MiFID II: a practical consideration of the new product governance requirements

Published on 1st Mar 2017

According to ESMA, the financial crisis has shown that the application of conduct of business rules to the provision of investment services to single clients may not always be sufficient to ensure that firms fulfil their duty of acting in the best interests of their clients. It is this view that led to the introduction in MiFID II of product governance obligations for manufacturers and distributors of structured financial products (the product governance requirements), with the overall aim of enhancing investor protection. Firms will now need to be able to show that they have acted in clients’ best interests during all stages of the life-cycle of financial products – from design, to manufacture and finally distribution.

The product governance requirements are set out in Article 16(3) and Article 24(2) MiFID II and elaborated on in Articles 9 and 10 of the Commission Delegated Directive of 7.4.2016 supplementing MIFID II (the Level 2 Directive). The draft guidelines which were published for consultation by ESMA in October 2016 are intended to aid implementation and application.

Do these rules apply to fund managers?

The product governance requirements apply to all categories of MiFID financial instrument including interests in funds. Much, though, will depend on a firm’s business model and the distribution model used to sell funds. For example, some firms have an integrated model whereby the management company and the distributor(s) are part of the same group; others appoint third party distributors instead. AIFMs are generally exempt from MIFID (although some are also MiFID firms). For an AIFM that is a manufacturer (i.e. it has created the fund) but is not involved in MIFID business, the product governance provisions will apply as guidance and not as rules.

For firms caught within the scope of MiFID (e.g. advisers and arrangers),the application of the new requirements will depend on whether that firm is:

  • creating, developing, issuing and/or designing financial instruments as the ‘product manufacturers’; or
  • offering, recommending or selling such instruments – in which case they will be subject to the ‘product distributors’ requirements.

Firms also caught by these requirements will include firms that use the Article 3 exemption (because MiFID II obliges the FCA to introduce at least analogous standards for product governance for distribution firms that use the Article 3 exemption).

What are the new product governance requirements?

Broadly, the product governance requirements cover arrangements that product manufacturers must adopt when creating financial products, and which product distributors must adopt when deciding on the range of products and services to offer to clients (and when actually offering or recommending those products or services).  The product governance requirements are in addition to requirements to carry out suitability or appropriateness assessments when providing investment services to a client.

The product governance requirements require product manufacturers to maintain, operate and regularly review processes for approving financial products. The financial products should be assessed with a target market in mind and the product manufacturer should ensure that the planned distribution strategy is appropriate for that target market. Product manufacturers must provide product distributors with information about the approval process and the target market, and product distributors should ensure that they have this information to hand. Additionally, product distributors must ensure that they understand the approval process and target market for the product, that they assess the compatibility of the product with the needs of their client, and that they only offer or recommend those products where it is in the client’s interest to do so. The Level 2 Directive adds to this by providing further clarity on the steps that firms should take in order to be compliant with the MiFID II product governance requirements.  It is worth noting that the directive extends the regime to investment services as well for product distributors.

The draft guidelines are intended to provide greater clarity on the obligations for manufacturers and distributors, with a particular focus on the target market assessment, given the challenges this description has been presenting. In the consultation paper, ESMA set out six categories that product manufacturers should use as a basis for defining the target market for each product.  These are:

  • the type of client at whom the product is targeted;
  • knowledge and experience;
  • financial situation, with a focus on the ability to bear losses;
  • risk tolerance and compatibility of the risk/reward profile of the product with the target  market;
  • clients’ objectives;  and
  • clients’ needs.

By considering these six categories (and any others which the product manufacturer thinks appropriate), the product manufacturer should be able to narrow down the profile of clients that the product is aimed at. ESMA is keen to point out that as product manufacturers usually don’t have direct client contact and therefore no detailed knowledge about the client base, the target market identification in the six categories may be abstract and the categories serve as “examples for orientation purposes“. The above six categories should form the minimum basis for a target market assessment.  However, product manufacturers can assess their target market using additional categories that they feel are important for describing the product.  ESMA considers it appropriate that distributors use the same six categorisations as product manufacturers for identifying the target market, but because they know the customers better, they should be able to assess a more concrete target market.

As part of its consultation, ESMA looked not only at the positive target market for a product and a market to which the product should not be sold, but also the 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.

UK implementation of the new product governance requirements

Currently, the FCA provides guidance which is set out in the Responsibilities of Providers and Distributors for the Fair Treatment of Customers (RPPD) and is based on the Principles for Business sourcebook.  RPPD focuses on what all firms should do when providing products and services to retail clients. In CP16/29, the FCA confirmed that it intends to implement the MiFID II product governance provisions as rules for: firms undertaking MiFID business, MiFID Article 3 exempt firms, branches of third-country firms, and firms that manufacture structured deposits.  By contrast, the provisions will just be guidance for other non‑MiFID firms involved that manufacture or distribute of MiFID products. Where appropriate, the FCA has copied existing relevant guidance, such as from the RPPD, into the rules to help explain certain concepts.

