Regulation of the EU Financial Markets: MiFID II and MiFIR (Oxford EU Financial Regulation) [1 ed.] 2016960865, 9780198767671, 9780191080302

Table of contents :
Title Page
Copyright Page
Contents
Table of Cases
Table of Legislation
List of Abbreviations
Author Biographies
I General Aspects
1. Who’s Afraid of MiFID II? An Introduction
I. Introduction
II. Investment Firms and Investment Services
III. Trading
IV. Supervision and Enforcement
V. The Broader View and the Future of MiFID
VI. Final Remarks
II Investment Firms and Investment Services
2. The Scope of MiFID II
I. Introduction
II. Investment Firms under MiFID II
III. Credit Institutions
IV. Investment Firms under the CRR
V. Structured Deposits
VI. General Exemptions to MiFID II Applicability
VII. Trading on Own Account
VIII. Dealings in Emission Allowances
IX. Financial Instruments
X. Insurance Companies and Insurance Intermediaries
XI. Managers of Collective Investment Undertakings
XII. Data-Reporting Service Providers
XIII. Market Operators
XIV. Conclusion
3. Governance of Investment Firms under MiFID II
I. Introduction
II. Governance-related Regulation of Investment Firms between Prudential and Conduct-of-Business Regulation
III. The Technical Framework under MiFID II
IV. Conclusions
4. The Overarching Duty to Act in the Best Interest of the Client in MiFID II
I. Introduction
II. Antecedents of the Investment Firm’s Duty to Act in the Best Interest of the Client
III. The Duty to Act in the Best Interest of the Client in MiFID II
IV. The Duty’s Functions and Contents
V. The Articulation of the Duty with Respect to Individual Services and Activities
VI. A Look Across the Atlantic
VII. Assessment
5. Product Governance and Product Intervention under MiFID II/MiFIR
I. Introduction
II. Product Governance
III. Product Intervention
IV. Conclusion
6. Independent Financial Advice
I. Introduction
II. Economic Background
III. MiFID I
IV. MiFID II
V. Conclusions
7. Conflicts of Interest
I. Foundations of the Regime
II. The Regime by Single Stages and Examples
III. Conclusion
8. Inducements
I. Introduction
II. Current Legislation
III. The Dutch Inducement Ban
IV. The UK Inducement Rules
V. MiFID II
VI. Research as an Inducement
VII. Conclusion
9. Agency and Principal Dealing under MiFID I and MiFID II
I. Introduction
II. Four Transaction Types
III. Investor Protection
IV. Acting as Agent or as Principal: Not a Justified Distinction to Serve as a Basis for Determining the Degree of Investor Protection
V. Conclusion
10. MiFID II/MiFIR’s Regime for Third-Country Firms
I. General
II. Scope of MiFID II/MiFIR’s Regime for Third-Country Firms
III. Eligible Counterparties and Per Se Professional Clients
IV. Retail Clients and Opt Up Professional Clients
V. Retail Clients, Professional Clients, and Eligible Counterparties
VI. Initiative Test
VII. Conclusion
III Trading
11. Governance and Organization of Trading Venues: The Role of Financial Market Infrastructure Groups
I. Introduction
II. Trading Facilities: Concept and Regulatory Framework
III. The EU Scenario of Trading Venues
IV. FMI Groups in an MiFID II World
V. Conclusion
12. EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance
I. Transparency Regulation and EU Financial Governance: Why It Matters
II. Transparency Regulation and EU Financial Governance
III. MiFIR, Transparency, and Supervisory Administrative Governance
IV. MiFIR, Transparency, and Administrative Regulatory Governance
V. Conclusion
13. SME Growth Markets
I. Introduction
II. Existing Alternative Markets for SMEs in Europe
III. SME Growth Markets under MiFID II
IV. Alternative Disclosure Obligations?
V. What Role for the ‘SME Growth Market’ Label? Some Reflections on Alternative Scenarios
VI. Conclusion
14. Dark Trading under MiFID II
I. Introduction
II. Dark Pools: Motivation, Classification, and Related Literature
III. Dark Pools under MiFID I
IV. Dark Pool Regulation under MiFID II/MiFIR
V. Summary
15. Derivatives: Trading, Clearing, STP, Indirect Clearing, and Portfolio Compression
I. Introduction
II. The Trading Obligation
III. The Clearing Obligation
IV. The Straight-Through-Processing Obligations
V. The Obligations in Respect of Indirect Clearing
VI. The Obligations in Respect of Portfolio Compression
VII. A Few Final Remarks
16. Commodity Derivatives
I. Introduction
II. Features of the Commodity Derivatives Markets and Its Relation to the Crisis
III. Overview of the Most Important EU Provisions on Commodity Derivatives
IV. The Regulatory Perimeter of the MiFID II/MiFIR Package
V. The New Position Limits Regime
VI. A New Set of Intervention Powers for Authorities and Trading Venues
VII. Conclusion
17. Algorithmic Trading and High-Frequency Trading (HFT)
I. Introduction
II. Algorithmic Trading
III. High-Frequency Trading
IV. Conclusion
18. MiFID II and Equity Trading: A US View
I. Basic Building Blocks
II. High-Frequency Trading
III. Dark Pools and Internalization
IV. Conclusions: Reflections on Issues Raised by MiFID II
IV Supervision and Enforcement
19. Public Enforcement of MiFID II
I. Introductory Remarks
II. Structure of the Study
III. Competent Authorities: General Aspects, Powers, and Redress Procedures
IV. Cooperation Arrangements
V. Concluding Remarks and Assessment
20. The Private Law Effect of MiFID I and MiFID II: The Genil Case and Beyond
I. General
II. May Civil Courts Be Less Strict Than MiFID I and MiFID II?
III. May Civil Courts Be Stricter Than MiFID I and MiFID II?
IV. May Contracting Parties Be Less Strict Than MiFID I and MiFID II?
V. May Contracting Parties Be Stricter Than MiFID I and MiFID II?
VI. Influence of MIFID I and MiFID II on the Principle of Relativity
VII. Influence of MiFID I and MiFID II on Proof of Causation
VIII. Influence of MiFID I and MiFID II on a Contractual Limitation or Exclusion of Liability
IX. MiFID I and MiFID II Assessments by the Courts of Their Own Motion in Relation to Private Investors?
X. Conclusion
V The Broader View and the Future of MiFID
21. MiFID II in Relation to Other Investor Protection Regulation: Picking Up the Crumbs of a Piecemeal Approach
I. Introduction
II. MiFID II versus IDD
III. MiFID II and IDD versus UCITS KII and PRIIPs KID
IV. Cross-Selling Practices
V. Conclusion
22. Shadow Banking and the Functioning of Financial Markets
I. Introduction
II. Shadow Banking: Concept and Terminology
III. Non-Regulated Activity According to the FSB Approach
IV. What Financial Activity is not Subject to Banking Supervision?
V. The European Response to Shadow Banking
VI. Conclusion
23. Investment-Based Crowdfunding: Is MiFID II Enough?
I. Introduction
II. Benefits, Risks, and Challenges
III. MiFID I
IV. National Approaches to Crowdfunding
V. MiFID II
VI. Concluding Remarks
Index

Citation preview

REGULATION OF THE EU FINANCIAL MARKETS MiFID II and MiFIR

REGULATION OF THE EU FINANCIAL MARKETS MiFID II and MiFIR

Edited by

DANNY BUSCH GUIDO FERRARINI

Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © The editors and several contributors 2016 The moral rights of the author[s] have been asserted First Edition published in 2016 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2016960865 ISBN 978–0–19–876767–1 eISBN 978–0–19–108030–2 Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

PREFACE

Investment firms and trading venues have been closely regulated by the EU Markets in Financial Instruments Directive (MiFID I), the MiFID I Implementing Directive, and the MiFID I Implementing Regulation since 1 November 2007. MiFID I aims to provide a high level of harmonized investor protection, financial market transparency, and greater competition between trading venues. On 3 January 2018—some ten years later—the MiFID I regime will be replaced by MiFID II, which comprises, among other things, a directive (MIFID II), the Markets in Financial Instruments Regulation (MiFIR), and a truly impressive number of implementing measures, commonly referred to as Level 2 legislation. MiFID I may have the reputation of being strict, but MiFID II/MiFIR tightens the reins even more. It is not hard to guess the reason: the financial crisis has also revealed gaps in the MiFID I legislation, notably in investor protection, as well as shortcomings in the functioning and transparency of financial markets. The MiFID II/MiFIR regime will have a major impact on the financial sector in Europe. This volume aims to analyse and discuss the main changes and new provisions introduced by MiFID II/MiFIR. Its chapters are grouped in a thematic way, covering the following areas: (i) general aspects, (ii) investment firms and investment services, (iii) trading, (iv) supervision and enforcement, and (v) the broader view and the future of MiFID. Part I offers an overview of the developments leading to MiFID II and clarifies the central term ‘investment firm’. It also provides an overview of the volume’s contents.

Part II considers the main changes of MiFID II’s scope and exemptions in comparison with MiFID I, followed by a treatment of the governance rules for investment firms. It also analyses the duty to act in the client’s best interest, as well as the new product governance and product intervention rules. Moreover, the novel distinction between independent and nonindependent advice is scrutinized, followed by an assessment of the conflicts of interest provisions and the inducement rules. It further discusses the regulatory relevance of the distinction between agency and principal dealing. This part concludes with an outline of the new rules for thirdcountry investment firms. Part III discusses the governance and organization of trading venues and outlines the main features of the extensive new transparency regime which will apply to trading in a wide range of asset classes under MiFIR. It also contains a treatment of the new rules for SME growth markets, as well as an analysis of the concept of dark trading. Moreover, it outlines the new mandatory trading obligation for derivatives and the new commodity derivatives provisions. This part concludes with a treatment of the new rules for algorithmic and high-frequency trading, also from a US perspective. Part IV analyses the MiFID II provisions on supervision, enforcement, and cooperation by competent authorities. It also examines to what extent the civil courts are bound by MiFID I and II under EU law. Part V clarifies the relationship between MiFID II and several other closely related directives, such as the Insurance Distribution Directive, the PRIIPs Directive, and the UCITS Directive. It also analyses and discusses shadow banking and the functioning of financial markets. Finally, this part explores the policy and regulatory issues generated by investment-based crowdfunding in Europe. The volume was preceded by a meeting on 28 and 29 January 2016 of the International Working Group on MiFID II, established as a joint initiative between the Institute for Financial Law within the Business & Law Research Centre of Radboud University, Nijmegen, the Netherlands, and the Genoa Centre for Law and Finance, University of Genoa, Italy. We thank the Business & Law Research Centre of Radboud University,

Nijmegen for its sponsorship. We also thank NautaDutilh Amsterdam for hosting the meeting. We are grateful to the distinguished members of the Working Group for their dedication to the project and, in particular, for their contributions to this book as authors. We also thank the invitees to the meeting for providing the members of the Working Group with invaluable comments on their draft chapters. Last, but not least, we acknowledge our gratitude to the editorial team at Oxford University Press, who successfully brought a lengthy and complex project to completion. The law is stated as of 1 November 2016. Danny Busch Nijmegen, the Netherlands Guido Ferrarini Genoa, Italy

CONTENTS

Table of Cases Table of Legislation List of Abbreviations Author Biographies I GENERAL ASPECTS 1. Who’s Afraid of MiFID II? An Introduction Danny Busch and Guido Ferrarini I. II. III. IV. V. VI.

Introduction Investment Firms and Investment Services Trading Supervision and Enforcement The Broader View and the Future of MiFID Final Remarks

II INVESTMENT FIRMS AND INVESTMENT SERVICES 2. The Scope of MiFID II Kitty Lieverse I. II. III. IV. V. VI. VII.

Introduction Investment Firms under MiFID II Credit Institutions Investment Firms under the CRR Structured Deposits General Exemptions to MiFID II Applicability Trading on Own Account

VIII. IX. X. XI. XII. XIII. XIV.

Dealings in Emission Allowances Financial Instruments Insurance Companies and Insurance Intermediaries Managers of Collective Investment Undertakings Data-Reporting Service Providers Market Operators Conclusion

3. Governance of Investment Firms under MiFID II Jens-Hinrich Binder I. Introduction II. Governance-related Regulation of Investment Firms between Prudential and Conduct-of-Business Regulation III. The Technical Framework under MiFID II IV. Conclusions 4. The Overarching Duty to Act in the Best Interest of the Client in MiFID II Luca Enriques and Matteo Gargantini I. Introduction II. Antecedents of the Investment Firm’s Duty to Act in the Best Interest of the Client III. The Duty to Act in the Best Interest of the Client in MiFID II IV. The Duty’s Functions and Contents V. The Articulation of the Duty with Respect to Individual Services and Activities VI. A Look Across the Atlantic VII. Assessment 5. Product Governance and Product Intervention under MiFID II/MiFIR Danny Busch I. Introduction II. Product Governance III. Product Intervention

IV. Conclusion 6. Independent Financial Advice Paolo Giudici I. II. III. IV. V.

Introduction Economic Background MiFID I MiFID II Conclusions

7. Conflicts of Interest Stefan Grundmann and Philipp Hacker I. Foundations of the Regime II. The Regime by Single Stages and Examples III. Conclusion 8. Inducements Larissa Silverentand, Jasha Sprecher, and Lisette Simons I. II. III. IV. V. VI. VII.

Introduction Current Legislation The Dutch Inducement Ban The UK Inducement Rules MiFID II Research as an Inducement Conclusion

9. Agency and Principal Dealing under MiFID I and MiFID II Danny Busch I. II. III. IV.

Introduction Four Transaction Types Investor Protection Acting as Agent or as Principal: Not a Justified Distinction to Serve as a Basis for Determining the Degree of Investor Protection V. Conclusion

10.

MiFID II/MiFIR’s Regime for Third-Country Firms Danny Busch and Marije Louisse I. II. III. IV. V. VI. VII.

General Scope of MiFID II/MiFIR’s Regime for Third-Country Firms Eligible Counterparties and Per Se Professional Clients Retail Clients and Opt Up Professional Clients Retail Clients, Professional Clients, and Eligible Counterparties Initiative Test Conclusion III TRADING

11. Governance and Organization of Trading Venues: The Role of Financial Market Infrastructure Groups Guido Ferrarini and Paolo Saguato I. II. III. IV. V. 12.

Introduction Trading Facilities: Concept and Regulatory Framework The EU Scenario of Trading Venues FMI Groups in an MiFID II World Conclusion

EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance Niamh Moloney I. Transparency Regulation and EU Financial Governance: Why It Matters II. Transparency Regulation and EU Financial Governance III. MiFIR, Transparency, and Supervisory Administrative Governance IV. MiFIR, Transparency, and Administrative Regulatory Governance V. Conclusion

13.

SME Growth Markets Rüdiger Veil and Carmine Di Noia I. Introduction

II. III. IV. V.

Existing Alternative Markets for SMEs in Europe SME Growth Markets under MiFID II Alternative Disclosure Obligations? What Role for the ‘SME Growth Market’ Label? Some Reflections on Alternative Scenarios VI. Conclusion 14.

Dark Trading under MiFID II Peter Gomber and Ilya Gvozdevskiy I. II. III. IV. V.

15.

Introduction Dark Pools: Motivation, Classification, and Related Literature Dark Pools under MiFID I Dark Pool Regulation under MiFID II/MiFIR Summary

Derivatives: Trading, Clearing, STP, Indirect Clearing, and Portfolio Compression Rezah Stegeman and Aron Berket I. II. III. IV. V. VI. VII.

16.

Introduction The Trading Obligation The Clearing Obligation The Straight-Through-Processing Obligations The Obligations in Respect of Indirect Clearing The Obligations in Respect of Portfolio Compression A Few Final Remarks

Commodity Derivatives Antonella Sciarrone Alibrandi and Edoardo Grossule I. Introduction II. Features of the Commodity Derivatives Markets and Its Relation to the Crisis III. Overview of the Most Important EU Provisions on Commodity Derivatives IV. The Regulatory Perimeter of the MiFID II/MiFIR Package V. The New Position Limits Regime

VI. A New Set of Intervention Powers for Authorities and Trading Venues VII. Conclusion 17.

Algorithmic Trading and High-Frequency Trading (HFT) Pierre-Henri Conac I. II. III. IV.

18.

Introduction Algorithmic Trading High-Frequency Trading Conclusion

MiFID II and Equity Trading: A US View Merritt B. Fox I. II. III. IV.

Basic Building Blocks High-Frequency Trading Dark Pools and Internalization Conclusions: Reflections on Issues Raised by MiFID II IV SUPERVISION AND ENFORCEMENT

19.

Public Enforcement of MiFID II Christos V. Gortsos I. Introductory Remarks II. Structure of the Study III. Competent Authorities: General Aspects, Powers, and Redress Procedures IV. Cooperation Arrangements V. Concluding Remarks and Assessment

20.

The Private Law Effect of MiFID I and MiFID II: The Genil Case and Beyond Danny Busch I. General II. May Civil Courts Be Less Strict Than MiFID I and MiFID II?

III. May Civil Courts Be Stricter Than MiFID I and MiFID II? IV. May Contracting Parties Be Less Strict Than MiFID I and MiFID II? V. May Contracting Parties Be Stricter Than MiFID I and MiFID II? VI. Influence of MIFID I and MiFID II on the Principle of Relativity VII. Influence of MiFID I and MiFID II on Proof of Causation VIII. Influence of MiFID I and MiFID II on a Contractual Limitation or Exclusion of Liability IX. MiFID I and MiFID II Assessments by the Courts of Their Own Motion in Relation to Private Investors? X. Conclusion V THE BROADER VIEW AND THE FUTURE OF MIFID 21.

MiFID II in Relation to Other Investor Protection Regulation: Picking Up the Crumbs of a Piecemeal Approach Veerle Colaert I. II. III. IV. V.

22.

Shadow Banking and the Functioning of Financial Markets Eddy Wymeersch I. II. III. IV. V. VI.

23.

Introduction MiFID II versus IDD MiFID II and IDD versus UCITS KII and PRIIPs KID Cross-Selling Practices Conclusion

Introduction Shadow Banking: Concept and Terminology Non-Regulated Activity According to the FSB Approach What Financial Activity is not Subject to Banking Supervision? The European Response to Shadow Banking Conclusion

Investment-Based Crowdfunding: Is MiFID II Enough? Guido Ferrarini and Eugenia Macchiavello I. Introduction

II. III. IV. V. VI. Index

Benefits, Risks, and Challenges MiFID I National Approaches to Crowdfunding MiFID II Concluding Remarks

TABLE OF CASES

BELGIUM

Belgian Constitutional Court, Judgment no. 89/2016 (9 June 2016) 21.24 EUROPEAN UNION

Alpine Investments v Minister Van Financier [1995] ECR I-114 23.47 Asbeek Brusse and De Man Garabito, EU CoJ 30 May 2013, NJ 2013/487, with note by Mok 20.39 Asturcom, EC CoJ 6 October 2009, no. C-40/08, NJ 2010/11 20.39 CaixaBank France v Ministère de l’Économie, des Finances et de l’Industrie (Case C-442/02) 1 CMLR 39 23.47 Cassis de Dijon—Rewe Zentral AG v Bundesmonopolverwaltung Fuer Branntwein (Case 120/78) [1979] ECR 649 23.47 Commission of the European Communities v Federal Republic of Germany (Case 205/84) [1986] ECR 3775 23.47 Commission of the European Union v Italy [1996] ECR I-2691 23.47 Genil 48 SL and Other v Bankinter SA and Others EU CoJ 30 May 2013, no. C-604/11, AA (2013) 663 1.47, 4.02, 4.37, 9.43, 9.45, 20.03, 20.05, 20.19, 20.21, 20.23, 20.29, 20.33, 20.36, 20.37, 20.40 Littlewoods Retail and others, no. C-591/10¸19 July 2012 9.43, 20.03 Meroni v High Authority (Case 9/56) [1957–1958] ECR 133 12.40, 12.55, 22.75 Mostaza Claro, EC CoJ 26 October 2006, no. C-168/05, NJ 2007/201, with note by Mok 20.39 MyTravel (C-291/03) [2005] ECR I-8477, paragraph 17 9.43, 20.03 Nationale-Nederlanden Levensverzekering Mij NV/Hubertus Wilhelminus van Leeuwen EU CoJ 29 April 2015, no. C-51/13, AA (2015) 696 1.47, 20.05–20.17, 20.18, 20.20, 20.24, 20.40

Pennon, EC CoJ 4 June 2009, no. C-243/08, NJ 2009/395, with note by Mok 20.39 Reinhard Gebhard v Consiglio dell’Ordine degli Avvocati e Procuratori di Milano [1995] ECR 1465 23.47 San Giorgio Case No. 199/82 [1983] ECR 3595 20.03 UK v Parliament and Council (C-270/12) 22 January 2014, not yet reported 12.40, 22.75 Weber’s Wine World Handels-GmbH and others v Abgabenberufungskommission Wien (Case C-147/01) [2003] All ER (D) 45 (Oct) 20.03 C-51/13, Opinion of Advocate-General Sharpston, 12 June 2014 ECLI:EU2014:1921, para 15 20.07 ITALY

Decision no. 18615/2013 (2013) Consob, Bollettino n. 9.1 (Cassa di Risparmio di Savigliano) 6.17 Decision no. 19283/2015 (2015) Bollettino n. 9.1 (Poste Italiane) 6.17 Decision no. 19368/2015 (2016) Bollettino n. 1.2 (Banca Popolare) 6.17 Decision no. 19497/2016 (2016) Bollettino n. 1.2 (Cassa di Risparmio di Bolzano) 6.17 Tribunal of Prato, 13 June 2015 6.28 Tribunal of Turin, 20 November 2012 6.28 NETHERLANDS

ABN AMRO v Van Welzen, HR 23 March 2007, NJ 2007/333 9.41 Bugro v Rabobank, Dordrecht District Court, 29 February 2012, FR 2012/48, ground 4.17 9.37 Coöperatieve Rabobank Vaart en Vecht UA v X, HR 3 February 2012, NJ 2012/95, AA (2012) 752; JOR 2012/116 9.41, 20.20 Fortis Bank v Bourgonje, HR 24 December 2010, NJ 2011/251 9.41 Holding Westkant B.V., in liquidation v ABN AMRO Bank N.V., Den Bosch Court of Appeal 15 April 2014, JOR 2014/168, with note by Van der Wiel and Wijnberg; Ondernemingsrecht 2014/92, with note by Arons 20.34 Nationale-Nederlanden v Van Leeuwen Rotterdam District Court 28 November 2012, ECLI:NL:RBROT:2012:BY5159, para 2.9 20.13 Treek v Dexia Bank Nederland, HR 5 June 2009, JOR 2009/199 9.41, 9.51

Vereniging van Effectenbezitters and Others v World Online International NV, HR 27 November 2009, NJ 2014/201, with notes by Du Perron, AA (2010) 336, Raaijmakers, JOR 2010/43, and Frielink 20.21, 20.33, 20.34, 20.35 UNITED KINGDOM

Gorham and others v British Telecommunications plc and others [2000] 1 WLR 2129 (CA) 9.40 Grant Estates Ltd v Royal Bank of Scotland [2012] CSOH 133 9.30–9.36, 9.45 Kelly v Cooper [1993] AC 205 4.90 Seymour v Ockwell [2005] EWHC 1137 (QB) 9.40 UNITED STATES

Basic, Inc. v Levinson, 485 US 224 (1988) 6.03 Lehl v SEC, 90 F.3d 1483 4.46 SEC v Capital Gains Research Bureau, Inc., 375 US 180 (1963) 4.76 SECv Goldman, Sachs & Co. and Fabrice Tourre (ABACUS case), 10 Civ. 3229 (BJ) (S.D.N.Y. filed April 16, 2010) 4.73

TABLE OF LEGISLATION

INTERNATIONAL INSTRUMENTS

Basel II Capital Accord 2004 3.01, 3.17, 3.19, 3.23 Charter of Fundamental Rights of the European Union 19.32, 20.26 Art 16 20.26 OECD Model Tax Convention on Income and on Capital Art 26 10.47 Treaty on European Union (TEU) Art 5 21.01 Treaty on the Functioning of the European Union (TFEU) Art 26 19.03 Art 53(1) 7.10, 19.03 Art 102(d) 7.75 Art 114 12.40, 19.03, 22.77 Art 114(1) 22.07 Art 127(2) 19.106 Art 127(2), last indent 19.106 Art 289(1) 19.01 Art 290 1.02 Art 290-1 19.06 Art 291 1.02 EUROPEAN UNION Directives

73/239/EEC First Council Directive 73/239/EEC on the coordination of laws, regulations and administrative provisions relating to the taking-up and pursuit of the business of direct insurance other than life assurance, [1973] OJ L 228/13 16.67

77/780/EEC First Council Directive of 12 December 1977 on the coordination of the laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions, [1977] OJ L 322/30 3.10 Art 3(2) 3.10 89/646/EEC Second Council Directive of 15 December 1989 on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/780/EEC, [1989] OJ L 386/1 (Second Banking Directive) 3.10, 3.12 Art 5 3.10 Art 11 3.10 92/96/EEC Council Directive 92/96/EEC of 10 November 1992 on the coordination of laws, regulations and administrative provisions relating to direct life assurance and amending Directives 79/267/EEC and 90/619/EEC, [1992] OJ L 360/1 (Third Life Assurance Directive) 20.05, 20.14 recital 23 20.16 Art 31 20.10 Art 31(3) 20.11, 20.14, 20.16 Annex II 20.10, 20.11, 20.16, 20.18 Annex II(A) 20.10 Annex II(B) 20.10 93/13/EEC Directive of 5 April 1993 on unfair terms in consumer contracts, [1993] OJ L 95/29 20.39 93/22/EEC Council Directive of 10 May 1993 on investment services in the securities field, [1993] OJ L 141/7 (Investment Services Directive (ISD 1993)) 1.04–1.06, 3.01, 3.02, 3.05, 3.07, 3.08, 3.09, 3.11, 3.12, 3.14, 3.15, 3.16, 3.23, 3.50, 3.59, 11.34, 16.38, 16.44 Preamble 3.08 recital 2 3.08 recital 5 3.08 recital 6 3.09 recital 27 1.05 recital 41 3.08 Art 3(3) 3.41 Art 3(3)(1) 3.10

Art 3(3)(1), 2nd indent 3.01 Art 3(3)(2) 3.01, 3.10 Art 3(4) 3.01, 3.11 Art 3(7)(e) 3.11 Art 4 3.01, 3.10 Art 8(1) 3.12 Art 9 3.01, 3.10 Art 10 3.01, 3.12, 3.14 Art 10, sentence 1 3.11 Art 10, sentence 2, 1st indent 3.11 Art 10, sentence 2, 2nd –5th indent 3.12 Art 11 3.12 Art 11(1) 4.06 Art 14(3) 1.06 Art 17(4) 1.05 Art 18(2) 1.05 95/46/EC Directive of the European Parliament and of the Council of 24 October 1995 on the protection of individuals with regard to the processing of personal data and on the free movement of such data, [1995] OJ L 281/31 19.39 Arts 25–26 19.124 97/9/EC Directive of the European Parliament and of the Council of 3 March 1997, [1997] OJ 84/22 (ICS Directive) 10.47 98/26/EC Directive on settlement finality in payment and securities systems, [1998] OJ L 166/45 (SFD) 15.83, 15.98, 15.99 Art 2(f) 15.99 Art 8 15.98 2001/24/EC Directive on the recognition and winding up of credit institutions, [2001] OJ L 125/15 (Banks RWD) 15.98 2002/83/EC Directive of the European Parliament and of the Council of 5 November 2002 concerning life assurance, [2002] OJ L 345/1 16.67 2002/87/EC Directive of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives 73/239/EEC, 79/267/EEC, 92/49/EEC, 92/96/EEC, 93/6/EEC, and 93/22/EEC, and Directives 98/78/EC and

2000/12/EC of the European Parliament and of the Council, [2003] OJ L 35/1 (Financial Conglomerates Directive) 11.82, 11.84, 11.86 recital 2 11.84 Chap II 11.84 Art 6 11.84 Art 7 11.84 Art 8 11.84 Art 9 11.84 Art 9(b) 11.84 Art 10 11.84 2002/92/EC Directive of the European Parliament and of the Council of 9 December 2002 on insurance mediation, [2003] OJ L 9/3 (Insurance Mediation Directive (IMD)) 2.22, 2.52, 2.53, 21.06 Arts 12–13 21.06 2003/6/EC Directive of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation, [2003] OJ L 96/16 (Market Abuse Directive (MAD)) 13.01, 13.24, 13.33, 15.01, 17.52, 20.34 Art 6(6) 17.53 Art 6(9) 17.53, 17.55 2003/41/EC Directive of the European Parliament and of the Council of 3 June 2003 on the activities and supervision of institutions for occupational retirement provision, [2003] OJ L 235/10 Art 6(a) 16.67 2003/71/EC Directive 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, [2003] OJ L 345/64 (Prospectus Directive) 5.28, 10.35, 13.09, 13.21, 20.31, 20.34, 22.44 Art 3(1) 13.09 Art 6(2) 20.33 Art 6(2), 1st para 20.31 2003/87/EC Directive of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, [2003] OJ L 275/32 2.42, 2.45, 19.97

2004/39/EC Directive 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, [2004] OJ L 145/1 (MiFID I) 1.01, 1.02, 1.04–1.06, 1.07, 1.09, 1.11, 1.13, 1.14, 1.20, 1.21, 1.29, 1.30, 1.32, 1.34, 1.40, 1.44, 1.46, 1.47, 1.50, 1.51, 2.01, 2.16, 2.25, 2.26, 2.59, 2.61, 3.01, 3.04, 3.05, 3.07, 3.14, 3.15, 3.16, 3.17, 3.23, 3.50, 3.59, 4.02, 4.14, 4.48, 4.52, 4.53, 4.56, 4.58, 4.60, 4.61, 4.71, 4.91, 6.02, 6.15–16, 6.20, 6.23, 6.36, 6.37, 6.45, 7.02, 7.03, 7.06, 7.08, 7.09, 7.10, 7.11, 7.34, 7.36, 7.43, 7.45, 7.46, 7.48, 7.54, 7.55, 7.57, 7.62, 7.88, 8.01–8.05, 8.18–8.19, 8.24, 8.25, 8.48, 8.54, 9.01–9.06, 9.08–9.10, 9.15, 9.19–9.21, 9.23, 9.27, 9.28, 9.31, 9.33–9.34, 9.36, 9.44, 9.45, 9.47–9.48, 9.54, 11.01, 11.15, 11.16, 11.18, 11.31, 11.34, 12.02, 12.04, 12.06, 12.14, 12.16, 12.18, 12.19, 12.22, 12.27, 12.28, 12.36, 13.01, 13.04, 13.53, 14.01, 14.03, 14.07–14.09, 14.36, 14.39– 14.41, 14.44, 14.45, 14.47, 14.50, 14.52, 14.59, 14.64, 14.66, 14.67, 14.71, 14.75, 14.92, 14.101, 16.45, 16.46, 16.52, 16.56, 16.57, 16.67, 17.07, 17.23, 17.34, 17.39, 17.52, 18.97, 18.105, 18.110, 18.118, 18.125, 19.01, 19.15, 19.18, 19.23, 19.26, 19.27, 19.40, 19.78, 19.82, 19.83, 19.99, 19.100, 19.107, 19.110, 19.114, 19.117, 19.123, 19.126, 19.129, 20.01, 20.02, 20.04–20.05, 20.19, 20.20, 20.22–20.27, 20.30–20.40, 21.04, 21.05, 21.06, 21.11, 21.57, 23.12–23.17, 23.19–23.22 recital 2 7.10, 9.02, 20.25, 20.33, 20.39 recital 17 3.14 recital 18–19 3.14 recital 22 3.14 recital 24 3.14 recital 25 3.14 recital 29 7.11 recital 31 7.10 recital 33 4.71, 7.10 recital 40 4.61 recital 44 7.10 recital 53 14.44 Title II 1.09, 11.59 Title III 1.09 Art 1(2) 1.13

Art 2(1)(d) 4.52, 9.20 Art 2(1)(d)(iv) 4.52, 4.61 Art 2(1)(k) 16.54 Art 2(1)(2) 4.61 Art 3 23.15, 23.16, 23.17, 23.22, 23.37 Art 4(1) 1.09 Art 4(1)(2) 14.41, 14.42, 14.43 Art 4(1)(4) 23.16 Art 4(1)(5) 9.06, 23.15 Art 4(1)(6) 9.08 Art 4(1)(7) 9.10, 14.43 Art 4(1)(10) 9.21 Art 4(1)(14) 9.05, 14.41 Art 4(1)(15) 1.11, 9.05, 14.42 Art 4(1)(18) 21.04 Art 4(1)(19) 21.04 Art 4(2) 1.09 Art 5(1) 1.12 Art 5(5) 19.12 Art 6(3) 1.12 Art 6(31) 1.12 Art 6(32) 1.12 Arts 9–13 1.12 Art 9 3.14, 3.56 Art 10 3.14, 3.56 Art 13 3.14 Art 13(2) 3.15, 7.33, 17.23, 17.24, 17.34, 17.39, 17.55 Art 13(2)–(8) 3.15 Art 13(3) 7.09, 7.26, 7.28, 7.34, 7.36, 7.45 Art 13(4) 3.14, 7.33, 17.23, 17.24, 17.34 Art 13(5) 3.14, 3.15, 7.33, 17.23, 17.24, 17.34, 17.39, 17.55 Art 13(6) 7.26, 7.33, 17.23, 17.24, 17.34, 17.39, 17.55 Art 13(7) 3.15, 7.33 Art 13(8) 3.15, 7.33 Art 14(1) 17.34, 17.39 Art 14(4) 17.39 Art 15 10.20

Art 16 1.12 Art 16(3) 19.12 Art 17(2) 19.12 Art 18 et seq 7.09 Art 18 7.09, 7.11, 7.26 Art 18(1) 7.07 Art 18(2) 7.28, 7.48 Art 18(3) 7.09 Art 18ff 1.12 Art 19 4.61 Art 19(1) 4.06, 4.92, 7.57, 8.01, 20.20 Art 19(3), last sentence 20.20 Art 21 3.54, 4.71, 7.09, 7.63 Art 21(1) 7.67 Art 22(3) 7.38 Art 23(1) 23.42, 23.43 Art 24 4.14 Art 25 7.38 Art 25(1) 9.20 Art 26 17.39 Art 27 7.09 Art 27(1) 14.50 Art 27(1), first para 9.10 Art 28(1) 9.10 Art 29 14.52 Art 29(1) 14.51 Art 29(2) 14.51, 23.43 Art 31(1) 8.24 Art 34 11.59 Art 39(b) 17.34, 17.53 Art 39(c) 17.34 Art 39(d) 17.53 Art 42(3) 17.39 Art 43 17.53 Art 44 14.52 Art 48 19.15 Art 48(2) 19.12

Art 49 19.19 Art 50 19.27, 19.30 Art 51 19.40 Art 52 19.79 Art 53 19.82 Art 54 19.23 Art 55 19.26 Art 56 19.83 Art 56(2) 19.92 Art 56(5) 19.95 Art 57(1) 19.99 Art 57(2) 19.100 Art 58 19.107 Art 58a–59 19.110 Art 60 19.114 Art 61 19.118 Art 62 19.123 Art 62a 19.84 Art 63 19.126 Annex I, Section A 1.09, 21.04 Annex I, Section A, point (1) 3.25 Annex I, Section A, point (2) 3.25 Annex I, Section A, point (4) 3.25 Annex I, Section A, point (5) 3.25 Annex I, Section B 21.04 Annex I, Section B, point (1) 3.25 Annex I, Section C 1.09, 1.11, 21.04, 23.13 Annex I, Section C(5) 16.38, 16.45 Annex I, Section C(6) 16.38, 16.45 Annex I, Section C(7) 16.38, 16.45 Annex I, Section C(9) 16.38 Annex I, Section C(10) 16.38 2004/72/EC Directive of 29 April 2004 implementing Directive 2003/6/EC of the European Parliament and of the Council as regards accepted market practices, the definition of inside information in relation to derivatives on commodities, the drawing up of lists of insiders, the notification of managers’ transactions and the notification of suspicious

transactions, [2004] OJ L 162/70 (MAD Implementing Directive for regulated markets) Arts 7–10 17.53, 17.55 2004/109/EC Directive of the European Parliament and of the Council of 15 December 2004 on the harmonization of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC, [2004] OJ L 390/38 (Transparency Directive) 5.28, 13.01, 13.13, 13.33, 20.34 Art 3(1a) 13.33 Art 4 13.23 Art 5 13.23 Art 9 3.56 Art 10 3.56 Art 12(4) 3.56 Art 12(5) 3.56 2005/1/EC Directive of the European Parliament and of the Council of 9 March 2005 amending Directive 2002/87/EC, [2005] OJ L 79/9 11.84 2005/29/EC 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 and amending Council Directive 84/450/EEC, Directives 97/7/EC, 98/27/EC and 2002/65/EC of the European Parliament and of the Council and Regulation (EC) No 2006/2004 of the European Parliament and of the Council, [2005] OJ L 149/22 (Unfair Commercial Practices Directive) 21.08, 21.16, 21.54, 21.60 Annex II 20.34 2005/68/EC Directive of the European Parliament and of the Council of 16 November 2005 on reinsurance and amending Council Directives 73/239/EEC, 92/49/EEC as well as Directives 98/78/EC and 2002/83/EC, [2005] OJ L 323/1 16.67 2006/43/EC Directive of the European Parliament and of the Council of 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC, [2006] OJ L 157/87 3.35, 19.24 Arts 3–14 19.24 Art 41 3.35

2006/48/EC Directive 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, [2006] OJ L 177/1 (recast Banking Directive) 3.17, 16.67, 22.41 Art 22 3.47, 3.48 Art 22(1) 3.17 Annex V 3.17 2006/49/EC Directive of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast), [2006] OJ L 177/201 (recast Capital Adequacy Directive) 3.17, 3.19, 3.20 Art 34 3.18 2006/73/EC Commission Directive of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, [2006] OJ L 241/26 (MiFID I Implementing Directive) 1.01, 3.15, 3.16, 3.48, 3.50, 6.15, 7.34, 7.39, 8.05, 8.05–8.07, 8.08–8.09, 8.25, 8.26, 8.30, 9.01, 11.01, 11.15, 20.01 recital 4 3.16 recital 5 3.16 recital 7 3.16 recital 27 4.91 recital 69 4.71, 9.09 recitals 81–83 4.39 recital 81 4.24 recital 82 4.38 Chap 2 3.15 Chap 3 3.15 Art 4 8.25, 8.27, 8.28, 8.33, 8.59 Arts 5–9 17.24, 17.34 Art 5 3.15, 17.23, 17.55 Art 6 3.15, 17.23, 17.55 Art 7 3.15, 17.23 Art 7(2) 3.48 Art 8 3.15 Art 9 3.15, 17.23, 17.55

Art 13 17.23, 17.24, 17.34, 17.39 Art 14 17.23, 17.24, 17.34, 17.39 Art 14(1) 20.37 Art 16 3.15 Arts 21–26 7.36, 7.38 Art 21 7.36, 7.38 Art 21(a) 7.36, 7.38 Art 21(b) 7.36, 7.38, 7.75 Art 21(c) 7.38 Art 21(d) 7.38 Art 21(e) 7.38, 8.09 Art 22(3) 7.34, 7.36, 7.38 Art 22(3)(2)(a) 7.38 Art 22(3)(2)(b) 7.38 Art 22(3)(2)(c) 7.38 Art 22(3)(2)(d) 7.38 Art 22(3)(2)(e) 7.38 Art 22(4) 7.48 Art 26 8.06, 8.09, 8.17, 8.25, 8.31 Art 39 6.15 Art 44(1) in fne 9.05 Art 44(3) 7.67 Art 51 17.23, 17.24, 17.34, 17.39 Art 52 4.24, 4.37 2008/25/EC Directive 2008/25/EC of the European Parliament and of the Council of 11 March 2008 amending Directive 2002/87/EC on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate, as regards the implementing powers conferred on the Commission, [2008] OJ L 81/40 11.84 2009/65/EC Directive of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities, [2009] OJ L 302/32 (UCITS IV) 2.32, 2.55, 5.02, 16.67, 19.17, 21.03, 21.27, 21.28, 21.30, 21.33, 21.35, 21.50, 21.61, 22.79 Art 1(2) 19.17

Art 5 19.22 Art 6 2.56 Art 6(3) 5.02 Art 50(1) 16.85 Art 50(2) 16.85 Art 52 22.79 Art 73 19.24 Art 78 21.28 Art 80 21.28 2009/111/EC Directive of the European Parliament and of the Council of 16 September 2009 amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements and crisis management, [2009] OJ L 302/97 (CRD II) 3.14, 22.41 3.14, 22.41 Art 122(a) 22.55 2009/138/EU Directive of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance, [2009] OJ L 335/1 (Solvency II) 2.32, 22.44 Art 15 2.51 Art 16 2.51 2010/73/EU Directive of 24 November 2010 amending Directives 2003/71/EC on the prospectus to be published when securities are offered to the public admitted to trading and 2004/109/EC on the harmonization of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market, [2010] OJ L 327/1 22.110 2010/76/EU Directive of the European Parliament and of the Council of 24 November 2010 amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for resecuritizations, and the supervisory review of remuneration policies, [2010] OJ L 329/3 (CRD III) 3.18, 3.19, 22.41 Preamble 3.18 recitals 7–10 3.18 recital 17 3.18 recitals 17–22 3.18 Art 1(3) 3.18

2010/78/EU Directive of the European Parliament and of the Council of 24 November 2010 amending Directives 98/26/EC, 2002/87/EC, 2003/6/EC, 2003/41/EC, 2003/71/EC, 2004/39/EC, 2004/109/EC, 2005/60/EC, 2006/48/EC, 2006/49/EC and 2009/65/EC in respect of the powers of the European Supervisory Authority (European Banking Authority), the European Supervisory Authority (European Insurance and Occupational Pensions Authority) and the European Supervisory Authority (European Securities and Markets Authority), [2010] OJ L 331/120 11.84 2011/61/EU Directive of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010, [2011] OJ L 174/1 (AIFMD) 1.24, 2.32, 2.55, 2.56, 5.02, 10.23, 10.26, 16.39, 16.41, 16.67, 19.06, 22.44, 22.82 Art 4(1)(a) 19.22 Art 6 2.56 Art 6(4) 2.56, 5.02 Art 6(6) 2.56 Art 21(5) 10.26 Art 21(6) 10.26 Art 21(6), last para 10.26 Art 25(7) 22.39 Art 37 10.26 Art 37(2) 10.26 Art 37(23)(b) 10.26 Art 53 22.39 Art 67 10.26 2011/89/EU Directive of the European Parliament and of the Council of 16 November 2011 amending Directives 98/78/EC, 2002/87/EC, 2006/48/EC and 2009/138/EC as regards the supplementary supervision of financial entities in a financial conglomerate, [2011] OJ L 326/113 11.84 2013/34/EU Directive of the European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/EC of the European Parliament and of the Council and

repealing Council Directives 78/660/EEC and 83/349/EEC, [2013] OJ L 182/19 19.52 Art 2(11) 19.113 Art 22(1)–(2) 19.112 Art 34 19.24 2013/36/EU Directive of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, [2013] OJ L 176/338, (Capital Requirement Directive (CRD IV)) 1.13, 1.15, 1.26, 2.15, 2.16, 2.17, 2.22–2.25, 2.28, 2.39, 3.03, 3.06, 3.18, 3.21, 3.23–3.28, 3.34–3.36, 3.44–3.50, 3.52, 3.55, 3.58–3.63, 3.65, 4.67, 10.18, 10.27, 10.34, 10.48, 10.62, 11.25, 11.84, 12.06, 12.41, 15.01, 15.45, 15.79, 15.110, 16.36, 16.53, 16.60, 17.45, 19.05, 19.50, 19.105, 22.06 Preamble 3.59 recital 55 3.26 recital 60 3.43 Art 2(1) 3.25 Art 3(1)(7) 3.26, 3.28 Art 3(1)(33) 3.56 Art 3(2) 3.26 Art 9(1) 3.25 Art 13(1) 3.29 Art 14 3.56 Art 14(1) 3.56 Art 14(2) 3.57 Art 18 19.50 Arts 22–24 3.57 Arts 22–27 3.56 Art 23(1) 3.57 Art 28(2) 2.22 Art 29(1) 2.22 Art 29(2) 2.22 Art 30 2.22 Art 31(1) 2.22 Art 31(2) 2.22

Art 67(1) 19.50 Art 67(2)(f)–(g) 3.33 Arts 74–87 3.47 Art 74 7.34 Art 74(1) 3.47 Art 74(2) 3.48 Art 76(1) 3.48 Art 76(2) 3.48 Art 76(3) 3.27, 3.35, 3.48 Art 76(4) 3.48 Art 76(5) 3.48 Arts 77–84 3.48 Art 88 3.21, 3.25, 3.26, 3.27, 3.33, 7.34, 10.47, 11.18 Art 88(1) 3.29, 3.48, 11.25 Art 88(1)(e) 3.26, 3.63 Art 88(1)(2) 3.30 Art 88(2) 3.27, 3.35, 11.25 Art 88(2)(a) 3.39 Art 88(2)(2)(a)–(d) 3.35 Art 91 3.21, 3.25, 3.33, 7.34, 10.47, 11.18 Art 91(1) 3.37, 11.25 Art 91(2) 3.37, 11.25 Art 91(7) 3.39 Art 91(8) 3.33, 3.38 Art 91(9) 3.39 Art 91(10) 3.39 Art 91(12) 3.40 Art 92(1) 3.45, 3.46 Art 94 3.45 Art 95(1) 3.27 Art 95(2) 3.35 2014/17/EU of the European Parliament and of the Council of 4 February 2014 on credit agreements for consumers relating to residential immovable property and amending Directives 2008/48/EC and 2013/36/EU and Regulation (EU) No 1093/2010, [2014] OJ L 60/34 (Mortgage Credit Directive (MCD)) 21.53, 21.54 Art 4(26) 21.54

Art 4(27) 21.54 Art 12 21.53, 21.54 2014/49/EU Directive of the European Parliament and of the Council of 16 April 2014 on deposit guarantee schemes, [2014] OJ L 173/149 (Deposit Guarantee Schemes Directive) 22.27 Art 2(1)(c) 2.27, 5.05, 19.05 Art 2(1)(3) 21.06 2014/57/EU Directive of the European Parliament and of the Council of 16 April 2014 on criminal sanctions for market abuse, [2014] OJ L 173/179 (Market Abuse Directive (MADII)) 10.15, 10.35, 15.01, 16.22, 18.10, 18.118, 19.33 recital 1 6.03 2014/59/EU Directive of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, [2014] OJ L 173/190 (Bank Recovery and Resolution Directive (BRRD)) 4.67, 10.55 Art 1(1)(e) 10.55 Art 2(1)(89) 10.55 Art 43ff 4.34 Art 95 10.56 Art 96 10.55 Art 96(1), 2nd para 10.55 Art 96(3) 10.56 Art 103(1) 10.56 2014/65/EU Directive of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (recast), [2014] OJ L 173/349 (MiFID II) 1.01, 1.02, 1.03, 1.07, 1.09, 1.11, 1.13–1.30, 1.33, 1.34, 1.40, 1.42–1.48, 1.50–1.52, 1.56, 1.57, 2.01–2.03, 2.05–2.06, 2.09, 2.11, 2.13– 2.16, 2.19–2.35, 2.37–2.39, 2.41–2.45, 2.49, 2.51–2.53, 2.55–2.61, 3.01– 3.04, 3.06, 3.18, 3.20–3.25, 3.28, 3.34–3.36, 3.44, 3.45, 3.47, 3.50–3.57, 3.59–3.63, 3.65, 4.01, 4.03, 4.07, 4.14–4.16, 4.18, 4.19, 4.24, 4.31, 4.32, 4.47–4.51, 4.54, 4.58–4.62, 4.68, 4.71, 4.72, 4.75, 4.82, 4.83, 4.88–4.92,

5.01–5.04, 5.06–5.07, 5.09, 5.11, 5.12, 5.27, 5.28, 5.40, 5.41, 5.61, 5.62, 5.74, 6.01, 6.02, 6.13, 6.19, 6.20, 6.22–6.24, 6.27, 6.28, 6.31–6.33, 6.37, 6.38, 6.44, 6.45, 6.47, 7.01, 7.02, 7.06–7.09, 7.11, 7.12, 7.18, 7.20, 7.25, 7.36, 7.37, 7.40, 7.42, 7.43, 7.46, 7.48–7.50, 7.52, 7.53, 7.55, 7.57, 7.58, 7.60, 7.63–7.65, 7.72, 7.74, 7.88, 8.03, 8.18, 8.26, 8.28, 8.37, 8.47, 8.60, 8.61, 8.64, 8.66, 9.01–9.06, 9.08, 9.10, 9.16, 9.19–9.21, 9.23, 9.44, 9.45– 9.47, 9.50, 9.54, 9.55, 10.01–10.07, 10.09–10.13, 10.14, 10.15, 10.16, 10.18, 10.20–10.23, 10.27, 10.31, 10.34, 10.41, 10.45–10.50, 10.52– 10.54, 10.62, 10.67, 10.68, 10.70, 10.72, 10.76–10.78, 11.01–11.02, 11.04, 11.15–11.17, 11.20–11.22, 11.27, 11.31, 11.34, 11.40, 11.64, 11.65, 11.73, 11.75, 11.76, 11.80, 11.81, 11.86, 12.01, 12.02, 12.04, 12.05, 12.15, 12.23, 12.31, 12.40, 12.50, 12.51, 13.02, 13.03, 13.15, 13.17–13.18, 13.27, 13.32, 13.48, 13.53, 13.54, 14.07–14.09, 14.59, 14.60, 14.62, 14.64–14.67, 14.70, 14.75, 14.91, 14.92, 14.94, 14.100, 14.101, 14.102, 14.104–14.106, 15.01, 15.04, 15.36, 15.109, 15.112, 15.126, 16.02–16.03, 16.18, 16.21, 16.29, 16.31–16.34, 16.42–16.44, 16.46–16.48, 16.50–16.53, 16.55, 16.58, 16.60, 16.65, 16.67, 16.71– 16.74, 16.82, 16.88–16.89, 17.02, 17.20, 17.23–17.24, 17.28, 17.31, 17.33, 17.34, 17.39, 17.41–17.44, 17.51, 17.56, 17.61, 17.62, 18.03, 18.40, 18.94, 18.105, 18.106, 18.111, 18.113, 18.115, 18.118, 18.127, 19.01, 19.04, 19.06, 19.08, 19.12, 19.27, 19.33, 19.34, 19.37, 19.40, 19.41, 19.43, 19.50, 19.58, 19.62, 19.75, 19.78, 19.79, 19.80, 19.83, 19.85, 19.98, 19.119, 19.121, 19.129, 19.130, 19.131, 20.01, 20.02, 20.04–20.05, 20.19, 20.20, 20.21–20.27, 20.20–20.40, 21.03, 21.04, 21.06–21.10, 21.13–21.20, 21.22–21.30, 21.32, 21.33, 21.34, 21.35, 21.38, 21.43, 21.44, 21.50, 21.52–21.55, 21.57, 21.59, 21.61, 21.62, 22.06, 22.62, 22.87, 23.12, 23.19–23.22, 23.34–23.36, 23.38–23.40, 23.43–23.44, 23.51–23.52, 23.57, 23.59 Preamble 3.20, 3.59 recital 4 3.04 recital 5 3.04, 3.23 recital 7 7.10 recital 9 2.49 recital 10 2.49 recital 11 2.45 recital 12 2.12 recital 18 2.38

recital 19 2.38 recital 20 2.38, 16.59 recital 20(2) 2.39 recital 21 16.72 recital 22 2.40 recital 24 2.08, 9.48, 9.49 recital 26 2.11 recital 27 2.32 recital 28 2.34, 10.01 recital 32 2.35 recital 33 2.35 recital 34 2.32 recital 38 2.15 recital 39 2.26 recital 40 2.28, 11.31 recital 41 2.33 recital 42 7.10 recital 45 2.06, 9.47 recital 51 7.10 recital 53 et seq 7.10 recital 54 5.30 recital 55 3.26 recital 56 7.11 recital 64 14.62 recital 69 7.11 recital 70 9.02, 20.25, 20.33, 20.39 recital 71 5.15, 5.16, 5.27, 5.32, 5.40, 6.41, 7.37, 7.40 recital 71 et seq 7.10 recital 71, 1st para 4.10 recital 71, 2nd para 4.10 recital 74 8.40, 8.41 recital 75 8.42 recital 77 4.20, 7.10 recital 78 21.30, 21.31 recital 80 7.10, 7.74 recital 81 7.10, 7.75 recital 85 4.66, 10.73

recital 87 2.52, 7.10, 21.06 recital 88 7.11 recital 89 23.34 recital 91 4.71, 7.10 recitals 91–98 7.62 recital 92 7.64 recital 93 4.72 recital 95 7.68 recital 97 7.64 recital 109 4.61, 10.45 recital 111 10.69, 10.73 recital 115 2.59 recital 116 2.59 recital 123 7.11 recital 132 13.15 recital 134 13.15, 13.49 recital 136 19.103 recital 137 19.27, 19.130 recital 138 19.37, 19.38 recital 139 19.132 recital 140 19.92 recital 141, 1st sentence 19.42, 19.43 recital 141, 2nd sentence 19.48 recital 142 19.52 recital 143 19.32 recital 144 19.33 recital 145 19.55 recital 146, 1st–5th sentences 19.56 recital 146, 6th sentence 19.69 recital 146, 7th sentence 19.62 recital 147 19.76, 19.78 recital 148 19.40 recital 149 19.42 recital 150 19.44 recital 151 19.81 recital 154 19.93

recital 155 7.10, 7.11 recital 164 4.14, 7.10 recitals 10.72 Title II 1.09, 2.04, 9.16, 11.22, 11.23 Title III 1.09, 11.17, 11.65 Title IV 2.47 Title V 10.13 Title VI 19.07 Art 1(1) 2.01, 10.04, 10.11, 19.04 Art 1(2) 19.04 Art 1(2)(b) 10.09 Art 1(23) 19.05 Art 1(3) 1.13, 2.15, 2.33, 19.05 Art 1(3)(a) 5.02 Art 1(3)(a)–(d) 2.15 Art 1(3)(b) 5.02 Art 1(4) 1.13, 2.26, 2.28, 5.05, 5.12, 5.15, 5.16, 5.18, 5.19, 5.24, 5.25, 5.27, 5.29, 5.30, 5.31, 5.32, 5.40, 10.09, 10.10, 19.05, 21.06 Art 1(4)(a) 5.05, 5.18, 5.19, 5.24, 5.25, 5.27, 5.29, 5.30, 5.32, 5.40 Art 1(4)(b) 5.05, 5.15, 5.16, 5.31 Art 1(4)(c) 5.41, 5.61, 5.62 Art 1(6) 15.106 Art 2 2.31 Art 2(1)(a) 2.31 Art 2(1)(b) 2.31, 2.34 Art 2(1)(c) 2.13, 2.31, 2.35 Art 2(1)(d) 2.19, 2.31, 2.37, 2.38, 2.39, 2.40, 9.20 Art 2(1)(d)(iii) 17.31, 17.44 Art 2(1)(e) 2.31, 2.42 Art 2(1)(f) 2.31, 2.34 Art 2(1)(g) 2.31, 2.34 Art 2(1)(h) 2.31, 2.35 Art 2(1)(i) 2.31, 2.37, 2.55, 16.53, 16.56 Art 2(1)(j) 2.19, 2.31, 2.37, 2.39, 2.40, 9.20, 16.53, 16.55, 16.58, 16.61 Art 2(1)(j), 1st sentence 2.39 Art 2(1)(k) 2.13, 2.31, 2.35, 2.37 Art 2(1)(l) 2.31

Art 2(1)(m) 2.31 Art 2(1)(n) 2.31 Art 2(1)(o) 2.31, 2.33 Art 2(2) 2.31, 2.56 Art 2(4) 2.39, 16.43 Art 2(9)–(10) 19.52 Art 3 2.30 Art 3(1)–(2) 2.30 Art 3(1) 23.37, 23.51 Art 3(1)(a)–(c) 2.30 Art 3(1)(c) 23.37 Art 3(1)(d) 2.30 Art 3(1)(e) 2.30 Art 3(2) 23.37, 23.51 Art 3(2), 2nd indent 23.37 Art 4(1) 1.09, 2.11, 2.28, 2.57 Art 4(1)(a)–(d) 2.11 Art 4(1)(1) 2.02, 2.10, 2.11, 2.16, 3.25, 19.04 Art 4(1)(2) 2.03, 2.10, 2.14, 19.04, 23.39 Art 4(1)(2)(a)–(c) 3.25 Art 4(1)(3) 2.10, 19.05 Art 4(1)(4) 2.04, 2.14, 23.40 Art 4(1)(4)–(7) 2.10 Art 4(1)(5) 2.04, 2.06, 2.14, 4.54, 4.58, 9.06, 9.47 Art 4(1)(6) 2.04, 2.14, 9.08 Art 4(1)(7) 2.14, 2.38 Art 4(1)(8) 2.04, 2.10 Art 4(1)(9) 2.10, 2.14, 9.21 Art 4(1)(11) 21.24 Art 4(1)(13) 13.17 Art 4(1)(14) 12.31 Art 4(1)(15) 1.11, 2.03, 19.34 Art 4(1)(16) 2.49 Art 4(1)(17) 2.46 Art 4(1)(18) 19.04 Art 4(1)(20) 9.10, 11.06, 12.16, 15.31 Art 4(1)(21) 9.05, 10.14, 11.17, 12.15, 19.04

Art 4(1)(22) 9.05, 10.14, 11.23, 12.15, 13.01, 19.05 Art 4(1)(23) 2.04, 2.60, 10.14, 11.22, 12.15, 23.44 Art 4(1)(24) 2.60, 10.14, 11.05, 19.05 Art 4(1)(27) 19.05 Art 4(1)(29) 23.43 Art 4(1)(30) 19.04 Art 4(1)(31) 3.56 Art 4(1)(32) 2.34, 19.52, 19.113 Art 4(1)(33) 2.34, 19.52 Art 4(1)(35(b)) 19.112 Art 4(1)(36) 3.26, 3.28, 19.42 Art 4(1)(38) 2.08, 9.48, 11.29 Art 4(1)(39) 17.03 Art 4(1)(40) 17.05 Art 4(1)(41) 17.29 Art 4(1)(42) 7.75, 21.52 Art 4(1)(43) 2.27, 5.05, 19.05, 21.06 Art 4(1)(44) 2.46, 23.39 Art 4(1)(44)(c) 15.03, 16.47 Art 4(1)(50) 19.31 Art 4(1)(51) 19.22 Art 4(1)(52)–(54) 19.04 Art 4(1)(52) 2.57, 15.105 Art 4(1)(53) 2.57 Art 4(1)(54) 2.57 Art 4(1)(55) 10.11, 19.91 Art 4(1)(56) 19.91 Art 4(1)(57) 10.04, 19.04 Art 4(1)(63) 19.04 Art 4(2) 1.09, 4.37, 23.41 Art 4(4) 6.15 Arts 5–43 19.05 Art 5 13.48, 19.47 Art 5(1) 1.12, 11.23 Art 5(2) 11.23 Art 5(4)(b) 2.11 Art 6 19.78

Art 6(2) 19.47 Art 6(3) 1.12 Art 6(34) 1.12 Art 6(35) 1.12 Art 7(2)–(3) 19.78 Art 7(3) 10.31 Art 8 10.50 Art 8(d) 3.33 Arts 9–16 1.12 Art 9 3.33, 4.37, 11.25 Art 9(1) 3.21, 3.25, 3.27, 3.29, 3.35 Art 9(3) 2.28, 3.29, 3.31, 3.34, 7.10 Art 9(3)(a) 5.30 Art 9(3)(b) 5.02, 5.12, 5.24 Art 9(3)(c) 3.34, 3.45 Art 9(3)(3) 3.32 Art 9(3)(4) 3.53 Art 9(3)–(6) 3.21 Art 9(4) 3.37 Art 9(6) 2.11, 3.29 Arts 10–13 3.21 Art 10 3.57, 11.25 Art 10(1) 3.56, 11.77, 11.78 Art 10(1)(2) 3.57 Art 12 2.56, 3.57 Art 13 2.56, 3.57 Art 13(1) 3.57 Art 16 3.50, 11.26 Art 16(2) 3.53, 7.33 Art 16(3) 2.28, 4.49, 6.40, 7.09, 7.26, 7.28, 7.34, 7.37, 7.45, 19.35, 21.08, 21.13, 21.16, 23.35 Art 16(3) 2nd para 5.18, 23.35 Art 16(3) 3rd para 5.19, 5.29, 23.35 Art 16(3) 4th para 5.29, 5.32, 23.35 Art 16(3) 5th para 5.29 Art 16(3) 6th para 5.27

Art 16(3) 7th para 5.40 Art 16(3)(1) 3.54, 7.36 Art 16(3)(2) 3.54, 7.40 Art 16(3)(2–6) 7.40 Art 16(3)(2–7) 5.02 Art 16(3)(3) 3.54 Art 16(3)(4) 3.54, 7.40 Art 16(3)(6) 7.40 Art 16(3)(7) 3.54 Art 16(4) 3.51, 7.33 Art 16(5) 7.33 Art 16(5)(2) 3.52 Art 16(5)(3) 3.52 Art 16(6) 3.54, 7.26, 7.33 Art 16(7) 3.54, 7.33 Art 16(8) 2.23, 7.33 Art 16(8)–(10) 3.54 Art 16(9) 2.23, 7.33 Art 16(12) 3.50 Art 17 3.50, 7.33, 17.20, 17.21 Art 17(1) 17.24, 17.56, 18.118 17.26, 17.46 Art 17(3) 17.27 Art 17(4) 17.27 Art 17(5) 17.31, 17.56 Art 17(6) 17.32 Art 18 11.76, 22.89 Art 18(1)–(4) 11.27 Art 18(5) 11.27 Art 18(11) 11.77 Art 19 2.56 Art 19(1) 11.26, 11.28 Art 19(2) 11.28 Art 19(3) 11.28 Art 19(4) 4.15 Art 19(5) 11.28 Art 20 2.60, 12.15 Art 20(1) 11.29

Art 20(2) 11.24, 11.29 Art 20(3) 11.29 Art 20(4) 11.29 Art 20(6) 4.15, 11.29 Art 20(6), 2nd para 9.16 Art 20(6)(8) 11.11 Art 20(7) 11.24, 11.66 Art 21 1.12 Art 22 19.52 Art 23 et seq 7.09 Art 23 3.54, 4.01, 4.25, 7.09, 7.11, 7.26, 21.13 Art 23(1) 7.07 Art 23(2) 7.28, 7.45, 7.48 Art 23(3)(a) 7.45 Art 23(3)(b) 7.48, 7.49, 7.52 Art 23(4) 7.09 Art 23ff 1.12 Arts 24–25 19.117 Art 24 2.28, 4.08, 4.11, 4.15, 4.61, 6.38, 8.40, 23.47 Art 24(1) 1.18, 4.01, 4.06, 4.07, 4.09, 4.10, 4.11, 4.12, 4.13, 4.15, 4.16, 4.24, 4.31, 4.33, 4.37, 4.60, 4.82, 4.92, 9.20, 20.20, 21.08, 21.16 Art 24(2) 4.10, 4.49, 4.60, 5.02, 7.40, 21.08, 21.38 Art 24(2) 1st para 5.15 Art 24(2) 2nd para 4.08, 5.16, 5.25, 5.31 Art 24(2)(2) 7.40 Art 24(3)–(5) 4.42 Art 24(3) 21.16 Art 24(4) 4.14, 4.60, 21.10, 21.13, 23.34 Art 24(4), last para 21.29 Art 24(4)–(9) 7.09 Art 24(4)(a) 6.20, 6.31, 6.34, 7.51 Art 24(4)(a)(i) 7.56 Art 24(4)(a)(ii) 6.25 Art 24(4)(b) 7.40, 7.51 Art 24(4)(c) 6.29, 7.51 Art 24(5) 4.14, 4.60, 23.34 Art 24(5), last sentence 20.20

Art 24(6) 4.60, 7.73, 21.13 Arts 24(7)–(9) 21.18 Art 24(7) 4.44, 6.21, 6.13, 7.58, 21.19 Art 24(7)(a) 4.35, 6.21 Art 24(7)(b) 4.08, 6.22 Art 24(8) 4.08 Art 24(9) 4.01, 4.25, 4.60, 7.59, 8.47, 21.18 Art 24(9), 1st para, sub (b) 4.09 Art 24(9), 3rd para 4.09 Art 24(10) 4.01, 4.08, 4.20, 4.60 Art 24(11) 4.60, 6.38, 21.09, 21.52, 21.55 Art 24(11)(1) 7.76 Art 24(11), 3rd subpara 4.18 Art 24(11)(2) 7.76 Art 24(12) 8.28, 8.58, 8.59, 9.54, 19.117, 21.10, 23.47, 23.48 Art 24(13) 8.38, 21.25, 21.29 Art 24(13)(d) 4.09, 4.18 Art 24(14) 21.25, 21.29 Art 24(14)(c) 7.49 Art 25 2.28, 6.38, 12.04, 23.47 Art 25(1), 4.12, 4.24, 4.60, 6.38 Art 25(2) 2.28, 4.01, 4.12, 4.60, 21.43 Art 25(2)(2) 7.76 Art 25(2)(4) 21.13 Art 25(3) 2.28, 4.01, 4.28, 4.60, 7.76 Art 25(4) 2.28, 4.13, 4.60, 4.62, 4.64, 4.72, 7.74, 23.36 Art 25(4)(a)(v) 2.28 Art 25(4)(b) 4.35 Art 25(4)(d) 4.68, 4.91 Art 25(5) 21.13 Art 25(6) 4.14, 6.43, 21.13 Art 25(7) 4.60 Art 25(9)(c) 7.49 Art 25(10)(b) 2.28 Arts 27–28 19.117 Art 27 4.01, 4.71, 4.91, 15.106, 23.47 Art 27(1)(2) 7.67

Art 27(2) 7.70 Art 27(3) 7.69 Art 27(4) 7.65 Art 27(5)(2) 7.66 Art 27(6) 7.69 Art 27(9)(a) 7.49 Art 28 23.47 Art 28(2) 12.31 Art 28(3) 21.24 Art 29 6.35 Art 29(1) 23.43 Art 29(3) 4.60 Art 29(4) 19.12 Art 30 4.14, 4.61, 4.62 Art 30(1) 4.14, 4.68 Art 30(1), 2nd indent 23.34 Art 30(2) 4.14 Art 30(6) 21.24 Art 31 et seq 7.10 Art 33 13.48, 22.116, 23.44 Art 33(1) 13.16 Art 33(2) 13.16 Art 33(3) 13.16, 13.18 Art 33(3)(a) 13.17, 13.51 Art 33(3)(e) 13.32 Art 33(4) 13.32 Art 33(7) 13.47 Art 33(8) 13.19 Arts 34–35 19.47 Art 34 10.58, 10.78, 19.118, 23.47 Art 35 10.78 Art 35(8) 23.47 Arts 35–36 11.79 Arts 36–38 11.79 Art 37(1) 22.90 Art 37(2) 22.88 Art 38 22.90

Arts 39–43 1.27, 10.04, 10.45 Art 39 10.13, 10.33, 10.42, 10.48, 10.51, 10.55, 10.64, 10.68, 10.69, 10.70, 10.78, 19.47, 23.35 Art 39(1) 10.05, 10.09, 10.10, 10.45, 10.78 Art 39(2) 10.78 Art 39(2), opening words 10.46, 10.47 Art 39(2)(a) 10.47 Art 39(2)(b) 10.47 Art 39(2)(c) 10.47 Art 39(2)(d) 10.47 Art 39(2)(e) 10.47 Art 39(2)(f) 10.47 Art 39(3) 10.46 Art 40 10.46, 16.32, 16.84, 23.35 Art 41(1), opening words 10.47 Art 41(1)(b) 10.47 Art 41(2) 10.10, 10.52, 10.62 Art 41(2), 1st para 10.48 Art 41(2), 2nd para, first part of the sentence 10.47 Art 41(2), 2nd para, second part of the sentence 10.47 Art 42 10.08, 10.10, 10.68, 10.69, 10.71, 10.75, 10.78, 16.32, 23.35 Art 42, last sentence 10.69 Art 42(2)(f) 16.32 Art 43 19.50 Art 43(a) 10.49 Art 43(b) 10.49 Art 43(c) 10.49 Art 43(d) 10.49 Art 43(e) 10.49 Art 44 10.14, 19.47 Arts 44–56 19.05 Art 44(1) 11.17 Art 44(1)(1) 11.17 Art 44(2) 11.17 Art 44(5) 19.50 Art 45(1) 11.18 Art 45(2)(a) 11.18

Art 45(2)(b) 11.18 Art 45(2)(c) 11.18 Art 45(3) 11.18 Art 45(4) 11.18 Art 45(6) 11.18 Art 46 11.20 Art 46(1) 11.78 Art 46(2) 11.77 Art 47 11.76 Art 47(1) 11.21 Art 48 11.21, 11.27, 12.05, 17.20, 17.21 Art 48(1) 11.21, 17.34, 17.36 Art 48(2) 17.37 Art 48(5) 17.37 Art 48(6) 17.40 Art 48(8) 17.40 Art 48(9) 17.40, 17.56 Art 48(10) 17.50 Art 49 11.27, 17.20, 17.21, 17.48, 17.49, 17.50 Art 50 17.20, 17.21 Art 51 11.21 Art 51(2) 22.63 Art 52 11.21 Art 54 11.21 Art 53(2) 22.88 Art 53(3) 11.28 Art 53(4) 4.15 Art 55 22.90 Art 57 2.47, 16.21, 16.63, 16.87, 19.35 Art 57(1) 16.71 Art 57(3) 16.64 Art 57(4) 16.86 Art 57(8)–(10) 16.89 Art 57(12) 16.64, 16.71 Art 57(12)(f) 16.73 Art 57(13) 16.87 Art 58 2.47, 16.29

Art 59 10.11, 19.47 Art 59(1) 2.58 Art 59(2) 10.13 Art 60(2) 10.13 Art 62 19.50 Art 63 2.58 Art 64 2.58 Art 65 2.58, 19.50 Art 66 2.58 Arts 67–88 1.45, 19.07, 19.129 Art 67(1) 19.11, 19.50, 19.103, 19.104 Art 67(2) 19.19, 19.38, 19.54 Art 67(2), 1st subpara 19.12 Art 67(2), 2nd subpara 19.12 Art 67(2), 3rd subpara 19.13 Art 67(3) 19.14 Art 68 19.17, 19.132 Art 69 19.30, 19.47 Art 69(1) 19.28 Art 69(2) 4.02 Art 69(2), 1st para 19.30 Art 69(2), 2nd para 19.29 Art 69(2), 3rd para 19.29 Art 69(2), last para 20.04, 20.21, 20.29, 20.33, 20.36, 20.37 Art 69(2), in fine 9.45 Art 69(2)(o) 19.89 Art 69(2)(p) 16.82, 16.87, 16.88, 19.89 Art 69(2)(s) 5.41, 5.62 Art 69(2)(t) 5.41, 5.61 Arts 70–71 19.40 Art 70 19.46, 19.50, 19.85 Art 70(1), 1st subpara, 1st sentence 19.41 Art 70(1), 1st subpara, 2nd sentence 19.42 Art 70(1), 2nd subpara 19.43 Art 70(1), 3rd subpara 19.46 Art 70(2) 19.42

Art 70(3) 19.47 Art 70(3)(a)(x) 4.02 Art 70(3)–(5) 19.42, 19.47 Art 70(6) 19.48, 19.50 Art 70(6)(f) 19.52 Art 70(7) 19.53 Art 71 19.49, 19.105 Art 71(1), 1st subpara 19.58 Art 71(1), 2nd subpara 19.59 Art 71(1), 3rd subpara 19.59 Art 71(2) 19.60 Art 71(3) 19.69 Art 71(3), 1st subpara 19.61 Art 71(3), 2nd subpara, 1st sentence 19.69 Art 71(3), 2nd subpara, 2nd –4th sentences 19.71 Art 71(3), 2nd subpara, 3rd sentence 19.70 Art 71(3), 2nd subpara, 4th sentence 19.70 Art 71(3)–(6) 19.63 Art 71(4), 1st subpara, 1st sentence 19.66 Art 71(4), 1st subpara, 2nd sentence 19.66 Art 71(4), 2nd subpara, 1st sentence 19.72 Art 71(4), 2nd subpara, 2nd sentence 19.73 Art 71(5) 19.67, 19.73 Art 71(6) 19.68, 19.74 Art 71(7) 19.64 Art 71(7), 3rd subpara 19.65 Art 72 19.40 Art 72(1) 19.38, 19.54 Art 72(2) 19.55 Art 73(1) 19.76 Art 73(2) 19.77 Arts 74–75 19.105 Art 74 19.105 Art 74(1) 19.78 Art 74(2) 19.79

Art 75 19.105 Art 75(1)–2) 19.81 Art 75(3) 19.82 Art 76 19.105, 19.106, 19.124 Art 76(1) 19.19 Art 76(2) 19.20 Art 76(3) 19.20 Art 76(4)–(5) 19.22 Art 77 19.104 Art 77(1) 19.24 Art 77(2) 19.25 Art 78 19.39 Arts 79–88 19.132 Art 79 11.80, 16.33, 19.83 Art 79(1) 19.103 Art 79(1), 1st subpara 19.83 Art 79(1), 2nd subpara 19.85 Art 79(1), 3rd –5th subpara 19.86 Art 79(2) 11.80, 19.91 Art 79(3) 19.87 Art 79(4) 19.88 Art 79(5) 19.90 Art 79(6)–(7) 19.98 Art 79(8) 19.94 Art 79(9) 19.56 Art 79(9), 3rd subpara 19.96 Art 80(1) 19.99 Art 80(2) 19.100 Art 80(3) 19.100 Art 80(4), 3rd subpara 19.100 Art 81(1) 19.103 Art 81(2) 19.104 Art 81(3) 19.105 Art 81(4) 19.108 Art 81(4), 3rd subpara 19.108 Art 81(5) 19.106, 19.107

Art 82(1) 19.109 Art 82(2) 19.110 Art 83 19.111 Art 84(1)–(2) 19.112 Art 84(3) 19.113 Art 84(4) 19.115 Art 84(4), 3rd subpara 19.115 Art 85 19.116 Art 86(1) 19.118 Art 86(1)–(3) 19.122 Art 86(2) 19.120 Art 86(3) 19.121 Art 86(4) 19.122 Art 87 19.84 Art 88 19.104, 19.106 Art 88(1) 19.124 Art 88(2) 19.125 Art 91 21.06 Art 93(1), 1st subpara, 1st sentence 19.02 Art 93(1), 2nd subpara 19.02 Art 94 2.16 Art 95 2.49, 16.50 Art 96 19.02 Art 97 19.02 Annex I, Section A 1.09, 2.03, 2.04, 4.55, 11.23, 19.04, 23.39, 23.40 Annex I, Section A(1) 2.20 Annex I, Section A(2) 2.20 Annex I, Section A(4) 2.20 Annex I, Section A(5) 2.20 Annex I, Section A(9) 1.09 Annex I, Section B 8.62, 19.05 Annex I, Section B(2) 7.73 Annex I, Section B(5) 4.24, 4.37 Annex I, Section C 2.03, 2.43, 2.44, 2.46, 19.04, 19.34, 23.39 Annex I, Section C(1) 2.46, 23.39 Annex I, Section C(2) 2.46 Annex I, Section C(3) 2.46

Annex I, Section C(4) 2.46, 2.47 Annex I, Section C(4)–(10) 15.03 Annex I, Section C(5) 2.46, 2.48, 16.47 Annex I, Section C(6) 2.46, 2.49, 16.47, 16.49, 16.50 Annex I, Section C(7) 2.46, 2.50, 16.47 Annex I, Section C(8) 2.46 Annex I, Section C(9) 2.46 Annex I, Section C(10) 2.46, 2.47, 16.47, 16.60 Annex I, Section D 2.57 Annex I, Section II 10.06 2014/91/EU Directive of the European Parliament and of the Council of 23 July 2014 on the coordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards depositary functions, remuneration policies, and sanctions, [2014] OJ L 257/186 (UCITS V) 1.48, 5.02, 16.39, 16.40, 16.85 Art 2(1), 2nd para 5.02 Art 49 16.85 2014/92/EU Directive of the European Parliament and of the Council of 23 July 2014 on the comparability of fees related to payment accounts, payment account switching and access to payment accounts with basic features, [2014] OJ L 257/214 (Payment Accounts Directive (PAD)) 21.53, 21.54 Art 4(3) 21.53 Art 5(2) 21.53 Art 8 21.53 2016/97/EU Directive of the European Parliament and of the Council of 20 January 2016 on insurance distribution (recast), [2016] OJ L 26/19 (Insurance Distribution Directive (IDD)) 1.48, 2.53, 2.54, 21.03, 21.04, 21.06, 21.07, 21.08, 21.09, 21.10, 21.11–21.13, 21.15, 21.16, 21.18– 21.26, 21.27, 21.29, 21.20, 21.32–21.35, 21.38, 21.50, 21.53, 21.54, 21.55, 21.59 recital 56 21.06 Art 17(1) 21.08, 21.16 Art 17(2) 21.08, 21.16 Art 18 21.10 Art 19 21.06, 21.10

Arts 20–22 21.10 Art 20 21.11 Art 20(1) 21.11 Art 21 21.53 Art 22(2) 21.10 Art 23 21.08 Art 24 21.09 Art 25 21.06, 21.08 Art 25(2) 21.16 Arts 27–28 21.13 Art 29(1) 21.13 Art 29(2) 21.14, 21.18 Art 29(3) 21.14, 21.18 Art 29(3), 4th para 21.19 Art 29(3), last para 21.21 Art 29(4) 21.19 Art 29(4), 2nd para 21.29 Art 30 21.13 Art 30(1) 21.11 Art 30(4) 21.13 Art 30(5) 21.13 2016/1034/EU Directive of the European Parliament and of the Council of 23 June 2016 amending Directive 2014/65/EU on markets in financial instruments, [2016] OJ L 175/8 1.02 Draft Commission Delegated Directive of 7 April 2016, supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or nonmonetary benefits, C(2016) 2031 final 5.07, 5.08, 5.32, 8.39, 8.46, 8.48, 8.52, 8.53, 8.63, 8.67 recital 15 5.07 recital 15 in fine 5.09 recital 17 5.06 recital 17, 2nd sentence 5.29 recital 18 5.09 recital 19 5.22

recital 20 5.36 recital 23 8.51 recital 24 8.41 recital 28 8.63 recital 29 8.67 Art 1(2) 5.05, 5.07, 5.10, 5.12, 5.13, 5.17, 5.19, 5.20, 5.22, 5.24, 5.26, 5.27, 5.28, 5.29, 5.30, 5.31, 5.32, 5.33, 5.34, 5.35, 5.37, 5.38, 5.39, 5.40 Art 9(1), 1st para 5.07 Art 9(1), 2nd para 5.07 Art 9(3) 5.24 Art 9(4) 5.24 Art 9(5) 5.30 Art 9(6) 5.12 Art 9(6) 2nd sentence 5.13 Art 9(6) 3rd sentence 5.13 Art 9(7) 5.17 Art 9(8) 5.08 Art 9(9) 1st sentence 5.23 Art 9(9) 2nd sentence 5.23 Art 9(9) 1st para, 2nd sentence 5.19 Art 9(9) 1st para, 3rd sentence 5.19 Art 9(9) 2nd para 5.20 Art 9(10) 5.24 Art 9(11) 5.24 Art 9(12) 5.24 Art 9(14) 5.32, 5.33 Art 9(15) 5.32 Art 9(15) 1st sentence 5.34 Art 9(15) 2nd sentence 5.34 Art 9(15) 3rd sentence 5.35 Art 9(15) 4th sentence 5.35 Art 10(1), 1st para 5.09 Art 10(1), 2nd para 5.28 Art 10(1), 3rd para 5.28

Art 10(2), 1st para 5.26 Art 10(2), 2nd para 5.27 Art 10(2), 3rd para 5.28, Art 10(2), 3rd para 1st sentence 5.29 Art 10(2), 3rd para 2nd sentence 5.29 Art 10(3) 5.40 Art 10(4) 5.32, 5.38 Art 10(5) 5.32, 5.39 Art 10(6) 5.17 Art 10(7) 5.31 Art 10(8) 5.12 Art 10(8) 2nd sentence 5.13 Art 10(8) 3rd sentence 5.13 Art 10(9) 5.37 Art 10(10), 1st sentence 5.10 Art 10(10)(a) 5.10 Art 10(10)(b) 5.10 Art 10(10)(c) 5.10 Art 10(13) 5.29 Art 11 8.43 Art 11(2) 8.49 Art 11(5) 8.55 Art 12 8.41 Art 12(1) 8.41 Art 12(3) 8.44 Art 13 8.65 Proposal for a Directive of the European Parliament and of the Council on insurance mediation (recast), COM(2012) 360 21.06 Proposal for a Directive of the European Parliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC of the European Parliament and of the Council (Recast), COM/2011/0656 final 10.52, 11.15 recital 73 10.52 Art 4 10.52 Regulations

45/2001/EC Regulation of the European Parliament and of the Council of 18 December 2000 on the protection of individuals with regard to the processing of personal data by the Community institutions and bodies and on the free movement of such data, [2001] OJ L 8/1 19.39, 19.126 Art 9 19.124 1606/2002/EC Regulation of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards, [2002] OJ L 243/1 Art 3 16.71 1287/2006/EC Commission Regulation implementing Directive 2004/39/EC as regards record-keeping obligations for investment firms, transaction reporting, market transparency, admission of financial instruments to trading, and defined terms for the purposes of that Directive, [2006] OJ L 241/1 (MiFID I Implementing Regulation) 1.01, 9.01, 11.01, 11.15, 14.57, 14.68, 14.75, 20.01 Art 2(1) 16.45 Art 16 19.95 Art 18(1)(a) 14.53 Art 18(1)(b) 14.55 Art 18(2) 14.56 Art 20 14.57 Art 21 9.10 Art 22 14.50 Annex I 19.69, 19.72 Annex II 19.66 Annex II, Table 1 14.45 Annex III 19.72 1234/2007/EC Council Regulation of 22 October 2007 establishing a common organization of agricultural markets and on specific provisions for certain agricultural products, [2007] OJ L 299/1 (Single CMO Regulation) 5.56, 5.71, 16.32, 16.84 713/2009/EC Regulation of the European Parliament and of the Council of 13 July 2009 establishing an Agency for the Cooperation of Energy Regulators, [2009] OJ L 211/1 19.90 1060/2009/EC Regulation of the European Parliament and of the Council of 16 September 2009 on credit rating agencies, [2009] OJ L 302/1 (CRA Regulation) 1.24, 10.23, 10.25, 10.27

Art 5(6) 10.25 583/2010/EU Commission Regulation of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards key investor information and conditions to be met when providing key investor information or the prospectus in a durable medium other than paper or by means of a website, [2010] OJ L 176/1 (UCITS Implementing Regulation) 21.28 Art 4(8) 21.36 Art 4(9) 21.29 Art 6 21.28 Art 8 21.36 Art 8(1) 21.36 Arts 10–13 21.29 Annex I 21.36 1092/2010/EU Regulation of the European Parliament and of the Council of 24 November 2010 on European Union macro-prudential oversight of the financial system, [2010] OJ L 331/1 19.106 1093/2010/EU Regulation of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/78/EC, [2010] OJ L 331/12 (EBA Regulation) 5.64, 5.73 Art 9 5.64 Art 9(2) 5.64 Art 9(5) 5.65, 5.66, 5.73 Art 9(5), 3rd para 5.66 Art 18 5.73 1095/2010/EU Regulation of the European Parliament and of the Council establishing a European Supervisory Authority, [2010] OJ L 331/84 (ESMA Regulation) 5.64, 5.73, 12.36, 12.47, 19.83 Art 1(2) 19.110 Art 9 5.64 Art 9(2) 5.64 Art 9(5) 4.84, 5.65, 5.66, 5.73 Art 9(5), 3rd para 5.66 Arts 10–14 19.100 Art 10 1.02

Art 10(1) 5th subpara 19.100 Art 15 1.02, 17.24, 19.65, 19.96, 19.100, 19.108, 19.115 Art 15(1) 19.65, 19.100 Art 17 19.110 Art 18 5.73 Art 19 12.36, 19.109, 19.110, 19.111, 19.122 Art 21 19.100 Art 31(c) 19.109 Art 33 19.124 Arts 35–36 19.84 1227/2011/EU Regulation of the European Parliament and the Council of 25 October 2011 on wholesale energy market integrity and transparency, [2011] OJ L 326/1 (REMIT) 2.49, 16.05, 16.49 Art 2(4) 16.49 236/2012/EU Regulation of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps, [2012] OJ L 86/1 (Short Selling Regulation) 12.43, 16.92, 22.75 Art 14(2) 22.76 648/2012/EU Regulation of the European Parliament and of the Council of 4 July 2012, on OTC derivatives, central counterparties and trade repositories, [2012] OJ L 201/1 (European Market Infrastructure Regulation (EMIR)) 1.24, 1.29, 1.39, 2.49, 10.16, 10.24, 10.25, 10.27, 11.01, 11.65, 11.73, 11.80, 11.82, 11.83, 11.85, 11.86, 12.06, 12.49, 15.01, 15.04, 15.13, 15.15, 15.16, 15.17, 15.18, 15.19, 15.23, 15.24, 15.25, 15.26, 15.31, 15.33, 15.40, 15.45, 15.46, 15.50, 15.51, 15.57, 15.74, 15.77, 15.78, 15.79, 15.82, 15.83, 15.103, 15.104, 15.106, 15.110, 16.03, 16.14, 16.25, 16.28, 16.35, 16.46, 16.47, 16.50, 16.67, 16.69, 16.71, 16.72, 16.73, 22.62, 22.63, 22.64, 22.65, 22.68, 22.69, 22.72, 22.73, 22.104, 22.105, 22.139 recital 23 22.68 recital 26 15.16 recital 34 11.31 recital 38 15.15 recital 52 11.83 recital 64 22.74 Title IV 10.24, 10.27 Title V 11.31, 11.59

Art 1(1) 16.67 Art 2(1) 19.22, 22.66 Art 2(3) 15.36 Art 2(6) 15.24 Art 2(7) 15.04 Art 2(8) 15.13, 16.67, 22.67 Art 2(9) 15.13 Art 2(12) 11.31 Art 2(14) 15.49 Art 3 15.15 Art 4(4) 15.14 Art 5(2) 15.33 Art 5(4) 15.18 Arts 7–8 11.79 Art 7 11.59 Art 10 22.64 Art 10(1)(b) 15.13 Art 10(3) 15.13, 16.25, 22.67 Art 16 22.66 Art 17(4) 15.83 Art 18 11.83 Art 25 15.104, 22.73 Art 25(1) 10.24 Art 25(6) 10.24 Art 34 22.63 Art 39 15.45, 15.76, 15.104, 22.74 Art 39(7) 22.74 Art 39(9) 15.46 Art 41 22.66 Art 42 22.66 Art 43 22.66 Art 45 22.66 Art 48 15.76, 15.104 Art 48(5) 15.47 Art 48(6) 15.47 Art 48(7) 15.47 Arts 51–54 11.79

Art 89 15.16 918/2012/EU Commission Delegated Regulation of 5 July 2012 supplementing Regulation (EU) No 236/2012 of the European Parliament and of the Council on short selling and certain aspects of credit default swaps with regard to definitions , the calculation of net short positions, covered sovereign credit default swaps, notification thresholds, liquidity thresholds for suspending restrictions, significant falls in the value of financial instruments and adverse events, [2012] OJ L 274/1 22.75 149/2013/EU Commission Delegated Regulation of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP, [2013] OJ L 52/11 (EMIR Regime (EMIR ICA RTS)) 15.79, 15.99, 15.103, 15.110 Chap II 15.82 Art 1(a) 15.80 Art 4(4) 15.79 Art 7 15.18 Art 10 15.13, 16.25, 16.68.16.71 Art 11 15.13, 16.25, 16.68 575/2013/EU Regulation of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, [2013] OJ L 176/1 (Capital Requirements Regulation (CRR)) 1.26, 2.15, 2.16, 2.17, 2.19, 2.20–2.25, 3.58, 4.67, 10.18, 10.27, 10.34, 10.62, 12.06, 15.01, 15.110, 16.36, 16.37, 22.06, 22.39, 22.44, 22.50 Art 4(1) 2.16 Art 4(1)(b) 3.25 Art 4(1)(c) 3.25 Art 4(1)(1) 19.05, 22.27 Art 4(1)(2) 2.16, 2.20 Art 4(1)(2c) 2.22 Art 4(1)(3) 2.20, 3.25 Art 4(1)(4) 2.18 Art 4(1)(26) 19.17

Art 4(1)(36) 3.56 Art 4(2) 2.16, 3.25 Art 52 4.51 Art 92 2.22 Art 95 2.22 Art 96 2.22 Art 395(2) 22.39 Art 435 3.58 Art 450 3.58 Art 493 2.25 Art 493(1) 16.38 Art 498 2.25 Art 498(1) 16.38 1308/2013/EU Regulation of the European Parliament and of the Council of 17 December 2013 establishing a common organization of the markets in agricultural products and repealing Council Regulations (EEC) No 922/72, (EEC) No 234/79, (EC) No 1037/2001 and (EC) No 1234/2007, [2013] OJ L 347/671 19.98 596/2014/EU Regulation of the European Parliament and of the Council of 16 April 2014 on market abuse repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC, [2014] OJ L 173/1 (Market Abuse Regulation (MAR)) 1.33, 10.15, 10.35, 13.02, 13.24, 13.25, 13.27, 13.32, 13.33, 13.41, 13.45, 13.54, 15.01, 16.23, 16.31, 17.56, 19.33 recital 5 13.32, 13.33 Art 1 13.33 Art 2(1) lit. (b) 13.24 Art 7 13.31 Art 7(2) 13.28 Art 17 13.29 Art 17(1) 13.27, 13.31 Art 17(4) 13.28 Art 18(6) 13.25 Art 19(1) 13.27 Art 19(4) 13.27 Art 30(2)(j)(ii) 13.29

600/2014/EU Regulation of the European Parliament and of the Council of 15 May 2014 on Markets in Financial Instruments and amending Regulation (EU) No 648/2012, [2014] OJ L 173/84 (MiFIR) 1.02, 1.03, 1.07, 1.19, 1.24, 1.25, 1.26, 1.28, 1.30, 1.31, 1.32, 1.38, 1.40, 1.50, 1.56, 2.45, 2.49, 3.54, 4.51, 4.83, 5.01, 5.40, 5.42, 5.58, 5.65, 5.66, 5.68, 5.73, 7.08, 9.01, 9.45, 10.01–10.07, 10.09, 10.10, 10.14, 10.15, 10.19, 10.20– 10.23, 10.27, 10.32, 10.34, 10.41, 10.45, 10.62, 10.67, 10.70, 10.72, 10.74, 10.76–10.78, 11.01, 11.31, 11.73, 11.75, 11.81, 12.01–12.09, 12.12, 12.13–12.17, 12.19, 12.23, 12.29–12.31, 12.34, 12.36, 12.40, 12.42, 12.44, 12.45–12.51, 12.53, 12.55–12.57, 14.07–14.09, 14.60, 14.64, 14.69, 14.71, 14.77, 14.102, 14.106, 15.01, 15.03, 15.04, 15.10, 15.14, 15.15, 15.16, 15.26, 15.27, 15.33, 15.35, 15.36, 15.40, 15.50– 15.52, 15.57, 15.75, 15.77, 15.94, 15.104, 15.106, 15.111, 15.114, 15.117, 15.131, 15.132, 16.02–16.03, 16.14, 16.18, 16.25, 16.26, 16.31, 16.32, 16.42–16.43, 16.47, 16.71, 16.72, 16.84, 16.88, 16.89, 19.01, 19.03, 19.33, 19.34, 19.58, 19.75, 19.78, 19.79, 20.01, 20.04, 22.06, 22.63, 22.76, 22.139, 23.12, 23.34, 23.35 recital 3 11.16 recital 6 14.92 recital 7 11.22 recital 8 14.60, 15.06, 15.106, 22.65 recital 9 7.07, 9.16 recital 26 7.07, 15.06 recital 27 15.06 recital 28 14.61 recital 34 22.76 recital 37 15.33 recital 41 10.01, 10.02, 10.19, 10.22, 10.28 recital 43 10.67, 10.74 recitals 10.72 Title III 15.31 Title V 1.35, 11.30, 11.65, 15.01, 15.02, 15.06, 15.32, 15.49, 15.76, 15.105 Title VI 11.30, 11.65 Title VII, Chap 1 5.48 Art 1(1)(f) 10.04, 10.09, 22.63 Art 1(30) 2.47

Art 1(32) 15.04 Art 2(1)(28) 22.62 Art 2(1)(29) 15.03 Art 2(1)(30) 16.47, 19.31 Art 2(1)(34) 15.105 Art 2(1)(42) 10.04 Art 2(1)(47) 15.109, 15.111 Arts 3–22 12.02 Art 3(1) 12.18, 14.64 Art 3(2) 12.18 Art 4 12.19, 12.36, 12.37, 14.67 Art 4(1)(a) 14.67, 14.77 Art 4(1)(b) 14.69 Art 4(1)(b)(i) 14.77, 14.81 Art 4(1)(b)(ii) 14.73 Art 4(1)(c) 14.75 Art 4(1)(d) 14.71 Art 4(2)(a) 14.68 Art 4(2)(b) 14.68 Art 4(3)(a) 14.69 Art 4(3)(b) 14.69 Art 4(4) 12.37 Art 4(7) 12.37, 14.106 Art 5 12.20, 12.48, 14.78, 18.106, 18.110 Art 5(2) 14.82 Art 5(3) 14.82 Art 5(7) 14.84 Art 5(8) 14.85 Art 6 2.57, 12.21 Art 7 2.57, 12.21, 12.38 Art 7(1), 3rd sentence 19.47 Art 8 12.22, 12.23, 15.106 Art 8(1) 14.64 Art 9 12.23, 12.39 Art 9(4) 12.24 Art 9(5) 12.32 Art 10 2.57, 12.25, 12.39, 15.105, 15.106, 15.125

Art 11 12.25 Art 11(1) 19.47 Art 12 2.57 Art 13 2.57 Arts 14–15 12.27 Arts 14–26 19.117 Art 14 22.63, 23.47 Art 14(1) 9.10, 12.28 Art 14(2) 12.28 Art 14(3) 12.28 Art 14(4) 12.28 Art 14(5) 12.28 Art 15(1) 12.28 Art 15(2) 12.29 Art 15(3) 12.29 Art 17 12.30 Art 18 12.27, 12.33, 15.106 Art 18(1) 9.10, 12.32 Art 18(3) 12.32 Art 18(5) 12.32 Art 18(6) 12.33 Art 18(7) 12.33 Art 18(9) 12.32 Art 20 2.57, 12.26, 22.62 Art 20(1) 9.10 Art 21 2.57, 12.26, 15.106 Art 21(1) 9.10 Art 23 14.93 Art 23(1) 14.93 Art 23(2) 14.93 Art 25 15.126 Art 26 22.62 Arts 28–34 11.30, 12.15 Art 28 15.06, 15.106, 16.26 Art 28(1) 10.16, 15.15, 15.16 Art 28(2) 15.14, 15.28 Art 28(4) 10.15, 10.16

Art 29(1) 15.32 Art 29(2) 15.49, 15.57 Art 30 15.76, 15.103 Art 30(1) 15.104 Art 31 15.105, 22.65 Art 31(2) 15.117, 15.124 Art 31(3) 15.126 Art 31(4) 15.117 Art 31(4)(a) 15.117 Art 31(4)(b) 15.117 Art 32 10.16, 15.18, 16.26, 22.63 Art 32(1) 15.17, 15.27 Art 32(1)(b) 15.26 Art 32(2) 15.18, 15.21, 15.25 Art 32(2)(b) 15.20 Art 32(3) 15.20 Art 32(4) 15.25, 15.31, 22.63 Art 32(5) 15.27 Art 33 15.02 Art 34 10.16, 15.29, 16.26 Arts 35–36 10.15 Art 35 15.34 Art 35(1) 11.30 Art 36 15.34 Art 36(1) 11.30 Art 37 10.15 Art 37(1) 10.22 Art 38 10.15 Art 38(1) 10.15 Art 38(2) 10.15 Art 38(3) 10.15 Arts 39–43 5.41 Arts 40–42 19.35 Art 40 4.84, 5.62, 5.65, 16.32 Art 40(1) 5.66 Art 40(2), 1st para 5.67 Art 40(2), 2nd para 5.66

Art 40(2)(c) 4.85 Art 40(3), 1st para 5.71 Art 40(3), 2nd para 5.72 Art 40(4) 5.66 Art 40(5) 5.66 Art 40(6) 5.66 Art 40(7) 5.70 Art 40(8) 5.68 Art 40(8)(b) 5.69 Art 41 5.62, 5.65 Art 41(1) 5.66 Art 41(2), 1st para 5.67 Art 41(2), 2nd para 5.66 Art 41(3), 1st para 5.71 Art 41(3), 2nd para 5.72 Art 41(4) 5.66 Art 41(5) 5.66 Art 41(6) 5.66 Art 41(7) 5.70 Art 41(8) 5.68 Art 41(8)(b) 5.69 Art 42 4.84, 5.62, 16.84, 23.48 Art 42(1) 5.42 Art 42(2) 2nd para 5.42 Art 42(2) 3rd para 5.42 Art 42(2)(a) 5.45 Art 42(2)(b) 4.85, 5.52 Art 42(2)(c) 5.53, 16.84 Art 42(2)(d) 5.54, 16.84 Art 42(2)(e) 5.55 Art 42(2)(f) 5.56 Art 42(3)(a) 5.57 Art 42(3)(b) 5.57 Art 42(3)(c) 5.57 Art 42(4) 5.58 Art 42(5) 5.43

Art 42(6) 5.44 Art 42(7) 5.46 Art 42(7)(d) 5.69 Art 43(1) 5.59 Art 43(2) 5.60, 5.72 Art 43(3) 5.60 Art 45(1) 16.88 Arts 46–49 1.26, 10.04, 10.17 Art 46 10.66, 10.67 Art 46(1) 10.05, 10.09, 10.10, 10.29, 10.33, 10.40, 10.60, 10.78 Art 46(2) 10.29 Art 46(2)(b) 10.29 Art 46(2)(c) 10.29 Art 46(3) 10.34, 10.62 Art 46(4) 10.17, 10.78 Art 46(4), 1st para 10.29 Art 46(4), 3rd para 10.29 Art 46(4), 5th para 10.67 Art 46(4), last para 10.40, 10.41 Art 46(5), 1st para 10.34 Art 46(5), 2nd para 10.34 Art 46(5), 3rd para 10.08, 10.10, 10.65, 10.66, 10.67, 10.69, 10.75, 10.78 Art 46(6) 10.34, 10.44 Art 46(7) 10.29 Art 47 10.20, 10.23, 10.27, 10.29 Art 47(1) 10.18, 10.22 Art 47(2) 10.29 Art 47(3) 10.33 10.57, 10.58, 10.60, 10.62, 10.63, 10.64, 10.78 Art 47(3), 1st para 10.58 Art 47(3), 1st para, last sentence 10.58 Art 47(3), 2nd para 10.59 Art 47(4) 10.40 Art 49(1)(a) 10.37 Art 49(1)(b) 10.37 Art 49(1)(c) 10.37 Art 49(1)(d) 10.37

Art 49(2) 10.38 Art 49(3) 10.39, 10.41, 10.63 Art 52 12.05 Art 54(1) 10.36 Art 55 15.50 Art 55, first subpara 19.02 Art 55, last subpara 19.02 806/2014/EU Regulation of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/2010, [2014] OJ L 225/1 Art 18(1)(c) 22.27 Art 27 4.34 909/2014/EU Regulation of 23 July 2014 on improving securities settlement in the EU and on central securities depositories and amending Directives 98/26/EC and 2014/65 and Regulation (EU) No 236/2012, [2014] OJ L 257/1 (CSDR) 22.91, 22.92, 22.93, 22.96, 22.97, 22.139 recital 5 22.92 Art 2(1)(1) 19.22 Art 12(1) 22.94 Art 25 22.98 Art 49 22.95 Art 54 22.98 Arts 59–60 22.98 1187/2014/EU Commission Delegated Regulation of 2 October 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and the Council as regards regulatory technical standards for determining the overall exposure to the client or a group of the connected clients in respect of transactions with underlying assets, [2014] OJ L 324/1 22.38 1286/2014/EU Regulation of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products, [2014] OJ L 352/1 (PRIIPs Regulation) 1.48, 7.80, 10.09, 21.03, 21.24, 21.27, 21.28, 21.30, 21.33, 21.35, 21.37, 21.49, 21.50, 21.61, 22.114 recital 35 21.49 Art 2 10.09

