A closer look at the inducement regime for fund managers in Cyprus
Xenia Kalogirou of Elias Neocleous & Co discusses the inducement rules for fund managers in Cyprus and the impact of restrictions on inducements for asset management
The recast Markets in Financial Instruments Directive (2014/65/EU) (MiFID II) and the Markets in Financial Instruments Regulation (Regulation (EU) 600/2014) (MiFIR), along with other pieces of EU legislation, set out a harmonised EU framework for the regulation of investment services and activities.
Generally, AIFMs and UCITS ManCos are exempted from the scope of application of MiFID II. However, certain MiFID II rules apply to those managers of collective investment undertakings which perform non-core ancillary MiFID services, in addition to the collective portfolio management activities. With reference to the investment management, separate legal framework applies on inducements as further analysed herein.
This article sheds light on the restrictions on inducements which for the past years have transformed the European market for asset management.
Inducement rules under MiFID II
The inducement rules (the ’MiFID Inducement Rules’) are set out under the MiFID II provisions on operating conditions and investor protection. Those rules have been transposed into Cyprus law by the ‘Investment Services and Activities and Regulated Markets Law 87(I)/2017’ as amended (the ‘IF Law’) via Article 24 (1) and Article 25 (1), (7), (8) and (9) and Article 28 (2).
MiFID II Commission Delegated Directive 2017/593 (the ’Delegated Directive’), supplements MiFID II with regard to, amongst other things, inducement restrictions.
In harmonisation with the Delegated Directive, the Cyprus Securities and Exchange Commission (CySEC) has issued the ‘Directive DI87-01 for the Safeguarding of Financial Instruments and Funds belonging to Clients (Replacing RAD 360/2017)’ which fully transposed the provisions of the Delegated Directive (the ‘CySEC Directive’). In particular, Part IV of the CySEC Directive focuses on inducements with successive articles dealing with inducements generally (Article 13), inducements regarding the investment advice on an independent basis or portfolio management services (Article 14), and inducements in relation to research (Article 15).
Relevant provisions are also included in the Commission Delegated Regulation (EU) 2017/565 supplementing the Delegated Directive.
Furthermore, the European Securities and Markets Authority has issued a Questions and Answers document on MiFID II and MiFIR investor protection and intermediaries topics which provides clarity on the application of the inducement rules.
Inducement rules for fund managers
Under Article 109 (6) of the ‘Open-Ended Undertakings for Collective Investment (UCI) Law 78(Ι)/2012’ as amended, it is stipulated that the IF Law shall apply to the provision of the following services (the ‘MiFID top-up activities’):
(a) The service of management of portfolios of investments, including those owned by pension funds, in accordance with mandates given by investors on a discretionary and client- by-client basis, where such portfolios include one or more financial instruments;
(b) Investment advice concerning one or more financial instruments; and
(c) Safekeeping and administration in relation to units of undertakings for collective investment.
To this effect, the MiFID Inducement Rules apply to UCITS ManCos in relation to the aforementioned MiFID ‘top-up’ activities.
In respect of collective portfolio management activities, CySEC Directive DI78-2012-03 regarding the Conditions for Authorisation and Ongoing Obligations of a Management Company and the Agreement between a Depositary and a Management Company of UCITS (the ‘UCITS CySEC Directive’), adopts similar inducement principles as those described under the MiFID Inducement Rules. In particular, Article 24 stipulates that in relation to the investment management and administration of UCITS, UCITS ManCos shall not be regarded as acting honestly, fairly and in accordance with the best interests of the UCITS they manage, if, they pay or are paid any fee or commission, or provide or are provided with any non- monetary benefit, other than the following:
(a) A fee, commission or non-monetary benefit paid or provided to or by the UCITS or a person on behalf of the UCITS;
(b) A fee, commission or non-monetary benefit paid or provided to or by a third party or a person acting on behalf of a third party, where the UCITS ManCos can demonstrate that the following conditions are satisfied:
(i) The existence, nature and amount of the fee, commission or benefit, or, where the amount cannot be ascertained, the method of calculating that amount, is clearly disclosed to the UCITS in a manner that is comprehensive, accurate and understandable, prior to the provision of the relevant service;
(ii) the payment of the fee or commission, or the provision of the non-monetary benefit are designed to enhance the quality of the relevant service and not impair compliance with the UCITS ManCos’ duty to act in the best interests of the UCITS it manages;
(c) Proper fees which enable or are necessary for the provision of the relevant service, including custody costs, settlement and exchange fees, regulatory levies or legal fees, and which, by their nature, do not give rise to conflicts with the UCITS ManCos’ duties to act honestly, fairly and in accordance with the best interests of the UCITS and its unit-holders.
