriate risk management systems (Discussion Paper No. 05/3, p. 9) and later pointed to the risks of increased derivative use: Financial Risk Outlook 2008, p. 49. It raised derivative management risk again as a key risk for the asset management sector in 2009: Financial Risk Outlook 2009, p. 65. P. Skypala, ‘No Verdict Yet, in Advice vs Passive Debate’, Financial Times, Fund Management Supplement, 19 May 2008, p. 6. CESR, Implementation of the European Commission’s Recommendations on UCITS: Report of the Review Conducted by CESR (CESR/05-302b, 2005). Member States are recommended to adopt a differentiated approach for ‘non-sophisticated UCITS’ and ‘sophisticated UCITS’, although limited guidance is given on these categories. Sophisticated funds are to adopt more nuanced ‘value at risk’ approaches and apply stress tests to manage risks related to abnormal market movements (recital 3.3). CESR, Implementation, p. 7.

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institutional concern,232 although regulatory arbitrage does not appear to be a risk.233 CESR is certainly doubtful as to the resilience of the current risk management regime234 and has suggested risk management principles.235

c) Investor understanding Despite the empowerment flavour of the UCITS III regime, the risks to investor understanding, exacerbated by the strength of the UCITS brand, are considerable, as has been highlighted by the French and UK regulators236 and FIN-USE.237 The UCITS III regime has also radically increased the range of products which can be marketed under the UCITS label, increasing the risks of investor confusion.238 Perception and expectation risks239 are therefore considerable, particularly where investors have previously bought UCITS products. They are exacerbated as UCITS are still treated as conservative, retail-investor-friendly products by regulation, and are designated as ‘non-complex’ products and eligible for nonadvised execution-only sales under the MiFID regime (Article 19(6)); paradoxically, simple derivatives are excluded from the regime as complex products.240 d) Advice and distribution But, while the UCITS III product can carry significantly high levels of risk, this alone is not, particularly given the potential for higher returns and 232 233 234 235

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European Parliament, Resolution on Asset Management (P6 TA-PROV(2007)0627, 2007) (‘Klinz II Resolution’). 2008 PwC Investment Powers Report, p. 79. Its credit crunch agenda included examination of the ‘orderly functioning’ of CIS (CESR Press Release, 1 October 2008 (CESR/08-791, 2008)). CESR, Risk Management Principles for UCITS (CESR/09-178, 2009). CESR suggested that the harmonized regime was limited and that recent market turbulence called for a comprehensive approach. The Delmas Report warned that UCITS III schemes were ‘increasingly esoteric and difficult to understand for the average investor and even the seller’ (p. 9), while the AMF warned of the increasingly sophisticated products marketed under the UCITS brand: AMF, Response to Green Paper on Retail Financial Services (2007), p, 6. The FSA has also raised concern that retail investors may not have fully understood the impact of the UCITS III regime: Discussion Paper No. 05/3, p. 7. FIN-USE, Opinion on the European Commission Green Paper on the Enhancement of the EU Framework for Investment Funds (2005), p. 2. Oxera, Current Trends, p. xii, and suggesting that ‘too much choice might not be in the investor’s best interests’ (p. xiii). D. Langevoort, Managing the Expectations Gap in Investor Protection: The SEC and the Post-Enron Reform Agenda (2002), ssrn abstractid=328080. See further ch. 2.

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protection against general market risk, an occasion for undue concern. But the supporting distribution regime, to which trusting investors are particularly exposed, must be robust. And considerable risks arise from the loose mooring of the UCITS III product within the wider advice and marketing regime and its failure, accordingly, to engage fully with the vulnerable, trusting investor. UCITS units may be sold without advice in execution-only sales (MiFID, Article 19(6)), under a regime which was negotiated well before the full extent of the UCITS III regime became clear and without any apparent concern from the institutions as to the potential reach of UCITS investments – pointing to the dangers in product design where the boundaries of the product shift. The execution-only regime is available for ‘noncomplex products’, a classification which is based on liquidity, valuation, leverage and transparency requirements.241 Although the industry appears to be developing non-UCITS retail market schemes in compliance with these four principles,242 whether or not all UCITS III products meet these requirements is not clear, although a preoccupation with these four requirements is a feature of CESR’s approach to the level 3 eligible assets regime. CESR certainly appears to have some doubts as to the appropriateness of some UCITS schemes for execution-only treatment.243 Risks also arise with advised sales. Although increased demand for advice concerning UCITS has been predicted,244 the extent to which the new MiFID suitability regime (which covers UCITS advice by MiFID firms) will address the significant mis-selling risks associated with complex UCITS III schemes is questionable,245 particularly given the severity of commission risk and of the incentive risks generated by proprietary sales (chapter 4). Distribution difficulties also arise with respect to disclosure. Although MiFID imposes product disclosure obligations on investment 241 242

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See further ch. 2. Presentation by Schroders Investment Management, ‘Are Non-Harmonized Investment Funds Ripe for the Retail Market?’, European Commission Open Hearing on Retail Non Harmonized Funds, April 2008. Although its suggestion in the course of the consultations on UCITS disclosure reform that product providers be required to flag whether a UCITS was designed for sophisticated investors met the robust response that all UCITS were retail products and were classified as non-complex instruments for execution-only sales: EFAMA, Response to the CESR Consultation Paper on the Content and Form of KII Disclosure for UCITS (2007), p. 7. Investment Funds Green Paper, p. 5. The extensive 2003 SEC hedge fund report pointed to the need for vigilance in monitoring whether broker-dealers were meeting suitability requirements in advising on fund-ofhedge-fund products: SEC, Implications of the Growth of Hedge Funds: A Staff Report to the SEC (2003), p. 99.

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firms, it does not require that a UCITS prospectus or summary prospectus be provided at the point of sale (chapter 5). Questions also arise as to the competence of advisers on the risks of UCITS III products where appropriate disclosure is not provided by the product provider. The initial development of the UCITS III regime occurred without reference to distribution and advice and before the MiFID discussions got underway. Nonetheless, the disjunction between the two regimes246 points to the dangers of product regulation and of the risks which arise where radical product reforms are not reflected in the supporting distribution and advice regime. The need to consider how the UCITS product sits within the EC’s disclosure and advice regimes was, however, recognized throughout the UCITS IV reform process, suggesting growing appreciation of the holistic nature of investor protection.247 But the retail-investor-facing UCITS IV reforms are, for the most part, directed to disclosure,248 which remains a problematic retail market device.

3. Beyond UCITS III: alternative investments and product design risks a) Retailization of alternative investment and its benefits The extent to which product regulation can rapidly become obsolete and also reflect tangled conceptions of retail investor competence is well illustrated by the alternative investments question. The UCITS III regime, however problematic, appears all the more so as it excludes the range of alternative investments currently experiencing retailization.249 Retail market interest in non-UCITS alternative investments, often initially developed for the institutional sector but ‘handed down’ to the retail sector, and which typically carry greater liquidity, valuation, leverage and transparency risks, is increasing significantly.250 Assets under management by non-UCITS schemes, including private equity, venture capital, real estate, commodity and hedge funds, amount to almost 10 per cent of total assets 246

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J.-P. Casey, Shedding Light on the UCITS–MiFID Nexus and the Potential Impact of MiFID on the Asset Management Sector, ECMI Policy Brief No. 12 2008 (European Capital Markets Institute, 2008). See also ch. 4. E.g. ESC, Minutes, 3 March 2005. Although one useful reform requires the UCITS to supply distribution systems with UCITS disclosure (ch. 5). Reviewed in the 2008 PwC Retailization Report. E.g. the 2006 Oxera Report (which pointed to changes in retail market demand and a commoditization of hedge-fund-type strategies: Oxera, Current Trends, pp. vi–vii); and the 2008 PwC Retailization Report, suggesting that retail investors are being attracted to these investments (at p. 15).

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under management251 and alternative investment schemes are growing strongly.252 Two asset classes in particular are drawing attention: real estate investment funds,253 which have experienced considerable growth;254 and hedge-fund-related products (including funds of hedge funds (FoHF)) which, while experiencing more modest growth,255 have attracted close political and regulatory attention. Alternative investments can deliver non-correlated and accordingly stronger returns and can provide effective diversification.256 As highlighted in chapter 2, closer regulatory consideration of how to support retail investor access to alternative investments, whether through product strategies or otherwise, is therefore warranted given the scale of the market risk carried by investors. Reflecting an international focus on these investments,257 the FSA (along with other Member States), although somewhat sceptical of mass retail market engagement with alternative investments,258 has expanded the permissible asset classes for its nonUCITS regulated schemes regime to include FoHFs and has accepted the 251

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Investment Funds White Paper, p. 11. The 2008 PwC Retailization Report quantified the EC market at €1.79 trillion in 2007 (up from €1.56 trillion in 2006): 2008 PwC Retailization Report, p. 6. European Commission, Financial Integration Monitor (2006) (SEC (2006) 1057), p. 19. The main forms of collective property investment are real estate investment trusts or REITs (in the form of companies, usually listed), closed-end real estate funds and open-ended real estate funds. The sector (real estate funds, rather than real estate trusts in the form of companies) represented €198 billion of assets under management in 2007, with retail investors representing a ‘moderate’ level of activity at 24 per cent: 2008 PwC Retailization Report, pp. 6 and 13. IOSCO has highlighted significant growth in this area and called for it to be kept ‘under close watch’: IOSCO, Review of the Regulatory Issues Relating to Real Estate Funds (IOSCO, 2008), p. 2. While hedge-fund-like products are increasingly being made available to the ‘mass affluent’ (PricewaterhouseCoopers, The Regulation and Distribution of Hedge Funds in Europe (2005) (‘2005 PwC Report’), p. 2), including through UCITS III products, levels of FoHF investment remain relatively low: 2008 PwC Retailization Report (reporting that retail investors represent only 1 per cent of hedge fund investment and 10 per cent of FoHF investment (at p. 13)). As acknowledged by the FSA: Financial Risk Outlook 2007, pp. 6–7 and 49. The FSA has highlighted a ‘general international acceptance that advances in investment management techniques make [FoHFs] appropriate for the retail environment’: Consultation Paper No. 07/6, p. 7. IOSCO, in particular, has closely examined FoHF risk: Consultation Report – The Regulatory Environment for Hedge Funds: A Survey and Comparison (IOSCO, 2006); Report on Funds of Hedge Funds (IOSCO, 2008), and Proposed Elements of International Regulatory Standards on Funds of Hedge Fund Related Issues Based on Best Market Practice: Consultation Report (IOSCO, 2009). ‘[T]hese alternative investments are likely to be suitable only for a minority of consumers who understand the risks involved and then usually as part of a diversified portfolio’: Financial Risk Outlook 2005, p. 46.

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consequent liquidity constraints259 given the potential for diversification, stronger returns and wider choice.260 Investments in real estate schemes are regarded as offering a good balance between risk and return and as providing effective diversification as these schemes are not correlated to market returns. They may also be considerably less risky than UCITS III products – although, as recent convulsions in the property market have made clear, not always.261 Direct hedge fund investment is an unwelcome distraction for retail market policy. While the liquidity, transparency, complexity, market, costs, valuation and incentive risks (given the structure of manager remuneration) to investors are very considerable,262 hedge funds do not normally welcome retail investors. Investment thresholds, whether by way of fund practice or by law, are typically very high.263 FoHFs are exposed to hedge fund risk in relation to the underlying hedge fund assets. The additional risks to retail investors, who can access FoHF products more easily, include poor due diligence by the manager,264 excessive remuneration costs and conflict-of-interest risks as FoHFs adopt similar fee structures to hedge funds, fraud risks given their opacity and complexity, overall

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The FSA’s proposed regime allows funds of alternative investment funds to impose limited redemption periods, although funds must redeem once in every six-month period: Consultation Paper No. 07/6, p. 13. Ibid., p. 3. In its earlier discussion paper, the FSA emphasized the danger that investor choice could be restricted were ‘wider range’ or alternative investments not supported: Discussion Paper No. 05/3, p. 23. The FSA has highlighted the redemption deferrals required by property funds following mass withdrawals which may have arisen as investors did not understand the funds’ characteristics: Financial Risk Outlook 2008. Temporary suspensions have also occurred elsewhere, notably in Germany in 2005–6. E.g. H. McVea, ‘Hedge Funds and the New Regulatory Agenda’ (2007) 27 Legal Studies 709; N. Moloney, ‘The EC and the Hedge Fund Challenge: A Test Case for EC Securities Policy after the Financial Services Action Plan’ (2006) 6 Journal of Corporate Law Studies 1; and Karmel, ‘Mutual Funds’. Industry feedback to the Commission’s December 2008 consultation on hedge funds, for example, highlighted the widespread view that retail investor exposure to hedge funds was not a positive development and that any moves to support access should be accompanied by strong safeguards: DG MARKT, Feedback Statement on Hedge Fund Consultation (2009), p. 18. The 2008 Madoff scandal and the US$50 billion losses sustained by many FoHFs pointed not only to regulatory failure by the SEC, but also to a failure of due diligence by FoHF asset managers: Financial Times, Lex Column, 16 December 2008, p. 16. Retail investors in France and Spain suffered exposure to the Madoff fraud through FoHF investments: D. Ricketts, ‘Mutual Funds Move Back into the Black’, Financial Times, Fund Management Supplement, 19 January 2009, p. 11.

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liquidity265 and valuation risks and failures in disclosure. But, and, in a very significant assumption, assuming appropriate due diligence by and effective regulation of the FoHF manager266 (and particularly if, in the wake of the ‘credit crunch’, more extensive regulation is imposed on the underlying hedge funds with respect to valuation and liquidity risks267 ), FoHFs may provide investors with stronger market returns and better diversification opportunities. They may also deliver stronger returns than the very complex proxies (including UCITS III schemes which invest in hedge fund indices) which UCITS product regulation has produced.268 The EC’s willingness to allow UCITS III schemes to invest in what can often be unstable, derivative-based and highly complex hedge fund indices,269 but its reluctance to engage with what can be more straightforward FoHFs, not only suggests some regulatory incoherence. It also suggests a muddled view of retail market risk, which is also evident in the exclusion of ‘plain vanilla’ derivatives from execution-only services under MiFID.270 A controlled extension by the EC of the retail product regime to include alternative investments has some attractions. The empowerment/ 265

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As became clear during the credit crunch as FoHFs imposed redemption restrictions: B. Aboulian, ‘Liquidity Tightening Now on the Agenda’, Financial Times, Fund Management Supplement, 12 January 2009, p. 11. IOSCO has produced standards to support adequate due diligence by the manager, particularly with respect to the quality of valuation by the underlying fund and liquidity risks (n. 257 above; and H. McVea, ‘Hedge Fund Asset Valuations and the Work of the International Organization of Securities Commissions (IOSCO)’ (2008) 57 International and Comparative Law Quarterly 1), while the FSA’s guidance and rules for FoHFs similarly focus on manager due diligence. The EC is moving in this direction, despite considerable institutional tensions, with a Commission consultation on hedge funds launched in the wake of the autumn 2008 convulsions in December 2008 and a subsequent proposal for a Directive on Alternative Investment Fund Managers (COM (2009) 207). The proposal seeks to impose standards on the managers of alternative investment schemes and to provide them with a marketing passport for their alternative investment schemes; the passport will be restricted to cross-border marketing to professional investors only. Hedge fund reform has also been identified by the G20: London Summit – Leaders’ Statement, 2 April 2009, para. 15. Hedged/long-short mutual funds typically under-perform hedge funds: V. Agarwal, N. Boyson and N. Naik, Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds (2006), ssrn abstractid=891621. The Alternative Investment Management Association has expressed concern as to UCITS III investment in hedge fund indices and suggested that FoHFs are a better vehicle for retail investment: P. Skypala, ‘Hedge Fund Indices Access Likely’, Financial Times, Fund Management Supplement, 12 February 2007, p. 2. The European Parliament has criticized the exclusion of FoHFs and REITs from the UCITS III regime which accommodates ‘fairly volatile and less transparent assets’: Klinz II Resolution.

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responsibilization model, to be internally consistent, suggests that, if investors are to take on more responsibility, they should not be restricted from investment strategies which promise stronger returns and better diversification,271 even if advanced regulatory technology is required. The rate at which market convulsions occur, and the repeated exposure of regulatory failures, might even call for the ‘alternative’ brand to become otiose and for regulators to focus on how the retail sector can efficiently hedge and protect against market risk. The current emphasis on capability also suggests that retail investors should be exposed to learning opportunities.272 Neither should the trusting investor be excluded from the opportunity to learn and generate stronger returns, although this investor requires considerably more of regulation than facilitative product regulation; serious attempts must be made to engage with the potential for product design, investor confusion and distribution risks which the UCITS III regime has exposed. The siren call of investor choice might also suggest that a pan-EC alternative investment product, whether through extension of the UCITS regime or in the form of a discrete vehicle, might be warranted. While a range of alternative investment products are available in local markets, they do not benefit from a cross-border passport. Retail investor choice is therefore restricted,273 as is competition in the investment product market; extending the regime might, therefore, ‘enrich fund offers’ to investors.274

b) The risks It is not clear that retail investors are prejudiced by the UCITS III limitations. Retailization of non-UCITS schemes remains limited.275 Member States already have in place tailored non-UCITS regulatory regimes which support the public marketing of domestic non-UCITS schemes, particularly property funds,276 and which reflect local preferences and demand. 271 272 273

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H. Shadab, ‘Fending for Themselves: Creating a US Hedge Fund Market for Retail Investors’ (2008) 11 New York University Journal of Legislation and Policy 252. The FSA has queried whether restrictive product regulation might inhibit investors in learning about the full range of investment products: Discussion Paper No. 05/3, p. 23. 2008 PwC Retailization Report, pp. 8–9 and 15 (particularly as Member States tend to adopt an ‘equivalence’ approach to access which, given the differences among schemes, and differing regulatory perceptions of product risk, can restrict cross-border access). Commission, UCITS IV Impact Assessment, p. 10. As the 2008 PwC Report, which also recommended that a harmonized non-UCITS market would not significantly benefit retail investors, concluded: 2008 PwC Retailization Report, p. 16. Property funds, for example, can be authorized in the UK under the FSA’s NURS regime.

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Hedge fund investment has also been addressed in a number of Member States, particularly through FoHF vehicles.277 The UCITS III product may also meet demand for alternative investments.278 Low levels of financial capability call for caution before any attempt is made to give more risky investments, with additional liquidity, leverage, valuation and transparency risks, some type of quality label through authorization devices. The UCITS III injection of greater risk into the retail investment product market does not suggest that the retail market is well equipped to cope with an expansion in the range of ‘riskier’ but authorized products. CESR adopted a robust approach to retail investor risk which colours the level 2 and level 3 regimes, but the related consultations shed unforgiving light on the extent to which the industry dominated discussions.279 Effective regulatory design may also be difficult to achieve280 given the febrile and highly politicized debate which has accompanied hedge fund retailization in particular.281 The gulf between retail and industry concerns is all too clear in the 2006 clash between FIN-USE and

277 278 279

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2005 PwC Report. 2008 PwC Retailization Report, p. 15, suggesting that non-UCITS strategies were becoming ‘retailized’ through the UCITS III product. E.g. CESR’s 2004 Call for Evidence on the Level 2 Eligible Assets regime elicited fifteen responses, many from trade associations, all from the industry sector, and all in support of increased choice for fund managers: CESR, Level 2 Eligible Assets Consultation Paper (CESR/05-064b, 2006), Annex A, pp. 45–7. CESR’s Issues Paper on the treatment of hedge fund indices generated twenty-two responses, all from the industry sector: CESR, Consultation Paper on Hedge Fund Indices (CESR/07-045, 2007), p. 7. The SEC has struggled with hedge fund regulation and been heavily criticized for its ill-fated attempts to address retailization risks by regulating hedge fund managers: T. Paredes, On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission (2006), ssrn abstractid=893190. The European Parliament has repeatedly called for hedge fund intervention. While its 2008 Resolution on hedge funds and private equity accepted the role of hedge funds in supporting market efficiency, it also highlighted the stability, transparency and valuation risks and called on the Commission to consider a regulatory response (European Parliament, Resolution with Recommendations to the Commission on Hedge Funds and Private Equity (P6 TA-PROV 0425, 2008). The Resolution was followed by calls from leading MEPs for the resignation of Commissioner McCreevy for his failure to bring forward proposals. An earlier contribution from the Parliament’s Socialist Group (Hedge Funds and Private Equity – A Critical Analysis (2007)) heavily criticized market economy principles in its discussion. On the EC hedge fund debate, see further N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008), pp. 333–5; and P. Athanassiou, Hedge Fund Regulation in the European Union: Current Trends and Future Prospects (Kluwer Law International, 2009).

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the Commission’s Expert Group on Alternative Investment.282 Governance risks are also acute given the under-representation of retail interests in policy development; the Commission’s 2008 Open Hearing on nonharmonized retail market funds saw broad support for greater retail access to non-harmonized schemes but, with a few exceptions, was dominated by the industry perspective and calls for easier industry access to the retail markets.283 Adventures in product design are rewarding for the industry if the brand benefits of the UCITS III product can be stretched. They are also more appealing for policy-makers than the hard work required to make distribution and disclosure regimes fit for purpose and to ensure product providers develop appropriate products. But they distract policy attention from more fundamental and intractable questions concerning the retail product market. The real retail market risk lies in the failure of the industry to develop, test and provide transparent and investor-facing products which support long-term savings, manage market risks and reflect investor needs. And, as long as distribution remains closely tied to proprietary product providers, or, as it ‘opens’, exposed to commission risks, mis-selling risks remain. Any incentives to construct ever more complex products may simply further misalign retail investor and industry interests. While efforts to support retail access to alternative investments are important given the significant market risk carried by vulnerable but engaged trusting investors and by more independent empowered investors, they demand very careful regulatory design across a number of dimensions.

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The Report called for a ‘rational and dispassionate debate on the conditions under which retail access to hedge-fund-based investments could be contemplated’, and argued that retail investor access ‘should no longer be a taboo’: Report of the Alternative Investment Expert Group, Managing, Servicing, and Marketing Hedge Funds in Europe (2006), p. 6. FIN-USE was ‘alarmed’ by the Group’s view that MiFID could support the distribution of hedge funds without further restrictions at the level of the fund, its managers or elsewhere in the value chain, save for a €50,000 investability threshold: FIN-USE, Response to the Report of the Alternative Investment Expert Group – Managing, Servicing, and Marketing Hedge Funds in Europe (2006), p. 1. Earlier, it warned that ‘any significant opening of the retail mass market to these new products would raise very large questions about effective consumer protection’: FIN-USE, Opinion on the European Commission Green Paper on the Enhancement of the EU Framework for Investment Funds, p. 11. Commission, Report on the Open Hearing on Non-Harmonized Funds (2008). Similarly, none of the seventeen responses to the Expert Group on Open-Ended Real Estate Funds represented retail interests (although three regulators responded) and all the responses supported the construction of a passportable vehicle.

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c) Designing a response Although the empowerment and choice model appears to have a strong supporter in the Parliament,284 the Commission, hearteningly, appears cautious285 (not least given the liquidity problems experienced by the alternative sector over the financial crisis286 ). It is concerned to take a ‘sound and empirically based’287 decision, and an extensive consultation process has taken place. In addition to the consultation rounds which accompanied the 2005 Green and 2006 White Papers on investment funds, it included the 2006 report of the Commission-appointed Expert Group on Alternative Investment, the 2008 Open Hearing on non-harmonized retail markets funds and the 2008 report of the Commission-appointed Expert Group on Open Ended Real Estate Funds.288 Initial efforts have focused on real estate investment funds which are well established across the EC and may often be more low-risk than UCITS III products. The 2008 Expert Group Report recommended that a passport and accompanying regulatory scheme be developed for open-ended real estate investment funds. But, while granting a passport to property schemes might provide additional diversification opportunities, caution is warranted. Liquidity risks are considerable.289 To the extent that local market appetite exists, industry and local regulators have already responded in many Member States. Developing a passportable vehicle might also suggest trend-chasing risks, given the recent high returns in the property sector which have since collapsed.290 The UK experience with split-capital 284

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Committee on Economic and Monetary Affairs, The Future of Hedge Funds and Derivatives (A5-0476/2003, 2003), pp. 6 and 8–10. The Parliament’s 2007 Klinz II Resolution also called on the Commission to address wider investor access, and argued that the exclusion of openended real estate investment trusts and FoHFs from the UCITS regime was limiting the diversity of investment products available to retail investors. Commissioner McCreevy suggested that any move to address non-harmonized retail funds would require assessment of whether demand existed, whether these funds were really retail products given their risk/return profile, and much greater understanding of the sector: Commissioner McCreevy, Speech on ‘Fulfilling the Promise of Europe’s Asset Management Industry’, 24 November 2006, available via http://europa.eu/rapid/searchAction.do. Skypala, ‘Squabbling’. European Commission, Investment Funds White Paper, p. 12. Expert Group Report, Open Ended Real Estate Funds (2008). Skypala, ‘Squabbling’. The Report acknowledged that open-ended real estate funds are vulnerable to mass redemptions and to the risks attached to rapid liquidation of illiquid property assets but suggested that this could be managed by liquidity management and regulatory devices such as deferral and suspension mechanisms: Open-Ended Real Estate Funds. The Report acknowledged that the real estate market performed ‘particularly well’, as compared to other asset classes, during the review period: ibid., p. 15.

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trusts is instructive. ‘Split caps’ were listed investment trusts with different classes of shares which were designed to reflect different investment objectives. They had complex structures and high levels of gearing and were heavily marketed to the retail sector. While a long-established investment vehicle, they increased rapidly in complexity and expanded rapidly over the dotcom equity market boom.291 As the market fell, large-scale investor losses were sustained as severe stresses were placed on the trusts from their high levels of borrowing (lending covenants were breached as the trusts’ asset value dropped) and their cross-holdings in other trusts.292 Although the FSA responded with regulatory reforms,293 the scale of the losses and the failure of the regulatory regime to predict the risks caution against regulatory support for products where the risks may not yet be entirely clear and the supporting distribution, disclosure and financial capability structures are shaky; a similar lesson might be drawn from the emerging problems with the marketing of structured retail investment products.294

4. Beyond product regulation: the product provider and the provider/distributor relationship Given the difficulties in the CIS product market, it might be asked whether closer attention should be paid to the product provider. The 2008 PwC study on UCITS investment strategies suggests some discipline in the UCITS III sector with respect to marketing to the retail sector, but this is a matter of self-regulation. The UCITS regime focuses almost entirely on the structure of the UCITS product. It does not – and in this it reflects international practice – require that product providers consider whether a particular product, while UCITS III-compliant, reflects retail investor demand and investor competence295 or simply repackages a product designed for, 291

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The sector grew from £5.78 billion in 1980 to £49.5 billion in 2002: FSA, Split Capital Investment Trusts: Update Report on the FSA’s Enquiry into the Split Capital Trust Market (Policy Statement, 2002) (‘Split Capital Trusts Statement’), p. 4. Risks to investors became ‘exponential’ as the gearing effect multiplied the risks, the effects of falling markets magnified, and it became difficult to unwind fund positions: ibid., pp. 5–6. Targeted reforms to ‘split caps’, including board independence requirements and a prohibition on investment in schemes which were not subject to a prohibition on investments of more than 15 per cent of scheme assets in other schemes, followed. J. Hughes, ‘Products Backed by Lehman Spark FSA Probe’, Financial Times, 8 May 2009, p. 3. Regulators generally do not impose requirements on the product design process: Basel Committee on Banking Supervision, International Organization of Securities Commissions, International Association of Insurance Supervisors, Customer Suitability in the Retail

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and trialled in, the institutional sector.296 It does not require that particular retail investor weaknesses, particularly diversification, or vulnerabilities, particularly with respect to market risk, be addressed. Neither does the regime address the provider’s choice of distribution channel, although this choice dictates the extent to which riskier products are distributed to the public and has implications for the quality of advice and the extent to which advisers ‘know their products’. But – and reflecting the contrast between EC investor protection rules ‘on the books’ and the nuance which can be delivered by domestic regimes ‘in action’ – product design and distribution-selection is being addressed in some national markets.297 The Delmas Report, for example, called for more careful delineation of producer and distributor responsibilities, highlighted failures to target products appropriately,298 and suggested that product providers identify the savings needs which products were designed to meet.299 It recommended that products be segmented into ‘standard products’ (designed to meet basic savings needs and including indexed or guaranteed equity schemes) and ‘diversified products’ (designed to offer more advanced investment options) in order to support more carefully targeted marketing and to facilitate the sales and advice process.300 In the UK, the FSA’s ‘law in action’ Treating Customers Fairly (TCF) initiative has been applied to the ‘product life cycle’ and to the respective responsibilities of product providers and distributors.301 Related FSA Guidance also addresses product provider and distributor responsibilities302 and focuses on the TCF Outcome that products and services marketed and sold in the retail market be designed to meet the

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Sale of Financial Products and Services (Bank for International Settlements, 2008) (‘Joint Forum Report’), p. 22. ‘Hand-me-down’ products, not tested in the retail market, are a growing concern for the FSA: Financial Risk Outlook 2009, p. 64; and D. Waters (FSA), Speech on ‘Current Regulatory Issues and Challenges for the Funds Industry’, 14 November 2007, available via www.fsa.gov.uk/Pages/Library/index.shtml. The US regime also has some experience in this area, with FINRA guidance on product design for complex products: Joint Forum Report, p. 22. Delmas Report, pp. 9–10 and 40. 299 Ibid., p. 24. 300 Ibid., p. 30. FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Discussion Paper No. 06/4, 2006); and FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Policy Statement No. 07/11, 2007). Detailed examples of good practice are also set out in FSA, Treating Customers Fairly in Product Design (2007) and a TCF ‘cluster report’ (FSA, Product Design: Considerations for Treating Customers Fairly) which has been supported by 2005 and 2006 case studies. Regulatory Guide, annexed to Policy Statement No. 07/11. It covers the responsibilities of providers (with respect to product design, information to distributors and customers, selection of distribution channel and post-sale responsibility) and distributors (marketing,

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needs of identified consumer groups and targeted appropriately (TCF Outcome 2). It provides guidance on how firm processes can be used to support better product design including with respect to: the design of products for target markets (which should be based on a clear understanding of the needs and financial capability of the target group); product stress testing;303 and the management of product design risks.304 The FSA has also focused on product providers’ choice of distribution channels and suggested that providers should consider whether investors should seek advice; they should also examine distribution patterns in practice.305 The FSA is also concerned as to problems at the provider/distributor interface306 and has recommended that providers ensure that information is sufficient, appropriate and comprehensible.307 But product provider strategies may deepen the risks posed by product regulation as they involve the regulator engineering further into the design process; the FSA has produced a regime of very considerable prescription which is ‘hard-wired’ into the design and testing of investment products. The TCF regime calls on sophisticated regulatory technology and significant supervisory resources, but success has been elusive. Although some positive outcomes have been recorded, outcomes have been variable, particularly with respect to the identification of target markets;308 commercial incentives are such that some very heavy lifting is required to drive product providers to produce clear and appropriately targeted products. But the difficulties do not detract from the ambition of the strategy and its concern to get to the root of poor product design. This ‘in action’ model is some considerable distance from the EC’s UCITS III regime. This is not to suggest that the Delmas or FSA strategies be incorporated into the EC regime, not least as they are rooted in local market experience. But they do shed some unforgiving light on the limitations of the UCITS regime and the challenges posed by product regulation

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disclosure, advice and post-sale responsibility). It is supported by good practice illustrations for product providers: FSA, Treating Customers Fairly and UK Authorized Collective Investment Schemes – Good Practice Illustrations (2008). Products should also be stress-tested to identify how they perform in a range of different market environments and how the target investor(s) might be affected: for example, FSA, Discussion Paper No. 06/4, Annex I, p. 6. Regulatory Guide, para. 1.17. 305 Ibid., para. 1.20. FSA, Policy Statement No. 07/11, p. 10. 307 Regulatory Guide, para. 1.18. The FSA has reported that, while progress had been made, more work was required with respect to identifying target markets, stress-testing, adequate systems and controls and producing appropriate information: Treating Customers Fairly in Product Design, pp. 1 and 4.

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‘in action’. CESR may have a role to play, particularly as experience with national models emerges, by establishing guidance in this area. There are also some signs that the industry might not resist a ‘life-cycle’ model. The European Fund and Asset Management Association’s (EFAMA) Code of Conduct recommends that management companies take reasonable care that their schemes are sold through distributors who meet the Code’s standards, that an appropriate product information framework is developed between the distributor and the management company and that the distributor is monitored.309 In the more febrile structured retail products context, efforts have also been made to address the design process and the provider/distributor relationship, with a group of leading trading associations (through their Joint Associations Committee (JAC)) producing Standards in 2008 for the management of the product provider/distributor relationship.310 Like the EFAMA Code, the Standards echo, if somewhat faintly, the FSA’s ‘life-cycle’ approach. A similar effort in the Netherlands has seen some industry concern to engage with the risks posed by the product design process and poorly targeted products.311 The resilience of the JAC Standards is doubtful in that they are non-binding312 and short on detail; the FSA appears sceptical as to their effectiveness.313 Nonetheless, the appearance of design elements in industry codes points to an emerging concern to address design risks by means other than formal product regulation.

IV. Structured and substitute products 1. The substitute product market and structured products a) Substitute products The risks of product regulation have recently been brought into sharp relief by the rapidly emerging risks from products which are substitutable with, or comparable to, the heavily regulated UCITS. 309 310 311

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EFAMA, Code of Conduct (2006), pp. 19–20. Joint Association Committee, Retail Structured Products: Principles for Managing the Provider–Distributor Relationship (2008). The Dutch Banking Association (the NVB) has adopted an ‘urgent recommendation’ to banks to consider the product’s profile, its risks, the expected returns, different scenarios (including ‘bad weather scenarios’) and the target market: AFM, Exploratory Analysis of Structured Products (2007), p. 39. They are designed to ‘help inform firms’ thinking’: Joint Association Committee, Retail Structured Products: Principles for Managing the Provider–Distributor Relationship, p. 1. FSA, Policy Statement No. 07/11, p. 15.

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The Community savings market is experiencing rapid growth in the range of products which can deliver market-linked returns.314 Market returns and leverage are no longer the preserve of UCITS, as is reflected in the pre-financial crisis outflows from the European CIS industry,315 but can be achieved through a range of products. These can be broadly classified as unit-linked life insurance products, locally regulated non-UCITS CISs (in particular, property schemes and investment trusts), deposits with investment components (structured deposits) and other structured products or securities. Unit-linked insurance products, which provide a market-based return based on the performance of an underlying asset pool, dominate as savings vehicles in the Community, although investment patterns vary,316 and are experiencing strong growth.317 The risks to the retail sector are similarly increasing; massive growth in the unit-linked product sector in a number of Member States in the late 1990s left many retail investors, who had not appreciated the risk transfer to policyholders, exposed in the dotcomrelated equity market downturn and led to particular concern in the Netherlands.318 Non-UCITS closed-end investment trusts and companies also account for a significant portion of the investment product market, with investment trusts representing a significant proportion of the London Stock Exchange, for example. Together, the UCITS/CIS, unit-linked life insurance and structured product market is valued at more than €10 trillion and sees net sales of nearly €500 billion annually.319

b) Structured products But it is the recent explosive growth in retail market structured products320 which has heightened the policy focus on substitute investment products. 314 315

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EFAMA, Response to Commission’s Call for Evidence on Substitute Products (2007), p. 1. Outflows reached €137 billion in the 12–18 months prior to summer 2008: P. Skypala, ‘What Does Brussels Really Want?’, Financial Times, Fund Management Supplement, 14 July 2008, p. 6 (citing Lipper Feri). Net sales of UCITS fell by 5 per cent in 2006, while sales of structured products and unit-linked insurance products rose by 18.5 per cent and 50 per cent, respectively: Commission, UCITS IV Impact Assessment, p. 10. See further ch. 1. 317 BME Report, p. 66. 318 Joint Forum Report, pp. 76–7. Commission, Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008) (‘Need for a Coherent Approach’), p. 8. By the end of 2008, the market was estimated at €8–10 trillion in the European Commission’s impact assessment for the Packaged Products Communication: SEC (2009) 556 (‘Packaged Products Impact Assessment’), p. 43. Retail market ‘structured’ products are different to the ‘structured’ debt instruments strongly associated with the financial crisis, although some retail structured products have

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Like alternative investments, structured products do not form a discrete product class.321 They are typically, although not always, bonds issued by specialist vehicles, the return on which is derived from a range of underlying or embedded assets, including securities, indices,322 foreign exchange,323 commodities, derivatives or debt and combinations thereof. Product design, rather than asset management, dictates the risk/return profile. Structured products can also take the form of bank or term deposits, the yield from which is calculated by reference to the performance of different indicators. The European retail market, which was valued at €136.9 billion in 2005, an 11.1 per cent increase on 2004,324 and which represents approximately two-thirds of the global market and far outstrips the US market,325 has recently experienced explosive growth, reflecting retail investors’ search for yield in a low interest environment326 as well as their demand for tailored products which reflect different savings needs.327 Growth has also been linked to greater demand for alternative and more short-term savings products from retired investors in particular.328 European growth is being driven by the mass retail market which accounted for 79 per cent of total sales in 2005 and by active retail trading on specialist trading markets.329 Growth has not, however, been uniform across the EC and is concentrated in Italy and Spain, although there has been considerable growth in the

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been based on underlying CDO structures, typically the AA or AAA tranches: ‘Credit Risk: Retail CDOs’ 18 Risk, No. 4 (April 2005), available via www.risk.net/public/. The potential confusion in terminology has been associated with a potential reduction in retail investor demand: ‘How Retail Investors Are Influencing Structured Products’ in KPMG, The State of the Investment Management Industry in Europe (2008), p. 22, p. 23. J. Benjamin and D. Rouch, ‘Providers and Distributors: Responsibilities in Relation to Structured Products’ (2007) 1 Law and Financial Markets Review 413. Equity- and index-linked products dominate in the European market, representing 61.3 per cent of the retail market in 2005: Soci´et´e G´en´erale, The European Retail Structured Investment Product Market: Panorama and Trends (2006) (‘Soci´et´e G´en´erale Report’), p. 8. Particularly in Germany: Deutsche Bank Presentation, Retail FX – Overview, Implications, and Discussion, ECB Foreign Exchange Contact Group, March 2006, available via www.ecb.int. Soci´et´e G´en´erale Report, p. 5. BME Report, pp. 59–60. The US market is roughly half the size of the European market, although structured products are becoming popular: J. Bethel and A. Ferrell, Policy Issues Raised by Structured Products (2007), ssrn abstractid=941720. Joint Forum Report, p. 5. FSC Report, p. 20. 328 Bethel and Ferrell, Policy Issues, p. 22. The European Warrant Exchange, Europe’s largest exchange for securitized derivatives, specializes in retail investor products and experiences high levels of retail trading: M. Burghardt, M. Czink and R. Riordan, Retail Investor Sentiment and the Stock Market (2008), ssrn abstractid=110038, p. 13.

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Netherlands,330 Germany331 and France.332 The UK market lags considerably behind, although it is growing.333 The market is also characterized by a concentration of different products in different national markets. Warrants, which give the investor the right to buy or sell the underlying asset at a specified price and within a specified time-frame, have experienced strong growth in Germany,334 although they are rare elsewhere,335 while index-linked/tracker bonds have enjoyed considerable growth in the Danish retail market.336 As is regularly acknowledged by regulators, structured products can offer attractive returns and allow retail investors diversified and hedged access to assets337 (and combinations of assets) which may not otherwise be available, particularly in the commodities and derivatives markets.338 They accordingly provide some protection against market risk. They also provide investors with opportunities for increased gains (and increased risks) through leverage. Conversely, the capital protection associated with these products has proved to be particularly popular with risk-averse investors339 and makes them attractive products for investors close to retirement;340 capital protection led to strong growth in the market in the wake of the 2002–3 equity market downturn.341 A spectrum of investor needs can therefore be met. The risks are, however, considerable. Many Member States, reflecting policy support for a widening of the range of investments available to empowered retail investors, have adopted tailored and supportive 330

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AFM, Annual Report 2006, pp. 44 and 48. Retail investor holdings in structured products increased from €3 billion in 2003 to €30 billion by the end of 2006, with one investor in three (500,000 households) holding structured products (p. 48). BaFIN, Annual Report 2005, p. 34. and Annual Report 2006, p. 27. Soci´et´e G´en´erale Report, p. 5. Financial Risk Outlook 2006, p. 42. Structured Capital at Risk Products represented only a small part of the UK investment product market in 2007–8 (20,000 of the 844,000 investment products sold); nonetheless, this represented a 60 per cent increase on 2006–7: FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 8. Lower levels of investment reflect greater investor familiarity with equity risk and a strong bias towards packaged products: S. Johnson, ‘UK Takes Shine to Structured Products’, Financial Times, Fund Management Supplement, 26 May 2008, p. 3. Deutsche Bank, Retail Certificates: A German Success Story (Deutsche Bank Research, EU Monitor 43, 2007), pp. 2–3; and BaFIN, Annual Report 2006, p. 27. BME Report, p. 60. A.-S. Rang Rasmussen, ‘Index-Linked Bonds’ in Danish Central Bank Monetary Review, Second Quarter 2007 (Danish Central Bank, 2007), p. 51. KPMG, The State of the Investment Management Industry, p. 23. E.g. FSA, Financial Risk Outlook 2007, p. 55; and AFM, Exploratory Analysis, p. 12. Soci´et´e G´en´erale Report, p. 7; and BME Report, p. 60. FSA, Financial Risk Outlook 2005, p. 40. 341 AFM, Exploratory Analysis, p. 12.

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regulatory regimes.342 But the empowerment attractions of these products must be carefully balanced with the risks to vulnerable trusting investors. From a design perspective, structured products are complex343 and often opaque. Investor competence risks are accordingly heightened344 and disclosure risks become severe.345 Liquidity risks are considerable as the secondary market for structured products tends to be illiquid.346 Difficult market conditions can cause product providers to withdraw from market-making, increasing the potential investor losses.347 While advice may take on some of the weight of investor protection, distribution risks and mis-selling risks can be considerable.348 Retail investors are also acutely vulnerable to products marketed as low-risk and capitalprotected and may not appreciate the impact of capital protection on returns349 or that protection depends on the guarantee’s resilience.350 Although capital-protected products should have provided protection against the ‘credit crunch’ market convulsions, they are only as strong as the guarantor(s). The 2008 Lehman insolvency saw the first largescale stress on capital-protected structured products as Lehman-provided capital protection failed for derivatives-based products.351 All these risks are heightened as retail investor appetite for structured, and particularly capital-protected, products is increasing, particularly in the UK,352

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As is the case in Germany where the regulatory regime has been linked to the success of certificates. Although equity-based products are most popular, some European products have been based on CDOs, exposing investors to the risks of poor understanding of the implications of different tranches: Credit Risk. These risks were highlighted during the credit crunch by the impact of the Lehman collapse on capital-protected products (K. Burgess and A. Ross, ‘L&G Will Pay Price of Lehman Collapse’, Financial Times, 16 December 2008, p. 17) and by the exposure of retail investors to the Madoff hedge fund fraud through structured notes: J. Mackintosh, F. Guerrera and H. Sender, ‘Leading Banks Lent Billions to Feeder Funds for Bets on Madoff’, Financial Times, 19 December 2008, p. 1. See further ch. 5. 346 Bethel and Ferrell, Policy Issues, p. 22. EFAMA, Response to Call for Evidence, p. 5. 348 See further ch. 4. FSA, Financial Risk Outlook 2005, p. 46. 350 FSA, Financial Risk Outlook 2009, p. 64. More than 2,000 investors in two Legal & General capital-protected funds which were exposed to Lehman were warned of capital losses in December 2008: Burgess and Ross, ‘L&G Will Pay Price’. Complaints have also been made to the Financial Ombudsman Service with respect to the sale and marketing of Lehman-guaranteed products (which represented only £101 million of the total structured product market (£35 billion)) and the FSA has a launched a wider review of structured product marketing and sales: Hughes, ‘Products’. Drawing on industry data, the FSA has reported ‘significant pick-up’ in structured product sales in the UK, particularly of products with capital protection, with a 25 per cent increase in sales in 2008 from 2007, contrasting with downward trends in the sale of other

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in response to recent extreme market volatility353 and historically low interest rates and as advisers rely more heavily on these products.354 But most serious, perhaps, are the regulatory risks; structured products, which reflect the ability of the market to exploit different forms of regulation,355 are vulnerable to considerable regulatory arbitrage risks, as discussed in the following section.

