RIS – restoring consumer trust by shrinking the investment universe

On 24 May 2023, the European Commission (Commission) published its Retail Investment Strategy (RIS), a legislative package intended to empower retail investors to take more informed investment decisions that would better correspond to their investment needs and objectives. The RIS was published in response to concerns that, in the EU, the level of retail participation in capital markets remains low compared with other advanced economies. For example, one startling figure that the Commission quoted was that in 2021, approximately 17% of EU household assets were held in financial securities (listed shares, bonds, mutual funds and financial derivatives). There are a number of reasons for this low participation including inertia but also low levels of financial literacy and a lack of trust in those providing the products who stand to receive commissions. Another important factor that the Commission is also acutely aware of and wants to harness are new trends, particularly digitalisation which offers easier access to a wide range of services including low-cost automated sales and retail investors focussing more on sustainability.

• RIS
• Disclosure rules
• Conflicts of interest and inducements
• Product governance and oversight
• Other changes
• Changes to PRIIPs
• The UK approach
• Next steps and conclusion

RIS

The RIS comprises of a Directive as regards the EU retail investor protection rules. This Omnibus Directive amends the EU retail investor protection framework set out in the:

• Markets in Financial Instruments Directive II (MiFID II).
• Alternative Investment Fund Managers Directive (AIFMD).
• Undertakings for Collective Investment in Transferable Securities Directive (UCITS Directive).
• Directive on the provision of insurance or reinsurance distribution services to third parties (IDD).
• Directive on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II).

Accompanying the Omnibus Directive is a proposed Regulation which amends the Regulation on key information documents for packaged retail and insurance-based investment products (PRIIPs).

Political process

On 5 October 2023, European Parliament rapporteur Stéphanie Yon-Courtin (Renew, FR) published her two draft reports concerning the RIS. On 20 March 2024, the European Parliament's Economic and Monetary Affairs Committee (ECON) had considered the rapporteur's draft report and adopted it by 32 votes to 21 (with 1 abstention). A press release was issued although at the time of writing the draft legislative text was not.

However, the European Parliament will cease its work in April 2024 to prepare for the June 2024 elections. It is therefore doubtful whether the Council of the EU and European Parliament can adopt a final text of the RIS before the European Parliament elections, which could cause significant delay.

This briefing note considers the key points arising from the Omnibus Directive as it impacts MiFID II. It does not cover changes to AIFMD, UCITS Directive, IDD and Solvency II.

Measures

According to the Commission's factsheet concerning the RIS the intended aim of the legislative package is to:

• Modernise disclosure rules, adapting them to the digital age and investors' sustainability preferences.
• Develop benchmarks against which the value of financial products need to be assessed.
• Address potential conflicts of interest by banning inducements for "execution-only" sales and strengthening conditions where inducements are allowed.
• Ensure financial advisors examine retail investors' financial situation more carefully.
• Require that marketing be fair, clear and not misleading also via digital channels and finfluencers.
• Improve both financial advisors' and retail investors' knowledge of financial markets.
• Improve investor categorisation by reforming the eligibility criteria for professional investors.
• Enhance supervisory cooperation between Member State competent authorities (NCAs) and European supervisory authorities.

Disclosure rules

In essence the Commission's approach to modernising the disclosure rules is threefold, covering risk warnings, marketing communications and unauthorised access via digital channels.

Risk warnings

While for contracts for differences there is an obligation to mention a risk warning (also on social media), there is no such risk warning for other risky financial services or instruments at the EU level.

The Omnibus Directive seeks to rectify this by inserting a new paragraph into Article 24 of MiFID II which will require investment firms to display appropriate risk warnings in all information materials concerning particularly risky financial products. Member States will also ensure that their NCAs have the power to impose the use of risk warnings for particularly risky financial products.

Obviously, the key issue for the market will be coming to terms with what is and what is not particularly risky financial products. The European Securities and Markets Authority (ESMA) has been tasked to deal with this and is provided with a mandate to develop, within 18 months of the Omnibus Directive coming into force, guidelines which will specify the concept of particularly risky financial products, as well as technical standards specifying the content and format of such risk warnings.

