MiFID - Financial promotions and other communications

December 2006

The FSA has published a Consultation Paper (CP) containing proposals to implement a more principles-based system of regulation for financial promotions and other communications. The paper is linked to the overhaul of the Conduct of Business (COB) rules proposed in a sister consultation. The move is also linked to the implementation of the EU's Markets in Financial Instruments Directive (MiFID) and particularly the obligations covering "all information" and "marketing communications". Together, the combined papers propose removing around half the content of the old COB rulebook with the end result being a new Conduct of Business rulebook - NEWCOB - which will be substantially shorter. (When the changes become part of the Handbook, the term "COBS" will replace both COB and NEWCOB.)

1. Introduction and overview - What this is about?

   The CP (CP), entitled "Financial Promotions and Other Communications" (CP 06/20), follows the Financial Promotions Review which was announced in the FSA's 2005-06 Business Plan. This was conducted with the forthcoming MiFID in mind, and the proposals are intended not only to implement the Directive, but also to complement the Treating Customers Fairly (TCF) initiative. NEWCOB will apply to all regulated firms and business coming under the FSA Conduct of Business regime, not just those firms and types of business which are covered by MiFID.

   1.1 Principles-based Regulation

   The change from detailed rules and regulations towards high-level rules that focus on results rather than processes, with the minimum necessary prescription, is known as principles-based regulation. The FSA intends to focus more on management's responsibility for delivering the right outcomes for consumers and giving management more flexibility in delivering the required standard of consumer protection.

   The experience from the move towards principles based regulation in the TCF project has lead the FSA to admit that many firms are concerned that, with higher-level rules, there will be uncertainty about the minimum standards required. The FSA has said that it recognises that firms should be able to predict, at the time, whether an action would be in breach. It is proposing to continue its practice, started under the TCF initiative, of providing statements of good and poor practice, worked examples and case studies illustrating ways in which firms have successfully met the requirements. A separate Discussion Paper ("FSA confirmation of Industry Guidance - DP 06/5") has also been published covering greater use of industry codes and guidelines.

   In this instance, the proposals are intended to permit firms to exercise more discretion and flexibility when marketing, but place responsibility for oversight clearly on the senior management of firms. The changes are also intended to allow firms to interpret the standards for themselves and will allow promotions to be tailored more closely to the needs of the consumers to whom they are directed

2. Implementation of MiFID and other European Directives

   The new rules are heavily driven by the need to implement MiFID in the UK. The overall approach is to:

   • use "intelligent copy-out", that is, rules will generally be based on directly copied-out directive text; and
   • where proposals go beyond the strict directive requirements, to ensure these are justified in market failure and cost benefit analysis terms. Limited scope exists for exceeding or "gold plating" the Directive provisions, and Article 4 requires an application to be made to the EU Commission in each instance (Article 4 notification). No measures have been proposed in this paper which go beyond the strict MiFID requirements.

   2.1 Client categorisation

   The detailed changes on client categorisation are contained in the Reforming COB CP issued simultaneously. The FSA is proposing to adopt the MiFID terminology (retail client, professional client and eligible counterparty) for financial promotions issued in conjunction with both scope and non-scope business.

   As a result, there are several changes to financial promotions and the new client categorisation regime is likely to result in more "retail clients" although certain classes of client who are "private customers" under the existing COB regime will be categorised as professional or even eligible counterparties under MiFID. There will be a series of transitional grandfathering arrangements allowing firms in most cases to continue scope business with existing retail and intermediate customers on the same basis without the need to review, "re-paper" or notify these clients of the change to the client category. It is likely that similar grandfathering provisions will be made for non-scope business to allow existing client classifications to be carried over into the new terminology, with a minimum amount of re-categorisation required.

