On 5 October, ESMA published its consultation on product governance guidelines under MiFID 2. MiFID 2 seeks to protect investors better by regulating each stage in a product's lifecycle. Its provisions on product governance cover not only the "traditional" MiFID investment products but also structured deposits.
What is the purpose of the proposals?
ESMA says several stakeholders have asked it to clarify how the MiFID 2 requirements should be implemented and applied. It notes that the onus on ensuring firms comply with the requirements is on national regulators, and stresses expectations on firms must be proportionate to each firm's business, but nevertheless hopes the guidelines can help firms to meet their regulators' expectations.
ESMA is of course not new to this type of guidance – it, together with the other ESAs, has already published its position on manufacturers' product oversight and governance processes, and has published its opinion on good practices for product governance arrangements for structured retail products.
What are ESMA's proposals in this consultation?
In line with the Level 1 proposals, the guidelines address the requirements on each of manufacturers and distributors.
Guidelines for manufacturers
ESMA has set out six categories that it suggests manufacturers use to define the target market for their products. Although the categories appear, on the face of it, to be very detailed, ESMA recognises that manufacturers may often not have direct client contact and so its target market identification may be abstract and not based on individual client information. It also notes that, although there will inevitably be overlaps between the product design and governance process and suitability and appropriateness assessments on distribution, the two demands are separate. On this basis, ESMA recommends these categories form the minimum basis for assessment, with manufacturers encouraged to add more, better focused, ones. It also notes manufacturers can focus on the type of clients who need most protection while still offering the relevant product to more sophisticated clients.
- type of client at whom product is targeted
- knowledge and experience
- financial situation, in particular a client's ability to bear losses
- risk tolerance and compatibility of the risk/reward profile of the product with the target markets
- clients' objectives
- clients' needs.
ESMA also notes that the depth of assessment should be proportionate to the nature of the product, and that the manufacturer should define its distribution strategy with the target market in mind – and this should also allow the manufacturer to propose to distributors the manner in which the product should be acquired (specifically, whether it should be sold on an advised basis, and what channels are appropriate).
Guidelines for distributors
ESMA groups its distributor guidelines into several more granular sections (and, again, notes the need for a proportionate approach):
- that distributors should have in place product governance decisions that affect all their business generally, before considering individual products and clients
- that distributors should essentially use the same six categorisations as manufacturers for identifying the target market, but because they know the customers better, they should be able to assess a more concrete target market
- while investors may often require a diversified portfolio, whether a particular product is suitable for their individual needs will come at the individual point of sale – and at this point, it may be that the distributor recommends a product for which the investor is not in the target market. The purpose of product governance is around what in principle should be the target market for the product
- the need for the distributor to consider the manufacturer's distribution strategy, which may not mirror its own – particularly if the manufacturer is outside MiFID 2. Using products of non-MiFID 2 manufacturers will place additional burdens on distributors to conduct due diligence on the products and their target markets
- the need, in principle, to assume any product manufactured before MiFID 2 takes effect has not been assessed in accordance with its product governance requirements – at least until a review has taken place. MiFID 2 requires, in any event, that there be a regular review by both manufacturer and distributor.
The negative target market
The final part of the guidelines addresses the "negative target market". ESMA notes there will often be both a positive target market for a product and a market to which the product should not be sold. However, there will often be a grey area in between, where products may in some individual instances be suitable for selling outside the defined positive market, and in other instances should not be sold.
Finally, the guidelines look at how the categorisations could be adapted where professional clients and ECPs are end-clients.
How do the proposed guidelines compare to the level 1 requirements?
As explained above, ESMA has taken a particular angle on the Level 1 requirements, choosing to focus on the "target market assessment", which is a part of the Level 1 provisions. The Level 1 provisions, embellished in the Level 2 MiFID 2 Delegated Directive set both the fundamental requirement for product governance obligations for both manufacturers and distributors, and note several topics that are relevant in any assessment. ESMA feels that by choosing to focus on the target market assessment it can help significantly towards a common, uniform and consistent application of the legislative requirements.
What impact will the guidelines have on manufacturers and distributors of financial instruments?
The level of impact will depend to a large extent on the current practices of manufacturers and distributors, and the complexity of their respective product and customer bases. For the riskier products, and those which have traditionally caused significant losses or mis-selling scandals, firms will have an extra reason to assess the circumstances in which it is safe to offer the products. For firms that manufacture and sell plainer products, the guidelines should be less onerous.
How do these proposals differ from existing practice?
As is increasingly the case with EU measures, the proposals (and the underlying MiFID 2 requirements) will affect relevant firms to a different extent in different jurisdictions. In the UK (some might say ironically), the FCA and before it the FSA have been aware of the risks of unsuitable products and distribution processes for many years. Its Regulatory Guide on the Responsibilities of Providers and Distributors for the Fair Treatment of Customers (RPPD) has been around for nearly 10 years, and there have been many more recent thematic reviews and guidance, including FG12/09 on structured product development and governance. Added to which, UK firms are well aware of the risks (and indeed the restrictions) on selling certain products to certain markets. So, while UK firms will need to carry out a gap analysis to assess where the MiFID 2 requirements and ESMA proposals do not exactly match the rules and guidance they currently take into account, they will have less fundamental work to do than firms from jurisdictions which have no current equivalent.
What are the next steps?
ESMA has asked for comments by 5 January 2017, and then plans its final report in mid-2017. This should coincide with the date on which Member States are publishing their final transposition measures for MiFID 2.
How should lawyers and their clients prepare for the proposed changes?
Preparing to comply with ESMA's proposed guidelines should be factored into firms' MiFID 2 preparations. Most firms should by now have started a detailed gap analysis of their current policies and procedures against what MiFID 2 requires. Changes that go to the heart of the customer experience are likely to take significant time to plan and embed, to be ready for compliance in January 2018. In this, and in many other areas of compliance, firms can work with their professional advisers to assess the areas of their business that will require most attention and devise a plan to address the new requirements.