Art 6(4) 21.24, 21.28 Art 8(3)(d) 21.36 Art 8(3)(f) 21.29 Art 13 21.28 Art 32(1) 21.49 Art 33(1) 21.49 2205/2015/EU Commission Delegated Regulation of 6 August 2015 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation, [2015] OJ L 314/13 15.33 1033/2016/EU Regulation of the European Parliament and of the Council of 23 June 2016 amending Regulation (EU) No 600/2014 on markets in financial instruments, Regulation (EU) No 596/2014 on market abuse and Regulation (EU) No 909/2014 on improving securities settlement in the European Union and on central securities depositories, [2016] OJ L 175/ 1 1.02 Draft Commission Delegated Regulation (EU) of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, C(2016) 2398 final, 25 April 2016 3.03, 3.28, 3.50, 3.52, 3.53, 3.54, 17.21, 21.08, 21.25, 21.29, 21.31, 21.38 Arts 12–17 15.31 Art 20 17.29 Art 31(1), 1st sentence 20.37 Arts 46–50 21.29 Art 46 21.08 Arts 47–50 21.08 Art 48(2)(c) 21.43 Art 50(1) 21.32 Art 50(4) 21.31 Art 50(5) 21.30, 21.32 Art 50(6) 21.30 Draft Commission Delegated Regulation (EU) of 18 May 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and

positions, C(2016) 2860 final, 18 May 2016 (Draft Commission Delegated Regulation) 2.28, 3.50, 4.37, 5.41, 5.47, 5.48, 5.49, 5.50, 5.51, 9.10 recital 15 4.24, 4.38 recital 16 4.38, 15.117 recital 17 4.38 recital 18 5.51 recital 19 5.50 recital 48 4.91 recital 103 4.71, 9.09 recital 114 13.23 Art 9 4.24 Art 12 9.10 Art 13 9.10 Art 14 9.10 Art 15 9.10 Art 16 9.10 Art 17(2) 15.123 Art 17(3) 15.123 Art 17(4) 15.119 Art 17(5) 15.121 Art 17(6) 15.122 Art 18(1) 15.124 Art 18(2) 15.125 Arts 19–21 5.41 Art 19(1) 2nd para 5.50 Art 19(2) 1st para in fine 5.59, 5.68 Art 20(1) 2nd para 5.50 Art 20(2) 1st para in fine 5.59, 5.68 Art 21 3.50 Art 21(1) 1st para 5.47 Art 21(1) 1st para in fine 5.48 Art 21(1) 2nd para 5.50 Art 21(2)(a)–(v) 5.47, 5.50 Art 22 3.50, 3.53 Art 22(2) 3.53

Art 22(3) 3.53 Art 23 3.50, 3.52 Art 24 3.50, 3.52 Art 25 3.50 Art 27 3.45 Arts 33–35 3.54 Art 41(2) 4.68 Art 41(4) 4.67 Art 64(1), in fine 9.05, 9.09 Art 77(1) 13.17 Art 77(2) 13.01 Art 78(2)(c) 13.21 Art 78(2)(d) 13.22 Art 78(2)(e) 13.22 Art 78(2)(g) 13.23 Art 78(2)(h) 13.41 Annex 15.117 Draft Commission Delegated Regulation (EU) of 26 May 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on criteria for determining whether derivatives subject to the clearing obligation should be subject to the trading obligation (Draft Commission Delegated Regulation on the Trading Obligation) 15.21 recital 3 15.22 recital 10 15.30 Draft Commission Delegated Regulation (EU) of 13 June 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on the direct, substantial and foreseeable effect of derivative contracts within the Union and the prevention of the evasion rules and obligations recital 6 15.14 Art 2 5.14 Draft Commission Delegated Regulation (EU) of 19 June 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to regulatory technical standards

specifying the obligation to clear derivatives traded on regulated markets and timing of acceptance for clearing (Draft Commission Delegated Regulation on STP) recital 1 15.50 recital 9 15.68 recital 10 15.71 recital 11 15.72 recital 12 15.73 Art 1 15.58 Art 2(1) 15.63 Art 2(2) 15.59 Art 2(3)(a) 15.59 Art 2(3)(b) 15.59 Art 2(4)(a) 15.59 Art 2(4)(b) 15.59 Art 3(2) 15.60 Art 3(3) 15.60 Art 3(4) 15.61, 15.62 Art 4(1) 15.64 Art 4(2) 15.66 Art 4(3) 15.68 Art 4(4) 15.70 Art 4(5) 15.68 Art 5(1) 15.71 Art 5(2) 15.72 Art 5(3) 15.73 Draft Commission Delegated Regulation on Algorithmic Trading 15.70 Draft MIFIR ICA RTS 15.79, 15.81, 15.84, 15.97, 15.99, 15.101, 15.103, 15.104 recital 1 15.77 recital 3 15.83 recital 4 15.87 recital 6 15.87 recital 17 15.93 Art 1(1) 15.80 Art 2(1) 15.83 Art 3(2) 15.86, 15.92

Art 3(3) 15.83 Art 4(2) 15.85 Art 4(3) 15.92 Art 4(4) 15.86 Art 4(5) 15.89 Art 4(6) 15.89 Art 4(7) 15.79, 15.90 Art 4(8) 15.83, 15.93 Art 5(1) 15.85 Art 5(2) 15.88 Art 5(4) 15.92 Art 5(5) 15.86 Art 6(1) 15.95 Art 6(1)(c) 15.95 Art 6(2) 15.95 Art 6(2)(c) 15.95 Art 6(3) 15.94, 15.95 Art 6(3)(c) 15.95 Art 6(3)(d) 15.95 Art 6(4) 15.96 Art 6(4)(b) 15.82 Art 6(5) 15.96 Art 6(5)(b) 15.82 Art 6(6) 15.96 Art 6(6)(b) 15.82 Proposal for a Regulation laying down common rules on securitization and creating a European framework for simple, transparent and standardized securitization and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) 648/2012, COM (2015) 472 final 22.49, 22.50 recital 11 22.56 Art 2(12) 22.55 Art 3(1) 22.55 Art 3(3) 22.50, 22.55 Art 4(2) 22.52 Art 4(4) 22.55 Art 4(5) 22.51

Art 5 22.53 Arts 8–10 22.52 Art 10(2) 22.57 Art 14(4) 22.58 Proposal for a Regulation of the European Parliament and of the Council on markets in financial instruments, SEC(2011) 1227 final 11.15 Proposal for a Regulation of the European Parliament and of the Council on the prospectus to be published when securities are offered to the public or admitted to trading, COM (2015) 583 final recital 25 21.33, 22.111 Art 7 21.33 Proposal for a Regulation on Money Markets Funds, COM (2013) 615 final 22.83 Proposal for a Regulation on reporting and transparency of securities financing transactions, COM (2014) 040 final 22.101, 22.103, 22.104, 22.108 Art 2(1) 22.104 Proposal for a Regulation on structural measures improving the resilience of EU credit institutions, COM (2014) 43 final 22.101 NATIONAL LEGISLATION France

Code monétaire et financier Art 421-16-2 16.82 Art 547-1 et seq 23.22 Art L547-3 23.23 Art L547IV 23.23 Art L547-9 23.26 Decree no. 2014-1053 of 16 September 2014 implementing Ordinance no. 2014-559 23.22 Ordinance no. 2014-559 of 30 May 2014 23.22 Separation and Regulation of Banking Activities Act L.2013-672 of July 2013 16.82 Art 580-1 16.82 Art 580-2 16.82 Germany

Banking Act (Kreditwesengesetz–KWG) 23.24 § 1(1a), sentence 2 no 2 23.24 § 2.6 23.24, 23.25 § 32.1 23.24 BGB (Bürgerliches Gesetzbuch) §181 9.11, 9.17 Commercial Code (Wetboek van Koophandel) Arts 76–85a 9.07 HGB (Handelsgesetzbuch) §§ 383–406 9.07 § 400 9.13 Small Investor Protection Act (Kleinanlegerschutzgesetz) of 23 April 2015 23.24 Stock Corporation Act (Aktiengesetz) s 76 3.33 s 77 3.33 s 91 3.33 s 91(1) 3.33 s 91(2) 3.33, 3.64 s 93 3.33 Trade, Commerce and Industry Regulation Act (Gewerbeordnung–GewO) s 34c 23.13, 23.25 s 34f 23.24 Italy

Delibera Consob no. 18592/2013 (Consob Crowdfunding Regulation) 23.22 Art 13(3) 23.27 Art 13(5) 23.27 Art 14 23.27 Art 15 23.27 Art 15(1)(g) 23.27 Art 15(2) 23.32 Art 17(3) 23.22 Arts 24–25 23.27 Art 24(1) 23.27 Art 24(1)(a) 23.33 Art 24(1)(b) 23.27

Art 24(2) 23.22 Annex 3 23.27 Delibera Consob no. 19520/2016 (Consob Regulation) 23.22 Art 13(5-bis) 23.22 Art 13(5-ter) 23.22 Art 17(2)–(3) 23.22 Art 17(4) 23.22 Art 24(2-bis) 23.22 TUF (Testo Unico della Finanza) Art 50-quinquies(3) 23.22 Luxembourg

Civil Code Art 6 20.22 Netherlands

Bulletin of Acts and Decrees 8.21, 8.23, 8.26 Decree implementing the Pensions Act and the Occupational Pension Scheme (Obligatory Membership) Act Chap 4 20.27 Art 13(2)(e) 2.27 Dutch Civil Code (DCC) Art 6:2 20.15, 20.16, 20.17, 20.18 Art 6:2(1) 20.15 Art 6:2(2) 20.15 Art 6:233(a) 9.37 Art 6:235(1) 9.37 Art 6:248 20.15, 20.16, 20.17 Art 6:248(2) 9.37 Art 7:401 9.37 Art 7:416 9.14 Art 7:416(1) 9.14 Art 7:416(2) 9.14 Art 7:416(3) 9.14 Art 7:417 9.18 Art 7:417(1) 9.18 Art 7:417(2) 9.18

Dutch Draft Legislative Proposal for Implementation of MiFID, p. 11 10.42, 10.48 s 1:19c 10.67 Dutch Market Conduct Decree Art 168a 8.19 Exemption Regulation FSA (Vrijstellingsregeling Wft) Art 10 10.42, 10.48 Art 18 10.42 Art 35 10.42 Financial Supervision Act (FSA) (Wet op het financieel toezicht, Wft) 8.24 Art 2:96 10.42 Art 3:5 10.42 Art 3:6 10.42 Art 3:7 10.42 Art 4:20(6) 20.20 Occupational Pension Scheme (Obligatory Membership) Act (Wet verplichte beroepspensioenregeling) 20.27 s 43(1) 20.27 Pensions Act (Pensioenwet) 20.27 s 34(1) 20.27 Spain

Ley de fomento de la financiación empresarial (28 April 2015 No 5) 23.21 Art 46 23.21, 23.49 Art 47 23.49 Art 48 23.21, 23.49 Art 51 23.21 Art 51(1) 23.21 Art 52 23.21 Arts 55–56 23.21 Art 60 23.28 Art 61 23.28 Art 62 23.28 Art 66 23.21 Art 68 23.30 Art 71 23.28 Art 81 23.30

Arts 89–93 23.21 United Kingdom

Financial Services Act 1986 4.05 Financial Services and Markets Act 2000 (FSMA) 13.04 Pt X, Chap I 9.33 s 138D 9.33 s 150 9.33, 9.34 Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 Art 19 16.56 Art 53 4.39 United States

Commodity Exchange Act (CEA) 1936 16.77 s 5(d), core principle 5 16.77 Dodd-Frank Wall Street Reform and Consumer Financial Protection Act 1.36, 4.75, 11.67, 16.78, 16.91 Title VII 16.07, 16.78 Title VII, Pt II 15.18 s 723(8) 15.18 s 733 11.67 s 737 16.78 s 913 4.75 s 913(b) 4.80 s 913(f) 4.80 s 913(g) 4.79, 4.80 Investment Advisers Act 1940 4.74 s 206 4.76 s 206(3) 4.79 s 211(g) 4.79 Securities and Exchange Act Section 6, 15 USC § 78f (1934) 18.55 § 80b-2(a)(11)(C) 4.74 Securities Exchange Act s 10(b) 18.10 r 10b-5 18.10 s 15(k) 4.79, 4.80

LIST OF ABBREVIATIONS

ABCP ABS ABSPP ACER ACPR ADT AFM AFME AGR AIF AIFM AIFMD AIM AMF APA APM ARM AT ATS

Asset-Backed Commercial Paper Asset-Backed Securities Asset-Backed Securities Purchase Programme Agency for the Cooperation of Energy Regulators Autorité de contrôle prudentiel et de résolution Average Daily Turnover Authority for the Financial Markets Association for Financial Markets in Europe Average Growth Rate Alternative Investment Fund Alternative Investment Fund Manager Alternative Investment Fund Managers Directive Alternative Investment Market Autorité des Marchés Financiers Approved Publication Arrangement Adverse Price Movement Approved Reporting Mechanism Algorithmic Trading Alternative Trading System

Banks RWD BCBS BDCN BGB BIS BRRD BTSs

Directive 2001/24/EC on the Reorganisation and Winding Up of Credit Institutions Basel Committee on Banking Supervision Broker/Dealer Crossing Network Bürgerliches Gesetzbuch—German Civil Code Bank for International Settlements Banking Recovery and Resolution Directive Binding Technical Standards

CB CCP CDS CEA CEMA CEO CESR CFTC CIP CLOB CMU CN CNAV CNVM COBS COFIA CP CRA CRD I CRD IV CRR CSD CSDR CSMAD CTP

Clearing Broker Central Counterparties Credit Default Swaps Commodity Exchange Act Committee for Economic and Markets Analysis Chief Executive Officer Committee of European Securities Regulators Commodity Futures Trading Commission Conseiller en Investissement Participatif—French crowdfunding investment advisor Central Limit Order Book Capital Market Union Crossing Network Constant Net Asset Value Spanish Securities Commission Conduct of Business Sourcebook Classes of Financial Instruments Approach Consultation Paper Credit Rating Agency Capital Requirements Directive I Capital Requirements Directive IV Capital Requirements Regulation Central Securities Depository Central Securities Depositories Regulation Criminal Sanctions for Market Abuse Directive Consolidated Tape Provider

DCB DCC DEA DFSA DGS DJIA DM DMA DP DVC

Dutch Central Bank Dutch Civil Code (Burgerlijk Wetboek) Direct Electronic Access Dutch Financial Supervision Act Deposit Guarantee Scheme Dow Jones Industrial Average Dealer Market Direct Market Access Discussion Paper Double Volume Cap

DVP

Delivery versus Payment

EB EBA EBBO ECB ECGI ECJ EEA EFAMA EIOPA ELA EMIR EP ESA ESCB ESMA ESRB ETD ETF ETP EU

Executing Broker European Banking Authority European Best Bid or Offer European Central Bank European Corporate Governance Institute European Court of Justice European Economic Area European Fund and Asset Management Association European Insurance and Occupational Pensions Authority Emergency Liquidity Assistance European Market Infrastructure Regulation European Parliament European Supervisory Authority European System of Central Banks European Securities and Markets Authority European Systemic Risk Board Exchange-Traded Derivative Exchange Trade Fund Exchange Traded Product European Union

FATF FC FCA FINRA FMI FR FSA FSB FSMA FSMA 2000 FVC

Financial Action Task Force Financial Counterparty Financial Conduct Authority Financial Industry Regulatory Authority Financial Markets Infrastructure Final Report Financial Services Authority Financial Stability Board Financial Services and Markets Authority Financial Services and Markets Act 2000

GDP

Gross Domestic Product

Financial Vehicle Corporation

GEL GewO GOICA

Grant Estates Limited Gewerbeordnung—German Trade, Commerce, and Industry Regulation Act Gross Omnibus Indirect Client Account

HFT HGB

High-Frequency Trading/Trader Handelsgesetzbuch—German Commercial Code

IDD IEX IF IFP

Insurance Distribution Directive Investors Exchange Investment Firm intermédiaire en financement participative— French crowdlending investment advisor

IFRS IM IMD IMF IOSCO IPO IRSA ISA ISD 1993 ISDA ISICA ITS

International Financial Reporting Standards Initial Margin Insurance Mediation Directive International Monetary Fund International Organization of Securities Commissions Initial Public Offering Interest Rate Swap Agreement Individually Segregated Account Investment Services Directive 1993

KID KII KOM KWG KYC

Key Investor Document Key Investor Information Key Operating Milestone Kreditwesengesetz—German Banking Act Know Your Customer

LIS LSE LP

Large-in-Scale London Stock Exchange Liquidity Premium

International Swap and Derivatives Association Individually Segregated Indirect Client Account Implementing Technical Standards

MAC MAD MAR MCD MI MiFID MiFIR MMF MRM MTF

Mercato Alternativo del Capitale Market Abuse Directive Market Abuse Regulation Mortgage Credit Directive Market Impact Markets in Financial Instruments Directive Markets in Financial Instruments Regulation Money Market Funds Market Risk Measure Multilateral Trading Facility

NASD NBB NBO NCA NFC NMS NMS NT

National Association of Securities Dealers National Best Bid National Best Offer National Competent Authority Non-Financial Counterparty Normal Market Size National Market System Negotiated Trade / Negotiated Transaction

OAM OICA OFIs OMF OSA OTC OTF OTR

Officially Appointed Mechanism Omnibus Indirect Client Account Other Financial Institutions Order-Management Facility Omnibus Segregated Account Over the Counter Organized Trading Facility Order-to-Transaction Ratio

P2B P2P PAD PBBO PD PRA PRIIP PSI

Person-to-Business Peer-to-Peer Payment Accounts Directive Primary Best Bid and Offer Prospectus Directive Prudential Regulation Authority Packaged Retail and Insurance-based Investment Product Prestataire en Services d’investissement— French investment

firms RBS RDR REMIT RFQ RIE RMs RP RTS SA SDP SFTs SEC SEF SFD SFT SI SIB SIM

Royal Bank of Scotland Retail Distribution Review Regulation on Wholesale Energy Markets Integrity and Transparency Request for Quote Recognized Investment Exchange Regulated Markets Reference Price Regulatory Technical Standard

SMEs SMSG SPV SRM SRRI SSM SSS STP STS

Sponsored Access Single-Dealer Platform Securities Financing Transactions Securities and Exchange Commission Swap Execution Facility Settlement Finality Directive Securities Financing Transactions Systematic Internalizer Securities and Investments Board Società di investimento mobiliare—Italian banks and investment firms Small and Medium-Sized Enterprises Securities and Markets Stakeholder Group Special Purpose Vehicle Single Resolution Mechanism Synthetic Risk and Reward Indicator Single Supervisory Mechanism Systems of Settlement of Securities Straight-Through-Processing Simple, Transparent and Standardized Securitization

T2S TD TEU TFEU

Target 2 Securities Transparency Directive Treaty on European Union Treaty on the Functioning of the European Union

TR

Trade Repository

UCITS US

Units for Collective Investment in Transferable Securities United States

VC VDO VM VNAV

Venture Capitalist Volume Discovery Order Variation Margin Variable Net Asset Value

Wft

Wet op het financieel toezicht (Dutch Act on Financial Supervision) Wertpapierhandelsgesetz (German Securities Trading Act) Written Statement on Suitability

WpHG WSS

AUTHOR BIOGRAPHIES

Editors Danny Busch is Professor of Financial Law and Director of the Institute for Financial Law, Radboud University, Nijmegen, the Netherlands. He is Visiting Professor at Università Cattolica del Sacro Cuore di Milano, Visiting Professor at Università degli Studi di Genova and a Member of the Dutch Banking Disciplinary Committee (Tuchtcommissie Banken). He is extensively engaged in the provision of training to attorneys-at-law, financial regulators and financial professionals. He is author of many articles in the field of financial and commercial law, and editor of several books, including A Bank’s Duty of Care (with C.C. van Dam), Hart, 2017; Agency Law in Commercial Practice (with L. J. Macgregor and P. Watts), OUP, 2016; European Banking Union (with G. Ferrarini), OUP, 2015; Alternative Investment Funds in Europe (with L.D. van Setten), OUP, 2014; and Liability of Asset Managers (with D.A. DeMott), OUP 2012. After having graduated with highest honours in Dutch law from Utrecht University in 1997, he was awarded the degree of Magister Juris in European and Comparative Law by the University of Oxford (St. John’s College) in 1998. From 1998 until 2001 he held the position of lecturer and researcher at the Molengraaff Institute of Private Law in Utrecht. In 2002 he defended his PhD in Utrecht (Indirect Representation in European Contract Law, KLI, 2005). From 2002 until 2010 he was an attorney-at-law (advocaat) with the leading Dutch international law firm De Brauw Blackstone Westbroek in Amsterdam where he practised banking and securities law (both the private law and regulatory aspects). Guido Ferrarini is Professor of Business Law, University of Genoa, Italy, and Professor of Governance of Financial Institutions, University of

Nijmegen, the Netherlands. He holds a J. D. (University of Genoa, 1972), an LL.M. (Yale Law School, 1978) and a Dr. jur. (h.c., Ghent University, 2009). He is a founder and fellow of the European Corporate Governance Institute (ECGI), Brussels. He was a member of the Board of Trustees, International Accounting Standards Committee (IASC), London, an independent director at several Italian blue-chip companies, and Chairman of EuroTLX (an Italian MTF). He was an adviser to the Draghi Commission on Financial Markets Law Reform, to Consob (the Italian Securities Commission), and to the Corporate Governance Committee of the Italian Stock Exchange. He has held Visiting Professor positions at several universities in Europe (Bonn, Católica Lisbon, Frankfurt, Ghent, Hamburg, LSE, UCL, Tilburg, and Duisenberg) and the US (Columbia, NYU, and Stanford), teaching courses on comparative corporate governance and financial regulation. He is author of many articles in the fields of financial law, corporate law, and business law, and editor of several books, including Financial Regulation and Supervision: A Post-Crisis Analysis (with E. Wymeersch and K. Hopt) OUP, 2012, Boards and Shareholders in European Listed Companies (with M. Belcredi) CUP, 2013, and European Banking Union (with D. Busch) OUP, 2015. He is presently board chair of a securities firm, board member of a private bank, and adviser on corporate law and financial regulation.

Contributors Antonella Sciarrone Alibrandi is Professor of Law at the Università Cattolica del Sacro Cuore di Milano. Aron Berket is an attorney-at-law at Simmons & Simmons, Amsterdam. Jens-Hinrich Binder is Professor of Law and holds a Chair in Private, Commercial, and Corporate Law at Eberhard-Karls-University, Tuebingen, Germany. Veerle Colaert is Professor of Financial Law at KU Leuven University, a member of the advisory Securities and Markets Stakeholder Group of

ESMA and a member of the Sanctions Commission of the Belgian Financial Services and Markets Authority (FSMA).. Pierre-Henri Conac is Professor of Commercial Law at the University of Luxembourg and ECGI Research Associate. Carmine di Noia is a Commissioner at CONSOB (Italian Securities and Exchange Commission). The chapter was written when the author was deputy director General at ASSONIME and member of the Securities and Markets Stakeholder Group at ESMA. Luca Enriques is Allen & Overy Professor of Corporate Law at the University of Oxford and ECGI Research Fellow. Merritt B. Fox is Michael E. Patterson Professor of Law and NASDAQ Professor of the Law and Economics of Capital Markets at Columbia Law School. Matteo Gargantini is a Senior Research Fellow at the Max Planck Institute, Luxembourg. Paolo Giudici is Professor of Business Law at the Free University of Bozen-Bolzano and ECGI Research Associate. Peter Gomber is Professor of e-Finance and Co-Chair of the E-Finance Lab, Research Center SAFE, at Goethe University, Frankfurt. Christos V. Gortsos is Professor of Public Economic Law at the Law School of the National and Kapodistrian University of Athens and visiting Professor at the European Institute of the University of Saarland.. Edoardo Grossule is a Researcher at Università Cattolica del Sacro Cuore di Milano. Stefan Grundmann holds the Chair of Transnational Private Law at the European University Institute, and is on leave from Humboldt University where he is a Professor of Private and Business Law.

Ilya Gvozdevskiy is Research Assistant to the Chair of e-Finance, EFinance Lab, at Goethe University, Frankfurt. Philipp Hacker is a postdoctoral fellow and research assistant at Humboldt University of Berlin; in autumn 2016, he joined the European University Institute as a Max Weber Fellow. Kitty Lieverse is Professor of Financial Regulatory Law at the Radboud University, Nijmegen, and an attorney-at-law and partner at Loyens & Loeff, Amsterdam. Marije Louisse is an attorney-at-law at Loyens & Loeff, Amsterdam. Eugenia Macchiavello is a Lecturer in Banking Law at the University of Genoa and Senior Research Fellow at the Genoa Centre for Law and Finance. Niamh Moloney is Professor of Financial Markets Law at the London School of Economics and Political Science. Paolo Saguato is a Senior Fellow at the Institute of International Economic Law at Georgetown Law Centre and a Senior Fellow at the Genoa Centre for Law and Finance. Larissa Silverentand is an attorney at law and partner at NautaDutilh, Amsterdam. Lisette Simons is an attorney at law at NautaDutilh, Amsterdam. Jasha Sprecher is an attorney at law at NautaDutilh, Amsterdam. Rezah Stegeman is an attorney-at-law and partner at Simmons & Simmons, Amsterdam. Rüdiger Veil holds the Alfried Krupp Chair for Civil Law, German and International Business, and Corporate Law and is managing director of the Institute for Corporate and Capital Markets Law at Bucerius Law School.

Eddy Wymeersch is Professor Emeritus at the University of Gent. He has been Chairman of the Committee of European Securities Regulators (CESR) and of the European Regional Committee of IOSCO. He was Chairman of the CBFA (Chief Executive 2001–7 and Chairman of the Supervisory Board 2007–10).

PART I

GENERAL ASPECTS

1 WHO’S AFRAID OF MIFID II? An Introduction Danny Busch and Guido Ferrarini

I. Introduction 1. General 2. From ISD to MiFID I 3. From MiFID I to MiFID II 4. The Term ‘Investment Firm’ II. 1. 2. 3. 4. 5. 6. 7. 8. 9. III. 1. 2. 3. 4. 5. 6.

Investment Firms and Investment Services Scope and Exemptions Governance of Investment Firms The Duty to Act in the Client’s Best Interest Product Governance and Product Intervention Independent and Non-Independent Advice Conflicts of Interest Inducements Agency and Principal Dealing Third-Country Investment Firms Trading Governance and Organization of Trading Venues The New Transparency Regime for Trading SME Growth Markets Dark Pools Derivatives Trading and the New Mandatory Trading Obligation Commodity Derivatives

7. Algorithmic Trading and High-Frequency Trading 8. MiFID II and Equity Trading Regulation: a US Perspective IV. Supervision and Enforcement 1. Public Enforcement of MiFID II 2. The Private Law Effect of MiFID I and MiFID II V. The Broader View and the Future of MiFID 1. MiFID II and Investor Protection: Picking Up the Crumbs of a Piecemeal Approach 2. Shadow Banking and the Functioning of Financial Markets 3. Investment-Based Crowdfunding: Is MiFID II Enough? VI. Final Remarks

I. Introduction 1. General [1.01] Investment firms and regulated markets have been closely regulated by the EU Markets in Financial Instruments Directive (MiFID I), the MiFID I Implementing Directive, and the MiFID I Implementing Regulation since 1 November 2007.1 MiFID I and the MiFID I Implementing Directive have been transposed into national legislation in the various Member States of the European Union (EU) and the European Economic Area (EEA). Naturally, the MiFID I Implementing Regulation has not been transposed into national law. The regulation has direct effect and, under European law, may not therefore be transposed into national law. MiFID I aims to provide a high level of harmonized investor protection, financial market transparency, and greater competition between trading venues. [1.02] On 3 January 20182—some ten years later—the MiFID I regime will be replaced by MiFID II, which comprises, among other things, a Directive (MIFID II), the Markets in Financial Instruments Regulation (MiFIR), and a truly impressive number of implementing measures,

commonly referred to as Level 2 legislation.3 MiFID I may have the reputation of being strict, but MiFID II/MiFIR tightens the reins even more. It is not hard to guess the reason: the financial crisis has also revealed gaps in the MiFID I legislation, notably in investor protection, as well as shortcomings in the functioning and transparency of financial markets. The MiFID II/MiFIR regime will have a major impact on the financial sector in Europe. [1.03] This book aims to analyse and discuss the main changes and new provisions introduced by MiFID II/MiFIR. The book chapters are grouped in a thematic way, covering the following areas: (i) investment firms and investment services, (ii) trading, (iii) supervision and enforcement, and (iv) the broader view and the future of MiFID II/MiFIR. This chapter provides a summary and overview of the chapters of this book. But before doing so, we will first briefly outline the history of the European regulation of investment firms and regulated markets, followed by a treatment of the central term ‘investment firm’.

2. From ISD to MiFID I [1.04] The European regulation of investment firms and regulated markets started not with the MiFID I regime but even earlier. 1993 saw the adoption of the Investment Services Directive (ISD).4 The ISD introduced a rather elementary scheme, which was fairly soon found to have deficiencies. The ISD provided for insufficient harmonization, weak investor protection, and limited competition between trading venues. In the view of lawmakers, the MiFID I regime was intended to rectify these shortcomings.5 [1.05] It is hardly surprising that the ISD provided insufficient harmonization since it was only intended to provide minimum harmonization. This meant that the Member States were able to introduce stricter rules, thereby detracting from the concept of a level playing field.6 In the interests of the general good, the Member States could also create obstacles for investment firms from other Member States.7 And this actually happened in many Member States, especially in relation to conduct of business rules (i.e. the rules on how investment firms should treat their

clients). Investor protection was also inadequate. This was mainly because the ISD did not cover all services and financial instruments. Indeed, the ISD did not even cover such an essential service in practice as investment advice, and commodity derivatives did not come under the ISD because they were not treated as financial instruments. This posed risks for investors and jeopardized the efficient and stable operation of financial markets. MiFID I has largely addressed these points. Unlike the ISD, MiFID I for the most part provides for maximum harmonization so that the Member States may not introduce supervision rules that are more strict or less strict than the MiFID I regime. Moreover, MiFID I covers investment advice, and the definition of ‘financial instrument’ has been expanded in such a way that it now also includes commodity derivatives.8 [1.06] Finally, as various rules had gradually become outdated, the ISD no longer provided an answer to changed market structures such as the advent of alternative trading venues. Alternative trading venues fulfil the same economic functions as regulated markets and came across to Europe in the 1990s from the United States, where they had been around for longer. In the 1990s alternative trading venues tended to be based in London. Regulated markets are, in common parlance, stock markets. The purpose of both established stock markets and alternative trading venues is to marry up supply and demand for financial instruments in a multilateral setting. It should be noted that financial instruments listed on a stock market can be traded not only on the stock market concerned but also on other stock markets or through an alternative trading venue. During the negotiations on the ISD, free competition between the established (at that time still mainly national) stock markets and other stock markets or alternative trading venues was already a reality.9 The northern and southern Member States took diametrically opposed positions on this subject during the negotiations. The United Kingdom, Germany, Luxembourg, the Netherlands, Ireland, and Denmark were in favour of free competition between trading venues because competition reduces trading costs. As they saw it, investors only stood to benefit from this. But France, Italy, Spain, Portugal, Greece, and Belgium saw things differently and pointed to the risk of market fragmentation. If an order in a financial instrument could be executed on a multitude of trading venues, this would mean that there would be insufficient liquidity at each trading venue to establish efficient price

formation. And this would actually be to the disadvantage of investors. Naturally, national interests also played a role here. The southern Member States were undoubtedly fearful that the position of their own national stock markets would be weakened. They preferred not to see trade ebbing away to alternative trading venues in London. Conversely, the United Kingdom had for this very reason much less difficulty in accepting the concept of free competition between trading venues. Whatever the case, the two sides failed to reach agreement on this during the negotiations on the ISD. As a compromise, the so-called optional concentration rule was included in the ISD.10 This rule meant that it was up to the Member States themselves to decide whether retail orders in financial instruments should necessarily be executed by sending them to the stock markets, which were still mainly national. Hardly surprisingly, the northern Member States did not make use of this option, unlike the southern Member States.11 However, the issue was unexpectedly resolved during the negotiations on MiFID I. The optional concentration rule was abolished, and since 1 November 2007 there has been free competition between stock markets and alternative trading venues throughout the EU/EEA. Judging by the figures, this competition has become fairly well established in recent years.12

3. From MiFID I to MiFID II [1.07] MiFID I is a major advance on the ISD. Indeed, MiFID I has justifiably been called the ‘core pillar of EU financial market integration’.13 Nonetheless, as noted at the start of this chapter, the financial crisis has been one factor that has exposed major gaps in investor protection and shortcomings in the operation and transparency of financial markets. As a result of these gaps and shortcomings, strenuous efforts have been made since 2010 to carry out a thorough review of the MiFID I regime.14

4. The Term ‘Investment Firm’ [1.08] We have already used the term ‘investment firm’ on a number of occasions. Unlike terms such as ‘insurer’ or ‘bank’, ‘investment firm’ is

little used in common parlance, and even in the financial press it is rarely encountered. Moreover, it is often confused with the term ‘investment fund’.15 So there is more than sufficient reason to devote a section to clarify this central term. [1.09] Under MiFID I and MiFID II, an investment firm is defined as an entity that provides investment services and/or performs investment activities. Both the services and the activities relate by definition to financial instruments.16 The investment services and activities are (1) reception and transmission of orders in financial instruments; (2) execution of orders in financial instruments on behalf of clients;17 (3) portfolio management; (4) investment advice; (5) underwriting or placing of financial instruments with and without a firm commitment basis; (6) dealing on own account; and (7) operation of a multilateral trading facility (MTF).18 MIFID II adds an additional activity to the list, namely the operation of an organized trading facility (OTF).19 For the sake of clarity, it should be noted that although the operator of a regulated market is not an investment firm, it is subject to MiFID I and MiFID II, albeit to a different set of rules than those applicable to investment firms.20 [1.10] It should be realized in this connection that the categories listed above can overlap. When providing a service, an individual portfolio manager or an investment adviser will often execute orders in financial instruments on behalf of the client (although there are also portfolio managers and investment advisers who leave the execution of orders on behalf of clients to other parties). In short, individual portfolio management and investment advice may include the power to execute orders on behalf of clients. [1.11] If a given financial product is not a financial instrument, it cannot give rise to an investment service or activity and the relevant entity is not an investment firm in relation to that product and is not subject to the MiFID I and MiFID II regime for investment firms. It should be noted, incidentally, that the term financial instrument is a fairly broad concept. It includes not only equities and bonds but also interest rate swaps and many other derivative products. Under MiFID II the definition of financial instrument has been broadened still further.21

[1.12] In any event, the basic rule is that an investment firm needs authorization granted by the home Member State’s competent authority in order to act as such.22 Once an investment firm has this authorization, it can provide investment services and perform investment activities throughout the entire EU/EEA, insofar as these services and activities are covered by the authorization (the so-called European passport).23 To be eligible for an authorization, an investment firm must fulfil extensive requirements.24 These requirements also apply after the investment firm has obtained authorization. It follows that investment firms must comply with the conditions for initial authorization at all times.25 Moreover, they must also comply with any additional requirements that may be imposed.26 [1.13] Credit institutions authorized under Directive 2013/36/EU can also provide investment services and/or perform investment activities, in which case they are largely subject to the same MiFID I and MiFID II rules applicable to investment firms.27

II. Investment Firms and Investment Services 1. Scope and Exemptions [1.14] In Chapter 2, Lieverse discusses the main changes of the scope of MiFID II, in comparison with MiFID I. MiFID II introduces several changes to the scope of the supervision of investment firms and some other business related to the investment services industry, including data reporting service providers. The list of investment services has been extended by adding the operation of an OTF. Also, the revision and—in respect of some items—extension of the definition of ‘financial instrument’ has an impact on the scope of MiFID II supervision, including emission allowances. In addition, advisory and distribution services in respect of structured deposits by investment firms and credit institutions have been brought within the scope of MiFID II. Furthermore, supervision comparable to the MiFID II system is being introduced for insurers and intermediaries in respect of investment-based insurance products. At the same time, the

scope of some of the exemptions to MiFID II is revised, with an impact in particular for trading on own account. Trading on own account through high-frequency algorithmic trading techniques is brought within the scope of MiFID II, and the broad exemption for traders in commodities derivatives has also been limited. As a result, the scope of MiFID II is considerably broader than MiFID I. This has an effect beyond the applicability of MiFID II regulation, as currently the prudential requirements are as a starting point also linked to the MiFID II qualification, though with specific exemptions. In addition, the concept of linking prudential supervision to the MiFID II qualification, rather than to the prudential risk profile of the underlying services and activities, is subject to review and reconsideration.

2. Governance of Investment Firms [1.15] In Chapter 3, Binder discusses the governance of investment firms. In response to widespread concerns about the quality of governance arrangements in financial intermediaries as a source of systemic risk, the revised framework for the regulation of investment services in the EU has not just reinforced the governance requirements that have been in place for a long time, but has significantly increased their complexity and intensity. Investment firms, which are subject to both the Capital Requirements Directive (CRD) IV and MiFID II, now have to comply with a wide range of regulatory requirements, covering board structure and composition, as well as individual duties of board members and their remuneration, general organizational and risk management arrangements, and the supervisory scrutiny of shareholders and owners with qualifying holdings. The author concludes that the underlying policy (to address systemic implications of financial intermediation irrespective of the business model) is certainly consistent, but that the equal treatment of banks and investment firms under broadly identical regulatory frameworks (albeit with additional requirements imposed by MiFID II) is nonetheless questionable in view of the diversity of existing business models and activities. Starting with an analysis of the historical emanation of the new approach and the underlying policy, the author seeks to identify potential weaknesses and implications for its implementation.

3. The Duty to Act in the Client’s Best Interest [1.16] In Chapter 4, Enriques and Gargantini analyse the scope, contents, and implications of MiFID II’s new framework regarding the duty to act in the client’s best interest. The authors analyse the duty as an autonomous source of obligations for investment firms and as a guidance principle for both EU bodies in charge of implementing MiFID II and judges and supervisory authorities interpreting more specific duties. The authors also discuss the implications of extending the duty to intrinsically at-arm’slength activities such as dealing on own account and self-placement. [1.17] MiFID II confirms, in line with its predecessors, that investment firms must act in accordance with the best interests of their clients. Besides being an overarching principle for firms’ professional conduct, the duty to act in the client’s best interest is further specified by more detailed provisions within the body of MiFID II, and therefore plays a role in their interpretation. Rules concerning the management of conflicts of interest, including at the level of staff remuneration practices, limitations to inducements, and best execution are just a few examples of obligations aimed at ensuring that clients’ interests are pursued even when firms’ incentives may be tainted. The ‘best interest’ principle may have direct application as well, thus grounding firms’ liability even in cases where no specific rule of conduct is violated. [1.18] Although the general principle set forth by Article 24(1) is not new, MiFID II further specifies its implications and, overall, enhances its effects: it does so by introducing new specific rules of conduct implementing the ‘client’s best interest’ standard and by broadening its scope of application. For instance, new provisions ensure that firms pursue clients’ interests both during product distribution and before customers are approached: MiFID II mandates a thorough understanding of the marketed financial instruments and of clients’ needs when financial instruments are offered or recommended, and requires firms to design financial instruments in the light of the characteristics of the target groups at the early stage of product manufacturing. At the same time, the expansion of the regulated activities brings new business areas within the purview of the ‘best interest’ standard: this is particularly the case with placement of firms’ own products on the

primary market (self-placement), now explicitly included in the list of investment services and activities.

4. Product Governance and Product Intervention [1.19] In Chapter 5, Busch analyses and discusses the product governance and product intervention rules introduced by MiFID II/MiFIR. According to the author, the combination of these two approaches designed to exclude harmful products from the market is a major step forward in investor protection. On the other hand, complying with the product governance rules will entail costs for the firms concerned. They will have to put in place the requisite internal procedures and there will be a statutory duty for the firm developing the product and the firm distributing it to exchange a considerable volume of information. All in all, the author believes that these extra costs (which will undoubtedly be discounted in the cost price of the product) are acceptable. In any event, they are dwarfed by the social costs caused by the marketing of harmful financial products (e.g. interest rate swaps sold to small and medium-sized enterprises in many European countries). The author argues that MiFID II’s introduction of both product governance rules and product intervention rules is no more than common sense. It would be naive to think that product governance rules could in practice guarantee that harmful products are no longer marketed.

5. Independent and Non-Independent Advice [1.20] In Chapter 6, another noteworthy innovation is discussed by Giudici: MiFID II (unlike MiFID I) draws a distinction between independent and non-independent advice. The author submits that the quickest policy indication for increasing households’ trust in financial markets, to the benefit of the economic system, seems to be the offer of professional financial advice on affordable terms. The problem is how to convince investors to pay for advice, and how to protect investors who do not want to pay for conflicted advice and for hard sell under the guise of personal recommendation—an area where MiFID I has not performed well. MiFID II’s answer is to pose a new set of information duties on financial

advisors with the clear intention of nudging investors towards independent, fee-only advice. The intention is good. However, the author argues that the new regime raises many important issues, among which are: the ambiguity of the ‘independent’ suit, which can be taken or demised by investment firms from time to time and from client to client; the interaction between the product governance regime and the suitability assessment; the regulatory inconsistency that is emerging between investment advice and portfolio management; and the potential costs of the written statement of suitability.

6. Conflicts of Interest [1.21] In Chapter 7, Grundmann and Hacker analyse and discuss the issue of conflicts of interest in the ambit of services regulated by MiFID. The authors do so mainly with respect to the MiFID II regime, but take the MiFID I regime as a background because it has been more abundantly discussed and because the largest part of the basic structure and also many single solutions have remained unchanged. The chapter combines (several) legal and social science theories with an analysis of the substantive law solutions, and presents them in an evolutionary perspective, but also with a focus on a more detailed analysis of the status now reached. The authors argue that the legislature did not take sufficient care in specifying the different approaches which (may have) influenced the substantive law solutions found, and did not even specify clearly the interests involved. The authors further argue that it is best to expose the regime by segregating the single main stages of an investment services relationship and approaches which have been used (and solutions which have been found). Such segregation is all the more important as solutions and approaches used at the different stages are indeed highly heterogeneous in kind. The authors do not criticize, but clarify this—it may well be that the factual background of the different stages and situations calls for such heterogeneity in regulatory approach (which will be discussed for the single situations). For presenting this programme, the authors first expose the foundations—(i) the most important theoretical approaches to a regulation of conflicts of interest, and (ii) the legislative bases (and history)—and then proceed to analyse the five different stages and situations (and, in addition, linked contracts) step by

step. The authors always start by characterizing the type of approach taken in the legislative regime, then move on to the main features of innovation in the transition from MiFID I to MiFID II, before finally discussing in greater detail the substantive solution found in MiFID II.

7. Inducements [1.22] In Chapter 8, Silverentand, Sprecher, and Simons analyse and discuss the MiFID II inducement rules. During the negotiations on MiFID II, it became clear that inducements were a topic on which there was no easy agreement between the Member States. Where certain Member States pressed for a total ban on inducements, other Member States were unwilling to impose such strict rules. As is not uncommon in these situations, the political compromise that was reached was to allow for deviating rules by those Member States that wished to see stricter rules. Allowing for this may be regarded as counter to the general trend set by the European legislator to create less room for Member State options by creating ‘single rulebooks’ and an increase in the use of regulations. The authors conclude that it is disappointing to see that on such an important topic, the European market will continue to have rules that deviate per Member State. The Dutch legislator has already indicated that it will make use of the (continued) room for ‘gold plating’, and it can according to the authors be expected that other Member States where stricter rules apply will do the same, leaving an un-level playing field for investment firms regarding the use of inducements.

8. Agency and Principal Dealing [1.23] In Chapter 9, Busch focuses on the question of whether allowing the extent of the protection afforded to an investor under MiFID to be largely dependent on the distinction between dealing on own account on one hand and trading on behalf of the client (and other forms of investment service) on the other is justified. The author submits that this question must be answered in the negative. An investor may reasonably expect the investment firm used by him to look after his interests adequately and thus

to observe certain duties of care towards him. The investment firm is, after all, ideally placed to use its expertise. Its fund of knowledge is bound to be superior to that of an investor, particularly a retail investor. Nor is this any different where the investment firm acts purely as the investor’s contractual counterparty. In such cases, the investor is reasonably entitled to expect the investment firm to observe the same duty of care that would apply if it were providing an execution-only service. Moreover, the distinction between dealing on own account (principal dealing) on one hand and trading on behalf of the client (and other forms of investment service) on the other is tenuous, arbitrary, and easy to manipulate. This is all the more so where a contractual clause providing that an investment firm acts solely as contractual counterparty is claimed to apply even where an employee of the investment firm advises the investor, contrary to the terms of the agreement. According to the author, MiFID II provides no practicable criterion either. To achieve an adequate level of investor protection MiFID II resorts to the artifice of reclassifying certain types of dealing on own account as acting on behalf of the client. Finally, both the UK Government (in response to the Kay Review) and the Dutch Supreme Court take the view that duties of care must also apply where an investment firm acts solely as an investor’s contractual counterparty. Under a future MiFID III, an investment firm which acts solely as contractual counterparty should be required to observe the same duty of care as applies in the case of the investment service of execution of orders on behalf of the client.28

9. Third-Country Investment Firms [1.24] In Chapter 10, Busch and Louisse analyse and discuss the MiFID II/MiFIR rules for third-country investment firms (i.e. investment firms established outside the EU/EEA). Under MiFID II the position of thirdcountry firms will no longer be a purely national matter. MiFID II now itself sets the parameters. But, as the authors explain, the legislation is unfortunately complex and does not provide for full harmonization. The Commission and the Member States found it hard to reach agreement on this point. The phenomenon of differing national regimes is therefore not precluded even under MiFID II. The fact that MiFID II regulates the position of third-country firms reflects a European trend. The European

Market Infrastructure Regulation (EMIR), the CRA Regulation, and the AIFMD all deal with the position of parties established in a third country. These may be CCPs, CRAs, AIFMs, or depositaries. [1.25] MiFID II/MiFIR introduces a common regulatory framework that should harmonize the existing fragmented framework for the provision of services by third-country firms, ensure certainty and uniform treatment of third-country firms accessing the EU/EEA, ensure an assessment of effective equivalence by the Commission, and provide for a comparable level of protection to clients in the EU/EEA receiving services from thirdcountry firms. [1.26] Articles 46–49 MiFIR (the MiFIR third-country regime) regulate the provision of investment services to eligible counterparties and per se professional clients and performance of investment activities by thirdcountry firms following an equivalence decision by the Commission. Upon adoption of such equivalence decision, a third-country firm can register itself with ESMA. Once a third-country firm has been registered by ESMA, it may provide investment services or perform investment activities to eligible counterparties and per se professional investors throughout the EU/EEA. Member States may not impose any additional requirements on such third-country firms in respect of matters covered by MiFID II/MiFIR and CRD IV/CRR. In the absence of an equivalence decision in relation to a third country, the national regimes of the Member States continue to apply. [1.27] The provision of investment services to retail and opt up professional clients and performance of investment activities through the establishment of a branch is regulated in Articles 39–43 MiFID II (the MiFID II third-country regime). Under the MiFID II third-country regime, Member States have the option to require the opening of a branch by a third-country firm wishing to provide investment services and/or perform investment activities (with or without ancillary services) in a Member State to retail clients or to opt up professional clients (i.e. clients who have obtained professional client status by opting up). If a Member State requires the opening of such a branch harmonized requirements will apply. Otherwise, the national regimes of the Member States continue to apply.

[1.28] Although the basics of the third-country regime under MiFID II/MiFIR seem to be set, the authors show that the devil is in the detail. There is still a considerable lack of clarity in relation to the scope of the MiFID II/MiFIR’s third-country regime, as in where it concerns investment activities, and activities other than investment services and investment activities (such as selling and advising in relation to structured deposits), or the initiative test. In addition, the concurrence between MiFID II and MiFIR, if a third-country firm provides investment services eligible counterparties and retail clients, raises interesting questions that are not easily answered.

III. Trading 1. Governance and Organization of Trading Venues [1.29] In Chapter 11, Ferrarini and Saguato analyse the governance and organization of trading venues. The authors show that MiFID II brings modest changes to the EU landscape of trading venues. The newly introduced Organized Trading Facilities (OTFs) are going to be the reference venues for a significant portion of the derivatives trading in years to come. The regulated markets (RMs) and Multilateral Trading Facilities (MTFs) regimes have been aligned, and specific provisions strengthen the governance of the venues and their operators. However, market dynamics are already challenging the MiFID II regulatory framework for the governance and organization of trading venues. Trading venues have developed over the last twenty years into Financial Markets Infrastructures (FMI) groups that provide both trading and post-trading services. These new conglomerates test the capacity of the current regulatory and supervisory regime of financial markets—and MiFID II itself—to oversee their activities and to guarantee competition and stability in the trading and post-trading industry. MiFID II does not explicitly take FMI groups into account—trading venues are regulated as individual entities, which may or may not be operated within a group. In MiFID II, only three sets of rules address, to varying degrees, some of the potential risks underlying FMI

groups: (i) conflicts of interest between firms operating and RMs, MTFs, and OTFs; (ii) transparency of ownership of trading venues and suitability of trading venues’ shareholders; and (iii) non-discriminatory access to trading and post-trading services. However, the prudential regulation and supervision of the FMI group has not been included in the MiFID I review process. The authors conclude that this regulatory gap might be a threat to the stability of financial markets, and regulators should consider a regulatory intervention to fill it. The experience of the regulatory and supervisory colleges of CCPs under EMIR and the regulatory framework of the financial conglomerates Directive could be two possible ways to strengthen the oversight of FMI groups.

2. The New Transparency Regime for Trading [1.30] In Chapter 12, Moloney outlines the main features of the extensive new transparency regime which will apply to trading in a wide range of asset classes under MiFIR. By contrast with MiFID I, which limited transparency requirements to the equity markets and which contained extensive exemptions and waivers, MiFIR adopts a maximalist approach to transparency. The most extensive transparency requirements apply to the three forms of ‘trading venue’ for multilateral trading which are established under the MiFID II/MiFIR venue classification system (RM, MTF, and OTF). Bilateral/OTC trading between counterparties is subject only to posttrade transparency requirements. Overall, MiFIR’s regulatory design has been shaped by a driving concern to protect liquidity, particularly in nonequity asset classes. Indeed, exemptions, waivers, suspensions, and calibrations, designed to protect liquidity, are a recurring feature of the new transparency regime. The pre-trade equity/equity-like transparency regime is subject, for example, to a series of waivers designed to allow venues to support ‘dark’ trading, given the efficiencies which dark trading can bring, notably for institutional investors and for market liquidity generally. [1.31] Once the Level 2 process which governs the adoption of administrative rules is completed, the MiFIR transparency rulebook will form a regulatory regime of vast breadth and depth. But operational supervisory decision-making by national supervisors will, in addition,

become subject to EU-level controls and processes. The waivers which are available from the transparency requirements for equity and non-equity trading can be regarded as the key battleground on which national supervisors (and the Member States) will seek to protect national territory, in that the waivers afford national supervisors the possibility to apply tailored treatment to distinct national trading systems and practices. [1.32] In one of the key changes from MiFID I, ESMA is now empowered to oversee national supervisory decision-making with respect to equity and non-equity pre-trade transparency waivers. Under MiFID I, waiver decisions in relation to the equity transparency rules are currently at the discretion of national supervisors, but under voluntary arrangements proposed supervisory waiver decisions are notified to ESMA, which then adopts a common position across its member supervisors on the waiver. This informal process has now been formalized. The author submits that while the new regime will have significant market-shaping effects, it will also prove revealing as to the effectiveness of the administrative governance apparatus which currently supports EU financial governance. In particular, the new transparency regime is exposing weaknesses in regulatory administrative governance, notably with respect to how the EU deals with uncertainty. Specifically, the absence of a power to suspend administrative rules where they prove to have destabilizing effects may prove a significant challenge to the effectiveness of EU financial governance, given the uncertain impact of MiFIR on financial markets.

3. SME Growth Markets [1.33] In Chapter 13, Veil and Di Noia analyse and discuss SME Growth Markets, introduced under MiFID II as an important strategy to improve access to finance for SMEs in Europe. SME Growth Markets should be more flexible than regulated markets. However, the authors submit that this will not be the case. The regime for SME Growth Markets will consist of strict rules about insider trading and market manipulation which are subject to supervision by NCAs. These parts of the regime are important to ensure investor confidence. It is also convincing to protect investors by a disclosure regime ensuring the publication of price-relevant information on

SME Growth Markets. However, the authors argue that it is neither necessary nor recommendable to apply the respective disclosure obligations (as well as the similar regime for insiders’ lists and the identical one for managers’ transactions) under the MAR. Instead, a system based on current event reports is sufficient in order to tackle information asymmetries on SME Growth Markets. The authors conclude that the disclosure regime for SME Growth Markets in Europe should be re-assessed with the aim of allowing market operators to experiment with alternative disclosure obligations on SME Growth Markets.

4. Dark Pools [1.34] In Chapter 14, Gomber and Gvozdevskiy focus on the concept of dark trading in the context of MiFID II. This is analysed against the background of the MiFID I regulation and its economic consequences for European equity markets. Dark trading implies orders with partial or missing pre-trade transparency, meaning that these orders are hidden from the rest of the market. Dark pools of regulated venues and in (un-regulated) OTC markets allow institutional investors to execute large blocks of shares in one lot, reducing information leakage, diminishing market impact, and providing price improvements. MiFID II aims to increase market transparency and to bring trading of financial instruments into regulated platforms. Extending the waivers introduced by MiFID I, the new Directive announces the double volume cap regime. The first cap of the mechanism restricts the usage of waivers by individual trading venues if the proportion of total value traded under negotiated transactions and reference price waivers together exceeds 4 per cent of total trading volume. The second cap suspends all trading venues across the Union from trading under negotiated transactions and reference price waivers, if the cumulated proportion of total value traded under these waivers across the Union exceeds 8 per cent of total trading volume. And additional trading obligation of shares will reduce the extent of OTC trading in Europe. Some market participants and trading venues recently introduced MiFID II-ready solutions preventing dark executions from being subject to the double volume cap regime either by classifying the orders as large in scale or by introducing trading systems

based on auction market models. These models and functionalities, which already anticipate the future MIFID II regime, are also discussed.

5. Derivatives Trading and the New Mandatory Trading Obligation [1.35] In Chapter 15, Stegeman and Berket analyse and discuss the new mandatory trading obligation for derivatives provided in Title V of MiFIR. The authors conclude that time will tell whether the new rules discussed in this chapter will impact on the derivatives markets as they stand today, and, if so, to what extent and in what ways. [1.36] The opinions on whether the trading obligation will have any effect are very fragmented. This makes it hard to predict the exact consequences it may have. However, looking at the US, activity and liquidity in the USD and EUR plain vanilla IRS markets have increased following the Dodd– Frank trading mandate, according to a Bank of England Staff Working Paper.29 Furthermore, it is concluded that the associated execution costs in these markets are significantly reduced, the causes of this reduction likely to be the shortening in dealer intermediation chains and more competitive pricing by dealers. Both are potentially attributed to mandatory exchange trading, as the results of the research suggest that inter-dealer market activity has reduced following the trading mandate entering into force. However, the researchers could not scientifically prove a causal link between the trading mandate and the reduction in inter-dealer trading. As such, the full impact of the trading mandate remains uncertain. [1.37] With respect to the clearing obligation and the rules on the timing of acceptance for clearing (STP obligation) the authors expect the impact to be relatively limited as they seem to be in accordance with current market practices, or at least not too far off. However, it remains to be seen whether the mandatory reduced timeframes increase the risk of errors. [1.38] With the portfolio compression rules under MiFIR the European legislator continues stimulating portfolio compression by regulation. The light-touch regime seems to strike the right balance between, where

possible and appropriate, encouraging parties to compress their portfolios on one hand and increasing transparency for the entire market on the other hand. According to the authors it is therefore conceivable that portfolio compression will remain a much used exercise in the foreseeable future. [1.39] When comparing the new obligations, according to the authors the rules relating to indirect clearing have the most velar impact on the current market practice. Since, different from the indirect clearing rules for OTC derivatives under EMIR, indirect clearing is commonly seen in the ETD space, these rules will definitely impact these existing client clearing processes.

6. Commodity Derivatives [1.40] In Chapter 16, Sciarrone Alibrandi and Grossule analyse and discuss the MiFID II/MiFIR regulation of the commodity derivatives sector. The authors submit that this sector is one of the areas most affected by the financial markets reform process, particularly in the MiFID I review. Under the G20 mandate, EU policymakers issued specific provisions to increase transparency, tackle the turbulences affecting commodity markets, and curb the negative effects of speculation. [1.41] This chapter analyses the position limits regime establishing limits on ex ante positions related to all commodity derivatives and prohibiting participants from holding contracts beyond a certain limit. Furthermore, this chapter deals with the new rules amplifying the regulatory and supervisory powers of ESMA, of national competent authorities (NCAs), and trading venues, introducing a range of interventionist tools that can affect operators’ investment business. The chapter also stresses the need to introduce a specific regulation depending on different commodity derivatives (e.g. energy and food). The main provisions and the specific technical standards are analysed, paying particular attention to controversial measures such as the definition of the ancillary activities, the methodology to calculate the position limits, and the authorities’ new powers (especially in the field of product intervention).

7. Algorithmic Trading and High-Frequency Trading [1.42] In Chapter 17, Conac analyses the MiFID II rules on algorithmic trading (AT), including high-frequency trading (HFT). The author argues that AT raises serious issues of volatility and systemic risk while HFT raises issues of systematic front-running of investors. However, there are serious differences of opinion within the EU as to the benefits and risks of those two trading techniques, and especially of HFT. Therefore, MiFID II takes a technical approach mostly focused on prevention of a repeat of the 2010 Flash Crash and some provisions on market abuse. [1.43] Since the MiFID II will not be implemented before 2018, the ESMA 2012 Guidelines will remain the most effective regulation to frame the development of HFT. The author submits that this reveals the usefulness of having ESMA adopting Guidelines in order to tackle market developments with relative speed. However, since the EU legislator decided not to tackle HFT strongly, and since implementation of the Directive is still far away, it is probable that some legislators and supervisors will do it themselves. The successful case of enforcement in France is a sign of this possible trend. Therefore, regulation by prosecution of market abuse by HFT traders could lead to a de facto ban of HFT in some Member States. The author argues that this would be a huge cost for supervisors as they would need to allocate scarce resources to this topic, which means that only the most motivated supervisors will do it.

8. MiFID II and Equity Trading Regulation: a US Perspective [1.44] In Chapter 18, Fox provides a US perspective on the MiFID II equity trading regulation. The author concludes that a comparison of the EU and US market structure rules, and the concerns that generated them, suggests three key differences. Relative to the United States, the EU shows (i) more concern with having an effective price-formation process, (ii) more concern with the possibility that HFTs contribute to price instability and engage in market abuse, and (iii) less concern with promoting competition among trading venues. These differences have characterized the MiFID I

era and are reflected in MiFID II as well, although MiFID II does evince somewhat greater concern about competition among trading venues than was true before.

IV. Supervision and Enforcement 1. Public Enforcement of MiFID II [1.45] In Chapter 19, Gortsos provides a systematic presentation, analysis, and assessment of the MiFID II provisions (Articles 67–88) on supervision, enforcement, and cooperation by competent authorities. The author addresses the role of Member States’ competent authorities within the system of the MiFID II, with particular emphasis on the competent authorities’ supervisory powers, their power to impose administrative sanctions and measures, as well as criminal sanctions and redress procedures. Cooperation arrangements between Member States’ competent authorities, the obligation to cooperate with the ESMA, and cooperation with third countries are addressed as well. Finally, the rules are briefly assessed on the basis of three (out of the five) elements pertaining to financial supervision, which, in the author’s view, are essential for the preservation of financial stability and the attainment of the other goals underlying (public) capital markets law and which are addressed by the provisions of the MiFID II: (i) micro-prudential supervisory effectiveness, (ii) the efficient and unobstructed exercise of competent authorities’ sanctioning powers, and (iii) the effectiveness of supervisory cooperation arrangements.

2. The Private Law Effect of MiFID I and MiFID II [1.46] In Chapter 20, Busch examines to what extent the civil courts are bound by MiFID I/MiFID II under European law. In addressing this subject, the author discusses the following topics: (i) whether the civil courts may be less strict or stricter than MiFID I/MiFID II, (ii) whether the contracting

parties may be less strict or stricter than MiFID I/MiFID II, (iii) whether there is any influence of MiFID I/MiFID II on the principle of ‘relativity’ or ‘proximity’ in the Member States where this is a requirement for liability in tort, (iv) whether there is any influence of MiFID I/MiFID II on proof of causation, (v) whether there is any influence on a contractual limitation or exclusion of liability, and (vi) whether the civil courts are obliged to determine of their own motion whether there has been an infringement of MiFID I/MiFID II (conduct of business) rules in disputes between investment firms and private investors. [1.47] The author concludes that the last word has not been spoken about the effect of MiFID I/MiFID II on private law. MiFID II is as unclear about this as MiFID I. Although the possible contours are somewhat clearer as a result of the judgments in the Genil30 and Nationale-Nederlanden31 cases, the EU Court of Justice has not yet explicitly answered the main questions. For more definitive answers it will be necessary to await the further judgments of the Court of Justice.

V. The Broader View and the Future of MiFID 1. MiFID II and Investor Protection: Picking Up the Crumbs of a Piecemeal Approach [1.48] In Chapter 21, Colaert clarifies the relationship between the MiFID II and several other closely related Directives, such as the Insurance Distribution Directive, the PRIIPs Directive, and the UCITS Directive. The interaction between different pieces of EU financial legislation becomes ever more important—and difficult. [1.49] The analysis reveals numerous inconsistencies and interpretation difficulties. The author argues that while some of the shortcomings are inherent to the EU piecemeal approach, other problems should and could have been avoided, by adopting a holistic approach of financial regulation and supervision.

2. Shadow Banking and the Functioning of Financial Markets [1.50] In Chapter 22, Wymeersch analyses and discusses shadow banking and the functioning of financial markets; that is, activities that are outside the regulatory perimeter of MiFID I and MiFID II/MiFIR. The author shows that financial activity that is taking place outside the traditional and often regulated financial sphere of the securities markets has become quite substantial and especially diverse. This segment is often designated as ‘shadow banking’—a misnomer. The activities to be classified under this characterization have been mapped by the Financial Stability Board, and include a wide variety of entities which either specialize in specific financial activities, or offer financial services as part of their overall product offer. The risks they create are essentially of a macro or ‘systemic’ nature, leading to major financial disruption and contagion. In the securities markets, this activity is often indirectly regulated as part of the wider market regulation. For example, this is the case for the market in derivatives, or for the use of securitized instruments; for derivatives, certain trading venues have been mandated, not always with comprehensive results. The author submits that the post-trade sector may be a source of considerable risk: therefore OTC derivatives are subject to mandatory clearing in the CCP, while title security for most traditional securities will be organized within the Central Securities Depositories. The recent Securities Financing Regulation, dealing with repos and similar instruments, clarifies the position of investors that see their securities ‘reused’ in a second collateral transaction, for which in the future their express consent will be necessary. The author concludes that, although thought to be on the border of the traditional securities systems, these matters and the related regulation have a considerable impact on the framing of certain classes of securities and may determine the safety of the overall system, including that of the final investor.

3. Investment-Based Crowdfunding: Is MiFID II Enough?

[1.51] In Chapter 23, Ferrarini and Macchiavello explore the policy and regulatory issues generated by investment-based crowdfunding in Europe. First, the authors argue that crowdfunding raises serious investor protection concerns, particularly when directed to retail investors. As governments try to stimulate innovation and the formation of new enterprises, a trade-off is created between investor protection and economic growth. EU law and the laws of Member States try to solve this trade-off in different ways, as the authors show with reference to MiFID I and the laws of the UK, France, Italy, Spain, and Germany. Second, the authors focus on MiFID II and show that the new Directive, while enhancing investor protection in general and furthering harmonization, does not create all the conditions needed for the formation of a pan-European crowdfunding market. At the same time, MiFID II narrows the potential for exemptions under which some Member States have adopted special regimes for crowdfunding, therefore restricting the scope for an enabling approach to investment-based crowdfunding at the national level.

VI. Final Remarks [1.52] On the whole, this volume’s chapters show that MiFID II will have a major impact on the financial services sector. MiFID II introduces a veritable flood of new rules (not only at Level 1 but certainly also at Level 2) and tightens up certain aspects of existing rules. [1.53] Naturally, only time will tell whether the package of measures under MiFID II will have the desired effect and always allow the right balance to be struck between costs and benefits. And the question arises of whether compliance with the flood of new regulatory provisions is even possible.32 [1.54] In any event, the Commission has recently indicated that it will pay more attention to the regulatory burden. Under the direction of Frans Timmermans, the Commission has developed an improved regulation programme: fewer new rules and more evaluation of existing rules.33 This is yet another real challenge.

[1.55] It is also worth noting here that the Commission published a call for evidence on 30 September 2015. In the space of just six years the Commission has published no fewer than forty Directives and regulations relating to the financial markets with the aim of preventing another crisis. The Commission now wishes to examine whether the structure as a whole is consistent and whether any of the rules overlap or give rise to undesirable economic consequences. On 17 May 2016, the Commission published a summary of the 288 responses it had received. Overall, stakeholders did not dispute the reforms of recent years and many expressed support, highlighting the benefits of the new rules. But the Call for Evidence was also welcomed as giving all interested parties the opportunity to assess the potential interactions, overlaps, and inconsistencies between different pieces of legislation.34 [1.56] Finally, there is Brexit. A referendum was held on Thursday 23 June 2016, to decide whether the UK should leave or remain in the EU. Leave won by 52 per cent to 48 per cent.35 Only time will tell what this means for the financial sector in Europe and the UK financial sector in particular. However, it seems safe to assume that the UK will not formally leave the EU before MiFID II/MiFIR becomes binding on the financial sector in Europe. So Brexit should not delay a UK MiFID II implementation beyond the EU’s 3 January 2018 effective date.36 [1.57] Whichever way you look at it, MiFID II will be a fact of life for the financial sector in Europe for the years to come.

1

Directive 2004/39/EC, OJ L 145, 30 April 2004, pp. 1–47 (MiFID I); Directive 2006/73/EC, OJ L 241, 2 September 2006, pp. 26–58 (MiFID I Implementing Directive); Regulation (EC) No 1287/2006, OJ L 241, 2 September 2006, pp. 1–25 (MiFID I Implementing Regulation). 2 Initially, Directive 2014/65/EU, OJ L 173, 15 May 2014, pp. 349–496 (MiFID II) and Regulation (EU) No. 600/2014, OJ L 173, 15 May 2014, pp. 84–148 (MiFIR) stipulated that the bulk of the new legislation would become binding on the financial sector as per 3 January 2017, but this has been extended to 3 January 2018. See Directive 2016/1034/EU OJ L 175, 23 June 2016, pp. 8–11; (2) Regulation (EU) No. 2016/1033 OJ L 175, 23 June 2016, pp. 1–7. The reason for the extension lies in the complex technical infrastructure that

needs to be set up for the MiFID II package to work effectively. The European Securities and Markets Authority (ESMA) has to collect data from about 300 trading venues on about 15 million financial instruments. To achieve this result, ESMA must work closely with national competent authorities and the trading venues themselves. However, the European Commission was informed by ESMA that neither competent authorities nor market participants would have the necessary systems ready by 3 January 2017. In light of these exceptional circumstances and in order to avoid legal uncertainty and potential market disruption, an extension was deemed necessary. See . 3 MiFID I and MiFID II are both based on the ‘Lamfalussy process’ (a four-level regulatory approach recommended by the Committee of Wise Men on the Regulation of European Securities Markets, chaired by Baron Alexandre Lamfalussy and adopted by the Stockholm European Council in March 2001 aiming at more effective securities markets regulation) as developed further by Regulation (EU) No 1095/2010 of the European Parliament and of the Council, establishing a European Supervisory Authority (European Securities and Markets Authority or ESMA): at Level 1, the European Parliament and the Council adopt a Directive in co-decision which contains framework principles and which empowers the Commission acting at Level 2 to adopt delegated acts (Article 290 The Treaty on the Functioning of the European Union C 115/47) or implementing acts (Article 291 The Treaty on the Functioning of the European Union C 115/47). In the preparation of the delegated acts the Commission will consult with experts appointed by Member States within the European Securities Committee. At the request of the Commission, ESMA can advise the Commission on the technical details to be included in Level 2 legislation. In addition, Level 1 legislation may empower ESMA to develop draft regulatory or implementing technical standards according to Articles 10 and 15 of the ESMA Regulation, which may be adopted by the Commission (subject to a right of objection by Council and Parliament in case of regulatory technical standards). At Level 3, ESMA also works on recommendations and guidelines and compares regulatory practice by way of peer review to ensure consistent implementation and application of the rules adopted at Levels 1 and 2. Finally, the Commission checks Member States’ compliance with EU legislation and may take legal action against non-compliant Member States. See e.g. European Commission, MiFID Impact Assessment (COM(2011) 656 final), p. 356, footnote 1. 4 Directive 93/22/EEC, OJ L 141, 11 June 1993, pp. 27–46. For a commentary, see Guido Ferrarini (ed.), European Securities Markets: The Investment Services Directive and Beyond (Kluwer Law International 1998). 5 Cf. Ryan Davies, Alfonso Dufour, and Brian Scott-Quinn, ‘The MiFID: Competition in a New European Equity Market Regulatory Structure’ in Guido Ferrarini and Eddy Wymeersch (eds) Investor Protection in Europe: Corporate Law Making, the MiFID and Beyond (OUP 2006), p. 163; Barbara Alemanni, Giuseppe Lusignani, and Marco Onado, ‘The European Securities Industry. Further Evidence on the Roadmap to Integration’, ibid, p. 199; Guido Ferrarini and Fabio Recine, ‘The MiFID and Internalisation’, ibid, p. 235;

Johannes Köndgen and Erik Theissen, ‘Internalisation under MiFID: Regulatory Overreaching or Landmark in Investor Protection’, ibid, p. 271; Peter Mülbert, ‘The Eclipse of Contract Law in the Investment Firm–Client Relationship: The Impact of the MiFID on the Law of Contract from a German Perspective’, ibid, p. 297; Luca Enriques, ‘Conflicts of Interest in Investment Services: The Price and Uncertain Impact of MiFID’s Regulatory Framework’, ibid, p. 321. 6 See Recital 27 ISD. 7 Article 17(4) and Article 18(2) ISD. See David O’Keeffe and Nelius Carey, ‘Financial Services and the Internal Market’ in Guido Ferrarini, Klaus Hopt, and Eddy Wymeersch (eds) Capital Markets in the Age of the Euro: Cross-border Transactions, Listed Companies and Regulation (Kluwer Law International 2002), p. 3; Niamh Moloney, ‘Investor Protection and the Treaty: an Uneasy Relationship’, ibid, p. 17; Michel Tison, ‘Conduct of Business Rules and Their Implementation in the EU Member States’, ibid, p. 65. 8 Cf. Niamh Moloney, ‘Effective Policy Design for the Retail Investment Services Market: Challenges and Choices Post FSAP’ in Ferrarini and Wymeersch (eds) (n. 5), 381; Michel Tison, ‘Financial Market Integration in the Post FSAP Era: In Search of Overall Conceptual Consistency in the Regulatory Framework’, ibid, p. 443. 9 Cf. Marco Pagano, ‘The Changing Microstructure of European Equity Markets’ in Ferrarini (ed.) (n. 4), 177. 10 Article 14(3) ISD. Cf. Guido Ferrarini, ‘Exchange Governance and Regulation: An Overview’ in Ferrarini (ed.) (n. 4), 245. 11 Davies, Dufour, and Scott-Quinn, (n. 5), 179–87; Ferrarini and Recine, (n. 5), 235; Köndgen and Theissen, (n. 5), 271 (specifically about Germany). 12 See European Commission, MiFID Impact Assessment (COM(2011) 656 final), p. 88 ff. 13 As regards the use of the description ‘core pillar of financial market integration’, see European Commission, 20 October 2011, COM(2011) 656 final, Proposal for a Directive of the European Parliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC of the European Parliament and of the Council (Recast) (MiFID II), p. 1. 14 The Commission formally kick-started the process through a public hearing over two days on 20–21 September 2010, followed by a public consultation dated 8 December 2010. Cf. also the Commission’s impact assessment dated 20 October 2011 (SEC(2011) 1226 final), p. 7, § 2.1., accompanying the Commission’s initial proposal for MiFID II and MiFIR, p. 7, § 2.1. 15 Investing by participating in an investment fund is a form of collective investment. The invested capital is then raised by a number of parties, whose capital is then collectively invested by the investment manager. In other words, profits and losses are apportioned among the participants in proportion to the amount of their participation. On this subject, see e.g. Danny Busch and Lodewijk van Setten, ‘The Alternative Investment Fund

Managers Directive’ in Lodewijk van Setten and Danny Busch (eds) Alternative Investment Funds in Europe: Law and Practice (Oxford: OUP, 2014), pp. 1–122. 16 See Article 4(1) and (2) MiFID I in conjunction with Annex I, Sections A and C; Article 4(1) and (2) MiFID II in conjunction with Annex I, Sections A and C. 17 In practice this type of investment service is often termed ‘execution only’. This is however a confusing term, as in practice ‘execution only’ is also used to refer to the investment activity of dealing on own account (see main text). 18 See Annex I, Section A of both MiFID I and MiFID II. Most investment services and activities are defined in more detail. 19 See Annex I, Section A(9) MiFID II. 20 Title II MiFID I and MiFID II sets out the rules for investment firms, and Title III MiFID I and MiFID II the rules for regulated markets. 21 See Article 4(1)(15) in conjunction with Annex I, Section C MiFID I; Article 4(1)(15) in conjunction with Annex I, Section C MiFID II. See on the broadening of the scope of ‘financial instrument’ under MiFID II: § II sub (1), below. 22 See Article 5(1) MiFID I and Article 5(1) MiFID II. 23 See Article 6(3), (31), and (32) MiFID I and Article 6(3), (34), and (35) MiFID II. 24 Articles 9–13 MiFID I and Articles 9–16 MiFID II. 25 Article 16 MiFID I and Article 21 MiFID II. 26 Article 18 ff MiFID I and Article 23 ff MiFID II. 27 See Article 1(2) MiFID I and Article 1(3) and (4) MiFID II. 28 See also n. 17 above. 29 E. Benos, R. Payne, and M. Vasios, ‘Centralized trading, transparency and interest rate swap market liquidity: evidence from the implementation of the Dodd–Frank Act’, Bank of England Staff Working Paper, No. 580, January 2016. 30 EU CoJ 30 May 2013, no. C-604/11, AA (2013) 663, with note by Busch; JOR 2013/274, with note by Busch (Genil 48 SL and Other v Bankinter SA and Others). 31 EU CoJ 29 April 2015, no. C-51/13, AA (2015) 696, with note by Busch and Arons (Nationale-Nederlanden Levensverzekering Mij NV/Hubertus Wilhelminus van Leeuwen). 32 See on the (im)possibility of compliance with the flood of new regulatory requirements recently: V. Colaert, Normvlucht en systeemdwang in de financiële sector— Wetsnaleving in tijden van normatieve expansie (Acta Falconis VI) (inaugural lecture K.U. Leuven), Intersentia, Antwerpen/Cambridge 2015. 33 On the subject of better regulation, see for example the European Parliament, Briefing of September 2014, Hearings of European Commissioner-designate—Frans Timmermans, p. 2: ‘The aim of Better Regulation is to promote the simplification of EU law, reducing the administrative burden, especially for business, and to ensure respect for the principles of subsidiarity and proportionality.’ (Available at: .)

34

The Call for Evidence, the 288 responses from stakeholders, and the Commission’s summary of the responses are available at: . 35 See . 36 See .

PART II

INVESTMENT FIRMS AND INVESTMENT SERVICES

2 THE SCOPE OF MIFID II Kitty Lieverse

I. Introduction II. Investment Firms under MiFID II III. Credit Institutions IV. Investment Firms under the CRR V. Structured Deposits VI. General Exemptions to MiFID II Applicability VII. Trading on Own Account VIII. Dealings in Emission Allowances IX. Financial Instruments X. Insurance Companies and Insurance Intermediaries XI. Managers of Collective Investment Undertakings XII. Data-Reporting Service Providers XIII. Market Operators XIV. Conclusion

I. Introduction

[2.01] The basic provision on the scope of MiFID1 II is Article 1(1), stating that MiFID II applies to investment firms, market operators, data reporting services providers, and third-country investment firms providing investment services or performing investment activities through the establishment of a branch in the European Union. In this chapter, the focus will be on investment firms located in the EU.2

II. Investment Firms under MiFID II [2.02] MiFID II defines an investment firm as any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.3 This definition contains four elements that are relevant to determining the scope of MIFID II. [2.03] The first and most important element is the reference to (i) the provision of investment service to third parties and (ii) the performance of investment activities on a professional basis. These investment services and investment activities are defined by reference to Section A of Annex I to MiFID II, relating to any of the instruments listed in Section C of Annex I.4 As a result, the list of investment services and investment activities relating to any of the financial instruments listed in Section C are the primary tool for determining the scope of MiFID II. The list of financial instruments is further discussed below. [2.04] The investment services and activities listed in Section A of Annex I are: (1) Reception and transmission of orders in relation to one or more financial instruments. (2) Execution of orders on behalf of clients. This means: acting to conclude agreements to buy or sell one or more financial instruments on behalf of clients and includes the conclusion of agreements to sell financial instruments issued by an investment firm or credit institution at the moment of issuance.5

(3) Dealing on own account. This means: trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments.6 (4) Portfolio management. This means: managing portfolios in accordance with mandates given by clients on a discretionary clientby-client basis where such portfolios include one or more financial instruments.7 (5) Investment advice. This means: the provision of personal recommendations to a client, either upon its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments.8 (6) Underwriting of financial instruments and/or placing financial instruments on a firm committed basis. (7) Placing of financial instruments without a firm committed basis. (8) Operation of an MTF.9 (9) Operation of an OTF.10 [2.05] Compared to MiFID, there are two changes in this list of investment services and activities that are worth noting. The first one is that the operation of an OTF has been added as the ninth category on the list of investment services and activities. As a result, under MiFID II the operation of an OTF is subject to an authorization requirement and other supervisory requirements.11 [2.06] The second change relates to the definition of ‘execution of orders on behalf of clients’, which has now been extended to include ‘the conclusion of agreements to sell financial instruments issued by an investment firm or credit institution at the moment of issuance’.12 The background of this addition has been clarified in Recital 45, which states that MiFID II applies if an investment firm (including a credit institution) provides investment advice to its clients on financial instruments that it distributes and issues itself. If an investment firm distributes financial instruments issued by itself without providing any advice, such service should also be covered by MiFID II, according to Recital 45. This is effectuated by extending the definition of the service ‘execution of orders on behalf of clients’ to this effect. This leads to the question whether every

issuance of financial instruments constitutes an investment service by the issuer. As a starting point, it would seem unlikely that an issuer which is an ordinary commercial company would qualify as an investment firm solely because of the qualification of conclusion of agreements to sell financial instruments in the primary market as ‘execution of orders on behalf of a client’. Under Recital 45 it would seem that the European legislator rather aims to include ‘execution only’ distribution activities to clients, regardless of whether the financial instruments are issued by the investment firm/credit institution itself or by another issuer. As a result, the test would be to determine whether the distribution activities towards the clients would trigger the qualification ‘execution of orders on behalf of a client’ if the distribution is done by a firm that is not the issuer. If this is the case, the same qualification applies if the distribution is done by the issuer itself. In other words, the fact that the issuer of the financial instruments does not engage a third-party investment firm or credit institution for the distribution to its clients but performs such distribution itself would no longer mean that the distribution activities are not subject to MiFID regulation. The qualification of such distribution activity towards clients as ‘execution of orders on behalf of clients’ would seem more likely if the financial instruments are investment type products than in the case where the financial instruments are shares in the capital of the investment firm or credit institution, or corporate bonds. The investors that would purchase such shares or bonds could typically not be qualified as clients of the issuer. [2.07] As a result, the extension of the definition of ‘execution of orders on behalf of clients’ in my view does not mean that an investment firm (or credit institution) acting as issuer in the primary market would at all times simultaneously act as an investment firm, providing the service of order execution to a client, if a client subscribes for shares or other financial instruments issued by the investment firm. This is primarily based on the fact that this category of service implies the existence of a client relationship which follows from the definition itself: ‘execution of orders on behalf of clients’. As a result, if an investment firm/credit institution is solely acting in a capacity as issuer in the primary market and not simultaneously servicing clients in this regard, this extended definition would not be relevant. This requires that a determination must be made whether the relation between the investor and the investment firm/issuer is

to be qualified as one of servicing a client, that is, whether the investment firm/issuer is acting in the capacity of an investment firm towards clients when issuing and placing financial instruments. [2.08] Reference is also made to the definition of matched principal trading, as set out in Article 4(1), para. 38 MiFID II. ‘Matched principal trading’ means a transaction where the facilitator interposes itself between the buyer and the seller in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee, or charge for the transaction. Based on Recital 24, this system of matched principal trading should be viewed as ‘dealing on own account when executing client orders’ if in this way the investment firm executes orders from different clients. This manner of order matching is considered to be, under Recital 24, both dealing on own account and execution of orders on behalf of clients. [2.09] Based on these items, MiFID II has effectively extended the scope of the service ‘execution of orders on behalf of clients’ and has limited the scope of dealing on own account, in the sense that in the instances mentioned above an investment firm would both be dealing on own account and executing client orders. Based on the revisions in MiFID II just discussed, it is now clear that if the investment firm acts as issuer (of a financial instrument) and also as investment firm in a client relationship, the rules for order execution apply. In addition, if the investment firm acts as facilitator to match opposing client orders, this role as facilitator includes that the investment firm provides order execution services to each client, even though technically the investment firm in its role as facilitator would also be dealing on own account vis-à-vis each individual counterparty. [2.10] The existence of a client relationship is a defining element of any investment service.13 Based on the definitions above and the type of service these typically entail, items (1), (2), and (4)–(7) qualify as investment services, while items (3), (8), and (9) qualify as investment activities.

[2.11] The second element of the definition of investment firm is the reference to ‘legal person’. Although Recital 26 to MIFID II makes clear that any reference to persons should be understood to include both natural and legal persons, Article 4(1) para. 1 MiFID II makes clear that natural persons can only be included in the scope of the definition of ‘investment firm’ if: (i) their legal status ensures a level of protection for third parties’ interests equivalent to that afforded by legal persons, and (ii) they are subject to equivalent prudential supervision appropriate to their legal form.14 The possibility that natural persons qualify as investment firms and are authorized as such under MiFID II will not be further discussed in this chapter.15 [2.12] The third element entailed is that the conduct of the investment services or activities must constitute the regular business or profession of the firm. This is confirmed by Recital 12 which reads as follows: The purpose of this Directive is to cover undertakings the regular occupation or business of which is to provide investment services and/or perform investment activities on a professional basis. Its scope should therefore not cover any person with a different professional activity.

[2.13] This does not mean, however, that any incidental performance of an investment service or activity by a person with a different professional capacity would be per se outside the scope of MiFID II. This can be derived from the exemptions in Article 2(1)(c) and (k) MiFID II. These exemptions entail that persons who provide investment services in the course of another professional activity are excluded from the scope of MiFID II only if certain conditions are met. The first available exemption is for persons who provide investment services in an incidental manner in the course of a professional capacity if such capacity is regulated by legal or regulatory provisions or a code of ethics which do not exclude the provision of that service,16 provided that such activity is regulated and the relevant rules do not prohibit the provision, on an incidental basis, of investment services. The second exemption is for persons providing investment advice in the course of another profession (not covered by MiFID II) provided that the provision of investment advice is not specifically remunerated.17

[2.14] The fourth element is the addition of ‘third party’ as the addressee of the investment services. In my view, this reflects that the provision of investment services is by definition directed to a third party; a client. Simply said, the absence of a client relationship means that the relevant service does not qualify as an investment service. In Article 4(1), para. 9 MiFID II, ‘client’ is defined as any legal or natural person to whom an investment firm provides investment or ancillary services. As set out above, in the discussion of the scope of the various investment services, the element that a third party/client is involved is also part of the description or definition of the various individual services.18 Despite the fact that the absence of a client relationship would mean that the relevant service should not qualify as an investment service under MiFID II, there are a couple of exemptions to the scope of MiFID II that apply this principle, as will be further set out in what follows in the discussion of the general exemptions.

III. Credit Institutions [2.15] Credit institutions that provide investment services and/or investment activities technically (reading the definition set out above) qualify as investment firms but are subject to a revised scope of MiFID II, as set out in Article 1(3)(a–d) MiFID II. This is determined by the fact that credit institutions are primarily regulated19 by the Capital Requirements Directive, CRD IV, and the Capital Requirements Regulation, CRR.20 The MiFID II provisions provide a ‘top-up’ regulation for credit institutions to the extent that they provide investment services and activities. An additional authorization is however not required for credit institutions that wish to conduct investment services and/or investment activities.21

IV. Investment Firms under the CRR [2.16] As set out above, the MiFID II definition of an investment firm basically covers all persons who conduct investment services and activities which by definition relate to financial instruments as defined under MiFID

II. As will be further set out in Sections VI, VII, and VIII, there are a number of exemptions from the scope of MiFID II, for example for persons who are solely dealing on their own account, provided certain conditions are met. As a starting point, the scope of MiFID II also determines the applicability of prudential requirements on the basis of CRD IV22 and CRR.23 This is based on Article 4(1) under (2) of the CRR. For the definition of investment firm under the CRR reference is made to the definition in MiFID I (which should be read as a reference to MiFID II24). More specifically, in Article 4(1) under (2) of CRR, reference is made to a person as defined in point (1) of Article 4(1) of MiFID II, ‘which is subject to the requirements of that Directive’, while this provision subsequently excludes three categories of investment firms, as will be further set out in the next paragraphs. The reference to persons being subject to the requirements of MiFID II implies that persons that technically qualify as investment firms but are exempted from the scope of MiFID II are also as a starting point excluded from the prudential requirements under CRR. The additional three exclusions from the definition of an investment firm under CRR are: (a) credit institutions, (b) local firms, and (c) certain other investment firms depending on the scope of the services that they perform. [2.17] The exclusion of credit institutions logically follows from the fact that even though they technically qualify as investment firms if they conduct investment services and/or activities, they are already captured by CRD IV/CRR as their primary source of regulation, as set out in the previous paragraph. [2.18] The second exclusion relates to so-called local firms. Under Article 4(1), para. 4 CRR, a local firm means a firm dealing for its own account on markets in financial futures or options or other derivatives and on cash markets for the sole purpose of hedging positions on derivatives markets, or dealing for the accounts of other members of those markets and being guaranteed by clearing members of the same markets, where responsibility for ensuring the performance of contracts entered into by such a firm is assumed by clearing members of the same markets.

[2.19] The reference to ‘local’ should historically be read rather literally,25 but this additive has basically lost its meaning. The defining elements of a

local firm include that it is a firm dealing for its own account, but it may have external clients as the definition includes that it may also be ‘dealing for the accounts of other members of those markets’. The markets on which a local firm may deal are restricted (‘financial futures or options or other derivatives and on cash markets for the sole purpose of hedging positions on derivatives markets’). This specific definition of the concept of a local firm is for the CRR-exemption purposes only. It does not coincide with a MiFID II definition or exemption. As a result, a local firm within the meaning of CRR typically qualifies as an investment firm under MiFID II (for dealing on own account on a professional basis), and may or may not be exempt from requirements under MiFID II depending on the exact scope of its dealing on own account activities.26 [2.20] The third CRR exclusion from the MiFID II concept of an investment firm basically comprises investment firms that are not permitted to hold client money or securities (and for that reason may not at any time place themselves in debt to those clients) and provide certain MiFID II investment services only. These are the services (1), (2), (4), and (5) of Section A of Annex I. These services basically entail: receipt and transmission of orders, execution of orders, portfolio management, and investment advice. As a final condition, the investment firm, in order to be CRR exempt under this category, may not be authorized to provide the ancillary service safekeeping.27 An investment firm that fulfils these three cumulative requirements is an investment firm within the meaning of MiFID II, but not an investment firm (and thus it also does not qualify as an ‘institution’28) within the meaning of the CRR. [2.21] As will be further discussed in Section VII, compared to MiFID, the scope of certain exemptions under MiFID II, including the exemption for dealing on own account, is more restrictive. Based on the approach as set out above, the result of this is an extension of the prudential requirements under CRR to investment firms that were previously exempted under MiFID, but no longer have an exempted status under MiFID II. [2.22] In addition to the CRR-specific definition of an investment firm, as set out above (which is based on the MiFID II scope and provides for some

specific exemptions), there is also an additional relevance to the MiFID II list of investment services and activities in determining the initial capital and solvency requirements contained in CRD IV. As a starting point, each CRR investment firm must have initial capital of €730,000.29 A reduction to €125,000 of initial capital, however, applies to such a CRR investment firm that does not deal for its own account or underwrite issues of financial instruments on a firm commitment basis, but does hold client money and securities and performs one or more of the services as listed (receipt and transmission of orders, execution of orders, and/or portfolio management).30 Furthermore, local firms are made subject to a specific initial capital requirement of €50,000 if they are authorized under MiFID II and use a MiFID II passport.31 Finally, the investment firms that are exempt under CRR in the third category as reflected above32 are subject to an initial capital of €50,000 or €25,000.33 A somewhat comparable system applies to solvency requirements, in the sense that there are solvency requirements for CRR investment firms that apply by default,34 while specific requirements apply to other categories of CRR investment firms and also to some of the investment firms that are exempted from the CRR definition.35 [2.23] Notably, and as specified above, the list of investment services and activities under MiFID II co-determine the applicable initial capital and solvency requirements, in addition to the element whether or not the investment firm is permitted to hold client money or securities. On this latter element, it is noted that this element is added by CRD IV and CRR, without a clear link to the meaning of this element, in view also of the fact that under MiFID II asset segregation rules apply.36 The national implementation of these rules would typically entail that investment firms are in fact not allowed to hold client money and securities, which makes it somewhat unclear what this element in fact means.37 The link to the MiFID II scope means that the interpretation of the MiFID II services and activities not only determines the scope of the MiFID II authorization requirement and additional rules, but is equally important to determine the applicability of the prudential requirements under CRD IV and CRR. [2.24] In this regard, it is noted that in its Report on Investment Firms,38 the EBA has provided an analysis for its view that this link between the

MiFID II investment services and investment activities on one hand and the determination of the applicability of CRD IV/CRR, including the scope thereof, on the other, should be reconsidered as the MiFID II description of services and activities does not necessarily properly reflect the risk profile of the relevant investment firm and the appropriateness of prudential requirements. Ultimately, this position may lead to a situation where the CRD IV/CRR requirements will be reserved for ‘bank-like’ investment firms, while a tailored prudential system for other types on investment firms will be introduced.39 [2.25] As will be further discussed in Section VII, certain exemptions, including the exemption for dealers in commodity derivatives, are more limited under MiFID II than under MiFID I. Based on the system described above, this would bring such dealers within the scope of CRD IV/CRR. In this regard, it is worth noting that the EBA Report on Investment Firms recommends that the current waiver for certain prudential requirements for dealers in commodity derivatives40 remains in place until 31 December 2020.41 From the EBA Report it can be deduced that this is also the date that is linked to the views of the EBA on the proposed timing of a new prudential regime for investment firms as referred to earlier.

V. Structured Deposits [2.26] The fact that investment firms and credit institutions are regulated by MiFID II for their investment services and investment activities is no different from MiFID I. However, MiFID II has added so-called structured deposits to the scope of supervision for investment firms and credit institutions. Under MiFID II, structured deposits do not qualify as financial instruments, but nevertheless are subject to MiFID II regulation. The background of this change is clarified in the Recitals to MIFID II, where it is stated that structured deposits have emerged as a form of investment product but are not covered under any legislative act for the protection of investors at EU level, while other structured investments are covered by such legislative acts. In the interest of a level playing field and to enhance an adequate level of investor protection across the EU, it has been

considered appropriate, so the Recital states, to include structured deposits in the scope of MiFID II.42 This inclusion, however, only concerns investment firms and credit institutions ‘when selling or advising’ clients in relation to structured products. This means that selling or advising in respect to structured products by other parties is not subject to MiFID II. Also, other investment services relating to structured deposits (i.e. portfolio management) are not covered by this extension.43 [2.27] Structured deposits are defined in MiFID II44 as deposits45 which are fully repayable at maturity and under the terms of which interest or premium will be paid or is at risk, on the basis of a formula containing factors such as an index, a financial instrument, a commodity, and/or an exchange rate, or combination thereof. Structured deposits do not include deposits linked solely to interest rates, such as Euribor or Libor, regardless of whether or not the interest rates are predetermined, or whether they are fixed or variable.46 [2.28] The inclusion of structured products under MiFID II means that when investment firms and credit institutions are selling or advising clients in relation to structured deposits, this should be understood as their acting as intermediaries for those products issued by credit institutions that can take deposits in accordance with Directive 2013/36/EU.47 Article 1(4) MiFID II lists the MiFID II provisions that should be observed if distribution or advisory services in respect of such structured deposit are provided to a client. These provisions include the suitability test of Article 25(2) MiFID II or the appropriateness test of Article 25(3) MiFID II, depending on the service that is provided. 48 In the event the services are limited to execution of orders or the receipt and passing on of orders, the appropriateness test does not have to be performed.49 This exception is however not applicable if the structured products qualify as complex, as set out in Article 25(4) under (a)(v) MiFID II. These are products that incorporate a structure which makes it difficult for a client to understand the risk of return of the costs of exiting the product before the term has lapsed. Under Article 25(10)(b) MiFID II, it is the task of ESMA to develop and keep updated guidelines to determine which products fall under this description (and thus also require an appropriateness test if the services are

limited to order execution or the receipt and transmission of orders).50 Also, the provisions on product governance as included in Article 24 apply to structured deposits. In short, these provisions entail that investment firms and credit institutions that manufacture or distribute structured deposits are subject to the product-governance requirements, which include that a product approval process must be in place.51

VI. General Exemptions to MiFID II Applicability [2.29] As stated, the provision of investment services to clients and/or the conduct of investment activities on a professional basis, in each case to the extent relating to financial instruments, triggers the qualification as an investment firm and thus MiFID II applicability. MiFID II maintains the general exemptions that were provided by MiFID, however, narrowing the scope of the exemptions for some of them, as further set out in the next section. [2.30] Next to these general exemptions, Article 3 of MiFID II offers an optional exemption to Member States. Member States may choose not to apply MiFID II to persons for which they are the home Member State, provided that national authorization and regulation apply. This optional exemption may only be applied to persons that meet certain conditions52 and are made subject to certain local requirements.53 [2.31] The general exemptions to MiFID II include exemptions for the following categories:54 (i) Insurance companies;55 (ii) Persons providing investment service ‘intra-group’;56 (iii) Persons providing investment services incidentally or investment advice in the course of another professional activity, subject to some further conditions;57 (iv) Persons dealing on own account;58 (v) Operators dealing in emission allowances;59

(vi) Administrators of employee participation schemes, whether or not in combination with providing intra-group services;60 (vii) Public bodies;61 (viii) Pension funds and collective investment undertakings, including their depositaries and managers;62 (ix) Persons that can benefit from some Member States’ (Denmark, Finland, and Italy) specific exemptions;63 (x) Transmission system operators;64 (xi) Central Securities Depositories (CSDs).65 [2.32] Some of these exemptions are triggered by the fact that the relevant entity would conduct the investment services or activities in the context of business that is already regulated at the EU level through a different set of rules. This is true for the insurance companies’ exemption66 and also for the pension funds and collective investment undertakings, including their managers.67 [2.33] As noted, for credit institutions a system applies whereby the authorization and operation are governed by the EU law specific to credit institutions, while for any investment services and activities the MiFID II rules apply.68 A similar system is considered to apply to CSDs. As is reflected in the Recital (41) of MiFID II, CSDs are to be specifically regulated under EU law and are to be subject, in particular, to authorization and certain operating conditions. In the Recital it is noted that CSDs might, in addition to the core services referred to in other EU law, provide investment services and activities which are regulated under MiFID II. In order to ensure that any entities providing investment services and activities are subject to the same regulatory framework, it is appropriate, so it is stated in the Recital, to ensure that such CSDs are not subject to the requirements of this MiFID II relating to authorization and certain operating conditions but that EU law regulating CSDs as such should ensure that they are subject to the provisions of MiFID II when they provide investment services or perform investment activities in addition to the services specified in that EU law. Based on this reasoning, CSDs are exempt from MiFID II to the extent they are regulated under EU law on the basis of Article 2(1)(o) MiFID II. Reference is also made to the specific exemption

for transmission system operators: when carrying out tasks under specific EU law and in accordance with this specific regulation, they are exempt from MiFID II.69 [2.34] Other exemptions seem to be triggered by the fact that the services are not provided to ‘clients’, but rather to a pre-determined group of related persons. This is true for the exemption of persons who provide investment services consisting exclusively in the administration of employeeparticipation schemes and who therefore do not provide investment services to third parties.70 The limited scope of the clients (namely only the parent company, the other subsidiaries, or the own subsidiaries71 of such parent) is also a trigger for the so-called intra-group exemption.72 This exemption is in fact an application of the criterion that MiFID II aims to regulate the provision of services to third parties, while the group entities as described in this exemption (parent, other subsidiaries, own subsidiaries) could be considered not to be such third parties. This is also reflected in Recital 28: Persons who do not provide services for third parties but whose business consists in providing investment services solely for their parent undertakings, for their subsidiaries, or for other subsidiaries of their parent undertakings should not be covered by this Directive.

[2.35] Also, exemptions are available for persons with a different main professional activity to providing investment services or investment activities, subject to certain conditions.73 Exemption (h) is triggered by the public task of certain entities which may trigger the conduct of investment services or activities.74 [2.36] The other exemptions will be discussed in more detail in Sections VII, VIII, and IX.

VII. Trading on Own Account [2.37] Under MiFID II, the exemptions for trading on own account have been revised and reshaped. In general, the scope of the exemptions for trading on own account has been narrowed by MiFID II.75 As can be

derived from the Recitals, the following reasoning has been applied in redefining the exemptions for trading on own account. [2.38] As a starting point, it is expressed in the Recitals76 that persons administering their own assets and undertakings, who do not provide investment services or perform investment activities other than dealing on own account in financial instruments, should not be covered by MiFID II. There are, however, two important limitations to this general exception for dealing on own account. The first one is that a special regime applies for dealing on own account in the following financial instruments: (i) commodity derivatives and (ii) emission allowances or derivatives thereof, as set out in the next paragraph. The second limitation is that persons who deal on their own account are nevertheless covered by MiFID II, if they are market makers,77 members or participants of a regulated market or an MTF or have direct electronic access to a trading venue, apply a high-frequency algorithmic trading technique, or deal on own account when executing client orders. Based on this rationale, the exemption of Article 2(1)(d) MIFID II has been formulated. [2.39] Persons not covered by this exemption may be able to benefit from the exemption reflected in Article 2(1)(j) MiFID II. This exemption is available for (i) persons who deal on own account (including market makers) in commodity derivatives, emission allowances or derivatives thereof, but excluding persons who deal on own account when executing client orders, or (ii) persons who provide investment services (so no dealing on own account) in commodity derivatives or emission allowances or derivatives thereof to the customers or suppliers of their main business. These persons are not covered by the scope of MiFID II, provided that (a) that activity is an ancillary activity to their main business on a group basis, and that main business is neither the provision of investment services within the meaning of MiFID II nor of banking activities within the meaning of CRD IV, nor market making in commodity derivatives, and (b) those persons do not apply a high-frequency algorithmic trading technique. Notably, having direct electronic access to a trading venue is not an exclusion to this exemption.78 Technical criteria for when an activity is ancillary to such a main business should be clarified in regulatory technical standards, taking into account the criteria specified in MiFID II.79 As a

condition to this exemption, it is required to report the contemplated use of the exemption to the relevant authorities.80 The criteria set out above are aimed to ensure that non-financial firms dealing in financial instruments in a disproportionate manner compared with the level of investment in the main business are covered by the scope of MiFID II.81 [2.40] Exemptions (d) and (j) can be combined. This means that persons that deal in commodity derivatives, emission allowances, and derivatives thereof may also deal in other financial instruments as part of their commercial treasury risk-management activities to protect themselves against risks, such as exchange rate risks (and rely on exemption (d) for this activity).82 [2.41] Based on these exemptions, market makers in financial instruments (other than market makers in commodity derivatives, emission allowances, or derivatives thereof provided that their market-making activity is ancillary to their main business considered on a group basis and provided that they do not apply a high-frequency algorithmic trading technique) are always covered by the scope of MiFID II and cannot benefit from any exemption. The same applies to persons: (a) dealing on own account when executing client orders or (b) applying a high-frequency algorithmic trading technique. These persons are covered by the scope of MiFID II and cannot benefit from any exemption.

VIII. Dealings in Emission Allowances [2.42] A new exemption has been added to the list.83 This new exemption is for operators dealing in emission allowances. This exemption is triggered by the fact that under MiFID II (as further set out in paragraph 2.47) emission allowances have been added to the list of financial instruments. This brings all investment services and activities with regard to emission allowances into the scope of MiFID II as a starting point. However, under certain conditions an exemption is available. These conditions comprise: (i) the operator dealing in emission allowances is acting on the basis of compliance obligations under Directive 2003/87/EC, (ii) the transactions

constitute solely dealing on own account, and (iii) there is no execution of client orders and no application of HFT.