   2.2 Legal/legislative issues

   The government will need to amend the Financial Services and Markets Act (FSMA) and also the Financial Promotions Order (FPO) to give UK structure to MiFID. This means that where MiFID does not apply, firms will be able to take advantage of FPO exemptions as they do now. However, for MiFID firms carrying on MiFID business and communicating about a MiFID instrument, the FPO exemptions will not be available and the relevant financial promotion rules in NEWCOB will apply. The FSA is expecting that some MiFID firms will need to reconsider their business models; such firms will include:

   • firms who rely on the one-off exemption;
   • the exemptions relating to high net worth individuals or sophisticated investors; or
   • the "sale of a body corporate" exemption.
   Firms who fall into the above should take particular note.
3. The key points

   The proposals involve the replacement of the existing provisions in COB with requirements in NEWCOB outlining the standards in high-level terms. The requirements will be relevant to all firms when communicating with professional and retail clients.

   3.1 NEWCOB 4

   NEWCOB 4 will cover communications by firms, and retains the key rule that all communications are "fair, clear and not misleading". It will also include some new provisions copied from MiFID that will apply for the first time to "all information". Where relevant, the FSA is proposing to apply these to both scope and non-scope business. However, some will only apply to scope business.

   3.2 NEWCOB 5

   NEWCOB 5 contains proposals to expand on the fair, clear and not misleading high-level rule for financial promotions. They also contain revised, simplified and largely high-level requirements for the approval and communication of financial promotions aimed at retail clients.

   3.3 Fair, Clear and Not Misleading - Change of Emphasis

   The importance of "fair, clear and not misleading" financial promotions is central to the new regime. At present, it is a high-level rule, restating an FSA Principle (No 7). The significant change is that at present firms must take reasonable steps to communicate in a way that is clear, fair and not misleading. The changes are intended to make firms ensure that all information they address to customers in relation to relevant business is fair, clear and not misleading.

   For non-promotional communications, some of the provisions in NEWCOB 4 will apply to scope and non-scope business and some will only apply to scope business.

   3.3.1 Communications Covered
   The MiFID term "all information" is wide, and covers any communication, including marketing communications, between a firm and its client or potential client. It includes financial promotions, product disclosure documentation, communications between the firm and the client during face-to-face interviews (e.g. during sales advice), telephone conversations and any casual reference by a member of staff.

   3.3.2 Application
   The fair, clear and not misleading requirement will apply to information addressed to "retail clients" and "professional clients", but not to information addressed to eligible counterparties (ECPs) operating within the ECP regime - unless ECPs request otherwise.

   Currently, firms communicating with market counterparties only need to ensure that the information is "not misleading". The introduction of the MiFID-style client categorisation of ECP will affect the application of this principle for some firms. Some market counterparties may not qualify for classification as ECPs under MiFID and will be owed greater obligations under this, and other rules as retail or professional clients. Firms dealing with market counterparties at present will need to review this area of their business.

   The proposed rules require firms to ensure that all information addressed by the firm to retail and professional clients is fair, clear and not misleading for scope business. For non-scope business the current "reasonable steps" standard is not to be carried forward but instead, the proposal is to apply the MiFID requirement to all firms.

   3.3.3 Retail Clients - Additional Conditions
   MiFID imposes additional requirements expanding on the fair, clear and not misleading principle, for information addressed to, or likely to be received by, retail clients. The FSA is not planning to extend these requirements to professional clients or ECPs, and the FSA is also not proposing that all the additional requirements should apply in all cases. Some of the provisions will apply only within MiFID scope, as detailed below.

   MiFID requires information to:

   • include the name of the investment firm;
   • be accurate and in particular not emphasise any potential benefits of an investment service or financial instrument without also giving a fair and prominent indication of any relevant risks;
   • be sufficient and presented in a way that is likely to be understood by the average member of the group to whom it is directed, or by whom it is likely to be received; and
   • not disguise, diminish or obscure important items, statements or warnings.

   The proposal is to apply these high-level rules to all firms, as they form part of Principle 7. Additional guidance will not be forthcoming, but firms will be expected to apply ordinary meanings to terms. The FSA quotes the example of the "average member" and says it is not expecting detailed arithmetic calculations, but the application of common sense.