According to Article 6(8) of ‘The Alternative Investments Fund Managers Law 56(I)/2013)’ as amended, certain provisions of IF Law apply to the MiFID ‘top-up’ activities including the reception and transmission of orders in relation to financial instruments. Whilst such provisions do not include the MiFID Inducement Rules apart from reference to the general Article 25 (1) of IF Law (based on the relevant correlation and transposition table), explicit reference to some principles of the MiFID Inducement Rules is made under the CySEC Directive as analysed further below.
In relation to the collective portfolio management activities, the Commission Delegated Regulation (EU) No 231/2013 with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision (Article 24) adopts the same inducement principles as those described under the UCITS CySEC Directive.
General inducement principles
Article 25 (1) of IF Law stipulates that when investment services or, where appropriate, ancillary services to clients are offered by an investment firm (including by extension AIFMs and UCITs ManCos), it shall act honestly, fairly and professionally in accordance with the best interests of its clients and comply, in particular, with the principles set out in Article 25 [General principles and information] and in Article 26 [Assessment of suitability and appropriateness and reporting to clients] of IF Law.
According to Article 25 (9) of IF Law, an investment firm is only permitted to pay, or be paid, an inducement (i.e. a fee, commission or non-monetary benefit) in connection with the provision of an investment service or ancillary service where the relevant payment or benefit:
(i) is designed to enhance the quality of the relevant service to the client; and
(ii) does not impair compliance with the firm’s duty to act honestly, fairly and professionally in accordance with the best interests of its clients.
In all other cases, the firms will be deemed not to have fulfilled their obligations to identify and prevent or manage conflicts of interest (Article 24 (1) of IF Law) or their obligations to act honestly, fairly and professionally (Article 25 (1) of IF Law).
Payments or benefits received or provided by an investment firm 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 are inherently incapable of giving rise to conflicts with the investment firm's duties to act honestly, fairly and professionally in accordance with its clients' best interests are not considered to be inducements (Article 25 (9) of IF Law).
Inducements designed to enhance quality
The CySEC Directive which contains more detailed rules on inducements, not only applies to investment firms but also to UCITS ManCos and AIFMs in relation to the MiFID ‘top-up’ activities, including for the AIFMs the activity of reception and transmission of orders in relation to financial instruments.
Article 13 of the CySEC Directive provides further information as to when a fee, commission or non-monetary benefit will be designed to enhance the quality of the relevant service to the client. Specifically, such an inducement must meet cumulatively the below three conditions on an ongoing basis:
(i) Be justified by the provision of an additional or higher-level service to the relevant client, proportional to the level of inducements received, such as:
(a) 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 firm;
(b) 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 on-going service that is likely to be of value to the client such as advice about the suggested optimal asset allocation of the client; or
(c) 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 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.
(ii) Not directly benefit the recipient firm, its shareholders or employees without tangible benefit to the relevant client;
(iii) Be justified by the provision of an on-going benefit to the relevant client in relation to an ongoing inducement.
An inducement will not be considered acceptable if the provision of relevant services to the client is biased or distorted as a result of the inducement.
Disclosures to clients
In relation to any payment or benefit received from or paid to third parties, firms must disclose to the client the following information according to Article 13 (5) of the CySEC Directive:
(i) Prior to the provision of the relevant investment or ancillary service, the firm must disclose to the client information on the payment or benefit concerned in accordance with section 25(9)(b) of the IF Law. Minor non-monetary benefits may be described in a generic way. Other non-monetary benefits received or paid by the firm in connection with the investment service provided to a client shall be priced and disclosed separately;
(ii) Where a firm was unable to ascertain on an ex-ante basis the amount of any payment or benefit to be received or paid, and instead disclosed to the client the method of calculating that amount, the firm must also provide its clients with information of the exact amount of the payment or benefit received or paid on an ex-post basis; and
(iii) At least once a year, as long as (on-going) inducements are received by the firm in relation to the investment services provided to the relevant clients, the firm must inform its clients on an individual basis about the actual amount of payments or benefits received or paid. Similarly, minor non-monetary benefits may be described in a generic way.
Evidence to be held by firms
Pursuant to Article 13 (4) of the CySEC Directive, firms must hold evidence that any fees, commissions or non-monetary benefits paid or received by the firm are designed to enhance the quality of the relevant service to the client by:
(a) Keeping an internal list of all fees, commissions and non-monetary benefits received;
(b) Recording how the fees, commissions and non-monetary benefits paid or received by the firm, or that it intends to use, enhance the quality of the services provided to the relevant clients; and
(c) Recording 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.
Independent advice and portfolio management
MiFID II tightened the aforementioned general inducement principles, insofar as it applies to portfolio management and independent advisory firms.