IX. Financial Instruments [2.43] As set out above, one of the most defining instruments to determine the scope of MiFID II is that MiFID II regulates investment services and activities to the extent only that these relate to financial instruments, which are defined by means of reference to Section C of Annex A to MiFID II. An exemption to this has been discussed above: even though structured deposits do not qualify as financial instruments, advising on and selling of these products by investment firms and credit institutions have been brought under the scope of MiFID II, at least to a certain extent. [2.44] On the demarcation of MiFID II by means of the reference to financial instruments as listed on Section C of Annex I, the following comments can be made. [2.45] First of all, an addition has been made to the list of financial instruments by including emission allowances. The background for this is clarified in Recital 11 to MiFID II, which states that a range of fraudulent practices have occurred in spot secondary markets in emission allowances which could undermine trust in the emissions trading scheme.84 One of the measures to address this is bringing emission allowances fully into the scope of MiFID II and MiFIR, by classifying them as financial instruments. As discussed above, a limited exemption has been made available for operators that deal on own account in emission allowances, subject to some further conditions. [2.46] Other parts of Section C of Annex A have remained unaltered. This is true for items (1), (2), (3), (8), and (9): (1) (2) (3) (8)

Transferable securities;85 Money-market instruments;86 Units in collective investment undertakings; Derivative instruments for the transfer of credit risks; and

(9) Financial contracts for differences. The other items ((4), (5), (6), (7), and (10)) have been reshaped. This can be clarified as follows. [2.47] Item (4) now contains a reference to emission allowances, which was previously included under item (10). As a result of this replacement, derivative contracts in respect of emission allowances do not qualify as ‘commodity derivatives’ as defined in Article 1(30) of MiFIR.87 Derivatives of emission allowances qualify as financial instruments (by means of their inclusion in item (4)), but do not qualify as commodity derivatives which provides a exclusion from the applicability of the new provisions on the determination of position limits and position management controls in respect of commodity derivatives.88 [2.48] In item (5) the reference to interest rate forward contracts has been replaced by the more general reference to forward contracts. [2.49] The type of commodity derivatives referred to in item (6) (physically settled commodity derivatives) is extended to those traded on an OTF. As a result, commodity derivatives traded on an OTF which can be physically settled qualify as financial instrument. However, outside the scope of the definition are wholesale energy products traded on an OTF that must be physically settled. The element ‘must be physically settled’ will be specified in a delegated act which, according to Recital 10, will take into account at least the creation of an enforceable and binding obligation to physically deliver, which cannot be unwound and with no right to cash settle or offset transactions except in the case of force majeure, default, or other bona fide inability to perform. The background to the exclusion of wholesale energy contracts is that these products are regulated by REMIT. This is confirmed in Recital 9 which states that the scope of financial instruments will include physically settled energy contracts traded on an OTF, except for those already regulated under REMIT.89 A special regime applies to a subcategory of instruments covered by item (6) of Section C, which are the so-called C6 energy derivative contracts.90 These are commodity derivatives relating to coal or oil that are traded on an OTF and must be physically settled. The C6 energy derivatives contracts are not

covered by REMIT and qualify as financial instruments. As a result, in respect of these financial instruments the provisions on position limits and transaction reporting apply upon the effectiveness of MiFID II and MiFIR. In respect of certain other obligations that are triggered by the qualification as financial instrument, Article 95 MiFID II provides for a transitional regime.91 [2.50] Item (7) of Annex C contains the remainder of commodity derivatives that can be physically settled, do not fall under item (6), are not for commercial purposes, and which have the characteristics of other derivative financial instruments.

X. Insurance Companies and Insurance Intermediaries [2.51] As set out above, the general exemption available to insurance companies remains unaltered under MiFID II. This exemption entails that insurance companies that provide investment services or conduct investment activities are not covered by MiFID II. Obviously, the potential for insurance companies to conduct any investment services or activities is limited by the fact that insurance companies may not engage in any other business than insurance business.92 This allows insurance companies to conduct all investment services and activities that may be deemed to be within the scope of the business of an insurance company (such as the investment of premium income in financial instruments) without applicability of MiFID II. [2.52] MiFID II, however, adds a new angle for so-called investmentbased insurance products. The background for this is clarified in Recital 87. In this Recital reference is made to the fact that investments can be made by clients through insurance contracts, and such a route to make investments would often been seen as an alternative or substitute for financial instruments regulated under MiFID II: To deliver consistent protection for retail clients and ensure a level playing field between similar products, it is important that insurance-based investment products are subject to appropriate requirements. Whereas the

investor protection requirements in this Directive should therefore be applied equally to those investments packaged under insurance contracts, their different market structures and product characteristics make it more appropriate that detailed requirements are set out in the ongoing review of Directive 2002/92/EC rather than setting them in this Directive. Future Union law regulating the activities of insurance intermediaries and insurance undertakings should thus appropriately ensure a consistent regulatory approach concerning the distribution of different financial products which satisfy similar investor needs and therefore raise comparable investor protection challenges. [2.53] Insurance-based investment products therefore still do not qualify as financial instruments. The revisions to the Insurance Mediation Directive93 prescribed by MiFID II, however, arrange for the applicability of certain MiFID II rules to such insurance contracts, based on the rationale that these insurance-based investment products are comparable, from the client’s perspective, to MiFID II-regulated investment products and thus the client should be offered a similar level of investor protection. For this purpose, MiFID II includes revisions to the IDD, incorporating a definition of insurance-based investment product. Based on this new definition, such product is basically an insurance product which offers a maturity of surrender value and where such value is wholly or partially exposed to market fluctuations. Non-life products and life products that provide for payable benefits only in the event of death or in respect of incapacity due to injury, sickness, or infirmity as well as certain pension products are excluded from the definition. [2.54] The additional rules included in the IDD for the insurance-based investment products include: (i) rules on conflict of interest, (ii) general principles relating to acting in the best interest of clients, and (iii) rules on information to clients. As an option, Member States may prohibit or limit the acceptance or receipt of fees paid or provided to insurance intermediaries or insurers by any third party (other than the client itself).

XI. Managers of Collective Investment Undertakings

[2.55] On the basis of Article 2(1)(i) MiFID II, collective investment undertakings as well as their managers and the depositaries are exempted from MiFID II. These collective investment undertakings cover the alternative investment funds as regulated under the AIFMD94 as well as the undertakings for collective investments in securities.95 Based on Recital 34, this exemption is based on the fact that the collective investment undertakings and their managers are subject to specific rules directly adapted to their activities. From this reasoning, it can be deduced that the exemption from MiFID II applies to any investment services and activities typical to the business of the manager of a collective investment undertaking, such as the execution of orders in units in the collective investment undertaking. [2.56] Notably, the specific Directives applicable to collective investment undertakings and their managers allow the managers to be authorized for the provision of certain investment services. On the basis of Article 6 AIFMD,96 Member States may authorize an external manager of a collective investment undertaking under the AIFMD to provide, inter alia, management of portfolios of investments, investment advice, and reception and transmission of orders in relation to financial instruments. In that case, certain MiFID II provisions should be made applicable.97

XII. Data-Reporting Service Providers [2.57] MiFID II introduces supervision on a new group of servicers, namely providers of data-reporting services. Based on Section D of Annex I to MiFID II, these services include three different categories, namely: (i) operating an APA, (ii) operating a CTP, and (iii) operating an ARM. These services are defined in Article 4, para. 1 MiFID II. APA or ‘Approved Publication Arrangement’ means a person authorized under MiFID II to provide the service of publishing trade reports on behalf of investment firms pursuant to Articles 20 and 21 of MiFIR.98 CTP or ‘Consolidated Tape Provider’ means a person authorized under MiFID II to provide the service of collecting trade reports for financial instruments listed in Articles 6, 7, 10, 12, and 13 of MiFIR from market operators and APAs and consolidating

them into a continuous electronic live data stream providing price and volume data per financial instrument.99 ARM or ‘Approved Reporting Mechanism’ means a person authorized under MiFID II to provide the service of reporting details of transactions to competent authorities or to the ESMA on behalf of investment firms.100 [2.58] The supervision that is introduced by MIFID II on these providers includes that they are subject to prior authorization by their home Member State.101 In addition, requirements apply to the management body of a data reporting-service provider.102 Organizational provisions apply which are specific to the type of data-reporting service provider.103 [2.59] The background to this new supervision introduced by MiFID II on data service providers is the renewed focus on the importance of transparency, both pre and post trade. MiFID II extends the transparency requirements,104 and the simultaneous introduction of supervision on data service providers underlines the importance that accurate and comprehensive information on market data is to be available to the users of such data, which include the supervisors.105

XIII. Market Operators [2.60] The scope of MiFID II in respect of market operators has basically remained unchanged, with the exception of adding the operation of an OTF to the list of investment services and activities that trigger an authorization requirement and applicability of MiFID II requirements.106

XIV. Conclusion [2.61] MiFID II introduces several changes to the scope of the supervision of investment firms and some other business related to the investment services industry, including data-reporting service providers. The list of investment services is extended by adding the operation of an OTF. Also,

the revision and—in respect of some items—extension of the definition of ‘financial instrument’ has an impact on the scope of MiFID II supervision. This includes emission allowances. In addition, advisory and distribution services in respect of structured deposits by investment firms and credit institutions are brought within the scope of MiFID II. Furthermore, supervision comparable to the MiFID II system is being introduced for insurers and intermediaries in respect of investment-based insurance products. At the same time, the scope of some of the exemptions to MiFID II is revised, with an impact in particular for dealing on own account. Dealing on own account through a high-frequency algorithmic trading technique is brought within the scope of MiFID II, and the broad exemption for traders in commodities derivatives has also been limited. As a result, the scope of MiFID II is considerably broader than MiFID I. This has an effect beyond the applicability of MiFID II regulation, as currently the prudential requirements are also linked as a starting point to the MiFID II qualification —however, with specific exemptions. In addition, the concept of linking prudential supervision to the MiFID II qualification, rather than to the prudential risk profile of the underlying services and activities, is subject to review and reconsideration.

1

MiFID I stands for the Markets in Financial Instruments Directive (Directive 2004/39/EG). MiFID II stands for the Markets in Financial Instruments Directive II (Directive 2014/65/EG). 2 For this chapter, use has been made of preparations for a publication on the scope of MiFID II with a focus on the Dutch law implementation by Kitty Lieverse and Marije Louisse in ‘De reikwijdte van MiFID II’, Tijdschrift voor Financieel recht, December 2015, pp. 437–46. 3 Article 4, para. 1(1) MiFID II. 4 Article 4, para. 1(2) MiFID II. Financial instruments are defined in Article 4, para. 1(15) MiFID II. 5 Article 4, para. 1(5) MiFID II. 6 Article 4, para. 1(6) MiFID II. 7 Article 4, para. 1(8) MiFID II. 8 Article 4(1), para. 4 MiFID II. 9 MTF stands for Multilateral Trading Facility. 10 OTF stands for an Organised Trading Facility, defined in Article 4(23) MiFID II as a multilateral system which is not a regulated market or an MTF and in which multiple third-

party buying and selling interests in bonds, emission allowances, structured financial products, or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of MiFID II. 11 This change to the scope of MiFID II is not further discussed in this chapter. 12 Article 4(1) para. 5 MiFID II. 13 Based on the definition in Article 4(1), para. 1 MiFID II. 14 If a natural person is an investment firm and provides the service of holding thirdparty funds or transferable securities, Article 4(1) MiFID II requires that additional items listed as (a–d) are complied with. 15 Additional requirements for natural persons acting as investment firms can be found in Article 5(4)(b) MiFID II and Article 9(6) MiFID II. 16 Article 2(1)(c) MiFID II. 17 Article 2(1)(k) MiFID II. 18 The element of a ‘client’ is included in the description of service under (2) and in the definition of service under (4) and (5). Services (6) and (7) in my view imply that these underwriting and placing services are typically provided for the relevant issuer as a client. 19 Reference is made to Recital 38 to MiFID II. The credit institution-specific regulation is included in CRD IV: Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, EU L 176/338 (Activity of Credit Institutions Directive); and Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, EU L 176/1. 20 Regulation (EU) 573/2013, EU L 176/1. 21 Article 1(3) MiFID II does not refer to the authorization requirements under MiFID II. 22 Directive 2013/36/EU of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (CRD IV), EU L 176/338. 23 In fact, on this basis the scope of MiFID II is also a relevant factor for determining the scope of other pieces of legislation, including the Banking Resolution and Recovery Directive. 24 Article 94 MiFID II. 25 This is based on the EBA Report on Investment Firms of December 2015: Response to the Commission’s Call for Advice of December 2014, EBA/Op/2015/20. In this report interesting background on the concept of a local firm is provided: Historically, when there was still a physical presence or ‘open market outcry’ on an exchange, futures (derivatives) trading floors included a type of individual trader, known as the ‘local’, who made their living by buying and selling and seeking a profit from the spread. In effect, they were market makers, providing intra-day liquidity to

the market. With trading taking place physically on the floor of the exchange, ‘locals’ sought to place themselves in close proximity to the traders working for the major proprietary houses, so that they could benefit through such relationships and from being part of larger orders. They were, therefore, genuinely local in terms of their presence and their business with the relevant exchange. On further developments in this regard, the EBA reports continues: The assumption has been that local firms are small enterprises with a limited risk profile. The definition of ‘local firm’ in the CRR has remained virtually unchanged from the definition in the original version of the CAD in 1993. Local firms were, indeed, originally small firms (usually self-employed traders), only active on a single exchange. However, over time these small trading firms have grown, resulting in firms that are, to all intents and purposes, no longer local despite still being able to qualify under the ‘local firm’ definition. Some local firms are active in multiple jurisdictions and across all continents, employing hundreds of employees and having average trading positions of several billion. The assumption that a local firm is small and relatively low risk is, therefore, becoming more and more obsolete. 26

As further discussed below, see: Article 2(1)(d) and (j) MiFID II. Article (4)(1), para. 2 under c, CRR. 28 Article (4)(1), para. 3 CRR. 29 Article 28(2) CRD IV. 30 Article 29(1) CRD IV. Article 29(2) CRD IV provides for a Member State option to reduce this amount to €50,000 where a firm is not authorized to hold client money or securities, to deal for its own account, or to otherwise underwrite issues on a firm commitment basis. 31 Article 30 CRD IV. 32 Article 4(1), para. 2c, CRR. 33 Article 31(1) CRD IV and Article 31(2) CRD IV for those investment firms in this category that are also subject to registration under the Insurance Mediation Directive (Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on insurance mediation, OJ L 9/3), in both cases with the option to wholly or partially seek replacement by means of professional indemnity insurance as set out under items (b) and (c) of this provision. 34 Article 92 CRR. 35 Articles 95 and 96 CRR. A useful overview is provided in the EBA Report on Investment Firms (2015), on p. 15 and also on p. 17. 36 Article 16(8) and (9) MiFID II. 37 As is also noted in the EBA Report on Investment Firms (2015), p. 14. 38 EBA/Op/2015/20. 27

39

Reference is made to para. 2.5.3 of the EBA Report on Investment Firms and the recommendations, the analytical review of investment firms’ risk in Chapter 3, and the recommendation resulting therefrom in Chapter 4. On this topic the two main recommendations are as follows. Recommendation 1: ‘Recommendation for a new categorisation of investment firms distinguishing between systemic and “bank-like” investment firms to which the full CRD/CRR requirements should be applied; other investment firms (“non-systemic”) with a more limited set of prudential requirements; and very small firms with “non-interconnected” services.’ Recommendation 2: ‘Recommendation for the development of a prudential regime for “non-systemic” investment firms.’ 40 Articles 493 and 498 CRR, relating to the large exposures and capital adequacy provisions, currently set to expire by 31 December 2017. 41 Reference is made to recommendation 3 on p. 87 of the EBA Report on Investment Firms. 42 Reference is made to Recital 39. 43 This is based on the wording of Article 1(4) MiFID II, with the proviso that the terminology ‘selling’ is somewhat vague in the MiFID II context. This is further discussed below in respect of the scope of the suitability and appropriateness test. 44 Article 4(1), para. 43, MiFID II. 45 As defined in point (c) of Article 2(1) of Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on deposit guarantee schemes, OJ L 173, 12.6.2014, 149–78. 46 Article 4(1), para. 43 under a, MiFID II. 47 Reference is made to Recital 40 to MiFID II. 48 The terminology of Article 25 MiFID II is not tailored to the services in respect of structured deposits as mentioned in Article 4(1) of MiFID II (selling or advising) that have been made subject to MiFID II. I would understand the reference to either the suitability test or appropriateness test to be determined by whether or not the involvement of the investment firm or credit institution when distributing structured deposits includes advice. If so, the suitability test applies. Otherwise, when ‘selling’ without advice the appropriateness test applies. 49 Article 25(4), under (a)(v) MiFID II. 50 Reference is made to the Commission Delegated Regulation which is to be determined on the basis of the ESMA RTS on Complex debt instruments and structured deposits, on the basis of Article 25(10)(b) MiFID II. 51 Article 1(4), Article 9(3), Article 16(3), and Article 24 MiFID II. 52 These are the cumulative conditions listed under Article 3(1)(a–c), or (d) or (e) MiFID II. 53 Article 3(1)(2) MiFID II. 54 Article 2 MiFID II. 55 Article 2(1)(a) MiFID II.

56

Article 2(1)(b) MiFID II. Article 2(1) under (c) and (k) MiFID II. 58 ibid under (d) and (j) MiFID II. 59 ibid under (e) MiFID II. 60 ibid under (f) and (g) MiFID II. 61 ibid under (h), Article 2, para. 2 MiFID II. 62 ibid under (i) MiFID II. 63 ibid under (l) and (m) MiFID II. 64 ibid under (n) MiFID II. 65 ibid under (o) MiFID II. 66 Insurance companies are regulated at the EU level through Directive 2009/138/EU of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II); reference is made to Recital 27 to MiFID II. 67 Reference is made to Recital 34 to MiFID II. Collective investment undertakings, or at least their managers, are regulated by means of Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (AIFMD); or Directive 2009/65/EU of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities, OJ L 302/32 (UCITS Directive). 68 Article 1(3) MiFID II. 69 Article 2(1)(o), as explained in Recital 41. 70 This applies to the exemption of Article 2(1) under (f) and (g) MiFID II. 71 It is noted that the concepts ‘parent’ and ‘subsidiaries’ are defined in Article 4(1), paras. 32 and 33 MiFID II. 72 Article 2(1) under (b) MiFID II. 73 Reference is made to Article 2(1) under (c) and (k) and the comments made above under ‘Investment firm under MiFID II’. 74 Reference is made to Recital 32: 57

It is necessary to exclude from the scope of this Directive central banks and other bodies performing similar functions as well as public bodies charged with or intervening in the management of public debt, which concept covers the investment thereof, with the exception of bodies that are partly or wholly state-owned the role of which is commercial or linked to the acquisition of holdings. See also Recital 33 for the limitation of the exclusion of the ESCB, etc. from the scope of MiFID II.

75

Article 2(1)(k) of MiFID, the commodity dealer exemption, has been deleted and Article 2(1)(i) MiFID, the ancillary exemption, has been narrowed and replaced to Article 2(1)(j) MiFID II, while the dealing on own account exemption of Article 2(1)(d) MiFID has also been amended. 76 Reference is made to Recitals 18, 19, and 20 to MiFID II. 77 ‘Market maker’ is defined in Article 4(1)(7) MiFID II as a person who holds himself out on a continuous basis as being willing to deal on own account by buying and selling financial instruments against that person’s proprietary capital at prices determined by that person. 78 As set out above, this is different for the exemption mentioned in Article 2(1)(d) MiFID II, as set out under item (iii). 79 Reference is made to Article 2(4) MiFID II. On the basis of this provision ESMA has published a RTS: Criteria for establishing when an activity is to be considered to be ancillary to the main business. 80 Article 2(1)(j), final sentence, MiFID II. On the contents of these RTSs to determine whether an activity is ancillary at group level, it is stated in Recital 20, para. 2 to MiFID II: In doing so, those criteria should take at least into consideration the need for ancillary activities to constitute a minority of activities at group level and the size of their trading activity compared to the overall market trading activity in that asset class. It is appropriate that where the obligation to provide liquidity on a venue is required by regulatory authorities in accordance with Union or national laws, regulations, and administrative provisions or by trading venues, the transactions entered into to meet such an obligation should be excluded in the assessment of whether the activity is ancillary. 81

Reference is made to Recital 20, second paragraph, to MiFID II. Recital 22 to MiFID II. 83 Article 2(1)(e) MiFID II. 84 Set up by Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, OJ L 275/32. 85 As defined in Article 4(1)(44) MiFID II. 86 As defined in Article 4(1)(17) MiFID II. 87 This definition refers to an underlying value referred to in item (10) of Section C of Annex I which now no longer includes emission allowances. 88 Title IV MiFID II, Articles 57 and 58. 89 Regulation (EU) No 1227/2011 of the European Parliament and the Council of 25 October 2011 on wholesale energy market integrity and transparency, OJ L 326/1. 90 Reference is made to Article 4(1)(16) MiFID II. 82

91

This applies to the clearing obligation and margining requirements under Regulation 648/2012. 92 Reference is made to Articles 15 and 16 of Solvency II. 93 Replaced by the Insurance Distribution Directive (IDD) of 20 January 2016, Directive 2016/97/EU of the European Parliament and of the Council of 20 January 2016 on insurance distribution (recast), OJ L 26/19. 94 AIFMD (2011/61/EU). 95 UCITS (2009/65/EU). 96 A comparable provision is included in Article 6 of Directive 2009/65/EU (UCITS Directive). 97 Reference is made to Article 6(6) AIFMD which states that Article 2(2) and Articles 12, 13, and 19 of MiFID II shall apply to the provision of the services referred to in para. 4 of this Article 6 by managers. 98 Article 4(1)(52) MiFID II. 99 Article 4(1)(53) MiFID II. 100 Article 4(1)(54) MIFID II. 101 Article 59(1) MiFID II. 102 Article 63 MiFID II. 103 Article 64 for APAs, Article 65 for CTPs, and Article 66 for ARMs. 104 For example, while MiFID I limited the pre- and post-trade transparency to equity instruments, MIFID II also extends as a starting point to non-equity instruments such as bonds (but some waivers are allowed). Reference is made to II and III of MiFIR. 105 Reference is made to Recitals 115 and 116 to MiFID II. 106 Article 4(1)(23) MiFID II, which adds the definition of an OTF, which qualifies as a trading venue, in Article 4(1)(24). OTFs are subject to specific requirements; reference is made for example to Article 20 MiFID II.

3 GOVERNANCE OF INVESTMENT FIRMS UNDER MIFID II Jens-Hinrich Binder*

I. Introduction II. Governance-related Regulation of Investment Firms between Prudential and Conduct-of-Business Regulation 1. The Case for Governance-Related Regulation According to MiFID II—Some Preliminary Observations 2. Governance-Related Regulation since the ISD 1993 3. Some Preliminary Conclusions III. 1. 2. 3. 4. 5. 6.

The Technical Framework under MiFID II General Principles and Problems The Board Organization and Risk Management Shareholders and Owners with Qualifying Holdings Governance Reporting Assessment

IV. Conclusions

I. Introduction

[3.01] The regulation of the governance of investment firms—for present purposes to be understood as referring to the internal corporate governance, that is, the rules and arrangements relating to the board, the organization, and internal procedures1—is by no means a post-financial-crisis phenomenon, and MiFID II is not the first European law instrument to prescribe relevant requirements in this regard. In fact, their history reaches back beyond MiFID I2 and, to a considerable extent, has been part of the regulatory framework for the prudential supervision of banks and investment firms generally. Long before the financial crisis reinforced concerns about the management of financial intermediaries, the first components of the regulatory concept were already laid down in the Investment Services Directive (ISD) of 19933—then, as continues to be the case to date, in the form of fundamental prudential requirements that must be met both as a precondition for authorization as a licensed investment firm and on a day-to-day basis in the course of the firm’s operations.4 In addition, non-bank investment firms have been subject to the governancerelated provisions applicable to banks in particular after the implementation of the Basel II capital accord in Europe from 2006.5 In short, governancerelated regulations have been part and parcel of the European framework regulation of investment intermediaries from the start, as a precondition for authorization and a complement to conduct-of-business regulation. [3.02] Against this backdrop, a superficial observer could be forgiven for concluding that governance-related regulatory requirements appear to have been both an uncontroversial and a rather immutable component of the relevant EU framework for the setting-up and operation of financial intermediaries engaged in the business of investment services to date. On closer inspection, however, neither holds true. As will be discussed in detail in subsection II below, both the rationale of governance-related regulatory requirements and their technical content have changed significantly over time. It is also as a result of this rather complex history that some of the technical regulatory concepts, reinforced and expanded under MiFID II, continue to pose significant challenges to the diverse range of financial intermediaries that are subject to these requirements across the European Union. Again, as will be discussed below, these challenges are reinforced by the absence of clear-cut policy foundations, which has been a

characteristic of the regulatory framework for the pursuit of investment services ever since the adoption of the ISD 1993. [3.03] The present chapter seeks to explore both the relevant policy background and the technical content of governance-related regulation of investment firms under MiFID II and, in addition, secondary legislation complementing the Level 1 requirements,6 and the CRD IV package, which extends not just to credit institutions but also to investment firms. Section II below will first analyse the rationale for governance-related regulation against the backdrop of the historic emanation of governance-related requirements for investment firms in European financial regulation. Section III then examines the technical features of the new regime, and identifies some challenges for transposition and enforcement. Section IV concludes.

II. Governance-related Regulation of Investment Firms between Prudential and Conduct-of-Business Regulation 1. The Case for Governance-Related Regulation According to MiFID II—Some Preliminary Observations [3.04] Judging from the preamble to MiFID II, the case for governancerelated regulation would appear to be rather straightforward. In addition to the general policy objective to combat ‘weaknesses in the functioning and in the transparency of financial markets’,7 the Directive expressly identifies ‘weaknesses in corporate governance in a number of financial institutions, including the absence of effective checks and balances within them’, as a ‘contributory factor to the financial crisis’, and then continues to set out the rationale for regulatory interference by arguing that [e]xcessive and imprudent risk taking may lead to the failure of individual financial institutions and systemic problems in Member States and globally. Incorrect conduct of firms providing services to clients may lead to investor detriment and loss of

investor confidence. In order to address the potentially detrimental effect of those weaknesses in corporate governance arrangements, Directive 2004/39/EC should be supplemented by more detailed principles and minimum standards.8

[3.05] Starting from this wording, governance-related regulation of investment firms can thus be said to serve a dual objective, namely (i) the prevention of failures of financial institutions with a view to protecting systemic stability, and (ii) the prevention of losses to investors and the protection of investor confidence. On the surface, this is hardly surprising, as it merely reflects the traditional set of—interrelated—objectives of financial regulation generally: the preservation of the economic functions of financial markets (in particular, the effective allocation of capital within a market economy), and the protection of customers (whose confidence is essential for the preservation of financial stability).9 Irrespective of this general background, however, the relevance of the above statement of policy objectives goes far beyond stating the obvious. It is worth noting that, although the relevant regulations under MiFID I are expressly referred to as a starting point for the reform, systemic stability considerations, for the first time in the history of European securities regulation, are expressly mentioned as a key driver for the further refinement of the relevant requirements. This takes up corresponding considerations first laid down in the Commission’s 2010 Green Paper on the governance of financial institutions.10 By contrast, as will be examined in further detail below, neither the ISD 1993 nor MiFID I made any reference to such considerations in the context of governance-related regulation. To be sure, neither of these earlier instruments were very outspoken with regard to the motives for governance-related regulation. This was consistent with the original objective to realign the prudential requirements pertaining to nonbank investment firms with those applicable to credit institutions in the interest of equal market access,11 but indicates that the rationale for regulatory intervention was rather obscure under the predecessors of the present regime. [3.06] In view of lessons learnt from the global financial crisis, the reinforcement and expansion of governance-related requirements by MiFID II therefore reflect not just a desire for further refinement of existing regulatory requirements and strategies but also, importantly, a shift in the

underlying policy objectives: In addition to the protection of investors and investor confidence, systemic considerations have entered the scene—and seem to play a more important role than the traditional focus on investor protection as such. To be sure, this development reacts to widespread concerns about the quality of governance arrangements in financial intermediaries generally. These have arisen as a result of (well-founded or perceived) lessons learnt from the global financial crisis and have inspired not just the substantive overhaul of the governance-related provisions in the MiFID regime but also, and to a larger extent, the corresponding reforms of governance-related requirements for banks under the CRD IV package of 2013.12 As illustrated, in particular, by the Lehman Brothers failure in September 2007, systemic implications triggered by the insolvency of financial intermediaries are not necessarily confined to licensed banks. They arise out of the relevant firm’s size, its connectedness to other market participants and to providers of market infrastructure, and the complexity of its operations and legal structure, as well as the market perception of the relevance of the firm—rather than out of the nature of its business (deposittaking, provision of investment services) as such.13 On closer examination, however, the available evidence is mixed. While it is generally agreed that risk management systems failed to mitigate excessive risk-taking in financial intermediaries in the run-up to the crisis,14 empirical findings with regard to other aspects of corporate governance are, at best, inconclusive.15 In particular, it is far from settled that those corporate governance standards that had been established already prior to the financial crisis can be said to have contributed to safer organizational arrangements.16 Specifically to what extent prudential concerns about firm soundness and, ultimately, financial stability implications are warranted in the case of (different types of) investment firms is still rather uncharted territory. As international regulatory standards, in response to the global financial crisis, have understandably focused on systemically important financial institutions,17 it is, in principle, hardly surprising that the relevant provisions under MiFID II and secondary legislation, as a rule, are intended to apply indiscriminately across the full range of investment firms operating within the European Union. Given the high level of diversity of market participants in terms of size, business models and interconnectedness with counterparties, the underlying rationale is nonetheless somewhat

questionable.18 Against this backdrop—and somewhat in contrast to the exposition of the policy rationale expressed in the preamble to MiFID II— the case for governance-related regulation of financial intermediaries in general thus seems to be less clear than might be expected in view of the wave of failures of investment banks experienced globally in recent years. The same applies, and to a greater extent, to the technical design of the reformed regulatory framework under MiFID II.

2. Governance-Related Regulation since the ISD 1993 [3.07] To understand the full dimension of the considerations presented above, it is appropriate to explore the historical evolution of governancerelated regulations for investment firms in some more detail. In this context, the political objective to realign the regulatory frameworks for banks and non-bank financial intermediaries with the ISD 1993 deserves particular attention (infra II.2.A). Arguably, neither this Directive nor the subsequent amendments to existing requirements under MiFID I (infra II.2.B) fully acknowledged the functional parallels and differences between banking regulation, from which the relevant concepts were adapted, on the one hand, and investment services on the other hand.

A. Governance-Related Regulation under the ISD 1993 [3.08] In the context of governance-related requirements, specific references to the objective of investor protection in the ISD 1993 are rare. To be sure, the Preamble did acknowledge the need ‘to protect investors and the stability of the financial system’19 as key policy objectives generally. In addition, it argued that […] it is necessary, for the protection of investors, to guarantee the internal supervision of every [investment] firm, either by means of two-man management or, where that is not required by this Directive, by other mechanisms that ensure an equivalent result.20

[3.09] Beyond these few—and erratic—remarks, however, the rationale for governance-related regulations received no further explanation. Instead,

the focus clearly was on the equal treatment of banks and investment firms under the new framework.21 As such, the rationale for governance-related prudential requirements in the industry—as distinct from corresponding regulations for credit institutions in the technical sense—was mentioned neither in the Directive nor in contemporary literature. Consequently, governance-related regulation under the ISD 1993 remained somewhat haphazard, and limited to very few specific requirements. [3.10] Among these, the requirement that ‘the direction of a firm’s business must be decided by at least two persons’ of ‘sufficiently good repute and […] sufficiently experienced’22 was an early predecessor of today’s fit-and-proper regime,23 modelled after the corresponding provisions in the Second Banking Directive of 1989.24 In addition, the Directive prescribed a regime for supervisory scrutiny of owners of qualified holdings in investment firms,25 which again took up earlier precedents established in the area of banking regulation.26 [3.11] By comparison with subsequent developments, the ISD 1993 did not prescribe any substantive requirements with regard to business models or organizational issues. As part of the licensing process, however, enterprises seeking to be recognized as investment firms had to submit a ‘programme of operations setting out inter alia the types of business envisaged and the organizational structure of the investment firm’.27 While this ensured access of supervisory authorities to the relevant information, the definition of more specific requirements was left to the Member States, which were to ‘draw up prudential rules which investment firms shall observe at all times’,28 a serious and ‘systematic’ infringement of which could result in the revocation of the respective firm’s licence.29 Specifically, investment firms, in this context, were to be required to have sound administrative and accounting procedures, control and safeguard arrangements for electronic data processing, and adequate internal control mechanisms including, in particular, rules for personal transactions by […] employees.30

[3.12] In addition, Member States had to draw up requirements with regard to the protection of client assets and funds as well as the

documentation of transactions, and had to prescribe institutional arrangements designed to minimize the impact of conflicts of interest on clients.31 It is in this regard that the ISD 1993 went beyond the level of governance-related requirements already present in contemporary European banking regulation, reflecting earlier US American precedents.32 And it is here that the development of a specific organizational regime for investment firms in European financial regulation, distinct from governance-related requirements for banks, can be said to have its roots—a regime that goes beyond a mere replication of the organizational requirements for banks and specifically addresses the agency problems characteristic for investment firms which, because of the wide range of different types of investment services, are more complex than within the relationship between a bank and depositors.33 In these provisions, the functional link between prudential regulation and conduct-of-business regulation,34 discussed above, is particularly obvious. However, it is also in this regard that the lack of a consistent rationale for governance-related regulation of investment firms in early European regulation is evident. While investor protection is clearly the key motive for most of the organizational requirements stipulated by Article 10, the case for the remaining provisions examined above—and the rationale for the substantive synchronization of governance requirements for investment firms with those for banks generally—remains somewhat obscure. At least for the early stages of European regulation of investment firms and, specifically, the ISD 1993 it can only be explained on the grounds of the general motive to create a separate but equal single licence for the non-bank securities firms while ensuring that they do not have a competitive advantage in terms of funding requirements vis-à-vis credit institutions when such institutions are providing investment firms.35

[3.13] In other words, in addition to the general objective of investor protection, concerns about the conditions for fair competition among different types of providers of investment services—more specifically, universal banks and non-bank investment firms—and considerations of equal market access across the Common Market rather than concerns for financial stability, have to be considered as a key rationale for the early regulatory framework for the governance of investment firms.

B. Governance-Related Regulation under MiFID I and the CRD II package [3.14] In principle, the substitution of the ISD 1993 by MiFID I as such hardly changed this picture. To be sure, the new Directive, just as its predecessor, quoted both the protection of investors and the ‘stability of the financial system’ as key policy objectives.36 Whether and to what extent financial stability concerns actually warranted regulation of the corporate governance of investment firms was not discussed, however. Just as under the ISD 1993, governance-related requirements under MiFID I, in principle, mainly reflect investor protection concerns and, to the extent that they replicate corresponding requirements in banking regulation, merely continue to synchronize both regimes with a view to ensuring a level playing field between universal banks and specialized investment firms.37 In principle, the Directive carried forth the main elements of governancerelated regulations already established by the ISD 1993. Directors and shareholders as well as members with qualifying holdings continued to be subject to suitability tests in order to prevent undue influence on the firms’ management.38 In terms of organizational requirements, Article 13 also took up the requirements established by the ISD 1993, but with some alterations to the catalogue stipulated by Article 10 ISD 1993 that reflected more specific concerns about operational risks.39 [3.15] Notwithstanding the continuity of substantive regulations visible in the wording of ISD 1993 and MiFID I, the latter clearly triggered a conceptual departure from the earlier instrument in that it formed the basis for extensive Level 2 legislation on organizational requirements and operating conditions.40 In addition to these rather general provisions, the governance and organization of investment firms now were subjected to a complex, harmonized regime of institutional and procedural substantive requirements, compliance with which would be monitored by the licensing authorities. In addition to general requirements relating to the internal organization,41 Directive 2006/73/EC on organizational requirements and operating conditions, insofar as it is of interest for the purposes of this chapter, stipulated detailed provisions and definitions on compliance,42 risk management,43 internal audits,44 the corresponding responsibility of senior

management,45 and on specific organizational requirements designed so as to ensure the safeguarding of client funds.46 [3.16] Irrespective of the substantial increase in detail brought about by the Organisational Requirements Directive 2006/73/EC, however, the fundamental policy basis for governance-related requirements did not deviate conceptually from earlier regulation. Just as in MiFID I, considerations of equal market access on one hand and investor protection on the other hand can be identified as the key motives inspiring the technical specifications stipulated by the Organisational Requirements Directive. If the new regime differed at all from its predecessor in this respect, ensuring a level playing field for all providers of investment services throughout the (then) European Community—rather than systemic stability concerns—appears to have been an even stronger determinant of governance-related requirements than under the ISD 1993. This motive was expressly mentioned as the objective for technical harmonization of organizational requirements and conditions for authorization, as well as for the principle of maximum harmonization imposed by the Implementing Directive,47 whereas investor protection was identified as a key rationale for requirements for operating conditions48 (i.e. conduct-of-business rules) —and systemic stability concerns were not quoted at all in either MiFID I or the Organisational Requirements Directive 2006/73/EC. [3.17] To stop the analysis at this point would be misleading, however, as it was outside the MiFID I regime that governance-related requirements for investment firms first received a much more comprehensive treatment in EU financial services regulation. With the transposition of the Basel II capital accord of 200449 into European law by the CRD I package in 2006,50 not just credit institutions but also investment firms became subject to a reformed set of comprehensive governance-related requirements, which reflected the Basel Committee’s emphasis on the need for sound and robust governance arrangements in addition to reliable capital cushions in financial intermediaries.51 In particular, Article 22(1) of the recast Banking Directive, which was supplemented with complex technical requirements in Annex V to that Directive, required banks to establish and maintain

robust governance arrangements, which include a clear organisational structure with well defined, transparent and consistent lines of responsibility, effective processes to identify, manage, monitor and report the risks it is or might be exposed to, and adequate internal control mechanisms, including sound administrative and accounting procedures.

[3.18] The scope of these provisions was extended to investment firms pursuant to Article 34 of the recast Capital Adequacy Directive. In 2010, the new regime was supplemented by new rules on remuneration policies as part of the CRD III reform in November 2010.52 To be sure, particularly this latter reform can be characterized as a first step towards the subsequent comprehensive overhaul of the regulatory framework for banks and investment firms by the CRD IV package and MiFID II, in that the Preamble discusses at length weaknesses in remuneration policies and risk governance as a determinant for failures in the financial crisis and also reflects the Commission’s plans for extensive enhancements of governancerelated provisions developed in its 2010 Green Paper.53 [3.19] In short, the modern trend for comprehensive regulation of investment firms’ governance arrangements clearly had its roots already in the CRD I package (as recast in 2006), which implemented the Basel II Accord within the European Union. As such, the new regime clearly was motivated by systemic stability considerations and did not reflect specific investor protection concerns. By and large, the extension of the organizational requirements not just to credit institutions but also to nonbank investment firms continued to reflect the traditional rationale of ensuring equal market access and a level playing field for both types of financial intermediaries. Until the 2010 reform of the CRD III package, which reflected already the more comprehensive insights into the determinants of financial crisis gained during 2007–9, the inclusion of investment firms in the general regulatory framework for credit institutions cannot be said to have been based on an analysis of the functional parallels and differences in the respective business models, and on the resulting challenges to financial stability associated with them.

3. Some Preliminary Conclusions

[3.20] In retrospect, the policy rationale for the treatment of investment firms in European financial regulation can be said to have oscillated between three rather different aspects: investor protection, the protection of financial stability, and the creation of a ‘level playing field’, that is, the harmonization of requirements for market access for investment firms in the Internal Market. As a closer analysis of the emanation of governancerelated regulations in European law reveals, their conceptual basis has been rather weak from the early stages of EC Securities Law to the present day. The recent shift towards systemic risk considerations as the key rationale formulated in MiFID II is certainly consistent with a broader trend in postcrisis financial regulation, which started to influence the regulation of governance arrangements in financial intermediaries already under the CRD I package in the form of the 2006 reforms. Specifically with regard to the governance of non-bank investment firms, however, the relevant policy foundations continue to be open to doubts, mainly in two respects: First, as discussed above, their historical emanation since 1993 has by no means been organic. In contrast to the wording of the relevant Recitals in the Preamble to MiFID II, the key drivers for the EU-wide harmonization of relevant standards until MiFID II have been considerations of equal market access within the Common Market, and also, to a somewhat lesser extent, investor protection. Systemic stability concerns, by contrast, were cited only superficially in the earlier documents, with no significant role in the design of the relevant provisions. In this respect, the new emphasis on systemic stability concerns in MiFID II, now expressly identified as key determinants for the governance-related regulation of investment firms, appears to mark a significant shift in the underlying policy foundations, whereas the relevant technical instruments, to a large extent, are mere adaptations of the earlier regime. It remains to be seen whether and to what extent the rearranged and expanded set of regulatory requirements can be reconciled with the specific challenges posed by non-bank investment firms. Second, empirical evidence as to concrete deficiencies in existing arrangements is rather limited, which further weakens the case for specific regulatory interventions in the organizational choices of regulated firms. Both aspects will have to be considered in the course of the analysis of specific technical requirements discussed in Section III below.

III. The Technical Framework under MiFID II 1. General Principles and Problems [3.21] In principle, the governance-related requirements stipulated by MiFID II—and, in addition, the new Organisational Requirements Regulation54—continue to combine general prudential requirements established in the field of banking regulation with specific additions designed to address the specific characteristics of investment services (as distinct from banking activities). This is particularly visible with regard to the Directive’s provisions on the management body, which expressly adapt the regime set out in the CRD IV of 201355 and add further requirements in the interest of investor protection56 (see infra III.2). Just as in EU banking regulation, these duties are inextricably intertwined with organizational and procedural requirements, which are directed both to the firm and to the management body and, again, address both general prudential concerns and issues specific to the provision of investment services (as distinct from core banking services) (infra III.3). With regard to regulatory requirements for shareholders and owners with qualifying holdings, the new regime builds on, and develops further, the corresponding provisions under MiFID II,57 showing significant similarities with, but no direct cross-references to, the corresponding provisions in EU banking regulation (infra III.4). Finally, investment firms are subject to certain governance reporting requirements (infra III.5). [3.22] In terms of technical content, the departure from earlier policy concepts, at least at first sight, thus seems to be far less dramatic than the changes in the underlying policy would suggest. This finding, in turn, triggers a number of interrelated questions, to be addressed in the overal assessment (infra III.6): If it is true that the reformed set of governancerelated requirements under the MiFID II regime (unlike the corresponding requirements under the earlier instruments) focuses on the preservation of systemic stability rather than the protection of individual investors, to what extent is that change in policy reflected in the substantive content of the

relevant provisions, and what are the practical implications in terms of construction, implementation, and enforcement of the new regime? [3.23] To be sure, the policy objectives formulated in MiFID II58 (in conjunction with those set forth in the CRD IV) still do not quite reflect a clear-cut understanding of the relationship between systemic concerns and investor protection, or at least fail to present a consistent case for regulation in this regard. However, they certainly do highlight the functional link between prudential regulation, that is, institutions-oriented regulation aiming at enhancing the resilience and soundness of intermediaries, and conduct-of-business regulation, that is, transactions-oriented standards for the provision of financial services. ‘Detriment’ to investors, in the words of the Directive, can result both from the failure of individual firms and ‘incorrect conduct’; and both types of risks, in the view of the authors of MiFID II, can be traced back to ‘weaknesses in corporate governance’.59 While these considerations are consistent with the determinants of the reformed governance-related requirements under the CRD IV,60 they deserve some attention especially in the present context, as it is for the first time in the history of EU securities regulation that the functional link between the two regimes has been spelled out with such clarity. From this perspective, governance-related regulation of investment firms almost by definition serves a dual objective—the protection both of the interests of systemic stability and of individual investors. This clearly goes back to the considerations formulated above—and it suggests that, indeed, the crisis has helped to refine the understanding of relevant risks as well as to recalibrate the regulatory responses to such weaknesses. In this respect, securities regulation appears finally to have caught up with the area of banking regulation, where the dual objective of (prudential) regulation has always been defined as encompassing both the preservation of financial stability and the protection of depositors. In sum, based on the construction of the formulation of relevant policy objectives quoted above, the concept of governance-related regulations under MiFID II, in comparison with its predecessors in the ISD 1993 and MiFID I, can be said to have converged with the rationale of the corresponding requirements in the area of banking regulation: In European (and international) banking regulation, requirements for the internal governance of regulated institutions have been an integral part of the prudential toolbox since the implementation of the

Basel II Capital Accord—and, as such, have been aiming at the protection of both systemic stability and depositors.61 This, again, evokes some key questions for further exploration in the present chapter: In view of the functional differences between the economic nature of banking activities and those associated with the provision of investment services, should that conceptual convergence be welcomed? Similarly, and even more farreaching: To what extent is the underlying rationale corroborated by the available evidence on governance failures? As discussed before,62 the empirical case for enhanced governance-oriented regulation after the global financial crisis is, at best, mixed, making a refined understanding of the specific governance standards for non-bank investment services even more desirable. [3.24] Finally, in a more technical respect, the following analysis will have to address the question of whether the new regime, despite the increase in technical detail in comparison with its predecessors, continues to be sufficiently flexible with regard to the variety of regulated investment firms across the EU. Just as is the case in the area of the reformed regime for the prudential regulation of banks under CRD IV,63 this is not just a question of proportionality in view of differences in terms of size and complexity of the regulatees, but also of flexibility with regard to differences in terms of their legal nature and respective governance structures. Under the MiFID II regime, these concerns are particularly pressing because implementing Level 2 instruments no longer take the form of Directives but now come in the form of regulations.

2. The Board A. Organizational Structure [3.25] Just like banks, investment firms under the new regime are subject to a rather complex set of fundamental requirements as to the organizational structure of the board. In this respect, MiFID II does not establish independent criteria, but merely incorporates the corresponding

requirements prescribed by CRD IV (Article 9(1) in conjunction with Article 88 CRD IV). In this regard, it should be noted that the reference to the CRD IV in Article 9(1) MiFID II is of a declaratory nature for the majority of investment firms within the EU, which are covered by the definition of ‘investment firms’ set out in Article 4(2) of the Capital Requirements Regulation (the ‘CRR’)64 and therefore qualify as ‘institutions’ as defined in Article 4(1)(3) of the CRR which in turn includes them directly in the scope of the CRD IV requirements anyhow.65 Consequently, Article 9(1) MiFID II merely extends the CRD IV regime to (non-CRR) investment firms not covered by the CRD IV package.66 [3.26] Within this framework, Article 88 CRD IV lays down specific requirements both for the division of responsibilities and for the organization of the board. In principle, although both the CRD IV and MiFID II seek to establish a neutral system for adaption across different systems of corporate governance,67 this framework is tailored primarily to one-tier board models, where board management and supervisory functions are exercised from within a single board of directors (as distinct from— German-style—two-tier board systems, which separate management and supervisory boards). Both Directives leave it to the Member States to make the necessary adjustments for two-tier boards.68 Nonetheless, the prescription whereby the chairman of the management body in its supervisory function must not exercise simultaneously the functions of a chief executive officer within the same institution, unless justified by the institution and authorised by competent authorities,69 clearly addresses two-tier board systems70 and imposes a separation of functions which, while commonly practised at least within the United Kingdom for some time, has never been established as preferable over a combination of the two functions in one person.71

[3.27] Within the board, firms must establish a risk committee, a nomination committee, and a remuneration committee, if they are ‘significant in terms of their size, internal organization and complexity of their activities’. This, again, follows directly from provisions in the CRD IV,72 of which only Article 88 is expressly referred to in Article 9(1) of the MiFID II.

B. Duties i. The Board as a Whole [3.28] The duties of the management body in general and its committees—in a rather complex and partly duplicative way —are set forth in both the CRD IV and MiFID II, as well as in the provisions of Chapter II of the Commission Delegated Regulation of 25 April 2016.73In line with the concept of functional neutrality with regard to different legal structures in the national laws on corporations and partnerships,74 neither the CRD IV nor MiFID II lays down a positive definition of the board’s duties, which are determined exclusively by autonomous legislation in the Member States. This is clearly reflected in the identical definition of the term ‘management board’ in both Directives, which expressly refers to those strategic, oversight, and management duties that are determined by the applicable national laws.75 While accepting the general duties of management (and supervisory) boards as prescribed by national legislation in principle, both the CRD IV and the MiFID II lay down additional specifications with regard to, in particular, organizational duties, however. For regulated entities, the organizational duties of management (and supervisory) boards form a two-tier system, with the first level consisting of general principles under the applicable national law of business associations (companies or partnerships, as the case may be), which are then complemented and, in part, superseded by specific organizational duties prescribed by European financial regulation. It is worth noting that the requirements addressed directly to the management body in both CRD IV and MiFID II are, to a large extent, of a procedural rather than a substantive nature; they specify the responsibility of the board for the definition of strategies and procedures and for the implementation of relevant standards, rather than defining the relevant standards themselves (which are specified in other provisions and in additional Level 2 legislation76). [3.29] Generally, pursuant to the identical formulation in both Article 88(1) CRD IV (referred to in Article 9(1) MiFID II) and Article 9(3) MiFID II, the management body77 is required to define[ ], oversee[ ] and [be] accountable for the implementation of the governance arrangements that ensure effective and prudent management of the [firm], including

the segregation of duties in the [firm] and the prevention of conflicts of interest, to which Article 9(3) MiFID II adds the further specification that the management body must exercise these functions ‘in a manner that promotes the integrity of the market and the interest of clients’.

[3.30] Article 88(1)(2) CRD IV then specifies these functions further and requires the board, in particular, to (a) approve and oversee the firm’s ‘strategic objectives, risk strategy and internal governance’, (b) ensure ‘the integrity of the accounting and financial reporting systems’, (c) oversee ‘the process of disclosure and communications’, and (d) effectively oversee senior management. [3.31] These requirements are then complemented by additional, albeit to some extent duplicative, specifications in Article 9(3) MiFID II, pursuant to which the management board shall define, approve and oversee

(a) the organisation of the firm for the provision of investment services and activities and ancillary services, including the skills, knowledge and expertise required by personnel, the resources, the procedures and the arrangements for the provision of services and activities, taking into account the nature, scale and complexity of its business and all the requirements the firm has to comply with; (b) a policy as to services, activities, products and operations offered or provided, in accordance with the risk tolerance of the firm and the characteristics and needs of the clients of the firm to whom they will be offered or provided, including carrying out appropriate stress testing, where appropriate; (c) a remuneration policy of persons involved in the provision of services to clients aiming to encourage responsible business conduct, fair treatment of clients as well as avoiding conflict of interest in the relationships with clients. [3.32] Moreover, the management board is required

to monitor and periodically assess the adequacy and the implementation of the firm’s strategic objectives in the provision of investment services and activities and ancillary services, the effectiveness of the investment firm’s governance arrangements and the adequacy of the policies relating to the provision of services to clients and take appropriate steps to address any deficiencies.78

[3.33] Both Article 88 of the CRD IV and, to an even larger extent, Article 9 MiFID II thus formulate a rather comprehensive catalogue of standards for the board’s responsibilities with regard to organizational and compliance aspects. In principle, the set of functions thus defined does not significantly deviate from the allocation of powers and responsibilities under general company or partnership law (whereby the relevant functions will usually be allocated to the board, even if, in many cases, the applicable law will be much less detailed than its regulatory counterpart79). However, the far more explicit definitions of responsibilities in regulatory law, a breach of which may ultimately trigger the revocation of the licence,80 evidently not only seek to enhance legal certainty, but also to facilitate effective supervisory control of the different aspects. This is reflected in the specific sanction provided for breaches of the requirements set forth in Article 91 CRD IV, which may trigger administrative penalties of up to €5 million or double the loss that has been incurred as a consequence of the breach, with the sanction, as a rule, to be made public.81 When assessing compliance, authorities will apply a specific standard of care that has been defined in Article 91(8) CRD IV, within the context of requirements on the suitability of board members.82 [3.34] All in all, the reformed set of specific board duties primarily reflects prudential concerns about the soundness of risk profiles and operational arrangements of institutions (i.e., credit institutions and investment firms) and, as such, systemic stability considerations. This is illustrated, first and foremost, by the fact that the most important part of the relevant duties is set forth in the CRD IV rather than MiFID II—without any differentiation whatsoever between the business models characteristic for credit institutions and those of non-bank investment firms. Even the additional requirement to a similar effect imposed by Article 9(3) MiFID II evidently focuses on the definition of standards aiming at the soundness of operational arrangements and risk sensitivity rather than on such aspects

that may directly benefit the position of investors, with the limited exception of Article 9(3)(c) MiFID II (quoted above, paragraph 3.31). As indicated above, this is not inconsistent with lessons learnt from the global financial crisis, which clearly reinforced the notion that systemic risk is not confined to commercial banking but attributable to other factors (size, interconnectedness, complexity of business organizations).83 Against this backdrop, it may be considered helpful that the new regulatory framework, by specifying the board’s responsibility for organizational and strategic decisions and risk management in most comprehensive terms, clarifies the delineation of powers and duties in regulated firms, which could potentially lead to increased awareness among board members as to the specific challenges and needs associated with their respective supervisory and management functions. ii. Board Committees [3.35] Just as with credit institutions, investment firms, pursuant to Article 88(2) CRD IV (in conjunction with Article 9(1) MiFID II, where applicable), are subject to detailed requirements with regard to the formation and tasks of the nomination committee. The committee is not only responsible for the selection of candidates for management body positions and the evaluation of the knowledge, skills, and experience, as well as periodical assessments and reviews of the policy for the selection and appointment of senior management, but also for the promotion of gender equality.84 Remuneration committees are responsible for ‘the preparation of decisions regarding remuneration, including those which have implications for the risk profile and risk management of the institution concerned’.85 Risk committees are to advise the management body with regard to the ‘risk appetite and strategy’, and to assist with the implementation of the strategy. The risk assessment also has to review the impact of prices of liabilities and assets on the firm’s business model and risk strategy, and to propose remedies if deficiencies are detected.86 By contrast, no specific requirements are set forth in either the CRD IV or MiFID II with regard to the duties of audit committees, which credit institutions and investment firms are required to establish under Article 41 of Directive 2006/43/EC.87

C. Personal Requirements [3.36] Reflecting widespread concerns about the quality of management and supervision in the boards of financial institutions before and during the global financial crisis,88 enhanced requirements for the eligibility for board membership and for board diversity have become a central aspect of the reformed regulatory framework for both credit institutions and securities. Just as in the area of board duties, discussed above, the relevant requirements are laid down partly in the CRD IV (for credit institutions and investment firms alike), with—again, to some extent duplicative—additions stipulated by MiFID II. [3.37] Generally, all board members, executive and non-executive, are subjected to a rigorous fit-and-proper test. Pursuant to Article 91(1) and, in identical wording, to Article 9(4), they are required at all times ‘[to] be of sufficiently good repute and possess sufficient knowledge, skills and experience to perform their duties’ and to commit sufficient time to perform their functions.89 [3.38] Moreover, pursuant to a requirement that links personal qualifications with a standard of care for the execution of the board duties, each member of the management body is required to act with honesty, integrity and independence of mind to effectively assess and challenge the decisions of the senior management where necessary and to effectively oversee and monitor decision-making.90

[3.39] In addition to the individual requirements, the board as a whole is required to have ‘adequate collective knowledge, skills and experience to be able to understand the [firm’s] activities, including the main risks’.91 In order to maintain the standard, regulated firms are required to ‘devote adequate human and financial resources to the induction and training of members of the management body’.92 Particular attention has been given to ensuring board diversity, which is reflected not only in the requirement to engage a broad set of qualities and competences when recruiting members to the management body and for that purpose to put in place a policy promoting diversity on the management body,93

but also in the definition of tasks of the nomination committee, which must not simply strive for ‘diversity’ in its proposals for vacant management body positions, but is also required to decide on a target for the representation of the underrepresented gender in the management body and prepare a policy on how to increase the number of the underrepresented gender in the management body.94

[3.40] Pursuant to Article 91(12) CRD IV, the relevant criteria are to be complemented by EBA guidelines in due course.95 [3.41] With these requirements, the new regime clearly goes far beyond the design and content of traditional ‘fit-and-proper’ tests in the area of financial regulation, which usually set a rather broadly defined set of benchmarks against which supervisory authorities would have assessed the qualifications and character of persons nominated for board positions.96 To be sure, these earlier requirements already facilitated a significant degree of supervisory control over board decisions, if and to the extent that the relevant authority, under the applicable national law transposing the European requirements, was willing to use board members’ readiness to comply even with informal supervisory guidance as indicative for the purposes of the ‘fit and proper’ test.97 [3.42] Under the reformed regime, by contrast, the traditional, flexible approach, which left further specification to the discretion of national legislators and authorities, has been complemented with a considerable range of new procedural and substantive elements. Among these, requirements that the personal qualification of board members be commensurate with the cognitive and strategic problems to be expected in the performance of their respective functions can surely be said to be rather uncontroversial, although it remains to be seen whether the more prescriptive approach really yields a more effective enforcement of qualitative standards by relevant authorities. In particular, it remains open to doubt whether the (still rather abstract) standard of ‘honesty, integrity and independence of mind’ can be operationalized in a way that substantively adds to the effectiveness of authorities’ scrutiny of board composition.98

[3.43] More controversial, however, has been the policy decision to promote gender diversity as a means to foster good corporate governance in financial institutions. The underlying rationale is to prevent ‘groupthink’, which, according to a widely held view of the global financial crisis, can supposedly be traced back not least to a greater risk appetite of male management than could be expected to be found among a gender-diverse board.99 As empirical analysis of what has become known as the ‘Lehman Sisters Hypothesis’ (insinuating that, with a female board of directors, excessive risk-taking and the ensuing crisis would not have happened) appears to be inconclusive,100 the effectiveness of mandatory board diversity as a precaution against excessive risk-taking practices can, at best, be described as doubtful. It is to be expected that regulated firms, in redefining their diversity policies, will attend to the relevant supervisory authority’s expectations rather than to what they themselves would perceive to be an optimal balance.101 [3.44] At any rate, just as has been diagnosed for the highly prescriptive set of board duties above,102 the focus of the reformed personal requirements applicable to board members under the new CRD IV/MiFID II regime clearly reflects systemic stability rather than investor protection considerations. Also in this context, credit institutions and non-bank investment firms are indiscriminately subjected to a regime which seeks to improve the quality of corporate governance in the interest of the individual firm’s soundness of operations and, ultimately, the prevention of contagious effects that would arise from their financial failure. To be sure, clients that have an ongoing relationship with the firm (e.g. in the context of assetmanagement contracts) could benefit as well, but rather indirectly.

D. Remuneration of Board Members and Senior Management [3.45] Among the different policy initiatives to foster effective corporate governance in financial institutions in recent years, prescriptive requirements for remuneration (or ‘compensation’) arrangements have clearly played a major, albeit somewhat independent, role. This is

particularly visible in the EU Commission’s 2010 Green Paper, which discusses remuneration policies as a distinct part of the regulatory agenda on issues related to the corporate governance of financial institutions.103 At the international level, sound remuneration standards, designed to remove incentives to engage in excessive risk-taking, have been promoted as a priority within the post-crisis reform agenda of the Financial Stability Board,104 whose recommendations have been influential not just for the design of relevant provisions at the European level, but also—prior to EUwide harmonization—within individual Member States.105 Under the European framework harmonized by the CRD IV, investment firms are subject to the regime applicable also to credit institutions, to which MiFID II adds the requirement that the management board has to develop a specific ‘remuneration policy’ for persons involved in the provision of services to clients,106 while more detailed requirements for the development of remuneration policies and practices, including on the protection of client interests in this context, are prescribed in Article 27 of the Delegated Council Regulation of 25 April 2016.107 Leaving this aside, investment firms have to comply with the general qualitative principles governing the remuneration policies for senior management, so-called risk-takers, staff in control functions, and any employee whose remuneration is equivalent to that of senior management and risk-takers and persons whose decisions have a material impact on the firm’s risk profile stipulated in Article 92(1) CRD IV. Specifically, Article 94 delineates the extent to which variable elements may be included. As mentioned before, remuneration committees must be established within ‘significant’ firms108 as an institutional means to ensure sound remuneration policies. [3.46] The substance of these requirements, as well as the underlying rationale, has been discussed extensively elsewhere.109 This and the fact that investment firms, to the extent that they are included in the scope of application of the CRD IV,110 are subjected to the same regime as credit institutions hardly necessitates in-depth treatment of the remuneration regime within the present chapter. It should be noted, however, that the extension of the relevant requirements to investment firms does not reflect a careful analysis of the similarities and the differences existing between remuneration practices in credit institutions and investment firms,

respectively—and of their implications for risk-taking and, ultimately, systemic risk. In this regard, the same applies as to other parts of the regulatory framework for investment firms, which also extend the regulatory regime for banks without a sound empirical basis. While it may be possible to address such differences under the proportionality test prescribed by Article 92(1) CRD IV, the policy foundations for the equal treatment still appear to be rather weak.

3. Organization and Risk Management A. General Requirements Laid Down in the CRD IV Regime [3.47] To be sure, the governance-related provisions for investment firms, as laid down in MiFID II, follow a more autonomous approach with regard to organizational duties and risk management than with regard to the regulation of the board and its duties (infra III.3.B). Nonetheless, the CRD IV regime also lays down a general basis applicable without discrimination to banks and non-bank investment firms in this respect. The substantive requirements on risk management in Articles 74–87 CRD IV clearly form the core of the Directive’s provisions on internal governance arrangements and clearly aim at enhancing the soundness of its business as a whole.111 This becomes obvious from the very first provision on governance arrangements, which builds on the wording of Article 22 of the recast Banking Directive of 2006 and requires that [i]nstitutions shall have robust governance arrangements, which include a clear organisational structure with well-defined, transparent and consistent lines of responsibility, effective processes to identify, manage, monitor and report the risks they are or might be exposed to, adequate internal control mechanisms, including sound administration and accounting procedures, and remuneration policies and practices that are consistent with and promote sound and effective risk management.112

[3.48] While the relevant arrangements, processes, and mechanisms are to be specified further by EBA Guidelines,113 the following provisions of the CRD IV themselves continue to lay down a rather tight framework of

procedural and substantive requirements for the different aspects of risk governance. As mentioned before, this includes the need to establish a risk committee with both advisory and assistant functions in the formulation and implementation of risk strategies.114 In addition, ‘significant’ credit institutions and investment firms covered by the CRD IV are required to establish a ‘risk management function’ with independent resources and access to the management body.115 But these requirements are ‘without prejudice to the application of Directive 2006/73/EC to investment firms’, which in Article 7(2) already prescribes the creation of an independent risk management function and thus prevails over the CRD IV. The management body itself is expressly required to approve[ ] and periodically review[ ] the strategies and policies for taking up, managing, monitoring and mitigating the risks the institution is or might be exposed to, including those posed by the macroeconomic environment in which it operates in relation to the status of the business cycle,116

and has to ‘devote[ ] sufficient time to consideration of risk issues’.117 These core provisions are then complemented with detailed technical requirements in Articles 77–84. [3.49] In general, the approach to risk management taken by the CRD IV can best be described as a multi-tier concept, which seeks to incentivize the firms (or, more specifically, management boards) to actively define, control, and improve the culture of their respective firms, the substantive standard for which is defined in rather abstract terms (‘robust’ arrangements; ‘clear’ structure; ‘well-defined, transparent, and consistent’ lines of responsibility, etc.). While this is clearly reflective of a principles-based approach to governance regulation, the Directive is much more specific with regard to organizational features designed to bolster the firms’ own efforts. In particular, the specialist risk-management function that has to be established under the new regime has rightly been explained by the desire to create an institutionalized ‘antidote to overcome certain risk management flaws observed in the banks and financial institutions that suffered in the global financial crisis’,118 and other features designed to increase the board’s sensitivity vis-à-vis the risk culture fit into the picture too.119 In particular, the new approach evidently seeks to allocate specific responsibilities and to

formulate qualitative standards for the risk-management organization and the resources (financial and human) dedicated to it, in order to activate the boards that are perceived to have been too passive and complacent before the crisis.120 Whether or not this concept is enough to overcome residual deficiencies remains to be seen, however. It could well be the case that firms’ future behaviour may be driven more by the need to demonstrate compliance with the regulator’s expectations rather than a genuine effort to improve the quality of existing arrangements. In this context, it is worth noting that proceduralist, principles-based approaches of corporate and financial behaviour have repeatedly been criticized on account of their structural tendency to foster ‘compliant non-compliance’121—to provoke formalistic efforts to ‘tick the boxes’ in generic to-do lists rather than encourage the regulatees’ creativity with a view to accomplishing the regulatory objectives through instruments that match the needs of the individual case.122 At any rate, specific models for the design of riskmanagement arrangements, which could be referred to as ‘best practice’ by both authorities and regulated institutions, have evolved rather slowly, and widely advocated standards are still far from universally accepted.123

B. Specific Organizational Requirements under MiFID II [3.50] Although the CRD IV regime on risk management is highly prescriptive and rather detailed, the corresponding requirements stipulated by MiFID II go still further. The relevant provisions are to be found in Articles 16 and 17 MiFID II, of which the former lays down general requirements applicable for all investment firms, while the latter (not to be examined in detail hereafter) specifically addresses risk-management issues in firms engaging in algorithmic trading. As noted before, this regime is supplemented by implementing Level 2 legislation promulgated by the Commission pursuant to Article 16(12) MiFID II, which has adopted a rather abstract approach and does not provide very detailed specification, however.124 Thus, the regulatory framework for organizational duties for investment firms—which takes up the coexistence of general requirements applicable to both credit institutions and non-bank investment firms under

the predecessors of the present regime125—will continue to reflect a complex interplay of different sources of law. Conceptually, the new regime will become even more complex to implement than its predecessors because of the fact that, unlike under MiFID I, implementing legislation now takes the form of a Council Regulation rather than a Directive. Investment firms regulated under both CRD IV and MiFID II will thus simultaneously be subject to risk-management requirements under the national laws transposing the CRD IV and MiFID II (and Directive 2006/73/EC) and the Council Regulation Implementing MiFID II. This requires, at the very least, a careful design of national regimes with a view to minimizing the potential for interferences, but will still prove problematic in cases where the provisions of CRD IV and MiFID II overlap. [3.51] In substantive terms, part of the relevant provisions reflect, again, prudential concerns aiming at enhancing the stability and soundness of the individual firms, while others focus on improving the legal and commercial position of investors and other clients. With respect to the former, MiFID II requires investment firms to take reasonable steps to ensure continuity and regularity in the performance of investment services and activities. To that end the investment firm shall employ appropriate and proportionate systems, resources and procedures.126

[3.52] Moreover, in what is in part a (redundant) repetition of the general CRD IV requirements examined above, investment firms must have sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment, and effective control and safeguard arrangements for information processing systems

as well as […] sound security mechanisms in place to guarantee the security and authentication of the means of transfer of information, minimise the risk of data corruption and unauthorised access and to prevent information leakage maintaining the confidentiality of the data at all times.127

[3.53] To be sure, the latter requirement aims not exclusively at the soundness of the relevant firm as such, but also at the protection of the commercial relationships with investors and other clients. The same applies to the duty to establish a compliance organization within the firm, which must include adequate policies and procedures sufficient to ensure compliance of the firm including its managers, employees and tied agents with its obligations under this Directive as well as appropriate rules governing personal transactions by such persons.128

In this context, Article 22 of the Commission Delegated Regulation of 25 April 1016129 provides a considerable degree of further specification, including on the responsibilities and duties of the compliance function (Article 22(2)) and the requirements that must be satisfied in terms of organizational design (Article 22(3)). Generally, firms must ensure that the management board has access to all relevant information.130 [3.54] Exclusively in the interest of investors, the Directive prescribes a detailed set of procedural requirements which build on Article 21 MiFID I but are considerably more detailed and prescriptive. These include institutional arrangements designed to prevent conflicts of interest,131 product approval processes for the ‘manufacturing’ (!) of financial products for sale to clients,132 and obligations to review the financial instruments offered or marketed by the firm.133 They supplement, but are without prejudice to, the general requirements of MiFIR relating to disclosure, suitability or appropriateness, identification, and management of conflicts of interests and inducements.134 Additional requirements are made with regard to record keeping and documentation135 and to the preservation of ownership and other rights of clients.136 [3.55] While the underlying policy rationale of the organizational provisions stipulated by MiFID II thus differs in part from those set out in the CRD IV, with investor protection coming into play as a second determinant in addition to systemic stability concerns, the regulatory strategy employed is essentially the same in both instruments.137 Just like in the CRD IV, we find a combination of substantive standards in the form of a multitude of rather vague criteria (‘reasonable’ steps, ‘sound’ mechanisms

and processes, ‘effective’ procedures, ‘adequate’ policies, etc.), which leave a considerable discretion to supervisory authorities, with procedural requirements that expressly allocate responsibilities and require the implementation of specific organizational arrangements, such as the creation of a compliance function. Just like the CRD IV in this respect, the MiFID II organizational framework can thus be said to reflect the expectation that the management board’s sense of responsibility can be activated in a way that ultimately may yield improvements in the corporate culture—the attitude of directors and senior and junior management with regard to risk-taking and qualitative standards in the provision of investment services to clients. Just as with the CRD IV regime, however, doubts as to the efficacy of proceduralist approaches may also be warranted in this context.

4. Shareholders and Owners with Qualifying Holdings [3.56] With regard to the supervisory scrutiny of shareholders and owners of qualifying holdings, the new regulatory framework takes up the previous regime established by Articles 9 and 10 MiFID I. The new framework adopts a far more complex approach, however, underlining the relevance of shareholder control as a means to promote sound business practices and good corporate governance. Significantly, the new provisions are broadly in line with the corresponding requirements under Articles 14 and 22–27 of the CRD IV (on the disclosure and supervisory assessment of shareholders and owners prior to authorization and in connection with a proposed acquisition at a later stage, respectively). Both regimes cover ‘the shareholders or members, whether direct or indirect, natural or legal persons, that have qualifying holdings’,138 defined as a direct or indirect holding in an investment firm which represents 10% or more of the capital or of the voting rights, as set out in Articles 9 and 10 of Directive 2004/109/EC […], taking into account the conditions regarding aggregation thereof laid down in Article 12(4) and (5) of that Directive, or which makes it possible to exercise a significant influence over the management of the investment firm in which that holding subsists.139

[3.57] As a condition for authorization, the competent authorities must be ‘satisfied as to the suitability’ of the holders of such positions, ‘taking into account the need to ensure the sound and prudent management of an investment firm’.140 With regard to the acquisition of positions in an already authorized firm, these requirements are supplemented with specific qualitative criteria including, inter alia, the reputation of the proposed acquirer, the reputation and experience of persons who will direct the business as a result of the acquisition, the financial soundness of the acquirer, and the likely impact of the acquisition on future compliance with regulatory requirements.141 Articles 12 and 13 MiFID II lay down the procedural framework for the assessment process in this context, which is clearly modelled on the corresponding provisions of Articles 22–24 CRD IV.

5. Governance Reporting [3.58] Again, just as with credit institutions, investment firms covered by the CRD IV/CRR framework are subject to the governance reporting requirements stipulated by Articles 435 and 450 CRR, which provide for the disclosure on the risk-management function and certain aspects of board organization, as well as remuneration policies, respectively.142 While details remain outside the scope of this chapter, it should be noted that the general approach to using external disclosure as a means to foster compliance with prudential standards is thereby also extended to the governance-related regulation of investment firms.

6. Assessment A. Systemic Stability Concerns versus Investor Protection: A Reappraisal of Policy Rationales [3.59] As has been discussed above, the policy rationale for governancerelated provisions in the CRD IV/MiFID II regime remains somewhat obscure, in particular if measured by the formulations of the respective Preambles. For the first time, specific systemic stability considerations

explicitly have made their way into the policy foundations of the organizational framework set out in MiFID II, reflecting a departure from the earlier approach which was informed mainly by the motive to realign the regulatory frameworks for non-bank investment firms with those applicable to universal banks, and, in addition, to introduce some specific requirements addressing the principal–agent conflicts characteristic for the provision of investment services.143 Although the new regime still falls short of providing a fully consistent and convincing regulatory answer to the functional parallels and differences of universal banks and non-bank investment firms regarding the two fundamental objectives of securities regulation—market stability and investor confidence—it should be noted that the functional relationship between systemic stability considerations on one hand and investor protection on the other has become more balanced, and the policy mix pursued with regard to the regulation of investment firms is more convincing than under the predecessors. Both Directives jointly seek to address a list of shortcomings in the governance arrangements of financial intermediaries that have come to be perceived as drivers for the excessive risk-taking and insufficient control of risks that ultimately triggered the global financial crisis. Rightly, unlike under the ISD 1993 and MiFID I, the inclusion of investment firms into the governance-related regulatory framework for credit institutions is no longer justified merely on the grounds of equal market access (a concept that had been rather unconvincing from the start), but reflects genuine considerations of the risks pertaining to the legal and economic nature of the commercial relationships between (non-bank) investment firms and their clients and other counterparties. In many ways, the shift in policy rationales is also reflected in the substantive and procedural technical framework established by both Directives, as both the technical requirements aiming at enhancing the soundness of strategies and operations and those aiming at improving investor protection have become more refined, compared to the earlier concept. [3.60] In sum, the CRD IV/MiFID II framework, at a very abstract level, should therefore be regarded as an improvement of the status quo ante. It should be noted, however, that this positive assessment is confined to the policy foundations as such; that is, to the concept of addressing systemic risk wherever it occurs and, therefore, irrespective of the commercial nature

of the relevant entity (‘credit institution’ or ‘investment firm’). To be sure, as noted before, this approach reflects a broader, international approach to dealing with systemic relevance of financial institutions generally, which effectively removes the traditional sector-specific boundaries in financial regulation in response to lessons learnt during the global financial crisis.144 Whether the rather indiscriminate treatment of both types of institutions within the scope of the CRD IV is actually justified is a different story, however. In this regard, it should be noted that the empirical basis for the assessment of systemic risk associated with the specific activities undertaken by investment firms continues to be extremely weak. On closer inspection, the decision to include a wide range of diverse firms, which engage in an equally diverse range of activities, within the scope of a legal framework whose main focus still remains on the activities of commercial banks may well turn out to be too simplistic to actually satisfy the test of proportionality. In this context, it should be noted that the categorization of investment firms laid down in MiFID II and the CRD IV is far from uncontroversial even within the European regulatory landscape. It is particularly telling that the European Banking Authority, in a recent report, strongly promotes the introduction of a new approach, which would be more sensitive to the implications of the firms’ activities not just in terms of their individual soundness, but also in terms of systemic stability.145 [3.61] Irrespective of these general considerations, it is far from clear whether the technical design draws the right conclusions; that is, whether the new framework addresses real deficiencies with adequate, effective remedies. While the need for enhanced systemic stability and investor protection can hardly be disputed as such, the first doubts arise just below this rather high-level set of objectives. As noted before, it is not just the empirical evidence of weaknesses in governance arrangements prior to the global crisis that is rather thin, but also the available body of ‘best practice’ that could be referred to by both supervisors and regulated firms in the course of implementing the new regime. In this respect, while it is true that the CRD IV/MiFID II reflects a sound definition of fundamental policy objectives, the question of whether the same could also be said of the corresponding mix of policies and strategies remains open.

B. Principles-Based Regulation versus Ever Tighter Rules: Some Observations on Regulatory Strategy [3.62] As noted previously in respect of organizational requirements,146 the preference for a combination of a large amount of vaguely defined principles (compliance with which will be monitored by authorities enjoying a rather high level of discretion) with highly prescriptive procedural requirements has become characteristic for both the CRD IV and the MiFID II. This could well turn out to be a major problem for the effective implementation in future practice. If anything, this approach is likely to reduce the flexibility associated with a genuine principles-based strategy, where the supervisor is free to act on the basis of a few, broad principles rather than the present array of detailed qualitative standards. Effective implementation will succeed only if the regulated firms and their supervisors manage to interpret, and apply, the new framework in ways flexible enough to cater for the needs arising out of individual business models and the legal and organizational structures of firms. This in turn will happen only if supervisors abstain from one-size-fits-all approaches that would streamline existing arrangements without any positive yield in terms of either systemic resilience or improved investor protection.147 In this context, it should not go unnoticed that the complex set of vague definitions is likely to give rise to substantial legal uncertainty on the part of regulated firms. This in turn could incentivize board members to strive for uncontroversial, if formalistic, compliance with the supervisor’s expectations rather than creative, albeit perhaps controversial, independent solutions which might be preferable not just for the firm itself but also for systemic stability.148

C. Technical Inconsistencies with Company and Partnership Law [3.63] These concerns are aggravated by the technical inconsistencies between the governance framework laid down by both the CRD IV and MiFID II on one hand and the real-life variety of different legal and organizational structures in investment firms on the other hand, which in turn reflect differences in the underlying national company and partnership

laws. Such inconsistencies are resolvable, although perhaps not in the most efficient way; the Directives clearly restrict the scope for organizational choices of firms. For example, as investment firms must introduce a separation of the functions of chairman of the board and chief executive officer,149 it is clear that a combination of functions is not permissible from the regulatory perspective, even where general company or partnership law would allow it and although the rationale may well be debatable.150 Technical inconsistencies between the regulatory framework and the applicable national regimes for the formation of business enterprises are more difficult to resolve in cases where the Directives’ approach is too inflexible to take account of the mandatory restrictions of national law. As pointed out by Peter O. Mülbert and Alexander Wilhelm in a careful analysis of the applicable CRD IV provisions, this is particularly the case with regard to the Directive’s organizational duties for the management board, which cannot easily be adapted to the legal environment of two-tier boards or corporate forms without any mandatory supervisory functions.151

D. Impediments to Effective Enforcement: The Public– Private Dichotomy [3.64] From a company law perspective, the new regulatory framework for the governance of investment firms can be characterized as a complex supplement to the existing company (or partnership) law provisions relating to the formation of business enterprises, board duties, and, in particular, organizational requirements that have hitherto been defined exclusively by the applicable laws of the country of registration. As discussed above, these provisions do not necessarily conflict with the regulated firms’ best interests. Viable risk-management systems, for example, are surely desirable not just for financial intermediaries and, indeed, will be required by some national company laws.152 In certain cases, regulatory requirements may nonetheless conflict with the commercial interests of a regulated firm.153 At any rate, the management board may, rightly or wrongly, find a particular organizational measure required by the supervisory authorities to be undesirable commercially, for example because the costs of implementation are high while the possible benefits

appear to be rather abstract. In any such cases, the management board will find themselves in a conflict of interest between the need to comply with supervisory requirements on one hand and the duty to best serve the company’s commercial interests on the other. If that is the case, the effective enforcement of regulatory requirements may be compromised by the interference with private-law duties of directors under the applicable company law. At the very least, private enforcement of regulatory standards is unlikely to happen in such circumstances, which could well weaken the de facto influence of regulatory standards.154

IV. Conclusions [3.65] Compared with credit institutions, investment firms under the reformed framework laid down in the CRD IV and MiFID II have been subjected to an even more complex set of corporate governance requirements, which extend not just to the composition and organization of the board of directors and risk management, but also to remuneration issues and the supervisory scrutiny of qualified holdings. The underlying rationale to address systemic risk wherever it occurs—irrespective of the character of an intermediary’s business—is certainly sound as such, and MiFID II clearly constitutes a step forward in terms of consistency of the underlying policy objectives. However, as argued in the present chapter, the equal treatment of banks and investment firms in the area of corporate governance requirements should clearly be justifiable on the grounds of systemic risk considerations and, in this regard, the empirical evidence supporting the convergence of regulatory approaches in the fields of banking and securities regulation remains weak. The notion that all investment firms covered by MiFID II, irrespective of size and business models, should be required to comply with rules designed to address governance failures in large, systemically important firms is open to doubt. At the very least, this calls for a careful handling of the proportionality tests required to be applied under both the CRD IV and MiFID II, while calls for a recategorization of the scope of application, so as to enhance sensitivity to potential systemic implications of firm failures, should be taken up in the medium and long run. Moreover, this chapter has identified a number of general concerns as

to the effectiveness of the new framework, which are not only confined to the regulation of investment firms. Whether or not the new set of requirements will succeed in promoting sound corporate governance of financial intermediaries remains to be seen. This chapter argues that there are reasons to remain sceptical.

* The author would like to thank Guido Ferrarini and Victor de Seriere, as well as other participants in the International MiFID II Working Group conference in Amsterdam, for insightful comments. The usual disclaimer applies. 1 See, for a similar approach, e.g., Klaus J. Hopt, ‘Corporate Governance of Banks and Other Financial Institutions After the Financial Crisis’, (2013) Journal of Corporate Law Studies 13, 219, 222; Klaus J. Hopt, ‘Corporate Governance of Banks after the Financial Crisis’ in Eddy Wymeersch, Klaus J. Hopt, and Guido Ferrarini (eds) Financial Regulation and Supervision—A Post-Crisis Analysis (Oxford: OUP, 2012), para. 11.01. 2 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 L 145 p. 1 (hereafter: ‘MiFID I’). 3 Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field, OJ L 141 p. 7 (hereafter: ‘ISD 1993’). 4 See, in particular, ISD 1993, Article 3(3)(1), second indent (directors of investment firms to be ‘of sufficiently good repute and … sufficiently experienced’) and 3(3)(2) (at least two responsible directors required), Article 3(4) (organizational structure to be submitted to supervisory scrutiny before authorization), Article 4 (identity of owners and qualifying holdings to be disclosed and their ‘suitability’ to be assessed prior to authorization), Article 9 (notification procedure for the acquisition of qualifying holdings), and Article 10 (specific governance requirements, including ‘sound administrative and accounting procedures, control and safeguard arrangements for electronic data processing, and adequate internal control mechanisms’). 5 See infra II.2.B. 6 Commission Delegated Regulation (EU) no. …of 25 April 2016 on Directive 2014/65/EU of the European Parliament and of the Council as regards organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive. As of end October 2016, the document has not yet been published in the Official and has not entered into force. The version adopted by the Commission is document no. C (2016)2398 final. 8 MiFID II, Preamble, Recital 5. 7 MiFID II, Preamble, Recital 4.

9

See generally, e.g., Rüdiger Veil, ‘Concept and Aims of Capital Markets Regulation’ in Rüdiger Veil (ed.) European Capital Markets Law (Oxford: Hart Publishing, 2013), pp. 18–19. 10 Commission, Green Paper on Corporate Governance in Financial Institutions, COM(2010) 284 final. See also Niamh Moloney, EU Securities and Financial Markets Regulation, 3rd edn (New York: OUP, 2014), 357–8. 11 See further infra II.2. 12 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, OJ L 176, 27.6.2013, p. 338. For an in-depth analysis of that regime, see Peter O. Mülbert and Alexander Wilhelm, ‘CRD IV Framework for Banks’ Corporate Governance’ in Danny Busch and Guido Ferrarini (eds) European Banking Regulation (Oxford: OUP, 2015), Chapter 6. 13 Cf., for useful analyses of the Lehman collapse and its systemic implications, e.g., Michael Fleming and A. Sarkar, ‘The Failure Resolution of Lehman Brothers’ (2014) Special Issue: Large and Complex Banks, FRBNY Econ. Pol’y Rev. 20, 175; Stephen J. Lubben and Sarah Pei Woo, ‘Reconceptualizing Lehman’ (2014) Texas International Law Journal 49, 297; Rainer Kulms, ‘Lehman’s Spill-over Effects’ (2012) Peking University Journal of Legal Studies 3, 3. And see, from a policy perspective, Basel Committee on Banking Regulation, ‘Report and Recommendations of the Cross-border Bank Resolution Group’ (March 2010), available at http://www.bis.org/publ/bcbs169.pdf, paras 49 and 50; Centre for Economic Policy Research, A Safer World Financial System: Improving the Resolution of Systemic Institutions, Geneva Reports on the World Economy No. 12 (London: CEPR, 2012) (available online at ), pp. 42–6. 14 E.g., Marco Becht, Patrick Bolton, and Ailsa Röell, ‘Why Bank Governance is Different’ (2011) Oxford Review of Economic Policy 3, 437, 455.; Klaus J. Hopt, ‘Corporate Governance of Banks after the Financial Crisis’ in Wymeersch, Hopt, and Ferrarini (eds) (n. 2), paras 11.16 et seq., 11.45 et seq.; see also René M. Stulz, ‘Governance, Risk Management, and Risk-Taking in Banks’ (2014), available at http://ssrn.com/abstract=2457947. 15 Cf., e.g., Becht, Bolton, and Röell (n. 15), 437 (discussing both board incompetence and deficient risk management); on the relationship between shareholder-friendly governance structures and risk appetite of intermediaries, see (with mixed results) Deniz Anginer et al., ‘Corporate Governance and Bank Insolvency Risk. International Evidence’ (2014), available at http://ssrn.com/abstract=2491490; Andrea Beltratti and René M. Stulz, ‘Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation’ (2012) Journal of Financial Economics 105, 1; David H. Erkens, Mingyi Hung, and Pedro P. Matos, ‘Corporate Governance in the 2007– 2008 Financial Crisis: Evidence from Financial Institutions Worldwide’ (2012) Journal of

Corporate Finance 18, 389; Luc Laeven and Ross Levine, ‘Bank Governance, Regulation and Risk Taking’ (2009) Journal of Financial Economics 93, 259. For comprehensive reviews of the available literature, see, e.g., James R. Barth, Chen Lin, and Clas Wihlborg (eds) Research Handbook on International Banking and Governance (Oxford: OUP, 2012); Jakob de Haan and Razvan Vlahu, Corporate Governance of Banks: A Survey (Oxford: OUP, 2013), available at . See also, discussing possible implications from a legal perspective, Andreas Kokkinis, ‘A Primer on Corporate Governance in Banks and Financial Institutions: Are Banks Special?’ in Iris Chiu (ed.) The Law on Corporate Governance of Banks (Cheltenham: Edward Elgar, 2015), paras 1.37 et seq.; Klaus J. Hopt, (2013) JCLS 13, 219, 237 ff.; Klaus J. Hopt, in Wymeersch, Hopt, and Ferrarini, (n. 2), paras 11.16–11.22; Peter O. Mülbert, ‘Corporate Governance of Banks’ (2009) European Business Organization Law Review 10, 411, 433– 4; Peter O. Mülbert and Ryan Citlau, ‘The Uncertain Role of Banks’ Corporate Governance in Systemic Risk Regulation’ in Hanne S. Birkmose, Mette Neville, and Karsten E. Sørensen (eds) The European Financial Market in Transition (Aalphen aan den Rijn: Kluwer, 2012), p. 275; Christoph Van der Elst, Corporate Governance and Banks: How Justified is the Match? (Oxford: OUP, 2015), available at . 16 Contrast, e.g., Aslɩ Demirgüç-Kunt and Enrica Detragiache, ‘Basel Core Principles and Bank Soundness’, World Bank Policy Research Working Paper No. 5129 (2009), available at (reaching a rather negative conclusion); with the more positive assessment by Richard Podpiera, ‘Does Compliance with Basel Core Principles Bring Any Measurable Benefits?’, IMF Working Paper WP/04/204 (2004), available at . 17 Starting with the 2009 London summit, G20 Finance Ministers and Governors have called for guidance on the assessment of the systemic importance of financial institutions and special regulatory measures to address relevant risks; see International Monetary Fund, Bank for International Settlements and Financial Stability Board, ‘Report to G20 Finance Ministers and Governors: Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations’, October 2009, available at ; and see further Financial Stability Board, ‘Reducing the moral hazard posed by systemically important financial institutions’, 20 October 2010, available at , and see Financial Stability Board, Press Release: ‘G20 Leaders endorse Financial Stability Board policy framework for addressing systemically important financial institutions’, 12 November 2010, available at For an industry perspective, cf. also Institute of International Finance, ‘Systemic Risk and Systemically Important Firms: An Integrated Approach’ (May 2010), available at , in particular pp. 17–40. 18 See further infra III.6.A.

20

ibid., Preamble, Recital 5. ISD 1993, Preamble, Recitals 2 and 41. 21 ibid., Preamble, Recital 6. 22 ibid., Article 3(3) sentences 1 and 2. 23 As to which, see infra III.2. 24 First Council Directive 77/780/EEC of 12 December 1977 on the coordination of the laws, regulations, and administrative provisions relating to the taking up and pursuit of the business of credit institutions, OJ L 322, 17.12.1977, p. 30, Article 3(2). The origins of this requirement can be traced to earlier precedents in national legislation, e.g., in Germany, see Jens-Hinrich Binder, ‘Organisationspflichten und das FinanzdienstleistungsUnternehmensrecht: Bestandsaufnahme, Probleme, Konsequenzen’ (2015) ZGR— Zeitschrift für Unternehmens- und Gesellschaftsrecht, 667, 677. 25 ISD 1993, Articles 4 and 9. 26 See Second Council Directive 89/646/EEC of 15 December 1989 on the coordination of laws, regulations, and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/780/EEC, OJ L 386, 30.12.1989, p. 1, Articles 5 and 11. 30 ibid., Article 10 sentence 2, first indent. 27 ISD 1993, Article 3(4). 28 ibid., Article 10, sentence 1. 29 ibid., Article 3(7)(e). 31 ibid., Article 10 sentence 2, indents 2–5, respectively. 32 Binder (n. 25), 688. The organizational requirements for banks under the Second Banking Directive of 1989 (Second Council Directive 89/646/EEC of 15 December 1989 on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/780/EEC, OJ L 386, 30.12.1989, p. 1) were confined to the very vaguely defined rule ‘that every credit institution have sound administrative and accounting procedures and adequate internal control mechanisms’ (Article 13(2)). Taking an even narrower perspective, Article 8(1) of the ISD 1993 required that ‘institutions’ internal control mechanisms and administrative and accounting procedures permit the verification of their compliance with [the Directive’s requirements] at all times.’ 33 See, for an excellent overview of the relevant issues, Moloney (n. 11), 320–3. And see further infra III.6.A. 34 As prescribed by Article 11 of the Directive. 35 In the words of a contemporary analysis, see Marc Dassesse, Stuart Isaacs, and Graham Penn, EC Banking Law, 2nd edn (London: Lloyd’s of London Press, 1994), para. 7.2. 36 MiFID I, Preamble, Recital 17, see also Recital 25 (scope of prudential regulation to be confined to ‘those entities which, by virtue of running a trading book on a professional basis, represent a source of counterparty risk to other market participants’). 19

37

For an exposition of the underlying policy considerations, cf. MiFID I, Preamble, Recitals 18–19, 22, and 24. 38 MiFID I, Articles 9 and 10, respectively. 39 Significantly, Article 13(4) MiFID I now required specific precautions in the interest of business ‘continuity and regularity in the performance of investment services and activities’, while Article 13(5) stipulated more detailed provisions for the outsourcing of operational functions. 40 See Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ L 241, 2.9.2006, p. 26 (hereafter: ‘Implementing Directive 2006/73/EC’), Chapters 2 and 3. 41 ibid., Article 5 (specifying the requirements under Article 13(2) to (8) MiFID I). 42 ibid., Article 6 (specifying the requirements under Article 13(2) MiFID I). 43 ibid., Article 7 (specifying the second subparagraph of Article 13(5) MiFID I). 44 ibid., Article 8 (specifying the second subparagraph of Article 13(5) MiFID I). 45 ibid., Article 9 (specifying Article 13(2) MiFID I). 46 ibid., Article 16 (specifying Article 13(7) and (8) MiFID I). 47 ibid., Preamble, Recitals 4 and 7. 48 ibid., Recital 5. 49 Basel Committee on Banking Supervision, ‘International Convergence of Capital Management and Capital Standards—A Revised Framework’ (June 2004). 50 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, OJ L 177, 30.6.2006, p. 1 (the ‘recast Banking Directive’); Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast), OJ L 177, 30.6.2006, p. 201 (the ‘recast Capital Adequacy Directive’). 51 See, e.g., Mülbert and Wilhelm (n. 13), para. 6.05. 52 Directive 2010/76/EU of the European Parliament and of the Council of 24 November 2010 amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitizations, and the supervisory review of remuneration policies, OJ L 329, 14.12.2010, p. 3, Article 1(3). 53 ibid., Preamble, Recitals 7–10 and 17–22. As for the Green Paper, see ibid., Recital 17 and supra text and n. 11. 54 Supra n. 7. 55 See MiFID II, Article 9(1), referring to CRD IV, Articles 88 and 91. 56 MiFID II, Article 9(3)–(6). 57 MiFID II, Articles 10–13. 58 See, again, supra text accompanying n. 9.

59

See, again, MiFID II, Preamble, Recital 5 (quoted supra text accompanying n. 9). See, for further discussion, Mülbert and Wilhelm (n. 13), paras 6.75 and 6.76. 61 See, for further discussion, infra III.6.A. 62 Supra II.A. 63 For a good introduction to the problem and analysis of the CRD IV framework in this respect, see Mülbert and Wilhelm (n. 13), paras 6.38–6.47. 64 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJ L 176, 27.6.2013, p. 1. Article 4(2) CRR extends to persons subject to the 60

requirements imposed by [MiFID I], excluding (a) credit institutions; (b) local firms; (c) firms which are not authorized to provide the ancillary service referred to in point (1) of Section B of Annex I to Directive 2004/39/EC, which provide only one or more of the investment services and activities listed in points 1, 2, 4 and 5 of Section A of Annex I to that Directive, and which are not permitted to hold money or securities belonging to their clients and which for that reason may not at any time place themselves in debt with those clients. Obviously, this definition must now be read as referring to the definition of investment firms as stipulated by Article 4(1)(1) MiFID II, with the exception of firms specified in Article 4(1)(2)(a)–(c) MiFID II; see Mülbert and Wilhelm (n. 13), para. 6.11 notes 23 and 24. 65 Cf. Articles 88, 91 in conjunction with Article 2(1) CRD IV. 66 That is, those firms mentioned in CRR, Article 4(1)(b) and (c): ‘local firms’ and ‘firms which are not authorized to provide the ancillary service referred to in point (1) of Section B of Annex I to Directive 2004/39/EC, which provide only one or more of the investment services and activities listed in points 1, 2, 4 and 5 of Section A of Annex I to that Directive, and which are not permitted to hold money or securities belonging to their clients and which for that reason may not at any time place themselves in debt with those clients’. 69 CRD IV, Article 88(1)(e). 67 Cf. CRD IV, Preamble, Recital 55; replicated in MiFID II, Preamble, Recital 55. Consequently, the definition of a ‘management body’ set out in Article 3(1)(7) CRD IV and, in almost identical wording, Article 4(1)(36) MiFID II follows a functional approach, referring to the ‘body or bodies […] which are appointed in accordance with national law, which are empowered to set the institution’s/entities strategy, objectives and overall direction, and which oversee and monitor management decision-making, and include the persons who effectively direct the business of the institution/entity’. 68 Cf. Article 3(2) CRD IV and Article 4(1)(36) MiFID II, pursuant to which, ‘Where this Directive refers to the management body and, pursuant to national law, the managerial and supervisory functions of the management body are assigned to different bodies or

different members within one body, the Member State shall identify the bodies or members of the management body responsible in accordance with its national law, unless otherwise specified by this Directive’. See, for an in-depth discussion and critique, Mülbert and Wilhelm (n. 13), paras 6.38–6.47. 70 Mülbert and Wilhelm (n. 13), paras 6.38. 71 See, critiquing the underlying policy decision against the available empirical evidence, Luca Enriques and Dirk Zetzsche, ‘Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive’ (2015) Theoretical Enquiries in Law 16, 211, 233–5; similarly Mülbert and Wilhelm (n. 13), para. 6.77 (expressing their preference for a more flexible comply-or-explain approach). 72 CRD IV, Articles 76(3), 88(2), and 95(1). 73 Supra n. 7. 74 See supra n. 69. 75 See, again, CRD IV, Article 3(1)(7) and MiFID II, Article 4(1)(36), quoted supra n. 68. 76 To be discussed in detail infra III.3. 77 At least two persons, cf. CRD IV, Article 13(1) and MiFID II, Article 9(6)—note the exception in the second subparagraph of the latter provision. 78 MiFID II, Article 9(3)(3). 79 Contrast, e.g., the requirements pursuant to Article 88 CRD IV and Article 9 MiFID II with the general exposition of tasks of the management body in Sections 76, 77, 91, and 93 of the German Aktiengesetz (Stock Corporation Act), which are formulated in much more general terms and, with the exception of Section 91(1) (on bookkeeping) and Section 91(2) (on risk-control arrangements) hardly mention any specific responsibilities at all. 80 Cf. MiFID II, Article 8(d). 81 CRD IV, Article 67(2)(f)–(g). 82 As to which, see infra text accompanying n. 90. 83 See supra text accompanying n. 18. 84 See, for details, CRD IV, Article 88(2)(2)(a)–(d). For a discussion of the diversity requirement as such, see infra 3. 85 CRD IV, Article 95(2). 86 CRD IV, Article 76(3). 87 Directive 2006/43/EC of the European Parliament and of the Council of 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC, OJ L 157, 9.6.2006, p. 87. But cf. CRD IV, Article 76(3), pursuant to which non-significant institutions may combine their risk committee and their audit committee in one committee. For further discussion, see Mülbert and Wilhelm (n. 13), para. 6.13. 88 Cf., e.g., Hopt, in Wymeersch, Hopt, and Ferrarini (n. 2), para. 11.18; for empirical assessments, see again supra n. 16. 89 CRD IV, Article 91(2) and MiFID II, Article 9(4).

90

CRD IV, Article 91(8). CRD IV, Article 91(10). 94 CRD IV, Article 88(2)(a). 91 CRD IV, Article 91(7). 92 CRD IV, Article 91(9). 95 Promulgation of which was required by 31 December 2015. As of October 2016, however, the guidelines have yet to be published. 96 Cf., e.g., the much less complex requirements under the ISD 1993, Article 3(3) (quoted supra text accompanying n. 23). 97 Cf., discussing the German practice in banking supervision in this regard, JensHinrich Binder, ‘Vorstandshandeln zwischen öffentlichem und Verbandsinteresse— Pflichten- und Kompetenzkollisionen im Spannungsfeld von Bankaufsichts- und Gesellschaftsrecht’ (2013) ZGR Zeitschrift für Unternehmens- und Gesellschaftsrecht, 760, 774–5. 98 See, expressing similar doubts, also Mülbert and Wilhelm (n. 13), para. 6.67; see also Jaap Winter, ‘The Financial Crisis: Does Good Corporate Governance Matter and How to Achieve It?’ in Wymeersch, Hopt, and Ferrarini (eds) (n. 2), para. 12.28; Enriques and Zetzsche (n. 72), 226. 99 Cf. CRD IV, Preamble, Recital 60, according to which board composition ought to be ‘sufficiently diverse as regards age, gender, geographical provenance and educational and professional background to present a variety of views and experiences’. 100 Contrast, e.g., Irene van Staveren, ‘The Lehman Sisters hypothesis’ (2014) Cambridge Journal of Economics 38, 995 (finding that women in boards tend to perform better than men when deciding under uncertainty), with Renee B. Adams and Vanitha Ragunathan, ‘Lehman Sisters’ (2015), FIRN Research Paper, available at SSRN: (finding that this is not necessarily the case). For an extensive review of the available economic literature without a special focus on the financial sector, see Enriques and Zetzsche (n. 72), 219–25. For a general analysis of ‘groupthink’ as a corporate governance problem, cf. Andrew Howard, ‘Groupthink and Corporate Governance Reform: Changing the Formal and Informal Decision-making Processes of Corporate Boards’ (2011) S. Cal. Interdisc. L. J. 20, 425. 101 Enriques and Zetzsche, ibid., pp. 224–5. 102 Supra paragraph 3.34. 103 Green Paper (n. 11), 17–18. 104 Cf. Financial Stability Board (then Financial Stability Forum), Principles for Sound Compensation Practices (2 April 2009), available at , and FSB, Principles for Sound Compensation Practices— Implementation Standards (25 September 2009), available at . 105 Cf., e.g., discussing the introduction of relevant regulations in Germany, Jens-Hinrich Binder, ‘Steuerung und Kontrolle von Vergütungssystemen durch die BaFin’ in Volker 93

Rieble, Abbo Junker, and Reinhard Giesen (eds) Finanzkriseninduzierte Vergütungsregulierung und arbeitsrechtliche Entgeltsysteme (Munich: ZAAR-Verlag, 2011), p. 63. 106 Cf. MiFID II, Article 9(3)(c), pursuant to which the policy has to aim ‘to encourage responsible business conduct, fair treatment of clients as well as avoiding conflict of interest in the relationships with clients’. 107 Supra, n. 7. 108 Supra n. 73 and accompanying text. 109 See, for introductions to the regime, e.g., Moloney (n. 11), 388–90; Mülbert and Wilhelm (n. 13), at paras 6.16–6.20. And see generally Tom Dijkhuizen, ‘The EU’s Regulatory Approach to Banks’ Executive Pay: From Pay Governance to Pay Design’ (2014) European Company Law 11, 30; Eilís Ferran, ‘New Regulation of Remuneration in the Financial Sector in the EU’ (2012) ECFR 9, 1; Guido Ferrarini and Maria Cristina Ungureanu, ‘An Overview of the Executive Remuneration Issue Across the Crisis’ in Birkmose, Neville, and Sørensen (eds) (n. 16), 349; Guido Ferrarini and Maria Cristina Ungureanu, ‘Lost in Implementation: The Rise and Value of the FSB Principles for Sound Compensation Practices at Financial Institutions’ (May 2011) Revue Trimestrielle de Droit Financier, 1–2, 60; Andrew Johnston, ‘Preventing the Next Financial Crisis? Regulating Bankers’ Pay in Europe’ (2014) Journal of Law and Society 41, 6; for a US perspective, cf. Lucian Bebchuk and Holger Spamann, ‘Regulating Bankers’ Pay’ (2010) Geo. L. J. 98, 247. 110 See, again, supra n. 65 and accompanying text. 112 CRD IV, Article 74(1). 111 See, for a brief comparison with the CRD I–III regimes, Mülbert and Wilhelm (n. 13), para. 6.21. 116 CRD IV, Article 76(1). Note the similarities with the formulation of board duties in Article 88(1), quoted supra text accompanying n. 77. 113 CRD IV, Article 74(2), The present version dates back to the corresponding provision of Article 22 in the recast Banking Directive of 2006 (supra text and n. 51), see EBA, Guidelines on Internal Governance (GL 44) (27 September 2011). 114 CRD IV, Article 76(3) and (4), see supra text accompanying n. 86. 115 See, for details, ibid., Article 76(5); Mülbert and Wilhelm (n. 13), para. 6.23. 117 ibid., Article 76(2). 118 Iris H.-Y. Chiu, Regulating (from) the Inside—The Legal Framework for Internal Control in Banks and Financial Institutions (Oxford: Bloomsbury, 2015), p. 87. 119 See, again, supra III.2.A. 120 For an excellent, in-depth analysis see Chiu (n. 119), 77–118. 121 In the words of John Braithwaite, ‘Rules and Principles: A Theory of Legal Certainty’ (2002) Australian Journal of Legal Philosophy 27, 47, 55–6. 122 See generally, e.g., Jens-Hinrich Binder, Regulierungsinstrumente und Regulierungsstrategien im Kapitalgesellschaftsrecht (Tübingen: Mohr Siebeck, 2012), p.

