Product intervention under MiFID II/MiFIR

This article provides a brief overview of one of the main novelties introduced by MiFID II[1]/MiFIR[2], that is the attribution of new product intervention powers to National Competent Authorities (“NCAs”) and, in exceptional cases, to ESMA or EBA (“ESAs”) (NCAs and ESAs, hereinafter jointly referred to as the “Authorities” and, each, the “Authority”), and identifies some potential issues relating to the above powers.

It is worth preliminarily pointing out that such intervention powers, which complement the Authorities’ existing ones, are to be read in conjunction with the new product governance requirements imposed upon “MiFID firms”[3].

1. Product governance

1.1 Product governance requirements

The purpose of the introduction of product governance requirements is to increase the level of investors’ protection by requiring MiFID firms to take responsibility, from the beginning of and during the whole life-cycle of their financial instruments or structured deposits (hereinafter jointly referred to as “Products” and, individually, as “Product”), that the latter are designed in the best interest of target clients.

In particular, product governance aims at anticipating the investors’ protection to the very first stage of the product life-cycle (i.e. the manufacture phase). Indeed, manufacturers are called to conceive, from the outset, the financial instruments they intend to offer on the market taking into due account the needs of target clients.

Therefore, product governance requirements[4] must be satisfied by firms, which:

(i) manufacture financial products (“Manufacturers”[5]); and

(ii) offer or recommend the above products to the end-clients (“Distributors”[6]).

In particular:

• prior to marketing or distributing a Product, Manufacturers must adopt an approval process, which identifies a target market of end-clients for such Product, and ensures an adequate assessment of the above market, as well as a consistent distribution strategy for that Product;
• Manufacturers must ensure that the Products they intend to offer meet the needs of an identified target market of end-clients, with a distribution strategy compatible with the latter, and that the Distributors take reasonable steps to ensure that the Products are distributed to such identified target market;
• Manufacturers must make available to Distributors all appropriate information on the Products offered and their approval process, including the identified target market, whilst Distributors must make arrangements to obtain the above information from the Manufacturers and understand the characteristics, as well as the target market, of each Product they are going to distribute;
• Distributors must periodically assess the consistency of the Products with the needs of the identified target market, as well as with the related distribution strategy, taking into account any event that could materially affects the potential risks to such market;
• Distributors must fully understand the Products to be placed, assess their compatibility with the needs of the target clients, whilst taking into account the latter’s identified target market, and ensure that each Product is offered or recommended only when it is in the interest of the clients.

The underlying rationale of such a detailed list of obligations being the introduction of effective policies and arrangements aimed at identifying ex ante a category of clients to whom Products are to be offered and ensure that such clients’ best interest is met not only in the manufacturing phase, but also in the distribution one.

1.2 ESMA’s guidelines on product governance requirements

In order to ensure a consistent and harmonised implementation and application of the new product governance requirements laid down in MiFID II and in the Delegated Directive[7], ESMA[8] has recently published some guidelines[9], which:

(i) provide a list of five categories to be cumulatively referred to by Manufacturers when identifying a potential target market, as well as by Distributors when defining such market on a more concrete level, as follows:

1. the type of clients to whom Products are targeted (i.e., retail clients, professional clients or elegible counterparties);
2. client’s knowledge and experience;
3. client’s financial situation, with a focus on their ability to bear losses;
4. client’s risk tolerance and compatibility of the risk/reward profile of the Products with the target market; and
5. clients’ objectives and needs.

(ii) set forth that the identification of the “potential” target market by Manufacturers, as well as of the “actual” target market by Distributors, should be carried out in an appropriate and proportionate manner, considering the nature of the Products to be offered[10];

(iii) provide that the Distributors’ obligation to identify the actual target market and ensure that a Product is distributed in accordance with such market is not substituted by the assessment of suitability or appropriateness, and must be carried out in addition to, and prior to such assessment;

(iv) require, in line with the Delegated Directive, Manufacturers and Distributors to review Products on a regular basis, so as to assess whether the latter remain consistent with the needs, characteristics and objectives of the identified target market, as well as whether the intended distribution strategy remains appropriate;

(v) require Manufactures and Distributors to consider whether Products are incompatible with certain target clients (the so-called “negative” target market test)[11]; and

(vi) envisage justified deviations from the identified target market (i.e., sale of Products outside the positive[12] or within the negative target market[13]).

In light of the above, ESMA expects that the nature of the Products be duly taken into account when identifying the target market, with particular attention to those characterised by complexity/risk or other features (e.g., illiquidity and innovation)[14].