ESMA is also empowered, after consultation with the relevant NCAs, to impose the use of risk warnings on investment firms in instances where an absence of risk warnings may have a material impact on investor protection. How ESMA will utilise this power remains to be seen particularly in relation to individual Member States.

In her amendments the rapporteur took a more bullish approach and suggested broadening the power to impose risk warnings so that they are not limited to particularly risky financial products given that NCAs might need to impose risk warnings for reasons other than excessive risk. She also added a provision that enabled NCAs to use webscraping tools in order to perform their monitoring activities of new models of communication emerging from social networks and online platforms.

Marketing communications

Article 24(3) MiFID II provides that all information, including marketing communications, addressed by the investment firm to clients or potential clients shall be fair, clear and not misleading. Marketing communications shall be clearly identifiable as such. Supplementing Article 24(3) is Article 44 of Commission Delegated Regulation 2017/565 (MiFID II Delegated Directive) which provides further colour on fair, clear and not misleading information requirements.

For some time the Commission has been concerned that these MiFID II rules are not sufficiently adapted to the risks associated with the growth of digital channels offering services. In January 2023, ESMA launched a common supervisory action (CSA) with NCAs on the application of MiFID II disclosure rules with regard to marketing communications across the EU.

The Omnibus Directive therefore introduces new provisions to address the risk of unbalanced or misleading marketing communications. In particular the Omnibus Directive inserts into MiFID II a new Article 24c which:

• Introduces new obligations on investment firms that include clearly identifying marketing communications and ensuring they are appropriately attributed to the investment firm by which or on whose behalf they are made. In addition, the essential characteristics of the investment product or service is to be clearly presented in all marketing communications.
• Provides that marketing communications and practices should be developed, designed and provided in a manner which is fair, clear and not misleading, and should be balanced in their presentation of risks and benefits as well as appropriate for the target group of investors they are aimed at. The Commission is empowered to adopt a delegated act specifying those essential characteristics and the conditions to an appropriate design.
• Provides for the division of responsibility with respect to the content and use of marketing communications between manufacturers and distributors of investment products.
• Requires Member States to ensure firms' management bodies receive annual reports on the use of marketing communications and strategies aimed at marketing practices, compliance with obligations on marketing communications and marketing practices, and on signalled irregularities and proposed solutions with obligations on marketing communications and marketing practices, pursuant to MiFID II.
• Extends the existing record keeping obligation to all marketing communications which are directly or indirectly made by investment firms. The obligation covers a period of 5 years, allowing for a derogation of up to 7 years at the request of NCAs.

The Omnibus Directive also:

• Amends Article 9(3) MiFID II to include a requirement for investment firms to have a policy on marketing communications and practices, which the management body of an investment firm should define, approve and oversee.
• Inserts a new paragraph 3a in Article 16 MiFID to include a requirement for investment firms to have effective organisational and administrative arrangements in place to ensure compliance with all obligations related to marketing communications and practices under Article 24c.
• Amends Article 24(2) of MIFID II by requiring investment firms that manufacture financial instruments to ensure that the strategy for the distribution of those financial instruments is compatible with the identified target market also in relation to any marketing communications and marketing practices.

The rapporteur generally welcomed the new provisions concerning marketing communications focussing in particular on the emergence of so-called 'finfluencers' operating on social media and mobilising mainly younger generations. The rapporteur also proposed additional elements including imposing a requirement on firms to sign a contract with finfluencers to ensure responsibility.

Unauthorised activities offered through digital means

The Commission is aware that digitalisation presents various risks for retail investors not least that unauthorised investment services or activities may be offered through them. To this end the Commission is inserting into MiFID II a new Article 5a which provides for certain requirements to address unauthorised activities offered through digital means including updating the powers in Article 69(2) MiFID II and creating a new ESMA database setting out the measures that NCAs have taken against entities offering unauthorised investment services or activities.