181; Jens-Hinrich Binder, ‘Prozeduralisierung und Corporate Governance— Innerbetriebliche Entscheidungsvorbereitung und Prozessüberwachung als Gegenstände gesellschaftsrechtlicher Regulierung’, (2007) ZGR Zeitschrift für Unternehmens- und Gesellschaftsrecht 745, 783–7. And see, stressing similar potential weaknesses in the context of governance-related regulation of financial institutions, also Chiu (n. 119), 30–3. For a more optimistic call for a regulatory focus on board processes, cf. also Nicola Faith Sharpe, ‘Process Over Structure: An Organizational Behavior Approach to Improving Corporate Boards’, (2011) S. Cal. L. Rev. 85, 261. 123 Binder (n. 25), 703. 124 See Commission Delegated Regulation of 25 April 2016 (n. 7), in particular Articles 21 (general requirements), 22 (on compliance requirements), 23 (on risk management), 24 (on internal audit), and 25 (responsibilities of senior management). 125 See, again, the summary of organizational requirements under the ISD 1993 and MiFID I supra II.B. 126 MiFID II, Article 16(4). 127 ibid., Article 16(5), subparas 2 and 3, respectively. These requirements are complemented—again, in rather abstract and vague terms—by corresponding implementing provisions in Articles 23 and 24 of Commission Delegated Regulation of 25 April 2016 (n. 7). 128 ibid., Article 16(2). 129 Supra, n. 7. 130 ibid., Article 9(3)(4). 131 ibid., Article 16(3), first subparagraph. This requirement, in conjunction with Article 23 of the Directive, is specified further in Articles 33–35 of the Commission Delegated Regulation of 25 April 2016 (n. 7). 132 MiFID II, subparas 2 and 3. 133 ibid., subpara. 4. 134 ibid., subpara. 7. 135 ibid., Article 16(6) and (7). 136 ibid., Article 16(8)–(10). 137 It is perhaps telling, in this context, that the relevant international standards on riskmanagement approaches for securities firms have been developed in line with prudential standards developed for credit institutions—compare, e.g., International Organization of Securities Commissioners, ‘Risk Management and Control Guidance for Securities Firms and their Supervisors’ (May 1998), available at , with Basel Committee on Banking Supervisors, ‘Risk Management Practices and Regulatory Capital’ (November 2001), available at . 139 MiFID II, Article 4(1)(31), see also CRD IV, Article 3(1)(33), referring to CRR, Article 4(1)(36). 138 Article 10(1) MiFID II and CRD IV, Article 14(1).

140

MiFID II, Article 10(1)(2), cf. CRD IV, Article 14(2). MiFID II, Article 13(1), cf. CRD IV, Article 23(1). Note that—convincingly, but in contrast to the MiFID II, where Article 10 makes no reference to Article 13—these requirements are also to be applied in conjunction with the supervisory scrutiny of qualifying holdings in the initial authorization process (CRD IV, Article 14(2)). In practice, however, authorities are also likely to apply the same criteria under the initial authorization process in a ‘pure’ MiFID II scenario. 142 See also Moloney (n. 11), 391. 143 See supra II. 144 See, again, supra n. 18 and accompanying text. 145 EBA, ‘Report on Investment Firms—Response to the Commission’s Call for Advice of December 2014’, EBA/Op/2015/20 (2015), available at . See also EBA, ‘Opinion of the European Banking Authority on the First Part of the Call for Advice on Investment Firms’, EBA-Op-2016-16 (2016), available at . 146 See, again, supra III.3. 147 See, again, Binder, ZGR Zeitschrift für Unternehmens- und Gesellschaftsrecht (2015), pp. 667, 702–3; cf. also, discussing the prospect of governance-oriented regulation of banks participating in the Banking Union, Binder, ‘The Banking Union and the Governance of Credit Institutions: A Legal Perspective’ (2015) European Business Organization Law Review 16, 467, 478–87. 148 See, again, Binder, ZGR Zeitschrift für Unternehmens- und Gesellschaftsrecht (2015), pp. 667, 702–3, 707; Chiu (n. 119), 30–3; Enriques and Zetzsche (n. 72), 227–9. 149 See, again, CRD IV, Article 88(1)(e), on which, see supra III.2.A. 150 See, again, Enriques and Zetzsche (n. 72), 232; Mülbert and Wilhelm (n. 13), para. 6.77. 151 See, again, Mülbert and Wilhelm (n. 13), paras 6.38–6.47. 152 Cf., e.g., Section 91(2) of the German Stock Corporation Acts. 153 Cf. Binder, ZGR Zeitschrift für Unternehmens- und Gesellschaftsrecht (2015), pp. 667, 704 (discussing group-wide organizational requirements under EU and national banking regulation, which may conflict with limits to organizational choices within groups under German group law). 154 ibid., pp. 705–6. 141

4 THE OVERARCHING DUTY TO ACT IN THE BEST INTEREST OF THE CLIENT IN MIFID II Luca Enriques and Matteo Gargantini

I. Introduction II. Antecedents of the Investment Firm’s Duty to Act in the Best Interest of the Client III. The Duty to Act in the Best Interest of the Client in MiFID II IV. The Duty’s Functions and Contents V. The Articulation of the Duty with Respect to Individual Services and Activities 1. The Duty and Its ‘Natural Bedfellows’: The Boundaries of Investment Advice 2. The Duty and Its ‘Odd Bedfellows’: At-Arm’s-Length Services 3. Manufacturing 4. Self-Placement 5. Dealing on Own Account VI. A Look Across the Atlantic VII. Assessment

I. Introduction [4.01] MiFID II confirms, in line with its predecessors, that firms providing investment services (hereafter, ‘investment firms’) shall act in accordance with the best interests of their clients (Article 24(1)). Besides being an overarching principle for firms’ professional conduct, the duty to act in accordance with the client’s best interest (hereafter, ‘the best interest duty’ or simply ‘the duty’) is further specified by more detailed provisions within the body of MiFID II and its implementing measures, playing a role itself in their interpretation. Rules concerning the management of conflicts of interest, including at the level of staff remuneration practices (Articles 23 and 24(10)), limitations to inducements (Article 24(9)), and best execution (Article 27) are just a few examples of obligations aimed at ensuring that clients’ interests are pursued even when firms’ incentives may be tainted. Another typical specification of the duty is the duty to apply a suitability or, depending on the service provided, an appropriateness assessment before entering a transaction with a client (Article 25(2) and (3)). [4.02] The duty may have direct application as well, thus grounding firms’ liability even in cases where no specific rule of conduct is violated. Not only does breach of the generic best interest duty trigger administrative sanctions (Article 70(3)(a)(x) MiFID II), but it may also entail private enforcement by dissatisfied investors (Article 69(2) MiFID II).1 [4.03] Although the duty is not new, MiFID II further specifies its implications and, overall, enhances its effects: it does so, as we shall see, by introducing new specific rules of conduct implementing the ‘client’s best interest’ standard and by broadening its scope of application. After sketching out the origins of this duty (Section II), the chapter maps its use in MiFID II (Section III) and analyses it in its various functions: first, as a self-standing source of obligations for investment firms; second, as guidance for the interpretation of the more specific duties MiFID II imposes on investment firms; third, as guidance for EU policymakers in their drafting of implementing rules (Section IV). Section V focuses on how the duty fits well with some of the traditional investment services (portfolio management, advice, and order execution), while it is hard to reconcile with

the features of typically arm’s-length activities such as dealing on own account and self-placement. Section VI takes a look at the ongoing US debate on whether fiduciary duties – to which the best interest duty is normally ascribed – should apply to brokers, reporting the problems with their extension as highlighted by US legal scholars. Finally, Section VII provides an overall assessment of the MiFID II framework concerning the best interest duty and of its efficiency.

II. Antecedents of the Investment Firm’s Duty to Act in the Best Interest of the Client [4.04] The best interest duty has a long history in common law countries, where it is often associated with fiduciary relationships. In the common law tradition, the duty was first developed in equity as a flexible tool capable of ensuring protection in circumstances where this would be impossible under predetermined rules.2 The principle offered a highly protective standard implying the duty to pursue the clients’ interests above the fiduciaries’,3 if not even to act in the clients’ sole interests.4 Such an obligation is regarded as a core element of fiduciary relationships—so much so that it is sometimes regarded as the archetypical component thereof5—and has a pervasive role in ensuring investor protection in trust-based relationships.6 [4.05] Financial market law in the UK has initially been reluctant to make explicit reference to this duty as a general principle. For instance, in setting out the rules applicable to the advice and distribution industry, the Core Conduct of Business Rules adopted by the Securities and Investments Board (SIB) upon delegation by the Financial Services Act 1986 made independent financial advisers and tied agents subject to a ‘best advice rule’ when they made personal recommendations on packaged investment products (including units in regulated collective investment schemes). The complexity and the opacity of such products justified strengthened rules of conduct that prevented both independent advisers and tied agents from recommending a packaged product if they were ‘aware of a […] packaged product which would better meet [the client’s] needs’.7 However, while

identification of the best product was to be made out of the products generally available on the market for independent financial advisers, tied agents could also refer to products of their firm or marketing group alone.8 For this reason, the ‘best interest’ requirement was considered a distinguishing feature of independent advisors, in line with their nature as investors’ agents, with tied agents acting as salespersons on behalf of product manufacturers.9 In this context, scholars considered the best advice rule as an application of the best execution principle,10 where the duty to act in the best interest of the client was explicitly stated,11 in line with its origin as a typical fiduciary duty.12 The 1986 ‘polarized’ system was subsequently abandoned for a more homogeneous regulatory framework for investment advice,13 and in 2004 the UK FSA (now FCA) Principles for Businesses adopted the current milder14 formulation that refers to the duty to pay ‘due regard’ to the interests of customers, and to treat them fairly.15 [4.06] International recommendations and codifications of best practices have been less reluctant to openly expand the obligation to pursue the customers’ best interest into an across-the-board principle applicable to any business activity, with no explicit differentiation between arm’s-length (e.g. dealing) and fiduciary-based activities (e.g. advice): the 1990 IOSCO International Conduct of Business Principles—which were overall strongly influenced by the UK conduct of business rules16—recommended that firms should act ‘with due skill, care and diligence, in the best interests of [their] customers and the integrity of the market’;17 a wording subsequently reflected in Article 11(1) Directive 93/22/EEC and, later on, in Article 19(1) MiFID I and Article 24(1) MiFID II.

III. The Duty to Act in the Best Interest of the Client in MiFID II [4.07] According to Article 24(1), ‘member states shall require that, when providing investment services or, where appropriate, ancillary services to clients, an investment firm act […] in accordance with the best interests of its clients’ (emphasis added). Such a wording may seem to imply something

less than a ‘duty to act in the best interest of the client’, but the two can be regarded as synonymous, given their interchangeable use throughout MiFID II. [4.08] In fact, the expression ‘[duty to act] in accordance with the best interests of its clients’, the seemingly broader ‘[duty to act] in the best interests of its clients’, or even the expression (emphasis added in the following instances) ‘[duty to act] in the interest of the client’ can be found elsewhere in Article 24 to refer to the same duty. First, Article 24(2), second para., requires investment firms ‘to ensure that financial instruments are offered or recommended only when this is in the interest of the client’. Second, Article 24(7)(b) clarifies that advice can be qualified as independent also when the investment firm receives ‘[m]inor nonmonetary benefits that are capable of enhancing the quality of service provided to a client and are of a scale and nature such that they could not be judged to impair compliance with the investment firm’s duty to act in the best interest of the client’. The exact same wording can also be found in Article 24(8), which allows investment firms providing portfolio management services to accept inducements with the same characteristics. In addition, according to Article 24(10), an investment firm ‘shall ensure that it does not remunerate or assess the performance of its staff in a way that conflicts with its duty to act in the best interests of its clients’. [4.09] Other provisions in the same Article rather repeat the wording of Article 24(1) (‘duties [or obligation] to act … in accordance with the best interests of its clients’), namely Article 24(9), first para., sub (b), and third para., and Article 24 (13)(d), addressing the conditions for receiving inducements. [4.10] As anticipated, there is no reason whatsoever to consider the duty to act in the best interest of the client as a different—and possibly stricter— standard than the one in Article 24(1). Recital 71 first para., confirms that the two are one and the same: referring to Article 24(2), it states that investment firms need to understand the features of the financial instruments they offer or recommend as this enables them to comply with the duty to ‘act in accordance with the best interest of their clients’, while Article 24(2), as reported above, considers the same duty as a means ‘to

ensure that financial instruments are offered or recommended only when this is in the interest of the client’.18 [4.11] References to Article 24(1) in other MiFID II provisions provide a better understanding of the duty’s scope. In some cases, such provisions clarify that Article 24 applies to a specific service, in others that it does not. For the sake of exposition, we can identify four different settings, depending on how the best interest duty combines with other general standards and with more detailed rules of conduct. [4.12] In the first setting, the best interest duty applies along with the companion Article 24(1) duty ‘to act honestly, fairly and professionally’ (hereinafter, the companion standards) and with more detailed conduct of business rules. For instance, Article 25(1) and (2) specify how investment firms shall assess the suitability/appropriateness of a service or a product, a conduct of business rule which is normally regarded as a specification of the best interest duty.19 Investment firms performing sales activities must make sure that investors have a proper understanding of the investments they are entering into (appropriateness test), while for the higher added value services of financial advice and individual portfolio management the assessment must also include customers’ ability to bear the risk of the losses financial instruments may cause as well as the ability of those instruments to match customers’ investment objectives (suitability test). This regulatory technique raises the questions of whether and, if so, to what extent the best interest duty coexists with requirements established by detailed rules of conduct and therefore potentially adds on further duties to those stemming from such rules. [4.13] In a second setting, the best interest duty, together with other general standards of conduct, applies, but one or more specific rules of conduct are explicitly waived. For example, the duty to assess the appropriateness of investment services and financial instruments is waived for the execution or reception and for transmission of trading orders concerning non-complex financial instruments, to the extent that such activities are performed at the initiative of the clients (‘execution-only’: Article 25(4) MiFID II). This means that investment firms do not have to obtain information on the (potential) clients’ knowledge and experience,

nor must they assess whether the envisaged investment services or products are appropriate for customers in the light of their knowledge and expertise. However, Article 25(4) does not exempt investment firms from the Article 24(1) duties, including that of best interest. Here, the question is to what extent some of the waived requirements may still be deemed applicable by way of interpretation of the best interest duty and its companion standards, irrespective of the lighter protective regime set forth by detailed rules of conduct. [4.14] In a third setting, investment firms are exempted from the best interest duty, but not from the companion standards. This happens when investment firms perform straightforward execution or transmission of trading orders of—as well as when they deal on own account with —‘eligible counterparties’ (a subset of professional clients: Article 30). In this case, MiFID II requires pre-contractual information and reports on the service provided and its costs (Article 24(4) and (5) and Article 25(6)), with the exclusion of any appropriateness assessment.20 Eligible counterparties receiving those services are also protected by investment firms’ companion standards and by the duty to provide clear and not misleading information, but they cannot rely on the best interest duty (Article 30(1)). This is a remarkable innovation in the MiFID II framework, as MiFID I exempted pure sales transactions with eligible counterparties from both the duty and the companion standards (Article 24 MiFID I). The inapplicability of the best interest duty reflects the fact that parties to an arm’s-length transaction on the wholesale market do not normally protect each other’s interests, unless otherwise agreed. However, MiFID II acknowledges that eligible counterparties may still expect investment firms to comply with companion standards, even if they do not need special protection when making their investment choices. The expansion of fairness principles to such transactions reflects the policy consideration that conduct of business rules should serve not only investor protection, but also market integrity purposes (MiFID II, Recital 164). Hence, the requirement that investment firms behave according to professional standards in all their activities allows for public enforcement intervention beyond the interests and the incentives of clients, who can only be expected to enforce their own rights when their private interest so commands.

[4.15] Fourth, and finally, in some cases MiFID II excludes application of Article 24(1) in its entirety. For instance, non-discretionary crossing of buying and selling interests represents a key protective tool for multilateral trading facilities (MTFs) and regulated markets’ members and participants when they route their orders to such trading venues: no space is left for assessing counterparties’ interests with regard to transactions concluded on MTFs and regulated markets and therefore Article 24 does not apply (Articles 19(4) and 53(4)).21

IV. The Duty’s Functions and Contents [4.16] As a preliminary matter, let us first clarify that it would make no sense to ask whether the best interest duty stems from the fact that investment services give rise, as such, to fiduciary relationships. Fiduciary relationships are a product of national private (common) law traditions, and nothing authorizes the consideration of MiFID II as a vehicle for the legal transplanting of fiduciary obligations from those jurisdictions to others. Continental European jurisdictions have developed alternative, albeit equivalent, tools in order to satisfy the need to integrate clear-cut but rigid rules with more flexible standards of behaviour, the most cited example being the duty of good faith and fairness.22 MiFID II also refers to this fairness principle (Article 24(1)), along with the best interest duty, thus juxtaposing legal principles with different origins23 in a somewhat uneasy combination. In addition, MiFID II is an autonomous instrument and contains a set of overlapping and complementary duties which would make an inquiry into the fiduciary nature of the best interest duty quite purposeless. [4.17] We are rather interested in understanding, first, what the functions and the common EU core content of the best interest duty are and, second, how the duty applies to the provision of the various investment services. The present section deals with the former question, while Section V focuses on the latter. Both try to answer these questions from a positive, rather than normative, perspective.

[4.18] The best interest duty plays a key role in MiFID II’s framework. First, it acts as a self-standing duty filling the gaps in investor protection left by more specific conduct of business rules. Here, the duty complements such rules of conduct when these do not apply because of their limited scope or when they fall short of delivering a sufficient level of investor protection, however subjective this assessment can be. Second, the duty provides justification for pro-client interpretations, both by supervisors and courts, of the more specific MiFID II conduct of business rules, once again when narrow interpretations would not yield satisfactory results. Third, as an overarching principle in MiFID II, the duty provides guidance to EU policymakers in charge of drafting implementing regulations. Implementing rules or guidelines will sometimes have to be enacted to clarify whether some practices are consistent with the duty: this is namely the case with cross-selling and inducements (Article 24(11), third subpara. and 24(13) (d)). [4.19] As a gap filler, the best interest duty complements the specific conduct of business rules, such as the obligations related to conflicts of interest management, the duty to run appropriateness or suitability tests, the duty of best execution, and so on. First of all, the duty reaches beyond the scope of these specific rules when these do not apply. By the same token, the duty ensures that compliance with the specific rules effectively results in the degree of investor protection that in the given circumstances MiFID II requires. [4.20] Note that, as a self-standing duty, the best interest principle is not limited to areas left uncovered by the specific conduct of business rules. In one case, this is even explicit: Article 24(10) prevents firms from remunerating or evaluating their staff in a way that conflicts with the duty to act in the best interest of their clients. Here, the duty explicitly shapes the contours of a specific governance rule imposed on the investment firm. As the provision itself specifies [i]n particular, [an investment firm] shall not make any arrangement by way of remuneration, sales targets or otherwise that could provide an incentive to its staff to recommend a particular financial instrument to a retail client when the investment firm could offer a different financial instrument which would better meet that client’s needs.

Recital 77 makes clear that, despite the reference to recommendations, such a provision applies to both advisory services and selling activities. [4.21] More generally, and even in the silence of the Directive, the duty also applies to behaviours that specific conduct of business rules do cover: in circumstances where substantial compliance with such rules is insufficient to ensure that the investor’s interest is duly protected, the duty itself kicks in.24 [4.22] In other words, full compliance with the specific conduct of business rules provides no safe harbour for the investment firm: if the treatment the client receives as an outcome of such compliance is not in line with her best interest, then the best interest duty will have been breached. [4.23] But what exactly are the duty’s contents? And how far does it reach? The regulatory framework for investment advice offers a good starting point to illustrate the duty’s implications. [4.24] Investment advice falls within the scope of investment services insofar as it consists in personal recommendations on specific financial instruments (Article 9 EU Commission Delegated Regulation supplementing MiFID II as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive—hereinafter ‘Delegated Regulation’; previously Article 52 Directive 2006/73/EC). This would in principle exclude the provision of general advice on a generic kind of financial instrument from its scope, even when that kind of financial instrument is presented as suitable. However, according to Recital 15 Delegated Regulation (previously Recital 81 Directive 2006/73/EC), providing generic advice of this sort – i.e., accompanied by a misleading or false statement of suitability or of previous consideration of the circumstances of a client – would likely result in the violation of the duty: direct application of the duty fills the gaps left open by the inapplicability of the suitability test, because the provision of general recommendations would merely qualify as an ancillary service, subject to less stringent conduct of business rules (Articles 24(1) and 25(1) and Annex I(B)(5) MiFID II).

[4.25] The duty can also complement specific rules of conduct. Rules on conflicts of interests and inducements set obligations aimed at ensuring unbiased recommendation of financial products and investment services (Articles 23 and 24(9)), while the suitability test prevents investment firms from recommending inadequate transactions. When more than one financial instrument or investment service matches the suitability test for a specific client, investment firms will comply with the suitability rule by recommending any of them. And, so long as they comply with processbased rules on conflicts of interest, they are not prevented from recommending products in respect of which they are conflicted.25 [4.26] Such conduct of business rules are also compatible with a model of investment advice where investment firms simply assess whether investment products are suitable and, hence, recommendable, but clients retain full responsibility for selecting among them.26 A more protective form of advice may however add on top of this an investment firm’s duty to identify the best option, in terms of risk-adjusted performance and fees, within the set of suitable products.27 Whether investment firms take on this responsibility may depend on the specific contractual terms, also in the light of the specific circumstances,28 but the best interest duty may facilitate such a result and has occasionally been indicated as functionally equivalent to a duty to select the most suitable product, together with other conduct of business rules.29 [4.27] As hinted already, the best interest duty also acts as guidance to interpretation of specific conduct of business rules. Attempts to enhance investor protection in non-advised services, where specific conduct of business rules aim to ensure appropriateness rather than suitability of the products concerned, provide good examples of how our duty may perform this function. [4.28] In general, the appropriateness test aims to verify whether clients have the expertise and skills required to understand the features of the specific type of product or service they are going to receive. Investment firms have to warn their clients in case they are not satisfied that the product or the service is appropriate, but this does not prevent investment firms and their clients from performing the devised transactions. Therefore,

the appropriateness test helps clients evaluate their ability to take adequate choices, but once the test is performed—with either a positive or a negative result—investors retain full responsibility for their choices and caveat emptor would seem to apply (Article 25(3) MiFID II). The appropriateness test does not ensure the same level of investor protection as the suitability test: it leaves the final say to clients and is not designed to ensure that transactions in financial instruments meet clients’ needs. [4.29] Noteworthy attempts to enhance investor protection in services requiring the mere assessment of appropriateness have been carried out in the wake of the mis-selling scandals that have affected investors in a number of EU Member States.30 Recently, diffuse losses among retail investors were reported in the UK, Germany, Spain, Italy, the Netherlands, and elsewhere.31 Investment decisions taken in connection with such misselling practices were flawed in many respects. Sometimes, investors could not seemingly grasp the actual risks hiding behind the complexity of prepackaged structured products,32 and therefore received a payoff which underperformed that of non-structured products with an equivalent risk.33 In its opinion on MiFID I practices for firms selling complex products, ESMA acknowledged that investment firms’ compliance with rules on (suitability and) appropriateness in the placement of complex financial instruments had been insufficient.34 In what appears to be an implicit use of the general standard to act in accordance with the client’s best interest, the opinion invites national competent authorities to make sure that firms do not rely excessively on standardized processes to assess appropriateness, as they should rather focus on a substantial assessment of clients’ ability to understand complex products.35 At the national level, this guideline has been further specified by some national competent authorities in the sense that relevant information concerning clients’ features should be gathered in ‘indirect’ ways, so as to avoid any self-assessment by customers.36 [4.30] Observing that the best interest duty can fill regulatory gaps or complement detailed conduct of business rules, including by way of interpretation, begs of course the question of what kind of behaviour the duty requires. Of course, no precise a priori answer to this question can be given: as a general standard of behaviour, only ex post specification by the

relevant enforcement actors is possible. Hence, what can be said is that the duty is open-ended, lending itself to imposing client-regarding behaviour and therefore protection of the client’s interests in the absence of specific conduct of business rules or whenever existing conduct of business rules do not cover a given situation, but at the same time the investor-protection rationale that justifies the application of specific rules in similar circumstances applies to that very situation. Another way of putting this is that the best interest duty moves the guiding principles underlying client– firm relationships in investment services provisions away from caveat emptor, but to what extent that results in requiring investment firms to neglect their own interests to the benefit of their counterparties depends on the specific circumstances and, crucially, given decentralized enforcement, on prevalent interpretations at national level. [4.31] This is the result of MiFID II’s approach of shaping the contractual relationships among private parties—a technique sometimes referred to as of ‘regulatory contract law’37—by mandating the application of general principles whose contents cannot easily be defined in a uniform manner across the EU. The best interest duty and the companion standards are largely inspired by national legal systems and, absent a sufficiently broad EU case law and ESMA guidance, national courts and regulators will inevitably interpret them according to their own legal traditions. In this respect, it is of little consequence whether, in principle, such duties should be defined by way of autonomous interpretation or whether Article 24(1) should instead be understood as an implicit reference to national legal systems. Irrespective of the abstract answer to such questions, the second prevails in practice, so that those general duties are sometimes considered as a way to ensure that investment firms comply with the national private law duties underlying the core aspects of the investment service provided in the light of the contractual agreement between the parties.38 Far from being a mere repetition of already applicable rules, this regulatory technique would strengthen investor protection by enabling public enforcement of such duties.

V. The Articulation of the Duty with Respect to Individual Services and Activities [4.32] Having articulated the core functions of the best interest duty in the MiFID II framework, we are ready to move on to delineate how the duty operates with respect to individual investment services. To do so, we will distinguish between services based on a trust-like relationship and services (otherwise) entailing arm’s-length transactions (hereinafter also arm’slength services). The analysis will confirm the intuition that the less an investment service or activity displays the features of a fiduciary relationship, the harder it is to gauge how the duty applies to it and, correspondingly, the more awkward the position of the investment firm is if, in these cases as well, the duty is to be taken seriously. [4.33] In fact, the operation of the investment firm’s best interest duty is unproblematic when it comes to the provision of investment advice and individual portfolio management, which are normally classified as fiduciary relationships.39 The problems come when applying the same duty to (otherwise) arm’s-length (or transactional) relationships such as selfplacement and dealing on one’s own account. Here, the question is to what extent Article 24(1) reflects an actual reliance on investment firms’ commitment to act to the benefit of their counterparties in the same fashion as in a relationship of pure trust and confidence.40 Introducing quasifiduciary legal obligations in transactional investment services may not always be efficient, as it may increase uncertainty as to investment firms’ expected behaviours even when the parties prefer to negotiate clear-cut rules in advance rather than relying on flexible, but fatally vague, general standards.41

1. The Duty and Its ‘Natural Bedfellows’: The Boundaries of Investment Advice [4.34] Investment advice and discretionary portfolio management are, so to speak, the natural bedfellows of the best interest duty. These financial services are inevitably prone to contractual incompleteness, because the

parties cannot foresee all future states of the world and, hence, set in advance how they should behave with regard to any possible circumstances. By the same token, investments normally need quite a long time before their results can be evaluated, meaning that investors are only able to assess the quality of the provider’s performance when it might be too late to react; in addition, they may well never be able to tell whether a lower than expected return is the outcome of disloyalty, incompetence, or just bad luck.42 It is therefore inherent to both investment advice and discretionary portfolio management services that the investment firm serves its clients’ interests in making delegated investment and divestment choices and in providing recommendations on which investment choices to make. In this context, the best interest duty may still play a decisive and sometimes problematic role in the determination of the boundaries of investment advice, in particular when this combines with other services and activities, such as placing of financial instruments and self-placement. Some of the mis-selling scandals that have occurred in recent years reveal that household investors’ portfolios were excessively concentrated. Recent bank resolutions through bail-in43 in markets characterized by widespread direct access by retail investors to bonds44 have provided anecdotal evidence that in a number of cases small investors’ portfolios’ exposure to subordinated bonds would not have stood a suitability scrutiny. Whether this excessive concentration depends on diffuse violation of rules implementing MiFID I is hard to tell, as its determinants may be manifold. [4.35] ESMA has recently qualified subordinated bonds as complex financial instruments,45 but this was not necessarily the interpretation at national level beforehand.46 Thus, some purchases might have taken place according to the execution-only regime, which may be opted into if the service is provided at the initiative of the client (Article 25(4)(b)). Although a limited offer of products for sale can easily skew the composition of investors’ portfolios in peripheral market contexts where competition is reduced, high concentration of investments can reasonably be taken as indirect evidence that the relevant financial instruments had been recommended to clients. The critical element is whether such messages were presented as suitable or based on a consideration of the clients’ characteristics, bearing in mind, though, that no duty exists for providers of

non-independent advice to consider a broad range of financial instruments (Article 24(7)(a), a contrario). [4.36] Whether or not MiFID I conduct of business rules were violated, it still comes as no surprise that disgruntled investors or national competent authorities may invoke an extensive interpretation of rules mandating a suitability test to hold investment firms accountable in these scenarios, and an even more protective effect may be achieved by stressing the flexibility of general standards such as the duty to act in the client’s best interest. [4.37] The definition itself of investment advice, as previously complemented by Level 2 Directive 2006/73/EC (Article 52), was somewhat ambiguous in providing that such an investment service was only provided when recommendations were presented as suitable for the client or were based on a consideration of the circumstances of that client. The Delegated Regulation adopted pursuant to Article 4(2) MiFID II substantially replicates the previous rule (Article 9), so that the question on non-tailored recommendations remains unanswered at the legislative level.47 As a by-product of an apparently misguided attempt to regulate through definitions rather than by way of straightforward rules of conduct, recommendations that are neither grounded on the client’s characteristics nor presented as such fall outside the scope of investment advice and merely qualify as ancillary services (Annex I(B)(5) MiFID II). Requested to clarify the point, the Commission has acknowledged that Article 52 requirements on personalization of recommendations belong to the definition of investment advice, while stating at the same time that a recommendation which is given to a client with no consideration of its suitability would be forbidden ‘in the light of the fiduciary obligations firms are subject to’.48 The Commission’s position on recommendations that are not presented as suitable highlights the role of the quasi-fiduciary duty to act in the client’s best interest as a potential gap-filler, because Article 24(1) prevents circumvention of the suitability test. As a result, investment firms cannot take advantage of the narrow definition of investment advice with a view to recommending unsuitable financial products when they perform pure brokerage or dealing activities.49

[4.38] In principle, brokers’ required or voluntary provision of information to clients entails no presumption that investment firms assess the suitability of the displayed products. This distinguishes selling services coupled with generic advice from investment advice tout court, although the previous analysis shows this distinction may be blurred in practice. As mentioned, Recital 15 Delegated Regulation specifies that providing generic advice on a type of financial instrument which is presented as suitable would not qualify as investment advice—as this requires a recommendation be given on a specific financial instrument—but would contravene the best interest duty and its companion standards if that advice were not suitable. By the same token, Recitals 16 and 17 expand conduct of business rules from the core investment service provided (e.g. order execution) to preliminary steps such as the provision of generic advice or of general recommendations through distribution channels. This broadened scope of investor protection beyond the limits of clear-cut rules of conduct in some critical circumstances such as placing of financial instrument heavily relies on the gap-filling function of the best interest duty. In particular, it prevents investment firms from easily circumventing those rules by steering their clients’ investment decisions while providing nonadvised services. [4.39] This is a very sensitive area where policymakers are still struggling to find a proper regulatory balance, 50 and simply relying on a broad interpretation of the best interest duty may not be sufficient.51 Empirical evidence suggest that extending the scope of investment advice, or of the duties attached to its provision, outside a well-defined area of personalized recommendations concerning specific products may induce investment firms to refrain from providing any kind of information to their clients, as this would entail the risk of being bound by higher standards of behaviour and of being exposed to the ensuing costs and liability risk.52 Such unintended consequences may occasionally reduce investor protection for those clients who cannot afford the costs of fully fledged investment advice.53 [4.40] This makes remuneration of advice a particularly sensitive issue. Fee-free advice is widespread across many EU jurisdictions because of households’ notorious reluctance to pay to obtain personalized

recommendations.54 Conflicts of interests associated with commissionbased remuneration are however particularly problematic, and facilitated some past mis-selling scandals: in the UK, investor protection concerns led to national super-equivalent provisions aimed at curbing commission-based advice.55 However, non-advised sales accompanied by provision of complete information on a wide range of financial instruments entail significant costs: such a business model may not be economically viable without at least implicit personal recommendation and the subsequent higher take-up of products.56 This brings us back to the original problem: is commission-based advice preferable to a system where investment firms have no incentives to provide investors with sufficient information? Or is no information still better than biased information, considering investment firms’ incentives? [4.41] When investment services and activities other than investment advice and discretionary portfolio management are involved, things become even less straightforward. In the absence of a statutory duty to act in the client’s best interest, parties may or may not explicitly contract for such a duty. In their silence, however, an external observer could hardly tell whether a transaction is accompanied by an investment firm’s implicit commitment to act in the client’s best interest, or by the corresponding client’s expectation, and ex post unilateral statements on the matter could hardly be relied upon.57 We deal with these issues in the following subsections.

2. The Duty and Its ‘Odd Bedfellows’: At-Arm’sLength Services [4.42] When providing pure execution and ‘sale’ services, such as brokerage, placement, self-placement, and dealing on own account, investment firms, which we refer to as broker-dealers in the following, do not take final decisions on client’s investments, nor are they per se required to provide assistance in the assessment of the financial instrument that is being traded or sold, let alone of alternative investment choices. Their contribution to the decision-making is in principle null when investors are

addressing them in order to trade products they have already identified as the target of their purchase, although information concerning the services provided and the financial instruments forming the object of those services is to some extent required (Article 24(3)–(5) MiFID II) or may be provided voluntarily. [4.43] Broker-dealers may also take a more active stance and make potential customers aware that they have financial instruments for sale on their ‘shelves’ and inform them about such products’ features, thus taking the initiative for the execution of trades with or on behalf of clients. Still, this entails no presumption that marketed financial instruments and investment services are regarded as suitable to the potential customers addressed, nor that they are recommended as such, but the risk is of course high that promotional communications slip into concealed recommendations and, thus, investment advice. Concerns that investment firms may circumvent fiduciary-style obligations seem to underlie some national competent authorities’ opinion that investment firms should design standardized internal models for business-to-client relationships and enforce their application by firms’ staff, as any free interaction in such critical circumstances may easily result in investment advice.58 [4.44] It is certain that no presumption exists that the products sold by broker-dealers comprise a wide enough selection of what is on the market or, in other words, that investment firms will make any attempt to display all the available products that would satisfy investors’ needs. This is not even required of investment advisers, unless they present themselves on the market as independent advisers (Article 24(7) MiFID II). [4.45] While the best interest duty entails no obligation to offer a minimum range of financial instruments, it still has some implications that are hard to reconcile with the very nature of sales activities. This is the case, for instance, with the no-profit rule, one of the implications of the duty in its purest form,59 which prevents the agent from taking advantage of its position by extracting wealth from the activities it performs for the beneficiary without authorization (as is the case with incentive-based compensation arrangements60). This restriction is shaped on agency relationships where no room is left for the fiduciary to pursue her own

interest, even when doing so does not harm the beneficiary: intuitively, it sits uneasily with arm’s-length contractual relationships. [4.46] Because the typical remuneration system for investment firms operating as principals, rather than as their customers’ agents, consists of mark-ups and mark-downs61—as opposed to commissions and fees— dealers are inevitably earning from spreads on market prices. This may produce an inherent conflict of interests only to the extent that the dealer is subject to duties that go beyond what is expected from a mere buyer or seller; in any contract, one of the parties has an incentive to appropriate the maximum possible part of the counterparty’s reservation price, but qualifying this as a form of misappropriation would simply place dealers out of business.62 Indeed, the no-profit rule and the remedies typically associated to it, such as disgorgement of profit,63 can hardly fit the normal activity of dealers, because the investment firm has its own (legitimate) interest in the transaction and no one would expect dealers to transfer earnings made out of such a transaction to their clients. At most, the duty of fair dealing may become relevant in this context, if an ‘excessive’ mark-up or mark-down can justify a finding that the contract lacks equilibrium, to the extent that the applicable private law provides for specific remedies (e.g. for unconscionability) or that the competent supervisor can set the appropriate level of spreads. In the US, this is for instance the case with FINRA Rule 2121, which specifies the duty of fair dealing64 by preventing dealers from excessively marking up the price of securities.65 [4.47] Occasionally, a stringent interpretation of the best interest duty may lead to more pervasive effects in the MiFID I and II framework, too. Investment firms offering derivative contracts and acting at the same time as their clients’ counterparties inevitably make (or lose) money when their clients lose (or make) money. An ESMA Q&A document has recently stressed this divergence between the investment firms’ and the clients’ interests in the context of contracts for difference (CFDs) and other complex speculative products such as binary options and rolling spot forex. In the Authority’s view, those contracts entail a conflict of interest that cannot be adequately managed as it is inherent to the investment firms’ proprietary position, unless investment firms hedge, in whole or in part, their client orders. As a consequence, ESMA believes that the incentives to

profit from investors’ losses can by no means comply with the best interest duty, and that the offer of CFDs and other speculative products to retail clients should therefore be avoided altogether.66 [4.48] The Q&A document therefore adopts a very broad notion of conflict of interests. This latter is normally not understood by scholars as to encompass situations where contractual counterparties, which are not linked by any principal–agent relationship, simply aim to maximize their own welfare on a market-based transaction.67 However, the flexibility of the best interest duty seems to offer supervisors a ready-to-use tool to address such situations.

3. Manufacturing [4.49] Not only does MiFID II strengthen rules concerning firm–client relationships, but it also sets specific obligations to consider clients’ interests in manufacturing68 and distribution activities (Article 24(2)).69 These obligations also apply when no suitability assessment is required,70 as they also include mere securities offers besides recommendations, so that the workability of the new provisions for activities falling within the scope of the lighter appropriateness regime remains uncertain. [4.50] By addressing the organizational side of potential misbehaviours, MiFID II leverages on firms’ incentives, as a complement to directly regulating their conduct. This focus on upstream elements de facto broadens the scope of the (quasi-fiduciary) suitability test to the detriment of lighter appropriateness scrutiny regardless of the service actually provided downstream. [4.51] Rules setting out obligations to consider clients’ interests in manufacturing and distribution activities may also result in a selling ban when the client’s best interest principle would be impossible to meet (or to ascertain) for any possible target. In ESMA’s view, when this is the case, national competent authorities ‘should monitor that firms do not offer advice on that envisaged product, or sell it at all’:71 the reference to mere selling activities shows how remarkable the effects of fiduciary-like duties

can be when they apply to arm’s-length transactions. While some competent authorities had already restricted the marketing of certain complex financial instruments at national level long before ESMA’s opinion was released,72 this opinion may facilitate the adoption of similar prohibitions by other authorities, as demonstrated by recent national recommendations that products falling within certain categories of ‘complex products’ not be sold to retail customers, unless ESMA’s standard is met.73 As the provision of arm’s-length investment services and activities creates frictions with the best interest duty, one can easily see how a strict interpretation of this general standard of behaviour may drift into a creeping form of product intervention, and how this may take place outside the procedural requirements for imposing restrictions on the distribution of certain financial instruments or to the performance of certain financial activities under the MiFID II/MiFIR system (Articles 40 ff MiFIR).74

4. Self-Placement [4.52] Under the MiFID I regime, the treatment of direct placement of proprietary financial instruments (self-placement) by investment firms was uncertain. At least in some jurisdictions, the traditional view was that direct placement by issuers—whether corporate or financial institutions—did not fall within the scope of MiFID-regulated activities, because the ability to raise capital that is inherent to the very essence of every company inevitably requires direct contacts with multiple potential investors, and no indication exists that such day-to-day contacts qualify as reserved activities.75 In other countries, self-placement by investment firms was regarded as an investment activity, rather than as an investment service, and hence excluded from the application of conduct of business rules on the basis that dealing solely as a contractual counterparty does not entail any activity performed on behalf of investors.76 Pursuant to either interpretation, the MiFID I investor-protection regime did not extend to self-placement,77 so that in order to make MiFID I conduct of business rules applicable to it, some countries enacted specific provisions.78

[4.53] The Commission’s Q&A Database on MiFID I addressed the point in an inconclusive way. While making clear that financial institutions were subject to ‘know your client’ requirements when their sales persons, on their own initiative, addressed potential investors and recommended financial instruments issued by their own financial institutions, no clear indication was given for cases where no such active solicitation was performed.79 In the 2010 MiFID I review exercise, CESR called for greater clarity on self-placement, no matter whether in connection of investment advice or on a stand-alone basis.80 [4.54] In MiFID II, self-placement explicitly qualifies as an investment service: order execution now includes ‘the conclusion of agreements to sell financial instruments issued by an investment firm or a credit institution at the moment of their issuance’ (Article 4(1)(5)). This broadened definition brings new activities into the scope of EU rules, thereby extending the scope of the best interest duty to an area where firms’ duties as investment firms may combine with firms’ interests as issuers, or as contractual counterparties in a derivative contract, in problematic fashions. In their capacity as issuers or parties to a derivative contract, banks and investment firms have an incentive to reduce the cost of their (debt and equity) capital and to maximize their returns. This can easily jeopardize investor protection because investment firms will benefit from increasing the price of the financial instruments they place, or from placing financial instruments even in cases where these would not stand a suitability or appropriateness scrutiny. [4.55] Self-placement displays peculiar features that might have in principle suited different investment services. Indeed, it shares similarities with at least three investment services listed in MiFID II Annex I (Section A), namely placing of financial instruments, dealing on own account, and order execution. Far from being confined to taxonomy, such qualification has remarkable regulatory implications on the applicability of the best interest duty and its specifications, especially when it comes to the exemptions regime, as we will show. Similarities between placing of financial instruments and self-placement flow from the common element that (debt or equity) capital is raised

through newly issued financial instruments marketed (with or without a public offering81) to a large number of investors. At the same time, it is widely understood that placing requires by its own nature a separation between a service provider and an issuer (or an owner, on secondary markets) because the service provider facilitates access to investors by making its sales network available and therefore operates on the issuer’s (or the owner’s) behalf.82 This explains why no placement service can be generally carried out absent such separation between issuer and investment firm83 and why—as stated by the EU Commission84—no placement occurs when financial instruments are issued on a continuous basis upon investors’ demand rather than being actively marketed on behalf of issuers, as is typically the case with securities offerings during IPOs. [4.56] This does not, of course, mean that that placement (or selfplacement, as the case may be) of financial instruments cannot combine with other investment services, such as investment advice or execution of orders: in this case, investment firms owe their obligations also (or exclusively, in the case of self-placement) to clients buying the relevant financial instruments.85 As CESR noticed under the MiFID I regime, absent such combination, investment firms may be considered as acting on behalf of issuers or offerors alone or, in the case of self-placement, in their own interest, with the risk of leaving investors unprotected.86 [4.57] Self-placement is even closer to selling financial instruments on own account.87 In both circumstances, investment firms operate as direct counterparties to their clients and, at least at the level of the investment firm (as opposed to that of its salespersons or traders), have their incentives driven by price considerations, rather than by commissions or fees. The distinction here concerns not so much the activity provided (as is the case with placing of financial instruments), but rather the context where principal trading is performed, namely the primary versus the secondary market. [4.58] Perhaps in light of the differences between self-placement on one hand, and placing and dealing on own account on the other, the new regime opts instead for the third alternative and assimilates self-placement to execution of orders on behalf of clients (Article 4(1)(5) MiFID II).88 MiFID

II’s focus is therefore on the investor’s side of the transaction, while the role of investment firms in marketing their own financial instruments and/or acting as clients’ direct contractual counterparties plays a minor role.89 [4.59] As a consequence, the sale of financial instruments in the context of self-placement is now subject to MiFID II conduct of business rules. How much this will strengthen investor protection and make the supervisory and judicial scrutiny on investment firms’ behaviour more intense remains to be seen, as legal uncertainty remains high for many reasons. At least four sources of uncertainty can be identified. First, the remaining uncertainties on the reach of the new definition of execution of orders on behalf of clients; second, the MiFID II generous exemptions regime; third, the interactions between self-placement and investment advice; fourth, the implications of the conflict-of-interest regime. [4.60] Let us start with the uncertain reach of the broadened definition of order execution. Some commentators have submitted that the new definition does not include primary market transactions where issuers are not acting in their capacity as investment firms, but just as mere contractual counterparties in arm’s-length transactions.90 This opinion is based on the distinction between the provision of investment services (in favour of a client) and the performance of an investment activity (with a counterparty not receiving any service),91 a distinction which the wording of some of the provisions outlining conduct of business rules would seem to justify: some key MiFID II provisions setting forth rules of conduct explicitly refer, just like MiFID I, to the provision of investment (and in some cases also ancillary) services, but not to the performance of investment activities.92 [4.61] Yet, the Commission has adopted a different interpretation with regard to MiFID I, on the basis that the Directive provided no clear criterion for distinguishing ‘between cases where a service is being provided to a client and […] those where an activity is simply being carried on with a person who is not a client.’93 Therefore, every person entering into a transaction with an investment firm should (shall) be regarded as either an eligible counterparty—and hence as a client, as per Recital 40 MiFID I, now Recital 109 MiFID II94—or as a professional or retail client, and the transaction would (will) necessarily be subject to MiFID conduct of

business rules (Article 19 MiFID I, now Article 24 MiFID II), with the limited exception of best execution in transactions that are not carried out on behalf a client. Nor does MiFID II seem able to materially affect this conclusion, absent any further clarification on the point. For instance, the exemption for persons dealing on own account applies to the extent that such persons do not provide any ‘other’ investment service or perform any ‘other’ investment activity, which suggests that dealing on own account may constitute both a service and an activity (Article 2(1)(2)). In a similar vein, the same exemption does not include dealing on own account when executing client orders (Article 2(1)(d)(iv)), but this does not clarify whether pure dealing on own account would qualify as a service or an activity in the taxonomy of MiFID II.95 All in all, these remaining uncertainties may pave the way to divergent national practices on a crucial matter for investment firms’ proprietary trading, in spite of MiFID II’s harmonization efforts. [4.62] Doubts on the boundaries of order execution reverberate on the exemptions regime, which is the second element of uncertainty. The classification of self-placement as order execution, rather than as placing or dealing on own account, ensures at first sight the widest possible exemptions regime. In fact, order execution qualifies for exemption from MiFID II conduct of business rules both in the case of transactions with eligible counterparties (Article 30, which also entails inapplicability of the best interest duty) and in the case of transactions carried out as executiononly services (Article 25(4)). To the contrary, dealing on own account falls within the special rules for eligible counterparties only, while placement does not qualify for any of the two exemptions. [4.63] The rationale of such policy choice and the related implications are not entirely straightforward. One may wonder why placement of the investment firms’ own products on the primary market can take advantage of the execution-only regime, while this would not seem to be possible for secondary market transactions carried out on a principal basis as long as these qualify as dealing on own account. The opposite might rather be expected, as primary market transactions are normally riskier, for retail clients, than secondary market transactions (if only for lack of a market price). This contradiction would be partially solved if one adopted the

opinion mentioned above that dealing on own account is not subject to (most) conduct of business rules because it is an investment activity rather than an investment service, and is therefore not performed vis-à-vis any ‘client’. In this manner, dealing on own account would simply need no exemptions because it would fall outside the scope of application of the rules addressed by the exemption for execution-only services. However, the EU Commission’s reading of the MiFID I regime on the impossibility of distinguishing between investment activities performed with counterparties and investment services provided to clients makes this interpretation uncertain at best.96 [4.64] Other commentators submit instead that, despite the wording of Article 25(4), the execution-only regime includes cases where an investment firms executes client orders by dealing on its own account.97 As dealing on own account is not mentioned in the rule, this interpretation applies more easily to cases where dealing on own account and execution of client orders—which is explicitly exempted—are jointly performed. But it is hard to see how the execution-only regime could be extended to cases where dealing on own account is carried out at the initiative of clients without entailing an execution of order on their behalf: this is the case when clients request to buy or sell financial instruments ‘from the investment firm’.98 Yet, clients would seem to be more in need of protection when investment firms are executing orders on their behalf, because in that case investment firms’ discretion is broader. [4.65] Furthermore, it is not clear why placing of own products—that qualifies as order execution and is therefore eligible for the execution-only regime—is regarded as less risky than placing of other issuers’ products— which is not eligible instead. Again, one might expect the opposite, due to obvious inherent conflicts of interests. More generally, the scope of the exemption may be significant if one considers that a service is provided at the initiative of the client even if the client demands it on the basis of a promotion or an offer ‘that by its very nature is general and addressed to the public’ (Recital 85). In the light of this, a selling strategy where firms deliver informative brochures concerning their own products to clients after being asked whether they have some interesting securities on their shelves would seem to be compatible with the execution-only regime.

[4.66] In addition, and moving to the the third source of regulatory uncertainty, how much the new definition of order execution and the exemption regime will shape investment firms’ behaviour in the context of self-placement will also depend, in practice, on whether self-placement will be accompanied by personal recommendations. When this is the case, the relationship between investment firms and their clients switches from order execution to investment advice, and no exemption for execution-only services applies. But while differentiating investor-specific recommendations and pure sales is easy on the books, we have already seen how old and recent mis-selling scandals show that primary markets are often characterized by strong selling pressure concerning firms’ own products, so that investors cannot always tell advice from sales.99 Fee-free advice, which often accompanies self-placement, remains a key feature of many Member States’ financial markets.100 This persistent dominance may easily drift into mis-selling practices when generic recommendations not qualifying as investment advice are dropped to clients, thus increasing selling pressure outside the context of suitability-based protective rules. [4.67] The complex interaction between self-placement and the best interest duty justified an ad hoc joint statement by the Joint Committee of the three ESAs in July 2014, which echoes concerns that financial instruments qualifying as regulatory capital for prudential regulation under CRD/CRR IV and BRRD might be abusively sold to unaware investors even if inappropriate or unsuitable.101 The Joint Committee statement provides some further guidance on a sensitive area, for instance by restating that the suitability test should not focus on financial instruments in isolation but rather consider the importance of a balanced portfolio composition, as risk diversification represents a crucial issue in investor protection.102 Unfortunately, the statement falls short of delivering clear indications as to when self-placement encroaches upon investment advice, thus triggering the suitability test, and leaves questions on the extent of the best interest duty in this setting, as well as the ensuing litigation risk, unresolved. Against this backdrop, Article 41(4) Delegated Regulation relies on enhanced disclosure to protect investors, as it requires banks and investment firms offering own financial instruments that are included in the calculation of prudential requirements to clarify the differences between those instruments and bank deposits.

[4.68] Finally, how protective the new regime for self-placement will be also depends on the conflict-of-interests regime, which remains applicable both to execution-only services and to transactions with eligible counterparties and cannot therefore be escaped in the context of selfplacement (Articles 25(4)(d) and 30(1) MiFID II).103 In its consultation paper on the technical advice to be delivered to the Commission in view of the adoption of MiFID II Level 2 measures, ESMA stressed that selfplacement inevitably entails conflicts of interests for banks, and suggested that procedures adopted for their identification and management ‘may include consideration of refraining from engaging in the activity, where conflicts of interest cannot be appropriately managed so as to prevent any adverse effects on clients’.104 Upon the suggestion of the Securities and Markets Stakeholders Group, the requirement was strengthened in ESMA’s final technical advice, subsequently reflected by Article 41(2) Delegated Regulation, according to which investment firms’ procedures on conflicts of interest ‘must’ include the option of refraining from engaging in selfplacement.105 [4.69] How should these rules apply within the context of the executiononly regime, where firms operate as mere order-takers? A possible answer is that, if the issuing investment firm is simply informing its potential clients that its products are available for sale, rules on conflicts of interests still apply, but the firm should not be expected to refrain from selling the product as long as the client’s decision to purchase is taken autonomously (and is therefore not influenced by the firm’s conflicting interest).106

5. Dealing on Own Account [4.70] Extending fiduciary-style duties to dealing on own account is obviously an uncomfortable task. When firms are operating as principals, incentives to sell financial instruments they own at the best possible price are inherent to the very essence of the activity they perform, and charging them with protection of client’s best interest is problematic.107 In this case, the fiduciary duty to put the ‘best interest’ of clients first can hardly be

reconciled with the fiduciary duty that trading desk employees owe to their principals.108 [4.71] These contradictions have initially induced some national competent authorities to interpret MiFID I in the sense that its conduct of business rules do not apply when investment firms simply provide quotes and then deal with investors on the basis of such information: this would qualify as investment activity and not as investments service because no client (or no client order) exists.109 However, the same Commission opinion110 that ruled out the possibility to confine conduct of business rules to the provision of investment services to clients, with the exclusion of investment activities with mere contractual counterparties, militates against disapplication of MiFID II rules to provision of quotes (either continuously or in response to a request). In a similar vein, an ESMA Q&A document on CFDs111 stresses that conflicts of interest relevant for the MiFID I framework may also arise when investment firms execute orders on such financial instruments on the basis of quotes they provide. As a consequence, dealing on own account is always subject to conduct of business rules, including the client’s best interest rule.112 Some qualification should however be made for investment firms’ obligation to execute orders on terms most favourable to the client (best execution: Article 21 MiFID I and Article 27 MiFID II).113 Recital 103 Delegated Regulation (previously Recital 69 Directive 2006/73/EC) makes clear that best execution also applies when client orders are executed against proprietary capital,114 but it also points out that if a client simply accepts a quote provided by an investment firm that complies with the best execution duty, then the firm does not have to take further steps when executing the quote, unless this has become manifestly out of date under the new market conditions. Furthermore, MiFID II Recital 91 (former MiFID I Recital 33) specifies that best execution applies ‘where a firm owes contractual or agency obligations to the client’. The Commission has interpreted this statement in the sense that, when orders are executed against proprietary capital, investment firms are subject to the obligation to execute orders on the terms most favourable to the client only if they are operating ‘on behalf of the client’, as is the case when the decision to deal

on own account is taken by investment firms themselves, other alternatives being available.115 This narrow scope is accompanied by a presumption that best execution applies when the counterparties are retail clients, as these are more likely to rely on the firm to act in their best interests.116 However, this may be a weak safeguard when the relevant financial instruments are illiquid and the firm is the only available counterparty.117 To avoid regulatory loopholes, some scholars have submitted that in such cases the rule should be interpreted as mandating the adoption of a ‘fair price’ rule.118 The effect of this interpretation echoes the US FINRA Rule 2121 summarized above.119 [4.72] MiFID II appears also to be aware that some limitations to best execution are necessary in the context of proprietary trading. MiFID II Recital 93 specifies that the obligation to execute orders on terms most favourable to the client involve no duty to compare own execution policies and commissions or fees with those of other firms. As a consequence, investor protection in this scenario mainly relies on disclosure of execution policies under Article 25(4) MiFID II.

VI. A Look Across the Atlantic [4.73] Concerns on the extension of fiduciary-style duties to transactional relationships are not confined to the EU. In the US, a wide echo was triggered by the ABACUS case, where enforcement actions were brought for the violation of (trust-based) anti-fraud provisions in the context of a securitization transaction involving professional counterparties.120 [4.74] Conduct of business standards applicable to broker-dealers have also been troubling the US policy and scholarly debate in recent years. Here, the absence of clear-cut guiding criteria on the boundaries of incidental advice has paved the way to a broad interpretation of fiduciarystyle duties.121 In the US, broker-dealers may give advice without falling into the (more stringent) fiduciary standards set forth by the Investment Advisers Act (1940) if such advice is ‘solely incidental to the conduct of [their] business as a broker or a dealer’ and is not remunerated with any

‘special compensation’ (15 USC 80b-2(a)(11)(C)).122 However, an express or implied representation of fair dealing by brokers triggers application of Rule 10b-5, so that misrepresentation of the risk involved is regarded as a violation of the duty of fair dealing grounded on the ban on securities fraud (the so-called shingle theory).123 Although the theory is mostly invoked to enforce fair commercial practices in purely brokerage or dealing services,124 it also applies to investment recommendations made by brokerdealers on the basis that clients may legitimately rely on the broker-dealer’s implied representation that it had good reasons to believe the recommended investment was suitable.125 [4.75] The troublesome task of identifying the boundaries between pure salesmen’s activities and advice under EU law echoes the attempts to clarify similar questions in the US based on the shingle theory. In a similar vein, uncertainties in the interpretation of the MiFID II duty to act in accordance with the client’s best interest mirror the US debate on the applicability of fiduciary (or fiduciary-like) obligations to firms providing brokerage or dealing activities. The Dodd–Frank Act granted the SEC rulemaking powers on the broker-dealers’ duty of care, to be exercised after conducting an ad hoc study (Section 913). At the time of writing, the SEC has published a proposal (‘the 2011 SEC proposal’) to extend advisory-style fiduciary duties to broker-dealers providing advice,126 but no such regulation has been adopted to date. [4.76] Whether a broadened scope of fiduciary standards would actually strengthen protection of US investors vis-à-vis broker-dealers is debated, the doubts partially depending on uncertainties concerning the current scope of the duty of fair dealing for these firms.127 For instance, the duty of loyalty is normally more intense for advisers as per Section 206 of the Investment Advisers Act, as interpreted by the US Supreme Court,128 which entails a duty to eliminate or, if this is not possible, to declare any conflict of interest that can taint the provision of advice. The duty of care is better specified for broker-dealers when they provide implicit129 or explicit recommendations on a transaction or an investment strategy, as in these circumstances a suitability rule applies, as well as ‘know your customer’ and ‘know your security’ rules (FINRA Rule 2111).130

[4.77] Some of the arguments raised by US scholars and practitioners in favour of or against the 2011 SEC proposal are worth recalling because they may shed light on the complex role of fiduciary-style duties when these mandatorily apply to at arm’s-length services. For instance, an agency relationship only exists when the broker is representing its client while purchasing securities, rather than matching the order on a principal basis, hence performing an activity that goes beyond mere selling and involves professional skills in finding the desired investment; to the contrary, no such relationship can be construed when the firm is operating as a counterparty.131 In the latter scenario, stronger investor protection requires, normally, a finding of fraud. That finding, in turn, can be based either on the breach of the duties stemming from an implicit fiduciary relationship or on the shingle theory.132 However, both solutions are prone to high legal uncertainty, as no consolidated criteria can be identified in the relevant case law.133 [4.78] Against this backdrop, and in line with the nature of these activities, the SEC 2011 proposal does not purport to extend fiduciary duties to brokerage and dealing services which are provided without (explicit or implied) recommendations.134 By the same token, US courts may qualify brokers as fiduciaries on appropriate facts, such as when they act as agents while pursuing their customer’s mandate according to their discretion, but refrain from doing so when brokers are acting as mere ordertakers.135 [4.79] For similar reasons, no duty exists upon brokers to offer the best available securities, that is, the ‘most suitable ones’,136 even if they know that other cheaper products are available for sale on the market.137 Section 15(k) Securities Exchange Act—introduced by the Dodd–Frank Act Section 913(g)—enables the SEC to mandate that brokers and dealers, as well as investment advisers, act in the client’s best interest without regard to their financial or other interests, but only insofar as such broker-dealers are providing personalized investment advice about securities (either to a retail customer or to any other customers as the Commission may provide by rule).138 To the contrary, the same provision excludes that brokers and dealers have a continuing duty of care or loyalty to the customer after

providing personalized investment advice about securities. Most importantly, mere trading of proprietary products does not, as per an explicit provision, violate fiduciary standards the SEC may impose, if customers are duly informed of such limitation.139 [4.80] Although the provisions above restrict SEC’s rulemaking powers, the scope of the study commissioned by Section 913(b) of the Dodd–Frank Act is broader, as the Commission is enabled to formulate any other consideration it may deem necessary and appropriate.140 Fears were therefore voiced that the study could be a prelude to possible further additional legislation by Congress extending fiduciary duties to pure brokerage and dealing services.141 Among the drawbacks of this possible regime, commentators often mention the risk of market distortions. Increased compliance costs—so the opinion goes—may oust retail customers from the market for financial services,142 so that the reform may harm the group of investors it is supposed to protect.143 We do not purport to assess whether these fears are grounded, especially because they are partially based on the expectation that commission-based remuneration (i.e., inducements) may be restricted in the future,144 a measure not recommended by the SEC 2011 proposal. In the EU, indeed, commissionbased advice is also allowed.145 Although associated with reduced quality of recommendations,146 commission-based remuneration is also considered a way to ensure investors have cheap access to investment advice.147 [4.81] However, concerns for increased costs for retail investors as a consequence of tightened suitability standards have also been voiced in more general terms,148 and particular attention is devoted in the US debate to the duty to recommend the best suitable product in all circumstances.149

VII. Assessment [4.82] MiFID II confirms, in line with its predecessors, that investment firms shall act in accordance with their clients’ best interest. This overarching fiduciary-style duty is directly applicable to investment firms,

which may be held liable if they do not comply with this principle in their professional conduct. In the preceding sections, we have highlighted how the best interest rule set forth by the MiFID II regime applies across the board, encompassing situations where such a duty does not easily fit with the nature of the activities performed.150 Fiduciary-style duties are a wellgrounded regulatory tool to reduce the risk of opportunistic behaviour in long-term relationships, such as portfolio management and investment advice, characterized by information asymmetries, as they curb agents’ incentives to take advantage of their principals’ reduced ability to monitor agents’ performance.151 To the contrary, the fiduciary paradigm is hard to reconcile with the very nature of arm’s-length services. The ensuing divergence in the interpretation of Article 24(1) duties results in reduced legal certainty for investment firms and investors alike. [4.83] As we have seen, the best interest duty fits some investment firms’ activities so little that, under the current regime as interpreted by ESMA, some of these activities cannot be performed at all.152 In other words, the best interest rule acts as an indirect ban on some conduct. Whether such conduct is only high-risk from the clients’ perspective or is inherently abusive is key in understanding the impact of the overarching best interest duty on the market for investment services. The MiFID II/MiFIR system provides for a special product intervention regime with a view to tackling significant investor-protection concerns, but the best interest duty may achieve the same purpose by virtue of its broad scope and its inherent flexibility. [4.84] Yet, product intervention is subject to specific procedural requirements that ESMA and national competent authorities have to comply with in order to restrict or prohibit the sale of certain financial instruments or the performance of certain financial activities. For instance, national competent authorities have to notify all other fellow authorities—after consulting them if these are likely to be affected by the measure—one month (or twenty-four hours in the case of urgency) in advance of the planned restriction or prohibition. ESMA must also be notified, so that it can release a non-binding opinion on whether the measure is proportionate and non-discriminatory. Furthermore, evidence shall be provided that the conditions for the restriction or prohibition measure are met, including that

existing regulatory requirement under Union law would not suffice to address the relevant regulatory concerns (Article 42 MiFIR). For measures taken by ESMA, Article 9(5) Regulation (EU) No 1095/2010 applies, so that restrictions and prohibitions must be reviewed at least every three months and expire otherwise (Article 40 MiFIR). [4.85] In light of these burdensome procedural rules, supervisors may be inclined to address investor-protection concerns by exploiting the catch-all provision on clients’ best interests. Stretching the best interest duty can indeed curb excessive risk-taking by retail clients even in the absence of a clear abuse by investment firms acting as mere contractual counterparties. Whether this is the best tool to implement a paternalistic supervisory policy agenda—which we do not question here—is, however, debatable. Some overlap between strict supervision and the straight ban of practices that jeopardize investor protection is probably unavoidable, as demonstrated by the requirement that product intervention measures may only be taken, at national and EU level, insofar as the enforcement of existing requirements would not adequately address regulatory concerns such as a threat to investor protection (Articles 40(2)(c) and 42(2)(b) MiFIR). [4.86] Take, for example, the ESMA Q&A document on CFDs.153 ESMA holds that unhedged execution of retail client orders concerning certain complex financial instruments would inevitably breach the best interest duty and should therefore be avoided. The conclusion is based on the economic incentives in arm’s-length transactions, as any increase in the investment firms’ returns is mirrored by a corresponding disadvantage for their clients. However, the complexity of the product—combined with asymmetric information vis-à-vis retail clients—seems to be the actual determinant of the threat to investor protection in this case. The Q&A document therefore relies on the uneasy relationship between the best interest duty and purely transactional relationships to protect retail investors from the risk of being mis-sold high-risk products. A regulatory strategy such as that makes the boundaries of dealers’ legitimate market practices highly uncertain. Contractual counterparties’ interests naturally diverge in any transaction carried out on a principal basis, and situations where investment firms’ and clients’ profits are inversely correlated are not exclusive to complex derivative instruments or to retail clients. Hence,

market participants may not be in a condition to assess when arm’s-length transactions violate the best interest duty and when they do not. [4.87] A sceptical observer may stress that the expansion of quasifiduciary duties to cover arm’s-length services tilts towards indulging investors—strikingly, no matter whether retail or professional, the only exception being eligible counterparties—at the risk of going along with misguided or biased perceptions of an investment firm’s role. Paving the way to redress for breach of fiduciary-style duties when no portfolio or investment advice relationship is established entails the risk of facilitating investors’ actions to obtain restoration for wrong investments even in the absence of any investment firm’s wrongdoing.154 Such a strategy may lure policymakers because investors and the public at large have full perception of individual investors’ losses triggered by major defaults or resolutions, while the increased costs for all investors under the form of higher commissions stemming from undeserved redress normally go unnoticed. [4.88] At the same time, broad principles setting fiduciary-style duties are a key tool for effective enforcement in critical situations where detailed rules of conduct leave loopholes that investment firms can exploit to the detriment of their clients. MiFID II rules of conduct are not immune to this risk, as the previous analysis demonstrates. Broad principles such as the best interest duty and its companion standards play an important role in ensuring a reasonable regulatory equilibrium. To avoid the risk that invoking general standards may lead to over-enforcement, fiduciary-style obligations need to be interpreted in a flexible manner,155 and in the light of the nature of the service provided.156 While increased protection of clients’ best interest makes perfect sense when a fiduciary relationship between clients and investment firms combines with personalized recommendations of firms’ own products, purely transactional relationships taking place in the context of own-account dealing do not warrant such intense protections. In this second scenario, the best interest duty is sometimes implemented, at national level, as a requirement that investment firms pay due regard to their clients’ interests, rather than focusing exclusively on them.157 The MiFID II principle that firms shall act ‘in accordance with’ the client’s best interest would seem flexible enough to be compatible with such

interpretation, when the very nature of the relationship between firms and their clients has no fiduciary component. [4.89] Besides being directly applicable, the best interest duty is further specified by more detailed provisions within the body of MiFID II, including rules concerning the management of conflicts of interest and inducements, best execution, and suitability or appropriateness of financial instruments and investment services. The combination of detailed provisions setting out conduct of business rules and of more general standards of behaviour has many advantages, as it can ensure that firms are subject to a regime that is clear and, at the same time, flexible enough to address ex post shortcomings that the lawmaker cannot possibly predict because of limited rationality in forecasting future states of the world.158 However, this regulatory technique requires careful coordination between rules and standards at the enforcement stage, in order to avoid conflicts and suboptimal outcomes.159 [4.90] A crucial factor to make sure that the duet between rules and standards is harmonious is regulatory consistency. MiFID II, just like its predecessor,160 falls short of clarifying how the two regulatory layers interact. This lack of clarity seems to be the result of an unresolved tension between two different approaches. The first approach reflects the idea, which has gained traction in recent decades,161 that parties should be able to deviate from general standards of conduct, as private-ordering solutions are able to reduce or to better address contractual incompleteness.162 The second approach relies instead more heavily on mandatory rules, on the assumption that deviations from the law may deliver undesirable results both for individual investors and in terms of social welfare. [4.91] Inherent to the first approach is the qualification of conduct of business rules as default provisions whose compliance costs may not always be justified. When compliance costs exceed the corresponding benefits, opting out of those rules may occasionally produce a net benefit that may accrue to one party only or be allocated through bargaining. Clearly representative of this philosophy are MiFID II rules on investment suitability and appropriateness, as they modulate the intensity of investor protection on the basis of the service provided. 163 Relevant elements of

mandatory law—attributable to the second regulatory approach—remain to maintain higher protection in favour of a core subset of ‘weaker’ retail investors that cannot be classified as professional even upon request:164 for them, the risk that investment firms will take advantage of investors’ overconfidence (false negatives) is considered higher than the risk of imposing an excessive regulatory burden in some cases (false positives).165 However, MiFID II allows166 contracting parties, including weaker retail clients, to deviate from some core specific conduct of business rules when investment firms are operating within the execution-only regime, that is, as mere order-takers to the benefit of customers that are only looking for execution services at a low cost. Here, the first regulatory approach prevails and enables significant deviations from core specific conduct of business rules: among these, only conflict-of-interest provisions remain in place for execution-only services (Article 25(4)(d) MiFID II). More precisely, disclosure is the principal—though not exclusive—safeguard addressing possible organizational and administrative ineffectiveness in managing alien interests.167 In such circumstances, the duty to take all reasonable steps to obtain the best possible result in the execution of clients’ orders (Article 27 MiFID II) buttresses investment firms’ duty of care in the provision of the trading service, while no explicit obligation exists to ensure that the traded financial instruments are appropriate for the ordering customer. [4.92] Therefore, with the qualifications outlined above, specific conduct of business rules are optional, the parties being allowed to tailor the level of protection for the client. To the contrary, the second regulatory approach seems to prevail for more general standards. As a consequence, the overarching duty to pursue the client’s best interest, on one hand, and specific conduct of business rules, on the other, are the expression of divergent and potentially conflicting approaches.168 The general standards set forth in Article 24(1) MiFID II are indeed applicable even in cases where some of their main specifications, such as the suitability/appropriateness test, are waived.169 This second regulatory approach reflects the understanding that mandatory standards of behaviour aimed at protecting investors are needed to curb the risk that individual

choices impair market integrity (one of MiFID II’s underlying regulatory objectives).170 [4.93] Yet, once again, uncertainties remain. In particular, it is unclear how firms can comply with the general principle to act in the client’s best interest when they are explicitly exempted from applying rules that are best understood as a specification thereof.171 Investment firms performing execution-only sales services, and thus enabled not to collect information on customers’ features, cannot of course pursue their clients’ best interests in the same way as when such information is available to them.172

1

See also ECJ, C-604/11, Genil, 30 May 2013, § 57 (principles of equivalence and effectiveness bind Member States in the determination of private-law consequences of MiFID I violations). 2 J. Benjamin, Financial Law (Oxford: OUP, 2007), 556–7. 3 ibid 558. 4 The ‘sole interest’ standard prevents transactions that may be in the clients’ interests, as well, as long as the fiduciary also takes a benefit out of them and irrespective of any detriment to the beneficiary; this is not the case with the ‘best interest’ standard, where clients may not reject transactions that satisfied their needs in the best possible manner; see T. Frankel, Fiduciary Law (Oxford: OUP, 2011) 149–52. 5 L. D. Smith, ‘Can We Be Obliged to Be Selfless?’ in A. S. Gold and P. B. Miller (eds) Philosophical Foundations of Fiduciary Law (Oxford: OUP, 2014), pp. 143–58 (fiduciary duty is a requirement to exercise judgement in what the fiduciary perceives to be the best interests of the beneficiaries). 6 A. Hudson, The Law of Finance (2nd edn, London: Sweet & Maxwell, 2013), pp. 299– 300. 7 J. Black, Rules and Regulators (Oxford: OUP, 1997), pp. 140–3, 146, 149, 152. 8 SIB, Core Conduct of Business Rules, Core Rule 17. 9 N. Moloney, How to Protect Investors. Lessons from the EC and the UK (Cambridge: CUP, 2010), p. 268. 10 Black (n. 7), 176. 11 SIB, Core Conduct of Business Rules, Core Rule 21. 12 J.-P. Casey and K. Lannoo, The MiFID Revolution (Cambridge: CUP, 2009), pp. 58– 60. 13 For a description see Moloney (n. 9), 268; G. McMeel, ‘Agency and the Retail Distribution of Financial Products’ in D. Busch et al. (eds) Agency Law in Commercial

Practice (Oxford: OUP, 2016), pp. 182–3. 14 See n. 157 and accompanying text. 15 UK FCA Principles for Business, Principle 6. 16 G. Ferrarini, ‘Towards a European Law of Investment Services and Institutions’ (1994) Common Market Law Review 31, 1283, 1304; M. Tison, ‘Conduct of Business Rules and their Implementation in the EU Member States’ in G. Ferrarini et al. (eds) Capital Markets in the Age of the Euro (Oxford: OUP, 2002), p. 68. 17 IOSCO, International Conduct of Business Principles (1990) Principle 2. The 2003 IOSCO Objectives and Principles of Securities Regulation (at 36) specified that firms should ‘observe high standards of integrity and fair dealing and should act with due care and diligence in the best interests of [their] customers’ in the comment to Principle 12, which required market intermediaries to comply with standards for operational conduct that aim to protect the interests of clients; see now Principle 31 IOSCO Objectives and Principles of Securities Regulation (2010). 18 Furthermore, the same Recital 71, second para., refers to the duty to act ‘in the interest of the client’ as a perfect substitute of the duty to act ‘in accordance with’ the same interest referred to in the first para. 19 Casey and Lannoo (n. 12), 46. 20 Eligible counterparties may ask to be treated according to the ordinary investor protection regime (Article 30(2)). 21 Of course the general Article 24(1) duties and their corollaries will continue to apply between members and participants of trading venues on one hand, and their respective clients whose orders are transmitted to the trading venue on the other (Articles 19(4) and 53(4) MiFID II). Note also that Article 24(1) applies, instead, to organized trading facilities (OTFs), which match orders on a discretionary basis (Article 20(6)). 22 German law has also traditionally mandated agents in a contract concluded on a commission basis (Kommissionvertrag) to protect the principal’s interest and to deliver him any asset obtained in the execution of the business commissioned (P. Mülbert, ‘The Eclipse of Contract Law in the Investment Firm–Client Relationship: The Impact of the MiFID on the Law of Contract from a German Perspective’ in G. Ferrarini and E. Wymeersch (eds) Investor Protection in Europe (Oxford: OUP, 2006), p. 300). 23 Benjamin (n. 2), 568, 573 (fairness to consumers does not originate in English case law and is inherently unclear and historically alien to English law). 24 With specific reference to conflict of interests rules, see L. Enriques, ‘Conflicts of Interests in Investment Services: The Price and Uncertain Impact of MiFID’s Regulatory Framework’ in G. Ferrarini and E. Wymeersch (eds) (n. 22), 326 (complying with the specific conflict-of-interest rules will never be enough for firms, as these will always have to ensure that their clients are treated in accordance with their best interests). 25 Moloney (n. 9), 218. 26 See e.g., for Italy, F. Parrella, ‘Consulenza in materia di investimenti’ in R. D’Apice (ed.) L’attuazione della MiFID in Italia (Bologna: Il Mulino, 2010), p. 191 (no specific

rule requires investment firms to recommend the most suitable product). 27 See G. Rubin, ‘Advisers and the Fiduciary Duty Debate’ (2015) Business and Society Review 120, 519–20. 28 For instance, Consob requires investment firms to compare different financial instruments and to recommend the best available option when advice is spontaneously given with a view to dissuading investors from placing an order (see Consob Comm. No 9019104 (2 March 2009)). 29 See FSA, Reforming Conduct of Business Regulation (Consultation Paper 06/19) (2006), 77 (an explicit obligation for advisers to recommend the ‘most suitable’ packaged product from the prescribed range on which they advise would go beyond MiFID I, but the combination of other MiFID I rules, including the obligation to act in the best interests of the client, and the suitability test, reaches the same outcome); this view was subsequently confirmed in FSA, Reforming Conduct of Business Regulation (Policy Statement 07/06) (2007), 50. 30 Benjamin (n. 2), 579 (arm’s-length approach ensures effectiveness of risk-transfer function of financial markets, but it might not be viable when retail investors face hardship in bear markets). 31 Moloney (n. 9), 199, 256–63. 32 Pre-packaged financial products are widespread among investors in the UK (ibid, 210). 33 ESMA’s Committee for Economic and Markets Analysis (CEMA), Economic Report: Retailisation in the EU (ESMA/2013/326) (2013) (performance of structured products with 100% capital protection is relatively low when compared to risk-free investments). 34 ESMA, MiFID practices for firms selling complex products (ESMA/2014/146) (2014) 2. 35 ibid 5. 36 Consob, Comm. No 97966 (22 December 2014). 37 The expression ‘regulatory contract law’ describes the increasingly pervasive role of lawmakers and authorities in defining mandatory contractual provisions and in ensuring their enforcement when contractual remedies prove insufficient (J. Köndgen, ‘Policy Responses to Credit Crisis: Does the Law of Contract Provide an Answer?’ in S. Grundmann and Y. Atamer (eds) Financial Services, Financial Crisis and General European Contract Law. Failure and Challenges of Contracting (Alphen aan den Rijn: Kluwer Law International, 2011), pp. 39–40). 38 M. Kruithof, ‘A Differentiated Approach to Client Protection: The Example of MiFID’ in Grundmann and Atamer (eds) (n. 37), 147 f. 39 Smith (n. 5), 148 (advisory services, just like portfolio management, belong to fiduciary relationships). 40 Hudson (n. 6), 299. 41 S. M. Davidoff Solomon et al., ‘The SEC v Goldman Sachs: Reputation, Trust, and Fiduciary Duties in Investment Banking’ (2012) Journal of Corporation Law 37, 529,

550–1 (explaining the reasons why mandating fiduciary duties in the context of arm’slength transactions may be inefficient and submitting that this may hold true, to some extent, even when retail investors are involved). 42 Black (n. 7), 141; A. M. Pacces, ‘Financial Intermediation in the Securities Markets: Law and Economics of Conduct of Business Regulation’ (2000) International Review of Law & Economics 20, 478, 484. 43 Articles 43 ff. Directive 2014/59/UE (BRRD); Article 27 Reg. (EU) No 806/2014 (SRM). 44 This is typically the case with Italy, see e.g. ESME, Non-Equity Market Transparency (2007), 10 (bonds comprise 22.4% of total financial assets for Italian retail investors— compared with 1.5% in the UK and 6.9% in the US—and are often held directly). Other countries with significant direct participation in bond markets are Germany and Belgium, while figures are lower for France: CEPR, European Corporate Bond Markets: transparency, liquidity, efficiency (2006), 32. 45 ESMA (n. 34), 3. More explicitly ESMA, Guidelines on complex debt instruments and structured deposits (ESMA/2015/1783) (2015), 21, 32. 46 Consob, Comm. No 97996/14 (22 December 2014) (subordinated debt not listed among complex financial products). 47 See ECJ Genil (n. 1), §§ 51–5. 48 See EU Commission, ‘Investment advice’—meaning of ‘personal recommendation’, Your Questions on Legislation, Question 158 (p. 335). 49 The question remains whether firms may be required, under the general Article 24(1) duties, to warn investors if non-personalized advice is given (Moloney (n. 9), 204). 50 Recently ESMA, MiFID Suitability Requirements. Peer Review Report (ESMA/2016/584) (2016) 7–8 (national competent authorities are often trying to clarify the boundary between information and advice); see also McMeel (n. 13), 184 (reporting UK case law were banks’ liability has been excluded on the basis that they did not cross the dividing line between giving information on, and selling, a product, on one hand, and the activity of giving advice on the other). 51 For instance, in the UK investment advice not involving personal recommendations is still subject to the best interest duty in COBS Rule 2.1.1R (FCA, Retail Investment Advice. Finalized Guidance (FG15/1) (2015) 11), but this apparently reduces legal certainty for investment firms. 52 See FCA, Financial Advice Market Review. Final report (2016), 28–32 (considering a MiFID-like definition of advice as preferable to that provided by Article 53 Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, which includes generic advice, and suggesting adopting MiFID I definition to reduce legal risk. Remarkably, the analysis does not take into account the effects of Recital 81–83 Directive 2006/73/EC on the scope of application of investment advice). 53 ibid.

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FCA (n. 52), 7; see also Chapter 6 in this volume [p. 3 working paper] (households normally expect advice to be provided for free). 55 FCA COBS 6.1A.4. See EU Commission, MiFID Transposition state of play, Notification 6, at (reporting on the reasons for ‘banning retail investment product providers from offering predetermined amounts of commission to UK adviser firms, in relation to the recommendation of their products’); see also Moloney (n. 9), 210–11. 56 FSA, Distribution of Retail Investments: Delivering the RDR (CP 09/18) (2009), 19. 57 Davidoff Solomon et al. (n. 41), 542. 58 Consob, Prime linee di indirizzo in tema di consulenza in materia di investimenti [Preliminary guidelines on financial advice] (2007) 4; Consob, Comm. No 9019104 (n. 28), 8–9. 59 Smith (n. 5), 150. 60 R. H. Sitkoff, ‘The Economic Structure of Fiduciary Law’ (2011) Boston University Law Review 91, 1039, 1041 (incentive-based compensation arrangements normally used to reduce—although not eliminate—agency problems). 61 SEC, Study on Investment Advisers and Broker-Dealers (2011), 10–11. 62 In fiduciary relationships, misappropriation infringes the duty of loyalty (Sitkoff (n. 60), 1043). 63 Sitkoff (n. 60), 1048; J. Getzler, ‘Financial Crisis and the Decline of Fiduciary Law’ in N. Morris and D. Vines (eds) Capital Failure (Oxford: OUP, 2014), p. 199. 64 J. Campbell et al., ‘The Regulation of Consumer Financial Products: An Introductory Essay with Four Case Studies’ HKS Faculty Research Working Paper Series RWP10-040 (2010) 16; T. L. Hazen, ‘Are Existing Stock Broker Standards Sufficient?: Principles, Rules and Fiduciary Duties’ (2010) Columbia Business Law Review 709, 731. Lack of disclosure of excessive mark-ups is also considered a violation of antifraud provisions: L. Loss et al, Fundamentals of Securities Regulation (Alphen aan den Rijn: Wolters Kluwer, 2011), pp. 1420–31. See also A. F. Tuch, ‘Conduct of Business regulation’ in N. Moloney, E. Ferran, and J. Payne (eds) Handbook of Financial Regulation (Oxford: OUP, 2015), p. 551 (FINRA ‘catch-all’ Rule 2010 allows policing maintenance of ‘high standards of commercial honor’ and ‘just and equitable principles of trade’ by broker-dealer); J. J. Park, ‘The Competing Paradigms of Securities Regulation’ (2007) Duke Law Journal 57, 625, 646, 649 (FINRA Rule 2010—former NASD Rule 2110—provided the legal basis for principle-based enforcement against kickbacks in the IPO allocation process). 65 See FINRA Rule 2121. Fair Prices and Commissions (dealers shall buy or sell at a price which is fair, taking into consideration all relevant circumstances; a similar provision applies to commissions charged by brokers. Commissions exceeding 5% of market prices are in principle regarded as excessive, but in the case of low-priced securities a slightly higher percentage may be justified). See also Lehl v SEC, 90 F.3d 1483, 1488 (5% benchmark calculated by NASD, now FINRA, on the basis of practices adopted by the majority of broker-dealers). A similar provision also existed in the UK in the past but was

subsequently repealed. See G. McMeel, ‘Standards of Conduct for Investment Advice, Stockbroking, and Portfolio Management’ in G. McMeel and J. Virgo (eds) McMeel and Virgo on Financial Advice and Financial Products (Oxford: OUP, 2014) 333 (reporting that the FSA, which had the power to prevent investment firms from excessively charging their clients under the old COB Rule 5.6, had never used such power). 66 See ESMA, Questions and Answers relating to the provision of CFDs and other speculative products to retail investors under MiFID (ESMA/2016/590) (2016) 18, 20. 67 C. Kumpan and P. Leyens, ‘Conflicts of Interest of Financial Intermediaries’ (2008) European Company and Financial Law Review 5, 72, 79. See also Chapter 7 in this volume (Section§ A.I.1) (only situations where a position of influence is entrusted to the counterparty and accompanied by a consideration are relevant for MiFID I and II regime on conflicts of interest). 68 For further specifications see ESMA, Structured Retail Products: Good practices for product governance arrangements (ESMA/2014/332) (2014). 69 Article 16(3) requires identification of a target market of end clients and consideration of all risks relevant to such a target when manufacturing financial instruments; the distribution strategy shall be coherent with the target, too. Article 24(2) reinforces this duty by ensuring that manufacturing and distribution of financial instruments meet the target market’s needs. 70 Article 16(3) para. 7 MiFID II clarifies that rules on product manufacturing and distribution apply without prejudice to requirements concerning appropriateness. See also N. Moloney, EU Securities and Financial Markets Regulation (3rd edn, Oxford: OUP, 2014), p. 800. 71 ESMA (n. 34), 3. 72 For a summary of national measures see Moloney (n. 70), 825–6. 73 Consob, Comm. 97966, 22 December 2014, 5 (also establishing some specific procedural guarantees if such complex products are sold notwithstanding Consob’s recommendation. Among the complex products to which the recommendation applies are asset-backed securities (ABS), CoCo bonds, financial instruments qualifying as additional tier 1 capital as per Article 52 Reg. (EU) No. 575/2013 (CRR), credit linked notes, and derivatives not negotiated in a trading venue and not held for hedging purposes). 74 See Section VII. 75 For Italy see Consob, Comm. DAL/RM/96011036, 11 December 1996; Consob, Del. No DIN/58349, 29 July 2000; see also Consob, Del. No 18696, 12 November 2013 (Del. No DIN/58349 still applicable). In the UK, an appropriateness test is required to nonMiFID firms that arrange or deal in relation to certain financial instruments (such as nonlisted securities or derivatives) with retail clients, to the extent that the client order is in response to a promotion (FCA Conduct of Business Sourcebook (COBS) R.10.1.2; FSA (n. 29), 85). 76 D. Busch, ‘Agency and Principal Dealing under the Markets in Financial Instruments Directive’ in D. Busch et al. (eds) (n. 13), 142, 146, 151.

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For other entities, an exemption could be found in Article 2(1)(d) MiFID I, which excluded from the Directive’s scope of application persons exclusively acting as dealers on own account. See now Article 2(1)(d)(iv) (restricting the same exemption to cases where dealing on own account is not performed when executing client orders; see n. 93 and accompanying text). 78 In Italy, banks and insurance companies are subject to MiFID I conduct of business rules when placing own financial products (Article 25-II Consolidated Law on Finance). 79 EU Commission, Credit institutions. Application of MiFID, Your Questions on Legislation, Question 230 (p. 420). 80 CESR, Responses to EU Commission Questions on MiFID Review (CESR/10-860) (2010) 3. 81 ibid 2–3. 82 ibid 2. 83 C. Comporti, ‘La sollecitazione all’investimento’ in A. Patroni Griffi et al. (eds) Intermediari finanziari, mercati e società quotate (Turin: Giappichelli, 1999), p. 551; R. F. Schiavelli, ‘Il contratto di collocamento’ in E. Gabrielli and R. Lener (eds) I contratti del mercato finanziario (Turin: UTET, 2004), pp. 1003–4. 84 EU Commission, Fund management. UCITS—characterisation of investment service, Your Questions on Legislation, Question 92 (p. 259); EU Commission, Fund management. Investment services—application to distribution of units in collective investment undertaking, Question 96 (p. 263). 85 ESMA, Consultation Paper. MiFID II/MiFIR (ESMA/2014/549) (2014) 77 (on ensuing conflicts of interests). For Italy see Consob, Comm. No 9019104 (n. 28), 3 (placing of financial products shall also be performed in the client’s interests). 86 CESR (n. 80), 2. 87 See Busch (n. 76), 172. 88 See Moloney (n. 70), 344, 799. 89 In the MiFID I framework, the focus by some rules on client orders was sometimes understood in the sense that such rules did not apply when client orders were matched by dealers’ own positions (CESR (n. 80), 3). 90 See Chapter 2 in this volume [p. 2 of the working paper]. 91 See Chapter 2 ibid [p. 3 of the working paper]. See also I. MacNeil, An Introduction to the Law on Financial Investment (2nd edn, Oxford: Hart Publishing, 2012), p. 463 (appropriateness test applies to arm’s-length transactions as well, although legal presumptions reduce the regulatory burden when investment firms are dealing with professional clients). 92 See MiFID II, Article 24, Sections (1), (2), (4), (5), (6), (9), (10), and (11) on general principles; Article 25, Sections (1), (2), (3), (4), and (7) on the appropriateness test; Article 29(3) on tied agents. 93 EU Commission, Answers to CESR scope issues under MiFID and the implementing directive (Working Document ESC-07-2007) (2007). See also P. Nelson, Capital Markets

Law and Compliance, The Implications of MiFID (Cambridge: CUP, 2008), p. 228–9 (FSA initially excluded application of MiFID I to ‘non-clients’, which was clearly not the intention of MiFID I, and later on tried to stress that in some circumstances client orders are missing, but the EU Commission ‘killed the argument’). See also R. Kent et al. ‘Conduct of Business’ in R. Fox and B. Kingsley (eds) A Practitioner’s Guide to the UK Financial Services Rulebook (London: Sweet & Maxwell, 2013), pp. 218–19 (EU Commission’s restrictive position on the possibility to exclude investor protection on the basis that no client relationship exists suggests erring on the side of caution when excluding that a counterparty qualifies as a ‘client’). 94 See also Kruithof (n. 38), 142–4 (in MiFID I regime, arm’s-length transactions between eligible counterparties are regarded as services even if this would not be the case in day-to-day language, so that such transactions are subject to MiFID I conduct of business rules unless these are explicitly made inapplicable). 95 At the same time, exemptions from application of conduct of business rules for dealing on own account with eligible counterparties can only make sense if such rules would otherwise be applicable (Article 30). See however Busch (n. 76), 151, 153 f., 159 (dealing on own account not performed vis-à-vis clients, hence not subject to client classification duties and to conduct of business rules—with the possible exception of fair dealing—including on conflict of interests). 96 See n. 93 and accompanying text. 97 A. Srivastava, ‘Conduct of Business Standards: Fair Dealing with Clients’ in J. Herbst (ed.) A Practitioner’s Guide to MiFID II (2nd edn, London: Sweet & Maxwell, 2015), p. 158. 98 EU Commission (n. 93), § 7. 99 See also Chapter 6 [p. 3 and 8 working paper] (distinguishing between actual advice and ‘cheap talk’ where advice is simply mimicked, possibly to promote own products, is difficult). 100 Moloney (n. 9), 259–61. 101 ESAs Joint Committee, Placement of financial instruments with depositors, retail investors and policy holders (‘Self placement’) (JC 2014 62) (2014). 102 ibid 8–9. 103 See Moloney (n. 70), 353. 104 ESMA (n. 85), 82–3 and 86. 105 ESMA (n. 50), 86 (‘may’ replaced with ‘must’). 106 This approach would be similar to that adopted by the EU Commission on best execution (n. 115 and accompanying text). 107 SEC (n. 61), (‘engaging in principal trading with customers or clients represents a clear conflict for any fiduciary’); A. B. Laby, ‘Reforming the Regulation of Broker-Dealers and Investment Advisers’ (2010) Business Lawyer 65, 395, 425 (profit-driven motive behind principal trading runs counter to traditional fiduciary notions); Busch (n. 76), 142.

108

See S. W. Simon, reported by Rubin (n. 27), 536: ‘That’s an inherent conflict of interests that no serious-minded person well-versed in these issues can ‘harmonize’ in any way’. See also SEC (n. 61) (acknowledging that principal trading brings to inextricable contradictions with the best interest duty, as ‘engaging in principal trading with customers or clients represents a clear conflict for any fiduciary’). 109 UK FSA, Implementing MiFID’s Client Classification Requirements (2006), 20–3. The UK FSA original position on best execution reflected its original interpretation on client classification: UK FSA, Reforming Conduct of Business Regulation (2006), 94. For further analysis see G. Ferrarini, ‘Best Execution and Competition Between Trading Venues: MiFID’s Likely Impact’ (2007) Capital Markets Law Journal 2, 404, 411–13. 110 See n. 93 and accompanying text. 111 ESMA (n. 66), 20. 112 EU Commission (n. 93), Issue 1, § 3. See also EU Commission, Review of the Markets in Financial Instruments Directive (MiFID), 8 December 2010, 64 f. 113 Namely, investment firms shall endeavour to obtain the best possible result for their clients taking into account, inter alia, price, costs, speed, likelihood of execution and settlement, size, and nature of the order. For retail customers, investment firms shall take into account the total consideration required for executing the order. 114 According to the Recital, ‘dealing on own account with clients by an investment firm should be considered as the execution of client orders, and therefore subject to […] obligations in relation to best execution’. 115 EU Commission (n. 93), Issue 1, § 6. For a more detailed analysis see Nelson (n. 93), 393 ff. 116 EU Commission (n. 93), Issue 1, § 9. 117 Consob Comm. No 9019104 (n. 28), 2–3. 118 Casey and Lannoo (n. 12), 72. 119 See n. 65 and accompanying text. 120 See Davidoff Solomon et al. (n. 41), 535–42. 121 D. C. Langevoort, ‘Brokers as Fiduciaries’ (2010) University of Pittsburgh Law Review 71, 439, 444. 122 Tuch (n. 64), 548. 123 A. Marcacci, ‘The US Suitability Rule and Fiduciary Duty and Their EU “StepSister”’ (2014–15) Consumer Finance Law Quarterly Report 68, 234, 236. 124 Loss et al. (n. 64), 1422–3. 125 R. Karmel, ‘Is the Shingle Theory Dead?’ (1995) Washington and Lee Law Review 52, 1271, at 1276. 126 SEC (n. 61), (proposing a ‘uniform fiduciary standard’ for advisers and brokerdealers providing personalized investment advice). 127 For a general description see Tuch (n. 64), 549–52. 128 SEC v Capital Gains Research Bureau, Inc., 375 US 180 (1963).

129

Implicit recommendations to hold securities are not covered by the definition of advice (FINRA Rule 2111 (Suitability) FAQ). 130 Relaxation is allowed when recommendations are addressed to institutional investors (FINRA Rule 2111(2)). 131 A. D. Madison, ‘Derivatives Regulation in the Context of the Shingle Theory’ (1999) Columbia Business Law Review 271, at 279: Langevoort (n. 121), 444 (pure sales of securities by brokerage firms might involve a high degree of trust, but this does not necessarily go along with a legal ‘fiduciarization’ of the relationship). 132 J. D. Cox et al., Securities Regulation. Cases and Materials (6th edn, New York: Wolters Kluwer, 2009) 1027–30. 133 ibid. See also Tuch (n. 64), 549 (‘no clear consensus exists as to when broker-dealers owe fiduciary duties’). 134 Langevoort (n. 121), 444 n. 21. 135 Hazen (n. 64), ,735–7, 741–3, 746–7 (with respect to non-discretionary accounts, the brokers’ duty is limited to proper execution of transactions. Upon completion of the trade, brokers acing upon a customer’s order do not have further duties to call upon their professional skills concerning the wisdom of customers’ trades). 136 See Rubin (n. 27), 536 (‘broker-dealers, unlike [investment advisers], have an obligation to serve their firm’s interest ahead of those of the customers’). 137 Langevoort (n. 121), 445. 138 Section 211(g) Investment Advisers Act (1940) sets a similar restriction. 139 See also Section 206(3) Investment Advisers Act (1940) (acting as principals for their own account is unlawful for investment advisers if they do not disclose in writing such capacity and obtain the client’s consent. This prohibition does not apply to brokerdealers that are not acting as an investment adviser in relation to the relevant transaction). 140 Furthermore, Section 913(f) of the Dodd–Frank Act, which also contains rulemaking provisions in favour of the SEC, is slightly broader in its scope (A. B. Laby, ‘Implementing Regulatory Harmonization at the SEC’ (2010–11) Rev. Banking & Fin. L. 30, 189, 193). The SEC is more likely to rely on Section 913(g) as this provides a more solid background to its rulemaking authority (ibid, 194). 141 Laby (n. 140), 190–1. 142 The matter is debated: compare e.g. M. S. Finke and T. S. Langdon, ‘The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice’ (2012) Journal of Financial Planning 25, 28 (finding no evidence that heightened fiduciary duties would harm small investors) with Langevoort (n. 121), 445 (except in the true fee-based account, commissions and mark-ups pay for the advice customers receive when remuneration is not fee-based; threatening such revenue stream may freeze customers out of any but the lowest-cost brokerage services). 143 Confusion on the different rules applicable to broker-dealers and to advisers is one of the driving factors behind the SEC reform proposal (SEC (n. 61), 94).

144

Rubin (n. 27), 531 (reporting industry’s concerns that the SEC study may be the first step of a longer series of regulatory acts tightening rules applicable to broker-dealers, including those on remuneration). Commission-based remuneration is explicitly allowed by Section 15(k) Securities Exchange Act (commission-based remuneration shall not, in and of itself, represent a violation of fiduciary standards that might be made applicable by the SEC if broker-dealers provide such recommendations). 145 Yet restrictions on inducements may narrow down its scope in the future: see the concerns expressed by ESMA Securities and Markets Stakeholder Group, Investor Protection Aspects of the Consultation Paper on MiFID II and MiFIR (ESMA/2014/SMSG/035) (2014), 15–18. 146 Moloney (n. 9), 257–62; Tuch (n. 64), 553. 147 At the same time, some scholars notice that fee-based advice is no panacea: see Langevoort (n. 121), 449 (‘sufficiently gullible investors would end up paying too much in advisory fees, unless those, too, were regulated’). The fact remains, of course, that high fees are more observable than inducements and other indirect fees, no matter how transparent these are thanks to regulation. 148 This risk was also pointed out in a dissenting opinion by two SEC Commissioners: see K. L. Casey and T. A. Paredes, Statement Regarding Study on Investment Advisers and Broker-Dealers, 21 January 2011. 149 Rubin (n. 27). 150 For a different opinion see, however, Busch (n. 76) (considering purely transactional activities outside the scope of MiFID II investor-protection regime, but suggesting a more homogeneous regulation). 151 Sitkoff (n. 60), 1042–5. 152 This may be the case with complex products that cannot meet the best interests of their clients or the risk of which cannot be assessed for lack of sufficient information (n. 71 and accompanying text); similarly, investment firms selling CFDs or other complex derivative financial instruments would breach their (retail) clients’ best interest unless they hedge, at least in part, their exposure (n. 66 and accompanying text). 153 ESMA (n. 66). 154 Park (n. 64), 667–72; Benjamin (n. 2), 581–2 (widespread hardship for retail investors may trigger political desire to find financial institutions responsible on the basis of ex post losses rather than ex ante risks); Moloney (n. 9), 218 (risks of fairness standards are ‘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’). 155 Moloney (n. 9), 218 (reasonableness criteria needed to countervail excessive discretion in ex post review). 156 Cf. Sitkoff (n. 60), 1043–5 (principles should not be considered in isolation. Duty of care establishes a reasonableness standard that ‘is informed by industry norms and practices’).

157

Benjamin (n. 2), 558, 572, 579 (under UK FSA’s Principles for Business—Principle 6—firms ‘must pay due regard to the interests of customers, and treat them fairly, i.e. balance the interests of the clients with their own, rather than always and loyally promote the clients’ interests above their own’ (emphasis in original)). 158 Park (n. 64), 640 (rules are promulgated ex ante, while principles are defined ex post). Similarly Hazen (n. 64), 718 ff. 159 Benjamin (n. 2), 556–61, 580–3 (highlighting risk of uncertainty inherent to widespread reliance on equity and standards as opposed to rules and the common law). 160 Moloney (n. 9), 212. (wondering whether MiFID I regime maintains an appropriate balance between rules and principles). 161 Benjamin (n. 2), 559 (also referring to Kelly v Cooper [1993] AC 205, per Lord Browne-Wilkinson). See also H. N. Butler and L. E. Ribstein, ‘Opting Out of Fiduciary Duties: A Response to the Anti-Contractarians’ (1990) Washington Law Review 65, 1; R. Cooter and B. J. Freedman, ‘The Fiduciary Relationship: Its Economic Character and Legal Consequences’ (1991) New York University Law Review 66, 1045; F. H. Easterbrook and D. R. Fischel, ‘Contract and Fiduciary Duty’ (1993) Journal of Law & Economics 36, 425. 162 Underpinning this scholarly view is also the consideration that fiduciary duties are often regarded as a recessive feature in investment services and are increasingly deviated from by contractual parties: Getzler (n. 63), 201; Davidoff Solomon et al. (n. 41), 543–6. 163 G. Ferrarini, ‘Contract Standards and the Markets in Financial Instruments Directive: An Assessment of the Lamfalussy Regulatory Architecture’ (2005) European Review of Contract Law 1, 19, 26 (at least some conduct of business rules are inherently contractual and, hence, optional). 164 Moloney (n. 9), 209 (MiFID I conduct of business regime allows opt-out only for retail investors that can qualify as professionals, while vulnerable trusting investors remain protected). 165 Sitkoff (n. 60), 1047 (mandatory provisions addressing fiduciary duties have a protective and cautionary function). 166 A different problem is whether national law can allow contractual opt-out even in other circumstances. The question is normally answered in the negative, although with some uncertainties in some jurisdictions: see D. Busch, ‘Why MiFID Matters to Private Law: The Example of MiFID’s Impact on Asset Managers’ Civil Liability’ (2012) Capital Markets Law Journal 7, 386, 402. 167 Enriques (n. 24), 330–1. To be sure, under MiFID I it was clarified that disclosure of conflicts of interest provided no safe harbour with regard to the requirement that conflicts of interest be managed. See Recital 48 Delegated Regulation (previously Recital 27 Directive 2006/73/EC). 168 This troublesome interaction between contractarian and non-contractarian views on fiduciary duties also afflicts the US debate: Langevoort (n. 121), 443.