   MiFID makes it clear that all information containing comparisons (including non-promotional material) must be "meaningful and presented in a fair and balanced way". This requirement is to be applied to all cases in the UK as at present. In addition, MiFID requires firms to include information on its "sources of information" and "key facts and assumptions used to make the comparison" in all communications. This is not a current UK requirement, and the FSA has decided not to extend the requirement to non-scope business on cost benefit and market failure (none perceived) grounds. These requirements will therefore only apply within MiFID scope.

   On past performance, the aim of MiFID is to reduce the emphasis generally placed on it. MiFID contains provisions on how past performance, simulated past performance and future performance (i.e. projections) must be disclosed. The CP contains some detail on how the MiFID requirements are to be applied, taking into account the means of communication and the information that the communication is intended to convey. The detailed requirements will appear in NEWCOB 5.

   The FSA is not proposing to apply MiFID-based rules on past, simulated past or future performance to non-promotional material outside of MiFID scope; firms will only need to comply with the high-level fair, clear and not misleading rules for non-scope non-promotional communications.

   Where a communication refers to a particular tax treatment, MiFID requires the inclusion of extra wording that the tax treatment depends on the individual circumstances of each client and may change in the future. The FSA will rely on the high level requirements for non-scope non-promotional communications, but in order to achieve this, it may be relevant for them to disclose this information in some situations.

   An additional proposal is to be made to apply to all firms concerning the use of competent authority endorsement. MiFID prevents firms from using the name of any competent authority in such a way that it appears it has an endorsement or approval. This goes beyond the current provision in COB by banning references even if approval is received in writing.

   3.4 Financial Promotions

   The present COB regulations for financial promotions build on the overall requirement for financial promotions to be clear, fair and not misleading; some are product-specific. The new requirements will be included in NEWCOB 5, and the changes have been brought about largely by the Financial Promotion Review, rather than the introduction of MiFID. NEWCOB 5 will contain fewer detailed, and particularly product specific rules, with the FSA relying more on the high-level requirements. Where an existing provision is not covered obviously by the fair, clear and not misleading requirement, it is retained.

   The key rule that communications must be fair, clear and not misleading, is to be used and referred to, and will apply to financial promotions of all types of investment (including deposits) covered by NEWCOB.

   The existing requirements on promotions make clear who is providing the information; that the information is accurate and sufficient for the needs of the promotion; that important facts are not masked; and, where benefits are discussed, that it provides balance by including details of relevant risks. This information must be presented in a way that is likely to be understood by the average member of the audience. The MiFID requirements are very similar, and although there are some differences, these are generally minor.

   The high-level standards will apply in place of the existing product-specific rules which are to be deleted. Firms will thus be required to provide consumers with relevant product details in financial promotions, but the specific disclosures or actions will no longer be the subject of detailed rules.

   The new standard will apply to both MiFID and non-MiFID business and communications.

   3.4.1 Comparative information
   MiFID does contain requirements on comparisons and contrasts to "all information" produced by firms; this will include financial promotions. The requirement is that comparisons must be "meaningful and presented in a fair and balanced way". This requirement will apply for both scope and non-scope business (including financial promotions relating to deposits and certain pure protection contracts). The additional requirements (to include particular detail on the "sources of information" and "key facts and assumptions used to make the comparison") will only apply to scope business.

   All other existing requirements on comparisons in financial promotions are to be deleted.

   3.4.2 Past performance
   The FSA is proposing rules that will require that:

   • past performance disclosure must not be the most prominent feature of a communication;
   • a past performance risk warning must be included, that the figures refer to the past and that past performance is not a reliable indicator of future results; and
   • the information must cover at least the immediately preceding five years (or all years, if less) and be based on complete twelve-month periods. It will not be possible to provide past performance data for funds with fewer than twelve months of performance.

   These will apply to all scope non-marketing communications and to all financial promotions of designated investments and structured deposits (but see 2.4.4 below).

   It should be noted that MiFID does not specify a standard presentation (either in terms of format or calculation), whereas COB currently requires information to be provided in a table using percentage format. Also the MiFID requirement for a past performance risk warning is not as specific as the current COB rules.