2. A segmented product regime and its risks a) Sectoral regulation Depending on the complexity of the investment, investors in insurance-, deposit- and investment-related substitutable products, including structured products, are exposed to similar risks concerning product design but also with respect to disclosure and distribution.356 But these sectors have traditionally been subject to discrete, silo-based regulation357 which does not respond easily to substitute product risk. This has led to an international policy concern,358 well reflected in the wide-ranging 2008 report by the Joint Forum359 and in the 2008 US Treasury Blueprint for reform of the US regulatory and supervisory regime,360 as to the effectiveness of sectoral regulation.

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investment products and balancing outflows from retail CISs: D. Waters, FSA, Speech on ‘Industry Response to Developments in Regulation of Structured Products’, 12 February 2009, available via www.fsa.gov.uk/Pages/Library/index.shtml. EFAMA reported a shift in demand from UCITS to structured products (and deposits) over the worst of the market turbulence: Quarterly Statistical Release No. 36, p. 2. Forty per cent of advisers canvassed by a Morgan Stanley survey in 2008 were more likely to suggest structured products in volatile market conditions: Waters, ‘Industry Response’. S. Claessens, Current Challenges in Financial Regulation (2006), ssrn abstractid=953571. For a review in the Canadian context, see A. Fok Kam, Implications for the Investment Wrapper, Research Report prepared for the Task Force to Modernize Securities Legislation in Canada: Evolving Investor Protection (2006). Silo-based regulation was, for example, implicated in the UK 1990s pension mis-selling scandal: J. Black and R. Nobles, ‘Personal Pensions Misselling: The Cases and Lessons of Regulatory Failure’ (1998) 61 Modern Law Review 789. For a critique of the multi-sectored approach to the US financial services industry, see Jackson, ‘Regulation’. E.g. Fok Kam, Implications (in the Canadian market); and SFC, Investors Lack Understanding of Structured Products (2006) (in the Singapore market). Joint Forum Report. The US Treasury Blueprint’s call for an integrated supervisory structure was based, in part, on the cross-sectoral nature of financial products: Department of Treasury, Blueprint for a Modernized Financial Regulatory Structure (2008).

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Under the silo-based EC regime, different regulatory regimes and varying levels of protection apply according to whether a product is insurancebased, a UCITS, deposit-based or a MiFID-scope investment product; the current EC regime ‘does not form a homogeneous framework of rules aimed at advising and protecting retail investors’.361 This segmentation reflects the origins of the regime at a time when products were segmented for regulatory purposes according to their different insurance (insurance), savings (deposits) and investment (UCITS) functions and profiles, were often subject to different tax treatment, and were distributed through different channels.362 Some tantalizing evidence of an earlier, if ambitious, commitment to a horizontal approach is contained in the 1985 Internal Market White Paper which saw the Commission call for a mutual recognition regime which would support the cross-border ‘exchange’ of ‘financial products’, including UCITS.363 Regulatory untidiness in itself is not problematic, particularly where local rules fill the gaps, although they do not always do so.364 But the risk of investor and firm confusion as to the relevant protections arises.365 Most seriously, particularly where sectoral regulation is uneven, regulatory arbitrage risks are generated.366 Regulatory arbitrage is a long-established feature of sectoral regulation and is a rational response to regulation.367 But it is significant in the EC regime, as has been highlighted by FINUSE368 and the Delmas Report; the Report highlighted the example of a French product provider who was able to avoid AMF oversight of its complex and high-risk investment product by repackaging a UCITS product as a functionally identical structured product within a unit-linked insurance product issue which was listed by a subsidiary in another 361 363 364

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Need for a Coherent Approach, p. 9. 362 Ibid., pp. 3 and 8. European Commission, Completing the Internal Market (COM (85) 310), para. 102. Structured deposits, for example, are, for the most part, not treated as investments (with some exceptions, including marketing requirements) under the UK FSMA regime reflecting, in part, the prudential regulation of banks, although the regime is under review and banking conduct-of-business regulation is being reformed: for example, Waters, ‘Industry Response’. HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC (2007) (‘UK Article 4 Application’), p. 11. Joint Forum Report, p. 6. Jackson, ‘Regulation’. Arbitrage risks were one of the drivers for the proposed new US Consumer Financial Protection Agency. E.g. FIN-USE, Response to Expert Group on Market Efficiency (2006).

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Member State.369 Retail investors already face formidable difficulties in exercising informed choice and driving the production of appropriate products. These are exacerbated by regulatory arbitrage which leads to products being designed to avoid regulation rather than in response to investor needs.

b) Product regulation and substitute products The regulatory arbitrage and investor protection risks posed by the segmented distribution and disclosure regime for different investment products are discussed in chapters 4 and 5. But these fragmented product design regime is also problematic. Unlike UCITS, unit-linked insurance products are not subject to specific liquidity and diversification requirements. Under the harmonized life insurance regime, insurance company authorization is given to an insurance company for unit-linked insurance as a class.370 Structured securities are subject only to the issuer’s obligation to produce an authorized prospectus under the prospectus regime.371 Structured deposits are not subject to any harmonized product requirements. Regulatory arbitrage risks are increased by the more cumbersome authorization procedures which apply to UCITS and the longer ‘time to market’ of the UCITS product. The high-level requirements of the EC’s admission regime do not provide back-stop product design protections with respect to listed products.372 The principles-based admission-to-trading regime which applies under MiFID and the MiFID Level 2 Regulation373 is designed to support fair, orderly and efficient trading. It focuses on the availability 369 370

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Delmas Report, p. 17. Directive 2002/83/EC of the European Parliament and Council of 5 November 2002 concerning life assurance, OJ 2002 No. L345/1. The related investments are, however, limited to specified financial assets. The insurance regime is being significantly reformed and recast under the wide-ranging Solvency II reforms (based on COM (2008) 119), due to be adopted by summer 2009 and implemented by 2012, which will consolidate but also reform the different insurance measures, including the life assurance regime, notably by the adoption of a risk-based approach to solvency requirements. Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64. See further ch. 4. Listing accounts for only approximately 4 per cent of overall non-UCITS scheme sales to individual investors; listed real estate funds represent about 50 per cent of the total: 2008 PwC Retailization Report, p. 12. MiFID Level 2 Regulation (OJ 2006 No. L241/1), Arts. 35 (transferable securities and shares) and 36 (CISs).

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of disclosure, the extent of the security’s distribution and, particularly for CISs, compliance with marketing preconditions in the relevant regulated market’s jurisdiction, redemption arrangements and the transparency of unit valuation. Although the admission requirements are designed to support investor protection, they impose only minimal requirements and are designed to allow regulated markets to develop their own admission regimes and market segments, as the London Stock Exchange has done.374 They do not engage with product design.

3. Developing a response Domestic regimes are already grappling with substitute product risks. But, reflecting the expanding reach of EC retail market policy, the Commission, following an ECOFIN request in May 2007, has seized the agenda,375 publishing an initial Call for Evidence on substitute products in November 2007.376 Institutional concern has also come from the 3L3 committees, which are independently considering substitute product risks,377 the Council378 and the European Parliament.379 From the outset, there appeared to be some support from the retail and supervisory sectors for a degree of harmonization.380 But the risks of a massive re-engineering of the EC design, distribution and disclosure regime to apply to a notional class of investment products, which would not reflect international practice,381 are considerable. A key threshold 374

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The London Stock Exchange’s Specialist Fund Market is a regulated market subject to MiFID’s admission requirements and supports the trading of specialized schemes including closed-end private equity funds, hedge funds, sovereign wealth funds and specialist property funds. E.g. European Commission, Staff Working Paper, p. 5; and European Commission, Green Paper on Retail Financial Services in the Single Market (COM (2007) 226), p. 17. Need for a Coherent Approach. CESR, 3L3 Medium Term Work Programme: Consultation Paper (CESR/07-775, 2007), pp. 11–12. ECOFIN Council Conclusions, 2798th ECOFIN Meeting, 8 May 2007, Press Release, p. 11. The Council’s Financial Services Committee also suggested that the advice and sales regime be considered to ensure that investors were not disadvantaged by particular sales channels or products: FSC Report, p. 36. Klinz II Resolution. The Parliament called for a review of the legislative framework for marketing, advice and sales for all retail investment products to ensure a coherent approach to investor protection. European Commission, Feedback Statement on Contributions to the Call for Evidence on Substitute Retail Investment Products (2008), pp. 29–30. The Joint Forum simply suggested that countries have consistent, or similar, disclosure and suitability standards: Joint Forum Report, p. 52.

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question concerns whether the risks of regulatory arbitrage and of gaps in the harmonized regime (particularly with respect to structured products) are outweighed by the costs of intervention. Risk appetites for different products vary considerably across the Member States; products are often designed for local market investment needs. The cross-border market in investment products is limited, as is clear from the UCITS regime,382 and cross-border distribution structures are only developing. Local regulators may therefore be best placed to address any gaps which arise in the harmonized regime;383 the FSA’s packaged product regime, for example, is designed to address the risks of segmented regulation, and the FSA has not appeared supportive of harmonization.384 A harmonization strategy might provide a focal point for industry lobbying efforts which, given that battle-lines for competitive advantage are being drawn,385 might increase the risks of poor regulatory design. Substitute products are an elusive class to define; whether or not investment products are in practice substitutable can be unclear.386 Intervention is likely to be poorly designed without considerably greater evidence on MiFID’s effectiveness, particularly with respect to product disclosure and distribution risks. Ill-judged and costly harmonization could stifle investors’ opportunities for higher 382

383

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Pan-EC cross-border activity is low, with less than one-fifth of all UCITS in the form of cross-border schemes in that they are sold in more than one Member State outside the Member State of registration: Investment Funds Green Paper, p. 12. The UK FSA is supportive of domestic solutions given divergences in investor preferences and distribution structures and limited cross-border activity: FSA, Response to the European Commission’s Call for Evidence on Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008) (‘FSA Substitute Products Response’), p. 1. See further ch. 1. The FSA has highlighted that two major recent mis-selling scandals (concerning personal pensions and endowment policies used to repay mortgage debt) concerned products outside MiFID’s scope but which were addressed through the FSA’s packaged products regime and its horizontal approach to distribution and disclosure risks: UK Article 4 Application. The Commission’s 2008 Industry Workshop, for example, saw battle-lines drawn, with the European Derivatives Association resisting a roll-out of the UCITS disclosure regime and EFAMA calling for a level playing field: European Commission, Minutes of the Industry Workshop on Retail Investment Products (2008), pp. 3–4. The European Banking Federation, for example, has argued that UCITS operate under a collective mandate and expose investors to the risks of investment management while structured products offer a return linked to the product’s design: European Banking Federation, Response to Call for Evidence (2008), pp. 1 and 3. The European Derivatives Association has similarly argued that structured products represent a contractual obligation while CIS management involves a fiduciary obligation to act in the best interests of investors: Commission, Minutes of Industry Workshop, p. 3.

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returns and better diversification. Market solutions are developing,387 perhaps in response to the threat of intervention implicit in the EC policy debate. But regulatory (and supervisory) arbitrage between different sectoral regimes remains a risk both locally, where Member States do not ‘fill the gaps’ through local rules, and on a pan-EC basis. It is particularly acute on a pan-EC basis as regulators’ incentives vary; the UCITS experience suggests that Member States who are net UCITS exporters are likely to take a more relaxed approach to regulation and supervision than those with significant local markets.388 The retail market is also somewhat fragile. Widespread mis-selling could damage confidence in more tightly regulated products and in long-term saving. It is not efficient that the massive regulatory and industry resources expended on the UCITS product can be so easily wasted where the UCITS is wrapped in another product or where a UCITS-style product is constructed as a unit-linked insurance product or structured security. Neither is it efficient that MiFID’s distribution regime can be side-stepped by designing a product as an ex-MiFID deposit- or insurancebased product. The risks of harmonization may also be mitigated by what appears to be a measured approach to potential reforms. A wide range of stakeholders have been engaged in an extensive consultation process389 (although retail engagement remains troublesome390 ). The Commission’s Call for Evidence was carefully couched in terms of whether intervention across the market was desirable; Commissioner McCreevy warned that ‘throwing European rules at the problem will not make it go away’ and that such a major undertaking called for care and an evidence-based approach.391 The UCITS experience suggests that further product design and labelling efforts, even in an attempt to address particular risks (such as 387

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Joint Associations Committee (representing a group of trade associations), Retail Structured Products: Principles for Managing the Distributor–Individual Investor Relationship (2008). European Commission, Simplified Prospectus Workshops 15 May 2006 and 11 July 2006: Issues Paper (2006), pp. 10–11. The 2007 Call for Evidence was followed by a Feedback Document, a 2008 Industry Workshop and a 2008 Open Hearing. See further ch. 7. FIN-USE has, however, been engaged from the outset and has called for harmonized high-level principles on conflicts of interests, training and competence, and disclosure. Closing Address, Public Commission Hearing on Retail Financial Services, 19 September 2007, available via http://europa.eu/rapid/searchAction.do.

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the liquidity risks of structured products), are ill-advised and wasteful of regulatory resources. The removal of regulatory arbitrage possibilities with respect to disclosure and distribution may have the indirect effect of limiting the proliferation of complex and subtly differentiated products and thereby improve product design. But, in the absence of more radical ‘law in action’ reforms on the lines of the FSA’s ‘product life cycle’ model, there is little that harmonized regulation can do to drive better product design. Investor discipline may be strengthened by financial capability and disclosure initiatives, but these are long-term strategies. Ultimately, the risks of structured/substitute products must be carried by the horizontal distribution and, to a lesser extent, disclosure regimes. The Commission issued its first formal response to the substitute products question in April 2009 with its Packaged Products Communication. The ambition of the proposed reform is striking and somewhat unexpected given the ‘light-touch’ tenor of earlier policy discussions. The Commission has suggested that the current fragmented harmonized disclosure and distribution/advice regimes be radically reconfigured such that new horizontal disclosure and ‘selling’ regimes apply to ‘packaged products’ and that there is ‘a coherent basis for the regulation of mandatory disclosures and selling practices at European level, irrespective of how the product is packaged or sold’.392 It appears that radical reforms to MiFID are therefore envisaged, despite the massive resources already expended on its negotiation and implementation, although the Commission has acknowledged that MiFID’s conduct-of-business and conflict-of-interest rules could act as a benchmark. The reform is designed to address the risks of investor detriment, remove regulatory arbitrage risk and minimize divergent national approaches. A sweeping reform of this nature would certainly address regulatory arbitrage risk and it is heartening that product design reforms are not being canvassed.393 More advanced regulatory technology could also be applied; CESR has become considerably more experienced with retail market risks and their management since the MiFID negotiation period. But the challenges are very considerable. Great care will be needed in defining the ‘packaged products’ which will define the scope of the 392 393

Packaged Products Communication, p. 2. The Commission noted that product design strategies were difficult to implement effectively given financial innovation (ibid., p. 5), while the related impact assessment noted that the ‘practical challenges . . . would be immense and net market outcomes deleterious’ (p. 10).

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regime.394 The scale of the new regime, and the related scope for error, looks to be significant; the Commission has suggested that core principles could be adopted for all products (presumably at level 1) but that detailed rules, adapted to specific products, could also be adopted (presumably at level 2).395 It appears that the existing sectoral legislation will be repealed;396 unintended effects and regulatory error could therefore be considerable. Industry costs in adapting to a new regime are likely to be significant, however similar that regime may be, in terms of selling requirements, to MiFID. Any roll-out of a new disclosure regime will also impose immense demands on the industry as detailed harmonization has thus far been limited to UCITS. Local innovation and flexibility may be prejudiced; the Commission appears to be in search of much greater regulatory tidiness, warning of the lack of coherence in the current framework, acknowledging local regulatory and market efforts but warning of the limited geographical scope of local reform efforts and of barriers to the single market, highlighting that gold-plating restrictions may inhibit local efforts and calling for a systematic and co-ordinated approach.397 It also may not be unreasonable to imply some Commission empire-building dynamics. Certainly, some investor detriment is likely to be associated with the current fragmented regime, particularly given the popularity of unit-linked insurance products which fall outside MiFID, but the impact assessment is not entirely convincing, focusing for the most part on expert opinion and highlighting the patchwork nature of the current regime but presenting little empirical evidence of market failure.398 The risks of this proposed massive redesign are very considerable unless great care is taken. But, if nothing else, it points to the scale of the Commission’s ambitions in the retail markets. 394

395 398

The Commission seems to envisage that CISs, unit-linked products and structured deposits would be included as packaged products and, more vaguely, has suggested that packaged products offer exposure to underlying assets, are designed to support capital accumulation, have the mid-to-long-term market in mind and are marketed directly to retail investors: Packaged Products Communication, p. 3. Ibid., p. 9. 396 Ibid., p. 11. 397 Ibid., pp. 6 and 8. To the contrary, it acknowledged that the risks of investor detriment were difficult to quantify, that there was little systematic empirical evidence on disclosure failures, that there was no strong evidence of the extent to which inconsistencies and gaps in the selling regime might have led to investor detriment or competitive distortions and that there was limited practical experience with the MiFID regime: Packaged Products Impact Assessment, pp. 13 and 16–17.

4 Investment advice and product distribution

I. Intermediation, its risks and regulation 1. The benefits of advice The EC retail market is strongly characterized by intermediation in the form of investment advice and related investment product distribution services.1 Reliance on advisers, whether in the form of independent advisers or, more commonly, bank-based financial supermarkets, is significant.2 This reliance is in many respects inevitable and rational, and it can lead to stronger market engagement. Investment advice has an educational dimension.3 The adviser can counter decision-making defects4 and dilute deeply rooted biases, including framing effects,5 the status quo effect, the tendency to sell winners more quickly than losers6 and the home bias, which can drive poor diversification.7 Given that information-gathering represents a significant barrier to retail market entry, advice may improve market engagement in that information-gathering is outsourced to the 1 2 3 4

5 6 7

The relationship between ‘advice’ and product distribution and sales is explored in sect. X below. See further ch. 2. FIN-USE, Financial Education: Changing to Second Gear (2008), p. 8. E.g. G. La Blanc and J. Rachlinski, In Praise of Investor Irrationality (2005), ssrn abstractid=700170, p. 22; J. Rachlinski, ‘The Uncertain Psychological Case for Paternalism’ (2003) 97 Northwestern University Law Review 1165; and J. Arlen, ‘Comment: The Future of Behavioral Economic Analysis of Law’ (1998) 52 Vanderbilt Law Review 1765. J. Drukman, ‘Using Credible Advice to Overcome Framing Effects’ (2001) 17 Journal of Law, Economics, and Organization 62. Z. Shapira and I. Venezia, ‘Patterns of Behavior of Professionally Managed and Independent Investors’ (2001) 25 Journal of Banking and Finance 1573. A. Palmiter and A. Taha, Mutual Fund Investors: Divergent Profiles (2008), ssrn abstractid=1098991; and Shapira and Venezia, ‘Patterns’. The BME Report predicted that better informed advisers would increasingly offer the most competitive products to investors, regardless of the products’ country of origin: BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems and Consumer Savings Patterns (2007) (‘BME Report’), p. 215.

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adviser.8 Market risks may be contained where advice is sought and higher returns may follow;9 evidence from Germany10 and the UK11 suggests positive outcomes from advice.

2. The risks But investors face a series of risks from advice services. The relationship between the service provider and the investor is characterized by often severe informational asymmetries and by limited investor competence. Retail investors are rarely in a position to monitor advisers effectively12 and have difficulties in assessing the quality of advice.13 Decision-making difficulties are exacerbated as adviser failures may not become apparent for some time14 and as retail investors are unlikely to gain experience as investment decisions tend to be irregular.15 Over-reliance on and excessive trust in advisers is likely,16 particularly by older investors seeking to change 8

9

10 11

12

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14 15 16

P. Shum and M. Faig, ‘What Explains Household Stock Holdings’ (2006) 30 Journal of Banking and Finance 2579 (the study, based on US household investment, is inconclusive, given the range of variables which affect market participation). Professionally managed accounts have been shown to display better performance: Shapira and Venezia ‘Patterns’. A link has also been made between positive future returns and trades through full-service brokers: B. Barber and T. Odean, ‘Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’ (2000) 55 Journal of Finance 773. R. Bluethgen, A. Gintschel, A. Hackethal and A. Mueller, Financial Advice and Individual Investors’ Portfolios (2008), ssrn abstractid=968197. Financial Services Authority (‘FSA’), Stopping Short: Why Do So Many Consumers Stop Contributing to Long-Term Savings Policies (Occasional Paper No. 21, 2004), p. 6 (finding longer persistence where products are sold by advisers rather than agents). H. Jackson, ‘Regulation in a Multisectored Financial Services Industry: An Exploration Essay’ (1999) 77 Washington University Law Quarterly 319; and, for a stakeholder perspective, FIN-USE, Financial Services, Consumers and Small Businesses: A User Perspective on the Reports on Banking, Asset Management, Securities, and Insurance, of the Post FSAP Stocktaking Groups (2004), p. 10. The Australian regulator (ASIC) has found that 85 per cent of retail investors were happy with advice which it regarded as non-compliant with quality standards: ASIC, Shadow Shopping on Superannuation Advice: ASIC Surveillance Report (2006), p. 22. UK and EC investors appear to be similarly trusting: n. 16 below. Oxera, Assessment of the Benefits of the Suitability Letter: A Report Prepared for the FSA (2007), p. 4. The Sandler Report, Medium and Long-Term Retail Savings in the UK: A Review (2002) (‘Sandler Report’), p. 4. Only 10 per cent of EC consumers surveyed sought information independently when they took advice: BME Report, p. 194. It also reported generally high levels of trust in intermediaries (p. 197). The FSA has found that 92 per cent of those receiving financial advice were confident as to the appropriateness of the advice (Consumer Awareness of the

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the composition of their portfolios and who face very considerable risks from poor-quality advice.17 Imperfect information, weak monitoring, poor decision-making and excessive trust can expose investors to a series of risks from the principal/agent relationship which characterizes the service provider/investor relationship18 and from the related incentive misalignment risk.19 These include fraud, misuse of investor funds, conflicts of interests, poor-quality advice/mis-selling and incompetence;20 although there is some evidence of advisers improving investment performance, this is not always the case.21 Many of these failures reflect behavioural weaknesses on the part of the adviser which may simply replace, and not displace, those of the investor.22 The risks of intermediation are exacerbated in the integrated market as domestic supervision of cross-border advisers may not be robust (chapter 8) and locally tailored regulation may be threatened by harmonization requirements.

17

18 19 20 21

22

FSA and Financial Regulation (Consumer Research No. 67, 2008), p. 36) and that investors regard the possibility of serious loss as remote, in part because of a belief that advisers would not recommend a risky product: FSA, Consumer Research No. 5, Informed Decisions? How Consumers Use Key Features: A Synthesis of Research in the Use of Product Information at the Point of Sale (Consumer Research No. 5, 2000), p. 18. SEC, North American Securities Administrators Association, and FINRA, Protecting Senior Investors: Compliance, Supervisory and Other Practices Used by Financial Services Firms in Serving Senior Investors (2008) (‘Senior Investors’). S. Choi, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1 Berkeley Business Law Journal 45. M. Condon, ‘Rethinking Enforcement and Litigation in Ontario Securities Regulation’ (2006) 32 Queen’s Law Journal 1. T. Odean, ‘Are Investors Reluctant to Realise Their Losses?’ (1998) 53 Journal of Finance 1775. Palmiter and Taha, Mutual Fund Investors, pp. 50–4 (advisers can exercise poor judgment and may be prone to over-reliance on past performance information); and D. Bergstresser, J. Chalmers and P. Tufano, ‘Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry’ (2007), ssrn abstractid=616981 (finding, with respect to CIS sales, that brokers did not provide superior market timing ability, sales were directed towards schemes with higher distribution fees and brokers appeared to chase returns). Similar findings were made in an FSA-commissioned study (CRA International, Benefits of Regulation: Effect of Charges Table and Reduction in Yield (2008)), which found that intermediaries rely more heavily on past performance information (60 per cent) than on charges disclosure (25 per cent): p. 19. The pan-EC Optem Report on disclosure highlighted that, notwithstanding high levels of reliance on advisers, there was concern that advisers were not competent, did not make efforts to educate investors, were salespersons rather than advisers and had limited commitment to the investor: Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’), p. 96. La Blanc and Rachlinski, In Praise; and D. Langevoort, ‘Selling Hope, Selling Risk: Some Lessons from Behavioral Economics about Stockbrokers and Sophisticated Investors’ (1996) 84 California Law Review 627.

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Conflicts-of-interest and mis-selling risks are particularly acute. Intermediation must be paid for and the scale of intermediation in the EC means that commission payments from product sales or advice, discussed in section X below, pose significant risks to the quality and objectivity of investment advice. But incentive misalignment is not simply a function of commission risk; it is also a function of regulatory risk. Capital requirements and the relative costs of product production can distort advisers’ and distributors’ incentives. The new Solvency II regime for insurance companies has been associated with the risk of unit-linked insurance products, which are often complex and opaque but which are burgeoning in the EC market, being pressed on insurance customers as these products are subject to a lower capital charge under the solvency regime.23 A similar dynamic can lead to advisers and distributors promoting products, such as unit-linked products and deposit-based products, which fall outside MiFID’s requirements and, in particular, its commission disclosure requirements.24 Crisis conditions also exacerbate conflict-of-interest risks. Over the ‘credit crunch’, banks, under pressure to repair their balance sheets, were reported to be promoting deposit-based products more heavily than CIS investments.25 Retail investors, displaying high risk aversion in the short term, may also be exposed to increased mis-selling risk,26 particularly with respect to costly capital-protected products. The risks are all the greater as investment advisers are largely concerned with shaping demand, and with promoting willingness to take on risk.27 Technological advances also mean that investors may face conflict-of-interest and other risks where advice is provided online or through platforms and wraps (online services which are growing in popularity in the UK and continental Europe28 and which are used by advisers to view and administer investment portfolios and to buy and sell investment products).29 23

24 25

26 27 29

As highlighted in FIN-USE, Solvency II Regime – Principles to Ensure End-User Protection (2009), p. 4. The Solvency II regime (based on COM (2008) 119) was due to be adopted by summer 2009 and to be implemented by 2012. Sect. IX below. P. Skypala, ‘ETFs the Only Bright Spot as Outflows Roll on’, Financial Times, 24 November 2008, p. 15, noting banks’ attempts to repair their balance sheets and steer customers from bond funds into deposits; and S. Johnson, ‘UCITS Outflows Soar in Q3’, Financial Times, Fund Management Supplement, 1 December 2008, p. 2, reporting higher levels of switching from CISs to deposits in southern Europe. The European Fund and Asset Management Association (EFAMA) also reported an outflow from UCITS to deposits (and structured products): EFAMA, Quarterly Statistical Release No. 36 (2008). FSA, Financial Risk Outlook 2009, pp. 39–40 and 64. Langevoort, ‘Selling Hope’, 649. 28 BME Report, p. 172. FSA, Platforms: The Role of Wraps and Fund Supermarkets (Discussion Paper No. 07/2, 2007), pp. 3 and 7.

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Although they can enhance the quality of advice, wraps and platforms also pose risks where suitability requirements are not met in the selection of the wrap or platform and where conflicts of interest arise where firms hold financial interests in wraps and platforms.

3. Regulating advice As suggested in chapter 2, an effective retail market policy must include imaginative supply-side rules ‘in action’ if it is to reflect appropriately retail investor vulnerabilities while supporting engagement. These rules must focus on the pivotal advice and related product distribution process. Notwithstanding the advantages of advice, the extent of investor reliance, particularly by trusting investors but also by more empowered investors who are faced with increasingly complex choices, coupled with poor investor monitoring, suggests that regulation is necessary. So too do the risks posed by the advice process and the corresponding need to ensure that the ability of the advice industry to strengthen market engagement is not compromised.30 More positively, investment advice and its regulation provide the strongest line of defence for investors31 who are faced with a proliferating, substitutable and complex range of products and with voluminous regulated and other disclosures. Disclosure is a severely limited tool. Product regulation has failed to control the proliferation of a vast range of often highly complex products and is a weak investor protection mechanism.32 Segmentation strategies can struggle in shielding investors from the riskiest and most complex of products and in, at the same time, ensuring that 30

31

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The Delmas Report warned of the danger that mis-selling could dissuade savers from the markets, generate reputation and litigation risks for firms and risk damage to the financial system as a whole (J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government (2005) (‘Delmas Report’), p. 12), while the Joint Forum has highlighted the risks mis-selling poses to firm solvency, reputational risk and innovation (Basel Committee on Banking Supervision, International Organization of Securities Commissions, International Association of Insurance Supervisors, Customer Suitability in the Retail Sale of Financial Products and Services (Bank for International Settlements, 2008) (‘Joint Forum Report’), p. 6). The International Swaps and Derivatives Association (ISDA), in the context of the substitute products debate, has suggested that the ‘best investor protection model would be that of independent advice’: European Commission, Minutes of the Industry Workshop on Retail Investment Products (2008), p. 4. E.g. Joint Associations Committee (representing a group of leading financial market trade associations), Response to Commission Call for Evidence on Substitute Products 2008, calling for a distribution/suitability-based approach rather than one based on product regulation (p. 2). See ch. 3.

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retail investors benefit from innovation, particularly with respect to the management of market risk. The advice process, however, can filter disclosure and products. Horizontal advice and distribution strategies can also deliver stronger protection against market risk. This can take the form of high-quality diversification advice. But the regulation of advice can also support the sale of riskier products33 which may manage market risks more effectively.34 Where investment advice fails, however, the risks to investors can be acute given limited product regulation and the inadequacies of disclosure regulation.35 The concern to promote engagement, increased recourse to advice36 and the risks of the advice process have led to an international regulatory focus on distribution and advice and, in particular, on the quality of advice.37 Internationally, the 2008 Joint Forum Report placed the sale of financial products and services ‘at the core of consumer confidence in financial markets’.38 Earlier, and following the recommendations of the 1997 Wallis Committee,39 large-scale reform to the delivery of investment advice was adopted in Australia under the Financial Services Reform 2001.40 Following a spate of scandals,41 mis-selling risks in the advice and sales process and the consequent risks to household financial planning, have become a regulatory preoccupation in the Community42 and of the

33 34 35 36

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38 39 40 41

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J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 252. In the UK, non-regulated CISs may be recommended to investors in the course of an advice relationship and where suitability requirements are met: COBS 4.12. As is clear from the emerging concern in the UK market as to the potential mis-selling of structured products in the wake of the Lehman collapse. The European independent advice market is likely to grow as investments become more complex and as the need for market savings becomes more acute: Oxera, Description and Assessment of the National Compensation Schemes Established in Accordance with Directive 97/9: A Report for the Commission (2005), p. 106; and Subgroup (of the Council of the EU’s Financial Services Committee) on the Implications of Ageing on Financial Markets, Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’). The 2008 US Treasury ‘blueprint’ (Department of Treasury, Blueprint for a Modernized Financial Regulatory Structure (2008)), for example, considered the differential treatment in the US of investment advisers and broker-dealers. Joint Forum Report, p. 4. Wallis Committee, Final Report on the Financial System Inquiry (1997). A subsequent series of reforms were adopted in 2005: Australian Treasury, Refinements to Financial Services Regulation: Proposals Paper (2005). ‘[M]ost large countries in the development of their financial market economy have experienced in the recent past problems of misselling ranging from recourse to abusive marketing practices to the sale of unsuitable products’: Delmas Report, p. 9. ‘[R]egulatory regimes which previously focused almost solely on prudential issues are gradually putting an increasing focus on the quality of the sales process’: FSA, A Review of Retail Distribution (Discussion Paper No. 07/1, 2007) (‘2007 RDR’), Annex 3, p. 12.

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EC institutions,43 although in practice the 2007 BME Report suggests that mis-selling is not a major concern for European households.44 The FSA has consistently highlighted the importance of an effective investment advice and product distribution market given pressure on household savings and the need for greater financial independence,45 and acknowledged investor dependence on advice channels.46 The FSA’s experience of mis-selling47 was one of the drivers for its opening of the Retail Distribution Review (RDR) in 2007 (sections XI and XII below),48 which was designed to address ‘significant and persistent problems’ in the distribution of retail investment products and particularly commission risk.49 Advice was also the focus of the Thoresen Review, which recommended the establishment of a ‘generic advice’ service, independent of the sales process (chapter 7); the quality of advice is also a central pillar of the FSA’s ‘law in action’ Treating Customers Fairly (TCF) strategy.50 But the concern to address advice and product distribution risks crosses different national advice and distribution patterns. The 2005 Delmas 43

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45

46

47

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49 50

The Council’s Financial Services Committee has warned that the pressure on households to cover welfare needs previously carried by government, and the increased product selection risk, required that appropriate advice mechanisms be in place to mitigate mis-selling risks: FSC Report, p. 15. The report found that ‘only’ 8.1 per cent of consumers had personal experience of misselling (although 20.8 per cent knew of someone who had experienced mis-selling): BME Report, p. 197. E.g. Financial Risk Outlook 2008, p. 46; Financial Risk Outlook 2007, p. 94; and Financial Risk Outlook 2006, pp. 84–5. FSMA also requires the FSA to take into account consumers’ needs for advice and accurate information: sect. 5(2)(c). HM Treasury has highlighted the importance of advice: HM Treasury, Financial Capability: The Government’s Long-Term Approach (2007), p. 6. ‘[M]any people will continue to find financial services bewildering and will want some customized help to identify their financial needs and so make better decisions’: FSA, Building Financial Capability in the UK: The Role of Advice (2004), p. 1. The RDR, discussed in sects. XI and XII below, is heavily based on meeting the needs for effective advice and distribution: 2007 RDR, p. 17. The FSA has warned that shortcomings persist in the way in which investment products are sold and with respect to the quality of advice and highlighted that the reputation of financial advisers and other distributors had suffered from mis-selling: FSA, Financial Risk Outlook 2007, p. 10. 2007 RDR; Retail Distribution Review – Interim Report (2008) (‘2008 Interim RDR’); and Retail Distribution Review: Feedback Statement No. 08/6 (2008) (‘2008 RDR Feedback Statement’). Concrete proposals were made in June 2009: Consultation Paper No. 09/18, 2009. C. Briault, FSA, Speech on ‘Regulatory Developments and the Challenges Ahead’, 30 January 2008, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml. Which includes one of the largest research studies undertaken into the quality of advice: FSA, Quality of Advice Process in Firms Offering Financial Advice: Findings of a Mystery Shopping Exercise (Consumer Research No. 52, 2006).

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Report for the French AMF highlighted the increased need for clear, fair and not misleading investment advice as increased pressure was placed on households for long-term savings provision.51 It pointed to repeated mis-selling episodes, notably with respect to structured fund sales,52 and emphasized the importance of impartial, accurate and appropriate advice.53 The Netherlands has experienced particular difficulties in the sale of unit-linked insurance products, related, in part, to commission risks, as well as with respect to sales of share lease agreements;54 the Dutch market conduct regulator (the AFM) has isolated the quality of advice as a priority issue and supported a shift from product-oriented to investor-oriented services.55 The German BaFIN has also highlighted the risks posed by commission sales,56 and has recently focused its supervisory efforts on the advisory process, as has the Italian supervisor, CONSOB.57 Following an increase in demand for investment advice, Spain is also focusing on advice and the role of regulation,58 while Sweden adopted a new regime for financial advisers in 2004.59 Member States’ efforts occur, however, within an extensive harmonized regulatory framework ‘on the books’, governed by MiFID. At bedrock, MiFID reflects the dictates of market integration and the harmonization necessary to support the investment firm passport. But it is also strongly regulatory in orientation and adopts a generally protective approach which implies support for the trusting investor and which gives priority to supplyside conduct rules, as discussed later in this chapter. But the risks of regulation are considerable in the advice context. The trusting investor and the risks of the advice process suggest that regulation must reflect investor vulnerabilities and investor over-reliance on advisers; but, as discussed in this chapter, it is very difficult to achieve strong outcomes ‘in action’ through regulation. Retail market policy with ambitions to build an engaged retail investor constituency must also 51 53

54 55 56 57

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Delmas Report, p. 8. 52 Ibid., p. 10. Ibid., p. 8. It called for: improvements in product information; better-targeted marketing; appropriate, objective and impartial advice; and an improvement in after-sales service. Summarized in AMF, Working Program for Domestic and International Regulation 2006– 2008 (2006), p. 19, which supported the proposed reforms. Joint Forum Report, pp. 76 and 78. AFM, Policy and Priorities for the 2007–2009 Period (2007), pp. 7 and 23. BaFIN, Annual Report 2006, p. 27. BaFIN, Annual Report 2006, p. 136 and Annual Report 2005, p. 131. CONSOB has targeted sales networks, suitability assessments and conflict-of-interest requirements: CONSOB, Annual Report 2006, p. 109. Financial Services Consumer Group, Minutes, 3 July 2007, p. 4. 59 BME Report, p. 182.

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grapple with more subtle problems. Investor engagement and empowerment call for measures which support the investor in identifying advice needs, and in demanding, accessing and assessing appropriate services. Access to advice is related to the sustainability of the advice sector;60 it is therefore a function of solvency, liquidity and risk management, and thus of prudential requirements (section XI below). It is also a function of supervision and enforcement and of how the compensatory costs to the industry of poor advice are managed.61 But access is also related to whether the regulatory regime supports different advice channels of varying cost which are sufficiently commercially viable. As discussed in section XII below, the UK’s efforts in the retail advice and distribution market have focused closely on access to advice and, although the design difficulties faced by the FSA are formidable, the reforms represent a paradigm shift from MiFID’s regulatory ‘on the books’ approach. Effective regulation must also address the correct risks. As discussed further in section X below, advice in the Community context is probably better characterized in terms of product sales, or, at least, ‘advised sales’, rather than in terms of full-scale, independent advice. But it is not clear that this distinction is captured by the harmonized regulatory regime.

II. Scope of the advice and product distribution regime 1. The advice and distribution regime MiFID and the MiFID Level 2 Directive,62 along with ancillary soft law measures, including the Commission’s MiFID Q and A,63 CESR’s MiFID 60

61

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The FSA has highlighted the viability of firms, given the financial crisis, as a risk to its retail market objectives: FSA, Business Plan 2008–2009, p. 23; and FSA, Financial Risk Outlook 2008, p. 46. The FSA has become concerned as to the costs of mis-selling in terms of the detriment suffered by surviving firms: FSA, Review of the Prudential Rules for Personal Investment Firms (Discussion Paper No. 07/4, 2007) and Review of the Prudential Rules for Personal Investment Firms (Feedback Statement No. 08/2, 2008). Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’); and Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ 2006 No. L241/26 (‘MiFID Level 2 Directive’). ‘Your Questions on MiFID’, available via http://ec.europa.eu/internal market/securities/ isd/questions/index en/.

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Q and A64 and CESR’s level 3 guidance on MiFID,65 are at the heart of the EC’s regulation of advice and of product distribution. The Insurance Mediation Directive66 applies to insurance agents and brokers67 and imposes minimum registration and professional competence requirements on agents and brokers,68 as well as disclosure, independence and suitability-related standards on the sale of insurance products, including unit-linked investment products which are outside MiFID’s scope.69 The banking regime70 does not impose advice and distribution requirements on non-MiFID banking products (such as structured deposits); while MiFID applies to credit institutions, it does so only with respect to their MiFID-scope investment services activities.71 MiFID applies, however, to the management companies of UCITS, which are otherwise excluded from the regime under Article 2(1)(h), where they provide, in addition to collective portfolio management services, investment advice or discretionary portfolio management services. Marketing risks are addressed by a matrix of consumer protection directives, chief among them the Distance Marketing of Financial Services Directive72 and the Unfair Commercial Practices Directive,73 as well as by MiFID. The contractual protections of the horizontal Unfair Contract Terms Directive74 provide additional retail 64 65

66 67 68 69 70

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CESR. Questions and Answers on MiFID: Common Positions Agreed by CESR Members (December 2008 version) (CESR/08-943, 2008). Including guidance on: the MiFID Passport (CESR/07-337 and CESR/07-337b); inducements (CESR/07-228b); best execution (CESR/07-320); record-keeping (CESR/06-552c); passport notification (CESR/07-317); branch supervision (CESR/07-672); and transparency (CESR/07-043). European Parliament and Council Directive 2002/92/EC of 9 December 2002 on insurance mediation, 2003 OJ No. L9/3. The Directive applies to insurance mediation but not to activities carried out by an insurance undertaking or an employee of an insurance undertaking. Arts. 3 and 4. Indemnity insurance requirements are also imposed (Art. 4(3)). See sections IX below on the insurance regime. Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast), OJ 2006 No. L177/1. MiFID, Art. 1(2). European Parliament and Council Directive 2002/65/EC of 23 September 2002 concerning the distance marketing of consumer financial services and amending Council Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No. L271/16 (‘Distance Marketing Directive’, or DMD). Directive 2005/29/EC of the European Parliament and of the Council of 11 May 2005 concerning unfair business-to-consumer commercial practices in the internal market, OJ 2005 No. L149/22 (‘Unfair Commercial Practices Directive’, or UCP). Council Directive 93/13/EEC of 5 April 1993 on unfair terms in consumer contracts, OJ 1993 No. L95/29.

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investor protections. The segmented nature of the advice and distribution regime, and, in particular, MiFID’s troublesome interaction with the distribution of UCITS units and of non-MiFID products, raises some doubts as to its effectiveness in addressing real mass market risks and underlines the difficulties in capturing advice and distribution risk in a segmented regime.

2. MiFID’s scope: a wide range of instruments and services MiFID applies to specified ‘investment services’ with respect to a wide range of simple and complex ‘financial instruments’.75 These include structured products,76 which come within the scope of the ‘transferable securities’ which are included as financial instruments,77 and contracts for differences, bringing spread-betting in financial instruments within MiFID’s protections. A wide range of derivatives, including commodity derivatives, also come within MiFID’s scope. But MiFID does not cover unit-linked insurance investments78 or deposit-based investments,79 which generates significant regulatory arbitrage risks;80 Member States have the option, of course, of extending MiFID distribution and advice requirements across the universe of investment products (section IX below). Neither does it cover decumulation, annuity products which are derived from pension/life-assurance products and which pay a regular income. The key MiFID-scope ‘services’81 from a retail investor perspective include the reception and transmission of orders and order execution 75

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The list (set out in MiFID Annex I, sect. C) includes: transferable securities; money market instruments; units in collective investment undertakings; and financial derivatives in the form of options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash. J.-P. Casey, Shedding Light on the UCITS–MiFID Nexus and the Potential Impact of MiFID on the Asset Management Sector, ECMI Policy Brief No. 12 2008 (ECMI, 2008). Art. 4(1)(18). In its MiFID Q and A, the Commission, in confirming the exclusion of life assurance contracts from MiFID, stated that there were no current plans to extend MiFID’s scope to life assurance contracts, although it highlighted the substitute products debate. As has been confirmed by the Commission in its MiFID Q and A. In response to a question as to the application of MiFID to a product of identical design, but structured in one case in the form of a deposit (principal guaranteed) with a return linked to an index, and in the other in the form of an issuer’s structured note, with capital protected by a guarantee and the return linked to an index, the Commission suggested that MiFID would only apply to the latter structure: MiFID Q and A. Including: reception and transmission of orders on behalf of investors in relation to one or more ‘financial instruments’; execution of such orders; dealing on own account; portfolio

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(broking) (chapter 6), asset management services (for more affluent and sophisticated investors) and, critically, investment advice (and the related distribution of products). There are, however, some significant exclusions from MiFID’s scope from the retail market perspective.82 Article 2(1)(c) excludes those providing an investment service where it is provided incidentally in the course of a professional activity, and where that activity is regulated by legal or regulatory provisions or a professional code of ethics. Similarly, Article 2(1)(j) excludes persons who provide investment advice in the course of providing another professional activity not covered by MiFID, as long as the advice is not specifically remunerated. Incidental investment advice by accountants and legal professionals does not, therefore, require MiFID-authorization. While this might suggest some risks, investment advice activity would typically be addressed by the relevant professional bodies, and this approach supports the delivery of advice through a range of channels and, therefore, easier access to advice.