169

CESR (n. 80), 3 (‘even under the execution-only regime, firms must comply with all the applicable conduct of business rules (such as, e.g., the obligation under Art. 19(1) [now Art. 24(1) MiFID II] to act honestly, fairly, and professionally in accordance with the best interest of its [sic] clients)’). 170 M. Tison, ‘The Civil Law Effects of MiFID in a Comparative Law Perspective’ in S. Grundmann et al. (eds) Festschrift für Klaus J. Hopt (Berlin: De Gruyter, 2010), pp. 2612, 2633–4. 171 I. MacNeil, ‘Rethinking Conduct Regulation’ (2015) Butterworths Journal of International Banking and Financial Law 30, 413, 415–16 (MiFID I rules often result in ‘a regulatory scheme that implements a diluted form of fiduciary duties’). 172 An interesting combination of principle-based and rule-based regulation is offered by Australia, where a best interest standard is coupled with more detailed conduct of business rules that have the function of a safe harbour: while sticking to the safe harbour is sufficient for compliance purposes, firms are free to find other ways to ensure compliance with the general standards (Tuch (n. 64), 557–8).

5 PRODUCT GOVERNANCE AND PRODUCT INTERVENTION UNDER MIFID II/MIFIR Danny Busch

I. Introduction II. 1. 2. 3. III. 1. 2. 3.

Product Governance Scope Manufacturers and Distributors Three Perspectives Product Intervention Introduction and Scope Product Intervention by NCAs Temporary Intervention Powers of ESMA and EBA

IV. Conclusion

I. Introduction [5.01] Some of the financial products sold in recent years have not been in the interests of the client, such as interest rate swaps sold to small- and medium-sized enterprises in many European countries. This is why consideration has been given to ways of nipping this problem in the bud; in other words by preventing harmful products from even reaching the market.

Under MiFID II this has taken the form of a mandatory product-approval process. But, as usual, firms will look for ways around these requirements. It would be naive to think that product-approval schemes could in practice guarantee that harmful products are no longer marketed. This is why there must be a safety net. This safety net takes the form of a power for the national competent authorities (NCAs) and also for the ESMA and EBA to remove harmful products from the market—a system known as product intervention. In this chapter, the new MiFID II/MiFIR rules on product governance and product intervention are analysed and discussed.

II. Product Governance 1. Scope [5.02] The product-governance rules apply first and foremost to investment firms and banks that may provide investment services.1 However, they also apply to other entities which can provide investment services, in particular managers of undertakings for collective investment in transferable securities (UCITS) and alternative investment funds (AIFs) when such entities are authorised to perform MiFID investment services (pursuant to Article 6(3) of UCITS2 and Article 6(4) of [the Alternative Investment Fund Managers Directive, or] AIFMD3 respectively) and only in connection to the performance of such services. Such UCITS management companies or alternative investment fund managers that distribute or manufacture UCITS or AIFs to investors will only be directly subject to the requirements applicable to the investment services they provide.4

[5.03] In short, the product-governance rules apply to these managers only in connection with the provision of investment services. This means that UCITS management companies and AIF managers which offer investors units in UCITS or AIFs managed by them (without also providing them with investment services) are not subject to the product-governance rules of MiFID II as a result of making such an offer. It follows that UCITS management companies and AIF managers which provide no investment

services at all will therefore not be subject in any way to the productgovernance rules of MiFID II. ESMA rightly states that it would be preferable for the UCITS and AIFM Directives to be amended in such a way that these managers too are subject to the product-governance rules under MiFID II.5 [5.04] Nonetheless, many managers will also be bound de facto by the product-governance rules under MiFID II as the unit rights are often marketed through intermediaries—investment firms. These investment firms will qualify as distributors.6 To be able to comply with their productgovernance obligations, the distributors are reliant on cooperation with the manufacturer of the product, in this case the UCITS management company or AIF manager. Although managers are admittedly not bound by the product-governance rules, it seems to me that they have every interest in ensuring that their distributors comply with the rules. It follows that they must determine the target market properly so that distributors can offer the units to the correct investors.7 In the remainder of this chapter I will disregard the situation in which a UCITS management company or AIF manager provides investment services. [5.05] Finally, it should be noted that the product-governance rules apply not only to financial instruments but also to selling and advising on structured deposits.8 A party that offers or advises on structured deposits may be a bank which does not provide investment services. The productgovernance rules therefore do not apply solely to investment firms, banks, UCITS management companies, and AIF managers that may provide investment services, but also to ‘ordinary’ banks. In this chapter I will often use the more neutral terms ‘firm’ and ‘product’.

2. Manufacturers and Distributors A. General [5.06] MiFID II distinguishes between firms that manufacture the product (manufacturer) and those that distribute the product (distributor). Each of these categories has its own responsibility in respect of product governance.

In practice, a firm can naturally be both a manufacturer and a distributor. In such a case, it must comply with both sets of product-governance rules.9

B. Manufacturers [5.07] Following ESMA’s technical advice, the Draft Commission Delegated Directive published on 7 April 2016 makes it clear that the term ‘manufacturer’ must be interpreted broadly. Manufacturing of products ‘encompasses the creation, development, issuance and/or design of financial instruments’.10 This includes firms ‘advising corporate issuers on the launch of new financial instruments’.11 In short, if an investment firm advises a company on the issue of shares or bonds, it must complete the product-approval process.12 It has been argued in the literature that is going rather far,13 but we must bear in mind that the product-governance requirements should be complied with in an appropriate and proportionate manner, ‘taking into account the nature of the financial instrument, the investment service and the target market for the product’.14 ESMA also recommends that the product-governance obligations should apply to all financial instruments, for example ordinary shares and bonds, even if the term ‘manufacture’ perhaps does not seem (linguistically) applicable to them.15 Nonetheless, ESMA’s approach seems to me to be correct in view of the object of investor protection and the text of MiFID II and the Draft Commission Delegated Directive, which both provide, after all, that the product-governance rules apply to all financial instruments (and structured deposits). [5.08] In practice, it is naturally quite conceivable that two or more manufacturers collaborate to create a new product. In such a case, following ESMA’s technical advice, the Draft Commission Delegated Directive stipulates that they outline their mutual responsibilities in a written agreement.16

C. Distributors

[5.09] The Commission also chooses a broad approach in the case of distributors. In response to the previous consultation, various market participants had requested that the obligations for distributors should not be extended to investment firms which distribute financial instruments on an execution-only service basis. However, ESMA saw no cause for such a restriction,17 and this approach, which seems to me to be correct, is followed by the Commission. See Recital (18) of the Draft Commission Delegated Directive: In light of the requirements set out in [MiFID II] and in the interest of investor protection, product governance rules should apply to all products sold on primary and secondary markets, irrespective of the type of product or service provided and of the requirements applicable at point of sale. However, those rules may be applied in a proportionate manner, depending on the complexity of the product and the degree to which publicly available information can be obtained, taking into account the nature of the instrument, the investment service and the target market. Proportionality means that these rules could be relatively simple for certain simple, products distributed on an execution-only basis where such products would be compatible with the needs and characteristics of the mass retail market.18

[5.10] In practice, there is quite often likely to be a chain of distributors. According to the Commission (following ESMA’s technical advice), the final distributor in the chain (i.e. the party with the direct client relationship) has ultimate responsibility for meeting the product-governance obligations that apply to distributors.19 But the intermediate distributors too have responsibilities. They must ensure that relevant product information is passed from the manufacturer to the final distributor in the chain.20 Similarly, if the product manufacturer requires information on product sales in order to comply with its own product-governance obligations, the intermediate firm must enable him to obtain it.21 And, finally, an intermediate distributor must apply any relevant product-governance obligations for manufacturers in relation to the service they provide.22 This provision is as opaque as it is remarkable. After all, an intermediate distributor is only a manufacturer if it has ‘manufactured’ the product or, for example, has itself made modifications to the product, whether or not in cooperation with one or more other manufacturers (for this purpose, the term ‘manufacturer’ should be broadly interpreted23). If that is not the case,

I can see no good reason why an intermediate distributor should be bound by the product-governance rules for manufacturers.

3. Three Perspectives [5.11] MiFID II approaches the subject of product governance from three perspectives: (1) corporate governance, (2) investor protection, and (3) organizational requirements.

A. Corporate Governance [5.12] From the corporate governance perspective, it is apparent that the management body has final responsibility for product governance. MiFID II provides that the management body defines a policy as to products (and other matters) which is in accordance not only with the risk tolerance of the firm but also with the characteristics and needs of the clients of the firm to whom they will be offered or provided, including carrying out appropriate stress testing. The management body is also responsible for approving this policy and overseeing its implementation.24 In other words, firms must ensure that the management body has effective control over the firm’s product-governance process. The provision applies both to firms that manufacture products (manufacturers) and to firms that offer or recommend those products (distributors).25 [5.13] Firms must ensure that the compliance reports to the management body systematically include information about (1) the products they manufacture, including information on the distribution strategy, if they are manufacturers, and (2) the products they offer or recommend and the services provided, if they are (also) distributors. Firms must make the reports available to their NCA on request.26

B. Investor Protection

[5.14] From the investor protection perspective the ultimate goal of product governance is apparent, namely protection of both professional and non-professional clients. The relevant provisions distinguish between the duties of care of firms which manufacture products (manufacturers) and parties which offer or recommend those products (distributors). [5.15] Manufacturers must ensure that (1) products are manufactured which meet the needs of an identified target market of end clients within the relevant category of clients, (2) the strategy for distribution of the products is compatible with the identified target market, and (3) they take reasonable steps to ensure that the product is distributed to the identified target market.27 [5.16] Distributors must (1) understand the products they offer or recommend, (2) assess whether the products are compatible with the needs of the clients to whom they provide investment services, and (3) ensure that the products are offered or recommended only when this is in the interests of the client.28 This requirement applies both to firms which sell products they have manufactured themselves (distributors-cum-manufacturers) and to firms which sell or recommend products manufactured by others (pure distributors).

C. Organizational Requirements i. General [5.17] Finally, from the perspective of the organizational requirements it can be seen how product governance must be firmly embedded within the firm’s organization. The compliance departments of manufacturers and distributors play an important role in this connection. It is their responsibility to ensure that the product-governance obligations are implemented and complied with within the organization.29 ii. Product-Approval Process for Manufacturers [5.18] Each manufacturer must have put in place a product-approval process. Through this process each newly manufactured product (and each significant adaptation of an existing product) must be approved before it is marketed or distributed to clients.30

[5.19] A product is always assessed in relation to the intended target market, for example retail or wholesale (or naturally a more specific target market). The approval process must ensure that all risks to such identified target market are assessed. The process must also ensure that the intended distribution strategy is consistent with the identified target market.31 As part of this process, the manufacturer must also identify any groups of investors for whose needs, characteristics, and objectives the product is not compatible.32 Where firms collaborate to manufacture a product, only one target market needs to be identified.33 [5.20] Manufacturers distributing their products through other parties (i.e. distributors) must determine the needs and characteristics of clients for whom the product is compatible based on their theoretical knowledge of and past experience with the product or similar products, the financial markets, and the needs, characteristics, and objectives of potential end clients.34 [5.21] Various market participants indicated in the previous consultations that they would appreciate guidance from ESMA on how to determine the target market for a new product. However, according to ESMA this was not necessary: ESMA considers that it would be inappropriate to specify in too much detail the level of granularity that is required, since this will vary according to the specific circumstances. For simpler, more mainstream investments, such as ordinary shares, it is likely that the target market will be identified with less detail. In many cases, it is understood that such products can be considered compatible with the mass retail market. For more complicated, less mainstream products, such as contingent convertible securities or structured products with complicated return profiles, the target market should be identified with more detail.35

[5.22] This approach is followed by the Commission, see Recital (19) of the Draft Commission Delegated Directive: The level of granularity of the target market and the criteria used to define the target market and determine the appropriate distribution strategy should be relevant for the product and should make it possible to assess which clients fall within the target market, for example to assist the ongoing reviews after the financial instrument is launched. For simpler, more common products, the target market could be identified

with less detail while for more complicated products such as bail-inable instruments or less common products, the target market should be identified with more detail.36

[5.23] See also Article 9(9), first sentence, Draft Commission Delegated Directive, stipulating that Member States shall require investment firms to identify at sufficiently granular level the potential market for each financial instrument and specify the type(s) of client for whose needs, characteristics and objectives the financial instrument is compatible.37

[5.24] What other aspects should the manufacturer take into account in the product-approval process? 1. Firms manufacturing products must ensure that the design of the product, including its features, (a) does not adversely affect end clients or (b) does not lead to problems with market integrity by enabling the firm to mitigate and/or dispose of its own risks or exposure to the underlying assets of the product, where the investment firm already holds the underlying assets on own account.38 2. The manufacturers must prepare a conflict-of-interest analysis each time a product is manufactured. In particular, firms must assess whether the product creates a situation where end clients may be adversely affected if they take (a) an exposure opposite to the one previously held by the firm itself, or (b) an exposure opposite to the one that the firm wants to hold after the sale of the product.39 3. Firms must consider whether the product may represent a threat to the orderly functioning or to the stability of financial markets before deciding to proceed with the launch of the product.40 4. The manufacturer must also prepare a scenario analysis. This involves studying the risk of poor end client outcomes posed by the product and in which circumstances these outcomes may occur. The firm must assess the financial instrument under negative conditions (stress testing). The following circumstances can be taken into account here: (a) the market environment deteriorates, (b) the manufacturer or a third party involved in the manufacturing and/or functioning of the product experiences financial difficulty or other counterparty risk materializes, (c) the product fails to become commercially viable, or (d) demand for

the product is much higher than anticipated, putting a strain on the firm’s resources and/or on the market of the underlying product.41 5. The manufacturer must consider whether the product meets the identified needs, characteristics, and objectives of the target market. It is necessary to check, for example, whether (1) the product’s risk/reward profile is consistent with the target market, and (2) the product design is driven by features that benefit the client and not by a business model that relies on poor client outcomes to be profitable.42 6. Manufacturers need to consider the charging structure proposed for the product and check, for example, that (a) the product’s costs and charges are compatible with the needs, objectives, and characteristics of the target market; (b) charges do not undermine the return expectations of the product; for example, where the costs or charges are equal, exceed or remove almost all the expected tax advantages linked to a product, and (c) the charging structure of the product is appropriately transparent for the target market (e.g. it must not be too complex to understand and must not disguise charges).43 iii. Product-Governance Procedures for Distributors [5.25]  Distributors do not need an approval process, but, as noted above,44 they must, among other things, (1) assess whether the products meet the needs of the clients to whom they offer investment services, taking account of the identified target market of end clients, and (2) ensure that products are offered or recommended only when this is in the interests of the client.45 [5.26] This objective must be implemented within the firm’s organization as follows. If a distributor decides what products and services it wishes to provide or recommend, it must have implemented adequate productgovernance procedures which ensure that (1) the products and services it intends to offer are compatible with the needs, characteristics, and objectives of the identified target market, and (2) the intended distribution strategy is consistent with the identified target market. Distributors must therefore determine the needs of the clients that they intend to focus on, so as to ensure that clients’ interests are not compromised as a result of commercial or funding pressures. As part of this process, distributors must identify any groups of investors for whose needs, characteristics, and objectives the product or service is not compatible.46

[5.27] A distributor must obtain from manufactures that are subject to MiFID II information to gain the necessary understanding and knowledge of the products they intend to recommend or sell, in order to ensure that these products will be distributed in accordance with the needs, characteristics, and objectives of the identified target market.47 [5.28] A distributor must take all reasonable steps to ensure it also obtains adequate and reliable information from manufacturers not subject to MiFID II to ensure that products will be distributed in accordance with the characteristics, objectives, and needs of the target market. Where relevant information is not publicly available, the distributor must take all reasonable steps to obtain such relevant information from the manufacturer or its agent. Acceptable publicly available information is information which is clear, reliable, and produced to meet regulatory requirements, such as disclosure requirements under the Prospectus Directive48 or the Transparency Directive.49 This obligation is relevant for products sold on primary and secondary markets and applies in a proportionate manner, depending on the degree to which publicly available information is obtainable and the complexity of the product.50 [5.29] A distributor which has not itself manufactured a product is dependent on the manufacturer for the provision of information on the product. This is why the manufacturer is obliged to provide adequate information about the product and the product-approval process to all distributors, including the product’s identified target market.51 This includes information about the appropriate channels for product distribution, the product-approval process, and the target market assessment. The information should be of an adequate standard to enable distributors to understand and recommend or sell the product properly.52 A distributor, in its turn, must use the information obtained from manufacturers and information on its own clients to identify the target market and distribution strategy.53 Where a firm is both manufacturer and distributor, it is naturally necessary to determine the target market only once.54 iv. Product-Governance Requirements in Respect of Staff [5.30]  Manufacturers must ensure that relevant staff involved in the manufacturing

of products possess the necessary expertise to understand the characteristics and risks of the products they intend to manufacture.55 [5.31] Distributors have a comparable obligation. However, they must ensure not only that relevant staff understand the characteristics and risk of the products they are distributing, but also the needs, characteristics, and objectives of the identified target market.56 v. Monitoring Obligation General [5.32] Product-governance obligations do not only apply at the start of the process. A firm must regularly review products which it ‘offers or markets’, taking into account any event that could materially affect the potential risk to the identified target market, in order to assess at least (1) whether the product remains consistent with the needs of the identified target market and (2) whether the intended distribution strategy remains appropriate (together known as the monitoring obligation).57 Although the words ‘offers or markets’ are not crystal clear, this must be read as meaning that both the manufacturer and the distributor have a monitoring obligation. In any event, following ESMA’s technical advice, the Draft Commission Delegated Directive subjects both manufacturers and distributors to a monitoring obligation.58 Monitoring Obligation—Manufacturer [5.33] A manufacturer must review the products it manufactures on a regular basis, taking into account any event that could materially affect the potential risk to the identified target market. A manufacturer must consider if the product remains consistent with the needs, characteristics, and objectives of the target market and if it is being distributed to the target market, or is reaching clients with whose needs, characteristics, and objectives the product is not compatible.59 [5.34] A manufacturer must review (i) products prior to any further issue or relaunch, if it is aware of any event that could materially affect the potential risk to investors and (ii) at regular intervals to assess whether the products function as intended. A manufacturer must determine how

regularly to review its products based on relevant factors, including factors linked to the complexity or the innovative nature of the investment strategies pursued.60 [5.35] Manufacturers must also identify crucial events that would affect the potential risk or return expectations of the product, such as (a) the crossing of a threshold that will affect the return profile of the product, or (b) the solvency of certain issuers whose securities or guarantees may impact the performance of the product.61 What happens if such an event occurs? The manufacturer must take ‘appropriate action’. It is up to the manufacturer to determine what action it will take, provided that this is appropriate. However, following the lead of market participants, the following suggestions are made (the list is not exhaustive): (1) the provision of any relevant information on the event and its impact on the product to (a) clients, or (b) the distributors of the product if the manufacturer itself does not offer the product directly to the clients; (2) changing the productapproval process; (3) stopping further issuance of the product; (4) changing the product to avoid unfair contract terms; (5) considering whether the sales channels through which the products are sold are appropriate if it transpires that the product is not being sold as envisaged (e.g. if a product was designed for a niche market of sophisticated investors, but is being sold to a much larger group of clients); (6) contacting the distributor to discuss a modification of the distribution process; (7) terminating the relationship with the distributor; or (8) informing the relevant NCA.62 [5.36] To be able to comply with its monitoring obligation, however, a manufacturer needs information about its distributors. ESMA proposes that distributors must inform the manufacturer periodically about their experience with the product. This proposal has encountered resistance from the market. The criticism is that a reporting duty of this kind would entail extra costs and be so disproportionate to the expected benefits that small distributors would limit the number of manufacturers with which they work in order to minimize their reporting obligations. Ultimately, this would also not be in the interests of investors since they would have less choice. However, most consumer organizations consider that a reporting obligation would be useful, particularly if feedback from clients were to be included in the information supplied to the manufacturer. After considering all these

comments, ESMA decided to maintain its proposal, on the basis that such reporting can be beneficial for the functioning of product-governance obligations.63 The Draft Commission Delegated Directive closely follows ESMA’s technical advice. See Recital (20): For the efficient functioning of product governance obligations, distributors should periodically inform the manufacturers about their experience with the products. While distributors should not be required to report every sale to manufacturers, they should provide the data that is necessary for the manufacturer to review the product and check that it remains consistent with the needs, characteristics and objectives of the target market defined by the manufacturer. Relevant information could include data about the amount of sales outside the manufacturer’s target market, summary information of the types of clients, a summary of complaints received or by posing questions suggested by the manufacturer to a sample of clients for feedback.

[5.37] See finally Article 10(9) Draft Commission Delegated Directive, stipulating that ‘[…] distributors provide manufacturers with information on sales and, where appropriate, information on […] reviews to support product reviews carried out by manufacturers’.64 Monitoring Obligation—Distributor [5.38] But as the distributor too is subject to a monitoring obligation, it also has a responsibility. Distributors must periodically review and update their product-governance arrangements in order to ensure that they remain robust and fit for their purpose, and take appropriate actions where necessary.65 [5.39] Distributors must also review the products they offer or recommend and the services they provide on a regular basis, taking into account any event that could materially affect the potential risk to the identified target market. Distributors must assess at least whether the product or service remains consistent with the needs, characteristics, and objectives of the identified target market and whether the intended distribution remains appropriate. Distributors must reconsider and/or update the product-governance arrangements if they become aware that (1) they have wrongly identified the target market for a specific product or service, or (2) the product or service no longer meets the circumstances of the identified target market (e.g. where the product becomes illiquid or very volatile due to market changes).66

vi. Relationship with KYC Rules and Other MiFID II/MiFIR Provisions [5.40] The measures, processes, and arrangements described above are without prejudice to all other requirements of MiFID II and MiFIR, including those relating to disclosure, suitability or appropriateness, identification, and management of conflicts of interest and inducements.67 This means, among other things, that the firm must still comply with the applicable KYC rules even in relation to a client who comes within the product’s target group. In ESMA’s words: [t]he analysis of the target market for the purposes of product governance arrangements is distinct from and does not replace the suitability/appropriateness assessments which are conduct of business rules that take place for each specific transaction concluded by a given investor in relation to a given product.68

III. Product Intervention 1. Introduction and Scope [5.41] The previous section dealt with the MiFID II rules on product governance. As noted in the introduction to this chapter, it would be naive to think that these rules are watertight and guarantee that harmful products will never again be marketed. It is therefore no more than realistic to introduce (and enforce) ex post product-intervention provisions in addition to the ex ante product-governance rules. A distinction is made in this connection between (1) product intervention by NCAs and (2) the intervention powers of ESMA and EBA. Like the product-governance rules, the product-intervention rules apply to both financial instruments and structured deposits (referred to collectively below as ‘products’).69

2. Product Intervention by NCAs A. Powers of NCAs under MiFIR

i. General [5.42] The NCAs are the first in line to act. They may prohibit or restrict the following: 1. the marketing, distribution, or sale of (a) certain products or (b) products with certain specified features; 2. a type of financial activity or practice in or from the Member States concerned.70 [5.43] The NCA may impose a prohibition or restriction on a precautionary basis before a product has been marketed, distributed, or sold to clients. A prohibition or restriction may apply in circumstances, or be subject to exceptions, specified by the NCA.71 The NCA must publish on its website notice of any decision to impose a prohibition or restriction.72 [5.44] An NCA may impose a prohibition or restriction only if it is satisfied on reasonable grounds that the below cumulative requirements have been complied with. Once the below conditions are no longer all complied with (insofar as they are applicable), the NCA must revoke the prohibition or restriction.73 ii. ‘Significant Concern’ or ‘Threat’ [5.45] (1) (a) A product, financial activity, or practice gives rise to ‘significant investor protection concerns’, poses ‘a threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of whole or part of the financial system within at least one Member State’; or (b) a derivative has a detrimental effect on the price-formation mechanism in the underlying market.74 [5.46] But what exactly constitutes ‘a significant investor protection concern’? And when is there ‘a threat to the orderly functioning and integrity of financial markets or commodity markets’ or a threat to ‘the stability of whole or part of the financial system within at least one Member State’? The Commission adopts delegated acts specifying criteria and factors to be taken into account by NCAs in order to determine this. The criteria and factors comprise:

(a) the degree of complexity of a product and the relation to the type of client to whom it is marketed, distributed, and sold; (b) the degree of innovation of a product, activity, or practice; (c) the leverage a product or practice provides; (d) in relation to the orderly functioning and integrity of financial markets or commodity markets, the size or the notional value of an issuance of products.75 [5.47] Article 21(2)(a)–(v) Draft Commission Delegated Regulation published on 18 May 2016 specifies the criteria and factors to be taken into account in a detailed manner.76 The NCAs must assess the relevance of all factors and criteria listed in the Draft Commission Delegated Regulation, and take into consideration all relevant factors and criteria in determining when (1) the marketing, distribution, or sale of (a) certain products or (b) products with certain specified features or (2) a type of financial activity or practice, creates ‘a significant investor protection concern’, ‘a threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system within at least one Member State’.77 [5.48] In its technical advice, ESMA stated that for NCAs the listed factors and criteria ‘are not intended to represent an exhaustive list’.78 It is not entirely clear whether this advice has been followed by the Commission. First of all, the Draft Commission Delegated Regulation provides that [t]he factors and criteria to be assessed by competent authorities to determine whether there is a significant investor protection concern or a threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system within at least one Member State shall include [emphasis added] the following […].79

[5.49] In respect of ESMA and EBA, the Draft Commission Delegated Regulation uses the words ‘shall be the following’, instead of ‘shall include’.80 This provides strong evidence that for NCAs the listed criteria and factors are not intended to represent an exhaustive list, whereas for ESMA and EBA they are intended to represent such an exhaustive list.

[5.50] But there are some doubts. The Draft Commission Delegated Regulation also provides that an NCA may determine the existence of ‘a significant investor protection concern’, ‘a threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system within at least one Member State’ based on ‘one or more’ of the factors and criteria specified in Article 21(2)(a)–(v) Draft Commission Delegated Regulation, suggesting that for NCAs the listed criteria and factors are intended to represent an exhaustive list.81 The exact same formulation is used for ESMA and EBA.82 See also Recital (19) Draft Commission Delegated Regulation: The need to assess all criteria and factors that could be present in a specific factual situation should not prevent however the temporary intervention power from being used by competent authorities, ESMA and EBA where only one of the factors or criteria leads to such a concern or threat.

[5.51] In relation to investor protection, reference is made to a ‘significant concern’, whereas in relation to the orderly functioning and integrity of financial and commodity markets, reference is made to a ‘threat’. Recital (18) Draft Commission Delegated Regulation explains the difference: The existence of a ‘threat’, one of the prerequisites of the intervention in the perspective of the orderly functioning and integrity of financial or commodity markets or stability of the financial system, would require the existence of a greater concern than a ‘significant concern’, which is the prerequisite of the intervention for investor protection.83

iii. Other Requirements [5.52] (2) The existing regulatory requirements under Union law applicable to the relevant product or financial activity or practice do not sufficiently address the risks, and the issue would not be better addressed by improved supervision or enforcement of existing requirements.84 [5.53] (3) The action must be proportionate taking into account (a) the nature of the risks identified, (b) the level of sophistication of investors or market participants concerned, and (c) the likely effect of the action on investors and market participants who may hold, use, or benefit from the product, activity, or practice.85

[5.54] (4) The NCA has properly consulted NCAs in other Member States that may be significantly affected by the action.86 [5.55] (5) The action does not have a discriminatory effect on services or activities provided from another Member State.87 [5.56] (6) The NCA has properly consulted public bodies competent for the oversight, administration, and regulation of physical agricultural markets under Regulation (EC) No 1234/2007, where a product or activity or practice poses a serious threat to the orderly functioning and integrity of the physical agricultural market.88

B. Consultation with Other NCAs and ESMA/EBA [5.57] Before an NCA may impose a prohibition or restriction it must consult with the other NCAs and ESMA/EBA. It is not entirely clear whether there must be consultation with all other NCAs or only with NCAs in other Member States that may be significantly affected by the action. In the latter case, the provision would to this extent seem to repeat cumulative condition (4) under paragraph 5.54 above. Whatever the case, not less than one month before the measure is intended to take effect, it must notify all other NCAs and ESMA in writing (or through another medium agreed between the authorities) the details of: (a) the product89 or activity or practice to which the proposed action relates; (b) the precise nature of the proposed prohibition or restriction and when it is intended to take effect; and90 (c) the evidence upon which it has based its decision and upon which it is satisfied that each of the conditions at paragraphs 5.43–5.56 above, are met.91 [5.58] The period of a month is naturally very long in cases where speed is of the essence. MiFIR therefore provides for an exception in such cases: if the NCA deems it necessary to take urgent action in order to prevent detriment arising from products, practices, or activities, it may take action

on a provisional basis with no less than twenty-four hours’ written notice, before the measure is intended to take effect, to all other NCAs and ESMA or, for structured deposits, EBA, provided that all the criteria are met and that, in addition, it is clearly established that a one-month notification period would not adequately address the specific concern or threat. However, the NCA may not take action on a provisional basis for a period exceeding three months.92

C. Coordinating Role of ESMA and EBA [5.59] ESMA (for financial instruments) or EBA (for structured deposits) perform a facilitation and coordination role in relation to action taken by NCAs. In particular they ensure that action taken by an NCA is justified and proportionate and that where appropriate a consistent approach is taken by NCAs.93 [5.60] After receiving notification of any action that is to be imposed, ESMA or EBA will adopt an opinion on whether the prohibition or restriction is justified and proportionate. If ESMA or EBA considers that the taking of a measure by other NCAs is necessary to address the risk, it will state this in its opinion. The opinion must be published on ESMA’s website (in the case of financial instruments) or EBA’s website (in the case of structured deposits).94 Where an NCA proposes to take, or takes, action contrary to an opinion adopted by ESMA or EBA or declines to take action contrary to such an opinion, it must immediately publish on its website a notice fully explaining its reasons for so doing (comply or explain).95

D. Powers of NCAs under MiFID II [5.61] NCAs also have product-intervention powers under MiFID II. First of all, the NCA may suspend the marketing or sale of products where the firm (which may be a manufacturer or a distributor) has not developed or applied an effective product-approval process or has otherwise failed to comply with the product-governance rules.96 I assume that this provision relates to the situation where the product-governance rules have not been

complied with in relation to a given product and there is therefore no guarantee that the product is ‘safe’. To ensure this safety after all, the NCA can then suspend the marketing and sale of the product. Another interpretation is also possible, but seems less likely. If the productgovernance rules have not been observed in relation to a given product, the NCA may also suspend trading in other products which are marketed or sold by the firm in question, even if the product-governance rules have been adequately complied with in relation to such products. In such a case the power of suspension would be more in the nature of a sanction. [5.62] Second, the NCA may suspend the marketing or sale of products where the conditions of Article 40, 41, or 42 MiFIR are not met.97 Articles 40 and 41 MiFIR relate to the temporary intervention measures of ESMA and EBA.98 So should we interpret MiFID II as meaning that the NCAs may suspend the marketing or sale of products in all cases in which ESMA and EBA are unable to do so because the conditions of Articles 40 (ESMA) and 41 (EBA) MiFIR have not been met? This would then constitute a very broad intervention power. And what about the reference to Article 42 MiFIR? This provision relates to the intervention measures which the NCAs can themselves take under MiFIR (see above99). On a literal interpretation of Article 69(2)(s) MiFID II, an NCA may, in all cases where it cannot prohibit or restrict the marketing or sale of a product under Article 42 MiFIR because the conditions of application are not met, still suspend the marketing or sale of products under Article 69(2)(s) MiFID II. Although suspension is only a temporary measure and an outright prohibition or restriction under Article 42 MiFIR seems much more final, I cannot help but wonder whether Article 69(2)(s) MiFID II is really intended to confer an unconditional power of suspension. Perhaps the provision should be read as meaning that if a legal prohibition or restriction under Article 40, 41, or 42 MiFIR is not complied with by the firm concerned, the NCA may halt the actual marketing and sale.

3. Temporary Intervention Powers of ESMA and EBA A. General

[5.63] Besides the NCAs, ESMA and EBA may themselves also intervene. However, these powers are secondary to those of the NCAs. [5.64] But let us first retrace a few steps. Under the ESMA and EBA Regulations, ESMA and EBA have obtained tasks relating to consumer protection and financial activities.100 ESMA and EBA supervise new and existing financial activities and can adopt guidelines and recommendations with a view to promoting the safety and soundness of markets and convergence of regulatory practice.101

B. Powers under MiFIR [5.65] ESMA and EBA may temporarily prohibit or restrict certain financial activities that threaten (1) the orderly functioning and integrity of financial markets or (2) the stability of the whole or part of the financial system of the EU/EEA in the cases specified and under the conditions laid down in further legislative acts.102 MiFIR is a further legislative act of this kind. MiFIR sets out what activities may be prohibited and on what conditions.103 The powers of ESMA and EBA are always identical, although ESMA is in each case the competent authority in relation to financial instruments and EBA in relation to structured deposits. ESMA/EBA may prohibit or restrict the following activities in the EU/EEA: (1) the marketing, distribution, and sale of (a) certain products or (b) products with certain specified features; (2) a type of financial activity or practice. [5.66] A prohibition or restriction may apply in circumstances, or be subject to exceptions, specified by ESMA/EBA.104 ESMA/EBA may impose the prohibition or restriction on a precautionary basis before a product has been marketed, distributed, or sold to clients.105 ESMA/EBA publishes on its website notice of any decision to take any action.106 In short, ESMA/EBA has powers and duties of publication comparable to those of the NCAs (see above107), although the powers relate to the entire EU/EEA and are not limited to a Member State, and any action taken by

ESMA/EBA will always be temporary. Before ESMA/EBA decides to take action, it must notify the NCAs of the action it is proposing.108 ESMA/EBA must review a prohibition or restriction at appropriate intervals and at least every three months. If the prohibition or restriction is not renewed after that three-month period, it will expire.109 As the action under MiFIR must be taken ‘in accordance with Article 9(5) [ESMA/EBA Regulations]’,110 a Member State may request ESMA/EBA to reconsider its decision under MiFIR. In such a case ESMA/EBA will decide whether to maintain its decision.111 [5.67] ESMA/EBA may act only if the following cumulative conditions have been fulfilled: 1. The proposed action addresses a ‘significant investor protection concern’ or a ‘threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system’ in the EU/EEA. 2. Regulatory requirements under Union law that are applicable to the relevant product or activity do not address the threat. 3. An NCA or NCAs have not taken action to address the threat, or the actions that have been taken do not adequately address the threat.112 [5.68] The first two of these conditions are virtually identical to those imposed in respect of product intervention under MiFIR by NCAs.113 In the case of the first requirement, the Commission (like in relation to the NCAs) must adopt delegated acts specifying criteria and factors to be taken into account in determining when there is a ‘significant investor protection concern’, a ‘threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system’ of the EU/EEA. This covers the same criteria and factors as those which are relevant to NCAs.114 For ESMA and EBA there are no doubts that the list of criteria and factors is intended to represent an exhaustive list.115 [5.69] The size or the notional value of an issuance of products is mentioned separately in the case of ESMA/EBA, whereas in the case of the

NCAs this factor is explicitly related to the orderly functioning and integrity of financial markets or commodity markets.116 [5.70] It is apparent from the third condition that the powers of ESMA and EBA are secondary to those of the NCAs. But if ESMA or EBA takes action, its measures prevail over those of an NCA.117 I understand this provision to mean that supervised investment firms/banks which are affected by the product intervention must be guided by the measures taken by ESMA/EBA and can ignore any previous measures taken by NCAs. This would in any event seem to be the most logical explanation, because in view of condition (3) above ESMA/EBA can act only once the measures taken by NCAs have failed to deal with the threat adequately. If the national measures are not adequate, it makes little sense for them to be complied with by the sector unless it is assumed that cases can arise where the NCA’s action is not sufficient on its own but is sufficient in combination with a measure taken by ESMA/EBA. [5.71] When taking action ESMA/EBA must ensure that the action: (a) does not have a detrimental effect on the efficiency of financial markets or on investors that is disproportionate to the benefits of the action; (b) does not create a risk of regulatory arbitrage; and (c) has been taken after consulting the public bodies competent for the oversight, administration, and regulation of physical agricultural markets under Regulation (EC) No 1234/2007, where the measure relates to agricultural commodities derivatives.118 [5.72] As we saw above,119 after receiving notification of any action that is to be imposed, ESMA/EBA must adopt an opinion on whether the prohibition or restriction is justified and proportionate. If ESMA or EBA considers that the taking of a measure by other competent authorities is necessary to address the risk, it must state this in its opinion.120 However, if an NCA has already taken a measure without awaiting the opinion, ESMA or EBA may itself take a corrective or other measure without adopting the opinion.121

C. Power under ESMA/EBA Regulation: Emergency Situations [5.73] Besides the intervention powers which ESMA/EBA has under MiFIR (see above) and independently of any elaboration in further legislative acts, ESMA/EBA may also temporarily prohibit or restrict certain financial activities in the case of an emergency situation in accordance with and under the conditions laid down in Article 18 of the ESMA/EBA Regulations.122 The requirements for intervention on this basis are strict. As the conditions for exercise of the powers which ESMA/EBA has under MiFIR are more flexible, the power to intervene in an emergency is expected to have little added value in practice.

IV. Conclusion [5.74] Both the ex ante product-governance rules and the ex post productintervention rules are far-reaching. The combination of these two approaches to preventing harmful products from reaching the market is an important step forward in protecting investors. On the other hand, compliance with the product-governance rules is bound to entail costs for the firms concerned. As seen above, the internal procedures must be configured and the arrangement requires a considerable exchange of information between the firm that manufactures a product and the firm that distributes it. All in all, I believe that these extra costs (which will undoubtedly be discounted in the cost price) are acceptable. The social costs caused by marketing harmful products are many times greater. In my view, the fact that MiFID II introduces not only product-governance rules but also far-reaching product-intervention rules shows a sense of realism. After all, as I noted in the introduction, it would be naive to think that the product-governance rules could in practice guarantee that harmful products are no longer marketed.

1

See Article 9(3)(b); Article 16(3), second to seventh subparagraphs; Article 24(2) (non-bank investment firms) in conjunction with Article 1(3)(a) and (b) MiFID II (banks

which also act as investment firms). 2 Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities, OJ L 302/32 (UCITS IV), as amended by Directive 2014/91/EU of the European Parliament and of the Council of 23 July 2014 on the coordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards depositary functions, remuneration policies, and sanctions, OJ L 257/186 (UCITS V). UCITS V should have been implemented in the national laws of the Member States of the EU/EER from 18 March 2016 (Article 2(1), second paragraph, UCITS V). 3 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (AIFM Directive or AIFMD), OJ L 174/1. 4 ESMA/2014/1569, Final Report—ESMA’s Technical Advice to the Commission on MiFID II and MiFIR (19 December 2014), p. 52 (no. 9). 5 ibid. 6 See paragraphs 5.09–5.10, below. 7 See paragraphs 5.25–5.29. 8 It is evident from Article 1(4), opening words and (a) and (b), MiFID II, as well as from Article 1(2), Draft Commission Delegated Directive, C(2016) 2031 final, 7 April 2016, that the product-governance rules also apply to structured deposits. A structured deposit is a deposit on which the interest to be paid is not determined by reference to an interest rate (such as Euribor), but is instead dependent, for example, on the position of the AEX index. See the definition of structured deposit in Article 4, para. 1(43) MiFID II in conjunction with Article 2(1)(c) of Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on deposit guarantee schemes, OJ L 173/149 (Deposit Guarantee Schemes Directive). On the subject of structured deposits, see ESMA/2015/610, Consultation Paper, Draft guidelines on complex debt instruments and structure deposits (24 March 2015). 9 See Recital (17), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 51. 10 See Article 9(1), first paragraph, Draft Commission Delegated Directive (n. 8); ESMA (n. 4), 51, 55 (no. 2). And the same obviously applies to structured deposits, see Article 1(2), Draft Commission Delegated Directive (n. 8). 11 See Recital (15), Draft Commission Delegated Directive (n. 8); ESMA (n. 4), 51. And the same obviously applies to structured deposits, see Article 1(2), Draft Commission Delegated Directive (n. 8). 12 See below at paragraphs 5.18–5.24. 13 L. J. Silverentand, ‘MiFID II—Product Governance’, Tijdschrift voor Financieel Recht (2015), p. 63.

14

See Article 9(1), second paragraph, Draft Commission Delegated Directive (n. 8). And the same obviously applies to structured deposits, see Article 1(2), Draft Commission Delegated Directive (n. 8). 15 ESMA (n. 4), 53–4 (no 12). Cf. L. J. Silverentand (n. 13). 16 See Article 9(8), Draft Commission Delegated Directive (n. 8); ESMA (n. 4), 56 (no. 9). 18 See Recital (18), Draft Commission Delegated Directive (n. 8). See also Recital (15), in fine, Draft Commission Delegated Directive (n. 8), stipulating that firms ‘that offer or sell financial instruments and services to clients should be considered distributors’. That product-governance obligations for distributors must be applied in an appropriate and proportionate manner is also apparent from Article 10(1), first paragraph, Commission Delegated Directive (n. 8). See also ESMA (n. 4), 55 (no. 1). 17 ESMA (n. 4), 56 (no. 9). 19 See Article 10(10), first sentence (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 61 (no. 31, first sentence). 20 See Article 10(10)(a) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive, (n. 8). See also ESMA (n. 4), 61 (no. 31 sub (i)). 21 See Article 10(10)(b) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 61 (no. 31 sub (ii)). 22 See Article 10(10)(c) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 61 (no. 31 sub (iii)). 23 See above, paragraph 5.07. 24 Article 9(3)(b) (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II. 25 Article 9(6) (manufacturers) and Article 10(8) (distributors) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 7) (manufacturers), 60 (no. 28) (distributors). 26 Article 9(6), second and third sentence (manufacturers) and Article 10(8), second and third sentence (distributors) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 7, second sentence) (manufacturers), 60 (no. 28, second sentence) (distributors). See also on the role of the compliance function paragraph 5.17. 27 Article 24(2), first paragraph (financial instruments) in conjunction with Article 1(4), opening words and (b) (structured deposits) MiFID II. See also Recital (71) MiFID II. 28 Article 24(2), second paragraph (financial instruments) in conjunction with Article 1(4), opening words and (b) (structured deposits) MiFID II. See also Recital (71) MiFID II.

29

See Article 9(7) (manufacturers) and Article 10(6) (distributors) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 8) (manufacturers), 60 (no. 26) (distributors). See on the compliance function also paragraph 5.13. 30 Article 16(3), second paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II. 31 Article 16(3), third paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II. 32 Article 9(9), first paragraph, second sentence (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 10). 33 Article 9(9), first paragraph, third sentence (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 10). 34 Article 9(9), second paragraph (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56–7 (no. 11). 35 ESMA (n. 4), 51 (no. 5), 56–7 (nos. 10 and 11). 36 See Recital (19), Draft Commission Delegated Directive (n. 8). And the same obviously applies to structured deposits, see Article 1(2), Draft Commission Delegated Directive (n. 8). 37 And the same obviously applies to structured deposits, see Article 1(2), Draft Commission Delegated Directive (n. 8). 38 Article 9(2), second sentence (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 3). 39 Article 9(3) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 4). 40 Article 9(4) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 56 (no. 5). 41 Article 9(10) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 57 (no. 12). As regards stress tests, see also Article 9(3)(b) (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MIFID II, referred to in paragraph 5.12 above. 42 Article 9(11) (financial instruments), in conjunction with Article 1(2) (structured deposits) Commission Delegated Directive (n. 8). See also ESMA (n. 4), 57 (no. 13). 43 Article 9(12) (financial instruments), in conjunction with Article 1(2) (structured deposits), Commission Delegated Directive (n. 8). See also ESMA (n. 4), 57 (no. 14). 44 At paragraph 5.16.

45

Article 24(2), second paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II. 46 Article 10(2), first paragraph (financial instruments), in conjunction with Article 1(2) (structured deposits), Commission Delegated Directive (n. 8). See also ESMA (n. 4), 59 (no. 21, first three sentences). 47 Article 10(2), second paragraph (financial instruments), in conjunction with Article 1(2) (structured deposits), Commission Delegated Directive (n. 8). See also ESMA (n. 4), 60 (no. 29). See Article 16(3), sixth paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II and Recital 71 MiFID II. 48 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 L 345/64. 49 Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonization of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC, OJ L 390/38. 50 Article 10(2), third paragraph (financial instruments), in conjunction with Article 1(2) (structured deposits), Commission Delegated Directive (n. 8). See also ESMA (n. 4), 60–1 (no. 30). See also Article 10(1), second and third paragraph, Commission Delegated Directive (n. 8). See also ESMA (n. 4), 59 (no. 20). 51 Article 16(3), fifth paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II. 52 Article 10(13) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 57–8 (no. 15). 53 Article 10(2), third paragraph, first sentence, (financial instruments), in conjunction with Article 1(2) (structured deposits) Commission Delegated Directive (n. 8). See also ESMA (n. 4), 59 (no. 21, sentences four and five), where in sentence five reference is made to Article 16(3), fourth paragraph, MiFID II. This is evidently an error, since ESMA intends to refer to Article 16(3), third paragraph, MiFID II. 54 Article 10(2), third paragraph, second sentence, and Recital (17), second sentence, (financial instruments), in conjunction with Article 1(2) (structured deposits), Commission Delegated Directive (n. 8). See also ESMA (n. 4), 59 (no. 21, sentence 6). 55 Article 9(5) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive. See also ESMA (n. 4), 56 (no. 6). Cf. also the corporate governance requirement that the management body should approve the internal organization of the firm, including criteria for the selection, training, knowledge, skills, and experience of the staff. See Article 9(3)(a) (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II; see also Recital (54) MiFID II.

56

Article 10(7), (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 60 (no. 27). See also Article 24(2), second paragraph, (financial instruments) in conjunction with Article 1(4), opening words and (b) (structured deposits) MiFID II, which provides that ‘an investment firm shall understand the financial instruments they offer or recommend’. See also paragraph 5.16 above. 57 Article 16(3), fourth paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II. 58 Article 9(14) and (15) (manufacturers) and Article 10(4) and (5) (distributors), (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4) 58 (nos. 16–19) (manufacturers), 60 (nos. 23 and 24) (distributors). As to manufacturers see also Recital (71) MiFID II, making it clear that ‘[i]nvestment firms that manufacture financial instruments […] periodically review the identification of the target market of and the performance of the products they offer’ (emphasis added). 59 Article 9(14) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). 60 Article 9(15), first and second sentence (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). 61 Article 9(15), third sentence (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). 62 Article 9(15), fourth sentence, in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive(n. 8). See also ESMA (n. 4), 58–9 (no. 19). See also pp. 54–5 (nos. 15–17). 63 ESMA (n. 4), 54 (no. 14) and 60 (no. 25). 64 See also ESMA (n. 4), 60 (no. 25). As for structured deposits, Article 10(9) must of course be read in conjunction with Article 1(2), Draft Commission Delegated Directive (n. 8). 65 Article 10(4) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 60 (no. 23). 66 Article 10(5) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8). See also ESMA (n. 4), 60 (no. 24). 67 Article 16(3), seventh paragraph (financial instruments) in conjunction with Article 1(4), opening words and (a) (structured deposits) MiFID II, Recital 71 MiFID II. See in a similar vein Article 10(3) (financial instruments), in conjunction with Article 1(2) (structured deposits), Draft Commission Delegated Directive (n. 8), with the addition that ‘[…] particular care shall be taken when distributors intend to offer or recommend new products or there are variations to the services they provide’. See also ESMA (n. 4), 59 (no. 21, in fine). 68 ESMA (n. 4), 51 and 59–60 (no. 22).

69

See the text of the Articles 39–43, MiFIR and Articles 19–21, Draft Commission Delegated Regulation , C(2016) 2860 final, 18 May 2016. See also Article 69(2)(s) and (t) (in conjunction with Article 1(4)(c)) MiFID II. 70 Article 42(1) MiFIR. 71 Article 42(2), second and third paragraphs, MiFIR. 72 Article 42(5) MiFIR. The notice must specify details of the prohibition or restriction, a time after the publication of the notice from which the measures will take effect, and the evidence upon which it is satisfied each of the conditions are met. A prohibition or restriction applies only in relation to actions taken after the publication of the notice. 73 Article 42(6) MiFIR. 74 Article 42(2)(a) MiFIR. 75 Article 42(7) MiFIR. 76 Draft Commission Delegated Regulation (n. 69). See also ESMA (n. 4), 191–6 (no. 3). 77 Article 21(1), first paragraph, Draft Commission Delegated Regulation (n. 69). 79 Article 21(2), first paragraph, in fine, Commission Delegated Regulation (n. 69). 78 ESMA (n. 4), 191 (no. 3, second sentence). EBA even seems to suggest that in respect of structured deposits the list of criteria is non-exhaustive not only for the NCAs but also for EBA. See EBA/Op/2014/13, Technical Advice on possible delegated acts on criteria and factors for intervention powers concerning structured deposits under Articles 41 and 42 of Regulation (EU) No 600/2014 (MiFIR) (11 December 2014), p. 7 (no. 3): ‘In accordance with the overall conditions for intervention specified under Title VII, Chapter 1 of MiFIR, EBA and CAs should also be able to intervene in new instruments, services or activities that may not meet these factors or criteria or, conversely, not necessarily intervene if given criteria are met but overall detriment is not foreseen or detected, or the relevant proportionality test is not satisfied.’ 80 Article 19(2), first paragraph, in fine (ESMA), Article 20(2), first paragraph, in fine (EBA), Draft Commission Delegated Regulation (n. 69). 81 Article 21(1), second paragraph, Draft Commission Delegated Regulation (n. 69). 82 Article 19(1), second paragraph (ESMA), Article 20(1), second paragraph (EBA), Draft Commission Delegated Regulation (n. 69). 83 Draft Commission Delegated Regulation (n. 69). See also ESMA (n. 4), 190–1 (no. 2). 84 Article 42(2)(b) MiFIR. 85 Article 42(2)(c) MiFIR. 86 Article 42(2)(d) MiFIR. 87 Article 42(2)(e) MiFIR. 88 Article 42(2)(f) MiFIR. 89 Article 42(3)(a) MiFIR refers only to ‘financial instrument’ and not also to ‘structured deposit’. This seems to me to be an error. In the body of the text, I have therefore assumed that Article 42(3)(a) MiFIR also relates to structured deposits.

90

Article 42(3)(b) MiFIR. Article 42(3)(c) MiFIR. 92 Article 42(4) MiFIR. 93 Article 43(1) MiFIR. 94 Article 43(2) MiFIR. 95 Article 43(3) MiFIR. 96 Article 69(2)(t) (financial instruments) in conjunction with Article 1(4)(c) (structured deposits) MiFID II. 97 Article 69(2)(s) (financial instruments) in conjunction with Article 1(4)(c) (structured deposits) MiFID II. 98 See below, paragraphs 5.63–5.72. 99 At paragraphs 5.42–5.56. 100 Article 9, Regulation (EU) No 1095/2010, OJ L 331, 15 December 2010, pp. 84–119 (ESMA Regulation); Article 9 Regulation (EU) No 1093/2010, OJ L 331, 15 December 2010, pp. 12–47 (EBA Regulation). 101 Article 9(2) ESMA Regulation; Article 9(2) EBA Regulation. 102 Article 9(5) ESMA Regulation; Article 9(5) EBA Regulation. 103 Article 40 (ESMA’s temporary intervention powers) and 41 (EBA’s temporary intervention powers) MiFIR. 104 Article 40(1) (ESMA); Article 41(1) (EBA) MiFIR. 105 Article 40(2), second paragraph (ESMA); Article 41(2), second paragraph (EBA) MiFIR. 106 Article 40(5) (ESMA); Article 41(5) (EBA) MiFIR. The notice must specify details of the prohibition or restriction and a time after the publication of the notice from which the measures will take effect. A prohibition or restriction will only apply to action taken after the measures take effect. Article 40(5) (ESMA); Article 41(5) (EBA) MiFIR. 107 At paragraphs 5.43–5.56. 108 Article 40(4) (ESMA); Article 41(4) (EBA) MiFIR. 109 Article 40(6) (ESMA); Article 41(6) (EBA) MiFIR. See also Article 9(5), third paragraph, ESMA/EBA Regulations. 110 See Articles 40(1) (ESMA) and 41(1) (EBA) MiFIR. 111 Article 9(5), third paragraph, ESMA/EBA Regulations. 112 Article 40(2), first paragraph (ESMA); Article 41(2), first paragraph (EBA) MiFIR. 113 See above at paragraphs 5.42–5.56. 114 Article 40(8) (ESMA); Article 41(8) (EBA) MiFIR. See also paragraphs 5.42–5.56 above. 115 See above, paragraphs 5.45–5.51, and see Article 19(2), first paragraph, in fine (ESMA), Article 20(2), first paragraph, in fine (EBA), Draft Commission Delegated Regulation (n. 69). 91

116

Compare Article 40(8)(b) (ESMA) and Article 41(8)(b) (EBA) MiFIR with Article 42(7)(d) MiFIR (NCAs). 117 Article 40(7) (ESMA); Article 41(7) (EBA) MiFIR. 118 Article 40(3), first paragraph (ESMA); Article 41(3), first paragraph (EBA). 119 At paragraphs 5.59–5.60. 120 Article 43(2) MiFIR. 121 In any event, this is how I understand Article 40(3), second paragraph (ESMA); Article 41(3), second paragraph (EBA) MiFIR. 122 Article 9(5) ESMA Regulation; Article 9(5) EBA Regulation. See R. H. Maatman and M. H. J. M. ter Braak, ‘Financiële crisis en noodsituatie’ (2012) Ondernemingsrecht, pp. 291–3.

6 INDEPENDENT FINANCIAL ADVICE Paolo Giudici

I. Introduction II. 1. 2. 3. 4.

Economic Background Households’ Participation in Financial Markets Households’ Bias Advice Missing Research

III. MiFID I 1. MiFID I on Advice 2. The Problem with the MiFID I Regime IV. 1. 2. 3. 4.

MiFID II MiFID II on Information Independent Advice and Other Investment Services Contractual Obligations Investment Advice and Portfolio Management

V. Conclusions

I. Introduction [6.01] In this chapter I analyse the new MiFID II regime concerning investment advice, and in particular independent investment advice. There are important new provisions concerning investment advice and it is clear

that the directive places a lot of emphasis on the role of independent investment advice as an instrument to restore trust and help investors, especially retail ones, in taking financially sound decisions concerning their savings. [6.02] The chapter is organized into four further sections. Section II provides background for the growing importance attributed to financial advice as an instrument to improve the overall efficiency of financial markets. It reviews the main economic literature on households’ biases and the role that advice plays in their investment decisions. Section III briefly analyses the MiFID I regime and highlights its main issue, namely the ambiguous boundary between investment advice and the related suitability assessment, and guidance or promotion, with the much more forgiving appropriateness test or execution-only regime. Section IV focuses on MiFID II provisions concerning investment advice, exploring some of the main problems emerging from the new framework, which must be understood as an attempt to nudge European investors towards independent investment advice. Section V concludes.

II. Economic Background 1. Households’ Participation in Financial Markets [6.03] Trust is a fundamental value in financial markets. Any investment decision requires reliance on the information available, and therefore trust in the market’s integrity. There is a burgeoning literature on the role of trust in financial markets,1 and legal rules2 and doctrines3 abound with references to trust in the market. A significant amount of studies report that over the course of the financial crisis trust in financial institutions has decreased. Given the importance of financial markets as intertemporal and interpersonal resource-transfer mechanisms, along with their monetary role, this lack of trust might have a significant impact on economic development. Traditionally, households have not been as active on financial markets as might have been expected.4 Levels of participation, especially in equity

markets, vary with wealth, age, race, education, cognitive capacities, risk appetite, and social trust.5 In any event, and generally speaking, household participation appears to be suboptimal.6

2. Households’ Bias [6.04] Households have major problems with financial investments. Indeed, when households participate in financial markets, their investment choices are often ripe with mistakes. Households are generally financially illiterate.7 They tend to be overconfident8—male investors more so than women.9 They trade too much.10 Indeed, self-ignorance is one of the most important biases, and wealthy and self-confident financially illiterates represent a big group. [6.05] Financial ignorance and overconfidence are amongst the leading factors in investors’ lack of diversification.11 Households are prone to a home-bias that leads them to hold too many local financial instruments.12 Households tend to maintain fixed beliefs about the fundamental value of shares in the face of market price movements, even though they do not do so with regard to mutual funds.13 They are therefore extremely vulnerable to the disposition effect and thus to ‘momentum behaviour’, which lead them to ride losses and quickly realize gains.14 [6.06] The question as to how well retail investors fare by trading in financial markets should be rephrased: ‘how much do retail investors lose?’. The answer is straightforward: they are likely to be losers, and to lose significant amounts of money in comparison with professional traders.15 Financial literacy and access to financial advice seems to improve retail investors’ portfolios. Recent research convincingly shows that big losers in financial markets are retail investors who neither seek financial advice nor possess a good understanding of basic financial–numerical operations.16 This research confirms experimental evidence concerning retail investors’ inability to take optimal investment choices, even in an artificial and highly simplified investment environment.17 The policy implications are clear,

even though it is not so clear whether financial literacy and advice are complements or substitutes and, therefore, which one should have a preferred track.18 However, since it is not yet evident that policy measures aiming at improving financial literacy are really working, and any benefits from them will only come through in the long term, the quickest policy indication for increasing households’ trust in financial markets and improving their portfolios to the benefit of the economic system seems to be the offering of professional financial advice on affordable terms.19 Of course, this policy indication will not be particularly effective if advice and financial literacy are complements rather than subsitutes.

3. Advice A. Supply Side [6.07] Whilst overconfidence is a trait of many retail traders on stock markets, a large number of households struggle to understand today’s complex financial markets, and expect to be helped by banks and other financial institutions. A large cross-country survey in Europe has shown that almost 90 per cent of investors expect financial intermediaries to give advice through their personnel.20 However, retail investors are not used to paying for advice21 and expect it to be provided for free, which it often is, as part of the interpersonal relationships established with investment firms’ personnel. This advice can be part of a dedicated service offered by the financial institution and paid for indirectly by the client through distribution fees or commissions. Quite often, however, it is what can be termed ‘false advice’—perhaps just a chat, often with a non-specialized employee or agent,22 or a promotional effort by the financial intermediary’s salespeople where a hard sell comes under the guise of advice. [6.08] In a large online survey among purchasers of investment products in the EU, the great majority of the investors reported that their choice was directly influenced by an ‘adviser’.23 The economic research, however, is not able to distinguish the nature and quality of the advice through the data, precisely because it is very difficult if not impossible for many households

to distinguish between true professional advice and the cheap talk referred to above.

B. Is Conflicted Advice Better Than No Advice? [6.09] Investors do not like, and, in significant numbers, do not accept, paying for advice, which they somehow consider an accessory of the provision of financial services. Accordingly, advice is either paid for by product providers through ‘commissions and kickbacks’24 and is therefore open to potential conflicts of interests, or it is cheap talk offered by a salesperson or, even worse, a promotional effort which mimics qualified professional advice. [6.10] Nevertheless, there are models of ‘cheap talk’25 concerning the financial industry, where reputation protection and the fear of legal sanctions tame conflict of interest. According to these models, particularly illiterate households may benefit from cheap talk, because making judgements based on cheap talk is better than having no idea whatsoever about how to employ savings. In an influential paper Inderst and Ottaviani have modelled the different situations that can occur when two firms compete through commissions paid to an adviser. In their model, the adviser controls producers’ access to investors, and monitors the suitability of the financial products that she suggests to clients. The analysis shows commission and kickbacks are not always necessarily bad, and that mandatory disclosure can backfire and lead to suboptimal situations. In the authors’ words, ‘policies that chill commissions through mandatory disclosure or bans may have unintended consequences for efficiency because they inefficiently reduce the responsiveness of advice to supplyside differences’.26

C. Demand Side [6.11] The policy problems are increased by a demand-side puzzle. Customers expect to receive advice, but there is no real understanding of when and how retail investors rely on it. According to recent studies, more

financially educated retail investors seek more professional advice but are, at the same time, less dependent on it.27 Less sophisticated investors do not often look for advice; but if they do, they rely more on it.28 A much-cited paper that deals with this demand-side puzzle reports a situation where an investment bank proactively offered to provide advice that, according to the researchers involved, was unbiased and theoretically sound. The results are striking. A small percentage of the customers (5%) accepted the offer of advice. They were the more financially sophisticated clients. However, and rather surprisingly, they generally did not follow the advice and, accordingly, did not improve their portfolio performance, just as with all the other customers that simply refused the offer.29 It is not clear what the determinants are that make private investors ask and then rely on advice. [6.12] The demand-side puzzle apparently does not worry ‘robo-advisers’, which are joining the market and hope to attract the attention of investors whose portfolio is too small for the costs of independent, personal investment advice. Of course, the advent of robo-advisers might represent an unexpected technological shock in this area of finance, and might change the market environment and investors’ mindset.30

4. Missing Research [6.13] There are many missing parts in the economic research on investment advice. One missing part concerns the financial literacy of employees and agents of European financial institutions. There is some anecdotal evidence that employees who are more prone to recommending unsuitable products are those that do not themselves distinguish a suitable product from an unsuitable one. MiFID II addresses the problem of the competence of personnel,31 but empirical research is missing in this area. It would be worth knowing whether low-competence personnel can really be more prone to misselling and, more generally, how personnels’ financial literacy compares to those of their institutions’ customers. [6.14] Another black box concerns the contractual mechanisms that govern the relationship between financial intermediaries and the natural

persons who work on advisory services.32 Commissions and kickbacks apparently delink customers’ interest from the financial intermediary providing advisory services. However, contractual mechanisms between the financial institution and its advisory workforce might realign interest, though even a simple mechanism that connects the adviser’s income to the client’s portfolio story would add a layer of complexity to the analysis of conflict of interest conducted so far by economists. Research in this area would be very welcome.

III. MiFID I 1. MiFID I on Advice [6.15] Under the MiFID I regime, investment advice was included as a stand-alone, core investment service, subject to the suitability requirement. Investment advice was restricted to advice on particular financial instruments, presented as suitable for a person or based on a consideration of the circumstances of that person,33 and it did not require a written basic agreement.34 Accordingly, the suitability requirement could operate in any situation where an investment firm was communicating to the client that an investment in a specific financial product was ‘good for him’. This regime was not related to any specific contractual setting. Indeed, the suitability test was a legal obligation that did not arise out of a specific contract, but was the consequence of specific communications between the investment firm and the client. Indeed, investment advice means the provision of personal recommendations to a client in respect of one or more transactions relating to financial instruments.35

2. The Problem with the MiFID I Regime [6.16] The MiFID I regime was heralded as a great improvement in customer protection, even though in some Member States it actually limited the range of the suitability test, thereby reducing the protection of retail

investors.36 The problem is that when the suitability requirement does not attach to placing and other forms of distribution, ‘investment advice’ can still be mimicked by a seller who wants to promote a financial product as particularly well suited for the client. Notwithstanding the absence of an investment advice contract, firms can still place financial products with intense ad hoc personal recommendations attached. These personal recommendations can take the form of an aside where the seller rather casually ‘recommends’ the transaction to the customer, or be part of a systematic attempt to influence clients’ decisions without facing the burdens of the investment advice regime. [6.17] In civil litigation, the real nature of these personal recommendations as an expression of a ‘non-contractualized’ investment advice service, being part of ‘one-to-one’ communication between the investment firm’s employee or agent and the client is very difficult to prove. Securities watchdogs, instead, can employ a range of investigative instruments to spot recurrent red flags that signal such practices, amongst which the most important is probably an unreasonable concentration of clients’ investments in the firm’s products. Other red flags that have been mentioned in some decisions by the Italian authority are the massive reprofilings of clients, when they take place just before the issuance or distribution of a specific financial product to be sold to those clients, or the financing of the purchase through special loans.37 In any event, it is clear that in placing services the distinction between promotion, guidance, and advice creates many ambiguities, and that a private litigant can face great problems of burden of proof when he seeks to offer evidence that the investment firm was not only distributing but was also advising, and was doing so outside any contractually regulated framework. [6.18] Some prominent European cases have shown situations where, under the guise of distribution, retail investors as well as small and medium-sized businesses were allegedly subject to misselling that was largely grounded on biased and hidden advice. The Spanish case of ‘partecipaciones preferentes’ (‘preferred shares’) is probably the most famous one concerning retail investors,38 but many others followed. At the end of 2015, an alleged case of misselling hit the Italian political arena. Four small insolvent regional banks—Banca Etruria, Banca Marche,

CariFerrara and CariChieti—were rescued by the Italian government. The rescue deal forced shareholders and junior bondholders to incur losses, and it was thus discovered that a disproportionate amount of junior bonds were held by retail investors who, allegedly, were personally recommended to buy them and were holding them in very undiversified portfolios, where the concentration of risk on a single issuer was beyond any reasonable level.39 Similar cases followed in the same period with regard to clients of Banca Popolare di Vicenza and Veneto Banca.40 [6.19] Thus, the issue is whether MiFID II will substantially improve this grey area of European regulation.

IV. MiFID II 1. MiFID II on Information [6.20] The MiFID II regime poses a new set of information duties on financial advisers. When investment advice is provided, the investment firm must, in good time before providing investment advice, inform the client about three specific issues. These are: whether the advice is independent or not; whether it is based on broad or restricted analysis of financial instruments; and whether the firm will periodically assess the suitability of the financial instruments recommended, and inform the client of its findings.41

A. Independent Basis of Advice [6.21] Is the advice is provided on an independent basis or not? If the advice is labelled independent, pursuant to Article 24(7) the investment firm must ‘assess a sufficient range of financial instruments available on the market which must be sufficiently diverse with regard to their type and issuers or product providers to ensure that the client’s investment objectives can be suitably met’.42 More specifically, the range of financial instrument

must not be limited to financial instruments issued or provided by (i) the investment firm itself or by entities having close links with the investment firm; or (ii) other entities with which the investment firm has such close legal or economic relationships, such as contractual relationships, as to pose a risk of impairing the independent basis of the advice provided. In short, the financial instruments must be of a sufficiently various type and origin; and as to origin, the financial instruments must not exclusively come from related issuers or providers. ‘Sufficient’ is the key word here. [6.22] Where the advice is independent, the investment firm shall not accept and retain fees, commissions, or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients.43 MiFID II exclusively allows non-monetary benefits that are capable of enhancing the quality of service provided to a client and are of a scale and nature such that they could not be judged to impair compliance with the investment firm’s duty to act in the best interest of the client. These minor non-monetary benefits must be clearly disclosed to the client. [6.23] Accordingly, independence is not a prerequisite of a financial advisory service under MiFID II, as it was not under MiFID I. Independence is merely a MiFID II label. MiFID I did not mention independence. On the market, however, firms were actively promoting themselves as independent advisers and this self-promotion could only be challenged on the grounds of misleading marketing. Now MiFID II sets clear rules for promoting advisory services as ‘independent’. [6.24] Financial advice can be non-independent, with the adviser paid by third parties and assessing a limited range of financial instruments, which can be issued or provided for by related parties. The European legislator has therefore decided that a straightforward ban on commission from third parties might make financial advice unaffordable for investors who need it most and that it is better to have potentially conflicted advice than no advice at all, as the economic literature has suggested. Thus, the UK experience of the Retail Distribution Review (RDR)44 was not followed. Whereas the RDR bans all advisers offering either ‘independent’ or ‘restricted’ advice

from receiving commissions or other benefits from third parties, MiFID II applies the ban exclusively to advisers that pretend to be ‘independent.’

B. Broad or Restricted Analysis [6.25] Once it has specified whether its advice is independent or not, the investment firm must inform the client on ‘whether the advice is based on a broad or on a more restricted analysis of different types of financial instruments and, in particular, whether the range is limited to financial instruments issued or provided by entities having close links with the investment firm or any other legal or economic relationships, such as contractual relationships, so close as to pose a risk of impairing the independent basis of the advice provided’—Article 24(4)(a)(ii). [6.26] As mentioned, the investment firm which claims to be providing independent advice must assess a sufficient range of sufficiently diverse financial instruments. Here, instead, the information concerns the broadness of the analysis. Accordingly, an independent adviser might choose to inform the client that its analysis is based on a restricted but sufficiently wide and diverse base of financial instruments, which of course is not limited to those offered or issued by related parties. [6.27] Also in this respect, MiFID II does not follow the UK RDR distinction between independent and restricted advice. Under that distinction, independent advisers are able to consider and recommend all types of retail investment products, whereas restricted advisers work with a limited range of products or focus on a particular market, and do not cover all the types of retail investment able to meet the customer’s need and objectives. Under MiFID II, instead, an independent adviser can consider and recommend a sufficient range of investment products, whereas a nonindependent adviser might potentially consider and recommend a broad (i.e. wider) base of investment products and yet be non-independent because it receives commissions from some of the financial product providers or issuers.

C. Periodic Assessment of Suitability [6.28] Finally, the investment firm must inform the client as to whether it will provide the client with a periodic assessment of the suitability of the financial instruments recommended to that client. In various European jurisdictions investors have brought claims against investment firms and banks alleging that the financial intermediary had an ongoing duty to inform the client about the fall in value of the financial instruments that the institution had previously suggested to the client as a suitable investment. Financial intermediaries objected that they had no duty of this sort, owing to the absence of a specific contractual provision on the issue.45 Accordingly, MiFID II tackles the issue from an information perspective. The underlying idea is probably that this information could help reduce customer reluctance about paying for advice. Indeed this particular issue shows the limits of the market praxis where customers do not pay for advice. If advice is paid for by financial product providers and issuers through commissions and kickbacks, or if advice is paid for through brokerage fees or other cross-subsidies, the incentives for the adviser to continuously track the client’s portfolio and suggest modifications might be not aligned with the client’s interest.46

D. Other Information [6.29] Pursuant to Article 24(4)(c), the investment firm must also provide information on all costs and associated charges. In the case of investment advice, this information concerns the cost of advice and how the client may pay for it, and encompasses any third-party payments. This means that there must be full disclosure on how advice services that are not directly paid for by the client are financed.

2. Independent Advice and Other Investment Services A. Offering Independent and Non-Independent Advice at the Same Time

[6.30] There are some issues concerning the relation between independent advice and other services. The first is whether the financial intermediary can label its advice as independent with some clients and non-independent with others. In other words, is independent advice exclusive or not? The answer depends on whether the term ‘independent’ is attached to the service or the firm. [6.31] The wording of MiFID II is not straightforward. However, Article 24(4)(a) seems to attach the independent requirement to the service and not to the firm (‘when investment advice is provided, the investment firm must …’). The same seems to be true under Article 24(7) (‘Where an investment firm informs the client that investment advice is provided on an independent basis … that investment firm shall not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients’). [6.32] If this construction of MiFID II rules is correct, an investment firm could, for instance, opt to offer independent advice to clients that are willing to pay for the service, while offering non-independent advice to clients that are not prepared to face its costs or that cannot sustain those costs because of the amount of money involved. Accordingly, there is no ‘independent adviser’ in MiFID II. Instead, there is ‘independent advisory service’. The ‘independent’ suit can be taken or left from time to time, and from client to client.

B. Coupling Independent Advice and Distribution [6.33] A strictly related issue is whether ‘independent’ advice can be coupled with distribution. Can a firm be a distributor of proprietary or thirdparty products and, at the same time, be an independent adviser? Again, since MiFID II’s ‘independent’ regime appears to attach to the service and not to the investment service provider, it seems that the firm can offer independent advisory services to selected clients even though it offers distribution services or sells its own products to another class of clients. If this is true, the firm can promote itself on the market as an independent

consultant while in reality primarily being a product distributor. Since research shows that retail investors do not read the very long contracts that they sign, and that the nature of the service they receive is, in their perception, characterized by what the person they interact with tells them, as well as by advertisement, the ‘independent adviser’ label might be used to attract clients and then offer them distributed products, and in particular proprietary products. [6.34] If this is true, what has really changed? In such an ‘ambiguity scenario’ certain retail clients are not offered independent advice contracts, and therefore the information mentioned by Article 24(4)(a) is not even referred to. Yet, the investment firm can advertise itself as an ‘independent adviser’ because it actually offers independent advice to other clients, and this can be sufficient to make the former think that the promotional efforts of the salespeople or the guidance they give in relation to the investment products they are placing is advice and, even worse, is ‘independent advice’. In the end, the problem has not changed much. The core problem is how to help clients distinguish ‘advice’ from ‘guidance’ or from promotion.47

C. Tied Agents and Advice [6.35] An area of further potential confusion is advice by tied agents. Under Article 29 MiFID II, Member States shall allow an investment firm to appoint tied agents ‘for the purposes of promoting the services of the investment firm, soliciting business or receiving orders from clients or potential clients and transmitting them, placing financial instruments and providing advice in respect of such financial instruments and services offered by that investment firm’. Thus, tied agents provide advice concerning financial instruments. [6.36] Is this advice different from investment advice? Investment firms have tried to argue that it is, under MiFID I, thereby seeking to distribute products with advice attached without facing the burden of the suitability test. The attempt was generally rebutted, but confusion still reigns, as a recent amendment to the Italian law shows, which now refers to Italian tied

agents as ‘financial advisers allowed to make off-premises offers’ (consulenti finanziari abilitati all’offerta fuori sede). The change reflects the new reality of the financial market, where tied agents are no longer door-to-door salesmen, but are moving towards financial planning and true financial advisory work. However, there are still many financial networks where tied agents operate as salesmen of products distributed by their investment firms or, even worse, salesmen of proprietary products. Needless to say, to term these people ‘advisers’ increases confusion.

3. Contractual Obligations A. Suitability Assessment and Investment Firms’ Personnel [6.37] As was the case under MiFID I, when providing investment advice the investment firm has to obtain the necessary information regarding the client’s or potential client’s knowledge and experience in the investment field relevant to the specific type of product or service, that person’s financial situation including his ability to bear losses, and his investment objectives including his risk tolerance. This ‘passive’ information (from the client to the financial intermediary) must enable the investment firm to recommend to the client or potential client the investment services and financial instruments that are suitable for him and, in particular, are in accordance with his risk tolerance and ability to bear losses.48 [6.38] There are glaring misunderstandings about what a suitable financial instrument is,49 and financial intermediaries continue to have problems in coping with suitability assessments, as a recent FCA review of suitability of retail investment portfolios provided by wealth management and private banking shows.50 Amongst the reasons, there is certainly the fact that many employees and agents that work for financial intermediaries and give financial advice are not financially literate.51 On this point, MiFID II rightly takes a stand. It establishes that Member States shall require investment firms to ensure and demonstrate to competent authorities on request that natural persons giving investment advice or information about financial instruments, investment services, or ancillary services to clients on behalf

of the investment firm possess the necessary knowledge and competence to fulfil their Articles 24 and 25 MiFID II obligations. Pursuant to Article 25(1), Member States shall publish the criteria to be used for assessing such knowledge and competence.

B. Suitability Assessment and Product Governance [6.39] There is considerable confusion about the interaction between product governance and the suitability assessment. According to the product governance provisions, the manufacturer has to ensure that the financial instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients. Moreover, the manufacturer shall ensure that the strategy for distribution of the financial instruments is compatible with the identified target market, and that the investment firm takes reasonable steps to ensure that the financial instrument is distributed to the identified target market. [6.40] With regard to firms that offer or recommend financial instruments, they shall understand the financial instruments and assess the compatibility of the financial instruments with the needs of the clients to whom they provide investment services. In doing so, the investment firms shall also take into account the identified target market of the clients, and ensure that financial instruments are offered or recommended only when this is in the interest of the clients.52 [6.41] Accordingly, there is a double-check system. The manufacturer monitors the distribution system, and the offering or recommending firm takes into account the target market that has been identified by the manufacturer. For this purpose, the latter must have appropriate arrangements in place to obtain and understand the relevant information concerning the product-approval process, including the identified target market and the characteristics of the product they recommend.53 How does this system actually work in the area of advice? What happens if the adviser believes that a certain financial product fits a client’s investment portfolio, and recommends the purchase of that product even though the

product, in isolation, does not match the client’s target market? It should be clear that the suitability assessment concerns a financial product within an investment portfolio, and that the single financial product should not be considered in isolation under a suitability assessment. Diversification is the only free lunch in finance, and a large part of the suitability assessment is about portfolio composition and correct asset allocation and diversification.54 Accordingly, the suitability assessment does not overlap with product governance. They are two distinct steps in the protection of clients’ interests, and the suitability assessment should not be absorbed by the product governance process. The logical consequence is that an adviser can recommend a financial product that is not targeted to the client’s class identified by the manufacturer, when that product fits well with the clients’ portfolio. [6.42] Nevertheless, the interaction between product governance and suitability assessment will create problems. It is clear that the courts will have problems in understanding how an investment adviser might have recommended a product to a client that was not part of the product’s target market. Therefore, product governance risks creating a warped idea about what the suitability assessment really is. Of course, a related issue will be whether the manufacturer should consider the adviser as a distributor and intervene when it appears that the product is destined for the portfolios of investors who are outside the target market.

C. The Written Statement of Suitability [6.43] Pursuant to Article 25(6), the investment firm must specify in a written statement on suitability (WSS) how the advice given meets the preferences, needs and other characteristics of the retail client. Accordingly, Member States are free not to impose the WSS to non retail clients. The WSS, of course, increases the cost of advice. The amount of the increase depends on how detailed the WSS has to be. Drafted in a very short form, the cost can be limited but the role of the document as an instrument to understand ex post the basis of the recommendation becomes negligible. By contrast, if the WSS must be a clear document that offers a

thorough view of how the financial adviser formed his judgement, then the cost of drafting it can become significant. The question concerning retail clients’ openness to pay for this extra cost resurfaces as one of the major problems of the MiFID II regime.

4. Investment Advice and Portfolio Management [6.44] The last point is about the relationship between investment advice and portfolio management. Under both services, a suitability assessment is required. Portfolio management is something more than investment advice, because the investment firm, instead of recommending an investment product, directly manages an investment portfolio owned by the client. However, and rather surprisingly, under MiFID II advice is subject to stricter requirements in terms of information to the client. The portfolio manager is not required to inform the client on whether the management is provided on an independent basis, nor on whether the advice is based on a broad or on a more restricted analysis of different types of financial instruments and whether the range is limited to financial instruments issued or provided by entities having links so close as to pose a risk of impairing the independent basis of the service offered. If the portfolio manager asserts to be offering independent portfolio management, it is not obliged to respect the stringent rules attached to independent advice. Moreover, the portfolio manager has no duty to write any statement of suitability. The peculiar inconsistency of this regulatory divergence is striking.

V. Conclusions [6.45] The main problem of the current MiFID I regime concerning advice is ambiguity. Investment firms can too easily add personal recommendations to their distribution efforts, and then defend themselves against accusations of a breach of the suitability assessment by asserting that they were placing financial instruments and not advising on them. The shift from the appropriateness test of distributary services to the suitability assessment attached to personal recommendations is extremely difficult to

prove for an investor, in the absence of written evidence or an explicit investment advice contract. This issue is not addressed by MiFID II, which mainly addresses information issues, above all the ones concerning independent advice. Ample room for ambiguities continues to exist, because investment firms will be able to wear too many hats, as will their tied agents. This is the natural implication of not going the UK or Dutch way, imposing fee-only advice. MiFID II policy effort is to nudge investors, especially retail investors, towards fee-only advisory services. [6.46] The written statement of suitability is a good idea. However, if rigorously construed it will also be an expensive one, because it takes time to write a statement that one day might be used against you. This is one of the areas where the regulation of advice and portfolio management diverge, with the latter curiously treated more gently than the former. This might create room for some forms of regulatory arbitrage between the two services. [6.47] The interaction between product governance and the suitability assessment looks likely to generate confusion. If MiFID II delivers the message that the suitability assessment is a sub-exercise that takes place within the boundaries of product governance (i.e. a derivate of the product governance process), there will be less reason to look for advice, and MiFID II as a law signal might have an undesirable impact on financial education—at least on that of laywers and courts.

1

Luigi Guiso, Paola Sapienza, and Luigi Zingales, ‘Trusting the Stock Market’ (2008) The Journal of Finance 63, 2557. 2 Directive 2014/57/EU of the European Parliament and of the Council of 16 April 2014 on criminal sanctions for market abuse (Market Abuse Directive), OJ L 173/179, Recital no. 1: ‘An integrated and efficient financial market and stronger investor confidence requires market integrity. The smooth functioning of securities markets and public confidence in markets are prerequisites for economic growth and wealth.’ 3 Basic, Inc. v. Levinson, 485 US 224 (1988), ‘reliance on the integrity of the price set by the market’. 4 Luigi Guiso, Michael Haliassos, and Tullio Jappelli, Household Portfolios (Cambridge, MA: MIT Press, 2002).

5

John Y. Campbell, ‘Household Finance’ (2006) The Journal of Finance 61, 1553; Dimitris Christelis, Tullio Jappelli, and Mario Padula, ‘Cognitive Abilities and Portfolio Choice’ (2010) European Economic Review 54, 18. 6 Campbell (n. 5). 7 Maarten van Rooij, Annamaria Lusardi, and Rob Alessie, ‘Financial Literacy and Stock Market Participation’ (2011) Journal of Financial Economics 101, 449. 8 Hans-Martin Von Gaudecker, ‘How Does Household Portfolio Diversification Vary with Financial Literacy and Financial Advice?’ (2015) The Journal of Finance 70, 489. 9 W. Montford and R. E. Goldsmith, ‘How Gender and Financial Self-Efficacy Influence Investment Risk Taking’ (2016) International Journal of Consumer Studies 40, 101; B. M. Barber and T. Odean, ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’ (2001) Quarterly Journal of Economics 116, 261; cf. also M. Gentile, N. Linciano, and P. Soccorso, ‘Financial Advice Seeking, Financial Knowledge and Overconfidence’ (2016) Consob, Quaderni di finanza 83, 10–11. 10 Brad M. Barber and Terrance Odean, ‘Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’ (2000) Journal of Finance 55, 773. 11 William N. Goetzmann and Alok Kumar, ‘Equity Portfolio Diversification’ (2008) Review of Finance 12, 433. 12 Laurent E. Calvet, John Y. Campbell, and Paolo Sodini, ‘Down or Out: Assessing the Welfare Costs of Household Investment Mistakes’ (2007) Journal of Political Economy 115, 707. 13 Laurent E. Calvet, John Y. Campbell, and Paolo Sodini, ‘Fight or Flight? Portfolio Rebalancing by Individual Investors’ (2009) Quarterly Journal of Economics 124, 301; Tom Y. Chang, David H. Solomon, and Mark M. Westerfield, ‘Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect’ (2016) Journal of Finance 71, 267. 14 Andrea Frazzini, ‘The Disposition Effect and Underreaction to News’ (2006) Journal of Finance 61, 2017; Camelia M. Kuhnen, ‘Asymmetric Learning from Financial Information’ (2015) Journal of Finance 70, 2029. 15 Brad M. Barber et al., ‘Just How Much Do Individual Investors Lose by Trading?’ (2009) Review of Financial Studies 22, 609. 16 H.-M. von Gaudecker, ‘How Does Household Portfolio Diversification Vary with Financial Literacy and Financial Advice?’ (2015) The Journal of Finance 70, 489. 17 Nick Chater, Steffen Huck, and Roman Inderst, ‘Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective’ (2010) Final Report 22, para. 590. 18 Cf. Riccardo Calcagno and Chiara Monticone, ‘Financial Literacy and the Demand for Financial Advice’ (2015) Journal of Banking & Finance 50, 363 (complements); M. Gentile, N. Linciano, and P. Soccorso (n. 9), 30 ff (complements); H.-M. von Gaudecker (n. 16), 500 (neither complements nor substitutes).

19

Commission Staff Working Document, Economic Analysis Accompanying the document Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions Action Plan on Building a Capital Markets Union (2015) 64. 20 ICPSR Eurobarometer 60.2, 21. 21 In an experimental setting, Chater, Huck, and Inderst (n. 17) found that a significant minority of retail investors are disproportionately averse to paying an up-front fee for advice: see in particular at para. 603. 22 See paragraph 6.37. 23 Chater, Huck, and Inderst (n. 17) 131 ff. 24 Roman Inderst and Marco Ottaviani, ‘Competition through Commissions and Kickbacks’ (2012) American Economic Review 102, 780. 25 Patrick Bolton, Xavier Freixas, and Joel Shapiro, ‘Conflicts of Interest, Information Provision, and Competition in the Financial Services Industry’ (2007) Journal of Financial Economics 85, 297; Roman Inderst and Marco Ottaviani, ‘Misselling through Agents’ (2009) American Economic Review 99, 883. 26 Inderst and Ottaviani (n. 24), 782. Cf. also Andreas Hackethal, Michael Haliassos, and Tullio Jappelli, ‘Financial Advisors: A Case of Babysitters?’ (2012) Journal of Banking & Finance 36, 509. 27 Calcagno and Monticone (n. 18). 28 Dimitris Georgarakos and Roman Inderst, ‘Financial Advice and Stock Market Participation’ (2014). Available at SSRN 1641302. 29 Utpal Bhattacharya et al., ‘Is Unbiased Financial Advice to Retail Investors Sufficient? Answers from a Large Field Study’ (2012) Review of Financial Studies 25, 975. 30 Financial Times, ‘UK banks set to launch “robo-advisers”’, 22 January 2016; FINRA, ‘Report on Digital Investment Advice’ 15 March 2016, available at . 31 See paragraph 6.38. 32 But see Inderst and Ottaviani (n. 25). 33 Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ L 241/26 (MiFID I Implementing Directive). 34 Article 39, MiFID I Implementing Directive (2006/73/EC). 35 This is the definition offered by Article 4(4) MiFID II, which contains minor amendments to the one contained in MiFID I. 36 Italy was a case in point. Up to MiFID I, Italian courts considered the suitability test to be applicable to any investment service and, in particular, to distributional services such as placing. 37 Consob, decision no. 18615/2013, (2013) Bollettino n. 9.1 (Cassa di Risparmio di Savigliano); decision no. 19283/2015, (2015) Bollettino n. 9.1 (Poste Italiane); decision no.

19368/2015 (2016) Bollettino n. 1.2 (Banca Popolare); decision no. 19497/2016 (2016) Bollettino n. 1.2 (Cassa di Risparmio di Bolzano). 38 Fernando Zunzunegui, ‘Mis-selling of Preferred Shares to Spanish Retail Clients’ (2014) Journal of International Banking Law and Regulation 174; Securities and Markets Stakeholder Group, ‘Advice to ESMA: Investor Protection Aspects of the Consultation Paper on MiFID II and MiFIR’, 8 August 2014, available at . 39 J. Brunsden and P. Jenkins, ‘Bank Rescue: Putting Bondholders on the Hook’, Financial Times, 4 January 2016. 40 With regard to small and medium enterprises, the mis-selling cases have mainly involved derivatives, and more specifically swaps. However, they are mainly pre-MiFID I cases. 41 See MiFID II, Article 24(4)(a). 42 Article 24(7)(a). 43 Article 24(7)(b). 44 This is a set of new rules enforced since 2013 in the UK, which is currently under review precisely because it apparently enlarged the ‘advice gap’: see HM Treasury—FCA, ‘Financial Advice Market Review’, March 2016, available at . 45 In Italy courts have not offered a uniform answer to the problem: cf. Tribunal of Prato, 13 June 2015 (the investment firm had a duty to inform the client about the collapse in value of Greek bonds); Tribunal of Turin, 20 November 2012 (no ongoing duty on the investment firm after the brokerage service has been rendered). 46 As far as I know, economic research has not analysed this issue. 47 Niamh Moloney, UE Securities and Financial Markets Regulation (Oxford: Oxford University Press, 2014), p. 805 (‘the reform … sits uneasily in an EU market dominated by sales of proprietary products’). 48 Whereas the concept of suitability of a financial instrument or a financial portfolio is understood, at least in its general terms, it is more difficult to understand what it is referred to with regard to a suitable investment service. Here MiFID II, as well as MiFID I, mentions something that it is outside its own boundaries: whereas ‘investment advice’ is defined as the provision of personal recommendations to a client in respect of one or more transactions relating to financial instruments, both the old and the new Directives cover recommendations of ‘services’, which differ conceptually from recommendations of ‘financial instruments’. 49 It is even more so, of course, with regard to bundled products, to which the suitability test applies as well—assessing them as an overall bundled package: Article 24(11) MiFID II. 50 FCA, Wealth management firms and private banks. Suitability of investment portfolios. TR15/12 (2015). 51 Curiously, this issue is not covered by the blossoming economic literature on financial literacy, where the true financial literacy of banks’ and investment firms’ employees is

never investigated. 52 Article 16(3). 53 Recital 71. 54 See ESMA, ‘Guidelines on certain aspects of the MiFID suitability requirements’ (2012), para. 60: ‘A firm should establish policies and procedures which enable it to ensure inter alia that: (a) the advice and portfolio management services provided to the client take account of an appropriate degree of risk diversification.’

7 CONFLICTS OF INTEREST Stefan Grundmann and Philipp Hacker*

I. Foundations of the Regime 1. The Ambit of the Topic 2. Theoretical Approaches for Regulating and Limiting Conflicts of Interests 3. The Range of Regulatory Approaches II. The Regime by Single Stages and Examples 1. Organizational Requirements Minimizing Conflicts of Interest 2. Conflicts of Interest in the Formation of Investment Services Contracts 3. In Particular: Conflicts of Interest and the Regime on Fees 4. Conflicts of Interest in the Execution of Investment Services Contracts (‘Best Execution’) 5. Conflicts of Interest in the Case of Linked Contracts 6. New Strategies: the Future of the Regulation of Conflicts of Interest III. Conclusion

I. Foundations of the Regime [7.01] We shall first provide an overview of the foundations of the regulation of conflicts of interest in investment services both with respect to

theory and to positive law.1 First, however, we must specify which conflicts of interest we are interested in.

1. The Ambit of the Topic [7.02] Conflicts of interest span a wide area in the law. We shall therefore first demonstrate what specific conflicts of interest this chapter will focus on and then argue that the specific types of problems of these conflicts of interest do not sit comfortably within the general framework of the objectives of the MiFID I and II regulations.

A. Which Conflicts of Interests? [7.03] Conflicts of interest abound in many settings in private law. Real estate brokers recommend flats to incoming residents, directors manage companies for the shareholders, rating agencies are paid by those whose papers they are evaluating, and car dealers resell used cars. In all of these cases, the agents are subject to conflicts of interest that decisively impact on their strategies and actions. In a first, very broad approach, conflicts of interest typically arise under two conditions. First, an agent is entrusted to look after the assets, health, or other interests of another person.2 Second, her utility-maximizing strategy does not maximize the benefit of the other party, that is, the agent has an incentive to act opportunistically or to otherwise not fully maximize the benefit of the other party.3 While some conflicts of interest have been regulated for a long time (corporate fiduciary duties) or are coming under increasing regulatory scrutiny (rating agencies), many conflicts of interest in general contract law remain fairly untouched by mandatory or even default law. They form part and parcel of the bargaining process which is often entrusted to work as a balancing device between the parties: as a matter of positive law, both parties are free, within certain limits, to pursue their own interests without regard to the interest of the other party or even disclosing conflicts of interest. Therefore, the core question is: What distinguishes a conflict of interest worth regulating from one whose solution is left to bargaining? This difference can also be coined as one of terminology, for instance contrasting opposed interests from a

conflict of interest in the strict sense.4 Terminology, however, exists for the sake of clarity mainly; it provides a term for a distinction for which there are plausible or even mandatory substantive reasons. The substantive reasons are what really matters. In a contract relationship, these have to be found primarily in the implied terms agreed upon or in the expectations and interests of the parties (and the client–intermediary relationship is contractual in essence even if it is also subject to public regulation and supervision). In the light of this starting point, the main difference would seem to be whether the situation is one where the parties involved know that they are bargaining about a certain solution or whether the decision on the solution is left by one party to the other—with the expectation that that party will then use this power for the benefit of the first.5 From a normative perspective, this explanation/expectation becomes even more convincing when this power to influence the assets/rights/interests of the other is handed over by the counterparty to the decision-maker without the counterparty receiving any compensation in return and without any investment made by the decision-maker.6 In this case, the decision-maker can be seen to have received a position not only with an implied term to see solely after the interests of the other party, but also without her own efforts legitimizing her interest to be taken into account. Thus, in such a case, the rule that the decision-maker should take solely the interests of the other party as the guideline to her action can be justified both by (implied) agreement and by objective reasons. The additional criterion—entrusting a position of influence plus doing so without compensation—also helps to distinguish borderline cases. If an enterprise drafts standard contract terms, it certainly has a position of power to influence the other parties’ interests; but it does not receive it for free, as the overall package of conditions (with the price) cannot be split into parts without distorting the balance of price and duties. Imposing a duty to take only the other party’s interest as a guideline would force the enterprise to forego the possibility to calibrate its own duties when making an offer in return for a certain price. The absurd result would be that whoever drafts standard contract terms always has to draft them taking the clients’ interests as sole guideline for such drafting. Since the regulation in standard contract terms relates to duties costly to comply with, drafting in one way or another is not without costs and hence such an absurd conclusion is not warranted.

[7.04] One can frame our focus—on conflicts of interest in the narrow, regulated sense—not only by looking to the case patterns, but also by defining the legal consequences attached. We focus on those situations in which the party subject to a fiduciary duty does indeed have to take the interests of the other party as the sole guideline (strict fiduciary duty) and— moreover—where this duty is even accompanied by some mechanism which is aimed at rendering compliance with this substantive guideline even more efficient. [7.05] While this situation and its legal consequence are, of course, not limited to financial services, that is, while they do exist also in other areas of the law—clearly in company law, but also in distribution chains, for instance with respect to sales’ agents7—both the situation and legal consequence are particularly important for the area of financial services; moreover, the area is one by which this situation and its legal consequence have been shaped in a particularly meaningful way. They are so important here that one could even say that they are all-pervasive and that financial services are unique in the mode and consistency with which conflicts of interest have been regulated. In this sense, the regulatory and theoretical landscape looks quite different in the financial services field. [7.06] In this domain, two, perhaps even three aspects are striking. First, as has already been stated, the interests of one party strictly prevail in the regulatory setting—those of the client—and this is or can be justified by the fact that an (entrusted) position of influence has been conveyed (without compensation). Second, this general rule is reinforced by specific, in large part mandatory provisions about on one hand organizational features intended to minimize conflicts of interest and on the other hand the disclosure of conflicts of interest. This immediately raises the question of why conflicts of interest are treated differently or more intensively in the area of financial services than in other parts of contract law or private law more generally, or at least with more emphasis on a strict rule to have clients’ interests prevail. A third element may be seen in the fact that the duty to take the client’s interest as a guideline seems to be strong even if it is difficult to see conveyance of an entrusted position. In other words, there seems to be an overspill from the many situations in which there is indeed conveyance of an entrusted position to other situations in the bank–client

relationship. Why, for instance, is there a right to banking secrecy in a very general sense, and also in the credit business (where solely the client or her interests decide whether the bank may pass on the details of the relationship), and why does there also seem to be a duty to disclose conflicts of interests in situations where a loan agreement is bargained for? However, as the cases regulated by MiFID I and II fall into the core area of entrusted positions being conveyed, the questions of overspill are not paramount in the following, for our purpose. Section I.2 on theoretical approaches will provide an account of the characteristics that distinguish these cases of uncompensated conveyance of entrusted positions from others and legitimize regulation. [7.07] There is a second and often neglected difference within conflicts of interest, but this time not concerning the field in which they arise but rather the parties whose interests are affected. On one hand, we can distinguish between the interests of the client and the interest of the financial services provider which are in conflict. On the other hand, however, the provider may also be conflicted between the interests of different clients that he simultaneously advises.8 Both types are mentioned in Article 18(1) MiFID I and Article 23(1) MiFID II. The latter case, however, has not received much attention in the literature9 and the regulatory provisions; we shall thus focus on the difference between the provider’s and the client’s interest, and only briefly address the other situation: it is important mainly when clients really ‘compete’, namely in questions of ‘execution’, for instance to know which order should take preference, and what ‘best execution’ is more generally. In other areas of the law, such as directors’ duty to respect the share of minority shareholders according to strict equal treatment standards, this problem is much more important.10

B. No Consistent System of Goals in the Exposition of MiFID I and II [7.08] If one asks about the importance of conflicts of interest and their regulation in the ambit of application of MiFID I and II, the overall image seems ambivalent.

[7.09] On one hand one does not only find both specific provisions for the organization of the provider of investment services aimed at minimizing conflicts of interests (Article 13(3) MiFID I and Article 16(3) MiFID II) and contract rules (namely disclosure rules, Article 18 et seq. MiFID I and Article 23 et seq. MiFID II), but there is also one specific rule on the overall problem of conflicts of interest (Article 18 MiFID I and Article 23 MiFID II). Moreover, two core problems of conflicts of interest, the regime on ‘best execution’ (Article 21 MiFID I and Article 27 MiFID I) and the one on inducements (Article 24(4) through 24(9) MiFID II), have aroused enormous interest, both in theory and in the courts, and/or were at the core of legislative development in the reform (with, again, one, now two, specific norms only on this). Finally, there is also a special provision allowing for particular Level 2 and Level 3 legislation, especially with respect to the key aspects of conflicts of interest (definition, main organizational means, main kinds of disclosure) (Article 18(3) MiFID I and Article 23(4) MiFID II). All this would seem to speak for an absolutely core role of the regulation of conflicts of interest in the overall regime of MiFID I and II. [7.10] On the other hand, however, despite their importance, the aims of the regime on conflicts of interest are not systematically dealt with or related to the overarching regulatory objectives in MiFID I and II. This is partly fuelled by the confusion about the aims of MiFID I and II themselves. The most often and most notably stated purpose of MiFID I and II is to protect investors;11 in some parts, this is complemented by the— necessarily interlinked—aim of safeguarding the integrity of capital markets (explicitly in this sense Article 9(3) MiFID II as the core rule defining the board’s duties, see also Article 31 et seq. MiFID II).12 Since the regulation was also passed in an effort to harmonize the conditions for offering investment services in the European single market, the two aforementioned goals are joined by a third: the creation of one (harmonized) European Financial Market, which some even see as the main goal, really,13 and which could probably be supported by Recital 7 MiFID II,14 but is contradicted by what is arguably the most meaningful Recital, as it puts all goals into one context: Recital 164 states that the objective of this Directive [is to create] … an integrated financial market in which investors are effectively protected and the efficiency and

integrity of the overall market are safeguarded, [and this] requires the establishment of common regulatory requirements … so as to prevent opacity or disruption on one market from undermining the efficient operation of the Union financial system as a whole which cannot be sufficiently achieved by the Member States but can rather [by the] … European Union. This Recital can probably be seen as a general one, which also states the set of goals with respect to conflicts of interest regulation—in fact as the most general one—and it clearly establishes the goal of harmonization (only) as instrumental to achieving (i) ‘investor protection’ and (ii) ‘efficiency and integrity of the overall market’. [7.11] Conflicts of interests are mentioned a few times in the MiFID I and II regime, but the relationship to the three aims is not clarified, particularly not with respect to investor protection. In MiFID I, only Recital 29 speaks about conflicts of interest and explains the need of regulating them by the proliferation of products. In MiFID II, this is taken up in Recital 56 where now—at last and at least—the link to investor protection is also specified.15 Therefore, it seems clear that mitigation of conflicts of interests is central to investor protection (a point apparently confirmed in Article 9(3) MiFID II already mentioned, which also mentions market integrity); this goal is chiefly pursued through business conduct rules. However, the main provisions regulating conflicts of interest in MiFID I and II, Articles 18 and 23 respectively, do not form part of the section on investor protection which comprises the business conduct rules. [7.12] The prevailing view for capital market law more generally would seem to be that good investor protection is also functional for furthering market efficiency, even being one of the main tools for doing so. Therefore, it seems fair to start from the assumption that conflicts of interest are combated with the aims of investor protection and market integrity and also market efficiency—at least in the core cases of conflicts of interest. Here, the argument is accepted more than in any other area of regulation that sound protection of individual investors’ interests also helps the market to function.16 This, however, is only a rough description. First, the link between conflicts of interest and market integrity and efficiency is not

explicitly made, even in MiFID II. Second, there is no specification of how investor protection or market integrity should be conceived in more detail, for instance whether investor protection should be directed towards rationally acting investors or those with bounded rationality, or both (in which combination?), and for instance whether the goal of market integrity should be understood as requiring ‘fair’ solutions in each single case or as only defying more general distrust in markets. [7.13] As the goals are not described in sufficient detail (namely in the Recitals), the discussion has to be based on a survey of the main discussed and possible approaches, refining the goals of investor protection and market integrity/efficiency (see Section I.2)—followed by a short survey of the main rules and their main thrust (see Section I.3)—before we enter into a stage-by-stage analysis (Section II below).