2. Product intervention

As a response to the financial markets’ crisis initiated in August 2007, the introduction by MiFID II and MiFIR[15] of formal intervention powers in favour of the Authorities aims to complete the new product governance regime by ensuring the effectiveness of the latter[16]. Indeed, by means of Articles 39 to 43 of MiFIR[17], an innovative mechanism is introduced, whereby the Authorities are granted the authority to prohibit or restrict, in or from the relevant EU Member State:

1. the marketing, distribution or sale of certain financial instruments or structured deposits, or financial instruments or structured deposits with certain specified features; or
2. a type of financial activity or practice.

Moreover, it is worth preliminarily pointing out that such powers are addressed to MiFID firms and do not apply to UCITS[18] management companies and AIFMs[19], even when marketing units or shares of UCITS and AIFs they manage and/or when carrying out certain MiFID services/activities (i.e. individual portfolio management, investment advice and, for AIFMs only, reception and transmission of orders)[20].

As a result, product intervention powers may affect the entire Products’ life-cycle; in particular:

1. the concept and manufacture phase;
2. the distribution phase;
3. the post-distribution phase.

In brief, pursuant to MiFIR, product intervention powers are allocated among the Authorities according to the following key-rule: the relevant NCA(s)’ are the first in line to act, whereas the relevant ESA(s)’ intervention is triggered only in “exceptional cases”.

In addition, with regard to the NCAs, they may take action only on the ground that[21]:

1. there is a significant investor protection concern, or a threat to the orderly functioning and integrity of financial markets or commodity markets, or to the stability of whole or part of the financial system within at least one Member State, or where a derivative has a detrimental effect on the price formation mechanism in the underlying market;
2. the existing regulatory requirements do not sufficiently address the mentioned risks, and the issue would not be better addressed by improved supervision or enforcement of existing requirements; and
3. the action is proportionate given the risk, level of sophistication of investors or market participants concerned, and the effects of such action on investors and market participants.

Please also note that product intervention powers must be exercised provided that the principles of proportionality and non-discrimination are complied with. In this respect, pursuant to Article 42, paragraph 2, sub-paragraph c), of MiFIR, “the action is proportionate taking into account the nature of the risks identified, the level of sophistication of investors or market participants concerned and the likely of the action on investors and market participants who may hold, use or benefit from the financial instrument, structured deposit or activity or practice”.

In addition,Article 42, paragraph 2, sub-paragraph e), of MiFIR provides that the action should not have “a discriminatory effect on services or activities provided from another Member State”. In this respect, before exercising intervention powers, NCA(s) of a given Member State shall consult with the competent NCA(s) of (an)other Member State(s), when the latter is/are (or could be) significantly affected by the intended action.

In light of the above, intervention powers are to be seen as an “extrema ratio”, to be triggered only if there is no other available action to be taken in order to tackle the risk at issue. In other words, the authority to prohibit marketing, distribution or sale of Products or ban certain financial practices is to be construed as a safeguard measure, which could be triggered only in consequence of a failure in the application of product governance rules by MiFID firms. However, MiFIR grants to the Authorities the power, as a precautionary measure, to impose the same restrictions mentioned above even before the marketing, distribution or sale of a Product to end-clients[22].  

Moreover, although MiFIR expressly admits[23] that, for obvious proximity reasons, NCAs “are better placed to monitor market developments”, it nevertheless assigns intervention powers even to ESAs (in particular, to ESMA with regard to financial instruments, and EBA with regard to structured deposits).

In fact, Products’ market will be simultaneously monitored by both NCAs and ESAs[24].

In order to avoid conflicts, MiFIR provides for specific rules to be observed by the Authorities so as to govern their relationships. In particular:

1. before imposing a ban/restriction (more specifically, at least one month before the measure is intended to take effect), the relevant NCA(s) must inform the competent ESA(s), as well as any other interested NCA(s)[25];
2. the competent ESA(s) must then issue an opinion on whether the proposed action is justified and proportionate. However, such opinion is not binding. In fact, should the relevant NCA(s) decide to take an action that is contrary to the ESA(s)’ opinion, it will be necessary to justify such a decision by publishing the grounds thereof on its/their website (according to the so-called “comply or explain” principle).

Furthermore, direct intervention powers of the competent ESA(s) are also envisaged under MiFIR[26], when:

1. there is a significant investors’ protection concern or a threat to the orderly functioning and integrity of the market or to the stability of the whole or part of the financial system;
2. existing regulatory requirements are deemed insufficient to address the situation at issue; and
3. the competent NCA remains inactive, and/or has not taken adequate actions to sort out the problem.