3. MiFID’s scope: the pivotal investment advice definition The inclusion of investment advice, which was not addressed in the precursor Investment Services Directive, marks MiFID as a key retail market measure. Its definition is also a key perimeter for the regulatory regime; whether or not the service amounts to ‘investment advice’ dictates whether suitability requirements apply. Investment advice is defined as the provision of ‘personal recommendations’ to a client, either on its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments (Article 4(1)(4)). It has been further clarified at level 2, by Article 52 of the MiFID Level 2 Directive, which defines a ‘personal recommendation’ as one made to a person in his capacity as an investor or potential investor, presented as suitable for that person or based on a consideration of the circumstances of that person, and constituting a recommendation: (a) to buy, sell, subscribe for, exchange, redeem, hold or underwrite a particular financial instrument; or (b) to exercise, or not to exercise, any right conferred by a particular financial instrument to buy,

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management; investment advice; underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis; placing of financial instruments without a firm commitment basis; and operation of multilateral trading facilities (MTFs): Annex I, sect. A. A wide range of exemptions to MiFID’s scope apply under Arts. 2 and 3, but many of these are concerned with the professional markets.

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sell, subscribe for, exchange or redeem a financial instrument. The personalization of the advice to the client’s personal situation, and the specificity of the advice given are therefore central to its regulatory characterization as regulated ‘investment advice’. This restriction of ‘investment advice’ suggests a somewhat robust approach to investor protection and a concern to ensure that suitability controls, the most paternalistic expression of investor protection under MiFID, are confined appropriately, given their costs.83 Although generic and non-personalized advice falls outside the perimeter, some care will be needed to ensure the ‘investment advice’ perimeter does not catch activities which are useful for demand-side initiatives which build informed investors and which should not be subject to costly regulation. Investment firms’ online self-assessment tools, for example, which require personalized inputs from investors, are a potentially important tool in supporting investor learning and low-cost access to advice and should be regarded as distinct from ‘investment advice’.84 The regime also fails to address whether risk warnings are necessary where the investor receives non-personalized advice; given the need to build an informed cohort of investors, this represents a lost opportunity.

4. MiFID’s scope: supporting access to advice? As discussed in section XII below, support of wider access to investment advice has emerged as a policy priority. In principle, MiFID should support greater competition in the EC market for advice and so easier access to competitively priced services. Authorization under MiFID is not only a prerequisite for the supply of investment services; it supports the MiFID passport which allows MiFID-authorized firms to provide investment services in host States,85 anchored to home Member State supervision (for the most part).86 But whether or not MiFID can support competition in 83

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CESR, Technical Advice on Possible Implementing Measures of Directive 2004/39/EC: 1st Set of Mandates Where the Deadline Was Extended and 2nd Set of Mandates (CESR/05-290b, 2005) (‘2nd Mandate Advice’), p. 7. The Australian Treasury, for example, regards online calculators as useful in supporting consumers in understanding and comparing financial services and has undertaken to keep such tools outside the equivalent ‘personal advice’ characterization: Treasury, Refinements Proposals. A host Member State is one, other than the home Member State, in which an investment firm has a branch or performs services and/or activities: Art. 4(1)(21). Arts. 31 and 32. Under Art. 32(7), the Member State in which a firm’s branch operates is responsible for the supervision of certain rules, particularly conduct-of-business requirements.

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cross-border advice services remains unclear.87 Given that investors have strong preferences for local providers,88 the growth of the pan-EC retail market is likely to depend on the extent to which firms can disguise themselves, particularly through online services, subsidiaries or branches, as home firms,89 by operating in investors’ home languages and selling services and products closely linked to the domestic market; cross-border activity is generally the preserve of the subsidiaries of banks which act as ‘financial supermarkets’ in continental Europe.90 But whether investment firms and advisers have sufficient incentives to act cross-border is uncertain,91 particularly given MiFID’s costs. MiFID may lead to a contraction in the advice industry if it consolidates in reaction to an increased regulatory burden.92 Strong cultural and local factors, different levels of welfare provision, radically different saving patterns, demographic trends and differing financial literacy and risk-appetite profiles93 also all impact on the extent to which investors are willing to engage with the advice industry.94 The development of smaller, fee-based investment advice firms 87

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Although the FSA has produced a factsheet explaining to ‘Article 3 firms’ (investment advice firms exempted from MiFID, discussed below) how they can opt in to MiFID where they provide cross-border business, it appears to be designed as a guide to MiFID compliance with respect to pre-existing cross-border relationships, rather than in response to demand for access to the cross-border advice market: FSA, FactSheet on Financial Advice and Passporting (2007). Some non-MiFID ‘Article 3 firms’ have, however, opted for MiFID authorization to benefit from the passport: FSA, Review of the Prudential Regime for Personal Investment Firms (Feedback Statement No. 08/2, 2008), p. 4. This is a recurring theme of recent assessments: for example, European Commission, European Financial Integration Report (SEC (2009) 19), p. 14, and Green Paper on Retail Financial Services in the Single Market (COM (2007) 226, 2007), p. 6. See also ch. 1. BME Report, p. 31. The FSA has similarly linked an increase in cross-border merger and acquisition activity to retail investors’ preference for local providers: FSA, Response to the European Commission’s Call for Evidence on Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008) (‘FSA Substitute Products Response’), p. 4. See further ch. 1. UK firms appear sceptical, with only half of those canvassed in one leading survey of the view that any new opportunities will be material: Europe Economics, The Benefits of MiFID: A Report for the Financial Services Authority (2006), p. 23. MiFID’s retail market benefits have been projected as limited to large banks who may gain business from smaller financial advisers: S. Morris, ‘MiFID – The Winners and Losers’, Financial World, November 2007, p. 14. The FSA has also suggested that the benefits of MiFID will be spread unevenly and will mainly accrue to firms operating cross-border: FSA, The Overall Impact of MiFID (2006). E.g. HM Treasury, FSA and Bank of England, Supervising Financial Services in an Integrated European Single Market: A Discussion Paper (2005), p. 13; and A. Knight, ‘MiFID’s Impact upon the Retail Investment Markets’ in C. Skinner (ed.), The Future of Investing in Europe’s Markets after MiFID (Chichester: John Wiley & Sons, 2007), p. 207, p. 209. BME Report, pp. 212–14.

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may also be prejudiced by the demands of MiFID’s principles-based model for smaller firms.95 But MiFID can be regarded as supporting access to advice across two dimensions: the Article 3 regime, which supports local advice structures; and the tied agents regime. An important optional exclusion from MiFID applies under Article 3, which was originally negotiated by the UK to exempt a significant proportion of its domestic investment advice industry. Article 3 allows Member States to exempt entities (for which they are the home Member State) which do not hold client funds or securities, which only receive and transmit orders with respect to a limited range of instruments (transferable securities and CIS units), and which provide investment advice in relation to these instruments.96 As outlined in chapter 1, UK ‘Article 3 firms’ typically provide advice and sales services with respect to the ‘packaged products’ which dominate in the UK retail market. While the FSA has subjected these firms to MiFID distribution and advice rules, for the most part, and while these firms compete with MiFID firms, the MiFID regime has been tailored under the Article 3 exemption where the cost of MiFID compliance has been identified as exceeding the benefits, given the small range of activities these firms engage in and their particular risk profile. ‘Article 3 firms’ can also deliver low-cost, and less highly regulated, ex-MiFID ‘Basic Advice’ (section XII below).97 On the other hand, the parallel operation of MiFID and non-MiFID regimes has the potential to cause confusion and to generate regulatory arbitrage.98 A new but limited regime, designed to clarify when an investment firm can use tied agents, also applies to tied agents appointed to act on behalf of one investment firm.99 The clarification may generate wider access to 95

FSA, Principles-Based Regulation: Focusing on the Outcomes That Matter (2007), p. 18. The exemption is only available where these entities transmit orders to a range of nominated actors, essentially regulated market participants including investment firms, credit institutions and CISs. 97 The UK’s ‘Basic Advice’ regime for ‘stakeholder products’ applies to non-MiFID advisers who do not hold client money and who are exempted under Article 3: FSA, Reforming Conduct of Business Regulation (Consultation Paper No. 06/19, 2006), p. 82. 98 Concerns were raised during the FSA’s review of the capital resource requirements which apply to ‘Article 3’ firms as to regulatory arbitrage risks, given, in particular, that some notional ‘Article 3’ firms have opted for MiFID authorization to benefit from the passport. These firms are subject to MiFID’s lighter capital adequacy regime for firms which do not engage in proprietary dealing or hold client assets. The FSA has, nonetheless, limited its reforms to non-MiFID firms: FSA, Review of the Prudential Rules for Investment Firms (Consultation Paper No. 08/20, 2008), pp. 4–5. 99 European Commission, Overview of Proposed Adjustments to the Investment Services Directive: Working Document of Services of DG Internal Market: Document 1, July 2001, p. 21. 96

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investment advice by supporting the appointment by firms of tied agents in other Member States and cross-border distribution and advice structures which rely on tied agents.100

5. MiFID’s scope: the nature of investor protection ‘on the books’ a) Authorization and prudential requirements MiFID delivers investor protection in the advice and distribution context across a number of dimensions. MiFID’s authorization requirement (Article 5) and supporting rules (Articles 6–12) support the investmentservices passport and market integration. But they also support investor protection by imposing perimeter controls on intermediation. These perimeter requirements cover initial capital requirements (Article 12),101 management requirements (in the form of ‘fit and proper’ requirements) (Article 9), programme of business requirements (Article 7(2)) and shareholder review requirements (Article 10). MiFID’s extensive operational or ongoing prudential regime, and, in particular, its organizational risk-management rules and its ongoing capital-adequacy regime,102 is designed to support firm stability and ability to withstand risk events. The organizational risk management regime (Article 13) has been amplified by the MiFID Level 2 Directive which covers decision-making, internal controls and risk management, employee competence, internal reporting, record-keeping, data protection, business continuity, accounting and monitoring (Article 5), and senior management responsibility (Article 9), as well as the compliance (Article 6), risk management (Article 7) and internal audit (Article 8) functions. It also addresses the outsourcing of ‘critical or important operational functions’ (Articles 13–15) and record-keeping (Article 51). An extensive asset protection regime applies under Articles 16–20 and reflects the MiFID Article 13(7) and (8) obligation to maintain asset and money protection systems. 100 101

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Art. 23. The defining characteristic of a tied agent under MiFID is that the agent operates under the sole responsibility of the appointing investment firm. Initial capital requirements for investment firms range from €125,000 to €730,000 depending on the services carried out and, in particular, or whether the firm deals on own account and so faces trading risk. The capital adequacy requirements imposed on investment firms are governed by the 2006 Capital Requirements Directive which is composed of Directive 2006/48/EC, OJ 2006 No. L177/1 and Directive 2006/49/EC, OJ 2006 No. L177/201.

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These prudential rules have important implications for investor protection by supporting the stability of the firm. Prudential requirements also play an important role in supporting firm sustainability and accordingly access to advice.103 More specifically, prudential rules are also particularly significant for asset management services where assets are transferred to the investment firm. This is reflected in the level 2 outsourcing regime which, in addition to the general conditions which apply to outsourcing,104 imposes specific requirements, linked to the authorization of, and supervisory co-operation with respect to, the outsourcing service provider.105 The extensive asset protection regime is also an essential protection against investment firm fraud, incompetence or insolvency. It addresses asset segregation and record-keeping, when client deposits and instruments may be held with third parties, the circumstances in which an investment firm may use client instruments on own account (and the conditions to which firm stock-lending is subject) and external auditing of asset protection arrangements.106

b) Conduct-of-business regulation and conflict-of-interest management Although they are important investor protection mechanisms, prudential organizational and capital requirements are firm- rather than investorfacing,107 particularly with respect to their supervision and enforcement. But they remain closely related to individual investor protection in the conduct of the adviser/investor relationship, given, in particular, the influence of firms’ systems and quality controls on the investor experience, particularly in large firms.108 Conduct-of-business and conflict-of-interest management rules, however, have a direct bearing on the firm/investor relationship and are on the frontline of investor protection; FSA research suggests that capital rules have only an indirect bearing on the prevention of mis-selling and that conduct-of-business rules and fair treatment principles are more cost effective and efficient in addressing the quality 103 104 105 106

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The UK FSA has frequently associated prudential and soundness rules with good retail market outcomes: FSA, Major Retail Thematic Work Plan for 2008–2009, p. 1. MiFID Level 2 Directive, Art. 14. Ibid., Art. 15 (the regime applies to outsourcing to third countries). On the importance of asset protection rules, see J. Franks, C. Mayer and L. Correia da Silva, Asset Management and Investor Protection: An International Analysis (Oxford: Oxford University Press, 2003), pp. 17–18 and 88. D. Gros and K. Lannoo, The Euro Capital Market (Chichester: John Wiley & Sons, 2000), p. 122. FSA, Consumer Responsibility (Discussion Paper No. 08/5, 2008), highlighting the importance of systems and prudential requirements to investor protection (p. 23).

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of advice.109 Nonetheless, the efficacy of conduct rules depends on the quality of the firm’s systems and resources. MiFID’s major retail market innovation concerns its adoption of a detailed conduct-of-business and conflict-of-interest regime. Along with the disclosure regime discussed in chapter 5, these rules form the frontline of MiFID’s protections. The Article 19 conduct-of-business regime and its extensive level 2 rules, in particular, establish an investor protection code which addresses risks in the investor/investment firm relationship through a foundation fair treatment obligation, marketing rules, processbased suitability/know-your-client requirements, disclosure and reporting rules and contract requirements. Although conduct-of-business rules can be regarded as rooted in private bargaining and as optional, default contract rules,110 the regime suggests a concern to protect the vulnerable trusting investor, as its protections must be applied to retail investors; retail investors may only ‘opt out’ where they can be treated as ‘professional’ investors following a request to be so classified.111 The stringent conditions which apply make it unlikely that mass market consumers of investment products will be able to opt out, while the extensive procedural requirements suggest that any opt-out will only take place where the investor clearly understands the implications and the firm is confident as to the appropriateness of the professional designation.112 This approach reflects that of the Distance Marketing of Financial Services Directive (DMD), which provides that consumers may not waive Directive rights (Article 12). But MiFID also reflects some degree of investor autonomy: the nature of the suitability protections provided reflects the service provided and the degree of reliance by the investor on the investment firm (section VI below).

III. Regulatory design choices 1. Regulatory design choice (1): maximum harmonization MiFID’s effectiveness with respect to advice and distribution is in large part hostage to the success of its three major and interlinked design choices:

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FSA, Feedback Statement No. 08/2. G. Ferrarini, ‘Contract Standards and the Markets in Financial Instruments Directive: An Assessment of the Lamfalussy Regulatory Architecture’ (2005) 1 European Review of Contract Law 19. MiFID, Annex II, sect. II.1. See further ch. 2. MiFID, Annex II, sect. II.2, imposes detailed procedural requirements.

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maximum harmonization; principles-based regulation; and conductshaping regulation. Article 4 of the MiFID Level 2 Directive113 represents an important innovation for EC harmonization by prohibiting Member States from adopting rules for their local markets which are additional or super-equivalent to the MiFID regime; by contrast, the Unfair Commercial Practices (UCP) Directive contains an express derogation for financial services, in respect of which Member States may impose more restrictive or prescriptive measures, given ‘their complexity and inherent serious risks’ (recital 9).114 Article 4 raises considerable centralization risks for the retail market, not simply because investment behaviour varies across the EC, but also given variations in advice and product distribution channels and in the related risks to investors (section X below). While certain risks are repeatedly raised by domestic regulators with respect to advice and distribution, notably commission risk and quality of advice risks, their effective treatment requires that rules reflect local market characteristics. While MiFID’s principles-based approach suggests that flexibility and diversity is supported, this comes at the level of the firm and of practical supervision. The effect of Article 4 is that flexibility and diversity are not supported by the regulatory regime and that the risks of poor regulatory design are magnified. The UK experience provides an instructive example. As noted in chapter 1, long-term and often complex packaged investment products (such as CISs and unit-linked insurance) dominate in the UK retail market and are typically distributed or sold by commission-based advisers. This raises sharp conflict-of-interest and disclosure risks for retail investors and has led the FSA to adopt a tailored cross-sector regime for the sale of ‘packaged products’. In order to protect the packaged product regime, the UK Treasury made an Article 4 notification to the Commission.115 The application116 highlighted the importance of private welfare provision in 113 115

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See further chs. 1 and 2. 114 Art. 3(9). HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC (2007) (‘UK Article 4 Application’). The ‘notified’ rules cover: (i) the conditions advisers must meet to call themselves ‘independent’ (the firm must advise on the ‘whole of the market’ and offer clients a fee option with respect to remuneration); (ii) the provision of a UCITS simplified prospectus or KFD; (iii) the disclosure of actual commissions and commission equivalents with respect to the sale of packaged products; and (iv) the use of dealing commission. The FSA based its identification of necessary Article 4 rules on the extent to which there were likely to be

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the UK, as well as the higher proportion of home ownership which led to investments being relied on to repay mortgage debt.117 It underlined the FSA’s extensive testing efforts, which pointed to an investor base which struggled in understanding the risks of often complex products and had little experience in choosing products, the complex charging structures often employed and the danger that risks would typically take a long time to emerge.118 The application also pointed to heavy reliance on advisers and risks from incentive misalignment in commission-based advisers and from investor reluctance to pay a fee for investment advice, which had led to a series of mis-selling scandals.119 Although public statements by Commissioner McCreevy had previously suggested some Commission hostility to Article 4 applications,120 the application was successful.121 The Commission also appears willing to characterize certain local rules as simply more specific applications of general MiFID rules and falling outside the notification obligation.122 Nonetheless, some nervousness is warranted, particularly as Article 4 appears to have influenced the FSA’s decision to remove its pre-MiFID requirement that investment advisers, when advising on packaged products, provide advice as to the ‘most suitable’ product in the range on which they advise. Although the FSA has pointed to MiFID’s matrix of conflictof-interest, disclosure and suitability rules, consumer stakeholders have called for the potential effects of the changes to be monitored.123 Article 4, in combination with MiFID’s adoption of a high-level, principles-based approach to disclosure and marketing communications, has also raised concerns as to standardization and comparability risks;124 so too has the

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material market failures and investor protection risks in the UK market which were not adequately addressed by MiFID: FSA, Reforming Conduct of Business Regulation (Policy Statement No. 07/14, 2007), p. 5. UK Article 4 Application, pp. 11–12. 118 Ibid., p. 12. 119 Ibid., pp. 12–14. Commissioner McCreevy, Speech on ‘Integration of Financial Markets in the Context of Globalisation’, High-Level City Group, 20 February 2007, available via http://europa.eu/rapid/searchAction.do. A senior FSA official commended the Commission’s ‘sensible and proportionate’ approach: D. Waters, Speech on ‘MiFID, Threats and Opportunities’, Insurance Institute of London, 9 January 2008, available via www.fsa.gov.uk/Pages/Library/Communications/ Speeches/index.shtml. This was the case with the FSA’s suitability letter (sect. VI below) which the Commission regarded as a local application of the Art. 19(8) record-keeping obligation: FSA, Reforming Conduct of Business Regulation (Policy Statement No. 07/6, 2007), p. 5. Ibid., p. 50. See further ch. 5. Concerns have been highlighted with respect to the adoption of a highlevel approach to projections and past performance disclosure in particular: Financial Services Consumer Panel (FSCP), Annual Report 2007–2008, p. 38.

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MiFID-driven removal of the previously detailed FSA requirements which applied to the content of the investor/investment firm contract.125 It would make little sense if MiFID’s much-trumpeted retail investor protection regime were to result in the elimination of local rules expressly designed to protect investors in a particular risk environment. Nonetheless, Article 4 generates this risk. The Commission does, however, appear open to the need to retain some regulatory diversity in the retail markets. The pan-EC systemic risk of poor regulatory design remains, however, significant.

2. Regulatory design choice (2): principles-based regulation Although the desirability or otherwise of a principles-based model was not discussed during the level 1 negotiations, the Commission adopted a principles-based approach during the level 2 negotiations for the pivotal conduct-of-business and conflict-of-interest management regimes. It was at some pains to assert that the MiFID Level 2 Directive focuses on the standards and objectives which investment firms must attain, rather than on detailed, prescribed rules, describing it as a ‘principles-based but tightly worded Directive’.126 The Directive is asserted to create ‘strong incentives’ for firms to monitor their activities and to assess whether they are in compliance with the Directive’s principles and to avoid the restrictions of ‘one-size-fits-all’ models.127 The level of prescription in both the conduct regime and the conflicts regime might be regarded as diminishing MiFID’s claim to be principles-based.128 But a wholesale adoption of a principles-based approach was neither practical nor feasible; the question is as to whether the appropriate balance is maintained between rules and principles.129 Overall, a focus on outcomes, process and firm judgment strongly characterizes the MiFID regime.

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FSCP, Response to Consultation Paper 06/19 and Consultation Paper 06/20, Reforming Conduct of Business Regulation (2006), p. 3; and FSCP, Annual Report 2007–2008, p. 38. Background Note to the Draft Commission Directive implementing Directive 2004/39/EC as regards organisational requirements and operating conditions (February 2006) (Background Note), p. 5. Ibid., pp. 5–6. Recital 11 to the Level 2 Directive states that a ‘regulatory regime should be adapted to [investment firm] diversity while imposing certain fundamental requirements which are appropriate for all firms’. I. Mason, ‘Principles-Based Regulation – Will It Work?’ in Skinner, Future of Investing, p. 85. W. Buiter, Lessons from the 2007 Financial Crisis (Centre for Economic Policy Research, Policy Insight No. 18, CEPR, 2007), p. 3.

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The principles-based model is well illustrated by MiFID’s reliance on a general fiduciary-style fair treatment obligation for firms to act in the ‘best interests’ of clients (Article 19(1)) and its requirement that all firm communications with investors be ‘fair, clear and not misleading’ (Article 19(2)). The level 2 conflicts-of-interest regime is similarly designed to be principles-based and to ‘ensure that investment firms take a holistic approach to conflicts management, regularly reviewing their business lines to ensure that at all times their policies reflect the full scope of their activities and the possible conflicts that may emerge’.130 The principles-based model is also reflected in MiFID’s generic approach to retail market risks. Some considerable strains are placed on MiFID’s generic advice and product distribution regime where it intersects with financial market innovation, evolving conflict-of-interest risk (such as the greater pressure on firms to chase commissions and sales in the current bear market) and fast-developing and complex products, including UCITS III products, structured securities and alternative investments. MiFID’s success ‘in action’ is accordingly closely tied to its doubtful ability to contain the particular risks associated with principles-based intervention. The ‘credit crunch’, however, appears to have placed MiFID’s principles-based approach under strain given concerns as to the effectiveness of advice disciplines in the sale of structured products.131

3. Regulatory design choice (3): shaping firm conduct and the eclipsing of disclosure MiFID is also strongly associated with the eclipsing of disclosure and with a sharper focus on the supply-side reforms associated with support of the trusting investor. Reflecting a more interventionist approach to the retail markets, MiFID embraces a ‘conduct-shaping’ style of regulation,132 which emphasizes the firm/investor fiduciary relationship133 and which limits the extent to which disclosure and investor consent, strongly associated with 130 131 132

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Background Note, p. 13. CESR, The Lehman Brothers Default: An Assessment of the Market Impact (CESR/09-255, 2009), p. 3. The Commission has described MiFID as entailing ‘reinforced fiduciary duties [which] protect consumers by enhancing responsible behaviour by firms’: European Commission, Retail Financial Services Green Paper, p. 12. And so reflects the view that intermediary regulation tends to be consumer-oriented and to protect investors against the abuse of fiduciary duties: T. Frankel and L. Cunningham, ‘The Mysterious Ways of Mutual Funds: Market Timing’ (2006) 25 Annual Review of Banking and Financial Law 235.

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empowerment strategies, can serve to ensure compliance with regulatory requirements.134 Nonetheless, and as discussed in chapter 5, disclosure persists as a regulatory technique135 for managing the investor/firm relationship and is ‘designed to give regulators and investors the necessary tools to . . . discern and punish inefficiency and unprincipled conduct by firms’.136 The Commission, however, sought to limit disclosure and to ‘reinforce the fiduciary duties of firms’ through the conduct-of-business regime.137 Disclosure is limited to those elements essential for retail investors to understand the nature of the investor/firm relationship, and the Commission was concerned to ‘avoid overloading clients with information of no immediate use’.138 Investor protection under MiFID is accordingly designed to be primarily a function of the firm’s duties to the investor, rather than of the investor’s ability to make rational, disclosure-based decisions.139 A similar approach has been adopted with the conflict-of-interest regime. Organizational requirements are at the heart of the regime, reflecting the assumption that ex ante prevention of conflicts of interest is more effective than ex post review and disclosure.140 Simple disclosure of conflict 134

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This is most apparent in the suitability regime, under which the firm cannot proceed where certain disclosures are not provided, and in the conflicts-of-interest regime, where disclosure of an inducement is not sufficient to comply with MiFID where the inducement does not enhance the delivery of the service. The EC is not alone in finding it difficult to shake off the attractions of disclosure. Elaborate mandatory disclosure obligations, concerning in particular compensation, conflicts of interest and the suitability of investment advice, apply in the US: Jackson, ‘Regulation’; and, in the asset management context, Franks et al., Asset Management. Background Note, p. 16. Commission Working Document EC/24/2005, Explanatory Note to ESC/23/2005 (July 2005) (‘July 2005 Explanatory Note’), p. 1. Ibid., p. 2. The Commission’s Director of Financial Services Policy and Financial Markets described MiFID’s ‘regulatory philosophy’ in terms of high levels of investor protection and limited reliance on disclosure: D. Wright, Presentation on Markets in Financial Instruments Directive, 27 October 2007, available via http://ec.europa.eu/internal market/ securities/isd/mifid en.htm. The Commission’s FAQ document issued on the eve of MiFID’s application similarly stated that MiFID was designed not to flood consumers ‘with reams of information which may not be relevant to them and which they may have difficulty understanding. Instead, the emphasis will be on the fiduciary duties of firms towards their clients’: European Commission, Markets in Financial Instruments Directive: Frequently Asked Questions (2007). The Commission has described MiFID in terms of ‘specific attention [being] granted to retail clients for which a specific regime has been established, which entails reinforced fiduciary duties upon the firm’: Green Paper on Retail Financial Services, p. 12. D. Cain, G. Loewenstein and D. Moore, ‘The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest’ (2005) 34 Journal of Legal Studies 1. ASIC has concluded

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of interests is not sufficient to meet the conflicts obligation (recital 27) and, although disclosure is relied on as a strategy for managing conflict of interests, it is not a panacea but a last resort.141 While attuned to the trusting investor in that it downplays disclosure, the conduct-shaping approach, in combination with principles-based regulation, is not without risk, particularly given limited Member State discretion by virtue of Article 4, unless careful attention is paid to regulatory design ‘in action’. MiFID’s standards grapple with nebulous regulatory outcomes such as ‘fairness’ (Article 19(1)), that disclosure is ‘fair, clear and not misleading’ (Article 19(2)) and that investment advice is ‘suitable’ (Article 19(4)). These concepts are difficult to articulate as regulatory prescriptions. They have the potential to support an outcomes-based approach to retail market regulation and to capture the ever-increasing complexity of markets and changing market conditions.142 But, as discussed in the next section, significant cultural and organizational change, supported by sophisticated supervision, appears necessary to entrench principles-based, firm-facing obligations and, accordingly, to support effectively trusting and empowered investors.

IV. Regulatory technique (1): the fairness principle and ‘law in action’ 1. The fair treatment principle A foundation fiduciary-style obligation to act fairly in the client’s best interests is imposed on investment firms under Article 19(1). The ‘fair treatment’ principle requires a firm to act honestly, fairly and professionally in accordance with the best interests of its clients when providing investment services (and to comply with the Article 19(2)–(8) conduct-ofbusiness principles). Save with respect to the inducements regime (section X below), the principle has not been amplified at level 2. Fairness is, however, a recurring theme of MiFID’s investor protection regime. Disclosure must be ‘fair, clear and not misleading’ (Article 19(2)). In the execution context, client orders must be handled in a manner which provides for their ‘prompt, fair, and expeditious’ execution (Article 22(1)) and firms must adopt a policy for the ‘fair allocation’ of orders (MiFID Level 2

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that disclosure is rarely sufficient to manage conflicts of interest and accompanying internal controls are needed: ASIC, Managing Conflicts of Interest in the Financial Services Industry (Consultation Paper No. 73, 2006). Background Note, p. 14. 142 Jackson, ‘Regulation’.

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Directive, Article 48). The inducements regime is related to whether the inducement prevents a firm from acting honestly, fairly and professionally in the best interests of the investor (MiFID Level 2 Directive, Article 26). The extensive disclosure regime incorporates fairness requirements, including that the potential benefits of a service or instrument must not be emphasized unless a ‘fair and prominent’ indication is given of risk and that comparisons must be presented in a ‘fair and balanced way’ (Article 27) and information on guarantees must allow the retail investor to make a ‘fair assessment’ (MiFID Level 2 Directive, Article 31). MiFID’s reliance on fairness also reflects a wider reliance on fairness in the background consumer protection regime. The Unfair Contract Terms Directive prohibits terms determined to be unfair (section VII below), while, in the marketing context, the Unfair Commercial Practices Directive prohibits unfair practices (section V below). Although fairness is a troublesome and inchoate concept, it is often associated with investor protection.143 Its adoption in Article 19(1) injects a protective element into MiFID and suggests a withdrawal from empowerment-driven disclosure techniques. It reflects support for a trusting model of the retail investor by assuming that investor engagement with investment firms, given the imbalance in bargaining power and the expectations, however flawed, of retail investors, should be imbued with some sense of fairness – however shadowy a notion this is.144 While an appealing notion, the injection of an undefined fairness obligation carries considerable risks in terms of the potential for flawed ex post review, but also given that that fairness assessments may become an occasion for value judgments on the investment process (section IV.2 below). The risks may be balanced by the need to focus on law ‘in action’ in supporting empowered and trusting investors in volatile, evolving and complex markets and given the risks of regulatory design. Prescriptive rules are problematic in terms not only of design but also of compliance.145 An umbrella fair treatment obligation may allow regulatory authorities to 143

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Fair access to disclosure was controversially pursued by the SEC in its Regulation FD which prevents issuers from making selective disclosure to analysts in particular; ‘prompt and fair disclosure of information’ is also sought by the EC’s prohibition on selective disclosure (European Parliament and Council Directive 2003/6/EC of 28 January 2003 on insider dealing and market manipulation, OJ 2003 No. L96/16, Art. 6(3)). The rhetoric of ‘fair and orderly markets’ is also long-established: C. Bradley, ‘Disorderly Conduct and the Ideology of “Fair and Orderly Markets”’ (2000) 26 Journal of Corporation Law 63. Reliance on ‘fairness’ concepts in financial market regulation has been described as reflecting a ‘consumerist theme’: Benjamin, Financial Law, pp. 563 and 571. E.g. sect. VI below on suitability rules.

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drive closer engagement by firms with the needs of retail investors and to achieve more effective investor protection ‘in action’,146 particularly with respect to those risks not expressly addressed by rules147 and those which develop in the future. The fair treatment principle also provides supervisors and courts with an ex post mechanism for reviewing investment firm behaviour. Fairness might also be associated with an ethicsand trust-based approach to the achievement of regulatory objectives148 which, assuming that the embedding of ethics provides better incentive alignment than close supervision of prescriptive rules, might lead to better investor outcomes in practice.149

2. The risks of ‘fairness’ But fairness is a complex objective to achieve. Any regulatory ‘marketing’ dynamic to the effect that firms behave fairly may be troublesome given investor over-reliance on advice. Interpretation difficulties are considerable. The legislative history of Article 19(1) casts little light on the meaning of fairness. As it is likely to reflect local market conditions and traditions,150 fairness is likely to generate widely varying interpretations.151 Although supervisory convergence through CESR may support a consistent approach by supervisors, it is considerably more difficult to achieve pan-EC consistency of judicial interpretations, absent a ruling from the European Court of Justice; the Commission has, however, established a database of national rulings in the unfair contract terms sphere which 146

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Under Art. 19(1), ‘it will never be enough for firms to comply with the specific conflict-ofinterest rules . . . [They will] always have to ensure that their clients are treated honestly, fairly, and professionally’: L. Enriques, ‘Conflicts of Interest in Investment Services: The Price and Unfair Impact of MiFID’s Regulatory Framework’ in G. Ferrarini and E. Wymeersch (eds.), Investor Protection in Europe: Corporate Law Making, the MiFID and Beyond (Oxford: Oxford University Press, 2006), p. 321, p. 326. Recital 81 to the Level 2 Directive, for example, applies Art. 19(1) to the provision of generic advice which is not subject to the MiFID suitability regime. The move to principles-based regulation has been associated with the support of ethics as a means of disciplining firms: L. Cunningham, A Prescription to Retire the Rhetoric of ‘Principles-Based Systems’ in Corporate Law, Securities Regulation, and Accounting (2007), ssrn abstractid=970646, p. 52. The fiduciary relationship has also been characterized in terms of trust: M. Blair and L. Stout, Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law (2000), ssrn abstractid=241403, p. 3. D. Langevoort, ‘Monitoring: The Behavioral Economics of Corporate Compliance with Law’ (2002) Columbia Business Law Review 71. Enriques, Conflicts of Interest, p. 333. M. Hopper, ‘The MiFID Measure’ (2006) 64 European Lawyer 9.

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might usefully be replicated.152 The difficulties will be all the greater if firms prefer to settle with regulators rather than carry the risks of fairnessbased enforcement action.153 Ultimately, if divergent and unpredictable ex post interpretations are accompanied by increased enforcement costs, reputation risks or litigation risk,154 the sustainability of an innovative distribution and advice industry and firms’ willingness to carry the costs of retail market activity may be threatened. Over-investment in compliance may also follow which can lead to mistrust within firms and a hampering of innovation.155 On the other hand, this very diversity may become a strength which allows the regime to respond to different market contexts. The risks are also considerable if the fairness obligation becomes a supervisory or judicial occasion for reflecting, ex post, wider societal discontent with the financial markets, particularly in times of market turbulence;156 the ‘credit crunch’ period may prove revealing. They are also considerable if ex post assessment focuses on whether a particular outcome or approach was ‘good’ or in some way the ‘best’ one for the investor. Any move in this direction would suggest a merit-based and paternalistic approach to regulation which has been out of favour for some time. It would also sit uneasily with MiFID’s regulatory focus on a matrix of process/systemsbased, suitability/conflict-of-interest rules, rather than on a requirement to advise on the ‘best’ product, necessitating a change to the UK’s ‘most suitable’ regime. It might be suggested that notions of fairness should therefore be imbued with countervailing reasonableness criteria. Reasonableness is a recurring theme of the MiFID conflicts-of-interest regime, for example (firms must take ‘all reasonable steps’ to identify conflicts of interest) (Article 13(3)), and also appears in the suitability regime 152

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The Commission’s CLAB database on the Unfair Contract Term Directive collates decisions by administrative bodies, voluntary agreements, out-of-court settlements and arbitration awards. One assessment has pointed to the risk that FSA settlements on TCF violations could lead to artificial, customer-oriented precedents on what is ‘fair’: Freshfields Bruckhaus Deringer, Fairness in the UK Financial Services Sector, Briefing March 2008, pp. 1–2. Cunningham has cautioned against vague concepts, such as fairness, given the risk of arbitrary enforcement: Prescription, p. 19. Ambiguous standards may lead compliance departments, seeing rent-seeking opportunities from ambiguity, to overstate compliance requirements and acquire excessive resources: Langevoort, ‘Behavioral Economics’, 100. Enforcement based on principles can become imbued with societal values or reflect public outrage with perceived unfairness in securities markets, by comparison with rule-based enforcement which emerges from consultation and cost/benefit analysis: J. Park, ‘The Competing Paradigms of Securities Regulation’ (2007) 57 Duke Law Journal 625.

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(firms must have a ‘reasonable’ basis for believing that a transaction is suitable (MiFID Level 2 Directive, Article 35(1))). The extent to which fairness drives more effective investor protection ‘in action’ also depends on how it is embraced by national regulators. The UK experience points to the power of ‘fairness’ as an animating principle which may lend coherence and focus to rule-making and to supervisory efforts. The FSA has placed fairness at the heart of its retail market regime157 and has identified it as a motivating principle in its shaping of the wider UK and EC regulatory environment.158 Since 2002, it has adopted ‘ensuring a fair deal for retail consumers’ as its retail market strategic aim.159 Fairness is also at the centre of its firm-facing Treating Customers Fairly (TCF) initiative under which fairness is not an abstraction; the TCF initiative has produced a detailed and practically oriented articulation of what fairness demands operationally in terms of firm structures and process and, as such, carries risks.

3. Fairness and the TCF model: ‘law in action’ Compliance with a high-level, ill-defined fairness principle is likely to be a challenge to achieve organizationally as the challenges posed by the embedding of a particular ethics culture are considerable.160 Employees already have different incentives to firm managers and owners. Misalignment may be exacerbated where they are expected to pursue principles which are not carefully delineated, and where immediate employee incentives are in conflict with long-term firm objectives concerning fair treatment,161 as has been acknowledged by the FSA’s TCF initiative.162 The UK experience with the TCF strategy is instructive. UK investment firms operate under MiFID’s conduct-of-business regime which has been largely ‘copied out’ in the FSA’s Conduct of Business Sourcebook. But, 157 158

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The TCF objective has been described as a ‘core means of fulfilling the FSA’s consumer protection objective’: FSCP, Annual Report 2007–2008, p. 6. FSA, Business Plan 2008–2009, p. 23. The FSA’s decision to move from the previous selfregulatory model in the banking conduct-of-business sphere to a regulatory model, for example, is based in part on the absence of an over-arching fairness obligation: FSA, Regulating Retail Banking Conduct of Business (Consultation Paper No. 08/19, 2008), p. 4. See further ch. 2. J. Edwards, ‘Treating Customers Fairly’ (2006) 14 Journal of Financial Regulation and Compliance 242, 246. Langevoort, ‘Behavioral Economics’, 107. FSA, Remuneration: Considerations for Treating Customers Fairly.

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in practice, compliance with the conduct-of-business regime is also a function of the FSA’s TCF initiative which operates in parallel with MiFID. The TCF initiative, which took root in 2004163 and is now an ‘over-arching priority’ for the FSA’s retail work,164 central to the fair deal objective165 and embedded in its supervisory framework,166 is based on Principle 6 of the FSA’s eleven high-level Principles for Business. In a formula akin to Article 19(1), which has been directly implemented in the Conduct of Business Sourcebook,167 Principle 6 requires that a firm pay due regard to the interests of its customers and treat them fairly. The related TCF initiative represents a considerable shift from a ‘laws on the books’ approach in that it adopts strategies which are expressly designed to ‘change firms’ behaviour in order to deliver fairer outcomes for consumers’ while ‘recognizing the scale of cultural change’ within firms which it seeks.168 The TCF initiative is not based on the production of additional rules.169 Partly in response to repeated instances of mis-selling, including the splitcapital trust and precipice bonds failures (and the related failure of prescriptive regulation),170 which were dealt with by a discouraging cycle of mis-selling, loss, enforcement and reform, it is designed to focus senior management attention on the delivery of fair outcomes, embed a ‘TCF culture’ and allow firms flexibility in delivering the TCF outcomes. The six TCF outcomes address core aspects of the investment life-cycle and are designed to provide a description of the characteristics of a retail market in 163 164 165

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For an early discussion, see FSA, Treating Customers Fairly – Progress and Next Steps (2004). FSA, Treating Customers Fairly Initiative: May 2007 Progress Report (2007), p. 8. The FSA’s Major Retail Thematic Work Plan for 2008–2009 highlighted that ‘TCF is the cornerstone of our efforts to help consumers achieve a fair deal and underpins much of our thematic work’ (p. 1). From January 2009, delivery of TCF outcomes was to be tested as part of a firm’s usual supervision by the FSA, embedded within the FSA’s supervisory framework, and to become ‘an integral part of regular assessments of relationship managed firms’: FSA, Press Release, 12 November 2008 (FSA/PN/130/2008). COBS 2.1.1. The FSA has described Art. 19(1) as a high-level requirement which overlaps with the existing Principles for Business, including Principle 6: Consultation Paper 06/19, p. 30. FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008), p. 49. ‘[The FSA is] reluctant to press on with ever more intrusive regulation, which could create defensive and costly markets which are smaller and less innovative. Instead, we would prefer to see our rules supported by an intelligent, thoughtful, and effective implementation by firms of the high-level principle that they must Treat Customers Fairly’: FSA, Progress and Next Steps, p. 4. S. Wilson (FSA), Speech on ‘Treating Customers Fairly – Progress and Next Steps’, 19 March 2007, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/ index.shtml.

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which customers are treated fairly.171 TCF material has been produced on the three key retail market elements: product design, distribution (including on the quality of advice, remuneration and managing conflicts of interest) and disclosure (including on marketing and promotion). The strategy also covers contractual matters and unfair contract terms. The TCF outcomes are related to the MiFID conduct-of-business regime but are considerably more operational; the fairness principle, far from being nebulous, becomes a detailed and practical manual for how firms should design procedures and processes which address risks to the fair treatment of investors. The TCF strategy is designed to drive firms to review their business models and to embed a long-term ‘TCF culture’, through ‘awareness’, ‘strategy and planning’, ‘implementing’ and ‘embedding’ stages;172 all of this is a very long way from the stark Article 19(1) ‘law on the books’ formula. Firms were to have evidence in place to test TCF by March 2008 and to be able to demonstrate that they were treating customers fairly by December 2008. The extent of the FSA’s commitment to the TCF model became clear during 2008 when, in the teeth of market turbulence and with a sharp market and political focus on the FSA’s effectiveness in managing wider prudential and liquidity risks, it described the TCF initiative as central to its work in ensuring a fair deal for customers and warned that, notwithstanding difficult economic conditions and market turbulence, it would not be diverted from the March and December deadlines and urged firms to continue with their TCF programmes.173 Firms are supported in delivering the TCF outcomes through a wide array of non-regulatory tools including examples of best practice, case studies, FAQs, self-assessment tools (particularly for smaller firms, who 171

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The six outcomes are: (i) consumers can be confident that they are dealing with firms where the fair treatment of consumers is central to the corporate culture; (ii) products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly; (iii) consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale; (iv) where consumers receive advice, the advice is suitable and takes account of their circumstances; (v) consumers are provided with products that perform as firms have led them to expect, and the associated service is both of an acceptable standard and as they have been led to expect; and (vi) consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim, or make a complaint: for example, FSA, Treating Customers Fairly – Towards Fair Outcomes for Consumers (2006). FSA, Progress Report May 2007, pp. 2–3. FSA, Meeting the 2008 Deadlines – An Update for Firms (2008); and FSA, Business Plan 2008–2009, p. 24. Nonetheless, some downgrading of supervisory efforts appears to have occurred as the credit crunch intensified in autumn 2008 (n. 188 below).