2. Theoretical Approaches for Regulating and Limiting Conflicts of Interests [7.14] Against this partly dissatisfying state of positive law, it is all the more important to consider the theoretical foundations for the regulation of conflicts of interest. Three different, yet interlinking, approaches can be uncovered: an appeal to fairness, the pursuit of efficiency, and the acknowledgment of cognitive errors and limitations.

A. Fairness: Entrusting Positions of Influence (without Compensation) [7.15] Fairness is a key principle both in economics17 and in the law.18 Ever since Aristotle, the regulation of exchange through contract has been closely linked to notions of justice and fairness.19 In modern times this was highlighted, in different ways and with different assumptions, by the leading political philosophers of the twentieth century, John Rawls20 and Jürgen Habermas.21

[7.16] In contract law, fairness standards have mainly been derived (i) from what has been called ‘justice of consensus’ and/or (ii) on the basis of objective considerations. With ‘justice of consensus’, all those considerations are addressed which argue that agreement, at least if duly formed (information, no overreaching, etc.), can be seen as sufficient source of legitimacy—certainly when the parties’ will and interests are seen as the ultimate yardstick, but also when contract law is seen to be inspired first and above all by the interests of society at large.22 Among the explanations already given when defining which conflicts of interest are discussed in this chapter, the first criterion of differentiation would seem to go particularly into this direction. If regulation of conflicts of interest targets situations where a position of influence has been entrusted from one party to another and if in this situation a rule is meant to apply which requires the latter to act solely in the interest of the former, the main argument would seem to be this: The position which allows one party to influence the affairs of the other has been entrusted to the former on the condition—at least on the implied condition—that the former has to exercise such power solely to the benefit of the latter.23 Thus, the rule envisaged is justified as being agreed upon and hence ‘just’, at least in the consensual notion. The second explanation given above for such a rule (when defining which conflicts of interest are discussed in this chapter) points to the fact that the situation can also be defined as one where the party to whom such power has been entrusted has not given anything in return for it and does not make sacrifices (‘uncompensated’ entrustment). Indeed, the argument is that this criterion has to be satisfied in addition to the one of entrusting powers/influence if one wants to justify the rule that solely the interest of the client has to be used as a guideline of action. It can neither be assumed nor would it be obviously ‘fair’ that a party who receives a power to influence needs to act solely in the interest of the other party if this implies a loss, that is, if the party entrusted would have to give in assets or funds which she owned before acting in this way.24 [7.17] It should be noted that the fairness concerns apply equally to all cases of conflicts of interest. This is not the case or is at least less so with the two remaining theoretical approaches, efficiency and cognitive limitations (which, however, are perhaps more telling on the question of

whether financial services providers are different from other segments in this respect).

B. Efficiency: Avoiding Hidden Gains (Fundamental Lack of Transparency) [7.18] The second line of argument is about efficiency and the effect of hidden gains. In the transactions governed by MiFID II, there are many where the outcome of the action—for instance a piece of advice given— could be compared with so many other outcomes possible that this renders any comparison with outcomes which would have been achieved without any conflict of interest influencing the outcome practically impossible. One such example is the advice given on the—theoretically unlimited range of —investment instruments. In this case, hidden gains derived from the use of the position of power lead to a fundamental lack of transparency in the offers made for the client. This is so with respect to the cost of the investment advice (as the adviser earns the fees plus the hidden gains) and with respect to the value of the investment advice to the client, that is, how high the chances are that the client would have been offered a better investment opportunity without such conflicts of interest existing.25 In this case, obliging the fiduciary to act solely in the interest of the client is aimed at avoiding such fundamental opacity—and the well-known adverse selection problems associated with it.26 As we will see, even such an obligation as this is not seen as being sufficient; rather a procedural rule preventing conflicts of interest is added to the legal framework. [7.19] There are also, however, situations where hidden gains may occur, but end prices can be compared—be they the result of a better price which the investment services provider could get, but to which he added a hidden gain, or of a less favourable price to which then, however, no additional hidden gains would have been added. Such a situation is possible once the investment instrument is chosen and it comes to ‘best’ execution. In this situation, the exercise of discretion by the investment services provider may well be much better observable for the client, and the end price paid may not differ for him. In these situations, the conflict of interests may have repercussions at other levels—for instance with respect to the choice of

trading venue, but need not lead to an adverse selection problem for the client.27 Thus, the argument from a hidden gains and adverse selection (efficiency) perspective might imply that divergent strategies of dealing with conflicts of interest at different stages of the investment relationship are indeed at least plausible. [7.20] This leads to yet another, more segment-specific consideration of conflicts of interest with respect to efficiency concerns: the efficiency argument seems particularly strong in the case of financial services. While in other areas of the law (renting a house, buying a car) clients can at least theoretically be entrusted to take care of their own interests, this seems close to impossible in investment contracts due to the complexity of the investment products and the resulting size of the information asymmetry between the service provider and the client. This speaks in favour of segment-specific concerns. Thus, Enriques for instance suggests that financial services are special because of their vague standards and the often small amounts of damages awarded in cases of conflicts of interest, leading to under-enforcement. Moreover, he sees reputational negative externalities for the entire industry that arise from ‘scandals’.28 In our view, some doubt is cast upon at least the second point by the fact that poor—or biased— investment advice often affects good parts of a person’s wealth or savings (for old age, for estate planning, etc.) and that, at least in Germany, the large majority of investment services cases centre on allegedly undisclosed conflicts of interest and the large majority of all cases based on violation of conflicts of interest rules resides in the area of financial services. We even think that MiFID II transactions are particularly prone to leading to existential risk and to potentially ruinous transactions in a relatively high ratio of cases. The argument that a particular design of conflicts of interest rules can be traced back to or even justified by scandals only seems convincing from a post-crisis perspective. However, most of the MiFID II reform had already been discussed and even designed before 2007/08. Therefore, the vagueness argument would seem to be the most credible. As has been shown above, this affects only certain cases of conflicts of interest in the financial services area, not really all of these cases. Moreover, this is a phenomenon which is indeed particularly important in financial services, but is certainly not limited to it. In terms of information theory, the problem of vagueness is that of quality of the advice (service) being a credence

rather than an experience or even an inspection good.29 This would seem to imply that since quality is so difficult to observe for clients, a procedural rule—to avoid conflicts of interest as much as possible and to disclose them when they do occur—seems needed more here than in other segments.

C. Cognitive Limitations: Mitigating Processes of Suboptimal Use of Information [7.21] A third aspect has received increasing attention in the wake of the financial crisis: the cognitive limitations of investors. This argument draws heavily on research in cognitive psychology and behavioural economics. In recent decades, these areas have engendered a shift of paradigms in economics: homo economicus has increasingly come under attack and is perhaps even in part being replaced by a more realistic, more empirical figure.30 The behavioural approach to economics and the law has uncovered two sets of specific limitations that are of interest here: cognitive capacity limits and bounded rationality.31 The first notion refers to the limited number of pieces of information that the working memory of the human brain can simultaneously process. The concept is simple: Once all channels of information processing are fully used, any additional information provokes information overload.32 It leads not only to stress and scrambling but to a deterioration in the quality of decisions.33 In a classic article, George Miller suggested back in 1956 that the maximum number of pieces that can be processed simultaneously (so-called chunks) is roughly seven.34 It turns out that this number varies greatly between agents and tasks. However, contemporary research shows that the limit will often already be reached at four chunks.35 This has deep implications for traditional regulatory strategies such as disclosure. If too many items are disclosed at a time, they might not reach the working memory. Moreover, limited attention may result in clients ignoring vital information in the first place.36 [7.22] Furthermore, even if the amount of information does remain within cognitive capacity limits, the correct processing of the information may be subject to cognitive biases. In recent decades behavioural economics research has identified a whole range of different biases that testify to what

has come to be called ‘bounded rationality’, borrowing a term from Herbert Simon.37 Bounded rationality may interact with the disclosure of conflicts of interest in several ways.38 First, optimism bias may lead a client to believe that the negative impact of conflicts of interest will not materialize in her case.39 Second, a confirmation bias40 may operate if the client is inclined to have a positive view of the service provider: she will filter information given by the provider in a way that reflects her benevolent attitude toward the provider, thus downplaying her perception of the potential impact of conflicts of interest. This is particularly pertinent in the case of investment advice since trust in advisers is generally quite high: More than 80 per cent of investors in the EU used advisers in the retail investment market,41 and naïve trust is generic,42 with more than 80 per cent of the advisees generally trusting their advisers.43 Consequently, confirmation bias can be considered to be widespread among advisees. Perseverance—a similar phenomenon denoting the continued holding of beliefs even after the rational basis for these beliefs has been removed— may have a similarly frustrating effect on the effectiveness of disclosure of conflicts of interest.44 [7.23] However, as in all discussions of bounded rationality, a note of caution is in order.45 On one hand, other biases may cut against the ones just mentioned. For example, if the client believes the chance of being affected by unwanted behaviour by the service provider is quite small, probability weighting may lead to an overestimation of this probability: one of the central tenets of Kahneman and Tversky’s Prospect Theory is that very small probabilities tend to be overweighted.46 Furthermore, the availability heuristic may work in either direction depending on whether stories of benevolent or malevolent providers are mentally available to the client.47 On the other hand, it is crucial to note that not all clients will be acting in a boundedly rational way. Rather, they will act along a continuum ranging from full to bounded rationality. Regulatory theory must thus take uncertainty inherent in empirical research into account.48 [7.24] Despite all uncertainty, however, it remains clear that cognitive limitations must be dealt with thoroughly in financial markets. This is not only a consequence of the financial crisis of 2008 but also reflects the fairly

advanced state of knowledge on empirical behaviour of investors. In fact it is quite ironic to see that behavioural economics has found most traction within the economic discipline in the area which was formerly a stronghold of rationality: finance.49 Richard Thaler traces the rise of behavioural finance to the exceptional amount of data available in financial markets and hence the possibility to run empirical studies easily.50 The truth of this claim notwithstanding, the prevalence of behavioural finance—coupled with the often existential impact of unplanned consequences of financial contracts on clients—perhaps provides an explanation of why conflicts of interest, which may form an unholy alliance with biased perceptions, are regulated so tightly within the finance industry. It is this range of regulatory approaches that we turn to now.

3. The Range of Regulatory Approaches [7.25] To address these issues, that is, to safeguard fairness, to enhance efficiency, and to mitigate cognitive limitations, the law has adopted a range of regulatory approaches. The two most important ones are organizational rules on one hand and contract or disclosure rules on the other (see below Section I.3.A).51 However, if analysed more carefully and within this twofold main thrust, MiFID II seems to follow a considerable range of quite heterogeneous regulatory strategies for different questions and different stages (see below Section I.3.B.). In all the explanations in the following, while primarily commenting the MiFID II regulatory body, we also investigate both the theoretical underpinning and—at least where appropriate—the alternative strategies possible.

A. Organizational Rules and Contract/Disclosure Rules [7.26] The division between organizational rules and contract or disclosure rules is reflected in the provisions of MiFID I and II. Article 13(3) MiFID I holds that ‘[a]n investment firm shall maintain and operate effective organizational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest […] from adversely affecting the interests of its clients.’ This is reiterated in

Article 16(3) MiFID II. To ensure effective monitoring of the competent authorities, Article 13(6) MiFID I and Article 16(6) MiFID II impose a duty of record keeping. Disclosure rules can be found in Article 18 MiFID I and Article 23 MiFID II. The first paragraph of each provision enjoins the provider to identify and manage all possible conflicts of interest between himself and the client or between different clients. In fact, this two-step approach still largely relates to organizational measures and not yet to contractual or disclosure rules proper. (Only) the second paragraph, adding a third step, truly embarks on the route of the contractual relationship and contains a duty to disclose conflicts of interest whenever organizational matters are insufficient to protect the client. [7.27] Both types of provisions, organizational and disclosure rules, are designed to prevent conflicts of interest in the first place (organizational) and, where not possible, to at least prevent damage to the investor by enabling an informed decision (disclosure). Both features are also an expression of the general duty of the provider to safeguard the interests of the client (see Chapter 4). However, this rule was deemed too vague and had to be qualified by provisions on the conflicts of interest mandating specific prospective measures in the organizational and contractual domain. Thus, the regulation is not only based on the assumption that the services provider has to be bound to strictly follow the client’s interests as the sole guideline, but also requires that a rule of precaution be added: All three steps are meant to make the provider (i) aware of a conflict of interest and document it; then (ii) minimize the conflict, that is, avoid as far as possible situations where it is more likely that she might violate her obligation to strictly observe the client’s interests; and (iii) at least call on the client to be alert that this risk is particularly high in a conflict of interests situation. Thus, the regime on conflicts of interest constitutes a preventive measure which is aimed at a better compliance with the obligation to strictly observe the client’s interests. [7.28] The first question that arises from this dichotomy is the relationship of the two types of prospective measures to one another. The answer of positive law is that organizational measures need to be pushed as far as possible in order to ensure the maximum mitigation of conflicts of interest; it is not sufficient simply to disclose and to abstain from the best

organizational prevention structures. This becomes apparent in the formulation of Article 18(2) MiFID I and Article 23(2) MiFID II where disclosure is envisaged as a subsidiary tool to which the company may only have recourse if organizational measures prove insufficient. The same can be deduced from the unconditional nature of the organizational duties in Article 13(3) MiFID I and Article 16(3) MiFID II. While being unconditional, the organizational duties only go as far as is ‘feasible’. The exact amount of effort required will be investigated further below.52 It may be noted that the institutionalization of the duty to safeguard the clients’ interests by organizational means is a typical instrument in banking and financial services supervision whenever the mere duty to act in the interest of the client is deemed insufficient. [7.29] Second, if the disclosure duty is triggered, the question of the reach of disclosure arises. More particularly, it is unclear from the provisions in MiFID I and II whether the provider only has to warn that a conflict of interest exists or whether she also has to explain the specific conflict she is subject to. This too will be investigated in detail below.53

B. Heterogeneous Approaches in the Different Stages of the Client Relationship [7.30] Disclosure rules are most often contract rules. However, the new MiFID II regime in particular operates with a whole range of different regulatory approaches that go well beyond such a contract standards approach to deal with conflicts of interest. More specifically, three further types of approaches can be discerned: a market structure approach, a strict investors’ interest approach, and an unfair trade practices/competition law approach. These different methods correspond to the regulation of different stages of the transaction. The formation of the contract is subject to the contract standards and the market structure approaches, the execution to a strict investors’ interest approach, and linked contracts are governed by an unfair trade practices/competition law approach. In the remainder of this chapter, we will describe the details of the different approaches and relate them to the corresponding stages of the transaction.

II. The Regime by Single Stages and Examples [7.31] The different stages and corresponding duties contemplated in the next sections are as follows: organizational duties; formation of the investment services contract and disclosure; remuneration regimes in particular; execution and multiplicity of contracts, and the duty of best execution; and linked contracts. Thus, while the organizational duties are meant to minimize and even exclude conflicts of interest and therefore take precedence, the stages concerning the contractual relationship are much more manifold and rich in regulatory ideas. The section concludes by outlining new strategies with regard to the future of the regulation of conflicts of interest.

1. Organizational Requirements Minimizing Conflicts of Interest [7.32] One of the specific components of the regulatory regime on conflicts of interest in the field of financial services is the precautionary rules that mandate specific organizational features within the company of the provider.

A. A Company Structure Solution [7.33] The regulation of the organization of investment firms is not restricted to the mitigation of conflict of interests. Rather, the MiFID regime mandates effective organizational structures for general compliance (Article 13(2) MiFID I, Article 16(2) MiFID II), continuity of service (Article 13(4) MiFID I, Article 16(4) MiFID II), the avoidance of undue operational risk in the outsourcing of functions (Article 13(5) MiFID I, Article 16(5) MiFID II), record keeping (Article 13(6) MiFID I, Article 16(6), (7) MiFID II), protection of the client’s ownership rights (Article 13(7), (8) MiFID I, Article 16(8), (9) MiFID II), and algorithmic trading (Article 17 MiFID II). The depth of regulation shows that organizational requirements are considered a key component of risk regulation in financial services by the

European legislator. While this regime can be seen to supplement company law in that it regulates the organizational structure of companies engaging in investment banking, it is striking for at least one novelty as compared to typical company law:54 it does not only specify the work of the organs of the company and impose duties on members of such organs, but also independently specifies structural duties well below the level of organs. Under general company law, these aspects would rather be subject of duties of proper organization imposed on the board, but whose arrangement as such and certainly whose details would be left to the board’s discretion.55 [7.34] Thus, it does not come as a surprise to see that conflicts of interest are also subject to organizational precautionary provisions in Article 13(3) MiFID I and Article 16(3) MiFID II. The Level 2 Directive implementing MiFID I56 provided for further detail in organizational regulation, mandating inter alia the establishment of Chinese walls (Article 22(3) MiFID I ID). The core idea behind the regulation of the organization of the provider is to set up a company structure designed to minimize conflicts of interest in the first place. Since conflicts of interest raise the mentioned problems of fairness, efficiency, and cognitive limitations on one hand, and since the mere duty to act in the client’s best interest does not seem sufficient to exhort providers to do so in fact, financial services regulation, also in other fields such as general banking supervision law,57 makes specific provisions concerning the governance and organizational structure of the company. These provisions erect the first line of defence against the negative impact of conflicts of interest: while they will often not be sufficient to fully eradicate them, the hope is to contain them to a minimum. Only where these organizational measures are deemed insufficient is disclosure of the remaining conflicts required as a second line of defence (see below, Section II.2.C). [7.35] The guiding principle in the organizational requirements is that while they are necessary, they should not be too rigid. Rather, the regime of MiFID I and II spells out general principles and guidelines and leaves the discovery of the best organizational structure for a particular firm to the firm itself. The above-mentioned exception of Chinese walls shows their importance. The open-endedness of the regime is aimed at providing

incentives for innovation and at tapping the efficiency of decentralized decision-making.58

B. From MiFID I to MiFID II [7.36] The paragraph governing organizational requirements has been copied and pasted word for word from Article 13(3) MiFID I to Article 16(3)(1) MiFID II. It mandates the maintenance and operation of effective organizational and administrative arrangements to prevent conflicts of interest. This general provision was spelled out in greater detail in Articles 21–26 MiFID I ID. Article 21, for example, provides that firms must identify situations which are particularly likely to provoke conflict of interest, such as when the firm is likely to make a financial gain at the expense of the client (Article 21(a)) or when the firm has an interest in a specific outcome that differs from the best outcome for the client (Article 21(b)). In its para. 3, Article 22 notably compels the firm to establish Chinese walls, that is, provisions that interrupt the flow of information between different sections of the firm in order to minimize conflicts of interest. [7.37] The key difference between the old and the new regimes is the insertion of a provision on product governance in Article 16(3) MiFID II.59 The fact that the provision was added specifically to the section governing organizational requirements concerning conflicts of interest suggests that the European legislator intended to introduce the rules on product governance as part of the regulatory strategy to minimize conflicts of interest. This is also highlighted by Recital 71 of MiFID II which connects product governance with the duty to act in the best interest of the client.

C. Core Parameters of the MiFID II Regime [7.38] The key components of the organizational measures undertaken to prevent conflicts of interest are spelled out in Articles 21–26 MiFID I ID. According to Article 21, the firm must identify all situations from which conflicts of interest may arise. These comprise situations of direct financial

gain of the firm (Article 21(a)), an interest of the firm in an outcome different from the best one for the client (Article 21(b)), incentives to favour one client over another (Article 21(c)), direct competition between the firm and the client (Article 21 (d)), and finally inducements other than the standard commission fees (Article 21(e)). To counter conflicts engendered by such tempting circumstances, the key organizational feature contemplated by Article 22(3) MiFID I is the establishment of Chinese walls between persons and departments within a firm whenever the flow of information between these would generate or aggravate conflicts of interest. Article 25 specifies that this implies in particular the separation of financial analysts from other persons within the firm who are in client relationships, creating ‘areas of confidentiality’. These structures are intended to promote a sufficient degree of independence of the actors in the client relationship from the general interests of the firm or specific interests of other departments and persons within the firm. They include the prevention of the exchange of information (Article 22(3)(2)(a)), separate supervision (Article 22(3)(2)(b)), the independence of remuneration of one person from the actions of another person within the firm (Article 22(3)(2)(c)), prevention of inappropriate influence (Article 22(3)(2)(d)), and the avoidance of involvement of a single person in different business activities (Article 22(3) (2)(e)) wherever non-compliance with any of these would give rise to conflicts of interest. [7.39] The core features of the ‘areas of confidentiality’ are the following: non-public information may not travel from the one department to the other and both departments have to take their decisions independently from each other. So-called Chinese walls have to be erected:60 via mutual exclusion from access, if possible also physically; via instruction of employees about the function and the functioning of these walls, namely through guidelines; via observation of the information flows and the ways by which information proliferates. The core decision to be taken is which zone should be separated from which: typically at least the area for the loan business and for issuing of securities from the area of investment advice and the latter again from fund management and portfolio management.61 The fine tuning is done via ad hoc decisions in individual cases for which the compliance management is responsible: either by introducing additional bans on transfer of information, if it is particularly sensible (‘secondary Chinese

wall’), or in favour of exceptionally disregarding the wall (‘wall crossing’). The core criterion is how vital the knowledge also is in the area with which information could potentially be shared, particularly whether it is necessary to properly carry on the business (‘need-to-know’). The ESMA Final Report on MiFID II does indeed go even further in suggesting that ‘[t]he MiFID Implementing Directive should be amended by inserting new provision to require a physical separation between the financial analysts involved in the production of the investment research and other relevant persons whose responsibilities or business interests may conflict with the interests of the persons to whom the investment research is disseminated’.62 This would, for example, tackle cases in which the provider simultaneously provides investment banking services to an issuer,63 a duality of roles from which conflicts of interest between different clients may arise. [7.40] The central novelty of the MiFID II regime, however, beyond the establishment of Chinese walls, is the product governance regime laid out in Articles 16(3)(2–6) and 24(2) MiFID II. It complements the assessment of appropriateness and suitability of financial products for clients’ needs by establishing—early, in the manufacturing stage of the product—a match between product characteristics and a specific target market,64 even though product governance does not prejudice the assessment of appropriateness or suitability (Recital 71). The basic idea is that manufacturers of financial products must now identify a suitable target market of end clients for these products and distribute them within this target market (see Article 16(3)(2) MiFID II). The target market is defined primarily by the risk structure of the product, but it is also defined by the time horizon of the investor.65 Furthermore, the manufacturers must monitor the performance of the product post sale and make adaptations if it fails to conform with the needs of the target market (see Article 16(3)(4) MiFID II). Thus, the design of the product must primarily be aimed at coinciding with the core interest of the clients in the targeted market. Moreover, investment firms offering these products must ensure, by organizational means, that they understand the product-approval process and the characteristics of the different target markets and of the products they offer in these (see Article 16(3)(6) MiFID II). This includes the appropriate training of staff and control over the governance process by the management body.66 In doing so, a greater alignment of particularly the risk preferences of clients and the products

they are being offered is meant to be achieved. The main connection to the sphere of conflict of interest is the following: once the client has been allocated to a specific target market, the firm must offer products in the client’s best interest, taking account of the target market (Article 24(2)(2) MiFID II). In our view, this prevents the firm from simply offering products outside the target market;67 at the very least, such an extra-target offer must be accompanied with a clear warning to the client.68 Generally, the firm must take the target market into account when disclosing the risks associated with a recommended product (see Article 24(4)(b) MiFID II). [7.41] The establishment of target markets testifies to the fact that even within the group of retail or professional investors there are various subgroups with different risk preferences. The subgroups can now be identified with a certain target market and products that are tailored to their needs, both in the manufacturing and in the recommendation process. Since the target market helps to define the preferences of the client, it reduces discretion of the firm to offer products and thus limits the scope for biased advice based on conflicts of interest. A weakness of the proposal lies in the fact that firms will be in a position to determine what clients form part of what target market,69 permitting discretion that can be affected by conflicts of interest. However, if the target market is neatly defined in terms of risk preferences and time horizon, and if these are elicited by the firm from the client, there is a good chance that the allocation of clients to target markets will be fairly obvious and thus less open to manipulation. [7.42] With respect to all of these organizational duties, the question remains of how much effort a firm must exert in order to minimize conflicts of interest, and from what point on the disclosure regime concerning the remainder of conflicts of interest takes over. Here again, the ESMA Final Report offers a convincing reading of the MiFID II provisions: it describes the disclosure of information as a measure of last resort.70 The point where organizational measures end and disclosure begins is determined by the companies themselves: they must be reasonably confident that the range of organizational measures will suffice to avoid conflicts of interest if they intend to avoid disclosure.71 In this, they need not take every possible prudential measure; rather it is deemed sufficient by the majority of literature to limit the efforts to those strategies that a firm can reasonably be

expected to be undertaken given its size and structure.72 Eventually, the provider has to choose the most effective strategy amongst those that it is required to consider under the proportionality principle.

2. Conflicts of Interest in the Formation of Investment Services Contracts [7.43] We shall first discuss the provisions pertaining to the general regime on formation of the investment services contract (then to be followed by explanations on fees, below Section II.3). After a brief theoretical introduction, the differences between MiFID I and II will be highlighted before turning to the core parameters of the MiFID II regime.

A. A Contract Standards Solution [7.44] As was noted earlier, the regime of MiFID I and II comprises the general duty to safeguard the interests of the client and combines this with a more concrete prospective rule: the disclosure of conflicts of interest which endanger the due discharge of the duty to safeguard the clients’ interest. These duties are boundary conditions that influence the content of the investment service contract. The MiFID regime therefore tries to mitigate conflicts of interest in the formation of investment services contracts by giving the client the information necessary to make an informed choice on the kind of contract she wants to conclude. Thus, the organizational regime of precaution is supplemented by a second, contract-based regime still of precaution—all to safeguard as far as possible compliance with the actual substantive law standard: to take as sole guideline for action the interest of the client. There does indeed seem to be a need for (precautionary) regulation. In a study for the European Commission, Nick Chater, Steffen Huck, and Roman Inderst showed that more than half of the consumers were unaware of conflicts of interest of financial advisers and wrongly believed that advice was provided on a fully independent basis.73 The beneficial effect of disclosure would not only be ideally to enable clients to make an informed decision but also to discipline providers so that commissions do not lead to biased advice but rather incentivize information

seeking and selection of efficient investment instruments.74 Thus, the scope is threefold, really: first, to make (a good part of the) clients aware of the fact that there are considerable conflicts of interests potentially affecting investment advice; second, to give them the information needed to properly assess the number and the mechanisms of the different sources of conflict of interests possible or existing in this case, which should empower clients to ask more specific questions and take more specific precautions, for instance to choose between providers subject to more or to less conflicts of interests; and third, to serve as a disincentive for providers to cede to their conflicts of interests. In Section II.6, focusing on cognitive biases, we ask the additional question of whether this regime should be—or is already—supplemented by debiasing features for those investors who do not draw the appropriate conclusions from such information and whether the information required is already calibrated in a cognitively optimal way (see below Section II.2.C, but mainly Section II.6).

B. From MiFID I to MiFID II [7.45] Except for the introduction of product governance, the organizational duties of the provider have remained exactly the same in the transition from Article 13(3) MiFID I to Article 16(3) MiFID II. The disclosure regime, however, did see some changes. First, disclosure now needs to be made in a durable medium (Article 23(3)(a) MiFID II); such a provision was lacking in MiFID I.75 Second, the client must not only be informed about the conflicts of interest per se, as in MiFID I, but also about the organizational measures taken to mitigate them (Article 23(2) MiFID II). Third, and perhaps most importantly, the disclosure must be sufficiently detailed, but also take into account the nature of the client (Article 23(3)(a) MiFID II). The implications of this last provision will be discussed in Section II.2.C. [7.46] Generally, however, MiFID II deals with conflicts of interest at the pre-contractual stage in a fashion very similar to the one inaugurated under MiFID I: the organizational duties have remained exactly the same. The general structure of tackling precontractual conflicts of interest with organizational measures and disclosure was kept. The disclosure regime

was slightly, but not significantly, updated—unless one puts emphasis on the disclosure rule potentially requiring much more meaningful information and even de-biasing. What is undoubtedly a huge novelty at this stage, the introduction of a market structure approach, will be discussed under Section II.3, when it comes to fees.

C. Core Parameters of the MiFID II Regime [7.47] Under the regime of MiFID I and II, disclosure steps in where organizational measures fail. It is meant to warn the client of the conflict of interest so that she can reassess her stance on the quality of advice accordingly. In order for the disclosure to be effective, two key questions must be addressed: first, how much detail must be disclosed about the concrete conflict in question; and second, whether repeated disclosure is necessary. [7.48] The question alluded to above about the reach of the disclosure duty thus arises with renewed force under MiFID II. Does the provider only have to mention that she is conflicted or also explain the concrete facts that lead to the specific conflict of interest? The provisions are ambivalent about this point. Article 18(2) MiFID I held that ‘the general nature and/or sources of conflicts of interest’ must be disclosed. Article 23(2) MiFID II reiterates that phrase. The question therefore comes down to whether the general nature of the conflict of interest is to be portrayed in more abstract or concrete terms. Here, Article 23(3)(b) MiFID II adds that the disclosure shall ‘include sufficient detail, taking into account the nature of the client’.76 Thus, two questions arise. First, what is sufficient? Second, what characteristics define the nature of the client? In fact, the second question has to be answered first because the degree of detail is meant to depend on the nature of the client. [7.49] A first interpretation of the phrase ‘nature of the client’ can point to other instances in MiFID II in which it is used. For example, Article 24(14) (c) holds that delegated legal acts protecting the investor shall take into account the ‘retail or professional nature of the client’. This is reiterated, for

delegated acts in similar contexts, in Article 25(9)(c) and Article 27(9)(a). On one hand, one could conclude that the nature of the client in Article 23(3)(b) also refers to its professional or retail status. This would mean that greater detail can be given to professional actors, which seems reasonable. On the other hand, however, one might also argue that the fact that the retail/professional investor dichotomy was not mentioned in the specific provision points to the possibility of taking other features into account as well. Against the backdrop of the theoretical approaches to conflicts of interest mentioned above, one possible and sensible distinction might be the one between fully and boundedly rational actors. Indeed, it seems convincing to mandate disclosure in greater detail vis-à-vis rational actors who can be expected to adequately process the information while cutting back on the amount of information vis-à-vis boundedly rational ones who might be overwhelmed and overloaded. The problem with this interpretation is that in many cases it will be difficult for the provider to assess whether the client is either more fully or more boundedly rational, especially given that this distinction does not necessarily coincide with the retail or professional status of the investor. Therefore, the most sensible construction of the phrase ‘nature of the client’ would probably attach first to the retail or professional status of the investor, which can be easily assessed. Only in a second step, if possible, can the degree of rationality be taken into account if and only if it is determinable by the provider. What remains clear, however, is that this new addition in MiFID II calls for greater personalization of disclosure. ESMA seems to support this, suggesting that ‘disclosure of risks arising as a result of the conflict is essential for clients to understand the nature of the conflict of interest itself’.77 [7.50] This has a direct influence on the reach of the disclosure duty, the other question mentioned above. If the client is a professional investor and the provider does not have any reason to believe that she is boundedly rational, disclosure must be of greater detail. If, however, the client is a retail investor, disclosure should be of less detail unless the provider has reason to believe that the investor is fairly rational. What remains to be analysed is: How far should the degree of detail comprise the exact concrete type of conflict of interest? On one hand, a more specific exposition of the conflict of interest may put the client in a better position to judge which

recommendations may be affected and which may not. Strictly speaking, rational clients will therefore benefit from greater detail of disclosure. On the other hand, boundedly rational clients may be overwhelmed or bored by too much detail, leading in both cases to a neglect rather than a deeper appreciation of the information. This remains a problem even under a more personalized regime because the provider often will not be able to adequately ascertain whether she is dealing with a boundedly or fully rational type. In this context, it is to be kept in mind that under MiFID II even the organizational measures undertaken to mitigate conflict of interest need to be disclosed, adding to the amount of information delivered (with questionable benefit to the client). [7.51] The answer to the question of the reach of disclosure must take the whole situation in which disclosure takes place into account. Notably, conflicts of interest are certainly not the only items that need to be disclosed —they are followed by information on the specific nature of the service (Article 24(4)(a)) and of the investment products (Article 24(4)(b) and (c)), particularly its risk components. Therefore, to prevent information overload, it seems wise to avoid driving the details of disclosure to a maximum.78 However, if the conflict is of a specific nature so that it affects only a part of the obligations of the provider and if it can be expected that rational parties will be able to digest and act on the information, then more specific disclosure is warranted. In this case, rational parties stand to gain much from more detailed disclosure, while the disadvantage to boundedly rational actors may be limited. At least a part of those would not have taken the disclosure into account even if it were shorter; the rest may benefit from a disciplining effect that the detailed disclosure unfolds if rational agents act upon it and providers are unable to distinguish prima facie between rational and boundedly rational agents. To make things more complex, however, these disciplining effects of the disclosure are called into question by the results of an experiment by Ismayilov and Potters, who noted that disclosure did not affect either the providers’ nor the clients’ actions.79 All in all, disclosure should thus be limited in detail unless specific reasons (high rationality of the client; particular nature of the conflict) speak in favour of divulging the details of the conflict in question. A short description of the most relevant features of the mechanism generating the

conflict of interest would seem to be what is required if such rationality cannot be assumed. [7.52] This position arguably finds itself in accord with the recommendations by ESMA. Speaking on the reach of disclosure, the authority finds that it must be made ‘in sufficient detail to enable that client to make an informed investment decision’.80 However, clients will only be able to make an informed decision when they are not overwhelmed by the disclosed data, that is, if the amount of disclosure remains within their cognitive capacity limits. Therefore, making the reach of disclosure depend on the status as well as, at a secondary level, the rationality of the investor sits comfortably within both the wording and the purpose of Article 23(3) (b) MiFID II. [7.53] Going beyond interpretation, the following proposal for a reform of the disclosure strategies might fit both fully and boundedly rational types as well as retail and professional investors. Providers have to disclose to all investors how the rational professional investors typically react to the most important sources of conflicts of interests inherent in the particular case. The less experienced could thus opt for ‘following’ the more experienced ones. This solution would link investor protection closely to overall concerns of market integrity. It thus leverages the reactions of rational professional investors for the sake of other types of investors and simultaneously enhances the incentive structure for providers. Empirical tests should be conducted to analyse whether such an enhanced disclosure would make any difference for investor choice. Then, even Level 2 legislation may suffice, as the main thrust is laid down in MiFID II already. [7.54] Finally, we can now turn to the issue of repeated disclosure. Here, the literature and practice are still divided about the best approach.81 One may argue at the outset that providing the same disclosure before every transaction if the conflict of interest has not changed is cumbersome to both the provider and the client: it causes compliance costs on the side of the provider and cognitive costs of processing the information on the side of the client. That said, people tend to forget—more boundedly rational investors tend to forget more. Therefore, repeating disclosure may be necessary in some cases to raise the salience of conflicts of interest and to ensure that

their effects are really taken into account by the investor in every decision. CESR’s Technical Advice for the implementation of MiFID I noted that the frequency of disclosure should take into account the nature of the client.82 Luca Enriques thus suggests that generally retail clients should be informed more frequently.83 This makes sense since retail clients, other than more sophisticated institutional investors, will be less generally aware of conflicts of interest; in fact, 80 per cent of advisees in the retail sector fully trusted their advisers and did not seem to be aware of conflicts of interest.84 Enriques also notes that ‘standard’ conflicts of interest should only be disclosed only once. 85 However, the survey just mentioned which uncovered blithe and undeserved trust in advisers arguably speaks for a continual updating of the relevance of conflicts of interest in the minds of retail investors. Therefore, it is suggested here that the disclosure of generic conflicts of interest should be made at least periodically, perhaps roughly at every fifth encounter with the adviser. This disclosure of specific conflicts of interest remains necessary according to the guidelines visited in paragraph 7.50.

3. In Particular: Conflicts of Interest and the Regime on Fees [7.55] The disclosure strategy discussed in the previous section is complemented by the regulation of the fees of the service provider. These provisions have seen a particular and noteworthy change in the transition from MiFID I to MiFID II; since these démarches are the subject of separate chapters in this volume, we shall restrict ourselves to a few observations.86

A. A Market Structure Approach [7.56] In tackling conflicts of interest that arise by virtue of the fee structure, the new MiFID II provisions now take a market structure approach. They create two different markets for the offering of investment services: dependent services where the remuneration mostly comes from

inducements and where it should therefore be visible to all clients that conflicts of interests may considerably influence the advice given (where, however, the conflict of interest still has to be disclosed); and independent services where the client directly pays for the advice, and inducements (and also some other specific sources of conflicts) are ruled out. Thus, the rule is organizational—preceding disclosure and enhanced by it (Article 24(4)(a) (i))—but different from the prime organizational requirements affecting the organization of the (one) provider of investment services in that it now concerns the market structure and thus (consciously structured) competition between different kinds of providers of investment services.

B. From MiFID I to MiFID II [7.57] Indeed, this market structure approach is perhaps the greatest novelty in the MiFID II regime concerning conflicts of interest. It was absent under MiFID I, which only contained, under Article 19(1), the duty to act in the best interest of the clients, but did not say anything about how that duty should affect the fee structure of the company. Via gold-plating, important Member States had, however, introduced sophisticated regimes on inducements, statutory or in case law. The cases of the UK (Retail Distribution Review banning commissions) and of Germany (§ 31d Wertpapierhandelsgesetz (WpHG)) are noteworthy.87 The former in particular strongly influenced the MiFID II market structure regime, to which we now briefly turn.

C. Core Parameters of the MiFID II Regime [7.58] The two markets created by dependent and independent services treat conflicts of interest quite differently. The market for independent services attempts to reduce conflicts of interest to a minimum by removing their core element: first, one of the, perhaps even the, key source of conflict of advice,88 namely fees from issuers or other entities with an interest in selling their investment products; second, limited product range (Article 24(7)).

[7.59] In the market for dependent services, however, the source of conflict remains and has to be disclosed, and further requirements have to be met (Article 24(9)). Thus, in the dependent regime, the market is structured so as to maximize the probability that inducements will still benefit, or at least not damage, the client. And these market structure requirements are coupled with disclosure rules. Whoever wishes to contract for the high-quality, independent market has to pay for it directly out of her own pocket, while in the other market, the client pays indirectly through worse quality or higher prices (part of which are passed on to the provider).89 [7.60] It remains to be seen in how far these schemes will reshape the advice landscape in Europe. In the UK, following the Retail Distribution Review mentioned before which foreshadowed the MiFID II regime,90 empirical evidence suggests that product bias has indeed decreased.91 However, as a reaction to the ban on commissions Lloyds banking group has begun to restrict investment advice (of an independent nature) to retail customers investing more than £100,000. The decision was taken in response to an in-house study conducted by Lloyds purportedly showing that willingness to pay directly for investment advice decreases with the sum to be invested.92 If more companies follow this lead, and refrain from even offering independent investment advice to small investors, the wellintentioned rules could end up hurting small retail investors by making advice less accessible to them—broadening what has been termed the ‘advice gap’ in investment services, especially for less affluent customers.93 This is particularly worrying given that, as noted earlier, 80 per cent of retail investors in the EU use advice to inform their purchase decisions.94 Ex post evaluation of the MiFID II regime should therefore inquire into these potentially regressive effects.

4. Conflicts of Interest in the Execution of Investment Services Contracts (‘Best Execution’) [7.61] Conflicts of interest do not only arise in the formation of the contract but also in its execution. The regime of MiFID I and II deals with

this in a range of specific provisions.

A. A Strict Investors’ Interest Approach [7.62] The central idea behind the protection of the interest of the investor in the execution phase of the contract is to specifically oblige the provider to act in the best interest of the client and to specify precisely the benchmark against which the actions taken are to be assessed. This is necessary because the protection of the client interest faces two difficulties in this domain. First, the execution is out of reach for the client; she is not in a position to accept or decline certain kinds of execution after the formation of the contract. Rather, the provider executes the trade on her own, which is one of the reasons she was retained in the first place. Second, the provider must elaborate an execution policy against which her performance is measured ex post. However, it seems utopian to hope for market solutions based solely on the best terms of execution. The information asymmetry between the provider and the client in this technical domain is so great that it seems difficult to overcome by means of disclosure alone, which would be a prerequisite, however, for a functioning market on the terms of the execution. Therefore, the MiFID regime specifies what constitutes ‘best execution’; that definition, in turn, varies substantially between the two Directives—so fundamentally that, in fact, the two regimes can be seen as following different philosophies and that the philosophy based almost exclusively on disclosure has been largely given up or at least modified (see now Recitals 91–8 MiFID II, instead of only three Recitals in MiFID I).

B. From MiFID I to MiFID II [7.63] Article 21 MiFID I set out the ancient regime of best execution. This required the provider to design a best execution policy that would work in the best interest of the client. This policy had to be disclosed to and consented by the clients before the execution of an order. The success of the policy needed to be monitored, and assessed comparatively with alternative policies, such as those of competitors, the policy being adapted if necessary.

Material changes again had to be disclosed to clients. The freedom of the provider to define the execution policy was therefore indirectly limited by the obligation to report on the relative success of the chosen strategy. [7.64] MiFID II keeps this regime in general but updates it in two dimensions in view of the greater variety of trading venues available within the European Union (Recital 92). First, disclosures of execution policy were considered too generic to make a meaningful difference (Recital 97). Second, the new provisions seek to protect retail clients in a specific manner (Recital 92).

C. Core Parameters of the MiFID II Regime [7.65] According to MiFID II, providers still have to elaborate an execution policy that is to further the clients’ interests in the best way possible (Article 27(4)), regularly monitor and update it, as well as disclose it to and obtain consent from the client. However, as noted above, some key changes were undertaken. [7.66] First, the European legislator intended to improve the quality of the disclosure in order to spur, where possible, market selection processes based on the terms of the execution policy. In what seems to be an attempt to square the circle, Article 27(5)(2) notes that the information must be given ‘clearly, in sufficient detail and in a way that can be easily understood by clients’. What seems problematic is that more detail will often entail less understanding. It remains to be seen therefore whether the ‘improved’ disclosure will have any beneficial effects on the content of the execution policies or on execution itself. [7.67] Second, the best interest of the client is defined differently for professional and retail investors (Article 27(1)(2)). For professional investors, the provider has to take into account, as under Article 21(1) MiFID I, the ‘price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order’. For retail investors, however, only the best total price is installed as a proxy for best interest. Under the old regime, this narrow definition of the

best execution was mentioned only on a Level 2 implementation;95 it has now moved up the ladder to Level 1. For retail clients, this change takes into consideration the tension between their information needs and willingness to retrieve information (which is typically lower) and the interest in the parameters of execution other than price (which typically is lower as well). The total price (total consideration) comprises the actual price as well as any costs incurred directly by the execution such as venue trading fees, commissions, etc. The advantage of looking exclusively at the total consideration is clear: while the speed of the transaction is often a lesser concern for retail investors, the price is not only a key dimension retail investors care about but is also relatively easy to ascertain and monitor.96 This clear provision therefore helps to safeguard clients’ interests even if the market does not function adequately on the terms of the execution policies. However, it should be noted that the rule may present an advantage to established, and thus more liquid, trading venues, thus mitigating competition in the transaction market, at least in the retail investment services.97 There is reason to believe, though, that the trade of large blocks of products in the professional investor market, for which price is not the determining characteristic, will be sufficient to spur competition between established and new trading venues. Since retail clients certainly have more limited power to (algorithmically or cognitively) process information than professional ones, it seems sensible to restrict ‘best execution’ in their case to a single, easy-to-determine parameter. [7.68] Third, the focus on price as the key proxy for best execution in the retail financial services market is complemented by an anti-discrimination rule, see Recital 95: All costs incurred in the transaction market, that is, in the execution of the order, must be passed on to the client as they are. Particularly, this means that a sudden drop in prices on the transaction market must be reflected in the total consideration charged to the client; the provider may not use the transaction market to charge hidden fees to the client by topping up on the transaction fees. This seems sensible since such hidden fees cannot be easily discovered by the client (screening problem) and providers should not be allowed to use this information asymmetry which would also be difficult to overcome. The ultimate desideratum is that the beneficial effects of competition of venues are not reduced, due to the

fact that price reductions by one venue or another are not passed on to the investors. [7.69] Fourth, still more reporting duties are installed to raise the accountability of the provider in the execution. Providers themselves have to publish an annual report in which they name the top five execution venues in terms of trading volume of the last year (Article 27(6)). And trading and execution venues have to make available to the public, without any charges, data relating to the quality of execution of transactions in that venue on at least an annual basis (see Article 27(3)). This comprises details about price, costs, speed, and likelihood of execution for individual financial instruments. The public disclosure of these parameters will enable checking the validity of the provider’s reports on the relative success of their execution strategy and thus contributes to the disciplining function of public scrutiny in indirectly delimiting the freedom-to-choose execution policies. [7.70] Fifth, and finally, it is restated that providers may not receive any remuneration from trading execution venues that would contravene the interest in taking away adverse incentives from investment service providers on key competition parameters—just like in the rules on inducement described in the previous section, Article 27(2).

5. Conflicts of Interest in the Case of Linked Contracts [7.71] Finally, conflicts of interest can also arise when different contracts are linked in the hands of the service provider. On one hand, she may opt to not only to provide the investment service but also credit services, such as a loan agreement, designed to finance the contemplated investments. On the other hand, different investment services can be linked by the provider by means of cross-selling, that is, by bundling or tying together essentially different services in a single product.

A. A Balancing and Unfair Trade Practices/Competition Law Approach [7.72] The linking of different contracts provides two different challenges to regulation: first, the possible exploitation of investor errors in the financing of investment services; and second, in addition to concerns of investor protection, harm to competition in the wake of cross-selling techniques. The MiFID II regime addresses these concerns by employing a balancing approach which includes an unfair trade practices/competition law approach for cross-selling: the freedom to conduct a business is thus traded off against investor protection on one hand and against the safeguarding of competition on the other. In the case of financing of investment through loans, the practice is generally permitted because the duties imposed on investment advice are high enough to also include the risks stemming from an investment financed by a loan. Therefore, financing is forbidden where this protection is largely missing, namely in cases in which the degree of investor protection is greatly reduced, namely the mere execution of client orders. Conversely, cross-selling is seen as a risk to both competition and investors and is thus subjected to heightened scrutiny.

B. Investment Contracts Financed by Loan Contracts [7.73] The first regulatory challenge arises when investment contracts are simultaneously financed by credit contracts. The granting of credits or loans to an investor to allow him to carry out a transaction in a financial instrument is defined as an ancillary service in Annex I Section B (2) MiFID II. What are the legal implications of the coupling of credit and investment services? In the realm of disclosure, MiFID cedes to the specific provisions on the regulation of consumer credit, that is, it is sufficient to fulfil the disclosure obligations contained in the consumer credit regulation (see Article 24(6) MiFID II). [7.74] Most notably, however, according to the MiFID II regime, loan contracts may not be coupled with the performance of investment services

whenever the latter consist only in the execution of client orders (see Article 25(4)). Indeed, since the degree of investor protection through exploration and disclosure is reduced to a minimum in the case of execution-only services, it seems sensible to rule out the rendering of such services on credit basis (cf. Recital 80). Otherwise, the provider might be tempted to persuade clients wishing to speculate on their own (through execution only) to take out loans in order to take greater chances. In this case, the conflict of interest would with good likelihood come together with some of the biases discussed in Section I.2.C. Execution-only clients, by ordering these services, consider themselves not to be in need of the protection of exploration and disclosure provided by the usual investment services regime. While this may be true with regard to many of them, at least some will come to this conclusion through a bias towards optimism and overconfidence in their own ability to make assessments concerning the future development of the products they invest in and their own capacity to bear risk. It would indeed be a mischievous coincidence if such clients, having erroneously opted out of most investor-protection schemes, were now faced with aggressive credit strategies by the service providers. While some rational clients might be able to benefit from these, the boundedly rational, overoptimistic, and overconfident ones would most likely also underestimate the chance of defaulting on that credit. Therefore, severe financial harm could ensue for these investors. Article 25 (4) thus wisely excludes the simultaneous provision of credit and investment services in the guise of execution-only agreements.

C. Cross-selling of Different Investment Services [7.75] The second case of linked contracts is contemplated in Recital 81 MiFID II: cross-selling. In this situation, the provider ‘offers an investment service together with another service or product as part of a package or as a condition for the same agreement or package’ Article 4(1)(42). ESMA helpfully distinguishes between bundled and tied packages:98 in a bundled package, each of the components can be purchased separately by the client; in a tied package, at least one of the components can only be bought through the package. For example, a tied package may force the investor, when purchasing stock, to also open a current account with the same

provider. Not surprisingly, the Recital highlights the potential anticompetitive effects of such practices. After all, cross-selling is one of the classic examples of the abuse of a dominant position, explicitly cited in Article 102(d) TFEU. The very provision of tied packages in most cases reflects a conflict of interest since the tying benefits the provider while reducing investor choice and the possibility to combine services from different providers—one of the situations contemplated in Article 21(b) MiFID I ID as an epitome of conflict of interest. Recital 80 therefore notes that such practices should be carefully assessed to safeguard competition and consumer choice. Indeed, as antitrust scholarship has shown99 and as the Recital suggests, tying may distort competition, reduce mobility, and lead to worse outcomes for investors. [7.76] Under the MiFID II regime, Article 24(11)(1) holds that providers must inform clients which of the different components can be purchased separately and provide evidence of the costs for each of these separately. If the risks of the package are different from the risks of the individual components, the modification of risk by the bundling or tying strategy must be explained to the investor (see Article 24(11)(2)).100 Here, it may be doubted whether it will always be possible to do so in a manner understandable to most investors; therefore, the focus should be put on simple categories (such as ‘greater risk’ or ‘lower risk’, potentially coupled with colour coding or even a ‘traffic light’ system). Furthermore, according to Article 25(2)(2) and Article 25(3) the firm must ensure that the whole package is suitable or appropriate to the investor. [7.77] In December 2015, ESMA published guidelines on cross-selling practices.101 It stressed that price transparency is key to investor protection in this area, and that prices need to be disclosed in good time before the investment decision and in an understandable manner.102 The same holds true for risk disclosure; risk components must furthermore be disclosed with equal salience as price components.103 Importantly, in the case of bundled packages, the default must not be the purchase of the bundled package but rather of the separate components (no pre-ticked boxes).104 This strategy makes use of default effects such as the status quo bias.105 Finally, ESMA notes that staff must be trained and incentive and

remuneration practices designed to minimize conflicts of interest in crossselling practices.106

6. New Strategies: the Future of the Regulation of Conflicts of Interest [7.78] Particularly in view of bounded rationality, the literature has suggested a host of further regulatory tools that might mitigate the problem of conflicts of interest. In this section, we shall therefore briefly review cognitively optimized disclosure, debiasing, and caps on commissions.

A. Cognitively Optimized Disclosure [7.79] The beneficial effects of disclosure depend on its effectiveness in educating clients. As mentioned, clients may suffer from limited attention, weak motivation, and cognitive capacity limits which prevent the proper cognitive reception of the disclosure of conflicts of interest. Against the backdrop of the possibility of bounded rationality and information overload, disclosure thus seems at least problematic. As Omri Ben-Shahar and Carl E. Schneider have powerfully argued, disclosure cannot be trusted to automatically work its magic.107 Therefore, it should be empirically tested in every specific instance whether the provision of disclosure really enhances decision-making.108 In a recent experiment, Huseyn Ismayilov and Jan Potters demonstrated that the rate by which clients follow providers’ advice is not affected by the disclosure of conflicts of interest: they conclude that it is neither beneficial for nor detrimental to the decisionmaking of the client.109 [7.80] Does this mean that disclosure should be discarded altogether? This chapter claims that such a reaction would ‘throw the baby out with the bathwater’. Rather, disclosure should be cognitively optimized. Behavioural economics has recently focused much regulatory attention on the concrete format and design of disclosures, going beyond the mere provision of ever more detailed forms of information.110 For example, the ESMA guidelines

on cross-selling stress the importance of providing price information in simple language.111 This exhortation joins a full array of provisions designed to simplify disclosure.112 However, in a recent paper, Ben-Shahar and Chilton have presented results of a series of experiments that point to the limits of cognitively optimizing disclosure.113 In the context of privacy disclosures, even the most advanced formats fared no better than traditional boilerplate disclosures—indeed, both were equally ignored. As with every empirical study, however, close attention must be paid to the limits of external validity. In the context of conflicts of interest, Inderst and colleagues were actually able to demonstrate that a strong health warning (‘[n]ote that this means that the advisor did not necessarily have your own investment earnings in mind when he gave his advice’) did make a difference: people spent more time on the disclosure when the warning was present.114 While one must be careful not to attach warning signs to all disclosures—this would raise the danger of wear out—the central status of conflicts of interests might justify enhancing the salience of disclosure with warning signs. In another recent study,115 Geneviève Helleringer demonstrated that ‘explanatory disclosures’, which not only disclosed a conflict of interest but also explained that this implied that the interests of provider and client were not aligned,116 did significantly affect clients’ trust in the advice and, under additional conditions,117 their willingness to invest. Such enhanced disclosure formats that increase the salience of conflicts of interest present a potential way forward to make naïve clients more sophisticated, which in turn promises to set market forces in motion that enhance efficiency and client welfare.118

B. Debiasing [7.81] As was further mentioned above, clients may not only suffer from information overload but also from different biases which prevent the proper processing of information. In particular, the significance and degree of conflicts of interest may be misunderstood due to optimism bias, confirmation bias, perseverance, and other phenomena. The behavioural literature has long suggested debiasing through law as one of the strategies to cope with such cognitive errors.119 In this context, it is very important to

reiterate that not all clients suffer from the same biases, or from biases at all. For debasing strategies to be justified, two conditions therefore must be met: debiasing must be expected to be effective among the boundedly rational clients, and it must not unduly affect rational types.120 [7.82] The effectiveness of debiasing continues to be an issue of scientific debate.121 Much depends on the concrete bias and the concrete practice of debiasing. One strategy would be to simply disclose the relevant bias to clients, for example in the form of a warning. In some settings, such strategies have proven successful to mitigate biases; in others not.122 [7.83] As to the second condition, the effect of the debiasing on rational actors obviously also strongly depends on the type of intervention. While disclosure of the bias is not particularly intrusive, it may have two negative effects on rational actors. First, it increases the amount of information to be disclosed and thus makes overload more likely. Second, it may induce bias in formerly rational actors if these correct for biases they are not actually subject to. [7.84] Therefore, more empirical research is needed before debiasing strategies can be fruitfully installed in this context. Moreover, information overload seems to be a greater problem than biases in regulating conflicts of interest. However, if simple and unintrusive debiasing strategies can be operationalized in this setting, they would present a welcome addition to the regulatory toolbox.

C. Caps [7.85] Price caps on commissions are a final regulatory instrument. This can be considered a measure of last resort in case the previously mentioned strategies fail. If the cap is set at a low level, this will reduce the incentive to the provider to give biased advice. If most of the clients are naïve about the dependent nature of the services and the commission and fee structures that induce these biases (as the study by Chater, Huck, and Inderst suggests123), the cap can therefore serve to realign the interests of provider and client. However, as Inderst and Ottaviani have rightly pointed out,

commissions can also have beneficial effects that are endangered by outright caps.124 For example, they can generate incentives for otherwise sluggish and disinterested providers to search for information about new financial products that could be marketed with a commission fee, enlarging the pool of products that providers can recommend. Furthermore, it may be expected that at least to a certain extent the most efficient products will come with the highest commissions so that a free commission scheme channels clients to better products. These functions of information search and efficient allocation are hindered by caps. [7.86] In a recent paper, Oren Bar-Gill125 has analysed the effects of price caps on consumer goods and pointed out a final complexity: often, products will comprise multiple price components. If only one of the components is regulated by a cap, this can have the unintended consequence of sellers reacting with an increase in other price dimensions which renders the cap futile but still produces significant administration costs. In the case of financial services, it might for example be expected that providers would potentially raise or introduce different kinds of ‘service fees’ to make up for a loss of commission revenue. However, while it is true that this would eventually maintain a similarly high price structure, it might have the beneficial effect of reducing incentives to recommend specific products only because of the high commissions attached to them. While the price effect of a cap may therefore be disputable, it could have a bias-reducing effect. Nevertheless, if a cap is to be considered, a clear focus must be put on ruling out the substitution of commissions by other kinds of monetary or non-monetary rewards offered by third parties for marketing and selling of their specific products.

III. Conclusion [7.87] This chapter has inquired into both the theory of the regulation of conflicts of interest in general and the practice of such regulation in the case of financial services regulation under the MiFID regime. We first reviewed theoretical approaches potentially legitimizing the regulation of conflicts of interests and then applied these insights in a step-by-step survey of the

different stages over which the client–service provider relationship evolves, from the first point of contact to the execution of the investment services contract in specific trading venues. Finally, going beyond positive law, we discussed the conclusions that the theoretical overview warrants for the future of the regulation of conflicts of interests. [7.88] In doing so, we have argued for the following seven distinct propositions. First, not all conflicts of interest are worthy of regulation; rather such a necessity arises only when one party is entrusted with a position of influence while simultaneously not offering any compensation for this discretion to the counterparty. Second, the domain of financial services stands out in several respects vis-à-vis general contract law with respect to such conflicts of interest: on one hand, the interest of the client is often the sole guideline under MiFID; on the other, we suspect that this result may be fuelled by the nature of investment advice as a credence good and by the prevalence of behavioural finance as a discipline highlighting cognitive biases. Third, given the centrality of conflicts of interest for financial services regulation, it is all the more deplorable that the current regime of European positive law, both under MiFID I and under MiFID II, does not provide a convincing account of the goals of the regulation of conflicts of interest. Therefore, fourth, an inquiry into the theoretical and interdisciplinary foundations of such regulation is warranted. We claim that the current regime can be explained by having recourse to duties of fairness (resulting from the conveyance of a position of influence without compensation); to efficiency (aiming at the reduction of the possibility of hidden gains and thus generating trust in investment advice); and to cognitive limitations (highlighting the effects of biases on investment choice and evaluation of investment advice). Fifth, these three main legitimizing forces for the regulation of conflicts of interests can be uncovered in the range of regulatory approaches under the MiFID regime. These generally fall into either the category of organizational or that of contract/disclosure rules. However, a mix of heterogeneous strategies is employed at different stages of the client–service provider relationship: the organizational requirements follow a company structure solution; the regime on the formation of investment services contracts a contract standards solution; the regime on fees and inducements a market structure approach; the execution stage a strict investors’ interest approach; and the

regulation of linked contracts a balancing and unfair trade practices/competition law approach. Sixth, while much continuity exists, the most innovative parts of the MiFID II regime can probably be found in the product governance rules and in the market structure approach governing the regime of fees, with its characteristic division of services into dependent and independent ones. Finally, we argue that some of the theoretical concerns, such as cognitive limitations, have been insufficiently addressed by the MiFID II regime and that future strategies should include cognitively optimized disclosure, and in the appropriate cases also debiasing, and perhaps even mandatory price caps on commissions.

* The authors would like to thank Mikaella Yiatrou and George Papaconstantinou for excellent research assistance. 1 For an early assessment of the positive law of conflicts of interest, see Guido Ferrarini, ‘Contract Standards and the Markets in Financial Instruments Directive (MiFID): An Assessment of the Lamfalussy Regulatory Architecture’, (2005) ERCL 1, 19, 33–5, 37–9; cf. for a more policy-oriented approach Luca Enriques, ‘Conflicts of Interest in Investment Services: The Price and Uncertain Impact of MiFID’s Regulatory Framework’ in Guido Ferrarini and Eddy Wymeersch (eds) Investor Protection in Europe. Corporate Law Making, the MiFID and beyond (Oxford: OUP, 2006), p. 321; and (with respect to the transition to MiFID II) namely Christoph Kumpan and Patrick C. Leyens, ‘Conflicts of Interest of Financial Intermediaries: Towards a Global Common Core in Conflicts of Interest Regulation’ (2008) ECFR 72. 2 Cf. Kumpan and Leyens (n. 1), 79–80: ‘discretionary decision-making power to affect the wealth of another’, and at 84 for a proposal of a definition of conflicts of interest; more extensively, Christoph Kumpan, Der Interessenkonflikt im deutschen Privatrecht (Tübingen: Mohr-Siebeck, 2014), p. 14–29. 3 Cf. also CESR’s Technical Advice on Possible Implementing Measures of the Directive 2004/39/EC on Markets in Financial Instruments, 1st Set of Mandates, January 2005, at 41: ‘It is not enough that the firm stands to make money or that the client stands to lose money, this must then involve a conflict with a duty the firm owes to the client.’ 4 See, for instance, Kumpan and Leyens (n. 1), 79 who distinguish between conflicts of interest and opposition of interests. 5 First discussed clearly in this sense, to our knowledge, in Wolfgang Zöllner, Die Schranken mitgliedschaftlicher Stimmrechtsmacht bei den privatrechtlichen Personenverbänden (Munich: Beck, 1963), pp. 341–56 et passim; more ample development of this theory (and literature, also in English), below Section I.2.

6

First discussed clearly for this additional criterion, to our knowledge, in Stefan Grundmann, Der Treuhandvertrag: die werbende Treuhand (Munich: Beck, 1997), Chapters 4 and 5; and summary in English in Stefan Grundmann, ‘Trust and Treuhand at the End of the 20th Century: Key Problems and Shift of Interests’ (1999) The American Journal of Comparative Law 47, 401–28; more ample development of this theory, below Section I.2. 7 For a broad survey of cases from different areas, see both Stefan Grundmann (above n. 7), Chapters 9–12 and Christoph Kumpan (above n. 3), 105–17, 201–20, and 508–55. 8 Kumpan and Leyens (n. 1), 80; Marc Kruithof, ‘Conflicts of Interest: Is the EU Approach Adequate?’, December 2005, Ghent University Financial Law Institute Working Paper No. 2005-07, available at , at 12–18. 9 For a treatment in the literature, see Kumpan and Leyens (n. 1), 97–8; Kruithof (n. 9), at 13–14. 10 While in the scope of application of MiFID II such clashes between interests of different clients do not seem paramount, in the scope of application of MiFIR this is different. Conflicts of interest are regulated with a view to mitigating clashes of interest between different (groups of) clients, via rules regulating the organization of particular kinds of markets, see Recitals 9 and 26 of Regulation (EU) Nr. 600/2014 of the European Parliament and of the Council of 15 May 2014 on Markets in Financial Instruments and amending Regulation (EU) Nr. 648/2012, EU OJ 2014 L 173/84. For more detail on these rules on market organization, see Chapter 5. 11 See Recitals 42, 51, 53 et seq. (together with market integrity); 71 et seq., 77 (for inducements and ‘best execution’); 80, 81, 87, 91 (again for ‘best execution’); and 155 and 164 of MiFID II (the latter two for all three goals). See also Recitals 2 (for the regulation as such, plus facilitating EU-wide offers), 31 (investor protection requiring differentiation between kinds of clients), 33 (for ‘best execution’ in particular), and 44 of MiFID I (for aftersales transparency). 12 See Recitals 53 et seq. (together with investor protection) and 155 and 164 of MiFID II (the latter two for all three goals), and Recital number 44 of MiFID I (for aftersales transparency). 13 Enriques remarks that market integration may even be the central aim of securities regulation in the EU and thus also the overriding aim of the MiFID (I) regime: Enriques (n. 1), 338. 14 This Recital reads as follows: ‘Since the main objective and subject-matter of this Directive is to harmonise national provisions …’. One realizes, however, that this phrase is mainly meant to differentiate between several legal bases which seemed possible (and is not so much about the validity of different goals of the Directive) when one continues to read. The Recital continues as follows: ‘… concerning the areas referred to, it should be based on Article 53(1) of the Treaty on the Functioning of the European Union (TFEU)’. 15 Recital 69 where conflicts of interest are mentioned a second time relates only to trading venues and is therefore of limited interest for this chapter, where the client

relationship is core. Recitals 88, 123, and 155 relate to procedural rules and do not contain additional content for our purposes. 16 For protection of functioning markets and of individual investors (as mutually reinforcing each other), see the groundbreaking (and not only for German literature) Klaus Hopt, Kapitalanlegerschutz im Recht der Banken (Munich: Beck, 1975), p. 51 et seq., 334– 7; today, see for instance, Stefan Grundmann, European Company Law: Organization, Finance and Capital Markets (2nd edn, Antwerp/Oxford: Intersentia, 2012), § 19 paras 16–18; also Niamh Moloney, EC Securities Regulation (3rd edn, Oxford: Oxford University Press, 2014), pp. 564–71; apparently, however, of little importance in UK practice, see: Alistair Alcock, The Financial Services and Markets Act 2000: A Guide to the New Law (Bristol: Jordans, 2000), pp. 178–80 (‘In the UK, such private resort to the courts has been much rarer.’). 17 See, e.g., Werner Güth, Rolf Schmittberger, and Bernd Schwarze, ‘An Experimental Analysis of Ultimatum Bargaining’ (1982) J. Econ. Behav. & Organization 3, 367; for an overview, see Ernst Fehr and Simon Gächter, ‘Fairness and Retaliation: The Economics of Reciprocity’ (2000) J. Econ. Persp. 14, 159; see further Wolfgang Fikentscher, Philipp Hacker, and Rupprecht Podszun, FairEconomy. Crises, Culture, Competition and the Role of Law (Heidelberg: Springer, 2013). 18 Grundmann (n. 7), Chapters 4 and 5; and summary in English in Stefan Grundmann, ‘Trust and Treuhand at the End of the 20th Century: Key Problems and Shift of Interests’ (1999) American Journal of Comparative Law 47, 401–28; Philipp Hacker, Verhaltensökonomik und Normativität (Tübingen: Mohr-Siebeck, forthcoming), Part 2. 19 Aristotle, Nicomachean Ethics, Book V. 20 John Rawls, A Theory of Justice (Cambridge, MA: Belknap Press of Harvard University Press, rev. edn, 1999), e.g. Chapter 1: ‘Justice as Fairness’; for context, see also Stefan Grundmann, ‘Gesellschaftsordnung und Privatrecht’ in Stefan Grundmann, Hans Micklitz, and Moritz Renner (eds) Privatrechtstheorie (Tübingen: Mohr-Siebeck, 2015), Vol. 1, pp. 405–43 (forthcoming in English). 21 Jürgen Habermas, ‘Discourse Ethics: Notes on a Program of Philosophical Justification’ in Moral Consciousness and Communicative Action 43 (Christian Lenhardt and Shierry Weber Nicholsen trans., 1991); Jürgen Habermas, Between Facts and Norms (Cambridge, MA: The MIT Press, William Rehg. trans., 1996), e.g. Chapter 3: ‘A Reconstructive Approach to Law I: The System of Rights’. 22 This cannot be developed in detail here. Highly influential in this, at least in Germany, but paradigmatic well beyond German private law: Walter Schmidt-Rimpler, ‘Grundfragen einer Erneuerung des Vertragsrechts’ (1941) Archiv für die civilistische Praxis (AcP) 147, 130–97 (the ‘guarantee of justness’, today, under the influence of Habermas, rather coined as the ‘chance of justness’); and Ludwig Raiser, ‘Vertragsfunktion und Vertragsfreiheit’ Festschrift zum hundertjährigen Bestehen des Deutschen Juristentages 1860–1960, pp. 101–34; short survey on the main explanations given (in different jurisdictions, but also beyond strict legal theory, namely in economics) in Stefan Grundmann, ‘Privatautonomie,

Vertragsfunktion und “Richtigkeitschance”?’ in Grundmann, Micklitz, and Renner (n. 21), Vol. 1, pp. 875–902. 23 Most explicitly and with lengthy explanation (and potentially also the first to address this): Zöllner (n. 6), 341–56 et passim; the argument can, however, also be found in the common law literature and case law on fiduciary duties, see from the early development of this idea J. C. Shepherd, The Law of Fiduciaries (Toronto: Carswell, 1981), pp. 35–42, 93– 123 (‘Encumbered Powers’); critical in this respect, however: Deborah DeMott, ‘Beyond Metaphor: an Analysis of Fiduciary Obligation’ (1988) Duke L. J. 879–924, 912 seq.; see also, with ample reference to case law, Paul Finn, Fiduciary Obligations (Sydney: Law Book Company, 1977); Ernest Vinter, A Treatise on the History and Law of Fiduciary Relationship and Resulting Trusts (3rd edn, Cambridge: Heffer, 1955); Tamar Frankel, ‘Fiduciary Law’ (1983) Cal. L. Rev. 71, 795–836. 24 See nn. 6 and 7. 25 For the efficiency implication of hidden gains with respect to the cost of investment advice, see more in detail Chris Bryant and Graham Taylor, ‘Fund Management Charges, Investment Costs and Performance’ (May 2012) Investment Management Association, Statistics Series Paper 3, Chart 1; Council of Economic Advisers of the President of the United States, ‘The effects of conflicted investment advice on retirement savings’ (February 2015) Accessed on 30/03/2016 from ; David Blake, ‘On the Disclosure of the Costs of Investment Management’ (May 2014) Pensions Institute Discussion Paper PI-1407; and with respect to the value of the investment advice to the consumer see: Michael Finke, ‘Financial Advice: Does it Make a Difference?’ in Olivia S. Mitchell and Kent Smetters (eds) The Market for Retirement Financial Advice (Oxford: OUP, 2013), p. 229; in general see: Jason G Cummins and Ingmar Nyman, ‘The Dark Side of Competitive Pressure’ (2002) Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board. 26 For more detail on the adverse selection implications of fundamental lack of transparency in market offers, see Daniel Schwarcz, ‘Beyond Disclosure: The Case for Banning Contingent Commissions’ (2007) Yale Law & Policy Review 25, 289–336; Stewart C Myers and Nicholas S Majluf, ‘Corporate Financing and Investment Decisions When Firms Have Information that Investors Do not Have’ (1984) Journal of Financial Economics 13, 187–221, 196. 27 On conflicts of interest implications that lead to issues other than adverse selection see more in detail Jeremy Burke, Angela A Hung, Jack W Clift, Steven Garber, and Joanne K Yoong, ‘Impacts of Conflicts of Interest in the Financial Services Industry’ (2015) RAND Working Paper WR-1076, 1–65. 28 Enriques (n. 1), 324; see also Paul A. Gompers and Josh Lerner, ‘Conflict of Interest and Reputation in the Issuance of Public Securities: Evidence from Venture Capital’ (April 1999) Journal of Law & Economics 42(1), 1–28. 29 On this (rough) categorization of situations into three paradigmatic cases—in which quality can either be assessed before the transaction, with hindsight, or not at all—see more

in detail Anthony Creane and Thomas D. Jeitschko, ‘Endogenous Entry in Markets with Unobserved Quality’ (2012) Economic Analysis Group Discussion Paper 12-6, 1–37; as for search goods and experience and credence goods, see the pioneering works of Phillip Nelson, ‘Information and Consumer Behaviour’ (1970) Journal of Political Economy 78, 311–29 and Michael Darby and Edi Karni, ‘Free Competition and the Optimal Amount of Fraud’ (1973) Journal of Law and Economics 16, 67–88; and today Wesley A. Magat and W. Kip Viscusi, Informational Approaches to Regulation (Cambridge, MA: MIT Press, 1992); Wesley A. Magat, ‘Information Regulation’ in Paul Newman (ed.) The New Palgrave Dictionary of Economics (London: MacMillan, 1998); Eirik G. Furubotn and Rudolf Richter, Institutions and Economic Theory: The Contribution of the New Institutional Economics (2nd edn, Ann Arbor: University of Michigan Press, 2005), pp. 318–26; and Hans-Bernd Schäfer and Claus Ott, Lehrbuch der ökonomischen Analyse des Zivilrechts (5th edn, Berlin: Springer, 2012), p. 465 et seq. 30 See, e.g., Colin Camerer, Behavioral Game Theory: Experiments in Strategic Interaction (Princeton, NJ: Princeton University Press, 2003); Colin Camerer, George Loewenstein, and Matthew Rabin (eds), Advances in Behavioral Economics (New York: Russell Sage Foundation/Princeton and Oxford: Princeton University Press, 2004); and more recently, George A. Akerlof and Robert J. Shiller, Phishing for Phools. The Economics of Manipulation and Deception (Princeton and Oxford: Princeton University Press, 2015); Richard Thaler, Misbehaving. The Making of Behavioral Economics (New York and London: W. W. Norton & Company, 2015). 31 For an overview of bounded rationality, and the classical distinction between bounded rationality, bounded willpower, and bounded self-interest, see, e.g., Richard Thaler, ‘Doing Economics Without Homo Economicus’ in Steven G. Medema and Warren J. Samuels (eds) Foundations of Research in Economics: How Do Economists Do Economics? (1996), pp. 227 et seq.; for cognitive capacity limits, see, e.g., Nelson Cowan, ‘The Magical Number 4 in Short-Term Memory: A Reconsideration of Mental Storage Capacity’ (2000) Behav. & Brain Sci. 24, 87; Baddeley, ‘Working Memory: Theories, Models, and Controversies’ (2012) Ann. Rev. Psychol. 63, 1. 32 See, e.g., Martin J. Eppler and Jeanne Mengis, ‘The Concept of Information Overload: A Review of Literature from Organization Science, Accounting, Marketing, MIS, and Related Disciplines’ (2004) Info. Soc’y. 20, 325, 326. 33 Angela Edmunds and Anne Morris, ‘The Problem of Information Overload in Business Organizations: A Review of Literature’ (2000) Int’l J. Info. Mgmt. 20, 17, 19. 34 George A. Miller, ‘The Magical Number Seven, Plus or Minus Two: Some Limits on Our Capacity For Processing Information’ (1956) Psychol. Rev. 63, 81; see further Robert S. Owen, ‘Clarifying the Simple Assumption of the Information Load Paradigm’ (1992) Advances Consumer Res. 19, 770, 773 (noting that evidence supports Miller’s magical number ‘as a rough benchmark’); see also Cowan (n. 32); Baddeley (n. 32), 15. 35 Cowan (n. 32); Alan Baddeley (n. 32); on the upper end, in some consumer choice situations 10 product alternatives or information on 15 attributes of a product were reported

as a limit: Naresh K. Malhotra, ‘Information Load and Consumer Decision Making’ (1982) J. Consumer Res. 8, 419, 427. 36 On limited attention, see, e.g., Christopher Chabris and Daniel Simons, the invisible gorilla [sic] (New York: Crown, 2010). 37 Herbert Simon, ‘A Behavioral Model of Rational Choice’ (1955) Quarterly Journal of Economics 69, 99, 115 (‘approximate rationality’); Simon, ‘Theories of Bounded Rationality’ in C. B. McGuire and Roy Radner (eds) Decision and Organization (Amsterdam and London: North Holland, 1972), pp. 161, 163. 38 Cf. also Kumpan and Leyens (n. 1), 89 who name overconfidence as a further possible source of concern. 39 On optimism bias, see Neil D. Weinstein, ‘Unrealistic Optimism About Future Life Events’ (1980) Journal of Personality and Social Psychology 39, 806; Neil D. Weinstein and William M. Klein, ‘Unrealistic Optimism: Present and Future’ (1996) Journal of Social and Clinical Psychology 15, 1; for a cautionary note from a mathematical perspective, however, see Adam G. L. Harris and Ulrike Hahn, ‘Unrealistic Optimism about Future Life Events: A Cautionary Note’ (2011) Psychological Review 118, 135. 40 See Charles Lord, Mark R. Lepper, and Elizabeth Preston, ‘Considering the Opposite: A Corrective Strategy for Social Judgment’ (1984) J. Personality & Soc. Psychol. 47, 1231 (calling the effect ‘biased assimilation of new evidence’); Raymond S. Nickerson, ‘Confirmation Bias: A Ubiquitous Phenomenon in Many Guises’ (1998) Rev. Gen. Psychol. 2, 175. 41 Nick Chater, Steffen Huck, and Roman Inderst, Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective. Final Report, November 2010, available at , at 385. 42 ibid., at 343; trust is lower when advisers are biased, however: ibid., at 371. 43 ibid., at 385. 44 On perseverance, see, e.g., Cathy McFarland, Adeline Cheam, and Roger Buehler, ‘The Perseverance Effect in the Debriefing Paradigm: Replication and Extension’ (2007) Journal of Experimental Social Psychology 43, 233. 45 See Hacker (n. 19); Hacker, Overcoming the Knowledge Problem in Behavioral Law and Economics: Uncertainty, Decision Theory, and Autonomy (17 July 2015), available at . 46 This is a characteristic of the function they introduce to formalize probability weighting, see Daniel Kahneman and Amos Tversky, ‘Prospect Theory: An Analysis of Decision under Risk’ (1979) Econometrica 47, 263, 281; for a more nuanced assessment of the treatment of small probabilities, however, see Colin Camerer and Howard Kunreuther, ‘Decision Processes for Low Probability Events: Policy Implications’ (1989) Journal of Policy Analysis and Management 8, 565. 47 See, e.g., Amos Tversky and Daniel Kahneman, ‘Availability: A Heuristic for Judging Frequency and Probability’ (1973) Cognitive Psychol. 5, 207; Baruch Fischhoff, Paul Slovic, and Sarah Lichtenstein, ‘Fault Trees: Sensitivity of Estimated Failure Probabilities

to Problem Representation’ (1978) J. Experimental Psychol.: Hum. Perception & Performance 4, 330; Amos Tversky and Daniel Kahneman, ‘Extensional versus Intuitive Reasoning: The Conjunction Fallacy in Probability Judgment’ (1983) Psychol. Rev. 90, 293. 48 The authors have made two proposals that are differently nuanced with respect to the treatment of uncertainty concerning the existence, direction, and intensity of biases, see on one hand Stefan Grundmann, ‘Targeted Consumer Protection’ in Dorota Leczykiewicz and Stephen Weatherill (eds) The Images of the Consumer in EU Law (Oxford: Hart, 2016), pp. 223 et seq (holding that a fully rational model should be chosen unless danger for existential goods, such as a threat to health or large financial losses, looms), and on the other hand, Hacker (n. 46) (arguing that regulatory theory should by default adopt a pluralistic model of rationality that posits the simultaneous presence of both rational and boundedly rational actors and comparatively weighs the impact on the different groups). 49 See, e.g., David Hirshleifer, Behavioral Finance, MPRA Paper No. 59028, available at ; Nicholas C. Barberis and Richard H. Thaler, ‘A Survey of Behavioral Finance’ in Richard H. Thaler (ed.) Advances in Behavioral Finance, Vol. II (New York, Princeton, and Oxford: Princeton University Press, 2005), 1 et seq. 50 Thaler (n. 31), Conclusion. 51 See Kumpan and Leyens (n. 1), 85. 52 See nn. 71 et seq. and accompanying text. 53 See Section II.2.C. 54 Yet another feature where banking company law reaches considerably beyond general contract law, is, of course, the imposition on boards to take financial stability as the guideline of action which takes precedence over all others: see, among others, Jens-Hinrich Binder, ‘Vorstandshandeln zwischen öffentlichem und Verbandsinteresse – Pflichten- und Kompetenzkollisionen im Spannungsfeld von Bankaufsichts- und Gesellschaftsrecht’ (2013) Zeitschrift für Gesellschaftsrecht (ZGR) 760–801; Stefan Grundmann, ‘The Banking Union Translated into (Private Law) Duties: Infrastructure and Rulebook’ (2015) EBOR 16, 357–82, 369–79. 55 In relation to the exploration of the legal control on managerial discretion, see J. E. Parkinson, Corporate Power and Responsibility: Issues in the Theory of Company Law (Oxford: Oxford University Press, 1995), pp. 73–96; for an economic analysis of managerial discretion, see Oliver Williamson, ‘Managerial Discretion and Business Behaviour’ (1963) The American Economic Review 53(5), 1032–57; for an up-to-date empirically oriented paper pertaining to the role of the board’s discretion in a company’s internal organization, see D. B. Wangrow, D. J. Schepker, and V. L. Barker, ‘Managerial Discretion: An Empirical Review and Focus on Future Research Directions’ (2015) Journal of Management 45(1), 99–135. 56 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 L 241/26 (hereinafter MiFID I ID). 57 See, for instance, Articles 74, 88, and 91 of the Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (CRD IV), OJ 2013 L 176/338. 58 Cf. CESR’s Technical Advice (n. 4), 41; see also Stefan Grundmann, ‘Das Wertpapier- und Effektengeschäft’ in Karlheinz Ebenroth, Carsten Thomas Boujong, Detlev Joost, and Lutz Strohn (eds) Handelsgesetzbuch (Munich: C. H. Beck/Franz Vahlen, 3rd edn, 2015), Vol. 2, n. VI 294. 59 For more on product of governance under MiFID II, see, e.g., Hacker (n. 19), Part 3, under Product Governance; Hartmut Renz, Ingrid Kalisch, Sandra Pfister, Stuart Axford, and George M. Williams, Jr., ‘ESMA Opinion on Structured Retail Products: Good Practices for Product Governance Arrangements’ (2014) Journal of Investment Compliance 15, 19. 60 Harry McVea, Financial Conglomerates and the Chinese Wall: Regulating Conflict of Interest (Oxford: Clarendon Press, 1993), pp. 122–234; Thomas Möllers, ‘Kölner Kommentar zum Wertpapierhandelsgesetz (WpHG)’ (2nd edn, Cologne: Heymanns, 2014), § 33, para. 69 et seq.; in more detail Thomas Lösler, Compliance im Wertpapierdienstleistungskonzern (Berlin: De Gruyter, 2003), pp. 73–92. 61 Lösler (n. 61), 79–84; Dieter Eisele and Alexander Faust, Bankrechtshandbuch (4th edn, Munich: Beck, 2011), § 109, para. 141 et seq. 62 ESMA, Final Report: ESMA’s Technical Advice to the Commission on MiFID II and MiFIR, ESMA/2014/1569, December 2014, at 83 (emphasis added). 63 ibid., at 82. 64 Cf. European Commission, Public Consultation: Review of the Markets in Financial Instruments Directive (MiFID), December 2010, at 68–9; ESMA, Consultation Paper MiFID II/MiFIR, ESMA/2014/549, May 2014, at 41. 65 See, e.g., Martin Brenncke, ‘Der Zielmarkt eines Finanzinstruments nach MiFID II’ (2015) Wertpapiermitteilungen (WM) 1173, 1174–5. 66 ESMA (n. 63) Final Report ESMA’s Technical Advice to the Commission on MiFID II and MiFIR, ESMA/2014/1569, December 2014, at 60 nn. 27–8. 67 See for an assessment of the general legality of offering products outside the target market ESMA (n. 63) 52, 59. 68 This is the view of Brenncke (n. 66), 1173, 1179. 69 See ESMA (n. 63), 52 n. 6. 70 ESMA (n. 63), 82. 71 ESMA (n. 63), 82. 72 See, e.g., Grundmann (n. 59), n. VI 315; contra Christoph Kumpan and Alexander Hellgardt, ‘Haftung der Wertpapierdienstleistungsunternehmen nach Umsetzung der EU-

Richtlinie über Märkte für Finanzinstrumente (MiFID)’ (2006) Der Betrieb (DB) 1714, 1715–16. 73 Chater, Huck, and Inderst (n. 42), 7. 74 Roman Inderst and Marco Ottaviani, ‘Regulating Financial Advice’(2012) European Business Organization Law Review 13, 237, 241. 75 It did appear in the CESR’s Technical Advice (n. 4), 53. 76 Again, the same provision can be found in the MiFID I ID, Article 22(4), which was moved up to Level 1 in MiFID II. Therefore, under MiFID I, a minority view already held that disclosure has to be such that the mechanism for how the conflict of interest works and why lack of neutrality has to be feared has to be disclosed: see namely, even before introduction of Level 2 legislation: Grundmann (n. 59), n. VI 227 (also in the previous editions and with further references). 77 ESMA (n. 63), 80. 78 Consumer Financial Protection Bureau/Kleimann Communication Group, Inc., Know Before You Owe. Evolution of the Integrated TILA-RESPA Disclosures, July 2012, available at , at 7 and 175; see also James M. Lacko and Janis K. Pappalardo, Improving Consumer Mortgage Disclosures: An Empirical Assessment of Current and Prototype Disclosure Forms, Federal Trade Commission Bureau of Economics Staff Report, June 2007, available at . 79 Huseyn Ismayilov and Jan Potters, ‘Disclosing Advisor’s Interests neither Hurts nor Helps’(2013) Journal of Economic Behavior & Organization 93, 314, 317. 80 ESMA (n. 63), 83. 81 See, e.g., Enriques (n. 1), 331. 82 CESR’s Technical Advice (n. 4), 44. 83 Enriques (n. 1), 331. 84 Chater, Huck, and Inderst (n. 42), at 385. 85 Enriques (n. 1), 331. 86 For a more detailed treatment of inducements, see Chapter 8; for the division between dependent and independent services, Chapter 6; see also brief discussion of the need for the market structure (‘governance’) approach on remuneration in Rik Mellenbergh, ‘MiFID II: New Governance Rules in Relation to Investment Firms’ (2014) European Company Law 11, 172. 87 See George A. Papaconstantinou, ‘Investment Bankers in Conflict: The Regime of Inducements in MiFID II and the Member States’ Struggle for Fairness’ (2016) European Review of Contract Law (forthcoming); for the UK, see also the Retail Distribution Review commenced in 2006 and implemented in 2012 with the aim of raising minimum qualifications for advisers, improving transparent disclosure of charges, and removing commission payments to advisers: ; for Germany, see short survey on the large number of decisions rendered by the Supreme Court on Inducements: Grundmann (n. 59), n. VI 287–90. 88 Cf. Inderst and Ottaviani (n. 75), 237, 239. 89 See Inderst and Ottaviani (n. 75), 237, 240. 90 See n. 88 and accompanying text. 91 Europe Economics, Retail Distribution Review Post Implementation Review, 16 December 2014, available at , p. 2. 92 Michelle Abrego, ‘Lloyds U-Turns and Scraps Plans for Mass Market Advice’, New Model Adviser (27 September 2012), available at . 93 See, e.g., Towers Watson, Advice Gap Analysis: Report to FCA, 5 December 2014, available at , particularly pp. 8–9. 94 Chater, Huck, and Inderst (n. 42), 385. 95 Article 44(3) 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 L 241/26. 96 On the difficulty to assess the quality of an execution in a multi-dimensional scheme taking into account factors other than price, see Guido Ferrarini, ‘Contract Standards and the Markets in Financial Instruments Directive (MiFID): An Assessment of the Lamfalussy Regulatory Architecture’ (2005) ERCL 1, 19, 38; Ferrarini, ‘Best Execution and Competition between Trading Venues: MiFID’s Likely Impact’ (2007) Capital Markets Law Journal 2, 404, 407–9. 97 Guido Ferrarini, ‘Best Execution and Competition between Trading Venues—MiFID’s Likely Impact’ (2007) Capital Markets Law Journal 2, 404, 407. 98 ESMA, Final Report: Guidelines on cross-selling practices, ESMA/2015/1861 (December 2015), at 36–7. 99 Loci classici include Ward S. Bowman, Jr., ‘Tying Arrangements and the Leverage Problem’ (1957) Yale Law Journal 67, 19; Donald F. Turner, ‘The Validity of Tying Arrangements under the Antitrust Laws’ (1958) Harvard Law Review 72, 50; for a more recent treatment, see Jean Tirole, ‘The Analysis of Tying Cases: A Primer’ (2005) Competition Policy International 1, 1; W. David Slawson, ‘Excluding Competition without Monopoly Power: The Use of Tying Arrangements to Exploit Market Failure’ (1991) Antitrust Bulletin 36, 457. 100 See also ESMA (n. 99), at 39. 101 ESMA (n. 99). 102 ESMA (n. 99), 38. 103 ESMA (n. 99), 40. 104 ESMA (n. 99), 41.

105

See William Samuelson and Richard Zeckhauser, ‘Status Quo Bias in Decision Making’ (1988) Journal of Risk and Uncertainty 1, 7. 106 ESMA (n. 99), 41–2. 107 Omri Ben-Shahar and Carl E. Schneider, More Than you Wanted to Know (Princeton and Oxford: Princeton University Press, 2014); see also Hacker (n. 19), Part 3. 108 See, e.g., the exemplary study of the US Consumer Financial Protection Bureau on the effectiveness of different mortgage disclosure formats (n. 79). 109 Ismayilov and Potters (n. 80) 314, 318. 110 See Hacker (n. 19), Part 3. 111 ESMA (n. 99), 38. 112 See, e.g., Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs), OJ 2014 L 352/1. 113 Omri Ben-Shahar and Adam S. Chilton, Simplification of Privacy Disclosures: An Experimental Test, Working Paper (2016), available at . 114 Chater, Huck, and Inderst (n. 42), at 336–7. 115 Geneviève Helleringer, Trust Me, I Have a Conflict of Interest! Testing the Efficacy of Disclosure in Retail Investment Advice, Working Paper, 2016, available at ; the results do not show how far actual investment decisions would follow the stated changes in attitudes analysed by the study; however, the study makes such behavioural change at least a plausible result of enhanced disclosure. 116 The explanation reads: ‘For your information, your financial advisor will be paid a percentage of your total investment. Please note that this means that the advisor did not necessarily have your own investment earnings in mind when giving advice.’ Helleringer (n. 116), 41. 117 These include the possibility to compare offers, advice, and disclosures among different statements advertising advised investment opportunities, see Helleringer (n. 116), 21. 118 Inderst and Ottaviani (n. 75), 237, 241–2. 119 Christine Jolls and Cass R. Sunstein, ‘Debiasing through Law’ (2006) Journal of Legal Studies 35, 199. 120 See for a theoretical account of such asymmetrical effects of behavioral interventions Camerer, Issacharoff, Loewenstein, O’Donoghue, and Matthew Rabin, ‘Regulation for Conservatives: Behavioral Economics and the Case for “Asymmetric Paternalism”’ (2003) University of Pennsylvania Law Review 151, 1211. 121 See Hacker (n. 19), Part 3. 122 See, for successful debiasing strategies through warnings, e.g., Marc Alpert and Howard Raiffa, ‘A Progress Report on the Training of Probability Assessors’ in Daniel Kahnemann, Paul Slovic, and Amos Tversky (eds), Judgment under Uncertainty: Heuristics and Biases (Cambridge, UK: Cambridge University Press, 1982), p. 294; for

unsuccessful strategies, e.g., Neil D. Weinstein and William M. Klein, ‘Resistance of Personal Risk Perceptions to Debiasing Interventions’ in Thomas Gilovich, Dale Griffin, and Daniel Kahneman (eds) Heuristics and Biases: The Psychology of Intuitive Judgment (Cambridge, UK: Cambridge University Press, 2002), p. 313; more generally Hacker (n. 19), Part 3; Baruch Fischhoff, ‘Debiasing’ in Kahnemann, Slovic, and Tversky (eds) (ibid.), p. 422; Richard P. Larrick, ‘Debiasing’ in Derek J. Koehler and Nigel Harvey (eds) Blackwell Handbook on Judgment and Decision Making (Malden, MA.: Blackwell Publishing, 2004), p. 316. 123 Chater, Huck, and Inderst (n. 42). 124 Inderst and Ottaviani (n. 75), 237, 241–2. 125 Oren Bar-Gill, ‘Price Caps in Multi-Price Markets’ (2015) The Journal of Legal Studies 44, 4 53.

8 Inducements Larissa Silverentand, Jasha Sprecher, and Lisette Simons

I. Introduction II. 1. 2. 3.

Current Legislation MiFID I MiFID I Implementing Directive Guidance by ESMA

III. 1. 2. 3.

The Dutch Inducement Ban Introduction The Dutch Inducement Ban Dutch Inducement Rules for Investment Services Outside the Scope of the Inducement Ban

IV. 1. 2. 3.

The UK Inducement Rules Introduction MiFID I Implementation Retail Distribution Review

V. MiFID II 1. Introduction 2. Investment Advice on an Independent Basis and Portfolio Management 3. Other Investment Services and Ancillary Services 4. Deviating Requirements VI. Research as an Inducement 1. Introduction

2. Definition of ‘Research’ 3. Research as an Inducement VII. Conclusion

I. Introduction [8.01] Pursuant to the Markets in Financial Instruments Directive1 (MiFID I), an investment firm must act honestly, fairly, and professionally in accordance with the best interests of its clients.2 This general duty forms the basis for all conduct rules applicable to the provision of investment services. [8.02] With the entry into force of MiFID I, rules regarding inducements were introduced as part of a set of more detailed rules expanding on this general duty of care. Inducements are payments or other benefits received by or paid for by an investment firm in relation to investment services. When an investment firm receives payments or benefits from other persons or entities than its clients, there can be a conflict between the interests of the investment firm and the interests of the client. In such case, there is a concern whether the investment firm will be led by its obligation to act in accordance with the best interests of its clients, or whether the investment firm will be led by its own interests in receiving payments or other benefits from other persons. As follows from the reference to ‘benefits’, it is not only payments made to an investment firm that may bring about such a conflict of interests; non-monetary benefits, such as free trips or gifts, may also lead to reward-driven behaviour by the investment firm. [8.03] Ever since the introduction of the inducement rules in MiFID I, the inducement rules have led to a lot of debate and discussion.3 This chapter provides an overview of the current rules on inducements, as well as the changes under the Markets in Financial Instruments Directive II4 (MiFID II).

II. Current Legislation 1. MiFID I [8.04] As set out above in paragraph 8.01, the inducement ban finds its origin in MiFID I. MiFID I was adopted in April 2004 and the national legislation implementing MiFID I was due to apply as of November 2007. MiFID I prescribes amongst others inducement rules. These rules are intended to better protect customers against reward-driven advice behaviour, in view of the fact that at that time many investment firms were being partly paid by issuers or providers of financial instruments. [8.05] As set out above, the legal basis for the inducement ban is the loyalty obligation laid down in MiFID I. This obligation stipulates that investment firms, when providing investment services and/or ancillary services, must act honestly, fairly, and professionally, in accordance with the best interests of the client.5 This general duty is set out in more detail in both MiFID I itself as well the MiFID I Implementing Directive.6 It includes, in addition to the inducement rules, more detailed information requirements and the know-your-customer obligation.7 In the following section, we will describe the rules set out in the MiFID I Implementing Directive in more detail.

2. MiFID I Implementing Directive [8.06] In August 2006, the European Commission adopted Level 2 implementing measures, including a regulation and a Directive, to further specify the requirements and obligations laid down in MiFID I. The Level 2 Directive (the ‘MiFID I Implementing Directive’) introduced the inducement ban. Pursuant to this Directive, investment firms are not regarded as acting honestly, fairly, and professionally in accordance with the best interests of a client if they pay or are paid any fee or commission, or provide or are provided with any non-monetary benefit. As a result, the

Directive contains, as a starting point, a general prohibition on inducements. There are, however, three exceptions to this prohibition:8 1. when the inducement is paid or provided to or by the client (or a person on behalf of the client); 2. when the inducement is paid to or by a third party, provided that each of the following conditions are met: i. prior to the provision of the investment service, the existence, nature, and amount of the inducement must be disclosed to the client in a comprehensive and understandable manner. An investment firm may disclose the required information in summary form, provided that it provides more detailed information at the client’s request;9 ii. the payment must be designed to enhance the quality of the relevant service to the client; and iii. the inducement does not impair the investment firm’s duty to act in the best interest of the client. 3. when the inducements are proper and necessary for the provision of investment services, such as custody costs, settlement and exchange fees, regulatory levies, or legal fees, and which, by their nature, cannot give rise to conflicts with the investment firm’s duties to act honestly, fairly, and professionally in accordance with the best interests of its clients. [8.07] The conditions included in this Article are fairly open-ended. As a result, the introduction of the inducement ban caused quite a bit of confusion and uncertainty in practice. Specifically the question under what circumstances an inducement enhances the quality of the provision of the service and does not impair the firm’s duty to act in the best interest of the client was discussed extensively.

3. Guidance by ESMA [8.08] The Committee of European Securities Regulators (currently and hereafter referred to as the European Securities and Markets Authority, ‘ESMA’) adopted recommendations10 (the ‘ESMA Recommendations’) on

inducements in May 2007. The main objective of these recommendations was to provide guidance on inducements and, consequently, ensure a consistent implementation and application of the MiFID Implementing Directive.11 In what follows, we will elaborate upon the conditions set out in the provision on inducements on the basis of the ESMA Recommendations and its ‘Good and Bad Practices’, of April 2010 (the ‘ESMA Practices’).12 First, we will discuss the scope of the inducement ban, and second, we will analyse the application of the exceptions thereto.

A. Scope of the Inducement Ban i. Standard Fees [8.09] Standard fees are payments that are considered standard in the specific market. In consultations preceding the ESMA Recommendations, market participants had argued that such standard fees should be placed outside the scope of the inducement ban.13 It was argued, for example, that normal business arrangements between two investment firms, whereby one firm pays the other, should fall outside the scope of the inducement ban, as such payments should be considered part of normal business, rather than inducements. It was argued that the provision in the MiFID I Implementing Directive with respect to the conflict of interest, which stated that ‘other than the standard commission or fee for that service’, implied that standard fees should be allowed.14 ESMA, however, stipulated in its recommendations that Article 26 of the MiFID I Implementing Directive covers (emphasis added): ‘any fee or commission or non-monetary benefit that an investment firm may receive or pay in connection with the provision of investment and ancillary services to clients including commissions or fees that […] are standard in the market’.15 It is clear from this statement that the inducement ban has a broad scope of application. ii. Intra-group Payments [8.10] In addition to that, ESMA stated in its ESMA Recommendations that the inducement rules also apply to a payment provided to or made by a legal entity within the same group as the investment firm providing the investment service.16 This means that intragroup payments for investment services are, in principle, not excluded from

the scope of the inducement ban. In the ESMA Practices, however, ESMA took a different position on payments with regard to tied agents, which can be intra-group payments. A tied agent has a special status under MiFID, as it acts under the full and unconditional responsibility of the investment firm. It does not have its own licence, but it acts under the licence of the investment firm. ESMA stipulates in the ESMA Practices that, under certain circumstances, payments made from the investment firm to the tied agent may be seen as an internal payment. Consequently, the inducement ban does not apply to such payments. However, if such payment is related to a payment from a third party, such as a product provider, to the investment firm, the whole of the payment from the product provider has to be considered as a third-party payment, which falls within the scope of the inducement ban.17

B. Exceptions i. Direct Fees [8.11] The first exception to the inducement ban are fees that are paid by clients (we refer to this category as ‘direct fees’). With regard to direct fees, ESMA clarified that a fee is (also) deemed to be provided by the client when a third party pays the fee on behalf of the client. An example of such a situation is a lawyer or accountant paying an invoice for a client relating to the investment service. Relevant in this respect is whether there is a specific instruction by the client to the third party to make or receive a payment. In addition, ESMA stipulates that the fact that the client bears the economic cost of the fee is not by itself sufficient to be regarded as provided by the client, and, consequently, to qualify as a direct fee.18 There should be other factors indicating that the payment is made directly by or to the client. ii. Fees Enhancing the Quality of the Service [8.12] As set out above, inducements are also allowed if two conditions are met. First, the fee should enhance the quality of the service and should not impair the obligation to act in the client’s best interests. Second, prior to the provision of the investment service, the fee should be disclosed to the client in a clear manner.19

[8.13] With respect to the first condition, the following factors are, amongst others, relevant in determining whether fees/commissions can be considered to be designed to enhance the quality of the service and not to impair the firm’s duty to act in the best interest of the client: (i) the type of service and any specific duties the investment firms owes to the client, (ii) the expected benefit to the client versus the expected benefit for the investment firm, (iii) the existence of an incentive for the investment firm not to act in the client’s best interest, (iv) the relationship between the investment firm and the entity which is receiving or providing the benefit, and (v) the nature of the payment, that is, does it cause any conflicts with the conduct of business obligation to act honestly, fairly, and professionally in the best interest of the client.20 [8.14] With regard to the second condition, the requirement to disclose the fees, it is important that the investment firm discloses the details of the payment to the client. This should be done in such way as to enable the client to have clear insight into the payment structure. As set out above, an investment firm may disclose the required information in summary form, as long as it provides more detailed information at the client’s request. iii. Proper Fees [8.15] Finally, there is a third exception, which we shall refer to as ‘proper fees’.21 In order for a fee to fall under the third exception, the following two conditions must be fulfilled: (i) the payment must enable or be necessary for the provision of the service, and (ii) the fee, by its nature, cannot give rise to conflicts with the firm’s duty to act honestly, fairly, and professionally in accordance with the best interests of the client. [8.16] In order to pass the test referred to under (ii), the nature of the payment should be kept in mind rather than the question of whether the result of the payment actually gives rise to a conflict for the investment firm to act in the client’s best interest.22 [8.17] Article 26 of the MiFID I Implementing Directive refers to custody costs, settlement and exchange fees, regulatory levies, and legal fees as proper fees. According to ESMA, the list of examples stated in the article itself is not exhaustive. For other fees it should be determined whether they

meet the two requirements set out above.23 ESMA indicates that payments that are made in order to access and operate on a given execution venue should also be considered proper fees.24 However, the ESMA Practices indicate that this category of fees should not be considered as a broad category and should be applied strictly.25

III. The Dutch Inducement Ban 1. Introduction [8.18] After the financial crisis, both the Dutch legislator and the AFM intensified their scrutiny on inducements in relation to all financial products available in the Netherlands (such as financial instruments, insurance products, and credit products). This led to an inducement ban on a wide range of financial products in the Netherlands in 2013, with the exception of financial instruments. Financial instruments were not covered by the inducement ban, because MiFID I already provided for rules on inducements and the Dutch government intended for this to be part of MiFID II. In the meantime, however, the AFM did not want to wait for a Dutch or European ban on inducements for financial instruments. The AFM therefore approached the largest retail banks in the Netherlands and announced in early 2013 that it had come to a ‘voluntary’ agreement that these banks would no longer receive distribution fees with respect to investment funds from 1 January 2014. In the same period it became apparent to the Dutch legislator that the inducement ban it had envisaged had not received sufficient political support at a European level in MiFID II. In response, the legislator introduced the Dutch ban on inducements in relation to investment services from 1 January 2014, effectively rendering the AFM agreement moot. In the following paragraph, we will describe the Dutch ban on inducements in more detail.