However, the action[27] taken by the competent ESA(s) is effective for three months only, following which the action may be renewed, but if it is not, it will expire. Yet, even if only temporary, the relevant ESA(s)’ action prevails over any action previously taken by the competent NCA(s).

In light of the above, the functional diversity of NCAs’ powers, on the one hand, and ESAs’ powers, on the other hand, make them differ from each-other in so far as:

1. the action taken by NCAs(a) is neither subject to periodic review nor to a final term, and (b) must be revoked only if the grounding facts no longer exist;
2. the action taken by ESAs(a) must be reviewed every three months, (b) is subject to a final term, and (c) produces only temporary effects.

In order to define the limits of the above powers, MiFIR[28] entrusts EU Commission with the task of adopting delegated acts which lay down factors and criteria to be considered by the Authorities when taking action. Among those: (i) the degree of complexity of the financial instrument in question and the relation with the type of clients to whom it is marketed, distributed and sold, (ii) the degree of innovation of the financial instrument, the activity or the practice at issue, (iii) the leverage of such financial instrument or practice, and (iv) the size or the notional value of an issuance of financial instruments in relation to the orderly functioning and integrity of financial markets or commodity markets[29].

Pursuant to such provision, on 18^th May 2016, the European Commission issued a delegated regulation (the “Delegated Regulation”)[30], which contains a detailed list of the aforesaid criteria and factors that the Authorities’ must take into account in order to take action pursuant to MiFIR[31].

3. Product intervention powers in the EU Member States

As of today, Belgium, Czech Republic, Denmark, Germany, Ireland, Spain, France, Italy, Cyprus, Luxembourg, Hungary, Austria, Portugal, Slovakia, Sweden and the United Kingdom have already implemented MiFID II into national law[32].

In the meanwhile, the Securities and Markets Stakeholders Group (“SMSG”)[33] has recently published a report on product intervention measures which Member States (and Norway) have adopted or meditate to adopt under MiFIR[34].

The product intervention measures adopted or proposed to be adopted can be classified in four categories:

(i) ban on the sale of certain Products to retail clients:

1. Belgium introduced a ban on the sale of life settlements, products derived from virtual currencies and financial products derived from unusual products;
2. the UK introduced a ban on the sale of contingent convertible instruments (“CoCo’s”) and CoCo-funds;
3. Germany introduced a ban on the sale of financial contracts for difference (“CFD’s”).

(ii) ban on certain Products’ features:

1. Belgium and France introduced a limit on the level of complexity;
2. Malta, Poland and the UK introduced leverage limits;
3. Germany introduced a minimum denomination of credit-linked notes.

(iii) ban on marketing of certain Products to certain investors:

1. the Netherlands, the UK and Germany introduced a ban on all types of marketing to retail investors;
2. Belgium and France introduced a ban on the on-line marketing.

(iv) extra information or warnings in respect of certain Products introduced by France, Malta, the UK and Norway.

With regard to the scope of protection, almost all product intervention measures in question aim at defending retail investors. Only Malta has taken a measure with respect to the maximum leverage of complex products, which affects both retail and professional investors. The Netherlands, on the other hand, are considering to target only a subgroup of retail investors (namely, “consumers”).

Moreover, in respect of product intervention measures adopted or proposed to be adopted, two different approaches can be distinguished:

(i) certain Member States have taken product-specific measures against:

1. CFD’s (Belgium, Germany, Malta and the UK);
2. binary options (Belgium);
3. life settlements, financial products derived from virtual currencies and financial products derived from unusual products (Belgium);
4. credit-linked notes (Germany);
5. Forex (Malta);
6. CoCo’s and CoCo-funds (the UK).

(ii) other Member States (namely, Belgium, France, the Netherlands, Malta, the UK, Norway and Italy) have adopted measures targeting a range of “complex” products, often including therein one or more of those mentioned above.

4. Product intervention powers in Italy

4.1 “Pre-MiFID II/MiFIR” measures: CONSOB Communication on the distribution of complex financial products to retail investors

A list of highly complex financial products that may be offered to the public only if some requirements are satisfied was provided by CONSOB (Commissione Nazionale per le Società e la Borsa; the Italian Companies and Stock Exchange Commission) in 2014[35]. In addition, CONSOB clarified that, within the types of highly complex financial products included in the above list[36], someare “not normally suitable for retail clients”[37].

