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The Commission Delegated Directive 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 (MiFID II Delegated Directive) includes specific provisions on how MiFID firms may receive third party research such that it is not deemed to be an inducement.
This part of MiFID II is of particular interest to portfolio managers and independent advisers who are otherwise banned from accepting any inducements except for minor non-monetary benefits.
MiFID created two categories of investment research: the first one that is presented as objective or independent, and the second one that does not meet that standard and is labelled as a marketing communication. As stated in Recital 28 of the MiFID Implementing Directive 2006/73/EC, both categories of research are intended to sit under the MAR definition of investment recommendations.
Some respondents to the consultation indicated there is a risk that the wording of Article 20(1) of MAR, "persons who produce or disseminate investment recommendations or other information recommending or suggesting an investment strategy shall take reasonable care to ensure that such information is objectively presented", fails to include non-independent research. In this respect, ESMA clarifies that requirement is not intended to apply only to those recommendations that are held out as being objective or independent.
At the same time, ESMA confirms that irrespective of the label attached to a note, as long as a note meets the MAR definition of "investment recommendations" (Article 3(1)(35)) or of "information recommending or suggesting an investment strategy" (Article 3(1)(34)), is in scope of Article 20(1) and (3) of MAR.
ESMA's Final Report Draft technical standards on the Market Abuse Regulation of 28 September 2015 (ESMA/2015/1455), p. 73
In principle, MiFID II prohibits firms who provide independent investment advice or portfolio management services from receiving any inducements in relation to these services to clients, except for minor non-monetary benefits (Article 24(7) and (8)).
Nevertheless, the MiFID II Delegated Directive recognises that third party research is an important input for investment firms.
It allows investment firms providing portfolio management, or other investment or ancillary services, to receive research from third parties in a way that does not contravene the inducements rules.
Article 13(1) of the MiFID II Delegated Directive stipulates that research received from third parties is not regarded as an inducement for an investment firm if it is received in return for either of the following:
a. direct payments by the investment firm out of its own resources, or
b. payments from a separate Research Payment Account controlled by the investment firm (provided a number of conditions relating to the operation of the account are met).
In order to comply with the latter option above and operate an acceptable Research Payment Account model, a firm must ensure that:
- the Research Payment Account can only be funded by a specific research charge to the client,
- they set and regularly assesses a research budget,
- they are held responsible for the account, and
- they regularly assess the quality of research purchased based on robust quality criteria and its ability to contribute to better investment decisions.
Research charge further must only be based on a research budget set by the investment firm for the purpose of establishing the need for third party research in respect of investment services rendered to its clients not be linked to the volume and/or value of transactions executed on behalf of the clients
The requirements in Article 13 of the MiFID II Delegated Directive also include disclosure obligations on firms relating to the research charge and use of the research budget, requiring both ex ante and ex post disclosures, and producing a 'research policy' to be provided to clients.
Further governance and oversight requirements stipulated in Article 13 of the MiFID II Delegated Directive, which apply to the Research Payment Account, are designed to ensure that the said account is operated by a firm in the best interests of its clients, and that the firm is fully accountable for the use of additional research, allocating costs to clients fairly.
The respective requirements include, in particular, an obligation that investment firms who provide both execution services and research goods and services to other investment firms (e.g. investment banks and other brokers) must identify separate charges that only reflect the cost of executing the transaction, while the provision of each other benefit or service must be subject to a separately identifiable charge.
The supply of, and charges for, those benefits or services must not be influenced by or be conditioned by levels of payment for execution services.
FCA Consultation Paper III, Markets in Financial Instruments Directive II Implementation, September 2016, CP16/29 (p. 28, 29) gives the following directions for setting budgets for use of Research Payment Accounts and client‐specific research charges:
"While the MiFID II delegated directive requires a specific charge to a client based on a research budget, it does not state that a budget has to be set at an individual portfolio level. So, we consider firms can set a research budget that applies to a number of client portfolios or funds where they share similar investment strategies and objectives, such that they can benefit from the same inputs based on the asset allocation and underlying instruments they can invest, or are invested, in. This may allow firms to set a budget at a desk-level or strategy level provided the individual and collective portfolios subject to the budget share sufficiently similar research needs. A firm may choose to set a top-down, firm-level research budget as part of a process by which it then sets specific budgets at the level of groups of portfolios based on a bottom up assessment of research needs.
