The implementation of MiFID II
The development of financial services legislation at the European level and its transposition into Irish continues to present opportunities and challenges in Irish financial services. This note provides a brief overview of recent regulatory developments with consequences for investment funds and investment firms respectively. An analysis is provided of the changes to the Irish regulatory market likely to be ushered in by the implementation of the Markets in Financial Instruments Directive II (“MiFID II”). Further, a short summary of the key provisions of the Alternative Investment Fund Managers Directive (the “AIFMD”) is provided which came into effect on 1 July 2011 and was transposed in Ireland on 16 July 2013.
The aim of MiFID II is to introduce new post-financial crisis conduct of business requirements and seek to improve the transparency, stability, and regulation of the financial markets. MiFID II aims to tighten rules on the derivative markets to curb speculative investment and protect investors’ interests. The changes reflect fears that speculative commodity trading has affected the price of staple goods. MiFID II also introduces a new category of trading venue called organised trading facilities (“OTF”) for non-equity instruments. It aims to push the trading of standardised derivatives onto visible regulated venues such as a multilateral trading facility.
MiFID II will also extend the scope of the original directive to cover more firms. For example, a wider range of commodities firms will be covered than is the case at present and certain data providers will fall within the scope of the regulation for the first time.
MiFID II will also introduce consumer protection rules governing the distribution of insurance-based investment products by amending the Insurance Mediation Directive 2002/92/EC. A Recital to MiFID II explains that this amendment is being made in order to deliver consistent protection for retail clients and ensure a level playing field between similar products. MiFID II defines an insurance-based investment product as “an insurance product which offers a maturity or surrender value and where that maturity or surrender value is wholly or partially exposed, directly or indirectly, to market fluctuations”. This indicates that an insurance-based investment product for these purposes would need to include an investment component that is expected to provide a variable rate of return. This would be likely to cover investment-based insurance products such as unit-linked and index-linked contracts, fixed index annuities, and variable annuities.
The European Securities and Markets Authority (“ESMA”) will have powers under the MiFID II to prohibit or limit the marketing and distribution of certain types of financial instruments in particular circumstances, and the European Banking Authority may have similar powers in relation to structured deposits.
The conduct of business requirements is modified in order to grant additional protection to investors. The rules for investment advice are improved both when advice is provided on an independent basis and in the long term. Advisers declaring themselves as independent will need to match the client’s profile and interests against a broad array of products available in the market and say whether they will provide the client with a periodic assessment of the suitability of advised products.
In a fundamental development, it is also proposed to permit third-country firms (i.e. non-EEA firms) that wish to provide cross-border investment services across the EEA to do so on the basis of a “passport”. Under the proposals, the passport will be exercised either:
- Establishing an EEA branch which will be mandatory if the intention is to deal with retail clients and professional clients within the meaning of Section II of Annex II to the Directive (clients who request to be treated as professional clients) and gain authorisation for the branch; or
- By becoming licensed by an EEA competent authority to provide services from outside the EEA on a cross-border basis (this is possible where the firm only intends to provide services to professional clients within the meaning of Section I of Annex II to the Directive (deemed professional clients) and eligible counterparties).
In the second case, the non-EEA firm must pass an equivalency test to be devised by the Commission. It is also envisaged that persons within the EEA will be able to receive services cross the border from non-EEA firms that are not authorised in the EEA where the person in the EEA requests services from the non-EEA firm at their “own exclusive initiative”, i.e. on an unsolicited basis. The proposed new regime for non-EEA firms will inevitably lead to a re-write of the cross-border business “safe harbour” in Regulation 8 of the MiFID Regulations and the introduction of a formal “unsolicited business” exemption.
ESMA is now faced with the challenge of translating the MiFID II requirements into practically applicable rules and regulations. The process began prior to MiFID II’s publication in the Official Journal on 12 June 2014.
AIFMD applies to Alternative Investment Fund Managers (“AIFM”) based inside or outside of the European Union who are involved in managing EU-based funds or who wish to market funds to professional investors in the EU. The AIFMD was transposed in Ireland on 22 July 2013 and Ireland was the first country to accept applications for authorisation as an AIFM. Notably, Ireland offers somewhat of a ready-made solution to many of the issues arising from the AIFMD’s introduction. A self-managed qualifying investor alternative investment fund (“QIAIF”) may apply for authorisation as an AIFM and may delegate its investment management functions to either an EU or non-EU investment manager.
The AIFMD requires that any fund manager who is regularly involved in the management of AIFs within the EU is subject to authorisation or registration with a competent authority within the EU. The AIFMD provides that each Alternative Investment Fund (“AIF”) must have a single AIFM, which is responsible for ensuring compliance with the AIFMD. The legislation itself is broad and essentially all AIFMs fall within the scope of the AIFMD with the exception of managers located outside of the EU who manage non-EU funds that are not marketed to EU investors. The AIFMD creates harmonised requirements for both the structure and the operation of AIFMs and in turn permits AIFMs to avail of a passport to market AIFs to professional investors across the EU and to manage AIFs domiciled outside of the AIFM’s home member state.
There are a number of significant provisions set out by the AIFMD. Some of the most noteworthy aspects of the AIFMD include:
- As regards marketing provisions, an AIFM can only market an AIF to investors within the EU if the AIFM is authorised by a relevant EU regulator or is compliant with national private placement regimes. The AIFMD provides a framework for marketing to professional investors and no passport exists for marketing to retail investors.
- Under the AIFMD, each AIF managed by an AIFM must have a single depositary appointed to it. This depositary may be an EU credit institution, an EU investment company or a UCITS depositary. However, the depositary may not be an AIFM. It is required that the registered office or branch of the depositary of an EU AIF must be in the AIF’s home Member State. In situations where the depositary is established in a third country, there is a requirement that cooperation and information exchange agreements are in place between the supervisor of the depositary, the regulator of the AIFM and the regulator in each Member State where the AIF is to be marketed. Regulation and supervision to the same effect as that under the EU must be in place.
- It is required that the AIFM sets a maximum level of leverage for each of the AIFs it manages. The levels set must be reasonable and this must be demonstrable to its regulator. The maximum level of leverage set must be complied with and the risks of the leverage employed by the AIFM are subject to assessment by the regulator.
- The AIFMD requires that where any functions of the AIFM are delegated, the regulator must be notified. The delegation structure must be objectively justifiable and any delegated services must be reviewed by the AIFM. Where the AIFM wishes to delegate any risk management or portfolio management functions it is required to do so only to regulated entities and any such delegations are subject to prior authorisation by the regulator. The AIFMD seeks to combat ‘letterbox entities’ and conflicts of interest are strictly monitored. Any delegate must be sufficiently experienced, have sufficient resources and hold a good reputation.
- Valuation functions may be carried out either by the AIFM or an appointed external valuation agent. The AIFMD requires both competence and independence for any personnel who perform a valuation. Prior to the AIFMD, responsibility for the valuation procedures and AIF’s resided with the board of directors of that AIF. The board can retain this responsibility under the AIFMD as a self-managed AIF or where an external entity is appointed as AIFM, that entity will assume the responsibility for this function.
The marketing passport is automatically available to all EU AIFMs managing EU AIFs. This passport does not however become available to non-EU AIFs until at least two years after transposition to national law, in the case of Ireland around July 2015. Where a non-EU manager intends to avail of the passport they will have to apply for authorisation from their member state of reference (“MSR”). The MSR should be where the AIFM intends to develop effective marketing.