By doing so, CONSOB anticipated in Italy, yet by means of a non-binding measure[38], some of the principles enshrined in MiFID II/MiFIR. This initiative was taken by considering that the transparency requirements imposed by the then current regulation was insufficient to ensure a full investors’ protection, as well as to prevent distortion in the placement of highly complex financial products.

Moreover, the Communication recommended intermediaries to:

• verify the coherence between the products offered and the clients’ profile;
• prevent conflicts of interest that may occur in the distribution of complex financial products to retail clients; and
• recur to the same assessment and simulation methods used (for internal purposes) to manage risks when preparing the information to be provided to retail clients in the distribution phase.

Furthermore, should intermediaries decide not to comply with the above recommendations, for they deem that the distribution of a specific complex product is in the interest of the retail clients and that the latter have been provided with adequate information concerning such product (and the related risks), they may be invited by CONSOB to adopt certain precautions during the placement phase^[39].

For the purpose of this article, it is just the case to note that the Communication may be read as an anticipation, in substance, of the rules on product governance[40]/product intervention[41] under MiFID II/MIFIR, in so far as CONSOB’s recommendations provided therein have been normally followed by intermediaries, also taking into account that “the decisions taken by the latter will contribute to guide the supervisory actions of CONSOB”[42].

4.2 The implementation of product intervention powers into national law

Italy has recently transposed MiFID II into national law and adapted the latter to MiFIR provisions by means of Legislative Decree no. 129 of 3^rd August 2017, published on the Official Gazette no. 198 of 25^th August 2017 and entered into force on the following day, 26^th August (the “Decree”).

The Decree introduced several changes to the Consolidated Financial Act (“Testo Unico della Finanza”; namely, Legislative Decree no. 58/1998, as amended), among which those relating to product governance^[43] and product intervention^[44].

It is important to note that the new provisions are in line with the supervisory model currently in place, which is based on the allocation of competences “for purposes” (“per finalità”)[45] between CONSOB and the Bank of Italy, according to which[46]:

1. CONSOB shall be competent for investors’ protection, orderly functioning and integrity of financial or commodity markets, as well as in case of prohibitive or restrictive actions whether it is reasonable that a derivative has a detrimental effect on the price formation mechanism in the underlying market; and
2. the Bank of Italy shall be competent for the stability of the whole or part of the financial system.

Among the main novelties introduced by the Decree, it is worth mentioning the changes made to the existing Article 7, as well as the new Article 7-bis of the Consolidated Financial Act.

In particular, Article 7[47] confers new intervention powers upon the above mentioned NCAs, as follows

1. the Bank of Italy and CONSOB, within their respective competences, are allowed to issue public notices^[48];
2. CONSOB must intimate to authorised subjects not to make use, in their own business and for a period not exceeding three years, of the professional activity of a natural person which could cause detriment to the transparency and the correctness of behaviours^[49];
3. CONSOB must remove, within its competences and after consulting with the Bank of Italy, one or more natural person from the management board of an investment firm or market operator^[50], whenever their tenure of office could be detrimental to the transparency and the correctness of behaviours of the authorised subjects; and
4. CONSOB must order, for a period not exceeding 60 days for each time, the suspension of the marketing or sale of financial instruments in case of violation of the obligations concerning the product governance, and whenever there could be a detriment to the investors’ protection^[51].

In addition, Article 7-bis[52] grants to CONSOB and the Bank of Italy, only under certain conditions^[53] and after consulting with each-other^[54], the authority to prohibit or restrict:

1. marketing, distribution or sale of certain financial instruments or structured deposits, or financial instruments or structured deposits with certain specified features; or
2. a specific type of financial activity or practice^[55].

Without prejudice to such intervention powers, the afore-said NCAs may finally order, after consulting with each-other and within their respective competences, the suspension, for a period not exceeding 60 days each time, of the marketing and sale of financial instruments and structured deposits where the conditions pursuant to Articles 40, 41 or 42 of MiFIR are met^[56].

It will be interesting to see how the industry will react to the new set of rules summarised above, and to the new intervention powers. As far as the competent Italian NCAs are concerned, the comments officially made so far[57] did not go beyond generic statements about the importance of such new intervention powers, yet without going into details on how, for instance, the latter would necessarily imply the strengthening of the internal organisation of the NCAs in question.