[...] Firms must ensure the specific charge to a client and the corresponding budget that charge is contributing towards does actually pay for research which can assist its investment decisions for the client. Firms should document and be able to justify how they have grouped client portfolios for this purpose. Firms must have robust systems and controls to ensure a fair allocation of research costs in the best interests of their individual clients. A group of portfolios for which a shared budget is set should not be so broad that portfolios with substantively different research needs are subject to the same budget.
[...] Client-specific charges must still be estimated and disclosed upfront, based on the relevant pre-set budget. The firm should have a transparent methodology for how they determine a fair allocation for these purposes. This may involve a pro-rated split of a research budget across the identified group of client portfolios to derive an estimated charge for each client."
Article 24(7) and (8)
7. Where an investment firm informs the client that investment advice is provided on an independent basis, that investment firm shall:
(a) assess a sufficient range of financial instruments available on the market which must be sufficiently diverse with regard to theirtype and issuers or product providers to ensure that the client's investment objectives can be suitably met and must not belimited 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 contractualrelationships, as to pose a risk of impairing the independent basis of the advice provided;
(b) not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or aperson acting on behalf of a third party in relation to the provision of the service to clients. Minor non-monetary benefits that arecapable of enhancing the quality of service provided to a client and are of a scale and nature such that they could not be judgedto impair compliance with the investment firm's duty to act in the best interest of the client must be clearly disclosed and areexcluded from this point.
8. When providing portfolio management 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 theservice to clients. Minor non-monetary benefits that are capable of enhancing the quality of service provided to a client and are of ascale and nature such that they could not be judged to impair compliance with the investment firm's duty to act in the best interest ofthe client shall be clearly disclosed and are excluded from this paragraph.
Commission Delegated Directive 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
Inducements in relation to research
1. Member States shall ensure that the provision of research by third parties to investment firms providing portfolio management or other investment or ancillary services to clients shall not be regarded as an inducement if it is received in return for any of the following:
(a) direct payments by the investment firm out of its own resources,
(b) payments from a separate research payment account controlled by the investment firm, provided the following conditions relating to the operation of the account are met:
(i) the research payment account is funded by a specific research charge to the client;
(ii) as part of establishing a research payment account and agreeing the research charge with their clients, investment firms set and regularly assess a research budget as an internal administrative measure;
(iii) the investment firm is held responsible for the research payment account;
(iv) the investment firm regularly assesses the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions.;
(c) where an investment firm makes use of the research payment account, it shall provide the following information to clients:
(i) before the provision of an investment service to clients, information about the budgeted amount for research and the amount of the estimated research charge for each of them.
(ii) annual information on the total costs that each of them has incurred for third party research.
2. Where an investment firm operates a research payment account, Member States shall ensure that the investment firm shall also be required, upon request by their clients or by competent authorities, to provide a summary of the providers paid from this account, the total amount they were paid over a defined period, the benefits and services received by the investment firm, and how the total amount spent from the account compares to the budget set by the firm for that period, noting any rebate or carry-over if residual funds remain in the account. For the purposes of point (b)(i) of paragraph 1, the specific research charge shall:
(a) only be based on a research budget set by the investment firm for the purpose of establishing the need for third party research in respect of investment services rendered to its clients; and
(b) not be linked to the volume and/or value of transactions executed on behalf of the clients.
3. Every operational arrangement for the collection of the client research charge, where it is not collected separately but alongside a transaction commission, shall indicate a separately identifiable research charge and fully comply with the conditions in paragraph 1, points (b) and (c).
4. The total amount of research charges received may not exceed the research budget.
5. The investment firm shall agree with clients, in the firm's investment management agreement or general terms of business, the research charge as budgeted by the firm and the frequency with which the specific research charge will be deducted from the resources of the client over the year. Increases in the research budget shall only take place after the provision of clear information to clients about such intended increases. If there is a surplus in the research payment account at the end of a period, the firm should have a process to rebate those funds to the client or to offset it against the research budget and charge calculated for the following period.