2. The Dutch Inducement Ban

[8.19] The inducement ban for investment firms is set out in the Dutch Market Conduct Decree,26 which is the ‘Dutch Level 2’ legislation for code of conduct rules. Just as in MiFID I, the inducement ban (and other inducement rules for investment firms) is a further elaboration of the general duty of an investment firm to act honestly, fairly, and professionally in accordance with the best interests of the client. The Dutch inducement ban is only applicable in relation to investment services provided to retail investors. For professional investors the (Dutch implementation of) MiFID inducement rules are still applicable (we refer to paragraph 8.06 above). [8.20] The scope of the inducement ban is quite broad. It prohibits investment firms to directly or indirectly pay and receive any inducement in relation to the provision of investment services or ancillary services to a retail client. Inducements are defined as any remuneration or fee in any form in relation to the provision of an investment service or ancillary service. The inducement ban applies to all ancillary services and to the following investment services: (i) (ii) (iii) (iv)

reception and transmission of orders; execution of orders on behalf of clients; investment advice; and portfolio management.

[8.21] There are only a few exceptions to the inducement ban: • inducements in relation to investment services/ancillary services provided to professional investors (see a further description below); • inducements in relation to placing/underwriting services (see a further description below); • business gifts that do not exceed €100 on an annual basis; • inducements that are necessary for the service provided or inducements that enable the provision of the service. In practice, this exception does not provide much room for parties to pay or receive inducements, because this exception is interpreted in a very strict way by the regulators. Examples of inducements that are permitted in this category are custody fees, settlement fees, transaction fees of a trading venue, statutory fees, and legal fees;27

• fees paid to and by tied agents; and • inducements paid to a crowdfunding platform. This exception was introduced in 2016 to take away hurdles for equity based crowdfunding platforms that effectively provide the investment service of reception and transmission of orders. [8.22] The effect of the inducement ban is that only payments made by the retail client directly to the investment firm are a permitted way of receiving income for the investment firm. In practice the prohibition on receiving fees has proved to be especially burdensome. This part of the ban not only prohibits the retention of the fees by the investment firm, but also prohibits the firm from receiving the inducement and subsequently paying such inducements on to the client. This has resulted in a substantial effort of Dutch distributors to move all their clients into non-rebate-paying financial instruments and sometimes resulted in firms requiring their clients to sell instruments that could not be made ‘rebate free’. The choice of an inducement ban that allowed for on-payment of inducements would have been far less burdensome with the same end result for the retail client. [8.23] The investment services of underwriting/placement with or without a firm commitment basis fall outside the scope of the inducement ban. We refer to paragraph 8.06 for a description on the inducement regime applicable to these investment services. The Dutch legislator has given several arguments for excluding these services from the scope of the inducement ban.28 First, because these are services that relate to the primary markets and not the secondary markets. Second, the fees paid in the context of these investment services are generally paid by the investment firm for the preparation of the prospectus and research reports, the structuring of transactions, and assuming risks. In the eyes of the Dutch legislator, this does not run counter to the purpose of the inducement ban.

A. Territorial Scope [8.24] The Dutch inducement ban applies to investment firms as defined in the Dutch Financial Supervision Act (DFSA). This includes almost all investment firms that provide investment services in the Netherlands

(including banks, third-country investment firms, and branches of EEA investment firms operating under a European passport). Investment firms active in the Netherlands that are not subject to the Dutch inducement ban are EEA investment firms making use of their European passport to provide investment services in the Netherlands on a cross-border basis. The reason for this is that MiFID I provides that Member States may not impose any additional requirements on such investment firms where this concerns matters covered by MiFID I.29

B. Legal Basis and Necessity for ‘Gold Plating’ [8.25] MiFID I provides for maximum harmonization. This means that national rules may not impose stricter rules than those laid down in MiFID I, unless such is explicitly provided for in MiFID I. Because the Dutch inducement ban is clearly stricter than the inducement rules provided for in MiFID I, the Dutch legislator needed to find a legal basis for imposing these stricter rules. As discussed in paragraph 8.06, the MiFID I inducement rules follow from Article 26 MiFID I Implementing Directive, which does not provide for a Member State option to impose stricter rules. The Dutch legislator therefore decided to make use of the option provided by Article 4 MiFID I Implementing Directive, allowing Member States to impose additional requirements on investment firms. A Member State must be able to demonstrate that certain exceptional circumstances require the Member State to impose such additional rules. In short, the Member State may use this option: (a) in an exceptional case; (b) if such requirement is objectively justified and proportionate; (c) if such requirement addresses risks to investor protection or market integrity; (d) if such requirement is not adequately addressed by the MiFID I Implementing Directive; and (e) (i) if the risks addressed are of particular importance looking at the market structure of the Member State, or (ii) the risk has emerged/became evident after the date of application of the MiFID I Implementing Directive.

[8.26] In the view of the Dutch legislator, the measures under the MiFID I Implementing Directive were not adequate to prevent negative incentives of inducements.30 Furthermore, in its view transparency was not an adequate measure to balance the information gap between market parties and clients, especially in respect of the influence of inducements on services provided by investment firms. The Dutch legislator furthermore argued that the deficiency in the rules is evidenced by the fact that MiFID II (which was at that point still under negotiation) provides for stricter rules and a partial inducement ban and that for instance in the United Kingdom measures had been taken to ban certain inducements. Finally, the Dutch legislator argued that Netherlands market parties were relatively dependent on the revenue source of inducements and that banning inducements would be favourable for competition on the Dutch market because of greater price transparency. [8.27] In our view, it can be questioned whether the argumentation of the Dutch legislator meets the (seemingly) strict criteria of the exception provided by Article 4 of the MiFID I Implementing Directive. For instance, one could question whether the inducement ban is proportionate. In particular, the ban on paying-on fees seemed to be disproportionately burdensome on market parties without any added benefit. Having said that, the inducement ban in the Netherlands has so far not been challenged nationally or in a European context. [8.28] Because MiFID II includes a very similar possibility for stricter inducement rules in Article 24(12), it is likely that the Dutch legislator will therefore continue to rely on this exception and argumentation under MiFID II in imposing a stricter inducement ban than introduced by MiFID I (we refer to paragraph 8.05 of this chapter). Unlike the exception provided for in Article 4 of the MiFID I Implementing Directive, MiFID II requires the European Commission to provide its opinion on the proportionality of and justification for the additional requirement. Unfortunately, we will not see whether the European Commission deems such stricter rules to be proportionate and justifiable in the light of the inducement requirements that have been agreed on at a European level in MiFID II, given the fact that MiFID II provides Member States with the option to continue to rely on stricter rules that were set under Article 4 of the MiFID I Implementing Directive prior to the implementation of MiFID II.

3. Dutch Inducement Rules for Investment Services Outside the Scope of the Inducement Ban [8.29] As discussed above, the Dutch inducement ban does not apply where it concerns the investment services of placement or underwriting (with or without a firm commitment) and in respect of services provided to professional investors. The Dutch implementation of the MiFID I inducement rules applies to these categories of services. In short, this means that inducements are permitted if the client is informed of the nature and amount of the inducement and the inducement does not negatively affect the quality of the service provided or impair the investment firm’s compliance with its duty to act in the best interests of the client. For a more detailed description of these rules we refer to our discussion thereof in paragraphs 8.06 et seq.

IV. The UK Inducement Rules 1. Introduction [8.30] Similar to the Netherlands, the United Kingdom has also implemented rules providing for stricter requirements in relation to inducements than what is set out in MiFID I and the MiFID I Implementing Directive. In this section we will describe the rules applicable in the United Kingdom and the scope thereof.

2. MiFID I Implementation [8.31] The UK implemented the conduct of business obligations laid down in MiFID I in the Conduct of Business Sourcebook (COBS). Article 26 of the MFID I Implementing Directive has been implemented in COBS 2.3. This clause is effectively identical to Article 26 of the MiFID I Implementing Directive, but, in addition, also elaborates on the application of the provision to non-MiFID-business. This provision was effective as of

1 November 2007. Hereinafter, we refer to this provision as the ‘MiFID implementation provision’.

3. Retail Distribution Review [8.32] In addition to the implementation of MiFID I, the Financial Services Authority (the predecessor of the Financial Conduct Authority, ‘FCA’) started the Retail Distribution Review (RDR) in 2006. The RDR was aimed at improving the retail financial investment market and increasing consumers’ confidence and trust in the market. The main objectives of the RDR were: (i) raising the level of qualification and professionalism of advisers, (ii) improving the transparency of costs charged for advice, and (iii) changing remuneration structures between providers, platforms, and advisers.31 Specifically relevant for this chapter are (ii) and (iii).

A. Inducement Rules [8.33] The FCA decided that it was necessary to introduce more stringent rules with respect to inducements in order to realize a change in the remuneration structures between providers, platforms, and advisers. By introducing more stringent rules, the UK went beyond what was required by MiFID I. Similar to the Netherlands, as stated in paragraph 8.26, gold plating was deemed to be justified on the basis of Article 4 of the MiFID Implementing Directive. The UK implemented the following rules with respect to inducements in the COBS: • ban on payments from providers to advisers for advice on retail investment products;32 • ban on payments by providers to platforms and cash rebates by product providers to consumers using platforms;33 • requirements for advisers to establish a fee structure for advice to consumers, as well as disclosing requirements in respect of the fees

charged.34 [8.34] The rules under (i) and (iii) became effective as of 31 December 2012, one day before the inducement ban entered into force in the Netherlands. However, the FCA stated that it would refrain from enforcement measures during the first year post implementation. The rule under (ii) with regard to platforms became effective as of 6 April 2014. [8.35] The inducement rules only apply to the retail market and do not involve investment services that are provided to professional investors. The rules are applicable to advisers, platforms, and product providers. [8.36] The inducement rules in principle also apply to tied agents. The COBS stipulates that the fact that a fee is paid by a tied agent does not mean that the inducement rules do not apply.35

V. MiFID II 1. Introduction [8.37] Under MiFID II,36 the rules regarding inducements have been further restricted. Under MiFID II, it is important to determine which investment service is provided when analysing the inducement requirements. A distinction is made between (i) investment advice on an independent basis and portfolio management, and (ii) all other investment services and ancillary services. [8.38] Pursuant to Article 24(13) of MiFID II, the European Commission may adopt delegated acts, amongst others, setting out the criteria to assess compliance of firms receiving inducements with the obligation to act honestly, fairly, and professionally, in accordance with the best interest of the client. [8.39] The European Commission mandated ESMA to provide it with technical advice on possible delegated acts. On 22 May 2014, ESMA

published a consultation paper (the ‘Consultation Paper’) asking for input with respect to its technical advice.37 ESMA delivered its technical advice (the ‘Technical Advice’) on 19 December 2014.38 On 7 April 2016, the European Commission published a Draft Delegated Directive (the ‘Draft Delegated Directive’) based on the Technical Advice.39 At the time of writing this chapter, the Directive was still in draft. Below we will describe the provisions of the draft Directive. In addition, we will (where relevant) pay attention to the Technical Advice.

2. Investment Advice on an Independent Basis and Portfolio Management [8.40] Pursuant to Article 24 of MiFID II, an investment firm that provides investment advice on an independent basis, or that provides portfolio management, may not accept and retain fees, commissions, or any monetary or non-monetary benefits (hereinafter ‘inducements’) paid or provided by any third party in relation to the provision of the service to clients. This is often referred to as the ‘inducement ban’. Recital 74 of MiFID II states that this ban applies particularly to inducements from issuers or product providers. [8.41] The wording ‘accept and retain’ means that inducements may be paid by third parties to an investment firm, but that they must be paid on in full to the client as soon as possible after receipt of those payments by the firm, and that the firm is not allowed to offset any third-party payments from the fees due by the client to the firm.40 Recital 24 of the Draft Delegated Directive provides that no specific timeframe is imposed—other than ‘as soon as possible’—since third-party payments may be received by the investment firm at various points in time and for several clients at once. Firms providing independent advice or portfolio management must draw up a policy, as part of their organizational requirements, to ensure that thirdparty payments received are allocated and transferred to each individual client.41 The client must be accurately and, where relevant, periodically, informed about all inducements that the investment firm has received in

connection with the investment service provided to the client and transferred to the client.42 [8.42] The inducement ban does not apply to inducements paid or provided by a client or a person acting on behalf of a client. Inducements paid or provided by a person on behalf of the client should be allowed only as far as the client is aware that such payments have been made on that client’s behalf. In addition, the amount and frequency of any payment must be agreed between the client and the investment firm and not determined by a third party.43 According to Recital 75 of MiFID II, there are several examples which would satisfy that requirement, including where a client pays a firm’s invoice directly. Examples in respect of permitted payments by third parties on behalf of the client are those cases where the investment firm is paid by an independent third party who has no connection with the investment firm regarding the investment service provided to the client and is acting only on the instructions of the client and cases where the client negotiates a fee for a service provided by an investment firm and pays that fee. According to this same Recital, this would generally be the case for accountants or lawyers acting under a clear payment instruction from the client or where a person is acting as a mere conduit for the payment.

A. Minor Non-Monetary Benefits [8.43] The above inducement ban does not apply to minor non-monetary benefits. These must meet three criteria: they should be capable of enhancing the quality of service provided to a client; they must be of a scale and nature such that they could not be judged to impair compliance with the investment firm’s duty to act in the best interest of the client; and they must be clearly disclosed. According to Article 11 of the Draft Delegated Directive, disclosure of minor non-monetary benefits must be made prior to the provision of the relevant investment or ancillary services to clients. Such disclosures may be made in a generic way. [8.44] Article 12(3) of the Draft Delegated Directive states that benefits shall only qualify as acceptable minor non-monetary benefits if they are:

(a) information or documentation relating to a financial instrument or an investment service, that is generic in nature or personalized to reflect the circumstances of an individual client; (b) written material from a third party that is commissioned and paid for by a corporate issuer or potential issuer to promote a new issuance by the company, or where the third-party firm is contractually engaged and paid by the issuer to produce such material on an ongoing basis, provided that the relationship is clearly disclosed in the material and that the material is made available at the same time to any investment firms wishing to receive it or to the general public. Contrary to the other items in this list, this particular non-monetary benefit was not specifically included in the list as set out in ESMA’s Technical Advice; (c) participation in conferences, seminars, and other training events on the benefits and features of a specific financial instrument or an investment service; (d) hospitality of a reasonable de minimis value, such as food and drink during a business meeting or a conference, seminar, or other training event mentioned under point (c); and (e) other minor non-monetary benefits which a Member States deems capable of enhancing the quality of service provided to a client and, having regard to the total level of benefits provided by one entity or group of entities, which are of a scale and nature unlikely to impair compliance with an investment firm’s duty to act in the best interest of the client. [8.45] As per ESMA’s Technical Advice, this list appears to be intended to be exhaustive, despite the fact that in the consultation most respondents disagreed with ESMA’s proposal. One of the reasons considered by many was that an exhaustive list would be too rigid. [8.46] In addition, the Draft Delegated Directive provides that acceptable minor non-monetary benefits must be reasonable and proportionate and of such a scale that they are unlikely to influence the investment firm’s behaviour in any way that is detrimental to the interests of the relevant client.

3. Other Investment Services and Ancillary Services [8.47] The fact that MiFID II includes a specific ban on inducements for advice on an independent basis and portfolio management only does not mean that there are no inducement rules applicable to investment firms that provide other investment services or ancillary services. Article 24(9) of MiFID II provides that investment firms may not pay or be paid any inducement in connection with the provision of an investment service or an ancillary service, to or by any party other than the client, except where the inducement: (a) is designed to enhance the quality of the relevant service to the client; and (b) does not impair compliance with the investment firm’s duty to act honestly, fairly, and professionally, in accordance with the best interest of its clients. [8.48] These criteria are the same as under MiFID I. However, in the Draft Delegated Directive, the European Commission provides more detailed rules on when inducements are considered to be designed to enhance the quality of the relevant service. [8.49] Article 11(2) of the Draft Delegated Directive provides that an inducement shall be considered to be designed to enhance the quality of the relevant service to the client (i.e. the criterion set out under (a) above) if all of the following conditions are met: (a) the inducement is justified by the provision of an additional or higherlevel service to the relevant client, proportional to the level of inducements received, such as: (i) the provision of non-independent investment advice on, and access to, a wide range of suitable financial instruments including an appropriate number of instruments from third-party product providers having no close links with the investment firm; (ii) the provision of non-independent investment advice combined with either: an offer to the client, at least on an annual basis, to assess the continuing suitability of the financial instruments in which the client has invested; or with another ongoing service that

is likely to be of value to the client such as advice about the suggested optimal asset allocation of the client; or (iii) the provision of access, at a competitive price, to a wide range of financial instruments that are likely to meet the needs of the client, including an appropriate number of instruments from third-party product providers having no close links with the investment firm, together with either the provision of added-value tools, such as objective information tools helping the relevant client to take investment decisions or enabling the relevant client to monitor, model, and adjust the range of financial instruments in which they have invested, or providing periodic reports of the performance and costs and charges associated with the financial instruments; (b) the inducement does not directly benefit the recipient firm, its shareholders, or employees without tangible benefit to the relevant client; and (c) the inducement is justified by the provision of an ongoing benefit to the relevant client in relation to an ongoing inducement. [8.50] Contrary to ESMA’s Technical Advice, the above list appears to be intended to be exhaustive. [8.51] The above requirements must be fulfilled on an ongoing basis by the investment firm as long as the firm pays or receives the inducement. However, this does not imply that investment firms are required to ensure a continuously increasing quality of services over time. Recital 23 of the Draft Delegated Directive only requires that investment firms should, once they have fulfilled the quality-enhancement criterion, maintain the enhanced level of quality. [8.52] The Draft Delegated Directive goes on to say that an inducement shall not be considered acceptable if the provision of relevant services to the client is biased or distorted as a result of inducement. [8.53] The Draft Delegated Directive also provides that investment firms must hold evidence that any inducements paid or received by the firm are designed to enhance the quality of the relevant service to the client:

(a) by keeping an internal list of all inducements received by the investment firm from a third party in relation to the provision of investment or ancillary services; and (b) by recording how the inducements paid or received by the investment firm (or the inducements that the investment firm intends to use) enhance the quality of the services provided to the relevant clients, and the steps taken in order not to impair the firm’s duty to act honestly, fairly, and professionally, in accordance with the best interests of the client. [8.54] As under MiFID I, the existence, nature, and amount of the inducement, or, where the amount cannot be ascertained, the method of calculating that amount, must be clearly disclosed to the client, in a manner that is comprehensive, accurate, and understandable, prior to the provision of the relevant investment or ancillary service. New is that, where applicable, the investment firm must also inform the client on mechanisms for transferring the inducement received in relation to the provision of the investment or ancillary service to the client. [8.55] According to Article 11(5) of the Draft Delegated Directive, the following information must be disclosed to the client: (a) prior to the provision of the relevant investment or ancillary service, the investment firm must disclose to the client information on the inducement concerned in a manner that is comprehensive, accurate, and understandable. Minor non-monetary benefits may be described in a generic way. Other non-monetary benefits received or paid by the investment firm in connection with the investment service provided to a client must be priced and disclosed separately; (b) where an investment firm is unable to ascertain on an ex ante basis the amount of any inducement to be received or paid, and instead discloses to the client the method of calculating that amount, the firm shall also provide its clients with information of the exact amount of the payment or benefit received or paid on an ex post basis; and (c) at least once a year, as long as (ongoing) inducements are received by the investment firm in relation to the investment services provided to the relevant clients, the investment firm shall inform its clients on an

individual basis about the actual amount of payments or benefits received or paid. Minor non-monetary benefits may be described in a generic way. [8.56] When more firms are involved in a distribution channel, each investment firm providing an investment or ancillary service shall comply with its disclosure obligations to its clients. [8.57] The above requirements do not apply to ‘necessary fees’, that is, inducements which enable or are necessary for the provision of investment services, such as custody costs, settlement and exchange fees, regulatory levies, or legal fees, and which by their nature cannot give rise to conflicts with the investment firm’s duties to act honestly, fairly, and professionally, in accordance with the best interests of its clients.

4. Deviating Requirements [8.58] According to Article 24(12) of MiFID II, Member States may, in exceptional cases, impose additional requirements on investment firms (we also refer to paragraph 8.28). These requirements must be objectively justified and proportionate so as to address specific risks to investor protection or to market integrity which are of particular importance in the circumstances of the market structure of that Member State. If a Member State wishes to impose additional requirements, it must notify the European Commission. This notification must also include a justification for the additional requirement. The European Commission shall then provide its opinion on the proportionality of and justification for the additional requirements. In addition, the Commission shall make public on its website the additional requirements imposed by Member States. [8.59] MiFID II also provides that Member States may retain additional requirements that were notified to the Commission in accordance with Article 4 of the MiFID Implementing Directive before 2 July 2014, provided that the conditions laid down in that Article were met.

VI. Research as an Inducement 1. Introduction [8.60] As discussed in paragraphs 8.40–8.41, the inducement rules in MiFID II prohibit investment firms from accepting and retaining monetary and non-monetary benefits paid or provided by third parties in relation to the provision of independent advice or portfolio management. Only a limited category of inducements will be permitted, that is, minor nonmonetary benefits that enhance the quality of the service to the client. In its Consultation Paper and Technical Advice for the delegated acts under MiFID II, ESMA gives specific attention to research as a possible form of such non-monetary inducement. In this section we will discuss how the rules regarding the use of research in relation to the inducement ban will most likely turn out under MiFID II. As this will be laid down in Level 2 legislation, of which only a draft is available at the time of writing of this chapter, the final rules regarding research as described below may turn out differently.

2. Definition of ‘Research’ [8.61] In the Consultation Paper and the Technical Advice, ESMA uses the terms ‘research’, ‘financial research’, and ‘investment research’ without defining such terms and without much consistency. The scope of what type of research is meant here is therefore not entirely clear. In any event, it can be derived from the Consultation Paper that ESMA considers investment research as defined in Annex 1 Part B of MiFID II to fall within the category of research within the scope of these rules.44 As the term ‘research’ is used most predominantly in the Consultation Paper and the Technical Advice, we will use that term in the rest of our chapter. [8.62] A further explanation of what is to be considered research in this respect can be found in the Draft Delegated Directive. In Recital 28, research is described as follows:

Research in this context should be understood as covering research material or services concerning one or several financial instruments or other assets, or the issuers or potential issuers of financial instruments, or be closely related to a specific industry or market such that it informs views on financial instruments, assets or issuers within that sector. That type of material or services explicitly or implicitly recommends or suggests an investment strategy and provides a substantiated opinion as to the present or future value or price of such instruments or assets, or otherwise contains analysis and original insights and reach conclusions based on new or existing information that could be used to inform an investment strategy and be relevant and capable of adding value to the investment firm’s decisions on behalf of clients being charged for that research.

3. Research as an Inducement [8.63] Research as indicated above and investment research (the provision of which qualifies as an ancillary service) is provided to and used by investment firms such as portfolio managers in determining their investment advice or portfolio management. Because research has value to investment firms, it can be seen as an inducement if provided free of charge or at a discount. In the course of ESMA’s consultation and Technical Advice, market parties feared that rules would be imposed that would hinder investment firms’ access to research and would pose concerns for the viability of firms providing research. Concerns were also expressed by France, Germany, and the United Kingdom in a letter to the European Commission and ESMA, in which letter these Member States indicated that they considered the limitations on research to go beyond what was agreed in MiFID II.45 [8.64] The European Commission decided to incorporate the rules regarding research as an ‘exception’. The European Commission included Article 13 in the Draft Delegated Directive, which includes the circumstances in which research is not to be considered an inducement. This exception leaves two permitted ways of receiving research. The first option is research in return for direct payments by the investment firm out of its own resources. The second exception is an elaborate and complicated exception. It leaves room for the investment firm to use client money to fund research, if a number of strict rules are followed, including using a

separate research payment account, a specific research charge to the client, regular assessments by the investment firm of the quality of the research, making research budgets, provision of overviews to regulators, drawing up a policy, and several requirements safeguarding transparency to clients. This rather complicated and detailed requirement seems to be the opposite of what the three Member States requested in their letter regarding research as an inducement. The three Member States indicated that ‘the mechanism for the payment of research shouldn’t be overly prescriptive’. It therefore remains to be seen whether these Member States will be happy with this part of the draft delegated acts and whether this will be cause for further negotiations between the parties involved.

A. Research as a Minor Non-Monetary Benefit [8.65] Besides the exceptions under which research does not qualify as an inducement, research can also qualify as a minor non-monetary benefit. As discussed in paragraphs 8.43–8.46, certain minor non-monetary benefits are not caught by the inducement requirements and are thus permitted under MiFID II. In its Consultation Paper ESMA considered that certain ‘tailored or bespoke’ research would likely not fall within the category of nonmonetary inducements, including bespoke reports or analytical models, market data services, or investor field trips.46 In the same Consultation Paper, ESMA indicates that an example of research that may fall within the category of minor non-monetary benefits is financial analysis accessible by a large number of persons or the public at the same time.47 [8.66] In the Draft Delegated Directive, the European Commission gives a description of areas of research that are likely to qualify as minor nonmonetary benefit. Such research includes short-term market commentary, company results, and information on upcoming events.48 The Draft Delegated Directive makes clear that substantive analysis, or substantiated opinions or any other research to which valuable resources are allocated, should not be considered as minor and therefore does not fall under the exemption of such minor benefits that fall outside the scope of the inducement rules.

VII. Conclusion [8.67] During the negotiations on MiFID II, it became clear that inducements were a topic on which there was no easy agreement between the Member States. Where certain Member States pressed for a total ban on inducements, other Member States were unwilling to impose such strict rules. As is not uncommon in these situations, the political compromise that was reached was to allow for deviating rules by those Member States that wished to see stricter rules. Allowing for this may be regarded as counter to the general trend set by the European legislator to create less room for Member State options by creating ‘single rulebooks’ and an increase in the use of regulations as a legislative tool. It is therefore disappointing to see that on such an important topic in the MiFID rules the European market will continue to have deviating rules per Member State. The Dutch legislator has already indicated that it will make use of the (continued) room for ‘gold plating’, and it can be expected that other Member States having applied stricter rules will do the same, thus not creating a level playing field for investment firms regarding the use of inducements.

1

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, OJ L 145/1; and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ L 177/1. 2 Article 19(1) MiFID. 3 In addition, according to a report from 2011 commissioned by the European Commission (Synovate, Consumer Market Study on Advice within the Area of Retail Investment Services—Final Report, 2011), it seemed likely that a number of firms in that study failed to comply with the MiFID rules regarding inducement. 4 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU. 5 See in this respect D. Busch and D. A. DeMott, Liability of Asset Managers (Oxford: Oxford University Press, 2012), p. 45. 6 Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ L 241/26.

7

See also Busch and DeMott (n. 5), 42; R. Panasar and Philip Boeckman, European Securities Law (Oxford: Oxford University Press, 2010). 8 See in this respect also M. Kenny, J. Devenny, and L. Fox O’Mahony, Unconscionability in European Private Financial Transactions (Cambridge: University Press, 2010), p. 331 and onwards. 9 Article 26 MiFID Implementing Directive. See also J. P. Casey and K. Lannoo, The MiFID revolution (Cambridge: University Press, 2009), p. 131. 10 CESR Recommendations Inducements under MiFID, CESR 07-228b, May 2007. 11 ESMA Recommendations (n. 10), p. 2. 12 Inducements: Good and poor practices, CESR/10-29619, April 2010. 13 See for instance comments by the Luxembourg Bankers’ Association on CESR Consultation paper on inducements, ABBL, ‘CESR consultation paper on Inducements under MiFID’, available at . 14 Article 21(e) of the MiFID Implementing Directive. 15 ESMA Recommendations (n.10), p. 6. 16 ibid. 17 ESMA Practices (n. 12), p. 16. 18 ESMA Recommendations (n. 10), p. 4. 19 ibid, p. 6. 20 ibid, pp. 8–9. 21 See also D. Busch and D. A. DeMott, Liability of Asset Managers (Oxford: Oxford University Press, 2012), p. 45. 22 ibid, p. 7. 23 ibid, p.7. 24 ESMA Practices (n. 12), p. 16. 25 ibid, p. 17. 26 Besluit gedragstoezicht financiële ondernemingen Wft, Article 168a. 27 Stb. 2013, 537, p. 51 (Bulletin of Acts and Decrees). 28 Stb. 2013, 537, p. 30 (Bulletin of Acts and Decrees). 29 Article 31(1) MiFID I. 30 Stb. 2013, 537, p. 28 (Bulletin of Acts and Decrees). 31 See FSA, ‘A Review of Retail Distribution’, Discussion Paper 07/1 (1 June 2007), p. 17, available at . 32 COBS 6.1.A.4. 33 COBS 6.1.B.5. 34 The rules under (i) and (iii) do not apply to fees charged or payments made before 30 December 2012. 35 COBS 2.3.7.

36

Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (recast). 37 Consultation Paper, MiFID II/MiFIR, 22 May 2014, ESMA/2014/549. 38 Final Report, ESMA’s Technical Advice to the Commission on MiFID II and MiFIR, 19 December 2014 ESMA/2014/1569. 39 Commission Delegated Directive (EU) …/… of 7.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations, and the rules applicable to the provision or reception of fees, commissions, or any monetary or non-monetary benefits. 40 Recital 74 of MiFID II and Article 12(1) of the Draft Delegated Directive. 41 ibid. 42 Recital 74 of MiFID II and Article 12 of the Draft Delegated Directive. 43 Recital 75 of MiFID II. 44 Consultation Paper (n. 37), p. 121. 45 Letter of 25 August 2015. 46 Consultation Paper (n. 37), p. 121. 47 ibid. 48 Recital 29 Draft Delegated Directive.

9 AGENCY AND PRINCIPAL DEALING UNDER MIFID I AND MIFID II Danny Busch

I. Introduction II. Four Transaction Types 1. General 2. Execution of Client Orders through the Regulated Market or an MTF 3. Dealing Solely on Own Account 4. Execution of Client Orders through Internalisation or Systematic Internalization 5. Execution of Client Orders by Means of Agency Crosses III. Investor Protection IV. Acting as Agent or as Principal: Not a Justified Distinction to Serve as a Basis for Determining the Degree of Investor Protection 1. General 2. Investors’ Reasonable Expectations 3. Tenuous, Arbitrary, and Easy to Manipulate 4. Grant Estates Ltd v Royal Bank of Scotland 5. No Practicable Distinction under MiFID II either 6. Dutch Supreme Court has Already Extended Civil Duty of Care to Dealing on own Account 7. The UK Government Response to the Kay Review

V. Conclusion

I. Introduction [9.01] Investment firms regularly act as agent or intermediary in the execution of transactions in financial instruments. Such transactions can take place in the context of an execution-only service, investment advice, or portfolio-management service. Investment firms also carry out transactions as principal (i.e. on own account). In such a case, the investment firm acts solely as the investor’s contractual counterparty (principal dealing). In some transactions an investment firm acts both as intermediary and on own account. Although transactions in financial instruments carried out by an investment firm are traditionally governed by the applicable private law, transactions in financial instruments are now also very tightly regulated by financial supervision law, in particular the European Markets in Financial Instruments Directive (MiFID I) and the related MiFID I Implementing Directive and MiFID I Implementing Regulation.1 On 3 January 2018 the MiFID I regime will be replaced by the MiFID II regime, which includes a directive (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR).2 Below, MiFID I and MiFID II will be jointly referred to as ‘MiFID’. [9.02] One of MiFID’s key objectives is to offer investors a high level of protection.3 In the case of transactions in financial instruments the level of protection afforded to an investor under MiFID largely depends on the distinction between acting on behalf of the investor and dealing on own account. If an investment firm deals wholly or partly on behalf of the investor (as intermediary or representative), it has all kinds of duties of care to the investor. If, on the other hand, an investment firm enters into a transaction with an investor solely as a contractual counterparty, it has few if any duties of care. Once it has been established that the firm is acting on behalf of the client, the level of protection depends next on the classification of the client and the exact framework in which the transactions are carried out (i.e. whether the transactions involve executiononly, investment advice, or portfolio-management services).

[9.03] The central question addressed in this chapter is whether allowing the level of protection afforded to an investor under MiFID to be largely dependent on the distinction between dealing on own account on one hand and acting on behalf of the client on the other is justified.

II. Four Transaction Types 1. General [9.04] Investment firms can carry out transactions in financial instruments in various ways.4 It is important to distinguish between these different transaction types, as the level of protection afforded to an investor under MiFID may differ from one type to another.

2. Execution of Client Orders through the Regulated Market or an MTF [9.05] The first transaction type involves cases where an investment firm executes an order on behalf of a client and uses an external party for this purpose. This can be done in two ways. For example, suppose that the client instructs the investment firm to buy 100 Shell shares for it (for a price not exceeding x per share). The investment firm can execute the order by transmitting it to the regulated market5 on which the financial instrument is admitted to trading. A regulated market is known in common parlance as a stock exchange. Examples are NYSE Euronext Amsterdam, and the London Stock Exchange (LSE). Second, the investment firm can execute the order by transmitting it for further settlement to one of the now many competitors of the established stock exchanges—the so-called alternative trading platforms, otherwise known as multilateral trading facilities (MTFs), for example Turquoise.6 A regulated market or MTF is referred to in the terminology of MiFID as the ‘execution venue’.7

[9.06] Whether the investment firm executes the client order by transmitting it to a regulated market or to an MTF, it is treated in both cases as executing an order on behalf of the client and in both cases an external party is involved (i.e. a regulated market or an MTF).8 Through the regulated market or the MTF, which brings together multiple buying and selling interests in financial instruments, a party is found who is willing to sell 100 Shell shares.9 In MiFID terminology, the investment firm is then providing the investment service known as ‘execution of orders on behalf of clients’. This service has been defined in MiFID as ‘acting to conclude agreements to buy or sell one or more financial instruments on behalf of clients’.10 As the investment firm is acting on behalf of the client, it is providing an investment service and accordingly owes a high duty of care to the client.11 [9.07] For private law purposes, the investment firm will be treated as acting as intermediary in the transaction type described above. It may act as the client’s direct representative (direct vertegenwoordiger in the Netherlands, direkter Stellvertreter in Germany, and disclosed agent in England and Wales).12 In the case of civil law jurisdictions such as Germany and the Netherlands, there may also be forms of indirect representation (middellijke vertegenwoordiging in the Netherlands and mittelbare Stellvertretung in Germany), in particular in the case of stockbrokers (commissionair in effecten in the Netherlands and Kommissionär in Germany).13 Although the position of stockbroker is still separately regulated by law in Germany (Handelsgesetzbuch, §§ 383–406), this is no longer the case in the Netherlands.14 In England and Wales, where the legal concept of indirect representation is unknown, commission agency is a somewhat similar concept. However, this is a rather controversial concept whose exact legal consequences are not entirely clear.15 It would also be possible to think in terms of undisclosed agency in England and Wales, at least in theory.16

3. Dealing Solely on Own Account

[9.08] A second transaction type concerns cases in which the investment firm only deals on its own account and does not also act on behalf of the investor (principal dealing). In such cases, the investment firm does not in any way act on behalf the investor (either as representative or agent), but instead acts merely as the contractual counterparty of a party buying or selling financial instruments. ‘Dealing on own account’ is defined in MiFID as ‘trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments’.17 As this solely concerns dealing on own account, the investment firm has few if any duties of care to the investor.18 Naturally, where a firm solely deals on own account, there is no representation or agency under private law.

4. Execution of Client Orders through Internalisation or Systematic Internalization [9.09] A third transaction type concerns cases in which an investment firm acts in different capacities on the two sides of a single transaction, on one hand on behalf of a client when executing an order and on the other on own account. An example may help to clarify this. A client once again places an order with an investment firm for the purchase of 100 Shell shares (at a price not exceeding x per share). Unlike the situation in transaction type 1, the investment firm does not execute the order by transmitting it to the regulated market or an MTF. In this third transaction type, the investment firm executes the client order by selling its own Shell shares (i.e. Shell shares which it has ‘on its own books’). The investment firm acts in its own name (dealing on own account) on the selling side of the transaction and on behalf of the client (execution of orders on behalf of the client) on the buying side. In the supervision legislation, this third transaction type is known as internalizing the order (or systematic internalizing if it is carried out on a systematic basis).19 This is therefore a way of executing an order without the involvement of an external party. Internalization (or systematic internalization if it is carried out on a systematic basis) is not a separate investment service or activity, but a combination of the investment service known as ‘execution of orders on behalf of the client’ (see Section II.2 above) and dealing on own account

(see Section II.3 above). As the investment firm is therefore acting partly on behalf of the client, this constitutes in part an investment service and thus entails a high duty of care to the client.20 [9.10] Although systematic internalization is not a separate investment service or activity but a combination of dealing on an account and acting on behalf of the client, the fact that the internalization is described as ‘systematic’ does mean that an investment firm must fulfil certain transparency obligations prior to the dealing.21 This is why MiFID provides a detailed definition of the term ‘systematic internalizer’.22 It should also be noted that after the dealing investments firms are also subject to transparency obligations, but these apply regardless of whether or not the internalization is ‘systematic’.23 [9.11] In private law this third transaction type is sometimes said to involve self-dealing (England and Wales). In Germany this is one of the two subcategories of the Insichgeschäft (§ 181 BGB).24 This concerns the situation in which an agent or direkter Stellvertreter acts as the investor’s contractual counterparty. [9.12] As far as self-dealing is concerned, a distinction must first be made between a purchase from the principal and a sale to the principal. In the former case the agent cannot purchase [… property] for himself without full and fair disclosure of all the facts to the principal. The onus in such a case is on the agent to show that the price was adequate, that the sale was as advantageous to his principal as any other sale he could have obtained from a third party, and that he disclosed all the relevant facts to his principal before the purchase and that the principal gave his informed consent.25

In the latter case, an agent may not sell his own property to his principal without full and fair disclosure and the obtaining of his principal’s informed consent […]. He must also prove that the transaction was fair. But however fair the transaction may be, it can still be set aside by the principal if there has not been full disclosure.26

Finally, there is the special case of self-dealing where the agent has received specific instructions from the principal:

[w]here, however, the agent has specific instructions to buy or to sell at a particular price and no element of advice or discretion is involved, there may be cases where he is free to sell his own property to the principal or buy the principal’s property himself, there being no possibility of conflicting interest.27

[9.13] Owing to the risk of conflicts of interest, Insichgeschäft is permitted only with the client’s prior consent.28 Likewise, the German concept of Selbsteintritt in relation to Kommissionsgeschäft is a form of internalization, systematic or otherwise. Here an indirect representative acts as the client’s counterparty. Strictly speaking, this is impossible. A Kommissionär acts in his own name (but on behalf of the client) and has no power to bind his client directly to a contract with a third party. If the Kommissionär acts as contractual counterparty in the transaction, the contract would have only one discernible contracting party, whereas two parties are required for a valid contract. For this reason, the consequence of Selbsteintritt is nonetheless that the ultimate client (Kommittent) becomes the contractual counterparty of the Kommissionär, given the express statutory provision to this effect (§ 400 HGB). Unlike the situation with Insichgeschäft, the client’s prior consent is not required. However, Selbsteintritt is permitted only if there is a stock exchange or market price available for the financial instrument in question and the price charged for the transaction is in keeping with it. [9.14] In the Netherlands this transaction type is regulated in Article 7:416 of the Dutch Civil Code (DCC). This provision relates not only to cases in which a direct representative acts as the client’s contractual counterparty but also to cases where the contractual counterparty is an indirect representative. To ensure that in the latter case the contract is concluded between the indirect representative in his capacity as counterparty on one hand and the client on the other, it is expressly provided that a mandatory (lasthebber) who may act only in his own name may nonetheless act as the counterparty of the mandatory (lastgever) (Article 7:416(2) DCC). In both the former and the latter cases it is necessary for the content of the juristic act to be determined so precisely that the possibility of a conflict of interest is excluded (Article 7:416(1) and (2)). However, the parties may derogate from this provision and use this method even where the possibility of a conflict of interest between them is

not excluded. If the client is a consumer, such consent must always be given in writing as the juristic act is otherwise voidable (Article 7:416(3) DCC).29

5. Execution of Client Orders by Means of Agency Crosses [9.15] A fourth type of transaction involves the matching of opposite client orders (i.e. ‘sell’ orders and ‘buy’ orders) by an investment firm. Such transactions are also known as in-house matching or agency crosses. In these cases, the investment firm acts on one side of the transaction on behalf of one client (the seller) and on the other side of the transaction on behalf of the other client (the buyer). Such a situation may occur, for example, where an investment firm is instructed by one client to buy 100 Shell shares and by another client to sell 100 Shell shares.30 The firm can then buy the 100 Shell shares in the name (or, in any event, on behalf) of one client and sell the 100 Shell shares in the name (or, in any event, on behalf) of the other client. Unlike transaction type 1, no external party (a regulated market or an MTF) is called in for the execution of the order, and unlike transaction type 3 the investment firm does not execute the order by itself acting as the counterparty. In type 4, the investment firm executes an order on both sides of the transaction on behalf of a client within the meaning of MiFID I. It therefore acts on both sides of the transaction on behalf of a client. Consequently, the investment firm must observe a high duty of care in relation to both clients.31 [9.16] Under MiFID II the supervision law definition of matching opposite client orders seems rather more complicated. In certain cases, the matching of opposite client orders may amount to the operation of an organized trading facility (OTF). OTF is defined in MiFID II as follows: ‘a multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of this Directive’. This definition includes cases where an investment firms matches opposite client orders with one another (agency crossing

systems).32 As is apparent from the definition of OTF, trading through an OTF can relate only to non-equity instruments (such as derivatives and bonds) and not to equities (shares). Nonetheless, it can be assumed that insofar as client orders are executed on an OTF by matching opposite orders with one another, such transactions in each case involve acting on behalf of the client and thus constitute an investment service, and the investment firm must therefore observe a high duty of care to both clients.33 [9.17] In private law, the fourth transaction type described here is said to involve multiple agency (England and Wales). In Germany this is one of the two subcategories of Insichgeschäft (§ 181 BGB).34 This involves a situation in which a disclosed agent or direkter Stellvertreter acts on behalf of both the buying and the selling client. In England and Wales, one manifestation of the agent’s fiduciary duty to avoid conflicts is that he must not serve two principals whose interests may conflict. So he may not act for both parties to a transaction unless he ensures that he fully discloses all the material facts to each party and obtains their informed consent to his so acting. In this the agent does not prefer his own interest, but equally may not act entirely in the interests of either single principal. There may also be a breach of the duty of loyalty in the sense that the loyalty must be undivided. In such cases he may cause loss to one by failure to disclose information acquired in connection with the other—information, indeed, the disclosure of which would be a breach of the duty of the first.35

[9.18] The above provides a summary of the general rules. However, there may be an exception to these general rules: [p]erhaps where it is notorious that agents do act for both sides to a transaction, and where the agent explains all the circumstances fully to the principal and the principal consents to the agent receiving two commissions, he cannot subsequently call the agent to account for the commission paid by the other party, nor can he himself refuse to pay his own commission. Even if the agent is improperly acting for two opposing principals, the court will not normally make an order on the application of one of the principals which will result in the agent breaking his confidence towards his other principal, at least where the other principal has acted in good faith.36

In view of the risk of a conflict of interest, this variant of Insichgeschäft too is permitted only if the client consents in advance.37 In the Netherlands a provision of this kind is contained in Article 7:417 DCC (serving two masters). A mandatory may also act as mandatory of the counterparty only

if the content of the juristic act is determined so precisely that the possibility of a conflict of interest between the two parties is excluded (Article 7:417(1) DCC). However, the parties may derogate from this provision and use this method even where the possibility of a conflict of interest between them is not excluded. If the client is a consumer, such consent must always be given in writing as the juristic act is otherwise voidable (Article 7:417(2) DCC).38

III. Investor Protection [9.19] It has been explained above that an investment firm can execute an order for a client in a financial instrument through (i) a regulated market, (ii) an MTF, (iii) internalization, or (iv) agency crosses. Under MiFID, the firm is said in all these cases to be acting on behalf of the client and consequently to be providing, among other things, an investment service. Just as in the case of other investment services, the basic principle here is that the investment firm owes a high duty of care to the investor. Where an investment firm acts for both parties to a transaction (internalization and agency crosses), it has additional obligations to prevent conflicts of interest. [9.20] If, on the other hand, an investment firm deals solely on own account (i.e. acts solely as an investor’s contractual counterparty), the investor has little if any protection since most conduct-of-business rules are not applicable. It can at most be argued in such cases that the general obligation of fair dealing is applicable. Article 25(1) MiFID I provides, after all, in a general sense that investment firms must act honestly, fairly, and professionally. Under MiFID II this provision is included in Article 24(1) MiFIR. It can therefore be argued that this also applies where an investment firm is dealing solely on its own account in relation to an investor. Most legal practitioners will probably disagree with this analysis. They generally tend to assume that where an investment firm deals on own account it owes no MiFID duties of care whatsoever. As some situations where a firm deals on own account are, in fact, entirely exempted from MiFID, the general obligation of fair dealing does not apply at all. For an investment firm to be entirely exempted from MiFID I, it must deal solely

on own account (and not provide any investment services or activities) unless (i) it is a market-maker or (ii) it deals on own account outside a regulated market or an MTF on an organized, frequent, and systematic basis by providing a system accessible to third parties in order to engage in dealings with them.39 This exception has been tightened up still further in MiFID II in the sense that it has become more difficult to invoke it successfully.40 [9.21] It should be emphasized that the client classification obligation applies only if the investment firm provides investment services to an investor. Where an investment firm acts solely as a contractual counterparty of an investor, its actions constitute dealing on own account. As this is an investment activity and not an investment service, the client classification obligation does not apply. This is also apparent from the definition of ‘client’ in MiFID: ‘any natural or legal person to whom an investment firm provides investment or ancillary services’.41 [9.22] In brief, if an investment firm acts solely as an investor’s contractual counterparty (dealing on own account), this constitutes an investment activity and the investor is not a ‘client’. Nor, therefore, is there a client classification obligation.

IV. Acting as Agent or as Principal: Not a Justified Distinction to Serve as a Basis for Determining the Degree of Investor Protection 1. General [9.23] As we have seen, as soon as an investment firm does business on behalf of the client (acts as agent), it owes a high duty of care under MiFID. By contrast, where an investment firm acts solely as a contractual counterparty with an investor (principal dealing), it has few if any duties of care. In my view, allowing the degree of investor protection to be dependent on this distinction is unjustified. This proposition is expounded below.

2. Investors’ Reasonable Expectations [9.24] First of all, an investor is reasonably entitled to expect that an investment firm with which he deals will look after his interests adequately and thus fulfil certain duties of care towards him. The firm is, after all, the financial expert. As such, its knowledge is bound to be superior to that of the investor, certainly a retail client. This is no different where an investment firm acts solely as an investor’s contractual counterparty. In such cases the investor is reasonably entitled to expect that the investment firm will discharge the duty of care that also applies in the case of an execution-only service. [9.25] In fact, the European Commission acknowledged in its letter to the Committee of European Securities Regulators (CESR) of 19 March 2007 that the investor’s reasonable expectations play a role of some importance in answering the question of whether in a given case the investment firm transacts as agent or solely as principal. That is understandable, since whether or not the investment firm transacts as agent or solely as principal is a matter of interpretation of the legal relationship. But this approach has its limits. If it is absolutely clear on the facts that the investment firm transacted solely as principal, it is not possible to argue that the investment firm in fact transacted as agent. Preferably, therefore, the distinction between acting as agent and acting as principal should simply no longer be treated as relevant in determining the degree of investor protection.42

3. Tenuous, Arbitrary, and Easy to Manipulate [9.26] Moreover, in practice the distinction between acting on behalf of a client and dealing on own account is often tenuous, arbitrary, and easy to manipulate. For this reason it does not justify different treatment. This can be illustrated by two examples.

A. Example 1

[9.27] An investment firm gives an undertaking to a client to enter into a swap agreement on his behalf with another party. At that moment, this entails execution of an order in a financial instrument on behalf of the client (i.e. an execution-only service). Subsequently, the investment firm may often decide on the basis of the agreement with the client that it will itself act as contractual counterparty in the swap agreement (internalization/selfdealing). In that case, the investment firm combines dealing on own account with acting on behalf of the client and is therefore subject to the high duties of care referred to above as the firm is acting on the client’s behalf. Where, however, it is established from the outset that the investment firm is the client’s contractual counterparty (and the firm does not otherwise provide advice or another investment service), it is treated under MiFID I as dealing solely on own account, which means, in practice, that the firm has virtually no duty of care.

B. Example 2 [9.28] An investment firm can match opposite client orders with one another (agency crosses). In that case the firm can be said to be acting on behalf of the client on both sides of the transaction and therefore owes the high duty of care discussed above to both clients. However, this transaction can also be arranged in such a way that the investment firm takes opposite positions on own account in relation to different counterparties with the same maturity (back-to-back trading or matched principal trading). In such cases the investment firm does not in fact run any risk. The economic result is the same as if opposite client orders were matched (agency crosses). Nonetheless, there are virtually no duties of care under MiFID I in the case of matched principal trading since the investment firm is dealing solely on own account on both sides of the transaction. This means, in short, that whether there is a high duty of care or virtually no duty of care depends on how what is essentially the same economic transaction is arranged in law. [9.29] Naturally, it could be argued that it is up to the investor himself to urge the investment firm to execute the order on his behalf, but most investors will not be aware that the rather arcane legal distinction between dealing on own account and executing an order on behalf of the client can

have far-reaching consequences for the level of protection he enjoys. This is especially true in the case of retail clients. Moreover, the type of transaction is not explicitly discussed with the client. To find this out, the client must read the ‘small print’ of the contract.

4. Grant Estates Ltd v Royal Bank of Scotland [9.30] As noted above, where an investment firm arranges a transaction with an investor in such a way that it deals solely on own account, it can exclude virtually all duties of care under MiFID I. This is why interest rate swap agreements often contain a provision that the investment firm acts only as contractual counterparty and does not provide advice. But what happens if, despite the agreement, an employee of the investment firm nonetheless provides advice? Is the contractual clause limiting the role of the investment firm to that of counterparty still valid in such a case? If it is wished to answer this question in the affirmative, the distinction between dealing on own account on one hand and acting on behalf of the client and providing other investment services (such as advice) on the other would be even more likely to produce unjustified outcomes from the perspective of investor protection. [9.31] This can be illustrated by the Scottish case Grant Estates Ltd v Royal Bank of Scotland plc.43 In this case Lord Hodge44 held that a clause providing that the investment firm acted solely as contractual counterparty was valid, despite the fact that an employee had advised the investor. The facts were as follows. Grant Estates Limited (GEL) was a small property developer. On 6 and 11 July 2007 it took out two loans with the Royal Bank of Scotland (RBS) for a total amount of ₤775,000. The rate of interest on the loans was variable, namely 1.4 per cent over base rate (which was 5.75 per cent (LIBOR) on 6 July). In December 2007 RBS concluded with GEL an interest rate swap agreement (IRSA) to cover the risk of a rise in interest rates on the underlying loans. As a result of the financial crisis, however, the interest rate fell below the level of the fixed rate under the IRSA, and GEL ended up paying more than it would have done without the IRSA. In the course of 2008 GEL got into financial difficulties as a result of the economic downturn and was no longer able to meet its obligations to RBS.

On 25 February 2011 RBS applied for GEL to be placed in administration. GEL then instituted proceedings against RBS. In essence, GEL alleged that RBS had mis-sold the IRSA to GEL. GEL sought, inter alia, damages for (1) infringement of the financial supervision requirements of the Conduct of Business Sourcebook (COBS) issued by what was then the Financial Services Authority (FSA), now known as the Financial Conduct Authority (FCA) (these rules constitute the implementation of MiFID I in the United Kingdom); (2) negligent advice and negligent misrepresentation;45 and (3) breach of contract.46 [9.32] The applicable Terms of Business (ToB) provided, inter alia, that RBS ‘will not provide [GEL] with advice on the merits of a particular transaction’ and that GEL ‘should obtain […] independent financial, legal and tax advice’ (ToB 3.3). The ToB also provided that RBS ‘will provide [GEL] with general dealing services on an execution-only47 basis’ (ToB 3.2) and that [a]s we or our affiliates will act as principal in all transactions covered by these Terms, no duty of best execution arises under FSA Rules as no transactions are executed in circumstances giving rise to duties similar to those arising on an order to execute a transaction as agent. [GEL] may either accept or reject the price we offer [GEL] and we do not represent that such price is necessarily the best price (ToB 10).48

The ToB also provided that ‘[w]here these Terms of Business conflict with Applicable Regulations, the latter shall prevail. Applicable Regulations shall include the FSA Rules’ (ToB 2.2), and that ‘[n]othing in these terms shall oblige us to do anything that we believe to be contrary to Applicable Regulations. Nothing in these terms will exclude or restrict any liability that we owe you under the FSA Rules’ (ToB 19.1). Finally, schedule 1 to the ToB provided that GEL had been classified under the supervision rules as a ‘private customer’. This does not mean, by the way, that GEL had to be treated as a private investor. GEL was an SME company and was, as such, a retail, non-private investor. [9.33] GEL argued that the express provision in the ToB that no advice would be provided and that RBS would act only as contractual counterparty in the IRSA did not change the reality of the situation, namely that RBS staff had provided GEL with advice within the meaning of the FSA’s

supervision rules. This was viewed by GEL as decisive, since the ToB clearly provide that the FSA rules prevail in the event of a conflict with the ToB. GEL therefore considered that it could institute a civil claim for an infringement of the supervision rules relating to the provision of advice on the basis of the then section 150 of the Financial Services and Markets Act 2000 (FSMA), which provided that a contravention of supervision rules issued by the FSA on the basis of Part X, Chapter I FSMA ‘is actionable at the suit of a private person who suffers loss as a result of the contravention, subject to the defences and other incidents applying to actions for breach of statutory duty’.49 GEL argued that the limitation to private persons was in conflict with the EU legal principle of equal treatment, and that professional clients such as GEL could also therefore bring a civil claim for infringement of MiFID I provisions as implemented in the United Kingdom.50 [9.34] In evaluating this submission, Lord Hodge held that MiFID I does not stipulate that clients—whether professional or private—must be able to bring a civil claim against banks for a breach of MiFID I rules implemented in national law. Although MiFID I is admittedly intended to protect both retail and professional clients, the protection is solely under supervision law. MiFID I makes no provision for protection under civil law. Although section 150 FSMA provides that a contravention of supervision rules is actionable at the suit of a private person, this is a choice made by the legislator in the United Kingdom even before the implementation of MiFID I and is not in any way connected with the MiFID I provisions. Lord Hodge also stated that he was also not aware of any EU legal principle of equal treatment between corporate and private persons. As GEL was quite clearly not a private person but a corporate client, he held that GEL had in any event no right of action under section 150 FSMA.51 [9.35] Nor was there any contract with GEL to provide advice. The ToB are clear. Whether or not advice was provided by RBS staff in practice is immaterial in view of the clear provision of the ToB. Nor, according to Lord Hodge, was the situation altered by the fact that advice was possibly given in practice within the meaning of supervision law, even taking into account the provision of the ToB to the effect that ‘[w]here these Terms of Business conflict with Applicable Regulations, the latter shall prevail. Applicable

Regulations shall include the FSA Rules’. In Lord Hodge’s view, the sole purpose of the provision is to make clear that contractual provisions that differ from financial supervision law cannot be invoked by the bank against the FSA as regulator. In short, the contractual provision that no advice would be provided cannot be invoked by the bank against the FSA if the latter considers that for the purposes of supervision law advice has been provided and the applicable COBS rules have been contravened. According to Lord Hodge, the aim of this provision is not to incorporate the COBS rules into the contract, which would mean that the classification as advice under supervision law would also apply for civil law purposes, including all supervision rules applicable to the advice. An infringement of supervision rules on advice would then automatically constitute a breach of contract. However, Lord Hodge was not prepared to take this step.52 [9.36] Lord Hodge was crystal clear. A contractual provision to the effect that the bank acts solely as contractual counterparty and not as adviser is applicable even where a bank employee does actually provide the client with investment advice as referred to in MiFID I. This is so even if the IRSA contains a provision to the effect that financial supervision law prevails over the contract in cases where contractual provision is not compatible with the applicable regulatory regime. In Lord Hodge’s view, a statutory provision of this kind is intended solely to make clear that contractual provisions that differ from financial supervision law cannot be invoked by the bank against the FSA as regulator. In other words, the contractual provision that no advice is provided cannot be invoked by the bank against the FSA if the latter considers that advice was given for the purposes of supervision law and that the applicable supervision rules were infringed. According to Lord Hodge, the aim of this provision is not to incorporate the COBS rules into the contract, which would mean that the classification as advice under supervision law would also apply for civil law purposes, including all supervision rules applicable to the advice. [9.37] The civil courts in the Netherlands would probably take a different view of the matter. This is apparent, for example, from an interim judgment of Dordrecht District Court of 29 February 2012.53 This concerned the question of whether Rabobank had breached its civil duty of care in entering into an interest rate swap with Bugro BV (the owner of an inland

waterways oil tanker). In the transaction documents Rabobank had included a provision that it did not act as adviser and that the documents could not be construed as advice to enter into the specified transactions. The District Court took the view that this did not alter the fact that Rabobank had advised Bugro. In providing the advice, Rabobank was therefore subject to the obligation to meet the standard of care expected of a good services provider (Article 7:401 DCC). In other words, it had to demonstrate the competence and conduct that could reasonably be expected of a firm in this business. In short, in the light of what actually happened, the contractual provision that the bank did not provide advice had no effect since a bank employee had, in reality, provided investment advice to the corporate (nonprivate) client. This approach is in keeping with the German literature and also seems to me to be correct for Dutch law.54 Although in this case Dordrecht District Court made no mention of the principle that a rule may be derogated from on the grounds of good faith (redelijkheid en billijkheid), this could serve as a basis for this approach in the Netherlands. Another possible basis would be the argument that, in the case of SMEs, a contractual provision stipulating that the bank acts solely as contractual counterparty and does not provide advice is unreasonably onerous in view of the actual course of events.55 [9.38] If the contract explicitly provides that supervision law prevails over the contract (as in the Scottish case), a Dutch or German civil court would, in my view, have little hesitation in giving precedence to financial supervision law. A provision stipulating that the bank acts solely as contractual counterparty and does not provide advice would then be set aside on the basis of a reasonable interpretation of the contract. It seems unlikely that the Dutch and German civil courts would follow the lead of the Scottish court by interpreting the provision as merely clarifying the fact that the contractual provision (to the effect that no advice is provided) cannot be invoked by the bank against the regulator if the latter concludes that advice within the meaning of supervision law has been given and that the supervision rules have been breached. [9.39] GEL based its claim for damages not only on a direct infringement of the supervision rules but also, more indirectly, on negligent misrepresentation and negligent advice. However, Lord Hodge did not go

into this because he considered that the contract was clear. RBS never intended to enter into an investment advice relationship with GEL that would give rise to a duty of care. Insofar as GEL relied on the statements of RBS staff as investment advice, this reliance was not justified in view of the background of the clear arrangements between the parties as contained in the ToB, namely that there was no investment advice relationship. [9.40] More generally, Lord Hodge held that a common law duty of care cannot be based on supervision rules. The correctness of this assertion seems rather dubious under Scottish law. This is due in part to two English judgments, namely Gorham and others v British Telecommunications plc and others and Seymour v Ockwell. These judgments were not brought to the attention of Lord Hodge by the parties. In the latter judgment one of the judges held in relation to the supervision rules that ‘whilst the ambit of the duty of care owed by a financial adviser at common law is not necessarily co-extensive with the duties owed by that adviser under the applicable regulatory regime, the regulations afford strong evidence as to what is expected of a competent adviser in most situations’.56 Although English judgments are not binding on Scottish courts, they do constitute persuasive authority. If the parties had submitted these judgments to Lord Hodge, he might well have come to a different decision. [9.41] Whatever the case, the Dutch courts would presumably have concluded, unlike Lord Hodge, that the bank did have a civil duty of care (in functional terms somewhat comparable to common law duty of care) to GEL, and that this civil duty of care could also be defined in more concrete terms by reference to the applicable supervision rules. However, this is not entirely certain. As yet there is no case law whatever from the Dutch Supreme Court (Hoge Raad) on the civil duty of care to corporate (nonprivate) investors such as GEL. Naturally, however, there is extensive Supreme Court case law on the civil duty of care owed to retail investors, but it is debatable whether this case law can be applied one-on-one in relation to corporate (non-private) investors.57 [9.42] Finally, GEL based its claim on breach of contract. According to GEL, the contractual provision that no advice would be given amounted to an exclusion of liability for incorrect advice and was therefore an

unreasonably onerous clause to be incorporated in terms of business. The Scottish judge rejected this argument as well. This line of reasoning, based on the unreasonably onerous nature of the clause, might well stand a greater chance of success in the Netherlands. See my previous remarks about this. [9.43] Whatever the case, it is certain that a judgment exists in Scotland58 which provides that a contractual clause stating that an investment firm acts solely as contractual counterparty will be respected, even if, in reality, bank staff do provide advice. It is questionable whether this is compatible with the European principle of effectiveness. To assess this we first need to go back a little. In the judgment of the European Court of Justice in Genil 48 SL v Bankinter SA, it was held that in the absence of European legislation it was up to the Member States themselves to determine the contractual consequences of an infringement of the KYC rules, subject to observance of the principles of equivalence and effectiveness (effet utile) (para. 57).59 The Court of Justice referred here to paragraph 27 of a judgment of 19 July 2012 concerning a tax case (Littlewoods Retail and others, no. C-591/10) and the case law cited there. This reads as follows: In the absence of EU legislation, it is for the internal legal order of each Member State to lay down the conditions in which such interest must be paid, particularly the rate of that interest and its method of calculation (simple or compound interest). Those conditions must comply with the principles of equivalence and effectiveness; that is to say that they must not be less favourable than those concerning similar claims based on provisions of national law or arranged in such a way as to make the exercise of rights conferred by the EU legal order practically impossible [emphasis added]. (See, to that effect, San Giorgio, paragraph 12; Weber’s Wine World, paragraph 103; and Case C-291/03 MyTravel [2005] ECR I-8477, paragraph 17.)

[9.44] First, in the context of MiFID, the effectiveness principle would therefore seem to mean that the conditions on which an investor can hold an investment firm contractually liable may not be of such a nature as to make the successful exercise of rights impossible or extremely difficult in practice. It would thus seem to follow from this judgment that civil courts may not apply a more relaxed interpretation of MiFID rules. If, according to MiFID, the KYC rules are infringed in a specific case and the aggrieved investor sues for damages, the civil courts may not dismiss the claim on the ground that, in the particular circumstances of the case, it was not necessary to observe the KYC rules. This would, after all, be contrary to the

effectiveness principle. Moreover, it would jeopardize the high level of investor protection which MiFID aims to provide and be detrimental to the level playing field envisaged by MiFID. MiFID sets out, wherever possible, to maximize harmonization of financial supervision law for investment firms that provide investment services and carry out investment activities. It follows that the Member States no longer have the power to adopt more stringent or lenient supervision rules, unless this is apparent from MiFID itself. This approach is also conducive to legal certainty in the financial services sector and can be extended to claims for damages in respect of infringements of other MiFID provisions, such as an infringement of other conduct-of-business rules. [9.45] Second—and this brings us back to the Scottish case—it could be inferred from the Genil judgment that the civil courts are bound to hold that a contractual clause which is less stringent than MiFID cannot be applied. Naturally, this is not as strong as the argument that the civil courts may not apply a more relaxed interpretation of MiFID rules since the investor has himself agreed to the contract. Having said this, investors (even professional investors) often have little influence over contract terms. Needless to say, the fact that clauses of this kind jeopardize the high level of investor protection which MiFID aims to provide and are detrimental to the level playing field envisaged by MiFID is also a factor of importance. An example of a contract clause less stringent than MiFID is where an investment firm stipulates that it is acting solely as contractual counterparty, although in reality bank staff advise the client (as in the Scottish case). In keeping with the aim of the contract, the investment firm will then not fulfil the MiFID duties of care that apply to an investment firm. If, as a consequence of one or more of these infringements, the investor suffers loss, it could be argued that under the EU effectiveness principle he should have a real possibility of obtaining compensation for his loss. He will not do so if a contractual clause to the effect that the investment firm acts solely as contractual counterparty is held by the courts to remain fully effective. After all, a claim for compensation for infringement of MiFID rules on investment services would then be frustrated by the contractual clause.60

5. No Practicable Distinction under MiFID II either

[9.46] It is also apparent from MiFID II that the distinction between dealing on own account and executing orders on behalf of the client (and other forms of investment service) is not a practicable criterion for determining the degree of protection to which an investor is entitled. To achieve adequate investor protection, after all, MiFID II resorts to the artifice of reclassifying certain types of dealing on own account as acting on behalf of the client, specifically with a view to improving investor protection. [9.47] First, the definition of ‘execution of orders on behalf of clients’ has been modified to such an extent that some instances of dealing on own account have been reclassified and brought within its ambit, with the result that the definition of ‘dealing on own account’ is now much narrower. Likewise, under MiFID II the phrase ‘the conclusion of agreements to sell financial instruments issued by an investment firm or credit institution at the moment of their issuance’ comes within the definition of ‘execution of orders on behalf of clients’.61 What is the exact scope of this change? Some examples may help to clarify this. If an investment firm sells an investor shares in its own capital at the time of issuance and the sale does not involve the provision of any form of investment service, the investment firm acts solely as the investor’s contractual counterparty. Under MiFID I this is an instance of dealing on own account. Under MiFID II, however, it is reclassified as acting on behalf of the client and is suddenly treated as a form of investment service. Issuance is usually taken to mean the issuance of marketable shares and bonds, but in MiFID II it has a broader meaning. In the terminology of MiFID II the concept of issuance is linked to financial instruments. This means that where an investment firm acts as contractual counterparty in an interest rate swap this too is treated as the conclusion of an agreement for the sale, at the time of issuance, of a financial instrument issued by an investment firm. After all, an interest rate swap is a financial instrument, like many other derivatives. This interpretation also benefits investor protection, which is one of the key objectives of MiFID. Recital 45 in the preamble to MiFID II explicitly states that this reclassification is intended ‘to eliminate uncertainty and strengthen investor protection’. [9.48] Second, although this is apparent not from the broadening of the definition of ‘execution of orders on behalf of clients’ but from Recital 24

in the preamble to MiFID II, matched principal trading (back-to-back trading) is regarded, inter alia, as execution of orders on behalf of the client, although under MiFID I it was treated solely as dealing on own account. In Article 4(1), point (38) of MiFID II matched principal trading is defined as: a transaction where the facilitator interposes itself between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction.

In terms of economic result, matched principal trading resembles the position in which the firm acts on both sides of a transaction for the client, that is, matching opposite client orders (agency crosses). [9.49] More precisely, Recital 24 in the preamble to MiFID II provides that dealing on own account when executing client orders [i.e. (systematic) internalization] should include firms executing orders from different clients by matching them on a matched principal basis (back-to-back trading), which should be regarded as acting as principal and should be subject to the provisions of this Directive covering both the execution of orders on behalf of clients and dealing on own account.

Equating matched principal trading with (systematic) internalization is in fact based on a fallacy. In economic terms, matched principal trading much more closely resembles agency crosses, as opposite client orders are in fact matched with one another. [9.50] In any event, these two instances of reclassification enhance investor protection, but this is in my view not sufficient. If an investment firm sells a financial instrument that it has not issued itself, I cannot see any reason why the investor should not enjoy the protection of the MiFID II duties of care that apply to execution-only services.

6. Dutch Supreme Court has Already Extended Civil Duty of Care to Dealing on own Account

[9.51] Moreover, the Dutch Supreme Court has already extended the special civil duty of care to dealing on own account. In a case involving the offering of risky and complex financial products to retail investors, it held that it followed from the special civil duty of care that there was a duty to warn investors of the risks involved and a duty to comply with KYC rules, even though the bank was only acting as contractual counterparty.62

7. The UK Government Response to the Kay Review [9.52] Finally, it is worth briefly mentioning the Kay Review of UK Equity Markets and Long-term Decision Making. This report indicated that all participants in the equity investment chain should observe the same standards.63 The UK Government in its response to the Report agreed: The Government believes that it would be appropriate to instead adopt the following principle for equity markets, which reflects Kay’s Good Practice Statements for Asset Managers and Asset Holders: All participants in the equity investment chain should act: • in good faith; • in the best long-term interests of their clients or beneficiaries; • in line with generally prevailing standards of decent behaviour. This means ensuring that the direct and indirect costs of services provided are reasonable and disclosed, and that conflicts of interest are avoided wherever possible, or else disclosed or otherwise managed to the satisfaction of the client or beneficiary. These obligations should be independent of the classification of the client. They should not be contractually overridden.64

[9.53] The UK Government has asked the FSA (and its successor the FCA) ‘to consider to what extent current regulatory rules in this area align with this principle, with particular reference to the issues raised in the Kay Report around conflicts of interest requirements and contractual mechanisms to limit the obligations of intermediaries, to determine what action might be desirable’.65 It has added as follows: ‘We note that the current regulatory rules in this area are substantially influenced by harmonised EU legislation, and that changes to regulatory requirements at EU level may therefore be desirable.’

[9.54] This latter statement is significant, given this chapter’s argument that even the new MiFID II regime falls short. Given that MiFID II, like MiFID I, provides for the most part for maximum harmonization, the FCA would not seem to have the authority to introduce rules extending the high duties of care to all intermediaries, including those who act purely as contractual counterparties. The FCA could conceivably invoke Article 24(12) MiFID II, which provides that in exceptional circumstances Member States may impose additional requirements on investment firms. However, such requirements must be objectively justified and proportionate so as to address specific risks to investor protection or to market integrity which are of particular importance in the circumstances of the market structure of the Member State concerned. It seems unlikely that this test could be met.

V. Conclusion [9.55] This chapter has focused on the question of whether allowing the extent of the protection afforded to an investor under MiFID to be largely dependent on the distinction between dealing on own account on one hand and trading on behalf of the client (and other forms of investment service) on the other is justified. This question must be answered in the negative. An investor may reasonably expect the investment firm used by him to look after his interests adequately and thus to observe certain duties of care towards him. The investment firm is, after all, ideally placed to use its expertise. Its fund of knowledge is bound to be superior to that of an investor, particularly a retail investor. Nor is this any different where the investment firm acts purely as the investor’s contractual counterparty. In such cases, the investor is reasonably entitled to expect the investment firm to observe the same duty of care that would apply if it were providing an execution-only service. Moreover, the distinction between dealing on own account (principal dealing) on one hand and trading on behalf of the client (and other forms of investment service) on the other is tenuous, arbitrary, and easy to manipulate. This is all the more so where a contractual clause providing that an investment firm is acting solely as contractual counterparty is claimed to apply even where an employee of the investment firm advises the investor, contrary to the terms of the agreement. Clearly,

MiFID II also provides no practicable criterion. Indeed, to achieve an adequate level of investor protection MiFID II resorts to the artifice of reclassifying certain types of dealing on own account as acting on behalf of the client. Finally, both the UK Government (in response to the Kay Review) and the Dutch Supreme Court take the view that duties of care must also apply where an investment firm acts solely as an investor’s contractual counterparty. Under a future MiFID III, an investment firm which acts solely as contractual counterparty should be required to observe the same duty of care as applies in the case of an execution-only service.

1

Directive 2004/39/EC, OJ L 145, 30 April 2004, pp. 1–47 (MiFID I); Commission Directive 2006/73/EC, OJ L 241, 2 September 2006, pp. 26–58 (MiFID I Implementing Directive); Commission Regulation (EC) No. 1287/2006, OJ L 241, 2 September 2006, pp. 1–25 (MiFID I Implementing Regulation). 2 Directive 2014/65/EU, OJ L 173, 15 May 2014, pp. 349–496 (MiFID II); Regulation (EU) No. 600/2014, OJ L 173, 15 May 2014, pp. 84–148 (MiFIR). See Chapter 1, n. 2. 3 Recital 2 in the preamble to MiFID I; Recital 70 in the preamble to MiFID II. 4 Where an order is received and transmitted to another investment firm, this does not constitute carrying out a transaction in financial instruments. In such a case it is the other investment firm which carries out the transaction in one of the ways described in the main body of this chapter’s text (unless that other investment firm receives the order and then transmits it to yet another investment firm). This does not cause problems in investor protection. Like the carrying out of transactions in financial instruments on behalf of a client, the reception and transmission of orders constitutes an investment service. In both cases, therefore, there is a fairly high level of investor protection. 5 ‘Regulated market’ is defined in Article 4(1), point (14) MiFID I, and Article 4(1), point (21) MiFID II. 6 Turquoise is majority owned by the London Stock Exchange Group in partnership with the user community (see ). Multilateral trading facility (MTF) is defined in Article 4(1), point (15) MiFID I and Article 4(1), point (22) MiFID II. MTFs perform the same function in an economic sense as regulated markets, but are subject to supervision rules that differ to some extent from those for regulated markets. As operating an MTF constitutes an investment activity, the operator is deemed to be an investment firm and is subject to the MiFID rules that apply to investment firms. As operating a regulated market does not constitute an investment service or investment activity, the operator is not deemed to be an investment firm (in any event in this capacity). The operator is admittedly subject to MiFID rules, namely the rules governing the operation of a regulated market, but these are not the same as those applicable to investment firms.

7

See the definition of ‘execution venue’ in Article 44(1), in fine, MiFID I Implementing Directive: ‘a regulated market, an MTF, a systematic internaliser, or a market maker or other liquidity provider or an entity that performs a similar function in a third country to the functions performed by any of the foregoing’. In Article 64(1), in fine, Draft Commission Delegated Regulation, C (2016) 2398 final, 25 April 2016 this definition has been expanded so as to include OTFs. 8 It is also conceivable that an investment firm which executes an order for a client is itself the operator of an MTF or even of a regulated market. In such a case, no external party is involved in the carrying out of the transaction because the MTF or regulated market forms part of the investment firm’s own organization. 9 Naturally, there may also be a situation in which two or more parties act as seller, each contributing part of the 100 Shell shares. 10 See Article 4(1), point (5) MiFID I. The definition has been expanded in MiFID II (Article 4(1), point (5)). On this subject see Section IV.5. 11 See Section III below. 12 See D. Busch, Indirect Representation in European Contract Law (PhD Utrecht), (The Hague: Kluwer Law International, 2005), pp. 5–10 (the Netherlands), 75–9 (Germany), 128–33 (England and Wales). 13 See ibid., pp. 10–15 (the Netherlands), 79–83, 100–5 (Germany). As regards stockbrokers, see also L. D. van Setten, De commissionair in effecten (PhD Utrecht), (Deventer: Kluwer, 1998). 14 See the former Articles 76–85a of the Commercial Code (Wetboek van Koophandel). 15 See on commission agency Peter G. Watts, Bowstead & Reynolds on Agency, 20th edn, (London: Sweet & Maxwell, 2014), § 1-021; Busch (n. 12), 168–73. 16 See on undisclosed agency Watts (n. 15), § 8-068–8-082; Busch (n. 12), 133–6 and 139–68. 17 Article 4(1), point (6) MiFID I. Although Article 4(1), point (6) MiFID II contains the same definition, fewer cases are designated as dealing on own account under MiFID II. On this point see Section IV.5 below. 18 See Section III below. 19 For detailed accounts of systematic internalization, see: Guido Ferrarini and Fabio Recine, ‘The MiFID and Internalisation’, in Guido Ferrarini and Eddy Wymeersch (eds), Investor Protection in Europe: Corporate Law Making, the MiFID and Beyond (New York: OUP, 2006), p. 235; Johannes Köndgen and Erik Theissen, ‘Internalisation under MiFID: Regulatory Overreaching or Landmark in Investor Protection’, ibid., p. 271; S. Mutschler, Internalisierung der Auftragsausführung im Wertpapierhandel. Eine rechtliche und ökonomische Betrachting unter besonderer Berücksichtigung der Richtlinie 2004/39/EG des Europäischen Parlaments und des Rates vom 21 April 2004 über Märkte für Finanzinstrumente (PhD Universität Freiburg), (Baden-Baden: Nomos Verlag, 2007); A. Stefanski, Eigenhandel für andere. Market-making und Internalisierung im deutschen,

europäischen und US-amerikanischen Recht (PhD Universität Bonn), (Baden-Baden: Nomos Verlag, 2009). 20 See explicitly Recital (69) MiFID I Implementing Directive: ‘Dealing on own account with clients by an investment firm should be considered as the execution of client orders, and therefore subject to the requirements under Directive 2004/39/EC and this Directive and, in particular, those obligations in relation to best execution.’ This is repeated in Recital (103), Article 64(1), in fine, Draft Commission Delegated Regulation, C (2016) 2398 final, 25 April 2016. See on the duty of care Section III below. 21 A systematic internalizer quotes a price at which it is prepared to carry out a transaction in listed shares internally, provided that a liquid market exists in these shares, and makes this quote public on a reasonable commercial basis and in a manner which is easily accessible. In the case of shares to which there is not a liquid market, systematic internalizers must disclose quotes to their clients on request. See Article 27(1), first paragraph, MiFID I. In MiFID II these transparency obligations apply not only to dealing in shares but also to all kinds of other financial instruments. See Article 14(1) and Article 18(1) MiFIR. 22 In Article 4(1), point (7) MiFID I ‘systematic internaliser’ is defined as ‘an investment firm that, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or an MTF’. Article 4(1) (20) MiFID II contains a comparable definition. The criteria for determining whether an investment firm is a systematic internalizer are set out in Article 21 of the MiFID I Implementing Regulation. In Draft Commission Delegated Regulation, C (2016) 2398 final, 25 April 2016, the criteria for determining whether an investment firm is a systemic internalizer are spelled out in more detail, distinguishing between systemic internalizers for (1) equity and equity-like instruments (Article 12), (2) bonds (Article 13), (3) structured finance products (Article 14), (4) derivatives (Article 15), and (5) emission allowances (Article 16). 23 Investment firms which, either on own account or on behalf of clients, conclude transactions in shares admitted to trading on a regulated market outside a regulated market or MTF are required to make public the volume and price of those transactions and the time at which they were concluded. See Article 28(1) MiFID I. In MiFID II these posttrade disclosure obligations apply not only to shares but also to all kinds of other financial instruments. See Article 20(1) and Article 21(1) MiFIR. The execution of transactions outside a regulated market or MTF in fact comprises not only execution by means of internalization but also the matching of opposite client orders (agency crosses). See Section II.5 below. 24 The other sub-category of Insichgeschäft concerns serving two masters. On this subject, see Section II.5 below. 25 Watts (n. 15), § 6-064. 26 ibid, § 6-065. 27 ibid, § 6-066. 28 For a detailed comparison of Insichgeschäft and the English concept of self-dealing, see: S. Festner, Interessenkonflikte im deutschen un englischen Vertretungsrecht (PhD MPI

Hamburg), (Tübingen: Mohr Siebeck, 2006), p. 69 ff. 29 See for a treatment of Article 7:416 DCC in relation to transactions in financial instruments D. Busch, Vermogensbeheer (Monografie BW B8), (Deventer: Kluwer, 2014), § 17.3.2. 30 Naturally, it is also quite possible that where an investment firm is instructed to buy 100 Shell shares it is able to match this order with two or more orders to sell Shell shares. 31 See Section III below. 32 See, for example, Article 20(6), second paragraph, MiFID II. 33 See Recital 9 in the preamble to MiFIR. See also Section III below. 34 The other subcategory of Insichgeschäft concerns cases in which the representative acts as contractual counterparty in the transaction. On this point see Section II.4 above. 35 Watts (n. 15), § 6-048. 36 ibid. 37 For a detailed comparison of Insichgeschäft and the English concept of self-dealing, see: Festner (n. 28), 249. 38 See for a treatment of Article 7:417 DCC in relation to transactions in financial instruments Busch (n. 29), § 17.3.3. 39 Article 2(1)(d) MiFID I. 40 See Article 2(1)(d) and (j), MiFID II. 41 Article 4(1), point (10) MiFID I and Article 4(1), point (9) MiFID II. 42 For the European Commission’s letter, see: Working Document ESC-07-2007, Commission answers to CESR scope issues under MiFID and implementing directive (Appendix to CESR, Best Execution under MiFID, Questions & Answers, May 2007, CESR/07-320). 43 Court of Session 21 August 2012 [2012] CSOH 133. 44 Now a Justice in the UK Supreme Court. 45 Initially, the claim for damages was also based on fraudulent misrepresentation, but this ground was retracted in the course of the action (see para. 8 of the judgment). Nonetheless, Lord Hodge did consider this ground (see paras 85–93 of the judgment). I will not give any further consideration to this retracted ground here. 46 See paras 1–8 of the judgment. 47 Merely a synonym here for contractual counterparty. See about the confusing term ‘execution only’ Chapter 1, n. 17. 48 See para. 29 of the judgment. 49 Since 1 April 2013 this provision can be found in section 138D of the Financial Services and Markets Act (FSMA) 2000. 50 See paras 31, 40, 43, and 44 of the judgment. 51 See paras 45–62 of the judgment. 52 See paras 63–67 of the judgment.

53

Dordrecht District Court, 29 February 2012, FR 2012/48 (Bugro v Rabobank), ground

4.17. 54

See M.-P. Weller, Die Dogmatik des Anlageberatungsvertrags. Legitimation der strengen Rechtsprechungslinie von Bond bis Ille ./. Deutsche Bank, ZBB (2011), pp. 191–9, at p. 193 (left column). 55 See Article 6:248(2) DCC and Article 6:233(a) in conjunction with Article 6:235(1) DCC. Cf. D. Busch, ‘Best Execution’, in D. Busch and C. M. Grundmann-van de Krol (eds), Handboek beleggingsondernemingen (Deventer: Kluwer, 2009), pp. 715–17. 56 Gorham v British Telecommunications plc [2000] 1 WLR 2129, 2141 (CA) per Pill LJ (‘The courts can be expected to attach considerable weight to the content of codes […] but are not excluded from making their own assessment of a situation.’); Seymour v Ockwell [2005] EWHC 1137 (QB), 77 per Judge Havelock-Allan QC. On this subject, see for example L. D. van Setten and T. Plews, Chapter 11 (England & Wales) in D. Busch and D. A. DeMott (eds), Liability of Asset Managers (Oxford: OUP, 2012), §§ 11.24–11.27. 57 As regards the civil duty of care towards retail investors, see inter alia: HR 23 March 2007, NJ 2007/333, annotated by Mok (ABN AMRO v Van Welzen) (duty of care in relation to trade in options); HR 5 June 2009, JOR 2009/199, annotated by Lieverse (Treek v Dexia Bank Nederland) (duty of care in relation to offering of securities lease products); HR 24 December 2010, NJ 2011/251, annotated by Tjong Tjin Tai (Fortis Bank v Bourgonje) (duty of care of portfolio manager); HR 3 February 2012, AA (2012) 752, annotated by Busch (Coöperatieve Rabobank Vaart en Vecht UA v X) (duty of care when providing investment advice). See for further references to Dutch Supreme Court case law: Busch (n. 29), § 15.1. 58 Albeit a decision of one judge in the Outer House, that is the lower house of the Court of Session. Only a decision of the Inner House would bind a Scottish judge in future. 59 EU CoJ 30 May 2013, no. C-604/11, AA (2013) 663, annotated by Busch; JOR 2013/274, annotated by Busch (Genil 48 SL and others v Bankinter SA and others). 60 The effectiveness principle has been explicitly codified in MiFID II (unlike MiFID I). Article 69(2) MiFID II provides, in fine: ‘Member States shall ensure that mechanisms are in place to ensure that compensation may be paid or other remedial action be taken in accordance with national law for any financial loss or damage suffered as a result of an infringement of this Directive or [MiFIR]’. 61 Article 4(1)(5) MiFID II. 62 See HR 5 June 2009, JOR 2009/199, annotated by Lieverse (Treek v Dexia Bank Nederland), ground 5.2.1. 63 The Kay Review of UK Equity Markets and Long-Term Decision Making (Final Report July 2012), p. 65. 64 Ensuring Equity Markets Support Long-Term Growth. The Government response to the Kay review (November 2012), para. 2.8. 65 Government response (n. 64), para. 3.35.

10 MIFID II/MIFIR’S REGIME FOR THIRDCOUNTRY FIRMS Danny Busch and Marije Louisse

I. General II. 1. 2. 3. 4. 5.

Scope of MiFID II/MiFIR’s Regime for Third-Country Firms Third-Country Firms Investment Services and Investment Activities Selling and Advising Clients in Relation to Structured Deposits Data-Reporting Services Operating Trading Venues

III. 1. 2. 3. 4. 5. 6.

Eligible Counterparties and Per Se Professional Clients General Equivalence Decision by the Commission Registration with ESMA Continuing Obligations for Registered Third-Country Firms Transitional Regime Withdrawal of Registration by ESMA/Equivalence Decision by the Commission 7. No Equivalence Decision by the Commission

IV. 1. 2. 3. 4.

Retail Clients and Opt Up Professional Clients General Exercise of Member State Option Non-Exercise of Member State Option No European Passport!

5. Resolution of a Branch of a Third-Country Firm V. Retail Clients, Professional Clients, and Eligible Counterparties 1. After the Adoption of an Equivalence Decision and Exercise of the Member State Option 2. If no Equivalence Decision is in Effect 3. If the Member State Option has not been Exercised VI. 1. 2. 3.

Initiative Test Initiative Test Under MiFIR Initiative Test Under MiFID II Own Exclusive Initiative

VII. Conclusion

I. General [10.01] MiFID II/MiFIR introduces major changes for third-country firms —that is, investment firms and credit institutions, providing investment services and performing investment activities, established outside the EU/EEA. Under MiFID I, the position of such firms is a purely national matter. Each country within the EU/EEA has to decide for itself on the access of a third-country firm to its own national market. As the national regimes differ quite markedly from one another, the overall picture is fragmented.1 Consequently, a third-country firm cannot gain access to the European market all at once, and must instead apply to each country individually for access to its national market on the basis of the different requirements.2 This was considered by the Commission to damage the functioning of the single market as well as to create additional costs for these firms.3 [10.02] Under MiFID II/MiFIR, the position of third-country firms will no longer be a purely national matter. MiFID II/MiFIR now itself sets the parameters. It introduces a common regulatory framework that should harmonize the existing fragmented framework for the provision of services by third-country firms, ensure certainty and uniform treatment of thirdcountry firms accessing the EU/EEA, ensure an assessment of effective

equivalence by the Commission, and provide for a comparable level of protection to clients in the EU/EEA receiving services from third-country firms.4 However, as will be seen below, the legislation is unfortunately complex and does not provide for full harmonization. The Commission and the Member States found it hard to agree on all aspects of the regime for third-country firms. [10.03] This chapter is structured as follows. We first discuss the scope of MiFID II/MiFIR’s regime for third-country firms (Section II). Subsequently, we explain MiFIR’s regime for third-country firms (Section III) and MiFID II’s regime for third-country firms (Section IV). In Section V we discuss the friction between both regimes when a third-country firm provides investment services to eligible counterparties, professional clients, and retail clients. In Section VI we take a closer look at the initiative test. The Conclusion (Section VII) includes a diagram of the provisions of MiFID II/MiFIR’s third-country regime.

II. Scope of MiFID II/MiFIR’s Regime for ThirdCountry Firms 1. Third-Country Firms [10.04] Both the MiFID II third-country regime (Articles 39 up to 43 MiFID II) and the MiFIR third-country regime (Articles 46–49 MiFIR) apply to ‘third-country firms’.5 A third-country firm is a ‘firm that would be a credit institution providing investment services or performing investment activities or an investment firm if its head office or registered office were located within the Union’.6 A third-country firm is therefore a party with its head office or registered office outside the EU/EEA that would have qualified as a credit institution or investment firm if it had its head office or registered office in the EU/EEA.

2. Investment Services and Investment Activities [10.05] Under the MiFID II/MiFIR’s third-country regime, third-country firms may provide investment services or perform investment activities with or without any ancillary services.7 The MiFID II/MiFIR’s thirdcountry regime hence does not apply if a third-country firm provides any other services, such as selling, and advising clients in relation to, structured deposits or data-reporting services. We refer to Sections II.3 and II.4. [10.06] Different regimes apply for the provision of investment services depending on the type of client to whom the investment services are provided. The MiFID II third-country regime applies to the provision of investment services to retail and opt up professional clients (i.e. clients who have obtained professional client status by opting up)8 and the MiFIR thirdcountry regime applies to the provision of investment services to eligible counterparties and per se professional clients (i.e. with the exception of clients who have obtained professional client status by opting up).9 For further details of the regimes we refer to Sections III and IV. [10.07] The question is what regime applies to the performance of investment activities, since there is no client involved in the performance of such activities. If, for example, the third-country firm provides investment services to eligible counterparties and per se professional clients and performs investment activities, it could be argued from a pragmatic point of view that the third-country firm may perform such investment activities in compliance with the regime that applies to the provision of investment services to eligible counterparties and per se professional clients (the MiFIR third-country regime). This would entail that the third-country firm can register itself with ESMA, if the Commission has taken an equivalence decision, and can subsequently perform the investment activity (e.g. dealing on own account) throughout the EU/EEA.10 But what if the third-country firm intends to perform investment activities only, without providing any investment services, in the EU/EEA? What regime would then apply? Should the firm obtain an ESMA registration in accordance with the MiFIR third-country regime or should it open a branch, if the Member State in which the third-country firm intends to perform investment activities has

opted for the branch requirement, in accordance with the MiFID II thirdcountry regime? [10.08] In order to answer these questions it could be relevant to determine when investment activities are actually performed in the EU/EEA. For the provision of investment services, this can be determined by applying the initative test as set out in Articles 42 MiFID II and 46(5), third paragraph, MiFIR (see Section VI). As there are no clients involved in the performance of investment acitvities, the initiative test seems not to be of much help here. Articles 42 MiFID II and 46(5), third paragraph, MiFIR do however also contain a reference to investment activities.11 One could therefore argue that investment activities are performed in the EU/EEA when the counterparty is located in the EU/EEA (i.e. if the investment activity concerns dealing on own account) or when the multilateral trading facility (MTF) or organized trading facility (OTF) that is operated by the third party is open for members or participants that are located in the EU/EEA, and that it should therefore be possible to rely on the iniative test, if investment activities are performed on the exclusive initative of such counterparty or member/participant.12 Subsequently, one could argue that the identity of such counterparty or member/participant determines which third-country regime applies. The European legislator has, however, not provided any further guidance in that respect.

3. Selling and Advising Clients in Relation to Structured Deposits [10.09] MiFID II contains a new requirement in Article 1(4) for investment firms and credit institutions to comply with certain provisions of MiFID II when selling or advising clients in relation to structured deposits.13 Article 1(4) MiFID II does not contain a reference to thirdcountry firms,14 and as such this new requirement seems not to apply to third-country firms that sell or advise clients in relation to structured deposits. The MiFID II/MiFIR’s third-country regime also does not provide for a basis to apply Article 1(4) MiFID II to third-country firms, since the MiFID II/MiFIR’s third-country regime only applies to the provision of

investment services and performance of investment activities.15 Structured deposits do not qualify as financial instruments. Any services or activities that are conducted by a third-country firm in relation to structured products therefore do not qualify as the provision of investment services or the performance of investment activities. As a result, we are inclined to say that selling, and advising on, structured products is not an activity that is included in the scope of MiFID II/MiFIR’s third-country regime.16 This would have as a consequence that each Member State can set its own requirements for access to its market by third-country firms wishing to sell and advise clients in relation to structured deposits in its jurisdiction. [10.10] The wording of the initiative test under MiFID II/MiFIR17 is, however, somewhat confusing in this respect, since it includes a reference to investment products (which term includes structured deposits). The reference to investment products in the wording of the initative test seems to indicate that marketing investment products would be a regulated activity under MiFID II/MiFIR, if the third-country firm cannot rely on the initiative test. As said, Articles 1(4) and 39(1) MiFID II and Article 46(1) MiFIR indicate otherwise. Hopefully, this will be clarified in future amendments of MiFID II/MiFIR.

4. Data-Reporting Services [10.11] MiFID II introduces supervision on a new category of entities, namely data-reporting services providers.18 The provision of data-reporting services will be subject to prior authorization by the home Member State’s competent authority.19 The home Member State is the Member State where the data-reporting services provider has located its registered office or head office.20 The authorization will be valid for the entire EU/EEA and will allow the data-reporting services provider to provide the services for which it has been authorized throughout the EU/EEA. [10.12] MiFID II does not contain a third-country regime for datareporting services providers. It therefore seems that data-reporting services providers from third countries will have to establish a subsidiary in the

EU/EEA that will subsequently have to obtain an authorization to be able to provide these services in the EU/EEA, unless a national regime provides otherwise. [10.13] Member States may allow an authorized investment firm operating a trading venue (MTF or OTF) to provide data-reporting services subject to the prior verification of its compliance with Title V of MiFID II.21 It could therefore be that a branch of a third-country firm that has obtained an authorization pursuant to Article 39 of MiFID II may also provide such data-reporting services throughout the entire EU/EEA.22 This seems, however, not to be expressly intended under MiFID II.

5. Operating Trading Venues [10.14] Trading venues are regulated markets, MTFs, or OTFs.23 The operation of an MTF or OTF is an investment activity that may be performed by a third-country firm under the MiFID II/MiFIR’s thirdcountry regime. MiFID II/MiFIR’s third-country regime does not cover market access of third-country (operators of) regulated markets. Such market access will continue to be a purely national matter.24 [10.15] Notwithstanding the foregoing, MiFIR contains several provisions that apply to ‘third-country trading venues’, a term that is not defined in MiFIR. It is our understanding that the term refers to (operators) of trading venues that are established outside the EU/EEA.25 This could be thirdcountry firms that operate an MTF or OTF, or (operators of) regulated markets established outside the EU/EEA. The following provisions of MiFIR apply to such third-country trading venues: 1. A third-country trading venue may request access to a central counterparty (CCP) established in the EU/EEA, only if the Commission has adopted an equivalence decision relating to that third country. In accordance with Article 28(4) MiFIR the Commission may adopt an equivalence decision, if the legal and supervisory framework of a third country ensures that a trading venue authorized in that third country complies with legally binding requirements which are equivalent to the requirements for trading venues, resulting

from MiFIR, MiFID II, and MADII/MAR,26 and which are subject to effective supervision and enforcement in that third country.27 2. A third-country trading venue is only permitted to make use of the access rights in Articles 35 to 36 of MiFIR if the Commission has adopted a decision that the legal and supervisory framework of the third country is considered to provide for an effective equivalent system for permitting CCPs and trading venues authorized under foreign regimes (e.g. EU/EEA CCPs and trading venues) access to CCPs and trading venues established in that third country.28 3. Third-country trading venues may only request a licence and the access rights in accordance with Article 37 of MiFIR if the Commission has adopted a decision that the legal and supervisory framework of that third country is considered to provide for an effective equivalent system under which CCPs and trading venues authorized in foreign jurisdictions (e.g. EU/EEA CCPs and trading venues) are permitted access on a fair, reasonable, and non-discriminatory basis to: (a) relevant price and data feeds and information of composition, methodology, and pricing of benchmarks for the purposes of clearing and trading, and (b) licences, from persons with proprietary rights to benchmarks established in that third country.29 [10.16] Finally, we note that financial counterparties (as defined in EMIR30) and certain non-financial counterparties may conclude certain transactions with other such financial or non-financial counterparties in derivatives pertaining to a class of derivatives that has been declared subject to the trading obligation in accordance with the procedure set out in Article 32 MiFIR and listed in the register referred to in Article 34 MiFIR on thirdcountry trading venues, provided that the Commission has taken an equivalence decision and provided that the third country provides for an equivalent system for recognition of EU/EEA trading venues.31

III. Eligible Counterparties and Per Se Professional Clients

1. General [10.17] The regime for the provision of investment services to eligible counterparties and per se professional clients following an equivalence decision by the Commission is laid down in Articles 46–49 of MiFIR and is therefore directly applicable in the Member States. In the absence of an equivalence decision by the Commission, the provision of investment services to eligible counterparties and per se professional clients is, however, still a national matter (Article 46(4) MiFIR).

2. Equivalence Decision by the Commission [10.18] The Commission may adopt an equivalence decision in relation to a third country stating that (i) the legal and supervisory arrangements of that third country ensure that third-country firms authorized in that third country comply with legally binding prudential and business conduct requirements which have equivalent effect to the requirements set out in MiFID II/MiFIR and CRD IV/CRR32 (for this purpose it examines the authorization process, supervision, enforcement, capital requirements, governance, organizational requirements, conduct of business rules, and rules on market transparency and integrity) and (ii) the legal framework of that third country provides for an effective equivalent system for the recognition of investment firms authorized under third-country legal regimes (Article 47(1) of MiFIR). As a result, the equivalence decision by the Commission is not only an assessment in respect to the equivalence of the legal systems of the EU/EEA and third-country legal regimes, but also in respect to reciprocity (mutual recognition). [10.19] Taking into account that the Commission may adopt an equivalence decision, it is our understanding that there is no obligation for the Commission to adopt an equivalence decision, if there is equivalence and reciprocity in respect to a certain third country.33

A. Reciprocity Test

[10.20] Under MiFID I, reciprocity already was acknowledged as an important factor in the relations with third countries. According to Article 15 of MiFID I, Member States should inform the Commission of any general difficulties that their investment firms encounter in establishing themselves or providing investment services, and/or performing investment activities in any third country. Whenever it appeared that a third country did not grant EU/EEA investment firms effective market access comparable to that granted by the EU/EEA to third-country firms from that third country, the Commission could arrange for negotiations with the third country with a view to obtaining comparable competitive opportunities. If the conditions of effective market access were not fulfilled and EU/EEA investment firms were not granted national treatment affording the same competitive opportunities as were available to domestic investment firms, the Commission could decide that the competent authorities of the Member States must limit or suspend their decisions regarding requests pending or future requests for authorization and the acquisition of holdings by direct or indirect parent undertakings governed by the law of the third country in question for a maximum period of three months (a period which could be extended by the Commission). Such measures could then be used to exert pressure on the negotiations. Although Article 15 is withdrawn under MiFID II/MiFIR, reciprocity still is of importance in the decision by the Commission to adopt an equivalence decision under Article 47 of MiFIR (we refer to paragraph 10.18).

B. Equivalence Test [10.21] While the importance of reciprocity was stressed by many of the banks and brokers in their replies to the public consultation on MiFID II/MiFIR, because of possible increased competition with no reciprocity, other market parties (also including asset managers, funds, exchanges, and market operators) were mostly concerned about a ‘strict equivalence’ test for third-country firms.34 This could be viewed as protectionist and, as a result, could threaten access of EU/EEA investment firms to third countries.35

[10.22] A ‘strict equivalence’ test would entail that the Commission, instead of focusing on the result, would focus on specific means to achieve equivalence. To pass the strict equivalence test the EU framework for MiFID II services should be replicated in third countries. This is unrealistic. The concerns on the ‘strict equivalence’ test have been taken into account by the realization of MiFIR. The final text of Article 47 now reads that the prudential and business conduct framework of a third country may be considered to have equivalent effect where it fulfils all the conditions of Article 47(1) MiFIR, where the Commission Proposal stated that the framework may be considered equivalent where it fulfils all the conditions of (at that time) Article 37(1) MiFIR.36

C. The Equivalence and Reciprocity Test in Other EU/EEA Legislation [10.23] The fact that MiFID II/MiFIR regulates the position of thirdcountry firms reflects a European trend. EMIR, the CRA Regulation,37 and the AIFMD38 all deal with the position of parties (CCPs, credit rating agencies (CRAs), managers of alternative investment funds (AIFMs), and depositaries) established in a third country.39 These regimes all contain an equivalence and reciprocity—or similar—test, though the scope of and assessment for each of such regimes differ. [10.24] Under EMIR, a CCP established in a third country may, for example, provide clearing services to clearing members or trading venues established in the EU/EEA only where that CCP is recognized by ESMA.40 One of the conditions for such recognition is that the Commission has adopted an implementing act determining that the legal and supervisory arrangements of a third country ensure that CCPs authorized in that third country comply with legally binding requirements which are equivalent to requirements laid down in Title IV of EMIR, that those CCPs are subject to effective supervision and enforcement in that third country on an ongoing basis, and that the legal framework of that third country provides for an effective equivalent system for the recognition of CCPs authorized under

third-country legal regimes.41 Currently, the Commission has adopted ten equivalence decisions following the technical advice of ESMA.42 [10.25] The CRA Regulation contains an equivalence test for CRAs. In accordance with Article 5(6) of the CRA Regulation, the Commission may adopt an equivalence decision stating that the legal and supervisory framework of a third country ensures that CRAs authorized or registered in that third country comply with legally binding requirements which are equivalent to the requirements resulting from the CRA Regulation and which are subject to effective supervision and enforcement in that third country and the regulatory regime in that third country prevents interference from the supervisory authorities and other public authorities in the content of credit ratings and methodologies. Currently, the Commission has adopted nine equivalence decisions following the technical advice of ESMA.43 [10.26] The AIFMD contains a ‘same effect’ test for depositaries. In the case of a third-country alternative investment fund (AIF), the depositary can be in the third country in which the AIF is domiciled, inter alia, if the depositary is subject to effective prudential regulation, including minimum capital requirements and supervision which have the same effect as EU/EEA law, and are effectively enforced.44 The Commission will adopt implementing acts, stating that the prudential regulation and supervision of a third country have the same effect as EU/EEA law and are effectively enforced.45 Currently, no such implementing acts have been adopted.46 In addition, Article 37 of the AIFMD provides for the authorization of nonEU/EEA AIFMs intending to manage EU/EEA AIFs and/or market AIFs managed by them in the EU/EEA.47 Such a non-EU/EEA AIFM has to comply with the AIMFD, unless such compliance is incompatible with the law to which the non-EU/EEA AIFM and/or the non-EU/EEA AIF marketed in the EU/EEA is subject and the non-EU/EEA AIFM can demonstrate that: (i) it is impossible to combine such compliance with compliance with a mandatory provision in the law to which the nonEU/EEA AIFM and/or the non-EU/EEA AIF is subject; (ii) the law to which the non-EU/EEA AIFM and/or the non-EU/EEA AIF is subject provides for an equivalent rule having the same regulatory purpose and offering the same level of protection to the investors of the relevant AIF; and (iii) the non-EU/EEA AIFM and/or the non-EU/EEA AIF complies

with the equivalent rule referred to in point (ii).48 ESMA will develop draft regulatory technical standards on the conditions under which the law to which a non-EU/EEA AIFM or non-EU/EEA AIF is subject is considered to provide for an equivalent rule having the same regulatory purpose and offering the same level of protection to the relevant investors.49 We note that the ‘equivalence test’ pursuant to Article 37 AIFMD only relates to the applicability of the AIFMD and not to the authorization requirement. In any case, there is an authorization requirement for the non-EU/EEA AIFM, but the scope of the provisions of the AIMFD that apply to such a non-EU/EEA AIFM may differ, depending on the outcome of the ‘equivalence test’.