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receive close supervisory attention under the TCF framework174 ), assistance in the design of the management information required to evidence TCF outcomes175 and a TCF ‘culture framework’ which highlights the importance of senior management engagement with TCF (including the appropriate design of incentive schemes).176 Monitoring,177 industrywide thematic review,178 supervision and, where necessary, enforcement tools179 are all wielded by the FSA. Despite this investment in supervisory technology, the FSA has faced difficulties in ensuring the TCF initiative is embedded, particularly within smaller firms where investors may be more vulnerable.180 The FSCP is, however, supportive181 and consumers appear to be reasonably confident that they are receiving fair treatment generally, although confidence is shaky.182 The critical translation of TCF initiatives from implementation into enhanced outcomes for retail investors, the acid test for its 174

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The FSA has adopted an enhanced strategy for small firm TCF supervision. The FSA’s June 2008 progress update on firms’ TCF management information systems, for example, includes specific case studies for small firms: FSA, Treating Customers Fairly: June 2008 Progress Update (2008), Annex 2A. FSA, A Guide to Management Information (2007). Progress in preparing management information to evidence the achievement of TCF outcomes was measured in June 2008, with variable results: FSA, Progress Update June 2008. FSA, Treating Customers Fairly – Culture (2007). The culture framework addresses: leadership; strategy; decision-making; controls; internal communication; recruitment; training and competence; and rewards. A series of reports addressed progress under the TCF initiatives both generally and with respect to particular outcomes, including FSA, May 2007 Progress Report; and FSA, Treating Customers Fairly: Measuring Outcomes November 2007 (2007). The FSA’s 2008–2009 Major Retail Thematic Work Plan, for example, highlighted the TCF initiative. FSA, Measuring Outcomes November 2007, p. 4. Firms were to be implementing TCF in a substantial part of their business by March 2007. While 93 per cent of major retail firms and 87 per cent of medium-sized investment firms met this deadline, only 41 per cent of small firms did: Progress Report May 2007, p. 3. Although the FSA acknowledged that the results were ‘particularly disappointing’ for smaller firms, they also noted that firms were making slow progress rather than failing to engage with TCF (p. 5). Its 2007–2008 Annual Report commended the FSA’s ‘strong’ performance on TCF and the increased money and energy devoted to communicating the TCF message to small firms: FSCP, Annual Report 2007–2008, p. 6. The FSA reported in 2006 that 63 per cent of consumers canvassed were very or fairly confident that firms were treating customers fairly (Consumer Awareness of the FSA and Financial Regulation (Consumer Research No. 57, 2006)). By 2007, this had dropped to 54 per cent (Consumer Awareness of the FSA and Financial Regulation (Consumer Research No. 62, 2007)). Despite challenging market conditions, it had increased to 56 per cent in 2008 (Consumer Research No. 67).

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effectiveness ‘in action’, is, however, proving troublesome183 as management has struggled to turn a commitment for change into ‘coalface improvements’.184 Compliance costs can be high, particularly with respect to the gathering of the management information required to evidence TCF. Firms, notwithstanding the volume of practical guidance, may not be clear on what the FSA seeks.185 Conversely, by focusing on internal management processes, and ‘recommending’ increasingly prescriptive procedures, the TCF initiative carries the risk of increased quasi-prescription of internal processes. The TCF initiative is also vulnerable to the risks of principlesbased regulation more generally, particularly with respect to enforcement uncertainties and the accretion of opaque, quasi-regulatory requirements which are not subject to the disciplines of the law-making process. The demands it places on supervision, not least in terms of the preparation of explanatory materials, are considerable, with the TCF initiative generating something of a tidal wave of supporting FSA documentation. But, while the evidence points to the difficulties in delivering the ambitious TCF agenda, it also points to the likely even more severe difficulties in delivering high-quality investment advice on the basis of rules ‘on the books’.

4. The implications of the TCF model In practice, the TCF initiative operates in parallel with, but somewhat independently of, the MiFID regime.186 While it represents an imaginative and pragmatic attempt to inculcate firm responsibility for nominated outcomes, it is rooted in the UK market and reflects the dominance of notionally ‘independent’ but commission-based investment advisers, the popularity of often complex investment products and the legacy of misselling scandals. The TCF initiative also reflects the FSA’s statutory consumer protection and awareness objectives and forms part of a wider retail matrix, together with the FSA’s financial literacy strategy and Retail Distribution Review. Regulatory learning through CESR may see the wider application of aspects of the TCF model, particularly if MiFID’s principlesbased approach takes root. But the high levels of resources demanded, its 183

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In November 2007 the FSA reported that it had seen little evidence that firms’ TCF work was translating into improved outcomes for retail consumers: Measuring Outcomes November 2007, p. 3. FSA, Discussion Paper No. 08/3, p. 50. 185 Ibid. Mason, ‘Principles-Based Regulation – Will It Work?’.

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relationship to the UK context and its linkage to the FSA’s principles-based agenda caution against any direct importation or wider application of the model. There are, however, some lessons for MiFID’s fair treatment principle. The TCF initiative points to the limitations of principles-based ‘law on the books’ in driving cultural change within firms and to the importance of robust ‘law in action’ in delivering change on the scale demanded by MiFID.187 The difficulties faced by the FSA in delivering outcomes under the TCF model, and the extensive supervisory resources required, do not augur well for the success of MiFID’s principles-based approach, unless firms’ systems and supervisory action are robust. And the rigorous supervision needed may become a casualty of wider events. Although earlier in 2008 the FSA restated its commitment to TCF, it is hard not to relate the FSA’s subsequent November 2008 decision to scale back its resource-intensive review of TCF compliance, to cancel its planned final December 2008 report on TCF preparation and to fold TCF supervision instead into the annual supervision cycle for investment firms, to the resources demanded by the financial crisis which intensified in autumn 2008.188

V. Regulatory technique (2): marketing risks 1. Marketing risks The marketing of investment services and products is a major concern for retail policy.189 Intuition suggests that an expansion in the range of products and services to meet greater investor demand, exacerbated in the pan-EC context and clear from the explosion in complex structured products, increases the risk of confusion and of unfair or misleading advertising.190 Marketing communications typically represent the first stage in the investment process, carry disproportionate impact and are a 187 188

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Either specific regulatory requirements or more pervasive monitoring appear necessary to reorient firm culture: Condon, ‘Rethinking Enforcement’, 33. The Financial Times, for example, reported that ‘the City watchdog is rowing back on plans to assess comprehensively the performance of retail financial services companies in “TCF” as it focuses on its responsibilities as a bank supervisor’: J. Hughes, ‘FSA Lowers the Customer Fairness Bar’, Financial Times, 13 November 2008. Both BaFIN and the AMF have focused on marketing risks: AMF, Annual Report 2007, p. 4; and BaFIN, Annual Report 2007, p. 146. CESR’s 2005 Retail Investor Workshop saw stakeholders call for a ‘high degree of vigilance in relation to financial promotion’: CESR, Annual Report 2005, p. 37. The FSA has also

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key risk point for vulnerable investors, ill-equipped to decode marketing strategies and trusting of firm communications.191 The evidence from behavioural finance suggests that investors are particularly vulnerable to marketing,192 not least as retail investors, reflecting the availability heuristic, can over-rely on ‘simpler’ marketing disclosures where regulated product disclosures are complex,193 tend to trust firms194 and can over-react to how marketing frames the investment decision,195 particularly as communications tend to accentuate opportunities rather than risk.196 The risks can be exacerbated in a cross-border context; the Equitable Life mis-selling scandal, which affected a number of Member States, highlighted not only the risk of misleading marketing communications, but also the tendency of cross-border investors, in particular, to rely on advertising.197 As pressures for retirement financing increase, marketing risks also increase concerning the decumulation of assets and the purchase of investment products, particularly where advisers are marketed as having specialist expertise with retirement issues.198 Current turbulent conditions and investor demand for safer but potentially higher-cost products also exacerbate marketing risks.199 The emerging data-set on investor behaviour certainly suggests considerable levels of concern as to aggressive marketing techniques in

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noted the risk of an increase in misleading or unfair marketing practices concerning complex products: FSA Substitute Products Response, p. 17. The FSA has warned that financial promotions are invitations to engage in investment activity and so play an influential role in the purchase decision: FSA, Financial Promotions and Other Communications (Consultation Paper No. 06/20, 2006), p. 9. Similarly, ‘marketing communications may have a material effect [on the investment decision]. This effect may outweigh the counterbalancing effect of other information produced at a different stage of the sales process’: CESR, Technical Advice on Possible Implementing Measures of Directive 2004/39/EC: 1st Set of Mandates (CESR/05-024c, 2005) (‘1st Mandate Advice’), p. 45. La Blanc and Rachlinski, In Praise, p. 22 (with respect to the over-confidence bias). Delmas Report, p. 26. The FSA has similarly warned of over-reliance on marketing: Financial Risk Outlook 2007, p. 91. See further ch. 2 and n. 16 above. D. Langevoort, ‘Towards More Effective Risk Disclosure for Technology Enhanced Investing’ (1997) 75 Washington University Law Quarterly 753, 759. Ibid. European Parliament, Committee of Inquiry into the Crisis of the Equitable Life Assurance Society, Report on the Crisis of the Equitable Life Assurance Society (A6-0203/2007, 2007), pp. 255–7. Senior Investors, pp. 12–13. The FSA has highlighted financial promotions in its 2009–2010 Business Plan and is concerned to raise standards of advertising in what are challenging market conditions: FSA, Business Plan 2009–2010, p. 26.

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the EC.200 More positively, the regulation of marketing communications may reap dividends as communications may support investor learning and better decision-making.201 The EC marketing regime, which is now extensive, has three dimensions: the discrete rules which apply to distance and online contracts; generic consumer protection marketing rules; and MiFID’s rules governing the marketing of MiFID-scope products and services, all with different regulatory designs.

2. Delivery-specific protection: online and distance contacts The Distance Marketing of Financial Services Directive (DMD) represented the EC’s first serious foray into the distribution process and marketing risks.202 Although it has been overtaken by MiFID, it remains a core investor protection measure, particularly for non-MiFID services and products.203 It addresses the risks posed to investors204 in the context of distance marketing of financial (including investment) services.205 In this context, investors’ informational disadvantages and monitoring difficulties may be deepened given the lack of personal interaction206 and they may be unable to assess the product or service and the rights and 200

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European Commission, Special Eurobarometer No. 230, Public Opinion in Europe on Financial Services: Summary (2005), p. 17, reporting that 35 per cent of respondents (38 per cent in the EU-15) agreed that the marketing techniques of financial institutions were aggressive. High-quality marketing communications have been associated with investor education, better decision-making, and the countering of information asymmetries: FSA, Consultation Paper No. 06/20, p. 9. See generally N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008), pp. 571–86. Review of the Directive (required under Art. 20) is a key element of the Commission’s consumer protection agenda and has generated a series of SANCO-commissioned reports including U. Reifner et al., Final Report: Part I: General Analysis: Impact of Directive 2002/65/EC (2008) and Civic Consulting, Analysis of the Economic Impact of Directive 2002/65/EC (2008). The Directive applies to the ‘consumer’ (any natural person who, in distance contracts covered by the Directive, is acting for purposes outside his business, trade or profession: Art. 2(d)). Arts. 2(a) and (e). FIN-USE, Response to the Green Paper on Financial Services Policy (2005–2010), pp. 10– 11. On the other hand, investors tend to over-rely on face-to-face communications: R. Shiller, Irrational Exuberance (Princeton and Oxford: Princeton University Press, 2000), pp. 154–62.

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obligations involved. Reflecting the empowerment model, the DMD is heavily based on investor-facing disclosure requirements (chapter 5). But, by providing a mandatory fourteen-day withdrawal right,207 it also takes a more interventionist approach to investor protection and reflects some degree of paternalism.208 This protection is, however, of limited relevance, as it does not apply where the price of a product or service reflects market fluctuations which may occur during the withdrawal period,209 although the withdrawal right does apply to contracts to receive investment advice or portfolio management services. Cold-calling, however, is addressed only tangentially by the Directive (section V.4.b below). Ancillary protections are also available under the E-Commerce Directive210 concerning online services, largely with respect to disclosure, but online commercial communications211 are also subject to clarity requirements,212 while unsolicited communications follow the DMD model for cold calls (section V.4.b below) and are, in essence, permitted.213 The E-Commerce Directive also engages with contractual requirements and introduces rules on the conclusion of contracts by electronic means which are designed to ensure that contracts concluded by e-commerce are electronically workable.214

3. Horizontal protection: consumer protection directives Retail investors are also protected by the horizontal, consumer protection directives which address marketing, chief among them from the 207

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Arts. 6 and 7. Withdrawal rights have also been granted in respect of life assurance products in Directive 2002/83/EC of the European Parliament and Council of 5 November 2002 concerning life assurance, OJ 2002 No. L345/1, Art. 35. C. Camerer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin, ‘Regulation for Conservatives: Behavioral Economics and the Case for Asymmetric Paternalism’ (2002–3) 151 University of Pennsylvania Law Review 1211, 1240 and 1243. These include services relating to: foreign exchange; money-market instruments; transferable securities; units in CISs; financial futures contracts; forward interest rate agreements; interest rate, currency, and equity swaps; and options to acquire any of these instruments, including equivalent cash-settled instruments. The Delmas Report, however, called for a discrete two-day cooling-off period to be granted to UCITS investors. Directive 2000/31/EC of the European Parliament and of the Council of 8 June 2000 on certain legal aspects of information society services, in particular electronic commerce, in the internal market, OJ 2000 No. L178/1. Any form of communication designed to promote, directly or indirectly, the goods, services or image of the provider (Art. 2(f)). Art. 6. 213 Art. 7. 214 Arts. 9–11.

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retail investor perspective the 2005 Unfair Commercial Practices (UCP) Directive. The Directive,215 which has its roots in EC consumer law and policy,216 represents a significant addition to the arsenal available to the retail investor. Like the DMD, its protections apply to ‘consumers’.217 It adopts a considerably more interventionist approach than MiFID which, for the most part, does not prohibit particular forms of marketing but relies heavily on firm compliance with the over-arching requirement that communications are ‘fair, clear and not misleading’;218 the UCP, by contrast, prohibits certain types of marketing outright. It applies to ‘unfair’ business-to-consumer commercial practices, before, during and after a commercial transaction in relation to a product (Article 3(1)). The wide and generic definitions of business-toconsumer commercial practices (Article 2(d)) and products (Article 2(c)) bring investment services within the Directive’s scope, although commercial practices which are not directly designed to influence transactional decisions,219 such as annual reports and corporate promotional literature, are excluded (recital 7). The risks posed by the misleading marketing of financial products are expressly addressed by recital 10, which highlights the Directive’s importance for complex products with a high level of risk to consumers, and particularly financial services products, where a trader seeks to create a false impression of the product’s nature. ‘Unfair’ commercial practices are prohibited (Article 5), although a reasonableness regime applies. A practice is ‘unfair’ if, reflecting notions of reasonableness, it is contrary to the requirements of professional 215

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B. De Groote and K. De Vulder, ‘European Framework for Unfair Commercial Practices: Analysis of Directive 2005/29’ (2007) Journal of Business Law 16; and S. Weatherill and U. Bernitz (eds.), The Regulation of Unfair Commercial Practices under EC Directive 2005/29/EC: New Rules and Techniques (Oxford and Portland, OR: Hart Publishing, 2007). European Commission, Green Paper on EU Consumer Protection (COM (2001) 531), pp. 11–15. Any natural person who, in commercial practices covered by the Directive, is acting for purposes outside his trade, business, craft or profession (Art. 2). Conflicting provisions in specific sectoral directives take precedence (Art. 3(4)), but MiFID’s prohibitions on particular forms of marketing communication are very limited. Any decision taken by a consumer concerning whether, how, and on what terms to purchase, make payment in whole or in part for, retail or dispose of a product or to exercise a contractual right in relation to the product, whether the consumer decides to act or to refrain from acting: Art. 2(k).

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diligence220 and materially distorts,221 or is likely to materially distort, the economic behaviour with regard to the product of the ‘average consumer’ whom it reaches or to whom it is addressed (or the average member of the group where the practice is directed to a particular group of consumers). Reasonableness is further supported by the robust approach taken to the competent and informed ‘average consumer’.222 A commercial practice is characterized as ‘unfair’ and so prohibited where it is ‘misleading’, within the terms of Articles 6 and 7, or ‘aggressive’,223 within the terms of Articles 8 and 9. ‘Misleading’ practices are those which contain false information and are untruthful or, in any way, including overall presentation, deceive or are likely to deceive the average consumer across a number of different dimensions,224 or are likely to cause the consumer to take a transactional decision which would not otherwise have been taken (Article 6). Of particular relevance to the investor protection context is the determination that practices can be misleading where material information (including required investment-related disclosures)225 is omitted which the average consumer, according to the context, needs in order to take an informed transactional decision, and the omission causes, or is likely to cause, the average consumer to take a transactional decision that would not otherwise have been taken (Article 7(1)). This provision, and the consequent 220

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Which relates to the standard of special skill and care which a trader may reasonably be expected to exercise towards consumers, commensurate with honest market practices and/or the general principle of good faith in the trader’s field of activity. Behaviour is materially distorted where the practice appreciably impairs the consumer’s ability to make an informed decision, causing the consumer to take a transaction decision that would not otherwise have been taken (Art. 2(e)). The ‘average consumer’ concept is based on the European Court’s consumer law jurisprudence and assumes a consumer ‘who is reasonably well-informed and reasonably observant and circumspect, taking into account social, cultural and linguistic factors’: recital 18 (see further ch. 2). Aggressive practices are of less direct relevance to the investor protection context; a practice is aggressive if by harassment, coercion or undue influence it significantly impairs or is likely to significantly impair the average consumer’s freedom of choice or conduct with regard to the product and causes the consumer to take a transactional decision which would not otherwise have been taken (Article 8). These are listed in Art. 6(1) and include the existence or nature of the product, its main characteristics, the extent of the trader’s commitments, the motives for the practice and the nature of the sales process, the price and the nature, attributes and rights of the trader, including qualifications. Art. 7(4) lists information which is to be regarded as material, including the main characteristics of the product, the price, and withdrawal rights, where they apply. MiFID’s disclosure requirements are also regarded as material under Art. 7(5).

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prohibition of the related commercial practice or marketing communication and the prospect of enforcement action,226 dovetails with MiFID’s imposition of positive disclosure requirements on the investment firm. Of similar importance is the determination that a practice is misleading where a trader hides material information or provides material information in an unclear, unintelligible, ambiguous or untimely manner, or fails to identify the commercial intent of the practice and where, in either case, this causes, or is likely to cause, the average consumer to take a transactional decision which would not otherwise have been taken (Article 7(2)). This requirement chimes well with MiFID’s over-arching requirement that disclosure be ‘fair, clear and not misleading’ (Article 19(2)) and ‘comprehensible’ (Article 19(3)). It also imposes discipline on UCITS product providers with respect to UCITS marketing. The Directive’s key concepts are challenging from a legal certainty perspective, certainly by comparison with the process-based suitability protections which characterize MiFID, and even by comparison with the ‘fair, clear and not misleading’ concept which governs MiFID’s marketing regime and the over-arching Article 19(1) fair treatment principle. In an attempt to provide legal certainty, the ‘misleading’ and ‘aggressive’ regime is supplemented by Annex I to the Directive which sets out a ‘blacklist’ of commercial practices which, in all circumstances, are to be regarded as unfair.227 On the continuum of retail market measures from empowermentdriven and disclosure-based measures to interventionist and protective measures which direct firm behaviour, the Directive has a distinctly paternalistic and interventionist feel; despite the risks of the consumerist agenda for investor protection policy,228 where investor protection derives from consumer protection measures, EC protections can, at times, become considerably more interventionist and less reliant on disclosure. On the other hand, there are synergies between the Directive and investor protection 226

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The Directive requires that penalties be effective, proportionate and dissuasive (Art. 13) and that actions for injunctions can be brought by persons and organizations with a legitimate interest in combating unfair commercial practices (Art. 11). These are the only practices which can be deemed ‘unfair’ without a case-by-case assessment against Arts. 5–9 (recital 17). Practices of particular importance to the retail investor include: falsely claiming to be a signatory to a code of conduct; falsely claiming that a code of conduct has an endorsement from a public or other body; falsely claiming that a trader or product has been approved, endorsed or authorized by a public or private body; and stating or otherwise creating the impression that a product can be legally sold when it cannot. Chs. 1 and 2.

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regulation and policy; the tension in investor protection policy between the empowered and the vulnerable investor is reflected in the Directive’s linkage of what is ‘unfair’ to the ability of what seems to be a robust average consumer to make an informed decision.

4. Investment-specific protection: MiFID a) Marketing communications Retail investor protection against marketing risk is largely a function of MiFID’s specialized rules. Article 19(2) addresses marketing risks through an over-arching, conduct-shaping rule which requires that all information, including marketing communications, which is addressed by a firm to (potential) clients must be ‘fair, clear and not misleading’ – a formula which will be clarified through supervisory action, industry practice and, potentially, litigation. It governs all communications between the firm and the investor, and so is central to the disclosure regime, but has particular significance for marketing communications. Article 19(2) is amplified by the related level 2 regime (MiFID Level 2 Directive, Article 27) which is expressly targeted to retail investors. The regime does not require preapproval of marketing communications or prescribe their content; it is designed to be principles-based, facilitative, and to allow firms flexibility in designing their marketing disclosure and accordingly sets out the general conditions with which information must comply in order to be ‘fair, clear and not misleading’.229 The regime’s main concern is with requiring key disclosures and risk warnings rather than with prohibiting or prescribing particular forms of disclosure. The undercutting ‘fair, clear and not misleading’ obligation is tightened, however, in that it is not couched in ‘take reasonable steps’ terms, but is absolute. Much of the regime reflects traditional approaches to protecting investors from marketing. So marketing communications must be accurate and must not emphasize the potential benefits of an investment without also giving a fair and prominent indication of risk, and communications must not disguise, diminish or obscure important items, statements or warnings (Article 27(2)). Particular requirements apply to a range of marketing techniques which are prone to investor over-reaction, 229

‘After some consideration’, the Commission decided not to prescribe the content or characteristics of marketing communications but to base the regime on guiding principles as to whether a communication was ‘fair, clear and not misleading’: July 2005 Explanatory Note, p. 2.

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such as suggestions of endorsement by a regulatory authority (prohibited under Article 27(8)), tax information (a warning must be provided that tax treatment depends on individual investor circumstances) (Article 27(7)), simulated historic returns (Article 27(5)), past performance disclosure (Article 27(4)), comparisons (Article 27(3)) and projections (Article 27(6)).230 But, by adopting an essentially facilitative approach, the regime also reflects a generally robust approach to investor competence by, for example, permitting simulated returns231 and past performance disclosures.232 Investors are particularly vulnerable to marketing communications in the form of direct offers and non-advised offers of investment products, as became clear in the UK following the split-capital investment trust scandal. Direct offers are expressly addressed by Article 29(8) which imposes specific disclosure requirements. But disclosure is an unreliable method for dealing with retail investor risks, particularly given the range of complex products which may be sold through these executiononly channels and the related failures in the investment product market, outlined in chapter 3. A notable innovation, however, concerns the requirement that marketing communications be appropriately targeted; an innovation which would be well applied to product design.233 Firms must ensure that information is presented in such a way that it is likely to be understood by the ‘average member’ of the group addressed (Article 27(2)). While this is a challenging requirement given the different capabilities of investors,234 it is an innovative attempt to steer the marketing of complex and risky products away from vulnerable investors and to embed the production of ‘fair, clear and not misleading disclosure’ within the firm.

b) Cold calls and boiler rooms Retail investors are likely to be most vulnerable with respect to cold calls, particularly where the calls relate to ‘boiler room’ frauds which seek to sell worthless shares to vulnerable investors.235 Unusually given investor vulnerability in this context, but reflecting the DMD which only curtails 230 231 232 234 235

See further ch. 5. CESR, by contrast, prohibited simulated historic returns: 1st Mandate Advice, p. 47. See further ch. 5. 233 See further ch. 3. Although the FSA has suggested that a ‘common sense’ approach be adopted and that arithmetical calculations are not required of firms: Consultation Paper No. 06/20, p. 14. The Australian conduct regulator (ASIC) reported that approximately €509 million was lost to cold-calling and other financial scams between 2001 and 2003: reported in OECD, Examining Consumer Policy: A Report on Consumer Information Campaigns Concerning Scams (OECD, 2005). Significant losses have also been sustained in the UK,

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the use of automatic-calling machines and fax machines236 and does not prohibit cold calls,237 MiFID does not directly address cold calls. In one of the few examples of an area of significant importance to the retail markets which falls outside the EC regime, the treatment of cold calls remains with the Member States;238 the Alpine Investments ruling suggests that the European Court of Justice will be sympathetic to Member State rules in this area even where they pose an obstacle to the Treaty freedoms.239 Where the calls are made by MiFID-scope firms, they are, however, subject to the general fair treatment obligation and to the Article 19(2) requirement that any information communicated during a call be fair, clear and not misleading. The UCP Directive also characterizes ‘persistent and unwanted solicitation’ by phone, email and fax as ‘unfair’ in the annex blacklist (and so prohibited), although this is without prejudice to the DMD regime.240 But investors are typically most vulnerable to cold calls from overseas ‘boiler rooms’ which are usually beyond the reach of EC regulation and national enforcement, leading to the FSA’s efforts in this area241 being focused in part on building international co-operation in addressing boiler room frauds.242 The treatment of cold calls is therefore perhaps best regarded as a function of investor education,243 and not of regulation alone.

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with the FSA reporting in 2008 that around 30,000 people became victims of boiler room frauds, representing losses of £300 million: FSA, Press Release, 10 November 2008 (FSA/PN/128/2008). BaFIN has also recently engaged in an audit of cold calls: Annual Report 2007, p. 145. The FSA has also highlighted the greater vulnerability of older people to share scams and adopted a targeted awareness campaign: FSA, Press Release, 27 April 2009 (FSA/PN/055/2009). Art. 10(1) requires the consumer’s prior consent before the use of automatic-calling machines and fax machines is permitted. Art. 10(2) appears to leave the issue of prior consent to the discretion of the Member States under an opt-in/opt-out model. Cold calls are prohibited in the UK unless there is an existing client relationship and the call relates to nominated lower risk investments (readily realizable securities and generally marketable, non-geared packaged products): COBS 4.82. Alpine Investments v. Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93). Annex I, para. 26. Which include a successful application to wind up a UK partnership which facilitated offshore boiler-room share sales: J. Gray, ‘At FSA’s Application High Court Orders Winding up of UK Partnership Which Facilitated Offshore Boiler Room Share Sales to UK Investors’ (2007) 15 Journal of Financial Regulation and Compliance 343. FSA, Press Release, 10 November 2008 (FSA/PN/128/2008). The FSA has issued an education leaflet on the dangers of boiler rooms, pointing to the non-application of UK (and EC) law: FSA, Share Investment Scams (2004).

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c) An effective regime? Notwithstanding its facilitative approach, the MiFID marketing regime is designed to address vulnerable and trusting investors. But it avoids overt paternalism, and the related risks of over-prescription and ‘tick-the-box’ compliance, which the UK experience points to,244 by focusing on core principles and the treatment of specific disclosures which are vulnerable to over-reaction, rather than on prescribing content and requiring ‘laundrylists’ of risk warnings which are of limited use to investors.245 Lengthy catalogues of risks may only generate investor resistance and overload, lead to poor engagement with warnings246 and obscure key messages. The over-arching Article 19(1) fair treatment obligation and the Article 19(2) ‘fair, clear and not misleading’ obligation, together with the novel requirement that firms consider the ‘average investor’ targeted by the communication, form a regime which requires investment firms to consider the overall fairness and clarity of communications ‘in action’. Combined with the Article 4 prohibition on gold-plating, it has the potential to give firms flexibility in designing marketing, drive cultural change within firms and closer communication between compliance and marketing departments and, ultimately, support more informed decisionmaking by investors with well-designed communications. It also has the potential, at least, to capture the different risks raised by the expanding universe of investment products, including structured products. MiFID’s marketing regime certainly seems to have some catalytic potential. Although the FSA was already committed to its ‘more-principlesbased’ regulation agenda, MiFID implementation and the Article 4 goldplating prohibition were key drivers in its Financial Promotions Review of the previously detailed financial promotions regime and the adoption of a principles-based approach;247 by contrast with the pre-MiFID 244

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The pre-MiFID detailed regulation of marketing communications in the UK has been associated with ‘tick-the-box’ compliance, particularly with respect to risk warnings, and failures to make promotions fair, clear and not misleading: T. Katz (FSA), Speech on ‘Financial Promotions and More Principles-Based Regulation – Freedom and Responsibility’, 28 November 2007, available via www.fsa.gov.uk/Pages/Library/Communications/ Speeches/index.shtml. One FSA study has reported that investors feel too much is expected of them by financial marketing and that small print disclosures and risk warnings are of limited value: FSA, Report of the Task Force on Past Performance (2001), p. 10. FSA research on the reaction by investors to the scripted questions used to test the Basic Advice regime for stakeholder products found a low recall of warnings, particularly where multiple warnings were given: FSA, A Basic Advice Regime for the Sale of Stakeholder Products (Consultation Paper No. 04/11, 2004), p. 12. Although the FSA was already committed to reforming its prescriptive and product-specific financial promotions regime under the Financial Promotions Review, and to substantially

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regime,248 the FSA’s rulebook249 no longer prescribes specific rules for particular investments and products but relies on firm judgment in the application of the high-level MiFID rules.250 But, while the new regime’s design appears reasonable, its effectiveness will depend on how competent authorities police the new regime and support firms in its application. Poor compliance with marketing requirements has emerged in the UK, where the FSA has identified marketing as a key supervisory and enforcement priority given persistent weaknesses,251 and elsewhere,252 and strenuous supervision is likely to be required.253

VI. Regulatory technique (3): quality of advice and suitability 1. Suitability and objective advice Although the MiFID distribution and advice regime is composed of several interlocking elements, the current policy focus is largely on the quality and objectivity of advice and, accordingly, on rules to address commission

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reducing its prescriptive rules, MiFID was a key driver: Consultation Paper No. 06/20, pp. 7–8. Pre-MiFID, detailed and often product-specific rules applied which governed when promotions were ‘fair, clear and not misleading’. The new principles-based regime is designed to address the risks that detailed rules can divert firm attention from the purposes of regulation, that product-related requirements can be inflexible and that extensive rules can act as a barrier to entry for small firms, and to encourage greater senior management responsibility and allow firms greater freedom: ibid., p. 7. The new MiFID regime is set out in COBS 4. Consultation Paper No. 06/20, pp. 15–16. The new approach is asserted to deliver ‘real benefits’ for firms and consumers in the form of greater flexibility for firms and in the form of financial promotions which are tailored more closely to the needs of consumers: p. 3. The 2007–2008 Retail Market Thematic Plan highlighted the FSA’s focus on financial promotions and its concern that one-quarter of promotions were difficult to navigate: FSA, Major Retail Thematic Work Plan for 2008–2009, p. 7. The FSCP has also identified marketing communications as a key vulnerability for investors given the potential for consumer detriment where communications are unclear and unbalanced, the contagion risks which arise where a firm pushes at the boundaries of what it is acceptable and is followed by other firms and lack of understanding of the new MiFID regime: FSCP, Annual Report 2007–2008, p. 23. E.g. AFM, Annual Report 2006, p. 53. The FSA’s experience is not encouraging. The FSCP, which was hostile to the adoption of a principles-based approach to marketing communications (Annual Report 2007–2008, p. 38), has expressed concern as to the FSA’s track record on enforcement of marketing requirements, rating the FSA’s performance on financial promotions as ‘weak’ and criticizing it for concentrating only on major rule breaches (Annual Report 2006–2007, p. 6), although its 2007–8 Annual Report reported more proactive and themed monitoring (p. 23).

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risk (section X below) and on process-based rules to ensure that advice and products are ‘suitable’ for the investor. Traditionally, suitability rules have been associated with a paternalistic approach to the retail investor254 and thus the trusting rather than empowered investor. More recently, they have been associated with minimizing the behavioural defects under which investors operate.255 Increasingly, they are regarded, in tandem with conflict-of-interest and commission risk rules, as a key mitigant for misselling risks in the mass retail market,256 particularly in the sale of complex and alternative investments,257 and as of central importance in protecting and empowering retail investors. Suitability rules carry a number of potential benefits. Unlike the Article 19(1) fairness obligation, which implies some form of troublesome value judgment, and the related reliance on fairness and ‘not misleading’ standards for marketing, suitability requirements, while ultimately based on adviser judgment, are process-based. They do not prescribe a particular outcome. But they do require that an adviser ‘knows the client’258 and makes a personalized recommendation which reflects the investor’s needs and profile. Together, conflict-of-interest and suitability-based quality-ofadvice rules can also dilute the risks of failures in product regulation and mitigate the limitations of disclosure. Suitability requirements can also support wider investor access to riskier products, and engage with market risk, by allowing regulatory regimes to support retail investor access to products which might otherwise be restricted through public marketing restrictions by placing firms under an obligation to assess an investment’s suitability. Although there were traces of suitability in the earlier Insurance Mediation Directive,259 MiFID’s introduction of suitability requirements brought major change to the EC’s investor protection regime. Suitability requirements have, however, long been a staple of the UK regime, with suitability one of the FSA’s High Level Principles for Business.260 254 255 256 257

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J. Markham, ‘Protecting the Institutional Investor – Jungle Predator or Shorn Lamb’ (1995) 12 Yale Journal of Regulation 345. L. Cunningham, ‘Behavioral Finance and Investor Governance’ (2002) 59 Washington & Lee Law Review 767, 798–9. Joint Forum Report, p. 6. European Parliament, Resolution on Asset Management (P6 TA-PROV(2007)0627, 2007) (‘Klinz II Resolution’), noting the importance of MiFID’s suitability and appropriateness rules as protections against mis-selling: para. 41. D. Smith and S. Legett, ‘Client Classification’ in Skinner, The Future of Investing, p. 65, p. 72. See sect. XI below. 260 Principle 9.

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The MiFID regime, which the FSA regarded as reinforcing existing standards of good market practice,261 has now been ‘copied out’ into the FSA rulebook.262 But, even here, MiFID has required changes, particularly in the form of the new MiFID ‘appropriateness’ regime (which allows for a lighter-touch suitability test in certain circumstances),263 the removal of the requirement that advisers recommend the ‘most suitable’ product from the range on which they advise,264 and restrictions on the extent to which the UK regime can experiment with suitability models. As discussed in section XII below, the costs of suitability, and the related impact on access to advice, led to the adoption of the Basic Advice regime, which follows a lighter suitability process based on pre-scripted questions265 – but it can apply only to non-MiFID firms.

2. The suitability regime: suitability and appropriateness The suitability assessment required under Article 19 takes two forms: (1) the assessment of ‘suitability’ (Article 19(4)) and (2) the assessment of ‘appropriateness’ (Article 19(5)), depending in each case on the degree of investor reliance on the adviser. In a clear expression of support for investor choice and competence, and in an example of how empowerment and protection can be blended, execution-only services in ‘non-complex products’ are not subject to suitability requirements.266 The centrality of investor choice to the regime has been recognized by CESR’s MiFID Guide for Retail Investors, which emphasizes the importance of the investor’s decision as to the degree of reliance on advice in driving the level of protection provided.267 Under Article 19(4), where the firm provides investment advice or portfolio management services, a suitability assessment is required. The process-based regime allows firms a significant degree of flexibility; 261 262 263

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FSA, Consultation Paper No. 06/19, p. 77. COBS 9 (suitability) and 10 (appropriateness). The FSA has made some efforts to explain the nature of the new and unfamiliar test (FSA, The New Appropriateness Test – A New Requirement (2007)) and industry guidance has been adopted (MiFID Connect, Guidance on the Application of the Suitability and Appropriateness Requirements under the FSA Rules Implementing MiFID in the UK (2007)). Additional and detailed guidance to the copied-out COBS appropriateness obligation is also set out in COBS 10. Consultation Paper No. 06/19, p. 77; and FSA, Policy Statement No. 07/6, p. 49. COBS 9.6.3 and 9.6.6. 266 See further chs. 2 and 6. CESR, A Consumer’s Guide to MiFID: Investing in Financial Products (CESR/08-003, 2008), p. 6.

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the process is calibrated to the nature of the investor, the service and the investment.268 This flexibility also allows the suitability assessment to apply to the range of choices which may be made by the firm; it captures, for example, any decision by the firm to choose a particular platform on which to manage an investor’s portfolio.269 It may also, as the FSA has assumed in its Retail Distribution Review, support access to advice by allowing firms to develop cheaper ‘advised-sales’ processes which are based on a more limited suitability assessment but within MiFID’s requirements.270 The firm must obtain the ‘necessary information’ regarding the investor’s knowledge and experience in the investment field, which must be relevant to the specific type of product or service, and regarding the investor’s financial situation and investment objectives,271 so as to enable the firm to recommend the investment services and financial instruments ‘suitable’ for the investor.272 Where the ‘necessary information’ is not provided, the regulatory response is paternalistic; the investment firm must not recommend investment services or instruments (MiFID Level 2 Directive, Article 35(5)).273 A firm can, however, proceed with a particular transaction on a non-advised basis, under the execution-only regime, as long as the conditions of that regime and the Article 19(1) fair treatment principle are met; the same strategy could be adopted where a firm determines that a transaction is unsuitable for the investor. Although the suitability regime 268 269 270 271

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Level 2 Directive, Arts. 35 and 37. The FSA has identified suitability rules as a key technique for managing risks to investors where platforms and wraps are used: Discussion Paper No. 07/2, pp. 24 and 29–30. 2008 RDR Feedback Statement, p. 63. The information which must be collected concerning the investor’s financial situation includes, where relevant, information on the investor’s source and extent of regular income, assets, investments and real property, and regular financial commitments (Art. 35(3)), while the information with respect to investment objectives covers the investor’s time horizon, risk-taking preferences, risk profile, and the purposes of the investment (Art. 35(4)). Information related to knowledge and experience includes the level of education and the profession or former profession of the investor (Art. 37). MiFID, Art. 19(4). The firm must obtain such information as is necessary for it to understand the ‘essential facts’ about the client, and for the firm to have a ‘reasonable basis for believing’, given due consideration of the nature and extent of the service provided, that the transaction satisfies three suitability criteria: it meets the client’s investment objectives; the client is able financially to bear the related investment risks consistent with his investment objectives; and the client has the necessary experience and knowledge to understand the risks involved in the transaction or in the management of the portfolio (MiFID Level 2 Directive. Art. 35). Although the FSA is of the view that MiFID offers ‘inherent flexibility’ as to what ‘necessary information’ includes, and that it can be calibrated according to the type of client and the nature of the service: Consultation Paper No. 06/19, p. 80.

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therefore has a paternalistic tinge, it allows for a degree of flexibility and investor autonomy. A lighter touch ‘appropriateness’ regime (Article 19(5)) applies where services ‘other than Article 19(4)’ services are provided.274 These ‘nonadvised’ services275 include in particular execution-only transactions in complex products.276 Investor choice, and support of the empowered investor, lies behind this classification: ‘the impetus behind a light touch sales regime is to simplify current sales practices, to reduce costs to the consumer and to encourage them to make active choices about the products or services offered’.277 Implicit in the regime is that the transaction is investor-led rather than adviser-led.278 The assessment requires the firm to ask the investor to provide information only regarding the investor’s knowledge and experience in the investment field279 relevant to the specific type of product or service demanded, so as to enable the firm to assess whether the service or product is ‘appropriate’; the firm must simply assess whether the client has the necessary experience and knowledge in order to understand the risks involved in relation to the specific type of product or service offered or demanded.280 Article 19(5) also appears to support low-cost, online assessments of appropriateness.281 By contrast with the suitability regime, an assessment is not required of the client’s financial situation or investment objectives and, in practice, the focus is on whether the investor is an appropriate client to be offered the product or service282 – such as execution-only access to complex products. Also by contrast with 274

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Its exact scope caused some confusion, with market participants asking CESR for clarification on when the regime applied, which CESR did not supply (as to do so would have been outside the level 2 mandate): CESR, Technical Advice on Possible Implementing Measures of Directive 2004/39/EC: 1st Set of Mandates where the Deadline Was Extended and 2nd Set of Mandates: Feedback Statement (CESR/05-291b, 2005), p. 25. The FSA has described the appropriateness regime as aiming to increase investor protection in the non-advised market: FSA, Appropriateness, p. 1. CESR has linked ‘appropriateness’ to execution-only services in complex products: MiFID Consumer Guide, p. 7. Economic and Monetary Affairs Committee, A5-0114/2004, 2004, amendment 19. Ibid. 279 Specified in Art. 37. 280 MiFID Level 2 Directive, Art. 36. The FSA has suggested that the assessment could occur online through electronic application forms which automatically process clients’ answers to targeted questions: Appropriateness, p. 6. Clifford Chance, The Future in the UK for Retail Structured Products, Client Briefing (2007), p. 2. The FSA has interpreted the test as, in certain cases, requiring little more than establishing or confirming that the client is a sufficiently experienced investor in the type of product, although it has warned that the assessment should be particularly rigorous where more complex products are offered to less experienced clients: FSA, Appropriateness, p. 6.

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the suitability regime, investor failure to supply the information does not prevent the firm from supplying the service, as long as a risk warning is provided; greater investor autonomy and capacity is assumed. Similarly, where the firm finds that a product or service is not appropriate for the investor, the firm must warn the client but is not prevented from supplying the product or service, but due regard should be given to the Article 19(1) fair treatment obligation. The suitability regime reflects the reality of reliance by trusting investors on advisers. But it also reflects the empowerment and engagement movement in that it accommodates considerable investor autonomy and freedom to choose lower cost services. Whether or not engaged but vulnerable investors who heavily rely on advice are sufficiently supported, however, depends on the effectiveness of the regime ‘in action’.

3. Suitability ‘in action’ The advent of a new suitability regime ‘on the books’ might promise much for better quality advice, including stronger diversification-based protection against market risks, not least given some pre-MiFID evidence of poor practices.283 But the delivery of an effective suitability regime, and support of high-quality and objective advice, requires strategies beyond regulation. The quality of advice depends on a range of factors which are very difficult to support through regulatory fiat, including the impartiality of advisers (section X below), and which can disable the suitability assessment. It also depends on the extent to which process-based regulation can support the exercise of judgment; this is likely to represent a very considerable challenge, not least given herding dynamics, given that rules alone cannot dictate the quality of advice.284 The ‘credit crunch’, for example, has revealed concern as to adviser reliance on ratings in assessing the suitability of structured products.285 But it is highly questionable whether it is realistic to assume that the competence and conflict-of-interest risks to which rating agencies appear to have been prone, and which were not predicted ex ante, can be captured by suitability standards, particularly where

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C. Jansen, R. Fischer and A. Hackenthal, The Influence of Financial Advice on the Asset Allocation of Individual Investors (2008), ssrn abstractid=1102092 (based on a German retail bank data-set). J. Black, Rules and Regulators (Oxford: Oxford University Press, 1997), pp. 176 and 180. CESR, Lehman Default, p. 3.

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industry-wide herding dynamics arise. Suitability, while process-based, is also personalized and context-specific; the line between suitable and unsuitable advice is likely to be a difficult one to draw.286 Laws on the books are unlikely, of themselves, to achieve stronger quality of advice outcomes. MiFID’s suitability standards have been supported in the UK regime by extensive TCF standards.287 By comparison with MiFID’s broad-brush requirements, the TCF model imposes very considerable practical prescriptions on the advice process. The FSA’s TCF Factsheet on quality of advice, for example, considers how firms should consider the quality of advice with respect to the knowledge and skills of advisers, the assessment of client needs, recommendations, client communications, corporate culture and good practice,288 and intervenes in some detail in internal management processes. The FSA has also provided two detailed case studies which consider how a firm might engage in a stock-take of its quality of advice process289 and which bring firms through the advice process (based on previous mystery shopping exercises).290 Further detail is provided in the FSA’s July 2006 statement on the quality of advice process291 and in MiFID Connect’s extensive and detailed guidance, which has been reviewed by the FSA, on the nature of the suitability and appropriateness assessments. This approach is some distance from MiFID’s principles-based approach and suggests considerable FSA scepticism as to the ability of suitability rules ‘on the books’ to deliver good quality of advice outcomes. But, even under this more interventionist model, delivering high-quality advice through suitability requirements has proved troublesome and has required strenuous supervisory and monitoring efforts. In 2007, the FSA found an ‘unacceptable number of weaknesses in firms’ processes around 286 287

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Langevoort, ‘Behavioral Economics’, 95, describing suitability as ‘indeterminate and fact specific’. TCF Outcome 4 states that, where consumers receive advice, the advice must be suitable and take account of their circumstances (e.g. FSA, Measuring Outcomes November 2007, p. 17). FSA, Fact Sheet – Improving the Quality of your Financial Advice Process. FSA, Quality of Advice – Case Study 1. The range of factors to be considered by firms include: management oversight; quality of advisers; training and competence; monitoring; the impartiality of advisers; assessing customer needs; and suitability letters. FSA, Quality of Advice – Case Study 2. FSA, Quality of Advice Process in Firms Offering Financial Advice: Conditions for Treating Customers Fairly (2006). Similar detail is set out in FSA, Medium and Small Firms: Considerations for Treating Customers Fairly.