Conflicts of interest and inducements

Whilst stopping short of a full ban on inducements, the Commission is introducing a number of important changes to the MiFID II rules in this area.

Retail investors may not always get the best deal

In its impact assessment the Commission noted that retail investors may not always get the best deal and that the current economic climate was exacerbating this. It gave the example that in 2021 retail clients were charged on average around 40% more than institutional investors across asset classes. Retail investors were also heavily dependent on advised services, and retail investment products were mostly distributed through a commissions-based model. Critically the impact assessment asserted that "the existing rules do not sufficiently mitigate the conflicts of interest which are inherent in this distribution model, and which lead to the distribution of more expensive products and deliver suboptimal outcomes for retail investors."

MiFID II

Currently, MiFID II allows for the payment of fees, commissions or the provision of non-monetary benefits (so called "inducements") to financial services providers by third parties (typically the manufacturer of the product). The MiFID II rules provide the basis for the "commission-based" distribution model of retail investment products, whereby financial intermediaries (e.g. financial advisors) are remunerated for their services not by the retail investors directly, but by the manufacturers of those products. The rules do not, however, exclude a purely "fee-based" model, whereby financial intermediaries (e.g. independent financial advisors) are only paid directly for their services, including advice, by the retail client. Under MiFID II, an advisor that informs his/her clients that the investment advice is provided on an independent basis, cannot accept commissions from third parties but needs to rely on fees from the client. The "fee-based" model has had limited uptake whereas the "commission-based" model is currently predominant for the distribution of retail investment products in the EU.

Conflicts of interest at the level of the distributor are inherent in the "commission-based" distribution model, as financial intermediaries receive remuneration from persons other than the retail investor for the products they are recommending and selling. The existing safeguards, such as the quality enhancement test under MiFID II, lead to different interpretations across Member States and firms, despite convergence efforts by ESMA.

Changes

In terms of inducements, the Omnibus Directive introduces three important measures:

• The existing ban on inducements regarding independent advice and portfolio management are maintained. However, a new Article 24a(2) MiFID II introduces a ban on inducements paid from manufacturers to distributors in relation to the reception and transmission of orders, or the execution of orders to or on behalf of retail clients.
• A new Article 24a MIFD II clarifies that the ban on inducements in relation to the services of execution of orders and reception and transmission of orders is not applicable in situations where the investment firm provides advice to the same client relating to one or more transactions covered by that advice. The ban on inducements is also not applicable in relation to fees or remuneration received or paid from an issuer for placement and underwriting services. However, such exemption is not to apply as regards instruments that qualify as packaged retail investment products.
• Further requirements are added to MiFID II as regards advised sales which oblige a distributor to ensure that the payment or receipt of inducements does not impair compliance with their duty to act honestly, fairly and professionally in accordance with the best interests of their client and to disclose the existence, nature and amount of inducements to the client.

The European Parliament's rapporteur took a different approach in her draft report arguing that the proposed approach on inducements looked like a first step and did not fully address the issues. Strong views were expressed against a full ban on inducements, she did not see the alleged conflict of interest which the Commission claimed as the reason for banning inducements in execution only situations and instead she opted for increased transparency. She also noted that in the absence of a clear and precise definition of the reception and transmission of orders, the actual scope of the ban remained unclear.In terms of the review clause, the rapporteur felt that it should not be biased as to lead to the automatic introduction of a full inducement ban and proposed to prolong it for five years starting from the end of the transposition period of the Omnibus Directive. In addition, the review clause's scope should be broadened to provide for an assessment based on potential conflicts of interest, evolution of costs, level of retail investment in capital markets, consumer protection and the relevance of distribution rules.