5. Final remarks

In the last decades or so, financial products sold have generally neither been conceived nor marketed in the real interests of end-clients. As a result, the global financial crisis has revealed gaps in the level of protection granted by MiFID I, as well as shortcomings in the functioning and transparency of financial markets. Strenuous efforts have been thus made to carry out a detailed review of MiFID I regime by introducing, among others, ex ante product governance and ex post product intervention rules, both necessary to prevent harmful financial instruments from reaching the market.

However, the new intervention powers could lead, for instance, to an excessive interference of the Authorities in the banks and investment firms’ policies, as well as in the parties’ contractual autonomy.

Below please find a summary of preliminary criticisms that could be moved to the new set of rules:

5.1 The NCA(s) will operate as a filter before the creation and distribution of financial products?

MiFIR expressly states that intervention powers “do not imply any requirement to introduce or apply a product approval or licensing by the competent Authority, ESMA or EBA, and do not relieve investment firms of their responsibility to comply with the all relevant requirements laid down in this Regulation and in MiFID II”[58].

Therefore, MiFIR expressly excludes the introduction of a product pre-approval procedure before the competent NCA(s), maintaining upon the investment firms the obligation to satisfy the relevant product governance requirements.

However, in light of the characteristics of the new intervention powers, it would be advisable to promote, at least during the financial product’s conception phase, a dialogue between investment firms and competent NCA(s), aimed at understanding whether such product complies or not with the new product governance rules. This would considerably reduce the risk of ban and/or restriction actions to be taken by the relevant Authorities once the product in question is already being distributed to the public.

5.2 Limitation of the parties’ contractual autonomy and effects on the investment contracts already entered into force

As anticipated above, the Authorities’ intervention could affect the whole product life-cycle, and so entail two sets of potential issues depending on the production/distribution’s phase involved.

With reference to the conception phase, intervention powers aimed at banning the creation of financial instruments seem to introduce a new kind of limitation on the private parties’ contractual autonomy enshrined in the Italian Civil Code (the “Code”)[59], as well as a restriction of the freedom of private economic initiative[60].

In respect of the distribution and post-distribution phases, one could easily identify a potential harmful impact of the triggering of the intervention powers under examination on contracts already entered into force between intermediaries and end-clients.

In fact, according to Article 1418, paragraph 2, of the Code, contracts are to be considered void should, inter alia, the object thereof become unlawful. Therefore, the contracts entered into force and then banned as a result of the intervention of a competent Authority could become void due to the fact that they would no longer be lawful, with a subsequent effect on the contractual relationship between investment firms and end-clients[61]. As a result, the investment firm in question should immediately return to the client the amount of the investment made.

Also, in case an action for damages is brought before a competent Court, the latter could declare the termination of the contract at issue for breach of the general rule of good faith and fair dealing, set forth by Articles 1175 and 1375 of the Code, and award compensation for the potential damages caused.

5.3 Limitation of the parties’ participation in the NCA(s)’ decision-making process

Once it has decided to prohibit/ban a Product, the competent NCA is obliged to publish such decision on its website. The notice shall contain: the details of the measure, the period from which the measure will take effect, and the evidence upon which the action is taken[62]. There is no obligation to inform the interested parties of the NCA’s intention to take such an action.

The above circumstances seem to violate some of the pillars of Italian administrative law[63]: the principle of the parties’ participation in sanctionary proceedings and the right of defence.

For this reason, the promotion of a dialogue between competent NCA(s) and investment firms prior to the adoption of the ban/prohibition of a Product pursuant to the intervention power under MiFIR is deemed advisable so as to allow the participation and, where appropriate, the objection to such action and to avoid that the latter could be wrongful due to missed information regarding the Product in question.

5.4 NCA(s)’ liability for lack of intervention?

Another foreesable issue that deserves to be pointed out concerns NCA(s)’ potential liability in the event of omitted exercise of its/their new intervention powers.

As of today, Italian Courts[64] have, in several occasions, ruled upon CONSOB’s liability for the damages suffered by the investors on the ground of falsehood in prospectus[65] when:

• the prospectus was ascertained to be false;
• such a falsity was ictu oculi ascertainable solely through a formal exam;
• the action (or omitted action) was taken (or not taken) with wilful misconduct or gross negligence by CONSOB’s employees or officers;
• if promptly and correctly exercised, CONSOB’s powers of control and ban would have discouraged the damaged parties from investing in such fraudulent transactions.

It is thus possible to foresee that the omission in the recourse to the new intervention powers under MiFIR may imply the occurrence of potential liabilities where damages to end-clients will be judicially ascertained as a direct consequence of the afore-said omission[66].