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the giving of advice’.292 Mystery shopping tests have delivered less than impressive results, with only one-third of recommendations proving to be suitable.293 The nature of complaints to the Financial Ombudsman Service also suggests persistent problems, with 63 per cent of new complaints with respect to investment and pension products related to sales and advice in 2007.294 The FSA has also found a bias towards new investments and that appropriate consideration was not being given to whether mortgage debt should be repaid.295 The opportunity may also have been missed to support investor monitoring of the quality of advice. Firms are not required to produce a suitability letter which outlines the course of action advised and why it is deemed suitable.296 Notwithstanding the costs of such a requirement unless it is carefully designed,297 this appears to be a missed opportunity – particularly given the incentives it may provide for industry compliance. FSA testing298 suggests a relationship between the quality of advice and a suitability letter or report,299 although the FSA has also reported considerable difficulties with the quality of suitability letters.300 From the demand 292

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The FSA found ‘limited direct evidence available to satisfy us that consumers are experiencing improvements with quality of advice’: Measuring Outcomes November 2007, pp. 17–18. The FSA’s ‘mystery shopping’ tests have suggested that the sales and advice process in one-third of firms had a negative impact on advice, that a half of firms gave advice before a relevant or in-depth fact-find, that only one-third could demonstrate a fair sales process and adequate recommendations, that two-thirds of firms were not able to display a full and fair recommendation process, and that one-fifth of firms undertook a cursory assessment of needs and generated a serious risk of detriment: FSA, Consumer Research No. 52, pp. 7, 11 and 14. FOS, Annual Review 2007–2008, p. 21 (excluding complaints with respect to mortgage endowment products, where 96 per cent of complaints related to sales and advice). E.g. FSA, Consumer Research No. 52, p. 9. Although Member States have the option of requiring one, as the UK and the Netherlands have done: Joint Forum Report, p. 14. The requirement for a ‘statement of advice’ under Australia’s Financial Services Reform generated concerns as to its costs and led to its subsequent refinement: Treasury, Refinements Proposal. Similarly, the major cost of regulation study commissioned by the FSA (Deloitte, Cost of Regulation (2006)) reported that, with respect to investment advice business, the FSA’s suitability letter requirement was the most costly rule: p. 52. The FSA regime requires firms who advise on packaged products to produce a suitability report (COBS 9.4.1); the report, which allows firms discretion in design and content but is subject to detailed TCF requirements, is a streamlined version of the earlier and more prescriptive pre-MiFID suitability letter. Oxera, Assessment of the Benefits of the Suitability Letter (2007), pp. 37–8. The FSA concluded that removing the requirement could prejudicially affect firms’ behaviour: Policy Statement No. 07/14, p. 16. FSA, Investment Quality of Advice Processes II (2008), p. 2.

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perspective, the educative possibilities of such a letter and its potential for empowering investors to take subsequent action, where appropriate, may be considerable.301 MiFID does, however, impose record-keeping obligations under Article 19(8) and CESR has suggested that appropriate records be kept such that compliance with the suitability regime can be assessed.302 Suitability requirements are also problematic in terms of supervision and enforcement. While process-based, suitability is based on context, information, experience, judgment and the nature of the investor, which all pose considerable ex ante assessment and enforcement difficulties. Supervisory fact-finds are complex and may require troublesome ex post benchmarking of advice and a considerable commitment of supervisory resources and expertise. The difficulties are exacerbated by the limited ability of investors to assess the quality of advice and to take enforcement action. Resource-intensive supervision, including mystery shopping, is required. The evidence of improvements which is emerging from the FSA experience (by 2008, improvements had occurred in the impartiality of advice, particularly with respect to non-commission-earning advice on debt repayment303 ) should be related to the strenuous efforts and resources exerted by the FSA in monitoring quality of advice progress under the TCF initiative. Following the poor results from its 2006 review, for example, the FSA developed tools to support small firms in providing investment advice.304 Review of the quality of advice was also a priority of the FSA’s Retail Thematic Work Plan for 2007/2008 and for 2008/2009.305 The most serious risk posed by the suitability regime in terms of supporting engaged but vulnerable and trusting investors may, however, derive from an over-emphasis on the suitability of personalized and specific ‘advice’ at the expense of a focus on the conflict-of-interest risks posed by what are, for most retail investors, ‘sales’ of often proprietary or commission-based investment products (section X below).

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FSA, Discussion Paper No. 08/5, p. 13 (suggesting that investors should make reasonable efforts to read, understand and evaluate such letters). The Dutch requirement is based on supporting investors in understanding the advice given: AFM, Brochure – The Most Important Amendments to the Supervision of Conduct Following the Introduction of the Act on Financial Supervision (Wft) (2006). CESR, Level 3 Recommendation on the List of Minimum Records in Article 51(3) of the MiFID Implementing Directive (CESR/06-552c, 2007), p. 3. FSA, Investment Quality of Advice Processes II 2008, p. 10. FSA, Assessing Customer Needs (2007); and FSA, Communicating with Customers (2007). FSA, Major Retail Thematic Work Plan for 2008–2009, pp. 3 and 5.

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VII. Regulatory technique (4): conflict-of-interest management 1. Conflict-of-interest risks Conflict-of-interest management within the multi-service investment firm or bank-based financial supermarket has become a preoccupation of regulators worldwide306 as the nature of investment banking has changed and the potential for conflicts has increased along with an expanding range of activities.307 In the retail sphere, corporate finance and securities underwriting can generate risks where poor-quality securities are offloaded to the retail sector. For a subset of more sophisticated investors, asset management generates particular risks.308 ‘Soft commissions’ and ‘bundling’ arrangements309 – under which services and goods, including research but also office facilities, computer facilities, databases, training and so on, are supplied by brokers to asset managers in return for order execution flow – can generate significant conflicts of interests and raise costs (as the costs of soft commissions are typically passed on to the investor in the form of higher dealing fees). Retail investors also face the risk that portfolios are inappropriately churned to increase portfolio fees and to increase deal flow to brokers; evidence of high CIS sales over 2005–7 at a time when net purchases of CISs dropped led to concerns that churning was being resorted to by distributors and independent advisers in an attempt to recoup income.310 Execution quality may also be poorly monitored and best execution, a central pillar of investor protection in the execution context (chapter 6), may be threatened. Asset management also generates discrimination risks (in the form of the allocation of more resources and expertise to more sophisticated investors) and the risk of inappropriate allocation of proprietary products and own account securities to investor portfolios. The most significant risk 306 307

308 309 310

E.g. ASIC, Managing Conflicts of Interest in the Financial Services Industry (Consultation Paper No. 73, 2006). H. Mehran and R. Stulz, The Economics of Conflicts of Interest in Financial Institutions, ssrn abstractid=943447; and A. Tuch, ‘Investment Banking: Immediate Challenges and Future Directions’ (2006) 20 Commercial Law Quarterly 37. M. Kruithof, Conflicts of Interest in Institutional Asset Management: Is the EU Regulatory Approach Adequate? (2007), ssrn abstractid=871178. E.g. IOSCO, Soft Commission Arrangements for Collective Investment Schemes (IOSCO, 2007). Between 2005 and 2007, net purchases of investment funds fell by 94 per cent but gross fund sales soared by 47 per cent, raising churning risks: S. Johnson, ‘Funds Data Raise Churning Fears’, Financial Times, Fund Management Supplement, 10 March 2008, p. 21 (reporting on evidence from Lipper Feri of fund sales across thirty leading cross-border groups).

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in the mass retail market, however, remains commission risk, which is a persistent and apparently intractable risk in the advice and distribution sector (section X below) and which can disable other quality of advice protections, notably suitability requirements. The development of new technologies also increases conflict-of-interest risk: the arrival of platforms and wraps has increased commission risks where advisers are incentivized through commissions to move investor accounts to platforms.311

2. MiFID and retail market conflict-of-interest risk Although an obligation to avoid prejudicial conflicts of interest is implicit in the Article 19(1) fair treatment principle, conflict-of-interest management is expressly addressed by MiFID’s generic conflicts regime, Articles 13(3) and 18,312 and by a specific regime governing inducements (section X below). Conflicts of interest in the trading process are also governed by the best execution and order-handling regime (chapter 6). The generic conflicts-of-interest regime is designed to contain damaging conflicts ex ante through identification and management techniques. Firms must take ‘all reasonable steps’ to identify conflicts of interests (Article 18(1)) and to adopt organizational and administrative arrangements with a view to taking ‘all reasonable steps’ to prevent conflicts of interest from adversely affecting client interests (Article 13(3)). Where the organizational and administrative arrangements adopted are not sufficient to ensure ‘with reasonable confidence’ that risk of damage to client interests will be prevented, the firm must clearly disclose the general nature and/or the sources of the conflicts of interest to the client before undertaking business on its behalf (Article 18(2)). This regime is supported by a principlesbased level 2 framework which addresses conflict identification.313 It is also supported by an organizational requirement for a conflicts-of-interest policy314 which must identify the circumstances which may give rise to a damaging conflict of interest315 and specify the procedures for managing conflicts and for supporting independence. Although the level 2 311 312 313 314 315

ASIC, Managing Conflicts of Interest, p. 11. Amplified by the Level 2 Directive, Arts. 21–23. Art. 21 requires firms to take into account a series of non-exhaustive and potentially conflicted situations in identifying conflicts. Art. 22. Firms must pay ‘special attention’ where combinations of investment research and advice, proprietary trading, portfolio management and corporate finance activities occur.

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regime suggests the procedures which may be ‘necessary and appropriate’ to support independence, the determination of particular organizational requirements remains for the firm to determine.316 In the asset management context, and although the fair treatment obligation and the generic conflicts-of-interest regime provide background supports, EC investor protection has not directly tackled the difficult market structure questions raised by bundling and softing arrangements (which also arise with respect to collective asset management and the UCITS regime).317 A disclosure-based approach, albeit confined to the UCITS sector, was adopted in the UCITS Summary Prospectus Recommendation.318 The MiFID inducements regime also provides a mechanism for the control and disclosure of dealing commissions in the form of inducements, but it does not apply to collective asset managers, the disclosure requirements are generic and high level and the rules do not engage directly with the risks of bundling and softing. The FSA’s concern that the inducements regime was not sufficiently specific to address the market failures surrounding dealing commissions, given the considerable evidence of failures in the UK and the over-consumption of services by managers,319 led to an Article 4 notification concerning the FSA’s disclosure rules for dealing commissions and the restrictions imposed on the services which may be received by managers.320 CESR has consulted on whether a common approach should be developed at level 3, but appetite seemed to be limited, with concerns as to the typically local nature of these arrangements and support for an industry approach.321 While regulatory intervention may follow, it does not form part of the UCITS IV reforms 316

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Art. 22(3). These include Chinese Walls to control information flows, the separate supervision of persons in potentially conflicted situations and ensuring remuneration is not subject to conflict-of-interest pressures. E. Wymeersch, Conflicts of Interest – Especially in Asset Management (Financial Law Institute Gent, Working Paper No. 2006–14, 2006), p. 4, available via www.law.ugent.be/fli/. European Commission Recommendation 2004/384/EC of 27 April 2004 on some contents of the simplified prospectus, OJ 2004 No. L144/42 (‘Simplified Prospectus Recommendation’), para. 2.2.2.2. UK Article 4 Application. The retained COBS rules are designed to build on the MiFID inducements regime. Soft commissions have been the subject of close regulatory attention in the UK, following the Myners Review (Institutional Investment in the UK: A Review (HM Treasury, 2001)) and are addressed by COBS 11, 15 and 18 which restrict the goods and services which may be received by discretionary and collective asset managers (in essence they must not impair the firm’s ability to act in the best interests of the investor) and impose disclosure requirements. CESR/07-316, p. 12.

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and there seems to be limited appetite to revisit MiFID’s conflicts-ofinterest regime. The ability of local regimes to address this specific question, and of Article 4 notification to contain specific solutions addressed to MiFID-scope asset managers, as well as the likely complexity of any response, calls for caution in the adoption of a harmonized approach. But it certainly stands as an example of the difficulties in capturing the range of risks faced by retail investors under a generic, principles-based regime. Successful management of conflicts of interest, particularly under a principles-based model, and certainly in the EC where there are limits on the ability of investors to take private actions, depends on effective enforcement by supervisory authorities.322 The regime’s success rests to a large degree, therefore, on the effectiveness of supervisory practices, communications with the regulated community and supervisory experience in managing a flexible, outcomes-driven regime. The weakening of more detailed organizational requirements (by Article 4) may ultimately prejudice investor protection, particularly in those markets where market discipline is weaker, investors are inexperienced in monitoring, and supervisory resources are more limited.323 More seriously, however, the generic regime does not appear to be notably successful in addressing the most acute retail market risks concerning commissions in the sales and advice process (section X below).

VIII. Regulatory technique (5): the investment firm/investor contract Notwithstanding the imbalance in bargaining power between retail investors and investment firms, regulatory intervention in the substance of the bargain between the retail investor and the investment firm is typically associated with prejudicial paternalism324 and is limited in the EC investor protection regime. This stance mainly reflects, however, the sensitivities attendant on private law harmonization. CESR’s initial highly interventionist approach to the firm/investor bargain under MiFID325 generated very considerable market resistance, based on the doubtful competence on which CESR’s recommendations were based and the very substantial costs of ‘re-papering’ contracts. Close negotiations in the European Securities 322 324

Ferrarini, ‘Contract Standards’, 34–5. 323 Enriques, Conflicts of Interest, pp. 334–8. Camerer et al., ‘Behavioural Economics’. 325 1st Mandate Advice, pp. 59–64.

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Committee (ESC)326 led to a light-touch approach, designed to allay concerns as to potential interference with national private law.327 But these sensitivities have had legacy effects in the form of a regime which assumes that rational investors will bargain for appropriate protections and which may carry some risks to retail investors. Harmonization risks aside, attempts to impose notional standards of substantive contractual ‘fairness’ through legislative fiat are, however, perilous as a significant incursion into freedom of contract. In the investment field, this argument might appear all the stronger given the strength of the caveat emptor principle and the generally heavy (although diminishing) reliance on disclosure and informed decision-making. On the other hand, process-related distribution rules and product requirements might be regarded as default contracting rules328 which recognize the very limited bargaining power of the retail investor, while the fair treatment principle admits the possibility of a fairness assessment with respect to the firm/investor balance of power. More generally, the prevalence of standard form contracts, information asymmetries and limited consumer competence has led to the recognition that some intervention in the substance of the contractual bargain may be warranted. This assumption is reflected in the Unfair Contract Terms Directive,329 which is of some importance to retail investors,330 and seeks to impose standards of ‘fairness’ on private bargains by providing that certain ‘unfair contract terms’331 will not be 326 327

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ESC, Minutes, 29–30 March 2006 and 26–7 April 2006. The sensitivities are clear from the Commission’s statement that the Directive does not impose requirements on the form, content and performance of contracts, which are left to the discretion of the Member States: Background Note, p. 21. A similar assertion is made in recitals 41 and 62 of the MiFID Level 2 Directive. Ferrarini, ‘Contract Standards’. It has been described as ‘the first incursion of Community law into the heartland of national contract law thinking’: S. Weatherill, EU Consumer Law and Policy (2nd edn, Cheltenham: Edward Elgar, 2005), p. 115. The Commission has proposed that the Directive, along with other key contractual measures in the consumer field, be incorporated into a horizontal directive which would be based on maximum harmonization: Directive on Consumer Rights (COM (2008) 614). The FSA’s FSCP has highlighted the importance of the Directive (Annual Report 2007– 2008, p. 33), which has also been monitored by the FSA (Fairness of Terms in Consumer Contracts: Firms’ Awareness of and Compliance with the Unfair Contract Terms Regulations 1999 (Consumer Research No. 66, 2008)). The Annex to the Directive sets out an ‘indicative and non exhaustive’ (Art. 3(3)) list of terms. Where certain of these terms are used by suppliers of (undefined) financial services, exemptions are available which are designed, like the DMD’s withdrawal regime, to reflect rapidly changing conditions in financial markets, although consumer protection conditions apply.

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binding on the consumer where, contrary to the requirements of good faith,332 they cause a significant imbalance, to the detriment of the consumer, in the parties’ rights and obligations under the contract (Article 3(1)), and as long as they are not individually negotiated; standard form contracts are, however, likely to be the norm between retail investors and investment firms. The limiting bargaining power of retail investors is also reflected in the withdrawal right provided by the DMD, which represents the high water mark of direct EC intervention in the firm/investor contract, despite some earlier enthusiasm for mandatory contractual protections.333 Despite its contractual context, the Unfair Contract Terms Directive might, however, be best regarded as a creature of regulation and public enforcement, rather than as a measure which enhances private bargaining and enforcement; the FSA has highlighted unfair contract terms as a strong indicator of firm failure to implement TCF principles and regards fair terms as representing an important part of the delivery of TCF outcomes throughout the product life-cycle.334 This approach also suggests a relationship between breach of the Article 19(1) fair treatment principle and firm reliance on unfair contract terms. It might also be suggested that, because investor protection is now mainly a function of conduct-shaping rules, policed, it is likely, by supervisory enforcement, contractual rights and obligations and private enforcement may become somewhat eclipsed. Certainly, MiFID does not focus much attention on the investor/investment firm contract, although contracts for MiFID services, by implication, must comply with MiFID’s obligations335 and the fair treatment principle. Article 19(7) simply requires the investment firm to establish a documentary record of the relevant rights, obligations and terms of the relationship. 332

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The good faith concept, which has been extensively examined, reflects the civil law tradition. Some indications as to its sweep are given in the recitals to the Directive which, inter alia, suggest that good faith may be satisfied where the seller or supplier deals fairly and equitably with the other party whose legitimate interests he has to take into account. Good faith should also be assessed by reference to the strength of the parties’ bargaining positions, whether the consumer was induced to enter into the contract, and whether the goods and services were supplied to order. The Commission’s 2000 Report on the Implementation of the Unfair Contract Terms Directive (COM (2000) 248) supported a clear and standard contractual framework in the field of cross-border provision of financial services (although the Commission also reported that unfair terms in investment contracts represented only 2 per cent of the unfair terms reported). FSA, Business Plan 2008–2009, p. 25. 335 Ferrarini, ‘Contract Standards’.

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IX. Segmentation risks 1. The UCITS regime The uneasy intersection between sectoral product regulation and horizontal advice/distribution regulation in retail market regulatory design is well illustrated by the MiFID/UCITS interaction. The UCITS Directive does not currently address the marketing of UCITS units by the UCITS or its manager; direct UCITS marketing also falls outside MiFID. Any UCITS may advertise its units in the Member State in which it passports, but it must comply with the ‘provisions governing advertising’ in that Member State, as well as any rules applicable which fall outside the Directive’s coverage (Article 44(2)). Host State control over UCITS marketing appears to encompass marketing techniques, publicity and distribution infrastructures.336 Host State control may therefore support investor protection, and address failures in product targeting and in choice of distribution channel, which are not addressed by the UCITS Directive, by allowing Member States to limit the marketing of complex UCITS III products, in particular, to ‘qualified investors’, as defined in national law.337 The background Treaty freedoms, and particularly the freedom to provide services, suggest that any restrictions would have to comply with the European Court of Justice’s jurisprudence on national rules which restrict Treaty freedoms, which requires, inter alia, that the restriction is in the public interest. It may be that a public interest argument could be made. Complex products which have not been adequately targeted to a particular market might, under the UCITS passport, be unleashed on an inexperienced and vulnerable market. Some leeway for national authorities in the interests of investor protection appears reasonable, although the threat of protectionism remains. Article 44 may therefore provide a safety valve for local market concerns. In practice, however, Member States differentiate sharply between product regulation (and adopt generally facilitative approaches, authorizing a wide range of products for public distribution) and horizontal distribution-related selling and marketing restrictions.338 The UCITS IV Proposal, however, promises to enhance the marketing regime and to align UCITS marketing more closely to 336 337

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ESC, Minutes, 17 November 2006. The Delmas Report argued robustly that the ability of the host State to restrict the marketing of complex UCITS to sophisticated investors was implicit in Art. 44: Delmas Report, pp. 10, 13 and 25. Following a Commission request in March 2007, CESR collated practices across the Member States. The report was discussed in the ESC: ESC, Minutes, 13 September 2007.

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MiFID’s model. It proposes a new marketing obligation for UCITS, based on the principle that all marketing communications must be fair, clear and not misleading, and be consistent with prospectus disclosures, although it does not incorporate MiFID’s more detailed marketing requirements (Article 77). Difficulties also arise with distribution and commission risks. In practice, many UCITS sales take place through entities associated with the UCITS or are proprietary sales, thus restricting competition and increasing conflict-of-interest risk. National distribution systems in the form of local banc-assurance (financial supermarket) institutions339 dominate. This distribution structure raises a series of risks to investor choice and informed decision-making. Quality of advice risks arise where proprietary products are sold (section X below). ‘Closed distribution networks’ are difficult to access by cross-border or third-party UCITS products,340 particularly given high ‘retrocession’ access fees which are often passed on to investors, typically in the form of management fees;341 distribution charges amount to two-thirds of total expenses incurred by EC investors, as compared to one-third in the US market,342 and can represent as much as three-quarters of costs in some Member States.343 As a result, high distribution costs can prejudice competition and efficiency and weaken the ability of the UCITS industry to support long-term savings. Inclusion of a product within a network may also suggest a quality label to investors, although inclusion may be fee-driven rather than based on performance. The more limited range of products carried by closed networks344 may also prejudice the quality of advice. UCITS providers may be compelled to wrap a UCITS in other product wrappers to facilitate its distribution, which may distort the application of key MiFID regulatory disciplines, particularly where an insurance wrapper is used. UCITS distribution is 339 340 341

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Sect. X below. Asset Management Expert Group, Financial Services Action Plan: Progress and Prospects (2004), p. 21. L’Observatoire de l’Epargne Europ´eenne (OEE) and Zentrum f¨ur Europ¨aische Wirtschaftsforschung (ZEW), Current Trends in the European Asset Management Industry (2006), pp. 9–10. European Commission, Financial Integration Monitor (SEC (2006) 1057), p. 22. European Commission, Impact Assessment of the Legislative Proposal Amending the UCITS Directive (SEC (2008) 2236), p. 12. It was reported in 2005 that 46 per cent of CIS distributors did not offer one third-party scheme, while, of those networks which were ‘semi-open’, 33 per cent offered fewer than five third-party schemes: European Commission, Green Paper on the Enhancement of the EU Framework for Investment Funds (COM (2005) 314), p. 13.

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undergoing change,345 however, as the industry slowly moves towards a more competitive ‘open’ or ‘guided’ architecture model under which intermediaries, including independent advisers, fund supermarkets and banks which offer third-party products, offer a range of UCITS products. But commission risk then arises which may prejudice the quality of advice as well as prejudicially influence the range of schemes carried; in the UK market, the FSA has pointed to the risk that product providers compete for distribution on commission rates and adjust commission in ways which can lead to unsuitable sales.346 Whether or not MiFID’s distribution and advice regime will, where it applies, capture distribution risks in the indirect sale of UCITS is not clear. The Commission appears unsure and is to monitor the resilience of the regime for UCITS distribution.347 Related disclosure reform concerning the cost structure of CISs and distribution costs is also being canvassed (chapter 5), but effective costs disclosure is very difficult to design and has had only limited success in addressing conflict-of-interest risk.

2. Structured and substitute products MiFID’s generic, principles-based regime, on the face of it, is sufficiently flexible to address mis-selling risks in the distribution of MiFID-scope structured retail products, and particularly the risks associated with capital-protected products where a careful assessment of the guarantee must be made.348 But its success depends on MiFID’s effectiveness ‘in action’ and is uncertain. CESR’s review of the Lehman collapse suggests some concern as to the recent quality of advice concerning structured products, as does the FSA’s 2009 decision to review marketing and the quality of advice in this area.349 The UK experience with structured ‘precipice bonds’ had earlier shown the potential for mis-selling risks. Designed to deliver a high income, they did not provide capital protection. Although the FSA issued a series of risk alerts, retail investors sustained very considerable 345

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As was reported in two major reports prepared for the European Commission: OEE and ZEW, Current Trends, p. 7; and Oxera, Current Trends in Asset Management: Prepared for the European Commission (2006), pp. iii and vii. FSA, Financial Risk Outlook 2007, p. 96. Commission, UCITS IV Impact Assessment, p. 13. D. Waters (FSA), Speech on ‘Industry Response to Developments in Regulation of Structured Products’, 12 February 2009, available via www.fsa.gov.uk/Pages/Library/ Communications/Speeches/index.shtml. CESR, Lehman Default, p. 3; and J. Hughes, ‘Products Backed by Lehman Spark FSA Probe’, Financial Times, 8 May 2009, p. 3.

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losses as the market dropped and a series of enforcement actions followed based on suitability failures.350 Structured products are also often sold without advice through execution-only sales;351 whether the conditions which apply to determining whether the product is ‘non-complex’, and so eligible for execution-only sales, are sufficiently calibrated and robust can be unclear. But MiFID applies only to MiFID-scope investments. While these include a wide array of investments, including structured products, UCITS units and non-UCITS units, MiFID does not, reflecting international practice,352 cover unit-linked investment products, the distribution of which is often subject to the Insurance Mediation Directive (IMD). The IMD applies to insurance agents and brokers but not to employees of insurance companies.353 In addition to imposing registration requirements on insurance agents and brokers, it imposes limited disclosure and quality of advice/conflict-of-interest rules. Prior to contract conclusion, brokers must provide investors with certain disclosures concerning the firm354 and its status (Article 12(1)). The latter disclosures, which are not mirrored in MiFID, address the independence or otherwise of the intermediary. The intermediary must disclose whether: advice is given on a ‘fair analysis’ basis; whether the broker is under a contractual obligation to conduct insurance mediation business exclusively with one or more insurance undertakings (and their identities); or whether the intermediary is not under a contractual obligation to conduct insurance mediation business exclusively with one or more insurance undertakings and does not give advice on a ‘fair analysis’ basis (in which case the identities of the undertakings with which the intermediary may and does conduct business must be supplied). This disclosure obligation is supplemented by controls 350

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The FSA fined, for example, the Bradford and Bingley Building Society £650,000 for failing to make suitable recommendations, not maintaining adequate records of sales and not having in place adequate systems and controls to address mis-selling failures: FSA/PN/112/2004. The Dutch AFM, for example, recently reported that 95 per cent of structured products ‘find their way to investors directly, without the mediation of an adviser’: AFM, Exploratory Analysis of Structured Products (2007), p. 4. Joint Forum Report, pp. 3 and 50. Which was of some concern in the Delmas Report (p. 18). Art. 12 requires, inter alia, that the intermediary disclose whether the intermediary has a holding, direct or indirect, representing more than 10 per cent of the voting rights or capital of a given insurance undertaking, whether a given insurance undertaking (or parent undertaking) has a holding, direct or indirect, representing more than 10 per cent of the voting rights or capital in the insurance intermediary and provide disclosure concerning complaints and redress (Art. 12(1)(a)–(e)).

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on the nature of ‘fair analysis’ advice, which must be given on the basis of a ‘sufficiently large’ number of insurance contracts available on the market to enable the intermediary to make a recommendation, in accordance with professional criteria, regarding which contract would be ‘adequate’ to meet the customer’s needs (Article 12(2)). In a quasi-know-your-client requirement, prior to the conclusion of any specific contract the intermediary must at least specify, on the basis of information provided by the customer, the demands and needs of that customer as well as the underlying reasons for any advice given to the customer on a given insurance product (Article 12(3)). MiFID’s considerably more extensive fair treatment, marketing, suitability, conflict-of-interest/commission risk and contract requirements do not apply to insurance brokers or to insurance products. The distribution of, and advice with respect to, structured deposit-based products, which are outside MiFID’s scope, is not subject to any specific harmonized requirements. This segmented regime generates particular difficulties concerning commission risk. As discussed in section X below, MiFID imposes disclosure and inducement rules which, while problematic, are designed to alleviate the risks of commission bias in the sale of MiFID-scope instruments. The regulatory arbitrage risks in the distribution of unitlinked investments355 and deposit-based investments are therefore considerable, given that distributors have incentives to promote, and advise on, products which are not subject to MiFID disclosure and inducement requirements.356 The treatment of marketing and advertising risks is also uneven. Marketing risks are considerable with respect to structured products, as suggested by the precipice bond and split-capital investment trust failures in the UK357 and the mis-selling of guaranteed fonds a` promesse in France.358 It remains to be seen whether MiFID’s generic Article 19(2) requirement that communications be ‘fair, clear and not misleading’ is sufficiently robust. Offerings of structured securities are also subject to the 355 356 357

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The BME Report linked the growth of unit-linked products at the expense of CISs to differential regulatory treatment under MiFID in particular: BME Report, p. 67. As has been frequently noted by the EC institutions and CESR; for example, Klinz II Resolution, paras. 12–19. The FSA estimated in 2003 that 250,000 consumers had invested £5 billion in precipice bonds: FSA/PN/026/2003. It issued alerts as to the risks of these investments repeatedly, particularly in 2001 and 2002, but action was also subsequently taken against investment firms for mis-selling. See also n. 350 above. Delmas Report, p. 9.

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Prospectus Directive359 which, under Article 15, requires that related advertisements highlight the publication of a prospectus and be accurate, consistent with the prospectus and not misleading. But the marketing of non-MiFID-scope structured deposits and unit-linked insurance is governed by the more general requirements of the horizontal consumer-protection marketing regime, including the DMD and the UCP Directive. Member States may, however, choose to apply MiFID disciplines to providers of non-MiFID products and services, particularly as the IMD is a minimum-standards measure and given the absence of relevant banking sector rules. A number of Member States have extended MiFID’s distribution rules.360 These include the FSA which, reflecting FSMA, adopts a ‘level playing field’ approach to firms dealing with retail clients and has extended MiFID’s conduct-of-business requirements to non-MiFID firms and businesses.361 As a result, the scope for regulatory arbitrage in the UK is limited.362 MiFID’s principles-based model certainly lends itself to a cross-sector application. Indeed, the extent to which MiFID is being used as a template for product distribution across the Member States suggests a new form of quasi-harmonization, as well as the risk that MiFID’s weaknesses will be injected across the advice and distribution sector more generally. It now appears that the substitute products policy debate363 has led the Commission to suggest a massive recasting of the harmonized advice and distribution regime. Its April 2009 Packaged Products Communication has suggested that the ‘fragmented regulatory patchwork’ be replaced by a coherent, cross-sector horizontal ‘selling’ regime addressing conflict of interests, inducements and conduct-of-business regulation; the IMD and MiFID may, if the Commission is successful, be repealed and 359

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Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’). Ireland, Italy, Portugal, the UK, the Czech Republic, France and Germany all, to varying degrees, adopt a horizontal approach to the major categories of retail investment products: European Commission, Feedback Statement on Contributions to the Call for Evidence on ‘Substitutive’ Retail Investment Products (2007), pp. 33–4; and the European Commission impact assessment for the Packaged Products Communication (SEC (2009) 556), pp. 45–6. The FSA’s approach has been to impose MiFID standards, for the most part, on regulated firms in the retail advice and product market (including with respect to unit-linked insurance). See ch. 1. FSA Substitute Products Response, p. 2. 363 See further ch. 3.

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replaced by a new measure which will apply to sales of ‘packaged products’ by distributors/advisers and by product providers.364 Level 1 principles and level 2 detailed rules for the sale of specific products are envisaged. While the harmonized regime certainly leads to inconsistencies in sales practices, particularly with respect to sales of unit-linked insurance products, which are popular EC retail investments, this ambitious project is risk-laden, as discussed in chapter 3. The risks are exacerbated in the selling context as there is still only limited experience with MiFID although it is being used widely across the EC as a template for product sales. The Commission has suggested that MiFID could act as the benchmark for the new cross-sector selling regime and hailed it as a ‘sophisticated regime’ for the management of conflict-of-interest risk.365 But MiFID, as discussed in the following sections, is not well equipped to deal with access to advice risks and the risks of commission-based sales. This new adventure on which the Commission is embarking may prove to be an unwelcome distraction and the costs may outweigh the benefits. Allocating policy resources to ‘advice in action’, and in support of local solutions to commission risk and access to advice difficulties, might be a more efficient response.

X. Advice or sales? Addressing the ‘right risks’ 1. Delivering high-quality investment advice MiFID’s articulation of investor protection in the advice and distribution context is troublesome. Effective regulatory design ‘in action’ in this context requires sensitivity to the channels through which advice is delivered and their risks. The distinguishing feature of MiFID ‘investment advice’ is that it is personal, specific and tailored to an assessment of the investor’s circumstances (section II.3 above). But MiFID ‘investment advice’ does not fully capture the nature of the EC’s advice and distribution industry, which incorporates fee-based independent advisers 364

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European Commission, Communication from the Commission to the European Parliament and the Council: Packaged Retail Investment Products (COM (2009) 204), pp. 6 and 9. The Commission has suggested that the regime cover conduct of business, conflict-of-interest management and inducements, and include: a fair treatment principle; suitability rules where advice is given; disclosure concerning the limits of execution-only services; conflictof-interest management; clear disclosure on remuneration; and an obligation that those assessing product suitability fully understand the product sold (p. 11). Packaged Products Communication, pp. 7 and 10.

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and commission-based advisers, single and multi-tied agents in product providers’ distribution networks and bank-based advisory/sales services linked to the distribution of proprietary products. In practice, the structure of the Community advice industry suggests that ‘advice’ is better characterized in terms of product ‘sales’ by banks and commission-based advisers, rather than in terms of independent, personalized advice services. But the MiFID regime grapples only indirectly with the related nuanced and difficult questions concerning adviser remuneration, incentives and industry structure which in practice drive the quality of investment advice and particularly ‘sales’. Nor, despite the policy concern to promote informed investor decision-making, does MiFID focus closely on the sustainability of the advice industry or investor access to advice services. Although these weaknesses might be better regarded not as specific failures of EC policy but as a reflection of the limitations of law in the retail markets, a more muscular approach to the delivery of investor protection in the advice context is emerging in some quarters.

2. Incentive and commission risks: advice or sales? Independent, objective, fee-based and accessible investment advice is often regarded as representing the zenith of product distribution/advice policy,366 not least given the higher levels of trust and the consequent potential for stronger market engagement associated with fee-based advice.367 Suitability requirements similarly assume, or strive towards, personalization and objectivity in the advice relationship. But the widespread availability of independent, objective investment advice is an elusive goal which is very difficult to achieve through regulation given the extent to which ‘advice’ in practice takes the form of the distribution or sale by banks of proprietary products or is based on commission-based remuneration. Commission-based remuneration, and remuneration-based incentive structures related to the distribution of proprietary products, generates serious risks for investors. Remuneration structures have very considerable 366 367

2007 RDR, Annex 3, p. 2. While allowance must be made for its articulating an industry position, APCIMS challenged the FSA’s critical review of the retail market in its 2007 RDR, arguing that low levels of trust in the sale of investment products were not reflected in the asset management/brokerage/advice industry, which had seen a 55 per cent increase in discretionary mandates between 2002 and 2006: APCIMS, Response to DP 07/1, 13 December 2007.

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potential to misalign incentives,368 as has already been made graphically clear by the Enron-era scandals369 and by the financial crisis.370 The welldocumented risks371 include biased advice,372 failures to provide debtreduction advice, poor product selection373 and inappropriate advice to switch products,374 all of which can be exacerbated in difficult market conditions when investors are already vulnerable to market risks,375 and ultimately mis-selling. This is clear from recent German evidence376 as well from the FSA’s persistent difficulties in embedding strong suitability disciplines, misalignment between UK investors’ risk appetites and the investment products they hold377 and repeated UK mis-selling failures, as outlined in this section below. The risks are all the greater given the

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M. Krausz, and J. Paroush, ‘Financial Advising in the Presence of Conflicts of Interest’ (2002) 54 Journal of Economics and Business 55. E.g. J. Coffee, ‘Understanding Enron: It’s the Gatekeepers, Stupid’ (2002) 57 Business Lawyer 1403. FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009) (‘Turner Review’), pp. 79–81. The risks of commission-based services in the brokerage context were, for example, examined in detail by the SEC’s 1995 Tully Committee (D. Tully and A. Levitt, Report of the Committee on Compensation Practices (1995)) which recommended as best practice those commission practices which aligned investor and broker interests and which led to wider use of fee-based brokerage accounts. Although many retail investors probably benefited from advice from continental banks to switch to deposits over 2008, one commentator has suggested that ‘it could . . . have proved bad for customers had markets gone in the other direction. Banks did not redirect savings in expectation of a market crash but to serve their own purposes [in rebuilding balance sheets]’: P. Skypala, ‘FSA Has Chance to Clarify “Sales” and “Advice”’, Financial Times, Fund Management Supplement, 24 November 2008, p. 6. ASIC has reported that advice that was clearly or probably non-compliant with suitability requirements was six times more common where advisers had an actual conflict of interest concerning remuneration: ASIC, Shadow Shopping, p. 8. The FSA has reported that ‘concerns around bias and churn feature highly in most countries’: 2007 RDR, Annex 3, p. 2. In the UK, adviser failure to advise investors in ‘with-profits’ unit-linked products to switch out of these products before the market collapsed has been linked to commission incentives: A. Ross and S. Goff, ‘Advisers Criticized over Savings Plans’, Financial Times, 23 January 2009, p. 4. The FSA also reported that commission rate increases were used during difficult trading conditions over the credit crunch to stimulate sales of life assurance bond products: 2008 RDR Feedback Statement, p. 28. A recent German study has suggested that bank advisers have incentives to promote equity-concentrated asset allocation as equity products have higher margins: Jansen et al., The Influence of Financial Advice. As noted in ch. 2, FSA research points to a persistent pattern of investors with no willingness to take on risk holding equity-based products.

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difficulties vulnerable, trusting investors, hamstrung by poor decisionmaking, face in identifying conflict-of-interest risk and assessing relevant disclosures.378 The delivery of objective investment advice is all the more an intractable problem as investors display a well-documented reluctance to pay a fee for advice.379 Some very heavy lifting is demanded of regulation in delivering incentive-alignment and good-quality objective advice in a commissionbased and proprietary-product sales-based environment. Although commission risk is a common problem internationally,380 the difficulties are particularly pronounced in the Community where the fee-based, independent-adviser model, and investor reliance on advice outside of commission-based or proprietary product sales, is rare. Investment advice and product distribution typically occurs through commission-based tied agents of product providers (e.g. Germany381 ), multi-tied agents who advise on a range of products (e.g. Netherlands) and integrated banc-assurance (financial supermarket) banking models (e.g. Germany,382 France,383 Spain and Italy384 ).385 Overall, banks are key suppliers of ‘advice’ 378

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Langevoort has suggested that the question as to ‘why do investors so readily pay for and accept so much investment advice, especially from sources subject to palpable conflicts of interest’ is one of the more puzzling phenomena in economics, finance and securities regulation: Langevoort, ‘Selling Risk’, 633. Sect. XI below. New Zealand’s 2008 reforms to investment advice include enhanced disclosure requirements concerning commissions and fees (www.newsecuritieslaw.govt.nz), while the Australia–New Zealand Shadow Financial Regulatory Committee has highlighted the incentive risks in commission-based advice (Australia–New Zealand Shadow Financial Regulatory Committee, Responding to Failures in Retail Investment Markets, Statement No. 3, 25 September 2007, p. 3). The Canadian Deaves study highlighted the risks posed by the trust placed by investors in advisers and commission-rich products (R. Deaves, C. Dine and W. Horton, How Are Investment Decisions Made?, Research Study prepared for the Task Force to Modernize Securities Legislation in Canada (2006) (‘Deaves Report’)), commission risks were the subject of the US Tully Committee, while the Joint Forum highlighted commission risks and called for appropriate incentive structures to be adopted for sales forces: Joint Forum Report, p. 6. BaFIN, Annual Report 2005, p. 128. One study has suggested that two-thirds of investors obtain financial advice through a bank while only 20 per cent rely on independent financial advisers: Bluethgen et al., Financial Advice. Bank (and insurance) networks dominate: Delmas Report, p. 10. Bank branches generate approximately 70 per cent of total commission income on investment products and services in Italy: CONSOB, Annual Report 2006, p. 76. 2007 RDR, Annex 3, p. 5; and BME Report, pp. 100–47.

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and investments, particularly CISs386 and bonds.387 The recent explosion in the sale of structured products reflects this trend, with banks accounting for 86 per cent of retail market sales and independent advisers accounting for 12 per cent.388 The bank model is also growing in some Member States, with Dutch banks, for example, increasingly acting as ‘financial centres’ and servicing a wide range of financial needs.389 Long-standing cultural practices, such as the familiarity of consumers with local branch networks and agents, have driven these advice and distribution practices; so too have different savings patterns, with greater wealth associated with more complex investment needs and more sophisticated advice structures,390 and pension-provision patterns.391 But the integrated-bank delivery model carries considerable incentive and misselling risks relating to internal commissions and sales targets given the incentives to promote high-earning proprietary products.392 It also carries risks with respect to the limited distribution of third-party products.393 386

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BME Report, p. 113 (reporting that retail banks account for almost 80 per cent of scheme distribution). The FSA has similarly reported that bank distribution networks account for 86 per cent of CIS sales in Spain and 34 per cent in Germany, while advised sales in those Member States represent 11 per cent and 26 per cent, respectively: FSA, Financial Risk Outlook 2006, p. 52. In France, for example, 82 per cent of UCITS products are sold through bank branches, while only 5 per cent are sold through independent advisers: Delmas Report, Annex IV, p. 3. Sales of non-harmonized UCITS across Europe are also dominated by banks (42 per cent), followed by insurance companies (22 per cent) and advisers (17 per cent): PricewaterhouseCoopers, The Retailization of Investment Funds in the European Union (2008), p. 11. BME Report, p. 108 (of the investors surveyed, 50 per cent purchased debt securities through banks; only 21 per cent used brokers). Similarly, ‘in most Member States, retail clients are still heavily reliant on their local banks for investment decisions’ (Oxera, Current Trends in Asset Management, p. iv). Soci´et´e G´en´erale, The European Retail Structured Investment Product Market: Panorama and Trends (2006), p. 6; in the Dutch market, which has seen strong growth, sales are typically in the form of non-advised proprietary sales by banks: AFM, Exploratory Analysis, p. 11. 2007 RDR, Annex 3, p. 6. The FSA has pointed to the range of factors, including tax, shifting employment patterns, benefits systems, changing consumer behaviour and technological developments concerning product distribution, which influence the structure of the investment advice industry (2007 RDR, p. 14), as has the BME Report (pp. 212–14). FSC Report, p. 21. E.g. advising on structured products in preference to bond funds: P. Skypala, ‘ETFs the Only Bright Spot as Outflows Roll on’, Financial Times, Fund Management Supplement, 24 November 2008, p. 15. This commentator has also suggested that banks tend to ‘sell fashionable products rather than encouraging long-term saving in core investments’: ‘Tackling the Issue of Sky-High Wages’, Financial Times, Fund Management Supplement, 30 March 2009, p. 6. BME Report, p. 114.

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Recent litigation in Germany (pre-MiFID) saw the German Federal Court rule that, while it was within a bank’s sole discretion to offer a limited range of ‘in-house’ products (the scheme in question was produced by the bank’s group), and while a bank was not liable for poor advice where it did not advise on competitor products, it was under a duty to disclose whether it earned a sales commission in order to alert the investor as to the conflict of interest.394 The distinction between ‘advised sales’ subject to the full rigours of the MiFID investment advice regime and execution-only non-advised ‘sales’ may also blur. The 2005 Delmas Report highlighted the importance of suitability disciplines being applied to ‘advised sales’, that the distinction between non-advised, execution-only sales and ‘advised sales’ should be made clear and that sales advisers should be provided with advice supports in the form of, for example, standard know-yourclient/suitability questionnaires.395 The Dutch AFM has also noted the importance of providers of proprietary products complying with advice requirements.396 Commission risks also arise with ‘open-architecture’, commissionbased product distributors, whether in the form of ‘independent’ advisers or networks of agents.397 Although ‘independent’ financial advisers are slowly becoming more popular across Europe,398 notionally ‘independent’ investment advisers are generally uncommon and dominate in only one Member State, the UK.399 Sixty-four per cent of all reported investment product sales in the UK took place on an advised basis in 2007–8,400 and commission-based ‘independent’ advice by small, often MiFID-exempt ‘Article 3 firms’401 dominates (although not all advisers are commission-based). Underlining the difficulties the EC faces in supporting the quality of advice through harmonized measures, adviser dominance reflects in part the local popularity of complex packaged products 394 395 397

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Bundesgerichtshof, 19 December 2006, available in (2007) Zeitschrift f¨ur Bank- und Kapitalmarketrecht 160. Delmas Report, pp. 32 and 46. 396 AFM, Priorities 2007–2009, p. 24. Delmas Report, pp. 11–12 and 38. The BME Report also pointed to heavy consumer reliance on ‘advisers’ whose income depends heavily on commission and the related risk of incentive misalignment (p. 183). Ibid., p. 116. Over 5,000 notionally independent ‘whole of the market’ advisers, largely paid by commission, account for more than 75 per cent of all sales of CISs: UK Article 4 Application, pp. 12–13. FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 2. Although these firms fall outside MiFID, the FSA has applied the MiFID advice regime. Sect. II.4 above.