   The FSA is proposing to apply the same rules to scope and non-scope business, but has made it clear that this deregulation may lead to consumer detriment. It has said that it will be monitoring how these new rules operate in practice and has not ruled out the imposition of later requirements under Article 4 if required. It will also apply guidance with consumer protection issues in mind.

   3.4.3 Simulated Past Performance
   In some situations where past performance data does not exist, it is possible for firms to simulate how an investment would have performed in the past. The FSA is proposing to apply rules to stop firms with actively managed investments (where the discretionary element would allow the firm to overstate performance) from providing simulated past performance. As with past performance, simulated past performance must comply with the requirements set out in paragraph 2.4.2 above. The MiFID rules on the disclosure of simulated past performance are also to be applied to promotions of non-scope business.

   3.4.4 Other Performance Issues and Proposals
   

   • Additional proposals on future performance illustrations in non-scope business product disclosure have not yet been made, but will be the subject of separate consultation in due course.
   • The FSA considers that while it is appropriate to apply the MiFID requirements on past, simulated and future performance to scope business for "all information" in all financial promotions, it is not always appropriate for all non-marketing communications. Therefore, the detailed rules are located in NEWCOB 5, with a cross-reference to them in NEWCOB 4, reminding firms that for non-marketing communications these detailed requirements may not be appropriate or proportionate in all instances.
   • MIFID requires that "marketing communications shall be clearly identifiable as such". This is a new provision for the UK, although the FSA points out in the CP that firms should be doing this to comply with the fair, clear and not misleading requirement. The proposal is that the requirement should apply to all firms.
   • Currently the financial promotion rules specifically prohibit financial promotions that give a misleading impression of the identity of a product's producer. The high-level rules (including the requirement to disclose the firm's name and provide accurate and sufficient information) mean that a detailed rule on co-branding (or white labelling) is no longer necessary. However, guidance on the standards expected of firms when they communicate or approve financial promotions about another firm's products is to be provided.
   • If a financial promotion contains advice, then the revised "suitability" rules proposed in NEWCOB 10 will also be relevant. If the promotion refers to a packaged product, NEWCOB 7 may also be relevant. Further detail on this is contained in the parallel Reforming COB Regulation CP (see link below or our separate bulletin).

   3.5 Packaged Product Disclosure Requirements

   There are new rules covering content and format of product disclosure documents for packaged products in the parallel CP Reforming COB Regulation CP (see link below or our separate bulletin). The current approach on direct offer financial promotions assumes that the direct offer financial promotion is the final contact between the firm and the client before a transaction. The rules surrounding these promotions are to be revised (mainly as a result of the Financial Promotion Review). In the future, disclosure requirements will not be triggered by whether or not a promotion is a direct offer. Instead, for non-advised sales, disclosure may be supplied at any stage in the sales process (including within the promotion), so long as it is provided in good time before a transaction resulting from the promotion.

   In addition, because of the increased flexibility over timing of disclosure material and the move away from product-specific rules, the FSA has decided that it is no longer necessary to distinguish between direct offer financial promotions and other promotions; the "direct offer financial promotion" defined term is therefore to be removed.

   3.5.1 Appropriateness Test
   This is a new concept in UK regulation, introduced by MiFID. The detail is contained in the Reforming COB Regulation CP (see link below or our separate bulletin on the subject). The appropriateness test in summary:

   • The appropriateness test obliges a firm to seek information from a retail client to enable it to determine whether the client has the necessary knowledge and experience to understand the risks involved in the transaction or service;
   • if the firm considers that the client does not have that knowledge or experience (or is unable to determine either way) then the firm must warn the client;
   • the appropriateness test must be conducted before the transaction is completed or the service entered into;
   • Firms do not have to make the assessment before they send out a promotion, as is currently required with the "may be suitable" assessment;
   • the test applies to all in-scope "complex" products sold by MiFID firms to retail clients. The FSA will replace the current "may be suitable" assessment with the appropriateness test for all retail transactions in derivatives and warrants that result from a specified type of financial promotion;
   • MiFID firms will also need to consider whether a communication for a MiFID "non-complex" product is "personalised", since such communications may trigger the need for the appropriateness test (see the Reforming COB Regulation CP for further detail).

