The MiFID II inducements regime is complex and can cause confusion. MiFID II contains a number of inducements requirements, including rules relating to conflicts of interest, research, hospitality, corporate access, and payment for order flow. Not only do these different requirements apply to different scenarios, but the same requirements apply differently to the different parties involved in a single scenario. As a result, parties to a transaction may reach different conclusions when conducting their own assessment of whether a particular fee structure or benefit is permissible.
This post outlines the MiFID II inducements regime and applies the rules to a number of common scenarios. It will assist firms that are subject to MiFID II understand how the inducement related obligations interact and apply both to themselves and to their counterparties.
Relevant MiFID II Requirements
The following MiFID II requirements are relevant to the provision and receipt of inducements.
- Clients’ best interests: MiFID firms must act honestly, fairly, and professionally in accordance with the best interests of their clients.
- Conflicts of interest: General MiFID II conflicts of interest provisions require firms to identify, prevent, and manage conflicts of interest, and implement effective organisational arrangements to prevent conflicts of interest adversely affecting their clients.
- Inducements regime: MiFID II contains two rules which expressly reference payment or receipt of benefits:
- General inducements rule: The general inducements rule prohibits firms from paying benefits to or receiving benefits from third parties, unless the benefits are designed to enhance the quality of the relevant service to the client, and do not impair compliance with the firm’s duty to act honestly, fairly, and professionally in accordance with the best interests of its clients.
- Prohibition on third-party benefits in relation to portfolio management and independent investment advice: MiFID II contains a specific prohibition on a firm accepting and retaining benefits received from third parties in relation to the firm’s provision of portfolio management or investment advice services to its underlying clients, other than certain specified minor non-monetary benefits. This prohibition applies only to firms providing portfolio management or independent investment advice, and only to the recipient firm (rather than the party providing the benefit).
- Unbundling: MiFID II unbundling requirements require firms providing execution services to identify separate charges for execution, and to unbundle and apply separately identifiable charges to other benefits or services.
- Payment for order flow: MiFID II best execution provisions prohibit payment for order flow. The prohibition applies to the firm receiving the payment, and will apply to a firm routing underlying client orders to a venue or executing broker in return for receipt of fees or other benefits.
Corporate securities issuance
- Scenario: An investment bank is providing underwriting and/or placing services to a corporate client issuing securities to investors.
- Analysis: The investment bank will be subject to the general inducements rule. As a result, the investment bank will need to consider whether sales and trading commission received from investors is designed to enhance the quality of the service provided to its corporate client, does not impair compliance with the firm’s duty to act in accordance with the best interests of its corporate client, and should be disclosed. If the investment bank is acting only for the corporate client this should be straightforward. The analysis may be complicated if the investment bank regards the investors as its clients in relation to the transaction (ie, if the investment bank does not rely on the UK corporate finance contact exemption). If so, the investment bank will have two clients with opposing interests in the same transaction, and will also need to ensure that it complies with (i) conflicts of interest requirements, and (ii) the general inducements rule, this time also considered in respect of the investor clients (ie, that any fees paid by the corporate client are designed to enhance the quality of the service provided to the investor clients, do not impair compliance with the firm’s duty to act in accordance with the best interests of its investor clients, and are disclosed). In practice, trade associations have considered the possibility of analysing this scenario as one in which two separate and unconnected transactions occur (one with the corporate client, the other with the investors) such that disclosure is not required.
- Comment: Even in this relatively straightforward scenario, multiple MiFID inducements requirements may apply depending on the facts.
Manufacturing and distribution
- Scenario: A manufacturer is structuring and issuing products (such as structured notes) to a distributor for onward distribution to underlying investors.
- Analysis: From the perspective of the manufacturer, it is simply interacting with a single distributor client. As a result, there are no third parties to this relationship and conflicts of interest / the general inducements rule will not apply to any distribution fee it pays to the distributor. However, the analysis is more complicated from the perspective of the distributor. The distributor is passing products on to underlying investor clients. The distributor will therefore need to consider whether accepting the fee is compatible with the general inducements rule or the prohibition on third-party benefits, depending on what services it is providing to underlying investors. The distributor may also wish to consider whether it could be viewed as routing orders from underlying investors to the manufacturer — in which case, a distribution fee could constitute payment for order flow, if the manufacturer is a market maker and the distributor is seen as a broker.
- Comment: This scenario provides a clear example of how the MiFID inducements analysis may differ from the perspective of different parties within a single transaction. In this scenario, the various requirements fall primarily on the distributor as recipient of the potential inducement.
- Scenario: A sell-side firm is providing research services to buy-side clients.
- Analysis: The sell-side firm will be subject to unbundling requirements, and must ensure that the research services are subject to a separately identifiable charge. The obligations on the buy-side firm will depend on whether or not the firm is providing independent investment advice or portfolio management services to its underlying investors. If so, the prohibition on third-party benefits will apply. However, MiFID II contains an express carve out if the buy-side firm pays for the research from its own resources or a separate research payment account. If not, the buy-side firm must instead ensure receipt of research complies with the general inducements rule.
- Comment: Again, inducements requirements generally fall on the recipient of the potential inducement. However, MiFID II contains a specific carve out for research paid for in particular ways.
- Scenario: A sell-side firm is providing hospitality to buy-side firms.
- Analysis: No specific inducements requirements apply to a sell-side firm providing hospitality (unless the hospitality is being provided in the context of providing services to another client). From the buy-side firm’s perspective, MiFID II inducement rules will apply; however, reasonable de minimus value hospitality is expressly provided for as an acceptable minor non-monetary benefit.
- Comment: Again, inducement requirements relating to hospitality generally fall on the recipient, which will need to make its own assessment of whether the hospitality is of sufficiently de minimus value to be permissible.
- Scenario: A sell-side firm is providing corporate access to buy-side firms.
- Analysis: The sell-side firm will generally be providing access in the context of a particular relationship with a corporate client, and so will need to consider the general inducements rule in relation to its corporate client. In addition, the sell-side firm may wish to ensure the firm is not treating the buy-side firms as clients in relation to the provision of corporate access, as this would trigger general conflicts of interest requirements (and potentially the need to consider unbundling requirements). The buy-side firm would need to make its own assessment of whether the access is permissible, which may depend on the nature of the access.
- Comment: The case is structurally similar to the hospitality scenario. However, the analysis may differ given that the buy-side firm will be providing access in the context of a client relationship, and corporate access could potentially constitute a service subject to unbundling requirements.