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as UK household investments. But commission-based remuneration and adviser distribution has been associated with a range of failures, including poor-quality advice, a series of mis-selling scandals402 (notably with respect to pension schemes, precipice bonds and split-capital investment trusts403 ), excessive product switching, viability risks to the distribution sector and increased claims on the FSA’s investor compensation scheme.404 Incentive risks are exacerbated by poor levels of financial literacy, increasing product complexity and the limited ability or willingness of retail investors to exercise choice, which leads to competition among product providers for distribution channels, rather than for investors, and an increased likelihood of commission risk.405 All this has led to a lengthy, and thus far relatively fruitless, struggle by the FSA to address deep-seated conflicts-of-interest risk. While rooted in the particular features of the UK market, the risks of the UK market and the repeated reform attempts have, nonetheless, relevance for EC distribution and advice policy. This is not only because they highlight the need for flexibility. The wider EC movement towards the support of independent advice (section XI below) is an important feature of the UK policy debate, while, notwithstanding the importance of ‘independent’ advisers, the classic conflict of interest associated with retail market ‘advice’ and ‘sales’ in continental Europe and related to proprietary ‘sales’ by banking groups is also found in the UK.406 In this distribution-based and deeply conflicted European environment, heroic regulatory design efforts ‘in action’ are required to support vulnerable and trusting investors in what is often a commission-based sale or a sale of a proprietary product, and in which suitability and other supplyside protections, notably the fair treatment principle, may be disabled by entrenched and flawed incentives. The demands on regulation are all the greater as MiFID must capture, given the Article 4 gold-plating restriction, a range of different distribution and advice channels and their risks. 402

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The persistence of commission risk and the history of mis-selling by the personal investment firm industry were both highlighted in the UK’s Article 4 application to retain its discrete packaged products regime: Article 4 Application, pp. 12–14. E.g. A. Lang, ‘Investment Firms – Retail Sector’ in W. Blair and G. Walker (eds.), Financial Services Law (Oxford: Oxford University Press, 2006), p. 449, pp. 451–3. 2007 RDR, pp. 4, 17 and 50; and Financial Risk Outlook 2007, pp. 10 and 95–6. Ibid., p. 96. In 2007–8, 46 per cent of investment products (predominantly CISs (including UCITS) and unit-linked investment products) and 47 per cent of tax-wrapped Individual Savings Accounts (ISAs) investments were sold via banks and building societies and products were often proprietary: FSA, Retail Investments Product Sales Data, pp. 2 and 12.

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But the treatment of commission risk must be at the heart of regulatory design for the pan-EC market given investor dependence on distribution and advice channels and the limitations of allied product regulation and disclosure strategies.

3. MiFID and commission risk a) The demand side: disclosure As outlined in chapter 5, MiFID relies in part on disclosure to manage commission risks. The effectiveness of disclosure in this sphere is doubtful, although in the long term it may support better investor monitoring. b) The supply side: advice or sales; conflict-of-interest requirements or detailed suitability rules? Supply-side rules must carry out the heaviest lifting in protecting retail investors against incentive risk. MiFID’s articulation of investor protection in the advice relationship in part in terms of suitability requirements may well respond to the risks of the asset management/full-scale advice sector. But the emphasis on personalized suitability requirements, which are difficult to embed and enforce, sits uneasily in a environment dominated by sales risks and in which investors are purchasers of products and do not usually seek fee-based, extensive advice. The suitability regime does provide an ex ante mechanism for focusing firm attention on the investor’s needs in the sales context; it also provides an ex post private or public enforcement mechanism. But supervision and enforcement is challenging in this context, and severe incentive misalignment may disable suitability protections. The Article 19(1) fair treatment obligation might also be called in aid, particularly with respect to ex post enforcement. But the effectiveness of this provision depends in large part on the consistency with which it is applied and how it is embedded. Of more importance is the extent to which internal systems to manage incentive misalignment are embedded ex ante within a firm’s culture, particularly as MiFID identifies situations in which the firm has an interest in the outcome of a service provided to a client or a transaction carried out on behalf of a client, which is distinct from the client’s interest, as carrying conflict of interest risk (MiFID Level 2 Directive, Article 21). Firms should, accordingly, have systems to manage remuneration-based conflicts, based on the general obligation to manage conflicts (MiFID Level 2 Directive, Article 22); this obligation might also be inferred from the fair treatment

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principle. The FSA has targeted objective remuneration (linked to indicators such as the incidence of complaints, portfolio reviews and investor satisfaction) in its TCF reviews407 and best practice advice.408 Objective remuneration has also been raised by other Member State regulators,409 internationally,410 and by leading trade associations.411 But the success of Article 22 (MiFID Level 2 Directive) and Article 19(1) (MiFID) in dealing with commission risk is heavily dependent on national supervision and/or quasi-regulatory guidance and is vulnerable to the wider risks of the fair treatment and conflict-of-interest regimes. Considerably more specific protections are provided by the level 2 inducements regime, which, as has been acknowledged by the FSA, represents an important addition to the investor protection arsenal.412 Under the MiFID Level 2 Directive, Article 26, inducements are prohibited unless particular conditions are met. CESR has also adopted important, if controversial, level 3 Guidance on Inducements.413 While the inducements regime includes a disclosure element (chapter 5), it also, and primarily, imposes fiduciary-style duties on the investment firm. Under Article 26, the Article 19(1) fair treatment obligation is not met where the firm is provided with any fee, commission or non-monetary benefit which does not meet the Article 26 conditions. The first condition (Article 26(a)) is met where the fee, commission, or non-monetary benefit is paid or provided to or by the client or a person on behalf of the client. Article 26(c) allows the payment of ‘proper fees’ which enable or are necessary for the provision of investment services414 and which, ‘by their nature’, cannot give rise to 407

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In its ‘cluster report’ on remuneration and TCF, the FSA warned of the need to further align the commercial need to sell products with the aspiration to treat customers fairly and that further progress was needed in building factors other than short-term profit variables into remuneration packages. E.g. FSA, Quality of Advice Process. Delmas Report, p. 37; and BaFIN, Annual Report 2006, p. 136. ASIC has suggested that remuneration structures be linked to, for example, the incidence of complaints, continuing education and the quality of advice (ASIC, Conflicts of Interest), while the Joint Forum Report suggested that firms consider remuneration systems that reward compliance with the highest suitability and disclosure standards: Joint Forum Report, p. 52. ESF, CMA, ISDA, SIFMA (the Joint Associations Committee), Retail Structured Products: Principles for Managing the Distributor – Individual Investor Relationship (2008), Principle 3. The new regime is more extensive than the pre-MiFID FSA regime, particularly with respect to the requirement that the payment be designed to enhance the quality of the service and disclosure: FSA, Consultation Paper No. 06/19, pp. 32–3. CESR, Inducements under MiFID (CESR/07-228b, 2007) (‘Inducements Guidance’). Including custody costs, settlement fees and legal fees.

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conflicts with the firm’s duties to act in accordance with the best interests of the client. The central condition (Article 26(b)), which applies to all other payments if they are to escape the Article 26 prohibition, requires: disclosure of the inducement/payment; that the payment is designed to enhance the quality of the service; and that it must not impair compliance with the firm’s duty to act in the best interests of the client.415 Commission payments linked to product sales and advice clearly come within Article 26 in principle. But, unsurprisingly, given the structure of the advice industry, the regime does permit commission payments, as long as the advice is not biased and the Article 26 conditions are met.416 CESR has also advised that payment for product distribution, where no advice or recommendation is provided, is legitimate as the firm is providing quality enhancement in the form of distribution services which, in the absence of the payment, might not be provided, and as long as the disclosure and best interest conditions are met.417 The inducement regime is considerably more detailed than the fair treatment principle; but it is also considerably more operational, with CESR’s Guidance containing a number of illustrative examples, the overall tenor of which suggests some concern to preserve existing distribution agreements and to acknowledge the distribution service provided by investment firms, but also a focus on conflict-of-interest risk where the risk of incentive misalignment becomes more acute.418 CESR was also concerned to ensure that intra-group inducements are covered and that payments made in the context of ‘open-architecture’ distribution are treated equally with payments between legal entities within the same group.419 The regime is also likely to capture ‘hidden commissions’, notably the non-cash benefits which flow from the product provider to the investment firm (such as office facilities and administrative support), although MiFID does not address how these benefits might be quantified 415

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CESR’s Guidance identified the range of factors to be considered as including: the type of service provided and the specific duties owed to the client; the expected benefit to the client, including the nature and extent of the benefit and any expected benefit to the firm; whether incentives have arisen for the firm to act other than in the best interests of the client and whether they are likely to change firm behaviour; the relationship between the firm and the entity providing the benefit; and the nature of the benefit (recommendation 4). MiFID Level 2 Directive, recital 39; and Inducements Guidance, recommendation 5. Inducements Guidance, p. 10 and recommendation 5. The examples include CESR’s view that it would be difficult to meet the Art. 26(b) requirement where a one-off or ‘override’ payment is made once sales of a particular product reach an agreed level as the risks of conflict of interest increase as product sales approach the payment threshold. Inducements Guidance, p. 4.

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and how investor understanding of the hidden costs of advice might be enhanced.420 The inducement regime has some potential to contain the risks of commission-based advice/sales, as long as it is rigorously enforced, and it has enjoyed support from retail market stakeholders.421 But the MiFID rulebook is only a partial response to the commission-risk debate. Much remains to be done in terms of its effectiveness ‘in action’ and in terms of examining and assessing its impact in practice and enhancing supervision and enforcement. As discussed in the following final two sections, the delivery of mass market quality advice also demands strenuous efforts ‘in action’ beyond traditional regulation if commission risk is to be mitigated and the advice lever is to be able to carry out the heavy lifting required to engage and protect investors. Although ‘in action’ strategies remain largely the preserve of the Member States, EC resources would be well spent in supporting and encouraging more innovative local strategies for addressing commission risk.

XI. Fee-based investment advice: segmenting regulated advice 1. Delivering independent investment advice: the UK Retail Distribution Review and other international experience A more radical response might be to consider whether fee-based independent advice could be supported by harmonized regulation. Engineering the retail advice and distribution markets to deliver particular outcomes is a complex undertaking, however, and demands nuanced regulatory choices and considerable supervisory expertise. Internationally, the US regulatory regime has struggled with the labelling and differential regulatory treatment of ‘investment advisers’, who, broadly, provide fee-based advice, are not involved in the management of trading accounts, are regarded as fiduciaries and are subject 420

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The FSA successfully included its pre-MiFID requirement that commission-equivalents be disclosed in cash terms in its Article 4 Application in order that investors understand the full costs of the service and to promote market transparency and market discipline: Policy Statement No. 07/14, p. 14. The FSA’s FSCP supported CESR’s approach, arguing that ‘it is critically important that all necessary measures are taken to maintain and boost consumer confidence’: FSCP, Response to CESR’s Public Consultation CESR/06-687 Inducements under MiFID (2007), p. 1. Similarly, FIN-USE highlighted the importance of the regime in its criticism of CESR’s failure to highlight it in the CESR MiFID Consumer Guide: FIN-USE, Letter to CESR on A Consumer’s Guide to MiFID, 24 May 2008.

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to stringent fiduciary duties, and ‘broker-dealers’, who provide account management and broking services but only provide advice incidentally, are, broadly, associated with commission-based remuneration and are not regarded as fiduciaries. As both perform very similar functions, the SEC has grappled for some time with the distinction, particularly as investment advisers must be registered under, and are regulated by, the 1940 Investment Advisers Act, and as broker-dealers are not subject to this Act but must be members of a self-regulatory organization under the 1934 Securities Exchange Act (in practice, FINRA422 ) and are subject to SEC and FINRA conduct rules (although the investment adviser regime is perceived as being stronger).423 Following repeated attempts to adopt rules to clarify the status of broker-dealers who offer fee-based brokerage accounts424 and the striking-down of a remedial 2005 SEC rule, the SEC commissioned the extensive 2008 Rand Report on the investment advice and brokerage industry.425 It found that the advice industry supported a range of business models and that, although investors appeared generally satisfied with the advice services available, they did not understand the regulatory distinction. It suggested that the key driver for distinct treatment was not (unlike the developing UK regime) the form of compensation but whether the adviser or the investor made the investment decision. As part of its now-overtaken post-credit-crunch reform agenda for the US regulatory and supervisory system, the 2008 Treasury ‘blueprint’ also criticized the bifurcated system as having failed to adjust to market realities and caused investor confusion and called for a harmonized regime.426 In the EC, the FSA’s repeated struggles with product distribution and mass market advice are instructive, if, until recently, disheartening. While reflecting the particular risks of the UK market, they serve as a more general 422

423

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The Financial Industry Regulatory Authority was formed in 2007 from a merger between the NASD (the previous self-regulatory organization for broker-dealers) and the member regulatory, enforcement and arbitration units of the New York Stock Exchange. For a discussion of the investment adviser/broker-dealer controversy, see the 2008 ‘Treasury Blueprint’ for a remodelling of US financial market regulation: Department of the Treasury, Blueprint, pp. 118–26. In the wake of the recommendation by the Tully Commission that broker-dealer remuneration be related to assets managed rather than trading activity, many broker-dealers who previously had operated on a commission basis began to offer fee-based accounts. Rand Institute for Civil Justice, Report on Investor and Industry Perspectives on Investment Advisers and Broker-Dealers: Sponsored by the SEC (2008). Department of the Treasury, Blueprint, pp. 13 and 125–6. Similar concern was expressed in the 2009 proposals: Department of the Treasury, Financial Regulatory Reform (2009), p. 71.

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warning as to the challenges raised by intervention to address commission risk and industry structure and as to the scale of the regulatory ‘technology’ and resources required. The UK investment advice and distribution regime has experienced a series of reforms designed to address commission risk, but, after more than twenty years of intervention, the FSA’s conclusion was that regulation had tended to focus on ‘the symptoms arising from problems rather than the root cause’ and that insufficient progress had been made towards a market which delivered services which reflected consumer needs.427 Support of fee-based independent advice has been a recurring and problematic theme. The advice and distribution industry was ‘polarized’ in 1987, by law, into independent advisers (who acted as investors’ agents and, in compliance with a ‘best interests’ requirement, advised on the market range of products) and tied agents (who acted as product providers’ agents and could advise only on that provider’s products);428 disclosure requirements applied to highlight the adviser’s regulatory status, as did conflictof-interest requirements.429 Following concerns that this approach was anti-competitive and not delivering benefits to investors,430 the ‘depolarization’ reforms,431 which came into force in June 2005, allowed firms to choose whether to be tied to one product provider, multi-tied, untied and commission-based ‘whole of the market’ firms or independent advisers advising on ‘whole of the market’ products and offering a ‘fee option’. The depolarized regime initially relied heavily on disclosure to manage incentive risks, in the form of a ‘Menu’, which required firms to disclose the maximum commission they received on products as well as the market average for a range of products, and in the form of an Initial Disclosure Document (IDD) on the type of service provided432 these requirements were reformed and lightened post-MiFID (chapter 5). Conflict-ofinterest and commission risks are also dealt with through labelling-style 427

428 429 430 431

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2007 RDR, p. 5. Its 2007 Risk Outlook similarly noted that, while the sale of retail investment products had been subject to regulation for more than two decades, shortcomings continued to emerge in the way in which products were sold and with respect to the quality of advice: Financial Risk Outlook 2007, p. 10. Black, Rules and Regulators, pp. 138–84, examines the political, market and institutional tensions which accompanied the initial polarization reforms. In particular, product providers were to make efforts to ensure that appointed representatives were not incentivized by remuneration structures to give unsuitable advice. Office of Fair Trading, The Rules on Polarization and Investment Advice (1999). See generally I. MacNeill, An Introduction to the Law on Financial Investment (Oxford and Portland, OR: Hart Publishing, 2004), pp. 168–9; and FSA, Reforming Polarization – Making the Market Work for Consumers (Consultation Paper No. 121, 2002), pp. 10–14. FSA, Reforming Polarisation: A Menu for Being Open with Consumers (Consultation Paper No. 04/3, 2004).

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controls on the term ‘independent’, which can only be employed where the adviser (with respect to personal recommendations concerning packaged products) advises on a ‘whole of the market’ range of products and offers investors the option of paying a fee.433 But this attempt to promote feebased advice has proved troublesome given the strong incentives generated by commission payment, with the FSA reporting that a number of firms do not offer investors a fee option and, in some cases, that investors are dissuaded from paying a fee.434 The UK experience has also been that investors find it difficult to decode labels and do not equate commission payments, even with specific disclosure, with potential prejudice to the independence of advice.435 Despite these reform efforts and a matrix of suitability, conflict-ofinterest and disclosure requirements, persistent failures in the advice and distribution system, industry consensus that reform is required,436 and an over-arching, empowerment-driven concern to ensure that individuals are better equipped to take on responsibility for welfare provision and long-term financial planning, led to the FSA’s groundbreaking 2007 RDR437 which completed its initial consultation phase in late 2008.438 It has the potential to alter radically UK advice and distribution. It forms part of a wider reform strategy for advice and distribution which includes reform of conflicts-of-interest disclosure,439 prudential regulation440 and the treatment of platforms and wraps.441 The RDR strand is designed to address a series of market flaws which, reflecting 433

434 435 437

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A firm may not hold itself out as independent in relation to advice (or personal recommendations) on packaged products unless it intends to look across the ‘whole of the market’ (or the whole of a sector of the market) in making a recommendation and offers a client a fee (rather than commission) option with respect to the packaged product transaction (COBS 6.2.15 and 6.2.16). FSA, Investment Quality of Advice Processes II (2008), p. 3. FSA, Consultation Paper No. 121. 436 2007 RDR, p. 13. Although it warned that it is not the role of government or regulators to dictate business models, the Treasury welcomed the 2007 review given that a ‘more efficient distribution system that aligns the interests of firms and clients, and improves access to financial services, will help to promote consumer confidence and a willingness to engage with financial services’: HM Treasury, Financial Capability, p. 17. The 2008 RDR Feedback Statement followed almost two and a half years of discussion and marked the beginning of the formal consultation process on specific proposals. It is expected to be implemented, following consultation on related rule changes, by December 2012. See further ch. 5. FSA, Discussion Paper No. 07/4; FSA, Feedback Statement No. 08/2; and FSA, Review of the Prudential Rules for Personal Investment Firms (Consultation Paper No. 08/20, 2008). FSA, Discussion Paper No. 07/2; and FSA, Platforms and More Principles-Based Regulation (Feedback Statement No. 08/1, 2008).

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the interplay between disclosure, distribution and product regulation, include: the complexity of retail investment products and their charging structures; limited financial capability and retail investors being unable to act as a strong force on the industry; heavy reliance on commissionbased advisers and interest misalignment; access to advice difficulties; and limited adviser competence.442 Its ambition is considerable. Investor protection is not characterized in terms of traditional conduct regulation and disclosure ‘on the books’. It is characterized in terms of a radical reengineering of the structure of the retail distribution and advice market443 to deliver better outcomes for consumers through a clearly segmented distribution and advice system; this new system is designed to distinguish between sales and advice, provide clarity on the different services provided, raise professional standards and reduce conflicts of interests in remuneration.444 Support of independent, fee-based advice is at the heart of the new system. The initial 2007 proposals were based on segmenting the industry into, first, an independent, fee-based (or ‘customer-agreed-remuneration’) financial planning and advice sector, which would separate the product costs from advice costs, deliver the highest standards of competence and be targeted to more affluent investors with more complex needs445 and, secondly, a low-cost advice/sales segment, designed to facilitate mass market access to advice and to address closely ‘sales’ risks. At the heart of this policy therefore is the assumption, which cuts against MiFID’s design, that regulatory models for investment advice which merge independent investment advice and product distribution/advised sales, using common conduct and disclosure requirements, are flawed, and that a distinction must be made between highly regulated and fee-based investment advice and other forms of transaction-based advice and distribution to mitigate investor confusion and risks to the objectivity of advice. The independent advice strand, which, from the outset, enjoyed considerable support,446 was based on ‘eroding the perception that advice is 442 443

444 446

2007 RDR, pp. 3–4. The FSA found that only 10 per cent of advisers holding the basic entry-level qualification received higher qualifications (p. 16). Although the review is designed to act as a ‘catalyst to facilitate, where we can, industry solutions that will improve market efficiency and lead to better outcomes for consumers’: FSA, Business Plan 2008–2009, p. 27. 2008 RDR Feedback Statement, p. 3. 445 2007 RDR, p. 22. The FSA’s FSCP highlighted the attempt to promote fee-based advice as ‘one of the most important developments in financial regulation since the FSA was created’: 2006–2007 Annual Report, p. 2.

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a free commodity’447 and on supporting a move from transaction-based, product-driven services to fee-based advisory services. The ‘independent’ label was, accordingly, to be reserved for advisers who met the highest standards of competence and professionalism but who also were, in a robust attempt to address conflicts of interest, only remunerated by fees or by ‘customer-agreed-remuneration’; the latter could take the form of commission, but only as long as this was agreed by the investor. Sustainability concerns were also addressed, with the increased costs of this service related to a ‘regulatory dividend’ in the form of lighter prudential supervision related to the firm’s risk management profile.448 Higher standards of professionalism were also highlighted, reflecting a concern that competence improvements were needed to restore investor trust in advice.449 Additional categories of advice included ‘general financial advice’, which could be provided by commission-based advisers who had less in-depth knowledge or qualifications, and ‘focused advice’, which could be provided by ‘top tier’ and ‘general’ advisers.450 This segmentation was expected to carry out some very heavy lifting in that it was to remove the potential for remuneration-linked conflicts of interests, advice costs were to be separated from product costs, the adviser’s freedom from potential product bias would be more clearly signalled, product providers would be required to compete on quality rather than on commission (and might have incentives to produce less complex and more effective products) and the likely lower incidence of mis-selling was to support industry sustainability.451 The new regime was also associated with better investor engagement with the investment process given greater clarity on the advice process and closer investor involvement in establishing remuneration. While initial reaction was positive, the FSA withdrew its proposal to segment the market into ‘independent advice’ and ‘other advice’ channels. It adopted instead a radical model under which all ‘advisers’ would be independent and subject to enhanced regulatory requirements, including a prohibition on commission (unless it was agreed with the customer) and higher professional standards; all other services and transactions would be classed as sales.452 In its final 2008 RDR discussion, although the advice/sales segmentation became more nuanced (section XII below), the core distinction between ‘independent advice’ and other sales, including advised sales, was maintained; this approach was also followed in the 447 450

2007 RDR, p. 55. Ibid., pp. 25–7.

448 451

Ibid., pp. 42–3. 449 Ibid., p. 6. Ibid., pp. 24 and 32–3. 452 2008 Interim RDR.

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June 2009 proposals (section XII below). Under the new model, ‘independent advice’ will be subject to rigorous remuneration rules designed to remove product provider influence, high professional standards and additional quality of advice requirements. The pivotal remuneration regime, based on ‘adviser charging’, is considerably more practical, eschewing the troublesome consumer-agreed model which had limited practicality given limited investor competence (although it chimed well with the FSA’s fondness for empowerment strategies). It will require independent advisers to set advice charges independently and disclose them to investors; product provider influence over remuneration will be removed, although providers may provide facilities whereby preset adviser charges are, under a ‘matching’ system, deducted from products’ costs, in a lump sum or periodically, and passed to the adviser.453 A step-change in professional standards will also follow. The RDR is to lead to the establishment of a statutory Professional Standards Board which will adopt professional standards and review compliance across all independent and non-independent advice channels.454 Additional suitability requirements, akin to the ‘whole of the market’ rule,455 will also be imposed, which will require independent advice firms to be equipped to give a comprehensive and fair analysis of their relevant markets;456 firms will also be required to provide unbiased unrestricted advice.457 So how does this robust approach ‘in action’ to reforming advice and addressing commission risk fit with MiFID? The reforms certainly highlight the limitations of the traditional disclosure, suitability and conflictof-interest rules ‘on the books’ which remain at the heart of MiFID. They also highlight the need for flexibility given the difficulties distribution and 453

454 455 456

457

Reflecting in part the reality that many investors prefer instalment payments and that firms may prefer periodic charges for advice which are designed to align firm and investor incentives more closely: 2008 RDR Feedback Statement, p. 33. Any arrangement under which product providers advance advice fees to advisers and recover these through product charges will, however, be prohibited from December 2012. Ibid., pp. 47–52. Although this rule only applies to packaged product providers and the new regime will apply to all independent advisers. The rule is based on the principle that independent advisers be able to review the whole market but acknowledges that the relevant market may be differently defined, for example, where an firm restricts itself to an ethical investments strategy but defines the market in an independent manner and discloses this clearly: ibid., pp. 42–3. E.g. ‘independent’ advice firms with contractual links with product or service providers could breach this requirement where those links limit their ability to select the best solution for the investor (such as choice of a platform which only offers the platform provider’s products).

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advice can pose locally given a Member State’s particular market features. But the FSA’s ability to deliver its radical independent advice model will be constrained by EC rules,458 unless these ‘top tier’ advisers can be carved out from MiFID by an exemption; given that these advisers are likely to engage in asset management, this is unlikely as the Article 3 exemption will not be available. The Article 4 gold-plating exemption provides a safety valve, however, which the FSA is likely to open.459 The Commission certainly has little to gain from refusing an Article 4 application where the result may be to expose weaknesses in MiFID or to expose it to charges of obstructing retail market efficiencies at a time of heightened political focus on the retail investor.

2. An EC model? Management of commission risk through support of an independent, fee-based advice industry is emerging as a preferred policy option, not just in the UK but across the Member States.460 FIN-USE has repeatedly raised concerns as to commission bias461 and access to independent advice in markets where tied advisers dominate462 and suggested that regulation ‘of some form’ might be needed to facilitate the emergence of independent advice.463 The Commission, which had shown an earlier, if poorly executed, enthusiasm for an independent advice model during MiFID negotiations,464 warned in its 2007 Green Paper on Retail Financial Services that the sales and distribution infrastructure ‘is not 458 459

460

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463 464

Ibid., p. 33. It is ‘fully prepared to make cases where necessary to achieve the outcomes of [the] review’: 2007 RDR, p. 74. Thus far, the Commission seems supportive: Consultation Paper No. 09/18, p. 6. BME Report, p. 181. The Delmas Report, for example, supported the encouragement of fee-based advice, noting that it ‘will take time’ (Delmas Report, p. 12), and examined the ways in which it could be encouraged (p. 40). Its first report in 2004 noted that investors were dependent on ‘sound independent advice’ and raised the risks of distribution structures and investor lack of awareness as to whether advisers were tied or independent: FIN-USE, User Perspective, pp. 26 and 28. FIN-USE, Response to the Green Paper on Financial Services Policy 2005–2010 (2005); and FIN-USE, Opinion on the European Commission Green Paper on the Enhancement of the EU Framework for Investment Funds (2005). FIN-USE, Response to the Green Paper on Financial Services Policy, p. 10. The Commission’s 2001 ‘Initial Orientations’ for ISD reform suggested that ‘advice’ could be defined as ‘independent investment advice’ paid for by the client and distinguished from the provision of advice through tied agents (Commission, Overview of Proposed Adjustments, p. 11). It did not, however, reflect market realities, with the Commission somewhat helplessly acknowledging that the treatment of advice in the sale of proprietary products

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always optimal’;465 the subsequent consultations also raised the difficulties posed by the sales/advice tension.466 The European Parliament has highlighted the importance of access to ‘unbiased investment advice’,467 while a key report by the Council’s influential Financial Services Committee has warned that the capacity of existing EC distribution channels to deliver the required advisory and sales services is underdeveloped and poses a risk to effective retirement provision.468 Commission risks have also been a recurring feature of the recent consultations on substitute investment products.469 As long as investors suffer from competence difficulties in decoding commission risks, and depend on advice services but have limited ability to drive optimum services, and while supply-side regulation remains problematic in the face of entrenched commission risk, the use of more muscular regulatory/supervisory devices ‘in action’ to influence the structure of the advice industry seems reasonable. But the risks of an EC strategy are considerable. As outlined in section X, delivery channels for advice across the EC industry vary, reflecting different industry, cultural and savings influences. Were a fee-based model to be canvassed, any reforms would have to grapple with the very considerable investor resistance to fee-based investment advice470 and the strength of the perception that advice is free where the adviser receives a commission. Intense education of investors as to the benefits of fee-based advice, and the implications

465 466 467 468 469 470

was ‘unclear’. Following support during the consultation process for the independence of advice to be supported through background conflict-of-interest and disclosure techniques (European Commission, Revised Orientations on ISD Reform (2002), Annex 4, p. 16), the latter model was followed in MiFID. European Commission, Green Paper on Retail Financial Services, p. 17. European Commission, Report of Hearing on Green Paper on Retail Financial Services (2007), p. 4. European Parliament, Resolution on Financial Services Policy (2005–2010) (P6 TA(2007) 0338, 2007) (‘Van den Burg II Resolution’), para. 36. FSC Report, p. 21. E.g. Investment Management Association, Response to Commission Call for Evidence (2007), p. 4. Recognition of investor reluctance to pay a fee is a recurring theme of recent major policy reviews and studies including: the Delmas Report (p. 39); the FSA’s RDR (2007 RDR, p. 49) (the FSA noted the ‘generally held view’ that consumers in the mass market will not pay a fee for advice); FSA, Accessing Investment Products (Consumer Research No. 73, 2008), p. 2 (finding a ‘real resistance’ to paying for advice in cash rather than through ‘more invisible’ charges and commissions)); and the pan-EC 2008 Optem Report (finding that inexperienced consumers did not envisage paying a fee for advice (p. 100)).

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of different advice labels, would be required;471 and EC policy has up to now struggled with education and disclosure techniques ‘in action’. The risks in terms of supporting wider access to advice are considerable; some evidence suggests that commission-based advisers are more receptive to investors who might, initially at least, be unprofitable.472 The direct policy levers are limited and the regulatory choices are, as the US and UK experience underlines, complex. They are also, particularly where prohibitions on commissions are concerned, politically combustible given the structure of the EC advice industry. On the other hand, EC regulatory policy has until now reflected the traditional focus on disclosure, suitability and conflict-of-interest requirements ‘on the books’ in managing advice risks. The FSA approach builds on this model (as it must), but it is also based on a muscular, outcome-based strategy ‘in action’ designed to focus on how the outcome of independent advice can be delivered and on a more careful atomization of the nature of investment advice. Although the FSA review is rooted in the UK marketplace, the centrality of investment advice to investor-protection policy, particularly given weaknesses in allied product and disclosure regulation, might call for a little more drilling beneath the surface and some exploration of which regulatory levers might support the development of a viable, but high-quality, fee-based, independent advice industry. So, acknowledging that the large-scale engineering proposed by the FSA is impracticable and inappropriate to the fragmented EC market, the question arises how best to proceed in segmenting the advice market, at Community level, to promote a fee-based independent advice sector? Viability is a key risk. Some traces of a concern to support sustainable, independent, fee-based advice can be identified in MiFID. MiFID applies a lighter regulatory regime to investment firms which only provide investment advice or transmit orders and do not hold client assets, but which do not benefit from the Article 3 exemption.473 Although these firms are subject to the conduct-of-business and conflict-of-interest regime, they benefit from lighter prudential controls and initial capital requirements. 471

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J. Lee and J. Cho, ‘Consumers’ Use of Information Intermediaries and the Impact on Their Information Search Behaviour in the Financial Markets’ (2005) 39 Journal of Consumer Affairs 95. Research for the FSA has suggested that commission-based firms are more willing to take on client relationships which are unprofitable: Deloitte and Touche, Costing Intermediary Services: A Report for the FSA (2008). See sect. II above on Art. 3.

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They must either provide initial capital of €50,000,474 have professional indemnity insurance meeting MiFID’s coverage requirement or rely on a combination of insurance and capital which results in an equivalent level of coverage. The final option allows firms to reduce the MiFID capital charge by holding insurance, and reflects the similar regime which applies to insurance brokers under the Insurance Mediation Directive. This regime is based on the assumption that insurance is an adequate means of protecting investors where mis-selling represents the most serious risk, where client assets are not held and where counterparty risk is limited.475 But it also supports the development of fee-based independent investment advice in that new entrants could face high barriers to entry were high capital requirements imposed. Insurance-related regulation carries, however, moral hazard risks, particularly as insurance cover tends not to be based on individual firm risk assessment, as well as the risk that insurance becomes more difficult for firms to obtain where there is insufficient capacity in the insurance market.476 It is not yet clear whether the MiFID regime and its incorporation of an insurance requirement is distorting the insurance market.477 Article 5(5) also reduces the regulatory burden by providing that Member States may allow competent authorities to delegate administrative, preparatory or ancillary tasks relating to the authorization of these firms, a relaxation which also applies to ongoing supervision of authorization and compliance with MiFID’s operational requirements.478 Fee- and advice-based services might develop organically in response to industry trends, technological developments and investor demand, in 474 475

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The capital regime applies via Directive 2006/49/EC, OJ 2006 No. L177/201 (CRD). The Commission argued that firms of this type do not represent a source of counterparty or systemic risk but that the main risk to which investors were exposed was of a failure of ‘due diligence’ with respect to the advice given: European Commission, MiFID Proposal (COM (2002) 625), p. 81. The capital charge option was introduced following Member State and Parliamentary concern that indemnity insurance might become more difficult to obtain and that excessive burdens might be imposed on firms providing investment advice and insurance mediation: Final Report of the European Commission on the Continued Appropriateness of the Requirements for Professional Indemnity Insurance Imposed on Intermediaries under Community Law (COM (2007) 178). The 2007 Commission Report on the indemnity regime found that the policy justification remained sound and that there was insufficient evidence to indicate that reforms were necessary. But it focused on the insurance mediation regime and acknowledged that no evidence was available on the MiFID regime. An FSA study into the insurance market for non-MiFID ‘Article 3 firms’ has also found that the market is working efficiently: Feedback Statement No. 08/2. Arts. 16(2) and 17(2).

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which case the appropriate policy response may be simply not to obstruct innovation and to ensure the robust application of core MiFID disciplines. Significant growth in the market for high-quality, independent advice, at the expense of financial-supermarket banks, has been predicted.479 Spain, for example, has seen demand rising for independent advice as investment products have become more sophisticated and financing needs more complex, as has Germany.480 A shift from product-oriented marketing by banks to client-oriented services has also been predicted.481 The recent development of platforms and wraps, while in some respects increasing conflict-of-interest risk, has also been associated with reducing reliance on commissions and with a movement away from product transactions and towards ongoing, fee-based, advisory relationships.482 The growing popularity of exchange-traded funds in some markets is also reducing pressure on commission risks as these products are not commission-based.483 A more radical approach might be to encourage segmentation by reference to the UK model and with a voluntary, but pan-EC, ‘label’ or ‘kite mark’, associated with fee-based advice and high standards of competence, particularly as MiFID deals only tangentially with competence.484 Adviser competence is becoming an EC policy concern, linked to the concern that advisers do not always understand the products they sell, but reform efforts are not consistent485 and competence standards and professional oversight are typically a function of national regimes. But, even if an appropriate model, linked to harmonized national competence standards, could be designed, the difficulties investors face in decoding different ‘labels’ are considerable. The political risks are also significant given the dominance of the bank/financial-supermarket model and resistance from interest groups.486 Segmentation/labelling reforms might also 479 482

483 484

485

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Note 36 above. 480 2007 RDR, Annex 3, pp. 3 and 6. 481 BME Report, p. 168. FSA, Discussion Paper No. 07/2 and 2008 RDR Feedback Statement, p. 4, noting a growing focus on asset allocation, risk and performance rather than on product selection. Initial commission payments have reduced in Australia following the development of wraps and platforms: 2007 RDR, Annex 3, pp. 2 and 8. 2008 RDR Feedback Statement, p. 28. Investment firms must ensure that ‘relevant persons’ (Art. 2(3)) are aware of the procedures which must be followed for the proper discharge of their responsibilities and employ personnel with the skills, knowledge, and expertise necessary for the discharge of their assigned responsibilities (MiFID Level 2 Directive, Art. 5(1)(b) and (d)). BME Report, p. 181. The Report pointed to Sweden’s 2004 law on financial advice which requires financial advisers to have formally demonstrated competence on financial instruments and the regulatory framework. R. Rajan and L. Zingales, ‘The Great Reversals: The Politics of Financial Development in the Twentieth Century’ (2003) 69 Journal of Financial Economics 5.

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represent a poor use of scarce resources; extensive fee-based advice is only likely, initially at least, to be of significant interest to more affluent and sophisticated investors. The immediate concern of advice policy must be the mass market, which is ill-equipped to navigate a complex universe of different advice providers, unlikely to be in need of complex financial advice and not in a position, or disinclined, to pay fees. It may be that this group is best dealt with by ensuring the regulatory regime focuses sharply on the particular confusion and commission risks of ‘advised sales/sales’ ‘in action’ and, in particular, on the rigorous enforcement of conflict-ofinterest/inducement and suitability rules. Domestic measures designed to address fee-based advice should also be accommodated within the Article 4 process, although the fate of the FSA’s RDR remains to be seen, and efforts should be made to support local best practice and pan-EC supervisory learning, whether through CESR or otherwise. Although the difficulties are considerable, efforts to address the fee-based advice conundrum, however troublesome, seem a better use of resources than the new packaged products agenda.

XII. Access to mass market advice and the sales problem 1. Access to advice Effective regulation ‘in action’ of the advice process requires more than management of the risks of the advice relationship. It also demands a focus on access to advice487 as investor need for advice increases. Fullscale, highly personalized advice is costly and likely to be prohibitive for much of the mass market.488 A tiered advice system which allows investors to move through different forms of regulated advice, based on graduated regulatory (and particularly suitability) regimes which allow cost differentiation and which support the development of simpler advice 487

488

‘The regulation of a market cannot compensate for unfairness which derives from a lack of expertise. Where such lack of expertise is combined with a lack of resources to buy in expertise, unfairness truly exists’: Bradley, ‘Disorderly Trading’, 392. Similarly, the BME Report highlighted the asymmetry which arises where consumers with higher incomes and better education have access to superior advice and those most in need of advice are unable to afford it (p. 183). BME Report, p. 183. The FSA’s FSCP has argued that the cost of independent advice was a ‘fundamental limitation’ for consumers and that consumers were, as a result, attracted to banks who provide a more limited ‘and probably not independent’ advice service: Response to the Commission’s Green Paper on Retail Financial Services in the Single Market (2007), p. 3.

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channels, may better reflect investor needs.489 But the design challenges are considerable, not least among them MiFID’s requirement for a suitability assessment whenever a personalized recommendation is made, industry risks where the applicability of suitability requirements is unclear and the limited ability of retail investors to choose and monitor different advice services.490

2. A mass market advice regime and MiFID: generic advice MiFID allows for some degree of segmentation in that regulated MiFID ‘investment advice’ is limited to specific and personalized recommendations (section II.3 above) and does not include what can often be valuable general asset allocation, financial planning and debt reduction advice. This exclusion suggests a pragmatic approach to the trade-off between protection and costs; advisers are not disincentivized from providing this form of advice earlier in the sale or advice relationship. Hybrid advice forms, such as guided execution-only sales which, at various stages in the sales process, provide generic advice on asset allocation,491 may also be supported by this model, as long as a personalized recommendation is not made. It also reflects a pragmatic approach to the different channels through which investors receive basic financial advice: ‘the exclusion of generic advice . . . avoids the danger of regulating financial planning entities that, in many cases, operate as charities providing valuable financial advice free of charge’.492

3. Access to advice and the UK experience a) Basic advice Investment advice in the UK has a number of regulatory dimensions. At the bottom of the pyramid, a free, public Money Guidance advice 489 490

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UK retail investors have shown a preference for simple and straightforward advice services: FSA, Consumer Perceptions of Basic Advice (Consumer Research No. 70, 2008), p. 6. The FSA has found that, while retail investors support simplified advice services, when asked to design an ideal advice model they constructed a model very similar to the MiFIDbased, commission-driven, independent adviser model: FSA, Consumer Research No. 73. The UK’s RDR suggested at an early stage that an ‘assisted-purchase’ execution-only model could be used, outside the investment advice regime, to guide investors to make the right decision (2007 RDR, p. 66) although considerable risks arise concerning the boundary between non-regulated guided sales and regulated personalized advice. Background Note, p. 31.

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model, personalized but not tied to the sales process, is being trialled by the FSA.493 But, between generic advice and MiFID-regulated investment advice (whether by non-MiFID ‘Article 3 firms’ which follow the MiFID regime or MiFID firms), the UK regime also includes Basic Advice.494 Basic Advice is designed to support wider access to investment products and advice by those with no practical knowledge of investing495 and to address advice costs and manage commission risks by linking less costly regulatory (particularly suitability) requirements to the distribution of the ‘stakeholder’ products;496 the construction of these products is designed to obviate the need for a close assessment of individual needs. Limited advice is delivered by advisers operating from pre-scripted questions,497 warnings and statements;498 a detailed assessment of the investor’s circumstances is not made.499 Basic Advice is designed to lead to a ‘suitable’ recommendation from the limited range of stakeholder products offered and reflecting the information provided by the investor during the sales process. The related FSA Guidance closely reflects the risks to which inexperienced investors with limited resources are exposed. Advisers are recommended, for example, to provide an unambiguous warning as to the desirability of making debt repayments, of access to liquid cash, or of acquiring insurance, where appropriate, and not to recommend equity-based investments where the client does not wish to place capital at risk. Its close focus on the needs of more vulnerable investors is imaginative and laudable. But Basic Advice has had only limited success, partly given its unattractiveness to providers given the stakeholder product charges cap. Basic Advice investors also tend to invest only small amounts, making supply of the products uneconomical. The target market of low to middle income savers, while generally happy with Basic Advice,500 has also proved 493 494

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See further ch. 7. FSA, A Basic Advice Regime for the Sale of Stakeholder Products (Consultation Paper No. 04/11, 2004); and FSA, A Basic Advice Regime for the Sale of Stakeholder Products (Policy Statement No. 04/22, 2004). FSA Basic Advice Guidance, COBS 9, Annex 2 G. See further ch. 3. The Basic Advice regime does not, however, apply to the stakeholder smoothed investment product (COBS 9.6.10). The pre-scripted advice model did not test well and investors appeared confused as to the nature of the investment: FSA, Policy Statement No. 04/22, p. 22. Although the FSA has developed a Basic Advice script, most firms use proprietary models: 2007 RDR, p. 58. Policy Statement No. 04/22, pp. 3, 5 and 7. The regime is set out in COBS 9.6. Extensive guidance is set out in COBS 9, Annex 2 G. Consumer Research No. 70, p. 6.