Quality enhancement test

The so called 'quality enhancement' test in MiFID II is to be replaced. To many this may not come as a complete surprise given that, for instance, in 2020 the Securities and Markets Stakeholder Group noted studies by several NCAs which showed that many investment firms were not fully meeting their obligations under the test, and that NCAs often had differing interpretations of the quality enhancement criteria

So that in order for financial advisors to act in the best interests of their clients ('best interest' test), they must, as a minimum:

• Base their advice on an assessment of an appropriate range of financial products.
• Recommend the most cost-efficient financial product from an appropriate range of suitable financial products.
• Offer at least one financial product without additional features which are not necessary to the achievement of the client's investment objectives and that give rise to additional costs.

The Omnibus Directive adds a review clause requiring the Commission to assess the effects of third-party payments on the retail investor segment three years after the transposition of the Directive.

As regards the cost efficiency criterion the rapporteur called for an assessment in practice with the notion of net performance, taking into account the level of return and not just costs. She also suggested that ESMA provide further guidance as to the practical meaning of an appropriate range of suitable financial products and how to fulfil this obligation in instances of non-independent advice.

Product governance and oversight

MiFID II's product governance requirements have proven to be one of the most important elements of the MiFID II investor protection framework, aiming to ensure that financial instruments and structured deposits (products) are only manufactured and/or distributed when this is in the best interest of clients. Articles 16(3) and 24(2) MiFID II provide that firms that manufacture products for sale to clients or distribute products to clients shall maintain, operate and review adequate product governance arrangements. As part of these arrangements, a target market of end clients shall be identified and periodically reviewed for each product, and a distribution strategy must also be consistent with the identified target market.

In March 2023, ESMA issued a final report updating its 2017 guidelines on MiFID II product governance requirements in light of various regulatory developments including the 2021 CSA on product governance which found room for improvement in various areas including the requirement to perform a charging structure analysis as required under Article 9(12) of the MiFID II Delegated Directive.

The updates to the 2017 guidelines have not been enough though.

Perhaps the most contentious aspect of the RIS is the Commission's proposals to develop benchmarks against which the value of financial products need to be assessed and this has led to criticism that maximum prices are to be set by the state for the services of asset managers and banks in the investment sector.

Benchmarks

Among the changes being introduced by the Omnibus Directive is a new Article 16a MiFID II which seeks to strengthen product governance rules and regulate pricing processes, and with a view to limit the offer of products that bear poor or no 'value for money' for retail investors. The changes apply to PRIIPs and at the level of the product manufacturer and distributor.

The key change is a requirement not to approve products that deviate from a relevant benchmark unless the manufacturer is able to establish that the costs and charges are justified and proportionate. ESMA is to develop and update cost and performance benchmarks against which manufacturers must compare their products prior to offering them on the market. To facilitate the development of the benchmarks certain requirements are placed on manufacturers and NCAs as regards reporting data on costs, charges and performance of PRIIPs. Any deviation from a relevant benchmark is to introduce a presumption that the costs and charges are too high and that the product will not deliver value for money unless it can be demonstrated otherwise. Therefore any deviation would need to be documented setting out the reasons for doing so.

In its impact assessment the Commission asserted that the main adjustment costs for investment firms resulting from the value for money process would be one-off changes to IT systems. As calculations can be automated, the Commission felt that these additional costs would not be significant. This was on the basis that most of the data and IT infrastructure are already in place in order to comply with existing disclosure requirements and product governance rules. The Commission also accepted that reporting to supervisors will entail additional administrative costs but did not say how significant these costs would be as they would be dependent to a significant extent on how value for money is ultimately implemented, and the degree of granularity required.

The rapporteur felt that the proposal for value for money could be disruptive for the market leading to reduced diversity of products and supressed innovation. Also, she felt that further discussions were needed given the lack of clarity regarding the methodology which would be applied to the design of the benchmarks which prevented any assessment as to how these would unfold in practice. As such the rapporteur deleted the benchmarks in her draft report.

