Proposed conduct of business rule changes: the potential impact on institutional firms

January 2007

1. BACKGROUND

   In October 2006, the FSA published its Consultation Paper (CP) - CP06/19. The paper outlines its proposals regarding the reform of the Conduct of Business rules under the Markets in Financial Instruments Directive (MiFID). The paper specifically looked at implementing a less prescriptive and more principles-based approach to regulation. Though mainly involving the proposed NEWCOB sourcebook, changes to SYSC, SUP, DISP and TC were also discussed. Proposals for amendment to the financial promotions and communication rules were made in the complimentary CP - CP06/20: "Financial Promotion and other communications".

   The consultation process to date has covered only the proposed changes to the rules for retail firms, with the consultation process on institutional rule changes expected in early 2007. However, some of the proposals could also have an effect on institutional firms, particularly those firms also dealing with retail clients.

2. SPECIFIC ISSUES FOR CONSIDERATION

   CP06/19 considers the proposals in relation to a number of specific areas. Whilst some of these are clearly irrelevant to the majority of non-retail firms, for example identifying client needs, other chapters contain a large amount of potentially relevant material. In many cases, the requirements under MiFID are broadly equivalent to existing FSA rules. In others, specific rules have been replaced by higher level principles. In such cases, it may well not be necessary for a firm to change its existing method of operation.

   The main points arising from the proposals which may be relevant to institutional firms are summarised below. All institutional firms should consider whether each specific issue is likely to be of relevance to them and if so what, if any, changes will be necessary as a result.

   2.1 Conduct of Business Requirements

   The main issues addressed within this section are customers' interest, inducement, third party information and exclusion of liability. The main effects on institutional firms will be as follows:

   • The FSA considers that it would be inappropriate to allow a MiFID firm to rely on information from a non-MiFID firm where the standard of protection offered by MiFID is materially higher. This means that institutional firms under the effects of MiFID may have to take increased responsibility for their own information gathering.
   • Firms should, however, note that, based on proposals to extend MiFID suitability requirements to non-MiFID business, the FSA still intends to allow MiFID firms to rely on recommendations made by non-MiFID firms to their clients.
   • The FSA intends to remove the exclusion of liability rules under COB 2.5 from NEWCOB. Firms should note that this is not a license to make unreasonable exclusions, however, the FSA believes that existing legislation gives adequate cover in this area.
   • MiFID firms will be required to disclose to the client the existence, nature and amount of any fee, commission or benefit, and, to provide further details at the request of the client.

   2.2 Client Categorisation

   The FSA proposes to adopt the MiFID client categorisation of "retail", "professional" and "eligible counterparty". It should be noted that the category boundaries may not correspond exactly with the ones in use at present. Where both MiFID and non-MiFID business is carried on with a client, the client should be classified in accordance with MiFID rules. Reclassification of certain clients may be required and under NEWCOB 3.7.6 notification must be made to a client which a firm has reclassified off its own back. It should be noted that the FSA intends to retain the COB 4.1.5 concession where a firm dealing with an intermediary is entitled to classify the firm rather than the underlying client.

   The FSA has dictated that where terms such as "other institutional clients" are used within MiFID and not clearly defined, firms should take a "purposive" approach. It also been stated that no further guidance will be issued in this area. Under certain circumstances, retail clients may request to be upgraded to professional status, hence waiving some of the protection afforded to them by the NEWCOB rules.

   2.3 Financial Promotions and other communications

   CP06/20 contains the FSA's proposals for amendments to the rules on communications with clients and financial promotions. The paper's stated aim is to invoke "a substantial reduction in the number of detailed financial promotion rules, and a much greater focus on principles and high-level standards". The FSA is keen to offer firms greater flexibility in considering how best to offer customers protection whilst removing the "tick box" approach to compliance. The new rules are set to be much less prescriptive and we would not expect that firms currently using a fair and reasonable approach to compliance would be subject to any more onerous requirements.

   2.4 Information about the firm, its products and services

   MiFID introduces different disclosure requirements for firms, wholesale as well as retail, which fall within its scope. The FSA's proposal for implementation is to copy-out the MiFID requirements for firms in the Directive's scope, and to leave existing statutory status disclosure rules in place for other firms. This means that MiFID firms will only have to provide the following information, in good time and where relevant:

   • A statement of the fact that the firm is authorised and the address of the regulator; and
   • Information on the name and address of the firm and contact details necessary to enable clients to communicate effectively with the firm.

