The entry into force of the second version of the Markets in Financial Instruments Directive (MiFID II) is since 2018 amongst the greatest challenges for the financial sector. Among the most striking novelties in MiFID II are without doubt the product governance rules, which to this day cause a lot of interpretation and implementation difficulties. They introduce a kind of ‘know-your-customer’ requirements at product level: both in the design and the distribution phase of a product, investment firms should identify the target market for each product. As a result, product manufacturers and distributors need to properly understand all product features and assess with what type of clients those products would be compatible. The product governance rules should prevent that products are sold or recommended to investors for whom they are not intended and come on top of pre-existing measures, such as the suitability and appropriateness assessments.
Although the aim of the product governance rules is commendable, the new regime is far from perfect, as I have argued in a recent article. After briefly describing the MiFID II rules on product governance for product manufacturers and product distributors, the article discusses four major shortcomings and perverse effects of the MiFID II product governance regime, which have a detrimental effect on investor protection and the level playing field between financial institutions offering and distributing investment products.
A first shortcoming is that MiFID II does not cover important groups of product manufacturers, which disturbs the level playing field and undermines the potential efficacy of the product governance rules as an investor protection tool. The article argues that an amendment to the Regulation on Packaged Retail and Insurance-based Investment Products (the PRIIPs Regulation), requiring that all PRIIPs manufacturers should comply with the MiFID II product governance rules for product manufacturers, would, in respect of EU product manufacturers, solve this issue to a large extent.
A second problem is that distributors are not able and/or willing to devote sufficient resources to provide target market descriptions for the vast quantities of products from manufacturers not subject to MiFID II. In order to reduce their compliance burden, product distributors limit the number of products they offer. Even though an amendment to the PRIIPs Regulation in accordance with the previous paragraph should alleviate the problem, many third country product manufacturers will still not be covered by MiFID II, putting a heavy burden on product distributors which still need to provide a target market for those products if they want to grant their clients access to these products. The article argues that this problem can be reduced by two changes in the Product Governance Guidelines issued by the European Securities and Markets Authority (ESMA) (the Guidelines). First, ESMA should clarify that the same target market description could be used for types of plain vanilla products with the same characteristics. Second, even though distributors should not promote products for which they have not defined a target market, if a client on its own initiative seeks to deal in such a product, the distributor should be allowed to grant this client access to that product, subject to clear warnings.
Third, distributors have to comply with individualized product feedback requirements to manufacturers, for all products they offer to their clients. Many distributors face difficulties in managing the administrative burden resulting from compliance with those requirements, and solve this problem by reducing the number of products they offer — not necessarily because those products would not be compatible with their client base, but because they are not able or willing to devote the necessary resources to manage the product governance feedback requirements. The article argues that this problem could be reduced by a clarification in the Guidelines of the exact scope of feedback information, in a way which would allow the creation of a standardized format for such feedback information.
Finally, the article argues that self-censoring behaviour of financial institutions, which attempt to avoid liability claims and administrative fines, further reduces the product offer for their clients. Confronted with rules which leave room for interpretation, many financial institutions prefer to err on the safe side, resulting in target markets which are stricter than necessary from an investor protection perspective as well as in reluctance of those financial institutions to sell outside the target market, even in cases where this may be legally permissible, and even if the client is financially capable and willing to bear the risks involved. This is a third reason why, especially for retail clients in an execution-only environment, the product offer has been heavily reduced since the entry into force of MiFID II. The article argues that an amendment to the Guidelines could reduce this issue. They should clarify that (i) financial institutions should never actively market or offer a product to a client who falls outside the target market for that product, but that (ii) if such a client nevertheless wants to invest in such a product, he or she should be able to do so at his or her own initiative and responsibility, subject to the motivation and reporting duties applicable to sales to clients outside the target market or in the negative target market. The amendment should explicitly clarify that such a motivation could refer to the fact that the client (i) has been warned that he or she does not fall under the target market for that product; (ii) was explicitly informed of the concrete risks he or she would bear by investing in the product; but (iii) nevertheless wished to acquire the product on his or her own responsibility. While the majority of retail investors will typically remain unaware of the existence of products for which they fall outside the target market (no marketing), and thus not acquire it, more active investors who would want to invest in such products and are willing to bear the related risks, would not be frustrated.
The contribution concludes that, even though this may not have been the intent of the legislator, the effects of the MiFID II product governance regime, represent nothing less than a paternalistic revolution. Under the MiFID I regime, the investor in principle always had the last word on execution-only services: the financial institution should warn against investments which it deemed inappropriate for the client, but the client could persist and nevertheless acquire the product. Likewise, in an advice environment the investor could always go against the advice of the distributor. The MiFID II product governance rules seem to have a different effect. Even if an individual client understands and accepts all the risks involved in a certain product, he or she will in principle not be able to acquire it, if the product distributor (a) is not willing to grant access in order to avoid the need to comply with the product governance regime, or (b) decides that the client falls outside the target market for the product.
Awaiting further research on the broader question of whether the product governance rules are a useful means of investor protection, the article concludes that the system could already be much improved if the four shortcomings set out above would be remedied on the basis of the suggested changes. The article proposes concrete amendments to the PRIIPs Regulation and the Guidelines to that effect. Without losing the potential benefits of the product governance rules as a means of investor protection, those amendments would result in an improved scope of the product governance rules, alleviate the compliance burden for distributors and allow the product governance rules to get rid of their paternalistic edge.
Veerle Colaert is Professor of Financial Law at KU Leuven University, co-director of the Jan Ronse Institute for Company and Financial Law and chair of the Securities and Markets Stakeholder Group advising ESMA.