6. For the purposes of point (b)(ii) of paragraph 1, the research budget shall be managed solely by the investment firm and is based on a reasonable assessment of the need for third party research. The allocation of the research budget to purchase third party research shall be subject to appropriate controls and senior management oversight to ensure it is managed and used in the best interests of the firm's clients. Those controls include a clear audit trail of payments made to research providers and how the amounts paid were determined with reference to the quality criteria referred to in paragraph 1 (b) (iv). Investment firms shall not use the research budget and research payment account to fund internal research.
7. For the purposes of point (b)(iii) of paragraph 1, the investment firm may delegate the administration of the research payment ac-count to a third party, provided that the arrangement facilitates the purchase of third party research and payments to research providers in the name of the investment firm without any undue delay in accordance with the investment firm's instruction.
8. For the purposes of point (b) (iv) of paragraph 1, investment firms shall establish all necessary elements in a written policy and provide it to their clients. It shall also address the extent to which research purchased through the research payment account may benefit clients' portfolios, including, where relevant, by taking into account investment strategies applicable to various types of portfolios, and the approach the firm will take to allocate such costs fairly to the various clients' portfolios.
9. An investment firm providing execution services shall identify separate charges for these services that only reflect the cost of executing the transaction. The provision of each other benefit or service by the same investment firm to investment firms, established in the Union shall be subject to a separately identifiable charge; the supply of and charges for those benefits or services shall not be influenced or conditioned by levels of payment for execution services.
Recitals 26 - 30 of the Commission Delegated Directive 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
(26) Investment firms providing both execution and research services should price and supply them separately in order to enable investment firms established in the Union to comply with the requirement to 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 set out in Article 24(7) and (8) of Directive 2014/65/EU.
(27) In order to provide legal certainty concerning the application of new rules for the reception or payment of inducements, in particular with respect to investment firms providing investment advice on an independent basis or portfolio management services, further clarifications in relation to the payment or reception of research should be provided. In particular, where research is not paid directly by the investment firm out of its own resources but in return for payments from a separate research
payment account certain essential conditions should be ensured. The research payment account should only be funded by a specific research charge to the client which should only be based on a research budget set by the investment firm and not linked to the volume and/or value of transactions executed on behalf of clients. Any operational arrangements for the collection of the client's research charge should fully comply with those conditions. When using such arrangements, an investment firm should ensure that the cost of research funded by client charges is not linked to the volume or value of other services or benefits or used to cover any other purposes, such as charges for execution.
(28) In order to ensure that portfolio managers and independent investment advisers properly monitor the amounts paid for research and to ensure that research costs are incurred in the best interests of the client, it is appropriate to specify detailed governance requirements on research spending. Investment firms should retain sufficient control over the overall spending for research, the collection of client research charges and the determination of payments. 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.
(29) For further clarity concerning the restriction on the receipt of inducements by investment firms in relation to independent investment advice or portfolio management and the application of research rules, it is also appropriate to indicate how the minor non-monetary benefit exemption may be applied in relation to certain other types of information or material received from third parties. In particular, 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 that company, or where the third party is contractually engaged and paid by the issuer to produce such material on an ongoing basis, should be deemed acceptable as a minor non-monetary benefit subject to disclosure and the open availability of that material. In addition, non-substantive material or services consisting of short term market commentary on the latest economic statistics or company results for example or information on upcoming releases or events, which is provided by a third party and contains only a brief summary of its own opinion on such information that is not substantiated nor includes any substantive analysis such as where they simply reiterate a view based on an existing recommendation or substantive research material or services, can be deemed to be information relating to a financial instrument or investment service of a scale and nature such so that it constitutes an acceptable minor non-monetary benefit.
(30) In particular, any non-monetary benefit that involves a third party allocating valuable resources to the investment firm shall not be considered as minor and shall be judged to impair compliance with the investment firm's duty to act in their client's best interest.