However, in the European Parliament's press release concerning ECON's approval the concept of benchmarks had not been deleted. The press release provided that ESMA and EIOPA should after consulting NCAs develop common European benchmarks for products manufactured and distributed in two or more Member States. Products manufactured and distributed in one Member State would be subject to national benchmarks. The press release added that the benchmark should not lead to price regulation and should instead be used as a supervisory tool, to assess the monetary and non-monetary benefits of the products and identify potential outliers on the market.

Other changes

The Omnibus Directive makes further changes to the suitability and appropriateness tests, investment advisors, the thresholds for client categorisation and financial literacy.

Suitability and appropriateness tests

The Omnibus Directive amends the Article 25 MiFID II appropriateness test so as to require investment firms to explain the purpose of their assessment to their retail investors in a clear and simple manner. They must also obtain all relevant information from such investors which may be necessary and proportionate for these assessments. Retail investors will need to be informed, via standardised warnings, about the consequences on the quality of the assessment where they do not provide accurate and complete information. In addition, the Omnibus Directive will introduce the possibility for independent advisors to provide advice although this will be limited to a sufficient range of diversified, non-complex and cost-efficient financial instruments.

Investment advisors

The Omnibus Directive contains revised rules which aim to strengthen and align the requirements on the knowledge and competence of investment advisors set out in MiFID II and IDD. Article 24d MiFID II will be amended and certain requirements that are currently stipulated in ESMA guidelines are to be moved to a new Annex V of MiFID II. Furthermore compliance with the requirements will be proved by obtaining a certificate. There will also be ongoing professional training.

Thresholds for client categorisation

The Omnibus Directive adjusts the eligibility criteria for professional investors upon request. It does this by lowering the monetary threshold from EUR 500,000 to EUR 250,000. In addition, a fourth criterion relating to relevant education or training is inserted which reads:

'the client can provide the firm with proof of a recognised education or training that evidences his/her understanding of the relevant transactions or services envisaged and his/her ability to evaluate adequately the risks'

Legal entities will also be able to qualify as a professional client on request by fulfilling certain total balance sheet (€10 million), net turnover (€20 million) and own funds criteria (€1 million).

Financial literacy

In its impact assessment the Commission noted low levels of consumer financial literacy noting in particular that the OECD/INFE 2020 International Survey of Adult Financial Literacy showed that on average, consumers could only reply to around 60% of questions on basic knowledge concepts and financially prudent behaviours and attitudes. Only 26% of all adults responded correctly to questions on both simple and compound interest - which are crucial concepts for investment.

In light of this a new Article 88a MiFID II seeks to promote financial education measures at the Member State level so that retail investors are able to investment responsibly. The rapporteur noted that according to a recent Eurobarometer survey, only 18% of EU citizens have a high level of financial literacy, 64% have a medium level and 18% a low level, while there were also huge divergences among Member States.

Supervisory enforcement

Certain measures are being introduced to strengthen cross border supervisory enforcement. For example, the Omnibus Directive introduces a new Article 35a MiFID II which deals with investment firms reporting on their cross-border activities. A new Article 87a MiFID II further provides for the establishment of collaboration platforms that facilitate closer collaboration between NCAs and the European Supervisory Authorities to address cross-border issues.

The rapporteur proposed certain amendments to boost cross-border supervision, including placing an obligation for companies to register in the same Member State where their head office is located, in order to avoid forum-shopping. She argued that the current Recital 46 of MiFID II establishes an anti-forum-shopping principle by requiring that an investment firm operates effectively in its home Member State. Until now, it has been a 'floating' recital, with no corresponding provision in the MiFID II articles. This requirement should become more explicit.