   In practice, we would envisage that the effects of this will be minimal. Where a firm falls within the scope of MiFID, it may become necessary to add the address of the FSA to some of its documents. The FSA believes that this will incur minimal time or expense to the firm in question.

   2.5 Client Agreements

   The FSA proposes to apply the MiFID rules on client agreements and timing to both MiFID and non-MiFID business. This will remove its current distinction between one-way ("Terms of Business") and two-way ("Client agreement) documents and the requirement for a signature for certain types of business. In particular, Terms of Business documents will no longer be required for professional clients. In practice, most of the information required on current Terms of Business documents will still be required, however, firms will have more flexibility on how to provide this. It is believed that timing requirements under MiFID will be broadly equivalent to those under the current COB rules.

   2.6 Preparing and Providing Product Information

   The FSA proposes to maintain its requirement to provide a Key Features Document (KFD) at the point of sale for both MiFID and non-MiFID business. In line with the move to principles-based regulation, many of the detailed content requirements for a KFD (e.g. risk warnings and special situations) will be replaced.

   The FSA also intends to require the introduction of a "key facts" logo and a regulatory disclosure on the KFD to bring this into line with the IDD and Menu. Firms would also need to rename their KFDs "Key Facts of the [insert name of product]".

   The FSA intends to carry out thematic work based upon improving the standard of the KFD, aimed at making this shorter, more focused and better laid out. This would be achieved by means of supervisory liaison and a thematic review. We would expect more specific details to become available in due course.

   2.7 Outsourcing

   The FSA has proposed a unified standard on outsourcing critical or important operational functions, while giving firms flexibility to manage the risks in a way which is appropriate and proportionate. A firm will be required to take reasonable steps to avoid undue operational risk and must not impair the quality of its internal control or the activities of its supervisor. It should be satisfied that:

   • The service provider has the ability, capacity and necessary authorisation to perform the outsourced activities reliably and professionally;
   • The firm can assess the standard of performance; and
   • It can supervise the service provider appropriately and manage risks associated with outsourcing.

   A firm will have to act if it appears that the service provider is not carrying out the functions effectively or in compliance with legal and regulatory requirements. For functions which are not critical or important, the FSA has proposed that a firm should take these rules into account, as appropriate and proportionate.

   2.8 Risk Control Policies

   Both MiFID and the CRD stress the importance of firms establishing effective risk control policies and procedures. The FSA's proposals for risk control are not substantially different from the current Handbook provisions, but detailed guidance will be replaced by high-level rules. A number of requirements on risk control contained in the CRD will apply only to CRD firms.

3. ACTION POINTS

   Further consultation is expected in early 2007 and we would expect the impact of the initial proposals to be minimal on many institutional firms. However, the following are actions which institutional firms can take now to help prepare for implementation in November 2007:

   • Review information gathering procedure. If substantial reliance is placed by a MiFID impact firm upon information from non-MiFID firms, it may be necessary to alter procedure in order to take more direct responsibility.
   • Ensure arrangements are in place to account to a client, intermediate or other, for any benefit derived from doing business with them or on their behalf. This may include fees, commission or any other benefit and disclosure must be made on the client's request.
   • Make arrangements for a full review of client classification and prepare a letter to be sent to any client who may potentially be reclassified. Further work can be done on this when the precise category definitions are released.
   • Where the firm falls under MiFID, ensure that the required regulatory disclosure and the details of the FSA are added to communications.
   • Where a firm provides a product which requires a KFD, ensure that the relevant logos and disclosures as described above are added in good time.
   • Implement a procedure for monitoring and reporting on the standard of any outsourced critical or important functions.
   • Review currently used risk control policies and procedures to ensure that these remain robust and appropriate for purpose.

4. THE NEXT STEP

   The FSA intends to consult further on its proposals for changes to the Conduct of Business rules in early 2007. The rules are expected to be published in mid-2007, coming into force on 1st November 2007. Any transitional provisions or waivers which have been affected will cease to be in effect as of this date. A post-implementation review is expected to take place to ensure the effects of the changes are as expected.

   Further information on the FSA proposals, is available through the relevant Consultation Papers at http://www.fsa.gov.uk/pubs/cp/cp06_19.pdf and http://www.fsa.gov.uk/pubs/cp/cp06_20.pdf.

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