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smaller than initially expected.501 Concerns have arisen as to liability risks to firms, that firm mis-selling risks may be replaced by investor mis-buying risks502 and that an inferior service is provided to vulnerable investors.503 Basic Advice came under review during the RDR which led the FSA to conclude that the Basic Advice market had not developed as expected and to consult on withdrawing the regime, although it has since decided to retain it as a form of ‘restricted advice’.504 While the FSA remains committed to supporting a spectrum of advice services, the experience with Basic Advice points to the commercial difficulties which can arise in designing a lower-cost model and to the challenge posed by blending product and advice regulation.

b) The Retail Distribution Review: primary advice and ‘sales’ Access to advice was a central theme of the RDR, related to the FSA’s concern that retail investors should have access to low-cost advice and that the advice sector should be sustainable.505 As outlined in section XI above, the RDR is based on the premise that, for those who can afford full-scale advice, this sector should be conflicts-free and expert. But significant difficulties then arise as to how to support mass market investors who cannot afford full-scale independent advice.506 Working from the disheartening assumption that its high-quality, independent advice regime would inevitably exclude mass market investors,507 and in order not to exacerbate the advice gap, the FSA initially proposed a low-cost ‘Primary 501 502

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One report estimated the target market at only 1.5 million customers: Volterra Consulting, The Market for Basic Advice: A Report for the FSA (2008). J. Gray, ‘The Sandler Review of Medium and Long-Term Retail Savings in the UK: Dilemmas for Financial Regulation’ (2002) 10 Journal of Financial Regulation and Compliance 385; and O. MacDonald, ‘The Sandler Review’ (2003) 11 Journal of Financial Regulation and Compliance 102. FSA, Policy Statement No. 04/22, p. 5. 2008 RDR Feedback Statement, pp. 65–6 and Consultation Paper No. 09/18, pp. 20–1. The 2007 RDR argued that rising income and wealth meant an increase in those needing financial help (p. 5), while the 2007 Outlook noted the FSA’s concern that investors were buying products without advice (p. 9). One commentator suggested that, although the FSA has accepted that ‘the mass market cannot afford face-to-face holistic advice’, differentiating too sharply between sales and advice would drive advice ‘even further upmarket, increasing the gap between the professionally served top end and the mass market, which has been abysmally served by transaction-oriented independent financial advisers and high street banks’: S. Fowler, ‘A Simple Call for Good Retail Advice’, Financial Times, Fund Management Supplement, 9 July 2007, p. 6. The FSA was concerned that an increase in the costs of independent advice could lead to the exclusion of ‘middle income’ investors (£25,000–£50,000): 2007 RDR, pp. 7–8.

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Advice’ model which would have seen a radical move away from personalized advice and towards suitability being assessed ‘at the level of consumer segments’ which, while it might ‘lead to suboptimal outcomes for some, overall . . . would put consumers in a better position than having no access at all’.508 Like the Basic Advice regime, it would have been restricted to a limited range of products (although wider in scope than the stakeholder suite)509 to counteract advice risks.510 The flaws of the Primary Advice model underline the challenges of intervention in support of easier access to advice. Drawing a line between different forms of investment advice on a spectrum from ‘independent’, to ‘personalized’, to ‘generic’,511 risks all manner of unintended effects, as has been the Australian experience.512 The FSA’s original assumption that commission risk was somehow more acceptable in certain ‘advice’ relationships is troubling. A lighter advice regime could have entrenched lower-quality ‘advice’ in the mass market.513 The Primary Advice model remained transaction-related and, as such, was unlikely to lead to recommendations to repay debt. Any success would have depended on industry take-up and on the costs outweighing the more limited benefits; but Basic Advice had already highlighted the commercial difficulties. Difficult questions also arose as to the range of products involved, the risk of distortion to market forces and the competence of the regulatory system to design some form of endorsement mechanism for the related products which would not carry the risk that investors assumed some form of government guarantee. A simpler but more radical model was proposed in the FSA’s 2008 Interim Report. While it retained the independent advice model, the FSA, reflecting stakeholder support for a simplified regime, concern as to any 508 509

510 511 512

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Ibid., p. 60. A ‘simplicity’ qualification was suggested which would have segmented products with respect to risk, charges and other characteristics (access to capital with/without loss, taxation, premium levels and contract length, term and ease of access to information): ibid., p. 63. Ibid., p. 28. The FSA’s original model was ambitiously based on full advice, focused advice, primary advice, generic advice, non-advised purchases and Basic Advice: ibid., p. 27. Australia’s Financial Services Reform has struggled with the distinction between general and personal advice and, in particular, with when firms become subject to the risk warning requirements which attach to general advice: Treasury, Refinements Proposal, pp. 24–5. APCIMS argued that the Primary Advice regime could amount to a second class service, providing a convenient training ground for less-experienced advisers. APCIMS, Response to RDR, pp. 11 and 12. Consumer reaction was also negative: FSCP, Response to a Review of Retail Distribution, p. 3.

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dilution of the ‘advice’ brand, support for a distinction between advice and sales and hostility to the Primary Advice model,514 proposed that all other regulated transactions, other than ‘independent advice’, were to be classified as non-advised ‘sales’. This radical simplification of the regulatory landscape and the distribution/advice industry, which would have, for example, excluded tied advice from the ‘advice’ universe, was bold and engaged directly with commission risk and with investor confusion as to the nature of ‘advice’; it also assumed that ‘advice’ in the mass market should not be treated as a second-tier service. While this model might have suggested that those investors who could not afford full-scale ‘advice’ be thrown to the wolves,515 as advice could not otherwise have been provided under the FSA’s model, it incorporated the allied Generic Advice/Money Guidance strand.516 But the related commoditization of the investment product market implied by the blunt advice/sales segmentation risked that investment products would have become treated as consumer goods and that empowerment-based information and choice strategies would have been inappropriately relied on. It also flew in the face of the evidence that product providers have flawed incentives when it comes to producing simple, clear and high-performance products which meet investor needs. Commoditization of this nature also risked that ill-informed and nervous investors would have simply withdrawn from the investment process in the absence of, however illusory the quality of the service, some form of advice or guidance given high dependence on advice. Entirely non-advised sales are also not likely to have been commercially viable given that investors need some element of persuasion, which can quickly become characterized as advice, before they buy a product.517 514

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The FSCP argued trenchantly that commission payments should be prohibited for all forms of advice and argued that Primary Advice would lead to suboptimal outcomes for large numbers of investors and an unacceptable reduction in standards. It rejected the implied assumption that investors be classified in terms of the complexity of their advice requirements and suggested that the independent advice label and an enhanced regulatory regime might lead to better understanding of advice and its costs. Industry reaction to this model was hostile, with the British Bankers’ Association arguing that investors would either have to pay for expensive advice or take important decisions blind: T. Burgis and A. Felsted, ‘Banks Face Advice Bar in FSA Shake-up’, Financial Times, 30 April 2008. The banking and insurance industry had, however, most to lose from the loss of the advice label: P. Skypala, ‘FSA Has Chance to Clarify “Sales” and “Advice”’, Financial Times, Fund Management Supplement, 24 November 2008, p. 6. 2008 RDR Feedback Statement, p. 6. 2008 Interim RDR, p. 25. The industry has expressed concern that investors still need to be persuaded to buy a product and that non-advised sales, without any additional support, may not be commercially viable.

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Despite the FSA’s preference (and that of many stakeholders) for a simple advice and sales landscape, following significant criticism518 and concerns that access to some form of advice would be reduced for less affluent consumers,519 it revisited the model in its final Feedback Statement in which it proposed a third way. It suggested a distinction between, first, full-scale ‘independent advice’ and, secondly, a spectrum of ‘sales’ (including ‘non-independent advice’, guided advisory and non-advisory sales and execution-only sales) which would provide investors with different needs, preferences and financial profiles with a range of services and with assistance in purchasing products.520 Reflecting empowerment concerns, the FSA suggested that different forms of ‘advised process’ were necessary to raise investors’ awareness of their needs, to manage the deterrent effect of long-term products and to ‘encourage’ investors to make the decision to take action.521 The proposed ‘sales’ spectrum accordingly included a ‘full’ but ‘non-independent’ advice segment which, while regarded and labelled as a ‘sale’, would be based on a comprehensive review of investor needs (unlike a straightforward sale),522 be personalized and reflect equivalent remuneration/adviser charging523 and professionalism standards524 to those imposed on ‘independent advice’. But, unlike ‘independent advice’, it would be based on a limited range of suitable solutions and so accommodate advice from tied agents and from institutions advising on proprietary products; the distinction between it and ‘independent advice’ related to the more limited range of products concerned and not to the degree of adviser professionalism or the extent of the conflict-of-interest risk from remuneration.525 The ‘sales’ spectrum also included a ‘guided sale’ segment designed to address the risk of reduced access to advice services and to provide cost-effective, advice-based solutions for less affluent investors with more straightforward needs.526 Here, however, the FSA, while supportive, left it to the industry to develop relevant models, showing some reluctance to develop a discrete regime.527 518 519 522 523

524 527

‘Strong but diverse’ views emerged: 2008 RDR Feedback Statement, p. 17. Ibid., p. 7. 520 Ibid., p. 55. 521 Ibid., pp. 55–6. The FSA suggested that, without a personal recommendation, some consumers would be unwilling to buy or would not identify their savings priorities: ibid., p. 17. While the model is under development, remuneration structures are to reflect the ‘Adviser Charging’ principle but, acknowledging the difficulties in delivering full independence from product providers in the wider ‘sales’ sector (particularly where advice is given by bank employees on proprietary products), they are to be calibrated to reflect the relevant incentive risks: ibid., pp. 57–60. Ibid., pp. 60–1. 525 Ibid., p. 23. 526 Ibid., p. 57. And generated some nervousness from the FSCP as a result: Press Release, 25 November 2008.

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But it highlighted that the suitability rules which are engaged where MiFID ‘advice’ is given provide for some flexibility528 while underlining the need for some form of suitability where MiFID ‘advice’ is given.529 The FSA’s objective was not, by contrast with its earlier approach to Basic Advice, to design these systems; it was more concerned with providing greater clarity as to how these services would be treated and on liability risks.530 The FSA’s subsequent June 2009 proposals followed this model although, reflecting consumer testing of the labelling dynamics, a more streamlined approach has been adopted. The new regime will be based on an ‘independent advice’ model and a ‘restricted advice’ model (both of which can include ‘simplified advice processes’), supported by disclosure requirements. Independent advisers will be required to provide unbiased, unrestricted advice, based on a comprehensive and fair analysis of the ‘relevant market’, comprising all the retail investment products capable of meeting investor needs and objectives. An adviser charging model will apply to ‘independent’ and ‘restricted’ advice (calibrated to reflect advice on proprietary products) – commission-based payments will be prohibited; enhanced professional standards will also apply to both advice models. The FSA has also decided to retain the Basic Advice model in order to support the sale of stakeholder products.

4. The EC and access to advice How to support mass market access to low-cost, but safe and high-quality, advice channels which support trusting and empowered investors is probably the most intractable problem faced by retail market policy. But commission risk and poor access to high-quality advice represent serious threats to retail market efficiency and to retail investor engagement. They call for action and for the allocation of considerable policy and regulatory resources. The range of levers being pulled in the UK, including the education-based generic advice/Money Guidance lever, point to the scale of the challenge and the resources demanded. Sophisticated education strategies might cut a path through the impasse. Many of the key messages which advice should deliver to vulnerable and inexperienced investors (such as with respect to debt repayment and the 528

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‘[S]uitability is a flexible standard, determined with reference to the nature and extent of the service provided . . . [T]here is scope for firms to design simplified advice processes . . . capable of meeting the suitability requirement’: ibid., p. 64. Ibid., pp. 61–4 and Annex 8. 530 Ibid., p. 6.

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costs of investing) will always be difficult to deliver through suitability/fair treatment obligations, given the profit-maximization incentives which drive rational investment firms. Outsourcing the educative aspects of advice to the distribution and advice sector raises the risk that key messages are not delivered. As discussed in chapter 7, more imaginative (and costly) solutions as to how to deliver generic advice, whilst not on the scale of the UK model, may be required, although here the EC’s powers are limited. MiFID’s conceptualization of ‘investment advice’, its support of generic advice and the flexibility of the suitability regime may support the incubation of innovative, low-cost, local responses to the access and commission risk problems and to the sales/advice conundrum; EC resources would be well directed to the encouragement of imaginative solutions and the sharing of best practices. But MiFID does not provide for the weakening of protections where ‘advice’ comes within its definition of ‘investment advice’ in the form of a personal recommendation. The FSA has acknowledged the restrictions MiFID places on its reforms;531 although the FSA has the freedom to impose new, lighter rules on ‘Article 3 firms’, it does not have this freedom with MiFID firms, typically banks and larger investment firms. The EC shackle may not necessarily be a bad thing; EC restrictions, in part, led to the FSA’s adoption of a more nuanced advice and sales distinction532 and the prevalence of commission risk and limited investor competence suggest that great caution is required before suitability protections are disabled. But the core suitability requirement and its activation on a personal recommendation does, nonetheless, limit the extent to which low-cost, non-advised models can be safely used by firms.533 The risk remains that MiFID will inhibit the development of the imaginative advice and distribution structures ‘in action’ required to support trusting and empowered investors. The fit between MiFID and low-cost advice, and how regulators and the industry can be supported in developing high-quality but low-cost advice models, might, accordingly, be better preoccupations for the Commission than the massive

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2007 RDR, p. 75; 2008 RDR Feedback Statement, pp. 63–4; and Consultation Paper No. 09/18, p. 6. 2008 RDR Feedback Statement, p. 18. Considerable caution is evident in the FSA’s discussion of decision trees in its 2008 RDR Feedback Statement, which warned firms of the need to be alert to providing personal recommendations and to avoid providing any judgment on the suitability of investments: Annex 7, p. 4.

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re-engineering of the selling regulatory regime envisaged in the Packaged Products Communication. But it appears that rules ‘on the books’ and the easier challenges of ensuring regulatory tidiness across the substitute products sector have greater appeal than the difficult challenges and wide range of strategies associated with ensuring access to high-quality advice ‘in action’.

5 Disclosure

I. Disclosure and EC investor protection 1. The retail market disclosure regime Disclosure, with its ‘self-help’ connotations, is strongly associated with the empowerment model. It forms a central element of current retail market policy internationally, reflecting the ingrained assumption that disclosure can support better decision-making and stronger market-based saving;1 this assumption is evident in the UK regime by the FSA’s placing of clear information at the heart of its Treating Customers Fairly initiative2 and of its regulatory and supervisory strategies generally.3 The post-FSAP EC retail market disclosure regime for the intermediated and product-based transactions which strongly characterize the EC retail market has two dimensions: investment products; and investment services. Product disclosure is primarily a function of the UCITS regime.4 But it is also addressed by MiFID’s5 disclosure requirements for the ‘financial instruments’ in respect of which investment services are provided, 1

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S. Tanner, The Role of Information in Savings Decisions, Briefing Note 7 (London: Institute for Fiscal Studies, 2000) in the UK context; and, in the EC context, BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007) (‘BME Report’), p. 174. An extensive US scholarship highlights the prevalence of ‘more disclosure’ as a retail market technique: for example, D. Langevoort, The SEC as a Lawmaker: Choices about Investor Protection in the Face of Uncertainty (2006), ssrn abstractid=947510; and H. Jackson, ‘Regulation in a Multi-Sectored Financial Services Industry: An Exploration Essay’ (1999) 77 Washington University Law Quarterly 319. Financial Services Authority (FSA), Good and Poor Practices in Key Features Documents (2007), p. 5. Clear, simple and understandable information is a core element of FSA’s current retail market strategy: C. Briault, Speech on ‘The FSA’s Retail Strategy’, 27 February 2008, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml. Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities, OJ 1985 No. L375/3. Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC

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and by the Prospectus Directive, 6 particularly with respect to structured securities but also with respect to direct investments and execution-only sales generally.7 Services disclosure is governed by the Distance Marketing of Financial Services Directive8 and MiFID, which address marketing communications, pre-contractual and pre-service disclosure and best execution disclosure. Disclosure is, however, employed across MiFID; execution-only services, for example, can be offered only with respect to ‘non-complex’ products, which determination depends in part on whether ‘adequately comprehensive’ information is available such that the ‘average retail investor’ can make an informed judgment about the product (MiFID Level 2 Directive, Article 38(d)). The informed and empowered investor is a recurring feature of EC disclosure rhetoric9 and a persistent motif of the FSAP disclosure regime10

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and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’); and European Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ 2006 No. L241/26 (‘MiFID Level 2 Directive’). Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’). It is supported by ongoing issuer disclosure requirements under the Market Abuse and Transparency Directives: European Parliament and Council Directive 2003/6/EC of 28 January 2003 on insider dealing and market manipulation, OJ 2003 No. L96/16 (‘Market Abuse Directive’); and Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2000/34/EC, OJ 2004 No. L390/38 (‘Transparency Directive’) (see further ch. 6). European Parliament and Council Directive 2002/65/EC of 23 September 2002 concerning the distance marketing of consumer financial services and amending Council Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No. L271/16 (‘Distance Marketing Directive’, or DMD). E.g. European Commission, Communication on Article 11 (COM (2000) 722), p. 16; Green Paper on Retail Financial Services (COM (2007) 226), p. 3; and White Paper on Financial Services 2005–2010 (COM (2005) 629), p. 7. The European Parliament has called for ‘succinct consumer-friendly information’ (European Parliament, Resolution on Financial Services Policy (2005–2010) White Paper (P6 TA(2007)0338, 2007) (‘Van den Burg II Resolution’) para. 39) and highlighted information as ‘essential to empowering investors’ (Resolution on Asset Management (P6 TA-PROV(2007)0627, 2007) (‘Klinz II Resolution’), para. 11). The Prospectus Directive, for example, is designed to support ‘informed assessment’ by investors (Art. 5), the DMD is designed to allow the consumer to ‘properly appraise’ the financial service and ‘make an informed choice’ (recital 21), the UCITS Directive disclosures should allow an investor ‘to make an informed judgment of the investment

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and ancillary consumer protection measures, notably the Unfair Commercial Practices Directive.11 The assumption under-cutting the regime, at least until the recent UCITS reforms, has been that the retail investor is essentially rational, willing to decode disclosure, receptive of regulatory efforts to increase the volume, and improve the clarity, of disclosure and, when armed with appropriate disclosure, able to navigate an expanding universe of products and service and to exert market discipline.12 The weight of expectation placed on the retail investor is evidenced across the disclosure regime and the policy rhetoric, including the repeated references to disclosure being provided in advance of the purchase/investment decision,13 the need for disclosure to be clear and understandable14 and the troublesome assumption that disclosure supports comparability, informed choice and investor disciplining of services and products.15

2. The investor understanding problem a) Investor understanding Disclosure has considerable attractions as a retail market tool. Poor information has been associated with higher participation costs and low levels of market engagement.16 Disclosure interferes only to a limited extent with the autonomy of the investment firm and the investor.17 It can empower

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proposed . . . and . . . of the risks’ (Art. 28), while MiFID is directed to investors being ‘reasonably able to understand the nature and risks’ and able to ‘take investment decisions on an informed basis’ (Art. 19(3)). The Directive’s ‘average consumer’ concept assumes a consumer ‘who is reasonably wellinformed and reasonably observant and circumspect, taking into account social, cultural and linguistic factors’: Directive 2005/29/EC of the European Parliament and of the Council of 11 May 2005 concerning unfair business-to-consumer commercial practices in the internal market, OJ 2005 No. L149/22, recital 18. The EC is not alone in this regard. E.g. A. Palmiter and A. Taha, Mutual Fund Investors: Divergent Profiles (2008), ssrn abstractid=1098991, in the context of US mutual fund disclosure. MiFID Level 2 Directive, Art. 29; DMD, Art. 3; and UCITS Directive, Art. 33. E.g. Prospectus Directive, Art. 5(1) and (2); UCITS Directive, Art. 28; and MiFID, Art. 19(2). European Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (SEC (2006) 1451), para. 2. E.g. B. S´ejourn´e, Why Is the Behaviour of French Savers So Inconsistent with Standard Portfolio Theory? (AMF Working Papers, 2006). G. Howells, ‘The Potential and Limits of Consumer Empowerment by Information’ (2005) 32 Journal of Law and Society 349; and J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 233.

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investors to achieve their investment objectives18 and support regulatory efficiencies by accommodating asymmetric investor ability.19 It can mitigate regulatory risks; the risks of interventionist product regulation, for example, can be mitigated by disclosure.20 In the EC context, it can generate less political tension than firm-facing rules which may disrupt national markets and business models.21 But disclosure is not, in itself, an objective of retail market regulation, despite the ever-increasing volume of regulated information. Retail market disclosure is a means whereby investors overcome an informationasymmetry-based market failure22 to make informed and effective decisions, monitor market actors and drive the production of products and services which meet their needs. Unlike issuer disclosure, which has systemic, market efficiency dynamics, retail market disclosure is addressed to individual decision-making.23 But effective disclosure design for the retail markets, and particularly for the expanding universe of complex investment products, represents one of the most intractable of retail market problems.24 Behavioural finance suggests that the biases and competence failures which dog investor decision-making are unlikely to be dealt with through disclosure. The over-confidence bias, for example, suggests that retail investors can be overly credulous and not sufficiently sceptical of

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E. Tafara and R. Peterson, ‘A Blueprint for Cross-Border Access to US Investors: A New International Framework’ (2007) 48 Harvard International Law Journal 31. C. Camerer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin, ‘Regulation for Conservatives: Behavioral Economics and the Case for “Asymmetric Paternalism”’ (2003) 151 University of Pennsylvania Law Review 1211. By contrast with the UCITS regime, US retail mutual fund regulation allows greater freedom to the fund. It imposes general diversification requirements where funds are marketed as ‘diversified’ but otherwise relies on disclosure. S. Weatherill, EU Consumer Law and Policy (2nd edn, Cheltenham: Edward Elgar, 2005), p. 85. ‘[A]rguments in favour of transparency are often framed in the context of the retail markets, where information asymmetry between consumers and firms can lead to dysfunctional markets and outcomes’: FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008), p. 4. R. Gilson and R. Kraakman, ‘The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias’ (2003) 28 Journal of Corporation Law 715. The financial crisis has, of course, also exposed the inadequacies of market monitoring and disclosure in the wholesale markets: E. Avgouleas, What Future for Disclosure as a Regulatory Technique? Lessons from the Global Financial Crisis and Beyond? (2009), ssrn abstractid=1369004; and S. Schwarcz, ‘Disclosure’s Failure in the Subprime Mortgage Crisis’ (2008) Utah Law Review 1109.

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disclosure.25 Disclosure may not be able to address framing effects. The confirmation bias suggests that information which conflicts with prior assumptions may be discounted. The anchoring effect suggests that common anchors, such as past performance information, are likely to be over-relied on.26 Oral communications are likely to be considerably more effective than written communications27 – notwithstanding the resources poured into the design of written disclosures. The problem of information overload has been well documented,28 if sometimes contested.29 Labels pose particular problems;30 investors are, for example, inclined to judge risk based on thoughts associated with the label, rather than with reference to underlying exposures.31

b) The evidence A growing body of empirical evidence suggests that retail-market-oriented disclosure struggles to enhance the investor decision. The 2006 French TNS-Sofres report32 into mandatory disclosures found that small investors had only limited awareness of mandatory disclosures, finding them technical and inaccessible, often alarmist, too long, austere and inadequate in prioritizing key risks. It also bore out the intuition that different investor groups, with different risk profiles, react differently to disclosure,33 which compounds the difficulties faced by domestic regulators, and the EC, in designing disclosure for the elusive ‘average investor’. The FSA has, 25

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R. Deaves, C. Dine and W. Horton, How Are Investment Decisions Made?, Research Study prepared for the Task Force to Modernize Securities Legislation in Canada (2006) (‘Deaves Report’), p. 262. J. Gray and J. Hamilton, Implementing Financial Regulation: Theory and Practice (Chichester: John Wiley & Sons, 2006), pp. 207–8 (summarizing the impact of biases). R. Prentice, ‘Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for Its Future’ (2002) 51 Duke Law Journal 1397. T. Paredes, ‘Blinded by the Light: Information Overload and Its Consequences for Securities Regulation’ (2003) 81 Washington University Law Quarterly 417. D. Grether, A. Schwartz and L. Wilde, ‘Irrelevance of Information Overload: An Analysis of Search and Disclosure’ (1985–6) 59 Southern California Law Review 277; and R. Romano, ‘A Comment on Information Overload, Cognitive Illusions, and Their Implications for Public Policy’ (1986) 59 Southern California Law Review 313. See further ch. 3. L. Koonce, M. Gascho Lipe and M. McAnally, Judging the Risk of Financial Instruments: Problems and Potential Remedies (2004), ssrn abstractid=557863. TNS-Sofres, Report for the AMF, Investigation of Investment Information and Management Processes and Analysis of Disclosure Documents for Retail Investors (2006) (‘TNS-Sofres Report’). Ibid., p. 6. The FSA has highlighted similar difficulties: FSA, Financial Risk Outlook 2007, p. 81.

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from its establishment,34 and reflecting a long-standing UK disclosure preoccupation,35 engaged in extensive research on its retail market product disclosures; MiFID implementation has intensified these efforts.36 The FSA has focused primarily on the ‘packaged product’ regime and the requirement since 1994 that a Key Features Document (KFD) be prepared by product providers and distributed by those selling packaged products (section III below). As discussed in section II below, the tidal wave of research is ultimately doubtful as to the KFD’s impact on investor decisionmaking. In a revealing finding, the FSA has also found that retail investors associate the FSA and regulation with the prevention of mis-selling and sales practices, rather than with disclosure.37 The FSA’s research and the TNS-Sofres Report are located in the investor experience in two different markets and provide only a snapshot of investor reaction. But they, and the assumptions of behavioural finance, certainly suggest that the post-FSAP EC disclosure regime, which now dictates product and investment firm disclosure, to a very large extent, across the Member States, is required to do some very heavy lifting in both protecting and empowering investors, as seems to be borne out by the slowly emerging, pan-EC empirical evidence. The 2005 Eurobarometer on financial services found that only 15 per cent of respondents agreed that the information from financial institutions was clear and understandable.38 The 2008 Optem Report examined reaction to pre-contractual

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E.g. Informed Decisions? How Consumers Use Key Features: A Synthesis of Research on the Use of Product Information at the Point of Sale (Consumer Research No. 5, 2000). J. Black, Rules and Regulators (Oxford: Oxford University Press, 1997), p. 183. Including: FSA, Services and Costs Disclosure – Stage 3: Qualitative Research – Mock Sales Testing (Consumer Research No. 65c, 2008); FSA, Services and Costs Disclosure – Stage 2: Qualitative Research with Potential and Recent Purchasers of Financial Products (Consumer Research No. 65b, 2008); and FSA, Services and Costs Disclosure – Stage 1: Qualitative Research with Potential and Recent Purchasers of Financial Products (Consumer Research No. 65a, 2008). In 2008, only 10 per cent of those canvassed associated the FSA with information, while 28 per cent and 44 per cent associated the FSA with preventing mis-selling and ensuring fair treatment: FSA, Consumer Awareness of the FSA and Financial Regulation (Consumer Research No. 67, 2008), pp. 9–10. European Commission, Special Eurobarometer No. 203, Public Opinion in Europe on Financial Services: Summary (2005), p. 17 (the survey did not require participants to respond to all statements in the survey, so it cannot be safely assumed that 85 per cent were unhappy with disclosures). An earlier survey found that 58 per cent of respondents disagreed with the statement that information was clear and understandable (European Commission, Special Eurobarometer No. 202, Public Opinion in Europe: Financial Services: Highlights (2004), p. 12).

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investment disclosure,39 based on survey evidence from groups of consumers with some experience with investment products and from groups of inexperienced consumers, in all the Member States. Overall, attitudes to information ‘were marked by widespread distrust and dissatisfaction’, although investors were generally happier with information levels than consumers of financial services generally. Those more conservative investors who dominate in the EC market (typically consumers of investment products which the Report characterized as prudent ‘savers’) found disclosures to be complicated, obscure, complex, incomplete, often designed as marketing rather than information documents and insufficiently focused on risk; they relied on advice rather than on personal assessment of disclosure. More experienced and risk-tolerant investors, characterized by the Report as ‘gamblers’, had fewer difficulties, although they tended to gather information independently and from a wide range of sources. The third category, the inexperienced consumers who are critical to any attempts to promote stronger market savings, found disclosures complex and difficult to understand. Despite the focus of the EC regime on published disclosures, the Report also found that face-toface or telephone contact was preferable to written disclosures.

c) Comparability The link between disclosure, informed decision-making and comparability is particularly troublesome. Reflecting the empowerment model, greater comparability and informed choice are often associated with retail market disclosure internationally, and with product disclosure reform in particular.40 This link has particular resonances in the EC given the association between choice, competition and market integration. But comparability demands much of the retail investor. Typically, the retail investor struggles in making an informed comparison, as has been highlighted in a series of FSA studies41 and by the Optem Report, which found that comparisons were difficult to make and that investors were 39 40

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Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’) (it also considered other financial services disclosure). Comparability is, for example, one of ASIC’s ‘Good Disclosure Principles’, the 2008 SEC reforms concerning mutual fund interactivity data are designed to support comparability (SEC, Press Release 2008-94, available via www.sec.gov/news/press/2008/) and the Dutch AFM’s ‘Financial Leaflet’ regime is designed to support comparability (AFM, A Quantitative Risk Indicator for Financial Products (2007), p. 5). Including FSA, Levels of Financial Capability in the UK: Results of a Baseline Survey (Consumer Research No. 47, 2006), pp. 96–100 (finding that less than 50 per cent of those surveyed collected information from more than one company and that only 7 per cent

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‘overwhelmed’ by the range of ‘increasingly numerous and confusing’ offers available.42 The FSA, with considerable experience in the retail product market, has appeared sceptical as to the ability of product disclosures to support comparability,43 although it remains an important element of its product disclosure strategy;44 in particular, with its 2008 MiFID-related reforms to its firm services and costs disclosure regime, the FSA appears to favour clarity and firm flexibility over standardization and comparability.45 The comparability assumption appears entrenched, however, in the EC’s UCITS regime. The UCITS IV disclosure reform process saw some initial cooling of enthusiasm for comparability as an objective of the new regime and, by implication, a lightening of the load placed on the retail investor. The Commission’s May 2006 summary prospectus workshop, for example, acknowledged that immediate comparability between CISs, and a search for absolute uniformity of content and format, would be a ‘fool’s errand’, that a distinction was required between support of investor understanding and support of comparability and that investor understanding was the priority for UCITS disclosure.46 But the UCITS IV Proposal,47 and its adoption of the new Key Investor Information (KII) model, is firmly anchored to comparability and empowerment.48

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bought products on the basis of a ‘best buy’) and Consumer Perceptions of Basic Advice (Consumer Research No. 70, 2008) (finding that retail investors found the limited range of products sold under Basic Advice to be an advantage (p. 7)). Even more experienced investors tended to compare only two or three products. FSA, Consumer Research No. 5, p. 14; and FSA, Informing Consumers at the Point of Sale (Consultation Paper No. 170, 2003), pp. 44–5. The UK’s MiFID Article 4 application to retain its KFD product-disclosure requirements argued that standardization of format and content was necessary to minimize the risk of a lack of comparability between substitute products: HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC (2007) (‘UK Article 4 Application’), p. 20. FSA, Simplifying Disclosure: Information about Services and Costs – Feedback on CP0/3 and Final Handbook Text (Policy Statement No. 08/7, 2008). European Commission, Simplified Prospectus Workshop. Summary of the First Meeting of 15th May 2006 (2006) (‘May 2006 Workshop’), pp. 1 and 10. References to the reform (the ‘UCITS Recast’ or ‘UCITS IV’) are to the European Parliament text: European Parliament, Legislative Resolution of 13 January on the Proposal for a Directive of the European Parliament and of the Council on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (2009) (P6 TA-PROV(2009)0012, 2009). European Commission, Impact Assessment of the Legislative Proposal Amending the UCITS Directive (SEC (2008) 2236), pp. 30–1 and 34.

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The substitute product debate saw the Commission acknowledge the limitations of disclosure and the doubtful benefits of efforts to promote comparability across the universe of investment products.49 But comparability has re-emerged as an objective in its April 2009 proposals to reform the disclosure regime for packaged products (section III below).

3. The risks of disclosure The demand-side, investor-facing aspect50 of disclosure presents regulators who seek to empower investors through information with a formidable, and perhaps insurmountable, challenge51 given poor decisionmaking52 and an ever more complex product market.53 And, even where strenuous efforts are expended in the attempt to deliver effective disclosure, it does not follow that decision-making will be optimal.54 Responsibilization strategies which place more responsibility for savings and for risk monitoring on the investor, and which regard disclosure not only as a means of addressing information asymmetries but also as a technique for inculcating certain values,55 become highly troublesome.56 And, even if some degree of investor competence could be assumed, or even delivered through regulatory reform, the ability of retail investors to monitor and discipline firms on the basis of disclosure is doubtful given the severe difficulties they face in seeking redress, particularly cross-border. 49 50

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European Commission, Minutes of the Industry Workshop on Retail Investment Products (2008), p. 8. Disclosure has been characterized in terms of the demand side (interpretation) and the supply side (production and distribution): J. Macey, ‘A Pox on Both Your Houses: Enron, Sarbanes–Oxley and the Debate Concerning the Relative Efficiency of Mandatory Versus Enabling Rules’ (2003) 81 Washington University Law Quarterly 329. A. Schwartz and L. Wilde, ‘Intervening in the Market on the Basis of Imperfect Information: A Legal and Economic Analysis’ (1978–9) 127 University of Pennsylvania Law Review 630. Gray and Hamilton, Implementing Financial Regulation, pp. 212–15 (critiquing FSA reliance on disclosure). In the EC context, it has been queried whether EC reliance on disclosure may mask substantial unfairness in the bargaining process: Weatherill, EU Consumer Law and Policy, p. 85. S. Claessens, Current Challenges in Financial Regulation (2006), ssrn abstractid=953571, pp. 21–2. J. Rachlinski, ‘The Uncertain Psychological Case for Paternalism’ (2003) 97 Northwestern University Law Review 1165, 1177, suggesting that information and warnings are ‘useless’ if individuals make bad choices even in possession of good information. T. Williams, ‘Empowerment of Whom and for What? Financial Literacy Education and the New Regulation of Consumer Financial Services’ (2007) 29 Law and Policy 226; and Gray and Hamilton, Implementing Financial Regulation, pp. 49–50. It has been highlighted that responsibilization strategies can make ‘heroic assumptions’ as to investor ability: I. Ramsay, ‘Consumer Law, Regulatory Capitalism and the New Learning in Regulation’ (2006) 28 Sydney Law Review 9, 13.

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The considerable industry and regulatory resources expended on disclosure may therefore be misallocated57 at a time when regulation is under intense pressure from market turbulence and innovation, and given the demands of managing a cohort of novice investors and meeting the public policy expectation of wider market engagement. The assumption that disclosure can be used effectively by investors can lead to more specific regulatory design failures. Comparability difficulties, for example, are more likely to be addressed by industry58 or regulatory59 comparative search mechanisms, than by investors corralling and comparing mandated disclosures; information overload and product complexity can quickly lead to the rational response being not to exert choice given the costs of comparison.60 A key design question accordingly relates to whether disclosures provide information which is easily incorporated by these search mechanisms; the inconsistent requirements applied to UCITS and other substitutable investment products, to take a current example, limits the development of comparability tables.61 Industry compliance remains a formidable challenge, as is clear from the FSA’s experience;62 in 2008, the FSA warned that problems persisted with communications and disclosure generally, leading to the risk of investors being misled.63 The French AMF has also struggled with ensuring effective disclosure practice64 as has the Dutch AFM65 and CONSOB.66 The 57

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‘The . . . image of the investor bound up in a web of cognitive illusions and processing deficiencies, with little appetite for the truth, offers the discouraging possibility that many traditional strategies of investor protection may not be worth the cost’: D. Langevoort, ‘Theories, Assumptions and Securities Regulation: Market Efficiency Revisited’ (1992) 140 University of Pennsylvania Law Review 851, 912. Such as the Morningstar website which rates different funds. Such as the FSA’s Comparative Tables which provide comparative disclosures on a range of investment and savings products. Grether, Schwartz and Wilde, ‘Irrelevance’, 277. A point made by the admittedly partisan European Fund and Asset Management Association (EFAMA) during recent Commission consultations: European Commission, Minutes of the Industry Workshop on Retail Investment Products (2008), p. 4. FSA, Treating Customers Fairly: Measuring Outcomes (2007), pp. 14–15, noting poor compliance with TCF obligations with respect to the Key Features Document and marketing promotions. In its 2008 Financial Risk Outlook, the FSA warned that it was still seeing problems with communications and disclosure: Financial Risk Outlook 2008, p. 48. One survey revealed that only one in eight retail investors advised on fund investments received a fund prospectus: TNS-Sofres Report, p. 16. It has reported that the required Financial Information Leaflet was only provided for 8 per cent of complex products, in 30 per cent of cases no leaflet was provided and that Leaflets misrepresented costs, risks and returns: AFM, Annual Report 2006, pp. 52–3. A survey of split-capital UCITS marketed in Italy found that disclosure was often incomplete and not sufficiently comprehensible: C. Bracaloni, M. Antinarella, F. Martiniello and

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difficulties are all the greater given the adoption by MiFID of a principlesbased model for disclosure and the strains this places on supervision and enforcement. Reliance on disclosure may also mask the need for more radical firmfacing measures and for robust ‘law in action’ strategies, particularly with respect to deepening incentive risks in the product and advice market and when regulators face well-organized industry lobbies and the retail voice is muted. While structured and alternative investment products, for example, offer the benefits of potentially higher returns and sophisticated diversification techniques, disclosure is a very limited tool for dealing with the risks they pose to investors, which are likely to be better dealt with through the firm-facing and/or product rules which pose difficult design challenges. Harmonization injects further risks given wide variations in investor competence and experience, different degrees of retail investor trust in regulated disclosures, and divergences in how investors respond to different formats. Although the BME and Optem Reports point to common decision-making failures, evidence thus far is largely based in local markets; the Eurobarometer studies point to varying levels of satisfaction with disclosure across the Member States.67 Developing a disclosure template for the notional ‘average EC investor’ remains a challenge, even allowing for CESR’s capacity, in combination with the cross-sector 3L3 committees, CEBS and CEIOPS, to capture national regulatory expertise and market evidence, although the KII experience is heartening (section II below). The risks are increased by the limitations which harmonization may place on Member States’ ability to experiment with different disclosure formats and to respond to local risks. Some scepticism as to the value of disclosure as a retail market tool has become a feature of the UK regime. Although its efforts to improve investor understanding and processing of disclosure ‘in action’ are intensifying, the FSA appears to be withdrawing somewhat from heavy reliance on disclosure in the retail markets. While the unenthusiastic position of the FSA’s Financial Services Consumer Panel (FSCP) towards disclosure is not surprising,68 the FSA appears increasingly to appreciate the limits

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T. Marcelli, Survey on Disclosure and Correctness of Behaviour in Marketing Classes of Units and Shares of Harmonised UCITS in Italy (CONSOB Quaderno No. 60, CONSOB, 2007). The 2004 Study reported that, while 64 per cent, 66 per cent and 67 per cent of French, Italian and Swedish respondents, respectively, did not agree that information provided was clear and understandable, 44 per cent of Luxembourg respondents, 46 per cent of Finnish respondents and 44 per cent of Belgian and Irish respondents did: European Commission, Special Eurobarometer No. 202, p. 12. The Panel has criticized the FSA where regulatory solutions have increased the understanding burden placed on consumers, but where consideration has not been given to whether

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of disclosure, particularly in those policy areas currently outside the reach of the EC regime and where some flexibility exists.69 Its 2005 review of the treatment of ‘bundling’ and ‘softing’ conflict-of-interest risks in the execution process, and with respect to collective investment, for example, saw the FSA acknowledge that disclosure was a very limited tool in dealing with the conflicts-of-interest risks faced by retail investors.70 It proposed instead an innovative model based on CISs being required to appoint an ‘investors’ representative’ who would monitor disclosure, engage with the CIS and report to investors.71 Its 2005 review of whether its nonUCITS CIS regime (the ‘NURS’ regime) should be recast to incorporate wider range (alternative investment) products also saw some concern as to the effectiveness of disclosure,72 while the related extension of the NURS regime to accommodate funds-of-hedge-funds saw the FSA rely more heavily on manager-facing controls than on disclosure requirements.73 The FSA’s recent approach to substitute product risk also reveals some scepticism as to disclosure and a concern that the effectiveness, rather than the breadth, of disclosure be considered in any EC policy response.74 The radical attempts by the FSA to reform the advice and distribution regime through predominantly supply-side reforms under the Retail Distribution

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consumers can manage this burden: Financial Services Consumer Panel (FSCP), Annual Report 2004–2005, p. 16. ‘We have to acknowledge the findings from many of our reviews of the retail market which call into question how far traditional regulatory tools such as disclosure can really help consumers make sensible, informed decisions’: C. Briault, FSA, Speech on ‘Regulatory Developments and the Challenges Ahead’, 30 January 2008, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml. FSA, Bundled Brokerage and Soft Commission Arrangements for Retail Investment Funds (Consultation Paper No. 05/13, 2005), p. 8. Ibid., pp. 10–18. The FSA ultimately adopted a self-regulation model and ‘strongly encouraged’ firms to promote the representative model: FSA, Bundled Brokerage and Soft Commission Arrangements for Retail Investment Funds: Feedback Statement (Policy Statement No. 06/5, 2006), p. 4. The FSA queried whether disclosure could be provided on risks and outcomes in a manner which investors would understand and highlighted the importance of investability thresholds, conduct-of-business rules and product regulation in protecting investors: FSA, Wider Range Retail Investment Products: Consumer Protection in a Rapidly Changing World (Discussion Paper No. 05/3, 2005), p. 25. Although the FSA emphasized the importance of clear disclosures, it also noted the limitations of disclosure for opaque and complex products, particularly given low financial capability, and focused on manager-facing strategies: Funds of Alternative Investment Funds (Consultation Paper No. 08/4, 2008), p. 12. FSA, Response to the European Commission’s Call for Evidence on Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008) (‘FSA Substitute Products Response’), p. 13.

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Review (RDR) also suggest an acceptance of the limits of disclosure,75 as might the strenuous efforts being expended on the Treating Customers Fairly regime. Disclosure, rather than prescriptive asset allocation rules, has, however, been relied on in the FSA’s recent review of the listing rules for listed investment trusts;76 prescriptive asset allocation rules have been removed in favour of governance/board independence requirements and high-level transparency requirements.77 This disclosure-centric approach reflects, however, the institutional market in which trusts partly operate,78 and the roots of the investment trust regime in company law and its disclosure requirements, rather than in retail-market-focused product regulation.79 Disclosure is also central to the FSA’s recent discussion of how greater transparency can be used as a supervisory tool, but the FSA addressed the costs and risks of disclosure as well as its benefits, warning that disclosure was not a panacea for all market failures.80

4. Disclosure ‘in action’ But disclosure is not without merit. The engaged but vulnerable trusting investor who requires support in navigating the financial markets is not entirely irrational, has the capacity to learn and should be supported in becoming empowered and independent. Disclosure is central to long-term efforts to improve investor decision-making81 and to the appearance of a truly empowered investor. FSA evidence, for example, points to disclosure’s potential to enhance understanding of investment product charges.82 Demand-side disclosure strategies also carry the long-term promise of reducing the risks of more direct intervention in the 75

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While the RDR includes a labelling of advice services element, the FSA has acknowledged that ‘disclosure alone may be insufficient to ensure good consumer outcomes’: Retail Distribution Review (Feedback Statement No. 08/6, 2008), p. 25. FSA, Investment Entities Listing Review (Consultation Paper No. 07/12, 2007). FSA, Listed Investment Entities Review (Consultation Paper No. 06/21, 2006). Although the FSA highlighted the importance of its proposals for the retail sector given that ‘retail investment in listed investment entities totals many billions of pounds’: Consultation Paper No. 06/21, p. 4. Where investment trusts have a regular savings component, and thus a more direct retail market link, they are subject to the KFD requirement, but only 10,000 of the 844,000 investments sold in 2007–8 took this form: FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 8. FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008). Camerer et al., ‘Regulation for Conservatives’, 1233. CRA International, Benefits of Regulation: Effect of Charges Table and Reduction in Yield (2008) (‘2008 CRA Report’). The research into the impact of the FSA’s requirement that investment product disclosure include a Reduction in Yield figure and an Effect of Charges

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retail markets83 and of easing the severe pressure which must, by necessity, be placed on advice and distribution regulation. Persistence is required.84 But the focus must be on disclosure ‘in action’ and on ‘processability’85 rather than on expanding and refining disclosure ‘on the books’. Rather than despairing as to the irrationality of the decision-making process, regulators should embrace its complexity;86 the dominant short-cuts used in complex decision-making environments can, for example, be applied.87 Perseverance is required with labelling, format and design strategies. Practical reforms might include more attention to the time at which disclosure is provided; although variants of the ‘in good time’ formula are used across the directives, in practice disclosures are likely to be provided simultaneously with contract conclusion. Online disclosures require more attention, particularly if comparability is to be achieved. Clearly, design must not occur in a vacuum; much more careful testing of disclosure, the consolidation (and encouragement of the collection) of evidence from different local markets, and pan-EC studies on the lines of the 2007 BME Report and the 2008 Optem Report are all required.88 Design must also be linked to the achievement of identified and enhanced decision-making outcomes.89 The question is not simply whether the investor understands the disclosure. The key question is whether disclosure supports the investor in making an optimum investment decision. While the investment decision is highly personalized, the

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Table (n. 232 below) showed that 6–15 per cent of consumers experienced improvements in their ability to compare funds, rank funds and identify cheaper funds. Langevoort, Lawmaker. The FSCP has suggested that the FSA’s removal of its ‘Menu’ requirement (with respect to standardized disclosure of firm commissions) was premature, partly as the FSA had not considered the possibility of long-term improvements in investor understanding: FSCP, Annual Report 2007–2008, pp. 37 and 43. J. Cox and J. Payne, ‘Mutual Fund Expense Disclosures: A Behavioral Perspective’ (2005) 83 Washington University Law Quarterly 907, drawing on concepts developed by Russo (E. Russo, ‘The Value of Unit Price Information’ (1977) 14 Journal of Marketing Research 193); and, for a practical application, J. Kozup and J. Hogarth, ‘Financial Literacy, Public Policy and Consumers’ Self Protection – More Questions, Fewer Answers’ (2008) 42 Journal of Consumer Affairs 127. Rachlinski, ‘Uncertain Psychological Case’. 87 Kozup and Hogarth, ‘Financial Literacy’. Calls for disclosure to be ‘road-tested’ on retail investors are becoming increasingly frequent. E.g. Australia–New Zealand Shadow Financial Regulatory Committee, Responding to Failures in Retail Investment Markets, Statement No. 3, 25 September 2007. E.g. Better Regulation Executive (BERR) and National Consumer Council (NCC), Too Much Information Can Harm: A Final Report by the BERR and the NCC on Maximising the Positive Impact of Regulated Information for Consumers and Markets (2007) and BERR and the NCC, Warning! Regulated Information: A Guide for Policy-Makers (2008).