Changes to PRIIPs

The RIS makes several changes to the PRIIPs Key Information Documents (KIDs) including:

• Introducing a summary dashboard, to make key information on costs and risks of investment products highly visible at the top of the document.
• More flexibility to display information from PRIIPs key information documents in a digital and user-friendly way, notably by allowing the use of layering, i.e. the possibility to click on the titles of different sections of the key information document and expand the text of the sections of interest, which complements the fixed document, such as in PDF format, which exists today. The package also specifies conditions for more interactive features.
• A new sustainability section in the KID titled 'How environmentally sustainable is this product?'. The section will make information on sustainability-related characteristics of investment products more visible, comparable and understandable for retail investors. This section will build entirely on existing sustainability disclosures, avoiding any new reporting burdens.
• A definition of electronic format.
• A new section in the KID titled 'Product at a glance' to summarise and highlight the information on an investment product type, its costs and the level of riskiness, recommended holding period and presence of insurance benefit.
• Adapted rules for presentation of key information on multi-option products.
• Clarifications intended to provide greater legal clarity on the exclusion of specific products (e.g. corporate bonds) that were not originally intended to be captured by the PRIIPs regulation.

Among other things the rapporteur suggested deleting the 'Product at a glance' section of the KID. The justification for this was that such content would be redundant with those of the KID and would use space in a document that is already very dense. This addition did not concur to the much-needed simplification of PRIIPs.

In a separate vote MEPs in ECON approved proposed changes to KIDs, with 38 votes to 13 (with 2 abstentions).

The UK approach

The reforms to the EU retail sector as set out in the RIS are still in their early stages. The framework directive has not been completed and is still going through political discussions. Level 2 measures that provide clarity on the key aspects of the Directive like benchmarks have not yet been drafted. The UK on the other hand is much more advanced, having introduced a new Consumer Duty (Duty) on 31 July 2023 for all products and services that were open for sale or renewal. The Duty will apply to all closed products and services from 31 July 2024.

The key question for investment firms operating in both the UK and EU will be how aligned or how far apart is the Duty from the RIS.

For example, under the Duty the Financial Conduct Authority (FCA) expects firms to provide products and services that, among other things, provide fair value with a reasonable relationship between the price retail investors pay and the benefit they receive. But fair value is about more than just price, the Duty aims to tackle factors that can result in products or services which are unfair or poor value, such as unsuitable features that can lead to foreseeable harm or frustrate the customer's use of the product. The introduction of benchmarks and a structured pricing process under the RIS are much more formalistic. UK firms under the Duty will no doubt conduct benchmarking but that is only part of the fair value assessment, firms need to satisfy themselves that the product in and of itself provides fair value.

The Duty introduced a new FCA principle that firms "must act to deliver good outcomes for retail customers". The RIS introduces certain changes that firms will need to consider when considering the clients' best interests but arguably the less prescriptive UK approach provides for broader application.

The RIS introduces new obligations regarding marketing communications and updates to the PRIIPs KID. The Duty has introduced a consumer understanding outcome which builds on Principle 7 of the FCA's Principles for Businesses that firms communicate information in a way which is clear, fair and not misleading. For example, the Duty adds that firms must tailor communications taking into account the characteristics of the customers intended to receive the communication and when interacting directly with a customer on a one-to-one basis, where appropriate, tailor communications to meet the information needs of the customer, and ask them if they understand the information and have any further. On PRIIPs more generally, the UK is looking to revoke the regime and put in its place a "future disclosure framework". An FCA consultation paper is expected sometime this year.

Outside of the Duty, the UK and the EU have taken different paths when it comes to the ban on inducements. The UK has a full ban on commissions paid from manufacturers to distributors. The EU currently proposes a partial ban.

Next steps and conclusion

As mentioned above, the European Parliament will cease its work in April 2024 to prepare for the June 2024 elections. It is therefore doubtful whether the Council of the EU and European Parliament can adopt a final text of the RIS before the European Parliament elections, which could cause significant delay.

The Commission seriously underestimates the additional costs investment services firms will have to bear even if only the slimmed-down version of the RIS, as proposed by the rapporteur, is implemented. For investment firms and their clients, the investment universe will shrink, as only products that are - based on hard to test predictions - "cost effective" can be sold. This is bad enough in the context of investment advisory services, but not justifiable, from a proportionality viewpoint, when it comes to execution-only business.

Hopefully, the RIS - which can, if implemented properly, help investment firms to regain the trust of their clients - benefits from an extended summer break.