The FCA expects the new provisions to be introduced in a new sourcebook for Product Governance and Product intervention (PROD) but the application of the rules is expected to be in an appropriate and proportional manner taking into account taking into account the nature of the investment product, the investment service, and the target market for the product. Given this would mirror the existing approach, the introduction of the new provisions are being seen as an evolution of existing standards rather than a significant change.

Although existing provisions are being retained, firms should expect much more prescription in terms of what needs to be complied with.  For example, manufacturers will be subject to wide-ranging conflict of interest obligations in the new rules, including ensuring that the design of the product does not lead to market integrity issues. Distributors will have a greater breadth of responsibility under the new regime in identifying the target market and ensuring that products and services they distribute comply with all applicable rules. In addition, they will be responsible for providing manufacturers with much more information regarding the product or service they distribute. Where firms collaborate in the development of products, the design of an effective agreement to share their responsibilities will be key.

Practical implications

Key industry concerns following the finalisation of the level 1 directive text have focused on:

  • the definition of ‘target market’;
  • the distinction between a product manufacturer and product distributor; and
  • what data will need to flow back from product distributors to product manufacturers in order to allow the latter to monitor and assess whether their product is not only distributed to the target market but also whether that strategy remains appropriate.

It is therefore not surprising that ESMA states in the draft guidelines that the target market assessment is the most important aspect of the product governance requirements, and as such this may very well be the focus of regulatory scrutiny going forward. The consultation paper explains that firms should therefore ensure that they have appropriate systems and checks in place to ensure that prior to launching a product; they have considered and defined the profile of the client that the product will be marketed to. There should be a clear record of the identification process as well as the categories under which the target market has been defined. As a minimum, the criteria should include the six ESMA categories.  However, careful thought should be given to what other categories the target market assessment can be undertaken by reference to. The thought process behind selecting the additional categories should again be clearly recorded.

The costs of establishing and maintaining a target market assessment process may prove significant for some firms. However, ESMA’s view is that the importance of sound product governance arrangements has for some time been promulgated in the industry.

Governance requirements for manufacturers and distributors
  • firms will be required to operate and maintain effective organisational and administrative arrangements to prevent conflicts of interest from adversely affecting the interests of clients.
  • product manufacturers will need to maintain, operate and review processes for the approval of financial instruments before they are marketed or distributed to clients.
  • the product approval process for each financial instrument will need to specify an identified target market of end clients and ensure that: (i) the instrument is designed to meet the needs of that market; (ii) all the relevant risks of that target market are assessed; and (iii) the intended distribution strategy is appropriate for that target market. The firm will need to take reasonable steps to ensure that the financial instrument is distributed to the target market.
  • firms will be expected to regularly review financial instruments offered or marketed and assess whether the financial instrument remains consistent with the needs of the target market and whether the intended distribution strategy remains appropriate.
  • product manufacturers will have to make available to product distributors, all appropriate information on the financial instruments and the product approval process, including the identified target market.
  • where a firm offers or recommends financial instruments which it does not manufacture, it will need to establish arrangements to be able to obtain all appropriate information on the product and to understand the characteristics and target market in order to ensure that it can assess the compatibility of the financial instruments with the needs of the clients and only offer or recommend where it will be in the interests of that client.

Enhanced obligations arising as a result of the Level 2 Directive

Product manufacturers should:

  • establish, implement and maintain procedures and measures to ensure that the manufacturing of financial instruments complies with proper management of conflicts of interest.
  • analyse potential conflicts of interests each time a financial instrument is manufactured.
  • consider whether the product represents a threat to the stability of financial markets.
  • ensure the staff have the necessary expertise to understand the characteristics and risks of the products.
  • ensure the management body has effective control over the firm’s product governance process.
  • ensure the compliance function monitors the development and periodic review of product governance arrangements to detect any risk of failure by the firm in not complying with these obligations.
  • (where firms collaborate to create a product) outline their mutual responsibilities in a written agreement.
  • identify the potential target market for each product and specify the type of client that the product is compatible for and who the product is not compatible for.
  • undertake a scenario analysis to assess the risks of poor outcomes for end clients.
  • determine if a product meets the identified needs, characteristics and objectives of the target market.
  • consider the charging structure for the product.
  • provide information about the distribution channels, the product approval process and the target market assessment to enable distributors to sell the product.
  • review the products regularly, consider any event that could materially affect the potential risk to the target market and check that the product is only going to the target market and not others that it is not compatible for.
  • review products before any further issue if there are any potential risks to investors.

Product distributors should:

  • obtain all necessary information from manufacturers to be able to understand the product and ensure that products are distributed to the target market.
  • maintain procedures and measures to ensure compliance with disclosure, assessment of suitability or appropriateness, inducements and conflicts of interest.
  • ensure that the relevant staff understand the products and the target market.
  • provide information to manufacturers on sales and product governance reviews.

It is also confirmed that where firms collaborate to distribute a product, the firm with the direct client relationship has ultimate responsibility to meet the product governance obligations.

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* This article is current as of the date of its publication and does not necessarily reflect the present state of the law or relevant regulation.

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