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regulatory regime already grapples with how regulation might support the achievement of optimum outcomes through the suitability regime.90 So too must the disclosure regime. Optimum decisions against which disclosure could be tested might include the investor adequately addressing diversification, market risks and the impact of costs and aligning the investment choice with her risk appetite and investment needs. An outcomes-based approach to disclosure is demanding.91 It requires much more than fiddling with formats and content.92 It calls for much deeper drilling into investor needs and risks and into how investors and disclosure interact. But it is necessary if disclosure is to be more than cosmetic. Efforts are also needed to integrate EC disclosure policy with the emerging financial literacy strategy;93 the strategy could, for example, highlight the importance of investors using regulated disclosures.94 Given incentive misalignment, it falls to public authorities to deliver key risk messages on the investment process more generally, whether through an investor education strategy or by requiring educational disclosures in regulated disclosures. There is also some evidence from the CIS context that financial capability strategies can improve decision-making, and thus the effectiveness of disclosure.95 But the EC’s investor education strategy is embryonic and, thus far, more concerned with overall financial literacy and basic money skills and there is no evidence of any enthusiasm for education messages to be incorporated into regulated disclosures. Some recent developments, however, augur well for EC disclosure policy ‘in action’. The UCITS Directive (section II below) has experienced a series of reforms which have culminated in the new KII model which – for the first time in EC investor protection regulation – is being tested on retail 90 91

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See further ch. 4. A recent US study on the proposed SEC mutual fund summary prospectus has found no evidence that it affected the quality of portfolio choice: J. Beshears, J. Choi, D. Laibson and B. Madrian, How Does Simplified Disclosure Affect Individual Mutual Fund Choices? (2008), available via www.aeaweb.org. ‘[T]he key lies not in the constant tweaking of documents in the hope that this time they will work to encourage rational and informed decision-making, but requires a return to “first principles” and a reassessment of the aims of, and potential for, information disclosure’: Gray and Hamilton, Implementing Financial Regulation, p. 213. The FSA is now relating disclosure reform to its financial capability initiatives and to ‘helping consumers to recognize the importance of these documents’: FSA, Reforming Conduct of Business Regulation (Consultation Paper No. 06/19, 2006), p. 124. J. Kozup, E. Howlett and M. Pagano, ‘The Effects of Summary Information on Consumer Perceptions of Mutual Fund Characteristics’ (2008) 42 Journal of Consumer Affairs 37. The 2008 CRA Report suggested that the increase in reliance on charges disclosure in investor CIS selection from 14 per cent in the 2002 Sandler Report to 28 per cent in its research might be related to FSA efforts to improve financial capability (p. 19).

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investors. While MiFID’s more general disclosure regime for investment services and investment products is problematic in many respects, it contains some innovations and its principles-based model carries the promise, at least, of supporting market innovation; the over-arching requirement that disclosure be fair, clear and not misleading may see disclosure become less a function of tick-the-box compliance and more a function of careful consideration of what is likely to meet investor needs, although this demands strenuous supervisory efforts. More generally, heartening evidence is emerging of an appreciation of the limits of retail market disclosure, particularly in MiFID’s support of supply-side fiduciary principles, and of the need to test disclosure formats.96 Institutionally, FIN-USE has emerged as a vocal sceptic of disclosure;97 it should provide the constant irritant required to drive improvements. The 2007 Green Paper on Retail Financial Services revealed some scepticism concerning disclosure, and highlighted concerns that investment product disclosure, in particular, is too complex, inadequate, difficult to understand and does not support informed choice,98 while the Commission’s commitment to reviewing the pre-contractual disclosure regime, given the risk that the ‘current variety and accumulation’ of information could confuse both the industry and consumers,99 generated the important 2008 Optem Report. Even in the troublesome issuer disclosure field, where disclosure reform lags some considerable distance behind reform in the investment product sphere (despite some evidence of heavier reliance by direct investors on disclosure100 ), there are some signs of an emerging concern to improve prospectus disclosure, if not ongoing disclosure.101 The lesson from the mass of evidence now emerging on the effectiveness of disclosure is a cautionary one. Disclosure is arguably the most cumbersome of the three main levers (design, disclosure and distribution) 96

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The US SEC, by contrast, has been described as having a ‘hard cultural shell’ of resistance to evidence which might suggest that its reliance on disclosure is not warranted: Langevoort, Lawmaker, p. 20. E.g. FIN-USE, Opinion on the Commission Green Paper on the Enhancement of the EU Framework for Investment Funds (2005); and FIN-USE, Financial Services, Consumers and Small Businesses: A User Perspective on the Report of the Banking, Asset Management, Securities and Insurance of the Post FSAP Stocktaking Groups (2004). European Commission, Green Paper on Retail Financial Services, p. 16. European Commission, White Paper on Financial Services, pp. 6–7. Deaves Report, p. 247. By contrast, however, the TNS-Sofres Report found that 49 per cent of investors described as active shareholders used disclosures from listed companies, while 75 per cent of collective investment scheme investors used disclosures from financial institutions: TNS-Sofres Report, pp. 9–10. See further ch. 6.

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at the regulator’s command, given its dependence on investor capability. Real improvements in investor outcomes are, in the short to medium term at least, most likely to be a function of the advice/distribution process, the efficiency of which is related to the product design process. But disclosure has a role to play in the advice/distribution process. It may be that alternative targets for disclosure should be factored into the design of disclosure. Given the evidence of heavy dependence on advisers, of some form or other, across the Community, and persistent concerns as to the quality of advice and, increasingly, concern that advisers do not understand the products which they distribute, it may be that product disclosures are better regarded as targeted towards the adviser, rather than the ultimate investor.102

II. Investment product disclosure (1): the UCITS regime 1. Designing CIS disclosure: the challenge a) Disclosure difficulties Disclosure is strongly associated with investor protection in the CIS sphere.103 By improving decision-making it can, in theory, enhance product quality and lead to downward pressure on CIS costs.104 But designing effective disclosure for CISs is complex given the weight of evidence demonstrating that investors do not read CIS disclosures, find them complex and favour short-form disclosures.105 The difficulties are compounded by the dual role of pre-contractual CIS disclosures as investor 102

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As has been suggested by the FSA’s FSCP (FSCP, Annual Report 2007–2008, p. 43). CESR has similarly acknowledged that the KII model should allow advisers to compare products (CESR 2008 KII Advice, p. 24), while a leading retail market stakeholder has suggested that the effectiveness of the KII be tested on advisers: Danish Shareholders’ Association, Response to CESR’s Key Investor Information Consultation (2007), p. 1. E.g. Zingales’ prescription for post-credit-crunch securities regulation reform includes CIS disclosure reforms (L. Zingales, The Future of Securities Regulation (2009), ssrn abstractid=1319648), while the Dutch AFM has noted that ‘consumer responsibility in an increasingly dynamic financial arena starts with proper provision of information’: AFM, Risk Indicator, p. 5. Cox and Payne, ‘Mutual Fund Expense’, 930. One US industry study (Investment Company Institute, Understanding Investor Preferences for Mutual Fund Disclosure (2006)) found that only one-third of investors surveyed read fund prospectuses, 60 per cent found them difficult to read and 90 per cent preferred short-form disclosure: pp. 4–5 and 8–9. The similar and extensive UK evidence includes FSA, Consumer Research No. 5, which reported that investors were ‘simply not reading’ product disclosures (at pp. 22–3) and FSA, Key Facts Quick Guide: Research Findings (Consumer Research Paper No. 41, 2005).

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information and as marketing devices and the risk that investors dismiss disclosures as marketing efforts. Complex CIS prospectuses, it is now clear, serve little purpose for the retail investor who prefers concise summaries. Past performance information, a widely used marketing tool for CISs (and notwithstanding firms’ awareness that past performance is not a good indicator of future performance106 ), is particularly problematic. While it is emphasized by retail investors,107 extensive research shows that it is often poorly understood and vulnerable to over-reaction.108 Strong past performance has been repeatedly shown to lead to abnormally high CIS inflows.109 Past performance disclosure has also been associated with often prejudicial procyclical investment patterns.110 Decision-making risks have led to calls for a prohibition in some quarters, given that the risks might be accentuated by its inclusion in regulated disclosures.111 The traditional pairing of past performance disclosure requirements with risk warnings as to its limitations certainly appears disingenuous.112 The FSA appears keen to downplay its importance,113 although it persists in the EC regime; the 106 107

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P. Jain and J. Wu, ‘Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows’ (2000) 55 Journal of Finance 937, 957. Forty-eight per cent of investors surveyed in the BME study identified past performance information as fairly or very important in making an investment decision: BME Report, p. 148. A series of FSA studies show that past performance is not a reliable indicator of future CIS performance, that it is not exploited effectively by investors, who can react emotionally to it, and that interpretation difficulties are considerable: FSA, Report of the Task Force on Past Performance Information (2001); FSA, Past Imperfect: The Performance of UK Equity Managed Funds (Occasional Paper No. 9, 2000); and FSA, Standardization of Past Performance Information (Consumer Research No. 21, 2003), p. 7. The FSA has also highlighted the particular risks it poses in the promotion of complex products: FSA, Financial Risk Outlook 2006, p. 87. Deaves Report, pp. 241, 258–9. J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government (2005) (‘Delmas Report’), p. 9. A minority of the FSA’s 2001 taskforce recommended a prohibition given that past performance does not predict future performance, is difficult to present without inviting over-reliance and risks the perception of regulatory endorsement: FSA, Report of the Taskforce, p. 15. Hu has criticized the SEC’s past performance disclosures and risk warnings citing an experiment in which students told ‘not to think of a white bear’ found it very difficult to comply: H. Hu, ‘The New Portfolio Society, SEC Mutual Fund Disclosure, and the Public Corporation Model’ (2005) 60 Business Lawyer 1303, 1314–16. Similarly, Palmiter and Taha argue that the tendency for investors to be ‘mesmerized’ by past performance disclosure is unlikely to be addressed by a requirement for this disclosure: Palmiter and A. Taha, Mutual Fund Investors, pp. 27–8. E.g. Consultation Paper No. 170, p. 9.

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recent KII reforms have not grasped the abolition nettle. Projections, another feature of CIS disclosure, raise similar difficulties. Retail investors also face particular difficulties in comparing risk profiles and risk-return models. Standardized or synthetic risk indicators can support investor understanding and comparability114 and have emerged as a feature of the recent market115 and regulatory116 attempts to enhance disclosure. But they raise complex issues for regulatory design, not least as they must engage with poor retail investor understanding of risk and must balance risk proxies with investor perceptions of risk. There is also some doubt as to whether they can drive informed decision-making,117 particularly as they may over-simplify the investment decision.118 Similarly, labelling devices, designed to signal the type of investors likely to invest in the fund, carry the risk of blurring the distinction between product development and the suitability obligations imposed on the distribution layer. Costs disclosure is particularly sensitive given the range of costs which can be incurred directly and indirectly by the investor119 and as costs are a key determinant of, and can impact heavily and detrimentally on, returns.120 Costs are also the most important way in which managers can extract value to the detriment of investors, given the conflict-of-interest 114

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The retail sector tends to support risk indicators. The Optem Report found poor investor engagement with terms such as ‘medium-low’ risk but support for numerical indicators (p. 109). Nationally, the TNS-Sofres Report noted that investors were receptive to composite risk indicators (p. 41), while the Dutch AFM has reported that consumers attach great importance to visual risk presentations, with 63 per cent preferring graphic presentations: AFM, Risk Indicator, p. 6. Similarly, the FSA’s FSCP undertook research which showed retail investor appetite for risk indicators, although some concern as to whether indicators were trustworthy (FSCP, Annual Report 2007–2008, p. 41). CESR has pointed to the efforts made by the asset management industry to develop risk indicators on a voluntary basis: CESR, Advice to the European Commission on the Form and Content of Key Information Disclosures for UCITS (CESR/08-087, 2008) (‘CESR KII Advice 2008’), p. 33. The AFM’s Financial Information Leaflet for investment products requires that a graphic risk indicator of volatility, in the engaging form of a person carrying a burden, is provided (it is designed to reflect the average payout in the event of unfavourable contingencies after particular time periods), although only 50 per cent of risk indicators were found to be in order following a 2006 review: AFM, Annual Report 2006, p. 52. Palmiter and Taha, Mutual Fund Investors, pp. 35–6. IMA, Response to CESR KII Consultation, 18 December 2007, pp. 2 and 15. Including: direct exit and entry costs; indirect costs charged to the scheme, including marketing and distribution costs, management and administration costs, and portfolio transaction costs (or the brokerage costs of executing fund transactions); performance fees; and fee-sharing arrangements and soft commissions. Oxera, Towards Evaluating Consumer Outcomes in the Retail Investment Products Markets: A Methodology: Prepared for the Financial Services Authority (2008), pp. i–ii.

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rules and asset protection rules, concerning managers and depositaries, which typically apply (including under the UCITS regime121 ) to potentially prejudicial transactions between managers and the CIS.122 Distributionlinked conflict-of-interest risks also arise through the payment of fees and commissions to distribution networks and advisers. The difficulties are exacerbated by the well-documented difficulties faced by investors in extracting and understanding the extent, nature and implications of different costs from prospectus disclosure.123 There is some evidence that investors may, over time, become more aware of the impact of front-end fees and so impose competitive discipline on high-cost schemes.124 But investors appear to have considerable difficulties in assessing the impact of more opaque operating expenses and in discounting the effect of marketing costs.125 The complexities of effective cost disclosure are only increased by the growing tendency for investment product sales and advice to be provided through wraps and platforms, which can further complicate cost disclosure.126 The difficulties are all the greater as cost disclosure in isolation is of limited use without comparability.127 The design challenges are therefore formidable. The UK regime, for example, relies on two devices, Reduction in Yield disclosure and the Effect of Charges Table; but, although FSA research suggests that these devices can improve investor understanding, the margin for improvement is considerable.128 121 122 123

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See further ch. 3. J. Coates and R. Hubbard, ‘Competition in the Mutual Fund Industry: Evidence and Implications for Policy’ (2007) 33 Journal of Corporation Law 151, 161. The 2008 CRA Report, for example, found that, while retail investors had some understanding of the importance of charges, there was a weak correlation between fund inflows and charges and that only 28 per cent of investors highlighted charges as a main factor in the product decision: pp. 3 and 17–19. In the Australian context, ASIC (ASIC, Report 23, A Model for Fee Disclosure in Product Disclosure Statements for Investment Products (2003) (which followed the Ramsay Report on fee disclosure (I. Ramsay, Disclosure of Fees and Charges in Managed Funds (2002)) has highlighted that fee disclosure is the ‘most difficult to understand’ for retail investors (p. 10). Poor investor ability to assess costs has also been the subject of an extensive US scholarship. E.g. J. Freeman and S. Brown, ‘Mutual Fund Advisory Fees: The Costs of Conflicts of Interests’ (2001) 26 Journal of Corporation Law 609; and J. Bogle, ‘Reformulating the Mutual Fund Industry: The Alpha and Omega’ (2004) 45 Boston College Law Review 391. Coates and Hubbard, ‘Competition’. B. Barber, T. Odean and L. Zheng, ‘Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows’ (2005) 78 Journal of Business 2095. FSA, Platforms: The Role of Wraps and Fund Supermarkets (Discussion Paper No. 07/2, 2007), pp. 45–7. Payne and Cox, ‘Mutual Fund Expense’, 935–6. 2008 CRA Report, pp. 37–43.

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b) Reform efforts The disclosure challenge is therefore considerable. But its careful management lies at the core of efforts to support an effective demand side, although resolution thus far appears to have eluded regulators, despite strenuous international reform efforts. A convincing argument can be made that CIS disclosure, which traditionally focuses on the scheme’s investment management mandate and objectives, does not capture retail investor risks, as returns are largely dependent on the scheme’s choice of asset class, and regulated disclosures should accordingly focus on the relative risks and performance of different asset classes.129 The current international reform movement is, however, less ambitious and focuses on the simplification of detailed prospectus disclosures.130 Following concerns as to the inappropriateness of fund disclosure in delivering key investor protection messages,131 the US SEC, for example, reformed its disclosure regime in 1998 to allow funds to prepare a ‘profile’ containing key disclosures.132 The voluntary profile was not, however, widely used by retail market funds given the liability risks from any omission of material information, and in 2007 the SEC announced significant reforms, requiring product providers to include standardized, simplified disclosures in prospectuses.133 These efforts have been followed by reforms designed to facilitate the comparability of required disclosures across funds through an interactive data model.134 The simplification of product disclosure has also been a feature of the Australian regime which has seen short-form, principles-based disclosure reforms.135 These efforts have been replicated in the Community. The FSA’s Key Features Document (KFD) for ‘packaged products’, which includes a ‘key facts’ logo to raise investor awareness of the importance of regulated disclosures and to deal with the risk of confusion between marketing documents and regulated disclosures, supports disclosure across a range 129 130 131 132

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Hu, ‘The New Portfolio Society’. Well reflected in IOSCO, Investor Disclosure and Informed Decision-Making: Use of Simplified Prospectuses by Collective Investment Schemes (IOSCO, 2002), p. 2. R. Robertson, ‘In Search of the Perfect Mutual Fund Prospectus’ (1999) 54 Business Lawyer 461, 475. Release No. 33-7513 (1998). The SEC also amended its disclosure rules for full mutual fund prospectuses as it was concerned that prospectuses are often ‘legalistic disclosure documents that are difficult to read, hard to understand and prepared with litigation in mind’: SEC Release No. 33-7512 (1998). SEC, Press Release 15 November 2007, available via www.sec.gov/news/press/2007/. SEC, Press Release 2008-94, available via www.sec.gov/news/press/2008/. Australian Treasury, Refinements to Financial Services Regulation: Proposals Paper (2005).

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of packaged investment products (including UCITS, non-UCITS CISs, investment trusts with a regular savings component and unit-linked insurance products). The KFD is delivered at the point of sale, along with disclosure on product charges and, for life insurance products, projections of the possible return based on different growth assumptions (the Key Features Illustration). From the outset, it has undergone a series of reviews which all point to the complexities of effective disclosure design.136 A 2000 review found that consumers did not have greater understanding when provided with the KFD, that they sought other disclosures, were confused by the terms used and unable to compare products, had poor understanding of charges, often did not read the documents and that the brand and reputation of the product provider were more influential on the investment decision than disclosure;137 investors also preferred to rely on advisers or choose investments on the basis of past performance.138 In 2005, the FSA considered replacing the KFD with a shorter ‘Quick Guide’139 following market testing which underlined the importance investors attach to clear and short documents.140 But this reform was abandoned in 2006 following extensive research141 which suggested that, while investors liked the Quick Guide, its benefits as compared to the KFD would be limited and implementation costs considerable.142 The FSA has, however, streamlined the KFD, partly in response to MiFID’s disclosure requirements, to make it shorter, more focused and better laid out and to allow firms flexibility in tailoring KFDs to their specific products and target audiences.143 But, despite the FSA’s long experience with, and focus on, 136 137 138 139

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E.g. FSA, Consumer Research No. 5; FSA, Consultation Paper No. 170; and FSA, Projections Review – The Case for Change (Discussion Paper No. 04/1, 2004). FSA, Consumer Research No. 5. Ibid., p. 25. Similar results concerning heavy adviser reliance were reported later in FSA, Key Facts Quick Guide: Research Findings (Consumer Research No. 41, 2005), pp. 8–9. FSA, Investment Product Disclosure: Proposals for a Quick Guide at the Point of Sale (Consultation Paper No. 05/12, 2005); and FSA, Consumer Research No. 41. In addition to format and presentation reforms, the Quick Guide was designed to adopt a ‘less is more’ approach. The KFD was found to be failing to lead investors to read the document and to support informed decision-making, given a perception that it was ‘boring’ and failed to ‘stand out’ as an important source of information. Investment Disclosure Research (Consumer Research No. 55, 2006); and Point of Sale Investment Product Disclosure: Feedback Statement (Feedback Statement No. 06/5, 2006). FSA, Consultation Paper No. 6/19, pp. 119–32. A. Sykes (FSA), Speech, KFD Seminar, 6 May 2008, available via www.fsa.gov.uk/Pages/ Library/Communications/Speeches/index.shtml.

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the KFD, it remains problematic.144 A 2007 assessment revealed that only 15 per cent of KFDs met the required standard, over one-third were poor or ineffective,145 and that, while the remaining documents met formal regulatory requirements, only well-informed and engaged investors would have been able to understand the important features of the product in question.146 While the FSA has called for significant and sustained improvements in KFD standards,147 the scale of the supervisory effort required, the range of levers which the FSA deems necessary to drive stronger compliance (including enforcement and industry measures148 ) and the persistence of industry failures149 does not augur well for MiFID’s principles-based investment product disclosure regime, discussed below. The Dutch AFM has also focused on investment product disclosure. Since 2002, it has required a ‘Financial Information Leaflet’ for a range of investment products.150 Reflecting the FSA’s experience, the leaflet has been reformed,151 but nevertheless it is generally regarded as a successful model.152 CIS disclosure has also been a concern of empirical study and reform in France.153

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E.g. FSA, Consumer Purchasing and Outcomes Survey (Consumer Research No. 76, 2009). FSA, Treating Customers Fairly – Measuring Outcomes (2007), p. 15. FSA, Good and Poor Practices. FSA, Major Retail Thematic Work Plan for 2008–2009, p. 5. The drive to improve the KFD is based on engagement with trade associations, the inclusion of KFD quality in the FSA’s Major Retail Thematic Work Plan and specific supervisory and enforcement strategies. The 2008–2009 Major Retail Thematic Work Plan, for example, saw the FSA commit to addressing poor KFD compliance with individual firms, working with trade bodies to improve KFD production and reviewing a subsequent sample of KFDs to assess compliance: ibid. Poor compliance occurs across small and large firms: FSA, Good and Poor Practices, p. 7. Enhancing product transparency has been a key priority of the AFM: AFM, Policy and Priorities for the 2007–2009 Period (2007), p. 7. A 2004 assessment concluded that its effectiveness could be improved if it contained less information, the language was simpler and the presentation more attractive: European Commission, Simplified Prospectus Workshops 15 May 2006 and 11 July 2006: Issues Paper (2006) (‘Prospectus Workshops Issues Paper’), p. 20. More than 70 per cent of consumers regard the Leaflet as assisting their understanding of investment products: AFM, Development of a New Obligatory Financial Leaflet (2006), presentation attached to European Commission, Simplified Prospectus Workshop 11 July 2006. In addition to the TNS-Sofres Report, 2006 also saw the French AMF, in collaboration with the industry, test a standardized format which highlighted key features on one side and set out regulatory information on the other: Delmas Report, p. 26.

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CIS disclosure reform also requires consideration of the degree to which intervention is appropriate. Detailed prescription in support of comparability and standardization is likely to lead to obsolescence risk, stunt industry innovation and impose regulatory perceptions as to investor needs which may be ill-considered. Innovative industry solutions can be developed: EFAMA has developed a CIS classification system designed in part to address the severe limitations on effective investor choice across the universe of UCITS and non-UCITS funds.154 It has also developed a model simplified prospectus.155 But industry incentives to produce effective disclosure can be weak given the limited discipline exerted by retail investors and the evidence of poor industry compliance unless the regulatory incentives are strong. Quality may also be a significant casualty if standards are not sufficiently rigorous;156 the Dutch AFM’s experience with self-regulatory codes of conduct for disclosure on structured securities has not been encouraging.157 The difficulties are all the greater in the EC/UCITS context. Harmonization carries a series of benefits aside from supply-side cost reduction, including support of standardization, which seems to be favoured by EC investors.158 But the relative inexperience of the EC as a retail market regulator stands in stark contrast to the intensive and yet often flawed efforts made by regulators worldwide. Particularly acute difficulties arise concerning the target investor, given the wide variances in competence, risk appetite and investment behaviour across the EC and the inevitable tendency of reforms to rely on troublesome models of the ‘average’ or ‘typical’ investor. But some conception of what information is, in practice, regarded by ‘EC investors’ as important must be married to rule design if effective 154 155

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EFAMA, The European Fund Classification (2008). FEFSI, User Manual for its Model Simplified Prospectus. In the UK, the Association of British Insurers’ Raising Standards Quality Mark Scheme has also been associated with a simplification of disclosure standards. In its Article 4 application to retain its KFD regime for non-UCITS products, the FSA argued that ‘past experience in the UK market indicates that the standard and quality of information provided to clients would be uneven and inconsistent without an obligation to provide prescribed information in a relatively standard form’: Article 4 Application, p. 20. European Commission, Record of the Open Hearing on July 15 2008 on Retail Investment Products (2008), pp. 16–17 (in which the AFM highlighted the difficulties it faced in ensuring consistent and comparable information). The Optem Report reported some investor enthusiasm for a ‘standardized sheet’ for investment product disclosure as it would ‘facilitate comparisons’ and help investors to ‘get to grips with the sector’ and ‘gain back some autonomy from banks, financial institutions and other professionals’: Optem Report, p. 113.

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outcomes are to be achieved. Effective disclosure depends heavily on ‘processability’, on formats and on standardization; but these have not been features of the EC retail market regime until very recently. Some degree of flexibility is also required to support innovation and avoid cumbersome ‘one-size-fits-all’ models; the UCITS regime has prevented Member States from making radical reforms, such as the abolition of past performance disclosure requirements or with respect to format requirements.159 The market integration imperative can also mask the nature of the reforms required in practice. The troublesome UCITS simplified prospectus was designed to support market integration and to be used as a ‘single marketing tool throughout the Community’160 in that the host Member State is not permitted to impose any additional prospectus requirements or modifications, bar translation requirements (UCITS Directive, Article 28(3)). But the document failed to support investor understanding, although it was described as ‘a benchmark marketing tool, the culmination of the Commission’s maximum harmonization approach in this matter’.161 The prize is considerable, however, not least as effective disclosure ‘in action’ may reduce the tendency of investors to over-rely on potentially conflicted intermediation channels.

2. The EC laboratory a) The UCITS disclosure regime The harmonized UCITS disclosure regime is of central importance to the EC’s attempt to build an informed cohort of retail investors. It is also a key indicator for whether the EC’s commitment to the demand side is anchored to practical, operational innovations and disclosure ‘in action’. The evolution of the disclosure regime from an arcane original model, based on extensive disclosure and designed, in part, to support cross-border marketing by the UCITS, to an evidence-based, investorfacing model, designed to support informed decision-making, marks a sea-change in EC retail disclosure policy. It also illustrates the ability of the 159

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The restrictions imposed by the UCITS simplified prospectus regime were highlighted by the FSA in its attempts to remodel its KFD: for example, FSA, Consultation Paper No. 170, p. 9. European Commission Recommendation 2004/384/EC of 27 April 2004 on some contents of the simplified prospectus, OJ 2004 L144/42 (‘Simplified Prospectus Recommendation’), recital 1. European Commission, Communication to the Parliament on the Common Position (SEC (2001) 1004), para. 3.2.2.7.

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EC investor protection regime to incorporate practical disclosure reforms and, through CESR, to capture national innovation in disclosure design. It remains to be seen whether the new KII design, which forms part of the UCITS IV reforms, will be effective, but the redesign process is a landmark in the development of the EC investor protection regime.

b) Poor disclosure design The UCITS Directive disclosure regime is characterized by its assumption that disclosure can support investor understanding but also, until recently, unsatisfactory attempts to deliver processability. It is unfair to criticize the regime for its original (and current) requirement for detailed prospectus disclosure and annual/half-yearly financial reports, which must be made available to UCITS subscribers, and distributed cross-border where the UCITS is marketed outside its home State (Articles 27(1), 32, 33 and 47), which reflects in part the requirements of professional investors. Similarly, the linkage between the UCITS III reforms and the introduction of related disclosure requirements concerning the increased risk profile of UCITS III products is not unreasonable in principle (Article 24a). But difficulties arise concerning the treatment of UCITS disclosures which are expressly targeted to the retail investor and the poorly executed attempts to support investor understanding, particularly with respect to UCITS III products.162 The UCITS regime has struggled in reconciling its attachment to the notion that retail investors can decode disclosures with the challenges posed by achieving processability ‘in action’. The detailed prospectus must, for example, contain the information necessary for the investor to make an informed judgment of the investment proposed (Article 28), and the current cumbersome translation regime, which requires translation of disclosures into host State languages (Article 47), carries the implication that investors will read the disclosures. On the other hand, prospectus and financial report disclosures are lengthy (Schedules A and B) and prospectus disclosures can be distributed and fragmented across the UCITS prospectus and constitutional documents (Article 28(2)). The simplified prospectus requirement, introduced with the UCITS III reforms,163 162

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Concerns have been raised that UCITS III prospectus disclosure might be insufficient to support retail investor understanding of the risks: PricewaterhouseCoopers, Investment Funds in the EU: Comparative Analysis of the Use of Investment Powers, Investment Outcomes and Related Risk Features in Both UCITS and Non-Harmonized Markets (2008) (‘2008 PwC Investment Powers Report’), p. 67. Directive 2001/107/EEC of 21 January 2002, OJ 2001 No. L41/20 (‘Management Company and Prospectus Directive’).

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while an important staging post (along with its partner 2004 Recommendation on the content of the simplified prospectus), clung to the notion that short-form disclosures, without more, could support better decisionmaking. The simplified prospectus was to constitute a ‘key element of investor protection’,164 to deliver key information about the UCITS in a clear, concise and easily understandable way165 and to allow the investor to make an ‘informed judgment’ of the investment proposed and its risks (Article 28(1)). Its partner Recommendation was designed in part to support comparability (recital 7). These ambitious aims were delivered largely by means of a requirement that it provide a ‘clear and easily understandable’ explanation of the UCITS risk profile (Article 28(1)). It also introduced the elusive notion of the ‘average investor’ who should be able to understand the prospectus easily (Article 28(3)) and required a discussion of the profile of the ‘typical investor’ the UCITS is designed for. But the simplified prospectus was adopted without ex ante testing.166 It only shortened and highlighted the still lengthy disclosures to be made to retail investors (UCITS Directive, Schedule C). It did not address format and did not address the particular decision-making difficulties, notably with respect to past performance and costs, experienced by retail investors. Although, for the first time in EC securities regulation, it addressed past performance, requiring that details of UCITS past performance be provided and a warning that it is not an indicator of future performance (Schedule C), it did not engage with presentation or format (although the Recommendation suggested bar-chart presentation (Recommendation 1.5.1)). The Recommendation was equally traditional, containing, for example, a risk disclosure regime of such detail167 as would represent a challenge to the most diligent of retail investors, although it also recommended that risk disclosures be relevant, material and based on risk impact and probability, and prioritized (Recommendations 1.4.1 and 1.4.2.3). More innovative attempts to support understanding included the suggestion that Member States develop a quantitative synthetic risk indicator to represent the volatility of UCITS, and the important recommendation that Member States adopt a Total Expense Ratio (TER) (Recommendation 2.2.1) which 164 165 166 167

Management Company and Prospectus Directive, recital 2. Management Company and Prospectus Directive, recital 15. FIN-USE, User Perspective, p. 25; and CESR KII Advice 2008, p. 11. The Recommendation covers the specific and horizontal risks which should be covered by a ‘brief and understandable’ explanation, including market, credit, settlement, liquidity, custody, concentration, performance, capital, guarantee, flexibility, inflation and environmental (including taxation) risks.

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would indicate all costs borne by the investor in relation to the investment, calculated with respect to the fund’s total operating costs (the TER does not, however, include entry and exit costs or portfolio transaction costs or address distribution costs directly168 ). The Recommendation was, however, constrained by its voluntary nature and variable implementation, particularly with respect to the risk indicator which, in theory at least, had some potential,169 did not reflect domestic presentation innovations and did not engage with the standardization of formats. The UCITS regime also struggles with ‘point-of-sale’ delivery of disclosure, often identified as key for informed decision-making.170 The prospectus delivery requirement applies only to the UCITS investment company or management company, and so to direct sales to investors. But the range of channels through which UCITS can be sold include intermediated/advised sales through UCITS-affiliated actors, third-party channels, including open-architecture distribution networks and independent financial advisers, and sales of wrapped products. The prospectus may not, therefore, be delivered at the point of sale. Where the third-party distributor or adviser is a MiFID firm, MiFID disclosure requirements apply, but MiFID imposes only high-level disclosure requirements and does not require that investors be provided with a UCITS prospectus (although its disclosure requirements may be satisfied by supplying investors with a UCITS prospectus (MiFID Level 2 Directive, Article 34)). The quality of advice also depends on MiFID distributors and advisers receiving effective disclosure from UCITS product providers,171 which is not addressed by the UCITS regime. Dissatisfaction with the simplified prospectus soon emerged; in itself, this groundswell is revealing, reflecting the emergence of a wider concern 168

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It covers the total UCITS operating costs deducted from the UCITS’ assets and includes management costs and performance fees, administration costs and audit fees: Recommendation, Annex I. The indicator was adopted by only five States: CESR, Implementation of the European Commission’s Recommendations on UCITS: Report of the Review Conducted by CESR (CESR/05302b, 2005), p. 5. FSA, Consultation Paper No. 170, p. 12; and Deaves Report, p. 305. The FSA has warned that distributors can receive poor-quality information from product providers: FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Discussion Paper No. 06/4, 2006). Point-of-sale disclosures were the subject of US reform proposals which would have required broker-dealers to provide investors with a short-form document (addressing key risks and commission disclosure) which acknowledged the need for close communication between product providers and brokerdealers: NASD Mutual Fund Taskforce, Report on Mutual Fund Distribution (2005).

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to support the retail sector and enhance processability. Industry dissatisfaction combined with concerns as to the inadequacies of the simplified prospectus, particularly given its length and complexity,172 its inability to represent costs effectively and the failure of the TER, its failure to support standardization and the weaknesses of the detailed and complex Recommendation.173 The difficulties were exacerbated by the constraints the regime placed on regulators in developing innovative local disclosure documents. By 2006, the Commission’s dismal finding was that the prospectus had ‘manifestly failed . . . [it was] too long . . . not understood by its intended readers’ and had generated a ‘massive paper chase of limited value to investors and a considerable overhead for the fund industry’.174

c) Reforming UCITS disclosure: the Key Investor Information document Unlike the previous incremental and untested approach, the redesign of UCITS disclosure and the construction of the new Key Investor Information (KII) document, a two-page document which will replace the simplified prospectus and harmonize format, content and presentation, has been based on a vastly more nuanced appreciation of investor competence and vulnerability and on a much clearer vision of the role of summary CIS disclosure. The reform has been traditional in that it has eschewed soft law and industry measures and is based on greater harmonization, rather than on the supervisory convergence techniques which are now available at level 3 but which were, reflecting unhappiness with the Recommendation, rejected as insufficiently robust to support a new disclosure system.175 The EC’s regulatory role in developing retail market disclosure formats now appears to enjoy relatively wide industry and investor support.176 The 172

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The TNS-Sofres Report found that only one-quarter of investors read or skimmed the simplified prospectus (p. 26) and that, while it was generaly popular with retail investors and regarded as ‘reassuring’, it was not easy to understand (p. 41). FIN-USE warned that, ‘while a step in the right direction’, it contained far too much information: FIN-USE, Opinion on the Investment Funds Green Paper, pp. 3 and 6. Major concerns included: inconsistent implementation of the Recommendation leading to increased complexity and poor comparability; overly long and complex simplified prospectuses which varied in length from two to four pages (UK), to eight (France), to eleven (Italy); and its non-binding nature: Commission, Feedback Statement to the Green Paper on Enhancing the European Framework for Investment Funds (2006), p. 8; and May 2006 Prospectus Workshop, p. 6. European Commission, Investment Funds White Paper, p. 10. E.g. Prospectus Workshops Issues Paper, p. 10. 176 Ibid.

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risks of harmonization have, however, been mitigated by a considerably more sophisticated approach to disclosure design. In particular, efforts have been made, for the first time, to test the reforms; notwithstanding the risks associated with the notion of the ‘average EC investor’,177 this marks a sea-change in disclosure design. Consultation with stakeholders has been extensive. The initial 2006 Commission prospectus workshops, in which a wide range of stakeholders participated, saw the policy debate engage, for the first time, with a range of practical design issues (including how to differentiate the KII from a marketing document, structure, cost disclosures, risk disclosure and synthetic risk indicators and past performance) and, overall, adopted a practical approach, addressing ‘What does the investor need to know?’ The subsequent Commission ‘Initial Orientations’ document set out a framework for possible reforms and was followed by a detailed request for advice to CESR.178 CESR’s extensive initial consultation included three calls for evidence (one on the content of the prospectus, one on distribution and one targeted to the retail sector179 ) in April 2007, a subsequent October 2007 consultation paper180 (including a summary retail market version181 ) and concluded with its February 2008 advice.182 CESR’s advice was followed by the UCITS IV Proposal, strenuous testing efforts,183 further CESR consultation184 and a mandate from the Commission to CESR for level 2 KII rules.185 CESR has proved effective in dealing with the reform. The Commission originally requested of CESR a ‘root and branch rethink’ of how UCITS disclosure should be structured and delivered, including how key risk disclosures, cost disclosures and past performance information (the Commission challenged CESR to consider whether past performance information should be prohibited) should be presented, and how distribution risks could be addressed. In its response, CESR has emerged as central 177

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The Commission’s initial approach was to direct the disclosures towards the ‘man in the street’: European Commission, Exposure Draft, Initial Orientations for Discussion on Possible Adjustments to the UCITS Directive: Simplified Prospectus (2006), p. 5. Attached to CESR/07-241. CESR/07-241; CESR/07-214; and CESR/07-205. 180 CESR/07-669. CESR/07-753. 182 CESR KII Advice 2008. The initial test results, and the testing process, are outlined in European Commission, Workshop on KII 20 October 2008 and, in outline, in CESR, Consultation Paper on Technical Issues Related to KII Disclosures for UCITS (CESR/09-047, 2009). CESR/09-047. European Commission, Provisional Request to CESR for Technical Advice on Possible Implementing Measures Concerning the Future UCITS Directive (2009).

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to retail market reforms and as able to corral a range of Member State expertise, research and experience to inform the new regime. CESR’s 2008 model, reflected in the new UCITS IV KII regime discussed in this section below, was based on a single, one-sheet document model186 (the Key Information Document (KID), now the KII), the contents of which would follow a standardized order, and which would be subject to plain language requirements.187 CESR based its advice on a clear articulation of the purpose of the KII; it was, reflecting the empowerment model, ‘fundamentally a tool for helping retail consumers to reach informed investment decisions’. CESR warned that it should not be encumbered with information serving only legal or regulatory requirements, or regarded as a marketing or investor education document.188 A clear appreciation of the importance of ‘processability’ is clear from its concern that testing not simply address the relative popularity of different formats, but also, and much more ambitiously, whether they would be used and understood by investors.189 What is significant about this approach, other than the welcome focus on an informed decision-making outcome, is the breaking of the link between Community action and market integration. The disclosure regime had hitherto been, in part, a function of the need to ease the cross-border UCITS notification process. The KII, however, is entirely a function of investor protection, although increased ease of comparability, if it follows, may of course support stronger cross-border investment. CESR also emerges as convinced of (and prepared to grapple with the difficulties of) testing disclosure reforms on a pan-EC basis. Its past performance discussion, for example, considered the evidence on investor misunderstanding190 and its advice more generally was placed in the context of international and Member State research on investor difficulties in interpreting CIS disclosures.191 Although CESR’s pivotal 2008 KII advice might be vulnerable to a fundamental weakness in that it is based on domestic research which reflects national market characteristics, persistent themes concerning investor understanding reappear across national studies. The 2007 BME Report suggests that common assumptions can be made as to the generally limited knowledge base of investors across the EC,192 while the 2008 Optem Report also supports the assumption 186

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It rejected earlier building-block models on the grounds that investors were likely to be confused and that useful comparisons would be impossible: CESR KII Advice 2008, p. 7. Ibid., pp. 18–23. 188 Ibid., pp. 6 and 18. 189 Ibid., p. 57. Ibid., p. 41. 191 Ibid., p. 12. 192 See further ch. 2.

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that, while disclosure requirements are likely to differ depending on the sophistication of the investor, certain requirements are requested by all investors, and by certain categories of investor, regardless of Member State.193 CESR also recommended that its proposals be tested. Testing is in principle problematic given the lack of homogeneity in the EC retail market, although troublesome references to the ‘average retail investor’ are scattered across the KII policy trail. But, while the difficulties are considerable,194 they should not lead to an abdication of attempts to design an evidence-based disclosure regime. Although CESR proved willing to jettison previously required disclosure where they had proved ineffective,195 some (generally justified) conservatism is evident. With respect to risk indicators, for example, which were supported by the retail constituency196 (support from other stakeholders was mixed), CESR pointed to the complexities and the risks where indicators did not adequately capture all key risks and called for tests on whether an indicator could improve investors’ perceptions of risk and reward.197 A similar theme emerges from its past performance advice. CESR’s advice focused on how this data could be safely presented and suggested that mandatory performance benchmarks, against which past performance data might be assessed, be tested.198 In an example of the emerging voice of the retail sector, this controversial requirement was suggested by the retail sector, although it was rejected by leading industry trade associations.199 CESR eschewed the more radical option of prohibiting past performance information (always unlikely given the industry furore likely to have followed) on the pragmatic grounds that investors were likely to source this information from other, perhaps more unreliable, sources.200 193 194 195

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Optem Report, pp. 89–92. The subsequent Testing Workshop grappled with the difficulties of extrapolating findings in the sample Member State to others. It recommended, for example, that the portfolio turnover rate, recommended by the 2004 Recommendation, be removed as the average investor was not well equipped to interpret it: CESR KII Advice 2008, p. 51. Including FIN-USE, the AMF’s consultative panel and the Spanish CNMV’s consultative panel; although the Danish Shareholders’ Association argued against the adoption of an indicator. CESR KII Advice 2008, p. 33. 198 Ibid., pp. 43–4. Support came from FIN-USE and the Danish