D. Will there ever be Equivalence Decisions under Article 47 of MiFIR? [10.27] Although the Commission has adopted equivalence decisions under EMIR and the CRA Regulation, there is no guarantee that the Commission will ever adopt an equivalence decision under Article 47 of MiFIR. The equivalence assessment for each of these regimes is different. Under the CRA Regulation, equivalence should be established with regard to the requirements resulting from the CRA Regulation, while under EMIR these are the requirements laid down in Title IV of EMIR. The equivalence assessment under EMIR and the CRA Regulation is rather limited, if you consider that for an equivalence decision to be taken under MiFIR, the third-country requirements should be equivalent to MiFID II/MiFIR and CRD IV/CRR. It could therefore take a considerable amount of time before the Commission will reach an equivalence decision under Article 47 of MiFIR, if indeed it ever comes to that point. [10.28] The Commission should initiate the equivalence assessment on its own initiative. Member States should be able to indicate their interest that a certain third country is or certain third countries are subject to the equivalence assessment carried out by the Commission, without such indications being binding on the Commission to initiate the equivalence process. When initiating those equivalence assessments, the Commission should be able to prioritize among third-country jurisdictions, taking into account: the materiality of the equivalence finding to EU/EEA firms and

clients, the existence of supervisory and cooperation agreements between the third country and the Member States, the existence of an effective equivalent system for the recognition of investment firms authorized under foreign regimes, and the interest and willingness of the third country to engage in the equivalence assessment process.50

3. Registration with ESMA [10.29] Following an equivalence decision in relation to a third country, a third-country firm that is authorized in that third country may provide investment services or perform investment activities with or without ancillary services to eligible counterparties and per se professional clients established throughout the EU/EEA where it is listed in the register of thirdcountry firms kept by ESMA. If cumulative conditions 1 to 3 below are fulfilled, ESMA will have to register the third-country firm.51 1. The Commission has adopted an equivalence decision in respect of the third country where the third-country firm is authorized. 2. The third-country firm is authorized in the jurisdiction where its head office is established to provide the investment services or activities to be provided in the EU/EEA and is subject to effective supervision and enforcement ensuring full compliance with the requirements applicable in that third country.52 3. ESMA has established a cooperation arrangement with the regulator(s) in the third country in respect of which the Commission has adopted an equivalence decision. A cooperation arrangement must specify at least: (i) the mechanism for the exchange of information between ESMA and the regulator(s) in the third country (including access to all information regarding the non-EU firms authorized in the third country that is requested by ESMA); (ii) the mechanism for prompt notification to ESMA where a third-country regulator deems that the third-country firm is infringing the conditions of its authorization or other law to which it is obliged to adhere; (iii) the procedures for coordination of supervisory activities (including on-site inspections).53

[10.30] In order for the applicant third-country firm to be registered with ESMA, it has to provide its contact details, national and international identification codes, proof of its authorization to provide investment services in its home country (through a written declaration issued by the competent authority of its home country), contact details of the competent authority of the home country, and the investment services to be provided and/or investment activities to be performed in the EU/EEA, together with any ancillary services.54 [10.31] ESMA has to assess within thirty working days whether the application is complete. If the application is not complete, the applicant third-country firm will have the possibility to provide additional information before a deadline set by ESMA. Within 180 working days of the submission of a complete application, ESMA will inform the applicant third-country firm whether the registration has been granted or refused. After a third-country firm has submitted a complete application, it can therefore take up to thirty-six weeks (about nine months) before the registration will be granted. To compare: an applicant for a MiFID II licence will be informed within six months of the submission of a complete application whether or not authorization has been granted.55 The question therefore arises of whether MiFID II/MiFIR’s third-country regime actually provides for effective market access.56 [10.32] Once a third-country firm has been registered by ESMA, it may provide investment services or perform investment activities to eligible counterparties and per se professional clients throughout the EU/EEA. The registration by ESMA hence replaces the authorizations from individual Member States and functions as a European passport.

A. Only on a Cross-Border Basis? [10.33] The question arises of whether a third-country firm that is registered with ESMA may conduct its activities only on a cross-border basis, thus without opening a branch; or also with a branch in one or more Member States. Article 46(1) MiFIR provides that a third-country firm ‘may’ operate within the EU/EEA without the establishment of a branch.

But ‘must’ it do so? Or does the rule contained in Article 46(1) MiFIR also permit a third-country firm to operate from a branch in the EU/EEA (rather than on a cross-border basis)? Our inclination would be to interpret Article 46(1) MiFIR as meaning that the regime it describes may be operated only on a cross-border basis and not from a branch in the EU/EEA. Article 47(3) MiFIR, however, seems to enable third-country firms to provide investment services or perform investment activities through a branch that has obtained an authorization under Article 39 MiFID II. Only in such a case can the competent authority of the home Member State of the branch exercise effective supervision. We will return to this subject in Section V.1.

4. Continuing Obligations for Registered ThirdCountry Firms [10.34] Third-country firms that are registered with ESMA no longer come within the scope of MiFID II/MiFIR and CRD IV/CRR.57 Member States may therefore not impose any additional requirements on such thirdcountry firms in respect of matters covered by MiFID II/MiFIR and CRD IV/CRR. This is a consequence of the equivalence decision by the Commission in which it has established that the legally binding prudential and business conduct requirements of the third country have equivalent effect to the requirements set out in MiFID II/MiFIR and CRD IV/CRR. This does not mean that a third-country firm is completely out of scope of any European legislation. A third-country firm that is registered with ESMA still has to comply with the following obligations: 1. Before providing any investment service, it has to inform its clients that are established within the EU/EEA: (a) that it is not authorized to provide services to clients other than eligible counterparties and per se professional clients, and (b) that it is not subject to supervision in the EU/EEA. The third-country firm must indicate the name and address of the competent authority or authorities responsible for supervision in the third country. This information must be provided in a durable medium and ‘in a prominent way’. The information has to be provided in English or in the official language of the Member State where the services are to be provided.58

2. Before services are provided or activities performed to an eligible counterparty or per se professional client established in the EU/EEA, the third-country firm must offer to submit any disputes relating to those services or activities to the jurisdiction of a court or arbitral tribunal in a Member State.59 3. The third-country firm has to inform ESMA, within thirty days, of any change of the information that has been provided in the application for registration with ESMA.60 [10.35] In addition, the third-country firm might have to comply with other European legislation, such as the prospectus requirement under the Prospectus Directive, if it issues securities to the public in the EU/EEA or such securities are admitted to listing in the EU/EEA, or the market abuse rules under MAD II/MAR.61

5. Transitional Regime [10.36] Third-country firms that already provide investment services or perform investment activities to eligible counterparties and per se professional clients established in the EU/EEA in accordance with national regimes will be able to continue to provide such services or perform such activities until three years after the adoption by the Commission of an equivalence decision in relation to the relevant third country.62

6. Withdrawal of Registration by ESMA/Equivalence Decision by the Commission [10.37] ESMA will withdraw the registration of a third-country firm if the following conditions are met. 1. ESMA has well-founded reasons based on documented evidence to believe that, in the provision of investment services and activities in the EU/EEA, the third-country firm (a) is acting in a manner which is clearly prejudicial to the interests of investors or the orderly

functioning of markets, or (b) has seriously infringed the provisions applicable to it in the third country and on the basis of which the Commission has adopted the equivalence decision;63 2. ESMA has referred the matter to the regulator in the third country and the regulator: (a) has not taken the appropriate measures needed to protect investors and the proper functioning of the markets in the EU/EEA, or (b) has failed to demonstrate that the third-country firm concerned complies with the requirements applicable to it in the third country; and 3. ESMA has informed the third country regulator of its intention to withdraw the registration of the third-country firm at least thirty days before the withdrawal.64 [10.38] If ESMA withdraws the registration of a third-country firm, ESMA must inform the Commission without delay and publish its decision on its website.65 [10.39] It should be noted that it is always the Commission (and not ESMA) that assesses whether the conditions under which an equivalence decision has been adopted ‘continue to persist in relation to the third country concerned’.66 Naturally, there is to some extent a link between the withdrawal of individual third-country firms from the register by ESMA and the withdrawal of an equivalence decision by the Commission, because if two or more third-country firms from a given third country are withdrawn from the register by ESMA, this would seem to indicate that something is wrong with the quality of the local regulatory oversight. And this may in turn be a reason for the Commission to carry out further investigation and, ultimately, to withdraw the equivalence decision. [10.40] If the Commission withdraws an equivalence decision in relation to a third country, any firm authorized in that third country may no longer use the rights under Article 46(1) MiFIR.67 Such third-country firms may then again only provide investment services or perform investment activities to eligible counterparties and per se professional clients that are established in the EU/EEA in accordance with the national regimes of the Member States.68

7. No Equivalence Decision by the Commission [10.41] In the absence of an equivalence decision in relation to a third country (because the Commission has not (yet) adopted such a decision or has actually withdrawn a decision69), a Member State may itself determine whether and, if so, on what conditions a third-country firm from that third country may provide investment services and/or perform investment activities (with or without ancillary services) to eligible counterparties and per se professional clients in its jurisdiction.70 In such cases a third-country firm could end up complying with differing national regimes. As an example, we discuss the national regimes of the Netherlands and the UK.71 [10.42] In the Netherlands the national regime for servicing eligible counterparties and per se professional clients varies depending on the state where the third-country firm is established. Third-country firms established in Australia, the United States, or Switzerland are exempt from the licence obligation for the provision of investment services and performance of investment activities under Article 10 of the Dutch Financial Supervision Act (Wft) Exemption Regulation (Vrijstellingsregeling Wft). Besides the exemption from the authorization requirement, these third-country firms are also partially exempt from the conduct of business supervision by the Netherlands Authority for the Financial Markets (Stichting Autoriteit Financiële Markten, AFM)72 and almost completely so from prudential supervision.73 Third-country firms established in a country, other than Australia, the United States, or Switzerland, that intend to provide investment services to eligible counterparties and per se professional clients on a cross-border basis or through a branch must apply for full authorization under Article 2:96 of the Dutch Act on Financial Supervision (Wet op het financieel toezicht, Wft). The conduct of business rules and prudential rules in the Wft apply in full. Where a third-country firm is authorized under Article 2:96 Wft it will not be able to benefit from any European passporting rights. Another option would be to establish a Dutch subsidiary that applies for full authorization under Article 2:96 Wft.74 [10.43] Under the current UK regime, third-country persons are subject to the same general prohibition as UK persons against providing investment services or performing investment activities in the UK without

authorization. A third-country person can provide investment services or perform investment activities to eligible counterparties and per se professional clients in the UK by establishing a UK subsidiary, which could apply to the Financial Conduct Authority (FCA) or Prudential Regulation Authority (PRA) for authorization, or through an authorized UK branch. The assessment for the authorization of such UK branch is primarily of a prudential nature (of the third-country firm and its home country’s prudential standards), and cooperation with the third-country jurisdiction in which the firm is authorized is an important factor. Where a third-country firm with a UK branch is authorized it will not be able to benefit from any European passporting rights. No exemption applies to third-country firms with their seat in designated third countries. The UK however does apply the ‘overseas persons’ exclusion.75 We refer to paragraph 10.70 for more information on the ‘overseas persons’ exclusion. [10.44] Although national regimes apply in the absence of an equivalence decision by the Commission, some provisions of MiFIR still apply. Also, in the absence of an equivalence decision, a third-country firm will have to inform its clients that are established within the EU/EEA, before providing any investment service: (a) that it is not authorized to provide services to clients other than eligible counterparties and per se professional clients, and (b) that it is not subject to supervision in the EU/EEA. The third-country firm must also indicate the name and address of the competent authority or authorities responsible for supervision in the third country and offer to submit any disputes relating to those services or activities to the jurisdiction of a court or arbitral tribunal in a Member State.76

IV. Retail Clients and Opt Up Professional Clients 1. General [10.45] MiFID II contains a Member State option regarding the position of a third-country firm wishing to provide investment services and/or perform investment activities (with or without ancillary services) in a

Member State to retail clients or to opt up professional clients. The Member State concerned may require such third-country firm to establish a branch in its territory.77 Where a Member State considers that the appropriate level of protection for its retail clients or opt up professional clients can be achieved by the establishment of a branch by the third-country firm, it is considered appropriate to introduce a minimum common regulatory framework at EU/EEA level with respect to the requirements applicable to those branches and in light of the principle that third-country firms should not be treated in a more favourable way than EU/EEA firms.78 This regulatory framework is laid down in Articles 39–43 MiFID II.

2. Exercise of Member State Option [10.46] If a Member State exercises the Member State option, MiFID II prescribes the following procedure. The branch must acquire a prior authorization from the competent regulator of such Member State.79 The third-country firm should submit its application for authorization to the regulator of the Member State where it intends to establish a branch.80 When making the application, the third-country firm must provide the regulator with certain information to ensure that it can adequately assess the application.81 [10.47] The regulator will grant the authorization if the cumulative conditions referred to below at 1–7 are fulfilled.82 This constitutes maximum harmonization: the Member States may not impose any additional requirements on the organization and operation of the branch in respect of the matters covered by MiFID II.83 Nor may a Member State treat any branch of third-country firms more favourably than firms from the EU/EEA.84 1. The provision of services for which the third-country firm requests authorization is subject to authorization and supervision in the third country where the firm is established and the requesting firm is properly authorized, whereby the competent authority pays due regard to any recommendations of the Financial Action Task Force (FATF) in

2.

3. 4. 5.

6. 7.

the context of anti-money laundering and countering the financing of terrorism.85 Cooperation arrangements, which include provisions regulating the exchange of information for the purpose of preserving the integrity of the market and protecting investors, are in place between the regulator in the Member State where the branch is to be established and the regulator of the third country where the firm is established.86 There is sufficient initial capital at the branch’s free disposal.87 One or more persons are appointed to be responsible for the management of the branch and they all comply with the governance requirements laid down in Article 88 and Article 91 CRD IV.88 The third country where the third-country firm is established has signed an agreement with the Member State where the branch is to be established, which: (a) fully complies with the standards laid down in Article 26 OECD Model Tax Convention on Income and on Capital, and (b) ensures an effective exchange of information in tax matters, including, if any, multilateral tax agreements.89 The firm belongs to an investor-compensation scheme authorized or recognized in accordance with the ICS Directive.90 The branch must (insofar as is relevant) be able to comply with various MiFID II provisions: (a) organizational requirements; (b) algorithmic trading; (c) trading process and finalization of transactions in an MTF and an OTF; (d) specific requirements for MTFs; (e) specific requirements for OTFs; (f) various conduct of business obligations (conflicts of interest; general duty to act honestly, fairly, and professionally; provision of adequate information; KYC rules; best execution; client order handling; transactions with eligible counterparties); (g) market transparency and integrity; (h) the transparency rules for trading venues; and (i) transaction reporting rules.91

[10.48] The Netherlands intends to exercise the discretion to apply the MiFID II regime of Article 39, since it could enhance investor protection. If a branch were established in the Netherlands, the regulators (AFM and Dutch Central Bank92) would be better placed to supervise compliance with the applicable rules by a third-country firm. The requirement of a branch

also means that the branch’s records and accounts would be better accessible to the regulators. Clients of the third-country firm would also have a contact point in the Netherlands to which they could apply if they have questions or complaints about the service. Moreover, it would be easier for the regulators to contact those persons responsible for the day-today running of the branch of the third-country firm in order to address matters relevant to supervision. In such a case, the prudential supervision exercised by DCB can also focus on the branch established in the Netherlands rather than on the third-country firm as a whole. If the Netherlands exercises the discretion to apply the MiFID II regime of Article 39 MiFID II, the current exemption for third-country firms established in Australia, the US, or Switzerland providing investment services to retail clients and opt up professional clients from the licence obligation as a thirdcountry firm under Article 10 of the Wft Exemption Regulation will be withdrawn.93

A. Withdrawal of Branch Authorization [10.49] The regulator may withdraw an authorization it has granted to a branch of a third-country firm in the event of one or more of the following situations: 1. The third-country firm: (a) does not use the authorization within twelve months, (b) expressly renounces the authorization, or (c) has provided no investment services or performed no investment activity for the preceding six months, unless the Member State concerned has provided for the authorization to lapse in the cases referred to at (a)–(c) (and withdrawal is therefore not necessary).94 2. The third-country firm has obtained the authorization by making false statements or by any other irregular means.95 3. The third-country firm no longer meets the conditions under which authorization was granted.96 4. The third-country firm has seriously and systematically infringed the provisions adopted pursuant to MiFID II governing the operating conditions for investment firms and applicable to third-country firms.97

5. The third-country firm falls within any of the cases where national law, in respect of matters outside the scope of MiFID II, provides for withdrawal.98

3. Non-Exercise of Member State Option [10.50] If a Member State does not exercise the Member State option, MiFID II merely provides one thing: the Member State may not require a third-country firm to establish a branch, if the firm wishes to provide investment services and/or perform investment activities (with or without ancillary services) in the Member State concerned to retail clients or opt up professional clients. After all, the harmonized requirements described in Section IV.2 apply in such a case. Whether and, if so, on what conditions a third-country firm may provide investment services and/or perform investment activities (with or without ancillary services) to retail clients or opt up professional clients in a Member State that has not exercised the Member State option depends on the national regime of the Member State concerned. [10.51] At the time of writing this chapter, the UK government was minded not to exercise the discretion to make use of the Member State option of Article 39 MiFID II. The reasons for not exercising this discretion were that the current regime has the virtue of being sufficiently tailored to client types and to the risks in question and balances the need to maintain investor protection, market integrity, and financial stability, while remaining open to business internationally.99

4. No European Passport! [10.52] Whether or not a Member State exercises the Member State option, an authorization does not constitute a European passport.100 If Member State A has exercised the Member State option and granted an authorization to a branch in its territory of third-country firm X, the authorization does not qualify as a European passport. In short, if thirdcountry firm X subsequently wishes to provide investment services and/or

perform investment activities (with or without ancillary services) in Member State B to retail clients and opt up professional clients, and Member State B has also exercised the Member State option, third-country firm X will also have to establish a branch in Member State B for which application must be submitted to the regulator in Member State B for separate authorization. However, the advantage of the MiFID II regime in comparison with the present, pre-MiFID II position is that the requirements to be imposed in respect of an authorization for a branch of a third-country firm have been harmonized. Consequently, the requirements to be met by third-country firm X in Member State B should not differ from those that apply in Member State A. It might be possible that Member State B will, in practice, rely on the assessment that has been made by Member State A. Third-country firm X will, however, be subject to the supervision of the competent authorities in both Member State A and Member State B.101 [10.53] As indicated in Section IV.3, if Member State B has not exercised the Member State option, the requirement that third-country firm X should also establish a branch in Member State B does not apply. Whether and, if so, on what conditions third-country firm X may provide investment services and/or perform investment activities (with or without ancillary services) in Member State B to retail clients and opt up professional clients will depend on the national regime of Member State B, although Member State B cannot demand the establishment of a branch since in such circumstances the harmonized requirements will apply (see Section IV.2). In comparison with the situation described in the previous paragraph, namely where Member State B has exercised the Member State option, this has the disadvantage that the requirements to be met by third-country firm X may differ between Member State B and Member State A, which is precisely the same as in the present pre-MiFID II position. [10.54] It remains to be seen which Member States will exercise the Member State option. It can in any event be inferred from the fact that this is a Member State option that during the negotiations on MiFID II no agreement could be reached on a regime in which a third-country firm which wishes to provide investment services and/or perform investment activities (with or without ancillary services) in a Member State to retail clients and opt up professional clients is by definition obliged to open a

branch in that Member State and apply for an authorization for the establishment of that branch.

5. Resolution of a Branch of a Third-Country Firm [10.55] The EU Bank Recovery and Resolution Directive (BRRD)102 lays down rules and procedures relating to the recovery and resolution of branches of third-country institutions (that is, credit institutions and investment firms within the meaning of Article 2(1)(2) and 2(1)(3) BRRD) —the so-called Union branches.103 Branches of such third-country institutions that are authorized pursuant to Article 39 MiFID II fall within the scope of the BRRD. Although a material discussion on the recovery and resolution of Union branches falls outside the scope of this chapter, we note the following. Article 96 BRRD requires that Member States ensure that resolution authorities have the powers necessary to act in relation to a Union branch that is not subject to any third-country resolution proceedings or that is subject to third-country resolution proceedings and one of the circumstances referred to in Article 95 applies (as a result of which recognition or enforcement of third-country resolution proceedings may be refused). Such powers, inter alia, include the exclusion of certain contractual terms in early intervention and resolution.104 Resolution authorities may exercise their powers where the resolution authority considers that action is necessary in the public interest and one or more of the following conditions are met: 1. The Union branch no longer meets, or is likely not to meet, the conditions imposed by national law for its authorization and operation within that Member State and there is no prospect that any private sector, supervisory, or relevant third-country action would restore the branch to compliance or prevent failure in a reasonable timeframe. 2. The third-country institution is, in the opinion of the resolution authority, unable or unwilling, or is likely to be unable, to pay its obligations to EU/EEA creditors, or obligations that have been created or booked through the branch, as they fall due and the resolution authority is satisfied that no third-country resolution proceedings or

insolvency proceedings have been or will be initiated in relation to that third-country institution in a reasonable timeframe. 3. The relevant third country authority has initiated third-country resolution proceedings in relation to the third-country institution, or has notified the resolution authority of its intention to initiate such a proceeding. [10.56] Where a resolution authority takes action in relation to a Union branch, it shall have regard to the resolution objectives and principles and the requirements relating to the application of the resolution tools.105 Union branches will have to contribute to the national resolution financing arrangements.106

V. Retail Clients, Professional Clients and Eligible Counterparties [10.57] Naturally, a third-country firm may wish to provide investment services and/or perform investment activities (with or without ancillary services) in the EU/EEA to: (a) retail clients, (b) professional clients (per se professional clients and/or opt up professional clients), and (c) eligible counterparties. Article 47(3) MiFIR provides for a—somewhat complicated —regime in that respect that can only be used by a third-country firm, if (i) the Commission has adopted an equivalence decision in relation to the third country where the third-country firm is established, and (ii) the Member State in which the third-country firm intends to be active has exercised the Member State option.

1. After the Adoption of an Equivalence Decision and Exercise of the Member State Option [10.58] If: (i) a third-country firm has an authorized branch in a Member State (this will necessarily be a Member State which has exercised the Member State option), and (ii) the Commission has adopted an equivalence decision in relation to the third country concerned, the third-country firm

may then provide investment services and perform investment activities covered by the branch authorization, in Member States other than that in which the branch is established,107 to eligible counterparties and per se professional clients, without the need to establish a branch in those other Member States.108 The branch remains subject to supervision by the regulator in the Member State in which it is established. Nonetheless, the regulator of the Member State in which the branch is established and the regulator of the host Member State may conclude ‘proportionate cooperation agreements’ to deliver the appropriate level of investor protection.109 [10.59] This is hardly surprising since, if the third-country firm wishes to provide services solely to eligible counterparties and per se professional clients within the EU/EEA, and it has registered itself with ESMA following an equivalence decision by the Commission in relation to the third country concerned, the third-country firm could do so even without establishing a branch. Nor should things be any different just because the third-country firm has to establish a branch in a Member State, because: (a) it provides services in that Member State to retail clients and opt up professional clients, and (b) that Member State has exercised the Member State option. [10.60] A potential difference might be that a third-country firm that makes use of Article 47(3) MiFIR does not have to register itself with ESMA to be able to provide investment services and perform investment activities to eligible counterparties and per se professional clients established throughout the EU/EEA, where this would be necessary if the third-country firm makes use of Article 46(1) MiFIR. However, the text of Article 47(3) MiFIR is not clear in this respect. It could be that a thirdcountry firm can choose. Either it can register itself with ESMA and provide services from the third country on a cross-border basis to eligible counterparties and per se professional clients within the EU/EEA (Article 46(1) MiFIR) or it can provide services to eligible counterparties and per se professional clients from an authorized branch in the EU/EEA on a crossborder basis without a registration with ESMA (Article 47(3) MiFIR).

[10.61] Naturally, everything would be different if the third-country firm also wishes to provide services in a Member State other than the one in which the branch is established to retail clients and opt up professional clients. No passport applies in that respect. If that other Member State has also exercised the Member State option, the third-country firm must also have an authorized branch there. If that other Member State has not exercised the Member State option, that Member State may not require the firm to establish a branch, but may impose other requirements under the national regime applicable there. We refer to Section IV.4.

A. Applicability of MiFID II/MiFIR Requirements [10.62] Can additional requirements be imposed on a third-country firm that provides investment services to eligible counterparties and per se professional clients through an authorized branch (that is, in accordance with Article 47(3) MiFIR)? In other words, does Article 46(3) MiFIR apply if a third-country firm provides investment services to eligible counterparties and per se professional clients throughout the EU/EEA from an authorized branch? If that is the case, the third-country firm would not be subject to MiFID II/MiFIR and CRD IV/CRR and the branch would not be subject to effective supervision in the EU/EEA (at least, insofar as investment services are provided to eligible counterparties and per se professional clients). This seems undesirable. As a result, it seems to be intended that a third-country firm may provide investment services to eligible counterparties and per se professional clients throughout the EU/EEA from an authorized branch only if the third-country firm is not registered with ESMA, since Article 46(3) MiFIR only applies where a third-country firm is registered with ESMA. We are therefore inclined to say that if a third-country firm provides investment services to eligible counterparties and per se professional clients throughout the EU/EEA from an authorized branch Article 41(2) MiFID II should be complied with.

2. If no Equivalence Decision is in Effect

[10.63] If no equivalence decision is in effect in relation to a third country (because the Commission has either not yet adopted such a decision or withdrawn a decision110), the European passport for the provision of investment services to eligible counterparties and per se professional clients in accordance with Article 47(3) MiFIR is not available for a third-country firm that has established an authorized branch in a Member State that has exercised the Member State option. In addition, it cannot register itself with ESMA. In such cases, a third-country firm is therefore once again put in the position of having to contend with the different national regimes for the provision of investment services to eligible counterparties and per se professional clients. See Section III.7 above. No passport would be available.

3. If the Member State Option has not been Exercised [10.64] If a Member State has not exercised the Member State option, the European passport for the provision of investment services to eligible counterparties and per se professional clients in accordance with Article 47(3) MiFIR is not available for a third-country firm, since this would require the establishment of an authorized branch in accordance with Article 39 MiFID II. If a Member State has not exercised the Member State option, it would not be possible to open an authorized branch in accordance with Article 39 MiFID II in such Member State. The provision of investment services to retail clients and opt up professional clients would in that case only be possible on a cross-border basis and would be regulated under the national regime of the Member State. Even if a Member State has not exercised the Member State option, it would still be possible for a thirdcountry firm to register with ESMA, if the Commission has taken an equivalence decision in relation to the third country in which the thirdcountry firm is established. Such registration functions as a European passport.

VI. Initiative Test

1. Initiative Test Under MiFIR [10.65] Article 46(5), third paragraph, MiFIR reads as follows: Member States shall ensure that where an eligible counterparty or [per se professional client] established or situated in the [EU/EEA] initiates at its own exclusive initiative the provision of an investment service or activity by a third-country firm, this Article does not apply [emphasis added] to the provision of that service or activity by the third-country firm to that person including a relationship specifically related to the provision of that service or activity. An initiative by such clients shall not entitle the third-country firm to market new categories of investment product or investment service to that individual.

[10.66] Article 46(5), third paragraph, MiFIR introduces an initiative test. The provision of investment services or activities to eligible counterparties and per se professional clients established or located in the EU/EEA is not subject to Article 46 MiFIR, if such eligible counterparty or per se professional client at its own exclusive initiative initiated the provision of an investment service or activity by the third-country firm. A client’s individual initiative does not entitle a third-country firm to market new categories of investment products or investment services to that individual.111 [10.67] The scope of the provision is not crystal clear. What is clear, however, is that if an eligible counterparty or a per se professional client established in the EU/EEA initiates at its own exclusive initiative the provision of an investment service or activity by a third-country firm and the Commission has adopted an equivalence decision in relation to that third country, there is no need to apply to ESMA for registration. But, does the initiative test also apply in relation to third-country firms in respect of which no equivalence decision is in effect (see Section III.7)? Purusant to Article 46(5), third paragraph, MiFIR ‘this Article does not apply’ if the initiative test is passed. However, Article 46 MiFIR only covers the situation where the Commission has adopted an equivalence decision in relation to a third country. Although Article 46(4), fifth paragraph, MiFIR admittedly provides that Member States may allow third-country firms to provide investment services or perform investment activities in their territories, if the Commission has not yet adopted an equivalence decision in relation to that third country or such a decision is no longer in effect, the

result of Article 46(5), third paragraph, MiFIR, if interpreted literally, is merely that this option for Member States ‘does not apply’ if the initiative test is passed. Undoubtedly it was not so intended. Although the literal text therefore creates an element of doubt, the initiative test should, in our opinion, be interpreted as meaning that the Member States must ensure that it is always available for third-country firms in relation to the provision of investment services or activities to eligible counterparties and per se professional clients established in the EU/EEA, regardless of whether the Commission has adopted an equivalence decision in relation to the third country concerned. Recital 43 MiFIR supports this interpretation as it refers to third-country firms generically. Another outcome would also be unfeasible, since the initiative test would be especially important for the third-country firms that are established in third countries for which the Commission has not adopted an equivalence decision yet. Another question would be whether the provisions of MiFID II/MiFIR, other than in respect to market access, apply if a third-country firm provides investment services based on the initiative test. This seems not to be the case, since Recital 43 MiFIR states that services that are provided on the exclusive initiative of a person should not be deemed as provided in the territory of the EU/EEA.112

2. Initiative Test Under MiFID II [10.68] Article 42 MiFID II reads as follows: Member States shall ensure that where a retail client or [opt up professional client] established or situated in the [EU/EEA] initiates at its own exclusive initiative the provision of an investment service or activity by a third-country firm, the requirement for authorization under Article 39 shall not apply [emphasis added] to the provision of that service or activity by the third-country firm to that person including a relationship specifically relating to the provision of that service or activity. An initiative by such clients shall not entitle the third-country firm to market otherwise than through the branch, where one is required in accordance with national law, new categories of investment products or investment services to that client.

[10.69] This provision also introduces an initiative test. The provision of investment services or activities to retail clients and opt up professional clients established or situated in the EU/EEA is not subject to the

requirement for authorization under Article 39 MiFID II, if such retail client or opt up professional client at its own exclusive initiative initiated the provision of an investment service or activity by the third-country firm. As is the case with Article 46(5), third paragraph, MiFIR, an individual initiative by a client does not in itself give a third-country firm the right to market new categories of investment products or investment services to the person concerned.113 The scope of the provision is once again not crystal clear. As reference is made to ‘the requirement for authorization under Article 39’, the provision, if interpreted literally, applies only to Member States which have exercised the Member State option and made it obligatory for a third-country firm to establish a branch if it wishes to provide investment services and/or perform investment activities (with or without ancillary services) in the Member State concerned to retail clients and to opt up professional clients. By this reasoning, Member States which have not exercised the Member State option would not have to apply the initiative test introduced in Article 42 MiFID II. However, they could introduce their own initiative test under a national regime. This strikes us as a less than desirable interpretation of Article 42 MiFID II. It would therefore benefit legal certainty if the initiative test introduced by Article 42 MiFID were to be applicable irrespective of whether a Member State has exercised the Member State option. Recital 111 of MiFID II supports this interpretation as it refers to third-country firms generically. [10.70] Some Member States might, however, think differently. One of the considerations for the UK government not to exercise the discretion to apply the regime of Article 39 MiFID II is that the UK’s ‘overseas persons’ exclusions would be substituted with the narrower concept of reverse solicitation for retail and opt up professional clients. The exclusion for ‘overseas persons’ includes exclusions for particular investment services and activities carried on in the context of a ‘legitimate approach’ or carried on ‘with or through’ an authorized or exempt UK person. The concept of ‘legitimate approach’ is linked to the UK restriction on making financial promotions. It allows cross-border business to be carried out on the basis that the overseas person has not solicited in any way the particular service to be provided to the UK client (which is similar to the MiFID II and MiFIR concept of ‘own exclusive initiative’), and also permits certain limited forms of client solicitation along the lines of exemptions in the FSMA

Financial Promotions Order 2005. These exemptions include, for example, certain types of solicitations made to certified high net worth individuals and previously overseas customers—both of which might be categorized as retail clients under MiFID II.114 [10.71] Lastly, we note that it seems that EU/EEA investment firms cannot rely on the initiative test when providing investment services to clients in other EU/EEA Member States, taking into account that Article 42 MiFID II only refers to third-country firms.

3. Own Exclusive Initiative [10.72] For the initiative test under both MiFID II and MiFIR, it should be determined whether the investment services are provided at ‘the own exclusive initiative’ of the client that is established or situated in the EU/EEA. The recitals of MiFID II and MiFIR give some further guidance in that respect. [10.73] It can be derived from Recital 111 MiFID II that: 115 [w]here a third-country firm provides services at the own exclusive initiative of a person established in the Union, the services should not be deemed as provided in the territory of the Union. Where a third-country firm solicits clients or potential clients in the Union or promotes or advertises investment services or activities together with ancillary services in the Union, it should not be deemed as a service provided at the own exclusive initiative of the client.

[10.74] Recital 43 MiFIR contains similar wording, although Recital 43 MiFIR clarifies that the provisions of MiFIR regulating the provision of services or undertaking of activities by third-country firms should not affect the possibility for EU/EEA investment firms or credit institutions to receive investment services or activities from a third-country firm at their own exclusive initiative or for a client to receive investment services from a third-country firm at their own exclusive initiative through the mediation of such a credit institution or investment firm.

[10.75] As a result, where a third-country firm solicits clients or potential clients in the EU/EEA or promotes or advertises investment services or activities together with ancillary services in the EU/EEA, it should not be deemed as a service provided at the own exclusive initiative of the client, as a result of which the third-country firm cannot rely on the initiative test of Article 42 MiFID II or Article 46(5), third paragraph, MiFIR.

VII. Conclusion [10.76] MiFID II/MiFIR introduce a common regulatory framework that should harmonize the existing fragmented framework for the provision of services by third-country firms, ensure certainty and uniform treatment of third-country firms accessing the EU/EEA, ensure an assessment of effective equivalence by the Commission, and provide for a comparable level of protection to clients in the EU/EEA receiving services by thirdcountry firms. But as we have seen, the legislation is unfortunately complex and does not provide for full harmonization. [10.77] Although the basics of the third-country regime under MiFID II/MiFIR seem to be set, the devil is in the detail. There is still a considerable lack of clarity in relation to the scope of the MiFID II/MiFIR’s third-country regime, for example where it concerns investment activities, and activities other than investment services and investment activities (such as selling and advising in relation to structured deposits), and the initiative test. In addition, the concurrence between MiFID II and MiFIR, if a thirdcountry firm provides investment services to eligible counterparties, professional clients, and retail clients, raises interesting questions that are not easily answered. [10.78] Table 10.1 provides a summary that may assist in finding a way through the provisions of the third-country regime under MiFID II/MiFIR.

Table 10.1: Provisions of the third-country regime under MiFID II/MiFIR

Retail clients and opt up professional clients

Eligible counterparties and per se professional clients

Provision of services through a branch

Member State has exercised the Member State option (Article 39(2) MiFID II) This is possible, if the branch has obtained authorization from the regulator of the Member State in which the branch is established. Member State has not exercised the Member State option We deem this not to be possible.

Commission has taken an equivalence decision (Article 47(3) MiFIR) We deem this to be possible, if the thirdcountry firm has an authorized branch in accordance with Article 39 MiFID II. Commission has not taken an equivalence decision (Article 46(4) MiFIR) This is only possible if this is in accordance with the applicable national regime of a Member State.

Provision of crossborder services

Member State has exercised the Member State option (Article 39(1) MiFID II) This is not possible. Member State has not exercised the Member State option This is only possible if this is in accordance with the applicable national regime of a Member State.

Commission has taken an equivalence decision (Article 46(1) MiFIR)This is possible, if the third-country firm is registered with ESMA. Commission has not taken an equivalence decision (Article 46(4) MiFIR) This is only possible if this is in accordance with the applicable national regime of a Member State.

Provision of services through the

This is possible (Article 42 MiFID II).

This is possible (Article 46(5), third paragraph, MiFIR).

initiative test Provision of services throughout the EU/EEA (European Passport)

1

Member State has exercised the Member State option (Article 39(1) MiFID II) This is not possible, unless the third-country firm establishes an EU/EEA subsidiary that obtains an authorisation that can subsequently be passported. Member State has not exercised the Member State option (Articles 34 and 35 MiFID II) This is not possible, unless the third-country firm establishes an EU/EEA subsidiary that obtains an authorisation that can subsequently be passported.

Commission has taken an equivalence decision (Article 46(1) MiFIR / Article 47(3) MiFIR) This is possible, if the third-country firm (i) is registered with ESMA or (ii) has an authorized branch in accordance with Article 39 MiFID II and has fulfilled the applicable information requirements under Article 34 MiFID II. Commission has not taken an equivalence decision (Articles 34 and 35 MiFID II) This is not possible, unless the thirdcountry firm establishes an EU/EEA subsidiary that obtains an authorisation that can subsequently be passported.

Cf. Recital 41 MiFIR, which talks of highly differentiated and fragmented regimes, and Commission Staff Working Paper accompanying the document Proposal for a Directive of the European Parliament and of the Council on Markets in financial instruments (Recast) and the Proposal for a Regulation of the European Parliament and of the Council on Markets in financial instruments, 20.10.2011, SEC (2011) 1226, final (Impact Assessment MiFID II), p. 114. 2 Cf. Recital 28 MiFID. However, the third-country firm can of course decide to establish a subsidiary in the EU/EEA, in which case the subsidiary can make use of the European passport. 3 Cf. Impact Assessment MiFID II (n. 1), p. 15. 4 Cf. Recital 41 MiFIR.

5

Article 1(1) MiFID II and Article 1(1)(f) MiFIR. Article 4(1)(57) MiFID II and Article 2(1)(42) MiFIR. 7 Article 46(1) MiFIR and Article 39(1) MiFID II. 8 In accordance with Section II of Annex II to MiFID II. 9 In accordance with Section II of Annex II to MiFID II. 10 We note that if such investment activity falls outside the scope of MiFID II/MiFIR, the third-country firm could perform such investment activity without complying with the MiFID II/MiFIR’s third-country firm regime at all. It can however be read in Chapter 2 that the scope of the exemptions for dealing on own account has been narrowed by MiFID II. 11 This comment equally applies for underwriting activities. Also in that case, no typical client relationship exists between a third-country firm and an investor, since the underwriting activities would typically be performed for an issuer. 12 In the Netherlands, the Netherlands Authority for the Financial Markets (Stichting Autoriteit Financiële Markten, AFM) has published an interpretation on the question of when activities of trading platforms (that is, regulated markets and MTFs) established abroad qualify as holding a market in financial instruments in the Netherlands (Interpretatie Beheren of exploiteren v.e. gereglementeerde markt of het exploiteren v.e. multilaterale handelsfaciliteit in Nederland, 15 March 2007). To answer this question the AFM assesses if the trading platform is active in the Netherlands. Previously, the AFM qualified the activities in the Netherlands of a foreign trading platform by using the criterion ‘the placing of trading screens’ by this trading platform. Due to the increased role of the Internet in the access to a trading platform, this criterion was deemed to be no longer appropriate. The AFM has therefore developed new assessment criteria. The AFM qualifies a trading platform, established abroad, as being active in the Netherlands if both of the following criteria are met: (i) the trading platform offers direct access (without making use of a local broker) to Dutch parties (connectivity test), and (ii) the trading platform (plans to) actively approach and market its activities to Dutch professional parties (initiative test). If only the connectivity test provides a positive outcome the following three factors could indicate, according to the AFM, that the foreign-based trading platform is active in the Netherlands: (i) the (relative) number of Dutch professional parties active on the platform; (ii) the relative share of Dutch professional parties on the total volume of the platform; and (iii) the impact of the platform on the Dutch capital markets. It is to be seen whether this interpretation will continue to be in place under MiFID II/MiFIR. 13 Article 1(4) MiFID II. See also Chapter 2. 14 You could say that third-country firms are investment firms and therefore Article 1(4) MiFID II applies to third-country firms. This seems, however, not to be in line with the systematics of MiFID II that includes a specific definition of third-country firms. 15 Article 46(1) MiFIR and Article 39(1) MiFID II. We also refer to Article 1(2)(b) MiFID II and Article 1(1)(f) MiFIR. 16 If structured deposits qualify as PRIIPs (Packaged Retail and Insurance-based Investment Products), the third-country firm should however act in accordance with the Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 6

November 2014, OJ L 352, pp. 1–23 (PRIIPs Regulation), when acting as a PRIIP manufacturer or person selling a PRIIP, irrespective of whether it falls under MiFID II/MiFIR’s regime for third-country firms (Article 2 PRIIPs Regulation). 17 Article 42 MiFID II and Article 46(5), third paragraph, MiFIR. 18 Article 1(1) MiFID II. See also Chapter 2. 19 Article 59 MiFID II. 20 Article 4(1)(55) MiFID II. 21 Article 59(2) MiFID II. 22 Cf. Article 60(2) MiFID II. 23 Article 4(1)(24) MiFID II. See Article 4(1)(21), (22), and (23) MiFID II for the definitions of regulated market, MTF, and OTF. 24 Article 44 MiFID II. 25 See Article 38 MiFIR. 26 Directive 2014/57/EU of the European Parliament and of the Council of 16 April 2014, OJ L 173/179 and Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014, OJ L 173/1. 27 Article 38(1) MiFIR. 28 Article 38(1) MiFIR. The equivalence decision should be taken in accordance with Article 38(3) MiFIR. 29 Article 38(2) MiFIR. The equivalence decision should be taken in accordance with Article 38(3) MiFIR. 30 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012, OJ L 201, pp. 1–59. 31 Articles 28(1) and (4) MiFIR. We also refer to Article 23(1) MiFIR that allows investment firms to comply with the trading obligation by trading on a third-country trading venue that is assessed equivalent in accordance with Article 25(4)(a) MiFID II. 32 Strictly speaking Article 47(1) MiFIR does not refer to CRR. It is however our understanding that Article 47(1) MiFIR should be read as if it includes a reference to CRR. 33 We also refer to Recital 41 MiFIR. 34 Impact Assessment MiFID II (n. 1), p. 300. 35 ibid, pp. 304, 310. 36 Article 37(1) of the Commission Proposal. We also refer to Recital 41 MiFIR. 37 Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009, OJ L 302, pp. 1–31, as amended. 38 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011, OJ L 174/1. 39 Cf. N. Moloney, EU Securities and Financial Markets Regulation (Oxford: Oxford University Press, 2014), p. 403. 40 Cf. Article 25(1) EMIR. 41 Cf. Article 25(6) EMIR.

42

The Commission has determined that ten countries (Australia, Canada, Hong Kong, Japan, Mexico, Singapore, South Africa, South Korea, the US, and Switzerland) have equivalent regulatory regimes for CCPs to the EU/EEA. 43 The Commission has determined that nine countries (Argentina, Australia, Brazil, Canada, Hong Kong, Japan, Mexico, Singapore, and the US) have equivalent regulatory regimes for CRAs to the EU/EEA. 44 Article 21(5) AIFMD in conjunction with Article 21(6) AIFMD. 45 Article 21(6), last paragraph, AIFMD. 46 See also ESMA/2016/1140, Advice – ESMA's advice to the European Parliament, the Council and the Commission on the application of the AIFMD passport to non-EU AIFMs and AIFs (18 July 2016), para. 22. 47 Article 37 is currently not yet applicable in the Member States. This requires a delegated act from the Commission, which will be taken following positive advice from ESMA in accordance with Article 67 AIFMD. At the time of writing this chapter, ESMA has advised the Commission on the application of the passport to non-EU/EEA AIFMs and AIFs in twelve jurisdictions (ESMA (n. 46)). 48 Article 37(2) AIFMD. 49 Article 37(23)(b) AIFMD. 50 Recital 41 MiFIR. 51 Articles 46(1) and (2), opening words, in conjunction with Article 47 MiFIR. As regards the procedure to be followed by a third-country firm with ESMA, see Article 46(4), first and third paragraphs, MiFIR. See also Commission Delegated Regulation (EU) …/... of 14.7.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to regulatory technical standards concerning the information for registration of third country firms and the format of information to be provided to the clients (C(2016)4407 final) for the information that is necessary for the registration At the time of writing this chapter, this delegated act had not yet entered into force. 52 Article 46(2)(b) MiFIR. 53 Article 46(2)(c) in conjunction with Article 47(2) MiFIR. 54 Commission Delegated Regulation (n. 51), Articles 1 and 2. 55 Article 7(3) MiFID II. 56 The relevance of this question also relates to the element of reciprocity. If a third country assesses that third-country firms established in its territory do not have effective market access to the EU/EEA, it may decide not to grant effective market access to EU/EEA investment firms willing to access the market in such third country. 57 Article 46(3) MiFIR. The scope of MiFID II also determines the applicability of the requirements on the basis of CRD IV and CRR. We refer to Chapter 2. 58 Article 46(5), first and second paragraphs, MiFIR. Commission Delegated Regulation (n. 51), Article 3. 59 Article 46(6) MiFIR. 60 Commission Delegated Regulation (n. 51), Article 2(1).

61

Although the equivalence test by the Commission also includes whether the prudential and business conduct framework of the third country ensures market transparency and integrity by preventing market abuse in the form of insider dealing and market manipulation, we would expect that the market abuse rules under MAD II/MAR also apply to third-country firms that are registered with ESMA. 62 Article 54(1) MiFIR. 63 Articles 49(1)(a) and (b) MiFIR. 64 Articles 49(1)(c) and (d) MiFIR. 65 Article 49(2) MiFIR. 66 Article 49(3) MiFIR. 67 Article 47(4) MiFIR. 68 Article 46(4), last paragraph, MiFIR. 69 Article 49(3) MiFIR. 70 Article 46(4), last paragraph, MiFIR. 71 Following a Brexit (see Chapter 1, paragraph 1.56), the UK may qualify as a third country itself, depending on the arrangements be agreed upon between the EU and the UK. In such a case, any investment firm that has its head office or registered office in the UK, will qualify as a third-country firm and will only have access to the EU/EEA under the MiFID II/MiFIR’s third-country regime. As it is foreseen that the process of Brexit will take at least two years, MiFID II/MiFIR will already have entered into force in the UK prior to Brexit. After Brexit, the UK could, however, decide to no longer comply with MIFID II/MiFIR, again depending on the agreements established between the EU and the UK. The contents of such agreements are currently not yet known. 72 Article 35 Wft Exemption Regulation currently provides for a partial exemption from the conduct-of-business supervision. It is, however, intended that third-country firms that are exempt from the licence obligation under Article 10 of the Wft Exemption Regulation will be fully exempted from the conduct-of-business supervision after entry into force of MIFID II/MiFIR (Explanatory Notes to the Netherlands Draft Legislative Proposal for Implementation of MiFID II, p. 12). 73 With the exception of Articles 3:5, 3:6, and 3:7 Wft, see Article 18 Wft Exemption Regulation. 74 In the Netherlands the same national regime applies to the provision of investment services to retail clients and opt up professional clients, though there is then no exemption from the prudential requirements and the conduct of business rules are more extensive. 75 HM Treasury, Transposition of the Markets in Financial Instruments Directive II, March 2015, pp. 9–10. The same national regime applies for the provision of investment services to retail clients and opt up professional clients. 76 Article 46(6) MiFIR. 77 Article 39(1) MiFID II. 78 Recital 109 MiFID II. 79 Article 39(2), opening words, MiFID II.

80

Article 39(3) MiFID II. See Article 40 (Obligation to provide information) MiFID II. 82 Article 39(2), opening words, and Article 41(1), opening words, MiFID II. 83 Article 41(2), second paragraph, first part of the sentence, MiFID II. 84 Article 41(2), second paragraph, second part of the sentence, MiFID II. 85 Article 39(2)(a) MiFID II. 86 Article 39(2)(b) MiFID II. 87 Article 39(2)(c) MiFID II. 88 Article 39(2)(d) MiFID II. 89 Article 39(2)(e) MiFID II. 90 Article 39(2)(f) MiFID II; Directive 97/9/EC of the European Parliament and of the Council of 3 March 1997, OJ L 84/22. 91 Article 41(1)(b) in conjunction with (2), first paragraph, MiFID II. 92 De Nederlandsche Bank NV, DCB. 93 Explanatory notes to the Dutch Draft Legislative Proposal for Implementation of MiFID II, p. 11. 94 Article 43(a) MiFID II. 95 Article 43(b) MiFID II. 96 Article 43(c) MiFID II. 97 Article 43(d) MiFID II. 98 Article 43(e) MiFID II. 99 HM Treasury, Transposition of the Markets in Financial Instruments Directive II, March 2015, p. 11. 100 In the interests of completeness, we note that in the Commission Proposal for MiFID II (Proposal for a Directive of the European Parliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC of the European Parliament and of the Council (Recast), 20.10.2011, COM/2011/0656 final) it was envisaged that the thirdcountry firm should be able to provide services in other Member States through the authorized and supervised branch, subject to a notification procedure (Recital 73 Commission Proposal MiFID II, Article 44 Commission Proposal MiFID II). This possibility for a European passport was however repealed under MiFID II. The only option under MiFID II for third-country firms wishing to obtain a European passport for the provision of investment services to retail client and opt up professional clients is to establish an EU/EEA subsidiary. 101 Cf. Article 41(2) MiFID II. 102 Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014, OJ L 173, pp. 190–348. 103 Articles 1(1)(e) and 2(1)(89) BRRD. 104 Article 96(1), second paragraph, BRRD. 105 Article 96(3) BRRD. 81

106

Article 103(1) BRRD. If a third-country firm can operate from a branch within the EU/EEA on a crossborder basis throughout the EU/EEA, we see no reason why it should be prevented from providing services from the branch to eligible counterparties and per se professional clients in the Member State where the branch itself is established. 108 See Article 47(3), first paragraph, MiFIR. However, the third-country firm must fulfil certain information requirements in relation to the regulator in the Member State where the branch is established, for example by (a) indicating in which other Member States it wishes to perform its activities, and (b) submitting a programme of operations. See Article 47(3), first paragraph, last sentence, MiFIR in conjunction with Article 34 MiFID II. 109 Article 47(3), second paragraph, MiFIR. 110 Article 49(3) MiFIR. 111 Article 46(5), third paragraph, MiFIR. 112 In the Netherlands, this interpretation seems to be followed (see Section 1:19c of the Netherlands Draft Legislative Proposal for Implementation of MiFID II). 113 Article 42, last sentence, MiFID II. 114 HM Treasury, Transposition of the Markets in Financial Instruments Directive II, March 2015, pp. 9–11. 115 Besides Recital 111 MiFID II, Recital 85 MiFID II sets out that: 107

a service should be considered to be provided at the initiative of a client unless the client demands it in response to a personalized communication from or on behalf of the firm to that particular client, which contains an invitation or is intended to influence the client in respect of a specific financial instrument or specific transaction. A service can be considered to be provided at the initiative of the client notwithstanding that the client demands it on the basis of any communication containing a promotion or offer of financial instruments made by any means that by its very nature is general and addressed to the public or a larger group or category of clients or potential clients. This recital does however not relate to the initiative test, but clarifies one of the conditions for not carrying out the suitability test, that is, that the service is provided at the initiative of the client or potential client (Communication from the Commission to the European Parliament pursuant to the second subparagraph of Article 251 (2) of the EC Treaty concerning the common position of the Council on the adoption of a Directive of the European Parliament and of the Council on markets in financial instruments, markets, 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, 12.1.2004, COM (2004) 15, p. 16).

PART III

TRADING

11 GOVERNANCE AND ORGANIZATION OF TRADING VENUES The Role of Financial Market Infrastructure Groups Guido Ferrarini and Paolo Saguato

I. Introduction II. 1. 2. 3. 4. 5. III. 1. 2. IV. 1. 2. 3. 4. 5.

Trading Facilities: Concept and Regulatory Framework An Introduction to the Scenario of Trading Facilities The Regulatory Framework of EU Trading Venues Regulated Markets MTFs and OTFs Non-Discriminatory Access to Trading Venues and to CCPs The EU Scenario of Trading Venues The Evolution of the Trading Venues Market A Case Study of Six FMI Groups FMI Groups in an MiFID II World Formation of Pan-European Groups The OTF in FMI Groups Challenges of FMI Groups to Regulators MiFID II’s Approach to FMI Groups Consolidated Supervision?

V. Conclusion

I. Introduction [11.01] Ten years after its adoption and six years after the 2008 global financial crisis, the Markets in Financial Instruments Directive (MiFID I)1 underwent significant revisions. The reform spirit embraced by European institutions resulted in the adoption of two pieces of Level 1 legislation, a ‘revised’ Markets in Financial Instruments Directive (MiFID II)2 and a Markets in Financial Instruments Regulation (MiFIR),3 which intend to provide an updated regulatory framework for European financial markets so they will be up to the challenges posed by financial and technological innovation as well as the financial crisis.4 Market structures and market infrastructures are two of the areas touched by MiFID II.5 Faced with two compelling needs—to strengthen transparency and resilience in the over-the-counter (OTC) markets,6 and to increase efficiency and competition in the always evolving financial markets— European policymakers were induced to reconsider and reform the panorama of trading venues and the organizational environment in which they operate. [11.02] This chapter looks into the reformed regulatory framework for trading venues under MiFID II and how the trading venues scenario has evolved over the past few years. It is structured as follows. Section II introduces the concept of trading facilities and trading venues and provides an overview of the reforms brought about by MiFID II in the trading venues scenario. Regulated markets (RMs), multilateral trading facilities (MTFs), and organized trading facilities (OTFs) are the designated trading venues in the EU financial markets. Section III presents six case studies: the London Stock Exchange Group, the Deutsche Börse group, the Euronext group, the Bolsas y Mercados Españoles group, the NASDAQ OMX Nordic Exchange, and the BATS group. Each case study looks at the organizational structure of the trading venue, its governance, and the coexistence and relationship—within the same group—of trading venues and central clearing counterparties (CCPs). Section IV then critically and systemically evaluates the role of MiFID II in reorganizing the framework of trading venues and considers whether MiFID II’s regulatory and supervisory tools

are effective in tackling the emergence of Financial Market Infrastructure (FMI) groups. Finally, Section V concludes.

II. Trading Facilities: Concept and Regulatory Framework 1. An Introduction to the Scenario of Trading Facilities [11.03] A trading facility is the place where buyers and sellers meet to trade financial instruments (either securities or derivatives).7 The concept of a trading facility has become more fluid in recent decades due in part to the need to create marketplaces suitable for market participants’ evolving needs and in response to the impact that technological innovation is now playing in re-shaping the financial system.8 [11.04] Generally, trading facilities group together different categories of platforms providing trading services.9 Looking at two main features in the structure of trading facilities—first whether trading is bilateral or multilateral; and second whether the facility is regulated or unregulated— we can pinpoint three groups of facilities: trading venues, systematic internalizers, and alternative finance platforms.10 [11.05] A trading venue means an RM, an MTF, or an OTF;11 it is a multilateral regulated facility that provides a location for brokers and traders to meet and execute their trades, thus reducing traders’ searching costs for potential counterparties.12 In addition, a trading venue publicizes the related information concerning the prices, volumes, and often times the parties of the executed transactions, thus providing trade transparency; plus it offers quotes, namely the prices at which market participants are willing to sell (‘ask quotes’) and to buy (‘bid quotes’) financial instruments.13 These are the core activities that characterize any trading venue. Only some authorized trading venue operators provide additional services, such as listing of securities, the regulation and monitoring of issuers and broker-

dealers, and market supervision.14 Moreover, post-trade services are provided either directly by firms within the venue’s group or by institutions linked to them, such as clearing and settlement agents and CCPs, which facilitate the clearing and settlement of the executed transactions.15 [11.06] Systematic internalizers are regulated trading facilities operated by an investment firm that, ‘on an organized, frequent and substantial basis, offers bilateral trading by dealing on its own account (i.e. being a contractual part of the deal)’.16 [11.07] Moreover, technological innovation and regulatory arbitrage have contributed to the development of a vast array of alternative trading (electronic) platforms and systems operated by investment firms in a framework of bilaterally concluded financial transactions that fuel the OTC markets.17 These platforms are also found in primary markets, where they offer the facilities for crowdfunding and other alternative finance transactions (such as invoice trading).18 [11.08] Generally speaking, trading facilities have given rise to two main types of markets: public markets and private markets. Public markets are formal (being subject to a regulatory framework), multilateral (operating as an open marketplace where buyers’ and sellers’ trading interests meet), non-discretional (as they execute trades applying pre-set rules or parameters), and transparent (being subject to pre- and post-trade transparency). Conversely, private markets are informal (not being subject to a regulatory framework), bilateral (in that the venue enters into a trade with a client), discretionary (leaving the venue the authority to admit to the platforms and to the trades), and dark (not being subject to transparency requirements).19 Despite all being trading venues, RMs, MTFs, and OTFs create different markets. [11.09] RMs, traditional exchanges, and multilateral platforms more generally (such as MTFs), are usually associated with the first type of markets: public markets. [11.10] The second type of market, the private market, is generally linked to alternative trading (electronic) platforms and OTC markets, where

investment firms provide discretionary and bilateral (and in some instances multilateral) trading services, and also ‘dark pools’. This clear classification, however, has become more blurred due to the creation either by market actors or by regulatory intervention of a range of trading facilities that consequently contributed to the evolution of a spectrum of hybrid markets, which have evolved from the tuning at different levels of transparency regime, access rules, regulatory oversight, organizational aspects, etc.20 [11.11] Having at the antipodes public markets and private markets, hybrid markets are mixed organizational models of trading facilities which combine, to varying degrees, elements of both public and private markets. OTFs, for instance, because of the peculiarities of their architecture, create semi-public markets. OTFs are multilateral and formal venues, subject to pre- and post-trade transparency, but also subject to discretion in the execution of trades and therefore owing certain conduct of business duties to their clients including the ‘best execution’ requirement.21 Similarly SIs, because of their bilateral structure, lie in the private market sphere, although the increased regulation of their transparency regime shifted them away from the traditional private market OTC paradigm to a semi-private sphere. [11.12] The governance of trading venues has evolved substantially following the technological and competitive developments of globalization.22 First, exchanges, run in the form of mutual enterprises owned by their members, were generally demutualized, while public exchanges—trading venues open to all interested parties and run by a public entity governed by administrative law, and often enjoying broad selfregulatory powers—were mainly privatized.23 The resulting firms became public companies with diffuse shareholders or were merged into or acquired by other exchanges.24 Second, exchanges, mainly focused on the development of electronic platforms and the offer of liquidity services, became more similar to their competitors, such as MTFs and internalizing firms. They correspondingly became less (or poorly) incentivized to perform self-regulatory activities, to the extent that this generated positive externalities to competing platforms, and powerful conflicts of interest were created between exchanges’ regulatory and business activities.25

[11.13] Regulators highlighted these conflicts as problematic and as sufficient to justify regulatory reform.26 However, they also took the opportunity to expand their regulatory turf and to undertake some of the traditional rulemaking and monitoring functions of exchanges. In 2000, for example, the UK Listing Authority was transferred from the demutualized London Stock Exchange to the Financial Services Authority (FSA), now Financial Conduct Authority (FCA).27 Leaving the Listing Authority to a for-profit firm like the LSE – competing in the international market for trading services – would have raised concerns as to its independence and incentives to efficiently perform the relevant function. [11.14] More generally, two types of re-regulation followed the privatization and demutualization of exchanges. First, the governance of trading venue operators has generally been regulated to reflect the policy view that exchanges and other trading venues are firms offering transaction services to intermediaries and investors in a competitive setting.28 Both in the US and the EU, the various types of trading venues (including alternative trading systems and MTFs) are subject to rules that are increasingly similar across the sector given that these venues perform similar functions.29 Second, the role of exchanges in the regulation and supervision of listed issuers has been reduced and replaced by public regulation and supervision, which has correspondingly widened its scope of application.30

2. The Regulatory Framework of EU Trading Venues [11.15] The application of MiFID I31 to the EU’s equity trading markets in November 2007 heralded a new era for the EU’s financial markets.32 MiFID I’s securities trading rules were designed to reshape the EU trading market. The abolition of national ‘concentration rules’ in particular, while contributing to the fragmentation of securities markets, enhanced competition between trading venues in the EU, harnessing industry innovation and technological advances. Moreover, the financial crisis experience ‘largely vindicated’ MiFID I’s design.33 However, the European Commission highlighted four difficulties in the post-MiFID I scenario. (i)

The benefits of competition were not flowing efficiently to all market participants and had not always been passed on to end users, and market fragmentation had made the trading environment more complex and opaque. (ii) MiFID’s classification model had been outpaced by innovation. (iii) The financial crisis had exposed weaknesses in the regulation of nonequity instruments. (iv) Finally, rapid innovation and increasing market complexity called for higher levels of investor protection. The Commission thus sought a safer, sounder, more transparent, and more responsible financial system.34 [11.16] Toward this result, MiFID II brings about a structural reform in the design of multilateral trading systems—defined as the platforms or systems where buying and selling interests in trading financial instruments come together. It updates the trading venues classification, extending the regulatory perimeter around trading facilities operating in the OTC markets, and applies the same set of rules to this wider set of venues.35 A driving concern appears to be the ‘future-proofing’ of MiFID against changes to the nature of organized trading and to address current and potential regulatory arbitrage risks.36 MiFID II, while retaining the same taxonomy of multilateral trading venues operated by MiFID I, introduces a third one, the OTF, designed to capture all those non-equity trades that occur outside RMs and MTFs. At the same time RM and MTF rule-books have been aligned, as they ‘represent the same trading functionality’.37 MiFID II also introduces broader rules in terms of governance structure of the venues.38 The next sections analyse the regulatory framework of the three organized trading venues classified by MiFID II, and finally present what is a novelty in the regulation of the EU financial markets, namely the rule on nondiscriminatory access to CCPs and trading venues.

3. Regulated Markets [11.17] RMs represent the archetype of a public market. In practice, they encompass the main stock and derivatives exchanges. RMs are multilateral and non-discretionary trading venues, where buyers and sellers can trade in accordance with preset rules, and where trades conform to transparency

requirements.39 Market operators of RMs are the main target of MiFID II attention.40 Article 44(1) in particular makes a distinction between the market operator and the systems of the regulated market, both of which must comply with the relevant RM provisions. Para. (2) of the same Article specifies that the market operator performs the tasks relating to the organization and operation of the RM under the supervision of the competent authority. As a result, both market operators and the systems run by the same are subject to regulation and supervision.

A. Corporate Governance [11.18] In comparison with MiFID I, MiFID II has enhanced the governance requirements of market operators, aligning them with those applicable to investment firms, which in their turn track the governance requirements foreseen by the Capital Requirements Directive of 2013 (CRD IV, Articles 88 and 91) for banks. Members of the management body of a market operator must be of sufficiently good repute and possess sufficient knowledge, skills, and experience to perform their duties, and their composition shall reflect an adequately broad range of experience (Article 45(1)). In addition, all members shall commit sufficient time to perform their functions in the market operator, while the management body as a whole shall possess adequate collective knowledge, skills, and experience to be able to understand the market operator’s activities, including the main risks (Article 45(2)(a) and (b)).41 For this purpose, market operators shall devote adequate human and financial resources to the induction and training of their management body (Article 45 (3)). Furthermore, each member of this body shall act with honesty, integrity, and independence of mind to effectively assess and challenge the decisions of the senior management and to effectively monitor decision-making (Article 45(2)(c)). In addition, market operators which are significant in terms of size, internal organization, scope, and complexity must establish a nomination committee within the management body, to perform the tasks relating to the appointment of new members and the assessment of the board that are typical of such a committee both in financial and non-financial firms (Article 45(4)).42

[11.19] The overarching governance requirement for market operators asks their management body to define and oversee the implementation of the governance arrangements that ensure effective and prudent management of an organization, including the prevention of conflicts of interest, in a manner that promotes the integrity of the market (Article 45(6)). This requirement shows the two main objectives of corporate governance regulation in this area. On one side, (supervisory) boards should exercise their oversight on the management of the organization—including the market operator and the systems of the regulated market—and ensure that it is performed efficiently and with the prudence required in all financial institutions. On the other side, regulated markets are a particular type of institution, creating risks of a special type which are mainly connected with the need to ensure fair and orderly trading and the integrity of markets. This explains the focus on conflicts of interest, which can arise out of the multiplicity of parties involved in the organized trading of financial instruments, and on the resilience of trading systems. Both conflicts of interests and trading systems’ failures may not only jeopardize market integrity, but also threaten the financial system as a whole. The management body should therefore ensure that there are risk-management systems in place apt to minimize the risks at issue. [11.20] MiFID II also requires the ownership of market operators to be regulated (Article 46). First, the persons who are in a position to exercise, directly or indirectly, significant influence over the management of the RM should be suitable. Second, information regarding the ownership of the RM and/or market operator should be provided to the competent authority, including information as to any transfer of ownership which gives rise to a change in the identity of the persons exercising significant influence over the operation of the RM. Third, the competent authority should refuse to approve changes to controlling interests of the RM and/or market operator where there are objective grounds for believing that they would pose a threat to the sound and prudent management of the regulated market.

B. Organization

[11.21] Consistently with what we have seen for corporate governance in the preceding subsection, MiFID II defines some of the main tasks of the organizational structure of an RM as follows: (a) to identify conflicts of interest and manage their potential adverse consequences; (b) to manage the risks to which the RM is exposed; (c) to have arrangements for the sound management of the technical operations of the system, including contingency arrangements; (d) to have rules and procedures that provide for fair and orderly trading and efficient execution of orders; (e) to facilitate the efficient and timely execution of transactions; and (f) to have sufficient financial resources to facilitate its orderly functioning (Article 47(1)). The Directive takes specific care of the resilience of trading systems under Article 48(1), requiring an RM to have in place effective systems, procedures, and arrangements to ensure its trading systems are resilient, have sufficient capacity to deal with peak order and message volumes, are able to ensure orderly trading under conditions of severe market stress […] and are subject to effective business continuity arrangements to ensure continuity of its services if there is any failure of its trading systems.43

Other parts of the RM regime include aspects which are traditional in exchange regulation, such as admission of financial instruments to trading (Article 51), suspension and removal of financial instruments from trading (Article 52), access of members or participants to an RM, and market monitoring requirements (Article 54).

4. MTFs and OTFs [11.22] MiFID II is innovative in aligning the regulation of MTFs and RMs. However, the most radical reform in the trading venues architecture is the introduction of a new category,44 the OTF.45 The latter trades in nonequity assets—mainly derivatives and bonds—and is designed to capture all non-RM/MTF trading on organized venues, other than ad hoc bilateral trading between counterparties, which does not take place in an organized venue.46

A. Definitions [11.23] An MTF is a multilateral trading system operated by an investment firm or a market operator.47 The operation of an MTF is an investment service included in the lists of services and activities found in Annex I, Section A, MiFID II. Therefore, the operation of an MTF is subject to authorization both for investment firms and market operators.48 [11.24] An OTF is also a multilateral trading system or facility, the operation of which by either an investment firm or a market operator is an investment service requiring authorization. For an OTF to be authorized a detailed explanation must be provided to the competent authority of why the system cannot be operated as an RM, an MTF, or an SI.49

B. Corporate Governance [11.25] Like all investment firms,50 an investment firm operating either an OTF or an MTF must comply with the corporate governance requirements provided by CRD IV, which are similar to those already considered for RMs (Section II.3.A above).51 First, the firm’s governance arrangements should ensure the effective and prudent management of the same, including the prevention of conflicts of interest.52 Second, a nomination committee must be appointed in those institutions which are significant in term of their size, internal organization, and the nature, scope, and complexity of their activities.53 Third, members of the management body must possess sufficient reputation and knowledge, skills, and experience to perform their duties, and are subject to limitation on the number of directorships they can simultaneously hold.54 In addition, like all investment firms, those operating MTFs or OTFs must inform and notify the competent authority about the identities of their shareholders or members, whether direct or indirect, natural or legal persons, who have qualifying holdings and the amount of those holdings.55

C. Organization

[11.26] The organizational requirements of investment firms also apply to those firms operating an MTF and/or an OTF.56 Additional organizational requirements are either common to MTFs and OTFs or specific for each type of venue. [11.27] The common requirements include establishing transparent rules and procedures for fair and orderly trading, for the admission of financial instruments to trading, and for access to the trading facility, and identifying and managing the potential adverse consequences of any conflict of interest.57 Moreover, the requirements concerning systems resilience, circuit breakers, and tick sizes stated by MiFID II for RMs (Section II.3.B above), also apply to MTFs and OTFs.58 [11.28] Specific requirements for MTFs include the establishment and implementation of non-discretionary rules for the execution of orders in the trading system.59 In addition, investment firms and market operators operating an MTF must have arrangements in place to manage the risks to which the system is exposed and to facilitate the efficient and timely finalization of transactions.60 Moreover, firms operating an MTF should not execute client orders against their proprietary capital nor engage in matched principal trading.61 [11.29] The specific requirements for OTFs take care of keeping the multilateral character of these trading systems. First, firms operating an OTF are precluded from executing client orders against their proprietary capital or the capital of any entity that is part of the same group.62 Second, they are allowed to engage in matched principal trading only with respect to some instruments and only where the client has consented to this process.63 Third, dealing for own account other than matched principal trading is allowed to firms operating an OTF only for sovereign debt instruments for which there is not a liquid market.64 Fourth, the operation of an OTF and of a systematic internalizer cannot take place within the same legal entity.65 However, orders are executed on an OTF on a discretionary basis. This marks an important difference from MTFs, which must have nondiscretionary rules for the execution of orders. The discretion of the OTF operator is exercised when deciding to place or retract an order on the OTF

and/or when deciding not to match a specific client order with other orders available in the system at a given time.66

5. Non-Discriminatory Access to Trading Venues and to CCPs [11.30] Title VI of MiFIR is particularly important in EU financial markets regulation.67 It covers clearing services of traded financial instruments and access to CCPs and trading venues. More precisely, a CCP shall accept to clear financial instruments on a non-discriminatory and transparent basis, regardless of the trading venues at which a transaction is executed.68 Similarly, a trading venue shall provide trade feed on a nondiscriminatory and transparent basis upon request to any authorized CCP that wishes to clear transactions in financial instruments that are concluded at a trading venue.69 [11.31] Despite being only tangential to the direct regulation of trading venues, these provisions are very relevant considering the evolution of the exchange business, where in many instances, as Section IV underlines, trading venues and CCPs are a part of larger financial groups wherein a parent company controls firms operating in both the trading and posttrading businesses.70 As MiFID I intended to increase competition in the trading markets, at that point in time concentrated in a handful of national exchanges, MiFID II and MiFIR intend to guarantee the competitiveness and non-discriminatory access to infrastructural services, given that exchanges have morphed into conglomerates of trading and post-trading services providers and also in view of the growing trading and clearing market for derivatives.71

III. The EU Scenario of Trading Venues [11.32] This section explores how trading venues have evolved into FMI groups over the past few years and looks at the current structure of the FMI

groups in the EU. In doing so, we first provide a general overview on the business evolution in the trading section and conclude with six case studies on the largest FMI groups in the EU.

1. The Evolution of the Trading Venues Market [11.33] Over the last twenty years the trading industry has undergone significant reforms and transformations that have contributed to reshape the system of trading venues.72 Three main factors contributed to the reorganization of the trading industry: regulation, competition, and technology. Each of these factors, at some point in time, caused industry members to evolve their business structure. [11.34] The first signs that the trading industry had significantly evolved from its historic models appeared when traditional stock exchanges changed their corporate structure: from private companies to publicly owned entities, from member-owned mutual firms to investor-owned for-profit firms.73 Opening up equity capital to investors made it easier for firms to raise fresh resources for investments. These investments became necessary to keep pace with technological innovation and the increasing competition in the markets fostered by milestone reforms such as ISD,74 MiFID I,75 and now MiFID II.76 [11.35] To face the challenges posed by the heightened active competition of new platforms, which were able to increase market shares by exploiting technological innovation and by benefiting from the opening of the market, exchanges began a season of strong corporate investments. In the last twenty years, the market for corporate control of firms operating in the trading and post-trading services boomed.77 Through mergers and acquisitions, the champions among the traditional exchanges created big conglomerates of FMIs and financial services providers. This consolidation of the ‘exchange’ industry led to the growth of FMI groups, where a group parent company has the control, via vertical or horizontal silo structure, of different types of venues (both for cash instruments and derivatives instruments), central clearing houses, settlement and custody services providers, and market information services providers.

2. A Case Study of Six FMI Groups [11.36] This section explores the scenario of trading venues in the EU. More specifically, we examine six case studies of FMI groups to show how trading venues have evolved in their organizational structure in the last twenty years creating FMI groups wherein RMs, MFTs, and CCPs coexist.78 Our case studies are: the London Stock Exchange Group (LSEG), the Deutsche Börse group (Deutsche Börse), the Euronext group (Euronext), the Bolsas y Mercados Españoles group (BME), the NASDAQ OMX Nordic Exchange (Nasdaq Nordic), and the BATS group (BATS).

A. The London Stock Exchange Group [11.37] LSEG, a UK incorporated company, is a diversified international group that operates a broad range of international equity,79 bond, and derivatives markets, including the London Stock Exchange,80 Borsa Italiana,81 MTS (Europe’s leading fixed income market),82 and Turquoise (one of Europe’s largest MTFs).83 Post-trading and risk management services are also a significant and growing component of the LSEG’s business. Cassa di Compensazione e Garanzia (CC&G)84 and LCH.Clearnet Group85 are the clearing houses operating in the group, while Monte Titoli86 and globeSettle SA87 provide settlement and custody services. The current structure of LSEG is the result of ten years of active investment campaigning. After failed attempts to merge with Deutsche Börse in 2000 and with NASDAQ in 2004,88 LSE merged with Borsa Italiana in 2007. The merger with the Italian stock exchange and the appointment of a former investment banker as CEO of the new group invigorated the investment campaign of the newly created LSEG. Starting from the acquisition of one of the largest European MTFs—Turquoise—in 2009, in 2012 LSEG expanded its post-trading information business by acquiring FTSE International Limited and then completing the creation of a vertical silo of trading and post-trading services by acquiring the majority stake in LCH.Clearnet Group Limited—one of the largest European CCPs. Finally, in 2014, Frank Russell Company become part of LSEG, expanding the business of the group to global asset management.89 In March 2016 LSEG

and Deutsche Börse negotiated a merger agreement, which—if approved by the competent regulatory and competition authorities—would result in the creation of one of the largest FMI groups in the world. A group that— among other business lines—would include five main trading venues (LSE Main Market and AIM, Borsa Italiana, Frankfurter Börse, Turquoise); two of the largest CCPs in Europe (LCH.Clearnet and Eurex Clearing); Clearstream, a leading securities and collateral depository; and three main information providers, FTSE, Russell Group, and Stoxx.90 [11.38] If we break down the revenue of the LSEG, we see that ‘capital market income’, here including both primary and secondary markets, accounts for 23 per cent of the £1,418.6m total income for 2015.91 Revenue generated by primary markets—Main Market, AIM, and Borsa Italiana (on the equity side), and Exchange Trade Funds (ETFs) and Exchange Traded Products (ETPs) market (for exchange traded products)—amounts to 26.8 per cent of the capital markets revenue; while 73.2 per cent of revenue comes from the secondary markets—equity (59.2%), derivatives (8.5%), and fixed income (32.3%).92 Post-trading services offered by the group— including both CC&G, Monte Titoli, and LCH.Clearnet—represent 33 per cent of the global income; information services represent 37 per cent; and the remaining 7 per cent comprises technology services.93 [11.39] LSEG is a publicly traded company on the London Stock Exchange. As of 2 August 2016 LSEG had four notified substantial shareholders: Qatar Investment Authority (10.3%), BlackRock Inc (6.9%), Lindsell Train Limited (5%), and Veritas Asset Management LLP (3.0%). In general terms, 79 per cent of LSEG’s capital at as 8 June 2015 was held by institutional investors and 8 per cent by market participants and hedge funds.94 [11.40] In its 2014 report, LSEG identified the broad scope of MiFID II and the issues related to the access provisions affecting trading venues, CCPs, and benchmark providers, and acknowledged that is likely that almost all aspects of group operations will be affected to some degree by the MiFID II implementation. However, while in the process of waiting for the implementation of the Level 2 regulation, they cannot quantify the impact of the reforms on the group’s activities. The areas of biggest

regulatory development that will affect the group are the market structure measures aimed at promoting integration, competitiveness, and efficiency in the financial markets, namely the rules on non-discriminatory access to trading venues and CCPs.95

B. Deutsche Börse Group [11.41] Deutsche Börse AG is Europe’s largest exchange group for capitalization and it is an integrated provider of products and services covering the entire process chain of securities and derivatives trading and post trading.96 [11.42] Trading services (equity and derivatives) within the group are offered by the Frankfurter Börse, the German stock exchange, which operates through the Xetra electronic trading platform; and by the Eurex group, fully owned by Deutsche Börse, which operates a Eurex derivatives exchange, two MTFs (Eurex Bonds and Eurex Repo), and ISE, a US-based derivative exchange. [11.43] Of the group’s €2,367m total income for 2014, 51 per cent was represented by trading and clearing revenue (of which 8% represented the Xetra equity trading segment and 43% the Eurex derivative trading and equity and derivatives clearing); 32 per cent of the total income derived from the post-trading services offered by Clearstream (the fully owned posttrade settlement and custody provider). The commercialization of market data and market infrastructure technology accounted for 17 per cent of the group’s total income. [11.44] As for its shareholder structure, 94 per cent of shares in Deutsche Börse are held by institutional investors and 6 per cent by private investors.97 [11.45] Deutsche Börse fully owns Eurex group and its subsidiary Eurex Clearing AG, the group-owned clearing house, which exclusively carries out the central counterparty service of the group’s trading venues. Eurex Clearing is designated to clear all transactions executed on the group’s

exchanges and MTFs (general clearing conditions), but also provides clearing services to a non-group market, the Irish stock exchange.

C. Euronext Group [11.46] Euronext is a pan-European exchange group, offering trading services with multiple markets for equities, fixed income securities, and derivatives.98 Euronext holding was created in 2000 after the merger of the Dutch, French, and Belgian exchanges into a single cross-border entity. In 2002 the Portuguese stock exchange and the London-based London International Financial Futures and Options Exchange (LIFFE—a derivatives market) were acquired by Euronext. In 2007 the New York Stock Exchange—interested in expanding in the derivatives trading segment of Euronext—merged with Euronext, creating the first transatlantic exchange, called NYSE Euronext. In 2012, the Intercontinental Exchange (ICE), the leading network of regulated exchanges and clearing houses for financial and commodity derivatives markets, interested in LIFFE and in expanding its share in the European derivatives markets, acquired NYSE Euronext. Two years later, Euronext was spun off from ICE (with the exception of LIFFE) and listed again in Europe, reviving as a stand-alone exchange group. During the initial public offering of the new Euronext, a consortium of eleven investors took the lead in acquiring a significant holding in the new company (33.36%).99 [11.47] Differently from LSEG and Deutsche Börse, which developed their business as integrated vertical silos, Euronext grew via a horizontal integration, by focusing on trading activities on different products (both cash and derivatives) in different jurisdictions, but outsourcing the posttrading services. Of the €458.5m revenues in 2014, 50 per cent came from the equity and debt (cash) markets (14% listing fees and 36% cash trading); the derivatives trading markets represented a modest 10 per cent of the total income, with post-trading clearing and settlement services reaching 13 per cent. The sale of market data and indexes accounted for 20 per cent of all the revenues.100

[11.48] The post-trading services within Euronext are outsourced from the group to major CCPs. Clearing is provided by LCH.Clearnet SA (part of the LSEG), while settlement is offered by Euroclear (the leading custody and settlement provider), and, for Euronext Lisbon, by Interbolsa, the fully owned Portuguese Central Securities Depository.101

D. Bolsas y Mercados Españoles Group [11.49] In Spain, BME manages all the trading and post-trading infrastructures of the country, except for the futures exchange—Sociedad rectora del mercado de futuros del aceite de oliva SA.102 [11.50] BME is structured as a vertical silo; the BME holding group was founded in 2001 in order to consolidate the four regional exchanges (Bolsa de Bilbao, Bolsa de Valencia, Bolsa de Madrid, and Bolsa de Barcelona); the four stock exchanges’ governing companies also own 25 per cent each of Sociedad de Bolsas, SA, which manages and operates the Spanish electronic trading platform (SIBE).103 BME, in addition to being the operator of the four regional exchanges, is the market operator of two MTFs: Mercado Alternativo Bursátil (the market segment for SMEs) and Latibex (the market for European investors to trade euro-denominated Latin American stocks).104 [11.51] Furthermore, looking at the non-equity venues, the Mercado de Renta Fija, SA operates a regulated market and two MTFs in the fixedincome segment, while in the derivatives area BME is active through the MEFF Exchange, which manages the derivatives exchange. [11.52] Post-trading clearing services (for the moment only for derivatives and repos) are provided by BME clearing, SA, the group’s fully owned clearing house, which was set up in 2013 after the implementation of EMIR, and the consequential segregation of trading activities and clearing activities in two separate legal entities. Finally, settlement services are managed by Iberclear, which operates as a CSD for equities and bonds and offers trade reporting services.105

E. NASDAQ OMX Nordic Exchange [11.53] Nasdaq Nordic is a fully owned subsidiary of Nasdaq Inc, and manages and integrates through a single platform the stock exchanges of the Nordic and Baltic countries.106 It operates these venues as well as MTFs under a single rulebook for listing, equity, and derivatives trading; and offers, through First North, a growth market, designated for small and growing companies.107 [11.54] Nasdaq Nordic is also active in the management of post-trading infrastructures: it operates CSDs in Estonia, Latvia, Lithuania, and Iceland, and furthermore runs the group’s clearing house, Nasdaq Clearing AB, an investment company incorporated under Swedish law, which provides clearing services to Nasdaq Nordic markets. Every Nasdaq national market is authorized and supervised by the competent national authority. Nasdaq Inc. also controls Nasdaq NLX, a London-based MTF for trading interest rates derivatives. The trades executed on NLX are cleared trough LCH.Clearnet.108

F. BATS Group [11.55] BATS Global Markets is an international trading group specializing in the management of US and European exchange infrastructures.109 BATS is a privately held company owned by a consortium of banks and other investors.110 Founded in 2005, BATS is recognized and supervised by the SEC and provides trading services in the US as a registered national securities exchanges for the US equity markets.111 In 2011, BATS acquired Chi-x, the first established European MTF, which merged with BATS European MTF and became BATS Chi-x, a fully owned subsidiary of BATS Global Markets, which is currently one of the biggest European equity markets. [11.56] BATS Chi-x maintained the qualification of MTF until 2013, when it was recognized as an RM by the FCA, becoming the first panEuropean RM, offering trading services across fifteen European national markets over one platform and under one rule book.112

[11.57] In January 2012, BATS Chi-x adopted a user-driven model for clearing activities, providing CCPs’ interoperability options to its customers. Traders on BATS Chi-x may choose one of three different counterparties to clear their trades: LCH.Clearnet (the LSE majority-owned CCP), SIX x-clear (the CCP owned by SWZ, the Swiss stock exchange), and EuroCCP NV (where Bats Chi x holds an ownership interest of 25% and is also represented on the board).113

IV. FMI Groups in an MiFID II World 1. Formation of Pan-European Groups [11.58] The scenario that emerges from the analysis of the European trading venues is the result of market trends towards integration—at a firm level—and consolidation—at a geographical level. [11.59] After the de-mutualization and privatization of the historical exchanges, trading venues became active players in the markets. By going public and attracting new investors, venues were able to raise funds and expand their lines of business. New venues were also created, often at the initiative of banks and other intermediaries, with the effect of increasing competitive pressure on the incumbent exchanges. Regulation supported this market transition and played a central role in shaping the environment for structural changes. The injection of competition into the trading venues scenario and into the clearing markets operated by MiFID I114 and EMIR,115 and the necessity of stock exchanges to foster greater efficiency in their activities, resulted in trading venues updating their business models, structures, and governance, and integrating their trading and post-trading services. [11.60] Facing competition from new trading markets players, venues soon joined the new and growing segment of alternative trading systems— either by directly setting up their own MTFs or by acquiring existing ones.

Furthermore, they horizontally integrated cash and derivatives trading platforms. [11.61] In an alternative process, venues vertically integrated their trading activities with the post-trading businesses of CCPs and CSDs, offering their clients the whole chain of trading and post-trading services, and actual FMI groups. [11.62] In the aftermath of the financial crisis and the introduction of mandatory central clearing for OTC derivatives, the business structure of these groups shifted significantly. The FMI groups realized the potential of the clearing business—especially for derivatives—and, facilitated by the non-discriminatory access and interoperability policies enforced by the authorities, made their clearing activities one of the most profitable lines of their groups. Similarly, by taking advantage of their position as FMI operators they expanded their market information (indexes, market data statistics, real time data, regulatory news services, etc.) and technology businesses (trading platforms, settlement software, etc.). [11.63] In fact, it seems at the European (and in some ways also at the transatlantic) level, FMI groups have morphed into pan-European ventures, offering cross-border trading and post-trading services across different jurisdictions. [11.64] With this background in place, this section moves to question the current structure of the trading industry. First, MiFID II has impacted the industry by fostering competition with the introduction of a new class of multilateral trading venues, the OTF. How will this reform impact the current structure of the EU securities and derivatives markets? Second, trading venues have evolved into FMI groups with a systemic role; so it is important to consider what risks they pose to the financial system and what tools the authorities have to monitor them.

2. The OTF in FMI Groups

[11.65] MiFID II will reshape the trading landscape by introducing a new actor, the OTF. The set of rules on OTFs (Title III MiFID II), mandatory trading of derivatives (Title V MiFIR), and non-discriminatory access to CCPs and trading venues (Title VI MiFIR), represents the ‘crisis-driven’ pieces of regulation in the MiFID Review and completes the reform of the OTC derivatives market started by EMIR. [11.66] EU regulators, implementing the international guidelines set by the G20 in Pittsburgh in September 2009,116 which were then expanded by the Financial Stability Board to mandatory trading for OTC derivatives,117 opted for the creation of a more flexible form of venue as a marketplace for eligible derivatives (OTF trading activities would also include bonds, structured finance products, and emission allowances).118 The market operator or investment firm managing an OTF will have to provide the competent authority with a detailed explanation of why the trading system cannot be operated as an RM, MTF, or SI.119 [11.67] At the current stage, it is difficult to assess how markets are going to react to this new trading venue and how OTFs will be able to capture a relevant share of OTC trades. It is worthwhile to note that the International Swap and Derivatives Association (ISDA) welcomed the establishment of the OTF category.120 Furthermore, in the US, the Dodd–Frank Act introduced a new player in the trading landscape.121 Essentially, the Act established the swap execution facility (SEF)—similar to the European OTF—to provide trading services for derivatives. In the US, since the introduction of the secondary level regulation by the Commodity Futures Trading Commission, twenty-three SEFs have registered.122 [11.68] Because of the relevant role that derivatives clearing plays in FMI groups, it is very likely that the existing groups, which in many instances already offer trading services for more standardized derivatives on RMs or MTFs, will expand their trading business to the operation of OTFs. From the end of 2017, eligible derivatives will be required to be centrally cleared. At that time, centrally cleared derivatives that are today mainly traded and executed OTC will have to find a regulated locus for trading. The growth of OTFs within the current FMI groups is a very likely outcome.

3. Challenges of FMI Groups to Regulators [11.69] The trading venues environment has evolved a great deal over the last twenty years. From monolithic national stock exchanges, firms evolved into cross-border multi-business entities. The trading business has been integrated with post-trading services like clearing, settlement, and custody. Firms have expanded their market shares in the data and information market and in the IT trading and post-trading services. Having a look at the lines of business that primarily contribute to the profits of FMI groups, the role of the traditional trading business is generally relatively modest, compared to the growing weight of clearing activities and information and technologies services. [11.70] FMI groups are cross-border multi-business entities with a silo structure—either vertical or horizontal—and mostly run as unitary enterprises. The parent company—in the majority of the instances a listed company—is either a holding or a market operator, owning a controlling participation or full ownership of different lines of business, each operated as separate legal entities, often located in multiple jurisdictions. Primary listing markets, trading venues (both RMs and MTFs), CCPs, CSDs, and information services and IT services companies all coexist in the FMI group, where the parent company pulls the strings, setting the strategy and business plans for the whole group. [11.71] The evolution of stock exchanges into FMI groups is a relevant trait of the evolution of financial markets in the last twenty years and raises important challenges to financial regulators and competition authorities. First, FMI groups can potentially distort competition in the chain of trade and post-trade services. Increasing the clearing costs for transactions not traded in the group’s venues, or even blocking the access to clearing for the very same transactions, requiring contracts traded in the group’s venues to be centrally cleared in the group’s CCP, are examples of how FMI groups might distort competition in the financial markets. [11.72] Second, FMI groups are systemic institutions, not just for their size, but mainly for their structural/social role in providing a primary service for the smooth functioning of the financial markets. A situation of

financial distress in an FMI group might cause systemic disruption and undermine financial stability.

4. MiFID II’s Approach to FMI Groups [11.73] Does MiFID II acknowledge the potential risks connected to the activities of FMI groups? Do MiFID II and MiFIR (or EMIR) offer specific ‘tools’ to deal with FMI groups? The answer to these important questions is rather short. MiFID II does not explicitly take the FMI group into account. Trading venues are regulated as individual entities, which may or may not be operated within groups. The same is true for CCPs under EMIR. The fact that trading and post-trading services can give rise to a common enterprise within FMI groups is left in the background of EU financial regulation. [11.74] This could be explained historically, by arguing that trading and clearing have always been regulated differently; the first within securities regulation, the second more in the domain of banking and financial regulation because of the systemic implications of clearing activities. It is also possible that because the regulators are different—securities authorities for trading services, central banks for clearing and similar services—they want to keep their regulatory turfs separate. An additional explanation could be that governments and regulators want to avoid the joint exercise of trading and post-trading services within an individual enterprise, as this could cause mutual contamination with serious systemic consequences. From this perspective, keeping the relevant activities separate, under different regulatory and supervisory umbrellas, is a kind of ring-fencing of each area of activity, clearing in particular, which is more likely a cause of systemic concern. [11.75] However, the present EU regulation is not totally blind to the existence of FMI groups, and includes some tools which may prevent some types of contamination amongst trading, post-trading, and other activities when exercised in a group context. As shown in the following subsections, three sets of rules allow, to varying degrees, for the partial tackling of some of the potential risks underlying FMI groups, despite the fact that they are not specifically considered by MiFID II or MiFIR.

A. Conflicts of Interest [11.76] The first set of rules looks into the conflicts of interest that might arise in those situations where an investment firm or market operator runs an MTF or an OTF. In this scenario, the market operator or investment firm shall have arrangements in place to clearly identify the conflicts of interest between themselves, their owners, and the trading venue and its sound functioning; and manage the potential adverse consequences of these conflicts for the operation of the relevant venues or for their members or participants or users.123 This will require the individual firm within an FMI group to ring-fence the operation of its trading venue or venues, so as to avoid contamination of their sound functioning from conflicting interests found either in the same firm or within the FMI group to which the firm belongs. Similarly, RMs could be subject to the same set of rules on conflicts of interest prevention, which require clear identification and management of the potential adverse consequences of any conflict of interest between the RM, its owners, or its market operator, and the sound functioning of the RM. Assuming that in the same FMI group there are all three types of trading venues, the group’s market operators operating RMs, MTFs, and OTFs (and investment firms only for MTFs and OTFs) shall have in place effective arrangements to prevent and/or manage conflicts of interest arising between these different venues, their owners, and operators.124 However, no specific provisions of MiFID II look into the dynamics of conflicts of interest between the trading and post-trading activities within the FMI group.

B. Transparency of Ownership and Suitability of Shareholders [11.77] The second set of rules targets transparency in the shareholders structure. Regulators impose a disclosure regime on venues with regard to the ‘persons’ exercising particular influence on the management, qualifying shareholders, and connections between trading venues. The investment firms and market operators operating an MTF or an OTF are required to provide the competent authority with a detailed description of the functioning of the MTF or OTF, including any links to or participation by a

regulated market, an MTF, an OTF, or a systematic internalizer owned by the same investment firm or market operator, and a list of their members, participants, and/or users.125 Investment firms operating MTFs or OTFs as well as market operators of RMs have to disclose the competent authority all information regarding the ownership of the trading venue and of the investment firm/market operator.126 [11.78] Moreover, in the case of RMs, the persons who are in a position to exercise, directly or indirectly, significant influence over the management of the venue must be suitable.127 The same requirement applies to an investment firm intending to operate an MTF or OTF.128 Similar provisions have an impact on group structures, particularly when the venue is operated by a subsidiary of an FMI group and the executives of the parent company influence its management by determining the strategies and taking other key decisions.

C. Rules on Access [11.79] The third set of rules spots the risks connected to potential distortive effects that having an FMI group might create in the trading and post-trading market. These risks were exacerbated by the post-crisis reform of the OTC markets, which introduced mandatory trading and clearing for derivatives. EU policymakers addressed this point by focusing on the access to trading venues and CCPs.129 As mentioned earlier, these rules intend to foster competition between venues and between CCPs and support nondiscriminatory access to essential infrastructural financial services.130

5. Consolidated Supervision? [11.80] While addressing competition issues, MiFID II does not include provisions for the prudential regulation and supervision of FMI groups. As argued above, trading venues (and CCPs) are regulated as ‘ring-fenced’ stand-alone legal entities, each of them subject to prudential regulation and supervision. The trading venues within an FMI group, as well as their

market operator or investment firm operating the venue, are regulated under the national rules implementing MiFID II. When based in different countries, the regulators of these countries will supervise the trading venues and their operators under the rules implementing the ‘Obligation to cooperate principle’ stated in the Directive (Article 79).131 The same holds for CCPs under EMIR. As a result, FMI groups find themselves subject to multiple regulators, each supervising one or more of the entities composing the group. [11.81] Despite their systemic relevance as integrated enterprises, FMI groups are not subject to consolidated supervision. Regulators may, in practice, take a holistic view of their activities and supervise individual entities as part of a larger group, as they are well advised to do. However, this approach is not mandated by EU law, even though fragmented provisions of MiFID II and MiFIR hint at the need to consider individual entities operating trading venues as linked to other entities within a group, which may create the potential for conflicts of interest in the management of trading venues or for external influence in the strategy and business plans of individual entities in the FMI group. Also, their internal control and risk management systems should be centralized under company law and best practices of corporate governance, but similar requirements for an integrated risk-management system at group level are not foreseen by financial regulation. [11.82] A comprehensive consolidated approach to the supervision and regulation of FMI groups is lacking. The cross-border reach and the multibusiness span of FMI groups’ activities challenge the current regulatory and supervisory architecture of the European financial markets. This could generate problems, to the extent that the crisis of an entity within the FMI group could reverberate onto other entities of the same group, which also highlights the possible need for crisis-management systems, including recovery and resolution plans, at the FMI group’s level. After surveying the financial industry’s regulatory landscape, we spotted two regulatory responses to cross-border and multi-business ventures that might be considered as possible models to deal with the FMI groups phenomenon: the supervisory colleges of CCPs in EMIR and the Financial Conglomerates Directive.

[11.83] Under EMIR, when a CCP’s members are established in different member States and the potential default of a CCP might have cross-border effects, all relevant competent authorities and ESMA are involved not just in the supervision, but also in the authorization process of the CCP, with ESMA playing a coordination role in the ‘college of supervisors’, guaranteeing the consistent and correct application of EU law.132 The composition of the colleges reflects in some ways the indirect acknowledgement of EU regulators of the infrastructural role of CCPs. Supervisors of the CCP sit together with the supervisors of the entities which operate with the CCP: clearing members, trading venues, interoperable CCPs, and central securities depositories.133 [11.84] The Financial Conglomerates Directive provides the first comprehensive supplementary supervisory framework for financial groups operating multiple businesses in different sectors of the financial markets and across borders.134 Recognizing the systemic role of financial conglomerates, the Directive sets in place mechanisms to ‘enhance the prudential soundness and effective supervision of financial conglomerates’.135 To achieve this result the Directive builds a supplementary supervisory framework for financial conglomerates. The financial conglomerates regime has three peculiarities that make it a feasible regulatory solution to be considered for FMI groups. First, the Directive introduces a supplementary layer of supervision for financial conglomerates that is built on top of—and does not substitute—the sectorial supervisory and regulatory regimes of the individual financial activities within the conglomerate. Second, the Directive acknowledges that even though financial conglomerates are often managed on a business line basis, a crucial role is played by the holding company, whose management should be monitored and subject to specific conduct requirements. Finally, coordination should be ensured among the regulatory and supervisory entities involved in the oversight of the financial conglomerate, with an authority acting as a ‘coordinator’.136 [11.85] As financial conglomerates, FMI groups are multi-business and cross-border entities playing a systemic role in the financial markets; as CCPs, the business of FMI groups directly affects many stakeholders’ interests. For these reasons, prudential supervision of FMI groups on a

group-wide basis would be desirable to more effectively assess: the financial stability of the group; risk concentration and intra-group transactions; and internal risk-management processes and sound management at a conglomerate level. Furthermore, more coordination among authorities responsible for the supervision of the sectorial businesses within the conglomerate should be achieved. Two paths could be followed: the college approach—adopted for the supervision and authorization of CCPs under EMIR—has the benefit of creating a single forum where multiple regulatory and supervisory agencies meet. The coordinator solution—adopted for financial conglomerates—empowers the competent authority of the most relevant entity of the group to coordinate the gathering and dissemination of information on the conglomerate and to oversee and assess the financial situation, compliance, organization, and internal control of the financial conglomerate. A mix solution, which would combine elements of both the college and coordinate regimes, would be a desirable regulatory solution to the current regulatory gap, and a stronger role of ESMA could be envisioned.

V. Conclusion [11.86] MiFID II brings modest changes to the EU landscape of trading venues. The newly introduced OTFs are going to be the reference venues for a significant portion of derivatives trading in years to come. The RM and MTF regimes have been aligned, and specific provisions strengthen the governance of the venues and their operators. However market dynamics are already challenging the MiFID II regulatory framework for the governance and organization of trading venues. Trading venues have developed over the last twenty years into FMI groups that provide both trading and post-trading services. These new conglomerates test the capacity of the current regulatory and supervisory regime of financial markets—and MiFID II itself—to oversee their activities and to guarantee competition and stability in the trading and post-trading industry. MiFID II does not explicitly take FMI groups into account—trading venues are regulated as individual entities, which may or may not be operated within a group. In MiFID II, only three sets of rules address, to varying degrees,

some of the potential risks underlying FMI groups: conflicts of interest between firms operating RMs, MTFs, and OTFs; transparency of ownership of trading venues and suitability of trading venues’ shareholders; and, finally, non-discriminatory access to trading and post-trading services. However, prudential regulation and supervision of the FMI group has not been included in the MiFID review process. This regulatory gap might be a threat to the stability of financial markets, and regulators should consider a regulatory intervention to fill it. The experience of the regulatory and supervisory colleges of CCPs under EMIR and the regulatory framework of the Financial Conglomerates Directive could be two possible ways to strengthen the oversight of FMI groups.

1

European Parliament and Council Directive 2004/39/EC 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 (MiFID I) [2004] OJ L 145/1; see also 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 organizational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive [2006] OJ L241/26; European Commission Regulation (EC) 1287/2006 of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards record-keeping obligations for investment f