   3.6 Other Deregulatory Proposals

   A series of other proposals introducing high-level requirements, and removing product specific rules have been made:

   • the current requirement for direct sales promotions for Collective Investment Schemes to disclose whether charges are taken from capital or income is to be removed;
   • the current explicit ban on projections in financial promotions for Enterprise Investment Scheme (EIS) shares is to be removed;
   • the disclosure requirements relating to an EIS are also to be removed (but not the appropriateness test above);
   • the current ban on the direct sales promotion of broker funds is to be removed;
   • the provisions for qualified investor schemes (QISs) are not to be carried forward. However, the rules that govern the operation of QISs in the new Collective Investment Schemes Sourcebook (COLL) will continue to include a requirement for a QIS operator to act as a gatekeeper and take reasonable care to ensure that only eligible investors invest in the fund. A further CP is planned for 2007 covering any necessary consequential amendments. It is likely that this will relocate the material relating to eligible investors to a new COLL annex.

   3.7 Public offer advertisements

   An advertisement about an offer or admission to trading of transferable securities may currently be covered by both the financial promotion rules and by the advertising rules in the Prospectus Rules sourcebook (PR). The proposal is that the NEWCOB requirements will mirror the requirements on content under the PR rules. The rules will apply where the advertisement is issued by a MiFID firm providing a MiFID service. Where PR or NEWCOB rules apply to such an advertisement that is issued in the course of non-MiFID scope business, the information in the promotions must not be inaccurate or misleading. The existing clear, fair and not misleading standard will no longer apply to such business.

4. Implications

   The proposals outlined in this CP will mean that firms may need to review their communication strategies and, possibly, alter their approach to the communication and approval of financial promotions. This will particularly be the case for firms using direct sales marketing.

   Some firms will need to review and possibly amend their existing systems and controls, particularly on the communication of past, simulated and future performance. However, although there are some additional requirements for non-scope business, most firms will already be following the required standards, and the changes should not result in significant differences.

   Firms will need to review their financial promotions to ensure that they meet the requirements, but will no longer have to abide by detailed, product specific, rules. Additional flexibility is therefore being introduced.

   Firms should be aware that the FSA will be looking at the issue of presentation of past performance material carefully post-implementation, and has signalled discomfort with the additional consumer detriment possibilities that may arise.

5. What is going to happen next

   The consultation period on the substantive proposals closes on 23rd February 2007. The FSA plans to publish feedback in a Policy Statement in the second quarter of 2007. The new rules will take effect on 1st November 2007.

   The move to principles-based regulation means that the FSA will have to provide firms with more "soft" information so that they are able to apply best practice. The FSA has announced that it will use its website and other publications to set out its views; highlight issues arising from thematic work; give examples of good and bad practice, including case studies; provide bulletins; establish dedicated web pages, and provide training.

6. Where to go for extra detail

   The Consultation Paper can be found at the following link: http://www.fsa.gov.uk/pubs/cp/cp06_20.pdf

   The Reforming COB CP can be found at the following link: http://www.fsa.gov.uk/pubs/cp/cp06_19.pdf

   Additional bulletins from Grainger Consulting, on MiFID and other topics can be found at: http://www.graingerconsult.com/topics/index.shtml

WARNING
Errors and Omissions Excepted. This communication is for the general information of subscribers. It is not a professional opinion relating to a specific set of circumstances or a specific client. Recipients must not place reliance upon it in relation to their own specific circumstances without seeking professional guidance specific to those circumstances. Unless recipients are current clients (full service or Compliance Counsellor service), Grainger Consulting Limited will not enter into correspondence with recipients in relation to the content of this communication or provide further guidance or opinion.

COPYRIGHT
Copyright 15/12/06 Grainger Consulting Limited, part of the Compliance.co.uk Group. All rights reserved. Copying or forwarding of this communication without the express written permission of Grainger Consulting Limited is prohibited. Should you or your colleagues require additional copies, please contact us for subscription details and an application via info@graingerconsult.com.