Specifically, under Article 25 (7) and Article 25 (8) of IF Law there is express prohibition or ban in the below situations on accepting and retaining inducements paid or provided by third party or a person acting on behalf of a third party in relation to the provision of services to the clients:
Where the firm informs the client that the investment advice is being provided on an independent basis; and
Where the firm provides the client with a third-party discretionary portfolio management service.
Exceptions apply in respect of certain acceptable minor non-monetary benefits as set out under Article 14 (3) of the CySEC Directive that are:
Capable of enhancing the quality of service provided to a client; and
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 interests of the client.
According to Article 14 (1) of the CySEC Directive, where firms receive any such fee, commission or monetary benefit, they must return it in full to the client as soon as reasonably possible after its receipt.
Firms are required to set up and implement a policy to ensure that any fees, commissions or any 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 independent investment advice and portfolio management are allocated and transferred to each individual client.
Firms must also inform clients about the fees, commissions or any monetary benefits transferred to them, such as through the periodic reporting statements provided to the client.
In this effect, MiFID II effectively outlawed the traditional distribution model, in which advisors received commission for recommending funds to their clients.
In the context of investment research, there is an exemption under Article 15 of the CySEC Directive that the provision of research by third parties to firms providing portfolio management or other investment or ancillary services to clients will not be regarded as an inducement, if it is received in return for any of the following:
(i) Direct payments by the firm out of its own resources (P&L model); or
(ii) Payments from a separate research payment account (RPA) controlled by the firm, provided the following conditions relating to the operation of the RPA are met:
(a) The RPA must be funded by a specific research charge to the client;
(b) As part of establishing a RPA and agreeing the research charge with their clients, firms must set and regularly assess a research budget as an internal administrative measure;
(c) The firm is held responsible for the RPA;
(d) The firm must regularly assess the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions.
In other words, firms that provide portfolio management or investment advice on an independent basis must pay for the research that they obtain, either by paying themselves or by passing on that charge to their clients. In either case, they must budget, monitor and evaluate research to ensure that they are not receiving research below market prices which might constitute an inducement.
Throughout the years, various authorities examined the costs bundled in with execution costs, known as “soft commissions” in an attempt to prevent inter alia market failures, in particular relating to transparency of the arrangements, the potential for conflicts of interest and lack of efficient competition for those services typically bundled in with execution.
It is noteworthy that the CySEC Directive introduced a new dealing commission regime. Specifically, according to Article 15 (9) of the CySEC Directive, an investment firm providing execution services shall identify separate charges for these services that only reflect the cost of executing the transaction. Such separation of charges was mandatory as it enables firms to comply with the requirement not to 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.
As a result of the aforementioned developments, entities that provided both research and brokerage and other investment-related services (i.e. investment firms as research producers) to asset managers (research consumers) were obliged to separately identify the cost of the research they provide and unbundle it from the cost of other services provided to the asset managers. UCITS ManCos and AIFMs that delegate discretionary portfolio management to a MiFID-regulated entity (i.e. investment firm) were also indirectly impacted from this “unbundling rule”.
Industry response and European Commission’s proposal
Industry surveys tend to agree that the introduction of the MiFID II inducement regime has led midsize and large firms to pay for research directly out of their own P&L, while smaller businesses made greater use of the RPAs since absorbing research costs in P&L model was not a viable option for them.
The study of the European Commission on the impact of MiFID II on SME and fixed income investment research revealed, among others, that MiFID II reduced research budgets and lowered equity research prices particularly for larger investment firms.
On December 15 2020, following an earlier legislative proposal from the European Commission on July 24 2020, the European Council approved the so-called Capital Markets Recovery Package. The proposal includes amendments to the Delegated Directive through creation of an optional exemption when research is exclusively on small and mid-cap issuers or on fixed income instruments to help the recovery from the Covid-19 pandemic. Small and mid-cap issuers would be defined as “issuers that did not exceed a market capitalisation threshold of EUR 1 billion over a period of 12 months”.
While EFAMA appreciates the Commission's efforts in pursuing an alleviation of certain MiFID II requirements in the interest of promoting recovery from the economic crisis, it is of the opinion that there are more effective methods to improve SME access to markets and urges the Commission to consider a set of further measures (such as sponsored research and free-trials).
The MiFID II inducement regime is complex and technical, when conducting an assessment of whether a particular fee structure or benefit is permissible. It is observed that not only different requirements apply to different facts, but the same requirements and conditions apply differently to the different parties involved in a single scenario. In this context, some firms may proactively require third parties (such as distributors) to provide relevant evidence on their implementation of MiFID II inducement rules.
Any proposals to adapt the current inducement regime through regulatory interventions, in an effort to improve the visibility and financing opportunities of SME companies during the recovery from the Covid-19 pandemic, might again lead to adjustment of the practices of fund managers, other financial market participants and investors.
Senior associate, Elias Neocleous & Co